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Positive Corporate Governance and its Implications for Executive Compensation

Published online by Cambridge University Press:  06 March 2019

James McConvill

Abstract

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As a result of a series of high-profile corporate collapses worldwide, along with regular reporting of shareholder money being spent on corporate jets, executive golf days and increasingly excessive executive compensation arrangements, the common perception is that the executives of our largest corporations are driven by self-interest with little regard for what is best for the corporation. Due to this negative perception, there has been an exponential increase in the amount of laws, rules and guidelines setting in place a heightened standard of corporate governance best practice. Without such regulation, it is believed, another collapse or scandal is inevitable. In this article, I dispute this reasoning. In my view if we embrace “positive corporate governance”, in which the positive strengths and virtues of company executives are emphasised, we can move towards an environment in which heavy regulation is replaced by positive corporate norms inside the corporation. I then apply my approach of positive corporate governance to address one of the most significant issues confronting corporate regulation at present- how to deal with the rapid increase in executive compensation in our largest corporations. I suggest that the dominant methodology of pay for performance is ultimately flawed.

Type
Articles
Information
German Law Journal , Volume 6 , Issue 12 , 01 December 2005 , pp. 1777 - 1804
Copyright
Copyright © 2005 by German Law Journal GbR 

References

1 See McConvill, James and Bagaric, Mirko, Give The Corporate Crooks A Break, Lawyers Weekly (Australia), 19 August 2005.Google Scholar

2 See Bebchuk, Lucian and Fried, Jesse, Executive Compensation at Fannie Mae: A Case Study of Perverse Incentives, Non-Performance Pay, and Camouflage, John M. Olin Center for Law, Economics & Business Working Paper, Harvard Law School, January 2005.Google Scholar

3 See Clark, Robert C., Corporate Governance Changes in the Wake of the Sarbanes-Oxley Act: A Morality Tale to Policymakers Too, John M. Olin Center for Law, Economics & Business Working Paper, Harvard Law School, September 2005 (forthcoming in 2006 in The Corporate Governance Law Review). Clark believes that because of this, “major legal reform to stop corporate fraud was [seen as a] needed response (at 2). See also Larry Ribstein, Sarbanes Oxley After Three Years, Illinois Law and Economics Working Paper Series, Working Paper No. LE05-016, June 2005.Google Scholar

4 The most significant changes made by the Public Company Accounting Reform and Investor Protection Act 2002 (‘Sarbanes-Oxley Act’) included:Google Scholar

  1. 1.

    1. prohibiting registered public accounting firms from performing specified non-audit services contemporaneously with a mandatory audit, with firms only allowed to perform such services if they are approved by the client's audit committee, or the fees for non-audit services amount to no more than 5% of total revenues paid to the auditor by the company.

  2. 2.

    2. requiring that the lead audit partner and the review partner for each audit client be replaced every five years.

  3. 3.

    3. prohibiting a registered public accounting firm from performing statutorily mandated audit services for a company if the audit client's senior management officials had been employed by the audit firm and participated in the client's audit during the one-year period proceeding the audit initiation date.

  4. 4.

    4. requiring that a company's audit committee have the responsibility for the appointment, compensation and oversight of a registered public accounting firm, that is required to perform the audit. Members of the audit committee must be members of the board of directors of the company, and be independent.

  5. 5.

    5. the establishment of a Public Company Accounting Oversight Board with the following mandate:

    1. a.

      a. overseeing the audit of public companies that are subject to the securities laws;

    2. b.

      b. establishing audit reporting standards and rules; and

    3. c.

      c. investigating, inspecting, and enforcing compliance relating to registered public accounting firms, associated persons, and the obligations and liabilities of accountants.

As to the New York Stock Exchange Rules on corporate governance, which were approved by the SEC in November 2003 (with amendments made in 2004), see section 303A of the NYSE Listed Company Manual. The main corporate governance rules introduced by the NYSE were that:Google Scholar

  • Listed companies must have a majority of independent directors and ‘independence’ is defined in detail.

  • To empower non-management directors to serve as a more effective check on management, the non-management directors of each listed company must meet at regularly scheduled executive sessions without management.

  • Listed companies must have a nominating/corporate governance committee composed entirely of independent directors.

  • Listed companies must have a compensation committee, with a minimum of 3 members, composed entirely of independent directors (as defined in section303A.02).

  • Each listed company must have an internal audit function.

  • Listed companies must adopt and disclose corporate governance guidelines

  • Listed companies must adopt and disclose a code of business conduct and ethics for directors, officers and employees, and promptly disclose any waivers of the code for directors or executive officers.

  • Listed foreign private issuers must disclose any significant ways in which their corporate governance practices differ from those followed by domestic companies under NYSE listing standards.

  • Each listed company CEO must certify to the NYSE each year that he or she is not aware of any violation by the company of NYSE corporate governance listing standards, qualifying the certification to the extent necessary.

  • Each listed company CEO must promptly notify the NYSE in writing after any executive officer of the listed company becomes aware of any material non-compliance with any applicable provisions of this Section 303A.

See further Jean J du Plessis, James McConvill and Mirko Bagaric, Principles of Contemporary Corporate Governance Ch 12 (2005). Also Mark J Roe, The Inevitable Instability of American Corporate Governance, 1 The Corporate Governance Law Review 1 (2005).Google Scholar

5 Romano, Roberta, The Sarbanes-Oxley Act and the Making of Quack Corporate Governance, 114 Yale L. J. 1521 (2005). According to Professor Romano, there is no justification for prescriptive rules (with the principal focus of the paper being on the federal Sarbanes-Oxley Act) mandating corporate governance practices.Google Scholar

6 McConvill, James, Reflections on the Regulation of Contemporary Corporate Governance (2006, forthcoming).Google Scholar

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8 Martin Seligman, Authentic Happiness 1 (2002). Seligman provides an even more succinct explanation in saying positive psychology ‘… seeks to cultivate human strengths, rather than focus on human weaknesses’: see Martin Seligman, Paul R Verkuil & Terry H Kang, Why Lawyers are Unhappy, 23 Cardozo L. Rev. 33, 35 (2001); 10 Deakin L. Rev. 49 (2005) See also Martin E P Seligman & Mihaly Csikzentmihalyi, Positive Psychology: An Introduction, 55 American Psychologist 5, 13 (2000):Google Scholar

The prevailing social sciences tend to view the authentic forces governing human behavior to be self-interest, aggressiveness, territoriality, class conflict, and the like. Such a science, even at its best, is by necessity incomplete. Even if utopianly successful, it would then have to proceed to ask how humanity can achieve what is best in life.Google Scholar

On the nature and utility of positive psychology, see also C R Snyder & Shane J Lopez, Positive Psychology (2005); the March 22, 2005 edition of the Journal of Positive Behavior Interventions; and Flourishing: Positive Psychology and the Life Well-Lived (Corey L.M. Keyes & Jonathan Haidt, ed., 2002).Google Scholar

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10 See Lucian Bebchuk and Jesse Fried, Pay without Performance: The Unfulfilled Promise of Executive Compensation (2004).Google Scholar

11 For a review of this literature, see James McConvill, The False Promise of Pay for Performance: Embracing a Positive Model of the Company Executive Ch 5 & 6 (2005).Google Scholar

12 On the importance of developing a normative theory of the corporation for contemporary corporate governance, see Stephen M Bainbridge, Competing Concepts of the Corporation (‘a.k.a. Criteria? Just Say No’)', UCLA School of Law, Law- Econ Research Paper, No 05-01. Available on-line at: <www.ssrn.com>..>Google Scholar

13 See, for example, Ian E Thompson and Bryan A Howieson, Ethics 92 (1997); Barbara Mescher & Bryan Howieson, Beyond Compliance: Promoting Ethical Conduct by Directors and Corporations, 1 The Corporate Governance Law Review 93 (2005).Google Scholar

14 See Phillip Lipton & Abe Herzberg, Understanding Company Law 295 (11th ed, 2003).Google Scholar

15 See James H Davis, F David Schoorman & Lex Donaldson, Towards a Stewardship Theory of Management, 22 Academy of Management Review 20, 22 (1997).Google Scholar

16 Id. at 23.Google Scholar

17 Published in 2004 by Harvard University Press.Google Scholar

18 For a critique of the Bebchuk-Fried thesis, see for example, William W. Bratton, The Academic Tournament Over Executive Compensation, 93 Cal. L. Rev. (2005, forthcoming); Stephen Bainbridge, Executive Compensation: Who Decides?, 83 Tex. L. Rev. 1615 (2005).Google Scholar

19 See Bebchuk, Lucian, Fried, Jesse M & Walker, David I, Managerial Power and Rent Extraction in the Design of Executive Compensation, 69 U. Chi. L. Rev. 751 (2002).Google Scholar

20 Id. at 753-5.Google Scholar

21 See, for example, Christine Jollis, Cass R Sunstein & Richard Thaler, A Behavioral Approach to Law and Economics, 50 Stan. L. Rev. 1471 (1998)Google Scholar

22 Quinn, Michael, The Unchangeables- Director and Executive Remuneration Disclosure in Australia, 10 Australian Journal of Corporate Law 2, 4 (1999).Google Scholar

23 Bebchuk, & Fried, , supra note 10, at 19.Google Scholar

24 Id., at 15-16.Google Scholar

The principals (the shareholders) cannot directly ensure that the agents (the managers) will always act in the principals’ best interests. As a result, the manager-agents, whose interests do not fully overlap those of the shareholder-principals, may deviate from the best course of action for shareholders. This is called the “agency problem”. Managers’ departures from shareholder-regarding strategies in turn may involve “inefficient” behavior- behavior that reduces the size of the corporate pie. The reductions in aggregate company value caused by such deviations are called “agency costs”.Google Scholar

25 See, for example, Ramsay, Ian M, Directors and Officers’ Remuneration: The Role of the Law, Journal of Business Law 351 [1992]; Ruth Bender, Why Do Companies Use Performance-Related Pay for their Executive Directors?, 12 Corporate Governance: An International Review 521 (2004).Google Scholar

26 A good source discussing in detail various ‘models’ of human behaviour (and the importance of these models in understanding how organisations function), including the economic model of agency theory, is Michael C Jensen & William H Meckling, The Nature of Man, 7(2) Journal of Applied Corporate Finance 4 (1994).Google Scholar

27 Bebchuk, & Fried, , supra note 10, at 25-7.Google Scholar

28 Id. at 31.Google Scholar

29 Seligman, , supra note 8, at 10.Google Scholar

30 Id, at 168.Google Scholar

31 The Wall Street Journal, 23 December 2004, D8.Google Scholar

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33 See Gavin J Nicholson & Geoffrey C Kiel, Motivated Actors: Agency Costs and Burkean Acts, Paper to be presented at the Annual Meeting of the Academy of Management: Creating Actionable Knowledge, New Orleans, August 6-11. 2004. Available on-line at: <http://www.competitivedynamics.com.au/Papers&Publications/P&P.htm>>Google Scholar

34 A H Maslow, A Theory of Human Motivation, in Management and Motivation 27-41 (V H Vroom & E L Deci, eds., 1970).Google Scholar

35 Bender, , supra note 25, at, 523.Google Scholar

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37 See for example the collection of papers in Choices, Values and Frames (Daniel Kahneman & Amos Tversky, eds., 2000).Google Scholar

38 See Jollis, Christine, Sunstein, Cass R & Thaler, Richard, A Behavioral Approach to Law and Economics, 50 Stan. L. Rev. 1471, 1471 (1998)Google Scholar

39 See generally Behavioral Law & Economics (Cass R Sunstein, ed., 2000).Google Scholar

40 The prisoner's dilemma is defined as a ‘situation in which the noncooperative pursuit of self-interest by two parties makes them both worse off’ (see <http://www.wwnorton.com/college/econ/stiglitz/ glossp.htm>). In the prisoner's dilemma, in each game the prisoner has to decide whether to ‘cooperate’ with an opponent, or otherwise defect. The prisoner and the opponent must make a choice, and then their decisions are revealed. The prisoner's dilemma demonstrates that the ‘rational’ choice in each instance is not the one which maximises personal self-interest as neo-classical economists suggest, but rather the one that maximises the collective good of the two or more persons who are each making the decision. In other words, the most rational decision or strategy is the one that promotes cooperation between the participants in the game. Thus, the prisoner's dilemma is studied in a range of different contexts to try and find, and understand, strategies that promote cooperation.).+In+the+prisoner's+dilemma,+in+each+game+the+prisoner+has+to+decide+whether+to+‘cooperate’+with+an+opponent,+or+otherwise+defect.+The+prisoner+and+the+opponent+must+make+a+choice,+and+then+their+decisions+are+revealed.+The+prisoner's+dilemma+demonstrates+that+the+‘rational’+choice+in+each+instance+is+not+the+one+which+maximises+personal+self-interest+as+neo-classical+economists+suggest,+but+rather+the+one+that+maximises+the+collective+good+of+the+two+or+more+persons+who+are+each+making+the+decision.+In+other+words,+the+most+rational+decision+or+strategy+is+the+one+that+promotes+cooperation+between+the+participants+in+the+game.+Thus,+the+prisoner's+dilemma+is+studied+in+a+range+of+different+contexts+to+try+and+find,+and+understand,+strategies+that+promote+cooperation.>Google Scholar

This example demonstrates that it is best to cooperate and confess, instead of choosing to defect by not confessing based on the hope that you won't get caught and will not personally serve time in prison (which would of course be in one's self-interest).Google Scholar

For an explanation of the prisoner's dilemma, see A W Tucker, Contributions to the Theories of Games (2001); William Poundstone, Prisoner's Dilemma (1993).Google Scholar

41 Game theory encompasses an interdisciplinary approach (covering, for example, mathematics, economics, sociology and information technology) to the study of the behaviour of humans. A ‘game’ in this context is a scientific metaphor for a wide range of human interactions between two, or more than two, persons, such persons possessing opposing (or at least mixed) motives. In constructing these games, game theorists contend that the rational choice of game participants involves maximizing the rewards of the group of decision-makers involved in the game. See Morton Davis, Game Theory: A NonTechnical Introduction (1997), Oskar Morgenstern & John von Neumann, The Theory of Games and Economic Behavior (1944).Google Scholar

42 See Stout, Lynn A, Other-Regarding Preferences and Social Norms, Georgetown Law and Economics Research Paper No. 265902. Available on-line at: <http://papers.ssrn.com/sol3/papers.cfm?abstract_id=265902&gt;Google Scholar

43 In fact, these concepts (trust in particular) are integrated into Stout and Blair's widely-disseminated and accepted ‘team production’ theory of the corporation: see Margaret Blair & Lynn Stout, A Team Production Theory of Corporate Law, 85 Va. L. Rev. 247 (1999); also more recently, Margaret Blair & Lynn Stout, Specific Investment: Explaining Anomalies in Corporate Law (J. Corp. L., forthcoming, 2006) (available via: <http://www.ssrn.com>). Blair and Stout's team production theory has generated a great deal of interest in academic circles as it challenges the dominant view of shareholder primacy by suggesting that the role of the corporation is not limited to maximising economic returns for shareholders, but rather is intended to resolve team production problems. As a result, neither shareholders nor other stakeholders are the primary concern, rather the corporation and the legal rules regulating corporations treat shareholders and stakeholders as a ‘team’, each contributing to the corporation in different ways.).+Blair+and+Stout's+team+production+theory+has+generated+a+great+deal+of+interest+in+academic+circles+as+it+challenges+the+dominant+view+of+shareholder+primacy+by+suggesting+that+the+role+of+the+corporation+is+not+limited+to+maximising+economic+returns+for+shareholders,+but+rather+is+intended+to+resolve+team+production+problems.+As+a+result,+neither+shareholders+nor+other+stakeholders+are+the+primary+concern,+rather+the+corporation+and+the+legal+rules+regulating+corporations+treat+shareholders+and+stakeholders+as+a+‘team’,+each+contributing+to+the+corporation+in+different+ways.>Google Scholar

Team production, and in particular the problems arising from team production, has been a popular area of research in economic literature for years, and this literature was the source of Blair and Stout's theory of the corporation. According to Blair and Stout, team production problems arise in situations where a productive activity requires the combined investment and coordinated effort of two or more individuals or groups. The problems arise because if the investment of members of this ‘team’ is firm-specific (meaning difficult to recover once committed to the project), and if output from the enterprise is non-separable (meaning that it is difficult to attribute any particular portion of the joint output to any particular member's output), it becomes very difficult to determine how any ‘surpluses’ generated by this production should be divided. This is because surpluses invite both ‘shirking’ (which essentially means free-riding off the efforts of others) and ‘rent-seeking’ (whereby individuals waste time and money competing for a share of a fixed amount of wealth). Blair and Stout suggest that as trying to prevent these team production problems through the mechanism of explicit contracts is next to impossible, this function can be achieved by the corporation as an ‘institutional substitute’ for explicit contracts. The structure of the corporation, along with the legal rules regulating the corporation, act as a ‘mediating hierarchy’ by which team members give up important rights (including property rights over the team's joint input) to the corporation as a separate legal entity. At the top of this hierarchy is the board of directors, whose authority over the use of corporate assets is virtually absolute. For more information on team production theory, one good source is the website: <www.teamproduction.us>>Google Scholar

44 See Blair, Margaret & Stout, Lynn, Trust, Trustworthiness and the Behavioral Foundations of Corporate Law, 149 U. Pa. L. Rev. 1735, 1807 (2001).Google Scholar

45 According to John Stuart Mill in his classic work Utilitarianism, we ought to pursue happiness because we do pursue happiness.Google Scholar

46 Paul Martin, Making Happy People: The Nature of Happiness and its Origins in Childhood 2 (2005).Google Scholar

47 Richard Layard, Happiness: Lessons from a New Science 24 (2005).Google Scholar

48 Id., at 224 (emphasis added).Google Scholar

49 It is important to note, however, that some recent economic studies of well-being (using so-called ‘regression equations’) have shown that one's level of income, and the nation's level of GDP (gross domestic product) were factors that contributed to the happiness levels of the individuals that were studied. See, for example, Rafael Di Tella, Robert J MacCulloch & Andrew J Oswald, The Macroeconomics of Happiness, 85 Review of Economics and Statistics 809 (2003); Andrew J Oswald, How Much Do External Factors Affect Well-Being? A Way to Use ‘Happiness Economics’ to Decide, 16 The Psychologist 140 (2003); Andrew E Clark & Andrew J Oswald, A Simple Statistical Method for Measuring How Life Events Affect Happiness, 31 International Journal of Epidemiology 1139 (2002). What these empirical studies do not show, however, is whether so-called ‘psychological needs’ of individuals contribute more or less to happiness than money and wealth. Further, similar to the findings discussed in this article by the author, what these economic studies generally show is that beyond satisfaction of basic needs, money contributes little to happiness. The results from happiness regression equations used in studies by economists show that higher income is associated with higher happiness for poorer countries, but the evidence is less strong within richer countries.Google Scholar

50 Ronald Ingelhart, Culture Shift in Advanced Industrial Society (1990).Google Scholar

51 David Myers, The Pursuit of Happiness 36 (1992).Google Scholar

52 Id. at 43-44Google Scholar

53 Id. at 39.Google Scholar

54 Id. at 53.Google Scholar

55 Martin, , supra note 46, at 147.Google Scholar

56 See Wallis, Claudia, The New Science of Happiness, Time Magazine, 17 January 2005.Google Scholar

57 Myers, , supra note 51, at 56.Google Scholar

58 Layard, , supra note 47, at 7.Google Scholar

59 Id. at 31.Google Scholar

60 Id. at 151.Google Scholar