Improving Governance Performance: Rules versus Principles

There is a debate running through the governance world about how to improve the level of trust communities place in the governing bodies of companies, charitable corporations, Indigenous communities, professional associations and much else. The highest-profile version of it plays out in securities regulation, with other kinds of organization taking their lead from there. To many directors, the argument can look detached from day-to-day responsibility. It is not: understanding the positions and the reasoning behind them should help any board develop policies and practices that improve its own transparency and strengthen community trust in its organization's leadership.

First and foremost, this is about restoring trust

The fallout from a continuing sequence of transgressions by senior figures, each duly exposed in the media, is a general deterioration in the trust ordinary citizens place in people occupying positions of power, influence and community responsibility.

The specific cases of the period need not be relitigated here, and this article will not name them: they included executive compensation arranged without proper authorization, large-scale accounting fraud, kickbacks in public procurement, directors who claimed no knowledge of what their own company was doing, extravagant perquisites approved by boards at publicly owned utilities, institutional failures to act on serious abuse, improper fundraising and receipting by registered charities, and trading abuses in retail investment funds. Each revelation lands on the public conscience and trust in governors and governance takes another hit. Meanwhile conflict-of-interest problems at the governance level continue to surface as an almost everyday occurrence.

So the question for those who are trustworthy and of good character is how to restore what has been lost, so that the already difficult work of governing can proceed. Broadly, two answers are on offer: set out new rules for ourselves and our colleagues to follow, or agree stronger principles and hold ourselves to them.

A difference of faith

Underneath the technical argument is something closer to a difference of belief about people.

The rules-based position holds, in effect, that behaviour must be specified, because where discretion exists it will eventually be abused, and because a standard that cannot be tested cannot be enforced. The principles-based position holds that behaviour must be reasoned from intent, because rules can be complied with in letter and defeated in substance, and because no rulebook can anticipate every circumstance in which judgement is required.

Both positions are held by serious people, and both are responses to real failures.

The value and the challenge of a rules-based approach

Rules have obvious virtues. They are clear. They are testable. They apply identically to everyone, which makes them defensible and reduces the scope for arbitrary treatment. They allow an auditor or regulator to reach a determination without adjudicating anyone's motives. For directors, they answer the question of what is expected without ambiguity.

The difficulties are equally well known. A rulebook grows, because every failure produces a new rule and no rule is ever removed. Compliance costs rise, disproportionately for smaller organizations, and can consume the board time that governance actually needs. Worse, rules invite a compliance mentality: the question becomes whether an action is permitted rather than whether it is right, and a determined party can usually construct an arrangement that satisfies every rule while defeating the purpose of all of them. And a rulebook is always written against the last failure, never the next one.

The value and the challenge of a principles-based approach

Principles have the reciprocal profile. They are durable, because they do not depend on anticipating specific circumstances. They can be applied proportionately to organizations of very different size and complexity. They ask the right question - what is the purpose here, and does this serve it - and they place responsibility for the answer on the board, which is where responsibility for governance belongs.

Their difficulties are real too. Principles are harder to enforce, because reasonable people can reach different conclusions in good faith. They can shelter poor practice behind a claim of considered judgement. They demand a level of competence and integrity from directors that cannot simply be assumed. And they place a great deal of weight on the comply-or-explain discipline: where explanation becomes formulaic, a principles regime degrades into a rules regime with worse enforcement.

Putting the debate to good use

A board does not have to resolve the argument at the level of national policy in order to profit from it. The useful move is to run the distinction across the board's own work and ask, area by area, which instrument is doing the job.

Where the board's requirements are clear, testable and universal - signing authorities, conflict declarations, meeting quorums, reporting deadlines - rules are the right instrument and should be written plainly and enforced without exception. Where the board's requirements turn on judgement - what constitutes an acceptable risk, when a matter is material enough to escalate, what candour in reporting to owners requires, how performance should be evaluated - principles are the right instrument, and the board's task is to articulate them well enough that a director can reason from them.

Applied across policy implementation, communication and transparency, and performance evaluation, the exercise usually reveals two faults. First, rules being used where judgement is unavoidable, which produces box-ticking. Second, principles being invoked where a plain rule would settle the matter, which produces inconsistency and, in due course, an incident.

Both approaches, in the end, aim at the same thing, and neither achieves it on its own. Trust is not restored by the instrument. It is restored by governing bodies that visibly do what they said they would do, and account for it afterwards.

Readers wanting to see the two philosophies side by side in practice can compare the G20/OECD Principles of Corporate Governance with the comply-or-explain construction of the UK Corporate Governance Code, and both against the prescriptive statutory approach taken by the US Securities and Exchange Commission in the same period.

The structural counterpart to this argument is Issue 21 on models of governance, and the disclosure counterpart is Issue 8 on transparency. The full library is in the Leadership Acumen archive.