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Corporate Governance in China

 

In a recent posting on this blog, I wrote about the Chinese government’s attempt to exert more control over state owned enterprises (SOEs).   That led to some questions about how SOEs were actually governed.  Since I am currently involved in an ongoing study of corporate governance in China with a Hong Kong colleague, Dr Gregg Li, a brief summary of the evolution of corporate governance ‘with a Chinese face’ may be of interest.

 

The People’s Republic of China (PRC) was established in 1949, by Mao Tse Tung, following the defeat of the Nationalist Army under Chiang Kai Shek and its retreat to Taiwan.   Mao founded the PRC and remained Chairman of the Chinese Communist Party from 1949 until his death in 1976.

 

Over that period, the state proclaimed ownership of the means of production, prohibited private property, and banned incorporated companies.  In 1958, Chairman Mao initiated the Great Leap Forward, relocating millions of farmers, peasants, and city workers. Massive economic dislocation and famine resulted. The Cultural Revolution began in 1966 and lasted a decade. Communes were reorganized and state-owned enterprises (SOEs) were created, most relying on state subsidies.

 

In the 1970s, Mao’s successor as paramount leader, Deng Xiao Ping, introduced a pragmatic form of market economy, whilst still maintaining an orientation towards a centralized communist state.  The industrial SOEs, which were large bureaucracies, continued to receive their production and distribution orders from state planners.  Employees of the SOEs received housing, medical care, and schooling for their children.  Deng stood down in 1989, and is now recognized as the initiator of the changes that led to the subsequent incredible economic growth up to the present day.

 

In 1988, the State Council of the PRC, advised by experts from the Organization for Economic Co-operation and Development (OECD), produced a set of corporate governance directives for SOE reform.  In September 1999, the Fourth Plenary Session of the 15th Chinese Communist Party’s Central Committee took a vital decision on enterprise reform, in what was termed a ‘strategic adjustment’ of the state sector, it was agreed that that ‘the state should be withdrawing from what should be withdrawn’.  Interestingly, corporate governance was recognized as being at the core of the modern enterprise system.

 

A new companies’ law was enacted in 1994, and revised in 2006. Two types of company were created:

  • a ‘limited liability company’ (LLC), with at least two and no more than 50 shareholders, somewhat similar to private companies in other jurisdictions
  • a ‘company limited by shares’, in other words a joint stock company (JSC) with some similarities to public companies in other jurisdictions.

Both types of company were defined as legal persons with shareholder liability for corporate debt limited, and with property rights as well as civil rights and duties.

 

Companies were given autonomy to run their businesses according to the market in order, as the Companies’ Act said: ‘to raise economic efficiency, improve labour productivity, and preserve and increase the value of assets.’  Companies were also called on by the new law ‘to conduct their business activities abiding by the law and by business ethics, strengthen the construction of socialist spiritual civilization and accept the supervision of the government and the public.’  Companies were allowed to invest in other companies and to create groups of companies with subsidiaries and branches.

 

China’s corporate governance rules were influenced by Western experience, including the advice from the OECD, drawing principally from practice, pioneered in countries including the USA, the UK, Germany, and South Africa.  Typically, these countries are democracies with independent judiciaries. In developing and emerging economies, including Russia, Latin American countries and India, corporate governance still tends to be emergent, with the state playing a more significant role, and corruption sometimes being endemic.

 

China stands out as a case on its own.  Government is an oligarchy, exercising considerable central control.  The PRC has developed an innovative corporate governance regime, and in the process became one of the worlds leading economies.

 

The SOEs include vast companies in the oil, telecoms, steel, finance, and other major sectors. In some cases, a minority of their shares are quoted on stock exchanges in Shanghai, Shenzen, or Hong Kong, with a few being floated in London or New York.

 

Although influenced by Western experience, the governance of SOEs is unique.  Separate boards of supervisors and boards of directors were formed, partly reflecting the German two-tier board system, but with independent directors on the board of directors, as in the USA and UK.

 

For decades governance was left to companies, under the overall supervision of the State-Owned Assets Supervision and Administration Commission (SASAC) and the China Securities Regulatory Commission (CSRC).   State involvement at a higher level tended to be distant.  Some felt that the Communist Party’s leadership had been undermined.  But central authorities have recently sought to reassert Party influence over the SOEs, as mentioned in a recent blog.

 

Although SOEs remain central to China’s economy, other types of enterprise evolved with diverse ownership structures and governance practices.  Many of these firms are family businesses but others are run as village or township entities.

 

Although Hong Kong is now part of the PRC, the governance of companies there reflects a quite different story.  Since the mid-nineteenth century, Hong Kong had been a British Protectorate under a lease from Mainland China.  That lease ended In 1997 and Britain transferred its rights over Hong Kong to the PRC, which deemed it a Special Administrative Region of China.

 

Under the British influence, Hong Kong developed its own legislature, an independent judiciary based on UK-style common law, and its own currency linked to the US$.  The Hong Kong Stock Exchange began life in 1891, and now oversees the Hong Kong Corporate Governance Code.  Institutions for company registration and regulation were created, and strong professions were formed – legal, audit, accountancy, finance, and company secretarial.

 

This infrastructure and these institutions remained after the 1997 handover; as the Joint Agreement between the PR: and the UK put it – ‘one country two systems.’ But as the business worlds of China and Hong Kong grow together, some Hong Kong institutions are coming under China’s influence.

 

To reach its present economic and political significance in the world, China has travelled a unique road.  This historical and cultural context means that corporate governance in China has developed a distinct ‘Chinese face,’ unlike anywhere else in the world.  Exploring and understanding the special features of Chinese corporate governance and the challenges they might present in the future is an ongoing project

 

Bob Tricker

May 2017

Shareholder Committees

In a previous blog post, I discussed the Department for Business, Energy & Industrial Strategy (BEIS) Green Paper on Corporate Governance Reform issued in November 2016.

One of the options suggested in the Green Paper in relation to shareholder engagement on pay, was to ‘Establish a senior “shareholder” committee to engage with executive remuneration arrangements’. According to para 1.36, ‘A complementary or alternative way to enable greater shareholder engagement on pay might be to establish a senior Shareholder Committee to scrutinize remuneration and other key corporate issues such as long term strategy and directors’ appointments. The full implications of adapting any such model in the UK, however, would need careful consideration given its potential impact on our long-established unitary board structure.’

The idea of a shareholder committee received support from some organisations including a joint response to the Green Paper from The UK Shareholders’ Association (UKSA) and the UK Individual Shareholders’ Society (ShareSoc).  Both of these organisations represent the interests of private shareholders who invest directly or indirectly via nominee accounts in public companies or in other forms of equity-based investment.

Their joint response stated ‘We strongly support the concept of Shareholder Committees, provided that they represent the interests of all shareholders, including private investors and investors in employee share plans.’ They are of the view that ‘Shareholder  Committees  are  a  core  part  of  the  solution  to  the  problems  of  corporate  governance. There are many  other elements of governance and control that can be improved and we have commented  in  our  response  on  those  where  we  have  specific  knowledge.  However, without Shareholder  Committees,  and  concomitant  reform  to  restore  the  rights  of  individual  shareholders, other changes to corporate governance are unlikely to produce meaningful change.’

However, certain organisations, for example, Tomorrow’s Company, are wary of widening the scope to include issues such as remuneration.  Tomorrow’s Company’s website states that ‘The original idea proposed by Tomorrow’s Company in 2010 was for a Shareholder Committee which would involve shareholders large (and small) in the most important single governance decision – who represents them on boards. Later variants, like this one and that by Chris Philp MP, have widened the scope to involving investors in discussions about remuneration.’ Tomorrow’s Company then points out that ‘The risk of this more complicated approach is that it compromises the clear leadership responsibility of the board.’

 

Royal Bank of Scotland

A case in point is that of the Royal Bank of Scotland (RBS).  With over 70% ownership by UK taxpayers, there is a very real argument that its governance is of interest to the public more generally.  Aime Williams in her article ‘Shareholders clash with RBS’, (1st April 2017, Financial Times) reports that ‘About 160 individual investors are pushing RBS to form a shareholders’ committee, which would allow retail investors to have a formal say on RBS proposals, such as executive pay, company strategy and director appointments.’

However, RBS’ preference is for a stakeholder committee which would allow a wider stakeholder group to have a voice and air any concerns to directors.  A key difference though, is that a stakeholder panel would have less power and therefore would likely be less effective than a shareholder committee, which would be able to wield more influence.

The RBS Annual General Meeting will be held on 11th May 2017.  It will be interesting to see the outcomes of various resolutions, especially on potentially contentious issues such as executive remuneration, and whether a shareholder committee is established in the future.

 

 

Chris Mallin

April 2017

Corporate governance is not management

For many years, I have said that the major focus of business throughout the 20th century was professional management – new management theories, management schools, management consultants, and management gurus – whereas the focus for the 21st century would be governance.   I think we can safely say that this has happened.

Unfortunately, in the process some people are now conflating the two quite different concepts: ‘management’ and ‘governance.’  There is talk about ‘the importance of governance in the NHS’ when the issue is mainly management.  Even the UK government’s consultation on the green paper on the review of corporate governance (see Chris Mallin’s most recent blog) writes: ‘The purpose of corporate governance is to facilitate effective, entrepreneurial, and prudent management that can deliver the long-term success of a company.’

If ‘management’ and ‘governance.’  are used interchangeably, the fundamental distinction between the two  is lost.  The notion of management as a hierarchy is commonplace: the classical management pyramid showing a chief executive officer, or managing director, with overall managerial responsibility and the reporting relationships of the managers down the management hierarchy.  Authority and responsibility are delegated downwards, with matching accountability expected upwards.

The board of directors seldom appears- because the board is not part of the management structure; nor is it a hierarchy.  Each director has equal responsibility and similar duties and powers under the law. There is no executive ‘boss’ of a board.  In a unitary board, that is a board with both executive and non-executive outside directors, the executive directors hold managerial roles in addition to their responsibilities as directors.   As executives, they are employees of the company and employment laws apply.  Directors, as such, are not employees and company laws apply.  Executive directors, of course, wear two hats: and are subject to both company law and employment law.

In the two-tier board structure, the executive board consists entirely of executives and is responsible for management.  The supervisory board consists entirely of outside members and is responsible for governance, including the hiring and firing of management.

In other words, management is responsible for running the business.  The board is responsible for its governance, ensuring that the corporate strategy is appropriate and being achieved, that corporate policies are in place, overseeing management’s performance, and being accountable to investors and other legitimate stakeholders.   Briefly, management runs the business; the board ensures that it is being well run and achieving is objectives. The concepts and the responsibilities of management and governance are quite different.  To conflate the two invites confusion.

-Bob Tricker, 2017

UK Corporate Governance Reform 2017

 

BEIS Green Paper on Corporate Governance Reform

In November 2016, the Department for Business, Energy & Industrial Strategy (BEIS) issued a Green Paper on Corporate Governance Reform.  The Green Paper states ‘The aim of this Green paper is to consider what changes might be appropriate in the corporate governance regime to help ensure that we have an economy that works for everyone’. It considers three specific areas of corporate governance which might be built on to enhance the UK’s current corporate governance framework.  These areas are:

– executive pay

-strengthening the employee, customer, and supplier voice

– corporate governance in the UK’s largest privately-held businesses.

There are 14 Green Paper questions with six relating to executive pay, three to strengthening the employee, customer and wider stakeholder voice, and five relating to corporate governance in large, privately-held businesses. The consultation closed on 17th February 2017 and responses to the consultation will be made available by BEIS around May 2017.  However, the responses will be made available in collated format and the anonymity of individual responses will be retained.  Nonetheless those who have responded to the consultation are free to publish their own responses or make them more widely available.

Executive remuneration

An interesting article by Aime Williams and Madison Marriage ‘Investors back UK drive to curb executive pay levels’ (Financial Times, 18/19 February 2017, page 17,www.ft.com/Executive_Pay) reports that ‘some of the UK’s largest investors have revealed support for government proposals designed to curb high executive pay in the latest pushback against the widening wealth gap between bosses and workers’. The article cites the views of investors including Old Mutual Global Investors and Fidelity International; also the Pensions and Lifetime Savings Association (PLSA) which has a membership including over 1,300 pension schemes; and the Confederation of British Industry (CBI). The publication of pay ratios received broad support whilst other areas mentioned included more robust consequences for companies whose directors’ remuneration is not approved by shareholders and also implementing an annual binding vote on pay.

Turning now to the High Pay Centre, an independent non-party think tank focused on pay at the top of the income scale. It is interesting to note that the High Pay Centre joined forces with the Chartered Institute of Personnel and Development (CIPD) to submit a joint response to the Green paper consultation, marking the commencement of a formal relationship between the two bodies, to ‘advocate fairer and more ethical approaches to pay and reward’. Their recommendations include:

  • All publicly listed companies should be required to publish the ratio between the pay of their CEO and median pay in their organisation.
  • All publicly listed companies should be required to have at least one employee representative on their remuneration committee
  • All publicly listed companies should be required to establish a standalone human capital development sub-committee chaired by the HR director with the same standing as all board sub-committees.
  • The Government should set voluntary human capital (workforce) reporting standards to encourage all publicly listed organisations to provide better information on how they invest in, lead, and manage their workforce for the long-term.

The CIPD/High Pay Centre joint response is available at: http://highpaycentre.org/files/CIPD_and_HPC_response_to_BEIS_Green_Paper_on_Corporate_Governance_%281%29.pdf

Pay ratios

Another High Pay Centre publication which is of particular interest in relation to pay ratios – which seem to be gaining increasing support from various quarters as we have seen earlier – is ‘Pay Ratios: Just Do It’ available at: http://highpaycentre.org/files/Pay_Ratios_-_Just_Do_it.pdf

Going forward

Just a few responses have been mentioned in this blog in relation to executive pay but it seems as though overall the 14 questions posed in the Green Paper will have stimulated wide-ranging debate on key issues which will likely lead to significant reform of the UK’s corporate governance system in the not too distant future.

Chris Mallin

February 2017

Developing a shareholder strategy

A survey of shareholder communications in more than 400 companies listed on the Hong Kong Stock Exchange (HKSE) was published recently by the Hong Kong Institute of Chartered Secretaries (HKICS).   Since the HKSE ranks third equal with the Singapore Stock Exchange in world rankings (behind London and New York), it is likely that the findings have a wider significance.

The report, which I drafted, suggested that effective shareholder communications rest on an understanding of the shareholder base and their information needs. A key conclusion was that whilst some listed companies recognize that shareholder communications are vital, the majority do not and have some way to go to be effective.

Some of the key findings in the study were that:

  • A sizeable proportion of listed companies did not know much about their shareholders – the survey results showed that a third of respondent companies did not know who their shareholders were. They did not regularly or routinely monitor their shareholder base.
  • Some listed companies were not even bothered to find out – 5% of respondents said that they felt that they should be routinely monitoring who their shareholders were but did not: and a further 15.5% said they should be monitoring them on an ad hoc basis but did not.
  • The majority of listed companies lack a shareholder communication strategy

–  58.3% of respondents recognized that their communications with their shareholders were inadequate or ‘somewhat inadequate’.  Most saw the need for improvement.  But 8.6%, although they recognized that their communications were inadequate, saw no need for change. Only 33.1%% thought that their shareholder communications were adequate.

  • The vast majority did not think that all shareholders should be treated equally – Whilst respondents strongly believed that shareholders should be engaged more effectively, only a few (92) felt that all shareholders should be involved, whilst the majority (269) felt that engagement should only be with institutional investors and long-term shareholders. However, respondents believed that these investors had a stewardship role to proactively engage with the company.
  • There is little accountability for shareholder communications at the CEO or board levels – Many companies (172) report information on their shareholder profile to senior management, the board, or board committees. But more companies (241) did not report the data or did not know how it was used.
  • The company secretary is a source of help on investor relations profiling the shareholder base in 52.5% of the companies responding, followed by the Head of Investor Relations (21.0%). Companies reported devoting more resources to investor relations activities including shareholder communication and engagement, with increasing significance for an investor relations function.

Five ‘imperatives’ were developed to give practical and effective guidance to the board of directors and senior management to enhance shareholder communications and investor relations for listed companies, namely to:

  1. Develop an investor relations strategy within the corporate strategy
  2. Know and regularly review the shareholder base
  3. Formulate and regularly review shareholder communication policies
  4. Formulate and regularly review shareholder engagement policies
  5. Review the responsibility and accountability for investor relations

‘The full report can be read at: https://www.hkics.org.hk/index.php?_room=10&_action=detail&_page=3

(Click for the English or Chinese versions)

-Bob Tricker, 2017

 

Ethnic Diversity on UK Boards

There has been much emphasis on the importance and value of board diversity. However the focus has generally tended to be on gender diversity, for example, in the UK the Davies Report (2011) recommended that representation of women on FTSE 100 boards be increased to at least 25% by 2015. By 2015 this 25% target had been exceeded with FTSE 100 boards having 26.1% of women on the board.

Various corporate governance codes and guidelines have stated that firms should have a ‘balanced board’. In 2014, when updating the UK Corporate Governance Code, the Financial Reporting Council pointed out that constructive and challenging debate on the board can be encouraged ‘through having sufficient diversity on the board. This includes, but is not limited to, gender and race. Diverse board composition in these respects is not on its own a guarantee. Diversity is as much about differences of approach and experience, and it is very important in ensuring effective engagement with key stakeholders and in order to deliver the business strategy’.

‘A Report into the Ethnic Diversity of UK Boards: Beyond One by ’21’

Earlier this month The Parker Review Committee, chaired by Sir John Parker, issued ‘A Report into the Ethnic Diversity of UK Boards: Beyond One by ’21’.

Starting from the premise that UK boardrooms, including those of leading public companies, do not reflect the UK’s ethnic diversity nor the stakeholders that companies engage with (customers, employees, etc.), the Parker Report states that ‘ethnic minority representation in the Boardrooms across the FTSE 100 is disproportionately low, especially when looking at the number of UK citizen directors of colour’. For example, the Report highlights that of 1087 director positions in the FTSE 100, UK citizen directors of colour represent only about 1.5% of the total director population with 90 individual directors of colour (four hold two Board positions) whilst total directors of colour represent about 8% of the total (compared to 14% of the UK population). Some 53 FTSE 100 companies do not have any directors of colour. Seven companies account for over 40% of the directors of colour, interestingly five out of the seven companies have headquarters historically located outside the UK. In terms of the key board roles of Chair and CEO, only nine people of colour hold the position of Chair or CEO.

The Parker Report’s recommendations can be found at http://www.ey.com/Publication/vwLUAssets/A_Report_into_the_Ethnic_Diversity_of_UK_Boards/$FILE/Beyond%20One%20by%2021%20PDF%20Report.pdf and are as follows:

 

 

  1. Increase the Ethnic Diversity of UK Boards

1.1. Each FTSE 100 Board should have at least one director of colour by 2021; and each FTSE 250 Board should have at least one director of colour by 2024.

1.2. Nomination committees of all FTSE 100 and FTSE 250 companies should require their internal human resources teams or search firms (as applicable) to identify and present qualified people of colour to be considered for Board appointment when vacancies occur.

1.3. Given the impact of the ‘Standard Voluntary Code of Conduct’ for executive search firms in the context of gender-based recruitment, we recommend that the relevant principles of that code be extended on a similar basis to apply to the recruitment of minority ethnic candidates as Board directors of FTSE 100 and FTSE 250 companies.

  1. Develop Candidates for the Pipeline & Plan for Succession

2.1. Members of the FTSE 100 and FTSE 250 should develop mechanisms to identify, develop and promote people of colour within their organisations in order to ensure over time that there is a pipeline of Board capable candidates and their managerial and executive ranks appropriately reflect the importance of diversity to their organisation.

2.2. Led by Board Chairs, existing Board directors of the FTSE 100 and FTSE 250 should mentor and/or sponsor people of colour within their own companies to ensure their readiness to assume senior managerial or executive positions internally, or non-executive Board positions externally.

2.3. Companies should encourage and support candidates drawn from diverse backgrounds, including people of colour, to take on Board roles internally (e.g., subsidiaries) where appropriate, as well as Board and trustee roles with external organisations (e.g., educational trusts, charities and other not-for-profit roles). These opportunities will give experience and develop oversight, leadership and stewardship skills.

  1. Enhance Transparency & Disclosure

3.1. A description of the Board’s policy on diversity be set out in a company’s annual report, and this should include a description of the company’s efforts to increase, amongst other things, ethnic diversity within its organisation, including at Board level.

3.2. Companies that do not meet Board composition recommendations by the relevant date should disclose in their annual report why they have not been able to achieve compliance.

 

Chris Mallin

November 2016

Worker directors – we’ve been here before

At the UK’s Conservative Party conference, in early October 2016, the Prime Minister, Mrs. Theresa May, raised some significant corporate governance issues:

‘So if you’re a boss who earns a fortune but doesn’t look after your staff, an international company that treats the tax laws as an optional extra…a director who takes out massive dividends while knowing that the company pension scheme is about to go bust, I’m putting you on warning…’

Each of these issues has been discussed in recent blogs. But she also suggested that workers should be appointed to boards of directors. As could be predicted, this suggestion was welcomed by the Trades Union Council but raised alarm in some British boardrooms.

But we have been here before. Extracts from Corporate Governance: Principles, Policies, and Practices (3rd ed., 2015, pages 12 and 85) explain why:

 ‘In the 1970s, the European Economic Community (EEC), now the European Union, issued a series of draft directives on the harmonization of company law throughout the member states. The Draft Fifth Directive (1972) proposed that all large companies in the EEC should adopt the two-tier board form of governance, with both executive and supervisory boards. In other words, the two-tier board form of governance practised in Germany and Holland, would replace the British model of the unitary board, in which both executive and outside directors oversee management and are responsible for seeing that the business is being well run and run in the right direction.

In the two-tier form of governance, companies have two distinct boards, with no common membership. The upper, supervisory board monitors and oversees the work of the executive or management board, which runs the business. The supervisory board has the power to hire and fire the members of the executive board.

Moreover, in addition to the separation of powers, the draft directive included employee representatives on the supervisory board. In the German supervisory board, one half of the members represent the shareholders. The other half are chosen under the co-determination laws through the employees’ trades’ union processes. This reflects the German belief in co-determination, in which companies are seen as social partnerships between capital and labour.

The UK’s response was a Committee chaired by Sir Alan Bullock (later Lord Bullock), the renowned historian and Master of Saint Catherine’s College, Oxford. His report – Industrial Democracy (1977) – and its research papers (1976) were the first serious corporate governance study in Britain, although the phrase ‘corporate governance’ was not then in use. The Committee proposed that the British unitary board be maintained, but that some employee directors be added to the board to represent worker interests.

The Bullock proposals were not well received in Britain’s boardrooms. The unitary board was seen, at least by directors, as a viable system of corporate governance. Workers had no place in the boardroom, they felt. A gradual move towards industrial democracy through participation below board level was preferable.

Neither the EEC’s proposal for supervisory boards nor worker directors became law in the UK. Since then, the company law harmonization process in the EU has been overtaken by social legislation, including the requirement that all major firms should have a works council through which employees can participate in significant strategic developments and changes in corporate policy.’

Proponents of industrial democracy still argue that governing a major company requires an informal partnership between labour and capital, so employees should participate in corporate governance. Maybe an extension of the Shareholder Senate idea, suggested in a recent blog, called a Stakeholder Senate could provide another forum to inform, liaise with, and influence the board.

Bob Tricker October 2016

 

 

BHS – an ongoing corporate governance classic

On Sunday 29 August 2016, BHS (British Home Stores) closed the last of its 164 remaining stores, making around 11,000 employees redundant and jeopardizing the future of over 20,000 pensioners. The media took delight, at the same time, in showing the previous owner of BHS, Sir Philip Green, sailing around the Mediterranean on Lionheart, his new $100 million luxury yacht.

 The business of BHS

BHS was a department store business, with over 150 shops around the UK and others abroad. These stores sold a wide range of merchandise relatively cheaply–women, men, and children’s clothing; furniture and household goods; garden equipment; fashion accessories; toys, cameras, and wide range of other goods. Many also had a restaurant. In its heyday, BHS had a store on the high street of the most important towns in Britain.

But in recent years, high street shopping has been challenged by shopping malls, where specialist stores offered wider ranges of specific goods and, of increasing importance, free parking. Internet shopping then developed, bringing further challenges to department stores.The retail industry underwent a period of rapid challenges and growing competitiveness. BHS reflected a by-gone shopping era.

 Arcadia Group Ltd.

Founded in 1928, BHS traded successfully and grew around Britain for generations before being acquired by the Arcadia Group Ltd, an investment company running a network of subsidiary companies mainly in clothes retailing under the brand names of Topshop, Topman, Dorothy Perkins, Burtons Menswear, Wallis, Evans, Miss Selfridge, and Outfit. Arcadia had over 3,000 retail outlets and nearly 7 million square feet of space. The Arcadia accounts list seventy-seven wholly owned subsidiaries, some of them with their own chain of subsidiaries.

In 2014/15, the Arcadia Group turnover was £2,069 million, giving it an operating profit of £229 million. However, exceptional costs including pre-opening costs of overseas stores and pension fund adjustments, and a loss on the disposal of BHS (£311 million) led to an overall loss of £94 million. The 2014/15 accounts note that the UK Pensions Regulator was seeking information from the company in connection with the BHS pension schemes.

Arcadia Group Ltd is wholly owned by Taveta Investments (No.2) Ltd., the first link in a network of trusts and companies, with many registered in Jersey, a Channel Islands tax haven. The Arcadia Group is dominated by Sir Philip Green and its major shareholder, allegedly, is Green’s wife, Lady Tina Green, who is a British-born South African resident in Monaco, a Mediterranean tax haven. Neither Green nor his wife is now on the Arcadia board of directors. Green resigned from the board on 15 December 2015. Lord Grabiner QC also resigned from the Arcadia board on that day.

The Arcadia accounts and annual return for 2014/15, filed with the UK Companies’ Registry, show the Arcadia directors as:

Paul Budge,  Finance Director

Richard Burchill, Accountant (appointed 15 December 2015)

Ian Grabiner, Company Director

Gillian Hague, Group Financial Controller (appointed 15 September 2015)

Christopher Harris,  Company Director

Richard de Dombal (appointed 15 December 2015)

Directors’ remuneration for 2014/15 was £5,271,000, with the highest paid director receiving £1,955,000 (supposedly Ian Grabiner, who is said to be Green’s right-hand man).

Carmen Ltd, a property company owned by the Green family, received over £10 million in rent on BHS stores in 2014/15; and a further £20 million was paid to the family by BHS to repay loans.

PriceWaterhouseCoopers LLP are the Arcadia Group auditors. The 2014/15 accounts show audit fees for the Group and subsidiaries of £355,000 plus fees for non-audit services of £1,798,000 (including £1,151 million for ‘pension advisory services’).

Sir Philip Green

Green is a flamboyant and confrontational billionaire. Many reporters have experienced his explosive temper. He is not one to give interviews. So he was unlikely to provide information to your case writer, who has relied on company accounts, published reports, and newspaper commentary.

Over the years, Green built up a network of retail stores within the Arcadia Group, principally in clothing, both in Britain and abroad, through acquisition, merger, and re-structuring. He received his knighthood for contributions to retailing.

Green and his family own and dominate Arcadia Group, including BHS until its sale. Therefore, Green felt that Bhs was his own company: so he and his family were entitled to pay themselves substantial dividends and fees. He is reported to have said; ‘It’s my money, I can do what I like with it.’

The sale and collapse of BHS

However, BHS had made losses for the past seven years, which had to be funded by the Arcadia Group. In other words, Green family interests had funded BHS losses. But BHS was a private company. Corporate governance codes that cover public companies did not apply to BHS.

By 2015, BHS was struggling. In March 2015, the company was sold for a nominal £1 to Retail Acquisitions Ltd., a company owned by Dominic Chapell, a three times bankrupt former racing driver. The sale to Retail Acquisitions was negotiated by bankers Goldman Sachs.

According to the Guardian newspaper, Arcadia insisted on three protective covenants before selling BHS:

  1. All monies available to BHS at the time of sale shall be used for the day-to-day running of BHS.
  2. All proceeds realised from the sale of BHS properties shall be used to operate BHS as a going concern and to pay its debts.
  3. No steps are to be taken by the buyer that would adversely affect the ability of BHS to continue as a going concern.

Finance Director Budge explained that this was to ensure that all monies available to BHS should be used for that company’s business and not drawn down by the new owners.

The financial impacts of the BHS sale are clear in the Arcadia accounts for 2014/15. £216 million due to Arcadia Group Ltd were waived. Provisions relating to BHS disposal and cash transferred by Arcadia to BHS cost £88 million. The cash costs of the BHS disposal came to £2.3 million.

Administrators Duff and Phelps were appointed to administer BHS in April 2016. Unable to find a buyer, the closure of its stores followed in August, 2016.

The pension fund deficit

The deficit in the BHS pension fund was initially reported as being around £570 million. The stock market crisis in 2008 had reduced the fund’s value and subsequent losses at BHS had prevented funding the short-fall. In evidence to Members of Parliament, Chappell alleged that Green made a condition of any deal not to contact the Pensions Regulator.

The UK’s Pension Protection Fund can contribute to failed pension funds, but BHS pensioners would probably face reduced benefits. The UK’s Pensions Regulator has powers to call on Arcadia to contribute to the BHS pension fund deficit either through a financial support direction or a contribution notice. Green has claimed that he was ‘being tortured by the Regulator.’

 Green is reported to have made an informal offer of a £300 million contribution to the pension fund but only on condition that investigations against him be stopped and any legal action against him or his wife would be dropped.

Parliamentary probe into BHS sale

Members of Parliament from the Works and Pensions, and Business Innovation and Skills select committees called on evidence to probe the BHS collapse. The Chairman of the Works and Pensions Select committee, Frank Fields, suggested that Green, himself, should fund the deficit or risk losing his knighthood. Green responded aggressively claiming that he had offered to support the pension fund but his offer had been rejected. He also suggested that the Chairman, Field, was biased against him.

In his defence, Green said: ‘Any fair review of the BHS balance sheet would show the support we had provided to the BHS business throughout; It is clear that we invested substantially in the business. We lent substantial sums to the business and we gave Retail Acquisitions every chance, with a solid platform to take the business forward’.

The Chairman of the BHS pension fund trustees, Chris Martin, told the MPs that he had raised concerns about the deficit in the BHS pension fund after meeting Chappell. He felt that Retail Acquisitions had done little due diligence during their acquisition.

Business Select Committee member, Richard Fuller, called for an investigation by the Financial Reporting Council (FRC) of the conduct of directors and professional advisers involved. The FRC launched a probe into the involvement of BHS auditor one of the Big Four audit firms, PriceWaterhouseCoopers (PwC).

MPs called for Lady Tina Green to shed light on the complex web of companies registered in her name in tax havens, and their profits. They also wanted to know more about the relationship between Green and Goldman Sachs.

More critical comments

The Institute of Directors (IOD) commented that the action of Green ‘has the potential to be deeply damaging to British business. We spend a lot of time agonizing over the loss of trust in the business community and I think we can see why…When someone ends up behaving like this people think that is how business is: and it is not’.

The IOD also called on the UK’s Financial Reporting Council to investigate whether the board of Arcadia Group had failed in its duty to promote the success of a company it owned.

The Daily Mail said that Green had ‘obfuscated and dodged questions about the liabilities when he sold BHS to a former bankrupt, using a front page banner headline: ‘STRIP SIR SHIFTY OF HIS TITLE.’

Lord Myners, a corporate governance stalwart, asked the Attorney General whether the Serious Fraud Office was considering a formal criminal investigation into the collapse of BHS.

Although the SFO, the FRC, the Pensions Regulator and the administrator/liquidator have yet to report, the BHS case seems set to become a corporate governance classic. One is reminded of the Robert Maxwell case (page 25-26, Corporate Governance 3e, Tricker). Maxwell, a dominant entrepreneur, used funds from two public companies and their staff pension funds to prop up his private interests. Maxwell’s business empire finally collapsed leaving a £753 million deficit. He died of a heart attack having fallen from his yacht in the Mediterranean. But Maxwell had taken monies from two listed public companies, and their pension funds. BHS was a private company predominantly owned by the Green family.

 

Discussion questions

  1. Was anything wrong with the governance of BHS? This was a private company, wholly owned by another private company, itself in a network of overseas trusts and holding companies. No public company was involved.
  2. Should there be a corporate governance code for significant private companies, say those with sales revenues or employees over a certain figure? Should such significant private companies be required to have independent, non-executive (outside) directors or explain why they do not? Should they have audit committees, remunerations committees, and nomination committees with independent directors? Should the chairmanship of the board be separate form the CEO?
  3. Should independent auditors provide non-audit services and advice to their audit clients? (PWC were paid £355,000 in audit fees plus fees for non-audit services of £1,798,000).
  4. The UK Companies’ Act 2006 applies to all limited liability companies in the UK–public and private. It, therefore, applied to the Arcadia Group Ltd and to BHS Ltd. The Companies Act specifically spells out a statutory duty to recognise the effect of board decisions on a wider public, including ‘the interests of the company’s employees’, and ‘the need to foster the company’s business relations with suppliers, customers and others’. Did the decisions that led to the liquidation of BHS meet these requirements? If not, how might the Act be enforced?

A new idea in corporate governance – Shareholder Senates

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.

Shareholder Senates

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.

 

Bob Tricker
September 2016

The ongoing saga of the governance of Britain’s Railways

A case in Corporate Governance: Principles, Policies and Practices (Network Rail case 3.2, page 80) raises some interesting philosophical questions about the appropriate relationship between individuals, enterprises, and the state. The people in this case are British train travellers and taxpayers; the enterprises are the state-controlled Network Rail and private train-operating companies; the state is the UK government. Where should power and accountability lie? What is the most appropriate governance structure – a nationalized entity like the previous British Rail, individual private, profit-orientated train operating companies as now, with Railtrack plc responsible for the tracks, stations and signalling selling its services to the operating companies, or a re-classified state-owned corporation, with the national Treasury responsible for its debt?

The case quotes the then leader of the UK’s Labour opposition party, Ed Miliband, saying that when he returned to power at the 2015 election, he would consider re-nationalising the British railways system, re-establishing British Rail and taking over the privatised train operating companies. In the event the Labour party lost that election.

In June 2015, the Government suspended work upgrading two of the country’s most congested rail lines – Mainline Midland and the TransPennine route – because of cost overruns and missed targets. The decision came from the Treasury, which took over responsibility for Network Rail funding and therefore its debt after Network Rail was reorganized into a state-owned company.

Three months later, the rail regulator, the Office of Rail and Road, warned that the company might be in breach of its licence after they found flaws in the way it handled major projects. But the Government refused to release a critical report, which spelt out serious problems with Network Rail and might have undermined Government pledges, because of pending elections.

In July 2015, the Government replaced the Chairman of Network Rail, Richard Parry-Jones with Sir Peter Hendy. The Government also appointed Nicola Shaw, head of HS1[1] (the company known as High Speed 1, which runs the successful Channel Tunnel Rail Link) to draw up plans for Network Rail’s structure and funding. “Network Rail is not working,” she said, “There was a big change last year when its debt (then £38bn) was taken over by the Government. When you have a big change you ought to think about what you want to do from here.” The options she is considering include:

  • government continuing to fund the operation;
  • auctioning various routes (sections of track) as concessions to pension funds and sovereign wealth funds;
  • privatising the entire operation through a public listing.

Shaw said that she would stop short of considering reuniting track and train operations, as was the case under the previously nationalised British Rail. In September 2015, government ministers moved closer to a break up and sell off of Network Rail with plans for a radical overhaul of operations, shifting decisions on track maintenance and new projects to regional line managers. By February 2016, Shaw was suggesting spinning off individual lines to investors and introducing an agency to oversee the industry at arm’s length from government.

While waiting for the Shaw proposals, it seemed that the Chief Executive of Network Rail, Mark Carne, was being overseen by a civil servant, Philip Rutnam, permanent secretary at the Department of Transport, who was previously a merchant banker.

In October 2015, the Regulator issued a damning report naming ‘systemic failings’: a third of railway upgrades – new stations, extra track capacity, electrification of lines – were running late, and key project costs were spiralling out of control. In November 2015, the regulator fined Network Rail £2 million for delays and cancellations that constituted a breach of its licence. By November 2015, Network Rail admitted that train punctuality was not good enough as its debts mounted and six-month pre-tax profits fell by 23% to £246 million while operating costs rose by £88 million.

Meanwhile, Jeremy Corbyn, unexpectedly elected leader of the Labour Party in May 2015, put forward detailed proposals for the re-nationalisation of the fifteen independent train operating companies. Citing the continuing increase in rail fares, he said that bringing the entire network, including Network Rail, back under government control, had widespread support. Legal experts pointed out the potential difficulties, not least European Union law which requires member states to open up their transport networks to cross-border competition, which would rule out UK nationalisation. But in June 2016, the electorate decided in a referendum (Brexit) that the UK should leave the European Union.

Meanwhile the problems of the British railway system continue unabated. Blaming labour disputes, old rolling stock, and track delays, the Southern Railway network cut over 300 trains a day claiming this would make their services more “resilient”. Plans to re-route the new high speed line from London to the North ran through a newly built housing estate. Delays to rail, signalling, and electrification upgrades led to further late running and cancelled trains.

The Times in an editorial wrote that: ‘Thirteen years after its creation, Network Rail remains a byword for botched corporate governance. Without shareholders, ministerial oversight or direct contact with passengers, it is accountable chiefly to itself. It carries an unsustainable £38 billion debt burden but as a public body it has little incentive to pay this down or force on its staff the efficiencies that would cut costs.’

This has to be one of the longest running, unresolved corporate governance cases in the world.

[1] HS1 is owned by the Canadian investment funds Borealis Infrastructure and the Ontario Teachers’ Pension Plan.  It has a 30 year concession to run the Channel Tunnel rail link.

Bob Tricker, July 2016