Has governance lost its focus?

The guest speaker attacked the hysteria surrounding corporate governance with the gusto of a hardened cynic.

“A visitor from Mars would think a new industry had been created, one which was a bonanza for conference organisers, for consultants, for the media and even for the Committee on Corporate Governance,” he complained.

But this was no corporate governance cynic. The speaker was none other than Sir Ronald Hampel (pictured left), chairman of ICI and the man in charge of the second committee on corporate governance. Hampel, who accepted the committee chair a year ago, broke one of his own golden rules about discussing the subject while the committee’s work is still in progress to express his concern about the “worrying” public perception of governance.

In an address to the Institute of Chartered Accountants in England & Wales, Hampel argued the whole debate had drifted too far into the area of controlling the behaviour and limiting the power of company directors.

The business community was in danger of overlooking corporate governance’s single most important aim: providing the environment for prosperity and growth.

Fortunately it does not require the landing of a Martian with a grasp of modern management theory to prove Hampel’s point.

Ever since Sir Adrian Cadbury (pictured centre) and, later, Sir Richard Greenbury (pictured right) published their recommendations on good boardroom practice, the media has provided saturation coverage of what Hampel describes as the “negative” aspects of corporate governance: focussing on companies’ willingness or otherwise to curb boardroom excess, limit the influence of all-too-powerful executive chairmen, and implement, more generally, greater checks and controls.

Advisers on corporate governance have played their part, too. The lexicon of corporate governance reads like a security guard’s handbook, brimming with words such as “watchdog”, “safeguard” and “policing”. For most shareholders, directors and tabloid newspaper readers corporate governance is synonymous with “stopping the rot” in the boardroom and providing greater transparency of the management decision making processes.

In fairness, it is hardly surprising that this should be the case, given that Sir Adrian Cadbury’s original committee was set up to address issues raised by the collapse of companies such as Polly Peck and the Maxwell empire in the late 80s. The Cadbury committee identified a very real need to concentrate on the “prudential” side of governance. Its key recommendations – which included splitting the chairman and chief executive functions, the appointment of at least three independent non-executive directors at board level, and the establishment of audit and remuneration committees to combet possible conflicts of interest – were aimed at creating an environment in which fraud or bad management could be more easily identified and dealt with. The recommendations have been widely applauded and implemented.

The legacy of the Cadbury and Greenbury “voluntary” codes, however, is that companies feel compelled to comply with all or most of the recommendations even where they consider compliance more burdensome than productive. Certain recommendations, such as the publication of statements on the effectiveness of companies’ internal financial controls, have resulted in sleepless nights for directors and their auditors worried about the potential liability risk and the interpretation of the word “effective”.

Institutional investors have used governance as a strap to whip incompetent boards into shape and to increase their influence on the decision making process. Companies which eschew the recommendations risk being pilloried as second class corporate citizens. “Voluntary” in the Cadbury context means companies are not obliged to comply but have to state their reasons in the annual report if they do not. While few companies would consider corporate governance to be anything but a good thing, most will be hoping the Hampel committee reduces rather than adds to the list of recommendations when it delivers its draft report next year.

Sir David Barnes, chief executive of Zeneca group, represents the majority view when he argues governance should not become so prescriptive and inflexible that it strangles corporate activity and innovation.

“Truly improved corporate governance will come only if shareholders genuinely seek to understand why one practice is right for company A and a different practice is right for company B in their different circumstances,” he told last month’s CBI national conference. “And where does the boundary lie between legitimate shareholder interest and purely prurient non-shareholder curiosity? When considering any possible changes to current practice it will be essential to recognise the very different motivations of the two groups, and shape change according to the requirements of the former rather than the latter.”

Martin Broughton, chief executive of BAT Industries and chairman of the CBI Companies Committee, says the non-prescriptive nature of the Cadbury code is one of its biggest strengths.

“This flexible approach could be undermined by the growing number of self-appointed guardians with a box-ticking mentality who seek to require companies to comply with every provision of Greenbury or Cadbury – regardless of the circumstances. Over-prescription kills innovation.”

But shifting the emphasis of the debate to the “positive” aspects of governance may prove less easy than it sounds. The correlation between good governance practice and corporate prosperity has yet to be proved.

In fact, as one participant at the English ICA conference pointed out, it may still be too early to measure the success of the Cadbury recommendations in terms of performance and profitability. The buoyant economic conditions which have prevailed since the Cadbury code was published four years ago could be covering up underlying board weaknesses in some of those companies which have performed well in recent years.

It stands to reason that there will be companies publicly perceived as going through the motions of corporate governance – setting up audit committees, ensuring there is the right number of non-executives on the board – who will fail because of a more fundamental flaw in the effectiveness of the board. As one finance director points out, no number of codes will ensure that a board, when it sits down to determine corporate strategy, will make the right decisions.

Many directors, especially of small-to-medium-sized companies would argue that by spending so much management time ensuring compliance with Cadbury and Greenbury – as well as meeting the requirements of the Accounting Standards Board, the Auditing Practices Board, the Stock Exchange’s yellow book – company directors risk taking their eye off the task of identifying opportunities for growth.

There certainly seems to be support for this view among quoted companies outside the FTSE 350. A recent survey by Arthur Andersen and Binder Hamlyn of the 1700 companies which fall into this category, indicated that the majority of directors believed the cost of complying with the Cadbury code outweighed the benefits achieved. Only 24% of executive directors agreed compliance with the Cadbury code had increased the effectiveness of their boards.

According to Clive Reay, partner in the mid-market division of Arthur Andersen, the majority of directors believe existing Cadbury recommendations place a disproportionate burden on non-FTSE 350 companies. From the perspective of an executive director of a small company, the pressure from institutional investors and the media to extend decision making to various committees and non-executive directors, restricts their ability to be “fleet of foot”, says Reay.

According to Reay, the burden on smaller companies can be measured in both time and cost. “If you look at something like internal financial control, most companies have come out with a fairly standard anodyne statement about their control system,” says Reay. “But to make that statement they have to go through a lengthy and costly review process of their entire financial control system.

For the larger company there is likely to be more people on hand to go through the bureaucracy and the box ticking but in a smaller company that work will probably fall on someone like the finance director – all to produce a standard statement which, in terms of simplifying the accounts, doesn’t help or prove anything.”

Hampel is aware of the problems Cadbury poses for smaller companies and, on taking over the committee chairmanship last January, promised it would be an important area of review. “I think the problems, in part, have arisen over the interpretation of Cadbury and Greenbury have been that people simply have not realised the breadth of the target audience,” he says.

Sir Sydney Lipworth, chairman of the Financial Reporting Council, says there should not necessarily be a conflict between good internal controls and entrepreneurial aims. “The only danger would be if companies started adopting the codes too slavishly,” he says. A good management would not allow the need for vigilance within the company to interfere with its entrepreneurial spirit.

Lipworth believes the need for good governance practice will become ever stronger as UK businesses face increasing complexities, such as the problems with derivatives, increasing pressure from stakeholders to influence the way the company is run, increasing global competition and an increasing burden of domestic and EU regulation.

Hampel resoundingly supports the view of Sir Anthony Cleaver, chairman of AEA Technology and the chairman of the RSA Inquiry into “Tomorrow’s Company”, who argues that while Cadbury and Greenbury have provided a clearer framework for corporate governance “perhaps we should now pay more attention to what a board can actually contribute beyond simply ensuring compliance”.

To do this effectively, Cleaver believes companies need to identify and respond to the needs of all their stakeholders: shareholders, customers, employees, suppliers and the communities in which they operate. “Every company is going to have to address all of these relationships if it is to safeguard its competitiveness,” he says. “The future of the business is not determined by last year’s balance sheet. It is determined by how loyal your customers are, the efficiency of suppliers, the investment you are making in people and, maybe, whether you have the licence to operate in your community.

“I think as a business, the only way we can avoid further regulation, legislation and rules which can turn out to be unhelpful is to take the initiative and put in place this sort of system now.”

To illustrate the impact of corporate governance on performance, Hampel draws on the experience of ICI, which he claims is one of eight companies in the equivalent of the FTSE in 1930 which still survives. Companies in sectors such as engineering, shibuilding, motor cars and coal mines which lost their industrial customer base in the 50s, 60s and 70s did so, not because of decisions of the managements at the time, but the decisions of managements 10 years earlier, he says.

“They had not actually determined the right strategy. They had not seen the competitive environment developing. That seems to me to be the fundamental requirement of any board.

“If the ICI board of the 50s and 60s had not seen the demise of the customer base in ICI coming and had driven the company globally, it would not exist today.”

Alastair Ross Goobey, chief executive of Hermes, which manages #31bn of investment funds on behalf of the Post Office and BT pension schemes, argues that the question of whether good corporate governance will lead to profitability should be reversed.

Corporate governance, or the lack thereof, can be a leading indication of failure, he says. “After all, Cadbury started in the wake of Polly Peck and Maxwell, both of which were a consequence of poor corporate governance.”

Hampel rejects suggestions of charting new territory in the corporate governance debate. While the visitor from Mars might conclude that UK plc’s preoccupation with corporate governance is a fad which began with the original Cadbury committee, Hampel insists British business has been “about” good governance practice for decades. “We may not have called it that, but we have been about it for a long time,” he says.

“Without prospering business we have no governance, we have no stakeholders, we have nothing and that is the fundamental that lies behind all the deliberations.

We must not stifle we must stimulate.”

A Guide to the Future of Corporate Governance

Clues to the future direction of corporate governance can be found in the consultation paper recently published by committee on corporate governance.

Although the document was sent to business organisations rather than individual companies, the committee says it would welcome feedback from directors and other interested parties.

The committee, which is expected to publish its draft report in the second half of next year, outlined five areas in which it is especially keen to receive feedback. The following is an edited version of some of the key issues raised.

The Cadbury Code Should the code differentiate between companies by type of business or size and should individual points in the code be regarded as “firm prescriptive rules” or broad guidelines?

The Role of the Directors

Is the unitary board structure adequate to fulfil the role of the board in corporate governance? Is the primary function of a non-executive director to contribute to the strategic direction of the company or to monitor the performance and conduct of executive management, or both? Would it be helpful to recommend good practice regarding the number, age, total length of service and frequency of re-election of directors?

Greenbury Recommendations Do the guidelines for the performance-related element of remuneration require refinement, particularly in relation to the design of long term incentive plans (L-tips)? What factors should boards take into account in setting the levels of directors’ remuneration, and should these be the subject of prescriptive rules?

The Role of Shareholders Do institutional investors have an obligation to those whose money they invest to exercise their ownership rights actively? If so, should institutional investors concern themselves with non-financial aspects of corporate conduct, such as social, environmental and ethical issues? Are AGMs an effective means for shareholders to contribute to corporate governance?

The Role of Auditors Should the reporting requirements on auditors, in the context of Cadbury, Greenbury and the Stock Exchange listing rules, be extended, restricted or remain unchanged? In what terms should auditors review directors’ internal control statements and to whom should they report on them? Do auditors need greater legal protection for “whistle blowing” when they uncover suspected fraud or malpractice by company managements?

Choosing the Board – the Pros and Cons of Tiers

Lord Hanson once said of the governance push for more independent non-executive directors in UK businesses, “we want hound dogs in our boardrooms not watchdogs”. Yve Newbold (pictured above), one-time company secretary at Hanson and now chief executive director of Pro Ned, the organisation for the promotion and recruitment of non-executive directors, says simply: “He was wrong. We want both.”

Identifying the shape and structure of the company board has, in recent months, become one of the hotly discussed issues in the corporate governance debate. How many non-executive directors should there be and how should they be chosen? Should companies have a unitary board or a two-tier board such as can be found in companies across Europe? And is the board’s mandate to maximise shareholder interest or serve the broader interest of all the company’s stakeholders?

Despite the apparent willingness of British companies to improve the balance between non-executives and executives on their boards, research by Pro Ned suggests a surprisingly large number of non-execs are appointed without a rigorous selection process.

In a recent survey of company chairmen carried out by Pro Ned, most respondents claimed they looked for non-executive directors who could bring substantial business experience to the board, with over half saying there should be a greater diversity of backgrounds. Yet, according to Newbold, 53% admitted they already had an individual or individuals in mind at the outset of the selection process. Another 36% said they consulted their advisers informally about possible board candidates. While this did not necessarily mean chairmen were currying favours with pals at the rugby club, “I don’t think that is good governance,” adds Newbold.

The selection of non-execs will become more important as expectations increase for outside directors to be as much part of contributing to corporate strategy as overseeing the actions of the senior management. According to Martin Broughton, chief executive of BAT Industries and chairman of the CBI Companies Committee, this has also raised questions about whether directors have sufficient involvement and access to information and whether they should be held equally liable for company actions of which they were not fully informed.

Although there is widespread concern about the degree of liability a non-executive should be expected to bear “a separation of duties in law might lead to a separation of roles in practice, which would weaken the collegiate nature of boards and undermine the incentive to probe and challenge – one of the strength’s of the non-executive’s contribution to the boardroom”, Broughton says.

The CBI has lead the call to retain the existing board structure in Britain.

Its report, Boards Without Tiers, grants that the two-tier models in Germany and the Netherlands – which allow for wider stakeholder representation – have had some success. “But we strongly believe the unitary board structure is best for UK companies. If it ain’t broke, then don’t fix it,” says Broughton.

The CBI, which has been lobbying Brussels for several years to prevent secondary boards becoming a statutory requirement under EU company law, believes “putting the interests of shareholders first should continue to be the goal for boards of directors and the measure against which they are held to account.”

Alastair Ross Goobey, chief executive of Hermes Pensions Management, agrees. “My conclusion is that there can be no doubting the prime responsibility of a company is to maximise long-term shareholder value. The company is responsible for its relationships with other parties, but it is responsible to its shareholders,” he says.

“Most companies need to access equity capital at some stage, a fact which even European companies are now facing up to, and, unless shareholders believe that their long-term interests are being maximised, then the cost of supplying that capital will increase.

“Shut a company off from access to capital and it may not meet its prime long-term test, its survival.”