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The wild, wild world of compliance

Tracy E. Houston //January 20, 2012//

The wild, wild world of compliance

Tracy E. Houston //January 20, 2012//

Blind Compliance or Effective Compliance

Just when you thought that the world of corporate directors could not be more complex and challenging, the meltdown of 2008 brings in what may be an entirely new governance environment. Liability and the regulatory consequences of the catastrophe have intensified directors’ concerns. Just a few years after the passage of Sarbanes-Oxley and its instillation of a “compliance mindset,” we find ourselves in another crisis!

The question naturally arises: will greater levels of compliance and the more attention to regulatory nuances in decision making lead us to a better future? Directors have always been charged with oversight of their company’s business strategy and assessment of the risks involved. Extensive regulatory compliance does not build business nor does it shed much light on the risks and assumptions that underlie most business strategy.

Thoughtful examination of the effectiveness of regulation and best practices codes is clearly needed. In this context, it may be useful to look at the civil law jurisdictions of European countries. I recently interviewed an American businessman who is was chairman of the board of a Norwegian company. Norwegian codes of practice are less definitive than US regulations, and directors are therefore obliged to interpret the law in order to apply it, and to explain their interpretation to investors. Because a company is not bound to act in a rigidly specified way, a director such as this chairman must contact a variety of experts to understand current practice and how to interpret them, then explain [to investors] the reasoning for the course of action. Arguably, this approach requires more business judgment and thus deeper engagement on the part of directors.

His experience in Norway offers insight into decision making in two environments, contrasting what might be called the “apply and explain” philosophy of the civil law system to our U.S. approach, which is increasingly “comply or else” Are there advantages of ‘apply or explain’ versus ‘comply or else’ when it comes to how a company board should work? With the comply or else approach, a compliance mode or box ticking mentality can override deeper conversations around strategy and risk. An apply or explain approach requires more informed dialogue on the board’s part. While some parts of the economy may need the protection of a set rules approach, the shortening of business cycles and complexities of a global market require a real time approach to strategic planning and risk assumptions.

Arguably, the best interests of a company require that a board evince the flexibility needed to compete and build rather than simply protect value, and this truism argues for effective compliance over blind compliance. What may appear to be a subtle difference in emphasis reflects a profound shift in emphasis when boards must act. In the comply mode, the general counsel can advise a board how to comply and decision making starts from that point. When the apply approach is dominant, boards have to work harder to assess how the strategic plan will succeed in the dangerous waters of business.

The prudence of particular risks to build value is clearly on the table in the apply mode. The board’s level of expertise is put into use or put into question. In the apply mode, the questioning rigor about the business of business not the business of governance is increased. In other words this is a time when excessive compliance can stifle innovation – the creation of value as well as too high a level of debt (excessive risk) can lead to inefficiencies in the market – think of the mortgage crisis in the US. The need for thought leadership, not ideology, as to when and why markets work has clearly never been more important.

A comply mode turns the perceived gray areas into black – a comforting but potentially costly approach. In its focus on how the rules have been violated, a hardened approach to compliance and enforcement tends to put less emphasis on the more difficult assessments of company strategy and its underlying assumptions . Inevitably, such an approach knee jerks into more regulations to define a playing field which may have little resemblance to the world of increasing unknowns in which business must be built.

Informed dialogue on company strategy and risk draws out the potential, the greater wisdom of the board and the importance of its oversight role. Comply or explain can dumb down a board and its shareholders by causing undue attention to the less complex issues of compliance rather than to strategy. For stakeholders, opportunities to understand the components of strategy and risk and create an informed dialogue with the board are diminished, not increased, by the diverted focus of the world of “comply or else.”

What the Norwegian company chairman described was a change in the mindset and boundaries of judgment under Norway’s different approach to corporate governance. He is clear that the goal of both systems is the same – to create shareholder value. What is different is that the field for the exercise of a board’s decision making is larger and less prescriptively bounded.

Arguably, the effect on the quality of the Board’s deliberation is necessarily enhanced. On a football field whose goal posts are farther out, any pass that is thrown has to have the momentum to reach a longer distance. The necessity of sound decision making and business judgment is still very present, but the input from legal counsel does not play the same part. My interviewee summed up his experience in this manner: US directors – and legislators — need to ask questions about whether quantity of regulation equates to quality.

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