Advancing corporate governance reform

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By Timothy Copnell – Chairman of KPMG’s UK Audit Committee Institute

 

 

 

The UK Government’s recent Green Paper on Corporate Governance Reform seeks to find a new approach to corporate governance that gives the UK an international competitive advantage, makes the UK an attractive place in which to invest and helps ensure we have an economy that works for everyone.

It focusses on giving a greater voice to employees and consumers in the boardroom, ensuring that executive pay is properly aligned to long-term performance and raising the bar for governance standards in the largest privately held companies. These are issues about fairness and addressing public disquiet about standards in business life as much as they are about competitiveness and creating the right conditions for investment. This feels right. If the events of 2016 have taught us anything it is that public concerns can no longer be ignored.

However, public concerns about standards in business life involve broader issues than corporate governance. There are many high-profile examples that, while not representative of the whole, have damaged public trust in business and raise genuine questions as to why some companies have done things that are unlawful or engaged in practices the public perceive to be ‘bad’ even though they appear to be lawful?

Regarding the former, the Government needs to address the perception – real or imagined – that individuals are not being held to account for what might appear to be unlawful practices. Is law enforcement – including the Company Directors Disqualification Act – working as satisfactorily as it might do and, if not, why not? After all, this might be expected to be a natural mechanism to address public concerns relating to standards in business life.

The question as to why some companies have engaged in practices the public perceive to be ‘bad’ even though they appear to be lawful goes straight to the heart of a company’s ‘licence to operate’ – the relationship between the company and its stakeholders. It’s a relationship brought into stark focus in the social media age where society has proved to be an effective driver of cultural change in areas such as tax planning and transparency.

Reducing the pay gap requires a change of mind-set

One area undermining the public’s trust in business is the thorny topic of executive pay – one of three central pillars in the Green Paper. This is a complex area and one that has vexed Government, the investment community and society at large since the early 1990s. At first sight, executive pay structures might be considered a private matter between a company and its shareholders. However, a constantly widening pay gap might be telling of a company’s attitude towards employees and any impact on employee morale will compromise a company’s productivity and ability to hire and retain talent. Also, at a macro level, there is a cost to society. Corporate leaderships  do not exist independently of the economies in which they operate, so public disquiet about the remuneration of corporate leadership is, therefore, a legitimate point of view with which business must engage and respond.

“One area undermining the public’s trust in business is the thorny topic of executive pay – one of three central pillars in the Green Paper. This is a complex area and one that has vexed Government, the investment community and society at large since the early 1990s”

However, there is no silver bullet and it is unlikely that any single measure will remedy the problem. Reducing the gap between high earners and everyone else – if that is an ‘unspoken’ objective of the Green Paper – will require a radical solution as successive reforms focussed on transparency, remuneration committees and shareholder votes have done little to curb public concerns. More radical solutions might include a wage cap (an idea that is largely discredited and imposed by no major economy in modern times other than Cuba) or at the very least a shift in culture and aspirations. Perhaps even a change of mind-set is required, wherein business leaders revert to being viewed and rewarded as managers of businesses rather than as entrepreneurs. That said, this must be balanced with the need for incentive arrangements in the UK not hampering UK companies from securing the talent to ensure their competitiveness, given the mobility of senior executives in a global marketplace.

Executive pay structures are overly complicated and the link between pay and performance can be opaque. Not only does executive pay fail to incentivise performance, the complexity of the system is creating a growing reputational risk for companies and investors alike.

Long-term incentive plans (LTIPs) – with all the inherent difficulties in agreeing appropriate performance metrics – have been allowed to dominate executive pay to the exclusion of other remuneration structures that may be more appropriate to a company’s business model or strategy. Furthermore, we have performance metrics, such as total shareholder return, that are strongly influenced by capital market conditions and other generic factors rather than the implementation of long-term strategy. Of course, reducing a complicated strategy into a small number of metrics is difficult, and choosing metrics that reflect the executive’s role and contribution to that strategy and company performance can be even more challenging.

These issues prompt the question as to whether LTIPs are doing what they are supposed to do and, in many cases, the answer is that they are not. Consequently, a new approach is needed where the default pay structure is not the LTIP – possibly even an approach where variable pay is only a fraction of basic pay rather than a multiple, as is the case for most employees, including those considered to be in short supply. While basic pay would necessarily rise, greater transparency around a larger proportion of pay would address the impact of complex LTIPs, which have largely been the source of the widening pay gap.

Promoting the stakeholder perspective through transparency

The second pillar in the Green Paper looks at how employees and consumers might be given a stronger voice in the boardroom. At the heart of this is the question of directors’ responsibilities which, as set out in the Companies Act 2006, are to act in a way most likely to promote the success of the company for the benefit of the members. However, the subsequent emphasis that, in so promoting the company, the directors should have regard to a wide range of other matters (including the interests of employees, the impact of the company’s operations on the community and the environment, etc) gives rise to certain challenges, not least the extent to which directors have such regard, which  at one end of the spectrum might verge on accountability and at the other might merely be to be cognisant of such matters.

Directors’ responsibilities were codified as recently as 2006 so there is probably little appetite to re-open that debate by (say) calling for an extension of their accountability to parties other than the members as a whole. Therefore, the challenge is whether the requirement to ‘have regard to a wider range of factors’ needs to be enhanced with guidance or whether better and more consistent governance could be achieved by greater transparency as to how the directors have taken such factors into account.

“Diverse boards – comprising individuals with different perspectives – can be more able to consider issues in a rounded way than boards that are less diverse”

The former risks creating a ‘tick-box’ approach which would be inconsistent with the best traditions of UK corporate governance. The latter is, however, more readily achievable by creating an explicit requirement to disclose within a company’s annual report the key stakeholders identified by the board and the information necessary to enable shareholders to understand how the board has had regard to those stakeholders in acting to promote the success of the company for members. This could be supported by augmenting the Financial Reporting Council’s 2014 Guidance on the Strategic Report to provide examples of good practice.

…but be wary of undermining the unitary board

Other mechanisms to encourage a stronger voice for employees and consumers in the boardroom might include stakeholder advisory panels, assigning individual non-executive directors with the responsibility to ensure key stakeholders are being heard at the board, or appointing individual stakeholder representatives, such as ‘workers’ to the board. Each of these ideas has some merit, but ultimately the wider group of stakeholders are not proxy owners (albeit any company will be cognisant of the views of the wider stakeholder community if it is to succeed), so great care must be taken to avoid both undermining the unitary board concept and creating a conflict with the general duties of directors. All directors – executive and non-executive – are responsible for having regard to stakeholder interests to promote the success of the company for the benefit of its shareholders.

That said, diverse boards – comprising individuals with different perspectives – can be more able to consider issues in a rounded way than boards that are less diverse. In this regard, it makes sense to appoint directors with an understanding of specific stakeholder viewpoints (including ‘non-executive’ employees) where the shareholders as a whole believe it is in their best interests to do so. Of course, such individuals would be subject to the same broad responsibilities as other (non-stakeholder aligned) directors with a duty to promote the company’s interests for the benefit of the members, rather than participating as a director with the sole focus on promoting the interests of the stakeholder group they represent. And, like other unitary board members, they would serve subject to the appointment of shareholders and act to promote the interests of shareholders – albeit being well placed to understand the interests of whatever stakeholder group they have experience of.

Raising governance standards

Corporate governance codes alone are not an effective means for raising governance standards in large privately held businesses – but good governance is in the interests of owner-managers.

The final pillar of the Green Paper looks at raising the bar for governance standards in the UK’s largest privately held companies by either extending the application of the UK’s Corporate Governance Code from premium listed companies to encompass such businesses or through developing a separate governance code tailored specifically to the needs and challenges faced by privately held businesses. The problem is that corporate governance codes are only one means of raising governance standards and while it would be a fairly easy task to adapt or craft a governance code specifically for large privately held companies, there is a big question mark as to how effective such a code would be in practice. For codes to be effective they need a mechanism whereby boards are held to account for their behaviour. For UK companies with a premium listing on the main market this is a combination of the Listing Rule disclosure requirements and the oversight provided by institutional shareholders. It is difficult to see what equivalent mechanisms could be employed effectively in the privately-held sector.

More importantly, there is a question as to whether the introduction of any code for such companies will actually address the board behaviours that have likely triggered the need for the Green Paper. It would be regrettable if the regulatory response to recent events was to encourage or even mandate practices that are out of tune with the value achievable. It is often stated that the UK has a world-leading corporate governance framework and that the UK Corporate Governance Code is admired across the world. This is certainly true. But, and this is the crux of the matter, success breeds complacency.

While codes have proved useful in improving governance structures and tightening governance processes, particularly in those companies that embrace good governance practices, they have proved less useful at exposing and addressing some of the behavioural deficiencies at the root of the most notorious cases of governance failure – in the UK or elsewhere. Indeed, when it comes to behaviours that directly disadvantage the wider group of stakeholders, such as treating employees and customers poorly or failing to be a responsible tax payer, then maybe the world has moved on and public disquiet – given a voice through social media – is now a more effective tool for bringing boards to account than the codes that have become such a common feature of business life.

 

About the Author:

Timothy Copnell is the Chairman of KPMG’s UK Audit Committee Institute. Timothy qualified as a chartered accountant in 1989 and joined KPMG’s Department of Professional Practice in 1993 where he took responsibility for corporate governance matters and KPMG’s non-executive programme. His role includes advising on private sector corporate governance and responding to major UK corporate governance developments. In 2004/5 Timothy was awarded the Accountancy Age ‘Accountant of the Year’ for his work with audit committees. Timothy writes regularly for various publications and is the Author of the Audit Committee Guide (ICSA 2010) and Shareholders Questions and the AGM (ICSA 2007).