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Evaluating governance codes

Can corporate-governance codes actually get companies to clean up their acts? McKinsey finds that such codes can indeed be effective--within limits.

Evaluating governance codes
From the McKinsey Quarterly
Special to CNET
April 18, 2004, 6:00 AM PDT

Corporate-governance codes have proliferated in the 12 years since the Cadbury Code of Best Practice came into effect in the United Kingdom.

In the past two years alone, new codes have emerged in every G-7 country except Japan, as well as in places as diverse as Brazil, Mauritius, the Netherlands, Oman, the Philippines, Russia, South Africa, Switzerland and Turkey. Today, 50 countries have their own such codes.

Governance codes emanate from securities commissions, stock exchanges, investors and investor associations, and supranational organizations. To put it simply, the codes embody their views of what good governance is all about. The Cadbury Code, for instance, made 19 recommendations addressing the structure, independence and responsibilities of boards; effective internal financial controls; and the remuneration of directors and executives.

Since companies are not required by law to comply with codes of practice, there is clearly a risk they won't work. The evidence, however, suggests that they do work. In the United Kingdom, the Cadbury Code has sparked real improvements: for instance, the increasing professionalism of many boards (as measured by their composition, structure and processes) can be directly related to it.

Even in countries where progress has been slower, the codes? existence has at the very least put corporate governance into the public domain and made managers and directors more aware of what is expected of them. Yet the very success of the codes raises concerns about their future development.

The pioneering Cadbury Code was a response to a series of scandals and corporate failures among U.K.-listed companies in the early 1990s. It aimed to help prevent similar scandals and to rebuild the trust of the public and investors by prodding companies to improve their governance practices. The codes that have followed around the world embody similar goals. In emerging markets, which typically provide for much less transparency about what companies do, the stakes are even higher: Policy-makers there fear that scandals might trigger the indiscriminate selling of stocks and a systemic crisis.

Fundamental issues
Codes vary in scope and detail, but most tackle four fundamental issues: fairness to all shareholders, whose rights must be upheld; clear accountability by the board and management; transparency, or accurate and timely financial and nonfinancial reporting; and responsibility for the interests of minority shareholders and other stakeholders and for abiding by the letter and spirit of the law.

Policy-makers around the world increasingly argue that codes embodying these principles not only protect investors against fraud and poor stewardship but also may help reduce the corporate sector?s cost of capital. Provisions for securing these benefits can vary significantly, often reflecting each country?s particular circumstances.

The pioneering Cadbury Code was a response to a series of scandals and corporate failures among U.K.-listed companies in the early 1990s.
The attraction of a code (as opposed to a law) lies in its flexibility. Legislating every aspect of corporate behavior would clearly be impossible, and statutory prescriptions would be inappropriate for many governance issues. Moreover, companies need room to maneuver. One that unexpectedly lost its CEO, for example, could want the chairman to step in while it recruited someone else--which might not be allowed under legislation prohibiting the same person from holding both positions. And, crucially, codes can be amended to reflect changing needs and circumstances much more quickly than legislation can.

Despite an apparent lack of teeth, codes undoubtedly improve corporate governance. They focus attention on it and often influence broader policy debates about the regulation of business. They help educate companies, often by collecting and clarifying best practices. And codes drafted by powerful institutional investors, such as the California Public Employees? Retirement System (Calpers) and Hermes, have had a direct impact on corporate practice by stating what these investors expect from the companies in which they invest.

Comply or explain
Codes are most effective when combined with mandatory disclosure, a practice known as "comply or explain." In adopting the Cadbury Code, for instance, the London Stock Exchange demanded that listed companies reveal in their annual reports whether they were complying with it--and, if not, why. The comply-or-explain approach has since spread to dozens of countries, including Australia, Canada, Mexico, the Netherlands, and Singapore.

Even in the United States, where legislation (most recently exemplified by the Sarbanes-Oxley Act) is preferred, the comply-or-explain approach has crept in. The U.S. Securities and Exchange Commission, for example, now requires companies to disclose whether they have financial experts on their audit committees and, if not, to explain why.

Despite an apparent lack of teeth, codes undoubtedly improve corporate governance.
Comply-or-explain requirements have made corporate-governance practices much more transparent and forced companies to think about them carefully, since any departure from the code must be publicly justified. Such requirements are particularly effective in countries where the media and activist shareholders monitor corporate behavior, since companies would often rather comply than risk intense media scrutiny of their explanations. To comply with a new Dutch corporate-governance code, ABN Amro Bank, for instance, recently decided to abolish an anti-takeover provision.

Ultimately, corporate-governance codes and laws must support each other. All countries have such statutes--for example, the requirement that companies file financial statements. Legislation and government regulations, we believe, should provide a floor: minimum standards for issues such as financial reporting, auditing requirements, and the frequency and content of shareholder meetings. Corporate-governance codes, by contrast, can encourage best practices in these and other areas, including shareholder relations and executive compensation.

The boundary between laws and codes will shift over time and vary by country. A run of financial scandals might call for the strengthening of regulations dealing with the responsibilities of audit committees. Conversely, legislators in some countries have relaxed their capital requirements because laws against fraudulent conveyance have been strengthened and because innovative financial contracts make it easier for a creditor to protect itself. By contrast, in some emerging markets, where corporate-governance awareness is low and public scrutiny weak, legislation might be favored over voluntary codes.

Triple jeopardy
Despite the codes? enormous success in promoting change, three developments could jeopardize their use. Paradoxically, it is their very success that has given rise to these threats.

"Regulation creep" is the first. Because codes have improved corporate governance, many people are tempted to broaden their scope and add more detail. In the United Kingdom, for example, the Higgs review of 2003 recommended raising to 82, from 45, the number of provisions in the 1998 Combined Code, a successor to the Cadbury Code. Some of the proposals--for instance, expanding the role of senior independent directors--had limited support within the United Kingdom. Such provisions risk being ignored and can imperil a code?s credibility.

The second concern is an overemphasis on "complying" rather than "explaining." Increasingly, attempts to show why companies have deviated from codes are dismissed without thought, as though the "comply or explain" approach was being interpreted as "comply or breach." This tendency, inspired by the desire to judge corporate governance by ticking off boxes rather than undertaking a deeper analysis, threatens a fundamental virtue of the codes: flexibility.

Third, the progressive convergence of codes around the world, if taken too far, might generate a one-size-fits-all mentality. A powerful force driving that convergence is the listing of corporate shares in many different countries, thereby helping to spread best practices from one jurisdiction to another. Furthermore, industry bodies want common standards in the countries and companies where their members invest. Ratings agencies around the world use similar criteria to evaluate governance practices.

The convergence of corporate-governance codes should be welcomed because it signals broad acceptance of certain basic standards. But it shouldn?t be pushed too far. The Combined Code, for instance, has been emulated in many countries, but its increasing emphasis on the independence of boards may make the latest version less relevant for emerging markets, where it is common for a company to have a single majority owner.

In these countries, the appointment of a senior independent director and requirements that boards meet without the presence of management shouldn?t be a priority. Codes in emerging markets should concentrate on more basic things, such as the full and timely disclosure of information and efforts to ensure that controlling shareholders don?t expropriate minority ones.

For more insight, go to the McKinsey Quarterly Web site.

Copyright © 1992-2004 McKinsey & Company, Inc.

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