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Governance Guide (Part 1)

Governance Guide (Part 1)

According to the Chartered Institute for Personnel and Development

there are a number of key principles that companies must adhere to:

•    The design of remuneration plans should be clear, appropriately simple and relevant
•    The mix of fixed and variable remuneration should be commensurate with each executive’s role and level in the organisation. They should not lead to inappropriate risk-taking, for example incentives that drive inappropriate behaviours such as revenue growth to the detriment of profit (see below, ‘When corporate governance fails’)
•    Incentives should reward outcomes that lead to, and reflect, sustainable and measurable value creation.
•    Remuneration committees should act independently
•    When agreeing remuneration decisions, remuneration committees should have the discretion to exercise judgement and take the broader context of an organisation into account alongside its performance, as appropriate.

External Governance

Who are the regulators?

Corporate governance rules are influenced by a number of bodies. The government sets the framework with its primary legislation. The Companies Act 2006 set out the general rules for companies. Within that, principle responsibility for policing corporate governance lies with the FRC, a body made up of industry experts and professional regulators. Part-funded by the government, the FRC works with corporates as well as the users of company reports (investment funds, pension funds and so on) to lay down appropriate rules for board composition and corporate governance.

Every few years, the regulators update the guidance relevant to the latest events and developments. That has been a regular occurrence since the first publication of the Cadbury Report back in 1992. Since then, there have been numerous updates to the Combined Code. The last, which occurred in 2009, revealed a corporate constituency broadly happy with the current guidelines. According to the FRC, “All FTSE 100 participants and the majority of those from FTSE 250 and Small Cap companies considered that the Combined Code had had a broadly beneficial effect and remained fit for purpose, and its relative lack of prescription [ie a principles-based approach] was seen as a strength.”

Interestingly, however, the further down the food chain to the smaller companies the FRC went, the lower the satisfaction levels. Smaller listed companies in particular registered their unhappiness with the burden imposed by corporate governance principles. There have been calls for an adapted code for smaller entities, though a separate set of principles has yet to emerge.

The FRC has had its position strengthened by the new government and now sits unchallenged at the head of the corporate governance pyramid.

How corporate scandals have shaped governance

For PLCs, the rules on corporate governance have been refined in the last decade to reflect the various scandals and business failures. In the US, the collapse of Enron and the scandals that followed at Tyco and elsewhere led to a change in corporate governance and reporting rules principally through the introduction of the US Sarbanes-Oxley Act.

The UK and Europe follow a principles-based approach, which lays down the basic principles companies should follow. This is in direct contrast to the US approach which holds to a rules-based prescriptive system which lays down directly what company boards must and must not do. This is a similar approach to US accounting rules and can be partly explained by the heavily litigious nature of US corporate life.

Principles versus Rules

However in the UK there remains a ‘comply or explain’ culture that sets out how it should be done and allows directors to explain why a certain guideline has not been followed. This principle is enshrined in most corporate and accounting law in the UK.

However, there are fears that the rush to regulate in the wake of the banking crisis might lead to a significant increase in the rules covering corporate governance, and a serious increase in the amount of regulations. So far that hasn’t happened.

In the UK, the FRC was quick to react to the market’s demand for greater clarity on corporate governance by updating its Code of Practice. The latest iteration came out in 2010 and represented a stock taking exercise of the current rules.

The Financial Reporting Council reviewed the Code in 2009 and set out a number of changes to the rules. The review was instigated by the continuing downturn, which was placing undue strain on many businesses.

Responses to the Combined Code update

“We believe that the UK has one of the best governance regimes in the world.  The comply or explain approach is effective and flexible.  It is up to companies and shareholders to fulfill their roles conscientiously in order to make the process work  more effectively.”  [Aviva Investors]  

Meanwhile Odgers Berndtson, executive headhunters and corporate consultants summarised the support among external stakeholders for the principles-based approach.

“We engage daily with the key people responsible for creating effective boards – chairmen, executive and non-executive directors, and company secretaries. The Code is an essential reference tool in these conversations … The principles-based approach, as opposed to a more prescriptive rules-based regime, is an essential part of what makes the Code valuable, allowing companies to devise for themselves a governance structure and processes that are most relevant.”

Clearly, the corporate community in the UK accepts that the Code, while not perfect in all cases, does largely get the balance right between oversight and allowing board discretion.

In part II of this guide we look at the latest trends and developments, the role of the vital non-executive director and the audit committee in enforcing governance.

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