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concepts flexibly, boards generally become better disposed to shareholder views.

Of course, there will always be specific situations where companies and shareholders confront considerable differences, but the relatively close alignment of interests between many boards and a large portion of the institutional investment community means the relationship is not a naturally confrontational one. The hostile mood that prevailed when the Higgs Report was being debated should be seen as the exception rather than the norm. The key to a successful contribution by shareholders should be seen not in the degree to which they wrest control of the boardroom from the directors, but more in the degree to which they provide an effective check and balance, which reduces risk, enhances the quality of decision-making and helps create sustainable value.

The overall result of this philosophy has been that British companies generally enjoy relatively high standards of governance. Thanks to the Code approach, the incidence of individuals combining the role of Chairman and Chief Executive is now rare; most companies have fully independent audit committees; and it has been possible to introduce a generally high standard of internal controls through the recommendations contained in the Turnbull guidance. None of this has required prescriptive legislation. Indeed it has been possible to avoid potentially serious legislative difficulties such as a requirement for a legal definition of independence in a non-executive director. This is all thanks to the fact that, having been empowered to dismiss boards, shareholders do a job which in other countries might be tackled by regulators. Though there are certainly some exceptions, the weight of the evidence from the generally rising standard of corporate governance is that shareholders are generally effective and that their interventions involve less compliance cost than those of regulators.

Where shareholders make a difference

One reason why the UK has been able to harness shareholder power to develop high standards of corporate governance has been the ownership structure of British companies. Traditionally there has been a heavy institutional presence on UK company registers and this presence is normally widely dispersed. This is different from other countries, especially in continental Europe where a single large holder may dominate the register. The comply-or-explain approach works less well in these cases because the block holder is normally very close to the management and will therefore be less effective in acting as a check and balance.

Moreover two types of institution, insurance companies and pension funds, have traditionally been large holders of equities. Again, this is not necessarily replicated in other jurisdictions where funded pensions are less common and/or insurance companies have been more heavily invested in bonds. A feature of equity investment by UK insurers and pension funds is that it is long term in nature. Though holdings may be adjusted at the margin, these institutions have typically had a long-term commitment to the equity market. This

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gives them a reason for being concerned with corporate governance. They believe it reduces risk over the longer term and helps companies deliver highquality sustainable earnings. Moreover, both insurance companies and pension funds are effectively owners, unlike mutual fund managers who are merely agents.

Yet if the dispersed ownership by long-term institutions, which are prepared to act as owners, helps create a situation where companies can be made effectively accountable to shareholders, there are also limits to the degree to which this can be a substitute for regulation. One important aspect of company law is that it does make companies accountable to their shareholders, for example by giving them the right to appoint and dismiss boards, by ensuring some basic rights such as that to subscribe for new capital in proportion to existing holdings (pre-emption), by ensuring that companies put key issues to a vote and by ensuring that shareholders are properly informed. Shareholders cannot exercise their rights of ownership unless a suitable framework allows them to do so. Nor can they substitute for the law or regulation in every single case. The requirement for audit, for example, needs to be set out in the law. Shareholders have a role in ensuring that the governance of the audit process is appropriate and that the audit committee is suitably independent, but they cannot design and enforce audit requirements themselves.

So what are the areas where shareholder power can work as well as, or better than, regulation to maintain high standards of corporate governance?

Certainly one of these must be board structure. It is quite rare in the UK for shareholders to promote individuals as candidates for a particular board. This normally only happens after a company has run into trouble. Even then, there is a reluctance to usurp the nomination committee’s right to make the actual selection. In 2004, shareholders were clear in their rejection of the choice of Sir Ian Prosser as Chairman of Sainsbury, the supermarket chain, which had been steadily losing ground to rivals, notably Tesco. As a former Chairman of Bass, the brewing and hotel concern, Sir Ian had a strong experience in leading a retail-facing company. However, City institutions made it plain that they did not feel he had the right touch to guide the company out of the troubles it was then facing. Sir Ian gracefully withdrew and, though the nomination committee subsequently consulted shareholders, the subsequent choice of Philip Hampton was the committee’s own. Shareholders in these circumstances are more likely to indicate the type of skills they feel are needed Sir Philip Hampton’s previous roles as finance director of several leading companies, including BT and the Lloyds TSB banking group, meant he had City experience that complemented the retail skills of Justin King, Sainsbury’s Chief Executive.

Similarly, Michael Green was forced to withdraw in 2003 from the chairmanship of the new ITV television company as a result of shareholder desire for a properly independent chairman. It was widely felt in the City that the combination of Mr Green as Chairman and Charles Allen as Chief Executive would not work. They had each been in charge of one of the companies that

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had united to form the merged ITV and were used to running their own show. However, while there was general agreement that the board needed to change, there was none around the need to push for a particular replacement candidate. In the event the chosen candidate, Sir Peter Burt, a former banker, was once again a figure familiar with the City.

So, even in these quite extreme cases, the shareholders’ role is to ensure proper process leading to the selection of a candidate who meets the right sort of criteria rather than to undertake the selection themselves. Normally it is possible to leave the selection up to the nomination committee precisely because the shareholders have the long-stop possibility of veto in the event of a bad decision. This concentrates the minds of the nomination committee in a way that allows shareholders to let boards be largely responsible for their own renewal. This is important for a board that is supposed to function as a unit with collective responsibility for decision-making and risk management.

By extension this approach works for the composition of the board as a whole. Shareholders do seek to satisfy themselves that there is an appropriate balance of executive and non-executive directors; that the non-executive directors are sufficiently independent; that committees, whose responsibility covers areas such as remuneration and audit, are properly constituted and independent. Shareholders are keen to see the appointment of a senior independent director who can be an additional point to turn to in trouble, especially when the concern is about the Chairman. They are increasingly wary of situations where the Chief Executive goes on to become Chairman of the same company, and they want to be sure that directors who are supposed to be independent really are independent in practice.

Ideally, problems should be averted before they arise through consultation between companies and their shareholders. There are now fewer cases of Chief Executives becoming Chairmen. This is partly because companies are aware of shareholder concerns and therefore reject the idea at the outset. Sometimes initial, private soundings may have deterred companies from proceeding. Even when the company believes it has a good case, there will normally be an extensive discussion with shareholders so that both sides understand each other’s views. The Association of British Insurers (ABI) held ground-breaking discussions with Barclays over its decision to appoint Matt Barrett, its former Chief Executive, as Chairman in 2004. This helped Barclays to produce, and then subsequently flesh out, a full explanation of its thinking. It may also have influenced the bank’s decision to look outside for its subsequent Chairman, Marcus Agius, from the Lazard investment banking concern, in 2004. Similarly HSBC went out of its way to consult shareholders about its decision to appoint its Chief Executive, Stephen Green, as Chairman in 2006.

Executives and other directors have sometimes grumbled about the need for such discussions but, generally speaking, the powers granted to shareholders, and the way they have exercised them, have led to an improvement in board structure and practice, with fewer situations where unfettered power is

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concentrated in the hands of one person. As mentioned already, it is now rare to find the roles of Chairman and Chief Executive combined. In recent years there has also been a new focus on board evaluation. One important factor in achieving this has been the development of consultation between boards and shareholders on key issues. This has grown considerably since the introduction of the new Combined Code.

Shareholders also play an important role in remuneration policy. In this area too, consultation has grown considerably since the introduction of the new Directors’ Remuneration Report. The ABI now receives over 200 requests a year from companies seeking shareholder views on remuneration policy. In many cases these consultations produce changes which help avert a row before the proposals are formalised and put to a vote.

Companies are now obliged to offer shareholders an advisory vote on their remuneration report, which covers all aspects of remuneration ranging from base salary through to pensions, bonuses and share incentives. As before, a separate binding vote is required on share incentive schemes that are dilutive and/or involve the issue of shares to directors. The press watches votes on remuneration closely, and companies are concerned about the loss of reputation that may flow from evidence of widespread opposition to their remuneration policy. Moreover, a public dispute over remuneration can seriously demotivate directors at the centre of the disagreement. For these reasons, companies increasingly seek dialogue with shareholders in order to sort out problems before they arise. Nowadays, this dialogue extends beyond the design of share-based incentive schemes into new areas such as pensions, which has become a focus of attention and change in the wake of new tax arrangements.

The introduction of the Directors’ Remuneration Report Regulations has created a dilemma for shareholders. For the first time they are able to pronounce on absolute amounts paid to executives. Indeed, they are obliged to do so through the vote. Many are, however, deeply unsure of their ability to determine the ‘going rate’ for a particular executive role. They believe this is an issue that ought to be left to the market, while their own focus has always been principally on the structure of the remuneration package. What matters to shareholders is that rewards reflect performance and that they align the interests of the management with those of shareholders.

There are three reasons why shareholders have become involved with remuneration. First, a conflict of interest arises when boards have the task of deciding the remuneration of directors who sit on these same boards. As owners, shareholders have an obligation to help mitigate this conflict. Second, remuneration creates incentives that will determine the approach taken by the management in driving the company forward. Shareholders have a strong interest in what happens. Finally, there is a general need to preserve the integrity of the system. If a lack of discipline and oversight allows companies to bestow lavish rewards on mediocrity and failure, it will no longer be possible to reward success. This will damage entrepreneurialism and inhibit wealth creation.

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The efforts of shareholders over the years have met with some success, particularly with regard to the structure of remuneration. It was always possible for the UK to avoid the extremes witnessed in the US at the height of the bubble. Shareholder voting rights on incentive schemes enabled them to limit dilution (the limit of 10 per cent set out in the ABI’s guidelines is widely respected). Moreover, thanks also to different taxation arrangements, it has been possible for shareholders to insist that awards of options only vest after medium-term performance conditions have been met. In other words, directors only actually receive the benefits after the performance has been delivered and in proportion to their actual achievements. By contrast, in the US, directors have been able to cash-in their options immediately. This leads to a short-term focus on the share price. Directors have an interest in ramping it up in order to maximise this benefit. There is also evidence that some US boards have awarded options to directors ahead of positive news which is likely to drive up the share price, or backdated them to a time when the share price was low. This, of course, further accentuates the gain and the transfer of value away from shareholders.

Shareholders in the UK have also managed to exercise some detailed influence on the design of share schemes. When options first became fashionable, it was normal for them to be allocated sporadically in large amounts. This created a particular risk for the executives, who could lose the entire benefit if the company failed to meet performance hurdles. Nowadays, it is normal for grants to be made annually so that executives have a continuing incentive to meet performance targets and will not lose all their benefit if targets are not met in one crucial year. Following this change, it has also been possible virtually to eliminate the practice of retesting, which allows executives to have a second chance to meet performance targets if they fail the first time. Shareholders always saw a retesting provision as seriously weakening the link with performance. Shareholder influence has also encouraged remuneration structures that limit the amount of reward for median performance and increase it for outstanding results. Finally, shareholders have taken a strong line on severance pay, as set out in the joint paper by the Association of British Insurers and the National Association of Pension Funds mentioned above. There is now more discipline in this area, and a growing tendency to make sure that severance is paid in instalments that stop when the executive concerned finds a new job rather than in one irretrievable lump sum.

Shareholders have been less successful, however, in restraining overall amounts of remuneration. This is partly because they do not wish to become involved in setting a going rate, as mentioned, but also because there are strong forces at work which drive executive remuneration continually higher. One of these is the ratchet effect that follows from the increased level of disclosure. No executive wants to be paid less than others in his or her peer group. Another is the activity of remuneration consultants who generate fee-income from helping companies revise their remuneration policy, a process which almost invariably

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leads to increases. There is a real risk that, without more discipline, there will be a public backlash which will lead to more political interference in remuneration.

There is a limit, however, to what shareholders can do here. The responsibility for setting absolute amounts must lie with the directors who sit on the remuneration committee. They are the ones who can determine the amount that is actually needed to provide pay that is genuinely competitive. They understand better than shareholders the conditions and competitive pressures facing the industry, and can therefore adjudicate more effectively on benchmarks proposed by consultants. They are also the ones who should say ‘no’ to excessive demands. Shareholders cannot do this without being involved in micro-management.

As mentioned above, another area where shareholders wield a potentially important indirect influence is internal controls. This is not because of any involvement in the work of audit committees, but is more to do with the obligation facing listed companies to confirm that boards have examined the effectiveness of their internal controls. The realisation by directors that shareholders can ‘dismiss’ them if they fail to live up to their obligations in this respect clearly concentrates minds. The result is a constructive approach to risk management, which has been achieved at far lower compliance cost than the equivalent regulation under the Sarbanes-Oxley Act in the US.

Similarly, the Association of British Insurers in 2002 launched a short set of guidelines calling on boards to disclose in their annual report that they had considered the risks inherent in the way their company managed social, ethical and environmental issues and to confirm that these risks were being managed. This was a purely voluntary requirement promoted by a group of leading shareholders, but the fact that companies started to make the statement, and boards began to consider the risks more conscientiously, has certainly had an impact on behaviour. A couple of years after the guidelines were first introduced, nearly 100 companies confirmed that they had included management of environmental, social and ethical risks in their general risk-management policies.

Finally, shareholders have a significant say in important strategic questions. This is not just a matter of companies listening to fund managers and analysts about the direction their business is taking. UK governance arrangements give shareholders a direct say on large transactions, which will alter the shape of a company. This goes beyond their right to vote on whether or not to accept a bid, which is common in other jurisdictions. The UK Listing Rules also give them a right to vote when a company wishes to make a substantial purchase or disposal of assets. This right is regarded as highly important. It is not the case that shareholders frequently use it to block company actions, but more that the need for a vote imposes a discipline on boards to consider in advance whether they will be able to carry their shareholders with them in any decision. At the very least, this should mean that the decisions taken by boards are more closely aligned with the interests of shareholders than would otherwise be the case.

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