Marc Goergen's Blog, page 7

RETHINKING THE WAY CORPORATE GOVERNANCE IS TAUGHT IN BUSINESS SCHOOLS

In February, I wrote a blog about the UK approach to corporate governance, which started with the Cadbury code. I argued that we need to review the UK approach as it is not enough evidence based. A few years ago, I organised a conference on corporate governance at Cardiff Business School. One of the participants, one of the authors of an important review of UK corporate governance which was commissioned by the UK government, expressed utter surprise at the fact that there was indeed research being conducted on corporate governance. It seems weird that policy makers and executives have so little awareness and knowledge of corporate governance research, which by its very nature is highly practice oriented and often also has important policy implications.

Why would this be the case? Imagine that your general practitioner (GP) refuses to keep up with recent developments in medical research. What would be your reaction? You would very likely lose confidence in your GP and try to find a doctor with up-to-date knowledge. So why aren't executives interested in corporate governance research? The answer to this question is not obvious. First, executives are frequently prejudiced about business and management research (and not just corporate governance research), believing that it is too remote from what they do on a daily basis, too theoretical and fails to deliver clear prescriptions about what to do in practice. Both sides are probably to blame. While there is research out there that is highly theoretical and sometimes has predictions that cannot be tested, a lot of research is of an empirical nature using primary data (e.g. from interviews and questionnaire surveys) or secondary data (e.g. from companies' annual reports). Clearly, such research will provide insights into corporate governance practice. In turn, a lot of academics may still have a rather blasé attitude in the sense that they believe that it is beneath them (and a waste of their time) to engage directly with (potential) users of their research. Nevertheless, attitudes are changing in academe whether this is voluntary or not. For example, the latest government exercise of rating UK universities in terms of the quality of their research, the Research Excellence Framework , gives marks for impact, defined as the 'reach' and 'significance' of research. Second, as anything else that is driven by government policy or at least government pressure, vested interests are likely to be an important driving force pushing regulation in a particular direction or, even worse, preventing it altogether. The sub-prime mortgage crisis is a good illustration of how powerful pressure groups can mold and/or prevent regulation that is against their self-interest. Third, there is clear path dependence. If one goes down a particular path (e.g. emphasising the role of non-executive directors in corporate governance), it is difficult to make radical changes to that approach later on.

However, I believe that it is also important to rethink the approach to teaching corporate governance within business schools. Too often, that approach is too simplistic and grounded in existing regulation rather than evidence. For example, some of the earlier textbooks on corporate governance, after a very cursory review of corporate governance theory (to be frank there isn't much), embark on an extensive review (typically devout of any criticism) of existing corporate governance regulation and codes of best practice. This is then followed by chapters discussing how to achieve the key recommendations of the codes (e.g. board independence). As I have written in a previous blog, there is very little evidence that board independence creates firm value. There is also now emerging evidence suggesting that, while board independence may be good for more mature firms, it may cause more harm than good for younger, high-growth firms.

I believe that when teaching corporate governance it is important to keep an open mind approach, which would include a critical review of existing regulation. It is also crucial to convey to students that to date there is still a lot we do not know about corporate governance. Finally, we need to get back to basics. What are the aim and the objectives of corporate governance? Looking up the definition of corporate governance on Wikipedia [accessed on 22 March 2014] is a hair raising experience:

Corporate governance refers to the system by which corporations are directed and controlled. The governance structure specifies the distribution of rights and responsibilities among different participants in the corporation (such as the board of directors, managers, shareholders, creditors, auditors, regulators, and other stakeholders) and specifies the rules and procedures for making decisions in corporate affairs. Governance provides the structure through which corporations set and pursue their objectives, while reflecting the context of the social, regulatory and market environment. Governance is a mechanism for monitoring the actions, policies and decisions of corporations. Governance involves the alignment of interests among the stakeholders.

Corporate governance is much more far reaching. I believe it is wrong to limit corporate governance to a set of rights, rules, procedures and mechanisms. We are actually experiencing some of these far reaching consequences at this very moment in time. The 2007/8 bank failures are now redefining the social contract in the UK, in particular the distribution of the country's wealth across social classes. This is reflected in recent as well as ongoing cuts to social benefits and employee rights. Yes, corporate governance is also about rights, rules, procedures and mechanisms. However more importantly, I believe it is about the prevention or mitigation of conflicts of interests. Such conflicts of interests may exist between:
the providers of finance and the managers;the shareholders and the stakeholders;different types of shareholders (mainly the large controlling shareholder and the minority shareholders).The way these conflicts of interests are addressed has major implications for the distribution of economic wealth across society. Ultimately, corporate governance is about the design of capitalist systems.

This is the approach I adopt in my textbook on International Corporate Governance . Hence, the inclusion of chapters on Corporate Governance, Types of Financial Systems and Economic Growth, and Employee Rights and Voice across Corporate Governance Systems, as well as the discussion of important concepts such as capture of gatekeepers (e.g. regulators and auditors) by firms.

A suggested outline for a module on corporate governance can be found here.


Legal disclaimer: This blog reflects my personal opinion and not necessarily that of my employer. Any links to external websites are provided for information only and I am neither responsible nor do I endorse any of the information provided by these websites.

BOARDROOM DIVERSITY AT ANY COST?

Improving diversity on corporate boards is definitely on the agenda, and increasingly so. Typically, diversity is limited to gender diversity. Unfortunately, we still seem to be light years away from a broader approach to diversity, including diversity in terms of age, race, culture, religion and other personal attributes.
So is increased board diversity good or bad? There are many commentators on social media who unequivocally advocate greater diversity and equate increases in diversity to shareholder value creation. Here is just one recent example from Twitter:

Yes, #diverseboards create value MT“@TheWomanEffect: Gender #diverseboards – a financially significant issue? http://t.co/2dC87UW8” #corpgov
— Tommaso Arenare (@tommaso_arenare) March 9, 2012

The author of this Tweet is obviously convinced that greater diversity is always good and that there is no doubt whatsoever about this. So what does the academic literature tell us? First of all, and this comes as no surprise, women are underrepresented on corporate boards. For example, Marianne Bertrand and Kevin Hallock report that women hold only about 2.5% of top managerial jobs in stock-market listed US firms. They also earn on average 45% less than their male counterparts. Female representation on UK boards is not any better as a study by Clara Kulich and colleagues suggests: only 3% of board seats in listed UK firms are held by women and their pay is 19% lower. However, there are also significant differences in the structure of compensation contracts between female and male executives. Indeed, female executive pay is less performance-sensitive than male executive pay. This goes both ways: the pay of women has less upward potential, but also less downward potential.
Could this suggest that women are more risk averse than men? There seems to be some evidence suggesting that this is indeed the case. John Coates and Joe Herbert study the link between testosterone and risk taking for traders on the London Stock Exchange. They find that testosterone --  at first -- is good as increases in the hormone make traders more willing to take risk and make them look for novel investment opportunities. It also makes traders more persistent which is an important trait for those wanting to outperform others. However, if testosterone continues to increase and remains at consistently high levels traders become less rational and end up taking more risk without greater returns on their investments. While testosterone is mostly a male hormone, it also exists in women but at much lower levels. There also seems to be some evidence that testosterone decreases with age, although that is not the case for all males. 
This can only suggest that diversity is good. An all male board may end up taking excessive risks and compromise the survival of the organisation. In contrast, an all female board may take too little risk and forego some lucrative investment opportunities. This would suggest that it is important to have some diversity on the board. Having too many board members with similar characteristics is also likely to result in group-think, that is too little scrutiny of the strategic choices proposed by the CEO and the other executive directors.
So is the Norwegian way of imposing a quota (of 40% for both genders) the way forward? The Norwegian experience has been somewhat mixed. Those that criticise the Norwegian approach argue that the quota has been introduced too quickly, ignoring the lack of suitable female candidates. They argue that it has resulted in the same few women (the so called 'golden skirts') sitting on most boards. This could have dire consequences for board independence. Øyvind Bøhren's research suggests that some Norwegian firms have even changed their legal form to escape the mandatory gender balance. So what does this suggest? Interestingly, he finds that those firms that change their legal form to escape the quota are of a particular type. They are young, high growth, unlisted and profitable firms with few female directors but powerful non-family owners. This seems to suggest that these firms believe that the costs from greater gender balance outweigh the benefits. So we are back to 'one size does not fit all' (see my blog on the Cadbury Code). 
More generally, and contrary to what some practitioners seem to think, the evidence is still out there as to whether greater representation of females on corporate boards creates or destroys value. Some academic studies (see chapter 7 of my book 'International Corporate Governance' for an overview) find that female directors have a positive impact on corporate performance whereas others find no effect or, even worse, a negative effect. In a nutshell, the type of female director is important. While female CEOs tend to create value (probably because they have to work so much harder and be so much better than their male counterparts to break through the glass ceiling), other female directors tend to destroy value. The firm's industry also seems to matter as female directors seem to create value only (in terms of reputation) in firms that are close to their final customers.
What does this call for? The answer is simple: more evidence based corporate governance regulation. While the intentions of regulators and leading practitioners may be entirely honourable, frequently those behind new policies ignore the implications for firm value. Quotas seem to be a radical way of increasing board diversity, imposing the 'one size' on all firms, whether it fits or not. I am all in favour of board diversity, but at the same time the way to achieve it is important.
Note: Parts of the above blog post are based on chapters 7 and 15 of my book 'International Corporate Governance'.  

Legal disclaimer: This blog reflects my personal opinion and not necessarily that of my employer. Any links to external websites are provided for information only and I am neither responsible nor do I endorse any of the information provided by these websites. 

THE CADBURY CODE -- A BLESSING OR A CURSE?

It is now more than 20 years since the Cadbury Committee's Code of Best Practice, commonly known as the Cadbury Code, has been published. While at first its focus was on financial fraud as a reaction to corporate scandals such as Coloroll and Poly Peck, its remit was extended after the Robert Maxwell and BCCI scandals. A common feature of most of these scandals was a domineering chief executive officer (CEO) combined with a weak board of directors. This kind of problem is commonly referred to in the academic literature as the principal-agent problem. This problem arises in widely held firms that are owned by many small shareholders who tend to be passive and who tend not to get involved in the running of the firms they have invested in. This problem is effectively caused by conflicts of interests between the managers (the agents) and the shareholders (the principals). While the managers are expected to run the firm in the interest of the shareholders, they may prefer to pursue their own interests. So how did the Cadbury Code try to reduce these conflicts of interests between the agents and principals? Weirdly enough, it did so by introducing (or more precisely reinforcing the role of) another type of agent, the non-executive director. Indeed, the Cadbury Code (Section 2.5) defines corporate governance as follows:

"Corporate governance is the system by which companies are directed and controlled. Boards of directors are responsible for the governance of their companies. The shareholders’ role in governance is to appoint the directors and the auditors and to satisfy themselves that an appropriate governance structure is in place."

Effectively this means that the Cadbury Code turned the principal-agent problem into a principal-agent-agent problem. In other words, whereas initially firms were supposed to be run by executives who looked after shareholder interests firms from now on were about non-executives whose role was to ensure that the executives did exactly that. Why would the non-executives do a better job than the shareholders (and/or the executives)? Put differently, why would they be more responsible than the executives? This a very good question. If one studies the literature on the impact of non-executives on firm value and firm performance, there are very few studies that find an impact (whether positive or negative) of the non-executives on firm value. There is a review of that literature in Section 5.6 of my new book International Corporate Governance .Well, you could say that academics are not always right and that frequently they are removed from what happens in the real world. Let us now take a time machine to early 2007, when Northern Rock plc published its 2006 annual report and accounts. On p.13 (forget about superstition!) of the annual report, it is stated that:

"For the period 1 January 2006 to 31 December 2006, the Company [Northern Rock plc] complied with all aspects of the Combined Code and with the 2005 Turnbull Guidance on Internal Control (Turnbull Guidance)."

The Combined Code was the successor to the Cadbury Code. More than 50% of the members of the board of directors of Northern Rock were non-executive directors as recommended by the Code. The non-executive directors were also doing what the Code expected them to do:

"Both individually and collectively, [the non-executive directors] provide scrutiny of the performance of management and the reporting of its performance."

How could such an exemplary follower of the Code fail so miserably so soon? Indeed, Northern Rock was the first UK bank to experience a bank run for about 150 years. Without going into too much detail here, Northern Rock's business model had been highly risky relying on the availability of short-term financing (via the money markets) at low interest rates. More importantly, despite a strong or highly independent board, Northern Rock saw its demise in 2007. Returning to the above quote from Northern Rock's annual report, it is important to note that this is very close paraphrasing of the 2006 Combined Code which states on p.3 that:

"As part of their role as members of a unitary board, non-executive directors should constructively challenge and help develop proposals on strategy. Non-executive directors should scrutinise the performance of management in meeting agreed goals and objectives and monitor the reporting of performance. They should satisfy themselves on the integrity of financial information and that financial controls and systems of risk management are robust and defensible. They are responsible for determining appropriate levels of remuneration of executive directors and have a prime role in appointing, and where necessary removing, executive directors, and in succession planning."

In line with the academic literature, when I teach corporate governance I refer to two and not just to one role of the non-executive directors. Indeed, their role is not just to scrutinise the performance of the executives (or to monitor the latter), but also to provide advice. In fact, an emerging body of research suggests that, for some types of firms, less rather than more board independence may create value. See for example Renée Adams and Daniel Ferreira's paper on friendly boards. These would be firms where the advisory role of the board of directors is more important than its scrutinising or monitoring role. My own research with Salim Chahine from the American University of Beirut suggests that social ties between the management and the board of directors create rather than destroy firm value. Again, this would suggest that friendlier boards rather than more independent boards are appropriate for firm where guidance is important for the management.I am not necessarily suggesting that more guidance of the management by the non-executives would have prevented the collapse of Northern Rock. Rather what I am trying to convey is that corporate governance is much more complex and that it clearly cannot be reduced to boards of directors or board independence. Also, an important lesson is that definitely "one size does not fit all". What might be best practice in corporate governance for a certain type of firm may actually be worst practice for other types of firms.   

In the aftermath of the financial crisis, several reviews (e.g. Walker Review) of the UK corporate governance regulation were conducted. However, they all pretty much concluded that the UK approach was still pretty much valid (see e.g. p.8 of Walker Review). Is it not time now to review the UK's approach, maybe by adopting a more evidence based approach?   


Legal disclaimer: This blog reflects my personal opinion and not necessarily that of my employer. Any links to external websites are provided for information only and I am neither responsible nor do I endorse any of the information provided by these websites. 

IS PRIVATE EQUITY ALL GOOD OR BAD?

Ed Miliband thinks that all private equity investors are bad, "stripping assets for a quick buck ... [and that] they aren't the values of British business". So is he right or wrong?
Similar to most other politicians, Ed Miliband is right and wrong. In what follows, I shall focus on the effects of private equity acquisitions on employees as there is an existing body of academic research studying that particular link. This research suggests that, on the whole, private equity acquisitions are good for employees, resulting in increases in employee numbers as well as improvements in employment practices and employee voice. However, most of this research does not distinguish between the different types of private equity investors.
Nevertheless, I first want to define what I mean by private equity. Private equity involves the acquisition of a public firm or at least the facilitation of that acquisition. The firm is taken private in a so called public-to-private (PTP) transaction. Importantly, there is a change in management or at least a change in management style.
The three main types of private equity acquisitions are:
management buy-outs (MBOs),management buy-ins (MBIs), andinstitutional buy-outs (IBOs).MBOs are carried out by the existing management and the role of the private equity investor is typically limited to the financing of the acquisition. As there is no change in management the effects of MBOs on the employees are likely to be neutral or positive. In contrast, MBIs are undertaken by a new, outside management team that takes the firm private. As there is a complete change in management the effects for the employees are likely to be negative. The main reason for this is that so called implicit contracts, that is unwritten, verbal contracts that the existing management had with the workforce are more likely to be broken. Finally, IBOs are undertaken by private equity houses and other specialist investors. They involve the complete replacement of the management and, as in the case of MBIs, it is likely that the effects on employees will be detrimental.
Existing research has typically looked at samples of private equity acquisitions including MBOs as well as MBIs, and maybe also IBOs, but has not clearly distinguished between these three types. This may explain why the observed overall effects on employment is mostly positive, both in terms of employment growth and in terms of a wide range of human resource policies. I have conducted some research with Prof. Noel O'Sullivan at Loughborough University and Prof. Geoff Wood at Warwick Business School. We focused on IBOs rather than on MBOs/MBIs. We found that, after correcting for differences in productivity and differences in wage costs, there is a significant drop in employee numbers in IBOs. An equivalent drop is not observed in other non-acquired firms that operate in the same industry. The results of this study have been published in Corporate Governance: An International Review . A pre-publication version is available from SSRN. This paper won the Standard Life prize of the best working paper in finance in the paper series of the European Corporate Governance Institute in 2012.
A follow-up study on a larger sample, which also includes evidence from interviews and regression analysis, has been published in the 2014 April issue of the Human Resource Management Journal . This is the study which the British Venture Capital Association (BVCA) criticised in a press release. See also our response to the BVCA as well as a letter by Alex Barr from Aberdeen Private Equity fund in the Financial Times and our response to his letter.
Legal disclaimer: This blog reflects my personal opinion and not necessarily that of my employer. Any links to external websites are provided for information only and I am neither responsible nor do I endorse any of the information provided by these websites.

"INTERNATIONAL CORPORATE GOVERNANCE" SHORTLISTED FOR CMI MANAGEMENT BOOK OF THE YEAR AWARD

My textbook "International Corporate Governance" has been shortlisted for the Management Book of the Year 2013 award by the Chartered Management Institute (CMI). The CMI received 137 entries across 5 categories. In October 2012 the CMI shortlisted 25 of the entries for the award. The winner in each of the 5 categories as well as the overall winner will be announced on 28 January 2013 at the British Library Conference Centre.
I had been toying for a long time with the idea of writing a textbook on corporate governance. However, it was only when I moved to Cardiff Business School and was asked to teach an entire course on corporate governance that I seriously started thinking about this. When I was designing the course I felt uneasy about adopting one of the existing textbooks. I found these to be very limited in terms of their scope and their view of corporate governance. Not only were these textbooks Anglo-centric, but they also limited corporate governance to accountability and compliance. My view is that corporate governance is much more than this.The main approach I took in my book is to study the conflicts of interests that corporations may suffer from. The book also adopts an international approach, comparing the advantages and drawbacks of the various systems of corporate governance across the world.
The book is organised into 5 different parts. Part I introduces corporate governance, reviews the theoretical body and develops the main concepts of corporate governance that are used across the book. Part II focuses on international corporate governance; including taxonomies of corporate governance systems; how to incentivise managers and how to discipline those that perform badly; the link between corporate governance, types of financial systems and economic growth; and corporate governance regulation. Part III analyses the role of various stakeholders in corporate governance. These stakeholders include debtholders, such as banks, employees and gatekeepers. This part also studies the role of corporate social responsibility (CSR) and socially responsible investments (SRIs). Part IV looks at possible ways of improving corporate governance. This part looks at corporate governance in emerging markets, contractual corporate governance, corporate governance in initial public offerings, and behavioural biases that affect managers' decision making. Finally, Part V of the book concludes.
An extensive glossary at the end of the book enables the reader to revisit quickly the concepts and technical terms used throughout the book. Complimentary teaching support material - including a test bank with 100 multiple choice questions, an instructor's manual and a complete set of PowerPoint slides - is available from here.
Reviews of the book include James McRitchie's review at corpgov.net.

Legal disclaimer: This blog reflects my personal opinion and not necessarily that of my employer. Any links to external websites are provided for information only and I am neither responsible nor do I endorse any of the information provided by these websites.