The Case for Contingent Governance

To cure weak corporate governance, new regulations and codes of best practices might be necessary, but they won’t be sufficient. What is also required is the acknowledgment that governance has to continually adapt to changing conditions because a company, its management and business environment are forever evolving. As a result, corporate boards must adopt the right roles to reflect and shape those governance conditions.

In an ideal world comprising competitive markets and transparent information, the legal system and market processes would, by themselves, provide perfectly adequate corporate governance. Specifically, the markets would weed out and penalize — through declining share prices and takeovers — executives who tried to manipulate their companies in any way that was adverse to long-term value creation. Everything affecting value creation (including environmental costs such as pollution) would be priced by the markets and rewarded or punished in line with the contribution to or subtraction from value creation that those factors engendered.

Indeed, if the market could capture everything and no one could manipulate decision making with monopoly power, companies that maximized their economic value (the difference between projected revenues and the market cost of all the resources used) would also maximize the public good.1 The real world, however, is far from ideal. Thus, governance is necessary to deal with the things that fall outside markets as well as the people who would manipulate decisions in their own interests.

Two broad streams of commentary and research deal with these issues and the need for different governance roles. Sociologists have explored the role and impact of companies on society, especially the relationships between organizations and other stakeholder groups.2 Markets alone do not capture the full impact of companies; in particular, they do not price certain inputs and outputs of the business, so-called externalities, such as the effect of an organization’s activities on society at large. Thus, regulations and governance are needed to deal with the consequences of those externalities, especially those promoted by stakeholder groups. But the right role of the board depends on the importance of the externalities, which can vary from country to country and from market to market over the life of the company.

Economists have explored how shareholders can get managers to run a company as agents acting in the owners’ interests, given the appropriate regulations and incentives.