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UKSA Submission to the Treasury Select Committee
Treasury Committee announces terms of reference for corporate governance and remuneration inquiry
The Treasury Select Committee today published the terms of reference for a new inquiry into corporate governance in systemically important financial institutions.
All written evidence should be sent to email@example.com . The deadline for submissions is 24 May.
The Chairman of the Treasury Select Committee, Andrew Tyrie MP, commented:
“The task of improving corporate governance is not just about avoiding mistakes of the past but also providing opportunities for the future.
“The global financial marketplace will locate to places with high quality governance. So the UK can benefit by taking a lead on improving it.
“The Committee will seek to address, among other things, why it was that so many experienced and technically competent non-executives - the cream of British corporate life - appeared to be asleep in some of the boardrooms of our major financial firms.
“In systemically risky institutions, it is particularly important to find a way to encourage more constructive engagement with shareholders on crucial governance issues, including risk and remuneration.
“We will look at whether, and if so how, they can and should do more. Rightly, shareholders have shared the blame and the losses.
“When it came to the destruction of major banks, the taxpayer also lost out, making corporate governance a crucial issue of public and Parliamentary concern.”
The terms of reference are as follows:
Board structure and composition
1. What outcomes should corporate governance in the financial services sector seek to achieve?
The objectives of corporate governance in the financial sector should be the same as those in other sectors.
A Long term survival of the business:
Long term is difficult to define but emphasises the need (inter alia) to look at continuity, to seek to avoid the tyranny of quarterly reporting, to recognise that investment in new products and services may take time, to encourage well founded persistence in such developments, to recognise that risks can take a long time to appear, and to ensure that the company takes full account of the changes which will inevitably occur in the business, political and environmental world.
B The proper recognition of responsibility and a willingness to ensure that those with the responsibility for the running of the business are held to account both for their successes and, importantly, their failures.
C The proper recognition of the businesses’ owners- the shareholders- whether those be institutional or personal.
This needs to go with an acknowledgement that dealing with private shareholders will be both more difficult than with institutional but also more beneficial in that those private shareholders will offer both a different view and one more geared to the concept of stewardship and the achievement of long term survival.
2. Are Board structures effective? For example, should UK financial institutions consider adopting alternatives to the unitary Board structure?
A key issue in corporate governance is the balance which has to be struck between having a board which is not adequately critical of its executives and one which is overly so. The concept of “friendly” criticism is difficult to maintain. Boards can often fail to adequately review the plans and polices of management in the interest of both “not rocking the boat” and avoiding the inevitable personal discomfort of a board where the management feel persecuted or not properly valued. Unless there is immediate pressure to act for some reason it is easier for non-executives to suppress doubts than to express them.
There is therefore a case for a supervisory board where this sense of antagonism might be avoided. However UKSA has little experience of the way in such supervisory boards actually operate and cannot comment on them in detail.
Whilst audit committees have the advantage that they allow time for greater consideration of accounting and auditing matters there is, on occasion, a sense in which the full board can feel detached from crucial decisions in this area for which the full board is, and must be, collectively responsible.
3. Does the UK approach to regulation and supervision of financial services incentivise Boards to perform their role effectively?
To the extent that a number of financial institutions failed one can only conclude that any incentive arising from regulation was ineffective. It is in any case arguable as to whether regulation in itself either is or should be the prime driver (possibly however a necessary one) but acceptance of the outcomes listed above to the first question in section 1 would be more effective. The main incentive to boards to perform effectively is for such boards to know that if they are ineffective their company will fail. There must be no possibility of a business being “too big to fail” and thus having the implicit guarantee of a taxpayer funded bailout. The consequence of this is that efforts have to be made to ensure that no business is
” systemically important” however that is defined.
Is more intrusive regulation a substitute or complement to effective corporate governance?
Certainly not a substitute for. The evidence from the 2008 collapse was that the then regulator, the FSA, failed to prevent the disaster. There is an inevitable tendency for regulators to become “box tickers”, unwilling or unable to ask the most fundamental questions. Even if such a tendency were to be avoided problems then arise as to who is really running the business. As previously suggested boards have and must have full responsibility for the company. If this is in doubt responsibility will fall between two stools. Moreover there is a risk, if not a likelihood, that the regulators become shadow directors and acquire the responsibility and liabilities of that role. Thus regulation can only be and must only be a complement to effective corporate governance.
Is a “comply or explain” approach an effective framework for governance?
In principle yes. There will always be circumstances which are not envisaged by regulations. If there is an explanation as to why a regulation has not been complied with then those treating with the company as investors, debtors or creditors can make their own decisions as to whether they are happy with the failure to comply. However some companies have been able to develop a style of governance reporting that satisfies the letter of this requirement without providing any real explanation. Without teeth, ‘comply or explain’ is neutered. There should be an opportunity for shareholder scrutiny, for example by a non-binding vote at the AGM.
4. What type of corporate culture should financial services firms seek to foster?
The first requirement is to distinguish those firms offering service to a client from those dealing with a customer. The concern, quite rightly, has been to seek to protect depositors with and clients of firms dealing with the affairs of those clients. The culture in these cases clearly has to be one in which the interests of the client come first. This has both a long term financial benefit to the business, in that a well-treated client is more likely to return, and a benefit to society in that it protects the interests of the clients who may not have the resources to protect themselves.
In firms which seek to deal in financial matters on their own account the culture can and probably should be different. Such businesses should have a culture of profit maximisation in the interests of their owners. Historically such businesses were often partnerships and thus the risk decisions were taken directly by those who stood the risks unlike the present situation. If these businesses are to be public limited companies the need is to have a form of regulation which makes clear to all, the risks and potential rewards involved. The difficulty is in drawing distinctions between the two types of businesses but this has been done before. (See e.g. Glass-Steagall Act 1933 USA)
In what way can this be encouraged?
There is no one culture to be encouraged. It is up to the respective boards to set incentives (if they feel those are needed) in ways designed to achieve their differing objectives for the cultures of their businesses.
How effective are Boards at shaping corporate culture within their institutions?
The culture should come from the board led by the chairman. However, a forceful CEO can
often effectively create the culture he wants. How in practice cultures develop UKSA cannot
Impact of previous reviews and new regulatory developments
5. What difference would the proposals in the Independent Commission on Banking’s report on the Boards of ring-fenced banks make to corporate governance in these institutions?
This is presumably a reference to the proposal that “ ring fenced “ banks shall have a majority of non-executive directors of whom one will be the chair and that they are to report as if they were an independent PLC. UKSA believes that this would certainly help if those boards fully accepted the guidelines laid out in the replies to question 1 above
6. What benefits, if any, come from EU regulatory engagement with corporate governance issues?
UKSA believes that relatively little benefit comes from EU regulatory involvement. This is for two reasons:
A The UK financial services industry represents by far the largest part of the EU financial services
B Any advantages from common standards would be minimal as the EU cannot influence those standards outside the EU, for example in countries such as Switzerland, USA and Hong Kong.
7. What impact has the Walker Review (2009) had on corporate governance and corporate behaviour in financial services?
Non Executive Directors
8. Should non-executive directors bear greater liabilities than under current law?
It is not clear what is being envisaged here. Under UK company law all directors have the same responsibilities and liabilities. UKSA is not aware of any arguments in favour of such a suggestion and thus has no view on this point.
Should executives in FTSE 100 companies be able to hold non-executive positions in other firms?
UKSA believes that the main advantage of executives holding non-executive positions in other firms is that it broadens their experience. Clearly each board must be happy that such use of executive time is not at the cost of their own company.
9. Is the existing FSA approval process for significant influence functions (SIF), including non-executive directors, effective?
The role of shareholders
10. Should shareholders be required to exercise a stronger role in systemically important financial institutions?
UKSA would wish to see explicit recognition of the role of private shareholders as against institutional and an acknowledgement that the two groups of shareholders can, and often do, have very different approaches.
Shareholders presumably look to protect their own position as owners of the company. Those investors acting for principals e.g. pension schemes and insurance companies have a responsibility to do their best to protect the interest of their principals. Given the preponderance of institutional shareholders it is important that they are active in discharging their responsibilities. There is evidence that they have sought to do this more by selling shares rather than being proactive. That is easier, less time consuming1 and less confrontational than working for changes in a company. However just recently (E.g. Barclays, HSBC, Standard Life, BP and National Grid) there is some evidence of change here. It is difficult to see what obligations to act would be effective. It is also encouraging that by December 2011, 175 firms in investment management had signed up to The UK Stewardship Code published by the FRC in 20102
However private shareholders can normally be expected to act more directly and UKSA believes that using this approach could help if such private shareholders were properly empowered.
The particular problem of effective disenfranchisement caused by the insistence on nominee accounts urgently needs to be addressed.
UKSA has for some years been advocating the use of Shareholder Committees for this purpose
and believes that all companies, not just those deemed systemically important, could benefit
from the idea.( See interim report of the Kay review: article by Alistair Blair in the Investors
Chronicle- 21 March 2012: private member’s bill by William Cash, MP 2009: Walker Report
In the meantime, the Financial Reporting Council should reintroduce to its Corporate Governance
Code of Conduct a requirement that all votes at general meetings be taken first on a show of
hands, to give private investors in attendance the opportunity to show their opinions in the
most visible way, which will often have a salutary effect even though the institution-
dominated proxy votes may determine the issue. Denying those who have their own money
1 A recent poll of asset managers found that they have, on average, holdings in 450 businesses. Fewer than half claim to engage with all their investee companies.(Economia (ICAEW magazine)May 2012 page 47).
2 Economia May 2012 Page 48
invested the chance to demonstrate their opinion has been wholly counter-productive.
What are the key barriers to greater shareholder activism by institutional investors in financial institutions?
The barriers have been outlined above: effort, time, the avoidance of confrontation in a narrow pool of people, conflicts of interest, prevalence of index-tracking and/or fund performance measurement relative to an index making absolute performance irrelevant, cheaper (and more profitable) to sell or short the stock instead of engage to improve performance, commission on sales all of which constitute the agency problem, much compounded by the practice of stock lending.
What risks are associated with it?
11. Is it realistic to expect sovereign wealth funds and hedge funds to undertake a more active role?
Sovereign wealth funds are reluctant to be seen as “interfering”. Presumably hedge funds can be expected to act in a manner similar to the institutions.
12. What role should institutional investors, remuneration consultants, employees and others play with respect to remuneration in the financial services sector?
UKSA assumes that this question is still addressed to those businesses which remain systemically important. It assumes that those which deal on their own account with appropriate disclosures of risks are not included.
Institutional investors have an important role here if they are willing to undertake it. It has been commented above that they have found it easier not to get involved but this may be changing.
UKSA believes there should be little or no role for remuneration consultants. They have a clear incentive to seek to maximise pay. They can become a way for a board to attempt to slough off responsibility for pay levels to someone else. The UKSA manifesto states “Remuneration consultants must be made accountable to the shareholders, their reports made available to the shareholders and their reappointment sanctioned at each AGM.”
UKSA cannot see how employees could be involved in such decisions unless there were either two level boards with employee representation (EG Germany) or some sort of formal structure for workers’ councils.
Once again, Shareholder Committees as suggested above should have a role to play here.
It also supports the government’s approach for binding votes, (but as ordinary resolutions), as suggested by the recent BIS consultation. UKSA’s response to this consultation is attached.
13. Is there a case for introducing still greater transparency for senior executives with respect to remuneration in the financial services sector?
UKSA would wish to see the remuneration of senior executives brought into the proposed provisions of the BIS consultation as well as executive directors. It is essential that the ‘performance’ incentives of directors and senior employees are subject to independent scrutiny – not necessarily as to quantum but definitely as to structure. ‘One way’ incentives such as stock options and threshold triggers reward volatility and therefore incentivise risk-taking .
14. Should there be further reform of the remuneration arrangements of senior executives in the financial services sector? Should this extend to those highly paid individuals who sit below executive level?
See reply to 13
15. The Chairman of the Financial Services Authority has argued that there may be a case for changing the personal risk return trade-off for bank executives. He has suggested either a ‘strict liability legal sanctions or an automatic incentives based approach. What are the merits and drawbacks of these proposals? Are there other ways to achieve the same objective?
See reply to 13
Governance of risk
16. Has the management of risk in firms improved since the financial crisis?
UKSA has no evidence on this point.
Diversity and background
17. What is the relationship, if any, between Board diversity and company performance in the financial service sector?
Any further comments relevant to corporate governance in financial institutions would be welcomed.
R A Collinge F.C.A
Head of Corporate Governance Group