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Red, amber and green

16 May 2017 by Peter Swabey

BEIS Select Committee report: Red, amber and green - read more

With some caveats, the BEIS Select Committee report is broadly positive

On 5 April, the Business, Energy and Industrial Strategy Select Committee of the House of Commons published the report of its inquiry on corporate governance. This focused on executive pay, directors’ duties and the composition of boardrooms, including worker representation and gender balance in executive positions, and is a development of the Committee’s recent inquiries into BHS and Sports Direct.

The report was a detailed and rigorous analysis of corporate governance issues in the UK and included some innovative ideas. It made a number of recommendations, one of which was the introduction of an annual rating exercise to review examples of good and bad practice using a ‘traffic light’ assessment. In this article we apply a similar approach to the report’s recommendations.

Code amendment to require informative narrative reporting on the fulfilment of section 172 duties

At first sight this is a good idea. When we prepared the ICSA response to the inquiry and the Government Green Paper, we were told by many members that boards do, very much, bear their section 172 responsibilities in mind when considering the issues before them, but this process is not always well reported.

This is one of the drivers behind our joint initiative with the Investment Association to look at how boards take note of stakeholder views. Our concern with this recommendation is how it will be implemented and, more particularly, how some stakeholders will expect it to be implemented.

We believe that explaining ‘precisely’ how ‘each of the different stakeholder interests’ have been considered, has the potential to be very onerous, as it is our members’ experience that the interested stakeholders will change with each matter before the board. There is also the question of who decides that there have ‘been failures to have due regard to any one of these interests, [which] should be addressed directly and explained’.

One key issue for our members was that companies should have only one ultimate master. In the shareholder primacy model, this is the shareholder. Board decisions are often the result of balancing shareholder and various stakeholder interests and, naturally, any stakeholders or their supporters who feel they have been disadvantaged in some way will argue that ‘due regard’ has not been had to their interests. Unless carefully prescribed in regulation, this risks companies having to provide detailed explanations of every single board decision.

An annual rating exercise

Again, this recommendation is sound in principle, but very difficult in practice. Chris Hodge captured the issue in his recent ICSA blog ‘Red lights spell danger’ on 10 April – and again it is about who carries out the analysis.

“We are concerned that this proposal will tend to measure compliance with a ‘norm’ and, consequently, encourage a tick-box mentality”

Whoever analyses company reports will be affected by their own preferences. Proxy advisors already provide these ratings for their clients and, in some cases, more publicly, but they do not always agree between themselves.

We are concerned that this proposal will tend to measure compliance with a ‘norm’ and, consequently, encourage a tick-box mentality rather than the more flexible ‘comply or explain’ model that defines corporate governance in the UK and which the Committee ‘do not see sufficient reason to depart from ... [as it] is well understood and widely emulated around the world’.

Additional powers for the Financial Reporting Council

On balance we support this recommendation. One of the challenges with the current system that we noted in our response to the Committee was the fact that while directors’ duties, as set out in sections 171–177 of the Companies Act 2006, are clear and unambiguous, there is a case for more rigorous enforcement by regulatory authorities, as well as by shareholders.

It should not be forgotten that companies do fail, and failure alone should not be regarded as evidence of a breach of duty. Historically, the FRC has not had the power to sanction directors personally, unless they happened to be members of the accounting profession. Extending this power to cover all directors seems proportionate.

More routine dialogue via the Investor Forum

We believe dialogue between companies and their principal investors already happens effectively. One of the advantages of engagements by the Investor Forum is that it has been able to bring pressure to bear in specific circumstances where individual investor engagement has not been effective. We believe there should be no change to this model.

Reporting on stakeholder engagement

As noted above, this seems sensible.

More detailed engagement guidelines in the Stewardship Code and disclosure of voting records

We support these recommendations. The FRC’s ‘tiering’ approach to signatories of the Stewardship Code is a welcome step in this direction, although it could usefully be made more rigorous. Publication of voting records will demonstrate activity, although not the rigour of the process behind the voting decision, which we believe is more important.

Publication of information about the use of advisors

This seems reasonable, subject to the proportionality of the threshold chosen.

Support for non-executive directors and availability of time

We support these recommendations – indeed we see professional support for non-executive directors as a core part of the company secretary’s role – and look forward to working with the FRC on developing any such guidance. One slight nuance is that we think reporting should be part of the governance report – as it currently is for many companies – rather than part of people reporting. The issue of time commitments is more difficult, but reporting the approximate time spent in the previous year on each commitment would address this issue.

A corporate governance code for private companies

We support the development of a corporate governance code for the largest privately-held companies. However, the details of this recommendation seem to us to miss some fundamental points.

We believe the code should be developed and overseen by the FRC as the competent regulator, rather than by a new body focused only on this code – this will help to ensure that the relevant expertise is available to support the new code.

We also believe the new code should be mandatory, albeit on the usual ‘comply or explain’ basis, recognising that there is no effective enforcement mechanism for many of these companies.

Finally we would be concerned if the development of the code relied too heavily on vested interests and, unsurprisingly, consider that, as the professional body for governance, we would be better placed to help the FRC than other business organisations.

Executive pay structures

We support these recommendations, although we believe it is already common practice for bonuses to be linked to corporate objectives and that the measures proposed are rather ‘vanilla’.

There are significant issues with the structure of executive pay arrangements and we believe these need careful examination to ensure that any changes meet the needs of the market.

For example, it has always been possible for companies to offer deferred stock rather than long-term investment plans (LTIPs), but investors have generally preferred LTIPs to deferred stock on the basis that outcomes are more directly related to company performance, generally in terms of earnings per share or total shareholder return.

Binding vote more frequent

This proposal sounds reasonable in principle and has the merit that it will have greater effect on the minority of companies that receive significant votes against their pay structures. However, the experience of votes on pay so far does not fill us with confidence that this will be effective.

Remuneration committee chairman

We support the recommendation that the chairman of the remuneration committee should have experience on a remuneration committee, but do not believe it necessary that this should be within the same company. We do not agree that chairmen of remuneration committees should be expected to resign if their proposals do not receive the backing of 75% of voting shareholders, who already have the opportunity to vote them off if they so choose.

People policy

The recommendation that companies should set out clearly their people policy seems sensible and proportionate.

“Diversity is important, but the aim should surely be that it ceases to be an issue in our society ”

Pay ratios

We do not believe pay ratios are necessarily meaningful or helpful, but have no objection to their being published.

Diversity

The Committee makes a number of recommendations to encourage diversity, especially gender and ethnic diversity, on company boards. In our view, these are generally helpful, but should not be looked upon as a panacea. Diversity is important, but the aim should surely be that it ceases to be an issue in our society – and that will take much more significant action than aspirational targets for company boards and senior management.

Although the additional reporting proposed will create an additional burden for business, it seems proportionate to create a mechanism for monitoring success. The discussion of ‘cognitive diversity’ in the report is particularly welcome.

Board appointments

The recommendations on board appointments are also generally sensible. While encouraging the use of ‘internal candidates’ for directorships, it stops short of recommending workers on boards. We also support the recommendation of open advertising of vacancies, where appropriate, and the use of an external search consultancy.

It has been argued that headhunters have been part of the diversity problem, because they are limited by the diversity of candidates on their books. It has also been said that open advertising only brings forward self-promoters, rather than realistic candidates for board appointment. However, our research last year on the role of the nomination committee revealed that there are still a minority of boards that rely on people they know, with the associated risk that they will be ‘people like us’.

Open advertising is one means of ensuring that others are, at least, considered. Our caveat here is that it is not always practicable, especially in listed companies, for reasons of commercial confidentiality and the need to inform the market. If this recommendation is to be taken forward, safe harbours will need to be carefully thought through.

FRC oversight of board evaluation

Finally, we are cautious about the recommendation that the FRC should have oversight of the rigour of the evaluation process to ensure it is genuinely independent, thorough and consistent across companies. It must be remembered that the board evaluation is a tool for the self-improvement of the board, much of which must remain confidential if open feedback is to be obtained.

Positive recommendations

Overall, we regard the recommendations of the Committee as positive. We are pleased to see the recognition given to the strength of the UK corporate governance framework. We also support the greater powers being proposed for the FRC to bring the central oversight of corporate governance and compliance with section 172 more into line with the level of regulatory oversight given to audit and accounting.

The review of the UK Corporate Governance Code, being undertaken by the FRC later this year, will be an opportunity to balance the recommendations of the Committee against the need for proportionate response to the issues the Committee has identified. It also offers the opportunity to examine the balance between legislation, regulation and market practice that is essential, given the variety of companies and stakeholders in our market.

We welcome the focus on stakeholders in the report. This aspect of governance is vitally important. Stakeholder engagement is good business sense and the introduction of stakeholder panels will help some companies achieve this better.

“We are pleased to see the recognition given to the strength of the UK corporate governance framework”

It is sometimes asserted that directors do not pay sufficient attention to the interests of stakeholders, but that is not the experience our members have reported to us. ICSA is working with the Investment Association on developing some guidance around good practices in stakeholder engagement, with examples of how many boards already successfully ascertain the views of their stakeholders due to be published this summer.

We also welcome the attention on the importance of the role of non-executive directors, the appropriate training of directors and their need for professional support. It is our members’ experience that the overwhelming majority of companies provide this through the company secretary, but, where this is not the case, it certainly should be.

Peter Swabey is Policy and Research Director at ICSA: The Governance Institute

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