Governance: Springboard or constraint

Looking at the myriad of new regulations and requirements, and the responsibilities that go with them, it is easy to understand why many directors feel like they spend all their time dealing with compliance, particularly at committee level. Traditionally the board’s role was to provide strategic oversight and assessment. At many firms this is no longer the case.
 
There is a growing school of thought that suggests increased compliance duties of boards could be damaging the long-term efficiency and profitability of corporate America. While this may well be the case, many of those proposing the theory also believe that, as companies become more accustomed to the new regulatory regime, the effect might be reduced. 

‘Perhaps the biggest change in corporate governance is the extent to which people are observing it,’ comments Robert Lamm, managing director and associate general counsel of Financial Guaranty Insurance Company (FGIC). ‘The second very significant factor is the extent of regulation, and obviously Sarbanes-Oxley is a significant part of that. If there’s paranoia in the boardroom, it’s justified – people are really watching what boards do.’ 

Lamm is, of course, referring to the landmark regulatory and stock exchange requirements imposed after corporate governance went awry, and the colossal corporate meltdowns occurred. Few would challenge the basic premise that good governance makes for good companies. Nevertheless, there is healthy discussion that, in some respects, the new ‘culture of compliance’ may have caused the pendulum to swing a little too far the other way. With everyone looking over boards’ shoulders, have other governance considerations such as corporate strategy, growth and shareholder value been set aside – at least temporarily?
 
‘Most of the influences have been positive,’ observes Lamm. ‘All the concentration on corporate governance at institutions from the rulemakers has certainly caused boards to focus on what their job really is.’ 

At the same time, though, Lamm expresses some concern about all the box checking he has observed. ‘The SEC rules adopted under Sox require boards in certain committees to do certain things, so [boards] have to pay attention to that,’ he points out. ‘But I fear that, sometimes, when they finish that box-ticking exercise, there’s not a great deal of time left over for things like strategy and overall direction and growth.’ 

One governance observer believes many companies need to advance beyond compliance basics to higher levels of governance. ‘Overall the focus of corporate governance should be the oversight of the capital entrusted to the enterprise, as a fiduciary duty to the shareholders, and the growth and sustainability of the business and its ability to create value,’ says Mark Van Clieaf, managing director of MVC Associates International, consultants in organizational design, leadership and shareholder value. 

Not enough time

‘All of this compliance has been very time-consuming,’ reports Ann Mulé, chief governance officer, assistant general counsel and corporate secretary at Sunoco, a leading manufacturer and marketer of petroleum and petrochemical products. Even though her company has been proactive in governance for many years, Mulé says her work ballooned at the outset of the new rules. ‘It certainly has taken a fair amount of board and board committee time to sort of work through these compliance issues,’ she says. ‘Obviously, that’s taken some time away from the focus on strategy and all the other good things the board should be focusing on.’ 

But Mulé adds that this is to be expected. ‘Obviously the first year or two of a new regulation or compliance takes more of the directors’ time,’ she points out. Once directors are educated about and comfortable with the new processes, she expects compliance will ‘take a lot less time at board level.’

Mulé also says ‘one huge positive’ already evident is that her board, which has always comprised ‘very engaged directors’, has become even more engaged with an ‘even sharper focus’ on doing the right thing. ‘It took us much less time on the compliance side than it might have taken in another company where governance wasn’t already part of the culture,’ she reflects. 

Katherine Combs, vice president, corporate secretary and deputy general counsel at Exelon Corporation, one of the largest US electricity suppliers, agrees. ‘Our company has been a student of corporate governance since its inception,’ she notes. ‘As corporate secretary, part of my job has always been to monitor corporate governance trends and make sure our company is keeping up with the best in corporate governance practices. Because of this, Sox changes have not had as dramatic an impact on our corporate operations as they might have had at other companies. 

‘The new regulations have not diverted the company’s attention from corporate strategy, on which we have monthly reports to the board. We have a management strategy and policy committee that meets regularly [to look] into issues of strategic importance. We have an annual board retreat that takes the results of the work of the strategy and policy committee and looks in depth at corporate strategy and where the company is going or should be going. The board has very considerable impact on the strategic direction the company takes.’ 

Disproportionate impact

While the implementation costs of Sox are enormous, larger companies may have greater flexibility to allocate staff and resources, and still keep corporate governance on track. Small companies, especially, are feeling the brunt. 

‘I would say there is a fair number of companies that either cannot – as a result of limited resources, personnel or monetary reserves – or still do not want to be responsive to the philosophical and conceptual framework for good governance and accountability,’ says Lance Kimmel, founding partner of SEC Law Firm. ‘For the most part those companies that are not doing it yet are smaller public companies.’ 

With limitations on their in-house resources and their ability to engage outside assistance, some smaller companies are taking a reactive rather than a proactive or holistic approach to corporate governance. ‘Unless we have some form of relief, either from Congress or the SEC, I’m afraid that smaller public companies are going to remain trapped in trying to comply with corporate governance requirements,’ says Kimmel. ‘They are either just being overwhelmed by the volume of what they have to do and the fixed cost of what they have to do, or trying to decide how to allocate their monetary resources. We’re all hopeful that with the recent establishment of the small business advisory panel to the SEC there will be some thoughtful reflection on scaling down certain elements of Sox and all the related elements of corporate governance so that a smaller public company can deal with the financial and personnel burdens – and they can be utterly crushing – of compliance.’ 

A study conducted by MVC Associates International tracked the performance of the top 2,100 US companies listed in the Russell 3000 over the five-year period 1999-2003. According to Van Clieaf, results indicate that ‘56 percent have had five years of declining economic profit’ and ‘most have failed to return a profit greater than their cost of capital over the same five years. This means their business model is probably neither viable nor sustainable.’ 

Does governance equal growth?

Viewed from a governance perspective, the study may have further implications. The results raise questions about how much time the board is spending on strategic issues with the CEO or vetting the strategic direction management proposes. ‘It is not the board’s job to develop the business strategy and model – that is management’s accountability,’ explains Van Clieaf. ‘But it is the board’s job to set the strategic goals and metrics against which management’s performance relative to the agreed strategy will be measured. The board has probably fulfilled its compliance duty but that is just the beginning, not the end, of its fiduciary duty to shareholders.’ 

As the focus on corporate governance heightens, research seeks to explore whether any correlation might exist between governance ratings and company performance. In 2004 Georgia State University and Institutional Shareholder Services (ISS) released results of a study that examined the relationship between corporate governance and four fundamental areas: total return, profitability, risk and dividend payout. 

The study found a correlation between corporate governance and company performance and linked ‘bad boards’ to higher risk and increased volatility.
 
‘If a company does not have good corporate governance, corporate performance, growth and shareholder value can go up in smoke – a lá Enron,’ comments Mulé. ‘Conversely, there has been a number of recent academic studies that increasingly show there’s a link between good corporate governance and good corporate performance. Some large institutional investors – in particular the pension funds – are starting to focus on this link. They are starting to take the position that if the company doesn’t have good
corporate governance, they’re not going to buy the stock even if, on the financial side, when they look at just the figures they would be likely to think, Oh, this is a great stock.’ 

The Ohio Public Employees Retirement System (Opers), which manages total assets of about $64.5 bn, is looking at corporate governance as a risk factor in its decision-making process. ‘The governance program here is relatively young,’ says Cynthia Richson, Opers’ corporate governance officer. As a result, it’s a little too early to discuss how the portfolio might be weighted, percentage-wise, to favor companies with good corporate governance. 

‘We’re looking at all the academic research, just like everybody else,’ Richson comments. ‘We’ve tried to start moving in the direction of best practices. But we don’t subscribe to a one-size-fits-all philosophy. We realize that the needs of smaller companies and medium companies differ. I really believe we’re just starting to see the benefits materialize of this renewed focus on good corporate governance. I have no doubt that this is going to be a win-win situation for both companies and investors.’
 
Information exchange

‘Institutional investors, commercial lending officers, insurance underwriters and other people who are concerned about valuing corporate risk are starting to look at corporate governance as a new analytical tool,’ says Howard Sherman, COO of GovernanceMetrics International (GMI), a corporate governance research and ratings agency. At the same time, public firms are exploring ways to turn governance into a competitive advantage. 

‘When I talk to companies – both the governance officers and members of the board – they are trying to move away from regulatory and legalistic discussions, and figure out how to use corporate governance to their advantage, as a strategic asset of the firm,’ continues Sherman. ‘And that means evaluating how they address cultural issues inside the corporation, how they communicate their governance practices and procedures externally, and how they stay abreast of current developments in the market.’ 

According to Dan Posin, Judge René H Himel Professor of Law at Tulane Law School, governance has been a kind of ‘sleeping’ issue. ‘One of the most important factors that needs to receive greater attention is the flow of information to the board,’ he asserts. ‘How does it get its information? Where is the data coming from and how does the board know it is getting all the information it needs? Making sure the board gets the information it needs and that there’s a regular information flow is a very useful role for the corporate secretary.’ 

‘At its most basic, corporate governance is making sure the board is able to weigh in on the issues that are of greatest importance to the company,’ says Combs. ‘Everything we are doing as corporate secretaries helps the board focus and make better decisions that ultimately contribute to increasing shareholder value.’ 

Whether that means keeping directors educated and aware of governance trends, helping to keep board meetings focused on the essential strategic issues, or ensuring that directors receive pertinent materials in sufficient time prior to board meetings, corporate secretaries can help governance stay on the right track. 

‘When boards have the time and resources to focus on the issues that will influence and increase shareholder value, that result does come to pass,’ adds Combs.
 
‘Today, much of corporate governance is focused primarily on meeting the compliance needs of the enterprise with key regulators,’ notes Van Clieaf. ‘If the company is expected to grow and create innovation and value, the accountability of the CEO and the level of corporate governance at that firm must move beyond mere compliance. And this is the problem today – too many boards are spending all their time on compliance when, depending on the level of complexity of the enterprise, they need to be doing far more to fulfill their strategic duty to shareholders.’ 

Lamm looks forward to the time when corporate governance becomes ‘just something else that a company does – literally part of the furniture. Governance shouldn’t be the sole focus of the corporation or the board.’ It should become part of the process, he adds, and not create a whole separate bureaucracy. Once governance becomes second nature, Lamm says, it will ‘undergo continuous improvement and evaluation – just like everything else a company does.’ 

Then, in time, the firms that demonstrate superior, best-in-class governance practices may just find that good governance pays.