Archive for the ‘corporate governance codes’ Category

Business ethics is the bedrock of corporate governance

Serious study of corporate governance is relatively new.  Early books on the work of directors and boards date back no more than forty years and the subject only acquired its title in the mid 1980s.  Throughout the 20th century, the focus of attention was not on corporate governance but on management.  Marketing, production, finance, operations research, and management information systems were at the forefront of interest.   Organizational studies forged ahead, but the board of directors seldom appeared on the organization chart.

Now corporate governance has become the focus for the 21st. century.  True, the US Securities and Exchange Commission had existed since 1934, promoting sound corporate regulation and reporting practices.  But that was before the collapse of Enron, the world-wide implosion of Arthur Andersen, and the sub-prime financial catastrophe.  Corporate scandal and collapse in the 1980s led to the first corporate governance code: the UK’s Cadbury Report.  This seminal work soon led to codes in other countries around the world.  

These codes, however, tended to concentrate on form rather than function, emphasizing the importance of independent outside directors, the need for audit, remuneration, and nomination committees of the board, and the separation of the role of the board chairman from the CEO.   More recently, enterprise risk assessment, and corporate social responsibility have been added to the lexicon.  Corporate governance reports were required confirming that public companies had complied with the code or, if not, explaining why.    With the emphasis on structure, little concern was shown for the process of corporate governance: what actual goes on inside the board room, the leadership style of the chairman, internal political manoeuvres, and directors’ inter-personal behaviour when strong personalities meet.

 Corporate governance is about the way power is exercised over corporate entities. 

It involves the behaviour of boards and their directors, the interaction between the governing body and management, the company’s links with its shareholders and other players in the stock market, and the relations between the company and its many stakeholders.  It involves strategy formulation and policy making on the one hand, and executive supervision and accountability on the other.

Corporate governance codes have been incorporated into the rules of many stock exchanges and compliance has become a requirement for listing.  They have developed and reinforced good governance structures. But have they changed corporate behaviour? 

Have the codes worked? 

The corporate governance codes have certainly been a force for improving governance structures, procedures, and reporting.  But the codes have not changed perceptions of corporate behaviour.  Consider a few cases. 

  • BP, the oil company, published policies on corporate social responsibility and sustainability, yet lost over half its share value following the Deepwater Horizon oil-rig debacle in the Gulf of Mexico. 
  • Companies claiming to be good corporate citizens have been criticized for ‘aggressive’ tax avoidance by moving their profits, legally but questionably, through offshore tax havens. 

Despite companies’ declared commitment to corporate social responsibility, publishing ethics codes and compliance reports, concerns about business ethics are widespread and serious.  Around the world, the behaviour of companies, the attitudes of their directors and the actions of key executives have come under the public spotlight.  Fraudulent management in Australia’s HIH Insurance, the world-wide collapse of auditors Arthur Andersen, corruption in Italy’s Parmalat, allegations of bribery against BAE Systems in Europe, the rigging of Libor interest rates by British banks and, of course, excessive risk taking by financial institutions around the world that sparked the global economic crisis, provide just a few examples.

Critics of business behaviour point to fraud, bribery and corruption.  They allege price-rigging, pollution, and counterfeiting.  They see arrogance, greed, and abuse of power by those at the top of companies.  Some are cynical about business behaviour. How can you trust these people, they ask?  Protestors challenge the basis of capitalism. For them, business ethics has become an oxymoron, citing corporate avarice, disparity of wealth, and excessive director remuneration that does not reflect corporate performance.

Yet business exists by satisfying customers, creating employment, and generating wealth.  Business provides the taxes that society needs to function.  Many companies accept a social responsibility to be sound corporate citizens.  They recognize that they have a duty to respect the interest of all the stakeholders who might be affected by their actions. Many also seek a sustainable, environmentally friendly approach to their operations. To those who doubt whether modern business can be trusted, they point out that business dealings and the very concept of the limited-liability company are based on trust.  Not everyone is convinced.

Since the 19th century, the underpinning of corporate governance has been company law, with ownership as the basis of power.  Shareholder members of the company appoint directors, approve the directors’ reports and financial accounts, receive the report of the auditors, and approve dividends.  The fiduciary duty of the directors is to be stewards for their shareholders’ interests.  The reality, as we all know, is very different, particularly in large, international, listed companies.  It is the directors, not the shareholders, who wield the power over the corporate entity, despite valiant attempts by institutional investors to regain the initiative.

Meanwhile, interest in business ethics seems to be at an all time high. The subject of business ethics has grown significantly, with interest focusing on corporate citizenship, companies’ social responsibilities, and their relations with stakeholders.  More recently, green credentials and sustainability have been added to the agenda.  But business ethics is not just about corporate citizenship: business ethics are basic to running successful business. 

Ethics and the corporate governance codes

Ethics are hardly mentioned in the corporate governance codes, yet the examples just cited all raise ethical issues.  They concern the way those companies were governed, how power was exercised over them, and the way business risks were taken.  In other words, business ethics are inherently part of corporate governance. They are not an optional exercise in corporate citizenship. 

Ethics involve behaviour.  Business ethics concern behaviour in business and the behaviour of business.  Decisions at every level in a company have ethical implications – strategically in the board room, managerially throughout the organization, and operationally in each of its activities.  Ethical risks abound, whether decisions are at the strategic, managerial, or operational level.

Corporate entities, though granted many of the legal powers of human beings, have no moral sense. The board has to provide the corporate conscience.  Directors set the standards for their organization, provide its moral compass. British-based Barclays bank was fined £290 million by US and UK regulators for colluding with other banks to rig the interest rates set for loans between them.  Misstating the rate improved the financial standing of the bank and increased traders’ bonuses.  The British regulator said that “the misconduct was serious, widespread and extended over a number of years…There was a cultural tendency to always be pushing the limits… a culture of gaming, and gaming us.  The problem came from the tone at the top.”  Every organization’s culture is fashioned by its board and top management.  

Ultimately, the board of directors and top management are responsible for the ethical behaviour of their enterprise.  The board of directors with top management are responsible for establishing their company’s risk profile, determining the acceptable level of risk.  Some companies accept higher levels of risk than others.  Determining the acceptable exposure to ethical risk needs to be part of every organization’s strategy formulation, policy making, and enterprise risk management.

With moral dilemmas in business it is often not a matter of right or wrong, but what’s best for all concerned, both in the company and among all those affected by its actions.  Boards have to recognize issues and make choices.  This is a function of corporate governance, which needs to be built on the bedrock of business ethics.  It seems likely that future codes of corporate governance will find their foundations in ethics.

Bob Tricker

6.9.2012

UK Stewardship Code – Compliance

As reported in an earlier blog post (5th July 2010), the Financial Reporting Council (FRC) issued the UK Stewardship Code in the summer of 2010 with the aim of enhancing ‘the quality of engagement between institutional investors and companies to help improve long-term returns to shareholders and the efficient exercise of governance responsibilities’.

The principles of the UK Stewardship Code are:

 Principle 1: Institutional investors should publicly disclose their policy on how they will discharge their stewardship responsibilities.

 Principle 2: Institutional investors should have a robust policy on managing conflicts of interest in relation to stewardship and this policy should be publicly disclosed.

 Principle 3: Institutional investors should monitor their investee companies.

 Principle 4: Institutional investors should establish clear guidelines on when and how they will escalate their activities as a method of protecting and enhancing shareholder value.

 Principle 5: Institutional investors should be willing to act collectively with other investors where appropriate.

 Principle 6: Institutional investors should have a clear policy on voting and disclosure of voting activity.

 Principle 7: Institutional investors should report periodically on their stewardship and voting activities.

 To what extent have asset managers, asset owners and service providers complied with the recommendations of the Stewardship Code?  Several reports have been produced which detail the level of compliance.

Level of compliance

The FairPensions (2010) survey analysed 29 of the largest asset managers and found that 24 of these had published a formal statement/response with respect to the Stewardship Code. An additional four (Insight, Invesco, Morgan Stanley and State Street) had posted short statements on their website referring to the Code. FairPensions reviewed the 24 compliance statements to assess the quality of disclosures made with respect to the Code.

They were disappointed as they felt that the investors’ statements often gave ‘tick-box’ responses to the Stewardship Code principles whereas it was an opportunity to “tell their story” as to how they monitor companies and incorporate stewardship activity into their wider investment process. http://www.fairpensions.org.uk/sites/default/files/uploaded_files/whatwedo/StewardshipintheSpotlightReport.pdf

The Investment Management Association (IMA) (2011) survey of adherence to the Stewardship Code analysed the questionnaire responses from 41 asset managers, seven asset owners and two service providers. The questionnaire was developed with the oversight of a Steering Group chaired by the FRC’s Chief Executive.  The IMA (2011) survey covered the period to 30 September 2010 and showed widespread adherence by 50 UK institutional investors to the best practice set out in the FRC’s Stewardship Code. The IMA reported:

“Over 90% of major institutional investors now vote all or the great majority of their shares in UK companies; nearly two thirds now publish their voting records.

At the time the survey was conducted, 43 out of 50 respondents had published a statement on adherence to the Code, and another six did so subsequently.

Over 1,300 people focusing on stewardship activities are employed by 43 of the respondents to the survey.”

http://www.investmentfunds.org.uk/research/stewardship-survey

The FRC (2011) published Developments in Corporate Governance 2011, The Impact and Implementation of the UK Corporate Governance and Stewardship Codes, FRC, London.

http://www.frc.org.uk/images/uploaded/documents/Developments%20in%20Corporate%20Governance%2020117.pdf

They reported that, as of December 2011 the Stewardship Code had attracted 234 signatories, including 175 asset managers, 48 asset owners and 12 service providers23. This level of take-up indicates that the concept of stewardship is being taken seriously.  Importantly there has been a wide base of support for the Stewardship Code including from both large and small institutional investors.

There seems to be rather mixed evidence as to whether institutional shareholders are engaging more with their investee companies since the Stewardship Code was introduced. However over time it is to be expected that overall there will be a higher level of engagement.

Reasons for non-compliance

Organisations not complying with the Stewardship Code tend to fall into two groups: (i) those not signing based on their specific investment strategy, and (ii) those who do not commit to codes in individual jurisdictions.

Future developments

The FRC proposes to make limited revisions to both the UK Corporate Governance Code and the Stewardship Code which, subject to consultation, will take effect from 1st October 2012. As far as the Stewardship Code is concerned, they FRC state that it is ‘not currently envisaged that new principles will be introduced but it may be helpful to clarify the language in certain places, for example on the different role of asset managers and asset owners.’

Areas where the FRC might consider strengthening the language include conflicts of interest, collective engagement, and the use of proxy voting agencies, and possibly a recommendation that investors disclose their policy on stock lending.

Finally a Stewardship Working Party has been formed consisting of Aviva Investors, BlackRock, Governance for Owners, Railpen Investments, Ram Trust and USS together with Tomorrow’s Company.  They will determine whether it is possible to devise a “scale of stewardship” which would enable institutions to differentiate themselves.

 Chris Mallin 8th March 2012

The Cultural Dependence of Corporate Governance

In September 2011, the Corporate Secretaries International Association (CSIA) hosted an international corporate governance conference in Shanghai, jointly with the Shanghai Stock Exchange.  CSIA represents over 100,000 governance practitioners worldwide through its 14 company secretarial member organizations. Speakers and panellists from Africa, Australia, mainland China, Hong Kong SAR, India, the UK and the US plus delegates from the 14 CSIA member countries discussed the cultural dependence of corporate governance.  For more information on CSIA see http://www.csiaorg.com

The conference considered whether corporate governance principles and practices around the world were converging.  Would a set of world-wide, generally-accepted corporate governance principles eventually emerge?  Or was differentiation between corporate governance practices inevitable because of fundamental differences in country cultures?  

Speaking at the conference the writer of this blog suggested that:

“A decade or so ago, it was widely thought that corporate governance practices around the world would gradually converge on the United States model.   After all, the US Securities and Exchange Commission had existed since 1934, sound corporate regulation and reporting practices had evolved, and American governance practices were being promulgated globally by institutional investors.  But that was before the collapse of Enron, Arthur Andersen, the sub-prime financial catastrophe, and the ongoing global economic crisis.  A decade ago it was also believed that the world would converge with US practices because the world needed access to American capital. That is no longer the case. So the convergence or differentiation question remains unanswered. 

Forces for convergence

“Consider first some forces that are leading corporate governance practices around the world to convergence.

Corporate governance codes of good practice around the world have a striking similarity, which is not surprising given the way they influence each other.  Though different in detail, all emphasise corporate transparency, accountability, reporting, and the independence of the governing body from management, and many now include strategic risk assessment and corporate social responsibility.  The codes published by international bodies, such as the World Bank, the Commonwealth of Nations, and OECD, clearly encourage convergence.  The corporate governance policies and practices of major corporations operating around the world also influence convergence.

Securities regulations for the world’s listed companies are certainly converging.  The International Organisation of Securities Commissions (IOSCO), which now has the bulk of the world’s securities regulatory bodies in membership, encourages convergence.  For example, its members have agreed to exchange information on unusual trades, thus making the activities of global insider trading more hazardous. 

International accounting standards are also leading towards convergence.  The International Accounting Standards Committee (IASC) and the International Auditing Practices Committee (IPAC) have close links with IOSCO and are further forces working towards international harmonization and standardization of financial reporting and auditing standards.   US General Accepted Accounting Principles (GAAP), though some way from harmonization, are clearly moving in that direction.

In 2007, The US Securities and Exchange Commission announced that US companies could adopt international accounting standards in lieu of US GAAPs.   However, American accountants and regulators are accustomed to a rule-based regime and international standards are principles-based requiring judgement rather than adherence to prescriptive regulations.

Global concentration of audit for major companies in just four firms, since the demise of Arthur Andersen, encourages convergence.  Major corporations in most countries, wanting to have the name of one of the four principal firms on their audit reports, are then inevitably locked into that firm’s world-wide audit, risk analysis and other governance practices.

Globalisation of companies is also, obviously, a force for convergence. Firms that are truly global in strategic outlook, with world-wide production, service provision, added-value chain, markets and customers, which call on international sources of finance, whose investors are located around the world, are moving towards common governance practices. 

Raising capital on overseas stock exchanges, also encourages convergence as listing companies are required to conform to the listing rules of that market. Although the governance requirements of stock exchanges around the world differ in detail, they are moving towards internationally accepted norms through IOSCO.

International institutional investors, such as CalPers, have explicitly demanded various corporate governance practices if they are to invest in a specific country or company. Institutional investors with an international portfolio have been an important force for convergence.  Of course, as developing and transitional countries grow, generate and plough back their own funds, the call for inward investment will decline, along with the influence of the overseas institutions.

Private equity funding is changing the investment scene.  Owners of significant private companies may decide not to list in the first place. Major investors in public companies may find an incentive to privatise. Overall the existence of private equity funds challenges boards of listed companies by sharpening the market for corporate control. 

Cross-border mergers of stock markets could also have an impact on country-centric investment dealing and could influence corporate governance expectations; as could the development of electronic trading in stocks by promoting international securities trading.

Research publications, international conferences and professional journals can also be significant contributors to the convergence of corporate governance thinking and practice.            

Forces for differentiation

“However, despite all these forces pushing towards convergence, consider others which, if not direct factors for divergence, at least cause differentiation between countries, jurisdictions and financial markets.

Legal differences in company law, contract law and bankruptcy law between jurisdictions affect corporate governance practices.  Differences between the case law traditions of the US, UK and Commonwealth countries and the codified law of Continental Europe, Japan, Latin America and China distinguish corporate governance outcomes.

Standards in legal processes, too, can differ.   Some countries have weak judicial systems. Their courts may have limited powers and be unreliable.  Not all judiciaries are independent of the legislature.  The state and political activities can be involved in jurisprudence. In some countries bringing a company law case can be difficult and, even with a favourable judgement, obtaining satisfaction may be well nigh impossible.                

Stock market differences in market capitalisation, liquidity, and markets for corporate control affect governance practices.  Obviously, financial markets vary significantly in their scale and sophistication, affecting their governance influence.

Ownership structures also vary between countries, with some countries having predominantly family-based firms, others have blocks of external investors who may act together, whilst some adopt complex networked, leveraged chains, or pyramid structures.

History, culture and ethnic groupings have produced different board structures and governance practices. Contrasts between corporate governance in Japan with her keiretsu, Continental European countries, with the two-tier board structures and worker co-determination, and the family domination of overseas Chinese, even in listed companies in countries throughout the Far East, emphasise such differences.  Views differ on ownership rights and the basis of shareholder power.

The concept of the company was Western, rooted in the notion of shareholder democracy, the stewardship of directors, and trust – the belief that directors recognise a fiduciary duty to their company.  But today’s corporate structures have outgrown that simple notion.  The corporate concept is now rooted in law, and the legitimacy of the corporate entity rests on regulation and litigation. The Western world has created the most expensive and litigious corporate regulatory regime the world has yet seen.  This is not the only approach; and certainly not necessarily the best.  The Asian reliance on relationships and trust in governing the enterprise may be closer to the original concept.   There is a need to rethink the underlying idea of the corporation, contingent with the reality of power that can (or could) be wielded.  Such a concept would need to be built on a pluralistic, rather than an ethnocentric, foundation if it is to be applicable to the corporate groups and strategic alliance networks that are now emerging as the basis of the business world of  the future. 

Around the world, the Anglo-Saxon model is far from the norm. A truly global model of corporate governance would need to recognise alternative concepts including:

  • the networks of influence in the Japanese keiretsu
  • the governance of state-owned enterprises in China, where the China Securities and Regulatory Commission (CSRC) and the State-owned Assets Supervision and Administration Commission (SASAC) can override economic objectives, acting in the interests of the people, the party, and the state, to influence strategies, determine prices, and appoint chief executives
  • the partnership between labour and capital in Germany’s co-determination rules
  • the financially-leveraged chains of corporate ownership in Italy, Hong Kong and elsewhere
  • the power of investment block-holders in some European countries
  • the traditional powers of family-owned and state-owned companies in Brazil
  • the domination of spheres of listed companies in Sweden, through successive generations of a family, preserved in power by dual-class shares
  • the paternalistic familial leadership in companies created throughout Southeast Asia by successive Diaspora from mainland China
  • the governance power of the dominant families in the South Korean chaebol, and
  • the need to overcome the paralysis of corruption from shop floor, through boardroom, to government officials in the BRIC and other nations.

The forces for convergence in corporate governance are strong. At a high level of abstraction some fundamental concepts have already emerged, including the need to separate governance from management, the importance of accountability to legitimate stakeholders, and the responsibility to recognize strategic risk. These could be more widely promulgated and adopted. But a global convergence of corporate governance systems at any greater depth would need a convergence of cultures and that seems a long way away.

Bob Tricker

5.11.2011

 

Stock Lending

Stock lending is the lending of securities (including equities, government bonds and corporate debt obligations) to a borrower, with the borrower agreeing to return equivalent securities to the lender at a pre-determined time. The focus of this article is on the lending of securities and, in particular, the potential impact on shareholders’ votes.

Benefits and costs

The International Corporate Governance Network (ICGN) Securities Lending Code of Best Practice (2007) identifies the potential benefits but also the potential corporate governance implications of stock lending.  Benefits of stock lending include that it ‘improves market liquidity, reduces the risk of failed trades, and adds significantly to the incremental return of investors.’  However, there are potentially significant adverse effects on corporate governance in terms of shareholders’ voting rights. The ICGN state ‘Misconceptions as to its [stock lending] nature have led to loss of shareholder votes in important situations, as well as to cases of shares being voted by parties who have no equity capital at risk in the issuing company, and thus, no long-term interest in the company’s welfare. Lenders’ corporate governance policies may also be undermined through lack of coordination with lending activity. It is also imperative that there be as little risk as possible that a poll of the shareholders may be compromised through misuse of the borrowing process.’ The issues identified by the ICGN are very real ones which may have heightened importance in situations where investors are voting on contentious issues.  Resolutions which otherwise may have failed to be passed, may be passed because of the way in which votes secured through stock lending have been cast, and vice versa.

Pauline Skypala in her article ‘Securities lending – kept from view’ (FTfm, Page 6, 5th September 2011) points out that last year the Pensions Regulator advised pension fund trustees and others managing schemes they should be aware of whether scheme assets could be lent and on what terms. In particular, they should know how much of the income earned was passed on to the scheme.

Ellen Kelleher in her article ‘Inquiries starting into “empty voting”’ (FTfm, Page 3, 26th September 2011) gives the example of an activist hedge fund which might briefly borrow shares in a company purely to vote in favour of its takeover at the next general meeting.  This would be legitimate in most markets but can hardly be called best practice.

SCM Private, an actively managed passive investment firm, carried out research which revealed that UK retail fund managers controlling over £241 billion may lend out up to 100% funds but investors would be kept in the dark.  Furthermore, levels of disclosure, transparency and protection within current legislation are, SCM find, totally inadequate. http://www.scmprivate.com/content/file/pressreleases/press-release-scm-private-stock-lending-release-01-september-2011.pdf

Meanwhile the Investment Management Association (IMA) has defended stock lending pointing out that they are happy with the level of disclosure required.

ICGN basic tenets of best practice

Lenders and borrowers would do well to take note of the ICGN Securities Lending Code of Best Practice (2007) basic tenets of best practice:

1. All share lending activity should be based upon the realisation that lending inherently entails transfer of title from the lender to the borrower for the duration of the loan.

2. During the period of a stock loan, lenders may protect their rights only with the borrower, since they have no rights with the issuer of the shares which have been lent.

3. Institutional shareholders should have a clear policy with respect to lending, especially insofar as it involves voting.

4. Lending policy should be mandated by the ultimate beneficial owners of an institution’s shares.

5. Where lending activity may alter the risk characteristics of a portfolio, the policy should state the extent to which this is permitted.

6. The returns from lending should be disclosed separately from other investment returns when reporting to clients or beneficiaries. They should not be hidden under management and other costs.

7. It is bad practice to borrow shares for the purpose of voting. Lenders and their agents, therefore, should make best endeavours to discourage such practice.

Concluding comments

Stock lending has ramifications in a number of areas including fee income, portfolio risk, and voting rights. Lenders have a responsibility to be aware of the full implications of lending their shares and borrowers should not borrow shares with the intention of using the attached voting rights to circumvent corporate governance best practice.

 Chris Mallin 16th October 2011

 

Is director independence so important?

The New York Stock Exchange Commission on Corporate Governance has reported.

In autumn 2009, the New York Stock Exchange (NYSE) formed an independent commission to examine core governance principles in the light of changes that had occurred in governance over the past decade, and to make recommendations which could be widely supported by listed companies, directors and investors. Chaired by Larry W. Sonsini, Chairman of Wilson Sonsini Goodrich & Rosat, a US law firm specializing in business and securities law, the commission members represented investors, listed companies, broker-dealers, and governance experts. On 23 September, 2010 the NYSE Euronext (NYX) published the Commission’s final report which identified 10 core principles of corporate governance covering the scope of the board’s authority, management’s responsibility for governance and the relationship between shareholders’ trading activities, voting decisions and governance.

The Commission argued that a board’s fundamental objective is to build long-term sustainable growth in shareholder value, so corporate policies that encourage excessive risk-taking for the sake of short-term increases in stock price are inconsistent with sound corporate governance. Corporate management has a critical role in corporate governance, the Commission concluded, as management has the primary responsibility for creating an environment in which a culture of performance with integrity can flourish.
Consistent with business opinion in many other parts of the world, the Commission felt that while legislation and agency rule-making are important to establish the basic tenets of corporate governance, over-reliance on legislation may not be in the best interests of shareholders, companies or society. The Commission, therefore, called for market-based governance solutions whenever possible.

The 10 core principles outlined by the Commission on Governance were:
1. The Board’s fundamental objective should be to build long-term sustainable growth in shareholder value for the corporation
2. Successful corporate governance depends upon successful management of the company, as management has the primary responsibility for creating a culture of performance with integrity and ethical behaviour
3. Good corporate governance should be integrated with the company’s business strategy and not viewed as simply a compliance obligation
4. Shareholders have a responsibility and long-term economic interest to vote their shares in a reasoned and responsible manner, and should engage in a dialogue with companies thoughtful manner
5. While legislation and agency rule-making are important to establish the basic tenets of corporate governance, corporate governance issues are generally best solved through collaboration and market-based reforms
6. A critical component of good governance is transparency, as well governed companies should ensure that they have appropriate disclosure policies and practices and investors should also be held to appropriate levels of transparency, including disclosure of derivative or other security ownership on a timely basis
7. The Commission supports the NYSE’s listing requirements generally providing for a majority of independent directors, but also believes that companies can have additional non-independent directors so that there is an appropriate range and mix of expertise, diversity and knowledge on the board
8. The Commission recognizes the influence that proxy advisory firms have on the markets, and believes that it is important that such firms be held to appropriate standards of transparency and accountability
9. The SEC should work with exchanges to ease the burden of proxy voting while encouraging greater participation by individual investors in the proxy voting process
10. The SEC and/or the NYSE should periodically assess the impact of major governance reforms to determine if these reforms are achieving their goals, and in light of the many reforms adopted over the last decade the SEC should consider the expanded use of “pilot” programs, including the use of “sunset provisions” to help identify any implementation problems before a program is fully rolled out

Principle #7 has raised some eyebrows in the United States. “While independence is an important attribute for board members”, the Commission said, “boards should seek an appropriate balance between independent and non-independent directors to ensure an appropriate mix of expertise, diversity and knowledge. The NYSE’s Listing Standards do not limit a board to just one non-independent director.”

The US-based Corporate Governance Alliance Digest, December 1, 2010, asked “Is this a good idea? Including more non-independent members on an issuer’s board may be a very hard sell to investors, given the fact that in all markets investors rank board independence as the most important governance topic. Is adding non-independent members an irritant worth creating?”

On the unitary board of a listed company, directors are responsible for both the performance of the enterprise and its conformance. In other words, the board is expected to be involved in strategy formulation and policy making, whilst also supervising management performance and ensuring appropriate accountability and compliance with regulations. It has been suggested that this means the unitary board is effectively trying to mark its own examination papers. Of course, the two-tier board structure avoids this problem by having the executive board responsible for performance and the supervisory board for conformance, with no common membership allowed between the two boards.

Typically, corporate governance codes and stock exchange listing rules call for independent outside (non-executive) directors to play a vital role in the unitary board. Independence is precisely defined to ensure that these directors have no interest in the company that could adversely affect genuine independent and objective judgement. The number or percentage of independent board members on listed company board is usually specified. Audit, remuneration and nomination committees of the board must be mainly or wholly comprised of these independent, outside directors.

The definition of independence in most corporate governance codes is exhaustive. To be considered independent a director must have no relationship with any firm in the up-stream or down-stream added-value chains, must not have previously been an employee of the company, nor be a nominee for a shareholder or any other supplier of finance to the company. Indeed, the definition of independence is so strict that an independent director who has served on the board for a long period is often assumed to have become close to the company and is no longer considered independent.

Herein lays a dilemma. The more independent directors are, the less they are likely to know about the company, its business and its industry. Conversely, the more directors know about the company’s business, organization, strategies, markets, competitors, and technologies, the less independent they become. Yet such people are exactly what top management needs to contribute to its strategy, policy making and enterprise risk assessment.

This argument looks set to run a long way.

Bob Tricker 6 December 2010

Twenty Steps to Better Corporate Governance

Twenty steps to better corporate governance

 A new international corporate/company secretary organization was launched in March 2010 at the Headquarters of the Word Bank in Paris.

 The Corporate Secretaries International Association (CSIA) is an international federation of professional bodies formed to promote good governance and corporate secretary-ship. Member organisations include national representative organisations from Australia, Hong Kong/China, India, Kenya, Malaysia, New Zealand, Singapore, South Africa, the United Kingdom, the United States and other jurisdictions representing some 70,000 governance professionals in more than 70 countries.

 A research paper was presented at the launch of CSIA: Twenty Steps to Better Corporate Governance.  Corporate governance experts from around the world, including the two authors of this blog site – Professor Chris Mallin and Professor Bob Tricker – were asked for their opinions on possible corporate governance implications arising from the recent global financial crisis and the ongoing economic hiatus. 

The other contributors to the paper were (in alphabetical order):

  • Sir Adrian Cadbury, widely known for his chairmanship of the UK Committee on the Financial Aspects of Corporate Governance and the seminal corporate governance code of best practice that bears his name,
  • Dr John Carver, a corporate governance consultant, originator of the Policy Governance® model and author of Corporate Boards that Create Value, 2002, USA
  • Professor Gabriel Donleavy, Professor of Accounting, University of Western Sydney, Australia,
  • Professor William Judge, E.V. Williams Chair of Strategic Leadership, Old Dominion University and editor of Corporate Governance – an international review, USA,
  • Dr Gregg Li, Head of Governance and Risk Management, Aon Global Risk Consulting, Hong Kong,
  • Professor Jay W. Lorsch, Louis Kirstein Professor of Human Relations at the Harvard Business School, USA,
  • James McRitchie, CEO, Corporate Governance Network, USA.
  • Dr Shann Turnbull, Principal, International Institute for Self-governance, Australia.

 To read more about the CSIA go to http://www.csiaorg.com.

The full paperTwenty Steps to Better Corporate Governance can be accessed at http://www.csiaorg.com/pdf/research_paper.pdf

 Bob Tricker, 1 June 2010

UK Corporate Governance Code

The Financial Reporting Council (FRC) has issued an updated corporate governance code for UK companies. Formerly known as the Combined Code, the newly issued UK Corporate Governance Code is a response to the financial crisis which caused shock waves around the world.

The FRC traces the roots of the UK Corporate Governance Code to the Cadbury Committee Report (1992) http://www.ecgi.org/codes/documents/cadbury.pdf and its successor reports. They recognise that ‘The Code has been enduring, but it is not immutable. Its fitness for purpose in a permanently changing economic and social business environment requires its evaluation at appropriate intervals’.

The UK Corporate Governance Code (hereafter ‘the Code’) continues to have at its heart the ‘comply or explain’ approach which was introduced in the Cadbury Committee Report. Sir Adrian Cadbury in his seminal book ‘Corporate Governance and Chairmanship, A Personal View’(2002) stated ‘The most obvious consequences of the publication of the 1992 Code of Best Practice was that it put corporate governance on the board agenda. Boards were asked to state in their reports and accounts how far they complied with the Code and to identify and give reasons for areas of non-compliance’. The flexible approach provided by the ‘comply or explain’ approach is a great strength and has been adopted in many countries.

Code structure

The Code has five sections being Section A: Leadership; Section B: Effectiveness; Section C: Accountability; Section D: Remuneration, and Section E: Relations with Shareholders. There is also currently a Schedule in the Code (Schedule C) ‘Engagement Principles for Institutional Shareholders’. This schedule contains three principles: dialogue with companies; evaluation of governance disclosures; and shareholder voting. However it will cease to apply when the Stewardship Code for institutional investors which is being developed by the FRC comes into effect.

Main changes to the Code

The FRC identifies six main changes http://www.frc.org.uk/press/pub2282.html as follows:

(i)     ‘To improve risk management, the company‘s business model should be explained and the board should be responsible for determining the nature and extent of the significant risks it is willing to take.

(ii)    Performance-related pay should be aligned to the long-term interests of the company and its risk policy and systems.

(iii)   To increase accountability, all directors of FTSE 350 companies should be put forward for re-election every year.

(iv)   To promote proper debate in the boardroom, there are new principles on the leadership of the chairman, the responsibility of the non-executive directors to provide constructive challenge, and the time commitment expected of all directors.

(v)    To encourage boards to be well balanced and avoid “group think” there are new principles on the composition and selection of the board, including the need to appoint members on merit, against objective criteria, and with due regard for the benefits of diversity, including gender diversity.

(vi)   To help enhance the board’s performance and awareness of its strengths and weaknesses, the chairman should hold regular development reviews with each director and FTSE 350 companies should have externally facilitated board effectiveness reviews at least every three years.’

Contentious changes?

The changes that seem most likely to be contentious and attract most debate relate to the annual re-election of directors and the move to encourage boards to consider diversity, including gender, in board appointments.

 

Annual re-election of directors

According to Rachel Sanderson and Kate Burgess, in their article ‘Directors must be re-elected annually’ (FT, page 17, 28th May 2010), the annual re-election of directors in FTSE 350 companies is the most controversial aspect of the Code. They state ‘Critics, including the Institute of Directors, have said it will encourage short-termism and be disruptive. Those in favour have said it will make boards more accountable to shareholders’.

The widespread concern about the underperformance of some UK board directors prior to, and during, the recent financial crisis no doubt led to increased support for the idea of the annual re-election of directors.

Diversity

Another potentially contentious change is the fact that boards are now encouraged to consider the benefits of diversity, including gender, to try to ensure a well-balanced board and avoid ‘group think’. Similar provisions may be seen in the German Corporate Governance Code (2009) ‘The Supervisory Board appoints and dismisses the members of the Management Board. When appointing the Management Board, the Supervisory Board shall also respect diversity’ (5.1.2) and the Dutch Code of Corporate Governance (2008) ‘The supervisory board shall aim for a diverse composition in terms of such factors as gender and age (111.3).

The UK has not gone as far as Norway which has, since 2008, enforced a quota of 40% female directors on boards of all publicly listed companies. Similarly Spain introduced an equality law in 2007 requiring companies with 250+ employees to develop gender equality plans which clearly has implications for female appointments to the board.

Whilst it is fair to say that the number of females with experience at board level in large UK companies is relatively limited, non-executive directors can be drawn from a much wider pool including the public sector and voluntary organisations. Their experience can bring new insights to the board, maybe challenging long-accepted views and hence adding value.

Institutional shareholders

As mentioned above, the Code currently contains Schedule C ‘Engagement Principles for Institutional Shareholders’ but this will be withdrawn when the Stewardship Code becomes operational. The Stewardship Code is being developed separately by the FRC and will set out standards of good governance for institutional investors, the FRC hopes to publish it by the end of June 2010.

Andrew Hill in the FT Lombard column (FT, page 18, 28th May 2010) ‘New code sets the high-water mark for governance’ discussed the new Code. He points out that ‘Now it is up to shareholders, encouraged by their own forthcoming stewardship code, to rise to the challenge……the FRC has set a new high watermark for post-crisis governance standards. The test will be whether investors use it responsibly and maintain sensible pressure on boards, as recession turns to recovery and chief executives’ and directors’ risk aversion dissipates’.

Concluding comments

The FRC has produced a robust UK Corporate Governance Code, building on the earlier Codes and retaining the flexibility of the ‘comply or explain’ approach. Future success will be measured by companies following the substance, or spirit of the Code, and not just its form and by institutional shareholders and boards engaging more fully.

The new edition of the Code will apply to financial years beginning on or after 29 June 2010. The Code, and a report explaining the main changes, can be found at: http://www.frc.org.uk/corporate/ukcgcode.cfm

Chris Mallin 28th May 2010

Rethinking the Exercise of Power over Corporate Entities

Society, acting through their legislative processes, provides for the incorporation of corporate entities in their midst, and permits companies to limit the liability of their shareholders for the debts of those companies.   But over time, the accountability of those companies to society, and the way that power is exercised over them has slipped for society to shareholders, and from shareholders to incumbent management.

We need to re-think the way that power is exercised over companies for the good of all affected by their activities. But before such ideas can evolve, some fundamental dilemmas have to be resolved.  We lack a coherent unifying theory of corporate governance.  The most widely used research tool, agency theory, is proving to be a straight jacket: useful in context but inevitably constraining. We need some new theoretical insights that will take us beyond agency theory or the perspectives of jurisprudence.

The corporate governance principles published by the Organisation for Economic Co-operation and Development (OECD) were designed to assist countries develop their own corporate governance codes.  They reflected what was considered best practice in the UK and USA.  This so-called Anglo-Saxon model of corporate governance required listed companies to have unitary boards, independent outside directors, and board committees.  The principles focused on enhancing shareholder value, and in the process richly rewarded top executives. In this model shareholders are widely dispersed, in markets that are liquid, with the discipline of hostile bids.

This so-called ‘Anglo-American approach’ to corporate governance, became the basis for governance codes around the world.  Indeed, in the United States it was widely assumed that the rest of the world would eventually converge with American corporate governance norms and reporting requirements, simply because it was thought the rest of the world needed access to American capital.

But a schism has emerged in the ‘Anglo-American approach’.  In the United States, Sarbanes Oxley mandated conformance with corporate governance by law.  Whilst in the United Kingdom and those other jurisdictions whose company law has been influenced over the years by UK common law, including Australia, Hong Kong, India, Singapore and South Africa, compliance is based on a voluntary ‘comply or explain’ philosophy.  Companies report compliance with the corporate governance code or explain why they have not.  This ‘rules versus principles’ dilemma seems to have been amplified by the ongoing global financial crisis.  It needs resolving.

But the Anglo-Saxon system is not the only governance model and some are questioning whether it is necessarily the best. Corporate governance is concerned with the way power is exercised over corporate entities.  In other parts of the world, alternative insider-relationship systems exercise power through corporate groups in chains, pyramids or power networks, by dominant families, or by states.  These markets are less likely to be liquid, the market for control poor, and the interests of employees, and other stakeholders more important.

In Japan, keiretsu organizational networks spread power around a group of inter-connected companies in ways that might provide insights for complex western groups.  The view that business involves relationships with all those involved – employees, customers, suppliers, and society, as well as shareholders, has only recently been recognized in the West under the umbrella of ‘corporate social responsibility’.

The governance of Chinese family businesses throughout East Asia can provide some valuable insights: for example, the emphasis on top-level leadership, the view that the independence of outside directors is less important than their character and business ability, and the way that the Chinese family business sees business more as a succession of trades rather than the building of empires.

In China, the link between state, at the national, provincial and local levels, and companies relies on a network of relationships, and policies can be pursued in the interests of the people, seen as the Party.

Of course there are problems with Asian approaches: corruption, insider trading, unfair treatment of minority shareholders, and domination by company leaders, to name a few.  But these are not uniquely eastern attributes as case-studies of US and UK company failures show.

These diverse models reflect more concentrated ownership, different cultures, and varied company law jurisdictions. But they also show different perceptions about the way power should be exercised over corporate entities. The eastern experience suggests that board leadership and board-level culture, in other words people and the way they behave, are more important than board structures and strictures, rules and regulations.  New theoretical perspectives will need to embrace such diversity.

Bob Tricker