Can corporate governance keep up with the 21st century?

I was invited to join a panel to discuss this question at the conference of the British Accounting and Finance Association this week. the panel was chaired by Keith Hoskin and the other members were Prem Sikka and Nigel Garrow. We each had ten minutes to speak and then the audience posed questions. This is what I said:

What is corporate governance? A commonly used definition is the one given by the Cadbury committee in 1992 – the system by which companies are directed and controlled – which leads to a central focus on the board of directors and is quite narrow, which is understandable given the context in which the committee was working because it was tasked with looking at the financial aspects of corporate governance.

But the term existed before then, although not in such wide use as today, and it’s worth looking at its history. The earliest use of the term that I’ve been able to trace is in a paper published in 1953 written by a US lawyer on the economic consequences of an atomic attack: the author notes that flexibility in corporate governance would be needed with reference to the legislative arrangements required to enable companies to continue under such catastrophic circumstances. No explanation of the term is provided which, to me, suggests that it was in fairly common use among US lawyers at that time.

A decade later a US management scholar, Richard Eells, published an extended discussion of corporate governance in his book The Government of Corporations, in which he focused on the role of companies in society, rather than a purely legal approach. Later studies have shown how the vocabulary of corporate governance developed from the 1970s onwards in the US and observe how the meaning of the term shifted from a broad concern with public policy and corporate social responsibility to boards and internal company arrangements.

It seems to have travelled across the Atlantic in the 1980s, largely in the work of Bob Tricker who studied the role of non executive directors, wrote the first corporate governance text book, established the first academic journal  devoted to corporate governance and was an important influence on the thinking of Sir Adrian Cadbury.

So we can see that the idea of corporate governance originated in the US where it started with a broader scope but then in the UK narrowed from its earliest focus to concentrate on boards and internal processes.  Which are potentially easier to fix.

However, a major problem with the UK corporate governance system is that it exists within a regulatory framework devised in the 19^th century to meet 19^th century business requirements. And we’re now in the 21^st century when businesses are very different and exist within very different economic, social and political environments.

Another problem is a developing expectation gap.  Corporate scandals give rise to blame placing: the auditors are often the first in line but scandals are also characterised as failures of corporate governance. Sometimes boards make bad business decisions or fail to exercise proper oversight. Such events happen in companies which apparently comply fully with relevant legislation and codes. Corporate governance cannot prevent such things happening.

To address these problems, we need to broaden the perspective again, look away from boards and reconsider the role of corporations in society.

We need to consider much more carefully exactly who companies should be accountable to. From that basis, we can define how a new accountability system can be designed: what information is needed, how it can be communicated and how its credibility can be assured. This would also address the seemingly intractable issues encountered with corporate reporting and audit.

This is difficult. It needs some radical thinking. In the past, the accountancy profession has done radical thinking (The Corporate Report 1975, Making Corporate Reports Valuable 1988, even the more recent integrated reporting framework which revisits some of the ideas in those papers) but it doesn’t seem inclined to do more than defend audit at the moment. Maybe we need a bigger crisis to spark it off. But really, we have enough crises to deal with at the moment.

The danger, though, is that solutions purporting to improve corporate governance will be proposed which may appear attractive because they are easier than a fundamental rethink, but which may have unintended consequences. Prescribing board composition is just such a dangerous solution.

This prescription really started with the Cadbury Code in 1992 which recommended that boards should appoint non-executive directors. Many large UK public companies already had NEDs on board but they tended to be decorative in terms of their status, rather than functional. Cadbury found them a new monitoring role in board sub-committees – audit, remuneration and nomination. No-one thought too deeply about how this created a difficult paradox: all directors have the same duties responsibilities and liabilities under law so how could this little group of part-timers effectively monitor their executive colleagues?

The NED requirement has persisted and become stronger in later iterations of the code but it remains the most frequently cited area of non-compliance with the code.

And at the same time boards have become smaller. The only remaining executive directors on the boards of many FTSE 100 companies are now the CEO and CFO. The executives form another group under the leadership of the CEO. They no longer sit around the same boardroom table as the NEDs. How do the NEDs know what is going on? How do the two groups communicate? I’m not aware of any research looking at this but it seems to me that the corporate governance developments that were intended in part to curb the power of the CEO have effectively increased it, as the CEO is the main link.

The fear of many critics of the Cadbury committee’s report was that establishing audit committees would destroy the unitary board which has puzzlingly long been seen as something to be protected. It seems that we do now have two tier boards in practice but by a process of attrition rather than through any rational approach to their construction.

Add into this situation further prescriptions about board representation with regard to gender and ethnicity, and the assembly of an appropriate board becomes a very complex issue.  and certainly doesn’t guarantee good governance, whatever that is. Surely a board should be constructed with regard to the most appropriate combination of skills and competence relevant to a company’s objectives?

But tinkering with board composition makes it look as if steps are being taken to improve corporate governance – and, importantly, steps that can easily be measured.

But as we’ve seen corporate governance was not originally all about boards. It shouldn’t be. we need to return to its original conception. Our current system assumes that shareholders should be the focus of corporate accountability, dating from an era when shareholders were a relatively homogenous group of resource providers. That is clearly no longer the case. The investment intermediary chain is complex.  Mapping accountability through it is hampered by its opacity. And how does our corporate governance system account for company relationships to lenders, employees, consumers and society at large?

A number of groups are currently exploring issues around corporate governance and the role of the corporation in society. These include: The Purpose of the Corporation. The Modern Corporation. The Purposeful Company. The members of such groups usually comprise academics and practitioners in the area.

And there are other things happening which impact corporate governance. Experiments with different legal forms of business organisations such as benefit corporations. The integrated reporting project. So there is some broader thinking going on. But it’s fragmented and locked in silos.

The role of academic research in this area could be stronger. There are big gaps in our understanding. For example, the structures recommended by Cadbury are now standard in the public sector – government departments, NHS Trusts, universities now have boards with NEDs and audit committees. Yet we know very little about how these structures work in the context of completely different accountability frameworks. Is there something to be learned from this adaptation?

Disciplinary silos are also a problem. For example, corporate governance studies by academic lawyers are rarely cited by accounting academics – US legal scholars in particular have done some really interesting thinking about the role of boards.

So from a practical point of view there needs to be some co-ordinated leadership to bring together the various strands of thinking around corporate governance issues and to arrive at some consensus for substantial change to the regulatory structure which at the moment constrains major change.

Accountability is the key element to address. To whom should companies be accountable? I would argue it should be those who provide all the resources to enable companies to function. Determining those groups could then lead to an examination of the information they require in order to hold companies accountable and the processes by which that information can be made available and be assured. Reform of corporate reporting and audit could follow within a coherent accountability framework, rather than being undertaken in a piecemeal fashion as is currently happening via government and regulators.

We need to move away from a focus on boards and back to that initial broad conception of corporate governance and to question some of our fundamental assumptions about who is accountable to whom.