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Three disciplines of good corporate governance
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LAST week I received an e-mail that made me realise it might be worthwhile explaining the limits of regulation in achieving good corporate governance, before going on to discuss the board’s six principal responsibilities.

Datuk Seri Panglima Andrew Sheng and Datuk Seri Zarinah Anwar, chairman of the Securities Commission, talk often about three disciplines needed for effective corporate governance.

They are self-discipline, market discipline and regulatory discipline, in that order.

Self-discipline comes first. Self-discipline is at the heart of good governance and it consists of personal integrity and good business judgment.

Without personal integrity there cannot be the right “Tone at the Top”. Without the right “Tone at the Top”, all business decisions run the risk of being undermined by personal gain at the expense of the company, or even society as a whole, as we have seen only too clearly in the current Wall Street disasters.

Good business judgment is essential. It is the only way a board can prevent itself from falling into the trap of following blindly, strategies proposed by academics and consultants, without understanding what the new activities could do to the overall risk profile of the company. As Warren Buffet might put it, “If you don’t understand it; don’t do it”, no matter how plausible the arguments.

Market discipline comes next. Market discipline is the result of two factors – the willingness to invest in the company, reflected in companies’ market capitalisation, and social sanctions for bad behaviour.

Research by McKinsey, PwC and others suggests that there is a considerable premium investors who are prepared to pay both for individual firms that are perceived to be well-governed and for markets where there is a good governance regime.

The market is good at disciplining companies found guilty of poor governance. Failures of strategy destroyed Marconi, Lehman Brothers and Bear Stearns. Even suspected failures of strategy in the case of Bank of America and Citigroup have driven their values down by 90% or more.

These huge penalties are the market disciplining companies and their boards for not understanding the risks involved.

The writing down of GM’s market capitalisation is the penalty for incompetence – another form of poor governance. Of course, when it comes to fraud, the decimation of market value is extremely rapid and expensive, witness Enron, WorldCom and Parmalat.

However, “Irrational exuberance,” to use Alan Greenspan’s phrase, suggests that the market is not so good at instilling discipline in a boom, when everybody gets on the dance floor, as Chuck Prince, ex-CEO of Citigroup, put it.

No one wants to be the party pooper; everybody wants in on the act, and so we find many emperors with no clothes getting away with it while all is going well. However, once the markets turn, companies are punished as Ponzi schemes, bad calls on risk and poor investments come to light.

So, from a financial perspective the market does its job of providing discipline well when things go wrong, even if it is late in reacting.

Where, sadly, the market is less good at providing discipline, is through its social sanctions.

White-collar crime is somehow seen as being less serious than blue-collar crime. There is an unfortunate tendency to lionise big white-collar criminals.

Nick Leeson has had a film made about him; he has made money from his writings and from commenting whenever there is a scandal. Michael Milken and Ivan Boesky have not been ostracised for what they did in the 1980s, even though Milken went to jail.

The CEOs of Wall Street have yet to pay socially for the terrible damage they have inflicted on countless thousands of peoples’ savings and pension plans. They are not judged in the same way as thieves who break in and steal property; and yet the harm they have done is many hundreds of times greater.

Regulatory discipline comes last. Regulation exists to reinforce self-discipline and to recognise the importance of integrity. It is there to help boards exercise sound business judgment.

Unfortunately, it is no substitute for either. Regulators cannot impose integrity or judgment. If the people at the top have no integrity or lack business judgment there is little regulators can do, except after the fact, by seeking to punish them through the application of rules and laws.

Regulation is critical, however, in reinforcing market discipline, promoting transparency, good practices and fair dealing. Good regulation can also prevent irrational excesses creating asset bubbles where fraud and incompetence can thrive.

It is designed to stop intermediaries cheating the public and protects the innocents from scams. It also penalises lack of transparency and malpractice, when it can be proved. Even here, regulators are often hampered by the fact that society seems to be more forgiving of white-collar than blue-collar crime.

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