The Shareholder Value and Stakeholder Models
of Corporate Governance Compared
Nancy Edwards
s1621246
MSc. International Business and Management
Abstract
Underlying any corporate governance regime is an accountability and control
arrangement that specifies the key actors in firm governance, their respective roles in the firm and the goals associated with these roles. These roles are institutionally scripted and, as such, reflect the institutional context of the governance regime. In the study of
1 Introduction... 5
2 An Overview of Corporate Crime and the Fraud Environment... 6
3 Research Methodology ... 11
4 Literature Review and Theoretical Background ... 12
4.1 Corporate Governance: An Institutional Perspective ... 12
4.2 Models of Corporate Governance: The Shareholder Value Model ... 14
4.2.1 Executive Accountability... 17
4.2.2 Internal Control: The Board of Directors... 19
4.2.3 External Control: The Market... 20
4.3 Models of Corporate Governance: The Stakeholder Model ... 23
4.3.1 Executive Accountability... 24
4.3.2 Internal Control: The Supervisory Board ... 27
4.3.2.1 The Representation of Capital on the Supervisory Board: Ownership Structure and the Special Role of Banks... 28
4.3.2.2 Labor ... 29
4.3.2.3 The Effects of Ownership on Control: An Illustrative Example ... 30
4.3.3 External Control: The Market? ... 31
5 Corporate Governance and the Fraud Environment ... 32
5.1 Role Conflict, Goal Conflict and the Fraud Environment ... 34
5.2 Roles and Goals as Institutionally-scripted Constructs ... 35
5.3 Role Ambiguity, Goal Ambiguity and the Fraud Environment... 38
6 Case Studies ... 39
6.1 Volkswagen Case Study ... 39
6.1.1 History of the Firm and Business Objectives ... 39
6.1.2 Volkswagen within the Institutional Context ... 40
6.1.3 Firm Objectives, Labor and Corporate Governance ... 41
6.1.4 Volkswagen in Institutional Transition... 44
6.1.4.1 The Four-day Week - 1993 ... 46
6.1.4.2 Temporary Jobs and the Two-Tier Wage System – 1997... 46
6.1.4.3 “Workholder Value” Initiative - Late 1990s... 47
6.1.4.4 5000 x 5000 Project – 2001 ... 48
6.1.4.5 Marathon Negotiations – 2004... 48
6.1.5 The Scandal... 50
6.1.6 Analysis of Governance Actors in the Scandal... 51
6.1.6.1 Management... 51
6.1.6.1.1 Peter Hartz ... 51
6.1.6.2 Labor ... 52
6.1.6.2.1 Klaus Volkert ... 52
6.1.7 Within-case Analysis ... 53
7 Enron Case Study... 55
7.1 History of the Firm and Business Objectives ... 55
7.2 Enron in an Institutional Context... 56
7.2.2 Gatekeeper: Arthur Andersen, Auditor... 58
7.3 The Scandal... 58
7.3.1 Financial Strategies and Special Purpose Entities ... 59
7.4 Analysis of Governance Actors in the Scandal... 61
7.4.1 Executives ... 61
7.4.1.1 Ken Lay, CEO and Chairman of the Board of Directors... 61
7.4.1.2 Andrew Fastow, CFO ... 62
7.4.2 Gatekeepers... 63
7.4.3 Board of Directors... 64
7.5 Within-case Analysis ... 64
8 Cross-case Analysis and Theory... 65
8.1 Propositions... 65
9 Analysis and Conclusions ... 67
9.1 The Shareholder Value Model ... 67
9.2 The Stakeholder Model... 70
10 Limitations of Current Study and Opportunities for Future Research... 72
10.1 Limitations ... 72
10.2 Opportunities for Future Research... 73
11 References... 75
12 Tables... 86
Table 1 The Governance Diamond ... 86
Table 2 The Shareholder Value Model: Accountability and Control ... 86
Table 3 Institutional Elements of the Shareholder Value Model... 87
Table 4 The Stakeholder Model: Accountability and Control... 88
Table 5 Institutional Elements of the Stakeholder Model ... 89
Table 6 The Fraud Diamond ... 90
Source: Wolfe and Hermanson, 2007 ... 90
Table 7 The Governance Fraud Diamond... 90
Table 8 Inter- and Intra-Individual Goal Conflict in the Agency Relationship... 91
Table 9 Theoretical Framework... 91
1 Introduction
The corporate scandals that shook the U.S. financial world between 2001 and 2004, beginning with Enron, and including such cases as WorldCom, Global
Crossing, and Tyco,have generated discussion amongst both academics and policy makers on the relative strengths and weaknesses of corporate governance as it is practiced in the US and the legitimacy of the shareholder value paradigm that underlies this system (Friedrichs, 2004). Some observers have alluded to inherent flaws in U.S. corporate governance, citing the lower incidence of comparable scandals occurring in Europe during this period. Implicit in this criticism of the US system is the view that the system most widely in practice in (Continental) Europe - the stakeholder model of corporate governance - is superior.1 However, such a view trivializes the large scandals that have occurred during this period, for example, in Italy, the Netherlands, and, most recently, Germany; all of which observe the stakeholder paradigm. Whatever the merits of the criticism of the US system, these scandals suggest that the stakeholder model, too, suffers from some weaknesses and is not immune to scrutiny. The aim of this paper, therefore, is to evaluate recent corporate scandals within the context of each paradigm of corporate governance, with the goal of determining the extent to which scandals are unique to the particular institutional (i.e., governance) context. Rather than focusing on specific symptoms of and possible policy remedies for particular types of scandals, I suggest that a more comprehensive review of the theoretical premises which underlie each system of governance be analyzed in order to identify their respective strengths and weaknesses. I argue for a conception of corporate scandal as a consequence of
institutional incongruities; namely, that scandals result from role and goal incongruities in agency relationships which confront actors in the governance regime. To this end, the two models of governance are evaluated within the “fraud diamond” framework used in assessing the essential elements observed in corporate scandals. Propositions are then formulated regarding the problems of role and goal conflict and ambiguity and the extent to which they contribute to the development of a “fraud environment” within the firm. A
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new framework is derived from this, from which elements of a “governance fraud diamond” is suggested. Germany and the US have been chosen due to both the recency and magnitude of the scandals that have occurred in each country, but also because each represents, respectively, the archetypal stakeholder model and shareholder value model of corporate governance (Aguilera and Jackson, 2003; 1991; Hall and Soskice, 2001; La Porta, Lopez-de-Silanes, Shleifer, and Vishny, 1998). The paper develops a new theoretical framework for describing and explaining corporate scandals based on
evidence from an analysis of two recent corporate scandals and from a unified application of theory fragments from the criminology, organization theory, and institutional
economics literature.
2 An Overview of Corporate Crime and the Fraud Environment
Corporate crime encompasses a broad range of criminal acts and perpetrators. For example, the legal conception of corporate crime covers fraud, including financial statement fraud or “earnings management”, embezzlement, bribery, money laundering and insider trading, to name but a few of the many acts it covers. Perpetrators are often employees of the firm, but can also be business partners, such as suppliers or customers, or even unknown third parties (as in the case of information theft or “cybercrime”). So-called “white collar” crime is a subset of corporate crime that is characterized by the high social status of the perpetrators; namely, the predominance of top executives who abuse their position of power and authority in committing criminal acts during the course of employment. As such, the position or function of an individual within the organization largely determines his or her ability to create or exploit an opportunity for fraud not available to others (Wolfe and Hermanson, 2007).
While the majority of corporate crimes are committed by lower level employees or managers, it is the minority of white collar crime cases that generates headlines and captures the attention of the public and politicians. It is likely that white collar crime attracts the most attention because these acts have the highest costs for the firm, both in absolute monetary terms and in damage to the firm’s reputation and its business
which they are held by the rest of society. Even the use of the word “scandal” to
characterize this category of corporate crime implies a breach of social norms and values that transcend “mere” lawbreaking.
Criminologists and others who are interested in studying corporate crime have developed a framework for assessing what is described as the “fraud environment”. This framework typically consists of either three (the “fraud triangle”) or, more recently, four (the “fraud diamond”) essential elements: Incentive; capability; opportunity; and, the ability to rationalize (Price Waterhouse Cooper’s Global Economic Crime Survey, 2005; Wolfe and Hermanson, 2007).
Insert Table 6 here
The first element, “incentive”, addresses the underlying factors that motivate an
individual (or group of individuals) to commit a crime. The second element, “capability”, is a very recent addition to the traditional “fraud triangle” of incentive opportunity and rationalization (Wolfe and Hermanson, 2007). This element extends the earlier view that corporate crime was largely a function of environmental or situational factors by
illuminating the importance of individual attributes. Furthermore, “capability” entails a number of executive attributes that are highly relevant to the study of corporate scandals and corporate governance, including: an individual’s position or function within the organization, which may enable him or her to create or exploit an opportunity for fraud not available to others; familiarity with the internal control system, with the ability to detect and exploit weaknesses in it; and, a strong sense of self-confidence and the ability to coerce others to commit or conceal fraud (Wolfe and Hermanson, 2007). The third element, “opportunity”, suggests that an individual perceives that an opportunity exists in which he or she can abuse his or her position of trust for personal gain and with a low perceived risk of getting caught (AICPA website). Whether or not the opportunity, in fact, actually exists is not particularly relevant. What is important is the perception of opportunity. Finally, the fourth element, the ability to “rationalize” fraud, addresses the way in which a perpetrator comes to terms with his or her criminal behavior
So far there exists a fragmented body of theory that can potentially explain individual elements of the fraud diamond. For example, a great deal of work has been done in the study of ethics on the relationship between individual attributes and behavior, as well as on the effects of group dynamics on individual behavior.
With regard to individual behavior, psychological attributes such as an individual’s level of moral development play an important role in influencing his or her ability to make moral judgments that lead to either ethical or unethical behavior (Trevino, 1986). However, the reward and punishment mechanisms utilized by the firm, such as the compensation structure or the credible threat of dismissal, also play an important role in influencing the attitudes and behaviors of employees. Laboratory studies conducted by Hegarty and Sims (1978) and Trevino, Sutton, and Woodman (1985) indicate that subjects confronted with the punishment of ethical behavior or the reward of unethical behavior were significantly more likely to make an unethical decision and that the most ethical behavior was achieved under the condition where unethical behavior was clearly punished (Trevino, 1986).
Complementary to the work on individual behavior is work in the field of group socio-psychology. With respect to corporate crime, certain group attributes such as
demographic homogeneity increase the probability that unethical behavior will occur. Homogeneity contributes to interpersonal attraction amongst executives, which in turn contributes to group cohesiveness (Daboub et al., 1995; Forbes and Milliken, 1999; Roberts, McNulty and Stiles, 2005). Cohesiveness can lead to positive outcomes, such as increased trust and improved decision making. However, it can also have negative
dysfunctional decisions. The term groupthink has been coined for this process that threatens effective group decision making” (Manz and Neck, 1995). Thirdly, it can contribute to the phenomena of “differential association,” in which a group of individuals redefine norms in such a way as to legitimize behavior that is clearly in conflict with prevailing social norms.
In short, these studies provide some insights into the element of capability, but fail to provide an adequate understanding of the remaining elements that create a fraud environment and induce unethical behavior.
Similarly, a body of literature has evolved that deals with the aspect of incentives and the propensity toward unethical or criminal behavior. A variety of antecedents to unethical behavior have been identified, including an adverse economic environment, industry norms, and the structure of executive compensation.
With respect to the economic environment, Daboub et al (1995) cite several studies that support a relationship between the environment and organizational illegality2. For example, they cite Staw & Szwajkowski (1975), who provide empirical evidence that links adversity in the economic environment to the propensity to engage in legally questionable activities (Daboub et al, 1995: 143). Simpson (1986) found a negative relationship between profitability and criminality in the special case of anti-trust violations. Finally, Baucus and Near (1991) found evidence that criminality is just as likely in a favorable as in an unfavorable environment, suggesting instead that the tendency toward criminality is more likely attributable to the level of dynamism in the firm’s economic environment.
Many of these authors also found that firms in certain industries are more likely than others to engage in illegal acts (Baucus & Near, 1991; Cressey, 1976; Simpson, 1986). Various explanation for this “industry effect” include: “industry culture”, such as shared norms, values, and beliefs, which influence managers to engage in wrongdoing (Baucus,
1990); organizational isomorphisms (DiMaggio and Powell, 1983), which suggests that firms within an industry learn to behave illegally through observation of and interaction with other firms in that industry (Daboub et al, 1995); and, industry structure (Baumol, 1991) and differential vulnerability to regulation, monitoring, and opportunity for wrongdoing (Daboub et al, 1995)3.
Recent corporate scandals in the US have focused the debate for corporate governance reform on the use of performance-based pay. In particular, many critics argue that the prevalence of stock options in executive compensation has created a perverse incentive for executives to manage earnings in order to boost share prices. Thus, the structure of compensation can contribute to the incidence of corporate illegal acts.
Similarly, Hill and Yablon (2001) studied the effects of performance based pay on managerial discretion over the timing and content of firm information disclosure; specifically, the authors sought to determine whether executives abuse managerial discretion over disclosure with the intent to manipulate stock prices around options grant and exercise dates. Their findings highlight the perverse outcome of stock options in performance-based compensation with respect to information disclosure:
We have seen that the rationale for managerial discretion over disclosure timing rests on the belief that managers, acting on the facts of the individual case, can resolve, or at least lessen, uncertainties and conflicts inherent in the disclosure rules. This rationale, however, presupposes in turn that managers will exercise their discretion over disclosure in the best interests of the corporation and the shareholder group… Performance-based pay now frequently makes this assumption false. These days, managers often have clear, personal, pecuniary reasons to favor certain types of disclosure at certain times. Accordingly, these managers can, and apparently frequently do, use their legal discretion over disclosure timing to increase the value of their performance-based pay.
Once again, these studies provide a number of important insights into the incentives and, in some cases, the rationalization, that motivate corporate crime that culminates in
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scandal, but fail to provide a comprehensive understanding of the remaining elements that create a fraud environment.
The goal of this paper is to develop a theoretical framework with which to account for all elements of the fraud diamond at once. Ideally, this theory should provide a
comprehensive and integrated explanation of corporate scandals. In particular, such a theory should provide better insight into the relationship between corporate governance and corporate scandal. Furthermore, it should clarify the extent to which corporate
scandals are unique to a particular governance (and therefore, institutional) context and, if so, how. In this respect, the theory should be generally applicable. The theoretical
framework developed here will draw on insights from institutional theory, organization theory and agency theory.
3 Research Methodology
As mentioned above, the goal of the paper is to develop a new theoretical framework with which to describe and explain the institutional antecedent conditions that contribute to the incidence of corporate scandal. As such, this study could be categorized
methodologically as “grounded theory” (Corbin and Strauss, 1990:5). Development of this theory has been based on publicly-available information gathered that relates to actual events; thus, a case study approach to theory-building is used (Eisenhardt, 1989).4 The information compiled from the case studies and the resulting analyses are qualitative rather than quantitative in nature. This can be attributed to the nature of the topic. To be sure, the nature of corporate wrongdoing that culminates in scandal is complex. It is the result of myriad decisions made by a number of different individuals spanning some length of time. Identifying the individuals involved, the decisions they made and the factors influencing those decisions is based largely on qualitative rather than quantitative information.
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Analysis of the cases will be undertaken with the goal of formulating generalizable theoretical propositions regarding the factors most likely to contribute to the creation of a fraud environment in the two corporate governance regimes under consideration here. This implies that the theory should apply at the institutional and firm levels. However, the acts that result in scandal are perpetrated by individuals who operate within firms and institutions. Thus, each case study involves multiple levels of analysis: the individual; the firm; and, the institutional (Eisenhardt, 1989; Yin, 1984).
The case studies presented here are based on detailed analysis of scandals at two firms: the Volkswagen AG (Germany) and Enron Corp. (USA). Data on the firms, the scandals, and the key individuals involved have been gathered from a variety of sources, including: print media and internet news sources; company documents; company websites;
government documents; and, academic literature.
Since the paper is primarily concerned with the determination of the institutional
antecedents of corporate scandals in general, and the role played by corporate governance (if any) in scandal, in particular, the paper focuses on particular institutional features (i.e., key actors in firm governance and scandal, actors’ role in the firm and agency
relationship with others, etc.) of corporate governance regimes that are thought to contribute to the creation of a fraud environment. These institutional features were identified during the course of the case study research and developed into a theoretical framework. The theoretical framework draws from existing theoretical material, which is presented in a literature review which precedes the case studies. Providing a review of the literature and the theoretical background before the vase studies is intended to afford the reader a better frame of reference for evaluating the results of the case studies that follow.
4 Literature Review and Theoretical Background 4.1 Corporate Governance: An Institutional Perspective
and controlled. The corporate governance structure specifies the distribution of rights and
responsibilities among different participants in the corporation, such as, the board,
managers, shareholders and other stakeholders, and spells out the rules and procedures
for making decisions on corporate affairs. By doing this, it also provides the structure through which the company objectives are set and the means of attaining those objectives and monitoring performance" (OECD, 1999: emphasis added). Thus, a corporate
governance regime is a normative construct that: is premised on a particular conception of the firm (in other words, what a firm ought to do), from which appropriate objectives for executives and other key actors are implicitly and explicitly derived; and, that establishes the key actors of the firm and their respective roles in firm governance.
In this sense, corporate governance can be viewed as an institution, as conceived of by North (1991), in that it is a humanly devised constraint that structures economic interactions and social interactions within the context of the firm. Furthermore,
institutions can be thought of as human contrivances used in attempting to create order and reduce uncertainty, which coincides with the monitoring and control functions that are central elements of any corporate governance regime. A key concept underlying corporate governance as an institution, therefore, is the notion of accountability
(Sternberg, 1999: 20). This is important in two ways. First, the rights and responsibilities established by corporate governance presuppose accountability and control arrangement in which certain individuals or groups are granted the authority to act on the behalf of others but are then accountable to those on behalf of whom they act. This is important with respect to corporate scandal for the simple reason that an effective system of
identification of the firm’s objective.5 The objective of the firm should provide a focus for setting performance goals as well as methods and metrics for performance evaluation. The shareholder value and stakeholder models of corporate governance seek to answer these questions in very different ways.
Insert Table 1 here
4.2 Models of Corporate Governance: The Shareholder Value Model
One perspective is offered by the shareholder value model of corporate governance. The cornerstone of the shareholder value model is the normative view of the firm as an economic entity that should be operated with the objectives of maximizing profits and firm value (Fiss and Zajac, 2004; Friedman, 1970; Jensen, 2001; Lantos, 2001; Sternberg, 2001) 6.
This view of the firm is premised on important assumptions about the ownership
structure of the firm and the objectives of the firm’s owners. Namely, it is presumed that ownership is widely dispersed among many minority shareholders;7,8 that these
5
Lantos (2001: 3) poses some fundamental questions, including: “Why do corporations exist? Should enterprises also be concerned with their social performance as well as economic results? ... Should economic performance be sacrificed for social performance? ... To whom do businesses owe
“responsibilities” (a.k.a. “duties” or “obligations)? … How can we measure social performance and thereby know when companies have fulfilled their societal obligations?”
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As Sternberg observes, “The specific objective that is unique to business, and that distinguishes business from everything else, is maximizing owner value over the long term by selling goods or services. Actual commercial enterprises, of course, often do much else: they collect taxes and support charities and constitute social environments. But it is only in virtue of maximizing long-term owner value that they can
be recognized as businesses. It is the objective of maximizing long-term value that differentiates a business from a village fête or a family, a government or a game, a profitable hobby or a commercially successful club” (39; emphasis added). This is consistent with Friedman’s (1970) earlier assertion that, “there is one and only one social responsibility of business–to use it resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud.”
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shareholders tend to be primarily interested in financial returns on their investment (Aguilera and Jackson, 2003); and, that these owners rely on the capital markets to express their views on management performance, due to collective action problems (i.e., they choose “exit” over “voice” (Aguilera and Jackson, 2003; Hill and Jones, 1992; Preston and Sapienza, 1990)). Thus, the view of the firm as an economic entity with profit and value maximization as its chief objectives follows from the characterization of owner-shareholders as being participants in the capital markets who are primarily
interested in the firm as an investment vehicle.
It also follows from such an ownership structure that owners hire professional managers to run the firm for them.9 This is generally attributed to the obvious impracticalities of the involvement of hundreds or thousands of minority owners in the day-to-day running of the firm. It also results from the fact that the average shareholder lacks the necessary knowledge and information that he or she would need to possess in order to effectively manage the firm himself or herself (consider that many minority shareholders in a given firm are also minority shareholders in several other firms). Regardless of the reasons, in so doing, owner-shareholders cede to managers considerable control rights over the allocation and uses of the firm’s resources (Bebchuk and Fried, 2003: 1; Hall and Jones, 1992; Schleifer and Vishny, 1997: 742).
From this view of the firm and the related assumptions regarding ownership and managerial characteristics, a model of governance has evolved that has its theoretical roots in both agency theory10 and in the seminal contributions on managerial behavior and firm ownership made by Berle and Means (1932).
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Although concentrated share holdings by families and individuals are more common than is often assumed, dispersed ownership is much more the rule than the exception amongst large publicly traded firms in the United States (Roe, 1993; Schleifer & Vishny 1997). According to Roe (1993), despite the recent trend toward concentration and institutionalization of firm ownership, the largest five shareholders rarely together control as much as 5% of a large firm's stock in the U.S. Therefore, ownership of publicly traded firms is, for the most part, widely dispersed among individual shareholders who rely on executives to manage the firm on their behalf.
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In simple terms, agency theory describes the relationship between two parties in which one party, the principal, engages another party, the agent, to act on his behalf (Hill and Jones, 1992; Jensen and Meckling, 1976). Thus, the agent is a fiduciary of the principal and is therefore obliged to act for the benefit of the principal and is subject to control by the principal. Although an agent’s specific authority is determined by the principal, in general the agent has the (legal) authority to bind the principal contractually with third parties (Whittington and Delaney, 2006). An agency relationship therefore delineates a clear accountability and control arrangement between the parties to the agency
agreement. Applying the logics of agency theory to the assumptions underlying the shareholder value model of the firm, the relationship between shareholders and
executives, respectively, can be viewed as a classic principal-agent relationship (Jensen and Meckling, 1976: 310). Combining these lines of reasoning, a shareholder value model of corporate governance has been formulated.
Implicitly underlying the perspective of firm governance as a principal-agent relationship between shareholders and management are two important assumptions: first, that the interests of principals and agents diverge (Hill and Jones, 1992); and, second, that the interests of shareholders are homogeneous. The application of agency theory, and these two assumptions, provides a framework which specifies: the key actors in the governance regime and their respective roles11; the accountability and control arrangements inherent in the agency relationship, whereby shareholders (principals) seek to deter opportunistic behavior by executives (agents); and, which performance goals and metrics for
performance evaluation are established.
Insert Table 2 here
(Freeman and Evan, 1990; Williamson, 1984), though with similar results (Donaldson and Preston, 1995: 78).
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4.2.1 Executive Accountability
As noted above, an important assumption underlying the application of agency theory to the governance of the firm is that the interests of shareholders and executives diverge. It is therefore important to first discuss who executives are, what motivates them, and where their interests lie.
Professional managers in the US and other Anglo-Saxon countries are often recruited from outside the firm based on their reputation from their proven performance and executive leadership at other firms (Aguilera and Jackson, 2003). External recruitment is viewed as allowing executives to execute decisions in an impersonal and professional manner, as they will generally have no strong personal relationships within the firm that might bias their views. This allows the executive, primarily the CEO, the latitude to act autonomously. It is often the case that decision-making is hierarchically structured, with top executives (especially the CEO) given broad scope of action, which further reinforces managerial autonomy (Aguilera and Jackson, 2003: 458). Thus, the CEO has a clear and powerful mandate to operate the firm using his or her own discretion, so long as it is consistent with the interests of the shareholders.
The power of the CEO is often not limited to operational discretion; rather, he or she may also wield considerable influence on the board of directors. In the U.S., for example, CEOs are typically very influential in the nomination and re-appointment of
non-executive directors to the board (Bebchuk and Fried, 2003: 3-4). And, in some instances, the CEO receives a dual mandate, as both the chief executive officer of the firm as well as the chairman of the board of directors, also known as “CEO duality” (Finkelstein and D’Aveni, 1994).
separation of ownership and control that arises in large firms in which professional managers hold a (negligibly) small ownership stake in the firm. It is expected that executives will use their discretion to exploit the firm for their own personal benefits, at the expense of shareholder-owners (Preston and Sapienza, 1990: 365). Hill and Jones (1992) elaborate further on this line of reasoning by postulating that shareholders and executives have differing utility functions (137). While shareholders, on the one hand, are wealth maximizers whose utility can best be realized by maximizing the efficiency of the firm, executives, on the other hand, “maximize a utility function that includes
remuneration, power, job security, and status” which “requires increasing the size of the firm (remuneration, power, job security, and status are argued to be a function of firm size)” (Hill and Jones, 1992: 137). Thus, empire building, entrenchment, the extraction of excessive non-pecuniary benefits (e.g., perquisites) and the misappropriation or even expropriation of assets are included among the personal benefits that can induce
managers to act contrary to the best interests of shareholders. Corporate governance seeks to minimize these problems by providing incentives to managers that align their behavior with the interests of shareholders, while at the same time utilizing mechanism to monitor and control management behavior (Conyon and Schwalbach, 2000; Schleifer and Vishny, 1997).
(Bebchuk and Fried, 2003: 1). Stock options feature prominently in such performance-based compensation plans (Bebchuck and Fried, 2003; Bebchuck and Grinstein, 2005; Coffee, 2004). As such, the shareholder model establishes a clear financial goal that guides management decisions and is, in itself, the metric with which to evaluate executive performance: firm value maximization (Jensen, 2001)12.
In addition to incentives, such as performance-based pay, other monitoring and control mechanisms may be employed with which to check the accountability of executives to shareholders. While the board of directors is the most important monitoring mechanism, a variety of market-based institutions are among the most influential in disciplining
managerial behavior (Hill and Jones, 1992: 132). 4.2.2 Internal Control: The Board of Directors
The board of directors serves as the conduit through which shareholders attempt to monitor and control the actions of executives.13 In the U.S. and other countries where the shareholder value model of corporate governance prevails, firms typically have a unitary board structure, comprised of executive directors (from the ranks of the firm’s top
executives) and non-executive members, who are, ideally, recruited from outside the firm in order to ensure independence.14 The function of the board is to monitor and control the decisions of executives to ensure that they are behaving in a manner consistent with the best interests of shareholders (Finkelstein and D’Aveni, 1994). The board pursues its monitoring and control mandate through structural arrangements, such as the design of
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As mentioned earlier, implicit in this line of reasoning is the premise that shareholders are a largely homogeneous group, insofar as they share a single, common interest (maximizing the return on their investment) and common view of the firm’s objective (maximizing profits). This is a key difference between the shareholder value and stakeholder models, the latter of which is premised on the assumption of multiple and often diverging (stakeholder) interests.
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An alternative means by which shareholders can express their views on executive performance is through the market: by either selling the shares they hold (“exit”) or by purchasing more shares (Aguilera and Jackson, 2003: 451).
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executive compensation plans, and through procedural arrangements, such as the hiring and firing of CEOs (Walsh and Seward, 1990; 427).
4.2.3 External Control: The Market
During the past two decades, a number of external actors and mechanisms in the governance constellation have emerged which monitor executive behavior and exert control when executives fail to satisfy shareholder expectations. Chief among these mechanisms are: the capital markets (i.e., the market for corporate control) and so-called “reputational intermediaries” or “gatekeepers,” such as the external auditor, financial analysts, investment bankers and the like (Coffee, 2004).
The shareholder value model of governance is a surprisingly recent development in the U.S. Prior to 1980, the governance of firms was much more similar to the stakeholder model, which is described in much greater detail in subsequent sections of the paper:
Before 1980, corporate managements tended to think of themselves as
representing not the shareholders, but rather “the corporation.” In this view, the goal of the firm was not to maximize shareholder wealth, but to ensure the growth (or at least the stability) of the enterprise by “balancing” the claims of all
important corporate “stakeholders”— employees, suppliers, and local communities, as well as shareholders. (Holstrom and Kaplan, 2003: 10)
A paradigm shift in firm capitalization brought about by the restructurings, conglomerate bust-ups, and leveraged buy-outs of the 1980’s, accompanied by the increasing
importance of institutional shareholders, illuminated the power of markets in disciplining poor or underperforming management (Holstrom and Kaplan, 2003: 11; Jensen, 1993: 869, 871; Manne, 1965). The active market for corporate control of chronically
underperforming firms was intended to correct the managerial “failures” of the past, such as shirking, empire building and entrenchment (Schleifer and Vishny, 1997). As
mentioned above, it also led to the notion of tying executive pay-for-performance to capital markets (Jensen, 1993: 871).
it was typically tied to accounting measures, such as sales growth or earnings per share rather than to shareholder value (Healy, 1985; Holmstrom and Kaplan, 2003). In line with the paradigm shift in firm capitalization, market-based performance pay has increasingly been viewed as an appropriate incentive with which to align the interests of managers and shareholders and thereby to motivate managers to work in earnest toward the goal of maximizing firm and shareholder value. The seemingly logical and widely accepted answer to this question has been the use of stock and stock option programs (Hall and Liebman, 1998: 654). It is consistent with the objectives of the firm, it aligns the interests of both shareholders and executives and it provides a clear goal for executives and at the same time a clear metric for the evaluation of executive performance, thus ensuring a transparent and consistent accountability and control arrangement between executives, the board and shareholders.
The shift toward a market-orientation of the firm has had an important impact on the accountability and control arrangements in firm governance by introducing a new set of actors who discipline management by performing an external monitoring and control function. Specifically, it has introduced what Coffee (2004) has described alternatively as “gatekeepers” or “reputational intermediaries”.
Coffee (2004) provides the following broad and narrow definitions of “gatekeeper”. Broadly conceptualized, “gatekeepers” are outside professionals (e.g., auditors, securities analysts, investment bankers and securities attorneys) who serve the board or investors by preparing, verifying, or certifying corporate disclosures to the securities markets (p. 9). A gatekeeper trades on his “reputational capital,” which lends credibility to the accuracy of the statements or representations that he either makes or verifies and that is accumulated by repeated transactions with a sufficiently large number of clients (p. 10). This leads to the narrow definition of gatekeeper as a reputational intermediary who provides
that they then sell to shareholders and other stakeholder groups (Hill and Jones, 1992: 140). Although this informational arbitrage is profitable for the gatekeeper, it is
nevertheless less costly for shareholders and thus allows them to economize on the costs of information gathering and analysis (140).
Gatekeepers play a role in both corporate governance regimes but certainly a greater role in economies that follow the shareholder value model of governance for several reasons. First, these economies tend to be primarily market-based, liberal economies, whereas the stakeholder model has been more closely associated with bank-centered, coordinated market economies in the comparative business systems literature (Aguilera and Jackson, 2003; Hall and Soskice, 2001; Vitols, 2004). The nature of the services provided by these professionals is generally more relevant where there are large and active securities markets. Secondly, since financial market participants rely primarily on the information dissemination provided by reputational intermediaries, they presumably play a key role in the market for corporate control, which is very active, for example, in the U.S. and other shareholder value regimes and virtually nonexistent in Germany and other stakeholder value regimes (Höpner, 2001; Höpner and Jackson, 2001). If internal controls fail, gatekeepers function as the external monitors, or monitors of last resort, and the market for external control depends on their information. Thirdly, the gatekeepers’ interests are more aligned with those of capital than other stakeholder groups, which is more relevant in a shareholder-oriented governance regime.
As the control mechanism of last resort, gatekeepers, and particularly the firm’s auditors, should possess qualities similar to those of the board. The role of the external auditor is to safeguard the interests of shareholders and the capital markets by attesting to the integrity of the financial statements provided by the firm’s executive management. As such, the competence and independence of the external auditor should represent a deterrent to fraud. The competence of the auditor should be ensured if the auditing firm meets the standards established by professional organizations who license and monitor
the firm; where the firm is a long-time client of the auditor and close personal ties have developed between firm executives and the partner who oversees the audit engagement; and, where the audit partner can engage the firm in other, more lucrative consulting services. Any of these circumstances can result in a breakdown of the control over management and provide opportunities for executives to engage in unethical behavior.
Insert Table 3 here
4.3 Models of Corporate Governance: The Stakeholder Model
The most serious challenger to the shareholder value paradigm is the stakeholder model of corporate governance (Jensen, 2001). The view of the firm on which the stakeholder model is based differs substantially from that of the shareholder value model.
Specifically, the stakeholder paradigm sees the firm as a “social institution whose purpose is to further the interests of the corporation itself, typically considered to be comprised of multiple stakeholders (e.g., shareholders, employees, creditors, customers, and the community/society in which the corporation resides)” (Fiss and Zajac, 2004). “According to … stakeholder theory, businesses exist not to serve the interests of their owners, but to benefit all their stakeholders” (Sternberg, 1999: 14). “In contrast to the grounding of value maximization in economics, stakeholder theory has its roots in sociology, organizational behavior, the politics of special interests and, […], managerial self-interest.” Jensen (2001: 7-8). The theory has gained in popularity and has received the formal endorsement of many professional organizations, special interest groups, and governmental bodies, including the British government. (Donaldson and Preston, 1995: 65; Jensen, 2001: 2-3). As a serious challenger to the shareholder value model, the stakeholder model provides an alternative perspective on the objectives of the firm, the role of executives and the purpose and function of corporate governance.15
15
Insert Table 4 here
4.3.1 Executive Accountability
As with the shareholder value model, agency theory has been used to characterize the relationships that bind the key actors in stakeholder firm governance (Hill and Jones, 1992). In this agency model, managers act as agents on behalf of a potentially large and diverse number of stakeholder-principals whose interests are, at least in theory,
represented through the supervisory board. Here, shareholders are viewed as just one of many stakeholder groups and do not command any preferential treatment vis-à-vis other stakeholder groups in the terms of having their interests pursued by management
(Sternberg, 2001). “Stakeholder theory says that managers should make decisions that take account of the interests of all the stakeholders in a firm” (Jensen, 2001: 2). In this regard, the stakeholder model, like the shareholder value model, can also be characterized as a principal-agent relationship, but with one critical difference: executives are thought to be engaged implicitly and explicitly in an agency relationship with
multiple principals (Hill and Jones, 1992).
A frequently cited definition of stakeholder is provided by R. Edward Freeman (1984), who defined a stakeholder as, “any group or individual who can affect or is affected by the achievement of the organization’s objectives.” Thus, the stakeholder model is implicitly more flexible with respect to firm and stakeholder goals than the shareholder value model. This is because the stakeholder firm’s relevant stakeholders may change over time and, even if they remain the same, their goals might change. And since stakeholder goals determine the goals of the firm, these may also change over time.
obligations of executives to stakeholder groups other than the shareholders. Thus, the emphasis of the stakeholder model is on management’s accountability to all of the firm’s relevant stakeholders, who may have either complementary or competing interests.16
Characteristic of the stakeholder model, firms tend to follow a less hierarchical management structure, which underlies an egalitarian view of firm governance and emphasis on management by consensus (Aguilera and Jackson, 2003). Executives are expected to reach consensus among themselves and with major stakeholders, particularly employee representatives. As Aguilera and Jackson (2003) suggest, “the legal principle of collegiality in German boards gravitates against strong individual dominance to
principles of consensus that foster managerial commitment to organizational relationships and constituencies” (458). In this respect, a key element of job performance is the ability to reach consensus with others in the course of setting and executing the strategic agenda for the firm.
The emphasis on consensus and building relationships with firm constituents is in sharp contrast with the Anglo-Saxon practices fostering executive autonomy and the
hierarchical decision-making described earlier. These distinctions are further underscored by differing executive recruitment and pay practices.
Whereas external recruitment supported by competitive compensation packages are utilized to attract, retain and motivate executives in firms following the shareholder value model, stakeholder firms tend toward internal recruitment, with promotions based for example on seniority17 to motivate firm managers, with less emphasis on variable pay in
16
A further consideration, similar to that made in the shareholder value model, is that some principals may also be agents in another agency relationship. For example, an employee who is elected to the supervisory board has a fiduciary duty to represent the interests of other employees, as their agent,while also bearing in mind the interests of the firm and other stakeholders. This can obscure or at the very least complicate the accountability and control arrangements in the governance of the firm.
17
This is also a function of the degree of openness of the executive labor market and other institutional aspects of the educational and training systems of a particular country. However, Aguilera and Jackson (2003) implicitly associate these institutional attributes with a particular corporate governance regime. That is, shareholder value regimes tend to be associated with open executive labor markets and external
the form of bonuses and stock options (Aguilera and Jackson, 2003: 459). In Germany, for example, executives tend to take a functional or “productionist” approach to
management. Financial considerations are often eclipsed by concerns about technological innovation. Managers are inclined to disdain the demands of the stock market, which they consider fickle and short-sighted (Fiss and Zajac, 2004; Jürgens, et al., 2000). Similarly, executive compensation tends to be comparatively low (by U.S. standards) and the differential between executive pay and that of the average employee is also much lower, underscoring the greater value placed on social equity (Aguilera and Jackson, 2003; Conyon and Schwalbach, 2000)18. This also supports the argument made above that less emphasis is placed on the agency problem presumed in the shareholder value model and may also explain why the use of ownership (i.e., stock and stock options) is not utilized as a remedy to the agency problem.
Traditionally, high salaries and performance-based compensation plans in particular have been utilized to a much lesser extent as incentive mechanisms for executives in
stakeholder model firms for several reasons. First, top executives tend to be recruited from within the firm. This has been attributed to the “functional” orientation of executive management in such firms, which emphasizes accumulated experience in and knowledge of the various aspects of the firm gained during a long career tenure with the firm. Thus, the prospect of selection for a top executive position is, in itself, an incentive, because of the recognition by colleagues and the status within the firm (and the society) accruing to executives (Palazzo, 2002). Secondly, the inherently egalitarian nature of the stakeholder firm implicitly (and sometimes explicitly) militates against a large discrepancy in pay
closed executive labor markets and internal recruitment (e.g., as found in Germany and Japan). See Aguilera and Jackson (2003) pages 458-459.
18
between executives and the average worker. Thirdly, there tends to be a greater emphasis on conservative, long-term growth in stakeholder firms, which is often attributed to both the ownership structure and composition of owners and to the conservative financial views of other important stakeholders (e.g., creditors and employees). Finally, balancing the interests of stakeholders implies different firm objectives, some of which are not always consistent with traditional performance measures utilized in a shareholder value governed firm (e.g., maintaining the labor force, making contributions to the community, etc.). Thus, tying executive compensation to typical firm performance measures is essentially meaningless as an incentive. Consequently, status and recognition within the firm and the wider society provide the incentives for managers to work toward an appointment as a top executive in the stakeholder firm.
4.3.2 Internal Control: The Supervisory Board
As in the shareholder value model, the board of directors is chiefly responsible for performing the monitoring and control functions in the stakeholder firm. However, there are important structural and compositional differences that affect the fulfilling of these mandates. Chief among these differences are the dual board structure and the
representation of stakeholders other than shareholders on the board.
Unlike the unitary board, in which non-executive directors work alongside executive directors, the dual board structure makes a clear separation of the operational or executive management and the monitoring, or supervisory functions. In this system there is an executive board, which is comprised of top executives who are responsible for the operational management function, and a supervisory board, which has responsibility for monitoring the executive board and overseeing the strategic direction of the firm (Mallin, 2007: 122). The executive board is appointed by the supervisory board, while the
supervisory board is elected by shareholders and, in countries that provide for labor representation (most notably Germany), by employees.
An extreme or idealized conception of the supervisory board in a stakeholder firm has been offered by Dahl (1970), in which, he argues, “the board of directors might consist of third representatives elected by employees, third consumer representatives, one-third delegates of federal, state and local governments”.19 This would appear to be the best, most equitable and most logically consistent way to ensure that the interests of all relevant stakeholders are met. Nevertheless, though Dahl’s idealized board composition is more consistent with the theoretical arguments and normative assumptions underlying the stakeholder model, no such board exists to date.
4.3.2.1 The Representation of Capital on the Supervisory Board: Ownership Structure and the Special Role of Banks
Whereas the shareholder value model has gained favor in countries with market-based economies, in which firm ownership is widely dispersed among many minority
shareholders, the stakeholder model tends to be more prevalent in countries with a bank-centered economy, where equity markets are relatively less developed and ownership of firms is concentrated in majority blockholdings. Germany provides a good example of such a country.
German executives’ disdain for market pressures, mentioned above, can be viewed as a consequence of the comparatively low reliance on capital markets for financing. Indeed, Germany is typically characterized as a bank-centered economy in the comparative business systems literature (Heinze, 2003; Lane, 2003; Vitols, 2004). As this
characterization implies, companies have historically relied primarily on bank credit for external financing. Banks in turn have taken a “patient”, or long-term role in financing and an active role in advising the companies in which they are involved. Due to their involvement with many important industrial firms, they have also played a coordinating role amongst these firms. Banks are therefore perceived as taking a strategic rather than financial interest in the firms to which they lend. To the extent that companies have utilized equity, ownership has been largely concentrated in blockholdings.
Both banks as creditors and large shareholders are said to be more committed to the long-term interests of the firm, due at least in part to the relative illiquidity of their respective stakes in the firm, than are minority shareholders. Consistent with the normative
assumptions of strategic interests and commitment, they both exert control or “voice” over firm management through their influence on both the executive and supervisory boards. The long-term orientation and concentration of ownership associated with a strategic ownership in the firm implies a greater degree of commitment to the firm on the part of investors, which furthermore implies a greater degree of stability for other firm stakeholders. 20 Thus, banks and majority shareholders represent important constituencies in the German stakeholder firm (Höpner, 2001).
4.3.2.2 Labor
Although an infinitely long list of conceivable stakeholders could be made, if Freeman’s definition of stakeholder is applied, much of the literature on stakeholder management has focused on employees as the most salient stakeholder group for several reasons. Firstly, employees in some firms develop skills and knowledge that are quite specific to that particular firm. Thus they are said to have invested heavily in “transaction-specific assets” (Williamson, 1984) and therefore have an arguably larger stake in the firm than even shareholders (Gower, 1969 and Summers, 1982 cited in Williamson, 1984: 1199-1200). Secondly, some countries (most notably Germany) have provided a formal legal basis for employees as a stakeholder group (Aguilera and Jackson, 2003; Preston and Sapienza, 1990: 363). Finally, workers can organize and collectively exercise influence over management and owners by going on strike or engaging in work stoppages.
In Germany, the rights of employees, including employee representation at the board-level, are based in law and enjoy strong support from the government. Specifically, the German Codetermination Laws and Works Constitution Act provide workers with important rights vis-à-vis management and owners. German Codetermination Laws provide employees in larger firms seats (up to 50% in larger firms) on the supervisory
20
board and therefore with voice at the executive level. It is the spirit of the law that management and owners should view employees as “social partners” and not simply as economic factor inputs (Lane, 2000). Consequently, employees, as a stakeholder group, have a disproportionately large influence on management.
As the example of Germany illustrates, the accountability and control dynamics of a stakeholder firm depend on a number of institutional factors, including: which stakeholders are represented on the supervisory board; the relative diffusion or
concentration of power among stakeholder groups; how stakeholder groups exert their power vis-à-vis management and other stakeholders (on the board and beyond); and, how effective stakeholders are in exerting their power. Again, Germany provides a good example for purposes of analysis.
4.3.2.3 The Effects of Ownership on Control: An Illustrative Example As mentioned above, a concentrated ownership structure is more pervasive among German listed firms than is a widely held shareholder structure (Faccio and Lang, 2002). The two most important block holders are other firms and families (Franks and Mayer, 2001; Kaserer and Wenger, 2006). These block holders are very influential in the
for sales of blocks of shares are not accompanied by a turnover in executive board members, even in loss-making firms, suggesting that changes in control do not serve as a disciplinary mechanism for poorly performing executives. This implies that in German firms, the credible threat of dismissal as either a deterrent against unethical behavior or as an incentive toward ethical executive behavior is rather weak.
In their study of the effects of ownership on control in German firms, Franks and Mayer (2001) found that in firms where ownership is widely dispersed, significant control is exercised by banks as a consequence of the proxy voting arrangement whereby banks represent the shareholders whose shares are held on deposit at the bank. This also supported by the findings of Conyon and Schwalbach (2000). The influence of banks is especially reflected in their influence on the selection of supervisory board members, which has authority to appoint members of the management board and the responsibility to monitor this board. They found that “insiders”, defined as former members of the management board and bank-selected supervisory members, control nearly half of all widely held firms. This raises the issues of clubbing, groupthink and other perverse group dynamics, which have the effect of undermining the accountability and control
arrangement of firm governance.
4.3.3 External Control: The Market?
contrast with much of the literature on takeovers in U.S. and U.K. firms, where
management turnover subsequent to the takeover is quite high, thus resulting in a market for corporate control that disciplines poor management (Franks and Mayer, 1990, 1996; Martin and McConnell, 1991). This has important implications for management
incentives and board control, as it suggests that where internal controls fail (i.e., the supervisory board) unethical behavior could proceed undeterred.
Gatekeepers play a role in both U.S. and Germany corporate governance but certainly a greater role in the U.S. institutional setting for several reasons. First, the U.S. is a market-based economy, whereas Germany is a bank-centered economy (Lane, 2000; Vitols, 2004). The nature of the services provided by these professionals is generally more relevant where there is a large and active securities market. Secondly, since financial market participants rely primarily on the information dissemination provided by
gatekeepers, they presumably play a key role in the market for corporate control, which is very active in the U.S. and virtually nonexistent in Germany (Höpner, 2001 Höpner and Jackson, 2001). If internal controls fail, gatekeepers function as the external monitors, or monitors of last resort, of the firm and the market for external control depends on their information. Thirdly, the gatekeepers’ interests are more aligned with those of capital than other stakeholder groups, which is more relevant in a shareholder oriented governance regime.
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5 Corporate Governance and the Fraud Environment
George and Jones (2002) define a role as, “a set of behaviors or tasks a person is expected to perform because of the position he or she holds in a group or organization” (295). The roles of the key actors in a given corporate governance regime are arguably, to a large extent, institutionally determined.21 This is consistent with the normative
perspective of the corporate governance regime (and the firm itself, for that matter) as an institution to be understood within the broader context of a larger institutional framework (i.e., a particular society). As such, behavior is guided by a specific set of expectations attributed to an actor’s particular role in the firm (Scott, 1995: 37-40). March and Olsen (1989: 23) emphasize the influence of social rules and obligations in scripting
interactions among actors: “To describe behavior as driven by rules is to see action as a matching of a situation to the demands of a position. Rules define relationships among roles in terms of what an incumbent of one role owes to incumbents of other roles.” In the context of corporate governance, roles and goals have been defined in terms of are
institutionally-scripted agency relationships. Thus, the role of the agent-executives is to act as a fiduciary on behalf of stakeholder-principals. The goal associated with this role is therefore to fulfill this fiduciary duty by acting in the best interest of principals. How agents fulfill their duty and how this duty is defined and evaluated by principals are institutionally-scripted.
21
According to Scott (2001: 38), “the normative approach to institutions emphasizes how values and normative frameworks structure choices. Rational action is always grounded in social context that specifies appropriate means to particular ends; action acquires its very reasonableness in terms of these social rules and guidelines for behavior”. Also, norms define legitimate means to pursue valued ends and are morally governed (Scott, 2001: 37). Indeed, while some values and norms apply to all members of a society, others apply only to a specific subset. These special values and norms are referred to as roles and are defined by normative theorists as, “conceptions of appropriate action for particular individuals or specified social positions” (Scott, 2001: 38). Other scholars of Institutionalism define roles as institutionally constructed
As discussed earlier, each corporate governance regime has a distinctive and seemingly consistent schema by which key actors and agency relationships are identified. However, a closer analysis of each schema reveals some problems; namely, that of role conflict and goal conflict on the one hand, and role ambiguity and goal ambiguity on the other hand. These problematic elements, it will be argued, contribute significantly to the creation of a fraud environment in firms following these models of governance.
5.1 Role Conflict, Goal Conflict and the Fraud Environment
The first problem that can be identified is that of “role conflict”. “Role conflict occurs when expected behaviors or tasks are at odds with each other” (George and Jones, 2002). In other words, pressure is exerted upon an individual to either take incompatible actions or achieve incompatible goals (Locke et al, 1994). According to Rizzo, House and Lirtzman (1970), the principles of “chain of command” and “unity of command” offered by classical organization theory provide insights into role conflict in complex
can also be appropriately applied to executives, directors and other actors in the firm governance regime.
The corollary to role conflict proposed here is the problem of goal conflict. As Locke et al (1994) observe, “although role conflict and goal conflict are not identical, they are closely related (69). I suggest that, at least in the governance context, goal conflict is often a consequence of role conflict. This is due to the fact that a particular goal is associated with a particular role and that these associations are institutionally
embedded.22 Therefore, where roles conflict, it may well follow that the related goals are also in conflict.
Insert Table 7 here
5.2 Roles and Goals as Institutionally-scripted Constructs
As discussed earlier, the application of agency theory to models of corporate governance presupposes a conflict of goals between executives as agents, on the one hand, and shareholders and/or stakeholders as principals, on the other hand. Indeed, the problem of conflicting interests among parties to the agency relationship has been dealt with
explicitly and extensively by scholars (Eisenhardt, 1989). If roles and goals in firm governance are defined by agency relationships, then this implies that role and goal conflict are intrinsic elements of both governance regimes. Where multiple agency relationships are present (i.e., executives have agency relationships with multiple stakeholders), goal conflicts will also arise where the various stakeholder goals are incompatible.
The conflict most frequently addressed in discussions of the agency relationship is the inter-individual goal conflict between executives and shareholders (or stakeholders). What has been neglected, however, is a more thoughtful consideration of intra-individual goal conflict (Locke et al, 1994). In the consideration of corporate scandals and the corporate fraud environment, both inter- and intra-individual goal conflict problems are salient.
Insert Table 8 here
Intra-individual goal conflict may take different forms or may be the outcome of different circumstances. For example, conflict may result where the personal goals of the
individual may differ from the goals or tasks assigned to them. Another example of intra-individual goal conflict is the situation in which multiple or tasks are assigned to an individual, with no clear ranking with which the individual should prioritize
accomplishing the goals. Finally, conflict may arise even where only one goal is set, yet there is ambiguity over which dimension of performance should be prioritized in
accomplishing the goal (e.g., the dimensions of quantity versus quality).
Intra-individual goal conflict, in the context of the firm governance regime, most frequently arises where a single actor has multiple roles in the firm, either explicitly or implicitly, each with its own respective set of goals. In fact, many examples of such a situation are readily identifiable: stakeholders (e.g., employees, customers, suppliers, the government, etc.) as shareholders; creditors or shareholders as board members,
executives as shareholders and/or board members, and so on. Intra-individual goal conflict may be the result of external pressures brought to bear on the individual but may also be totally internal, as when a person wishes to achieve goals that are either partially or wholly incompatible (Locke et al, 1994: 69).
Where the CEO is concerned, intra-individual role and goal conflict jeopardizes the proper functioning of the control and accountability arrangement on which the
governance regime is based by undermining performance evaluation. On the control side, where there is no clear performance objective it becomes impossible to accurately and objectively measure, evaluate, reward or punish behavior. On the accountability side, an absence of a clear performance objective (or, conflicting performance objectives) opens the door for agents to pursue their own interests with a reduced chance of punishment (Becker, 1968; Jensen, 2001; Rizzo et al, 1970). Thus, role and goal conflict compromise the control and accountability arrangement of the governance regime and create
opportunity and incentives for executives to commit fraud.
Where stakeholders are engaged in conflicting agency relationships, and thus experience role conflict, a breakdown in accountability and control may also be expected. For example, a works council member may also be elected by employees to the supervisory board. In his capacity as a works council member, the representative has a fiduciary duty to advance the best interests of employees’ vis-à-vis management. However, as a member of the supervisory board, he must pursue the interests of employees and other
5.3 Role Ambiguity, Goal Ambiguity and the Fraud Environment
The second problem is that of role ambiguity. Role ambiguity describes, “the uncertainty that occurs when workers are not sure about what is expected of them and how they should perform their jobs” (George and Jones, 2002). The corollary to role ambiguity proposed here is the problem of goal ambiguity. As with role conflict and goal conflict, both the problems of role ambiguity and goal ambiguity need not be present
simultaneously, however goal ambiguity is likely to accompany role ambiguity. Thus, where roles are not clearly defined and delineated, it would be difficult to assign clearly specified goals.
Goals are central to the function of the accountability and control mechanism which underlies corporate governance. This is because the setting of performance goals and the subsequent evaluation of performance is the primary way by which this function can be realized.
As noted above, Cools and Praag (2003) emphasize the importance of performance goals and metrics of evaluation. Specifically they highlight the importance of setting a few, clearly quantifiable and measurable goals as a way to increase executive performance and accountability. Their findings echo the arguments posed by Jensen (2001), in which he argued for a single performance goal in his “accountability” thesis.
It is logically impossible to maximize in more than one dimension at the same time unless the dimensions are monotone transformations of one another, Thus, telling a manager to maximize current profits, market share, future growth in profits, and anything else one pleases will leave the manager with no way to make a reasoned decision. In effect it leaves the manager with no objective. The result will be confusion and lack of purpose that will fundamentally handicap the firm in its competition for survival.” Jensen (2001:10-11)
