Corporate governance

It used to be that executives were able to
have a big impact on who sat on their
boards: They were the same people who were ostensibly monitoring and controlling
the executives on behalf of the shareholders. The importance of corporate governance grew as executives found themselves
with more and more power.

“I define corporate governance as the
roles, responsibilities and balance of power
among corporate executives, directors and
shareholders,” says Lori Verstegen Ryan,
associate professor of management and
director of the Corporate Governance
Institute at San Diego State University. “The
basic idea is that over the last 100 years or
so in the U.S. these three groups have balanced power among themselves, with executives having the most power in the 20th
century because of shareholders’ very diffused holdings.”

Smart Business talked with Ryan about
the effect corporate governance has had on
the business world.

When did the power start to shift toward the
investors?

Investors got clever in the 1980s and 1990s
and pulled their money out of individual
stocks and put it into diversified equity
funds, which meant that the fund managers
then controlled huge blocks of stocks that
the executives couldn’t ignore. Since that
time, the Securities and Exchange Commission has listened to these institutional
investors and rolled back some of the
restrictions that had kept shareholders from
intervening with their portfolio firms. Now
investors are a force to be reckoned with.

What is the effect of hedge funds on today’s
corporations?

Hedge funds don’t face the same legal
restrictions that institutional investors, like
mutual funds, do when considering intervening with a portfolio firm. They can buy
large blocks of a firm’s shares, often augmenting their power with large blocks of
‘rented’ votes in addition to the votes
attached to the shares they own. Hedge
funds also often work in concert, giving them even more leverage. They can move in
and make drastic changes in management
or the strategic direction of a firm and earn
large, quick returns.

Are hedge funds and private equity here to
stay?

These funds have enormous flexibility in
their investments. Right now, due to
Sarbanes-Oxley and public suspicion, publicly traded companies face a lot of bureaucratic overhead that privately funded firms
do not. Both hedge funds and private equity
are likely to focus on corporate equity as
long as they believe that they can make fast,
high returns. As soon as the lucrative corporate targets dwindle, these funds are likely
to leave the equity market and focus their
attention on another investment sector,
such as real estate.

Why is CEO pay such a hot topic with
investors?

Shareholders are very unhappy with the
current level of CEO compensation because
it is often disassociated from firm performance. They may see their share price going
down while the CEO receives a huge compensation or even exit package. But the packages are generally negotiated upfront,
before the firm has a chance to see what the
executive will be able to do in that particular corporate context. It will always be difficult for a board to determine in advance the
appropriate level of compensation for any
given CEO, so the key is to ensure that the
board uses proper processes and safeguards to determine future compensation.

What do you foresee as the biggest challenges ahead in corporate governance?

The biggest danger right now is that
investors could cause harm by micro-managing the firms whose stock they hold.
Shareholders are not generally experts in
running large corporations. We’ve already
seen a flight to private equity, including top-level executives who have taken positions
leading private firms, with astronomical
compensation packages and very few of the
distractions that face the CEOs of publicly
traded firms. Activist investors should not
push so hard that they encourage the best
talent to flee public corporations or the best
companies to flee the publicly traded
market.

What about developments on the global
level?

Most countries’ corporate governance systems fall into a handful of general categories, based on their common histories and
cultures. However, South Africa is developing a distinctive approach that blends its
British history with postapartheid social
consciousness. It could evolve into a new
model of corporate governance that has an
impact throughout Africa.

And in 2001, Brazil opened the Novo
Mercado, a very successful sector of its
stock exchange that requires listed firms to
have a strong model of corporate governance that is very different from Brazil’s prevailing model, where controlling shareholders are able to take advantage of powerless
minority holders.

LORI VERSTEGEN RYAN is associate professor of management and director of the Corporate Governance Institute at San
Diego State University. Reach her at [email protected].