Governance reform should support investment for the greater good
by Laurie Fitzjohn-Sykes, Director of Research, Tomorrow's Company The key focus of governance reform should not be on reducing the...
by Guy Beringer, Chairman, The Legal Education Foundation
Seeing the big picture.
This article makes three broad arguments.
The first is that the modern business establishment in the United Kingdom has become narrowly based. Its thinking is dominated by financial analysis and the financial interest of shareholders with the consequence that it regularly overlooks the broader picture of the underlying purpose of business activity.
The second argument is that there has been a significant change in the attitude of both government and civil society to the business world. This change has not been reflected in the thinking of the collective leadership of the business world which may accordingly be sleepwalking into crisis.
The third argument is that business and government are locked into a downward regulatory spiral which arises principally from the failure of the business world to respond actively to the change in thinking which has taken place around it.
These arguments lead to the conclusion that the only effective response will be active leadership from within the business community which recognises and embraces the shift in thinking which has taken place around it. Much of this thinking will reflect the historic origins of business and governance. Historical perspectives can therefore show the shortcomings in contemporary thinking.
The opening decades of a new century have often proved to be periods of reform and change. This has not always been wholly apparent to contemporaries.
The opening decades of the 19th century were shaped by the economic burden of the Napoleonic Wars and the social unrest which resulted from economic recession. It was a period which reshaped the British political landscape but which also saw reform in the arts and the professions.
The opening decades of the 20th century were shaped by conflict on a scale not previously seen in Europe. The resulting economic burden and upheaval led to irreversible change in the social and political structure of British society.
It would be wrong to equate the opening decades of the 21st century directly with the two preceding centuries but there are parallels from which lessons may be drawn.
Contemporary Britain has participated in several wars which have shaken public confidence. It has also experienced economic upheaval which has caused many previously unchallenged assumptions about British society and the market economy to be questioned. This has led to possible fragmentation of the state itself and a rethinking of many of its institutions.
Change is not always immediately visible to those who are experiencing it. It is often seen as a challenge or a choice when, in retrospect, it may be portrayed as an inevitability. The business establishment of the 21st century may possibly be clinging to the landmarks of the old world and may not have fully understood the changes which have been set in train by the crises which have marked the opening years of the century.
Cobbett and the Corporations
Last year’s stirring of the hostile M&A market involving Pfizer and Astra Zeneca threw up a number of challenging questions as to the role of the public interest in corporate decision taking. There was a strong lobby for the introduction of a more interventionist approach to the protection of the public interest in M&A deals. The debate, however, begs one further fundamental question: why is the current, apparently sophisticated system of corporate governance generally assumed to be inherently incapable of providing any defence of the public interest against corporate predators without government intervention?
The reason most commonly given is that boards of directors must look overwhelmingly to the interests of shareholders. Shareholders will be motivated by financial gain and nothing more. Boards of directors will weigh the financial balance as it affects shareholders and will give a view which is predominantly one of financial value.
Yet the directors of public companies are the last great fiduciaries of our age. If the trusts from which their fiduciary duties flow do not anywhere touch on the public interest as one of their objects, what is the point of business? Some commentators have observed that the deliberations of boards are increasingly dominated by finance and financiers. Are the fiduciaries simply guarding a balance sheet or might they have been entrusted with more than that?
This question does point to a great divide between the theory of responsible business and the practical lack of anyone to implement it. The public look to directors to safeguard the broader interests of society because the directors control the actions of companies whose impact is felt across society. Directors evince a strong desire to safeguard those broader interests but say that, unfortunately, they are overridden by the interests of their institutional shareholders who are preoccupied with financial returns. Institutional shareholders evince a strong desire to safeguard these interests but say that, unfortunately, they are overridden by the need to satisfy the financial interests of those whose money they invest. These people are, of course, to a large degree the public who originated the complaint which arrives back at their feet. It is a very modern system of circular accountability which provides scapegoats but no solutions. It is a system which appears to be impenetrable as each element claims to be inescapably driven by the financial interests of others.
The broad-brush analysis of ‘system’ and the effect of systems on the public interest was the hallmark of one of the great popular polemicists in English history: William Cobbett. Exactly 200 years ago, his weekly Political Register produced blistering attacks on the different systems which Cobbett saw as the fount of injustice. He identified systems ranging from the Pitt system (of paper money) to the child-bed-linen-system, from the tea-drinking system to the borough system, from the corruption system to the system of learned fraud. He memorably dismissed the paper money system (in a prescient anticipation of quantitative easing) as the ‘great puff-out’.
What relevance does this have today? Cobbett’s most fertile ground was his recurring critique of the parliamentary system. He came to be a supporter of limited parliamentary reform. He was also a supporter of Catholic Emancipation. He referred to the establishment as ‘the thing’ and he was deeply frustrated by its lack of real visibility and accountability. Cobbett’s thing may well be alive today and living in the corporate world. To understand why this might be a proper analogy for today’s world of corporate governance, a little explanation is required.
The March 1818 editions of the Political Register were written in America. Cobbett had (not for the first time) absented himself from England in the face of legal retribution by a wounded establishment. Cobbett was not, however, lying low. The 28th March edition of the Register was stridently entitled: ‘On the absolute sway of the Great Seat Owners over King, Ministers and People’.
The article culminates in a grand description of ‘the thing’ which ran as follows:
‘After seeing that about three or four hundred Boroughmongers actually possess all the legislative power, divide the ecclesiastical, judicial, military and naval departments amongst their own dependents, what a fine picture we have of that system of checks and balances of which so much has been said by many great writers! What name to give such a government is difficult to say… it is a band of great nobles who have obtained an absolute sway in the country, having under them for the purpose of show and execution, a thing they call a King, sharp and unprincipled fellows whom they call Ministers, a mummery which they call a church, experienced and well tried and steel hearted men whom they call Judges, a company of false money-makers whom they call a Bank and a talking, corrupt and impudent set whom they call a House of Commons. Such is the government of England. Such is the thing…’
Cobbett’s underlying thesis is that the thing was not the product of the public faces which normally represented it. It was not (as was popularly supposed) the King; it was not the politicians; it was not the aristocracy or the religious establishment. All of these elements played a role in doing the thing’s bidding and they are duly berated for this. Cobbett argues, however, that the thing is in fact a narrow group of less than 400 Boroughmongers – the people who owned the seats in the House of Commons and who controlled government through their control of the people who sat in the House as their placemen.
Cobbett argued forcefully that the Boroughmongers remained in the shadows whilst the King, his Ministers and the Bishops attracted the wrath of the population for a system which was beyond the control of all of them. The Boroughmongers did not themselves choose to appear on the stage where the public interest was played out but they were the real obstacle to Catholic Emancipation and parliamentary reform.
Cobbett’s picture was one of a system which was unaccountable and seemingly resistant to reform despite growing popular pressure. It was a system which appeared to have an unassailable life of its own. This is a picture which has interesting resonances if its principles were applied to the contemporary business world and if its more outrageous personal attacks are laid aside.
Reform of the business world is seen by outsiders as increasingly necessary. Their criticisms are frequently headed off by the demands of the global market. It is said that the global market requires remuneration more suited to owners than employees. It is the global market which requires governance and regulation which is competitive in order to avoid a stampede elsewhere. The global market is king and prevents people from acting in a way they might otherwise choose.
In Cobbett’s world, however, the king is not the real obstacle but is pushed forward as an excuse by the Boroughmongers who own the process. This was triumphantly demonstrated for Cobbett by the fact that the assumption of power by the Prince Regent (who was known to favour reform) made no difference. The time may have come to be sceptical of the global market which demands higher remuneration, which demands lower standards of compliance and which demands short term financial performance. It was thought that the banking crisis (like the Regency crisis) would usher in a new era. In neither case did this happen. Might this indicate that the thing is still with us?
If not the market, then what precludes a different approach? In Cobbett’s world it is the Boroughmongers who hide behind the King but who, in effect, owned him. Imagine the glee with which Cobbett would have dismantled those who own and control the corporate world but who remain in their institutional strongholds.
Given Cobbett’s views on Catholic Emancipation, imagine also the potential offered for Cobbett’s analysis by the issue of boardroom diversity. Cobbett lampoons the appointment system for bishops: ‘The king, who is called the Head of the Church, sends these gentlemen who are called the Dean and Chapter a conge d’elire or a leave to elect; but he sends them, at the same time, the name of the man whom, and whom only, they are to elect. With this name in their possession, away they go into the Cathedral, chant psalms and anthems and then, in a set form of words, invoke the Holy Ghost to assist them in their choice. After these invocations, they, by a series of good luck, wholly without parallel, always find that the dictates of the Holy Ghost agree with the recommendation of the King’.
How might Cobbett have drawn parallels between contemporary nomination processes for senior boardroom positions and his own world of episcopal appointments? He might have noted that 94 individuals between them occupied the chairs of the FTSE 100 in 2010 but that this number had fallen in 2014 to 90, no doubt due either to a shortage of talent or a surfeit of Holy Spirit.
How might Cobbett have warmed to the causes of regulation and governance and the particular attractions of the ‘comply or explain’ doctrine? He might have enjoyed pointing out that a vast edifice of regulation is intended to curb unethical behaviour but that it would clearly be intrusive to require board members to have any recognised prior training in business ethics before they are eligible to serve. To be a doctor, it is considered useful to have studied medicine; to be a great fiduciary, it is not considered necessary to have studied issues of public interest and business ethics.
Finally, consider the world of corporate social responsibility which is viewed as tangible progress towards the public interest. A brief consideration of Cobbett’s views on the Royal Dukes is instructive:
‘Some of the Royal Dukes gain a little popular favour by running about to Bible Societies, and sometimes to societies for assisting lying-in women and to the most celebrated Methodist Meeting Houses. Their names are in all great subscription lists; and they make speeches on many of these occasions and always give away some of their money’.
Cobbett clearly felt that the CSR activities of the Royal Dukes did not address the fundamental issues of the thing and the stranglehold it had on society.
Cobbett would, perhaps, have identified a gentle irony in the fact that directors, the great fiduciaries of our age, are amongst the greatest beneficiaries of the trusts held by them in an age where our great corporations have the reach and power of small governments. It is a system that the Boroughmongers are content to tolerate whilst allowing the visible players at the board table to absorb the discontent of a public whose interest has been lost to sight.
‘What a fine picture we find of that wise system of checks and balances, of which so much has been said by many great writers’. So said Cobbett of the thing. He may have said the same of the business world and its governance. We are not faced by a system which is governed impenetrably by global market forces which are beyond our control. Neither are we faced with a conspiracy. We have drifted into an acceptance of market forces which is self sustaining. As one commentator has put it: ‘There is no conscious conspiracy. They just move together like a shoal of herring or a murmuration of starlings’.
Sleepwalking in the Boardroom
It is puzzling that a well resourced and able group of people does not apparently see the shift in thinking around it. To understand how this might be, an early 20th century perspective may be helpful. Professor Christopher Clark, in his acclaimed and magisterial analysis of the people who occupied the international stage in the period leading to the First World War and the influences and forces which shaped their actions, concludes his analysis by describing the statesmen of 1914 as ‘sleepwalkers, watchful but unseeing, haunted by dreams, yet blind to the reality of the horror they were about to bring into the world’.
Yet many of these statesmen were men of outstanding ability and considerable experience. Many of the reasons for their collective arrival at a point which none expressly sought individually are failings which are easily replicable in a business context. This observation is not intended either to trivialise tragedy of war or to exaggerate the importance of business but Chris Clark himself opens his conclusion to his book by reflecting on the parallels between protagonists of the 2011-12 Eurozone crisis and the men of 1914: both groups faced a potentially catastrophic collective outcome to which they might inadvertently contribute by reason of their own apparently justifiable and rational individual actions.
What factors conspired to cause this apparent disconnection between individual actions and collective outcomes in 1914?
One factor was the capacity of each of the principal players to misunderstand the capacity and motivation of the others. Russia and Germany each arrived at the view that the other would not go to war and accordingly took steps that rendered that presumption untenable.
Another factor was the lack of unity within the different states themselves. Most had constitutional heads of state who spoke with a different voice from the political leadership of their governments. Most also had a diplomatic corps which actively promoted views which ignored the apparent policy of their political masters.
A third factor was the general acceptance of hugely flawed and untested data. It was generally presumed that Russian power and economic strength were on an upward growth curve which would, if left to mature, become unstoppable and dominant. This influenced the actions of allies and opponents alike.
A fourth factor was the apparent familiarity of many of the key individual players with each other. This familiarity encouraged false assumptions and uncritical appraisal.
A fifth factor was an unwillingness or an inability to see into the heart of potential counterparts to understand what really drove them. Russian sensitivity to the fate of Constantinople and Austrian sensitivity to Serbian challenge were significant factors which were neither properly weighed nor understood by their counterparts.
Finally, there is the issue of ‘opting decisions’. According to modern decision theory, an opting decision is a decision which is of life changing and irrevocable significance but which will leave the decision taker conscious of the alternative which was not taken. At one point in his book, Chris Clark draws on this theory to consider the influences which can lead anyone (in this case some of the statesmen of 1914) contemplating an opting decision to conclude a long and detailed period of rational reflection with a final intuitive leap which apparently abandons rationality for gut feeling in the final analysis. There are many instances of modern corporations taking bold M&A decisions which, with hindsight, are disastrous but which also ignore strong empirical evidence that M&A transactions are generally hazardous.
Why might this analysis of the events of 1914 be relevant to modern day business thinking?
The story of 1914 is of entities which were solipsistic: they knew their own worlds well but had failed to understand their counterparts and the collective forces which shaped the world outside their own boundaries. The increasing preoccupation of modern day business corporations with the desires and needs of their own shareholders is tending towards a similar shortsightedness.
Each of the factors at play in 1914 may have a parallel in the contemporary business world.
There is a contemporary failure to understand what drives regulators, government, public institutions and civil society and a preoccupation with one’s own shareholders to the exclusion of society at large.
There is an absence of a clearly articulated view as to the purpose of business corporations which is shared widely within them. There are accordingly mixed messages from corporate entities about their objectives which confuse the outside world.
There is an unthinking acceptance that shareholder value is the central influence which shapes sustainable businesses and there is an uncritical acceptance of financial markets and market indicators which repeatedly fail to identify companies which have no sustainable long term strategy.
There is a relatively small community from which the business world and the institutional shareholding world draw their leaders. This can obscure the pace of change in thinking outside the established group.
There is a lack of understanding of the danger of opting decisions and the likelihood that they will be flawed, particularly in relation to M&A and other major corporate events
The dichotomy between views expressed by heads of state, political leaders and diplomats in 1914 has an uneasy echo in the unchallenged business view that that the best governance arises where power is shared between chairs, chief executives and non-executives. This may lead to a beneficial equilibrium and healthy accountability; equally, it may well lead to division, confusion and a situation where external observers may simply select the view most attractive to them.
The most concerning parallel perhaps operates at the highest level. If individual actions do not take account of likely collective outcomes, those outcomes will be wholly unpredictable. In 1914 statesmen managed to fashion their own actions and reactions in a way which failed to understand or predict the collective consequences which would engulf all of their national interests.
Contemporary business leaders have been faced with crises which have arisen from individual actions leading to the events of 2008 which, taken collectively, produced a result which was disastrous yet largely unforeseen by them or by governments, regulators or commentators. This has led many people to re-examine the inter-relationship between business and society by simply asking the question: what is the purpose of business? If the accumulated wisdom of the business world led it to M&A opting decisions; if that accumulated wisdom led it to a false presumption that unchecked individual reliance on derivative instruments would not lead to collective calamity; if it led to an inability voluntarily to articulate clear and binding behavioural principles, then perhaps something fundamental was missing.
The final part of this article argues that business can only prosper if its leaders have the courage to challenge conventional wisdom.
How might that challenge be framed? The starting point is a recognition that business and society are interwoven. The credit crisis required the state to give financial underpinning to certain financial institutions. This led to an accepted view that this underpinning was not a free good. It brought with it an obligation on the part of those institutions to have regard to the interests of the society which bailed them out.
There is another, more fundamental privilege which has been accorded to the majority of businesses and which is now erroneously regarded as a natural right. It is the privilege of limited liability and it is instructive to recall its origins.
The parliamentary debate which preceded the Limited Liability act of 1855 was split as to the desirability of limited liability. Those who favoured it did so because it allowed capital from ordinary people to be channelled into corporate entities whose actions would benefit society. ‘Individuals having small capital could effect nothing of themselves, but by a combination of these small sums a large capital might be created and great public service rendered’. The opponents of the bill feared that it would lead to ruinous speculation and that ‘all the mischief… that attended the railway companies had emanated from the fact of the directors being masters of the company and not the company [masters of] the directors’. Lord Palmerston considered the bill to be ‘for the benefit of the country at large’.
Limited liability was not, therefore, a natural right. It was an artificial construct designed to benefit society. That is why fiduciary duties are owed to the company because its success is intended to benefit society. Limited liability is conferred on certain entities in return for public benefit.
This view calls into question contemporary views of directors’ duties and the unthinking acceptance that shareholder value and shareholder interests carry all before them. It also leads rapidly to the conclusion that the success of a company can only be determined after the purpose of a company has been clearly articulated. This purpose may differ considerably from one company to another but no director can properly consider what his or her duties are without knowing why their company exists. An investment trust and a healthcare company will produce very different answers to the question: ‘What is our company for?’
If one accepts the proposition that limited liability was conferred in return for some public benefit, it very rapidly becomes apparent that the wholesale alignment of executive remuneration with shareholder interests is a seriously flawed construct. If variable remuneration is required to inform performance (a presumption which is itself flawed by conflict of interest), it should be linked to the success of the company. To make this link, the architects of incentive schemes need to understand why limited liability was introduced and what limited companies are for. It is ironic that one of the results of the financial crisis has been to identify shareholder interest and shareholder value as a benign proxy for corporate achievement. The complexity of remuneration schemes and the solemn intensity with which they are disclosed mask an edifice built on sand if shareholder value does not in fact offer a real proxy for successfully achieving corporate purpose.
If the corporate establishment can collectively have arrived at basic failure to understand that limited companies are created for the benefit of society, might it be possible that our regulators have similarly missed the target?
The history of financial crises shows that the normal regulatory response is to shoot the wrong fox. It may, therefore, be time to take a different approach. I would offer, as a starting point, the proposition that risk is essentially indivisible. This is shorthand for saying that any risk management approach which divides that risk into different elements is likely to fail. It is clearly possible to structure financial products which seek to repackage and reallocate risk. If, however, the system for evaluating that risk is separated and packaged, the risk will, to some degree, become invisible. Unless an institution or a regulator is capable of taking an undivided overview of risk, it will not be capable of understanding it. Aggregating different elements of divided risk will not produce a view of the whole.
Boardroom governance reflects this flawed approach to risk. Increased emphasis on the role of the non-executive director has been accompanied by a dramatic growth in compliance functions and increasing faith in audit and risk committees. The result has been an insidious move towards the division of risk. An element of risk is pushed down to a micro product level assessment of compliance. Another element is pushed sideways to the audit committee. Another is pushed to the preparation of an all encompassing risk register. Many of the weapons of risk management, when separated in this way, are like a gun in the hands of a drunkard: it is unclear whether he will shoot the target or himself.
The quest for accountability simply results in ever increasing division of risk and a consequent unintentional concealment of risk. If one divides the sub-prime story into its many separate intermediated parts, a respectable account can be given of the risk assessment at each point. The systemic risk and the basic underlying risk became invisible.
If a divided view of risk is dangerous, it follows that our corporate governance structure is dangerously flawed. It attempts to divide power and responsibility amongst Chairs, Chief Executives, non-executives and various committees. This simply ensures that the big picture may never emerge but that everyone can show their particular role in the process has been properly performed.
It is therefore time to pare back the structure to its core. This would mean, for example, that the role of non-executives should change. We have consistently overestimated the role which they can play. Indeed, it may now be time to accept that the elevation of non-executive directors to the front line of risk management simply provides another element of risk division which, in turn, is likely to exacerbate the problem.
It is probable that the indivisibility of risk also calls for a short term reduction in the size of compliance teams. The proliferation of compliance teams is, in some instances, likely to produce a greater compartmentalisation (and consequent division) of risk with inevitable consequences. Whilst it would be a brave board that decides to reduce this capability, this may the only way of ensuring that the senior executive team take back risk assessment into the corporate mainstream.
The conclusion reached, if the proposition regarding the indivisibility of risk is accepted, may therefore be counter-intuitive: a diminution in the emphasis on the role of non-executive directors and committees; a requirement that each executive boardroom itself speaks to risk in a coherent, unassisted manner (preferably briefly to camera rather than via the undiscerning lexicon of risk contained in Annual Reports); a reduction in the resource dedicated to compliance as a separate discipline; a unified regulatory approach; a reduction in the volume of standard risk reporting which simply aggregates responses from disconnected sources.
Why would regulators accept such an argument? The only circumstances in which they might do so would be where the leadership of the corporate world has convinced them that it understands the purpose of companies and the role of business in society. This would be a world where business leaders have articulated corporate success in terms which set out a credible explanation of the underlying purpose of the company whose affairs they direct. It would be a world where fiduciary duties are properly understood. It would not be a world where corporate responsibility is a cloak for a hollow centre which has no such articulation. If we continue in a world where compliance with codes of practice and externally directed CSR programmes are the order of the day, we will continue in a world where regulation is cumulatively stifling. The solution lies in the hands of those who lead the corporate world. It is a time for them to lead by seeing the big picture.
Guy is Chairman of The Legal Education Foundation, UK Export Finance and City Music Services. He is an Adjunct Professor at the Imperial College Business School, Co-Chair of the Bingham Centre Development Board and a founder Director of BCKR Limited.
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