On Business: Soft regulation, not rules

Hard law and jail are no substitutes for proper boardroom and shareholder monitoring of managers.

by Bruce Kogut, INSEAD

A wave of corporate governance reform has swept the world in recent years, strongly influenced by the US experience of trying to come to terms with its scandals and with the chronic problem of governance when shareholders are too many to be powerful. However, the reaction of many outside the US has been to recognise the need for better governance without accepting the American solutions.

Last spring at the Ecole de Paris, Daniel Lebegue, president of the French Institute of Directors, referred to the American system as relying on 'hard law' for the exercise of governance. Hard law consists of explicit rules, such as those in the Sarbanes-Oxley Act, which spell out in detail the requirements for governance and the penalties for failure to comply with them. European governance relies on 'principles' that establish professional norms over sanctions for rule violation.

Hard law works ultimately by the threat of prison. Over a year ago, Bernie Ebbers, CEO, and Scott Sullivan, CFO, of WorldCom were sentenced to 25 and five years of jail time respectively; Sullivan was given a lenient sentence in exchange for testifying against Ebbers.

These prison terms reflect the economics of law philosophy that influence the US sentencing guidelines. The reasoning is quite simple and appealing. White-collar crimes are difficult to detect and they can 'return' considerable profit to those who perpetrate them. As a result, the only way to deter such crimes is to penalise heavily those convicted. Thus, even if the probability of being caught is low, the penalties are daunting.

The interesting question is not whether this approach works, but why corporate governance in America appears to require law and jail as substitutes for boardroom and shareholder monitoring of managers. The traditional concept of governance was that shareholders should be the motivated party to govern. Since they are the residual claimants to net profits after everyone else is paid, they have the most interest in making sure there is a profit left to distribute.

Over 70 years ago, Adolf Berle and Gardiner Means' book, The Modern Corporation and Private Property (1932), challenged this concept, not on the basis of theory, but of fact. Most of the US corporations they examined had 'dispersed' shareholders who did not have enough information or incentive to monitor. Who then would monitor management?

The obvious candidate is the board of directors. Though boards are hardly inconsequential for good governance, they have not stopped recent scandals.

A few bad cases should not be used to condemn the whole system, but these cases are not minor examples. They involve fraudulent acts to conceal billion-dollar losses that resulted in the loss of jobs and wealth of hundreds of thousands of workers. If it takes billions to be lost in order to discover fraud, the unnerving suspicion is that there may well be many other smaller but significant acts that go unreported, uncorrected, unobserved.

As is often the case with free markets, innovative solutions to nasty problems can be expected. An appealing solution is the growing concentration of shares under the control of mutual funds. Perhaps they will be the new eyes on management. Jerry Davis and Han Kim, professors at the Ross School of Business at the University of Michigan, note that 30% of shares in American public firms are now controlled by mutual funds.

Following a new SEC ruling that funds report their votes, Davis and Kim were able to collect information on whether funds voted to improve shareholder voice in corporate governance. The results are not encouraging, especially for mutual funds whose companies also manage the pension funds of the companies in which they hold significant ownership positions.

Many good practices have been learned over the years: increasing the independence of directors, mandating a strong audit committee, improving transparency. But rules and laws are oddly not enough and yet often too much. What is required is the professionalisation of directors: careful selection, periodic training and a peer professional association.

Speaking from his experience as a director on many French boards, Lebegue advised his colleagues to avoid the excesses of governance by hard law.

The true hope of governance in the US is the independence of the external director. This role is not an easy one to fulfil and it requires taking minority positions on complicated questions. To be effective, a board operates not as a collection of individuals, but as an organisation that promotes a culture of governance. Getting along with other directors does not mean going along with bad ideas. Effectiveness requires being a collegial member while monitoring conflicts of interest.

We need soft regulations and soft institutions to create hard spines and to give independent directors the professional identities vital to fulfilling their obligations to shareholders.

Bruce Kogut is the Eli Lilly professor of innovation, business and society at INSEAD, and a member of non-profit boards

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