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The uneasy marriage of governance and innovation

by Robert Teitelman | Published March 10, 2011 at 1:04 PM

Corporate governance is, technically, a neutral description of who holds power in a corporation. Shareholder democracy, on the other hand, is prescriptive, that is, it describes who should hold power and how that power should be used. Generally these days the terms are casually substituted for each other. And as a result, the study and debate of corporate governance tends to involve a search for proving the tenets of that theoretical construct, shareholder democracy. Sometimes it doesn't work out.

In a new paper available here, two professors at Quinnipiac University in Connecticut, Matthew O'Connor and Michael Rafferty, attempt to prove the hypothesis that poor corporate governance, that is entrenched management and disenfranchised shareholders, creates agency problems, which result in a disinvestment of research and development and a decline in innovation. The paper, "Corporate Governance and Innovation," lays out the standard theoretical logic that appears in much of the research in the area. In the very first line, the paper harkens back to a seminal 1976 paper by Michael Jensen and William Meckling that argues that agency problems, in which managers seek their self-interest rather than that of shareholders, "are an inherent part of modern corporations with diffuse ownership structures." Second, with appropriate citations, they "find empirical support that corporate governance influences capital expenditures." In particular, they accept the fact that CEOs "have an incentive to undertake inefficient projects for their private benefit." Third, they cite a paper that argues that companies that adopt anti-takeover measures" experience a decline in capital expenditure and R&D relative to sales."

Then they toss a small bomb. They admit -- this is rare -- that the evidence linking entrenched management and R&D "is currently weak." They propose their own study, in which they marry up Tobin's q models (an efficient-markets model that argues that market participants efficiently incorporate all relevant information into the market valuation of the firm) for examining investment behavior with measures of "corporate governance." Equations follow. Then they discuss the data, most of which also consists of standard measures of corporate governance provisions from public filings, plus some R&D numbers from Compustat.

What do they conclude? Beneath the math, the data, the theory, not a hell of a lot. "We do find evidence of a negative relationship [between strong managers and reduced R&D]," they write, "but the relationship all but disappears" after they fine-tune their math. And then they drop the hammer. "We believe our results are most consistent with the view that corporate governance has little to no influence on innovative activity. Thus our results do not support the view that agency costs play an important role in determining the level of innovative activity. Our results also do not support the view that protecting executives from the disciplines of the corporate takeover market allows them to focus on long-term investments such as innovative activity." One might add, in terms of that last statement, which seems to sneak in a shareholder-centric argument at the last second, that their results also don't support the view that exposing executives to takeovers -- to shareholder pressures -- makes them more innovative.

There's much about this that's fascinating, though mostly in terms of what it says about the field of governance research in academia. Here's what we know about R&D in the real world, divorced from the math. The relationship between R&D and innovation is a black box; companies differ, managers differ, technologies differ, times differ. As far as I know, no one has come close to quantifying that relationship by adjusting for serendipity, individual genius, feel and smarts, organizational history and structure, and of course the presence or absence of money. Why is Steve Jobs or Larry Ellison -- no monuments to good governance, by the way -- so fabulously successful? Why is the industry that spends more than any other on R&D, the big drug companies, currently sucking wind when it comes to new products? Early on in their paper, O'Connor and Rafferty offer up the conventional wisdom of good governance that "if the agency problem is severe enough then executives may reduce risky investment strategies (like innovative activity) in favor of much less risky forms of investment." Well, no, not necessarily. Some CEOs may act cautiously, depending on the circumstances; others may go for broke. It depends. Besides, what's the risk here? If it's an insanely risky project, might it not be rational to cut it back? How many CEOs have been sacked when they gambled on a high-risk deal that fizzled? And isn't the current mantra that excessive incentive-based comp -- certainly in finance, but elsewhere as well -- drives CEOs to take on too much risk? Isn't risk, in the current governance view, bad?

In fact, like the attempt to fit compensation into governance theory, innovation can be looked at in many different ways; it eludes the theory. High pay can reward risk or it can lead to risk-averse activity. One entrenched and already rich CEO may pour money into crazy R&D in the hope of a big score -- and perhaps because the company is loaded -- while another, similarly dug in, may reduce R&D because it's a sheer waste of money. How do we quantify what's an agency problem and what's a rational attempt to predict an unknowable future? And, stepping back, of all areas of corporate life, how can we expect shareholders to ever offer any valuable input into a decision so nuanced, so technical and so risky as R&D? Who could blame shareholders for letting managers handle R&D?

The real problem here, besides the fact that R&D resists prediction or quantification, is that governance is an incredibly rigid and impossibly simple iron frame that tries to hold a remarkably varied and dynamic reality. This explains why so many of these research papers, trying to prove that all variety of corporate sins emerge from giant uber-sin, entrenched management (the measurement of which is a flimsy house of abstract logic), seem to come apart in your hands when you awaken from your stupor and look at the world, in all its buzzing variousness and ambiguity, that really exists. - Robert Teitelman

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