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OPINION

Lessons from history

Lessons from history
May 22, 2017
Lessons from history

Tighter controls

In 1992, the Cadbury Report reinforced the idea that nobody can police themselves effectively. We are often blind to our own faults; we need critical friends. In companies, this is where independent directors come in, led by the chairman. (Although female, Dame Alison Carnwath, who currently chairs Land Securities (LAND), and Susan Kilsby, who chairs Shire (SHP), both call themselves “chairman”.) Independent directors are not employees (they are non-executives); they come from outside the company and they have to outnumber the executive directors. A key part of the role is to ensure that internal controls are sound and that financial reporting is transparent. To avoid conflicts of interest, nobody should double as both chief executive and chairman. Today, few companies combine both roles, although some, such as Micro Focus (MCRO) fudge the distinction by having an executive chairman.

By the mid-nineties, there was an increasing concern that executives were paying themselves too much. The Greenbury Report’s answer was to require remuneration committees, who determine executive pay, to consist entirely of non-executive directors. They now had to justify to shareholders each year exactly how they had come up with their pay recommendations.

Another three years and the Hampel report pulled Cadbury and Greenbury together in the Combined Code (of Corporate Governance) that all companies were expected to follow. But what about enforcement? That’s what the Turnbull report looked at. It confirmed the principle of comply or explain – either companies have to say how they are keeping within the guidelines or come up with convincing reasons for why they do things their way.

 

This century

These reforms might have sorted companies out within themselves, but what about external pressures? Some feared that institutional shareholders had become too obsessed with short-term results and were distorting companies’ decision-making processes. So in 2001, the Myners review encouraged institutions to act more like long-term owners and recommended better communications between investors and companies. A year later, new rules defined the Directors’ Remuneration Report on executive pay and required shareholders to approve it each year. This vote, though, is advisory, meaning that directors need only take note of shareholders’ concerns, rather than taking any other action.

Another two years, and the Higgs Report picked up on where Cadbury had left off a decade before and sharpened the rules about Non-Executive Directors. They had to be truly independent, more rigorous in recruiting key executives and more forthcoming about their own performance. By 2005, there’d been the Smith Report about audit committees, the Tyson Report about recruiting and developing non-executive directors and the Turnbull Report, which updated the Combined Code that had been established by Hampel.

In the midst of this, the 1985 Companies Act was revised. With over 1,300 sections, the 2006 Companies Act is the longest piece of legislation ever enacted in the UK – it took until 2009 before all its provisions finally became law. While this was trundling through, the financial crisis brought home to executives that they’d been overlooking a crucial element. Risk. So in 2009, the Turner Review (on banking) and the Walker Review came up with much stricter guidance on the management of risk, igniting a boom for risk and compliance specialists.

This was also when high pay was made more transparent, but it was not until 2013 that uniform reporting of the total amount actually received by an executive director (the “Single Figure of Total Remuneration”) became mandatory. Pay-in-the-past was still subject to an advisory vote, but now companies have also to ask shareholders to approve its pay policy, which lays down the parameters for the future pay of executive directors. Since the 2014 reporting season, this vote has been binding.

 

Democracy in action

The highest protest vote against executive pay so far this year has been at Pearson (PSON). In 2015, chief executive John Fallon received a zero bonus, but in 2016, he was awarded £343,000. This is in addition to salary and benefits worth £1.1m. Only 32 per cent of the votes cast approved of this in the directors’ remuneration report; 64 per cent backed the pay policy. At Crest Nicholson’s (CRST) AGM 41 per cent supported the report, but 96 per cent supported the policy. There were similar voting patterns at Inmarsat (ISAT), AstraZeneca (AZN) and Drax (DRX), all of whom had significant votes against their report, but strong backing for their pay policy.

Corporate governance is now under review again, and one concern is that too many investors fail to vote. At each of these five companies, the equivalent of turnout was over 70 per cent, so this may not be such a problem after all. It is “equivalent of” because companies operate a one-share-one-vote system, rather than one-person-one-vote that members of Parliament are more familiar with. But maybe they should look at themselves. Every vote cast in company meetings is equal, whereas in our political system they are not. In general elections, about a tenth of the votes (those in marginal constituencies) have by far the greatest influence on the national outcome - and in terms of turnout, less than 70 per cent of people have bothered to vote in all general elections this century.

 

Divergence

The unsung bastion of the boardroom is the company secretary. This modest title belies a host of responsibilities, including not only keeping directors on the straight and narrow, but also being in charge of the share register and managing shareholder meetings. Company secretaries are the ones who ensure that dividends reach shareholders. And they need to know company law and governance backwards. For example, how major must a change be to require a company to hold an extraordinary general meeting? Such changes need 75 per cent of shareholder votes as against the 50 per cent needed to pass business-as-usual resolutions.

As far as pay is concerned, companies have kept a clear distinction between the concept of an advisory vote and a mandatory one. Pearson’s comments after losing their advisory vote on pay was not unusual: “Naturally, we acknowledge this feedback and thank those shareholders who have spoken with us and explained their reasons for not supporting the relevant resolutions,” the company said in its AGM statement. It paid Mr Fallon his bonus anyway. Nationally, the EU referendum was advisory but, unlike other countries, the UK chose to treat its result as mandatory. One of the new corporate governance measures being proposed for companies could make the current advisory votes on pay mandatory in future.

There are several other differences between companies and members of the Government in what is considered acceptable. Commercial, but not political, advertising has to be legal, decent, honest and true. In public listed companies, it is common to pay for performance. True, pay at the top sometimes seems to be on a different planet, but bonuses can apply to pay lower down, where salaries are typically near the national average of about £27,000. MPs, on £76,000, or the prime minister on double that, would be discomfited if they suffered personal financial penalties for their errors and failures.

The need for governance

There is an irony in an organisation lacking in corporate governance itself tightening corporate governance on others. In companies, the principle is that shareholders elect those responsible for applying corporate governance (the directors, led by the chairman). This was how British democracy started off – the elected House of Commons was a check on the power of the monarch and the Lords. But over the years, power shifted to the Commons, then to the Cabinet, and in recent years, it has become concentrated in the Prime Minister. The Lords has become more of an advisory body and the monarch has little power over legislation. Members of Parliament would argue that the winning party’s manifesto sets out the policies they must follow. And apart from that, they police themselves, through the official Opposition and to a lesser extent, through select committees. Cadbury would not approve.

Landslide victories erode these checks and balances and, as with leadership in companies, whether strength of personality is then a good thing depends on whether the leader delivers what you want. It comes down to cognitive bias and human behaviour. According to Adrian Furnham, a professor of psychology at University College London, more leaders fail than succeed at work. Writing in Psychology Today last August, he asked what derails promising chief executives. He says that the dark side of strong personalities can be arrogance, duplicity and emotional coldness. If they bolster this by cultivating naïve followers, such as ambitious yes-men who fail to challenge their decisions, and find themselves in situations of flux where they can get away with offering easy solutions to complex problems, the stage is set for failure. They then see governance not as a wise system of checks and balances but as a suffocating system of bureaucracy that prevents them from acting boldly.

These were the sorts of characteristics shared by Mr Maxwell and Mr Nadir that led to their downfall of all those years ago. Corporate governance is designed to constrain strong leaders of fully listed companies from causing too much mayhem, although there are still aberrations on AIM, which has looser controls. That warning about unlimited power corrupting minds, still holds sway. The prime minister who said that was William Pitt. And that was in 1770.