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Reviewing the governance black box

08 December 2017 by Brett Simnett

Reviewing the governance black box - Read more

The many recent governance failures show the code is not enough in isolation

In the 25 years since the foundation of the UK Corporate Governance Code – the Cadbury Report – was published, its various iterations have been lauded for boosting transparency and gaining insight into the behaviour and performance of company boards.

The code states that ‘corporate governance is about what the board of a company does and how it sets the values of the company’. It also states ‘the responsibilities of the board include setting the company’s strategic aims, providing the leadership to put them into effect, supervising the management of the business and reporting to shareholders on their stewardship’.

The core principles of the code are leadership, effectiveness, accountability, remuneration and shareholder engagement. These principles, in their raw form, aim to encourage responsibility, ethical behaviour, measurement and communication.

As an investor there are key considerations if you are looking to invest or continue to invest in a business: considerations around whether the board is structured to fulfil its responsibilities, and how its behaviours and actions instil those same behaviours across the business.

“Corporate governance reports are not always giving us those answers or the necessary clear insight into how the business is being run”

Shareholders want to know how performance is measured and remunerated – it is important the board is communicating this effectively to them, as well as to wider stakeholders.

The answers should provide a real sense of how a board is conducting business. But the reality is corporate governance reports are not always giving us those answers or the necessary clear insight into how the business is being run.

Since the reports launch in 1992, the numerous examples of corporate governance failure must question whether we have really seen consistent good governance and true transparency, and, more importantly, why those failures were not identified and managed more effectively.

Barings Bank

In 1995, an employee of Barings Bank in Singapore, Nick Leeson, was trading futures, signing off on his own accounts and taking the bank further and further into debt, resulting in losses of £827 million.

As floor manager and department head, Leeson had free reign to settle his own trades. More importantly, there was little or no governance leadership coming from the London board. Those London directors were subsequently disqualified as being unfit to run a company.

Leeson claimed the lack of oversight and risk management from management was as much to blame as his own actions. Yet there was a lack of clarity in reporting to allow others outside the company to question the way it was operating – that questioning is essential to good governance.

MG Rover Group

MG Rover’s collapse in 2005 is not a simple example of one management team’s failure, but a case study of multiple owners and management teams fundamentally failing to address the core issues facing the business.

In an analysis of the company’s collapse by the academic partnership Cambridge-MIT, entitled ‘Who killed MG Rover?’ it said: ‘Its decline from the 1960s was because of a range of ignored factors: an ill-conceived product strategy, a failure to integrate various elements of the business, multiple ownership changes and a lack of capability to develop new products for key markets.’

Ultimately, the various owners of the car manufacturer – whether British Leyland Corporation, BMW, British Aerospace and finally, the Pheonix consortium – did not recognise core weaknesses in the business: weak products, poor market analysis and lack of long-term financial capital.

The owners tried to paper over the cracks rather than resolve them. The report stated: ‘The main reason behind Rover’s demise was an inability, which started to manifest itself 50 years ago, to manage its constituent’s operations as well as its competitors were able to do so.’

After diminishing demand and a £6.5 million loan in April 2005 from the UK government, the company went into administration. This is an example of where proper checks and evaluations have systemically failed, and the question of whether the business was fit-for-purpose was never sufficiently challenged.

Financial crisis

Looking at the fundamentals of the 2007–8 financial crisis, the Financial Crisis Inquiry Commission concluded the crisis ‘was avoidable and was caused by widespread failures in financial regulation and supervision, dramatic failures in corporate governance and risk management at many systemically important financial institutions’.

The heart of the issue was that the complexity of financial instruments had overtaken the ability of boards to govern their businesses effectively. While financial success was the norm, the need to tighten governance was either overlooked or, even worse, ignored.

“The results of 2008 were prime examples of how governance can slip when the going is good”

From Northern Rock, RBS, LBG and HBOS – to name a few firms – the results of 2008 were prime examples of how governance can slip when the going is good, and the results can be dramatic and destructive.

Again, board challenge and checks fell by the wayside. Those who should have been challenging their activities failed to act while business was good, although whether there was true transparency for stakeholders to challenge can be debated.

Tesco

In 2014, the revelation Britain’s biggest grocer had overstated its profits came to light. With pressures on constant financial growth, Tesco looked beyond the traditional buy-and-sell to customers, and to suppliers as a source of profit.

Dave Lewis, the newly appointed chief executive, said: ‘Since 2014 we have made extensive changes across our leadership, our structures, our financial controls inside the business, and we’ve changed the way Tesco buys and sells’. But the damage made to supplier relationships was felt across the business and the spotlight on its behaviours is still as strong today as it was in 2014.

The question here is how did a major force in its sector lose sight of the importance of its supply chain relationships over profit, and why was the demand for short-term financial gain seen as more important than long-term, sustainable viability?

Recent history

More recent history does not fill the heart with optimism. 2016 saw Rolls-Royce’s £671 million corruption case and, in 2017, we had governance issues such as Barclays’ whistleblowing saga and the strategic errors at Provident Financial Group.

The code is viewed by many as a global standard, yet it failed to ensure good governance in these cases.

Insight, challenge, change, reward

The key to the success of the code is to ensure the board, shareholders and stakeholders have clear insight, and the ability to challenge and change direction. Rewards should recognise ethical and sustainable behaviour as well as financial success.

All of the examples demonstrate fundamental faults in the approach to governance and its reporting.

Insight

Firstly, there is the question of insight. This falls into two categories: the insights for the board and insights for shareholders and stakeholders.

Examples such as Barings and Tesco show that without clear channels of information from operations to the board it is impossible to drive behaviour from the top. Good governance requires clear channels of communication on how various parts of the business are performing.

This is not just financial. Viewing performance through one lens obscures the true picture. Boards need to be supported by clear communication with their operations to successfully drive culture and behaviour.

Without honest insight from across the value chain, boards cannot be effective. They must be responsible to seek and demand that information.

Secondly, if shareholders and wider stakeholders are not given clear insight into how the board is operating, communicating with the business and making decisions, how can they effectively challenge things?

“I believe better communication between management and the financial floor would have saved Barings Bank”

Governance reports that proudly tell us the board has discussed strategic, financial and risk over the year, without any clear insight into what was actually discussed and what actions came from those discussions, are deliberately being obtuse and avoiding communication with the true owners of the business.

Again, this is the responsibility of the board, but shareholders need to demand more transparent insight and actively interrogate whether financial success is driven by proper business practices.

Challenge

With clear insight comes the ability to truly challenge the status quo. Boards that are communicating effectively with their businesses at operational level can look to encourage and enhance behaviours.

The recent discussions, driven by the government green paper, to encourage better employee representation at board level is an interesting concept in helping solve the problem. However, it is actually better lines of two-way communication with staff, supply chain and customers that will drive collective behavioural change.

How many of the examples covered in this article could have been avoided by better-governed communication with the people at the coal face of the business, allowing them to question and challenge?

Not only does this help a business feel as one, it creates a collective responsibility for how the business is governed and helps a board in its responsibilities.

Change

Insight drives challenge; challenge drives change. It is a simple concept, but difficult to achieve.

Change is a word used far too flippantly in the corporate world. Change is always viewed as ‘big’, whereas effective change is constant development and tweaking of small elements that can have a ‘big’ effect.

Would better communication between management and the financial floor – and the ability for all involved to question processes – have saved Barings Bank? I believe so.

Would more effective customer and market insight have changed MG Rovers product strategy for the better? In my view, we would still see MG Rover on our roads today if there had been better collaboration across the business to drive change.

Collaboration and communication is the key to a business’ ability to manage changing circumstances, avoiding ‘big’ issues through adaptive rather than radical change.

Reward

How a board and, just as importantly, its staff are rewarded needs to go beyond financial performance. A business’ ability to adapt and change to market, economic and political forces dictates how it will continue to create value.

Key performance indicators and performance measures should look at operations and communication as well as economic indicators.

Yes, these are difficult to measure in real terms, but a successful business is one that avoids negative ‘big’ change. Reliability is a positive for investors and this comes from effective management and communication, so they have be a key element of remuneration measurement.

Back to the code

As a collective, we must ensure the principles of the code are lived by companies. Boards and those they are responsible for and communicate to should ask four simple questions.

  1. Does the leadership of the business have the insight, tools and communication channels to do their jobs?
  2. Is the board making effective decisions that are supported by clear insight that is transparent to its stakeholders?
  3. Do stakeholders have enough information and access to two-way dialogue to assess the performance and accountability of the board?
  4. Are remuneration targets based on long-term operations and financial viability?

When boards and stakeholders can comfortably answer these questions with an affirmative, I believe we will see the code achieve its goals.

Brett Simnett is director of investor engagement at Radley Yeldar

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