Corporate governance - an update

This month in Article 13’s expert view, we are focusing on corporate governance. Not only has this hot potato been gaining regular headlines, but Article 13 has also been getting the inside story, through our extensive networking and research activity...

In this article, we bring together the complex strands to give an update on the following issues: what is meant by corporate governance? Why it has been gaining headlines? What does “good” and “bad” corporate governance look like? What is coming up on the national and international stage, that we need to look out for?

The wider context

The core principles of corporate citizenship and business responsibility ask companies to understand how they fit into the wider context of a community, on a local, national and global scale, and to consider their impacts in light of this.

Similarly corporate governance fits into a wider “governance” context which provides the framework in which societies function.  And it is not only corporate governance that has been in the spotlight in recent months.  Governance within the public sector and the media is increasingly being brought to question: the decision to go to war with Iraq and what has been surfacing through the Hutton Inquiry being recent salient examples.

What is corporate governance and why all the big fuss?

In very broad terms, corporate governance concerns the way a company governs itself⁽¹⁾, the manner in which a company manages itself – in particular the role of the board. The way corporate governance works is through all the systems and procedures that operate within an organisation to ensure that it is properly managed.

Whilst the principles of corporate governance tend to be applied only to listed companies, as Robert Blanks of The Institute for Chartered Secretaries and Administrators states: “As citizens of a Borough or as a beneficiary of a charity we all have an interest in the way all organisations are run”.

There is also a feeling that corporate governance tends to be too often interpreted as relating to specific issues, with the past few years seeing a focus on remuneration and board composition and structure⁽²⁾. However, in a participative workshop we ran recently with Finance Directors of FTSE 100 companies, a much broader definition of corporate governance emerged:

So, why is it so important?

Frits Bolkestein, the European Union’s internal market commissioner highlighted some of the wider impacts of corporate governance in a recent speech: “Economies only work if companies are run efficiently and transparently. We have seen vividly what happens if they are not: investment and jobs will be lost – and, in the worst cases - of which there are too many - shareholders, employees, creditors and the public are ripped off.”⁽³⁾

High profile accounting scandals, “fat cat” pay packages and the handling of the pension crisis in the U.K., have led to a crisis in confidence in how companies are run and how transparent they are.⁽⁴⁾ According to a MORI poll conducted for the Financial Times, “eight people in ten disagree that “directors of large companies can be trusted to tell the truth”.  And nearly two-thirds of those in full time employment, 65% say that they do not believe that “companies can be trusted to honour their pension commitments to employees”. These findings strike at the heart of corporate Britain, and are a measure of scepticism even cynicism, of the public towards business leaders”.⁽⁵⁾

Leading commentators now note that society is raising its expectations – or at least making explicit its expectations – of good governance.  Companies are coming under increasing pressure from their stakeholders to engage with good corporate governance.  This has been reflected in the raft of new legislation and codes in Europe and the U.S. (see our briefing paper “A snapshot of recent codes and legislation” for an overview).

As well as external pressure from society and government, there is also growing “internal” pressure in the form of what is being termed “shareholder activism”. Further, it is also in a company’s own interest to focus its attention on its corporate governance practices, as there does seem to be a link between good corporate governance and company performance.

Although it is difficult to measure whether corporate governance delivers to the bottom line, it is certainly true that bad governance subtracts value.  There are numerous examples of high profile cases in recent years where a lack of communication between the Board and lower tiers of management has had catastrophic results⁽⁶⁾. 

Research by Deminor, a Belgian corporate governance consultancy, reveals that “well governed companies perform up to 3 per cent better than less well governed rivals”.⁽⁷⁾

A commentator from Hermes, a leading UK pension fund manager, argues that it is not so much compliance with codes that gives a positive correlation between corporate governance and company performance, but “the process of active ownership” or what is being termed “shareholder activism”, where investors are engaging much more in a company’s management decisions⁽⁸⁾.  This can be through collaborative meetings and dialogue but also less collaborative methods. The most striking example of this was GSK shareholders’ recent stand against “fat cat pay”. 

So, what is “good” corporate governance?

Finance Directors at the workshop we ran on corporate governance, raised some interesting issues.  One of the top questions that they asked was: “How do I know I’m doing it [corporate governance] right?”

We spoke to Professor Rutherford of Canterbury Business School and he described what “not doing it right” is: “Poor corporate governance is doing things to improve the short term appearance of the company in financial statements.  This can sometimes pay off but these things often come back to haunt you”.⁽⁹⁾ To consider the manner in which a company is governed and what best practice might look like, it is useful to think in terms of layers. 

The first layer of corporate governance is to do with accountability mechanisms i.e. the procedural mechanisms by which management within companies are held accountable. These mechanisms need to be in place to ensure that people feel accountable to the company as a whole, rather than a particular individual.  For real accountability to be delivered, the concept of the company as an entity is an important one.  This concept can engage shareholders, employees and even the consumers that buy a company’s products and services⁽¹⁰⁾.

The second layer has more to do with attitudes than procedures. Corporate governance is governed by codes but problems arise when these codes are applied too literally.  For example, in 99% of cases splitting the role of Chairman and Chief Executive may be the best way to run the company but in some cases combining the role is better for the company e.g. to allow a more considered recruitment process.  Compliance can be bad if it causes damage to the company.  In other words, companies should steer away from a box-ticking attitude.  It is the principles and spirit of corporate governance that is important.⁽¹¹⁾

Another key element of good corporate governance is the composition and functioning of the board.  Much has been written on this topic, but some basic principles are:

• Creating a climate of trust and candour
• Fostering a culture of open dissent
• Utilising a fluid portfolio of roles
• Ensuring individual accountability
• Evaluating a board’s performance⁽¹²⁾

So what lies ahead?

There has been a lot of activity at government level, in the U.K., Europe and the U.S.  A quick look at some of this activity gives us an indication of how the agenda is moving forward.

We have seen that there are some issues which are key to good corporate governance: effective boards, living the principles of corporate governance rather than a box-ticking approach, investor activism/involvement in management decisions.

Most of these have been highlighted by recent reports and codes:

The focus on effective boards was stressed in the recent Higgs report in the U.K. which highlighted the importance of the role of independent non-executive directors (NEDs).  A further government task force has released a report, the Tyson Report, which stresses the following aspects of recruitment to the board:

• A more rigorous and transparent selection process for NEDs  - this would enhance board talent and effectiveness as well as foster greater diversity in NEDs.
• More and better training and evaluation of board members –an initiative is recommended to bring together companies and training providers to establish guidelines to ensure that training programmes for directors are providing what is needed.
• Research and measurement to encourage greater board diversity⁽¹³⁾

In the US, following the Sarbanes-Oxley Act 2002, new plans announced by the Securities and Exchange Commission will give shareholders more power over the election of a company’s board of directors.⁽¹⁴⁾

A new code on corporate governance has also been introduced in the U.K. specifically for investment trust companies. Historically, this sector has been associated with poor governance, poor accountability and lack of transparency. Trust fund collapses have led to the loss of savings for thousands of investors. Although this code has been criticised by the industry, managers will now be subject to the provisions of this new code.

With the emergence of new reports and codes, the debate on mandatory regulation versus the voluntary approach has gathered pace. In the meantime, the E.U. has been doing its share of pushing corporate governance up the agenda. It has published a corporate governance and company law “action plan”. This action plan, not legislation yet, but more a statement on where the E.U. is heading over the next few years with these issues, lays out some key recommendations. Some of them support already existing initiatives and codes in member states.

• Companies should be required to publish an annual corporate governance statement
• The E.U. should
  • produce a directive on shareholder rights
  • promote the role of non-executive or supervisory directors 
  • create a European Corporate Governance Forum
• Member states should ensure companies give detailed disclosure of directors’ remuneration

Clearly a lot going on, at home and abroad.

Summing up

This whistle-stop tour of corporate governance has given an overview of some of the latest developments and debates.

A good way to summarise, might be to quote what the finance directors fed back to us on corporate governance at our recent workshop.  These quotes encapsulate the key messages that are coming through from all sides on this issue:

We asked: How far does corporate governance reach i.e. what is the legitimate range of activities that corporate governance might cover? The FDs said:

And finally we asked: Does corporate governance promote short-termism or can it enhance shareholder return through increased accountability, disclosure and transparency? The FDs said:

References:

1. ABI, 2003:  Interview with Andy Woods – IVIS Manager, ABI 
2. Ibid.
3. Financial Times, 21.07.03
4. FT, 30.06.03
5. FT, 30.06.03
6. ABI, 2003:  Interview with Andy Woods – IVIS Manager, ABI  
7. FT Money, 2003
8. Colin Melvin, FT Money 2003
9. Brian A Rutherford – Professor of Accounting, Canterbury Business School
10. Paul Smee – Chief Executive, Association of Independent Financial Advisors (AIFA)  
11. Robert Blanks – Policy Division, The Institute for Chartered Secretaries and Administrators (ICSA) 
12. Harvard Business Review, Best Practice – What makes Boards great, p110
13. The Tyson Report on the Recruitment and Development of Non-Executive Directors (June 2003)
14. FT 16.07.03

Also in this feature:

• Building an effective board 
• Legal & General - recognised for best practice in corporate governance by the ABI 

© Article 13 – September 2003

See also:

• The small business and corporate social responsibility 
• Making corporate governance a reality