On good corporate governance

Corporate culture and the indifference of society

Too many recent corporate disasters - some fatal and others that, although not fatal, caused an enormous destruction of economic and social value - have shown serious problems of corporate governance in Portugal. And they also showed that the first deficiency in this matter lies in the business culture and in the indifference with which society considers this matter.

As a result of various vicissitudes, including careless macroeconomic management, Portugal has an extreme shortage of equity capital, and has therefore become highly dependent on foreign capital. This vulnerability has attracted, especially, capital from political geographies with less acceptance in global markets, and opportunistic capital seeking to take advantage of assets undervalued by the country's situation. Such capital should not be discouraged, on the contrary, but the reputational contagion effects of an excessive predominance that it may assume in the control of the main national companies, with the consequent devaluation of national assets, should be prevented.

In this context, a good corporate governance system, keeping shareholders at arms length from management, and with adequate mechanisms for supervision and control of executive management, is the best antidote to these risks. Therefore, and in addition to the general reasons that recommend it in any circumstance, the requirement for such a system should become a strategic objective of the country.

In order to contribute to that goal, this essay seeks to explain why good governance is necessary and what specific concerns it should address. From this reasoning, practical corollaries are then drawn for any regulations aimed at good corporate governance. Unsurprisingly, the text points out that the most important aspects of good governance are the people involved and the values that guide them.

Actions aimed at good corporate governance must focus on changing the dominant culture. Hence, imposing principles, rules and procedures in the careful and transparent selection of the people involved in that governance. Transformation that will only be achieved if led by the regulatory path.

Companies and the lesson of Descartes

René Descartes began his Discourse of Method by writing that "common sense is the best distributed thing in the world, for everyone thinks he is so well provided with it." When it comes to good governance, too, it doesn't seem that any of our big companies feel, or have ever felt, inadequately provided for. However...

There arealready too many business disasters and the destruction of economic and social value, caused by examples of bad governance, for self-contentment in this area to be reassuring and to be passively accepted by public authorities and civil society.

There is no tradition of good corporate governance in Portugal, which is partly due to the prevailing rentier culture. It would, in fact, be an interesting exercise to assess how many companies in the PSI 20 could, for example, currently be accepted on the London Stock Exchange.

António Horta Osório, in an environment where corporate governance is seen and treated with great demand, both by regulators and by the capital market itself, recently put his finger on the spot of our bad practices. In a conference held by Jornal de Negócios on 17 April 2015, he mentioned, as reported by the online version of the newspaper that same day, that:

In Portugal"we do not have a system of governance, in general terms, at the level of the best international practices, such as in England or the United States". There must be, he added, "checks and balances". In Portugal, according to this banker,"we give excessive power to the chief executive, devaluing the role of the chairman and non-executive directors". He gave as an example: in Portugal, a regulator never has meetings with chairmen, non-executives or committee chairmen, as is done in England. The board of directors should be the shareholders' representative in overseeing management. Companies"must have high-level boards of directors, with a chairman responsible for appointing the CEO (Chief Executive Officer) and ensuring good governance".

Corroborating the acuity of this diagnosis, as well as the cultural deficit in this area, I recall that a Parliamentary Commission of Inquiry was recently set up to assess the events surrounding the fall of BES (Banco Espírito Santo). Among the dozens of people that Parliament wanted to hear about the matter, no one considered it necessary or convenient to include theChairman or other non-executive directors of the company. And no one, inside or outside Parliament, seemed surprised at this omission. In the same way that when a former non-executive director of the same bank stated in a newspaper interview that, during the six years he was a director, he went in mute and came out silent, no one, among the economic and political elites, showed any surprise.

Both cases clearly demonstrate the irrelevance that our business culture, political society and even qualified opinion attach to these positions in the governance of companies. This reveals that it is at this level that the main deficiency that hovers over it lies. Because it is in this deficiency that the bad practices are rooted, unfortunately too widespread, which led to the referred business disasters (although not all of them were fatal for the companies involved, at least not immediately). And it is also in this same deficiency that much distributive asymmetry of corporate value is based, and that the persistent resistance to change is founded.

I do not intend to make a detailed analysis of corporate governance in Portugal, nor an inventory of bad practices, although I understand that this could be a very useful exercise to be carried out by any institution, regulatory or self-regulatory, with the means to do so. Rather, I propose to approach the subject from the constructive perspective of justifying the need for good corporate governance and identifying essential elements that it should address.

But before that, I would like to explain why I believe that it is strategic for Portugal at this moment to ensure the conditions for good corporate governance and why such objective, more than business, should be political.

Good governance must be a strategic objective for Portugal

Dependence on foreign capital

The successive accumulation of high external deficits between 1995 and 2011, not only eroded the savings base accumulated by Portugal, but also left the economy heavily indebted to the outside. In fact, accumulated national savings represented, until 1995, more than 80% of the stock of physical capital of the economy; since then, this indicator of strategic autonomy has been continuously waning and corresponds, currently, to little more than 50%.

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This indicator is quite telling of the strong erosion of the national capital-savings base and the enormous dependence on foreign capital in which this erosion has placed the country and its companies. Hence, by the time the recent international financial crisis emerged, almost half of the country's physical capital stock was either directly foreign owned or was mortgaged abroad (indebtedness). This provides a macroeconomic prism to better understand some of the business disasters of recent times, as well as the foreign control to which the main national companies have been passing (in some cases at 'bargain prices').

Each individual case will have a microeconomic explanation, i.e. of the corporate nature, but the set of all cases can only be properly explained if the macroeconomic environment is understood, i.e. the erosion of the national savings base caused by the accumulation of almost a decade and a half of high external deficits. What the country has been witnessing in this field can thus be described as a process triggered by the international crisis, of resolution (in some cases uncontrolled) of the "mortgages" to which national property was subject.

It is also important to mention that one cannot fail to take into account that the destruction of private savings capital that the state carried out twice within the space of a generation also contributed greatly to the notorious shortage of national savings capital faced by the country, and which made it so dependent: first, when it nationalised almost the entire economy without compensating the owners; and later, when it squandered the revenue obtained from the reprivatisation of the companies it had nationalised.

Valuing the country and its assets

Be that as it may, what is important for the theme that I proposed to address - the strategic imperative of good corporate governance - is that the country has become deeply dependent on foreign capital, not only for the dynamisation of the economy - productive investment - but for the very sustainability and development of companies - financial investment.

Given this dependence, the country needs to remain attractive to international investors, especially those that are likely to commit to it in the long term and become a lever for development and competitiveness of the economy; and to ensure a reasonable geographical distribution of the origins of that investment, in order to avoid economic dependence that would condition the country's political freedom and control over its own development. In these circumstances, ensuring attractive conditions for investment, while preserving the fair value of its assets, cannot but be considered strategic for Portugal's development.

Financial vulnerability, however, has made Portugal particularly attractive to capital from political geographies with little reputation in global markets and to "opportunistic capital", i.e. funds that seek undervalued assets, in order to realise quick capital gains, but without exactly having a long-term development project for the acquired companies.

Portugal cannot and should not refuse this capital. In the first case, because the political and friendship ties with the countries of origin are important to the country and, as such, the reciprocal relations should be stimulated and not discouraged. In the second case, because they are agents that are part of the "natural ecology" of the capital market, whose hostilisation would negatively impact the perception of investment conditions in Portugal.

But the excessive dependence on such capital and its possible predominance in the control of national companies, especially in the context of the governance practices referred to in the introduction to this article, may devalue the country's reputation, narrowing its attractiveness and excessively devaluing national assets. All the more so since some indications have already been mentioned of the possibility of repeating paths similar to those that led to the aforementioned disasters that originated in national investors.

While it is not desirable, as I have already mentioned, to discourage such investments, that risk can be greatly mitigated by ensuring that Portuguese companies adopt the best practices of good governance, protecting the direct management of the companies from undue interference by some shareholders (keeping both shareholders and direct management, at arms length, in the most appropriate English expression) and ensuring that the rights of all other stakeholders, and other potential investors, will be fully respected.

That is why I consider, in the circumstances in which the country finds itself, the objective of ensuring the generalised practice of good governance in national companies to be absolutely strategic, so that Portugal is not overlooked from the route of institutional investors, nor from the radar of strategic investors from a wider geography.

Achieving such an objective also has the collateral advantage of providing shareholders from the political geographies concerned with the not insignificant benefit of their own credibility in the global markets, whose access may be facilitated in this way.

I do not believe, however, that the achievement of this objective can come from within the business world or even from civil society. The latter, as I pointed out earlier, is not sensitive to the issue and the business culture is comfortable with the status quo and the asymmetries it provides. Only the public powers may lead the achievement of such a desideratum. But time is a crucial variable if possible reputational damage is not to be solidified.

There is yet another reason for the political leadership of the process. A reason which, being timeless in essence, has also been made urgent by the current economic circumstances - competitiveness. For already the Cadbury Report - which remains a prime reference of good governance, despite its more than 20 years, - pointed out, right at the beginning and focusing on its own country, that

"The country's economy depends on the energy and efficiency of its businesses. Thus the effectiveness with which its administrations discharge their responsibilities determines Britain's competitive position" [see footnote 2].

What are the conditions for good governance?

Conceptualisation

To properly understand what good corporate governance should take into account, it is necessary to start by understanding what a company is and what interests it involves, because it is this perception that is at the root of many of the misconceptions about governance.

A company - and I am focussing only on public limited companies - is not only its shareholders, nor do these represent the only legitimate interests on which a company bases its existence and on which its operation depends. A company is a much broader set of combined interests. It is an articulation of contractual arrangements between various parties - some explicit, others implicit - aimed at achieving their own objectives, jointly coordinated through its operation [see footnote 3]. These parties, legitimately interested in the company and its operation, include, in particular, shareholders, managers, employees, suppliers, customers, creditors, authorities and the society itself in which the company operates.

Therefore, the fundamental duties of good corporate governance are, on the one hand, to promote their good overall performance in value creation and, on the other hand, to ensure the effective and fair articulation of the interests of the various parties involved in the contractual relationships on which their existence is based.

And if the creation of value can be easily identified as an interest common to all parties - and, as such, easily articulated - the distribution of this value among the interested parties is likely to involve interests and objectives that are not only diverse, but often conflicting.

It follows, then, that, since the convergence of interests regarding the creation of value is easy, it is reasonable to delegate to shareholders the free choice of executive management, since they are the hierarchically residual recipients in the distribution chain and are the most interested party in this objective. But for the distribution of the value created, the delegation to shareholders should already be conditioned, since the interests to be served are diverse and potentially conflicting. Not only cannot the interests of shareholders prevail absolutely over other interests, but neither can the interests of some shareholders - especially majority shareholders - prevail over those of others - especially minority shareholders.

Good governance is therefore about ensuring the fair distribution of created value by giving everyone what is rightfully their s [see footnote 4]. This includes, among other things, treating employees, customers and suppliers fairly, respecting social standards, preventing the imposition of negative externalities on third parties and contributing to the enhancement of the society in which the company operates.

Put like that, it may sound like an easy task. But it is not. Just look at the example of some recent corporate disasters and how they resulted from the appropriation, or attempted appropriation, of a disproportionate and undue share of the value of the companies by one or a few shareholders, at the expense of the others and of other stakeholders. And how, as a result, some parties have even been totally deprived of what they are entitled to, or have had to pay a disproportionate share of the burdens resulting from the disaster.

Or the cases of companies with polluting activities, or with sanitary deficiencies, which pass on to society the costs of remedying their damage, while they exclusively appropriate the results. Or, if we consider more recent examples of the international financial crisis, cases of financial institutions that, having privately appropriated for their shareholders and managers the results - often artificially created at the cost of sophisticated accounting and financial gymnastics - ended up making their survival - and, therefore, the safeguard of all other associated interests - dependent on the assumption of heavy costs by taxpayers.

Therefore, and to be more precise, good governance should ensure that no shareholder, minority or majority, captures the management of the company in his favour, at the expense of the others (especially minority shareholders) and other stakeholders. Likewise, it should ensure that shareholders do not misappropriate - through direct or indirect forms - value that would be due to the other stakeholders. Not forgetting that one of the ways in which value can be "diverted" from a company by one or more shareholders is through the realisation of that value, due to the company, in other companies or organisations, owned by them, where it is easier for them to capture it exclusively.

On the other hand, it should be noted that when speaking of value, this does not only mean directly financial value; it also involves intangible, private or social values, such as, for example, the environment or social order, i.e. respect for standards and ethically correct behaviour.

But there are other forms of improper and disproportionate distribution of company value that good governance should protect against. One of them is the possible appropriation by executive management, overlapping their own interests with those of the shareholders they are supposed to represent. A problem profusely treated in economic literature as the agency problem and the associated risk of the agent overlapping its preferred function with that of the principal, i.e., in this case, the shareholders. And, I would add, of the other legitimately interested parties.

Another is their intertemporal distribution, when the future (and sometimes the very sustainability of the company) is sacrificed to force the achievement of immediate results. This usually involves taking excessive risks or reducing the capacity to create future value.

For protection, against these problems, it is fundamental that executive management be subject to permanent and committed supervision by agents, not only detached from that management, but independent of it. And for protection against the other forms of misappropriation of value by some parties, ensuring the fair distribution of that value, it is necessary that all, or a substantial part of those agents, be truly independent of all parties interested in the distribution of the value, and thus capable of exercising disinterested judgment in supervising executive management.

From my point of view, what I have just listed is the analytical foundation of the need for good corporate governance and the concerns it should address. And, I believe, it will also help to understand that the governance of private companies is associated with a social value, which goes beyond private interests, directly at stake in the life of the company, since not only does it interact with society, leaving its mark, but the articulation of interests on which its operation is based involves moral values, such as distributive justice, which are part of the social order.

In this way, and with important social values at stake, the grounds are also established for society to have the right, through its political representation, to regulate the governance of companies, conditioning the choices and room for manoeuvre of their owners.

Practical Corollaries

Moving from theoretical conceptualisation to the practical field, and insofar as governance is embodied in a series of structures and processes, it is important to start by retaining some practical corollaries of that conceptualisation. Thus:

- Governance must, as is already generally accepted, contain two clearly separated functions: an executive function and a supervisory and control function;

- The supervisory and control function should be equipped with the capacities - members and powers - that guarantee the practical effectiveness of the function, enabling it, in particular, to prevent undue or objectionable actions;

- To ensure effectiveness in protecting against unfair value distribution, or the capture of management by shareholder parties, the members of the supervisory and control function should be, for the most part, independent from the parties involved and offer guarantees of autonomy of judgement and opinion;

- In order to prevent capture, and to avoid that the interests of the agent - executive management - override those of the principal - the body of shareholders -, it is necessary for the executive leadership to be directly accountable to the supervisory and control function (in this regard, one should recall António Horta Osório's criticism referred to in the introduction to this article);

- For the same reasons, the leadership of the supervisory and control function should not be cumulative with the leadership of the executive function, and should preferably be performed by a member independent from the direct stakeholders.

3 pillars of Good Governance

Respecting the corollaries explained above, good governance is achievable in practice through three fundamental pillars:

1. An adequate model of standards and procedures

The first pillar is the easiest to achieve, at least in its enunciation, as it only requires good regulatory rhetoric. The failure that is often associated with it, however, is related to the (lack of effectiveness in) adherence of practice to the statements, which stems from the failure of the other two pillars.

2. A careful selection of suitable persons for the competent populating of the organs of governance

The second pillar is the most important, because people, with their technical and ethical skills, are the crucial component of good governance. Therefore, and in order for this pillar to be truly effective, it does not stop at compliance with formalities, but requires, among other things, a transparent process of rigorous selection and scrutiny, and external certification of the conditions of independence for the positions where it is required.

The "Cadbury Report" was very peremptory on this issue:

"Given the importance of their distinctive contribution, non-executive directors should be selected with the same impartiality and care as senior executives. We recommend that their appointment should be a matter for the board as a whole and that there should be a formal selection process, which will enhance the independence of non-executive directors and make it evident that they will have been appointed on merit and not through patronage" [see footnote 5].

3. A culture of good governance

The third pillar is crucial for the effectiveness of the second because it contains the values that guide, or are expected to guide, the actions of those involved in governance. And it is known that it is on the misalignment of these values - between what should be and what is - that much bad governance is based. Its effectiveness, however, depends not only on what can be undertaken at company level, but on social morality (i.e. the values, and their gradation, prevailing in the society where the company has its social roots). Hence it is the most difficult to modify.

And if this pillar is not established on healthy bases, the second can hardly ensure its expected effectiveness, because people with more demanding values, and who try to go against the socially dominant morality on their own, will be more easily centrifuged from the system than they can impose themselves on that morality. That is why the Basel Committee on Banking Supervision, in the recently released (July 2015) Principles of Corporate Governance for Banks, recognises that:

"A key component of good governance is a corporate culture of reinforcing appropriate standards for responsible and ethical behaviour."

It is not easy to change social culture. It is very difficult for change to occur spontaneously, unless it takes a very long time. That is why relying on self-regulation to achieve such a result seems unwise to me. More rapid changes, at least in the effects produced, are normally only achieved with incentive and penalty systems that become inducers of effective behavioural changes. For example, uncontrolled parking on the pavements in Lisbon, which until not many years ago was the general norm in the city, was only effectively contained when the city council put up bollards in many places and enforcement of illegal parking, which became a business, became widespread. Few would doubt that if these two instruments are removed, uncontrolled parking will once again become the norm.

Therefore, cultural change in corporate governance will only be effective in a reasonable timeframe if certain behaviours are imposed through regulation, through principles and rules, processes and procedures, sanctions and eventual preferential treatment in regulatory and institutional relations for those who comply.

And on this subject it is not worth putting too much effort into trying to invent what has long been invented. The subject is more than studied and there is sufficient experience of good practices, so that it is enough to simply copy those experiences, as in a trivial benchmarking exercise. The United Kingdom, with codes that are simple in their wording but vast in their content, and contemplating different situations - from large companies to small and medium-sized listed companies to unlisted ones - is, perhaps, the experience from which one can most profit, especially if one is aware that time is short. For my part, and without prejudice to further research, I would recommend the immediate adoption of the following documents of the United Kingdom's Financial Reporting Council: The UK Corporate Governance Code and Guidance on Board Effectiveness.

In any case, the quality of corporate governance will certainly be much better if:

- If making the supervisory (non-executive management) function truly effective, through its formal empowerment;

- Central to the board is thechairman, who should be independent and whose recruitment should be particularly careful and who should "demonstrate the highest standards of integrity and probity and set clear expectations regarding the company's culture, values and behaviours" [see footnote 6];

- If the chairman is not independent, institute the position of "Leading Independent Director" to lead and coordinate the independent directors;

- Formal mechanisms are established for the rigorous and transparent selection of members of the non-executive management.

Does good governance guarantee the company's success?

Even so, it is reasonable to ask the following question: provided all the assumptions and conditions for good governance are scrupulously met, is it possible to ensure that it guarantees the company's success and prevents its eventual failure? No, of course not. Good governance is a necessary condition for success, insofar as it provides a favourable environment for it, but it is not a sufficient condition.

Entrepreneurial activity involves risks, as:

"Risk is to some extent at the heart of any business. Risks are taken in the pursuit of return. No system of governance can prevent mistakes from being made or can protect companies and their stakeholders from the consequences of mistakes" [see footnote 7].

In fact, governance is a work carried out by people, and people make mistakes. The opportunities for them to make mistakes can be minimised, but it cannot be guaranteed that they never make mistakes. On the other hand, good governance can minimise the risks of choosing wrong business strategies, but it cannot guarantee their elimination; and wrong choices can have very adverse consequences.

This vulnerability, intrinsic to the human nature of institutions, can be a source of inspiration for fallacious arguments against change and improved governance, arguing that there are no perfect systems and that all are fallible. But this type of argument, intrinsically reactionary, neglects a fundamental point (from which its fallacy derives). Since all human works are imperfect and unsafe, there is an abysmal difference between those that provide an 80% level of security and those that provide a 20% level. And in this, as in many other things, the quantity of good and bad results determines the quality of the system.

Again, the seminal work of the committee led by Adrian Cadbury was already illuminating:

"No system of corporate governance can be fully proof against fraud and incompetence. The test is how much these aberrations can be deterred and how quickly they can be brought to light. Crucial safeguards are properly constituted boards, separation of chairman and CEOroles , audit committees, vigilant shareholders and financial reporting and audit systems that provide complete and timely information" [see note 8].

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Notes

1- The companies underlying this analysis are those incorporated as public limited companies.

2- Report of the Committee on The Financial Aspects of Good Governance (Cadbury Report), December 1992 (paragraph 1.1)

3- Definition inspired by another, taken from http://www.succurro.com.au/articles/49-governance/85-what-isgood- corporate-governance-.html : "The most fundamental definition for corporate governance is based on the idea that an organization is essentially a nexus of contractual agreements between many parties for the purpose of achieving the organization's goals. These parties include shareholders, directors, managers, suppliers, employees, customers, financiers, government authorities, other stakeholders and the society in which the company operates. Whilst some of these contractual agreements are formal written ones, many are implicit. Likewise, some of these contractual agreements are financially based but many are not".

4- Note that the "right" referred to here is not necessarily the positivist right, but the philosophical concept of what is rightly due to each.

5- Cadbury Report (paragraph 4.15)

6- Financial Reporting Council, Guidance On Board Effectiveness (Chapter "The Role of the Chairman", paragraph 1.5)

7- Judge Owen, in "The HIH Royal Commission", Canberra, 2003

8- Cadbury Report (paragraph 7.2)