Directors Hazard and the New Rules of Governance

July 20th

The Murdoch hearings before Parliament gained a global audience and once again served to focus attention on the governance issues that now seem to arise at every turn.  Or, at least, when something goes wrong and we look back to determine who was responsible? or who should have been responsible? we seem to be confronted repeatedly with issues of governance and questions of moral hazard.

Where you responsible Mr. Murdoch?  No, he answered the people he trusted were responsible and the people that they trusted.

Unfortunately, since there had plainly been wrongdoing in the interest of selling more newspapers, Mr. Murdoch’s answer became the centerpiece of much of the coverage that followed.  Should he have assumed greater responsibility?  Was it even true that he didn’t know what was happening?

For directors who are responsible for protecting the well being of their companies, this answer raised troubling questions (once again) about the nature of moral hazard.  Economists talk about moral hazard (a condition that occurs when a party that is insulated from risk behaves differently than they would if they were exposed to the risk) as a case of information asymmetry.  Insurers need to be protected, according to the theory, from cases where the insured do not behave as they would if they had no insurance, if they were themselves subject to the full risks of their behavior.

In the 17th Century when insurance companies were first grappling with the concept of risk, they sought to understand whether the people that they insured would behave in a riskier manner as a result of the insurance.  In the case of health insurance today, there is ongoing debate over whether insurance encourages an overconsumption of health care and then there is a debate over whether that’s a bad thing.  Co-payments and other devices are used to encourage the consumer to assume part of the risk.

But in recent years, especially after the financial crises of 2008, the question of risk to the taxpayer became clear as institutions were protected, at taxpayer cost, from behaviors in which they had assumed too much risk.  Directors and national leaders, it was reasoned, would be better able to protect shareholders and taxpayers if the actions of CEOs were less protected and if their decisions were required to be transparent.

Michael Anteby, an associate professor of organizational behavior at Harvard Business School, writes in Working Knowledge, an HBS blog that “many companies today operate like Russian nesting dolls, relying heavily on other companies or external individuals to conduct many of their activities”.  (“Rupert Murdoch and the Seeds of Moral Hazard”)  Anteby expands the concept of agency and moral hazard by looking more broadly at the implications of the interconnectedness of our society.  He is concerned that when companies interconnect the “associated moral hazard often goes unnoticed.  Such risk can prove even greater when the various elements of the ‘delegation chain’ obey different standards.”

Whether or not the Murdochs knew about the phone hacking at the News of the World they were plainly in a situation of “plausible deniability”.  In the food and apparel industries, Anteby argues, there is a need to “secure” all elements of the production chain.  Whether they have in fact recognized this and whether there is a similar requirement in other industries is a debatable point.  But certainly one of the most interesting consequences of Rupert Murdoch’s denial of responsibility for the actions of his agents was to raise once again the question:  If not you, then who is responsible for the actions of your employees?

Future directors will have to think carefully about what these emerging concepts of “responsibility” will mean for them.  Will transparency be sufficient to protect the shareholders and the public?

We have reached a time when every company is an IT company.  Some Boards are beginning to see this and to grapple with the risks associated with information.  They may not yet have reached the point where they are grappling with the risks of information asymmetry and, if transparency is an antidote to the problem of the Russian nesting dolls, the consequences that this form of insurance will convey.

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