Corporate governance moves into the mainstream
Alastair Ross Goobey CBE
International Corporate Governance Network
In a globalised world, we have to accept that the largest economy and only super-power will tend to dictate the agenda. Unless the United States is engaged in an issue – no matter how important it seems to the rest of us – it remains marginalised. For those who, in the 1990s, alerted friends and colleagues in North America to the role of good corporate governance in preventing excess in a period of exciting growth, the u-turn on this issue in the United States over the past two years has been remarkable. When one visited New York during the bubble phase, warning of the dangers of the untrammeled powers of the imperial chief executive officer (CEO), the response was: “The economy’s great, the stock market is great; what particular problem is it that you want to fix?” Indeed, even after the bubble had burst and the consequences of this excess were beginning to appear, President of the Federal Reserve Alan Greenspan spoke approvingly of the “CEO-dominant paradigm”. He took the view that since investing institutions were unable or unwilling to act as proxies for the ultimate owners of quoted businesses – the trustees of pension funds or the policyholders of insurance products – the CEO was the only possible controller of businesses. The change in attitude to this element of investing since then has been dramatic.
The Sarbanes-Oxley Act was drafted and passed in a very short period following the eruption of the Enron and WorldCom scandals. The introduction of criminal sanctions for directors who knowingly sign off false financial statements has certainly concentrated the minds of boards in the United States and beyond. The extra-territorial effect was not a consideration to the US Congress when it passed the measure, but it has had a negative impact on the desirability of foreign companies with a representation of any sort on US markets. If Sarbanes-Oxley is to be the only serious legislative change resulting from the collapse of one of the biggest bubbles in world history, investors and companies should consider themselves relatively fortunate. After the 1929 Crash, the Securities and Exchange Act was passed and the Securities and Exchange Commission set up. Further back still, following the South Sea Bubble of 1720, the so-called ‘Bubble Act’ prevented what we would now know as initial public offerings for over 100 years in Britain, except by act of Parliament. The faces of investment bankers are not a pretty sight when this precedent is described to them.
But there has been much more movement than simply one heavyweight piece of legislation in the United States. The New York Stock Exchange and NASDAQ have tightened up their listing requirements in the area of corporate governance, particularly in the definitions of independence for directors. The Conference Board, jointly chaired by Pete Peterson and, until his appointment as Treasury Secretary, John Snow, has produced two striking recommendations. The first is that companies should expense share options. It has been almost an article of faith that American entrepreneurship has depended on the share option, and to make the cost of their issue obvious in the revenue accounts of companies was held to be un-American. Nevertheless, the international accounting standards to be introduced in the next two years will insist on this. After all, as stock market sage Warren Buffett has asked: if options are not remuneration, what are they? If they are remuneration, where do they appear in the income and cost statements?
The second and perhaps most dramatic change recommended by the Conference Board’s Blue Ribbon Committee was that the roles of chairman and chief executive be split. The CEO-dominant paradigm has thus been undermined. Interestingly, the only person on the committee to vote against this recommendation was the head of one of the United States’ largest institutional fund managers; perhaps it was because he himself held both roles in his own organisation. This change has taken root much faster than anyone had a right to expect, considering the steadfast opposition to it from many chairmen/CEOs. The catalyst for change may arguably have been Jeff Immelt of GE. On his appointment to succeed Jack Welch, he appointed a senior independent director who has taken on the role of chairman in all but name. This director is involved in preparing the agenda for board meetings and holds meetings of the board with none of the executives present. Immelt still holds the titles of chairman and CEO, but the power nexus is clearly diffused.
Perhaps the most striking development over the past 12 months has been the increasing evidence that the investing agents are being forced – some willingly, some less so – to accept a role in the governance of companies. Institutional investors, acting on behalf of the ultimate owners, the pension funds or the individual pension account holders, are agents in the same way that company managements are agents, not principals. American economist Larry Summers has summarised the crux of this double-agency problem in this way: “In the history of the world, no one has ever washed a rented car.” The point he makes is that without the responsibilities of ownership, the agent may feel inclined to do what will benefit him in the short term, rather than looking to longer-term issues. While corporate governance has focused primarily on the monitoring of company managements to ensure that they do not act in their own short-term interests, rather than the long-term interests of the owners, there is increasing understanding that the other agents – the investment managers – have a responsibility too. Until the recent bear market, most institutional managers, particularly in the competitive commercial sector in the United States, protested that their expertise is in buying and selling shares. They do not, they insist, buy ‘bad’ companies. If one of their investments turns out to be a mistake, they execute what is graphically known as the ‘Wall Street Walk’. They play what Buffett calls ‘Gin rummy capitalism’: discard the worst stock from your portfolio. However, there is a growing realisation that this merely passes the inherent problems to another institution, since the market is increasingly controlled by professional investors. If no one intervenes, then the poor management will continue to prevail and may eventually ruin the company entirely.
The institutions have not decided to act out of altruism. They are being encouraged to do so by governments and by their clients. In the United States and the United Kingdom, the most active investors tend to be the state and local government funds. There is clearly an element of politics in this, since many of these funds have a substantial representation on their trustee boards from organised labour. The enlightened Left have seen that capitalism can work with them as participants. They represent the members of pension schemes, and it is the pension schemes that control the votes. Nevertheless, it would be wrong to characterise the increase in activism as simply a manifestation of post-socialist politics. The critical driver is the idea that good governance leads to a lower cost of capital for the companies in which funds are invested. Until this can be established beyond doubt, it will be difficult to persuade all investors to act. In the United Kingdom, the government has forced the industry body to go further. The Institutional Shareholders’ Committee has undertaken to intervene proactively in companies where there are perceived to be shortcomings in governance, or more business-oriented failures. The UK government is monitoring whether this undertaking has been fulfilled or whether other measures need to be taken. One of the problems is that much of the intervention goes on in private, and the changes are not reported in the media. This is proper, since the investors and managers should be on the same side, and public wrangling does no one any good. Unfortunately, however, it is too easy for observers to believe that nothing is going on at all unless there is a newspaper report of change forced on a company.
There is a further problem for the institutions: proper monitoring of governance is an expensive business. Analysing businesses in order to make informed interventions about strategy or management consumes even more resources, and requires skills not usually present within fund management companies. To make matters worse, those shareholders who spend not a penny on such matters reap as much of the benefit in the improved performance and share returns as those who incur all the costs – the ‘free-rider’ problem. In a period of lower asset values, the fund managers, whose revenues are mostly ad valorem fees, do not have the appetite to spend money on these extras. Although a rising number of studies suggest that good governance is rewarded by better medium to long-term performance in the markets, the evidence is by no means conclusive.
Of course, the first line of defence against poor management is a good board of directors. In the past, there have been too many instances where the board has not been independent of the executives, and has been supine in its exercise of the role which has been vouchsafed it. The directors have been content to collect their fees for attending undemanding meetings where their opinions do not count for too much. In many cases they owe their appointment to the CEO and are unlikely to rock the boat. The role of the independent director has become a feature that is common to all the recent governance codes around the world. In over 35 years in the investment business, I have yet to meet an outside director who has not believed himself to be absolutely independent. That includes such people as the CEO’s brother, or even their spouse. In their own minds they may well feel they are truly independent, but the outside shareholder cannot depend on them always putting their relationships behind them when the chips are down. The same goes for very long-serving directors. We have all seen cases where someone who has served for many years on a board becomes part of the establishment. It is very difficult for people to avoid building strong personal relationships with colleagues with whom they have worked for many years. Good relationships and good stewardship by a director are not incompatible, but there is a point at which so much of the grit has been eroded that the director becomes more of a lubricant than a real tester of management.
Recent improvements in the definition of the independence of directors have been an important step forward. Even in the United Kingdom, which has one of the most embedded governance codes in the world, it has hitherto been left to boards themselves to determine who is and who is not independent. The new Combined Code of Corporate Governance, based on the Higgs Review, has for the first time listed the badges of independence. As well as commenting on relationships, both familial and business, a time limit of service is suggested. It is important to emphasise that no investor believes that, simply because a person has served more than 10 years on a board or is over 70, they are disqualified from further service. Rather, the emphasis is on board balance, so that where there are people on the board who do not display these badges of independence, they should be outnumbered by others whose independence is unquestionable. It would certainly be perverse to require all people who had reached a certain age or served for a defined period to resign from boards, even if they were still adding enormous value to the board’s deliberations. However, outside investors need to be entirely comfortable with the balance of the board.
The increasing activity of shareholders has been graphically demonstrated by some very high-profile cases, particularly in the Anglo-American markets, where these matters tend to reach the media more easily. Michael Eisner, the chairman and CEO of Disney, faced a massive withholding of support for his re-election to the board from the institutions, and in this case that must have included many of the commercial fund managers. The result was a division of his role, leaving Eisner as CEO but appointing Senator George Mitchell as chairman of the board. In the United Kingdom, GlaxoSmithKline had its remuneration committee report voted down at the 2003 annual meeting, while the potential chairman of newly merged commercial television operator ITV was prevented from taking up his role by a shareholder protest. Yet these events are still the exception rather than the rule. Most changes, even when inspired by investor intervention, happen without the world being aware of the initiative. This is a dilemma for the investor. A public row may well damage the company; yet if there are no institutional fingerprints on such changes, the world may believe that the investors are doing nothing and demand more regulation to force them into action.
Commercial fund managers have yet another problem in executing their agency responsibilities. Many of them are inherently conflicted, not only because they are parts of much larger financial conglomerates whose clients will include the managements of many companies in their investment portfolios. They may also have clients in their own part of the business whose governance demands changes. It simply asks too much of companies to act against their own clients. Unfortunately, too often this is seen as acting ‘against’ a company, when in fact it might be very helpful to the company. The problem is that such action is almost always against the interests of the current managements, who control the purse strings when it comes to investment banking fees and investment management contracts. The only way around this is for the authorities to ensure, as much as is possible, that the governance of pension funds is kept at arm’s length from the sponsor company’s management, with truly independent trustees. A trustee’s responsibility is to act entirely in the interests of the trust: he must leave behind any other relationships at the door of the meeting room. This is true, too, of the director of a company. Boards should not be delegate bodies.
These, then, are two of the developing themes of governance around the world, and not only in the developed markets: independent directors and the responsibilities of the institutional shareholders. What are the others? There remains an unresolved question of equal treatment of shareholders in proportion to their economic interest in companies. The recent merger of AmBev with Interbrew is a good illustration of this problem. Interbrew bought control through the purchase of the relatively small number of voting ordinary shares, and made no offer for the much larger class of preferred shares. One share, one vote seems to be equitable, but it is by no means universally accepted. In the European Union, the Takeover Directive was, to many minds, undermined by the insistence of the Swedes, with support from Germany, that they should be able to preserve their unequal voting rights. Swedish companies protest that any removal of voting control would be tantamount to theft. There is, of course, another agenda – that of maintaining domestic control over Swedish companies. This attitude is particularly strong in emerging markets, where family control is still overwhelmingly the pattern for businesses. Too often, in such cases, we see a real confusion between the private assets of the family and those of the quoted entity. The Parmalat case may prove to be only the most extreme example of this. Why should the countries in which this ownership model prevails worry about investors’ attitudes to these characteristics? If they have no need of foreign portfolio investment, then they should ignore the protests. However, if companies are going to tap the global capital markets, they will have to pay a much higher price for this capital than if they showed some sensitivity to the worries of the international investor.
The other element of governance is transparency. Here I make a distinction between disclosure and transparency. While the latter is not possible without the former, simple disclosure of information does not always clarify; indeed, it can make things more opaque. It would be preferable for companies to be more straightforward about the risks they face and the remuneration structures they have created, rather than trying to baffle the observer with too much information, scattered throughout their statutory documents.
The coming year will continue to see challenges to both companies and investors. The new Organisation for Economic Cooperation and Development Principles of Governance build on the existing Principles, and, like their predecessors, will represent a base case level of acceptable behaviour around the world. For the European Union, now with its new members, there is the Bolkestein Action Plan to be implemented. Investors are keen that this not become too prescriptive with legislative provisions. The ‘comply or explain’ regime that has been recommended is preferable in a world where business does not always easily fit into pre-determined forms. However, the problem with ‘comply or explain’ is that it depends on the investors doing the necessary monitoring.
After a year in which further corporate scandals have emerged in various parts of the world, it is inevitable that we will suffer more in the coming 12 months. Corporate governance codes and investor monitoring will not prevent fraud or bad behaviour; our best hope is that it will make it a lot more difficult. This will be good for capital markets, for the cost of capital, and for investors and their beneficiaries. That is the purpose of corporate governance: we forget it at our peril.