Red lights spell danger

There are many excellent suggestions in the BEIS Select Committee’s new report on corporate governance that I hope the powers that be will act on. These include making the Stewardship Code more challenging for investors and extending any actions to highlight pay differentials between senior executives and the workforce to other sectors, as well as listed companies.

However, there is also one suggestion that I hope gets knocked on the head pretty quickly. This is the proposal that the Financial Reporting Council and business organisations should carry out an annual rating exercise of the governance of FTSE 350 companies, marking each of them as red, yellow or green.

The Committee’s argument is that ‘rigorous, transparent rating exercises should become an integral part of the business landscape, helping shareholders to engage with, and challenge, companies whose standards appear low’.

I agree. But there are already many such rating exercises undertaken by investors, proxy advisors, ratings agencies and so on. The Investment Association’s IVIS service even uses the traffic light system advocated by the Committee.

Your view on their usefulness will depend on where you sit. Many companies argue that they are exercises in box-ticking that are faulty because they fail to take into account their own specific circumstances. Many shareholders, on the other hand, would argue that they serve precisely the purpose the Committee seeks to achieve – helping them to engage with and challenge companies.

It is hard to envisage why investors would place greater reliance on a rating system based on metrics chosen by business organisations rather than by themselves. But even if the proposed new system were as rigorous and transparent as the Committee hopes, it would suffer from the same limitations as the existing rating exercises.

For these sort of exercises to be remotely objective, they can only look at a company’s formal governance structure and processes and assess whether certain desirable features – for example, independent directors – are present or absent. Measuring a different selection of structures and processes does not get round that limitation.

The results of this sort of assessment can be a useful starting point for a conversation between shareholders and companies. What they are not, though, are a measure of the quality of a company’s actual governance. This is because the rating systems do not and cannot reflect all the intangible – and therefore subjective – factors such as corporate culture that really determine how well a company is run.

Attributing a totemic status to a traffic light rating is more likely to encourage the tick-box mentality within companies that the Committee says it wishes to eliminate, and could be actively misleading if readers of the annual report and accounts thought it implied a guarantee of good governance.

 It is also hard to see why the FRC would want to do it.

When I was at the FRC we were asked at different times to publish ‘approved’ lists of remuneration consultants and board reviewers (an idea that I see also crops up again in the Select Committee report). We declined on the grounds that we did not have the ability to judge the actual quality of their work, as opposed to the processes they followed, and did not want to pretend that we could provide assurance as to their ability. The reputational risk of ‘approving’ consultants that turned out to be charlatans was too high.

The Committee’s proposal seems to me to present the same risk writ large for the FRC. You could almost guarantee that at least one ‘green’ rated company would shortly afterwards be discovered to be guilty of serious governance failures. The potential reputational damage to the FRC – and perhaps also liability if people claimed to have invested in the company because of its rating – would seem to outweigh any benefit of getting involved in such an exercise.

Before joining ICSA's policy team as a consultant, Chris Hodge was the FRC Director of Corporate Governance.

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