Reshaping corporate governance — comply-or-explain versus rule

Corporate governance is the framework of laws, rules, and procedures that regulate the interactions and relationships between the providers of capital (owners), the governing body (the board or boards in the two-tier system), seniors managers and other parties that take part to varying degrees in the decision making process and are impacted by the company’s dispositions and business activities. Corporate governance defines their respective roles and responsibilities and their influence in steering the course of the company.

Corporate governance is a relatively new (hot) field of study. Its roots can be traced back to the work of Adolf Berle and Gardiner Means in the 1930s, but the field as we now know it emerged only in the 1970s. Since then, the mandate and role for corporate governance have been set within well-defined boundaries, in which the business is responsibility of business was business and the well-being of society was the summed up in 1970 by economist Milton Friedman who noted, “there is one and only one social responsibility of business — to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game”.

We now live in a globally networked age where companies operate with a new set of principles and assumptions on how to become successful and competitive. Also, the neat dividing line between business and governments in terms of roles and responsibilities for society is blurring rapidly. As governments struggle, business has prospered. Not surprisingly, society is looking to business to take greater responsibility for its impact.

Good corporate governance solves internal company problems by (i) giving incentives, (ii) controlling the internal decision-making process, and (iii) managing the company with the intention to minimize risks and maximize the return on investment for investors. Thus, good corporate governance distributes power and responsibilities and tries to prevent the abuse of corporate power.

One big discussion centres on the general progress of governance and whether companies are better governed with “hard” or “soft” law approaches  rules or principles?

Jurisdictions like the US practise a rules-based approach. Following scandals such as Enron and WorldCom, this approach enshrined standards of corporate governance in the Sarbanes-Oxley Act 2002, thereby making compliance mandatory. The irony is that once in place, the shortcomings of this almost draconian legislation was glaringly exposed with the collapse of Lehman Brothers — and another kneejerk reaction followed with the Dodd-Frank Act of 2010, perpetuating the black-letter-law approach.

Europe mostly embraces a self-regulatory and principles-based approach  the comply-or-explain model (whose evolution has continued over the years). While voluntary compliance with good corporate governance practices based on the model of comply-or-explain has gained wide recognition as possibly one of the best and most comprehensive examples of self-regulation, questions have nonetheless arisen regarding whether it is the most effective way of ensuring that corporations act responsibly.

The focal point of discussion, anyway, is no longer management itself, but how it is controlled. In the field of corporate governance two important forms of control are distinguished: internal and external control.

(i) Internal control is executed primarily by the board as the central body for management and control. In a two-tier system these tasks are split up. The “management board” is in charge of management and is controlled by the “control board” with regard to its economic performance, integrity, and compliance with the law. This leads to more transparency. The two-tier board is a typical structure for Austrian and German boards because it is required by the stock companies act in each respective country. In most countries, companies have a one-tier board. Within this board the directors control themselves, by distinguishing between executive and non-executive directors and creating committees that are often required to be filled only with non-executive or independent directors.

(ii) External control is executed by investors, banks, and other external monitors through their decisions to invest or not. In terms of external control, good corporate governance is a question of competition of the corporate governance systems. The better the corporate governance, the more investors will be enticed to invest, and the higher a company will be valued.

While in the USA external control is exerted through the capital markets, as well as through institutional investors and hostile takeovers, in Europe hostile takeovers are rare.

How do we get corporate boards to move away from the shareholder primacy model — where only profits matter, as charity has no seat at the board — to one that encompasses a more diverse range of interests, including shareholders, employees, consumers, the community and the environment?

One of the biggest failure of corporate governance today is its emphasis on short-term performance. A good corporate governance model should focus on the long term and promote continuity and stability in the boardroom. In exchange for the right to run the company for the long term, good corporate governance model should have mechanisms to ensure the best possible people in the boardroom. Measures to push toward this goal are principally age limits and term limits, but also gender and other diversity requirements. But those limits are a blunt instrument for achieving optimal board composition. A correct approach would incentivize (a) the composition of board in a tailored manner, focusing more on making sure that boards really engage in meaningful selection and evaluation processes, and (b) the attribution of  rights to put director candidates on the company’s ballot to shareholders with a significant ownership stake in the company.

OECD Principles of Corporate Governance

First published in 1999, the OECD Principles were revised in 2004 and aimed at helping governments around the world to create “legal and regulatory frameworks for corporate governance”. The six principles, or headings that the OECD addresses, are:

(i) Ensuring the basis of an effective corporate governance framework;

(ii) The rights of shareholders and key ownership functions;

(iii) The equitable treatment of shareholders;

(iv) The role of stakeholders in corporate governance;

(v) Disclosure and transparency;

(vi) The responsibilities of the board.

Last year (2017) the OECD published another revision, born out of the financial crisis and which took account of the fact that listed companies are proliferating in developing markets; also that stock markets themselves have become listed companies and no longer the quasi-national institutions they once were.

Sarbanes-Oxley Act 2002

The Sarbanes-Oxley Act of 2002 predates the financial crisis but came as a direct response to the collapse of Enron and WorldCom. It formed major changes to financial reporting in the US, but had knock-on effects for overseas companies with operations in the US.

Among the many measures contained within the Act were introducing a responsibility on directors for signing off internal controls and publishing a report on internal controls. Financial statements should include all material from balance-sheet liabilities.

The Act also introduced penalties, including imprisonment of up to 20 years for “altering, destroying, mutilating and concealing” essential records or documents.

Dodd-Frank Act 2010

To give it its full name, the Dodd-Frank Wall Street Reform and Consumer Protection Act is widely hailed as one of the most complex pieces of legislation ever written. President Trump has pledged to repeal the legislation.

The Act aimed to consolidate the regulation of financial markets and create a new body to monitor systemic risk. It also introduced a new consumer protection agency for financial products and a new regime for winding down bankrupt businesses.

It also aimed to effect changes in accounting standards and improve regulation of credit-rating agencies.