Governance rules OK: A look back over the last 25 years

Standing amid the rubble of a recession deemed by many to be as bad as or worse than the 1929 Great Depression, with our central bank effecting emergency measures never before tried in the UK that may not even work, and one of our most important bankers flicking Vs at the prime minister while cradling his legally-binding, but bank-busting pension pot, you might reasonably baulk at the idea that the British corporate governance system is one of the world’s most effective and sophisticated.

But until recently that was a widespread belief. Until the implosion of our banking industry, we’d had no Enron and no Ken Lay figure since Robert Maxwell. At least in those cases, cut-and-dried fraud was the story. At RBS, HBOS and Northern Rock, a more complicated case of systemic failures underpinned by laziness and greed at the top levels of management was at play, their path smoothed by a regulator frightened to ask searching questions lest it transgress its light-touch mandate, and regulation or guidance so complex it provides as many loopholes, opportunities for confusion to be exploited and smokescreens, as it does boxes to be ticked.

In their efforts to have those boxes ticked, companies pay huge sums of cash to leading auditors who, it is now beginning to dawn on us, can’t seem to make much more sense of the biblical collection of codes, laws and guidelines to be adhered to than anybody else. Moreover, auditors aren’t exactly independent when their paymasters are their auditing clients though they’re still operating within the law all the while – and they’re not immune to the need to please. Then we have to consider our obsession with principles-based regulation rather than rules, which, of course, presumes the will of the market to be good and puts all our faith in its ability to self-correct.

Financial Director has covered the raft of pivotal corporate governance reports and guidelines that have steadily emerged in the past qu arter century, and most conspicuously, in the last 15 years. There has been a correlation over that period between these fast-growing burdens and an increasing risk appetite, particularly in the financial services sector, spreading right through business as cheap capital has become easily available to even the least creditworthy.

No time to think
Our corporate governance columnist Robert Bruce noted in these pages five years ago how process, essential for companies who have to comply with myriad rules, threatens time to think laterally over a company’s potential transgressions and the opportunity to communicate properly. “Financial reporting will no longer be a partnership between external auditors and internal finance function – instead, it will be something which will be consigned to the process function within the company,” he said. As far back as 1996 we ran a piece titled, ‘Has governance lost its focus?’ arguing that good governance is about creating an environment for prosperity, rather than restricting company directors’ every move at a time when the UK economy was in boom and such restrictions to a sector reporting seemingly unfettered growth were unwelcome. “The buoyant economic conditions which have prevailed since the Cadbury Code was published four years ago could be covering up underlying board weaknesses in some of those companies which have performed well in recent years,” our reporter Lucinda Horne suggested. How clearly that has been proven right a decade on.

We can no longer fool ourselves. The market is not good and it clearly cannot correct the state it is in now without serious intervention. We’ve arrived at a place where corporate governance means adhering to the letter of the law, but ignoring the spirit to allow the market to set its own size, its own risk appetite and to be skewed in favour of more Maxwell types. Human nature, we are reminded yet again, cannot be legislated for. That has been demonstrated time and again with the emergence of characters such as Polly Peck CEO Asil Nadir and Coloroll chairman John Ashcroft.

Much of the corporate governance guff we are wrestling with today came as a result of fraud these people committed. The value of the resulting guff we swiftly deconstructed in 1998 when we ran the accounts of the by then defunct Maxwell Communication Corporation and Mirror Group and other, better run companies such as Marks & Spencer and Cadbury Schweppes, against the Combined Code in its proposed form. Miraculously, MCC and Mirror Group ticked off as many if not more boxes as those other companies did, passing all the governance tests the Code then demanded.

Regulation overload
What’s curious is why the march of corporate governance legislation continues regardless of the fact that fraud lives on. This year alone two more doorstops – FSA chairman Lord Turner’s March tome on the overhaul of the regulator, which will add to the burden of its subjects to bump up liquidity reserves and curb their enthusiasm for risk, and at the close of the year, Sir David Walker’s review of corporate governance and risk management among UK banks – will be added to the Empire State Building-sized pile of books company boards, their non-executives and their auditor must know intimately.

In the 17 years since the Cadbury report set out recommendations on the arrangement of company boards and accounting systems designed to mitigate corporate governance risk and failure, giving birth to the current Combined Code, we have had five other major works in that vein: the Rutteman guidance in 1994, Cadbury II in 1995, the Hampel report on director remuneration in 1998 – the same year the Combined Code came into force – followed by the Turnbull report on internal control a year later. Then came the Higgs report on the role and effectiveness of non-execs in 2003, which saw a revision to the Code that year. Turnbull was revised in 2006, bumping up the need for more narrative to accompany the numbers in company financial reports. We still refer to UK corporate governance as principles-based, but with this hefty lot, it’s debatable.

That said, each of these reports had a pivotal effect on British business today. Cadbury required listed companies to ensure most of their non-executive directors are independent and on fixed terms, and that companies should have both an audit and a remuneration committee. Ruttemen required listed companies to disclose in their financial statements their systems of financial control, while Hampel enshrined the UK belief in principles of governance rather than rules for the explicit aim of avoiding a box-ticking culture and reducing red tape, which shaped the Code as it is today. The 2003 revisions to the Code required companies to separate the role of chairman and chief executive.

“All of them, to a greater or lesser extent, have brought a steady tightening of the rules and a gradual change to UK corporate culture,” Bruce said of Cadbury, Rutteman and Hampel in 2002. “At the time, the investment world – to say nothing of pensioners and employees – had suffered from a surfeit of larger-than-life characters. Looking back at the mighty achievements of the Cadbury Committee, it is now clear that the most essential and influential refo rm it instituted was the separation of the roles of chairman and chief executive.” Note the word ‘rules’.

Governance fatigue
By 2005, with Sarbanes-Oxley well in train on top of the UK-centric guidance downpour and International Financial Reporting Standards about to break, corporate governance fatigue was beginning to show. The Cadbury revisions that year had the stock exchange and the Confederation of British Industry up in arms, while even FSA chairman Lord Turner – then plain old Adair in his role as CBI director general – bemoaned the cloud of ‘corporate governance fatigue’ that settled over British business, asking if there wasn’t a way to slim-line the burden on companies. (Ironic, perhaps, that Turner finds himself adding to the library this year.) Risk management systems, as Bruce had feared, have become embedded in the machinery of business to the point where no real critique or instinct had a chance.

In summer 2004, Bryan Elliston, group head of audit and financial control at materials technology company Cookson, UK-listed but with shares registered with the Securities & Exchange Commission, told Financial Director that finance personnel had so many compliance pressures, added to recently by the introduction of IFRS, that they were suffering “initiative fatigue” – “pulled in so many directions that perhaps some things can be missed.” He added that having a regularly checked, documented approach could counter the risk of that fatigue, which put finance professionals at risk of not crossing all the T’s and dotting all the I’s – either by virtue of missing them or by opting out.

Warnings of this sort of effect came as far back as 1995 when, in our April issue, we published a survey of FDs, in association with Leeds Business School, on their thoughts around Cadbury II. Almost half said they intended not to comply with the code on the formal selection process of non-execs, for example, compared with only a few percent more who said they complied in full.

All told, there is as much confusion, willful non-compliance and fraud today as there was before any of these bibles of conduct hit. Corporate fraud has ballooned in the last year and will keep increasing, according to KPMG’s fraud barometer. Meanwhile, the accounts and reports companies publish have grown in tandem: the average annual report from a FTSE-100 company in 2007 was 140 pages – up 7% on 2006: Royal Mail told HSBC that it would restrict the number of its annual reports postal workers could deliver at one time, given how heavy it had become. And the bulge was formed of corporate governance bumph. As Deloitte partner Isobel Sharp told Accountancy Age, “It’s actually a case of, the more you explain it, the more I don’t understand it.”

For more, see 25th anniversary – featured interviews