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Governance must evolve

16 May 2017 by Henry Ker

Iain Wright: Governance must evolve - read more

Iain Wright discusses the BEIS Select Committee inquiry and how governance can reconnect business with its stakeholders

Iain Wright is a former MP and chaired the BEIS Select Committee inquiry on corporate governance.

What is your overall opinion of the current state of UK corporate governance?

Our corporate governance system is strong and has a very good reputation internationally. The key is how to keep it strong, and how to adapt to take into account multi-business practices, different technologies, different ways of doing things and so on. You cannot just say ‘job done’ with corporate governance – it has to evolve, but that is one of its strengths.

One of the things we tried to emphasise in our report is that we do not believe in revolutions; we do not believe in kicking everything out. The comply or explain system is a particular strength, for example, and nobody wanted to move away from it. But the Cadbury report was 25 years ago and we need to think about the next step in the evolutionary process to ensure the UK corporate governance system remains as strong and receptive as ever.

Corporate governance seems to be seen as the answer to an increasingly large set of issues. Can the current system really fulfil everything being asked of it?

It is not going to stop businesses going wrong. It is not the answer to everyone’s prayers, and you cannot just think that if you follow and comply with a certain set of rules, you will have business success. It is not that easy. Even if you have good corporate governance, sometimes there will be bad business decisions and businesses can fail. However, if you have bad corporate governance, it is more likely your business will fail.

“Governance is not the answer to everyone’s prayers, and you cannot just think if you follow and comply with a certain set of rules, you will have business success”

One of the things that came out strongly in the report when we looked at this in the context of Sports Direct and BHS, is disconnect. Disconnect from different stakeholders, disconnect from customers, disconnect from workers, and disconnect from the society in which business operates. Corporate governance can help with that, in terms of managing stakeholder expectation for the good of the business.

Were there any particular challenges to chairing a cross-party group? Did members struggle to avoid party politics?

I was fortunate that we had a very positive team spirit in respect of all our reports. We did not vote on any of these recommendations. We talked them through, negotiated, discussed and debated, and every single member of that Select Committee can be proud of what we achieved.

There are always challenges in chairing a Select Committee, but in terms of pulling together and letting everyone have their say and debating the matters, this was a particularly strong report from a very strong team of MPs.

The report includes a large list of recommendations – are there a few key ones you feel are the most important?

We looked at three broad areas: directors’ duties and questioning if section 172 of the Companies Act 2006 is fit for purpose; the diversity of board composition and whether diversity matters from a business point of view rather than just a moral or ethical point of view; and whether there is a disconnect between pay and performance in executive remuneration.

First, on directors’ duties, there have been no prosecutions with regard to section 172. Courts and judges are very reluctant to get inside business people’s heads, and so a business person can simply say ‘of course I am thinking about the long-term success of the company, but I got it wrong’. The judiciary is reluctant to go down the route of trying to prosecute.

“We recommend the abolition of long-term incentive plans as soon as possible, because we do not think they provide meaningful incentive”

However, we can look at directors’ duties in terms of narrative reporting and how section 172 is explained to shareholders and stakeholders. We thought the recommendation for informative narrative reporting on fulfilment of section 172 duties was an important one.

Second, the diversity of boards. Half of society are women; although there have been some improvements, why are half of non-executive positions not held by women? We are not forcing targets, but boards should explain to their stakeholders why they may be falling short on diversity, and what they are doing to replenish the pipeline to ensure more women and greater diversity comes through. I think that is really important.

The third element is the huge disconnect between pay and performance. We recommend the abolition of long-term incentive plans as soon as possible, because we do not think they provide meaningful incentive in order to create long-term value for a company through executive remuneration.

Underpinning a lot of that is an enhanced role for the Financial Reporting Council. We recommend an enhanced system for reporting, as well as expanding reporting by companies. Because of all this, the FRC should be given additional powers and resources. We did not see the case to set up a new quango or regulator.

We were also very taken by the notion of the ownerless company. Often the shareholding of a company is very diverse, and fund managers might only hold tiny amounts of a large number of companies, and that being the case, who is holding executives to account? Is that why executive pay has been rising in recent years?

On the recommendation for informative narrative reporting on fulfilment of section 172 duties. Could you explain the thinking behind this recommendation?

There were a number of things we looked at with regard to section 172. Is it fit for purpose? Should it be amended? If it is fit for purpose, are there improvements that have to be made? I mentioned that no directors have been prosecuted as a result of non-compliance with section 172. Does that mean it is working well, or mean it is not working at all? We looked at whether we should get rid of it, but decided against that.

Instead we decided that expanding reporting, with an explanation on a company-by-company basis, and then being looked at by the FRC, was the right way to tackle this.

In addition, the Secretary of State has got a number of powers, when it comes to directors, that were last used a long time ago. There is an armoury of different tools that could be used to hold directors to account. They fulfil an important role in promoting long-term success and we should ask them how they doing it, how they are reporting, and how the success of their duties is being assessed.

However, we are keen to avoid boilerplate reporting – this is why we did not prescribe a standard form of words they should be using. Reporting of directors’ duties has to be on a company-by-company basis, and then shareholders, together with the FRC, need to suggest whether it is fit for purpose through the UK Corporate Governance Code and through shareholder consideration.

ICSA and the Investment Association are currently producing guidance on stakeholder engagement. Some of the initial feedback suggests engagement often goes on at operational level, but then does not reach the board. How do you overcome that?

In terms of engagement with boards, one of the key things I want to keep reinforcing is the disconnect. The current failure of corporate governance is essentially a disconnect of the system. This disconnect with members and wider stakeholders needs to be addressed and this cannot be just during the build-up to AGMs and through the annual report.

We need to ensure board members are engaged with stakeholders and engaged with what is happening in the company. One of the really crucial modern attributes of a good director is constant stakeholder engagement. Good corporate governance is all a matter of connection.

The report encourages companies to consider putting worker directors on boards. How can this benefit the company?

This chimes very much with the previous question. It is about connection between strategy and operational matters, connection between the various stakeholders, and linking it to how we promote long-term success. We are too short term at the moment.

“We hear time and time again, that ‘staff are our best asset’. If that is the case, one, pay them as such, and two, put them on the board to help with strategy”

Employees really want their company to work well in the long term because they want a job for a long time. They are involved in operational matters and can often see weaknesses in processes, and they interact with customers and suppliers. They can provide a different viewpoint to that of other non-executive directors. Do not discount that if you are a chair.

We did not want to dictate or make this mandatory, but I think it is really telling that you see in company reports, time and time again, the notion that ‘staff are our best asset’, and ‘the staff makes us competitive’ or ‘give us a comparative advantage’. If that is the case, one, pay them as such, and two, put them on the board to help with strategy, because they will give you a perspective on different matters that can be absolutely invaluable.

How would worker non-executives work in practice, given they would potentially be involved in the oversight of their management? How do you ensure they remain an independent voice?

There is no conflict of interest. They would have to be there as directors in their own right – they are not there as shop floor representatives. In terms of the principle of being directors, that is absolutely key.

Having said that, one of the problems with corporate governance is information asymmetry. Obviously, executives will have much more information about the company than non-executive directors. But because they live and breathe the company every day, workers can help mitigate the information asymmetry that non-executives have.

For example, you have got listed companies like the FirstGroup transport company, which has workers on its board and it has worked incredibly well. If FirstGroup can do it, I do not see why other listed companies cannot do so.

You also mentioned putting employee representatives on remuneration committees. Is that key to tackling excessive executive pay?

In the past 20 years or so, executive pay has gone up disproportionately compared to the median pay of other workers. There are examples where a company has seemingly failed in many respects: there have been profit warnings, there may have been job redundancies, and production facility closures, and yet the chief executive still got a pay increase.

The remuneration committee needs to challenge a lot more. There does not seem to be enough downward restraints on executive pay. When a company does well and a chief executive has created value, absolutely they should be rewarded appropriately. I am the first to celebrate the point that running a major company is an extremely difficult task that requires skills and should be remunerated accordingly.

But when there is that disconnect between pay and performance, and failure to challenge and put real downward pressure on remuneration, that is where remuneration committees are failing. Having a worker on a remuneration committee would help provide that downward restraint.

Do you feel shareholder votes can have the required impact on executive pay, given the lack of evidence so far?

Shareholders are waking up to this and institutional investors understand it as a business risk. Some of the corporate governance reforms on executive pay introduced in 2013 by the Coalition Government are starting to bear fruit, although they are isolated and small scale at the moment.

We need to make sure shareholders and institutional investors understand this is a really important matter.

Our published recommendations build on what has been going on. The role of the remuneration committee, and the role of the chair of the remuneration committee, cannot be just to go to the AGM and ask ‘are people happy with this?’

Instead there must be active engagement on an almost continual basis over executive pay. If you cannot get a sizeable chunk of the shareholders to agree with the policy, you have failed in your duty as chair of the remuneration committee, and that is why we suggest you must stand down. You have failed in your connection, failed in that stakeholder engagement, and you have to go.

We were very mindful of the fact that the current system already has a shareholder vote on the director who chairs the remuneration committee. But a lot of the new rationale is because sometimes shareholders do not want a public, high-profile corporate governance row. That is entirely understandable.

How do we ensure the recommended code of governance for private companies is effective? There is a lack of transparency and no shareholders to answer to.

We looked at this very much on the back of the BHS scandal. We were mindful that BHS was a major company, with thousands of employees and thousands of pensioners. It had a big impact on society and could not be run like a fiefdom, and yet that is what it was. There was weak corporate governance and a dominant individual.

It is a case of trying to have more connection and reporting requirements that strike a balance. We want entrepreneurial spirit and companies and chief executives to have energy and passion to take their business forward.

However, we must recognise there are major stakeholders involved too, and if we do not have good corporate governance, then the fallout could be immense. We saw that with BHS.

“It is a strength of the UK economy that we can build on the successes of an effective corporate governance system to evolve with the requirements of the future”

We want to strike a balance between ensuring that stakeholders, wherever they come from, feel reassured, while allowing private companies to be able to carry on. That balance is really important. We do not want to it be heavy handed, and we do not want any reporting to be disproportionate. The recommendation for private companies is a bit lighter in many respects in terms of ensuring there is adequate reporting.

What do you think the future of corporate governance will be? I ask that in the context of Brexit and the Chancellor of the Exchequer’s comments about the possible need to change our economic model to regain competitiveness?

This is something I really want to stress, because good corporate governance should not been seen as regulation. It should not be seen as bureaucracy. It is the framework by which good business can take place, and effective successful enterprises can have their ideas challenged, but then ultimately endorsed. Good corporate governance can be a comparative advantage.

It is a strength of the UK economy that we can build on the successes of an effective corporate governance system to evolve with the requirements of the future. One of the reasons to do business in this country is that shareholders and stakeholders in general recognise that the UK is still the number one for corporate governance.

That is my vision, and that is one of the things that we wanted to do on the Select Committee. To ensure that good corporate governance lends itself to great business decisions and creates a comparative advantage for the UK, but makes sure people feel reassured and continue to invest.

Henry Ker is Editor of Governance and Compliance

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