The global crisis shows us that the issue of corporate governance is key for the economy’s well being. Personally, I have been involved for at least fifteen years in a heated debate with several Wall Street movers and shakers on this issue. It should be explained that, ironically, what we knew as “Wall Street” has ceased to exist, due, to a large extent, to problems related to corporate governance.
There are different models in the world that define the way companies are governed. The American model is not the only one, although some are unable to see beyond it.
The American Way
In the American Model, thanks to a system of short-term incentives, there are few long-term shareholders, and from this, to a large extent, flow all the other problems, and believe me, they are extensive.
In this model, the Board of Directors names its own members, who in turn name and ratify the main top executives (CEO, CFO, COO and all three-letter combinations that begin with “C” and end with “O”). Once the top executives and board members are named, it is very difficult to change them, because the shareholders are very atomized and rarely have a long-term interest in the company.
In this model, the shareholders quickly become irrelevant. They cannot even call a shareholders’ meeting without the backing of the Board. For this reason, the shareholders effectively lose control of the corporation.The Board of Directors acquires a life of its own and is easily controlled by its executive board, and neither of them takes the interest of the shareholders into account. In fact, there are terrible conflicts of interest within the folks who are listed in name as the owners of these companies.
Economists have not been able to resolve this question and have pompously called it the Principal-Agent Problem (it’s strange, but it seems that when economists cannot solve a problem they always opt for a grandiose name to make us believe that it is very complicated; perhaps this explains the amount of grandiose economic terms).
The Problem consists in the shareholders’ long-term interests being in conflict with the interests of the executives and the Board of Directors. The executives are those who make the daily decisions and, together with the Board, most of the strategic long-term decisions, with the aim of maximizing their annual bonuses and, perhaps, the short-term return on the company stock. Finally, the constant rotation of leadership posts is what ends up destroying the little value that can be created under such circumstances.
It occurred to someone that the solution was to create committees and to designate independent board members, but this often complicates the problem. The committees eliminate flexibility and leadership and many times risky decisions are not made. Meanwhile, the board members are often so independent and concerned with their own permanency and legal risks that they do not show an interest in the long-term future of the business. The closest parallel to this situation is a government agency, with considerable bureaucracy, politicking, and little accountability.
To understand the importance of the problem of American corporate governance, let’s just say that to a large extent it explains the current financial crisis. The bank executives took excessive risks without consulting the shareholders. The system was designed in a way that bank executives earn more money with increased risk. In fact, the system reached such a degree of absurdity that those who were not willing to take excessive risks on many occasions were fired for not meeting their “goals.”
This model worked very well for some, as long as the government encouraged cheap liquidity and lax supervision. This fed a time bomb that finally exploded, which we will all wind up paying for.
Meanwhile, and perhaps to distract attention and to make us believe that the government was doing its job, absurd laws were enacted such as the Sarbanes-Oxley Act, a reactive law that undermines the legal security of individuals while leaving unresolved fundamental questions of corporate governance. By the way, what is frankly ridiculous is that some financial authorities around the world (ours included) made the error of introducing similar legislation.
The excessive risks taken by banks directly affected shareholders’ capital, the publics deposits, and the taxpayers’ patrimony. If this is not a flaw in corporate governance, I dont know what is.
The Latin Model
There is another model, which we will call the Latin Model, in which the companies have a majority stockholder whose assets are totally tied to the future of the firm and under this premise, is involved in daily management and strategic corporate decisions. This is the predominant model in Latin America.
For many years, this model was aggressively criticized by Wall Street. The reason is that U.S. bankers were seeking major influence in the corporate decisions of Latin American companies, in exchange for a minimum investment. Above all, they were seeking quick profits that would justify their bonuses. This is the same system of incentives that led U.S. banks to bankruptcy.
The perfect model of corporate governance has still not been invented, but the Latin Model has many advantages: (1) majority stockholders remain on board and over time they acquire key experience that protects them from a short-term vision of the problems, (2) for this same reason, a controlling shareholder will never sacrifice the future of the company in exchange for short-term earnings; he or she will surely make errors, but (3) his or her batting average will be better than that of a CEO who tomorrow might be working for the competition, or enjoying the benefits of his or her Golden Parachute, which is nothing but a multimillion dollar prize for failure.
For these reasons, it is absurd to adopt the American Model in our laws. It’s only result is to increase the cost of managing companies, while they become hopelessly bureaucratized. If we wind up having a thief in the company management, not even the best corporate governance will resolve the problem.
Wall Street has wanted to make us think that the American Model is the only valid one, but this is not the case. Around the world there are different systems of corporate governance and in Latin America we should adopt the one that is best adjusted to our needs to maximize the long-term value of the company, not the one suited for those who take short-term speculative positions.
The global crisis is an opportunity for reflection. This should not be confused with following the impositions of those who have led the global economy into a crisis of enormous proportions.