The Illusion of Corporate Governance “Best Practices”

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The best boards focus on solutions and structures tailored to their companies, ignoring cookie-cutter “gold standards.”

Contrary to what good parents have long taught their children, it’s now acceptable in corporate governance to say “everyone else is doing it, you should too.” Advocates of so-called good governance urge companies to take specific actions because they “lag behind their peers” on some favored practice. 

This is new. A generation ago, the norm in corporate governance was to recognize differences among companies — the need to tailor governance to fit needs, to shun cookie-cutter approaches. In recent years, however, the norm has veered to a universal expectation that all boards should follow identical guidelines, usually anointed as “best practices” or “gold standards.”
 
There are legions of examples, beginning with the rise of independent directors in the 1990s and the structure of the audit committee dating from the early 2000s. They include separating the board chair and chief executive roles and de-staggering board service in the 2010s to valorizing diversity of race and gender today, along with disclosure around fashionable but vague ESG concepts. 

Why has this genuflection to best practices and gold standards occurred, and what should we hope for the future of corporate governance?

Generalists and Generalizations

A dominant reason is the expanding power of generalists offering only a macro-perspective. A generalist viewpoint is understandably held by all passive asset managers and proxy advisors, most policy makers and many empirical researchers who favor working with large general datasets. All have incentives to identify and promote universal practices for all boards. 

In contrast, specialists take a micro-perspective on particular companies, including stock-picking shareholders, the directors who serve them, and analysts and researchers prepared to immerse themselves in the details of particular companies. Such cohorts would undoubtedly endorse universal practices that work, but they have an interest in resisting overgeneralized prescriptions.
 
In recent years, generalists have wielded far more power than specialists in corporate governance, and their worldview now dominates. As a result, gold standards and best practices are everywhere in governance, even if they are not good for particular companies. A catalog of good governance reigns, including refreshment imperatives, such as director age limits and term limits, and control-related rules, like majority voting in director elections and negative views of dual-class capital structures. 

Yet, while good governance may exist in theory or on paper, formulaic approaches can be perilous in practice. There, what’s critical is nuance that formulas can’t capture, such as director wisdom, board chemistry, capital allocation sophistication and mastery of a company’s culture. Against the powerful forces of generalists, it's up to individual directors to defend their company’s circumstances and its optimal arrangements. To do so, it helps for them to appreciate why the generalists favor uniform practices and why they wield the greater power.

Preferences and Power

Index funds are concerned about the performance of a portfolio, not specific companies. They, therefore, have an incentive to prescribe policies expected to benefit the overall stock market on average, not particular stocks. Even if they wanted to, industry competition keeps fee revenue so low that they can’t afford company-specific research: As few as 45 staffers cover 3,000 companies, posing tens of thousands of governance questions every year. In the past two decades, they have become enormous — one-quarter of corporate America’s equity is managed by just three massive index funds — gaining inordinate power in corporate governance.
 
Proxy advisors operate on shoestring budgets as well, with around 1,000 people asked to make recommendations on 100,000 questions annually. It is far easier to make general recommendations than to study specific companies and their needs. Moreover, these firms generate considerable revenue advising companies on best practices, increasing the value of recognizing such constructs. Their power has mushroomed in the past decade since federal law gave them a regulatory license under which passive asset managers meet their duties to clients simply by relying on proxy advisors.

In government, policy entrepreneurs from think tanks, universities and lobbyists encourage a cookie-cutter approach as well. Lawmakers in Congress often change corporate governance in times of crisis, such as after the collapse of trust following debacles like Enron. The winning political solutions are often broad proclamations of fixing a general problem — like reforming wholesale audit committee failure — rather than performing fine surgery to correct particular pathologies plaguing particular companies. 

Securities regulators and stock exchanges address corporate governance more regularly and outside the limelight. But both find it easier to pass and enforce standardized rather than tailored governance. Many of today’s most pervasive examples of best practices in governance originated in the ESG principles adopted in 2005 by the United Nations, an organization prone to favoring gold standards.

Against these powerful forces pushing standardization have been the old-fashioned securities research analysts and stock pickers who support them. But their valuable voices are often drowned out, and individual investors among them have no way to exert collective power. 

Individual directors can toil inside their boards yet still face overwhelming pressure from generalists. Professional associations such as the NACD or publications such as this one can help.

As for scholars and researchers, recent evidence is emerging to question the generalist catalog, producing facts that even the powerful cannot forever avoid facing. 

Poverty and Promise

Research dating back two decades created the generalist’s framework to differentiate between good and bad corporate governance. Using data created by the predecessor to today’s powerful proxy advisor, Institutional Shareholder Services (ISS), finance professors led by Paul Gompers said good governance increases “democratic” shareholder rights, like one-share/one-vote, while bad governance encompasses things that increase “despotic” managerial power, like a CEO also chairing the board.  

ISS and other powerful advisors to large institutional investors commercialized recommendations based on such data. The generalists created a catechism of best practices and gold standards in corporate governance that remains talismanic today. 

But new research, by law professors led by Eric Talley, challenges this bedrock work as founded on errors. Coders misinterpreted source material on basic features, such as whether a company had dual-class shares, a staggered board or supermajority voting. In a multiyear effort, released by the European Corporate Governance Institute as Cleaning Corporate Governance, the professors built a new dataset hand-coded from the governance provisions of thousands of public companies. Comparing their findings with the original ISS data, the professors report “alarming” errors in the original coding. Aggregate effects are dramatic, such as erasing most of any return premium for “democratic” compared to “despotic” companies.

The new evidence, consistent with common sense, makes clear that generalities in corporate governance are suspect. The issue should always be what is best for a particular company and its shareholders, not what index funds, proxy advisors or policy entrepreneurs declare is best. 

Take splitting the chair/chief executive roles: Leading indexers and proxy advisors oppose combining the roles because boards appoint and oversee the CEO. Having one person wear both hats creates a conflict, they say. Yet, many corporations thrive when led by an outstanding person serving as both chair and chief, while others have failed amid split roles — think Enron. After all, board chairs get only one vote, so it comes down to the capability of the other directors. Effective ones neutralize such a conflict.
 
Debate over staggered boards reflects a similar general versus specific divergence. At some companies, every director stands for election every year, while at others only one-third do, each for three-year terms. Critics oppose such three-year terms as impairing board accountability. Yet, a staggered board may enable a company to embrace a longer time horizon than one that can turn over completely in any year. There is substantial value in commitments to long-term strategies.

Scrutiny is warranted for every topic in the good governance catalog. Dual-class capital structures may be bad for some companies but good for others. Director ownership of stock may be good or bad, depending on whether the director paid cash using her own money or received stock grants. And so on for board size, director elections, term limits, age limits, ESG disclosure and the rest.

There are some gold standard governance practices that are highly probative of a board’s stewardship, such as disclosure of individual director biographies and each director’s qualifications to represent shareholders. But far less obvious are general rules addressing factors such as whether directors serve together on other boards or serve on multiple boards and individual directors’ ages, genders and skin colors.

The best directors focus on what’s best for their companies, not on what generalist consensus ordains as best practices. They try to lead in their own way, not fear that they lag behind their peers. After all, as any parent will tell you, following the crowd is among the worst arguments you can make for doing something and the most dangerous.  

Lawrence A. Cunningham is vice chairman of the board and director of Constellation Software Inc., director of Kelly Partners Group Holdings, founder and managing partner of Quality Shareholders Group and professor emeritus of corporate governance at George Washington University.

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