Speeches

CORPORATE GOVERNANCE –
KEY TO SUSTAINABLE WEALTH CREATION

Dr Madhav Mehra
President, World Council for Corporate Governance

Seismic waves of corporate collapses continue to rip through the boardrooms across the world. Markets all over the world are sinking to their bottom. Dow Jones index has been below 8000, FTSE 100 is well bellow 4000 and Sensex hovering around 3000, their lowest levels since 9/11. The upper most question in everybody’s mind is how to bring back sanity into the markets. The general belief is the market collapse is because of the lack of investor confidence due to accounting frauds. One, however wonders whether these frauds would have been noticed had the markets continued to remain bullish as in 1990s. It is curious that accounting frauds and misgovernance always gets noticed when the market is on its downward trend. The fact is the corporations are in a muddle today not because of accounting frauds but the management failures. Accounting frauds were resorted to because of the poor business performance. The real reasons for the poor performance though are the shorttermism and an excessive focus on quarterly profits showing double digit growth.

The malaise in the governance of corporations is far deeper than what appears on the surface. Capitalism, it has now emerged, is far more deeply flawed than our analyses suggest. By feeding on ruthless competition and promoting a culture of winner takes all, capitalism has spawned virulent individualism which has grossly discounted the value system based on ethics. Corporates still use moral language but they do not believe it has any objective foundation. Like George Bush they tell other corporates “Do as I tell you, not as I do.” Naturally nobody listens.

With growing dominance of the markets and emphasis on immediate gain people’s behavior is guided almost exclusively by prudential and not moral consideration. They obey the rules, remain within the law, follow the norms, respect values only if they calculate that these will benefit them personally. They do not accept the validity of moral discipline if it runs counter to their personal objectives. In a policy driven by competitiveness and aimed to enhance the authority of markets, individual action has little to do with ethical behavior.

The centrality of corporate governance lies in its emphasis on transparency. It is far easy to say but most difficult to implement. You cannot obtain transparency if investors expect double digit profits in each quarter. In our rapidly changing economy variations are an integral part of business. So why are we defensive about shortfalls?. We practice the three types of truths we all know - first truth is what we tell others; the second truth is what we tell ourselves but do not tell others. The third truth is what we do not even tell ourselves. The malaise in corporate governance is so deep rooted that we do not even tell ourselves that it exists. This is why it has to make its presence felt every so often by market collapses causing pain and suffering to poor shareholders for no fault of theirs.

The problem of the American system is that it is skewed heavily in favour of shareholders. The practice of corporate governance was aimed to give the CEO unfettered authority to hire, fire and reward in the name of creating wealth for shareholders and to mitigate “principal – agent problem”. In practice most CEOs use this authority to reward themselves with huge pay hikes and vast bonuses by inflating earnings. This was largely an American disease. But of late European CEOs are also copying their US counter parts in this respect and awarding themselves hefty rises. Prudential shareholders had a hard job in preventing their boss to award himself bonuses worth £900,000. While CEO’s salary in US quadrupled in 1990s, the employees salaries only increased by 3%. Such actions take away employees confidence in management. Governance that says shareholders should get most benefits and does not care about employees who dedicate their lives for corporation is not governance but corporate greed.

In their book, “The Stakeholder Corporation” published in 1997, Wheeler and Silanpaa have asserted that “during most of the 20th century in the UK and USA, stakeholder inclusive enterprises fared better than “shareholders - first” companies. Stakeholder inclusive corporations invariably lead to better long term business performance”.

More and more people today, individuals and groups expect a business organization to adopt a triple bottomline approach, be economically viable while becoming, environmentally and socially responsible. They also expect the business to be inclusive and ethical. Kenichi Ohmae argued in The Borderless World: Power and Strategy in the interlinked Economy that: A corporation is a social institution whose responsibilities extend far beyond the well being of its equity owners to giving security and a good life to its employees, dealers, customers, vendors and subcontractors. Their whole life hinges on the well being of the corporations.

Peter Drucker, in his now classic The Concept of the Corporation, said over 50 years ago that what is needed in a redefining of the corporation as a social “institution “is an integration of the worker as a partner in the industrial system and as a citizen in society”. Yet most corporate governance definitions even today do not include employees as the beneficiary of the corporate rewards in the same way as shareholders.

If the capitalism is to survive, if it is to create wealth, it is absolutely essential that it adopts an inclusive approach to make it sustainable in the long haul. It must incorporate the social and environmental agenda, not as add-ons to a company’s economic activities but as an essential and integral, part of business strategy and its processes, to reflect the rapidly changing post-industrial economy.

It is important to define what is meant by corporate governance. There are many definitions of Corporate Governance. The classical view is that its main purpose is to define relationship between those who own the capital and those who control it. This is a narrow definition. The end purpose of Corporate Governance must be to maximize company’s value. Unfortunately for far too long this value has been determined only by the financial value. It has now been realized that the financial value depicts merely a small percentage of the total value. The value of human capital and natural capital is infinitely more than the value of financial capital. Admittedly there are problems in calculating the cost or value of human capital, cultural capital or natural capital. This by no means suggests we can ignore it. Specially now that we find that our progress is not being limited so much by the financial capital but the human and natural capital.

It has been estimated that the value of biological services flowing from natural capital is around $36 trillion annually. Capitalizing it on the basis of current return on capital gives a capitalized monetary value of world’s natural capital at about $500 trillion. Compared to this, the World’s gross product is only $39 trillions. Similarly the World Bank’s 1995 Wealth Index found the total value of human capital to be three times greater than all financial and manufactured capital reflected in global balance sheets. This is a conservative estimate as it counts only the market value of human employment, not uncompensated effort or cultural capital.

The true purpose of corporate governance is to maximize creation of company’s total value. The social and environmental issues, therefore, are equally important in any corporate governance debate. There is a need, therefore, for corporations to disclose their environmental & social performance.

Business has to take on the responsibility of upgrading the environment. Society will not gain if financial capital increases at the cost of natural capital. We have to create new production and distribution processes to reverse the loss of natural capital and eventually increase its supply. This will involve more than product design, more than marketing and competition. It will mean a fundamental redesign of business models, its roles and responsibilities.

We have to question how did we come to create an economic system which is so contrary to natures biological processes and is based primarily on extraction, depletion, waste and disposal. How did we create an economic system that confuses the capital liquidation with income? How is it that our pricing system tells us it is cheaper to destroy the earth than to conserve it? Is it normal to have an economic system that discounts the future and sells of the past? Wasting scarce natural resources to achieve immediate profits does not lead to value creation and wasting environment to achieve economic growth is neither economic nor growth.

Corporate governance framework has to be established on the simple proposition that all capital be valued. While it may be difficult to value a forest, a river, grassland or a mountain, it is wrong to give it no value at all. Ask how much will it cost to make a 700 year old tree or new atmosphere or a new culture? It is you who as professionals have to determine the methodology of replacement cost.

Today’s business faces multitude of challenges, increasing business pressure on all fronts, globalization, shorter product life cycles, internet, over capacity, complex regulations, currency volatility, value migration etc. Meeting these challenges will bring about economic discontinuities that are unprecedented in rate and scope, and would require highly innovative approaches. We have to leapfrog over existing technologies rather than incrementally improve them. Using Nicholas Negroponte’s expression for the times that we are living ”incrementalism is our worst enemy”. But innovation will bring tremendous resistance from vested interest. One only has to refer to Jim Utterback’s (An MIT Professor) case studies of pressures on electric companies brought by gas lighting companies in the 1880s, recorded in his book “Mastering the Dynamics of Innovation”. To understand how hard it is to resist change. This is the Board’s number one job in today’s economy which is driven by innovation.

The greatest challenge facing the accountancy profession today is the determination of the true costs. Market economy cannot function effectively without internalizing costs of each input. Environment is a key input in the creation of wealth. Shattering of a huge ice shelf Larsen B weighing 500 million billion tonnes in Antarctica a few days ago is a sharp reminder of the cost of industrial activity on environment. Counting what is not easily countable is the greatest challenge of your profession. For globalization to succeed prices must tell the economic truth. Socialism collapsed because it concealed the economic truth. Capitalism will collapse if it does not allow prices to tell the ecological and social truth. Pursuit of good corporate governance framework therefore, has to take care of a triple bottom line approach i.e. it must look after profits, people and planet.

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