So what does good governance look like?

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By Beatriz Araújo & Joanna Hewitt, Beatriz and Joanna are both Partners at Baker McKenzie LLP, London

 

Public trust in business has eroded since the financial crisis of 2008 but a shift appears to be happening which investors and boards need to seize. The 2018 Edelman Trust Barometer found that business is now expected to be an agent of change.

The employer is the new safe house in global governance, with 72 per cent of respondents saying that they trust their own company. And 64 per cent believe a company can take actions that both increase profits and improve economic and social conditions in the community where it operates. 2017 saw CEO credibility rise sharply by seven points to 44 per cent after a number of high-profile business leaders voiced their positions on the issues of the day.

Nearly two thirds of respondents say they want CEOs to take the lead on policy change instead of waiting for government, which now ranks significantly below business in trust in 20 markets. This show of faith comes with new expectations. Building trust is now the number one job for CEOs (according to 69 per cent), surpassing producing high-quality products and services (according to 68 per cent). This is consistent with the greater focus from the business world and regulators on a healthy corporate culture and constructive relations with a wider range of stakeholders in delivering long-term sustainable success.

Investors and boards are not always aligned as regards what a company should be focussed on – the long-term or the short-term, how to balance both. Transparency, culture and integrity are the new buzzwords. A company’s licence to operate is at risk if it fails not only investors/shareholders but its other stakeholders including employees, customers, suppliers, the environment and the community in which it operates. There is a lot of noise regarding corporate governance, that it needs to improve in practice. Corporate collapses are often blamed on poor governance and ‘bad’ conduct. In most countries, directors owe their duties to the company as a whole, not to its shareholders; this needs to be understood better in the boardroom. The agency theory of corporate ownership, most prevalent in the US, has led shareholders to act as if they own the company and directors’ decision making has often reflected this – shareholders believe they have ultimate authority over a company’s business and demand that its activities be conducted in accordance with their wishes. In addition to being legally incorrect, this approach puts directors in conflict with their duties at law. However, this dilemma is being acknowledged with more focus being placed by regulators on the stewardship role investors must play in their interactions with companies.

So, what does ‘good’ look like in governance? Good corporate governance is not simply about codes or rules; it involves strong leadership, a positive culture, robust systems and effective risk management. These all encourage and reinforce behaviours that ensure company representatives act to protect the interests of the company and its long-term success. Good corporate governance also encourages shareholders/investors to align their expectations with the duties directors of companies are subject to. The key actors in ensuring a company’s long-term sustainable success are boards/directors and, we would argue, also investors/shareholders – so we look in turn at what good looks like for each of them.For boards, we would summarise the five essential elements of ‘good’ as follows:

1. Structure (chair, board composition and committees) A good chair is one that has the independence to set a challenging agenda for the board, sets clear expectations for performance of directors, including non-executive directors and has the right balance in terms of her/his challenge and support of the CEO. S/he also has the board focussed on CEO succession. In addition to an effective chair, boards should be diverse, consist of members who cover a balance of skills, backgrounds, experience and knowledge relevant to the company’s current strategic aims, with each director fully understanding her/his duties and capable of making a valuable contribution. Boards need to be supported by strong committees

2. Understanding their legal duties The current focus of regulators, in the UK especially, is to ensure directors of companies understand their legal duties and act accordingly. In particular, their duty to promote the long-term success of the company for the benefit of all shareholders and in doing so having regard to the interests of all relevant stakeholders. This duty is being ‘enforced’ via reporting obligations – asking boards to state in their annual reports how they have complied with their duty, to explain the stakeholders they consider relevant and why, the main methods of engagement with stakeholders and the effect such engagement has had on the company’s decisions and strategies

3. Effective decision-making For this, the following elements are necessary (i) good team dynamics; (ii) a solid understanding of company’s strategy and strategic and model; (iii) incentives that are aligned to desired outcomes; (iv) reliable and complete information from management; and (v) effective challenge of management

4. Good tone at the top and a belief in the company’s purpose (and ability to articulate it)

5. Good communication and transparent relationship with investors/shareholders

Unlike directors, shareholders (and indeed investors) have no fiduciary duties at law towards the companies they hold shares in. Where shareholders are long-term owners of the shares (such as family companies) their interests are, on the whole, aligned with appropriately incentivised boards, namely, long-term value creation. But where shares are owned more indirectly (such as via managed funds), the interests of the fund managers can be on a collision course with the legal duties of the board. There can be a mismatch between the expectations investors place on boards (essentially, to deliver ever faster and increasing returns) and the duties of directors (which, in effect, require them to take into account the long-term effect on the company’s prospects of decisions they take).

Mindful of this mismatch, the UK’s Financial Reporting Council (FRC) has set out an initial line of inquiry about the future of the country’s Stewardship Code and has highlighted support for new stewardship requirements for investors similar to those currently imposed on company directors. The response to date suggests there is general support for Stewardship Code signatories to report on how they have considered a wide range of stakeholders in their own organisations, their investment process and the companies in which they invest.

For investors, we would summarise the five essential elements of ‘good’ as follows:

1. Engagement Good and constructive engagement with companies; investors should discuss with boards gaps in good governance regarding the five elements described above. Understand the duties of directors to promote the long-term success of the company and in the context of that framework discuss performance. Hold the board to account for the fulfilment if its responsibilities (but not for the performance promised by investors to their clients)

2. Knowledge A solid understanding of the company’s individual circumstances, including strategy, industry, markets and competitive environment. This allows better interactions when seeking explanations for or clarifying company decisions

3. Relevant Investors must avoid engaging in tick-the-box exchanges with companies, one size does not fit all

4. Advisors Investors need to make sure they are clear of the role they expect their advisors, in particular proxy advisors, to undertake, consistent with their stewardship role

5. Client voice It is important that investors take account of the factors that their clients value and vote their shares accordingly, including as regards incentives for company management

 

About the Authors:

Beatriz Araujo is a Partner at Baker & McKenzie, a leading global law firm and is based in the London office. She has also served on the Firm’s global Board and the Executive Committee prior to which she was a member of the London office’s Board/Management Committee. As a senior lawyer, Beatriz has advised global companies who operate various industries on Mergers & Acquisitions and cross border issues, recently shifting her focus to corporate governance. She was the architect of a successful forum for board level executives, Beatriz has recently been awarded business school INSEAD’s Certificate in Corporate Governance.

 

Joanna (Jo) Hewitt is a partner in the Corporate Department of Baker McKenzie London, and advises clients on a wide range of corporate law matters. Jo’s focus is advising multinational groups on the structuring, implementation and management of complex corporate reorganisation projects including post-acquisition integrations, supply chain restructurings and business carve outs. She is part of a dedicated team in London focused on international reorganisations and business transformation projects. Jo’s practice also encompasses general company law advisory work for private companies.