Allan McRae: Accountability far too important to be left to directors to decide

Photo / Bay of Plenty Times

Many people on Main Street consider that poor corporate governance on Wall Street played a major role in the financial crisis of 2008-09.

People have expressed outrage at the excessive power some American boards have exercised simply to better their own personal interests.

Even United States President Barack Obama has weighed into the debate, with his current focus on the American banks.

But as the President will know, the fundamental issue surrounding corporate governance has remained unresolved (and largely unaddressed) for more than two centuries now.

That issue, put simply, is how to actually achieve good corporate governance. How do shareholders: (a) hand over management control to a board; and (b) require that board to account to the shareholders for its performance?

The first part is easy. Unfortunately, the second often doesn't happen.

Back in the 18th century, Adam Smith, the architect of modern economics, was alert to the issue. He was highly critical of joint stock companies. Smith believed shareholder blocks did not exist to counteract the power of the directors.

Smith's concerns proved to be well founded. The idea of boards accounting for their actions got fudged as companies moved from being vehicles established under royal charter (and for public benefit) to associations of individuals with limited liability.

Later on, the company came to be recognised as being a person separate from its shareholders, but the corollary that its directors should be accountable to those shareholders has proved difficult to achieve.

This issue was first formally identified in more modern times in the 1930s with concerns being raised over the division between ownership and control in companies. Some now argue that there is no longer any significant division between ownership and control in New Zealand, and therefore no issue. But closing ownership and control does not solve the issue if owners do not demand accountability of their appointees.

Obviously mechanisms for board accountability exist in various forms; the main one being the duties developed by the courts that directors owe to the company, which ordinarily means the shareholders (as a whole).

Notwithstanding this development, there has been a tendency to leave boards to adopt the platonic role of deciding for themselves how they will account to shareholders. One therefore finds statements of corporate governance principles (prepared at the board's behest) prescribing how "the board should respond to the interests of stakeholders".

To be fair, corporate governance statements do contain detailed prescriptions of accountability, from the board's perspective. But such charitable benevolence does not constitute accountability. The question remains whether shareholders get involved in the formulation of governance principles, let alone use them to hold boards accountable.

Admittedly the Shareholders Association does a very good job, but its very existence is a continuing reminder of the issue.

For some, this issue doesn't really matter. For them, the market imposes any necessary accountability. Undoubtedly the market does impose its own accountability. But the financial crisis has clearly shown this to be an incomplete mechanism, particularly overseas.

The issue is also not helped by those who suggest that companies are not only accountable to shareholders, but to wider stakeholders. Boards may choose to account to wider stakeholders in order to better discharge their duties to shareholders. They should also do so in order to maximise the company's performance. But if there is to be any legal requirement to do so, then that should be a matter that sits outside of the core requirements of corporate governance.

Despite what is said here, there are some good examples of shareholder primacy in action: Infratil, Fonterra, Foodstuffs and Rank Group spring to mind.

Never mind that these represent an eclectic group of ownership/management models. Nor is it relevant that management may have struggled to put a persuasive case to shareholders (Fonterra), or that accountability takes the form of the left brain accounting to the right brain (Rank Group). What matters is substance, not form.

In each of the examples just mentioned it appears that directors are aware of their accountability to those who demand value for the skin they have in the game.

Obviously, shareholder primacy has its own risks. In some cases, shareholders wield their power excessively (wearing both the shareholder and director hats). But that is a separate issue, although it also has to be dealt with in terms of accountability, this time to minorities.

A lack of accountability does not mean that directors are necessarily doing a bad job. Many directors are obviously doing a very good job, but too often they do so subject only to the accountability they impose on themselves.

Leaving accountability as an optional extra for corporate governance is not really an option at all. Without improvement in this area more companies are likely to go private as shareholders question the value of separate management. But irrespective of whether their company is public or private, shareholders can only hope for value where they don't require accountability.

What are the chances of improved accountability? History tells us not to hold our breath. But if we really do want good corporate governance, improve it must.

Allan McRae is a partner at Minter Ellison Rudd Watts. The views expressed here are his own.