Corporate Governance Briefing

The UK Model of Corporate Governance: An Assessment from the Midst of a Financial Crisis

If you can keep your head when all about you

Are losing theirs and blaming it on you,
If you can trust yourself when all men doubt you,
But make allowance for their doubting too.
Rudyard Kipling

Key points

• After 15 years of development, the UK model of corporate governance has attained a position in which
it is broadly “fit for purpose”.

• In contrast to the legislatively-based approach of the United States, UK corporate governance

emphasizes board engagement with shareholders and compliance with a voluntary code of best
practice. This promotes high standards of corporate governance behaviour without stifling wealth
creation.

• However, there are no grounds for complacency. Efforts to further improve corporate governance
should focus on intensifying the dialogue between boards and shareholders, the effectiveness of non-
executive directors, and more meaningful implementation of the “comply or explain” principle. There is
also a need to address the distinctive governance needs of smaller companies.

• Longer term, the UK corporate governance approach - based on the assumption of significant dialogue
between boards and UK institutional investors - must adapt to the challenge of a transformation in the
ownership structure of UK plc.

• The regulatory burden imposed on boards should be carefully monitored. An excessive focus on
compliance – rather than issues of strategy and value-creation – undermines the viability of the UK’s
unitary board concept.

• Efforts to resolve the current financial crisis should focus on globally-coordinated reforms to financial
regulation (particularly relating to capital adequacy). Knee-jerk changes to the broader corporate
governance framework should be resisted. The imposition of direct government control over areas such
as executive remuneration would be counterproductive, and do little to rebuild the liquidity or solvency
of the banking system.

Over the last one-and-a-half decades, the UK has developed a distinctive framework of corporate governance. This
framework – revolving around the Combined Code and the “comply or explain” principle – is finding increasing favour
amongst policy makers around the world, based on its ability to promote high standards of governance without stifling
the wealth creation process. In particular, it is seen as being less costly and more flexible than the main alternative
approach: the legislatively-based corporate governance model of the United States.

The current juncture is an opportune moment to assess the effectiveness of the UK model. At the time of writing,
regulators are intervening on an unprecedented scale in support of the global financial system. Politicians and media
commentators on both sides of the Atlantic are voicing understandable concern at the scale of what is required, and
arguing that the quid pro quo for this assistance will be substantially more regulation. The causes of the crisis are often
expressed in terms of the inadequacy of corporate governance. For example, FT columnist John Plender writes that “the
credit bubble was not just a simple market failure, but a failure of business leadership, corporate governance and risk
management, exacerbated by flawed incentive structures within banks”1.

1
Financial Times, 22 August 2008.

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It is unfortunate that the “bright new financial system” – based on securitisation and financial engineering - has imploded
in such a dramatic manner. Such financial fragility does not serve the process of long-term wealth generation in the real
economy. Nonetheless, it is important at such a moment to resist the temptation of knee-jerk policy responses. Amidst
an atmosphere of fear and recrimination in financial markets, we should not lose sight of the underlying strengths of
many aspects of the wider UK corporate governance framework, particularly relative to the alternatives.

The objective of this paper is to highlight the distinctive nature of the UK model of corporate governance. It describes its
strengths, and identifies those areas where there remains scope for improvement. Although there are no grounds for
complacency, the UK system emerges from this analysis as broadly “fit for purpose”. It is hence important that the
natural desire of policy makers to “do something” in the current environment is channelled in the appropriate direction,
i.e. towards internationally coordinated reforms of the global financial architecture, and not against the broader UK
model of corporate governance, which is a source of competitive advantage for the UK economy.

What is corporate governance?

Corporate governance refers to the framework within which companies are directed, controlled and held to account.
This is distinct from the management of enterprises on a day-to-day basis, which is a task delegated by boards to
executive management. Rather, corporate governance has a more strategic and overarching function: it is concerned
with steering a company in a direction that is consistent with its long-term values and objectives.

For an individual company, an appropriate framework of corporate governance – coordinated by a properly functioning
board of directors - serves to increase confidence in the firm’s longer-term viability. This builds trust and credibility with
investors, creditors, employees and other stakeholders. At the national level, corporate governance is a determinant of
national competitiveness, and helps to establish the legitimacy of corporate activity vis-à-vis the rest of society (which
cannot necessarily be taken for granted).

Corporate governance practices around the world are surprisingly diverse. Differences partly reflect the varying sizes,
sectors of activity, and lifecycle stages of enterprises. However, the nation state is still the main driver of corporate
governance variation. For example, prominent multinational corporations like Toyota, VW, and General Motors are
engaged in broadly similar economic tasks, i.e. the manufacture and distribution of automobiles. However, their
activities are subject to entirely differing frameworks of monitoring, oversight and control due to the distinctive
governance environments of their respective countries of incorporation.

This is not to say that global market forces do not have an impact on governance practices. Large publicly-quoted firms
around the world increasingly conform to international standards of corporate governance “best practice”, as defined by
organisations such as the OECD, the EU, and the International Accounting Standards Board. Such behaviour helps
them to win the favour of capital market investors, and thereby gain access to external finance at the lowest possible
cost.

However, such globally-operating incentives have yet to override the importance of national-level factors in determining
governance choices. This is partly testament to the significance of smaller, non-listed enterprises in the corporate
sectors of most economies; the SME segment is less exposed to the capital market influences that affect larger
companies. It also reflects the continued importance of domestic politics and regulation on the national business
environments. Various other factors of relevance to corporate governance behaviour – such as the intensity of
competition in local product markets, norms of business behaviour, and corporate ownership structures – also vary
significantly across countries.

Consequently – despite the increasingly global nature of much corporate activity - it still makes sense to talk of
national “models” of corporate governance.

The corporate governance debate

A long-standing debate has raged around which national model of corporate governance is most desirable.
Conventional wisdom on this issue exhibits a strong correlation with the performance of the underlying economy with
which a national model is associated.

For example, at the beginning of the 1990s, Professor Michael Porter of Harvard Business School – along with many
other leading management thinkers - praised the strengths of the German and Japanese business models. Enterprises
in these countries enjoyed a stable ownership structure, and worked in close collaboration with banks and controlling
shareholders. According to Porter, this gave rise to more effective corporate decision-making than observed in the
short-termist Anglo-Saxon business world, particularly in the manufacturing sector.

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However, by the mid-1990s, the US model – with its emphasis on arms-length ownership, powerful management, and
capital market financing – had staged a comeback. The US business environment was seen as offering better
opportunities for new company formation and the application of new technology, particularly in emerging sectors of the
“new economy” such as IT, telecommunications and life sciences. High levels of productivity and employment growth in
the US during the 1990s appeared to substantiate this claim. In contrast, by the 1990s, the German and Japanese
models were no longer delivering much economic growth, and appeared resistant to change and innovation.

Unfortunately, the bursting of the dot-com bubble in 2001 - and a series of high profile scandals at major corporations
(e.g. Enron, WorldCom, Global Crossing) – shattered many illusions concerning the US business framework. It also
catalysed a punitive regulatory response from US legislators (in particular, the Sarbanes-Oxley Act of 2002), that
imposed significant costs on the US economy. Although US corporations continue to dominate many important sectors
of the world economy, the US corporate governance framework is no longer viewed as the “gold standard” that
should be emulated around the world.

The UK model of corporate governance

This brings us to the UK. The current system of corporate governance in the UK has its origins in a series of corporate
scandals in the late-1980s and early-1990s, including the collapse of BCCI bank, Polly Peck, and the Robert Maxwell
pension fund. The UK business community recognised a clear need to improve the robustness of its governance. This
led to the establishment, in 1991, of the Committee on the Financial Aspects of Corporate Governance, chaired by Sir
Adrian Cadbury, which issued a series of recommendations - known as the Cadbury Report – in 1992.

The Cadbury Report addressed a number of issues of corporate governance that were not dealt with in existing
company law - such as the relationship between the chairman and chief executive, the role of non-executive directors,
and the reporting of internal controls – and defined best practice in these areas. The key policy innovation following this
report was to introduce a requirement – within the Listing Rules of the London Stock Exchange - that companies should
report whether they had followed Cadbury’s recommendations, or explain why they had not done so (the so-called
“comply or explain” principle). It was then up to shareholders – not regulators - to determine if this deviation was
appropriate, and subsequently engage with company boards.

The recommendations in the Cadbury Report have been reviewed and refined at regular intervals since 1992. In 1995
the Greenbury Report set out recommendations on the remuneration of directors. In 1998 the Cadbury and Greenbury
reports were brought together and updated in the form of the Combined Code. In 1999 the Turnbull guidance was
issued to provide directors with guidance on how to develop an effective system of internal control.

Following the Enron and WorldCom scandals in the US, the Combined Code was updated (in 2003) to incorporate
recommendations from reports on the role of non-executive directors (the Higgs Report) and the role of the audit
committee (the Smith Report). In the same year, the UK Government announced that the Financial Reporting Council
(FRC) was to assume responsibility for publishing and maintaining the Code. The FRC made further limited changes to
the Code in 2006 and 2008.

The UK approach to “best practice” in corporate governance reflects the belief that the governance should
promote both accountability to shareholders and the board's ability to manage the company effectively. This
fusion of roles is encapsulated in the notion of the unitary board, which is both the “pilot” and the “watchman” of the
company. The benefits of such a dual role were emphasized by the Cadbury Report: "The effectiveness with which
boards discharge their responsibilities determines Britain's competitive position. They must be free to drive their
companies forward, but exercise that freedom within a framework of effective accountability. This is the essence of any
system of good corporate governance".

The key features of UK best practice – as envisaged by the Combined Code, company law, and the Listing Rules - may
be summarised as follows:

• A unitary board with members collectively responsible for leading the company.
• Division of powers at the top of the company. Running the board and running the company are two distinct
roles. The chairman is responsible for running the board. The CEO is responsible for running the company.
• A balance of executive and independent non-executive directors. For larger companies, at least 50% of the
board members should be independent non-executive directors. Smaller companies (e.g. outside the FTSE
350) should have at least two independent directors.
• Formal and transparent procedures for appointing directors, with all appointments ratified by shareholders.
• Regular evaluation of the effectiveness of the board and its committees.
• Formal and transparent procedures for setting executive remuneration, including a remuneration committee
made up of independent directors and an advisory vote for shareholders.
• A significant proportion of executive remuneration linked to performance.

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 • Board responsibility for disclosing a balanced assessment of the company's position (including through the
accounts), and maintaining a sound system of internal control. Formal and transparent procedures for carrying
out these responsibilities, including an audit committee made up of independent directors with the necessary
financial experience.
• A close relationship between the board and shareholders, so that the former understands the latter’s opinions
and concerns.
• Separate resolutions on all substantial issues at general meetings, to allow shareholders to express their
opinions on individual items.

A key aspect of the UK approach is that many of these principles of best practice are not defined by company
law, but arise from the Combined Code. They are, therefore, based on a form of “soft law”, i.e. a non-binding code of
conduct to be monitored and enforced by shareholders. This reflects the view that not all aspects of corporate
governance behaviour should (or can) be defined by the inflexible requirements of formal legislation.
Furthermore, it also acknowledges that there is a strong commonality of interest between companies and
shareholders that should be encouraged by giving shareholders a central role in the enforcement of corporate
governance standards.

A practical advantage of such a soft law approach is that it allows individual companies a degree of flexibility in their
choice of corporate governance processes. Whereas regulators find it difficult to allow exceptions - as they must be
seen to be applying rules consistently - shareholders can be more pragmatic. They can permit deviations from defined
codes of conduct if they are persuaded that they are justifiable in specific instances. Such flexibility is likely to exert a
positive impact on company performance, as governance needs differ from company to company, depending on factors
such as size, ownership structure, and the nature of individual business activities.

However, for the “comply or explain” principle to work effectively, shareholders need to have appropriate and relevant
information. They need to be able to make an informed judgement on a firm’s governance choices. Consequently,
disclosure requirements for information to be made public in periodic reports and accounts are defined by law. These
disclosures include a Business Review (in which the board sets out a narrative description of the principal risks and
uncertainties facing the company), and a report on directors' remuneration, on which shareholders have an advisory
vote.

Shareholders can also – in extreme cases - resort to legally-underpinned shareholder rights (enforceable through the
courts) if more informal negotiations with boards prove inadequate. According to UK company law, shareholders have
comparatively extensive voting rights (e.g. relative to US shareholders), including the right to appoint and dismiss
individual directors and, in certain circumstances, to call an Extraordinary General Meeting. Certain requirements
relating to the AGM, including the provision of information to shareholders and arrangements for voting on resolutions,
are also set out in company law.

This legislative framework is reinforced by the Listing Rules that must be followed by companies listed on the Main
Market of the London Stock Exchange (and which are policed by the Financial Services Authority). The Listing Rules
provide further rights to shareholders (for example, that major transactions must be put to a vote), and require certain
information to be disclosed to the market. They also include the formal requirement to provide a corporate governance
statement in the annual report, explaining how the company has applied the Combined Code. In the case of companies
incorporated abroad – but listed in the UK – the firm must disclose how its domestic governance practices differ from
those set out in the Code.

Hence, the UK emphasis on a voluntary corporate governance code – although representing a lighter
regulatory touch than systems based entirely on “hard law” – is nonetheless underpinned by a certain amount
of carefully-targeted law and regulation. This polices the extreme borders of corporate governance behaviour, and
provides an incentive for boards and shareholders to engage with one another in a constructive dialogue on non-
statutory aspects of corporate governance.

The strength of the UK model: High standards, low costs

The UK corporate governance model is often placed in a similar category to that of the United States, reflecting the
dispersed pattern of ownership in both countries, and a common emphasis on capital market financing. However, this
classification is misleading. Since the Depression years of the 1930s, government regulation has played a central
role in US corporate governance (initially as a means of protecting small private investors, which have historically
formed a major component of US corporate ownership). In contrast, the UK has placed greater reliance on institutional
shareholders to enforce high standards of corporate behaviour. This divergence of approaches has intensified over the
last 10-15 years.

A key strength of the UK approach to corporate governance is its ability to deliver high standards of corporate
governance with relatively low associated costs. The measures outlined by the Combined Code – although

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voluntary in nature – have been successful in driving significant changes in governance behaviour. For example, prior to
1992, very few companies split the role of Chairman and CEO. Today there is a division of roles in 94% of FTSE 350
companies (Grant Thornton 2007). Non-executive directors and board committees have grown in numbers and
influence, and now play a major governance role. The result is that the UK outperforms the US and most other countries
in terms of governance standards. Reports published in 2005 by the FTSE ISS Corporate Governance Index and
Governance Metrics International both put the UK at the top of the list of countries by average corporate governance
score.

Furthermore, compliance costs in the UK are considerable lower than in the United States, particularly since the advent
of the Sarbanes-Oxley Act in 2002. The onerous requirements of Sarbanes-Oxley – particularly those relating to internal
control structures – have given rise to massive implementation costs for US corporations. One estimate – published by
the American Enterprise Institute - quantifies the cumulative cost to the US economy at $1.4 trillion. This has led foreign
companies to avoid New York as a location for a dual listing, and migrate to London and other financial centres. This
contrasts with the situation immediately prior to Sarbanes-Oxley, when New York captured 90% of foreign listings.

The Financial Reporting Council (FRC) undertook its latest review of UK corporate governance in 2007. Its broad
conclusion was that the current UK framework was working reasonably well, and there was no need for major changes.
There were only two relatively minor changes made to the Combined Code in 2008:

• The restrictions on chairing more than one FTSE 100 company were removed.
• The chairman of a listed company outside the FTSE 350 was permitted to be a member of the audit committee,
provided he was regarded as independent on appointment.

Nonetheless, although the UK model is in good shape, it is important not to become complacent. There are a number of
areas which are worthy of renewed attention from policy makers and market participants. The next section considers
eight of these areas, and makes some proposals as to how the operation of the system could be improved.

i) Improving dialogue between shareholders and boards

A constructive dialogue between companies and shareholders is a key component of the UK model of corporate
governance. This sentiment is reflected in the recommendations of the Combined Code. According to the Code, “The
board as a whole has responsibility for ensuring that a satisfactory dialogue with shareholders takes place” (Section 1,
D.1). The Code also states that “institutional shareholders should enter into a dialogue with companies based on the
mutual understanding of objectives” (Section 2, E.1).

The late Jonathan Charkham, a leading authority on corporate governance, once famously described UK institutional
investors as “supine”, reflecting their lack of engagement with the companies that they owned. This issue has been
addressed in recent years by the Myners (2001) and Higgs (2003) reports. In response to this criticism, institutional
investors have made some progress in increasing their active ownership capabilities. Furthermore, UK
board/shareholder relations are generally less confrontational than those in the United States, where hostile activist
campaigners try to impose their will on “imperial” CEOs.

Nonetheless, there is room for significant improvement in the relationship. The assessment of another prominent analyst
of corporate governance is that “the relationship between shareholders and the board is often neglected and often
unsatisfactory” (Sir Geoffrey Owen 2008)2.

An obstacle to dialogue between shareholder/board relations is the relatively small ownership stakes taken by
institutional investors in individual companies (often less than 3%). Furthermore, non-passive institutional money is
typically turned-over on a relatively short-term time horizon (e.g. of 1 year or less). Consequently, the incentive for
individual shareholders to engage with company boards – and vice versa - is often inadequate. The preferred response
of many active investors to disagreements over company strategy is simply to sell the shares, i.e. “exit” rather than
“voice”. As one commentator expresses it, “no-one ever washes a rental car” (Steele 2008)3.

Furthermore, although there are more corporate governance specialists employed by asset management companies,
they tend to interact with companies at a relatively junior level. Such individuals frequently lack the experience or
seniority to develop meaningful relationships with company chairmen or board members. Governance specialists may
also exert little influence on their fund-managing colleagues, which further reduces their credibility as effective
discussion partners for boards. The consequence of this lack of ongoing communication is that board contact with
shareholders tends to be focused on times of crisis. However, by then it may be too late.

2
See Sir Geoffrey Owen’s chapter on The Role of the Board in “The Business Case for Corporate Governance”, edited
by Ken Rushton. Cambridge University Press, 2008.
3
See Murray Steele’s chapter in the same publication.

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One obvious solution to the problem of insufficient dialogue between investors and companies is that institutional
investors could nominate their own non-executive board members (see Sykes 2000). However, this option has not been
embraced by the investment community, as it reduces their flexibility in buying and selling a company’s shares (and
exposes them to insider dealing legislation).

There is arguably a need for a code of responsibilities for institutional investors to match the Combined Code that
relates to companies. Various bodies have produced proposed codes of investment practice. For example, the
Institutional Shareholders Committee published a code in 2002 (updated in 2005) relating to the engagement of
shareholders with the companies that they own. This called on institutions to disclose their engagement policies and
voting records. The International Corporate Governance Network published a code of practice in 2006, which also
addressed the internal governance of institutions in relation to their beneficiaries. As a result of these efforts, more
institutions publish their engagement policies and voting records.

However, these are voluntary codes, and there is no requirement for shareholders to “comply or explain” with them, as
is the case with listed companies. Furthermore, it is still the case that less than 55% of shareholder votes are cast (on
average) at company AGMs, which is not suggestive of an overwhelming degree of shareholder engagement.

Ultimately, a strong dialogue between boards and shareholders is essential for the UK model of corporate
governance. Without it, there is the risk that government will perceive a corporate governance vacuum, and
transfer responsibility for corporate governance enforcement from shareholders to regulators. This would
reduce the flexibility of the UK model, and impose significant additional compliance costs on UK companies.

ii) Retaining the viability of the unitary board

The unitary board is the “central paradox” of the UK approach to corporate governance (Owen 2008). It attempts to
combine a monitoring function – geared to the interests of shareholders – with a strategy-setting and business advisory
role within a single institutional structure. This dual role lends a certain ambiguity to the role of the board. Should the
board see itself as being about management “one step up”, or “shareholder ownership “one step down”?

A commonly expressed view during the 1970s and 1980s was that a German dual board structure – splitting the
supervisory and management functions – was more logical than the unitary board. However, support for this proposal
has declined due to growing evidence of the ineffectiveness of German supervisory boards. In practice, such bodies
suffer from paralysis due to excessive size, poor information flow from the management board, and a lack of cohesion in
membership. In contrast, the unitary board is seen as promoting better cooperation and communication between
executive and non-executive board members.

However, arguably the growth of the corporate governance burden since the 1990s is effectively transforming UK
boards into largely supervisory bodies. The increased presence of non-executive directors and board committees
serves to fragment board composition and function. Ultimately, if the function of the board is just about “policing”, there
is very little rationale for the unitary board.

The effect of greater statutory regulation on board function has been most prominently observed in the US. Since the
passage of the Sarbanes-Oxley Act, the average board meeting has doubled in length, and legal advisers play a much
more significant role in board proceedings. Although the situation is not as bad in the UK, the FRC review of the
Combined Code in 2007 found that 69% of directors believe that “strategic issues do get crowded out from time to time”
by corporate governance concerns, particularly the governance requirements arising from company law.

Consequently, there is a need for extreme caution in introducing any more statutory corporate governance
requirements for directors. A greater regulatory burden will push boards too far in a supervisory direction, and
damage the scope for a unitary board to contribute to business strategy in a meaningful way.

iii) More meaningful implementation of “comply or explain”

The preamble to the Combined Code offers the following advice: “If a company chooses not to comply with one or more
provisions of the Code, it must give shareholders a careful and clear explanation which shareholders should evaluate on
its merits. In providing an explanation, the company should aim to illustrate how its actual practices are consistent with
the principle to which the particular provision relates and contribute to good governance” (paragraph 5).

Only around 10% of FTSE 350 companies are fully compliant with all aspects of the Combined Code. Consequently,
most are required to justify their corporate governance behaviour in their annual reports. However, explanations of non-
compliance should be meaningful. The FRC have argued - in their recent reviews of the functioning of the Combined
Code - that there is a need for more informative explanations of non-compliance in annual reports.

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In addition, companies should not necessarily feel an obligation to comply with all aspects of the code. It may be the
case that advisers put pressure on companies to “play safe” and “comply”. However, a widespread box-ticking
approach undermines the entire “comply or explain” concept, which is about retaining flexibility in corporate
governance behaviour. With that in mind, it has been suggested that the term “apply or explain” should be used in
preference to “comply or explain”, in order to avoid the impression that failure to comply equals non-compliance, i.e.
rule-breaking.

It is also important that shareholders devote adequate time to evaluating the reasons for non-compliance with the
Combined Code. Non-compliance should not necessarily be treated as synonymous with poor governance.
However, the FRC have found evidence of this kind of box-ticking approach amongst shareholders. Such a mentality
also often guides the way in which corporate governance issues are reported by the media. Box-ticking appears to be a
particular problem when investors outsource voting to voting advisory services.

iv) Enhancing the effectiveness of non-executive directors

Non-executive directors are an essential part of the UK corporate governance approach, particularly for companies
which lack substantial shareholder engagement. NEDs now provide over half of board members in large UK public
companies, and dominate board committees. There is evidence that boards are taking more trouble to appoint good
NEDs, and that they are more professional than they used to be, i.e. they do not just consist of “the great and the good”.

However, it is fair to say that NED’s governance role is still a work in progress. NEDs often have insufficient time and
company-specific knowledge to effectively challenge executive management. This has been highlighted during the
current financial crisis. For example, NEDs at Equitable Life and Northern Rock were unable to prevent the collapse of
their respective institutions.

A further issue is the increasing difficulty in recruiting suitably qualified individuals to serve as non-executive chairmen
and directors. This concern was emphasized by company chairmen and investors in their latest consultation responses
to the FRC. The financial rewards for non-executive positions are relatively small. In contrast, the potential risks are
substantial, given that the law does not recognise any formal distinction between executive and non-executive directors.
The reputation and standing of an individual director can now be severely damaged by the actions of other directors on
a board.

Consequently, private equity has become an increasingly attractive alternative for the prospective talent pool, with
greater rewards and less public exposure. Recruitment of the chairman of the audit committee of public companies is
proving a particular problem in the current environment, as the incumbent must have “recent and significant” experience
of finance, which limits the number of people that can serve in the role. According to the latest FRC consultation, 30% of
FTSE 350 companies are experiencing difficulties in hiring suitable candidates for audit committees.

In recognition of the difficulties facing NEDs, the Higgs report (2003) argued for a big increase in NED training.
However, this has only occurred to a limited extent (Steele 2008: 62). It is now essential to renew the focus on board
training, so that NEDs can improve their effectiveness and manage their risks. Board membership is a distinct
role, which requires knowledge and skills that differ from those of an operational manager. Professional
development programmes – such as the IoD’s Chartered Director designation – have an important role to play
in this process, and ideally should be mentioned explicitly in the Combined Code framework.

v) Clarifying the distinctive governance needs of smaller companies

During the consultation for the Higgs Review, small firms indicated that they did not wish to be considered second class
citizens in terms of governance. They wanted to operate in broadly the same manner as larger companies, albeit with a
greater degree of flexibility in certain areas. Consequently, there were some concessions in the Combined Code for
smaller firms, e.g. fewer numbers of NEDs are required than in larger companies.

According to the FRC, smaller companies are increasingly adopting the provisions of the Combined Code, despite not
being subject to the “comply or explain” requirements of the LSE’s Listing Rules. Although the costs of implementing the
Combined Code are proportionately higher, SMEs often see Code compliance as a way of inspiring confidence in their
operations with other stakeholders, or possibly with an eye to a future listing. In addition, smaller firms do not often have
the resources to develop their own corporate governance template. They need an “off-the-shelf” solution, and see the
Combined Code as providing such a solution.

However, the governance of SMEs is not subject to the same sort of dialogue with institutional investors as is the case
with larger companies. There is a danger that the Combined Code becomes a checklist of rules to be complied with,
rather than the starting point for a discussion of the most appropriate governance structure for individual enterprises.
Consequently, although the UK governance framework – centred on the Combined Code and “comply or

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explain” – may be positive for larger companies, it may unwittingly lead to an excessive governance burden for
smaller companies.

An alternative approach would be to develop an alternative code of best practice for smaller companies. The Quoted
Companies Alliance (QCA) has already produced an alternative code of best practice for AIM-listed companies. Also, in
March 2007 the National Association of Pension Funds (NAPF) produced a policy document in respect of AIM corporate
governance.

It is, therefore, an appropriate moment to reconsider if smaller companies – particularly unlisted enterprises –
would benefit from their own corporate governance code, rather than feeling an obligation to implement the
Combined Code.

vi) Meeting the challenge of a changing ownership structure

The current UK model of corporate governance depends on at least some shareholders behaving like owners. However,
it is ironic that, just at the moment when UK institutional investors are attempting to become more engaged with
companies, their influence in terms of corporate ownership is declining. Whereas the UK institutions owned well over
50% of UK equities in the early-1990s (at the time of the Cadbury Report), this share is now down to less than a third.
Hedge funds and, in particular, foreign investors have substantially increased their share of UK corporate ownership.

The uncertainty of this new ownership structure is that the new investors may not share the corporate governance
perspectives of traditional UK institutional investors. Consequently, it may be harder for boards and shareholders to
establish relationships. This poses risks for the UK model of corporate governance, which relies on shareholders to
monitor and enforce corporate governance standards (in partnership with boards).

However, a change in the composition of corporate ownership need not necessarily disrupt the effective functioning of
the UK model. The content of corporate governance codes can be adapted over time to reflect the new priorities of
owners. Indeed, one of the advantages of voluntary codes is their greater flexibility in adjusting to changing governance
perspectives in comparison with formal company law.

However, a more substantive problem arises if the new owners are simply not interested in engaging with companies
over governance. Alternatively, they may seek to use their ownership stakes in the pursuit of non-economic objectives
(e.g. as an instrument of the foreign policy of their controlling governments). These are the main concerns relating to the
growing role of sovereign wealth funds in corporate ownership.

The success of the UK model is based on the consent and participation of shareholders. If that is no longer
present, it could encourage a shift towards a more legislative approach, e.g. where EU and national policy
makers decide that “comply or explain” is no longer viable, and increasingly hand-over governance
enforcement to SEC-style regulators.

vii) Formulating a proportionate approach to corporate social responsibility

Corporate social responsibility (CSR) is a valid part of any corporate governance framework, given its relevance for
reputational risk management. In 2002, the Association of British Insurers called on boards to disclose their evaluation
of social, ethical, and environmental risk. Increasing numbers of firms have started to do this. Furthermore, in 2004, the
UK government introduced legislation requiring an operating and financial review, which would have included disclosure
with respect to environmental and social issues. This proposal was subsequently withdrawn (on grounds of cost).
However, since 2005, it has anyway been necessary for companies to report on non-financial issues within a Business
Review in the annual report. This was a requirement of the EU Accounts Modernisation Directive (2003) which was
implemented through the Companies Act 2006.

In the run up to the Companies Act 2006, there was significant parliamentary debate about whether directors should
formally be required to take a stakeholder approach to running the company. In the end, the primacy of shareholders
continued to be recognised, albeit in the context of the objective of “enlightened shareholder value”. The meaning of
enlightened shareholder value was clarified by including a number of CSR-type considerations in the Act’s definition of
how directors should promote the success of the company. There are now calls to go beyond this, and introduce CSR
responsibilities into the Combined Code.

However, although it is reasonable that companies should be seen to be behaving as responsible corporate
citizens, it is important that companies should retain some flexibility over their CSR activities. One of the factors
underpinning the efficiency of private enterprise is the clarity of its primary objective: the creation of long-term
shareholder value. Consequently, it is important that companies are not used – under the banner of CSR – as a means

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of implementing various aspects of social policy. Regardless of political orientation, social policy objectives are better
achieved through direct government action rather than by distorting company behaviour.

Ultimately, it is the wealth generating capabilities of companies that provide the means to achieve wider-social
objectives. It is not in anyone’s interests that this is compromised by the imposition of a rigid CSR agenda.

viii) Retaining flexibility in executive remuneration

Executive remuneration is unfortunately the aspect of corporate governance with the greatest ability to sustain a high
level of visibility in the popular media.

A significant reform in the governance of remuneration in the UK was the advent of the Directors Report in 2002. This
introduced a legislative requirement to publish details of executive remuneration in annual reports, and allowed
shareholders an advisory vote on the issue. It was believed at the time that this would engender significant engagement
between boards and shareholders over remuneration. However, this has not occurred to the anticipated extent.

The UK business community has responded in recent years to public disquiet over executive remuneration with a range
of voluntary actions. This approach has worked well in many respects. There have been significant changes in respect
of director’s service contracts, which are nowadays rarely longer than one year. UK companies have also made more
sensible use of share options and severance pay than in the US. The latter is nowadays often paid in instalments, and
terminates when the executive commences a new position.

Nonetheless, the current turmoil in the financial sector has once again raised the spectre of the executive remuneration
issue. Highly rewarded bankers are blamed by the media for the adoption of excessively risky and short-termist trading
strategies. This is stoking the public appetite for measures that control executive pay.

However, there is no automatic link between the current financial crisis and remuneration levels in banking. The recent
problems experienced by UK financial institutions have, so far, largely arisen due to the freezing-up of wholesale
funding markets, on which the business models of certain UK banks (e.g. Northern Rock, HBOS, Alliance and Leicester,
Bradford and Bingly) had grown highly dependent. The link between remuneration and these problems is tenuous.

A UK policy response to the current crisis would be better focused on areas such as the adequacy of banks’ capital
requirements, the introduction of a special resolution regime for failing banks, improved monitoring of bank’s liquidity
management, better regulation of the rating agencies, and more rigorous stress testing of bank’s business models.
Ideally reforms should be coordinated on a global basis in order to ensure that changes do not impact on the
international competitiveness of London as a financial centre.

In contrast, any attempt by regulators to micromanage remuneration structures will be counterproductive. Such
measures will not address the underlying causes of financial sector instability. Furthermore, they will have the
negative effects of undermining UK competitiveness and distorting the allocation of resources within
enterprises.

It is, however, entirely appropriate for shareholders to increase their engagement with companies over remuneration. If
necessary, they should make more effective use of their voting rights if they believe that levels of director remuneration
are not consistent with long-term value generation. Shareholder voting on director’s pay is an important safeguard within
the UK model of corporate governance which is not present in the United States. Arguably, the US corporate
governance framework would benefit from the granting of similar voting rights to US shareholders

Conclusion: Corporate governance and the financial crisis

The credit crunch – and the resulting crisis amongst leading financial institutions – is increasingly presented as a crisis
of corporate governance. However, although current problems are indicative of shortcomings in the global
financial architecture, they should not be interpreted as reflecting dysfunction in the broader UK corporate
governance model. Consequently, it is essential that UK policy makers focus their response to the crisis on the
underlying source of the problem: the financial regulatory framework (both in the UK and globally). They should resist
populist calls for more general corporate governance reform.

The main corporate governance alternative to the UK model is the US model. The latter places a much greater
emphasis on company law, state regulation, and state enforcement. Critics of the UK’s light regulatory touch often
suggest that emulation of the more “robust” US approach would improve corporate governance standards, and thereby
reduce the risk of systemic economic crisis in the future. However, it is worth remembering that the United States is
the primary source of the current financial crisis. The Sarbanes-Oxley Act – with all of its statutory requirements for
rigorous internal controls – has not prevented the collapse of many of the leading names of US banking and finance.

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This suggests that a highly regulated approach to corporate governance is not a sure fire means of avoiding economic
instability.

The more reasoned consensus amongst most directors, shareholders, and academics is that the UK model of corporate
governance has reached a state in which it is broadly “fit for purpose”. It has attained a good balance between hard law
and self-regulation. And it has found a way to promote good governance standards without stifling the wealth-generation
process of entrepreneurs and innovators. For this reason, the UK model is increasingly used as a template for corporate
governance reform in other countries. This is particularly the case in the EU, where 26 out of 27 Member States have
adopted UK-style corporate governance codes during the last few years.

However, notwithstanding this vote of confidence, there is little appetite amongst directors for further significant change
at the current time. A number of major pieces of legislation relating to corporate governance have been introduced in
recent years, including the Companies Act 2006, the Corporate Manslaughter and Homicide Act 2007, and a large
number of European Directives. Company directors are still coming to terms with this legislation. Furthermore, there
remains significant scope for improvement in terms of the implementation of the Combined Code, both by directors and
shareholders. Consequently, the main emphasis during the next few years should be on improving the practical
application of the existing corporate governance framework, not on introducing major new corporate
governance initiatives.

Good corporate governance is a delicate balancing act between “too little and “too much”. The broadly favourable
position that has been achieved in the UK could be easily upset. The challenge for the future is to ensure that the UK
model of corporate governance remains an asset rather than a liability for the UK business community.

3 October 2008.

Dr Roger Barker
Head of Corporate Governance
Institute of Directors, 116 Pall Mall, London SW1Y 5ED
Tel: +44 (0)20 7451 3344
Email: roger.barker@iod.com
Website: www.iod.com/policy

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