Is the UK model working?

example, underwriting fees charged in the US ranged from 6.5 to 7 per cent, compared to 3.25 to 4 per cent in the UK.

Reactions to the US markets’ requirements are such that there has been a growing stream of European companies delisting from US exchanges. For example, the Rank Group delisted from NASDAQ, citing that ‘complying with the legislation could more than double our annual audit bill’.10 It appears that companies are no longer willing to pay the premium required, whether as fees or excessive regulatory burdens, to be listed in the US. Indeed Ben Bernanke, the Federal Reserve chairman, went on record in May 2007, urging the US financial watchdog to look at the UK model of principles-based, risk-focused supervision as the basis for future regulation.

The irony is that it is commercial pressure (arguably the driver of many of the US’s recent corporate collapses) which could end up driving an easing of the regulatory regime in the US.

Quality of corporate governance disclosures in the UK

One way to judge the extent to which the principles of good corporate governance are considered by company boards is to review the quality of disclosure produced in their annual reports and accounts.

The annual report and accounts is the only regulated medium available to the investor. As such, if a company chooses to disclose only the barest minimum of information, it should be considered to be dissenting from the principles-based approach to UK corporate governance.

A primary objective for guidance in the UK for disclosure is full transparency of governance and risk-management procedures adopted by the company’s board. Best practice is when a company chooses to set the standard in governance disclosure by providing clear and transparent information which exceeds the Code’s recommendations. Such practice should be considered to be a benchmark for UK governance. However, by 2006, according to Grant Thornton’s Review, only a handful of companies in the FTSE had achieved such disclosure.

Have UK companies embraced the principles of the Combined Code?

The Grant Thornton review showed that only thirty-one companies (10 per cent) in the FTSE 350 fully complied with the Code as opposed to choosing the explain rather than the comply option.

The 2005 Ernst & Young Corporate Governance Web Survey11 found that communicating corporate governance principles within companies could be improved; only a third of management believe the principles are widely disseminated throughout the company. Furthermore 59 per cent of investors indicated

10www.financialnews-us.com/?contentid=540316.

11Ernst & Young Corporate Governance Web Survey 2005.

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they did not feel well informed about the principles of corporate governance in the companies in which they invest.

The Flint review reflected strong institutional support (those responsible for £2.4 trillion of funds) in favour of keeping the existing UK approach, but encouraged greater voluntary disclosure by directors, a positive assertion as to the effectiveness of the controls and greater disclosure regarding a company’s risks and controls. The conclusions of this review were also supported by the findings of Grant Thornton: that over the past few years UK companies have made great progress in the field of internal control. The 2006 Grant Thornton review found that effectively all boards acknowledged their responsibility for reviewing the effectiveness of the systems of internal control. The review concluded, however, that more could be done to apply the principles of Turnbull through voluntary disclosure of additional information to assist the reader’s understanding. It is encouraging therefore to find that 70 per cent of companies in 2006 provided a strong level of additional disclosure in respect of risk and control processes. In addition, it was noted that 40 per cent chose to provide more than the minimum in respect of the roles and responsibilities of committees and how they are appraised. This is a heartening sign that UK companies are starting to adopt the spirit as well as the letter of the Code. However, there is still room for improvement. What the Flint review was looking for in governance disclosures was further detail on how risk management operates and how it is embedded in an organisation. The fact that only 27 per cent of companies gave more than the bare minimum of explanation suggests that the review group’s words of encouragement are timely.12

There is little doubt that the quality of corporate governance disclosures is improving. However, the Flint review’s message was heavily infused with a strong encouragement to forsake boilerplate in favour of giving greater insight into governance practice. The message to the regulators has to be that guidance rather than regulation will be more effective in bringing about lasting change, even though it may take a little longer.

Do they do what they say they do?

There is an ongoing debate as to whether companies and their boards actually practise what they preach in order to comply with the Combined Code. The Code is guidance and not law, so there is an element of trust involved: that what is being disclosed in the compliance statement is a fair reflection of, for example, the risk management and internal control processes in place within the company.

Of course, the report and accounts are a regulated disclosure, and external audit assesses what has been disclosed (directors’ report, governance statement,

12 Grant Thornton’s Fifth FTSE 350 Corporate Governance Review, 2006.

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and so forth) as part of the audit to ensure it does not mislead the reader. However, the extent to which the board implements its governance systems as disclosed may not be entirely clear from the governance statement.

The only way of knowing whether companies actually perform the governance procedures described is to conduct a governance compliance review. Best practice would suggest that this should be conducted by a third party, with the assurance report referenced in the corporate governance disclosure section of the annual report, to substantiate any Code compliance claimed.

As a medium-term goal, a company should set its governance sights on achieving full compliance with the Code and associated guidance, giving clear disclosure and being able to confirm such compliance through external assurance. Such a review could be performed in conjunction with the internal audit effectiveness review which is required every five years, in line with the Institute of Internal Auditors’ (IIA) recommendations in the International Standards for the Professional Practice of Internal Auditing.

Resources and investor interest

Market capitalisation may play a significant role in determining how much resource companies will dedicate to complying with the requirements of the Code. There is believed to be a correlation between the level of market capitalisation and the level of compliance, and the FRC in its 2007 review wished to explore this relationship. Grant Thornton’s 2006 review considers this by splitting the FTSE 350 into the FTSE 100 and the Mid 250. When looked at over the five years of the review, whether through lack of manpower, funds or commitment from senior management, it is apparent that the Mid 250 have been much slower than the FTSE 100 to react to emerging practice in the field of governance.

There still remains a clear difference between these two groups, with the FTSE 100 displaying greater compliance with the Code and providing a greater level of detail, particularly for softer governance requirements such as Turnbull compliance and corporate responsibility (CR). However, the latest figures show that the gap is now closing. Regardless of the artificial distinction between FTSE 100 and FTSE 250, they all represent significant companies with market capitalisation in excess of £300 million. The greater challenge faces the small cap companies. If it has taken at least five years for the FTSE 250 to catch up to the FTSE 100, it is possible that the small caps may never do so.

Market capitalisation, and by inference their access to resources, may give the advantage to the larger companies as they will have more dedicated resources available to address these compliance areas. For example, a FTSE 100 company will have a more established audit committee, an internal audit function to implement the internal control monitoring required by the Turnbull guidance, and possibly a separate risk and compliance committee, while smaller companies may struggle to justify the costs of such functions.

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Figure 11.2 Market capitalisation of UK companies

Given that the FTSE 350 are all large companies, perhaps the real driver for compliance is investor interest. The larger the company, the greater the institutional following; the more they are in the public eye, the greater the reputational risk. The result is that typically FTSE 100 companies have more substantial reporting mechanisms in place to implement CR initiatives, and report and monitor these initiatives as directed from the board. They tend to have a dedicated CR website and often provide a separate CR report.

Figure 11.2 gives an indication as to the distribution of companies against market capitalisation. The public companies with less than £300 million market capitalisation probably face the greatest challenge, not to mention those Alternative Investment Market (AIM) companies who aspire to the main market.

The challenge for smaller companies is recognised by the Code which grants certain exemptions to smaller companies, defined as those outside the FTSE 250. Further guidance is provided by the Quoted Companies Alliance (QCA), which makes the following suggestions as ‘de minimis compliance’:13

Two non-executive directors are recommended.

Board meetings should be held regularly, at least once in each month, with no fewer than six meetings in each year. The agenda should always include a report on the company’s management accounts from the finance director.

Certain matters should always be put before a board for consideration, for instance appointment of directors, appointment of chairman/managing

13 ‘Initial Public Offers on AIM for US Corporations’, Taylor Wessing.

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