Edited by International Center for Corporate Governance (www.icfg.org)
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Harry Korine
Preventing Corporate Governance Failure
HAUPT VERLAG
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Harry Korine teaches corporate governance at the London Business School and the Hochschule St. Gallen and strategy at INSEAD. He holds B.A. and B.S. degrees from Stanford University, an M.B.A. from UCLA, and a Ph.D. from INSEAD. He has held assistant Professorships on the faculties of the London Business School and the Pennsylvania State University, been an adjunct professor at INSEAD, served on the boards of several companies and worked as an associate at JP Morgan. His publications include “Entrepreneurs and Democracy: A Political Theory of Corporate Governance” (Cambridge University Press, 2008), “When You Shouldn’t Go Global”, (Harvard Business Review, 2008), “Strong Managers, Strong Owners” (Cambridge University Press, 2014), and “Succession for Change” (Palgrave Macmillan, 2017).
1st edition: 2020 Bibliographic information published by the Deutsche Nationalbibliothek: The Deutsche Nationalbibliothek lists this publication in the Deutsche Nationalbibliografie; detailed bibliographic data are available at: http://dnb.dnb.de ISBN 978-3-258-08150-2 All Rights reserved. Copyright © 2020 Haupt Berne Any kind of reproduction without permission of the owner of copyright is not allowed. Typesetting: Die Werkstatt Medien-Produktion GmbH, D-Göttingen Printed in Austria www.haupt.ch
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Foreword by the Editor of this Series Professor Martin Hilb
Over the last thirty years, corporate governance has evolved from a tangential topic primarily of legal concern to a central question for business leaders, investment managers and policy makers. As a result of this rise in importance, the field has become more specialized, with research and advisory practice branching out into numerous sub-issues: executive succession, board composition, and shareholder structure, to name just a few of the more prominent areas of expertise. In this context, it is rare for a work to go back to basics, as “Preventing Corporate Governance Failure” does, and remind us of what corporate governance is really about. Fundamentally, as Harry Korine writes, corporate governance is concerned with power and accountability, spelling out limits to power and describing how accountability can be ensured so that the corporation can stay healthy. Despite thirty years of increasing attention to corporate governance, however, the incidence of corporate governance failure does not seem to have declined. On the contrary, every year seems to bring us new, more egregious cases. One of the reasons may be that, in the field’s effort to specialize, we have lost sight of the essentials. As Harry points out, at its root, every corporate governance failure is traceable to unchecked power and inadequate accountability. I concur. Corporate governance is a cost incurred to ensure the viability of the corporation; as they become ever more sophisticated in their application of corporate governance frameworks, decision makers need to keep the basic purpose in mind. What I particularly appreciate about “Preventing Corporate Governance Failure” is the dynamic perspective. Not only does the book provide decision makers with stage by stage analyses of how corporate governance failure comes about, it also suggests how stakeholders can intervene before it is too late. Corporate governance failure does not happen from one day to the next; the warning signs are there to see for some time, if one knows where to look,
Preventing Corporate Governance Failure 5
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and Harry clearly articulates what to look for and, just as importantly, what to do about it. Individuals with significant involvement in the governance of a company, board members, of course, but also large shareholders and senior executives will find this guidance highly useful. As the epilogue stresses, taking a dynamic perspective on corporate governance implies that corporate governance work is never finished. Just as business conditions change and strategy adapts, so does corporate governance have to change with the context. As I see it, this is a very valuable lesson for practitioners at all levels and for any size of company. Going through the mechanics of corporate governance – establishing a succession plan, setting up a functioning board, and building shareholder agreement – is a time consuming exercise and may lead to governance fatigue. And yet, if corporate governance is to be dynamic and corporate governance failure is to be prevented, stakeholders cannot rest easy. Executives, board members, and shareholders share responsibility for maintaining the health of the company. “Preventing Corporate Governance Failure” offers a concise blueprint for doing so. St. Gallen/Switzerland, September 2019 Martin Hilb Chairman of the Board Foundation (www.icfcg.org) and its Swiss Board School at the IMP of the University of St. Gallen
6
Foreword
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Table of Contents Foreword by the Editor of this Series
5
Overview of the Book
11
Introduction Chapter 1 – It’s About Power and Accountability
15
Archetypes of Corporate Governance Failure in Parallel and in Interaction
18
Working with Warning Signs
19
Recommended Reading
21
Archetypes of Corporate Governance Failure – Unchecked Power: Chapters 2-6 Chapter 2 – One-Person Rule – The Hero Problem
25
One-Person Rule – The Warning Signs
27
One-Person Rule – In Listed and Non-Listed Firms
32
Conclusion 33 Recommended Reading
34
Chapter 3 – Single Shareholder Dominance – The Too Much or Too Little Problem
35
Single Shareholder Dominance – The Warning Signs
36
Single Shareholder Dominance – In Listed and Non-Listed Firms
41
Conclusion 42 Recommended Reading
42
Chapter 4 – Interest Group Hegemony – The Ganging Up Problem
43
Interest Group Hegemony – The Warning Signs
44
Interest Group Hegemony – In Listed and Non-Listed Firms
49
Conclusion 50 Recommended Reading
50
Table of Contents 7
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Chapter 5 – Absolute Obedience – The Shut Up, Do as I Say Problem
51
Absolute Obedience – The Warning Signs
52
Absolute Obedience – In Listed and Non-Listed Firms
55
Conclusion 55 Recommended Reading
56
Chapter 6 – Board of Director Weakness – The Lack of Backbone Problem
57
Board of Director Weakness – The Warning Signs
58
Board of Director Weakness – In Listed and Non-Listed Firms
60
Conclusion 61 Recommended Reading
61
Archetypes of Corporate Governance Failure – Inadequate Accountability: Chapters 7-11 Chapter 7 – Opaque Business Models – The Blurry Windshield Problem
65
Opaque Business Models – The Warning Signs
67
Opaque Business Models – In Listed and Non-Listed Firms
70
Conclusion 71 Recommended Reading
72
Chapter 8 – Unsustainable Performance Targets – The Big Hairy Audacious Goal Problem
73
Unsustainable Performance Targets – The Warning Signs
74
Unsustainable Performance Targets – In Listed and Non-Listed Firms
77
Conclusion 78 Recommended Reading
78
Chapter 9 – Counterproductive Incentives – The Doing the Wrong Thing Right Problem
79
Counterproductive Incentives – The Warning Signs
80
Counterproductive Incentives – In Listed and Non-Listed Firms
83
Conclusion 84 Recommended Reading
8
84
Table of Contents
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Chapter 10 – Concentrated Risks – The All Your Eggs in One Basket Problem
85
Concentrated Risks – The Warning Signs
86
Concentrated Risks – In Listed and Non-Listed Firms
89
Conclusion 89 Recommended Reading
90
Chapter 11 – Obsolete Control Systems – The No Way to Know Problem
91
Obsolete Control Systems – The Warning Signs
92
Obsolete Control Systems – In Listed and Non-Listed Firms
95
Conclusion 95 Recommended Reading
96
Epilogue Chapter 12 – Towards a Dynamic View of Corporate Governance
99
Table of Contents 9
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Overview of the Book Despite the fact that corporate governance has attracted a lot of attention over the last 30 years, corporate governance failures continue to occur regularly. Why? Inadequate oversight? Systemic malfunction? Human nature? The fact that the rate at which corporate governance failures occur has not slowed can be traced to a fundamental misunderstanding of what corporate governance is about. Regulatory and practitioner efforts to respond to crises have given rise to a ‘rules and police’ interpretation of corporate governance: for rules, read compliance and for police, read independent directors. By definition, it is not possible to make rules for every eventuality or prepare for every effort to mislead; similarly, it is not realistic to expect independent directors to be able to respond to every possible problem configuration. Rules and police are reactive measures. To deal with corporate governance failures proactively, one has to understand the underlying causes. Corporate governance concerns the institutions that allow the exercise of power and the structures that ensure the accountability of that power; the key questions that need to be asked in every corporate governance analysis are ‘who is running the firm’ and ‘how is accountability ensured’. When governance breaks down it is because of too much power concentration or not enough accountability or both. This book is built around ten archetypes of corporate governance failure: five defined by unchecked power and five defined by inadequate accountability. Armed with the warning signs that help predict the occurrence of these archetypes and supported by numerous examples from a wide variety of contexts, readers will be able to confront corporate governance failure, before it happens. Responsible practitioner or thorough analyst, concerned with the listed firm or the non-listed, the reader of this book will gain a precise understanding of the causes and take away a practical toolbox for preventing future incidents of corporate governance failure.
Preventing Corporate Governance Failure 11
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Archetypes of Corporate Governance Failure – Unchecked Power • One-Person Rule • Single Shareholder Dominance • Interest Group Hegemony • Absolute Obedience • Board of Director Weakness Archetypes of Corporate Governance Failure – Inadequate Accountability • Opaque Business Models • Unsustainable Performance Targets • Counterproductive Incentives • Concentrated Risks • Obsolete Control Systems
12
Foreword
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Introduction
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CHAPTER 1 It’s About Power and Accountability At its core, corporate governance, like political governance, is about limiting power and holding power accountable. Treating corporate governance reform as a response to highly publicized scandals involving financial misconduct and, in some cases, even bankruptcy, has tended to obscure the real meaning of corporate governance. Scandals are a symptom of corporate governance failure, but reacting to scandals is not necessarily the best way to make policy, not for governments and not for corporations. Regulatory and practitioner efforts to respond to crises have given rise to a ‘rules and police’ interpretation of corporate governance: for rules, read compliance and for police, read independent directors. By definition, it is not possible to make rules for every possible eventuality; similarly, it is not realistic to expect independent directors to be able to respond to every possible problem configuration. Rules and police are reactive measures. To deal with corporate governance failures proactively, one has to understand the underlying causes. Take the three scandals that prompted epoch-making pushes for corporate governance reform – Mirror Group/Maxwell (leading to the Cadbury Report in the United Kingdom, 1992); Enron/Arthur Andersen (leading to the Sarbanes-Oxley Act in the United States, 2003); and the financial implosion of 2008 on the back of trading in mortgage backed securities (MBS) and collateralized debt obligations (CDO) (leading to the Dodd-Frank Act in the United States, 2010). Since the scandals and the responses are separated by decades, centered on unrelated industries, and have led to different approaches to reform, it is difficult to recognize that they are, in fact, merely diverse manifestations of similar corporate governance failures. In corporate governance terms, every one of these corporate implosions can be traced to insufficient checks on power of the executive or of major shareholders, and/ or inadequate accountability, primarily opaque business models. This book
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argues that effective checks on power and effective means for holding power accountable can help prevent corporate governance failures. It is important to point out that corporate power can have different seats, the executive or CEO, as is most commonly supposed, but also the board of directors and the shareholders. When corporate governance works as it is supposed to, no one of these actors and no sub-group has a monopoly on power over the firm. Instead, they fulfill their respective roles in a manner that provides for checks on the use of power. Accountability or more precisely the capacity to hold power accountable plays a key role in making checks on power effective. Without the capacity to hold power accountable, grounded in access to the right information and precise understanding of the business, board members and shareholders, or even executives, are effectively operating in the dark. As illustrated in Figure 1-1 below, accountability is yin to power’s yang.
POWER
ACCOUNTABILITY
WHO?
HOW?
Figure 1-1: What is Corporate Governance?
In brief, corporate governance concerns the institutions that allow the exercise of power and the structures that ensure the accountability of that power; the key questions that need to be asked in order to determine the state of corporate governance in the firm are ‘who is running the firm’ and ‘how is accountability ensured’. By finding satisfactory answers to these two questions, the stakeholder can make a meaningful assessment of the quality of corporate governance in the firm. When governance breaks down it is because of too much power concentration or not enough accountability or both. In corporate governance practice, unchecked power and inadequate accountability follow distinct archetypes, archetypes that are clearly identifiable and occur in widely diverse contexts. In the case of unchecked power, the archetypes are one-person rule, single shareholder dominance, interest group
16
Introduction
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hegemony, absolute obedience, and board of director weakness. One-person rule is probably the easiest for a layperson to recognize and often overshadows the others, but it is not alone in its potential to do great harm. Each of the five archetypes is a manifestation of the inability to put effective checks on the power of individuals to run the firm in their own interest. Preventing them requires insight into the processes whereby executives, directors, and shareholders interact. Table 1-1: Archetypes of Corporate Governance Failure – Unchecked Power One-Person Rule Single Shareholder Dominance Interest Group Hegemony Absolute Obedience Board of Director Weakness
For inadequate accountability, the following archetypes can be identified: opaque business models, unsustainable performance targets, counterproductive incentives, concentrated risks, and obsolete control systems. Of these, opaque business models are probably the most frequently encountered in practice and the most destructive, but the others also commonly occur. Each of the five archetypes represents a structural weakness that significantly increases the firm’s vulnerability to failure. As such, they can only be properly understood and resisted by carefully studying the plans, inner workings, and financial data of the firm. Table 1-2: Archetypes of Corporate Governance Failure – Inadequate Accountability Opaque Business Models Unsustainable Performance Targets Counterproductive Incentives Concentrated Risks Obsolete Control Systems
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While not mutually exclusive, nor collectively exhaustive, the ten archetypes of corporate governance failure discussed in this book cover most of the variations that arise in business today. The reader is invited to make the test: he/ she should be able to analyze and understand every example of corporate governance failure observed in the last thirty years in terms of one or several of the archetypes described in this book.
Archetypes of Corporate Governance Failure in Parallel and in Interaction Although the five archetypes defined by unchecked power and the five archetypes defined by inadequate accountability are presented separately for ease of understanding in the following pages, it is important to recognize that they may be interdependent and interact. Thus, one-person rule and board of director weakness, for example, often go hand in hand with one of the archetypes of inadequate accountability, such as an obsolete control system. Indeed, one-person rule may become entrenched by prolonged efforts to weaken the board of directors and preserve an obsolete control system. Therefore, a responsible stakeholder will need to consider multiple archetypes of corporate governance failure at once and read the archetypes’ respective warning signs with an eye to understanding the whole. The large number of possible permutations makes it impractical to describe every one of the interdependencies and interactions separately, but I will point out the most frequent as they arise in the course of the text, and Figure 1-2 below provides a graphical account. For the moment, the reader should take note of the fact that archetypes of corporate governance failure by unchecked power often occur in parallel (i.e. are not mutually exclusive) and may also imply inadequate accountability; the reverse is also true: archetypes of corporate governance failure by inadequate accountability often occur in parallel and may also imply the presence of unchecked power.
18 
Introduction
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One-Person Rule Single Shareholder Dominance InterestGroup Hegemony Absolute Obedience Board of Director Weakness
Opaque Business Models Unsustainable Targets Counterproductive Incentives Concentrated Risks Obsolete Control Systems
Figure 1-2: Archetypes of Corporate Governance Failure: Interdependencies and Interactions
Working with Warning Signs The perspective I adopt in this book is that of a stakeholder who is in some manner responsible for the governance of the firm (i.e. a board member or a significant shareholder). In other words, I take the point of view of an individual or group who has a fiduciary responsibility to prevent corporate governance failure. The driving idea behind the book is that proactive stakeholders can help prevent some, if not all, corporate governance failures. Whereas responsible stakeholders are presented with the tools to act, portfolio managers can use the approach presented here to help them identify and eliminate rotting apples in their portfolios. Responsible practitioner or thorough analyst, concerned with the listed firm or the non-listed, the reader of this book will gain a precise understanding of the causes and take away a practical toolbox for preventing future incidents of corporate governance failure. It is important to recognize that corporate governance failures do not emerge fully formed. Thus, every one of the five archetypes defined by unchecked power and every one of the five archetypes defined by inadequate accountability takes time to come to light. As such, the archetypes are manifestations of corporate governance that has been allowed to degenerate. How-
Chapter 1 – It’s About Power and Accountability 19
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ever, without understanding the ultimate shapes of corporate governance failures, we cannot define the warning signs. Only if we know what one-person rule, for example, looks like in full-blown form, can we outline the warning signs that can be identified on the way to one-person rule. That is why every chapter starts with a discussion of a fully developed archetype of corporate governance failure and only then delves into the warning signs. The process leading to corporate governance failure can be likened to a slippery slope: at first, responsible stakeholders may simply overlook relevant warning signs; then, as the descent gathers speed, they may not know how to respond to warning signs, whether to call a halt or build a supporting structure to stop the slide; finally, when the archetype of corporate governance failure is fully developed and the company is on the ropes, they find themselves personally implicated and cannot credibly reverse course. All of this occurs in the context of collective decision-making, making it even more difficult for stakeholders to act. Acute vigilance is the only solution to the slippery slope problem, and it is this kind of informed vigilance that the book attempts to promote by clearly identifying the warning signs preceding archetypes of corporate governance failure. By definition, working with warning signs is an approach that is prone to error. Thus, just because the warning signs for a particular archetype of corporate governance failure are there does not guarantee that the archetype will fully develop, even if stakeholders do not intervene. A firm on the way to extreme levels of risk concentration, for example, may pull back from the brink by the natural evolution of the business, without board or shareholder action. Furthermore, even if a particular archetype does fully develop, the most severe consequences of corporate governance failure may not occur. Again, taking risk concentration as an example, a firm may be able to survive high levels for years without suffering serious negative repercussions. However, this book starts from the premise that board members and shareholders have a fiduciary duty to warn of corporate governance issues before they threaten the viability of the firm. Therefore, recognizing the warning signs of corporate governance failure archetypes and taking proactive measures to prevent larger problems is a necessary part of a responsible stakeholder’s toolkit, even if the warnings turn out to be incomplete or unwarranted.
20 
Introduction
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Recommended Reading Finkelstein, S. 2003. “Why Smart Executives Fail”. New York: Portfolio (Penguin). Gomez, P.-Y., and H. Korine. 2008. “Entrepreneurs and Democracy: A Political Theory of Corporate Governance”. Cambridge, UK: Cambridge University Press. Gomez, P.-Y. 2018. “Que sais-je? La Gouvernance d’Entreprise”. Paris: Presses Universitaires de France. Heffernan, M. 2011. “Willful Blindness: Why We Ignore the Obvious at Our Peril”. New York: Simon & Schuster. Kahneman, D., Slovic, P., and A. Tversky. 1982. “Judgement Under Uncertainty: Heuristics and Biases”. New York: Cambridge University Press. Korine, H., and P.-Y. Gomez. 2014. “Strong Managers, Strong Owners”. Cambridge, UK: Cambridge University Press.
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