In 25 years the purpose of corporate governance has moved beyond 'improving oversight' to 'saving capitalism'
The Government and Parliament are considering the case for reforming the approach to regulating corporate governance, amid criticism that it has failed to prevent some high-profile corporate scandals or deal with persistent concerns about executive pay.
The regulatory approach – based on 'comply or explain' standards and requirements to report to shareholders, who are expected to act as enforcers – has not fundamentally changed since it was first introduced a quarter of a century ago. Our expectations of what it should be able to achieve have, by contrast, changed considerably.
In its 1992 report that introduced the first version of the UK Corporate Governance Code, the Cadbury Committee defined corporate governance as simply 'the system by which companies are directed and controlled'. The aim of the code was to enable listed companies to 'strengthen their control over their businesses and their public accountability' – a relatively modest ambition.
Fast forward to 2015 and the Organisation for Economic Co-operation and Development, whose principles are now the global standard for corporate governance, defined its purpose as being 'to help build an environment of trust, transparency and accountability necessary for fostering long-term investment, financial stability and business integrity, thereby supporting stronger growth and more inclusive societies.'
In a similar vein, the Government's Green Paper identifies three objectives for its proposed reforms: to strengthen decision-making and accountability, restore faith in big business, and deliver growth, opportunity and choice for all.
In 25 years the purpose of corporate governance has gone from being 'improving oversight' to 'saving capitalism'. That is clearly a much bigger job – for boards of companies, but also for the regulatory framework within which they must work.
Before deciding either to build on or abandon the current approach to promoting and regulating corporate governance, we need to ask two questions:
- Is it still capable of delivering its original purpose?
- Is it capable of delivering the broader objectives that we now expect of corporate governance?
In my view, the answer to the first is 'mostly, yes'; the answer to the second is 'mostly, no'.
Strengthen accountability
As far as the original purpose of improved control and accountability is concerned, the rationale behind the regulatory approach recommended by the Cadbury Committee still applies.
Codes are more effective than regulation as a way of raising standards and spreading good practice as they can set those standards higher than is usually appropriate in law, which is better suited to setting out the minimum that is acceptable.
A requirement to report on the extent to which those standards have been adopted is desirable, so that companies cannot choose simply to ignore them. And because, under company law, directors are primarily responsible to the members of the company, it is right that they should report to their shareholders rather than regulators, provided those shareholders have the ability and willingness to act if they are not satisfied.
The effectiveness of the investor 'enforcement' mechanism is crucial to the success of this approach, and changes in the market over the past 25 years have created challenges.
In 1992, over 50% of shares were owned by UK pension funds and insurance companies, the investors who were implicitly expected to make 'comply or explain' work. That figure has now fallen to less than 10%.
Over half the shares in UK listed companies are now held by institutions based outside the UK, for many of whom the UK market represents only a small percentage of their overall portfolio. The UK equity market is also less important to UK investors than it used to be. Only 13% of assets managed by members of the Investment Association were invested in UK equities last year, down from over 25% in 2007.
Despite these changes, there is still a considerable appetite on the part of many investors to monitor and engage with the companies in which they invest.
There has been strong support for the Stewardship Code since it was introduced in 2010 – even though not all signatories have taken their commitments as seriously as they might – with companies and investors reporting increased levels of direct engagement in recent years. Industry initiatives such as the Investor Forum also appear to be having a positive impact.
The track record of the UK Corporate Governance Code is a strong one. Over time it has been extended to cover other aspects of governance and the standards it sets have become more rigorous as expectations and our understanding of good practice increase.
Over the years it has introduced practices that were seen as contentious at the time – such as the separation of chairman and CEO, regular board evaluations and annual director elections – but are now taken for granted as common sense and standard practice. Despite the regular ratcheting up of expectations, compliance rates remain high. Last year over 90% of FTSE 350 companies complied with all but one or two of its 54 provisions.
For me, this evidence of the past 25 years shows that the Code, and the regulatory framework of which it is part, by and large continues to achieve its original purpose. It may need further updating, and the FRC has recently indicated it plans to do so, but it should not be abandoned.
Restoring faith in business
However, I do not believe an approach based on standard-setting, public reporting and shareholder enforcement is – on its own – sufficient to protect or promote the public interest, restore faith and deliver opportunity and choice for all – and there are a number of reasons why it is not well-suited to the task.
First, although by promoting good governance the regulatory framework does reduce the risk of poor decisions and bad behaviour, it is not designed to deal with them when they happen. In particular, it cannot effectively sanction or punish bad behaviour.
There is a tendency to argue that every time a company behaves in a way that impacts adversely on one or other interest, it represents a failure of public policy or a failure of governance.
Blaming each example on systemic weaknesses encourages the assumption that the system can be adjusted to prevent them from being repeated. And branding them as governance failures encourages the assumption that adjusting the apparatus that has been put in place to regulate governance is the way to prevent them.
The human factor
Although there are exceptions, most corporate scandals are not caused by systemic failure, but by human failure. Most are examples of bad judgement, bad behaviour, or negligence. Their root cause is human nature, which is not something that can be remedied by regulation.
In other areas of public policy, the human factor is more explicitly recognised. Nobody assumes that the rules will always be obeyed. Sanctions for disobeying them are an integral part of the policy approach and serve as both a deterrent and a punishment. The governance framework as it is currently designed does not include sanctions that are adequate for the purposes of punishing bad behaviour by directors.
The sanctions shareholders are able to impose – voting against a resolution or selling their shares – can have a disciplining effect, but where serious damage has been done they will often be too little, too late; and they do nothing to reassure those who have suffered as a result of those directors' actions that justice will be done.
Wrong group to protect the public
The second, related, reason why the regulatory approach is unsuitable for achieving the broader objectives we expect of it, is that shareholders are not the right group to be given lead responsibility for promoting the public interest.
Through their actions shareholders can, and do, make a contribution to achieving broader public policy objectives. Levels of investment in environmental, social and corporate governance funds are at an all-time high; and so-called mainstream investors are increasingly paying attention to social, ethical and other factors that have the potential to affect adversely either the reputation or the performance of the companies in which they invest.
By putting pressure on companies to tackle these issues, investors can help to deliver public benefits, but that is not why they do so. It is merely a beneficial side-effect of their desire to achieve a good return for their clients. And the interest of those clients and the public interest, or the interest of one or another group of stakeholders, will not always coincide.
For this reason, shareholder pressure is at best an unreliable means of protecting the public interest, and on its own cannot be an adequate substitute for a broader, coordinated approach to tackling the issue.
Another obvious reason why relying primarily on shareholders to uphold the public interest is inadequate is that they only exercise influence in the listed sector. Listed companies represent an important but relatively small part of the economy. Taking action only in relation to that sector will have minimal impact on most parts of the UK economy and society.
A corollary of that argument is that more attention should be paid to the original purpose of corporate governance – improved control and accountability – in other sectors as well. If it is an important enough objective to justify government action in relation to listed companies, should that not also be true for other sectors or large organisations whose activities have a significant public impact?
Untangle the components
Rather than piling more expectations onto the regulatory framework for corporate governance and complaining when it does not meet them, we need to untangle the different components of what we now call corporate governance if we are to address each of them effectively.
Although the approach to improving control and accountability in the listed sector is largely working, there are some specific issues that need focusing on. These include getting companies to pay more attention to corporate culture and to the impact on all their stakeholders, which go together, and continuing to encourage investors to engage in a meaningful way with companies on these issues and others affecting their long-term viability.
New thinking is also needed in relation to the means through which companies report to, and are held to account by, their shareholders. There is a widely held view that the annual report and the AGM no longer serve their purpose for either companies or investors, and may need to be overhauled.
Other sectors
Greater attention should be paid to the standards of governance in other sectors, where practices are generally less developed than in the listed sector. This would help to reduce the risk of organisations failing or taking actions that impact adversely on the public and, in the public sector, will help to ensure that taxpayer's money is well managed.
The Government's interest in large private companies is a welcome start, but there are many other sectors and activities where paying more attention to raising general standards would be in the public interest. Investors ought also to be concerned about the governance of some of the asset classes other than equities which receive the bulk of the money invested by asset managers on behalf of their clients.
To achieve 'opportunity and choice for all', programmes addressing issues such as income inequality and equal opportunities need to be extended to all sectors of the economy, where this is not already the case, if they are to make a major difference. Addressing these issues only in the listed sector limits both the ambition and the impact.
We should also review the approaches that have been used within the listed sector to deliver public policy objectives. The current reporting and voting requirements on directors' remuneration, for example, have done little or nothing to address the issue of income inequality, whatever their merits in terms of increasing accountability to shareholders, and adding more of the same is unlikely to do so.
Finally, we need to address the issue of sanctions. At present, there is no effective means of appropriately punishing actions by directors that have a significant adverse impact on their shareholders, stakeholders or on society in general. Any sanctions must, of course, be proportionate and justified, and must distinguish between bad behaviour and poor decisions made in good faith. But that does not reduce the need for them.
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