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Corporate Governance and Smaller Companies

by Nigel Kendall

Some years ago I had a small company client whose ambitious CEO wanted to build it into a big, publicly quoted company and make a lot of money for himself in the process. Over the following ten years, this very driven owner-manager grew a small, local graphic display business into an international operation big enough to give him earnings in seven figures. His subsequent fall from grace was the result of breaking two of our Five Golden Rules of Good Corporate Governance and the story makes an interesting case study in corporate governance for small and medium-sized enterprises (SMEs).

Little research into corporate governance for SMEs

There appears to be little research into the needs of this sector, and hence little help for smaller businesses except for a vague acceptance on the part of the authorities that the plethora of corporate governance regulations produced to govern the behaviour of larger, quoted companies is too onerous for smaller companies. Hence SMEs generally are exempted from compliance, though exhorted to do their best to follow the principles anyway.

In the UK, the Institute of Directors encourages directors to take its courses, which teach students about the duties of directors and the way to run efficient boards. These courses arguably address the needs of smaller companies rather than larger companies. It also has a serious corporate governance function headed by Dr Roger Barker, which is represented in international corporate governance associations and their periodic gatherings. And it expresses its views about general principles of governance – a recent example being support for the Loi Florange in France, which gives extra voting power to longer term shareholders to counter perceived short termism on the part of fund managers.

The Financial Times runs a regular column by Kate Burgess on smaller businesses and particularly the happenings in AIM, the less regulated public market for smaller companies, controlled by the London Stock Exchange (LSE). This column has periodic horror stories on examples of bad governance in small listed companies and debates the effectiveness of the regulatory regime. But it doesn’t pretend to be an authority on the governance of smaller companies generally.

Then there are the analysts and commentators on smaller quoted companies, such as ShareProphets, whose Tom Winnifrith is ruthless in exposing bad practice in smaller quoted companies, but whose interest essentially lies in helping investors make money and avoid being conned by crooks.

Why does all the attention seem to be devoted to large companies when academics and regulators consider corporate governance, though everyone agrees that good corporate governance is just as applicable to smaller companies? To answer the question, we need to go back to the early days of company law and the development of the financial markets and then fast forward to the recent development of regulation specifically addressing corporate governance as it is currently understood by the authorities.

Corporate governance regulation is aimed at big companies

Company law governing the behaviour of corporations has been developed over the past two centuries to set out the duties of the directors who are responsible for the way in which the company, as a separate legal entity, is run. As companies grew larger and brought in capital through investors who were not involved in the actual management of the business, the fiduciary duties of the board became more critical in regard to the stakeholding group who were owners. Company law in the UK developed slightly further than that in the US and this is reflected in the different emphasis in subsequent regulation on corporate governance. In the UK, the duties of the directors have evolved to embrace the future health of the company as an independent entity, and more recently the interests of all the major stakeholders generally. In the US, the emphasis has remained on providing equal treatment to all investors rather than any larger interpretation.

When the UK embarked on its efforts to improve corporate governance in the early 1990s, the proximate cause was mistrust between investing institutions and management, following several financial scandals in the City. Fund managers feared that they couldn’t trust the directors of certain large companies to put the interests of the company above their own personal interests. They wanted to put rules in place to stop directors steering financial rewards in the direction of earnings for management rather than dividends and share price growth for investors. Hence the eponymous report produced by Sir Adrian Cadbury was entitled “The Financial Aspects of Corporate Governance”. The Report had a Code of Practice set out on just two pages and comprising four sections dealing with the Board of Directors, Non-Executive Directors, Executive Directors and Reporting and Controls. Compliance was required from quoted companies, but famously on a “comply or explain” basis, giving companies the flexibility to opt out of particular aspects of the Code if they felt it appropriate, but requiring them to provide credible justification.

The only part that realistically could have given problems to smaller companies was the requirement for the board to have a majority of non-executive directors, which would almost certainly be deemed unaffordable by smaller companies. All the other elements in the Code were applicable to all businesses.

Sadly, the simple Code created by Sir Adrian progressively grew larger and larger in the following years until its present incarnation as the Corporate Governance Code (though not in the same league as SarBox and Dodds-Frank). As a result, there is very little incentive for smaller, non-quoted companies to adopt the UK Corporate Governance Code, and they will only have done so when planning for a public listing.

Corporate governance consultancy and research focus on big companies

The result of this development is twofold: firstly, the big accountancy consultancies have built large businesses advising their clients on compliance matters and, secondly, research into compliance will have been confined to the larger companies. This is compounded by the global predominance of the biggest four accountancy firms who audit all the UK FTSE 100 companies between them. So almost all the corporate governance consultancy work will be directed at the largest companies and the incentive will be for most of the related research to focus on those self-same companies. Also, the big investing institutions will be primarily invested in the largest companies and their interest in corporate governance will be similarly focused.

This is the case in the UK, but the situation will be similar in all countries adopting the UK approach to corporate governance, where again the “big four” accountancy firms will be providing both audit and compliance consultancy. And in the US where the burden of compliance is, if anything, much greater, the same “big four” will be providing audit and compliance consultancy to the biggest corporations.

In a sentence, there’s no money in researching corporate governance in smaller companies.

Corporate governance is important to smaller companies as well

Notwithstanding the focus of regulation on larger companies, there is a definite need for smaller companies to be aware of what good corporate governance consists of and why it is so important for growth and success. To take a few examples:

In the UK, famous Scottish football club, Rangers, has achieved a terrible record of bad corporate governance in recent years. Listing on AIM at the end of 2012, in its first year as a public company, it lost all but one of its original directors and by the end of the year it was on its third NOMAD (Nominated Adviser – required by regulation to assure the market of the fitness of governance by the board and whether it meets the standards of behaviour appropriate for a public company). Ultimately, after failing to find a NOMAD it delisted its stock from AIM in April of this year.

Another AIM-quoted company, Vernalis, a biotech company with international aspirations, went through three NOMADs in three years, being faced with the disappearance of its NOMADs as a result of difficult market conditions. This wasn’t the fault of Vernalis, but it put them in the position where, to maintain their public quote, they had to keep looking for a new, and suitable, adviser who would guarantee their corporate governance to the market.

Most recently, Kate Burgess, in the FT, quotes the case of Mar City, which builds prefabricated housing and has a very successful record in recent years both of trading and of appealing to respected investors. Currently, after a profit warning and the resignation of a non-executive director whom it hasn’t yet replaced, its NOMAD has resigned and it faces an immediate requirement to fix its board and to replace its NOMAD or risk losing its quote.

Ferdinando Giugliano reports in FT.com on a study by the Centre for Economic Policy Research, a research network, and Assonime, the Italian association of joint-stock companies, called Restarting European Long Term Investment Finance (RELTIF) which, he suggests, argues that a European investment gap may actually be the consequence of widespread flaws in the governance of European companies and banks, rather than simply the result of insufficient financing.

He says that the researchers found evidence that Europe’s small-and-medium enterprises have suffered from an insufficient supply of credit from the banks. But he asks: do the difficulties SMEs face in accessing adequate funding reflect a shortage of liquidity in the system? Not necessarily, the researchers argue. “In Germany, and some other European countries, banks play a critical role in nurturing SMEs. They have long-term relationships with companies that involves them providing finance for growing firms on a substantial scale. The result is a vibrant SME sector … in the form of the Mittelstand,” the report says.

There is some research going on into smaller companies

On the website https://reltif.cepr.org/research, Assonime and CEPR say they are jointly developing a programme of research examining corporate financing in Europe. The research programme is structured in two phases.: the first consists in the releasing of a Green Paper which aims at identifying policy issues that are the forefront of current debates and at raising a list of research questions that they believe are important to address. The second phase is then to commission research on the issues identified in the first stage and to produce a final policy report (a “White Paper”) based on the accumulated evidence. The questions they are addressing regarding the importance of corporate governance are:

  • To what extent has corporate governance in the corporate sector contributed to problems of funding investment?
  • Are the problems associated with management, conflicts between different types of shareholders or excessive short-termism or long-termism in equity markets?
  • Are corporate governance problems particularly acute in small or large companies?
  • Are the deficiencies in corporate governance more acute in financial institutions?
  • Are policies to improve corporate governance alleviating or exacerbating problems?
  • Are the governance problems associated with regulatory institutions?

We wait with interest to see the results regarding small companies.

For our part, in Applied Corporate Governance, we are putting together a course directed at SMEs to show the CEOs and boards of ambitious, growth companies how our holistic approach to good corporate governance will provide them with the tools to grow their companies successfully and avoid the risks which have led otherwise successful SMEs to disaster.


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