Amidst the controversy over former New York Stock Exchange Chairman Dick Grasso’s compensation package, the debate over corporate governance has once more returned to the front page. The sum involved, US$180 million, is hard to comprehend, and my initial reac- tion was much like everyone else’s: the news report must have put the decimal point in the wrong place.

Then, on the next page of the same paper, there was the Breedon report on WorldCom/MCI with breathtaking ”œremuneration” payments to former executives in excess of $400 million. And even in Europe, which for a long time thought that it was exempt from managerial excess, the headlines in the UK, France, Germany and the Netherlands all attest to the fact that executive compensation has become the lightning rod for public frustration over weak economic growth and, most important of all, the steep correction of share prices from their highpoint during the bubble.

To make the situation even worse, investigations into Wall Street practices have also made it clear that at best unethical behaviour, and at worst illegal actions, extended to lower levels in the mutual funds industry and financial inter- mediaries more generally. It would not seem far-fetched to believe that the practices extend beyond the US, and, indeed, there is disquiet in Europe. It is hardly surprising therefore that public sentiment about the status of business leaders has fallen precipitously, and pressure on governments to take measures has not diminished following the first wave of scandals and reactions associated with, inter alia, Enron.

Headlines are, however, not always a reliable guide to what policy makers should be doing and considering as options. For illegal behaviour the answer is at hand, although investigation and punishment are expensive and not always successful. However, in a number of recent cases such as the NYSE, the situation is rather one of ethical judgement or, seen from the perspective of the economy, that inefficient and wasteful actions that, in addition, dam- age the legitimacy and integrity of a market economy. In these latter cases, but also with respect to more criminal- ly oriented behaviour, it is important to look at the overall corporate gover- nance framework to see how the rules, institutions, incentive systems and so on come together to produce an out- come widely considered undesirable.

For example, with respect to the case of the NYSE, a number of deeper questions arise that are common to other incidents. Why were the direc- tors of the NYSE surprised at the size of the payment? Why was there a lack of transparency between a board committee and the board as a whole, with the general details of the agreement known but not the bottom line? Why did the compensation commit- tee comprise directors with close business and social ties to the chairman and CEO, even if they had no close relation to the NYSE? Did the compensa- tion committee even know the ulti- mate consequences of the unusually detailed contracts that they had negoti- ated? In short, all the main issues of the corporate governance debate over the past few years appear to have played a role in the NYSE controversy, including the need for transparency and disclo- sure which finally led to the situation being exposed.

Thus from the perspective of poli- cy, one must consider executive remu- neration as the tail of the dog ”” not the dog ”” so that the options lie else- where than in legislation and regula- tion about salaries. And as I want to argue, it involves more than exhorting boards to do a better job.

Before developing my arguments further, it is worthwhile recapitulating what has happened since the Enron affair and subsequent scandals shook OECD countries and financial markets.

The scandals associated with Enron et al pointed clearly to poor accounting and audit practices and serious conflicts of interest in the accounting/audit profession. Taken together, financial market integrity was threatened. With the power of interest groups weakened, policy in many OECD countries has concentrated on improving disclosure and trans- parency. The whole process has been placed under examination, from inter- nal preparation of financial reports and internal controls through to the role of the board in approving pub- lished accounts, the accounting stan- dards being used and the integrity of the external audit process.

The responsibility of boards and their audit committees or similar bodies have been tightened, and a number of countries have now introduced public oversight of the setting of accounting and audit standards. With professional interest groups weakened, there is now a chance to reform practices such as not costing the issue of stock options. Professional self-monitoring has also been placed under tighter public over- sight and in an increasing number of countries auditors are being restricted in the nonaudit services that they can perform in order to avoid incentives that might lead to diminished inde- pendence in the enforcement of audit standards. Some form of auditor rota- tion is also being introduced in a num- ber of countries.

The scandals have also given a wel- come boost to the convergence of accounting standards, especially between the Generally Accepted Accounting Principles of the United States and the International Accounting Standards, which are to be adopted by the EU and other countries after 2005. The latter system is based on principles that should diminish the ”œshow me where I can’t do it” approach of the recent past, and in the US there are moves to redress the balance in favour of principles rather than rules. However, a great deal will depend on whether the IAS principles will be weakened in the process of international negotiation; a certain politicization is already apparent in Europe. In the United States, the dan- ger is that principles will be diluted by rules detailing interpretation so as to minimise the risk of litigation.

The first wave of reform has now moved on to the providers of financial information such as analysts and rating agencies that also face potential conflicts of interest. This is leading to both structural remedies such as separating activities into inde- pendent units and to greater disclosure, the balance varying between countries. In retro- spect, the development of large financial conglomerates might well have led to synergies, but the downside to this development was to enlarge the potential for conflicts of interest and strengthen the financial incentives to breach the trust of clients.

The focus on standards and market integrity was clearly the right reaction by policy makers to evidence that incentives for desirable conduct had been undermined by a booming stock market and the evolution of technology and organizational structures such as the development of financial one-stop shop companies. However, some of the measures might be heavy-handed, with an emphasis on form (i.e. signing decla- rations) rather than content and on detailed regulatory measures, in some instances. Others may not work as expected: for example, audit quality might decline as better minds are attracted to consultancy and the pool of auditors available for rotation declines. The situation will need to be monitored and flexibility might in some cases be required. Nevertheless the need to control conflict of interest must continuously be borne in mind. The call for higher ethical and profes- sional standards is also welcome. However, it is surely more important to get the incentives compatible with the desired ethical behaviour and in this we still might have some way to go.

In a number of OECD countries as well as elsewhere, concern that boards have often been surprised by adverse developments or have shown little crit- ical behaviour vis-à-vis the chair and CEO has led to provisions to increase the number of ”œindependent” board members and to strengthen their role. Such a reaction is certainly understand- able in the context of the Breedon report on WorldCom/MCI, which pro- vides a shocking indictment of a board that met infrequently and made no stand until the very end. In several countries there has also been concern to improve the quality of non- executive and ”œindependent” directors by both training and by more system- atic recruitment. Board members ”œindependent” of management are regarded as important for roles where the board might have a conflict of interest such as in the determination of executive and board member remuner- ation, nomination of board members and audit. In a number of OECD coun- tries where block holders are common, independence from a major sharehold- er is an equally important concern.

Just as important as the move to more ”œindependent” directors is how the concept is made operational. Considerable flexibility will clearly be required. For example, the Combined Code in the UK calls for at least half of the board to be independent and pro- poses a guideline as to what may dis- qualify a person from being considered as independent, which includes service for more than 10 years on the board. However, for the Combined Code, although part of the listing require- ments, the company must only either ”œcomply or explain,” that is, the compa- ny has to justify why it regards a direc- tor as independent for certain duties.

If the NYSE and Nasdaq proceed with their new corporate governance listing requirements, they will be mandatory, not ”œcomply or explain.” Under such a situation, the precise def- inition becomes extremely important, and this is the case with audit commit- tees where the Sarbanes-Oxley Act mandates independent directors. Some fear that the need for guidance from the SEC not only establishes a safe harbour, such as holding less than 10 per cent of shares in a company, but will move enforcement away from the current practice of looking at a specific transac- tion and the situation surrounding it in judging whether a director was capable of acting independently. It is this last point I wish to consider more fully.

The OECD Core Principles of Corporate Governance do not call for independent directors per se, but for directors ”œcapable of exercising inde- pendent judgement” and for boards able to ”œexercise objective judgement on cor- porate affairs, independent, in particular from management.” Will ”œindependent” directors be able to do this and under what conditions? While individuals may start out as ”œindependent,” there must be reason to doubt that they can be expected to remain so (except formally) after they have become members of the board team that, from the efficiency point of view, is claimed to be impor- tant. And most chairs and CEOs are sen- sitive to establishing a collegial team. Moreover, as the workload on independ- ent directors increases they will need to be paid correspondingly more and per- haps take on fewer directorships, which, it could be claimed, will make them more dependent on the firm. I am not against independent directors, but I do worry about an approach that sees them as resolving alone the problems we have seen in recent years.

What is crucial is the incentive for an independent director to retain inde- pendence of judgment, and this would appear to come down to how they are selected or nominated in the first place as well as the strength of the reputation effect. A director with a clear mandate from shareholders (or stakeholders) might be expected to remain more independent than one elected from a broad slate of candidates put forward by a CEO. There are other incentive effects that, in the meantime, are well known and accepted in some compa- nies: a director should be able to hold shares in a company (or even be partly paid in restricted shares) but with a requirement not to sell them for the period in office. This at least appears to better align their incentives with the interests of shareholders.

Greater incentives to remain capa- ble of independent judgement might also help to deal with another aspect of the current situation: the tendency to pack remuneration committees with CEOs who formally speaking might be ”œindependent” in the sense of no busi- ness relations with the firm but perhaps not in the sense of independent judge- ment. There has certainly been an ele- ment of what I have described as ”œyou scratch my back, I scratch yours,” with such interlocking arrangements that might be ameliorated by directors with more direct mandates.

In reviewing the Sabanes-Oxley Act, its implementation and associated reforms, Chandler and Strine, two judges ”œfrom a small state,” as they put it (the state happens to be Delaware, the registered home of many of the biggest US corporations), have argued that the most absent feature to date has been reform of the method of electing directors. They describe the present sys- tem as totally ineffectual, and there is good reason to believe that in many other countries a similar situation pre- vails. In this case, the policy focus on ”œindependent” directors is still not suf- ficient to overcome the problems we have seen, ranging from remuneration packages that do not appear to have been negotiated at arms length, to designs by CEOs for expansion border- ing on self-aggrandizement.

More needs to be done to open board elections, which would finally clear the way for a more effec- tive exercise of ownership rights. But the ability of shareholders to demand accountability of the board also needs to be improved by making it easier to ask questions of the board and to put forward proposals to the general meet- ing of shareholders. Moreover, resolu- tions passed by shareholders should be more binding on the board than is cur- rently the case in many countries.

For some directors and CEOs such proposals appear shocking, raising the spectre of shareholders running riot and destroying the carefully planned opera- tion of a company. Let me, therefore, make it clear that the fundamental and proven strength of the corporation ”” professional management ”” needs to be preserved. Moreover, second guessing business judgments by directors also needs to be strenuously avoided. The business judgment rule, however it is enforced in different countries, needs to be defended. Nevertheless, if corporate governance is to be reformed so as to regain its legitimacy, the board and the company must be account- able, and to higher standards than in the past. Policy mak- ers will therefore have to consider techniques to avoid disruptive behaviour ”” such as excessive class actions and litigation ”” while at the same time not taking their eyes off the real objective of more effective owners.

A marked feature of most of the OECD area is the impor- tance of institutional shareholders such as pension funds, collective investment schemes and insurance companies. A key policy question is whether they should be treated differ- ently from other shareholders and be required to vote their ownership rights. I am against requiring shareholders to vote, as some have argued recently, for the pragmatic reasons that this would not necessarily lead to the informed use of ownership rights and would detract from the advantages of liquid markets in financial assets, which give the individual enormous freedom to suit their own circumstances.

But institutional investors are in another category, not just because of their resources but because they have become delegated monitors: they own shares on behalf of other investors. This is most true for institutions acting in a fiduciary capacity such as pension funds and collective investment schemes such as mutual funds. To a certain extent it is also true of other institutions. I do not advocate that they must vote their ownership rights, but at a minimum they should disclose how they arrive at their voting policies so that final, beneficial owners are aware of the decisions being made about ultimately their own investment.

My argument has important impli- cations for the institutions them- selves. In particular, the corporate governance arrangements of such insti- tutions should correspond to good prac- tice, which often means that their own conflicts of interest ought to be made transparent to their investors together with information about how they will manage them. These aims are not unre- alistic but correspond in many ways to what the institutions themselves are aim- ing to establish. But as they continually point out, there is no point to being an informed investor, with the associated costs, unless one is capable of achieving results. As I have argued above, this is fre- quently not the case at the moment.

What I am arguing for here is for policy to grasp the fundamental ques- tion that has been creeping up on us for some time: the breakdown of tradi- tional ownership structures, which has seen the role of the owners of capital undermined through diffusion of interest, leaving no one to speak clear- ly and forcefully for the shareholders. True owners would hardly have voted for ratcheting up remuneration to lev- els far beyond the dream of avarice unless the returns from the entrepre- neurial activity were truly appropriate.

As a former board member of a major corporation myself, I have con- cluded that the malaise in much of corporate governance today has even deeper roots than the frequent lack of adequate shareholder oversight. Somehow we have come increasingly to substitute rules for values. We now look first of all to see if something is legal, satisfying the letter of the law and not necessarily its spirit.

It is often said, somewhat unfairly I am told, that economists know the price of everything but the value of nothing, claiming that little can be said about the latter. In a similar vein, policy makers often argue that ethics and values are not things that policy can do much about. That is true, but only to a certain extent. Applied poli- cy is very much about monitoring whether the incentive structures and institutions that are in part a function of policy choices are consistent with what society values, as revealed through the political process.

At its most general, policy must ensure sound macroeconomic funda- mentals. Bubble periods have usually been characterized by phases when opportunities for quick profits seemed to multiply, leading in turn to business plans that in retrospect appear just short of fanciful. More importantly, incentives became distorted leading often to a breakdown of business ethics on the part of some ”” like directors, analysts and accountants ”” as each strove to ”œget their share.” It is hardly surprising that such a breakdown was a major concern of the Bank of Japan as the boom reached intoxicating propor- tions in 1989. Perhaps the Federal Reserve might have considered such effects towards the end of the 1990s when it was clear to them, from recent- ly released board papers, that there was indeed a stock market bubble.

At a more microeconomic level, it is important for policy to monitor how institutions and practices are evolving and what this might mean for incentives and, at the end of the day, values. In retrospect, the develop- ment of large financial conglomerates should have been monitored more closely for conflict of interest.

The ethical environment of the company has taken on new impor- tance, as attention has shifted to how good corporate governance practices can be implemented. Observing ethi- cal standards such as those embodied in the OECD Guideline for Multinational Enterprises and the Anti-Bribery Convention is now widely regarded as an important function of the board, which will contribute to the longer- run value of the company. In a num- ber of countries, corporations are also encouraged to create their own codes of conduct, and the pressure from civil society organizations is now quite strong. However, I would note that the ethics committee of the board of Enron voted three times to lift its own code, so it may be a necessary though by no means sufficient condition for good corporate governance.

The OECD is responding in a num- ber of ways in order to keep abreast of changing circumstances. First and most importantly, the OECD is currently assessing and reviewing its Principles of Corporate Governance, which is due to be completed in 2004, with a view to maintaining them at the leading edge of developments. Many of the issues I have discussed above are figuring prominently in the review discussions. Moreover, we are closely monitoring and facilitating discussions about the evolving structure of institutional investors. We are reviewing the guide- lines that we developed several years ago for the management of pension funds and are developing guidelines, in conjunction with regulators, for collec- tive investment schemes.

The most important role is proba- bly, however, still ahead of us. It is fair to say that many of the current reforms are to some extent experi- mental, and there will be a need for countries to be able to compare their experiences and assess where they are against an ambitious benchmark. This is the type of service the OECD pro- vides in many fields for its members. There will be other problems concern- ing the international implications of domestic corporate governance poli- cy, as well as issues arising from regu- latory competition. We have not yet seen the latter in the OECD area (although probably between states in federal systems), but the potential is increasingly coming into place for firms to move their registered offices to countries with lower or more flexi- ble corporate governance standards. I am not saying that this will happen, for firms might be penalized by investors, merely that there needs to be a forum for discussing the inter- governmental issues.

As I have indicated, remuneration questions, including termination payments that often appear to be rewards for failure, have become a key political issue in a number of coun- tries. But policy interest in corporate governance needs to be seen in a forward-looking manner, and not just as an enforcement exercise to deal with past misdeeds and perceived cur- rent excesses. Member countries are also concerned to stimulate growth and employment in an increasingly competitive environment. There is now a growing body of empirical research linking a number of key aspects of corporate governance arrangements to both firm perform- ance and growth. Nevertheless, so long as key functional aspects are met, which are described well in the Principles of Corporate Governance, there does not appear to be a unique institu- tional or legal structure of corporate governance for ensuring growth.

Clearly, the balance in favour of management needs to be redressed in favour of a greater role for owners, especially institutional investors, although with safeguards to preserve entrepreneurial activity. Here policy makers will face a challenge in finding a balance between rules and regula- tions on the one hand and flexibility on the other. If there is one thing that is already apparent, it is that one size often does not fit all in the area of cor- porate governance. How to achieve this flexibility will remain a major challenge for policy makers.

Finally, a word needs to be said about the ”œinsider” (e.g. continental and Japanese arrangements) and ”œout- sider” (i.e. Anglo Saxon) models of corporate gover- nance, which have long dominated the literature and the polémique. My argument is that the ”œoutsider” model is in serious need of improvement by giving more ”œvoice” to owners and not just good opportunities, in the words of Hirschman, to ”œexit.” However, recent experience also casts doubt on the ”œinsider” model. Long-term relations, careful bank monitoring, balancing social commitments, etc., have in prac- tice proven to be often nothing more than self-appointed clubs where moni- toring was anything but effective. And insiders have often been shown to be totally ”œout of the loop” with regards to the actual situation of the enterprise. Although differences will remain, what I think we will see in the future is more of a system convergence with greater emphasis by both on effective moni- toring and real accountability.