issues are constantly in the headlines. Activist investors challenge
ask why companies binge on buybacks while skimping on value-creating
investment opportunities. But discussions of corporate governance
invariably miss the real problem: most public companies have extensive
governance procedures but no governing objective. As a result, there
is no sound basis for stakeholders, including shareholders, to assess
the performance of the company and its executives.
Corporate governance is a
system of checks and balances that a company designs to ensure that it
faithfully serves its governing objective. The governing objective is
the cornerstone upon which the organization builds its culture,
communications, and choices about how it allocates capital. Think of
it as a clear statement of what a company is fundamentally trying to
Today there are two camps
that aim to define the idea of governing objective, but neither is
effective. The first believes the company’s goal is to maximize
shareholder value. Countries that operate under common law, including
the United States and the United Kingdom, lean in this direction.
The second advocates that
the company balance the interests of all stakeholders. Countries that
operate under civil law, including France, Germany, and Japan, tend to
be in this camp.
The problem with the term
“maximize shareholder value” is that it has been
by those who incorrectly believe that the goal is to maximize
short-term earnings to boost today’s stock price. Properly understood,
maximizing shareholder value means allocating resources so as to
maximize long-term cash flow. Because an organization’s success
depends on long-term relationships with each of its stakeholders,
lengthening the investment time horizon benefits not only shareholders
but customers, employees, suppliers, creditors, and communities as
interests sounds like an entirely reasonable idea. But it
as a company’s singular governing objective because it is impossible
to simultaneously satisfy the interests of all stakeholders. In the
absence of a singular governing objective, executives are free to
decide as they see fit and to balance those interests however they
think is right. And without knowing how managers decide, it is almost
impossible to hold them accountable for what they decide.
Companies must take
to establish an effective corporate governance structure and thereby
achieve consistency between what they say and what they do.
First, corporate boards
must select a clear governing objective. That may mean choosing
shareholder or stakeholder value, but that is not enough. Those that
do embrace maximizing shareholder value as their governing objective
also need to specify the time horizons they will use in their planning
and decision-making processes.
Companies that choose to
balance the interests of stakeholders as their governing objective
must explain how they intend to manage the diverse and often
conflicting interests of their stakeholders. In particular, they need
to disclose the acceptable limits for tradeoffs they are willing to
make at the expense of their shareholders.
Time horizon is a
particularly important part of the governing objective’s definition.
Some observers contend that focusing on an uncertain long term
distracts the organization from what it needs to accomplish in the
short term. But the short term and the long term are not adversaries
in a zero-sum game. The overriding goal should be to focus
continuously on what the organization needs to accomplish in the short
and intermediate term in order to achieve its long-term goals. Peter
Drucker, the great management thinker, had it right when he said,
“keep [your] noses to the grindstone while lifting [your] eyes to the
Second, companies need to
adopt a set of policies that encourage behaviors consistent with the
governing objective. This includes non-financial and financial
performance metrics as well as incentive compensation plans.
shows that non-financial metrics that companies use are commonly
untethered to either long-term value creation or the company’s
strategic goals. It comes as no surprise that if companies can keep
score as they wish, they will often reward managers even when they
fail to create value. For example, companies can boost earnings per
share by repurchasing shares, thereby hitting compensation targets,
while forgoing value-creating investments in the business.
We recognize that
designing effective incentives is devilishly difficult and that
incentives alone are not the answer. But proper incentives are
essential for an organization to faithfully serve its governing
objective. Pursuing the governing objective becomes an act of
enlightened self-interest for all employees when the proper incentives
are in place.
stakeholder-centric companies have every right to prioritize an
objective other than creating shareholder value, but to honor their
implicit contract with shareholders they need to disclose the
acceptable limit for trade-offs they are willing to make at the
expense of their shareholders.
Third, companies must
communicate with all of their stakeholders. This includes public
disclosure of a governing objective, the time horizon the company will
use in its planning and decision-making processes, how it will resolve
trade-offs among stakeholder interests, and the specific policies in
place that support the governing objective.
This communication allows
all stakeholders, including shareholders, to opt in or opt out given a
company’s objectives. In particular, CEOs who are compelled to
disclose their time horizons are likely to lengthen them. This
disclosure alone would serve as a powerful antidote to corporate
Take a look at the
letter to shareholders
that Jeff Bezos, founder and CEO of Amazon.com, wrote to shareholders
in 1997. He states that the “fundamental measure of our success will
be the shareholder value we create over the long term.”
He then enumerates the
ways in which the firm’s policies will support the objective. For
instance, he states that “When forced to choose between optimizing the
appearance of our GAAP accounting and maximizing the present value of
future cash flows, we’ll take the cash flows.”
Not only has Bezos been
clear about the company’s objectives from the beginning, the company
reprints the 1997 letter every year to reinforce the message. Bezos
“As far as investors go, our job is to be superclear about our
approach, and then investors get to self-select.”
Proposed fixes of
corporate governance typically treat the symptoms and fail to address
the cause. The root problem is that few companies have a
clearly-stated governing objective. As a result, executives can
justify almost any decision they make. Our solution dwells not on
which governing objective a company should select, but insists that
the company be clear about what it is trying to do. Getting companies
to do as they say is a win-win for the long-term interests of
investors, the companies they invest in as well as all stakeholders.
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