Gambling on governance
Good governance certainly comes at a premium. The cost of complying with Section 404 of Sarbanes-Oxley is, as we are learning, no trivial sum. Section 404’s requirement that companies document their processes of internal control has increased the cost of internal audit by hundreds of thousands of dollars – or even tens of millions of dollars in large, complex corporations. Some companies have even bought risk management systems to track processes they believe were already under good control.
The issue for many is return on investment but, as with insurance, the payback on the gamble isn’t easy to see. Market confidence is worth something, but how much? McKinsey’s much-quoted survey in 2002 suggested institutional investors were willing to pay a premium for good governance – a premium of 18 percent in the US and the UK, much more in other countries. But the findings represented statements of intent, not measures of behavior.
Last year academics at Georgia State University, looking at both stock market performance and return on equity over long periods, demonstrated that good governance and good performance go hand in hand. Poorly governed companies had higher risk profiles, too, measured by stock price volatility, interest cover and the ratio of cash flow to current liabilities. But the research, commissioned by proxy voting advisers Institutional Shareholder Services (ISS), didn’t demonstrate which was the cause and which the effect, or even if the two were directly linked. It could just be that CEOs who excel at extracting commercial performance also choose to promote whatever constitutes best practice for governance.
Moreover, high standards of governance could as easily correlate with those companies being mature businesses. The hallmarks of good governance – strong, independent boards, and split CEO and chairman roles – tend to be found in companies with a wide range of shareholders and without a dominant founder-manager-shareholder at the helm. Their stock market returns, volatility and interest cover would tend to be better after a long period in which value investing has out-performed growth investing. The results of the Georgia State University research might have been less definitive if the end-date was 1999 instead of 2003.
It seems logical for investors to draw comfort from good governance practices and assign a lower risk rating to the stock. Donald Nicolaisen, chief accountant of the SEC, says he’s confident managers would also sleep better for knowing their internal controls were working well – which is probably worth something, too. Good governance might well be comforting; having insurance against any risk always is.
But to improve performance, you need more. The challenge is like the one proponents of enterprise risk management promise when they urge us to look beyond insurance. Better processes, they say, can help turn risks into opportunities. In risk management, it’s a notion with at least as many skeptics as believers. The challenge in governance, however, is one boards should embrace.
To get the better side of the bet, you need to change the odds. An independent board with strong committees needs to be more than an insurance policy for shareholders. To create opportunities you need to move beyond compliance with codes of conduct and corporate governance checklists – and remember to put strategy, customers, products and service on the board agenda.