We don't have much of an opportunity to comment on the approach taken by The Economist on corporate governance. When we do, however, it is usually to disagree. This week's edition provides an opportunity.
Schumpeter, Corporate Constitutions takes issue with corporate governance reform. It relies on a number of questionable assertions to buttress the argument.
First, the piece notes that directors now take courses at business schools “because Sarbanes-Oxley makes them personally liable for the accounts that they sign.” The part about the classes may be true and directors certainly obtained elevated responsibilities as a result of SOX. But impose liabilities on the accounts they sign? Not in the Act. SOX did require that the CEO and CFO certify financial statements. But this expanded liability for officers who signed the forms, not directors. Moreover, under the antifraud provisions, the person signing the false filing can generally be viewed as a primary violator. Still, the requirement did not emanate from SOX.
But the thrust of the article was a challenge to those using the financial crisis to argue for stronger corporate governance. As the piece noted:
- Corporate reformers immediately seized on the crisis as yet more proof of their arguments. Banks had always been badly managed, they argued. And banking CEOs were past masters at bamboozling shareholders and directors. Nell Minow, one of the most industrious of the reformers, flatly declared that “the recent volatility” proved that the “need for better corporate governance has never been clearer or more pressing.”
The response? That some companies with "weak" governance performed well and some with "good" corporate governance had not. The examples?
- But sceptics could point to counter-examples. Some banks which performed best during the crisis flouted the rules of good corporate governance: Santander had a familial culture and a powerful executive chairman. And some banks which did worse were paragons of good governance: Citigroup and Lehman Brothers employed powerful outside directors (including, in Lehman’s case, an economist known as “Dr Doom”). Royal Bank of Scotland received enthusiastic encouragement from its institutional shareholders for its acquisition of bits of ABN AMRO.
It's of course not a very strong argument to point to a couple of anecdotal examples on each side of the fence. But more amazing were the examples used to make the point. No one would point to the Lehman board as a paragon. True, there were many very experienced people on the board. But there were issues as well. As one source described: "Nine of them are retired. Four of them are over 75 years old. One is a theater producer, another a former Navy admiral. Only two have direct experience in the financial-services industry."
This is not to say that Lehman had a particularly bad board. There were in fact some high profile people serving on it. But as an example of a paragon of good governance, at least in the context of showing how good governance doesn't always result in positive outcomes, it was a cherry picked example that did not sufficiently support the point.
The piece went on to cite empirical evidence on governance practices.
- New research by David Erkens, Mingyi Hung and Pedro Matos, of the University of Southern California, powerfully reinforces the sceptics’ case. The authors conducted a comprehensive study of the performance in 2007-08 of 296 financial institutions with assets of more than $10 billion. They found that none of the tenets of good corporate governance stood up to close examination. Directors who were well informed about finance performed no better than know-nothings. Companies that separated CEOs and chairmen did no better. Far from helping companies to weather the crisis, powerful institutional shareholders and independent directors did worse in terms of shareholder value. Indeed, the proportion of independent directors on the boards was inversely related to companies’ stock returns.
Of course, the data arose before the financial crisis, the issue raised in the article. More importantly, it is not news that an increase in the number of independent directors does not result in improved share prices. The problem, however, is likely structural. Independent directors have no connection to the company and are dependent upon the chair for information. The common model in the US is to have the CEO be the chair. So more independent directors does not mean a more independent board.
The conclusion of the piece?
- Good corporate governance on its own will not protect companies from taking excessive risks. They need to tackle the problem directly, by setting up better risk control, rather than indirectly by ticking various corporate-governance boxes. Good corporate governance on its own cannot make up for a toxic corporate culture. Reformers should continue to experiment with systems of checks and balances. But they would also profit from spending less time drawing up ideal constitutions and more time thinking about intangible things such as firms’ values and traditions.
Certainly the conclusion is right that good corporate governance is not a box checking exercise (which it often can be under current circumstances). But it is a conclusion without a purpose. Proponents of improved corporate governance agree that governance should not be a box checking exercise.