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(Rob Friedman/Rob Friedman/iStockphoto)
(Rob Friedman/Rob Friedman/iStockphoto)

Economy Lab

Seeds of bad governance are sown in good times Add to ...

Give someone an inch and they'll take a mile, it's a common enough saying.

It's rare, however, to hear that if you give someone an inch, they'll take that mile, and go in the wrong direction.

But that's exactly what a recent working paper published by the National Bureau of Economic Research in Cambridge, Mass., suggests.

To be more specific: the paper, authored by MIT's Antoinette Schoar and Yale's Ebonya Washington, shows that "following periods of abnormally good performance managers are more likely to call special meetings and to propose and pass governance measures that are contrary to shareholder interests" - i.e. measures that diminish shareholder power and weaken oversight.

This occurs, prof. Schoar said in an email, "because shareholders are (temporarily) taking their eye off the ball since the good performance might make them less vigilant or because the shareholders feel that they have to make more concessions to the CEO after delivering a good outcome."

"This finding suggests," she added, "that CEOs know when their power is highest in the firm to push through their own agenda."

But, shareholders shouldn't kid themselves: more freedom for managers doesn't necessarily result in better outcomes and the authors find that, after these special meetings take place, firms perform negatively in the subsequent quarter.

Since profs. Schoar and Washington's work relies on statistical averages, they cannot identify which specific firms have particularly bad track records. But, prof. Schoar said that it is "a widespread phenomenon and not something that is concentrated in a few firms."

And, what is more, there are serious long-term implications. As the paper concludes, these new governance measures don't expire when management takes their leave, they persist, restricting shareholder power in the future and so "the seeds of bad governance," the authors say, "seem to be sown in good times."

So what's the upshot? What can investors and observers take away from this analysis?

"Shareholders should not become complacent when the firm is doing well," prof. Schoar said. "While you want to reward a CEO for good performance, this should not be done by making concessions which allow governance structures to deteriorate."

Instead, she said, managers should be rewarded on an individual basis.

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