Keeping the UK at the forefront of corporate governance practice

Paul Coombes, Chairman, Centre for Corporate Governance, London Business SchoolPaul Coombes, Chairman, Centre for Corporate Governance, London Business School writes:

There is a misleading narrative about the state of UK corporate governance today. According to this account, the financial crisis was indicative of wider systemic governance weaknesses across the entire corporate sector. Similarly, more recent instances of egregious corporate behaviour at BHS and Sports Direct were merely symptoms of a deeper malaise. In parallel, the growth in executive pay was yet another manifestation of a governance framework that failed to deliver proper accountability. Add to this, a widespread belief that asset managers have fostered short-termism and underinvestment by our largest companies. The result – the UK’s notoriously poor productivity, coupled with a lack of public trust in the legitimacy of markets and in the business community as a whole.

Dismantling this story is important because accurate diagnosis is the prerequisite for effective governance reform. So what’s wrong with this account? First, the assumption that the systemic problems of the banks were evidence of systemic problems facing the entire corporate sector; second, an unwillingness to recognise the statistical inevitability of periodic corporate scandals, however strict a governance regime; third, a reluctance to look rigorously at the actual evidence on executive pay; and fourth, an explanation of the UK’s productivity challenge that does not find support from the most recent evidence. Finally, on the crucial question of public trust in the corporate sector, a failure to distinguish between whether companies are demonstrably untrustworthy, or are – inaccurately – perceived to be so.

Fortunately, the Government’s recent White Paper proposals reject the more pessimistic diagnosis of the UK’s corporate governance framework. On the three dimensions of executive pay – process, design, and quantum – there are proposals for reforming the process of Remuneration Committees, for changing the design of long-term incentive plans, and on quantum, for strengthening shareholders’ powers to express dissent. The only recommendation that is clearly not supported by the best evidence is the decision to require quoted companies to publish pay ratios. This is a regrettable concession to short-term expediency that will store up needless problems for the future unless it is modified.

It is on stakeholder engagement, however, that the White Paper makes the most far-reaching suggestions for reform, with its recommendations for strengthening the voice of employees and other non-shareholder interests at board level, and for adopting one of three employee engagement mechanisms. This is timely recognition of a fundamental change in the landscape of corporate governance – the need to explain more visibly and effectively how companies are meeting their wider responsibilities, beyond shareholders, under section 172 of the Companies Act.

Assuming that these proposals are brought into effect by the middle of 2018, with a revised Stewardship Code shortly to follow, how will that position the UK for a post-Brexit environment?

Let’s begin with five points of context:

  • We know from rigorous academic research, as well as from a wealth of direct management experience, that companies which score highly on employee satisfaction perform better.
  • We also know that companies which have strong, engaged and wellinformed shareholders with sizeable blockholdings, perform better. That’s not because they are long-term holders regardless of performance, but because they apply the conditional loyalty that keeps boards and executive teams on their toes, keen to articulate and defend their strategies.
  • We know that the key corporate assets of the future will increasingly be intangibles – not plant and factories, but the talent and ideas of employees, R&D, individual brands and corporate reputation.
  • We know that risk-taking is essential to corporate success, that not every strategy succeeds, and that corporate failure by itself does not indicate governance failure. Markets work through a process of creative destruction. 
  • We know that UK corporate governance continues to be widely admired and emulated around the world and ever since the original Cadbury report has been regarded as a pace-setter in governance innovation

In light of this, what goals should companies, investors and regulators adopt to maintain the UK’s position at the forefront of governance practice?

Here are seven suggestions:

For companies:

More dialogue with employees. Boards and executive teams should consider a much wider range of imaginative ideas for enabling more regular collective interaction with employees. While the three employee engagement options in the White Paper are a starting point, these will operate on a comply or explain basis, so there is room for companies to adopt more innovative solutions if these can be justified. For example, much more creative use of interactive technology such as webcasts with senior executives and virtual Employee AGMs.

More explanation, less compliance. Ponderous box-ticking protocols are the bane of effective governance. Companies should be ready to divulge far more insights on their strategies, their business models and their people policies in exchange for serious, well-prepared engagement by asset managers.

For the investor community:

Rigorous self-appraisal of their institutional capacity to pursue independent value-added engagement with companies. Meaningful engagement is costly and is subject to inevitable free-rider problems. Unless an asset manager has substantial scale, it may simply not be in the best interests of a firm’s clients. Perfunctory engagement should be in no one’s interest. In turn, this may call for a reassessment of the role of proxy advisors and their obligations.

For regulators:

Boards: acknowledgment of the risk of governance overload on directors. Boards are simply one of the multiple mechanisms for achieving effective governance and minimizing the risks of corporate hubris or complacency. Board discussion time is a critical scarce resource that needs to be used wisely.

Standardisation: in the quest for better insights on individual corporate performance, a readiness to avoid imposing misleading standardization of governance metrics when sector- or company-specific indicators are more informative.

Competition: recognition that competition is typically a far more powerful engine of performance enhancement and cultural change than anything that regulators can achieve. Professional firms show the way: competition, not regulation, is what has driven the innovative steps that the largest firms have taken to attract and retain talent.

Divergence: a willingness to envisage increasing regulatory divergence from EU corporate governance norms if this can be shown to be creating a more nuanced and effective relationship between companies, investors, employees and the wider community.

To sum up, the coming era in UK corporate governance will be one in which the scope for governance innovation by companies and asset managers will be high if the overarching governance superstructure is adapted with finesse. Not ‘light touch’ but ‘sure touch’ regulation is the goal.