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May


Non-executive misdirection: Slavish adherence to the new rules of corporate governance is doing more harm than good

Sun, 20th Mar 2005

A WEEK in which Bernie Ebbers, the unlovable former chief executive of WorldCom, was convicted of an $11 billion fraud, and another prominent US CEO was forced to resign on suspicion of fiddling the figures, seems an uncomfortable one in which to query the direction of current corporate governance.

Yet while the crooks deserve everything that the law flings at them, it's harder to see the greater good that was served by the sacking of Boeing's chief executive, Harry Stonecipher, for having a fling with an (unmarried) Boeing employee.

Stonecipher's behaviour may not be admirable, but it does not seem a hanging offence. Yet such is the climate of corporate correctness that conformance to the letter of the law now takes precedence over all other considerations - with the very real danger that corporate governance 'improvements' are starting to have the opposite effect to the one intended, making senior recruitment more difficult and destroying the cohesion of the board.

Anecdotal evidence certainly points this way. US headhunters say prominent companies now have to settle for ninth or 10th choice when recruiting outside executives for the board.

According to a survey by PricewaterhouseCoopers, for 70 per cent of UK chief executives governance and compliance activities represent pure cost, rather than investment, and less than half believe they could be a source of competitive advantage. Even in the US, where CEOs are more positive, a different survey a year ago showed that fewer than one-third of directors thought that new governance standards would improve board operations, ensure detection of unethical behaviour or better protect shareholders. Overwhelmingly, boards were spending more time monitoring accounting and governance practices and financial performance rather than on more positive issues.

Special pleading? Academic evidence gives little support to the official line. For example, a Henley Management College study found that companies with many executive directors on the board did better than those with a high proportion of non-execs. This finding - which echoes those of two Australian surveys - contradicts two of the tenets of the combined code on board structure and director tenure. Other studies say the same thing over and over: the forms that are currently accepted as a prerequisite for 'good governance' do nothing for company performance.

Do they have an effect on wrongdoing? Probably, says Professor Vic Dulewicz, co-author of the Henley paper, but he warns that no amount of rules will deter the real villains. Enron is notorious proof that the form of best practice is worth very little without the content.

But some go even further. Said Business School's Chris McKenna, author of a forthcoming book on the history of management consulting, believes that, the best intentions of the US Sarbanes-Oxley Act on corporate governance notwithstanding, the stage is unwittingly being set for more Enron and WorldCom type scandals. He argues that making directors personally and financially liable for mismanagement - in a January settlement Enron and WorldCom directors agreed to stump up $31m to shareholders - will not only have the effect of pushing up directors' salaries and liability insurance premiums to match the increased risks it will also cause board members to offload ever more responsibility on to outside advisers, consultants and auditors. It was just this tactic of bringing the audit inside - acting as 'insurance policy' to management rather than independent regulator - that caused Enron's advisers to lose their objectivity.

'The likelihood of another long cycle that repeats the past 20 years and ends with another crisis of corporate governance is high,' McKenna concludes.

He doesn't add it, but the equal likelihood is that the next crisis will trigger yet another round of regulatory corset-tightening, further increasing bureaucratic drag. Meanwhile, as Anthony Hilton in the Evening Standard has pointed out, a boardroom split between power centres - chairman, lead non-exec, heads of remuneration and audit - and where non-execs are forbidden to trust the execs, is a recipe for dysfunctionality, not teamwork. It is difficult, notes the Henley paper, 'to envisage how 50 per cent non-executive director representation is calculated to do other than encourage adversarial friction with executive colleagues.'

How have we got into this mess? The fuel of the governance arms race, whether Sarbanes-Oxley or the UK's combined codes, is an American doctrine known as 'agency theory'. Under this ideology, the function of the board is to ensure that managers (agents) act on behalf of the shareholders (principals) to maximise shareholder value without this surveillance, the theory goes, managers will exploit their inside knowledge to advance themselves at the expense of the principals.

In governance terms, this requirement to police management is the basis for 'duality' (splitting chairman and chief executive roles), boosting the number of non-execs, incentivising managers and encouraging the market for corporate control. Unfortunately, as we have seen, these prescriptions don't work. As Dulewicz notes, agency theory, like all the other board theories in existence (13 at the last count), isn't particularly helpful for analysing what boards do, which is far more complex than than the mechanistic and simplistic theory suggests.

The trouble is, though, that the theory is doubly bad: not just wrong, but self-fulfilling. Assuming that managers are self-interested opportunists who need sacks full of share options to do their jobs creates managers like that. Telling them that their job is exclusively to maximise shareholder value ensures that they leave no legal stone unturned in their effort to do so. Then new inhibitions have to be put in place to temper the abuses and the whole cycle starts again.

It's time to rethink the whole corporate governance issue - not on the basis of tightening or modifying existing codes but from an entirely different starting point. Companies don't thrive and prosper by concentrating only on shareholder value, and agents and principals, but by simultaneously looking after all the elements that go into success - customers, suppliers, employees - and even communities. Unless it acknowledges that, governance practice will remain part of the problem, not the solution.

The Observer. 20 M<arch 2005


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