About Me

My photo
Reputability are thought leaders in the field of reputational risk and its root causes, behavioural risk and organisational risk. Our book 'Rethinking Reputational Risk' received excellent reviews: see www.rethinkingreputationalrisk.com. Anthony Fitzsimmons, one of its authors, is an authority and accomplished speaker on reputational risks and their drivers. Reputability helps business leaders to find these widespread but hidden risks that regularly cause reputational disasters. We also teach leaders and risk teams about these risks. Here are our thoughts, and the thoughts of our guest bloggers, on some recent stories which have captured our attention. We are always interested to know what you think too.

Wednesday, 18 July 2018

New FRC Code and Guidance: The Headlines


The Financial Reporting Council has delivered radical revisions of the UK Corporate Governance Code and of the Guidance on Board Effectiveness.  The purpose of this note is to bring you the most important headlines. 

NED Teams

One of the lessons of the Banking Crisis was that companies that failed frequently had non-executive teams that lacked sufficient know-how, curiosity or character to ask penetrating questions of the executives who were leading them towards a cliff.  As Andrew Bailey, now Chief Executive of the Financial Conduct Authority once put it, “Healthy scepticism channelled into intelligent and forceful questioning of the self-confident can be a good thing.” 

The FRC has given a strong, systematic emphasis to NED teams having the skills knowledge and experience to understand everything of importance that is going on in their company. It has focused on the importance of so-called 'soft' skills. Crucially it has put ‘Courage’ at the top of a list of desirable personal attributes of NEDs and steered boards towards actively seeking good candidates who are outside the (social) circles of classical head-hunters.

Short-termism

There has been growing political criticism of short-termism and covert asset stripping by those who lead and invest in UK companies.  This has been supported by criticism from economists and long term investors This behaviour is in part a result of Milton Friedman’s ‘Shareholder Value’ philosophy, which has put anything other than shareholder perspectives into ‘second class’ category.

Encouraged by a strong political steer, and despite seemingly coordinated resistance from large corporates, the FRC has now brought “long term sustainable success” to the core of the Code.  This philosophy has been reinforced throughout the Code and the Guidance, in which “long term” appears no less than 40 times.

Workforces

Friedman-ism has been dealt a second blow by forcing boards to listen to the workforce.  Political pressure arising from the increasing disparity between C-suite and worker pay is one driver.  The second is the recognition that workers often won’t give leaders unwelcome news because they fear the consequences – what we call the ‘Unknown known’ problem.

As regards the unknown known’ problem, the FRC has given renewed emphasis on going beyond ‘whistleblowing’ programmes towards systematising a culture which makes it both routine and safe for the workforce to ‘speak up’ if they feel anything is amiss. 

The pay disparity issue has been tackled by a variety of measures.  One is to force boards to institutionalise an ‘employee voice’ whether via an employee director, a director designated to listen to and bring workforce views to the board; or a formal workforce advisory panel.   Boards are expected to explain to the workforce the relationship between executive pay and wider company pay policies and corporate culture.

Bonuses and other incentives

Finally, the FRC made a promising and well-thought-through attempt to de-risk bonuses and other incentives. Among other measures, the FRC is encouraging simplicity and clarity in their structure and the thinking through of potential unintended consequences.    

But they have also taken a stand against the risk of a CEO burnishing present profits (and thus bonuses) by increasing risks ‘after I have gone’.  It is often easy, and given the wrong bonus architecture can be tempting, to boost profits (and bonuses) today by cutting back on, for example, maintenance or innovation.  Cut maintenance regularly causes costly disasters.  And many suspect that investment foregone is an important cause of lacklustre performance at UK companies. 

The FRC has tackled this through the best method of which we are aware: by encouraging boards to require executive bonus share awards to be held for “two or three years after leaving the company”.  That way retiring CEOs have a huge incentive to leave their company in excellent shape.  For if one thing is certain, it is that their successor will have a thorough look for skeletons left by their predecessor before setting the starting point for their own bonus scheme.

You will find the rationale behind most of the FRC's main changes fully explained in "Rethinking Reputational Risk - How to Manage the Risks that can Ruin Your Business, Your Reputation and You" by Anthony Fitzsimmons and the late Derek Atkins.

We have written a more detailed note on this, which you will find here.

Anthony Fitzsimmons
Reputability LLP
London
www.reputability.co.uk






Tuesday, 17 July 2018

Radical Code Revisions from the FRC

The Financial Reporting Council has delivered radical revisions of the UK Corporate Governance Code and of the Guidance on Board Effectiveness (the Code and the Guidance respectively).

The Code and Guidance have been substantially recast, with a focus on making 'tick-box' approaches and boilerplate reporting much more difficult.  To this end the Guidance is laced with over eighty penetrating open-ended questions for boards to consider. The new rules come into force as regards accounting periods beginning on or after 1 January 2019.

Our note concentrates on four important themes involving change:
  • Long term sustainable success
  • Board skills knowledge and experience
  • Interacting with the workforce and
  • Remuneration issues

Long Term Sustainable  Success

For years there has been trenchant criticism of short-termism and opportunism among UK company leaders and their shareholders at the expense of sustainable growth.  Recent examples include utilities accused of asset stripping that will leave their companies vulnerable when interest rates rise.  But examples go back many years.

The Code now begins:
"A successful company is led by an effective and entrepreneurial board, whose role is to promote the long-term sustainable success of the company, generating value for shareholders and contributing to wider society." (Code Principle A)
"The board should ensure that workforce policies and practices are consistent with the company’s values and support its long-term sustainable success."  (Code Principle E)
Boards have to report on this. The Provisions that elaborate Code Principles A to E provide:
The board should assess the basis on which the company generates and preserves value over the long-term. It should describe in the annual report how opportunities and risks to the future success of the business have been considered and addressed, the sustainability of the company’s business model and how its governance contributes to the delivery of its strategy."  (Code Provision 1)
This approach is underpinned by the Guidance, which begins by describing an effective board.
"An effective board defines the company’s purpose and then sets a strategy to deliver it, underpinned by the values and behaviours that shape its culture and the way it conducts its business. It will be able to explain the main trends and factors affecting the long-term success and future viability of the company – for example technological change or environmental impacts – and how these and the company’s principal risks and uncertainties have been addressed."  (Guidance 1) 
Whilst this respects the formal wording of s172 of the Companies Act 2006 with all its ambiguities, boards subject to the FRC will either have to comply with the Code on this or explain that, and why, they will not.

What remains is the potential for major shareholders to drive undesirable short-termism in the board.  The FRC intends to consult on revisions on the Stewardship Code.  In our view this problem cannot be resolved without drawing in the FCA to regulate issues between investment professionals and their ultimate clients, particularly as regards the disparity between the often short bonus-driven time horizons of investment professionals and the far longer horizons of retail investors saving for the long term to retirement.  Some have suggested more draconian measures such as the Loi Florange.

Board Skills Knowledge and Experience

The history of corporate disasters, including the 2007/8 Banking Crisis, is littered with boards that lacked key skills, knowledge or experience, a pattern that persists.   In an attempt to stem this steady flow, the FRC has tackled board composition.  They have three aims: to encourage NED teams that have an adequate combined skill-set; to encourage diversity of perspective; and to increase strength of NED character. The Code now provides:
"...Both appointments and succession plans should be based on merit and objective criteria and, within this context, should promote diversity of gender, social and ethnic backgrounds, cognitive and personal strengths." (Code Principle J)
"The board and its committees should have a combination of skills, experience and knowledge. ... " (Code Principle K)
These dry anodyne principles are reinforced in the Guidance, which includes a new emphasis on character - with courage heading the list.

The boardroom is not supposed to be a comfortable place:
"The boardroom should be a place for robust debate where challenge, support, diversity of thought and teamwork are essential features. Diversity of skills, background and personal strengths is an important driver of a board’s effectiveness, creating different perspectives among directors, and breaking down a tendency towards ‘group think’." (Guidance 16). 
Directors should be chosen to add value and effectiveness:
"Appointing directors who are able to make a positive contribution is one of the key elements of board effectiveness. Directors will be more likely to make good decisions and maximise the opportunities for the company’s success if the right skillsets and a breadth of perspectives are present in the boardroom. Non-executive directors should possess a range of critical skills of value to the board and relevant to the challenges and opportunities facing the company." (Guidance 87)
 Diversity, soft skills and character matter:
"Diversity of personal attributes is equally important. The nomination committee will want to ensure the board is comprised of individuals who display a range of softer skills, such as [sources of intellect, critical assessment and judgement, courage, openness, honesty, tact, ability to listen, ability to forge relationships, ability to develop trust and strength of character]" (Guidance, 91 combined with Figure 7)
 The Nomination Committee should be systematic in working out what the board needs, then set out to find them.  Competent boards will also create a person description setting out the personal attributes they seek.
"... The nomination committee should evaluate the skills, experience and knowledge on the board, and the future challenges affecting the business, and, in the light of this evaluation, prepare a description of the role and capabilities required for a particular appointment. .... It is important to build a proper assessment of values and expected behaviours into the recruitment process." (Guidance, 92)
"Skills matrices that map the existing skill-set against that required to execute strategy and meet future challenges can be an effective way of identifying skills gaps. They are a useful tool for role evaluation and succession planning." (Guidance 93)
 Boards should make efforts to attract recruits beyond the 'usual suspects':
"Publicly advertising board appointments and working with recruitment consultants who have made a commitment to promote diversity are examples of ways in which the nomination committee can access a more diverse pool of candidates from which to appoint. Attention also needs to be paid to how the interview process is conducted so that candidates with diverse backgrounds are not disadvantaged." (Guidance 94)
The Nomination Committee is asked four questions
  • "Have we assessed what skillset is required for the board and its committees?
  • Do we reassess the make-up of the board as a result of emerging trends?
  • Do we take account of the technical skills and knowledge required by the committees when recruiting members?
  • How often is a skills audit undertaken and are we keeping up with the pace of change?"  (Guidance before 92)
Interacting with the Workforce

The back story to these reforms includes public and political debate around how boards take account of relationships with stakeholders other than shareholders, and the workforce in particular.  Separately we have long raised the 'unknown known' problem - the all too common situation where the workforce knows important things that, for a variety of reasons, they will not, or dare not, tell their leaders.  The FRC has tackled both issues.  

The Code provides:
"The board should ensure that workforce policies and practices are consistent with the company’s values and support its long-term sustainable success. The workforce should be able to raise any matters of concern."  (Code Principle E)
"... The annual report should explain ... the company’s approach to investing in and rewarding its workforce." (Code Provision 2)
The board's engagement with the workforce is expected to include one or more of a director appointed from the workforce; a formal workforce advisory panel and/or a designated non-executive director (Code Provision 5).
"There should be a means for the workforce to raise concerns in confidence and – if they wish – anonymously. The board should routinely review this and the reports arising from its operation. It should ensure that arrangements are in place for the proportionate and independent investigation of such matters and for follow-up action." (Code Provision 6)
Boards are encouraged to draw the workforce into a collaboration when setting values because "Ownership of the values will be stronger if a collaborative approach is taken and both the leadership and the workforce are involved in a two-way process to define the company’s values (Guidance 18).  Similarly the Guidance advocates using "multiple qualitative and quantitative sources" to avoid gaining an incomplete picture of culture. "The workforce will be a vital source of insight into the culture of the company" (Guidance 23).

The FRC echoes our longstanding concern that boards are commonly in the dark about important things that the workforce knows but will not tell them - what we call the 'Unknown known' problem.  The FRC exhorts boards to make both whistle-blowing and more routine 'speaking up' safe for those with information to impart.
"Having policies in place that encourage individuals to raise concerns is a core part of an ethical and supportive business culture.  Whistleblowing policies that offer effective protection from retaliation ... are essential components of this. ..." (Guidance 57)
"Companies need to create an environment in which the workforce feels it is safe to raise concerns. Common fears include being negatively labelled, sidelined for promotion or bonuses, and even loss of employment. Leaders need to ensure there are no negative repercussions as a result of doing so." (Guidance 58)
"It is equally important to encourage individuals to speak up. Speak-up arrangements help build trust, act as an early warning system and help to manage risk. It is critical for success that leaders actively listen and feedback how the matter raised has been considered, including any action taken. Companies may want to consider the benefits of extending such arrangements beyond the workforce to external parties, like customers and suppliers. (Guidance 59)
One of the questions for boards to consider in this area is:
"What evidence do we have that the chief executive is willing to listen, take criticism and let others make decisions?" (Guidance below 26)
Remuneration issues

A crucial issue for behavioural risk specialists such as ourselves is the potential for executive reward systems to create incentives that encourage behaviour that is against organisation's best interests and that encourage treating the organisation's interests as pawns in a bigger game: the gaming of incentive schemes.  A long-running sore with the public and with politicians is the divergence between C-suite pay and workforce pay.  The FRC has tackled both.

As usual the FRC's approach begins with the Code.
"Remuneration policies and practices should be designed to support strategy and promote long-term sustainable success. Executive remuneration should be aligned to company purpose and values, and be clearly linked to the successful delivery of the company’s long-term strategy." (Code Principle P)
Remuneration Committee chairs are required to have had at least 12 months' service on a Remuneration Committee. (Code Provision 32).  The Committee should "review workforce remuneration and related policies and the alignment of incentives and rewards with culture, taking these into account when setting the policy for executive director remuneration." (Code Provision 22)

FRC Guidance on executive pay is now robust, encouraging rules that require the holding of shares awarded for long periods.  Foreshadowing the holding of shares well into retirement:
"Remuneration schemes should promote long-term shareholdings by executive directors that support alignment with long-term shareholder interests. Share awards granted for this purpose should be released for sale on a phased basis and be subject to a total vesting and holding period of five years or more. The remuneration committee should develop a formal policy for post-employment  shareholding requirements encompassing both unvested and vested shares." (Code Provision 36)
 The Code steers Remco towards clarity, simplicity, risk awareness and alignment with culture:
"When determining executive director remuneration policy and practices, the remuneration committee should address the following:
  • clarity – remuneration arrangements should be transparent and promote effective engagement with shareholders and the workforce;
  • simplicity – remuneration structures should avoid complexity and their rationale and operation should be easy to understand;
  • risk – remuneration arrangements should ensure reputational and other risks from excessive rewards, and behavioural risks that can arise from target-based incentive plans, are identified and mitigated
  • alignment to culture – incentive schemes should drive behaviours consistent with company purpose, values and strategy.  ..."  (Code Provisions 40)
Remco is expected to supervise all aspects of reward, including the relationshiop between workforce pay and executive pay.
"The remuneration committee is also tasked with reviewing workforce remuneration and related policies. The purpose of this review is to:
  • ensure the reward, incentives and conditions available to the company’s workforce are taken into account when deciding the pay of executive directors and senior management;
  • enable the remuneration committee to explain to the workforce each year how decisions on executive pay reflect wider company pay policy; and
  • enable the remuneration committee to feedback to the board on workforce reward, incentives and conditions, and support the latter’s monitoring of whether company policies and practices support culture and strategy." (Guidance 130)
In setting executive pay, Remcos are expected to "focus on the strategic rationale for executive pay and the links between remuneration, strategy and long-term sustainable success",  avoiding "pay structures based solely on benchmarking to the market, or the advice of remuneration consultants, as there is a risk this could encourage an upward ratcheting effect on executive pay."  (Guidance 133 and 134)

Once again, the theme of long term success reappears, with what is probably the most effective way of ending the gaming of incentives: forcing executives to hold shares until well after they leave.  New leaders tend to search for time bombs bequeathed by their predecessors.
"It is important that the remuneration committee takes steps to counteract the risk of incentives that are detrimental to the long-term success of the company. Packages that are structured to ensure exposure to the long-term share value, including for two to three years after leaving the company, can support alignment with shareholders and encourage executive directors to focus on the impact of their decisions over the long-term." (Guidance 135)
The FRC has asked Remcos to consider a suite of questions that probe:
  • alignment of executive pay with wider company pay policy
  • the extent to which workforce incentives support culture and encourage desirable behaviour?
  • How Remco has explained to the workforce the relationship between executive pay and wider company pay policies 
  • whether their pay policy strengthens long-term thinking
  • how they have addressed Provision 40 of the Code 
  • how performance measures support long-term thinking 
  • whether the choice of any measure may encourage negative behaviour and if so, what steps have been taken to manage the risks (Guidance after 132, 136 and 37) 
If you wish to understand the rationale behind most of these changes, you will find it explained in "Rethinking Reputational Risk - How to Manage the Risks that can Ruin Your Business, Your Reputation and You" by Anthony Fitzsimmons and the late Derek Atkins.  

Anthony Fitzsimmons
Reputablity LLP
London

www.reputability.co.uk
www.reputabilityblog.com









Thursday, 7 June 2018

Helping NEDs see through CEO charm

Leaders found to be dominant or hubristic regularly unleash unpleasant surprises after years of charming behaviour that camouflaged the vulnerabilities. Can investment managers reduce such risks?

Once upon a time, a bright young accountant called Fred Goodwin impressed John Connolly, then UK managing partner of Touche Ross. He became their youngest partner before moving on to be chief executive of Clydesdale Bank. Ian Fraser’s book Shredded relates how Goodwin shocked staff by his delight in “shredding” people in front of colleagues.

George Mathewson, then chief executive of Royal Bank of Scotland, was charmed by Goodwin, who arrived at RBS as chief financial officer and Mathewson’s heir apparent. He became confrontational, though charming when it suited him, leaving staff unwilling to speak up.

Weeks before becoming chief executive, Goodwin had a “contretemps” with Amyas Morse, PwC’s audit partner, who would not approve Goodwin’s accounting treatment of the NatWest acquisition.

Goodwin reportedly “unilaterally fired” PwC and “appointed” his old firm, by now called Deloitte and led by Connolly, only later seeking audit committee backing. If Fraser’s narrative is right, the alarm bells should have been deafening.

An effective board needs a non-executive director team with the skills, knowledge and experience to understand every aspect of the business, including its people, and especially the chief executive. NEDs need courage and social skills if they are to challenge executives. Most failures have their roots in board weakness.

The Ivey Business School “Leadership on Trial” research group, forged in the aftermath of the banking crisis, provides insights for boards into the role of character in leadership.

Two stand out. The notion that competencies determine what leaders can do, whereas character determines what they will do, is obvious. Less so is the conclusion on seemingly paradoxical traits. A leader with balanced characteristics — confidence with humility, drive with patience, candour with compassion — will be a better leader than one with unalloyed self-confidence, aggression or bluntness: and they will be less risky, too.

One of NEDs’ most important responsibilities is to select chief executives and the non-executive teams that should support and challenge them. Research from the London School of Economics, “Head-hunter methods for CEO selection” by Max Steuer and colleagues, suggests that outsourcing the recruitment of a chief executive to headhunters is a sign of widespread, fundamental board weakness.

Reputability’s research note, “Designing better boards”, confirms the weakness. It found FTSE 100 NED teams overwhelmed by board and financial experience and starved of NEDs with a deep understanding of people. A tiny proportion professed proficiency in fields such as social sciences, anthropology, psychology or HR, skills needed to evaluate character, behaviour and competence.

This makes it no surprise that so many boards seek seeming safety by outsourcing board appointments and pay to headhunters and consultants. The truth is that delegating any task without know-how is risky. The LSE report vividly illustrates the danger. In contrast, it seems no coincidence that at Weir — which recently devised a compensation structure beyond long-term incentive plans — Clare Chapman, an HR professional, chairs the remuneration committee.

Beyond recruitment and pay, it takes skill, know-how, self-awareness and effort to overcome deep-rooted biases and behaviours. Charm blinds us. We believe our own PR. Self-serving bias, the halo effect and overconfidence lead us to see ourselves, and those we have appointed, as better than we are. Social silences lead us to ignore subjects considered impolite, dull or taboo. NEDs who get past such issues need courage as well as social skills to overcome the social norms that shepherd us towards conformity.

The basic weakness is the lack of NEDs’ skills, knowledge and experience in recruiting people at and around board level. Responding to the Financial Reporting Council’s recent consultation on board effectiveness, we recommended putting a top-class people specialist in charge of the nomination and remuneration committees. In time, this will reduce the risk of unpleasant surprises. Investment managers, too, can encourage boards to follow suit.

Anthony Fitzsimmons
Reputability LLP
London
www.reputability.co.uk

This piece, published here by the Financial Times, has its origins in an article written for Financial World, the London Institute of Banking & Finance magazine.

Wednesday, 4 April 2018

Myths of Management

Twitter and Facebook are much discussed ‘echo chambers’ that reinforce existing ideas, closing our minds to new ones and polarising opinion.   This is not their purpose: they make money by keeping us glued to their sites so we see as many advertisements as possible.

Daniel Kahneman and Amos Tversky concluded you can think of our brains as having two systems.  System 1 is a machine designed to jump to conclusions: that shadow might be a tiger: Hide!  Slow, laborious System 2 is in charge of doubting and unbelieving.  It has limited thinking power and is energy intensive, so it becomes less effective if it is preoccupied, tired or lazy.

System 2 has another fundamental weakness.  Its default method is to search for memories that confirm what it is trying to test.  This is our ‘confirmation bias’.  As every scientist knows, a far better way to test a theory is to try to break it: but that takes far more energy, knowledge, thought and time.   

Twitter and Facebook keep us on their pages by analysing our data and feeding us information that we will like – material that fits our world view.  Many newspapers retain readers in a similar way.  This likeable material also feeds confirmation bias and lacks perspectives that challenge our world view as they see it.  The collateral damage is that they reinforce and entrench our existing attitudes whether these are a harmless obsession with cream coloured cats or pernicious political perspectives.  Unless we make considerable efforts to find contradictory information, we are easily, unwittingly, confined to our comfortable bubble.

Mental bubbles are neither new nor confined to the media.  Many myths, though widely believed, lack good foundations.  Webs of self-reinforcing sticky stories help them persist long after they have been debunked.  Management myths are no different.  Superficially plausible, many appeal to System 1’s tendency to jump to conclusions.  System 2 struggles to disbelieve them.  What we need is memorable myth-busting material to feed System 2 even on its dozy days.

One widespread myth is that our rational minds will overcome our emotions, leaving us to make logical decisions.  The Brexit vote and the election of Donald Trump will have convinced many that people are not always strictly rational, but most of us still believe that we (as opposed to “they”) make our decisions rationally.

This is where “The Myths of Management” by Stefan Stern and Cary Cooper can play a valuable role.  Myth 22 is “The business case will always prove persuasive”.  They explain that we are not rational creatures but rationalisers: we feel before we think.  This seems to be one reason why the Trump and Brexit campaigns prevailed over their rivals.  And it explains why politicians are addicted to policy-based evidence rather than evidence based policy.

Another popular myth is that problems that hit headlines are caused by bad people - rotten apples in a fine barrel.  Stern and Cary debunk this idea in Myth 33: “There’s nothing wrong with the business, there’s just a few rotten apples”. It is rarely bad people that are the real problem: a bad system will bring out the worst in most people.  There may have been bad apples at HBOS but a rotten system was an important cause of the crisis there.

This book debunks 43 myths of management, including gems such as “It is important not to show vulnerability or doubt” (Myth 4), “You need to be the smartest person in the room” (Myth 6) and “psychology is psychobabble and there’s no need or place for it” (Myth 22), adding nine interviews with well-known management sages such as Margaret Heffernan and Tom Peters.  They conclude by debunking Myth 44:  “There are only 44 things to get wrong.”

We all live in bubbles, and that includes leaders and managers.  It is easy for us to be attracted to alluring management slogans like “Keep your distance if you want respect” (Myth 27) but these need closer examination.  This readable book does us all a service by capturing and demolishing persistent, myths that mislead.  By giving their critiques snappy titles and flowing prose, Stern and Cooper provide a memorable source of stories we can turn to when System 1 likes a management idea but System 2 hasn’t got the time or energy to test it.  When you have read it, keep this book handy.  It will help you to test ideas that emerge from the management fad echo chamber.


Anthony Fitzsimmons
Reputability LLP
London
www.reputability.co.uk

Wednesday, 7 March 2018

Blindsided Boards


Board “blindsided” said the FT headline .  Volkswagen’s board is one of an endless stream that did not realise they were sitting on a time bomb with a dodgy fuse.  Others unwittingly presided over the incubation of the LIBOR and PPI scandals, bribery cases, most profit overstatements and countless other crises.  BP’s Deepwater Horizon, G4S’s Olympics problem, Volkswagen's emissions scandal  and the implosions of financial institutions such as Lehman, RBS, HBOS, AIG, Equitable Life and Independent Insurance are tiny sample from my bulging library.  These scandals exposed unrecognised reputational risks and the behavioural and organisational risks that underlay them.

Five days before Carillion’s £845 million write down, its chairman Philip Green was working towards an “upbeat announcement” to the City.  Yet the new new Finance Director had already sounded the alarm.

Two weeks before Tesco’s £250m profit warning, Terry Smith lucidly explained why he refused to invest in Tesco: it had, he wrote, been massaging its results for more than a decade to create growth in earnings per share, whilst return on capital had almost halved.   Even the firm’s auditors had insisted on public warning as to the difficulties in accounting for Tesco’s commercial arrangements. 

Independent Insurance was a stock market darling that reported stunning results.  Its charismatic chief executive, Michael Bright, was the FT’s “Entrepreneur of the Year” for 1998.  Yet the company collapsed two years later and Bright, and two colleagues were jailed for fraud: they had been hiding over £100m of liability claim reserves.  

Boards at Airbus, BAe, Rolls Royce, Glaxo and many more found their companies embroiled in bribery allegations, confirming long-running rumours of corruption in their sectors.

The role of NEDs is to challenge and support executives but why don’t they see trouble coming?  Having studied scores of scandals, it is clear that insufficient intelligence is rarely the problem.  But patterns of board weakness recur time and again. 

There are NEDSs who lack understanding of the business.  None of the NEDs at Tesco had retail experience  so it would not be surprising if they didn’t have enough insight into the Byzantine structure of ‘commercial arrangements’ between supermarkets and large suppliers.  

It was the same at Independent Insurance.  The main fraud was a scam I was taught about on day one of my reinsurance education.  There is always an element of estimation in the kind of liability claims the Independent underwrote, which makes it tempting to cook the books and gull the ignorant.  Months before the collapse, a friend and I, armed with no more than their published regulatory returns, found the hole the board had missed.  Unfortunately it seems the NED team lacked the skill, knowledge and experience to do this even with access to inside information.

Back at VW, renowned for its technical skills, the truth about the emissions scandal seems to have eluded leaders, who appear not to have questioned how their company was achieving results others thought impossible.  Elsewhere, many boards seem to have believed that corruption, rife in their industry, did not encompass their firm.

Competent NEDs worry about how and why their firm is successful, including the relative roles of skill and luck in success.  They know it is hard for unpalatable truths to reach leaders.  Taboos, loyalty to colleagues, and fear fracture frank communication channels to the top.  So do social bubbles, norms and silences.  Chinese whispers can transform messages as they rise up hierarchies.  Incentives and perceptions of leaders’ attitudes can discourage those with unwelcome news or views from bringing them to leaders.  Without curiosity and persistence, dissonances remain unexplored.

One reason for this is NEDs who do not recognise their humanity.  We are all affected by cognitive biases.  As Daniel Kahneman once wrote,
"We're blind to our blindness. We have very little idea of how little we know. We're not designed to." 
The optimistic bias leaves us thinking that bad things are less likely to happen to us.  Confirmation bias leaves us seeking to confirm, rather than disprove what we feel or believe.  Overconfidence leaves us believing we are better than an outsider would conclude.  Hubris overwhelms us.  Groupthink undermines our capacity for independent thought.  We are less rational and more deluded than our overconfidence leads us to suppose.

The greatest delusion is probably that an intelligent, well-meaning board is enough to lead a company to success.  An effective board needs a NED team with the skills, knowledge and experience to understand every aspect of the company’s systems and activities, including its people.  It takes NED self-awareness and courage plus forensic and social skills constructively to challenge charismatic or dominant leaders. 

Being blindsided is bad for your company and its reputation and for your board members and their reputations.  The questions are whether the board wants to remove its blinkers; and who will take the lead.  


Anthony Fitzsimmons
Reputability LLP
London
www.reputability.co.uk

Reputational risks, and the behavioural, organisational risks that underlie them, are discussed in more detail in Rethinking Reputational Risk - How to Manage the Risks that can Ruin Your Business, Your Reputation and You You can get a 20% discount hrough this link by using the code RRRF20



Tuesday, 2 January 2018

Introducing the New FRC Governance Proposals

The Financial Reporting Council (FRC) is consulting on revisions its Corporate Governance Code (the Code) and Guidance on Board Effectiveness (the Guidance).  The changes proposed by the FRC reflect their increasingly deep understanding of the root causes of company failures.   These changes develop the FRC's leadership on governance thinking to reflect the FRC's groundbreaking Guidance on Risk.  Our survey of Annual Reports shows that most companies have made poor progress towards meeting the FRC's guidance.  And board composition still has far to go.

The FRC's has put 'long term success' of the company at the heart of its thinking.  Their approach has two strands.  The first confronts the historic priority given to shareholders.  It begins to tackle the undesirable drivers of short-termism, including weak design of incentives granted to C-Suites.  And it recognises the pressure from investment managers whose own incentives are, reportedly, very short term.

You can think of the second strand as the result of reverse stress testing for risks to 'long term success'.  Exploring answers to the question 'what risks our long term success?' will take you in many directions.  Some will be specific to your organisation: changing markets, evolving consumer tastes, new sources of supply, increased competition  and much more.  But others will flow from the fact that, whatever your organisation does and however it is structured, its fate ultimately depends on the actions and inactions of people.  Most major failures are, at their root causes, system failures.  Since leaders are the ultimate deliberate or inadvertent creators or drivers of all the systems in their organisation, it follows that leaders really matter.  


This is why the FRC's renewed focus on leaders and people-systems is so desirable.

The FRC's proposals respond to almost all the types of corporate vulnerabilities we catalogued and illustrated in our book "Rethinking Reputational Risk: How to Manage the Risks that can Ruin Your Business, Your Reputation and You".  The revisions are thus also apt to encourage boards to strengthen their reputational resilience.  This makes it a double pleasure to be able to echo Sir Win Bischoff's own praise for "Rethinking Reputational Risk”.  We much endorse the FRC's recommendations to business leaders.  It is instructive to see the FRC handle the subject with such conviction and clarity.


In our more detailed note here we explain the FRC's new approach under six headings: 

  • Long term success for the benefit of all stakeholders
  • Board composition, diversity, skills and challenge
  • Leadership, Values, Culture and Behaviour
  • Interacting with the workforce and other stakeholders
  • Setting Pay
  • Reporting
To give you some flavour, the FRC laces its proposals with over seventy perceptive questions for boards to consider.  Examples include:
  • How have [our] values and behavioural expectations been reinforced in our recruitment, induction, performance management, incentives and reward policies, processes and practices?
  • How are we testing this with new recruits and the existing workforce?
  • What behaviours are being driven when setting strategy and financial targets?
  • Is management using root cause analysis when things go wrong? (Examining not just what went wrong but why.) For example, were incentives/rewards, social or power dynamics a contributing factor?
  • Is the company holding exit interviews with leavers and are we considering how the feedback reflects on the company’s culture?
  • What evidence do we have that the chief executive is willing to listen, take criticism and let others make decisions?
  • How does the ‘tone in the middle’ resonate with the workforce?
  • What action do we take against senior people or star performers who do not uphold the company’s values?
In the same spirit, the FRC lists a selection of 'warning signs' for NEDs that things might be going wrong on culture:
  • "Silo thinking
  •  Dominant chief executive
  •  Leadership arrogance
  • Pressure to meet the numbers/overambitious targets
  • Lack of access to information
  • Low levels of engagement between leadership and employees
  • Lack of openness to challenge
  • Poor succession planning
  • Misaligned incentives and flawed executive remuneration practices
  • Tolerance of regulatory or code of ethics breaches, e.g. by star employees
  • A lack of diversity
  • Hierarchical attitudes
These signs are all too familiar.  

Regular readers will have at least a general understanding of the issues the FRC is tackling.  For readers who wish to gain a deeper understanding of the issues, we recommend two influential publications.  'Roads to Ruin" is the seminal (2011) Cass Business School report for Airmic.  Based on twenty case studies it lays the ground for the field   A further six years' research made it possible for our book “Rethinking Reputational Risk” to take a more systematic approach and address the needs of both leaders and risk professionals.  They provide complementary perspectives on the insights that inform the FRC's approach.  

We have also written a more detailed analysis of the FRC proposals which you will find here


Anthony Fitzsimmons
Reputability LLP
London
www.reputability.co.uk
www.reputabilityblog.com
@reputability

"Rethinking Reputational Risk: How to Manage the Risks that can Ruin Your Business, Your Reputation and You" is available from Kogan Page who offer a 20% discount to our readers who use code BBLRRR20 via the link above.

Deconstructing the FRC's new Governance Proposals

Introduction

With strong encouragement from Parliamentarians, and drawing on its Culture Project, the Financial Reporting Council (FRC) is consulting on revisions its Corporate Governance Code (the Code) and Guidance on Board Effectiveness (the Guidance).  These drafts tackle two related families of issues afflicting publicly quoted UK firms:
  • UK companies' record of "eating themselves," as Andy Haldene called it, by over-distributing dividends at the expense of long term investment; and 
  • the unabated stream of unnecessary, predictable corporate failures of recent years and decades.  
The FRC's proposals respond to almost all the types of corporate vulnerabilities catalogued and illustrated in our book "Rethinking Reputational Risk: How to Manage the Risks that can Ruin Your Business, Your Reputation and You".  The revisions are thus also apt to encourage boards to strengthen their reputational resilienceThis makes it a double pleasure to be able to echo Sir Win Bischoff's own praise for "Rethinking Reputational Risk”.  We much endorse the FRC's recommendations to business leaders.  Whilst we shall recommend refinements in our response to their Consultation, it is instructive to see the FRC handle the subject with such conviction and clarity.

The Code Introduction summarises the FRC's aim:
"At the heart of this Code is an updated set of Principles that emphasises the value of good corporate governance to long-term success in this wider context. By applying the Principles, following the more detailed Provisions and using the associated guidance, companies are able to demonstrate throughout their reporting how the governance of the company contributes to its long-term success and achieves wider objectives."
We have drawn six key themes from the FRC's proposals.  These are:
  • Long term success for the benefit of all stakeholders
  • Board composition, diversity, skills and challenge
  • Leadership, Values, Culture and Behaviour
  • Interacting with the workforce and other stakeholders
  • Setting Pay
  • Reporting
We have used the FRC's own words to develop these themes because a synopsis would mask the FRC's tone and the depth of its understanding of the issues.  In what follows, references are to paragraph letters/numbers in the proposed revised Code and Guidance except where otherwise indicated.

Long term success for the benefit of all stakeholders

Profits retained by quoted companies for reinvestment fell from 90% in 1970 to about 35% in 2015  leaving firms with far less money for growth-boosting investment and risking "eating themselves".  Debt levels increased relative to equity. This is bad for the long term health of UK Plc and its ability to generate wealth.

There are many reasons for this.  A deep root is Milton Friedman’s ‘Shareholder Value' thesis which held that a corporate executive's duty was to maximise profits for shareholders, and that anyone arguing for business to show a social conscience was "preaching pure and unadulterated socialism".  Despite contemporary ministerial statements to the contrary, the wording of s172 of the UK Companies Act 2006 was widely interpreted as giving shareholder interests primacy over other stakeholders.  A prominent example is in the Preface to the current (2016) version of the Code, which concludes:
"While in law the company is primarily accountable to its shareholders, and the relationship between the company and its shareholders is also the main focus of the Code, companies are encouraged to recognise the contribution made by other providers of capital and to confirm the board’s interest in listening to the views of such providers insofar as these are relevant to the company’s overall approach to governance."
In a world where C-suites and institutional investors are rewarded on short term measures of profitability, the natural result is strong pressure to deliver short term profits to shareholders at any cost - including foregoing investment and other routes to longer term success.  As Professor John Kay wrote in in his Review of UK Equity Markets that:
"short-termism is a problem in UK equity markets, and that the principal causes are the decline of trust and the misalignment of incentives throughout the equity investment chain."
Reinforced by parliamentarians of all parties, the FRC has changed its emphasis, declaring that the function of a board is:
"to promote the long-term sustainable success of the company, generate value for shareholders and contribute to wider society." (Code Principle A)
The Guidance recommends boards to:
"consider input from the workforce and other stakeholders and be able to explain how this was taken into account and the impact it had on the decision." (Guidance19)
The FRC confronts the clash with investment managers whose time horizons are measured in quarters rather than years or decades.  Having stated that boards are responsible for the company’s health and need to take a longer-term view, the FRC observes:
This can be in contrast with some investors or potential investors who may focus on short-term returns." (Guidance 37)
This clash needs further remedial work.  Investment managers are regularly chastised for, among other sins, being ferociously focused by very short term bonuses.  Revising the Stewardship Code is a first step.  However we suspect that the Financial Conduct Authority will have to develop robust rules to force investment manager incentives and behaviour into alignment with the interests of their ultimate clients, most of whom will usually be retail investors and pensioners seeking steady long-term growth.

Board composition, diversity, skills and challenge

Few boards lack honesty or ample intelligence.  The vulnerabilities identified in "Rethinking Reputational Risk" were hitherto unrecognised gaps in NED skill sets, unrecognised biases, heuristics and social behaviours, insufficient diversity of thought and perspectives, cloistered world views and a reluctance to challenge. These present huge systemic risks to long term success.

These tendencies should be no surprise.  It is normal for we humans to surround ourselves with self-perpetuating "people like us".  In the UK there also seems to be a widespread, persistent but deeply mistaken notion that what matters most for boards is a combination of intelligence, financial literacy and an aptitude for 'strategy'.  Execution and systems, and the skills and knowledge relevant to
them, are too often looked down upon by, and absent from, boards.

Whilst gender diversity has improved somewhat, our research shows that there is much to improve in UK boards.  We found ethnic diversity largely absent, with boards dominated by accountants, investment bankers and people with experience in and around the C-Suite.  Given that all companies' systems depend on a combination of people and IT, it is astonishing that people with a deep understanding of IT and human behaviour rarely found on boards.

The FRC has taken substantial steps towards tackling these weaknesses.  The revised Code reiterates the Chair’s responsibility for the board’s effectiveness and for promoting a culture of openness and debate by facilitating constructive relations between directors, with particular attention to ensuring that NEDs make effective contributions.  Non-executive directors are expected to provide specialist advice and strategic guidance as well as holding management to account through constructive challenge. (Code Introduction and G)

The Code sets out to force boards to recruit beyond their, and their recruiters’, social sets, circles and comfort zones: "Both appointments and succession plans should be based on merit and objective criteria, and promote diversity of gender, social and ethnic backgrounds, cognitive and personal strengths." (Code J)  To reinforce this, “Regular evaluation of the board should consider the balance of skills, experience, independence and knowledge, its diversity ..." (Code K)
"Open advertising or an external search consultancy should generally be used for the appointment of the chair and non-executive directors. " (Code 20)
The Guidance develops the theme:
"The boardroom should not necessarily be a comfortable place. Challenge, as well as teamwork, is an essential feature. Diversity in board composition is an important driver of a board’s effectiveness, creating a breadth of perspective among directors, and breaking down a tendency towards ‘group think’.." (Guidance 13)
The Guidance tackles the tendency of some CEOs to bounce boards into new projects.
"Some chairs favour a series of separate discussions for important decisions; for example, concept, proposal for discussion, proposal for decision. This gives executive directors more opportunity to put the case at the earlier stages, and all directors the opportunity to share concerns or challenge assumptions well in advance of the point of decision." (Guidance 17)
The FRC recognises that humanity's ubiquitous psychological weaknesses are found in boardrooms as well as elsewhere when it recommends:
"putting in place additional safeguards to reduce the risk of distorted judgements by, for example, commissioning an independent report, seeking advice from an expert, introducing a devil’s advocate to provide challenge." (Guidance 20)
Turning to the practicalities of recruitment, the FRC recommends that when preparing to recruit a new director the nomination committee should "evaluate the balance of skills, experience, knowledge and diversity on the board and, in the light of this evaluation, prepare a description of the role and capabilities required for a particular appointment." (Guidance 76)

As to skills and perspectives:
"Appointing directors who are able to make a positive contribution is one of the key elements of board effectiveness. Directors will be more likely to make good decisions and maximise the opportunities for the company’s success in the longer term if the right skill-sets and a breadth of perspectives are present in the boardroom. This includes independence of mind, diversity and a range of skills, experience and knowledge. Non-executive directors should all possess critical skills of value to the board and relevant to the challenges and opportunities facing the company." (Guidance 79)
As to character and intellect:
"It is important to consider a diversity of personal attributes among board candidates, including intellect, critical assessment and judgement, courage, openness, honesty and tact; and the ability to listen, forge relationships and develop trust. Diversity of psychological type, background, gender and ethnicity is important to ensure that a board is not composed solely of like-minded individuals. A board requires directors who have the intellectual capability to suggest change to a proposed strategy, and to promulgate alternatives." (Guidance 82)
As the FRC observes, a board with diversity in all its dimensions is more likely to make better decisions as well as avoiding ‘group think’. (Guidance 89)

As to board evaluations, the FRC has retained its valuable, but under-used, suggestion that external board evaluations are particularly helpful to a newly appointed new Chair:
"External facilitation .... may also be useful in particular circumstances, such as when there is a new chair, if there is a known problem around the board table requiring tactful handling; or there is an external perception that the board is, or has been, ineffective." (Guidance 94)

Leadership, Values, Culture and Behaviour

Code Principles set the tone.
"… The board should establish the company’s purpose, strategy and values, and satisfy itself that these and its culture are aligned." (Code A)
"The chair … should … promote a culture of openness and debate by facilitating constructive relations between directors; in particular, the chair should ensure the effective contribution of all non-executive directors." (Code E)
Developing these principles, the Code continues:
"Directors should embody and promote the desired culture of the company. The board should monitor and assess the culture to satisfy itself that behaviour throughout the business is aligned with the company’s values. Where it finds misalignment it should take corrective action. " (Code 2)
"...alignment to culture: incentives should drive behaviours consistent with company purpose, strategy and values." (Code 40)
 This is supported by recommendations in the Guidance:
"[Boards should ask questions such as... ] How do we obtain assurance that the culture we are leading is open, accountable and aligned to purpose, strategy and values?" (Guidance 13, Box)
"... The board should consider the potential impact of [decisions] on the company’s culture, for example the behaviour it could drive or the message it might send. The board should ensure its decisions are consistent with its values and what the company says it stands for." (Guidance 18)
"Having policies in place that encourage individuals to raise concerns is a core part of a supportive ethical business culture. Whistleblowing policies that offer effective protection from retaliation, as well as policies that support bribery and corruption legislation are essential components of this. Such policies are important, for example when attempts to resolve things internally have not worked." (Guidance 32)
"It is equally important to create an environment that encourages individuals to raise concerns or ask questions about a wide range of issues. Speak up arrangements help build trust, and can act as an early warning system and help to manage risk. Some companies even extend such arrangements beyond the workforce to external parties, like customers and suppliers." (Guidance 33)
"The board sets the framework within which a healthy corporate culture can develop, that underpins the way in which the company operates. It then satisfies itself that the culture throughout the organisation is consistent with that framework, leading by example and taking action where it spots misalignment." (Guidance 39)
The FRC list a selection of tell-tale signs of a cultural problem:
"Silo thinking
Dominant chief executive
Leadership arrogance
Pressure to meet the numbers/overambitious targets
Lack of access to information
Low levels of engagement between leadership and employees
Lack of openness to challenge
Poor succession planning
Misaligned incentives and flawed executive remuneration practices
Tolerance of regulatory or code of ethics breaches, e.g. by star employees
A lack of diversity
Hierarchical attitudes
" (Guidance 40, Figure 2)
 The FRC directs attention to the influence of recruitment and reward systems on behaviour.
"Boards should seek assurance that management has put appropriate mechanisms in place to implement and embed the company purpose, strategy and values. In particular, incentives and rewards, promotion and development decisions should be aligned to these. Boards should satisfy themselves that this is clear in company policies and is applied in practice, challenging themselves and management on how effective they are at shaping and embedding culture, for example in the areas suggested below.
Examples include:
“How are we demonstrating ethical leadership, displaying and promoting throughout the company, behaviours we expect from others? (sic)
What steps have we taken to address any negative trends or misalignment between values and behaviours?
How have the values and behavioural expectations been reinforced in our recruitment, induction, performance management, incentives and reward policies, processes and practices?
How are we testing this with new recruits and the existing workforce?
What behaviours are being driven when setting strategy and financial targets?
Is company tax policy consistent with stated values?
What steps has management taken to ensure that suppliers meet expected standards of behaviour?"
(Guidance 42)
The Guidance points towards ending siloed thought and action on the corresponding risks:
"The board should engage different parts of the business, for example HR, internal audit, risk and compliance, in its assessment of culture and encourage an integrated approach. It should make use of technology to access and analyse information in order to develop a more sophisticated view of culture-associated risk and develop its understanding of how culture and behaviours impact performance." (Guidance 44)
 The FRC points boards towards sources of insight such as turnover and absenteeism rates, grievance and ‘speak up’ data,  promptness of payments to suppliers and attitudes to regulators, internal audit and employees" (Guidance 45).  These are reinforced with a raft of suggested questions such as:
"Is management using root cause analysis when things go wrong? (Examining not just what went wrong but why.) For example, were incentives/rewards, social or power dynamics a contributing factor?
Is the company holding exit interviews with leavers and are we considering how the feedback reflects on the company’s culture?
What evidence is there that the way the company conducts business in practice is consistent with what it claims to stand for?
Do employees feel that customers and suppliers are treated fairly and that the company cares about its impact on the environment and community?
What evidence do we have that the chief executive is willing to listen, take criticism and let others make decisions?
How does the ‘tone in the middle’ resonate with the workforce?
What action do we take against senior people or star performers who do not uphold the company’s values?
What do examples of communications from leadership and middle management tell us about the commitment to values, openness and accountability?"
(Guidance 46)
More generally, boards are encouraged to ask how well their values and expected behaviours are embedded in their HR system from recruitment to exit interviews and how the company structures remuneration and other forms of reward to produce appropriate incentives. (Guidance106)

Turning to Remuneration Committees (Remcos), it encourages asking questions such as:
"How effective are the financial and non-financial performance measures at supporting values and culture?
Are incentives across the organisation aligned to our culture and encouraging the desired behaviours?
Have we considered negative behaviour which the choice of any particular metric may encourage and what steps have we taken to manage such risks?"
(Guidance 113)

Interacting with the workforce and other stakeholders

The FRC defines 'workforce' in broad terms, including remote workers, agency workers and contractors and recognises them as both stakeholders and important sources of information for boards before stating:
"The workforce should be able to raise concerns in relation to management and colleagues where they consider that conduct is not consistent with the company’s values and responsibilities. ... "(Code D)
Turning to how workforce views can be brought to the boardroom, the FRC recommends:
"The board should establish a method for gathering the views of the workforce. This would normally be a director appointed from the workforce, a formal workforce advisory panel or a designated non-executive director. There should also be a means for the workforce to raise concerns in confidence and (if they wish) anonymously. The board should review this and ensure that arrangements are in place for the proportionate and independent investigation of such matters and for follow-up action." (Code 3)
Again the Guidance helpfully suggests questions for boards to consider.  For example, reaching beyond the workforce:
"How do we make sure the voice of the workforce, customers and wider stakeholders is heard at board-level and what impact has this had on our decisions?" (Guidance 13)
"[Before major decisions] the board should consider input from the workforce and other stakeholders and be able to explain how this was taken into account and the impact it had on the decision." (Guidance 19)
The Guidance emphasises the importance of speaking up and challenging authority becoming a part of normality.  Having identified the value of ‘speak-up’ and whistleblowing systems (Guidance 32) the Code continues:
"Engagement through a range of formal and informal channels helps the workforce to share ideas and concerns with senior management and the board, provides leaders with useful feedback about business practices from those delivering them and can help empower colleagues. Companies need to create an environment in which the workforce feel it is safe to voice their views. Common fears include being negatively labelled for speaking up, which might result in being side-lined for promotion, pay increases and bonuses. To be successful, leaders must actively listen, encourage the workforce to speak up and ensure there are no negative repercussions as a result of doing so.” (Guidance 34)
The FRC suggests questions for boards to consider, such as:
"Does management provide feedback to colleagues on how complaints and concerns have been dealt with?
How comfortable do the workforce say they are with challenging and reporting issues of concern and is there any evidence that they are doing this?
Do employees report that leaders and managers live the company’s values?
” (Guidance 36)
NEDs are expected to listen to all stakeholders including outsiders:
"To fulfil their duties, non-executive directors should take into account the views of shareholders, the workforce and other stakeholders, because these views may provide different perspectives on the company and its performance. They should avail themselves of opportunities to meet major shareholders, key customers and members of the workforce from all levels of the organisation." (Guidance 68)
This includes discovering how stakeholders view the board’s performance to achieve a 360 degree perspective:
"The chair should consider how to obtain input from the workforce and other stakeholders on the board’s performance.” (Guidance 91)
Setting Pay

The starting point on pay is Code Principle O:
"The board should satisfy itself that company remuneration and workforce policies and practices promote its long-term success and are aligned with its strategy and values." (Code O)
The Guidance gives the board ultimate responsibility for ensuring that all workforce remuneration, incentives and other workforce policies support the long-term success of the company and promote its values. (Guidance 102)

The Code recommends that the chair of the Remuneration Committee (Remco) "should have served on a remuneration committee for at least 12 months" before appointment.” (Code 32) continuing:
"The remuneration committee should have delegated responsibility for determining the policy for director remuneration and setting remuneration for the board and senior management. It should oversee remuneration and workforce policies and practices, taking these into account when setting the policy for director remuneration.” (Code 33)
The Code exhorts Remcos to use its independent judgement both when evaluating the advice of remuneration consultants and when they are hearing Executives’ views on pay. (Code 35)  This implies that Remco should have a sufficient skill and experience in understanding human behaviour to be capable of making such a judgement.

The FRC has recognised that incentive schemes can be gamed.  With strong Parliamentary encouragement it has recommended both longer vesting periods and that executives should continue to hold shares after they leave.
"Remuneration schemes should promote long-term shareholdings by executive directors that support alignment with long-term shareholder interests. In normal circumstances, shares granted or other forms of long-term incentives should be subject to a vesting and holding period of at least five years. Longer periods, including post-employment periods, may be appropriate." (Code 36)
The FRC recommends that Remcos address six aspects of remuneration that have caused trouble in the past.

  • "Clarity – remuneration arrangements should be transparent and facilitate effective engagement;
  • Simplicity – remuneration structures should avoid complexity; their rationale and operation should be easy to understand;
  • Predictability – the range of possible values of rewards to individual directors should be identified and explained at the time of approving the policy;
  • Proportionality and reward for individual performance – there should be a demonstrable link between individual awards and the long-term performance of the company.
  • Outcomes should not reward poor performance and total rewards available should not be excessive; and
  • Alignment to culture – incentives should drive behaviours consistent with company purpose, strategy and values. (Code 40)
This responsibility for remuneration extends beyond mere money but includes areas such as culture and incentives:
"This means overseeing not only pay, conditions and incentives but also other policies that have an impact on the experience of the workforce and drive behaviours. This includes policies around recruitment and retention, promotion and progression, performance management, training and development, re-skilling and flexible working." (Guidance 103)
The FRC suggests that boards should set principles for pay and reward across the enterprise, listening to the workforce and joining up thinking. (Guidance 105 and 106)  Once again the FRC suggests questions for boards to consider, such as:
Can we articulate our approach to investing in and rewarding our workforce?
Have we taken workforce views and priorities into account in developing our approach?
Does the balance between financial and non-financial incentives support the desired culture?
Are behavioural objectives included in leadership and employee goals and are behaviours formally assessed as part of performance review activity?
Have we considered whether executive pay incentives or those of other employees could undermine culture?
”(Guidance 106)
Remcos are expected to engage with the workforce to explain how executive remuneration aligns with wider company pay policy and promotes long-term value generation. (Guidance 113)  On this score too Remco is encouraged to ask itself questions such as:

  • "How is executive remuneration aligned with wider company pay policy?
  • How is corporate reputational risk considered in the setting of incentive pay?
  • What is the maximum award we think is reasonable for our executive directors and what will we do in the event the application of the formula produces an outcome in excess of that award?
  • How effective are the financial and non-financial performance measures at supporting values and culture?
  • Are incentives across the organisation aligned to our culture and encouraging the desired behaviours?
  • Have we considered negative behaviour which the choice of any particular metric may encourage and what steps have we taken to manage such risks?
  • Do employees feel that they are treated well and fairly in the workplace and that they are supported in developing themselves and fulfilling their potential?
  • What have we done to explain executive pay arrangements in comparison with those of the workforce? (Guidance 113)

Reporting

The overarching principle here is that more reporting, both internally and externally, will help boards better to listen and respond to to challenge as the workforce and other stakeholders learn what they do, how and why.

Setting the tone, the Code begins:
At the heart of this Code is an updated set of Principles that emphasises the value of good corporate governance to long-term success in this wider context. By applying the Principles, following the more detailed Provisions and using the associated guidance, companies are able to demonstrate throughout their reporting how the governance of the company contributes to its long-term success and achieves wider objectives."  (Code Introduction)
Moving to content:
"The board … should describe in the annual report how opportunities and risks to the future success of the business have been considered and addressed, the sustainability of the company’s business model and how its governance contributes to the delivery of its strategy." (Code 1)
"The annual report should explain the board’s activities and any action taken [in relation to culture]." (Code 2)
"The board should explain in the annual report how it has engaged with the workforce and other stakeholders, and how their interests and the matters set out in section 172 of the Companies Act 2006 influenced the board’s decision-making." (Code 4)
"There should be a description of the work of the remuneration committee in the annual report which should include:
an explanation of the strategic rationale for executive directors’ remuneration policies, structures and performance metrics;
reasons why the remuneration is appropriate using internal and external measures;
whether the remuneration policy operated as intended in terms of company performance and quantum, and, if not, what changes are necessary;
what engagement has taken place with shareholders and the impact this has had on remuneration policy and outcomes;
an explanation of the company’s approach to investing in, developing and rewarding the workforce, and what engagement with the workforce has taken place to explain how executive remuneration aligns with wider company policy; and
to what extent remuneration outcomes have been affected by board discretion.
(Code 41)
"Directors should ... explain... their decisions and how they have taken account of the interests of different stakeholders. This will include being able to explain how the benefits in terms of the long-term success of the company outweigh any negative impacts, and any action the company plans to take to mitigate those impacts." (Guidance 30)

Conclusion

The changes proposed by the FRC are radical, reflecting an increasingly deep understanding of the root causes of company failures.  They have strong support from both Government and the Parliamentary Inquiry into Corporate Governance.

Regular readers will have at least a general understanding of the issues the FRC is tackling.  For readers who wish to gain a deeper understanding of the issues, we recommend two influential publications.  'Roads to Ruin" is the seminal (2011) Cass Business School report for Airmic.  Based on twenty case studies it lays the ground for the field   A further six years' research made it possible for our book “Rethinking Reputational Risk” to take a more systematic approach and address the needs of both leaders and risk professionals.  They provide complementary perspectives on the insights that inform the FRC's approach.  Of course we can provide practical education tailored to the needs of your board and your risk team.


Anthony Fitzsimmons
Reputability LLP
London
www.reputability.co.uk
www.reputabilityblog.com
@reputability