Combined Code on Corporate Governance review

As the credit crunch has shown, no corporate governance model is perfect. Traditionally, the legalistic US model has been considered to be more prescriptive than the UK’s, with the latter’s ‘comply or explain’ model considered to be more flexible. Neither model prevented the large-scale financial system collapses we have witnessed on both sides of the Atlantic, however. 

While many expected the US to take the lead in introducing changes in the wake of these failures, it is the UK that has acted more swiftly, from a regulatory perspective. Two reviews of the Combined Code on Corporate Governance – the cornerstone of corporate governance in the UK – have been announced in recent months, and both are underway.

In February the UK government announced that Sir David Walker, former chairman of Morgan Stanley International and executive director of finance and industry at the Bank of England, is to lead a review of UK banks’ corporate governance with a focus principally on risk management. A month later, the UK’s Financial Reporting Council (FRC) announced that it was initiating its own consultation on the Combined Code. The FRC will liaise closely with Walker’s review and share relevant research and information.  

For both reviews, the key concern will be how to strike the right balance between increasing regulation (if that is what is proposed) and maintaining the flexibility of the existing model. It is the flexibility in the Combined Code that has helped make the UK one of the most competitive financial centers in the world.

Taking in the views
The FRC is inviting views on both the content of the Combined Code and the way that it has been applied by companies and enforced by investors using the comply-or-explain mechanism. In particular, views are being sought on the composition and effectiveness of the corporate board as a whole; responsibilities under various chairman role structures; the executive leadership of the company and the non-executive directors; the board’s role in relation to risk management; the role of the remuneration committee; the quality of support and information available to the board and its committees; and the content and effectiveness of Section 2 of the Combined Code, which is addressed to institutional shareholders.

A key area of focus will be the comply-or-explain regime. The Combined Code consists of high-level principles and more detailed provisions. Companies are expected to apply the principles, but the comply-or-explain approach gives them some degree of flexibility in choosing whether or not to follow the code’s individual provisions. 

In particular, the focus is likely to be on the usefulness of these corporate disclosures and the quantity and quality of engagement with investors. 

Supporters of comply or explain point out that it is this flexibility that has attracted many overseas companies to make the UK their primary listing. Critics of this approach, however, point to the fact that many of the financial institutions that failed in the global economic crisis were actually fully compliant with their obligations in connection with the Combined Code, having made the appropriate disclosures in their annual financial statements.

Possible areas of reform
Any changes to the code are most likely to be made in the following areas:

The role of non-executive directors. Many supporters of tighter regulation believe non-executive directors should be more independent and have a better knowledge of both the business sector in which the company operates and the company itself. Others argue that over-reliance on these attributes will lead to independent directors being selected because they have no affiliation with or historical or current interest in the company’s business or its fate, and that this will not help companies to develop strategy. 

It is also likely that there will be greater pressure to monitor such directors’ compliance with their responsibilities (in line with the codification of directors’ responsibilities contained in the Companies Act 2006). But these views will need to be balanced by the likely increased difficulty in locating suitably qualified individuals to take on a non-executive role.

Compensation. Shareholders are increasingly hawkish about big bonuses needing to be linked to performance as many remuneration schemes in the past months have been exposed as encouraging excessive risk-taking or rewarding failure. Shareholders are pushing for more disclosure of the risks that the structure of remuneration, including pay below board level, might pose to a business.  

Communication with major shareholders. Although the Combined Code currently enshrines the concept that companies should consult on a regular basis with their major shareholders, this has become more difficult as hedge funds and international investors have taken bigger shares in UK companies, so that shareholder registers have become more fragmented. As a result, the Combined Code might be amended to ensure investors have recourse to the company/board by either requiring that a senior independent director be designated as a primary contact point, or instigating deeper contact between a wider range of directors and shareholders.

Shareholder involvement. This whole area has come under the spotlight as a result of increased shareholder activism in recent months, most notably shareholder actions relating to the Royal Bank of Scotland and the adverse reaction by shareholders to the promotion of Marks & Spencer chief executive Stuart Rose to the post of executive chairman. 

This sort of reaction is only likely to increase as a result of the series of share capital issues made by the banks, as shareholders seek to ensure their preemption rights are provided with greater protection. 

Consequently, the role of the senior independent director as a channel between investors and companies is likely to be closely examined, with a number of commentators expecting an increase in the role played by major shareholders that could be in a position to check the management of companies and call directors to account. 

We will have to wait until the end of 2009 to see how the reviewers propose to strike the balance between regulation and flexibility in the UK, and perhaps longer for changes to be made in the US. It is likely that any US review will look at the changes in the UK, as the same issues are prevalent in the US, where shareholder involvement and say on pay are also on the increase.  

As the US libertarian Thomas Reed once said: ‘One of the greatest delusions in the world is the hope that the evils in this world are to be cured by legislation.’ Let’s hope his advice is heeded and that any new regulations fall under the heading of ‘better’ rather than ‘more’.