Corporate governance codes and laws are simply a baseline, says George Dallas. Stakeholders ought to examine each company closely to understand how well run they are

Should we all sleep better now that we have Sarbanes-Oxley? Have all the laws, regulations and codes of practice around the world raised the bar for public companies so that poor corporate governance is no longer a concern?

Alas, the answer is no to both questions. While many of the “top down” public policy responses to improve corporate governance might raise the bar, it is fair to say that poor corporate governance cannot be eliminated simply by regulatory fiat. Nor can good governance culture be established in a company by the stroke of a legislative pen. Corrupt governance in some cases and substandard governance in less extreme cases remain real concerns for investors and other stakeholders.

Compliance with a voluntary code, as is common in Europe, or with such legislation as the 2002 Sarbanes-Oxley Act covering financial and accounting disclosure in America, is becoming increasingly rigorous. But this will remain in many ways a baseline. Compliance can possibly contribute to a good governance architecture; but architecture alone will not spark a positive tone and culture for those individuals working within a given governance structure. There remains scope for differentiation at the company level, notwithstanding the numerous governance-related laws, regulations and codes of best practice instituted so ubiquitously in recent years.

Governance as a risk factor
Governance is a risk factor that needs to be better understood by investors, stakeholders and companies themselves. While researchers are still trying to build empirical evidence that good governance creates value, we have vivid and recent case studies in both developed and emerging markets that show how poor corporate governance can destroy value.

A company’s board of directors must therefore continue to exercise its fiduciary duties diligently in relation to management oversight. In turn, the company’s shareholders ought to monitor vigilantly the performance of the directors they elect as their agents. Where there are controlling shareholders, the alignment of interests between controlling and minority shareholders is also crucial. Creditors represent another important financial stakeholder, as do directors’ and officers’ liability insurers. And non-financial stakeholders in the corporate governance debate – notably employees, customers, suppliers and communities – also claim legitimacy in the corporate governance debate. This is a complex mix of actors and perspectives that all frame and influence the quality of a company’s governance.

Can governance be objectively measured?
For investors or others to gauge the extent to which governance might prove to be a risk factor or a source of comparative advantage, individual companies ought to be evaluated on a “bottom-up” basis, assessing objectively the qualitative nature of their governance with regard to key financial and non-financial stakeholders – in a way that complements “top-down” legal and regulatory initiatives. This is a challenging task, and care must be taken especially when looking at governance-related risks in an international context.

Governance evaluations can be conducted as “clinical” check-ups involving the senior executives and directors responsible for governance. This interactive approach is arguably the best way for a governance assessment to capture a sense of key qualitative factors, such as tone, independence and effectiveness.

But increasingly we are also seeing governance codes transformed into checklists, a “tick the box” process. But governance is ultimately about the effectiveness and the integrity of company oversight. These more qualitative factors are difficult, if not impossible, to capture on the basis of public disclosure about governance processes. Moreover, there are contrasting governance traditions around the world that make the standardization of individual governance structures inappropriate.

Given this diversity of approaches it can be challenging, if not misleading, to assess the quality of a company’s governance through a rigid template – particularly in cross-border analysis. An overemphasis on specific governance rules is a minefield. The analytical process needs to focus on principles as well as rules. The principles underlying the corporate governance guidelines of the Organisation for Economic Cooperation and Development (OECD) – fairness, transparency, accountability and responsibility – can serve as guides for in interpreting governance standards for individual companies in particular jurisdictions.

Is there a global standard for governance?
Differing ownership structures, financial market infrastructures, legal systems and cultural influences create alternative approaches to corporate governance structures and philosophies in markets around the world. The governance systems that exist, for example, in such markets as the United States, Germany, Japan, China and Russia are all distinctive and reflect their own political and market economies. America is characterized by dispersed ownership structures, has a strong shareholder orientation, and a tradition of “outsider” governance through independent non-executive directors. Japan and Germany are more stakeholder oriented, have a greater concentration of ownership and corporate control, and a tradition of “insider” governance involving controlling shareholders and in many cases banks or related industrial groups. Russia and China are in transition to more market-oriented economies, and have an insider/outsider mix.

Will these distinctions prevail or will we see a global governance standard emerge? There is no one country model that has proven to be ideal; all systems are vulnerable to problems. These can include conflicts of interest with controlling shareholders, ownership rights, stakeholder relations, problems of control and risk management, effectiveness and independence of board oversight and excessive executive compensation.

Ownership structure, in particular, can be a significant differentiator. The governance concerns of a widely held firm can be very different to those of one with concentrated ownership. So, many of the governance practices being advocated in America might fit closely held firms in Europe or Asia like an ill-cut suit of clothes. But this is not an excuse for passivity or complacency by European or Asian companies. Family-owned or closely held companies around the world generally benefit from protecting minority shareholder rights, disclosing relevant financial and non-financial information, and having a meaningful degree of independent board oversight.

There will probably be some convergence of corporate governance standards for companies that have international listings and need to maintain access to capital markets. These standards are likely to include Anglo-American characteristics, such as a tendency for more independent boards and committee structures. For companies attracted by the breadth and liquidity of American capital markets, Sarbanes-Oxley, in particular, will remain an important influence on audit and internal control processes. Conversely, those firms with more limited needs for public capital will be less inclined to introduce governance-related reforms. In closely held companies with concentrated ownership, good bank relations, and without a need for public equity, the controlling owners often value control over liquidity in their shareholding. In the extreme some companies will delist if they feel that the costs and regulatory costs of a public listing outweigh the benefits.

Thus we may see a “barbell” effect. At one end will be governance overachievers, including companies in both developed and emerging economies. At the other end will be the “underachievers” – those companies with limited external pressures from shareholders and/or limited incremental capital needs. At this end of the spectrum, there are few incentives to improve corporate governance standards beyond minimal legal compliance.

What is to be done?
Investors and stakeholders should:

Recognize that governance is a risk. Governance-related risks need to be better understood by shareholders, creditors, D&O; (directors and officers) insurers and non-financial stakeholders;

Understand that there are limits to governance-related laws, regulations and codes: governance risks will not be eliminated by compliance, and even with compliance there is scope for differentiation at the company level;

Institute case-by-case company analysis as standard practice. One size does not fit all. Governance assessment should be guided by principles, not rules. Be alert for both underachievers and overachievers.

Companies and directors should:
View governance as a dimension of enterprise risk management and as a source of sustainable competitive advantage;

Regularly assess governance structures and practices – especially listed companies wishing to maintain access to public capital markets;

Continually improve transparency and disclosure standards, particularly with regard to non-financial risks and how these are communicated to different stakeholder groups. Companies can use disclosure to signal their commitment to corporate governance specifically and to the management of non-financial risks more generally.

Neither the more legislative American approach to corporate governance reform nor the more flexible “comply or explain” European approach is a panacea. Regulation and codes might be a constructive part of the mix, but there is also a role for the market to play. Combining governance legislation and codes with greater engagement by market participants – directors, investors, employees and lenders – is likely to be the best combination of forces to tackle the task of raising corporate governance standards.

George Dallas
George S Dallas is managing director and global practice leader in Standard & Poor’s governance services unit, based in London. He is editor of the book Governance and Risk (McGraw-Hill, 2004).