The true value of corporate governance
Ethiopis
Tafara and Robert J Peterson
US Securities and
Exchange Commission
The modern public corporation and the separation of ownership from control
The evolution of the modern public corporation is one of the great developments of the twentieth century. That the evolution of these organisations has gone comparatively unnoticed is perhaps unsurprising: after all, the twentieth century saw the birth and death of two entire systems of political organisation (communism and fascism), ideological conflict between two forms of economic organisation (free market versus socialist centralised planning), and technological advances, from the aeroplane to the Internet. These developments have changed the lives of everyone. By contrast, the modern corporation – a form of social organisation designed to achieve economic objectives – evolved gradually from its eighteenth and nineteenth century roots. Its advent did not coincide with any singular event, unlike new forms of political organisation which generally announce themselves with a revolution, a coup or a constitutional convention. By the time of the 1929 stock market crash, the modern corporation was already well established in the United States and Western Europe.
Despite its somewhat unheralded debut, the modern public corporation has had a profound impact on the lives of countless individuals. Like other forms of business organisation, the modern public corporation is an entity designed to achieve certain economic objectives. But, unlike proprietorships and partnerships which pool the capital and resources of a relatively small number of individuals, modern public corporations can tap the investment capital of many people. These people may be spread out over large distances, and may or may not be particularly wealthy. In a large, generally middle-class country, corporations are able to raise far more investment capital by accessing the savings of thousands or even millions of small investors, than even the wealthiest individual industrialists would have been able to provide in the past.
However, as Adolf Berle and Gardiner Means pointed out 72 years ago, the modern public corporation is characterised by a separation of ownership and control. This fact means that modern public corporations are also subject to a type of agency problem not usually found in other forms of economic organisation. In modern corporations, the managers – who decide how a corporation’s capital is spent, how resources are allocated and what endeavours the corporation undertakes – do not themselves own the capital or resources. Those in control of the corporation,
“and therefore in a position to secure industrial efficiency and produce profits, are no longer, as owners, entitled to the bulk of such profits… The explosion of the atom of property destroys the basis of the old assumption that the quest for profits will spur the owner of industrial property to its effective use.”
Berle and Means believed this led to one simple, inescapable conclusion:
“[W]here the bulk of the profits of enterprise are scheduled to go to owners who are individuals other than those in control, the interests of the latter are as likely as not to be at variance with those of ownership and…the controlling group is in a position to serve its own interests.”
The costs and benefits of corporate governance
Over the past seven decades, experts in corporate and securities law, management consulting and academia have wrestled with reconciling the diverging interests of those who own corporations and those who control them. Corporate and securities laws have approached this problem from one direction: protecting the interests of shareholders from potentially self-serving actions of management. Management experts and economists have approached the issue from a different perspective: aligning the interests of management with shareholders, so that conflicts of interest between managers and shareholders disappear. The corporate scandals of the past few years – Enron, Worldcom, Vivendi, Parmalat and others – have shown that the tension has yet to be resolved.
While recent corporate scandals have shown that regulators, auditors, lawyers and shareholders must remain vigilant, they have also highlighted the important role corporate governance plays in mitigating the risks posed by the divergent interests of shareholders and managers. Corporate governance – that is, a system of legal, regulatory, organisational and contractual mechanisms designed to protect the interests of shareholders and limit opportunistic behaviour by management – can restore Berle and Means’ “old assumption”. The assumption posits that the collective decisions of individual investors lead to the most efficient allocation of capital, and thereby most effectively drive a nation’s economy. Without robust corporate governance mechanisms, such as an independent board of directors faithfully representing their interests, investors cannot be assured that their property rights are secure. Rather than acquiesce to such a situation, investors will demand a premium for their investments, or else seek investment opportunities elsewhere. In either case the cost of capital for issuers increases.
Indeed, universalising high-quality corporate governance measures is in everyone’s collective best interest. Such measures reassure investors, lower the costs otherwise associated with investor due diligence and, consequently, lower the cost of capital for issuers. However, strong corporate governance measures are not always perceived to be in every individual issuer’s best interests. Implementation of corporate governance measures has a cost. Extensive financial disclosures require a great deal of time and money to prepare, and thorough independent audits are expensive. Independent boards of directors may be perceived as troublesome infringements on management’s decision-making authority. Internal compliance and monitoring mechanisms may also entail high start-up costs, including costly legal and consulting fees. Even those issuers with independent boards of directors and strong internal controls may baulk at the costs associated with demonstrating in detail the strength of those controls and measures. And in truth, these concerns are not illusory.
A recent survey by Financial Executives International, a lobbying and research organisation of corporate and financial managers, claims that first-year implementation of the internal compliance requirements of the Sarbanes-Oxley Act in the United States could cost most large issuers an average of US$4.6 million. Similarly, a recent poll of chief financial officers by CFO Magazine found that 25 per cent of senior financial executives surveyed believe that the Sarbanes-Oxley requirements are costly and unnecessary. The costs associated with this act have even led some foreign issuers to threaten to delist from US stock exchanges. While respondents to these surveys are not unbiased and first-year implementation costs are likely to be significantly higher than the cost of ongoing compliance, the price of quality corporate governance standards should not be dismissed out of hand.
However, economics teaches us that no cost exists in a vacuum. Many issuers might prefer to avoid the costs associated with even minimal corporate governance measures, particularly if they can give the appearance of maintaining high corporate governance standards without actually having to do so. Yet as American president Abraham Lincoln almost said, you can’t fool all of the investors all of the time. Pyramid schemes inevitably collapse. Holes in corporate accounts are uncovered, if only because bills eventually go unpaid. Furthermore, recent empirical research – not to mention common sense – suggests a correlation between poor corporate governance and poor corporate performance, as well as a link between strong corporate governance standards and superior corporate performance. If nothing else, investors will notice these performance differences, and punish or reward issuers accordingly.
Potentially more problematic, however, is that where corporate governance standards are perceived to be weak, even those issuers with high corporate governance measures in place may have to spend a great deal of time and money overcoming investor suspicions. Under such circumstances, issuers may find private offerings, institutional loans or even commercial paper comparatively less costly. The result is a capital market that is less deep and less liquid than optimal, where issuers pay more for capital than do issuers in markets characterised by higher corporate governance standards. The costs such a situation imposes on an economy should not be underestimated. Corporations are deprived of capital, with the potential loss of jobs and economic vitality that this entails. Furthermore, the savings and pensions of an entire country may be subject to unnecessary risks or lower-than-optimal rates of return.
A price well worth paying
Historically, large investors mitigated their risks in these situations by taking a certain degree of control over the corporation, through a combination of detailed contracts and representation on a borrowing company’s board of directors. Small investors – the millions of individuals who invest in the capital markets through their savings and employee-sponsored retirement accounts – have neither the resources nor the expertise to monitor the management of issuers in which they invest. They make their investments based on their faith in corporate governance standards.
With investors’ faith shaken following the recent corporate failures, securities regulators around the world are now in the process of reviewing corporate governance requirements in their jurisdictions. Sarbanes-Oxley, passed by the US Congress in 2002, is to date perhaps the most far-reaching of these reforms, insofar as it establishes a new oversight body for the audit profession and requires extensive new disclosures and internal controls for public issuers. Other jurisdictions have enacted or are contemplating similar reforms.
Yet rather than being a costly and unnecessary over-reaction, evidence suggests that the recent US reforms represent a bold and decisive action on the part of the US government and American financial markets to counter a clear and present danger to US markets and the economy. The financial scandals that followed in the wake of the ‘dotcom bubble’ could easily have seriously undermined investor confidence in the integrity of the US capital market. The damage caused to investor confidence after the 1929 crash took decades to repair, despite Congress enacting four significant pieces of federal securities legislation, creating for the first time a federal securities regulator (the Securities and Exchange Commission) and establishing a national pension system (Social Security).
By contrast, Sarbanes-Oxley, the creation of the Public Company Accounting Oversight Board, and new rules mandating that a board’s audit and compensation committees be comprised exclusively of independent directors are focused, tailored responses designed to address specific, highly visible problems. The costs associated with these requirements – and even the potential costs of the oft-cited Section 404 of Sarbanes-Oxley – pale by comparison to the potential costs associated with raising capital in a market where investors place no faith in corporate governance standards or financial statements.
But there is more to corporate governance than proper mechanisms and the implementation of standards. An issuer must publicly announce its commitment to strong internal controls and high standards. The whole point of robust corporate governance is lost if you keep it a secret: you must tell the world! And issuers must tell the world in a manner that is believable. When all is said and done, the most cost-effective manner in which issuers can demonstrate their commitment to strong corporate governance standards remains compliance with the rules and regulations of a market that prizes investor protection and strictly enforces its corporate governance and disclosure requirements. For these reasons, the price of high-quality corporate governance, whether as required by Sarbanes-Oxley in the United States or through the requirements being proposed in Europe and elsewhere, is well worth paying.
Conclusion
Corporate governance philosophies differ around the world. However, with a few relatively minor exceptions, there exists a broad consensus on the elements of good corporate governance. It is widely understood that the most effective aspects of good corporate governance include:
• a strong board of directors, independent of management and with sufficient expertise to oversee corporate management on behalf of the company’s shareholders;
• management compensation oversight, such as a compensation committee comprised of independent directors, to prevent opportunistic behaviour by management and help link management compensation to corporate performance;
• strong corporation laws and regulations designed to protect the rights of shareholders;
• extensive public disclosure requirements, including both financial and non-financial reporting designed to give shareholders and potential investors an accurate, timely and thorough picture of the company’s performance and liabilities; and
• a robust independent audit function, with sufficiently thorough procedures to confirm the accuracy of a public company’s financial disclosure statements and overseen by a board committee comprised of independent directors, or by some other mechanism independent of management.
Furthermore, these aspects of good corporate governance must be made credible by strong government and private-sector enforcement mechanisms. Government regulators and law enforcement agencies must have the resources and legal authority to conduct thorough investigations of potential wrongdoing and self-dealing by corporate management. And regulators and law enforcement agencies must aggressively investigate and prosecute managerial and corporate wrongdoing on a constant, ongoing basis, not just when a major scandal arises. Likewise, corporate compliance officers must have the powers they need to ensure that all corporate employees (including senior management) comply with the law and abide by the company’s internal corporate governance requirements. Other corporate governance ‘gatekeepers’ – such as lawyers and outside auditors – must be bound by a strong code of ethics and abide by the laws and professional requirements which apply to their profession. Without such aggressive overlapping enforcement mechanisms, even the best corporate governance standards can be undermined.
Despite the consensus, there remain differences in the degree of implementation, and until all markets converge their requirements on the highest quality corporate governance standards, investors will express different degrees of confidence in different markets, and markets and issuers demonstrating the highest standards will continue to attract investors on the most favourable terms. In short, the best public companies will continue to view strong corporate governance as an investment well worth making.
The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employeee or commissioner. This chapter expresses the authors’ views and does not necessarily reflect those of the SEC, the commissioners or any other members of the staff.