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Company Law

Analysis - guidance - compliance

19 JUL 2013

Conclusions on governance of smaller companies

Professor John Mellor

Professor of Governance in Banking and Finance

Extract from Practical Corporate Governance, publishing September 2013

Overview

The need for sound and proper governance of organisations, if they are to continue to exist and prosper, is hardly a new phenomenon; it has been recognised for a very long time. That governance, that is corporate governance, of commercial organisations should have received so much attention over the last twenty or more years is largely as a result of the increase in the separation of ownership and control brought about by an ever widening dispersion of ownership through a wide distribution of shareholdings. Application of the principles of good governance, however, is relevant whether shareholding in a company is widely dispersed or closely held.

A practical approach to corporate governance must be firmly rooted in commercial reality. Commercial reality recognises that all business activity requires a measure of risk taking if business organisations are to exist in the first place, and then prosper and grow.  Some risks are basic to all business, such as market and financial, others are industry specific. Entrepreneurship and innovation, the life-blood of smaller companies, thrives on taking measured risks. There is always the danger that corporate governance, if pushed too far for its own sake, will impose a heavy burden on the smaller company and work against this dynamic of entrepreneurship, innovation and measured risk-taking, not only to the detriment of small companies themselves, but also, and most importantly, to the contribution smaller companies make to the economy.

Anecdotal evidence would suggest that governance of smaller companies has already reached, or is on the verge of reaching, this danger point. Directors, particularly non-executive directors, of smaller companies are known to complain about spending too much time on compliance with corporate governance taking precious time away from focussing on the business proper, its key drivers, risks and strategy. Further, an emphasis on compliance, and reporting on compliance, has caused company annual reports to balloon in length, leaving one to wonder just how much is read and taken into consideration and, therefore, to question its worth. There is surely a case for reducing the length of smaller company annual reports without compromising the integrity of reporting on corporate governance philosophy and arrangements, and for limiting the volume of ‘boiler plating'. Much of what is reported is merely ‘box ticking' to satisfy corporate governance compliance requirements.

Corporate governance arrangements which ‘ tick all the boxes' say little about what drives the business, its competitive position and commercial and financial strategy - all key ingredient to business success. A ‘clean' compliance statement may even give a misleading picture as to the health of the business. An extreme example of this (albeit a FTSE-100 company) is the Royal Bank of Scotland, before the financial crash of 2007-2008.

The key point is that good corporate governance is not a guarantee of business success, but just one ingredient which requires attention. Aside from adopting the principles of governance, good governance is about people, their skills, values, behaviours and, most importantly, their decision-making. And that decision-making rests ultimately with the board of directors, led by the chairman, who therefore fills a crucial role in setting the tone and maintaining standards of good governance. To that end practical corporate governance should be focussing on the application of governance principles and, therefore, it is more about appliance rather than compliance in order for it to be effective and rooted in commercial reality.

‘Apply or explain' not ‘comply or explain'

A ‘comply or explain' approach to corporate governance has, in many cases amongst board of smaller companies and other advisers, engendered a mindset of compliance with, rather than application of, corporate governance principles. This can, and has, demoted governance to no more than a burdensome exercise in bureaucracy in many cases, which undermines its true purpose. Not only that, it undermines the UK principles-based approach and regard for the Code as a framework and valuable source of guidance on practical corporate governance. The switch to a more positive mindset which acknowledges the value of good corporate governance, based on a set of sound principles, would be helped by replacing ‘comply' with ‘apply', so that ‘comply or explain' becomes ‘apply or explain', thereby placing emphasis on the application of governance principles, the essence of a practical approach which recognises commercial reality. It also recognises the central role that people and their decision-making play in governance operating in a commercial world.

Relations with shareholders

When it comes to governance of smaller companies, it is worthwhile considering the level of interest shown by shareholders. To begin with it is clear that, so long as the company is continuing to perform satisfactorily, many shareholders pay only passing interest at best to its governance. Their focus is on the company's financials, not its corporate governance. This is the more surprising when it is clear that a company with sound leadership, and therefore good governance, is more likely to be profitable and generate a satisfactory return than one without. However, even these shareholders take note of the company's corporate governance at the time of their initial investment, paying particular attention, for example, to the composition of the board and the chief executive.

As with any generalisation, there are exceptions and examples of more involved shareholders. The key point is for the company to develop a constructive relationship with its main shareholders (probably no more than six) through good communication, including engagement, but for the company to be aware of inertia on the part of some shareholders. This can only be resolved by identifying a clear purpose for any meeting, supported by a correspondingly clear agenda for discussion.

The future for governance of smaller companies

Premium Listed smaller quoted companies are required to adopt the UK Corporate Governance Code as a condition of listing and to report on their compliance. Compliance rather than appliance seems at odds with the UK's principle-based approach to corporate governance and could be responsible for the burden of administration falling on smaller company boards that results in diverting their focus from the business. This level of attention suggests a pre-occupation with governance that has gone too far and is out of proportion to its place in business enterprise. In other words, for the future, attention paid to corporate governance of smaller companies must be in better balance with the dynamics of business, otherwise there is a danger of it being a hindrance, rather than the asset it should be, to business prosperity and shareholder confidence.

At the same time, understanding of corporate governance needs to be widened to embrace more than the Code. It needs to be applied so as to include the principles of good governance alongside development and execution of strategy and risk management in particular and the link made with company financials and investment returns. Only in this way does governance become real for boards of directors and shareholders alike.

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