Investor perspectives on corporate governance

Investor perspectives on corporate governance – a rapidly evolving story

Paul Coombes and Simon Wong
McKinsey & Company, Inc

Over the last two years, the natural focus of institutional investors has been on the unfolding corporate governance saga in the United States. After the wave of scandals and corporate failures in the world’s largest capital market, it was inevitable that much attention would centre on the reform process triggered by the passing of Sarbanes-Oxley legislation and related proposals for modifying New York Stock Exchange (NYSE) and NASDAQ listing rules, and for changing the way in which fund management groups, stock analysts and investment bankers carry out their roles.

For all the evident failings of US governance practices, however, it is important to recognise that governance reform is a worldwide phenomenon that is addressing somewhat different challenges in different regions. In much of continental Europe, for example, the critical governance problem is the prevalence of controlling shareholder blocs. The existence of such blocs often creates significant vulnerabilities for investors outside the dominant grouping, and in these markets protection of minority or ‘outsider’ shareholder rights remains the central governance challenge. Elsewhere, in many emerging markets, in addition to controlling shareholders, the risk facing investors is not simply inadequate governance at the corporate level, but major uncertainties in terms of country-level governance standards. In these situations, the foundations of good governance from an investor perspective lie in such basic ingredients as secure property rights, an independent judiciary, reliable enforcement procedures and acceptance of the rule of law. Where these are deficient, investment is a speculative, high-risk venture.

In recent years we have conducted both global and country-level surveys of institutional investor opinion which underscore these findings. Our surveys consistently indicate three conclusions:

• First, corporate governance does matter, with 70 to 80 per cent of investors saying that they are willing to pay a premium for a well-governed company;

• Second, governance is of at least equal importance to reported financial performance for foreign investors in many regions, because of misgivings about the quality of corporate reporting; and

• Third, several dimensions of governance influence investors’ decision making – not only corporate factors, such as shareholder rights and reporting transparency, but also capital market and country-level factors such as accounting standards, property rights and levels of corruption. Around 60 per cent of investors say they will avoid certain corporations altogether because of such concerns.

Against this context, it is clearly wrong to assume that investors can take a ‘one size fits all’ approach to corporate governance. The risk profiles of different markets simply diverge too much. Nevertheless, it is now possible to identify certain common overarching governance themes of importance to investors today. From a global perspective, six themes of importance are apparent:

• rapid extension of governance codes worldwide;

• increased focus on board professionalism;

• selective redesign of corporate leadership roles;

• re-assessment of corporate reporting needs;

• more intensive external scrutiny of governance; and

• increased attention to corporations’ impact on society.

Rapid extension of governance codes worldwide

While Sarbanes-Oxley legislation has naturally been the focus of much attention, the broader picture is one of continued substantial progress, market by market, in introducing and refining governance codes. This progress predates the recent scandals, and over the last 10 years more than 50 countries have introduced codes of practice. The prize, sought by policymakers and business leaders alike, has been to reduce the cost of capital by reducing investor risk and improving trust. In this process the four core foundational principles of fairness, accountability, transparency and responsibility articulated by the Organisation for Economic Cooperation and Development have attracted widespread support. The real challenge now is to ensure that these principles are embedded in sufficient detail in local legislation or codes of practice, and are subsequently enforced.

Looking ahead, the two critical issues facing investors and corporate leaders in regard to these codes are as follows:

• How far, and under what conditions, will convergence take place?

• To what extent will mandatory rules predominate over principles?

One powerful force driving convergence is the listing of shares across multiple jurisdictions. For example, Sarbanes-Oxley, the US rules-based approach which many critics fear may be unduly rigid in its prescriptive requirements, has imposed a degree of extra-territorial harmonisation precisely because hundreds of non-US companies are listed on the NYSE and NASDAQ. Similarly, the principle of ‘comply or explain’ as embodied in the UK Cadbury Code has gained prominence internationally, in part because companies from dozens of countries are listed on the London Stock Exchange.

The contrasting approaches of Sarbanes-Oxley and comply or explain codes cannot, of course, be easily reconciled. In many countries, the principle of comply or explain has been gathering increasing acceptance as a flexible, evolutionary way for governance practices to develop. If business leaders prefer to comply or explain, however, it will be essential to ensure that every explanation is articulated in a full and convincing manner to sustain investor confidence.

Increased focus on board professionalism

One of the most critical components of corporate governance reform has undoubtedly been a major shift in expectations of the role of individual board members, especially the outside, or non-executive directors. The impact of this demand for greater professionalism within the boardroom will be far-reaching. Already it is leading to an increase in the time commitment of outside directors as the number of board meetings rises and the quantity of preparation escalates. While global averages are potentially misleading, in the Anglo-American environment an increased commitment of up to 15 to 25 days per annum for some outside director appointments is now the common experience. This has further consequences:

• It is dramatically limiting the number of external appointments that full-time executives can take on;

• It is increasing demand for truly effective induction and training, especially in regard to committee work; and

• It is raising the requirement for more disciplined evaluation processes, both for the board as a whole and for individual directors.

One of the most demanding tests of board professionalism is the handling of executive compensation. In some markets, most notably the United States, a perceived widespread failure to exercise appropriate discipline has been a major factor in causing the widespread loss of confidence in board procedures on the part of investors and the general public. At stake here is not the formal question of how compensation committees should be set up, but the more searching question of how to design remuneration frameworks that command greater legitimacy through achieving a tighter fit between pay and performance. This is almost certainly an area where the dialogue between corporations and the investor community will need to become more rigorous and disciplined.

The quest for greater professionalism is also exercising an impact on board composition. Regulators and investors are now placing considerable emphasis on the need to establish the independence of the nominations process, and on raising the proportion of clearly independent outside directors. Equally, there is a new focus on achieving greater boardroom diversity by drawing on different pools of talent for appointments. The challenge for corporate leaders here is to strike a sensible balance between opening up the boardroom to fresh new sources of talent without pursuing tokenism and the appointment of unqualified candidates. The constraint on this, of course, is that the language of the boardroom rests on the grammar of finance, and a high degree of financial competence is correspondingly a non-negotiable requirement for effective boardroom participation. However, corporate leaders have to be careful not to use this as a rationale for resisting board diversity and avoiding robust debate. Investors are, of course, keen to see strong, independent-minded boards; but they are also extremely wary of situations where boards appear split. Consequently, the protocol for vigorous boardroom discussion must be carefully established in each corporation.

Selective redesign of corporate leadership roles

The pressure for increased professionalism in board arrangements, especially in the light of recent corporate scandals, has also inevitably extended to an assessment of the appropriateness of combining the roles of chairman and chief executive, as is customary in the US corporate environment and common in other markets such as France. From a purist governance perspective, there is a strong argument for the division of these roles between two individuals, with the task of the chairman to run the board and the task of the chief executive to run the company. This is a point of view which has increasingly been accepted in governance codes and taken up by major investors. The passionate counter-argument to this from US corporate leaders has always been the risk of divided leadership and the consequent danger of slow-moving, ineffectual decision taking. Pragmatically, too, US corporate leaders have regularly pointed to the comparative success of US corporations in terms of productivity and global competitiveness as evidence that unified corporate leadership, at least in the US context, does not appear to stand in the way of effective performance for shareholders, while splitting the role is by no means a guarantee that governance failures will be avoided. Nevertheless, the emergence in the United States of the lead independent director concept is perhaps an important initial step in modifying the exceptional disparity of power with respect to other board members, executives and outside investors which US chairmen/chief executives currently possess. It remains to be seen just how far institutional investors are prepared to exercise collective pressure to achieve over time a more substantial division of chairman and chief executive responsibilities.

Re-assessment of corporate reporting needs

Alongside changes in boardroom structures and processes, a parallel trend of at least equal importance to investors has been the development of far-reaching changes in corporate reporting. It is important here to distinguish three different strands. The first is the need to increase the transparency of corporate performance through much more extensive and detailed disclosure of results which not only includes simple financial indicators, but increasingly involves a fuller explanation of the forces driving operating performance. Beyond this, there is strong pressure for corporations to extend the scope of reporting coverage to encompass ‘externalities’: their potentially adverse and unpriced impact on the social and physical environment in which they operate. In this regard, recent technological advances have enhanced the ability of corporations to communicate and explain their performance to a broader and more dispersed constituency.

The second trend in corporate reporting is the pressure to achieve a common global standard of accounting. Over 90 per cent of investors expressed strong support for this in our Global Investor Opinion survey. The debate, however, turns on how best to reconcile two different conceptions of accounting philosophy: should it be rule based or principle based? Each approach has its merits, and neither is practical in complete isolation. However, reconciling the two philosophies is a painstaking task, and it will take at least five to seven years before substantial convergence is achieved. In the meantime, corporations will frequently have to bear the costs of reporting against both standards.

The third and still deeper issue is the extent to which corporate reporting is actually measuring, even in principle, the full dimensions of corporate performance, particularly as developed economies increasingly move away from asset-intensive industries. Here, the question at stake is the extent to which financial capital is the only capital that can and should be measured. Traditional accounting has always found it difficult to deal with intangibles in the shape of goodwill, brand values and the like; but this debate is now extending more broadly to include the intellectual capital generated by employees working as individuals or in teams, and equally to embrace the social capital – the set of organisational capabilities for trust, resilience and renewal. How such elements should be calibrated is likely to be a major challenge to accountants and professional managers in the years ahead.

Each of these issues on corporate reporting is relevant to business leaders and boards because investors are becoming increasingly attentive to the significance of these elements as providing potentially more insightful lead indicators of future corporate success, and therefore critical pointers to longer-term share performance.

More intensive external scrutiny of governance

The top 1,500 or so corporations worldwide now have to come to terms with an environment which has permanently changed in terms of the detailed and intensive focus on corporate governance arrangements. This is not just a question of regulatory supervision and audit reports. In response to the heightened interest on the part of institutional investors, there has been a rapid expansion in governance rating services that are designed to provide more accurate insights into the quality of governance achieved by all major companies in comparison with their country peer group and also in comparison with global best practice. These new service providers include major rating houses such as Moody’s and Standard & Poor’s (which are building such assessments into their overall ratings), and investor voting advisory groups such as ISS. While some of the initial work of these new rating services has been regarded by corporates as little more than superficial box-ticking, there is no doubt that these services will progressively become more incisive and at least some will become more authoritative.

What this means is that increasingly, corporate leaders must recognise that they are living in a goldfish bowl, not only in relation to their financial and strategic performance, but also in relation to the way they conduct themselves in their board and other governance arrangements, including in particular increasingly intimate details of their compensation and related benefits. Tougher scrutiny is likely to result in much more adverse criticism by investors and the media when there is perceived divergence from codes of good practice. All this implies that board members will have to be able to articulate with exceptional clarity the logic that underpins the governance decisions they take.

Increased attention to corporations’ impact on society

Corporate leaders now face the challenge not only of meeting the increasing demands of rating agencies and professional investors, but also of responding constructively to the ever-growing and often divergent requirements and expectations of a wide range of other interested parties. For global corporations, these include customers and employees as well as business partners up and down the supply and distribution chain, and also an ever-widening range of pressure groups/non-governmental organisations, each of which has its own particular priority issue of concern, whether it be social, environmental or human rights in emphasis. On top of all of this there is the burgeoning array of multinational or global codes of practice, such as the Global Compact, the Global Reporting Initiative and the Sullivan Principles.

The governance challenge that all this activity and pressure represents is the fundamental challenge of coherently articulating the defining purpose of the corporation. Achieving this in a compelling way is becoming a more and more demanding task for management. What is emerging as the core notion here is the need to sustain reputational integrity. This requires a corporation’s leaders to develop a carefully articulated set of core values and to ensure that these values are translated in entirely consistent ways, not just to investors, but to all the different constituencies with which a corporation deals. Each corporation needs to determine its own particular set of values and goals within the broader legal framework and norms set by society, and corporate leaders should be ready to demonstrate that their character as corporations is deeply grounded in these values. Reputational integrity does not mean giving in to whoever is temporarily exercising the most painful pressure. But it does mean achieving consistency between actions and values.

Implications for investors

What are the implications of these six governance themes for institutional investors? More specifically, will they lead to greater investor activism in pursuit of desired governance changes? Essentially, there are two schools of thought. The traditional, and still mainstream, fund management perspective is that investor activism does not make sense. As Tom Jones, head of Citigroup’s fund management business puts it, he doesn’t see himself as a do-gooder, so doesn’t see why his funds’ shareholders should spend money on shareholder activity which all shareholders will benefit from. This ‘free-rider’ problem, allied to the issue of potential conflicts of interest that confront integrated investment banks, is the major reason why such investors may monitor governance practices more closely but will still continue to take the Wall Street Walk when they encounter difficult governance situations.

At the other end of the spectrum are some of the world’s largest pension funds – such as CalPERS (the California Public Employees’ Retirement System) and TIAA-CREF (the Teachers Insurance and Annuity Association – College Retirement Equities Fund) in the United States, and Hermes in the United Kingdom – which have been building up capabilities to engage constructively with companies where they believe they can exercise positive influence and at the same time provide support when difficult changes have to be made. Key to their commitment has been the growth of their indexed fund portfolios which in effect locks them in as long-term investors with, in their view, inescapable ownership responsibilities. Their willingness to engage in investor activism is also being strongly encouraged by some governments on the basis that unless institutional investors find a way to exercise stronger ownership responsibilities, boards and management teams remain insufficiently accountable.

We are clearly still in the early days of institutional investor activism and an established protocol for engagement has not yet emerged at the global level, although major progress has been made in markets such as the United Kingdom, stimulated by codes such as the Hermes Principles which endeavour to spell out the substance of the dialogue which corporations should be prepared to have with their major investors.

Equally, at the global level, initiatives such as the International Corporate Governance Network’s code of practice in relation to investors’ governance responsibilities are beginning to change the climate. In particular, the governance debate, which until fairly recently focused entirely on corporations and their boards, is now beginning to focus more intensively on how fund managers themselves discharge their fiduciary responsibilities on behalf of their clients, and on how pension fund trustees hold themselves accountable to their beneficiaries.

What is beginning to surface from this divergence of views within the institutional investor community is a potentially profound conflict between different groups of shareholders. It used to be taken for granted that shareholders essentially all wanted the same from the corporations in which they invested. But the latent conflict between highly short-term operators such as hedge funds and intrinsically longer-term players such as life insurance and pension funds may be pointing the way eventually to changes in the rules affecting the pattern of institutional investor incentives. At the very least, fund managers should bear in mind the possibility of future regulatory or fiscal measures designed to tilt the balance further in favour of those committed to long-term active ownership engagement. The strongest safeguard against any such potential intervention will be evidence of a new, more productive dialogue between fund managers and the corporations in which they invest.