Corporate Scandals of the 21st Century: limitations of
mainstream corporate governance literature and the need
for a new behavioral approach
Alexandre Di Miceli da Silveira*
School of Economics, Management and Accounting, University of São Paulo
Working Paper
January 14th, 2013
*
Associate Professor of Corporate Governance at the School of Economics, Management and Accounting of the University
of São Paulo (FEA/USP). Tel: (+55) 11 99342-5459. e-mail: alexfea@usp.br.
The author thanks Ricardo Leal and Angela Donaggio for valuable comments. All errors and omissions remain my own. ©
Alexandre Di Miceli da Silveira, 2012. All rights reserved. Short sections of text, not to exceed two paragraphs, may be
quoted without explicit permission provided that full credit is given to the source.
1
Electronic copy available at: http://ssrn.com/abstract=2181705
Corporate Scandals of the 21st Century: limitations of mainstream corporate
governance literature and the need for a new behavioral approach
Abstract
I provide a critique of mainstream corporate governance literature based on agency theory as
a conceptual solution in order to endure de facto well governed companies worldwide. This
critique is based on an analysis of common causes associated with 23 high profile corporate
scandals from the 21st century. It is also based on the limitations associated with the homo
economicus premise behind agency theory, which ignores psychological issues associated
with the human factor inside organizations. As a result, I argue that a new behavioral
approach to corporate governance shall emerge in order to reduce the emergence of corporate
scandals in the future. This new view should be based on three main components: 1) the
systematic focus on the mitigation of cognitive biases in managerial decisions; 2) the
continuous fostering of employee and executive awareness towards the promotion of
unselfish long-term oriented cooperative behaviors; and, 3) the reduction of the likelihood of
frauds and other dishonest acts through new corporate strategies developed after a deeper
understanding of their psychological motivations. By combining the traditional approach to
corporate governance based on incentive and controls with a new behavioral approach
focusing on the human factor, corporate stakeholders may expect to end up with truly wellgoverned companies.
Key-Words: corporate scandals, corporate governance, behavioral corporate governance,
homo economicus concept, agency theory critique, case study.
JEL Classification Codes: G30, G34, G02, M19.
2
Electronic copy available at: http://ssrn.com/abstract=2181705
1. Introduction
“We continue to be committed to industry best practices with respect to
corporate governance. Our Board of Directors consists of ten members. With the
exception of our CEO, all of our directors are independent. The audit,
nominating and corporate governance, finance and risk, and compensation and
benefits committees are exclusively composed of independent directors. The
Audit Committee includes a financial expert as defined in the SEC’s rules. The
board holds regularly scheduled executive sessions in which non-management
directors meet independently of management. The board and all its committees
each conduct a self-evaluation at least annually. Last year, overall director
attendance at board and committee meetings was 96%. We have an orientation
program for new directors. Our corporate governance guidelines also
contemplate continuing director education arranged by the company. Our Code
of Ethics is published in our website. We have designed our internal control
environment to put appropriate risk mitigants in place. We have a global head of
risk management and a global risk management division which is independent.
The company’s management assessed the effectiveness of our internal controls.
Based on our assessment, we believe that the company’s internal controls are
effective over financial reporting. These controls have also been considered
effective by the independent auditors. We also sponsor several share-based
employee incentive plans.”
The text above was extracted from the annual report of a company that probably would be
very well assessed by market agents regarding its corporate governance practices. It is
actually, though, an extract of Lehman Brothers Annual Report 2007, the U.S. investment
bank that collapsed just a few months after the release of this document.
Like so many other similar cases, Lehman’s case illustrates how companies that apparently
were role models in their top management practices collapsed due to different reasons such as
wrong business decisions, risk management problems or frauds.
The number of corporate scandals1 associated with corporate governance problems in the first
decade of this century is extensive. Wikipedia website, for instance, provides a list of more
than 75 corporate scandals throughout this period.2 Their economic relevance is enormous.
Table 1 below lists 23 selected high profile corporate scandals that, together, have destroyed
an estimated US$750 billion of their shareholders’ equity.
[Table 1 here]
The economic impact of the scandals portrayed in Table 1 on other stakeholders – such as
employees, communities, clients, suppliers, etc. – and on society as a whole was indeed much
1
A corporate scandal is assumed as a set of questionable, unethical, and/or illegal actions that a person or
persons within a corporation engage in. Source: BusinessDictionary.com
2
http://en.wikipedia.org/wiki/List_of_corporate_scandals
3
larger. These scandals have come from companies worldwide, including large emerging
countries such as Brazil and India and developed economies such as the U.S., Germany and
Japan. Although there has been a first wave of corporate scandals in the 2001-2003 period
epitomized by Enron and Parmalat in the U.S. and Europe, respectively, the lessons from
these cases do not seem to be fully understood, since the list has continued to grow, especially
after the emergence of the global financial crisis in 2007-2008.
Since the number of corporate scandals associated with corporate governance problems
continues to be relevant worldwide, I focus on the following question in this paper: Why do
we still see so much value destruction in the business world due to corporate governance
failures after years of debate and, in theory, learning about this subject?
I initially argue that governance scandals are the direct outcome of a common set of fourteen
interrelated factors detailed ahead such as: excessive concentration of power, ineffective
board of directors, passivity of investors, failure of gatekeepers, poor regulation, lack of the
right ethical tone at the top, etc.
My central point in this paper, nevertheless, is to argue that the root of the problem lies in the
way the corporate governance concept has been internalized by most of the companies,
investors and academics worldwide. Based on the work of orthodox economists (Jensen and
Meckling, 1976; Fama and Jensen, 1983), corporate governance has been widely grounded
on the agency theory perspective, which is basically concerned with creating ways to
motivate one party (the “agent”), to act on behalf of another (the “principal”). As a result, the
good governance of a business, a very complex subject, has been reduced to a mere set of
incentive and control mechanisms in order to induce agents (managers) to make decisions in
the best interests of their principals (shareholders).
The limitation of the debate to the theoretical framework of agency theory has at least two
fundamental problems. First, the dissemination of corporate governance as a mere set of
rewards and punishment mechanisms to be implemented in order to induce behaviors has left
business leaders free to treat this complex and intrinsically human subject as a mere checklist of recommended practices to be fulfilled in order to be well perceived by the outside
stakeholders. The Lehman Brothers’ case is just one among several similar scandals in which
there was a discrepancy between the essence of good governance – companies where
decisions are made in their best long-term interest and in which people comply with the rules
– and the way the governance practices were shown externally.
Second, agency theory – formulated almost forty years ago – is based on the homo
economicus premise, a concept that has been proved to be a very limited portrait of the
4
human nature by numerous recent researches (presented ahead) in different fields such as
sociology, psychology, neuroscience, behavioral economics, etc.
Specifically, these studies have consistently shown that people are not rational, exclusively
selfish, nor interested in breaking rules depending on its relative economic benefits as
predicted by the homo economicus concept. Since this accumulated knowledge in other fields
cannot be ignored, a rethink of the corporate governance concept is needed in light of these
works.
As a result, I argue that a new behavioral approach to corporate governance focusing on the
psychological aspects of human beings inside organizations shall emerge. This new approach
should be based in at least three main components ignored by agency theory: 1) the
systematic focus on the mitigation of cognitive biases in managerial decisions; 2) the
continuous fostering of employee and executives awareness towards the promotion of
unselfish cooperative behaviors; and, 3) the reduction of the likelihood of frauds and other
dishonest acts through new corporate strategies developed after a deeper understanding of
their psychological motivations.
This new approach does not dismiss, though, the importance of incentive and control
mechanisms recommended by the agency theory. Such mechanisms remain relevant, but
should not be seen as sufficient for well-governed companies. The expansion of the corporate
governance literature beyond agency theory towards a behavioral approach should be seen as
something crucial to ultimately reduce the emergence of new corporate scandals in the
coming years.
This paper relates with different fields of knowledge that provide complementary theoretical
frameworks to agency theory, such as the literatures of trust in organizations (Noreen, 1988;
Mayer et al. 1995; Schoorman et al., 1996; Bower et al., 1997; De Dreu et al., 1998; Zaheer
et al., 1998; Becerra and Gupta, 1999 and 2003; Sundaramurthy and Lewis, 2003; Cadwell
and Karri, 2005), stewardship theory (Donaldson and Davis, 1991; Davis et al., 1997; Arthurs
and Busenitz, 2003; Hernandez, 2012), and intrinsic motivation (Deci and Ryan, 1985; Frey
and Jegen, 2001; Fehr and Falk, 2002; Kolev et al. 2012). Trust literature criticizes agency
theory’s pessimistic assumptions about the human behavior pointing out that this approach
precludes trust and cooperation, crucial elements for successful organizations. It argues that
corporate agents may show an attitude of trust and cooperation depending on contextual and
personal factors, therefore not always behaving selfishly. Overall, this literature considers
trust as an efficient mechanism to maximize the principal’s utility. Stewardship theory views
executives as “stewards” of the organization who are motivated to act responsibly based on
5
an assumption of trust. It considers that managers obtain greater utility when developing a
collaborative approach rather than when behaving selfishly, especially when they identify
with organizational values and goals. The literature on motivation points out that nonpecuniary motives shape human behavior, including intrinsic pleasure arising from work, the
desire to obtain social approval and the sense of reciprocation. It also contends that extrinsic
rewards such as those emphasized by agency theory may indeed undermine the role of
intrinsic rewards on motivation and increase agent’s opportunistic behavior.
This paper also fits in an emerging line of research that criticizes agency theory’s simplistic
and inflexible assumptions about human behavior and the narrowness of its predictive
validity (Tirole, 2002; Charreaux, 2005; Van Ees et al., 2009; Cuevas-Rodríguez et al., 2012;
Martin et al., 2012; Wiseman et al., 2012). Overall, these works call for new approaches
toward corporate governance by widening the agency concept through a behavioral
perspective. I believe that this paper contributes to these literatures by prescribing three
specific areas of concentration for the emergent behavioral approach to corporate governance
based on an analysis of corporate scandals from earlier 21st century as well as on the
fragilities of the homo economicus premise evidenced by recent numerous works.
The paper is organized as follows. In section 2, I list the common factors explicitly associated
with governance scandals from the first decade of the 21st century. In section 3, I develop my
argument that the root of the problem lies in the homo economicus premise behind the
mainstream approach to corporate governance. I do so by presenting evidence from recent
researches in different fields that people: i) do not make rational decisions; ii) tend to behave
cooperatively instead of acting in a purely selfish way depending on the social context; and,
iii) behave dishonestly motivated primarily by psychological factors instead of applicable
penalties and the probability of being caught. As a result of this critique, I argue in Section 4
that the conceptual solution for the limitations of agency theory is the emergence of a
behavioral approach to corporate governance focusing on psychological factors associated
with people inside corporations. Section 5 then provides some concluding remarks.
2. Explicit reasons for corporate scandals from the first decade of the 21st century:
interrelated common factors
The 23 selected corporate scandals presented in Table 1 have quite heterogeneous natures.
Some involved fraud, while others were the outcome of risk management failures or of bad –
but not necessarily illegal – top level decisions. Analyzed on an aggregate basis, they raise
important red flags and provide valuable lessons.
6
After examining eight cases from the first wave of corporate scandals, Hamilton and
Micklethwait (2006) conclude that they were caused by six main causes: 1) poor strategic
decisions; 2) over-expansion and ill-judged acquisitions; 3) dominant CEOs; 4) greed, hubris
and a desire for power; 5) failure of internal controls; and, 6) ineffective boards.
Coffee Jr. (2005, 2006) lists the “gatekeeper failure” – the reliance on reputational
intermediaries such as auditors, stock analysts, credit rating agencies, and other professionals
who pledge their reputational capital to vouch for information that investors cannot easily
verify – as another reason for the emergence of corporate scandals. He also argues that
inadequate compensation systems allowed earnings management in several companies, being
a relevant factor for the scandals in companies with dispersed ownership structures such as
those prevalent in the Anglo-Saxon countries.
More recently, the OECD concluded that corporate governance failures at financial
institutions that collapsed in the 2007-2009 period have occurred due to four main causes: 1)
inadequate incentive systems; 2) deficient risk management practices; 3) poor board
practices; and, 4) the tendency for shareholders – especially institutional investors – to act
reactively rather than proactively.
Building upon these works, I propose an expanded framework with fourteen interrelated
common causes associated with the corporate scandals presented in Table 1.
[Chart 1 here]
According to the conceptual model presented in Chart 1, common causes associated with
corporate governance scandals can be divided into three groups: fundamental causes, those
lying at the root of the problems; immediate causes, those leading directly to the emergence
of the scandals; and, mediating causes, intervening factors by which fundamental causes
generate immediate ones.
1. Fundamental causes: those lying at the root of the problems by involving the
company’s leadership structure and its external monitoring. Five stand out: excessive
concentration of power; ineffective board of directors; passivity of investors; failure
of gatekeepers; and, poor regulation.
2. Immediate causes: those leading directly to the emergence of the scandals as a
consequence of fundamental or mediating causes. Five can be pointed out:
overexpansion of the business; biased strategic decisions; inflated financial statement;
weak internal controls; and, inadequate compensation systems.
7
3. Mediating causes: intervening factors by which fundamental causes generate
immediate causes. Four main mediating causes can be listed: the illusion of success of
the business, an internal atmosphere of greed and arrogance, the lack of the right
ethical tone at the top and, corporate governance seen as a marketing tool.
Table 2 details the rationale for these fourteen common causes lying behind recent corporate
failures.
[Table 2 here]
In Table 3, I provide a qualitative analysis of each corporate scandal presented in Table 1 visà-vis common factors associated with them, aiming to understand the specific relevance of
each factor for the selected cases.
[Table 3 here]
In spite of the limitations of this preliminary aggregate analysis, such as its admittedly
subjectivity, Table 3 suggests interesting qualitative interpretations. First, five main factors
seem to stand out among the possible reasons for corporate misdeeds in the first decade of the
21st century: excessive concentration of power, ineffective boards, lack of the right ethical
tone at the top; biased strategic decisions, and weak internal controls.
Second, since there was an initial wave of scandals in the 2001-2003 period and a second one
during the emergence of the global financial crisis in 2007-2008, I divide the scandals in two
groups: those taking place in the first half of the decade (2001-2005) and those taking place
in the second half (2006-2010). The comparison of the common causes associated with
scandals from each group indicates that two factors appear to have increased in relevance for
the emergence of scandals from the second half of the decade: 1) poor regulation; and, 2)
corporate governance seen as a marketing tool.
8
3. The root of the problem: the mainstream approach to corporate governance based
on the homo economicus concept
“Il faut tout attendre et tout craindre du temps et des hommes”
Luc de Clapiers, Marquis De Vauvenargues
Réflexions et maximes, 102 (1746)
Although governance scandals are the explicit outcome of a set of interrelated factors, the
root of the problem of business value destruction related with corporate governance failures
may lie in how the theme has been internalized by companies, investors and academics
worldwide.
Based on the work of mainstream economists (Jensen and Meckling, 1976; Fama and Jensen,
1983; Shleifer and Vishny, 1997; La Porta et al., 1998), corporate governance literature has
been widely grounded on agency theory, which is basically concerned in creating the most
efficient contract to align the interests of one party (the “agent”) with those of another (the
“principal”) in situations where the principal concedes authority to the agent to act on her
name.3
As a result, the good governance of a business, a very complex subject, has been reduced to
the implementation of an appropriate set of incentive tools (e.g. stock-based compensation,
periodic performance evaluations, etc.) and controls (e.g. independent boards, risk
management divisions, compliance programs, internal controls, internal and external audits,
etc.) in order to align interests and reduce agency costs.
This approach – deriving from the limited view of the “carrot and stick” that forms the basis
of mainstream economics – has left business leaders free to treat this intrinsically human
theme as a set of checklists to be fulfilled in a technical way, sometimes totally disconnected
from the company’s daily management.
Agency theory is based on the usual premise of neoclassical economic models that agents act
like homo economicus. This concept, originally coined by critics of John Stuart Mill’s work
(1836) on political economy (Persky; 1995)4, assumes that human beings always:
1. Make perfectly rational decisions;5
2. Think exclusively in maximizing their own personal economic gains6; and,
3
The principal-agent relationship also involves an information asymmetry in favor of the agent, such that the
principal cannot directly ensure that the agent always act in her best interest.
4
According to Persky (1995, p. 222), John Stuart Mill never actually used this designation in his own writings.
The term emerged in reaction to Mill’s work and initially carried a pejorative connotation reflecting the
widespread hostility of the historical school towards his postulation of blatant selfishness.
5
Rationality is defined in the sense that the personal “utility function” is optimized by individuals who seek to
attain maximum predetermined goals with minimum possible cost.
9
3. Are interested in breaking the rules if the applicable penalty multiplied by the probability
of being caught is lower than the expected benefit of a dishonest act7.
The reduction of people within corporations acting as agents to the concept of homo
economicus – an archetype initially applied to economic models created to explain the trading
of goods and services in anonymous markets and later indiscriminately extended to other
fields – ends up in a very limited and often inaccurate assumption about human behavior.
Hundreds of recent studies in sociology, psychology, neuroscience, behavioral economics,
etc. have provided mounting evidence that human behavior is far more complex, depending
on psychological, social and biological interactions.8 Even Jensen (1994a, 1994b), one of the
first authors to bridge agency theory with corporate governance, has later acknowledged the
inappropriateness of the economic model of human behavior,9 although he has not corrected
the premises underlying his 1976 seminal work in light of such review.10
These three premises behind mainstream corporate governance based upon the homo
economics concept bring with them three respective fundamental problems detailed in the
following subsections.
6
Economists tend to argue that they employ the concept of utility instead of economic benefits and that this
concept can even include altruistic behavior if defined appropriately. In practice, though, theoretical models
usually end up reducing the concept of “utility” into the maximization of economic gains for the decision maker,
invalidating this potential defense of the homo economicus approach.
7
This prediction is largely based on the classical work of Nobel Prize winner Gary Becker (1968).
8
This critique is admittedly not new even in the economics field. Thaler (2000) is one of the earlier critics of the
exclusive premise of homo economicus embedded in economic models. At the time of his paper, he already
emphasized that it was time for homo economicus to evolve into homo sapiens.
9
Jensen and Meckling (1994a) compare five models of human behavior, including the economic (or money
maximizing) one. They argue (p. 15) that “The economic model is, of course, not very interesting as a model
behavior. People do not behave this way. In most cases use of this model reflects economists’ desire for
simplicity in modeling; the exclusive pursuit of wealth or money income is easier to model than the complexity
of actual preferences of individuals”. They conclude that a so-called Resourceful, Evaluative, Maximizing
Model (REMM) – a model that (p. 33) “takes the assumptions from the economic model that people are
resourceful, self-interested, maximizer, but rejects the notion that they are interested in only money income or
wealth” – is the best one to predict human behavior. Following a critic by Brennan (1994) on the premises of
rational behavior and exclusive focus on incentives behind his models, Jensen (1994b) relaxes his premises on
strict rationality by proposing a so-called Pain Avoidance Model (PAM) that complements REMM by capturing
the non-rational component of human behavior. Although he recognizes that these self-control problems should
lead to an expansion of agency theory – since they are a second source of agency costs in addition to those
generated by conflicts of interests – he does not subsequently revises his 1976 seminal work based on this
finding. In his Jensen’s own words (1994b, p. 12): “Constrained at the time by our economists’ view of
rationality, Meckling and I discussed only one source of agency costs, that which emanates from the conflicts of
interest between people. There is clearly a second major source of agency costs, the costs incurred as a result of
the self-control problems – that is the actions that people take that harm themselves as well as those around
them – what Thaler and Shefrin (1981) years ago characterized as agency problems with one’s self”.
10
According to Jensen and Meckling (1976, p. 307), “We retain the notion of maximizing behavior on the part
of all individuals in the analysis to follow”.
10
3.1. First problem of mainstream corporate governance based on the homo
economicus concept: people do not make rational decisions
Firstly, we are subject to multiple cognitive biases, that is, deviations in judgment patterns
taking place in particular situations leading us to distorted interpretations of reality, illogical
interpretation, and, consequently, to irrational decisions. This well established body of
research has been initiated by Kahneman and Tversky (1974, 1979), growing exponentially
afterwards (Angner and Loewenstein, 2007; Thaler, 2000; Kahneman, 2011). Nowadays,
more than 100 cognitive biases have been identified from researches in cognitive science,
social psychology, and behavioral economics11. Table 4 below exemplifies some of the main
individual and collective cognitive biases, including their potential impacts for the corporate
governance debate.
[Table 4 here]
Among the cognitive biases presented in Table 4, take the example of the interrelated biases
of optimism and overconfidence. People who are overconfident tend to underestimate risks
due to an “illusion of control” over the outcomes of their initiatives, while optimists tend to
overestimate the future outlook of their outcomes in what is called the “better than average”
effect. As a result, even technically qualified executives with interests aligned with those of
their shareholders can make disastrous business decisions due to the pronounced presence of
these biases.
There is already some evidence of this in the literature. Malmendier and Tate (2004) observe
that companies with overconfident CEOs tend to undertake mergers that destroy value. BenDavid et al. (2007) find that companies with overconfident CFOs apply lower discount rates
to value cash flows, use more debt, and are less likely to pay dividends. Barros and Silveira
(2008) observe that companies run by more optimistic individuals tend to choose more
levered financing structures, ending up more indebted. Schrand and Zechman (2011) find that
overconfident executives are more likely to initially overstate earnings which start them on
the path to growing intentional misstatements or frauds.
These studies illustrate how just one of the several cognitive biases that possibly affect top
level managers – overconfidence – may impact relevant corporate decision making.
Therefore, the presence of counterbalances such as independent third-party reviews and the
11
https://secure.wikimedia.org/wikipedia/en/wiki/List_of_cognitive_biases
11
implementation of alternative decision making techniques could be useful by mitigating the
impact of cognitive biases such as overconfidence and optimism on company decisions.
Cognitive biases, however, are not part of the traditional view of corporate governance
exclusively concerned with the establishment incentive and control mechanisms.
3.2. Second problem of mainstream corporate governance based on the homo
economicus concept: people tend to behave cooperatively instead of acting in a
purely selfish way
Second, unlike the relentless search for the best personal economic outcome predicted by the
homo economicus premise, an increasingly growing body of literature (Henrich et al. 2001;
McCabe et al. 2001; Rilling et al., 2002; Gintis et al., 2003; Decety et al. 2004; Kosfeld et al.
2005; Singer and Frith, 2005; Katja et al. 2007; List and Cherry, 2008; Akitsuki and Decety,
2009; Krupka and Weber, 2009) summarized in Stout (2011) is showing that people may have
a tendency to act in a cooperative and unselfish way, acting in the best interest of the groups
to which they belong. In short, these papers, most of them based on experiments, provide
systematic evidence of altruistic behaviors fleeing from the orthodox economic view.
Take for instance three experiments that defy the view that people tend to behave like rational
economic maximizing individuals: the “trust game”, the “ultimatum game”, and the “dictator
game”.
In the “trust game” (Berg et al., 1995; Croson and Buchan, 1999; Anderhub et al. 2002;
McCabe et al. 2001; McCabe et al. 2003; Delgado et al., 2005; Cesarini et al. 2008), two
players (unknown to each other) are placed in two separate rooms. Player A (the trustor)
receives a sum of money (e.g. $20) and decides how much of it she will send to player B (the
trustee). Player A may decide to send nothing to B, leaving the experiment by keeping all the
cash. If A decides to send something to B, this amount is then tripled. After receiving the
tripled sum sent by A, individual B then has the opportunity to return some money to A or
simply to keep it. Homo economicus would give nothing on both occasions, acting either as
player A or B. However, different researches (Berg et al., 1995; McCabe et al. 1996, 2001,
Brülhart and Usunier, 2012) observe that cooperation flourishes in this game, with the
average player A cooperating with B by donating a significant share (about half) of her
monetary endowment, while the majority of individuals B tend to reward A’s generosity by
giving back a little more of the money initially sent by A.
In the “ultimatum game” (Güth et al. 1982; Dawes and Thaler 1985; Thaler, 1988; Camerer
and Thaler, 1995; Nowak et al. 2000; Sanfey et al. 2003; Oosterbeek et al. 2004; Koenigs,
12
2007), two players (also unknown to each other) interact the division of a monetary
endowment. Player A proposes how to divide the sum between the two players, whereas
player B can either accept or reject this proposal. If B rejects, neither player receives
anything. If B accepts, then the money is split according to A’s proposal. The game is played
only once so that reciprocation is not an issue. If individual A is homo economicus, then she
should always propose the minimum amount for B and the maximum for herself (e.g. $1 for
B and $49 for herself). If B, in her turn, is homo economicus, then she would always accept
any amount proposed by A (since rationally anything is better than nothing). However,
different researches (Güth et al. 1982; Kahneman et al., 1986; Hoffman et al., 1996a;
Oosterbeek et al. 2004) observe that, on average, people tend to offer “fair” splits (with a
modal offer around 50:50), whereas offers of less than 20% are usually rejected.
The “dictator game” (Camerer and Thaler, 1995; Bolton et al. 1988; Diekmann, 2004;
Henrich et al. 2004; Bardsley, 2008) is a variant of the ultimatum game. In it, player A, “the
dictator” or proposer, determines a split of some monetary endowment. Player B then simply
receives the remainder of the endowment left by the proposer. Player B’s role is entirely
passive, with no strategic input into the outcome of the game. If individuals are only
concerned with their own economic well being, dictators would allocate the entire money to
themselves, giving nothing to player B. Experimental results (Kahneman et al., 1986;
Forsythe et al., 1994; Hoffman et al., 1996b;) indicate that individuals often allocate money
to the responders, voluntarily reducing the amount of money they receive.
The overall result of experiments such as those presented is that people frequently do not act
like rational maximizers as predicted by the homo economicus model. On the contrary, people
usually tend to show a cooperative behavior based on reciprocity and altruism. More
importantly, since human behavior is flexible rather than rigid as presumed by the homo
economics model, this tendency can be reinforced through situational factors that create the
right social context in order to increase cooperation rates. Stout (2011)12 argues that unselfish
prosocial (or cooperative) behavior, including voluntary compliance with legal and ethical
rules, is triggered by the social context, which in turn depends on three main social
variables13:
12
Stout (2011, p. 98) calls this “a three-factor approach to social context”.
Fostering the “activation” of people’s conscience as an important corporate governance practice has one
limitation, however. About 1% to 4% of the general population is comprised of people with psychopathy
disorder, unable to feel guilt or empathy for others. There are suspicions that this percentage is higher in
corporate environments, especially at top hierarchical levels. As a result, cultivating conscience will not work
with people subject to this disorder, an especially relevant observation for organizations headed by these
psychopath individuals.
13
13
1. The instructions received by leaders, deriving from our tendency to obey authorities
(Sally, 1995; Balliet, 2010);
2. The reciprocity, or beliefs about the prosocial behavior of others when facing similar
circumstances, as a result of our propensity to conform and imitate the behavior of our
peers (Gintis, 2000; Henrich et al. 2001; Gintis et al. 2003; López-Pérez, 2009); and,
3. The magnitude of the perceived benefits of one’s actions on others, deriving from our
tendency to feel empathy (Eisenberg and Miller, 1987; Eisenberg and Fabes, 1990;
Batson and Powell, 2003; Decety and Jackson, 2004; Batson, 2009).
Since rational choice models ignore the influence of these three key elements on human
behavior, the traditional view of corporate governance based on incentives and controls do
not contemplate the need to continuously activate and cultivate people’s consciousness in
corporations in order to induce cooperative and long-term oriented behaviors.
3.3. Third problem of mainstream corporate governance based on the homo
economicus concept: dishonest behaviors are motivated by psychological factors
instead of applicable penalties and the probability of being caught
Third, another recent body of research (Bateson et al., 2006; Mazar et al., 2006, 2008;
Baumeister, 2007; Gino et al., 2008; Mead et al. 2009, Gino et al. 2009, 2010, 2011; Gino
and Pierce, 2010; Wiltermuth, 2010; Barnes et al., 2011; Chance et al., 2011; Gino and Ariely,
2011; Barkan et al. 2012; Shu et al., 2012) summarized in Ariely (2012) is increasingly
showing that the propensity of people to act dishonestly – at the root of relevant scandals – is
more dependent on psychological factors than on both the risk of being caught by breaking
the rules and its applicable penalty. Overall, there is evidence that at least ten psychological
factors seem to be relevant for people’s decision to incur into dishonest behavior:
1) The ability to rationalize its own dishonest acts (Mazar et al., 2006, 2008; Barkan et
al. 2012): people seem to find ways to rationalize their illegal behavior while
maintaining at the same time a positive self-image of themselves;
2) Distance from monetary references (Mazar et al., 2008): the propensity to dishonest
acts increases with the distance of people’s decisions to a monetary explicit payoff;
3) Being mentally depleted (Baumeister, 2007; Mead et al. 2009, Barnes et al., 2011;
Gino et al. 2011): mental exhaustion – due to stress, lack of sleep, etc. – increases
people’s propensity to dishonesty;
4) Previous illegal or immoral acts (Gino et al. 2010): the propensity of people to
dishonesty increases when they have already performed some previously illegal act,
14
especially if that comes with a built-in reminder (e.g. wearing counterfeits, using false
titles on business card, etc.);
5) Creativity (Gino and Ariely, 2011): a creative personality facilitate individuals’ ability
to justify their behavior, which, in turn, tends to increase unethical behavior;
6) Feelings of revenge (Ariely, 2012): dishonest acts are more easily justified when
viewed as compensations by people who feel initially harmed by an individual or
organization;
7) Being subject to sharp competition (Schwieren and Weichselbaumer, 2010): cheating
activity, especially from poor performers, tend to increase under stronger competitive
pressure;
8) Witnessing peers behaving dishonestly (Gino et al. 2009): exposure to unethical
behavior of a in-group peer tend to increase the propensity to dishonesty;
9) Perception that our peers benefit from our actions (Gino and Pierce, 2010;
Wiltermuth, 2010): the propensity to dishonesty increases when people think that such
actions may benefit others for whom they have empathy;
10) Living in a culture that fosters dishonesty (Gino et al. 2009): being exposed to an
unethical climate or culture tends to increase the frequency of unethical acts.
Similarly to the two previous sections, none of these psychological factors are addressed in
mainstream corporate governance thinking, which departs from the premise that increased
monitoring and tougher penalties are the sole elements to avoid unlawful behaviors.
4. The proposed solution for reducing the frequency of scandals: the need for a
behavioral approach to corporate governance focusing on psychological factors
Since the assumptions behind the mainstream corporate governance theory do not hold, the
mere implementation of incentive and control mechanisms, although relevant, will not be
sufficient to ensure well governed companies. In fact, this may largely explain the collapse of
companies that apparently adopted good governance practices.
The missing link in order to ensure well-governed companies over time is to focus on the
human factor, that is, on the creation of corporate environments in which intrinsically
motivated people want by themselves to make decisions in the best long-term interest of the
company as well as follows the rules.
Table 5 below summarizes this argument by presenting a comparison between the traditional
view of corporate governance and the new proposed approach based on behavioral aspects.
15
[Table 5 here]
To do this, business leaders must unceasingly devote their time to create social contexts in
their organizations that: 1) improve the managerial decision-making process by creating a
system with effective checks and balances that reduce cognitive biases; 2) continuously
fosters employee and executive conscience by promoting unselfish long-term oriented
cooperative behaviors; and, 3) reduce the propensity to dishonest acts by creating new
strategies such as enhanced internal controls based on a deeper understanding of their
psychological motivations.
Probably, the hardest part of this process towards de facto good corporate governance will be
to change the mindset of business leaders themselves. On the one hand, cases such as the
Lehman Brothers debacle have shown that top executives have been indoctrinated to think
exclusively in their own short-term economic outcomes without concerns about their impact
on other stakeholders. On the other hand, reducing cognitive biases in organizations depends
on an effective system of checks and balances, which implies a certain decentralization of
power, something not necessarily welcomed by leaders who are comfortable in maintaining
their status quo and the modus operandi of their decisions.
5. Concluding remarks
The emergence of numerous high-profile corporate scandals in the early years of the 21st
century with huge impacts on societies worldwide evidence that the corporate governance
debate must evolve in order to ensure de facto well-governed companies, that is, those in
which decisions are made in their best long-term interest and in which people comply with
the rules.
In this paper, I argue that the dissemination of corporate governance as a mere set of internal
and control mechanisms in order to induce behaviors has led some companies to internalize
this complex and intrinsically human subject as a mere check-list of recommended practices
to be fulfilled in order to be well perceived by the outside stakeholders. As a result, I provide
a critique of the traditional corporate governance literature based on the agency theory, since
the acceptance of this approach by companies, academics and regulators worldwide as the
sole relevant issue for the corporate governance debate has clearly failed to ensure well
governed companies.
I argue that a new behavioral approach to corporate governance focusing on the
psychological aspects of human beings inside organizations should emerge in order to benefit
16
from the accumulated knowledge on human behavior from other fields as well as to reduce
the emergence of new scandals in the future. This new approach14 should be based in at least
three main components: 1) the systematic focus on the mitigation of cognitive biases in
managerial decisions; 2) the continuous fostering of employee and executives awareness
towards the promotion of unselfish cooperative behaviors; and, 3) the reduction of the
likelihood of frauds and other dishonest acts through new corporate strategies developed after
a deeper understanding of their psychological motivations.
This new behavioral approach does not dismiss the need for the implementation of incentive
and control mechanisms in organizations as prescribed by agency theory15: it only argues that
these mechanisms should not be seen as sufficient ones in order to ensure de facto wellgoverned companies. By combining the traditional approach to corporate governance based
on incentive and controls with a new behavioral approach focusing on the human factor,
stakeholders may expect to end up with truly well-governed companies.
The acceptance of this expanded approach will indeed require a broader definition of the
meaning of the so-called good corporate governance, including the conception of new
recommended governance practices by codes of best practices.
It is time to move beyond the limited assumption of the homo economicus for corporate
governance. Psychological issues associated with the human factor within corporations
should become the new focus of corporate governance analysis.
14
The term “behavioral corporate governance” has already been used by Charreaux (2005) and Van Ees et al.
(2009). Their point of view for this term, however, is different than the one adopted in this paper.
15
In this sense, I agree with Jensen’s view (1994b, p. 14) that “even if we could instill more altruism in
everyone, agency problems would not be solved… Altruism, the concern for the well-being of others, does not
turn people into perfect agents who do the bidding of others”.
17
References
Akitsuki, Y., Decety, J. (2009), Social Context and Perceived Agency Affects Empathy for Pain:
An
Event-Related
fMRI
Investigation,
NeuroImage
47:
722–734,
DOI:10.1016/j.neuroimage.2009.04.091
Anderhub, V., Engelmann, D., Güth, W. (2002), An Experimental Study of the Repeated Trust
Game With Incomplete Information, Journal of Economic Behavior Organization 48(2): 197-216,
DOI: 10.1016/S0167-2681(01)00216-5
Angner, E., Loewenstein, G. F. (2012), Behavioral Economics, in: U. Mäki (ed.), Handbook of
the Philosophy of Science: Philosophy of Economic, 641-690, Amsterdam: Elsevier. Available at
SSRN: http://ssrn.com/abstract=957148
Ariely, D. (2012), The Honest Truth About Dishonesty: How We Lie to Everyone – Especially
Ourselves, Harper.
Ariely, D., Ayal S., and Gino, F. (2009), Contagion and Differentiation in Unethical Behavior:
The Effect of One Bad Apple on the Barrel, Psychological Science, 20(3) 393-398.
Arthurs, J., Busenitz, L., (2003), The boundaries and limitations of agency theory and
stewardship theory in the venture capitalist/entrepreneur relationship, Entrepreneurship Theory and
Practice, 28: 145–162.
Bardsley, N. (2008), Dictator Game Giving: Altruism or Artefact? Journal of Experimental
Economics, 11(2): 122-133, DOI: 10.1007/s10683-007-9172-2
Balliet, D., (2010), Communication and Cooperation in Social Dilemmas: A Meta-Analytic
Review, Journal of Conflict Resolution, 54: 39-57, DOI:10.1177/0022002709352443
Barkan, R., Ayal, S., Gino, F., and Ariely, D. (2012), The Pot Calling the Kettle Black:
Distancing Response to Ethical Dissonance, Journal of Experimental Psychology: General, Mar 12 ,
2012, No Pagination Specified, DOI: 10.1037/a0027588
Barnes, C. M., Schaubroeck, J., Huth, M., Ghumman, S. (2011), Lack of Sleep and Unethical
Conduct, Organizational Behavior and Human Decision Processes, 115(2): 169-180, DOI:
10.1016/j.obhdp.2011.01.009.
Barros, L., and Da Silveira, A. M. (2007), Overconfidence, Managerial Optimism and the
Determinants of Capital Structure, Available at http://ssrn.com/abstract=953273
Bateson, M., Nettle, D., and Roberts, G. (2006), Cues of Being Watched Enhance Cooperation
in a Real-World Setting, Biology Letters, 2(3): 412-414. DOI: 10.1098/rsbl.2006.0509
Batson, D., Powell, A., (2003), Altruism and Prosocial Behavior, Handbook of Psychology,
463–484.
Batson, D. (2009), in The Social Neuroscience of Empathy, J. Decety, W. J. Ickes, Eds., MIT
Press, Cambridge, MA, 3–15.
Baumeister, R., Vohs, K., and Tice, D. (2007), The Strength Model of Self-Control, Current
Directions in Psychological Science, 16: 351, DOI: 10.1111/j.1467-8721.2007.00534.x
18
Bazerman, M., Loewenstein, G., Moore, D. (2002), Why good accountants do bad audits,
Harvard Business Review, 80(11): 96-103.
Bazerman, M., Loewenstein, G. (2001), Taking the bias out of bean counting, Harvard Business
Review, 79(1): 28.
Bazerman, M., Moore, D. (2008), Judgment in Managerial Decision Making, 7th ed. Wiley.
Becerra, M., Gupta, A., (1999), Trust within the organization: Integrating the trust literature
with agency theory and transaction cost economics, Public Administration Quarterly, 23: 177–203.
Becerra, M., Gupta, A., (2003), Perceived trustworthiness within the organization:
The
moderating impact of communication frequency on trustor and trustee effects, Organization Science,
14: 32–44.
Becker, G. (1968), Crime and Punishment: An Economic Approach, Journal of Political
Economy, 76(2): 169-217. Available at http://www.nber.org/chapters/c3625.pdf
Ben-David, I., Harvey, C. R., Graham, J. R. (2007), Managerial Overconfidence and Corporate
Policies, NBER Working Paper w13711, Available at http://www.nber.org/papers/w13711
Berg, J., Dickhaut, J., McCabe, K., (1995), Trust, Reciprocity, and Social History, Games and
Economic Behavior, 10(1): 122-142, DOI: 10.1006/game.1995.1027.
Blass, T. (1999), The Milgram Paradigm After 35 Years: Some Things We Now Know About
Obedience to Authority, Journal of Applied Social Psychology, 29(5): 955-978.
Board, B. J., and Fritzon, K. (2005), Labcoat Leni’s Real Research: You Don’t Have to be Mad
Here, but It Helps, Psychology, Crime & Law, 11: 17–32.
Bolton, G. E., Katok, E., Zwick, R. (1998), Dictator Game Giving: Rules of Fairness Versus
Acts
of
Kindness,
International
Journal
of
Game
Theory, 27:2
269-299,
DOI:
10.1007/s001820050072.
Bower, A., Garber, S., Watson, J., (1997), Learning about a population of agents and the
evolution of trust and cooperation, International Journal of Industrial Organization, 15: 165–191.
Brennan, M. (1994), Incentives, Rationality, and Society, Journal of Applied Corporate
Finance, 7: 31–39. doi: 10.1111/j.1745-6622.1994.tb00403.x
Brülhart, M., Usunier, J.C., (2012), Does the trust game measure trust? Economics Letters,
115(1): 20-23, DOI: 10.1016/j.econlet.2011.11.039.
Cain, D. M., Loewenstein, G., and Moore, D. A. (2005), The Dirt on Coming Clean: Perverse
Effects of Disclosing Conflicts of Interest, The Journal of Legal Studies, 34(1): 1-25.
Cain, D. M., Loewenstein, G. F., and Moore, D. A. (2010), When Sunlight Fails to Disinfect:
Understanding the Perverse Effects of Disclosing Conflicts of Interest, Journal of Consumer
Research, 37(5): 836-857.
Caldwell, C., Karri, R., (2005, Organizational governance and ethical systems: A covenantal
approach to building trust, Journal of Business Ethics, 58: 249–259.
19
Camerer, C., and Thaler, R. H. (1995), Anomalies: Ultimatums, Dictators and Manners, The
Journal of Economic Perspectives, 9(2): 209-219.
Cesarini, D., Dawes, C. T., Fowler, J. H., Johannesson, M., Lichtenstein, P., and Wallace, B.
(2008), Heritability of Cooperative Behavior in The Trust Game, Proceedings of The National
Academy of Sciences of the USA – PNAS, 105(10): 3721-3726, DOI:10.1073/pnas.0710069105
Chance, Z., Norton, M. I., Gino, F., and Ariely, D. (2011), A Temporal View of the Costs and
Benefits of Self-Deception, Proceedings of the National Academy of Sciences – PNAS, 108(3): 1565515659, DOI:10.1073/pnas.1010658108
Charreaux, G. J. (2005), Pour une Gouvernance D’entreprise « Comportementale »: une
Réflexion
Exploratoire…,
Cahiers
du
Fargo
WP
No.
1050601.
Available
at
http://ssrn.com/abstract=740946
Coffee Jr., J. (2005), A Theory of Corporate Scandals: Why the USA and Europe Differ, Oxford
Review of Economic Policy, 21(2): 198-211, DOI:10.1093/oxrep/gri012
Coffee Jr., J. (2006), Gatekeepers: The Role of the Professions and Corporate Governance, 1st
ed. Oxford University Press.
Croson, R., and Buchan, N. (1999), Gender and Culture: International Experimental Evidence
from Trust Games, The American Economic Review, 89(2): 386-391.
Cuevas-Rodríguez, G., Gomez-Mejia, L., Wiseman, R., (2012), Has Agency Theory Run its
Course?: Making the Theory more Flexible to Inform the Management of Reward Systems,
Corporate Governance: An International Review, 20(6): 526-546, DOI: 10.1111/corg.12004
Dana, J., Kuang, D., Xi, J., and Weber, R. A. (2004), Exploiting Moral Wriggle Room: Behavior
Inconsistent
with
a
Preference
for
Fair
Outcomes,
Working
paper
available
at
http://ssrn.com/abstract=400900
Davis, J., Schoorman, F., Donaldson, L., (1997), Toward a stewardship theory of management,
Academy of Management Review, 22: 20–47.
Dawes, R., and Thaler, R. (1988), Anomalies: Cooperation, The Journal of Economic
Perspectives, 2(3): 187-197.
Decety, J., Jackson, P., (2004), The Functional Architecture of Human Empathy, Behavioral
Cognitive Neuroscience, Rev. 3, 71.
Decety, J., Jackson, P. L., Sommerville, J. A., Chaminade, T., and Meltzoff, A. N. (2004), The
Neural Bases of Cooperation and Competition: an fMRI Investigation, NeuroImage, 23: 744– 751,
DOI:10.1016/j.neuroimage.2004.05.025
Deci, E., Ryan, R., (1985), Intrinsic motivation and self-determination in human behavior, New
York: Springer.
De Dreu, C., Giebels, E., Van de Vliert, E., (1998), Social motives and trust in integrative
negotiation: The disruptive effects of punitive capability, Journal of Applied Psychology, 83: 408–
422.
20
Delgado, M. R., Frank, R. H., and Phelps, E. A. (2005), Perceptions of Moral Character
Modulate the Neural Systems of Reward During The Trust Game, Nature Neuroscience, 8: 1611 –
1618, DOI:10.1038/nn1575
Diekmann, A. (2004), The Power of Reciprocity: Fairness, Reciprocity, and Stakes in Variants
of the Dictator Game, Journal of Conflict Resolution, 48: 487-505, DOI:10.1177/0022002704265948
Donaldson, L., Davis, J. (1991), Stewardship theory or agency theory: CEO governance and
shareholder returns, Australian Journal of Management, 16: 49–64.
Eisenberg, N., Miller, P., (1987), The Relation of Empathy to Prosocial and Related Behaviors,
Psychological Bulletin, 101(1): 91-119, DOI: 10.1037/0033-2909.101.1.91.
Eisenberg, N., Fabes, (1990), Empathy: Conceptualization, Measurement, and Relation to
Prosocial Behavior, Motivation and Emotion, 14(2): 131-149, DOI 10.1007/BF00991640.
Fama, E., Jensen, M. (1983), Separation of Ownership and Control, Journal of Law and
Economics, 26: 301-327.
Fehr, E., Falk, A., (2002), Psychological foundations of incentives, European Economic Review,
46: 687–724.
Forsythe, R., Horowitz, J., Savin, N., Sefton, M., (1994), Fairness in Simple Bargaining
Experiments, Games and Economic Behavior, 6: 347-369.
Frank, R. H., Gilovich, T. D., Regan, D. T. (1996), Do Economists Make Bad Citizens? The
Journal of Economic Perspectives, 10(1): 187-192.
Frank, R., Gilovich, T., Regan, D. (1993), Does Studying Economics Inhibit Cooperation? The
Journal of Economic Perspectives, 7(2): 159-171.
Frederick, S. (2005), Cognitive Reflection and Decision Making, The Journal of Economic
Perspectives, 19(4): 25-42.
Frey, B., Jegen, R., (2001), Motivation crowding theory, Journal of Economics Surveys, 15:
589–611.
Gino, F., Moore, D., Ariely, D., Bazerman, M. (2008), See No Evil: When We Overlook Other
People's Unethical Behavior, Harvard Business School NOM Working Paper No. 08-045. Available at
http://ssrn.com/abstract=1079969
Gino, F., and Pierce, L. (2009), Dishonesty in the Name of Equity, Psychological Science, 20:9
1153-1160. DOI: 10.1111/j.1467-9280.2009.02421.x
Gino, F., Norton, M., Ariely, D. (2010), The Counterfeit Self: The Deceptive Costs of Faking It,
Psychological Science, 21: 712-720, DOI:10.1177/0956797610366545
Gino, F., and Ariely, D. (2011), The Dark Side of Creativity: Original thinkers can be More
Dishonest, Journal of Personality and Social Psychology, 102(3): 445-459. DOI: 10.1037/a0026406
Gino, F., Schweitzer, M.., Mead, N., and Ariely, D. (2011), Unable to Resist Temptation: How
Self-Control Depletion Promotes Unethical Behavior, Organizational Behavior and Human Decision
Processes, 115: 191–203, DOI:10.1016/j.obhdp.2011.03.001
21
Gintis, H., (2000), Strong Reciprocity and Human Sociality, Journal of Theoretical Biology,
206: 169-179.
Gintis, H., Bowles, S., Boyd, R., Fehr, E. (2003), Explaining Altruistic Behavior in Humans,
Evolution and Human Behavior, 24: 153–172, DOI:10.1016/S1090-5138(02)00157-5
Ghoshal, S. (2005), Bad Management Theories Are Destroying Good Management Practices,
Academy of Management Learning and Education, 4(1): 75-91, DOI:10.5465/AMLE.2005.16132558
Güth, W., Schmittberger, R., Schwarze, B. (1982), An Experimental Analysis of Ultimatum
Bargaining, Journal of Economic Behavior, 3(4): 367-388, DOI: 10.1016/0167-2681(82)90011-7.
Hamilton, S. and Micklethwait, A. (2006), Greed and Corporate Failure: The Lessons from
Recent Disasters, Palgrave Macmillian.
Harvey, A. H., Kirk, U., Denfield, G., and Montague, P. R. (2010), Monetary Favors and Their
Influence on Neural Responses and Revealed Preference, The Journal of Neuroscience, 30(28): 9597–
9602. DOI:10.1523/JNEUROSCI.1086-10.2010
Henrich, J., Boyd, R., Bowles, S., Camerer, C., Herbert, E., and McElreath, R. (2001), In Search
of Homo economicus: Behavioral Experiments in 15 Small-Scale Societies, The American Economic
Review, 91(2): 73-78.
Henrich, J., Boyd, R., Bowles, S., Camerer, C., Fehr, E., and Gintis, H. (2004), Foundations of
Human Sociality: Economic Experiments and Ethnographic Evidence from Fifteen Small-Scale
Societies, Oxford University Press.
Hernandez, M., (2012), Toward an understanding of the psychology of stewardship, Academy of
Management Review, 37: 172–193.
Hoffman, E., McCabe, K., Smith, V., (1996a), On Expectations and the Monetary Stakes in
Ultimatum
Games,
International
Journal
of
Game
Theory,
25(3):
289-301,
DOI:
10.1007/BF02425259.
Hoffman, E., McCabe, K., Smith, V., (1996b), Social Distance and Other-Regarding Behavior
in Dictator Games, The American Economic Review, 86(3): 653-660.
Jensen, M., and Meckling, W. (1976), Theory of the firm: managerial behavior, agency costs
and ownership structure, Journal of Financial Economics, 3: 305-360.
Jensen, M., and Meckling, W. (1994), The Nature of Man, Journal of Applied Corporate
Finance, 7: 4–19. doi: 10.1111/j.1745-6622.1994.tb00401.x
Jensen, M. (1994), Self-Interest, Altruism, Incentives, and Agency Theory, Journal of Applied
Corporate Finance, 7: 40–45. doi: 10.1111/j.1745-6622.1994.tb00404.x
Kahneman, D., and Tversky, A. (1979), Prospect Theory: An Analysis of Decision Under
Risk, Econometrica, 47: 263-291.
Kahneman, D., Knetsch J., Thaler, R., (1986), Fairness and the Assumptions of Economics, The
Journal of Business, 59(4): 285-300.
22
Kahneman, D. (2011), Thinking, Fast and Slow, 1 ed. Farrar, Straus and Giroux, ISBN-13: 9780374275631.
Koenigs, M., and Tranel, D. (2007), Irrational Economic Decision-Making after Ventromedial
Prefrontal Damage: Evidence from the Ultimatum Game, The Journal of Neuroscience, 27(4): 951956, DOI:10.1523/JNEUROSCI.4606-06.2007
Kolev, K., Wiseman, R., Gomez-Mejia, L., (2012), Incentive alignment as remedy or a symptom
of agency problems: Potential for opportunism and CEO excess returns, Working paper, Michigan
State University.
Kosfeld, M., Heinrichs, M., Zak, P., Fischbacher, U., and Fehr, E. (2005), Oxytocin Increases
Trust in Humans, Nature, 435(2): 673-676, DOI:10.1038/nature03701
Krupka, E., and Weber, R. (2009), The Focusing and Informational Effects of Norms on ProSocial Behavior, Journal of Economic Psychology, 30(3): 307-320, DOI:10.1016/j.joep.2008.11.005
La Porta, R., Shleifer, A., Lopez-de-Silanes, F., Vishny, R. (1998), Law and finance, Journal of
Political Economy, 106: 1113-1155.
List, J. A., and Cherry, T. L. (2008), Examining the Role of Fairness in High Stakes Allocation
Decisions, Journal of Economic Behavior & Organization, 65: 1–8, DOI:10.1016/j.jebo.2003.09.021
López-Pérez, R., (2009), Followers and Leaders: Reciprocity, Social Norms and Group
Behavior, The Journal of Socio-Economics, 38(4): 557-567, DOI: 10.1016/j.socec.2008.05.011.
Malmendier, U., and Tate, G. A. (2008), Who Makes Acquisitions? CEO Overconfidence and
the
Market’s
Reaction,
Journal
of
Financial
Economics,
89(1):
20-43,
DOI:10.1016/j.jfineco.2007.07.002
Martin, G., Wiseman, R., Gomez-Mejia, L., (2012), Stock options as a mixed gamble:
Revisiting the behavioral agency model, Academy of Management Journal, 55, in press.
Mayer, R., Davis, J., Schoorman, F., (1995), An integrative model of organizational trust,
Academy of Management Review, 20: 709–734.
Mazar, N., and Ariely, D. (2006), Dishonesty in Everyday Life and its Policy Implications,
Journal of Public Policy and Marketing, 25(1): 117-126
Mazar, N., Amir, O., and Ariely, D. (2008), The Dishonesty of Honest People: A Theory of SelfConcept Maintenance, Journal of Marketing Research, 45(6): 633-644
Mead, N. L., Baumeister, R. F., and Gino, F, Schweitzer, M. E., Ariely, D. (2009), Too Tired to
Tell the Truth: Self-Control Resource Depletion and Dishonesty, Journal of Experimental Social
Psychology, 45(3): 594-597, DOI:10.1016/j.jesp.2009.02.004.
Meier, S., and Frey, B. (2004), Do Business Students Make Good Citizens? Int. J. of the
Economics of Business, 11(2): 141-163.
McCabe, K., Rassenti, S., Smith, V., (1996), Game Theory and Reciprocity in Some Extensive
form Experimental Games, PNAS, 93(23): 13421-13428.
23
McCabe, K., Houser, D., Ryan, L., Smith, V., and Trouard, T. (2001), A Functional Imaging
Study of Cooperation in Two-Person Reciprocal Exchange, Proceedings of the National Academy of
Sciences of the United States of America, 98(20): 11832-11835
McCabe, K., and Rigdon, M., and Smith, V. (2003), Positive Reciprocity and Intentions in Trust
Games, Journal of Economic Behavior and Organization, 52(2): 267-275, DOI:10.1016/S01672681(03)00003-9
Mijović-Prelec, D., and Prelec, D. (2010), Self-Deception as Self-Signaling: a Model and
Experimental Evidence, Philosophical Transactions of the Royal Society, 365(1538): 227-240,
DOI:10.1098/rstb.2009.0218
Milgram, S. (1974), Obedience to Authority: An Experimental View, New York, N Y Harper &
Row.
Mill, J. S. (1836), On the Definition of Political Economy; and on the Method of Investigation
Proper to It, London and Westminster Review, October. Reprint, 1967, Collected Works, 4: 120-64.
Toronto: University of Toronto Press.
Morck, R. (2009), Generalized Agency Problems, NBER working paper 15051, available at
http://www.nber.org/papers/w15051
Morck, R. (2008), Behavioral Finance in Corporate Governance: Economics and the Ethics of
the Devil’s Advocate, Journal of Management and Governance, 12: 179-200.
Noreen, E., (1988), The economics of ethics: A new perspective on agency theory, Accounting,
Organizations and Society, 13: 359–360.
Nowak, M., Page, K., and Sigmund, K. (2000), Fairness Versus Reason in the Ultimatum Game,
Science, 289(5485): 1773-1775. DOI:10.1126/science.289.5485.1773
OECD, (2009), Corporate Governance and the Financial Crisis: Key Findings and Main
Messages, available at
http://www.oecd.org/corporate/corporateaffairs/corporategovernanceprinciples/43056196.pdf
Oosterbeek, H., Sloof, R., and Van De Kuilen, G. (2004), Cultural Differences in Ultimatum
Game Experiments: Evidence from a Meta-Analysis, Experimental Economics, 7(2): 171–
188. DOI:10.1023/B:EXEC.0000026978.14316.74
Persky, J. (1995), Retrospectives: The Ethology of Homo Economicus, The Journal of
Economic Perspectives, 9(2): 221-231.
Rilling, J., Gutman, D., Zeh, H., Pagnoni, G., Berns, G., and Kilts, C. (2002), A Neural Basis
for Social Cooperation, Neuron, 35: 395–405.
Rost, K., Weibel, A., and Osterloh, M. (2007), Good Organizational Design for Bad
Motivational Dispositions? Working paper available at http://ssrn.com/abstract=1019765
Sally, D., (1995), Conversation and Cooperation in Social Dilemmas: A Meta-Analysis of
Experiments
from
1958
to
1992,
Rationality
and
Society,
7:58-92,
Doi:10.1177/1043463195007001004.
24
Sanfey, A., Rilling, A., and Nystrom, C. (2003), The Neural Basis of Economic DecisionMaking in the Ultimatum Game, Science, 13(300): 1755-1758, DOI:10.1126/science.1082976
Schoorman, F., Mayer, R., Davis, J., (1996), Organizational trust: Philosophical perspectives
and conceptual definitions, Academy of Management Review, 21: 337–340.
Schrand, C. M., Zechman, S. L., Executive Overconfidence and the Slippery Slope to Financial
Misreporting,
Journal
of
Accounting
and
Economics,
53(1–2):
311-329,
DOI:10.1016/j.jacceco.2011.09.001
Schwartz, J., Luce, M. F., and Ariely, D. (2011), Are Consumers Too Trusting? The Effects of
Relationships with Expert Advisers, Journal of Marketing Research, 48: S163-S174.
Schwieren, C., Weichselbaumer, D. (2010), Does competition enhance performance or
cheating? A laboratory experiment, Journal of Economic Psychology, 31(3): 241-253, DOI:
10.1016/j.joep.2009.02.005
Shleifer, A., and Vishny, R. (1997), A Survey of Corporate Governance, Journal of Finance,
52(2): 737-783.
Shu, L., Mazar, N., Gino, F., and Bazerman, M. (2011), Dishonest Deed, Clear Conscience:
When Cheating Leads to Moral Disengagement and Motivated Forgetting, Personality and Social
Psychology Bulletin, 37(3): 330-349, DOI:10.1177/0146167211398138
Shu, L., Mazar, N., Gino, F., Ariely, D., and Bazerman, M. (2012), When to Sign on the Dotted
Line? Signing First Makes Ethics Salient and Decreases Dishonest Self-Reports, Harvard Business
School NOM Unit Working Paper No. 11-117.
Singer, T., and Frith, C. (2005), The Painful Side of Empathy, Nature Neuroscience, 8(7): 845846, DOI:10.1038/nn0705-845
Stout, L. (2010), Cultivating Conscience: How Good Laws Make Good People. 1 ed. Princeton
Univ. Press.
Sundaramurthy, C., Lewis, M., (2003), Control and collaboration: Paradoxes of governance,
Academy of Management Review, 28: 397–415.
Thaler, R., Shefrin, H. (1981), An Economic Theory of Self-Control, Journal of Political
Economy, 89(2): 392-406.
Thaler, R. (1988), Anomalies: The Ultimatum Game, The Journal of Economic Perspectives,
2(4): 195-206.
Thaler, R. (2000), From Homo economicus to Homo Sapiens, The Journal of Economic
Perspectives, 14(1): 133-141.
Tirole, J., (2002), Rational irrationality: Some economics of self-management, European
Economic Review, 46: 633–655.
Tversky, A., and Kahneman, D. (1974), Judgment Under Uncertainty: Heuristics and
Biases, Science, 185: 1124-1131.
25
Van Ees, H., Gabrielsson, J., Huse, M. (2009), Toward a Behavioral Theory of Boards and
Corporate Governance, Corporate Governance: An International Review, 17(3): 307-319,
DOI: 10.1111/j.1467-8683.2009.00741.x
Wiltermuth, S. (2011), Cheating more When the Spoils are Split, Organizational Behavior and
Human Decision Processes, 115(2): 157-168, DOI:10.1016/j.obhdp.2010.10.001
Wiseman, R. M., Cuevas-Rodriguez, G., Gomez-Mejia, L. (2012), Toward a social theory of
agency, Journal of Management Studies, 49: 202–222.
Zaheer, A., McEvily, B., Perrone, V. (1998), Does trust matter? Exploring the effects of
interorganizational and interpersonal trust on performance, Organization Science, 9: 141–159.
26
Table 1. List with major corporate scandals associated with governance problems of the first decade of the 21st Century.16
#
Company
Country
Year
Estimated losses
for
shareholders17
Did it involve
fraud?
What happened?
1
Enron
USA
2001
$60 billion
YES
Accounting fraud, inflation of assets debt hidden in special purpose entities
kept off the balance sheet.
2
Xerox
USA
2001
$2 billion
YES
The company improperly booked nearly $3 billion in revenues between 1997
and 2000, leading to an overstatement of earnings of nearly $1.4 billion.
3
Adelphia
USA
2002
$2.5 billion
YES
The Rigas founding family borrowed $2.3 billion from the company that was
not reported on its balance sheets. The firm overstated results by inflating
capital expenses and hiding debt.
4
Tyco
USA
2002
$1 billion
YES
The Chairman and CEO Dennis Kozlowski and former CFO Mark H. Swartz
were accused of diverting about $600 million from the company.
5
Worldcom
USA
2002
$186 billion
YES
The company overstated cash flow by booking $11 billion in operating
expenses as capital expenses. It also gave about $400 million to its Chairman
and CEO Bernard Ebbers in off-the-books loans.
Uncertain
The company was accused of misleading information about its Ebitda growth
and liquidity in its public filings and releases in order to meet targets in 2001.
It accumulated huge debts as a result of an aggressive acquisition strategy
prompted by its powerful CEO Jean Marie Messier.
YES
The company has overstated its profits by more than $1 billion as well as kept
billions in debt off its balance sheet. It also pursued a failed aggressive
strategy of acquisitions resulting in significant losses for its shareholders.
YES
The company collapsed in 2003 with $14 billion in off-balance sheet debts
hidden in special purpose entities, in what remains Europe's biggest
bankruptcy.
6
7
8
Vivendi
France
Royal Ahold
Netherlands
Parmalat
Italy
2002
2003
2003
$13 billion
$2 billion
$3 billion
16
Technically, the first decade of the 21st century ended on December 31, 2009. I included two scandals taking place in 2010 (BP and Olympus) due to their relevance and
usefulness for the analysis proposed in this article.
17
Estimated by the decrease of the company’s market capitalization right after the emergence of the scandals. All figures in US dollars.
27
#
Company
Country
Year
Estimated losses
for
shareholders17
Did it involve
fraud?
What happened?
9
Royal Dutch
Shell
Netherlan
ds / UK
2004
$1 billion
YES
The company has overstated its proved oil reserves by 23 percent, resulting in
profits being exaggerated by $276 million, as well as profits embellishment
by an additional $156 million.
10
Livedoor
Japan
2005
$7 billion
YES
The company was accused of doctoring financial figures of a subsidiary in an
effort to improperly boost stock prices.
11
Refco
USA
2005
$4 billion
YES
The Chairman and CEO Phillip R. Bennett had hidden $430 million in bad
debts from the company's auditors and investors.
YES
The company was fined $1.6 billion by American and European authorities
after being accused of using a US$ 500 million slush fund to pay around $1.4
billion in bribes in order to obtain contracts in emerging countries from 2001
until 2007.
In January 2008, the French bank reported losses of about $ 7billion from
fraudulent derivative operations. According to the bank, all of the operations
were performed singlehandedly by one operator, Jérome Kérviel, who
allegedly violated the institution's control system.
12
Siemens
13
Société
Générale
France
2008
$20 billion
YES
14
Lehman
Brothers
USA
2008
$60 billion
Uncertain
The company filed for Chapter 11 bankruptcy protection after huge losses
due to complex financial operations which led it to insolvency. There are
suspicions of fraud with Repo 105 transactions.
15
Bear Sterns
USA
2008
$20 billion
Uncertain
The company was sold off at a symbolic price in 2008, due to complex
financial operations which led it to insolvency.
Germany
2007
$3 billion
16
AIG
USA
2008
$239 billion
Uncertain
The world's former #1 insurance company got itself involved in treacherous
financial transactions that resulted in colossal losses, needing more than $150
billion in bailout money from the American government in order to escape
bankruptcy. The company had already been fined US$ 2 billion in 2005 due
to financial record manipulation and balance sheet fraud.
17
Sadia
Brazil
2008
$2 billion
NO
The food processing company reported billion dollar losses from speculation
through over-the-counter exchange rate derivative operations.
28
#
Company
Country
Year
Estimated losses
for
shareholders17
Did it involve
fraud?
What happened?
18
Aracruz
Brazil
2008
$3 billion
NO
The pulp and paper company reported billion dollar losses from speculation
through over-the-counter exchange rate derivative operations.
19
Madoff
USA
2008
$65 billion
YES
Founder and CEO Bernard Madoff confessed that a Ponzi scheme had been
running for decades at his asset management company, resulting in losses for
his approximately 4,800 investors.
20
Satyam
India
2009
$3 billion
YES
Ramalingam Raju, Chairman and founder of Satyam (India's fourth largest IT
company), sent a letter to both the board of directors and to the country's
regulator in which he confessed that the company had inflated its revenues by
76% and its profits by 97% in the previous year.
21
Panamericano
Brazil
2009
$2.5 billion
YES
The bank, which had successfully made its IPO just two years earlier,
announced a hole of about $ 2.0 billion on its balance sheet, about 2.5 its
equity and half of their total assets.
22
BP
23
Olympus
UK
2010
$45 billion
NO
An explosion at Deepwater Horizon, a drilling rig in the Gulf of Mexico
connected to a well owned by the oil company BP, led to the largest
accidental oil spill in history and to the death of 11 workers. The firm has put
aside $20 billion for compensation for damages incurred by victims of the
spill. Together with previous safety incidents at the company, BP was accused
of negligence regarding its operational risk management practices.
Japan
2010
$7 billion
YES
The company concealed losses by paying $687 million to advisers on
acquisitions. The company is also accused of siphon another $1.5 billion
through offshore funds.
Total Estimated losses
$751 billion
29
Chart 1. Common causes associated with corporate governance scandals.
30
Table 2. Rationale for the common causes associated with corporate governance scandals.
Type of Cause associated
with Corporate Scandals
Common Cause
This cause is manifested when…
Corporate decisions tend to come from the single views of specific individuals without the
Excessive concentration of power appropriate counterbalances.
Boards do not satisfactorily perform their role of monitoring managers and providing the right
strategic direction.
Investors do not correctly exercise their role as active shareholders, and end up wrongly rewarding
Passivity of investors
firms with unsustainable practices by inflating their stock prices.
Reputational intermediaries such as auditors, stock analysts, credit rating agencies, attorneys,
investment banks, and consultants who pledge their reputational capital to vouch for information
Failure of gatekeepers
that investors cannot verify fail in their duties.
Poor or nonexistent regulation allows the occurrence of governance problems.
Poor Regulation
People inside and outside the organization come to believe that the company is an absolute
Illusion of success of the business success, ignoring contrary evidence and generating a feeling of invincibility.
Ineffective Board of Directors
Fundamental Cause
Internal atmosphere of greed and
arrogance
Lack of ethical tone at the top
Mediating Cause
Corporate governance seen as a
marketing tool
An internal atmosphere of euphoria and hubris creates an inner sense of superiority to people
outside the company.
Leaders clearly fail to promote high ethical standards within their organizations, not treating the
issue as something essential and priority.
The company clearly seeks to meet the check-list of recommended governance practices without
actually embracing the theme at its core prior to the emergence of the scandals.
Three corporate statements below provide examples of this:
“Enron Values: 1) Communication: we have an obligation to communicate. 2) Respect:
we treat others as we would like to be treated ourselves. 3) Integrity: We work with
customers and prospects openly, honestly and sincerely. 4) Excellence: We are satisfied
with nothing less than the very best in everything we do.” – Enron Annual Report 2000.
“We are committed to being an active and responsible member of every community where
we do business worldwide and we’ve set the goal of becoming best-in-class in corporate
governance, business practices, sustainability and corporate citizenship… We believe that
an unwavering commitment to corporate responsibility is vital for our long-term success.
That’s why we go to great lengths to balance business, ethical, environmental and social
concerns… We are committed to financial transparency, compliance with the financial
31
Type of Cause associated
with Corporate Scandals
Common Cause
This cause is manifested when…
reporting requirements of German stock corporation law and U.S. capital market
regulations, and open communication with our shareholders. Binding rules and
guidelines ensure that our dealings with business partners are ethical and adhere to all
relevant legal requirements” – Siemens Annual Report 2005.
“Safety, people and performance, and these remain our priorities. Our number one
priority was to do everything possible to achieve safe, compliant and reliable operations.
Good policies and processes are essential but, ultimately, safety is about how people think
and act. That’s critical at the front line but it is also true for the entire group. Safety must
inform every decision and every action. The BP operating management system turns the
principle of safe and reliable operations into reality by governing how every BP project,
site, operation and facility is managed. Our work on safety has been acknowledged inside
and outside the group” – BP Report 2008.
Overexpansion of the business
Biased strategic decisions
Immediate Cause
Inflated Financial Statements
Weak internal controls
Inadequate compensation system
Excessive growth of the company in the years immediately preceding the governance problems,
especially via acquisitions, contribute to the scandal.
Unintentionally bad top level strategic decisions are made due to cognitive biases such as
overconfidence, groupthink, information cascades, etc.
The company intentionally publishes doctored financial statements, often inflating its profits or
hiding its debts.
The main components of a sound internal control system are missing, such as an adequate control
environment, effective risk management and control activities.
A compensation system too aggressive and too connected to short-term goals substantially
contributes to governance problems.
32
Table 3. Main reasons behind selected corporate scandals from the first decade of the 21st Century.
Common causes associated with corporate governance scandals from the first decade of the 21st Century on a 0-3 scale18
Fundamental Causes
#
Company
Mediating Causes
Immediate Causes
1
2
3
4
5
6
7
8
9
10
11
12
13
14
Year
Excessive
Concentr
ation of
Power
Ineffective
Board of
Directors
Passivity
of
Investors
Failure
of
Gatekee
pers
Poor
Regulat
ion
Illusion
of
Success
of the
Business
Atmosp
here of
Greed &
Arrogan
ce
Lack of
Ethical
Tone at
the Top
CG seen
as a
Marketi
ng Tool
Overexp
ansion
of the
Business
Biased
Strategic
Decisions
Inflated
Financial
Statemen
ts
Weak
Internal
Control
s
Inadequ
ate
Compen
sation
System
XXX
XXX
XX
XXX
XXX
XXX
XX
1
Enron
2001
XX
XXX
XXX
XXX
XXX
XXX
XXX
XXX
XXX
XXX
2
Xerox
2001
X
XX
X
XXX
XX
X
X
XX
X
X
3
Adelphia
2002
XXX
XXX
XX
XX
XX
X
XX
XXX
4
Tyco
2002
XXX
XXX
XX
X
X
XX
XXX
XXX
5
Worldcom
2002
XXX
XXX
XX
XXX
XX
XXX
XXX
6
Vivendi
2002
XXX
XX
XX
X
X
XX
7
Royal Ahold
2003
XX
XX
XX
X
X
8
Parmalat
2003
XXX
XXX
XX
XXX
XX
9
Shell
2004
X
XX
X
X
10
Livedoor
2005
XXX
XXX
XXX
XX
X
11
Refco
2005
XXX
XX
X
X
X
12
Siemens
2007
XXX
X
XX
XXX
X
13
Société
Générale
2008
XX
XX
X
X
XX
14
Lehman
2008
XXX
XXX
XXX
XX
XXX
XX
XX
XXX
XXX
XX
X
XXX
XXX
XX
XX
XXX
XXX
X
XXX
XXX
XXX
XX
XXX
XXX
XXX
X
XX
XXX
XXX
X
XX
XX
XX
XX
XX
XXX
XXX
XXX
XXX
XX
XXX
XX
XXX
X
XXX
XXX
XXX
XXX
X
X
XX
X
XXX
XX
X
XXX
XX
X
XXX
X
XXX
XXX
XXX
XXX
XX
XXX
XXX
XXX
XX
XX
XX
XX
XX
XX
X
X
XXX
XXX
X
X
XX
X
XXX
XX
XX
XXX
XX
XXX
X
18
The qualitative scale aims to analyze the different relevance of each common cause associated with corporate scandals. “X” indicates that the factor was relevant for the
emergence of the scandal. “XX” indicates that the factor was highly relevant and “XXX” indicates that it was critical for the eruption of the scandal. Void cells indicate that
the respective factor was not relevant to the case at hand.
33
Common causes associated with corporate governance scandals from the first decade of the 21st Century on a 0-3 scale18
Fundamental Causes
#
Company
Mediating Causes
Immediate Causes
1
2
3
4
5
6
7
8
9
10
11
12
13
14
Year
Excessive
Concentr
ation of
Power
Ineffective
Board of
Directors
Passivity
of
Investors
Failure
of
Gatekee
pers
Poor
Regulat
ion
Illusion
of
Success
of the
Business
Atmosp
here of
Greed &
Arrogan
ce
Lack of
Ethical
Tone at
the Top
CG seen
as a
Marketi
ng Tool
Overexp
ansion
of the
Business
Biased
Strategic
Decisions
Inflated
Financial
Statemen
ts
Weak
Internal
Control
s
Inadequ
ate
Compen
sation
System
Brothers
15
Bear Sterns
2008
XXX
XXX
XX
XXX
XX
XXX
XXX
XXX
XXX
XX
XXX
X
XX
XXX
16
AIG
2008
XXX
XXX
XX
XXX
XX
XXX
XXX
XXX
XXX
XX
XXX
X
XX
XXX
17
Sadia
2008
X
XXX
XX
XXX
XXX
XXX
X
XXX
XXX
XX
XXX
XX
18
Aracruz
2008
X
XXX
XX
XX
XXX
XXX
XX
XXX
XXX
XXX
XXX
X
19
Madoff
2008
XXX
XXX
XXX
XX
XX
XXX
XXX
XXX
XX
XXX
20
Satyam
2009
XXX
XXX
XX
XXX
X
XX
X
XX
XXX
21
Panamericano
2009
XXX
XXX
XXX
XXX
XX
XX
XXX
XXX
XXX
22
BP
2010
X
XXX
XX
X
X
X
XX
XXX
X
23
Olympus
2010
XXX
XXX
XX
XX
X
XXX
X
X
X
XX
XX
XXX
XXX
X
XXX
XXX
XX
XXX
XXX
XXX
XXX
XX
XX
XXX
XXX
Average (0-3) rating 20012005 (n=11)
2,5
2,5
2,0
1,9
1,5
2,1
2,2
2,6
1,3
2,3
2,7
2,8
2,3
2,0
Average (0-3) rating 20062010 (n=12)
2,3
2,9
2,2
2,3
2,1
2,3
2,3
2,8
2,7
1,8
2,1
1,9
2,7
2,4
Average (0-3) rating 20012011 (n=23)
2,4
2,7
2,1
2,1
1,8
2,2
2,2
2,7
2,1
2,1
2,4
2,4
2,5
2,2
34
Table 4. Individual and collective cognitive biases and their potential problems for the governance of businesses.19
Type of Bias
(Individual or
Collective)
#
Bias
Description
Individual
Optimism and overconfidence
Tendency for people to underestimate risks and / or
to overestimate the perspectives of future results.
Individual
Irrational obedience to
authority
Tendency to obey orders from authorities viewed as
leaders without questioning in certain
circumstances.
3
Individual
Irrational escalation of
commitment
4
Individual
Normalcy bias
5
Individual
Planning Fallacy
1
2
6
7
19
Individual
Gambler's Fallacy
Individual
Curse of knowledge
Propensity to increase the investment in a decision
– based on cumulative prior investment – despite
new evidence suggesting that the cost of continuing
the decision outweighs its expected benefit.
Tendency to underestimate the possibility of the
occurrence of disasters that never occurred, as well
as inability to cope with disasters once they occurs.
Propensity of people to underestimate how long
they will take to complete a task, even if they have
previous experience in similar tasks.
Tendency to think that the probability of future
events is altered by past events, even when the
events are independent and the probability remains
the same.
Difficulty of people with a lot of knowledge about a
topic to think about problems from the perspective
of lesser-informed agents.
Potential problems for the governance of
businesses






Overinvestment;
Too expensive M&A deals;
Excess financial debt;
Disregard of relevant risks.
Frauds;
Blind obedience to entrepreneurs or
powerful executives.
Attachment to initiatives and projects that
did not work and should be rationally
treated as sunk funds.
Reduced investment in risk management
initiatives dealing with risks that have high
impact but low probability of occurrence.
 Project delays;
 Unrealistic promises to stakeholders.
Belief that the results of past projects below
expectations will be “naturally” offset by
results of future projects, even when they
are independent activities.
 Release of products difficult to
understand by consumers;
 Dissonance between the strategic vision
of top management and that of the rest of
The description of the cognitive biases have been extracted from the “list of cognitive biases” available at http://en.wikipedia.org/wiki/List_of_cognitive_biases
35
#
Type of Bias
(Individual or
Collective)
Bias
Description
Potential problems for the governance of
businesses
the organization.
8
Individual
Déformation professionnelle
9
Individual
Endowment effect
10
Individual
Confirmation bias , selective
perception
11
Individual
Status quo bias
12
Individual
Interloper effect, the
consultants paradox
13
Individual
Framing effect
14
Individual
Outcome bias
15
Individual
The availability heuristic
Tendency to look things from one’s own
professional point of view, rather than from a
broader perspective: the professional training leads
to a distorted way of seeing the world.
Tendency to overvalue assets and personal projects:
people tend to ask a lot more to sell their assets than
they would be willing to pay for if the assets
belonged to a third party.
Tendency of people to favor information that
confirms their beliefs or hypotheses: the effect is
greater in subjects with greater emotional and more
rooted prejudices.
Propensity to maintain the current state of affairs in
situations where changes to the current course are
expected to provide higher benefit than the
maintenance of current situation.
Tendency to value third party consultation as
objective, confirming, and without conflicts of
interest, as well as to provide less support to
internally proposed solutions.
Propensity of people to reach different conclusions
from the same information, depending on whether it
is presented as a loss or as a gain.
Tendency judge a decision by its outcome rather
than based on the quality of the decision at the time
it was made, given what was known at that time
Tendency to believe that events in vivid memory
have a higher probability of occurring than they
Distortion of business activities and focus
due to the professional training of their top
leader.
 Refusal to sell assets at fair value;
 Overvaluation of their own initiatives.
Difficulty in accepting new visions and
paradigms in order to change problematic
courses of action: maintenance of status
quo.
Postponement of important decisions with
loss of opportunities and competitiveness,
resulting in increased losses.
No taking advantage of internal ideas, with
less motivation of employees and loss of
talent.
Wrong decisions due to manipulation in the
way the information is presented.
Wrong assessment of people for decisions
that resulted in poor results, even if taken in
the correct way at the time. The reverse is
also true.
Exclusive consideration of the leader’s
personal experiences in decision making,
36
#
Type of Bias
(Individual or
Collective)
Bias
16
Individual
Self-serving bias, illusory
superiority
17
Individual
Egocentricity bias
18
Individual
Hindsight bias
Individual
Anchorage
20
Collective
Herd behavior, conformity, and
information cascades
21
Collective
Groupthink
22
Collective
False consensus
19
Description
actually have statistically.
Tendency of individuals to attribute their success to
internal or personal factors but attributing their
failures to external or situational factors.
Tendency for people to claim more responsibility
for themselves for the results of a joint action than
an outside observer would credit them.
Propensity to see past events as more predictable
than they actually were before they took place (“I
knew-it-all-along” effect).
Tendency of people to rely too heavily, or “anchor”
on one trait or piece of information when making
decisions, even if it has no direct relationship with
the subject under review.
Tendency of group members - especially those with
less information for decision – to observe the
actions and initial opinions of others and then make
the same choice that the others have made,
independently of their own private opinion.
Trend excessively homogeneous groups to
minimize conflict and reach consensus at any cost,
ignoring external ideas that may contradict the
dominant view.
Individual’s tendency to think that their opinions,
beliefs, habits, values, etc. are “normal”,
overestimating the likelihood of other people
agreeing with his or her point of view.
Potential problems for the governance of
businesses
ignoring statistical parameters.
Assigning blame to others, with negative
impacts on meritocracy and employee
motivation.
Excessive centralization of power, reduced
motivation of employees.
Memory distortion in the analysis of past
decisions (such as non-recognition of
exogenous events) could make it very
difficult to distinguish bad decisions from
bad outcomes, ending up, for instance, in
unfairly attribution of blame.
Wrong decisions due to the availability of
initial information that distorted the
analysis.
Loss of the group collective wisdom, with
decisions being made according to the
specific interests of individuals more
knowledgeable about the subject under
analysis.
Possibility of more extreme decisions by
the group, with rejection of good outside
opinions.
Tendency of isolating people with
systematically different points of view.
37
Type of Bias
(Individual or
Collective)
Bias
Collective
In-group favoritism
24
Collective
Out-group homogeneity
25
Collective
Group-serving bias
#
23
Description
Tendency for people to support views and opinions
of members from their own group in comparison
with opinions people outside the group.
Misperception of individuals that members outside
the group are more similar to each other than they
really are and that his or her group is more diverse
than it actually is.
Tendency of group members to make dispositional
attributions for their group’s successes and
situational attributions for group failures.
Potential problems for the governance of
businesses
Disregard of valuable external views.
Difficulty in understanding the
heterogeneity of people outside the
organization and the external environment,
leading to a tendency to stereotype.
Erroneous assignment of blame to others,
maintenance of the status quo.
38
Table 5. Mainstream approach to corporate governance vs. the new behavioral approach based on psychological aspects.
Mainstream view: Corporate governance as a mere set of incentive and control mechanisms in order to make agents (managers)
act in the best interest of their principals (shareholders)
Conceptual root: The reduction of the human being to homo economicus
Premise
Reality (based on numerous recent researches)
1. People always make perfectly rational decisions.
People are subject to multiple cognitive biases, leading us to make
irrational decisions, both individually and in groups.
2. People think exclusively in maximizing their own
personal gain.
People usually tend to act in a cooperative and unselfish way, sacrificing
their own personal economic gains in favor of others.
3. People are always interested in breaking the rules if the
applicable penalty multiplied by the probability of being
caught is lower than the expected benefit of the
dishonest act.
Psychological factors are much more important motivators for the
decision to break the rules than the probability of being caught or the
applicable penalty.
Conclusion coming from the difference between the premises behind the mainstream approach to corporate governance and real
human behavior evidenced by recent researches:
“A new behavioral approach to corporate governance should be developed with a focus on:
1) the systematic search for mitigating cognitive biases in managerial decisions;
2) the continuous fostering of people’s awareness towards the promotion of cooperative and long-term oriented behaviors; and,
3) the reduction of the likelihood of frauds and other unlawful acts through new corporate strategies developed after a deeper
understanding of their psychological motivations.”
39