Codes of Corporate Governance

Photo courtesy of Diligent InsightsOpens in new window Codes of corporate governance often serve as a regulatory policy. Codes deal with the practical aspects of corporate governance such as the composition of the board of directors; its role and responsibilities; and communications with shareholders and other stakeholders.

Hong Kong is usually cited as the first country to formally issue a code of corporate governance in 1989 (although a code-like document was published in the United States in 1978) (Small 2011, p. 133).

Ireland was the next country to introduce a code in 1991, which was closely followed in 1992 by the UK’s influential Cadbury Code.

After this there was an amazingly fast diffusion of these codes worldwide: Aguilera and Cuervo-Cazzurra (2004) noted that there were 24 countries with codes in 1999; and López-Iturriaga (2009) reported 63 countries with codes in 2008.

The trend has continued with 93 countries providing their codes to the European Corporate Governance InstituteOpens in new window in 2015. Cuomo et al. (2016) report that national code proliferation accelerated markedly after the issuance of the OECD PrinciplesOpens in new window in 1999.

Although the legal status of these codes varies from country to country, in the large majority of nations they exist as a form of soft law (keay 2014).

This means that codes of corporate governance do not prescribe behavior but make suggestions, uptake of which is strongly encouraged but voluntary.

The most common regulatory mechanism used is known as comply-or-explain whereby the code requires disclosure rather than mandating specific practices. Companies must explain if they do not adopt a recommended practice but are permitted to choose.

This voluntary and flexible approach to corporate governance is justified on the basis that every company has different needs that change over time making a ‘one size fits all’ approach inappropriate (Cuomo et al. 2016).

The optimal structures and processes for any particular company will depend on contingencies such as size, ownership structure, industry and maturity (Lynall et al. 2003).

As a consequence, regulation is designed to give a high level of discretion to companies to permit them to adopt a governance structure that suits their particular needs whilst at the same time forcing accountability and transparency through disclosure (Cuomo et al. 2016). In this way corporate governance codes aim to achieve a balance between permitting flexibility and yet encouraging change.

Regulatory theories suggest that this kind of flexible regulation can engage companies to find cost-effective solutions to complex problems (Coglianese & Lazer 2003). However, whether companies fully make use of this flexibility is still open to question: early research on code compliance found a pressure to comply and a tendency for uniformity in corporate responses to codes (Klettner et al. 2010; Hooghiemstra & van Ees 2011). In contrast, recent research has demonstrated not only that code flexibility is utilized, but that it can provide financial benefits to shareholders (Seidl et al. 2013; Luo & Salterio 2014).

The theory behind the comply-or-explain mechanism is that adoption of good corporate governance practices will be enforced by the investment market.

Investors will assess the information disclosed in corporate governance statements and choose companies with good governance over those without. However, several researchers have found that investor engagement over corporate governance has been much less active than expected (MacNeil & Li 2006; Arcot et al. 2010; Keay 2014).

Governments are grappling with how to improve investor engagement, with some countries adopting additional ‘stewardship’ codes for investment organizations (Cheffins 2010). Nevertheless, adoption rates of corporate governance code provisions are generally very good, suggesting that investor engagement may be only one of several elements encouraging code adoption. Certainly, there is a pressing need for more research investigating the purpose and effectiveness of codes including assessment of their content and how they work.

Research on Codes of Corporate Governance

International comparative studies regarding codes of corporate governance have been relatively few and far between. In fact, the only commonly cited study dealing with a significant sample of countries was completed at a law firm in 1998 – 1999 and developed into a report for the European Union in 2002 (Gregory & Simmelkjaer 2002; Aguilera et al. 2009).

With the fast spread of codes worldwide it seems the task of comparing their content has perhaps become too large. López Iturriaga (2009) includes detailed coverage of 20 countries in his edited book, taking into account their differing national, legal and institutional settings. There have also been reports by professional service firms including a review of European codes by the law firm Clifford Chance in 2011.

Scholars have recognized that academic research has lagged behind the fast development of codes of corporate governance (Aguilera and Cuervo-Cazurra 2009). This has two consequences: first, code recommendations are not necessarily based on a sound understanding of the role of the board and its influence on company performance; second, research on the theory behind comply-or-explain corporate governance codes is scarce, and we do not fully understand how this mechanism functions (Seidl et al. 2013; Seidl 2007; Aguilera & Cuervo-Cazurra 2009).

With regard to the first point — there is only scattered academic work questioning the substance and content of corporate governance codes and whether, and in what circumstances, adoption of recommended practices has valuable outcomes for corporations and their stakeholders (Fineold et al. 2007).

As Finegold et al. put it, ‘there is, at best, weak guidance for policymakers on what governance practices will lead to more effective firm performance’ (2007, p. 865).

On the second point — other than several surveys of compliance rates, the fact remains that ‘very little scholarly research has been carried out on how the comply-or-explain mechanism functions in practice’ (Seidl et al. 2013, p. 792).

Seidl states: ‘Although codes of corporate governance have come to be widely used as a mode of regulating corporations, our understanding of how they function is still rather limited’ (Seidl 2006, p. 1s).

As introduced above, we do not fully understand why companies voluntarily adopt code provisions or whether they take full advantage of the flexibility inherent in the comply-or-explain system. Even the Organization for Economic Co-operation and Development (OECD), which has published Corporate Governance Principles since 1999, has made the statement that:

Although voluntary codes and principles have the advantage of maintaining flexibility and avoiding excessive and costly legal and regulatory measures, the question of their effectiveness does arise (OECD 2004, p. 52)