Sir David Walker’s final recommendations on corporate governance in the UK banking industry have received a mixed response, but early indications are that the proposals are already beginning to be translated into practice and that they may be of wider applicability than initially thought.
Sir David Walker's final recommendations on corporate governance in the UK banking industry (the review) have received a mixed response, but early indications are that the proposals are already beginning to be translated into practice and that they may be of wider applicability than initially thought (see box “Summary of the proposals”).
While the review largely focuses on corporate governance in banks and other financial institutions (BOFIs) (and indeed some of the more onerous recommendations are now only applicable to FTSE 100-listed banks and life assurance companies), Walker comments that many of the issues apply to other financial institutions such as hedge funds and asset managers.
In addition, Walker co-operated closely with the Financial Reporting Council (FRC), which published a report (the FRC report) on its proposed reforms to the Combined Code on corporate governance (the Code) less than a week after the review was issued. The revised Code is expected to incorporate those of the review’s recommendations which the FRC considers should be of wider applicability (see News brief “Corporate governance: room for improvement (www.practicallaw.com/0-501-3083)”, this issue).
What began as a review of UK major banks may therefore affect not just BOFIs but all UK and overseas premium listed companies.
The Financial Services Authority (FSA), the FRC and the government have primary responsibility for implementing the review’s recommendations. The government is expected to consult further and enact subordinate legislation (see box “Regulatory timetable”).
The review aims to replace "executive groupthink" (where a dominant chief executive dictates board decisions) with a culture of open debate and challenge, underpinned by informed and capable non-executive directors (NEDs). In particular, the review recommends the following:
Commitment. The typical time commitment of NEDs should be increased to ensure they participate fully in committees and have a thorough understanding of the risks taken by the institution. It remains to be seen whether this will result in an increasing number of NEDs devoting the majority of their time to one institution (ensuring a better understanding of the business but potentially reducing their independence compared to NEDs who hold a portfolio of directorships) or whether it will deter potential board members, who might want a more varied portfolio.
Behaviour, not black letter regulation. Better governance at board level should be more about the team’s composition and the way it goes about its business than about complying with black letter law and regulation. Interestingly, the FRC's report is even stronger in its emphasis on the behavioural issues dictating good governance. However, neither the FRC or Walker believes that there is anything to be gained from broadening BOFI directors’ statutory responsibilities.
Training. NEDs in particular should be provided with personalised induction, training and development to ensure that they are able to contribute effectively. There should be training for executives in business areas outside their own responsibility, and chairmen should receive an "appropriately intensive" induction and participate in continuing business awareness programmes.
Experience. The board members should have relevant and balanced experience. As a result, the FSA's role in the interview process for NEDs in FTSE 100-listed banks and life assurance companies should be strengthened. It will be interesting to see if the FSA interview process will help improve the calibre of NEDs and enhance communication between NEDs and the FSA or if it will simply result in NEDs being another group who should be "frightened" of the FSA. However, this is one of the few recommendations that involves direct FSA intervention; the review generally promotes collaboration with regulators.
The review does not address the key questions as to what extent the FSA will expect to be able to rely on NEDs to "police" the executive, and how that responsibility can best be managed by the NEDs, while retaining the confidence of the executives.
The review points out that the appointment of the right people to the board will not prevent banks and their shareholders from seeking short-term gains; NEDs should therefore be encouraged to challenge and test proposals on strategy and monitor board performance. The review recommends the following:
Chairmen. Chairmen should promote "an atmosphere in which different views...are seen as constructive and encouraged" and should "encourage and expect" the informed and critical contribution of directors. They should have substantial industry and leadership experience: "learning leadership on the job" is unacceptable. A substantial part of their increased time commitment (two-thirds of the time of chairmen of major banks) is expected to be spent developing good practice in board behaviour, including the constructive management of the relationship between the board and its sub-committees, and between NEDs and executive directors.
The FRC is also recommending that the Code be amended to highlight the equally important and separate issues of board leadership and board effectiveness.
Re-election. BOFI chairmen should be proposed for election on an annual basis. The board should review the possibility of the whole board becoming eligible for re-election annually. The FRC goes further in recommending that all NEDs should be put to an annual vote.
Evaluation. There should be a "formal and rigorous" evaluation of both the board and its committees. The review recommends an external evaluation every two to three years. A statement on the evaluation process and issues identified should be included in the annual report. The FRC recommends evaluation for all listed companies.
The review emphasises improving communication between directors and institutional shareholders and encouraging a climate of "stewardship" by shareholders and fund managers. Specific recommendations include:
Share register. A BOFI should notify “material cumulative changes” over a short period to the FSA.
Dialogue. The chairman and, to a lesser degree, the senior independent director should be responsible for shareholder communication. In contrast, the FRC places responsibility for satisfactory dialogue on the board, although the chairman is responsible for communicating shareholder views to the board.
Stewardship Code. The FRC is to be responsible for overseeing a revised code of best practice principles applicable to institutional shareholders and fund managers. Fund managers should confirm their compliance with the Stewardship Code or explain their alternative business model and reason for non-compliance. (The FRC issued a consultation document on this on 19 January 2010 (www.frc.org.uk/images/uploaded/documents/Stewardship%20Code%20Consultation%20January%202010.pdf).)
Voting. Institutional shareholders should be expected to exercise their voting powers and publicly disclose their voting records and policies.
Despite widespread support for the recommendations by stakeholder groups, it is unclear whether these recommendations will be sufficient to encourage institutional shareholders, most of whom are currently not equipped to be so, to be more pro-active. There are also concerns about the extent to which shareholders may meaningfully collaborate with BOFI boards and one another without breaching market abuse and Takeover Code rules.
Although the scope of some of the review’s initial recommendations on risk has been narrowed, risk management remains a matter for the board, which will be able to draw on the advice of a risk committee and credit risk officer (CRO):
Risk committee. All FTSE 100-listed banks and life insurance companies will be encouraged to establish a separate risk committee, chaired by a NED, to advise the board on risk exposure and strategy. The committee should ensure that due diligence is undertaken on strategic transactions. A risk committee report should be included in the annual report.
CRO. A BOFI board should be served by a senior, independent executive with responsibility for risk management and oversight.
External advice. Risk committees should have regard to the "potential added value" of external advice.
A concern here is that delegating risk management to a separate risk committee may lower the full board’s guard to risk issues.
Managing the relationship between the full board and its sub-committees is something about which behavioural experts have strong opinions and is one of the focus areas of the Tavistock/Crelos paper annexed to the report.
Despite much international attention on this subject, the review does not advocate the abolition of bonuses in the financial services sector. It does, however, make a number of practical suggestions:
Remuneration committees are charged with having a much greater oversight over firm-wide compensation systems. The review recommends that there should be one remuneration committee that establishes the relevant principles on a firm-wide basis. It also suggests that the remuneration committee should understand and be comfortable with the way in which these principles are incorporated into compensation structures.
The deferral of incentive payments as the primary risk adjustment mechanism. The review proposes the use of both long- and short-term incentive schemes to achieve this.
BOFIs should publicly disclose the compensation of high end directors and employees by bands of income. In addition, executive board members and high end employees should maintain a financial interest in the relevant BOFI that is in line with their historic or expected compensation (possibly following Canadian best practice).
The review is sensitive to the fact that the recommendations should not increase bureaucracy and box-ticking but rather facilitate a change in the organisation and behaviour of BOFIs. Whether this will be sufficient to avoid a repetition of the systemic failures of 2007-2008 remains to be seen, but the following observations can be drawn:
The review aims to enable BOFI boards to be more effective supervisors of their institutions. Recommendations requiring an increase in both the calibre of board members and their responsibilities may result in a reduction in the number of potential BOFI NEDs and, as a consequence, an increase in the fees payable to the right candidates.
The good practice statements in the review which translate into Code provisions may also be standards by which directors are held to account by regulators and potential shareholder claimants. The FSA may well seek to rely on these provisions, and it is unclear how much more onerous a burden they will impose on the boards of financial institutions.
The review maintains that a regulatory framework, however wisely drafted, is only as good as the behaviour of the individual board and its sub-committees implementing that regulation. This emphasis on behaviour has been followed by the FRC and can therefore be expected to affect listed companies, not just BOFIs.
James Bagge is a consultant, Claire O’Donnell is a senior associate and Peter Talibart is head of employment at Norton Rose LLP.
Board composition and behaviour have more of an influence on good governance than black letter regulation.
The Combined Code on corporate governance needs modification but the current "comply or explain" regime is fit for purpose and further legislation specifically to address systemic risk is largely unnecessary.
Non-executive directors should be equipped and encouraged to challenge the executive.
Board performance should be open to external evaluation.
Institutional shareholders should play a greater "stewardship" role.
Risk evaluation and management should be key concerns for the board.
Remuneration should be disclosed, at least at the "high end", and its role in risk management utilised.