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The role of the regulator

S I R B R YA N N I C H O L S O N

Introduction

In this chapter I will briefly explain the rationale for the market-based approach to promoting good governance and why I believe the comply-or-explain approach to be the most effective means of achieving this objective, before going on to set out what I see as the proper role for the regulator and governments in encouraging the uptake of good practice. I will then illustrate how this role works in practice using two examples from my period as chairman of the Financial Reporting Council (FRC): the revisions to the Combined Code made in 2003 following the Higgs and Smith reports on non-executive directors and audit committees respectively, and the review of the Turnbull guidance on internal controls in the wake of the US Sarbanes-Oxley Act in 2004–5. The FRC is the body designated by the Government, with the support of the business, investor and professional communities, to be responsible for corporate governance. Finally, I will consider some of the challenges to the success of the market-based approach.

The market-based approach to promoting good governance

To set the context for a discussion of the market-based approach to promoting good governance I can do no better than start with two quotes. The first is the opening paragraph from the 1992 Cadbury Report, which put in place the basic elements of the framework that is still used in the UK, and the second is the first principle in the Combined Code on Corporate Governance:

The country’s economy depends on the drive and efficiency of its companies. Thus the effectiveness with which their boards discharge their responsibilities determines Britain’s competitive position. They must be free to drive their companies forward, but exercise that freedom within a framework of effective accountability. This is the essence of any system of good corporate governance.1

1Report of the Committee on the Financial Aspects of Corporate Governance (The Cadbury Report), December 1992.

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The board’s role is to provide entrepreneurial leadership of the company within a framework of prudent and effective controls which enables risk to be assessed and managed.2

As these quotes make clear, accountability to the shareholders, while very important, is not the only objective of good governance. Good governance is a tool that can improve the board’s ability to manage the company effectively. For example, the board is more likely to come to better decisions if it has amongst its members the right mix of skills, experience and independent thinking, and if the strategy put forward by the executive management has been rigorously tested. The company will be better prepared for what the future might bring if it has a clear understanding of the risks and opportunities it faces and systems in place to manage them effectively. These are not accountability issues – they are good business sense.

A regulatory framework that aims to improve standards of corporate governance is more likely to succeed, and be accepted by those that it regulates, if it recognises that governance should support, not constrain, the entrepreneurial leadership of the company. This, of course, works to the benefit of the shareholder as well if it improves the long-term value of the company and their investment.

This in turn requires a degree of flexibility in the way companies adopt and adapt governance practices. To use an overworked phrase, there is no ‘one size fits all’. The Combined Code is specifically designed to allow the necessary flexibility for it to be used effectively across all listed companies.

To be effective, rather than simply accountable, good governance needs to be implemented in a way that fits the culture and organisation of the individual company. These vary enormously from company to company depending on factors such as company size and stage of development, the sector in which the company operates and the complexity of the business model. When the FRC reviewed the implementation of the Turnbull guidance on internal control in 2005, it found a clear correlation between a company’s perception of the benefits that had been delivered and the extent to which it had integrated the guidance into its normal business processes and systems.3

If the test of good governance is whether it is effective in improving the management of the business, who judges its effectiveness? In my view it has to be the intended beneficiaries – the shareholders. They share with the board the objective of creating wealth and achieving sustainable shareholder value; and where they take an active interest they will have a good understanding of the company, and are able to take an informed view on the appropriateness of the company’s governance practices.

2The Combined Code on Corporate Governance, Financial Reporting Council, July 2003 (also as updated June 2006).

3Review of the Turnbull Guidance of Internal Control: Proposals for Updating the Guidance’, Financial Reporting Council, June 2005.

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This was why the Cadbury Report emphasised the importance of transparency through disclosure to shareholders, and introduced the concept of comply-or-explain. While the content of the Code and the regulatory framework that supports it have evolved, this remains the basis of the UK’s corporate governance system for listed companies and has been increasingly adopted in other jurisdictions over recent years. Many other non-listed entities also use adopted versions of the Combined Code as the basis for their governance.

The Cadbury Code set out a selection of good practices and standards of behaviour that companies were encouraged to consider and, if appropriate, to adopt. If they felt the recommendations of the Code were not appropriate in their particular situation, they were encouraged to explain their reasoning for non-adoption to their shareholders.

The same approach was continued when the Hampel review of the Cadbury Code took place in the mid-1990s. Under the auspices of the FRC, a top-level group of people from the business, investor and other communities was set up under Sir Ronnie Hampel, then Chairman of ICI, to review the working of the Cadbury Code and to suggest any changes that might be thought desirable. It published its findings in 1998 and with it came into being an updated Code.4 That Code also included the recommendations of the Greenbury Report on remuneration,5 which had been published in 1995. Thus, for the first time it was called ‘the Combined Code on Corporate Governance’. That name has stuck and the shorthand of it, the Combined Code, is now universally recognised.

The 1998 Combined Code was strengthened as compared to Cadbury by making it an obligation on companies to disclose how they were applying the Combined Code by making comply-or-explain a requirement of the Listing Rules of the London Stock Exchange. The 1998 Combined Code added to the highly visible ‘provisions’ of the Code (those elements subject to comply- or-explain) the practice of stating ‘principles’ which companies should follow when implementing the Code. These principles set out some basic tenets of good governance such as objectivity and transparency. They are not prescriptive. Companies can decide how best to implement them in their own particular circumstances, but they must pay regard to them and tell their shareholders how they are implementing them. Later, the 2003 Combined Code divided principles into ‘main principles’ and ‘supporting principles’, but the same process of reporting to shareholders on implementation continued.

In this way enforcement takes place at two levels. The Financial Services Authority (FSA) is now the body responsible for enforcing the Listing Rules. It ensures that companies are disclosing their corporate governance practices in their annual report and accounts by reference to the Combined Code. However, neither the FSA nor the FRC, which is responsible for the content of the Combined Code, makes a judgement on how the company has applied the

4Committee on Corporate Governance: Final Report (The Hampel Report), January 1998.

5Directors’ Remuneration: Report of a Study Group Chaired by Sir Richard Greenbury, July 1995.

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Code – for example, whether the company should have complied rather than explained (or indeed whether the explanation given was adequate), or whether the explanation of how the principles and supporting principles have been implemented is acceptable. That is clearly the duty of the shareholders.

Advantages of the market-based approach and comply-or-explain

I believe this model has a number of advantages over more traditional forms of regulation as a means of raising standards of corporate governance among listed companies.

First and foremost is its inherent flexibility, which makes it both better able to deal with differing company circumstances, and easier to update as views on corporate governance evolve. It is not possible to draft legislation that could anticipate all the different methods of applying the main principles and supporting principles in the Combined Code, or identify all the various factors that might affect a company’s choice of governance practices; at best it could offer a choice of routes to compliance. Even when attempts are made to produce genuinely principles-based legislation, which sets only the outcome to be achieved not the means by which it must be achieved, there is almost inevitably a demand for greater clarity on the part of the regulator and/or the regulated which leads to more detailed rules, or of guidance which acquires the status of rules. Some might suggest that the rules and standards produced by the United States Securities and Exchange Commission (SEC) and the Public Companies Accounting Oversight Board (PCAOB) in relation to Section 404 of the US Sarbanes-Oxley Act were an example of this phenomenon.

The flexibility of the market-based approach is reinforced by the fact that the enforcement responsibility rests with the shareholders, not a regulator. Our experience with the Combined Code is that shareholders are often willing to take a pragmatic approach about how to apply best practice in a way that is in the best interests of the company. They can accept non-compliance on a particular issue if they are persuaded that there is good reason and can see that in overall terms the governance is good.

It is neither sensible nor desirable to ask a regulator to enforce a comply-or- explain regime beyond ensuring that the necessary disclosures are being made. A regulator cannot apply the same degree of flexibility. Regulators do not and cannot have sufficient understanding of the individual company to judge what is or is not appropriate for that company. There would be an understandable expectation of consistency from those being regulated that would make it very difficult for the regulator to endorse exceptions except in clearly defined circumstances. Shareholders do not have this inhibition.

This is a view shared by the European Corporate Governance Forum in its report on the operation of comply-or-explain issued in 2006. The Forum is an expert group set up by the European Commission in 2004 to examine best practice in corporate governance in EU Member States. As well as endorsing

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the comply-or-explain approach in its 2006 report it commented that ‘regulatory authorities should limit their role to checking the existence of the statement, and to reacting to blatant misrepresentation of facts. They should not try and second-guess the judgement of the board or the value of its explanations. This is a matter for the company’s shareholders.’6

One example of this would be the assessment of whether a non-executive director should be considered to be independent of the company or not. How this is done is still a source of considerable debate in the UK. When the Combined Code was revised in 2003, it set out for the first time some examples of circumstances which could potentially affect an individual’s ability to take an objective position, while making it clear that companies were nonetheless entitled to classify an individual as an independent non-executive director if they considered that the potential conflict of interest was being managed and had not affected the individual’s independence of mind.

Some companies consider that in practice this has led to a presumption on the part of investors that such individuals are unable to manage any conflict of interest; some investors feel that companies are somewhat opaque in their explanations as to why they consider individual directors to be independent notwithstanding the existence of such interests. But both sides agree that it would be wholly undesirable for the concept of independence to be defined in regulation. It was interesting to observe that when European Commission proposals for mandatory audit committees, which would include at least one member defined as independent, were being negotiated, opposition in the UK was led jointly by the CBI and the Association of British Insurers, one of the leading investor bodies.

Because of the need for legislation to be consistent and enforceable, such legislation could not countenance that an individual could be considered to be independent while another individual in exactly the same situation was not. Comply-or-explain does not have that problem; it allows a pragmatic judgement to be made case by case.

For example, the Combined Code includes a criterion relating to length of tenure, which requires the board to explain why it believes an individual remains independent when he has served on the board for more than nine years. If the Government had decided in 2005 to make regulations that stated that no non-executive director could serve for more than nine years, 10 per cent of all non-executive directors in FTSE 350 companies would immediately have had to step down.7 This would have meant a great amount of experience and expertise being lost and would be completely contrary to the objective of improving standards of governance. The fact that boards overwhelmingly rotate their members in nine years or less, and therefore by their actions implicitly

6Statement on the Comply-or-Explain Principle, European Corporate Governance Forum, February 2006.

7‘Board Structure and Non-executive Directors’ fees’, Deloitte, September 2005.

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accept that a maximum of nine years is appropriate for most members, does not mean that there should be a hard and fast rule. What there should be is an explanation to shareholders why any particular individual is being asked to serve beyond nine years.

I believe the other main advantage of the code-based approach is that it is more likely to lead to ongoing improvements in governance, for a number of interrelated reasons:

It is better able to adapt to changes in attitudes and business culture. What is seen as good practice in one era may be viewed differently in the next, and aspects of governance that were not previously seen as significant may become so. It is easier to update a comply-or-explain code to reflect the market than it is to update legislation.

It can be more aspirational than legislation. Legislation tends to be written in terms of the minimum necessary requirements. That is entirely right; to do otherwise would be to risk imposing unjustified or disproportionate burdens on those being regulated. However, to quote from the Cadbury Report, ‘Statutory measures would impose a minimum standard and there would be a greater risk of boards complying with the letter, rather than with the spirit, of their requirements.’8 On the other hand a comply-or- explain code can, and does, set out market leading practices and encourage the rest to aspire to the standards of the best, while recognising that it may take time for all companies to get there, or for certain concepts to be accepted or for good practice to emerge.

It can encourage good practice relating to softer issues for which it would be inappropriate to prescribe minimum requirements in law. For example, the Combined Code contains provisions relating to the induction and training of non-executive directors. It would be hard to imagine regulations setting out a minimum number of days of training a year for all directors.

By asking shareholders to act as the enforcers it encourages them to engage with the companies in which they invest and to take their responsibilities as owners seriously.

One example of how the Combined Code and its predecessors have encouraged and reflected changes in governance practice is the separation of the roles of Chairman and Chief Executive. When first recommended in the Cadbury Code in 1992 this was considered controversial, and the two roles were combined in many companies. Now it is almost received wisdom in the UK that it is desirable for them to be separated, and by 2007, 94 per cent of FTSE 350 companies had done so.9 Research into the views of the Chairmen of these companies carried out in 2005 found that ‘most of the Chairmen we interviewed believed that

8Cadbury Report.

9FTSE 350 Corporate Governance Review’, Grant Thornton, December 2007.

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