Good governance? By Marcel Côté Governance is a hot item on corporate agendas for a number of reasons: governments and regulatory bodies have instituted new rules; financial analysts have made it a main criteria for evaluating companies; and the media ranks them according to the quality of their governance. But let’s look at how this push for virtue impacts businesses and the economy. It’s no secret some companies have been guilty of governance violations. But at the same time, governance practices have improved significantly, as have all facets of management. How-ever, in the wake of scandals such as Enron, the pendulum may have swung too far in the other direction. Backed by public support, governance fanatics are pushing through unwarranted curbs and checks on the ability of public corporations to create value. Major governance reforms have been implemented in the past 10 years. The separation of chairman and CEO duties, the greater independence of directors and auditors, and the disappearance of employees, other than the CEO, as directors are positive trends. The same holds true for the increased rigor of accounting standards and the full disclosure of ties and transactions between related parties. However, many requirements imposed by the Sarbanes-Oxley Act, the Toronto Stock Exchange and Canadian securities commissions are expensive and may change the way business is conducted. In fact, most listed corporations do not need more stringent regulations. The truth is only about 1% of 20,000 companies in the US and Canada may have been delinquent. Stricter rules make sense for them, while creating unnecessary costs for the remaining 99%. Does improved behaviour by a few companies justify additional costs for all listed companies? Although direct legal and accounting costs are those most often publicized, they are just part of the burden of the new rules. More important is the increased risk-related cost imposed by them. By shifting the burden of risk management onto directors, the proponents of these new regulations demonstrated their good intentions. But they also require all well-run companies to develop procedures to track and minutely document risk, and that will have a significant impact on day-to-day business operations. To police 1% of the corporate world, we are imposing costs on the 99% whose behaviour has been correct.  Economic value is created  by finding new uses for existing resources. Finding these uses involves risk, and thus risk management is a critical element of any business. It is implicit in all business processes — from strategic planning through financial controls to investment review. Too many of the new governance rules try to regulate these processes, requiring more documentation and deliberation. Directors,  who now incur greater risk exposure, require more demanding reviews and although less informed than management, get to have more say in the decisions. As a result, risk-taking becomes more bureaucratic and gradually this culture spreads through the organization. Creating value becomes more complicated, whereas the status quo is not affected, but change becomes more complicated. One of the indications that reforms have gone too far is the privatization of many public corporations to escape regulations and the delisting of several large European companies from US stock markets. Another less obvious impact, more difficult to measure, is the increasing risk-aversion of businesses. When risk becomes more costly, companies become more cautious, invest less and the economy suffers. Three accounting professors at University of Pennsylvania’s Wharton School of Business published a study of 2,100 public corporations. It showed that financial performance has little relation to the governance criteria enshrined in the new regulations. Governance scoring on major Canadian public corporations published by The Globe and Mail last October showed a negative correlation between five-year financial performance and the governance criteria it measured. It is also ironic that the main feature of good governance, i.e. quality of directors, is not only ignored by the regulations but also can’t be measured. A good director can influence management and isn’t afraid to ask difficult questions. Such directors are rare, and the new rules do little to multiply them.  In fact, a governance rule that should be encouraged is an annual evaluation of directors’ performance, and the replacement of those that score worst. The fact that such a measure isn’t demanded by the regulations reveals their limits. Marcel Côté is a partner at SECOR Inc. in Montreal