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The unacceptable face of regulation

Sun, 28th Nov 2004

GOODHART'S Law - an insidious Catch-22 decreeing that targets are fine until you start using them to manage by, at which point they are irredeemably corrupted and therefore useless - is not just a public sector phenomenon. As a reader points out, it is alive and well in corporate governance, where it has the same debilitating effects.

John Drummond, chief executive of consultancy integrity works.com, told a Chatham House conference last week that corporate governance was becoming 'a mile wide and an inch deep'.

He notes that lots of indices and specifications have been developed for use by investment groups to establish governance quality, but most of them put the emphasis on structural elements - type, quality and independence of non-executive directors, separation of chairman and CEO and so on.

'All companies are being judged this way, with little regard for how employees are enlisted in the quest for good governance and sound conduct,' he complains. 'This disconnection means that the surface is getting lots of attention and what really matters - the culture - is getting none.'

In theory, everyone is against the deflection of attention from substance to form that has become known as box- ticking, but many believe that that is what is happening. Even in the UK, where the Higgs reforms were business-led or at least formulated, there is talk of 'governance fatigue' in the US, discontent with the Sarbanes-Oxley act is reaching mutiny proportions.

Enacted in 2002 with the attention of heading off more Enron and WorldCom-type scandals, Sarbanes-Oxley runs to 1,100 sections and complying with it, companies grouse, has become an industry in its own right. Meeting its requirements costs large firms about $9 million a year each, according to one survey, and the burden of detail is leading some European companies to considering delisting from New York to escape it.

Of course, many people would shrug and say that companies have brought tighter regulation on themselves. It wouldn't have happened if they hadn't misbehaved in the first place. Although there's some truth in that, there's a deeper issue. The late Sumantra Ghoshal pointed out that meta-analysis of 85 separate academic studies showed that neither the proportion of non-execs on the board nor splitting the top two roles had the slightest bearing on company performance. As for promoting better governance, Enron had in place many of the things that today's codes recommend: independent directors, separate chairman and CEO, independent directors in charge of key committees and regular self-evaluation by the board.

Because of the underlying assumption that the board's primary job is to police the actions of opportunistic and untrustworthy executives, Ghoshal argued, the codes had put in place a set of prescriptions based on 'ideologies, unfounded opinions and myths'. Not only did they not prevent wrongdoing; they had the effect of making it harder for the board to do its job of encouraging innovation and legitimate risk-taking.

At the same time, by prescribing precise legal limits, they encourage executives to work right up to them rather than change their behaviour. Anything that isn't forbidden is permitted compliance is with the letter rather than the spirit of the law. In fact, corporate governance is a particular subset of a larger case. The more extensive and detailed any regulation is, the greater the scope for unintended consequences (what we might call Goodhart effects). Take the financial services industry, where it is at least arguable that poor regulation has had the opposite effect to that intended. In the effort to foresee and forestall abuses, the rules are now so complicated and draconian that it's actually quite hard to buy or sell savings products. The result is that pension firms are closing funds and people who should be saving are buying property instead. Abuses may be fewer - but an improvement bought at the price of a property bubble and a pensions crisis is a Pyrrhic one.

Let's be clear. The argument is absolutely not the free-market one that there should be no regulatory constraint on companies' ability to make money for shareholders, nor the often mealy-mouthed plea for self-regulation as a way of softening the options. Rather the reverse: safeguards are needed, but they need to be real rather than bolt-ons.

As with corporate social responsibility, the only way of circumventing the diabolical consequences of Goodhart is to bring regulation inside the company. Internal regulation enforced by values is both more efficient and more effective than external regulation enforced by the compliance police.

In this context it's perhaps depressing to note that the Institute of Business Ethics, which among other things monitors the ethical temperature of the business world, notes declining interest in ethics in business schools - especially on MBA courses, where ethics, if it exists at all, is often taught as an elective rather than a mainstream part of business.

This, too, is a Goodhart effect, at least partly the result of business-school rankings that are heavily weighted towards before-and-after salaries as a criterion of merit.

Corporate governance is a means, not an end. Apparently impeccable behaviour on all the dimensions of Higgs or Sarbanes-Oxley, which drives out enterprise, may in the larger picture be a sterile bargain. The two don't have to be in opposition but reconciling them requires everyone in the company to know what their purpose and values are and stick by them. As with quality, you can't inspect good governance in after the event. Like letters in a stick of rock, it has to run all the way through.

The Observer, 28 November 2004


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