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How does corporate governance lead to short-termism?

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Chapter 11
How does corporate governance lead
to short-termism?1
Gregory Jackson and Anastasia Petraki
1. Introduction
The explosion of managerial pay, the crisis of Enron and the arrival of
new players on financial markets have brought the topic of short-termism
back into the limelight (see Tonello 2006). Now in the midst of an
unprecedented global financial and economic crisis, the time is right to
ask a fundamental question regarding the corporate economy: do
managers and investors tend to pursue short-term gains in ways that have
detrimental effects on the long-term prospects of companies or even
national economies?
Social scientific approaches to short-termism have been hindered by a
number of conceptual, methodological and empirical barriers. This
chapter will seek to reinterpret debates over short-termism within the
context of corporate governance. Managers, shareholders and other
stakeholders may have different and sometimes conflicting time horizons
for making economic decisions. This chapter suggests that short-termism
is caused by a self-reinforcing and dynamic calibration (shortening) of
time horizons produced through the interactions between shareholders
and managers, and amplified by the roles played by gatekeepers in
mediating these relationships. This relational character of the short-
termism phenomenon helps explain why it is both hard to measure, and
difficult to address through simple policy instruments aimed exclusively
at one stakeholder group. Reforms aimed at supporting alternatives to
shareholder value such as the Sustainable Company will therefore have
to address a wide range of institutions and policy areas.
199The Sustainable Company: a new approach to corporate governance
1. This chapter is a summary of research made possible by the generous support of the Glasshouse
Forum. For the full version of this report see Jackson and Petraki (2010).
2. What is short-termism?
Short-termism involves situations where corporate stakeholders (e.g.
investors, managers, board members, auditors, employees, etc.) show a
preference for strategies that add less value but have an earlier payoff
relative to strategies that would add more value but have a later payoff.
Short-termism arises in the context of intertemporal choice, where the
timing of costs and benefits from a decision are spread out over time
(Loewenstein and Thaler 1989). The survival of a firm often depends on
achieving short-term results (Merchant and Van der Stede 2003), and
ideally these actions will extrapolate into positive long-term performance.
However, in many situations, the course of action that is best in the short-
term is not the same as the course of action that is best in the long run.
Actors may suffer from myopia when they have difficulty in assessing the
long-term consequences of their actions (Marginson and McAulay 2008).
But arguments regarding short-termism go a step further in claiming that
decision making or behaviour of certain actors are demonstrably
suboptimal. Different authors have applied the idea in relation to
different sets of actors, such as managers (Narayanan 1985) or investors
(Miles 1993; Dickerson et al. 1995).
While the definition of short-termism is intuitively clear, finding the
‘right’ model to demonstrate short-termism is not straightforward due to
a number of fundamental conceptual challenges. Economists have usually
conceptualized short-termism in relation to models of discounted utility
(DU). Here economic actors face an optimization or maximization
problem, but choose a project that is demonstrably ‘wrong’ in relation to
a baseline model. Actually defining such a baseline has proven quite
difficult for at least four reasons:
Time preference: Economic models of decision making rightly assume
discounted utility of future rewards. But no theoretical criteria have been
established for assessing whether a particular actor discounts the future
‘too much’ and thus give some proportionately greater weight to cash
flows that occur closer to the present (Dobbs 2009, p.127).
Time horizon: Most studies assume that actors’ preferences are consistent
over time, and thereby do not look at how actors define their own time
horizons. While some studies consider two years as an empirically useful
rule of thumb for distinguishing the short-term from the long-term
(Tonello 2006), this benchmark is somewhat arbitrary. Time horizons
Gregory Jackson and Anastasia Petraki
200 The Sustainable Company: a new approach to corporate governance
for assessing future returns may be different between managers and
investors, or between different groups of investors (Hasty and Fielitz
1975).
Model of valuation: Many studies criticize project assessment methods
based on net present value, where expected cash flows are discounted by
the opportunity cost of holding capital from now (year 0) until the year
when income is received or the outgo is spent (Demirag 1998). While the
DU model assumes that the discount rate should be the same for all types
of goods and categories of intertemporal decisions, new findings in
behavioural economics show that gains are discounted more than losses,
small outcomes more than large ones, and improving sequences over
declining ones (Kahneman and Tversky 1979).
Uncertainty: Actors may behave myopically or make risk-averse decisions
to avoid uncertainty about the future. As the time horizon for decision
making extends into the future, the scope of uncertainty increases. The
interdependence between uncertainty and time horizons leads actors to
care about when events occur – hence, these two factors are nearly
impossible to separate outside of controlled experimental settings.
Depending on how one specifies a baseline model, short-termism may be
perfectly rational within the framework of economics, provided that we
assume an ‘appropriate’ discount rate. This approach has come under
growing criticism within economics (Frederick et al. 2002; Loewenstein
et al. 2001) and by emerging approaches to decision making in other
fields of study (Gigerenzer 2007; Todd and Gigerenzer 2007).
Given these challenges, empirical studies of short-termism remain
surprisingly scarce. Policy makers often cite the increase in stock market
turnover or shortening tenures of managers as evidence of a trend toward
more short-term decision making. These measures are however indirect
at best. Other approaches rely on survey evidence, where managers give
information on their orientations on a self-reporting basis. Interestingly,
these studies tend to find very strong evidence of short-term bias.
The harder issue remains establishing whether short-term decisions are
actually detrimental to long-term value creation. This question is
counterfactual - once a short-term decision is taken, we cannot know the
possible effect of a different, longer-term decision. Thus, most studies
adopt indirect proxies of either short-term or long-term decisions. Short-
How does corporate governance lead to short-termism?
201The Sustainable Company: a new approach to corporate governance
term orientations have been measured by the earnings restatements by
corporations, which reflect overly aggressive accounting practices and
overestimation of short-term profitability. However, this measure does
not capture all forms of short-term behaviour. Conversely, long-term
orientations are usually studied by examining the rate of investment in
R&D under the assumption that this expenditure is long-term in nature,
imposing a short-term cost but enhancing profitability years later.
However, this measure may miss other long-term drivers of value (e.g.
employee skills, corporate reputation, etc.), and the salience of R&D as a
key measure may differ across different types of firms and industries.
3. Short-termism as a problem of corporate governance
Our analysis attempts to overcome these obstacles in understanding ‘how
short is too short’ by asking a related but distinct question: why do
corporate stakeholders favour the short or long-term? Our focus shifts
away from the question of optimization to the dynamics of corporate
governance. By examining the interaction between stakeholders with
distinct time preferences, we do not claim to have resolved the debates
over existence of short-termism. Rather, we hope to identify the
mechanisms that trigger changes in time horizons of key players from the
perspective of corporate governance.
Myopic decisions compound into ‘short-termism’ if such decisions are
taken repeatedly and become institutionalized. Short-termism thus
reflects a systematic character of decision making within an organization
shaped by organizational culture, processes, or routines. Our focus is
accordingly on how corporate governance shapes intertemporal choices
within the organization. Corporate governance involves the rights and
responsibilities of actors with a stake in the firm (Aguilera et al. 2008;
Aguilera and Jackson 2003) and is discussed here with reference to
managers, various types of shareholders and gatekeepers.
3.1 Professional managers
Managers may make myopic decisions for a variety of reasons. Miller
(2002: 690) explains that ‘managerial myopia indicates cognitive
limitations in relation to the temporal dimension of decision making, and,
at the extreme, analyzes the implications that arise when decision makers
Gregory Jackson and Anastasia Petraki
202 The Sustainable Company: a new approach to corporate governance
find themselves without the necessary information to assess even the
present state.’ The discussion of ‘faulty decisions’ by managers (Laverty),
‘cognitive limitations’ (Miller), and the ‘difficulty in assessing’ (Marginson
and McAulay) stress the informational aspects of decision making
– managers may be unable to correctly assess and appraise investment
projects. Indeed, Laverty (2004) shows that managers are less short-term
oriented when they have better information about the tradeoffs between
short- and long-term results. While managers may be myopic and make
faulty project evaluations, our framework seeks to specify organizational
mechanisms that shape the identities and interests of managers toward
a short-term orientation in a systematic way.
Borrowing from stewardship theory, we examine whether managers’
professional orientations reinforce short- or long-term time horizons by
influencing their relative autonomy or commitment to the firm (Davis,
Schoorman, and Donaldson 1997). Professional orientations are an
element of wider managerial ideologies, as ‘the major beliefs and values
expressed by top managers that provide organizational members with a
frame of reference for action’ (Goll and Zeitz 1991: 191). Ideologies allow
managers to legitimate their authority and decisions toward other
stakeholders. But ideologies also shape the perception and framing of
organizational problems through taken-for-granted cognitive templates
and toolkits for decision making. Ideologies may become institutionalized
through mimetic processes of diffusion (e.g. managerial education),
normative processes (e.g. establishment of professional groups), or
coercion (e.g. state regulation).
First, different time horizons are embodied in the decision heuristics or
investment appraisal practices adopted by managers. Short-termism
may result from the application of faulty or biased methods for assessing
investment projects (Laverty 1996). Most measures that rely solely on
financial data lead to underestimating the intangible payoffs, such as from
trained employees or reputation (Atherton, Lewis, and Plant 2007). The
use of certain valuation practices like net present value models may lead
to short-termism, not only due to the omission of non-financial returns
but also through the use of excessive discounting, which undervalues cash
flows that accrue further in the future (Lefley and Sarkis 1997).
Second, these decision heuristics are cultural artefacts linked to
managerial experience and education. Different forms of managerial
expertise may influence the ability or willingness to assess a long-term
How does corporate governance lead to short-termism?
203The Sustainable Company: a new approach to corporate governance
investment and avoid managerial myopia (Marginson and McAulay
2008; Miller 2002). In particular, managers’ understanding of ‘extra-
financial’ assets and risk factors is likely to influence their propensity to
be myopic (Atherton, Lewis, and Plant 2007). Conversely, to the extent
that managers are oriented to stock prices, Liu (2005) finds that they may
behave myopically due to managers’ ‘effort to achieve a high stock price
by inflating current earnings at the expense of the firm’s long term
interest, or intrinsic value. Managers can inflate current earnings by
under-investing in long-term intangible assets.’ Managers are also likely
to perceive that investors are focused largely on short-term (quarterly)
earnings estimates and adjust their time horizons to these perceptions
(Demirag 1998; Grinyer et al. 1998; Marston and Craven 1998). In the
USA and Britain, the spread of shareholder-value as ideology (Lazonick
and O'Sullivan 2000) is related to the focus on education in ‘general’
management, with a strong emphasis on finance. In particular, the rise
and expansion of MBA education has been linked to the dominance of
the ‘financial conception of the firm’ and its focus on shareholder returns
(Khurana 2007; Fligstein 2001). The diffusion of shareholder value as
management ideology in the last decade is widely considered to have
reinforced the short-term focus of managers on quarterly earnings and
associated practices such as share buy-backs that aim at changing short-
term stock prices (Lazonick 2007).
Finally, a growing trend in board composition around the world regards
the role of independent or outside directors. This shift from an ‘advising’
to a ‘monitoring’ board has been part of a long-term shift in corporate
governance toward shareholder value as a dominant corporate ideology
(Gordon 2007). While independent directors are encouraged to increase
the accountability of managers, outside directors may simply lack the
amount and quality of information that insiders have. The information
available may be too dependent on formal disclosure, too focused on
finance rather than strategy and operations, and hence prone to
undervalue long-term future projects. Conversely, other studies have
found effective evaluation of top managers may be associated with a
majority of inside directors (Hoskisson et al. 1994; Hill and Snell 1988)
or participation of other stakeholders such as employees in the board
(Addison et al. 2004). For example, some studies on Germany suggest
that employee representation on boards results in higher capital market
valuations due to the fact that employees have strong inside knowledge
of company operations that aid in the monitoring of management (Fauver
and Fuerst 2006).
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204 The Sustainable Company: a new approach to corporate governance
Another set of factors influencing time horizons related to the financial
and career incentives of managers. Such incentives are shaped by
executive compensation practices and labour markets for top executives.
Managers have their own objectives and ambitions as individuals. In
particular, the time horizons attached to incentives (or lack thereof)
through executive compensation schemes or within managerial labour
markets shape the extent to which short- or long-term corporate
strategies will translate into higher individual income. For example,
opportunistic managers may reject long-term investment projects, crucial
for the future welfare of the firm, in order to concentrate on other short-
term alternatives whose earlier payoff boosts allows them to maximize
their own monetary incentives (Laverty 1996). Managers may also exhibit
moral hazard, pursuing investments with faster payoff, either because it
was a less risky option in the short-term or due to insufficient long-term
incentives.
The adoption of more sophisticated, variable or equity-based executive
remuneration schemes has been advocated as a means to solve such
agency problems by giving managers proper incentives to improve good
corporate performance. However, the nature of the reward can influence
a manager to follow a short-term investment strategy by creating excessive
incentives on short-term results or failing to focus on performance metrics
reflecting long-term value creation or sustainable strategies of growth.
For example, a survey of UK, US and German manufacturing firms show
that packages that include shares, option and any kind of profit-related
scheme are connected with a higher probability of short-term orientation
relative to other types of schemes (Coates et al. 1995).
Criticism of executive pay is not new in itself, but a new wealth of
evidence has accumulated to suggest that executive pay is itself a core
problem of contemporary corporate governance (for the most
comprehensive critical assessment, see Bebchuk and Fried 2004). The
core argument is that executives have a substantial influence over their
own salaries, and have used this power to weaken the link between pay
and performance. For example, recent studies have shown the size of
stock options outstanding had a very strong influence on the prevalence
of earnings restatements (Denis et al. 2006; Efendi et al. 2004). Other
recent studies of earnings management suggests that executives with
unexercised stock options were more likely to manage real earnings
management through abnormal changes in cash from operations,
production costs, or discretionary expenses such as R&D (Cohen et al.
How does corporate governance lead to short-termism?
205The Sustainable Company: a new approach to corporate governance
2008). Thus, even advocates of share options, such as Michael Jensen,
have started telling executives to ‘just say no’ to Wall Street, and criticized
managers’ focus on short-term earnings games (Fuller and Jensen 2002).
Other studies show that the relative talents of CEOs have little influence
of stock market capitalization, which are driven by firm size and market
sentiment (Tervio 2008; Kolev 2008). The money paid to attract ‘top’
executives doesn’t improve market returns relative to the ‘less talented’
and cheaper executives (Wyld and Maurin 2008).
The career patterns of managers also shape the time-horizon of decision-
making. One aspect concerns the prospect of job turnover. High turnover
may prevent the building of long-term trust relationships and weaken
social bonds (Webb 2004), thus undermining the importance of
reputation, norms of collegiality, and other social devices for increasing
commitment of people to the long-term future of the firm. For example,
Palley (1997) found that high turnover leads managers to invest only in
short-term projects in order ensure that the rewards take place while they
are still in the firm. This strategy discounts the risk of having lower or
even no return in the long-term, should they have stayed at the same
company. Conversely, if managers have the possibility of longer job
tenure, they are more likely to pursue some long-term projects, possibly
to diversify against this risk.
3.2 Shareholders
Many studies suggest that shareholders may put too much value on short-
term firm performance and push managers to inflate performance
measures or alter strategy even if it is harmful for the company in the
long run (Chaganti and Damanpour 1991; Hansen and Hill 1991; Kochhar
and David 1996; Samuel 2000). Studies of institutional investor myopia
typically examine whether higher levels of institutional investor
ownership are associated with outcomes such as corporate R&D
investment, which act as a proxy for long-term investment (Bushee 1998;
Hansen and Hill 1991). Yet while some studies find evidence of short-
termism, other studies find that institutional investors promote R&D,
engage in monitoring, or improve the market value of firms with good
future prospects but low current profitability (Davis 2002).
These mixed results suggest the need to differentiate between different
categories of shareholders and develop a more complex understanding
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206 The Sustainable Company: a new approach to corporate governance
of investor behaviour (Aguilera et al. 2008; Aguilera and Jackson 2003).
While some institutional investors are quite sophisticated and potentially
long-term, other transient investors with high turnover are associated
with lower R&D and focus on short-term earnings (Bushee 1998, 2001;
Liu 2006). Looking at the equity portfolios of various UK based investors
in the year 2007 substantial variation in the average holding periods of
different investor types is apparent (Jackson and Petraki 2010).
However, despite this variation, the long-term trend suggests a very
strong rise in overall stock market turnover. Looking at the New York
Stock Exchange, levels of turnover have expended from around 30 per
cent to nearly 100 per cent of stock market capitalization during the same
period (Windolf 2009).
What factors shape the orientation of investors to the short vs. long term?
A first dimension of investor orientation concerns whether shareholders
engage with the firm as owners, or whether they are essentially traders
of stock (Hendry et al. 2006)2. Traders may pursue a variety of
investment strategies and have heterogeneous portfolios, but they have
in common the focus on predominately financial criteria for their
investment and aim to make gains on the trading of stock. Meanwhile,
owners refer to shareholders having some strategic motivations in
exercising control over company decision making, such as in the context
of restructuring, family control, inter-firm business networks, and so on.
Trading thus represents a preference for exit as a response to
organizational decline, whereas ownership suggests the exercise of voice
as a way to alter the course of the organization and thus share in the
responsibility for future outcomes (Hirschman 1972).
These differences are manifest in shareholders’ involvement in corporate
governance. Black (1992) suggests that a ‘concern related to institutional
competence [in corporate governance] involves the institutions’ time
horizon… short-sighted institutions won’t do much monitoring because
the payoff from oversight is long-term.’ Most research assumes or implies
that more involvement in corporate governance issues and longer holding
periods characterize ‘better’ policies and may limit short-termism.
Investor orientation is also shaped by the organizational capacity of
investors to evaluate and monitor firms. Kochhar and David (1996) find
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207The Sustainable Company: a new approach to corporate governance
2. Elsewhere, a similar distinction is used between the strategic and financial interests of owners
(Aguilera and Jackson 2003).
that ‘[short-term] investors may lack access to proprietary firm-specific
information, and therefore find it difficult to evaluate the long-term value
of a firm. Instead, they may focus on performance measures, like current
earnings, that are easily quantifiable. Thus, they behave like arbitragers
to ‘churn’ or frequently turn over their portfolio of stocks in order to
capitalize on all possible short-term gains.’ Shareholders may focus only
on short-term benefits to the extent that they lack information or have
troubles quantifying intangible (human and other) assets, thus giving too
much weight to measures of return that refer to a relatively short-period
of time. If the reported return is low, they reshuffle their portfolio. Bushee
(1998) identifies a group of ‘transient” investors who hold a diversified
portfolio and high trading turnover, who exhibit this behavior. Likewise,
the lack of long-term engagement of shareholders may be related to
conflicts of interest, as in case of corporate pension funds (Davis and Kim
2007).
Investors also face economic incentives to engage in short or long-term
trading. What situations create incentives for investors to realize short-
term gains and externalize the costs of sacrificing longer-term gains?
Incentive problems may arise because the delegation of investment
decisions results in conflicts between principles and the personal
incentives of agents. Even if an investor prefers a long-term orientation,
actual investment decisions may be made by fund managers within the
organization or contracted out to external fund managers in different
organizations. Incentives may be given to fund managers that shorten
time horizons or fail to reward long-term investments in an effort to
control or monitor these managers. In studying institutional investors,
Hansen and Hill (1991) argue that the myopic institutions behaviour
arises because ‘institutional fund managers are under considerable
pressures from their superiors to perform. When they make decisions
they respond to organizational pressures and their own desires for job
security and advancement. This translates into risk aversion and short-
run focus. Similarly, Chaganti and Damanpour (1991) find that
‘institutional money managers cannot afford to take a long-term view
because their performance is evaluated frequently.’
Intermediation of investment also leads to agency problems between the
principles bearing ultimate risks for an investment and the
organizational incentives of agents. The rise of financial services has led
to a growing amount of intermediation, where investment advisors
manage ‘other people’s money’ and has become detached from risk taking
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208 The Sustainable Company: a new approach to corporate governance
(Windolf 2008). Fund managers chase high rates of return due to the
competition with other fund managers to gain and retain clients’
business. With high returns also comes greater risk, and hence the long-
term value creation of the firm is likely to be undervalued. While beyond
the scope of this report, the growth of derivatives and options market
have increased the ability of financial institutions to originate and
distribute liabilities without bearing the ultimate risks, thereby raising
new questions about the relationship between new financial instruments
and short-termism.
In sum, the different organizational orientations and incentives shaping
time horizons differ widely across different types of shareholders (see a
detailed discussion in Jackson and Petraki 2010).
3.3 Gatekeepers
Gatekeepers play a hitherto neglected role within corporate governance
(Coffee 2006). They occupy a boundary role that serves principally
information and advisory functions. Yet due to the importance that
markets place on this information, gatekeepers play a powerful role by
shaping the perceptions and interactions between market actors –
managers, shareholders, investors and the public. For example, Healy
(2001) finds that gatekeepers, including financial analysts, the business
press and rating agencies, significantly affect stock prices by shaping the
flow and evaluation of information from corporate disclosure. In the
context of short-termism, information asymmetry and uncertainty are
key triggers of myopic behaviour and hence short-termism. Gatekeepers
have a particular role as informational intermediaries since managers’
private information can be unavailable to the shareholders (Narayanan
1985) and their actions may be partially unobservable (Laverty 1996).
Overcoming such asymmetric information problems is important for
stakeholders to avoid making suboptimal investments (Dickerson et al.
1995).
Gatekeepers came under negative criticism through the Enron case.
Apreda (2002) writes: ‘this disgraceful tale of malfeasance uncovered the
ultimate actors that should be blamed for: the gatekeepers. They
neglected their fiduciary role and damaged the credibility of many
institutions and practices either in corporate or global governance.’
Bruner (2008) thus stressed the importance of gatekeepers as part of the
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209The Sustainable Company: a new approach to corporate governance
regulatory framework for financial markets. Windolf (2005) also focused
on gatekeepers’ ability to transform uncertainty into risk and thereby
provide essential support the operation of financial markets. Whereas
entrepreneurial decisions are truly uncertain, analysts and others look at
these strategies in terms of risks for investors. However, this can only be
done in the very short-term perspective – such as forecasting the
profitability of those investments next year and them comparing the
results. This ‘framing’ of corporate activity in terms of its short-term risks
is one of the major constraining factors whereby financial markets
encourage short-termism.
Here we note the example of securities analysts. Securities analysts collect
information, evaluate performance, make forecasts and recommend that
investors buy, hold or sell the stock of the firms they cover. Security
analysts are not only passive players within the marketplace, but exert
strong power by setting agendas and influencing the cognitive
frameworks through which investors evaluate firms. In his pioneering
study of U.S. firms, Zuckerman (1999) has shown how low coverage by
analysts led to a substantially lower valuation of company stock prices
and discounting of expected dividend payments. Francis et al (1997)
indicate that quarterly earnings are indeed more important than other
company features for analysts. Analysts tend to ignore ‘extra-financial’
features like human resources, which are very important for the long-
term wellbeing of the firm (Atherton et al. 2007). Conversely, based on a
case study of analyst ratings during the ‘new economy’ boom, Beunza and
Garud (2004) show how analysts shape the cognitive frames used by
investors to overcome uncertainty and justify taking on excessive
investment risks based on new and different models of valuation of IT
firms. Several studies have thus found that the use of quarterly earnings
reports increases stock return volatility and is more likely to undervalue
long-term strategies and assets (Bhojraj and Libby 2005; Rahman et al.
2007). So managers are under pressure to present good short-term
quantifiable results or conform with the expected features of analysts’
models, sometimes at cost of long-term investments.
Similar arguments can also be made with regard to credit ratings agencies
or auditors. Many of these gatekeepers are also riddled with various
conflicts of interest (Palazzo and Rethel 2007). Auditors are of special
interest because of their exposure to conflicts of interest. Although
auditors enhance the credibility of accounting reports, audit firms face
an incentive problem: they are more likely to act in the interests of
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210 The Sustainable Company: a new approach to corporate governance
managers who hire them and not in those of the firm's investors. This
conflict of interest is one of the factors that made in the Enron case
possible (Healy and Palepu 2001, 2003). In his influential account of
‘control fraud’, Black (2005) has focused on the crucial position of
auditors and how the recognition of accounting reports by auditors can
permit fraud by corrupt companies.
During the 1990s in the USA, the quality of audits declined, while the
marketing of non-audit services by auditing firms increased in parallel.
For example, the number of earnings restatements issued by listed
corporations more than tripled since 1990 (Coffee Jr. 2003: 17), and has
continued to climb through 2002. More worrying was the fact that the
size of earnings restatements increased greatly, revealing that income
smoothing had given way to much more aggressive accounting practices
aimed at the earlier realization of income. A key explanation here is the
explosion of non-audit income through consulting services (Coffee Jr.
2003). The main issue here is not necessarily the desire of auditors to
retain the larger share of consulting-related income, but the fact that
mixing these two services give client firms a low visibility way of firing
(or reducing the income) to auditing firms (Gordon 2002). It seems clear
that auditing firms were prone to avoid these short-term losses by
adopting more critical appraisals, but ultimately undermined long-term
benefits – most spectacularly in the case of Arthur Anderson.
4. Short-termism as a social process
Figure 1 summarizes the key mechanisms leading actors to adopt short-
term orientations. Yet corporate decision making is not the sole result
of any single group of stakeholders. Corporate governance involves a
sociological ‘double contingency’ in the sense of Parsons and Shils, who
describe this as follows:
since the outcome of ego’s action (e.g. success in the attainment
of a goal) is contingent on alter’s reaction to what ego does, ego
becomes oriented not only to alter’s probable overt behaviour but
also to what ego interprets to be alter’s expectations relative to ego’s
behavior, since ego expects that alter’s expectations will influence
alter’s behavior… (Parsons and Shils 1951: 105).
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211The Sustainable Company: a new approach to corporate governance
Gregory Jackson and Anastasia Petraki
212 The Sustainable Company: a new approach to corporate governance
Figure 1 Mechanisms promoting short-termism
Actors
Managers
Shareholders
Gatekeepers
Triggers
Professional
orientations
Incentives
Organizational
Orientations
Incentives
Orientations
Incentives
Specific mechanisms
Decision heuristics
Experience and knowledge
of ‘extra-financial” assets
and risks
Education
Role of independent
directors
Job turnover
Contract duration
Remuneration package
Engagement in corporate
governance
Organizational capabilities
for monitoring
Decision heuristics
Intermediation relative to
ultimate risk bearers
Delegation of investment
decisions
Agency problems along
the investment chain
Exposure to ultimate risks
(absence of) professions
Personal and impersonal
conflicts of interest
Potential policies/practices as remedy
Wider information dissemination and less use
of short-term measures for share evaluation
(Demirag 1998)
Less focus on investment appraisal methods
like NPV and more training about including
non-financial factors (Lefley and Sarkis 1997,
AccountAbility 2005, Atherton et al 2007)
Strengthen accountability to external
stakeholders, including investors and
employees
Longer contract duration (Narayanan 1985,
Palley 1997, AccountAbility 2005)
Less use of shares, options, and profit-related
schemes and more weight on sales orientated
compensation (Coates et al 1995).
Progressive taxation.
Encourage patient capital by linking
shareholder rights to holding period (Aspen
2009 report)
Increase communication and transparency
(Aspen 2009 report; CFA Report)
Assess performance using long-term strategic
plans by managers (CED Report)
Apply a higher degree of accountability and
enhanced fiduciary duties to financial
intermediaries (Aspen 2009 report)
Disclosure of asset manager incentive metrics
(Aspen 2009 report; CFA report;
AccountAbility 2005)
Align asset manager compensation with long-
term client interests (CFA report).
Speculation tax.
Employ one advisor for each different
‘gatekeeper” service
Clearly separate gatekeeper function from
corporate operations to ensure impartiality
Both investors and managers know that both know that each could
individually pursue a different strategy depending on the reaction of the
other. This process of contingency and expectation adds a temporal
dimension to the standard agency theory model.
Figure 2 presents a stylized model of possible interactions between
managers and shareholders. Ideally, managers and investors would
perceive each other as having long-term orientations. This scenario could
be described as the Sustainable Company, wherein all stakeholders share
a long-term vision of the firm (bottom right cell). While agency problems
may still exist with regard to the distribution of value among
stakeholders, both investors and managers share a long-term orientation
and commitment to the firm. Neither party will prematurely exit the
relationship and thereby be able to externalize the long-term
consequences of strategic decisions onto third parties (Dobbs 2009).
Without a mutual commitment to long-term objectives, the time horizon
will be inherently subject to conflicts among stakeholders and remain
unstable and open to opportunistic short-term behaviour.
While this type of long-term outcome is likely to be desirable, it is
important to recall the limiting case of over-commitment to the long-
term. Stakeholders may become over-committed to the organization,
postponing short-term gain inevitably or failing to preserve options for
creating value by pursuing outside alternatives (e.g. exiting the firm,
liquidation, merger, etc.). For example, the hazards of over-commitment
in risky or uncertain ventures help explain the incremental or
tournament-like pattern of investment in venture capital firms or joint
How does corporate governance lead to short-termism?
213The Sustainable Company: a new approach to corporate governance
Figure 2 Intertemporal agency conflicts: a simple framework
Short
Managers’ preferences
Shareholders’
preferences
Long
Long
Short
Short-termism Agency conflict - Long-term managers
pressured by short-term investors
Agency conflict - long-term investors
undermined by short-term opportunism
of managers
The Sustainable company
ventures, as well as the corresponding governance structure (Folta 1998).
Corporate governance mechanisms supporting exit, such as golden
parachutes as a form of executive compensation, may create long-term
value for all stakeholders by reducing vested interests or over-
commitment of managers to particular strategies (Evans and Hefner
2009).
A conflictual scenario arises when managers prefer long-term strategies,
but perceive shareholders to be interested in short-term results (top right
cell). For example, stakeholder models of corporate governance have
come under growing pressure as the long-term orientations of company
insiders have come under pressure from capital markets (Vitols 2004;
Jackson 2005). Institutional investors often call for more rapid company
downsizing, and fail to fully value the contribution of essential human
assets to the competitive success of the firm (Aoki and Jackson 2008).
One example of this is when Moody’s famously downgraded Toyota’s
bond rating in 1998 citing its policy of lifetime employment. However,
short-term orientations of investors are not sufficient to produce short-
termism without additional governance mechanisms to influence
managers. Shareholders may lack power to assert their agenda on
managers (e.g. the absence of a takeover market). Alternatively, managers
may be able to shield themselves from influence from short-term
shareholders by forming coalitions with other long-term shareholders,
such as family owners, banks, or cross-shareholdings with other firms.
This point is extremely important, since it suggests that the short-term
investment horizons of traders in secondary markets are not necessarily
a problem. Indeed, investors only cause short-termism when their time
horizons begin to influence the time horizons of managers and hence spill
over from financial markets to the ‘real’ economy.
An inverse scenario arises when investors pursue long-term strategies,
but these are threatened by short-term and opportunistic behaviour of
managers (bottom left cell). This scenario is a classic agency theory
situation. To the extent that agency problems cannot be sufficiently
resolved by other institutional mechanisms (e.g. independent directors),
investors may react by pursuing short-term strategies that do not require
them to trust managers, such as demanding higher short-term dividend
payments and lower levels of reinvestment. Indeed, agency theory
suggests that shareholders may prefer short-term payouts in order to
limit the scope for managerial opportunism. If a surplus exists at the end
of a financial year, shareholders may prefer higher dividends now rather
Gregory Jackson and Anastasia Petraki
214 The Sustainable Company: a new approach to corporate governance
reinvestment into the firm, because shareholders fear that managers may
consume this extra amount (Dickerson et al. 1995). This constellation
may also gravitate toward short-termism to the extent that shareholders
re-calibrate their time horizons to those of short-term oriented managers.
Agency conflicts arising from the misalignment of managerial and
investor time horizons in these scenarios may therefore potentially lead
to short-termism. But this is not always the case. To the extent that one
set of actors has limited power or can hedge against the influence of the
other, these situations may lead to isolated cases of myopia rather than
systematic processes of short-termism. However, each scenario raises the
possibility that one group (ego) may adapt their behaviour to the
expectations of the other (alter). For example, managers may begin to re-
orient themselves to the short-term horizons of investors trading in
financial markets. Mutually reinforcing short-term orientations are likely
to create externalities vis-à-vis future managers and shareholders, as well
as other stakeholders.
The concept of temporal calibration is used to describe how actors with
different time horizons engage in mutual or one-sided adjustment to the
horizons of other actors (Noyes 1980). One interesting aspect of this
process is its asymmetrical nature. If ego has a longer time horizon than
alter, ego has the capacity to adjust herself by shortening her time horizon
– but not necessarily vice versa:
Temporal calibration, by the adjustment of one’s time horizon for
purposes of improved communications, or even for purposes of
bringing about social reform, does not imply the abandonment of
that longer time horizon which makes either concept or early
support possible. One does not, simply by stressing the short term
advantages, diminish such inherent long-term or moral gains as
justice, economic liberty and the security of a society in which no
one need be poor. It is simply that the short term advantages are
‘easier to sell’ (Noyes 1980: 269).
Managers facing short-term pressures may adjust their strategy in
alignment with the perceived expectations of shareholders (Chaganti and
Damanpour 1991), thus pushing toward a more systematic and self-
reinforcing pattern of short-termism (top left cell). In this case, managers
may try to inflate earnings, but do so by cutting down investment in long-
term assets that are important for the future of the organization, like R&D
How does corporate governance lead to short-termism?
215The Sustainable Company: a new approach to corporate governance
and employee training. In fact, one reason why managers would
deliberately sacrifice long-term in favour of short-term investments might
be in order to inflate reported earnings, even if this is not in the best long-
term interests of the shareholders. Conversely, investors may shorten their
time horizons if they lack trust in management or perceive managers to
be driven by short-term considerations. To the extent that investors feel
unable to monitor managers effectively or derive long-term expectations
about company performance, risk-averse investors may demand greater
results in the short-term, thereby placing further pressure on managers.
In cases where both managers and shareholders are focused on the short-
term, intertemporal agency conflict may not manifest itself, since both
actors have calibrated their time horizon to the short-term. Samuel
(2000) described this as a self-reinforcing pattern, whereby shareholders
focus on the behaviour of stock prices in the short term and managers
similarly focus on improving earnings in the short-term. The absence of
agency conflicts may help to explain the fact that advocates of the
stakeholder model often frame their criticisms of the shareholder value
model of the firm in terms of short-termism – here both current
managers and shareholders externalize adverse effects on third parties,
such as employees or future managers and investors. The same fact may
also explain why the very issue of short-termism remains so disputed in
Anglo-Saxon countries, where the normative ideal of corporate
governance is centred on shareholder value maximization.
The interactions between shareholders and managers are also influenced
by gatekeepers. Gatekeepers may help resolve conflicts in ways that may
help calibrate the expectations and orientations of actors toward long-
term evaluations of company value. As such, gatekeepers do not strongly
influence the incentives of managers and shareholders, but have a strong
role in shaping and legitimating particular orientations of other
stakeholders. Consequently, gatekeepers may bias interactions among
these stakeholders toward the pattern of short-termism. If gatekeepers
focus only on easily quantifiable financial measures to assess the potential
of a firm, they may undervalue the ever-important benefits of long-term
investments with intangible payoffs (Atherton, Lewis, and Plant 2007). If
gatekeepers focus on short-term figures like quarterly profits, this pushes
managers to inflate those figures in expense of long-term investments.
If managers perceive capital markets (and the participants in them) to be
short-term in their share price evaluation, they will pursue short-term
Gregory Jackson and Anastasia Petraki
216 The Sustainable Company: a new approach to corporate governance
investment strategies (Demirag 1998; Grinyer et al. 1998; Marston and
Craven 1998; Samuel 2000). Interestingly, a two-country comparison
showed that managers in Sweden seem to be far less influenced by their
perceptions of capital markets’ reaction than in the US (Segelod 2000),
which may be due to differences in managerial orientations (Section 3.1)
in these two institutional environments.
The more interesting theoretical implication of these interactions may
create self-reinforcing dynamics, creating path dependent lock-in on
short-term orientations. Here initial orientations of ego are reinforced by
the orientations of alter. While third party gatekeepers, regulators, or
other institutional factors may help mitigate such interactions, these
factors can equally serve to amplify such effects. Once such as cycle is in
place, it may be impossible for actors to unilaterally change their
strategies even if both actors would in principle prefer to shift to a
different long-term pattern. This process aspect of short-termism may
help explain why managers, investors and analysis often feel trapped into
playing the ‘earnings game’, despite the fact that everyone involved is
critical of the process (Tonello 2006).
5. Conclusion : implications for policy, practice and
future research
This chapter has stressed that short-termism is not an isolated
phenomenon. Rather it reflects the complex interactions between the
incentives and orientations of different stakeholders. While it remains
difficult to demonstrate empirically that particular stakeholders
orientations are ‘too short’ from an economic perspective, we can find
substantial support for the idea that stakeholder orientations reinforce
each other in ways leading to a shortening of time horizons. Key triggers
here are the mechanisms whereby the short-orientations of managers
and investors become self-reinforcing. For example, stock-options help
managers internalize the short-term focus of investors and quarterly
earnings statements by managers help focus investors on short-term
targets.
Given the systemic nature of the problem, the authors of the 2009 Aspen
Institute paper on ‘Overcoming Short-Termism’ argued that ‘effective
change will result from a comprehensive rather than piecemeal
approach.’ No single policy in isolation is likely to address short-termistic
How does corporate governance lead to short-termism?
217The Sustainable Company: a new approach to corporate governance
behaviour among managers, shareholders and gatekeepers at the same
time. Indeed, Figure 4 shows how various past reports on policies against
short-termism have in common their stress on systemic policies and
recommendations that address different levels of the problem. New
policies and practices are needed that shift the incentives of key
stakeholders toward more long-term goals, either through adoption of
best practices, regulation or taxation policies. But the complex nature of
short-termism also relates to ‘softer’ factors related to the professional
and organizational orientations of those stakeholders – that is, their self-
understanding, social norms, and formal rights and responsibilities.
These issues go to the heart of corporate governance itself, affecting the
checks and balances between corporate stakeholders in ways to assure
that stakeholders with long-term interests are given sufficient voice in
decision making. The successful institutionalization of long-term
behaviour is only likely when adopting such practices increases their
legitimacy in the eyes of other stakeholders.
It goes beyond the remit of this chapter to discuss the prospects or
problems with specific policies. Indeed, these touch upon a wide array of
technically complex areas of corporate law, business practice, and
financial market regulations. However, a good starting point would be to
develop a detailed review of such existing policies in these areas. Future
research might compile an overview of existing policies in different
countries, thereby identifying the range of available policy instruments
and examining evidence on their relative effectiveness. To our knowledge,
no country has consciously undertaken a set of coordinated policies to
specifically counteract short-termism. Yet a large number of relevant,
yet little known policies exist already. For example, French shareholders
receive double voting rights after holding their shares in excess of two
years (Schmidt 2004). Likewise, Germany passed a new law on executive
compensation in 2009 calling for limits of total compensation to
‘reasonable’ levels and tightened the criteria applied to performance-
related pay.
Despite the complexity of the task, the time is ripe to rethink corporate
governance with a view to the long-term. Many of the current ‘best
practices’ in corporate governance seem are geared toward
institutionalizing decision making based around the idea of maximizing
value for shareholders, as viewed in the moment. Still, in looking to the
future, open questions remain about whether or not short-term value
maximization leads to long-term sustainable advantages. Indeed, short-
Gregory Jackson and Anastasia Petraki
218 The Sustainable Company: a new approach to corporate governance
termism is most likely to occur precisely in that moment when we feel
that little may be gained from waiting.
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... But markets may misprice risk and enhance short-termism in the sense that money today is valued more than money in the future ( Haldane and Davies, 2011). Such myopic behavior is enhanced by mutually reinforcing short-term expectations by companies, investors and other key actors in corporate governance ( Jackson and Petraki, 2011). Markets where a critical mass of investors rely on the same MPT-metrics and share a preference for shareholder-value maximizing governance might even explode in a systemic failure ( Davis et al., 2009;Haldane and Davies, 2011) such as the 2008 financial crisis. ...
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... There is a second source of short-termism, unrelated to the actual or perceived preferences of financiers as expressed in stock market pressures. This is referred to as 'managerial opportunism' , and is generated within businesses (Laverty, 1996;Jackson & Petraki, 2011). It stems from the fact that managers have their own objectives and ambitions which are shaped by how their achievements are recognised by employers (Narayanan, 1985). ...
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Translation of article in Swedish daily Dagens Industri April 21 2016. Sweden needs a shared dialogue on ownership around the citizens’ failing trust for the business sector. Such a dialogue deals with the short-term perspective in the business sector as well as in politics. It deals with today’s causally handling of alternative forms of ownership such as cooperatives and non-profit businesses. It aims to move the company away from profit maximization to long-term value creation. This is addressed in the report A sustainable ownership structure which has been initiated by the think thank Global Utmaning. It is a study of 140 pages with over 50 policy recommendations that can form a base for a broad discussion around how Sweden is owned. The publication goes through how ownership in Sweden is organised, sector by sector: the stock market, the venture capital industry, the civil society, cooperatives, the public sector, as well as family businesses. It opens up for seeing the role of the business sector in the society more broadly, and how quality can be increased in the welfare system. Sweden differs from many other countries. Swedes still work in either the private business sector or in the public sector. Nowhere in the Western world is the value based, the civil society and cooperative sectors smaller. Nowhere else is the business sector so open for short-term and volatile capital. This development is unsustainable in the long run. Good growth rates of 4 percentage of BNP do not do more than conceal the fact that Sweden has underlying structural problems. Otherwise it is impossible to explain 100 000 lost industry jobs since 2008, that a profitable local food factory in Bjuv is being shut down, that research leading life science is shrinking in Sweden, that start-ups in the IT-sector are moving abroad, that this year’s wage negotiations ended in failure, that headquarters are moving abroad, or that there is a discussion about the municipalities’ role in the welfare system that centres around who should be providing health care, education and elderly care, rather than around what quality that is offered to the citizens. A picture is being painted of Sweden where domestic capital does not invest, as a consequence of complicated and impeding taxes and out-dated investment rules. In many places, as the stock market and in the venture capital sector, it has been replaced by foreign capital. That has still not been enough, Swedish small and medium sized companies are not growing and investments are not carried out. In other sectors, such as the non-profit sector, capital is still entirely missing. What we see is a mismanagement of Swedish long-term patient capital. The Swedish tax system still handles labour and capital as if the country’s citizens are in a conflict regarding how resources should be distributed. Actually, we have a knowledge economy where labour and capital increasingly converge and where focus should be shifted to how common resources should be transformed. With time it has impoverished our ability for long-term value creation. With the discussion paper on A sustainable ownership structure, Global Utmaning wants to point to the opportunity of moving Sweden in the direction of what we call a value based market economy, which rest on three schools of thought, all which have Swedish roots: (1) Focus on corporate value rather than shareholder value. The Swedish economist Eric Rhenman developed the internationally popular stakeholder model in the 1960s. In the original, the corporate executive was to distribute the company’s value fairly. Today the stakeholder model has an excessive focus on shareholder value. The model could be developed to a business value model, which includes employees, clients and community resources as an integrated part of the company’s value creation. In the long run this opens up for Swedish actors to dare to discuss the concept of profit in the Swedish Companies Act, something that is discussed internationally. For example it could be written into the law that profit does not have to mean profit maximization, which sometimes is too short sighted, rather it means long term profit, and thus it would open up for more investments which as well has public benefits. (2) A diversity of models of ownership. It is based on the social scientist Hans L Zetterberg’s description of four sectors of society from the 1980s. An equal approach to the public sector, the private sector, the civil society and the individual sphere, is neither a right wing nor left wing project. Cooperatives and mutual structures for example include human values in its objective function, where the profit becomes the means, but not the goal per se. That reduces the risk for only short-term profit maximization or cost minimization to be governing. Sweden lacks mutual structures in other forms than in insurance companies. In England there are mutually managed schools and hospitals. Sweden has too few staff cooperatives. It is a fast growing form of organisation internationally and there are large corporations, which are managed as staff cooperatives. (3) The special value of domestic formation of capital. In the wake of the financial crisis in 2008 more and more experts and scientists recognizes that capital does not criss-cross across the entire world as if it was in line with classic rational economic models. Rather, there is capital, which because of proximity both has an information advantage, and a will to invest long term in a neighbouring area. Politicians and the Ministry of finance with its fiscal tax policies are not paying attention to this. It is however, highlighted by the former CEO of the Swedish Dept Office, Thomas Franzén, researchers at the Research Institute of Industrial Economics and the Swedish Entrepreneurship Forum, and by the study’s author Sophie Nachemson-Ekwall, who has looked closely at both hostile bids and institutional investments. Ultimately, it has significance for the level of investment, Sweden’s position as a science and knowledge nation and thus the number of employment opportunities. To create change a new law is needed. Swedish institutional investors, including the AP funds, have to be able to place long term capital in small and medium sized companies. Swedish business owners need to be encouraged to invest in Swedish business. We need employee stock options for entrepreneurs, a new Companies Act, loans and venture capital for mutual forms of organisation, tax exemptions for donations to non-profit organisations of foundations, venture capital deduction for innovation and social investments or employee ownership schemes through the, in the U.S. so popular, ESOP programs. In the work with the study we have talked with over 50 representatives on executive positions in the trade union movement, employers, foreign owners, venture capitalists, idea and value based organisations, cooperatives, researchers from different social science disciplines as well as politicians. We have found a clear interest for the importance of ownership. There is an understanding that ownership needs to be addressed for Sweden to be able to, on a solid ground, deal with the challenges of globalisation that follow free movement of capital, climate change, urbanisation, indebtedness, digitalisation and migration. Therefore we believe that the Swedish model’s building block of understanding, can reach up to a new level. A dialogue would also get extra leverage if the government and the parliament appointed an Ownership Commission, which would create a framework for a new sustainable ownership structure for Sweden. Sophie Nachemson-Ekwall, Author of the study Doctor in business economics at the Stockholm School of Economics Catharina Nystedt-Ringborg Vice chairman of the think tank Global Challenge Johan Hassel CEO of the think tank Global Challenge
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