Sumantra Ghoshal on Governance Theory and Practice
This paper, published just after Ghoshal died*, is one of the most important papers I have read on governance. Its attack on agency theory and the consequent obsession by board members with oversignt maserfully brings together work by Catherine Daily of the Kelley School of Business, Indiana University and colleagues and an earlier paper Ghoshal wrote with Peter Moran, “Bad For Practice: A Critique Of The Transaction Cost Theory”, Academy of Management Review, Vol. 21/1, p. 13, 35p (1996).
Daily and colleague’s work showed, through meta-analysis, that there was no correlation between firm performance and features of a company often mentioned as critical such as separation of the the roles of CEO and Board Chair. Jeffrey Sonnenfeld (see the same page) makes similar comments. To imagine that the arcane issue of Transaction Cost Theory, particularly one version of it, might be pivotal to how boards behave, must come as a shock to many.
The Crowdy Head Lighthouse, New South Wales (More)
Bad Management Theories Are Destroying Good Management Practices
This is the title of Sumantra Ghoshal’s paper in the Academy of Management Learning & Education Vol. 4/1, p 75-91 (2005). This is a series of extracts of that paper.
Business schools do not need to do a great deal more to help prevent future Enrons; they need only to stop doing a lot they currently do. They do not need to create new courses; they need to simply stop teaching some old ones. But, before doing any of this, we–as business school faculty–need to own up to our own role in creating Enrons. Our theories and ideas have done much to strengthen the management practices that we are all now so loudly condemning.In courses on corporate governance grounded in agency theory (Jensen & Meckling, 1976) we have taught our students that managers cannot be trusted to do their jobs–which, of course, is to maximize shareholder value–and that to overcome “agency problems,” managers’ interests and incentives must be aligned with those of the shareholders by, for example, making stock options a significant part of their pay. In courses on organization design, grounded in transaction cost economics, we have preached the need for tight monitoring and control of people to prevent “opportunistic behavior” (Williamson, 1975). In strategy courses, we have presented the “five forces” framework (Porter, 1980) to suggest that companies must compete not only with their competitors but also with their suppliers, customers, employees, and regulators.
“.. over the last 50 years business school research has increasingly adopted the “scientific” model–an approach that Hayek (1989) described as “the pretense of knowledge.” This pretense has demanded theorizing based on partialization of analysis, the exclusion of any role for human intentionality or choice, and the use of sharp assumptions and deductive reasoning”
Why then do we feel surprised by the fact that executives in Enron, Global Crossing, Tyco, and scores of other companies granted themselves excessive stock options, treated their employees very badly, and took their customers for a ride when they could? Besides, the criminal misconduct of managers in a few companies is really not the critical issue. Of far greater concern is the general delegitimization of companies as institutions and of management as a profession (The Economist, 25-31 October, 2003) caused, at least in part, by the adoption of these ideas as taken-for-granted elements of management practice.
As has been extensively documented in the literature over the last 50 years business school research has increasingly adopted the “scientific” model–an approach that Hayek (1989) described as “the pretense of knowledge.” This pretense has demanded theorizing based on partialization of analysis, the exclusion of any role for human intentionality or choice, and the use of sharp assumptions and deductive reasoning (Bailey & Ford, 1996). Since morality, or ethics, is inseparable from human intentionality, a precondition for making business studies a science has been the denial of any moral or ethical considerations in our theories and, therefore, in our prescriptions for management practice.
At the same time, a particular ideology has increasingly penetrated most of the disciplines in which management theories are rooted. Described by Milton Friedman (2002) as â€œliberalism,â€ this ideology is essentially grounded in a set of pessimistic assumptions about both individuals and institutionsâ€“a â€œgloomy visionâ€ (Hirschman, 1970) that views the primary purpose of social theory as one of solving the â€œnegative problemâ€ of restricting the social costs arising from human imperfections. Combined with the pretense of knowledge, this ideology has led management research increasingly in the direction of making excessive truth-claims based on partial analysis and both unrealistic and biased assumptions.
Why then do we feel surprised by the fact that executives in Enron, Global Crossing, Tyco, and scores of other companies granted themselves excessive stock options, treated their employees very badly, and took their customers for a ride when they could? Besides, the criminal misconduct of managers in a few companies is really not the critical issue. Of far greater concern is the general delegitimization of companies as institutions and of management as a profession (The Economist: 25-31 October, 2003) caused, at least in part, by the adoption of these ideas as taken-for-granted elements of management practice.
All of this would still not lead to any negative consequences for management practice but for the distinctive feature of double hermeneutic that characterizes the link between theory and practice in social domains. Unlike theories in the physical sciences, theories in the social sciences tend to be self-fulfilling (Gergen, 1973).â€¦ when managers, including CEOs, justify their actions by pleading powerlessness in the face of external forces, it is to the dehumanization of practice that they resort. When they claim that competition or capital markets are relentless in their demands, and that individual companies and managers have no scope for choices, it is on the strength of the false premise of determinism that they free themselves from any sense of moral or ethical responsibility for their actions.
Friedrich von Hayek dedicated his entire Nobel Memorial Lecture to the danger posed by scientific pretensions in the analysis of social phenomena. Speaking as an economist and acknowledging that â€œas a profession we have made a mess of things,â€ he placed the blame on â€œthe pretense of knowledge,â€ which is how he titled his talk (1989: 3-7). â€œIt seems to me that this failure of economists to guide public policy more successfully is clearly connected with their propensity to imitate as closely as possible the procedures of the brilliantly successful physical sciences,â€ said Hayek. Because of the very nature of social phenomena, which Hayek described as â€œphenomena of organized complexity,â€ the application of scientific methods to such phenomena â€œare often the most unscientific, and, beyond this, in these fields there are definite limits to what we can expect science to achieve.â€
As an example of how this pretense of science affects management practice, consider the dictum of Milton Friedman that few managers today can publicly question, that their job is to maximize shareholder value. Where did the enormous certainty that this assertion seems to carry come from?
After all, we know that shareholders do not own the company–not in the sense that they own their homes or their cars. They merely own a right to the residual cash flows of the company, which is not at all the same thing as owning the company. They have no ownership rights on the actual assets or businesses of the company, which are owned by the company itself, as a “legal person.” Indeed, it is this fundamental separation between ownership of stocks and ownership of the assets, resources, and the associated liabilities of a company that distinguishes public corporations from proprietorships or partnerships. The notion of actual ownership of the company is simply not compatible with the responsibility avoidance of “limited liability.”
We also know that the value a company creates is produced through a combination of resources contributed by different constituencies: Employees, including managers, contribute their human capital, for example, while shareholders contribute financial capital. If the value creation is achieved by combining the resources of both employees and shareholders, why should the value distribution favor only the latter? Why must the mainstream of our theory be premised on maximizing the returns to just one of these various contributors
The answer–the only answer that is really valid–is that this assumption helps in structuring and solving nice mathematical models. Casting shareholders in the role of “principals” who are equivalent to owners or proprietors, and managers as “agents” who are self-centered and are only interested in using company resources to their own advantage is justified simply because, with this assumption, the elegant mathematics of principal-agent models can be applied to the enormously complex economic, social, and moral issues related to the governance of giant public corporations that have such enormous influence on the lives of thousands–often millions–of people.
But then, to make the model yield a solution, some more assumptions have to be made. So, the theory assumes that labor markets are perfectly efficient–in other words, the wages of every employee fully represent the value of his or her contributions to the company and, if they didn’t, the employee could immediately and costlessly move to another job. With this assumption, the shareholders can be assumed as carrying the greater risk, thus making their contribution of capital more important than the contribution of human capital provided by managers and other employees and, therefore, it is their returns that must be maximized (Jensen & Meckling, 1976).
The truth is, of course, exactly the opposite. Most shareholders can sell their stocks far more easily than most employees can find another job. In every substantive sense, employees of a company carry more risks than do the shareholders. Also, their contributions of knowledge, skills, and entrepreneurship are typically more important than the contributions of capital by shareholders, a pure commodity that is perhaps in excess supply (Quinn, 1992). As Grossman and Hart (1986) showed, once we admit incomplete contracts, residual rights of control are optimally held by the party whose investments matter more in terms of creating value. If these truths are acknowledged, there can be no basis for asserting the principle of shareholder value maximization. There just aren’t any supporting arguments.
Once again, Milton Friedman (1953) has provided a compelling counterargument: Don’t worry if the assumptions of our theories do not reflect reality; what matters is that these theories can accurately predict the outcomes. The theories are valid because of their explanatory and predictive power, irrespective of how absurd the assumptions may look from the perspective of common sense.
What is interesting is that agency theory, which underlies the entire intellectual edifice in support of shareholder value maximization, has little explanatory or predictive power. Its solution to the agency model yields some relatively straightforward prescriptions: Expand the number and influence of independent directors on corporate boards so that they can effectively police management; split the roles of the chairman of the board and the chief executive officer so as to reduce the power of the latter; create markets for corporate control, that is, for hostile takeovers, so that raiders can get rid of wasteful managers; and pay managers in stock options to ensure that they relentlessly pursue the interests of the shareholders. The facts are that none of these factors have the predicted effects on corporate performance.
Why do we not fundamentally rethink the corporate governance issue? Why don’t we actually acknowledge in our theories that companies survive and prosper when they simultaneously pay attention to the interests of customers, employees, shareholders, and perhaps even the communities in which they operate? Such a perspective is available, in stewardship theory for example (Davis, Schoorman, & Donaldson, 1997); why then do we so overwhelmingly adopt the agency model in our research on corporate governance, ignoring this much more sensible proposition?
The honest answer is because such a perspective cannot be elegantly modeled–the math does not exist.
Consider, for example, the assumptions regarding human nature. As Herbert Simon observed, “Nothing is more fundamental in setting our research agenda and informing our research methods than our view of the nature of human beings whose behaviours we are studying…It makes a difference to research, but it also makes a difference for the proper design of…institutions” (1985: 293).
As Amartya Sen notes, “in acknowledging the possibility of prudential explanation of apparently moral conduct, we should not fall into the trap of presuming that the assumption of pure self-interest is, in any sense, more elementary than assuming other values. Moral or social concerns can be just as basic or elementary” (1998: xii). James Q. Wilson (1993) goes even further: “On balance, I think other-regarding features of human nature outweigh the self-regarding ones.”
The outcome of these negative feelings of both managers and employees is a pathological spiraling relationship, which has been described by psychologists Michael Enzle and Samuel Anderson (1993) as follows:
Surveillants come to distrust their targets as a result of their own surveillance and targets in fact become unmotivated and untrustworthy. The target is now demonstrably untrustworthy and requires more intensive surveillance, and the increased surveillance further damages the target. Trust and trustworthiness both deteriorate.
Combine agency theory with transaction costs economics, add in standard versions of game theory and negotiation analysis, and the picture of the manager that emerges is one that is now very familiar in practice: the ruthlessly hard-driving, strictly top-down, command-and-control focused, shareholder-value-obsessed, win-at-any-cost business leader of which Scott Paper’s “Chainsaw” Al Dunlap and Tyco’s Dennis Kozlowski are only the most extreme examples. This is what Isaiah Berlin implied when he wrote about absurdities in theory leading to dehumanization of practice.
The role I see business school governors play is more one of stewardship–involved, supporting, and challenging rather than detached and controlling. As senior representatives of the external (and, sometimes, internal) communities business schools serve, they can forcefully bring in different perspectives and external information into the highly insular world of business school faculty.
Excessive truth-claims based on extreme assumptions and partial analysis of complex phenomena can be bad even when they are not altogether wrong. In essence, social scientists carry an even greater social and moral responsibility than those who work in the physical sciences because, if they hide ideology in the pretense of science, they can cause much more harm.
For most business schools, the governing board–by whatever name–represents perhaps the worst caricature of ineffective corporate boards. Most members are irregular in their attendance; those who attend tend to see the board meetings as essentially social occasions. The actual realities of the school are rarely revealed in the board meetings. The agenda typically focuses on fund-raising, external relations, or on vacuous vision statements and the like.
Perhaps business school governors need to get more involved in ensuring that the external rhetoric of the institutions are actually reflected in their internal decisions and choices. This does not mean that the governors should set the research or teaching agenda for individual faculty or departments nor that they should have a direct influence on academic recruitment or promotion processes. I am not suggesting that they play the policing role that agency theory reserves for members of corporate boards. The role I see business school governors play is more one of stewardship–involved, supporting, and challenging rather than detached and controlling. As senior representatives of the external (and, sometimes, internal) communities business schools serve, they can forcefully bring in different perspectives and external information into the highly insular world of business school faculty. Given the extremely limited influence of students, staff, and other groups directly connected with business schools, it is only the governors who may have the legitimacy and power to challenge the dominant dogma with disconfirming information and perspective, and thereby to strengthen the hands of the deans.