Today the House of Commons Select Committee on Business, Energy, and Industrial Strategy (BEIS) published its report on corporate governance, after extensive consultation of oral and written testimony from a wide range of stakeholders. I applaud the Select Committee for such an extensive, thorough job with an issue of national importance, and am personally grateful to them for publishing my initial and supplementary written testimonies as well as inviting me to testify orally in Parliament. I endorse the vast majority of the recommendations and believe that they will help “make Britain a country that works for everyone”, in Prime Minister May’s words. This post aims to summarize the 81 page report into a few simple bullet points, and link them to the evidence.
Executive Pay
- LTIPs (bonuses based on hitting financial targets) to be scrapped from 2018; no existing LTIPs to be renewed.
- Instead, give executives equity that they are required to hold for the long term (at least 5 years). The equity must not vest (= become saleable) all in one go
- See here for the arguments for replacing LTIPs with equity, and here for evidence that CEOs cut investment when their equity vests
- These ideas are also advocated by The Purposeful Company, a leading consortium of leading executives, investors, consultants, and academics (full report here, short summary here)
- LTIPs are almost ubiquitous, but used because “we’ve always done it that way” rather than because they are effective. Given this common usage, the proposal is a radical one – but a highly desirable one – and I greatly applaud the Committee for its boldness
- Where bonuses are used, they should be on wider performance criteria (e.g. qualitative factors) and must be stretching
- Shareholders’ “say-on-pay” vote will remain advisory, rather than being changed to binding (as initially mooted).
- However, if an advisory vote has < 75% support, there should be a binding vote the next year and the Remuneration Committee (RemCo) chair should be encouraged to resign
- Firms should not be forced to put workers on RemCos, but worker representation to be on a comply-or-explain basis
- Firms, public sector, and large third-sector organisations to publish pay ratios between the CEO and senior management, and the CEO and all UK employees. The ratio must be on a consistent basis each year
- The actual advocacy of pay ratios was lukewarm, with little justification given. See my Harvard Business Review article for the potential unintended consequences of such disclosure (including for workers themselves).
Directors’ Duties and Reporting
- More specific and accurate reporting on directors’ duties to other stakeholders, including long-term consequences of decisions
- Reporting to contain fewer boiler-plate statements. Companies to be more imaginative and agile in communicating directly with stakeholders
- The report recognises that UK corporate governance is very well regarded internationally. Thus, it strongly supports maintaining
- The unitary board, where all directors share the same responsibilities
- The statement of directors’ duties in Section 172 of the Companies Act (that directors “promote the success of the company for the benefit of its members” (i.e. shareholders) while having regard for other stakeholders)
- “Comply or explain” guidelines (firms do not need to comply with certain guidelines, permitting flexibility – but if they do not, they must explain why not)
- I particularly applaud the report’s caution against overreacting to the scandals at BHS and Sports Direct. These scandals are tragic, but do not mean that all companies should have to suffer.
- The Report writes (paragraph 24): “Corporate governance in the UK is still strong and remains an asset to the country’s reputation for doing business. We are conscious that a small number of highly damaging examples of corporate governance failure should not lead to a hasty and disproportionate response. We do not believe that there is a case for a radical overhaul of corporate governance in the UK”
Expanded Role for the Financial Reporting Council (FRC)
- FRC to introduce a new tiering system (Red, Yellow, Green) for corporate governance
- FRC to engage and hold directors to account
- If engagement unsuccessful, report failings to shareholders
- If still no response, take legal action
- FRC to be renamed and resourced, to match this expanded role
Private Companies
- New governance Code for the largest private companies to be developed
- Compliance to be examined by an expanded FRC, funded by a small levy on businesses
Shareholder Engagement
- Paragraphs 13-16 recognise the importance of blockholders (large shareholders) and the dangers of the ownerless corporation
- However, this point is not subsequently picked up. Encouraging large shareholders to form, and helping shareholders to engage with companies, could further help the Government’s mission. See Chapter 4 of The Purposeful Company Policy Report.
- Investor Forum to facilitate better engagement between boards and shareholders, particularly if rated Yellow or Red by new FRC tiering system
- Shareholders encouraged to engage more in pay
Stakeholder Representation
- Companies to be encouraged to consider a Stakeholder Advisory panel, to consult stakeholders other than shareholders
- Annual Report to contain a section on how firms engage with shareholders
- Workers on boards should not be mandated, but report highlights that there is nothing in the law to prevent it. Would like it to become the norm by opening up new director positions to all.
- Worker directors will not be a delegate of the workforce as a whole but act in their own capacity, and have the same rights and responsibilities as other directors
Board Diversity
- 2020 target for half of new appointments to senior and executive management to be women. Companies should explain why they have failed to meet the target and the steps taken to address it
- Every existing FRC reference to gender diversity should also add a reference to ethnic diversity
Other
- Firms to report on their people policy in the Annual Report, i.e. approach to investing in people and how they ensure that their pay and working conditions are reasonable
- Investors to disclose voting records; FRC to name those who don’t vote
- Firms to provide full information on advisors engaged in transactions
A Note on the Use of Evidence
- The Report writes “The TUC states that “There is clear academic evidence that high wage disparities within companies harm productivity and company performance“.” This statement is actually false. The TUC (potentially inadvertently) quoted an unpublished 2010 paper by which found that high pay ratios are negatively correlated with firm performance. However, the final version of the paper was published in 2013 (i.e. 4 years ago). After going through peer review, it found the opposite result. In the authors’ own words, “We find that employees do not perceive higher pay ratios as an inequitable outcome. We do not find a negative relation between relative pay and employee productivity. We find that firm value and operating performance both increase with relative pay.”
- This highlights the potential issue of “confirmation bias”. You can always find some academic paper to support any viewpoint (some studies support vaccination, others oppose it). So, just having “evidence” to support a viewpoint means little – what matters is the quality of evidence. One cannot just hand-pick an unpublished draft that shows what you would like it to show, particularly when the published version shows the opposite.
- Claiming to be unaware of the published paper is not an acceptable defense. It is incumbent upon a witness, who chooses to quote an unpublished paper, to check whether it has since been published. Confirmation bias is not only misinterpreting evidence once you have received it, but the failure to search for new evidence. One cannot just stop at finding a half-finished paper because it shows what one would like it to show, and not bother to see if there is a finished version
- I highlighted in my supplementary testimony that the result was overturned (and the US evidence was independently confirmed using UK data in a paper forthcoming in a top journal). Thus, while the bulk of the Report is balanced and well evidenced, it is surprising that it contains a statement known to be wrong. The Oxford Dictionaries word of 2016 is “post-truth”, which has led to a widespread, and very welcome, acknowledgment of the importance of correcting untruths. Thus, when such corrections are made, they should not be ignored.
- As stated in my supplementary testimony, “The goal of the above is absolutely not to discredit the TUC, which is an organisation I respect, and whose goal of encouraging ethical treatment of workers I very much share. [Indeed, I expect that we both share strong support for the Committee’s recommendation for firms to disclose their people policy.] This is simply intended to be one example of how important it is to be critical with evidence.”
- Moreover, that the paper finds that pay ratios are positively correlated with future performance is far from the final word. Academic evidence is only one input into a decision. My concern is only that, when evidence is quoted, it should be quoted accurately.
- I will discuss best practices for the use of evidence in my upcoming TEDx talk, “From Post-Truth to Pro-Truth”, on 12 May in London. See here for details of the event and excellent other speakers.