Author: | Published: 9 Oct 2003
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Over the last two years corporate governance reform has been the focus of an intense worldwide effort. The starting point was, of course, the collapse of Enron in late 1991, followed closely by further spectacular scandals and corporate failures in the US market, notably WorldCom, Tyco and Global Crossing. The regulatory response was swift and dramatic in the US with the passing of the Sarbanes-Oxley legislation a year ago, and with major changes proposed to NYSE listing rules. Elsewhere, important recent initiatives include a renewed drive to harmonize and upgrade international accounting standards, plans to develop a common approach to governance arrangements across the EU and many individual country initiatives such as the Bouton Report in France, the Higgs Review in the UK and a new corporate governance code in Australia.

This burst of activity is now raising a number of fundamental questions. What is the real value of these reforms? Will they be enough to restore public faith in the workings of market-based capitalism and equally reassure investors? How can we tell whether a company is well governed or not? What, in fact, does good governance mean?

Many different viewpoints exist. For company directors and executives, the essence of good governance typically lies in the practical effectiveness of the board. For investment analysts, it is more about the formal features of board composition and procedures, the adequacy and reliability of reporting, and shareholder rights. For regulators, concerns about the prevention of fraud often predominate. For the legal profession in today's circumstances it is typically the need for meticulous compliance with prevailing laws and codes that is the focus of attention.

This diversity of perspectives points to the need for a clear definition of what good governance is designed to achieve, a balanced assessment of the global forces driving governance reform over the last twenty years, rather than just the last two, and a sound theoretical framework for analysing difficult governance issues. Armed with these, we can then examine the likely impact of recent reforms.


Corporate governance exists to deal with the accountability or agency problem: how can managers, as agents, be prevented from acting in a self-interested way when their interests are not fully aligned with the interests of owners, as in the classic Anglo-American corporate model with its dispersed investor base and professional management.

The challenge for investors has always been to design a relationship that will motivate management to act in ways that promote investors' interests, rather than just those of the managers themselves. Corporate governance can correspondingly be defined, in the words of Professor John Roberts of Stanford Business School, as "the collection of mechanisms intended to influence and control the decisions and actions of those associated with the firm to ensure that the interests of the relevant parties are protected".

The enduring problem for investors, of course, is that because they do not themselves possess the knowledge to run the business they run the risk of stifling growth and profitability if they impose too tight a set of controls. For this reason, TIAA-CREF, the leading US public sector pension fund, argues that corporate governance arrangements need to "maintain an appropriate balance between the rights of shareholders ... and the needs of the board and management to direct and manage the corporation's affairs".

Until the Enron debacle, it was widely accepted that the US system of corporate governance was at, or close to, the leading edge of governance practices worldwide in terms of its ability to foster entrepreneurship and at the same time protect investors. The conventional wisdom is now to dispute this claim, and in particular to focus on the excesses of personal greed in US boardrooms as having a deeply harmful effect on the future prospects for market-based capitalism. How far is this justified?


Memories are short, and the current obsession with governance failures in the US overlooks an important reality. Since the late 1980s, over forty countries have introduced new rules and codes of practice on corporate governance. This is a worldwide phenomenon and we need to be clear about the underlying driving forces which have spurred not only advanced economies right across Europe but also emerging markets such as Brazil, Russia, India and China to embark on typically quite radical programs to reform the way that corporate activity is disciplined. The impetus for this huge burst of reforming activity has been globalization, with its double-edged impact. First, the rapid globalization of corporate activity through the growth of multinationals and the opening up of previously protected economies. Second, the globalization of asset management which has greatly intensified the demand for reliable information on corporate performance of quoted companies around the world, presented in as standard and consistent a way as possible.

International agencies such as the World Bank, the OECD and the UN have been at the forefront of efforts to enhance governance standards worldwide. The goal has been to reduce the cost of capital and thereby, from a public policy perspective, to enhance prospects for economic growth. The OECD's principles of corporate governance correspondingly focus on four clear goals: the accountability of boards and management; accurate and insightful disclosure of performance; fair treatment of all shareholders, including minorities where dominant shareholding blocks are prevalent; and responsible behaviour to the broader set of stakeholders and other parties affected by a corporation's activities.

It is against this broader context that we need to examine the conventional wisdom on governance. The starting point is to have a clear analytic framework for looking at the different components of the corporate governance system.


The first element of the corporate governance system is of course the board and its interaction with management. This includes board composition, especially the proportion of genuinely independent outside directors, as well as board procedures and the appropriate design of management incentives. The second element includes corporate reporting, audit and shareholder rights, especially the fair treatment of minorities. But this is only part of the complete corporate governance system of checks and balances (see exhibit 1). The second important dimension is the institutional context. This includes the role of analysts, fund managers, investment consultants, trustees and beneficiaries, as the ownership dimension. It also includes the workings of the markets, specifically the effectiveness of the primary market, especially for new ventures, as well as the depth and liquidity of the secondary markets and the extent of the market for corporate control. It is this institutional context, taken as a whole, that exerts a pattern of discipline on individual corporations that is far more powerful in some countries than in others.

Exhibit 1

What is the importance of this institutional discipline? In part, it is indeed to act as a check on boards and managers behaving in a greedy or fraudulent manner. But from an economist's perspective and a public policy standpoint, a far more fundamental goal is to help ensure that, over time, capital is allocated to areas of highest opportunity. This naturally implies that governance arrangements should help facilitate the re-allocation of capital away from sunset to sunrise industries. Governance systems that can be regarded as working well are those that accomplish this task efficiently.

The third component of the governance framework is the outer ring in our exhibit, which includes the legal, social and cultural framework in which corporate activity takes place. This framework differs significantly across countries in terms of the support it provides to the whole market system and to investors' interests. Where property rights are insecure, even a good board may only offer modest protection to shareholders.

Applying this high-level, admittedly simplified, framework, we can see today that investors and managers are wrestling simultaneously with three different types of governance challenges. In emerging markets, the underlying governance problem is frequently the lack of adequate legal, social and administrative foundations for markets to work effectively. In much of Continental Europe, by contrast, the critical question is how far an internally consistent set of governance arrangements designed to protect the interests of dominant shareholding blocks needs to be modified to meet the expectations of cross-border, typically Anglo-American, institutional investment funds. This is not just a question of board structures, or information disclosure, but also a question about the role of markets in re-allocating capital from failing firms to growing ones. The third governance debate, now at an intensified level in the US following the scandals and the resulting Sarbanes-Oxley legislation, is about the role of boards and the adequacy of monitoring processes. Here the risk is that heavy-handed, hard-wired legislation may stifle entrepreneurial risk taking.


Despite these differences by region, two priorities for governance reform within corporations now command widespread global acceptance. These are: firstly, the need for much greater transparency and disclosure of corporate performance; and secondly, the requirement for a much higher standard of boardroom professionalism than has historically been seen, even in advanced markets. These priorities are underscored by the focus of recent reform efforts in the US and similar initiatives in Europe notably the Cromme Code in Germany, the Bouton reports in France and the Higgs Review in the UK. In the recent investor opinion survey that McKinsey conducted in Spring 2002, more timely, accurate disclosure, more independent boards and more effective board processes were cited by a large sample of leading institutional investors as the specific reform priorities they would most like to see.

In our experience, the boards and management of leading multinationals acknowledge these priorities. They do however express two strong concerns. First, they want the market to recognise that there is no such thing as the one true figure of corporate performance. Corporate reporting, however diligently undertaken, will always involve real questions of judgment about the appropriate way to record profits and asset values. In today's world, the huge importance of intangibles makes this judgment more complex than ever. Their second concern is that investors, along with regulators and the general public, are simply developing quite unrealistic notions of what an independent non-executive can achieve, however hard he or she works, in the course of the 20 - 25 days per year that board members are typically expected to dedicate to their board responsibilities. In that time they cannot possibly monitor every detail of significant corporate activity. Indeed, attempts to micro-manage and nail down executives through aggressive monitoring processes could well create an adversarial boardroom atmosphere, undermine entrepreneurial initiatives and stifle risk taking - the very reverse of what investors should be looking for. They believe that their primary focus - and that of investors too - should be on getting the major corporate events right. By that, they typically mean: first, the appointment, review, and periodic replacement of the chief executive; secondly, large scale investments and asset disposals that reshape the portfolio; and thirdly, mergers and acquisitions.


Healthy corporate governance requires engaged investors. Currently, however, the institutional investor community falls short and now faces its own agenda for reform.

The point of initial responsibility is the investment analyst community. Some of the criticisms about the conflicts of interest where analysts have divided loyalties to corporate finance departments as well as institutional clients have been well aired. In the most notable cases on Wall Street, fines have been levied and remedial reforms put in place. But in a way the more fundamental issue for analysts is rethinking the very nature of the analytic task. Far too much effort has, for example, been directed at estimating the next set of quarterly earnings, resulting in an increasingly sterile minuet with management with everyone having an interest in showing an apparent smooth trend of successive earnings increases, even when the underlying economic reality has been more choppy. Far too little attention, by contrast, has typically been directed at really understanding the driving forces of corporate performance and the real dynamics of each company's distinct business model. There are honourable and impressive exceptions, of course, but too much analysis has appeared perfunctory. The most common shortcoming has been an unwillingness to get to grips with the realities of managerial life. This is exemplified in a persistent faith in the existence of imperial chief executives as corporate heroes who singlehandedly turn round corporations. It is also manifest in a general, profound underestimation of the sheer difficulty of securing long term sustainable change. With governance now beginning to feature as an element of investment analysis, and with many new governance rating services now being marketed, corporate board members are also concerned about the risks of box-ticking by analysts who do not have either enough experience or indeed interest in exploring why a company that faces the requirement to comply or explain may indeed choose the second option.

Third party fund managers, too, face new challenges on governance questions. Collectively fund managers state that corporate governance is a consideration of broadly equal weight with financial issues such as profit performance and growth potential, according to McKinsey's second investor opinion survey in 2002, and around 60% of active managers assert that governance considerations would lead them at times to avoid certain companies or reduce their weighting. Such concerns might focus on doubts about the quality of boardroom processes or of financial disclosure. Alternatively, they might reflect real anxieties about the substance of strategy. In either case, the traditional response of simply selling the shares or doing nothing is for many such managers an unavailable strategy. They are locked in, either formally or informally as closet indexers. In this situation, the case for greater activist engagement with companies seems clear, and is now being encouraged by regulators, keen to remind fund managers of their fiduciary duties to ultimate owners and beneficiaries.

A lead in these matters is now being aggressively undertaken by the largest public sector US pension funds such as Calpers and TIA A-CREF, with significant programs of activist intervention. In Europe, Hermes, the activist arm of the BT Pension Fund, the largest such fund in the UK, is taking a pioneering course. Last year it published its ten so-called Hermes Principles, designed to spell out what investors expect of public companies in terms how explicitly they should describe their own business model and corporate goals (see exhibit 2). If more fund managers were to press for similar clarity, the quality of dialogue between investors and companies would be greatly enhanced. Needless to say, however, more sceptical perspectives are well in evidence. As Tom Jones, head of fund management and private banking at Citigroup recently stated in the Financial Times: "I've got to say that I've got higher priorities. I'm not a do-gooder. I want to do what I get paid for, and shareholder activism is not what I get paid for". As of now, a majority of fund managers almost certainly think the same way. The arguments for what economists term rational apathy are extensive and, for many managers, compelling (see exhibit 3).

Exhibit 2

Exhibit 3

Nevertheless, the pressures on fund managers and indeed trustees to clarify their policies on activist intervention and responsible engagement with companies are growing. Public opinion appears to be enlarging its focus from an exclusive preoccupation with corporations to the scrutiny of investing institutions and their advisers. Activism is of course potentially expensive, but disregarding stewardship responsibilities runs the risk of regulatory intervention. It is with this risk clearly in mind that the International Corporate Governance Network (ICGN) - a global club of institutional investors - tabled for its discussion at its annual meeting in late July 2003 a proposed policy statement on the governance practices that institutional investors should impose on themselves in respect of their responsibilities to their trustees and owners. These include specific areas of accountability such as specifying the mode of governance monitoring that an institution undertakes, providing summaries of voting records and details in contentious cases, together with explanations of actions taken, listing resources dedicated to governance, and explaining potential conflicts of interest and how these would be handled. It is clear that trustees, together with investment consultants, will increasingly need to spell out their own policies and practices in this area in the mandates that they are giving.


In the wake of so many recent initiatives, it can be argued that policymakers would be well advised to let the recent set of reforms bed down thoroughly before attempting further change. Looking ahead over the next five years, however, there are some tasks that will not wait. First is the need to make real progress with the harmonization of international accounting standards. In an era of ever increasing cross-border investment, we need to move actively towards a single rule of the road on the core rules governing corporate reporting. Institutional investors overwhelmingly express a preference for a single global standard and expect the accounting standards bodies to achieve this quickly.

The second priority is tougher enforcement. This applies not just to the oversight of corporate behaviour, but also to the institutional dimension of governance. In particular, implicit conflicts of interest on the part of third party fund managers may well need to be addressed in a more comprehensive way, and this is likely to go hand in hand with new efforts to empower ultimate beneficiaries of pension plans and other collective schemes. In emerging markets, conglomerate holding structures involving banks are another area for urgent reform, together with the workings of financial markets themselves, and the underpinning institutions of honest courts and secure property rights.

Areas where regulatory intervention runs the risk of being too heavy handed are, above all, in the specification of how boards should work. In particular, there is a developing point of view that independence is the single most important qualification to be an outside director. Such a standpoint ultimately values detachment and lack of prior connection over skill and judgment. Mechanisms will have to be found to enable committed and professional outside directors who happen to be technically non-independent to be retained and valued, rather than becoming second class citizens. A further area of concern is the risk of box-ticking in relation to governance codes. In general, the principle of comply or explain, first outlined in the UK Cadbury Code, has emerged as an extremely helpful way of introducing best practice with a light touch. But its success depends on a subtle dialogue between boards and investors. In particular, investors need to devote adequate time to understanding the explanations they are offered. Equally, regulators need to let the market decide whether explanations are acceptable.


Corporate governance has emerged in recent years to become a topic of widespread public interest. Current debate has focused in particular on the challenges facing the public corporation and this is unlikely to diminish for some while. The role of business in society is an issue of concern not simply to investors and regulators but also to employees, consumers and of course ever increasing numbers of pressure groups. But governance is not simply an issue for the large publicly quoted corporation. It also embraces other entities - private companies, mutuals and cooperatives, as well as state-owned enterprises, the non-profit sector and even non-governmental organizations. At present, nearly all of these institutions lag well behind the standards of governance achieved by leading public corporations and it is here that attention may increasingly turn.

McKinsey & Company
Paul Coombes
No. 1 Jermyn Street
London SW1Y 4UH
United Kingdom
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