Limits to governance; corporate reforms often have unintended

consequences

By Ed Waitzer and Marshall Cohen

One cumulative impact of governance failures (in both the private and public sector) has been a massive
loss of trust in leadership. Demand for more government (and consequential regulation) is re-emerging
although What this is to do is less clear. The continuing focus on the use of regulatory instruments to
curb executive compensation may be instructive and illustrative of a broader problem: unrealistic
expectations, both about corporate governance and, as importantly, efforts to effectively regulate it.

In recently announcing a new review into how to foster a long-term focus for corporate Britain, the U.K
Business Secretary noted that the remuneration of the FTSE 100 CEOs had risen on average 15% a year
between 1999 and 2008 while the FTSE 100 index had fallen 3% and average earnings growth had been
4%.

A universal regulatory response, including a recently announced initiative of the Canadian Securities
Administrators, is to require more disclosure on executive pay. Regulated disclosure of executive
compensation has consistently served to ratchet up pay levels. Few boards think their CEO shouldn't be
in the top quartile of compensation rankings. The problems are almost always elsewhere. In a recent
PWC survey of U.S. corporate directors, 83% thought their board's compensation committee was
effectively managing CEO compensation, while 58% thought boards, generally, were having trouble
controlling CEO compensation (and another 8% were unsure)

Likewise, the shift in compensation from salary to stock options was dramatically accelerated by changes
to U.S. tax laws designed to curb excessive employee remuneration. In hindaight, the flaws in this result-
encouraging excessive risk-taking and short-term focus-have become painfully obvious.a

While it may be counterintuitive, the rise of boards composed primarily of 'independent directors
-encouraged o mandated by regulation-may have also contributed to the explosion in executive
compensation. Typically, such directors have less intimate knowledge of a corporation's affairs and tend
to be more focused on their monitoring role. The resultant vacuum in widely theld corporations (ie
where there is no controlling shareholder) has tended to shift authority to the CEO (who generally
controls information flow). Directors often feel that they are hostage to their CEOs-replacing one is
disruptive and the costs are high.

A recent studý by three University of Southern California professors goes one step further, finding that
strongly independent directors (and powerful institutional shareholders) had a negative impactt on the
performance of a sample of 296 of the world's largest banks, brokerages and insurance companies (125
of them U.S-based and all with assets of more than US$ 10-billion) during the 2007-08 financial crisés.
Other efforts to strengthen boards directors with financial expertise, risk committees or the separation
of CEO and chair function-didn't appear to help.
Less surprisingly, another recent studý confirmed that as the proportion of 'independent' directors who
joined a board after the CEO assumed office increases, board monitoring decreases and CEO pay level
increases, as does firm risk.

Board independence and otherwise trying to regulated executive compensation are just two of many
examples where regulatory instruments dictating governance structures have often failed to achieve
intended results and have led to unintended consequences. Consider, for example the demand for audit
and credit-rating services, largely driven by regulatory requirements Aside from being a huge revenue
generator for the service providers, one obvious problem is the resultant lack of market discipline on
quality (and on conflicts of interest). Similar demand is now emerging for the regulation of proxy
advisory services as a regulatory-driven shift from director to more shareholder-centric governance
models increases the complexity of shareholder voting decisions.

This is not to suggest that regulation and resulting governance'structures are unimportant. It is striking
however, how public distrust in corporate governance continues to escalate in the face of enormous
investments made to better regulate through mandated structures and processes: Not surprisingly many
directors feel frustrated and increasingly less certain as to their role and how they might make a
difference

One diifficulty with trying to regulate conduct based on the assumption that actors are purely self-
interested is that precisely such behaviour will be reinforced. Building layers

the hope of channelling behaviour often serves to frustrateor governance mechanisms in the hope of
channeling behavior often serves to frustared meaningful stewardship on the part of corporate directors
and management. Regulation of compensation, independence or other structural requirements will
never.be the answer, in isolation.

It has become almost a matter-of conventional wisdom to observe that the lesson to be learned from the
collapse of our 'efficient financial markets paradigm is the need to focus on long-term, sustäinable value
creation Simplistic notions of short-term market performance and regulatory imposed better behaviour
will not work What remains elusive is the prescription to accomplish this end.

Perhaps we must look deeper into the DNA of the corpörate model to underistand and affirm it is role in
creating long termi value for individuals, firms sharehólders and communites. For example we need to
understand better the role of culture, character and reputation-on management , on the board, on the
institutional owner community-in defening and implementing a meaningful sense of 'ownership' and
responsibility Perhaps we have to challenge the structural paradigmitself, if we are to achieve
meaningful and permanent change.

Asking deeper questions must come first. Doing so is essential if we are to find effective answers and
thereby restore public trust.
Question:

1. This article discusses the increased use of regulation in corporate goyernance issues arguing that this
may produce 'unintended consequences' . Can you identify any unintended consequences that could
occur?

2.The focus of reforms on the need for sufficient independent directors is discussed in this article. What
is the underlying rationale for inclusion of independent directors? should independence override
concerns of competence and expertise?