Corporate Governance in UK Table of Contents 1. history3 1. 1Developments since 19796 2. evolution of corporate governance8 2. 1Cadbury Report (1992)8 2. 2Greenbury Report (1995)9 2. 3Hampel Report (1998)9 2. 4Combined Code (1998)10 2. 5Turnbull Report (1999)11 2. 6Myners: Review of Institutional Investment (2001)11 2. 7Higgs Report (2003)12 2. 8Smith Report (2003)12 2. 9Revised Combined Code (2003)13 2. 10Myners Report (2004)14 2. 11Financial Reporting Council14 3. Corporate Governance in UK TODAY15 3. 1The rationale behind the UK approach15 3. 2The UK regulatory framework15 . 3The essential features of UK corporate governance16 4. The Combined Code18 4. 1Directors18 4. 2Remuneration21 4. 3Accountability and Audit22 4. 4Relations with Shareholders23 4. 5Responsibilities of Institutional Investors24 5. Conclusions26 history The structure of the British financial system was shaped by the form which industrialization took in the 18th and 19th centuries. The industries which led the industrial revolution, principally cotton textiles, were characterized by numerous small firms which did not need access to large amounts of capital.
Initial finance came from family and friends, supplemented after 1750 by country banks, mostly set up by local merchants and manufacturers. These banks acted as a conduit between local savings and local investment, and provided manufacturers with working capital on a short-term basis. During the second half of the 19th century, as new industries emerged and the size of companies increased, the risks involved in short-term lending became more serious.
This prompted a wave of amalgamations among the country banks, leading to a concentration of the English banking industry in the hands of a small number of London-based joint stock banks; a similar process of concentration took place in Scotland. Following legislative changes in mid-century, principally the Joint Stock Companies Act of 1844 and the Limited Liability Act of 1855, a growing number of industrial firms converted themselves from partnerships into limited companies. Some of them remained private, while others chose to have their shares listed, either on one of the provincial stock exchanges or in London.
In some cases flotation was used as a way of raising new capital to be invested in the business. More commonly, it was a means whereby the owners could convert their stake in the company into marketable securities. At this stage there were few institutional investors in industrial companies, apart from the investment trusts which had made their appearance in the 1880s. The biggest potential investors were the insurance companies, but their premium income was invested mostly in government stock and other fixed-interest securities.
Up to the turn of the century the bulk of trading in domestic industrial securities took place on the provincial exchanges. The London Stock Exchange was primarily geared to the flotation of debt for the British government, and the raising of funds for overseas borrowers; the City of London supplied the investment capital which was needed for infrastructure development throughout the world, including railways, ports and mining. The merchant banks which handled this business, led by Barings and Rothschilds, had little involvement with domestic industry.
In the last few years of the 19th century some large British companies, such as Guinness, used the services of the merchant banks to issue shares in London, but these domestic flotation’s represented a small part of the merchant banks’ business; their expertise, and their main source of profits, lay outside Britain. In the period between 1870 and 1914 neither the joint stock banks (later known as clearing banks) nor the merchant banks developed as close a linkage with domestic industry as, say, Deutsche Bank in Germany.
The boards of publicly quoted companies consisted partly of members of the founding families, partly of salaried managers who were promoted to the board on the basis of their technical or administrative expertise. As for the relationship between listed companies and investors, this, too, was arm’s length in character. Boards of directors exercised considerable discretion over the assets at their disposal, subject to a series of Companies Acts which were designed to protect investors against fraud.
In 1920s the structure of British industry was changing, with the emergence of larger companies, often through merger; the creation in 1926 of Imperial Chemical Industries(ICI), formed out of four major chemical companies, was a notable example. These companies had larger demands for capital than their 19th century predecessors, and the flow of companies seeking a stock exchange listing increased; the number of domestic industrial and commercial companies listed in London reached 1712 in 1939, compared with 569 in 1907.
The increase in flotations by domestic companies created an opportunity for the merchant banks in the City to develop their corporate finance business, advising companies on capital-raising, and on mergers and acquisitions. In a few cases the merchant banks were represented on the boards of the companies they advised, but this was more because of personal connections than in any monitoring role on behalf of all shareholders. As the number of public issues increased, shares became a more popular form of investment, and ownership spread more widely.
Investors who had bought War Bonds during the First World War switched increasingly into corporate securities. Their main interest was in large British companies whose strong position in the domestic market offered some protection against the problems of the world economy. In 1926 ICI had 124,690 shareholders, Imperial Tobacco 94,690, and Courtaulds 59,940; the top five British banks had some 400,000 shareholders between them. Before the Second World War the largest institutional investors were the insurance companies.
They were joined after the war by pension funds, set up by companies and by public-sector organizations as a way of attracting and retaining employees. The typical occupational pension scheme consisted of a fund to which both employer and employee made contributions, and its purpose was to provide retired employees with a retirement income which bore some relation – usually one half or two thirds – to their salary immediately before retirement.
These arrangements were underpinned by a tax system which favored indirect investment by individuals in companies via financial institutions rather than direct share ownership. Pension premium paid by employers and employees were deductible for tax purposes up to certain limits, and the funds in which these premiums were invested were largely sheltered from taxation. The tax incentives channeling investment into financial institutions have historically been more generous in Britain than in other countries.
The increasing popularity of this form of long-term saving created a large pool of funds for investment. Initially the pension funds invested mainly in fixed-interest securities, as the insurance companies had done, but during the 1950s, as inflation rose and came to be seen as a permanent feature of the economy, pension fund managers began to switch into corporate equities. The growing demand for corporate securities was met by an increase in new issues. More companies went public, including some which had long been committed to continuing family ownership.
In 1970, for example, Pilkington, the glass maker which was then run by members of the fourth generation of the founding family, sold shares to the public for the first time; only 10 per cent of the equity was sold initially, but by the end of the decade the family holdings had been reduced to less than 20 per cent. The main reason for going public, according to Lord Pilkington, the chairman, was the effect of taxation on the financial position of family members. “Modern taxation makes it very difficult to either pass on the wealth you have accumulated or keep it in the company.
And without a public market for the stock death duties could place large individual shareholders in an impossible cash bind”. The market value of the commercial and industrial securities quoted on the London Stock Exchange rose from ? 5. 3bn to ? 18bn between 1950 and 1960. There was also a shift away from debentures paying a fixed return to ordinary shares. In 1950 56 % of the company securities issued was in the form of debt compared to 36 % in ordinary shares. Five years later the position had been reversed, with 65 % in ordinary shares.
By the early 1960s the insurance companies and pension funds, together with other institutional investors (principally unit trusts and investment trusts), owned about 29 % of all equities, and this proportion was to increase rapidly over the next two decades. The investments made by the institutions were spread widely among a number of companies, and in the early years their holdings in any one company rarely exceeded 5 per cent. Although this was often enough to make them the largest individual shareholders, they did not regard it as their business to interfere in the running of the company.
Only in cases of serious under-performance, as at BSA, the motor cycle manufacturer, in 1956, General Electric Company in 1959 and Vickers in 1969, did the institutions insist on a change in top management. In these and several other cases Prudential, the largest life assurance company, took the lead, often coordinating its activities with other institutional shareholders. The extent of intervention increased during the 1970s, partly in response to pressure from the Bank of England, which believed that the institutions should do more to improve the management of poorly performing companies.
All the four main investor groups – insurance companies, pension funds, investment trusts and unit trusts – set up investment protection committees (IPCs) which, in addition to dealing with matters of general interest to shareholders, such as non-voting shares, were also able to bring their influence to bear on individual companies. The principal challenge to incumbent management during this period came, not from institutional investors, but from a new breed of corporate predator.
These were the take-over bidders, led by Charles Clore, who saw that some companies were traded in the stock market at prices well below the underlying value of their assets; this was partly due to government-imposed dividend restraints, causing companies to accumulate cash which was earning a low return. By offering the shareholders of the company concerned a higher price (either in cash or in the shares of their own companies), they could win control of the business against the opposition of the board of directors.
The fact that the ownership of most publicly quoted companies was widely dispersed facilitated the bidder’s task. Another stimulus to take-over activity was the 1948 Companies Act, which obliged companies to make a fuller disclosure of their assets and profits. The hostile take-over was a new phenomenon, and the initial attitude of the authorities was suspicious. In the early 1950s the Bank of England discouraged banks and other financial institutions from lending to predators such as Clore; finance for takeovers was regarded as “speculation” and therefore undesirable.
However, the Bank’s ability to curb take-over activity was weakened at the end of the 1950s by the Conservative government’s decision to remove curbs on bank lending and to abolish the requirement for official consent for new issues. That the hostile take-over bid had become respectable was underlined at the end of 1961 when ICI launched an unsolicited bid for Courtaulds. Although the bid was successfully resisted, it was a sign that even large and conservatively run firms like ICI were willing to make use of the take-over weapon.
As the volume of take-over activity increased, merchant banks and other City institutions saw the need for a set of rules to ensure that bidders treated all shareholders fairly. The City Takeover Code was published in 1968, and the Takeover Panel, made up of City practitioners, was set up to police it. The creation of the Panel “served to protect the rights of shareholders from abuse, while in no way inhibiting the culture of takeover bids as a remedy for failure and a vehicle for change”. A commitment to worker control, or at least worker involvement, had long been a strand in Labour philosophy.
Some trade unionists looked enviously at co-determination in Germany, and when Labour returned to office in 1974, they renewed their efforts to install similar arrangements in Britain. In response the government set up a committee under Lord Bullock, an academic historian, to suggest ways of introducing worker democracy into British companies. In the event, the proposals put forward by the minority went much further than the business community would accept. The Bullock report “was attacked with one of the most vitriolic and damning campaigns ever mounted by Britain’s industrialists.
The government did publish a White Paper on industrial democracy in 1978 which considerably watered down the Bullock Committee’s proposals, but no legislation was introduced. In 1977 the Labour government, now headed by James Callaghan, appointed a committee under Harold Wilson, the former Prime Minister, to review the functioning of financial institutions – almost a re-run of the Macmillan Committee in the 1930s. The Wilson Report has been dismissed by historians as anodyne, but it did touch on one issue which was to become more prominent during the 1980s – the role and composition of boards of directors.
This subject had hit the headlines a few years earlier as a result of the Lonrho affair. Lonrho, a mining company with extensive interests in Africa, was dominated by an unusually powerful and idiosyncratic chief executive, R. W. Rowland. A financial crisis in the company in 1971 led to an investigation by a firm of accountants and the appointment of additional non-executive directors, with a view to keeping Rowland under tighter control. Boardroom dissension continued and in 1973 the anti-Rowland faction attempted to remove him from office.
However, Rowland enjoyed strong support from Lonrho shareholders; these were mainly private individuals, with very few institutions involved. At an extraordinary general meeting he secured an overwhelming majority for a resolution which confirmed him in office and dismissed the eight dissident directors. It was at this point that Edward Heath, the Prime Minister, made his famous comment that the goings-on at Lonrho constituted “the unpleasant and unacceptable face of capitalism”. 1 Developments since 1979
The Thatcher government’s central priority was to make markets work better and to reduce the role of the state in business. Two key elements in this programme, both of which had a profound effect on the financial system, were • The abolition of foreign exchange controls • Privatization The foreign exchange control system, which had been in operation since the start of the Second World War, restricted the ability of British investors to invest overseas, and partially insulated British financial markets from international competition.
The decision to abolish the system, taken soon after the election, was an important symbol of the new government’s approach to economic policy. Abolition meant that capital could flow easily into and out of the country. British companies would have access to a wider pool of savings, but they would also have to provide shareholders with returns that were at least comparable with those available in other countries. If the abolition of exchange controls marked a sharp break from the policies pursued by earlier post-war governments, so, too, did privatization.
The programme started modestly with the sale of part of the government’s holding in British Petroleum and continued with the privatization of several companies, including British Aerospace and Rolls-Royce, which had been nationalized by Labour in the 1960s and 1970s. The turning point was the decision, taken in 1982, to private British Telecommunications (BT); this had been the telecommunications arm of the Post Office, until it was separated in 1980, and had been in the public sector since before the First World War.
The Conservative governments of Margaret Thatcher and her successor, John Major, took a permissive attitude to these giant mergers, intervening only when they posed a clear threat to competition. They were equally relaxed about foreign acquisitions of British companies. Ministers argued that a policy of openness to foreign capital – whether in the form of takeovers or direct investment in new factories – was good for the economy. In finance as in other areas of the economy the government was determined to allow markets to work without hindrance.
At the same time the government was concerned to correct what it saw as market failures. One such failure concerned the financing of small and medium-sized firms. 1981 saw the launch of the Small Firms Loan Guarantee Scheme, designed to improve access to debt finance for firms which were viable but lacked a trading record or collateral; this was in line with the recommendations of the Wilson Committee. The government also sought to improve the supply of equity finance for high-growth entrepreneurial firms by stimulating what was in the early 1980s a small and under-developed venture capital industry.
To encourage financial institutions to invest in small, unquoted firms, two new schemes were introduced – Venture Capital Trusts and the Enterprise Investment Scheme – which offered up-front, tax relief on investment, as well as relief from capital taxation. The amount of capital raised by venture capital funds rose rapidly. If the supply of finance for small firms represented a market failure which required government intervention, the boom in share prices during the 1980s also exposed some serious regulatory failures.
Several ambitious entrepreneurs, with an ample supply of funds at their disposal, engaged in questionable practices which led to a number of well-publicized scandals. The rise and fall of Polly Peck, a fruit packing company built up by Asil Nadir, a Turkish businessman, has been described as “the most spectacular of all booms and busts in stock exchange history, going from practically zero to ? 1. 5bn in nine years and then (in 1990) back to zero in five weeks. Asil Nadir was charged with theft and false accounting. More shocking was the Robert Maxwell affair.
Having bought the Daily Mirror in 1984, Maxwell expanded his publishing group through a series of acquisitions and by the end of the decade his debts had reached unmanageable proportions. He died in mysterious circumstances in 1991, and soon afterwards it was revealed that he had looted the Daily Mirror pension fund to keep his empire afloat. The governance of companies became the subject of increasing interest given the concerns expressed about the standards of accountability and financial reporting of UK quoted companies.
As a result, a number of reports have subsequently been published which have attempted to improve the standard of governance in UK quoted companies. The reports, Cadbury (1992), Greenbury (1995) and Hampel (1998) called for greater transparency and accountability in areas such as board structure and operation, directors’ contracts and the establishment of board monitoring committees. They all also stressed the importance of the non-executive directors’ monitoring role.
Cadbury recommended that quoted companies should adopt a governance structure that complied with a specified set of criteria. The appropriate system was detailed in a Code of Best Practice. The inference to be drawn is that these governance structures should provide more effective monitoring of the board and the decision-making process. This in turn should improve performance because the monitoring mechanisms would ensure that shareholder interests were being promoted. The rest of report will discuss the various reports and discuss the corporate governance principles in UK. volution of corporate governance The development of corporate governance in the UK has its roots in a series of corporate collapses and scandals in the late 1980s and early 1990s, including the collapse of the BCCI bank and the Robert Maxwell pension funds scandal, both in 1991. 1 Cadbury Report (1992) As a result of public concern over the way in which companies were being run and fears concerning the type of abuse of power prevalent in the Maxwell case inter alia, corporate governance became the subject of discussion among policy makers.
The Cadbury Committee was established in May 1991 by the Financial Reporting Council, the London Stock Exchange, and the accountancy profession in response to the occurrence of financial scandals in the 1980’s involving UK listed Companies, which led to a fall in investor confidence in the quality of company’s financial reporting. In this sense the formation of the Cadbury Committee may be seen as reactive rather than proactive.
The Cadbury Report, formally entitled ‘The Report of the Committee on the Financial Aspects of Corporate Governance’ was published in December 1992, following the recommendations of the Cadbury Committee. However it is important to remember that the Cadbury Report was compiled on the basic assumption that the existing, implicit system of corporate governance system in the UK was sound and many of the recommendations were making explicit a good implicit system.
As such the Committee addressed the financial aspects of corporate governance and subsequently produced a Code of Best Practice, the provisions of which, in their belief, all boards of UK listed companies should comply with. Specifically, they recommended that listed companies should incorporate a formal statement into their Report and Accounts outlining whether or not they complied with each of the Code’s provisions. In respect of areas of non-compliance an explanation of the reason was sought.
Further to this, the Report recommended that the compliance statements made by the companies be reviewed by auditors prior to release of the Annual Report. The key focus of the provisions of the Code of Best Practice primarily related to the composition of the Board of Director’s, the appointment and independence of non-executive directors, the service contracts and remuneration of executive directors, and company’s financial reporting and controls. Some of the main recommendations made are as follows: There should be balance of power between board members such that no individual could gain unfettered control of the decision-making process • If the roles of the chairman and chief executive were not filled by two individuals, then a senior member of the board should be present who was independent • The majority of non-executive directors should be independent of management and free from any business or other relationship • Non-executive directors should be appointed for specified terms • Service contracts should not exceed three years Executive remuneration should be subject to the recommendations of a Remuneration Committee made up entirely or mainly of non-executive directors • An Audit Committee, comprising of at least three non-executive’s, should be established Following publication of the Code the London Stock Exchange introduced a requirement into the Listing Rules requesting all companies to include a statement of compliance, or non-compliance, with the provisions, in their annual Report and Accounts. Furthermore, institutional investors and Investment banks urged those listed companies for which they provided sponsorship and advice to adopt the provisions.
As a result many companies changed their governance procedures and conduct accordingly. The Cadbury Report focused attention on the board of directors as being the most important corporate governance mechanism, requiring constant monitoring and assessment. The focus on importance of institutional investors as the largest and most influential group of shareholders has had a lasting impact. 2 Greenbury Report (1995) During the 1990’s the issue of director’s remuneration was becoming a primary concern for investors and the public at large.
Specifically, the levels of remuneration of directors in privatized industries were rising and remuneration packages were failing to provide the necessary incentives for directors to perform better. Consequently, it was recognized that corporate governance issues relating to director’s remuneration needed to be addressed in a more rigorous manner. This led to the establishment of the Greenbury Committee. The Committee’s findings were documented in the Greenbury Report, which incorporated a Code of Best Practice on Director’s Remuneration. Specifically, four main issues were dealt with, as follows: The role of a Remuneration Committee in setting the remuneration packages for the CEO and other directors • The required level of disclosure needed by shareholders regarding details of directors remuneration and whether there is the need to obtain shareholder approval • Specific guidelines for determining a remuneration policy for directors; and • Service contracts and provisions binding the Company to pay compensation to a director, particularly in the event of dismissal for unsatisfactory performance As in the Cadbury Code, the Greenbury Code recommended The establishment of a Remuneration Committee, comprising entirely of non-executive directors, to determine the remuneration of the executive directors • The members of the remuneration committee should be listed in the annual committee report to the shareholders • The report should include full details of all elements in the remuneration package of each individual director by name • However, in terms of service contracts, Greenbury recommended a maximum notice period of 12 months rather than three years as suggested by Cadbury
Following publication, the recommendations of Greenbury were also taken on board by the London Stock Exchange and incorporated into the UK Listing Rules. However, unlike the Cadbury Code it was not widely accepted as many believed that the recommendations made did not sufficiently deal with the issue of linking directors pay to the Company’s performance in the interests of shareholders. 3 Hampel Report (1998) The Hampel Committee was established to review and revise the earlier recommendations of the Cadbury and Greenbury Committees.
The Final report emphasized principles of good governance rather than explicit rules in order to reduce the regulatory burden on companies and avoid ‘box-ticking’ so as to be flexible enough to be applicable to all companies. It was recognized that good corporate governance will largely depend on the particular situation of each company. This emphasis on principles would survive into the Combined Code. Hampel viewed governance from a strict principal/agent perspective regarding corporate governance as an opportunity to enhance long term shareholder value, which was asserted as the primary objective of the company.
This was a new development from the Cadbury and Greenbury Codes which had primarily focused on preventing the abuse of the discretionary authority entrusted to management. An important contribution made by the Hampel Report related to pension fund trustees, as pension funds are the largest group of investors. Pension fund trustees were targeted by the report as group who needed to take their corporate governance responsibilities seriously. In particular, the report favoured greater shareholder involvement in company affairs.
For example, while the report recommended that unrelated proposals should not be bundled under one resolution shareholders, particularly institutional shareholders, were expected to adopt a, ‘considered policy’ on voting. Another key advance was in the area of accountability and audit. The Board was identified as having responsibility to maintain a sound system of internal control, thereby safeguarding shareholders’ investments (although the Board was not required to report on the effectiveness of the controls).
Further, the Board was to be held accountable for all aspects of risk management, as opposed to just the financial controls as recommended by Cadbury. Hampel did not advance the debate on director’s remuneration, choosing only to reiterate principles inherent in Greenbury. In particular Hampel did not believe that directors’ remuneration should be a matter for shareholder approval in general meeting. This would not become a requirement until the introduction of The Directors’ Remuneration Report Regulations in 2002. Combined Code (1998) The Combined Code consolidated the principles and recommendations of the Cadbury, Greenbury and Hampel reports. It was formulated in 1998 and revised in 2003 following the publication of the Higgs report. The Code is divided into two sections: • The first outlines principles of best practice and their supporting provisions for companies • While the second does the same for shareholders While compliance with the Code is not mandatory, the Code was appended to the listing rules and listing rule.
It requires a statement by companies to provide shareholders with sufficient information to be able to assess the extent of compliance with section one of the Code. Instances of non-compliance should be justified to shareholders. Section one of the Code is comprehensive covering topics such as • The composition and operations of the Board • Directors’ remuneration • Relationships with shareholders • The supply of information • Accountability and audit
The fact that the Code has provided both principles and provisions has resulted in a Code that is powerful enough to effect specific recommendations and flexible enough to be applicable to most companies. Section two of the Code is much shorter, covering shareholder voting, dialogue with companies and the evaluation of governance disclosures. As institutional investors invest on behalf of the shareholders they represent they have a responsibility to hold the companies in which they invest to account.
In particular, the Code recognized that the responsibility for maintaining good dialogue and mutual understanding belongs to both companies and its institutional investors. Finally when evaluating the quality of governance disclosure by companies, institutional investors are to give due weight to all relevant factors. This is rather vague and the area has been recognized as a shortcoming of the Code, leading to membership associations of institutional investors having to produce guidance to its members on this area. Turnbull Report (1999) The Turnbull committee was established specifically to address the issue of internal control and to respond to these provisions in the combined code. The Turnbull guidance sets out best practice on internal control for UK listed companies, and assists them in applying section C. 2 of the Combined Code. The Turnbull report sought to provide an explicit framework for reference on which companies and boards could model their systems of internal control.
Even though many other countries are now focusing attention on the systems of internal control and corporate risk disclosure within their listed companies, few have established a specific policy or code of best practice dedicated to this issue. The aim was to provide a general guidance on how to develop and maintain internal control systems. 6 Myners: Review of Institutional Investment (2001) Paul Myners ‘Institutional Investment in the UK: A Review’ published in 2001, was commissioned by the Government, to consider whether there were factors distorting the investment decision-making of institutions.
Within the Report’s analysis, a number of problems with the current system are highlighted, in particular: • There are wholly unrealistic demands being made of pension fund trustees, whereby they are being expected to make crucial investment decisions without either the resources or the expertise needed • Consequently, there is too heavy a burden being placed on the investment consultants who advise the trustees to ensure the decisions made are correct • The job of asset allocation, the selection of which markets, as opposed to which individual stocks, to invest in, is under-resourced • There is a lack of clarity about objectives at a number of levels, for instance the objectives of Fund managers, when taken together, appear to bear little relation to the ultimate objective of the pension fund Overall therefore, the review concludes that the present structures used by the various types of institutional investors (for example pension funds and insurance companies) to make investment decisions lack both efficiency and flexibility, which often means that savers money is not being invested in ways which will maximize their interests.
In response to the problematic issues raised, Myners has outlined some basic principles of an effective approach to investment decision-making, which if adopted by pension funds and other institutional investors would likely result in an all round more efficient system. For example, he suggests Trustees should assess whether they have the right set of skills, both individually and collectively, and the right structures and processes to carry out their role effectively. They should draw up a forward-looking business plan. However, he stresses that making compliance to these provisions compulsory would not be the best approach; rather it would be more effective to take a similar stance to that of the Combined Code and proceeding reports.
Institutional investors would in that case either choose to adopt the recommendations of the Report, or if not publicly explain their reasons for not doing so. 7 Higgs Report (2003) Although the Cadbury Report and the Hampel Report stimulated substantial improvements in corporate governance in UK listed companies, certain areas have been highlighted for further examination. The fall of Enron spurred the UK and other countries into re-evaluating corporate governance issues, such as the role and effectiveness of non-executive directors. A report was published in 2003 following Derek Higgs’ report into the role of non-executive directors. The report recommended a number of changes to the Combined Code and a revision of the Code in July 2003 incorporated most of the Higgs recommendations.
The Report examined the role, independence and recruitment of non-executive directors. Higgs viewed the non-executive director’s role as: • Making contributions to corporate strategy • Monitoring the performance of executive management • Satisfying themselves regarding the effectiveness of internal control • Setting the remuneration of executive directors • Being involved in the nomination, removal and succession planning of senior management The Combined Code recommended that Boards should comprise of at least one-third non-executive directors, a majority of whom should be independent. However, the Code did not detail how to assess independence.
Therefore Higgs outlined a series of tests of independence such as • Length of service (10 years), associations to executive management • Financial interest or significant shareholding • In particular cross-directorships were identified as compromising independence, the simplest case being where two directors act as executive directors and non-executive directors alternatively at two companies However, in practice there may be a complicated network of inter-relationships known as, ‘an old boy’s club’ such that it remains difficult to externally determine a directors’ independence. With regard to recruitment, Higgs recommended stronger provisions governing nomination committees.
Higgs called for all listed companies to establish a nomination committee, chaired by an independent NED (not the Chairman) and comprising a majority of independent non-executive directors. However, it was recognized that the recommendations regarding non-executive directors would be harder for smaller companies to adopt. Other important recommendations of the Higgs report included: • Greater proportion of non-executive directors on the board • The Board should review its performance, the performance of its committees and individual directors at least once a year • The Company Secretary should be accountable to the Board through the Chairman on all governance matters • The terms of reference of the remuneration committee should be published 8 Smith Report (2003)
Following the major corporate failures in the US , the FRC was asked to set up an independent group to clarify the role and responsibilities of audit committees and to develop the existing Combined Code guidance. The role of audit committees in reinforcing the independence of the auditor was a major concern. Sir Robert Smith, Chairman of The Weir Group PLC and a member of the FRC, was invited to chair the group. The key points, to be reflected in the Combined Code and the detailed guidance, are: Composition of the audit committee: • Committee to include at least three members, all independent non-executive directors • At least one member to have significant, recent and relevant financial experience, and suitable training to be provided to all Role of the audit committee: To monitor the integrity of the financial statements of the company, reviewing significant financial reporting judgements • To review the company’s internal financial control system and, unless expressly addressed by a separate risk committee or by the board itself, risk management systems • To monitor and review the effectiveness of the company’s internal audit function • To make recommendations to the board in relation to the external auditor’s appointment; in the event of the board’s rejecting the recommendation, the committee and the board should explain their respective positions in the annual report • To monitor and review the external auditor’s independence, objectivity and effectiveness, taking into consideration relevant UK professional and regulatory requirements • To develop and implement policy on the engagement of the external auditor to supply non-audit services, taking into account relevant ethical guidance regarding the provision of non-audit services by the external audit firm In addition the Code will require that the committee should be provided with sufficient resources, that its activities should be reported in a separate section of the directors’ report (within the annual report) and that the chairman of the committee should be present to answer questions at the AGM. 9 Revised Combined Code (2003)
Following the Enron and WorldCom scandals in the US, the revised Combined Code, published in July 2003 was a direct result of the recommendations of the Higgs report outlined above and also the Smith review concerning Audit Committees. As with the 1998 Combined Code, companies are required to report on their compliance against the Code and should explain areas of non-compliance. The revised Combined Code is effective for Companies with financial years starting on or after 1 November 2003. The new Code amounts to a significant revision of the 1998 Code. In particular the Code calls for: • A separation of the roles of the Chairman and Chief Executive. The Chairman should satisfy the criteria for independence on appointment, but should not, thereafter, be considered independent when assessing the balance of board membership • A Board of at least half independent NEDs.
The Code defines independence as recommended by the Higgs Report • Candidates for Board selection to be drawn from a wider pool • the Board, its committees and directors to be subject to an annual performance review • at least one member of the audit committee to have recent and relevant financial experience • In contrast to the Higgs Report, the revised Code permits the Chairman to chair the nominations committee, except where the committee is considering the appointment of the chairman’s successor 10 Myners Report (2004) Paul Myners ‘Review of the impediments to voting UK shares,’ published in January 2004 for the Shareholder Voting Working Group, a network of investment industry and corporate bodies, was produced in response to the need to address concerns, ‘that the system for voting the shares of UK issuers is not as effective and efficient as it should be. Specifically, as stated in the Report, problems have arisen from the fact that the, ‘process…is still quite manually intensive…the chain of accountability is complex…there is a lack of transparency and…there is a large number of different participants, each of whom may give a different priority to voting. ’ While he states that if the existing paper-based system, which has a number of structural weaknesses, were to be, ‘overhauled and upgraded,’ it would lead to improvements being seen, his overriding conclusion is that, ‘electronic voting remains the key to a more efficient voting system, and all parties – issuers, institutional investors and the intermediaries – need to make conscious efforts to introduce electronic voting capabilities in 2004. ’ Further to this he recommends that, ‘issuers in at least the FTSE 350, nvestment managers, custodians and proxy voting agencies should all have introduced the necessary system changes so that electronic voting capabilities are universally available (and) that beneficial owners…make direct and specific enquiries of their agents and others to establish the extent to which they have, or will have, introduced electronic voting capabilities to be used this year. ’ 11 Financial Reporting Council In 2003 the UK Government confirmed that the Financial Reporting Council (FRC) was to have the responsibility for publishing and maintaining the Code. The FRC made further, limited, changes to the Code in 2006 and in 2008. Throughout all of these changes, the ‘comply or explain’ approach first set out in the Cadbury Report has been retained. Corporate Governance in UK TODAY United Kingdom company law is governed by the Companies Act 2006 which came into force, in its entirety, on 1 October 2009.
The Insolvency Act 1986, the Company Directors Disqualification Act 1986 are also important statutes. It applies across the United Kingdom, and is highly influential within Europe and around the world. The combined code is the driving factor behind corporate governance in UK. 1 The rationale behind the UK approach The UK approach starts from the position that good governance is a tool that can improve the board’s ability to manage the company effectively as well as provide accountability to shareholders. To quote from the Cadbury Report: “The effectiveness with which boards discharge their responsibilities determines Britain’s competitive position.
They must be free to drive their companies forward, but exercise that freedom within a framework of effective accountability. This is the essence of any system of good corporate governance. ” A regulatory framework that aims to improve standards of corporate governance is more likely to succeed, and be accepted by those that it regulates, if it recognizes that governance should support, not constrain, the entrepreneurial leadership of the company, while ensuring risk is properly managed. Governance must also work to the benefit of the shareholders by improving the long-term value of the company. This requires a degree of flexibility in the way companies adopt and adapt governance practices.
To be effective good governance needs to be implemented in a way that fits the culture and organization of the individual company. This can vary enormously from company to company depending on factors such as size, ownership structure and the complexity of the business model. The assessment of whether the company’s governance practices are effective should be made by the intended beneficiaries – i. e. the shareholders. Investors can take a pragmatic approach about how to apply best practice in a way that is in the best interests of the company. This is in contrast to regulators, who find it more difficult to allow exceptions as they must be seen to be applying the rules consistently. 2 The UK regulatory framework
The UK has developed a market-based approach that enables the board to retain flexibility in the way in which it organizes itself and exercises its responsibilities, while ensuring that it is properly accountable to its shareholders. This is done primarily through the Combined Code on Corporate Governance which operates on the basis of ‘comply or explain’. The Combined Code identifies good governance practices relating to, for example, the role and composition of the board and its committees and the development of a sound system of internal control, but companies can choose to adopt a different approach if that is more appropriate to their circumstances. Where they do so, however, they are required to explain the reason to their shareholders who must decide whether they are content with the approach that has been taken.
This ‘comply or explain’ approach enables judgements about, for example, the independence of non-executive directors, to be made on a case by case basis. It is supported by companies, investors and regulators in the UK, and has increasingly been adopted as a model in other financial markets. For the system to work effectively shareholders need to have appropriate and relevant information to enable them to make a judgement on the governance practices of the companies in which they invest. They also need the rights to enable them to influence the behaviour of the board when they are not content. ‘Comply or explain’ therefore needs to be underpinned by an appropriate regulatory framework.
Under UK company law, shareholders have comparatively extensive voting rights, including the rights to appoint and dismiss individual directors and, in certain circumstances, to call an Extraordinary General Meeting of the company. Certain requirements relating to the AGM, including the provision of information to shareholders and arrangements for voting on resolutions, are also set out in company law, as are some requirements for information to be disclosed in the annual report and accounts. These include requirements for a Business Review (in which the board sets out, inter alia, a description of the principal risks and uncertainties facing the company) and a report on directors’ remuneration, on which shareholders have an advisory vote.
This framework is reinforced by the Listing Rules that must be followed by companies listed on the Main Market of the London Stock Exchange. The Listing Rules provide further rights to shareholders (for example, by requiring that major transactions are put to a vote), and require certain information to be disclosed to the market. This includes the requirement to provide a ‘comply or explain’ statement in the annual report explaining how the company has applied the Combined Code (or, in the case of companies incorporated outside the UK, to describe how the companies’ governance practices differ from those set out in the Code). 3 The essential features of UK corporate governance 1 The role and composition of the board A single board with members collectively responsible for leading the company and setting its values and standards • A clear division of responsibilities for running the board and running the company with a separate chairman and chief executive • A balance of executive and independent non-executive directors – for larger companies at least 50% of the board members should be independent non-executive directors; smaller companies should have at least two independent directors • Formal and transparent procedures for appointing directors, with all appointments and re-appointments to be ratified by shareholders • Regular evaluation of the effectiveness of the board and its committees 2 Remuneration • Formal and transparent procedures for setting executive remuneration, including a remuneration committee made up of independent directors and an advisory vote for shareholders • A significant proportion of remuneration to be linked to performance Accountability and Audit • The board is responsible for presenting a balanced assessment of the company’s position (including through the accounts), and maintaining a sound system of internal control • Formal and transparent procedures for carrying out these responsibilities, including an audit committee made up of independent directors and with the necessary experience • Emphasis on corporate risk disclosure • Ensure auditor independence 4 Relations with shareholders • The board must maintain contact with shareholders to understand their opinions and concerns • Separate resolutions on all substantial issues at general meetings 5 Transparency Transparency is an essential element of a well-functioning system of corporate governance. • Corporate disclosure is the principal means by which companies can become transparent • Disclosure refers to o Operating and Financial Review (OFR) o Profit and Loss Account, Balance Sheet, Cash Flow Statement o Corporate communications like Management Forecasts, Analysts’ Presentations, Annual General Meetings (AGM), Press Releases etc. , o Information on company websites The Combined Code The Combined Code on Corporate Governance sets out standards of good practice in relation to issues such as board composition and development, remuneration, accountability and audit and relations with shareholders.
All companies incorporated in the UK and listed on the Main Market of the London Stock Exchange are required under the Listing Rules to report on how they have applied the Combined Code in their annual report and accounts. Overseas companies listed on the Main Market are required to disclose the significant ways in which their corporate governance practices differ from those set out in the Code. From April 2009, under the FSA’s revised Listing Regime, all companies with a Premium Listing will be required to report on how they have applied the Code regardless of their country of incorporation. The Combined Code contains broad principles and more specific provisions. Listed companies are required to report on how they have applied the main rinciples of the Code, and either to confirm that they have complied with the Code’s provisions or – where they have not – to provide an explanation. 1 Directors 1 The Board Every company should be headed by an effective board, which is collectively responsible for the success of the company. • A. 1. 1 The board should meet sufficiently regularly to discharge its duties effectively. There should be a formal schedule of matters specifically reserved for its decision. The annual report should include a statement of how the board operates, including a high level statement of which types of decisions are to be taken by the board and which are to be delegated to management. • A. 1. The annual report should identify the chairman, the deputy chairman (where there is one), the chief executive, the senior independent director and the chairmen and members of the nomination, audit and remuneration committees. It should also set out the number of meetings of the board and those committees and individual attendance by directors. • A. 1. 3 The chairman should hold meetings with the non-executive directors without the executives present. Led by the senior independent director, the non-executive directors should meet without the chairman present at least annually to appraise the chairman’s performance (as described in A. 6. 1) and on such other occasions as are deemed appropriate. • A. 1. Where directors have concerns which cannot be resolved about the running of the company or a proposed action, they should ensure that their concerns are recorded in the board minutes. On resignation, a non executive director should provide a written statement to the chairman, for circulation to the board, if they have any such concerns. • A. 1. 5 The Company should arrange appropriate insurance cover in respect of legal action against its directors. 2 Chairman and Chief Executive There should be a clear division of responsibilities at the head of the company between the running of the board and the executive responsibility for the running of the company’s business. No one individual should have unfettered powers of decision. • A. 2. The roles of chairman and chief executive should not be exercised by the same individual. The division of responsibilities between the chairman and chief executive should be clearly established, set out in writing and agreed by the board. • A. 2. 2 The chairman should on appointment meet the independence criteria set out in A. 3. 1 below. A chief executive should not go on to be chairman of the same company. If exceptionally a board decides that a chief executive should become chairman, the board should consult major shareholders in advance and should set out its reasons to shareholders at the time of the appointment and in the next annual report. 3 Board Balance and Independence
The board should include a balance of executive and non-executive directors (and in particular independent non-executive directors) such that no individual or small group of individuals can dominate the board’s decision taking. • A. 3. 1 The board should identify in the annual report each non-executive director it considers to be independent3. The board should determine whether the director is independent in character and judgement and whether there are relationships or circumstances which are likely to affect, or could appear to affect, the director’s judgement. • A. 3. 2 Except for smaller companies, at least half the board, excluding the chairman, should comprise non-executive directors determined by the board to be independent.
A smaller company should have at least two independent non-executive directors. • A. 3. 3 The board should appoint one of the independent non-executive directors to be the senior independent director. The senior independent director should be available to shareholders if they have concerns which contact through the normal channels of chairman, chief executive or finance director has failed to resolve or for which such contact is inappropriate. 4 Appointments to the Board There should be a formal, rigorous and transparent procedure for the appointment of new directors to the board. • A. 4. 1 There should be a nomination committee which should lead the process for board appointments and make recommendations to the board.
A majority of members of the nomination committee should be independent non-executive directors. The chairman or an independent non-executive director should chair the committee, but the chairman should not chair the nomination committee when it is dealing with the appointment of a successor to the chairmanship. The nomination committee should make available its terms of reference, explaining its role and the authority delegated to it by the board. • A. 4. 2 The nomination committee should evaluate the balance of skills, knowledge and experience on the board and, in the light of this evaluation, prepare a description of the role and capabilities required for a particular appointment. • A. 4. For the appointment of a chairman, the nomination committee should prepare a job specification, including an assessment of the time commitment expected, recognising the need for availability in the event of crises. A chairman’s other significant commitments should be disclosed to the board before appointment and included in the annual report. Changes to such commitments should be reported to the board as they arise, and their impact explained in the next annual report. • A. 4. 4 The terms and conditions of appointment of non-executive directors should be made available for inspection. The letter of appointment should set out the expected time commitment. Non-executive directors should undertake that they will have sufficient time to meet what is expected of them.
Their other significant commitments should be disclosed to the board before appointment, with a broad indication of the time involved and the board should be informed of subsequent changes. • A. 4. 5 The board should not agree to a full time executive director taking on more than one non-executive directorship in a FTSE 100 company nor the chairmanship of such a company. • A. 4. 6 A separate section of the annual report should describe the work of the nomination committee, including the process it has used in relation to board appointments. An explanation should be given if neither an external search consultancy nor open advertising has been used in the appointment of a chairman or a non-executive director. 5 Information and Professional Development
The board should be supplied in a timely manner with information in a form and of a quality appropriate to enable it to discharge its duties. All directors should receive induction on joining the board and should regularly update and refresh their skills and knowledge. • A. 5. 1 The chairman should ensure that new directors receive a full, formal and tailored induction on joining the board. As part of this, the company should offer to major shareholders the opportunity to meet a new non executive director. • A. 5. 2 The board should ensure that directors, especially non-executive directors, have access to independent professional advice at the company’s expense where they judge it necessary to discharge their responsibilities as directors.
Committees should be provided with sufficient resources to undertake their duties. • A. 5. 3 All directors should have access to the advice and services of the company secretary, who is responsible to the board for ensuring that board procedures are complied with. Both the appointment and removal of the company secretary should be a matter for the board as a whole. 6 Performance Evaluation The board should undertake a formal and rigorous annual evaluation of its own performance and that of its committees and individual directors. • A. 6. 1 The board should state in the annual report how performance evaluation of the board, its committees and its individual directors has been conducted.
The non-executive directors, led by the senior independent director, should be responsible for performance evaluation of the chairman, taking into account the views of executive directors. 7 Re-election All directors should be submitted for re-election at regular intervals, subject to continued satisfactory performance. The board should ensure planned and progressive refreshing of the board. • A. 7. 1 All directors should be subject to election by shareholders at the first annual general meeting after their appointment, and to re-election thereafter at intervals of no more than three years. The names of directors submitted for election or re-election should be accompanied by sufficient biographical details and any other relevant information to enable shareholders to take an informed decision on their election. • A. 7. Non-executive directors should be appointed for specified terms subject to re-election and to Companies Acts provisions relating to the removal of a director. The board should set out to shareholders in the papers accompanying a resolution to elect a non-executive director why they believe an individual should be elected. The chairman should confirm to shareholders when proposing re-election that, following formal performance evaluation, the individual’s performance continues to be effective and to demonstrate commitment to the role. Any term beyond six years (e. g. two three-year terms) for a non-executive director should be subject to particularly rigorous review, and should take into account the need for progressive refreshing of the board.
Non-executive directors may serve longer than nine years (e. g. three three-year terms), subject to annual re-election. Serving more than nine years could be relevant to the determination of a non-executive director’s independence (as set out in provision A. 3. 1). 2 Remuneration 1 The Level and Make-up of Remuneration Levels of remuneration should be sufficient to attract, retain and motivate directors of the quality required to run the company successfully, but a company should avoid paying more than is necessary for this purpose. A significant proportion of executive directors’ remuneration should be structured so as to link rewards to corporate and individual performance. • B. 1. The performance-related elements of remuneration should form a significant proportion of the total remuneration package of executive directors and should be designed to align their interests with those of shareholders and to give these directors keen incentives to perform at the highest levels. In designing schemes of performance-related remuneration, the remuneration committee should follow the provisions in Schedule A to this Code. • B. 1. 2 Executive share options should not be offered at a discount save as permitted by the relevant provisions of the Listing Rules. • B. 1. 3 Levels of remuneration for non-executive directors should reflect the time commitment and responsibilities of the role.
Remuneration for non executive directors should not include share options. If, exceptionally, options are granted, shareholder approval should be sought in advance and any shares acquired by exercise of the options should be held until at least one year after the non-executive director leaves the board. Holding of share options could be relevant to the determination of a non-executive director’s independence (as set out in provision A. 3. 1). • B. 1. 4 Where a company releases an executive director to serve as a non executive director elsewhere, the remuneration report8 should include a statement as to whether or not the director will retain such earnings and, if so, what the remuneration is. • B. 1. The remuneration committee should carefully consider what compensation commitments (including pension contributions and all other elements) their directors’ terms of appointment would entail in the event of early termination. The aim should be to avoid rewarding poor performance. They should take a robust line on reducing compensation to reflect departing directors’ obligations to mitigate loss. • B. 1. 6 Notice or contract periods should be set at one year or less. If it is necessary to offer longer notice or contract periods to new directors recruited from outside, such periods should reduce to one year or less after the initial period. 2 Procedure There should be a formal and transparent procedure for developing policy on executive remuneration and for fixing the remuneration packages of individual directors.
No director should be involved in deciding his or her own remuneration. • B. 2. 1 The board should establish a remuneration committee of at least three, or in the case of smaller companies’ two, independent non-executive directors. In addition the company chairman may also be a member of, but not chair, the committee if he or she was considered independent on appointment as chairman. The remuneration committee should make available its terms of reference, explaining its role and the authority delegated to it by the board. Where remuneration consultants are appointed, a statement should be made available of whether they have any other connection with the company. • B. 2. The remuneration committee should have delegated responsibility for setting remuneration for all executive directors and the chairman, including pension rights and any compensation payments. The committee should also recommend and monitor the level and structure of remuneration for senior management. The definition of ‘senior management’ for this purpose should be determined by the board but should normally include the first layer of management below board level. • B. 2. 3 The board itself or, where required by the Articles of Association, the shareholders should determine the remuneration of the non-executive directors within the limits set in the Ar
