| With corporate
malfeasance scandals and regulatory responses in
Europe as well as the United States, we should be
learning from each others’ mistakes and sharing
perspectives on the optimal steps to restore confidence
in corporates and in markets. We must work together
to prevent mistrust from persisting and further
dragging down the economy.
So I very much hope that
this dialogue will prove beneficial, by helping
to prevent future such extraterritorial disputes
from arising and contributing to best practice in
the area of corporate governance.
My remarks draw upon my
public and private sector experience, as well as
my firm’s transatlantic pedigree. However,
I hope you will forgive the fact that I am the only
corporate speaker on today’s programme, and
so my remarks will focus more on representing the
corporate perspective on corporate governance. And
in doing so, I will not even try to suggest we should
have a one size fits all model. The legal and structural
differences between US and European corporate models
are just too big to attempt this. Still I find some
common pivotal elements where improvement is necessary
on both sides of the Atlantic.
We all know that good
corporate governance is fundamental for confidence
in the market economy. As Alex Schaub pointed out,
and unfortunately as recent experience shows, corporate
governance failures can have significant economic
consequences at macro and micro levels, for markets,
economic growth and individual firm business, for
investors, counterparties and consumers. Reputation
and market confidence are crucial components of
individual firms’ profitability and contribute
to our collective economic well being.
Enron, WorldCom, Parmalat,
Ahold, Adecco, Adelphia became household names uttered
with contempt, following corporate scandals that
resulted in massive lost shareholder value and trust.
At the time when owners’ trust has been challenged
by failures of the boards, executive management,
auditors, brokers and advisors, it is not surprising
that the symptoms of the malaise have been aggressively
adddressed by policy makers.
Irate shareholders empowered
politicians and the judiciary to take charge, producing
impressively comprehensive volumes of legislation
and regulation on both sides of the Atlantic.
But more recently, after
the wave of legislative, regulatory and investigative
activity, some have begun to question whether the
cure for corporate malfeasance could be more lethal
than the disease. So, where are we going? Are we
on the way to achieving our goal, restoring trust
and improving the health of the economy and the
welfare of economic actors?
Critics of the reforms
say:
1) legislation and regulation
has been to a great extent a purely emotional
and populist response that will only serve to
shift responsibilities and incentives from investors
to other parties, primarily companies and managers;
2) this legislation tries to cope with a wide
variety of misbehaviour (for example fraud, conflict
of interest, unanticipated and unintended accumulation
of risks) in response to the particularities of
the various successive scandals as they have emerged.
Such legislation cannot be other than patchy,
ineffective and badly conceived;
3) too much is being asked of the law, such as
defining an “independent” director;
4) it is proving too costly to implement relative
to what it stands to achieve;
the fragmented regulatory
approach to global companies is not enhancing, but
rather hampering international capital markets and
investor interests.
Advocates of strong reforms
say:
1) politicians’
response was not so much to the scandals as to
shareholder demand for greater oversight;
2) the new rules are not bad, and what new legislation
may have missed the Spitzers, Donaldsons of the
world are fixing in court and through new legislation.
3) the European Commission and their counterparts
in Europe together with US regulators have done
a good job at patching up differences.
4) compliance costs are negligible compared to
shareholders’ losses following the scandals,
and this would certainly occur again in the absence
of legislation;
5) so long as investor trust has not been restored,
a tough, legislative approach to the problems
is warranted and must continue.
Considering the regulators’
response to the scandals, and noting the growing
negative corporate “response to the response”,
which has been much debated in the press lately,
I would be interested for this audience’s
thoughts on whether or not we are entering a situation
of “excessive” regulation, where the
regulatory pendulum has swung too far.
The question is, to what
extent can the problems underlying these scandals
be “cured” via procedural means, rulemaking
and enforcement? The tendency to over regulate in
times of crisis is well established and much debated,
and while in present circumstances there wouldn't
have been any viable alternatives to regulation,
I argue that regulation in itself is not enough
when excessive can be counter productive.
Of course, much of the
US legislation is new, and in the EU the Corporate
Governance Action Plan is just beginning, so it
is admittedly a bit early to pass judgement. A full
evaluation will not be possible until after the
rules have been operative for a time and we have
a track record by which to measure them. But even
so, I believe that there is a basis on which we
can evaluate whether regulation is “excessive”,
in terms of whether it is achieving its objectives
of preventing fraud.
Jurisdictional
Clashes Are Costly
One thing that is absolutely clear, as evidenced
by the focus of this conference, is that the cost
of trans jurisdictional regulatory clashes is high.
In the US, the Sarbanes-Oxley Act was legislated
as a swift and prescriptive response to Enron and
WorldCom, and promptly raised thorny jurisdictional
questions. Differential rules may create conflict
of laws for firms operating across borders, establish
opportunities for regulatory arbitrage or create
level playing field issues where standards are tougher
in one jurisdiction than in another. At a minimum,
even where they don’t conflict, they create
additional and potentially unnecessary costs. Some
might argue that some regulatory competition may
be beneficial in eventually leading to best practice,
but surely the optimal way to achieve common best
practice is via regulatory dialogue, preferably
BEFORE anyone legislates.
We are learning from the
Sarbanes Oxley experience. Following concerns in
Europe and other jurisdictions regarding its extraterritorial
provisions, accommodations have been reached that
go a significant way toward addressing the issues.
In Europe a body similar
to the PCAOB will be established, and greater coordination
among audit supervisory bodies is being implemented.
The EU and US are converging on independent public
oversight, audit quality and assurance, auditors’
rotation and rules governing conflict of interest
for auditors (eg in supplying non-audit services).
And now we have theTransatlantic Corporate Governance
Dialogue. These are all welcome developments.
Implementation
is Costly…
As companies implement Sarbanes-Oxley, however,
its costs are only just becoming apparent. A recent
Goldman Sachs research report noted a number of
implications with market impact. The report stated
that while companies and auditing firms are keenly
focused on implementation of Sarbanes Oxley Section
404 (requiring a separate audit opinion), investors
have not yet contemplated the following potential
implications of the new audit requirements:
• asymmetric reactions
to audits (clean audits go unnoticed, but qualified
audits may be punished);
• implementation costs to companies;
• potential slowdown in acquisitions by
highly acquisitive companies until after their
audits;
• potential to drive foreign companies tapping
the US markets elsewhere; and
• less time for corporate managers and board
to focus on business strategy.
In addition, investors
will have difficulty knowing in advance whether
or not a company is on track for an unqualified
audit.
We have seen a slew of recent complaints by companies
in the press, such as:
• A January survey
by Ernst & Young indicated that some large
US companies expect to spend over 200,000 hours
on Section 404 implementation;
• GE noted a cost of $30 million to implement
Section 404 alone – this figure only includes
measurable, not incremental costs;
• NYSE Chairman John Thain suggesting that
the Sarbanes-Oxley Act’s provisions are
becoming a disincentive to non-US corporate listings,
especially from European companies, that the NYSE
is seeing a slowdown in growth of new listings
by foreign companies from an average of 50 per
year during 1996 – 2001 to 25 per year in
2002 and 2003, and only 1 European company listing
so far in 2004.
• He cautioned, “American standards
of corporate governance should not become the
enemy of economic performance” and warned
that regulatory burdens could harm US competitiveness
and capital markets;
• Assertions by buy-out fund The Blackstone
Group that many CEOs are contemplating taking
their companies private or curtailing their careers.
And this is only the US
regulatory impact. Corporate governance in Europe
has largely been based around various voluntary
codes, but this is now changing. With the EU Corporate
Governance Action Plan and its component rules just
taking shape, companies have not yet felt their
implications. European policy makers should watch
closely the impact of Sarbanes Oxley and other US
governance reforms and draw upon any mistakes and
best practices as the Action Plan moves forward.
With all the reputational
pressure, some companies are going beyond legal
requirements in corporate governance. Even private
companies that are technically outside some of the
requirements are being judged to the same standards
(example: independence of directors, Marshall Cogan
case), and investors and institutional lenders are
increasingly evaluating private companies along
the same lines as public companies.
But recent reports also
suggest that some public companies may be contemplating
going private – however, it is not clear that
this will significantly reduce their compliance
demands, given investor scrutiny and activism. And
is this a good development?
But Worth It?
The main measure of “excessive” regulation
should not be cost alone. We must consider to what
extent regulation is successful in achieving its
objectives: improving or removing corporate fraud.
If the regulations prevent fraud that would otherwise
have taken place, then one could persuasively argue
that they are not excessive.
Well, from past experience
one could conclude that it is unlikely that rules
can ever fully prevent fraud, although items such
as auditor rotation and disclosure can reduce its
potential or enable earlier identification.
I believe much of the
new conflict of interest regulation is being effective,
but not so much directly as indirectly. It is difficult
to conceive of all the possible crimes and address
all of them, but we have increased awareness of
conflicts and the importance of managing them. Bankers
and corporates are questioning themselves or being
questioned by investors about their policies and
behaviour in this regard, as never before.
Reputational risk plays
a critical self-policing role in financial institutions’
incentives toward doing the right thing. Current
FSA rules are principles based, helping to avoid
narrow, legalistic interpretations that could defeat
the rules’ purpose. In addition to providing
a context in which to analyze the detailed rules,
the principles themselves are rules and can form
the basis for disciplinary action, and it is this
interaction that makes them so effective
Coming back to the risks
of over prescription, in addition to the potential
costs already mentioned, there is the risk of getting
it wrong and incentivising the wrong behaviour,
inducing moral hazard.
The example of new attempts
to legislate the requirements to become a director
show how problematic this can be. In attempting
to prescribe the right characteristics of a director,
how would you legally define concepts like, “competent”.
If you devise a set of
parameters that are too narrow and set the bar at
a particular level, you risk reducing the talent
pool to the same group of individuals – when
it has long been recognised, in the Higgs Report
among other studies, that the existing pool is too
narrow, and too integrated as a network, with “friendly”
directors sitting on each others’ boards.
A MORI survey conducted for the Higgs Report showed
that nearly half the non-executive directors of
UK listed companies had been appointed through personal
contact with a board member, with only 4% going
through a formal interview process.
Onerous requirements and
liabilities for directors risk disincentivizing
many legitimate, qualified individuals from accepting
posts. A recent survey by Deloitte in Ireland, where
requirements are considered to be more onerous than
on average in the EU, showed that 63% of business
people are less likely to take up an offer to become
a non-executive director of a company than they
were five years ago, due to the increased level
of responsibility involved.
Attempts to regulate the
behaviour of boards as entities are also problematic.
Half of a board’s activities are hard objectives,
and regulations can be used to further harden them.
But half of what a board does is social interaction,
much softer, and not desirable to regulate or to
disincentivize.
High compliance costs
bring their own opportunity costs and disincentives
to business, but it seems to me that the biggest
downside risk is that over reliance on rules could
overload the system, result in more box ticking
than proper thinking about the issues, and impede
achievement of their underlying objectives. Rules
can invite compliance with their letter, rather
than their spirit. I believe a strain exists between
continuous demands for more prescriptive legislation,
and improving and enhancing self-regulation.
Comply or Explain
The real key to well functioning capital markets
is the “comply or explain” principle,
ie either compliance with agreed rules of behaviour
or explanations for non-compliance. It is worth
noting that financial legislation in most countries
has long been based around this idea of comply or
explain, which revolves around providing information
to investors, who then make up their minds on that
basis. The UK’s corporate governance codes
are also based on this principle.
But this principle can
break down in several situations:
1) First and most obviously,
fraud;
2) Second, lack of shareholder activism –
challenge and questioning is critical to make
the “explain” part of the equation
work;
When they comply or explain
principle does break down due to fraud, or if investors
are insufficiently active, then political pressures
mount to do something more prescriptive, and we
are bound to accept more regulation. In which case
because of regulation, we may deprive the system
of flexibility, and instead of comply or explain,
we end up with comply or nothing.
There is a strong argument for retaining the comply
or explain principle as the main basis for corporate
governance. I believe this is the fundamental point
without which no amount of legislation can be fully
effective. I maintain that if comply or explain
works, then further regulation is excessive, because
investors will have the necessary information on
which to base their decisions. But the real key
to the effectiveness of comply or explain is shareholder
activism. Parmalat shows clearly that comply or
explain breaks down if no one asks questions where
there is no compliance.
The amount of publicly
available information about Parmalat’s substantive
non-compliance was staggering. The Board was mostly
made up by friends of Mr Tanzi. The CFO chaired
the audit committee making a mock of any pretence
of independence. Research reports by major investment
banks – incidentally Goldman Sachs was the
only international bank that had nothing to do with
Parmalat – had been indicating for months
that there was something very wrong with the published
balance sheet showing cash assets for roughly $3
billion and about an equivalent short term liabilities
coming due in the next three years. A position that
could be explained for a hedge fund but not for
an industrial company. All of the research reported
noted this and other anomalies yet came out with
buy or hold recommendations. Even in this instance,
all of the information was in the market, but nobody,
not board members, not auditors, not shareholders,
not the creditor banks, not the rating agencies,
asked questions.
My view of where the dividing
line should appropriately fall is that legislation
and regulation should protect the interests of third
parties, ie shareholders and investors and prescribe
specific behaviours only where shareholders, investors
and creditors’ own due diligence cannot reach.Apart
from that, it should aim to increase corporate transparency
and to remove barriers to shareholder activism.
Therefore, I say yes to
prescriptive legislation in the area of conflict
of interest and yes to any form of legislation that
makes companies’ behaviour more readable to
outsiders (including accounting); but no to legislation
that prescribes in detail directors’ prerequisites,
compensation, etc.
Shareholder Activism
To enable comply or explain to work means that we
need a stronger culture of shareholder activism.
In our present situation, it is interesting that
concurrent with the legislative approach, we are
seeing a significant uptick in shareholder activism,
which is playing an increasingly important role
in governance issues in Europe, as well as in the
US.
Examples abound:
• Dutch pension
funds pressure led to changes at Ahold and Shell;
• In the US CalPERS and other public pension
funds have witheld votes for director appointments
and pressed for governance changes;
• France’s CDC (state owned bank managing
civil servants’ pension funds) announced
it will push for governance improvements in French
companies in which it invests, including independent
audit, nomination and remuneration committees
and separating the positions of chief executive
and chairman;
• Numerous disputes over golden parachutes
and executive pay packages (Glaxo SmithKline,
Tesco, Barclays, Reuters);
• Ouster or rejection of Chairman or CEO
appointments (Ian Prosser at Sainsbury’s,
Michael Green at ITV, Michael Ovitz at Disney).
Corporate governance organisations
are also increasing their influence and upping the
pressure for example, European Corporate Governance
Services and Institutional Shareholders Services
track 900 of Europe’s companies and rate companies
on governance. Also, the three major rating agencies
factor in governance (Standard & Poor’s,
Moody’s, and Fitch).
US and EU companies are
increasingly subject to legal action over governance
failures.
The Role
of Ethical Culture
In addition to creating the right shareholder culture
to encourage companies’ owners to properly
exercise their authority, I’d like to address
the importance of encouraging the right ethical
culture within firms, to underpin proper management,
director and officer behaviour within the company.
My starting point is that
for developing ethical culture, rules are insufficient
in themselves. They must be supplemented by firms’
self-motivation in promoting the right internal
best practices and ethical culture for their senior
executives, as well as for responsible internal
and external officers such as auditors. Ethical
culture, creating the right “tone at the top”
is vital – we can have the best rules in the
world on paper, but if they are not applied in the
right spirit, they will become worthless. I would
argue that one of the chief benefits of the crises
and debates is the work being done by firms on their
own initiative – including private firms that
are not subject to the rules.
Conclusion
In conclusion, there are 3 ingredients for a successful
financial services industry:
a. measured prescriptive
legislation of the type defined before. It may
well be that such measure could be achieved by
competition rather than by coordination. I prefer
the second to the first, but the first to excessive
prescription.
b. vibrant sharehold activism. Substantial barriers
in some parts of Europe to real shareholder activism
remain, and they will have to be removed.
c. creation and promotion of ethical culture by
all actors of the industry.
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