Key drivers of 'good' corporate governance and the appropriateness of UK policy responses : final report

The DTI’s Corporate Law and Governance strategy aims to promote and deliver an effective framework for corporate governance in the UK, giving confidence to investors, business, and other stakeholders to underpin the relationship between an organisation and those who hold future financial claims against that organisation. However, corporate governance involves various problems of asymmetric information and incomplete contracts that generate a need for public policy responses to mitigate market failures and ensuring that companies moves towards ‘good’ corporate governance. Since the early 1990s, the UK has been very active in undertaking policy reforms that includes a number of corporate governance codes, expert reports, a high level review of company law, and new regulations and legislation. These policy initiatives need to be monitored and evaluated in terms of their success in influencing the key drivers of ‘good’ corporate governance. This Report undertaken for the DTI has several aims: to identify key drivers of good corporate governance based on a review of social science literature; to describe the content of UK regulatory initiatives with regard to those drivers; and to evaluate gaps in the content and implementation of UK policy regarding corporate governance, using those drivers as benchmarks. In addition, some further implications of this study are discussed for future policy and research on UK corporate governance. The Report identifies key drivers of good corporate governance based on extensive review of the broad social science literature. Good corporate governance is defined here with regard to the rights and responsibilities of company stakeholders, and the wealth-creating and wealthprotecting functions of corporate governance within this context. Based on this definition, a detailed review of the theoretical and empirical social science literature on corporate governance was undertaken across seven broad areas: boards of directors, shareholder activism, information disclosure, auditing and internal controls, executive pay, the market for corporate control, and stakeholders. The result was the identification of 18 key ‘drivers’ or governance mechanisms, which promote ‘good’ corporate governance. An internet-based survey of international corporate governance experts was conducted in order to confirm and further specify these drivers in relation to the UK context. Next, key gaps in the UK regulatory framework are explored with reference to the drivers of good corporate governance. A comprehensive review was undertaken to evaluate corporate governance-related developments in UK regulation since 1990. Policy initiatives were analysed with regard to both their content and effectiveness in promoting each of the identified drivers. Several potential gaps in coverage were identified in the areas of executive pay and employees stakeholders. A number of potential gaps in effectiveness were also identified with regard to other key drivers such as boards, shareholder involvement, information disclosure, auditing, and the market for corporate control. The analysis was supported by feedback from a Focus Group of expert practitioners that took place at the DTI in January 2006. The Report also emphasises that the effectiveness of corporate governance regulation depends very much on balancing different governance demands and regulatory trade-offs. Corporate governance is shaped by a number of contingencies, complementarities, and costs. Various organisational contingencies may place different demands on corporate governance drivers, and their implementation is also associated with different sorts of costs. Looking more generally, different drivers may act as complements or substitutes for one another. Better appreciation of such interdependencies is crucial to formulating a coherent regulatory strategy and balancing important regulatory trade-offs between the following - mandatory regulation (uniform requirements) and more flexible forms of soft-law such as codes based on comply-or-explain principles and self-regulatory norms of professional groups. This analysis suggests a number of areas for future research. Bearing in mind the depth and breadth of the UK regulatory initiatives, it is important to verify whether they were followed by behavioural changes of the participants in corporate governance mechanisms, including unintended consequences such as the development of ‘gaming’ practices. Further research is needed on a potential ‘gatekeeper failure’ in situations where reliance on ‘reputational intermediaries’, such as auditors, securities analysts, attorneys, and other professionals, is not fully justified. Other research recommendations are related to wealth creation and performance trade-offs. It is important to go beyond the question of maximizing shareholder returns and consider to what extent different corporate governance configurations promote long-term, value-creating economic production in a fashion that benefits not only shareholders but also other groups that make specific investments in corporations. Finally, a more holistic approach to the effectiveness of corporate governance drivers requires further research on such aspects as stakeholder involvement, contingencies, complementarities, and cost aspects that may affect the effectiveness of corporate governance mechanisms. The authors would like to point out that, since the report was written, there have been various developments, not least changes in UK law, which have overtaken some of the details in our analysis. However, the basic review of the evidence basis and the perspectives offered remain very much current.