Criticism of corporate governance has become common in recent months. As fundamental financial paradigms begin to shift, Fiona Rintoul asks whether we need to reconfigure the system...
“The financial crisis can be to an important extent attributed to failures and weaknesses in corporate governance arrangements,” says senior economist Grant Kirkpatrick in a new OECD report. “When they were put to the test, corporate governance routines did not serve their purpose to safeguard against excessive risk taking in a number of financial services companies.”
Do we need a new corporate governance model, then? Or can the existing model be tinkered with and made, to use the phrase du jour, fit for purpose?
The OECD plans to recommend improvements in priority areas, such as board practices, implementation of risk-management, governance of the remuneration process and the exercise of shareholder rights. There has also been much growling from the UK’s Financial Services Authority (FSA). Perhaps we should be afraid.
“Corporate governance has failed, though not in the way people were expecting or watching out for,” says Hugo Young, managing director at Aberdeen Asset Management Asia. “I don't think in more restricted conventional terms that corporate governance failed or that the model needs changing. We just need more people with common sense. It was, one must remember, collective hysteria for which politicians and regulators should take their share of the blame. Asian countries with similar corporate governance codes did not fail.”
Increasingly, blame is also being directed at institutional shareholders. Paul Myners, Britain’s financial services secretary to the Treasury, has said: “Institutional shareholders need to ask themselves: were they appropriately engaged in asking questions about the risk appetite of our banks? Were they asking sufficient questions about competency of directors and appropriately engaged in examining and approving compensation cultures?”
Ismail Erturk, a professor at Manchester Business School Worldwide, also suggests that institutional investors, by which he means primarily fund managers and pension funds, have failed to discharge their corporate governance-related obligations. “Although corporate governance reforms gave them [institutional investors] the power to question pay and ask difficult questions, they tended not to exercise those rights,” he says.
Erturk has coauthored a paper, Corporate Governance and Impossibilism, which suggests that “governance misrecognises the mechanisms around value creation in giant public companies because it is shareholders more so than managers who create value in a stock market that operates as a kind of Ponzi scheme”. But more corporate governance reform is not the answer, he feels. “There was a lot of effort with Sarbanes-Oxley, but it didn’t stop bankers getting paid high salaries and wrecking institutions with a high cost to society,” he says.
Upfront fees & bonuses
So what is the answer? One strand to it, believes Erturk, is to change the remuneration structure for fund managers so that they are encouraged to engage more with companies. “Fund managers don’t have anything to lose because they get their fees upfront,” he says. “They are not punished if they make bad investment decisions on the part of shareholders. Today there is a big debate about bank bonuses, but similar concerns are not raised about fund managers.”
But it’s not just a question of fees, suggests Philippe Carrel, vice president of enterprise risk at Thomson Reuters. It’s also about what is expected of fund managers. “Corporate governance was respected, which means that fund managers are bound by a very precise description of their investment strategy and they do comply with that,” he says. “They fill in compliance sheets every week, but this doesn’t bring the expected benefit to investors and society.”
Paul Abberley, chief executive of Aviva Investors, London, agrees that fund managers need to do more when it comes to corporate governance. “Corporate governance needs to develop beyond looking at simple structures,” he says. “We need to be more inquisitive about how the structures work in practice. A more inquiring mind is required when we look at the companies in which we invest. We need to be more challenging about strategies.”
It’s easy to say, but harder to do. Engagement costs money and while a large firm such as Aviva Investors can have a department dedicated to the task, that isn’t possible for smaller outfits. And what about companies that only have small shareholdings? Or hedge funds, which in many cases are betting against a company doing well? No one, presumably, would suggest that they should engage with a company to make sure it fails thereby benefiting their investors.
There are other issues too. Portfolio managers are good at managing portfolios and may know little about, say, steel manufacturing. When does engagement become interference? And when does it cross the line into insider trading? Fund managers also need to stay the right side of general rules regarding collusion, notes Abberley. “At what point does sensible cooperation with other shareholders become a conspiracy?” he asks.
Beyond corporate governance
Perhaps the truth is that the changes that need be made in the wake of the global financial crisis go a little bit beyond corporate governance. Carrel suggests that if risk management were implemented as a corporate culture, then the crisis would be over.
“That requires a corporate culture that involves everyone,” he says. “Risk management should not be the task of the risk management group or a bunch of quants. It means going back to shareholders and asking them what their risk appetite is, then turning that into risk policies with risk targets that are measurable and achievable by everyone.”
‘Capitalism isn’t working’ was a favourite slogan during the G20 protests in London this month and Erturk suggests that the protesters were, in a sense, right.
“Everything in the corporate world is based on the shareholder-value principle,” he says. “What the experience of the last 20 years has shown is that the shareholder-value principle is not achievable. People look at these things as technical issues, but they are more than technical. We need to ask if shareholder value is what we should be looking at.”
Perhaps we should be looking at the social role of companies, suggests Erturk. And then there are the forgotten shareholders: the workers.
“I recognise the relevance of the question,” says Abberley. “In many cases where firms have collapsed employees have been encouraged to put money into stock and in many ways they have come out worse.”
Out for debate
There are, he says, the first signs of a debate around shareholder value and what it means. There’s a change in sentiment in terms of how the interests of employees are considered, how they fit into the company’s strategy and how they are consulted.
So what of the future? Carrel is encouraged by the FSA’s recent Turner Review, which suggested that international cooperation needs to run in parallel with national action.
“Everyone has agreed to say that there has to be a global solution, but I don’t see how there can be one because we don’t have political unity,” he says. “I feel more confident if someone enlightened like the FSA hands on an approach, if someone can just naturally lead.”
But even if appropriate action is taken both he and Erturk see trouble ahead because there is a mismatch between our expectations and what is possible in terms of returns – a mismatch that may have caused the crisis in the first place. “There is a paradigm from the 1950s that over the long term you could not lose,” says Carrel. “This was a big institutionalised lie to the crowds.”
Carrel predicts deglobalisation in asset management and a return to simple investments as investors take fright, particularly post-Madoff. Erturk, meanwhile, says we need new minds, new ideas and alternative ways of running finance – perhaps a new banking system where banks are seen as utilities – that will tie in with attempts to solve the other great problem of our time: climate change.
“We need to look at what is achievable in terms of long-term returns,” he says. “We need to base pensions on stable long-term returns. The sub-prime mortgage crisis occurred because pension funds didn’t have enough shares to invest in, so sub-prime was offered to pension funds as an investment. We need to look at that balance. We need to redesign the banking system.”
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