Strategy & Operations » Governance » What are the principles of corporate governance?

Organisations tend to live or die based on the effectiveness of their respective corporate governance strategies. That’s why generations of executives, board members and shareholders across a wide range of industries have worked relentlessly to develop, implement and improve on the processes and mechanisms they’ve got in place to keep their businesses powering forward. Yet outside of the boardroom, it’s only relatively recently that the concept of corporate governance has made its way out into the public domain – and for all the wrong reasons.

The apocalyptic fall of British construction and facilities management multinational giant Carillion in January 2018 presents a sobering case study.

The Carillion case

At its colossal height, Carillion was the second-largest company in the UK – employing more than 43,000 workers across the globe, and with annual revenues in excess of £5bn. The sprawling organisation was widely treated as a legacy company in which Britain could place immense pride. Underneath its hood, however, unchecked decision-making and an aggressive risk-taking culture had led to crippling debt.

Since Carillion relied almost exclusively on large contracts that ultimately proved less lucrative than originally anticipated, last year the multinational was forced to slash the value of its contracts by more than 50%. As the overvalued contracts continued to underperform, company debts rapidly soared to £900m, and both lenders and the UK Government refused to bail out the oversized organisation because of its shambolic corporate governance and unsalvageable contracts.

When Carillion was forced to liquidate on 15 January 2018, it had £7bn in liabilities and less than £29m worth of cash – pushing the UK Government to step in and deliver on key services it had previously outsourced to Carillion. By the time officials finish picking up the pieces, the collapse and liquidation of Carillion is expected to have cost UK taxpayers at least £148m.

In Carillion’s wake, furious voters, stakeholders and lawmakers have justifiably mounted more pressure than ever on large organisations – particularly publicly-traded organisations – to demonstrate more accountability, better transparency and adhere to far more cautious standards of governance. That being said, establishing any sort of best practice has historically been incredibly tricky to do where corporate governance is concerned.

The never-ending pursuit of achieving best practice has always been hindered by the inherent piecemeal landscape in which companies are forced to operate in terms of mismatched regulation and a total lack of universally accepted metrics with which to judge corporate governance. But across many sectors, industry bodies are finally working to address this lack of clarity through regulatory convergence and a new system of mandatory corporate governance principles that all participating organisations must adhere to.

Heavily influenced by the financial collapse of 2008 and the subsequent crash of Carillion, these new corporate governance principles are beginning to generate a fresh sense of purpose for boards across the globe, and provide inspiration for smaller industry bodies and regulators across a variety of sectors.

For lessons on how and where to start establishing any sort of working definitions of best practice, it’s worth delving into the Financial Reporting Council’s most recent update to its UK Corporate Governance Code.

Changes to the Corporate Governance Code

Earlier this year, the Financial Reporting Council (FRC), which is the independent regulator responsible for promoting superior corporate governance and reporting in the UK and the Republic of Ireland, introduced a host of timely revisions to its UK Corporate Governance Code 2016. These changes will come into force from 1 January 2019, and compliance with the code will be compulsory for all companies with a Premium Listing of equity shares in the UK.

The latest revision, which has some pertinent changes that reflect public fury surrounding the fall of Carillion, has been simplified in order to make it quicker for companies to navigate their statutory responsibilities. For 2019, emphasis has shifted to application of the primary principles rather than prescriptive compliance with each individual provision. That being said, the code now contains more specific provisions than ever. More important still, companies must clearly and transparently demonstrate how they’re meeting those provisions.

Listed companies will be required to report their compliance with those provisions as part of their annual report and accounts – confirming which principles of the code they have adhered to, and explaining where and why the company may have fallen short in achieving particular targets. The code also calls for any accompanying corporate governance statement to relate to other parts of a company’s annual report and strategic report in order to assist shareholders and external stakeholders in assessing the quality of the board’s activities and corporate governance arrangements.

This year’s revision of the code has split best practice principles into five bite-sized sections:

  • Board leadership and company purpose
  • Division of responsibilities
  • Composition, succession and evaluation
  • Audit, risk and internal control
  • Remuneration.

This represents a departure from 2016’s code structure, placing a fresh and clear emphasis on the importance of stakeholders.

Key changes include rules on chair tenure, which was flagged as the most contentious issue in the code’s 2018 draft. From January 2019, the chair of all participating companies must be independent on an ongoing basis, demonstrating “objective judgement throughout their tenure”.

In fact, independence has been a key theme throughout the new code’s principles. The criteria around the independence of non-executive directors has been hardened for 2019, and a new provision has been added asking boards to take necessary actions to identify and mitigate any conflicts of interest.

Other controversial elements of corporate governance that have been tackled in the FRC’s new benchmarks include changes for nomination committees. Boards must now disclose more information on their composition, all board evaluations, and how boards engage with evaluators. This measure has been added to promote direct contact with evaluators, while new reporting requirements have been introduced dictating a nomination committee’s approach to succession planning, promoting diversity and gender balance.

Above all else, a key introduction to this latest permutation of the UK Corporate Governance Code has been the concept of purpose. From January 2019, companies are now obligated to establish their purpose and introduce a culture of board assessment and monitoring to ensure activity is aligned to the organisation’s purpose, strategy and values. This notion of purpose in corporate governance is also meant to feed into values and rewards surrounding remuneration.

Finally, the code has launched clarifications around previous requirements for companies to carry out robust emerging risk assessments and outline mitigation processes. This clause in particular highlights recent public frustration over too-big-to-fail organisations and their risk management strategies, as UK companies tend to focus primarily on principal risk management as opposed to emerging risks.

The five principles of corporate governance

The FRC’s comprehensive and statutory corporate governance principles are undeniably working to form renewed focus among large organisations and establish best practice across key business sectors. However, there are other industry bodies making notable contributions to the evolution and implementation of better and more standardised corporate governance practices.

The Institute of Business Ethics (IBE) and the Institute of Chartered Secretaries and Administrators (ICSA) have both produced their own guidance documents for members – while the Institute of Chartered Accountants in England and Wales (ICAEW) is pushing chartered accountants to demonstrate superior standards of corporate governance through its own Code of Ethics.

The ICAEW’s all-encompassing ethical guidance was introduced in 2011, and is based on the Code of Ethics for Professional Accountants of the International Ethics Standards Board for Accountants. It has also been designed to cross-reference the FRC’s Corporate Governance Code, and is centred on five fundamental principles of corporate governance: integrity, objectivity, professional competence and due care, confidentiality, and professional behaviour.

In practical terms, the principle of leadership revolves around a board’s ability to instil and implement purpose within its corporate governance strategy. Capability dictates participants promote an appropriate mix of skills and experience; accountability makes the board responsible for communicating to shareholders and stakeholders; and the principle of sustainability places a responsibility on board members to create value and responsibly reinvest and distribute to stakeholders.

It’s those five principles that guide each individual process within the ICAEW’s corporate governance Code of Ethics, which is obligatory. The ICAEW does enforce the code through disciplinary action. Participating members are responsible for assessing threats to non-compliance and creating safeguards to mitigate those threats – while the code also sets out basic approaches and ethical conflict resolution frameworks chartered accountants should be using in order to demonstrate best practice.

Establishing a sense of purpose

It appears the approach of these and other comprehensive attempts to establish uniform standards of corporate governance is to make compliance absolutely mandatory. More important still, they are all based on the establishment of a sense of purpose. Industry bodies and regulators are placing unprecedented emphasis on principles of independence, communication and transparency, and those principles should ultimately help to guide companies of all shapes and size towards establishing a new level of best practice – and just in time, too.

After all, the public’s appetite for forgiveness is absolutely non-existent where corporate governance is concerned – and government bodies haven’t got the resource nor the political capital in order to orchestrate massive corporate bailouts. That’s why companies have got no choice but to work together to identify shared principles of corporate governance and demonstrate those principles to regulators, stakeholders and consumers.