DATE: 01/15/08
Professor David F. Larcker and Brian Tayan prepared this case as the basis for class discussion rather than to
illustrate either effective or ineffective handling of an administrative situation.
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In 2007, corporate governance became a well-discussed topic in the business press. Newspapers
produced detailed accounts of corporate fraud, accounting scandals, excessive compensation, and
other perceived organizational failures—many of which culminated in lawsuits, resignations, and
bankruptcy. The stories ran the gamut from the shocking and instructive (epitomized by Enron
and the elaborate use of special purpose entities and aggressive accounting to distort its financial
condition in 2001) to the shocking and outrageous (epitomized by Tyco partially funding a $2.1
million birthday party in 2002 for the wife of CEO Dennis Kozlowski, which included a vodkadispensing replica of the statue David). Central to these stories was the assumption that
somehow corporate governance was to blame. That is, there was a functional failure in the
system of checks and balances established to prevent abuse by executives.
The need for a governance system is based on the assumption that the separation between the
owners of a company and its management provides self-interested executives the opportunity to
take actions that benefit themselves, with the cost of these actions borne by the owners.1
Economists refer to such a situation as the agency problem. To lessen agency costs, some type
of control or monitoring system is put in place in the organization. At a minimum, the
monitoring system consists of a board of directors to oversee management on behalf of
shareholders and an external auditor to express an opinion on the reliability of financial
statements. In the majority of companies, however, governance systems are influenced by a
much broader group of constituents, including creditors, labor unions, customers, suppliers,
investment analysts, the media, and regulators (see Exhibit 1). In order for governance systems
to be economically effective, they should decrease agency costs above and beyond the direct cost
of compliance and the indirect cost on managerial decision making.
1 This issue was the basis of the classic discussion in Berle and Means, The Modern Corporation and Private
Property, (New York: Harcourt, Brace and World, 1932).
Models of Corporate Governance: Who’s the Fairest of Them All? CG-11 p. 2
Broad standards of governance are required by regulatory bodies, based on the recommendations
of expert panels. For example, the Cadbury Committee—commissioned by the British
government “to help raise the standards of corporate governance and the level of confidence in
financial reporting and auditing”—issued a Code of Best Practices in December 1992 that in
many ways provided a benchmark set of recommendations on governance.2 These standards set
the basis for listing requirements on the London Stock Exchange and were in large part adopted
by the New York Stock Exchange (NYSE). Compliance with these standards, however, did not
always translate into effective governance systems. For example, Enron was compliant with
New York Stock Exchange requirements for an independent audit and compensation committee
and a majority of independent directors, but it still failed spectacularly.
Over time, a series of formal regulations and informal guidelines were proposed to address
perceived shortcomings in governance systems as they were exposed. The most important
formal legislation relating to governance was the Sarbanes-Oxley Act of 2002, which mandated a
series of requirements to improve corporate controls and reduce conflicts of interest.
Importantly, CEOs and CFOs found to have made material misrepresentations in the financial
statements were made subject to criminal penalties. Despite these efforts, corporate failures
stemming from deficient governance systems still continued. In 2005, Refco, a large U.S.-based
foreign exchange and commodity broker, filed for bankruptcy after revealing that it had hidden
$430 million in loans made to its CEO. The disclosure came just two months after the firm
raised $583 million in an initial public offering.
Several third-party organizations—such as The Corporate Library, Governance Metrics
International, and Institutional Shareholder Services (ISS)—attempted to protect investors from
these failures by publishing governance ratings on individual companies. These rating agencies
used alphanumeric or numeric systems that ranked companies according to a set of criteria that
they believed (in aggregate) measured effectiveness. Companies with high ratings were
considered less risky and most likely to grow shareholder value. Companies with low ratings
were considered the least safe and had the highest potential for failure or fraud. The accuracy of
these ratings, however, had not been clearly demonstrated, and critics alleged that they
encouraged a “one size fits all” approach to governance.3 The potential shortcomings of these
ratings were exhibited in the case of HealthSouth, which was accused in 2003 of systematically
making false accounting entries and overstating earnings by a total of $1.4 billion between 1996
and 2002. At the time, the company had an ISS rating that placed it in the top 35 percent of
Standard & Poor’s 500 companies and the top 8 percent of its industry peers.4
Despite the difficulty of evaluating corporate governance structures, investors still perceived
strong governance to be important. In a widely touted research report published by McKinsey &
Company in 2002, nearly 80 percent of institutional investors said that they would pay a
premium for a well-governed company. The size of the premium varied by market, from 11
percent for Canadian companies to around 40 percent for companies in countries with weak
Cadbury Committee, Report of the Committee on the Financial Aspects of Corporate Governance, (London: Gee,
See “Corporate Governance Ratings: Got the Grade… What was the Test?” GSB No. CG-08.
Cited in Jeffrey Sonnenfeld, “Good Governance and the Misleading Mythos of Bad Metrics,” Academy of
Management Executive, February 2004, Vol. 18 Issue 1, pp. 108-113.
Models of Corporate Governance: Who’s the Fairest of Them All? CG-11 p. 3
regulatory environments (such as Morocco, Egypt, and Russia).5 However, there is considerable
controversy among academics and executives regarding whether strong governance systems
actually resulted in higher market valuations, as the survey indicated. Nor had academics clearly
demonstrated which specific control mechanisms led to effective governance in the first place.
Standards of corporate governance were not uniform around the world, owing in large part to
differences in legal tradition, social and cultural values, and the structure of capital markets in
individual countries. The United States and Britain had adopted a shareholder-centric model of
corporate governance (often referred to as the Anglo-Saxon model). This model emphasized the
increase in shareholder value, in compliance with national laws and regulations, as the primary
objective of the corporation. A unitary board of executive and non-executive directors had
oversight control in the Anglo-Saxon model and was subject to considerable influence by the
chief executive officer. The Germans, along with several other European nations, adopted a
stakeholder-centric model of governance. This model placed more emphasis on the importance
of non-shareholder constituents—labor unions in particular—and reflected the large influence of
controlling owners and major German national banks. The Germans implemented a two-tiered
board structure that more clearly separated oversight from management. The Japanese model
was built around business relationships, with Japanese banks, customers, and suppliers all
influencing board-level decisions. The Korean model had its roots in that country’s emergence
from the Korean War, whereas the Chinese model reflected a transition from communism to a
capitalistic system. The Indian model was influenced by a history of powerful family ownership.