FRC: U.K. corporate culture needs serious work

If one was to assess the conduct of U.K. companies based on the number of fines, sanctions, and successful prosecutions and convictions for fraud and malpractice over the past 10 years, then one might be forgiven for thinking that all is well. Yet the conspicuous lack of corporate scalps and jailed executives belies the fact that the state of corporate governance is not as it should be and that boards have a lot to answer for this state of affairs.

On 20 July the United Kingdom’s corporate governance regulator, the Financial Reporting Council (FRC), released its “report of observations” on the relationship between corporate culture and long-term business success, called Corporate Culture and the Role of Boards.

Based on interviews with 23 FTSE CEOs and 58 FTSE chairmen, the report shows how some major U.K. companies are addressing culture in their organizations, with the hope of prompting those companies that are not already tackling the issue to do so.

The report discusses how boards—whose role, it says, is “to determine the purpose of the company and ensure that the company’s values, strategy, and business model are aligned to it”—can influence and shape culture, how they can put those values into practice, and how they can oversee, monitor, and assess behaviour in their organizations.

Highlighting areas that the regulator deems to be best practice, the report found that companies should recognise the value of culture as “a valuable asset, a source of competitive advantage, and vital to the creation and protection of long-term value.” It also found that it is important that companies demonstrate leadership (particularly from the CEO) in setting the tone of the organization’s culture, and that companies should foster a climate of being open and accountable. Furthermore, key functions such as human resources, internal audit, ethics, compliance, and risk management should be empowered and resourced to embed values and assess culture effectively. “Their voice in the boardroom should be strengthened,” says the FRC.

“[I]t is operational managers who will have the most direct influence on the actions of departments and employees because they are the ones who will have a better appreciation of how work is carried out, as well as how managers incentivise, reward, and chastise employees for their conduct.”

Ian Peters, CEO, Chartered Institute of Internal Auditors

The report also says that companies should use indicators to assess and measure engagement with culture, while they should also “devote sufficient resource to evaluating culture and consider how they report on it.” Furthermore, incentives should be aligned to the company’s purpose, values, strategy, and business model, while “effective stewardship should include engagement about culture and encourage better reporting.” Outside of the boardroom, investors should also challenge themselves about the behaviours they are encouraging in companies and to reflect on their own culture, says the FRC, referring to the Stewardship Code it launched in 2010.

Middle management are also singled out for the positive role they can play in ensuring that the tone set by the executives is cascaded down throughout the organization. It is an observation that many commentators agree with. Ian Peters, CEO at the Chartered Institute of Internal Auditors in the United Kingdom, which—along with the Institute of Business Ethics (IBE), the Chartered Institute of Management Accountants (CIMA), the Chartered Institute of Personnel and Development (CIPD), and the City Values Forum—is a member of the FRC’s so-called “culture coalition,” says while it is crucial that executives take the lead and set the tone from the top, he adds that middle management is largely responsible for "ensuring that employees understand and follow the organization's expectations of its culture on a day-to-day basis.”

“No change programme within the organization is going to happen without the approval, support, and allocation of resources by the board,” says Peters. “But it is operational managers who will have the most direct influence on the actions of departments and employees because they are the ones who will have a better appreciation of how work is carried out, as well as how managers incentivise, reward, and chastise employees for their conduct."

Currently, the regulator is not seeking to force companies to assess their culture—it is just encouraging more organizations to do so. Speaking at the report’s launch, Sir Win Bischoff, FRC chairman, said that “our aim is to deliver practical, market-led observations—not changes to the U.K. Corporate Governance Code.” The FRC hopes to gather feedback on the report and use it to inform a planned review next year—but not necessarily a revision—of its Guidance on Board Effectiveness issued in 2011.

KEY OBSERVATIONS

Below are key observations from the FRC on promoting coporate culture.
From our discussions with chairmen, chief executives, investors and a broad range of stakeholders and professional organisations we make the following observations about corporate culture:
Recognize the Value of Culture
A healthy corporate culture is a valuable asset, a source of competitive advantage and vital to the creation and protection of long-term value. It is the board’s role to determine the purpose of the company and ensure that the company’s values, strategy and business model are aligned to it. Directors should not wait for a crisis before they focus on company culture.
Demonstrate Leadership
Leaders, in particular the chief executive, must embody the desired culture, embedding this at all levels and in every aspect of the business. Boards have a responsibility to act where leaders do not deliver.
Be Open and Accountable
Openness and accountability matter at every level. Good governance means a focus on how this takes place throughout the company and those who act on its behalf. It should be demonstrated in the way the company conducts business and engages with and reports to stakeholders. This involves respecting a wide range of stakeholder interests.
Embed and Integrate
The values of the company need to inform the behaviours which are expected of all employees and suppliers. Human resources, internal audit, ethics, compliance, and risk functions should be empowered and resourced to embed values and assess culture effectively. Their voice in the boardroom should be strengthened.
Align Values and Incentives
The performance management and reward system should support and encourage behaviours consistent with the company’s purpose, values, strategy and business model. The board is responsible for explaining this alignment clearly to shareholders, employees and other stakeholders.
Assess, Measure, and Engage
Indicators and measures used should be aligned to desired outcomes and material to the business. The board has a responsibility to understand behaviour throughout the company and to challenge where they find misalignment with values or need better information. Boards should devote sufficient resource to evaluating culture and consider how they report on it.
Exercise Stewardship
Effective stewardship should include engagement about culture and encourage better reporting. Investors should challenge themselves about the behaviours they are encouraging in companies and to reflect on their own culture.
Source: Financial Reporting Council

The FRC’s report is not meant to say anything new necessarily. But, according to Philippa Foster Back, director at the IBE and a member of the FRC’s steering group on culture, “it is meant to make those executives who are not already addressing culture in their organizations do so by highlighting instances of best practice and showing what other companies are doing. As a result, the report is a useful contribution to that process.”

And it’s not as if companies don’t need the advice. Professional services firm EY’s 14th Global Fraud Survey 2016 of nearly 3,000 senior business leaders found that 42 percent of respondents admitted that they could justify unethical behaviour to meet financial targets, while 16 percent of finance team members below the CFO are ready to justify making a cash payment to win or retain business. Some 7 percent of finance team members would misstate financial performance.

Meanwhile, a global study released this year by international law firm Hogan Lovells into bribery and corruption risk, called Steering the Course, has found that 43 percent of CEOs are not prepared to walk away from a contract with high bribery and corruption risk. The report, based on interviews with more than 600 chief compliance officers (CCOs) and heads of legal of companies with revenues of over $350 million, found that the two biggest issues facing compliance teams are aligning the “tone at the top” with anti-corruption policies and business practice and implementing compliance programs on a worldwide basis because cultural differences contribute to a lack of support for ABC programs globally.

While few would disagree that auditing and reporting on business culture is a welcome move to try to improve transparency and corporate governance, there is little evidence that it is working as well as hoped, despite the encomiums from the heavy-hitter CEOs and chairmen featured in the report.

For example, Sir Martin Sorrell, chief executive of advertising company WPP, is quoted as saying that “the focus on long-term performance is critical and reduces the risks of short-term, inappropriate behaviour. Poor short-term behaviour and performance gets found out in the longer-term,” while Roberto Quarta, chairman of medical equipment group Smith & Nephew (as well as WPP), says that “leading by example is about ensuring boardroom behaviour is exemplary and in line with the values, ethics, and integrity.”

However, both companies have come under fire this year for their remuneration policies: 50 percent of investors voted against pay deals at the Smith & Nephew, while 33 percent gave a thumbs-down to Sorrell’s £70m (U.S.$91m) package.

Meanwhile, John Allan, chairman of supermarket chain Tesco, is quoted as saying that “it’s a challenge to influence the culture—it takes a lot of time and effort to change it.” It certainly appears so, given Tesco’s recent track record with regulators: in 2014 the company revealed it had mis-stated its accounts by £250m (U.S.$327m), pushing up the figures to make its balance sheet appear healthier than it actually was to keep the share price high. Last year the supermarket was formally criticized in a 60-page report by U.K. regulatory body the Groceries Code Adjudicator (GCA) for its “widespread” practice of encouraging suppliers to give it extra cash in return for more control over where products appeared on shelves, as well as for deliberately and repeatedly withholding money owed to suppliers to artificially boost the supermarket’s sales performance.

Also in the report, Stuart Gulliver, chief executive at banking group HSBC, says that “the tone” of the organization “has to come from the CEO—he is responsible for the delivery globally of a culture that values high standards of conduct.” However, a U.S. Congressional report released in July called Too Big to Jail said that the bank avoided prosecution for money laundering in 2012 because the US Department of Justice thought doing so would cause a “global financial disaster.” Instead, the bank paid a US$1.92bn settlement.

The wrongdoing occurred prior to Gulliver taking the reins as CEO in 2011, but more recently, in November 2014, HSBC was fined U.S.$275m by the U.S Commodity Futures Trading Commission and U.S.$343m by Britain’s Financial Conduct Authority as part of a settlement of charges that it and other major banks manipulated the foreign exchange (FOREX) market. And in 2015 HSBC came under fire for its role in abetting tax evasion by wealthy customers of its Swiss private banking unit.

It would appear, therefore, that while companies accept the wisdom of improving corporate culture, making a practical difference is not so easy.

Continue the conversation at Compliance Week Europe: 7-8 November at the Crowne Plaza Brussels. Join us as we look at changes in global anti-corruption regulations, slave labour risks in your supply chain, and how to detect fraud, to name just a few topics. Learn more