Is corporate governance a magic bullet?

Corporate governance is in danger of becoming a hackneyed phrase that generates negative rather than positive responses because of the proliferation of unimaginative corporate governance reports, governance experts and even governance ratings. 

Let’s put this development into perspective. In the past dozen years, corporate governance has risen to prominence in the aftermath of major corporate disasters.

The UK's Cadbury Report (December 1992), the first major review of corporate governance, was initiated (mid-1991) on the heels of the bankruptcy of Polly Peck (Sept 1990), the July 1991 collapse of the Bank of International Credit and Commerce (largest bank fraud in history ($US20 billion) arising from money laundering, drug deals, bribery and the corruption of public officials in dozens of countries) and the emerging Maxwell Communications fraud and bankruptcy in December 1991.

The Sarbanes-Oxley legislation was passed in the US in 2002, following the collapse of Enron, WorldCom, Global Crossing etc. Other notable milestones in the history of corporate governance are presented in the table, which offers highlights, rather than a comprehensive review. These pioneers of governance principles made explicit and substantive recommendations for change in board practice.

The OECD's Principles of Corporate Governance (1999, 2004) takes a higher level view: "Corporate governance is one key element in improving economic efficiency and growth as well as enhancing investor confidence. Good corporate governance should provide proper incentives for the board and management to pursue objectives that are in the interests of the company and its shareholders and should facilitate effective monitoring" of performance.

Report Principal contributions

Sarbanes Oxley Act July 2002 Focus: Restore public confidence in capital markets Major Conclusions/Actions: (1) enforce corporate accountability through new requirements, backed by stiff penalties, e.g. CEOs and CFOs must personally certify the accuracy of financial statements, with a maximum penalty of 20 years in jail and a $5 million fine for false statements; (2) new auditor independence standards; (3) more rapid disclosure of material changes etc

OECD Report (1999, 2004) Focus: Ensuring global dissemination of the basis for an effective corporate governance framework, the rights of shareholders and key ownership functions, the equitable treatment of shareholders, the role of stakeholders in corporate governance, disclosure and transparency, the responsibilities of the board

Turnbull Report September 1999 ICA of England and Wales Focus: internal controls and risk management of internal and external threats. Major conclusion: Produce timely, relevant and reliable reporting on the nature, extent, materiality, probability, and costs and benefits of managing internal and external risks.

USA Blue Ribbon Committee, Report (Feb 1999) Focus: Improving the effectiveness of corporate audit committees

UK Hempel Report (1998) Focus: Integration of Greenbury and Cadbury Report recommendations. Major conclusions: Companies should include in their annual reports how they are applying corporate governance principles

US Business Roundtable (Sept 1997) Focus: Risk management related to transparency, accountability and performance measurement. Major conclusions: Board must ensure effective system of controls is in place to: (1) safeguard assets; (2) manage major risks; (3) provide accurate financial and operational reporting; (4) ensure compliance with internal policies and significant laws and regulations, using internal and external advice as needed.

UK Greenbury Report 1995 Focus: Study group on directors' remuneration set up by the Council of British Industry. Major conclusion: To avoid potential conflicts of interest, boards of directors should set up remuneration committees of non-executive directors.

Ontario Securities Commission Dey Report, Dec 1994 Focus: identified the board's principal responsibilities: corporate stewardship, strategic planning, identifying and monitoring the main risks of the business, appointing and developing senior management and implementing a communications policy, examining board and committee structure, and directors' liability regarding timely disclosure of corporate information. Major conclusions: (1) majority of board should be independent (unrelated) directors; (2) rejects "one size fits all" solution; as a result the TSX does not require compliance with the guidelines - but every year companies must disclose and explain any differences between their corporate governance practices and the guidelines.

UK Cadbury Report December 1992 Focus: The Financial Aspects of Corporate Governance. Major conclusions: Comprehensive recommendations on a range of issues including the need for (1) an activist board; (2) strong independent directors where the CEO was also the chairman of the board; and (3) Board use of independent professional advice at the company's expense.

Results:

Most progress has been with the top 10 percent of listed companies in each jurisdiction where regulators have made an issue of governance, but UK research in 2003 showed that about 33 percent of businesses were ignoring corporate governance guidance even though they are aware of it.

Smaller companies often see adding corporate governance guidelines to their priority list as a regulatory and compliance cost burden.

Strengthening governance rules cannot alone prevent major business disasters in the future. In my 1999 book on Business Early Warning Systems, I examined the great industrial and commercial disasters of the 20th century such as the Titanic, the Hindenburg, the Challenger, Exxon-Valdez, Chernobyl, Bophal India pesticides disaster, the Barings Bank collapse among hundreds of other cases.

I concluded that generation after generation, people keep making the same mistakes (the eight footsteps to disaster).

Stopping this self-destructive behaviour requires training people to spot early warning signs, to better manage risk thresholds and risk communications etc and adopt new performance measurement tools which can anticipate the collapse of companies such as Enron long before the share price.

The enhanced profile of corporate governance has led some to create governance-rating systems. We have now examined some of these systems and have found serious deficiencies:

• selection bias: the range of evaluation criteria is too narrow
• ratings inflation: most big listed companies among those surveyed are given high ratings
• no risk analysis: the governance ratings provide little indication of the underlying financial stress or risks of the company, a key requirement of the highly influential 1999 UK Turnbull Report; hence these governance ratings have poor predictive value.
• absurd relativities: many companies with poor financial position and performance are given governance ratings similar to those of companies with excellent financial performance and position

Corporate governance is not a magic bullet. Enhanced corporate governance standards and intensified regulations to ensure corporate compliance with higher governance standards are necessary but not sufficient conditions for minimising corporate disasters.

We also need to use our imaginations to change corporate culture so that higher ethical standards prevail, smaller firms don't face large compliance costs, fear is driven out of the workplace, and companies adopt greater openness to new tools that can provide boards with better quality information and effective business early warning systems.

* Dr. Patrick Caragata is managing director and CEO of Rapid Ratings, a software-based global corporate credit rating agency, and the author of five books

Disclaimer

The purpose of this database is to provide a full-text record of all articles that have appeared in the CDJ since February 1997. It is aimed to assist in the research and reference process. The database has a full-text index and will enable articles to be easily retrieved.It should be noted that information contained in this database is in pre-publication format only - IT IS NOT THE FINAL PRINTED VERSION OF THE CDJ - therefore there might be slight discrepancies between the contents of this database and the printed CDJ.