Is the corporate governance model introduced in the early 1990s in the UK by the Cadbury code, and subsequently adopted in South Africa by the King code, redundant? In the wake of the global financial crisis, it would appear so.
Corporate executives have embraced this governance model, which is dependent on the "comply or explain" approach, with commendable rigour. A recent survey by Grant Thornton revealed that in the UK the FTSE 350 companies provide disclosure in their annual reports to comply with 91 percent of the provisions of the Cadbury code. In South Africa all listed companies have been obliged by JSE requirements to adopt the King codes.
However, despite this commendable commitment, the era of the "comply or explain" model has been dogged by governance scandals and crises.
The most damning indictment of this model is that so many of the high-profile culprits - think Marconi, Enron, Royal Bank of Scotland - that featured prominently in the various financial crises of the past decade had turned in excellent governance scorecards.
As the UK's Financial Reporting Council (FRC) remarked recently, the "comply or explain" approach allows companies the flexibility to deviate from the provisions of the code provided they explain to their shareholders the reasons for doing so. Shareholders are then expected to judge the explanation on its merits and either accept or challenge it.
This approach is in line with the theory that corporate executives do not own the companies but are agents acting on behalf of, and being accountable to, the shareholders who are the true owners.
So the "comply or explain" approach would seem to be an excellent system of governance except for one massive drawback: its effectiveness is wholly dependent on having sufficient investors who are willing and able to engage actively with the companies in which they invest.
The situation is further complicated by the fact that the vast majority of shares in listed companies are held by institutional fund managers on behalf of beneficial owners whose ranks include future or present pensioners, insurance policyholders, savers and unit trust investors.
In South Africa, where investment on the JSE is dominated by institutions, active engagement is extremely rare, with notable exceptions, such as the Public Investment Corporation (PIC), the Government Employees' Pension Fund (GEPF) and Element Investment Managers.
Many fund managers do claim to engage with corporate executives "behind closed doors" but it is impossible to determine the nature or outcome of such engagement. The generally low attendance at corporate annual general meetings, even to vote, suggests that the "behind closed doors" engagement is of an extremely limited nature.
Peter Butler, the chief executive of Governance for Owners and a member of Element Investment Managers' advisory board, is adamant that for the "comply or explain" model to work share ownership has to be at the centre of policy objectives.
"Comply or explain only works if shareholders monitor the behaviour of directors and make them accountable for their performance, but there has been no compliance mechanism so far to ensure that institutional or retail shareholders play their part," says Butler.
He adds that shareholder voting is not enough. "Share owners need to engage to make the company directors accountable."
Butler believes that the capital markets meltdown, the credit crunch and the global recession represent a failure of governance and ownership. "Whatever you think of Sir Fred Godwin of Royal Bank of Scotland, there was a vote by shareholders approving the purchase of ABN Amro," he says.
And while auditing firm Ernst & Young may have done nothing wrong at Lehman Brothers, Butler remarks that "if they did not do anything legally wrong this is surely proof that audit is not fit for purpose", adding: "The auditors are the agents of the shareholders."
The inevitable conclusion for Butler is that institutional fund managers and the beneficial shareholders on whose behalf they operate must share a significant amount of responsibility for the meltdown.
This is also the view of Sir David Walker, who was appointed by the British government to investigate the governance of financial institutions in the wake of the financial crisis.
In his report last November, Walker concluded: "There is a need for better engagement between fund managers acting on behalf of their clients as beneficial owners, and the boards of investee companies. Experience in the recent crisis phase has forcefully illustrated that while shareholders enjoy limited liability in respect of their investee companies, in the case of major banks the taxpayer has been obliged to assume effectively unlimited liability.
"This further underlines the importance of discharge of the responsibility of shareholders as owners, which has been inadequately acknowledged in the past." In addition, "there should be clear disclosure of the fund manager's business model, so that the beneficial shareholder is able to make an informed choice".
As a result of his findings, the British government requested the FRC to take responsibility for the sort of stewardship code that was at the heart of Walker's recommendations. The FRC has drawn up a consultation document and has requested comments.
In South Africa, the Institute of Directors, following an initiative by the PIC, GEPF and Element Investment Managers, has set up a working group to develop a code for responsible investing to address similar issues.
David Couldridge of Element Investment Managers says the initiative was prompted by the realisation that King 3 made no reference to shareholder responsibilities. "We are of the opinion that an 'apply or explain' code of governance requires the active involvement of institutional shareholders who have invested in an effective system of corporate governance."
Butler reckons that government involvement is a necessity because the conflicts of interest within the financial services industry "mean that radical changes just will not happen without government establishing the framework".
He believes the business model of asset managers is not aligned with the interests of share owners. For many of them, shareholder engagement is seen as a "peripheral activity, a cost centre that does not drive fund managers' profits." These passive shareholders get a free ride on the actions of the active shareholders.
In addition, the natural inclination to be passive is encouraged by the fact that so many institutional investors make money from share lending, which completely undermines the ability to be an active shareholder. This adds to the cost of the sort of responsible ownership that is needed to ensure the capitalist system works best for the largest number of people and not just the market players.
Harnessing shareholder activism effectively will also have to overcome the fact that shareholders are an extremely diverse group. They vary from being short-term gamblers in a casino economy seeking a fast buck, to long-term shareholders keen to develop sustainable corporate value.
Research shows that up to half of shareholdings are based on the application of mechanical formulas and result in ownership that varies from permanent to mere nano-seconds. (The recent brief collapse of global equity markets was the result of the application of mechanical formulas.)
There is also the considerable problem from a regulatory perspective that in a global financial community, a substantial bloc of shareholders is international and beyond the jurisdiction of any one government. In the UK it is estimated that British institutional shareholders only account for about 25 percent of the equity market.
Butler believes the solution should not only involve a government-backed code but also some form of reward for active shareholders. He talks about a levy on funds or on capital market transactions or even a levy on public companies to pay for stewardship programmes. "In the UK it could be administered by the FRC tasked with ensuring that share-owner stewards do comply with new strong stewardship codes and are rewarded for their efforts."
And given the potentially large rewards from short-term trading activities Butler argues: "Taxation may be needed to alleviate the problems of short-termism; maybe changes to capital gains tax rates or introducing stamp duty on stock lending."
Butler also talks of creating two classes of shares with higher dividends paid to shareholders who hold for a long time and are actively engaged.
In summary, just three months after the launch of King 3, it is becoming evident that dealing effectively with corporate governance must involve shareholders, not only corporate directors and executives.