6.It is 25 years since the Cadbury Report ushered in our modern framework for corporate governance, following a number of high profile governance failures and company bankruptcies. This report and its successors established an approach to corporate governance that mainly relied, not on hard law and enforcement mechanisms, but on encouraging dialogue between companies and their shareholders. This was to be based on a “comply or explain” principle of accountability, now overseen by the Financial Reporting Council (FRC). Under this regime, companies are required to comply with guidance, or to explain why they have not done so. This model was designed to preserve sufficient flexibility to cope with the diverse nature of businesses but also to foster a sense of accountability.
7.Since the Cadbury Report, corporate governance has gradually evolved, usually following reviews and reports established to tackle a particular failing. The Financial Reporting Council consolidated the previous Combined Code for listed companies into the UK Corporate Governance Code (hereafter “the Code”) in 2010 and published for the first time a Stewardship Code, covering best practice for investors. The Government’s Green Paper of 2016 represents the latest iteration of an ongoing process.
8.This evolutionary approach to reform, although frequently reactive in nature, has served to refresh the UK’s corporate governance framework and helped to keep it at the leading edge of international standards. The overwhelming majority of evidence we received considered the UK corporate governance framework to be in good health: standards are highly regarded internationally and help to promote investor confidence. High standards of governance are also an important driver of good business performance, as a clear framework for decisions to be made is conducive towards well-run and ultimately successful companies. Good corporate governance should not be seen as excessive regulation; it is in the interests of business, as the driver of productivity and economic growth, and the wider society in which it operates, for these standards to be maintained. The UK’s strong corporate governance regime is a considerable asset which enhances the reputation of the UK as a place to do business. The Government should therefore be very cautious about taking steps that risk adversely affecting the UK’s attractiveness as a place to invest. However, although the UK has a high international reputation in this field, there should be no complacency, nor any sense that improvements cannot be made. Within this context, the challenge is for businesses and Government to keep improving standards, without the impetus of high profile corporate scandals, in order to minimise the risks of future failings and to reflect both changes to the business environment and the rising expectations of society and stakeholders. The Government must help ensure that the UK stays ahead of the game in the light of changing business trends and practices.
9.Whilst the underlying reasons may be varied and complex, there can be little doubting the recent loss of public trust in authority has affected business, Government and other institutions, in this country and globally. It is concerning that, despite the UK’s generally good reputation for corporate governance, evidence suggests that in this country, levels of trust in business are lower than in many other countries (as indicated in Figure 1). Surveys suggest that perceptions of unfairness on executive pay levels and payment of tax are the main contributory factors to this erosion of trust, an issue we consider in detail in Chapter 5. Further damage may have been done by recent high profile examples of apparent corporate governance failings, which have involved some major and high profile companies, including Rolls Royce, Tesco and BAE Systems. Companies should be careful to give due regard to the public’s expectations regarding the conduct of business and take seriously the need to address this issue proactively.
Figure 1: Levels on trust in business
Source: Edelman Trust Barometer 2017
10.The Corporate Governance Code describes how the culture of a company should be set:
One of the key roles for the board includes establishing the culture, values and ethics of the company. It is important that the board sets the correct ‘tone from the top’. The directors should lead by example and ensure that good standards of behaviour permeate throughout all levels of the organisation. This will help prevent misconduct, unethical practices and support the delivery of long-term success.
11.As the Code makes explicit, to chair a corporate board is a hard task, taking into account constraints on time, individual knowledge and expertise, and the need to have mutual respect and openness between all executive and non-executive directors: “to achieve good governance requires continuing and high quality effort”. Simon Fraser, Chairman of the Investor Forum, stressed that culture is driven by the executive and board of the companies, and culture can change quickly. He told us “It comes back to transparency and the description of how you display that you are managing all aspects of your business and have a good culture within your business. That is critical.” Baroness Hogg went further, describing the importance of imbedding the culture from the top to each facet of the organisation:
You can be getting a lot of good noises at the board level, but if the board is not taking the trouble to deep dive and discover if the words expressed in the boardroom are being performed against further down the organisation, then you can easily get a disconnect. It is an important part of the board’s responsibility to be thinking and engaging on the culture of the business.
A recent study by the FRC on corporate culture reports evidence that companies are beginning to engage more with shareholders in discussions on culture and proposes a number of detailed practical ways in which companies can seek to ensure statements of values actually govern the way in which business is done.
12.The culture of a company will depend on its context and core values, as determined by the board and its chair. One company’s culture may centre on equality and purpose, whereas another’s might be based around risk-taking and innovation. But the culture of every company should be based upon values and behaviours that are consistent with the intentions of the Code. The fostering of a healthy culture in which to do business, particularly in terms of the means by which firms govern themselves and how they are accountable for the decisions they make lies behind the recommendations in this Report. Good company culture does not lend itself to easy measurement and cannot be enforced via a tick box exercise. Instead, the central tenets of good corporate governance should be embedded in the culture of all companies, so that it permeates activity at every level and in every sphere. It is cultural evolution, in line with the spirit of the Cadbury Report, that should be the long-term goal of Government, investors and companies.
13.Recent trends in shareholder structure in UK listed companies illustrate the changing nature of the challenge to companies in balancing the different interests of owners and shareholders. The UK has a relatively dispersed model of ownership, with relatively few large shareholders (or “blockholders”) able to exert considerable influence on the boardroom, a model which is more prevalent in parts of continental Europe. Institutional and other investors tend to have diverse portfolios, with small shareholdings in many companies, in order to spread the risks of their investments. The average period in which shares are held have also drastically reduced, from six years in 1950 to less than six months today. There has been a sharp fall in the proportion of shares held directly by individuals, from about half in the 1960s to little over ten per cent today. The nature of these holdings also tend in the modern age to be indirect, whereby individual shareholdings are held via nominee accounts and intermediaries.
14.Figure 2 shows how the proportion of shares owned by pension funds and insurance companies, and by individuals has fallen. We explore the consequence of these changes for engagement between companies and shareholders in Chapter 3.
15.The changes in shareholder structure have produced what have been described as “ownerless companies”, where no single investor has a sufficiently large stake in the business to act as a responsible owner, checking performance and behaviour. As Andy Haldane of the Bank of England has stated, “One consequence of a more dispersed and disinterested ownership structure is that it becomes harder to exert influence over management, increasing the risk of sub-optimal decision-making.”
16.This situation contrasts with the position of employees and some suppliers, who are heavily reliant on a single company for their income and have a clear interest for that company to be successful over the long-term, but very often have little influence on decision making.
Figure 2: Shareholder structure in the UK
Source: Office for National Statistics
17.Part of the process of improving trust lies in accentuating the generally high standards and good reputation of British business, and in acknowledging progress made. Witnesses pointed to recent improvements across a wide range of governance issues. The FRC reports that compliance with the Code remains high, with full compliance among the FTSE 350 companies increasing from 57 to 62 per cent and 90 per cent of companies reporting almost full compliance. Witnesses told us that attitudes were changing: some 57 FTSE 350 companies have established board-level committees that look at sustainability, behaviour, ethics and values. The Purposeful Company initiative, comprising a number of leading thinkers and businesses, has been producing reports on how best to pursue long-term shareholder value at the same time as society-related goals. Investors told us that culture and values are increasingly becoming a part of conversations with companies. There have been recent improvements to the quality of reporting, notably companies’ strategy reports, which now include better explanations of business models, culture and risk. Some companies already use high standards of environmental and social awareness, and other non-price factors, as a means of securing comparative advantage. Whilst there are signs that some investors are favouring these types of companies in response to client demands, there is much work to be done before these considerations become routinely considered in the dialogue between companies and investors.
18.One of the persistent problems in the UK economy has been relative low levels of investment in both infrastructure and research and development (R&D). These have been cited as evidence of a short-termist approach, by both Government and business. We explored some of the public policy solutions for encouraging a long-term approach in our Report on industrial strategy, but it is important that the country’s corporate governance framework is conducive to businesses taking a long-term approach.
19.There has been widespread concern for some time about the extent of a range of short-term pressures in the investment architecture and on decision making in boardrooms. The Kay Review of equity markets found, in 2012, “that short-termism is a problem in UK equity markets, and the principal causes are the decline of trust and the misalignment of incentives throughout the equity investment chain.” Witnesses in our inquiry suggested that an excessive focus on short-termism was in part responsible for relatively low levels of investment and referred to “an unhelpful tendency amongst listed companies to distribute cash flow to shareholders (through share buy-backs and dividends) rather than re-invest in innovation, training and long-term success”. This comment is supported by data from the Bank of England and its Chief Economist, Andrew Haldane, who cites “clear evidence” of investor activity moving towards a short-termist approach. He argues powerfully that the “short-term quest for smoothing shareholder returns has come to dominate payout behaviour, almost irrespective of profitability” and notes that share buybacks had also risen in prominence. Catherine Howarth, Chief Executive of ShareAction, argued that investors think that they have a single overriding duty to maximise short-term profitability, which produces “constant shortterm pressures” on companies. The Investor Forum confirms this view:
As companies find it increasingly difficult to articulate the importance of long-term investments in sustaining their competitive advantage, incrementally there can be more dependency on the reliability of shorter term financial measures.
Survey evidence indicates that company directors felt more pressure to work towards a two year time horizon in 2016 than in 2013 and that executives were most likely to feel pressure to demonstrate strong financial performance over a 1–2 year period.
Figure 3: Pressure on executive to demonstrate strong financial performance
Source: Focussing Capital on the Long Term: Rising to the challenge of short-termism, 2016
20.Other witnesses argued that the notion of short-termism was itself difficult to define and also that not all short-termism is undesirable. Sometimes companies may need to focus on the short-term, merely to survive, or they may be established specifically for short-term purposes. Equally, apparently long-termist decisions to invest may not necessarily increase long-term productivity: investment decisions must be sound in themselves to add shareholder value. More broadly, activist investors who seek to restructure companies to make them more profitable can serve a valuable economic purpose, in generating higher levels of productivity, even at the expense of short-term turbulence. Another witness argued that evidence showed that shareholders were not short-termist in outlook and that shareholder-motivated changes do have positive effects on society.
21.Professor Kay argues that regulatory structures demonstrate little recognition of the change in the role of the markets from capital allocation to secondary trading on existing assets, a business model which he says “now mainly serves the interests of a bloated finance sector.” Many of our witnesses pointed to this shift away from investment to trading, or “high frequency trading”, which has been made easier as technological progress and automation has brought down costs and improved access to the markets. Fund managers are incentivised on a short-term basis and consequently are liable to apply pressure on boards for short-term results. These pressures increase the difficulties for boards in balancing the interests of the different groups of shareholders—traders and long-term investors—with their own strategic vision.
Figure 4: Average holding period of shares between 1991 and 2010
Source: OECD, cited in the Purposeful Company, Interim Report, May 2016, p 70
22.The forces of globalisation and rising technological innovation are requiring companies to compete ever harder to prosper. This can unleash enormous tensions and trade-offs. In an employment market that is rapidly moving away from reliance on the traditional employer/employee relationship, and in which many individual workers are in a position of relative bargaining weakness with regard to employers, good corporate governance can play a part in protecting the interests of workers. But we recognise that some companies may only respond to legal remedies, as we explore in our inquiry into the Future World of Work.
23.By virtue of the requirements relating to consequences for the long term of boardroom decisions in the Companies Act, corporate governance also has a leading role in combatting the growing pressures for short-term behaviour, which can constrain the ability of companies to invest for the benefit of their long-term future and that of the wider economy.
24.Corporate governance in the UK is still strong and remains an asset to the country’s reputation for doing business. We are conscious that a small number of highly damaging examples of corporate governance failure should not lead to a hasty and disproportionate response. We do not believe that there is a case for a radical overhaul of corporate governance in the UK. We do believe that there is scope for significant improvements in order to address the changing nature of company ownership in a globalised economy. We explore these in the remainder of this Report.
8 Report by the Committee on , December 1992, paras 1.3 and 3.7
9 The Greenbury Report in 1995, following a review by the CBI, identified good practice in the determination of directors’ remuneration; the Hampel Report in 1998 resulted in a Combined Code (governance and remuneration) being established; the Turnbull Report, by the London Stock Exchange, refined the rules relating to financial reporting; the Myners Report in 2001, commissioned by the Government, considered the role of institutional investors and fund managers; in 2003 the Government-commissioned Higgs Report looked at the role of non-executive directors (NEDs); the Walker Review in 2009 made a number of recommendations for changes to corporate governance in banks and financial institutions.
10 Edelman Trust Barometer 2017, CIPD , December 2015.
11 Financial Reporting Council, , April 2016, preface, para 4.
12 Financial Reporting Council, , April 2016, para 7.
15 Financial Reporting Council, , July 2016.
16 Q400 [Tom Gosling]
18 FRC, , January 2017, p6
19 This is a strand of work by the Big Innovation Centre, a think tank established in 2011
20 Q51 [Peter Montagnon] [Alex Edmans]
21 Q52 [Mike Everett]
22 FRC, , January 2017, p25
23 The Investor Forum, 2015–16, p7; FRC, Developments in Corporate Governance and Stewardship 2016, January 2017, p25
24 Business, Energy and Industrial Strategy Committee, , Second Report of Session 2016–17, HC 616
25 , Final Report, July 2012
26 University College London (); see also Sheffield Institute of Corporate and Commercial Law ()
28 Q77 [Catherine Howarth]
29 The Investor Forum, 2015–16, p32
30 FCLT Global, Focussing Capital on the Long Term: , 2016
32 Manifest ()
33 Q52 [Professor Alex Edmans]
34 Professor John Kay ()
35 TUC (), Spencer Stuart, ()
36 UK Share Association ()
37 launched October 2016.
38 See Box 1; section 172 of the Companies Act 2006 requires directors to have regard to the likely consequences of any decision in the long-term.
4 April 2017