1

Corporate Scandals of the 21st Century: limitations of

mainstream corporate governance literature and the

need for a new behavioral approach

Alexandre Di Miceli da Silveiraa

School of Economics, Management and Accounting, University of São Paulo

Working Paper

November 26th

, 2012

a Associate Professor of Finance and Accounting at the School of Economics, Management and Accounting of the

University of São Paulo (FEA/USP). Tel: (+55) 11 99342-5459. e-mail: alexfea@usp.br.

* The author thanks Angela Donaggio for valuable comments. © Alexandre Di Miceli da Silveira, 2012. All rights

reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided

that full credit is given to the source.

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Corporate Scandals of the 21st Century: limitations of mainstream corporate

governance literature and the need for a new behavioral approach

Abstract

I provide a critique of mainstream corporate governance literature based on agency

theory as a conceptual solution in order to endure de facto well governed companies

worldwide. This critique is based on an analysis of common causes associated with 23

high profile corporate scandals from the 21st century. It is also based on the limitations

associated with the homo economicus premise behind agency theory, which ignores

psychological issues associated with the human factor inside organizations. As a result, I

argue that a new behavioral approach to corporate governance shall emerge in order to

reduce the emergence of corporate scandals in the future. This new view should be

based on three main components: 1) the systematic focus on the mitigation of cognitive

biases in managerial decisions; 2) the continuous fostering of employee and executive

awareness towards the promotion of unselfish long-term oriented cooperative behaviors;

and, 3) the reduction of the likelihood of frauds and other dishonest acts through new

corporate strategies developed after a deeper understanding of their psychological

motivations. By combining the traditional approach to corporate governance based on

incentive and controls with a new behavioral approach focusing on the human factor,

corporate stakeholders may expect to end up with truly well-governed companies.

Key-Words: corporate scandals, corporate governance, behavioral corporate

governance, homo economicus concept, agency theory critique, case study.

JEL Classification Codes: G30, G34, G02, M19.

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1. Introduction

“We continue to be committed to industry best practices with respect to

corporate governance. Our Board of Directors consists of ten members.

With the exception of our CEO, all of our directors are independent. The

audit, nominating and corporate governance, finance and risk, and

compensation and benefits committees are exclusively composed of

independent directors. The Audit Committee includes a financial expert as

defined in the SEC’s rules. The board holds regularly scheduled executive

sessions in which non-management directors meet independently of

management. The board and all its committees each conduct a self-

evaluation at least annually. Last year, overall director attendance at board

and committee meetings was 96%. We have an orientation program for

new directors. Our corporate governance guidelines also contemplate

continuing director education arranged by the company. Our Code of

Ethics is published in our website. We have designed our internal control

environment to put appropriate risk mitigants in place. We have a global

head of risk management and a global risk management division which is

independent. The company’s management assessed the effectiveness of our

internal controls. Based on our assessment, we believe that the company’s

internal controls are effective over financial reporting. These controls have

also been considered effective by the independent auditors. We also

sponsor several share-based employee incentive plans.”

The text above was extracted from the annual report of a company that probably would

be very well assessed by market agents regarding its corporate governance practices. It

is actually, though, an extract of Lehman Brothers Annual Report 2007, the U.S.

investment bank that collapsed just a few months after the release of this document.

Like so many other similar cases, Lehman’s case illustrates how companies that

apparently were role models in their top management practices collapsed due to

different reasons such as wrong business decisions, risk management problems or

frauds.

The number of corporate scandals1 associated with corporate governance problems in

the first decade of this century is extensive. Wikipedia website, for instance, provides a

list of more than 75 corporate scandals throughout this period.2 Their economic

relevance is enormous. Table 1 below lists 23 selected high profile corporate scandals

that, together, have destroyed an estimated US$750 billion of their shareholders’ equity.

[Table 1 here]

1 A corporate scandal is assumed as a set of questionable, unethical, and/or illegal actions that a person or

persons within a corporation engage in. Source: BusinessDictionary.com 2 http://en.wikipedia.org/wiki/List_of_corporate_scandals

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The economic impact of the scandals portrayed in Table 1 on other stakeholders – such

as employees, communities, clients, suppliers, etc. – and on society as a whole was

indeed much bigger. These scandals have come from companies worldwide, including

large emerging countries such as Brazil and India and developed economies such as the

U.S., Germany and Japan. Although there has been a first wave of corporate scandals in

the 2001-2003 period epitomized by Enron and Parmalat in the U.S. and Europe,

respectively, the lessons from these cases do not seem to be fully understood, since the

list has continued to grow, especially after the emergence of the global financial crisis in

2007-2008.

Since the number of corporate scandals associated with corporate governance problems

continues to be relevant worldwide, I focus on the following question in this paper:

Why do we still see so much value destruction in the business world due to corporate

governance failures after years of debate and, in theory, learning about this subject?

I initially argue that governance scandals are the direct outcome of a common set of

fourteen interrelated factors detailed ahead such as: excessive concentration of power,

ineffective board of directors, passivity of investors, failure of gatekeepers, poor

regulation, lack of the right ethical tone at the top, etc.

My central point in this paper, nevertheless, is to argue that the root of the problem lies

in the way the corporate governance concept has been internalized by most of the

companies, investors and academics worldwide. Based on the work of orthodox

economists (Jensen and Meckling, 1976; Fama and Jensen, 1983), corporate governance

has been widely grounded on the agency theory perspective, which is basically

concerned in creating ways to motivate one party (the “agent”), to act on behalf of

another (the “principal”). As a result, the good governance of a business, a very

complex subject, has been reduced to a mere set of incentive and control mechanisms in

order to induce agents (managers) to make decisions in the best interests of their

principals (shareholders).

The limitation of the debate to theoretical framework of agency theory has at least two

fundamental problems. First, the dissemination of corporate governance as a mere set of

rewards and punishment mechanisms to be implemented in order to induce behaviors

has left business leaders free to treat this complex and intrinsically human subject as a

mere check-list of recommended practices to be fulfilled in order to be well perceived

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by the outside stakeholders. The Lehman Brothers’ case is just one among several

similar scandals in which there was a discrepancy between the essence of good

governance – companies where decisions are made in their best long-term interest and

in which people comply with the rules – and the way the governance practices were

shown externally.

Second, agency theory – formulated almost forty years ago – is based on the homo

economicus premise, a concept that has been proved to be a very limited portrait of the

human nature by numerous recent researches (presented ahead) in different fields such

as sociology, psychology, neuroscience, behavioral economics, etc.

Specifically, these studies have consistently shown that people are not rational,

exclusively selfish, and interested in breaking rules depending on its relative economic

benefits as predicted by the homo economicus concept. Since this accumulated

knowledge in other fields cannot be ignored, a rethink of the corporate governance

concept is needed in light of these works.

As a result, I argue that a new behavioral approach to corporate governance focusing on

the psychological aspects of human beings inside organizations shall emerge. This new

approach should be based in at least three main components ignored by agency theory:

1) the systematic focus on the mitigation of cognitive biases in managerial decisions; 2)

the continuous fostering of employee and executives awareness towards the promotion

of unselfish cooperative behaviors; and, 3) the reduction of the likelihood of frauds and

other dishonest acts through new corporate strategies developed after a deeper

understanding of their psychological motivations.

This new approach does not dismiss, though, the importance of incentive and control

mechanisms recommended by the agency theory. Such mechanisms remain relevant, but

should not be seen as sufficient for well-governed companies. The expansion of the

corporate governance literature beyond agency theory towards a behavioral approach

should be seen as something crucial to ultimately reduce the emergence of new

corporate scandals in the coming years.

This paper relates with different fields of knowledge that provide complementary

theoretical frameworks to agency theory, such as the literatures of trust in organizations

(Noreen, 1988; Mayer et al. 1995; Schoorman et al., 1996; Bower et al., 1997; De Dreu

et al., 1998; Zaheer et al., 1998; Becerra and Gupta, 1999 and 2003; Sundaramurthy and

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Lewis, 2003; Cadwell and Karri, 2005), stewardship theory (Donaldson and Davis,

1991; Davis et al., 1997; Arthurs and Busenitz, 2003; Hernandez, 2012), and intrinsic

motivation (Deci and Ryan, 1985; Frey and Jegen, 2001; Fehr and Falk, 2002; Kolev et

al. 2012). Trust literature criticizes agency theory’s pessimistic assumptions about the

human behavior pointing out that this approach precludes trust and cooperation, crucial

elements for successful organizations. It argues that corporate agents may show an

attitude of trust and cooperation depending on contextual and personal factors, therefore

not always behaving selfishly. Overall, this literature considers trust as an efficient

mechanism to maximize the principal’s utility. Stewardship theory views executives as

“stewards” of the organization who are motivated to act responsibly based on an

assumption of trust. It considers that managers obtain greater utility when developing a

collaborative approach rather than when behaving selfishly, especially when they

identify with organizational values and goals. The literature on motivation points out

that non-pecuniary motives shape human behavior, including intrinsic pleasure arising

from work, the desire to obtain social approval and the sense of reciprocation. It also

contends that extrinsic rewards such as those emphasized by agency theory may indeed

undermine the role of intrinsic rewards on motivation and increase agent’s opportunistic

behavior.

This paper also fits in an emerging line of research that criticizes agency theory’s

simplistic and inflexible assumptions about human behavior and the narrowness of its

predictive validity (Tirole, 2002; Charreaux, 2005; Van Ees et al., 2009; Cuevas-

Rodríguez et al., 2012; Martin et al., 2012; Wiseman et al., 2012). Overall, these works

call for new approaches toward corporate governance by widening the agency concept

through a behavioral perspective. I believe that this paper contributes to these literatures

by prescribing three specific areas of concentration for the emergent behavioral

approach to corporate governance based on an analysis of corporate scandals from

earlier 21st century as well as on the fragilities of the homo economicus premise

evidenced by recent numerous works.

The paper is organized as follows. In section 2, I list the common factors explicitly

associated with governance scandals from the first decade of the 21st century. In section

3, I develop my argument that the root of the problem lies in the homo economicus

premise behind the mainstream approach to corporate governance. I do so by presenting

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evidence from recent researches in different fields that people: i) do not make rational

decisions; ii) tend to behave cooperatively instead of acting in a purely selfish way

depending on the social context; and, iii) dishonest behaviors are primarily motivated by

psychological factors instead of applicable penalties and the probability of being caught.

As a result of this critique, I argue in Section 4 that the conceptual solution for the

limitations of agency theory is the emergence of a behavioral approach to corporate

governance focusing on psychological factors associated with people inside

corporations. Section 5 then provides some concluding remarks.

2. Explicit reasons for corporate scandals from the first decade of the 21st

century: interrelated common factors

The 23 selected corporate scandals presented in Table 1 have quite heterogeneous

natures. Some involved fraud, while others were the outcome of risk management

failures or of bad – but not necessarily illegal – top level decisions. Analyzed on an

aggregate basis, they raise important red flags and provide valuable lessons.

After examining eight cases from the first wave of corporate scandals, Hamilton and

Micklethwait (2006) conclude that they were caused by six main causes: 1) poor

strategic decisions; 2) over-expansion and ill-judged acquisitions; 3) dominant CEOs; 4)

greed, hubris and a desire for power; 5) failure of internal controls; and, 6) ineffective

boards.

Coffee Jr. (2005, 2006) lists the “gatekeeper failure” – the reliance on reputational

intermediaries such as auditors, stock analysts, credit rating agencies, and other

professionals who pledge their reputational capital to vouch for information that

investors cannot easily verify – as another reason for the emergence of corporate

scandals. He also argues that inadequate compensation systems allowed earnings

management in several companies, being a relevant factor for the scandals in companies

with dispersed ownership structures such as those prevalent in the Anglo-Saxon

countries.

More recently, the OECD concluded that corporate governance failures at financial

institutions that collapsed in the 2007-2009 period have occurred due to four main

causes: 1) inadequate incentive systems; 2) deficient risk management practices; 3) poor

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board practices; and, 4) the tendency for shareholders – especially institutional investors

– to act reactively rather than proactively.

Building upon these works, I propose an expanded framework with fourteen interrelated

common causes associated with the corporate scandals presented in Table 1.

[Chart 1 here]

According to the conceptual model presented in Chart 1, common causes associated

with corporate governance scandals can be divided into three groups: fundamental

causes, those lying at the root of the problems; immediate causes, those leading directly

to the emergence of the scandals; and, mediating causes, intervening factors by which

fundamental causes generate immediate ones.

1. Fundamental causes: those lying at the root of the problems by involving the

company’s leadership structure and its external monitoring. Five stand out:

excessive concentration of power; ineffective board of directors; passivity of

investors; failure of gatekeepers; and, poor regulation.

2. Immediate causes: those leading directly to the emergence of the scandals as a

consequence of fundamental or mediating causes. Five can be pointed out:

overexpansion of the business; biased strategic decisions; inflated financial

statement; weak internal controls; and, inadequate compensation systems.

3. Mediating causes: intervening factors by which fundamental causes generate

immediate causes. Four main mediating causes can be listed: the illusion of

success of the business, an internal atmosphere of greed and arrogance, the lack

of the right ethical tone at the top and, corporate governance seen as a marketing

tool.

Table 2 details the rationale for these fourteen common causes lying behind recent

corporate failures.

[Table 2 here]

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In Table 3, I provide a qualitative analysis of each corporate scandal presented in Table

1 vis-à-vis common factors associated with them, aiming to understand the specific

relevance of each factor for the selected cases.

[Table 3 here]

In spite of the limitations of this preliminary aggregate analysis, such as its admittedly

subjectivity, Table 3 suggests interesting qualitative interpretations. First, five main

factors seem to stand out among the possible reasons for corporate misdeeds in the first

decade of the 21st century: excessive concentration of power, ineffective boards, lack of

the right ethical tone at the top; and, biased strategic decisions and weak internal

controls.

Second, since there was an initial wave of scandals in the 2001-2003 period and a

second one during the emergence of the global financial crisis in 2007-2008, I divide

the scandals in two groups: those taking place in the first half of the decade (2001-2005)

and those taking place in the second half (2006-2010). The comparison of the common

causes associated with scandals from each group indicates that two factors appear to

have increased in relevance for the emergence of scandals from the second half of the

decade: 1) poor regulation; and, 2) corporate governance seen as a marketing tool.

3. The root of the problem: the mainstream approach to corporate governance

based on the homo economicus concept

“Il faut tout attendre et tout craindre du temps et des hommes”

Luc de Clapiers, Marquis De Vauvenargues

Réflexions et maximes, 102 (1746)

Although governance scandals are the explicit outcome of a set of interrelated factors,

the root of the problem of business value destruction related with corporate governance

failures may lie in how the theme has been internalized by companies, investors and

academics worldwide.

Based on the work of mainstream economists (Jensen and Meckling, 1976; Fama and

Jensen, 1983; Shleifer and Vishny, 1997; La Porta et al., 1998), corporate governance

literature has been widely based on agency theory, which is basically concerned in

creating the most efficient contract to align the interests of one party (the “agent”) with

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those of another (the “principal”) in situations where the principal concedes authority to

the agent to act on her name.

As a result, the good governance of a business, a very complex subject, has been

reduced to the implementation of a set of incentive tools (e.g. stock-based

compensation, periodic performance evaluations, etc.) and controls (e.g. independent

boards, risk management divisions, compliance programs, internal controls, internal and

external audits, etc.) in order to align interests and reduce agency costs.

This approach – deriving from the limited view of the “carrot and stick” that forms the

basis of mainstream economics – has left business leaders free to treat this intrinsically

human theme as a set of checklists to be fulfilled in a technical way, sometimes totally

disconnected from the company’s daily management.

In addition, agency theory is based on the usual premise of neoclassical economic

models that people act like homo economicus, that is, they always:

1. Make perfectly rational decisions;

2. Think exclusively in maximizing their own personal economic gains3; and,

3. Are interested in breaking the rules if the applicable penalty multiplied by the

probability of being caught is lower than the expected benefit of a dishonest act.

The reduction of people within corporations to the concept of homo economicus – an

archetype initially created to explain the trading of goods and services in anonymous

markets and later indiscriminately extended to other fields – ends up in a very limited

and often inaccurate assumption about human behavior. Hundreds of recent studies in

sociology, psychology, neuroscience, behavioral economics, etc. have provided

increasingly evidence that human behavior is far more complex, depending on

psychological, social and biological interactions.

These three premises behind mainstream corporate governance based upon the homo

economics concept bring with them three respective fundamental problems detailed in

the following subsections.

3 Economists tend to argue that they employ the concept of utility instead of economic benefits. However,

the concept of “utility” is used somewhat loosely, since theoretical models always end up translating it

into the maximization of economic gains for the decision maker.

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3.1. First problem of mainstream corporate governance based on the homo

economicus concept: people do not make rational decisions

Firstly, we are subject to multiple cognitive biases, that is, deviations in judgment

patterns taking place in particular situations leading us to distorted interpretations of

reality, illogical interpretation, and, consequently, to irrational decisions. This well

established body of research has been initiated by Kahneman and Tversky (1974, 1979),

growing exponentially afterwards (Angner and Loewenstein, 2007; Thaler, 2000;

Kahneman, 2011). Nowadays, more than 100 cognitive biases have been identified from

researches in cognitive science, social psychology, and behavioral economics4. Table 4

below exemplifies some of the main individual and collective cognitive biases,

including their potential impacts for the corporate governance debate.

[Table 4 here]

Among the cognitive biases presented in Table 4, take the example of the interrelated

biases of optimism and overconfidence. People who are overconfident tend to

underestimate risks due to an “illusion of control” over the outcomes of their initiatives,

while optimists tend to overestimate the future outlook of their outcomes in what is

called the “better than average” effect. As a result, even technically qualified executives

with interests aligned with those of their shareholders can make disastrous business

decisions due to the pronounced presence of these biases.

There is already some evidence of this in the literature. Malmendier and Tate (2004)

observe that companies with overconfident CEOs tend to undertake mergers that

destroy value. Ben-David et al. (2007) find that companies with overconfident CFOs

apply lower discount rates to value cash flows, use more debt, and are less likely to pay

dividends. Barros and Silveira (2008) observe that companies run by more optimistic

individuals tend to choose more levered financing structures, ending up more indebted.

Schrand and Zechman (2011) find that overconfident executives are more likely to

initially overstate earnings which start them on the path to growing intentional

misstatements or frauds.

4 https://secure.wikimedia.org/wikipedia/en/wiki/List_of_cognitive_biases

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These studies illustrate how just one of the several cognitive biases that possibly affect

top level managers – overconfidence – may impact relevant corporate decision making.

Therefore, the presence of counterbalances such as independent third-party reviews and

the implementation of alternative decision making techniques could be useful by

mitigating the impact of cognitive biases such as overconfidence and optimism on

company decisions.

Cognitive biases, however, are not part of the traditional view of corporate governance

exclusively concerned with the establishment incentive and control mechanisms.

3.2. Second problem of mainstream corporate governance based on the homo

economicus concept: people tend to behave cooperatively instead of acting

in a purely selfish way

Second, unlike the relentless search for the best personal economic outcome predicted

by the homo economicus premise, an increasingly growing body of literature (Henrich

et al. 2001; McCabe et al. 2001; Rilling et al., 2002; Gintis et al., 2003; Decety et al.

2004; Kosfeld et al. 2005; Singer and Frith, 2005; Katja et al. 2007; List and Cherry,

2008; Akitsuki and Decety, 2009; Krupka and Weber, 2009) summarized in Stout (2011)

is showing that people may have a tendency to act in a cooperative and unselfish way,

acting in the best interest of the groups to which they belong. In short, these papers,

most of them based on experiments, provide systematically evidence of altruistic

behaviors fleeing from the orthodox economic view.

Take for instance three experiments that defy the view that people tend to behave like

rational economic maximizing individuals: the “trust game”, the “ultimatum game”, and

the “dictator game”.

In the “trust game” (Berg et al., 1995; Croson and Buchan, 1999; Anderhub et al. 2002;

McCabe et al. 2001; McCabe et al. 2003; Delgado et al., 2005; Cesarini et al. 2008),

two players (unknown to each other) are placed in two separate rooms. Player A (the

trustor) receives a sum of money (e.g. $20) and decides how much of it she will send to

player B (the trustee). Player A may decide to do not send anything to B, leaving the

experiment by keeping all the cash. If A decides to send something to B, this amount is

then tripled. After receiving the tripled sum sent by A, individual B then has the

opportunity to return some money to A or simply to keep it. Homo economicus would

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give nothing on both occasions, acting either as player A or B. However, different

researches (Berg et al., 1995; McCabe et al. 1996, 2001, Brülhart and Usunier, 2012)

observe that cooperation flourishes in this game, with the average player A cooperating

with B by donating a significant share (about half) of her monetary endowment, while

the majority of individuals B tend to reward A’s generosity by giving back a little more

of the money initially sent by A.

In the “ultimatum game” (Güth et al. 1982; Dawes and Thaler 1985; Thaler, 1988;

Camerer and Thaler, 1995; Nowak et al. 2000; Sanfey et al. 2003; Oosterbeek et al.

2004; Koenigs, 2007), two players (also unknown to each other) interact the division of

a monetary endowment. Player A proposes how to divide the sum between the two

players, whereas player B can either accept or reject this proposal. If B rejects, neither

player receives anything. If B accepts, then the money is split according to A’s proposal.

The game is played only once so that reciprocation is not an issue. If individual A is

homo economicus, then she should always propose the minimum amount for B and the

maximum for herself (e.g. $1 for B and $49 for herself). If B, in her turn, is homo

economicus, then she would always accept any amount proposed by A (since rationally

anything is better than nothing). However, different researches (Güth et al. 1982;

Kahneman et al., 1986; Hoffman et al., 1996a; Oosterbeek et al. 2004) observe that, on

average, people tend to offer “fair” splits (with a modal offer around 50:50), whereas

offers of less than 20% are usually rejected.

The “dictator game” (Camerer and Thaler, 1995; Bolton et al. 1988; Diekmann, 2004;

Henrich et al. 2004; Bardsley, 2008) is a variant of the ultimatum game. In it, player A,

“the dictator” or proposer, determines a split of some monetary endowment. Player B

then simply receives the remainder of the endowment left by the proposer. Player B’s

role is entirely passive, with no strategic input into the outcome of the game. If

individuals are only concerned with their own economic well being, dictators would

allocate the entire money to themselves, giving nothing to player B. Experimental

results (Kahneman et al., 1986; Forsythe et al., 1994; Hoffman et al., 1996b;) indicate

that individuals often allocate money to the responders, voluntarily reducing the amount

of money they receive.

The overall result of experiments such as those presented is that people frequently do

not act like rational maximizers as predicted by the homo economicus model. On the

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contrary, people usually tend to show a cooperative behavior based on reciprocity and

altruism. More importantly, since human behavior is flexible rather than rigid as

presumed by the homo economics model, this tendency can be reinforced through

situational factors that create the right social context in order to increase cooperation

rates. Stout (2011)5 argues that unselfish prosocial (or cooperative) behavior, including

voluntary compliance with legal and ethical rules, is triggered by the social context,

which in turn depends on three main social variables6:

1. The instructions received by leaders, deriving from our tendency to obey

authorities (Sally, 1995; Balliet, 2010);

2. The reciprocity, or beliefs about others’ prosocial behavior when facing similar

circumstances, as a result of our propensity to conform and imitate the behavior

of our peers (Gintis, 2000; Henrich et al. 2001; Gintis et al. 2003; López-Pérez,

2009); and,

3. The magnitude of the perceived benefits of one’s actions on others, deriving

from our tendency to feel empathy (Eisenberg and Miller, 1987; Eisenberg and

Fabes, 1990; Batson and Powell, 2003; Decety and Jackson, 2004; Batson,

2009).

Since rational choice models ignore the influence of these three key elements on human

behavior, the traditional view of corporate governance based on incentives and controls

do not contemplate the need to continuously activate and cultivate people’s

consciousness in corporations in order to induce cooperative and long-term oriented

behaviors.

3.3. Third problem of mainstream corporate governance based on the homo

economicus concept: dishonest behaviors are motivated by psychological

factors instead of applicable penalties and the probability of being caught

Third, another recent body of research (Bateson et al., 2006; Mazar et al., 2006, 2008;

Baumeister, 2007; Gino et al., 2008; Mead et al. 2009, Gino et al. 2009, 2010, 2011;

5 Stout (2011) calls this “a three-factor approach to social context”.

6 Fostering the “activation” of people’s conscience as an important corporate governance practice has one

limitation, however. About 1% to 4% of the general population is comprised of people with psychopathy

disorder, unable to feel guilt or empathy for others. There are suspicions that this percentage is higher in

corporate environments, especially at top hierarchical levels. As a result, cultivating conscience will not

work with people subject to this disorder, an especially relevant observation for organizations headed by

these psychopath individuals.

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Gino and Pierce, 2010; Wiltermuth, 2010; Barnes et al., 2011; Chance et al., 2011; Gino

and Ariely, 2011; Barkan et al. 2012; Shu et al., 2012) summarized in Ariely (2012) is

increasingly showing that the propensity of people to act dishonestly – at the root of

relevant scandals – is more dependent on psychological factors than on both the risk of

being caught by breaking the rules and its applicable penalty. Overall, there is evidence

that at least ten psychological factors seem to be relevant for people’s decision to incur

into dishonest behavior:

1) The ability to rationalize its own dishonest acts (Mazar et al., 2006, 2008;

Barkan et al. 2012): people seem to find ways to rationalize their illegal

behavior while maintaining at the same time a positive self-image of themselves;

2) Distance from monetary references (Mazar et al., 2008): the propensity to

dishonest acts increases with people’s decisions distance to a monetary explicit

payoff;

3) Being mentally depleted (Baumeister, 2007; Mead et al. 2009, Barnes et al.,

2011; Gino et al. 2011): mental exhaustion – due to stress, lack of sleep, etc. –

increases people’s propensity to dishonesty;

4) Previous illegal or immoral acts (Gino et al. 2010): the propensity of people to

dishonesty increases when they have already performed some previously illegal

act, especially if that comes with a built-in reminder (e.g. wearing counterfeits,

using false titles on business card, etc.);

5) Creativity (Gino and Ariely, 2011): a creative personality facilitate individuals’

ability to justify their behavior, which, in turn, tends to increase unethical

behavior;

6) Feelings of revenge (Ariely, 2012): dishonest acts are more easily justified when

viewed as compensations by people who feel initially harmed by an individual

or organization;

7) Being subject to sharp competition (Schwieren and Weichselbaumer, 2010):

cheating activity, especially from poor performers, tend to increase under

stronger competitive pressure;

8) Witnessing peers behaving dishonestly (Gino et al. 2009): exposure to unethical

behavior of a in-group peer tend to increase the propensity to dishonesty;

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9) Perception that our peers benefit from our actions (Gino and Pierce, 2010;

Wiltermuth, 2010): the propensity to dishonesty increases when people think

that such actions may benefit others for whom they have empathy;

10) Living in a culture that fosters dishonesty (Gino et al. 2009): being exposed to

an unethical climate or culture tends to increase the frequency of unethical acts.

Similarly to the two previous sections, none of these psychological factors are addressed

in mainstream corporate governance thinking, which departs from the premise that

increased monitoring and tougher penalties are the sole elements to avoid unlawful

behaviors.

4. The proposed solution for reducing the frequency of scandals: the need for a

behavioral approach to corporate governance focusing on psychological factors

Since the assumptions behind the mainstream corporate governance theory do not hold,

the mere implementation of incentive and control mechanisms, although relevant, will

not be sufficient to ensure well governed companies. In fact, this may largely explain

the collapse of companies that apparently adopted good governance practices.

The missing link in order to ensure well-governed companies over time is to focus on

the human factor, that is, on the creation of corporate environments in which

intrinsically motivated people want by themselves to make decisions in the best long-

term interest of the company as well as follows the rules.

Table 5 below summarizes this argument by presenting a comparison between the

traditional view of corporate governance and the new proposed approach based on

behavioral aspects.

[Table 5 here]

To do this, business leaders must unceasingly devote their time to create social contexts

in their organizations that: 1) improve the managerial decision-making process by

creating a system with effective checks and balances that reduce cognitive biases; 2)

continuously fosters employee and executive conscience by promoting unselfish long-

term oriented cooperative behaviors; and, 3) reduce the propensity to dishonest acts by

17

creating new strategies such as enhanced internal controls based on a deeper

understanding of their psychological motivations.

Probably, the hardest part of this process towards de facto good corporate governance

will be to change the mindset of business leaders themselves. On the one hand, cases

such as the Lehman Brothers debacle have shown that top executives have been

indoctrinated to think exclusively in their own short-term economic outcomes without

concerns about their impact on other stakeholders. On the other hand, reducing

cognitive biases in organizations depends on an effective system of checks and

balances, which implies a certain decentralization of power, something not necessarily

welcomed by leaders who are comfortable in maintaining their status quo and the

modus operandi of their decisions.

5. Concluding remarks

The emergence of numerous high-profile corporate scandals in the early years of the

21st century with huge impacts on societies worldwide evidence that the corporate

governance debate must evolve in order to ensure de facto well-governed companies,

that is, those in which decisions are made in their best long-term interest and in which

people comply with the rules.

In this paper, I argue that the dissemination of corporate governance as a mere set of

internal and control mechanisms in order to induce behaviors has led some companies

to internalize this complex and intrinsically human subject as a mere check-list of

recommended practices to be fulfilled in order to be well perceived by the outside

stakeholders. As a result, I provide a critique of the traditional corporate governance

literature based on the agency theory, since the acceptance of this approach by

companies, academics and regulators worldwide as the sole relevant issue for the

corporate governance debate has clearly failed to ensure well governed companies.

I argue that a new behavioral approach to corporate governance focusing on the

psychological aspects of human beings inside organizations should emerge in order to

benefit from the accumulated knowledge on human behavior from other fields as well

as to reduce the emergence of new scandals in the future. This new approach7 should be

based in at least three main components: 1) the systematic focus on the mitigation of

7 The term “behavioral corporate governance” has already been used by Charreaux (2005) and Van Ees et

al. (2009). Their point of view for this term, however, is different than the one adopted in this paper.

18

cognitive biases in managerial decisions; 2) the continuous fostering of employee and

executives awareness towards the promotion of unselfish cooperative behaviors; and, 3)

the reduction of the likelihood of frauds and other dishonest acts through new corporate

strategies developed after a deeper understanding of their psychological motivations.

This new behavioral approach does not dismiss the need for the implementation of

incentive and control mechanisms in organizations as prescribed by agency theory: it

only argues that these mechanisms should not be seen as sufficient ones in order to

ensure de facto well-governed companies. By combining the traditional approach to

corporate governance based on incentive and controls with a new behavioral approach

focusing on the human factor, stakeholders may expect to end up with truly well-

governed companies.

The acceptance of this expanded approach will indeed require a broader definition of

the meaning of the so-called good corporate governance, including the conception of

new recommended governance practices by codes of best practices.

It is time to move beyond the limited assumption of the homo economicus for corporate

governance. Psychological issues associated with the human factor within corporations

should become the new focus of corporate governance analysis.

19

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28

Table 1. List with major corporate scandals associated with governance problems of the first decade of the 21st Century.

8

# Company Country Year Estimated losses

for shareholders9

Did it involve

fraud? What happened?

1 Enron USA 2001 $60 billion YES Accounting fraud, inflation of assets debt hidden in special purpose entities

kept off the balance sheet.

2 Xerox USA 2001 $2 billion YES The company improperly booked nearly $3 billion in revenues between 1997

and 2000, leading to an overstatement of earnings of nearly $1.4 billion.

3 Adelphia USA 2002 $2.5 billion YES

The Rigas founding family borrowed $2.3 billion from the company that was

not reported on its balance sheets. The firm overstated results by inflating

capital expenses and hiding debt.

4 Tyco USA 2002 $1 billion YES The Chairman and CEO Dennis Kozlowski and former CFO Mark H. Swartz

were accused of diverting about $600 million from the company.

5 Worldcom USA 2002 $186 billion YES

The company overstated cash flow by booking $11 billion in operating

expenses as capital expenses. It also gave about $400 million to its Chairman

and CEO Bernard Ebbers in off-the-books loans.

6 Vivendi France 2002 $13 billion Uncertain

The company was accused of misleading information about its Ebitda growth

and liquidity in its public filings and releases in order to meet targets in 2001.

It accumulated huge debts as a result of an aggressive acquisition strategy

prompted by its powerful CEO Jean Marie Messier.

7 Royal Ahold Nether-

lands 2003 $2 billion YES

The company has overstated its profits by more than $1 billion as well as kept

billions in debt off its balance sheet. It also pursued a failed aggressive

strategy of acquisitions resulting in significant losses for its shareholders.

8 Parmalat Italy 2003 $3 billion YES The company collapsed in 2003 with $14 billion in off-balance sheet debts

hidden in special purpose entities, in what remains Europe's biggest

8 Technically, the first decade of the 21

st century ended on December 31, 2009. I included two scandals taking place in 2010 (BP and Olympus) due to their relevance

and usefulness for the analysis proposed in this article. 9 Estimated by the decrease of the company’s market capitalization right after the emergence of the scandals. All figures in US dollars.

29

# Company Country Year Estimated losses

for shareholders9

Did it involve

fraud? What happened?

bankruptcy.

9 Royal Dutch

Shell Netherlan

ds / UK 2004 $1 billion YES

The company has overstated its proved oil reserves by 23 percent, resulting in

profits being exaggerated by $276 million, as well as profits embellishment

by an additional $156 million.

10 Livedoor Japan 2005 $7 billion YES The company was accused of doctoring financial figures of a subsidiary in an

effort to improperly boost stock prices.

11 Refco USA 2005 $4 billion YES The Chairman and CEO Phillip R. Bennett had hidden $430 million in bad

debts from the company's auditors and investors.

12 Siemens Germany 2007 $3 billion YES

The company was fined $1.6 billion by American and European authorities

after being accused of using a US$ 500 million slush fund to pay around $1.4

billion in bribes in order to obtain contracts in emerging countries from 2001

until 2007.

13 Société

Générale France 2008 $20 billion YES

In January 2008, the French bank reported losses of about $ 7billion from

fraudulent derivative operations. According to the bank, all of the operations

were performed singlehandedly by one operator, Jérome Kérviel, who

allegedly violated the institution's control system.

14 Lehman

Brothers USA 2008 $60 billion Uncertain

The company filed for Chapter 11 bankruptcy protection after huge losses

due to complex financial operations which led it to insolvency. There are

suspicions of fraud with Repo 105 transactions.

15 Bear Sterns USA 2008 $20 billion Uncertain The company was sold off at a symbolic price in 2008, due to complex

financial operations which led it to insolvency.

16 AIG USA 2008 $239 billion Uncertain

The world's former #1 insurance company got itself involved in treacherous

financial transactions that resulted in colossal losses, needing more than $150

billion in bailout money from the American government in order to escape

bankruptcy. The company had already been fined US$ 2 billion in 2005 due

to financial record manipulation and balance sheet fraud.

30

# Company Country Year Estimated losses

for shareholders9

Did it involve

fraud? What happened?

17 Sadia Brazil 2008 $2 billion NO The food processing company reported billion dollar losses from speculation

through over-the-counter exchange rate derivative operations.

18 Aracruz Brazil 2008 $3 billion NO The pulp and paper company reported billion dollar losses from speculation

through over-the-counter exchange rate derivative operations.

19 Madoff USA 2008 $65 billion YES

Founder and CEO Bernard Madoff confessed that a Ponzi scheme had been

running for decades at his asset management company, resulting in losses for

his approximately 4,800 investors.

20 Satyam India 2009 $3 billion YES

Ramalingam Raju, Chairman and founder of Satyam (India's fourth largest IT

company), submitted a letter to both the board of directors and to the

country's regulator in which he confessed a billionaire that the company had

inflated its revenues by 76% and its profits by 97% in the previous year.

21 Panamericano Brazil 2009 $2.5 billion YES

The bank, which had successfully made its IPO just two years earlier,

announced a hole of about $ 2.0 billion on its balance sheet, about 2.5 its

equity and half of their total assets.

22 BP UK 2010 $45 billion NO

An explosion at Deepwater Horizon, a drilling rig in the Gulf of Mexico

connected to a well owned by the oil company BP, led to the largest

accidental oil spill in history and to the death of 11 workers. The firm has put

aside $20 billion for compensation for damages incurred by victims of the

spill. Together with previous safety incidents at the company, BP was accused

of negligence regarding its operational risk management practices.

23 Olympus Japan 2010 $7 billion YES

The company concealed losses by paying $687 million to advisers on

acquisitions. The company is also accused of siphon another $1.5 billion

through offshore funds.

Total Estimated losses $751 billion

31

Chart 1. Common causes associated with corporate governance scandals.

32

Table 2. Rationale for the common causes associated with corporate governance scandals.

Type of Cause associated

with Corporate Scandals Common Cause This cause is manifested when…

Fundamental Cause

Excessive concentration of power Corporate decisions tend to come from the single views of specific individuals without the

appropriate counterbalances.

Ineffective Board of Directors Boards do not satisfactorily perform their role of monitoring managers and providing the right

strategic direction.

Passivity of investors Investors do not correctly exercise their role as active shareholders, and end up wrongly rewarding

firms with unsustainable practices by inflating their stock prices.

Failure of gatekeepers Reputational intermediaries such as auditors, stock analysts, credit rating agencies, attorneys,

investment banks, and consultants who pledge their reputational capital to vouch for information

that investors cannot verify fail in their duties.

Poor Regulation Poor or nonexistent regulation allows the occurrence of governance problems.

Mediating Cause

Illusion of success of the business People inside and outside the organization come to believe that the company is an absolute

success, ignoring contrary evidence and generating a feeling of invincibility.

Internal atmosphere of greed and

arrogance An internal atmosphere of euphoria and hubris creates an inner sense of superiority to people

outside the company.

Lack of ethical tone at the top Leaders clearly fail to promote high ethical standards within their organizations, not treating the

issue as something essential and priority.

Corporate governance seen as a

marketing tool

The company clearly seeks to meet the check-list of recommended governance practices without

actually embracing the theme at its core prior to the emergence of the scandals.

Three corporate statements below provide examples of this:

“Enron Values: 1) Communication: we have an obligation to communicate. 2) Respect:

we treat others as we would like to be treated ourselves. 3) Integrity: We work with

customers and prospects openly, honestly and sincerely. 4) Excellence: We are satisfied

with nothing less than the very best in everything we do.” – Enron Annual Report 2000.

“We are committed to being an active and responsible member of every community where

we do business worldwide and we’ve set the goal of becoming best-in-class in corporate

33

Type of Cause associated

with Corporate Scandals Common Cause This cause is manifested when…

governance, business practices, sustainability and corporate citizenship… We believe that

an unwavering commitment to corporate responsibility is vital for our long-term success.

That’s why we go to great lengths to balance business, ethical, environmental and social

concerns… We are committed to financial transparency, compliance with the financial

reporting requirements of German stock corporation law and U.S. capital market

regulations, and open communication with our shareholders. Binding rules and

guidelines ensure that our dealings with business partners are ethical and adhere to all

relevant legal requirements” – Siemens Annual Report 2005.

“Safety, people and performance, and these remain our priorities. Our number one

priority was to do everything possible to achieve safe, compliant and reliable operations.

Good policies and processes are essential but, ultimately, safety is about how people think

and act. That’s critical at the front line but it is also true for the entire group. Safety must

inform every decision and every action. The BP operating management system turns the

principle of safe and reliable operations into reality by governing how every BP project,

site, operation and facility is managed. Our work on safety has been acknowledged inside

and outside the group” – BP Report 2008.

Immediate Cause

Overexpansion of the business Excessive growth of the company in the years immediately preceding the governance problems,

especially via acquisitions, contribute to the scandal.

Biased strategic decisions Unintentionally bad top level strategic decisions are made due to cognitive biases such as

overconfidence, groupthink, information cascades, etc.

Inflated Financial Statements The company intentionally publishes doctored financial statements, often inflating its profits or

hiding its debts.

Weak internal controls The main components of a sound internal control system are missing, such as an adequate control

environment, effective risk management and control activities.

Inadequate compensation system A compensation system too aggressive and too connected to short-term goals substantially

contributes to governance problems.

34

Table 3. Main reasons behind selected corporate scandals from the first decade of the 21st Century.

Common causes associated with corporate governance scandals from the first decade of the 21st Century on a 0-3 scale10

Fundamental Causes Mediating Causes Immediate Causes

1 2 3 4 5 6 7 8 9 10 11 12 13 14

# Company Year

Excessive

Concentr

ation of

Power

Ineffective

Board of

Directors

Passivity

of

Investors

Failure

of

Gatekee

pers

Poor

Regulat

ion

Illusion

of

Success

of the

Business

Atmosp

here of

Greed &

Arrogan

ce

Lack of

Ethical

Tone at

the Top

CG seen

as a

Marketi

ng Tool

Overexp

ansion

of the

Business

Biased

Strategic

Decisions

Inflated

Financial

Statemen

ts

Weak

Internal

Control

s

Inadequ

ate

Compen

sation

System

1 Enron 2001 XX XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX XX XXX

2 Xerox 2001 X XX X XXX XX X X XX X X XXX XXX XX

3 Adelphia 2002 XXX XXX XX XX XX X XX XXX XX XXX XXX XX

4 Tyco 2002 XXX XXX XX X X XX XXX XXX X XXX XXX XX XX XXX

5 Worldcom 2002 XXX XXX XX XXX XX XXX XXX XXX X XXX XXX XXX XX XXX

6 Vivendi 2002 XXX XX XX X X XX XXX XXX X XX XXX XXX X XX

7 Royal Ahold 2003 XX XX XX X X XX XX XX XX XXX XXX XXX XXX XX

8 Parmalat 2003 XXX XXX XX XXX XX XXX XX XXX X XXX XXX XXX XXX X

9 Shell 2004 X XX X X X XX X XXX XX X

10 Livedoor 2005 XXX XXX XXX XX X XX XXX XX XX XX XX XX XX

11 Refco 2005 XXX XX X X X X XXX X X X XXX XXX X

12 Siemens 2007 XXX X XX XXX X XXX XXX X XX X

13 Société 2008 XX XX X X XX XXX XXX XX XXX XX

10

The qualitative scale aims to analyze the different relevance of each common cause associated with corporate scandals. “X” indicates that the factor was relevant for

the emergence of the scandal. “XX” indicates that the factor was highly relevant and “XXX” indicates that it was critical for the eruption of the scandal. Void cells

indicate that the respective factor was not relevant to the case at hand.

35

Common causes associated with corporate governance scandals from the first decade of the 21st Century on a 0-3 scale10

Fundamental Causes Mediating Causes Immediate Causes

1 2 3 4 5 6 7 8 9 10 11 12 13 14

# Company Year

Excessive

Concentr

ation of

Power

Ineffective

Board of

Directors

Passivity

of

Investors

Failure

of

Gatekee

pers

Poor

Regulat

ion

Illusion

of

Success

of the

Business

Atmosp

here of

Greed &

Arrogan

ce

Lack of

Ethical

Tone at

the Top

CG seen

as a

Marketi

ng Tool

Overexp

ansion

of the

Business

Biased

Strategic

Decisions

Inflated

Financial

Statemen

ts

Weak

Internal

Control

s

Inadequ

ate

Compen

sation

System

Générale

14 Lehman

Brothers 2008 XXX XXX XX XXX XX XXX XXX XXX XXX XX XXX X XX XXX

15 Bear Sterns 2008 XXX XXX XX XXX XX XXX XXX XXX XXX XX XXX X XX XXX

16 AIG 2008 XXX XXX XX XXX XX XXX XXX XXX XXX XX XXX X XX XXX

17 Sadia 2008 X XXX XX XXX XXX XXX X XXX XXX XX XXX XX

18 Aracruz 2008 X XXX XX XX XXX XXX XX XXX XXX XXX XXX X

19 Madoff 2008 XXX XXX XXX XX XX XXX XXX XXX XX X XX XXX XXX XXX

20 Satyam 2009 XXX XXX XX XXX X XX X XX XXX X XXX XXX

21 Panamericano 2009 XXX XXX XXX XXX XX XX XXX XXX XXX XX XX XXX XXX XXX

22 BP 2010 X XXX XX X X X XX XXX X XXX XX

23 Olympus 2010 XXX XXX XX XX X XXX X X XX XXX XXX

Average (0-3) rating 2001-

2005 (n=11) 2,5 2,5 2,0 1,9 1,5 2,1 2,2 2,6 1,3 2,3 2,7 2,8 2,3 2,0

Average (0-3) rating 2006-

2010 (n=12) 2,3 2,9 2,2 2,3 2,1 2,3 2,3 2,8 2,7 1,8 2,1 1,9 2,7 2,4

Average (0-3) rating 2001-

2011 (n=23) 2,4 2,7 2,1 2,1 1,8 2,2 2,2 2,7 2,1 2,1 2,4 2,4 2,5 2,2

36

Table 4. Individual and collective cognitive biases and their potential problems for the governance of businesses.11

#

Type of Bias

(Individual or

Collective)

Bias Description Potential problems for the governance of

businesses

1 Individual Optimism and overconfidence Tendency for people to underestimate risks and / or

to overestimate the perspectives of future results.

Overinvestment;

Too expensive M&A deals;

Excess financial debt;

Disregard of relevant risks.

2 Individual Irrational obedience to

authority

Tendency to obey orders from authorities viewed as

leaders without questioning in certain

circumstances.

Frauds;

Blind obedience to entrepreneurs or

powerful executives.

3 Individual Irrational escalation of

commitment

Propensity to increase the investment in a decision

– based on cumulative prior investment – despite

new evidence suggesting that the cost of continuing

the decision outweighs its expected benefit.

Attachment to initiatives and projects that

did not work and should be rationally

treated as sunk funds.

4 Individual Normalcy bias Tendency to underestimate the possibility of the

occurrence of disasters that never occurred, as well

as inability to cope with disasters once they occurs.

Reduced investment in risk management

initiatives dealing with risks that have high

impact but low probability of occurrence.

5 Individual Planning Fallacy Propensity of people to underestimate how long

they will take to complete a task, even if they have

previous experience in similar tasks.

Project delays;

Unrealistic promises to stakeholders.

6 Individual Gambler's Fallacy

Tendency to think that the probability of future

events is altered by past events, even when the

events are independent and the probability remains

the same.

Belief that the results of past projects below

expectations will be “naturally” offset by

results of future projects, even when they

are independent activities.

7 Individual Curse of knowledge Difficulty of people with a lot of knowledge about a

topic to think about problems from the perspective

Release of products difficult to

understand by consumers;

11

The description of the cognitive biases have been extracted from the “list of cognitive biases” available at http://en.wikipedia.org/wiki/List_of_cognitive_biases

37

#

Type of Bias

(Individual or

Collective)

Bias Description Potential problems for the governance of

businesses

of lesser-informed agents. Dissonance between the strategic vision

of top management and that of the rest of

the organization.

8 Individual Déformation professionnelle

Tendency to look things from one’s own

professional point of view, rather than from a

broader perspective: the professional training leads

to a distorted way of seeing the world.

Distortion of business activities and focus

due to the professional training of their top

leader.

9 Individual Endowment effect

Tendency to overvalue assets and personal projects:

people tend to ask a lot more to sell their assets than

they would be willing to pay for if the assets

belonged to a third party.

Refusal to sell assets at fair value;

Overvaluation of their own initiatives.

10 Individual Confirmation bias , selective

perception

Tendency of people to favor information that

confirms their beliefs or hypotheses: the effect is

greater in subjects with greater emotional and more

rooted prejudices.

Difficulty in accepting new visions and

paradigms in order to change problematic

courses of action: maintenance of status

quo.

11 Individual Status quo bias

Propensity to maintain the current state of affairs in

situations where changes to the current course are

expected to provide higher benefit than the

maintenance of current situation.

Postponement of important decisions with

loss of opportunities and competitiveness,

resulting in increased losses.

12 Individual Interloper effect, the

consultants paradox

Tendency to value third party consultation as

objective, confirming, and without conflicts of

interest, as well as to provide less support to

internally proposed solutions.

No taking advantage of internal ideas, with

less motivation of employees and loss of

talent.

13 Individual Framing effect Propensity of people to reach different conclusions

from the same information, depending on whether it

is presented as a loss or as a gain.

Wrong decisions due to manipulation in the

way the information is presented.

14 Individual Outcome bias Tendency judge a decision by its outcome rather

than based on the quality of the decision at the time

Wrong assessment of people for decisions

that resulted in poor results, even if taken in

38

#

Type of Bias

(Individual or

Collective)

Bias Description Potential problems for the governance of

businesses

it was made, given what was known at that time the correct way at the time. The reverse is

also true.

15 Individual The availability heuristic Tendency to believe that events in vivid memory

have a higher probability of occurring than they

actually have statistically.

Exclusive consideration of the leader’s

personal experiences in decision making,

ignoring statistical parameters.

16 Individual Self-serving bias, illusory

superiority

Tendency of individuals to attribute their success to

internal or personal factors but attributing their

failures to external or situational factors.

Assigning blame to others, with negative

impacts on meritocracy and employee

motivation.

17 Individual Egocentricity bias Tendency for people to claim more responsibility

for themselves for the results of a joint action than

an outside observer would credit them.

Excessive centralization of power, reduced

motivation of employees.

18 Individual Hindsight bias Propensity to see past events as more predictable

than they actually were before they took place (“I

knew-it-all-along” effect).

Memory distortion in the analysis of past

events, ending up, for instance, in unfairly

attribution of blame by previous decisions.

19 Individual Anchorage

Tendency of people to rely too heavily, or “anchor”

on one trait or piece of information when making

decisions, even if it has no direct relationship with

the subject under review.

Wrong decisions due to the availability of

initial information that distorted the

analysis.

20 Collective Herd behavior, conformity, and

information cascades

Tendency of group members - especially those with

less information for decision – to observe the

actions and initial opinions of others and then make

the same choice that the others have made,

independently of their own private opinion.

Loss of the group collective wisdom, with

decisions being made according to the

specific interests of individuals more

knowledgeable about the subject under

analysis.

21 Collective Groupthink

Trend excessively homogeneous groups to

minimize conflict and reach consensus at any cost,

ignoring external ideas that may contradict the

dominant view.

Possibility of more extreme decisions by

the group, with rejection of good outside

opinions.

39

#

Type of Bias

(Individual or

Collective)

Bias Description Potential problems for the governance of

businesses

22 Collective False consensus

Individual’s tendency to think that their opinions,

beliefs, habits, values, etc. are “normal”,

overestimating the likelihood of other people

agreeing with his or her point of view.

Tendency of isolating people with

systematically different points of view.

23 Collective In-group favoritism Tendency for people to support views and opinions

of members from their own group in comparison

with opinions people outside the group.

Disregard of valuable external views.

24 Collective Out-group homogeneity

Misperception of individuals that members outside

the group are more similar to each other than they

really are and that his or her group is more diverse

than it actually is.

Difficulty in understanding the

heterogeneity of people outside the

organization and the external environment,

leading to a tendency to stereotype.

25 Collective Group-serving bias Tendency of group members to make dispositional

attributions for their group’s successes and

situational attributions for group failures.

Erroneous assignment of blame to others,

maintenance of the status quo.

40

Table 5. Mainstream approach to corporate governance vs. the new behavioral approach based on psychological aspects.

Mainstream view: Corporate governance as a mere set of incentive and control mechanisms in order to make agents (managers)

act in the best interest of their principals (shareholders)

Conceptual root: The reduction of the human being to homo economicus

Premise Reality (based on numerous recent researches)

1. People always make perfectly rational decisions. People are subject to multiple cognitive biases, leading us to make

irrational decisions, both individually and in groups.

2. People think exclusively in maximizing our own

personal gain.

People usually tend to act in a cooperative and unselfish way, sacrificing

their own personal economic gains in favor of others.

3. People are always interested in breaking the rules if the

applicable penalty multiplied by the probability of being

caught is lower than the expected benefit of the

dishonest act.

Psychological factors are much more important motivators for the

decision to break the rules than the probability of being caught or the

applicable penalty.

Conclusion coming from the difference between the premises behind the mainstream approach to corporate governance and real

human behavior evidenced by recent researches:

“A new behavioral approach to corporate governance should be developed with a focus on:

1) the systematic search for mitigating cognitive biases in managerial decisions;

2) the continuous fostering of people’s awareness towards the promotion of cooperative and long-term oriented behaviors; and,

3) the reduction of the likelihood of frauds and other unlawful acts through new corporate strategies developed after a deeper

understanding of their psychological motivations.”