Directors behaving badly

PIRC, a UK-based provider of corporate governance, proxy voting and corporate social responsibility investment research has accused the UK government of complacency on the issue of directors’ pay and consultants Deloitte & Touche of being too soft in its report on the subject.
PIRC published its latest set of shareholder voting guidelines in February which addresses this, and other issues of shareholder concern. In the guidelines PIRC is keen to stress the shift of emphasis from compliance to substance and understanding of governance arrangements in practice.
The new combined code on corporate governance introduced in 2003 goes further than its predecessor in that it requires disclosure of the committees activities during a given year. The 2003 Higgs report on corporate governance was the source of the new combined code. PIRC notes that two-thirds of Higgs’ recommendations reflected existing PIRC policy.
The Higgs report found that the nomination committees are the least developed of the three mentioned above. “Very few committees reported on performance appraisal before the publication of the Higgs report,” notes David Somerlinck, PIRC’s corporate governance policy manager. “Boards did not look at the strengths and weaknesses of the individual board members.”
Higgs recommended the separation of the powers of chairman and CEO, and that a CEO should not subsequently become chairman.
The risks are that the incoming CEO will find it harder to make his mark: if he wants to change strategy it will be more difficult if the former CEO who is responsible for the previous strategy is chairman. “It will be difficult to bring up matters of concern – Shell and Sainsbury are examples,” says Somerlinck. “Furthermore, someone who has been a good CEO might not necessarily make a good chairman.”
Other key issues for the nomination committee include the need for boards of directors to demonstrate to their shareholders that they are dealing with issues such as planning for the replacement of their CEO, performance appraisal of board members, bringing in new people to the board and refreshing the non-executive directors. “Boards of directors often have little or no structure in this regard, even though their HR departments may
be quite well structured and organised,” says Somerlinck.
Auditor independence is another key area of concern. PIRC carries out an annual review of audit work and found in 2001 that for every £1 (e1.4) spent on audit work £2.80 was spent on non-audit work. Even through the figure for other work has fallen to around £2 today, Somerlinck is still concerned. “We see this as a conflict of interest. Auditors have started to use the audit as a loss leader; this risks making the audit less rigorous. If the amount spent on other work is too high the value to the auditor of the audit is called into question.” It is PIRC’s policy objective to ‘reinvigorate’ the audit to address this shareholder concern.
And then there is the highly contentious and very current issue of directors’ pay. “This will not go away,” says Somerlinck. “This proxy season we will see some high-profile shareholder complaints on excessive reward for mediocre performance – or failure.”
He adds: “The combined code asks for clear, transparent and understandable disclosure. We have looked at the remuneration reports for all FTSE100 companies and most have complex arrangements. This isn’t a bad thing, but the companies often fall down on the explanation. So compliance with the legislation is not providing adequate reporting.”
Somerlinck notes that only one FTSE company has lost the vote on directors’ remuneration. “Average opposition to the remuneration vote was just 6%,” he says. “We would expect it to be a lot higher. People tend to cast their vote in favour of accepting even though they may have misgivings; many don’t communicate these properly.”
A recent report on directors’ remuneration carried out for the DTI by Deloitte & Touche concluded that companies comply with the letter of the law and that the law itself only needed tweaks. “The government has concluded from the report that it doesn’t need to do anything else on this issue,” says Somerlinck. “It is being complacent.”
He adds: “The majority of companies are too passive or just pay lip-service to the issue. The argument is that directors’ pay is a small percentage of overall expenses. But it is not a numbers game – it influences corporate behaviour.”
So how is the investment community responding to governance issues?
Somerlinck notes that fund managers are getting more involved but some companies do not welcome this. “They see shareholder activism as treason. What we need is mature dialogue.”
Myners found that institutional investors are passive and not getting involved in governance issues. “But we could teach trustees the basics of these guidelines in one hour,” says Somerlinck. “It is a growth issue in terms of people realising the impact on shareholder value.”

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