What is it?
Corporate governance (CG) is all about how well organisations 'behave' with respect to the various concerns of their stakeholders – especially shareholders (both public and private) and governments.
Why is it a hot topic right now?
Although being ethical in business is not a new principle. The recent US corporate scandals involving Enron and WorldCom have brought the topic into the public spotlight and resulted in changes to corporate law as a result.
In 2002, the Sarbanes-Oxley Act was introduced in the US. This law, often referred to as SOX, is now mandatory for all US organisations (refer to the members section for a brief summary of its contents) and non-US organisations listed in the US. In the UK, corporate governance has evolved more as a voluntary code, but of late there are signs that this is being replaced by legislation.
Who does it affect?
Although intended for public-listed companies, the prominence of corporate governance related scandals has brought the issue of business ethics and good governance to the forefront of the business world in general. Privately-held companies may also wish to implement some of the concepts as this may well help them position themselves better for possible future initial flotation or business continuity when the organisation needs to raise further capital for acquisition or growth.
An overview of recent high profile US corporate failures
Although the Enron and Worldcom scandals have brought corporate governance issues into the public forum, these are merely the tip of the corporate distress iceberg. In the past few years alone, there have been over 50 cases of US public corporations malfeasance.
A comprehensive list, including the key points of each scandal is presented in the members section.
A fundamental aspect of US legislature is the system of lobbying. The issue of political involvement between big business and political parties is exemplified by the link between Enron and the White House1. President Bush's difficulty in accounting for the fact he accepted $220,700 from Enron though campaign donations in 1999 typifies the delicacy of the issue2. Characterised by large donations, parallels might be drawn with the recent 'cash for honours' allegations here in the UK.
Of the cases in the US where share price change has been available, the average drop in the immediate years after each case was a staggering 71%. Clearly, whatever the cause of the scandal, the marketplace reacts very negatively to adverse governance news. Should UK institutional investors begin to use adherence to corporate governance principles as an investment criteria, this could have a potentially significant impact on share price performance and this issue should be high on the concerns list of a board of directors.
Differences between the US and UK corporate governance structures
Until recently, the US and UK approaches have been quite different. Here, the emphasis over the past few decades has been on building up a voluntary code, and morphing that into the self-declaration approach of 'comply-or-explain'. Corporate governance in the UK came to the fore with the publication of the Cadbury report in 1992, which was prompted by the late 1980s collapse of the Maxwell group3. However, perhaps in response to the increasingly severe scandals in Europe, the UK is now tending to follow the US lead of introducing mandatory and punitive measures.
Jill Treanor, commenting in the Guardian on this change of direction4 stated that UK company directors risked criminal charges in the future if they attempt to hide information from their auditors. Citing comments by Jacqui Smith (then DTI Minister for Industry and the Regions), she elaborated by surmising this is the first step of wider, comprehensive changes to company law, which were planned to be introduced in due course.
Some parallels with SOX can thus be drawn and aspects of recent and current amendments to UK law include:
- Company directors will have to state they have not withheld information from auditors
- Details of non-audit services provided by their auditors will have to be declared
- Immunity for whistleblowers
- Greater power to investigators to uncover information on companies – including access to company premises without a warrant
There has also been pressure for change from the EU in Brussels. Accounting directives collectively known as the Modernisation Directive5 have recently been issued which became mandatory in all member states and focuses on harmonising accounting practices.
With corporate governance not yet reaching maturity, many individuals, organisations and even nations are still getting to grips with it; not only what it is and how to implement it, but also how to measure its success. As an evolving topic that has not yet stabilised, CQI members might wish to keep abreast of European developments. A good way to do this perhaps is to regularly review the portal of European law at http://europa.eu.int/eur-lex/en/index.html.
The Combined Code6 is widely regarded as the definitive corporate governance reference in the UK. Pulling together several related studies, it contains most key governance aspects that have developed over the years, both as a result of, and in anticipation of corporate malfeasance. For example, the recommendations contained in the Higgs report7 on the role and contribution of non-executive directors and the activities of audit committees have been included, as was the issue of internal control.
Various sector-specific examples of self-regulation have emerged recently. As an example, following recent friction between the individual voluntary arrangement sector and the major banks, 27 companies have founded the debt resolution forum to establish best practice in their industry in an attempt to placate both the banks and the financial sector regulator.
However, minor corporate governance compliance issues continue to emerge within the UK. Some examples include:
- Alpha Airports was suspended from the stock exchange in 2006 due to corporate governance issues
- Healthcare Holding had its floatation cancelled due to the resignation of its nominated advisor (a sector specialist recognised by the stock market, similar to a non-executive director)
- HSBC plc received criticism when it planned to appoint its chief executive as chairman, which runs contrary to one of the basic corporate governance guidelines8
Full SOX compliance in the US is very expensive and a trend has started where US start-up companies prefer to list in London on the alternate investments market (AIM) where regulations are looser and listing costs are much lower. With more money now being raised on initial public offerings in London than in New York for the first time since 2000, it does appear that US organisations not willing or able to meet SOX regulations are taking the easy route and moving to London. One US company that floated here on AIM instead of in the US said it would have taken 18 months longer and cost an extra $1m because of SOX compliance regulations9.
On a positive note, many organisations are now publicly emphasising their commitment to corporate governance issues. For example, Aetna, one of the world's largest insurers, recently announced that it, 'has earned top quartile ratings for its corporate governance practices from Institutional Shareholder Services (ISS), an independent provider of proxy voting and corporate governance services'10.
Boardroom structure - committees and reporting structures
The various corporate governance codes are converging on what can be viewed as 'best-practice' boardroom composition. In a well-structured organisation, reporting to the board are three committees, each with an appropriate number of non-executive directors to ensure an independent approach is maintained. These are:
- Remuneration committee – setting the levels and conditions of executive director's salary and other benefits
- Nomination committee – selecting and appointing board members in the best interests of the organisation and its stakeholders
- Audit committee – ensuring the robustness and integrity of the financial reporting channels including liaising with the external auditors to prevent undue adverse influence from the board
The role of the non-executive director
It has become apparent that the role of the non-executive director (NED) plays a pivotal role in successful corporate governance implementation. This rise in prominence over the last few years is due, in no small part, to the influence of the Cadbury report. According to the IoD11, the NED's purpose is to provide: 'A creative contribution to the board by providing objective criticism. Non-executive directors are expected to focus on board matters and not stray into “executive direction”,' thus providing an independent view of the company that is removed from day-to-day running. Non-executive directors, then, are appointed to bring to the board: independence; impartiality; wide experience; special knowledge; personal qualities.'
This has evolved from the original NED role, which is actually not a new one. In the 19th century it was normal for companies to be run by part-time ie non-executive directors. Only when the business environment became more complex, did the non-executive boards begin to nominate full-time (executive) directors to manage the companies on their behalf.
However, the presence alone of NEDs does not guarantee good governance. Areas of concern include:
- A less rigorous selection process where the NED is selected from network contacts and not on merit
- Contribution criteria weakly defined resulting in the NED acting more like a less-informed executive director
- Insufficient number and variety of NEDs on the board to make a useful impact
- Resistance by the full-time directors to 'prying eyes' monitoring and commenting on their performance
- Limited time allocated for NED activity (often set at only several days per year)
Studies have analysed the limited time a typical NED has available to work for the company, and recommended at least 100 hours per year12. With some directors around the world shown to be involved with up to 80 companies it is no surprise that guidelines on this issue are being generated.
So, with a situation where a NED is active only for a limited number of days per year it is clear that roles and responsibilities need to be absolutely clear. The NED should not get involved in the daily operations of the company and equally, cannot be expected to be directly held accountable for poor company performance – that is the function of executive directors. They can however, most certainly be held accountable for not challenging the decisions, directions, plans and appointments of the executive group. Accordingly, emphasis needs to be placed on the NED appointment process, and care to be taken to ensure the NED is not a proxy voice for the appointer. Unfortunately in the past, this has been less than ideal. In a study it was found that 90% of NED appointments were already known to the CEO prior to the appointment13; a result that is in line with earlier work that found that 415 of UK boards contained retired executive directorss who were bestowed a NED position14.
In the UK and other countries where the structure of the company board is not legally defined, as it is in Germany, it seems the NED position will continue to grow in prominence over the executive role as it is perceived, in the short-term, as the torch bearer for good governance. However, this is against a legal backdrop where directors are jointly and severely liable for the activities of the company they direct; whether or not they are aware of the activity.
Although English law recognises the roles of the chairman of the board and of the managing director, it does not differentiate between other types of director. Hence, from the legal standpoint it appears that both executive and non-executive directors have the same statutory duties, responsibilities and liabilities. This does not support the need for greater NED activity in the UK and it would be prudent for adjustments in the relevant laws such as the Companies Act, to allow for some reduction in liability in line with the involvement of the NED.
Areas where the NED could make a real impact on corporate governance performance are listed in the members section.
Whilst the Combined Code elaborates on performance evaluation, to paraphrase Lord Kelvin, 'if it cannot be measured, it cannot be improved'. So, to quantifiably demonstrate improvements, it would be necessary to define clear performance measurement indices. Although there is much data on company financial performance, the causal links to board performance has not yet been fully explored.
The annual report
Traditionally this was relied on by smaller investors as the main source of official financial and non-financial information published by a listed company. In attempt to overcome the problem of lack of transparency, the UK government had planned to introduce a requirement to include defined reporting rules and formats called an operating and financial review. However in a surprise move, Gordon Brown dropped this requirement from the latest proposed changes to company law.
There are reports of growing frustration15 with the traditional printed annual report as it sometimes only becomes available many months after the AGM. Commenting on these often huge documents, it was reported that the Post Office refused to deliver the HSBC 2006 annual report on health and safety grounds! So a possible move in the near future to an on-line annual report as standard, might well save in excess of £50m for listed companies but will it come at a greater price for the small investor? Very often, it is not what is disclosed that is important but what is not.
References and useful links
- BBC, 2004, 'White House reveals Enron documents', available from http://news.bbc.co.uk/1/hi/business/2024157.stm
- Centre for responsive politics, 2004, general editorial, available from http://www.opensecrets.org/
- OECD, 2004, 'OECD countries agree new corporate governance principles', http://www.oecd.org/document/22/0,2340,en_2649_37439_31558102_1_1_1_37439,00.html and 'Survey of corporate governance developments in OECD countries' available from www.OECD.org
- Treanor, J, general commentary, The Guardian newspaper, Fri, Dec 5th 2003 edition
- Directive 2003/51/EC of the European Parliament and of the Council of 18th June 2003, http://www.dti.gov.uk/cld/accountdirec.htm
- The Combined Code on Corporate Governance, July 2003
- The Higgs review is available at http://www.dti.gov.cld
- Examples and commentary on comparison between US and UK listing costs are extracted from Investors Chronicle, a Financial Times Business magazine, editions between Sept 2006 and Jan 2007
- Aetna corporate comms., April 7th, 2003, NYSE Press release, HARTFORD, Conn, USA
- Commentary on Institute of Directors website, http://www.iod.co.uk
- Monks, Robert A.G. & Minow, Nell., 1995, Corporate Governance, Cambridge, Mass, Oxford: Blackwell
- Charkham J., 1994, Keeping Good Company, Clarendon Press, Oxford
- Mills, Geoffrey, 1981, On the Board, Gower in association with the Institute of Directors, Aldershot
- General editorial comment 15 Feb. 2004, Financial Times followed by an article on the changes to the annual report, 22 Feb. 2007, Financial Times