Strategy & Operations » Governance » There’s no escaping the new regulatory world

There's no escaping the new regulatory world

This year will see large adjustments to corporate governance. But can they override animal spirits?

2010 will see a real clash of cultures. All those business
reviews will turn into reports and will be implemented. In the banking and
financial services field, that means the Walker Review. For the rest of the
corporate world, it is the new UK Corporate Governance Code from the Financial
Reporting Council (FRC) – formerly the Combined Code on Corporate Governance
that will focus minds, or the lawyers who will be advising on what the real
implications are. And in the background there will be a turmoil of Turner
reports and all the other efforts at trying to keep the business world stable,
afloat and not so prone to alarming the populace as it has been in the past
couple of years.

The problem will be in this clash. All of these reports are based on the idea
that if you can get the regulation right, then all will be well. But, as the
revised FRC Code emphasises, it is human behaviour that is at the heart of
keeping everything on the straight and narrow (as well as off it). And human
behaviour, famously, does not click onto the tramlines and run in a true, fair
and straight line for evermore.

That means all these efforts are really aimed at squaring this peculiar
circle. People who know business know that regulations are very useful, but are
also the artificial scaffolding round the reality of the human beings operating
inside. People who don’t know business believe that, if you could only shackle
the bastards inside, all would be well.

What should FDs be focusing on as the year unfolds, then? A simple task: do
what needs to be done to maintain both the stability and reputation of your
organisation – but at the same time make the odd noise about the irrelevant
stuff that the world outside seems to be fixated on.

Press, populace, politicians
It is easy to recognise the irrelevant stuff. At a conference I attended just
before Christmas, one speaker summed up the drivers of this debate as “The Three
Ps”: the press, the populace and the politicians. They are not really interested
in such things as shareholder responsibilities, or board performance
evaluations, or risk appetite. They are only interested in the issue of
remuneration. So a huge smokescreen of activity has to be maintained by
regulators on this issue to show that, indeed, something is being done. As FD,
you’d be well advised to join in that fun during the year and ensure that noisy
initiatives are being taken over remuneration levels, particularly if it is
anything to do with bonuses.

To be fair, there is a serious point here. Remuneration, particularly in the
US, has gotten steadily out of hand in the past 20 years. Partly, it is fuelled
by consultants who insist that remuneration structures should always be in the
upper quartile and so install a mechanism which has only an upward path. And
partly it is just ego.

A newly published study of chief executive officer, Business At The
Crossroads: The Crisis of Corporate Leadership
, has a German CEO admitting:
“I know I’m overpaid. But the benchmarks say I’m not overpaid enough.” The book
argues that CEOs can be greedy, but the typical pyramid model of corporate
hierarchy reinforces the pay differential. “The consequence of this standard,
hierarchical model is that power and pay are invariably drawn, as if by a
siphon, to a CEO space at the top insulated from normal market disciplines,” the
author says.

But what you really need to do as FD is get to grips with human behaviour,
take all the new proposals, particularly those from the FRC and use them to
usefully bring about sensible change.

In principle
At the heart of this is what the FRC proposals enshrine as its principles. “The
purpose of the Code is to promote high standards of corporate governance, in the
belief that good governance should contribute to better long-term performance by
helping a board discharge its duties in the best interest of shareholders,” the
regulator says.

There are two areas worth looking at in detail. The first is risk management
and the second is board evaluation. Risk is obviously important. The Walker
Report suggests the creation of a board risk committee, for example. The FRC
takes a slightly more pragmatic line. While the banks and financial institutions
could hardly argue against having a greater emphasis on risk following the utter
disasters of the banking world’s efforts at containing it, the rest of the
corporate world probably needs to simply think a bit more about it rather than
necessarily create even more systems. The systems, after all, were already there
in the banks: it was just that no one thought about what it all meant.

So the FRC has followed the suggestion, floated by the Treasury Select
Committee, that a useful approach would be “to insist on all listed firms
setting out their business model in a short business review, in clear
jargon-free English, to detail how the firm has made (or lost) its money and
what the main future risks are judged to be”. The FRC, in turn, suggests that
“companies should disclose their business model and overall financial strategy”.

To be frank, that is obvious. But the companies that will gain in this
process will be the ones that take this very seriously. The battleground for the
hearts and minds of shareholders in the future is sited exactly in this area.
Companies that do it well will prosper. The rest won’t. As the FRC rightly says:
“Preparation of such a statement may also serve to prompt discussion in the
boardroom as to the long-term robustness of the business model.” The value is
not just in the communication of the model and strategy to the outside world: it
is also in the discussion of it among boards. It is my belief that the banks
that fell over tended not to discuss things, but simply accepted the blather
being foisted upon them by a bullying CEO. And companies, particularly
non-financial ones, often find this sort of stuff difficult. It is time to put
this right.

But seriously
The other area for examination is board evaluation. This represents real change.
The FRC review makes it clear that, in 2003, when the idea of a regular formal
evaluation of a board’s performance was first added to the Code, there was
enormous scepticism. But times change and people learn from experience. “In
discussions with company chairmen as part of this review, however,” it says,
“the FRC found almost universal agreement that regular evaluation can be a
beneficial process when taken seriously.” It is those last two words that carry
the resonance.

It will be perfectly possible, under both the Walker Review and the FRC
reports, for boards not to take this seriously, despite the insistence that such
evaluations take place every two or three years – in the case of the Walker
Review – or at least every three years, in the case of the FRC.

The extent of external facilitation could simply mean that a bunch of
consultants has been hired to do a questionnaire, for example. That will all
come out through the comply or explain principle, but the FRC also insists that
chairmen are “encouraged” to report personally on how the principles relating to
the role and effectiveness of the board have been applied. This is where the
real interest should lie. A board that has tried to evaluate how far its tone
from the top extends down the corporate hierarchy would be able to go a long way
in showing how far human behaviour was being influenced.

This is how the clash of the cultures will be resolved. The only way those
behaviours in the corporate context can hope to be regularised in any way is
through the route showing that where the benefits from good behaviour are being
achieved, those companies or organisations are also benefiting on the bottom
line, from greater stability, profitability and the likelihood of a long-term
future. Finance directors in the year ahead need to accept the new regulatory
world and extract as much positive benefit from it as they can.

Walker review and UK corporate governance code: boilerplate, or real

The Walker Review covers banks and financial institutions. The original
proposals published last summer have now been firmed up into final actions and
their primary focus is on risk and remuneration in banks. The proposed revisions
to the Corporate Governance Code cover all listed companies and are out for
comment until 5 March 2010, with the intention that the final version will come
into force for accounting periods beginning on or after 29 June 2010.

Walker Review
Much of the Walker Review represents the shutting of stable doors long after
horses have bolted. Politicians and the public will be reassured. Bankers are

  • The review insists that all of what it refers to as ‘high-end’ employees of
    banks earning more than a £1m should be disclosed, but remain anonymous. This
    has been criticised as being of no use to analysts and investors, who could use
    the information on where in a bank these rascally types operate or what
    departments and operations, therefore, pose the implied risk
  • Non-executive directors need to devote between 30 and 36 days every year to
    the bank’s work
  • Emphasis on new risk and remuneration committees means appointing a chief
    risk officer, who reports to the board
  • If there is less than 75% approval for the annual pay report the chairman of
    the remuneration committee must then stand for re-election.

UK Corporate Governance Code
The proposed UK Corporate Governance Code is intended, as Sir Christopher Hogg,
chairman of the Financial Reporting Council has so colourfully explained, to
remove “the fungus of boilerplate”. The proposals continue the process of
refining what is already a very effective corporate governance system:

  • Externally facilitated board evaluation reviews should happen at least every
    three years
  • Chairmen have to hold regular development reviews with all directors
  • Companies have to report on their business model and overall financial
  • It is proposed that companies should ‘comply or explain’ whether the
    chairman and/or all members of the board should stand for annual re-election.
    The overall aim of the Code is to be reinforced to emphasise the principles and
    importance of board behaviours. Unlike the Walker Review, which tends towards
    the boilerplate end of the spectrum, the Corporate Governance Code continues to
    stress the importance of changing human behaviours in corporate life.

Robert Bruce is a leading commentator on accountancy

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