The oath demands a commitment to bad corporate governance

The idea that crises can be averted if we sign an oath is dangerously naive.

Theo Vermaelen 0

(See also, “The MBA oath helps remind graduates of their ethical obligations.”)

I don’t believe that the MBA oath is a good idea, for three reasons. First, some parts of the pledge are inconsistent with fiduciary duties and ethical standards. Second, the oath is a misplaced response to the financial crisis. Third, I don’t believe in pledges as an instrument to guide people’s behaviour.

In many countries, board members and, as a consequence, managers have a fiduciary duty to maximize the wealth of shareholders. Even in countries where the corporate governance code insists on promoting maximizing ‘stakeholder’ value, none of these codes would accept that managers promote ‘social and environmental prosperity worldwide’ as the MBA oath requires. Externalities such as the consequences of business decisions for the environment have to be dealt with by the government, unless, of course, a business case can be made that shareholder value is increased by taking care of these externalities.

A second problem is that the oath assumes that the financial crisis was caused by unethical MBAs. For example, in a recent working paper, The Ethical Roots of The Financial Crisis, Wharton professor Thomas Donaldson argues that the financial crisis was caused by bad ethics, by bankers who were gambling with other people’s money. This accusation ignores the facts.

New research on the crisis shows that banks where the CEO held a lot of stock were also the banks with the biggest losses. So they were not losing other people’s money, they lost their own money. They apparently believed in their strategy. Moreover, we know that 81% of the mortgage-backed securities purchased by bankers for their own personal accounts were AAA-rated. These securities turned out to be the most mispriced securities: they produced lower returns than the lower-rated tranches.

Finally, my INSEAD colleague, Harald Hau, and his co-author Marcel Thum have shown that the largest bank losses in German banks were experienced by banks with board members who were least educated in finance.

So the evidence is that bankers have made mistakes and board members may have been ignorant, but they are not crooks. They believed rating agencies, which in turn made their forecasts of financial distress based on extrapolating historical data. Rating agencies behaved no differently than climate-change scientists who base their doomsday forecasts of man-made global warming on extrapolation of historical data. If, for example, it turns out that 30 years from now we enter a period of global cooling, will we then accuse climate-change activists of greed and unethical behaviour? Presumably not. Forecasting and modelling is a tricky business. So the solution is not more ethics or pledges, but more finance education and better forecasting and risk management models.

The idea that the next crisis will be avoided simply because we sign an oath, seems excessively naive. The donkey does not walk because he pledges to walk, but because of the carrot and the stick. Signing the oath doesn’t cost anything and is therefore not a credible commitment. Even if Bernie Madoff had signed the HBS oath, he would not have acted any differently. Rather than focusing on pledges, businesses should make sure that managers comply with their fiduciary and ethical responsibility to maximize the wealth of the people who pay their salaries—i.e., the shareholders.

The MBA oath aims to achieve exactly the opposite. It pushes the stakeholder value maximization idea to its extreme by including the whole world as a stakeholder. If this oath indeed would be implemented, then the resulting erosion of shareholder property rights would prevent the development of capital markets and undermine economic growth. As I interpret the oath as a commitment to bad corporate governance, companies that employ those who sign the oath as top executives should disclose this on the first page of their website. In this way, investors are warned that investing in these companies can be ‘dangerous to your wealth.’

If MBA students insist on taking an oath that promotes shareholder-friendly corporate governance, I would propose the following: ‘I pledge to maximize the wealth of the people who pay my salary—i.e., the shareholders, unless the shareholders tell me in advance that they want me to do something else. I will do my best to learn how to do this by taking the relevant courses.’

Theo Vermaelen is professor of finance at INSEAD, where he teaches in the MBA program.

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