The UK Corporate Governance Code – Is it still ‘Fit for Purpose’?

This is not a rhetorical question. Has the Code become yet another interesting, but now out-dated, artefact that has failed to evolve and consequently is becoming increasingly irrelevant? When the Cadbury Committee produced the first version of the Code, in 1992, it was rightly seen as a seminal event in UK Corporate Governance. Twenty-five years ago the Committee produced what was then considered the classic definition of Corporate Governance:

Corporate governance is the system by which companies are directed and controlled. Boards of directors are responsible for the governance of their companies. The shareholders’ role in governance is to appoint the directors and the auditors and to satisfy themselves that an appropriate governance structure is in place. The responsibilities of the board include setting the company’s strategic aims, providing the leadership to put them into effect, supervising the management of the business and reporting to shareholders on their stewardship. The board’s actions are subject to laws, regulations and the shareholders in general meeting.

The Financial Reporting Council (FRC) still considers this the ‘classic definition’, but is it? Take the very first sentence; seemingly corporate governance is a matter for companies, which might be perceived as unnecessarily restrictive. The FRC has made the Code yet more restrictive by taking the position that it only applies to companies with a ‘Premium listing of equity shares’. It seems to me that this excludes the vast majority of organisations in the UK, including, amongst others:

NHS Trusts; Charities; Companies Limited by Guarantee; Limited Liability Partnerships; and, Private Limited Companies.

Is there any good reason why the Code is so restrictive? If, as is often asserted, it is principles-based then why should its scope not be more inclusive? On the face of it, it would seem that simply replacing company with organisation might be a sensible starting point if we want to encourage greater inclusivity.

The same (first) sentence states that, “Boards of directors are responsible for the governance of their companies.” The Board must be accountable for the governance of their organisation and that accountability cannot be delegated, but is there an argument for saying that all an organisation’s people have some responsibility for promoting and maintaining good governance in the organisation?

The shareholders’ (stakeholders’) role includes a responsibility to, “satisfy themselves that an appropriate governance structure is in place.” Does ‘appropriate’ automatically equate to ‘effective’? I suspect that responsible shareholders, those who take their stewardship role seriously, may take the view that they want an organisation’s corporate governance, above all, to be effective; if that over-arching objective is achieved it suggests that the processes, structure and systems are indeed appropriate.

I am coming to the view that the Code is now more concerned with compliance than governance, which are clearly not the same. Of course the board’s actions are subject to laws and regulations, but that is compliance not governance. By the same token, I am at something of a loss to understand the relevance of accounting periods to the application of a principles-based approach to effective corporate governance. Either an organisation does, or does not, apply the principles of effective governance; procedures, processes, structure and systems should be secondary.

Is part of the problem a direct consequence of the FRC’s rather limited mandate and the restrictions evident in that mandate?

The FRC is responsible for promoting high quality corporate governance and reporting to foster investment. We set the UK Corporate Governance and Stewardship Codes as well as UK standards

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for accounting, auditing and actuarial work. We represent UK interests in international standard-setting. We also monitor and take action to promote the quality of corporate reporting and auditing. We operate independent disciplinary arrangements for accountants and actuaries, and oversee the regulatory activities of the accountancy and actuarial professional bodies.

Part of the FRC’s responsibility is to foster investment. This, by implication, excludes many, perhaps most, organisations in the UK. It also appears that the FRC is rather more focused on compliance than governance. The concentration on matters financial, whilst understandable for an organisation like the FRC, is hardly holistic and actually runs counter to recent research evidence that shows that an organisation’s culture, its values, behaviours, ethics and its human capital are at least as important, if not more so when it comes to effective corporate governance, than financial issues.

In its Preface to the Code, the FRC asserts that the Code has contributed to improved corporate governance in the UK, which sounds suspiciously like hubris. The Code may well have contributed to improved corporate governance in a rather small number of organisations in the UK; what about the rest?

The preface does make some valid points that are suggestive of a shift towards a more holistic approach to governance and well worth mentioning, “One of the ways in which constructive debate can be encouraged is through having sufficient diversity on the board.” The Code does not fall into the trap of regarding diversity solely as matters of gender and race. It goes on to say that, “Diversity is as much about differences of approach and experience, and it is very important in ensuring effective engagement with key stakeholders and in order to deliver the business strategy.” If the principle that Corporate Governance is about improving board and organisational performance and sustainability is accepted then it must also be accepted that increased diversity should only be encouraged if there is real evidence that it improves board and organisational performance. There is real evidence that differences of approach and experience can add value to a board. There is also a growing body of evidence that greater gender diversity can also add significant value, not least because it brings a different mindset to the board. Whether, or not, increased racial diversity has a positive impact on board performance is less certain. The over-arching principle must surely be that board appointments are made on the basis of merit, not to satisfy some ideological objective.

The preface is unequivocal on another key issue, “One of the key roles for the board includes establishing the culture, values and ethics of the company. It is important that the board sets the correct ‘tone from the top’. The directors should lead by example and ensure that good standards of behaviour permeate throughout all levels of the organisation. This will help prevent misconduct, unethical practices and support the delivery of long-term success.” Unfortunately, this is one of the few occasions when this ‘key role’ of the board gets a mention. Some observers may be forgiven that this statement is redolent of the phrase often found in a Chairman’s opening remarks in the annual report, “Our people are our most important asset”. The key message is surely that all board members must ‘walk the talk’; they must be exemplars of the organisation’s values, behaviours and ethics.

The preface also refers to the fact that running a corporate board successfully should not be under-rated. True, as far as it goes, but why restrict it to running a ‘corporate’ board? Running any board is demanding and the board of a company limited by guarantee, a private limited company (e.g. an SME), or a trust, very often lacks the resources that are readily available to a corporate board.

A final point on the preface and one that I consider to be fundamental: The preface states, “Chairmen are encouraged to report personally in their annual statements how the principles relating to the role and effectiveness of the board have been applied. Not only will this give investors a clearer picture of the steps taken by boards to operate effectively but also, by providing fuller context, it may make investors more willing to accept explanations when a company chooses to explain rather than to comply with one or more provisions.” The ‘Comply or Explain’ approach has been central to the operation of the Code since its beginnings and it may well still be appropriate to the ‘provisions’ of the Code. Some, indeed many, of the provisions may not be appropriate to all organisations, however the ‘principles’ contained within the Code should be both relevant and applicable to all organisations irrespective of their structure. It follows that I am inclined to the view that it may now be time to consider ‘Comply and Explain’, an approach first proposed by the King Committee; comply with the principles and explain why some, or all, of the provisions are not appropriate. This immediately creates significant problems. As currently drafted, the ‘Code’:

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Is too focussed (almost exclusively so) on listed companies;Because of its exclusivity, actually encourages the current and arguably unhelpful proliferation of widely differing approaches to corporate governance;Is more about detailed process and systems than providing general guiding principles that can/should be applicable to all organisations; and,

Focuses almost exclusively and contrary to the wording contained in the preface (One of the key roles for the board includes establishing the culture, values and ethics of the company) on financial issues to the exclusion of:

o Organisation culture;o Values, behaviours, and ethics; and,o The organisation’s intangible assets, not least its human capital.

The principles, together with some suggested amendments, are outlined below:

LeadershipEvery company should be headed by an effective board which is collectively responsible for the long-term success of the company.

This sounds good, but it is rather exclusive. Why only companies, why not replace ‘company’ with ‘organisation’? Board can be considered a generic term that could include: a Trust board; the elected Committee of an association/institution/society.

The board’s role is to provide entrepreneurial leadership of the company within a framework of prudent and effective controls which enables risk to be assessed and managed. The board should set the company’s strategic aims, ensure that the necessary financial and human resources are in place for the company to meet its objectives and review management performance. The board should set the company’s values and standards and ensure that its obligations to its shareholders and others are understood and met.

A minor point, but why not replace ‘shareholders’ with ‘members’, or ‘stakeholders’? Companies limited by guarantee, trusts, associations, et cetera, generally have members rather than shareholders.

All directors must act in what they consider to be the best interests of the company, consistent with their statutory duties.

Substituting ‘organisation’ for ‘company’ would make it far more inclusive.

Division of ResponsibilitiesThere 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.

Clear and to the point, but why not substitute ‘organisation’ for ‘company’?

ProvisionThe 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.

Obviously a problem for many SME’s and other organisations, but the fundamental principle (No one individual should have unfettered powers of decision) seems entirely appropriate to all organisations.

The ChairmanThe chairman is responsible for leadership of the board and ensuring its effectiveness on all aspects of its role.

The chairman is responsible for setting the board’s agenda and ensuring that adequate time is available for discussion of all agenda items, in particular strategic issues. The chairman should also promote a culture of openness and debate by facilitating the effective contribution of non-executive directors in particular and

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ensuring constructive relations between executive and non-executive directors.

The reference to “strategic issues” is perhaps a little odd. The board is responsible for the direction and government of the organisation; that being the case, why would non-strategic issues appear on the agenda?

The chairman is responsible for ensuring that the directors receive accurate, timely and clear information. The chairman should ensure effective communication with shareholders.

Substituting ‘stakeholders’ for ‘shareholders’ might be conducive to a less restrictive application of the Code.

Non-Executive DirectorsAs part of their role as members of a unitary board, non-executive directors should constructively challenge and help develop proposals on strategy.

Why just a “unitary board”? “Help” sounds a bit like a ‘weasel word’, “actively contribute to the development of…” sounds more positive.

Non-executive directors should scrutinise the performance of management in meeting agreed goals and objectives and monitor the reporting of performance. They should satisfy themselves on the integrity of financial information and that financial controls and systems of risk management are robust and defensible. They are responsible for determining appropriate levels of remuneration of executive directors and have a prime role in appointing and, where necessary, removing executive directors, and in succession planning.

No mention here of promoting the organisation’s values, behaviours and ethics.

Effectiveness

The Composition of the BoardThe board and its committees should have the appropriate balance of skills, experience, independence and knowledge of the company to enable them to discharge their respective duties and responsibilities effectively.

The board should be of sufficient size that the requirements of the business can be met and that changes to the board’s composition and that of its committees can be managed without undue disruption, and should not be so large as to be unwieldy.

The board should include an appropriate combination 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.

The value of ensuring that committee membership is refreshed and that undue reliance is not placed on particular individuals should be taken into account in deciding chairmanship and membership of committees.

No one other than the committee chairman and members is entitled to be present at a meeting of the nomination, audit or remuneration committee, but others may attend at the invitation of the committee.

This last point is, by implication, quite restrictive in that many organisations neither need, nor can afford, the expense of such committees.

Appointments to the BoardThere should be a formal, rigorous and transparent procedure for the appointment of new directors to the board.

The search for board candidates should be conducted, and appointments made, on merit, against objective criteria and with due regard for the benefits of diversity on the board, including gender.

This is clearly crucial, but the over-riding question should be, “Will this appointment enhance/improve board performance?” Diversity is all too often restricted to ethnicity and gender, with diversity of experience

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and opinion sacrificed on the altar of ‘political correctness’.

CommitmentAll directors should be able to allocate sufficient time to the company to discharge their responsibilities effectively.

DevelopmentAll directors should receive induction on joining the board and should regularly update and refresh their skills and knowledge.

The chairman should ensure that the directors continually update their skills and the knowledge and familiarity with the company required to fulfill their role both on the board and on board committees. The company should provide the necessary resources for developing and updating its directors’ knowledge and capabilities.

The last sentence raises an interesting point. The organisation should, as far as is practicable, provide the resources, but is this not a shared responsibility? Do not directors have a personal responsibility for developing and updating their knowledge and capabilities?

Information and SupportThe 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.

The chairman is responsible for ensuring that the directors receive accurate, timely and clear information. Management has an obligation to provide such information but directors should seek clarification or amplification where necessary.

Under the direction of the chairman, the company secretary’s responsibilities include ensuring good information flows within the board and its committees and between senior management and non-executive directors, as well as facilitating induction and assisting with professional development as required.

The company secretary should be responsible for advising the board through the chairman on all governance matters.

Many organisations do not have a company secretary and, even where they do, governance is surely a matter for the board as a whole, not for the company secretary. Where the post exists, the company secretary’s role is to advise on all compliance issues, not on all governance issues.

EvaluationThe board should undertake a formal and rigorous annual evaluation of its own performance and that of its committees and individual directors.

Evaluation of the board should consider the balance of skills, experience, independence and knowledge of the company on the board, its diversity, including gender, how the board works together as a unit, and other factors relevant to its effectiveness.

Diversity perhaps, but why even mention gender?

The chairman should act on the results of the performance evaluation by recognising the strengths and addressing the weaknesses of the board and, where appropriate, proposing new members be appointed to the board or seeking the resignation of directors.

Individual evaluation should aim to show whether each director continues to contribute effectively and to demonstrate commitment to the role (including commitment of time for board and committee meetings and any other duties).

Re-electionAll directors should be submitted for re-election at regular intervals, subject to continued satisfactory

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performance.

Accountability

Financial and Business ReportingThe board should present a fair, balanced and understandable assessment of the company’s position and prospects.

The board’s responsibility to present a fair, balanced and understandable assessment extends to interim and other price-sensitive public reports and reports to regulators as well as to information required to be presented by statutory requirements.

The board should establish arrangements that will enable it to ensure that the information presented is fair, balanced and understandable.

I can see little merit in the ‘supporting principles’, the main principle is quite explicit.

Risk Management and Internal ControlThe board is responsible for determining the nature and extent of the principal risks it is willing to take in achieving its strategic objectives. The board should maintain sound risk management and internal control systems.

Unfortunately, there is no mention of ‘People Risk’.

Audit Committee and AuditorsThe board should establish formal and transparent arrangements for considering how they should apply the corporate reporting and risk management and internal control principles and for maintaining an appropriate relationship with the company’s auditors.

The board should satisfy itself that at least one member of the audit committee has recent and relevant financial experience.

It is disappointing, but unsurprising, that the FRC focuses exclusively on matters financial. An organisation’s greatest potential risks lie with its people.

RemunerationExecutive directors’ remuneration should be designed to promote the long-term success of the company. Performance-related elements should be transparent, stretching and rigorously applied.

The remuneration committee should judge where to position their company relative to other companies. But they should use such comparisons with caution, in view of the risk of an upward ratchet of remuneration levels with no corresponding improvement in corporate and individual performance, and should avoid paying more than is necessary.

They should also be sensitive to pay and employment conditions elsewhere in the group, especially when determining annual salary increases.

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.

The remuneration committee should take care to recognise and manage conflicts of interest when receiving views from executive directors or senior management, or consulting the chief executive about its proposals. The remuneration committee should also be responsible for appointing any consultants in respect of executive director remuneration.

The chairman of the board should ensure that the committee chairman maintains contact as required with its

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principal shareholders about remuneration.

This last point is surely implicit in ‘Relations with Shareholders’

Relations with shareholders

Dialogue with ShareholdersThere should be a dialogue with shareholders based on the mutual understanding of objectives. The board as a whole has responsibility for ensuring that a satisfactory dialogue with shareholders takes place.

If the words ‘regular and constructive’ are inserted immediately before ‘dialogue’ then the supporting principles become superfluous.

Whilst recognising that most shareholder contact is with the chief executive and finance director, the chairman should ensure that all directors are made aware of their major shareholders’ issues and concerns.

The board should keep in touch with shareholder opinion in whatever ways are most practical and efficient.

Constructive Use of General MeetingsThe board should use general meetings to communicate with investors and to encourage their participation.

This assumes, again, that an organisation has investors/shareholders, which may not be the case. ‘Stakeholders’ might be more appropriate.

© Robert Purse 2017