Mandelbrot set image very small MohammedAmin.com
Serious writing for
serious readers
Follow @Mohammed_Amin
Join my
email list

Search this site

Custom Search
Tap here for MENU

Corporate governance – why it is needed and why it fails so often

Summary

Delivered 20 November 2015. Posted 9 December 2015.

I was introduced to the charity Speakers for Schools in late 2014 and in 2015 spoke for them at seven state schools in the North West.

While most of the schools have asked for a talk around my life, career and the nature of success, sometimes I am asked to cover a specific topic.

On 20 November 2015 King George V Sixth Form College asked me to address their sixth form, many of whom were taking Business Studies, on the subject of corporate governance. I have now converted that talk into this page, after making the changes needed for an article to be read rather than a speech to be listened to live.

Why corporate governance is needed

I want you to imagine that you are the teenage Bruce Wayne. At this stage you haven’t become Batman. Those familiar with Batman’s life history will know that a gangster killed Bruce Wayne’s parents while he was a teenager.

Bruce inherited his parents’ great fortune. Imagine this includes many different businesses which are subsidiaries of a holding company. You own all the shares of that holding company.

Some rules applicable to Bruce Wayne’s situation

You are not allowed to sell any of the shares.

That rule may look unrealistic but if you look at the whole stock-market, all of the shares listed on the London stock exchange are owned 100% of the time by all the shareholders collectively.

That is why Bruce Wayne is stuck with keeping all of the shares of the family holding company.

You are also not allowed to set foot on company premises or to get involved with trying to run any of the companies yourself.

You cannot even hire or fire the people who actually run these businesses.

What can Bruce Wayne do?

You can hire people to be non-executive directors of the holding company. These non-executive directors will hire and fire the people who actually run the businesses.

So how do you keep these non-executive directors loyal to you? You will be the only person who hires them. You will decide what they get paid. You will decide if you want to fire them.

You make it clear that these non-executive directors are not allowed to have any involvement with the people who run the businesses, and obviously not allowed to have any conflicting interests.

There is also something else you can do.

You can require every decision made by the non-executive directors to be properly recorded with details of exactly how each non-executive director voted on that issue.

A good example is the Bank of England’s Monetary Policy Committee. One of the key principles there is that they always take a vote on setting interest rates, the minutes of the meeting are published a few weeks later, and they state person by person exactly how the committee members voted.

How does the real world compares with Bruce Wayne’s company?

The shareholders don't actually select and hire the non-executive directors. Instead there is a nominations committee of the board which selects new proposed non-executive directors. The shareholders normally just "rubber stamp" the recommendations.

In all honesty, they couldn’t really do much else since, unlike Bruce Wayne, they are not in a position to interview candidates. Even though the chief executive and other management normally don’t serve on the nominations committee, in practice the chief executive will often be able to influence who gets proposed.

When I joined the Council of Salford University, I was interviewed jointly by the Chair of Governors, who was non-executive but alongside was the Deputy Vice Chancellor. In my view university management should have no say at all in the appointment of new governors. While I was on the Council I managed to get that changed.

The concept of “regulatory capture”

Whenever group A regulates group B, the group regulated, group B, will follow a strategy of trying to capture control of the regulator. This is known as "regulatory capture."

The normal strategy is to be helpful, until the regulator becomes dependent on you. If you can influence who gets appointed to the regulatory group, you are "home and dry."

This is why members of executive management, for example the vice chancellor of a university, should have nothing to do with choosing new members of the governing body.

Deciding the pay of non-executive directors

That is normally decided by the board of directors as a whole, with ratification by the shareholders.

In practice the shareholders are not setting the pay of the non-executive directors and company management have some level of influence, often very significant, over what the board as a whole recommends.

The irrelevance to many shareholders of voting

Bruce Wayne really cares about his holding company since it contains all of his money. And he has 100% of the voting shares.

Imagine you are a small shareholder in a big public company. How you vote actually makes no difference to the overall decision. In that situation it is very hard to galvanise yourself to vote.

I confess this applies to me. My wife and I have many investments and we almost never vote.

Corporate governance in mutual organisations

Imagine you are a member of a mutual organisation such as a building society.

Every member has one vote, regardless of whether you have 1 pound invested in the building society or £1 million. For most people in a mutual the impact of voting is almost zero.

So they don’t and in practice building societies are run by a self-perpetuating group of non-executive directors, heavily dominated in practice by the executive management.

Sometimes, fortuitously, if the self-perpetuating group behaves well, mutual organisations can be well run.

However, in my view, unlike public companies which do have major shareholders owning several percent or more each of the company, the one member one vote system in a mutual is almost designed to ensure that they are badly governed most of the time.

The most significant reason for corporate governance failures

In my view, the most significant reason for corporate governance failures is not structural. Instead it is behavioural.

My experience of being on boards is that most board members are very reluctant to "rock the boat." I think the reason is simple human nature.

Most of us want to be liked. Most of don’t want to be thought of as awkward, people who cause problems, people who are a nuisance. Those may be good characteristics in human beings but they are terrible characteristics for non-executive directors.

Shareholders are only properly served if the non-executive directors are willing to be awkward when required.

An example from my time on PwC’s Supervisory Board

In 2008, PricewaterhouseCoopers elected a new Senior Partner, Ian Powell. I knew Ian from the time we were very junior partners in our Manchester office. I was (and remain) a great fan of his.

At his very first Supervisory Board meeting as Senior Partner, when we were going round the table making introductions, I congratulated Ian on getting elected as Senior Partner.

I then told him with a smile on my face never to forget that it was our responsibility to fire him if he started doing a bad job!

The partner sitting next to me nearly choked on his coffee, and looked at me as if I had just committed an unforgivable sin.

However, a Supervisory Board that is not willing to ever contemplate firing the Senior Partner is a Supervisory Board that is not willing to do its job.

Suggestions to improve corporate governance

Instead of giving a long list of recommendations, I offer just a short list of just five practical suggestions which would help to strengthen corporate governance.

1. The internal auditor needs to be your friend

Internal audit is not independent. However, you need to make sure that it reports to the right level in the organisation.

In my view that should be directly to the chief executive, not to the finance director. Furthermore, it should be impossible to fire or otherwise penalise the head of internal audit without the express approval of the chair of the audit committee who of course must be a non-executive director.

The audit committee needs to be deeply involved in deciding what is covered by the internal audit work programme.

2. The external auditor also needs to be your friend

Company management have a vested interest in squeezing the fees of the external auditor and in making the external auditor beholden to management. Non-executive directors need to ensure that does not happen.

I recommend that the audit committee, consisting only of non-executive directors, start every meeting without management present to have a discussion with the external auditors, even if they only talk about the weather. That way the external auditors know that they always have an easy channel to the non-executive directors.

The external auditors should be left in no doubt that their relationship with the company depends entirely upon their relationship with the non-executive directors, and does not depend in any way on their relationship with management.

The non-executive directors should also be immensely sceptical about any proposals from management regarding a change of auditors.

3. Shareholders meeting with non-executive directors

I believe that major shareholders should form a committee which regularly meets with the non-executive directors in the absence of management.

This goes against the grain of present UK practice which prioritises executive management meeting with shareholders, with non-executives tagging along.

However, it is what Bruce Wayne would do and I think it is ridiculous that it does not happen now except very informally and occasionally.

4. Exclude management entirely from the nominations committee

At present the UK corporate governance code only requires that the nominations committee have a majority of independent non-executive directors.

I think this still leaves management with too much say in who becomes a non-executive director. Instead, I think that management should be excluded from the process entirely.

5. Require institutional investors to publish their voting records

A very large part of UK plc is owned by institutional investors. They are often very passive about voting or follow a policy of always voting with management.

They should be required to publish their voting record and in particular to highlight how often they have voted against management. If they never vote against management, or only on a tiny number of occasions, they should be asked by their own clients or by regulars to justify their voting record.

The goal would be to make it more common for shareholders to vote against management and become generally more “stroppy”.

The key point is that shareholders collectively are always compelled to own the shares, rather like Bruce Wayne, and therefore they need to act more like owners.

Concluding comments

The problem of corporate governance never goes away.

How do you ensure companies are run for the benefit of the people who really own them? How do you achieve that when there are so many layers between the ultimate owners and the people actually running the company?

At every stage, you have to design systems that take account of human nature and human fallibility.

The most important thing of all is to ensure that the people who exercise the governance are appointed by the people they are working for, and understand they are reporting to them.

 

The Disqus comments facility below allows you to comment on this page. Please respect others when commenting.
You can login using any of your Twitter, Facebook, Google+ or Disqus identities.
Even if you are not registered on any of these, you can still post a comment.
comments powered by Disqus

 

Custom Search

Follow @Mohammed_Amin

Tap for top of page