Archive for the ‘Cadbury Report’ Tag
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.
Corporate governance codes and guidelines have long recognised the important role that institutional investors have to play in corporate governance. As well as being influential in their home countries, institutional investors have increasingly become a more significant force in other countries through their cross-border holdings. Recent corporate governance reforms motivated by the global financial crisis have placed even more emphasis on the role of institutional investors.
Role of Institutional Investors
Back in 1992, the Cadbury Report recognised the role played by institutional investors stating that ‘we look to the institutions in particular ‘ to use their influence as owners to ensure that the companies in which they have invested comply with the Code’. Various codes since then have emphasised the importance of the role. The Financial Reporting Council (FRC) publishes the UK’s Combined Code on Corporate Governance (commonly known as the Combined Code). The Combined Code (2008), in Section E, identifies three main principles. Firstly it states that ‘institutional shareholders should enter into a dialogue with companies based on the mutual understanding of objectives’; secondly ‘when evaluating companies’ governance arrangements, particularly those relating to board structure and composition, institutional shareholders should give due weight to all relevant factors drawn to their attention’; thirdly, ‘institutional shareholders have a responsibility to make considered use of their votes http://www.frc.org.uk/corporate/combinedcode.cfm The first and third principles relate to two of the tools of governance being dialogue and voting. All three principles essentially require institutional investors to behave in a responsible and conscientious way, taking all relevant factors into account and making considered decisions.
Corporate Governance Reform
The UK Treasury commissioned the Walker Review of Corporate Governance of UK Banking Industry which reported in November 2009. The Walker Review recommends ‘strengthening the role of non-executives and giving them new responsibilities to monitor risk and remuneration; it also recommends a stewardship duty on institutional shareholders to play a more active role as owners of businesses.’ http://www.hm-treasury.gov.uk/walker_review_information.htm Kate Burgess and Brooke Masters in their article ‘Institutions urged to adopt tougher stance’ (FT, Pg 21, 26th November 2009) states ‘Institutional investors are being urged to be tougher on company boards by Sir David Walker, as the City grandee adds his weight to pressure for them to take their responsibilities more seriously.’
The FRC’s statement welcoming the Walker Report can be found at: http://www.frc.org.uk/press/pub2174.html. The FRC has agreed to implement those recommendations that it considers should apply to all listed companies. In addition the FRC has agreed to consult on adoption of a Stewardship Code for institutional investors as recommended by Sir David.
A recent review of the Combined Code http://www.frc.org.uk/corporate/reviewCombined.cfm has however recommended that Section E of the Code (addressed to institutional shareholders) be removed, ‘subject to sufficient progress being made on the Stewardship Code for institutional investors and its associated governance arrangements.’ The Stewardship Code for institutional investors as was proposed by Sir David Walker, and is an area on which the Financial Reporting Council (FRC) will be consulting separately http://www.frc.org.uk/corporate/walker.cfm
The final report on the review of the Combined Code (2008) makes various recommendations which include, inter alia, annual re-election of the chairman or the whole board; new principles for the roles of the chairman and non-executive directors. Kate Burgess in her article ‘Sir Christopher misses out on succession planning’ (Pg 21, FT, 2nd December 2009) highlights that more emphasis should have been put on succession planning in companies as this tends to be a weakness in many firms. Moreover it would be beneficial to investors in their stewardship role to have more knowledge of the process in place for succession planning.
The Institutional Shareholders’ Committee (ISC) membership comprises the Association of British Insurers, the Association of Investment Trust Companies, the National Association of Pension Funds, and the Investment Management Association. The ISC has previously published guidance on the responsibilities of institutional investors in 2002, 2005 and 2007. In November 2009, the ISC published its Code on the Responsibilities of Institutional Investors which is included as an Annex in the Walker Review and which is widely viewed as the basis for the Stewardship Code which will be monitored for the adherence of institutional investors on a ‘comply or explain’ basis. The ISC states that ‘the Code aims to enhance the quality of the dialogue of institutional investors with companies to help improve long-term returns to shareholders, reduce the risk of catastrophic outcomes due to bad strategic decisions, and help with the efficient exercise of governance responsibilities.’ http://www.institutionalshareholderscommittee.org.uk/ The Code discusses the stewardship responsibilities of institutional investors which include effective monitoring of investee companies and voting of all shares held.
Of course in order to carry out their responsibilities as shareholders, institutional investors need to be able to exercise their rights effectively – if they cannot, then they may be tempted to exit, i.e. to sell their shares. An article in the Financial Times, ‘Shareholder rights’ (FT, page 12, 30th November 2009) points out that ‘if selling the shares is a blunt instrument, then removing board members is the sharpest. More than nine in 10 international investors say the ability to nominate, appoint and remove directors is the most valuable shareholder right. It is wrong that efforts to boost this power in the US have been delayed by the business lobby.’ Clearly it is in the interests of effective stewardship for institutional investors to be able to exercise their rights. This will enable them to take action on prominent topical issues such as having a ‘say on pay’ in relation to directors’ remuneration, and removing underperforming directors from the board.
However another dimension to consider is that of free riders. Ruth Sullivan in her article ‘Walker plan points finger at freeriders’ (FTfm Pg 3, 30th November 2009) points out that some institutional investors will not engage more with their investee companies and be active owners, rather they will save their time and money and free ride on the efforts of other institutional investors.
The recent reforms mooted by the Walker Review and the Review of the Combined Code have made recommendations which will help to strengthen corporate governance in the UK. The role of institutional investors is seen an important one and institutional investors are being encouraged to engage more fully in their role as owners and adhere to the ISC Code of Responsibility for Investors.
Chris Mallin 2nd December 2009
The mid-nineteenth century vision of the joint stock, limited-liability company was exquisitely simple and superbly successful. Ownership was the basis of power. Shareholders appointed the directors, who reported regularly on their stewardship over the company. Shareholder democracy was based on one share – one vote.
Then something went wrong. Directors took control. As long ago as 1932, in research that is still among the most cited in the corporate governance lexicon, Berle and Means showed that power over public corporations in the United States had become concentrated in corporate boardrooms. What happened to the original notion that power over a corporation should be exercised by the owners? A similar erosion of shareholder power occurred in the United Kingdom, and indeed in most other countries whose company law reflected the old Commonwealth company law traditions.
The UK Cadbury Report (1992) and corporate governance codes in other countries attempted to redress the balance by requiring board-level nomination committees, with independent non-executive director members, to put forward the names of potential directors. But these non-executives, themselves, had been approved by the chairman and CEO, and owed some allegiance to them. The board then put their proposals to the members, who got to vote. But incumbent directors effectively could re-appoint themselves and, when the time came, appoint their successors.
The shareholders of a UK public company can now call for a special meeting of the members, at which a simple majority can vote to remove any (or indeed all) of the directors. Section 338 of the UK Companies Act 2006, broadly, enables members of a public company to require the company to give all shareholders notice of their resolution, provided they hold 5% of the total voting rights or total at least 100 members. But the financial risk and uncertainty of such actions make them newsworthy.
In the United States the situation is worse. One share one vote still prevails, but the board decides which names get on the ballot paper. The only way for outsider candidates to get nominated is through proxies circulated to all the other shareholders at the proposer’s expense. This financial exposure results in most board appointments being uncontested, with incumbent directors keeping their seats around the board room table, with the attendant benefits, even though in practice only a small proportion of shareholders actually voted for them
Attempts to persuade the Securities and Exchange Commission and state regulators to change the rules have been frustrated by aggressive lobbying from corporate director interest groups. The latest attempt by the SEC to reform the system was put on hold earlier this year.
Companies in the United States, of course, are incorporated by individual states. There are no provisions for incorporation at the federal level. Many companies are incorporated in Delaware, because company law and the Delaware companies’ court tend to be sympathetic to their interests. But Delaware company law was changed earlier this year to allow companies to reimburse the costs of circulating the names of outsider directors to other shareholders.
A straw in the wind was reported in the Economist (31 October 2009). The American company, HealthSouth, a company that runs private hospitals and clinics, which in the past has been criticized for poor corporate governance, changed its corporate governance rules to allow activist shareholders to propose candidates for election to its board. The company even offered to cover the costs involved, if 40% of the votes were subsequently cast for the outside candidates.
In his clumsily titled, but brilliantly perceptive book Corpocracy (Wiley, New Jersey, 2008), Robert (Bob) Monks showed how modern corporations have maximized their wealth, balked at government regulation, and locked-out their shareholders, whilst the executives rewarded themselves with massive pay packages. Shareholder control over large corporations, he argued, is weaker now than ever. Not only are these corporations rarely held to account by regulators, they face even less control by those whose interests they are ostensibly there to serve.
Bob Monks feels that shareholders, particularly institutional shareholders, should attempt to influence corporate behaviour and governance for the benefit of all shareholders and society. He has called for the United States to adopt the British approach, with a federal statute that would give investors the right to call a special meeting to remove directors.
The Economist commented “in a healthy shareholder democracy, such a rule would not be controversial.”
– in which Bob Tricker explains why he resigned from the Institute of Chartered Accountants in England and suggests a provocative future for auditors*
In the ongoing crisis facing financial institutions around the world, plenty of questions are being asked: why did the independent directors not act, did they even understand the risks in the business models being pursued; did the regulators fail; were the credit agencies at fault; are the risks of securitisation still properly understood; did short-term performance bonuses encourage greed and excessive risk taking?
But a crucial question remains: where were the auditors? Audit reports reassured readers about these companies’ accounts even though, as we now know, the underlying strategic model was suspect and the businesses exposed to massive risk, even the possibility of trading when insolvent.
In the original 19th century model of the joint-stock company, the state permitted incorporation of limited-liability entities provided certain safeguards were met to protect society. Auditors, appointed from amongst the investors, reported to these shareholder-owners that the directors of their company had faithfully recorded the company’s financial situation.
Then the accounting profession emerged. Small firms at first but, as companies grew in scale and complexity, they grew larger. Mergers enabled them to grow further. By the end of the twentieth century the world’s major listed companies were audited by just five vast, international accounting firms.
However, in essence the auditors’ duty has not changed since the founding years. It is still to report that the information given by the directors to the shareholders reasonably reflects the truth. But the relationship of the auditors to the companies they audit has changed. As scale and complexity increased, the role of the auditors properly became more professional. Inevitably, their relationships with the directors of their client companies grew closer. Although in many jurisdictions the shareholders still voted on a resolution to appoint the auditors, it was the board of directors who really made the decisions. And although nominally the auditors reported to the shareholders of the company, their detailed reports went to the directors.
Inevitably, a close relationship developed between the auditors and the staff of their client, particularly in the finance department. Issues that arose during the audit – questions about asset valuations, capital or revenue decisions, risk assessment or management control, for example – were resolved without the board even being aware of them. So audit committees were introduced, first in the US and then, following the Cadbury Report, in the UK. Sub-committees of the main board, these audit committees relied on independent outside directors to provide a bridge between company and auditor, avoiding too close a relationship between executive directors and audit staff, and ensuring that the directors were fully aware of audit issues.
Following the Enron debacle, the listing rules of most stock exchanges demanded audit committees composed entirely of independent directors, the rotation of audit managing partners, the prohibition of consultancy work for their audit clients, and a cooling-off period before audit staff could join the finance department of a client. The rotation of audit firms, though called for by some, was not demanded.
But I believe the issues go deeper. The real question is whether audit and accountancy is a profession or a business. Do the auditors offer a service to management or are they part of society’s regulatory function?
In the 1950s I was articled to a professional audit practice, which provided service for a fee. The number of partners was small. The phrase corporate governance had yet to be coined. In those days the accounting profession consisted mainly of relatively small firms. Of course, our partners were keen to be successful. In their community they were respected and well to do; but they were not rich. Neither would they compromise their principles. They would not sign an audit report, stating that the client’s account’s showed a true and fair view, unless the partner was personally convinced that they did. Better to lose a client than your integrity. This was a profession, after all. The audit process demanded absolute objectivity of thought and independence from the client.
How different at the beginning of the 21st century. The five major accounting firms had become vast, international and concentrated. They are major businesses, offering products and solutions, with market share and profit performance as watchwords. Partners were judged by fee generation and growth. Then in 2002 one of the five, Arthur Andersen, collapsed, brought down by the Enron catastrophe in the United States. Then there were four.
Partners’ expectations have been influenced by the remuneration levels of their ‘fat cat’ clients. But auditing is not astro-physics. True, the work demands detailed, intense and up-to-date work, but it is not actually difficult. Admittedly, too, these days the risks of litigation and forced resignation are higher. But the real challenge lies in determining standards and living up to them, as it always did.
When I began my accounting career in England, the Institute of Chartered Accountants was at the head of a self-regulating profession. Today, as the Arthur Anderson saga has shown, the market place, not the profession, regulates. Indeed, I believe that auditing has ceased to be a profession: it has become a business. So after nearly fifty years as a Chartered Accountant, including service as a member of its governing Council, I decided that the profession I had joined no longer existed and resigned my Fellowship.
Of course the business world has changed. Nostalgia has no place in strategic thinking. There is no going back to the profession of half a century ago. But I suspect that, unless auditing rediscovers what it means to be a profession and returns to its roots, state regulation of the audit process will have to be imposed to protect creditors, investors and the wider community.
Serious questions have to be asked about the auditors’ position. Who are their real clients: the directors or the shareholders? The de jure response that the client is the company and that somehow this means the body of shareholders will no longer wash. The de facto reality is that the client is the board, backed up by the board’s audit sub-committee. Is this satisfactory under current circumstances? What are the alternatives?
Consider some options:
1. Open the audit market with the second tier firms playing an increasing role in the audit of major listed companies. There has been slight movement in opening the market for audit. But financial markets like the assurance they think they get from an audit opinion signed by one of the big four firms. Predictably, the partners of the firms in this global oligopoly do not favour this solution.
2. Increase regulation introducing further rules to regulate auditors’ activities. This has been the approach adopted in many countries, with the Sarbannes Oxley Act (SOX) in the US, and tighter regulations and stock exchanges’ listing rules elsewhere. But SOX has proved far more demanding, expensive, and bureaucratic than expected; and less effective, as we see from its failure to identify the exposure underlying the financial institutions that have collapsed.
3. Face reality, require auditors to be appointed by and report to the state. It is the state that permits companies to incorporate, and the state that is responsible for protecting the interests of investors, creditors and other stakeholders. That is why we have regulators. A start could be made by introducing this requirement in those companies that have just been massively funded by the state. Surely, the auditors of companies that have been bailed out should not report solely to the directors. He who pays the piper…
The regulatory organisational structures already exist to manage such a relationship. The regulators, working with the shareholders in general meeting, would appoint, re-appoint, or if necessary replace the auditors, agree their fees and receive their reports. The company would, as now, bear the costs.
In this way cosy relationships between directors and auditors would be avoided. If they reported to the regulator rather than the directors, the auditors would have to develop a new mind set. Moreover, shareholders would now have a direct line to their auditors and the board’s audit committee.
Eventually, such an arrangement could be applied to all listed companies. Shareholders would benefit. Investors would know that their auditors worked for them, just as in the 19th century model.
* This is a personal view and the ideas are not necessarily shared by my fellow blogger Professor Chris Mallin nor the Oxford University Press.