Corporate Boards Should Represent a Broader Community of Interests

A documentary that came out in 1989 titled Roger & Me chronicles the slow death of the town of Flint, Michigan, as a result of massive layoffs and plant closings by the town’s major employer, General Motors. The title refers to Roger Smith, then GM’s chairman, whom filmmaker Michael Moore tries to track down in an effort to show him how impersonal, bottom-line-oriented decisions can devastate the lives of a whole community.

 

More recently, the actions of another large company, Hershey Foods, have raised questions about corporate responsibility towards the community that has helped it prosper. With $1.8 billion in sales in the first six months of 2002, Hershey Foods is a leading manufacturer of chocolates and other food products. The $5.4 billion Milton Hershey Trust, which holds 77% of the voting shares in Hershey Foods, has put the company up for sale, indicating it wants increased asset diversification.

 

The proposed sale has caused an uproar in Hershey, Pa., which is not just the company’s headquarters but home to HersheyPark theme park, the Hershey Museum and Chocolate World, and the Hershey Hotel – all of which draw huge numbers of tourists and employ hundreds of blue collar and white collar workers. In addition, more than 6,000 people are employed in Hershey Foods’ three factories.

 

Those who oppose the sale predict huge job layoffs for the residents of Hershey, a diminished tax base, and a potentially crippling blow to the tourism industry, especially if Hershey is sold to a foreign company. The list of potential buyers so far has included Nestle (based in Switzerland), Kraft (based in the U.S.) and Cadbury Schweppes (based in the UK).    

 

To Wharton marketing professor Scott Armstrong, situations like those described above are partly the fault of corporate boards whose members rarely represent interests beyond their own, those of top executives and, in some cases, those of major stockholders. He believes that boards should include individuals who represent various stakeholders, such as employees, the community, customers, small investors and others. Only then, he says, can boards reduce socially irresponsible, unethical and potentially illegal behavior by top management. Below, Armstrong presents research he has done on the subject of corporate governance.

 

Hershey Foods illustrates the primary problem with corporate governance: Firms in the U.S. are not run democratically. And the U.S. Congress has given no consideration to democracy in its proposal for corporate governance. Evidence, both empirical and anecdotal, suggests that democratic boards – those whose members represent various stakeholders in the firm – would substantially reduce socially irresponsible behavior by top management.

 

I have studied the effects of democratic boards on decision-making. Based on an article from Science about an Upjohn Pharmaceuticals drug, Panalba, I created an exercise in which participants (MBAs, executives, and undergraduates) played the roles of seven Upjohn board members. Descriptions of the board members, along with their stock holdings in Upjohn, were used. These “directors” were told “Panalba is causing about 14 to 22 unnecessary deaths per year; i.e., deaths that could be prevented if the patients had used a substitute made by a competitor.” They were also told that a scientific panel appointed by the National Academy of Sciences had recommended that the FDA ask the company to remove the drug from the market. “There are few instances where so many experts have agreed unanimously and without reservation (about banning Panalba),” one panel member noted at the time.

 

The participants were asked to stay in their roles (directors on the Upjohn board) and to act as they would act in the circumstances. They were offered a selection of decisions ranging from “Continue efforts to most effectively market Panalba and take legal, political and other necessary actions to prevent the authorities from banning Panalba,” to “Recall Panalba immediately and destroy.” These descriptions were used in 57 groups. None of the boards removed the drug from the market, while 79% of them decided to “continue efforts to most effectively market Panalba and to tie the case up in the courts.” In real life, this was the decision that Upjohn took. Surveys among individuals who were not playing a role showed that 97% believed this decision to be socially irresponsible.

 

I then examined what would happen if the boards consisted of representatives of stockholders, employees, the local community, and suppliers. In addition, the boards were given quantitative estimates of the impact of their decisions on the various stakeholder groups. We referred to this as “social accounting.” In this version, costs were estimated for stockholders, employees, and customers for each of the possible decisions. In this test, 59 boards were used; of these, 22% decided to keep Panalba on the market (down from 79% in the traditional boards), while 29% of them removed the drug immediately (up from zero). In other words, the democratically composed boards that were provided with estimates of the effects of their decision on the total system were much less likely to cause unnecessary deaths of customers. Interestingly, neither procedure – democratic boards or social accounting – was very effective by itself. Together, however, they were effective in reducing socially irresponsible decisions.

 

Corporations in the real world have used democracy. For example, most Western European countries have long required that employees be represented on boards of large firms. In some cases the representation approaches 50%. Over the past 30 years, Professor Richard Franke of Loyola College in Baltimore has been studying the effects of employee participation in board-level corporate decision making. He found that economic growth has been substantially higher in the countries that have a higher level of employee participation on their boards.

 

The most extensive use of democracy, however, has been by the Mondragon Cooperative in Spain, which consists of about 120 firms. They have had representative boards and other democratic procedures for half a century. If a group of workers needs a manager, they hire one; if the manager does not perform well, the group appoints a new manager. Those managers who are elected then elect managers above them on up to and including the board of directors. Numerous empirical studies by industrial economists have shown that the Mondragon system is profitable relative to traditionally run firms.

 

As shown by the Panalba experiments, firms with democratic boards are less likely to harm customers. I also expect that they would be less likely to trick suppliers, deceive investors, or permit exorbitant salaries for top managers. Imagine that a CEO comes to a democratically composed board and asks to be paid $20 million or to borrow $50 million at zero interest. One of these heterogeneous board members would question such a request and with good reason. Numerous empirical studies over the past half-century have shown that high CEO pay does not lead to better performance.

 

There is no empirical evidence to support the current system. It is used simply because it seemed reasonable to some people in the past. The system can easily lead to socially irresponsible behavior. Top executives select a set of friends and pay them lavishly to “oversee them.” (As we have learned from recent news stories, many such directors cannot even define “retained earnings” on a multiple choice test.) They then transfer funds from the corporation to their own accounts. Numerous studies in organizational behavior suggest that directors who raise questions would not last long on this type of board. For example, directors on the traditionally composed boards in the Panalba study became angry at those few members of their board who wanted to remove the drug from the market.

 

The changes that have been made and those under consideration do little to address the primary cause of the problem of socially irresponsibility by top management. Here are my recommendations.

 

1) As a condition for being listed on the major trading exchanges, a firm’s board of directors should consist solely of representatives of its stockholders, creditors, employees, local community, suppliers, and retailers.

 

2) Board members should be free of serious conflicts of interest. This means that the board would include no top managers and no individual who could benefit substantially from transactions with the firm.

 

3) The firms would provide details on the process for selecting board members, and potential conflicts would be described.

 

4) Perhaps, as we do with unions and with countries that are new to democracy, company elections should be supervised to ensure that top management has no influence.

 

5) The board members would each have a budget that could be used to allow them to monitor the effectiveness of the firm and to assess how their groups are affected by major decisions. For example, I am annoyed that each time one of my stocks is involved in a merger, the company sends me an obtuse document that convinces me they have made no serious attempt to forecast the merger’s effects.

 

Firms can implement the above recommendations directly. There is no need to wait for government mandates. Firms that implement procedures to reduce the likelihood of irresponsible actions by top management might find that their stock is valued more highly.

 

These recommendations call for substantial changes. It may be wise to move gradually in this direction and to monitor the effects of each change. It might also be useful to examine the effects that proposed changes might have on decision-making by boards. The procedure used in the study of the Upjohn situation, role playing, provides the most accurate way to make such predictions. However, as the weight of evidence is against the current role of board members, changes should be implemented without waiting for further research. It might do well to start with Hershey Foods, where a movement is underway to remove the board of trustees (http://www.friendsofhershey.org). Why not replace them with a board that represents all stakeholders, and encourage them to develop a system for social accounting? This would help Hershey and it might serve as a model to help all of us.

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