New principles for strengthening market integrity

Bill Witherell, OECD Observer/Paris

The newly revised OECD Principles of Corporate Governance which were released late last month are a stronger OECD instrument to help improve boardroom behavior globally. And that means better business and stronger markets for everyone.

How healthy are our corporate boardrooms? A vital question, since we all depend on businesses as the engines of wealth creation, innovation, employment, spreading development and technology, and much more. Healthy, well-governed companies make for thriving economies. But we need to rebuild our faith in them.

Recent high-profile corporate failures such as Enron in the U.S. or Parmalat in Italy have underlined the continuing need to improve corporate governance globally. They have also prompted a re-examination of how the OECD Principles of Corporate Governance might be updated to take account of latest developments.

The OECD has worked to promote use of the Principles since they were first adopted in 1999 to support good corporate governance policy and practice both within OECD countries and beyond.

Regional roundtables on corporate governance set up in partnership with the World Bank have allowed the OECD Principles to become a widely accepted global benchmark that is adaptable to varying social, legal and economic contexts in individual countries. They have helped to spur reforms in regions as diverse as Asia, Latin America, Eurasia, Southeast Europe and Russia.

Yet, the recent spate of scandals highlighted corporate governance weaknesses and naturally led to the question of whether the Principles had been on the mark or missed something important ; or indeed to what extent companies, boards and investors may have simply failed to follow good practice.

Good corporate governance is not simply about minimizing the risk of corporate failure and dealing with those guilty of fraud. It is also a fundamental prerequisite for improving economic performance, facilitating corporate access to capital, decreasing volatility in retirement savings and improving the general investment climate. These links to investment, public savings, market confidence and integrity make good corporate governance a central policy concern of importance to long-term economic growth and financial market stability.

The Principles already called for boards capable of independent judgment, yet the absence of such independence proved fatal.

Indeed, the review found that the original Principles represented the requirements for good corporate governance reasonably well. The difficulties arose largely in ensuring their effective implementation. The Principles already called for boards capable of independent judgment, yet in case after case the absence of such independence proved fatal.

Shareholder rights to appoint board members were supposed to lead to accountable boards, but one question repeatedly raised in the consultations was: Where were the informed owners? The Principles called for independent audits which in all too many instances proved a mirage. They called for transparency of ownership structures, but these structures remain opaque in many countries.

On the other hand, the Principles did not address issues of public concern in some countries, such as executive compensation, and the rise of institutional investors was only dealt with tangentially.

The 1999 Principles have now been strengthened to respond to the new challenges and concerns highlighted in the consultations. These revisions cover four main areas: Ensuring the basis for an effective corporate governance framework including effective regulatory and enforcement mechanisms; improving possibilities for the exercise of informed ownership by shareholders; a strengthening of board oversight of management; and increasing attention to conflicts of interest through enhanced disclosure and transparency.

To improve implementation, a new chapter has been added specifying principles for governments to follow in developing the regulatory framework which underpins good corporate governance. Broad principles have been developed covering implementation and enforcement, along with mechanisms that should be established for parties to protect their rights.

However, the Principles seek to minimize the risk of over- regulation and the costs from unintended consequences of policy action, both of which have been raised by business groups as potential dangers.

At the end of the day, good corporate governance comes down to effective and informed owners. These have all too often been absent. The chapter on shareholders has now been strengthened with the aim of lowering the cost and raising the returns from the informed use of ownership rights.

New principles call on institutional investors to disclose their corporate governance policies, including how they decide on the use of their voting rights and how they manage conflicts of interest that may compromise their voting. Restrictions on consultations between shareholders about their voting intentions should be eased, thereby reducing the cost of informed ownership.

The rights of investors have also been strengthened. Shareholders should be able to remove board members and participate in the nomination and election processes. Shareholders should also be able to make their views known about the executive and board remuneration policy of the company, and any equity component should be subject to their approval.

Greater attention is paid to ensuring auditor independence.

As to the board, its responsibilities have been more clearly specified to address corporate ethics, compliance with laws and standards and oversight of internal control systems covering financial reporting, all of which have at one time or another appeared weak. The principle covering board independence and objectivity has been extended to apply to situations characterized by block and controlling shareholders, and not just referring to independence from management.

One of the most striking features of corporate governance practices in recent years is that conflicts of interest appear to be widespread and can be quite pernicious. The principles covering disclosure have been strengthened, particularly with respect to those conflicts of interest and transactions between related parties, which in addition to being approved by the board, also need to be disclosed.

A new principle recognizes the role of various providers of corporate information, such as rating agencies and analysts, whose advice should not be compromised by conflicts of interest. The Principles aim to make auditors more accountable to shareholders, for example, by exercising due professional care in the conduct of the audit. Greater attention is paid to ensuring auditor independence.

Being principles-based and non-prescriptive, the success of the Principles will rely upon how they are actually applied in a given situation by companies, shareholders, stakeholders and governments.

There will always be a question of whether the balance of soft and hard law is appropriate and why the behavior of companies, shareholders and stakeholders might not be responding in ways considered conducive to good corporate governance.

The writer is Director, OECD Directorate for Financial and Enterprise Affairs. This view is strictly personal.