“Strategic” is one of the most overused words in business today, but there are two very good reasons why it should be used to describe corporate governance.
1. Current and future challenges of institutional investors: The corporate governance movement has made great strides since its early initiatives in the mid-1980s (CalPERS etc.). Institutional investors have gained legitimacy by using their voting power to change the composition of many boards and to help spread best practices for corporate governance around the world. As the United Kingdom’s Hampel Committee pointed out in its 1998 report, however, the focus has been mainly on formal accountability rather than on business prosperity.
This is not a sustainable situation. Corporate governance must increasingly focus on business prosperity aspects per se rather than assume that prosperity follows automatically once accountability has been established. After all, the ultimate goal of ownership is to create value, to make the capital invested grow. Thus, proponents of better corporate governance must recognize that their activism has to take on a new dimension. Recent events, including the bursting of the stock market bubble and the plethora of dotcom meltdowns, are cases in point. A dearth of competent, active owners was one of the main reasons why so many new-economy ventures went to the wall. Institutional investors, particularly the pension funds, must assume the challenges of active ownership to create sustainable value.
2. A second reason for using the word “strategic” is that the owner has an important role to play in the process of value creation. In my book, Ownership and Value Creation, I have included extensive examples of value-creating active ownership, particularly an in-depth case study of the so-called Wallenberg Sphere of Sweden. For five generations, the Wallenberg dynasty has played an outstanding role in Swedish finance and industry. Its active involvement in the companies it controls is a major reason why many of the largest Swedish corporations have become global leaders.
If ownership is so important, then, how do we ensure that owners are diligent, competent and capable of creating value? How do we make strategic corporate governance work?
The organizational perspective
How efficient is the individual company in creating renewal or value? This is one of the most crucial questions that directors, owners and managers must ask. The answer lies in developing sound ideas for how the vertically aligned owner-board-management relationship can be made as effective and efficient as possible.
The board and the owners
A board is supposed to represent all shareholders as well as the collective interests of the owners. In most cases, however, large, listed corporations have a very heterogeneous ownership, involving individuals, institutions or owner groups with differing interests and time frames concerning the company’s growth. In some companies, there is one dominant owner and a number of fragmented and heterogeneous owners. In other companies, there may be a couple of large owner groups of equal weight.
A case in point is Ericsson, which I discuss in my book in connection with an analysis of the Wallenberg Sphere, one of the dominant owners. Another example is The Industrivarden Sphere, a bank-related Swedish owner group whose voting power at Ericsson is roughly equal to that of the Wallenberg Sphere. Historically, Ericsson’s two largest owners have managed to co-operate on most critical issues. This is, of course, not always the case in similar owner constellations where conflicts of interest may arise over questions about how much the company should diversify or how long-term investments should be prioritized. There are often other driving forces behind these conflicts, e.g. the interest of a particular owner group to keep ownership control by avoiding new investments and expansion that would require new and large injections of capital that could alter the power structure.
In fact, the power of these special interests and their ability to assert control was one of the triggers in the movement to reform corporate governance practices in the United States. Another trigger was management’s interest in defending itself against the majority position of diverse owners.
In the U.S. and U.K., the development and acceptance of a sound corporate governance policy has become an important instrument for safeguarding the collective interests of owners. In the U.S., boards of directors have sometimes taken the lead—for example, General Motors and Campbell Soup were early movers in this respect. Some daring activists, notably Bob Monk, and a few American pension funds, have also been a driving force. Most boards in the U.S. have corporate governance committees that maintain ongoing surveillance to make sure that owners’ interests are being respected. They report on their work at the annual general meeting.
The meaning of ownership
Many companies in other countries have adopted valid corporate governance principles according to their own way of working. It is in each board’s interests to set out the rules and communicate them to the stock market and the general public. The collective interests of the owners are best served if the company’s total long-term potential is safeguarded, and long-term, sustained shareholder value is maximized. This is more than what financial whiz kids can define using a few simple formulas. Boards must possess the whole range of ownership skills—renewal capability and risk management competence, depending on the company’s line of business, organization, credibility and institutional position—called for by that company.
Ownership can mean important differences for the board in another respect. If there is a dominant owner or owner group with long-term interests in the company, there should also be an owner who can provide guidance on the company’s development and one who can address the board on matters of grave consequence. Dialogue between the owners would thus be more than a formal procedure during the annual general meeting. If the company is ownerless or if ownership is so fragmented that no one can or will assume direct ownership, can the board take upon itself to try to act as owner? Historically, this has not appeared to be feasible. Without some form of control by the owners, the board clearly loses its bite and is at the mercy of the management. A meta-management relationship between owners, boards and executive management are always needed. (Meta-management here means mobilizing power to change power.)
It is crucially important for even relatively small owners—for example, institutional investors, each with a holding of a few per cent of votes or capital—to assume responsibility for the board’s quality and accountability. Even investors with a limited ownership stake can make a big difference in this respect.
Aligning the interests of owners and directors
Since even a limited ownership position can make a difference, the issue of directors owning shares of companies they represent has come under considerable scrutiny. Directors are frequently remunerated with share options or shares. Wisely designed, such incentive systems can be constructive; they can also inhibit risk-taking by directors. Our studies of start up companies have shown how important “competent capital” is for their success. We know that “business angels,” the risk capitalists who combine significant equity stakes with relevant competence, play a crucial value-creating role in start-ups. Would not the same logic apply to established companies and large corporations? Institutional investors and other owners might do well, then, to expect board candidates to make a sizable investment in the corporation.
The board and management
For simplicity’s sake, let us assume that we are dealing with a unitary board with a two-tier structure that divides responsibilities between the board and the executive management. In this case, how can the board define its role in relation to executive management? To answer this question, it is helpful to apply the 3-D formula: Distance, Dialogue and Differentiation.
- Distance: Safeguarding the board’s ability to maintain an overview and global picture of the company is of key importance. The board must preserve its integrity when evaluating management proposals and investment decisions and review management compensation. Otherwise, the board could be co-opted by the company’s executive management and risk becoming involved in various types of suboptimal decision-making.
- Dialogue: Distance and integrity must be combined with ongoing dialogue with the company’s executive management. Whilst the board is the owners’ instrument for direct and ongoing exercise of ownership and owner control, it is also responsible for how the company is run. Executive responsibility should be delegated to the company’s senior management, but it should be the result of continuous dialogue. The implications of important decisions should be interpreted jointly by the board and the executive management.
- Differentiation: In the dialogue and interaction between the board and management, it is important to clarify the different roles. The following table illustrates some aspects of differentiation.
The fundamental function of exercising management differs in that the board applies meta-management in its relationship with the executive management. This is for reasons of both practicality and principle. The board has limited time to discuss and make decisions. It must concentrate on creating the right prerequisites to enable the day-to-day running of the company.
Executive management acts as a company’s driving force and sets high goals for growth and expansion. The board’s task is to act as a restraining force. As one professional board member put it, “My most important task is to say no.” This naturally does not mean that the board should be against expansion or thwart innovation. On the contrary, the most important task of the owners and the board is to ensure that the business renews itself and the company functions. The board, however, must maintain the balance between old and new: what currently exists should not be neglected because the company’s executive management has discovered new and exciting business opportunities. It is not unusual for companies engaged in new ventures to begin neglecting risks in their existing operations while underestimating risks associated with their new operations. This is particularly true when the logic and dynamics of the new risks and their repercussions are not fully understood. Capital is eroded from two directions, and the result is total disaster. To avoid this, the board must be competent in risk awareness and orientation and, of course, risk evaluation/risk management. The executive management should first and foremost be keen on expansion. If the board makes sure that the executive management has such a profile, then the organizational risk of having an inactive organizational management should also be minimized.
The difference between the board and executive management can be summarized by the following:
- Management should be young, ambitious, have drive, be expansive, energetic—and of course possess the necessary technical skills, whilst
- The board should be wise, experienced, able to assess and manage risk, have a detached but holistic perspective, whilst being both supportive and questioning.
Corporate governance is very simple. It is about ownership. To own is to care. There is only one snag: There are owners who do not care, owners who believe, maybe, that they do not need to care. They think somebody else cares for them. They are right in one sense: There is always somebody who cares –for that somebody’s own interest! Owners need to care for themselves. To care involves a concern for the accountability of those who have been given the authority to manage the owners’ investments. To care involves, above all, a concern for sustainable value creation.
Any movement for better practices begins with the individual investor. This is an indispensable prerequisite for a dynamic economy. Why, then are we letting the big institutions manage our indirect investments and assets to an increasing extent? It is essential that we do not abdicate our responsibilities as owners. We get what we deserve. Sound principles of corporate governance should apply to institutional investors as well. They should be accountable for how they exercise their franchised ownership as agents of the private owners, and how they contribute to fundamental and sustainable value creation in their total portfolios of investments. As citizens, we can also influence politicians to improve institutional frameworks and make the investment environment more owner-friendly. In some cultures, associations of small shareholders can provide effective support and leverage individual initiatives. But other means are also needed to take on the huge challenges of ownership.
