22 Apr 2002
CHINA SECURITIES REGULATORY COMMISSION
BEIJING
Speech by Howard Davies
Chairman, Financial Services Authority
I must begin by congratulating the China Securities Regulatory Commission and the State Economic and Trade Commission on their excellent initiative to produce a new code of corporate governance for listed companies in China. I have read the code carefully and can certainly endorse its contents. It is a very comprehensive statement of good practice in corporate governance, with many good ideas which companies everywhere, not just in China, would do well to follow.
But I am sure that the authors of the code would agree with me that preparing a code of good practice is the easy part of the job. Securing consistent implementation of both the letter and the spirit of the code is both more important, and more difficult. Certainly that has been our experience in the United Kingdom. So my aim this morning is to offer some thoughts on how to secure effective compliance with codes of good practice. And, to that end, I will – briefly – cover three points:
(i) First, a few words on why corporate governance is so important for the development of capital markets. In other words, why should we care so much about good practice in this area? What is the economic and public benefit?
(ii) Second, I will offer some comments on recent events in developed markets, and what they reveal about weaknesses about corporate governance even in countries which have had codes of corporate governance in operation for some time.
(iii) Third, I will conclude with some general principles of my own, drawn from my own personal experience, which I think should guide policymakers in this area. My own perspective is, perhaps, somewhat unusual. While I am now a regulator, I used to be the principal spokesman for the Confederation of British Industry and was a non-executive director of a major engineering company myself, so I am, in this area, a poacher turned gamekeeper.
At a time when the Chinese economy is growing extremely rapidly by international standards, and China is attracting an enormous volume of inward investment, it is perhaps easy to assume that it would continue to develop rapidly without improvements in corporate governance. But I know that the Chinese authorities are ambitious in the long-term, and are determined to create a sound and stable environment for continued economic development.
And if we look at the factors which are widely regarded as being essential to promote a healthy environment for long-term investment, then we can see that good corporate governance scores highly on the list.
One survey which attempts to pull together the various factors which go together to create a reputation for national competitiveness is produced by the World Economic Forum. In that survey China scores quite highly among developed markets for its overall competitiveness. Indeed in the most recent survey I saw, China was above countries like Italy and Greece. It was almost top of the global league, indeed, on gross domestic investment and gross domestic savings. But, on the other side of the account, China scored relatively poorly on the effectiveness of corporate Boards in monitoring management performance and representing shareholder interests, and also relatively less well on some measures of market regulation.
Interestingly, the United Kingdom’s strengths and weaknesses are almost exactly the opposite. We scored poorly on gross domestic savings and gross domestic investment, while our market regulation and corporate governance were very highly regarded by the respondents to the survey. (Perhaps that is why the Hong Kong SAR scores so high in the global league table. Hong Kong has somehow managed to combine the best features of mainland China with the best features of the UK!)
But these surveys are all somewhat impressionistic. And another, harder piece of evidence comes from some American research on the cost of capital. US academic researchers have found that in countries where the policing of insider trading is regarded as weak, or where the legal framework is poor, the cost of capital for firms is typically some 3 percentage points higher than in countries where insider dealing is policed effectively.
So good corporate governance, and effective regulation, contribute both to the attractiveness of a country in terms of inward investment and business development, and also to the efficiency of its capital markets, and their effectiveness in the service of the real economy. It is always as well to remember these points when considering what can sometimes be a rather dry topic. And it is important to make these arguments robustly to those who argue that efforts devoted to upgrading corporate governance are costly and bureaucratic, and add little value to the economy. In my view, investment in good corporate governance arrangements, and good regulation of those arrangements, is among the most effective and rewarding investments a developing market can make, and there are figures to prove it.
2. Corporate governance problems in developed markets
But for a country determined to upgrade its standards, where should it look for advice, and for an effective model to follow? Certainly, recent events would suggest that no individual country has a monopoly of wisdom in this area.
The dramatic collapse of Enron last year has cast some doubt on the efficiency and effectiveness of corporate governance practices in the United States. There appears to have been a failure on the part of the Board, a failure on the part of the auditors, and indeed in those other market mechanisms such as investment bank analysts and rating agencies, which might all have been expected to give a hint of trouble ahead. As a result, the US Administration, and US regulators, are giving intensive thought to the changes they need to make in response to the lessons they have now painfully learned.
And I do not draw attention to the Enron problem in order to say that, in the United Kingdom, it could never happen. There are some elements of our regime which are, I believe, an improvement on the US arrangements. Our accounting system, for example, would have taken a different view of Enron’s special purpose vehicles, and require them to be consolidated in the company’s accounts. But we have had our own corporate governance problems, too, and our own problems with auditors. The British Government have therefore set up two reviews to look at whether there are improvements we need to make to our auditing and accounting frameworks in the light of Enron, and also to examine whether we need to do more to upgrade our corporate governance arrangements. In particular, do we need further to strengthen the role of non-executive directors? At the FSA we are closely involved in these reviews, particularly the first.
And one could not look either, to Continental Europe for a foolproof model. There have been some well publicised collapses there, in which the roles of directors and auditors have been questioned, and some serious questions have been raised about the transparency of accounts.
It is interesting to note, too, that if one looks at the corporate governance arrangements in place in the US, the UK and, say, Germany, there are remarkable differences between them. In the United States, most companies are run by a single unitary Board, with a single chairman and chief executive officer. In many cases there are no other executives on the Board. The main Boards often meet only three or perhaps half a dozen times a year.
In the United Kingdom we also operate a unitary Board model, usually – though not always – with a majority of non-executive directors. But we almost always separate the role of the chairman and the chief executive – certainly since the Cadbury review of corporate governance 15 years or so ago. Our Boards also typically meet more frequently, usually once a month.
In Germany, by contrast, they operate a two tier Board system, with a supervisory Board including employee representatives overseeing a management Board which, usually, is wholly composed of executives. The supervisory Board meets only a few times a year and has, perhaps, a somewhat more formal role in relation to the oversight of the company than is typically the case in the United Kingdom.
In each country there are highly articulate and persuasive advocates of the particular model in force. In the United Kingdom it is a heresy to advocate a joint chairman and chief executive. In the United States few question their model, and most argue that it is the one which promotes accountability and effectiveness in the clearest possible way. In Germany corporate governance experts argue strenuously for their two tier Board structure.
In my view it is very hard to demonstrate that one model is unambiguously superior to the rest. As I have already mentioned, none of these models is an absolute guarantee of good and effective corporate governance in all circumstances. They have all experienced problems of one kind or another, and continue to do so.
My understanding of your own code is that you have adopted a model which borrows from all three structures, with a Board of directors including some independents, but also a supervisory Board with particular oversight responsibilities.
I can see the case for that approach, but, in my view, structure is less important than the way in which structure is operated.
3. Five useful principles
It is important to focus attention on the way things are done, and by whom they are done, just as much as on the formal framework, if one wants to develop an effective corporate governance regime which will serve to promote healthy and vibrant capital markets. To that end, I suggest we bear in mind five key principles. The first is the most important. It is that:
(i) People are more important than processes.
And while it is the most crucial, it is also the most difficult to achieve. One lesson of recent corporate collapses in the US and in Europe seems to be that no corporate structure can guarantee success if the individuals within it do not operate with the right degree of independence, with the right kind of expertise, and do not devote the required amount of time to the important role of non-executive director.
I am sure that issue will be at the heart of the British Government’s new inquiry into the role of non-executives. My impression is that in too many companies non-executive directors are chosen for reasons quite unrelated to their suitability for the task. They may be friends of the chairman. They may have been to the right university or school. Or they may fit a particular category which the Board thinks it needs to include, to show a balanced portfolio of members. Too often the skill and experience required to understand the business and, particularly, to understand the financials of the business are by no means at the top of the list of desired criteria for appointment.
We also too often find non-executives with a long string of appointments, who collect Boardroom chairs like pieces of Chinese porcelain, and can clearly not devote the time and attention needed to any individual position. That is particularly so when a company runs into difficulties, whether strategic, financial or managerial, which is precisely the time when a strong group of non-executives, with the time to devote to resolving the issues, is most needed.
In my view special criteria now apply to audit committees. Where companies are engaged in highly complex financial transactions the skills needed on the audit committee are particularly crucial. The Enron case is a cautionary example of that. In the UK, particularly in the financial sector, some firms are deciding to appoint individuals with specialist backgrounds to their audit committees and, in some cases, ensuring that they spend 2 or 3 days a week on the job. I suspect that in future, particularly in the cases of complex banks, we will see more of that.
More specialised audit committees do not, however, absolve the full Board of the requirement to confirm major financial transactions. Audit Committees tend to look backwards; the Board must look forward.
So I very much hope that, as they implement the provisions of the code, Chinese companies follow the spirit as well as the letter. In other words they ensure that they really do staff their Boards with people of independent mind, and of appropriate skill, and not simply find a list of superficially attractive sounding individuals whose photographs will look good in the annual report.
My second principle is:
(ii) Shareholder accountability
One problem we have found in the UK, and I am sure it exists elsewhere, is that the discipline of shareholder accountability does not always work as effectively as one would like. That is, in part, because shareholders frequently do not vote on important resolutions, do not vote on the appointment of auditors, and generally remain entirely passive, until a crisis hits.
In my view shareholders must accept their own responsibilities if we are to achieve a truly robust corporate governance system. If the shareholders, whether individual or institutional, take little interest in the corporate governance of a company, it is more difficult for the non-executive directors to perform their role as shareholder guardians effectively. Shareholders should not abdicate their responsibilities to Boards. Companies need active shareholders, prepared to make their views heard, or they will become inward looking and negligent in corporate governance matters.
My third principle is an obvious one, that:
(iii) External audit must be independent and penetrating.
The Enron case has already had important consequences for the audit function in the United States. In future there will be a new oversight Board, with independent membership, looking at the quality of auditing. We already have a similar arrangement in the United Kingdom.
It is also increasingly accepted, I think, that ways must be found of buttressing the independence of the auditor. It is important that that independence is not compromised by other consultancy work which auditors do for their clients. That may not necessarily mean that auditors should in no circumstances undertake non-audit work; in my view that could be an extreme response and one which would be hard to police. But certainly we must get away from the mentality encapsulated in a recent booklet issued by the American Institute of Chartered Public Accountants entitled "How to leverage the audit into a profitable relationship". That appears to have been taken to extremes in the Enron case, where both management and auditors boast of the closeness of the relationship between them, and one Enron auditor is reported to have boasted that "we don’t call audit audit round here".
It certainly appears that, in some cases, auditors have lost sight of their essential function as agents of shareholders, and lost sight of the public interest dimension of their role. If investors cannot be confident that the prime responsibility of the auditor is to his or her professional standards, and to market integrity, then they will lose confidence in financial markets. And that loss of confidence will be reflected in lower share prices and higher cost of capital. So some additional investment in audit oversight, and perhaps even additional direct cost of auditing, is almost certainly investment that will be amply repaid.
Which brings me to my fourth principle, that:
(iv) Disclosure and transparency are crucial to market integrity
It is a cliché, but nonetheless true, that for many of the ills of financial markets, sunshine is the best medicine.
That is why, in the United Kingdom, we have adopted an approach to corporate governance which is based heavily on disclosure. Over the last 15 years, as concerns about corporate governance have grown, a series of codes of practice have been put together, largely by British companies themselves. The basic corporate governance code was designed by Sir Adrian Cadbury. Since then it has been supplemented by another Greenbury code on disclosure of pay, and consolidated, together with a number of other requirements, into the combined code, which is known as the Hampel Code. (We now have another review under a man called Higgs, so I suppose we may find yet another Higgs code in due course).
I am sure you will not wish me to go through the detail of these various codes today. And there is no need for me to do so. The main principle is that companies should disclose in their annual report and accounts whether they meet the terms of these codes of good practice and if, for some good reason, they do not do so in every respect, they should explain how they fall short, and why. Those disclosure requirements are incorporated in the FSA’s listing rules and non-compliance with disclosure is potentially subject to our discipline.
Companies are required, for example, to disclose all payments to directors, including payments made in relation to pensions. They are required to disclose any connected transactions – in other words transactions with a company with which a director may have a connection. Remuneration policies are a particularly crucial feature of corporate governance today. Enron points up the danger of incentives for directors to take huge financial risks, which bring immediate financial benefits to them, and longer-term disaster for the company. Non-executives must keep a close eye on all aspects of director remuneration.
Directors are also required to certify explicitly that the company is a "going concern" and that all material disclosures have been made. There is legal liability in relation to these disclosures, something which has focused the minds of many UK company directors.
Which leads me to my fifth and, you will be pleased to know, last principle, which is that:
(iv) There must be an appropriate regime of regulatory discipline to back these obligations.
In the United Kingdom, and also in the United States, the prime responsibility for developing codes of good corporate governance has rested with companies themselves. When I was the Director General of the Confederation of the British Industry it was clear to me that we were in the front line in developing models of good practice, and keeping them up to date. In fact, the Bank of England stimulated the first corporate governance code in the United Kingdom, but since then the lead has typically been taken by company chairmen themselves. Even today, when the Government has wished, in response to Enron, to overhaul our own requirements, they have asked senior business persons to make proposals to them, rather than setting up a Government committee, or inviting the regulator to do the job.
But these industry developed codes are not, in my view adequate unless there is some kind of enforcement mechanism behind them. In this, as in other areas, our experience of pure self-regulation in recent years has been disappointing. And one can see that, in the United States, there is now move away from self-regulation in the audit field.
In the UK we have recently changed our enforcement approach to disclosure. And, as I have explained, our principal mechanism for ensuring standards of good corporate governance is disclosure. In the past, companies which fail to disclose relevant information to their shareholders in a timely fashion could be reprimanded by the Stock Exchange, whether in private, or in public. Since December of last year the responsibility for enforcing disclosure rules has rested with the Financial Services Authority. And we may enforce using all of the disciplinary mechanisms at our disposal, including fines and censures for companies and directors. There is an elaborate system of checks and balances to ensure that we do not use our powers in an overbearing way, including appeals to an independent tribunal. But it is clear that the new enforcement regime has caused companies to think harder about their practices, and in particular about the timeliness of their disclosures to the market.
I believe this is having a healthy effect on our markets, and will continue to do so. Full and timely disclosure is now being taken more seriously than it was before.
My last point, which I would not elevate to the status of a principle, is that good corporate governance is an evolving concept. One should not think that one code of conduct will suffice for all time. The markets are endlessly inventive. New corporate structures are formed. New entities are created. New types of financial instrument, with new types of risk are introduced. So it is important to continue to overhaul a country’s market practices to ensure that they respond appropriately to the changing environment.
So I conclude by repeating my congratulations to the CSRC and SETC for the work they have done so far on the code of corporate governance for listed companies in China. But I forecast that it will not be long before they need to review it in the light of experience, and in the light of market developments. The corporate governance industry is one which has considerable life in it yet.
