Principles, precedents, rules and etiquette governing the running of tea parties

GOVERNANCE - The control and regulation of companies.

The Drivers of Corporate Governance

The contemporary focus on corporate governance reached its peak during the scandals of Enron, Tyco and Worldcom - all apparently the result of rogue top managers who cared only for their own enrichment and not a jot for the interests of investors or anyone else. These outrages are assumed to be a consequence of the separation of the functions of financial ownership and management and a lack of proper scrutiny and control by the owners of companies - their shareholders. Thus a stringent set of rules needed to be created to control the actions of self-interested, potentially dishonest managers. The response in the US has been the Sarbanes-Oxley Act, currently the subject of much critical comment for being a massive sledgehammer to crack a medium-sized nut.
The assumptions which have essentially driven the actions of the regulatory authorities are underpinned by some deep beliefs about the values and conduct of people in their economic lives - that given the chance they will be self-interested and probably dishonest.
It is commonly the case, in our view, that individuals involved in corporate governance apply what they believe is common sense, when in reality they draw sub-consciously on long-established economic theory and assumptions that are challengeable. Probably the most influential one in this context is Agency Theory, which has helped to shape recent codes of practice in governance.

Agency Theory

The debate about corporate governance is typically traced way back to the early 1930s and the publication of Berle and Means 'The Modern Corporation and Private Property'. Adolf Berle and Gardiner Means noted that with the separation of ownership and control, and the wide dispersion of ownership, there was effectively no check upon the executive autonomy of corporate managers. In the 1970s these ideas were further refined in what has come to be known as Agency Theory. In a series of now classic articles writers such as Jenesen and Meckling, Fama, and Alchian and Demsetz offered a variety of explanations of the dilemmas faced by the 'principal' who employs an 'agent' to act on his or her behalf. As applied to corporate governance the theory suggests a fundamental problem for absent or distant owners/shareholders who employ professional executives to act on their behalf. The root assumption informing this theory is that the agent is likely to be self-interested and opportunistic. (The assumption of owner/shareholder property rights obviates any need to think about the principal's motives.) This raises the prospect that the executive, as agent, will serve their own interests rather than those of the owner principal. To counter such problems the principal will have to incur 'agency costs'; costs that arise from the necessity of creating incentives that align the interests of the executive with those of the shareholder, and costs incurred by the necessity of monitoring executive conduct to prevent the abuse of owner interests.

Agency theorists take self-interested opportunism as a given. They feel no need to explore the attitudes, conduct and relationships that actually create corporate effectiveness. Instead they have busied themselves with exploring the effectiveness of the various mechanisms designed to make executive self-interest serve shareholder interests. To date such studies have proved entirely equivocal in terms of the relationship between good governance and company performance. Agency theory assumptions have nevertheless been highly influential is shaping the reform of corporate governance systems. Here it is essential to distinguish between external, market-based governance mechanisms and board-based mechanisms.

Externally imposed control - market governance

In relation to market governance then clearly the openness and integrity of financial disclosures is vital to the operation of the stock market in determining a company's share-price and its underlying market valuation. Market governance relies for its effectiveness on the remote visibility such financial information creates, and, as importantly, on the effects on the executive mind of the knowledge of such visibility. Agency theorists point to the important disciplinary effects of two further market mechanisms. The first is the 'market for corporate control', the potential for takeovers to discipline executives by providing a mechanism whereby ineffective executive teams can be displaced by more effective executive teams. The second - 'the managerial labour market' - operates at an individual level; poor executive performance will threaten an individual's future employment potential whilst good performance will have career-enhancing effects.

To these external 'market' mechanisms must be added the disciplinary effects on company and executive performance of external monitoring, both direct and indirect. Formally, it is the Annual General Meeting provides an opportunity for directors to report face-to-face to their shareholders. In practice, however, the formal accountability of the AGM has been augmented and diverted by a variety of other mechanisms. At the time of results announcements, companies will typically conduct presentations for sell-side analysts who then serve as key intermediaries between companies and their investors. These general briefings are then supplemented by a large number of (typically annual) private face-to-face meetings between executives and their key investors.

Internally imposed governance - the role of non-executive directors

In addition to these external market and monitoring mechanisms, agency theory has also informed the internal reform of boards of directors. One of its most significant direct contributions came in the form of the widespread adoption of executive share-option schemes, which are only very recently falling into disrepute in the UK. Such schemes follow directly from the agency assumption that the exercise of executive self-interest must be aligned with the interests of shareholders. Less directly, the influence of agency theory assumptions can be seen in the seminal reforms promoted by the Cadbury Committee 'Code of Best Practice', and its subsequent elaboration by Greenbury, Hampel, Turnbull and most recently Derek Higgs, finally being consolidated in the compendious Combined Code of Corporate Governance.
With the possible exception of Turnbull, the work of these different committees was occasioned by visible corporate failures or perceived executive abuses of power, and has resulted in a progressive elaboration of the 'control' role of the board. The 'independence' of the non-executives directors who must now constitute 50 per cent of the board, their lead role on audit, nominations and remuneration committees where conflicts of interest between executive and shareholder are potentially most acute, along with progressively more stringent provisions around the separation of the roles of chairman and chief executive, are all consonant with agency theory's assumption that the interests of the owner/ shareholder are potentially at risk from executive self-interest, in the absence of close monitoring by independent non-executives.
As a footnote, research by Booz, Allen and Hamilton* in the US seems to undermine the current obsession with probity and control of directors. Their research indicates that, despite Enron and all the other scandals, over 80% of all value destruction by US companies comes not from dishonesty, but strategic incompetence, poor corporate decisions and execution of those decisions.
In the UK, where there have been few examples of gross misconduct, there has nevertheless been vast industrial destruction caused by misconceived and incompetent strategic leadership, such as in the cases of Marconi, Rentokil and Invensys.

*It's Time to Take your SOX off. Booz/Allen/Hamilton, 2006