How Much Regulation is Enough?
The wake of corporate failures in the early part of the decade and the subsequent economic crisis, which for many countries and industries is still not something of the past, resulted in a flurry of new laws and rules by legislatures and regulators. The intention of such reforms is clearly to enhance public protection, and ultimately the sustainability of corporations, economies and nations.
One of the main themes in the latest round of regulation is corporate governance. A recent publication by PricewaterhouseCoopers, entitled “World Watch” (Issue 1 of 2010), referred to no less than three countries that have published new or updated corporate governance requirements standards, and that was only what appeared in a single monthly publication. These were:
· The Securities and Exchange Commission in the United States set new requirements for proxy and information statements, such as compensation policies and practices, compensation tables and securities and option awards, information regarding directors and nominees, board leadership structures, the board’s role in risk oversight, etc.
· The revised Norwegian Code of Practice for Corporate Governance, which has been brought into line with changes in legislation on audit committees, general meetings and shareholders’ access to documents.
· The King III Report on Governance for South Africa, which broadens the scope of corporate governance, with its core philosophy revolving around leadership, sustainability and corporate citizenship.
The three countries mentioned in the PWC publication are certainly not the only ones at work on these questions at this time. There is also the Combined Code in the United Kingdom, the corporate governance principles of the International Corporate Governance Network, the OECD’s Principles of Governance, and many more.
It seems as if regulators want to ensure that companies ‘up their game’ in so far as governance is concerned. The underlying argument, I suppose, is that better governance will result in better, more profitable and more sustainable companies.
The question, though, is can corporate governance be regulated; and if it can be, how much regulation is needed to enhance public protection on the one hand, without stifling capital markets, and hence the creation of wealth, on the other?
What is corporate governance?
There are numerous definitions and descriptions for corporate governance, and as many sets of governance codes, principles and rules. One of the earlier definitions by the Corporate Governance Council of the Australian Stock Exchange (ASX), in my view, captures the concept quite well. It states the following:
“Corporate governance is the system by which companies are directed and managed. It influences how the objectives of the company are set and achieved, how risk is monitored and assessed, and how performance is optimised. ….Good corporate governance structures encourage companies to create value…and provide accountability and control systems…” Excellent, Linda: do you have a more precise reference to this document, name and date?
Corporate governance is therefore about optimising performance, but with a longer term view, thus creating a sustainable company, with a sustainable value to its shareholders. In order to achieve such sustainability, the company cannot be focused on short term goals only. It must also consider the impact of its decision making on its broader stakeholders, and their reaction, as well as compliance with laws and best practice in a wide range of areas, including its impact on the environment, the community, its labour force and the perception of the company.
The objective of corporate governance is not compliance, but sustainable performance. Compliance is merely one of the means to achieve sustainable performance. Compliance by itself with laws and regulation does not guarantee a successful company. Success is harder than that.
Who is responsible for corporate governance?
It is clear from the ASX definition that the board of directors of a company is a very important role-player in setting the tone in so far as governance is concerned. Only the board can steer the company to an optimum performance level.
In capital markets, the securities exchange is another important corporate governance role-player. An exchange cannot do much to ensure company performance, it can only play a role in ensuring that the company has structures and processes, such as a board of directors that understand its roles and plays within certain rules, in order to achieve an acceptable level performance. The exchange’s position in the area of listed companies’ corporate governance is thus mostly on the compliance side.
The level of regulation?
Corporate governance regulation can go to the end degree and regulate in detail, e.g., how boards and audit committees should be composed, what their role should be, the frequency of meetings and the content of the agenda.
Would this automatically enhance performance, and prevent shareholders from losing money? Clearly not, as a list of rules only speaks to the compliance side of governance. The USA Business Roundtable said: “The substance of good corporate governance is more important than its form; adoption of a set of rules or principles or any particular practice or policy is not a substitute for, and does not itself assure, good corporate governance.” Again, a reference for this quote?
The other side of the continuum is no regulation – thus leaving it up to the company to decide whether and how it wants to governance its affairs. This is probably acceptable and even appropriate in a family-owned business or small entity, but clearly not in a listed company that solicits money from the public and where public interest is at stake.
To strike the appropriate balance seems quite difficult. In practical terms, I can only refer to the South African experience. Were we successful in striking this balance in our legislation and regulation? In my view, on balance, probably yes.
However, our new Companies Act, in some instances, is probably an over-reaction to instill compliance and hold people responsible in instances of incorrect, false or misleading reporting. This result in strict rules relating to aspects such as the appointment, composition, role and reporting of audit committees is concerned. This is causing some companies, even at a listed company level, difficulty. It is also expensive for the listed companies on the smaller side of the scale and might result, in an attempt to save costs, in behavior that leads to working around the rules.
On the “yes” side, though, the legislature recognised the fact that requirements with a corporate governance code should not be legislated. The approach that South African courts are taking, when the action of directors is questioned, is measuring them against a reasonable director test. This principle has now been codified in the Companies Act, referred to as the business judgment rule. In other words, directors have a fiduciary duty/duty of care and skill towards the company. If this gets questioned, their action and decision making will be measured against that of a reasonable director. In some instances, the courts have determined that the practices of a reasonable director and board in South Africa is set out in King III, and hence the director in question needs to explain how and if not, why not, it applied the King III corporate governance requirements in circumstance being reviewed. That does not imply that all requirements must be applied, but it does meant that boards should apply their minds to the requirements and be able to justify their corporate governance practices or lack thereof.
The Johannesburg Stock Exchange (JSE) Listings Requirements are fairly balanced in setting requirements around corporate governance. Firstly, it specifically lists matters that are, in the view of the JSE, non-negotiable for listed companies, such as balancing the power between executives and non-executive directors on the board, splitting the role of CEO and chairman, disclosing the policy detailing the procedures for appointments to the board, having non-executive directors on the nomination committee, and requiring the audit committee to review annually the experience and expertise of the financial director, to name a few. This is not only an important minimum requirement on the compliance side, but is also critical for the perception of the South African market meeting international best practice.
In so far as compliance with a corporate governance code is concerned, in the case of South Africa King III, the JSE recognise that one size does not fit all, and that companies, depending on their size, complexity and the depth of their pockets, require different levels of corporate governance compliance.
It therefore adopted the “apply or explain” approach. It requires all listed companies to make a narrative statement of how the company has applied the principles set out in the King Code. The objective is to provide an explanation that enables stakeholders to evaluate how the principles have been applied, and give reasons for each and every instance of non-compliance with the principles.
Therefore, if a company has not applied a certain corporate governance principle per King III, it is acceptable. However, the fact and reason must be disclosed and stakeholders are able to make up their own minds on the state of governance within the company.
This is similar to the approach followed in Norway where companies have to provide a comprehensive corporate governance report, explaining how they complied with every requirement or explaining why they did not comply.
Would compliance with best governance practices have prevented the economic crisis?
Maybe not - there will always be elements of uncertainty. With the best insight, skills and experience, boards cannot predict the future and take that into account in their decision making. Therefore, every board will from time to time make the wrong decision, albeit a reasonable decision at the time.
On balance, yes - if the governance practices were not only focused on a ticking-the-box compliance approach, but also on the sustainable performance of the company. Maybe companies would have better considered and understood their risks and the impact of their decisions in a spectrum of scenarios. Maybe improved governance practices would have resulted in boards really evaluating the sustainability of some of their practices and products.
Ultimately for companies, it is all about striking the appropriate balance – between compliance and performance. And for regulators, it is ensuring that they do not allow the compliance pendulum to swing too far into either the over-regulation or self-regulation direction.
About Linda de Beer
Linda is an independent governance and reporting advisor, serves on a number of corporate boards, and is member of the King Committee on Governance for South Africa, the Issuers’ Services Committee of the Johannesburg Stock Exchange, and is Chairman of the Consultative Advisory Group of the International Auditing and Assurance Standards Board (IAASB), which is charged with setting global standards in this field. For this work, she is seconded by the World Federation of Exchanges.