"The right question now, it seems to us, is this: what is the purpose of governance and what, then, are the most effective structures to achieve effective governance?"
It is not so very long since the subject of corporate governance was a minority interest one: recognised within the investment, legal and academic fields but not much further. The global financial crisis and the ensuing spotlight of media and public attention have changed that for the long term. To some extent this is an inevitable progression – every major financial collapse and crisis is rightly followed by a period of reflection on lessons to be learnt and improvements to be adopted. That the events of 2008, with the profoundly shocking failure of major banking institutions on which fundamental economic confidence is built, have led to the most comprehensive such reflection is both understandable and appropriate. Politicians and press have ensured that activity is at least matched by publicity, and regulators have shown no sign of abating their determination to be seen raising standards. The investment community has, with varying levels of enthusiasm, been brought into the foreground, and corporate boards are the recipient of recommendations, requirements and advice from all quarters, carrying ever-greater demands and standards. Remuneration, diversity and gender balance, financial reporting, audit disclosure, and going concern status have all become topics capable of consuming vast amounts of management time and corporate resources.
The right question now, it seems to us, is this: what is the purpose of governance and what, then, are the most effective structures to achieve effective governance?
The debate of the last few years began with the issue of risk in the wider financial services industries and the responsibilities of governance bodies to take steps to avoid recurrence of the disastrous social impacts seen since the financial crisis. In some cases that has become confused or intermingled with the role of the regulators; in others, with a perception that investors need to take greater responsibility to influence management decisions. It has also broadened beyond the world of the financial institutions into the corporate community – certainly the listed one – as a whole. Focus has also been on other social issues linked to governance; notably, of course, remuneration. Indeed, in many people’s eyes, the governance debate is one about proportionality and balance, as well as control over remuneration. Controlling excess has become a matter of national and international debate, and many of the subtler elements at play in the events leading to 2008’s crisis are afforded very little public attention. There is a seemingly inexorable trend to determine that, whatever the question, the answer is a call for more disclosure by companies; yet there is an accompanying suspicion that the volume of the disclosure itself tends to devalue its utility.
How are boards and lawyers to react to all of this? There are it seems to us at least two issues to be addressed. The first, and most fundamental of these, is whether the company has adequate systems and behaviours to ensure that its business is properly managed, controlled and built. The second issue is whether it is communicating in an effective way with its owners, and with the external world as a whole, in such a manner that it gives confidence that it is satisfying the first criterion. Directors of an English company are, of course, delegates of the power to manage the company’s affairs – according to the company’s constitution – subject to the law and to the members taking positive action by special resolution to give directions. That broad division is a feature of most national laws. So the governance debate should really be about how that balance of authority and responsibility is overseen. Nor is this just a feature of recent events or of some manifestation of a best market practice theory. The law has always been an element in governance and the idea that governance is a non-statutory regime – for example, in the UK where the listed company “comply or explain” regime applies under the UK Corporate Governance Code – is a myth: the Companies Act has long established governance requirements as a matter of law and directors’ duties have supported those. The issue is always the balance between intervention and prescription and flexibility, and the debate needs to avoid becoming focused solely on reporting against problems such as risks and remuneration.
There are considerable anomalies inherent in the current heavy focus on the listed company sector: privately owned organisations where people also take entrepreneurial risks, with a potential impact on the wider group of stakeholders, are not subject to similar public scrutiny and are doubtless thankful that that is the case. Where organisations are responsible for assets and investment with multiple ultimate owners as well as other stakeholders, and where securities trade on the basis of public information, the reality is that boards need to recognise and deal with the current level of scrutiny, and with the consequent involvement of those extending beyond constituencies to whom duties are owed: to journalists, single interest groups and the like. It is perhaps not surprising that the position of controlling shareholders is being revisited in the UK, with the likely consequence of the return of the governing relationship agreement but also, potentially, of separate endorsement of independent directors by independent shareholders.
The fact that financial institutions are paying a heavier regulatory and governance price is again rational, given the history. Having said that, the debate seems to us to have become overly skewed to the public perception of the responsibilities of listed company boards, which are now expected to be peopled with superheroes able to ensure both business success and absence from risk of their organisations, whilst being the subject of unprecedented amounts of personal publicity. Whether that is the right way of applying the directorial mind to the main business in hand is a matter for debate. Failure of a commercial enterprise is not necessarily a failure of governance – it is entirely proper that risk is assessed and managed effectively, and the nature of it understood in the market, but not tenable that it be eliminated.
The essential feature of good governance is behavioural – the UK Financial Reporting Council is clear about this in the Governance Code and those who have observed boards in action in periods of both crisis and normal operation readily recognise it. A well-run board has a grasp of its own business fundamentals. It has confidence in the underlying information and in those who are responsible for it. It is able to address unpalatable facts rationally and takes collective decisions. The contrary case speaks for itself – the presentation of rapidly changing information, executives or senior managers whose attention is on delivering the news which they think the board wants to hear, and a culture lacking in the encouragement of rational debate. Reporting systems, of themselves, can neither make a good board bad nor a bad one good. It is a more sophisticated and qualitative matter than that. In short, disclosure does not equate to governance and in the worst case can obscure the important issues. For all of the intention to encourage decluttering, it does not seem likely to us that developments such as the increased disclosure around audit reports or indeed the conclusion of the “going concern” consultation will lead to greater brevity. The point at issue is whether it enhances the substantive analysis and management focus within companies and the ability of investors to make informed decisions.
The other side of the debate within the UK and Europe which is worthy of further scrutiny is the focus on stewardship and shareholder engagement. As we have said, fundamentally the whole purpose of incorporation is to delegate management of a business to those specialist experts with the capability to run the business on behalf of the shareholders, who themselves do not have the time or expertise to run the business. The focus on ensuring that managers are accountable to and increasingly guided by shareholders is one that needs to be challenged from time to time. That challenge needs to ensure that the focus is about intervention on the right issues and to the right extent, rather than a transfer back to shareholders of ultimate responsibilities for the conduct of the business, which they are not in a position to discharge. The UK government has continued to keep under consideration mandating greater levels of shareholder participation and voting and greater levels of shareholder engagement: the rationale for at least part of that rests upon the notion that shareholders need more involvement in the running of the business. In fact the idea that shareholders would have conducted businesses to avoid the problems that have emerged both in the financial crisis and other corporate collapses must be debatable: one of the findings of a number of the investigations and reports into the financial crisis was that over responsiveness to shareholder demands for returns was one of the generators of excessive levels of risk within the financial sector.
As to what the shareholders want, the picture is mixed. The essential need for transparency on remuneration, using the example of most current prominence, can give rise, on the one hand, to pressure to disclose complex and potentially sensitive information on performance targets, and on the other the wish to be able to understand remuneration structures at a glance. The proposals to revise the auditor’s report could operate to enable investors to form a better judgement of the material risks within a business; or they could produce longer and no more informative reports as auditors seek to cover every possible risk for fear of exposure if one is omitted. There is a potential overlap between this process and the responsibility of the board via the audit committee to supervise and report on the audit process. But it is a rare person who, when offered information, turns it away, and the discipline needed to stem the tide is considerable. As Professor John Kay says in his review of UK equity markets: “The quality – and not the amount – of engagement by shareholders determines whether the influence of equity markets on corporate decisions is beneficial or damaging.” The stated aims of the UK government in its narrative reporting proposals, and of the FRC, are laudable in their desire to produce relevant and cogent company reports which should facilitate such engagement: we are not so clear that without a determined approach by all concerned those aims will be achieved.
In summary, a great deal of change is afoot. It is absolutely right that the disciplines applying to those running corporate enterprises adapt to the demands of the time, and that the holders of capital are both reassured as to the adequacy of those disciplines and themselves encouraged to facilitate responsible behaviour. It is also inevitable that at a time of heightened activity, the needle will in some respects swing too far. The challenge for regulators, companies and investors in the medium term is to take stock and not to be afraid to press for that needle to be reset. However, in pursuing balance in governance, the fact of wider social interest in the broader aspects of governance needs to be faced as a lasting reality.