The 'compliance industry' is going too far - Thought Leader - corporate governance

Chief Executive, The, Nov, 2003 by Jeffrey Sonnenfeld

'The whole subject of board function and corporate governance is becoming a cottage industry in recent years and there is a lot of superficial thought." That statement was made by Securities and Exchange Commission Chairman William Donaldson--two years before he assumed his post.

In a speech after taking office, Donaldson wisely cautioned, "A 'check-the-box approach' to good corporate governance will not inspire a true sense of ethical obligation."

Sadly, Donaldson's warnings have not been heeded. A tidal wave of simplistic "check-the-box" governance metrics is hitting chief executives. The House Finance Committee has actually welcomed this misguided profiteering. Reviewing the first year of the Sarbanes-Oxley Act, the committee applauded the growth of such firms as Institutional Shareholder Services (ISS) and GovernanceMetrics International (GMI), which rate governance practices. The committee also commended the work of law firms that make money by pushing the uniform governance codes embedded in Sarbanes-Oxley.

Yes, it's true--governance has become the new "new thing." Management consultants also are jumping into the fray. Forget the New Economy, knowledge management, Y2K, business-process reengineering and TQM--governance is where the action is. Any moment, we'll see motivational speakers Tony Robbins, Depak Chopra and Steven Covey fold governance into their gigs.

Superficial thought is becoming institutionalized as great companies are disparaged for such practices as: failing to split the chairman/CEO roles; allowing former CEOs to sit on the board; not imposing a retirement age for directors; and tolerating large numbers of inside directors. Ironically, Enron, WorldCom and Tyro would have, on the surface, satisfied many if not all of such criteria. There is not only no research to support these governance myths--there is growing research that supports possible opposite conclusions.

The quality of governance, it turns out, doesn't necessarily hinge on structural mechanisms. It has more to do with issues such as trust and candor, the integrity of the board and management, accountability for decisions, tolerance for dissent and regular self-assessment.

The metrics assessed by ISS and GMI do not correspond to these governance outcomes, let alone superior reputations or financial returns. In fact, the lowest-rated companies by GMI include Wal-Mart, Dell, Southwest Airlines, eBay and UPS. Higher ranked, ironically, were such firms as HealthSouth, AOL Time Warner, Citigroup, AT&T and Merrill Lynch in their troubled earlier days.

Of near equal concern as the lack of accuracy of these metrics is the appearance of conflicting interests by the firms selling these instruments. Unlike truly independent ratings such as those by Consumer Reports, these firms treat client companies differently from non-clients. GMI clients are assessed on a much richer array of metrics and only GMI clients can correct errors on the reports. Firms rated by ISS cannot raise their scores on some opaque dimensions unless they become clients and have their scores interpreted.

Lucrative businesses have exploited the reform legislation far beyond the framers' intent. For example, Section 404 of Sarbanes-Oxley requires the audit committee to annually attest to the adequacy of the company's internal controls. It explicitly does not require a fresh audit by an outside accounting firm. But audit committees are now being held hostage by accounting firms and law farms advising them to conduct these reviews.

In short, costly uniform metrics are being introduced to please the commercial interest of consultants, lawyers and accountants. As the Senate Finance Committee begins its review of Sarbanes-Oxley and the Public Accounting Oversight Commission turns to these topics as well, we can only hope that Washington will begin to recognize that the "compliance industry" is going too far.

Jeffrey Sonnenfeld is associate dean, Yale School of Management, and president of Yale's Chief Executive Leadership Institute.