Growing market and regulatory complexity is placing the current governance model under increasing strain, a trend that is likely to heighten in the next decade. Tony Featherstone reports.
Another financial crisis rocks the world within three years. Rising US interest rates spark a capital exodus from emerging markets, driving larger developing nations into debt default. Asset bubbles, inflated by central-bank money printing, start to pop.
Under this scenario, commodity prices hit 20-year lows. Australia’s terms of trade decline further, the budget deficit balloons and recession strikes. House prices tumble and bank solvency, even after higher capital requirements, is questioned.
Australia, like other developed countries, responds to the crisis with new regulations that take effect in the next decade; regulations that lift the compliance bar so high that they challenge traditional governance models and the nature of the listed public corporation.
This gloomy scenario is, of course, only one of several possible outcomes. But the central tenet of governments responding to financial crises with extra regulation – and how that will affect boards – is exercising the minds of the world’s great governance thinkers.
“Governance will move towards a much more regulated environment over the next decade,” says Philip Armstrong, director of governance at Gavi in Switzerland. “Financial crises will continue to be seen as much a political as an economic issue and governments will need to be seen to respond with tougher laws. The big challenge for boards over the next 10 to 15 years is that governance will be seen as a parallel form of regulation.”
Armstrong says directorships could become less attractive if governments regulate too far. “The challenge will be: how do you encourage experienced directors to take on an increasingly cumbersome role that has as much to do with compliance and conformance as it is about making decisions that help build the enterprise’s value over time?”
Dr Roger Barker, director of corporate governance at the Institute of Directors (UK), says there is a risk that boards will be seen as quasi-regulators of corporations in coming years. “There is a real danger that governments push boards towards much more of a mandated, supervisory role for corporations. That would not be a very constructive or value-enhancing role for boards. Directors have a lot more to offer than focusing mostly on compliance.”
Dr Barker adds: “My hope is that we are approaching a new phase in corporate governance after the GFC that is less about taking a defensive approach and more about thinking how boards, shareholders and other stakeholders can work together to have a positive impact on the organisation and create sustainable value; a future where asset managers are much more engaged in governance and long-term value creation. But the trend is heading towards boards becoming quasi corporate policemen.”
Australian boards have long bemoaned the costs of excessive compliance. Red tape and regulation consistently rank among the top impediments to productivity growth in the Australian Institute of Company Directors’ (AICD) Director Sentiment Index. Directors want to spend their time on strategic governance – helping shape and guide organisation strategy – not “box ticking”.
Governance experts believe this is unlikely if governments continue to respond to crises with regulation. “We are at a point where we risk making boards sterile because of too much regulation,” Armstrong says. “Inevitably, boards will find themselves having to focus on compliance at the expense of strategy. The notion of corporate governance will take on new meaning and different models of governance could evolve in the coming decade, particularly as we see the emergence of so-called emerging market economies into the mainstream global economy.”
The global view
Company Director, with support from the AICD Governance Leadership Centre, spoke to experts in London, Switzerland, Canada and Australia on the future of governance. The goal: to understand the forces shaping governance for listed entities and how the traditional governance model might evolve by 2025.
Analysis of global governance trends is, by its nature, problematic because of different jurisdictions and laws. Moreover, the timetable for governance change is never quick or certain: significant reform takes years and is hard won. The most plausible scenario is the current governance trajectory continuing, and boards responding to a regulatory bar that lifts each year with greater focus on compliance.
But the confluence of several powerful forces in the coming decade could quicken governance change, spark debate on whether new governance models are needed, and lead to the privatisation of some companies because the costs of being listed on an exchange – and being subject to greater reporting and compliance requirements – outweigh the benefits.
Higher compliance could take different forms. Armstrong believes the comply/explain governance model for listed entities in more advanced markets is under threat. The model, known as the “if not, why not” principle in Australia, is the central tenet in the ASX Corporate Governance Council’s Principles and Recommendations. This mechanism provides important flexibility by allowing companies not to adopt a governance recommendation in the principles, provided they tell investors why. It is particularly useful for small companies that do not have the resources to comply with a governance framework designed for larger entities.
Armstrong says there has been a drift in the UK Corporate Governance Code towards a mandatory, rather than comply/explain lens. “More countries will treat their comply/explain governance model as a regulatory instrument over the coming decade, rather than leaving it up to companies to choose which governance requirements they comply with. In most markets I am familiar with, regulators tend to be confused by the comply/explain model and are uneasy with the concept of a governance code being enforced by the market, and leaving it up to companies to decide whether they comply fully or not.”
Rob Elliott FAICD, former executive director of the Governance Leadership Centre, also expects more governance requirements to become mandatory in the next 10 to 15 years. “You see this recurring trend of new governance rules being softer and voluntary at the start, then tightening up to where it becomes the norm, and then made mandatory,” he says. “The regulatory bar keeps being lifted, even though larger companies have greater capacity for self-compliance and less need for enforced, restrictive rules that add to reporting costs.”
Elliott says increasing red tape and an emphasis on conformance over performance could make boards too risk-averse in the coming decade. “Companies are having to develop their own internal red-tape procedures to deal with the regulatory environment. At a time when companies need to be more nimble, flexible and innovative than ever, to deal with the threat of technology disruption to their industry, we are tying them, and their boards, up in compliance.”
Changing social expectations about organisations will further add to the reporting burden over the coming decade, Elliott says. “The rise of environmental, social and governance (ESG) considerations and the global push towards integrated financial reporting (where organisations provide non-financial information) means companies are producing more information and have greater incentive to be risk-averse.”
Activism to redefine governance
As the compliance obligations rise, shareholder activism is emerging as another driving force for governance change. Overseas, what started as a niche investment field has almost become an asset class in its own right; giant mutual and exchange-traded funds back activist hedge funds that seek to exploit value in listed companies which are not unlocking enough shareholder value, by aggressively calling for change.
David Beatty, Conway director of the Clarkson Centre for Business Ethics and Board Effectiveness at the University of Toronto, says shareholder activism will transform governance over the next few years. “Every Fortune 500 company in the US now has at least one activist fund running the ruler over it, to assess if its assets are being underutilised.”
Professor Beatty says more than US$300 billion is invested directly in US activist funds. “We are now seeing asset managers who traditionally had a passive approach to shareholder activism, and exchange-traded funds, piling in behind activist funds. There is literally trillions of dollars being earmarked for these funds, and ‘wolf packs’ are being formed as investors join forces to hunt companies they believe are not creating enough shareholder value.”
The rise of shareholder activism could be a cyclical response to a low-growth environment: institutional investors striving to lift returns by forcing rapid change on listed companies. It could also be a structural trend as shareholders demand greater say on corporate strategy, believing boards are unable or unwilling to oversee strategic change fast enough.
Beatty says shareholder activism is also forcing executive teams and boards to rethink how they create, shape and communicate strategy to the market. “Traditionally, 99.9 per cent of strategy has been driven by management. The executive team and boards, in coming years, will have to seek greater input on strategy from shareholders. Strategy-planning sessions will need to become more externally focused. The discipline coming from the market on governance and strategy will be unprecedented.”
Executive teams and boards will spend more time communicating with shareholders, Beatty says. “Chairmen will have to play a bigger role in an organisation’s investor relations. Directors, too, will have to have more meetings with shareholders as investor relations becomes a key part of the board’s role.”
Beatty says shareholder activism and greater regulation could make it harder for boards to govern through the coming digital tsunami as traditional business models are destroyed and new ones created. “How does a board of directors deal with the fact that the world is transforming at a pace that we never imagined? How can boards be nimble enough to respond to the biggest single threat to their organisation: the digitisation of business models and the transformative effect of technology generally?”
As business experiences a step-change in machine-to-machine learning, automation and artificial intelligence over this decade and next, boards will have to reassess their ability to shape technology-driven strategy and oversee risks like never before.
Some governance experts believe the pace of technological change, and rising workloads and responsibilities, will lead to non-executive directors having more of an executive-like role in the coming decade, and acting as an extension of management. Others believe directors will rapidly upgrade their tech skills, that board renewal will quicken to allow for younger tech-savvy directors to be appointed, and that directors will spend more time studying overseas technology firms and sourcing information from tech experts, independent of management.
Less considered is whether technological change will start to overwhelm governance models by 2025. Having six to 10 non-executive directors, most of them not having deep technology experience, governing increasingly large and complex global organisations on a part-time basis, may prove inadequate.
Beatty believes digital disruption and the complexities of being listed on an exchange will encourage more companies to issue dual-class shares, where shareholders have different voting rights. Typically, the founders of entrepreneurial ventures issue different classes of shares to ensure they keep control of the organisation, spend less time on market communication, and run the listed company more akin to a private enterprise.
“The governance orthodoxy over at least the past 20 years has been one share, one vote,” Beatty says. “But very few companies these days, especially those in the tech sector, are coming to market without dual-class shares. Founders want to spend their time working on creating and implementing explosive growth strategies, not answering the same question over and over again from a 26-year-old analyst on Wall Street. They want control.”
Beatty says the rise of dual-class shares has important implications for boards. “Many directors over the coming decade will have to deal with a controlling shareholder in the boardroom. That shareholder will invite them to the join the board and expect a different type of governance that is much more hands-on and focused on value creation rather than compliance. That is the way most listed companies in Asia and a higher percentage in Europe are being run. The whole notion of independent governance could be challenged.”
Decline of listed corporations?
Professor Ian Ramsay, of the Melbourne Law School, says rising compliance costs and activist funds could challenge the future of the listed public corporation. “There is a debate to be had about whether the traditional model of the listed public corporation has peaked. In the coming decade, more boards will question whether the compliance costs of being listed, and the market pressures that come with it, have become too onerous and are impeding the ability of boards to govern. A key advantage of being listed – access to capital – is being diluted as alternative capital sources emerge for entrepreneurs with bright ideas.”
Ramsay expects the listed public corporation model to endure, but believes more companies will consider delisting from exchanges and privatising over the next 10 years. “There will come a point where some companies feel that being listed, in terms of rising reporting and governance requirements, has become excessively costly and unwieldy, and detrimental to long-term value creation for shareholders,” he says.
Heightened corporate mobility and the search for countries with favourable tax and governance regimes will be another key board issue by 2025, Ramsay says. “For example, shareholders might encourage a New York-based public corporation to reincorporate in, say, Singapore. I expect more corporations will reincorporate in different jurisdictions and be less wedded to their home country in coming years. For boards, that means being able to adapt to different governance regimes and legal frameworks, and having a global governance approach.”
This trend is well underway, a fact not lost on tax authorities. China will be home to more large companies (revenue of at least US$1 billion) than the US or Europe by 2025, and nearly half the world’s largest companies will be headquartered in emerging markets, predict the authors of No Ordinary Disruption.
Ramsay says countries will increasingly compete on governance: those with flexible regimes that support innovation and entrepreneurship will have a significant competitive advantage as corporations become more mobile and virtual. “An emerging issue is the linkage between tax and governance. If the dollars are right, companies will relocate to a new market to minimise tax. The country’s governance regime will also have a bigger say on where organisations move.”
Public corporations, Ramsay says, will look for governance frameworks that best suit the organisation and its shareholders, and provide sufficient investor protection. “It’s possible that a country’s governance and corporate law framework could be designed to appeal to certain types of companies or industries: Delaware’s success in attracting the incorporation of tech companies, for example, is in part because of its judicial expertise and efficiency in resolving complex disputes. Singapore’s judiciary and its ability to resolve disputes efficiently is attractive for corporations that want to be based in an international hub between the east and west.”
Australia’s governance regime and the reputation of its regulators compares favourably with other countries, Ramsay says, although an exception is the Corporations Act. “There is a real sense that parts of our corporate law have become too complex, as parliament keeps adding to the Corporations Act. I doubt many overseas companies would find the act an appealing piece of legislation.”
Ramsay says governments must consider the limitations of corporate law. “Rather than try to regulate everything that moves after a crisis, governments need to think about the right system of regulation that encourages companies to implement best practices. As business complexity increases, we need realistic expectations of what Parliament and regulators can achieve in governance. Shareholders, too, need a realistic understanding of the role of boards in this environment and what they can achieve over the coming decade.”
Ramsay adds: “There’s no doubt the current governance model is under increasing stress and strain as companies deal with growing market and regulatory complexity. Exceptional pressure is being applied to boards to ensure the organisation makes value-enhancing decisions while complying with a maze of regulation. That is likely to continue in the coming decade, but there is only so much boards can do.”