Limits to governance; corporate reforms often have unintended consequences By Ed Waitzer and Marshall Cohen One cumulative impact of governance failures (in both the private and public sectors) has been a massive loss of trust in leadership. Demand for more government (and consequen- tial regulation) is re-emerging, although what this is to do is less clear. The continuing focus on the use of regulatory instruments to curb executive compensation may be instructive and illustrative of a broader problem: unrealistic expectations, both about corporate gover- nance and, as importantly, efforts to effectively regulate it. In recently announcing a new review into how to foster a long-term focus for corporate Britain, the U.K. Business Secretary noted that the remuneration of the FTSE 100 CEOs had risen on average 15% a year between 1999 and 2008, while the FTSE 100 index had fallen 3% and average earnings growth had been 4%. A universal regulatory response, including a recently announced initiative of the Cana- dian Securities Administrators, is to require more disclosure on executive pay. Regulated disclosure of executive compensation has consistently served to ratchet up pay levels. Few boards think their CEO shouldn't be in the top quartile of compensation rankings. The problems are almost always elsewhere. In a recent PWC survey of U.S. corporate direc- tors, 83% thought their board's compensation committee was effectively managing CEO compensation, while 58% thought boards, generally, were having trouble controlling CEO compensation (and another 8% were unsure). Likewise, the shift in compensation from salary to stock options was dramatically accel- erated by changes to U.S. tax laws designed to curb excessive employee remuneration. In hindsight, the flaws in this result-encouraging excessive risk-taking and short-term focus - have become painfully obvious. While it may be counterintuitive, the rise of boards composed primarily of 'independent' directors - encouraged or mandated by regulation may have also contributed to the explosion in executive compensation. Typically, such directors have less intimate knowl- edge of a corporation's affairs and tend to be more focused on their monitoring role. The resultant power vacuum in widely held corporations (i.e., where there is no controlling shareholder) has tended to shift authority to the CEO (who generally controls information flow). Directors often feel that they are hostage to their CEOS-replacing one is disruptive and the costs are high. A recent study by three University of Southern California professors goes one step fur- ther, finding that strongly independent directors (and powerful institutional shareholders) had a negative impact on the performance of a sample of 296 of the world's largest banks, brokerages and insurance companies (125 of them U.S.-based and all with assets of more than US$10-billion) during the 2007-08 financial crises. Other efforts to strengthen boards - directors with financial expertise, risk committees or the separation of CEO and chair functions-didn't appear to help. Less surprisingly, another recent study confirmed that as the proportion of 'independent' directors who joined a board after the CEO assumed office increases, board monitoring decreases and CEO pay level increases, as does firm risk. Board independence and otherwise trying to regulate executive compensation are just two of many examples where regulatory instruments dictating governance structures have often failed to achieve intended results and have led to unintended consequences. Con- sider, for example, the demand for audit and credit-rating services, largely driven by regu- latory requirements. Aside from being a huge revenue generator for the service providers, one obvious problem is the resultant lack of market discipline on quality (and on conflicts of interest). Similar demand is now emerging for the regulation of proxy advisory services as a regulatory-driven shift from director to more shareholder-centric governance models increases the complexity of shareholder voting decisions. This is not to suggest that regulation and resulting governance structures are unimportant. It is striking, however, how public distrust in corporate governance continues to escalate in the face of enormous investments made to better regulate through mandated structures and processes. Not surprisingly, many directors feel frustrated and increasingly less certain as to their role and how they might make a difference. One difficulty with trying to regulate conduct based on the assumption that actors are purely self-interested is that precisely such behaviour will be reinforced. Building layers of governance mechanisms in the hope of channelling behaviour often serves to frustrate meaningful stewardship on the part of corporate directors and management. Regulation of compensation, independence or other structural requirements will never be the answer, in isolation. It has become almost a matter of conventional wisdom to observe that the lesson to be learned from the collapse of our 'efficient' financial markets paradigm is the need to focus on long-term, sustainable value creation. Simplistic notions of short-term market perfor- mance and regulatory imposed 'better' behaviour will not work. What remains elusive is the prescription to accomplish this end. Perhaps we must look deeper into the DNA of the corporate model to understand and affirm its role in creating long-term value for individuals, firms, shareholders and commu- nities. For example, we need to understand better the role of culture, character and reputation -on management, on the board, on the institutional owner community - in defining and implementing a meaningful sense of 'ownership' and responsibility. Perhaps we have to chal- lenge the structural paradigm itself, if we are to achieve meaningful and permanent change. Asking deeper questions must come first. Doing so is essential if we are to find effective answers and thereby restore public trust. Source: Excerpts from Ed Waitzer & Marshall Cohen, 'Limits to governance; Corporate reforms often have unintended consequences', Financial Post.61 Questions 1. This article discusses the increased use of regulation in corporate governance issues arguing that this may produce 'unintended consequences'. Can you identify any unintended consequences that could occur? KAS 2. The focus of reforms on the need for sufficient independent directors is discussed in this article. What is the underlying rationale for inclusion of independent directors? Should independence override concerns of competence and expertise? JK