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ORP37 - Corporate Governance and Wealth Creation
Paul Moxey, 2004
Executive summary
Getting corporate governance right is important to economic prosperity. Yet there is little objective evidence that good governance will either (a) prevent further corporate failure or (b) contribute to improved organisational effectiveness. Nor is there convincing evidence that supports the changes required by revised corporate governance reform, particularly regarding the role of independent non-executive directors.
In fact, some evidence counters two important provisions of the new Combined Code, that boards of FTSE 350 companies should comprise at least 50% independent non-executive directors and that their length of tenure should not exceed nine years. Other research refutes a generally accepted, fundamental principle of good governance that the roles of chairman and chief executive should be separate.
The problem may stem in part from lack of consensus over what comprises good corporate governance and how it can be assessed. Similarly, while there are also many measures of financial performance there is no single appropriate measure of either performance or effectiveness.
Aims of the research
This research aims to inform debate by eliciting and analysing the opinions held by chairmen and finance directors of UK listed companies about corporate governance. Its particular focus is on the generation of wealth, exploring respondents' perceptions of the relationships between corporate governance and corporate effectiveness. It also investigates views on the new elements of the Combined Code.
Profile of respondents
The survey was completed by 91 chairmen and finance directors from the top 1,000 listed companies ranked by market value.
Attitudes of directors to corporate governance
It was found that 30% believed the 'main purpose of corporate governance' to be 'protecting shareholders against loss' and another 30% believed it to be 'optimising the long-term financial ability of the organisation to create wealth'. The remaining 40% viewed both purposes as 'equally important'.
Relatively more directors from larger companies linked the purpose of corporate governance with generating wealth. Within the FTSE 100, 47% of directors viewed the 'main purpose of corporate governance' as 'optimising' compared with only 20% of directors from companies outside the FTSE 350. Also, within the FTSE 100 twice as many directors believed the main purpose to be 'optimising' than 'protecting'.
More negative comments than positive were made about the purpose of corporate governance, eg, referring to corporate governance as 'over-prescriptive', 'burdensome' and 'box ticking'.
When asked to rank other purposes of corporate governance, almost all directors ranked 'ensuring accountability of management to organisation owners' as most important and 'improving share price' as least important. There were some interesting variations, however, the biggest being on the importance of 'satisfying the needs of regulators'. Directors who viewed the main purpose of corporate governance as protecting shareholders ranked 'satisfying the needs of regulators' as most important, whereas those who believed that the main purpose is to 'optimise wealth' ranked this as least important.
FTSE 350 directors believed 'satisfying the needs of regulators' to be third most important, whereas FTSE 100 directors and directors from outside FTSE 350 ranked this eleventh out of 13.
Aspects of corporate governance important to companies now and in the next five years
Respondents were asked to rate the importance of 14 aspects of corporate governance to their organisation now and in the next five years. The four most important aspects of corporate governance to directors responding to the survey were 'strategy and goals' and 'financial reporting (disclosure)' followed by 'relationships with institutional shareholders' and 'the quality of the external auditors'.
Given the responses to the question on the purpose of corporate governance, it is surprising that 'strategy and goals' ranked top in importance. One possible explanation is that many respondents did not associate corporate governance with strategy.
The influence of corporate governance on factors relevant to the generation of wealth
Using a scale of one to five (where one is not at all influential and five is very influential), respondents were asked to indicate how much influence they think good corporate governance practice has on various aspects of a company's ability to generate wealth. Responses are summarised in Table 1. The Table 1 shows that respondents believed that corporate governance has more influence on matters relating to finance and investment than on organisational performance, particularly in relation to 'obtaining investment from institutional investors' and 'maintaining or improving relationships with the investment community', which scored higher than any of the other criteria. 'Contributing to your organisation's overall reputation' was the second highest criterion for influence, narrowly behind 'relationships with the investment community'.
The response is skewed towards corporate governance having little influence on profitability, with 12% of respondents believing that corporate governance does not influence profitability at all, and only 2% viewing it as very influential. Within the FTSE listing categories, directors of FTSE 100 companies were more likely to believe corporate governance to be a significant influence on profitability than directors in the other categories.
Directors' opinions on the effect of changes in the Combined Code
Responses suggest that the main changes in the revised Combined Code will have little positive effect on companies' ability to generate wealth. For example, 22% of directors agreed but 47% disagreed that 'a formal and rigorous annual evaluation' of the board will help create wealth. Respondents indicated little satisfaction with the changes relating to independent non-executive directors (NEDs) and in particular the new view implied by the Code that independent directors cease to be independent once they have been a board member for nine years and should be removed. It may be stretching inference to interpret the results as meaning these Combined Code changes could destroy value but such an interpretation seems possible and may warrant further research. Respondents from FTSE 350 companies expressed the strongest views against removing independent NEDs after nine years.
Nearly 30% of respondents were of the view that the revised Code could reduce the international competitiveness of UK companies. When broken down by type of respondent, responses show that this view was expressed by 37% of finance directors, 21% of chairmen, and ' most worryingly ' 40% of respondents from FTSE 100 companies. Comments made about the Code reveal concern that the revised Code will lead to more, not less, emphasis on box ticking, which may explain the apprehension expressed about reduced international competitiveness.
The revised Combined Code and the role of non-executive directors
Under both Cadbury and the revised Code, NEDs should have an important role in helping to create wealth and it should be a cause of concern that only 37% of respondents considered that they do, while 30% did not. Only 27% of respondents from FTSE 100 firms agreed that 'NEDs play an important role in the organisation's ability to generate wealth' compared with 41% of those from the FTSE 350 and 38% of those from outside the FTSE 350. This is a cause for concern because FTSE 100 companies have a higher proportion of NEDs on the board and FTSE 350 companies are being pushed to have more too.
Do independent NEDs play an important role in establishing effective corporate governance practice?
It seems that NEDs' main role is in establishing the appearance of governance practice rather than contributing to strategy and performance. There was strong agreement that independent NEDs play an important role in 'establishing effective corporate governance practice': 79% of respondents agreed and only 3% disagreed with this statement.
Independence criteria
The revised Code introduced new and more demanding criteria for establishing whether or not an NED is independent. Of those respondents who agreed that 'it is difficult to appoint truly independent NEDs', the highest proportion (35%) were from companies outside the FTSE 350. Many respondents accused the new approach of encouraging a 'tick box' attitude: 94% agreed and only 1% disagreed that 'independence of mind (ie objectivity and integrity) is more important than independence in appearance (ie meeting the compliance criteria)'.
The effect of increasing the proportion of independent directors to at least 50%
Derek Higgs (2003) recommends that boards should comprise at least 50% independent NEDs and this is now a requirement for FTSE 350 and above companies.
The results of this survey imply that many directors from boards who do not yet meet this requirement believe that doing so will lead to:- NEDs becoming less involved in the business (30%)
- an adverse effect on team work and decision making (55%) and
- other directors having to leave the board in order to meet the 50% requirement (43%).
In conclusion, it appears that there are two distinct, but related, aspects of corporate governance: one is to do with direction and control and the other is to do with accountability to shareholders.
Two sides of corporate governance
Some respondents viewed corporate governance simply in terms of a bureaucratic exercise while others viewed it as checks and balances to protect shareholders. A third group, however, viewed corporate governance as having a significant role in strategy and profitability.
This study suggests that the new Combined Code could have done more to ensure companies pay more attention to performance and make governance less of a box ticking exercise. Additionally, if the 29% of respondents who believed the revised Combined Code could reduce international competitiveness of UK companies are correct, the revised Code requires further change.
Corporate governance should be considered in the context of achieving objectives, how objectives are achieved and how risks are managed as well as how boards are accountable to, and engage with, shareholders. This research highlights the need to reconsider the approach to corporate governance and ensure that all parties in the process (including boards, shareholders and regulators) share a common understanding of what corporate governance is, what it should be expected to achieve and what it cannot be expected to achieve.