The Exercise of Power in Corporate Entities

Corporate governance concerns the exercise of power in corporate entities. [1] It is defined as “the system by which business corporations are directed and controlled” as it distributes management powers and authority to various participants in the corporation. [2] Although company law has the twin purposes of facilitating commerce and regulating companies, the law is perhaps not the most effective means of promoting good management practice in companies. Further initiatives were needed to improve the functioning of boards of companies within the existing legal structures. In 1991 the Cadbury Committee was appointed by the Conservative Government with a broad mandate to “…address the financial aspects of corporate governance”. [3] Self regulation was seen as the way forward and so large accountancy firms along with the Financial Reporting Council and the London Stock Exchange helped to set up the Committee under Sir Adrian Cadbury. After a trilogy of reports the Combined Code on Corporate Governance was formed.

In Autumn 2008 the world’s major banks took extreme risks which almost brought about the collapse of the global financial system. The UK, because of the importance of the banking sector to its economy, was particularly badly affected with the Government stepping in to save a number of major banks from collapse. “While at the heart of the crisis lay lax lending practices and complex mortgage backed securities, questions remained as to how shareholders and non-executive directors allowed and rewarded extreme risk taking by bank employees.” [4] This triggered widespread re-examination of the governance systems which might have alleviated it and so the FRC decided to bring forward the Code review scheduled for 2010.

The new UK Corporate Governance Code was published in May 2010 and replaces the existing Combined Code. It applies to UK publicly listed companies only and its purpose is to facilitate effective entrepreneurial and prudent management that can deliver the long-term success of the company. [5] The main principles of the Code have been outlined under the headings of Leadership, Effectiveness, Accountability, Remuneration and Relations with Shareholders. I will structure my essay by looking at each heading to establish whether the problems revealed by corporate scandals of recent times have been effectively addressed.

Leadership and Effectiveness

These sections relate to the role of the board stating that there should be an “effective board which is collectively responsible for the long-term success of the company.” The supporting principles provide a formidable specification for the board’s role which is difficult to glean from a reading of the Companies Act.

Considerable importance is attached to separating the key posts of chairman and chief executive in the Code. No one individual should hold these posts and when companies choose not to comply with this element, it is a contentious issue with their shareholders. The position adopted in the Code is that the division of responsibility between the two roles should be clearly established, set out in writing and agreed by the board to ensure that no one individual has “unfettered powers of decision.” [6] This effectively addresses the problems revealed from the Maxwell collapse where Robert Maxwell held both key positions.

The focus on the role of non-executive directors received its impetus in the late 1980s from a series of corporate scandals like Enron, Parmalat, WorldCom, among many others. This led to the emergence and growing popularity of the concept of non-executive directors (NEDs). There is no statutory definition of NEDs but as the name suggests they are directors without executive management responsibilities.

The Companies Act 2006 makes no reference to executive and non-executive directors and so the legal position for both is the same. As with the board as a whole the NEDs have a role both in setting the company’s strategy and supervising its implementation. In the case of the non–executive directors, however “supervising” includes monitoring the performance of the company’s executive directors. [7] They are intended to act as a counter-weight to executive directors to ensure transparency and accountability in the board’s decisions, while at the same time contributing to the leadership of the company. [8]

The Cadbury report recommended that the essential quality NEDs should bring to the board is that of independent judgement. This has been incorporated into the current Code. [9] NEDs could bring up to date and informed advice from their experience as executives in other companies along with a fresh, impartial and objective perspective. This would allow them to rise above boardroom politics in order to view things from an entirely new angle, thus facilitating change. Their presence is meant to improve the internal management and general performance of companies as executives would ensure they provided accurate and adequate information in the board meetings as they would be aware that the NEDs will scrutinise their views and opinions.

On paper the NEDs seem to be the perfect solution to the problems revealed by the corporate scandals of recent times. However, various factor compromise the effectiveness of their role. Firstly, they need to be truly independent and this is often not the case as they are appointed on an informal basis based on recommendations from fellow executives. It is for the board to determine (without any external scrutiny) whether the director is independent in character and judgement and whether there are relationships or circumstances which are likely to affect the director’s judgement. [10] The NEDs tend to be drawn from the same social and business environment which vitiates their independence from the very start; they are unlikely to scrutinise executive opinions or even ask challenging questions as regards excessive remuneration as they owe their appointment to their friends. [11] A recent example of the ineffectiveness of NEDs is the collapse of Northern Rock where NEDs have been criticised for their failure to restrain the CEO from “his turbo-charged business model, which was a bit like putting a Ferrari engine into a Micra.” [12]

The effectiveness of NEDs lies in their ability to secure quality and adequate information. They are dependant on the executives to provide this in order to enable them to form their own opinion. As some NEDs are drawn from competing companies, executives are in a position to edit or delay the disclosure of information to NEDs in order to maintain the company’s competitive edge. This problem of access to accurate information undermines the role of NEDs and has been the key cause behind most of the corporate scandals in companies like Enron and Maxwell Communications.

The Higgs Report appreciated the need to ensure that NEDs obtain relevant and adequate information in advance for them to be effective. However, the Code overlooks the NED’s disadvantaged position as regards to accessing information and only requires timely provision of information to the board as a whole. NEDs need to be more proactive and satisfy themselves that the information provided is appropriate to facilitate their monitoring role. Evidently, in light of their appointment it is doubtful that NEDs are sufficiently independent to execute their role effectively.

The UK Corporate Governance Code does set a high water mark making clear that mere “soundness” is not adequate to get you through the boardroom door and if you’re already a director, individual evaluation aims to show whether each director continues to contribute effectively to the role; a lack of commitment puts you at risk of being booted out at the next annual meeting. [13] The new Code recommends that, in the interests of greater accountability, all directors of FTSE 350 companies should be subject to annual reelection. [14]

The Code also responds to the need for diversity in the boardroom. Women, ethnic minorities, young people and the disabled are grossly under-represented in boards. [15] This is to avoid the perils of “group think” which were thought to have contributed to the Enron collapse. However, some chairmen of FTSE 350 companies and other large businesses, interviewed anonymously by IDDAS, warned against “formulaic representation” and tokenism. “Diversity of experience and wisdom is essential. Other types of diversity (ethnic background or sex) are completely irrelevant,” commented one. [16]

Accountability

The accountancy profession (ASB) regulate accounting standards, which are recognised by the Companies Act 2006 and used as the standard of skill and care by the courts. “the phrase the ‘inmates are running the asylum’ might be appropriate”. [17] Transparency is an essential ingredient for a sound system of corporate governance. Every company must keep adequate accounting records to show and explain the company’s financial position at that time. A failure to maintain records is an offence by every officer in default. [18]

The Code recommends that the board should establish an audit committee consisting of at least three independent non-executive directors that would monitor the integrity of the financial statements of the company. [19] This does not effectively address the concerns about the standards of financial reporting revealed by recent corporate scandals. Both the audit and accounting functions in the Enron scandal were found to be fraudulent and opaque, although their audit committee comprised of ‘independent’ non –executive auditors. Their independence was criticised and the unsettling issue is that the definition of independence is left to the board without any external scrutiny. It is only when a scandal is reported that the question of independence is challenged.

The Code also suggests the board should be responsible for determining the nature and extent of the significant risks it is willing to take to improve risk management. [20] This suggestion is undermined by the recent collapse of Northern Rock who did in fact have in place a risk committee.

Remuneration

Quoted companies are required to publish a report on directors’ remuneration as part of the company’s annual reports and to disclose within that report comprehensive details of each individual director’s remuneration package as well as the company’s remuneration policy. [21] This remuneration report must be submitted for shareholder approval by way of an ordinary resolution at the general meeting at which the company’s accounts are laid. [22] The shareholders are not entitled to vote on individual director’s packages but vote only on the report as a whole. This advisory vote has proved to be effective and has galvanised shareholders into positively considering directors’ remuneration. Companies who have had their reports voted down have suffered considerable adverse publicity with the results that boards go to some length to prevent rejection.

Although there are at least three independent non-executive directors on the remuneration committee in a large company [23] , the Walker Report found that bankers were being paid in a dangerous way which encouraged them to speculate imprudently. The general consensus is that badly designed remuneration policies and compensation schemes in the financial services sector contributed to “short-termism” and excessive risk-taking without regard to the long-term performance of financial institutions. [24]

One of the weaknesses of the system of voting remuneration packages to senior management is that remuneration committees, while intended to be independent of the executives, are made up of NEDs nominated and appointed by executive directors and so there is a serious risk of conflict or lack of independence. NEDs are not paid as much as their executive colleagues although there work is more challenging. Their pay is also not commensurate with their performance or that of the company and so this discourages them from effectively discharging their role as monitors, since the demands are not reflected on the payslips”. [25] Remuneration should reflect their challenging role and be sufficient to attract and retain high quality NEDs.

Relations with shareholders

In 1932 Berle and Means’ seminal work showed that the separation of ownership from control had created a situation where the true owners of companies, the shareholders, had little influence over company management. They “were rendered impotent by the wide dispersion of ownership and by a general apathy among shareholders towards the activities of investee company management.” [26] The study warned that unchecked corporate power had potentially serious consequences as it becomes difficult for shareholders to restrain any managerial excesses, whether they are the result of incompetence, self- dealing or fraud.

The typical division of power within a company is that the power to manage the company has been delegated to the board of directors by the articles leaving the shareholders with very limited powers. [27] Until those powers are taken away by an amendment of the articles the members in the general meeting cannot interfere with their exercise. However there are certain powers shareholders can use to exercise control of the directors at the general meeting. A director can be removed by ordinary resolution of the shareholders at any time; [28] articles can be amended for future to change powers by special resolution; [29] directions can be made by special resolution; [30] opinion may be expressed by ordinary resolution.

In the Walker Report, Sir David considered that shareholders in banks did little to curb recklessness gambling of financial institutions and that the owners didn’t “exercise proper stewardship”. The issue in large companies is trying to ensure shareholder engagement so that the shareholders act as an effective counterbalance to all powerful directors.

In theory shareholders have significant powers but in practice it is very difficult for them to exercise those powers especially if they are a minority shareholder. [31] In order to put a resolution on the agenda for the AGM there needs to be support shown from at least 5% of the total voting rights of all the members entitled to vote on the resolution. [32] Consequently institutional shareholders have a much bigger chance of affecting the corporate affairs as they usually already have 5 – 10% of shares than minority shareholders. However the legislation is such in order to exclude resolutions which would be ineffective, defamatory or vexatious. [33]

The Companies Act does attempt to address the lack of shareholder engagement by offering voting by proxy to encourage shareholders to take part even if they are not able to attend the AGM. Any member of a company who is entitled to attend and vote at meetings of the company may send in his vote in writing or assign his vote to the board of directors. However, the drawback is that by assigning a vote to the company chairman, which is not uncommon, is seen as a rubber stamping exercise and regenerates the notion of “apathetic shareholders”.

Conclusion

The UK Corporate Governance Code and the legislative framework regulating listed PLCs in the UK seem to address the problems revealed by corporate scandals of recent times. However, there is still a need to further strengthen the monitoring role of NEDs. From the recent scandals, it is clear that “best practice does not necessarily raise corporate governance standards, whereas legislation can compel it.” [34] This will provide a way of enforcing the duties of NEDs and ensuring accountability to shareholders.

At the heart of the Code is a ‘comply or explain’ principle and so to an extent it applies to any company that chooses to adhere to it. However, those who choose not to are judged on their explanations by investors and subject to intense scrutiny from market forces. The Code alongside the Companies Act has translated into “‘arm’s length’ regulation and has produced a regulatory style, which is based on accommodation, mutual respect and negotiation.” [35] The Code they cannot guarantee against corporate malpractices. In large companies,

The viability of such a “soft law” approach has depended on a reasonable level of engagement between the companies and institutional directors. These powerful shareholders exert a real, if not completely inflexible, pressure on companies to conform to a particular model of board composition and operation.

The UK corporate governance model has reached a stage where it is broadly “fit for purpose.” It is now up to the shareholders, encouraged by their forthcoming stewardship code to rise to the challenge to maintain sensible pressure on boards.