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E-MailKenneth Lehn is the Samuel A. McCullough Professor of Finance at the University of Pittsburgh Katz Graduate School of Business. This post is based on his recent paper.
The financial economics literature on corporate governance, largely non-existent prior to the 1970s, has grown enormously during the past forty years. Most of this literature focuses on three dimensions of governance that are relatively easy to measure—ownership structure, the size and structure of boards, and executive compensation—and most of it examines governance from the perspective of agency theory. This is understandable, given the obvious importance of these governance mechanisms and their role in mitigating agency costs. However, the literature’s focus on this approach has likely blinded us to other dimensions of governance that are difficult to measure, unrelated to agency costs, yet important determinants of firm performance and survival.
In this paper I suggest one such dimension, namely the extent to which governance facilitates or impedes a firm’s ability to adapt to changes in its environment. I refer to this dimension as “corporate agility.” From an evolutionary perspective, agility is likely to be a critical determinant of a firm’s long-run success and survival, yet the relation between governance and agility is largely unexplored in the literature. The value of agility is likely to be greater in rapidly changing environments, such as the one most firms face today with recent changes in technology and consumer preferences.
A large amount of anecdotal evidence suggests the importance of corporate agility as a determinant of firms’ success and survival. Arguably, the retail industry has been affected by technological change and the shift to online shopping as much or more than other industries. There are many recent examples of retailers whose operating and stock price performance have declined substantially in recent years because of their alleged sluggishness in adapting to changes in the retail environment, including, among many others, Macy’s, J.C. Penney, Kohl’s, Toys R Us, and The Gap.
In addition, the topic of corporate agility has been featured prominently in several recent proxy contests. For example, in Trian Partners’ proxy contest with Procter & Gamble in 2017, it stated that “disruptive and existential threats are impacting the entire consumer packaged goods industry, including changes in technology and consumer behavior,” and that “P&G must act with the greatest possible urgency to address the market share it is losing to both its peers and smaller local competitors, who are adapting to industry changes more effectively than P&G (italics added).” The proxy filing went on to say that “structural and organizational bureaucracy prevents management from identifying and responding to commercial opportunities in a timely manner, hinders product innovation and dampens sales growth,” and that “Trian has made the decision to nominate Mr. [Nelson] Peltz for election to the Board at the 2017 Annual Meeting so that he can act as a catalyst for faster and more significant change at P&G (italics added).”
In his classic paper on evolution and natural selection in economic systems, published in 1950 in the Journal of Political Economy, Armen Alchian writes that the economist “can predict the more adoptable or viable types of economic interrelationships that will be induced by environmental change … like the biologist, the economist predicts the effect of environmental changes on the surviving class of living organisms.” Along these lines, little is known about the role corporate governance plays in the natural selection process that separates firms into “winners” and “losers” when there is significant environmental change. Through its effect on corporate agility, corporate governance is likely to play an important role in the evolutionary process.
Corporate governance, in effect, defines how decision rights are allocated among various stakeholders within organizations. Whereas the mitigation of agency costs plays an important role in determining how decision rights are allocated, other considerations also are likely to affect the allocation of decision rights as well. One such consideration is the distribution of “specific knowledge” within organizations, which Jensen and Meckling, in a 1992 paper, define as knowledge that is costly to transfer from lower levels of the organization to headquarters. During periods of rapid environmental change, the cost of transferring specific knowledge about changes in markets, technology, consumer behavior, and so forth, are likely to increase, perhaps significantly. Insofar that agile decision-making is especially valuable during these periods, firms with decentralized decision-making (i.e., speedier) are likely to have a competitive advantage over highly centralized firms during periods of rapid environmental change.
The framework provided by Jensen and Meckling also has implications for our analysis of governance structures that often are depicted as “good versus bad” or “weak versus strong.” For example, the literature frequently presumes that insider-controlled boards are inherently bad for outside shareholders because the insiders can make decisions that benefit themselves at the expense of outside shareholders. However, the costs of transferring specific knowledge from corporate managers to outside directors is likely to inhibit corporate agility because it requires time, perhaps a considerable amount of time, for outside directors to process and understand the relevant specific knowledge. Absent regulatory constraints, it might well be that companies with insider-controlled boards would have an advantage during periods of rapid change, given that insider-controlled boards are likely to make speedier decisions than boards controlled by outside directors.
Similarly, dual classes of common stock with different voting rights often are depicted as inherently bad for outside shareholders because insiders can use their voting control to promote their private interests at the expense of the outside shareholders. While this may be the case, the argument by itself ignores a countervailing benefit of dual class structures, namely that they are likely to foster agility as controlling shareholders can make decisions more quickly, i.e., without the consent, in some cases, of outside shareholders and directors. This may explain in part why dual class structures are common among technology companies where the value of agility is likely to be high.
The integration of corporate agility into the corporate governance literature appears to be a promising area for future research. Although developing a generic measure of agility is challenging, industry studies that focus on industry-specific measures of agility seems tractable. For example, in the retail industry, what is the relation between governance and the speed with which “bricks and mortar” firms adapted to online commerce? Were retail firms that filed for bankruptcy during the past several years (e.g., Sears, Toys R Us) slower to adapt to the changing environment, and if so, did their governance or capital structures inhibit their agility? Addressing these questions, for the retail industry, as well as others, is likely to enrich our understanding of the relation between corporate governance, firm performance, and survival.
The complete paper is available for download here.
