Thoughts on ... Corporate Governance

Current corporate governance regulations make little sense to me, particularly concerning the composition of the board of directors and the selection and remuneration of independent auditors. It appears to me that these two issues are the root causes of the corporate scandals such as at Enron and Worldcom that have bedevilled the capitalist system.

I fail to understand why it isn't mandatory for boards of public companies to consist of the nominees of the largest shareholders. A board should represent the views of a large and disparate group of shareholders in an efficient manner corresponding to the size of the holding of each shareholder, which would logically lead me to the conclusion that it should consist of the nominees of the subset of shareholders with the largest shareholdings. Shareholders would of course be free to waive this right if they so wished, in which case it would simply pass to the next largest shareholder. This appears so obvious to me that I cannot comprehend how the current situation, i.e. often an 'old-boys club' of directors and management at public companies, has arisen. This was clearly a major cause of the Enron scandal, where the directors failed to scrutinise the partnerships essentially because their stakes weren't sufficiently large for them to be motivated to do so and also they didn't want to 'rock the boat'.

Secondly, and perhaps more importantly, it amazes me that the blatant and inherent conflict of interest of independent auditors has been allowed to continue to this point, even after Enron and Worldcom. In theory, 'independent' auditors are engaged by public companies to provide an unbiased account of the company's financial condition. 'Independent' is defined as being 'free from the influence, guidance, or control of another or others; self-reliant; not dependent on or affiliated with a larger or controlling entity'. How can auditors possibly be described as independent when they are selected and directly remunerated by the companies they are auditing? Suppose you alone were to learn that a company in which you owned shares was in a similar position as Enron was immediately before it collapsed, would you as a shareholder be in favour of an unbiased account of the company's financial position being made public immediately? By contrast, would an individual considering purchasing shares in this company be in favour of this? It appears clear to me that it is potential shareholders whose interests align with the goal of a true independent audit, current shareholders focused on maximising the value of their investment are more concerned that an audit contains no unwelcome bad news. An obvious solution, at least to me, is that independent auditors would be remunerated by new shareholders as they purchase shares, probably in the form of a nominal charge on each trade. It is also important that public companies do not have the power to select their independent auditor, this could perhaps be done by the stock exchange or alternatively via a bidding process for each company.

In essence, my argument is that when many people are in positions of power and are exposed to temptation, human nature is such that a certain percentage will succumb regardless of the regulations. The traditional response to this is to pile law and regulation upon law and regulation, e.g. Sarbanes-Oxley, and yet it appears to be a constant source of astonishment when the problem inevitably recurs. It always amuses me when I hear commentators bleating about the lack of ethics prevalent among those in positions of influence in business, with the inevitable conclusion that ethics classes for MBA's is the way to resolve the problem. I am extremely confident that if Enron's management had each taken two years of nothing but Ethics classes during their MBA's, the collapse would still have occurred in exactly the same way. The only way to resolve such problems is to alter the system so that individuals are not exposed to temptation. As things stand, the next Enron or Worldcom is only a matter of time.