By Robert Adamson
Executive Director, CIBC Centre for Corporate Governance and Risk Management

As corporate governance continues to be an area of focus for most companies, regardless of whether they are involved in global operations, there are many questions and issues that firms still struggle with:  What is good corporate governance and why is it so important? Why are so many firms and governments promoting improved techniques in corporate governance? What are those techniques and best practices and is there evidence that these reforms and policies are useful for firms in promoting transparency, sustainability and the confidence of global markets and investors? Continue reading Corporate Governance, Risk Management and Corporate Social Responsibility in Emerging Markets: A Symbiotic Relationship

There have been many efforts over the last 40 years to create a national securities regulator in Canada. According to the advocates of a national regulator, the current politicized system of provincial securities fiefdoms threatens the long-term future of capital markets and makes those markets less sophisticated and more prone to peculiar political interests. According to the opponents, the current system of provincial securities regulation works well and ensures that provincial interests and innovation are not trumped by narrow national interests, or more specifically, the interests of Central Canada.

As there is typically a lot of inertia in favour of the status quo – and many political interests who remain invested in this status quo – creating a single securities regulator has been, and remains, elusive. Though almost every group or report that has been tasked to analyse the issue concludes that a single securities regulator is beneficial for Canada’s position and reputation in global capital markets, the political obstacles appear to overwhelm those arguments. This persistent political opposition from several provincial governments has led the federal government to pursue a Supreme Court of Canada reference case that asks the Court to explicitly acknowledge the right of the federal government to create a national securities regulator under the trade and commerce power (Constitution Act, 1867, section 91(2)). The case will be heard next April.

Is this opposition to a national securities regulator merely a case of entrenched provincial interests clinging tenaciously to their own powers and interests to the exclusion of Canada’s national interests to improve its position in capital markets? Or is there merit in the provincial government position? Is there any way in which the current regime of provincial regulators with no common framework  is preferable to a national securities regulator? Could there, for example, be a benefit of having provincial regulators define their own regulatory rules? Could this system lead to more innovation, closer regulatory scrutiny and overall better corporate governance? Is there any evidence that this is the case?

In other areas of governance, such as health care, overlapping jurisdiction and shared responsibility  between the federal and provincial governments has worked relatively well. The power-sharing and overlapping jurisdiction has allowed for and accommodated innovation and local expression of priorities based on nationally agreed upon processes and minimum requirements. But this type of shared responsibility does not appear to function well in the area of securities regulation. First of all, capital markets seem to prefer predictable and common principles rather than variance, even if this variance can be occasionally exploited to a company’s benefit. For most businesses, their interests are not in being able to exploit local regulatory regimes but rather to have rules that will be the same for all companies: relatively consistent and unswerving to political interests. Secondly, other areas of shared governance such as health care rely on the federal government to define minimum standards and policy objectives. But there is no federal regulator or federal government role in creating common policy or minimum standards in securities. Provincial securities commissions work together through the Canadian Securities Administrators (CSA) but without the involvement or resources of the federal government. The CSA is an initiative of the provincial regulators  to create some consistency through programs such as the “passport system”; a program which allows investors to access other provincial markets by complying with the rules of their home province.

But is the passport system really enough to ensure consistency and efficiency in Canadian capital markets? This system was clearly inadequate in dealing with Canada’s asset back commercial paper (ABCP) crisis, particularly due to inadequate coordination and policy mechanisms. There must be a better model?

The United States is also a federal state which accords significant constitutionally entrenched rights to state governments. While states do maintain some jurisdiction over securities trading and activity through state-level responsibility for anti-fraud laws (“blue sky laws”), the securities regulatory regime is primarily federal with eight main statutes governing the general trade and administration  of capital markets. And despite the recent global financial crisis and the allegations that some of the problems during the crisis were linked to federal regulatory oversight problems and inefficiencies, there is still no compelling voice in the United States insisting that securities regulation would be improved if regulatory responsibilities were transferred to the states. Discussion of regulatory reform in the United States has focused instead on improving the effectiveness and resources of the federal securities regulatory framework, and particularly the Securities and Exchange Commission.

The fact is that most highly industrialized countries, including other federal states such as the United States, have created national securities regulators and this trend offers at least some prima facie argument for having a national securities regulator. The fact is that Canada is routinely targeted for its lax enforcement of securities fraud and abuses and this suggests that the provinces are not doing an adequate job either to enforce their securities laws, or have not created adequate laws to enforce. The fact  is that it is much more difficult for even the most willing provinces to enforce their securities regulations since enforcement resources are dispersed among 13 provinces and territories and this suggests that there is a more effective and efficient way to organize securities regulation, and particularly enforcement. The fact is that it is typically easier for individual corporate interests to influence  provincial regulators than to influence a national regulator and this influence-game creates undesirable outcomes by submitting the objectives of good corporate governance to pressure group politics. And despite this potential benefit of the status for companies, most companies  support having a national regulator and complain that the current system is ineffective and inefficient.

If Canada intends to protect and promote its reputation for providing stable and efficient capital markets, and its reputation for good corporate governance, is it not time for provincial political interests to act in the best collective interest for Canada’s position and reputation in capital and securities markets? Should it really take more than 40 years and a court challenge to the Supreme Court before political interests are forced to move aside in the pursuit of good- or at least better- corporate governance?

New research by scholars from the University of South California has provided some support for those who are skeptical of the role that good corporate governance plays in improving corporate performance. The study by David Erkens, Mingyi Hung and Pedro Matos followed the performance of 296 financial institutions with assets of more than $10 billion during the period 2007 to 2008. The study concluded that none of the typical practices that are supposed to measure good corporate governance actually helped companies perform better.

Really? None!  Can that possibly be? But the authors insist that their research showed that boards with expert directors fared no better than those without, and that companies that separated CEOs from chairmen were similarly no more likely to prosper than those that did not. Other presumed indicators of good governance such as the involvement of institutional shareholders and independent directors were even negatively correlated to company performance.

What could possibly lead to these counterintuitive results?  The authors provide their own potential explanation by arguing that preceding the financial crisis, financial institutions were under pressure from institutional shareholders to take additional risks in order to improve returns. Likewise independent directors  were more likely to encourage companies to raise more equity capital even when share prices were faltering. So rather than independent directors improving corporate governance, they actually detracted from it.

But are the results of this study really that counterintuitive? Are there not other reasons why the results of this study may not reinforce the merits of adopting good corporate governance practices. Could the problem really be inherent in trying to draw conclusions from arguably inadequate or inappropriate measures of good corporate governance? And could a problem also not lie in trying to draw too many conclusions about corporate governance in one type of firm (financial institutions) during an unusual and extraordinary event (the global financial crisis)?

So what of this idea that this study, and others like it, may be trying to measure corporate governance in the wrong way. What of this idea that board independence and the separation of the role of CEO and chairman are not good proxies for good corporate governance? What if, for example, the authors had used institutionalized risk management as a way of representing good corporate governance? And what if the authors had studied the correlation between this measure of corporate governance and resilience of share value rather than just share value during the crisis?

Beyond this challenge of trying to find adequate proxies for good corporate governance, there is another potential impediment to research that tries to draw simple correlations to share price. While share value may be an easily identified measure of company health, it is only one measure. And I would argue it is not a very good measure, at least not when examining corporate governance. There is a presumption that markets (i.e. shareholders) have the ability and interest to analyse and understand how companies implement good corporate governance and reflect their approval through demand for the stock. But many shareholders, including sophisticated institutional shareholders, focus on a very narrow number of indicators of good corporate governance: independent board members, the separation of CEO and chairman, effective and frequent communication with shareholders. Many shareholders also have very little understanding about how corporate governance is conducted and institutionalised at the firm other than through these same basic  corporate governance measures such as board independence etc.

But these traditional measures of good corporate governance may not really be the best way to ensure and promote the objective inherent in good corporate governance. Maybe good corporate governance is not really about these relatively simple indicators used in this study; measures such as the presence or number of independent directors. Maybe good corporate governance is rather about something much more complex and difficult to measure.

In fact, the authors recognize these difficulties and the confusion and contradictions that they create. The authors acknowledge that another financial crisis in another part of the world at another time illustrated that there was a positive correlation between corporate governance and company performance. During the Asian financial crisis of 1997-1998, there is evidence that increased external monitoring of companies produced better performance.

So what could explain this apparent contradiction? As always, there can be many explanations in our attempt to find measures and proxies for corporate governance as well as measures of a healthy and sustainable company. And here the authors of the study acknowledge a problem in the skepticism about corporate governance that most would take away having read their study.

The counterintuitive results of the study raise the question of whether traditional measures of corporate governance are adequate to protect companies from taking excessive risks. As the authors note, good corporate governance cannot be viewed as a simple box ticking exercise. Policies on board independence cannot immediately overcome entrenched preferences for risk-taking, corporate culture, and institutional lack of capacity for identifying and analyzing risk. Independent directors are, for example, only one measure of board objectivity and not an indicator of the quality of a board’s decision-making. If objectivity comes with lack of expertise, then the objectives of good corporate governance will have been thwarted.

So what if the authors had studied something else:  the correlation between a firm’s institutionalized risk management  and share value? Instititutionalised risk management would include issues such as whether the firm has a risk management team, whether that risk management team focuses on non-traditional risk beyond financial risks, whether there is a separate committee of the board dealing with risk beyond the audit committee, whether the firm attempts to define risk environments and risk tolerance, and whether risk managers have direct access to CEOs or directors.  If these measures had been used as proxies for good corporate governance, would the results of the study have been the same?

I would argue that this study should not be used to bolster skepticism of the benefits of corporate governance, and I suspect that the study’s authors would not want their research to be used in any way that reaches premature or inappropriate conclusions. The study should be used to further question the adequacy of how we understand and quantify corporate governance. Corporate governance cannot be a box-ticking exercise about numbers of independent directors and separating the roles of chairman and CEO. These practices will- to some degree and with important caveats- remain ways to prima facie improve corporate governance. But these good corporate governance practices may not always work, particularly if there are more meaningful impediments to good corporate governance at the firm, including the absence of ways of identifying and analyzing risk through what I call institutionalized risk governance.

The study should also prompt us to continue to question whether share value is the best measure with which good corporate governance will, or should, correlate. Perhaps a better measure of the impact of good corporate governance is the resilience of a company’s share value over a meaningful period of time, and not just one crisis.

Skepticism about the benefits of corporate governance is surely healthy. Skepticism about anything is healthy. However, our research program and research tools should assist us in working through this skepticism before the skepticism turns prematurely into cynicism. And as cynicism about the merits of any rules or regulation or interference with corporate practice has been ascendant, even following the recent global financial crisis,  we must ensure that our research is actually asking the right questions and using the right assumptions. Understanding the benefits and practices of good corporate governance will remain a challenge but let us not be too skeptical before we have right to be.

There is no one lesson  that has been learned from the financial crisis. Instead, the crisis has reiterated long-standing principles for boards and financial companies:  the importance for boards in exercising prudence and judgement, the  importance of diversification, the fleeting nature of liquidity, the importance of understanding the complex risks and products of modern global finance, and the risks associated with concentration.

But beyond reinforcing these principles, the financial crisis elevated certain concerns for boards to new levels of prominence: the forms and capacity of internal risk management, the issue of remuneration and executive compensation including its relationship to different types of risk, and the diversification of boards including how capable boards are in dealing with highly technical issues of global finance.

With these issues in focus, there is good reason -for boards and shareholders alike- to be concerned that risk management has become more of a “box-ticking exercise” than a sophisticated management strategy where managers and boards exercise their judgement through meaningful dialogue and discussion about complicated macro- and micro-economic risks. If boards learn something from the financial crisis it should be that risk management requires more resources and sophistication than a procedural and pro forma “box-ticking” exercise.

Boards should also be concerned about how remuneration policies- at least at some firms- may be out of line with shareholder interests. While some directors believe that the issue of executive compensation is a red herring which does not create risks for financial firms, others rightly express concerns that excessive and non-transparent compensation policies can create both systemic risks for the financial system as well as reputational risks for  firms. In attempt to improve compensation policies, boards should acknowledge and consider some of the “new” approaches or policies that some financial firms are using: holdback, vesting and other incentives.

Another potential lesson for boards is the importance of building diversified boards while maintaining the technical skills and capacity to oversee complex financial management issues. If managed and adopted skillfully, board diversification is an important strategy in creating more effective and informed boards. In addition to board diversification, boards should also be aware of and consider other means of institutional improvement including: promoting independent directors, limiting or eliminating “insiders”, ensuring that boards have more opportunities for and expectations of engaging with employees and shareholders, the use of board representatives within the company, and increased remuneration for directors so that there are incentives to spend more time on board responsibilities.

Despite the dramatic nature of the recent global financial crisis, there is also reasons to be concerned that very little had really changed in the way boards operate, including financial firms. The danger for these firms- and for the economy as a whole- is that the opportunity for reform and improvement will evaporates without any meaningful changes having been implemented. And, in order to target the most meaningful changes and reforms that are needed, we require a much better understanding of the things that went wrong during the financial crisis. Rather than moving toward “knee-jerk” reactions proposed by either firms or regulators, everyone should take the time and allocate the resources to better understand the problems and the types of firm-level and policy reforms that will be helpful in either preventing or mitigating future crises. Perhaps the biggest concern for us all is that the time, resources and level of introspection necessary for meaningful organizational and regulatory reform have faded away as impossibilities in the modern architecture of global finance and the cynical underworld of realpolitik.

It seems the list of things for corporate boards to consider during their meetings continues to get longer and more detailed. There continues to be an expansion of the types of issues that boards are expected to explore in order to fulfill both their legal duties as well as the expectations of shareholders. Continue reading Upcoming Corporate Governance and Risk Management Issues for 2010

CCGRM Corporate Governance Working Paper

August 2009

By Robert Adamson, Executive Director, CIBC Centre for Corporate Governance

Executive Summary: The purpose of this CCGRM Corporate Governance Working Paper is to outline some of the current corporate governance challenges facing Viet Nam, highlight the changes in corporate governance policy and practice that are currently underway, and to speculate on the issues and opportunities that government, firms and investors will likely encounter as this corporate governance regime evolves in a rapidly changing and volatile global marketplace. Continue reading “Tiger, Tiger Burning Bright”: Corporate Governance and Investor Opportunity in Viet Nam

It is highly likely that both hedge funds and private equity firms will be subject to new rules and regulations, and perhaps different rules depending on whether there is any serious and successful attempt to coordinate rules across and between jurisdictions.

In Europe, for example,  hedge funds and private equity have become the focus of the EU’s regulatory agenda. The EU has drafted a directive that mandates increased regulation of hedge funds and private equity whereby these financial managers will be subject to increased disclosure, more stringent limits on leverage and tighter restrictions on non-EU funds. The directive would, for example, require alternative fund managers, rather than funds themselves, to register and obtain government authorization. This government authorization was not previously required. The directive also includes reporting, governance and risk management standards, including minimum capital requirements. There are also non-binding recommendations on directors’ remuneration including caps on severance pay and the deferral of bonuses. Continue reading Hedge Fund and Private Equity: New Rules for the Game

Executive compensation has long been a controversial and divisive issue. It is obviously even moreso in our current economic malaise in which companies are vying for their survival while executives walk away with multimillion dollar compensation packages. It seems even more egregious and objectionable when the executives that are walking away with extraordinary bonuses and compensation packages are linked to the demise or near demise of the companies who are paying them their huge packages. In fact, executive compensation is also linked to creating or exacerbating the systemic risks in the financial system that created our current economic malaise. Continue reading Executive Compensation: Disclosure, Advisory Votes on Pay and Source of Systemic Risk

The focus on levels of executive compensation and how they are determined is not just about how much money business leaders are paid and whether that is appropriate or unfair. While shareholders and the general public are particularly annoyed when compensation levels rise to levels that do not seem warranted, or do not appear correlated to company performance, public and shareholder attention to these issues will most certainly wane as the economy rebounds, wages rise and people become less concerned about apparently egregious levels of pay. But failing to address executive compensation levels and the process for arriving at those levels is a potentially much more serious issue than how it speaks to issues of wealth distribution, equity and fairness in the employment marketplace. There is a strong argument that can be made that executive compensation contributed significantly to the current economic malaise and that our ongoing failure to understand and correct how compensation structure encourages ill-advised risk taking will continue to create and sustain dangerous systemic risks for the financial system; risks that may resurface in coming months or years with serious economic consequences. Continue reading Compensation Structure and Systemic Risk

Asian companies are increasingly powerful players in the global capital markets. The world media and business pundits have long prognosticated on the emerging and emerged economies of Asia, the Red Tigers,  the Asian tigers and the success that the Asian economies have had in engineering rapid economic growth. Business commentators, investors, policy makers all look with keen interest and foreboding at the potential for Asian economies and companies. The demographics, the entrepreneurial spirit, the relative stability of Asian economies have long foretold of the emergence of Asia as an economic powerhouse. Continue reading Corporate Governance in Asia