Why corporate governance reforms fail

The View from Taft


May 4, 2017

Last week, during the annual shareholders meeting of the San Francisco-based banking giant Wells Fargo, the board chairman, Stephen Sanger, apologized to shareholders. The company is still reeling from revelations that thousands of its employees opened close to two million fake banking accounts to meet overly aggressive sales targets set by management. The board had already fired several senior managers and has clawed back millions in compensation from two senior executives. The US Securities and Exchange Commission, among other agencies, is investigating the bank’s sales practices.

We’ve seen this scene in so many large companies before. A scandal breaks out. The investing public raises an uproar. Executives lose jobs or go to jail, and the company pays a fine. Government steps in to tighten regulations. New compliance enforcement positions are created. And the cycle goes on, until the next scandal.

With so many cycles of corporate governance reforms since the notorious Enron era of the early 2000s, we would expect to see less misconduct nowadays. But the reverse is true, with new scandals being more appalling than the previous ones (I mean, really? Fake bank accounts?), and often involving more prominent companies (think Volkswagen emissions). What’s going on here? Are regulatory reforms simply too little, too late? Or are the reforms actually making the corporate governance problem worse? I suspect that the second reason needs to be seriously considered.

Sustaining good corporate governance depends on building ethical corporate cultures. And ethical cultures depend on principled leaders who consistently communicate, demonstrate, and demand ethics. But the search for principled leaders and the building of cultures take time. Meanwhile, the short-term approach to promoting good corporate governance has been mainly through “carrots and sticks.”

The carrot is usually public recognition given by various organizations and media publications. These include the Philippine Stock Exchange’s Bell Awards, the ASEAN Corporate Governance Awards, and the Asian Excellence Awards given by Hong Kong-based publication Corporate Governance Asia. A key benefit gained by companies garnering such awards is, supposedly, an improved reputation with investors and other financiers. As a result, companies also expect that their share prices will improve and that they will have easier access to global funds.

But we should be careful to take such awards with a grain of salt. Businesses have always tried to project a good image to the public. Why should it be any different when it comes to corporate governance? In fact, with so much at stake, the bigger companies will have to earn such recognition, if only to appear at par with the rest. The question will always be whether the substance matches the public claims. Let’s not forget that Enron had a 64-page Code of Ethics.

What about the stick? This is usually a regulatory rule with a sanction for non-compliance. For what good is a regulation without teeth, right? Regulators, to be sure, can’t be blamed for tightening the screws on corporations after each wave of scandals. The public’s need for reassurance often combines with the tendency of politicians and government agencies to assert their mandates while gaining visibility points. And new and far-reaching corporate governance rules have come fast and furious after Enron and the global financial crisis. These rules cover required disclosures, qualifications of directors, independent directors, external auditors, compliance officers, corporate governance manuals, executive compensation, and risk management, among others.

These have resulted, however, in some companies’ viewing good governance as simply a compliance exercise or “check-the-box game.” The US Justice Department has voiced concerns that the corporate governance rules and the resulting compliance systems have encouraged companies to adhere to the letter but not to the spirit of the law.

The real problem with carrot-and-stick approaches is that they are merely external mechanisms to promoting good corporate governance. They do not tend to strengthen the ethical culture of companies. In fact, when used alone, external mechanisms weaken the moral judgment of corporate leaders and even undermine their ethical cultures. Board directors and executives learn to focus on appearance over substance by outsourcing their consciences to lawyers and accountants and their public communications to PR firms. Unfortunately, these service providers tend to view governance through the lenses of their own codes and practices, and not through principles of sound and ethical corporate management.

We need principled corporate directors and executives to build ethical corporate cultures in order to improve corporate governance practice. Without this, carrots and sticks produce morally stunted corporations that look good on paper and that can avoid punishments but actually sow the seeds of malpractice that produce tomorrow’s scandals.