Friday, July 24, 2009

The Efficacy of Conventional Corporate Governance Instruments

Each time there is a corporate governance scandal (whether in India or elsewhere), the response has been to use a set of instruments (implemented through regulation or best practices) to avoid a repetition of such occurrences. It appears that these instruments have not always been successful as they come with certain innate limitations, but they are often applied in situations that are different from the context in which these instruments were designed in the first place.

In Uses and Limits of Conventional Corporate Governance Instruments: Analysis and Guidance for Reform, Simon C.Y. Wong reconsiders the efficacy of the conventional corporate governance instruments and provides some suggestions for reform. Here is the abstract of the article:

The global financial crisis is forcing policymakers to again consider the most appropriate governance arrangements for publicly listed companies. As a way to contribute to the current debate on corporate governance reforms, this article examines the uses and limits of five commonly employed corporate governance instruments - transparency, independent monitoring by the board of directors, economic alignment, shareholder rights, and financial liability.

This article discusses how the individual instruments have worked in practice, including instances when they have failed to achieve their intended objectives and, in some cases, worsened the governance ailments that they were designed to cure. For example, the rapid growth of executive compensation persisted - and in some countries, accelerated - after the introduction of individual executive pay disclosure. In the financial sector, the shift toward a board dominated by independent directors ultimately proved to be its Achilles' heel as weak industry knowledge meant that non-executive directors were unable to pick up on warning signs of imprudent risk taking by management.

Following this analysis, suggestions are put forward on improving application of these instruments. Topics explored include 1) the extent to which the board of directors can be relied upon to monitor management, 2) how executive compensation arrangements can be restructured to better align management and shareholder interests, 3) under what circumstances would additional rights for shareholders - such as director nomination rights and an advisory vote on executive pay - be appropriate, and 4) the factors that should be considered when transplanting corporate governance practices across countries.

The article concludes with a discussion of how policymakers should approach corporate governance reform generally.

In addition to the general discussion of various corporate governance systems, the article offers some perspective on the issue of governance in emerging economies (into which category India would fall) where there is generally a concentrated ownership of companies:

When transplanting board models across countries, special attention must be paid to the surrounding context. In markets where controlling shareholders are the norm, the board’s oversight role will likely be substantially constrained because the [non-executive directors] are often elected by the same owner-manager that they are responsible for overseeing. Yet, policymakers in many of these countries continue to strive to replicate the board model in Anglo-Saxon countries, where the shareholder base is typically highly dispersed.

In many markets, ownership structure exerts a non-trivial influence on the character of shareholder rights. To illustrate, given the prevalence of controlling owners in Italy and Mexico, the corporate governance regimes in those countries reserve space on the board for minority shareholders. In other markets where concentrated ownership is the norm, tools such as cumulative voting are often employed to provide a counterweight to the controlling shareholder’s influence. These mechanisms are largely alien to the UK and US, where ownership is generally much more dispersed and, hence, special rights for minority shareholders are not perceived to be necessary.

Among the various contextual factors to consider, ownership structure is perhaps the most important. With dispersed ownership as the norm, the key issues in Anglo-Saxon countries are incumbent management pursuing personal interests at the expense of shareholders and the ongoing challenges in inducing atomized shareholders to actively monitor management. In these markets, the primary tools employed have been independent boards and performance-based remuneration arrangements, including disclosure thereof.

In countries where controlling shareholders are a common feature, the main governance issue is the risk of abuse by dominant owners, particularly through related-party transactions and denial of participation rights. Moreover, as discussed above, there are limits to which the board of directors in firms with concentrated ownership can serve as an effective oversight body. Nonetheless, policymakers in some markets continue to focus on replicating the Anglo-Saxon board model.

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