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The Growing Pains of Corporate Governance

February 11, 2016

What will corporate governance look like in 2040? Corporate governance, as most people know it, is just a generation old. Although the term existed it was rarely used until The Report of the Committee on the Financial Aspects of Corporate Governance. It was the response to the collapses of Coloroll and BCCI in 1990. Coloroll was a company that grew rapidly as an acquirer of other companies and using creating accounting to give the impression of healthy profit. BCCI (Bank of Credit and Commerce International) revealed massive losses following financial crimes. While the Committee was working, The Daily Mirror boss Robert Maxwell was found to have stolen from the pension fund and fruit trader turned conglomerate Polly Peck also collapsed in 1990 with debts of £1.3bn. These scandals caused considerable concern about the state of UK plc so the Cadbury Report in 1992 attracted much interest.

The Committee that gave birth to modern corporate governance was a voluntary initiative of great and good. Chaired by Sir Adrian Cadbury, then Chairman of Cadbury Schweppes, its members included representatives from the CBI, accounting firms, Bank of England, Hundred Group of Finance Directors, Financial Reporting Council, academia, ICAEW, Institutional Shareholders’ Committee, Law Society, London Stock Exchange and Institute of Directors. The most influential part of the report is the two page Code of Best Practice. The rest of it though is well worth reading and is as applicable today as it was in 1992.

Corporate Governance in the UK grew up influenced by further corporate problems and scandals. While still a toddler there were widespread concerns about executive pay, particularly in newly privatised companies such as British Gas. Another committee was formed chaired by Sir Richard Greenbury followed by another code of practice. The collapse of Barings Bank in 1995 renewed interest in a forgotten suggestion of the Cadbury report – that boards should review and report on the effectiveness of internal control. The result was the Turnbull Report containing guidance for directors on internal control and risk management. Corporate Governance was 9 years old when Enron failed. Enron was swiftly followed by a plethora of accounting and financial scandals in the USA, many of which were audited by Arthur Andersen. On mainland Europe there was an Italian accounting scandal involving Parmalat and a Dutch one with Ahold termed Europe’s Enron by the Economist. Had the UK approach to governance protected us from such scandals? Perhaps, but it did not protect us from a much bigger problem to come.

Corporate Governance was a teenager in 2007 when we first became aware of a Credit Crunch and achieved adulthood while we were still in the Global Financial Crisis. UK banks were very much involved and UK Corporate Governance was little help. Early reports into what went wrong did not see much problem with governance although that view subsequently changed as the nature of what was happening became clear. Even in 2008 though analysis of what happened at Enron and in banks such as Northern Rock and Bear Sterns showed many similarities. I wrote an article then about these similarities but, in 2008 and 2009, banks were very sensitive and vigorously defending their reputation; the magazine I wrote for would not publish it as lawyers advised it would be actionable to mention Enron and banks in the same article. The similarities I described included high gearing, a reliance on credit ratings, complex structures few understood, business models not understood by board members, off balance sheet entities, ultra high executive remuneration, conflicts of interest as well as accounting and auditing issues.

Now in its twenties, Corporate Governance has evolved and has enjoyed reviews and new editions of codes every two years or so over the last 10 years. But it still presides over an almost regular revelation of continuing problems of ethics, risk management and accounting.

So has Corporate Governance done any good? The answer must be ‘yes’ but surely we must be disappointed that Corporate Governance did not protected us better from scandal and economic failure. There are other problems which should be addressed. When failure happens our governance system seems to mean that no one is ever accountable. The chairman, CEO and all the other directors can claim either that they were ignorant of what was going on in their organisation or shelter under a collective protective board umbrella and say they did nothing wrong.

Short termism, despite much thought, is as intractable an issue as ever. The economy is driven increasingly by gyrating markets and attempts to control them by central banks. There is a marked reluctance by companies to invest in long term projects, except where backed in some way by government. This may be in large part the reason why the UK economy has gone ex growth and why there are few jobs for young people. Capitalism now seems driven by financial engineering rather than sound business principles.

Our accounting system does little to help. It gives little insight of the future value creating potential of companies and does a poor job in saying if value was created in the past. Profit is not the same as value and accounting profits can be made while destroying the potential to create value in the longer term. Accounting profits fail to distinguish between profits which contribute something useful to the world or profit derived from economic rent which merely appropriates value created others. Our accounting system also has a problem with accuracy. Company financial statements show figures to four significant figures yet some of these figures may be little better than guesses and are known with a confidence of + or – 10%. Company reports convey very little about the inherent uncertainty in many of the figures reported. I helped Z/Yen write a proposal on Confidence Accounting to address this problem.

How then might governance evolve? To date Corporate Governance seems to have taken something of a scientific management or machine view of people that expects them to behave rationally. If something goes wrong, the response is to tweak a code and introduce new requirements or piece of regulation.

It has been over simplistic. People are complex and work in complex systems. Corporate Governance should acknowledge this. All the scandals that influenced Corporate Governance as it grew up involved people. People who should have known better, better either as in better informed or better as in more moral. Sometimes people did know better but did not act on what they knew. They felt inhibited for some reason from acting or were motivated not to act. As governance evolves it should take this complexity, and human nature, into account.

There are some promising signs. There is much greater interest now in corporate culture, in business models and in reporting on value creation. Let’s hope that these initiatives will bring about real improvement in how organisations are directed and controlled. But perhaps the biggest change needed would be to recognise what Corporate Governance is for. It should not be to comply with a code, or provide a means of defence when things go wrong. Its purpose should be to help ensure that companies crate sustainable value. It should be judged on the extent to which it is doing that.

Over the next few weeks, SAMI will publish a series of blogs under the theme ‘future of governance’ which will explore these and other aspects of governance.

Paul Moxey, SAMI Fellow.

The views expressed are those of the author and not necessarily of SAMI Consulting.

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