Professor Georges M Selim looks at the impact of corporate governance initiatives on business
The past two decades have seen a phenomenal growth in the impact of corporate governance initiatives in corporate life. Board members in companies, senior executives and auditors, both internal and external, have been impacted by pronouncements and codes produced by committees and task forces including Cadbury, Greenbury, Hampel, Turnbull, Higgs and Smith in the UK, COSO and Sarbanes-Oxley in the US, and COCO in Canada.
The requirements to comply with corporate governance pronouncements and obligations have not been confined to the private sector and large companies, but have also been adopted by public sector organisations such as government departments, agencies and non-departmental public bodies.
Shareholders have not escaped pressures to think and act differently.
The traditional approach of shareholders quietly expressing their disapproval with companies' management by selling their shares has been replaced by a drive to encourage them to take a more proactive role in standing up to abuse by management. Shareholders are now rejecting - when necessary - resolutions which they do not believe to be in their best interests.
Examples in the public domain include the rejection by the shareholders of the remuneration package of the Chief Executive of UK pharmaceutical giant GlaxoSmithKlein, and the rejection of management's choice of top management at the new company created through the merger of UK TV broadcasters Granada and ITV.
The UK is not alone in having pronouncements and codes for companies and organisations to follow and comply with. The hesitant steps that began in the UK and the US have become worldwide phenomena, spanning five continents.
France, Italy, South Africa and Malaysia are some examples of countries that have developed their own codes which mirror, to a great extent, those developed in the UK and US.
Codes and pronouncements
One school of thought argues that companies operate under 'agency theory' where conflict of interests may arise between the principal and the agent acting on his/her behalf. In our case, conflict of interests may arise between shareholders and management who are their agents acting on their behalf. Hence pronouncements and codes are generated to address these issues. While a discussion of the merits of this theory over alternatives such as Transaction Cost Economics (TCE) and Stakeholder Theory are beyond the scope of this article, one argument that raises doubt about the comprehensiveness of this theory is the difficulty of applying it to family-owned businesses where the principal and the agent may be one and the same.
Leaving aside theory, there is no disputing the fact that financial scandals have forced the hands of government and regulators to act so as to protect the interests of the shareholders and other stakeholders from the misdeeds of senior management. In the UK, cases such as Maxwell, BCCI and Polly Peck were the trigger for the establishment of the Cadbury Committee.
In the US, the financial scandals around Enron, WorldCom, Global Crossing, Xerox and Tyco - to name just a few - resulted in the Sarbanes-Oxley Act of 2002.
However, it worth noting that these scandals are not confined to the UK and the US; more recent events have brought us Parmalat in Italy, Nortel in Canada and Ahold in Holland. In these cases, senior executives and board members committed fraud and deceit amounting to billions of dollars, as in the case of Parmalat, or have carried out accounting irregularities in order to enhance reported earnings in the case of the other two companies.
The sceptics will look at all these cases and argue that although we may have a number of rotten apples (and they were quite big apples!), where a lot of people were hurt through the misdeeds of certain individuals, there are thousands of companies which are well run, and which comply not only with the rules but also with the spirit of the laws, codes and pronouncements. I agree that these sceptics have a valid point, and I share their concern with the risk of all this getting out of control, so that we are inadvertently creating an industry around 'corporate governance'.
But to be fair, do we really believe that we have a 'corporate governance industry?' My answer is simple. The risk is there, and while the sceptics have my sympathies, I advocate another way of looking at corporate governance.
Good management sense
An alternative way of looking at corporate governance pronouncements and codes is to see them as vehicles that can be used to enhance our understanding of a company's operations and the means for managing and controlling them.
Taking, as an example, risk management as an area of significance for people in the insurance and reinsurance industry, we ask, 'Do companies need to build frameworks and systems to enable them to identify, measure, prioritise, communicate and manage risk?' The answer must be 'yes'. Put another way, if Turnbull's committee did not pronounce on internal controls and risk management, we would have had to invent it. Based on my own research, I know of a large number of companies which had developed formal risk management systems years before Turnbull's recommendations. However, their value is to raise others to the level of best practice.
Now let us move to the significant debate currently taking place between regulators, companies and auditing firms about the costs of complying with section 404 of the Sarbanes-Oxley Act. My answer to this complaint is to step back and to ask a question similar to that posed above. 'Do organisations need to have internal controls that are effective in achieving their objectives?' As the answer must be a 'yes', then it can be seen as legitimate for the board and senior management to ask themselves how they can prove that these controls are effective and are working as intended.
This is exactly what section 404 is asking us to do, to provide evidence that internal controls are working as intended and are effective in the delivery of companies' objectives.
Let us turn now to the issue of the cost, which some critics are claiming to be quite sizeable, especially for small companies. My answer is twofold: firstly, the cost of building up evidence includes a large component of what might be called 'one-offs', and second, more importantly, is to go back to the raison d'etre for these controls, which is to help companies more effectively manage their operations. If, using hindsight, you were a shareholder or a lender to Parmalat and/or Enron, would you have quibbled over the cost of ensuring that internal controls are not just effective, but that we have the evidence to prove such a statement? I am sure you will agree that the cost of compliance must be less that losing your investment in the case of a shareholder, your pension fund as a prospective pensioner, or the debt owed to you in the case of a lender. This is similar to the argument on the cost of education where doubters are reminded that if you worry about how expensive education is, then look at the 'cost of ignorance'. So what is the way forward?
The relationship between management and shareholders - especially institutional investors such as insurance companies and pensions funds - should be established on the basis that both parties need each other, and that a 'dialogue of the deaf' needs to be avoided at all cost.
The UK corporate governance approach of 'comply or explain' has at its heart the aim that management keeps main shareholders informed of decisions related to areas that fall within the code of best practice. An example of such a decision would be the promotion of the company's CEO to become Chairman, as happened in the case of supermarket Sainsbury's. However, this dialogue cannot be accomplished by management ignoring the fact that the shareholders are the owners of the business and, whether they like it or not, it is money that the business is investing on their behalf.
On the other hand, megaphone diplomacy does not get investors or their advisers very far. The recent attempts to create constructive dialogue between the City and businesses is a good omen for a way forward, helping to reduce confrontation and generate creative and positive relationships.
Companies in the insurance industry are not immune from having to comply with pronouncements on corporate governance. However, what is unique about such companies is the fact that they have a foot in both camps. They are contributors to the current debates as implementers of these pronouncements on the one hand and as members of the institutional investors' group on the other. In their first capacity, they are actively contributing, for example to the debate on accounting standards relating to derivatives, and in the second capacity, they were active participants in the dialogue between the City and businesses.
I firmly believe that the UK's set of corporate governance standards or pronouncements can provide a valuable example of best practice to the world. Our approach of 'explain or comply' is far superior to those that rely on the law to enforce a standard since compliance with the rules can often take precedence over the spirit of the law. The risk of companies 'box ticking' needs to be guarded against, as should be the reaction of 'Here is another set of pronouncements to comply with!' Such negative attitudes and behaviours need to be replaced with an appreciation that corporate governance makes good management sense. And this industry, with its unique position in the present corporate governance environment, can play a leading-edge role in helping change mindsets.
- Professor Georges M Selim is Director of the Centre for Research in Corporate Governance at Cass Business School, part of City University, London.