Enhancing the Efficiency of Board Decision Making: Lessons Learned from the Financial Crisis of 2008 (PDF of PowerPoint Slide Presentation)

Bernard S. Sharfman

Abstract

At the Loyola University (Chicago) Annual Conference on Risk Management and Corporate Governance (Oct 2009), I presented a paper that will soon be published in the Delaware Journal of Corporate Law, Volume 34, No. 3. The paper describes two intertwined stories, a corporate governance story and a corporate law story. Unfortunately, because the goal of my article was to identify a new tool of accountability under corporate law, I feel that the corporate governance story may not have been given the prominence it deserves. Therefore, my presentation at the conference focused on the corporate governance story.

The presentation described how Margaret Blair and Lynn Stout’s team production approach to corporate governance can be used to explain the compensation decisions made by Wall Street boards prior to and during the financial crisis of 2008. More specifically, it showed how the boards of Wall Street firms were required to act as “mediating hierarchies” when dealing in an environment where implicit contracts and short time horizons dominated.

According to Blair & Stout, team members can claim a residual interest in the firm when they make firm specific investments. However, identifying the firm specific investments made by investment bankers and traders was not so obvious. First, asset specificity was absent. That is, the skills and abilities possessed by traders and investment bankers were assumed to be fully transferable to other firms and therefore not dependent on the assets of any particular firm. Nevertheless, firm specific investments were created as a result of traders and investment bankers simply demanding and receiving a piece of the action (residual). Conceptually, these employees received a unique class of non-voting stock in exchange for providing their unique skills and abilities and thereby created residual interests that rivaled the residual interests of shareholders. Thinking in terms of options, traders and investment bankers can be viewed as receiving an in-the-money European call option in exchange for providing their services.

Several significant conclusions result from the telling of this corporate governance story. First, shareholder primacy is not a workable norm where implicit contracts dominate. Second, it can be conceptualized that shareholders indirectly contract away the shareholder wealth maximization norm to the extent they allow the firm to enter into implicit contracts. Shareholders allow this to happen because they trust the board to adequately perform its duty as a mediating hierarchy. If the board performs adequately, the shareholders believe they will be better off. Third, the relatively slow acceptance of Blair and Stout’s conception of the board as a mediating hierarchy may have been due to the lack of examples where it was clearly applicable. However, Wall Street has helped solved this problem.