Edward Waitzer

In his classic treatise on the Wealth of Nations, Adam Smith noted a discrepancy between the interests of owners and the managers who are handling those “other people’s money.” In the twentieth century, Michael C. Jensen and William H. Meckling—citing Smith as well as Adolf A. Berle and Gardiner C. Means’s The Modern Corporation and Private Property—gave new urgency to this issue by introducing the concept of agency costs—the costs of aligning the incentives of these different corporate actors. This led to more than four decades of searching for the best way to align the interests of shareholders and managers.

At first it seemed that the solution would be stock price, since shareholders and managers alike want to optimize that. The advent of the efficient market hypothesis reinforced the focus on market pricing as the arbiter of corporate performance, and of short term shareholder value as the purpose of the corporation. We have learned, painfully, that neither of these ways of thinking about governance issues is adequate.

Meanwhile, corporate law has been overwhelmed by the advent of a litany of corporate governance norms. This has spawned an active governance industry and a variety of new analytical models for framing corporate law, including:

• shareholder primacy, in which boards are accountable above all to shareholders;
• the stakeholder model, in which the interests of all stakeholders are to be considered and mediated by the board of directors;
• the team production model, in which the inputs of various stakeholders are acknowledged; and
• the nexus of contracts theory, director primacy, and others.

What has become clear is that there is no “right” corporate governance model. Governance is highly contextual, and is dependent on what a particular company does, its ownership structure, and the markets and political frameworks in which it operates. The focus on corporate governance reflects a move from a simple legal view of the corporation to one that has become increasingly complex and dynamic, constantly responding to societal expectations. Governance is messy because that is life.

One of the consequences is that there seem to be new controversies and consequential regulatory proposals every year. We have spawned a corporate governance reform industry (private sector and regulatory) that has become adept at generating activity to feed itself. A related oddity is the fact that many of the regulatory proposals are symbolic—they certainly cannot be explained by their relevance to improving corporate governance or performance.

To take a current example, think of say on pay. We now have several years of data resulting from the legal ability of shareholders in the US to cast an advisory vote on executive compensation. Rhetoric aside, shareholders have typically approved compensation with votes in favor, typically exceeding 90 percent.  There is a double irony here. First, executive compensation is paid mostly in equity with a value based mostly on short-term stock prices. Second, shareholder support for executive pay also appears to be highly correlated with a company’s short-term stock performance. To the extent that the say on pay vote has heightened executives’ incentives to focus on short-term stock price at the potential expense of creating sustainable value, this regulatory initiative would appear to be counterproductive.

Another recent example is last year’s shareholder resolutions asking companies to report on their exposure to climate risk (and related regulatory, technological, legal, and meteorological forces). In spite of proclaimed commitments to engagement on environmental, social, and governance issues, both executive management teams and investors seem indifferent to such proposals. Management typically recommends a vote against the measure, claiming that the company’s reporting is already thorough, and shareholders vote thumbs down accordingly. Preventable Surprises, a self-described “think-do” tank in the United Kingdom, reports that only one of nine such resolutions at the major U.S. utilities received majority support. Three of the largest institutional investors (owning, on average, close to 20 percent of the shares of the nine companies) voted against each of the resolutions. Equally surprising is the lack of disclosure by these investors regarding the impacts of climate risk on their portfolios and investment strategies.

It is unlikely that the explanation for this lies in false perceptions. The actors we are talking about are among the most sophisticated and influential in our society. A more likely explanation is that governance is often viewed as a moral crusade that is tapping into broader public sentiment without regard for materiality or the difficulty of effecting fundamental change. The exercise of governance then becomes largely symbolic and political and, as a result, it is often conservative and self-serving. One systemic danger is that such reforms dull the desire for deeper introspection and more fundamental change.

Might there be a more nuanced and constructive way to think about corporate purpose? Tamara Belinfanti and Lynn Stout begin to develop one such approach in their recent paper “Contested Visions: The Value of Systems Theory for Corporate Law.” They first describe two basic principles of systems theory:

1. That systems are integrated (i.e., more than the sum of their parts), and
2. That systems are fractal (i.e., they are comprised of subsystems which in turn are comprised of other subsystems on so on).

A third principle flows from the first two: that the overall health of the system depends on the continued health of each of its essential subsystems, as well as of the larger systems in which it is embedded. They then reflect on how each of these principles applies to corporations.

Well-managed corporations achieve resilience through positive mechanisms such as economy (i.e devoting the appropriate level of  resources based on current conditions), homeostasis (i.e., information and feedback loops that allow a system to adjust to disturbances in its environment and stay within the parameters necessary for its continued functioning), and self-organization (i.e., the ability of a system to learn, diversify and evolve in response to shifts in its environment that might otherwise threaten its survival).

By contrast, poorly managed corporations remain vulnerable due to negative mechanisms such as redundancy (i.e., devoting more resources than needed for a given purpose); imbalance (e.g., information asymmetry between management and directors); and rigidity (doing the same thing over and over and expecting different results).

In systems, multiple purposes are the rule, not the exception. What we observe about a system’s purpose or purposes, actual or apparent, will depend on our level of analysis. The relevant lesson that systems thinking offers on corporate purpose is that the overall goal of a corporate system should not be subordinated to the goals of any one of its subsystems (such as the share ownership subsystem). A critical, ongoing role of effective boards should be to mediate these competing interests.

Systems theory suggests that corporate purpose can be viewed from different perspectives, including the expectations of the state whose laws made incorporation possible. This doesn’t offer a definitive answer to the difficult question of corporate purpose. Indeed, one of the primary insights of systems theory is that the purpose and functions of a system is often the least obvious part of the system, especially to outside observers who pay attention to only a few events or to rhetoric or stated goals.

Where does this thinking lead? First, systems theory counsels against focusing on any single metric. To take the obvious example, short-term profitability is not so much an objective as a constraint a firm may have to meet in order to remain in business. Metrics such as profits, employee turnover, customer satisfaction, and so forth are not ends in themselves. Rather, they are a source of information about whether the corporation is relevant, resilient, and sustainable. Sustainable value creation is the singular goal boards should be focusing on and to which managers should be held accountable.

A related lesson is the need to develop new tools and techniques to measure system-level effects. Increasingly the focus will be on the ability of corporations to generate and account for positive externalities. The work of one organization, The Investment Integration Project, may provide guidance for corporations as well as institutional investors. The organization’s work looks beyond financial metrics to consider system-level events and the integration of the United Nations’ sustainable development goals, for instance.

A third lesson from systems theory is that, given multiple purposes and the complexity inherent in systems analysis, the three branches of government—courts, lawmakers, and regulators—will rarely be well positioned to judge corporate performance. (It is fortunate that the U.S. Securities and Exchange Commission has not yet finalized the proposed Dodd-Frank rule on pay versus performance, which defines performance as no more or less than three years of annualized Total Shareholder Returns (TSR) .)It will also be difficult for academics or the corporate governance profession to identify “one size fits all” reforms that can reliably improve the performance of all companies. Attempts to impose such silver-bullet solutions are more likely to result in what Roberta Romano has described as “quack corporate governance” that often does more harm than good.

This suggests the exercise of restraint by regulators—assuming positive intent and encouraging adaptive responses rather than imposing rigid and formal compliance requirements. In this manner, we can ensure that our corporations can continue to function as dynamic systems that foster the wealth of nations and the globe.

Edward Waitzer is a partner and head of the corporate governance group at Stikeman Elliott LLP. All thoughts are his own.