Enron, WorldCom, Global Crossing, Tyco are more than just the names of 2002. They are names that have started a massive reform into the way companies are managed and regulated around the world. Jamie Heard discusses global corporate governance reformIn response to the most serious corporate scandals since the Great Depression, governments, regulators and stock markets around the world have taken important steps to remedy major weaknesses in systems of corporate governance. The reforms are impressive but insufficient. Now, with attention on the issue fading as terrorism and weapons of mass destruction grab the headlines, there is a danger that the agenda of corporate reform will remain unfinished.
To create sound governance systems, there needs to be further action. Some of it can be voluntary, while some must be regulatory. To do less, to remain content with the reforms adopted to date, would be to leave in place the fundamental flaws that precipitated, or at least failed to prevent, the corporate implosions that have wiped out trillions of dollars in shareholder wealth.
There are five key reforms that I believe must be enacted in markets and jurisdictions around the world.
1 Encourage institutional investors to act like owners
Notwithstanding the reforms, a glaring weakness still stands out in the shape of owners who fail to act like owners. Pension funds, fund managers, mutual funds, and other institutional investors have fallen short in their oversight of corporate management. This is oversight that their fiduciary duties demand and that the public rightfully expects.
To be sure, some institutional investors deserve credit for their active engagement. But they are the exceptions, and the stakes are huge. Institutions own more than 50% of the publicly traded equity in many markets. They serve as fiduciaries for tens of millions of investors. They have an essential role to play in holding corporate management and boards accountable on a range of corporate governance issues, from board independence to executive pay.
Portfolio managers tend to take an admirably hard-nosed approach. The name of their game is to beat their benchmark, whether it is the FTSE, Nikkei, S&P 500, or a peer index. Clearly, portfolios will have a far greater chance of beating those benchmarks if they steer clear of companies that have poor corporate governance and implode. Increasingly, investment managers are beginning to recognise this. They are starting to include corporate governance factors in their research and decision making. When this practice becomes mainstream, the resulting market discipline will provide a compelling solution to many of today's corporate governance challenges.
Such market solutions should be coupled with regulatory oversight. In the US, the Securities and Exchange Commission's recent decision to require mutual funds to disclose their proxy-voting policies as well as their actual votes is a step in the right direction. This SEC ruling holds great significance, because mutual funds control nearly 20% of US equities. Equally important, the ruling sends powerful signals to institutional investors to think and act like long-term owners. Regulatory agencies in other markets need to adopt a similar approach to ensure that all institutional investors acting as fiduciaries discharge their ownership responsibilities.
2 Separate the offices of chairman and CEO
Independent boards stand at the heart of efforts to improve corporate governance. Yet the domination of boards by all-powerful chief executives remains common and, as such, represents one of the greatest obstacles to sound corporate governance. There is a clear solution: let someone other than the CEO chair the board.
Two prestigious reports recently issued on either side of the Atlantic lend their weight to the separation of the two positions. In the UK, the Higgs Review, a post-Enron analysis of the strengths and weaknesses of British corporate governance, strongly endorses the separation of the chairman and CEO positions, which has been the common practice in the U.K. for more than a decade. In the US, a Conference Board commission, co-chaired by newly appointed Treasury Secretary John Snow and former Commerce Secretary Peter Peterson, urged corporations to give careful consideration to separating the two offices.
3 Require public companies to rotate audit firms
The conflict between auditing and consulting unquestionably contributed to the failure of major accounting firms to provide independent and truthful audits. We can solve this dilemma by requiring mandatory rotation of audit firms and by prohibiting the termination of auditors' contracts for reasons other than cause.
In the US, new laws and regulations have been developed and applied to this important area. The Sarbanes-Oxley Act bans some types of consulting and requires that the audit committee approve others. In another move to strengthen auditor independence, the audit committee and not management now has the responsibility to retain auditors.
In late January, the SEC approved a new rule requiring rotation of the lead and concurring audit partners after five years, but not of the firms themselves. Despite these improvements, conflicts of interest remain. Even without consulting, auditors feel pressures to please audit committees and management to retain the client. The new Public Company Accounting Oversight Board has the power to require fixed terms and mandatory rotation and should, therefore, make mandatory auditor rotation a high priority.
4 Put an end to excessive compensation
Excessive compensation, particularly in the face of poor performance, feeds public distrust, while providing strong evidence that many boards are failing in their most basic task of evaluating the CEO. During the bull market of the 1990s, lavish bonuses and mega-grants of stock options became the norm, regardless of performance. Even when a poorly performing CEO was ousted, it became common practice to award a multi-million dollar severance package.
To fix the problem, compensation committees need stiffer backbones. They also need their own consultants – independent experts who work for them, not the CEO.
Investors, meanwhile, need enhanced rights to approve stock options. The NYSE has proposed standards to require shareholder approval of all option plans and material amendments, including option repricing, and to ban uninstructed broker votes on compensation plans. Nasdaq has proposed much weaker standards.
But no change will be more important than expensing stock options. The failure to account properly for the costs of options lies at the root of many compensation abuses.
Some companies are beginning to do this voluntarily, responding to strong sentiment among investors. Most companies, however, are rather less enthusiastic. The debate promises to spill over into annual shareholder meetings in this year's proxy season, with an increasing number of shareholder resolutions put forward on option expensing.
5 Permit shareholder nominees in proxy statements
One of the great disconnections in the system of corporate governance is that shareholders have little if any real say in the selection of directors, whose function is to represent them. Management and the board control the entire selection process, except in the rare instance of a proxy contest to elect an alternative slate – a proposition so expensive that it takes place only a few dozen times a year.
It is time to change this process and give shareholders access to the proxy statement for the purpose of nominating director candidates. There are some practical obstacles, but they can be overcome. The alternative – keeping the current system of excluding shareholders from the nominations process – defies justification.
Old ceiling, new floor
Across the globe there has been considerable progress in introducing a host of long overdue corporate governance reforms. The old ceiling has become the new floor. To assure a firm foundation, though, we cannot stop there. We must press forward with reforms to complete the task.
Jamie Heard is CEO, Institutional Shareholder Services.
TREASURERS' REACTION TO HIGGS
Richard Raeburn, chief executive of the UK Association of Corporate Treasurers, said that treasurers particularly welcome the Higgs emphasis on independence, and the report's central tenet that a majority of the board should be independent. "Our response to the Higgs consultation document called for the most stringent reform of corporate governance since Cadbury, and Higgs has not disappointed. Now is the time for all those with the professional expertise on which NEDs rely to come forward with their own proposals to make the Higgs recommendations work.
"In the vital area of risk management NEDs can only be as effective as their experience, background and the information available to them allows. The ability to exercise judgment about the adequacy and robustness of a company's overall risk management is at the centre of the role of NEDs. They must be able to assess the overall risk in the company and ensure it is fairly dealt with in communications."
