A New Era in Corporate Governance

Directors and investors are demanding reform. Companies had better prepare for it.

More progress has been made improving the governance of US corporations during the past couple of years than in the several decades preceding them. New reporting requirements that stock exchanges have ordered in response to high-profile scandals, together with tougher auditing standards under the landmark Sarbanes-Oxley Act, have pushed boards and managers to become far more diligent in preparing and reporting accurate financial information. Boards have also grown acutely aware of their responsibility to shareholders and of the consequences of failing to live up to it, so many have become more independent from management.

But our latest research on board governance in the United States indicates that directors and investors alike feel that, so far, reform has led to only modest improvement. Much more must change, they think, before high-quality board governance can be achieved.

Although the reforms so far have created more work for finance departments, as well as higher accounting expenses, the direct impact on executives and directors hasn’t been particularly troublesome. But the reforms now being demanded by investors and activist advisory groups will be much more of a burden. The investors and directors we surveyed want companies to move toward separating the roles of CEO and chairman, to make directors more independent and accountable, and to scale back and restructure executive compensation so that it is aligned more closely with the creation of long-term value.

It is perhaps understandable that these deeper reforms haven’t yet been pursued. As high-profile corporate abuses have unfolded, one after the other, most boards have become preoccupied with reassessing their responsibilities and implementing the new accounting rules. Although directors themselves shoulder a good deal of blame for the lack of profound reform, they join with investors in pointing to CEO resistance as a primary impediment to it. Certainly, few CEOs see the need for change. The US model of capitalism—with a combined chairman and CEO and a board comprising both insiders and independent directors—has worked well for many companies. So it is hardly surprising that CEOs have little desire to share their power or to sacrifice any of their stature or compensation.

Nonetheless, maintaining the status quo is probably a high-risk option. Investors seem intent on pushing a reform agenda—including regulatory change—that will make boards more responsive to their interests. Given the pressure from shareholders and the resistance from management, it will be up to boards to craft solutions that balance the expectations of all parties. Any failure to respond will leave boards more exposed to the investors’ ire and less prepared to handle a more challenging governance environment.

A Clear Split

In the summer of 2003 and the winter of 2004, McKinsey surveyed 150 US directors as well as 44 US institutional investors with more than $3 trillion in assets under management. (The surveys were undertaken in partnership with the Directorship Search Group and the Institutional Investors Institute.) Although the surveys were conducted 12 to 18 months after the passage of Sarbanes-Oxley, they revealed an even greater appetite for reform than did a comparable survey conducted in May 2002, just before the law’s enactment. (See Robert F. Felton and Mark Watson, “Change Across the Board,” The McKinsey Quarterly, 2002 Number 4, pp. 30—45.) For activist advisory groups, perhaps the most important item on the near-term agenda is splitting the roles of chairman and CEO.

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