The structure of the British financial system was shaped by the form which industrialization took in the 18th and 19th centuries. The industries which led the industrial revolution, principally cotton textiles, were characterized by numerous small firms which did not need access to large amounts of capital. Initial finance came from family and friends, supplemented after 1750 by country banks, mostly set up by local merchants and manufacturers. These banks acted as a conduit between local savings and local investment, and provided manufacturers with working capital on a short-term basis.
During the second half of the 19th century, as new industries emerged and the size of companies increased, the risks involved in short-term lending became more serious. This prompted a wave of amalgamations among the country banks, leading to a concentration of the English banking industry in the hands of a small number of London-based joint stock banks; a similar process of concentration took place in Scotland. Following legislative changes in mid-century, principally the Joint Stock Companies Act of 1844 and the Limited Liability Act of 1855, a growing number of industrial firms converted themselves from partnerships into limited companies.
Some of them remained private, while others chose to have their shares listed, either on one of the provincial stock exchanges or in London. In some cases flotation was used as a way of raising new capital to be invested in the business. More commonly, it was a means whereby the owners could convert their stake in the company into marketable securities. At this stage there were few institutional investors in industrial companies, apart from the investment trusts which had made their appearance in the 1880s.
The biggest potential investors were the insurance companies, but their premium income was invested mostly in government stock and other
fixed-interest securities. Up to the turn of the century the bulk of trading in domestic industrial securities took place on the provincial exchanges. The London Stock Exchange was primarily geared to the flotation of debt for the British government, and the raising of funds for overseas borrowers; the City of London supplied the investment capital which was needed for infrastructure development throughout the world, including railways, ports and mining. The merchant banks which handled this business, led by Barings and Rothschilds, had little involvement with domestic industry.
In the last few years of the 19th century some large British companies, such as Guinness, used the services of the merchant banks to issue shares in London, but these domestic flotation’s represented a small part of the merchant banks’ business; their expertise, and their main source of profits, lay outside Britain. In the period between 1870 and 1914 neither the joint stock banks (later known as clearing banks) nor the merchant banks developed as close a linkage with domestic industry as, say, Deutsche Bank in Germany.
The boards of publicly quoted companies consisted partly of members of the founding families, partly of salaried managers who were promoted to the board on the basis of their technical or administrative expertise. As for the relationship between listed companies and investors, this, too, was arm’s length in character. Boards of directors exercised considerable discretion over the assets at their disposal, subject to a series of Companies Acts which were designed to protect investors against fraud.
In 1920s the structure of British industry was changing, with the emergence of larger companies, often through merger; the creation in 1926 of Imperial Chemical Industries(ICI), formed out of four major chemical companies, was a notable example. These companies had larger demands for capital than their 19th century predecessors, and the flow of companies seeking a stock exchange listing increased; the number of domestic industrial and commercial companies listed in London reached 1712 in 1939, compared with 569 in 1907.
The increase in flotations by domestic companies created an opportunity for the merchant banks in the City to develop their corporate finance business, advising companies on capital-raising, and on mergers and acquisitions. In a few cases the merchant banks were represented on the boards of the companies they advised, but this was more because of personal connections than in any monitoring role on behalf of all shareholders. As the number of public issues increased, shares became a more popular form of investment, and ownership spread more widely.
Investors who had bought War Bonds during the First World War switched increasingly into corporate securities. Their main interest was in large British companies whose strong position in the domestic market offered some protection against the problems of the world economy. In 1926 ICI had 124,690 shareholders, Imperial Tobacco 94,690, and Courtaulds 59,940; the top five British banks had some 400,000 shareholders between them. Before the Second World War the largest institutional investors were the insurance companies.
They were joined after the war by pension funds, set up by companies and by public-sector organizations as a way of attracting and retaining employees. The typical occupational pension scheme consisted of a fund to which both employer and employee made contributions, and its purpose was to provide retired employees with a retirement income which bore some relation – usually one half or two thirds – to their salary immediately before retirement.
These arrangements were underpinned by a tax system which favored indirect investment by individuals in companies via financial institutions rather than direct share ownership. Pension premium paid by employers and employees were deductible for tax purposes up to certain limits, and the funds in which these premiums were invested were largely sheltered from taxation. The tax incentives channeling investment into financial institutions have historically been more generous in Britain than in other countries.
The increasing popularity of this form of long-term saving created a large pool of funds for investment. Initially the pension funds invested mainly in fixed-interest securities, as the insurance companies had done, but during the 1950s, as inflation rose and came to be seen as a permanent feature of the economy, pension fund managers began to switch into corporate equities. The growing demand for corporate securities was met by an increase in new issues. More companies went public, including some which had long been committed to continuing family ownership.
In 1970, for example, Pilkington, the glass maker which was then run by members of the fourth generation of the founding family, sold shares to the public for the first time; only 10 per cent of the equity was sold initially, but by the end of the decade the family holdings had been reduced to less than 20 per cent. The main reason for going public, according to Lord Pilkington, the chairman, was the effect of taxation on the financial position of family members. “Modern taxation makes it very difficult to either pass on the wealth you have accumulated or keep it in the company.
And without a public market for the stock death duties could place large individual shareholders in an impossible cash bind”. The market value of the commercial and industrial securities quoted on the London Stock Exchange rose from ? 5. 3bn to ? 18bn between 1950 and 1960. There was also a shift away from debentures paying a fixed return to ordinary shares. In 1950 56 % of the company securities issued was in the form of debt compared to 36 % in ordinary shares. Five years later the position had been reversed, with 65 % in ordinary shares.
By the early 1960s the insurance companies and pension funds, together with other institutional investors (principally unit trusts and investment trusts), owned about 29 % of all equities, and this proportion was to increase rapidly over the next two decades. The investments made by the institutions were spread widely among a number of companies, and in the early years their holdings in any one company rarely exceeded 5 per cent. Although this was often enough to make them the largest individual shareholders, they did not regard it as their business to interfere in the running of the company.
Only in cases of serious under-performance, as at BSA, the motor cycle manufacturer, in 1956, General Electric Company in 1959 and Vickers in 1969, did the institutions insist on a change in top management. In these and several other cases Prudential, the largest life assurance company, took the lead, often coordinating its activities with other institutional shareholders. The extent of intervention increased during the 1970s, partly in response to pressure from the Bank of England, which believed that the institutions should do more to improve the management of poorly performing companies.
All the four main investor groups – insurance companies, pension funds, investment trusts and unit trusts – set up investment protection committees (IPCs) which, in addition to dealing with matters of general interest to shareholders, such as non-voting shares, were also able to bring their influence to bear on individual companies. The principal challenge to incumbent management during this period came, not from institutional investors, but from a new breed of corporate predator.
These were the take-over bidders, led by Charles Clore, who saw that some companies were traded in the stock market at prices well below the underlying value of their assets; this was partly due to government-imposed dividend restraints, causing companies to accumulate cash which was earning a low return. By offering the shareholders of the company concerned a higher price (either in cash or in the shares of their own companies), they could win control of the business against the opposition of the board of directors.
The fact that the ownership of most publicly quoted companies was widely dispersed facilitated the bidder’s task. Another stimulus to take-over activity was the 1948 Companies Act, which obliged companies to make a fuller disclosure of their assets and profits. The hostile take-over was a new phenomenon, and the initial attitude of the authorities was suspicious. In the early 1950s the Bank of England discouraged banks and other financial institutions from lending to predators such as Clore; finance for takeovers was regarded as “speculation” and therefore undesirable.
However, the Bank’s ability to curb take-over activity was weakened at the end of the 1950s by the Conservative government’s decision to remove curbs on bank lending and to abolish the requirement for official consent for new issues. That the hostile take-over bid had become respectable was underlined at the end of 1961 when ICI launched an unsolicited bid for Courtaulds. Although the bid was successfully resisted, it was a sign that even large and conservatively run firms like ICI were willing to make use of the take-over weapon.
As the volume of take-over activity increased, merchant banks and other City institutions saw the need for a set of rules to ensure that bidders treated all shareholders fairly. The City Takeover Code was published in 1968, and the Takeover Panel, made up of City practitioners, was set up to police it. The creation of the Panel “served to protect the rights of shareholders from abuse, while in no way inhibiting the culture of takeover bids as a remedy for failure and a vehicle for change”. A commitment to worker control, or at least worker involvement, had long been a strand in Labour philosophy.
Some trade unionists looked enviously at co-determination in Germany, and when Labour returned to office in 1974, they renewed their efforts to install similar arrangements in Britain. In response the government set up a committee under Lord Bullock, an academic historian, to suggest ways of introducing worker democracy into British companies. In the event, the proposals put forward by the minority went much further than the business community would accept. The Bullock report “was attacked with one of the most vitriolic and damning campaigns ever mounted by Britain’s industrialists.
The government did publish a White Paper on industrial democracy in 1978 which considerably watered down the Bullock Committee’s proposals, but no legislation was introduced. In 1977 the Labour government, now headed by James Callaghan, appointed a committee under Harold Wilson, the former Prime Minister, to review the functioning of financial institutions – almost a re-run of the Macmillan Committee in the 1930s. The Wilson Report has been dismissed by historians as anodyne, but it did touch on one issue which was to become more prominent during the 1980s – the role and composition of boards of directors.
This subject had hit the headlines a few years earlier as a result of the Lonrho affair. Lonrho, a mining company with extensive interests in Africa, was dominated by an unusually powerful and idiosyncratic chief executive, R. W. Rowland. A financial crisis in the company in 1971 led to an investigation by a firm of accountants and the appointment of additional non-executive directors, with a view to keeping Rowland under tighter control. Boardroom dissension continued and in 1973 the anti-Rowland faction attempted to remove him from office.
However, Rowland enjoyed strong support from Lonrho shareholders; these were mainly private individuals, with very few institutions involved. At an extraordinary general meeting he secured an overwhelming majority for a resolution which confirmed him in office and dismissed the eight dissident directors. It was at this point that Edward Heath, the Prime Minister, made his famous comment that the goings-on at Lonrho constituted “the unpleasant and unacceptable face of capitalism”. 1 Developments since 1979
The Thatcher government’s central priority was to make markets work better and to reduce the role of the state in business. Two key elements in this programme, both of which had a profound effect on the financial system, were • The abolition of foreign exchange controls • Privatization The foreign exchange control system, which had been in operation since the start of the Second World War, restricted the ability of British investors to invest overseas, and partially insulated British financial markets from international competition.
The decision to abolish the system, taken soon after the election, was an important symbol of the new government’s approach to economic policy. Abolition meant that capital could flow easily into and out of the country. British companies would have access to a wider pool of savings, but they would also have to provide shareholders with returns that were at least comparable with those available in other countries. If the abolition of exchange controls marked a sharp break from the policies pursued by earlier post-war governments, so, too, did privatization.
The programme started modestly with the sale of part of the government’s holding in British Petroleum and continued with the privatization of several companies, including British Aerospace and Rolls-Royce, which had been nationalized by Labour in the 1960s and 1970s. The turning point was the decision, taken in 1982, to private British Telecommunications (BT); this had been the telecommunications arm of the Post Office, until it was separated in 1980, and had been in the public sector since before the First World War.
The Conservative governments of Margaret Thatcher and her successor, John Major, took a permissive attitude to these giant mergers, intervening only when they posed a clear threat to competition. They were equally relaxed about foreign acquisitions of British companies. Ministers argued that a policy of openness to foreign capital – whether in the form of takeovers or direct investment in new factories – was good for the economy. In finance as in other areas of the economy the government was determined to allow markets to work without hindrance.
At the same time the government was concerned to correct what it saw as market failures. One such failure concerned the financing of small and medium-sized firms. 1981 saw the launch of the Small Firms Loan Guarantee Scheme, designed to improve access to debt finance for firms which were viable but lacked a trading record or collateral; this was in line with the recommendations of the Wilson Committee. The government also sought to improve the supply of equity finance for high-growth entrepreneurial firms by stimulating what was in the early 1980s a small and under-developed venture capital industry.
To encourage financial institutions to invest in small, unquoted firms, two new schemes were introduced – Venture Capital Trusts and the Enterprise Investment Scheme – which offered up-front, tax relief on investment, as well as relief from capital taxation. The amount of capital raised by venture capital funds rose rapidly. If the supply of finance for small firms represented a market failure which required government intervention, the boom in share prices during the 1980s also exposed some serious regulatory failures.
Several ambitious entrepreneurs, with an ample supply of funds at their disposal, engaged in questionable practices which led to a number of well-publicized scandals. The rise and fall of Polly Peck, a fruit packing company built up by Asil Nadir, a Turkish businessman, has been described as “the most spectacular of all booms and busts in stock exchange history, going from practically zero to ? 1. 5bn in nine years and then (in 1990) back to zero in five weeks. Asil Nadir was charged with theft and false accounting. More shocking was the Robert Maxwell affair.
Having bought the Daily Mirror in 1984, Maxwell expanded his publishing group through a series of acquisitions and by the end of the decade his debts had reached unmanageable proportions. He died in mysterious circumstances in 1991, and soon afterwards it was revealed that he had looted the Daily Mirror pension fund to keep his empire afloat. The governance of companies became the subject of increasing interest given the concerns expressed about the standards of accountability and financial reporting of UK quoted companies.
As a result, a number of reports have subsequently been published which have attempted to improve the standard of governance in UK quoted companies. The reports, Cadbury (1992), Greenbury (1995) and Hampel (1998) called for greater transparency and accountability in areas such as board structure and operation, directors’ contracts and the establishment of board monitoring committees. They all also stressed the importance of the non-executive directors’ monitoring role.
Cadbury recommended that quoted companies should adopt a governance structure that complied with a specified set of criteria. The appropriate system was detailed in a Code of Best Practice. The inference to be drawn is that these governance structures should provide more effective monitoring of the board and the decision-making process. This in turn should improve performance because the monitoring mechanisms would ensure that shareholder interests were being promoted. The rest of report will discuss the various reports and discuss the corporate governance principles in UK.
evolution of corporate governance The development of corporate governance in the UK has its roots in a series of corporate collapses and scandals in the late 1980s and early 1990s, including the collapse of the BCCI bank and the Robert Maxwell pension funds scandal, both in 1991. 1 Cadbury Report (1992) As a result of public concern over the way in which companies were being run and fears concerning the type of abuse of power prevalent in the Maxwell case inter alia, corporate governance became the subject of discussion among policy makers.
The Cadbury Committee was established in May 1991 by the Financial Reporting Council, the London Stock Exchange, and the accountancy profession in response to the occurrence of financial scandals in the 1980’s involving UK listed Companies, which led to a fall in investor confidence in the quality of company’s financial reporting. In this sense the formation of the Cadbury Committee may be seen as reactive rather than proactive.
The Cadbury Report, formally entitled ‘The Report of the Committee on the Financial Aspects of Corporate Governance’ was published in December 1992, following the recommendations of the Cadbury Committee. However it is important to remember that the Cadbury Report was compiled on the basic assumption that the existing, implicit system of corporate governance system in the UK was sound and many of the recommendations were making explicit a good implicit system.
As such the Committee addressed the financial aspects of corporate governance and subsequently produced a Code of Best Practice, the provisions of which, in their belief, all boards of UK listed companies should comply with. Specifically, they recommended that listed companies should incorporate a formal statement into their Report and Accounts outlining whether or not they complied with each of the Code’s provisions. In respect of areas of non-compliance an explanation of the reason was sought.
Further to this, the Report recommended that the compliance statements made by the companies be reviewed by auditors prior to release of the Annual Report. The key focus of the provisions of the Code of Best Practice primarily related to the composition of the Board of Director’s, the appointment and independence of non-executive directors, the service contracts and remuneration of executive directors, and company’s financial reporting and controls. Some of the main recommendations made are as follows:
• There should be balance of power between board members such that no individual could gain unfettered control of the decision-making process • If the roles of the chairman and chief executive were not filled by two individuals, then a senior member of the board should be present who was independent • The majority of non-executive directors should be independent of management and free from any business or other relationship • Non-executive directors should be appointed for specified terms • Service contracts should not exceed three years
• Executive remuneration should be subject to the recommendations of a Remuneration Committee made up entirely or mainly of non-executive directors • An Audit Committee, comprising of at least three non-executive’s, should be established Following publication of the Code the London Stock Exchange introduced a requirement into the Listing Rules requesting all companies to include a statement of compliance, or non-compliance, with the provisions, in their annual Report and Accounts. Furthermore, institutional investors and Investment banks urged those listed companies for which they provided sponsorship and advice to adopt the provisions.
As a result many companies changed their governance procedures and conduct accordingly. The Cadbury Report focused attention on the board of directors as being the most important corporate governance mechanism, requiring constant monitoring and assessment. The focus on importance of institutional investors as the largest and most influential group of shareholders has had a lasting impact. 2 Greenbury Report (1995) During the 1990’s the issue of director’s remuneration was becoming a primary concern for investors and the public at large.
Specifically, the levels of remuneration of directors in privatized industries were rising and remuneration packages were failing to provide the necessary incentives for directors to perform better. Consequently, it was recognized that corporate governance issues relating to director’s remuneration needed to be addressed in a more rigorous manner. This led to the establishment of the Greenbury Committee. The Committee’s findings were documented in the Greenbury Report, which incorporated a Code of Best Practice on Director’s Remuneration.
Specifically, four main issues were dealt with, as follows: • The role of a Remuneration Committee in setting the remuneration packages for the CEO and other directors • The required level of disclosure needed by shareholders regarding details of directors remuneration and whether there is the need to obtain shareholder approval • Specific guidelines for determining a remuneration policy for directors; and • Service contracts and provisions binding the Company to pay compensation to a director, particularly in the event of dismissal for unsatisfactory performance
As in the Cadbury Code, the Greenbury Code recommended • The establishment of a Remuneration Committee, comprising entirely of non-executive directors, to determine the remuneration of the executive directors • The members of the remuneration committee should be listed in the annual committee report to the shareholders • The report should include full details of all elements in the remuneration package of each individual director by name • However, in terms of service contracts, Greenbury recommended a maximum notice period of 12 months rather than three years as suggested by Cadbury
Following publication, the recommendations of Greenbury were also taken on board by the London Stock Exchange and incorporated into the UK Listing Rules. However, unlike the Cadbury Code it was not widely accepted as many believed that the recommendations made did not sufficiently deal with the issue of linking directors pay to the Company’s performance in the interests of shareholders. 3 Hampel Report (1998) The Hampel Committee was established to review and revise the earlier recommendations of the Cadbury and Greenbury Committees.
The Final report emphasized principles of good governance rather than explicit rules in order to reduce the regulatory burden on companies and avoid ‘box-ticking’ so as to be flexible enough to be applicable to all companies. It was recognized that good corporate governance will largely depend on the particular situation of each company. This emphasis on principles would survive into the Combined Code. Hampel viewed governance from a strict principal/agent perspective regarding corporate governance as an opportunity to enhance long term shareholder value, which was asserted as the primary objective of the company.
This was a new development from the Cadbury and Greenbury Codes which had primarily focused on preventing the abuse of the discretionary authority entrusted to management. An important contribution made by the Hampel Report related to pension fund trustees, as pension funds are the largest group of investors. Pension fund trustees were targeted by the report as group who needed to take their corporate governance responsibilities seriously. In particular, the report favoured greater shareholder involvement in company affairs.
For example, while the report recommended that unrelated proposals should not be bundled under one resolution shareholders, particularly institutional shareholders, were expected to adopt a, ‘considered policy’ on voting. Another key advance was in the area of accountability and audit. The Board was identified as having responsibility to maintain a sound system of internal control, thereby safeguarding shareholders’ investments (although the Board was not required to report on the effectiveness of the controls).
Further, the Board was to be held accountable for all aspects of risk management, as opposed to just the financial controls as recommended by Cadbury. Hampel did not advance the debate on director’s remuneration, choosing only to reiterate principles inherent in Greenbury. In particular Hampel did not believe that directors’ remuneration should be a matter for shareholder approval in general meeting. This would not become a requirement until the introduction of The Directors’ Remuneration Report Regulations in 2002.
4 Combined Code (1998) The Combined Code consolidated the principles and recommendations of the Cadbury, Greenbury and Hampel reports. It was formulated in 1998 and revised in 2003 following the publication of the Higgs report. The Code is divided into two sections: • The first outlines principles of best practice and their supporting provisions for companies • While the second does the same for shareholders While compliance with the Code is not mandatory, the Code was appended to the listing rules and listing rule.
It requires a statement by companies to provide shareholders with sufficient information to be able to assess the extent of compliance with section one of the Code. Instances of non-compliance should be justified to shareholders. Section one of the Code is comprehensive covering topics such as • The composition and operations of the Board • Directors’ remuneration • Relationships with shareholders • The supply of information • Accountability and audit
The fact that the Code has provided both principles and provisions has resulted in a Code that is powerful enough to effect specific recommendations and flexible enough to be applicable to most companies. Section two of the Code is much shorter, covering shareholder voting, dialogue with companies and the evaluation of governance disclosures. As institutional investors invest on behalf of the shareholders they represent they have a responsibility to hold the companies in which they invest to account.
In particular, the Code recognized that the responsibility for maintaining good dialogue and mutual understanding belongs to both companies and its institutional investors. Finally when evaluating the quality of governance disclosure by companies, institutional investors are to give due weight to all relevant factors. This is rather vague and the area has been recognized as a shortcoming of the Code, leading to membership associations of institutional investors having to produce guidance to its members on this area.
5 Turnbull Report (1999) The Turnbull committee was established specifically to address the issue of internal control and to respond to these provisions in the combined code. The Turnbull guidance sets out best practice on internal control for UK listed companies, and assists them in applying section C. 2 of the Combined Code. The Turnbull report sought to provide an explicit framework for reference on which companies and boards could model their systems of internal control.
Even though many other countries are now focusing attention on the systems of internal control and corporate risk disclosure within their listed companies, few have established a specific policy or code of best practice dedicated to this issue. The aim was to provide a general guidance on how to develop and maintain internal control systems. 6 Myners: Review of Institutional Investment (2001) Paul Myners ‘Institutional Investment in the UK: A Review’ published in 2001, was commissioned by the Government, to consider whether there were factors distorting the investment decision-making of institutions.
Within the Report’s analysis, a number of problems with the current system are highlighted, in particular: • There are wholly unrealistic demands being made of pension fund trustees, whereby they are being expected to make crucial investment decisions without either the resources or the expertise needed • Consequently, there is too heavy a burden being placed on the investment consultants who advise the trustees to ensure the decisions made are correct • The job of asset allocation, the selection of which markets, as opposed to which individual stocks, to invest in, is under-resourced • There is a lack of clarity about objectives at a number of levels, for instance the objectives of Fund managers, when taken together, appear to bear little relation to the ultimate objective of the pension fund Overall therefore, the review concludes that the present structures used by the various types of institutional investors (for example pension funds and insurance companies) to make investment decisions lack both efficiency and flexibility, which often means that savers money is not being invested in ways which will maximize their interests. In response to the problematic issues raised, Myners has outlined some basic principles of an effective approach to investment decision-making, which if adopted by pension funds and other institutional investors would likely result in an all round more
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