09 December 2019 by Garry Honey
Boards need to develop skills for competent stewardship and to be made aware of the personal impact of fines, government inquiries and political censure for dereliction of duty
As a member of The Chartered Governance Institute, you should feel confident that you know good governance when you see it. However you might not be so confident after government enquiries into companies as large as Carillion and Thomas Cook. In both cases the firms complied with statutory reporting and had been audited by reputable accountants, yet both failed spectacularly in circumstances that in retrospect could shout out poor governance.
In both cases the external auditors were satisfied, the risk and audit committee was satisfied, and moreover the main board was satisfied that the companies were solvent and shareholders need not be concerned. Whose role is it to blow the whistle and say the emperor has no clothes? Some say it should fall to the external auditors, but the auditors of Tesco or Patisserie Valerie claimed it was not their job to determine illegality or insolvency, merely to sign off the company accounts. This is something the Department for Business Energy and Industrial Strategy (BEIS) now questions.
When you examine the BEIS Committee reports on Carillion and Thomas Cook, you find it alleged that the board collectively failed to question the accounts presented or demand detailed explanation. Is this because of a lack of skill or a lack of will? In terms of the former, not all board members will be qualified forensic accountants, nor should they be, but they should be able to read a balance sheet and understand their culpability for inadequate corporate stewardship. In terms of will, this opens up the question of the purpose of the business and whom it is designed to serve and reward.
Both Carillion and Thomas Cook failed their shareholders, under conditions the Corporate Code was designed to prevent. They also failed their customers most spectacularly: Carillion the government and Thomas Cook the public. In both cases it is clear that the business model had become unsustainable long before intervention by the official receiver, only nobody noticed or took action. Who is responsible for scrutinising the business model if not the board who agree strategy? Is there a collective blindness that descends on boards when faced with market signals that it refuses to acknowledge? This is where it is hard to differentiate between the causal elements: skill and will.
The Financial Reporting Council (FRC) has published its new Stewardship Code in October 2019, indicating that stewardship carries responsibility to a wider range of stakeholders than many boards currently accept. “Stewardship is the responsible allocation, management and oversight of capital to create long-term value for clients and beneficiaries, which leads to sustainable benefits for the economy, the environment and society”. This is a helpful guide but will require boards to re-examine their accountability beyond merely investors and regulators. For whose ultimate benefit are you directing the company?
We shall address the issue of governance skill later in the article, but first let’s explore governance will. The majority of governance rules have been designed to address the needs of investors and regulators, two important stakeholders but whose influence can distort the purpose of a business. If a business performance is measured purely in terms of satisfying investors or regulators, then who is left out – customers, employees, agents, suppliers plus a host of other contributors or beneficiaries?
There are two polarising views on business purpose: at one extreme is the belief that performance is a financial output: business must be viable above all else, earnings exceed costs and a profit is made. Popular indicators for productivity include Earnings before Interest, Taxes, Depreciation and Amortization (EBITDA) and Profit within the context of earnings (P-E ratio). These are important determinants for investors, but of less concern to employees or customers. Sceptics would say that attempts to measure non-financial environmental or societal values only serve to dilute business efficiency; some would go so far to say that all competitive advantage is achieved through some form of resource exploitation - human, natural or technological. They would therefore claim that resource exploitation, however unpalatable, is intrinsic to any successful, profitable business.
At the other polar extreme has always been the drive for Corporate Social Responsibility (CSR) within a lobby that has quietly grown over the past 30 years and is now unashamedly mainstream. Today it exists as Environment, Social & Corporate Governance (ESG) and has become an essential performance requirement for any institutional investor. Leading private equity firms now look for Total Societal impact (TSI) to determine the value of a business, and the new Stewardship Code from the FRC highlights how this has now become part of the regulatory framework in the UK.
What can a company secretary do to help the board? Sustainability needs to be on the agenda as a regular feature because the business model needs to be fit for purpose in a changing environment, where political or economic forces will alter the market landscape. In the case of Carillion unsustainable cash-flow problems were ignored, and in the case of Thomas Cook unsustainable debt levels were ignored until lenders pulled the plug. The board must take responsibility for ensuring a robust and resilient business model, so sustainability needs to be on the agenda for every meeting.
The collective will for good governance must extend beyond the mandatory requirements of regulatory codes and shareholder obligations, it must extend to a collective appreciation of what stewardship means and to whom the business is accountable. This includes those stakeholders who have no voice at the board table, yet who are vital to inputs and outputs of the business model. For whom does the business create value and how are its constituent parts rewarded? These are the questions a responsible board will address within the execution good governance in the future.
Let us now turn to the skill required to execute good governance. There is a distinct difference between executive and non-executive director (NED) roles, and although there are several training programmes for each level, many boardrooms understandably prefer industry experience to accredited qualification for role suitability. Nevertheless accreditation is available for those who seek it. The Institute of Directors (IoD) offers a certificate and diploma leading to chartered director qualification. Henley business offers programmes on Board Director skills and is launching a Master’s programme in Board Development.
Apart from Sustainability, Stewardship and Skill, how can a company secretary ensure that board meetings deliver robust and sound decisions? The fourth is scrutiny. The company secretary needs to ensure that the board agenda provides sufficient time for scrutiny of the accounts and the finance committee reports, especially those items which are considered exceptional costs. At Carillion a large outstanding debt was revealed only after accounts were filed, and at Thomas Cook the arbitrary goodwill valuation was never challenged, although its size kept the company technically solvent. While the government will demand more from external auditors in the future, the board must take collective responsibility for the accounts and scrutinise them thoroughly. The board will be acting illegally if the company is subsequently found to have been trading while insolvent.
What then should be the fifth‘s’ in the checklist for members? It must be shareholders who expect the business to create value and provide a return on their investment. If the board does not address shareholder value it will find itself at the wrong end of an EGM, with some likely defenestration activity to follow. The board challenge in the immediate future is to deliver performance in terms of both shareholder and regulatory expectations. The latter now representing the wider stakeholder community looking for non-financial values like society and environment.
To conclude on the subject of what good governance will look like in the coming decade, it is necessary to reflect on what performance metrics a modern board will chose to publish. For the company secretary tasked with convening, conducting and minuting board meetings, there are really five key ingredients: Sustainability, Stewardship, Skill, Scrutiny and Shareholders. If you can address all these you’ll be doing a good job.