In the world of corporate governance, the year 2012 is significant. It is exactly 20 years since the release of the Cadbury Report in the UK and 10 years since the enactment of the Sarbanes-Oxley Act in the US. Both were milestone developments.
The Cadbury Report was the first significant code published to guide companies in their interactions with stakeholders, particularly shareholders. The report’s thrust is a novel “comply or explain” approach which allows some flexibility for companies in choosing whether or not to go along with the guidelines it proposes.
The Sarbanes-Oxley Act takes a firmer stance, legislating responsibilities and tasks through a set of mandatory provisions affecting public companies. The requirements are cast in certain terms and companies have no choice but to comply or face legal consequences.
So, after several years of policy intervention, have our companies changed for the better? Are the corporate processes more sound, and are investors better protected?
Amidst the continuing distraction of many corporate scandals round the world, the impact would appear to be mixed. Perhaps the most fundamental and important question is: has stronger corporate governance given rise to better firm performance?
Researchers have grappled with the performance mystery of corporate governance over the past decades, delivering a motley and largely inconclusive mixture of results in various countries, many of which have stringent corporate governance codes and strong companies.
There are several possible reasons.
First, is the issue of models and methods. Information on many governance measures is publicly disclosed in delayed form, such as through annual reports. Practitioners of finance will know that no profits from shares can be made from public information in an efficient stock market. Thus it will be difficult for corporate governance information to result in abnormal stock returns that show up in performance studies.
Second, accounting statements may be used to indicate performance. As we know, boards of directors, particularly their audit committees, usually have a strong say in how finances are presented. Stringent boards may be more conservative and we may even have situations where stronger governance results in weaker reported profits.
Third, it may be that governance requirements actually lead to weaker performance due to high compliance costs. This has been the case for many companies, for example, after the Sarbanes-Oxley Act was rolled out in the U.S.
If corporate governance then has no impact or even negative impact, should companies just ignore it? Why should shareholders beat their chests and cry out for a plethora of governance safeguards?
Let’s examine some of the other activities companies do that have an unclear and often arguable relationship with value.
One of these, which itself is closely related to corporate governance, is good accounting and auditing. Are these wealth-creating activities? That is far from clear, but there is an obvious downside to not having them.
Or consider branding. Marketers will readily argue that branding adds to the intrinsic value of a product or service. However, that added value is intangible and difficult to measure. But on the flipside, even though its impact is uncertain, ignoring branding is highly likely to result in lost sales.
Another factor that has almost become a mantra is quality. Quality assurance is a cornerstone of business strategy for almost any product and service. Again the direct contribution of this assurance to performance is not clear cut, but it is certainly a confidence boosting measure for the customer in making purchase decisions.
How do these relate to the application of corporate governance?
It is that, yes, having corporate governance itself may seem to add very little in terms of tangible returns, but not having it makes a world of difference. It is like obeying the law – doing so is an expectation or a given, but not doing so will result in dire consequences.
The same perspective can be extended to corporate strategy. As the impact of corporate governance on firm performance is still unclear, we can argue that this governance probably does not result in competitive advantage.
To give rise to such advantage, corporate governance must allow the company to reap excess profits in the industries it operates in. Since this is not necessarily the case, we can only claim that it gives competitive parity at best.
As corporate governance is yet to be conclusively linked to firm performance, we need to put its practice in perspective. Our expectations for boards of directors and other related governance mechanisms have to be moderated.
Regulators should be circumspect in dishing out new rules as knee-jerk reactions to the headline-grabbing scandal of the day. At the same time shareholders should be more engaged and involved in discerning the dealings of companies and not just rely on corporate governance as the fallback.
Management’s duty meanwhile is to fundamentally work towards increasing the value of the company beyond superficial adherence to processes and procedures. Boards likewise should work in partnership with management towards this shared goal.
The science of unraveling performance in corporate governance will continue. But like the search for the elusive Higgs Boson in particle physics, hopefully it will one day be found.