The Neglected Role of Justification under Uncertainty in Corporate Governance and Finance

Research Retrieved: March 2019
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Issue

Financial incentives are a central corporate governance mechanism employed to limit the self-serving behavior of managers, and align managerial decision making with shareholder interests. However, shareholders and policy makers often voice concerns that financial incentives induce short-termism and motivate executives to sacrifice long-term growth in order to achieve short-term performance goals. In this paper, Hill and Paccess (2018) argue that accountability perhaps represents a counter-intuitive, alternative, and so far, underestimated driver of short-termism.

Key Findings

Accountability can be costly: If there is a pervasive need for managers to justify their decisions, managers can be forced to make decisions that are justifiable in the short-run, despite the existence of arguably better long-term opportunities. The higher the level of uncertainty, the more adverse the outcome, as managers are more likely to opt for alternatives that are more easily justified in the near future. The authors coin the resulting cost of this form of short-termism as justification cost.
Traditional agency versus justification cost: In order to limit managerial safe dealing, shareholders usually push for more managerial accountability. However, whereas more accountability might indeed reduce the traditional agency cost associated with self-dealing and empire building, more accountability can incur higher justification costs – particularly, in times of high uncertainty.
More leeway might be desirable: Therefore, high levels of uncertainty can mean that it would be preferable for shareholders to grant managers more freedom. This conclusion runs counter to the intuition that more accountability is always better. In order to limit managerial short-termism induced by the pressure on managers to justify their decisions, it can become optimal to make accountability contingent on uncertainty to enable better, long-term oriented decision making.

Meaning for Practice

The authors do not argue that management should not be held accountable, but that shareholders and society might be better off if accountability could be contingent on the levels of uncertainty. The authors suggest that justification cost could be countered without compromising accountability through a new governance mechanism: If managers are granted leeway under specific conditions and for a specified period of time through so called Control-Enhancing-Mechanisms, accountability standards can be generally upheld, but combined with more managerial flexibility.