King John signs the Magna Carta, engraving by James William Edmund Doyle, 1864 (Source: Wikimedia Commons)
Ideas for Leaders #299

Corporate Governance from the Bottom Up

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Key Concept

Non-executive directors are often seen as a way to avoid corporate ‘buccaneering’ and tame reckless CEOs. Their exact contribution to companies, however, remains unclear. Independent executives, on the other hand, have been shown to be accurate ‘predictors’ of profitability, performance and value creation.

Internal monitoring by the CEO's immediate subordinates should be the new area of focus in the corporate governance debate.

Idea Summary

Academics and practitioners have long known that without tight monitoring, CEOs of large public companies may take actions that are against the interests of their shareholders. The consensus has been that a strong board of directors, independent from management, provides checks and balances for executive power. Academic literature confirms that board independence improves governance — but there is no evidence that it affects the profitability or even the value of corporate assets.

A research paper from the Toulouse School of Economics, Princeton University and HEC and CEPR shifts the focus of the debate — away from external monitoring by non-executive directors and towards internal monitoring by the executive suite. It proposes a new measure of governance based on the degree of independence of the CEO’s immediate subordinates.

The researchers define ‘independent top executives’ as those who joined the company before the current CEO was appointed, reasoning that these executives are more likely to challenge the current management and less likely to share the same preferences as the current leader — or feel beholden to them because they ‘owe’ them their jobs.

Linking data on the make-up of executive committees with datasets for profitability, stock returns and the long-term success of acquisitions, they empirically relate the internal organization of a company with decision-making quality and corporate performance. Controlling for traditional governance measures such as board independence or other shareholder-friendly provisions, their study finds that:

  • A high proportion of independent top executives predicts high future performance, measured through accounting ratios or market valuation.
  • Independent subordinates tend to be a particularly important factor in more uncertain environments.
  • The number of independent executives can be said to affect the strategic performance of the CEO: companies with poor internal governance make largely under-performing acquisitions, losing more shareholder value.

These results are striking. What explains them? Building on an earlier paper, ‘Optimal Dissent in Organizations’, the researchers suggest that differences in points of view in a chain of command can help improve the way an organization functions. “In our model,” they say, “independent subordinates improve the likelihood of an ‘objective’ decision being taken, since they force the CEO to give in less to her bias. In other words, dissenting organizations are more reactive to new information.”

Independently minded executives, the paper concludes, may impose more constraints on the CEO. Sometimes, their mere presence might be enough to improve decision-making. The paper states that: “Top executives need not disobey, or enter into open conflict with their boss: knowing that the firm’s key executives might be less enthusiastic in their work when they disapprove decisions, the CEO has incentives to take their opinion into account.”

Business Application

This Idea supports the case against cronyism in the leadership and management of organizations and it underlines the value of people able to speak ‘truth to power’. Crucially, it illustrates the vital importance of internal monitoring or bottom-up governance.

There is a clear practical implication, it could be argued, for executive recruitment and for the composition of both executive committees and unitary boards. Companies and shareholders, the research suggests, should take care to ensure members of the ‘old guard’ remain in place when a new CEO is appointed. The independence of these members from the boss could mean the difference between success and failure or good performance and mediocrity.

More generally, the Idea confirms that robust decision-making usually results from robust debate. It may be naïve to imagine a company can be run or function effectively as democracy, but that’s not an argument for autocracy.

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Authors

Institutions

Source

Idea conceived

  • December 2012

Idea posted

  • January 2014

DOI number

10.13007/299

Subject

Real Time Analytics