Corporate governance is the system by which a company is regulated and controlled, and gives ‘an architecture of accountability – the structures and processes to ensure companies are managed in the interests of their owners’. Within the UK, such structures are principally based upon the notion of shareholder primacy, which is to say that the companies overarching aim is to provide profit to those who own the company. Under the Companies Act 2006, s33 provides that there is a contractual relationship between shareholders and the company, and between shareholders themselves. As a result, the key basis for how a company’s affairs are handled under UK law lies in the fact that shareholders effectively own the company, but that they delegate responsibility for management to the directors. This separation of ownership and control means that effectively the board of directors are responsible for the entrepreneurial enterprise of the company, but must also ensure that checks and balances exist to minimise risks. From a corporate governance standpoint, it is the interaction between the board and shareholders which is pivotal. For companies to be governed effectively, it is paramount that boards provide accurate, detailed information and act with a good degree of transparency, so that shareholders, in their turn, can make an accurate appraisal of the company’s affairs and contribute to the decision making processes of the company.
The other vital provisions relating to UK corporate governance come in the form of ‘The Combined Code on Corporate Governance’, most recently updated in 2003. It is important to note that the provisions of the code do not have the force of legislation, and that a company is free to deviate from the code provided an explanation as to why this has occurred is given (the ‘comply or explain’ principle6). As such it is clear that companies in the UK are fundamentally self-regulating, as they are not formally bound by any extrinsic rules. In this essay, I will be examining and assessing whether these key principles of self regulation and separation of ownership and control are responsible for the shortcomings of corporate governance in England and Wales, especially following the recent financial crisis.
The most fundamental issue as concerns the above approach involves risk. To paraphrase Adam Smith, as directors are in effect managing other people’s money (the shareholders), rather than their own, it is unlikely to expect that they will watch over it with the same degree of vigilance. Equally, whilst shareholders have a purely financial interest in the company, directors may wish to pursue divergent aims outside of solely looking to maximise profits. Due to the fact that shareholders may well lack the time and resources to stay fully informed of the company’s activities, and the obvious disparity in the level of information available between directors and shareholders where the separation of ownership and control exists, it would seem that the directors may be allowed to act in a relatively unchecked manner. It has been shown repeatedly, from the earliest corporate scandal of the South Sea Company, through to the present financial crisis, that such freedom is often abused. Furthermore, these issues concerning separation of ownership and control may well have impeded the British economy. The ACCA, in a recent report, identified poor corporate governance as one of the chief reasons underpinning the credit crunch, and noted the need for greater shareholder and wider stakeholder involvement in holding boards to account.
A recent LSE study notes that there is still a notable degree of failure by boards to explain non-compliances with codes. This highlights the fact that shareholders may often remain in the dark about corporate behaviours, another example of the potential issues with the current model of UK governance. It is clear, then, that the division of ownership and control as a model for corporate governance has significant shortcomings, in that boards typically possess too much control, and shareholders are unable to provide a satisfactory check upon them, through a combination of apathy or inability, and a lack of information coming from the directors. The recent OECD report on governance and the financial crisis states that shareholders have failed to hold boards to account and have made too little effort to engage and meet with directors, and cited low turnout of shareholders at key votes as a significant issue. This so-called principal-agency problem clearly pre-dates the current financial crisis, and is manifestly a key issue. A report from 2004 looking specifically into governance issues within the banking system, states that ‘A cursory review of recent banking crises would suggest that many causes for concern relate to management decisions which reflect agency problems involving management.
Management may have different risk preferences from those of other stakeholders including the government, owners, creditors, etc., or limited competence in assessing the risks involved in its decisions, and yet have significant freedom of action because of the absence of adequate control systems able to resolve agency problems…’, and that ‘The principal-agent problem, outlined above, poses a systemic threat to financial systems when the incentives of management for banking or securities firms are not aligned with those of the owners of the firm.’. Even the Institute of Directors, which feels that the current UK model of corporate governance is ‘fundamentally sound’, is in accord on these issues. In its response to the Walker report on corporate governance, the IoD voiced its opinion that ‘The financial crisis has highlighted the fact that shareholders are not always sufficiently committed to the fulfilment of this role. Leading up to the crisis, they failed to ask the right questions and did not engage sufficiently with boards in respect of proposed business strategies and risk profiles. As Lord Myners has commented, many institutional shareholders continue to behave like “absentee landlords’.
In assessing the above, it seems clear to me that the separation of ownership and control provides significant issues for corporate governance within England and Wales. The inequality in information available to shareholders versus directors ensures that boards are not effectively monitored and kept in check, and abuses may well go undetected. The discrepancy between the aims and attitudes to risk between directors and wider stakeholders also means that corporations are often governed and run in a manner that is inconsistent with the desire of the owners of the company. It is apparent that there is a definitive need for closer relationships to exist between board members and shareholders.
The IoD’s suggestion of introducing a reciprocal combined code for investors, ensuring that there is a framework enforcing shareholder involvement, and requiring a ‘comply or explain’ approach where shareholders did not adhere. A greater drive and emphasis on boards to ensure that quality, independently verified information is obtained and disseminated to shareholders to ensure that they are able to make informed judgements as regards the company and the manner in which it is run. This is especially so in light of the decline of UK institutional investors, those bodies who are perhaps best placed and able to hold boards to account. Hopefully, the recent crisis will focus minds on these issues and improvements of governance will come to fruition, as it is clear that the status quo is at best unsatisfactory.
In addition to the separation of ownership and control, the issue of self-regulation must be considered. Whilst there is some statutory regulation in place affecting corporations (specifically the Companies Acts of 1985 and 2006) which set out directors’ duties, for example, the Combined Code provides a more significant framework setting out standards for good practice. It is important to note that adherence to this code is voluntary in the sense that there are no legal sanctions for non-adherence. Compliance is sought through the ‘comply or explain’ approach, which following a report conducted by the LSE seems to be working well, and indeed improving year on year. It seems that in spite of the recent financial crisis, the Combined Code has retained strong support according to the Financial Reporting Council’s recent review and consultation thereon. It was noted in that review that the current ‘soft law’ approach is preferable to a more heavily legislative environment, in that it provides a greater deal of flexibility and the ability to adapt more rapidly to changes in the corporate climate. This echoes the view that the FRC put forward in 2003, where it accorded with Sir Derek Higgs’ view that legislation was not the way forward due to its general inflexibility, and the fact that it is best that the shareholders and directors come together to in order to consider what is in the company’s best interest, and cited the Cadbury Committee’s statement that ‘statutory measures would impose a minimum standard and there would be a greater risk of boards complying with the letter, rather than with the sprit, of the requirements’.
The IoD is particularly vociferous in its anti-regulatory stance, noting those issues stated above, but also stating that the UK benefits from the lack of regulation, citing the comparative impact of the Sarbanes-Oxley Act in the USA, which imposes onerous regulatory requirements, and has cost corporations a cumulative estimated total of $1.4 trillion, as well as driving companies away from registering in New York towards other financial centres. If we consider that much of the current global financial difficulties can trace their origins to the USA, this hardly suggests that firmer legislative regulation can really have a significant part to play, and certainly indicates that the UK’s current approach may well be preferable to a more regulatory climate.
It is perhaps understandable given recent events within the global economy to state that greater regulation is necessary to ensure that such events are not repeated and to be able to hold individuals responsible to account for negligent corporate practices. However, in assessing the above I am wholly unconvinced of the need for any introduction of legislation. Codes are advantageous in providing standards. Legislation may well be complied with to the letter, but as has been seen in the USA, such is no guarantee of good corporate governance, and may well carry more negative facets than positives, especially if wealth stimulation and creation is stifled.
However, the ‘soft law’ approach is of course not perfect. Compliance is voluntary and no sanction may be brought for non-compliance with the code. As such, boards must be relied on to engage with and adopt any code, something which naturally may be difficult to achieve. There may equally be some areas where corporate behaviour must be curtailed by legislation. I find it hard to imagine there is great desire amongst UK banks to adopt a model where commercial and investment banking are separated, but I would accord with Lord Lawson’s view that such a model (in line with the now repealed US Glass-Steagall Act) is highly desirable and definitively in the public interest. Increased regulation in other areas, especially re the environment, may also be necessary to ensure that companies adhere to principles of corporate social responsibility. Manifestly, compliance with codes on governance depends on corporate willingness to adhere. Such willingness may fluctuate, and presents the key weakness in such an approach
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