Uses and limits of conventional corporate governance instruments

As a way to contribute to the current debate on corporate governance reforms, I have written a practitioner-based article, to be published in two parts by the Global Corporate Governance Forum of the World Bank Group, examining the uses and limits of five commonly employed corporate governance instruments – transparency, independent monitoring by the board of directors, economic alignment, shareholder rights, and financial liability.

Entitled Uses and Limits of Conventional Corporate Governance Instruments: Analysis and Guidance for Reform, my article discusses how the individual instruments have worked in practice, including instances when they have failed to achieve their intended objectives and, in some cases, worsened the governance ailments that they were designed to cure. For example, the rapid growth of executive compensation persisted – and in some countries, accelerated – after the introduction of individual executive pay disclosure. In the financial sector, the shift toward a board dominated by independent directors ultimately proved to be its Achilles’ heel as weak industry knowledge meant that non-executive directors (NEDs) were unable to pick up on warning signs of imprudent risk taking by management. In addition, quarterly reporting of financial results has resulted in excessive short-termism, as management obsesses over meeting analysts’ earnings forecasts for each quarter because missing the “consensus estimates” by even one cent could pummel the share price and discredit management.

Even when these instruments have worked as intended, there are limits to their utility. For example, the structural issues that boards confront – such as potentially conflicting “watchdog” monitoring and strategy development roles, part-time status, vast information asymmetry, and boardroom group dynamics – mean that they will never be as objective and challenging of management as shareholders and others wish them to be. Likewise, there are limits to the use of economic incentives as an alignment tool, the most significant being that people are motivated by more than the prospect of financial gains. Due to free-rider problems, lack of competence (particularly for institutional investors with large portfolios), and conflicts of interest, shareholders may not be well-positioned to rigorously monitor boards and management, particularly in markets with dispersed ownership.

In this article, I also provide suggestions to improve the application of these instruments. For example, to enhance the board’s ability to understand the company’s business, its membership should comprise a substantial proportion, but not necessarily a significant majority, of independent directors. Ideally, boards should feature a diversity of perspectives, substantial formal independence, and strong company and industry knowledge.

When populating the board, it is also important to pay attention to the relative status of people in the boardroom, particularly vis-à-vis the CEO. Discussions with chairmen and direct observations of boardroom dynamics have revealed that CEOs are not always attentive to the views of non-executive directors whom they perceive to be less qualified than they are. At the same time, NEDs who are in awe of a CEO can be overly deferential to management.

On executive compensation, my recommendations include: 1) when setting the level of pay, carefully scrutinize the firms that are included in the benchmark group, 2) evaluate performance of executives through a multi-year lens and stagger payouts over several years, 3) attach performance conditions to the vesting of share awards, and 4) require executives to have “skin in the game” even after they have departed the firm.

In the area of shareholder rights, I caution policymakers – before introducing an advisory vote on remuneration (or “say on pay”) – to consider whether shareholders will devote the necessary time and develop sufficient expertise to evaluate each pay proposal on its merits, whether diverse investor views on executive pay will serve as an impediment in holding boards accountable, and whether the broader legal framework provides a sufficiently enabling environment.

My article concludes with a discussion of how policymakers should approach corporate governance reforms generally, with a view to strengthen the effectiveness of the conventional set of corporate governance instruments. Specifically, I make six suggestions: 1) calibrate reforms to fit the surrounding context, particularly ownership structure and the broader business environment; 2) assess how an instrument will influence the behavior and focus of the affected parties; 3) be prepared to take difficult decisions because the inherent complexity of certain issues means that simple solutions, while tantalizing, are unlikely to work; 4) ensure coherence of tools employed with the legal, regulatory, and tax regimes; 5) employ “carrots” – such as fast track issuance of securities and corporate governance-based stock listing tiers – as well as “sticks,” and 6) focus on values and culture.

The latest draft of my article is available here.