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SPEECH
13 July 2005
THE
ECONOMIC SOCIETY OF SINGAPORE ANNUAL DINNER
WEDNESDAY 13 JULY 2005
“SHAREHOLDER
VALUE: CORPORATE GOVERNANCE, BOARDS AND CEOS”
Dr Khor Hoe Ee, President,
Economics Society of Singapore,
Friends,
Distinguished Guests,
Ladies and Gentlemen:
As a wide-eyed 18-year old, I took up engineering on the assumption that it
is easier for an engineer to pick up economics than for an economist to pick
up engineering.
I had heard that it was pretty hard to find a one-handed economist who will
come to a definitive conclusion. An engineer, on the other hand, will make clear
decisions based on hard facts, logic and the realities of science and physical
laws. I thought I could help build a better world as an engineer.
I soon learnt my mistake.
Role of Economics
Just as a set of accounting statements simply sums up a cascading series of
considered judgments at a point in time, the best of engineering too is a series
of trade-offs between desires and constraints, of judgments of the art of the
possible against the odds of the improbable.
Likewise, economics can provide a practical framework for public policy and
cost-benefit tradeoffs that can impact the lives of people for better or worse.
Sound economic policies, sometimes seemingly heartless, can form a sustainable
blueprint for a society’s development and well-being in a practical and
efficient way. The wrong economic policies, no matter how well intentioned,
will introduce distortions and serious misallocations of resources which will
ultimately subvert the good intentions in the most counter-intuitive ways.
Tribute to Economists
Tonight, I want to make amends for my youthful mistake to pay tribute to all
economists, and especially to those who have helped frame the pragmatic policies
and trade-offs for our society. They helped set Singapore on a path of progress
and development 40 years ago. Many in the audience tonight have personally experienced
the dramatic change in their own life times. Indeed, many Singaporeans graduated
from sleeping as children, together with several other siblings with feet tucked
under the one shared bed, to owning their own apartments where their own children
have their own beds.
In particular, I want to make special mention of Dr Goh Keng Swee, one time
deputy prime minister of Singapore, and the architect of Singapore’s economic
miracle. He recognized the role of human capital long before talent and human
capital became buzzwords in the vocabulary of management consultants. He reasoned
that if labour was the key, then China and India would have been leading economies
over the past few centuries. If resources were the key, then Africa would have
been a bright prosperous continent. And so, among his many bold ideas and innovative
initiatives, he pushed for the development of human talent and invested in education
as the key to unlock the potential of an impoverished population on a bare granite
rock.
Dr Goh was also very clear about the dangers of misguided good intentions. Do
not add more rules, he admonished his bureaucrats – there may be unintended
outcomes if you do not know what the market knows. In other words, Dr Goh believed
in leaving as a wide a space as possible for the market to operate instead of
fostering a dirigiste hand of micro-managing planners and regulators. That was
how a young democratic socialist government came to adopt a free market economy.
Elements of a Thriving Economy
Within a robust market economy framework, businesses can grow and thrive, people
can learn and earn a living, and communities can progress in harmony. However,
an economic framework is a necessary but insufficient condition for a society
to grow and progress in a fair, just and efficient manner.
To give substance to the dream and vision, several elements are needed: a clean,
honest government and an efficient minimalist civil service, to form the solid
foundation for the house; an innovative and dynamic business community, with
businesses and companies forming the bricks; and a value system of integrity
and honesty, which provide the glue and mortar to hold the bricks together in
a strong leak-proof structure. Within the walls, resilient family units, ethical
values, education, healthcare, justice and security form the pillars and rooms
to make the house a home.
This evening, I would like to share some perspectives on governance and shareholder
value, and the roles of board, mgt and CEO, as one vital component for a vibrant
economy in the context of a fast globalizing world.
The original business unit
The business firm or company is the basic productive unit of an economy.
In the hunter-gatherer phase of human development, the basic productive unit
is also the family – you eat what you gather or hunt.
As civilizations formed, you may increase your productivity by working co-operatively
in villages, clans or cities. You may even have pepper futures in India or paper
money in China. True, you may also borrow from your extended family or friends
to fund the caravan expedition, but the basic ownership structure was the individual,
with his family as his labour force.
Evolution of the modern business unit
The word of honour was very important. You judge whether to lend or finance
a major expedition, through your assessment of the integrity and capability
of the man you know directly. In the pepper trade of Malabar during the Zheng
He voyages of the 15th century, pepper traders of Cochin agreed on contracts,
put their hands together with brokers and accountants, and under the watchful
eyes of the Maharaja’s personal representative, recited the pledge “whether
the price be dear or cheap, we will never repudiate it or change it”.
Everyone was bound by the legal contract, and was morally bound by it as well.
And yes, the maharaja’s personal representative was an important part
of the governance and compliance system. The enforcer, as people would say.
In the absence of enforceable laws or the bounds of moral obligation, high interest
rates and strong-arm harassment tactics were the twin tools of trade for lenders
and investors to secure sufficient risk adjusted returns against potentially
dishonest or defaulting borrowers. This was why moneylenders in under-developed
societies got themselves the loathsome reputation of being loansharks, and gave
usury a bad name.
With industrialization, impartially regulated markets became the more efficient
process to bring strangers together as lenders and borrowers. Laws were enacted
to throw contract cheats and loan defaulters into jail. Banks grew in place
of loansharks as regulated intermediaries between lenders and borrowers.
Modern business organizations began to take shape. Strangers can subscribe to
shares, whether to fund a tea and spice expedition or to build a ceramic factory.
Unlike the owner chef deciding each year, based on his own sense of honour,
obligation and gratitude, how much of his restaurant profits to share with his
former boss who had given him retirement money to start his restaurant business,
the share owners of today’s world have formal and legal rights to the
profits and assets of the company through the bylaws and memoranda of articles.
Shareholders no longer needed to wait for the ship to return before they can
tote up their share of loss and profits.
Thus was born the idea of shareholders and shareholder rights in a modern business
enterprise.
Shareholder value in modern businesses
Strangers and shareholders, no different from owner founders or chef owners,
invest with the expectation of returns. Just as management and labour put in
effort in return for wages, shareholders put in capital in return for profits.
They take the first risk of loss, in return for the first right to the profits.
If there were no adequate returns, there will soon be no shareholders willing
to invest in the enterprise. Even government shareholders are entitled to a
proper return for their investments like any other shareholder. Their resources
may be larger and hence may seem limitless, and their investment horizons may
be much longer and hence their patience seems boundless, but without the same
discipline of expecting a proper return, governments and countries like individual
or institutional shareholders will eventually become paupers.
As enterprises grew and became more complex, owner founders began to recruit
beyond their family and coterie of friends. Specialists and professionals began
to form the core of business management. Some founders retired and passed leadership
not to family members but to unrelated but trusted and proven professionals.
Other owners sit on boards together with advisors, friends or partners to supervise
the company, leaving the day to day operations to professional management led
by a CEO.
And so emerged the modern business structure, with owners and investors as shareholders,
management as the operational executives, and boards as shareholder trustees
to guide, supervise and oversee management in order to create shareholder value.
The board as shareholder trustee
The issue of governance today needs to take into account the wide spectrum of
shareholder configurations, ranging from sole proprietors and family owned businesses,
to large corporations with diffused ownership.
The role of the board as a dependable trustee to safeguard shareholder interests
becomes critical. This is what is meant by the fiduciary duty of the board,
ie the duty as a trustee to act in the collective interests of all shareholders.
Take a simple example of a takeover situation: the management may choose to
preserve their jobs, rather than accept a bid which gives the best returns to
shareholders but lose them their jobs. This is known as the agency problem.
Of course, matters are usually not so simple. Some shareholders may prefer a
short term immediate gain, through the sale, while others may see more potential
for the company to grow further and derive better future income flows. Ideally,
the board should base its recommendations on a realistic assessment of the net
present value of the various choices available to the shareholders. But ultimately
the choice is for the shareholders to make, individually and collectively, at
a shareholder vote. This is the right of the shareholders, which neither management,
nor board, nor regulators should usurp.
A more common example of a board’s oversight role on behalf of shareholders
is the structuring of proper incentives for management. Again, the aim is to
align management to shareholder interest, perhaps with a balance of short and
long term incentives.
In this role, the board should be independent of management in order to undertake
this duty objectively. It is not acceptable to incentivise management at the
expense of shareholders. Thus, it makes eminent sense for a board remuneration
committee to be independent of management, rather than of shareholders. This
is also the reason why shareholders have the vote on directors’ fees and
compensation as well – to align the board too with shareholder interests.
In the recent case of a global investment bank, the shareholders would logically
and most certainly have made a different decision from the board on the separation
package for the high profile departing CEO. Many observers believe that the
board had failed to act in the interest of shareholders, and was compromised
by a misguided sense of loyalty and personal friendship to the CEO.
The CEO compensation issue becomes more involved in the case of family owned
companies. Often, the CEO in a family controlled company may also be the chairman
as well as owner shareholder. Thus, the owner chairman or owner director should
not be involved in the setting of CEO incentive or compensation. The issue is
not about having a compensation committee that is independent of the shareholder.
Rather, it is an important guiding principle that the interested beneficiaries
should not be party to deciding their own compensation for themselves. Hence,
the board remuneration committee should be free and independent of management
as interested beneficiaries, rather than being independent of shareholders per
se.
Conflicting shareholder interests
But shareholders are not a homogenous group. They are no longer simply friends
who trusted the founder and invested in him. Instead, you may have a complex
mix of institutional investors with professional investment expertise, small
retail punters interested in the next rumour to cash out, retirees looking for
reliable income flows, family or founder shareholders, management and staff
with stock plans, as well as short term hedge funds, long term pension funds,
and even competitors and others.
Thus, judging what constitutes shareholder interest may be tricky. A hedge fund
manager may bet on a directional movement of the share price in the event the
company runs into trouble. He has zero interest what happens to the company
so long as the directional movement gives him his returns for that week or month
or quarter. Others may arbitrage between competitors. While they serve a useful
function to seek out and eliminate the imperfections of the market, their interests
are by no means aligned with other shareholders.
Therefore, in the modern economy, you have a complex interplay of different
shareholders, board and management, with various inter-group and intra-group
conflicts of interests.
Critical board functions
The board in such a complex environment has 4 critical functions.
- Guidance & Direction
The first is to guide and direct management steadily, professionally and objectively.
In this role, the board will normally work closely with management to map out
strategies, spot gaps, critique plans, and to serve as a foil for the management
to bounce off and refine ideas. The board functions as an experienced guide,
friend and mentor of management by offering expertise, experiences and suggestions
to further the business goals of the company. It also makes decisions on strategic
choices, and takes responsibility for steering the business forward. In an emergency,
the board may even take over the executive role in a company.
- Independent management oversight
The second role of the board is to provide independent oversight of management
and hold management to task for delivery of results. This is the supervisor
role. Here, the board needs to be independent of management in order to maintain
its capability and capacity for objective judgment. They need to maintain clarity
between their friendship and loyalty to the CEO and management, either from
social or long association, and their fiduciary duty as the trustee of shareholders.
- Management evaluation and succession
Third, the board is responsible to ensure a strong management is in place. It
has the responsibility to both hire and fire the CEO, and determine his or her
incentive. This is by far the most sensitive, most awkward and yet most critical
function of the board. To do this well, the board needs to continually and regularly
assess management and succession options, and take an interest in getting to
know the different management levels beyond quarterly interactions with the
CEO. No board should be held to ransom by the CEO.
For boards which do not yet have a succession planning or CEO review process
in place, it can be awkward to raise this. The decision to fire a CEO too is
often taken too late, and usually after everyone else in the company and perhaps
the investment community have come to that conclusion. This is even more so
when the CEO is also owner and chairman of the board.
It is for partly for this reason, that it is ideal to consider a separation
between the office of the board chairman as the leader of the board acting independently
of the CEO, and the CEO as the leader of management. While it dents the ego
of the CEO a little, having a separate chairman position is a constant reminder
that the CEO and management team are ultimately professionals with a responsibility
towards their shareholders. Regular executive sessions of the board without
the presence of CEO and management allow the board to discuss CEO performance,
compensation and succession freely and frankly. It helps to keep a healthy distance
between the board and CEO.
Nomination committees are also very useful for the purpose of keeping the board
spry and relevant, and membership selection independent of undue CEO influence.
Of course, election of directors are the prerogative and right of shareholders.
Shareholders exercise these rights regularly at shareholder general or extraordinary
meetings. Thus, it is illogical to structure the nomination committee to be
independent of shareholders. Indeed, many of the failings of boards can be traced
to the failure to maintain objectivity and independence from a CEO, especially
one who has been seen to have delivered, or one who is dominant or a friend.
- Proper conduct and compliance
Fourth, the board has a duty to ensure that the company and management comply
with the laws of the land, and understand the risks of the business. Business
risks in the modern context typically extend beyond single location business
operational risks. It may include a complex range of exoteric financial and
structured risks, as well as compliance and regulatory risk in a multi-national
and multi-jurisdiction spread of operations. Since the board does not typically
get involved with the day to day operations, it can fulfill this role only by
careful attention to the systems and processes for compliance and risk management,
and by their judgment of management integrity.
- Integrity as the glue
Ultimately, the proper functioning of a board and management in a company depends
on integrity. This includes integrity at the institutional, professional and
personal levels.
The simplest level is honesty at the personal and individual levels, to know
what is personal and what belongs to the institution, and not to cheat and steal.
The second level is professional integrity – to have the courage to act
objectively and professionally, and keep the obligations of friendship and personal
loyalty separate from the call of professional responsibilities and duties.
This applies to both board and management as well as other professional service
providers and regulators.
Finally, institutional integrity requires an ethical culture within the board,
management and staff to walk the talk, and protect and add to the reputation
of their institution. Those who make use of institutional positions or reputations
for their own personal interest are guilty of destroying the institutional integrity.
Governance framework
As you can see, quite apart from the already difficult business of earning a
dollar from customers, day in day out, in a highly competitive and volatile
market, and growing your business in a rapidly globalized world, boards, managements
and CEOs have to manage a complex web of regulations and relationships through
thoughtful and professional governance processes.
As McKinsey defined in a 1996 survey, a well-governed company is responsive
to investors, and has a board that is sufficiently independent of management
to hold management accountable to shareholders.
- Level playing field
In other words, the purpose of modern governance is to protect shareholder interests
and rights, reduce conflicts of interest and enable fair treatment of all shareholders,
especially but not limited to minority shareholders. Discrimination against
major shareholders or family shareholders is based on the misguided hope of
preventing the inevitable few black sheep from making mischief. It is simply
not possible to legislate crime and risks out from business and society, unless
you stop everyone from doing anything at all.
- Substance over Form
Governance is not about ticking the rule box. In the Enron case, each transaction
in the chain fulfilled the rules of form, but taken as a whole, were entirely
improper in substance.
- Calculated risk taking
Like the caravans of old, modern business is about taking risks, in return for
rewards. It is not a straight line linear relationship between input and output,
efforts and results. The best designed system may not necessarily be the winner.
In every venture, there are market risks, execution risks, financial and economic
risks. Consumer fads are unpredictable, and timing and luck counts too. There
will be failures even with the best of intentions and the best of execution.
Therefore, corporate governance is not about the absolute reduction of risks.
Without risks, we will at best be looking at risk free returns of government
bonds and treasury bills, or returns from money kept under the mattress or in
the home safe.
Conclusion
In conclusion, as we continue to refine and modernize our governance guidelines
for the next phase of our development as a regional and global business hub,
it is even more important that we recognize and celebrate the presence and rights
of shareholders. They are the capital providers to drive investments, innovations
and returns. Family shareholders and individual entrepreneurs continue to be
the engine of new enterprise formation, and should be encouraged and applauded,
and not conscribed. Institutional shareholders drive value and professionalism,
and should be co-opted to help set professional standards.
Regulators must not believe they can micro manage the business better than the
market – or better than the boards and managements of the businesses in
the market – or better than the shareholders whose capital has been put
at risk. Indeed, regulators should put shareholders at the centre of the effort
to improve governance, be they major shareholders, institutional shareholders,
minority shareholders or family shareholders. All other players, whether regulators,
lawyers, accountants or academics, play a supporting role in driving for shareholder
value on a fair footing, much as the maharaja’s personal representative
did several hundred years ago in Cochin.
We should also not mix up the roles of the individual as shareholder, board
member and CEO, when formulating rules of engagement.
Most of all, let us not believe that form can replace substance. Rules cannot
substitute for integrity, nor can rules eliminate risks.
We need regulators to entrust the board and management with as wide a space
as possible to make their business judgments, manage their business and innovate
within the bounds of ethics – remember what Dr Goh said. The corollary
is that we do require regulators and prosecutors to punish criminal acts of
cheats and crooks out to defraud others.
When in doubt, we should simplify rules, instead of adding to complexity. And
let the market determine the outcome, under the active participation of shareholders
of all stripes and colours.
The market needs a simple framework that is clear and practical, with clear
principles of shareholder rights, and of substance over form. This helps to
foster thriving, dynamic and innovative businesses, more than any number of
speeches exhorting the business community to be innovative and grow boldly.
May I end by wishing all
of you good health and prosperity in the year ahead, and also congratulate the
winners of the MAS-ESS Essay Competition.
Thank you.