Background Responses to specific questions Progress since the 2012 review Reporting obligations Differential share classes Directors' duties Board composition Remuneration And finally
Background
The public equity markets with which we are familiar came into existence in the nineteenth century to facilitate the building of railways. Railways were capital intensive projects, the investment required was highly specific to its purpose, and savings were collected from a large number of relatively well-off private individuals, who needed some liquidity in their holdings of railway equities and bonds and obtained it in a secondary market. This equity market model was effectively applied to the large manufacturing corporations which dominated the industrial landscape for most of the twentieth century – breweries, automobile and petrochemical plants, etc.
The business world today is very different. Most business is no longer capital intensive – operating assets account for only around 5% of the market capitalisation of companies such as Apple and Alphabet (Google). The assets which such companies do use are less functionally specific – offices, computers etc. Such assets need not be owned by the company that uses them in its business and typically are not owned by that company. Public equity markets are not a significant source of capital for business, even for those capital-intensive businesses that remain, such as energy companies and utilities. Long-term savings are overwhelmingly channeled through institutions.
And the structure of institutional investment has itself undergone recent and continuing change. Two to three decades ago equities were largely owned by insurance companies and pension funds, and these industries were in turn highly fragmented. The funded defined-benefit pension scheme and the with-profits insurance policy, then the primary vehicles for long-term saving and investment, are both products in terminal decline.
The present – and certainly future – structure of the investment industry lies with large asset managers. Today specialist asset management businesses such as BlackRock and Fidelity dominate the investment scene. As defined contribution pension saving grows, we should be looking to a future in which these asset managers operate alongside large pension funds with the scale to undertake their own diversified investment management, in the manner of Canadian and Australian funds. Sovereign wealth funds play a subsidiary, though significant, role. All these institutions have the potential for direct engagement with the assets in which the funds of their beneficiaries are invested, although they currently have limited capacity to do so; the skills of their managers are largely those of attempting to outguess each other in the anticipation of short-term market movements.
Because of the reduced significance of business investment as a proportion of the total, much of the opportunity and requirement for long-term investment will be in property and infrastructure. In the business sector, there is a requirement for search – looking for new investment opportunities, which will generally be in early stage businesses. Listed companies are overwhelmingly self financing and by the time new business has achieved a scale at which it might contemplate a listing it is typically cash generative. The purpose of listing is now to provide a liquidity event for early stage investors – necessary, but very different from the traditional capital raising function of the IPO; or to provide paper for acquisitions, an activity of dubious value.
There is also an ongoing requirement for stewardship – monitoring the performance of established companies which are no longer reliant on external funding – in what will, and should, be a largely passively managed listed sector. These established businesses are increasingly capital light and skill and knowledge intensive, and these characteristics of modern corporations necessitate a different kind of relationship between shareholders and employees than that which existed when the capitalists owned the plant and the workers lined up each day to operate the machinery.
Public policy discussion, and in particular our regulatory structures, demonstrate very little recognition of these changes in the nature of capital, business and the relationship between the two. Such discussion is wedded to the promotion of a model which is described as a market-based model of capital allocation, failing to notice that these markets play virtually no role in the allocation of capital for investment and are more or less entirely devoted to secondary market trading in claims on existing assets.
We have imposed requirements for liquidity and frequent valuation which severely inhibit the ability of asset managers to invest in instruments other than easily tradable listed securities, and which are wholly unnecessary given the long time horizons of the underlying beneficiaries and the small size of actual or potential outflows from asset managers or pension funds relative to the stock of existing assets. We have labelled attempts to gain better returns for beneficiaries by deeper knowledge of the activities of investee companies as fraud, through conceptions of insider dealing that are structured to protect financial intermediaries rather than to promote business efficiency. We are supporting a business model which was appropriate to a historic phase in business history which is now over and which is largely irrelevant to the needs of modern business and now mainly serves the interests of a bloated finance sector.
This primacy of finance over business is at the root of the more immediate crisis of corporate legitimacy which motivated the recent Green Paper and this Committee’s inquiry. That crisis is the result of a confluence of recent events – particular incidents of corporate misbehaviour at BHS and Sports Direct, public awareness of the extent of aggressive tax avoidance by multinational companies, excessive executive remuneration, and abuse of customers and taxpayers in the banking sector. The shareholder value mantra – the purpose of business is to maximise profits – provides no answer to the core issue of the legitimacy of any exercise of power in modern society – ‘what gives them the right to do that?’ ‘Because they want to make as much money as possible’ is not a coherent, far less defensible, answer to the question ‘what gives them the right to do that?’
Public concern for corporate governance is a proper concern for the legitimacy and propriety of the authority which is vested in the senior executives of the large businesses which are today among the most important social and economic institutions in the country. The correct answer in the business context to the question ‘what gives them the right to do that?’ is, or should be, ‘they acquire that right by virtue of their contribution to society in delivering goods and services that people want, in providing financially and emotionally satisfying employment, in earning profits which reward entrepreneurship and innovation and which underpin returns to long-term savings, and by improving the social and economic life of the communities in which they operate.’ That issue of the origins of legitimacy of executive authority is plainly central to any discussion of the definition of directors duties in section 172 of the Companies Act.
Responses to some specific questions
Progress since the 2012 review
The Investor Forum has been established, and is working effectively: it has played a constructive role in most of the problematic issues involving large listed companies in the last two years. It also draws attention to the central role of large asset managers in the investment chain, and their ability to improve business performance by working together. I hope that the Forum will move on to tackling generic issues in the corporate sector as well as ones relating to individual companies.
Since what is principally required is a cultural change, we have also been successful in promoting wider recognition of the problems of short-termism, which is the essential precondition of change. Where there has been little success is in weaning either asset managers or their clients off the futile obsession with frequent performance measurement and benchmarking, and towards an emphasis on five-year absolute returns.
Reporting obligations
If the analysis above is correct, private equity type investment should in future be a much larger part of the portfolio of large asset managers and the boundaries between private and public equity will be less clearly demarcated than they are today. Public policy has a role to play in facilitating and encouraging private equity investment with a longer time horizon than the three to five year exit which has recently been typical of recent activity: at present, regulatory demands actually get in the way. If it can no longer be expected that companies going beyond a certain size will naturally seek a listing, it follows that there is little future logic in a setup in which the categories of premium listing/listing/unlisted are the principal determinant of reporting and corporate governance obligations.
Moreover, if one rejects the view that the primary purpose of corporate reporting is to make life safe for anonymous traders, the existing structure of financial reporting must come into question. There are wide differences across industries and activities in the relevant metrics of performance and the appropriate time frame for these metrics. The attempt to impose a standard reporting template across the whole corporate sector has led in practice to very lengthy corporate reports, much of which consists of boiler plate, and which often conceal rather that highlight relevant information. The recent emphasis on narrative reporting is a helpful step away from this, but there is difficulty in ensuring that such reporting is substantive rather than platitudinous. The accounting firms and accounting standards bodies have a principal role to play in elaborating what is good and bad in narrative reporting, but such material is by its nature subjective and qualitative, and not readily amenable to prescriptive regulation.
The wider issue here is that corporate reporting should increasingly be – as it now is in private equity – a matter for negotiation between investors and companies, with an eye on key performance indicators, rather than the subject of one-size-fits-all regulatory prescription. The traditional function of formal financial reporting to Companies House – to provide a check on the honesty of the directors and executives and give potential creditors the information they need before they decide to do business with a company – remains, but has become confused with the provision of the, necessarily company specific, data needed to attempt a valuation of the company and assess its investment potential. The move to ‘fair value accounting’ is a reflection of such confusion of functions.
The Annual Report has naturally been the company’s principal means of communication with the wider public. That most large companies produce other documents with this aim is an indicator that the doorstop Annual Report no longer serves this purpose. In practice, most companies now communicate with the public through their website, and some such websites are well constructed and informative.
We have not rethought financial reporting for a world in which the internet is a primary vehicle of communication, in which the typical large business is no longer a manufacturing business but a knowledge factory, and in which the structure of asset ownership is increasingly dominated by a few large intermediaries. Instead, we have bolted on new requirements to an existing structure, creating a clumsy framework which does not serve any of its underlying functions well.
Differential share classes
The modern company is no longer a contractual relationship between capital and labour, but an engaged and continuing partnership between committed employees and investors and other stakeholders. This recognition requires a rethinking of the nature of share ownership and the rights and obligations that go with share ownership. The language that asserts that shareholders ‘own’ the company is patently anachronistic as applied to such businesses (and, incidentally, never reflected UK company law).
It also seems understandable and appropriate that the executives of such companies might wish to recruit committed and engaged investors who would accept relative illiquidity of their shares in return for an enhanced governance role. There will be a growing role for passive investors who free ride on the engagement activities of the active and the proper reward for such engagement should be the ability to earn better returns from superior knowledge and understanding.
It is inescapable, given the scale of market capitalisation of modern business, that there will be a large role for passive investors, who might have an economic interest in the business, but could not be expected to engage with the company in any substantive way, or to have any capability to do so, or to gain benefit from it for their investors. Passive investors do however have an interest in the integrity, legitimacy and governance capacity of the corporate sector as a whole. (This is highly relevant to issues, such as tax avoidance, where the pursuit of the interests of individual companies may be seriously damaging to the business world taken as a whole).
There are no obstacles in UK law to the creation of differential share class, but discussion of such differentiation is brought abruptly to a halt by the historically-based implacable hostility of UK investment institutions. It is time to challenge such hostility, with a view to encouraging experiments by individual companies that will give a clearer indication of the possible costs and benefits associated with alternative models.
Directors’ duties
In my view, there is nothing wrong with the definition of directors’ duties in Section 172 of the Companies Act: the problem is that many directors do not know what it says, or have not understood what it says. The plain and intended wording does not instruct directors to maximise profits or shareholder value, but to promote the success of the company; members will benefit from the success of the company. It does not say that the shareholders are or should be exclusive beneficiaries of the success of the company, and if anyone were minded to think that the words that follow put the matter beyond doubt. It might be helpful to say ‘promote the success of the company for the benefit of the members and the community’ but I do not think this really adds anything. ‘Promoting the success of the company’ does not oblige – and arguably does not permit – directors to implement artificial transactions to avoid tax or to break up the company to increase shareholder value.
That said, there are good reasons for regarding the role of shareholders as different from those of other stakeholders. As residual claimants to the assets and revenues of the company, they are, in principle, the stakeholder who must balance the competing claims of all other stakeholders: and because – in contrast to all other stakeholders – the contractual relationship of shareholders to the company is indefinite and cannot be straightforwardly terminated on either side, shareholders are in principle the best placed of all stakeholders to take a long-term view.
If an employee could only leave the company by inducing someone else to take his or her place, the relationship between the company and the employee would be very different. And this was once often true – grooming a successor, very possibly his own son, was one of the responsibilities of the skilled artisan – but that kind of employment has more or less disappeared. However the importance of the creating a team which will give continuity in the capabilities that lie behind the success of the company some extent again true of senior management roles in modern service businesses, another aspect of the way in which the relationship between employee and shareholder has become one of partnership rather than a contractual arrangement.
Of course, this theory of shareholder as residual claimant has been overtaken by the scale of trading activity in modern equity markets, which makes the typical shareholder’s role purely transactional, and in many cases more short term and disengaged than other stakeholder relationships. In the most absurd manifestation, much trading is conducted between computers using pre-programmed algorithms requiring no connection whatever between any human agent and the investee company.
The appropriate course, then, is not to change corporate law, but to increase awareness of the rights and responsibilities imposed by it. Directors should be more fully aware that their obligations are to the company, not to the people who happen to be shareholders at a particular time: and that although by law directors are accountable to shareholders they are responsible to and for all stakeholders. This cultural change should facilitate an asset management industry which understands that the promotion of the success of the company – and not simply the anticipation of the actions of other asset managers – is the only mechanism of generating better returns to beneficiaries over the long run.
Board composition
The dynamics of a group which is a committee representative of particular interests are very different from those of a team working together towards a common goal. Both types of organisation are needed for certain, different, purposes – especially in politics and government. The board of a company is – appropriately – seen as a team working towards a common goal – the success of the company. It is not, and is not intended to be, representative of the shareholders, even though it is (in principle though not in reality) appointed by the shareholders and is (to some degree in reality) accountable to the shareholders. Thus, the introduction of representatives of stakeholders to company boards, would represent a fundamental change in the nature of board dynamics, and not in my view a desirable one: the board is not a political entity mediating between divergent interests, but a management entity balancing claims in the interests of the company.
It is not, I think, an answer to this issue to visualise a stakeholder representative as someone appointed by the relevant stakeholder group (and perhaps reporting to them) but having the obligation to promote the success of the company as enshrined in section 172. It is genuinely difficult even for the most conscientious individual to wear multiple hats at the same meeting, as any conscientious individual who is a company appointed trustee of a defined benefit pension scheme can testify.
The most common example today of a stakeholder representative on a corporate board in Britain is where a large investor is appointed as a board member. In most cases, the interest of such an investor is in the long-term success of the company, and no conflict of interest arises. But this is not always the case, and the position of the representative director is then difficult. Even if he or she is clear about the overriding nature of the duty to the company, other directors will (quite reasonably) expect the person concerned to represent the position of the investor.
Thus any move towards representative democracy in the corporate sector is a move towards a two tier board structure, with a ‘political’ supervisory board and a cohesive executive board. This isn’t necessarily a bad thing, and may be less far from the practical reality of many (most) boards today than conventional wisdom would have it. The pretence that executive and non-executive directors have identical roles in strategic decision making in companies is a pretence, and it is not desirable that it should become a reality. As with investor opposition to multiple share classes, the commitment to the unitary board by the British corporate sector seems to be an article of faith rather than reasoned argument, and there is need for discussion and experiment. What is not desirable, however, is to muddle the functions of a unitary board.
Cognitive diversity is an essential feature of a functional board, and other kinds of diversity – such as gender or ethnic diversity – can improve the functioning of business only if they do add cognitive diversity. Cognitive diversity is, however, rarely welcomed by executive teams – my experience is that the statement ‘we want someone like you to challenge our thinking’ is not, in most cases, true.
Remuneration
The notion that, in addition to the salaries they receive for performing their duties, the senior executives of companies need to be incentivised to fulfil their duties to promote the success of the company is one which would rightly be regarded as insulting in most other professional contexts. And people who do need such incentivisation are mostly not appropriate holders of posts which carry heavy and wide-ranging responsibilities. The theory that share options and related bonus arrangements would align the interests of shareholders and senior executives has proved to be wholly false: such remuneration arrangements are today the principal source of friction between boards and shareholders.
The rise in – particularly – CEO pay relative to that of other employees is well documented, and indissolubly linked to the growth of supposed performance based remuneration. While these incentive schemes are unlikely to have much effect on the quantity of effort directors put into promoting the success of the company, they do direct management attention to whatever metrics are used to determine performance-based remuneration. Even the metrics which are included in so-called long-term incentive plans generally involve much shorter time scales than those needed to create sustainable competitive advantages in business. Moreover, where these incentive schemes fail to pay out, it is (correctly) pointed out that they are failing to fulfil their ostensible purpose (incentivisation) as they fail to fulfil their underlying purpose (increasing the overall scale of executive remuneration).
The state of executive remuneration in the UK today is a mess, whose results are damaging to the proper stewardship of companies and the perceived legitimacy not just of corporate governance but of corporate organisation itself. By its implication that at all levels of society financial rewards are an overriding motivation the bonus culture is potentially corrosive of a social order based around a market economy. Worse, some steps aimed at resolving the problem may have made matters worse. Transparency is not necessarily a virtue: what Board can properly determine that the pay of its chief executive should be in the bottom quartile, but a quarter of Boards must necessarily do so. The increased role of remuneration committees may have provided legitimacy to excess rather than control over it.
It is appropriate (or at least not necessarily inappropriate) that exceptional performance should be rewarded, in the boardroom as on the shop floor. However bonus as reward is distinct from bonus as incentive: such payment should normally be discretionary, non-formulaic, and awarded after the event. And reward for exceptional performance is, by its nature, exceptional.
Shareholder say on pay has forced boards to discuss remuneration schemes with major shareholders, with some beneficial effects both in controlling levels of remuneration and removing the more egregious features of incentive scheme design. Much of this effect is below the radar – remuneration committees are increasingly mindful of what shareholders will accept without demur. As a result, while strengthening say on pay provisions would do little harm it might do little additional good. Since data on pay ratios is already readily available from disclosures in listed company accounts, and tables are published by the proxy service Manifest and the High Pay Centre, it is not easy to see the value of a UK imitation of the Dodd-Frank provisions on publication of pay ratios. Adding further to public outrage is valuable only if there is clarity about the methods by which that outrage is to be addressed.
Here are some principles which should begin to provide such clarity:
- The key problem is not that senior and especially chief executive pay is insufficiently related to performance, but that it is too high
- Bonus pay for senior executives should be exceptional, ex post, non formulaic, and normally in the form of deferred shares, securing some degree of alignment between the reward and the long-term success of the company. Reward not incentive should be the guideline.
- Stock options are appropriate for start-up companies which are stretched for cash and in which employees can appropriately (and necessarily) share the risks of the business with founders. Payment schemes with asymmetric properties (beneficiaries share profits but not losses) are not appropriate remuneration structures for listed companies
- Remuneration consultants may be a useful source of information on pay levels at competitor companies. Remuneration policies are key signals of the values of the company and its desired culture and should be a matter for boards and executive management
- No one company can easily shift from current norms in terms of remuneration quantum and norms. Initiative in changing the bonus culture must come from investors acting collectively with the strong support of government.
- Such government support should be expressed in general not over-prescriptive terms. Regulation of pay is likely (as with much regulation of the financial sector) to lead to avoidance activity and a tendency for the limits of what is permissible to become the norm
And finally
Government has not made enough use of the power of political rhetoric. A few speeches from the Secretary of State would do much to clarify the meaning of Section 172. Many senior business people seem to have an almost pathetic craving for honours; these should be conferred on them on the basis of clear evidence of public benefit arising from their activities, not simply for occupying senior positions in large corporations. Asset managers and those who instruct them should be repeatedly reminded that emphasis on short-term relative performance is damaging to the economic prospects of the corporate sector and in consequence the interests of their beneficiaries. And regulation of the financial sector should be aimed at improving the performance of business rather than pursuing an abstract notion of the efficiency of securities markets.
