ACCORDING to a study by the consultancy Booz Allen Hamilton, of all the value destroyed by the largest US companies between 1999 and 2003 (including Enron, Tyco and friends), just 13 per cent was the result of failures of regulatory compliance or board oversight. Eighty-seven per cent was caused by strategic or operational error.
In other words, investors' health is, now as ever, at much greater threat from managerial cock-up than conspiracy. As Bob Garratt, visiting professor at Cass Business School, puts it: 'Think of Marconi, Equitable Life and Morrisons - the issue here isn't financial propriety, just basic competence.'
Yet, over recent years, the governance agenda has increasingly been driven by the former, impropriety. Britain was the early leader in code-setting: starting with Cadbury in 1992, through Hampel, Turnbull and finally Higgs in 2003, a succession of reports and ensuing codes have elaborated and refined the apparatus of corporate control.
Other jurisdictions have enthusiastically followed: there are now 273 governance codes in place around the world, according to Garratt. The current culmination of this trend is the US Sarbanes-Oxley Act, Sox for short, which takes a giant step further by making executives personally responsible for signing off the accounts, on pain of criminal sanction.
Now investors need to be protected from fraud, of course - but the effect is nullified if the cure exposes the patient to an even greater hazard. The results of governance's reverse Pareto effect (spending 80 per cent of attention on the state of the stable-door lock and 20 per cent on whether a contented horse is still inside) are now coming home to roost.
Interviewing chairmen, directors and other usual suspects for a new report, The Role of the Board in Creating a High-Performance Organisation , researchers John Roberts and Don Young found that the constant pressure on boards to spend more time on investor relations and meeting regulatory requirements was diverting attention from strategic and operational issues, thus perversely increasing the chances of corporate failure.
This likelihood was greater for those boards that they characterised as 'investor-driven' - that is, highly reactive to often conflicting short-term shareholder pressures and in which non-executives were cast in a primarily policing, compliance role. By contrast, 'strategy-led' companies aim to resist short- term City pressures in favour of long-term improvement. Their boards operate as a unified team, and non-execs are expected to be more than policemen, adding value by acting as a resource whose distinctive knowledge is available to the rest of the business.
Everyone agrees that the intentions behind the codes were good, but, especially in the US, regulation has gone 'miles too far, as even the Sox authors acknowledge', says Garratt. The orgy of box-ticking has 'developed into a bonanza for the people who got us into this mess in the first place, who are gold-plating the already onerous requirements. This is the theatre of the absurd.' Not only is compliance expensive - pounds 50 million and up for a UK firm, says Garratt - but it is also eroding the propensity to take risks. Sarbanes-Oxley is a greater threat to capitalism than Karl Marx, he concludes.
The effects are less marked in the UK, where the codes explicitly mention the need for boards to contribute to strategic direction. But the direction of travel is inexorably the same. This is not surprising, since all contemporary corporate governance principles share the same theoretical underpinnings: the enormously influential agency theory.
In brief, agency theory suggests that the prime role of the board is to ensure that executive behaviour is aligned with the interests of shareholder-owners. Otherwise, self interested managers will use their superior information to line their own pockets. This is the justification for the separation of the chairman and CEO roles, huge senior executive salaries, the overriding requirement for non-exec independence, and much more.
Putting the theory into practice, however, has revealed at least three main faultlines. First, prescriptions based on it don't seem to work. 'Good' governance according to the codes may or may not prevent fraud (Enron ticked all the boxes at the time), but it doesn't by itself stop catastrophic strategic mistakes nor is there any evidence that it improves performance. As the report notes, governance is necessary but not sufficient to create high performance.
Second, the theory is viciously self-fufilling. As even its main progenitor, Michael Jensen, now acknowledges, the share options that he advocated as the remedy for agency problems didn't so much align directors' self-interest as create it. They generated perverse incentives for fund managers and executives first to collude in hoisting share prices above their underlying value and then to use any means to keep them there Enron, again, and the internet bubble are the classic examples. It encourages the idea that, opportunism and greed being the norm, anything that isn't explicitly banned must be OK this, in turn, justifies the need for even tighter controls. Hence Sox.
Third, even the description of market actors as agents and principals collapses in today's market conditions. Where there is a reported 90 per cent churn of FTSE stockholdings annually, the idea of ownership and the primacy of shareholder rights, the fountainhead of agency theory, simply dissolves.
Paradoxically, if we want companies to create value rather than destroy it, boards may need to pay less rather than more attention to corporate governance as it has come to be understood. To be clear, this is not a matter of ignoring investors, but of creating their own code and thereby snapping the cord that is too often used to yank investor-driven boards around between conflicting priorities. Boards' first responsibility is the long-term sustainability of the organisation, not complying with investor demands for certain kinds of board structure and composition. Good governance is a means, not an end not just about seeking conspiracies but averting cock-ups, too.
The Observer, 27 November 2005