Governance and Virtue Ethics

Corporate Governance and Virtue Ethics

When control is separated from ownership, managers may not attempt to maximize profits and may pursue other objectives, like maintaining their own incomes, not working hard, or having plush offices (http://wps.aw.com/aw_carltonper_modernio_4/21/5566/1424929.cw/index.html)

This is called “moral hazard”.

What are some of the Governance mechanisms utilized in the modern Western-style corporation to solve these problems?

1. Ownership Concentration

= the no. of large-block shareholders and the total percentage of shares they own.

● large-block shareholders are increasingly active in their demands that corporations adopt effective governance mechanisms to control managerial decisions.

● In general, diffuse ownership produces weak monitoring of managerial decisions (makes it difficult for owners to coordinate their actions effectively; weak monitoring might result in product diversification beyond shareholders’ optimum level.)

Growing influence of institutional investors

Institutional owners = financial institutions, such as banks, mutual funds, pension funds, etc. that control large-block shareholders positions.

● Because of their prominent ownership positions, institutional investors are a powerful governance mechanism.

● Institutional owners have both the size and the incentive to discipline ineffective top-level managers and are able to influence significantly a firm’s choice of strategies and overall strategic decisions.

2. Board of Directors

● “The Board of Directors is primarily responsible for the governance of the corporation.  It needs to be structured so that it provides an independent check on management.  As such, it is vitally important that a number of board members be independent from management” (Phils. SEC Code of Corporate Governance).

Classification of Board of Directors’ Members:

Insiders

● The firm’s CEO & other top-level managers

Related outsiders

● Individuals not involved with the firm’s day-to-day operations, but who have a relationship with the company.

Outsiders

● Individuals who are independent of the firm in terms of day-to-day operations and other relationships

3. Executive Incentives

● Explicit and implicit incentives, in practice, partly align managerial incentives with the firm’s interest. (Salary, Bonus & Stock options)

● Capital market monitoring and product-market competition further keep a tight rein on managerial behavior.

● Also: ‘intrinsic motivation’, fairness, horizontal equity, morale, trust, corporate culture, social responsibility & altruism, feelings of self-esteem, interest in the job, etc.

4. Market for Corporate Control

= composed of individuals and firms that buy ownership positions in (or take over) potentially undervalued corporations so they can form new divisions in established diversified companies or merge two previously separate firms.

= The purchase of a firm that is underperforming relative to industry rivals in order to improve its strategic competitiveness.

A potential problem with the market for corporate control is that it may not be totally efficient.

  • A study of several of the most active corporate raiders in the 1980s showed that approx. 50 per cent of takeover attempts targeted firms with above-average performance –corporations that were neither undervalued nor poorly managed.

We, then, understand why Corporate Governance is defined in this way by the Philippines SEC Code of Corporate Governance:

Implication: Even in the “most perfect” of cases, all of these mechanisms (which are extrinsic in nature) may not totally resolve these ‘principal-agent problems’.

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What then can be proposed?

VIRTUE ETHICS

Note that mention is made above of TRUST (apart from fairness, morale, altruism…)  The principal-agent relationship can effectively be viewed as a relationship of TRUST: the principal trusts that the manager would act in such a way as to increase shareholder value.  When both parties are motivated by sheer material incentives, there is no way to solve definitively the problems between them.  However, if both principal and agent are VIRTUOUS (are fair and just, are courageous and professional, are temperate and sober, are disciplined and generous…, are CHARITABLE), many of the principal-agent problems would disappear.

For example: We all know the critical importance of INDEPENDENCE on the part of accountants and auditors (the adverse consequences for independence of taking on consulting and non-attest services for the audit client) (http://www.accountingweb.com/blogs/cpapastr/today039s-world-audits/are-you-performing-non-attest-services-impair-independence) If only each member of the auditing firm exercised enough self-discipline, self-control and moderation (a stubbornness to tell himself “I must not allow myself to lose my independence”, “I must reject the lure of money here”), then this particular governance problem could be alleviated…


“Aristotle’s Nicomachean Ethics: An Introduction”, by Michael Pakaluk

As another example: It is quite obvious that many of the unethical practices that have occurred in firms are due to GREED (the unbridled desire for and possession of maximum wealth, “profit-maximization brought to the extreme”, “capitalism gone haywire”).  If only owners and managers had a bit more of temperance and sobriety (Greek enkrateia) –if only they exercised moderation and self-control–, they would have done the firm a great deal of good, i.e., they would have achieved, for themselves and for the firm, what Aristotle called the Highest Good: happiness (Greek eudaimonia – sometimes translated as “living well”).  If only we could convert the owner-manager relationship into real FRIENDSHIP ―what do friends do to each other? who is a true friend?―, then many of the principal-agent problems would indeed disappear.  (see Michael Pakaluk’s treatment of friendship in Aristotle’s Nicomachean Ethics in the link above).

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Extending the discussion a bit further, we can show that corporate social responsibility, defined in ethical terms, can be a “better solution” to the principal-agent problem.  Many politicians, managers, consultants, and academics object to the economists’ narrow view of corporate governance as being preoccupied solely with investor returns; they argue that other ‘stakeholders’, such as employees, communities, suppliers, or customers, also have a vested interest in how the firm is run, and that these stakeholders’ concerns should somehow be internalized as well (Tirole, Jean [2006], “The Theory of Corporate Finance”, p. 16).

Freeman, in his book “Strategic Management: A Stakeholder Approach”, assumed that ‘‘managers bear a fiduciary relationship to stakeholders’’.  The interests of all stakeholders are of intrinsic value (that is, each group of stakeholders merits consideration for its own sake and not merely because of its ability to further the interests of some other group, such as the shareowners). Freeman and Philips, in normative stakeholder analysis, introduce the fairness principle based on six of Rawls’ characteristics of the principle of fair play: mutual benefit, justice, cooperation, sacrifice, free-rider possibility and voluntary acceptance of the benefits of cooperative schemes (Freeman, R. E. and R. A. Philips: 2002, ‘Stakeholder Theory: A Libertarian Defence’, Business Ethics Quarterly, 12(3), 331–349).  It is argued that a good number of virtues could enable the firm to attend to all stakeholders as it tries to achieve its goals (of profit-maximization and shareholder wealth enhancement).  Concretely, cooperation and sacrifice are mentioned as part of fairness.  [It can be shown that, ultimately, businesses have their long-run strategic objectives in mind when they undertake socially responsible initiatives. https://sites.google.com/site/catholicmanagement/] In addition, one could consider the Japanese concept of “Kyosei´(understood as “living and working together for the common good”) as the basis for some firms’ practice of social responsibility.  Note that these traits ―cooperation, sacrifice, harmony, peace, working for the common good― are present in VIRTUOUS individuals; in fact, it is FRIENDS who are capable of sacrificing themselves for the sake of their friends.  When the principal-agent relationship truly becomes a fiduciary relationship ―the summit of which can be reached only if each is capable of practicing CHARITY with the other―, then there may be no need for extrinsic governance mechanisms (Garriga, Elisabet, and Domènec Melé [2004], “Corporate Social Responsibility Theories: Mapping the Territory”, Journal of Business Ethics, 53: 51-71).

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Many more things can be said here, but I remit you to the 3rd Edition of “Understanding Accounting Ethics” (forthcoming).  For excerpts from the 2nd Ed., click here:

https://youniv.wordpress.com/category/ethics/

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For a more advanced (mathematical) treatment of the Principal-Agent Problem, see Jean Tirole “The theory of industrial organization”:

http://books.google.com.ph/books?id=HIjsF0XONF8C&printsec=frontcover&dq=The+theory+of+industrial+organization&hl=en&ei=LrNxTIrMN8PBccTIuP4M&sa=X&oi=book_result&ct=result&resnum=1&ved=0CCsQ6AEwAA#v=onepage&q&f=false

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Will expand this blog with ideas from Wijnberg’s “Stakeholder Theory and Aristotle”:

Also from the empirical paper “Ethical Character and Virtue of Organizations” by Rosa Chun:

ABSTRACT. Virtue ethics has often been regarded as complementary or laissez-faire ethics in solving business problems. This paper seeks conceptual and methodological improvements by developing a virtue character scale that will enable assessment of the link between organizational level virtue and organizational performance, financial or non-financial. Based upon three theoretical assumptions, multiple studies were conducted; the content analysis of 158 Fortune Global 500 firms’ ethical values and a survey of 2548 customers and employees. Six dimensions of organizational virtue (Integrity, Empathy, Warmth, Courage, Conscientiousness and Zeal) are identified through confirmatory factor analysis, and validated against satisfaction measure. Strategic implications of virtue characters are discussed.

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You may send feedback: aliza.racelis@up.edu.ph

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