Corporate Governance Regulation: A Primer

While public officials play a key role in shaping corporate governance practices that impact those affected by corporate activity, corporate governance commentators rarely reflect in a general way on the wisdom of state intervention. A recent working paper of mine that will be published in a forthcoming conference volume is a departure from the norm. The paper offers as part of a general primer on corporate governance regulation an overview of key justifications for state intervention in the governance context as well as summarizing potential downsides. The paper also provides a survey of “rule types” and concludes with an analysis of corporate governance codes.

Voluntary transactions and market dynamics do much to shape corporate governance. Justifications for regulation of private ordering are commonly divided into two categories. The first is comprised of economically-oriented rationales for state intervention where the animating principle is increasing economic efficiency through the correction of market failures. For instance, where imperfect information and transaction costs foster contractual incompleteness the law can play a potentially salutary transaction cost reduction role by supplying rules that mimic terms parties would agree upon under ideal contracting conditions. Government can also use a mix of taxes, regulation and liability rules to prompt beneficial cost internalization where interactions between corporate participants have adverse third-party effects (“negative externalities”). State intervention can additionally help to solve collective action problems arising when the rational, self-interested behavior of individuals precludes them from acting jointly when doing so would increase the aggregate welfare of all involved.

Regulation can also be justified on a number of grounds without invoking efficiency-related considerations. Promoting “fairness” is one potential departure point. Key variants are “procedural” fairness, which relates to the methods which market participants use to negotiate, formulate and conclude transactions, and “substantive” fairness, where the concern is the end result, either with respect to individual transactions or the distribution of wealth in society. The objective of fostering participation can also potentially justify state intervention, with the state seeking to ensure in the corporate context that those involved with companies have a say in decisions that materially impact their economic welfare. The state can additionally seek to preserve the public’s trust in business by imposing checks that discourage companies from pivoting away opportunistically from well-established social bonds to try to capture rewards markets can offer for bold change.

Analysts who advocate state intervention on the basis of problems with private ordering often tend to assume that government intervention will be beneficial whenever markets are not operating perfectly. Such reasoning, though, brings into play what some call the nirvana fallacy: one cannot make the case scenario B is superior to scenario A by simply setting out the problems associated with A. Instead, one must also consider B’s downsides, with B in this instance being state intervention.

One downside with government regulation is that it can give rise to significant costs, generated both by those subject to regulation and by public officials who have to implement rules that have been promulgated. The influence interest groups wield is another potentially detrimental feature of regulation, with the primary concern being that organizations strongly wedded to particular issues have a disproportionate and often counterproductive influence over regulatory moves. Insufficient awareness of market context on the part of public officials can additionally set the scene for detrimental policy errors, as can a disproportionate bias in favour of safety and soundness arising from eagerness to preclude attention-grabbing regulatory mishaps. There can also be difficulties with the timing of regulatory interventions, either in the form of counterproductive delay (“statutory stagnation”) or hasty crisis-driven lawmaking. Finally, since regulation is not self-enforcing, channelling the distinguished jurist Roscoe Pound, “law in action” may fail to match up with “law in books”.

Assuming that public officials determine that despite potential drawbacks regulatory intervention is justified in principle in the corporate context, the nature of the rules deployed can have an appreciable impact on how the costs and benefits play out in practice. To see how, assume that policymakers are seeking to reduce transaction costs by putting in place rules that match the expectations and needs of company participants, and have succeeded in formulating rules that meet that standard. What form should the rules take?

Legal rules can be divided into three basic categories: permissive (“may”), presumptive (“may waive”) and mandatory (“must” or “must not”). It makes little sense to use a permissive (or “enabling”) format with rules that match the expectations of most governed by them because those for whom the rule is beneficial will have to incur costs to opt in. As between a mandatory and presumptive (or “default”) format, the latter will be preferable. With a mandatory measure, the minority of market participants for whom the rule does not correspond to their preferences face an unenviable choice: remain governed by a sub-optimal rule or take whatever presumably extensive steps are required to side-step it. The situation should be markedly better when a rule is presumptive. Such measures apply without the parties affected taking an affirmative step — no opting in is involved as with an enabling rule – so parties for whom a rule suits their needs are all set. For the minority of market participants for whom a rule is a poor fit opting out will not be costless but carrying out the relevant procedure should be considerably simpler than end-running the rule in mandatory form. Transaction cost savings should accordingly follow.

Despite possible disadvantages with mandatory rules, their use can potentially be justified in the corporate context. This will be the case, for instance, where the objective of the laws in question is to deal with externalities. Presumptive rules may offer little protection for those who are adversely affected since those engaging in the conduct with negative side-effects may well opt out if the applicable laws do not serve their own interests. Mandatory rules also can have a role to play where public officials are seeking to achieve goals other than fostering efficiency gains. In the quite likely event that corporate participants governed by such rules dislike the potential outcome, a mandatory format likely will be necessary to preclude waivers that would undermine the policy logic underlying the laws in question.

A primer on corporate governance regulation would be seriously incomplete without canvassing codes, a prevalent feature of corporate governance worldwide. The focus in the present context is on codes that seek to shape corporate governance practice within a single jurisdiction rather than aim to provide guidance on a transnational basis. Topics such national codes typically cover include board structure and composition, executive pay, shareholder engagement and internal financial controls, with stakeholders and boardroom diversity additionally growing in prominence.

To get the measure of corporate governance codes, it is helpful to distinguish them from presumptive laws. With codes, in contrast to statutory default rules, a body other than the legislature has the task of determining what is said. Also, while presumptive company law rules apply unless displaced, if corporate participants do nothing code measures will not have any effect. Moreover, while from an efficiency perspective an obvious role for presumptive legal rules to play is to reduce transaction costs by mimicking arrangements parties would adopt under ideal bargaining conditions, with corporate governance codes the emphasis instead is on what drafters of the code believe is ahead-of-the-curve “best practice”. Typically, codes are designed to “nudge” companies toward adoption of beneficial governance arrangements, with the “nudge” mechanism often being a “comply or explain” arrangement backed by an obligation companies have to disclose and account for non-compliance with the corporate governance code in question.

The available evidence suggests that compliance with corporate governance codes typically is substantial despite them lacking direct legal force. While this might seem like good news for advocates of “better” corporate governance, such a pattern typically is a by-product of a criticized code trend: unwelcome “box ticking” pressure on companies arising because investors are unprepared to consider the persuasiveness of explanations companies offer for non-compliance. Likewise, the nature of the body tasked with promulgating a country’s corporate governance code can either be a virtue or a vice depending on the circumstances. A corporate governance committee vested with responsibility for determining the content of a country’s corporate governance code can potentially be staffed with members with substantial corporate governance expertise well positioned to anticipate beneficial best practice. Increasingly, however, governmental or quasi-governmental bodies are serving as code-setters, a trend that increases the risk that codes will be out of touch with market conditions.

If corporate governance codes are less advantageous in practice than in theory, what could replace them? A possibility would be an obligation for publicly traded companies to disclose publicly how their governance practices tally in relation to concise governance checklists financial services regulators compile under delegated statutory authority. Corporate governance innovation could then proceed with investors and other interested parties being able to find out readily how public companies are governed but in the absence of the potentially counterproductive “comply or else” mentality that corporate governance codes can foster.