Uses and Limits of Conventional Corporate Governance Instruments: Analysis and Guidance for Reform (Integrated version)

Abstract

[Note: This is the integrated version of a two-part article published by the Global Corporate Governance Forum of The World Bank Group. Part One, published in June 2009 (available at http://ssrn.com/abstract=1455166), examined the uses and limits of five conventional corporate governance instruments and suggested ways to improve their application. Part Two, published in August 2009 (available at http://ssrn.com/abstract=1455182), recommended how policymakers should approach corporate governance reform generally.]

The global financial crisis is forcing policymakers to again consider the most appropriate governance arrangements for publicly listed companies. As a way to contribute to the current debate on corporate governance reforms, this article examines the uses and limits of five commonly employed corporate governance instruments - transparency, independent monitoring by the board of directors, economic alignment, shareholder rights, and financial liability.

This article discusses how the individual instruments have worked in practice, including instances when they have failed to achieve their intended objectives and, in some cases, worsened the governance ailments that they were designed to cure. For example, the rapid growth of executive compensation persisted - and in some countries, accelerated - after the introduction of individual executive pay disclosure. In the financial sector, the shift toward a board dominated by independent directors ultimately proved to be its Achilles' heel as weak industry knowledge meant that non-executive directors were unable to pick up on warning signs of imprudent risk taking by management.

Following this analysis, suggestions are put forward on improving application of these instruments. Topics explored include 1) the extent to which the board of directors can be relied upon to monitor management, 2) how executive compensation arrangements can be restructured to better align management and shareholder interests, 3) under what circumstances would additional rights for shareholders - such as director nomination rights and an advisory vote on executive pay - be appropriate, and 4) the factors that should be considered when transplanting corporate governance practices across countries.

The article concludes with a discussion of how policymakers should approach corporate governance reform generally, in particular: 1) calibrate reforms to fit the surrounding context, particularly ownership structure and the broader business environment; 2) assess how an instrument will influence the behavior and focus of the affected parties; 3) be prepared to take difficult decisions because the inherent complexity of certain issues means that simple solutions, while tantalizing, are unlikely to work; 4) ensure coherence of tools employed with the legal, regulatory, and tax regimes; 5) employ “carrots” – such as fast track issuance of securities and corporate governance-based stock listing tiers – as well as “sticks,” and 6) focus on values and culture.

Keywords: corporate governance reform, transparency, board of directors, executive pay, shareholder rights, financial liability, conflicts of interest, unintended consequences, comparative

JEL Classification: G34, G38