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Corporate Governance: origins and challenges

Ever since humans came together to live in groups, governance of the community has been a matter for practical competition and theoretical reflection. The study of history tells us who won the competition to rule, whereas the study of political philosophy tells us how these rulers should have used their power.

In the ancient world, governance of organisations within the community was either considered to be an extension of state rule, for example, the military and the major religious organisations, or it was considered to be a private matter, for example households and family businesses. Aristotle starts The Politics with a discussion of household management before moving on to discuss the best form of government since, as he says, the state is made up of households.1

The modern world, by contrast, is characterised by the proliferation of non-state organisations that are quite unlike households or family firms. While the state retains control of the military, in many (but not all) cases religious organisations are now independent of state control. Other non-state organisations include charities, trusts, partnerships and co-operatives, as well as commercial businesses and companies, and autonomous public sector organisation. They range in size from local organisations that employ a handful of people to global organisations that employ hundreds of thousands of people.

As the number and scale of non-governmental organisations has grown, so too the question of how these organisations should be governed has become more important. While philosophers continue to debate the best form of government for the state, questions concerning corporate governance have been left to economists.

The problem of trust
The central questions of corporate governance - How do we make sure that organisations are well run? that they do what they are supposed to do? and that they do it in the way they are supposed to? - arise because of the "problem of trust". When we join an organisation, whether as a member or as an employee, we agree to accept the authority of others. We give up some of our freedom, to do as we wish, in order to gain from the benefits of membership, which might be payment of some kind or access to goods and services, or a feeling of solidarity and support. We are only likely to give up our freedom willingly if we trust that those who run the organisation will ensure that these benefits of membership are worthwhile.

Managers - those who run organisations - are trusted to make best use of the organisation's resources to achieve the organisation's goals, which will include the satisfaction of members and employees. They are trusted to make use of the organisations resources for the benefits of the owners, the members and the employees and not just for themselves. Good governance aims to build and sustain these relations of trust, to ensure that managers do their job well and that the expectations of shareholders and the other stakeholders are not unreasonably disappointed. What, then, is the basis for this trust?

Historically, most large organisations were run directly by the state. Ancient armies were huge organisations: Herodotus claims that the Persian army under Xerxes, which tried to conquer Greece around 2,500 years ago, numbered over 2.5 million fighting men, with at least an equal number of ancillaries and servants.2 Armies often conscripted their members, although some soldiers would have joined by choice. Either way, ancient military organisations maintained order and discipline by enforcement - often brutal - rather than trust. It would be a foolish soldier who thought his general cared at all about his well-being, except that it improved his willingness and ability to fight and to die.

At this time, most non-state organisations were based around the extended family, including family farms, small family businesses and trading companies and family banks. Extended families were often large groups that would have included several generations of parents and children, a range of cousins, and those who joined the family through marriage. In many cases wealthy families would have supplemented the extended family labour force with servants and slaves. They were able to organise economic and social activities collectively because family members were trusted to support each other and to preserve the benefits of their collective endeavours within the family group.

For hundreds of years this model - numerous family based organisations alongside a small number of state-controlled organisations - was the norm in all societies. It worked reasonably well while economies were small, with most goods grown or produced locally, and a limited amount of foreign trade. As the ability to travel safely improved and the benefits of trade became more widely understood, so the size and complexity of non-state organisations needed to grow. Sending a state-controlled naval force to fight a rival state was relatively easy; building a private commercial fleet that would promote trade and economic development was more tricky. Families started to combine together to increase the scale of their organisational capacity and to allow them to spread the costs and the risks of their trading activities.

At first, non-state organisations grew in size based upon shared identities: some organisations were built upon the co-operation of groups of neighbouring families; others were built upon the co-operation of families from the same tribe or ethnic group; yet other were built upon the co-operation of families from the same religious groups. Examples in Europe would include the Medici family in Italy, the Fugger family in Germany, and the networks of Jewish families whose wealth helped to finance trade and business, and who lent money to kings and popes; in India families from the same caste and the same region would come together to co-operate in business ventures.

In all these cases trust was based on a form of shared identity; but sometimes shared identities proved insufficient to sustain the growth of organisations. Not all family members get along with each other; religious and ethnic groups can be the source of conflict and rivalry as well as the source of common identities; sometimes the local can be as alien as the foreign. As the necessary conditions for success changed -- not just greater scale, but also a wider skill set among the organisational leaders to deal with greater complexity - so a different model was needed to allow for the growth of non-state organisations.

Common interests
Why would individuals who are not bound by the loyalties associated with a shared identity come together to create an organisation to promote their activities? Ronald Coase pointed out that the market-price mechanism provides a perfectly good model, in which individuals contract with each other and make a series of bilateral agreements about the conduct of business. However, Coase also argued that when the managers of an organisation (or, to use his term, "a firm") are able to organise its activities efficiently, thereby lowering its costs of doing business below those that would be incurred by a large sequence of transactions in the market place, then the organisation has an economic justification for its existence.3

The explanation for the continued growth of non-state organisations is economic, not social. It is the result of the growing economic value of the entrepreneur, whose quest for greater efficiency makes organisations superior in performance to the aggregation of individuals, linked by legal contracts. Non-state organisations allow individuals to further their shared interests in success: common interests rather than common identities.

For example, in 1602 the States General of the United Provinces of the Netherlands established the Dutch East India Company (known by its Dutch acronym as the VOC). The English (later British) East India Company was set up at the same time.4 In both cases these companies were established to capture as much trade as possible between Europe and the spice islands in the East Indies. Ships were sent on long voyages to trading outposts where they loaded up with tea, coffee, sugar and spices before returning to Europe to sell these luxury goods to the wealthy. The state supported these ventures because they allowed the government to increase its tax revenues on the traded commodities, which in turn funded military expenditure. Luxury consumption and military spending were the proximate causes, and commercial, financial and organisational innovation were the outcome.

The Dutch East India company was a joint stock, long-distance trading company. The shares were traded on local exchanges. Their capital value changed over time, according to expectations that returning ships would sell their cargo at high prices and that the resulting profits would be re-distributed as dividends. Shareholders would bear the risk of the voyages, but would benefit from the profits of the voyage. Between 1602 and 1650, dividend payments by the Dutch East India company averaged 16.5% per annum, a highly successful outcome for long-term investors. The Dutch East India Company was governed by 17 Directors; 8 from Amsterdam, whose merchants had provided half of the initial investment; 4 from Rotterdam and 4 from the other ports, each according to their financial contribution. There was one additional appointee from the smaller investors to avoid ceding overall control to Amsterdam. This complicated governance structure reflected the specific geographical and political situation in the Netherlands when the Company was established in 1602. However, other countries, notably Great Britain, copied the idea of a joint stock company and replicated it in its pure form: stock holders would be entitled to a vote according to how many shares they owned and directors would be elected to protect the interests of groups of stock holders according to their stakes in the company. The joint stock company was a hugely successful innovation: now large organisations were possible, built upon common interests of shareholders.

A second example is DuPont, which during the twentieth century was gradually transformed from a family owned explosives manufacturer into a public company that was the leading manufacturer of chemicals and synthetic consumer materials, inventing such well known products as neoprene, nylon, teflon, lycra and kevlar.5 Founded by the Du Pont family, who fled the French revolution at the end of the eighteenth century, the company grew to dominate the market for gunpowder in the US in the nineteenth century. In the twentieth century DuPont moved into industrial and commercial chemicals and it remains one of the largest chemical companies in the world today.

During the 1920s and 1930s DuPont was a leading participant in the revolution in company management that took place in the US. Pierre DuPont, a great grandson of the founder, became head of the family company. He also became chairman of General Motors, which he helped to finance during the 1910s and 1920s. He invested in research, and brought leading scientists to work at DuPont to diversify the company's activities. He also raised capital from the public stock markets to dilute the family's share of the company. He hired external managers to make the business successful and worked on the principle that DuPont family members would only be promoted on merit. Importantly, he established an executive board that set the strategy for the business and protected the interests of the investors.

The Dutch East India Company and DuPont both grew to become large, successful organisations. They both survived for a long time, much longer than the lifetime of one or two generations of family members. How did they achieve this? Investors pooling resources to create efficiencies and these resources were managed by leaders who were committed to securing the interests of their shareholders. Importantly, they both had governance structures that were designed to protect the interests of stakeholders and to ensure that the managers ran the organisations efficiently.

Corporate governance today
In modern non-state organisations there is normally a division of power and responsibility between the senior executives, who run the organisation on a day-to-day basis, and the governors or board, some of whom might be non-executives, who maintain overall control of the organisation. This is the case not just for commercial companies, but for charities and partnerships too. Once an organisation gets beyond a certain size it requires governance structures in place to oversee the executive leadership's management of the organisation. There is no fixed balance of responsibility between the executive team and the board: it varies from time to time and from organisation to organisation.6 However, there are three distinct roles that all boards must fulfil to ensure good governance of the organisation.

First, the board represents the interests of the stakeholders. These will include the shareholders, or other funders whose capital sustains the business, but might also include employees, customers, creditors, regulators, other interested parties, and the wider community. Boards should be clear who their stakeholders are and, when there are a variety of stakeholders, who the most important group are. For example, in a commercial business the shareholders might be the most important stakeholder; the board must ensure that customers are treated well but customers should not expect prices to be so low that there are no profits for the shareholders. In a university, the students might be the most important stakeholder; the board must ensure that the staff are of high quality and are well motivated, otherwise the students will not receive the quality of education they are entitled to; however, the staff should not expect their interests to be given priority over those of the students.

Second, the board should set the strategy for the organisation. This means taking a long-term view, to secure the interests not just of current stakeholders but future stakeholders too. One problem that many organisations face is that the management team and the employees give too much attention to the day-to-day business of the organisation and they neglect longer term issues. As a result, organisations become stale and out of touch with customers and clients and with longer term trends in society and the economy. The board is responsible for ensuring that the organisation takes time to think long-term and to take account of changes to the operating environment which might have a material impact on the organisation.

In addition, managers or employees might in some cases be tempted to take a short-term gain, because they plan to leave the organisation soon and go to work elsewhere. If there are cash reserves, or stock, or opportunities which have a long-term benefit to the organisation, current managers or employees or stakeholders might seek to capture some of the value of these resources and use them for their own benefit, damaging the long-term interests of the organisation. One of the responsibilities of the board is to ensure that the long-term interests of the organisation are not damaged by short term "rent seeking" behaviour by managers or other employees.

Finally, the board should hold the managers to account, to make sure that they are running the organisation properly and that its goals are met. As Coase explained, the reason why people give up some of their freedom to join an organisation is because they trust that the managers of the organisation can improve the likelihood of them achieving their aims as compared with using the market for prices. The organisation is supposed to create efficiencies by saving on transaction costs through the pooling of information and resources: if these benefits are not achieved, members of the organisation would do better to leave and seek the benefits elsewhere. One of the responsibilities of the board is to hold the management to account for the success of the organisation in meeting these goals.

There are two main obstacles to good governance - one caused by lack of knowledge and the other by lack of trust. These obstacles can be very difficult to overcome and there are many examples of governance failures that lead in turn to significant costs and loss of well-being for the members of non-state organisations.

One problem that besets all organisations is that the stakeholders - whether the owners, or the funders, or the regulators, or the employees, or the customers - never have as much information about what is going on as the managers do. This is often referred to as the "principal/agent problem". The principal (usually the owner) hires an agent (the manager) to do work for her, but it is hard for the principal to know whether the agent is doing her best to serve the organisation or to serve her own interests. Only the agent really knows how well the work has been done and how well it could have been done.

A great deal of the debate about executive pay centres on this issue - how to verify that the managers really are doing a good job and deserve their salaries (and bonuses). It is very hard for the board to know for sure that managers are worth what they are paid. As we have seen, the whole purpose of creating an organisation is to benefit from the knowledge and skill of the management team; good management is central to any organisation's raison d'Ítre. Good managers will almost always have better "domain knowledge" that those outside the management team and the cost of acquiring this knowledge is expensive for those on the board.7 Consequently good governance is always at risk from lack of good information.

Second, because different groups within an organisation, including managers, have different interests, often in conflict with each other, it can be difficult to maintain trust within an organisation. Trust is necessary for the organisation to function well, but trust is difficult to sustain when the interests of different groups are not well aligned. If certain groups of stakeholders do not trust other stakeholders, they will withdraw from the organisation and go elsewhere. The level of trust within an organisation is often indicated by the size of the organisation: the bigger the organisation the more the stakeholders are willing to trust that the board has the right balance of interests. Paradoxically, while big organisations imply trust, so the bigger the organisation becomes the harder the task of governance becomes.

Concluding thought
There is a tension at the heart of all organisations: the better they perform the bigger they are likely to become; but the bigger they become the harder it is to perform well. This tension between growth in scale based on trust and the difficulty of preserving trust at large scale, is one reason why all organisations eventually go into decline. Even the Dutch East India Company was closed down, albeit after 198 years. This is why, despite the growth of some very large organisations, we have not seen the evolution of a company that is big enough to dominate the whole economy.

Indeed, one lesson that economists who study organisations could teach political philosophers who study states, is that the more government is trusted the more it will be able to do; but the more it does the less likely it is to be trusted. The inherent problems of good governance suggest that we will not end up with one global company and that we will not end up with one global government.

End notes

1 Aristotle, The Politics, Book I, Chapter III.

2 Herodotus, The Histories, Book VII, Lines 184-186.

3 Ronald Coase, "The Nature of the Firm", in The Firm, the Market and the Law, University of Chicago Press, 1988.

4 Larry Neal, "Venture Shares of the Dutch East India Company", in William N Goetzmann & K Geert Rouwenhorst {eds.}, The Origins of Value: The Financial Innovations that Created Modern Capital Markets, Oxford University Press, 2005.

5 Kenneth Hopper & William Hopper, The Puritan Gift, pp.82-89, I B Tauris, London, 2009.

6 For example, Ram Charan, Dennis Carey & Michael Useem, Boards That Lead, Harvard Business Review Press, Boston Mass, 2014.

7 Kenneth Arrow, The Limits of Organization, WW Norton & Co, New York, 1974

© Mark Hannam January 2015