Corporate Governance Matters: A Closer Look at Organizational Choices and Their Consequences is a book by David Larcker and Brian Tayan. I found this excerpt interesting and worthy of discussion.
The first issue I have is with their definition of corporate governance. I find it too defensive:
We define corporate governance as the collection of control mechanisms that an organization adopts to prevent or dissuade potentially self-interested managers from engaging in activities detrimental to the welfare of shareholders and stakeholders. At a minimum, the monitoring system consists of a board of directors to oversee management and an external auditor to express an opinion on the reliability of financial statements. In most cases, however, governance systems are influenced by a much broader group of constituents, including owners of the firm, creditors, labor unions, customers, suppliers, investment analysts, the media, and regulators.
Surely, it is not just a monitoring system, designed to protect the shareholders and stakeholders from the evil management might inflict on their asset!
This is the OECD definition, which I prefer:
A set of relationships between a company's management, its board, its shareholders and other stakeholder. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined.
The Australian Stock Exchange has one I like as well:
The system by which companies are directed and managed. It influences how the objectives of the company are set and achieved, how risk is monitored and assessed, and how performance is optimized.
The summary of the HealthSouth Corp. fraud, where the CFO and other senior executives pleaded guilty to manipulating earnings, is a timely reminder. Note (a) that the audit committee only met once in 2001, and (b) the external auditor did consultancy work for which it received twice as much as the annual audit fee.
The book addresses whether there is a link between the quality of corporate governance and organizational performance. That is an interesting discussion and I have yet to see the correlation proven — sometimes the cowboys perform! Perhaps over the longer term, more responsible executives with oversight from an effective board will win out. But we have all seen high-performing companies that only showed the dirt beneath the surface when they failed — and that can take many years.
But even if you believe there is a link, how do you know whether a company's governance is effective or not? Can you trust the ratings from third parties? My belief is that these third parties only see the veneer of the company's governance processes. How can they know what is really going on? The book has confirmed my thinking with this statement about HealthSouth and the governance rating it received from RiskMetrics/ISS (acquired in 2010 by MSCI):
Before evidence of earnings manipulation was brought to light, the company had a RiskMetrics/ISS rating that placed it in the top 35 percent of Standard & Poor's 500 companies and the top 8 percent of its industry peers.
What do you think: of the book (or its summary) and the relationship between governance, ratings of governance, and performance?