The corporate governance model that existed before the crisis may not be entirely broken, but it is certainly in need of a major overhaul. In recent weeks there have been several initiatives intended to disassemble the stalled engine, take a long, hard look at the oily mess within and then seek to reinvent it as something that actually works.
The corporate governance failures that contributed (or caused) the global financial crisis of 2007-10 included:
- Failure by non-executive directors to control headstrong chief executives.
- Institutional investors drove corporate managements to take outrageous risks and to pursue unsustainable growth strategies.
- Flawed incentive programs that drove directors to pursue unsustainable strategies that were incompatible with the long-term interests of investors.
- Auditors who became too “cozy” with clients, were insufficiently sceptical about asset valuations and failed to spot corporate fraud.
One of the current crop of initiatives intended to shake things up is a green paper from European commissioner Michel Barnier.
This isn't published yet but has already been sparking a degree of terror in the City of London. This is because Barnier favors tightening up the rules and regulations covering corporate governance – for example forcing investors to vote their shares – and has little truck with the more porous "comply or explain" approach favored by the UK market.
The UK seems determined to pre-empt any unwanted rules-based invasions from continental Europe. It launched the Walker Review of the governance of financial institutions, dismissed as "anodyne" and "a crashing disappointment" when published in November 2009. In July the Financial Reporting Council, the UK corporate governance regulator, unveiled a voluntary Stewardship Code, which includes seven principles requiring signed-up investors to disclose how they will push for corporate change, how they vote, and how they scrutinize corporate behaviour.
The underlying assumption behind the Walker Review and the Stewardship Code is that institutional investors can be relied upon to take an active interest in policing corporate behavior and executive pay. This is surprising given they singularly failed to do this before the crisis. (Most fund managers are traders after a quick buck, rather than patient visionaries and their firms lack the resources anyway to properly engage with the managements of firms in which they invest.)
This probably explains why the UK government has launched yet another initiative. Following his attack on "murky" behavior and "corporate short-termism" on September 22, the business secretary Vince Cable has come up with an initiative called A Long-Term Focus for Corporate Britain.
Cable said the aim is to establish “whether the system in which our companies and their shareholders interact promotes long-term growth – or undermines it" and to get to the bottom of "the issues that may be causing a dislocation between what is best for the ultimate owners, the incentives of their agents, and what is best for managers."
"I want a serious examination and debate into the role of investors and the time horizons over which they operate; the factors influencing board decisions; the reasons for the growth of directors’ pay; the impact of the investment chain; why returns from equity have reduced; and why takeovers that are economically damaging still take place. The best solutions are those which are owned and driven by market participants, investors and companies. We need clear, consistent rules which work with the grain of the market.
Other snippets from Cable’s review, positioned as a “call for evidence” with submissions invited by January 14 2011, concern audit quality and investor behavior. The launch document states:
"There have been questions about the role of audit, including suggestions that audits do not address the issues of most concern to investors and are therefore little read. These questions are being considered by the House of Lords Economic Affairs Committee in its inquiry on “Auditors: Market concentration and their role”.
"Short-term investment behaviours may result in an inefficient allocation of capital, where those companies with potential for sustained growth in the longer term do not receive the financing they require."
Depending on the quality of the responses received and the bravery of the UK government in tackling the vested interests of the City of London, the initiative may yet culminate in the radical reform that we so desperately need.
Further reading on how to improve standards of corporate governance:
- Viewpoint: Stewart Hamilton: Regulation, Corporate Governance and Boardroom Performance Must Be Shaken Up If We Are to Avoid Another Financial Crisis
- Viewpoint: Jay W. Lorsch Lessons From the Credit Crisis: Governing Financial Institutions
- Viewpoint: Christopher Hogg: The Comply or Explain Approach To Improving Standards of Corporate Governance
Tags: audit , City of London , corporate governance , EU , fair-value accounting , Financial Reporting Council , hedge funds , international differences , regulation