Archive for the ‘UK Corporate Governance Code’ Category
Around twenty years ago I wrote that while the twentieth century had been the era of management, with its new management schools, management consultants, and management gurus, the twenty-first century would be the era of corporate governance. Corporate governance has certainly now moved centre stage. Google has 52 million references to the phrase.
Interest in corporate governance has flourished. The late Sir Adrian Cadbury wrote the first corporate governance code – the UK’s Financial Aspects of Corporate Governance (1992). He always emphasized that his report was not a comprehensive approach to corporate governance, but focused on the financial aspects. Nevertheless, he made proposals that are still pertinent ̶ the creation of board level audit committees, remuneration committees, and nomination committees, with independent outside directors; the separation of the board chairman from the CEO; and public reporting that the company had complied with the code or explaining why it had not.
Since then, corporate governance codes, often as stock exchange requirements, cover almost all listed companies around the world. But despite countless amendments, revisions, and rewrites most corporate governance development has been piecemeal. There has been relatively little original thinking. Most codes still adopt Cadbury’s voluntary ‘comply or explain’ approach. The principle exception is in the United States, where regulation and legislation are used to oversee the governance of corporations.
The development of corporate governance practice has almost always been in response to corporate failure or economic malaise. In the United States, the Securities and Exchange Commission (SEC) was set up in 1932–3, after the stock market crash of 1929 and the great depression that followed. The Cadbury report responded to concerns about corruption found in UK Government inspectors’ reports on failed companies including the collapse of Robert Maxwell’s’ corporate empire.
The US Sarbanes-Oxley Act (SOX 2002), was a response to the failure of Enron, Waste Management, and other companies, followed by the folding of the ‘Big Five’ accounting firm, Arthur Andersen, reducing the big five to the even bigger four. Unfortunately, SOX did not prevent the global financial crisis, starting around 2008, in which US companies such as Lehman Brothers failed and American International Group, Fannie Mae, Freddie Mac, and others were bailed-out by the US government. The result was further federal legislation. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, called by some SOX 2, attempted to improve American financial regulation and the governance of the US financial services industry.
As yet, no over-arching theory of corporate governance has emerged. New thinking and new ideas are badly needed in the governance of organizations. A fundamental governance question for the modern public company, for example, is: What role should the shareholders play in corporate governance?
In the original mid-nineteenth model of the joint-stock limited liability company, the shareholders were mostly individuals–aristocrats and members of the newly forming affluent middle class. These shareholders appointed the directors who reported to them on their stewardship of the company. The directors may have known their shareholders personally. Shareholder meetings and votes were the way boards of directors were held to account. Indeed, in the original model accounts were audited by an audit committee, elected from among the shareholders themselves.
But today, individuals running their own portfolios form only a small part of the shareholder base. These ‘retail shareholders’ typically have relatively small holdings and little influence. They might also include directors, executives, and other employees of the company.
Significant shareholders are more likely to be:
- active institutional investors, such as mutual funds, pension funds, and financial institutions, closely interested in the company’s affairs who may be actively involved in corporate governance matters; and
- passive institutional investors, such as index-tracking funds required by their constitutions to invest in a given range of securities, using computer algorithms to make investment decisions, with little interest in corporate governance issues. The shareholder base could also include:
- hedge funds gambling against the market and selling short, with real short-term interests in the business, but not in longer-term corporate governance;
- private equity investors seeking short term strategic opportunities;
- dominant investors, perhaps the company’s founders or their family trusts, who are closely interested in, and possibly actively involved in company affairs. Though they might hold only a minority of the voting equity, in some jurisdictions they can maintain ownership power through dual-class shares;
- state-owned corporations, perhaps with a minority of their shares traded publically, and possibly influenced by state economic and political interests; and
- sovereign funds, using state capital to invest, possibly with political or economic implications as well as financial interests.Concerns over corporate behaviour, such as allegedly excessive director remuneration, unclear or over-ambitious corporate strategies, or the lack of board diversity have led some politicians and other commentators to call for shareholders to exercise their duty to oversee board behaviour more fully. This has led to the emergence of proxy advisers; firms that study issues facing companies and advise institutional investors on voting decisions.
But votes in shareholder meetings are advisory; exhortatory at best. Shareholders’ votes do not bind the board. Directors do not have to follow them. Energetic efforts by some institutional investors, including grouping together, have not changed the underlying power structure.
Bob Monks, in his book Corpocracy (New York: Wiley, 2007), showed how power had moved over the years from owners to directors. Concerned by what he saw as an abuse of power, he co-founded Institutional Shareholder Services (ISS) in 1985 to wage proxy warfare on companies. These proxy battles continue to this day. However, the fundamental question remains: In the modern public company what should the role of shareholders be?
Is it, on the one hand, to preserve the nineteenth-century legal concept of the corporation–that the shareholders own the company and are expected to play a basic role in its governance by electing the directors and holding them to account. Or is it, on the other hand, for the shareholders to accept a corporate stakeholder role providing finance, just as suppliers provide goods and services, customers produce sales revenues, and the employees provide the work force?
I have just completed a study on shareholder communication for the Hong Kong Institute of Chartered Secretaries, which will be published shortly and duly noted in this blog. In a survey Hong Kong’s listed companies gave overwhelming support for the idea that shareholders should exercise a stewardship role in the governance of listed companies. In this they are in line with the opinions of many authorities around the world–regulators, legislators, and corporate governance commentators.
Had the alternative view been taken, that shareholders are just one of the various stakeholders in a corporation, appropriate governance models could be developed. The German supervisory level two-tier board could provide a start; members are nominated to represent both labour and capital (the employees and the investors). Representatives of other stakeholders could be added.
Such a development would reflect a change in the UK Companies’ law in 2006. Prior to that company law in the UK required directors to act in the best interests of the company, which effectively meant in the interest of the shareholders, in other words, by attempting to maximize shareholder value in the long term. But the Companies Act 2006 specifically spelled out a statutory duty to recognize the effect of board decisions on a wider public. For the first time in UK company law, corporate social responsibility (CSR) responsibilities were included among the formal duties of company directors:
‘A director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole, and in doing so have regard to:
(a) the likely consequences of any decision in the long term
(b) the interests of the company’s employees
(c) the need to foster the company’s business relations with suppliers, customers, and others
(d) the impact of the company’s operations on the community and the environment
(e) the desirability of the company maintaining a reputation for high standards of business conduct, and
(f) the need to act fairly as between members of the company.’
Thus UK company law now requires companies to consider employees, suppliers, customers, and other business partners, as well as the community and the environment, in their decisions.
However, if shareholders are to continue to be a responsible part of the corporate governance mechanism, how might that be achieved? If shareholders are really to affect corporate governance in the companies in which they invest, they need more power. New corporate governance models will have to be devised. One idea might be a Shareholder Senate.
A Shareholder Senate would be a new governance body set mid-way between the company and the body of shareholders. Members of the Senate would be nominated by long-term institutional investors and elected by all the shareholders.
The Senate would meet formally with the board’s remuneration committee, its nomination committee, and its audit committee with the auditors. Periodically, it would have discussions with the Chairman and the entire board. It would also meet independently to formulate reports and make recommendations to shareholders.
The overall responsibility for the company and its management would remain with the board of directors. The Senate would have the authority to question, to advise, and to influence the company on its strategies, operational performance, and financial matters. For example, a Senate could question and challenge levels and methods of executive remuneration, the adequacy of risk assessment systems, the balance of skills, experience, and adequacy of the directors, and confirm that succession plans existed for all senior executives.
The Senate would not have the power to block the board’s decisions, nor could it hire and fire directors (as the German supervisory board can). But it would have the responsibility to liaise with the shareholders, and the power to recommend how they vote on specific motions. It could also introduce motions for shareholder meetings. Over time, Shareholder Senates would supplement and probably replace the work of proxy advisers.
Shareholder Senates would become a fundamental component of companies’ corporate governance structures and processes. Accordingly, members of the Senate would have fees and expenses reimbursed by the company, just as non-executive, outside directors have. The company would be responsible for publishing Senate reports and other communications with investors, just as it publishes other corporate reports.
Concern might be expressed that members of Shareholder Senates would receive unfair insider information. But Senate members could be placed in a similar position to directors who may not trade shares prior to the announcement of results. In fact, Senate members would be in a less exposed position than a nominee director elected by a major shareholder, because they would not attend board deliberations.
In fact, it would not be difficult to introduce a requirement for shareholder senates into companies’ legislation or to include them in corporate governance codes, operating on the ‘comply or explain’ principle.
The proposal for Shareholder Senates will not be welcomed by most directors and their boards, because they would inevitably mean a shift of power away from the boardroom back to the owners. However, there was plenty of antagonism in British board rooms to the original Cadbury Report proposals: many thought independent outside directors were an unnecessary imposition and an infringement of executive directors’ right to run their own companies.
There is little doubt that Shareholder Senates will not be achieved without legislation and regulation. Such developments could be prompted by the ongoing dissatisfaction with the governance of the modern corporation. The newly appointed British prime minster, Theresa May, following the UK’s referendum vote to leave the European Union, mentioned problems with the governance of British companies in her inaugural statement.
Corporate governance evolves. Dissatisfaction exists over the present corporate governance model. Some boards readily accept a responsibility to engage with their shareholders. Others do not. Some companies are run for the benefit of their owners. Others are not. Criticisms multiply of board-level excess, particularly over board-level remuneration. Shareholder Senates would provide an opportunity to re-establish owners’ rights. They would give investors a more effective say in the governance of their companies. Power would no longer be abdicated by the owners to the directors.
In the Introduction and Overall Assessment to its Annual Report ‘Developments in Corporate Governance and Stewardship 2015’ (https://www.frc.org.uk/Our-Work/Publications/Corporate-Governance/Developments-in-Corporate-Governance-and-Stewa-(1).pdf), the UK’s Financial Reporting Council (FRC) highlighted that 2015 was a year of consolidation for the UK Corporate Governance Code (the Code) which had some significant changes made in 2014. Companies’ explanations improved in quality and there was a high level of compliance with the Code ‘with 90 per cent of FTSE 350 companies reporting compliance with all, or all but one or two, of its provisions’. The FRC’s ongoing strategy for 2016/19 is to give time for recent changes to embed and not to consider further changes – other than those arising from the implementation of the EU Audit Regulation and Directive – to the Code until 2019.
The importance of culture is recognised as the Code makes it clear that there is a role for the board in ‘establishing the culture, values and ethics of the company’ and in setting ‘the tone from the top’. The FRC plans to publish findings of a study looking at the role of boards in shaping and embedding a desired culture in the summer of 2016.
In relation to the Stewardship Code, the FRC intends to make a public assessment of the reporting of signatories – again in the summer of 2016 – as it is of the view that ‘the reporting of too many signatories does not demonstrate that they are following through on their commitment [to the Stewardship Code]’.
The next section of the Annual Report on the Governance of Listed Companies details how the UK Corporate Governance Code has been implemented during 2015 and provides an assessment of the quality of reporting on corporate governance. There is an interesting summary of the top 10 areas of non-compliance and ‘Code provision B.1.2, which states that at least half the board (excluding the chairman) should be independent, remains the lowest rated in terms of compliance among FTSE 350 companies’. In 2015, 42 FTSE 350 companies did not comply with this provision although the FRC note that ‘as with last year just under half had returned to having more than 50 per cent of the board as independent non-executive directors at the time their annual report and accounts was published. On the whole non-compliance was usually as a result of retirements rather than a specific wish not to comply.’ As well as overall compliance rates, this section of the Annual Report covers the quality of explanations for non-compliance; Code changes in 2012 including audit tendering, audit committee reporting, boardroom diversity, the ‘fair, balanced and understandable’ aspects of the company’s annual report and accounts; and Code changes in 2014 relating to risk management and internal control, remuneration, and shareholder engagement.
The following section of the Annual Report covers Stewardship and Engagement. The FRC points out that the quality of signatory statements varies considerably and that they would like to see improved reporting by all signatories across the seven principles of the Stewardship Code. The FRC will be contacting signatories individually to outline where their statements need to improve and will tier signatories publicly: ‘Tier 1 signatories will be those that meet our reporting expectations and provide evidence of the implementation of their approach to stewardship. We will pay particular attention to information on conflicts of interest disclosures, evidence of engagement and the approach to resourcing and integration of stewardship. Tier 2 signatories will be those where improvements are needed.’ As mentioned earlier, they will announce the outcome in the summer of 2016. This section of the Annual Report also covers engagement in the 2015 AGM season; company and investor expectations and reporting; collective engagement; proxy advisors; and voting and ownership.
The penultimate section of the Annual Report covers Other Corporate Governance and Stewardship Developments including Audit Regulation and Directive; Lord Davies Report on diversity (highlighting that FTSE 100 companies now have over 26% of the directorships held by women, and that whilst in 2011 there were 152 all male boards in the FTSE 350, now there are only 15 companies left with all male boards, all within the FTSE 250); the European Commission’s recommendation on the quality of corporate governance reporting (the ‘comply or explain principle’); the review of the OECD’s Principles of Corporate Governance; the European Commission’s Shareholder Rights Directive; the European Securities and Markets Authority (ESMA) Call for Evidence; fiduciary duties; the ICGN Global Stewardship Code consultation; other Stewardship initiatives; and the Capital Markets Union.
The final section of the Annual Report summarises the Corporate Governance and Stewardship Work for 2016/17. As well as mentioning the main activities, the FRC points out that its work in the ‘areas of governance and stewardship overlaps with that of many others, and we continue to work closely with market participants, representative organisations, service providers, regulators and Government departments.’
The Annual Report therefore provides both an interesting position paper in terms of where we are now in UK corporate governance and also highlights areas which the FRC will be focussing on for improvement.
As the AGM season is upon us, it will be interesting to see how companies deal with corporate governance hot topics such as the perennial executive remuneration issues – now very much in the headlines at BP and WPP – and how investors respond in terms of their stewardship role.
Chris Mallin, April 2016
The UK’s Financial Reporting Council (FRC) review of 2014
- on compliance with the UK Corporate Governance Code
- a call for better commitment to the Stewardship Code
- and focusing on corporate culture and board level behaviour
On 15th January 2015, in its annual review of developments in corporate governance and stewardship for 2014, the FRC reported that levels of compliance with the UK Corporate Governance Code had continued to increase. Reporting had become more transparent and informative, with audit committee reports much improved. Overall, levels of compliance with the UK Corporate Governance Code continued to improve, with full compliance by the FTSE 350 now at 61.2%, whilst 93.5% complied with all but 1 or 2 provisions. Reporting on board-diversity had also made good progress with a clear policy on diversity reported by 85% of FTSE 100 companies; although FTSE 250 companies have more to do, showing an improvement from only 20% to just 56%. The UK is on course, the FRC believes, to reach the Davies Report target of 25% female directors in FTSE 100 companies in 2015, with 22.8% of such directorships now held by women.
However, although the signatories to the UK Stewardship Code had increased to almost 300, with investment managers more engaged with large companies, the FRC felt that more needed to be done to ensure that action was taken on their commitment to the principles of the Code. Increasing levels of concern had also been expressed by companies and investors about the role of proxy advisors. In some cases a box-ticking approach seemed to be adopted by them and some investors, with a perceived lack of actual engagement with companies.
The report also highlighted the importance of appreciating the significance of culture and risk management in organisations, as the third edition of Corporate Governance – principles, policies and practices also emphasizes. The recent FRC guidance on risk management highlighted the need for boards to think hard about whether the culture practised within the company is the same as that which they espouse, particularly under pressure.
Commenting on board culture, FRC Chairman Sir Win Bischoff said:
‘The governance of individual companies depends crucially on the culture that is in place. The UK’s strong governance culture encourages companies to list in London and provides assurance to investors. Unfortunately, we still see examples of governance failings in this area. Boards have responsibility for shaping the culture, both within the boardroom and across the organisation as a whole.’
During 2015, the FRC plan to assess how effective boards are at establishing company culture and practices and embedding good corporate behaviour, and will consider whether there is a need for promoting best practice. The FRC will also be focusing on the application of the Stewardship Code and the role of proxy advisors.
20 January 2015