Until the twenthieth century the separation of ownership and control in companies was not a major issue in company law. Increasingly with the growth of corporate activity it was identified as problematic (see e.g. The Modern Corporation and Private Property (1932) by Adolf A. Berle and Gardner C. Means). Shareholdings were often diffuse and directors exercised massive economic muscle.
In response to the increasing tendency for economic power to be vested in the boards of directors of public companies, company law took account of newly identified interests and new forms of governance emerged.
Corporate governance developments in the United Kingdom are of relatively recent date. As has been seen in company law in the UK, the interests of shareholders have generally predominated until the first statutory intervention in the Companies Act 1980, to broaden the duties of directors to include a duty to employees.
Increasingly, however, it has been recognised that other stakeholders have an interest in the governance of companies. Particular concern was attached to larger companies and specifically to listed companies. Companies’ scandals at the end of the last century such as BCCI, Polly Peck and Maxwell heightened concerns.
Current thinking on corporate governance recognises a corporation’s obligations to society generally in the form of stakeholders. Corporate governance is concerned with issues such as:
the effectiveness of a company’s operations;
the reliability of a company’s financial reporting compliance with laws and regulations; and
the safeguarding of corporate assets.
Corporate governance has recently become increasingly focused on corporate failures, auditor independence, excessive remuneration for directors and other executives, ineffective non-executive directors, and the representation of large investors in public companies.
The origins of the corporate governance debate are in the need to respond to the problems that are caused by the separation of ownership and control in companies dating back to the formation of joint stock companies in the middle of the nineteenth century. Then, as now, the owners of companies were not necessarily involved in day-to-day operational matters. That is why shareholders were originally centre stage in the corporate governance debate. Now, however, as noted, it is recognised that a corporation’s obligations run more widely to society generally in the form of stakeholders.
It is widely recognised in the United Kingdom that a large number of financial failures have been caused by breakdowns in internal control. This is true also in the United States. The Tredway Commission in the USA found that in nearly 50 per cent of cases of corporate breakdown, fraudulent financial reporting was a contributory issue.
The Committee on the Financial Aspects of Corporate Governance (the Cadbury Committee) published its final report in December 1992. This report contained a Code of Practice which aimed at achieving the very highest standards of corporate behaviour.
The Committee was set up in May 1991 by the Financial Reporting Council, the London Stock Exchange and the accountancy profession. It adopted as its terms of reference: to consider the following in relation to financial issues arising from financial reporting and accountability, and to make recommendations on good practice:
(a) the responsibilities of executive and non-executive directors for reviewing and reporting on performance to shareholders and other financially interested parties, and the frequency, clarity and form in which information should be provided;
(b) the case for audit committees of the board, including their composition and role;
(c) the principal responsibilities of auditors and the extent and value of the audit;
(d) the links between shareholders, boards and auditors; and
(e) any other relevant matters.
The Cadbury Report in December 1992 attracted considerable attention. The concern about financial reporting and accountability was no doubt heightened by the then recent company scandals.
The Committee’s recommendations are for the most part centred upon the control and reporting functions of boards and the role of auditors. This reflects the Committee’s main aim, which was to review those aspects of corporate governance related to financial reporting and accountability.
At the core of the Committee’s recommendations was a Code of Best Practice which was designed to achieve the necessary high standards of corporate behaviour. The London Stock Exchange required all listed companies registered in the United Kingdom, as a continuing obligation of listing, to state whether they were complying with the Code and to give reasons for any points of non-compliance.
The Code was thus directed to listed companies. The principles upon which the code was based were principles of openness, integrity and accountability.
Many of the key recommendations of the Committee were incorporated into the code. Some of the key recommendations were as follows:
(a) There should be a clearly defined split of responsibilities at the head of a company to ensure a balance of power and authority between executive and independent non-executive directors.
(b) There should be a schedule of matters specifically reserved for board decision so that it is clear that the company’s control and direction are firmly in its hands.
(c) There should be an agreed procedure for directors in the furtherance of their duties to take independent professional advice if necessary, at the company’s expense.
(d) Ideally, the posts of Chairman and Chief Executive should be kept separate.
(e) Executive directors’ service contracts should not exceed three years.
(f) Executive directors’ pay should be subject to the recommendations of a remuneration committee made up wholly or mainly of non-executive directors.
(g) Non-executive directors should be appointed for specified terms and reappointment should not be automatic.
(i) The board should establish an audit committee of at least three non-executive directors with written terms of reference.
(j) The directors should report on the effectiveness of the company’s internal controls.
(k) There should be full disclosure of fees paid to audit firms for non audit work.
Various criticisms were made of the Cadbury Committee report. Some people criticised the lack of statutory teeth. This criticism was rejected by Sir Adrian Cadbury, who felt that the report had given companies a checklist and shareholders an agenda to improve the effectiveness of corporate governance in Britain. Yet some of the recommendations did not ‘go the whole hog’. Thus, the report urged, generally, there should be a split of the Chairmanship and post of Chief Executive between different people.
Another criticism that was levelled at the Cadbury report was that it failed to address itself to long-term solutions encouraging long-term incentives for management and a long-term view of the investment by investment institutions, despite its statement in the opening paragraph of the report: ‘The country’s economy depends on the drive and efficiency of its companies.’
The governance of companies remained a favourite topic of debate. Following the Cadbury Committee report, a further committee was set up by the CBI under the Chairmanship of Sir Richard Greenbury. The aim of this committee was to consider issues relating to directors’ remuneration and emoluments. The committee’s report, which was published in 1995, once again set out a Code of Best Practice. This Code was annexed to the listing rules and every listed company had to state, in its annual report and accounts, whether it had secured compliance with the Code. If it had failed to comply with the Code, it must explain why this was so.
Basically, the Code requires that directors of a listed company should establish a remuneration committee made up of non-executive directors to determine policy on remuneration packages for executive directors. The remuneration committee should have access to independent professional advice and the committee chairman, or alternatively another member of the committee, should attend the company’s AGM to be available to answer questions on remuneration.
A further committee on corporate governance, this time under the Chairmanship of Sir Ronald Hampel, was set up in November 1995. This was at the behest of the Financial Reporting Council.
(a) to review the Cadbury Code and its implementation to ensure that its purposes were being achieved and to suggest amendments to the code as necessary;
(b) to review the role of directors;
(c) to pursue any relevant matters arising from the report of the Greenbury Committee;
(d) to address, as necessary, the role of shareholders and auditors in corporate governance issues; and
(e) to deal with any other relevant matters.
The Hampel Committee published its preliminary report on 5 August 1997. The Committee:
(a) rejected the principle of stakeholder democracy and a two-tier board system;
(b) rejected the government’s idea for a standing panel on governance;
(c) asserted that companies are more concerned with accountability than business prosperity – the Committee indicated that it wanted to see this imbalance corrected;
(d) proposed a set of general principles rather than a detailed corporate governance blueprint and rejected what it termed the ‘tick-box’ attitude to compliance pursued by Cadbury and Greenbury; and
(e) stated that companies should include a statement in the annual report on compliance with broad corporate governance principles.
Following consultation, the Committee resisted pressure from the government to ‘beef up’ its proposals.
Sir Ronald Hampel, Chairman of the Committee and Chairman of ICI, indicated that the Committee had stuck to the fundamental principle of corporate prosperity before accountability.
Some criticisms have been made that the report dilutes the Cadbury guidelines in that, for example, it concludes that companies need not separate the roles of Chairman and Chief Executive, although this goes against a key principle of the Cadbury guidelines.
The Hampel Committee report (1998) considered that, in the debate on corporate governance, too much stress had been laid on accountability and not enough on business prosperity.
The report urged that companies should include in their annual report a description of how corporate governance is being applied in relation to their business. The Hampel Committee produced a set of principles and a Code which comprehends the work of the Cadbury, Greenbury and Hampel Committees – the Combined Code.
Companies should have a Nomination Committee to make recommendations for appointments to the board. Remuneration Committees should be made up of independent directors to consider remuneration packages and their application. Institutional investors are said to have a responsibility to use their vote sensibly and the key role of shareholders at the AGM is acknowledged.
The final Hampel report contained a proposal that each Board should have a lead non-executive director. He would be a focal point of contact for shareholders.
Some critics (for example, C.A. Riley in ‘Whither UK corporate governance?’, Amicus Curiae, October 1997) argue that the approach to corporate governance raises a deeper and more troubling problem. This is that the debate on corporate governance has been semi-privatised and carried out through the medium of relatively small and unrepresentative committees championing a narrow range of interests.
The Secretary of State announced that she did not intend to legislate on the Hampel recommendations, but preferred that they should be established by best practice:
There are those who would say the government has a responsibility to legislate for good corporate governance. However, while the legal system can be used to enforce aspects of best practice, I believe that the very best will adopt even better practice because they see its value, and will do so more readily of their own accord than if it is forced on them. That is why I would prefer to see many of the recommendations … embodied in good practice rather than enshrined in legislation.
The Turnbull Committee was set up by the Institute of Chartered Accountants in England and Wales. The report of the committee – Internal Control: Guidance for Directors on the Combined Code – was published in 1999 and sets out how directors of listed companies should comply with the UK’s Combined Code requirements in respect of internal controls. The guidance was supported and endorsed by the London Stock Exchange.
In April 2002, the Secretary of State for Trade and Industry and the Chancellor of the Exchequer appointed Derek Higgs to lead a short independent review of the role and effectiveness of non-executive directors. Derek Higgs published his report in January 2003.
The Higgs Report considered the position of non-executive directors. Among its recommendations were the need for a fuller discussion of the role and responsibilities of non-executives, a requirement to disclose attendance at board meetings, the need for the provision of training, and the need for non-executives to meet major investors as part of their induction and for the senior independent director to meet shareholders regularly.
The Smith Review, chaired by Sir Robert Smith and set up by the Financial Reporting Council, considered the guidance for audit committees. The Smith Report was published in January 2003. The committee recognised that the main role and responsibility of audit committees should be to monitor the integrity of the company’s financial statements and to review its internal financial controls.
The audit committee should be given written terms of reference by the board of directors tailored to the particular circumstances of the company. It should review annually its terms of reference and its effectiveness, and recommend any necessary changes to the board.