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The new governance frontier

16 March 2016

The new governance frontier - read more

Weak corporate culture is often at the root of failure

Corporate culture has become a new buzzword in governance, as we seek to learn the lessons from a series of corporate scandals – not just at banks, but also at companies like Tesco, Toshiba and VW. All these scandals, and others that preceded them, have cultural weakness as part of their cause.

It is now widely accepted that poor culture adds to risk and a strong one reduces it, but we are still a long way from reaching a clear understanding of what corporate culture is and how to shape and embed it.

The starting point should be a definition of culture. For most people, the definition comes back to the drivers of behaviour, which might be defined colloquially as ‘the way we do things round here’. Culture involves defining what is acceptable behaviour and what is not. That requires a clear set of values, agreed and promoted by the corporate leadership and used to benchmark decisions at every level in the company.

A shift in our understanding

This focus has led to an important shift in our understanding of corporate social responsibility and its contribution to corporate and community life. It is also leading to a shift in our thinking about corporate governance, which needs to become less about boardroom process and more about shaping how people work together. How do they respond under pressure? How does the company, through its employees, relate to the outside world?

The encouraging news is that boards appear to have taken on the task. Last autumn, the OECD published a report on Trust in Business, based on the results of an international survey of 88 companies. This showed that 80% of boards are strongly involved in the design and implementation of integrity policy and 20% reported a sharp recent increase in spending on ethics. Significantly most respondents now regard such spending as an investment rather than an expense. Moreover, about two thirds of the companies surveyed said that they had severed contact with a business partner or revised a project because of conduct risk.

Establishing a code

On the other hand, few directors had received in-person training on ethics. This seems to indicate that although boards are now acutely aware of values and culture, there is less systematic follow through. That has certainly been the experience of the IBE. Many boards accept the need to promulgate a clear set of values and to relate these to the business model and strategy. Often they reinforce these values through the establishment of a code of ethical behaviour, but quite often the effort seems to dwindle after that.

Follow-through is critical: boards need to ask whether the staff are aware of the code; whether it is monitored; whether there are opportunities for people to raise concerns without fear of retaliation; and whether they can be sure that the culture they have got is the one they want.

The risk of a half-hearted approach is that the firm falls foul of conduct and reputation risk, which can damage the franchise and lead to financial costs. The opportunity in following through is that trust in the company increases among its stakeholders and this strengthens the franchise, producing better quality earnings and more sustainable returns.

Indicators of culture

So what needs to be done? Last December, ICSA: The Governance Institute, together with the IBE and the International Corporate Governance Network, held a workshop for top regulators, company executives and investors to discuss the indicators of culture.

Apart from agreement on the need for a broader definition of governance beyond mere boardroom process, it suggested that boards should be: more aware of the pressures the company is placing on employees; more sensitive to the role of incentives throughout the company; more concerned about developing an open culture in which difficult problems can be discussed; and more wary of the risks that flow from toleration of minor breaches of ethical standards. More attention should be paid to the role of human resources and to internal audit as a means of assurance on culture and behaviour.

There is a risk that many directors will find all this a tedious imposition. Yet if there is some effort in setting up the framework and making it work, once it is achieved there is liberation. The board, management and the company can then safely get on with the business in hand.

Role of committees

The question is how best to organise this – and this is where our new research comes in. Given the new focus on culture, the research looked closely at companies whose boards have delegated some of the basic work to committees, and find out what these committees actually do.

We examined the FTSE 350 and found 55 companies that published terms of reference for dedicated board committees covering the broad area of sustainability, responsibility, ethics and values. This is neither an outstandingly large proportion nor tiny one. It is a sufficient number, however, to suggest that the committee option is one that should be taken seriously.

Based on our interviews and workshops, it appears that the adoption of the committee approach reflects the growing proliferation of non-financial risks. According to the OECD, oversight of these is often given to a board committee, usually compliance or audit. Yet audit committees are stretched. This may be an important reason why some companies are reaching for a new committee.

One important conclusion from a study of the terms of reference is that these committees are serious initiatives, called into existence for serious reasons. We are a long way from the days when corporate responsibility was driven by public relations and a sop to the NGO community. Now boards are more concerned about how to secure the right behaviours.

Ethics and values

Still only a minority of committees actually have the words ethics, values or integrity in their titles, even though a large proportion (55%) of mandates require the committee to advise the board on matters pertaining to ethics and values.

One concern, which is most definitely legitimate, is to avoid diluting the role of the board. Quite simply, boards cannot delegate the subject of ethics and values to a sub-committee. The board has absolute responsibility for this. Besides, there are already a lot of committees and a risk of overlap, duplication and a danger that important issues will fall between the cracks.

Many of the companies with committees state specifically in the terms of reference that the sustainability and ethics committee is to liaise with other committees. Mostly this involves the audit and compliance committee, but it sometimes directly involves the remuneration committee. It is interesting to note that there is also on occasion a relationship with internal audit.

Companies without committees

The research also looked at companies without a committee, though there is less public data on them. ICSA: The Governance Institute surveyed its members and found that the absence of a committee does not mean boards ignore the issue of ethics and values. Although about 40% of boards without a dedicated committee discuss ethics at least every six months and nearly 30% once a year, there are still a significant number that discuss the subject hardly at all or never.

One answer from this camp is that ethics and values pervade everything they discuss. This is at one level understandable – boards discussing a takeover may well look at the values challenge of integrating a different company. The agenda will refer to the takeover not to ethics. Yet it is also a cop-out because it suggests that these boards pay scant attention to the metrics associated with culture – how well is the code of conduct embedded, what is going on with the speak-up line, what is the staff survey saying? And so on.

Where boards only discuss ethics occasionally, one wonders about the quality of the discussion. Does it come at the end of the meeting when everybody is anxious to get home? How systematic is the discussion? How well informed is it? Having a committee, which reports regularly to the board is a way of ensuring that the discussion on ethics and values, when it happens, is meaningful and informed. The board will be able to pull out trends, spot strengths and weaknesses and ensure that the necessary action is taken.

Thus we cannot say that having a committee is best practice. It is not the only answer, but, however they cut it, boards do need to be able to give a satisfactory answer to the question about whether they are really on top of the culture over which they preside and able to ensure that it serves their purpose well.

These issues are not going to go away. Companies, which deal with them effectively, will find their license to operate secure. Those that do not will put themselves, their shareholders and other stakeholders at risk.

Peter Montagnon is Associate Director at Institute of Business Ethics

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