Corporate Governance Standards
There are no universally agreed-upon standards that determine good governance. Still, this has not stopped blue-ribbon panels from recommending uniform standards to market participants. For example, in December 1992, the Cadbury Committee—commissioned by the accountancy profession and London Stock Exchange “to help raise the standards of corporate governance and the level of confidence in financial reporting and auditing”—issued a Code of Best Practices that, in many ways, provided a benchmark set of recommendations on governance.26 Key recommendations included separating the chairman of the board and chief executive officer titles, appointing independent directors, reducing conflicts of interest at the board level because of business or other relationships, convening an independent audit committee, and reviewing the effectiveness of the company’s internal controls. These standards set the basis for listing requirements on the London Stock Exchange and were largely adopted by the New York Stock Exchange (NYSE). However, compliance with these standards has not always translated into effective governance. For example, Enron was compliant with NYSE requirements, including requirements to have a majority of independent directors and fully independent audit and compensation committees, yet it still failed along many legal and ethical dimensions.
Over time, a series of formal regulations and informal guidelines has been proposed to address perceived shortcomings in governance systems as they are exposed. One of the most important pieces of formal legislation relating to governance is the Sarbanes–Oxley Act of 2002 (SOX). Primarily a reaction to the failures of Enron and others, SOX mandated a series of requirements to improve corporate controls and reduce conflicts of interest. Importantly, CEOs and CFOs found to have made material misrepresentations in the financial statements are now subject to criminal penalties. Despite these efforts, corporate failures stemming from deficient governance systems continue. In 2005, Refco, a large U.S.-based foreign exchange and commodity broker, filed for bankruptcy after revealing that it had hidden $430 million in loans made to its CEO.27 The disclosure came just two months after the firm raised $583 million in an initial public offering. That same year, mortgage guarantor Fannie Mae announced that it had overstated earnings by $6.3 billion because it had misapplied more than 20 accounting standards relating to loans, investment securities, and derivatives. Insufficient capital levels eventually led the company to seek conservatorship by the U.S. government.28
In 2009, Sen. Charles Schumer of New York proposed additional federal legislation to stem the tide of governance collapses. Known as the Shareholder’s Bill of Rights, the proposal stipulated that companies adopt procedural changes designed to give shareholders greater influence over director elections and executive compensation. Requirements included a shift toward annual elections for all directors (thereby disallowing staggered or classified boards), a standard of majority voting for director elections (instead of plurality voting) in which directors in uncontested elections must resign if they do not receive a majority vote, the right for certain institutional shareholders to directly nominate board candidates on the company proxy (proxy access), the separation of the chairman and CEO roles, and the right for shareholders to have an advisory vote on executive compensation (say-on-pay). The 2010 Dodd–Frank Wall Street Reform and Consumer Protection Act subsequently adopted several of these recommendations, including say-on-pay. The interesting question is whether this legislation was a product of political expediency or based on rigorous theory and empirical research.29
Several third-party organizations, such as GMI Ratings and Institutional Shareholder Services (ISS), attempt to protect investors from inadequate corporate governance by publishing governance ratings on individual companies. These rating agencies use alphanumeric or numeric systems that rank companies according to a set of criteria that they believe measure governance effectiveness. Companies with high ratings are considered less risky and most likely to grow shareholder value. Companies with low ratings are considered more risky and have the highest potential for failure or fraud. However, the accuracy and predictive power of these ratings have not been demonstrated. Critics allege that ratings encourage a “check-the-box” approach to governance that overlooks important context. The potential shortcomings of these ratings were spotlighted in the case of HealthSouth. Before evidence of earnings manipulation was brought to light, the company had an ISS rating that placed it in the top 35 percent of Standard & Poor’s 500 companies and the top 8 percent of its industry peers.30
Changes in the business environment further complicate attempts to identify uniform standards of governance. Some recent trends include the increased prominence of activist investors, private equity firms, and proxy advisory firms in the governance space:
- Activist investors—Institutional investors, hedge funds, and pension funds have become considerably more active in attempting to influence management and the board through public campaigns and the annual proxy voting process. Are the interests of these parties consistent with those of individual shareholders? Does public debate between these parties reflect a movement toward improved dialogue about corporate objectives and strategy? Or does it constitute an unnecessary intrusion by activists who have their own self-interested agendas?
- Private equity firms—Private equity firms implement governance systems that are considerably different from those at most public companies. Publicly owned companies must demonstrate independence at the board level, but private equity–owned companies operate with very low levels of independence (almost everyone on the board has a relationship to the company and has a vested interest in its operations). Private equity companies also offer extremely high compensation to senior executives, a practice that is criticized among public companies but that is strictly tied to the creation of economic value. Should public companies adopt certain aspects from the private equity model of governance? Would this produce more or less shareholder value?
- Proxy advisory firms—Recent SEC rules require that mutual funds disclose how they vote their annual proxies.31 These rules have coincided with increased media attention on the voting process, which was previously considered a formality of little interest. Has the disclosure of voting improved corporate governance? At the same time, these rules have stimulated demand for commercial firms—such as ISS and Glass Lewis—to provide recommendations on how to vote on proxy proposals. What is the impact of shareholders relying on third parties to inform their voting decisions? Are the recommendations of these firms consistent with good governance?32