First published in The National Post
By: Anita Anand
Since the collapse of Enron and other corporate giants, observers of the capital markets have been bombarded with one message: Investors need greater protection than current law affords. This message has been very powerful and, in turn, legislation emanating from governments and regulatory bodies in the United States and Canada has been voluminous. But this message - and the legislation that results from it - is misguided.
The investor protection message is rooted in the concept of trust - a hot topic with corporate law academics these days. According to these scholars, trustworthy behaviour on the part of directors and managers is severely lacking in corporate relationships. Having managers that are more trustworthy would enable co-operative patterns of behaviour to develop within firms, even when external incentives such as legal sanctions are unavailable or ineffective. Trust plays an important role in discouraging opportunistic behaviour.
This idea is certainly compelling. If we could all reach out and trust each other a little more, then perhaps we would not need Sarbanes Oxley, new SEC rules, NYSE and NASDAQ proposals and, in Canada, Bill 198 (now law), TSE proposals, initiatives of the CICA and new proposals for securities regulation of the BCSC. Perhaps our legal regime would not be so complicated and corporate behaviour would not be so contentious.
Yet the concept of trust has, at best, a limited role in the analysis of corporate failures. The relationship between managers and shareholders is based not on this norm but on legal contract wherein shareholders, as rational investors, negotiate with management, diversify their portfolios and exit the company if management does not maximize shareholder wealth.
Furthermore, there will likely be a significant cost to individuals who engage in trust or other-regarding behaviour, particularly when managers face decisions regarding shareholders, employees and the allocation of corporate assets within their businesses. Under normal circumstances, trust will not improve the efficiencies of self-interested behaviour. Indeed, if individuals act in other peoples' interests rather than their own, efficiency losses, not efficiency gains, will likely be the result.
Let us consider the Enron, WorldCom and Adelphia situations. Would trusting or other-regarding behaviour on the part of management have changed the outcome and prevented these disasters? It seems highly unlikely that the managers in these cases, who were willing to deceive shareholders, creditors, employees and even regulators, would adopt other-regarding behaviour. Indeed, I am doubtful that such behaviour can be inculcated easily, and that it will therefore be able to prevent corporate misdeeds. In any case, the actions of managers in these firms were the exception, and certainly not the norm.
Further, it is unlikely that efficiency gains would result if managers' behaviours were really changed so that they acted in an other-regarding manner. The underlying basis for our economic system and the efficient allocation of resources is that each person acts in her own self-interest. Proponents of the trust argument focus on the limited circumstances in which trust may lead to superior outcomes, without considering the impact that a change in behaviours may mean in a broader market.
Take, for example, a manager of a company facing hard times and difficult decisions about employees and the allocation of scarce capital within the company. The manager may have close relationships with employees in a certain division. If the manager acted in an other-regarding fashion, she would not terminate the employees. However, the profitability of her business may depend to some degree on their termination. Arguably, altering the behaviour of managers so that their behaviour becomes other-regarding would undermine the profitability of the firm and, on a systemic level, the allocation of resources within firms, industries and the economy.
This is not to say that trust should have no role. In limited circumstances, parties may be better off by engaging in other- regarding behaviour. That is, when there is little cost and therefore little conflict with self-interested behaviour, marginal efficiency gains may result. However, in most circumstances there is likely to be a significant cost to "trust" or "other-regarding behaviour." Therefore, under normal circumstances, trust will not improve the efficiencies of self-interested behaviour.
Thus we must be cautious about endorsing the idea that more trust is needed in the modern corporation. Indeed, Enron has taught us little that we did not know before. Corporations are profit- maximizing entities run by managers who are inherently self- interested. We cannot regulate or force individuals to be trustworthy. And in light of inefficiencies that may arise if we do, trust is not a concept that we should readily embrace.