Corporate Governance: A review of the literature
By William Forbes, Lynn Hodgkinson and Jill Solomon
This paper surveys the academic corporate governance literature of the last decade with a
particular emphasis on British and European literature. To some degree this is because like cautious
authors “we write what we know” and believe US authors have already done a good job surveying
and interpreting the dominant strand of literature based on US evidence (see for example Farhina,
2003). But our choice also reflects the fact that problems we face outside the US are very different
to those discussed in the US literature.
Hart (1995) states that a corporate governance problem arises whenever
 There is a conflict of interest between owners, managers, workers or consumers,
 Transaction costs frustrate any attempt to solve these conflicts by contractual means.
To examine these issues we divide the conflicts that give rise to corporate governance issues into 4
discreet types
1. Those between the nation State and the corporation,
2. Those between the CEO and the Board of Directors,
3. Those between the Board of Directors and Shareholders,
4. Broader conflicts between the corporation and its workers and the community and its
environment more generally.
While the problem of incentivising shareholder’s agents to deliver value to their owner’s as
principals is a universal one in economics its reconciliation depends on the exact setting in which it
arises. So a classic text on the principal agent model (Laffont and Martimort 2002) points out that
while Adam Smith saw the practice of share-cropping in agriculture as giving rise to an investment
problem it was only in Chester Bernard’s classic text The Functions of the Executive (1938) that
Governance was introduced as we recognise it today. Barnard had spent a lifetime managing the
New Jersey Bell Telephone company and that new, technologically advanced, setting allowed an
entirely new understanding of the incentive problem. In this technologically advanced setting
owners may not even know what they want their company’s management to do beyond some
general exhortation to find medical applications of nanotechnology, or whatever, and hence details
of implementation or execution may not arise.
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1. State Governance of the corporation
John Coffee has recognised the distinct nature of Europe in the evolution of recent financial
scandals (Coffee, 2005). In particular, Coffee distinguishes between the dispersed owner corporation
that dominates the US and much of the UK economy and the concentrated ownership, often family
dominated, corporation in “continental” Europe. In the dispersed ownership firms’ manipulation of
earnings, especially via revenue-recognition scams, is of central policy concern. Conversely, in
majority shareholder dominated companies, minority shareholder oppression, via enforced tender
offers, is of major concern. Consequently, improvements in auditing are only likely to improve
governance in the dispersed ownership corporation whereas strengthening the rights of the
oppressed shareholder in majority shareholder corporations may have more success.
Sir John Hick’s pointed out, in 1935, the “the best of all monopoly profits is a quiet life.” One
of the prominent consequences of industrial dominance is to be able to discreetly allocate
oligopolistic profits amongst the prevailing elite. Mancur Olson (1982) has pointed to the importance
of special interest groups in diverting resources into distributional conflicts over monopoly rents and
away from productive engagement in the US and UK. Olson examined the economic success of
Japan and the Benelux states following the 2nd World War in terms of the inhibitory impact of any
reallocation of resources from production to redistributive activities within a national economy.
One consequence of the 2nd World War was to shatter the ruling elites in Japan, Germany,
the Netherlands and Belgium. Relatively stable, less war torn, economies, however, provide more
conducive environments for interest groups, unions, cartels and lobbying to exercise their power. In
the limit such distributional conflict can render an economy almost ungovernable as the UK is often
regarded as being in the mid-70’s as a rag bag of contradictory special interest groups vied to
dissipate the last drops of inherited monopoly power.
More generally the governance mechanisms founds in individual nations have been found to
have explanatory power in explaining the dispersion of economic growth rates (see Morck, et al,
2005) Higher growth rates are associated with a greater proportion of “new money” (self-made
millionaires) as opposed to old money from inherited wealth. Family controlled pyramid ownership
structures and strategic cross-holdings can further detach ownership from control creating
opportunities to “tunnel” shareholder wealth away from its rightful owners (see Johnson, et al,
2000). So good governance is more than a matter of corporate policy but also is rightly a matter of
national and transnational debate and regulatory intervention.
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Emerging from the current financial crisis it is hard not to be struck by the prominent role of
“the City” and its economic interests in influencing the UK’s response to the Crisis. Comparing the
UK, French and German policy response to the Crisis a marked timidity in confronting financial
capital interest is striking. This reflects the long history of internal stability in England at least since
the civil war of the mid 17th Century. During these centuries a marked dominance of financial capital
in the UK economy has been consolidated into what now appears an almost unassailable position?
1.2 Modes of Governance
Our primary focus in this paper is European corporate governance, but, even within Europe,
there is a marked distinction between the modes of governance we observe. Rafphael La Porta and
co-authors in a stream of papers have drawn the consequences between investor protection, of
both shareholders and bondholders, under UK/US common law, precedent-based, legal regimes and
various civil/codified law alternatives. While common law covers the US and UK Civil Law in three
separate forms, French, German and Scandanavian covers the rest of Europe. La Porta et al
characterise the common law as supportive of private contracting between individual citizens and
French/Napoleonic civil law as more consistent with a large centralised state. The overall conclusion
of these papers is that the Common law jurisdictions offer the greatest protection to both
shareholders and bondholders and civil law, especially of the French code of law tradition, offers the
least protection. But jurisdictions with poor investor protection typically compensate for the
weakness of investor’s legal protection by having more concentrated ownership structures. If you
cannot rely on your rights as a minority stakeholder it is perhaps best not to be one or not pay too
much to be one.
Your legal regime is not something you choose as an individual agent, whether corporate or
human, and is largely imposed on whole nations by conquest or progressive colonization. As such it
is beyond the remit of a choice theoretic area of study such as Finance. The individual may choose
how to fund his corporation given the legal settlement that he finds in his homeland. His only
alternative is to cross-list his corporation, or re-locate, to access an alternative legal regime. The
prevailing legal regime affects far more than just financial decisions, but also shapes the extent the
host government intervenes in the economy, the media and even occupational choice via
conscription. Nor does it appear that legal rights and their enforcement are substitutes across legal
jurisdictions. Rather they appear to operate as compliments with common law nations offering
investor’s more protective rights and enforcing those rights more assiduously (La Porta, 1998, pp
1141).
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Nor is it obvious that even if the legal system of a nation greatly affects its governance
arrangements that this is not because of some other political or economic trend that shaped the
legal system. Roe (2006) points out that while neither the US or the UK have suffered defeat and
occupation by a foreign power in a very long time (assuming we have recovered from the Norman
invasion by now) nearly every civil law country, France, Germany, Sweden, etc have suffered both
the pains of war and the humiliation of military defeat/occupation. Roe sees the political
consequence of the devastation of war as a key inhibitor of the respect for private property and the
private resolution of disputes that facilitates common law. What matters is the level of commitment
to a free, well-functioning, security market not the exact legal structure which presides over it. Thus
Roe states (2006, p 464)
The first order condition is a polity that supports capital markets. It is only then that law
becomes important and getting it wrong becomes costly. Getting corporate law right in the
US is important and worthy of attention. In other nation – even in wealthy ones like France,
Germany or Italy – the polity did not support capital markets in the immediate post war
decades
The precise origins of the difference between common law and civil law jurisdictions is now
rather lost in the sands of time. But Glaeser and Shleifer (2002) argue that in the12th century a
strong English King felt able to devolve dispute resolution largely to a Jury of a subject’s peers. In
France, where the King’s hold on the country was far less secure competing Barons feared each
other’s rapacious intentions more than the power of the Sovereign himself. As Glaeser and Shleifer
(2002, pp 1196) put it put it
“People demand a dictatorship when they fear the dictator less than they fear each other.”
So since some initial point of separation in the 12th century divergent developments of
governance structures were set in place in the UK where the common law took root and France
where civil law emerged. But the importance of this fundamental distinction in national modes of
governance must lie in the difference they currently make to national economic development as
opposed to remaining a simply a curiosity in legal history.
Glaeser et al (2004) trace out the endogenous relation between economic growth and good,
especially democratic, governance. Is Iraq so badly governed because its people are poor or are its
people poor because it so poorly governed? Korea makes an interesting case-study in this regard.
Prior to the Korean War, in 1950, poverty was rife in both the North and South. After 1950, the
prevailing dictators in the South chose a free-market open economy as its strategy for growth. North
Korea chose the sort of insular communist system for which it is now renowned as part of an “axis of
evil” (Bush, 2002). Only later in the 1980’s did democratic institutions tentatively emerge in South
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Korea. Wise economic policies followed by a dictatorial elite led to more attractive/better
government. Chile, under the often brutal Pinochet regime, may be seen as a similar case.
Glaester et al (2004) argue that most empirical metrics of good governance used in the
growth literature do not capture true constraints on the Executive’s choice and may quite conversely
capture good or bad choices by the Executive in managing economic growth. They conclude that
above average educational attainment predicts economic growth better than any good governance
proxy can . But better, more democratic, government is also, unconditionally, associated with
greater income. La Porta et al (1998,pp 1141) similarly find investor protection is enhanced as
national income rises regardless of the legal origins of the national laws. Overall they conclude the
evidence supports the view that economic growth and the progressive human capital it engenders
gives rise to solid, democratic, government and not vice-versa.
Since the fall of the Berlin Wall the triumph of democratic capitalism would seem all but
complete. Yet different “varieties of capitalism” and their several institutional settlements remain.
This has given new life to comparative economics, including the ability of different capitalist forms to
support liquid, efficient financial markets. Djankov et al (2003) build a theoretical framework to
evaluate the trade-off societies must make between the competing threats of disorder and
dictatorship in the social control of business in particular. How much laissez-faire can be allowed
before market capitalism degenerates into fruitless anarchy? Djankov et al (2003) thus locate
governance systems as lying on ascending planes of investor protection and overall social cohesion.
Djankov et al (2003) see state control as evolving along a trajectory from simply the
recognition and enforcement of contracts over private property at one liberal extreme, through
State adjudicated litigation, state regulation and finally collective State ownership, or Communism,
at the other illiberal extreme. Djankov et al (2003) locate governance systems as lying on
indifference curves trading off ascending levels of disorder and dictatorship. Since the common law
emerged from a relatively stable society of 12th Century England a lower level of dictatorship need
be imposed to counteract the (limited) potential for disorder.
So if legal origins matter for economic, and specifically financial development, by what
channels does it operate? Beck et al (2003) suggest two mechanisms for the law to induce greater
economic dynamism.
 political channels by which the common law privileges private dispute resolution within an
adversarial system whose central purpose is to maintain the integrity and consistent
enforcement of private property rights,
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 adaptability mechanisms that give the common law system greater flexibility to evolve as a
self-sustaining “grown order” in Hayekian terms as a state imposed “made order” imposed
by some transient ruling elite (Hayek, 1973)
Beck. (2003) et al using a sample of 115 countries examine the relative contribution of
political channels and mechanisms of adaptability to the degree of financial development in each
sample nation. Their results stress the centrality of a legal systems ability to facilitate change as a
facilitator of an active market in financial securities . The authors conclude (Beck et al, 2003, pp 672)
“legal origins matter because of different systems ability to adjust efficiently to evolving
socioeconomic conditions. Legal systems that adapt efficiently to minimise the gap between
the financial needs of the economy and the capabilities of the legal system will foster
financial development more effectively than will more rigid legal systems.”
Legal Origins and Legal evolution
While we observe large differences in modes of both ownership and control today these do
not always indicate radically different histories as work by Franks et al.( 2006) on the comparative
development of German and British stocks markets show. Using a specially constructed database on
the funding of German enterprises in the years 1860 to 1950 Franks et al (2006) are able to
substantially revise received wisdom about how German corporations are funded. Their analysis
uncovers the fact that in the latter part of the 19th century (1860 onwards) the primary difference
between Britain and Germany is not the level of activity in rapidly developing stock markets, or the
amount or proportion of equity funding raised. Rather the primary difference between early British
and German equity funding was the uses to which equity capital was put. While UK capitalists used
equity funding for acquisitions during an era of rapidly consolidating industrial production and
transport (especially in railway and canal companies) German capitalists preferred to take partial
stakes and cross-holdings in competing corporations in their sector as a means to reduce company
specific risk. Secondly, while both Britain and Germany saw a huge reduction in insider, often family
based, ownership within their corporations in Germany these sales usually resulted in equity being
held by banks, as opposed to the complete division of ownership and control documented by Berle
and Means ( 1932) in the US and also characterising the UK. Owners sold out in both Britain and
Germany, but in Germany weakening inside shareholder blocks were to be replaced by
strengthening, bank-based, external block shareholders. Regulation seemed, if anything, to follow on
from and reinforce market developments opposed to initiating the separate paths followed by
British and German Governance arrangements.
Whilst history may explain why different regimes have evolved John and Kedia (2000) argue that the
costs of bank monitoring play a role in maintaining these differences and argue that where such
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costs are low bank monitoring will be a major player whereas if such costs are high, a dispersed
market will be dominant if the takeover market is effective otherwise a concentrated ownership
structure will prevail.
So if the same legal origins can flower into very different governance systems is it possible
that the importance of legal origins has been overstated, or at least misplaced in the analysis of
corporative governance. Katharina Pistor and co-authors in a series of articles have argued that this
is the case (Pistor et al. 2002; Xu and Pistor 2002). Pistor and her co-authors argue what
characterises an effective legal system for the promotion of economic growth is not so much its
origins but its ability to adapt at key points in economic transition to facilitate the effective funding
of private ventures. Examining a sample of ten countries, four founding legal origin countries,
Britain, France, Germany plus the United States, plus six ”transplant” countries that adopted their
laws, they find few transplant nations straightforwardly adopt the laws of their founding nation.
Rather an initial skeletal schema of laws is slowly adapted to the needs and desires of the
transplant’s social and economic context. So Pistor et al (2002, p797) state.
“continuous evolution of the law is a key ingredient to “good law”. The corporation has been
a remarkably resilient legal institution for 200 years of industrialisation and modernisation
largely because of its ability to adapt constantly to a changing environment.”
So while the legal origins of a nation’s governance system may influence its corporate
governance system its subsequent evolution is of equal importance in determining its final structure
and its ability to enhance national growth. One such act of creative destruction is the dramatic
implosion of many of the major banks during the 2008 financial crisis. This gives us an opportunity to
observe, afresh, how governance relations transform themselves to deter new threats and emerging
faults in the inherited system of corporate governance.
Pagano, Röell and Zechner (2002) point out, however, that the increase in European
companies cross-listing in the US and UK has subjected continental Europe companies to dispersed
ownership corporate governance regimes more familiar in Anglo-Saxon settings.
Kose and Renneboorg (2004) using a comparison of UK and German corporations examine
how competitive pressures, especially financial distress, impact upon companies in these two
nations with very different governance regimes. The find that for their UK sample, which the
authors regard as a being drawn from a shareholder, and specifically institutional shareholder
“market orientated” system, displays a marked tendency for product market competition to raise
productivity. When the going gets tough then the roughed up get productive or wither away. The
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presence of a central institutional shareholder, or fund manager helps convey market pressures to
the shop floor. This suggest that Mark Roe may be correct in suggesting the Berle and Mean’s
corporation, characterised by fragmented shareholders but unified management teams need a stick
to of a block-holder on the Board to drive the productivity gains competitive pressures necessitate.
The analogous incentives to spur productivity rises is served by bank funding concentration for the
author’s German sample, which they characterise as existing within a block-holder system . For the
German sample bank concentration raises corporate productivity regardless of corporate
profitability this is not mirrored by their UK sample. In the UK sample weak product market
competition impedes productivity growth regardless of bank competition. But in profitable German
corporations the presence of a large block-holder in funding the corporation appears to offset the
dampening effect of weak product market competition. So it appears that in Continental Europe
product market competition and good governance structures are at least to some degree substitutes
in raising corporate productivity. But in the UK (and by implication the US?) product market
competition and good governance structures work as complements. In both cases the joint causative
mechanism poses a considerable challenge to standard empirical research on whether good
governance can of itself, regardless of corporate performance, safeguard shareholder wealth.
1.3 Governance in Crisis: The UK response
There can be little doubt that the recent financial crisis will be a game changer for the
governance of UK financial institutions. Given the importance of treasury management in most FTSE
100 corporations its governance impact is likely to be fairly systemic. In this section we discuss the
three major official responses to the Crisis; the report by Adair Turner for the Financial Services
Authority on appropriate regulatory response to the Crisis (Turner, 2009) the review for HM
Treasury of corporate governance in UK banks and other financial entities by David Walker (Walker,
2009) and the Financial Reporting Council’s newly issued Stewardship Code (FRC 2010).
But the Crisis of 2008 is best seen as a crescendo of a trend toward greater assumption of
risk and the consequent evolution of risk management at least since the sudden implosion of LongTerm Capital Management in 1998. Risk reporting in the UK has, in this period, really taken three
forms (see Abraham and Cox, 2007 for example)
 Narrative reporting via the Operating and Financial Review (OFR), although this type of
report was resolved to be non-compulsory in late 2005 and few companies gave much
detail in their disclosures anyway.
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 FRS13, which became effective in 1999 and requires companies to disclose how
derivatives and other financial products, caps, collars , swaps, for example are being used
to manage risk. Risks covered include, interest rate, foreign exchange and business risks.
 Internal control of reporting risks is reported on via compliance with the Combined Code
which includes requirements such as the following. ”The board should, as a minimum,
confirm that there is an ongoing process for identifying evaluating and managing
significant risks faced by the company...”.
More disturbing, perhaps, is the aversion institutional investors display for companies with
fairly sparse risk reporting. In their content analysis investigation of 78 UK non-financial listed
companies in the UK FTSE 100 in 2002 Abrahams and Cox (2007) report a marked distaste by some
institutional investors for investing in companies with extensive risk reporting. This confirms the
preference reported by John Holland (Holland 2006) for private, over public, communication. Of
course this implies that simply mandating more disclosures of companies may be a pretty ineffective
tool of reform unless the structure of incentives of investors, especially institutional ones, is also
changed.
The Turner review
The Turner review gives both a diagnosis of the origins and primary causes of the Crisis and
advances a set of regulatory responses designed to avoid the recurrence of a similar Crisis. Turner
sees the principal causes of the Crisis being international macroeconomic imbalances in savings with
the US in particular importing large amounts of Asian (often Chinese) savings capital to finance both
personal and governmental profligacy. One part of that savings channel was into largely unregulated
“shadow banks” who routinely lent long and funded their position though long-term borrowing. This
intensification of bank’s traditional role in maturity transformation left them and their shadows very
exposed to a catastrophic sudden loss of liquidity . It was this type of liquidity crisis in the autumn of
2007 that eventually engulfed global banks in the full blown Crisis with which we are familiar. To
some degree this development was left unregulated because of a widespread, but ultimately
incorrect, belief that techniques of risk management allowed greater exposures and leverage to be
assumed by banks and others without undue fear of collapse.
So if these were the problems at the root of the Crisis what are Adair Turner’s suggested
regulatory solutions? No magic solution is, of course, currently available because, as Mervyn King
has put it, major banks are “international in life, but national in death”. This became clear during the
final death throes of Lehman Brothers when Alistair Darling, the UK Chancellor, refused to place UK
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taxpayer’s money at risk to underwrite a bid by Barclay’s Global Capital for a much distressed
Lehman’s Thus global banking without global government puts severe strains on what a pure UK
specific solution to the Crisis can expect to achieve. Within these constraints Turner suggests a
number of controls
 A considerable strengthening of current capital adequacy rules implemented under the
Basle II agreement which should be primarily based on a doubling of the Tier 1 capital
retention requirement. While this may raise the cost of capital to corporates it helps
mitigate the risk of another financial crisis,
 In general a far greater interest in systematic as opposed to individual bank risk. This is
especially true of the largest “too big to fail” institutions who engulf everyone else in their
own demise,
 Introduction of liquidity regulation, possibly via a “core funding ratio”, preventing the need
for the balance sheet to be literally reconstructed overnight each night, such as occurred at
Northern Rock, as assets/mortgages with long maturities were funded in the commercial
paper market.
 A shift from measures of solvency and liquidity based on particular points in to over-thecycle measures on the manner of Spanish banks dynamic provisioning.
Turner finds no clear relationship to exist between the national regulatory structures for
banking supervision and the depth of bank losses reported. Spain and Canada’s banks both escaped
the Crisis relatively unscathed despite very different bank regulatory structures. Turner concurs with
the Deputy Governor of the Bank of England, Paul Tucker, in stating the central problem was one of
regulatory “underlap” not overlap (Turner, 1984). Whatever the regulatory structure seen as
appropriate after the Crisis there needs to be a new focus on the accretion of systematic risk,
especially amongst dominant players who may be expected to invoke a “too big to fail” justification
for a taxpayer bailout.
One clear problem is the absence of global government capable of regulating a global
economy. The collapse of both Lehman Brothers and Landsbanki (the Icelandic bank) illustrate this
point. Decisions by national regulators had global consequences that were both unforeseen and ill
prepared for. While the EU is working on structures for more integrated regulation the greater
problem currently is co-ordinating trans-Atlantic bank supervision.
Even within the national jurisdiction of the UK’s FSA (many of whose functions are now
passing to the Bank of England) a more intrusive regulatory framework is clearly needed in Turner’s
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view. Any naive belief in the self-stabilising nature of the market has been severely undermined by
recent events where a cataclysmic global depression was only averted by massive co-ordinated state
intervention. While Turner rejects the US system of the appointment of a small army of on-site bank
supervisors a need for closer contact and “more intense contact with bank management and
auditors” (Turner, pp 89) is justifiable and required. During the process of implementing the Asset
Protection Scheme substantial variation in definitions of capital reserves and asset valuations were
uncovered suggesting the same regulatory requirements implied different restrictions upon different
banks. A more proscriptive, invasive, system of capital adequacy provisioning seems the likely
outcome of ongoing banking reforms.
This resurgence of regulatory activism reflects a broader doubt about the “magic of markets” which
Turner discusses in Chapter 3 of his Report. In particular Turner is aware of the “need more overtly to
recognise trade-offs between the benefits of technical efficiency and liquidity and the potential for
harmful irrational momentum” (Turner, 2009, pp 105) in inducing bank runs and speculative death
spirals of suspect institutions. As Turner points out while short-selling can serve to expose business
models which lack credibility such trades can also intensify speculative panic sales. While none of
this places in jeopardy the FSA’s basic working assumption that the market knows best it does
“underscore the importance of the FSA adopting a philosophical approach which overtly balances the
benefits of increased liquidity in markets with the danger that in specific markets at particular times
financial stability concerns may be more important” (Turner, 2009, pp 112). This leads to Turner
advancing counter cyclical loan-to value and loan to income caps in the provision of mortgage offers
by UK financial institutions. The market knows best may not now be seen as good guidance for all
seasons within UK policy circles it appears.
The Walker report
While the Turner review studied the broad evolution of the crisis David Walker’s report on
the corporate governance of UK banks and other financial institutions addresses governance issues
in the banking crisis and their improvement, more specifically. Walker was charged to make
recommendations concerning “the effectiveness of risk management at board level, including the
incentives in remuneration policy to manage risk effectively, the balance of skills, experience and
independence required on the board”. Walker rejects any role for additional legislation to plug gaps
in the governance structures of banks and other institutions preferring to advance suggested
enhancements of the existing Combined Code of Code of Corporate Governance (2010) which is
currently being reviewed and reissued by the Financial Reporting Council.
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Walker’s Report is striking because it is almost alone in recognising the single greatest
injustice of the Crisis, that the Banks were allowed to socialise losses after decades of pocketing
huge gains with almost no accountability for doing so. So Walker states
“the liability of shareholders in major listed banks is limited to their equity stakes.... while the liability
of the taxpayer is seen to have been unlimited.” (pp 6, Walker 2009)
He who pays the piper calls the tune. So if the State is to offer occasional bailouts to reckless
bankers then greater accountability to the State must be enforced. Walker recommends changes in
existing governance arrangements in, at least, three areas, institutional shareholders monitoring of
banks or shareholder engagement, risk management and the disclosure of risks assumed.
Reading David Walker’s recommendations one is struck by how lax many prevailing
governance arrangements are even in fairly large institutions. So Walker admonishes Chairs of the
Boards of major banks to recognise this is a major call on their time and may at some points be a
primary duty in their working life (see recommendations # 3 and 7), a reminder that may be shocking
to many outside the Banking industry.
Part of the reason for this dilettante attitude of the Chairman is the failure of major
shareholders to engage in active management rather than simply relying on “exit” in times of
trouble. This leads to one of the primary recommendations of the Walker Report that the FRC issue
a Stewardship code (FRC 2010) outlining “comply or explain” standards for fund managers (see
recommendation 17). Funds are then encouraged to make public their adherence too, or reasons for
flouting, the Stewardship Code (FRC 2010).
The governance of risk and the establishment of a Risk Management Committee to who a
Chief Risk Officer reports should monitor primary risk exposures, capital adequacy and liquidity
needs (see recommendations # 23 and 24). All major financial institutions should include a report
from the Risk Committee as part of their Annual Report to shareholders, alongside the Auditing and
Remuneration Committee with details of aggregate risk exposures and stress test results provided.
Walker further questions the structure of incentives given to very highly paid (above the
median salary of those on the Board) employees not on the Board (see recommendations # 29 and
31). This suggestion addresses the problem of very highly paid traders whose reckless pursuit of
short-term profits sunk, or nearly so, a number of our major financial institutions. But in general the
“comply and explain” credo remains central to the governance philosophy of Walker’s report with
much reliance being placed on senior executives, particularly the Chairman of the bank.
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The UK Stewardship Code
The UK Stewardship code constitutes something of a new departure for State intervention in
corporate governance relations. Up until now the informal “market for corporate control so
extensively studied in John Holland’s and Richard Barker’s research and more recently Paul Cox’s
work has remained largely unregulated apart from insofar as funds managers and analysts might be
implicated in various forms of “market abuse” by means of insider dealing, concert parties, price
rigging, for example (Barker 1998; Holland 1998; Barker 1999; Holland 2006; Abraham and Cox 2007;
Cox, Brammer et al. 2007). The Stewardship Code gives guidance regarding good practice by fund
managers and other institutional investors, endowment funds and insurance companies for dealing
with listed corporation investees. The primary principles of the Code relate to
 Disclosure of voting records, procedures for applying pressure “as a method of protecting
and enhancing shareholder value”,
 Managing conflicts of interest between offsetting positions and competing constituents of
the portfolio of vested companies, policies for dealing with such inevitable conflicts of
interest should be devised and published for public scrutiny,
 Willingness to act with other fund managers to lobby company management for corrective
measures during a performance threatening episode, of CEO succession, product
obsolescence, etc.
It is only really the last principle which is a fairly radical departure from what would appear
to be the UK tradition of avoiding anything that smacks of active management. While the Cadbury
Committee Report had hinted at such activism little seems to have been done in response
Compliance with this voluntary best practice code can then be declared as a kitemark of quality by
funds seeking to attract the mandates of pension trustees, endowment Boards, for example. In
doing this a great care is needed to not assume a back-seat driver’s perspective on managing the
Code in its preface states “compliance with the Code does not constitute an invitation to manage
the affairs of investee companies or preclude a decision to sell a holding, where this is considered in
the best interest of investors”. Perhaps the most obvious reason for not wanting to be unduly close
to managers of investee corporations is that a revelation of price sensitive information forbids the
fund manager from trading on the basis of what he know until its privileged value has expired (see
UK Stewardship Code, p. 6, 2010). As Mervyn King was to find to his (and our) cost in seeking to
discreetly recapitalise Northern Rock giving effective help often means giving covert assistance. This
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sets up a tension between transparency and efficacy in governance relations which any successful
fund manager must manage. Unfortunately, for Northern Rock, the terms of the Market Abuse
Directive were seen as blocking any under the counter assistance, even though King was surely right
to have sought to offer it.
1.4 Shareholder primacy in Corporate Governance research
Romano (1996) outlines a transaction cost motivation for governance arrangements to
facilitate the transition from markets to internal hierarchies that the act of incorporation implies.
Romano portrays transaction cost economics as teaching us to “align transactions which differ in
their attributes, with governance structures, which differ in their costs and competencies, in a
discriminating way” (Romano, 1996). In doing this equity claimants are granted a privileged role.
Romano gives three reasons for shareholder’s special place as a claimant on corporate resources:
 Equity claimants are last in line to be paid off in any liquidation,
 Equity has no right to periodic review or renegotiation right,

Equity returns are contingent with no fixed regular pay-out.
In the first three sections of this review we accept this privilege granted to shareholder’s
interests and constrain ourselves to discussing how governance reform raises or destroys
shareholder wealth. Section 4 explores the importance of other stakeholders in determining
governance structures and their impact on performance.
One service good governance can yield for investors is to raise a company’s Sharpe ratio (the
ratio of a company’s share price return to the standard deviation of an appropriate market index) by
giving the same return for less risk. The high level of company-specific human capital company
managers have in the firm may make them too risk-averse in their investment choices than an
optimally divested investor, such as a fund manager, might wish. After all a corporate liquidation is
merely a financial loss to a shareholder but many senior managers are financially, emotionally and
physically traumatised by losing their job. Good governance, for example, the presence of outside
investors on the Board can motivate company management to think big and step up a gear for
riskier projects. Kose et al (2008) in a study of 39 countries in the decade 1992 to 2002 examine how
investment choices are influenced by the corporate governance regime in place. They find countries
offering stronger protection to equity shareholders also display greater risk-taking in the investment
choices of company managers. Repeating a similar analysis for US companies using a company-level
dataset they are able to confirm this conclusion. Companies which are governed to better protect
14
shareholder interests are able to better able to generate returns by taking on higher risk projects. Of
course the ability of management to identify appropriate metrics to actively manage the risk profile
of the company depends on the availability of adequate practical measures of risk. Some of the most
popular risks, such as variance at risk, VaR, techniques, have been found wanting in the recent
financial crisis. But since only what is measured is managed, for the most part, practical risk metrics
such as VaR, risk registers and Governance Risk and Compliance (GRC) performance indicators are
central to any implementation of good corporate governance (Bhimani, 2009).
In evaluating this choice the ownership structure of the corporation may itself be a choice
variable. Hughes (2010) in a study of 12 Western countries in the years 1997-2001 examines this
issue. Hughes (2010) concludes firms adjust their ultimate controlling ownership structure to
overcome value decreasing threats to corporate value arising from country specific laws regarding
investor protection. So if the protection offered to investor’s is weak, in France say, corporations
simply adjust their ownership structure to resolve this weakness. So Hughes (2010) reports that
French firms have the highest Tobin’s Q of all the national groupings represented in her sample (of
which French firms constitute 34% of a total sample of 1557 matched observations). French firms
seem to be able to thrive by retaining strong owner control thus reducing any need to combat
agency problems resulting from the separation of control and ownership. One central figure in the
protection of shareholder rights is the CEO and we now move our focus to the ability of the CEO to
control the Board of Directors and hence the creation of value within the corporation.
While the ascendancy of the role of the shareholder in discussions of appropriate
governance relations is clear its prominence should not be overplayed. Armour et al (2003) point out
that while shareholder value is dominant in discussions of takeovers and board structures it is far
less dominant in discussions of liquidation, and employment law rights. This reassertion of
stakeholder rights is occurring to some degree as a result of interventions by the European Union
but also because of the continuing role of the “business interest” rule at common law which gives no
special place to shareholder rights. One concrete illustration of a dilution of shareholder rights given
by Armour et al (2003) is the role of trade unions and rights obtained under the European Union’s
Acquired Rights Directive in determining the sale of BMW’s Rover plant in May 2000.
Furthermore there is some evidence that larger institutional investors are placing a stable
stake-holder inclusive approach to governance over a myopic search for shareholder wealth
maximisation. The recent swift implosion of once profitable financial institutions may well intensify
this trend. The UK shares a very diverse shareholder base with the US with more than 85% of
companies having no single shareholder voting in excess 25% of the voting rights. Hence a failure to
15
adequately organise in order to assert ownership rights is not surprising and thus free-riding
minority stakes are the norm.
One of the major changes in the governance of companies over the past decade is the
ascendancy of private equity. The market for corporate control has long been considered an
important governance mechanism for shareholders to oust poorly performing managers and this
role was, previously, achieved through takeovers or management buyouts assuming that there were
management teams on the prowl for poorly performing firms or, that managers were able to
leverage up their company’s assets to purchase their firm’s equity. Watt (2008) suggests that whilst
private equity funds appear to be able to increase firms’ share capitalisation and sale value it is likely
due to either superior ability in spotting under-performing companies or by successfully selling at an
over-inflated price. Watt points out that, contrary to management buyouts Private equity can
afford failures as they hold diversified portfolios but adds that the increased risk threatens jobs and
repayment of debt. Ernst & Young (2008) also report faster growth in enterprise value for large,
private equity deals in the EU and US.
The role of the market for corporate control for improving firm governance assumes that
synergy is the prime motivation for reorganisation, Goergen and Renneboog (2004), however, report
that one third of large European takeovers suffered from hubris although they do add that synergy
appears to be the prime motivation for takeovers. Hodgkinson and Partington (2008) also report
strong evidence of hubris in UK wealth-destroying takeovers.
The market for information and funds management
Given institutional investors now hold over 70% of equity in the UK’s largest corporations
the attitudes, motivations and actions of leading fund managers is of central importance to how
companies are managed. Hirschman (1971) characterises institutional investors as having three
choices (1) they can exit by selling their equity (exit); (2) challenge management by voicing their
dissatisfaction (voice) and (3) take a passive stance (loyalty). Both exit and voice might constrain
managerial excess: the exit of sufficient institutional investors triggering a takeover or change in
management and active participation potentially improving managerial decision making. Lysandrou
and Stoyanova (2007), however, consider the voice-exit paradigm to be outdated and argue that the
sale of equity by UK institutional investors may have nothing to do with dissatisfaction but more
more motivated by a desire to rebalancing portfolios. They argue that attempting to force UK
institutional investors to act similar to large investors in continental Europe, could, at worst, be
positively disruptive and add ‘the capital market’s corporate governance role is now exercised more
through the gravitational pull of equity trading than through the intermediary medium of hostile
16
takeovers.’ (p.1071). Lysandrou and Stoyanova argue that gravitational pull by institutional
investors’ requirements for transparency, accountancy and corporate governance criteria force
companies to comply to the benefit of small, as well as large, investors. This argument assumes that
institutional investors are concerned about companies’ long term prospects but as Cox et al. (2007)
find competition between fund managers for managing pension fund portfolios shifts their focus to
short-term objectives with financial performance remaining the dominant measurement of
performance. Cox et al further argue that the pressure from regulators for pension funds to adopt a
long term perspective is only likely to succeed where a relatively few fund managers are engaged to
manage a Pension fund’s portfolio. They add ‘A particular concern is the absence of any incentive
for companies to take actions that mitigate their social and environmental impacts’ (p.1323).
Holland, in a series of studies of the market for corporate control, also documents that fund
managers are hesitant about being too intrusive in company management for fear of attracting legal
liability. This suggests that if Lord Turner, the FRC and other state regulatory agencies are serious
about challenging the “Casino culture” of fund managers they may need to ease competitive
pressures within fund management to achieve that end.
A further impediment to institutional investors challenging management is the conflict of interest
hypothesis as coined by Pound (1988). An important aspect of the conflict of interest hypothesis is
that institutional investors may receive privileged information which might be restricted should they
challenge management and is likely to give rise to a long-term focus. Abraham and Cox (2007)
report that whilst companies with in-house managed pension plans tend to invest in companies
which constrain the amount of risk information disclosed managers of short-term institutions such
as life assurance funds tend to invest in companies which provide a higher level of financial risk
disclosure. As discussed above, the performance of managers of short-term funds is likely to be
measured in financial terms hence the provision of financial information is valued.
Becht et al. (2010), using previously not accessable data from the hedge fund Hermes, examines
whether activism yields rewards. They report that annual abnormal returns of 4.9% net of fees had
been earned by the fund and estimate that around 90% of this was due to activism. This suggests
much scope for investor activism to raise corporate performance despite a marked reluctance to
exploit that power as things currently stand in the UK.
2. Conflicts between the CEO the Board of Directors
Whether governance is seen as coming from the top down or the bottom up the CEO is a
central figure in governing the corporation. Furthermore regulatory change, currently focussed in
the financial services sector is increasingly “individualising” corporate governance through the
17
legislative specification of qualities of approved persons and their personal characteristics (Dewing
and Russell, 2008). Section 59 of Schedule V of the Financial Services and Markets Act (FSMA) 2000
requires that no person can perform a “controlled function” unless given approval by the Financial
Services authority to undertake it. Controlled functions include the Chairman, the CEO and risk
managers, for example. Perhaps the best known part of the British Combined Code tradition is its
“comply or explain” construction which leaves justification for idiosyncratic, company specific,
governance arrangements for managers to explain and justify. Compared to this the FSMA 2000
legislation seems to impose a “comply or else” top down governance standard. The possibility of
widespread economic losses from a collapse of the financial sector of the economy, such as occurred
in 2008 may be invoked to justify such an intrusive regulatory intervention in the public interest but
this trend suggests clear governance may be about individuals and not just internal corporate
processes of accountability and disclosure.
One very simple way to ensure shareholders get value for money from CEOs is to threaten to
get rid of them. Good governance requires shareholder destroying CEOs be sent packing. In a study
of over twenty-one thousand company/years of data drawn from 33 countries in the years 19972001 DeFond and Hung (2010) note wide probability variation in CEO removal across countries.
While only 4% of Portugese CEOs left their employing corporation over the 5 years of their sample a
quarter of South Korean CEOs lost their jobs in the same period (in the UK 16% of CEO’s left their
corporation over a five year period, in France 12% in Germany 19%). How can such huge differences
be explained? One obvious source is the legal origin of the national economies’ investor protection.
We might expect that countries in common law jurisdictions to oust CEOs who destroy shareholder
wealth more quickly and hence make CEO tenure more sensitive to financial performance. DeFond
and Hung (2010) find that the regime of investor rights prevailing in a nation does not matter for the
sensitivity of CEO removal to firm performance what matters is whether that regime, whatever it
may be, is enforced. Since almost all legal regimes restrict outright looting of owner’s interests in
the company what matters is that these limitations on the private benefits of control be enforced.
Even in strong enforcement jurisdiction it is only when the market value of the corporation has
fallen by nearly a third that the probability of a CEO being removed markedly increases. This
confirms previous US evidence that it is only truly dreadful CEOs who are likely to removed from
office, mediocrity being fairly acceptable to most shareholders in most observed contexts (see
Morck et al, 1989).
Modes of executive compensation are an alternative mechanism for potentially encouraging
effective leadership. Two conflicting views of executive compensation are the optimal contracting
18
view proposed by Holstrom (1979) and the managerial power view suggested by Bebchuck and Fried
(2003). The optimal contracting view suggests that arm’s length contracting between boards and
executives will lead to appropriate levels of compensation which create efficient incentives, whereas
the managerial power view suggests that managerial power over compensation increases agency
problems rather than mitigating them. Attempts to reduce managerial power by providing
shareholders with more rights concerning executive remuneration including more transparency led
to The Directors Remuneration Report Regulations (2002) which introduced regulations in the UK
requiring shareholder vote and the production of a detailed directors remuneration report. The EU
(2004) issued recommendations on executive pay similar to those introduced in the UK but Ferrarini
and Moloney (2009) report limited adoption in Europe but highlight UK companies as high adopters,
indeed, Deloittes (2004) report a 90% level of compliance for the top 350 UK companies with those
recommendations. The Directors Remuneration Report Regulations (2002) suggests concerns still
remain on the choice and measurement of performance targets. The EU published further
recommendations in 2009 on best guidance for executive remuneration.
A major US scandal involved the backdating of option grants but Hodgkinson et al. (2010) report
evidence of such practice in the UK and Van de Goot (2010) suggest that the opportunity to benefit
from backdating has reduced in the Netherlands of late but that there is still some evidence that
managers use private information to increase their wealth.
Maury (2006) provides further evidence of how the sensitivity of CEO removal is contingent on the
prevailing corporate governance regime for a sample of 145 Finnish companies in the years 19932000. Finland provides an interesting context in which to investigate these issues because corporate
law allows companies to both (1) choose between a unitary and dual Board structure and (2) the
CEO and Chair to be the same person. Hence, both the dual Boards could be chaired by the
incumbent CEO. Maury (2006) reports an increase Finnish CEO departures following declines in
share prices and earnings but finds that the CEO departure is less frequent for (1) companies with
the same person as CEO and Chairman and (2) companies with unitary boards. Further Maudy finds
that the CEO is easier to oust if he/she is not a major shareholder. Overall Maudy (2006) concludes
that poor performance increases CEO turnover and an appropriate governance structure, a dual
Board with separation of the Chairman and CEO roles , makes the disciplinary threat of removing the
CEO for poor company performance more intense.
Both the DeFond and Hung (2010) and Maudy (2006) studies suggest that governance
reform can achieve something at least in terms of putting greater pressure on CEO to deliver value
to shareholders, but as Aguilera (2006) points out, it is not possible to claim any improvement in
19
Board accountability without being clear to whom the Board is accountable and how. For the
purposes of this section we regard both the CEO and the Board as being accountable to shareholders
by means of maintaining solid equity returns and reporting healthy profits. Other perspectives will
be considered in Section 4 below.
Hillier and McColgon (2006) present some early evidence that these UK reforms are indeed
working for a sample of 683 companies for the years 1992 to 19971. They report evidence that
confirms the findings of Maudy (2006) that Board structure and ownership structure are
codetermined and changes in board structure often reflect changes in ownership structure or other
characteristics. Hillier and McGolgan (2006) measure Board independence by the proportion of nonexecutive directors (henceforth NEDs) on the Board and on this metric report Board independence
declines with the proportion of the Director’s share ownership and family affiliations. Furthermore,
Hillier and McColgon report that companies are more likely to comply with Cadbury style
requirements for Board independence the more exposure they have had to external market
pressures in issuing equity or during the replacement of a CEO. These findings suggest that
corporate governance reforms are more likely to succeed if companies are already subject to
external monitoring mechanisms.
Lehmann and Weigand (2000) suggest that the ownership structure is suboptimal for many
German companies and could be improved by having financial institutions as majority shareholders
although they do argue that the presence of large shareholders does not necessarily enhance
profitability.
Corporate governance and performance
Causality is a key issue in the relationship between governance and performance. Do wellperforming companies embrace corporate governance reform of does the imposition of corporate
governance reform improve performance? Renders et al (2010), building on work by Bhagat and
Jefferis (2002), try to answer this question by working through the many data problems and
econometric pitfalls this endogeneity issue raises. They do this by examining the relationship
between corporate governance ratings and reported corporate performance for a sample of roughly
nine hundred company/year observations drawn from 300 companies in 14 European countries
within the FTSEurofirst index for which both Deminor corporate governance ratings and Worldscope
accounting data are available for the years 2000-2003. As only large, successful, companies make
1
To be in their sample a company must survive the first three years from 1992 to 1994. This excludes
companies who reformed corporate governance arrangements during a crisis of survival.
20
the Deminor ratings list a sample selection problem is induced which compounds and confuses the
pre-existing endogeneity issue. Renders et al (2010) seek to surmount these problems by using a
three stage instrumental variable estimation technique and find, after controlling for both sampleselection bias and endogeneity, a clear positive relationship between corporate governance ratings
and corporate performance, whether that performance is measured by share price returns, or
accounting profits. This ability of good governance, as proxied for by corporate governance ratings,
to raise company performance is of both statistical and economic significance suggesting good
governance matters in much more than a routine administrative compliance way. Beiner et al.
(2006), also report a positive relationship for between corporate governance and firm valuation
using a three-stage least squares approach to examine Swiss firms corporate performance.
If econometric studies struggle to unwrap the causative mechanism of whether good
governance cause good performance or does good performance facilitate good governance it may
be time to consider alternative research methods to crack the problem. Fortunately Falatotchev and
Toms (2004) study of the decline of UK Cotton industry has attempted to achieve exactly that. The
authors examine what role good governance can exert in saving individual companies from the
bonfire that was the post-war UK Cotton industry. These authors point out that the UK Cotton
industry underwent both rapid industrial consolidation as specialised, often family firms, were
replaced by much larger vertically integrated conglomerates as well as major governance reform
often induced by the oversight of major institutional shareholders. The large institutional investors
in the remaining post-War diversified companies played an active role in choosing which of the
smaller, specialised, manufacturers could be salvaged by acquisition in the face of brutal, wagebased, overseas competition. By doing so they retained a smaller, but more durable, British Cotton
industry despite the surrender of most of the industry to overseas competitors.
3 Getting Boards to deliver value to shareholders
Much of the governance reform we have seen in the last two decades has focused on the structure,
size and composition of the Board of Directors. The Combined Code lays down best practice for
Board size, composition of executive and non-executive directors, tenure and re-election of Board
members, establishment and manning of subsets of the board to deal with, remuneration and risk,
for example.
One sometimes wonder whether any of this has any clear demonstrable effect on companies
ability to deliver what shareholders want; that is, good returns without unreasonable risk, or more
21
simply sustainable competitive advantage. Some of these recommendations are new and may take
some time to bed in and reap rewards. Dedman (2002) finds some evidence that the Cadbury
(1992) reforms improved how UK boards operate in several respects. She reports a decrease in
accounting manipulation and an increase in the discipline of top executives following poor
performance.
O'Sullivan and Diacon (2003) examine the number of NED on 53 life insurance company
boards from 1984 to 1991 dividing their sample depending on whether they are owned by
shareholders and run for profit or mutuals who operate in their membership's interest be that via
lower fees or higher returns. They find a greater use of NEDs in the mutual sector where their
presence might compensate for the lack of shareholders’ pressure to perform. Nevertheless there is
little evidence that the higher presence of NEDs and, in addition, splitting of the Chairman and CEOs
roles resulted in improved financial performance compared to their less well-governed proprietary
counterparts. So it is seems possible that the corporate governance reform agenda, at least as
expressed by Cadbury, is more responsive to dramatic, newsworthy, iconic corporate scandals than
reflecting more somber, evidence based, responses to generally observed trends in corporate life. It
may be that more NEDs and a division of CEO and Chairman's roles simply increases the number of
cooks without making for better meals for shareholders. It should be emphasised that Cadbury
advanced these proposals in the belief that they were already clearly established best practice in
British industry and the proposal was simply to bring the weaker brethren up to the standard of the
best. In a postal survey conducted shortly after the publications of the recommendations Conyon
(1994) reported that 58% of quoted companies separated the roles of Chairman and Chief Executive
in 1988, but by 1993 77% of quoted companies separated these offices. Follow up work by the
Cadbury Committee itself suggested by the end of 1994 some 80% of the largest companies had
separated the CEO and Chairman’s roles. Nevertheless Dedman (2002) reported that older
CEO/Chairmen were less likely to relinquish one of the roles after Cadbury than before suggesting
the cult of leadership was by then far from dead and the most entrenched executives feel quite
comfortable ignoring best practice guidelines.
With regard to firm size Peasnell et al (1998), studying a sample of UK non-financial firms,
report no significant change in the size of the average board from 1990 to 1996, while the
proportion of NEDs has risen from a sample average of 34% in 1990 to 45% in 1996. So by the mid
90's non-executive representation was increasingly the norm even if executives still numerically
dominated the Board. Dedman (2000) reported the median size of UK Boards to be smaller in the
22
UK than in the US, at 8 against 12. Peasnell et al. (2000) also report a reduction in income-increasing
accruals management following Cadbury for companies with a relatively high number of NEDs.
Audit Committee establishment also seems to have been given a boost by the Cadbury
recommendations. Gay (2001) in a survey of FTSE 350 constituents found that of 35 constituents
who reported no audit committee in their 1991 financial statements 31 had established such a
Committee by 1999. So it appears that Cadbury had, at least, induced public compliance in this
regard. It is in the area of institutional investor activism that Cadbury's recommendations met most
passive resistance. This is clear from the fact that the Stewardship Code issued 18 years after the
Cadbury report asks for much the same engagement in corporate management as Cadbury had
originally done.
But did the Cadbury reforms do their job in terms of delivering greater shareholder returns to
investors, especially in badly run firms? Dayha et al (2002), from a randomly selected sample of 460
UK companies, examines the relative performance of a subset of 288 companies who conformed
with Cadbury's requirement by splitting the roles of CEO and Chairman and having at least 3 NED's
on their Boards. Dayha et al (2002) report that the likelihood of a CEO being dismissed for poor
performance is enhanced for the recommendation compliant subsample.
Certainly the move toward greater NED representation on Boards has been contagious
with more than 18 nations adopting such recommendations between 1993 and 2000. Many
countries have made even more radical reforms than the UK, with Belgium and Greece requiring
more than half the members of the Board be NEDs. But has such a widespread political support been
associated with better, more shareholder wealth enhancing, decisions over time? In short have NEDs
being paying their way on boards?
Dhahya and McConnel (2005) study a sample of 700 UK companies in the year’s surrounding
the Cadbury reforms. If NEDs are of any value at all this should be implemented by making the
company less insular. Obvious evidence of such greater openness to new ideas comes when the
decision to replace the current CEO. Dhayha and McConnell (2005) study the CEO replacement
decision for the 523 departing CEOs in their sample which spans the Cadbury Committee’s report on
the NED’s. These authors find that companies with a higher proportion of NED’s are more likely to
choose an outside CEO but, more importantly, there are clear stock market excess returns paid to
reward companies that make such decisions to look outside to find a CEO. This suggests some scope
for governance reform in enhancing shareholder wealth at least at key points in the company’s life.
23
Much academic literature and anecdotal evidence suggests the role of NEDs in promoting
good corporate governance is hampered by inter-locking directorships leading to the provision of
reciprocal benefits for one another. A study of the largest 200 companies in the UK in 1995 suggests
that few executive Directors in the UK have the time or opportunity to serve as NEDs elsewhere
(O'Sullivan, 2000). Of the 960 executives in the 175 companies in O'Sullivan's final dataset only 90
hold one NED position, 39 two, 10 three and 3 executives in his sample hold four external NED
positions. So 85% of executives in the sample held no NED positions at all. To some degree this
might re-assure us that being an executive in a UK company is indeed a difficult job. But it does make
one wonder where NEDs are recruited from? Even controlling for a prominent role for retired
executives a large gap remains here. Examining the characteristics of those 15 % of executives who
do serve as NED's O'Sullivan (2000) finds they disproportionately come from companies with
relatively low market to book ratios. This suggests high growth potential companies are too busy
grabbing the opportunities they have to release their executives to NED positions elsewhere. But
more disturbingly it suggests most companies turn to NEDs drawn from companies with, at best,
mediocre performance to tell them what they should be doing.
4A holistic model of corporate governance and stakeholder accountability
Corporate governance cannot be determined or understood in isolation but is entwined with the
concept of accountability. Defining corporate governance is not as simple as some may make out –
the financial, shareholder-driven agency theory perspective of governance and accountability does
not succeed in encompassing the various needs and requirements of diverse stakeholder groups
who are affected by, and who affect, corporations. From a stakeholder accountability perspective,
corporate governance is more about seeking to define ‘good’ corporate governance, rather than
simply explaining corporate governance mechanisms and relationships. The term ‘corporate
governance’ has metamorphosed from a relatively unfamiliar phrase, restricted to use in academic
papers and in some ‘knowledgeable’, forward-thinking boardrooms, to a term in common parlance
in the business world, the newspapers, in restaurants and over the kitchen table. Despite its
transformation into coffee table status, a common understanding of corporate governance remains
elusive. Is corporate governance about restraining fat cat salaries? Is it about wealth maximisation?
Is it about following the Combined Code verbatim? Or does it involve more than this? Each of these
questions represents a myopic view of corporate governance: corporate governance is a more
complicated, multifaceted and holistic concept.
24
An emerging definition of corporate governance which is fit for purpose in today’s global society
needs to be holistic and inclusive, with a focus on achieving both effective and ‘good’ governance. A
decade after his groundbreaking, but essentially shareholder-centric Code of Best Practice (Cadbury,
1992), Cadbury (2002) expressed a need for good corporate governance to incorporate corporate
social responsibility and social accountability. Better governance and social responsibility can be
related to better company performance because they contribute to reputational risk management
as well as represent proxies for high quality management. A substantial body of academic literature
demonstrates a positive relationship between corporate social responsibility and corporate financial
performance (Griffin and Mahon, 1997). Management quality has been shown in the past to relate
positively to financial performance (Alexander and Buchholz, 1978) and corporate social
responsibility has been found to relate positively to corporate financial performance (Bowman and
Haire, 1975; Belkaoui, 1976; Cochran and Wood, 1984 and Johnson and Greening, 1994).
Perceptions among the institutional investment community are significant in driving a more socially
responsible form of corporate governance. Institutional investors believe that short-term profits can
be made without paying attention to social responsibility but in the long-term such an approach may
be disastrous (Solomon, 2010). Socially responsible companies have been shown to outperform the
market (Moskowitz, 1972) and certainly not to underperform (Cobb et al., 2005)2 and the
institutional investment community has acknowledged that companies with higher social,
environmental and governance ratings demonstrate the best performing shares3. Improving
corporate social performance has been shown not to discourage institutional investors from buying
shares (Graves and Waddock, 1994). Environmental, social and governance (ESG) issues are now
closely integrated into mainstream institutional investment (Solomon, 2009) and the evolution of
ESG investment per se shows the indivisibility between corporate governance issues and issues of
social and environmental sustainability (Solomon, 2010). The new Stewardship Code emphasises the
need to improve accountability within the financial services industry, specifically by insisting on
greater engagement and dialogue by institutional investors with their investee companies. However,
the Stewardship Code does not restrict its remit to engagement on financial aspects of governance
and accountability but also highlights the need for institutional investors to engage on material
social ethical and environmental issues, stating specifically that,
2
The researchers compared the performance of the UK FTSE4Good index (composed of more ‘socially
responsible’ companies) with that of the market and found that the FTSE4Good performed at least as well,
concluding that investors were not disadvantaged by investing in FTSE4Good..
3
For example, Innovest Strategic Value Advisors, an organization that rates companies according to social,
environmental and corporate governance issues, has provided evidence to support this association (see
Solomon, 2010 for a full discussion).
25
“Instances when institutional investors may want to intervene include when they have
concerns about the company’s strategy and performance, its governance or its approach to
the risks from social and environmental matters” (Stewardship Code, 2010).
A holistic, inclusive view of corporate governance implies that accountability is not a unidirectional
relationship, enforcing company directors to satisfy shareholder needs, but a far more complicated,
multidirectional web of relationships and responsibilities arising between companies and their
diverse stakeholder groups. ‘Good’ corporate governance requires accountability flows in a
multitude of directions between many stakeholder groups. Brennan and Solomon (2008)
demonstrated that academic research in the corporate governance domain has, in recent years,
spanned outwards to encompass a broader approach with an emphasis on multi-stakeholder
accountability.
Of course good corporate governance has at its centre the need for boards to satisfy their
shareholders’ expectations, as they are legally bound to protect those who lend capital to the
business. However, as outlined in the new version of UK Company Law, boards must also satisfy
demands of their non-shareholding stakeholders, and protect their interests. As we saw above,
institutional shareholders themselves are demanding stakeholder inclusivity from companies, for
their own reasons of long-term value creation. Thus, stakeholder accountability and inclusivity are
no longer additional to shareholder wealth maximisation but essential to the original agency
relationship.
But who are all these stakeholders? Boards may be forgiven for drowning in endless rhetoric, often,
unfortunately, arising from the academic world, about the many different types of stakeholder who
may not necessarily include groups of people affected by the company’s operations, but also ‘the
environment’, biodiversity, ecosystems, the Planet and future generations. Do not think I intend to
make light of this accountability, and corporate responsibilities in this regard: I am merely
highlighting the incredible difficulty for captains of industry to come to terms with the often illexpressed demands for stakeholder accountability which are increasingly addressed towards them.
The point is that it is not just boards of directors who need to discharge accountability to
stakeholders within an inclusive model of corporate governance. Many groups of stakeholders,
shareholding and non-shareholding, also need to consider their responsibilities in terms of corporate
governance and how they are going to discharge their accountability, and to whom. The shareholder
group, dominated by institutional investors in the UK, have a substantial responsibility to discharge
accountability to their clients, the ‘real shareholders’ by calling boards to account. This is the
26
essential message contained in the new Stewardship Code: shareholders as well as boards need to
take responsibility for ensuring ‘good’ governance.
As Walker (2010) demonstrated, failure leading to the global financial crisis was not limited to bank
directors: institutional investors failed to call bank directors to account. Non-shareholding
stakeholders failed to scrutinise and interrogate banks. The financial crisis represents a shared
failure because corporate governance is a shared responsibility. The chains of accountability defined
by a broad and inclusive model of corporate governance are far more complicated and intertwined
than a simple, orthodox agency theory description of corporate governance implied.
Studies conducted in the wake of the financial crisis have highlighted the need for greater
stakeholder accountability in governance, a more ethical approach to governance and a greater
focus on personal integrity and ethical behaviour (Moxey and Berendt, 2008; Davies, Moxey and
Welch, 2010)
Recent research suggests stakeholders are not engaging actively with companies and only a handful
of interested parties contact companies regarding their sustainability (or other) reports. This shows a
significant lack of stakeholder engagement from the stakeholder, not the company, side. As the
Walker Review and the Stewardship Code have elucidated, the responsibility for ‘good’ corporate
governance is not only in the hands of companies but also their primary shareholders and
stakeholders also have a responsibility to exercise accountability by engaging with companies,
contacting them, asking questions. One of the main criticisms from companies and institutional
investors is that stakeholders make very little effort to take the initiative with companies and ‘put
them on the spot’. This lack of preparedness to take responsibility by playing an active role in
governance renders stakeholders even weaker than they already are, per se, in the corporate
governance framework. As Cadbury showed major shareholders have a responsibility for corporate
governance – they should be taking the initiative by acting rather than complaining. So should
stakeholders.
In essence, prior to the credit crunch and ensuing global financial crisis, there was a tendency in both
the practitioner and academic spheres to consider that corporate governance had been ‘done’. The
tick box tendency of directors and management in response to corporate governance codes of
practice has led to a glaring oversight of one of Sir Adrian Cadbury’s most important challenges: i.e.
for companies to comply in spirit with corporate governance codes and principles of best practice,
27
not simply in letter. Again, there has been a tendency for companies to be transparent about
positive activities while being less transparent about their weaknesses and failings.
If corporate governance had been ‘done’, finished, achieved, through the continuous agenda of
corporate governance reform following from Cadbury’s 1992 Report, then how on earth could we
have witnessed the massive corporate governance failures which characterised and contributed to
the banking crisis? How could there have been such widespread failings in remuneration structures,
risk management and internal control systems, non-executive director functions and transparency,
especially in relation to risk management strategies? It is almost as though Cadbury never happened.
The Combined Code may have been followed in practice, technically speaking, but it was not being
followed in spirit by many directors and boards. It is almost as though Barings never fell: nothing
seems to have been learned from this banking collapse. It is almost as though Enron never happened
– why did boards not learn from this corporate collapse that boards must control risk management,
that non-executives must monitor strategic decision making and operational activities in relation to
risk management, that corporate transparency is paramount to good governance. Moxey and
Berendt (2008), Davies et al. (2010) suggest that the financial crisis has arisen from corporate
governance weaknesses and failures and that the root causes of corporate governance failure
require urgent research to uncover the elements of human behaviour which have contributed to the
erosion of what should have represented strong mechanisms and principles in practice of corporate
governance. What has gone wrong? What can we learn from the recent banking crisis that we for
some reason did not learn from the other corporate collapses and failures and banking failures
(Barings)?
It is amazing that even after the devastating impacts of the global banking and ensuing financial
crisis, bank directors are so quickly reinstating immense bonuses and resisting
Society is suffering swingeing cuts and tax increases and facing at least one lifetime of deterioration
in welfare and quality of life, yet some senior bankers continue to maintain their right to massive pay
increases, eye-wateringly high salaries and immense bonus payments. It is incomprehensible to the
man or woman in the street that lessons have not been learned from recent events and that
consciences can have such short memories and such little empathy with the society in which they
exist. Further, there are now concerns in the City that the Stewardship Code, which has so much to
offer in terms of strengthening accountability and governance, may suffer a similar fate, being
reduced to a further box-ticking exercise.
28
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