The Value Of Good Governance

We are witnessing a period of ever-growing financial regulation and new governance rules aimed at promoting transparency and avoiding the failures of the past. The intention is to prevent the world being plunged into another financial crisis as a consequence of inadequacies in how companies are run.

Few could sincerely question the nobleness of this crusade, not least amid the current economic climate, yet it is by no means a campaign that is universally welcomed. The mere encouragement of better practice – let alone its legislation – is innately difficult, and many firms make little secret of the fact that they view it as an invasion of their privacy.

Extensive research has frequently highlighted the reluctance of boards to improve corporate governance when they are free to choose not to do so. The traditional assumption is that changes have to be imposed or recommended from the outside, since the costs of implementing them outweigh any benefits a company might derive.

Regulators in some countries – including the UK, Brazil, Canada, Hong Kong, Malaysia, South Korea and South Africa – favor a “comply or explain” regime. Rather than establishing binding laws, they set out a code: listed companies must either adhere to it or explain publicly why they do not. This sometimes makes for what might be termed a rather liberal accord. Other nations – chief among them the US, in the form of the Dodd-Frank Act – prefer a “comply or else” philosophy. The more leeway is afforded, perhaps understandably, the less inclined towards acquiescence a board may feel.

Consider, for example, the phenomenon of staggered boards – that is, the arrangement by which only a fraction of a board of directors’ membership is elected each year. A recent study suggested 60% of US companies employ this stratagem, which just happens to be one of the most effective anti-takeover devices ever conceived. Although the percentage has declined of late, even Dodd-Frank does not prohibit the ruse, which remains prevalent among American firms in spite of destroying value for shareholders.

A devil’s advocate may well contend that boards and corporations have yet to be presented with any meaningful evidence that the self-motivated embracing of good governance practices delivers real, tangible benefits to a firm or its shareholders. In light of this, the argument might go, why should they change their behavior?

Maybe this will help.

We recently exploited an interesting organizational feature of the London Stock Exchange (LSE) to investigate the value of voluntarily adopting better governance. The key to our research was that for almost two decades companies incorporated outside the UK were permitted to feature in the LSE’s overseas segment via two distinct processes – one involving the ready acceptance of good practice, the other sidestepping it entirely.

The first method, culminating in an official listing, is a procedure that is still used today and is initiated by the firm itself deciding to list its shares in the UK. This involves abiding by a strict set of rules laid down by the Financial Services Authority, the UK’s principal regulator, as well as being monitored by its offshoot, the UK Listing Authority.

The second process, the Stock Exchange Automated Quotation International market – or SEAQ-I – was discontinued in July 2004. It demanded far less scrutiny, requiring only an application by a single LSE trading member for a firm to be traded on a specialized platform – even without the company’s own approval.

Our study examined data relating to hundreds of firms listed on the LSE or traded on SEAQ-I to determine the stock price reaction around listing/trading days. We found companies enjoyed an average stock price increase of 3.81% during a period of 20 days around the day they earned a regular listing on the LSE, whereas stock returns for firms traded on SEAQ-I – in other words, firms not embracing good governance – fell by an average of 0.038% in the same period.

The findings – whose robustness was verified by a variety of tests and regressions, including controlling for revenues, assets, sales, growth and capitalization – represent one of the first studies providing consistent evidence of how good corporate governance is recognized and rewarded by the markets. Since both listings are in the UK, we have to search for the key differentiator between the two approaches; and the inference must be that it is the decision to list voluntarily and all that this entails – specifically, a willingness to be pored over by the regulatory authorities.

There are vital lessons to be learned from this, particularly in the present economic climate and when a lack of transparency is widely regarded as having been a major factor in the last financial crisis.

Above all, it underscores that a board’s indisposition to comply with good corporate governance is usually the result of selfish behavior – as per the “staggered board” scenario mentioned above. In such instances, almost inevitably, the most effective approach for regulators is not one of “comply and explain” but rather one of “comply or else”.

We can only hope that genuine evidence of good governance being rewarded by the markets will persuade more boards and corporations to implement improved practices of their own volition. This – at last, some might say – is the carrot.

The stick, of course, is already familiar – and, if anything, is likely to become even more so. In the face of persistent and unwavering disinclination, the only realistic option for regulators is to forcibly impose ever-stricter rules and codes that leave those that refuse to comply with less and less room for maneuver. Should that prove the case, the directors and firms that make such an approach inescapable will have only themselves to blame.

Arturo Bris and Salvatore Cantale are Professors of Finance at IMD.

[This article has been reproduced with permission from IMD, a leading business school based in Switzerland. http://www.imd.org]