Corporate Governance - London Stock Exchange · current UK framework of legislation, ... It...

Corporate GovernanceA P R A C T I C A L G U I D E

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practical guide to CG v5 21/7/04 9:04 am Page FC1

RSM Robson Rhodes LLP is a leading firm ofchartered accountants and business advisors. Weoffer a full range of services to quoted companiesand other businesses and to organisations in thepublic and not-for-profit sectors. We work closelywith our clients in focused teams, recognising thateach one is unique with its own culture and values,needs and expectations. We provide independentadvice to national and international boards enablingthem to design and bring about strategic changeand to realise the full financial benefits from doing so.

Through our membership of RSM International, theworld’s sixth-largest accounting and consultingnetwork, our clients benefit from the skills andexperience of more than 20,000 professionals inover 70 countries.

The author of this guide, Anthony Carey, is theRSM Robson Rhodes partner responsible forboard effectiveness issues. He is a member of theCorporate Governance Committee of the Instituteof Chartered Accountants in England and Wales.

The London Stock Exchange is one of the world’sleading equity exchanges, offering companies fromall sectors and countries access to a world-classmarket. Our markets are supported by a diverserange of sophisticated investors providing one ofthe deepest pools of capital world-wide. Thecurrent UK framework of legislation, regulation andstandards relating to corporate governance isconsistently central to both attracting investors toand maintaining their confidence in the integrityand quality of our markets. Subsequently on-market companies and investors are placingincreased focus on corporate governance. We aretherefore delighted for corporate governance to bethe second topic in our developing Practical Guide

series and believe that this Guide lives up to itsname by providing some practical pointers oncurrent good practice in this area.

The Exchange is committed to developing furtherproducts and services to help companies meettheir disclosure obligations, whilst communicatingeffectively with both financial and non-financialmarkets, as well as other key audiences. To findout more about how the Exchange can help you toimprove either your investor relations or corporategovernance activities, please contact either yourrelationship manager or the IR Solutions divisionvia the contact details at the end of this Guide.

practical guide to CG v5 21/7/04 9:04 am Page FC2

ForewordBP has long recognised the importance of good governance and the pivotal role that the board plays inrealising it. First, it is vital to understand what is meant by the term “corporate governance”. For us itmeans “the system by which the owners of the corporation ensure that it pursues, does not deviatefrom and only allocates resources to its defined purpose”. In a corporation that is a business, thisdefined purpose will be generating long-term shareholder value. To this end, boards are accountable forsuccessfully governing and directing the corporation.

The foundations of world-class companies are laid in the boardroom. Companies need corporategovernance policies that place the interests of their shareholders at the heart of the enterprise. Intoday’s world of regulation and best practice codes it would be easy to think that compliance wassufficient. Nothing should be further from the truth – though best practice is just that, one size does notfit all and true governance best practice must be tailored for the unique facets of each corporation.

This guide has been developed by the London Stock Exchange and RSM Robson Rhodes LLP. It provides practical guidance on corporate governance issues for board members and other interestedparties alike. It acknowledges that addressing a corporation’s business purpose is critical while taking fullaccount of the new regulatory and governance environment of the Combined Code on CorporateGovernance for UK listed companies.

The guide covers a broad spectrum of issues from selecting and developing a high quality board andsuccession-planning to ensuring a board works effectively as a team. It goes on to explore a range ofissues that a board must address if it is to enable the company to achieve its full potential including itsinput to strategy, effective risk management, communicating with shareholders and the development ofan integrated approach to corporate social responsibility. It also discusses the work of boardcommittees.

The effective stewardship of businesses entrusted to our care must remain high on the agenda ofboards of all sizes and in all sectors. A successful economy depends on being able to build world-classcompanies which are leaders in the increasingly competitive global marketplace. Good governance isabout enabling entrepreneurship and innovation within a framework of accountability. It demands soundjudgement, high standards of probity and transparency in the relentless pursuit of the goals of thebusiness.

Peter D Sutherland, KCMG

Chairman, BP p.l.c.

practical guide to CG v5 21/7/04 9:04 am Page 1

A guide for the boardroomThe primary purpose of this guide is to help boards of listed companies to lead and direct theirbusinesses successfully. It strives to provide practical insights into best practice on boardroomeffectiveness so as to help boards achieve their strategic objectives and build enduring value in theirbusinesses.

The guide takes account of the principles and provisions of the new Combined Code on CorporateGovernance, applicable for financial periods beginning on or after 1 November 2003 to all UKincorporated companies listed on the London Stock Exchange. It also includes reference to otherauthoritative guidance.

Under the current listing rules, listed companies have to report on how they have applied the principlesin the Code although the form and content of this part of their disclosure statement are not prescribed.Companies also have either to confirm that they comply with the Code’s provisions or provide anexplanation of any departures from them. It is expected that companies will normally comply with theprovisions but recognised that departure may be justified in particular circumstances. The preamble tothe Code emphasises that an evaluation of a company’s governance should pay due regard to itsindividual circumstances including its size and the complexity of its business along with the risks andchallenges it faces.

It is intended that companies quoted on AIM should also find this guide a useful resource though theCombined Code does not formally apply to them.

AcknowledgementsThe author and the London Stock Exchange would like to acknowledge the help given by the following inconnection with the preparation of relevant sections of the guide:

Sandy Fleming, Head of UK Smaller Companies Team, F&C Management Ltd

Guy Jubb, Investment Director, Head of Corporate Governance, Standard Life Investments

Colin Melvin, Director Corporate Governance, Hermes Pensions Management Ltd

Iain Richards, Head of Governance, Public Policy, Morley Fund Management

Dr Daniel Summerfield, Responsible Investment Adviser, Universities Superannuation Scheme Ltd


Corporate GovernanceA P R A C T I C A L G U I D E

The effective board4

Building a talented board14

Tying remuneration closely to performance22

Strategic thinking30

Managing risk effectively 38

A robust audit committee46

Taking corporate social responsibility on board54

An active dialogue with shareholders62

Online resource centre70


Theeffectiveboard

Does the board have clear objectives and monitor itsperformance against them?

Is the board focusing on the correct areas for its decision-making?

Is the chairman leading the board effectively?

Does the board provide a challenging yet supportiveenvironment for the executive directors? Is there a fulldiscussion before major decisions are taken?

Is the board meeting schedule suitable for the needs of thebusiness? Does the board receive board papers of the rightlength and quality? Are they provided in a timely manner?

How have key board decisions turned out? How could thedecision-making process be strengthened for the future?

Is there a thorough boardroom appraisal process with a follow-up action plan?



Figure 1.1 The board in actionKey provisions of the Combined Code

The board should meet sufficiently regularly to discharge its duties effectively. There should be aformal schedule of matters specifically reserved for its decision.

Directors should receive accurate, timely and clear information. Management should provide suchinformation but directors should seek clarification/amplification.

The chairman should ensure that the directors continually update their skills and have theknowledge and familiarity with the company required to fulfil their role on the board and itscommittees.

The chairman should ensure that the views of shareholders are communicated to the board as awhole. The chairman should discuss governance and strategy with major shareholders.

The chairman should hold meetings with the non-executive directors without the executivespresent.

The board should undertake a formal and rigorous annual evaluation of its own performance andthat of its committees and individual directors.

Where directors’ concerns about the running of the company or a proposed action cannot beresolved they should ensure that they are recorded in the board minutes.

Source: Extracted from The Combined Code on Corporate Governance, 2003 (abridged)

The effective board“Every company should be headed by an effectiveboard, which is collectively responsible for thesuccess of the company. The board’s role is toprovide entrepreneurial leadership of the companywithin a framework of prudent and effectivecontrols which enables risk to be assessed andmanaged. The board should set the company’sstrategic aims, ensure that the necessary financialand human resources are in place for thecompany to meet its objectives and reviewmanagement performance. The board should setthe company’s values and standards and ensurethat its obligations to its shareholders and othersare understood and met”.

These opening principles of the new CombinedCode on Corporate Governance ('the Code')highlight the board’s responsibility for leading anddirecting the company. The quest for world-classperformance in the business must start in theboardroom. A summary of the specific provisionsin the Code dealing with the functioning of theboard is set out in Figure 1.1.

Leadership by the chairmanThe chairman has a pivotal role to play in helpingthe board achieve its full potential. He or she isresponsible for the leadership of the board,setting its agenda and ensuring its effectiveness.The chairman must facilitate effectivecontributions by the non-executive directors andensure that there is a constructive relationshipbetween them and the executive directors. Theunitary board structure in the UK – with its mix ofexecutive and non-executive directors on theboard – makes the nature of those relationshipsabsolutely crucial to an effective board.

In his book Letters to a New Chairman, (1) HughParker says that the 'intangible quality of personalleadership’ provided by the chairman is the onefactor above all others that influences theeffectiveness of any board. He believes that keyelements of that leadership include having a senseof what he or she wants the organisation to doand become in the next five to ten years; a clearand definable set of objectives; strong personalviews on how the company should seek toachieve those objectives; and, last but not least,real personal authority.

6 L O N D O N S T O C K E X C H A N G E


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Meanwhile, Sir Adrian Cadbury has likened thechairman's role (2) to being the conductor of anorchestra. He reflects that ‘taking the chair atboard meetings is the aspect of the job ofchairman which is furthest from the public eye,but the one where their personal contribution isdecisive’. The chairman must strike the balancebetween controlling the discussion in order tokeep it to the point while encouraging boardmembers to contribute to the debate.

Non-executive directorsThe Code calls on non-executive directors to:

constructively challenge and help developproposals on strategy;

monitor the reporting of performance;

scrutinise the performance of management inmeeting agreed goals and objectives;

satisfy themselves on the integrity of financialinformation and that financial controls and riskmanagement systems are robust anddefensible;

determine the appropriate level of remunerationof executive directors; and

have a prime role in appointing and, wherenecessary, removing, executive directors and insuccession planning.

Some of their duties will be performed on theboard, others in board committees made upwholly – or mainly – of non-executive directors.The new Code indicates that the chairman shouldhold some meetings solely with the non-executivedirectors. In turn, the non-executive directorsshould meet at least once a year without thechairman present in order to appraise his or herperformance. Those meetings with a non-executive focus should be included in the board'sregular schedule to reduce the risk of executivedirectors worrying that they are excluded fromcertain meetings. In addition to formal meetings,the whole board and the non-executive directorsas a group should meet informally on a periodicbasis in order to improve their ability to worktogether as a team.

The efficient working of the boardFigure 1.2 sets out a number of issues that mayhelp boards make their meetings more productive.The framework of issues that the board shouldconsider are as set out at the beginning of thischapter. As part of its responsibilities for strategyand resources, the board should approveacquisitions and other major capital expendituredecisions, the financing of the business, andbudgets and forecasts.

7P R A C T I C A L G U I D E T O C O R P O R A T E G O V E R N A N C E

Figure 1.2Successful board meetings Some areas to consider:

The board agenda should strike a balancebetween long-term strategic and shorter-term performance issues. All directorsshould have the opportunity to put items onthe agenda.

Agenda topics should be supported byconcise, informative papers with key pointshighlighted. Alternative courses of actionshould be proposed where relevant and therisks associated with proposed decisionsshould be noted and discussed.

Ensure that papers are distributed in goodtime.

Hold regular meetings including strategyaway days.

High attendance at meetings should beexpected and achieved.

Directors should come to meetings wellprepared.

The chairman should focus discussionaround the principal issues in each agendapaper.

All board members should feel able tocontribute at meetings and do so.

Major decisions should only be taken aftera full discussion at board meetings.

(Issues based on current good practice)


L O N D O N S T O C K E X C H A N G E8

A recent survey of large listed companies (3)

reveals that most boards meet between eight andten times each year – inclusive of strategy days,which can be a very valuable addition to the moreroutine meetings. Directors will find themselvessubject to increased pressure to attend board andcommittee meetings in the future since the newCode requires that individual director attendanceis publicly disclosed. This requirement and otherconsiderations should be borne in mind whenmeetings are being arranged though the meetingschedule will obviously have to fit around calendarrequirements such as the publication dates forinterim and final results. The chairman also needsto ensure that arrangements have been put inplace to allow for discussion among directorsbetween meetings, for example, by telephone,teleconferencing or e-mail.

Information available to the boardThe board needs information from inside andoutside the company to enable it to monitor andreview effectively the company’s performanceagainst its strategic objectives. This information

should embrace financial and non-financialmeasures of performance, taking proper accountof the company’s own performance and prospectsand how they compare to its principal competitorsand the market leaders. The board should have adashboard comprising a limited number of keyperformance measures with demanding targetsagainst which to assess progress. In doing so, itshould be careful to avoid excessive focus onshort-term performance at the expense of a morebroad-based understanding of the company’slonger-term positioning.

Non-financial measures of performance mightinclude:

market positioning of key brands;

customer satisfaction/retention;

employee satisfaction and turnover;

proportion of business attributable to newcustomers/products;

R&D and innovation measures;

social and environmental performance;

shareholder and other key stakeholderassessments of the business.


9

Performance evaluation anddevelopmentHuman resources’ best practice will no longerstop at the boardroom door: the new Codeindicates that the board should undertake a‘formal and rigorous’ evaluation of its ownperformance and that of committees and individualdirectors. At present, about two-thirds ofcompanies undertake some form of collectiveboard assessment (4) but even some of those arelikely to review and strengthen their existingprocesses in the light of the wording in the newCode.

Good Practice Suggestions appended to theCode outline a series of questions to assistboards in assessing their performance and in

identifying possible areas for future development(see Figure 1.3). The guidance also containssome questions on board procedures and on thechairman’s contribution to the effective functioningof the board.

Boards will obtain the most out of their evaluationif they have set themselves objectives againstwhich their performance can be measured. Theywill find it helpful to look back at some keydecisions the board has taken in the past year toconsider what can be learnt from them for thefuture. Was the information presented to theboard at the time the best available? Wouldfurther analysis have been helpful? Bearing inmind what is known now, how well did the boardaddress the main issues? Focusing on thechallenges ahead will be equally, if not more,

Figure 1.3Performance evaluation of the board

Has the board met its performance objectives?

What has been the board’s contribution to the testing and development of strategy?

What has been the board’s contribution to robust and effective risk management?

Is the composition of the board and its committees appropriate? Does it have the right mix ofknowledge and skills to maximise performance in the light of future strategy? Are the board’srelationships inside and outside the boardroom working effectively?

How has the board responded to any problems or crises that have emerged? Could or should thesehave been foreseen?

Are the right matters being reserved for the board?

How well does the board communicate with the management team, employees and others? Howeffectively does it use mechanisms such as the AGM and the annual report?

Is the board up to date with the latest developments in the regulatory environment and the market?

How effective are the board’s committees? Does each committee have the right composition? Howdo they interact with the main board? Do they fulfil their role?

Source: Related Guidance and Good Practice Suggestions, The Combined Code on Corporate Governance, 2003 (abridged)

P R A C T I C A L G U I D E T O C O R P O R A T E G O V E R N A N C E


L O N D O N S T O C K E X C H A N G E1 0

valuable. The board should think about how itneeds to approach those challenges if it is tomaximise the chances of achieving its goals. Anumber of boards are using questionnaires toidentify issues for discussion. They shouldconcentrate on those issues where most of theboard consider improvement is needed or wherethere is a divergence of view among boardmembers.

The evaluation should also consider how well theboard works as a team. Is constructive challengewelcomed or is it seen as dissent? Does it feellike a unitary board or is there evidence ofdifferent factions? Are there any dominant playersthat might – even accidentally – be restricting thecontribution of others? Some boards may find ituseful to involve an external facilitator in theevaluation process. The facilitator can manage the

information-gathering process and talk toindividual board members to discover key issuesfor discussion. The external input can help raiseissues that may not emerge if it was a purelyinternal process. Other boards may, however, feelmore comfortable in having a private discussionon their collective performance. Whichever path isfollowed, the board should develop an action planwith set timescales to ensure changes areimplemented as part of a process of continualimprovement in the boardroom.

Boards may find it helpful to look at the chart(Figure 1.4) showing seven types of board - aneffective board and six less successful variants.Each board should consider which unsuccessfulelements it possesses – it may be more than one– and how it can best steer back towards themost effective model.


P R A C T I C A L G U I D E T O C O R P O R A T E G O V E R N A N C E 1 1

Makes clear decisionsListens to in-house expertiseEnsures decisions are implemented

The Rubber StampDoes not consider alternativesDominated by executivesRelies on fed informationFocuses on supporting evidenceDoes not listen to criticismRole of non-executive directorslimited

Strong focus on futureLong-term strategies Consider social and environmentalimplications

The DreamersInsufficient focus on currentconcernsFail to identify and/or manage key risksUnrealistically optimistic

Short-term needs of investorsconsideredPrudent decision-making

The Number CrunchersFocus on financial impactLack of blue-sky thinkingLack of diversity of board membersImpact of social and environmentalissues largely ignoredRisk averse

Strong focus on externalenvironmentIntellectually challenging

The Semi-DetachedOut of touch with the companyLittle attempt to implement decisionsPoor monitoring of decision-makingIf out of touch with externalenvironment, board becomes totallydetached

All opinions given equal weightAll options considered

The Talking ShopNo effective decision-making/implementation processLack of direction from the chairmanLack of focus on critical issuesNo evaluation of previous decisions

The Effective BoardClear strategy aligned to capabilities

Vigorous implementation of strategy

Key performance drivers monitored

Effective risk management

Sharp focus on views of City and otherkey stakeholders

Regular evaluation of boardperformance

Clear decisions takenDecisions implemented

The Adrenalin GroupiesLurch from crisis to crisisFocus on short-term onlyLack of strategic directionInternal focusTendency to micro-manage

Figure 1.4Board Games: Common features of seven types of board - The effective board and those not achieving their full potential

Source: © 2004, RSM Robson Rhodes LLP



Figure 1.5Individual evaluation of non-executive directors

How well prepared and informed are the non-executive directors for board meetings? Is theirmeeting attendance satisfactory?

Do they demonstrate a willingness to devote time and effort to understand the company and itsbusiness? Do they have a readiness to participate in events outside of the boardroom such as sitevisits?

What has been the quality and value of their contributions at board meetings?

How successfully have they contributed to strategy development and risk management?

How effectively have they tested the information and assumptions with which they are provided?How resolute are they in maintaining their own views and resisting pressure from others?

How effectively and proactively have they followed up on any areas of concern?

Does their performance and behaviour engender mutual trust and respect within the board?

How actively and successfully do they refresh their knowledge and skills? Are they up to date withmarket and regulatory developments?

Are they able to present their views convincingly yet diplomatically? Do they listen and take onboard the views of others?

Source: Relevant Guidance and Good Practice Suggestions, The Combined Code on Corporate Governance, 2003 (abridged)

Most non-executive directors will not havepreviously been subject to individual assessment.The Good Practice Suggestions include proposedquestions that might help form a template fordiscussion between the chairman and each non-executive on their performance (Figure 1.5). Incertain circumstances the chairman may alsoprovide constructive feedback offered by otherdirectors. A balance needs to be struck thoughbetween a thorough evaluation and jeopardisingthe way in which the board works as a team.

It is the board’s responsibility to review theeffectiveness of its committees. Each committeeshould undertake its own performance evaluationbut board members who are not on a particular

committee should also have the chance tocontribute to the process. The results and follow-up plans should be approved by the whole board.

Performance evaluations will provide usefulinsights into the training and development needsof the board and its individual directors. This hastraditionally not been an area of high priority formany boards but the Code stipulates that newdirectors should receive a ‘full, formal and tailoredinduction’ on joining the board. All directors areexpected to continually update their skills,knowledge of, and familiarity with, the company.As a result, many more boards are likely to wantto establish board development and briefingprogrammes in the future.



DisclosureIn the past, the disclosures about the board havelargely centred on who is chairman, CEO andsenior independent director; the names of boardmembers serving on particular committees; andremuneration issues. The new Code goes muchfurther and calls for the following additionaldisclosures:

a statement of how the board operates,including a high level statement of which typesof decisions are taken by the board;

details of the number of meetings of theboard/committees and individual attendance bydirectors;

discussion of how performance evaluationshave been conducted;

disclosure of steps taken to ensure membersof the board develop an understanding of theviews of major shareholders about thecompany.

A light is being shone into the boardroom tohighlight how it operates as well as how it isconstituted. Boards will find, consciously orotherwise, that they are providing insights intohow they are discharging their responsibility forstewardship of the company. The informationprovided will be closely analysed by institutionalshareholders and other stakeholders.

References(1) Hugh Parker, Letters to a New Chairman, Institute of Directors, 1990

(2) Sir Adrian Cadbury, Corporate Governance and Chairmanship: A Personal View, Oxford University Press, 2002

(3) Spencer Stuart, 2003 UK Board Index

(4) Research study conducted by MORI for the Higgs Report – Review of the role and effectiveness of non-executive directors, 2003


Building atalentedboard

What are the board’s strengths and weaknesses?

Is there a strong presence on the board of both executive andindependent directors?

Is there sufficient diversity among board members?

What do institutional investors and other key stakeholdersthink of the board?

What new skills and experience will be needed to enable theboard to achieve its goals in the future?

Is there effective succession planning for board and seniormanagement appointments?

Is there a formal, rigorous and transparent process in place forselecting new directors?


P R A C T I C A L G U I D E T O I N V E S T O R R E L A T I O N S 1 5


Building a talented boardBuilding a talented board is a cornerstone of aneffective corporate governance system. Followingbest practice on effective board meetings will beworth very little if you do not have the rightpeople on the board in the first place. Recognisingthis, the new Code contains significant changes inrelation to board appointments that may alter theshape of many boards over time. It includes anumber of additional provisions relating to boardstructure and composition but the extent to whichthey will have their intended impact will bedependent upon the initial selection of boardmembers. Their collective skills, experience andapproach to running the business should makethem the best suited to driving it forward andachieving the company's goals. The process forselecting new directors will require significantattention by the board and its nominationcommittee. Currently, only 32% of respondents tothe Board Effectiveness Survey (1) agree that theirboards have a rigorous independent process inplace for selecting non-executive directors.

Board compositionFor the first time the new Code draws adistinction between the number of independentdirectors that are expected to be on the boards ofdifferent sizes of listed company. For FTSE 350companies, at least half the board (excluding thechairman) should comprise non-executivedirectors who are deemed independent. Theboards of other listed companies should include atleast two independent non-executive directors.This new two-tiered provision replaces the earlierone calling on at least a third of the board to bemade up of non-executive directors, a majority ofwhom should be independent. The Code nowincludes a set of criteria that ‘may appearrelevant’ in determining a director’s independence(see Figure 2.1). The board may decide that adirector is independent despite the existence ofone of the specified relationships orcircumstances but should then explain its reasonsfor doing so.

Figure 2.1

Reasons for challenging the independence of a directorHas been an employee of the group within the last five years

Has had a material business relationship with the company within the last three years

Received/receives additional remuneration apart from director’s fee; is in company share option orperformance-related pay scheme; or a member of the company’s pension scheme

Has close family ties with any of the directors, senior employees or advisers

Holds cross-directorships/has significant links with other directors

Represents a significant shareholder

Has served on the board for more than nine years

Source: The Combined Code on Corporate Governance, 2003 (abridged)



Figure 2.3

Average size of boards

NB: NEDs/Executive Directors figures exclude ChairmenSource: The Higgs Report - NEDs Review team analysis, 2003

FTSE 100 FTSE 250 Other listedExecutive Directors 3-6 2-5 2-4Non-executive Directors 4-6 3-5 1-3Total 9-12 7-10 5-7

Figure 2.2

Average board size and composition

Figures may not add up due to roundingSource: The Higgs Report – NEDs Review team analysis, 2003


The Code emphasises that the board should be ofa sufficient size so that its members’ skills andexperience are appropriate for the needs of thebusiness. The board's size should also allow it tochange its composition without undue disruption.At the same time, it should not be so large as tobe unwieldy and there should be a strongpresence on the board of both executive and non-executive directors. Given that executive directorsalready comprise, on average, less than half themembership of most FTSE 350 boards (see

Figures 2.2 and 2.3), these new provisions in theCode are unlikely to result in the hiring of largenumbers of new independent directors. They are,however, likely to lead to high-profile challengesfrom institutional investors as to theindependence of some long-serving, non-executive directors.

Figure 2.4 provides an overview of the currentcomposition of the boards of UK plc.

0

2

4

6

8

10

12

Non-executive directors

Executive directors

Chairman

FTSE 100 FTSE 250 Other listed All UK listed

6.0

4.0

2.32.7

4.5

4.0

2.83.0

1.01.0

1.0

1.0

11.5

9.0

6.06.7



The chairmanThe new Code clearly states that the roles ofchairman and CEO should be split, with thedivision of responsibility between them clearlyagreed and set out in writing. Research in 2003showed that only 5% of FTSE 100 companies, 4%of FTSE 250 companies and 11% of other smallerlisted companies still combined these positions. (2)

All of those companies that fall into this group andthat have institutional shareholders can expectcontinued pressure to have a separate chairmanand CEO.

Upon his or her appointment the chairman shouldnow satisfy the independence criteria set out inthe Code. There is also a new provision that, savein exceptional circumstances, the chief executiveshould not go on to become chairman of the

board, a relatively frequent occurrence until now.As a result, more boards are now likely to drawtheir future chairmen from among theirindependent board members. This is a factor thatwill need to be taken into account when selectingnon-executive directors and when allocating themtheir subsequent board responsibilities.

Senior independent directorThe Code advises that the board should appointone of the independent non-executive directors tobe the senior independent director. He or sheshould be available to shareholders to discussconcerns that they are unable to resolve throughthe normal channels of contact with the chairman,CEO or finance director. The senior independentdirector will also chair meetings of non-executivedirectors when the board chairman is not present.

Figure 2.4

Composition of boards of UK listed companies

Source: The Higgs Report - NEDs Review team analysis of data, 2003

Over 80% of those holding NED posts in UK listed companies hold one such post; comparative figure for chairmen is nearly 90%

Average age of FTSE 100 directors:

YearsChairmen 62NEDs 59CEOs 54Executive Directors 51

Proportion of UK listed directorships held by women:

FTSE 100 All listedChairmen 1% 1%NEDs 11% 6%Executive Directors 2.5% 4%



New board appointmentsThe board's nomination committee shouldevaluate the balance of skills, knowledge andexperience of the board and, in light of this,prepare a description of the role, experience andskills required for a particular new appointment.This should be done as part of a routinesuccession planning process, designed to ensurethat plans are in place for orderly succession tothe board and other senior management positions.On the executive side, this is likely to involve keyindividuals being given opportunities to gain abreadth of experience within the business and tobe visible to the board if they are not yet amember of it. The Conference Board hashighlighted the main features of a successfulsuccession planning process (3) (see Figure 2.5).

Looking at how an appointment will strengthen theboard as a whole rather than considering eachvacancy in isolation is welcome. There are plentyof examples in corporate history where highlytalented individuals did not work well together aspart of a team – to the detriment of all involved.

The nomination committeeThe nomination committee has the responsibilityfor leading the process for board appointmentsand making recommendations to the boardaccordingly. A majority of its members should beindependent non-executive directors. One ofthose independent non-executive directors or thechairman of the board should chair thenomination committee. An important point to notein the latter case: the board chairman should notlead the search for his or her own successor. Forsmaller listed companies with only twoindependent directors there would seem to bemerit in having the company chairman on thecommittee as the third member in order tofacilitate discussion among committee members.

The question of whether the company chairmanshould be permitted to chair the nominationcommittee was the subject of much discussionwhen the Code was being drafted. Given thechairman's responsibility for leading the board, astrong case can be made for his or herinvolvement in the committee alongside

independent directors. That case is strengthenedby the fact that the roles of the majority ofchairmen are non-executive in nature.

Whereas the previous version of the Codediscussed the need for a ‘formal and transparent’procedure for the appointment of board members,the new Code has crucially added the word‘rigorous’. The earlier version of the Code alsoallowed companies with a small board –irrespective of the size of the company – to avoidthe need for a nomination committee. Thatflexibility has now disappeared. As a result, manysmaller listed companies will wish to establish anomination committee in order to take on thedetailed responsibilities allocated to it within thenew Code. Last year, only 6% of FTSE 100companies and 19% of FTSE 250 companies didnot have a nomination committee but 71% ofsmaller company listed boards had yet toestablish one. (2)

Figure 2.5 Elements of a goodsuccession planning process

A continuous process

Driven and controlled by the board

Involves CEO input

Easily executable in the event of a crisis

Considers succession requirements basedon corporate strategy

Geared towards finding the right leader at the right time

Develops talent pools at lower levels

Avoids a 'horse race' mentality that may leadto loss of key deputies when the new CEOis chosen




Institutional investors and other stakeholders areincreasingly focusing their attention on the qualityof the board as a whole - including theindependent directors - rather than just themanagement team and the chairman. The views ofshareholders and other stakeholders will thereforebe valuable to nomination committees as theyseek to determine the board’s strengths andareas for improvement. As such, nominationcommittees should ensure that they can easilyaccess feedback from the financial community andother audiences. Comparing the board’scomposition relative to its main competitors andunderstanding the reasons for any substantialdifferences will also be worthwhile.

Issues for the nomination committee to address inevaluating the board’s skills and experience willinclude:

Is the board reasonably diverse or does it runthe risk of thinking in too uniform a fashion?An overly homogeneous board can provide aninsufficiently challenging environment fordecision-making - a highly risky approach intoday’s fast changing business world. Theboard needs to be properly balanced to enableit to address the current and, in particular,future challenges of the business. There shouldbe a mix of personality types so that there islively discussion of issues with alternativecourses of action considered. This requires theindependent directors to strike the rightbalance between being challenging yetsupportive of the executive team. Care shouldbe taken to avoid different factions emerging. Ifthis does happen some change in membershipmight be helpful. The board should have theright functional expertise, for example infinance, marketing, and people issues, butshould also be able to give appropriate weightboth to strategic and shorter-term tacticalissues. There needs to be a goodunderstanding of customers’ needs along withthe ability to engage the commitment of theworkforce and to communicate effectively withshareholders. Groups that are still frequentlyunder-represented include directors based inkey markets outside the UK, women, youngerdirectors, and those from ethnic minoritybackgrounds.

Does the board possess the in-depthexperience necessary for the work of itscommittees?The Code specifically calls for one member ofthe audit committee to have ‘recent andrelevant financial expertise’. However,questions about appropriate expertise shouldbegin rather than end there. The remunerationand nomination committees are increasingly inthe public eye and more boards may find ithelpful to have a non-executive director with ahuman resources background to respond tothese developments.

Is there a particular type of expertise that theboard would find helpful in the future?If a board knows that it will face a specificchallenge in the near future but lacks therelevant expertise around the table it may beworth recruiting a non-executive withexperience or skills in that field. That individualcan then provide advice to the board as itmoves forward. Examples may include adecision to improve corporate socialresponsibility performance, undergoing a majorchange management programme, growing newinternational markets, or planning an acquisitionprogramme

Is the board being regularly refreshed? The Code officially suggests that non-executivedirectors’ independence comes into questionafter nine years. Despite this, manycommentators would argue that two terms ofthree years each should be the normalbenchmark for a non-executive director.

When new appointments need to be made,consideration should be given as to how they canbest be phased in to ensure the smooth runningof the board. Forward planning of this nature willbe valuable if there is a perceived imbalance in theexisting range of skills, experience or personalitiesrepresented on the board; problems related to thecontribution of an individual board member; orsimply a desire to keep a winning team refreshed.A description of the role and the desirableattributes for the new director should be prepared– this will help determine the form the search forthe candidates will take and, for example, whichheadhunters or media outlets to use. A list ofgenerally desirable characteristics for boardmembers is shown at Figure 2.6.


References(1) RSM Robson Rhodes LLP and the London Stock Exchange, Board Effectiveness Survey, How does your board

shape up? General results report, October 2003

(2) The Higgs Report, NEDs Review team analysis of data supplied by Hemscott, 2003

(3) Corporate Governance Best Practices, A Blueprint for the Post-Enron Era, Conference Board, 2003

The Code calls for the company's annual report todisclose if neither an external search consultantnor open advertising has been used in theappointment of a chairman or of non-executivedirectors. This requirement highlights theexpectation that informal contacts should not bethe only means of identifying possible candidates.Smaller listed company boards, in particular, mayfind that thinking creatively about how to sourcecandidates for non-executive appointments willpay dividends. They may find it helpful, forinstance, to access registers held by a number ofprofessional bodies or to approach leaders ofsuccessful unquoted businesses. Other tacticsinclude building links with larger listed companiesin the area which may be interested in enablingtheir high flyers to gain boardroom experience,recruiting those on career breaks from marketleaders, or sourcing directors who have recentlystepped down from senior executive positions.

Time availableThe new Code makes it clear that companiesshould take steps to ensure that a potentialchairman or non-executive director has sufficienttime to undertake their duties. Those dutiesextend well beyond just attending meetings. Theymay include participating in site visits and relevantcompany activities, keeping up-to-date withdevelopments in the company and the sector, and allowing time for adequate preparation formeetings. When appointing a chairman, anassessment of the expected time commitmentshould be set out in the job specification,including recognition of their need for availability in crises. The board should be madeaware of a candidate's other commitments before any appointment is made and those details should then be disclosed in the next annual report once selection is confirmed.

Widening the poolThe new Code addresses the frequently raisedconcern that non-executive directors have oftenbeen drawn from a narrow pool based on existingdirectors’ contacts. The aim of the measures setout in it is to ensure that board appointments aremade on merit and against set objectives. Just asimportantly, the requirements help stakeholders toverify that this has been the case via improveddisclosure. Getting the appointment process rightis important as it determines how effectively theboard will function in the future. It will be mostsuccessful if the board and nomination committeeare prepared to devote the necessary time andcommitment to the selection of new boardmembers.


Figure 2.6 Behavioural characteristics of a good director

Asks the difficult questions

Works well with others

Has industry awareness

Provides valuable input

Is available when needed

Is alert and inquisitive

Has business knowledge

Contributes to committee work

Attends meetings

Speaks out appropriately at board meetings

Prepares for meetings

Makes long-range planning contribution

Provides overall contributionSource: Corporate Governance Best

Practices, Conference Board, 2003


Tyingremunerationclosely toperformance

Is the policy on directors’ remuneration in line with guidancein the Code and with guidelines of relevant institutionalinvestors’ organisations? Are the institutional shareholderssupportive of the company’s remuneration policy?

Has executive directors’ pay and performance been fairlycompared with that of a properly chosen peer group?

Are targets set for bonuses and long-term incentivepayments such that high rewards are only available foroutstanding performance?

Does the remuneration committee thoroughly assesswhether the targets have been met before making awards?

Are there any contract periods for executive directors inexcess of one year? If so, can they be justified?

Are arrangements in place to ensure that the company doesnot reward failure when directors leave early owing to poorperformance?

Is there a high level of transparency in publicly explaininghow remuneration has been determined?





Tying remuneration closely to performance‘Levels of remuneration should be sufficient toattract, retain and motivate directors of the qualityrequired to run the company successfully, but acompany should avoid paying more than isnecessary for the purpose. A significantproportion of executive directors’ remunerationshould be structured so as to link rewards tocorporate and individual performance’.

While this principle in the Code enjoys broadsupport in the business community, controversy islikely to remain in relation to its implementation inparticular cases. Among the issues attractingmost attention are the extent to which there is arobust linkage between performance andremuneration; avoiding rewards for failure; andtransparency of remuneration, both whenarrangements are being put in place and oncethey have been agreed.

Composition and role ofremuneration committeeThe Code calls on listed companies to have aremuneration committee wholly made up ofindependent non-executive directors. FTSE 350companies are expected to have a minimum ofthree members on their committee whereassmaller listed companies are allowed to have justtwo. The remuneration committee hasresponsibility for determining the remuneration forall executive directors and the chairman on behalfof the whole board. The committee alsorecommends and monitors the level and structureof remuneration for senior management, at leastfor the first layer below board level. The boarditself should normally determine the non-executivedirectors’ remuneration.

ABI Principles onRemunerationThe Association of British Insurers (ABI), whosemembers hold around 20% of the shares in UKlisted companies, has issued Principles andGuidelines on Executive Remuneration. (1) Theseare consistent with the Code and provide a

practical framework to help companies indetermining their remuneration policy andshareholders in making their voting decisions. Theprinciples call on remuneration committees tomaintain ‘a constructive and timely’ dialogue withtheir major institutional shareholders and the ABIon remuneration issues. They also suggest thatany departure from the stated remuneration policyshould be the subject of prior shareholderapproval.

The principles state that boards shoulddemonstrate that performance-basedremuneration arrangements are clearly aligned tobusiness strategy and objectives, regularlyreviewed and in line with current best practice.The ABI points out that simple remunerationstructures assist with motivation and enhance theprospects of successful communication with theemployees involved and with shareholders.Shareholders should also have their attentiondrawn to any special arrangements and significantchanges since the previous remuneration report.

The ABI Guidelines on the Structure ofRemuneration (1) call for companies to justify theiractions if they are seeking to pay salaries overand above median levels. This is designed toavoid a continual upward ratchet effect ondirectors’ remuneration which is inevitable if mostcompanies aim to pay above the medianbenchmark. Setting base salary levels below thecomparator group median provides moreheadroom for increasing performance-related pay.The guidelines also stress that shareholders donot support transaction bonuses as these providerewards irrespective of the future financialoutcomes of such deals.

Performance-relatedremunerationThe main provision in the Code on performance-related elements of remuneration indicates thatthey should align executive directors’ interestswith those of shareholders and give them ‘keenincentives to perform at the highest levels’. Moredetailed provisions set out how this should beachieved. On annual bonuses, for example, theCode states performance conditions should be‘relevant, stretching and designed to enhanceshareholder value’. Upper limits should be set and



disclosed. The ABI Guidelines for the Structure ofRemuneration (1) indicate that annual bonuses -which it notes will normally be payable in cash -can provide useful short-term incentivisation. Itsuggests that both individual and corporate

performance targets are relevant in setting annualbonuses.The key elements of the Code and the relevantABI guidelines dealing with share incentiveschemes are summarised at Figure 3.1.

Figure 3.1Share-based incentive schemes – some key elementsCombined Code provisions

Shares granted or other forms of deferred remuneration should not vest, and options should notbe exercisable, in less than three years. Directors should be encouraged to hold their shares for afurther period after vesting or exercise, subject to the need to finance any costs of acquisition andassociated tax liabilities.

Any proposed new long-term incentive schemes should be approved by shareholders.

Payouts or grants under all incentive schemes should be subject to challenging performancecriteria reflecting the company’s objectives. Consideration should be given to criteria that reflectthe company’s performance relative to a group of comparator companies in some key variablessuch as total shareholder return.

Grants under incentive schemes should normally be phased rather than awarded in one block.

The pension consequences and associated costs of base salary increases/other changes inpensionable remuneration should be considered especially carefully in the case of directors whoare close to retirement. In general, only salary should be pensionable.

Some additional elements in the ABI Guidelines for Share Incentive Schemes

Overall dilution under all schemes should not exceed 10% in any rolling ten year period. As ageneral rule, commitments under executive (discretionary) schemes should not exceed 5% of theissued share capital over a similar period.

Vesting of awards should be conditional on meeting challenging performance conditions related tooverall corporate performance.

Total shareholder return relative to a relevant index/peer group is one of a number of generallyacceptable performance criteria.

Share-based performance awards should not be made for less than median performance. Initialvesting levels should not be significant in relation to annual salary. Where an annual amountexceeds one times salary, a clear explanation of the stretching nature of the performance criteriashould be provided.

Shareholders welcome the trend towards sliding scale awards related to the achievement ofdemanding and stretching financial performance against a target group or other relevantbenchmark.

Performance conditions should be measured over a period of three or more years. Strongencouragement is given to using periods of more than three years. There should be no automaticwaiving of performance conditions in the event of a change of control or capital reconstruction.

Schemes should be designed to encourage share retention so that directors build-up/maintainmeaningful holdings in the context of their remuneration.

Source: Extracted from Combined Code on Corporate Governance, 2003 and ABI Guidelines for Share Incentive Schemes, 2003 (abridged)



Boards will also need to take account of theimpact of the International Financial ReportingStandard on Share-based Payment (IFRS 2). (2)

This will be applicable to listed companies’consolidated accounts for periods beginning on orafter 1 January 2005 and is also beingincorporated into UK GAAP. The standardrequires a charge to be made to the profit andloss account in respect of the expense associatedwith share-based payments and may well have theeffect of leading to more cash-based incentiveschemes. It is also retrospectively applicable togrants of shares or share options from November2002 that have not vested with the directors orother staff prior to 2005.

Not rewarding failureLarge pay-offs for departing executives in poorlyperforming companies have featured prominentlyin the business media for many years. Institutionalshareholders also find them a real cause forconcern.

The Code indicates that remuneration committeesmust carefully consider the total compensationcommitments their company would have in theevent of early termination of directors’ contracts –including those relating to pension contributions.The aim is to avoid rewarding poor performanceand the remuneration committee should take ‘arobust line’ on reducing compensation to reflectthe departing director’s obligation to mitigate loss.

The provision in the Code covering notice orcontract periods has been strengthened. Theyshould be one year or less and where it isnecessary to offer longer periods to new directorsrecruited from outside the company they shouldreduce to no longer than one year after the initial period.

The ABI and the National Association of PensionFunds (NAPF) have produced a statement of bestpractice on executive contracts and severancethat amplifies the guidance in the Code. Keyelements of the guidance are shown in Figure 3.2.

Non-executive directors’remunerationThe Code states that the remuneration of non-executive directors should reflect their timecommitment and responsibilities. The SmithReport on audit committees, appended to theCode, goes on to suggest that the remunerationof audit committee members may warrantparticularly careful review in light of the now moredemanding nature of the role. It says that‘consideration should be given to the timemembers are required to give to audit committeebusiness, the skills they bring to bear and theonerous duties they take on, as well as the valueof their work to the company’. In this respect, theremuneration of audit committee chairmen is likelyto require particularly careful consideration. Theextra emphasis placed in the new Code on thework of the nomination committee may also meanit is appropriate to review this committeechairman’s remuneration – if he or she is not theboard chairman. Meanwhile, if a company issetting up a nomination committee for the firsttime in the light of the Code's recommendations itwill also be worth considering the additional timecommitment that will be required from the relevantboard members.

The Code indicates that non-executive directorsshould not be paid in share options since to do somight impact their independence. If, however, acompany is absolutely intent on granting shareoptions to its non-executives then it should seekshareholder approval prior to going ahead with theplan. Any options should not vest until at least ayear after the non-executive director leaves theboard. Where an executive director is a non-executive director at another company, theremuneration report should indicate whether theywill retain the related earnings and, if so, theamount to which they are entitled.



Figure 3.2

Severance terms - desirable features of arrangements

At the outset, boards should calculate the potential cost of termination in monetary terms. Whenagreeing the terms of the director’s contract, boards should resist pressure to concede overlygenerous severance conditions. They should not support enhanced pension payments withoutbeing fully aware of the costs.

Objectives set for directors should be clear. This will make it easier to determine whether anexecutive has failed to perform and therefore to avoid making payments for this element ofremuneration in a severance package.

Initial contract periods of more than one year may be appropriate in ‘highly exceptionalcircumstances’. The example given is when a chief executive is recruited to a troubled company.

Phased payments are welcome. These involve paying the departing executive, say, on a normalmonthly basis for the outstanding term of his or her contract. The ABI/NAPF note thatshareholders believe this approach has ‘considerable advantages’ if it is also made clear that theexecutive has a legal obligation to mitigate their loss as in many cases they will obtain furtheremployment during the course of the payments, limiting future costs.

The liquidated damages approach is not generally desirable. The amount that will be paid underthis approach in the event of severance is agreed at the outset. Boards wishing to adopt thisapproach should consider modifying it to require arbitration to decide how much should be paid ifseverance occurs.

Where a director is dismissed as a result of disciplinary action a shorter notice period than set outin the contract should apply.

Consideration should be given to provide safeguards in extreme cases, for example if there were a very significant fall in the company’s share price relative to the sector.

Contracts should not normally provide compensation for severance as a result of change ofcontrol.

Source: ABI/NAPF Best Practice on Executive Contracts and Severance, 2003 (abridged)



DisclosureThe disclosure requirements dealing withdirectors’ remuneration are now contained in thestatutory based Directors’ Remuneration ReportRegulations (3) (see Figure 3.3 for a summary ofthe main disclosures).The Remuneration Report Regulations introduceda new requirement for the directors' remunerationreport to be approved by a resolution at theAGM. Entitlement to remuneration is not, strictlyspeaking, conditional on the resolution beingpassed. Despite this, it would be an unwise boardthat failed to heed a significant negative vote orabstention by shareholders even if a resolutionwas passed.

The ABI has welcomed the Remuneration ReportRegulations as ‘requiring both improveddisclosures by companies in their remunerationreports and greater accountability toshareholders’. Its Principles and Guidelines onExecutive Remuneration make it clear, however,that it expects companies to follow best practiceas regards disclosure rather than simply to complywith the regulations. Its primary interest lies inhaving a full and clear explanation of policy with aclear link established between reward andremuneration. The ABI stresses that companiesshould undertake a consultation process as theyformulate their remuneration policies rather thanrisk controversy when the resulting schemes arepublished in the annual report.

Figure 3.3 Key disclosures in the Directors’ Remuneration Report

Names of remuneration committee members and those who provided advice to it.

Statement of remuneration policy for the following and subsequent years.

For each director, the policy statement shall include a summary of performance conditionsregarding share options/long-term incentive schemes; an explanation of why they were chosen;and a summary of the methods to be used in assessing whether they have been met. The relativeimportance of elements that are/are not linked to performance are to be explained.

A performance graph showing total shareholder return for the company for the last five financialyears compared to that of a relevant broad equity market index.

Details of directors’ service contracts including potential early termination payments.

Audited details for each director of their remuneration, interests/movements in share options,interests in long-term incentive schemes, pension details. Payments to past directors.

Source: Department of Trade and Industry, Directors’ Remuneration Report Regulations, 2002 (abridged)



Promoting performance Remuneration committees will find it helpful tocarefully track total remuneration and itscomponents over time. This should be done byreference to the return being earned by thecompany and its shareholders and to thecompany’s performance relative to that of acomparator group. It is the remunerationcommittee's job when approving incentiveschemes to ensure that the linkage between payand performance is robust. They ought to checkthat the comparators chosen and the performancecriteria set are genuinely challenging and that theyare more suitable than possible alternatives.Members of the committee should also assessany 'small print' that may, for example, coverissues such as when the normal criteria may bewaived.

The Code’s exhortation to provide ‘keenincentives to perform at the highest levels’involves building significant levels of leverage intoremuneration packages. This does, however, needto be balanced against the risks of aggressiveearnings management if those packages are toodemanding. Outstanding performance should bevery well rewarded but average or modestlyabove average performance should not unlockhigh levels of performance-related remuneration.

It is worth remembering that the way directors’remuneration is set is seen by institutionalinvestors and others as an indicator of the board’soverall stewardship – as well as being animportant issue in its own right.

References(1) Association of British Insurers, Principles and Guidelines on Executive Remuneration, 2003

(2) International Accounting Standards Board, IFRS 2 Share-based Payment, 2004

(3) Department of Trade & Industry, Directors’ Remuneration Report Regulations, 2002


Strategic thinking

Does the group have a well-defined strategy? Have various alternative strategies been considered? Are theboard and senior management wholeheartedly committed tothe strategy?

Is the strategy aligned with its distinctive capabilities toprovide sustainable competitive advantage? Are the rightpeople in the right roles to implement it?

Does the group track its competitive environment on anongoing basis? Is it in a position to respond to changes inthat environment in a timely and effective manner?

Are the key performance measures and risks to be manageddirectly derived from the strategy?

Does the board keep the strategy - and its implementation -under regular review?

Is the board communicating the strategy successfully toinstitutional shareholders and other key stakeholders? Arethey fully supportive of it?





A strategic approach to gaining a sustainablecompetitive edgeWriting over a decade ago, Hugh Parker (1) used ayachting analogy to divide the strategic approachof boards into two groups – ‘day sailors’ and‘ocean-racers’. The former follow whatever coursethe prevailing winds and tide allow, with the leasteffort and discomfort for the crew, and return totheir moorings in the evening, back where theystarted. Successful ocean-racing teams, bycontrast, have a definite objective and course tofollow, recognise that they have a lot of toughcompetitors and possess a determination to win.They are highly organised and well-motivated with helmsmen, navigators, technicians and other specialists.

If boards are to fulfil their responsibilities underthe Code to set the group’s strategic aims theymust be ocean-racers and make fundamentalpolicy decisions – not just promote incrementalimprovements in operating efficiency. They musthave a keen understanding of the current andlikely future business environment; explore therange of strategic alternatives that are available;and be aware of the likely response ofcompetitors to their chosen path. Above all else,they must be absolutely clear as to the drivers oftheir success and the threats to their prosperity inthe years ahead. The board should also keep asharp focus on the main objectives that must befulfilled to keep the business strong and dynamic.

Developing a distinctivestrategyConstantinos Markides points out in All the RightMoves, A Guide to Crafting BreakthroughStrategy (2) that a strategic position is simply thesum of the company’s answers to the threequestions: Whom should I target as customers?What products or services should I offer them?How should I do this? He goes on to emphasise,however, that there are tough choices to be madewithin each of these three dimensions. It is just asmuch about the customers, products and servicesthat the business will not target and the activities

it will not pursue as those that it will. He arguesthat successful companies adopt a distinctivestrategy based on a unique combination of theabove dimensions so as to differentiatethemselves from their competitors. Moreover, afailure to make clear choices in each of thedimensions is a common cause of strategicfailure. Markides also stresses that strategy isdynamic. The advantages created by a uniqueposition will eventually be eroded by competitivechallenges. This implies that the only way tocreate enduring success is to perform well in theexisting strategic position while continuallysearching for new positions. Once one has beenchosen, the challenge lies in simultaneouslymanaging the old and new approaches.

Markides suggests a company must define itsbusiness in order to be able to answer the who,what, how questions outlined above. Thedefinition of the business must enable thecompany to fully leverage its unique competencies(or strengths). He says, for example, that aleading chain of coffee shops knows it is in the‘consumption experience’ market and not merelyselling coffee. In defining its business sector, acompany needs to assess whether it is likely togrow, whether it is protected by barriers to entryand whether it delivers what the company needsin order to be able to succeed. For successfulcompanies, the individual competencies andactivities support and reinforce each other. Theirpower lies in their unique combination in a givenbusiness. The most valuable capabilities are thosethat cannot be imitated or substituted by otherswithout significant expense.

Customer selection is not just about targetingpotential new customers within the chosensection of the overall marketplace; it also involveslooking at existing customers and asking whichshould be retained and which no longer fit with thechosen strategy. Likewise, having identifiedpotential new products or services, businessesneed to apply a cost-benefit screeningmechanism, taking account of their competenciesand their customer profiles, to see which will yieldthe best results. As with all aspects of a business,once products and services have been definedthey should be kept under constant review. It is aprocess that drives continual innovation.



Knowing at what you can bethe best in the worldMarkides’ views on the necessity of a clearly-analysed, well-focused strategy are supported byJim Collins in Good to Great. (3) He identifiedcompanies within the Fortune 500 list in theUnited States that had made the transformationfrom delivering good results to outstanding ones -and then sustained those results for a period of15 years. Their average stock market return wasabout seven times that of the market over thisperiod. Collins sought to identify common themesunderlying their growth. He concluded that the‘hedgehog concept’, drawn from Isaiah Berlin’sobservation that ‘the fox knows many things, butthe hedgehog knows one big thing’, lay at theheart of their success. The Good to Greatcompanies, in contrast to their less successfulcomparator companies, had a deep understandingof three key dimensions of their business and theinterrelationship between them. They were clearwhat they could be the best in the world at andequally the areas in which they could not achievesuch a level of excellence. They understood whatdrove their economic engine, that is how theycould most effectively generate sustainedprofitability and cash flow. As part of this, theyknew which measure of performance was themost important indicator of their success. Thirdly,they were very aware what they were deeplypassionate about, in other words the areas towhich they were really committed. Collins is clearthat the issue is not just about having a goodintention or plan to be the best at something but agenuine understanding of the fields in which youcan excel.

Capturing the soul of the organisationEarlier research by Collins with Professor JerryPorras of Stanford University reported in Built toLast (4) again demonstrates the merits of afocused strategy playing to deep strengths withinthe business. The distinguishing characteristic of

the companies in this study, all of whom had beensuccessful over a prolonged period, sometimesgenerations, was that everything was subject tochange except for ‘a cherished core ideology’comprising the company’s core purpose and corevalues. This core purpose ‘captures the soul ofthe organisation’ while the core values represent‘timeless guiding principles that require noexternal justification’. These might relate tocustomer service, quality, innovation, marketresponsiveness or teamwork, depending on theindividual company. In summary, the core ideologyis ‘the bonding glue that holds an organisationtogether’. See Figure 4.1 for an example of thecore ideology of a leading global pharmaceuticalcompany.

Figure 4.1 Example of ‘Built to Last’vision for a leading globalpharmaceutical companyCore ideology

Core values

Corporate social responsibility

Unequivocal excellence in all aspects of thecompany

Science-based innovation

Honesty and integrity

Profit, but profit from work that benefitshumanity

Core purpose

To preserve and improve human life.

Envisioned future

To transform the company into one of the pre-eminent drug-making companies in the world, with a research capability that rivals any majoruniversity.

Source: Collins, J.C. and Porras J.I., Built to Last, Successful Habits of Visionary Companies, Random House 1994



From drawing board to playing fieldBoards need to be constantly alert to emergingstrategic and market issues that call for strategicchanges or ‘jumps’. When the board decides thatits present strategy will not lead the company inthe desired direction in the longer term it will needto embark on a strategic review that may lead to asignificant change in course. Implementing thatchange will require a significant level of leadershipand commitment.

The Good to Great companies’ leaders werecommitted to producing sustained high levelresults and took the difficult decisions to achievethis goal. Their actions were relentlesslyconsistent with their chosen ‘hedgehog concept’(see Figure 4.2) and the combined impactgenerated great growth momentum. They wereambitious, but principally for the company rather

than themselves, and laid the groundwork for theirsuccessors to achieve even more than they did.They first got the right people on the team beforeaddressing issues such as strategy ororganisational structure and did not hire peopleunless they were absolutely sure that they metthe team’s needs. They acted when they neededto make personnel changes but first checked theydid not simply need to move someone intoanother position to make best use of theirstrengths. Perhaps most importantly, they puttheir best people to work on their bestopportunities, not their biggest problems.

Overall, the transformation of ‘Good to Great’companies was the result of cumulative effort withno single defining moment. Implementation oftheir strategy came down to persistent, consistentmovement in the chosen direction over asustained period. It was this dedication to thecarefully chosen strategic goals that ultimately ledto the point of breakthrough.


Figure 4.2

‘Good to Great’ – The key elements in the transformation

Their leaders were a paradoxical mixture of personal humility and professional skills rather thanthe high profile/celebrity type (Level 5 leadership).

‘They first got the right people on the bus, the wrong people off the bus, and the right people inthe right seats – and then they figured out where to drive it’ (First who --- then what).

They maintained unwavering faith that they would ultimately prevail but at the same time had thediscipline to confront ‘the brutal facts of their current reality’ (Confront the brutal facts).

Their strategies were founded on a deep understanding of three key dimensions that guided alltheir decisions (Hedgehog concept).

There was a culture of discipline – adherence to a consistent system but with freedom andresponsibility within its framework (Culture of discipline).

They did not use technology to ignite a transformation but were pioneers in the application ofcarefully selected technologies (Technology accelerators).

Source: Extracted from Collins, Good to Great, 2001(abridged)


BUILD UP

BREAKTHROUGH

Disciplined People Disciplined Thought

Level 5leadership

First who...then what

Confront the brutal facts

Hedgehogconcept

Culture ofdiscipline

Technologyaccelerators

Disciplined Action



Implementing a successfulchange programmeIn line with the above, Malcolm McKenziestresses (5) that if the board decides a strategy anda change/transformation programme is needed,then it must deliver in five areas in order to beeffective (see Figure 4.3). He suggests ‘thestrategy part is fun but not the most difficult part’.He considers it should take boards no more thanthree months to review, clarify and define thebroad strategy and goals for the company. Whereit takes significantly longer, he suggests that it isnormally an indication that insufficient effort hasbeen invested by the board in getting itself alignedaround the key issues. The resultingtransformation programme might, on the otherhand, last one to two years.

Strong commitment must be secured throughoutthe organisation to the way ahead with effectivemanagement of the desired change. Without it,the effort will be wasted and potentialperformance improvements will not be realised. Itis also essential to recognise that all changeprogrammes will encounter ups and downs - thechallenge is to navigate a route through whatMcKenzie calls the ‘valley of despair’. Three keymanagement actions will enable the business topass through this phase successfully: recognitionthat the ‘valley’ exists; continuous communication,feedback and support to help key stakeholdersthrough it; and understanding the importance of‘tipping points’. Tipping points occur when there isbroad acceptance of the new strategy, process orway of working as part of everyday life. Achievingthis takes real effort but a failure to reach thetipping point will lead to the old, embedded

practices re-emerging triumphant. McKenziesuggests the answer lies in data-based argumentssupporting the reason for change coupled withmanagement of the political and emotionaldimensions of it. Time needs to be spentconsulting around solutions, coaching keyinfluencers and addressing issues or resistance.Many transformation programmes fail becausethey start too many activities simultaneously andto avoid this problem the change should focusaround no more than two or three work streamsat any one time.

Quality timeDeveloping and implementing a strategy bestsuited to the business will largely determinewhether or not the company has a successfulfuture. The board should therefore ensure that itdevotes enough time and resources to the task. Itmust be careful not to let its responsibility tomonitor current performance deflect attentionfrom the vital role of giving longer-term strategicleadership to the business. Where strategicchange is called for, the role of the board iscritical throughout the whole process. It needs toget alignment around the need for change, thestrategic choices and the preferred final strategy.With consensus in the boardroom on this, its roleis to commit, communicate, lead and mobilise thebusiness as a cohesive team. The recent Board Effectiveness Survey of listed companiesfound that less than half of respondents wereconfident that their board had developed astrategy that gave their company a competitiveedge in line with its capabilities. Many companiesstill have a long way to travel on their strategicjourney.


References(1) Parker, H., Letters to a New Chairman, Institute of Directors, 1990.

(2) Markides, C., All the Right Moves: A Guide to Crafting Breakthrough Strategy, Harvard Business School Press, 2000.

(3) Collins, J.C., Good to Great, Random House, 2001.

(4) Collins, J.C. and Porras, J.I., Built to Last, Successful Habits of Visionary Companies, Random House, 1994.

(5) McKenzie, M. (RSM Robson Rhodes LLP), Institution of Mechanical Engineers, The 16th Annual Hugh Ford Lecture,“Manufacturing – does strategy matter?” 2004 (available at www.rsmi.co.uk).


Figure 4.3

Implementing effective strategy and change programmes

The blueprint for the strategy

What is a simple articulation of how the company is going to compete? What is the business model?How will the various parts of the organisation work together?

The business case

What would happen if there were no change? What is the value that will be created by the newstrategy? When, and how, can that be tracked?

The transformation programme

What are the key interventions that are going to be made? When? With what intended effect? Howdo these workstreams knit together to move the organisation towards its new goal?

A mobilised organisation

The board and cadre of senior management need, by this stage, to be committed and mobilisedaround the new strategy and transformation programme. There should be a plan as to how thismobilisation will be communicated and rolled out around the organisation.

A ‘transformation map’

There should be a joined-up ‘transformation map’ allowing everyone to view the scope of theactivities planned. This is not a timetable as such – rather a summary of the key activities and howthey work towards the strategic goal. This enables linkages between the various activities to be moreeasily identified and accommodated. The transformation map also facilitates deciding which activitieshave to come first and which can be delayed.

Source: McKenzie, Institution of Mechanical Engineers, 2004


Managingrisk effectively

Has the board determined its policies on risk managementfor the group? Is it clear on its risk appetite?

Is the board satisfied that the corporate culture is supportiveof the group’s approach to risk management?

Has the board identified the key risks inherent in thebusiness? Is the nature of those risks regularly reviewed inthe light of changes in the internal and external businessenvironment?

Does the board regularly receive reports on group riskmanagement and ensure necessary improvements are madeto maintain its effectiveness?

Is the group able to respond effectively to unexpectedcrises? Have any arisen that should have been anticipated?

Is risk management embedded in the board’s decision-making processes? For example, does the board give dueconsideration to risk when weighing up mergers andacquisitions? Is there a proper recognition of reputation risk?

Is the external reporting on risk management concise andinsightful?




Figure 5.1 Board’s role in reviewing the effectiveness of internal controlThe board should define the scope and frequency of reports on internal control during the year. The annual assessment process should consider:

Key risks and their identification/evaluation/management.

The effectiveness of the control system in managing those risks.

Whether prompt action has been taken to remedy any significant failings/weaknesses.

Any need for more extensive monitoring.

Changes between annual assessments in significant risks and the company’s ability to respond tochanges in the business/external environment.

Scope and quality of management’s ongoing monitoring of risks and the work of internalaudit/other assurance providers.

Communication of monitoring results to board.

Actual and potential impact of any failings/weaknesses on financial performance/condition.

Source: Extracted from the Turnbull Report, appended to The Combined Code on Corporate Governance, 2003 (abridged)


Managing risk effectivelyProfits are the reward for successful risk-taking ina modern competitive economy. Companies thatare overly cautious will miss opportunities and areunlikely to succeed in the longer run. Even morecertain failure awaits those who take risksrecklessly. The board’s challenge, therefore, is toensure risk is managed effectively in the business,not to eliminate it altogether. The board has to beproactive in its oversight role and to recognisethat the risks confronting a business areconstantly changing.

The board’s roleThe board’s risk management and controlresponsibilities include:

Promoting a culture that emphasises integrity

Embedding sound risk management in allaspects of the group’s activities

Approving the group’s ‘risk appetite’

Determining its principal risks and ensuring thatthey are communicated to the business

Setting the overall policies for risk managementand control

Adopting the most appropriate scheme ofdelegation of board responsibilities tocommittees

Receiving reports on a timely and regular basison the management of key risks and takingappropriate follow-up action. A list of theboard’s responsibilities with regard to theeffectiveness of internal control is set out atFigure 5.1

Integrating risk management into the board’sown decision-making

The Turnbull Report on risk management andinternal control is appended to the Code andprovides guidance on the application of therelevant sections of it. It allows the board todelegate tasks to the audit or other boardcommittees but the results of those committees’work should then be reported to, and consideredby, the board. The board retains responsibility forinternal control disclosures in the annual report.The new Code states that the audit committeeshould not only consider internal financial controlsbut should also review the broader internal controland risk management systems unless this hasbeen specifically addressed by a separate riskcommittee made up of independent directors.



Focusing on the principal risksThe board should consider all types of risks –whether strategic, operational, compliance orfinancial. A list of possible risks is set out inFigure 5.2. The board’s primary focus should beon the group’s principal risks, many of which willbe strategic but it should also ensure that financialand other basic controls are working effectively.Companies must identify and manage the risksthat threaten the achievement of their objectives –this involves having clear, unambiguous andmeasurable objectives that emanate from thestrategy.

To enable the board to decide which potentialrisks are most likely to be significant,management should advise it on the likely impactand probability of a range of events andcircumstances. The board, with its ‘helicopterview’ of the business, can have a valuable inputinto this process but it does need to becomplemented by the ‘bottom-up’ knowledge ofthose dealing with customers, suppliers andinternal processes on a regular basis. Care needsto be taken on two fronts. First, the board mustavoid taking too much of a ‘top-down’ approach torisk – an approach that floats over theorganisational structure and is not embedded in it.Secondly, it should resist the danger of a ‘bottom-up’ approach that misses strategic risks byfocusing only on day-to-day operational issues.Combining these approaches will, however, assistthe board in identifying the 'gross' risks it faces –that is, risk before any mitigation measures areapplied.

Determining the risk appetiteArmed with a list of 'gross' risks, the board candetermine, with appropriate delegation tomanagement, how these can be reduced to anacceptable level in line with the group’s riskappetite. Risks may be controlled internally (forexample, through supervision, division ofresponsibilities, quality control checks);

transferred through insurance or avoided bydeclining particular types of business or by way ofexclusion clauses in contracts. They can, ofcourse, also be carried as acceptable risks.

The risks remaining after mitigation measureshave been applied – the residual risks – are thosethat the board is willing to bear. The way in whichrisks are dealt with will depend on the group’s‘risk appetite’, namely, the amount of risk theboard believes it is appropriate for the business toaccept. The financial returns to the business, andtheir volatility around the mean, will vary accordingto the risk profile and the board needs to beconfident that it has the capabilities and resourcesto cope with the one chosen. It also needs to beconscious of the preferences of shareholders -they will be influenced by whether they areholding the stock for growth or income purposes.

Boards need to be alert to circumstances wheremanagement may be tempted to undertake riskybusiness transactions. Equally, they should ensureunnecessary controls are not imposed where thecosts outweigh the benefits and which might stiflethe spirit of entrepreneurship in the business.Appropriate opportunities to enter new markets,to develop products or services, or to beinnovative in their creation or delivery need to beseized. Unnecessary delays or a failure to act canbe very costly to the business.

Flexibility of responseThe board should be satisfied that responsibilityand accountability for managing risk is assigned toindividuals at an appropriate level in the business.It should also ensure that there are ‘early warning’mechanisms in place to identify problems whenremedial action can still be taken. Successfullyanticipating risks can prevent crises fromoccurring, saving valuable time and resources as aresult. Companies also increasingly need thespeed and flexibility to respond quickly andeffectively to circumstances that could not havebeen foreseen. Contingency and emergency plansshould be in place to minimise losses in the eventthat any crises do occur. These plans should bekept up to date, regularly tested and revised as aresult of experience gained.


Figure 5.2 Risks indicator

Source: RSMi International, Building World-Class Boards, 2003 (4)


StrategicUnfocused strategy

Strategy not aligned with capabilities

Complacency arising from past success

Unsuccessful acquisition/abortive bid

Failure to manage major change initiative

Reputational risk

Loss of investors’ confidence

Political/general economic risk

EthicalFailure to enact high standards of ethicsacross business

Obtaining contracts unethically

Stakeholder concerns on products/businessprobity

Suppliers/outsourcers/strategic alliances

Over-dependence on suppliers/outsourcers

Failure to manage cost/quality of outsourcedservice suppliers

Supply chain problems – human rights, childlabour

Joint ventures, strategic alliances notworking

FinancialCash flow/going concern problems

Treasury operations risk

Susceptibility to fraud/accountingirregularities

Legal/complianceFailure to protect intellectual property

Health, safety, environmental issues

Litigation risk

Breach of competition, corporate, employeeor taxation laws

PeopleLeadership/management not able to drivecompany forward

Inadequate succession planning

Loss of key players

Poor employee motivation

Internal communication weaknesses

MarketplaceNot responding to market trends/failure toinnovate

Missed opportunities – internetdevelopments, global markets

Weak brands

Over-reliance on a few customers

Poor level of customer satisfaction –quality/timeliness



Embedding risk managementThe board should ensure that risk management isfully embedded in the organisation’s culture andprocesses. Companies should have a code ofethics and be seen to uphold it when difficultchoices have to be made. A code that is out ofline with management behaviour, decisions andthe way that incentives are granted in practice canbe very corrosive so its application in practicemust be kept under regular review. Arrangementsshould be put in place to encourage those withconcerns about ethical breaches or otherirregularities to come forward – if need be,independently of line management. Formal self-assessment processes can also have a significantrole to play in successful risk management. Theycould, for instance, involve staff in key positionsbeing asked to give a signed statement to theboard concerning compliance with the company’sethical code and policies or confirming the

reliability of accounting and reporting procedures.Risk management issues should also feature inthe objective setting, appraisals and resultingremuneration of employees.

Communications and training across the group atall levels are essential to highlight everyone’s riskmanagement responsibilities. They can helpdevelop a culture of continuous improvement withlessons being learned from any failures orweaknesses identified in the system. Companiesshould also learn from their competitors' problemsor 'near misses', introducing new riskmanagement systems or processes accordingly.That said, a balance needs to be struck betweenmaking sure experience informs future action anddealing with something that has already been andgone. The primary focus must be on addressingtoday’s and tomorrow’s threats to theachievement of objectives. Some pitfalls to avoidin risk management are listed in Figure 5.3.

Figure 5.3 Risk management pitfalls

Box-ticking rather than business-led approach.

Failure to prioritise key risks.

Too narrow a focus on financial risks.

Not enough attention paid to changes in the internal or external environment.

Board discussing risk but not integrating it into their own decision-making.

Failure to embed risk management in organisational culture and processes.

Source: RSMi International, Building World-Class Boards, 2003 (4)



In the boardroomThe board has a responsibility to set a goodexample on risk management by carefullyaddressing risks in its own decision-making. Manyof those decisions, by their very nature, will havea crucial impact on the company’s future. Despitethis, only just over a third of respondents (36%)to the Board Effectiveness Survey fully agreedthat their boards ensure risk analyses aresubmitted to them prior to the approval of keyinitiatives.

Board-level discussion of risks will be essential,for example, in dealing with acquisitions.Companies with an experienced project managerworking on acquisitions from identification untilpost-implementation evaluation are 71% morelikely to have successful acquisitions than thosewho do not. (1) Issues to be addressed mightinclude:

Is there a strong business case for theacquisition? Has the target been carefullyidentified in line with the strategy rather thanbeing forced to fit it?

What risks might jeopardise achievement of theplanned synergies?

Are the political, regulatory and environmentalrisks understood?

How will competitors react to the bid?

Where it is desired for target management tobe ‘locked in’, what mechanisms are in place tosecure their motivation?

Capital structure risk also requires boardattention. Once again, only 41% of BoardEffectiveness Survey respondents were fullysatisfied that their board has the necessaryfinancial and human capital resources available toimplement its chosen strategy. Prudentpreventative measures in this area are likely toinclude: (2)

the avoidance of excessive, short-term,confidence-sensitive debt;

staggering debt maturities;

maintaining cordial relations and credibility withbanks during bad times and good;

negotiating ‘loose’ bank loan covenants whilethe company is financially strong;

maintaining bank lines in excess of anticipatedneeds;

negotiating renewals well in advance ofexpiration;

fully drawing credit lines at the onset of majordifficulties.

Reputation risk must also be high on the board’sagenda. Many leading businesses have enhancedinternal controls, reviewed auditor/accountingrelationships, revised codes of conduct andprovided ethics-related employee training inresponse to the much publicised corporatescandals of recent years. The risks of unethicalbehaviour remain at the forefront of CEOs' mindswhen asked to identify the main threats toreputation. They rate alongside product/serviceproblems, customer criticism, media criticism, adisaster disrupting operations and litigation oradverse court judgements. (3)



Managing risks, takingopportunitiesA wholehearted commitment to effective riskmanagement will help create a forward-lookingentrepreneurial business that is fully conscious ofits external and internal environment – and of theconstant changes in them. Such businesses willalways be striving to set priorities, develop andimprove.

References(1) International Federation of Accountants, Managing Risk to Enhance Stakeholder Value (B. Connell, Risks in the

Acquisition Process), 2002

(2) International Federation of Accountants, Managing Risk to Enhance Stakeholder Value (R. Darke, Capital Structure Riskand Bond-Rating Agencies), 2002

(3) Corporate Reputation Watch, Korn/Ferry International and Hill & Knowlton, 2003

(4) RSMi International, Building World Class Boards, 2003


A robustauditcommitteeDoes the audit committee possess the necessary financial,business and governance expertise? Does it have enoughmeeting time to fulfil its remit effectively?

Are all significant financial pronouncements thoroughlyreviewed by the committee before they are publicly released?How is the company’s quality of reporting regarded externally?

Does the committee lead in the company’s relationship withthe external auditors? Does it actively monitor auditeffectiveness and the auditors' independence?

Are the company’s internal financial controls and, whereapplicable, the overall internal control and risk managementsystems subject to rigorous ongoing review by the committee?Is any follow-up action monitored?

Does the internal audit function make a substantialcontribution to risk management in the business?

Are the ‘whistleblowing’ arrangements to enable staff to raiseconcerns about possible improprieties working well?

Are the annual report disclosures on the audit committee’swork concise and insightful?





A robust audit committee‘While all directors have a duty to act in theinterests of the company the audit committee hasa particular role, acting independently from theexecutive, to ensure the interests of shareholdersare properly protected in relation to financialreporting and internal control.’

The Smith Report, appended to the Code, thusdefines the role of the audit committee andprovides guidance as to the application of theCode in these areas. Whilst this definition placesa heavy burden of responsibility upon themembers of the audit committee, the SmithReport goes on to point out that all directors stillhold an equal legal responsibility for thecompany’s affairs. As a committee of the board,any disagreements between it and the rest of theboard should be resolved at board level. Wherean issue cannot be resolved, the audit committeeshould have the right to include it in its reportwithin the wider annual report.

The Smith guidance stresses that management isunder an obligation to ensure that the auditcommittee is kept properly informed and shouldtake the initiative in supplying information ratherthan waiting to be asked. The core functions ofthe committee relate to ‘oversight’, ‘assessment’and ‘review’ of the functions carried out bymanagement and the internal and externalauditors. The high-level overview role may,however, result in the need for members of thecommittee to undertake detailed work. The SmithReport stresses that the audit committee mustintervene if there are signs that something may beseriously amiss. Companies need to make thenecessary resources available to auditcommittees to enable them to undertake their‘wide-ranging, time consuming and sometimesintensive work’.

The Code indicates that the main role andresponsibilities of the audit committee should beset out in written terms of reference and shouldinclude the items shown in Figure 6.1. The overallrole of the audit committee has not been changedsignificantly in the new Code. Despite this, themuch more detailed discussion in the Smith

Report as to how audit committees shoulddischarge their responsibilities is likely to lead tomany of them spending more time in fulfilling theirremit. It may also require the companies toallocate more resources to assist them in their work.

Committee compositionAll members of the audit committee should beindependent non-executive directors. For FTSE350 companies, there should be a minimum ofthree members and for other listed companies atleast two members. The new Code adds that theboard should satisfy itself that at least onemember of the committee has recent and relevantfinancial experience. This requirement is likely tolead to a number of boards reviewing their auditcommittee membership. In practice, it will begenerally helpful if the audit committee chairmanhas strong financial skills but it is also importantthat the committee members have goodknowledge of the business and its sector. Inaddition, they should have appropriate personalcharacteristics such as the ability to askchallenging questions and to arrive at balancedjudgements in complex situations.

The results of the committee’s work should beconsidered by the board as a whole. Reportsshould include an indication of areas where actionor improvement is needed and recommendationson how matters should be followed up.

Meetings of the committeeThe Smith guidance recommends that thereshould be as many meetings as the auditcommittee’s role and responsibilities require. Itsuggests at least three meetings a year, forexample, when the internal and external auditplans are ready for review and when interimstatements, the preliminary announcement andthe full annual report are near completion. Itshould be stressed that three meetings is only aminimum recommendation – most audit committeechairmen will wish to call more meetings. Thepressures on audit committees have undoubtedly



increased so looking forward it would be wise forboards to ensure their audit committee membershave enough time at meetings to properly discusstheir areas of responsibility. It would not be agood idea to unduly condense the time allocatedto items in order to fit them in to the limitedamount of time that has traditionally beenavailable when a more appropriate solution wouldbe to increase the number of meetings held.

Training and updatesIn view of the pace of regulatory developments itis important to establish a developmentprogramme for audit committee members. TheSmith guidance suggests training should beprovided on an ongoing basis and should includean understanding of the principles of, and

developments in, financial reporting and relatedcompany law. However, it will be helpful for theprogramme to go beyond regulatory and standard-setting issues to enable the committee tounderstand the environment in which the businessis operating. Such training might cover emergingtrends, developments in best practice, the resultsof relevant surveys and new supportive guidancethat will assist the committee in fulfilling its remit.For the next few years at least, many companiesmay be applying International Financial ReportingStandards in their consolidated accounts and UKGAAP in other accounts. Audit committeemembers will need to be kept up-to-date on bothsets of standards. Similarly, for those with USlistings, it will be necessary to keep abreast ofdevelopments in accounting and regulatory issueson the other side of the Atlantic.

Figure 6.1 The audit committee’s main responsibilities

To monitor the integrity of the financial statements and any formal announcements on thecompany’s financial performance.

To review the company’s internal financial controls and (unless done so by the board/separate riskcommittee) its internal control and risk management systems.

To monitor/review the effectiveness of the internal audit function. If one does not exist, thecommittee should annually consider the need for establishing one, make a recommendation to theboard and explain the reasons for its continued absence in the annual report.

To make recommendations to the board on the appointment/removal of the external auditor and toapprove their terms of engagement and remuneration. If the board does not accept the auditcommittee’s recommendation, the committee should explain its recommendation in the annualreport and the board should set out its reasons for taking a different position.

To monitor/review the external auditor’s independence/objectivity and the effectiveness of theaudit process. If non-audit services are provided then the annual report should explain howobjectivity and independence are safeguarded.

To develop/implement policy on the engagement of the external auditor to supply non-auditservices and to report to the board on actions/improvements needed in this area.

To review arrangements by which staff may raise concerns about possible improprieties(‘whistleblowing’) in order to ensure arrangements are in place for their proportionate/independentinvestigation and for follow-up action.




Audit planningThe audit committee must ensure appropriateplans are in place for the audit at the start of eachaudit cycle. It should review the scope of theaudit; the planned levels of materiality; theseniority, expertise and experience of the auditteam; and the amount of time the auditors plan tospend on the audit. The committee should alsoagree the engagement letter with the auditor andbe satisfied that an effective audit can beconducted for the proposed fee.

Review of audit findingsIn reviewing findings from the audit, the SmithReport recommends that the audit committeeshould:

discuss with the external auditor major issuesthat arose during the course of the audit. Thisshould include issues that have subsequentlybeen resolved and those that have been leftunresolved;

review key accounting and audit judgements;

review levels of errors identified during theaudit, obtaining explanations from managementand, where necessary the external auditors, asto why certain errors might remain unadjusted;

review the audit representation letters beforesignature by management, giving particularconsideration where representation has beenrequested on non-standard issues; and

review the management letter from the auditorsand management’s responses to their findingsand recommendations.

Figure 6.2 Quality of financial reporting – areas of potential concern

Complex business/financing structures without obvious commercial rationale.

Transactions/adjustments around the year-end having significant impact on the financialstatements.

Results that are difficult to explain from an understanding of the underlying business.

Evidence of disagreements with auditors and/or management dominance of the audit team.Auditors experiencing difficulty/delays in obtaining sufficient audit evidence. Many misstatementsfound during audit.

Doubts on quality of reporting expressed by analysts, rating agencies or financial media.

Accounting policies/practices different from the industry norm, especially if there is a cumulativebias in the direction of management.

Unusual trends in financial ratios – for example, cash flows not in line with expectations giventurnover/profits, build-up of debtors/work in progress.

(Issues to consider based on current good practice)



Financial reportingManagement should inform the audit committeeof the methods used to account for significant orunusual transactions where the accountingtreatment is open to different approaches. Whenreviewing the company's annual financialstatements, the audit committee should then:

take account of the external auditor’s view andconsider whether the company has adoptedappropriate accounting policies and madeappropriate estimates and judgements;

review the clarity and completeness ofdisclosures and consider whether they areproperly set in context;

review the Operating and Financial Review, theDirectors’ Remuneration Report, corporategovernance and risk management statementsand other information presented with thefinancial report; and

report any concerns to the board.

As part of its review, the audit committee shouldstand back and make a judgement on the overallquality of the information being published. A list ofsome of the issues that might trigger concern isset out in Figure 6.2.

Evaluation of the auditorThe Institute of Chartered Accountants in England& Wales (1) has suggested a range of questionsthat the audit committee may wish to ask inevaluating the effectiveness of the audit process(see Figure 6.3). It suggests that the ‘overarching’issue will be the quality of leadership in theengagement team as this will set the tone for theaudit. One area that the audit committee mightwant to address is the quality of the auditpartner’s leadership in implementing the agreedaudit strategy. The auditors should also be able toshow that they are thinking about key issues andthat they can interact effectively with themanagement team while challenging them, ifrequired, on contentious issues.

Figure 6.3 Evaluating the audit process

Did the audit partners and senior audit staff have an up-to-date understanding of the business?

How effectively did the audit work focus on major issues and did it deal appropriately with them?

What recommendations were made for improvements to internal controls and other areas? Werethey useful?

Did the auditors make appropriate use of experts and technology in their audit work?

What was the quality of comments and reports on the non-statutory items? For example, did theaudit team report on the board’s corporate governance statement?

Was the work of internal audit used appropriately?

Were formal audit documents, for example, the audit plan and management letters, of sufficientquality?

Were the right numbers and quality of partners and staff used on the audit?

Source: Extracted from The Institute of Chartered Accountants in England & Wales, Evaluating your auditors, 2003 (abridged)



Independence and non-audit servicesIt is the audit committee's job to monitor theindependence and objectivity of the auditor. Itshould seek information on an annual basis fromthe audit firm on policies and processes formaintaining independence and on how it monitorscompliance with the relevant requirements.

The committee should develop a formal policy forthe provision of non-audit services by the auditor.It should specify the types of work from which theexternal auditors are excluded, those for whichthey can be engaged without referral to thecommittee and those for which a case by casedecision is necessary. The audit committee shouldalso check that there are safeguards in place toensure that there is no threat to audit objectivityand independence as a result of the provision ofnon-audit services. These checks will require aregular review of the nature of such servicesalong with a comparison of the fees relative to theaudit fee – for individual assignments and inaggregate.

Effectiveness of internal auditAn effective internal audit function can helpprovide assurance that there are appropriatecorporate governance processes in place. It maybe provided by employees of the company,outsourced or a mixture of both. A good internalaudit function can also reassure investors andother stakeholders that:

there is a robust risk management culture withall significant risks managed to the level agreedby the board;

effective controls exist over all businessoperations to prevent undesired exposure tothreats and to exploit opportunities; and that

actions are underway to remedy any controldeficiencies.

The Smith Report recommends that whenreviewing internal audit the audit committeeshould:

ensure that the head of internal audit has directaccess to the board chairman and the auditcommittee, and is accountable to thecommittee;

review and assess the annual internal auditwork plan;

receive a report on the results of the internalauditors’ work on a periodic basis;

review and monitor management’sresponsiveness to the internal auditor’s findingsand recommendations;

meet with the head of internal audit at leastonce a year without management present; and

monitor and assess the role and effectivenessof the internal audit function in the overallcontext of the company’s risk managementsystem.

To help audit committees appraise their internalaudit function, the Institute of Internal Auditors –UK and Ireland has developed 30 questions as astarting point for the exercise. (2) Some of thosequestions are shown in Figure 6.4.

WhistleblowingThe Institute of Chartered Accountants in England& Wales has pointed out (3) that the auditcommittee should have a 'high level' role inrelation to whistleblowing. As such, the committeeis not responsible for any whistleblowingarrangements or their operation although follow-upaction may be needed if there are signs that theyare inadequate or ineffective. However, itsuggests that the audit committee may wish toallow staff with concerns to contact its chairmandirectly. This open-door policy can be viewed ‘asan effective method of demonstrating the board’scommitment to the success of the process and itsindependence’.



The Institute’s guidance on whistleblowingincludes a range of questions that auditcommittees might ask. For example, are thereissues or incidents the board has learned of whichthey would have expected to have been raised atan earlier stage? Has the internal audit functionperformed any work on the effectiveness of thewhistleblowing procedures? Are there adequateprocedures to track the actions taken in relationto concerns raised? Do those procedures ensureappropriate follow-up action has been taken?

An open working relationshipAs the Smith Report highlights the most importantfeatures of the audit committee’s relationship withexecutive management and the internal andexternal auditors cannot be drafted as guidance orput into a code of practice. It stresses that it isabout ‘a frank, open working relationship and ahigh level of mutual respect’. It goes on to notethat ‘the audit committee must be prepared totake a robust stand, and all parties must beprepared to make information freely available tothe audit committee, to listen to their views and totalk through the issues openly’.

Figure 6.4 Assessing the effectiveness of internal audit – some key questions

Does the internal audit function have the appropriate technical expertise, qualifications andexperience to provide assistance in all areas of the business?

Has it given due consideration to the monetary/operational cost of control and assurance? Havethese been balanced against the benefits?

Have there been any significant control breakdowns or surprises in areas that have been reviewedby internal audit?

Is the internal audit function benchmarked against industry best practice?

Is it focused on key issues that concern the board?

Can it respond quickly to changes within the organisation?

Does the internal audit function ask powerful questions that stimulate debate and lead toimprovements in key risk areas?

Does management feel that recommendations made by internal audit are useful, realistic, forward-looking and meet their needs?

Source: Extracted from The Institute of Internal Auditors – UK and Ireland, Appraising internal audit, 2003 (abridged)

References(1) The Institute of Chartered Accountants in England & Wales, Evaluating your auditors, 2003

(2) The Institute of Internal Auditors – UK and Ireland, Appraising internal audit, 2003

(3) The Institute of Chartered Accountants in England & Wales, Whistleblowing arrangements, 2003


Takingcorporatesocialresponsibilityon board

Does the board’s approach to corporate social responsibilityflow directly from the corporate strategy?

Is there a board member with a special remit for corporatesocial responsibility issues?

Have key stakeholders been involved in determining thegroup’s corporate social responsibility focus? What are theirviews on the group’s approach and performance in this area?

Are relevant external guidelines being followed?

Have demanding targets and deadlines for action been set inkey areas?

Have the principal risks and opportunities related tocorporate social responsibility been identified?

Is there transparency in reporting progress made and indiscussing the scope for further development?


P R A C T I C A L G U I D E T O I N V E S T O R R E L A T I O N S



Taking corporate socialresponsibility on boardListed companies are increasingly recognising thattheir social and environmental performance canhelp create long-term value for shareholders andother stakeholders. They have also begun torecognise that a failure to monitor and developperformance in these areas can destroy value inthe business.

A recent World Economic Forum survey ofbusiness leaders (1) concluded that there is agrowing consensus of the key business reasonsfor supporting corporate social responsibility bestpractice. These include:

protecting and enhancing reputation, brandequity and trust;

attracting, motivating and retaining talent;

managing and mitigating risk;

improving operational and cost efficiency;

giving the business a licence to operate;

developing new business opportunities – newproducts and services, new markets, newalliances, new business models; and

creating a more secure and prosperousoperating environment.

Figure 7.1 illustrates the main sources of pressureon business to adopt high standards of corporatebehaviour. Successful businesses create avirtuous circle around their investors, employees,customers, suppliers and the communities inwhich they operate. Stakeholders will

demonstrate a stronger level of commitment tocompanies that address their needs andexpectations. Conversely, those who focus purelyon short-term financial results, ignoring theproblems that their businesses are causing toothers, risk becoming caught in a viciousdownward spiral. The result could be a decliningreputation that leads to difficulties in attractingcustomers or good employees and eventuallytranslates into a poor stock market rating.

Boardroom leadershipTo be effective, a commitment to corporate socialresponsibility must have the wholehearted supportof the board. It has to be a long-term commitmentthat involves ongoing improvement inmeasurement, verification, performance andreporting. Once decided, the company’s positionshould be reflected in its statement of values orpurpose and its core principles of doing business.

The board must also ensure that it devotesenough time to corporate social responsibilityissues and that they are taken into account as amatter of course when, for example, makingacquisitions or other major investments. It may beworth appointing an executive director with aspecial brief for corporate social responsibilityissues across the business. Alternatively, whenselecting independent directors there could bemerit in appointing somebody with corporatesocial responsibility expertise and giving them adesignated board leadership role in this area. Afew boards have appointed a separate committeeas a focal point for their work on corporate socialresponsibility.


Figure 7.1 Sources of pressure on business

Source: Centre for Tomorrow’s Company, included in Nelson, J. et al, The Power to Change, The Prince of Wales International Business Leaders Forum and Sustainability, 2001 (5)


Political opinion Law/regulationIndustry and

market standard

Public opinion/confidence Company Industry

reputation

Pressure groups

Individual attitudes:customers, suppliers,

consumers,employees, investors

and community

Media



A company-specific focusTo have credibility, the group’s corporate socialresponsibility policy and action plan must tacklethe significant issues confronting the company.They should be treated as mainstream businessissues.

A report commissioned by the Association ofBritish Insurers (ABI) (2) has identified three recentgeneral trends in corporate social responsibilitythat will help businesses formulate their approach.Firstly, corporate social responsibility is nowwidely accepted. It has spread throughout thebusiness world and is no longer seen as justaffecting those sectors where traditionally therehave been high profile issues such as oil,chemicals or branded merchandise businessessourcing their goods from the developing world.Secondly, corporate social responsibility hasstarted to move from the periphery of business toits core, where it is being integrated into businessstrategy and marketing. Thirdly, there is anincreasingly sharp focus on company and sector-specific issues. The ABI report concludes thatwhile all companies face generic risks, it is thespecific ones that may present the greater risk or

opportunity in many instances. Many of thegeneric risks are covered in key codes, forexample the UN Global Compact and the OECDGuidelines for Multinationals (see Figure 7.2).Examples of sector-specific risks are:

Social exclusion

A major issue for the financial sector in providingbanking and insurance services to those on lowincomes. It also tends to affect utilities andpharmaceutical groups, the latter as regardsaccess to drugs in the developing world.

Excessive consumption

A failure to discourage customers fromconsuming too much of their products or services.Alcohol, tobacco and gambling have long been inthis category but it has recently been extended to‘unhealthy’ – or too much – food and the provisionof credit cards.

Fair trade

Traditionally focused on offering a fair price tosuppliers of commodities in the developing world,for example tea and coffee. It has now beenextended to include relations between, say, UKfarmers and major food retailers.

Figure 7.2 Main issues covered by international codes

Treatment of employees/workers in the supply chain - embracing diversity, health and safety, payand conditions, child labour.

Human rights issues - for example torture, political imprisonment, bribery and corruption.

Environmental impacts - including sourcing of materials, product use and disposal.

Community impacts - including support for community organisations and the economic impacts oflocation decisions.

Transparency - engagement in dialogue and reporting of performance in the above areas.

Source: ABI, Risk, Returns and Responsibility, 2004



Engaging with keystakeholdersCompanies should engage with their keystakeholders to determine what they regard asthe group’s principal corporate social responsibilitychallenges and to understand if they areaddressing them. This feedback can then helpdevelop the group’s corporate social responsibilityagenda – a process that should be led by boardmembers or senior management. Much remainsto be done on engagement with stakeholders:less than one in seven of respondents (14%) tothe Board Effectiveness Survey fully agreed thattheir board monitors how key stakeholders viewtheir company’s corporate social responsibilityperformance. This was the least positiveresponse, by a wide margin, to any question inthe survey. Existing meetings with stakeholdergroups – for example, the financial community andemployees – can be used to ascertain their viewson corporate social responsibility issues. It mayalso be worth establishing whether thosestakeholders with whom the business regularlymeets have specific corporate social responsibilityrepresentatives. For example, many fundmanagement groups will now have somebody whois permanently focused on these issues. Newarrangements should also be made to meet withstakeholder groups that do not have a regularaudience with the company. There might be ‘oneoff’ meetings or more permanent advisory panels.A merit of cross-stakeholder discussions is thatboth they and the business can see the ‘trade-offs’ that will be required in responding to theirdiffering needs. Annual meetings and thecorporate website are also useful channelsthrough which to provide information andencourage two-way dialogue on corporate socialresponsibility issues.

GuidelinesWhile the Code does not directly refer tocorporate social responsibility, it falls squarelywithin the principle that ‘the board should statethe company’s values and standards and ensurethat its obligations to its shareholders and othersare met’. Corporate social responsibility willimpinge on the application of much of the Code,

including risk management, dialogue withinstitutional shareholders and reporting.

The UK Government is committed to introducingan expanded mandatory Operating and FinancialReview (OFR) in the annual report of quoted UKcompanies in the near future. It will requireforward-looking discussion of broader strategicissues. The draft regulations make specificreference to including relevant information onemployees, environmental matters and social andcommunity issues. The existing OFR, revised bythe Accounting Standards Board in 2003, alreadycalls on companies to discuss the objectives ofthe business which may include those in the areaof corporate responsibility.

The ABI’s best practice guidelines (3) outlinedisclosures that institutional investors would lookfor in the annual reports of listed companies (seeFigure 7.3). Their recent report showed that while80 of the top 100 companies have provided full ormoderate disclosure on social, environmental andethical issues (23% and 57% respectively) lessthan half of other listed companies have achieveda similar level. For FTSE 250 companies thecomparative figures are 2% full and 46%moderate disclosure, while for the FTSE All Sharecompanies only 6% provide full and 35%moderate disclosure. Full disclosure meanscompliance with the ABI guidelines on social,environmental and ethical issues. This includesdefining board and management responsibility inthese areas; identifying the relevant risks, theirbusiness impact and policies and procedures todeal with them; disclosing performance andtargets for quantifiable risks; and some form ofinternal or external verification or audit.

Another set of respected guidelines has beendeveloped by the Global Reporting Initiative (GRI).Over 600 companies around the world haveproduced hard-copy corporate social responsibilityreports in each of the last two years and abouthalf of them refer to the GRI guidelines. Asummary of those guidelines on report content isshown in Figure 7.4.

The UK's Business in the Community (BITC) hasalso developed a set of indicators, many of whichare similar to the GRI guidelines. BITC’sCorporate Responsibility Index (4) rates companiesaccording to their own assessment of theircorporate responsibility processes and



performance. The Corporate Responsibility Indexhas been designed to promote a systematicapproach to measuring, managing, and reportingthe various impacts that companies have uponsociety and their environment. The latest resultsfrom over 130 participating companies (4) suggestthat the majority are looking at corporateresponsibility issues across their businesses.However, the integration of responsible businesspractice across operations is less advanced than

the development of corporate strategy in thisarea. Likewise, corporate social responsibility isbeing considered as part of the risk evaluationprocess but further engagement of externalstakeholders is required. Four out of five of theparticipating companies have a board director withexplicit responsibility for human rights but manyneed to focus on educating and training their staffto ensure their codes of business behaviour arebeing implemented in practice.

Figure 7.3 ABI disclosure guidelines on socially responsible investmentBoard disclosures

The company should state in its annual report whether the board:

Takes regular account of the significance of social, environment and ethical (SEE) matters to thebusiness of the company.

Has identified and assessed the significant risks to the company’s short and long-term valuearising from SEE matters, as well as the opportunities to enhance value that may arise from anappropriate response.

Has received adequate information to make this assessment and that account is taken of SEEmatters in the training of directors.

Has ensured that the company has effective systems in place for managing significant risks.Where relevant, these should incorporate performance management systems and appropriateremuneration incentives.

Policies, procedures and verification

The annual report should:

Include information on SEE-related risks and opportunities that may significantly affect thecompany’s short and long term value and how they might impact on the business.

Describe the company’s policies and procedures for managing risks to short and long-term valuearising from SEE matters.

Include information about the extent to which the company has complied with its policies andprocedures for managing SEE risks.

Describe the procedures for verification of SEE disclosures. They should be such as to achieve areasonable level of credibility.

Source: ABI, Disclosure Guidelines on Socially Responsible Investment, 2001 (abridged)



A balancing actThe World Economic Forum report referred to atthe beginning of this chapter points out thatbalancing long-term goals with short-termimperatives and managing and accounting for aplethora of non-traditional risks and opportunities

calls for new leadership skills and newapproaches to communication. It also calls fornew types of co-operation. Investors andcorporations can do much to work together in amanner that makes sound business sense whilealso increasing our common ability to manage riskand promote sustainable prosperity.

Figure 7.4 GRI reporting guidelines: suggested content of sustainability reportVision and strategy – description of the reporting organisation’s strategy with regard to sustainability,including a statement from the CEO.

Profile – overview of the reporting organisation’s structure and operations. Also to include the scopeof the report.

Governance structure and management systems – description of organisational structure, policiesand management systems, including stakeholder engagement efforts.

GRI content index – a table supplied by the reporting organisation identifying where the informationlisted in Part C of the Guidelines is located within the organisation’s report. Part C covers directeconomic, environmental and social impacts (labour practices, human rights, society and product liability).

Performance indicators – measure of the impact or effect of the reporting organisation divided intointegrated economic, environmental and social performance indicators.

Source: Global Reporting Initiative, GRI Reporting Guidelines, 2002 (6)

References(1) World Economic Forum, Values and Value, Findings of a 2003 CEO Survey of the World Economic Forum

Global Corporate Citizenship Initiative in partnership with The Prince of Wales International Business LeadersForum, 2004

(2) Association of British Insurers, Risks, Returns and Responsibility, 2004

(3) Association of British Insurers, Disclosure Guidelines on Socially Responsible Investment, 2001

(4) Business in the Community, Corporate Responsibility Index, 2003(bitc.org.uk/docs/2nd_Corporate_Responsibility_Index_Executive_Summary.pdf)

(5) Nelson J. et al, The Power to Change: Mobilising board leadership to deliver sustainable value to markets andsociety, The Prince of Wales International Business Leaders Forum and Sustainability, 2001

(6) Global Reporting Initiative, GRI Reporting Guidelines, 2002


An activedialogue withshareholders

How effective is the company’s investor relations programmein developing two-way dialogue with institutional investors,private investors and analysts? How could it be enhanced?

Is the board fully aware of institutional investors’ views of thestrategy and performance of the group and of the quality ofits management/board?

Does the company thoroughly evaluate its investor relationsperformance?

Have new investors been identified and targeted formeetings?

Are there procedures in place to manage relationships withshareholders in the event of a crisis?

How satisfactory is the amount and content of companycoverage in the financial media? What improvements couldbe made in this area?

Do the annual report/AGM/website meet the needs of usersand accord with best practice?





An active dialogue withshareholdersLess than half the respondents to the BoardEffectiveness Survey – just 47% – said that theirboard has a complete understanding of investors’expectations of the company and how theyperceive its performance. It is therefore timelythat the new Code has enhanced coverage onmaintaining an effective two-way dialogue withinstitutional shareholders. Indeed, it is particularlyapt given the growing willingness of institutionalinvestors to express concern actively when theyfeel the situation demands it.

Dialogue with institutionalshareholdersInstitutional shareholders include insurancecompanies, life assurance companies, pensionfunds, investment trusts and other investmentmanagement groups. As a group, they aresignificant shareholders in many listed companiesincluding all larger ones. In some smaller listedcompanies, a handful of institutions sometimeshold a very significant proportion of the shares.Where hedge funds have an interest in acompany's shares this may introduce an elementof volatility through the buying and selling of largetranches of shares in a relatively short period.

The Code stresses that there should be adialogue with shareholders based on a mutualunderstanding of objectives. The board as a wholeis given the responsibility for ensuring that thedialogue is satisfactory. The Code acknowledgesthat most shareholder contact will be with theCEO and finance director but says that thechairman should maintain sufficient contact tounderstand issues and concerns. He or sheshould also be in a position to discussgovernance and strategy matters with investorsand feed their views back to the board. Inaddition, the senior independent director shouldattend sufficient meetings so that he or she, likethe chairman, can develop a balancedunderstanding of the issues and concerns of themajor shareholders. Non-executive directors

should be offered the opportunity to attendmeetings with major shareholders and areexpected to do so if shareholders request ameeting.

Added together, these provisions make it muchmore difficult for any institutional shareholderconcerns not to be known by the chairman andindependent directors. The Code also states thatthe annual report should set out the steps takento ensure the board and, in particular the non-executive directors, develop an understanding ofmajor shareholders’ views of their company. Thismay be achieved through a range of approaches,including face-to-face meetings, analysts’ orbrokers’ briefings and surveys of shareholders’opinions.

Getting to know your major shareholdersBoards should gain an understanding of each oftheir major institutional shareholders and, wherethere is a fund manager representing them, themandate(s) under which they manage the shares.This knowledge will give an invaluable insight intothe likelihood of those investors holding theshares for the longer term. Fund managers whoseperformance is judged over a period of yearsrather than by reference to quarterly returns ontheir portfolio are, for example, less likely to beregularly trading the shares they manage.Similarly, tracker funds will be required to holdshares across all of a given index.

It will be helpful for the board to understand howtheir institutional shareholders monitor theirholdings and approach governance issues. Someinstitutions employ a screening system based onfinancial performance and then look at the rootcause of a problem, for example in strategy orgovernance, when performance falls below aspecified financial benchmark. Others will followup governance concerns irrespective of thestrength of current financial performance andsome will act on issues of strategic importance,say risk management. In such instances it iscommon to look at how well the matter is dealtwith across a particular business sector in orderto make comparisons with a peer group.



Figure 8.1 Circumstances when institutional shareholders/agents may interveneIntervention may occur in response to concern about:

strategy;

operational performance;

acquisition/disposal strategy;

independent directors not holding executive management properly to account;

internal controls failing;

inadequate succession planning;

unjustifiable failure to comply with the Combined Code;

inappropriate remuneration levels/incentive packages/severance packages;

a poor approach to corporate social responsibility.Source: Institutional Shareholders’ Committee, The Responsibilities of

Institutional Shareholders and Agents - Statement of Principles, 2002 (abridged)

Despite the undoubted differences in approach,certain common themes do emerge amonginstitutional investors and fund managers:

Institutional investors and their fund managersdo not want to micro-manage their investmentsbut do want assurance that the board isactively directing and leading the company andthey want to know that it is well managed.

They want a company's board to have a clearstrategy that it is able to articulate and deliver.

Companies need to have a clear understandingof the principal risks that need to be managed ifthe business is to achieve its objectives.

Remuneration packages should be genuinelyaligned with shareholders’ interests. There is awillingness to see outstanding performancewell rewarded but concern that in someinstances average, or slightly above average,performance has been attracting high payouts.There is also strong interest in making surefailure is not rewarded – investors will generallybe suffering losses or low returns when thishappens.

Frustration exists at the amount of ‘boilerplate’,that is detailed but bland, disclosure in annualreports, especially in areas such as governanceand risk management. This is coupled with anaffirmation of the importance of the annualreport and a desire for effective accountabilityand communication through it as to how thecompany is performing, how it is governed andhow it is addressing the challenges it faces.

There is a willingness, especially in the case ofsmaller listed companies, to accept somedepartures from the Code and not to treatthem as breaches of good corporategovernance. However, in such instances thecompanies are expected to provide clearjustification for their actions.

Boards should take the above points into accountand make sure that they are aware of the views oftheir major shareholders on issues such asstrategy, performance, quality of leadership andboardroom remuneration. In certain instances,such as the appointment of a new chairman orCEO, they would be well advised to sound out theviews of those investors in advance. As well asconsidering the views of current institutionalshareholders, it can sometimes be worth talkingto potential investors in order to obtain analternative view. In the case of a larger listedcompany, potential investors might include anymajor institution that is unexpectedly light in its



holdings. The board should also keep up to datewith financial, trade and other press coverage ofthe company together with the current range ofviews on the company's outlook in brokers' notes.

Large institutional shareholders will want directcontact with the company through presentationsand one-to-one meetings. Subject to adhering tothe requirements concerning the release of price-sensitive information, there should be a regularflow of information to the market withmanagement available to respond to investors'questions after key announcements have beenmade. For example, after the announcement ofpreliminary results to the market at 7.00 amthrough a Primary Information Provider (PIP) thereshould normally be a range of follow-uppresentations and meetings that day. Somecompanies will also follow these initial meetingswith a roadshow to see other investors.

In addition to meetings with institutionalshareholders, companies often arrange separatemeetings with analysts. At all these events, theyshould make sure that they communicate theirstrategy and competitive strengths clearly andsuccinctly. Many companies also use site visits toprovide investors and analysts with a greaterinsight into their business, to demonstrate newproducts and to allow them to meet othermembers of the senior management team.

The Institutional Shareholders Committee (1) hasindicated the circumstances in which institutionsmay wish to discuss their concerns with an

investee company (see Figure 8.1). Its Statementof Principles goes on to outline the escalatingform that such interaction may take depending onthe response received (see Figure 8.2). TheCommittee has also set out the informationavailable to companies from institutional investors– companies will find it helpful to obtain this bothwith respect to current and potential institutionalshareholders (see Figure 8.3).

Foreign institutional ownership forms a growingelement of the UK market and companies shouldensure that the needs of their overseasshareholders are not overlooked. Marketinformation should be made available to a globalaudience via the web or other forms of electronicdistribution. Many companies are now makingpresentations of their results through conferencecalls and web casts allowing easy accessregardless of location. Companies with anincreasingly international shareholder base shouldmake sure that they visit their overseas investorson a regular basis as well as actively inviting thoseinstitutions to domestic investor events.

Private investorsThe Code focuses primarily on institutionalinvestors but companies should be careful not tooverlook private investors when organising theirinvestor relations activities. Private investors canbe especially important to smaller listedcompanies who may find it difficult to attract aninstitutional following. They can also be a very

Figure 8.2 Possible forms of intervention byinstitutional shareholders/agents

holding additional meetings with management

expressing concern through the company’s advisers

meeting with the chairman, senior independent director, all independent directors

intervening jointly with other institutions

making a public statement in advance of an AGM/EGM

submitting resolutions at shareholders’ meetings

requisitioning an EGM, possibly to change the boardSource: Institutional Shareholders’ Committee, The Responsibilities of

Institutional Shareholders and Agents - Statement of Principles, 2002 (abridged)



loyal group of shareholders, with many relying onpress comment and company communications forinformation on their holdings. On the downside,the cost per share of maintaining private investorson the share register, including sending themrelevant information, can be much higher than forinstitutional counterparts because of their smalleraverage shareholdings.

Smaller listed companies may find it helpful todevelop links with private client brokers in theirareas in order to build a strong local followingfrom private investors. Such moves can also beenhanced by developing good links with theregional financial press. Some companies seek toattract private investors by offering discounts ontheir products or services. Shareholder 'perks'such as these have proved a reliable way ofbuilding a following in the past in some instancesbut care needs to be taken that the cost of thediscount remains reasonable.

Attracting institutionalinterestThere is no ideal balance on the shareholderregister between institutional and privateshareholders. It will depend on the company'scircumstances including the current mix ofshareholders the resources available to targetnew investors and whether the board wishes tosource new capital in the near future.

Many smaller listed companies express concernabout not being able to attract an institutionalinvestor following. Without institutional interest,smaller company shares can suffer from lowliquidity meaning that moderate share purchasesor sales leads to volatility in the share price. Thereis no easy solution but the following may help inincreasing institutional interest:

ensure a sufficient ‘free float’ of shares so thatthere is a reasonable possibility of liquidity inthe market;

ensure the company is seen to be wellgoverned with a skilled management team andwell respected non-executive directors (wherea family business, it will be important topersuade the market that directors are selectedon grounds of merit);

develop a credible strategy that offerssignificant potential for the company – growthis the main reason for institutional investors ortheir fund managers to take an interest insmaller listed companies;

generate interest among analysts in thecompany, if possible securing it from analystsindependent of the company’s broker, ideallyaccompanied by published research;

develop links with financial journalists, whethernational, regional or from the trade press, andproject the company in a way that targets theselected journalists’ special interests; and

follow the cardinal rule of not surprising themarket, especially not with negative news.

Figure 8.3 Information available frominstitutional shareholders and their agentsA clear, publicly available policy statement ontheir approach to activism and how they willdischarge their responsibilities including onissues set out below:

How investee companies will be monitored

The policy on compliance with the CombinedCode

The policy for meeting with an investee’sboard and senior management

How they will deal with situations whereinstitutional shareholders/agents have aconflict

Strategy on intervention

Indication of circumstances when furtheraction will be taken and possible types ofaction

Voting policySource: Institutional Shareholders’ Committee,

The Responsibilities of Institutional Shareholders and Agents -Statement of Principles, 2002 (abridged)



IR websiteAn investor relations website is a cost-effectiveway of providing easily-updated information at alltimes to all locations. It can also be accessed byall of a company's audiences. While it is not asubstitute for the regulatory requirement ofkeeping the market informed through pressreleases via the PIP system, it can be an addedcommunications channel providing access toinvestor presentations, analysts’ meetings andsite tours. E-mail alerts can also be used to sendup-to-date news to investors and other interestedparties.

Good IR websites should be a mixture of abriefing tool for those coming to the company forthe first time; an ongoing information service forthose with an established interest in it and anelectronic library of corporate information. Theyalso help to create a more level playing-fieldbetween institutional and private investors – theweb grants all investors access to financialinformation as it is released. An indication of bestpractice website content suggested by theInvestor Relations Society is shown in Figure 8.4.

Measuring IR performanceLike all other parts of the business, the return onthe time and cost invested in the investorrelations programme should be measured andmanaged. It is hard to gauge precisely the impactof an investor relations programme since it willultimately be determined by its effect on the shareprice and increased interest in the company’sstock. It may, for instance, have the effect ofallowing the company to raise new capital onmore competitive terms but, once again, it isdifficult to compare before and after in suchinstances.

Notwithstanding this, it will be helpful to setmeasurable objectives. These might include:

setting targets for the number of analysts andinstitutional investors to be visited in the year.The latter group could be broken down furtherinto existing and potential investors;

checking the amount and quality of coverage innational, regional and trade media;

reviewing the number of analysts' researchreports written on the company and the degreeof support they show for the company’sstrategy, leadership and performance; and

assessing whether the shareholder registermoves in the desired direction over time, forexample in terms of greater institutionalinvolvement.

Promoting ongoing dialoguewith institutionsBoards will find that investing time and resourcesinto having an open, ongoing dialogue with current– and potential – institutional shareholders willmore than justify the cost. A critical element ofthis dialogue will involve listening carefully tomessages being relayed back to the board.Sometimes this may come indirectly through, say,an investor relations officer or agency but anyfeedback is to be ignored at the company's peril.A quality, ongoing dialogue with investors will putthe company on the front foot rather than force itto spend time justifying or reversing decisions thathave failed to command support. Communicationwill also help to build a high level of trust andunderstanding in the relationship between theboard and investors. Current and prospectiveshareholders not only supply the company'scapital – they also determine its value.



Figure 8.4IR best practice – site contentGeneral

A clear statement of strategy and vision.

Corporate profile including analysis of the company’s principal markets.

Financial Data

Annual Report, interim, preliminary and quarterly statements.

Archived financial information for a minimum of three years. Five to ten years history of key P&Ldata.

Key financial ratios should be on the site – including return on capital employed or return on netassets, cash flow per share, discounted cash flow per share, earnings per share, updated P/Eratios and margin information.

Relevant information on the main intangibles of the business, for example, brands and humancapital.

Corporate governance & corporate social responsibility (CSR)

Information related to application of/compliance with the Combined Code.

Comprehensive information on the company’s CSR policies including the policy objectives foreach CSR area with quantified progress towards their achievement. A note of any pendinglitigation on health and safety/other socially responsible investment matters.

Shareholder information

Shareholding analysis by size and constituent. Details of percentage shareholding of principalshareholders.

AGM reporting, including votes for and against each resolution.

Information on directors’ share dealings.

Brokers’ consensus earnings forecasts and a list of analysts covering the company’s stock.

Relevant news

Access to all news releases and to presentations, speeches, reports and articles by keyexecutives.

Access to electronic filings, for example those filing with SEC using the EDGAR system.

Identification of financial sites carrying specific company data.

Source: Investor Relations Society website – best practice section

References(1) Institutional Shareholders Committee, The Responsibilities of Institutional Shareholders and Agents – Statement

of Principles, 2002

(2) Investor Relations Society website – best practice section

This chapter also draws on advice contained in ‘Investor Relations – A Practical Guide’ published by the London Stock Exchange and Buchanan Communications



Onlineresourcecentre



Association of British Insurers www.abi.org.uk

The investment affairs section contains the ABI’sCorporate Governance Guidelines on ExecutiveCompensation and Share Based Remuneration,Corporate Governance and Social Responsibility aswell as the Institutional Shareholders’ Committeestatement on the Responsibilities of InstitutionalShareholders and Agents – Statement of Principles.

Business in the Community www.bitc.org.uk

The resources section contains a toolkit, updates ondevelopments in the responsible business practiceagenda and details on their Corporate ResponsibilityIndex and Corporate Reporting Impact Initiative.

CBI www.cbi.org.uk

The website includes CSR case studies which areupdated each quarter.

Conference Board www.conference-board.org

Details are included on a number of reports andbriefings on boardroom issues, principally from a USperspective, including Corporate Governance BestPractices, A Blueprint for the Post-Enron Era.

Department of Trade and Industry www.dti.gov.uk

Resources include research data on listed companyboards (produced as part of the Higgs Report), theDirector’s Remuneration Report Regulations, theAccounting for People report and guidance oncorporate social responsibility.

Financial Reporting Council www.frc.org.uk

The FRC website contains the Combined Code onCorporate Governance. The related AccountingStandards Board and Auditing Practices Boardwebsites can also be accessed from here.

Global Reporting Initiative www.globalreporting.org

The website includes information on the GRI ReportingFramework covering the latest guidelines, technicalprotocols, sector supplements and details onorganisations using the guidelines.

Institute of Chartered Accountants in England and Wales www.icaew.co.uk

The Institute’s series of booklets on audit committeescan be downloaded from the corporate governancearea of the technical policy section of the website.

Institute of Internal Auditors www.iia.org.uk

The website includes a useful briefing for the auditcommittee on Appraising Internal Audit and abenchmark audit charter setting out the purpose,responsibilities and powers of the internal auditdepartment.

Investor Relations Society www.ir-soc.org.uk

The IR best practice section of the website containscomprehensive guidelines on best practice in onlineinvestor relations.

London Stock Exchangewww.londonstockexchange.com

Providing a comprehensive guide to the London StockExchange and an important source of information,amongst other things, on how companies can maximisethe benefit of being on one of our markets. ThePractical Guide series can be ordered through theExchange website.

National Association of Pension Fundswww.napf.co.uk

The website includes details on the NAPF’s 2004Corporate Governance Policy which provides theframework for the NAPF’s voting guidelines.

RSM Robson Rhodes LLP www.rsmi.co.uk

The RSM Robson Rhodes website contains a numberof corporate governance resources including the resultsof the Board Effectiveness Survey and of theInvestment Trust Board Effectiveness Survey as well asa downloadable version of the RSM Internationalpublication Building World Class Boards . A copy ofMalcolm McKenzie’s lecture to the Institution ofMechanical Engineers on strategic issues can also bedownloaded from the website.

World Economic Forum www.weforum.org

Contains information on a number of initiatives includingCorporate Governance Dialogue and Global CorporateCitizenship. The latter section contains the report‘Values and Value, Communicating the Importance ofCorporate Citizenship to Investors’.


© July 2004, London Stock Exchange plc & RSM Robson Rhodes LLP

All rights reserved. No part of this guide may be reproduced in any form withoutpermission in writing from the publisher and the author.

London Stock Exchange plc registered in England and Wales No 2075721

RSM Robson Rhodes LLP registered in England and Wales No OC304188

This briefing is intended to provide useful guidance to directors and others on board effectiveness issues and isprovided for general information purposes. No warranty is given in respect of this publication and no responsibility orliability for any errors or omissions nor loss occasioned to any person or organisation acting or refraining from actingas a result of this publication can be accepted by the author, RSM Robson Rhodes LLP or London Stock Exchangeplc. The information should not be relied upon to replace professional advice.

The London Stock Exchange crest and logo are trademarks of the London Stock Exchange plc.


Contacts

Arabela MilitaruCompany Services020 7797 [email protected]

Georg BraunIR Solutions020 7797 [email protected]

Anthony CareyBoardroom Effectiveness/Corporate Governance 020 7865 [email protected]

Malcolm McKenzieBusiness Consulting020 7865 [email protected]


London Stock Exchange plc10 Paternoster SquareLondon EC4M 7LS+44 (0) 20 7797 1000www.londonstockexchange.com

RSM Robson Rhodes LLP186 City RoadLondonEC1V 2NU+44 (0) 20 7251 1644www.rsmi.co.uk

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