FRC review of the Combined Code: submission

From the commentaries available, it would seem that corporate governance practice in the UK has improved considerably since the Committee on the Financial Aspects of Corporate Governance was convened in the summer of 1991.  Since then, there have been numerous, considered reviews of corporate governance practice and of the Combined Code which emerged in 2000 from the review of the committee, then chaired by Sir Ronald Hampel, in early 1998.  Over the intervening decade, the Combined Code and its predecessor have accreted rather than altered materially.  We believe the backdrop of the current, severe economic crisis, albeit with its origins in the banking sector, provides the Financial Reporting Council (FRC) with an ideal opportunity to question the assumptions that have built up around the Combined Code and corporate governance more generally.

“Best practice” usually isn’t

In the debate about corporate governance and in the Combined Code and its predecessor documents, there is frequent reference to “best practice”.  In the latest review, the FRC adopts the “demonstrable need for best practice” as one of its “guiding principles”.  Inherent in the notion of “best practice” is the idea of corporate perfectibility.  We do not believe that this idea is valid; each company must adapt its governance practices to its own unique circumstances of markets, competition, ownership interests and capabilities.  Further, provision of guidance as “best practice” crowds out corporate attention to specific companies’ governance requirements, reducing innovation among companies and their advisors.  As a result, governance and related corporate practice has not adapted as rapidly to changing market conditions and evidence of performance (strong or weak) as it should have.  This is particularly evident in the areas of engagement between shareholders and companies, corporate risk management practice and internal control practice.

Governance principles

The claim often made of the Combined Code is that it is a ‘principles-based’ approach; this contrasts with a ‘rules-based’ approach such as that adopted by, for example, the US SEC.  In the corporate governance debate in the UK, the former is frequently presumed to be superior to the latter.  However, while the principles expressed in the Combined Code may be entirely valid, the Combined Code conflates principles of design with principles of a governance framework with principles of application with high-level statements of practice.  We provide examples of this conflation in the body of our submission.

We believe the FRC should prepare a clearer expression of the current Code (or as amended by this review) with these different types of principles separated and made explicit, along with the assumptions (both about behaviour and about corporate practice) which underpin them.  This forms part of our proposal for an alternative Combined Code regime (see below).

The Turnbull Guidance

While the Turnbull Guidance on internal control is, as written, a sensible document, its implementation has resulted in very conservative and unresponsive corporate practice in risk management and internal control.  The latter practice is still firmly rooted in the perspectives of COSO, originally published 17 years ago.  This represents a material failure of innovation.  In corporate risk management practice, methods derived from “best practice” standards and broadly advocated by professional advisors have led to the explosion of corporate practices the value of which is at best unproved and more likely simply irrelevant.  To address this, guidance on risk management and on internal control should be separated; guidance on internal control, if provided at all, should be prepared with greater attention to the vital behavioural aspects of control; guidance on risk management should either be abandoned and left to the market to innovate or should incorporate far greater focus on analytical and behavioural dimensions of risk management.

Evidence-based reform

The debate on corporate governance in the UK has, historically, largely been informed by discussions with corporate directors and other market participants; the current review by FRC has been conducted using this approach.  As a matter of research methodology, this approach inevitably introduces bias.  Within the FRC’s excellent summary documentation, there is reference to areas of uncertainty that should be readily settled with empirical data.  Particularly in the areas of risk management and internal control, there is an urgent need for greater, focused empirical research to establish actual corporate practice and to form an objective assessment of factors driving and inhibiting its effectiveness.

A proposal for introducing choice in to corporate governance regulation

As noted above, in order to encourage innovation, we believe the FRC should develop a clear and explicit statement of the principles and assumptions behind the Combined Code, where the different types of principles are separately and coherently presented in a hierarchy with statements of practice and detailed guidance separated.  Further, the reporting requirements against the ‘alternative Code’ (really an alternative presentation of the same Code) should be limited to a more laissez faire approach – requiring reporting companies to explain the logic and application of their governance frameworks and approaches in each area of principle.  Combined with a clear statement of support by the FRC for the need for innovation and adaptiveness to companies’ circumstances, we believe this approach could substantially improve governance practice in companies adopting the approach and would encourage, over time, greater differentiation between companies’ governance practices.

The broader corporate governance system will only operate effectively when corporate disclosures include enough substance to be differentiable by analysts and when analysts have the skill and the interest to interpret the impact of differing governance practices on firms’ potential for sustained value creation.   Therefore, a design criterion for corporate governance disclosure should be to encourage companies to provide reporting of sufficient relevance that it is differentiable.  This can only occur if firms are also encouraged by regulation and quasi-regulation to differentiate their governance activities.  This, in turn, would encourage analysts and research houses to pay greater attention to the governance practices reported by firms adopting the ‘alternative Code’; that is, they would have something material to review and opine on.

An example might be requiring companies and boards to explain how they have determined the capabilities required on their board of directors, how they have satisfied those capability requirements and how they intend to attract additional capabilities in future to satisfy expected changes in their requirements over time.

Such an approach could be introduced in parallel with the existing Code and be offered as an alternative to companies who wish to adopt the approach.  A thorough trial and review basis would be established along with the alternative Code.  Alternatively, the FRC could prepare such an alternative Code for comment and consideration by interested parties as a subsequent consultation exercise.

Specific issues for consideration

In addition to the comments on the general framework of corporate governance, we have provided detailed responses to many of the specific issues raised by the FRC for consideration.  These are contained in section 2 of our submission.


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