Compliance vs Culture

The fit and proper test for executives may be imperfect but for good and bad, corporate culture will always win over compliance

Following Nigel's article on stewardship yesterday, it is interesting to read Andrew Hill's blog post in the FT today (25 September) on the "fit and proper" test for executives. Andrew highlights the difficulties and highly subjective nature of the standard way of evaluating business leaders' suitability for office.

As I read, it reminded me of a paper by the Institute of Chartered Accountants in England and Wales (ICAEW) on the fundamental - but often unappreciated - difference between UK and US law and so corporate governance initiatives. The world seems to believe in the existence and spread of some Anglo-American model and although there are clearly similarities, including the unitary board structure, these tend to be more cultural than legal and even there, a distinct legal framework has inevitably led to differences in corporate culture as well.

While that will be the subject of a future article, in this blog post I wanted to refer to it to help explain the continuing popularity of the fit and proper test. In the US the focus - if not obsession - has always been on valuations/market value at the time of trading (shares or the whole company), and the regulation thereof, supposedly for the protection of investors. This compares to the UK (and other countries around the world that have followed suit), where there exists a more general common law approach of "good practices" and "comply or explain" corporate governance codes rather than tight regulation (though that has been eroded somewhat in recent years with the introduction of more regulation and gold-plating of EU directives).

In the same way that the UK has no written constitution (and therefore the oldest constitution in the world), using judgement and common sense, while clearly not perfect, has survived the test of time precisely because it does not attempt to dissect and legislate for every eventuality - a clearly impossible task. It is hard enough for companies to manage known risks and try to legislate for the "unknown unknowns"; how can a regulator outside operational business create a legal framework to protect against these risks? (See this FT article on why "the banking firemen won't prevent fires from breaking out").

Common law, like the comply or explain approach - and the "fit and proper" test - allows for individual circumstances to be taken into account and for genuinely repentant and capable people to be given a second chance. Everyone makes mistakes, not just bankers and other executives, but judges and regulators too; and while individual rulings can be reversed, legislation tends to stick. Stifling business with ever more stringent rules and an obsession with short term measures like quarterly reporting takes executive eyes off running the business for the long term while failing to stop corporate failures. Certainly the banking failures in the UK would not have been prevented by adherence to Sarbanes-Oxley (it did not prevent the biggest failure of all, Lehman Brothers) but, as suggested by the subsequent allocation of blame, came down more to globalised exposure to excessive risk and executive hubris and "disconnectedness".

No, the only way to guarantee good practice and avoid corporate failures is to build a culture of ethics, transparency and accountability (backed up, we argue, by independent research). That is the only way, as we have been saying for more than twenty years, to achieve compliance with the spirit, not just the letter, of the law. We need a set of rules, of course, but rules are only effective when people believe in them. As Lord Moutlon's definition of business ethics goes, people's conduct should be governed by "obedience to the unenforceable"!

Andrew Hill's article, while questioning the usefulness of the "fit and proper" test also concludes that because of this, executives "should be working out regularly to acquire a level of fitness that far exceeds the currently accepted norm.

We would, of course, concur completely, and our mission is precisely to promote the development of ethical business culture over an obsession with compliance to ineffective rules.

Arthur Kendall


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