Regulators are determined to avoid a repeat of Enron and other scandals. But will the corporate governance measures now being considered make things better or worse? Melvyn Westlake reports on the great corporate clean-up.

International companies are facing their worst crisis of confidence for several decades. The recent crop of bankruptcies has revealed much more than failed strategies: the governance of some corporations is fundamentally lacking.

Right now, companies should be concentrating on recovery and rebuilding profits following a couple of years of sluggish growth. Instead, they are under pressure from governments and regulators to carry out internal reforms. Talk to a chief executive offer these days and, whatever the starting topic, the conversation invariably gets round to corporate governance and what needs to be done.

Everyone accepts that a "clean-up" is on the way. The danger is that management could become so preoccupied with governance questions that they delay strategic decisions essential for economic recovery.

Some commentators fear that regulators will go overboard in their zeal to create a squeaky-clean environment. They argue that corporate governance issues go to the heart of modern capitalism, with its split between management and ownership, and can never be fully resolved.

All the same, the scale of abuse that has recently come to light - Enron being the most spectacular example - more or less dictates that changes will go ahead even if they are driven more by political sense than common sense. The big questions are what will be done and how will it affect corporate management, their financiers, shareholders and employees.

Research by The Banker has pinpointed two trends that are gathering momentum. One is the likelihood that the role of non-executive directors (NEDs) will be expanded and better resourced and made more independent - even though NEDs failed to prevent recent crises and have been strongly criticised.

"The theory is that these non-executive directors supervise the work of the executives. But it has signally failed in every case. The fact is that these non-executive directors actually become a shield behind which the executives shelter," says Lord Young, a businessman and cabinet minister in former UK prime minister Margaret Thatcher's government.

But Lord Young, whose views have received much attention, is in the minority. The groundswell of opinion is that NEDs will become more important; and chief executives fear they could constitute an alternative power base within companies.

The second trend is for institutional investors to be pressed into playing a larger role in the oversight of corporate governance standards. The British government looks set to put far greater onus on pension funds and other investment institutions to exercise an ownership responsibility. Additionally, companies and institutional investors will increasingly find themselves subject to the principle that they must "comply or explain". In other words, if they are not in compliance with the multiplying codes of best practice, they must publicly explain why not.

Setting the trend

Following on from the spate of corporate failures, many think-tanks, committees and inquiries have been set up to consider the issues and come up with proposals. The UK is at the forefront of this self-analysis and has often been seen as a trendsetter for other places - even the US. That's why what happens to corporate governance in the UK matters to everybody else.

"There is a crisis of confidence over corporate excesses in the US," says Peter Clapman, a leading shareholder activist, and chief counsellor at the teachers' pension fund TIAA-CREF, the world's biggest retirement scheme, managing $280bn. "The recession has revealed an underlying situation that is much worse than realised," he says.

Of course, company failure is not necessarily the same thing as corporate governance failure. The former is inevitable in a business downturn. But, in a high proportion of cases, a slide in a company's fortunes goes hand in hand with poor governance.

As another former shareholder activist says: "You can analyse every company that has hit the wall in the past 10 years and there has been a governance problem." Enron's board of directors ignored several red flags in the three years before the energy giant's collapse, according to US Congressional investigators.

Accounting practices are also being examined at bankrupt telecoms company Global Crossing. Also, there is the case of highly-indebted US long-distance carrier WorldCom. Although not facing imminent collapse, WorldCom has been damaged by the resignation of chief executive Bernie Ebbers, following revelations that he received a $366m loan from the company. This loan was approved by a board member with whom he had outside financial links. (WorldCom shares have fallen 95% from their peak value.)

In Britain, Marconi is being criticised for delays in informing investors about a sharp deterioration in its trading position. Two profit warnings in quick succession wiped billions of pounds off the company's market value. Marconi, which transformed itself in the late-1990s from an unfashionable industrial holding company known as GEC, into a trendy telecoms equipment maker, is now struggling under a crushing pile of debt.

At the same time, 15 former Equitable Life directors are being sued for more than £3bn by the new board of the troubled mutual assurance firm. And the Financial Services Authority (FSA), the market regulator, has severely censured the Big Food Group, formerly known as Iceland, the food retailer and wholesaler, for issuing misleading information about its trading position late last year. Despite a profits deterioration, the company issued a positive trading statement. This coincided with a sale of shares in the company by Malcolm Walker, the then chairman.

European moves to UK-US style

These problems of governance are not confined to the US and Britain. On the European continent, which is increasingly moving towards Anglo-American-style capital markets, Jean-Marie Messier, the flamboyant chief executive of Vivendi Universal, the loss-making French media and utility group, is battling with some directors and shareholders over strategy and a controversial share option plan. In Germany, the insolvent KirchMedia, largest subsidiary of Kirch Gruppe, stands condemned for its opaque accounting.

In many cases, the non-executive directors, who are effectively the shareholders' watchdogs on the board, were either party to the decisions that led to trouble or failed to raise the alarm in time. Often, they remain on the board despite their culpability.

But Peter Montagnon, London-based head of investment affairs at the Association of British Insurers (ABI), which actively engages with company directors over governance issues, does not think this signifies anything fundamentally wrong with the NED system.

He says: "Shareholders are not expecting non-executive directors to second-guess the executives or know as much about the business as the management. They are not there to do that. But they have to know enough to judge the validity of management decisions - at least, in terms of strategy - ask challenging questions and ensure robust board debate."

Reflecting current mainstream opinion, he argues that the role of NEDs is to provide checks and balances on managements deploying other people's money, but without stamping on entrepreneurial flair. "We will never know how many times NEDs have restrained management from making bad mistakes. Just because we have a few spectacular failures does not mean that the whole system is rotten," adds Mr Montagnon.

In Britain's boardrooms, however, there are already signs of restlessness among executives over the increasing levels of supervision to which they are being subjected. Privately, many say that increased shareholder activism and proposals for more powerful non-executive directors is undermining them and interfering with their functions. The announcement, in April, that the UK government is setting up an independent review into non-executive directors, has not been universally welcomed. It is assumed that the review, chaired by Derek Higgs, an accountant and NED on several British companies, will inevitably lead to the creation of an expanded cadre of professional non-executive directors, with increased supervisory responsibility.

British model

However, Britain's resolute pursuit of good corporate governance has actually made it something of a model for other European countries. Its codes of best practice have been widely adopted, notably the so-called Combined Code, which brought together the recommendations of three committees, under Sir Adrian Cadbury, Sir Richard Greenbury and Ronald Hampel. This code covers board appointments, financial reporting, disclosure, and audit and remuneration committees, as well as relations with shareholders.

In a recent study, undertaken for the EU Commission, Holly Gregory, a corporate governance specialist at New York law firm Weil, Gotshal & Manges, identified some 35 codes in the 15 members countries (plus four international codes), of which 11 were based on the British model. Ms Gregory concludes that there is considerable convergence between the codes, many of which were drawn up quite recently.

The biggest obstacle to a single harmonised code are differences in underlying national company laws. Not least of these differences is the existence of the unitary board in Britain and the two-tier board (a management board below a supervisory board) in some other European countries, notably Germany, where it was introduced by Chancellor Bismarck in the 1870s to enforce the rights of shareholders, and enshrined in the constitution.

Comply or explain

One British concept for better governance that is getting close attention in both Brussels and Washington is the so-called "comply or explain" approach. This is the basis of the Combined Code. But a widening of this concept to include the investment community has been suggested by yet another committee, headed by Paul Myners, chairman of Gartmore Investment Managers, looking into the role of institutional investors. In its report, published last year, the committee laid out a set of principles to assist investment decision making. These would not be mandatory. But institutional investors, initially pension fund trustees, would have to show whether they were complying with best investment practice or explain why they had chosen not to do so.

"Comply or explain" is viewed by some observers as providing a useful basis for many aspects of corporate governance. It gives company boards the flexibility not to do things, and leaves the markets to decide if they have a justified and credible case for their decision.

In its eagerness to improve the way companies are run, the UK government is likely to introduce legislation soon that will give force to the Myners Committee recommendation that pension funds should have a duty to engage with poor performing companies. Other secondary legislation in coming months will force companies to issue separate annual reports on directors' pay, long-term incentive schemes and the processes by which these are set. Shareholders will be able to cast an advisory vote on this report at each annual general meeting.

On top of this, a new company law is planned, probably for next year, which includes a substantial section on corporate governance, including a clarification of directors' duties. It promises to be the most extensive reform of company law for 150 years.

While all these initiatives might suggest that the corporate governance system is in dire need of attention, the majority view is that things have actually improved in the past decade. "Standards of corporate governance have dramatically improved in the past 10 years, on all fronts, whether in relation to non-executives or remuneration or board processes," insists Dr Daniel Summerfield, an Institute of Directors executive specialising in this area. In support of the argument that corporate governance has improved, others point to the string of scandals that rocked the business establishment in the 1980s and early-1990s, including the Robert Maxwell affair (the raiding of Mirror Group pension funds), Guinness, Blue Arrow, Polly Peck, and fraud at the Bank of Credit and Commerce International. But preventing corporate abuse is a never-ending process. "We will never reach a point when the job is finished and we can go home," says Mr Summerfield.

Cycle of governance issues

In fact, every economic boom, every financial bubble, brings a new crop of corporate governance issues. The Marconi board's disastrous strategic decision to focus on telecommunications equipment-making was fully supported - even encouraged - by market analysts and investment bank corporate finance divisions, which saw business opportunities in it. Whether any non-executive directors asked challenging and probing questions about the viability of such a strategic change of direction remains unclear. But they would have been flying in the face of the entire market even if they had.

Perverse incentives are built into the system, according to Michelle Edkins, London-based corporate governance director at Hermes Investment Management, which is both the principal investment manager of the BT and Consignia (formerly the Post Office) pension schemes, and a prominent shareholder activist.

Companies have their brokers and their corporate financiers, and both of these financial groups have "a keen interest in certain outcomes. The brokers want shares to be traded, because that is how they make their money for their firms, while the corporate financiers are always running round looking for deals. This is how both groups earn their, mostly short-term, bonuses," she says.

Some types of executive share options can also have perverse outcomes. In the Enron case "directors were very aggressively incentivised through such schemes", Ms Edkins notes. If executives have tens of millions of dollars at stake in options when the share prices drops, they will inevitably be tempted to massage their company's trading results. "Options should be designed to make executives behave like long-term shareholders. But they seldom achieve that goal. In the US, where executives have hugely valuable options, the misalignment of interests is worse than in Britain," she says. On some calculations, about 70% of US executive pay, on average, is in the form of options today compared with less than 20% five years ago.

The idea being touted by the UK government - that institutional investors should exercise more control over the companies in which they have a beneficial interest - also ignores some potential conflicts of interest. Investing pension fund money is an important business for many asset managers. It can be politically sensitive for an investment firm that is managing the pension scheme of a company to vote against the chairman of that company on behalf of other clients. The use by many investment managers of standard performance benchmarks also encourages "short termism" and herd behaviour.

Moreover, investment institutions "come in all shapes and sizes, with different styles, requirements, and time horizons", says Stuart Bell, research director at Pensions and Investment Research Consultants (PIRC), in London. PIRC advises global investors about companies' compliance with governance codes and how to vote on boardroom issues.

Many investors, says Mr Bell, do not want the responsibility of engaging with companies. They are used to trading and making stock selection. If they own shares in a company that runs into trouble, they just want to cut and run. They do not want to spend time trying to turn the company around. That is not what many people went into finance to do, says Mr Bell.

There is always danger that new legislation does not achieve what it was meant to do as could happen with the well-intentioned proposed expansion of the NED role. One way of addressing the problem of NEDs could be to provide them with more resources, such as an independent staff with full access to information flows, suggests Nick Bradley, head of corporate governance services at Standard & Poor's in London. Non-executive directors could also meet separately, away from the influence of the executives. And employees could be given direct access to NEDs to express concerns, and even "whistle blow" if that ever became necessary, says Mr Bradley.

The Japanese system

Some proponents of a separate non-executives unit, with its own staff and resources, point to the Japanese system of corporate auditors appointed by shareholders. They function full time within the company, aided by a small team, but are not employees. As they are full time and have complete access to documents, they know what is going on - in theory. But they are often former employees nearing retirement. And, frequently, say critics, the job of corporate auditors seems to be a consolation prize for senior managers that do not make it to the board, which, in Japan, can number 30 or 40 directors. Given the country's consensus culture, corporate auditors are rarely inclined to rock the boat.

Opponents of such ideas in Britain, however, say that independent power centres will result in fractious boards that are split by disputes and unable to provide clear leadership. This would not seem to be the case at BP, however, which has successfully gone some way down this road (see box on page 19).

In the US, too, shareholder activists are pressing for outside directors to be selected by nomination committees rather than being handpicked by all-powerful CEOs. Boards in the US are usually comprised mostly of external directors (most of whom are supposed to be truly independent with no current or former connection with the company), and one or two executives. The latter includes the CEO - who, unlike in Britain, is usually chairman as well - and, perhaps, the chief financial officer.

Although this would seem to give a lot of power to the external directors, they are largely beholden to the CEO, and do not tend to challenge him very often, says Peter Clapman of pension fund TIAA-CREF, which recently forced Disney Corporation to make extensive corporate governance reforms. Moreover, activism in the US tends to provoke a more hostile reaction from executives. "They do not love us," says Mr Clapham.

On the other hand, just $2000 of shares allows anyone to put a resolution to a shareholder vote in the US, whereas in Britain, such action requires either a single shareholder to own 5% of voting shares or for 100 shareholders to jointly table the resolution.

Ironically, continental Europe is moving more towards the Anglo-American model of corporate control at a time when the British and US systems are the subject of much soul searching. The large company cross-shareholdings, and block share ownership by banks and families that are common on continental Europe and parts of Asia, such as Japan and South Korea, were once viewed favourably. This pattern was held to encourage stability and long-term investment.

It went out of favour in the face of the east Asian and Japanese crises and the strong economic performance of the US relative to Europe. The shift from the old model is also being aided by the growing role of capital markets as a source of corporate financing and the spread of equity investing in Europe. But some corporate governance experts are arguing that it had many virtues after all.

The reality is that "nobody has found the perfect system. While the big issue for the Anglo-American system is how to align the interests of management and shareholders, the key issue in many other countries remains the rights of minority shareholders," observes one corporate governance specialist.

He points to Switzerland as one of the most egregious abusers of minority shareholders, whose voting rights are widely restricted. Although the division of shares into voting and non-voting varieties is less common, managements have found other ways to preserve their control. Many boards now restrict any single shareholder's voting rights to 3% of total shares outstanding, irrespective of the proportion of shares actually held. This has made takeovers difficult, and consequently left many Swiss companies seriously undervalued.

There is one point on which most corporate governance experts agree: whatever the model, the crucial key elements are financial transparency and good information disclosure. In surveys, investors say that they are prepared to pay a premium for the shares of well-run companies. At the very least, the authorities must ensure that they have the information necessary to make that choice.


All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker

For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Top 1000 2023

Request a demonstration to The Banker Database

Join our community

The Banker on Twitter