Update to Tricker Corporate Governance 4e

In some copies of the fourth edition of Bob Tricker’s Corporate Governance – Principles, Policies, and Practices, Figure 2.1 is incomplete.

This diagram shows the complete text.

Figure 2.1 CG4E FINAL

 

 

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The Corporate Governance of Huawei

When the Huawei case was written last year, for the fourth edition of Corporate Governance – Principles, Polices, and Practices, we did not anticipate the headlines that the company was about to attract. The original case was short, setting the scene for some interesting questions about corporate governance in China.

 

Case study 6.3 The Huawei Group

Huawei was founded in 1987 by Ren Zhengfei, a former electronics engineer in the People’s Liberation Army (PLA). During the 1980s and ’90s, the Chinese government saw the need to modernize telecommunications thought the country. Telephone exchange equipment needed electronics. Some companies in the industry negotiated joint ventures to link with foreign companies that had the technology: but they proved reluctant to divulge the latest technology. Ren took a different approach: his company obtained foreign hardware with its software, and then reverse engineered it to discover its secrets and replicate them.

In 1994, Huawei agreed to build a telecommunication system for the PLA; a relatively small project but crucial in political connections. Ren Zhengfei met Premier Jiang Zemin and convinced him that electronic switching-equipment technology was related to national security and that a nation that did not have its own switching equipment was like one that lacked its own military. Jiang agreed. In 1996, the government decided to support domestic telecommunications manufacturers and restrict access to foreign investors. The Huawei Group thrived and became a leading force in China’s creation of ‘smart cities’, bypassing the personal computer experience of Western nations and adopting smart phone technology as the basis for internet transactions and communication. Huawei became the largest manufacturer of telecommunications equipment in the world, overtaking the US-based Ericsson in 2012.[1]

Huawei was also expanding outside mainland China. In 1997, it signed a contract with Hong Kong’s Hutchinson Whampoa to provide a fixed-line network. In 1999, it opened an R&D centre in Bangalore, India, and in 2001 it opened four R&D centres in the USA. By 2005, Huawei’s international contracts exceeded domestic sales.

Huawei refers to itself as a private company and calls itself a ‘collective’, being owned by its employees. The nature of that ownership and the government’s continuing relationship with the company remain unclear.

 

Subsequent developments

Huawei is installing its technology in countries around the world. But concerns have been raised about the security of such systems, which could include software to obtain information and might prove a security risk. The fear was that since every Chinese company was subject to the Chinese judiciary system, which is not independent of the state, companies could be given orders by government officials.

In the United States, President Trump issued an order prohibiting Huawei from selling its systems in America. He subsequently prohibited US companies from supplying Huawei with electronic components. However, the British Prime Minister, Teresa May, approved the use of Huawei technology in the UK’s 5g network, having been advised that Britain had the counter-intelligence capability to meet any subversive interference in telecommunications.

In another issue of international interest, Huawei’s Deputy Chair and Finance Director, Meng Wanzhou, was arrested in Canada on a United States extradition warrant, which alleged that Huawei had broken various US laws. Meng is the daughter of Huawei founder Ren Zhengfei.

In an interview with CNN, Ren Zhengfei, speaking in Putonghua,[2] defended his company’s record, claiming that the United States boycott was because Huawei was now the largest telecommunications company in the world and its technology had outstripped American rivals. He claimed that Huawei was independent of the Chinese Government and made decisions on a commercial basis. Asked about his daughter, still under arrest in Canada, he said, that she was under house arrest and studying for her PhD. He claimed that the Canadian arrest was unlawful.

 

Comment

Viewing corporate governance as the way power is exercised over corporate entities, the Huawei case emphasizes the significance of the cultural context. Huawei is subject to Chinese company law and must provide information to relevant government authorities, in the same way that companies in the West must meet similar obligations. However, Chinese law and its law courts are not independent of the state but exist to ‘serve the people,’ which typically means the interests of the governing authorities, ultimately the Politburo of the Communist Party of China.

Nevertheless, although China is a one-party state, its economy is market-based, producing prodigious economic growth over the past twenty years. This has enabled the building of a major rail and motorway system; the creation of large new ‘smart cities based on information technology; and the launch of a ‘belt and road’ strategy to link China with trading partners throughout the Middle East and Europe.

Contrary to classical Communist doctrine, China permits the creation of corporate entities, recognizes private property, and has two highly successful stock exchanges (three if you include Hong Kong). A few Chinese companies are quoted in New York. Moreover, China now has an affluent, car-owning middle class.

Despite being the world’s largest telecommunications company, Huawei is privately owned. So it is not required publicly to disclose its ownership, which remains obscure. The company describes itself as a ‘collective;’ suggesting that employees own shares, although there is no evidence that they have any shareholder rights. The probability is that ownership is in the hands of the founder, his family and friends, senior executives, and possibly government agencies which have provided funding, including the People’s Liberation Army. In a recent interview, Ren said that the company had a management succession plan, which recognizes the need to provide for succession beyond the founder.

To appreciate the corporate governance of large private companies in China, the cultural context[3] is fundamental. It is different from the West. Since opening its economy to market forces, China has published a Companies Act, liaised with Western advisers on corporate governance, and produced a governance regime which reflects some aspects of Western approaches but includes aspects that are uniquely Chinese. Corporate governance with Chinese characteristics reflects the way business is done in China. Responsibility for decisions is often unclear, so is subsequent accountability. Personal relationships are very important. No one should lose face, even though everyone knows the situation. Control by the authorities is exercised less by clear mandated instruction, more by influence exercised quietly ‘through the window.’ The lack of clear job descriptions, with little written down, can be anathema to Westerners. Yet the incredible growth of the Chinese economy suggests that it works.

The Chinese Government recognized, when they launched the market-driven reforms, that corporate governance was vital. But unlike the West, where corporate governance tends to be seen as the means of regulating companies and controlling unacceptable behaviour, the Chinese see corporate governance as a means to economic growth and long-term success.

 

[1] www.forbes.com/sites/moorinsights/2017/12/04/ericsson-vs-huawei-whos-winning-the-5g-   race/#6821666a8aa5

[2] Putonghua is the official language of China, a version of classical Mandarin. The Chinese have many different dialects. In Hong Kong, for example, Cantonese is spoken, which is virtually unintelligible to Mandarin speakers; although written script is common to all.

[3] To delve more deeply into the cultural context see Tricker, Bob and Gregg L ,(2019), Understanding Corporate Governance in China, Hong Kong University Press, Hong Kong

Pay Ratios

 

Interest by the media, the public, and shareholders in the pay of CEOs has never been higher, and governments have increasingly taken notice of this in recent years. It is perceived as inequitable and often unjustifiable as to why there should be such large discrepancies between the pay of CEOs and of the employees in their companies. Recent legislation in some countries, and proposed legislation in others, has sought to address this concern by ensuring that companies disclose the ratio of CEO pay and the median employee’s pay in their company.

US Companies

In 2015 the SEC adopted amendments to Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act, and Item 402(u) of Regulation S-K, on pay ratio disclosure such that companies have to provide details of the relationship of the annual total compensation of their employees and the annual total compensation of their Chief Executive Officer (CEO), i.e. the ratio of the CEO pay to the median of the annual total compensation of all employees. This applies to companies’ for their first fiscal year beginning on or after 1st January 2017.

Honeywell International, a large multinational corporation, was the first major U.S. public company to disclose its ratio of CEO pay to that of the median employee with a pay ratio of 333:1.

The American Federation of Labor and Congress of Industrial Organizations (AFL-CIO) highlights that in the S&P 500, Mattel had the highest ratio of CEO pay to median worker pay with a ratio of 4987:1. They reported a higher ratio still in the Russell 3000 where Weight Watchers International had a pay ratio of 5908:1. More detail is available at:

https://aflcio.org/paywatch/company-pay-ratios

UK Companies

In the UK, listed companies with more than 250 UK employees will legally be required to annually publish and justify the pay difference between chief executives and their staff for the first time. The regulations governing pay ratios will, subject to Parliamentary approval, come into effect from 1 January 2019 with companies reporting their pay ratios in 2020.

The disclosure of pay ratios is part of a move to hold larger companies more accountable for CEO pay and will provide helpful insights into the difference between CEO pay and average employee pay in different sectors and in individual larger companies in the UK.

https://www.gov.uk/government/news/uks-biggest-firms-will-have-to-justify-pay-gap-between-bosses-and-their-workers

 

Japan

Japan is a country whose CEOs have traditionally earned less than their global peers and where the ratio of CEO pay to that of the average employee has been lower than in countries such as the US. Part of this is attributable to the culture of Japan where very high pay ratios between CEO pay and average employee pay would not be viewed favourably.

It will be interesting to see what the impact of the disclosure of pay ratios in the US and other countries will be in the coming years.  Already shareholder revolts over executive pay during 2018 are growing and high pay ratios of CEO pay to the average employee’s pay could increase shareholders’ dissent on this issue.

 

Chris Mallin

June 2018

 

Succession Planning

Why is succession planning important?

Succession planning is seen as crucial to ensuring that a successor is in place to carry on the work of key individuals in a business should they leave the company in either a planned manner (e.g. retirement, job move, generational succession, or ownership changes) or an unplanned manner (e.g. fatal accident, unplanned removal from post). Sometimes the immediate successor is seen as a safe pair of hands, ready and waiting to carry on the work pending the appointment of another individual, whilst at other times there has been more time to search for a successor.

Investors are keen to know that a succession plan is in place for key directors to help ensure the ongoing smooth running of the business, its strategy going forward, and to maintain a steady steer at the helm, thus retaining investor and market confidence. The successor may also be appointed for their new ideas on strategy, whether that is to take the business forward into new spheres or to concentrate more on a few core sectors which may be more appropriate for the company at that time.

 

Corporate Governance Codes

Corporate governance codes mention succession planning in different degrees of detail.  Looking at a few of these, the UK, Japan, and Italy, illustrates this.

The UK

The current UK Corporate Governance Code (2016) mentions succession planning in the context of the role of non-executive directors, they ‘have a prime role in appointing and, where necessary, removing executive directors, and in succession planning,’ (A.4, Non-executive Directors, Supporting principle, UK Corporate Governance Code 2016, Financial Reporting Council); and in the context of Appointments to the Board ‘The board should satisfy itself that plans are in place for orderly succession for appointments to  the  board  and to  senior  management,  so  as  to  maintain  an  appropriate  balance  of skills and experience within the company and on the board and to ensure progressive refreshing of the board (B2 Appointments to the Board, Supporting principle, UK Corporate Governance Code 2016, Financial Reporting Council) https://www.frc.org.uk/getattachment/ca7e94c4-b9a9-49e2-a824-ad76a322873c/UK-Corporate-Governance-Code-April-2016.pdf

However the proposed revisions to the UK Corporate Governance Code (2017) cover succession planning in more detail.  Section 3 is headed ‘Composition, succession and evaluation’, and its Principle J states ‘Appointments to the board should be subject to a  formal, rigorous and transparent  procedure, and an  effective succession  plan  should  be in  place for board and senior management. Both appointments and succession plans should be based on merit and objective criteria, and promote diversity of gender, social and ethnic backgrounds, cognitive and personal strengths.’ Provision 17 states that ‘The board should  establish a nomination committee that should lead the process for appointments, ensure plans are in place for orderly succession to both the board and senior management positions, and oversee the development of a diverse pipeline for succession.  A majority of   members of the committee should be independent non-executive directors, with a minimum membership of three. The chair of the board should not chair the committee when it is dealing with the appointment of their successor,’ (December 2017, Proposed Revisions to the UK Corporate Governance Code Appendix A – Revised UK Corporate Governance Code) https://www.frc.org.uk/getattachment/bff48ee6-4fce-4593-9768-77914dbf0b86/Proposed-Revisions-to-the-UK-Corporate-Governance-Code-Appendix-A-Dec-2017.pdf

Japan

Japan’s Corporate Governance Code (2015) states that ‘Based on the company objectives (business  principles, etc.) and specific business  strategies, the board should engage in the  appropriate oversight of succession planning for the CEO and other top executives,’ (4.1.3, Japan Corporate Governance Code, Seeking Sustainable Corporate Growth and Increased Corporate Value  over the Mid- to Long-Term (2015), Tokyo Stock Exchange) http://www.ecgi.global/sites/default/files/codes/documents/japan_cg_code_1jun15_en.pdf

Italy

Italy’s Corporate Governance Code (2015) refers to the fact that ‘The Board of Directors shall evaluate whether to adopt a plan for the succession of executive directors. In the event of adoption of such a plan, the issuer shall disclose it in the Corporate Governance Report. The review on the preparation  of  the  above  mentioned  plan  shall  be  carried  out  by  the nomination committee or by another committee established within the Board of Directors in charge of this task.  Should the issuer adopt a succession plan, the Corporate Governance Report shall disclose whether specific  mechanisms are set forth in the succession plan  in  case  of  early  replacement, the corporate bodies and the persons in charge of the preparation of the plan as well as the manners and timing of its review.  As far  as the succession  procedures  are  concerned, the Committee believes that these procedures shall clearly define their scope, instruments and timing, providing both for the involvement of the Board of Directors and for a clear allocation of tasks, also with regard to the preliminary stage of the procedure,’ Appointment of directors, 5.C.2. Corporate Governance Code (2015) http://www.ecgi.global/sites/default/files/codes/documents/cg_code_italy_15july2015_en.pdf

Also in Italy in 2017, the Corporate Governance Principles for Unlisted Family-Controlled Companies were issued. Article 9 relates to Planning and Succession Plans going into some detail. On this issue, there are two Principles: 9.P.1. ‘Being  aware  of  the  differences  that  the  company  size  and  ownership  structure  involve,  it  seems appropriate for the members and the Board of Directors to ensure the continuity of corporate governance and  management  of  the  company  by  defining  precise  regulations  for  effectively  addressing  generational transitions or ownership changes.’ Also 9.P.2. ‘For  the  purposes  of  administration  of  the  company,  succession  plans  must  be  appropriately established  in  advance,  taking into  account  the  specific  conditions  of  the  company,  the  Group  and possibly the currently controlling family.’

Five application criteria are then listed which provide guidance on the process to be followed including the timeliness of establishing the process and having it ready in good time. Corporate Governance Principles for Unlisted Family-Controlled Companies 2017 http://www.ecgi.global/sites/default/files/codes/documents/principi_per_il_governo_delle_societa_non_quotate_a_controllo_familiare._codice_di_autodisciplina%202017%20English_0.pdf

 

Examples of succession issues in practice

For many family firms – large and small – succession planning is a real issue when either the next generation doesn’t want to take on the mantle of the founder, or there is no obvious successor.  Leo Lewis in his article ‘New prescription’ about Takeuchi Optical, a Japanese glasses manufacturer, highlights that ‘thousands of family-owned businesses in Japan face uncertain futures due to a lack of heirs,’  (Financial Times, 5th April 2018, page 9). Whilst Japan has a rapidly ageing society, similarly, other countries also face succession planning issues.

In South Korea, for example, Lee Jae-yong, vice-Chairman of Samsung Electronics and grandson of the group’s founder, was arrested in February 2017 on charges relating to bribery and corruption connected to a nationwide political scandal. Lee Jae-yong was convicted and sentenced to five years in prison on corruption charges. However in February 2018, he was freed on appeal with his original sentence being halved and suspended for four years. In April 2018, Samsung Electronics announced that it would split the roles of CEO and Chair but there will continue to be three co-CEOs with ultimate power still residing with Lee Jae-yong as vice-chairman. However Elliott Management, the activist institutional hedge fund, is seeking a change in the company’s corporate governance to limit the power of the family successor in waiting, Lee Jae-yong.

Chris Mallin

April 2018

Yum China: A Case Study

The scale of the operations of Yum China Holdings is striking and the structure of the he board interesting.  But the vital questions are:

  1. Why did Yum China announce its Chairmen and CEO succession plans well in advance?
  2. Should all listed companies be required to declare their Chairmen and CEO succession plans?

 

Yum China Holdings

Kentucky-based Yum Brands Inc., owners of KRC (Kentucky Fried Chicken, Taco-Bell. and Pizza Hut brands), opened its first restaurant in China in 1987.   By the time their Chinese operations were spun off, on 31 October 2016 to Yum China Holdings Inc., it had become China’s largest restaurant chain.  Yum China owned the franchise for Pizza Hut in China with more than 1,500 restaurants in over 400 cities; and the franchise for KFC, with over 5,000 outlets in nearly 1,000 towns and cities.  Taco Bell operations were also starting.

Primavera Capital Group, a China-based global investment firm, made a strategic investment in Yum China and the company was then listed on the New York Stock Exchange (YUMC) in November 2016.  Yum China Holdings Inc. is registered in Louisville Kentucky with headquarters in Shanghai.

 

Yum China strategy

The company outlines its view of its potential on its website:

‘Our brands are integrated into popular culture and consumers’ daily lives.

We are dedicated to serving our customers’ evolving needs by enhancing the in-store experience, improving mobile connectivity, introducing innovative new products, and constantly delivering value.  We also remain focused on driving shareholder value by growing sales and profits across our portfolio of brands through increased brand relevance, new store development and enhanced unit economics.  With a rapidly growing consumer class and increasing urbanization, Yum China is well positioned for long-term growth’.

 

The board of directors of Yum China Holdings[1]

The board has nine members, seven of them independent according to the company.

 

Fred Hu is chairman and founder of Primavera Capital Group, a China-based global investment firm (“Dr. Hu has served as chairman of Primavera since its inception in 2010.  Prior to Primavera, Dr. Hu served in various roles at Goldman Sachs.)

Peter A. Bassi served as president then chairman of Yum! International Restaurants.  Prior to this, Mr. Bassi spent 25 years in a wide range of financial and general management positions at PepsiCo, Inc., Pepsi-Cola International, Pizza Hut (U.S. and International), Frito-Lay and Taco Bell.

 

Christian L. Campbell is currently owner of Christian L. Campbell Consulting LLC, specializing in global corporate governance and compliance.  Mr. Campbell previously served as senior vice-president, general counsel and secretary of Yum Brands from its formation in 1997 until his retirement in February 2016.

 

Ed Chan Yiu-Cheong is currently a vice-chairman of Charoen Pokphand Group Company Limited and has been an executive director and vice-chairman of CP Lotus Corporation since April 2012.  Mr. Chan was regional director of North Asia of the Dairy Farm Group.

 

Edouard Ettedgui currently serves as the non-executive chairman of Alliance Française, Hong Kong.  Mr. Ettedgui also currently serves as a non-executive director of Mandarin Oriental International Limited, the company for which he was the group chief executive.  Prior to that, Mr. Ettedgui was the chief financial officer for Dairy Farm International Holdings.

 

Louis T. Hsieh currently serves as a senior adviser to the chief executive officer and as a director of New Oriental Education & Technology Group.

Jonathan S. Linen is a member of the board of directors of Yum! Brands, a position he has held since 2005, and of Modern Bank, N.A.  Mr. Linen is advisor to the chairman of American Express Company after serving as the vice-chairman of American Express Company.  Mr. Linen also served on the board of The Intercontinental Hotels Group.

 

Micky Pant is the chief executive officer of Yum China.  Mr. Pant has served as chief executive officer of Yum! Restaurants China since August 2015.  Over the past decade, Mr. Pant has held a number of leadership positions at Yum! Brands, including chief executive officer of the KFC Division, chief executive officer of Yum! Restaurants International and president of Global Branding for Yum! Brands and President of Taco Bell International.

 

Zili Shao has served as co-chairman of King & Wood Mallesons – China.  Mr. Shao held various positions with JPMorgan Chase & Co., including chairman and chief executive officer of JPMorgan China, vice-chairman of JPMorgan Asia Pacific and chairman of JPMorgan Chase Bank (China) Company Limited.

 

Yum China announces its Chairman and CEO succession plans

On 5th October 2017, Yum China announced that its Chief Executive Officer, Mr. Micky Pant, would become Vice-Chairman of the board and Senior Advisor to the company on 1st March 2018.  Ms. Joey Wat, who currently serves as President and Chief Operating Officer, would succeed Mr. Pant as Chief Executive Officer.

 

The company explained that Mr. Pant had served as CEO and a member of the Board of Yum China since its spin-off from Yum! Brands, Inc. and, prior to that, he served as CEO of Yum! Restaurants (China), when it was a division of Yum Brands Inc.

“We are exceptionally grateful to Micky for leading the Company through its spin-off and building a solid foundation as an independent company,” said Dr. Fred Hu, Chairman of the Board of Yum China Holdings.  “We thank Micky for his many significant contributions and are pleased that he will be Vice-Chairman of the Board and will also continue to serve the Company as its Senior Advisor in order to ensure a seamless transition to Joey.”

“Joey is an extraordinarily talented executive and the ideal leader to become our next CEO,” Dr. Hu continued.  “Joey has a strong track record of achieving results, and with her unique ability to translate vision and strategy into future world-class operations, I have no doubt that the Yum China business will continue to grow under her strong leadership.

Ms. Wat spent seven years in management consulting, including time with McKinsey & Company’s Hong Kong office.  From 2004 to 2014, she served in both management and strategy positions in the Hong Kong-based Hutchison Whampoa group, including time as Managing Director of their UK company, which operates the pharmacy chain Superdrug.  Ms. Wat joined Yum China in September 2014, first as President of KFC China and then as Chief Executive Officer of KFC China in August 2015.  She has been the President and Chief Operating Officer of Yum China since February 2017 and was appointed as a member of the Board in July 2017.

 

Source: Tricker, Bob and Gregg Li, Understanding Corporate Governance in China, Hong Kong University Press [forthcoming]

 

[1] Yum China press release.

 

Cyber Security: A Question of Risk

Cyber security has been in the headlines recently with high profile incidences of hacking of various organisations’ IT systems and their supposedly secure data.

The ‘UK Corporate Governance Code (2016)’ discusses risk management and internal control stating ‘ The directors should confirm in the annual report that they have carried out a robust assessment  of  the  principal  risks  facing  the  company, including  those that would threaten  its  business  model,  future  performance,  solvency  or  liquidity.  The directors should describe those risks and explain how they are being managed or mitigated’, para C.2.1.

The UK’s Financial Reporting Council (FRC) placed cyber security firmly on the agenda for companies’ risk management strategies when, in October 2016, they wrote to audit committee chairs and finance directors, commenting “we encourage companies to consider a broad range of factors when determining the principal risks and uncertainties facing the business, for example cyber security and climate change”.

The Federation of European Risk Management Associations (FERMA) and the European Confederation of Institutes of Internal Auditing (ECIIA) published a joint report ‘At the Junction of Corporate Governance & Cyber Security (2017).’  The report recommends that the fundamentals of a cyber risk management framework should be based on the OECD  principles contained in ‘OECD  Recommendation – Digital Security Risk Management for Economic and Social Prosperity (2015)’ and the ‘Three  Lines  of  Defence’  model  promoted  in the joint FERMA-ECIIA publication ‘Audit and Risk Committees – News from EU Legislation and Best Practices (2014)’.

The FERM-ECIIA (2017) report’s conclusions include: beyond IT, cyber-security is also becoming a matter of corporate governance, and the right governance framework is crucial to an efficient management of cyber risks; organisations should create a “Cyber Risk Governance Group”, reporting to the Risk Committee and chaired by the Risk Manager, to determine with other functions the cyber risk exposure, expressed financially, and establish the possible mitigation plans. The Group should cooperate with Internal Auditors to avoid silos; Internal Auditors review the controls implemented and give an independent assurance to the Audit Committee about the cyber risk, the efficiency of the controls and the mitigation plans; the Risk Committees and the Audit Committees must collaborate to present a common view to the Board about cyber risk management.

Cyber security in large FTSE companies

In February 2017, Deloitte published its ‘Cyber Reporting Survey (2017)’ which is available here.  It provides useful insights into the cyber reporting practices of the UK’s FTSE 100 companies. The outcomes of their review of FTSE 100 annual report disclosures include that 87% companies disclose cyber as a principal risk; the value destruction capability of cyber risk is very high, ranging from remediation demands to huge reputation damage; detailed disclosure highlights the risks to shareholders and the better disclosures are company specific, year specific and provide sufficient detail to give meaningful information to investors and other stakeholders; boards and board committees are increasingly educating themselves about the cyber threat and challenging management on how they are dealing with the risk; companies should take credit for what they are doing, including describing who has executive  responsibility, board level responsibilities, the policy framework, internal controls, and disaster recovery plans. The Deloitte’s Cyber Reporting Survey also points out that the UK does not have a specific cyber security disclosure framework but that the USA may provide helpful guidance on such disclosure as the Securities and Exchange Commission (SEC) issued disclosure guidance as far back as 2011.

In July 2017, HM Government published their ‘FTSE 350 Cyber Governance Health Check Report 2017’. The Government has undertaken a regular survey of the UK’s top 350 companies since 2013, to understand how they are managing their cyber risks. Overall 105 companies responded to the 2017 Health Check survey with the majority being the Chair of their company’s audit committee. Cyber risk is now seen as a top, or group-level risk, among the majority of Boards (54%) when compared with all the risks faced by their company. Only 13% of respondents now say cyber risk is viewed as a low, or an operational-level risk for their Boards. Whilst 31% of boards receive comprehensive and informative management information on cyber risks, 68% say they have not received any training to deal with a cyber incident.

Concluding thoughts

The reports discussed above indicate a common theme that cyber security is of increasing importance, that cyber risk is recognized as a major risk facing companies, and that managing that risk is part of a robust corporate governance structure.  There is still a consensus to be reached on whether the risk committee, the audit committee, or a cyber risk governance group is the most appropriate to manage this risk and how they might work together to do so. However it seems clear that in the near future more attention will have to be paid to training in cyber security issues and the appointment of qualified individuals with relevant knowledge of this area to corporate boards/board committees.

Chris Mallin

November 2017

Boards need ability not diversity

Corporate governance thinking does not evolve: it skips from one topic to the next.  Ideas in corporate governance are like memes: they convey ideas just as genes convey physical characteristics, as I wrote on this blog some time ago.  These memes permeate thinking, and with today’s instant communication flash around the world, become the conventional wisdom.

A couple of years ago the theme was risk.  Cadbury and the early corporate governance codes had nothing to say about risk. Now boards needed to recognize their responsibility for identifying their company’s risk profile, assessing long-term strategic risk, and ensuring that appropriate risk policies were in place and working.  Risk had become a central issue in corporate governance.

More recently, it was culture- although commentators seemed unable to agree on what they meant by culture.  In March this year, I wrote in this blog that culture ‘can be thought of as the beliefs, expectations and values that people share’.  Like the skins of an onion, culture has many layers – national, regional, corporate cultures, and the culture of the board room.  Recent commentary about culture in corporate governance thinking has focused on board-level culture, which sets the tone throughout the organization and provides its moral compass.  Board-level culture reflects the experience, beliefs and expectations of the board members, particularly the leadership style of the board chairman and the effect of any dominant personalities on the board.

Introducing the concept of culture into corporate governance adds new dimensions, with behavioural, political, and psychological aspects that are difficult to identify, let alone quantify.  In February 2017, the UK Department for Business, Energy, and Industrial Strategy (BEIS) published a report on corporate governance reform that identified culture as ‘the central tenet of good corporate governance (which) should be embedded in the culture of all companies, so that it permeates activity at every level and in every sphere.’  Fine: but what does that actually mean?  What are boards expected to do to make the concept operational?

On board diversity

Now the focus has shifted again: board diversity has come into the spotlight. Again, however, ideas differ on what board diversity means.  The time has come for some clearer thinking.

It seems that most people, when talking about board diversity, mean gender diversity: the need to have more women directors.  That case seems clear and, around the world, efforts are being to increase the proportion of women on boards through mandatory quotas or voluntary targets. The challenge is to increase the pool of women with executive management experience. The BEIS report, mentioned above, recommends that ‘the UK Government should set a target that from 2020 at least half of all new appointments to senior and executive management level positions in all listed companies should be women’.

To others, however, board diversity means something quite different.

The UK’s Financial Reporting Council; welcoming the Hampton/Alexander report in November 2016, wrote that it:

‘looked forward to working with the review team to improve reporting on diversity. In light of the current public debate on corporate governance, we stand ready to revise the UK Corporate Governance Code following the Government consultation. Our work on succession planning this year suggested that nomination committees should take a more active interest in talent management, in particular that initiatives are in place to develop the talent pipeline and to promote diversity in board and executive appointments. To better inform boards about the link between diversity, strategy and developing the business, more consideration should be given to the nature, variety and frequency of interaction between the board and aspiring candidates at all levels.’
The BEIS report also refers explicitly to ‘ethnic diversity’ and recommends further measures ‘to ensure that diversity is promoted at all stages of careers to broaden the pool of talent at the executive level.’  The report further calls for ‘companies [to] recruit executive and non-executive directors from the widest possible base’. The report concludes with a rallying cry: ‘Overall, [our] recommendations are aimed at permanently ingraining the values and behaviours of excellent corporate governance into the culture of British business.’

Before we all rally to this banner, more clarity of thought is needed.

 

What is the purpose of the board of directors?

The role of the board of directors, indeed the role of the governing body of every organization, is to govern.  To put it in the vernacular, corporate governance means ensuring that the enterprise is being well run and that it is running in the right direction.  This is quite different from managing the business, as I have written many times in this blog. In essence, the governance of a company includes overseeing the formulation of its strategy and policy making, supervision of executive performance, and ensuring corporate accountability. Overall, the purpose of the board is to ensure that the company meets its objectives.

But that exposes a deeper question: what is the real purpose of a profit-orientated company?  The answer has not changed since the classical nineteenth century model of the joint-stock limited-liability company was invented: to create wealth, by providing employment, offering opportunities to suppliers, satisfying customers, and meeting shareholders’ expectations.

Companies meet their societal obligations by paying taxes, adopting socially responsible policies, and obeying the law of the lands in which they operate. Companies should not be seen as vehicles for social engineering.  The board does not need to reflect the structure of society.

Admittedly, the UK Companies’ Act does call for companies to recognize the interests of other stakeholders, including employees, suppliers and customers: though it is hard to see how a company could survive by ignoring them.   Stakeholder Senates, which I suggested in this blog preciously, could provide employee, market, and societal input to board deliberations, could include representatives of young and old, poor and rich, ethic and other minorities.

To fulfil the company’s primary purpose of creating wealth, a board does not need to reflect society. It needs people who can contribute effectively to its governance. In other words, the qualities needed to be a director are the experience, knowledge, and ability relevant to governing that company, backed up in a fast-moving business environment with the ability to continue to learn and adapt. Companies are often competing with other companies around the world, whose directors are experienced professionals, in China for example.

Attempts by the UK’s FRC to revise the corporate governance code needs to be clear on the proper role of the board of directors.  Ability at board level is vital for corporate success; social diversity has nothing to do with it.

Bob Tricker, October 2017

The views expressed in this blog are those of the author and are not necessarily those of the Oxford University Press, or fellow blogger Professor Chris Mallin.

 

British Airways loses IT – a case study

British Airways (BA) used to be called ‘the worlds favourite airline.’  Not any more.   On May 27 2017, a world-wide systems failure grounded all BA flights.  Check-in desks at London’s Heathrow and Gatwick and other airports around the world were unable to access passenger details.  470 flights were cancelled in London and a further 183 on the following day, with many more flights stranded around the world. Tens of thousands of passengers were left standing around for hours with no information, until being told to ‘come back tomorrow’.  BA airport staff seemed unprepared for the huge numbers of stranded passengers. BA web sites and inquiry operators had little information, other than that all flights had been cancelled. Passenger baggage piled up and did not reach them for days.  Compensation claims for delays and lost baggage were estimated at over £100 million.   The reputation loss for BA was immeasurable.

Although some immediately thought this must be a cyber attack, it was not.  BA’s initial explanation for the systems breakdown was loss of power to servers on the central reservation system. Other systems reliant on access to passenger data, including the flight loading system and the baggage handling system, then shut down.

IT experts suggested that with such sophisticated systems, BA must have included back-up power supplies.  Indeed they had, but it emerged that the power had failed totally because a maintenance worker had turned it off.  The back-up systems, a generator and batteries were working perfectly.  Then, once power was restored, efforts to re-boot the systems were bungled.

Some BA ex-employees, who had been laid off as a result of a head office cost cutting drive, suggested that the heart of the problem was a decision to out-source IT work to an Indian company.  ‘The BA system is a legacy system that has evolved over generations of equipment and software changes,’ they said. ‘The inter-relatedness of the systems and the complexity of the data is immense.  BA needed people who had grown up with the system.  This is not the first time the system has failed this year.’  BA denied this suggestion.

British Airways, once the country’s flag-carrier, is now a subsidiary of the International Airline Group (IAG), a Spanish company, which also owns Iberia, the Spanish airline.  IAG’s shares had risen significantly in the previous year and suffered only a small fall following the BA systems saga.

The CEO of IAG, Willie Walsh (who had previously headed BA) did not appear during the crisis, leaving the situation to be handled by BA’s CEO, Alex Cruz.  They were both criticised for delays in offering explanations or apologies.  An official raised a storm by suggesting that passengers would receive full refunds on their tickets, but BA would not pay for the cost of missed connecting flights, alternative travel arrangements, or accommodation.

Subsequently, BA apologised to its customers and commissioned an independent inquiry.  The British airlines’ regulator, the Civil Aviation Authority, was also called on to examine the case.

At the previous AGM of IAG, shareholders had received a letter from a corporate governance advisory group that ‘the board should consider bolstering the IT experience of its non-executive cohort: only one of the serving non-executive directors has IT experience.’

 

Discussion questions:

  1.  Who was responsible for this debacle?
  2. How might such a situation have been avoided?

New Developments in UK Corporate Governance

New Developments in UK Corporate Governance

In previous blogs, I discussed the Department for Business, Energy & Industrial Strategy (BEIS) Green Paper on Corporate Governance Reform issued in November 2016 and the BEIS report which detailed its recommendations and conclusions based on the consultation of this Green Paper.  On 29th August 2017, the UK Government published ‘Corporate Governance Reform, The Government Response to the Green Paper Consultation’, available at: https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/640631/corporate-governance-reform-government-response.pdf

In the Executive Summary, it states that ‘The purpose of corporate governance is to facilitate effective, entrepreneurial and prudent management that can deliver the long-term success of a company. It involves a framework of legislation, codes and voluntary practices.  A key element is protecting the interests of shareholders where they are distant from the directors running a company. It also involves having regard to the interests of employees, customers, suppliers and others with a direct interest in the performance of a company. Good corporate governance provides confidence that a company is being well run and supports better access to external finance and investment.’

The Executive Summary goes on to say that there are nine headline proposals for reform across the three specific aspects of corporate governance on which they consulted, ‘these being executive pay;  strengthening the employee, customer and supplier voice; and corporate governance in large privately-held businesses. It also takes into account the need for effective enforcement of the corporate governance framework.’

Of particular note are that all listed companies will have to reveal the pay ratio between bosses and workers; all listed companies with significant shareholder opposition to executive pay packages will have their names published on a new public register;  and new measures will seek to ensure employee voice is heard in the boardroom.

https://www.gov.uk/government/news/world-leading-package-of-corporate-governance-reforms-announced-to-increase-boardroom-accountability-and-enhance-trust-in-business

 

George Parker highlighted the emphasis on boardroom pay in his article ‘May maintains focus on boardroom pay’ (Financial Times, 26th/27th August 2017, page 2). The High Pay Centre welcomes the requirement for all listed companies to publish their pay ratios ‘Most significant of all, from our point of view, was the announcement that the pay ratio between the CEO and the average UK employee will now have to be published by every listed company. We have never claimed that this measure will solve the problem of excessive pay at the top, nor that it will suddenly halt and reverse a trend that has developed over 20 years and more. Unfair or misleading comparisons between pay ratios in very different businesses or organisations should not be made. But finally we will have a meaningful way of tracking the gap in pay between the top and the average employee. Shareholders and other stakeholders will be able to scrutinise these gaps and apply pressure to close them. And this can be done, of course, not just by restraining pay at the top but raising pay for those lower down the scale.’ (Stefan Stern September Update, High Pay Centre).

The Financial Reporting Council (FRC) will be undertaking a consultation on a fundamental review of the UK Corporate Governance Code later this year as the 25th anniversary of the UK Corporate Governance Code approaches later in 2017.

 

Chris Mallin

September 2017

On board culture and diversity

Corporate governance thinking and practice seems to evolve either as regulators respond to corporate failings or directors adopt the prevailing conventional wisdom.  A year or two ago, the call was for boards to recognize their responsibility for identifying their company’s risk profile, assessing long-term risk, and ensuring appropriate risk  strategies and policies were in place and working appropriately.   Cadbury and the other early corporate governance codes had nothing to say about risk: now it has become a central issue.

Today, the conventional wisdom is focusing on board culture and board diversity.  But commentators seem unable to agree on what is actually meant by culture or diversity.  The time has come for some clearer thinking.

In March this year, I wrote in this blog that culture ‘can be thought of as the beliefs, expectations, and values that people share.  Like the skins of an onion, culture has many layers – national cultures, regional cultures, the culture of a company, and the culture in a board room.’  Much of the recent commentary about culture in corporate governance has focused on board level culture and its reflection on the culture of the company. so that it permeates activity at every level and in every sphere.

In its February 2017 report on corporate governance reform[1], the UK Department for Business, Energy and Industrial Strategy identified culture as ‘the central tenet of good corporate governance (which) should be embedded in the culture of all companies, so that it permeates activity at every level and in every sphere.’  Now what does that actually mean?  What do directors need to do to make it operational?

Board level culture depends on the experience, beliefs and expectations of those involved and, in particular on the leadership of the bard chairman and any other dominant personalities on the board.

Composition of boards

Companies should recruit executive and non-executive directors from the widest possible base.

The Report supports the recommendations of recent reviews on gender and ethnic diversity but recommends further measures ‘to ensure that diversity is promoted at all stages of careers to broaden the pool of talent at the executive level. To this end, the Government should set a target that from May 2020 at least half of all new appointments to senior and executive management level positions in the FTSE350 and all listed companies should be women.’ Overall, the Report’s recommendations are aimed at permanently ingraining ‘the values and behaviours of excellent corporate governance into the culture of British business.’

 

[1] For more information see the most recent blog from Professor Chris Mallin on this website.