Risk Management

One of the main areas in corporate governance that has caught the headlines recently is risk management.  There is a widely held perception that in recent years many boards have not managed the risks associated with their businesses well – whether that was because they did not identify the risks fully or whether because having identified the risks, they did not take appropriate action to manage them.

 Review of UK’s Combined Code

The Financial Reporting Council (FRC)’s Review of the UK’s Combined Code published in December 2009 http://www.frc.org.uk/corporate/reviewCombined.cfm states that ‘One of the strongest themes to emerge from the review was the need for boards to take responsibility for assessing the major risks facing the company, agreeing the company’s risk profile and tolerance of risk, and overseeing the risk management systems. There was a view that not all boards had carried out this role adequately and in discussion with the

chairmen of listed companies many agreed that the financial crisis had led their boards to devote more time to consideration of the major risks facing the company.’  The FRC therefore proposes to make the board’s responsibility for risk more explicit in the Code through a new principle and provision.  Moreover it also intends to carry out a limited review of the Turnbull Guidance on internal control during 2010.  

Many companies, and especially those in the financial sector, have already established risk committees whilst other companies especially smaller companies, may combine the consideration of risk with the role and responsibilities of the audit committee.

Alternative investment market

The UK’s Alternative Investment Market (AIM) expanded rapidly during the 12 years following its inception in 1995.  Then from 2007 onwards it went into decline.  David Blackwell, in his article ‘Signs of recovery seen after years of famine’ (FT, page 23, 16^th December 2009) states that ‘Hundreds of companies have left the market, the number of flotations has collapsed and fines for Regal Petroleum and others – albeit for regulatory infringements dating back years – have once again sullied the market’s reputation’.  Nonetheless he points out that 2009 saw an improvement with the AIM index rising by 62 per cent over the year compared to a rise of 22 per cent in the FTSE 100. 

The lighter regulatory touch on AIM has both attractions and drawbacks.  On the one hand, companies find it easier to gain a London listing (albeit on AIM rather than the main market); on the other hand, this may bring concomitant risks for investors as they will be investing in companies which may well be riskier than their main market counterparts.

Family firms

Family firms are the dominant form of business in many countries around the world and range from very small businesses to multinational corporations.  Richard Milne in his article ‘Blood ties serve business well during the crisis’ (FT, Page 19, 28^th December 2009) points out that the attributes of a typical family business will have stood it in good stead during the recent financial crisis: ‘Long-term thinking, conservative, risk-averse: the very characteristics of the typical family business seem to be the ones needed in the economic crisis of the past two years’.  Given that they tend to be more conservative, family firms will take less risks, for example, by not over extending themselves with their gearing (leverage).

Banks and financial institutions

Many banks and financial institutions were widely criticised because of the perceived overly generous bonuses paid to some executive directors and senior management at a time when the world is suffering the consequences of a global financial crisis precipitated by bankers who did not seem to fully appreciate the risks involved with some of the products they were trading in.  And yet already we see banks again paying out enormous bonuses.  Megan Murphy in her article ‘Tycoon attacks return of bankers’ bonuses’ (FT, Page 3, 28^th December 2009) quotes Guy Hands, the private equity tycoon, who is highly critical of these big bonuses and speaks of bankers ‘taking home “wheelbarrows of money” on the back of taxpayers’ support’.  Moreover he is quoted as saying ‘It cannot be right to continue with a system that allows risk to be taken in the knowledge that, if things go right, bankers will take on average 60-80 per cent of the profits generated through compensation and, if they go wrong, shareholders and ultimately the government will pick up the costs’.

Asset managers

Managing risk is, of course, relevant to all parties in the business and financial world as the article by Sophia Grene ‘Managing risk is the main task ahead’ (FTfm, Pg 1, 4^thJanuary 2010) illustrates.  In her article, Sophia points out that ‘many financial models failed in the past two years as markets demonstrated they did not behave according to conventional assumptions’ and that ‘the main challenge for asset managers in the coming decade is understanding, managing and communicating risk’.

Concluding comments

Managing risk and managing it well is an important consideration for boards of directors, whether in main market firms, second tier markets, or family firms.  Firms, and especially those in the banking and financial sector, need to pay particular attention to executive director remuneration packages which should not encourage adverse decision-making in terms of the impact on risk, that is, remuneration packages should be designed so that they do not lead to unacceptable risk-taking which may be to the detriment of the long-term sustainability of the company and potentially, as we have already seen, the wider economy.

Please refer to the newly published third edition of my book ‘Corporate Governance’ for updates to various national and international corporate governance codes and guidelines; board committees including risk and ethics committees; the Alternative Investment Market (AIM); family firms; remuneration packages, and the global financial crisis.  

In addition, new material on many other areas including: private equity and sovereign wealth funds; governance in NGOs, public sector/non-profit organisations, and charities; and board diversity.  Many examples, mini case studies and clippings from the Financial Times are included to illustrate the application of corporate governance in the real world.

 Chris Mallin 7^th January 2010

Institutional Investors and Corporate Governance Reform

Corporate governance codes and guidelines have long recognised the important role that institutional investors have to play in corporate governance.  As well as being influential in their home countries, institutional investors have increasingly become a more significant force in other countries through their cross-border holdings. Recent corporate governance reforms motivated by the global financial crisis have placed even more emphasis on the role of institutional investors.

Role of Institutional Investors

Back in 1992, the Cadbury Report recognised the role played by institutional investors  stating that ‘we look to the institutions in particular ‘ to use their influence as owners to ensure that the companies in which they have invested comply with the Code’.  Various codes since then have emphasised the importance of the role.  The Financial Reporting Council (FRC) publishes the UK’s Combined Code on Corporate Governance (commonly known as the Combined Code).  The Combined Code (2008), in Section E, identifies three main principles.  Firstly it states that ‘institutional shareholders should enter into a dialogue with companies based on the mutual understanding of objectives’; secondly ‘when evaluating companies’ governance arrangements, particularly those relating to board structure and composition, institutional shareholders should give due weight to all relevant factors drawn to their attention’; thirdly, ‘institutional shareholders have a responsibility to make considered use of their votes http://www.frc.org.uk/corporate/combinedcode.cfm The first and third principles relate to two of the tools of governance being dialogue and voting.  All three principles essentially require institutional investors to behave in a responsible and conscientious way, taking all relevant factors into account and making considered decisions.

Corporate Governance Reform

The UK Treasury commissioned the Walker Review of Corporate Governance of UK Banking Industry which reported in November 2009. The Walker Review recommends ‘strengthening the role of non-executives and giving them new responsibilities to monitor risk and remuneration; it also recommends a stewardship duty on institutional shareholders to play a more active role as owners of businesses.’ http://www.hm-treasury.gov.uk/walker_review_information.htm  Kate Burgess and Brooke Masters in their article ‘Institutions urged to adopt tougher stance’  (FT, Pg 21, 26^th November 2009) states ‘Institutional investors are being urged to be tougher on company boards by Sir David Walker, as the City grandee adds his weight to pressure for them to take their responsibilities more seriously.’

The FRC’s statement welcoming the Walker Report can be found at: http://www.frc.org.uk/press/pub2174.html. The FRC has agreed to implement those recommendations that it considers should apply to all listed companies. In addition the FRC has agreed to consult on adoption of a Stewardship Code for institutional investors as recommended by Sir David.   

A recent review of the Combined Code http://www.frc.org.uk/corporate/reviewCombined.cfm has however recommended that Section E of the Code (addressed to institutional shareholders) be removed, ‘subject to sufficient progress being made on the Stewardship Code for institutional investors and its associated governance arrangements.’  The Stewardship Code for institutional investors as was proposed by Sir David Walker, and is an area on which the Financial Reporting Council (FRC) will be consulting separately http://www.frc.org.uk/corporate/walker.cfm

The final report on the review of the Combined Code (2008) makes various recommendations which include, inter alia, annual re-election of the chairman or the whole board; new principles for the roles of the chairman and non-executive directors.  Kate Burgess in her article ‘Sir Christopher misses out on succession planning’ (Pg 21, FT, 2^nd December 2009) highlights that more emphasis should have been put on succession planning in companies as this tends to be a weakness in many firms.  Moreover it would be beneficial to investors in their stewardship role to have more knowledge of the process in place for succession planning.

Stewardship Code

The Institutional Shareholders’ Committee (ISC) membership comprises the Association of British Insurers, the Association of Investment Trust Companies, the National Association of Pension Funds, and the Investment Management Association.  The ISC has previously published guidance on the responsibilities of institutional investors in 2002, 2005 and 2007.  In November 2009, the ISC published its Code on the Responsibilities of Institutional Investors which is included as an Annex in the Walker Review and which is widely viewed as the basis for the Stewardship Code which will be monitored for the adherence of institutional investors on a ‘comply or explain’ basis.  The ISC states that ‘the Code aims to enhance the quality of the dialogue of institutional investors with companies to help improve long-term returns to shareholders, reduce the risk of catastrophic outcomes due to bad strategic decisions, and help with the efficient exercise of governance responsibilities.’ http://www.institutionalshareholderscommittee.org.uk/ The Code discusses the stewardship responsibilities of institutional investors which include effective monitoring of investee companies and voting of all shares held. 

Effective Stewardship

Of course in order to carry out their responsibilities as shareholders, institutional investors need to be able to exercise their rights effectively – if they cannot, then they may be tempted to exit, i.e. to sell their shares.  An article in the Financial Times, ‘Shareholder rights’ (FT, page 12, 30^th November 2009) points out that ‘if selling the shares is a blunt instrument, then removing board members is the sharpest.  More than nine in 10 international investors say the ability to nominate, appoint and remove directors is the most valuable shareholder right.  It is wrong that efforts to boost this power in the US have been delayed by the business lobby.’  Clearly it is in the interests of effective stewardship for institutional investors to be able to exercise their rights.  This will enable them to take action on prominent topical issues such as having a ‘say on pay’ in relation to directors’ remuneration, and removing underperforming directors from the board. 

However another dimension to consider is that of free riders.  Ruth Sullivan in her article ‘Walker plan points finger at freeriders’ (FTfm Pg 3, 30^th November 2009) points out that some institutional investors will not engage more with their investee companies and be active owners, rather they will save their time and money and free ride on the efforts of other institutional investors. 

Concluding comments

The recent reforms mooted by the Walker Review and the Review of the Combined Code have made recommendations which will help to strengthen corporate governance in the UK.  The role of institutional investors is seen an important one and institutional investors are being encouraged to engage more fully in their role as owners and adhere to the ISC Code of Responsibility for Investors. 

Chris Mallin 2^nd December 2009

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