Corporate Governance: back on the agenda Angela Sormani reports on what’s actually happening and why and what, if any, impact the proposed changes will have on the private equity world and its non-exe

The collapse of Enron and Worldcom and the disastrous problems at Marconi and Energis have put the spotlight on corporate governance issues and placed the role of the non-executive director under scrutiny. Recent regulatory drive for greater disclosure and accountability in the wake of these corporate scandals has prompted a knee-jerk reaction from the US with the Sarbanes-Oxley Act, which came into force in July and proposed changes to New York Stock Exchange Listing standards and NASDAQ rules. Key changes include corporate governance procedures, auditor independence and regulation of audits and audit firms and enhanced company disclosures. Timothy Spangler, partner at Berwin Leighton Paisner, says: “The US put through the legislation unusually quickly and so there hasn’t been as much time as you would normally have for a consultation process. The reason it happened so quickly is primarily because someone had to be seen to be doing something post-Enron.”

In the UK, there is not the same kind of urgency. The point of reference today is Sir Ronnie Hampel’s Combined Code of Corporate Governance, published in 1998 (see box) which has worked well, but changes do need to be made, according to the Department of Trade and Industry (DTI), which in July issued a white paper on accounting and auditing issues.

The white paper sets out the government’s core proposals for simplifying and modernising the UK Company Law Review, which was launched in early 1998 and published its final report in July 2001. This review was the first across-the-board review of company law since the early 1960s. Company law regulates the way in which companies are organised and run. It does not include the way companies are wound up insolvency law nor does it deal with the regulation of financial services, the taxes companies pay, or the rules by which a company buys and sells goods and services. The DTI states that the law needs to be clearer, more certain and more accessible. The present framework has developed through a series of partial reviews and alterations. This has made it increasingly bulky and complex. The way it is written makes it particularly difficult to identify those provisions which apply to smaller companies. For example, the main rules on accounts are set out in one place with no indication that there is any simpler provision elsewhere for smaller companies. It takes another 20 pages to find these and it would be easy to overlook them, states the DTI.

A universal code?

The DTI’s initiative to develop a new Companies Bill will also take into account the European Commission’s initiatives to review and reform European company law. But a universal corporate governance model is a long way off, says John Bennett head of corporate at law firm Berwin Leighton Paisner. Part of the UK’s company law is the implementation of a series of European directives, the oldest of which is now 35 years old. The increasingly international nature of business means it is important for international companies to adopt common accounting standards. The main initiative underway will start from January 1, 2005 when all companies admitted to trading on the London Stock Exchange (and any other European regulated market) will need to compile their consolidated accounts in accordance with the EU Regulation on the Application of International Accounting standards, which was adopted on June 7, 2002.

Non-executive directors

The DTI acknowledges that the growing duties of non-executive directors (NEDs) means they are in no position to fulfil all expectations. Of most concern is the lack of appropriate statutory protection against personal liability for NEDs. The British law does not currently recognise any legal distinction between the responsibilities of NEDs and those employed full-time by a company. The position is of even more concern now following litigation against directors, including the NEDs of Equitable Life. “It seems strange that the law doesn’t recognise in any formal way that role,” says Simon Witney, partner and head of knowledge management at SJ Berwin. “If you want to encourage good people to take on this role, there needs to be a distinction. The biggest risk is the reputational risk that they run.”

Under the Enterprise Bill, due to become law next year, the Office of Fair Trading (OFT) will have the power to apply for the disqualification of up to 15 years of directors of companies which breach competition law. The OFT is proposing to make directors of the parent company liable for the actions of the subsidiary and issued draft guidelines on this on July 4, 2002, asking for interested parties’ views. A worrying statistic from a survey by law firm Berwin Leighton Paisner with regards to this reveals that 64 per cent of directors said they would not be aware if their subsidiaries were infringing the law, even though they would be personally liable. This is concerning as one would expect directors to be sharpening up their acts particularly in the light of recent scandals.

Adrian Magnus, competition partner at Berwin Leighton Paisner, is concerned about the effects the proposals may have on NEDs. He says: “Good corporate governance requires able and effective non-executive directors, but the threat of disqualification as a director for competition infringements may deter suitable candidates from accepting non-executive positions. The OFT’s guidelines should acknowledge the differing roles and day-to-day knowledge of executive and non-executive directors. Non-executives should not be immune from disqualification, but nor should they be first in the firing line.”

Higgs Review on non-execs

In June this year, the UK government appointed former investment banker Derek Higgs, to lead a review on the role and effectiveness of non-executive directors with a focus on listed companies. In launching the consultation paper Higgs said to enhance British productivity and competitiveness “the progressive strengthening of the role of non-executive directors is strongly desirable.”

The government has stated that an approach based on best practice rather than regulation or legislation is its preferred starting point. Commenting on the review John Bennett said: “I don’t expect there to be a radical revolution in the role of NEDs, but hopefully there will be an improvement.”

The review has prompted huge debate over what non-executive responsibilities should be, how much they should be paid, and how many such positions one person can hold. The National Association of Pension funds, which represents about 1,000 pension schemes, has told Higgs in its submission that non-executives must be prepared to expose failures in corporate governance and resign if a board does not act on their concerns.

The government is keen to attract a greater number and higher quality of NEDs, but may be loathe to raise the standards required for fear it will prevent potential candidates from coming forward, says John Bennett. In the light of the proposed changes, there is a worry that the supply of suitable candidates for non-executive roles will dry up. And in the public markets, to attract more high quality non-executives, renumeration issues must be reviewed. Bennett says many consider the pay of NEDs too low given the seniority of the position and the time commitment. “I don’t think we’ll attract the right calibre of people if there’s not a remuneration adjustment,” he says. John Mackie, chief executive of the British Venture Capital Association, agrees. He asks: “In the current climate would you want to be a NED of a publicly-quoted company for say GBP20,000 a year and with the same legal responsibilities as executive directors?” The changes coming through, says Mackie, mean quoted companies will need more and better NEDs.

VCs make good NEDs

For the VC world, the review of corporate governance issues is not going to have much impact, Mackie says, as the mechanics are already in place. The question that arises from the current review is where public companies are going to get higher quality NEDs? Where should they be looking? The answer may be the private equity market, which employs thousands every year.

Simon Witney of SJ Berwin says VC and PE houses use board representation as a central tool in the governance of portfolio companies and could provide a crucial lesson to NEDs of public companies. He says: “A board seat should cement the relationship between investors and management and provide a crucial voice in strategic decisions.”

The private equity industry, with its long-standing experience of non-executive directors, has a lot to teach the public equity sector, as public equity starts to wake up to the important role non-executives play in looking after shareholder interests, he says. “VC s have been playing that role for years, very, very effectively.”

Clearly there is a difference between public equity and private equity. The main difference is the size of the stake typically held in public equities is tiny, while private equity investors will hold a minority stake which is significantly larger or even a majority stake. The second difference is that private equity investors are in the business in part to add value to the underlying investee companies and so do take a much more active role in governance.

In the BVCA’s submission to the Higgs Review, Mackie highlighted the importance of letters of appointment of non-executive directors. In the private equity world these are extremely detailed, setting out exactly what is expected of the position. In public companies, he says, they are less detailed and if there is often a lack of clarity about the role of the NED, then this is an issue that needs to be addressed. “Setting out that relationship from the start is essential it’s common sense. Particularly concerning debates about acquisitions and international expansion the greater clarity you have at the start of the relationship, the easier it is.”

A private equity firm will almost always have a representative from the firm on the board of a portfolio company and one external NED, who will normally have a past track record with the firm. “The majority of people on the board will already be known to the VC,” says Mackie.

While the Higgs Review is predominantly aimed at quoted companies, Mackie looks at the implications for private equity. “What we perceive as differences in private equity and the public markets are typified by a number of things. Firstly, in private companies the board’s relationship with shareholders in the company is much closer. What we see in the private equity world is that the shareholder is much more active in terms of what is happening in the business. In publicly-quoted companies the shareholders are normally slower to react. They don’t have the same mechanisms that allow us to react that is a majority shareholding. In the public markets, how does a one per cent shareholder influence any sort of change? Because of the dispersion of shareholding they don’t have the same power.”

The reason for such high corporate governance standards in private equity portfolio companies is that PE firms have the mechanisms to be able to do it, says Mackie. “The mere fact that we have ownership positions means we have the control to do so, something that differs in the public markets.”

“If we are preparing a business for flotation or trade sale then generally those businesses are perceived as higher quality businesses with high corporate governance standards.” Of course for the private equity house this is all part of business strategy. Private equity-backed companies have this culture deeply embedded into their strategy from day one – the higher the quality of the company on exit, the higher price the firm will get for the company, says Mackie. “We stand or fall by the way we generate superior returns for investors everything we do is driven by that underlying culture.”

A recent Mckinsey survey demonstrates that investors are willing to pay up to 18 per cent more for companies in the UK which have high corporate governance standards, and providing additional information on how management treats the interests of shareholders is expected to nurture investor confidence.

But for the short term, any definite change in company law looks uncertain. Jonathan Morris of law firm Berwin Leighton Paisner says: “The Higgs Review could potentially be very interesting. We don’t think the changes in the UK will be that pronounced however.” His colleague John Bennett agrees: “I don’t think there’s going to be a radical change. There’s no greater threat of liability. In the UK, the only additional express obligation is to keep auditors informed.” Will there be a move to codify what NEDs should do?, asks Bennett. “I don’t think it will be codified under statute, but will be described as useful guidance’. I think it will emerge on a non-statutory basis.” For most companies, he concludes, there will be more sensitivity, but in substance there won’t be any dramatic revolution. For now it seems it’s a work in progress.