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Corporate Governance regulation is missing the point

by AppliedCG
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In recent years, as we have noted before, Corporate Governance has been, and continues to be interpreted as having a wider role than simply what directors should be doing to look after the interests of the owners of the companies on whose boards they sit.

Corporate social responsibility has now moved from the realms of academia into the  anterooms of big company boardrooms, and United Nations’ statements of recommended investment criteria from international symposia into the investment philosophies of global fund managers. ESG is now pretty well mainstream, and, as we predicted would happen several years ago, having been endorsed by the largest investing institutions, it is having a self-reinforcing effect on company valuations. Most recently, Purpose is the fashionable word in the corporate governance field, as the product of a union between the concepts of stakeholder interests and business ethics. And the Triple Bottom Line is now accepted as an integral part of the annual reports of the more forward-thinking listed companies.

Regulation has been dragged along in the wake of these developments, in consequence trying to reflect evolving views as to what is good practice in corporate behaviour.

The trouble is that, as has been the case since corporate governance came to the attention of the regulatory authorities with the publication of the Cadbury Report in 1992, there has never been a holistic and coherent approach. The Cadbury Committee focused on the limited objective of establishing a simple and consistent set of rules for directors to report on the financial aspects of governance, primarily to the shareholders. Since this was developed at the instigation of the Chartered Accountancy profession, all the subsequent regulation has had the same restricted focus, and the resulting proliferation of rules and guidance has all essentially closed its eyes to the wider picture.

Notwithstanding, since the early days post Cadbury, other strands of corporate governance have emerged from the academic world and from various engaged parties, and progressively established their legitimacy in the debate. In this process, such concepts as ethical investing, responsible investing, corporate social responsibility and ESG reached the wider public and political consciousness, and the idea grew that companies should have regard to the interests of a wide group of so-called stakeholders, rather than just to the shareholders.

The UK Companies Act 2006, which followed some ten years of wide consultation, took this significantly more open view of the responsibilities of directors in governing companies than its predecessor Acts. It still had to make concessions to get into law, but in critical sections was very specific about the new, much broader, duties of directors.

We discussed this in our article last year on the 2019 version of the Stewardship Code, which we recommended should be scrapped on the grounds of its major overlap with the provisions of the 2018 version of the Corporate Governance Code. More pertinently, we pointed out that there was minimal overlap between these Codes and the provisions of the 2006 Companies Act, most of their regulatory clauses being concerned with routine board practices and protocols rather than the underlying obligations of sections 170 – 177 of the Companies Act.

As a result of this failure to focus on the clauses and intentions of the Act, there have been continuing failures in governance, which have led to increasing disillusion with corporate behaviour and regulatory ineffectiveness in the minds of the public. And, in parallel, there has been an increasing number of articles in recent years both promoting and challenging the growing importance of parallel belief systems like ESG and more recently, Purpose, these opposing views themselves fostering cynicism about the whole notion of corporate governance, and suspicion about the integrity of company directors generally.

Of course, both strident critics and blind supporters of ESG and Purpose miss the central point, which is that none of these fashionable belief systems takes a holistic approach to the task of governance of companies, so, notwithstanding their beneficial effect in certain respects, they will always fail in some other aspect of corporate governance. Hence they will always be found wanting and blamed as ineffective protectors of one or another group of stakeholders. And, sadly and predictably, all this white noise of criticism leads inexorably to yet more layers of ineffective regulation from regulators who don’t take a holistic approach, and have just a superficial view about the intentions of the Companies Act.

What is a company and what’s it for?

A company is an independent legal entity, as corporate governance guru Professor Bob Garratt never ceases to stress. It is not owned by the shareholders, whatever they may think. They merely have a right to share in the rewards that come from its successful operations, and are thereby granted limited liability protection from the adverse consequences resulting from its unsuccessful actions.

However, the directors are in a very different situation. They are legally responsible for its behaviour and its long-term prosperity, and the Companies Act spells this out in the sections mentioned above.

So what is a company for?

A company is a vehicle set up to allow a group of people to come together to achieve a commonly agreed goal in a more effective way than if they tried to do this singly or through partnerships or in some other association. So the whole point of a company is to achieve this commonly agreed goal, and the role of the board of directors is to do their best to ensure that this goal is achieved. This is where the true meaning of the term governance needs to be spelled out, and rescued from the accountancy profession.

Governance of a corporation is the same role as that of the original Greek steersman of a ship, whose job was to guide the vessel towards its planned destination and to give guidance to the crew on handling the ship accordingly, along the way. It was not about the detail of how the steersman should address his fellow officers, or how often he should go on deck to take bearings (all the time!). It was about the big issues, such as the need to reassess the voyage’s plans in the light of changing circumstances such as a storm, or illness or mutiny among the crew.

Similarly, the role of the board of directors is to ensure that the company’s goal is still appropriate, that the strategy to achieve it is still valid, that the company has the capacity to achieve it and that the behaviour of those involved stands up to ethical scrutiny and is subject to openness and accountability. Having made these assessments, its job is to determine appropriate changes, and set a new course, as necessary.

If the term Purpose is relevant in this context, it means the accepted Goal of the company. What it doesn’t mean, is some well-intended social objective remote from the fundamental point of the company’s existence.

Hence, the Purpose of a company is to deliver a product or service that people want, generating a sufficient surplus to fund whatever innovation is necessary to keep it going, deliver rewards to participants, and distribute some of the wealth it creates to society in such a way that the benefits enhance the brand and promote strength and longevity. Hence, an appropriate Purpose is one which is a viable long-term commercial goal, and which by its very nature is in sympathy with the main stakeholders, and reflects the fact that the company is an independent entity, and not in thrall to any particular stakeholder group.

Duties of the board

We need here to summarise the directors’ legally enforceable duties as set out in the key sections of the Companies Act 2006 (and for he, read she as well, of course):

S 170   Scope and nature of general duties

The general duties specified in sections 171 to 177 are owed by a director of a company to the company.

S 171   Duty to act within powers

A director of a company must (a) act in accordance with the company’s constitution, and (b) only exercise powers for the purposes for which they are conferred.

S 172 Duty to promote the success of the company

A director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole.

S 173 Duty to exercise independent judgment

A director of a company must exercise independent judgment.

S 174 Duty to exercise reasonable care, skill and diligence

A director of a company must exercise reasonable care, skill and diligence.

S 175 Duty to avoid conflicts of interest

A director of a company must avoid a situation in which he has, or can have, a direct or indirect interest that conflicts, or possibly may conflict, with the interests of the company.

S 176 Duty not to accept benefits from third parties

A director of a company must not accept a benefit from a third party conferred by reason of (a) his being a director, or (b) his doing (or not doing) anything as director.

S 177 Duty to declare interest in proposed transaction or arrangement

If a director of a company is in any way, directly or indirectly, interested in a proposed transaction or arrangement with the company, he must declare the nature and extent of that interest to the other directors.

The most important section from our immediate point of view is S 172, whose provisions state:

A director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole, and in doing so have regard (amongst other matters) to—

(a)        the likely consequences of any decision in the long term,

(b)        the interests of the company’s employees,

(c)        the need to foster the company’s business relationships with suppliers, customers and others,

(d)       the impact of the company’s operations on the community and the environment,

(e)        the desirability of the company maintaining a reputation for high standards of business conduct, and

(f)        the need to act fairly as between members of the company.

So, the director’s role can be summarised as: plan the future, while protecting the present. And this means looking holistically at the business and the interests of all the key stakeholders.

How to ensure the board does its job and keeps the executive focused on keeping the company on track

So how do the directors monitor their performance in fulfilling their duties under the Companies Act, and how do the stakeholders receive confirmation that their interests are, indeed, being properly looked after?

Clearly, from the criticism of current arrangements by the public and various of the stakeholder groups at different times, coupled with periodic reorganising of the regulatory bodies and regular re-writing of regulation, the traditional approach isn’t working. And, as this article makes clear, this is hardly surprising, given the fragmented and un-co-ordinated development of regulation from Cadbury onward.

We have made the case for measured standards and independent data-gathering and analysis for twenty-five years, and now believe it’s time to re-visit the Companies Act 2006 and link these standards directly to the requirements of the Act, as it represents far better the holistic approach needed than the raft of regulation around the Corporate Governance Code and the Stewardship Code. So we have developed a set of standards based on our Five Golden Rules of good corporate governance, linked to the provisions of Sections 171 – 177 of the Companies Act, and a software tool to inform directors of their performance in directing the company, coupled with an examination of their own personal performance in carrying out their job.

The key elements are:

  • Mapping the requirements of Sections 171-177 on to our Five Golden Rules of good corporate governance
  • Similarly mapping them on to four tests of director competence
  • Setting up a communication system between directors and stakeholders to gather views of governance performance in a structured way by reference to the company’s corporate goals
  • Analysing the results to provide an on-going performance improvement programme.

Earlier this year, Professor Garratt published his thoughts on benchmarking a board’s level of maturity in relation to the current and future demands expected of it. He used a four-level scale, from Level Zero (Accidental Board), Level One (Grudgingly Compliant Board), Level Two (Learning Board), to Level Three (Professional Board). At Level Three, a learning board supervised a learning organisation, and directors were assessed individually and collectively for their competence. This approach chimes with our long-standing belief that any system adopted to manage corporate governance must include standards and measurements and reporting which lead to a programme of continuous improvement. We designed and implemented such a system with a big retail client using market research techniques some years ago, but technology has moved on, and we have now developed a powerful system, using our Dynamic Responses Software, which provides continuous monitoring at a fraction of the cost. It consists of independent, continuous communication with all the key stakeholders, having determined the appropriate issues on which to consult, and structured a set of criteria by which to judge performance in relation to pre-set standards to further the long-term future of the company concerned.

This system can be deployed to fulfil Professor Garratt’s aim of creating a learning board within a learning organisation, to the huge benefit of the companies benefitting from its use.

Role of regulation

We have argued in this article that compliance-based regulation is missing most of the point and is both ineffective and descending into disrepute, in the opinion of company boards, shareholders and the general public. The same argument applies to the focus on how a board conducts itself and related compliance with rules about board behaviour.

So our proposal is to replace the auditor’s role in corporate governance by establishing a new regulator using our Dynamic Responses system, or something similar, which would be linked to the individual companies’ internal Dynamic Responses systems. Such an arrangement would provide the regulator with selected access to key data which would enable it to monitor the critical elements of corporate governance performance both for the boards collectively and for individual directors.

A similar use of the system linking key stakeholder groups to this continuous information access and distribution would eliminate large parts of the voluminous annual reports, which are getting bigger and bigger as the years go by.

What a step forward that would be.

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