comparative corporate governance

Yesterday evening I was at a Round Table on Corporate Governance organised by the Centre for Research in Corporate Governance of the Cass Business School, London. Professor Terry McNulty gave a talk about a very interesting research he carried out with Andrew Pettigrew during the second half of the 1990s. The study consisted in a survey of board members of the 500 largest UK FTSE companies. The idea was to find out how the structure of the board influences the behaviour of board members and, more precisely, the relation between the Chairman and the CEO.

McNulty and Pettigrew show that after the Cadbury and Greenbury reports on corporate governance (and subsequent reports), boards of UK companies underwent considerable changes in structure. Already the Cadbury and Greenbury reports, but also the governance codes of 1998 (the Combined code elaborated by Hampel) and the revised version based on the Higgs report of January 2003, all ask that the chair of the board and the CEO be two different persons. They also claim that a certain number of board members should be non-executive directors (NEDs). Consequently, the most important evolution in board structure was the separation of the function of chairman of the board and CEO. This evolution led during the 1990s to the emergence of five types of board structures:

1. The traditional system of cumulation between the positions of chairman and CEO (only 8.7% of the firms in their sample still had this board structure in 1997. Since then, this ratio has further decreased and is today probably about 2%)

2. A board with a full-time, executive chair who has formerly been CEO of the firm (20.6%)

3. A full-time, executive chair who has not been CEO of the firm (6.2%)

4. A part-time, non-executive chair who was formerly CEO of the company (10.6%)

5. A part-time non-executive chair who has never been CEO of the firm (53.7%)

The figures show that compliance with the governance codes is high since approximately 64% of the UK companies have non executive chairs.

Yet, McNulty argued convincingly that this compliance with the structure does not necessarily imply compliance with substance. In fact, the separation of the role of the Chair and the CEO aims at creating an independent board, which is supposedly able to effectively monitor the company’s management. However, McNulty and Pettigrew show that some of these models weaken, rather than strengthen, the position of the chairman and of the other NEDs on the board. Thus, their survey shows that only in models 1 through 3 the chair sets the agenda for the board meeting, whereas in models 4 and 5, i.e. the models that notably the Higgs report preaches, the CEO sets himself the agenda. The most likely explanation is that since the chair is a non-executive, he has not enough information about what is going on in the company in order to set the agenda.

The agenda setting is but one out of 34 issues of McNulty and Pettigrew’s research for which the respective power of the CEO and the chairman was analysed. All the results tend to show that board structures with non-executive chairmen reduce rather than increase the power of the chairman.

This result is actually confirmed by structural analyses of organisations. In fact, the claim that a large portion of board members should be NEDs may lead to an organisational structure, where the CEO is the only person to bridge the “structural hole” between the board and the operative management of the company. This of course gives him considerable brokerage power concerning the control of information flows between the board and the company as such. Whereas if other executive directors are on the board there is at least a theoretical possibility that the information the CEO gives to the board is verified by these executives. Hence, the complete independence of the board – i.e. 100% of NEDs – does not maximise the boards influence over management’s decisions.

This result makes intuitively sense. However, the corporate governance reality does not pay much attention to this issue. In fact, corporate governance policy-makers put very much importance on the question of board independence from management, which should be achieved through rules concerning board structure and composition. As McNulty shows, these rules can be counterproductive. What misses in these reform efforts is a deeper understanding of how boards work in actual fact and the insight that at the end of the day boards are composed of people.

Related to this, one issue that was brought up yesterday during the discussion, was the question of competence. In fact, the competence of board members is probably the most important factor, which can guarantee that a chairman, or any other NED, is able to effectively control the management’s decisions. Competence however can not be guaranteed with rules concerning the composition or the structure of the board but only with recruitment procedures for board members; and such procedures are difficult to define. How can one make sure that the shareholder meeting elects the “most able” candidate on the board? In most countries board composition is ruled by other criteria than competence. Thus in some countries legal rules prescribe board representation for certain constituencies of the firm (such as employees’ representation in Germany). This limits of course the choice of people available for that job, which may further limit competence.

The link between competence of board members and effective control is an issue, which is virtually never addressed in discussions on good governance and does not appear as such in corporate governance codes or company laws. Of course finding a solution to this issue would greatly increase the quality of control mechanisms within the firm. However, as prof. McNulty pointed out last night, sometimes we can create as many new rules as we want, the outcome will always depend on how actors apply these rules and how they behave within the regulatory framework. This is a fundamental limitation to all efforts aiming at regulating the economy and making sure that things like Enron, Parmalat or Swissair do not happen again.

# posted by Gerhard Schnyder @ 2:57 AM