Image: Eric Dan, boardroom at Roppongi Hills, via Flickr.

Understanding ethical behavior in the context of corporate governance requires two levels of analysis: the internal concerns of corporate agency and the emergent effects on social welfare.

Corporate agency is based on the premise that employees, managers, and directors (i.e., agents) should behave in the best interests of owners or shareholders (i.e., principals). Two things get in the way of that ideal:

First, managers’ interests, while overlapping with those of shareholders, are distinct. Sometimes agents can help themselves in ways that hurt the firm and its shareholders. Examples include shirking, waste and, in extreme cases, fraud or other self-serving actions that can bring down the company, as have happened in numerous business scandals.

Second, shareholders have neither the specific knowledge nor skills possessed by management. That can create a dynamic where even well-intentioned managers may feel compelled to “short-termism,” i.e., acting in ways that look good to shareholders now, but actually undermine value creation over time. Various oversight, transparency, and incentive mechanisms have evolved, and continue to develop, to contain agency costs.

Social welfare is based on the premise that companies should engage in fair dealing with all of their stakeholders—including customers, employees, suppliers, and communities, as well as shareholders—in accordance with the expectations of the larger society in which they operate. The debate about what is “fair dealing” reflects the larger, ongoing debate about the purpose of corporations in society, but even a shareholder-centric model recognizes that companies benefit from at least nurturing their reputations among all stakeholders, and that minimizing their negative externalities (pollution, plant closures, etc.) preserves the freedom of companies to operate with otherwise minimal external constraints.

While traditional corporations are expected to prioritize shareholder interests above those of other stakeholders and, to a considerable extent, attempt to maximize shareholder value within their legal constraints, other corporate forms permit a more balanced approach between shareholders and vendors (cooperatives) or between shareholders and specified other constituencies (B-corporations).

This page features research on the best ways to address agency problems, and on the evolving relationship between corporations and society.


Ideas to Apply

Areas of Research

Case Studies

Open Questions

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IDEAS TO APPLY (Based on research covered below)

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  • “Shareholder value” is an economic imperative. The business judgment rule allows boards and managers to easily get away with pet projects, the avoidance of difficult decisions, or the excuse that “as long as the music is playing (for our industry), we have to dance.” But every time a corporation gives up ground in the capital markets through value-compromising behavior, it comes one step closer to losing its viability as a stand-alone entity, and its ability to afford the maintenance of its stakeholder ecosystem. (It will be interesting to see if “B-corps” will be able to survive in the current capital markets, or if they will have to derive capital exclusively from endowments, as non-profits are supported, or if some hybrid capital/endowment market will evolve to accommodate them.)

  • The single most important job of the board is getting the right CEO. A close corollary is its willingness to get rid of the wrong CEO. Boards have to force themselves to do this work conscientiously because it can be personally uncomfortable, especially if the CEO does not want to spend time on it. Boards are also reluctant to force changes, since CEO transitions generally create a dip in the stock price; but if done it right, the company will quickly end up further ahead than where it would otherwise be.

  • External shareholders are inherently, significantly constrained regarding what they can know. These constraints make it easier for management and the board, and in fact make it compelling, to practice “short-termism,” e.g., via earning management. But companies have considerable leeway in choosing whether or not to play that game.

  • When it comes to executive compensation, “How” is much more important than “How much.” Incessant criticism of CEO pay has driven most boards to focus on compensation cost to the point of ignoring incentive effects. Overpaying the CEO could result in the waste of millions of dollars to a large company, and should be avoided. However, for a similarly sized company, the difference between mediocre incentives and good incentives can easily be worth hundreds of millions of dollars.

  • Good boards provide a balance of advisory support as well as monitoring oversight. Much of the corporate governance discussion for the last two decades has (appropriately) focused on the need for better monitoring, but research indicates the pendulum may have swung too far, with the advisory roles of boards getting short shrift. When these two roles come into conflict, as they invariably must, the board’s job is to resolve that conflict as best as possible in favor of shareholder interests.

  • Overconfidence and hindsight bias are enemies of effective governance. Companies benefit from constantly questioning what they are doing right and what they can do better, rather than assume that everything is fine when times are good, or that sweeping changes are necessary when times get rough. (It’s tough for a public company to avoid these reactions since these biases are at least as strong among the investor community.)


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  • How can agency costs be reduced? There is a great deal of research on some of the most common approaches, including enhancing oversight, reducing informational asymmetry and improving alignment:

    • Improving oversight via specified board structures appears to have mixed results. Bhagat and Black (2002) show no relationship between board independence and firm performance, meaning that what one gains via better monitoring may be lost in specific knowledge needed to provide quality input. One exception is not having your CEO on the audit or compensation committees, (Klein 2002) which is now required by law. Annual terms for all directors (as opposed groups of directors elected to overlapping multi-year terms) may also increase value (Bebchuk & Cohen 2005, Cohen & Wang 2013), and boards with “busy” directors, i.e., three or more board seats (Fich & Shivdasani 2006) or interlocking directors (evidence from multiple countries) should be avoided.

    • The governance indicator most convincingly associated with better performance is the degree to which insiders own stock—up to a point. McConnell and Servaes (1990) found a strong relationship between insider ownership and firm performance (confirmed in numerous later studies, most recently von Lilienfeld-Toal & Ruenzi 2014), with stronger results at higher inside ownership up to about 30 percent. High inside ownership works to both reduce the impact of asymmetrical information and to enhance alignment. Increased exposure to stock value via option grants also appears to enhance alignment and value creation (Hanlon et. al 2003). Furthermore, it does not appear that equity incentives are associated with accounting fraud, as was assumed during the accounting scandals following the tech bust (Erickson et. al 2006). Nor does it appear that stock options or high cash bonuses contributed to poor performance during the credit crisis (Fahlenbrach & Stulz 2011). However, select incentive compensation mechanisms that improve alignment of management and shareholders do appear to enhance value creation (Hodak 2005).

    • While the legal requirements and constraints on boards have been historically low via state regulation, they are rapidly increasing via federal regulation (Bainbridge 2012), with mixed results (Romano 2005, Larcker 2011). Disclosure can increase transparency, but while voluntary disclosure enhances firm value, mandatory disclosure may not (Leuz & Wysocki 2008).

  • Alternative business forms are being developed to accommodate a focus on particular non-shareholder stakeholders. While many people believe such initiatives should originate in government agencies or NGOs, some believe that these initiatives properly belong within for-profit corporations (Austin and Reficco 2009), while some believe that they require a corporate vehicle that looks beyond profit, such as the B-Corp (The Economist 2012).

  • How can corporate behavior advance social welfare not already reflected by the firm’s economic value creation?

    • Corporate social responsibility (CSR) or corporate social performance (CSP) has been significantly correlated with financial performance (Orlitzky et. al 2003), but not necessarily with shareholder value (Becchetti et. al 2009). Whether CSR or CSP are the result of, rather of a driver of, strong financial performance is subject of ongoing study. See our page on when Ethics Pays.

    • Stout (2012) suggests that shareholder value is neither the appropriate standard against which to judge the effectiveness of corporate behavior, nor the actual practice of corporations. She suggests that companies actually show a revealed preference for a broader stakeholder standard of good governance. Porter and Kramer (2011) similarly argue that a broader societal view of value creation is essential to future corporate growth.


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  • Nucor Corporation (A) (Govindarajan 1998) a classic discussion of how radical decentralization, employee empowerment, and value-creating incentives led to enormous value creation. (The lack of discussion about the board is useful, if not instructive, given how unPC this company was governed relative to the expectations of modern governance critics.)

  • Progressive Insurance: Disclosure Strategy (Hutton Weber 2001): How they won by not playing “the earnings game.” An excellent example of voluntary disclosure yielding a competitive advantage.

  • Conscious Capitalism (Mackey and Sisodia 2013) (public library): The compelling story of Whole Foods’ implementation of their stakeholder management framework.


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  • How are governance practices evolving around the world, particularly between common law and civil law countries? What is the impact of ESG initiatives on this evolution?

  • Given the shift toward greater board independence—to the point where the CEO is usually the only insider director—how can boards regain the specific knowledge lost by the elimination of inside directors without compromising their monitoring role, or risking conflicts of interest?

  • How can institutional investors effectively handle the increased monitoring being forced upon them by SEC rules, e.g., regarding Say-on-Pay? To the extent that institutions are outsourcing this monitoring, e.g., via ISS, is this dynamic helping governance? (This entails expanding the growing research into the effectiveness of various governance standards in improving shareholder value.)

  • To what extent are governance considerations (e.g., the effect of regulations like SOX) driving the long-term flight of assets from public companies to private equity? Is this shift good for investors or for society?


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  • Mackey, John and Rajendra Sisodia (2013), “Conscious Capitalism: Liberating the Heroic Spirit of Business,” Harvard Business Review Press. (public library)

  • Stephen M. Bainbridge (2012), Corporate Governance After the Financial Crisis, Oxford University Press. (public library)

  • Stout, Lynn (2012), “The Shareholder Value Myth,” Berrett-Koehler Publishers. (public library)

  • Robert Monks & Nell Minow (2011), Corporate Governance, John Wiley & Sons. (public library)

  • David Larcker & Brian Tayan (2011), Corporate Governance Matters: A Closer Look at Organizational Choices and Their Consequences, Pearson Prentice Hall. (public library)


Relevant Images and Videos

  • Marc Hodak points out some ethical problems:                                                       

  • Marc Hodak discusses creating a good ethical climate:                                           

  • Marc Hodak talks about some signals of ethical culture:                                         

  • Marc Hodak comments on ethical systems design:                                                  

  • Barry Schwartz brings a Aristotelian perspective, applicable to corporate governance:  

  • Bruce Buchanan in a panel discussion concerning the evolving relationship between manufacturing corporations in China and society: 

  • Warren Buffet on absurd CEO pay:                                                                          

  • Michael Porter rethinking capitalism:                                                                               

  • John Mackey discusses conscious capitalism:                                                          

  • In 2011, Peter Senge hosted a discussion suffused with ethical systems thinking relevant to corporate governance titled "Game ChangersBusiness and NGOs Co-Evolving to Foster Social, Ecological, and Economic Well-Being," with Paul Polman, CEO of Unilever, and Barbara Stocking, then CEO of Oxfam Great Britain.

  • See more corporate governance ethics videos covering issues like,  shareholders v. stakeholders, short-termism, executive compensation, B Corporations, "Chainsaw" Al Dunlap, social entrepreneurship, and more on our Corporate Governance playlist, at the Ethical Systems YouTube channel


This page is edited by Marc Hodak and Bruce Buchanan. Other researchers may have contributed content.
Miscellaneous Links & References 

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