On Shareholder Democracy: what democracy?

The mid-nineteenth century vision of the joint stock, limited-liability company was exquisitely simple and superbly successful.  Ownership was the basis of power.  Shareholders appointed the directors, who reported regularly on their stewardship over the company. Shareholder democracy was based on one share – one vote. 

 Then something went wrong.  Directors took control.  As long ago as 1932, in research that is still among the most cited in the corporate governance lexicon, Berle and Means showed that power over public corporations in the United States had become concentrated in corporate boardrooms.  What happened to the original notion that power over a corporation should be exercised by the owners?  A similar erosion of shareholder power occurred in the United Kingdom, and indeed in most other countries whose company law reflected the old Commonwealth company law traditions.

 The UK Cadbury Report (1992) and corporate governance codes in other countries attempted to redress the balance by requiring board-level nomination committees, with independent non-executive director members, to put forward the names of potential directors.  But these non-executives, themselves, had been approved by the chairman and CEO, and owed some allegiance to them. The board then put their proposals to the members, who got to vote.  But incumbent directors effectively could re-appoint themselves and, when the time came, appoint their successors.  

 The shareholders of a UK public company can now call for a special meeting of the members, at which a simple majority can vote to remove any (or indeed all) of the directors.  Section 338 of the UK Companies Act 2006, broadly, enables members of a public company to require the company to give all shareholders notice of their resolution, provided they hold 5% of the total voting rights or total at least 100 members.  But the financial risk and uncertainty of such actions make them newsworthy.

 In the United States the situation is worse.  One share one vote still prevails, but the board decides which names get on the ballot paper.  The only way for outsider candidates to get nominated is through proxies circulated to all the other shareholders at the proposer’s expense.  This financial exposure results in most board appointments being uncontested, with incumbent directors keeping their seats around the board room table, with the attendant benefits, even though in practice only a small proportion of shareholders actually voted for them

 Attempts to persuade the Securities and Exchange Commission and state regulators to change the rules have been frustrated by aggressive lobbying from corporate director interest groups.  The latest attempt by the SEC to reform the system was put on hold earlier this year. 

Companies in the United States, of course, are incorporated by individual states. There are no provisions for incorporation at the federal level.  Many companies are incorporated in Delaware, because company law and the Delaware companies’ court tend to be sympathetic to their interests.  But Delaware company law was changed earlier this year to allow companies to reimburse the costs of circulating the names of outsider directors to other shareholders.

 A straw in the wind was reported in the Economist (31 October 2009).  The American company, HealthSouth, a company that runs private hospitals and clinics, which in the past has been criticized for poor corporate governance, changed its corporate governance rules to allow activist shareholders to propose candidates for election to its board.  The company even offered to cover the costs involved, if 40% of the votes were subsequently cast for the outside candidates. 

 In his clumsily titled, but brilliantly perceptive book Corpocracy (Wiley, New Jersey, 2008), Robert (Bob) Monks showed how modern corporations have maximized their wealth, balked at government regulation, and locked-out their shareholders, whilst the executives rewarded themselves with massive pay packages.  Shareholder control over large corporations, he argued, is weaker now than ever.  Not only are these corporations rarely held to account by regulators, they face even less control by those whose interests they are ostensibly there to serve. 

 Bob Monks feels that shareholders, particularly institutional shareholders, should attempt to influence corporate behaviour and governance for the benefit of all shareholders and society. He has called for the United States to adopt the British approach, with a federal statute that would give investors the right to call a special meeting to remove directors. 

 The Economist commented “in a healthy shareholder democracy, such a rule would not be controversial.”

 Bob Tricker

 

 

Divide and Conquer? Splitting the Roles of Chair and CEO

 It is widely recognised that corporate scandals and collapses often occur when there is a single powerful individual in control of a company.  This is exacerbated when there is a lack of independent non-executive directors on the board.  Therefore it seems axiomatic that powerful individuals can be constrained, and the temptations they may face conquered, by having in place a sound corporate governance structure achieved through dividing the roles of Chair and CEO.

UK Context

Back in 1992, the much lauded Report of the Committee on the Financial Aspects of Corporate  Governance, often referred to as the Cadbury Report after the Chair of the Committee, Sir Adrian Cadbury, identified the potential danger of combining the roles of Chair and CEO in one person.  The Cadbury report recommended ‘there should be a clearly accepted division of responsibilities at the head of a company, which will ensure a balance of power and authority, such that no one individual has unfettered powers of decision’.  This principle was embodied in corporate governance best practice in the UK, with the Combined Code on Corporate Governance (2008) stating ‘there should be a clear division of responsibilities at the head of the company between the running of the board and the executive responsibility for the running of the company’s business. No one individual should have unfettered powers of decision’, and furthermore the Combined Code explicitly states ‘the roles of chairman and chief executive should not be exercised by the same individual.’

Whilst combining the roles of Chair and CEO is rare in the UK’s largest companies, Marks and Spencer PLC is a notable exception.  In May 2004 Sir Stuart Rose was appointed to the position of Chief Executive and subsequently in 2008 he became both chairman and CEO until July 2011.  This combination of roles goes against the Combined Code’s recommendations of best practice.  As a result in 2008 some 22 per cent of the shareholders did not support the appointment of Sir Stuart Rose as chairman.  Nonetheless he remains in the combined role although there is still considerable shareholder unrest and 2009 has seen more dissent by shareholders on this issue.

US Context

In the US, the roles of Chair and CEO have often been combined but now more and more companies are appointing separate individuals to the two roles.  A recent example of a US company which has decided to appoint an independent chairman is Sara Lee, the famous producer of gateaux, beverages and body care products.  Sara Lee has decided to make this change as a response to investor pressure and also the growing trend in the US to split the two roles.  Kate Burgess (FT Page 27, 9^th October 09) in her article ‘Sara Lee to separate executive roles’ explores this case in more detail.

Institutional Investor Pressure

In the UK there has long been pressure brought to bear by institutional investors on companies which have tried to combine these roles.  This pressure, together with the long history in UK corporate governance codes against the combination of roles, means that few large companies seek to combine the roles (although as noted above, Marks and Spencer plc is an exception).

Recently Norges Bank Investment Management (NBIM), a separate part of the Norwegian central bank (Norges Bank) and responsible for investing the international assets of the Norwegian Government Pension Fund, has started a campaign to convince US companies to split the roles of Chair and CEO and appoint independent chairmen.   Kate Burgess (FTfm Page 10, 12^th October 09) in her article ‘Norwegian fund steps up campaign’ highlights how NBIM has submitted resolutions to four US companies calling on them to appoint independent chairmen.  The four companies are Harris Corporation, Parker Hannifin, Cardinal Health Inc, and Clorox.  In addition NBIM has also voted against combined Chair/CEOs at some 700 US companies.  Interestingly Sara Lee had also been the focus of action by NBIM before agreeing to appoint separate individuals to the roles in future. Also in Kate Burgess’ article, Nell Minow of The Corporate Library http://www.thecorporatelibrary.com/ states ‘NBIM can leverage a lot of shareholder frustration and a widespread sense that this is a sensible, meaningful but not disruptive initiative’.

Concluding comments

It seems to be only a matter of time before the vast majority of companies will split the roles of Chair and CEO.   Of course the individuals appointed to those roles must be both capable of fulfilling the tasks expected of them, and of ensuring that ultimately the two roles, carried out by separate individuals, unite the company under a common leadership approach.  That may prove more difficult than many imagine and so the appointments process must consider fully the many traits needed to ensure success.

 Chris Mallin 16^th October 2009

Corporate Governance in Japan – changes proposed but don’t hold your breath

Corporate Governance in Japan

            – changes proposed but don’t hold your breath

 Japan’s newly elected Democratic Party is planning to introduce a new law for public companies, according to Reuters (Tokyo 2 September 2009).  At least one third of their boards would need to be independent non-executive directors. Of course, this would do no more than bring Japanese board structures in line with those in many other countries, including China.  But it would mean a major shift in opinion and practice for most Japanese listed companies.

 The keiretsu networks in Japan, with companies connected through cross-holdings, inter-trading and interlocking directorships are well known. (Tricker page 90-1, 187-9)  Reflecting the social cohesion important to Japanese society, keiretsu emphasise unity throughout an organisation, non-adversarial relationships, lifetime employment, enterprise unions, personnel policies encouraging commitment, decision-making by consensus, and promotion based on loyalty and social compatibility as well as performance.

 Independent non-executive directors, in the Western sense, have been unusual.  Many Japanese executives do not see the need for such intervention “from the outside.”  Indeed, they have difficulty in understanding how outside directors operate. “How can outsiders possibly know enough about the company to make a contribution when the other directors have spent their lives working for the company” they ask?  “How can an outsider be sensitive to the corporate culture?  Surely they would damage the harmony of the group.”

 Traditionally, investors have played only a minor role in corporate affairs. Power lay within the keiretsu network.  There was no market for corporate control since hostile takeover bids were virtually unknown.   However, for the past decade, with the Japanese economy facing stagnation, traditional approaches to corporate governance have been questioned.  A 2008 report by the Asian Corporate Governance Association commented: (www.acga-asia.org)

“We believe that sound corporate governance is essential to the creation of a more internationally competitive corporate sector in Japan and to the longer-term growth of the Japanese economy and its capital markets. While a number of leading companies in Japan have made strides in corporate governance in recent years, we submit that the system of governance in most listed companies is not meeting the needs of stakeholders or the nation at large in three ways:

• By not providing for adequate supervision of corporate strategy;

• By protecting management from the discipline of the market, thus rendering the development of a healthy and efficient market in corporate control all but impossible;

• By failing to provide the returns that are vitally necessary to protect Japan’s social safety net – its pension system’

However, Tsutomu Okubo, a government policymaker, has suggested that the new bill will take three to four years to be introduced and at least another year to become law. Jamie Allen, Secretary General of the Asian Corporate Governance Association, believes that there will be strong lobbying against a mandatory requirement for independent outside directors.  Change in Japan comes slowly.

 Bob Tricker

UN Principles for Responsible Investment (PRI)

The UN Principles for Responsible Investment (PRI) were issued in 2006. The PRI were developed by an international group of institutional investors reflecting the increasing relevance of environmental, social and corporate governance issues to investment practices. The process was convened by the United Nations Secretary-General.  The PRI state: “As institutional investors, we have a duty to act in the best long-term interests of our beneficiaries. In this fiduciary role, we believe that environmental, social, and corporate governance (ESG) issues can affect the performance of investment portfolios (to varying degrees across companies, sectors, regions, asset classes and through time). We also recognise that applying these Principles may better align investors with broader objectives of society”.  http://www.unpri.org/principles/

Signatories to the PRI commit to incorporating ESG issues into investment analysis and decision-making processes; being active owners and incorporating ESG issues into ownership policies and practice; seeking appropriate disclosure on ESG issues by the entities in which they invest; promoting acceptance and implementation of the Principles within the investment industry; working together to enhance their effectiveness in implementing the Principles and reporting on their activities and progress towards implementing the Principles.

PRI Report on Progress (2008)

The ‘PRI Report on Progress 2008’ was published.  The report highlights progress made to date, special initiatives that have been undertaken, and areas for improvement.  Interestingly the PRI encourages signatories to disclose their responses to the annual Reporting and Assessment survey, and every year a number of signatories agree to make their responses publicly available.  The responses can be viewed at: http://www.unpri.org/report09/

One of the questions on the annual Reporting and Assessment survey asks respondents to rank the six principles on the level of difficulty of implementation of the principles.

There are currently 574 signatories to the Principles, comprising 183 asset owners, 282 investment managers, and 109 professional service partners. 

Aviva Investors is one of the signatories and their Head of Research and Engagement, Steve Waygood is quoted as saying: “There is now a critical mass of institutional investors who believe management of corporate responsibility or ESG issues is highly relevant to the long-term financial success of their investments”.

UN PRI Delists Members

The UN PRI recently delisted five of its signatories after they failed to report on their activities.  Sophia Grene (FTfm Page 6, 24^th August 09) in her article ‘UN Principles need sharper teeth’ states ‘it is a significant step forward for the UNPRI to demonstrate there are consequences to treating the principles as nothing but a brand-enhancer’.

Concluding thoughts

The UN PRI have taken some clear steps to hold its members (signatories) to account.  The UN PRI are also working on a transparency framework which, according to Grene, will give  ‘clients, customers, members and other stakeholders…a clear sense of their responsible investment processes, activities and capabilities’.   It will be interesting to see how the UN PRI evolve over time given the growing interest in this area.

Chris Mallin 24^th August  2009

Oxley of the SOX Act to chair business ethics group

Oxley, of the Sarbannes Oxley Act, to chair business ethics group

When, following the Enron debacle, Senator Sarbannes and Congressman Oxley co-sponsored the United States Sarbanes-Oxley Act (SOX) in 2002 their names, previously unknown outside America, became enshrined forever in the archives of international corporate governance.  The landmark Sarbanes-Oxley Act may have restored Americans’ confidence in the capital markets and in the process created a new accounting oversight board for publicly traded companies.

But what we had comfortably been calling the Anglo-American approach to corporate governance was shattered.  America now required corporate governance by the rule of law (obey the law or risk the consequences), whilst the UK and the Commonwealth countries, such as Australia, New Zealand, Canada, India, South Africa and many other jurisdictions still relied on self-governance (follow the corporate governance code or explain why you have not).

After a 25-year Congressional career, Michael G. Oxley has now retired from Congress, but maintains his interest in corporate governance.  Currently counsel in the Washington, D.C. office of Baker Hostetler and senior advisor to the board of NASDAQ, he has just been elected chairman of the board of directors of the Ethics Resource Center (ERC) – see www.ethics.org.  ERC is America’s oldest nonprofit, nonpartisan research organization devoted to business ethics and ethics in the workplace.

“I am proud to have been selected as the chairman of the board of the Ethics Resource Center, and I am excited by the opportunity to contribute to its mission,” Oxley said. “ERC is devoted to the study and practice of organizational ethics, a topic that has been at the forefront of my work for nearly a decade.”

Maybe business ethics is the new frontier of corporate governance.

Rethinking Corporate Governance

Sir David Walker’s government-commissioned review of corporate governance in UK banks and other financial entities was published on 16 July 2009, and a new acronym joins the corporate governance lexicon: BOFI boards: boards of banks and other financial institutions.

Britain has already produced more reports on corporate governance than any other country in the world. (Corporate Governance – principles, policies and practices, OUP 2009, page146). This is the tenth, if we include the UK combined code.  With 140 pages, Walker’s report is significantly longer than the first and paragon Cadbury Report in 1992 which had 90 pages. 

Walker believes that UK corporate governance should stay with the ‘comply with the Combined Code or explain why you have not’ principle.  No US corporate governance by law and Sarbanes Oxley Act for the UK.  

He concludes that the principal deficiency is the way directors behave.  They do not challenge the executives enough.  The right sequence in board discussion on major issues, says Walker, should be presentation by the executive, a disciplined process of challenge, decision on the policy or strategy to be adopted and then full empowerment of the executive to implement.  Yes.  One wonders what they did before.

A board structure needs the right mix of both financial industry capability and critical perspective from high-level experience in other major business, Walker concludes.  “Independence of mind is more relevant than formal independence.”  He also calls for a materially increased time commitment from non-executive directors. 

Leadership skills of the chairman of the board are important, too, Walker says, together with the “ability to get confidently and competently to grips with major strategic issues.”   So true.  One has only to read the Northern Rock case (Corporate Governance page 344) to see why.  The challenge to chairman is such that “the chairman’s role will involve a priority of commitment that will leave little time for other business activity.” 

The report calls for better risk management, with more attention to the monitoring of risk, with NED involvement in enterprise risk management, including risk strategies, quite separate from the work of the management risk committee.

Then Walker echoes a call heard many times before that shareholders should engage with the companies they invest in for long-term performance improvement. And the reaction is likely to be the same: some fund managers will continue their initiatives to improve governance and the rest will take the short-term view, voting with their feet when they feel like it.

Finally, Walker proposes that the “remit and responsibility of board remuneration committees be extended beyond board members to cover the remuneration framework for the whole entity.”  This is a response to the prevailing public anger at allegedly excessive executive bonuses and perceived rewards for failure. 

In other words, Walker calls for more of the same, only more so.  But as long as grandees of the City of London continue to write these reports, this is what we should expect. 

The metamorphosis of corporate governance will not happen until the 19th century concept of the limited liability company is rethought and brought in line with the reality of business in the 21st century. 

Alternatives that might be considered include:

• public companies to have realistic constitutions, which define and limit their objectives as society’s price for allowing their incorporation of the entity with limited liability
• a new governance structure – a governing body of independent directors appointed by the shareholders – not to run the company but to govern it
• this governing body to question the directors in public, scrutinizing strategies, policies and outcomes (as previously mentioned on this site)
• the external auditors to report to the regulators not the directors who appoint and pay them (as previously discussed on this site)
• developing a taxonomy for companies that reflects the way power is actually exercised over them

Voting – Having a Say

Voting ones’ shares is seen as one of the main tools of corporate governance.  In recent times, votes have been cast against adoption of the annual report and accounts, against the appointment, or re-appointment, of certain directors, and against certain proposed strategies.  Votes can also be used via the ‘say on pay’ to signal displeasure at executive remuneration packages.  Although the ‘say on pay ‘ (discussed in more detail in this blog on 6^th April 09) is an advisory vote, it may nonetheless be quite effective at making boards think twice about the proposed pay packages for executive directors. 

However companies do not always take as much notice of the votes cast as one would like.  For example, the recent annual general meeting of Marks and Spencer is a case in point as regards the use of voting as a (vociferous) voice.  Andrea Felsted and Samantha Pearson (FT Page 17, 9^th July 09) in their article ‘M&S chief defiant amid revolt by investors’ highlight that nearly 38% of votes cast backed a resolution seeking the appointment of an independent chairman within the next year.  Sir Stuart Rose, who has been the centre of much criticism since taking on the roles of both chairman and chief executive, did not seem overly bothered by the investors’ views on this matter.  There was also much shareholder dissent over the re-election of the chairman of the remuneration committee and over the adoption of the remuneration committee report.

Withheld votes

Whilst the importance of the vote is universally accepted, let us consider what happens in the UK when a vote is withheld.  A withheld vote may signal that an investor has reservations about a resolution, or it may be a stronger expression that an investor is unhappy about a resolution, whilst falling short of actually voting against the resolution.  However when the ‘vote withheld box’ is ticked on proxy forms in the UK, the withheld votes are not counted as part of the votes cast. 

For example, after its annual general meeting in May 2009, Shell published the voting results on its website.  On Resolution 1 : Adoption of Annual Report & Accounts, there were:  ‘votes for’  3,301,631,965, ‘ votes against’  3,394,595, and ‘votes withheld’ 16,026,721.  However when indicating the percentage split of the votes, ‘votes for’ are shown as 99.90% and ‘votes against’ as 0.10%.   The votes withheld were nearly 5 times that of the votes against but nowhere are they reflected in the percentage totals of votes cast.  Similarly, on Resolution 4 : Re-appointment of Lord Kerr of Kinlochard as a Director of the Company, there were ‘votes for’  3,161,974,849, ‘votes against’  77,443,311, and ‘votes withheld’ 77,876,289.  The percentage allocation indicated 97.61% ‘votes for’ and 2.39% ‘votes against’.  The ‘votes withheld’ which again exceeded the ‘votes against’ were not reflected at all in the percentage totals.  It should be said that Shell does clearly state that “a ‘vote withheld’ is not a vote under English Law and is not counted in the calculation of the proportion of the votes ‘for’ and ‘against’ a resolution.”    http://www.shell.com/home/content/investor/shareholder/agm/annual_general_meeting.html

The Combined Code on Corporate Governance (2008) under Code provision D.2.1, states that  ‘For each resolution, proxy appointment forms should provide shareholders with the option to direct their proxy to vote either for or against the resolution or to withhold their vote. The proxy form and any announcement of the results of a vote should make it clear that a ’vote withheld’ is not a vote in law and will not be counted in the calculation of the proportion of the votes for and against the resolution.  However it’s interesting to note that a decade ago, the Report of the Committee of Inquiry into UK Vote Execution (1999), published by the National Association of Pension Funds, stated that whilst it was initially attracted to the idea of adding a third box (being an ‘abstention’ or ‘vote withheld’ box), it then decided that there were several arguments against the inclusion of such a third box.  Firstly it might provide investors with an ‘easy option’ so that rather than voting against, they withheld their votes; and secondly since withheld votes are not counted, and have no legal effect, then it could drive down the level of recorded votes. 

However as we have seen, the Combined Code (2008) does advocate the inclusion of a ‘vote withheld’ box on the proxy form.   Therefore, it could be that in practice the addition of a third box which allows a withheld vote but which is not counted, may lead to the understatement of the level of dissatisfaction with some resolutions.  Given that institutional investors are coming under more and more pressure to be seen to be active owners of shares, it may be that a ‘vote withheld’ will increasingly become seen as sitting on the fence, rather than taking a decision to vote against.

In the US, it would seem that abstentions do have a legal effect under a majority voting system.  For example, in a director election if there were more votes withheld than were voted for the candidate, then the candidate would not be elected, hence the abstentions (votes withheld) would have a legal effect.

Broker votes

Turning to US issues, the SEC has recently made some important changes to proxy voting.  Weil, Gotshal and Manges (2009) report that ‘the SEC approved a change to NYSE Rule 452, eliminating broker discretionary voting of uninstructed shares in uncontested director elections, which will have the effect of reducing the number of votes cast in favor of the board’s nominees in the election of directors and strengthen the influence of institutional investors and activist shareholders.’ http://www.weil.com/

Blank votes

However James McRitchie http://corpgov.net/news/news.html has brought to our attention the problem of blank proxy votes which go to management.  He highlights that fact that the broker vote issue that the SEC took care of is ‘where retail shareowners don’t submit a proxy (or voter information form) at all.  When that happens, the broker or bank can vote within 10 days of the meeting. The “blank vote” issue arises when the shareowner votes at least one item on their proxy but leaves some other items blank……..[the voting] platform for institutional investors doesn’t allow submission of blank votes, [but the] platform for retail holders does and the SEC allows them to fill in the blanks as instructed by brokers and banks (always with management)’.  Furthermore he states that ‘As shareowners who believe in democracy, we have filed suggested amendments to take away that discretionary authority to change blank votes, or non-votes, as they might be termed. We believe that when voting fields are left blank on the proxy by the shareowner, they should be counted as abstentions.’

Concluding thoughts

Clearly the area of voting is a complex one and changes are being brought in over time to remove barriers to voting and to help ensure that votes are cast in a way which fairly reflects the owners’ intentions. A decade ago it would have seemed highly unlikely that many institutional shareholders would publish their voting levels in individual companies and on individual resolutions  but many institutional shareholders now do this.  In the US a number of institutional shareholders have gone a stage further and disclose their voting intentions prior to a company’s AGM.  Hopefully institutional shareholders in other countries will adopt this approach in future.

Chris Mallin 10^th July 2009.

Governance in China Companies – Is Convergence a Two-Way Street?

Bob Tricker writes from the Hong Kong Special Administrative Region of China with some up-dated insights into the way the Chinese authorities govern China’s listed companies.

China’s economy continues to grow, albeit at a slower rate during the global financial crisis, and the importance of China to the economies of the rest of the world becomes ever more apparent.  But how are major companies in China governed, by comparison with the rest of the world?

As I say in my book Corporate Governance – principles, policies and practices (OUP 2009): in a country with strong central control, in which the National People’s Congress, the State Council and the Communist Party play significant roles in the governance of enterprises, share ownership is not the obvious basis for governance power.  Yet the Peoples’ Republic of China has developed an innovative corporate governance regime.

Originally, industrial state-owned enterprises (SOEs), which were in effect large bureaucracies, received production and distribution orders from state planners.  SOE employees benefited from housing, medical care, and schooling for their children, and the government provided benefits for maternity, injury, disability and old age.  Many SOEs were heavily subsidized, with the government giving them easy access to bank financing, partly to pay for the social welfare needs of the workers. The concept of company, legal entity or corporation did not figure in the Chinese language at that time.

Then, between 1984 and 1993, the government introduced a transitional model of governance for SOEs throughout China, giving them more autonomy.  In 1994, a new Corporate Law provided for the restructuring of traditional large and medium-sized SOEs as legal entities. These laws transformed some SOEs into corporations clearly defining asset boundaries and ownership.  A dual system of governance was designed with boards of directors to represent owners’ interests, plus a board of supervisors.

In 1988, the State Council of the People’s Republic of China, advised by OECD experts, produced a set of corporate governance directives for SOE reform.  In September 1999, the Fourth Plenary session of the 15th.Chinese Communist Party’s Central Committee took a vital decision on enterprise reform, in what was termed a  “strategic adjustment” of the state sector, agreeing that the state should be “withdrawing from what should be withdrawn”.  Interestingly, corporate governance was recognised as being at the core of the modern enterprise system.

Some of the reformed corporate entities were floated on the two China stock markets in Shanghai and Shenzen (a city across the border from Hong Kong), which had been set up in 1991 and 1992 respectively.  After due diligence studies on their financial standing, a few China companies were listed in Hong Kong and others on stock exchanges around the world.  Some listed “through the back door” in Hong Kong, by acquiring a non-trading listed company and backing a China business into this shell.

In 2001, the China Securities Regulatory Commission (CSRC) formulated some basic norms of corporate governance, promoting the separation of listed companies from controlling shareholders.  These guidelines called for at least one-third of the board to consist of independent directors, including at least one accounting professional, although initially suitable people were scarce.

In 2002, CSRC formulated a Code of Corporate Governance for listed companies.  This included basic principles for the protection of investors’ rights, and basic standards of behaviour for members of the board and supervisory committee.  A guidance note, issued by CSRC in 2002, required every listed company to have at least two independent directors and by June 2003 at least one third of the board should consist of independent directors.  In 2005, CSRC allowed listed companies to remunerate managers with shares and stock options.

In 2006, a fundamental review of Chinese company law created two types of limited company – the limited liability company (LLC private companies) and the joint stock company (JSC public companies), bringing the legal context much in line with the company law of other countries. For example, the responsibilities of company (board) secretaries were established.

But the state maintains a significant ownership share and control at the national or provincial level.

Contemporary corporate governance in China

The regulatory structure does not appear to be significantly different from practices in the West, when presented simply:

But who are the ‘state regulators’ and what do they actually do?  The lines of control from various state and provincial authorities can be numerous:

The People’s Bank of China, the tax offices, the ministry responsible for the industry in which the company operates, and other state and provincial officials all act in what they see as the interests of the state and the people.  They can determine prices, regulate supplies, take action to avoid unacceptable economic or social stress such as unemployment, bankruptcy, corruption, or financial pressures on the state economy.  They can stop undesirable competition between state enterprises.

On reflection, these are not activities that are often found in Western economies.  Or are they?  As the effects of the ongoing global economic crisis unfold, similar activities seem to be appearing.

The China Securities Regulatory Commission of the State Council (CSRC) is the Chinese Government’s corporate regulator.  CSRC publishes the corporate governance code, other corporate governance regulations, and regular reports on corporate governance reform and performance in China.  CSRC also liaises closely with the management of the stock exchanges in Shanghai and Shenzen, and with those exchanges overseas which list China stock.  The CSRC is a regulatory body, with powers analogous to the SEC in the United States, with the prime aim of investor protection.  It seeks to maintain a tight control over directors’ behaviour.

The China corporate governance code and many of the regulations mirror those in the West.  Indeed, in some cases, in reporting for example, they are stricter.  In some 15 years China has achieved what took countries in the west many times longer.

But things are not always what they seem.  Xinhua, the national news agency recently let slip that although the published remuneration of some executive directors appears to be on a level with those in the West, actually these executives pay back significant sums so that their net pay is more in line with Chinese norms.

The State-owned Assets Supervision and Administration Commission of the State Council (SASAC) holds the China Government’s shareholding in all China’s listed companies (other than those in the finance sector). In 2008, total assets were over US$1.56 trillion, with eight of the world’s top 500 companies in the Fortune list.  So SASAC is the largest institutional shareholder in the world, surpassing the Government Pension Investment Fund in Japan, the Government of Singapore Investment Corporation and the California Public Employees’ Retirement System funds.

SASAC is a Commission of the State Council and wields considerable power over the SOEs.  It ensures that the State’s interests are represented in the activities of China’s listed companies.  This means that it is involved in the appointment and removal of directors and top executives.  Recently, it has moved chief executives around between companies.  Again, not an activity that one in the West would typically associate with the state, unless, of course, one remembered that the president of the United States recently removed the head of General Motors and the British Government are currently involved in the appointment of directors to various British banks they have nationalized.

Maybe convergence is a two-way street.

Bob Tricker

Say on Pay

Widespread concern at the high levels of executive director remuneration has led to calls for wider adoption of a ’say on pay’ in the US.  Investors in the UK and Australia have, for many years, had the right to vote on the remuneration committee report of the companies in which they invest.  The vote on the remuneration committee report is an advisory one meaning that it is not binding on the company.    However in practice institutional investors have tended not to vote against the remuneration committee reports and on the -until recently – relatively rare occasions on which the remuneration committee report was voted against, it was seen as a strong signal of disapproval about some aspect of executive remuneration and one which the directors would be unwise to ignore.

Royal Bank of Scotland

It was no surprise to anyone that the Royal Bank of Scotland shareholders overwhelmingly rejected the banks remuneration committee report at the companies Annual General Meeting on 3^rd April.  Jane Croft and Andrew Bolger (FT, Page 12, 4/5^th April 09) in their article ‘Thumbs down for RBS pay report’ stated that some 90.42% of votes cast rejected the report.  UK Financial Investments Ltd (UKFI) the Government owned company which manages the taxpayers’ shareholding in RBS, and controls 58% of the RBS shares, voted against the report.   Manifest, the proxy voting agency, stated that ‘the resolution on the remuneration report at Royal Bank of Scotland Group plc represents the highest ever “Total Dissent” vote on the remuneration report since the introduction of the requirement for the report to be put forward to a non-binding vote’.

Remuneration (compensation) committees

Remuneration committees have previously been criticised for having a ratcheting effect on executive directors’ remuneration.  The composition of such committees is usually independent non-executive (outside) directors but nonetheless this has not stopped the increasing levels of executive remuneration.  This is probably in part attributable to the fact that remuneration committees would tend to recommend remuneration for executive directors in the upper quartile of their peer group hence the ratcheting effect over time.  The Corporate Library  points out that, in the US, chief executives pay rose 24 percent in 2007 giving a median remuneration of $8.8 million. 

Trade Unions Involvement 

An interesting development is for trade unions calling for more worker involvement in setting top executive pay.  Brian Groom (FT, Page 3, 6^th April 09) in his article ‘TUC leader urges staff input over chiefs’ pay’ highlights that Brendan Barber, General Secretary of the Trade Union Congress (TUC), stated ‘there was “massive anger” among workers at paying the price for a recession made in the boardroom, not on the shop floor’.  The directors of FTSE 100 companies came in for criticism as well as the directors of banks, with Mr Barber arguing for ‘workforce representation involved in remuneration committees of major companies’.  The idea of representation of the workforce on the board or board committees has traditionally not been given much consideration by UK boards but maybe that might change in the future.

Shareholder proposals/resolutions

Another are where we may see change is in relation to shareholder proposals or resolutions. Although it is possible in the UK for shareholders to put forward shareholder proposals or resolutions, it is not that easy to do and hence dialogue has been the most frequently used tool of corporate governance with shareholder proposals maybe numbering just five or six a year. 

In the US it is much easier to put forward a shareholder proposal and so we can see 800 or 900 of these each year in US companies.  It is likely that in the future more of these shareholder proposals will be relating to executive remuneration and that they will achieve strong support from institutional investors who are increasingly being criticised for not having taken more action to help limit executive remuneration.   Francesco  Guerrera and Deborah Brewster in their article (FT, Page 21, 6^th April 09) ‘Mutual funds helped to drive up executive pay’ highlight that mutual funds have tended to vote in favour of companies compensation plans and this has effectively sanctioned these spiralling executive remuneration packages.  Kristin Gribben (FTfm, Page 5, 6^th April 09) in ‘Pay proposals to dominate proxy season’ puts forward the view that, in future, mutual funds in the US will be more likely to support remuneration (compensation) related resolutions filed by shareholders. 

Back-door pay

There is concern that some companies may seek to remuneration executive directors via the ‘back-door’ if, for example, bonus schemes do not pay out.  Pauline Skypala (FTfm, Page 2, 6^th April 09) in ‘Warning over “back-door” pay’ highlights that this is a concern to some investors including Co-operative Asset Management whose corporate governance manager, Paul Wade, states ‘If a company fails to create value for its shareholders, it is totally inappropriate to grant rewards to management that are disproportionate to shareholder returns’.

Future developments

With the continuing focus on executive directors’ remuneration packages, the forthcoming AGMs promise to give rise to many interesting debates, much emotive discussion, more shareholder proposals, and many more instances where ’say on pay’ will result in an emphatic ‘no’ to excessive remuneration or remuneration which does not have appropriately stretching performance links.

Chris Mallin 6^th April 2009.

A Grilling for Directors

- in which Bob Tricker continues his call for a radical rethink of the way power is exercised over companies by society.

In a previous blog, I argued that the relationship between auditors and directors, in which directors de facto appoint the auditors who then report to them, was too close. I proposed that auditors should be appointed by and report to regulators and, through them, to other interested stakeholders. In this blog I explore the way directors communicate with their shareholders and again develop a radical alternative to accepted practice.

The global financial melt-down and on-going economic explosion continues to expose weaknesses in corporate governance practices and, more importantly, attitudes. Giving wider powers to regulators and introducing more regulations, as is now being proposed, will have little effect if those regulators continue to be closely associated with, and often come from, the industry they are regulating. Long standing assumptions about the way things should be done need to be questioned not reinforced. Expectations and attitudes have to change.

Taking directors remuneration as a dramatic example, in recent years we have seen a massive increase in the ratio of CEO pay to that of their hourly paid workers, in many cases as their firms eroded shareholder value. The old legal concept of fairness, what a reasonable man would expect, has long been forgotten. As Barack Obama has written “what accounts for the change in CEO pay is not any market imperative. It’s cultural. At a time when workers are experiencing little or no income growth, many of America’s CEOs have lost any sense of shame about grabbing whatever their pliant, hand-picked corporate boards will allow.” [The Audacity of Hope, Crown Publishing Group (Random House), New York, 2007]

The director/shareholder relationship

At the heart of corporate governance are the relationships between shareholder-investors and top-management decision-makers. Shareholders’ ability to question directors and directors’ accountability to shareholders are crucial. In the 19th century that was relatively easy for the joint-stock limited-liability company. Companies were then smaller, less complex and licensed by the state to pursue a single aim, build a railway, run an iron foundry, supply a town with gas, for example. Moreover, the shareholders were individuals and could be counted in tens or hundreds. Institutional investors, mutual funds, and pension funds had yet to be invented.

How different today. Complex corporate groups, with hundreds of subsidiaries, associate companies and joint ventures in pyramids, networks and geared chains, with multiple shareholders – institutional investors including hedge funds, mutual funds, pension funds, insurance companies, even sovereign funds – not just individuals. The challenge is how to communicate with them, to listen to them, and be accountable to them.

The classical solution, of course, was to require meetings of shareholders so that the board could explain their stewardship of the corporate funds. That requirement still holds for the public company. But we all know the ongoing farce of meetings tightly organised by the company secretary, dominated by the chairman, with questions so restricted that communication is essentially one way, seldom providing an adequate opportunity for genuine dialogue.

Companies were also required by law to provide their members with regular written reports with information laid out in company law and stock exchange listing rules. Today, electronic mail and corporate internet sites supplement the printed word. But such reporting is still one-way: company to shareholders. The opportunity for investors to seek information about their directors’ activities is limited.

How can shareholders really find out what they want to know? How can they genuinely exercise power over the directors they have appointed to be stewards of their funds? Successive reports, including the British Myners Report, have called for institutional investors to play a bigger part in corporate governance. A few institutional investors, like CalPers in the United States and Hermes in the UK, together with some investor organisations, such as the Association of British Insurers have certainly made their presence felt. But others still prefer the option of ‘doing the Wall Street walk’ or voting with their feet as they say in Britain, avoiding the potential costs of getting locked-in should they get involved in governance issues.

A new approach

But there is another way. Anyone watching the recent grilling of directors of financial institutions by Congressional Committees in the USA and Commons Treasury Select Committees in the UK saw an alternative approach. Why should investors not be able to wield similar power? After all they actually own the companies.

Who would do the grilling? It would have to be representatives of the shareholders, who have not been captured by the company and its directors. Skilled representatives from institutional investors or perhaps a new breed of professionals come to mind.

In Australia, Shann Turnbull has proposed a corporate senate that might be adapted. He believes that “most corporations in the English speaking world are essentially corrupt because their unitary board structures concentrate on conflicts of interest and corporate power.” His alternative is a dual board structure with a corporate senate elected on the basis of one vote per shareholder, not per share. In his model the senate has no pro-active power, just the right to veto where it feels the board has a conflict of interest. Its members could certainly be trained to grill directors on behalf of the other shareholders.

Would directors readily agree to be grilled? Of course not! Self-regulation, exhortation, or listing rules requirements would not suffice. Legislation will be needed. Shareholders, who actually are the company, would need to be given power to carry out the level of grilling and transparency given to US Congressional and UK Treasury Select Committees. Proceedings would need to be public, probably carried live through the internet and available as a record on a web site.

Directors have a fiduciary duty to act in the interests of shareholders, not their own. Somehow this has been forgotten. Professional grilling by shareholders of their directors would move the original concept of directors’ stewardship, fiduciary duty, and accountability towards the reality of 21st century expectations and demands.

Bob Tricker