28 June 2018 by Elizabeth Colvin
An extract from the winning submission for the Tom Morrison Essay Prize
Tom Morrison Essay Prize
The competition was launched in 2016 in memory of Tom Morrison FCIS – an active member and past president of ICSA and a highly regarded and influential member of the share registration industry – and encourages new thinking and recognises original approaches to governance. Now in its third year, this year’s competition sought essay submissions that demonstrated an original perspective on the following topic:
‘It has been said that governance failures usually happen within the subsidiary structure of a large business, but all governance focus tends to be at the main board level. Is the focus on the right area and, if not, what improvements could be made?’
Following the accounting scandal at the Italian subsidiary of British Telecom, it was remarked that ‘if there is not strong supervision from the mother ship over the smaller vessels, things such as financial irregularities and fraud will almost certainly happen’1. Of the many governance failures that have occurred in recent memory, it can also be observed that many of these have occurred within the subsidiary structure, where there is not an imposed requirement for corporate governance, rather than at the main board level.
Recent notable examples include the accounting scandal relating to overstated profits at the FTSE-listed Tesco plc’s subsidiary Tesco Stores Ltd, the previously mentioned accounting irregularities scandal at the Italian subsidiary of FTSE-listed British Telecom plc and, in Switzerland, the recent scandal with the government-owned PostBus subsidiary understating its earnings to claim millions in government subsidies.
Arguably, for entities listed in the UK, with a corporate governance code that focuses requirements at the main board level combined with a number of recent high-profile governance issues that have been revealed in the subsidiary structures, now is the time to consider whether there should be more focus on subsidiary governance measures, rather than further focus at the main board level.
Over the course of this essay, I will consider whether a main board-centric approach to corporate governance is appropriate in a landscape comprising a wide variety of legal entities and will review a number of measures that could be implemented or extended to improve governance at a subsidiary level.
A theme that can be seen across many of the existing important corporate governance codes, particularly those that have their basis in the UK Corporate Governance Code (UKCGC), is they are rooted in the belief that good governance standards will have a trickledown effect if the right tone is set at the highest level.
The UKCGC focuses its requirements on the main board and suggests that governance should come through top-down leadership: ‘it is important that the board sets the correct “tone from the top”2, comparatively, while still asserting this, the new King Report on Corporate Governance (King IV) has ‘ethical and effective leadership’3 at its foundation. In South Africa, therefore, it could be argued that the importance of subsidiary governance, in addition to governance measures for the main board, is already recognised.
King IV not only requires all companies to apply and then explain how they manage the risk associated with subsidiary governance, but also views subsidiary entities as stakeholders of the group4. Part V of the code on stakeholder relationships outlines a number of recommended practices for how subsidiary governance within the group should be approached5.
King IV became applicable for financial years starting on or after 1 April 2017 and it will be interesting to see if these recommended practices prevent governance failures within the subsidiary structure as it continues to be applied. Should a demonstrably positive effect be evident, it may be the ideas in the recommended practices of King IV be considered to be included as provisions in future versions of the UKCGC.
Alternatively, if subsidiaries were to be included within the definition of stakeholders that directors of the main board should have consideration while discharging their duties under section 172 of the Companies Act 2006, this could also become an area of reporting in future. While a focus can be observed in the UK towards strengthening the stakeholder voice at board level, the scope of stakeholders that are currently outlined in section 172 does not include subsidiaries and legislative change would need to be considered for reporting to legitimately be required on subsidiaries as stakeholders.
Following the collapse of British Home Stores (BHS), in 2016, its failure was attributed, in part, to weak corporate governance which enabled Sir Philip Green to ‘use a network of private companies to channel profits to a family business located offshore’6. It is unsurprising therefore that the government consultation on corporate governance included a suggestion to extend the application of the UKCGC, which at the moment only applies to listed companies, to large privately held businesses.
It was recognised it would be inappropriate to extend an obligation to comply with the UKCGC to smaller or subsidiary companies, while simultaneously acknowledging that many companies already adopt elements of the corporate governance framework in their subsidiary businesses as part of their internal risk management7. I believe this is the right response regarding smaller entities as the UKCGC has been drafted with listed entities with a premium listing in mind and many of the requirements would be inappropriate for smaller subsidiary entities. Although it could prove beneficial if adoption of elements of the UKCGC, on a voluntary basis, were to be encouraged at a subsidiary governance level.
With a corporate landscape that seems to show a decline in the number of listed companies and an increase in private entities8, reform consultation on the implementation of a code for large private companies may highlight how the government perceives the future of corporate governance. It is unsurprising therefore that one of the areas of reform that the Department of Business, Energy and Industrial Strategy (BEIS) corporate governance reform consultation focused on was improving corporate governance in large private companies.
The recommendation provided that a voluntary code be developed to be adopted by the largest private companies but ‘should the voluntary regime fail to raise standards after a three-year period, or reveal high rates of acceptable non-compliance, then a mandatory regulatory regime should be introduced’9. Noting there already exist voluntary governance codes for unlisted entities, the corporate governance code applicable to large private companies that has been suggested could go some way to impose higher corporate governance standards if the voluntary measures are widely applied and may allay concerns a repeat of the BHS collapse could be experienced. The code may also be an important first step towards a mandatory code, firstly for large privately owned companies and, possibly in future, for all privately owned subsidiary entities.
While I think this could be a positive step for group structures where a large private company is at the top, a potential area for concern could be in the creation of complexities in reporting in instances where a large private company is a subsidiary, such as service companies frequently seen in a group structure. This could have the result that ‘complexities would arise if these subsidiaries would fall within the remit of a separate governance code’10.
With the introduction of a code for large private limited companies potentially signalling a future appetite for the implementation of codes for smaller entities, care would need to be taken so that these are drafted in a way that would be harmonious to the UKCGC and ensure that the reporting and governance requirements conflicts are not created.
Financial Times BT Italia scandal sparks soul searching over global, 1 July 2017
UK Corporate Governance Code 2016, preface, p.6
Institute of Directors Southern Africa, King IV: Report on Corporate Governance for South Africa 2016, p.10
Institute of Directors Southern Africa, King IV: Report on Corporate Governance for South Africa 2016, p.7
Institute of Directors Southern Africa, King IV: Report on Corporate Governance for South Africa 2016, Part V, p.72
House of Commons, Business, Energy and Industrial Strategy Committee. Corporate Governance. Third report of Session 2016–17, p.30
2016 Corporate Governance Reform: Green Paper, p.46
House of Commons, Business, Energy and Industrial Strategy Committee. Corporate Governance. Third report of Session 2016–17, p.31
GC100: conference on corporate governance, business and society Practical Law Corporate. p.8
This is an extract. To read the full winning and runner-up essays, visit icsa.org.uk/tmep