Corporate Governance Regulation
This article unveils the reasons behind the deluge of corporate governance regulation issued during the past decade. The differing nature of the various standards as well as their potential effectiveness in satisfying needs of different stakeholder is analysed by presenting the similarities, differences and the main construction blocks of the corporate governance standards and highlighting the challenges faced by the regulators.
The article also suggests that the key step to compliance with the corporate governance regulation is taking a ‘step back’ to take closer look on the needs of various stakeholder groups both in- and outside of the company. Introduction Over the last decade, an almost incessant deluge of corporate governance regulation, codes of practice and guidance has been issued by a range of government bodies, international organisations and regulators of financial markets.
This can largely be attributed to corporate collapses following the end of the Internet bubble and financial statement scandals of the early 2000s. Later, recent credit crisis, which led to the downfall of Lehmann Brothers and required various governments to bail out other large financial institutions further exacerbated the trend. It is often being forgotten what the added value of these regulations and codes is, making compliance a mere
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This articles attempts to recall the reasons behind the regulation in this area, address its fundamental principles and objectives and answer some of the prominent questions regarding usefulness of the corporate governance regulation to date: “Does compliance with such codes and regulation actually improve the way organisations are controlled and their disclosures? Is standardization required? Furthermore, does compliance to these codes satisfy the needs of company stakeholders?
” In order to adequately address these questions, this article first provides a brief historical perspective and overview of the various (characteristics of) corporate governance rules. Historical background The concept of corporate governance is nothing new. It is fundamentally based on the separation of ownership and management of a company. The potential issues resulting from this were already indentified in 1776 by Adam Smith, one of founders of modern economics.
Over a century and a half later, Berle and Means recognized the consequences of the separation and another half a century after that, the widely known agency theory was introduced by Jensen and Meckling. The need to address corporate governance evolved in accordance with the increasing number of stock-listed organisations as well as the ongoing consolidation and increasing size of those organisations. This has distanced ‘control’ further from ‘ownership’, the adverse affects of which were amply demonstrated by a succession of failures, financial statement frauds and scandals.
Finally it became evident that moral hazard arising in ‘any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly’ reinforces the need for system, a set of rules or information to control for them. In that sense, the need for corporate governance regulation became similar and complementary to the need for reliable financial statements. Corporate governance regulation The first widely accepted influential standard on corporate governance was issued in the UK in 1992: the Cadbury Report on Financial Aspects of Corporate Governance.
This code, which was applicable to listed companies in the UK, introduced a common benchmark for corporate governance and required companies to report on a ‘comply-or-explain’ basis. Although the issuance of the Cadbury code was originally triggered by UK public concerns about standards of financial reporting and accountability, the report’s recommendations have been adopted in varying degree by the European Union, the United States, the World Bank, and many others.
In 1999 OECD also issued their own Principles of Corporate Governance in order to assist (non-)OECD governments in their efforts to evaluate and improve the legal, institutional and regulatory framework for corporate governance in the countries. It was the Principles’ non-binding and principle-based approach – which recognised the need to adapt its implementation depending on the varying economic, cultural and political circumstances – that made it widely used as a basis for subsequent legislation and codes. However, after the corporate fraud scandals of the early 2000s, corporate governance legislation and codes started to diverge.
On the one hand, more directive and rule-based corporate governance regulation was introduced. Examples of this are the US federal Sarbanes-Oxley legislation (2002) and the Australian Corporate Law Economic Reform Program Act (2004). On the other hand, other countries (including the Netherlands) remained close to the original spirit of the OECD principles by introducing ‘comply-or-explain’ principle-based behavioural codes. Eventually to date majority of the less developed countries have issued at least one governance code, and majority of the developed countries have already undertook a series of improvements to already existing ones.
A non-exhaustive overview of important corporate governance regulation and codes is provided in the following diagram. It was apparently necessary for all these countries to issue their own guidance on the topic. However one cannot help but wonder what were the drivers behind this deluge of corporate governance regulation and codes and whether it led to issuance of contradicting or fundamentally different approaches. Characteristics of corporate governance regulation To understand the drivers behind the deluge it is important to examine the corporate regulation and codes.
Whether attributable to common sense or influential governance codes issued in the previous century, the corporate governance regulation and codes show similarities. Regardless of their origin, many of the recent corporate governance codes and regulations either implicitly or expressly cover the following main topics: * General principles of stakeholder protection – include provisions protecting the rights of the shareholders and often include stipulations that should be present in the Articles of Association (or Articles of Incorporation, in the US) on voting rights, rights to approve and fire supervisory board members, etc.
* Composition and role of the supervisory or executive board – Under this topic the principles prescribe the minimum requirements for supervisory or executive board, which include the range of requirement from level of experience, independence and specific skills to requirement prescribing the minimum number of members. The regulation also clarifies the supervisory role of the board in relation to management and its responsibility to guard the interests of the shareholders.
* Role and responsibilities of management – include the clarification of the management responsibilities in determining the strategy and overseeing the performance of the company. In relation to this oversight role the provisions often refer to the systems of controls, checks and balance within the company and in particular, management’s role in this system.
* Risk management – the principles that can be attributed to this topic are usually closely related to management responsibility with regards to the system of controls and address the need for the risk management system to be established within the organisation; * Audit – This topic usually covers principles prescribing the external audit of financial statements to be performed and often also provides for existence of the internal audit function; * Management remuneration policy – These principles typically address the relative size of the remuneration package of the management (often as compared to the remuneration of the staff or general market level) and attempts to ensure that the package is in line with the long-term objectives of the company. Notwithstanding the similar topics that they cover, the corporate governance rules also show a large degree of variation, which explains the deluge of corporate governance codes issued in the past twenty years.
As has been shown by our research, the differences between corporate governance regulation can be predominantly attributed to the interaction of three key factors: politics, which determines the focus areas; regulatory environment of issuing country (defined by its the market, legal, regulatory and informational environment (Dallas, 2004)); and the degree of granularity of that country’s corporate governance regulation, often driven by the combination of the first two factors. 1 Different focus areas – Corporate governance standards, codes and regulations have a tendency to focus on recent issues for the countries and/or sectors of the issuing bodies.
For instance, as compared to the UK code, IFF in its code provides a substantially more detail on the rights of the shareholders and specific provisions of the Articles of Association aimed at protecting shareholder rights. Closely related to issues encountered in the banking sector, CEBS next to its own corporate governance code also issued a separate complementary guidance on compensation and risk management. It should be noted, however, that to a limited extent, the codes and legislations have included requirements on topics that have manifested themselves in other countries or sectors ,but in practice such paragraphs rarely have priority in implementation. As for most legislation, corporate governance rules hence reflect a reactive approach where focus is placed on preventing problems and issues that already occurred.
2 Regulatory environment of issuing country – As was explained by Dallas (2004), based on its market, legal, regulatory and informational environment regulatory responses can be grouped into three main groups: * Anglo-American (shareholder-oriented) – this implies a strong focus on company profitability and hence the management’s accountability for maximising shareholder value; * Continental Europe (stakeholder-oriented) – the stakeholder-oriented approach, which takes account of other third parties with an interest in the company, including the employees and society as a whole. Here, the topics of corporate governance and corporate social responsibility meet; and * Emerging markets (transition-oriented) – relates to a more fundamental change in how companies are run and managed. I. e. from government-owned or privately-owned to publicly held. 3 Degree of granularity – Depending on the type of the regulatory environment and its’ political focus, degree to which corporate governance rules provide prescriptive rules or more general guidance also varies significantly.
As an example of this, the OECD principles (2004) prescribe merely a need for a ‘sufficient number of non-executive board members capable of exercising independent judgement’ and provide guidance on the possible implementation of the principle. The UK code goes as far as to suggest that ‘due regard for the benefits of diversity on the board, including gender’ should be taken. The above classifications help to identify and understand the different approaches taken to corporate governance regulators in different countries. It however inevitably leads practitioners to a set of different questions which are reinforced by the recent financial crisis and increasing regulatory scrutiny: “To what extent are these corporate governance rules effective? Which ones are the most or the least effective? These questions will subsequently be addressed. A Catch-22
Although politics and the regulatory environment do dictate the approach to the regulators, the countries and institutions still face a Catch-22 in choosing the approach to the regulation. Reactive versus prospective As for any code or regulation the choice of how to approach it comes down to two options: reactive or prospective (‘risk-based’). As it has already been discussed in the previous section, driven by politics the choice is very often made towards the reactive approach, which implies that problem have already occurred in the area under review. When rules are reactively designed based on past events, they may satisfy the general public (and at least part of the stakeholders), however they are unlikely to materially contribute to improving management’s control over the company’s activities.
For this reason there are many advocates to the risk-based approach to the regulation. The main problem with such an approach is dictated by the need to identify risks and issues that have not yet manifested themselves. This makes it very difficult to ensure that the right regulation is in place in time to prevent the next problem. In the end as it was vividly illustrated by the already issued regulation, it is not straightforward to come up with anything that would be universally accepted and welcomed. To illustrate the point, one only needs to look at the mixed receptions of legislation such as Basel (I, II and III), Sarbanes-Oxley and the Dodd-Frank Act.
All were criticised for being either too strict and having a too extensive scope (generally those having to comply) or for being too lenient and having a too limited scope (by those seeking protection). Principle-based vs. Risk-based approach A similar Catch-22 also applies to choice between the principle-based and rule-based approaches. On the one hand, principle-based corporate governance rules tend to be too generic and opaque, enabling compliance for almost any structure, system or organisation. On the other hand, a rule-based approach easily becomes too prescriptive, stipulating requirements that are not relevant for all organisations or environments.
As a consequence, rule-based principles tend to shift the focus to complying with regulation, rather than actually improving corporate control and transparency. Furthermore, rule-based legislation is inherently susceptible to ‘gaming’ by companies trying to actively overcome regulatory restrictions or burdens. An example of this is the upcoming implementation of a liquidity coverage ratio (LCR) under Basel III. The way the rule has been defined has driven banks to commence offering new corporate deposit products that provides a withdrawal options after 35 days as opposed to the 30-day limit (under which such deposits would have to be taken into account in the calculation of the LCR). In search of a best practice So what is the best practice or the best approach? Or is there one?
In order answer these questions it is important to go back to history and identify the main objectives corporate governance rules strives to achieve in the first place. There are two main objectives of corporate governance rules and both objectives should equally be considered: 1. The rules should contribute to entities establishing a sound governance framework, helping company management to remain in or enhance control. In other words, rather than simply promoting compliance with the rules, the rules should stimulate enhanced governance and transparency; 2. Because of the distance between stakeholders and management, the rules should satisfy the stakeholders’ informational requirements.
Many would agree with OECD statement that “to remain competitive in a changing world, corporations must innovate and adapt their corporate governance practices so that they can meet new demands and grasp new opportunities”, which would (at least partially) address the first objective. Following this line of reasoning, in order to enable them to do so, the governance regulation simply cannot be too prescriptive or alternatively needs to follow a constant evolution. Naturally, continuously evolving regulation would put strain both on the organisations and regulators. Principle-based regulation does not require such investment, is more flexible, but as it was highlighted earlier it is open to interpretations and therefore can only work if active involvement of shareholders and stakeholders (without overreliance of one on another) drives the company to provide adequate information sufficient to mitigate the agency problem.
If such a balance is achieved everybody can profit from the naturally evolving governance structures. This naturally leads to the second objective of the regulation – addressing the informational requirements of the stakeholders. Currently the organisations themselves do tend to comply to the relevant governance codes. A lot of companies and institutions do provide disclosures and more relevant data on their corporate web-sites. The study of Arcot, Bruno & Faure-Grimaud (2009) in UK also unveils “increasing trend of compliance with the Combined Code”. However, as highlighted by the same study and proven in our own research, such compliance often goes hand in hand with “frequent use of standard explanations in case of non-compliance”.
Surprisingly to this moment, despite the standard texts and often minimum informative value of such governance statements, shareholders, do not seem to be extremely involved and pushing for more or better disclosure standards. It seems that the ‘market discipline’ which should drive the companies to provide better disclosure is not working optimally to fully support the second objective of the corporate governance regulation. Perhaps, the key to addressing informational requirements of the stakeholders is in understanding that the concept of stakeholders includes more parties than just the shareholders or investors (Anglo-American and Emerging markets governance regulation respectively) and that all these parties may different set of expectations. This is the principle very often neglected in the provisions of the governance regulation.
Alarmingly most of the governance regulation to this date discusses the governance of the company from within the company as if the company exists in vacuum and on very occasional basis interacts with the rest of the world. In taking this approach it very often neglects the need to understand the requirements of the stakeholders – those stakeholders that the regulation intends to protect! Addressing the informational needs of stakeholders When it comes to the stakeholders’ informational requirements, it is important to understand that different stakeholders will require different approaches. The first step in the right direction for the companies would be trying to understand where the relationship between participants in the governance system actually requires additional attention for that particular company or institution.
Are there potential issues between shareholders and management, or is it the power of certain controlling shareholders over minority shareholders, or perhaps the important issue is the remuneration policy and proper alignment of the interests? Once the area(s) of attention have been identified, it should be easier to identify what actually needs to be and could be done to resolve the issue or to satisfy the informational requirements of the stakeholder groups. Uniformity and Comparability In addressing the concerns of the shareholders and investors – it is the comparability of the corporate governance structures of different companies that could be a key to addressing the concerns of the these stakeholder groups. This is typical for the Anglo-American (shareholder-oriented) model where the regulation actually sets more detailed and at times prescriptive frameworks.
In this context, the comparability of the governance structure would already provide the assurance that the minimum standards are adhered to and therefore address the some main concerns of these stakeholder groups regarding the corporate governance. However, looking at the already existing disclosures in the developed markets it can be concluded that this goal is already achieved to a sufficient extent. Certification and Assurance In case the issue concerns the relationship with the regulator or any other big influential stakeholder, certification and assurance on management statements can be a way out. This “way” combines the elements of comparability and transparency and at the same time mitigates the risk of disclosing too much sensitive information to the external parties.
This approach, however adds another ‘agent’ to the structure. As it has been shown to public during the financial crisis by the rating agencies – poorly regulated agents cannot always be relied on in terms of their independence and accuracy of their judgement. This agent will also needs to be controlled by the regulator and needs to be of good repute and integrity. Transparency Despite being cumbersome, the first two options are relatively straightforward to implement as compared to the situation where the issue concerns the transparency of the company’s governance. For example, what is the added value of knowing that there are 5 rather than 7 supervisory (executive) board members?
The profile of these board members may be helpful in showing that the board has sufficient experience and knowledge. However, if the key issue is transparency, it should also be disclosed how the board interacts with the management, what information is provided and requested by the board and how exactly is the board involved in the management and supervision of the company. Also if needs the references to make the judgment on the quality of Risk Governance and risk management in the company, it will not be sufficient to only disclose that the standard set of risk committees is in place and that there is a dedicated risk management department within that organisation.
The information that could be important disclose additionally is whether the risk management function has the proper influencing power within the organisation and provide more detail on how management of the company takes the risks into account is their daily activities. Encouraged disclosures according to IFC paper include: Board structure, Ownership structure, Names of beneficial owners, Remuneration policy for directors and senior management, Audit fees breakdown. The main issue with transparency in corporate governance is identical to the transparency issue in any of forms or substances – how much should and actually can be disclosed? The search for the ‘holy grail’ of disclosure transparency still continues.
“Specific comments and suggestions on the composition of the Encouraged Set [of disclosures] are particularly welcome”. One of the options in mitigating this information asymmetry is adding stricter disclosure requirements to the regulation. Second alternative is achieving a closer involvement of the regulators, that would put even more focus on making their own judgments on corporate governance. But perhaps the most prudent option is for companies to stop seeing it as the ‘box ticking’ exercise, be proactive and take their own steps? What is its’ added value in the end? What are we trying to achieve? There is no doubt about “the fundamental role that governance plays in a bank – and in any organisation for that matter.
Sound governance provides the foundation for everything else, including maintaining systems and controls for identifying, monitoring and managing business risks effectively. Conversely, poor corporate governance tends to undermine any other efforts to promote a strong risk management culture in a company… ”. There is, however no agreement on a single best practice model of good corporate governance. There cannot be a single model of good corporate governance as there are no identical people, institutions or countries. In this light it will not come as a surprise that a substantial amount of Corporate Governance regulation and guidance has been issued in past years by different countries and institutions.
The regulation and guidance vary substantially in their origin, the type of institutions it is primarily applicable to, its main attention points and degree of granularity. However the objectives of the regulation are very similar across all countries. The regulation is intended to contribute to entities establishing a sound governance framework and satisfying the stakeholders’ informational requirements. Experience tells us that standard disclosure information only shows that minimum standards have been adhered to and thus tells us very little about the quality of the governance system as the whole if it is taken out of the context of the organization, its people, nature and particularities of their business.
The current form of the regulation is of limited use, if the situation does not change. It currently only “serves to promoting an environment supportive of sound corporate governance”. And it is primarily up to the companies to decide whether they will wait for the regulator to take action or will address the issue themselves. After all “even if corporations do not rely primarily on foreign sources of capital, adherence to good corporate governance practices will help improve the confidence of domestic investors, reduce the cost of capital, underpin the good functioning of financial markets, and ultimately induce more stable sources of financing.
” Perhaps, one could say that it is all a known truth, but experience shows that due to the sheer volume of guidance and regulation, as the famous Dutch saying goes, it seems the people cannot see the forest for the trees anymore, and forget that the corporate governance regulation and guidance intend to achieve one primary goal, being adequate management of the principal-agents problem. And the companies are the ones that should convince its stakeholders (and not only the regulators! ) that the governance system they apply is sound, well thought off, well-managed and intended to adequately protect interests of all its main stakeholders. List of References ECGI. Index of codes. Available from: http://www. ecgi. org/codes/all_codes. php Last accessed on 12 September 2011. Berle A. A. , Means G. C. (1932) The modern corporation and private property.
Macmillan, New York Jensen M. , Meckling WH. Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics. 1976 Oct;3(4):305-360. Available from: http://dx. doi. org/10. 1016/0304-405X(76)90026-X Last accessed on 12 September 2011. Dallas, G. (2004).
Governance and risk. McGraw-Hill, New York Krugman P. The Return of Depression Economics and the Crisis of 2008. W. W. Norton; 2008. Available from: http://www. worldcat. org/isbn/0393071014 Last accessed on 12 September 2011. OECD (2004), OECD Principles of Corporate Governance . Available from: http://www. oecd. org/dataoecd/32/18/31557724. pdf Last accessed on 12 September 2011. Arcot S, Bruno V, Faure-Grimaudy A. Corporate Governance in the UK: Is the Comply or Explain Approach Working? International Review of Law and Economics. 2010 Mar; Available from: http://dx. doi. org/10. 1016/j. irle. 2010. 03. 002 Last accessed on 12 September 2011. IFC (2006) Global Assessment of Bank Disclosure Practices. Available from: http://www. ifc. org/ifcext/corporategovernance. nsf/AttachmentsByTitle/Global_Assesment_Bank_Disclosure_Practices+/$FILE/Bank+Disclosure+Index. pdf Last accessed on 12 September 2011. Bollard A. (2004) Promoting strong corporate governance in New Zealand banks.
The Reserve Bank of New Zealand Bulletin. September issue. Available from: http://findarticles. com/p/articles/mi_hb6059/is_3_67/ai_n29130524/ Last accessed on 12 September 2011. BIS (2010) Principles for enhancing corporate governance. Available from: http://www. bis. org/publ/bcbs176. pdf Last accessed on 12 September 2011. ——————————————– [ 1 ]. The European Corporate Governance Institute (ECGI) publishes an (extensive) index of corporate governance codes and regulation on their website: http://www. ecgi. org/codes/all_codes. php. [ 2 ]. E. g. WorldCom, Enron and Arthur Andersen. [ 3 ]. Berle, A. A. , & Means, G. C. (1932).
The modern corporation and private property. Macmillan, New York [ 4 ]. Jensen, M. C. & Meckling, W. H. (1976), Theory of the firm: Managerial behavior, agency costs and ownership structure, Journal of Financial Economics, 3, 305-360 [ 5 ]. Krugman, P. (2009). The Return of Depression Economics and the Crisis of 2008. [ 6 ]. Organisation for Economic Co-operation and Development. www. oecd. org [ 7 ]. OECD (2004), OECD Principles of Corporate Governance. [ 8 ]. Dallas, G. (2004). Governance and risk. [ 9 ]. The Institute of International Finance. www. iif. com [ 10 ]. Committee of European Banking Supervisors is as of 1 January 2011 replaced by the European Banking Authority (EBA). www. eba. europa. eu [ 11 ]. Dallas, G. (2004).
Governance and risk. [ 12 ]. OECD (2004), OECD Principles of Corporate Governance. [ 13 ]. OECD (2004), OECD Principles of Corporate Governance. [ 14 ]. Arcot S, Bruno V, Faure-Grimaudy A. Corporate Governance in the UK: Is the Comply or Explain Approach Working? [ 15 ]. IFC (2006) Global Assessment of Bank Disclosure Practices. [ 16 ]. IFC (2006) Global Assessment of Bank Disclosure Practices. [ 17 ]. Bollard A. (2004) Promoting strong corporate governance in New Zealand banks. [ 18 ]. BIS (2010) Principles for enhancing corporate governance. [ 19 ]. OECD (2004) Principles of Corporate Governance.