Corporate Governance: Conflicts of Interest, Financialization, and Accountability

Legal Separation and Conflicts of Interest

The vast bulk of economic activity today involves business corporations. Corporations are abstract legal entities that combine legal rights and obligations with a significant degree of flexibility.

The  legal  separation  between  corporations  and  their  stakeholders,  including shareholders, has been important to the success of the corporate form in organizing long-term, large-scale production, while limited liability and the tradability of shares help corporations 
acquire funds from a broad set of investors.  

However, this legal separation exacerbates conflicts of interest between those who control corporations and others, including shareholders, creditors, employees, suppliers, customers, public authorities, and the general public.

In large corporations, stakeholders vary enormously in the information and degree of control they have on corporate actions.

Contracts and markets do  not  generally  create  efficient  outcomes  if  markets  are  not  competitive,  contracts  are incomplete or costly to enforce, or if corporate actions create negative externalities for those with little information or control.

Laws and regulations can help alleviate these frictions, but their design and enforcement are also costly and subject to information and control frictions. 

In recent decades, much emphasis has been placed on aligning the interests of managers and shareholders. Managerial compensation typically relies on financial yardsticks such as profits, stock prices, and return on equity to achieve such alignment.

This development has been part of a broader trend referred to as “financialization,” whereby the financial sector and financial  activities  grow  in  prominence  within  the  economy,  and  financial  markets  and measures increasingly guide economic activity.  

Financialized governance may not actually work well for most shareholders. Even when financialized governance benefits shareholders, significant tradeoffs and inefficiencies can arise from the conflict between maximizing financialized measures and society’s broader interest.

For example, financialized governance provides incentives for slanted presentations of accounting data and even outright accounting fraud. Misconduct, fraud or law evasion directed at other stakeholders such as customers and governments may benefit shareholders, but they may ultimately have to bear legal expenses, large fines, and loss of reputation. 

2 mismanagement  of  risk,  whose  upside  benefits  those  controlling  corporations  while  the downside harms others, including shareholders and the broader economy.  

Effective governance requires that those in control are accountable for actions they take. 

However, those who control and benefit most from corporations’ success are often able to avoid accountability.

In cases such as corporate fraud or excessive endangerment in which the public is insufficiently aware of the potential conflicts, governments may fail to design and enforce the best rules because of the incentives of individuals within governments and their own lack 
of accountability.  

The important real-world issues around corporate governance do not fit neatly into most common economic frameworks and models. The history of corporate governance includes a parade of scandals and crises that have caused significant harm. Although each episode has its 
unique elements, fraud, deception or other forms of misconduct by individuals in corporations and in governments have often played a key role.

Economists, as well, may react to corporate scandals and crises with their own version of “we just didn’t know,” as their models had ruled out certain possibilities.

They may interpret events as benign, arising from exogenous forces out of anybody’s control, or try to fit the observations into alternative models. However, new models often still ignore highly relevant issues  around  incentives,  governance,  enforcement,  and  accountability.

Economists  may presume that observed reality is unchangeable or efficient under a set of frictions while leaving out other frictions and ways to address them through changes in governance practices or policy.

 
Effective  governance  of  institutions  in  the  private  and  public  sectors  should  make  it impossible for individuals in these institutions to get away with claiming that harm was out of their control when in reality they had encouraged or enabled harmful misconduct and could have and should have taken action to prevent it.