When 'making the numbers' makes sense

"Short-termism" – an ugly phrase for an ugly approach to management – is widely blamed for everything from asset bubbles to outsourcing. There's a argument, of course, that the long term is just the sum of all short terms, but when it comes to deciding on a specific project or investment, the outcome often differs radically based on which stance you take. The issue becomes more complex when investors (or at least certain types of investor) agitate for performance over a narrow time horizon. Corporations face constant demands for guidance on "the numbers" – the quarterly or half-yearly earnings report – and then get punished by markets (or really by certain types of market trader) when they fail to meet them. "Making the numbers" is a mug's game.

Or is it? According to a study by scholars at MIT and Harvard, there are conditions – a "tipping threshold" – above which is makes sense to make the numbers by focusing on the short-term at the supposed expense of longer term consideration. "We show that if the source of long-term advantage is modeled as a stock of capability that accumulates gradually over time, a firm's proclivity to manage short-term earnings at the expense of long-term investment can have very different consequences," they write. When the company operates above the threshold, earnings management can smooth revenue with few long-term consequences. "Below it, managing earnings can tip the firm into a vicious cycle of accelerating decline. Our results have important implications for understanding managerial incentives and the internal processes that lead to sustained advantage," they conclude.

Source document: The working paper "Making the Numbers? 'Short Termism' & the Puzzle of Only Occasional Disaster," by Nelson Repenning of MIT and Rebecca Henderson at Harvard, is a 39-page pdf file.

FEE responds to EU audit green paper with 'wait and see'

The European Commission wants ideas for what it should do about auditing in response to the financial crisis. The European Federation of Accountants thinks it may be well to do nothing, more, for now. The federation, known by its French acronym FEE, has issued a 59-page response to the European Union's green paper on audit. Green papers aren't intended as policy statements, more as calls for evidence, and among the evidence FEE presents is that a lot of changes already undertaken with respect to audit haven't yet come fully into effect. The EU's Statutory Audit Directive only became law in member states in 2010, it noted. The International Standards on Auditing are in force, but only for accounting period that begin after December 15, 2009, so in effect they haven't been through even a single cycle. "FEE also stresses that the majority of matters related to the audit market and the audit process have to be considered at a global level," it said. "There is a need for enhancing global convergence in relation to audit regulation, audit standards and ethical standards."

Source document: The FEE submission is a 59-page pdf file.

IASB issues guidance on talking about the business

"Management commentary" has been on the agenda of the accounting standard-setters for quite a while, but now there's movement. The International Accounting Standards Board has issues a report discussing the findings of its consultations on what such non-financial reporting should look like. This "broad, non-binding framework" suggests what companies should do to provide a narrative about the business to complement the numbers reported under international financial reporting standards. "Management commentary fulfils an important role by providing users of financial statements with a historical and prospective commentary on the entity's financial position, financial performance and cash flows," the IASB said. "It serves as a basis for understanding the management's objectives and strategies for achieving those objectives."

Nature of the commentary: For readers of corporate annual reports, the concept of a management commentary is already well understood. The "operating and financial review" that many UK companies provide, the "business review" that listed companies around the European Union are obliged to produce, the "management discussion and analysis" that UK companies need to present are all examples of the genre. But the IASB's intention is to make sure that genre doesn't turn into fiction. Sir David Tweedie, Chairman of the IASB, said: "Management commentary is one of the most interesting parts of the annual report. It provides management with an opportunity to add context to the published financial information, and to explain their future strategy and objectives. It is also becoming increasingly important in the reporting of non-financial metrics such as sustainability and environmental reporting."

For whose benefit? This question has long been the rub in financial reporting. Audited financial statements, for example, give comfort to creditors, including suppliers, employees, prospective employees and many other people than the shareholders for whom they are intended and who ultimately pay for the work done to produce them. Management commentaries are used by all sorts of people to assess the company as a business partner or even as a neighbour. The IASB's framework suggests taking this approach: "Management should determine the information to include in management commentary considering the needs of the primary users of financial reports. Those users are existing and potential investors, lenders and other creditors." The rest of you can look away now.

Look forward! Management commentaries aren't merely recitations of past performance. In a section called "Forward-looking information" the IASB writes: "Management commentary should communicate management's perspective of the entity's direction. Such information does not predict the future, but instead sets out management's objectives for the entity and its strategies for achieving those objectives. The extent to which management commentary looks forward will be influenced by the regulatory and legal environment within which the entity operates." Companies may, but are not required to, present forecasts or projections.

Source document: The IASB framework for presentation is a 28-page pdf file.

UK audit committee guidance voices special role

The UK Financial Reporting Council has issued new guidance to audit committee, making clear that audit committees have a special duty to shareholders. "While all directors have a duty to act in the interests of the company the audit committee has a particular role, acting independently from the executive, to ensure that the interests of shareholders are properly protected in relation to financial reporting and internal control," the guidance states. That role is described quite consciously in terms of oversight, rather than action, and the FRC is quick to note that nothing in its guidance should detract from the notion of a unitary board. "However, the high-level oversight function may lead to detailed work. The audit committee must intervene if there are signs that something may be seriously amiss," it says. "For example, if the audit committee is uneasy about the explanations of management and auditors about a particular financial reporting policy decision, there may be no alternative but to grapple with the detail and perhaps to seek independent advice."

Cognitive conflict? This approach may not threaten the unitary board. UK companies have lived with increasingly independent audit committees since the Cadbury Report in 1992, and when audit committee members join meeting of the full board they live with the internal conflict of overseeing the accounts as well as contributing to the policies that go into to making them. But stressing the independence of the audit committee involves stressing the role for cognitive conflict between board members, which can lead to divisions. Audit committee members will need to do more work than other board members, and the FRC thinks they should be paid more, too. Financial expertise comes at a premium.

Source document: The FRC audit committee guidance is a 28-page pdf file.

Tighter ethical standards for audit on the way in UK

Auditors in the UK face tougher ethical standards in the wake of a review of their code of conduct. Revisions by the Audit Practices Board came in response to the financial crisis and its aftermath, in which clean audit reports were followed by rapid collapses of banks and other financial institutions. One focus of the changes is on the level and nature of non-audit work that the audit firms undertake for clients. "Respondents to the APB's consultations on its Ethical Standards indicated that a total prohibition was not appropriate but acknowledged that there can be a perception of a loss of independence where certain non-audit services are provided by the auditor," the APB said. "This is heightened where the ratio of non-audit fees to audit fees is high."

The APB doesn't want to set in stone a formula for deciding when enough is too much. Instead, it lends moral force to the audit partner's control of the client relationship, rather than other members of the firm who might gain work from the client. In boldface type, it notes: "The audit firm shall establish policies and procedures that require others within the firm, when considering whether to accept a proposed engagement to provide a non-audit service to an audited entity or any of its affiliates, to communicate details of the proposed engagement to the audit engagement partner." The audit partner should then apply a "reasonable and informed third party" test, and then consider the likely risks to the firm's reputation, before assessing the safeguards in place to deal with those risks. Only then should the firm take on the work.

Source document: The news release has links to the documents.

EU wants views on scope, quality of narrative reports

The European Commission is looking, again, at whether to require companies to adopt a higher standard of reporting about environmental, social and other non-financial aspects of corporate affair. "The disclosure of non-financial information is important in the context of the current crisis and the challenge of sustainable development," it says in a consultation document. "Better disclosure of non-financial information may be a tool to further increase the number of European enterprises fully integrating sustainability and responsibility into their core strategies and operations in a more transparent way." So far for ordinary.

Benefits: The difficulties involve the lack of any consistent and broadly accepted standards, owing in part to the lack of a clear understanding of the interaction of these elements with corporate performance or social well-being. Proponents of enhanced reporting believe – as the European Union's document suggests – that the mere fact of having to report focuses the minds of managers on issues of the sustainability of the business. Seeking to measure performance on these matters gives managers a lever for changing policy and direction. Such information could also give investors insights into how well management is looking after the longer term issues of the business.

Drawbacks: Reporting is a burden, and disproportionately so for smaller companies. Adding detail will also serve to lengthen corporate annual report, making them harder to digest and understand. Ensuring the accuracy of their assertions – through external assurance statements or audits – isn't straightforward, raising questions about how managers might manipulate the reports.

So what to do? "The current EU programme is in favour of better regulation that aims at cutting red tape rather than adding to administrative burdens," the commission writes. But a variety of international activities are pointing increasingly towards common standards. The Global Reporting Initiative, the United Nations Global Compact and the Organisation for Economic Co-operation and Development's guidelines for multinational enterprises all get specific mention. So, the EU wants to know:

• How good is your country's current regime?
  
• What could be done to improve it?
  
• What items should such reports include: policy statements, risks, details of engagement and activities?
  
• To achieve "materiality and comparability" should any EU rules focus on principles, performance indicators, or something else?

And more. There is no formal consultation paper this time, just an online questionnaire, with boxes to be ticked and fields for free text entry. There's not even a discussion paper to explore the issues. Perhaps the issues are well enough understood not to need elaboration. Perhaps elaborating would tend to skew responses. Perhaps it's just an economy drive, or a way of forcing responses into standardised format that makes them easier to collate and less easy to challenge. Response, nonetheless, by January 14, please.

Source document: The consultation response form must be completed online in one go.

Italy seeks stronger minority protection in takeover rules

Italy's securities regulator thinks it's time to review takeover regulation to give greater protection to minority shareholders. Consob ran a consultation during October and November to collect views on what the new rules should look like, though its thinking was already well advanced before the process started. The most significant changes in envisages are:

• Reopening completed bids: The possibility, in case of success of the takeover bid, to reopen the offering period in order to allow shareholders who initially chose not to sell their securities to accept the offer. This would allow bidders to tidy up the shareholding by sweeping up the rest of the shares which would anyway be subject to disadvantage in future policy changes at the company.
  
• Best price: Extending the best price rule to the six months following the closure of the offer. Bidders would have to pay the best price paid during the offer to latecomers to the offer.
  
• Including derivatives: Counting indirect holdings – through equity swaps or the like, towards the pricing in offers and towards the 30 per cent threshold that triggers a full bid.
  
• Concert: More precise definition of what actions would be considered "acting in concert" between shareholders, and therefore trigger full bids.

"The proposed amendments align the national regulation with the best practices at international level," Consob said. "For example, the application of the rules regulating public offers for sale or subscription has been allowed for public exchange offers of debt securities, overcoming the existing obstacles to an effective equal treatment of Italian and foreign investors."

Source document: The English-language version of the news release wasn't ready before the consultation closed for responses, but it summarises the issues at stake.

Backdating is back – in an SEC settlement

The news came with a faint smell of a history lesson, though not an altogether obvious one. Jacob "Kobi" Alexander, a co-founder of Comverse Technology, has agreed to pay $53.6 million to settle a complaint by the US Securities and Exchange Commission about a scam that awarded him stock options backdated to make them a better value for him, and a worse one for shareholders. Alexander will be barred for life from serving as an officer or director of a public company. This case has been kicking around for a while, since the days of the backdating scandal in 2005 and 2006, when many cases came to light of boards awarding executives options that were already in the money, in violation of securities law. This, however, is a case with a twist. The SEC originally charged Alexander and two other former employees of Comverse with running a slush fund of options that they awarded themselves, which had originally been awarded to fictitious employees. "The SEC’s complaint alleged that Alexander made material misrepresentations to Comverse investors regarding Comverse's stock option grants and concealed from investors that Comverse had not recorded compensation expenses for the grants."

Source document: The SEC news release gives further details.
http://www.sec.gov/news/press/2010/2010-232.htm

Between enterprise and ethics

One of our occasional looks at old-ish books
There are times when you find something that just makes sense, irrespective of the data and independent of the criteria we might apply to prove a point through logic. Reading John Hendry's book is one of those. Published in 2004 in the aftermath of Enron and the rest, this isn't just a book about corporate governance. It's bigger, deeper and richer than that. It doesn't recite the platitudes of conventional ethics-in-action texts, with their "how-to-avoid" approaches to the practical but intractable problems that confront business people every day. Indeed, it's about that intractability, but somehow it also avoid the impenetrable language of the ethics-in-theory texts, with their "how-not-to-understand" approaches to the problems left over from the Greeks, the Reformation and the Enlightenment. And yet …

Hendry's book asserts in its subtitle that we live in a bimoral world. This uncomfortable phrase is key to understanding the book. On the one hand, we have – we all seem to have – some inherent understanding of morality that's linked, without the ponderous prose, to Kant's notion of an imperative, things that are simply the right thing to do. Hendry calls this "traditional morality", which many of us got from our parents and the church. But the family and the church are in decline around the Western world, at least, and the power of their voices have diminished. On the other hand, we have – almost all of us, at least – some recognition of good as arising from the benefits to well-being that derive from freedom. These values describe the utility functions of economists and the beneficial force of the invisible hand of markets that Adam Smith described way back in 1776. They have been in the ascendency as the sources of traditional morality have declined. They are both good, but they are not the same. Living in a bimoral world involves recognising the tensions between them, the fact that both are real and signify something of value.

In Hendry's view, both corporate governance and management are fields in which the tensions are laid bare, where we make decisions to side with one view and then the other, reconciling the irreconcilable, because somebody has to. The flexible organisations we need to respond to constant change and market-based competition undermines the traditional morality of hierarchical organisations in evidence in corporate cultures or codes of conduct. Yet our response to crisis – like Enron, then, or Lehman, now – is to grab for hierarchical solutions in law, regulation and codes of conduct, even though their traditional morality is on the wane. "Rules are still used for many of the unimportant things," he writes. "But for the more important things, such as development of markets and products, of the development of people, rules have become a hindrance. The consequence is that management must now learn to manage without rules."

But this isn't just about corporate governance or management. Society as a whole faces challenges in a bimoral world, as we wrestle with the value of saving for the future, helping those in need, or observing some notion of human rights.

This is a good, rich, thoughtful book, but not a dense one. It is a book full of answers that raise questions of a higher order. Don't read this, though, if you're looking for the answer that will settle the debate and tell you what to do. This book will tell you why it's so difficult to decide.

Source document: You can buy the book Between Enterprise and Ethics: Business and Management in a Bimoral Society, by John Hendry, at Amazon.

Breaking the deadlock on climate policy – a path forward?

Everybody knows that the Copenhagen summit in December 2009 was a disaster. Everybody knows that Cancun's follow-up, due shortly, will be, too. Global governance doesn't work. Even the Group of 20 is finding it hard to agree on urgent matters, like how to regulate the banking sector. How could we expect 190-odd countries to agree on sharing the burden of carbon reduction when there's nothing much to gain before the next election? We can't.

Try a different tack: When the winds are against you, you change direction. That's what a Stockholm-based think-tank is proposing that the world – no, some of the world – should do to address the issues of climate change. The Global Utmaning report, "An International Climate Investment Community – breaking the deadlock," suggests that the top-down approach we been trying, under guidance of the United Nations, cannot work, but a different, bottom-up one can. To be fair, it's not entirely bottom-up. The report, co-authored by Allan Larsson, a former Swedish finance minister who instigated that country's carbon tax system, suggests that governments and not the people they govern are the place to start. Given that European countries have something of an advantage in green technology development, there's even an economic incentive to start there. Not all European countries will go along with it, and under European Union rules that might be enough to damn his initiative as a non-starter. But Larsson thinks he has a way around it. Develop a "coalition of the willing" – not quite the phrase he uses, but close – and plough ahead. The much-disputed Lisbon Treaty, which now provides the EU's operating framework, contains a little-discussed provision to allow any nine member states to take action together towards common goals without having to bring everyone else on board, too. So Larsson and his co-authors reckon there's critical mass in a group that might include the Nordic EU members, Germany, France, the Benelux states and the UK. These governments all profess an interest in taking the lead on mitigating climate change. Their innovative capacities might benefit from measures that shared the climate opportunities and not just the climate burdens. They could club together to form an international investment community that would stimulate private-sector demand in investing in climate-friendly technologies. These states would need to do something to kick start the process, like enacting carbon taxes. These are likely to be unpopular measures, but so too are a lot of the other taxes that governments are raising now to fund their budget deficits. And carbon taxes, the authors argue, can be justified in that they counteract the "subsidy" in place in carbon-intensive industries, given that their damage isn't included in their cost.

Will it work? There are issues. When Larsson presented the report in London, among the objections was that the UK would never go along with ceding power to the European Union, or even to a subset of it, without a fight within the Conservative Party, which leads the coalition government. Perhaps. Importantly, Germany would resist any carbon tax, given that all parties, including the Greens now serving in coalition in the state of North Rhine-Westphalia, seem to be trying to squirm out of an agreement to end subsidies for the coal industry. Without Germany, the plan won't work.

What about a different coalition? Why not get a European grouping but add India, South Africa and Brazil? That notion comes from Michael Grubb, a Cambridge economist, who argued that the politics of climate change is more important now than the economics. Anthony Giddens, former director of the London School of Economics, worried about the Jevons Paradox: Any gains made in efficiency in one place will just lead for more consumption in another. Look at Spain: The wealth benefits of its strides in solar power were spent on increased use of cars and long-distance travel. The Jevons Paradox suggests that successful efforts on resource savings perversely increase the rate of resource depletion.

Climate change is a complex problem. And as Mike Hulme has written, complex problems often require messy solutions. The starting point of this report – that the simple answer is a global regime is wrong – seems right. What's less than clear is whether a portfolio of initiatives – like this and the others that will compete with it, should it show signs of being a success – will add up to the savings that climate science suggests we need.

Source document: The manifesto from Global Utmaning – or Global Challenge in English – is a 22-page pdf file.

Women do better, CIMA says

Amid all the talk of boardroom and senior management diversity, there's a nagging worry: does it matter to the economic health of the business? Would women do any better than men in leading economic enterprises? The Chartered Institute of Management Accountants has produced a report with the conclusion that it does matter, at least for the accountants. Female members of CIMA are six times more likely than men to reach the post of CEO, CFO or similar senior titles. This might, of course, be a circular argument. The pressure to have more women creates more jobs for senior women, and in a profession that is wildly disproportionately male, scarcity of female candidates drives up profession success. But CIMA found other link to support its case:

• Results: Having more women in senior roles is linked to stronger financial performance.
  
• Advantage: Women leaders work in different ways from men and can bring real competitive advantage to business.

Women still lag behind men in terms of seniority and salary, and the salary gap widens significantly after 10 years' work experience. "Employers can help by encouraging mentoring, offering flexible working practices, and actively developing female staff," it concludes.

Source document: The CIMA report "Breaking glass: Strategies for tomorrow’s leaders" is a 28-page pdf file.

In this climate, audit committees should be more watchful – FRC

The financial crisis may have receded to somewhat deeper parts of our consciousness, but audit committees shouldn't be fooled into complacency. The UK Financial Reporting Council, which oversees the accounting and audit professions and corporate reporting, has issued a note calling on audit committee to stay vigilant. Some wholesale financial markets remain illiquid and some banks are still dependent of government finance. "Audit committees are likely to want to be convinced that key judgments are supported by a more rigorous and robust analysis than in more benign circumstances and to consider how such matters have been explained in the annual report," it advised. "As part of this process they should set the appropriate expectations of the audit team and management." The document includes a list of key questions that audit committees should be asking, to keep management and internal audit on their toes. First on the list:
Has the Board set out in the annual report a fair review of the company's business including its principal risks and uncertainties? Are the risks clearly and simply stated? Are there many of them and if so, are they really principal risks? Is it clear how the risks might affect the company?

Source document: The FRC update is a seven-page pdf file.

Societas Europaea – good but not great

It seemed a good idea, back in the days when European integration was proceeding apace and the euro was becoming the currency of so many countries. With implementation of the single market in many aspects of life in the European Union, one barrier in this increasingly borderless market was that of incorporation. To do business in what soon thereafter became 27 member states required an awful lot of paperwork. The solution was "The European Company," also known by its neutral, Latin name: Societas Europaea, legal form created in 2001 and available since 2004 – well, in eight member states; the others were slow in letting it happen. Among major listed companies, there's been a serious lack of interest, at least outside Germany. For small companies it allowed a single corporate entity to employ and conduct business. Now the European Commission has published a commentary on an "external study" – that is, conducted externally but perhaps not entirely independently – into how it works. The conclusion could be summed up as good but not great. Most worrisome is this: The statute created 27 different types of SE, not one. The commission's summary notes – sadly without the statistics and detail – that "more SEs have been set up in countries that allow only the two-tier corporate governance system, rather than in countries that allow only the one-tier system, and very few SEs are set up in countries that already allow both systems". Nonetheless, here are some "pluses" the report found:

• Transfer of seat: The European Company has made it possible for companies with a European dimension to transfer the registered seat across borders, facilitating movement and competition. It also makes tax and regulatory arbitrage easier, an aspect not particularly highlighted in this report.
  
• Organisation design: The device makes it easier to "reorganise and restructure and to choose between different board structures, while maintaining the rights of employees to involvement and protecting the interests of minority shareholders and third parties". Note the language: "while maintaining the rights of employees". The reference here is to German and Austrian co-determination rules, while can't be breached by changing legal form, though they can change the character of the board, as Puma recently did. Some see this preservation of worker rights as a drawback of the compromises that allowed the legislation to pass and contributed to its differentiated adoption in different member states.
  
• Image: The report suggests that the SE form gives companies access to a "European image and supra-national character". Perhaps it just makes small companies look bigger than they are.

Six years of experience with the SE Regulation show that "application of the Statute poses a number of problems in practice", the report suggests. "The SE Statute does not provide for a uniform SE form across the European Union, but 27 different types of SEs. The Statute contains many references to national law and there is uncertainty about the legal effect of directly applicable law and its interface with national law. Furthermore, the uneven distribution of SEs across the European Union shows that the Statute is not adapted to the situation of companies in all Member States."

Source document: The SE report is an 11-page pdf file.

Asking 'fundamental' questions about the basis of corporate governance

Here's a thought experiment, courtesy of the IRRC Institute and Stanford University: Imagine an investor holds a million shares of a company's equity. How might it mess around with the company and make money? "It is today quite easy for investors to construct portfolios that increase in value as a corporation's stock price declines while retaining the right to cast large blocks of votes in shareholder elections," according to the report, sent to the US Securities and Exchange Commission as a guide to its rule-making under the Dodd-Frank Act. It works this way: The shareholder – remember, this could be a "long-only" investor, not a short-seller – enters into what the wizards of Wall Street call a "total return equity swap". The swap contract, a rather simple derivative strategy, creates, in effect, and insurance policy against losses. The swap protects against losses but requires the investor to forgo gains. So the investor is neutral on the company's fortunes but still gets to vote the shares, and under Dodd-Frank maybe even nominate directors. That's called empty voting and it's a puzzling notion of rights. Now imagine that instead of writing a swap for a million shares, the investor writes one for two million. It now has an incentive – quite a powerful one – to see the share price decline, and it retains its right vote and perhaps to nominate directors. That's called negative voting and it's not just puzzling – it's perverse.

The report, commissioned by the Investor Responsibility Research Center Institute and conducted by the Rock Center at Stanford, raises concerns that the financial markets now have the ability to divorce economic interests from ownership rights in ways that have outpaced both corporate governance approaches and bankruptcy law. "Ironically, we just enacted a massive reform of the financial system. The underlying presumption, however, was that economic and ownership interests are inseparable. We know this is not true," said Jon Lukomnik, IRRC Institute program director. "[I]f those who control ownership rights can be incentivized towards value destruction rather than value creation, it is only a matter of time until the real economy is affected due to a large-scale impact on corporations." So, what should directors and policy-makers do?

• Accept there's a problem: The report says the potential – as well as the reality – for of decoupling transactions that generate empty or negative voting can present challenges to shareowner and creditor governance practices.
  
• Recognise its impact: Because rights and interests may be easily decoupled, regulators, directors, other shareowners and creditors run the risk of making decision on a less-than-informed basis.
  
• More than disclosure: "Policy makers may therefore wish to consider substantive measures that might address the rights of shareowners or creditors to cast votes without regard to their participation in decoupling transactions that can give rise to empty or negative voting," the report concludes.

The report summarises 19 research studies and several key judicial opinions indicating in growing concerns in litigated transactions in a bid to inform the detailed rules that the SEC will produce to put Dodd-Frank into action. What the study make clear, if it weren't clear already, is that the concept of "shareholder value" needs to be rewritten or abandoned as a guide to what directors should do.

Source document: The IRRC-Stanford research report "Identifying the Legal Contours of the Separation of Economic Rights and Voting Rights in Publicly Held Corporations" is a 52-page pdf file.

Board diversity: not enough or too much?

The problem is working out what the question should be. Are we looking for boards that reflect the constituencies we serve? Are we looking for boards that monitor the performance of management? Are we looking for boards that produce a higher return on investment? Are we looking for boards that would produce a higher return on investment under different criteria for what constitutes return? Are we looking for boards that project a better image? Are we looking for boards that produce a better next generation of managers and directors?

All of the above. And that's the problem with boards. These largely part-time helpers have the world resting on their shoulders. These questions leap out from the pages of a literature review on board diversity undertaken by two scholars at the Rock Center at Stanford University. They've done an admirable job of reading both theoretical and empirical studies of the value and drawbacks of having greater numbers of women and racial, ethnic and religious groups on boards, in America, yes, but around the world as well. The picture is mixed. The relationship between diversity and financial performance has not been convincingly established, they note, though there's some basis for believing that when diversity is well managed, it can improve decision making and can enhance a corporation's public image. "To achieve such benefits, however, diversity must extend beyond tokenism and corporations must be held more accountable for their progress," they conclude. That's a pretty small outcome, given the political heat and public policy pressure for more diverse boards. Perhaps we have yet asked the right questions. What is it we really want the board to do?

Source document: The working paper "Diversity on Corporate Boards: How Much Difference Does Difference Make?" by Deborah Rhode and Amanda Packel of Stanford Law School, is a 26-page pdf file.

IFAC reforms – good, but could be better

The International Federation of Accounts issues reforms for the professions of accountancy and audit back in 2003, when the wounds from the Enron and WorldCom collapses were still hurting. After another governance crisis, the its Monitoring Group, made up of the International Organization of Securities Commissions, the Basel Committee on Banking Supervision, the European Union and three other public interest bodies, examined how well the IFAC reforms were working. The report suggests that most of its proposals have been enacted, but there's room for improvement and two issues to consider for the longer term.

• International competence: "Whether standard-setting Boards that operate within an accountant's professional membership organization can carry out the responsibilities that ultimately come with international standard-setting in the public interest."
  
• Monitoring synergies: "Whether there could be potential synergies associated with the two accountability functions now present for international standards; namely, the Monitoring Group for international audit-related standards and the Monitoring Board for international financial reporting standards."

Among the Monitoring Group's recommendations are that IFAC should stop having 15 of the 18 seats on its Audit and Ethics Boards reserved for people nominated by the professions themselves. The Ethics Board should have an independent chairman "in view of the inherent conflicts of interest that particularly relate to the work of this Board", it said.

Source document: The IOSCO report is a 22-page pdf file.

Bank governance heading for change – sometimes in wrong direction

Whatever are we going to do about the boards of banking corporations? Since the onset of the crisis in 2007, it's been apparent that directors of banks didn't have a clear view of where the risks and issues lay. Since then, regulatory moves have been set in train to alter remuneration practices and to give shareholders a greater influence over boards. Much of that work has yet to be made final, but according to a study of 25 European banks, Nestor Advisors reckons that much of the industry has already anticipated the changes in the pipeline by altering their own governance arrangements. They problem, however, is that not all of these moves seem likely to be helpful. Take one example: "The trend to promote shareholder alignment is also reflected in increasing participation of shareholders to have a say‐on‐pay," it writes. Only nine of the 25 top banks were required to involve shareholders in decisions on executive pay, by 2009 twelve of the banks did so. "Say‐on‐pay may actually be doing more harm than good," it continued. This type of shareholder engagement "undermines the role of the board to work in the broader company's interest" by focusing them on the narrower interest of shareholders. "For banks, it is more pernicious, as greater alignment of management with equity holders is associated with greater bank losses," it said.

Director turnover: The study also shows that directors of banks that did badly did lose their jobs, against the conventional wisdom that boards are not accountable to shareholders. But that raises another problem: "That shareholders were not in a position to raise red flags before the failings should not come as a surprise. As shareholders are not insiders, will they ever be able to do so?" the report states. The remedy for greater accountability promoted in the UK and now spreading to European is to have annual election of directors. To Nestor Advisors, that seems to be a medicine for an imaginary disease.

Source document: The report "Bank boards after the flood: The changing governance of the 25 largest European banks," by Catherine Lawton and Stilpon Nestor, is a 26-page pdf file.

Governing the professional service firm

Professional service firms – lawyers, accountants and the like – are a special kind of beast, but one with interesting parallels in other occupations. Moves to make these firms – traditionally partnerships – into something more like a joint-stock company have changed the ethos of firms to some extent. But they are still of a different character to normal companies. Professional service firms can draw less on hierarchical structures to create control. The allegiances of the professionals themselves are to clients, other professionals and to the profession itself. In the days now largely departed of unlimited liability for professions, adhering to standards was of profound importance, making these firms impediments to change even as they were the upholders of standards. Laura Empson at Cass Business School in London has written a brief note that describes the model of the tensions a professional service firm faces. It helps to understand how the governance of such organisations must be different. But it's useful beyond the professions. What she describes is a model of a knowledge-based business, too, where the means of production is firmly in the hands (and brains) of the workers. As other businesses become more knowledge-based those tensions will arise there as well. While the professionalism of the professions may be under threat from taking on more corporate-like approaches to their business, corporations may need to foster more a profession-like ethos to ensure quality.

Source document: The discussion note, A summary of "Beyond the firm: a new way of looking at professional service firms" by Laura Empson, is a three-page pdf file.

Imposters!

Germany's financial services regulator made clear in no uncertain terms: banks and other financial institutions should beware of imposters! There's a website – or there was at the time of its warning – calling itself the Frankfurt Financial Supervisory Authority and claiming to be the most important supervisory body in the country. Well, BaFin, whose full name in German translates into the Federal Financial Supervisory Authority, says it, and not the imposter is in charge. BaFin didn't say, for understandable reasons, how to find the fake website.

Source document: The news release doesn't even urge readers to beware. That's selbstverständlich.

FSB points way to reduced reliance on credit ratings agencies

"Banks, market participants and institutional investors should be expected to make their own credit assessments, and not rely solely or mechanistically on CRA ratings." That's Principle 2 of the new guidance from the Financial Stability Board, the Group of 20's collective think-tank and policy-shop. Principle 1, more long-winded, is of interest, too: "Standard setters and authorities should assess references to credit rating agency … ratings in standards, laws and regulations and, wherever possible, remove them or replace them by suitable alternative standards of creditworthiness." Collectively principles like those two would in another setting be enough to destroy the business models of established players. Imagine the governments of the world ordering public and private sector organisations not to use DDT because it was a health hazard, or CCFs because they damage the ozone layer.

If put into force – and that's a big IF – borrowers wouldn't have to have credit ratings, and new methods of assessment of credit risk might emerge, with new approaches to solving the problem of being able to assess from afar how secure a borrower's flow of funds are. Yes, we suspect, even if the FSB is successful, it won't put the rating agencies out of business. But perhaps their business will become what they've always said it was: information, not ersatz policy.

Source document: The FSB statement is a seven-page pdf file.

SEC work plan for accounting change aims at 2011 decision

The Securities and Exchange Commission has published a first progress report on work that will determine whether the US will join most of the rest of the world in adopting international financial reporting standards. Following completion of the work plan and the convergence projects of the Financial Accounting Standards Board and International Accounting Standards Board, the SEC "will be in a position in 2011 to determine whether to incorporate IFRS into the U.S. financial reporting system". SEC chief accountant Jim Kroeker said: "This progress report emphasizes the importance of transparency in the staff's activities, and can help the public's understanding of the magnitude of this project and the staff's progress." The work plan addresses six key areas:

• Domestic reporting: Sufficient development and application of IFRS for the U.S. domestic reporting system.
  
• Independence: The independence of standard setting for the benefit of investors.
  
• Education: Investor understanding and education regarding IFRS.
  
• Regulation: Examination of the US regulatory environment that would be affected by a change in standards.
  
• Impact assessment: The impact on issuers both large and small, including changes to accounting systems, changes to contractual arrangements, corporate governance considerations, and litigation contingencies.
  
• People: "Human capital readiness," in the SEC's inimitable prose.

There will further interim reports along the way. Oh, and there's a small matter of a Congressional election in early November. A new Congress, especially one full of Tea Party Republicans, might not take too kindly to taking accounting rules imported from abroad.

Source document: The progress report is a 44-page pdf file.

Corporate governance or regulation? That is the question

That is the question on the mind of Troy Paredes, one of the five members of the US Securities and Exchange Commission. In a speech to a meeting of the Transatlantic Corporate Governance Dialogue in Brussels, Paredes took a tone that his audience might have found unusual coming from a US official – humility. "Throughout the financial crisis itself, there was a great deal of uncertainty as to how the law would be applied and as to the nature and extent of the U.S. government's potential intervention. To me, all of this means that we must approach our regulatory responsibilities with humility, appreciating the complexity of the challenges before us," he said. The SEC would need to strike appropriate balances in exercising the discretion the SEC was given in the Dodd-Frank Act on financial regulation. That law was, in several ways, the biggest change in corporate governance as well as financial regulation since the 1930s. Humility, he said, involved three actions:

• Knowing the options: The SEC will need to hear the "full range of ideas and perspectives" before deciding what specific steps to take in implementing the law. What are the practical consequences, the costs and benefits?
  
• Data: Decisions should be supported by facts. The report on the May 6 "flash crash" was useful in understanding how financial markets had developed. Sometimes the data point to counterintuitive answers.
  
• Discretion: The SEC has options under Dodd-Frank to conduct incremental rather than radical change. "Proceeding with such caution – namely, taking some regulatory steps now while deferring others until we can assess how the private sector has adjusted – allows for a more efficient and better calibrated regulatory regime to develop over time, having been grounded in the learning of experience and our consideration of the market’s adaptations," he said.

Some of that discretion applies to how the SEC implements measures on the core corporate governance agenda: giving shareholders a "say on pay": how frequently should such an advisory vote on remuneration be? How should the SEC define the independence of members of compensation committee? How does it go about setting the ratio of medium employee pay to that of the CEO? These are areas where board discretion is eroded by regulatory discretion, and Paredes isn't sure how far the SEC should go into that realm: "a chief purpose behind the Dodd-Frank executive compensation provisions is to dissuade companies from taking excessive risks," he said. "While lawmakers should acknowledge the prospect of excessive risk taking, we also must recognize that companies can take too few risks."

And then there's that little matter of the election. His comments noted how the SEC's structure and mandate sought to make it independent of party politics, even if the President named the commissioners and by convention could secure a majority from his party. What Paredes didn't discuss was Congress. With control likely to shift to the Republicans after the November 2 elections, will the Dodd-Frank Act remain intact and in need of implementation?

Source document: The Paredes speech gives further insights into his thinking on boards of directors, too.

What's shareholder value when the board fires the owners?

Long-suffering supporters of Liverpool FC had something to cheer about, even if they lost the first game under new ownership to their cross-town rivals, Everton. It wasn't an unreserved delight. Having bemoaned the club's American owners for years – what could Americans know about football! – the club had been bought by another American. The ignominious exit of Tom Hicks and George Gillett was cheered nonetheless, after they left the club heavily in debt, unable to buy new players, and off to the worst start to a season in living memory, hanging on at the bottom of the league table. Hicks and Gillette were forced to sell their shares after losing support of a majority of the Liverpool FC board. Good for football, perhaps, and almost certainly good for Liverpool Football Club. But what does it tell us about corporate governance, when owners lose support of boards? The lesson is nuanced but clear.

Leave to one side the court cases: Both the High Court in London that backed the sale and the court in Dallas, Texas, that sought to block it, considered the finer points of property rights and contract. Those are important, but only in law. The story of boards lies elsewhere.

The Liverpool FC saga is a rare drama, where we can watch corporate governance unfold in a pure form. It didn't follow the script.

For more than a quarter of a century, the field of corporate governance has built up a central view – expressed in codes of conduct, in a voluminous academic literature based on agency theory, and in much of the public policy debate: boards work for shareholders. Agency theory gives both economic and moral justification to shareholder value as the central purpose of corporations. It sees the job of the board as making sure managers maximise shareholder return and not siphon off economic rents.

In public companies, with thousands or even tens of thousands of shareholders, deciding what constitutes shareholder value is less than straightforward. In this case, however, there can be no doubt. Yet the board voted – 3 to 2 – to reject explicit demands from shareholders. The two dissenting voices were the owners. Not representatives of the owners, not someone at the end of a long chain of fiduciary and beneficiary relationships. The owners. The board refused to stand down even when the owners voted by100 per cent to zero to dismiss them. Instead, the board fired the owners.

With big loans coming due and not renewable, most of the value Hicks and Gillett may have once enjoyed as shareholders was gone. Failing to find new funds would certainly have thrown Liverpool FC into administration, taking matters out of the hands of the board. But doing so might, just might, have left the owners with a small chance of salvaging some value, at some time, for themselves.

Yet the board chose in selling the club to New England Sports Ventures to ignore shareholders' wishes, even in the face of a probable lawsuit, against directors personally, for breach of trust. Why?

In law, the board's primary duty of care is to the company and its "members", that is, the owners. It seems unlikely, however, that the board based its decision purely on analysis of the ambiguities of the Companies Act of 2006. They took, I suspect, an ethical stance. What was, then, the "right thing to do"?

Ethical debate splits on how even to ask the question. Duty-based ethics demand that directors submit to a priori claims, ignoring the consequences. The board had a moral obligation, one might then contend, to Hicks and Gillette. That interpretation of duty is, however, precisely what the fans so noisily rejected. The duty of directors, they might argue between choruses of "You'll Never Walk Alone", was to the club, the fans, the tradition. This is a stakeholder view of duty, and it differs deeply, fundamentally from the duty to owners.

Utilitarianism – which underpins the concept of utility in neo-classical economics and with it aspects of company law – gives a different way to decide. It asks directors to weigh the outcomes of options and then decide. The value Hicks and Gillett perceived was higher without the forced sale. But sitting uncomfortably at the bottom of the Premier League table, Liverpool FC was already contemplating the spectre of relegation. Key players would surely leave in the January transfer window. A fall into administration would cost the club nine points, making relegation palpable if not quite inevitable. So a wider utility function – let's call it strategic and not shareholder value – gives the board ethical backing to go against the wishes of the owners for the sake of a greater value for the business.

Which of these ethical considerations motivated the decisions of the Liverpool FC board? Only those inside could know, and they might not have followed a clearly analytic route to their choice.

Unlike this case, very few corporate decisions go to the courts for final approval. Boards carry the final responsibility. So it matters for all companies how boards determine what's right. This case shows that when push comes to shove – as it once did on the terraces at Anfield and seems to have done in the boardroom this month – directors don't always back shareholder value. Sometimes they back the business.

Source document: The Guardian's account of the transfer speaks more of football than corporate governance.

Editors protest at FSA warning over media contact

In September, the UK's financial watchdog issues one of its quaint pieces of "non-guidance" to companies: don't talk to journalists about anything sensitive. The moves followed a persistent pattern over years, where the details of bids and other posturing of participants in mergers and acquisitions would show up in the newspapers without attribution. It's pretty easy to use journalists to sway market opinion. They're always on the lookout for scoops, and they play them prominently when they happen. That encourages those leaking information to leak more often. From the journalists' perspective, this is a good: free flow of information is just what the doctor ordered: Dr. Fama, that is, of the efficient market hypothesis. But from the perspective of the Financial Services Authority, it means an uneven and unequal flow of information, opening the market to abuse. The FSA warned companies and their advisers that it would investigate leaks through a circular that, while not official guidance of the regulator, served notice to all and sundry that it was on the prowl and ready to bite. Now the editors have bitten back.

Four prominent news organisations – The Financial Times, The Times, The Guardian and Reuters – issued a letter to the chairman of the FSA pointing out the danger of the non-guidance. "Properly functioning financial markets rely on the flow of accurate and timely information, available to all participants simultaneously. In the world of instant media, the pressure on journalists is to publish information ahead of anyone else," they wrote. "This information, in turn, is swiftly picked up by others. So the media, contrary to the assumptions underlying the recommendations, actually play a key role in protecting investors and other markets’ participant by inhibiting the creation of an unlevel and unfair market place due to the limited circulation of insider information." The media's on-line services help to create a level European playing field, too, they said. Why they didn't mention global markets is a bit of a mystery. What they really dislike is the FSA's Recommendation 2, under which all media enquiries to a regulated company would be directed to the company's media relations personnel. "The proposal that all contacts between journalists and regulated firms should become subject to a prior screening process is disproportionate and unacceptable, and should be corrected," the editors wrote.

This standoff, like many of the issues in and around financial markets, is a conflict of goods. There's nothing worse for the discovery of wrongdoing or unearthing the significant detail than having good quality journalism about a developing situation. Turn off the source of supply and the flow of information dries up. But market abuse is widespread, perhaps even rampant, and with journalists keen for scoops, manipulating them as a way of manipulating the market is not all that hard.

The biggest problem with the FSA's attack is its collateral damage. Companies that follow its advice will "err on the side of caution" in dealing with the media. That will stifle the discussion about a lot more than the bids and deals that represent the source of the problem. The FSA should try prosecuting insider trading more often rather than depriving the market of information.

Source documents: The editors' letter is available on FT.com. A story about it is on Reuters.

Giving new meaning to stakeholder theory

God help the directors of this company! The enterprise known as Bible.com Inc. is facing a shareholder lawsuit for failing to make enough money out of the website. According to a story on the Reuters newswire and making the rounds of other websites, broadcasters and newspapers, James Solakian acquired a 28 per cent shareholding in the company to settle a debt. But the other owner-directors rebuffed his idea that Bible.com was sitting on virtual real estate that worth perhaps $100 million. Now directors Roy Spencer Miller, Betty Miller, Andrew Miller, Stacy Fornara, Edward Cude and Michael Magnant as well as the company itself face a suit in Delaware Chancery Court for breach of duty. They should develop the site or sell it, not just let it sit fallow, he contends.

Whose law holds: God's or man's? The Chancery Court will decide. Delaware – the tiny state that owing to its management-friendly laws is home to about half the corporations in America – is home to the famous business judgement rule that prevents shareholders from winning suits against directors just because they disagreed with strategy. The legitimacy of the business judgement rule ought to protect the directors from this action. But it's not clear the court will agree that business judgement has been exercised in this case. Getting a trickle of advertising and selling a few bibles from the site may be what the directors think God wants. But it's not the size of business that Solakian thinks it could be with a more evangelical-entrepreneurial bent. Are directors duty-bound to make as much money as they can? Are there higher callings?

Source document: The Reuters news story gives a nice spin to the tale, though others may wish to twist it further. The court documents are available through the LexisNexis File & Serve service.

UK Stewardship Code gains backers, a few from abroad

The UK Financial Reporting Council wants a head of steam behind its Stewardship Code concerning how institutional investors engage with the corporations in which they invest. Launched in July to a mixture of fanfare and scepticism, the code asks investment funds to abide by a set of principles that aim at promoting the long-term growth of companies fostered by active dialogue with investors. Investors, it says, should act like owners, not commodity traders. Many of the usual suspects is on the list of firms adhering to it. A few – but only a few – come from outside the UK, and they too might be called usual suspects: CalPERS, the California state pension plan is one. It's a long-time activist investor noted for its engagement. Capital International, the London subsidiary of the US-based giant Capital Group is, too. It engages in a different way from CalPERS, but it's a regular on the scene. In all, 68 institutions have published statements of support: 48 asset managers, 12 asset owners and eight service providers. Baroness Hogg, the FRC chairman, said, perhaps somewhat optimistically: "A critical mass of investors is coming through and this is a very important first step. Not only do we wish to see these numbers increase, but we also want to see a better integration of governance and investment processes that will be vital in ensuring effective implementation of the Code. In that respect, actions will speak louder than words."

There are less familiar names, as well. Here's the response of one of them, Pyrford Investments, to the first of the Stewardship Principles:

Principle 1: Institutional investors should publicly disclose their policy on how they will discharge their stewardship responsibilities.

The Pyrford investment process requires that the management of any potential investee company is visited prior to a decision to invest. Any company in which we are invested is then revisited at least once a year. The purpose of these meetings is to determine the potential for changes in earnings over Pyrford’s five year investment horizon. However, particular focus is given to the way companies interact with all of their stakeholders (customers, employees and shareholders) to ensure that all are treated fairly and a positive relationship is maintained with the company.  

Impressive, but not the stuff of the rapacious hedge funds whose actions are so often seen to threaten a company's focus on long-term objectives in face of demands for short-term performance. Time will tell how well stewardship develops.

Source document: The lists of backers will be updated as others join.

Puma, the SE and the shape of the board

Another one bites the dust. The European Union's legal form Societas Europaea hasn't been quite the hit that its creators envisaged in the early days of the new century. Corporations around the Europe Union have had this legal form available as a way of operating across 27-member states without having to set up special subsidiaries and comply with national company law in all its variations. Yet few companies have taken advantage of it – except in Germany. Now Puma has joined the small crowd, another German convert to the cause. Puma's reason is perhaps a little different from the others – which include Allianz and Porsche. Those looked like attempts to break out of the straightjacket of Germany's Mitbestimmung regulations, the "co-determination" law under which members of the workforce get half the seats on the supervisory board. The change of status didn't diminish that requirement, but it did allow the companies to spread those seats to labour representatives across the European Union, thus diluting the power of German trade unions on the boards.

In Puma's case, the reasoning and the outcome is a little different. Now 71 per cent owned by PPR, the French luxury goods company, Puma is adopting a more forceful interpretation of the SE law. It's ending its German-style dual-board structure in favour of a single board, so that its CEO, Jochen Zeitz, can become executive chairman, still part of the management but also running the board. He'll also join the senior management of PPR as head of a new lifestyle division. Splitting his time between the two sets of responsibilities might have been messy for a CEO but it's just about manageable for a chairman. But there's scope for conflicts of interest. And there's the small question of the interests of the holders of the other 29 per cent of Puma to consider. That isn't to say it can't be done, of course. But Zeitz will have to perform a balancing act as he juggles his roles and responsibilities.

Source document: The news release gives a bit of the background to the decision, if not to the corporate governance nuances.

UK regulator 'does ethics' this time

A few years back the chairman of the UK Financial Services Authority famously said the agency "doesn't do ethics". Howard Davies has since retired to be director of the London School of Economics, and his successors have had a rockier rock to follow. Hector Sants, the incumbent FSA chief executive, says the agency still doesn't do ethics, but then went on to show that it does, really. Davies had said it was not for "the FSA to seek to act as the conscience of the square mile", as London's financial district is sometimes known. But after a big financial crisis that saw large banks swing into government control, the FSA has been stepping up it demands to approve ahead of time candidates for the boards of financial institutions as well as those in senior operating roles. But can it change their culture? Here's a bit of his view:

I do believe that determining an ethical framework is for society as a whole, not an unelected regulatory agency. In that sense, it is right that the FSA "does not do ethics" … However, regulators have a central role to play, which should be to ensure firms have the right culture for their business model – the right ethical framework – to facilitate the right decisions and judgements and we should intervene when we find those frameworks are lacking. Finally, may I return to the central theme of trust. Trust has been lost between the financial community and the rest of society. The principal agents for restoring that trust must be the firms themselves.
Regulators have their role to play, but Sants suggested that it will take more than a regulator to fix the problem: "this goal will not be achieved without far greater recognition of the importance of this topic across governments, regulators and firms around the world."

Source document: The Sants speech gives further details of his thinking.

'Dismal' corporate governance: 'Wall Street's to blame'

The culprit behind the dismal state of corporate governance is Wall Street capitalism. That's the view of Insead Professor Ludo Van der Heyden, who has been named Academic Director of the French business school's new corporate governance Initiative. "Corporate governance – and beyond that governance by the state – has failed in the USA," he says. "That is a major lesson of the recent financial crisis. Of course, it has failed in other countries as well, as the UBS debacle attests. But the absence of adequate corporate governance in the US financial sector has certainly been shown. And the response is now being worked out between the US government and the banks right now." The problem with corporate governance, he reckons, is that poorly performing CEOs have no downside risk. Market mechanisms for pay have created perverse effects. His colleague David Young suggests an alternative: "Executive Wealth Leverage", a metric of pay linked to shareholder wealth. Based on US data, Young calculates that the pay of CEOs in the US correlates to changes in shareholder wealth by a factor of only 0.4, based on the absence of a downside.

But that doesn't mean candidates for CEO will buy it. There is a market for CEOs, after all. It's one that lacks transparency as a matter of its structure, since we don't know the real quality of a CEO until long after the recruitment process – or even the retirement process – is finished. In the current market, there's little reason to expect that a candidate for CEO would accept anything other than a one-way bet.

Source document: The discussion is summarised on the Insead Knowledge website, with video and a link to its new corporate governance initiative website.

A 'user-friendly' version of Belgian governance code is on the way

Corporate governance codes have become longer, with more suggestions and prescriptions as the struggle to find a formula for better boards drags on. Belgium, which took a bumpy path to its 2004 code, revised it last year in the wake of the financial crisis and soon found that companies needed something a bit easier to use. Now the Corporate Governance Committee, reconstituted with some new members, has decided to do something to make it easier for corporations to respond to the code. It set out a work plan that involves:

• User-friendly instrument: The committee will produce a user-friendly instrument to help listed companies apply that country's revised company law and the 2009 Belgian Code on Corporate Governance.
• Pay reports: The committee will draw up a model remuneration report and review the remuneration grid for the managers of listed companies, based on the new law.
• Risk reports: The committee will design an instrument to clarify how listed companies can meet the requirements on internal risk control mechanisms.

Also on the agenda is trying to find ways to ensure that women are more adequately represented on boards.

Source document: The news release gives details of the committee's new membership in a three-page pdf file.

Governance codes: French regulator seeks role in overseeing boards

When France got its first code of corporate governance in 1995, it came with a conscious sense of "I guess we have to". That was three years after the Cadbury Code in the UK had begun to articulate a notion of good governance. The Vienot Code three years later told French companies that they ought to take some similar actions because "international investors" – for which you can read "British" – were expecting it. Nonetheless, the attitude in France hasn't been exactly a warm embrace of the principles of stronger boards. What has persisted even through Vienot II in 1999 and the Bouton Report of 2002 has been what one regulator now calls a case of French "peculiarism". Jean-Pierre Jouyet, chairman of the French securities regulator AMF, told a conference: "I am convinced that the market regulator has an irreplaceable role to play in designing a corporate governance model to which we should aspire." For a notion of what might be on the way, consider these ideas:

• Limits of volunteerism: Jouyet suggested that the voluntary nature of the main provisions has been shown to be less than adequate. The main code in France is a creation of AFEP and MEDEF, the federations of largest enterprises and the employers, which gained statutory backing in 2008. But Jouyet said: "the limitations of this method of drafting governance principles have recently become apparent." Recent progress on boardroom diversity came only after pressure from the regulator and parliament, which raises questions about the limits of voluntarism.
• A stakeholder view: "It never ceases to amaze me that shareholders – both institutions and minorities – are called on to express their views by voting at annual general meetings, whereas their representatives are not invited to sit on the working groups that take part in preparing the governance framework," he said. So watch out for a change in direction.
• Diversity: Leave gender and ethnicity to the side for the moment. Jouyet started his discussion of diversity in this way: "Our boards of directors are too inbred: 98 people hold 43 per cent of the directorships in major French companies." Yes, boards need more women, minorities and foreigners, he said. But the implication here is that they could do with more Frenchmen, too. The AMF may well put limits on multiple board mandates.
• Independence: The existing code asks companies to consider whether outside directors are independent of management and other ties that might influence their judgement. Jouyet acknowledged that this is a tough area to judge, and having the right skills and knowledge might well compromise independence. "It is therefore up to AFEP and MEDEF to clarify their thinking on the definition of independence and skills," he said. "And it is up to companies to explain how they interpret these concepts when choosing their board of directors."
• CEO duality: It is time, Jouyet asserted, to stop the "to-ing and fro-ing" about combining the role of chairman and CEO. But he added that the AMF doesn't plan to prescribe one model as the only way to proceed.

The speech didn't make clear precisely how the AMF might proceed. And Jouyet is only one of the members of its executive, so there's still a debate to be had. But be clear: The debate has started.

Source document: The Jouyet speech is a seven-page pdf file in English.

Change at top of HSBC shows mess – and success? – in succession

The story wasn't supposed to turn out this way, but the initial reactions make you wonder whether it was at least a Plan B from the start. One of the world's most successful companies – a bank that avoided most of the problems of financial crisis and seemed to be set for even greater things – has made a very messy change at the top. For HSBC Holdings, which likes to call itself the world's local bank, it was a bit of local disruption in the boardroom. The headlines have been so large that we need repeat only the basic information: the chairman, Stephen Green, decided to step down. The CEO, Michael Geoghegan, wanted to step up to the chairman's role. The board wanted to move a non-executive director into the chair. Geoghegan objected somehow his objection found its way onto the front page of the Financial Times.

Perhaps Geoghegan really wanted to retire, and if so he got his wish. The board looked set to approve a completely different constellation than it set out to achieve, with Douglas Flint, the finance director, moving up to chairman, Stuart Gulliver, head of investment banking, taking over as CEO from January 1, Geoghegan leaving the company three months later, and to reinforce independence, Simon Robertson, the senior non-executive director, will become deputy chairman. The would-be chairman, the former Goldman Sachs investment banker John Thornton, is left sitting on the sidelines. In some ways, this troubled situation is a triumph in corporate governance.

Think of it this way: Practice at the bank has been, for several successions in a row, that the CEO would step up to the chairmanship when the incumbent was ready to leave. HSBC has been what some scholars call a serial non-complier with the UK Corporate Governance Code. Such transitions go against the letter of the code on two counts:

• Independent chairmen: The code urges that chairmen be independent of management at time of appointment. It's a way to ensure, in the wording of the original 1992 Cadbury Code, that no one person has unfettered powers in the boardroom, providing a remedy for the "agency problem" in corporate governance. A strong chairman will provide a check on the power of the CEO. An independent chairman will give the CEO room to run the company. Best of both worlds.
  
• Former CEO not on the board: The code also recommends that CEOs retire from the board altogether when they leave. Even having the former boss serving as a non-executive director, the code suggests, would inhibit the new CEO and the rest of the board from deciding to change direction.

HSBC has in the past ignored both of these tenets. Stephen Green was CEO before becoming chairman, as was his predecessor, and his. The bank's performance – in terms of growth, earnings and risk – seems to suggest that an orthodox approach isn't necessarily the best. Losing the services of a retiring CEO means losing a lot of knowledge. CEOs know the company, the industry, and – in the case of highly regulated companies – the outsiders who exert a lot of control. Moreover, a CEO who retires but wants to keep working would be an especially valuable non-executive director for a competitor, so keeping the CEO on the board keeps the CEO on board. The trade-offs are clear.

The complexity of banking is one reason why the Walker Review in November 2009 recommended a nuanced approach to corporate governance for financial institutions, one the recognised the need for expertise, not just independence on bank boards.

The case of HSBC puts those notions to the test, and more. As Geoghegan departs, the bank will lose valuable knowledge and experience. But Geoghegan's desire for the chairmanship suggests he was already looking to step back from line management of the organisation, so the loss of service might not be so great. The ability to promote from within suggest the bank is richly enough endowed with talent that there might be benefits in the disruption that will no doubt follow – especially if the exclamations about a new "dream team" we read in the press prove to have substance.

Does it matter that both new people at the top will be insiders? Perhaps it's better that way, for this company, in this industry, at this time in its history. The case also shows that the company is bigger than the individuals that lead it. Having depth as well as breadth of talent, the board didn't have to acquiesce, even to a highly successful CEO.

And what does it say about the UK Corporate Governance Code? Perhaps the message is that flexibility is needed – and that codes can only take you so far.

Source document: The HSBC statement on the changes makes no reference to Thornton at all, though the FT reported he would be leaving soon.

Boardroom diversity valuable and rare – SEC's Aguilar

Strategists tell us that the source of competitive advantage comes from resources that are valuable and rare. When it comes to diversity in the boardroom, at least one member of the US Securities and Exchange Commission thinks this valuable resource should be a lot less rare. "It continues to amaze me that there remains a need to highlight the importance of diversity in the boardroom," Luis Aguilar told the SAIS Center for Transatlantic Relations. He cited a report from the California Public Employees' Retirement System, known as CalPERS, that found companies with diverse boards performed better than boards without. Companies without ethnic minorities and women on their boards "eventually may be at a competitive disadvantage and have an under-performing share value", he said. Aguilar, who came to the US as a six-year-old refugee from Cuba, has a rather personal interest in boardroom diversity. But he's interested in seeing diversity in more than just gender and ethnicity. "I firmly believe that if government agencies and the private sector mirrored the diversity of the general population, issues such as diversity in the boardroom, and other important issues such as financial literacy in minority communities, would be a natural focus."

Source document: The Aguilar speech elaborates on his thinking.

Connected directors – good for business?

One of the disconcerting factors in corporate governance is this: every time you find something to blame for the problem, you discover it has beneficial properties, too. "Discover" may not quite be the right word – at least not in the abstract. When a board tries to rid itself of some offending structure or practice it soon comes to see the good side it has lost. Two academics from Stanford University in California have pulled together a short analysis – perhaps just a thought experiment – about the reasons why having directors who are deeply connected isn't all that bad. A lot of academic studies as well as statements by governance experts consider the negative effects of board inter-connections, how they reduce independence, create a culture of back scratching, and leave us with an "old boy network" and all the nods and winks that go with it. "At the same time, it is important to understand that these connections can deliver tangible, positive value that benefits the organization and its stakeholders," they write. "Rather than evaluate boards based on independence standards and other superficial structural attributes, more attention should be paid to how board members' professional backgrounds and network of connections contribute to governance quality and shareholder value creation. Why is it so difficult for commercial governance ratings firms to incorporate this information into their analyses?"

Source document: The article "Director Networks: Good for the Director, Good for Shareholders," by David Larcker and Brian Tayan of the Stanford University Graduate School of Business, is a four-page pdf file.

Transparency – too much of a good thing?

One of our occasional looks at old-ish books.
The centrepiece of corporate governance and capital markets has long been disclosure. It's sometimes invoked in the expression from 1917 from the soon-to-be US Supreme Court justice Louis Brandeis as "sunlight … the best disinfectant". Others speak in the duller language of economics about how in reducing information asymmetries we make markets more efficient. Still others view disclosure as a right – invoking freedom of information consideration in public life and a near equivalent when the private sector affects broad social issues. In the larger sphere of governance, Woodrow Wilson famous sought to prevent a repeat of the horrors of the First World War by advocating "open covenants … openly arrived at", though he also favoured negotiations behind closed doors.

Downsides: But transparency has its disadvantages, too. While we might take as a simple moral principle the maxim "would you want your mother to know?", ethics are often messier and not quite so clear cut. Perhaps you care enough for the mother that you don't want to upset her with actions that arise from ethical consideration situated historically in a place she would feel uncomfortable. Discretion is often said to be the better part of valour. In markets and in public affairs, openness has an aim – fostering trust. Trust allows transactions without contracts, reducing the cost of doing business or government. But openness can have the opposite effect, making people more wary of doing business with someone who once made a mistake. Openness can have directions as well. One-way openness can weaken a negotiating position. Even two-way transparency without dialogue may not create communication and with it trust.

Too much of a good thing? The facets of transparency come clear in a collection of essays published a few years ago, partly in response to the UK government's drive to use published targets and reports as a means of increasing the accountability of public institutions. The book Transparency: A Key to Better Governance? takes more of a "government" than "governance" perspective, but it draws on corporate experience in accounting as a way of creating accountability, sometimes with unintended consequences. Crime statistics can make people feel less secure rather than more. The length of waiting lists for hospital appointment can highlight the lack of choice in a centralised healthcare service.

Beating expectations: Similar issues arise in corporate affairs, seen perhaps most prominently in the way that striving to meet or beat analyst earnings estimates can lead management to adopt a short-term focus, to the detriment of the business. Short-termism has its upside, though: the long term is, after all, the sum of all short terms.

Source document: The book, edited by Christopher Hood and David Heald, is available to purchase at Amazon.

Steps towards stewardship and 'responsible ownership'

The UK has its new Stewardship Code for institutional investors, the European Union is discussing something similar, and in other countries similar initiatives are afoot. They set the broad outline, but not the details of process that a fund management organisation would need to follow. Simon Wong, a London-based US lawyer associated with Cass Business School in London, Northwestern University in Chicago and the advisory firm Governance for Owners, has penned an essay for McKinsey's house journal discussing what asset managers should do. Stewardship, he writes, concerns wider issues than voting for directors. "Governance issues such as board effectiveness, executive remuneration, and succession planning should be high on the agenda, alongside matters such as strategy and risk. Just as important, investors should not pressure a company to deliver short-term returns," he says. The move to do it involves:

• New performance metrics: Fund managers should encourage long-term thinking and active ownership by lengthening the period for performance reviews and reducing the emphasis on relative returns.
  
• Reduce intermediaries: Instilling a mindset of ownership involves stripping away layers of external asset managers, investment consultants and funds-of-funds. Pension funds in particular should building internal expertise.
  
• Less passivity: Passively managed funds – index-trackers and other low-cost investment forms face a challenge, as their business model relies of avoiding expensive things like engagement. Wong suggests alternatives: "As investment houses expand their offerings of passive products, they should supplement the traditional marketing focus on low costs with an emphasis on good stewardship, perhaps charging clients for the expenses incurred in scaling up monitoring and engagement resources. In addition, firms that construct market indexes can help by reducing the number of companies in the largest ones or by developing benchmarks that provide a broadly equivalent exposure to each market segment but contain fewer companies."

Source document: The article "How institutional investors should step up as owners," by Simon Wong, is available in McKinsey Quarterly online.

Proxy voting - valuable, but value wasted

Share voting is rather central to the theory of shareholder democracy, and yet the evidence from annual meeting returns is often that little more than half the ballots are cast, at least among those widely distributed in the market. The reasons for this fact are many, ranging from legal and even illegal constraints on cross-border voting, to the awkwardness of the process itself. Most of all, though, there's a sense that voting shares is even less likely to influence the outcome than voting for your representative in Parliament. Institutional investors – the ones with any real clout, that is – are probably going to use face-to-face meetings with senior management to make their concerns known, rather than waiting until the annual meeting and then casting a vote for or against a particular director. According to a global survey of asset management firms by two German scholars, votes are still considerable valuable. They measured both attitudes and behaviour, using the gap between share prices of voting and non-voting shares as a proxy, and found that investors to put quite a large value on voting rights. Moreover, they detail what many have suspected: that the division of labour in asset management firms mean that the fund managers who buy and sell stock make voting decisions less than a third of the time. A majority uses a management process through proxy voting committees or decision of executive management of the firm. Their questionnaire didn't capture how often voting decisions are outsourced.

There's more detail, as well, on views concerning attitudes to corporate environmental, social and governance issues at the companies in which they invest.

Source document: The working paper "Corporate Governance: Ethical compliance in the asset management industry," by Alexander Bassen and Christine Zöllner, is a 53-page pdf file.

Do women on the board bring a special style?

There has long been a presumption that companies with greater female leadership might grow to perform differently from those led by men. Since 2006, Norway has provided the world with a sort of natural experiment. It introduced a quota requiring that the boards of directors of public companies be composed of at least 40 per cent female members, and since then it's been the focus of attention of governments around Europe and elsewhere as a model for possible. The role of women directors has been the subject of much academic interest, too. One study of US companies showed a clear difference in approach, with the rather startling finding that boards with a large number of women were rather better at monitoring management but rather less good at generating profits. Another on a similar dataset found, however, that having women on the board didn't make the company more risk averse.

The Norwegian case, however, gives us a chance to examine such issues without some of the sources of error that arise from certain companies or industries being more open to women. Researchers from Northwestern University in Chicago and the University of Virginia ran their calculators over some of the early data from Norway's experiment and found something of a stakeholder orientation among companies affected by the quotas. They increased labour costs and employment levels at the cost of short-term profits. The effects were strongest among firms that had no female board members before the quota was introduced, and therefore may have experienced a sort of culture shock in the boardroom. "The results are consistent with changes in board composition affecting corporate governance and strategy, and with prior research suggesting that female managers may be more stakeholder-oriented than men," they conclude.

Source document: The working paper "A Female Style in Corporate Leadership? Evidence from Quotas," by David Matsa of
Northwestern University and Amalia Miller of the University of Virginia, is a 40-page pdf file.