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 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
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 thinkingThe FRC directs attention to the influence of recruitment and reward systems on behaviour.
• 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)
"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)The Guidance points towards ending siloed thought and action on the corresponding risks:
• 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 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?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)
• 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)
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?NEDs are expected to listen to all stakeholders including outsiders:
• 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)
"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.
This responsibility for remuneration extends beyond mere money but includes areas such as culture and incentives:
- "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 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?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:
• 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)
- "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)
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)
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 is Chairman of Reputability LLP and, with the late Derek Atkins, author of “Rethinking Reputational Risk: How to Manage the Risks that can Ruin Your Business, Your Reputation and You”