As if we needed reminding that things are different on either side of the Atlantic, two recent corporate governance events—one in the United States and one in the United Kingdom—demonstrate this starkly.
In the United Kingdom, the Business, Energy and Strategy (BEIS) Committee has recommended that the U.K. Corporate Governance Code be rewritten so that the Financial Reporting Council (FRC) can take enforcement action against non-executive directors. In contrast, the U.S. House Financial Services Committee has just passed the Financial CHOICE Act, also known as the “Death of Dodd-Frank,” which seeks to claw back the enforcement activities of the SEC.
The BEIS Committee is recommending that the FRC be given additional enforcement powers, because currently, as its report says, the laws under the Companies Act 2006 Section 172 are: “not realistically enforceable by shareholders in the courts, even if they were minded to take action against their own company directors.”
But if the FRC were really to go after independent, non-executive directors (NEDs), there is a potential danger that the candidate pool will disappear. On the other hand, the threat of actual prosecution should they miss something—like the recent scandals at Tesco and Rolls-Royce—might actually make them do their oversight job properly. The balance of threat, however, will be a difficult one to achieve.
There have been great changes in board structures in the United Kingdom; there are now no longer numbers of executive directors on the board, though boards typically still include the Finance Director and the Company Secretary. This is the case at both Tesco and Rolls-Royce. Sarah Wilson, CEO of Manifest, commented: “Most boards of large cap companies only have [non-executive directors] who may or may not be independent, but there's a worrying lack of attention paid to the chairman’s role, I think; his/her job to set the agenda and ensure board effectiveness, evaluation etc.” Chairmen, of course, in the United Kingdom are almost universally independent.
Not so in the United States. So, let us look at some U.S. boards that have recently been engulfed in scandal. None of them are typical. At Wells Fargo, for example, the chairman is independent, though during the bank’s recent accounts scandal the CEO and chairman positions were combined under former CEO John Stumpf. At 21st Century Fox, there are four executives on the board, and most of them have the surname Murdoch. Finally, at Mylan Laboratories, there are three executives on the board including the CEO. Nevertheless, all of these boards, like the British boards, have a majority of non-executive directors.
“Too often in the wake of corporate failures we discover that directors, especially non-executives, have failed to provide sufficient challenge. Too often these individuals seem to be drawn from the same cosy club.”
Iain Wright MP, Chair, BEIS Committee
But what about enforcement? At Wells Fargo, the bank was the object of prosecutions by both the SEC and the Department of Justice. In addition, the bank has been hit with multiple lawsuits from customers and class actions from shareholders. But so far, no Wells Fargo director has suffered, even while some executives have been forced to repay part of their remuneration. Indeed, Wells’ directors were careful to exonerate themselves in a supposedly independent inquiry. Even if the class action lawsuits are successful, they might suffer reputational harm, but are unlikely to lose money. According to Matt Patsky, CEO of Trillium Asset Management, “I can’t understand why any of the executives, never mind the directors, are still walking the streets.” At Fox, the company is the object of employee and former employee lawsuits, though a federal inquiry has recently started. And at Mylan, multiple class-action lawsuits.
As Joe Mont pointed out in a recent editorial, the people who lose out the most here are shareholders. They might receive some money back to defray their losses through a successful class-action lawsuit, but end up paying the fines for the guilty parties in other prosecutions. According to Wilson: “Shareholders in the U.S. have weak rights, that are getting weaker by the day given the so-called CHOICE Act. But the problem is the SEC and the exchanges have too many powers. If you compare and contrast the U.S. and the U.K., the differences are institutional.”
In the United Kingdom? We are not such a litigious nation. Provided directors act “in good faith” or it could not be proved that they did not, according to evidence to the BEIS Committee from Professor Andrew Keay of Leeds University School of Law, “it would not be easy for the courts to question the motives of directors and noted that the courts have been cautious in granting shareholders permission to take action against a company.” The committee heard, for example, that there have been no reported cases of shareholders bringing actions against directors.
“We have a misalignment between all the parties in the system. Yes, we have very good laws and the U.K. Companies Act and Governance Code is something to be very proud of. But I am not in favour of new law; I want the existing ones to be enforced correctly.”
Sarah Wilson, Chief Executive, Manifest
The Committee illustrated this point further by the finding in 2016 by the Grocery Code Adjudicator that Tesco had breached a best practice code governing the grocery market by deliberately delaying payments to boost its profits. This might also have been seen to be a breach of Section 172(c), the duty to “have regard to the need to foster the company’s business relationships with suppliers, customers and others.” Yet no director was prosecuted.
The Committee’s attitude to regulation is sometimes difficult to pin down. On the one hand, the committee says that greater regulation would shift the culture towards a rules-based, compliance one, “encouraging a tick-box mentality, rather than seeking to embed high standards and cultural change across the board as a self-evidently desirable objective for companies.” Wilson agrees: “The FRC is better placed than the BEIS to be a company law regulator.” But while it eschews regulation on the one hand, one of its main recommendations is that the government bring forward legislation to give the FRC the additional powers it needs to hold NEDs accountable for their duties.
It seems that the Committee is recommending that this be accomplished through engagement in the first place, then, if this is unsuccessful, it recommends the FRC should report publicly to shareholders on failed boards or failed individual NEDs. If neither of these actions work, then the next step will be for the FRC to take legal action over a breach of Section 172 duties. Said the Committee: “Given the broader powers we have recommended in this Report, the Government should consider re-establishing, renaming and resourcing appropriately the FRC to better reflect its expanded remit and powers.”
However, at the same time as recommending that new powers be given to the FRC—which at the moment can only prosecute auditors and accountants—the Committee notes that there are already tools available to prosecute directors. Under the Companies Act 1985, the Secretary of State “has a range of powers to send in inspectors to investigate the affairs of a company, where for example, the circumstances suggest grounds for suspicion of fraud, misconduct, conduct unfairly prejudicial to shareholders or of failure to supply shareholders with information they may reasonably expect.” In addition, apparently, a specified percentage of shareholders can request that inspectors be sent in to investigate the “membership of any company in order to determine for certain those financially interested in the success or failure of a company or able to control it.”
Below is an excerpt from Section 172 of the Companies Act 2006, Duty to promote the success of the company.
1. A director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole, and in doing so have regard (amongst other matters) to—
the likely consequences of any decision in the long term,
the interests of the company’s employees,
the need to foster the company’s business relationships with suppliers, customers and others,
the impact of the company’s operations on the community and the environment,
the desirability of the company maintaining a reputation for high standards of business conduct, and
the need to act fairly as between members of the company.
2.Where or to the extent that the purposes of the company consist of or include purposes other than the benefit of its members, subsection (1) has effect as if the reference to promoting the success of the company for the benefit of its members were to achieving those purposes.
3.The duty imposed by this section has effect subject to any enactment or rule of law requiring directors, in certain circumstances, to consider or act in the interests of creditors of the company.
Source: Companies Act 2006
The Companies Act powers were used by the Insolvency Services, for example, in their ongoing inquiry into BHS. The Committee urges, in the report, that the Secretary of State be more prepared to use existing powers. “A public statement by Ministers to the effect of being considerably more pro-active in this area,” said the Committee, “may also have a welcome deterrent effect.”
This appears to be a bit of a double whammy. The FRC is to be given powers to take legal action against NEDs, and the Secretary of State is also being encouraged to prosecute directors where they have been derelict in their duties. Surely one or the other would be sufficient.
As Mont says in his piece, NEDs should be the real enforcers, clamping down on management misbehaviour, ruthlessly seeking out misdemeanours. A properly diverse and independent board should be sufficient to oversee management effectively. Except that, on paper, Wells Fargo’s board is one of the most diverse and independent boards in the S&P 500. Similarly, Rolls-Royce’s board is diverse and independent. Maybe with a management determined to misbehave, it doesn’t matter how independent and diverse a board is, it is still too easy to hide wrongdoing from an NEDs inquisitive gaze.
In a class-action lawsuit, there is a stage called “discovery” where companies are forced to disclose to prosecution lawyers and their clients any and all documents relevant to the suit. Rather than the threat of prosecution for themselves, perhaps that’s what NEDs need: discovery.