Some of the most important questions raised by regulators and commentators in the UK following last year's banking crisis related to board room controls at the institutions concerned. How such catastrophic problems had arisen so quickly and why existing corporate governance mechanisms had entirely failed to prevent them, or highlight their possible existence was quickly identified as an important question in the wider reaching review of the regulatory system which followed the crisis.  

Earlier this year, the UK Government announced that it had commissioned an independent review of corporate governance in the UK banking industry. At the same time the FRC is considering implementation of the Combined Code on corporate governance which applies to UK listed companies. The findings of these reviews are expected later in the year and this client memorandum looks at the background to this work and gauges some of the reaction which it has provoked so far.  

Current reviews of corporate governance  

On 9 February 2009, the Treasury announced that the Government had commissioned an independent review of corporate governance in the UK banking industry to be chaired by Sir David Walker, a senior figure in the UK banking industry and, previously, an executive director of the Bank of England, Chairman of the SIB and Chairman of Morgan Stanley International. The Review's terms of reference are:  

  • to examine corporate governance in the UK banking industry and make recommendations including in the following areas;
  • the effectiveness of risk management at board level, including the incentives in remuneration policy to manage risk effectively;  
  • the balance of skills, experience and independence required on the boards of UK banking institutions;  
  • the effectiveness of board practices and the performance of audit, remuneration and nomination committees;
  • the role of institutional shareholders in engaging effectively with companies and monitoring of boards; and  
  • whether the UK approach is consistent with international practice and how national and international best practice can be promulgated.  

The review will report its preliminary conclusions by the autumn and make final recommendations by the end of the year. A month later, an extension to the terms of the Walker Review was announced. This allows it to identify where its recommendations are applicable to other financial institutions as well as banks.  

Also in March 2009, the Financial Reporting Council (FRC) announced that it is seeking views from listed companies, directors, investors and other interested parties on their experiences of implementing the UK’s Combined Code on corporate governance. The Code applies to UK listed companies, which must describe how they comply with its requirements, and explain any deviations from its provisions in their annual reports and accounts. Since the last major revision to the Code in 2003, the FRC has reviewed its impact and implementation every two years, and this is the third such review. The 2007 review found the Code to be having a broadly beneficial impact and to have contributed to higher standards of governance in UK companies, and only minor changes were made to the Code as a result of the review. The FRC acknowledges that the recent significant change in economic conditions means that the Code’s effectiveness and the “comply or explain” regime described above are being tested to a greater extent than under previous, relatively benign, conditions. Whilst there is no assumption that the Code or the compliance mechanism are fundamentally flawed, the FRC considers it right that the current review should examine all aspects of the current regime to ensure that they remain effective. While some of the issues which the Walker review addresses have application to the listed sector, others do not, and the two reviews are to be conducted separately. However, the FRC has stated that it will work closely with Sir David Walker and relevant research and other evidence will be shared.  

The Walker Review will publish a consultation document in the summer of this year with conclusions following in the autumn. The FRC will publish its findings later in the year. If the review results in proposals to amend the Combined Code or to improve the “comply and explain” monitoring mechanism, a separate consultation exercise will be carried out.  

Responses to the reviews  

The closing date for comments for both reviews was the end of May and some recently published responses to the review, not surprisingly, reflect varying attitudes to regulation of boardroom behaviour as a means of dealing with financial crisis.

GC 100 GROUP  

In relation to the review of the Combined Code, the GC100 Group of general counsel and company secretaries of the FT-SE 100 acknowledges the challenges presented by the recent crisis, but argues strongly against “bright line” regulation and substantial change to the principles of the Combined Code. The Group makes the following points:  

  • that the dialogue between companies and shareholders needs to be as effective as possible with both sides understanding fully their role and responsibilities and playing an appropriate part. It recommends that the “comply or explain” principle should be changed to an “apply or explain” principle;
  • that the role of non-executive directors is crucial in ensuring effective governance. More should be done to promote understanding of their role as involved in the company’s governance, rather than its management, and the need for them to be properly resourced is vital. The Group also points out that good governance and good management do not necessarily go hand in hand and recommends that the Code requirement for boards to undertake rigorous annual evaluation of its own performance and that of individual committees and directors should be emphasised;  
  • the issue of risk is one for the board as a whole and individual boards need to decide how to discharge their responsibility in this area;  
  • Section 2 of the Code relating to listed companies’ dialogue with institutional investors may not always be adhered to and compliance with this significant part of the Code should be monitored; and  
  • the findings of the Walker Review should be used to ensure that any areas for improvement within the Code are captured, but the Code should not become industry specific and should continue to apply to all listed companies.  

In a separate response to the Walker Review, the GC100 Group makes many of the points outlined above, but discusses the role of non-executive directors, in more detail. Creating a full-time role for NED’s or one which would produce an alternative management team is considered unacceptable. Suggestions for change are promoting greater understanding of a NED’s role via a statement of NED’s responsibilities in the Code, although there should be no prescription about this. In one of NEDs’ key roles in practice is to ensure that the executive team is of appropriate calibre and enough time needs to be devoted to this. The Group also warns against the promotion of a definition of NED independence which would prevent the gathering of enough industry specific experience on the board.

Institution of Chartered Secretaries and Administrators (ICSA)

In a meeting with the Treasury in early March it was agreed that ICSA would contribute to the Walker Review by conducting research on appropriate boardroom behaviours. The conclusion drawn from this research is that appropriate boardroom behaviours are an essential component of best practice in corporate governance and that the absence of appropriate guidance is a structural weakness in the current system. ICSA believes that observance with such guidance could have made the consequences of the financial crisis less severe and that preventing the re-occurrence of these events is at least partly dependent on this being incorporated in the Code. It also believes that better articulation of the business case for best practice corporate governance and more focus on directors’ responsibilities and potential liabilities should incentivise directors to exhibit these appropriate behaviours.  

The response also includes a number of more detailed points including a view that a decrease in the number of executive directors attending board meetings may be detrimental. The current Code requirement for a majority of independent non-executive directors has, apparently, led to a reduction in the number of executive directors to, sometimes, just two, the CEO and the CFO in order to avoid increasing board size. An unintended consequence of this is that information flow to the board comes mainly through these two individuals who, despite best efforts, may be unable to encompass the whole of the company’s objective and operations. Periodic briefings by senior executives may not be enough to redress this imbalance and some companies may need to reconsider the balance between executives and non-executives.  

ICSA also believes that boards do not always include individuals with wide enough experience and backgrounds to provide the kind of independent challenge that would have been helpful in dealing with the financial crisis.  

Institutional Shareholders’ Committee (ISC)  

Not surprisingly, the ISC has looked in detail at the existing dialogue between companies and institutional investors (which is mostly conducted on an individual basis) and believes this system works for the great part. When it is failing, a collective approach my be more appropriate. A significant objective for the ISC is the establishment of a broader network of institutional investors, possibly including foreign investors and sovereign wealth funds, with a view to establishing a critical mass of involvement. The ISC points out that it should be made clear that no regulatory impediments, including the rules on acting in concert, prevent this dialogue from taking place, and that where it fails to achieve an appropriate response, shareholders should be prepared to use their powers, including voting against resolutions.  

In relation to board accountability, the ISC suggests that the chairmen of the key committees should stand for re-election each year with the chairman being required to stand for re-election in the following year if support for any individual falls below the 75 per cent. level.

Amendments proposed to the Combined Code by the ISC include:  

  • the chairman to retain overall responsibility for communication with shareholders and to inform the whole board of concerns. Where this does not happen, the senior independent director should intervene, take soundings and work with the chairman to achieve an appropriate responses;
  • succession planning should better emphasised;  
  • the audit committee’s terms of reference should be expanded to include oversight of the company’s risk appetite and control framework.  

Remuneration  

A further aspect of financial institutions' governance which is under close scrutiny is the remuneration of directors and senior executives. As in other jurisdictions, in the UK the financial crisis has prompted a sense of public disquiet over the spectacle of senior bankers at failing institutions receiving large pay-outs. Overall levels of remuneration in the banking sector were also highlighted and criticised strongly, with the Prime Minister declaring last autumn, “the days of big bonuses are over”.  

In October 2008 the FSA wrote to the CEOs of financial institutions setting out its concerns that firms’ remuneration structures may have been inconsistent with sound risk management and its wish to ensure that remuneration policies are aligned with sound risk management systems and controls and with firms' stated risk appetite. Whilst the FSA has no intention of becoming involved in setting levels of remuneration, it wants boards to ensure that they have in place appropriate mechanisms for establishing and monitoring levels of remuneration. Following this, in February of this year, the FSA published a draft code of practice on remuneration policies which is intended to apply to all authorised firms. This was followed, as expected, in March by a consultation paper (CP 09/10) “Reforming remuneration practices in financial services”. This contained a significantly revised version of the code of practice which the FSA intends to incorporate into its handbook and the FSA is consulting on the application of the code of practice which it intends should cover large banks, building societies and broker dealers. The FSA intends the general requirement in the code of practice, that “a firm must establish, implement and maintain remuneration policies, procedures and practices that are consistent with and promote effective risk management” should become a rule of the FSA handbook.  

The consultation period for these changes has ended. The FSA wants to bring the code of practice into force in November in time for it to apply for firms’ remuneration reviews and this means that new rules for the FSA Handbook should appear in early August.

What happens next?  

Some of the fundamental principles of the UK corporate governance regime are under detailed scrutiny and it is likely that the Combined Code will be the subject of significant change when the outcome of these reviews is decided. The extent of this change cannot accurately be predicted but, in the financial industry at least, it seems likely that stricter regulation, is inevitable. A clear indication of the regulatory action likely in relation to remuneration levels has already been taken, but the topic remains highly sensitive and further action may well follow.