Governing Corporations in a Shrinking World

Assessing the SEC’s changing role in a world where corporations increasingly operate across-borders and globally.

February 22, 2006

Current political and economic issues succinctly explained.

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As corporations increasingly operate across borders, the rules regulating their behavior are becoming relevant to a rapidly growing pool of investors. Corporate governance rules can differ sharply from nation to nation, posing risks not only for investors but for companies seeking access to financial markets. Regulatory bodies across the world are now seeking to align global standards on accounting and other matters in order to increase the confidence of international investors and attract business to national financial markets.

Many experts agree a common set of broadly supported governance principles would be helpful, both as a model for countries trying to develop national corporate governance laws, and as a guide to help investors judge the laws of countries in which they invest. But they acknowledge the difficulty in reaching this goal. Regulatory bodies like the U.S. Securities and Exchange Commission (SEC) are instead focusing on "converging" standards to add flexibility to market structures while maintaining some essential national rules.

According to a 2002 CFR special report by James Shinn and Peter Gourevitch, encouraging corporate governance standards abroad is more than just good business—it’s also good foreign policy. Solid standards, the report says, "defuse many trade disputes and reduce the likelihood of destabilizing financial meltdowns," something which benefits all Americans, not just those with direct holdings overseas.

Are there international governance principles?

In 1999, the Organization for Economic Cooperation and Development (OECD) published a lengthy set of corporate governance principles (PDF), endorsed by ministers from many of the world’s leading economies. These were intended as a framework for legislative and regulatory projects, both within OECD member states and internationally. Other governance groups have followed suit. The International Corporate Governance Network (ICGN), a U.K.-based group, issued its own set of principles in 2004, adding to what it called the OECD’s "minimum acceptable governance standards."

What do statements of principle mean, in practice?

In the eyes of many experts, the OECD and ICGN principles are little more than academic guidelines because they aren’t binding. “In my view, they don’t mean a whole lot, practically,” says Gourevitch, whose recent book (also co-written with Shinn) was the topic of this CFR meeting. “I wouldn’t say that they’re meaningless, but they’re only meaningful to the extent that some investors use them as pressure. That’s the optimistic model.”

In other words, principles that aren’t binding can only have an effect if shareholders refuse to invest in companies that do not meet those principles. That kind of pressure would require some of the world’s biggest institutional investors, organizations like CalPERS and TIAA-CREF, to throw their weight around. “The key players in this game are going to be the large institutional owners,” says B. Espen Eckbo, the founding director of the Center for Corporate Governance at Dartmouth’s Tuck School. “Especially pension funds. They look at themselves as having a longer time horizon than the average mutual fund, so I think the disciplinary effect of pension funds is going to be a growing factor.” There is currently some institutional pressure for companies to adhere to internationally recognized governance principles, experts say, but the process is just beginning.

Is the U.S. corporate model the world’s preeminent model?

No. The so-called Anglo-American corporate model, which is based on broad ownership by minority stockholders, is not shared around the world. In fact, it is the minority model. In the rest of the world, corporations more commonly feature block ownership, where executives control a significant percentage of the company’s stock. This means American corporate governance concerns do not neatly parallel those of other nations. "In the U.S. and U.K., the key corporate governance issue is managerial incentives, while the key issue in most other countries is whether the controller’s interests are aligned with those of minority shareholders," says Allen Ferrell, a Harvard Law School professor who also serves on the National Association of Securities Dealers’ (NASD) economic advisory board.

What arguments support globalizing accounting standards?

Foreign corporations often have strong incentives to meet American accounting standards, including the desires to tap enormous U.S. capital markets and to trade on American stock exchanges. Stock exchanges have financial interest in attracting companies to list with them, so the accounting standards they impose tend to be relatively easy for companies incorporated in that country to meet, experts say. But discrepancies in foreign accounting standards have made it difficult for companies incorporated outside the U.S. to list on American exchanges, particularly in the wake of the Sarbanes-Oxley Act of 2002, which tightened requirements on firms operating in the United States. Companies listed on the New York Stock Exchange (NYSE), for instance, are required to conform to GAAP, or Generally Accepted Accounting Principles.

The "Generally Accepted" in GAAP means generally accepted in the United States. International companies, such as Nestle, which operate in accordance with different, non-GAAP standards of accounting, often find GAAP requirements to be a major barrier to getting listed on U.S. stock exchanges. Nestle’s stock currently trades on a relatively new exchange called Virt-X, a Swiss-owned electronic exchange, operated out of London and intended to feature "pan-European blue chip" stocks.

"This is biggest issue that’s being debated right now at the SEC," says James P. Dougherty, CFR adjunct senior fellow for business and foreign policy. "Do you force international companies to produce standards in an American format, or do you allow them to do it in international formats?"

Is the SEC working to create convergence in accounting standards?

The SEC is working to make listing requirements more flexible for international companies, in recognition of the fact that the lines dividing U.S. and non-U.S. companies are not as clear as they once were. "The commission has indicated recently that it’s going to look favorably upon giving room to international companies to produce their earnings and results in [accordance with] international standards," says Dougherty.

A number of experts praise this potential course. "I think the requirement to reconcile foreign firms’ disclosures with GAAP is often a waste of time, so avoiding the need for such a reconciliation process would be desirable," says Ferrell.

But there is only so much the commission can do. While it has oversight over the private body that sets up U.S. standards, the Financial Accounting Standards Board (FASB), the FASB is no longer the sole major actor on the accounting stage. Some experts say the principles-based standards of the London-based International Accounting Standards Board (IASB) now apply more broadly than FASB’s rules-based standards.

Is convergence likely any time soon?

Ferrell is optimistic that change could come sooner rather than later: "I do think there is a sense (and some hope) that convergence in accounting standards is achievable in the near future." Dougherty goes so far as to suggest a specific time frame: "There could be a basic agreement on the most important aspects of an international agreement relatively soon. Five years could be realistic."

But Gourevitch says international agreements on accounting standards are a long way off. "Europe alone can’t agree on these, and the codes that exist become a framework for fighting," he says. Eckbo is similarly cautious. "Business culture in Europe is a little different," he says. "Standards are voluntary. Where the U.S. passed mandatory legal standards, Europe passed a set of recommendations. If you want governance standards to converge, you need to have some kind of uniform method."

Would this change the commission’s role?

Handling the international aspects of this debate would put commissioners in much more of a diplomatic role than they have historically known. The shift is already underway. "The SEC cooperates with the International [Accounting] Standards Board to try to broker compromises in terms of creating a set of standards," says Dougherty. "It’s working diligently to create this compromise [and] create one set of standards that are applied internationally."

Given the variation that exists in corporate structures, Eckbo says there isn’t one governance model that will work everywhere, and cautions that, at least so far as legal enforcement is concerned, "the SEC’s voice is not going to be looked upon as relevant in Europe." Ferrell echoes this. "There is meaningful variation across countries," he says. "When dealing with foreign companies, the optimal corporate governance regime might be very different than for the typical American firm." In other words, while some convergence and certainly some transparency may be desirable, it is unlikely that one reigning regulatory standard will be adopted any time soon.