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Behavioral finance in corporate governance: economics and ethics of the devil’s advocate

Journal of Management & Governance volume 12, pages 179–200 (2008)Cite this article

Abstract

The Common Law, parliamentary democracy, and academia all institutionalize dissent to check undue obedience to authority; and corporate governance reformers advocate the same in boardrooms. Many corporate governance disasters could be averted if directors asked hard questions, demanded clear answers, and blew whistles. Work by Milgram suggests humans have an innate predisposition to obey authority. This excessive subservience of agent to principal, here dubbed a “type II agency problem”, explains directors’ eerie submission. Rational explanations are reviewed, but behavioral explanations appear more complete. Experimental work shows this predisposition disrupted by dissenting peers, conflicting authorities, and distant authorities. Thus, independent directors, chairs, and committees excluding CEOs might induce greater rationality and more considered ethics in corporate governance. Empirical evidence of this is scant—perhaps reflecting problems identifying genuinely independent directors.

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Notes

  1. See e.g. Laski (1919).

  2. See e.g. Hermalin and Weisbach (2003) for a recent survey.

  3. A large strategy literature posits behavioral regularities in boardrooms. For example Westphal and Stern 2006, 2007 and references therein demonstrate networking effects in director selection. Behavioral explanations of governance issues also enter the finance literature—e.g. Shleifer and Vishny (2003) on merger waves, Baker et al. (2007) on capital spending, Kindleberger (1978) on financial crises, and others.

  4. See Bernardo and Welch (2001) for a discussion of group selection inducing seemingly irrational individual behavior in economics.

  5. Such reflexive behavior is appreciated by students of marketing, such as Cialdini (1998), and motivates free samples and “no obligation” gifts as sales strategies.

  6. This knowledge is used by, for example, professional pollsters to generate answers that lend the aura of popular support to causes advanced by their clients (see Cialdini (1998)).

  7. Shiller (1995) speculates, based on the anthropology literature, that compliance and herding echo social conventions of polite conversation that enhance group survival odds. Brown and Levinson (1987) argue that such aspects of conversational politeness are standard across cultures, and that real tolerance of dissent requires effort and challenges human nature.

  8. Though see Leuz (2007).

  9. See e.g. Hermalin and Weisbach (2003) for a recent survey.

  10. See e.g. Lakonishok et al. (1992).

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Acknowledgements

I am grateful for helpful comments and suggests by seminar participants at the University of Alberta, Århus University, Fu-Jen Catholic University, Hong Kong University of Science and Technology, the Journal of Management and Governance Symposium at the Università Cattolica Sacro Cuore of Milan, the National Bureau of Economic Research Universities Conference on Behavioral Corporate Finance, and the University of Toronto. I am especially grateful for specific suggestions from Malcolm Baker, Terry Burnham, Lorenzo Caprio, Joseph Fan, Steve Kaplan, Richard Ruback, Andrei Shleifer, Henry Tosi, Ivo Welsch, and Jeff Wurgler. This research was funded in part by the Social Sciences and Humanities Research Council.

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  1. University of Alberta School of Business, Edmonton, Canada

    Randall Morck

  2. National Bureau of Economic Research, Cambridge, MA, USA

    Randall Morck

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Correspondence to Randall Morck.

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This work was partially undertaken while a Visiting Professor at Harvard.

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Morck, R. Behavioral finance in corporate governance: economics and ethics of the devil’s advocate. J Manage Gov 12, 179–200 (2008). https://doi.org/10.1007/s10997-008-9059-4

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Keywords

  • Behavioral finance
  • Corporate governance
  • Agency problems
  • Information cascades
  • Herding
  • Opposition