Corporate governance and corporate finance

OECD work on corporate governance


by Angel Gurría, OECD Secretary-General
7 July 2006
Washington DC

I am pleased and honoured to address this annual conference of the International Corporate Governance Network (ICGN).

Corporate governance is a core responsibility of the OECD, and over the years we have benefited greatly from co-operation with the ICGN and its distinguished membership. I look forward to continuing and deepening this partnership. And what better way to start than this session where we will discuss some key future challenges in corporate governance.

In a dynamic field like corporate governance, the list of future challenges and opportunities can be very long indeed. And the list would vary, depending on whom you talk to. Today I will focus on three areas that I know arouse interest and that the OECD will be addressing in its future work.  These are: the role of institutional investors, the quality of the regulatory framework, and the need to improve corporate governance in state-owned enterprises.

But before I turn to these specific issues, I would like to reflect on why tomorrow’s corporate governance challenges are so important – including for public policy.  

Certainly, a major reason why the OECD is concerned with improving corporate governance is because of its link to increased investment and economic growth.  Countries that wish to reap the benefits of global capital markets, and companies that want to attract patient, long-term capital, must foster good corporate governance practices that are well understood by investors and aligned with international expectations and principles.

It is not only because companies drive economic growth that their governance is important.  Today, as governments step back, private companies have an increasing role in providing many basic services – such as electricity, water, transportation or communications – that affect the well-being of all citizens.  And, as we move to help conquer terrible problems of poverty, environment and social inequality in poor countries, the private sector will be a precious partner.  Private sector governance is therefore a matter of public policy.

Corporate governance is also in the public mind because private companies are playing a growing role in securing our retirement income.  In many countries governments are no longer the sole, or even main, provider of pension income.  Individual savings are becoming more important.  And funded pension systems are based more and more on defined contributions rather than on defined benefits.  These pension plans often hold as much as 30-40 percent of their assets in the form of equity. So that households and retirees are directly dependent on the performance of the private sector.  When Enron collapsed, pension plans lost in excess of 2 billon dollars:  an extreme example, but it opened our eyes to the critical role of corporate governance.

Ultimately, corporate scandals jeopardise not only jobs and retirement incomes, but also the credibility and public legitimacy of corporations and even of the market economy.  As governments work to improve their own economies – and the global economy – through market-oriented reform, such as privatisation and liberalisation of markets, they must also pursue an unambiguous commitment to good corporate governance.

The ones who actually exercise corporate governance are you, the shareholders.  You are the guardians of the good practices on which a well functioning private sector depend. At least in theory, the shareholders have the power to make key corporate decisions, and they also have the right incentives to monitor, evaluate and discipline corporate behaviour.  They are supposed to use their rights to make sure that managers and corporate boards not only stay on the straight and narrow, but create value. 

But after the judges have sent the chief executives to prison and the incompetent boards are dismissed, we must ask ourselves:  where were the shareholders?  Why didn’t they react earlier?   And for public policy, we need to ask whether we should do more to improve the role of shareholders in corporate governance. 

Of particular interest is the role of the institutional - or intermediary – investors who represent a large and growing share of stock ownership in most countries.  According to John Bogle, the founder of Vanguard, in 1950 direct individual owners held 92 percent of all US stocks.  Today they own only 32 percent, while institutions hold 68 percent.   The size and rapid growth of institutional investors undoubtedly makes their role in corporate governance one of the most important issues for the future.

Institutional owners of today have different portfolio strategies.  They have different incentives, and they have to comply with different legal frameworks.  They may also experience inherent conflicts of interest when they try to live up to the demands of their ultimate beneficiaries, their formal owners, and the companies in which they invest.  

Some of the main changes in the 2004 revision of the OECD Principles were related to the role of institutional investors:

  • The Principles recommend that institutional investors that are acting as fiduciaries should disclose their own corporate governance and voting policies, including their procedures for deciding on the use of their voting rights. 
  • If institutional investors claim to have an active corporate governance policy, they should set aside the necessary human and financial resources, so they can carry out this policy in a way that their beneficiaries and portfolio companies would expect. 
  • The Principles also state that institutional investors that act in a fiduciary capacity should disclose how they manage conflicts of interest that may influence how they exercise their ownership rights. For example how they vote their shares at the annual meeting.

These OECD Principles are ambitious and I am glad to see they are already starting to have an impact.  A very good sign is that the ICGN Shareholder Responsibilities Committee is now developing a code of best practice for the internal governance of investors.   This is a good example of a private sector initiative that will contribute to the integrity and professionalism of our financial markets.  Principles are necessarily general.  But I am pleased to note that the code will explicitly deal with the issue of conflicts of interest – a difficult issue.  But guidance will go a long way in advancing the role of institutional investors in corporate governance. 

Another important consideration is that institutional investors come in many different shapes and forms. They include large public pension funds, insurance companies, hedge funds and specialised private equity partnerships.  This diversity in terms of ownership, governance philosophies and investment strategies is important for a well functioning equity market.  This is extremely important to keep in mind when we contemplate reforms and possible changes in the regulatory framework.  Different institutions may have different needs, comparative advantages and duties.

An important question for the future is therefore how different categories of shareholders can co-exist and co-operate. How can they complement each other and benefit from each other’s relative strengths and competencies in corporate governance?  The fact that many pension funds make indirect investments through hedge funds and private equity partnerships could be seen as a first step towards much more elaborated strategies where different kinds of shareholders “join forces” to improve their combined contribution to corporate governance.  We may even be able to learn good practices from the large direct owners or family firms that still exist in many countries. 

Understanding the strengths of different kinds of owners, would also provide insights concerning the quality of the legal and regulatory framework - the second area I wish to discuss.  Many regulatory initiatives have been taken in recent years and the time is probably ripe to reflect upon their impact.

To understand regulatory impact we first need to look at the overall regulatory architecture and how different approaches to corporate governance, such as hard law, self-regulation and voluntary undertakings, can complement each other.  Why and under what circumstances should we prefer one approach over another? 

Parallel initiatives to improve corporate governance can confuse market participants.  For example, investors and companies are entitled to know about the status and enforcement of the various governance codes and guidelines. The revised OECD Principles state clearly that when codes are the national corporate governance standard or when they substitute for legal and regulatory provisions, the status of these codes - in terms of coverage, implementation, compliance and sanctions - must be clearly specified.

Beyond, or inside, the regulatory architecture is of course the issue of regulatory quality. Here, the question is not the best quantity or even the type of regulation. The challenge is to make sure that we have good regulation.  That means regulation that provides investors and corporations with the tools they need to develop dynamic and competitive enterprises that deserve to earn the confidence of financial markets.  As in any other field, we need to make sure that corporate governance regulations are cost-effective, that they can be implemented, and that they have the intended impact.

Controversial issues such as share lending, one-share one-vote, takeover barriers, board elections, conflicts of interest and the protection of minority shareholders should all be discussed within such a framework.  Has the problem been formulated correctly?  Is the issue suitable for mandatory rules or is the problem better solved through private contracting?  Have we thought about possible unintended consequences?

By developing our ability to make such assessments, we will get more effective rules and we will avoid unintended consequences and rules that impede rather than enhance sound financial markets and good business practices.

But corporate governance is a complex area.  It covers several legal domains and numerous economic relationships. The techniques for assessing the quality and impact of regulation are fairly advanced in other policy-areas.  But we are just beginning in the field of corporate governance. One obvious reason is the lack of experience. Compared with labor market or environment policy, corporate governance is still a young and rapidly evolving policy field.  More analysis and applied research is necessary.  The OECD will spearhead some of this work.  And we will host a global exchange of experience with different approaches to implementation and impact assessment. By pooling and disseminating this knowledge we will be able to offer a valuable tool to governments, regulators and anyone else with the ambition to design intelligent regulation.

In addition to their role as standard setters, most governments also have more immediate corporate governance responsibilities as owners of state enterprises, which is the third challenge I want to discuss.  In many countries, governments still own a substantial amount of commercial enterprises.  How well these companies are governed will have an important impact on public finance.  Furthermore, state-owned enterprises often provide infrastructure and basic commodities, such as water and electricity, that are of immediate importance to the public.

In India for example, the 242 companies controlled by the federal government contribute almost 25 percent of GDP.  And in many countries in Africa, state owned companies dominate economic life.   To me it is obvious that better corporate governance of state-owned enterprises must be part of any forward looking development agenda.

State-owned enterprises also play a role in the stock markets. In Asia, for example, they represent more than 30 percent of market capitalisation.  The quality of corporate governance in these companies is a concern for a large number of institutional investors that participate as minority shareholders.  This is of course also the case in Europe where some of the largest listed companies have a substantial portion of state ownership, or even state control.

Because state-owned companies are so important, governments are seeking strategies to improve their performance. Pressure to move forward comes from the general public which demands better services at a lower cost, from taxpayers who want better value for public finances, and from the private sector that wants a level playing field in competition with public sector companies.

It was against this background that in 2005 OECD countries agreed on Guidelines for Corporate Governance of State Owned Enterprises. These Guidelines complement the general OECD Principles and are primarily directed to governments in their role as owners.  We have received an overwhelmingly positive response to the Guidelines and they have rapidly developed into a global benchmark for both governments and investors. In the years ahead, OECD will foster their implementation by developing and disseminating supporting material based on real world experiences in reforming the corporate governance of state-owned enterprises.

In this work we will also seek partnerships with the private sector.  I am therefore happy that Ira Millstein and others at the Yale Center for Corporate Governance and Performance have agreed to take the OECD Boardroom Guide to China to discuss boardroom practices with government officials and board members in prominent state owned companies. I have no doubt that it will be a refreshing encounter, and that Ira’s experience trying to fix the governance of some 600 publicly owned entities in New York State will come in handy.  There may be more similarities than you would expect.

As I said, these are only 3 examples of challenges that we have ahead of us. And I know that more issues can be added.

But the most important challenge of all is that we have to deal with these issues in a world where the very nature the corporation and the character of capital markets themselves are undergoing fundamental changes.

These changes will affect how money is channeled from investors to corporations. And as a result it will automatically affect corporate governance practices. The developments are not unique to any country or region. They result from trends that direct capital all over the world.

In the corporate sector, fast growing and highly successful firms have very little in common with the traditional image of a smokestack blue-chip company. They often have a different asset base. They are more human capital intensive and highly dependent on intangible assets such as brand names, patents, strategic agreements and organizational know-how. What do these firms need from investors?

In the capital market we all know the long term trends towards institutional ownership. And the challenges that follow with that have been discussed at length during this meeting. But we are also experiencing a rapid development when it comes to new types of owners, such as hedge funds, private equity firms and even wealthy individuals. Importantly – how will boards and managers respond to this growing multitude of capital sources with possibly different goals?

I don’t claim to have the answers. But just as the OECD helped to establish the present agenda in corporate governance I am happy to invite both the corporate sector and the investment community to discuss tomorrow’s challenges.

As Ira said in his opening speech on Wednesday: “The effort requires the whole community – shareholders, management, boards and the public.  And the culmination will be indeed, the aggregate welfare we all seek.”

At the OECD, dialogue with stakeholders is an integral part of taking our corporate governance work forward.  As we look towards the future, we see a stimulating, challenging and sometimes problematic agenda. It will not be all smooth sailing. So, we should gather all good forces in order to make progress.  Improving corporate governance is a shared responsibility. And in that undertaking it is good to know that we have the support of the ICGN and its membership.


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