Corporate Governance -- Easier Said Than Done

In the wake of the distress at Abraaj, there have been the usual calls to enhance corporate governance.  

As the title above indicates, AA has a contrarian view.  

In particular, I want to address two assumptions that seem to be held regarding this topic: 

1. If only we adopt certain measures, we can greatly reduce and perhaps even eliminate instances of corporate misgovernance.  
2. When corporate governance fails, the tendency is to blame third parties never oneself.  This “shifting” of responsibility seriously detracts from enhancing corporate governance. 

Corporate governance or lack thereof is the result of the interplay of three factors:  

1. Governance systems 
2. People 
3. Situations 

GOVERNANCE SYSTEMS 

The primary focus in the pursuit of good governance appears to focus on establishing systems, perhaps because the difficulty of controlling the primary factor in corporate governance—people— is realized to be difficult. 

These systems are designed to: 

1. Establish “rules of the road” for conduct generally in the form of codes of conduct or ethics.   
2. Create organizational structures and limitation of personal authority/segregation of duties to (a) prevent individuals from exercising unfettered control over the corporate entity and (b) provide multiple review mechanisms to “catch” bad behaviour that has slipped through the ethical and  organizational “nets”.  

Rules establish standards of conduct.  Basically, these can be summarized as follows.  Don’t cheat, lie, or steal from the company’s owners and other stakeholders.  Don’t use your position to take advantage of the company’s owners or other stakeholders.  Discharge your duties as a faithful agent. Pretty simple and obvious “stuff”.   Presumably, this is the sort of moral sense we’d expect from board members, officers, and employees of a firm.  

And well might ask why do we need to tell people to be ethical unless we assume we’ve hired some pretty low lives.  Does any ethical person think it’s right to steal or lie?  

So if they’re so self-evident, what’s the need?  

1. Ideally they provide clear unambiguous rules of conduct.  If insider trading is properly defined, to use one example, then there is little room for debate on what constitutes insider trading.  They also provide an inventory of responsibilities. 
2. They can address gaps or ambiguities in the law or governmental regulations.  Also they can hold the board, officers, and employees to higher standards than mandated by the law or government regulations.  
3. If crafted properly, they provide a legal basis for the termination of employment or other service.  If you find a “bad apple” you’ll want to get him or her out of your barrel ASAP.  

Examples of organizational structures and procedures (exercise of authority) are segregation of duties, including management of key review functions, dual control, requirements for independent directors, an independent chairman, etc. 

Review functions are both internal and external. Internal review includes internal audit, compliance, risk management, etc.  External review includes external auditors, including requirement for rotation of firms or audit partners; government regulation (chiefly for financial sector entities).

In some cases firms or governmental regulatory agencies have “whistleblower” programs for individuals to report inappropriate behaviour.  

But these measures while necessary are not sufficient.   

And unless there are glaring deficiencies, the benefit of adding additional measures is often likely to be marginal.  Using AA’s wayback machine, here’s a post from 2009 which shows that sometimes enhancement to existing measures can be theoretically useful.  

PEOPLE

No matter how good the system, if those charged with implementing it don’t follow it for whatever reason, corporate misgovernance can occur.  People are the critical variable. 

To set the stage, some examples of system failures due to people:  

1. Wells Fargo had a fairly developed whistleblower program.  It received numerous complaints about unauthorized opening of customer accounts and credit cards.  There was no discernable impact on firm behaviour.    
2. Enron had a 65 page corporate ethics manual, which if it were followed to the letter, would have prevented much, if not all, of its inappropriate behaviour.  
3. For more examples, take a look at the Breeden report on Hollinger International.  Richard C. Breeden, former head of the US SEC, and his law firm have prepared other reports on corporate mis-governance, e.g., MCI,  WorldCom.  

Typically, an attempt is made to address the “people issue” by establishing “fit and proper” criteria for owners/partners of unlisted firms, board members, and senior managers; limitations on numbers of boards board members may serve on; requirements for a number of independent-of-management board members; and possession of relevant skills and experience. 

Enron had a distinguished Board: 15 independent directors, including a former regulator, a former British MP, a distinguished former accounting professor who served as head of its audit committee.  

If you were looking for the ideal board which on its face has all the “right” people–qualified with years of practical experience and as outsiders ostensibly independent—and every Corporate Governance box "ticked", Enron’s Board would be a very strong contender.  Yet, as per press reports, Enron’s Board “suspended” the Company’s Code of Ethics to allow the CFO to be a shareholder in an Enron-related offshore entity.  Articles here and here.  

Enron’s Chairman/CEO had a reputation for promoting corporate governance and ethics.  See the first page of the Enron Code of Conduct.   Read his stirring speech at a 1999 the University of St Thomas in Houston. 

What went wrong? 

People are not perfect.  

Laziness, self-interest, incompetence, a propensity to “go along to get along”, fear of displaying one’s ignorance, etc. are typical traits that lead to governance and other problems.  Add to that an increasing sense of entitlement at the senior that one deserves more and more.  In short human nature.

Efforts to fundamentally change human nature do not have a track record of success.  Nor do those that focus solely on changing behaviour.  

The Soviets brought the power of the state to bear in an attempt to create a new and better Soviet man.  Jamal Abdul-Nasser and his colleagues a new Egyptian, freed from the legacy of colonialism, and what was perceived to be the dead hand of tradition.  Various religions have sought to modify behaviour and have wound up neither achieving widespread practice of right thought, right speech, or at a minimum right action.   

Those working on corporate governance enhancement have to recognize (a) the limitation of the perfectability of man and (b) that enhanced systems will not solve the people element in corporate governance problems.   

That doesn’t mean that one doesn’t try, but that one needs to have a sense of practical limitations.  In short we will not eliminate corporate misgovernance.

SITUATIONS 

In extreme cases, corporate entities are set up as “criminal enterprises” from inception.  Systems may be put in place but there is no intent to adhere to them.  

In noncriminal corporations, there is an intent to adhere to control systems.  Much corporate mis-governance occurs in response to distressed circumstances.  These situations are the real tests of ethics.  

It’s easy to be ethical when the money is rolling in and the corporation is doing well.  

AA has not once been tempted to rob a 7-11.  But if my imagined investments in Dubious Gas went to zero (my entire portfolio), I lost my job, and couldn’t access money, I might like Jean Valjean steal to feed my family.   

The same in the corporate world.  

If an investment firm had an ongoing cash shortage and needed money to continue operations but couldn’t get it immediately from legal sources, might its managers decide to temporarily “borrow” some client funds to bridge a cashflow problem that they’ve persuaded themselves is a temporary state of affairs?  

No doubt making the argument that preserving the firm also preserves clients’ assets, doesn’t disrupt financial markets leading to economy-wide problems.  And also considering carefully the impact of failure on their reputations as well as the loss of the perks of their positions.  

It’s in these cases that people will try to subvert systems.  Often they can do so and do so for a long time.  

Interestingly, when corporate misgovernance occurs, opprobrium is generally directed at those whose misgovernance is followed by collapse of their firm.  

In other words, the market seems distinguish between two situations: “successful” misgovernance (not bad) and “unsuccessful” misgovernance (unconscionably bad).  

Misstating financials is considered a fairly serious breach of corporate governance.  

At the outset of the Latin Debt Crisis, all US money center banks and some large regionals were insolvent based on a proper valuation of their Latin Debt.  Not a single one of these banks produced accurate financials.  The Government and external accountants either were woefully ignorant of the true state of affairs or colluded in the charade.  Eventually, the banks were able to work their way out of insolvency with a helping hand from the US government.  

Enron mis-stated its financials.  Lehman misstated elements of its financials.  Sunbeam as well.  All crashed and burned.  The Boards and senior officers of Enron, Lehman, Sunbeam and other companies were pilloried for corporate malfeasance.    Their auditors were charged with dereliction of duty.  In one case a major auditing firm was destroyed.

On the other hand not a single word of opprobrium was directed at the banks or their auditors over the Latin American debt crisis.  

What’s the takeaway here?  

1. For non-criminal firms, one can’t predict the response to corporate distress.  What level of distress will cause the system to bend and then break?  To cause normally ethically sound people to relax and then abandon their standards of conduct?  How can one devise a governance system that prevents that from occurring?  
2. Some corporate mis-governance is apparently good, i.e, if the firm survives.  It’s a natural response of someone in a distressed situation to imagine all sorts of “good” reasons to justify breaking the rules.  

RESPONSIBILITY SHIFTING 

A general reaction to corporate governance problems is that management failed, the board failed, the auditors failed,  regulators failed.  Indeed, they may have.  

But there is additional culpability.  What about other stakeholders and market participants?  If they adopt this very convenient view that they are innocent victims, then corporate governance is the responsibility of others. If one has no responsibility, then one need take no action, other than complain about the turpitude, avarice, and incompetence of others.  

The next post will deal with the apparently inconvenient and uncomfortable responsibility of other market participants to promote corporate governance.