The Year that was...

As the year draws to a close, let us take stock of what happened in the sphere of Corporate Governance and Business Ethics in 2009. Did we make enough progress on these fronts, were there any new developments that have taken us forward, did we do enough to bring new energy and thought to these disciplines? Relevant questions indeed.

As I scan the last 12 months, what stand out are the large governance failures. We felt the full blast of the sub-prime. Many argue that the sub-prime is not a governance or ethical issue, but one of business failure. I beg to disagree. A system that is driven by greed and enriches a small group of senior employees in financial firms at the expense of millions of people worldwide can be anything but a governance failure. We also had large corporate debacles like Satyam in India. Indifference to the principle of conflict of interest lies at the core of both these examples. Familiar words that ring a bell that sounds Enron...Enron...Worldcom....Worldcom... That was almost a decade back!

Despite the large scale impact of the sub-prime, we have not seen enough thought given to governance reform to prevent a relapse. While discrete cases like Enron and Worldcom invited a high level of introspection on governance, one feels sad that the governance aspects of the sub-prime have been forgotten in the rush to bail out economies. Is there enough study to understand how the risks underlying the mortgage-based securities were not analysed by Boards, Audit Committees and Auditors? Is there enough investigation of who failed and why? How much of a role did the greed for higher compensation play in the whole drama?

A governance institution that has taken a severe dent to its reputation during this year is that of the Audit Committee. Top minds and talent sitting on the Audit Committee of Satyam Computers had no clue of what was brewing. Sitting on an Audit Committee has become similar to a marine fighting in the outback of Kandahar, one does not know what will hit you and when.

The concept of the Audit Committee is laudable and we do not have any potential replacement for the concept in sight. However, the way Audit Committees work needs major overhaul if they are not to be seen by investors as watchdogs that can neither bark nor bite. A serious examination is needed of why Audit Committees with top-class intellectuals tend to fail time and again. Very little happened on this front this year.

On balance, a year of missed opportunities.

Catch 22

Joseph Heller wrote the novel Catch 22 in 1962. It was a time when people started their careers in, and retired from, the same company. Variable pay was a remuneration practice limited to salesmen. Stock options were as far away from human imagination as the Internet. So Heller had to write a whole book on the concept called Catch 22. It caught the fancy of the world and the term became synonymous with "a situation from which there was no escape as it involved mutually conflicting or dependent conditions (Oxford English dictionary)".

If 1962 was fast forwarded to 2002, Heller would not have had to write a whole book on Catch 22. All he had to do was to direct people's attention to the listing requirements of stock exchanges that need quarterly disclosure of financial results.

All pundits of Business Ethics and Corporate Governance are unanimous that good governance is about thinking and working long term. They argue vehemently against short-term styles of management as these go against the interests of the shareholders and investors. They view PE-owned companies with circumspection for the same reason. Common sense and intuition indicate that these views are valid and have a lot of truth in them. How come we got into into the quagmire of quarterly reporting? To protect investors indeed.

Quarterly reporting started as an investor friendly devise meant to minimise potential shocks being delivered at the end of the year. Instead it has become the root cause of major governance earthquakes. Managements run from quarter to quarter trying to improve on the previous ones. Revenues are over-stated and costs understated. This sets in a motion a spiral that moves only upwards as more fabrication is needed to grow on an already fabricated base. R&D investments are cut back and new launches withdrawn from store shelves if they do not succeed within two months. Innovative financial derivatives are created to boost profits and phenomena like sub-prime make Enron and Worldcom look like small time tricksters.

In this quarterly circus, the analysts and stock market gurus wield enormous power. They can either dump a stock based on one bad quarter, or play God and give the company a few more quarters to perform. They love phrases like "the long-term is the aggregation of quarters" or "in the long-term everyone is dead". In this scenario, a company that says that it has an excellent long-term plan but the outlook for the next few quarters is poor would be like a piece of meat in front of a hungry lion. So what is a manager supposed to do in this situation, except focus on the short term?

Would you think that stock market regulators are not aware of these stark issues. Of course they do. Can they think of moving the reporting to once a year instead of quarterly? Of course not, we live in a global information age where a year is too long and stock markets would lose their dynamism in that case. Can the reporting evolve into a combination of long and short term performance indicators? No, this becomes too subjective and complicated to monitor.

We seem totally bound by a requirement we have invented. Can one think of a better example for illustrating Catch 22?

Footnote: Unlike in Heller's novel, the characters in this drama are not fictitious.

Separating men from mercenaries

The ability to learn from mistakes and not to repeat them is perhaps the most important requirement of any good governance mechanism. Unfortunately, this is sorely neglected by corporates and regulators alike. How else can we explain the sub-prime fiasco, when we had Enron to learn from?
The root cause of both crises was the unbridled greed of top management, reflected by insanely high compensations. Today, a top corporate executive anywhere in the world earns several times what a good surgeon or teacher earns. In fact, what the Chief of the Indian Army earns in a year is probably less than what the CEO of any of the top 100 Indian companies earns in a month. Now to imagine that a CEO has greater responsibilities or IQ than the Chief of the Army is not unexpected of corporate egotism!
I agree that if corporates are self-funded they legally have the right to pay their CEOs whatever they like, even though the morality and social justice of this would be questionable. But at a time when the free market across the world is being pulled out of the ICU by the State using tax payer's money, the question to answer is whether enough is being done in the form of regulation to rein in top management wages. As rescuers, the State and the public have a right to insist on such regulation. Sadly we do not see enough focus on this, and my fear is that history will repeat itself.
Effective regulation over managerial remuneration should include aspects like fair distribution between short-term and long-term rewards, limits on the multiple between wages of the top management and the lower levels, and equity between corporate wages and remuneration in other comparable sectors of the society. I would like to see if any progressive corporates have the courage to come out with affirmative action on this. That would certainly separate the men from the mercenaries.

Diversity - More Talk than Walk

A few days back I read with total astonishment a news item about a study by a leading UK University that tries to establish that companies with more female Board members have lower stock market valuations. I thought, how ridiculous can this get?
I have been working on an article about diversity in senior corporate management for a while now. The facts that I find are immensely interesting. A large number of companies worldwide talk about diversity being a major focus. But the average representation of women on Boards is around 20% in the US, 10% in Europe and 5% in India. More importantly, in most cases these are independent and non-executive Directors (only 3 of the 15 large US companies in my sample have Executive women Directors on their Boards).
I then looked at the composition of Management Committees and that is where this gets more bizarre. A large number of major global companies have no women on their Executive Committees and the overall average is well below 10%. I would not like to name these companies , but the information is readily available on their web sites.
We all say that Governance is about setting the tone at the top, and walking the talk. But when it comes to diversity Corporates seem to have a severe problem of cold feet while walking all that masculine talk. To blame women Directors for stock market valuations in a situation where they have not been given a fair opportunity to Govern is grossly unjust. I thought the British were known for their chivalry!

Of Apples and Oranges

It is amazing how many people think that Business Ethics (BE) and Corporate Governance (CG) are one and the same. I mean professionals in industry, academicians, etc. They tell you that they follow the latest CG norms, and hence are ethical. Comparing apples and oranges is slightly better, both are fruits, both are sweet and good sources of vitamin C!
There are three major differences between CG and BE. The former largely involves complying with what is legislated, while BE is largely about following what is not legislated (enforcing the unenforceable). Take a simple case in point. When a business in trouble restructures, it could legally retrench surplus headcount by giving notice and paying compensation as provided in the employment contract. Business ethics is about looking beyond this - counselling the employees, actively helping them get outplaced, helping them get re-skilled, etc. Few companies do this - who would repair a car before selling it?
Second, CG is meant mainly to meet the transparency criteria for publicly listed companies. Imagine a 5-bedroom villa. CG is its living room, where a large number of guests are entertained. The room is nicely carpeted, cracks in the wall covered by replicas of vintage artists and the door handles polished once a month. BE is like the last three bedrooms. How often have you strayed into a host's house beyond the living room, to be told "sorry, we are just back from a trip, so its all in a mess", when you can see that the mess is several trips old. A private firm or a PE managed firm is like a villa without a living room, they get very few guests and manage with a couple of sofas in the foyer!
The third difference is of recent origin, and very stark. CG is about keeping your top management out of court, and most importantly out of jail. BE is about keeping your business in business over the long run. Now that is a difference that very few people should have difficulty in appreciating.
So much for now.