Borrowing from the laws of nature

  • Date:01 Nov 2007
  • Type:CompanyDirectorMagazine
Shann Turnbull demonstrates how the laws that govern living things could be used to help us better govern companies.
Corporate Governance reform is failing. Worse, current reforms are heading in the wrong direction. The good news is that these problems can be corrected by applying the laws that govern the regulation of living things identified 60 years ago.

The most compelling evidence of failure is provided by the market. Private equity investors can extract more value from publicly traded companies by taking them private so that they do not need to comply with corporate governance codes.

Evidence of failure is also provided by increases in the size and complexity of the law and the budgets of regulators. The need for corporate governance codes proves that both the law and regulators have failed. Successful reform would reduce rather than increase the cost of business. The compliance cost the Sarbanes-Oxley (SOX) legislation has resulted in many US companies delisting as this can be done without shareholder approval or other expenses. Foreign companies are avoiding US listings. A leading scholar described SOX as ‘quack’ corporate governance.

Failure of SOX and governance codes was revealed in 2004 by the foreign exchange losses suffered by the National Australia Bank. The bank complied with SOX and was evaluated as having the ‘highest standard’ of corporate governance in Australia.

Another sign of failure is that law makers, regulators, stock exchanges and practitioners have no agreed definition of what is ‘good’, ‘higher standard’ or ‘best’ corporate governance. Such words are commonly quoted by law makers, regulators, commentators, and practitioners hustling for consulting business. However, if you cannot define where you want to be, then any road will take you there!

One fundamental problem is that corporate governance is described in terms of principles and practices that are not subjected to measurement, rather than in terms of outcomes that are measurable. It is difficult to manage what is not measured.

As there is no agreed definition of good governance, rating agencies use governance codes as a benchmark of ‘good’ or ‘best’ governance. This creates market forces to lock in current codes and practices. It has not only created a circular self-reinforcing, but also a self-deluding process for defining good governance.

The UK combined code and the ASX corporate governance code, like SOX, force auditors to be placed in the conflicted position of judging the accounts of the people who engage and pay them. Directors are conflicted by paying those who judge them. Directors are supposed to avoid conflicts.

The requirement to appoint so called ‘independent’ directors is not supported by research that they add value. Scholars have pointed out the lack of clarity of what type of independence is required and what ‘independence’, however defined, is suppose to achieve. This has led one US scholar to refer to the ‘fetishization’ of independence.

Worse still, corporate governance reform has fossilised. It has become a dead end street because corporate laws, regulations, listing rules and guidelines are based on practices rather than outcomes. An outcome-based approach would de-fossilise reform by allowing different practices to be developed. Companies could then compete in developing the best practices to achieve the desired outcomes in the most efficient manner. In addition, flexibility would be introduced so one practice would not need to be adopted by all companies.

The outcomes sought would be to protect and to further the interests of shareholders and other stakeholders. This should be the purpose of regulation and the mission of regulators and listing rules. Because these failed to prevent major corporate scandals, the ASX developed a Corporate Governance Code. This initiative has increased complexity and compliance costs with problems still arising as shown by the National Australia Bank.

This leads to the idea that good corporate governance should be defined as reducing the need for laws, regulations, regulators, listing rules and codes while improving the protection and interests of stakeholders. In other words, ‘good’ governance is achieved by furthering self-governance and ‘best’ governance is self-governance. This definition is consistent with the Science of Governance based on the laws of nature that regulates biota. It would also change the role of government from direct intrusive regulation to much more subtle and effective indirect regulation by requiring organisations to adopt self-governing constitutions.

The constitution of organisations represents their DNA. No living thing can survive unless self-regulating provisions are embedded in their DNA. Likewise no government should provide a licence for an organisation to exist unless its constitution possesses provisions that facilitate self-governance.

Stock exchanges already specify some elements of corporate constitutions as a listing condition. They could and should do much more. In this way, they could eliminate the need for corporate governance codes, simplify corporate law and reduce the size and cost of regulators while providing superior benefits for shareholders and stakeholders. For example, stock exchanges could require corporate constitutions to adopt the investor protection provisions found in sharehohlder agreements with venture capitalists and include conditions some bankers use in loan agreements to reduce and/or manage their risk.

The lack of inestor protection or the ability of shareholders to further their own interest has been created by corporate constitutions providing excessive or inappropriate powers for directors that also introduce untenable conflicts of interests. Power tends to corrupt and absolute power tends to corrupt absolutely. Directors possess absolute power as to how they manage their own conflicts of interest. Regulators and stock exchanges are irresponsible for allowing this situation to be perpetuated.

The solution is to require that power is appropriately shared with those that the law, regulations, regulators, listing rules and codes are created to protect and further their interests. In this way regulation can be ‘privatised’ and distributed to create a bottom up, custom-designed outcome-based approach to replace or complement the current top down ineffective, intrusive and costly one size fits all approach. However, current reform initiatives are moving in the opposite direction!

The current centralised top down strategy to regulation employed by governments and by a single board of directors to control large organisation can neither be efficient or effective. This is because the science of governance states that it is impossible to directly amplify regulation and control. Regulation and control can only be amplified indirectly through “supplementation” in the same way that it is impossible to directly amplify the signals of radio or TV transmissions. Their very weak signals require supplementation with the energy provided by power mains.

In social organisations, this means that to achieve efficient and effective regulation or control, the energy of co-regulators are required to amplify signals for the regulator or the borad of directors. It is in this way that organisations can obtain operating advantages. In particular, firms can also obtain competitive advantages by amending their constitutions to introduce a network of independently constituted in-house co-regulators composed of their shareholders and stakeholders.

The impossibility of amplifying control means that CFOs require co-regulators to improve the efficiency and effectiveness in the way they control large complex firms. So it is very much in the interests of directors and shareholders that large firms introduce bottom up co-regulators. Co-regulation within firms is required not only to achieve the outcomes sought by corporate regulators, ut by all the other regulators concerned with such matters as health, occupational safety, gender equality, equal opportunity, consumer protection, trade practices and other social and environmental concerns.

Co-regulators are also required for CEOs so that they can quickly, accurately and effectively identify and correct inefficiencies and ineffectiveness in achieving desired business outcomes. The natural laws of requisite variety state that the accuracy of communications and control can be improved as much as desired by introducing a requisite variety of independent channels of communication and control. A corollary of this law is that command and control hierarchies lack sufficient variety to reliably communicate or control complexity, let alone achieve regulation in a responsive and sensitive tailor-made manner.

The introduction of multiple communication and control channels in firms creates network governance. Firms in rapidly changing complex industries like IT and bio-technology are forced by competitive pressures to adopt network governance. The competitive advantage of network governance in more stable industries has been proven by the nested networks of stakeholder-controlled network firms located in Spain. It is through firms providing stakeholders a constitutionally-based right to voice their interests that requisite variety in communications can be achieved to reliably control complexity and further the interests of all parties.

This is analogous to how the complexity of the human brain is enriched in babies to enhance their intelligence. To simplify the complexity of DNA, it does not contain sufficient data to specify how to create all the complex connections for building a brain. Supplementary data is provided from the sensory stimulation obtained from the baby’s environment. Network governance likewise supplements the brain of a firm (board of directors) by introducing distributed intelligence with feedback and feed forward information from the business environment.

Network governance is a condition precedent for facilitating self-governance as it introduces a division of power to protect and further the interests of minorities against the interests of dominant shareholders, directors or management. One fundamental requirement to facilitate self-governance is for corporate constitutions to separate management powers that generate value from governance powers that can entrench and enrich directors and their associates. Another fundamental requirement is for corporate constitutions to give voice to the various stakeholder constituencies of a firm either, directly or indirectly, through establishing by-laws. No business can exist without its employees, suppliers, customers, agents, dealers and distributers so it is very much in the interest of shareholders for firms to formally engage and bond with their strategic stakeholders.

Research has revealed that stakeholders typically contribute more product innovations than the internal research and development departments of firms. Stakeholders also provide a source of competitive intelligence. The cost of stakeholder engagement can be less than employing market research, human relations and other consultants, but with added advantages.

Crucially for company directors, stakeholders can provide information independently of management on the Strengths, Weaknesses, Opportunities and Threats (SWOT) of their executives and the business. It is very much in the interest of shareholders that their directors have a credible process for carrying out their most fundamental role to direct and monitor management with information independent of management.

It is irresponsible and naïve for directors to only rely on information provided by management. It is naïve because it is not in the interests of management to report problems and deficiencies for which they might be held accountable. If directors do not obtain the other side of the story reported by management they are being irresponsible not only to themselves but to the company, its shareholders and stakeholders. It is simply not good enough for the fortunes of shareholders and superannuants to be invested in companies where their directors do not have systemic processes for discovering when their trust in management might be misplaced.

A corporate constitution is like the elephant in the living room that nobody notices. Every company has one, but they are not seen. They are commonly accepted as a being given – not a variable that needs to be designed to support and further the mission of the organisation. As a result, there are no courses to educate business people or their advisors on how to design corporate constitutions. Yet such education could provide competitive advantages for businesses with less risk and reduced director liability for mistakes, deficiencies or losses. While political scientists research and teach how to construct constitutions for countries, there is a global knowledge gap on how to design constitutions of firms or other types of organisations so as to sustain and further their operations.

Likewise, there is a global knowledge gap by social scientists, lawyers, accountants and economists on the existence of the science of governance. As a result, law makers and regulators do not have the intellectual tools to design efficient and effective regulation. While the science of communication and control was only identified in the middle of the last century, it is not ‘rocket science’ although the guidance, steering and governance systems of space craft depend upon it.

Until lawmakers and regulators apply natural laws to regulatory reform, reform will continue to head in the wrong direction. The time is overdue for education in the Science of Governance to be a pre-requisite for all regulators and board advisers.

Shann Turnbull is the principal of the International Institute for Self-governance based in Sydney.