Corporate governance must remain a priority for British plcs

Corporate Governance Report, IoD

On 10 October the IoD will launch the 2017 edition of its flagship Good Governance Report, which ranks the FTSE 100 on measures such as board effectiveness, external accountability and stakeholder relations. On the eve of the report’s publication, James Jarvis, the institute’s corporate governance analyst, examines the state of policy and practice in plcs and offers the IoD view on prospects for improving leadership standards in private companies and charities too

James Jarvis, IoD corporate governance analyst Governance failures continue to erode public trust in, and the effectiveness of, British enterprises including blue-chip firms, privately owned companies and charities. The government proposed reforms in this area last year, but it has been forced to shelve these for now after losing its majority.

The Financial Conduct Authority’s proposed relaxation of listing rules affecting state-controlled firms seems like a hasty attempt to show the world that the UK remains open for business. The IoD contends that such a plan is at odds with the idea that a more rigorous framework for effective governance would prove to be a competitive advantage for the nation in the long run.

The research that went into the IoD’s 2017 Good Governance Report on the quality of leadership in the FTSE 100 will produce insights that are also applicable to big private businesses and charities.

The UK’s existing governance framework, while imperfect, is still globally admired. But British enterprise must avoid complacency and resist any move to relax standards for short-term gain. The IoD believes that quality will win through in the end.

Last year was one of highs and lows in the world of corporate governance, producing some of the biggest scandals in recent memory as well as far-reaching proposed reforms. BHS, after being sold for £1, went into administration after more than 80 years in business, leaving thousands of people out of a job and a huge deficit in their pension fund. At another mainstay of the British high street, Sports Direct, the conditions for labourers in its warehouses were compared to those of Victorian workhouses. Both examples highlighted how decisions made at the top of a business can cause real harm further down the pyramid. In 2017 corporate governance is once again the story.

While there isn’t a universally agreed definition of corporate governance, most explanations of the term tie it to the control of a company. It refers to the interrelating rules, frameworks and behaviours that influence how organisations are directed. Corporate governance, when properly applied in a business, can promote its growth and contribute to improvements in efficiency and risk management.

The need for effective governance is of such enduring importance that, when the IoD’s royal charter was drafted in 1906, its promotion was given primacy. To this day, the institute has the tasks of fostering good practice in corporate governance and of helping British directors to attain high levels of knowledge and skill, which it ­achieves through its professional development department.

Theresa May

Corporate governance reforms had been central to Theresa May’s campaign to succeed David Cameron as PM, but these plans appear to have been shelved now that her government has lost its majority

Leading questions

The impact of companies on society is increasing: the digital revolution has put more and more of our personal information in the hands of firms for safe keeping and made us more reliant on their goods and services to help manage our lives. This factor, coupled with the growing onus on British firms to power the economy after Brexit, means that the quality of business leadership, in our view, has never been more crucial.

It appeared that Theresa May shared this opinion when she placed the reform of corporate governance at the centre of her pitch for “a fairer Britain” during the Conservative leadership campaign that culminated in her election as prime minister in July 2016. Her government wasted little time in publishing proposals to shake things up. Its November green paper, Corporate Governance Reform, recommended a number of credible measures to tackle long-standing problems facing blue-chip boardrooms. It suggested ways of curbing excessive executive pay in plcs – an issue of huge public concern that rears its head every AGM season. Other proposals addressed the lack of stakeholder engagement among businesses, many of which have long ranked their shareholders’ interests above all other considerations.

The green paper also examined large private companies and, in the shadow of the BHS debacle, considered whether they could be brought under a formal governance framework. While some suggestions, such as the appointment of an employee representative to the board, prompted widespread objection from employers, the consultation itself was welcomed as a good start.

In April 2017 the Commons select committee on business, energy and industrial strategy (BEIS) reported on its inquiry into the state of corporate governance, based on evidence submitted by 170 individuals and organisations, including the IoD. This also set out an agenda for radical change, proposing reforms designed to support a post-Brexit industrial strategy. The report asserted that a regulatory environment that was fit for purpose would be a competitive advantage. Rather than putting the brakes on commerce, corporate governance, done right, would provide the breeding ground for dynamic businesses, it argued.

Saudi Aramco logo

The UK Financial Conduct Authority has proposed to relax the listing rules that apply to state-controlled firms in order to attract IPOs by foreign giants such as Saudi Aramco, which is now thought to prefer New York to London for its flotation

On the back burner

Just as the ground seemed set for genuine reform, there was a rearrangement of priorities in Westminster. The close result of this summer’s general election has meant that major changes, at least in the form of primary legislation, seem unlikely at present. Indeed, corporate governance was notable by its absence from the Queen’s Speech and, as Director goes to press, the government has yet to publish its response to the feedback its green paper prompted. This is expected to lack many of the more radical original proposals and to instead suggest incremental reforms, reflecting a weakened government’s loss of appetite for pushing through transformational amendments.

In fact, with Brexit looming, there seems to be a push in the opposite direction to give the rest of the world the impression that the UK remains open for business. As can be seen from the Financial Conduct Authority (FCA) consultation on the proposed creation of a premium listing category for firms controlled by sovereign states, the temptation to relax some of our standards in a bid to win business is strong. The FCA’s recommendation to drop vital rules protecting the interests of such firms’ minority shareholders is being touted as an attempt to make listing in London a more attractive prospect for state-run businesses around the globe. Rightly or wrongly, it was linked in the press to the tantalising prospect of the world’s largest IPO – that of Saudi Aramco – in London. This would have shown that the City remains a marketplace of choice and brought millions of pounds into the Square Mile in fees and related contracts, but at what cost?

The cases of Asia Resource Minerals (formerly known as Bumi), which the FCA fined £4.6m in 2015 for having “inadequate systems and controls to comply with its obligations as a listed company”; the Eurasian Natural Resources Corporation (ENRC); and a number of other blockholder-controlled firms from developing nations should have served as salutary lesson for all concerned. When the ENRC floated on the London Stock Exchange in 2006 it became the darling of the City. The business pages lauded its climbing share price and savoured the idea that a new wave of similar companies would flock to the UK. Yet before long the ENRC changed from golden child to pariah as its boardroom battles became public knowledge. Ultimately, shareholders were left out of pocket as the firm beat the retreat, delisting in 2013. In response, constraints were placed on controlling shareholders, yet these are the very rules that the FCA would like to waive for firms in its proposed premium listing category.

BHS closure signs

In its report into the collapse of BHS last year, parliament’s work and pensions committee was scathing about the firm’s leaders, concluding that “a large proportion of those who have got rich or richer off the back of BHS are to blame”

An in-depth ranking

The IoD rates the FTSE 100 according to the quality of their corporate governance through its own Good Governance Report, an annual publication that’s now in its third year. As well as looking at “typical” indicators of governance quality, some of which are found in the Financial Reporting Council’s UK Corporate Governance Code – eg, the separation of the roles of chair and CEO – it also examines other key aspects, such as board diversity. This research is complemented by the findings of a survey of stakeholders in these companies.

This year we enhanced our approach in two ways: by increasing the number of indicators we applied and by engaging with the companies before publication. It was encouraging that almost half of them replied. Their responses have helped to ensure that the report’s findings are as accurate as possible.

This project is not an attempt to name and shame underperformers. It’s an exercise in both determining whether corporate governance can be measured and encouraging a conversation about governance beyond the code that applies to plcs. We are also keen to see whether there are lessons that can be applied beyond the FTSE, not only in privately owned firms but also in charities, among other organisations.

Corporate governance is not important only to the FTSE, of course. Most companies in this country are privately owned. They fuel the economy and are this nation’s biggest employer. Yet, when it comes to the governance arrangements of these firms – some of which rival plcs in their size and influence – it is a “black-box” situation. Both the green paper and the BEIS committee report on corporate governance reform discuss the idea of bringing the UK’s very largest private companies under some form of framework, be that a code or set of voluntary principles.

In 2010 the IoD proposed its own corporate governance guidance and principles for unlisted companies in the UK. Indeed, both the green paper and the BEIS committee report suggested that we could contribute if such a framework were ever implemented by regulators. We believe this is an important step, not out of a desire to burden these businesses with more regulation, but out of a recognition that governance failures can have a significant impact on the firms’ stakeholders and the wider economy.

These companies, while not having shareholders in the conventional sense, do have a wide range of people who depend on their sustained success. Again, BHS is as clear an example as any of the pain that can be inflicted on people when a company fails through mismanagement. This is not to say that all failures can be prevented; they are a natural part of business life. But, by opening up governance arrangements in private firms – and by encouraging them to consider the benefits of best practice and healthy organisational cultures – the risk of avoidable insolvencies is reduced.

The same can be said for the voluntary sector, which, much like the business community, has lost public trust in recent years. This is largely the result of poor leadership in a few very high-profile cases and does not reflect the hard and selfless work done by most people in charities. For instance, a 2015 inquiry by the parliamentary public accounts committee into the collapse of Kids Company blamed mismanagement at the top of the charity. Indeed, the Insolvency Service is to bring disqualification proceedings against a number of its former directors.

The IoD is pleased to see the work done by the National Council for Voluntary Organisations and the Association of Chief Executives of Voluntary Organisations as part of the effort to restore trust in the charitable sector. In the third edition of the Charity Governance Code, published in July, they and a number of other bodies have established a robust framework of best practice that we would encourage all organisations in the sector to adopt.

The IoD has long argued that directors of all organisations need to equip themselves with the knowledge and skills required to fulfil their duties properly. We therefore welcome the code’s emphasis on the training of trustees, along with its push for greater transparency and diversity in recruitment.

Kids Company protesters outside parliament

A 2015 parliamentary inquiry into the demise
of Kids Company, which had prompted protests outside Downing Street, found that its leaders had become “inured to the precariousness of the charity’s financial situation”

Genuine reform

Action from the government and regulatory bodies to improve corporate governance in business is clearly not the only option. Indeed, with encouragement, the best source of change is the private sector itself. While it would be too soon to suggest that boardroom pay is no longer an issue, last year saw a 17 per cent reduction in the average pay of FTSE 100 chief executives, according to research by the Chartered Institute of Personnel and Development and the High Pay Centre.

Their study also found that the pay ratio between CEOs and average employees fell from 148:1 to 129:1. There will need to be further reductions over the next few years for this to be confirmed as a trend, but it seems that companies are thinking more carefully about their remuneration policies. Indeed, while there were still some shareholder revolts during this year’s AGM season, a number of firms engaged with their investors to ensure that pay votes went through – BP being one of the more notable examples.

If executive pay in the FTSE 100 does continue to balance out with the rest of the market, this would make a good case in how pressure from investors, industry bodies and the public can change how plcs behave. The IoD has long called on firms to get ahead of the game and be willing to recognise systemic problems. By doing so they can pre-empt government intervention and go some way to restore the public’s trust, which has been worryingly lacking ever since the 2007-08 financial crash.

The positive news is that the UK is starting from a strong position. The governance framework we have, while imperfect, is globally admired. Held up as a model approach, it is widely replicated. This is part of why the UK has such a dynamic commercial environment and a GDP that’s far larger than the country’s size would suggest. But we must avoid complacency. In the run-up to, and aftermath of, our departure from the EU, there will be a temptation to relax standards in order to win business and open up new markets. Some of this is likely to be opportunistic and not in the best interests of our long-term prosperity.

It is important that any inappropriate move to weaken the laws and principles that promote properly conducted business should be opposed. Every stakeholder in business has a role to play here – government, industry bodies, the investment community, the public and companies themselves must co-operate to ensure that we remain able to face the challenges that await and seize the opportunities as well. This will require a governance framework that promotes true sustainability, ethical conduct and fairness with respect to pay.

IoD’s Good Governance Report

James Jarvis is the IoD’s corporate governance analyst

The institute launched the 2017 Good Governance Report, in partnership with Cass Business School, in October.

Read the full report here

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About author

James Jarvis

James Jarvis

James Jarvis is Corporate Governance Analyst at the IoD. Prior to this role he worked as Special Adviser to the IoD Chairman, Lady Barbara Judge CBE

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