Financial companies must set their own house in order

Speech by Rt Hon John McFall MP
To the 2nd ICSA Corporate Governance Conference


Corporate governance of course goes far wider than just the financial sector. However, it was the collapse of confidence in the stability of the financial system in 2008 which brought corporate governance into the limelight. And the financial sector has ensured that corporate governance stays in the limelight, since "bankers’ bonuses" continue to make the headlines. Scrutiny of things like bonus levels is not trivial: it matters how a company uses the money it generates, whether it is to give additional pay to employees, to rebuild reserves, or to reward shareholders. And it leaves a bad taste in the mouth if one group appears to benefit at the expense of all the others.

The banking crisis left many observers feeling that there was a problem of "ownerless corporations". Since then, the Walker review has set out proposals to tackle that problem, and the draft Corporate Governance Code is the result.

I cannot overemphasise how important it is that business sets its own house in order. The events of the last two years have shown that companies which are not properly controlled are not simply dangerous to themselves; they are dangers to the whole economy. Unless companies improve their own governance, or the institutions which ultimately own companies take steps to control them, pressure to legislate for such control will grow, and pressure for intensive, quite possibly inappropriate, regulation will build.

I don't think anyone wants that to happen: but nobody wanted a quarter of the world's GDP to be directed to bailing out the banks either. I travel extensively as Chairman of the Treasury Committee, and in every country I've visited I've heard the words "the public will not tolerate another bailout". They also will not tolerate a corporate governance system which does nothing to prevent a future bailout being needed. And I think this intolerance of financial mismanagement is spreading to suspicion about corporate governance in the non-financial sector.

So what would reduce this suspicion? Here are a few suggestions: 

An emphasis on the long-term.

The new code is helpful on this: it specifies that “Every company should be headed by an effective board that is collectively responsible for the long-term success of the company.”
but you have to be a very brave board to look long-term, if your owners look short term, and I discuss ownership later.

And you have to be very altruistic as a manager to look long-term if your bonuses are based on company performance over the next year or two.
The Walker review is actually very strong on this. It says:

“against a background of inadequate control, unduly narrow focus and serious excess in some instances, substantial enhancement is needed in board level oversight of remuneration policies, in particular in respect of variable pay, and in associated disclosures.”

If I was the owner of a major company, I would be very angry about some of the remuneration given in companies I owned. Wait a minute, as taxpayer, I do effectively own two large banks. When we discussed remuneration with Stephen Hester he effectively told us we had to pay huge amounts to ensure that the best staff were retained. I'm not going to criticise pay awards in individual institutions, but it doesn't take much to see that this attitude could easily lead to ever increasing compensation for employees, reducing rewards for shareholders, and reductions in retained capital.

I trust the industry will take note of David Walker's words:

“With expectation, guidance and, ultimately, pressure from major shareholders, the remuneration committee, in its enlarged role, should ensure that remuneration structures for all such “high end” employees are appropriately aligned with the medium and longer-term risk appetite and strategy of the entity; and should be a key and mature counterbalance to any executive pressure to boost short-term remuneration provision in response to a perceived threat of competitor pressure.”

I really hope that in the coming months and years we will see that this has happened. 

Proper challenge to management

Again the code makes the right noises: “No one individual should have unfettered powers of decision.” And “As part of their role as members of a unitary board, non-executive directors should constructively challenge and help develop proposals on strategy.”

Again, it's easy to say corporate challenge is good. It's far harder to secure it. It's particularly hard to secure challenge if everyone on the board thinks the same way.
They have to recognise that there is value in the person who asks the awkward question, not once but again and again.

Both the code and the Walker review implicitly accepted the challenge function can be carried out in a civilised way. Sir David’s description is almost like a dance

“The sequence in board discussion on major issues should be: presentation by the executive, a disciplined process of challenge, decision on the policy or strategy to be adopted and then full empowerment of the executive to implement”

I hope it can be done that way, but I fear there will have to be a recognition that sometimes board meetings will not be civilised; that they will be difficult, and that there is value in that.

A well-informed, diverse and expert board

The code provides that “The board and its committees should consist of directors with the appropriate balance of skills, experience, independence and knowledge of the company to enable it to discharge its duties and responsibilities effectively. There should be a formal, rigorous and transparent procedure for the appointment of new directors to the board. All directors must be able to allocate sufficient time to the company to perform their responsibilities effectively. All directors should receive induction.

Surely that should do it? Well, it will do it if people are committed to make it work. But there is a real danger that you could introduce your formal, rigorous, and transparent procedures and still end up with the usual suspects.

During our inquiry into Women In the City we were told again and again that boards recruited in their own image. That inquiry focused on female representation; I'm sure the same point could be made about many groups.

The Walker review called for the boards of financial institutions to have real financial expertise. But it also, quite rightly, recommended that " there will still be a need for diversity in skill sets and different types of skill set and experience." Companies really have to go out and get that diversity.
Without that diversity there will be no real challenge, and I believe challenge is crucial.

And if I was the owner of a company, I would want to look very hard at the board I trusted to run it, and I would want to make sure I thought the people on it were not all members of the same old club.

Reporting

Again, the draft code makes the right noises:

“The board should present a balanced and understandable assessment of the company’s position and prospects.”

A good board should do this.

And this is where the code is potentially so important. The recent report on Lehman's has shown a company using legal devices to misrepresent its financial position. The lawyers approved it. The auditors passed it.

In an editorial on Tuesday, the Financial Times claimed that this was because of the US box ticking culture

"Ernst and Young signed off on repo transactions that are pushed billions of dollars worth of Lehman's assets off-balance sheet not because it believed they served a real commercial purpose, but because accounting rules allowed this. It focused on the form, not the substance, of the deals"

The implication is that codes are more effective than rulebooks.

If Lehman’s had been a UK company, abiding by the new code, the board should have stopped the company using repo 105, whether it was legal or not.

I like to think that would have happened. It would really make me happy. But I suspect, in a lot of companies, in the United Kingdom like in the United States, the attitude will continue to be "if it is legal, we can do it".

The Financial Times has said that auditors should have a "robustly adversarial relationship with management." I'd like to see more of those robustly adversarial relationships in the system. And maybe if boards have the courage to appoint just one or two people who weren't the usual suspects the attitude that "if it is legal we can do it" would be challenged from within the system.

Shareholders

Managing the company for the long term will only work if shareholders, owners, are willing to take the long-term view as well. Sir David Walker and Paul Myners are agreed that we have “a culture where there is too much trading activity and not enough ownership”.

I think most people would agree with that. It’s hard to see how to change it.
The draft code comes with another document: the Institutional Shareholders’ Committee Code on financial stewardship.

That suggests that investors will engage properly, but it doesn't require it. I quote:

“The Code sets out best practice for institutional investors that choose to engage with the companies in which they invest. The Code does not constitute an obligation to micro-manage the affairs of investee companies or preclude a decision to sell a holding, where this is considered the most effective response to concerns.”

So the code only applies to "institutional investors that choose to engage with the companies in which they invest." So much for the long-term view.

I have some sympathy for investors; during our banking enquiry we were told about groups of concerned investors trying to engage with the management of RBS, and repeatedly being rebuffed. In those circumstances, getting out is a sensible reaction.

It's hard to see how to force owners to act responsibly, but it would not surprise me if changes were made: looking at the broader picture for a moment, the ease with which Kraft was able to take over Cadbury is already prompting calls for changes to the Takeover Code.

Conclusion

What would it be like if the code really worked? Well, I hope boards would become much more uncomfortable places. I would like there to be a real challenge to management. I would like to see boards exercising much stricter control of remuneration.

I don't just want boards to be uncomfortable; I would like owners to breathe down directors’ necks. I haven't even mentioned the relationship between boards and auditors, where I think both parties could get a lot tougher.

But I can tell you, it will get much more uncomfortable if the code doesn't work. Because we've seen what happens when societies stop trusting business to behave properly. Taking criminal behaviour first, the collapse of Enron led to the introduction of Sarbannes Oxley - I still remember the howls of outrage about that, although I do note that on our recent visit to the US, several people referred to it rather approvingly.

And board diversity? Well Norway has a quota of 40% for the representation of women on major company boards, and France is considering introducing a similar provision.

If it becomes obvious that mandatory rules are more effective in producing change than simply "comply or explain", then those rules will come. It's up to companies themselves to prevent it, by showing that the code can be made to work.