House of Commons

Treasury Committee

Corporate governance and remuneration in the financial services sector

Written Evidence

Only those submissions written specifically for the Committee for the inquiry into the corporate governance and accepted as written evidence are included.

List of written evidence Page

1 Investment Management Association 3 2 High Pay Centre 12 3 Association of Financial Mutual’s 18 4 British Bankers Association 23 5 Chartered Institute of Personnel and Development 31 6 Which? 34 7 Fairpensions 40 8 Andrew Dickson Ltd 46 9 Chartered Insurance Institute 48 10 Unite the Union 55 11 Financial Services Authority 60 12 Financial Services Practitioner Panel 70 13 Institute of Chartered Accountants of Scotland 73 14 Board Intelligence 82 15 ShareSoc 86 16 CBI 90 17 Simon Prior-Palmer 94 18 Gavin Palmer 106 19 UK Policy Governance Association 111 20 Hermes Equity Ownership Services Ltd 114 21 Legal and General Group Plc 125 22 Financial Services Consumer Panel 130 23 Pensions and Investment Research Consultants Ltd 138 24 Company Law Committee of the Law Society of England and Wales 143 25 Quoted Companies Alliance 146 26 Local Authority Pension Fund Forum 155 27 HSBC Holdings plc 161 28 Institute of Chartered Accountants in England and Wales 172 29 Association of British Insurers 175 30 The City of London Law Society 186 31 Cevian Capital 189 32 Barclays 195 33 Trade Union Congress 209 34 Towers Watson 220 35 Legal and General Investment Management 227 36 UK Shareholders Association 240

Written evidence submitted by the Investment Management Association1 (CGR 01)

1. EXECUTIVE SUMMARY

1.1 IMA’s members are impacted by systemically important financial institutions (SIFIs) as

investors in a SIFI’s own securities or securities a SIFI originates, such as asset-backed structures. As the “buy-side” our members interact with SIFIs as key constituents of the “sell-side” which are integral to many payment and clearing systems.

1.2 As asset managers do not give rise to systemic concerns, they should not be within the scope of the inquiry. A manager’s clients’ assets are segregated from the firms and the manager’s activities do not put them at risk, and as its fee is normally a percentage of assets managed, its interests are aligned with those of its clients.

1.3 The UK’s “comply or explain” regime under the Corporate Governance Code means that today the UK operates some of the best standards of governance. This framework remains sound, but it is now apparent that some of the causes of the crisis were around SIFIs’ governance. The risk that this poses to society, and ultimately the tax payer, means that a distinctive approach needs to be taken to a SIFI's governance and that regulators have a role.

1.4 In this it is important that a balance is struck between the constraints of regulation and allowing boards to decide what is in shareholders’ best interests. Regulation may undermine the role played by shareholders who, as owners of companies and providers of risk capital, are best placed to hold boards to account.

1.5 IMA supports investors engaging with companies, which can include SIFIs, and over the last ten years, engagement has been transformed. But the market provides clients with a choice and it is not for authorities to be prescriptive as to whether a manager should engage or not. There are also limitations in what engagement can achieve – asset managers do not run companies; they do not set strategy nor are they insiders, in that they only have access to information that is available to the market as a whole. Managers compensate for such information asymmetries by diversifying their portfolio construction.

1 IMA represents the asset management industry in the UK, which is responsible for the management of approximately £4 trillion of assets, which are invested on behalf of clients globally. The Annual IMA Asset Management Survey shows that IMA members managed holdings amounting to 40% of the domestic market.

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2. INTRODUCTION 2.1 The inquiry relates to SIFIs but the terms of reference refer to financial institutions

generally. There are a wide variety of financial institutions and whilst the crisis showed that SIFIs can give rise to systemic issues, the same cannot be said for other types of institution.

2.2 An asset manager’s business model is very different to that of a bank. Its clients’ assets are segregated from the firms, and the manager’s activities do not put their security at risk. In a bank, on the other hand, client funds are held on the balance sheet and used in the business. Asset managers, as agents for their clients, are rewarded a fee, normally a percentage of assets under management. Thus interests are aligned – the better companies perform, the better returns for a manager’s clients and the better a manager’s remuneration. If a manager over-trades, it adversely impacts performance because of the costs involved. Banks and brokers, on the other hand, earn revenue by trading with clients.

2.3 Asset managers do not give rise to systemic concerns and should not be within the scope of the inquiry. Unless otherwise stated, our comments focus on those, such as banks and brokers that do. In addition, many aspects of the inquiry are governed by EU legislation which covers a range of financial institutions.

BOARD STRUCTURE AND COMPOSITION

3 What outcomes should corporate governance in the financial services sector

seek to achieve?

3.1 Corporate governance is about behaviours and how a company in any sector, not just financial services, is directed and controlled. Good governance ensures a company is effectively managed, decisions are sound and success sustainable. It does not concern day-to-day operational management but what a board does.

3.2 It is widely accepted that today the UK operates some of the best standards of

corporate governance. The UK Corporate Governance Code codifies principles, structure and processes for governance. Any SIFI with a Premium UK listing has to report on how it has complied with its provisions or explain where it has not – “comply or explain”. Whilst this framework remains sound, it is now apparent that some of the causes of the crisis were around banks’ corporate governance which failed to safeguard against excessive risk taking.

3.3 A SIFI’s failure poses risks to society and the tax payer. Thus their governance involves a distinctive approach from the corporate sector generally and regulators have a role. It also continues to be high on the international and domestic agenda. The Basel Committee on Banking Supervision issued a set of principles in October 2010 for corporate governance practices in banks. Basel III is broadly being implemented by CRD4 which contains governance requirements for SIFIs, as well as other financial institutions such as MiFID asset managers.

3.4 Any SIFI headquartered in the UK should not be outwith European regulation and the scope for UK specific measures is limited. Even supervisory authorities are increasingly expected to follow harmonised approaches from European supervisory authorities.

4 Are Board structures effective? For example, should UK financial institutions consider adopting alternatives to the unitary Board structure?

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4.1 There are two types of board structure: unitary with a single board of executive and non-executive directors; and two-tier with a management board that manages the business and which is accountable to, and supervised by, a supervisory board.

4.2 Both structures are permitted under UK company law. Nor will CRD4 require SIFIs to adopt a particular model. But the preference is the unitary board where all directors decide by consensus. IMA does not consider UK financial institutions should consider an alternative. A unitary board can engage more effectively with executive management in providing direction and leadership, and there is better information flow between the supervisory and managerial bodies. The risks with a two tier board are:

• confusion over authority and accountability among board members; • concerns whether the supervisory board accesses quality and timely information;

and • a lack of exchange and pooling of expertise between executives and non-

executives.

5 Does the UK approach to regulation and supervision of financial services incentivise Boards to perform their role effectively? Is more intrusive regulation a substitute or complement to effective corporate governance? Is a "comply or explain" approach an effective framework for governance?

5.1 Good governance concerns behaviours which cannot be easily regulated - regulation runs the risk of standardising behaviours to ensure compliance rather than fostering sound governance. The “comply or explain” approach gives listed companies the flexibility to tailor the Corporate Governance Code to their circumstances.

5.2 The steps Government took in relation to SIFIs that were casualties of the crisis showed

they are “too big to fail” and, as such, are underpinned by the tax payer. Nor were all casualties listed. Thus regulators have a role in SIFI’s governance arrangements. But there needs to be a balance between the constraints of regulation and allowing boards to decide what is in shareholders’ best interests. Regulation may undermine the role played by shareholders who, as owners of companies and providers of risk capital, are best placed to hold boards to account.

5.3 Nevertheless FSA and Government have made it clear that regulators will be more intrusive in the future. Regulatory interaction with SIFIs will always be more timely and involve more detail than any shareholder could expect. One characteristic is said to be forming judgements upon judgements – not accepting what a board determines is in the SIFI’s interest. Time will tell if this makes a difference.

CORPORATE CULTURE

6 What type of corporate culture should financial services firms seek to foster? In

what way can this be encouraged? How effective are Boards at shaping corporate culture within their institutions?

6.1 It is not for investors to prescribe a financial services firm’s culture. Their role is to ensure that the right people are appointed to the board which incentivises a culture that delivers the right outcomes. Remuneration structures have an important role to play in this and often the focus has been on increasing profit in the short-term, as opposed to return on assets and prudent management of leverage. There has been much progress on this. Investors are more proactive in relation to the listed sector and the FSA has a remuneration framework that promotes effective risk management, and aligns shareholders’ and executives’ interests.

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IMPACT OF PREVIOUS REVIEWS AND NEW REGULATORY DEVELOPMENTS

7 What difference would the proposals in the Independent Commission on Banking's report on the Boards of ring-fenced banks make to corporate governance in these institutions?

7.1 In a financial institution, including a SIFI, the board should understand the risks and have systems and controls to manage them. It is also responsible for ensuring the SIFI complies with regulatory obligations.

7.2 The Independent Commission on Banking’s report2 makes several references to strong governance principally to ensure the relationship of the ring fenced bank to the rest of the group is “appropriate” and has “distinct governance arrangements”. This should mean its board has a more focused view of activities so as to allow earlier identification of risks and failings, and an earlier response.

8 What benefits, if any, come from EU regulatory engagement with corporate governance issues?

8.1 SIFIs are governed by EU Directives as regards their governance, fitness of shareholders, as well as remuneration of officers and risk takers. For asset managers engaging with SIFIs this is welcome but they would value uniform shareholder rights across Europe, for example, a vote on major transactions and the elimination of barriers such as share blocking which still exist. They would also welcome uniform rights to engage in terms of accessing and talking to directors and management, and in companies’ accountability so that they can, for example, appoint and dismiss directors. There would also be benefits in a more uniform approach to the application of the Takeover and Acquisitions Directives to co-operation and common principles on related party transactions.

8.2 The follow up to the Commission’s Green Paper on an EU Corporate Governance Framework of last year is awaited. It is not clear at this stage how this will interact with the requirements for SIFIs which already cover and add to corporate governance requirements.

9 What impact has the Walker Review (2009) had on corporate governance and

corporate behaviour in financial services?

9.1 Sir David Walker’s final report of November 2009 on the governance of banks and other financial institutions required specific initiatives, particularly by the FRC and FSA3. For many of the recommendations it is too early to assess their impact.

9.2 The FRC implemented those recommendations for listed companies in revising the

Corporate Governance Code for years beginning on or after 29 June 2010. Others were implemented through its Guidance on Board Effectiveness of March 2010. Following the report’s recommendation, the FRC published the Stewardship Code in July 2010 and the FSA introduced a requirement that UK authorised asset managers report whether or not they apply it4. We set out in the attached Annex our observations on how this is changing stewardship.

9.3 But for many SIFIs the step change in the intensity of FSA regulation has had the most impact.

2 http://bankingcommission.s3.amazonaws.com/wp-content/uploads/2010/07/ICB-Final-Report.pdf 3 http://webarchive.nationalarchives.gov.uk/+/http:/www.hm-treasury.gov.uk/d/walker_review_261109.pdf 4 Financial Services Authority Conduct of Business Rule 2.2.3, which was effective from 6 December 2010.

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NON EXECUTIVE DIRECTORS

10 Should non-executive directors bear greater liabilities than under current law? Should executives in FTSE 100 companies be able to hold non-executive positions in other firms?

10.1 Executive and non-executive directors have equal status and liability in law even though they have different roles. Executive directors develop and then, once agreed by the board, execute a company’s strategy. NEDs, on the other hand, challenge and scrutinise management’s performance5.

10.2 IMA supports directors being equally liable. Different liability regimes would undermine the operation of the unitary board and its accountability to shareholders. Whilst for SIFIs, it would be natural for FSA to have regard to their different roles when it considers directors that have failed, both executives and non-executives are controlled functions with identical obligations under the approved persons regime.

10.3 An issue highlighted by the crisis was the need to increase the pool of NEDs and many

consider they should have fewer posts. Undoubtedly a NED’s oversight would be enhanced if they devoted more time to their role but restricting an executive from a FTSE 100 company from being a NED in another firm, would further reduce the pool of available talent. Boards need to have the right skills - better to have a few days of someone who makes a valuable contribution than a month of someone who adds little.

11 Is the existing FSA approval process for significant influence functions (SIF),

including non-executive directors, effective?

11.1 Although this is strictly outside our remit, anecdotally FSA’s current level of inquiry, challenge and judgment means that more applicants now withdraw or are rejected through the process.

THE ROLE OF SHAREHOLDERS

12 Should shareholders be required to exercise a stronger role in systemically

important financial institutions? What are the key barriers to greater shareholder activism by institutional investors in financial institutions? What risks are associated with it?

12.1 Asset managers invest in companies, including SIFIs, with the aim of maximising returns for clients. They offer clients a choice and take a range of approaches. Some actively engage with companies to achieve better returns. Others believe the best way to send a signal to a badly managed company and ensure a better return is to sell their holding. An asset manager’s duty is to act in the best interests of its clients at all times. A healthy market needs a variety of models and whilst IMA is a long-standing supporter of engagement, we do not support a prescriptive approach or that shareholders should be required to exercise a stronger role in SIFIs.

12.2 There are also barriers to what engagement can achieve. Asset managers are restricted

in terms of the information available to them. They are not insiders or privy to the same information as the executive, NEDs or indeed the regulators. In many instances, it is now apparent that SIFI boards adn regulators failed to appreciate the risks fully, thus, asset managers could not have been expected to either; this was not a problem which could have been avoided by engagement.

5 The UK Corporate Governance Code, Principle A.4.

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12.3 UK asset managers also typically have relatively small holdings, particularly in larger companies, which limits their influence. This could be addressed by acting collectively with like-minded investors to bring pressure to bear on management. But there are concerns that this could trigger issues of insider trading, changes of control, and industry collusion and “the concert party” rules. Whilst FSA issued guidance and the Takeover Panel a Practice Statement to help allay these, there are still issues over whether collective action in relation to financial institutions would be caught by the controllers regime under the Acquisitions Directive6. This could mean that parties to an ad hoc agreement or understanding to vote together are treated as “acting in concert” and need prior regulatory approval if their holdings exceed 10 per cent. FSA’s current procedures do not necessarily envisage such notifications and there are concerns this would impede collective engagement.

13 Is it realistic to expect sovereign wealth funds and hedge funds to undertake a

more active role?

13.1 We do not comment save to note in relation to asset managers and engagement above, this includes when our members are managing money owned by sovereign wealth and hedge funds.

REMUNERATION

14 What role should institutional investors, remuneration consultants, employees and others play with respect to remuneration in the financial services sector?

14.1 Investors with a holding in any quoted company, whether or not a financial services company, have a non-binding vote on the Directors’ Remuneration Report prepared under the Remuneration Regulations. It is important to have such mechanisms for directors when independence is an issue – executive directors should not set their own pay.

14.2 Remuneration committees comprised of NEDs, similarly address these conflicts and are often advised by remuneration consultants. Investors would welcome better transparency to facilitate scrutiny of consultants - how they interact with the remuneration committee and how conflicts are addressed.

14.3 But investors do not oversee senior executive remuneration below board level - this is for line-managers. Investors do not micro-manage companies.

15 Is there a case for introducing still greater transparency for senior executives with respect to remuneration in the financial services sector?

15.1 SIFIs are required to make public Pillar III disclosures in relation to remuneration. We would caution against more disclosure of remuneration below board level as this could have the effect of ramping up pay over time, as has been seen with directors’ pay.

16 Should there be further reform of the remuneration arrangements of senior

executives in the financial services sector? Should this extend to those highly paid individuals who sit below executive level?

16.1 EU requirements already cover remuneration below board level for financial services firms with detailed requirements for “Remuneration Code7” staff. This includes those below executive level - senior management, staff engaged in control functions, any

6 http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2007:247:0001:0016:EN:PDF 7 http://fsahandbook.info/FSA/glossary-html/handbook/Glossary/R?definition=G2828

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employee with remuneration in the same bracket as senior management and risk takers, whose activities can have a material impact on the firm's risk profile. This should be sufficient.

17 The Chairman of the Financial Services Authority has argued that there may be

a case for changing the personal risk return trade-off for bank executives. He has suggested either a 'strict liability legal sanctions or an automatic incentives based approach. What are the merits and drawbacks of these proposals? Are there other ways to achieve the same objective?

17.1 IMA considers a robust incentives based approach where rewards are based on long-term performance and where clawback is allowed and used, where appropriate, is the way forward.

17.2 FSA already has extensive powers to take action against directors of regulated businesses. However, we do not support a strict liability regime where penalties are imposed without establishing fault. This would discourage many able applicants from seeking appointment and could be considered unjust, and therefore open to legal challenge.

GOVERNANCE OF RISK 18 Has the management of risk in firms improved since the financial crisis?

18.1 As regards the asset management industry, the collection of management information on and consideration of risk is now measurably more rigorous and timely.

DIVERSITY AND BACKGROUND

19 What is the relationship, if any, between Board diversity and company performance in the financial service sector?

19.1 Evidence from McKinsey8 is that gender-diverse boards have a positive impact on performance. However, diversity goes wider than just gender and whilst it would seem reasonable that boards make better decisions where a range of voices, drawing on different life experiences, can be heard other evidence is less conclusive9. This may be due to the difficulties in making the causal link between diversity and outcomes.

May 2012

8 Women Matter, McKinsey & Company, 2007 9 http://www.hbs.edu/units/ob/pdf/Board%20Diversity%20and%20Performance.pdf http://www.dypadvisors.com/2009/09/14/board-diversity-corporate-performance/

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The Development of Stewardship Annex In 2002, investors gave new impetus to stewardship and the Institutional Shareholders’ Committee (ISC10), whose members, including IMA, represent virtually all UK institutional investors, issued the Statement of Principles11. This was the first comprehensive statement of best practice governing the responsibilities of institutional investors in relation to the companies in which they invest on behalf of the ultimate owners.

IMA benchmarked the industry’s adherence to the Statement of Principles through regular surveys. Starting in 2003, these clearly demonstrated that engagement was evolving and becoming more transparent. The last survey to 30 June 2008 showed that 32 asset managers that managed equities amounting to 32 per cent of the UK market actively engaged, voted their UK shares, and increasingly published their votes12. Nevertheless, institutional investors recognised that in the run up to the financial crisis there were failings in their scrutiny and challenge to banks’ strategy and excesses, and that they needed to address this. The ISC took steps to do so and reissued the Statement of Principles as a Code in November 2009, modifying it to seek to improve the dialogue between institutional investors and companies. The Government at the time wrote to the FRC asking it to adopt the Code and, following a public consultation, the FRC issued it as the Stewardship Code in July 2010. In December 2010, the FSA made it a requirement that authorised asset managers disclose publicly their commitment to the Code or their alternative business model. This aimed to ensure that those that appoint asset managers are aware of how a manager exercises its stewardship responsibilities, if any. The Code also expects those that commit to it to report to their clients/beneficiaries on how they have exercised their responsibilities and to have a public policy on voting disclosure. It is important that this transparency is supported by practice. IMA undertook to look at the activities that underlie it and to see what impact the Code has over time. We published our first report last year which looked at the position as at 30 September 201013 and will shortly be publishing a follow up report one year later. The latest draft report summarises the responses to a questionnaire that was sent to all 173 signatories that had committed to the Code as at 30 September 2011. 83 institutions responded: 58 Asset Managers; 20 Asset Owners; and five Service Providers. The Managers that responded managed £774 billion of UK equities, representing 40 per cent of the UK market, and the Owners owned £62 billion. The latest draft report clearly demonstrates progress. For example: • as at 30 September 2011 173 institutional investors had committed to the Code up from 80

as at 30 September 2010; • all of the 2011 respondents now have complete policy statements on how they exercise their

stewardship responsibilities whereas in 2010, six respondents only had a statement of their intention to produce one;

• in 2011, more of the 2010 respondents have client mandates that refer to stewardship; • the 2010 respondents increased their resources responsible for stewardship by 4 per cent in

2011; • the proportion of votes cast increased in all markets in 2011; and

10 The members of the ISC were: the Association of British Insurers; the Association of Investment Companies; the National Association of Pension Funds; and the Investment Management Association. In 2010 this was reconstituted as the Institutional Investor Committee made up of the Association of British Insurers; the National Association of Pension Funds; and the Investment Management Association 11 http://www.investmentfunds.org.uk/press-centre/2002/20021021/ 12 http://www.investmentfunds.org.uk/press-centre/2009/20090520-01/ 13 http://www.investmentfunds.org.uk/research/stewardship-survey

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• a greater proportion of respondents publicly disclose their voting records - 73.4 per cent in 2011 as compared to 69.0 per cent in 2010.

In conclusion, although it is still relatively new the Stewardship Code is working in that more UK institutional investors are committing to stewardship and are increasingly transparent about doing so. This initiative should be given time to take effect.

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Written evidence submitted by the High Pay Centre (CGR 02)

The High Pay Centre recognizes the significance of this debate on the issue of executive pay specifically in the financial sector and of the current corporate governance and legal structures. There is a strong case showing that the status quo in relation to transparency and accountability when it comes to pay and other issues such as risk is simply not up to the challenges of the modern corporate world. Boards are too full of individuals from similar employment and social backgrounds and as such too often suffer from group think, and strive for consensus to the extent that constructive challenge becomes almost unheard of. Time and information asymmetries also mean that the board can be dominated by the executive in the interests of the executive rather than the shareholders or wider stakeholders. Shareholders also suffer from information asymmetry, a lack of time, capacity and interest in holding the executive to account. Increasingly short term interests prevail over the long term to the ultimate detriment of the company. In relation to pay it is clear that current oversight is not sufficient, there is little evidence that banks have substantially altered their pay structures in light of the financial crisis and tax payer bail out. As such we continue to see short term risk rewarded over the long term interests of the company and the behaviours that could improve this such as, long terms client relationships. It is increasingly clear that in institutions that are so instrumental to the UK economy there is a case for a fundamental rethink in terms of oversight, and the role of other stakeholders. 2. Are Board structures effective? For example, should UK financial institutions consider adopting alternatives to the unitary Board structure? The relationship between the board of directors and top management is fundamental to the functioning of a business. However, there are questions about how effectively the board is able to monitor the company’s management in the interests of shareholders and other stakeholders. It is the role of the board not only to monitor the executive in the interests of shareholders, but also to support the executive in its decision-making. This dual role can cause difficulties for boards generally, in particular we can see this when it comes to decisions on remuneration. It is arguable that issues of remuneration exacerbate existing tensions in relation to board dynamics. However, we would suggest that they are symptomatic of normal board relationships. The remuneration committee is made up of members of the board, and while they sit separately to make decisions on pay, this does not alter the existing board dynamic. According to interviewees, which have included executives and non-executive directors this board dynamic too often fails to effectively hold the executive to account. This is in part driven by an information asymmetry but also through a desire to reach a consensus rather than individually challenge the group views. This is exacerbated by the fact that the non-executive directors are generally from similar backgrounds and as discussed later susceptible to “group think”. As a result the non-executive directors often struggle to hold the executive to account, and boardrooms can become places which are too comfortable for the executive and offer little challenge to their views.

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8. Should non-executive directors bear greater liabilities than under current law? Should executives in FTSE 100 companies be able to hold non-executive positions in other firms? In response to the second part of this question we relate our evidence again to the issue of remuneration specifically. Most boards are made up predominantly of men from a managerial or financial background.1 While the vast majority of companies now have a remuneration committee to determine pay levels of the executive made up wholly or mainly of non-executive directors, many of these non-executives are either current executive directors at other companies or recently retired executives or indeed current or recently retired financial workers. While they may not have a direct financial interest in the company, they may have an indirect financial interest in the level of remuneration as a result of the benchmarking practices that are common among companies. Benchmarking is a very common process when it comes to decision on executive pay. To determine executive pay, remuneration committees design a comparator group, normally based on the advice of remuneration consultants. These comparator groups are normally based on a mix of market capitalisation and industry type. Once designed, the comparator group is used as a benchmark against which to measure reward and performance. The use of these comparator groups has been extensively criticised as a cause for ratcheting up pay as a result of both poorly designed groups and the prevalent practice of seeking to pay above median or upper quartile rates. As such we would suggest while having current executives sitting on boards should not be universally rejected there is a strong argument that they should not sit on remuneration committees. Additionally, there is a strong argument for greater board diversity as discussed below. 10. Should shareholders be required to exercise a stronger role in systemically important financial institutions? What are the key barriers to greater shareholder activism by institutional investors in financial institutions? What risks are associated with it? Shareholders as the owners of the business and ultimate beneficiaries are considered the best way of holding the executive and board to account through voting rights at the annual general meeting. However, there are limits to the efficacy of this model: The information asymmetry between the board and the executive is exacerbated in the relationship between the board and the shareholders. Shareholders are limited by the amount of information available to them and often depend on being guided by the board. While greater disclosure and shareholder votes have encouraged engagement between shareholders and boards, it is often not feasible because of the diversified portfolios and lack of time and resources of many institutional investors and fund managers devote to corporate governance issues. As a result, they often fail to engage meaningfully with any individual company over a sustained period of time.2 The changing nature of shareholders is of concern when if we are to consider shareholders having a stronger oversight role. At the beginning of the 1980s only 3.6% of shares in publicly listed companies were held outside the UK. By 1990 this figure had increased to 11.8%, and by 2008 41.5% of UK listed shares were held by overseas investors. Simultaneously, there has been a decline in the percentage of shares held by long-term UK investors such as pension funds and insurance companies from over 50% in 1990 to 25% in 2008.

1 Lord E.M. Davies, Women on Boards, 2011, www.ukcae.co.uk/pdfs/LordAbersoch‐February2011‐Womenonboards.pdf. 2 CBI, Evidence to BIS review. 

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Pension funds remain the largest group of institutional investors. In many cases the trustees of these funds delegate investment management to a fund management group. When investment is delegated there are important issues around the effectiveness of fund management groups’ to exert influence over companies. It has been suggested that trustees put fund managers under undue pressure to maximise short-term investment returns, or to maximise dividend income at the expense of retained earnings, and that the fund manager will, in turn, be reluctant to support board proposals that do not immediately enhance the share price or the dividend pay-out.3 However, we should recognise the complexity in this relationship, which requires further investigation, as there are also concerns over the extent to which agents of shareholder (investment fund) managers act on their clients’ views. Many large investors also have a large portfolio, and while they may hold a significant share in one company, they may not invest the necessary resources needed to scrutinise corporate governance issues adequately. There is little publicly available information on the extent to which investment funds scrutinise corporate governance issues, including those of remuneration, and no information, for example on how much as a percentage of fees is spent on governance. Many large institutional investors have relatively small teams focused on corporate governance issues. Indeed in the current difficult financial environment many investors are cutting back on their corporate governance teams, Aviva is an example of this. The effective time horizon of shareholders as measured by the frequency of turnover has also declined. Shares are now commonly held for a much shorter period than the time required to exert long-term discipline on company managers. Also our interviews suggest that larger institutional investors are decreasing their holding of shares and instead holding more bonds. In relation to pay, evidence suggests that the presence of an external monitoring shareholder strengthens the link between pay levels and skill,4 and excessive CEO pay is more likely in the absence of monitoring block shareholders.5 It is clear that this relationship between managers and owners is challenging. The ability of owners – shareholders – to exert influence over the company given their increasingly short-term time horizons raises questions about not only the issue of executive pay, but also fundamentally about in whose interests these companies serve.

3 J. Solomon, Corporate Governance and Accountability, 2004. 4 Daines, Nair and Kornhauser, The Good, the Bad and the Lucky. 5 M. Bertrand and A. Schoar, ‘Managing with style: the effect of managers on firm policies’, Quarterly Journal of Economics, 118, 2003. 

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12. What role should institutional investors, remuneration consultants, employees and others play with respect to remuneration in the financial services sector? While we are seeing somewhat of a revival in shareholder activism, the likelihood is that this will be short lived. Even in the currently contentious issue of remuneration defeats remain rare. At the height of the financial crisis only five companies lost the vote on their remuneration report. On average the vote against the remuneration report in companies was only 5.6% in the All Share index in 2010.6 This was significantly higher in the FTSE 100 with remuneration reports receiving on average 8%, up from 3.3% in 2006. We would argue that instead of relying on non-executive directors and shareholders, we should allow a greater oversight role for employees in determining remuneration. For this reason we would advocate an employee representation on the remuneration committee. 13. Is there a case for introducing still greater transparency for senior executives with respect to remuneration in the financial services sector? The original remit of the High Pay Commission was to find out what had happened to pay at the top of the income spectrum. However, there was a significant level of concern at the lack of available information. When it comes to pay in the corporate world, transparency has been undermined by the ever increasing complexity in the rewards that have been constructed for top executives. This level of complexity was introduced through ‘innovation’ in top pay designed to bring the interests of the executive in line with those of the shareholder. However, the extent to which this has been successful is contested and performance-related pay has gone on to undermine transparency as well as function as a major driver of the growth of executive pay.7 In relation to the financial services specifically there is an issue of public trust first of all. It seems that in many ways the public has lost patience. In 1983, 90% believed banks were well run, and their reputation for being well managed was higher than in many other institutions, including the police and the BBC. Now just 19% think banks are well run.8 The links between the financial crisis and pay in the financial sector have been presented in many reports of the crisis. The Financial Crisis Inquiry Commission (FCIC) conducted in the US reported that one of the causes of the crisis was ‘dramatic breakdowns in corporate governance, with too many firms acting recklessly and taking on too much risk’, combined with lax regulation and compensation that ‘too often rewarded the quick deal, the short-term gain’ and ‘encouraged the big bet’.9 Greater disclosure would allow more scrutiny by shareholders, government and other stakeholders. Most importantly, it could allow a greater understanding of where the risks lie within the business. We feel this issue of risk is particularly important and would advocate greater transparency for this reason.

6 PIRC, Annual Stewardship Review, 2010. 7 For a discussion on why pay for performance has driven the growth in top pay see High Pay Commission, More for Less. 8 British Social Attitudes Survey, 2010. 9 Financial Crisis Inquiry Commission (2011) Financial Crisis Inquiry Commission Final Report 

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14 Should there be further reform of the remuneration arrangements of senior executives in the financial services sector? Should this extend to those highly paid individuals who sit below executive level? This is important to companies and shareholders, as ideally there should be an even transition in the pay they receive between top executives and the boardroom to ensure smooth succession to the top roles. While in most businesses top pay refers to that awarded to boardroom executives, in banks it is very often the case that the highest earners are below board level, although the executives themselves are also well rewarded. This creates a perverse incentive for executives in banks to remain outside of the boardroom. Additionally, as above greater transparency would reveal information for shareholders on where the risk lies in the bank. While there is a move within banks encouraged by the FSA towards “claw back” arrangements we are sceptical about the efficacy of these. Any arrangements that encourage a short term outlook and allow bankers or the executive to experience the benefits of any risks without any of the downside should be unacceptable. However, we do not believe that claw back is the best way to resolve this. Clawing back money already paid to individuals will be inherently difficult, and may cost as much in legal fees as would be gained from doing it. We would advocate smaller variable rewards that would not be paid out until the impact of the action for which the reward was being offered was clearly evident. 17 What is the relationship, if any, between Board diversity and company performance in the financial service sector? Board diversity is incredibly important for successful companies. This should not be limited to simply greater ethnicity of gender diversity but should also include diversity of experience or background. Boards usually comprise of comparatively few women and a limited number of members from non-managerial backgrounds.10 Non-executives generally come from a very specific employment background and when making decisions about remuneration, or indeed takeovers, strategic direction or board appraisals, their decisions will be coloured by that experience Academic studies suggest that greater diversity of ethnicity, gender and social background can improve board and company performance. A number of studies show a correlation between the financial performance of a company and greater diversity in representation.11 It is possible that this can be accounted for by the fact that successful companies have the economic resources to encourage diversity.12 However, the growing evidence charting a positive relationship between the two using a wide variety of indicators, coupled with the fact that no investigation has found a negative relationship between them, suggests there is a clear business case for greater board diversity.13 10 Davies, Women on Boards (2011) 11 M. Bhogaita, ‘Companies with a better track record of promoting women deliver superior investment performance’, New Model Advisor, 2011. 12 R. Adams & D. Ferreira, ‘Diversity and Incentives in Teams: Evidence  from Corporate Boards.’ Working Paper. Federal Reserve Bank of New York, New York 2002  (found no relationship between the percentage of female directors and ROA). 13 D.A. Carter, B.J. Simkins and W.G. Simpson, ‘Corporate governance, board diversity, and firm performance’, Oklahoma State University Working Paper, 2002, http://ssrn.com/abstract=304499 or doi:10.2139/ssrn.304499; D.A. Carter, F.P. D’Souza, B.J. Simkins and W.G. Simpson, ‘The diversity of corporate board committees and financial performance’, 2008, http://ssrn.com/abstract=1106698. 

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A recent study demonstrated that the groups that are highly under-represented on most boards and management teams are generally significantly more capable of giving correct forecasts than those best represented on boards and management teams.14 May 2012

14 K. Rost and M. Osterloh, ‘You pay a fee for strong beliefs: homogeneity as a driver of corporate governance failure’, 2008, http://ssrn.com/abstract=1304719. 

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Written evidence submitted by the Association of Financial Mutuals (AFM)

(CGR 03)

Board structure and composition

1. What outcomes should corporate governance in the financial services sector seek to achieve?

2. Are Board structures effective? For example, should UK financial institutions consider adopting alternatives to the unitary Board structure?

3. Does the UK approach to regulation and supervision of financial services incentivise Boards to perform their role effectively? Is more intrusive regulation a substitute or complement to effective corporate governance? Is a "comply or explain" approach an effective framework for governance?

In our assessment, effective corporate governance is critical to the effectiveness of any organisation. The Board defines not just the strategy of the organisation, but also the culture, and the style and approach to governance is central to that.

Corporate governance should ensure the basis by which the organisation seeks to secure the best interests of all stakeholders. This includes their obligations to customers as well as the rights of owners, but also includes: business partners, regulators, and taxpayers. An effective Board structure must therefore be capable of understanding the expectations of all stakeholders, as well as providing knowledge and expertise of the business.

The unitary Board structure in the UK has proved an effective vehicle for a long time. By contrast, in the Netherlands, good practice envisages a discrete Supervisory and Management Board. We can see risks and opportunities in this, so dual Boards need to operate with clearly defined roles (as per the Dutch Code). In insurance for example, the Financial Services Authority requires with-profits providers to run a separate with-profits Committee, with responsibilities to ensure that the with-profits fund is operated in the best interests of the with-profits policyholders. However, this produces tensions in the system- where there is too great a risk of overlap.

The UK approach to regulation of corporate governance is of course already multi-agency, with both the FSA and the Financial Reporting Council defining requirements, and with legislative oversight from Treasury. In addition, we are seeing increasing focus on governance requirements in Europe.

The comply-or-explain process enables firms to consider how best to apply the main governance principles to their organisation, and accepts that there are practical reasons why some principles have less relevance to some organisations. For example, small mutuals would find the requirement to annually re-elect their Board onerous, and leave them exposed to risks in continuity, as well as capture by a relatively small number of individuals. In addition, some mutuals operate via a delegate system, rather than one-member-one-vote, so the approach to engagement is necessarily different. The more that governance is standardised, the greater the risk that business diversity is undermined.

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UK supervisors now focus on ‘judgment-led’ as well as ‘more intrusive’ regulation. In particular, judgment-led regulation puts the onus on the Board to best consider how to deliver regulatory outcomes, so rather than substituting effective corporate governance, we consider it reinforces it.

Corporate culture

4. What type of corporate culture should financial services firms seek to foster? In what way can this be encouraged? How effective are Boards at shaping corporate culture within their institutions?

Financial organisations should seek to develop a culture that is clearly communicated throughout the company and readily understood by the staff. It should seek to align the interests of the Board and the staff with those of the owners. It should emphasise that the organisation is run in the best interest of customers, and that for financial services in particular that means taking a long-term view. Whilst we would not expect individual organisations to take an economy-wide view, they should understand and communicate their role in the wider community.

The culture should reinforce the value of openness, transparency and fairness in all proceedings, and should ensure that rewards are made for doing the right thing, and for doing things right.

Impact of previous reviews and new regulatory developments

5. What difference would the proposals in the Independent Commission on Banking's report on the Boards of ring-fenced banks make to corporate governance in these institutions?

6. What benefits, if any, come from EU regulatory engagement with corporate governance issues?

7. What impact has the Walker Review (2009) had on corporate governance and corporate behaviour in financial services?

There has been a wealth of new regulatory initiatives in corporate governance since the financial crisis. Each has sought to provide a fit with other developments, and on the whole this has been achieved without too much duplication or inconsistency.

The strong focus on governance has unquestionably resulted in higher standards and a better understanding of best practice. It has though led to significant increases in costs, and for mutual organisations these have reluctantly been passed onto the customer. There has also been a risk of planning blight, with a steady stream of new provisions that makes compliance more difficult. We have also seen regulators try to move more quickly than good sense and infrastructure allows: for example, FSA introduced a new Significant Influence Functions regime in 2010, but has had to delay full implementation indefinitely due to shortcomings in its own systems.

Non Executive Directors

8. Should non-executive directors bear greater liabilities than under current law? Should executives in FTSE 100 companies be able to hold non-executive positions in other firms?

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9. Is the existing FSA approval process for significant influence functions (SIF), including non-executive directors, effective?

There is a balance needed between making NEDs more accountable, and in ensuring that people with the right skills and experience are not deterred from taking on an NED role. Similarly there is a balance between ensuring executives provide sufficient focus on their core role, and widening their experience by holding a NED role elsewhere.

In either case we do not believe the answer is legislation, but stronger self- and statutory regulation to ensure that appropriate practices are undertaken. This is the role we would expect of FSA’s new SIF regime once it is fully operational: it is too early to tell how effective the SIF regime has been in raising the quality of NEDs. We hear reports that a number of applications have been refused/ withdrawn as a result of FSA's intervention, and this is positive. We hear also however that the process is too bureaucratic and in some cases (all Approved Persons, not just NEDs) has resulted in unnecessary delays to key appointments, creating a governance and regulatory risk in firms being unable to fill vacancies in a timely fashion.

The role of shareholders

10. Should shareholders be required to exercise a stronger role in systemically important financial institutions? What are the key barriers to greater shareholder activism by institutional investors in financial institutions? What risks are associated with it?

11. Is it realistic to expect sovereign wealth funds and hedge funds to undertake a more active role?

Most organisations would be keen to see their owners take an active role in key decisions for the future: be those owners institutional shareholders, individual shareholders, members (in mutuals), or taxpayers within (part) state-owned organisations. Strong endorsement of the progress and strategy of the organisation by its owners is an effective foundation for effective management.

In the last few weeks we have seen a significant increase in shareholder activism. The ‘Shareholder Spring’ has demonstrated that where owners have a concern, they are adept at using the AGM to voice those concerns and to vote down the Board where deemed necessary.

Before recent events it was more legitimate to question whether shareholders could act decisively; instead the question is now about whether they are being given the right issues to debate or influence. The Shareholder Spring has been focused on executive remuneration and the poor returns for shareholders: in a capitalist system it is inevitable that the primary focus will be quite narrow and self-serving. It is not therefore apparent from recent events that shareholders would be able to, or should be expected to, take a more paternalistic view of the long-term interests of the organisation, its customers, or indeed the national interest.

Remuneration

12. What role should institutional investors, remuneration consultants, employees and others play with respect to remuneration in the financial services sector?

13. Is there a case for introducing still greater transparency for senior executives with respect to remuneration in the financial services sector?

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14. Should there be further reform of the remuneration arrangements of senior executives in the financial services sector? Should this extend to those highly paid individuals who sit below executive level?

15. The Chairman of the Financial Services Authority has argued that there may be a case for changing the personal risk return trade-off for bank executives. He has suggested either a 'strict liability legal sanctions or an automatic incentives based approach. What are the merits and drawbacks of these proposals? Are there other ways to achieve the same objective?

Remuneration practices have been held under close surveillance in financial services. The challenge that remuneration committees seek to achieve is to ensure that rewards are unequivocally linked to corporate performance. It is our strong view that corporate success and high earnings should go hand-in-hand, and that as a result high pay should not in itself be criticised.

It is important that remuneration policy establishes a clear and unambiguous set of goals, that are targeted towards the long-term value of the organisation. There needs to be greater transparency on how firms define such longer-term value- whether that be shareholder or member value- and how the performance measures used within remuneration schemes align with these. Short-term rewards in particular enable individuals to earn significant pay by taking decisions and/ or producing results that may result in longer-term harm to the business.

Equally executives and staff should not assume they have the same risk/ reward profile as partners in a business: risks in a large company should be lower and so should rewards, compared to an entrepreneur. Equally, executive pay should be seen to move in the same direction as shareholder returns, ensuring there is no perceived conflict of interest. The same may be inferred for staff at higher levels who do not sit on the Board but nevertheless enjoy a very high level of remuneration.

Governance of risk

16. Has the management of risk in firms improved since the financial crisis?

We have seen a massively increased focus in risk management over the last few years. This has been led by the widespread adoption of the Chief Risk Officer as a key role within organisations, as well as the focus on risk management through regulation such as via Basel or Solvency II.

Increased attention to, and improved techniques for risk management now enable firms to better model the robustness of the firm in different operating conditions. For insurance in particular this has had a significant impact on corporate strategy, and the mitigation of risk.

In addition, the financial sector has experienced increased regulatory focus on the need for regular stress testing since the crisis, and FSA has created rules that require firms to conduct Reverse Stress testing at least annually. This has helped firms and the regulator better understand and mitigate the risks that they face.

Diversity and background

17. What is the relationship, if any, between Board diversity and company performance in the financial service sector?

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There are different dimensions to diversity; traditionally this might include gender, race, age and affluence. The challenge for any Board should be to embrace all of these but also to ensure that it properly represents the interests of all stakeholders in the organisation, including owners, staff and customers. It is important therefore that Board’s recognise diversity of skills, to encourage a range of views and to avoid the trap of group think.

There is some very interesting research into the degree to which gender diversity improves performance; for a helpful summary see: www.nottingham.ac.uk/business/forum/documents/researchreports/paper74.pdf.

AFM members actively support gender diversity of their Boards, and our annual monitoring indicates the proportion of women on AFM member Boards is a little higher than the current rate in FTSE 350 firms. There remain however a number of organisations with no female directors, though we hear regular reports from members who are seeking to recruit new women Directors with appropriate skills and experience.

23 May 2012

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Written evidence submitted by the British Bankers’ Association

(CGR 04)

Introduction 1. The British Bankers’ Association welcomes the opportunity to provide written evidence to

the Treasury Committee in respect of its inquiry into corporate governance and remuneration. We represent 220 banks from 50 countries on UK and international banking issues.

2. We have structured this submission according to the 17 specific questions identified as the

terms of reference for the inquiry. Given the financial services sector focus of the inquiry we would underline the benefit of corporate governance principles being developed on the basis of general application through the FRC Corporate Governance Code. While there may be issues which have a particular relevance to a financial services firm these can usually be addressed within the context of the single overarching framework overseen by the FRC. Exceptions are the specific requirements placed on the industry whether through European Directive and requirements under the FSA’s Significant Influence Function (SIF) regime.

Board structure and composition 1. What outcomes should corporate governance in the financial services sector seek

to achieve?

Corporate governance can neither prevent failure nor guarantee success. Regardless of sector, however, it has a vital role to play in facilitating the creation and delivery of long-term shareholder value. Good corporate governance promotes behaviours and values which are ethical, legal and transparent. A well-governed and well-run company engenders trust, which in turn builds confidence in the company’s ability to create sustainable returns for its owners and to support the needs of its wider stakeholders, which in the case of a financial institution would include the regulatory bodies tasked with ensuring financial stability.

2. Are Board structures effective? For example, should UK financial institutions consider adopting alternatives to the unitary Board structure?

A Board has primary accountability for ensuring that, as a collective body, it has the appropriate skills, knowledge and experience to perform its role effectively. We believe that the UK unitary Board structure, where executives and non-executives are part of a single unified team, remains the most effective structure. Although it is arguable that with a two-tier Board independent directors find it easier to challenge management, there is an increased risk that these directors are too removed and isolated from the company’s activities to operate effectively. In any event, while the design and operation of Board structures are important, behaviours - including values, style and tone - are more instrumental to Board effectiveness. Other critical factors for effectiveness include the pivotal role of the Chairman, the quality of director induction and training, board evaluation and the transparency of the director recruitment process. Within an open culture, supported by an ethos of continuous improvement, independent directors on a unitary Board can appropriately challenge the executive directors whilst still having access to their knowledge and understanding around the Board table.

3. Does the UK approach to regulation and supervision of financial services

incentivise Boards to perform their role effectively? Is more intrusive regulation a

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substitute or complement to effective corporate governance? Is a “comply or explain” approach an effective framework for governance?

Our overall assessment is that the FRC Corporate Governance Code, which combines a series of central principles with reasonably detailed supporting provisions, provides a firm but flexible approach to corporate governance against which investors and other stakeholders can judge a company. While the principles must be complied with, applying the provisions under a “comply or explain” model allows for a degree of flexibility, which avoids a ‘one size fits all’ approach and incentivises companies by allowing them to assume responsibility for the development of their governance structure within a clear and understandable overarching framework. International comparisons do not support the view that approaches to corporate governance based on statute or intrusive regulation are stronger.

Within the context of a regulated industry, while it is recognised that the regulatory authorities need to ensure that financial institutions are well-governed, it is also important to maintain a clear distinction between the respective role and responsibilities of management and regulator. We would therefore say that regulators can contribute to good corporate governance but should take care to ensure that this complements and not substitutes the corporate governance practices implemented by management in keeping with the best practice recommendations of the Corporate Governance Code. There is also a need to ensure that UK-specific regulation does not impact upon the competitiveness of UK financial institutions vis-à-vis their peers and does not inadvertently hinder their ability to deliver on behalf of their customers, employees and shareholders and their ability to contribute to the wider economy.

Corporate culture 4. What type of corporate culture should financial services firms seek to foster? In

what way can this be encouraged? How effective are Boards at shaping corporate culture within their institutions?

For good corporate governance to exist, there must be both robust processes and the right culture, values and behaviours throughout the group structure. Culture, values and behaviours are modelled by the Chairman and the Board and actively promoted by the CEO and management throughout the company. Corporate culture cannot be directly regulated or determined by regulators or regulation.

Impact of previous reviews and new regulatory developments 5. What difference would the proposals in the Independent Commission on Banking’s

report on the Boards of ring-fenced banks make to corporate governance in these institutions?

The ICB report made clear that the Commission wished to see its ring-fenced model reinforced through a Board culture in which the emphasis within the ring-fenced bank was placed on meeting the needs of its core client group – households and SMEs. While we would not disagree with this focus, we believe much more careful thinking needs to be given to how this fits with directors’ duties under the Companies Act. Until the precise requirements for the ring-fenced model are finalised, it is not clear how the potential conflict for directors sitting on both the ring-fenced entity Board and the group Board can be overcome particularly in time of financial difficulty. We are also unsure about whether the independent subsidiary Board approach as advocated is inherently superior to a unitary Board approach in which specific responsibilities are placed upon the Board in respect of its

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ring-fenced operations. This is a matter which we believe has not received the attention it needs and we look forward to gaining a fuller appreciation of how this might work as a result of the publication of the Government White Paper which will precede the Banking Reform Bill announced in the Queen’s speech.

In any event, we view it as important that in a group structure the group Board should retain the ability to set the strategic direction of the group as a whole, including for the ring-fenced bank, and see a need for the potential for conflict with the independent subsidiary Board to be considered. There is also a need for the right balance to be achieved between respect for the principles of the ring-fenced bank and the group or holding company level to set the control framework and strategic policy agenda for the organisation as a whole.

6. What benefits, if any, come from EU regulatory engagement with governance

issues?

Since practices vary across Member States, the EU institutions have a role to play in promoting transparency and best practice. It needs to be appreciated, however, that the business environment and underlying company law vary considerably across the EU and that an approach based on EU legislation is unlikely to work. Indeed, it would most likely hold back those more advanced in developing their standards of corporate governance and further forward in making progress on diversity and transparency.

7. What impact has the Walker Review (2009) had on corporate governance and

corporate behaviour?

Incoming leaders of firms which underperformed during the crisis are highly aware of the damage done under previous regimes and are intent on ensuring that the restructured organisations operate in a way that constitutes a break from the past. The Walker Review has been an integral part in the reshaping of bank culture and has had a significant impact within financial services and more generally through revisions to the FRC Corporate Governance Code and the introduction of the Stewardship Code for institutional investors. It is a prime example of how best practice corporate governance can be developed and enacted largely without a need for legislation.

More specifically, during the review there was debate about whether the Chairman of a financial services institution must display both depth of industry specific knowledge and the necessary leadership skills to be effective. The Walker Review concluded that whilst industry specific knowledge is useful, the leadership aspects are the more crucial skills and we would fully support this conclusion. In fulfilling the role, the Chairman must possess the requisite skills, ability and expertise to develop and maintain a relationship of trust with each of the Board members, creating an environment which simultaneously stimulates open debate and constructive challenge yet also leads to a cohesive and supportive Board. The Chairman must ensure that the environment does not promulgate the potential for “groupthink”. Whilst a rigorous tailored induction and training programme can assist a chair to gain the requisite technical knowledge, leadership skills are much harder to acquire.

A further key impact arising from Walker is the focus on risk management. The establishment of a separate Board-level risk committee and the appointment of an independent CRO are now accepted best practice.

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Non Executive Directors 8. Should non-executive directors bear greater liabilities than under current law?

Should executives in FTSE 100 companies be able to hold non-executive positions in other firms?

Both the Walker Review and the subsequent changes made to the FRC Corporate Governance Code placed greater emphasis on being clear about the commitment expected from non-executive directors and the nature of the expertise or broader experience which they were expected to bring. This however is very different from the proposition that non-executive directors should bear a greater liability than under current law. Under UK law, all directors have the same responsibilities and duties and must exercise the same degree of skill, care and attention, whether they are executives or non-executives. We believe that individuals are fully aware of their responsibilities, in fact increasingly so given the events of the financial crisis, and view the suggestion that non-executives should bear a greater liability as working against the concept of the unitary Board and also against the grain of measures aimed at increasing Board diversity and the pool of talent available and drawn upon. It is far more important that NEDs can demonstrate that they can devote the requisite time to a defined Board commitment and avoid conflict of interest. Limiting the ability of executives in FTSE 100 companies to hold non-executive positions in other firms could have unintended consequences both in terms of an individual director’s development and Board diversity. The key determining factor should be each director’s ability to allocate sufficient time to each role and, subject to their being no conflict of interest, we view FTSE 100 executives holding non-executive positions in other firms as an exercise in skills and experience transfer, usually between different industrial sectors. The practice is also provides the means by which individuals working for FTSE 100 companies can gain Board experience outside their usual environment. Safeguards already exist under the FRC Corporate Governance Code to ensure that executive directors do not take on too many external non-executive commitments.

9. Is the existing FSA approval process for significant influence functions (SIF),

including non-executive directors, effective?

The FSA approval process has been applied more stringently in recent years and firms are fully aware that their nominations for key senior roles will be subject to a rigorous external examination. While this has not been unproblematic, difficulties encountered have had more to do with practical considerations such as the FSA’s capacity to undertake interviews on a timely basis rather than the principle. As Hector Sants explained in his final speech as CEO of the FSA, the FSA is seeking primarily to ensure that firms themselves have robust procedures in place. Rather than ‘gate keeping’ everyone, their aim is to focus on the Chair, the senior independent director, the chair of the risk and audit committee and on the principal executive functions: CEO, finance director and chief risk officer1. Outside these functions the need to interview is judged on a firm-specific basis. While this approach is more intrusive than that adopted in similar jurisdictions, it forms a natural part of the supervisory model introduced following the financial crisis. The key to its effectiveness is ensuring that the interview and approval process is suitably resourced and concluded in a timely fashion to ensure that there is no deterrent to individuals putting themselves forward as candidates.

1 Speech by Hector Sants, Chief Executive, FSA at Merchant Taylors’ Hall, 24th April 2012.

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The role of shareholders 10. Should shareholders be required to exercise a stronger role in systemically

important financial institutions? What are the key barriers to greater shareholder activism by institutional investors in financial institutions? What risks are associated with it?

We are broadly supportive of greater engagement with shareholders, but see risks from regulation seeking to impose upon shareholders responsibilities which they may not wish to shoulder. The Stewardship Code is seen as providing suitable leadership in this area but needs time to bring about the more positive engagement on the part of shareholders that lies behind its introduction. We do not believe that systemic importance should be a reason for increased activism in financial services but would make the point that changes in risk profile arising from aspects of the banking reform programme, such as the adoption of a bail-in regime in which bondholders be required to contribute to resolution in the event of failure, will generate closer stakeholder interest of the type viewed as beneficial.

11. Is it realistic to expect sovereign wealth funds and hedge funds to undertake a

more active role?

We see no need to distinguish between sovereign wealth funds, hedge funds and other institutional investors. Our observations in respect of the role of shareholders overall therefore apply equally to these investor groups.

Remuneration

12. What role should institutional investors, remuneration consultants, employees and others play with respect to remuneration in the financial services sector? The remuneration committee has a key part to play in the in ensuring that remuneration decisions take into account the views of various stakeholders and in recent years many companies have engaged more actively with shareholders on remuneration issues. It is likely that in future a binding vote on forward-looking remuneration policy will be required, which is likely to lead to greater shareholder engagement. CRD 3 specifically requires the engagement of remuneration consultants in the provision of information, analysis and advice to assist remuneration committees in their decision-making process. Institutional investors should also take part in regular and constructive engagement with companies to ensure that reward practices are aligned with superior performance and help to build a sustainable business that serves the long term interests of shareholders. The introduction of employees to the remuneration committee would not strengthen the existing corporate governance structure around remuneration, which has evolved in recent years. Employee representation is considered likely to provide a distraction rather than material advancement given that remuneration committees have a wide remit that goes beyond simply setting directors’ pay. The discussion required is about individual and firm performance, strategy and risk issues – much of which is market sensitive - and also the broader interplay between organisational priorities.

13. Is there a case for introducing still greater transparency for senior executives with respect to remuneration in the financial services sector?

Transparency on remuneration within the financial services sector has increased significantly in recent years including through the FSA Remuneration Code. The Walker Review included a recommendation on banded disclosure of remuneration and there are a number of

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requirements that are either in place or are proposed towards meeting this recommendation: ⋅ FSA Pillar 3 requirements to disclose aggregate remuneration for code staff; ⋅ Draft HM Treasury legislation to disclose individual remuneration for the eight most highly

paid individuals below Board applying broadly to the same group of organisations as identified by Walker; and

⋅ Potential CRD 4 changes requiring disclosure of code staff remuneration in bands of €0.5m from €1m upwards.

It is not clear what additional value would be derived from introducing any further requirements for banded disclosure, particularly once the EU requirements come into effect.

When considering extending the already substantial disclosure requirements for remuneration in the UK, it is important to consider how useful this data is to investors and how it informs their decision making. We caution against the risk of misuse, the ratcheting impact on pay and the potential advantage given to competitors not subject to equivalent disclosure requirements. There is a risk that increasing disclosures simply overloads investors with similar information cut in different ways as opposed to providing them with meaningful and clear data to aid informed decision making. A broader question to consider is whether it is appropriate or not for measures aimed at improving the transparency of the remuneration of senior executives to be limited to the financial services sector.

14. Should there be further reform of the remuneration arrangements of senior executives in the financial services sector? Should this extend to those highly paid individuals who sit below executive level?

The FSA’s Remuneration Code, which implements the Financial Stability Board’s principles and the EU Capital Requirements Directive, scopes in employees who have a material impact on the risk profile of their firm. This includes traders and audit, risk and compliance staff. Remuneration arrangements for code staff include the use of deferred awards with vesting dates spread over a number of years, claw back provisions prior to vesting and additional retention periods post-vesting. These arrangements allow for greater alignment of risk and reward and should be given time to embed before any further reform is proposed. Under the HM Treasury proposals referred to above, all large banks operating in the UK, excluding the UK operations of banks headquartered in other EU states, will be required to publish the pay details of their eight highest paid senior executive officers who are not main Board directors. Whilst the consultation is ongoing, some banks have already disclosed information in their most recent annual reports on this basis. The major UK banks made similar disclosures in the previous year. Therefore shareholders will have visibility of structure and quantum of remuneration arrangements below board level without the need for further reform.

15. The Chairman of the Financial Services Authority has argued that there may be a case for changing the personal risk return trade-off for bank executives. He has suggested either a ‘strict liability’ legal sanctions or an automatic incentives based approach. What are the merits and drawbacks of these proposals? Are there other ways to achieve the same objectives?

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We appreciate that shareholders and other stakeholders do not expect rewards for failure. We do not recommend, however, a strict liability sanctions or an automatic incentives-based approach as a method of ensuring this. A strict liability or automatic approach would entirely restrict remuneration committees’ current flexibility in making judgements on executive remuneration. It is important to appreciate that under the FSA Remuneration Code deferred remuneration is not a legal entitlement until vesting occurs. Vesting takes place over a number of years and enables the claw back of variable pay of code staff in the event of the misstatement of accounts, misconduct or other performance issues. Moreover, it is proposed that deferred remuneration should be within the scope of bail-in arrangements in the event that financial difficulty triggers a firm into resolution. The FSA already has extensive powers to ban people from working in an authorised institution, place restrictions on the roles they can undertake and to apply fines. There are an increasing number of high profile cases which suggests that the answer may lie in the regulator utilising enforcement powers already in existence.

We would also note that introducing any kind of automatic or formulaic approach to making remuneration decisions has inherent problems. There is the risk that it could encourage gaming and reward the wrong type of behaviours. Instead, the flexibility to take into account all internal and external factors should be retained. There are already arrangements in place, such as claw-back and malus, which are designed to deal with issues that arise after the date awards are made and we are not sure that an automatic approach would be stronger.

Governance of risk 16. Has the management of risk in firms improved since the financial crisis?

The financial crisis sent a shock wave through the financial services sector and resulted in a major reappraisal of the way in which firms appraised risk. The Walker Review built upon this in its recommendations, since reflected in changes to the UK Corporate Governance Code, that Board-level engagement in risk process should be materially increased, with more deliberate attention on the monitoring of risk and discussion leading to decisions on risk appetite and tolerance. This involves NED focus on risk issues, full independence in the group risk management function and the appointment of a CRO with enterprise-wide authority and independence, with tenure and remuneration determined by the Board. The wider use of stress testing, increased supervisory engagement on the effectiveness of risk oversight and greater input by the risk function into remuneration analysis have also strengthened the management of risk.

Diversity and background 17. What is the relationship, if any, between Board diversity and company

performance in the financial services sector?

An increasing body of research demonstrates that Board diversity, including different strands such as gender, nationality, skills and experience, as well as Board tenure, leads to better business results. Diverse perspectives help bring more clarity to Board discussions and decisions and help ensure that the status quo is challenged. A well balanced Board encourages diverse perspectives. We have therefore been supportive in principle of initiatives to improve Board diversity and welcome the provisions on gender diversity added to the UK Corporate Governance Code following consultation last year and also planned disclosure requirements. It is right that Boards give due consideration to the benefits of diversity, such as gender, ethnicity or

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industry background, but all Board appointments must be made on merit in the context of the skills and experience required. We are therefore not supportive of binding quotas of the type identified as an option in the currently open European Commission consultation ‘Gender imbalance in corporate boards in the EU’ or proposed in amendments to CRD 4. We instead see the answer as lying in suitable management development and good recruitment practices aimed at creating a supply of candidates who can progress to Board level. Progress being made under voluntary initiatives such as the Davies Report and the 30% Club shows what can be achieved without statute. We would add, specifically in respect of financial services companies, that this underlines the need to ensure that the SIF process relates to the Board overall and does not put a barrier in the way of individuals with less direct experience from becoming Board members in the financial services sector if they have the right skills and attributes.

24 May 2012

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Written evidence submitted by the Chartered Institute of Personnel and

Development Background

1. The CIPD is the leading independent voice on workplace performance and skills. Our primary purpose is to improve the standard of people management and development across the economy and help our individual members do a better job for themselves and their organisations.

2. Public policy at the CIPD exists to inform and shape debate, government policy and legislation in order to enable higher performance at work and better pathways into work for those seeking employment. Our views are informed by evidence from 135,000 members responsible for the recruitment, management and development of a large proportion of the UK workforce.

3. Our membership base is wide, with 60% of our members working in private sector

services and manufacturing, 33% working in the public sector and 7% in the not-for-profit sector. In addition, 76% of the FTSE 100 companies have CIPD members at director level. We draw on our extensive research and the expertise and experience of our members on the front-line to highlight and promote new and best practice and produce practical guidance for the benefit of employers, employees and policy makers.

General comments

4. One of the CIPD’s public policy priorities is to ensure ‘Higher Performance at Work’; that is, to promote good people management practices and workplace relations built on openness and trust. Corporate governance is an integral part of how an organisation functions, both internally and in the wider business community, and is something the CIPD takes an active interest in.

5. In 2009, we responded to the Walker Review of Corporate Governance in Financial Services. Our response stressed that unless the attitudes and behaviours of those individuals employed by financial institutions change, any changes in corporate governance will be largely ineffective. Corporate culture is not a “thing” but simply a reflection of “the way people behave around here”. Organisations’ culture is shaped in part by the environment or sector in which they operate and the demands made upon them, but also significantly by the way they are managed and led.

6. Organisations in any sector need to address a number of challenges if they want to establish and maintain a healthy culture. These include: • the need to balance short-term pressures e.g. to increase share prices, and the

need to protect the longer-term future of the organisation. In financial organisations subject to constant market pressures, this balance may be particularly hard to strike

• the need to balance the requirement for a clear sense of direction and purpose, in order to enable the organisation to move forward and meet its objectives, with the ability to challenge and reconsider that direction, or the methods adopted in order to achieve it, when necessary

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• the need to reflect on the appropriate style of leadership required to get this balance right. The focus of much current debate about leadership is around the contrast between the traditional “heroic” style and “engaging” or “distributed” leadership that is increasingly seen to support effective communication and learning across organisations

• the need to manage both systems and people. Surveys of CEOs suggest they see “people” risks as significant priorities, but they may not always have a clear idea how these can best be managed

• the need to encourage compliance and individual responsibility at all levels in the organisation while avoiding a “blame” culture and promoting trust-based relationships.

7. How can organisations develop a healthy culture? The evidence suggests that culture reflects the beliefs and behaviour of people at the top of the organisation, and that the board is critical in leading and implementing culture change. Boards can take a lead in many ways, provided always that employees believe board members are personally committed to the values and behaviours they endorse. For example, they can: • publish a values statement emphasising inter alia that employees should observe

legal and ethical standards • establish and maintain effective individual and collective “voice” mechanisms, to

support on-going dialogue with employees • have a whistle-blowing policy which encourages staff to report internally if they

suspect wrong-doing • provide coaching and other support to help line managers engage, motivate and

involve their teams.

8. Boards will often need help and support to implement this kind of agenda, and particularly to ensure an effective “challenge” role. Candidates for this role can include: • non-executive directors: many organisations are actively seeking to create a more

diverse non-executive team to help avoid “group-think” • HR directors who have business insight and can use their experience to focus on

issues about organisation culture, people management and wider organisation development.

9. It is clear that culture change cannot be required by legislation, nor guaranteed by corporate governance structures. Some systemic issues about the operation of financial markets may be beyond the immediate control of individual companies but there are nevertheless many useful things boards can do to protect themselves, as suggested above. The cost of getting it wrong, not least in terms of serious damage to corporate reputation, should be a significant incentive to financial institutions to think about what steps they need to take to get it right.

10. In the past few years, we have responded to a number of government consultations addressing issues of direct relevance to corporate governance, including board diversity and executive pay. These can be found at the links below, in case of interest to the Committee.

References CIPD response to the Walker Review of Corporate Governance in Financial Institutions: http://www.cipd.co.uk/publicpolicy/_walkerreview1109.htm

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CIPD response to European Commission consultation on Corporate Governance in Financial Institutions and Remuneration Policy: http://www.cipd.co.uk/publicpolicy/_ec-corporategovernance

CIPD response to the Department for Business, Innovation and Skills’ consultation on The Future of Narrative Reporting: http://www.cipd.co.uk/publicpolicy/_narrativereporting1010.htm

CIPD response to the Financial Reporting Council on Gender Diversity on Boards: http://www.cipd.co.uk/publicpolicy/consultations/previous_consultations.htm

CIPD response to the Department for Business, Innovation and Skills on The Future of Narrative Reporting: Consulting on a New Reporting Framework: http://www.cipd.co.uk/publicpolicy/_futureofnarrativereporting

CIPD response to the Department for Business, Innovation and Skills on Executive Pay: Consultation on Enhanced Shareholder Voting Rights: http://www.cipd.co.uk/publicpolicy/_executive-remuneration-shareholder-rights

May 2012

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Written evidence submitted by Which? (CGR 06)

1. What outcomes should corporate governance in the financial services sector seek to achieve?

It is important to start by considering the special features of the banking market which should be taken into account when considering what outcomes corporate governance should seek to achieve. Which? believes that these special features include:

• Consumers are not well placed to judge the price/quality of a financial product or bank due to complexity and the length of time before the quality of the product becomes apparent. This undermines consumers’ confidence or willingness to engage effectively with these markets. Consumers will not be able to monitor or to exert meaningful market discipline on a bank with a riskier business model by moving their accounts elsewhere. Financial products are also long-term in nature and it may be several years before the true consequences of their purchasing decision becomes apparent or whether they have been mis-sold.;

• For many consumers and small businesses, retail banking products are essential but invisible ‘utility’ services, with our attention only captured when things go wrong. Consumers and businesses cannot function without continuous access to these essential services;

• Banks can generate the appearance of greater short-term profits by taking more risk. Revenue is incurred before costs are fully realised. A borrower may pay interest for a while, but is not until they repay in full, or default, that the cost of the lending is known. For example, a bank which lends irresponsibly to consumers even though it is unlikely that consumers will be able to repay the money will make higher short-term profits. The true consequence of its business model will only become apparent when consumers begin to default on the loans. A bank may mis-sell insurance products for many years, making higher short-term profits, but at the expense of substantial redress costs in the longer-term. Which? calculates that the total provisions for mis-selling of Payment Protection Insurance are now greater than £9 billion and certain to rise further.

• Banks are inter-related through counterparty risk and taking similar exposures to the same source of risk that, with the subsequent steps to protect stability, erode market discipline and create moral hazard leading to banks that are too big or complex to fail. Bailing out poorly run banks which have not served consumers effectively distorts competition;

• Banks receive wide-ranging explicit and implicit subsidies from the Government/authorities. These can include direct subsidies by the injection of taxpayer money and explicit guarantees for toxic assets. Most importantly, the implicit guarantee of banks which are too-big-to-fail means that these banks have a lower cost of borrowing (because those who lend to the banks know that the Government will bail them out if things go wrong). The extent and distorting impact on competition of this implicit subsidy is a key concern.

A consequence of these features is that the incentives on banks and their senior executives are often not aligned with genuine consumer benefit or the longer-term costs and consequences of banks’ commercial decisions. Intertwining riskier, highly leveraged investment/wholesale

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banking with essential retail activities creates conflicts of interest due to the presence of Government guarantees.

Corporate governance in the financial sector should seek to achieve long-term sustainable value creation for shareholders and society. This can be achieved by putting long-term goals ahead of short term gains. Creating long-term sustainable value means putting the customer at the heart of everything the banks do and providing products and services of high quality at the best possible price. Corporate governance should seek to introduce a system of checks and balances which align the interests of banks, boards and shareholders with their customers. It should seek to control the inclination of management to take more short-term risk in ways which put the long-term stability of the individual bank and the financial system in jeopardy.

The essential nature of some banking services means that corporate governance should also seek an outcome of ensuring that customers have continuous access to these services. These could be similar to requirements imposed in the Water sector (please see our answer to question 5).

4. What type of corporate culture should financial services firms seek to foster? In what way can this be encouraged? How effective are Boards at shaping corporate culture within their institutions?

Which? believes financial services firms should seek to create a culture that focuses on the long-term creation of value for shareholders that is achieved by putting the customers at the heart of their business. There needs to be a significant change of corporate culture which moves away from a legalistic interpretation of whether a course of action complies with the rules and towards an ethical approach which asks whether it is the right thing to do and meets the needs of their customers and society. No amount of detailed rules will be effective if it just results in a process of banks looking for elaborate ways around them. Enhanced corporate governance also needs to involve a clear set of checks and balances encompassing independent directors on boards, shareholders who exercise proper oversight of the companies in which they invest and auditors who report on a banks performance with professionalism and independence. We think that there are a number of ways that an appropriate culture can be encouraged. These include: Effective executive leadership Culture change can only be led from the top. Senior Executives must seek to diffuse a positive culture throughout their organisations to all of their employees. Staff at all levels must know the standards that are expected of them and expect this standard to be attained by all of their colleagues. Senior Executives must embody the culture that the firm are trying to achieve in order for it to take hold across the firm. As Stephen Green, Chief Executive of HSBC told the Future of Banking Commission:

“No banking business can afford to do without a board-led, senior management supported ethical approach to behaviour – to understand that there is a purpose to the business that you do, which is not simply measured by short-term profitability…is profoundly important. Unless that culture is there in an organisation, no amount of rule setting and no amount of careful compliance is going to be an adequate substitute.”1

1 Future of Banking Commission report, page 18

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Board review The board must also have a clear understanding and focus on risks, both to the institution and in its treatment of customers. Ideally the board should have three qualities: the ability to lead the business; the expertise to take good decisions; and the independence to challenge and change course. The board should have a structured process in place for reviewing the firm’s culture. This should include areas such as:

Leadership/management: This should include not only the senior management, but whether middle management can express the firm’s culture and how they are delivering fair treatment of customers. Middle management should also feel able to challenge inappropriate decisions from senior management. Strategy: This should include whether the firms overall strategy builds in potential risks and the fair treatment of customers. This should include all stages of the product life-cycle including product development, delivering these products to market and after-sales service/complaints handling. Decision making: The firm should ensure that decision-making is competent and subject to robust challenge. This should include clear statements that it is acceptable to express a lack of understanding about particular issues and risks. Controls and Management Information: Can the board/management actually demonstrate that the metrics are in place to measure whether customers are being treated fairly? This needs to go beyond simple having a “policy” in place, but to check whether it is being adhered to by using Management Information, feedback from customers and mystery shopping. For example, if senior management say that they have a culture in place which “deals with complaints fairly” then we would expect the Board to interrogate what specific evidence and monitoring systems they had in place to demonstrate whether it was being achieved. It is also important that controls include sufficient challenge in the decision-making process. It is notable that in the run-up to the financial crisis those who did raise concerns about particular strategies tended to be side-lined. Performance management / recruitment training and competence: Does the firm’s recruitment and training procedures properly monitor and reinforce its culture? Does its performance monitoring procedures contain measureable objectives and mechanisms to identify and correct excessive risk or unfair treatment of customers. Reward and remuneration: We cover the characteristics of appropriate remuneration schemes below.

Appropriate remuneration/reward schemes

Remuneration and reward structures for staff at all levels within a financial services firm, from senior executives to frontline staff, should be linked to an appropriate culture. Metrics which govern the level of reward should include the fair treatment of customers, fair resolution of complaints, customer satisfaction and regulatory compliance. It should not merely reflect sales or short term goals. Remuneration schemes focused on sales encourage short term risk taking that is to the detriment of long-term shareholder value and to the interests of consumers. Clawback procedures must be in place and be exercised when excessive risk or unfair treatment of customers comes to light.

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Non-executive directors

Independent non-execs should make greater use of their powers to appoint independent advisers to assess risk and to measure the fair treatment of customers.

Individual accountability

Senior banking executives need to be held individually accountable for their failures. This needs to cover both consumer protection and prudential failures. We note that the only individual who was subject to enforcement action for the mis-selling of Payment Protection Insurance has been the chief executive of Land of Leather2 – a sofa shop. We would be interested to know whether the FSA will take into account the conduct of executives who have presided over mis-selling when conducting its assessment of candidates for ‘Significant Influence Functions’ (SIFs) within firms.

Professional standards

To bolster the process of cultural change, bankers should engage in the same sort of professional standards training undertaken by other professions such as lawyers and doctors. This should include training in the ethical and customer-focused behaviour expected of members of the profession. A code of conduct would be enforced by a new professional standards body.

5. What difference would the proposals in the Independent Commission on Banking’s report on the Boards of ring-fenced banks make to corporate governance in these institutions?

We support the Commission’s proposal to ring fence essential banking services from wholesale and investment banking activities. Under the current structure large integrated banks do not face a realistic threat of failure. The implicit (and in reality explicit) taxpayer guarantee to the banking system has allowed banks to grow beyond the level that they would if their risks were genuinely internalised. This must have an influence on corporate governance decision making. We can only expect meaningful changes in corporate decision-making when large banking groups are subject to proper market-discipline. The Government subsidies and bail-outs have led to a significant distortion of competition. Large banks have attained dominant positions in the market due to selective Government support rather than because they have grown by serving consumers and businesses effectively (or being prudently and competently run). It is clear to us that concentration in the market does matter and that larger banks have been able to use their increased market power to increase their margins on mortgages, loans, credit cards and overdrafts. The implicit subsidy has encouraged banking structures which intertwine highly leveraged wholesale and investment banking activities with retail deposits and the payment system. For a country such as the UK this is a particular problem because in the most extreme circumstances, the sector has outgrown the ability of the British taxpayer to underwrite its liabilities. The proposals to ring fence essential banking services from wholesale and investment banking activities should mean that banks face a credible threat of failure. The proposals should reward

2 FSA, Final Notice, 9th May 2008, http://www.fsa.gov.uk/pubs/final/paul_briant.pdf

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well run firms and prevent moral hazard and undue risk taking. Banks should feel some real downside risk and a credible threat of real loss. Assuming the ring fence is effectively designed it should encourage better corporate governance as, in the event of failure, the implicit taxpayer guarantee should be substantially reduced. The course of history suggests that crises will recur at regular intervals and it is not helpful to completely eliminate this risk of failure (or to claim that a government or regulator will eliminate the risk of failure in all circumstances). In practice this means that we should be trying to design a banking system, and a system of corporate governance, in which individual banks are less likely to fail but also one that, where necessary, allows the orderly failure of badly managed institutions, whilst securing the safety of deposits and the payment system. Corporate governance can play a role in ensuring that the ring-fenced bank is independent of the wider banking group. This means that the composition and duties of the board of the ring-fenced bank will need to be amended to ensure that it is independent of the Board of the wider banking group. This is the approach taken in other industries. For example, in the Water industry when Enron acquired Wessex Water, OFWAT imposed conditions including requiring the Board to act as if it was an independent company and prohibited cross-default provisions. For example, specific provisions include: require Wessex Water to operate as if it were a separate company, to act solely in the interests of the water company and for its board to act independently of the parent company; require the new owner to give a legal commitment to facilitate the proper performance of Wessex Water's functions (the supply of water and sewerage services); require Wessex Water to maintain an investment grade credit rating; prohibit cross defaults, whereby its financial liabilities are increased or accelerated because of a default of any other company; require it to maintain a minimum of three independent non-executive directors; require it to publish its results as if it were listed on the London Stock Exchange; and require Wessex Water to ensure that its dividend policy avoids any adverse effect on the company's ability to finance its functions as a water undertaker. 13. Is there a case for introducing still greater transparency for senior executives with respect to remuneration in the financial services sector? If the unfair treatment of customers or breaches of regulation result in liabilities for shareholders then bonuses should be clawed back from senior executives. Failure to do so will be in breach of the FSA’s remuneration code, which requires clawback of bonuses when there has been a “material failure of risk management”. At the end of 2011/start of 2012, Which? wrote to the chairs of the remuneration committees of the five largest banks3 asking them to undertake investigations into the role of senior executives in the mis-selling of PPI and to clawback bonuses from any senior executive who presided over mis-selling. This type of action should not have to be encouraged by third parties. Corporate governance boards that had a laser-like focus on “long-term sustainable value creation” would take action against executives who presided over mis-selling themselves. Those that serve on remuneration committees must take a more active role and demand greater transparency.

3 Submitted alongside this evidence

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For the 2010 RBS ‘Long-term incentive plan’, 50% of the award related to measures of ‘Total Shareholder Return’. Of the 50%, 25% related to ‘Relative Total Shareholder Return’ and 25% ‘Absolute Total Shareholder Return’. For the RBS 2011 ‘Long-term incentive plan’, only 25% of the award related to measures of ‘Total Shareholder Return’ and this was entirely dealt with by relative performance.4 2010 RBS Long-term incentive plan 2011 RBS Long-term incentive plan Economic Profit (50%) Core bank economic profit (25%) Relative ‘Total Shareholder Return’ (25%) Relative ‘Total Shareholder Return’ (25%) Absolute ‘Total Shareholder Return’ (25%) Balance Sheet & Risk (25%) Strategic Scorecard (25%) The RBS report only includes a list of the areas included in the ‘Strategic Scorecard’ and fails to list the precise targets which have been set as part of the incentive plan. It fails to list the specific targets set under headings such as “UK retail and commercial franchise” and “Measures from Group’s customer dashboard”. This means that not only has the Long-term incentive plan moved away from incentivising returns to shareholders, but has moved towards a set of objectives in the ‘strategic scorecard’ which are unclear and un-transparent. Other banks appear to be using measures for their Long-term Incentive plans which are inappropriate. For example, Lloyds banking group has chosen FSA reportable complaints per 1,000 customers as the sole measure of customer satisfaction in its Long-term Incentive Plan (LTIP). Given the ability of management to distort this number (only complaints which are outstanding at the close of the next business day are reportable to the FSA) we are surprised that the remuneration committee should choose to solely measure customer satisfaction by this metric. We would have thought that measures such as customer satisfaction and customer advocacy would be more appropriate. 24 May 2012

4 RBS Group, Annual Report, pages 251 & 259

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Fairshare Educational Foundation is a company limited by guarantee registered in England and Wales number 05013662 and a registered charity number 1117244. Printed on recycled paper

Written evidence submitted by FairPensions (Fairshare Educational Foundation)

(CGR 07) Summary

• Good corporate governance in financial institutions should promote sustainable wealth creation and effective management of risks, including systemic risks.

• Regulation and good corporate governance are complementary; comply or explain is effective if explanations are meaningful and properly scrutinised. There is now some recognition of a need for improvement in this respect.

• The Stewardship Code has been effective in gathering mainstream industry support for the concept of stewardship, but less so in translating this into meaningful behavioural change. This should be addressed, including through this year's review of the Code.

• Many of the key barriers to greater shareholder engagement can be traced to principal/agent problems in the investment chain. The challenge lies not just in encouraging greater engagement but in ensuring alignment of incentives between companies, investment intermediaries and savers so that this engagement promotes long-term value creation rather than short-term return-chasing. Evidence suggests that this challenge has not yet been met. Key barriers include:

◦ Narrow interpretations of institutional investors' fiduciary duties to savers, which (a) assume that fiduciaries cannot have regard to anything which is not immediately monetisable, and (b) encourage fiduciaries to 'follow the herd'. FairPensions has proposed statutory clarification to create a more flexible and enabling environment in which a broader approach can be taken to beneficiaries' best interests, including their interest in management of systemic risks.

◦ Conflicts of interest among fund managers. Conflicts management needs improvement, including through greater oversight either from institutional clients or from regulators.

◦ Lack of consumer demand due to the disconnect between 'ultimate owners' and the stewardship debate. Greater transparency and accountability to beneficiaries could help to generate market pressures for better shareholder oversight.

• Disclosure of remuneration in financial institutions should include not just the quantum of pay but also the performance criteria on which variable pay is based. Without this it is difficult to see how shareholders can assess whether incentives are appropriate.

About FairPensions 1. FairPensions is a registered charity that works to promote active share-ownership by institutional investors in the interests of their beneficiaries and of society as a whole. Our particular focus is on encouraging shareholder engagement with listed companies to ensure effective management of environmental, social and corporate governance (ESG) risks which may affect long-term financial returns. We work collaboratively with investors on issues where there is a strong business case for engagement. We also educate and facilitate individual pension savers to take an interest in their money, and advocate for greater transparency and accountability to beneficiaries about how shareholder rights are exercised on their behalf. 2. We are a member organisation. Our members include bodies representing pension savers, leading UK charities and thousands of individual pension fund members. We are independent of industry and are funded primarily by grants from charitable foundations and trusts. Regulation, governance and ‘comply or explain’

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3. Good corporate governance in financial services should seek to promote: • sustainable wealth creation (this may not coincide with the maximisation of short-run returns,

as the 2008 crisis all too clearly demonstrated); and • effective management of risk, including potential systemic risks posed by the institution’s

activities. 4. Both of these objectives serve the long-term interests of shareholders whilst also protecting the public interest in stable and sustainable financial institutions.

5. We regard regulation and good corporate governance as complementary. The 2008 crisis exposed failings in both regulation and corporate governance as mechanisms for ensuring that financial institutions pursued sustainable business models and managed risks effectively. Regulation should set the parameters of acceptable behaviour (external accountability), while good corporate governance should ensure effective strategic decision-making and risk management within those parameters (internal accountability). 6. 'Comply or explain' is only as good as the quality of explanations offered for non-compliance by boards, and the degree of critical scrutiny of those explanations by shareholders. Evidence suggests there is much room for improvement in this respect. A 2005 study by the London School of Economics found that firms who did not comply with the Combined Code of Corporate Governance “often did a very poor job explaining themselves”, with almost one in five cases of non-compliance not explaining themselves at all. Moreover, the study concluded that “shareholders seem to be indifferent to the quality of explanations”.1 7. Our recent research suggests this conclusion may still hold. The Stewardship Code suggests that asset managers should disclose their approach to company 'explanations' for non-compliance with the Corporate Governance Code. When we surveyed UK asset managers' disclosures under the Stewardship Code, this was a particular area of weakness. For instance, one firm simply stated “We evaluate each deviation on its own merits” without giving any insight into the criteria on which explanations were judged. Such detail was a feature of the better statements we examined, but unfortunately these were the exception rather than the rule.2 The recent attention given to the quality of explanations by the FRC and industry participants is welcome. This issue should continue to be monitored closely. Impact of previous reviews and regulatory developments EU regulatory engagement 8. Given the internationalisation of both ownership and company operations, as well as the systemic risks to the international economy posed by poor corporate governance of financial institutions, there is some justification for discussions about corporate governance taking place at European and international levels. For instance, a proliferation of national Stewardship Codes modelled on the UK Code would be costly and confusing both for companies with international ownership and for investors with international equities portfolios. The idea of a pan-European Stewardship Code may therefore have some merit. Impacts of the Walker Review 9. Though we engaged with many aspects of the Walker Review, our expertise on what has happened since relates primarily to the introduction of the Stewardship Code. This has certainly had an impact in

1 Arcot, Bruno & Grimaud, 2005, 'Corporate Governance in the UK: Is the comply-or-explain approach working?' 2 FairPensions, 2010, 'Stewardship in the Spotlight', p9,

http://www.fairpensions.org.uk/sites/default/files/uploaded_files/whatwedo/StewardshipintheSpotlightReport.pdf

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promoting the concept of stewardship (virtually the entire UK asset management industry, by assets under management, has signed up to the Code). What is less clear is its impact on the quality of stewardship in practice. 10. Examples such as the blocking of Prudential's planned takeover of the Asian arm of AIG in 2010, or the recent wave of rebellions over executive pay, might suggest a step up in shareholder oversight. However, the general picture is much more mixed. In the recent FT/ICSA Business Bellwether survey, 79% of responding FTSE 350 companies reported no increase in engagement since the introduction of the Code, with the remaining 21% reporting only a slight increase.3 Similarly, the FRC's first review of the Code found that most companies “[had] noticed relatively little change in approach to engagement”.4 11. Our own research5 suggests that the decision to keep the Code high-level and principles-based has not prevented a 'tick-box' approach to disclosures, with many asset managers simply repeating the wording of the Code's Principles. This was particularly the case regarding management of conflicts of interest. Disclosure of voting records under Principle 6 of the Code also remains poor. One study by PIRC found that just 15% of signatories disclose full records, and two-thirds do not disclose at all.6 12. The FRC’s success in gathering signatories to the Code must now be built on with efforts to raise standards of behaviour and disclosure. This year's review of the Code offers one opportunity for this. Non-Executive Directors 13. Our submission to the FRC’s review of the then Combined Code suggested that the Code should recommend that a full-time executive director should (by definition) not hold any other directorships, unless this was approved by the shareholders of all the companies concerned. We are still of the view that the Corporate Governance Code should be amended to this effect. The role of shareholders 14. There is now general consensus that managing the principal/agent problems associated with the shareholder/manager relationship requires active shareholder oversight. However, to achieve this there is a need to disaggregate what we mean by the term 'shareholder'. The investment chain itself is made up of a series of principal/agent relationships, the most important being that between asset managers and asset owners (such as pension funds), and that between asset owners and ultimate beneficiaries (such as individual pension savers). This 'triple agency problem' is the source of many of the key barriers to better shareholder oversight of systemically important financial institutions. Some of the specific issues we identify below are currently being considered by Professor Kay's Review of UK Equity Markets. Short-termism & misaligned incentives 15. It is important to note that 'absentee landlords' were not the only problem in the run-up to the 2008 crisis. Shareholder demands were an active driver of greater leverage and more risky strategies in the pursuit of short-term returns. Only one major asset manager (The Co-operative Asset

3 See http://www.ft.com/cms/s/0/9ec5594c-6f8f-11e1-b368-00144feab49a.html 4 FRC, December 2011, ‘Developments in Corporate Governance 2011: The impact and implementation of the UK

Corporate Governance and Stewardship Codes’. Available at http://www.frc.org.uk/images/uploaded/documents/Developments%20in%20Corporate%20Governance%2020116.pdf

5 See footnote 2 6 See http://www.pirc.co.uk/news/vote-disclosure-and-stewardship

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Management) voted against RBS' takeover of ABN-AMRO, with only one other (Royal London) abstaining. 16. This chimes with a more general picture of shareholder pressure towards short-term results which emerges from surveys both of directors and of investors themselves. In one US study, 78% of financial executives interviewed said they would give up long-term economic value to maintain smooth earnings flows to their investors in the short-term.7 In the recent FRC review of the Stewardship Code, many companies felt that “some shareholders still seemed to focus too much on specific issues of a short-term nature”.8 In a survey of ten large European pension funds, their ideal time horizon was estimated at 23 years and their actual time horizon at six years. Participants blamed short-term, benchmark-relative remuneration structures for the discrepancy.9 17. There is clearly a misalignment between the inherently long-term financial interests of pension savers and the short-term metrics used both by pension funds to assess fund manager performance, and by fund managers to assess company performance. It is unclear that the post-crisis focus on stewardship has done anything to alleviate this problem – and equally unclear that current norms of shareholder oversight would be effective in preventing a repeat of the 2008 crisis. Narrow interpretations of fiduciary duty 18. FairPensions' research10 suggests that one reason for this misalignment may be unduly narrow interpretations of institutional investors' legal duties. Pension fund trustees have a fiduciary duty to act in the best interests of their beneficiaries. However, this is widely interpreted as a duty to maximise short-term returns and ignore other considerations, even if they might have a material impact on long-term outcomes for beneficiaries. This is a real barrier to stewardship: legal advice given to one large UK pension scheme even suggested that their policy of exercising voting rights could breach their fiduciary duties if they could not demonstrate that the costs incurred were justified by monetisable benefits to that individual scheme. Since the benefits of stewardship almost inevitably accrue to the market as a whole, this contributes to a 'free-rider' problem. 19. Institutional investors' fiduciary duty to invest prudently has also been interpreted by UK and US courts as being relative to the behaviour of other investors.11 This encourages herding behaviour, sometimes characterised as 'reckless caution', and potentially exacerbates systemic risk. For instance, we have been told privately that, before the dot-com bubble burst, some managers who recognised the bubble and avoided tech stocks were sacked by pension fund clients for underperforming their peers in the short-term. 20. In combination, these widely held perceptions of the law contribute to a focus on chasing alpha (outperformance) rather than improving the quality of beta (market performance) through stewardship activities. This is one driver of the 'short-term, benchmark-relative remuneration structures' which incentivise fund managers to demand that their investee companies prioritise short-term returns. It also has no place for the wider interest of pension fund beneficiaries in the management of systemic risk: events like the 2008 crisis affect outcomes for pension savers far more than the degree to which their individual fund outperforms the market, yet current interpretations of the law require their agents to relentlessly prioritise the latter.

7 Graham et al, 2005, 'The Economic Implications of Corporate Financial Reporting', http://papers.ssrn.com/sol3/papers.cfm?abstract_id=491627 8 See footnote 4 9 Hesse, 2008, ‘Long-term and sustainable pension investments: A study of leading European pension funds’ . See http://bit.ly/uaPQdd 10 FairPensions, 2011, 'Protecting our Best Interests: Rediscovering Fiduciary Obligation'; FairPensions, 2012, 'The

Enlightened Shareholder: Clarifying investors' fiduciary duties'. http://www.fairpensions.org.uk/fiduciaryduty 11 See FairPensions, 2012, 'The Enlightened Shareholder', p7-8

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21. FairPensions has proposed statutory clarification to remove these perceived legal barriers to better shareholder oversight. The aim would be to create a more flexible and enabling environment by clarifying that fiduciary investors may consider factors beyond quarterly results, and to encourage a focus on sustainable wealth creation. We have published draft legislation which suggests, among other things, that investors should be explicitly permitted to have regard to “the impact of [their] investment activities on the financial system and the economy”.12 This is intended to help resolve the problems outlined above, and should create space for better shareholder oversight of systemically important financial institutions. Conflicts of interest 22. One less frequently invoked aspect of fiduciary duty is the duty to avoid conflicts of interest. There is considerable anecdotal evidence that conflicts of interest among fund managers are one barrier to more robust shareholder engagement. For example, one recent paper cites an instance where “the company secretary of a UK manufacturer reminded a fund manager who was intending to vote against the company’s remuneration report that his firm was bidding for an investment mandate from the corporation’s pension plan”.13 In financial conglomerates, conflicts may arise between asset management arms and investment banking arms. When we surveyed asset managers' disclosures under the Stewardship Code, we found that many gave little or no insight into how these conflicts were managed. The FRC has also identified this as an area for improvement. Asset owners should be more attentive to how conflicts are managed by their investment agents; greater clarity is also needed about asset managers' own fiduciary responsibilities. As the Law Commission has concluded, asset management is prima facie a fiduciary function,14 but this does not appear to be widely accepted or applied within the industry. Transparency and market pressures 23. An analysis of the chain of principal/agent relationships between saver and company also highlights the absence of market pressures from those whose money is ultimately at stake. Beneficiaries have been virtually absent from the stewardship debate: indeed, there is often some intellectual confusion about whether investors' 'stewardship responsibilities' are owed to companies or to savers (in law, it is clearly the latter). Most savers are disconnected from decisions made about their money and many do not even realise that it is being invested in stocks and shares. 24. FairPensions works to change this through consumer engagement – the most recent example being our online tool enabling individual savers to contact their pension fund or stocks-and-shares ISA provider asking about their voting intentions on remuneration. We believe that greater transparency to these 'ultimate owners' could ensure that demand for stewardship is transmitted along the chain. If the Stewardship Code continues to produce poor levels of voting disclosure (see paragraph 11), consideration should be given to the exercise of reserve powers in the Companies Act 2006 to make disclosure mandatory. Remuneration 25. In our submission to the Treasury's recent consultation on bank executive remuneration disclosure, we supported the extension of disclosure to significant risk-taking decision-makers below board level. However, we were concerned that the government's proposed requirements related only to the quantum of remuneration, and did not cover the performance criteria on which variable components

12 Ibid, Appendix A 13 Wong, S., ‘How conflicts of interest thwart institutional investor stewardship’, Butterworths Journal of International

Banking and Financial Law, Sept 2011. 14 Law Commission, 1992, ‘Consultation Paper No. 124: Fiduciary Duties and Regulatory Rules’ (HMSO), para 2.47

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were based. It is difficult to see how this meets the government’s stated objective of addressing the problem of “poorly designed remuneration structures [which incentivise] excessive risk taking”,15 since it does not provide information about the behaviours which remuneration is incentivising or disincentivising. 26. We also suggested that a disconnect exists between the role HM Treasury appears to envisage for institutional investors in making use of remuneration disclosures, and the way in which shareholders view their own responsibilities. The key objective of the reforms appears to be to facilitate oversight of systemically important actors. Institutional investors such as pension funds tend to be ‘universal owners’ (i.e. they have holdings across the economy), and therefore do have an interest in the long-term stability and sustainability of the economy as a whole, which may not coincide with their interest in maximising short-term profits at individual firms (see paragraph 20). In practice however, shareholders appear to evaluate executive pay precisely in the context of the recent performance of the individual firm in question. HM Treasury should work with the FRC in developing the UK Stewardship Code to ensure that it meets this challenge head-on, by encouraging institutional investors who are 'universal owners' to engage with systemically important companies in this spirit. 28 May 2012

15 HMT, 2011, Bank Executive Remuneration Disclosure: Consultation on Draft Regulations, p5

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Written evidence submitted by Andrew Dickson Limited (chartered financial planners) (CGR 08)

1. Introductory Summary: We are in favour of a two tier board structure with clear responsibilities for the Non-executive board. Their function should be to supervise and control the company’s capital exposure to risk undertaken by the executive board and to be responsible for a socially and economically acceptable level of remuneration of the senior management including, in particular, the executive board members. Their role would embrace ultimate responsibility for the corporate culture. As the supervisory body, the Non-Executive Board should also be directly answerable to the TSC and Regulators. 2. Board structure and composition The level of ethics now evident in the major banks has clearly deteriorated since the time they were regulated entirely by the Bank of England. The Geni is out of the bottle and without complete re-structuring of bank management, it is, in our opinion, highly unlikely that it can be returned. The next best thing, however, could be to impose by legislation, a mandatory “Supervisory” board of Non-Executive Directors with the express responsibility for the entire senior executive remuneration for both executive directors and senior management. The non-executive directors within a unitary board structure have proven to be completely ineffective following the recent credit crunch. By separating the non-executive directors from the executive board their supervisory role could surely be sufficiently well defined to ensure all issues of ethics (and decorum in general), control of high level risk exposure and all senior remuneration packages, are, in future, a matter for their shoulders in the first instance. Breach of appropriate conduct would be an issue for the supervisory board who, in turn, would be answerable to shareholders and in dire circumstances, to Parliament. Standing back from the banking industry, this structure might also be more appropriate for the Financial Conduct Authority as well, to avoid a repeat of the contempt shown to the Treasury Select Committee by the executives of the FSA not long ago and contentious decisions allowing FSA employees to be paid bonuses, for example, when the matter had already become a controversial issue for the banks. The supervisory board composed of solely non-executive directors should remove the need for regulatory intervention but with the proviso that shareholders should have a mandate to approve the appointment and re-appointment of the non-executive directors and their remuneration.

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When imposing this degree of responsibility it must be presumed that an adequate level of competence in the specific business is established and exhibited by the non-executive directors. 3. Corporate culture By standing back from the day to day work of the company and acting as eyes and ears of it, the non-executive board could, perhaps, be better placed to make fair judgement of the ethical standards of the employees and directors of their company. This duty could also improve the actual quality of behaviour and, indeed, the whole corporate culture. The ultimate responsibility for corporate governance especially within businesses of a certain size should be with a Non-Executive Board of Directors with suitable ability. When this level of specific responsibility is established, it may well prove difficult for individuals to be recruited onto such a non-executive board of more than one company. Conflicts of interest should be a greater issue and virtually unacceptable. 4. Remuneration We have witnessed the excessive benefit packages agreed for senior executives since the time of major privatisations of State utilities and transport. British Gas was a case where the benefits were so excessive there was a public outcry at the time. Even such massive enterprises were in effect largely left to settle their own terms of remuneration. External “regulation” was hardly expected to reach to the judgement of suitability or otherwise of board room remuneration. 21 May 2012

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Written evidence submitted by the Chartered Insurance Institute (CGR 09)

Summary

1. The near failure of a number of systemically important firms in 2007 and 2008 can, in part, be explained by poor standards of corporate governance and culture (see paragraph 17).

2. In particular, good standards of risk management at board level were lacking. Evidence suggests that certain boards were not competent enough to understand the risks facing their businesses, whilst in other organisations there was a pervasive culture that prevented effective understanding and communication of risk.

3. There have been numerous reviews of corporate governance in light of the crisis – most notably the Walker Review in 2009. Most recommendations from these reviews have focused on changing structural incentives to reduce risk taking and to foster stronger risk management functions.

4. Under the current regulatory restructure which seeks to disband the FSA, the new prudential regulator (PRA) is likely to remain focused on ‘hard factors’ like leverage ratios rather the ‘softer factors’ like the skills and experiences of board members and the risk cultures of organisations which are also vitally important in determining outcomes.

5. This trend must be reversed – cultures and behaviours must be given more prominence. In the early stages of reforming the tripartite structure it appeared as though the FSA was considering developing a framework for assessing the culture and behaviour of firms. For example, in a speech given by Hector Sants in October 2010 he proclaimed that regulators “cannot avoid judging culture”. The FSA has since backtracked on this stance to the extent that the new prudential regulator will not have “any right culture in mind” when making judgments about firms.

6. We believe it is possible to develop a framework for measuring organisation-wide commitments to best practise in terms of cultures, behaviours and competencies and we provide two examples of CII initiatives in this area. These initiatives demonstrate that firms in certain parts of the financial services sector are making voluntary commitments to improving standards in the wider public interest.

7. Regulators need to signpost examples such as this where firms act beyond minimum compliance. While identifying and promoting the ‘right corporate culture’ is difficult to lock into a regulatory approach, such an effort will be a vital part of shifting towards a more proactive regulatory regime.

About the CII

8. The CII is the world’s leading professional organisation for insurance and financial services. Its 101,000 members are committed to maintaining the highest standards of technical competence and ethical conduct.

9. A robust framework of learning and development solutions enables the CII to support corporate partners and individuals across the industry. It ensures that all members comply with minimum standards and inspires many more to achieve advanced levels of technical and professional competence.

10. This submission will focus on answering questions 1, 2 and 4 in the terms of reference.

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Q1 What outcomes should corporate governance in the financial services sector seek to achieve?

11. In light of the financial crisis it is easier to answer the question, “what outcomes should corporate governance seek to guard against”. There have been a number of well evidenced reports and reviews that have noted how failures in corporate governance helped play a key role in bringing about the financial crisis.

12. A key finding common to many of these reviews is that whilst firms roughly complied with the relevant governance codes of the time, in exercising decisions, senior management in firms such as Northern Rock, RBS, Halifax, Lehman Brothers AIG and others did not appropriately understand the risks associated with their business practises and act to change course accordingly. Perhaps the most obvious example of this was RBS’s takeover of ABN AMRO which took place without any due diligence of ABN’s assets, despite the notable experience of many members of the RBS board1.

13. Arguably, the risk management functions of these businesses were either largely silent or broadly ignored. Indeed a comprehensive study of crises2 amongst large corporations with traditionally good reputations (including those not part of the financial services industry) found seven common corporate governance failures at play:

• Board Skill and NED Control: Limitations on board skills and competence and on the ability of NEDs effectively to monitor and, as necessary, control the executive arm of the company.

• Board Risk Blindness: Board failure to recognise and engage with risks inherent in the business, including risks to business model, reputation and ‘licence to operate’, to the same degree as they engage with reward and opportunity.

• Inadequate Leadership on Ethos and Culture: Failure of board leadership and implementation on ethos and culture.

• Defective Internal Communication: Defective flow of important information within the organisation, including up to board level.

• Risks from Organisational Complexity and Change: Risks following acquisitions.

• Risks from Incentives: The effects on behaviour that results from both explicit and implicit Incentives.

• Risk ‘Glass Ceiling’: Inability of risk management and internal audit teams to report on and discuss, with both executive and nonexecutive directors, risks emanating from higher levels of their company hierarchy, including risks from ethos, behaviour, strategy and perceptions.

14. Trying to mitigate against many of these failings by amending various corporate governance codes is a significant challenge. Most efforts since the financial crisis have largely focused on structural reforms designed to change the incentive structures within which boards and firms operate.

15. For example, the Walker Review of 2009 stated that FTSE 100 listed bank or life insurance companies should establish a board risk committee separately from an audit committee. Walker argued this would allow “oversight and advice to the board on the current risk exposures of the entity and future risk strategy”. And to ensure board level risk governance, Walker recommended that “financial institutions should be served by a Chief Risk Officer who should participate...at the highest level on an enterprise-wide basis”. He further recommended that the CRO should have a “status of total independence from business units”3.

1 For further details see FSA (Dec 201) “The Failure of the Royal Bank of Scotland: Financial Services Authority Board Report” 2 See Atkins et al (June 2011) “Roads to ruin: a study of major risk events: their origins, impact and implications”, a report by Cass Business School on behalf of AIRMIC 3 “A review of corporate governance in UK banks and other financial industry entities: Final recommendations” (Nov 2009)

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16. Some of Walker’s recommendations on corporate governance have now been incorporated into the 2011 Financial Reporting Council guide on board effectiveness. Crucially though, a purely structural approach to reforming corporate governance is unlikely to be sufficient to prevent the kinds of systemic failures in risk management mentioned above. Provision must also be made to address some of the qualitative, human behavioural deficiencies which remain vital if largely overlooked factors in explaining the crisis.

Q2 Does the UK approach to regulation and supervision of financial services incentivise Boards to perform their role effectively?

17. Micro-level human and social factors (such as risk cultures, management attitudes and skills) are important if often neglected causes of financial crises. For the government and regulator this is partly because they are hard to measure and quantify. For firms this is because they can be “taboo internally...they touch on the behaviour, decisions and performance and perceptions of the senior managers of the company”4.

18. Research undertaken by risk management expert and Associate Professor Simon Ashby of Plymouth University, reveals that many practicing risk managers place significant emphasis on human factors as key reasons for the recent financial crisis5.

Figure 1. Some commonly cited causes of the financial crisis

Source: Ashby (2011) undertook in depth interviews with twenty risk management professionals from across financial services. This diagram shows the spectrum of reasons for the crisis identified by these professionals.

19. During his interviews with risk management specialists, Ashby found that none of the managers supported the view that risk-based capital regulations underpinning initiatives such as solvency II or Basel II, “will lead to improvements in risk management. Indeed for some risk managers, the financial sector’s increasing reliance on models was seen as a key cause of the crisis.” Ashby therefore argues that discussions about the “structure of financial institutions cannot be divorced from those about the behaviours and competencies” of management:

20. “Even in high risk environments, risk can be controlled by effective management (who are competent and professional, and are prepared to communicate with each other and work together) operating within an appropriate risk culture that promotes awareness,

4 See Atkins et al (June 2011) “Roads to ruin: a study of major risk events: their origins, impact and implications”, a report by Cass Business School on behalf of AIRMIC 5 Simon Ashby (August 2011), Back to Basics: Rethinking Risk Management and Regulation in a post-crisis world, CII Thinkpiece no. 61. This thinkpiece follows on from Ashby, S. (2010) The 2007-2009 Financial Crisis: Learning the Risk Management Lessons, Financial Services Research Forum, Nottingham

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values management judgement as much as models and links risk and strategic management.”

21. In this context Ashby believes that there should be more of a regulatory focus on Pillar II of Solvency II which is concerned with systems of governance and risk management, rather than the current focus which is predominantly related to capital and modelling requirements under Pillar 1. For firms, Ashby argues that managers must have the relevant skills and experiences to deal with both the ‘hard factors’ – such as risk/financial models- and the soft factors – such as ‘human behaviour’. In this context delivering appropriate training and experience is crucial.

Taking account of corporate governance and culture under the financial services bill

22. The Financial Services Bill and the related overhaul of the regulatory structure provides a unique opportunity to rethink the way regulation is exercised and to shift away from the tick box mentality which prevents supervisors from taking a step back and considering more qualitative risks to business practises and the wider economy. In this regard, it should be welcomed that the Prudential Regulatory Authority will have a so called “judgement based approach” to regulation though it will still be guided by a new “risk assessment framework”.

Figure 2. PRA risk assessment framework for insurance firms and previous FSA general risk assessment framework

Proposed PRA risk assessment framework for insurance firms (2011)

FSA risk assessment framework (2006)

23. There are three key differences between the new and old frameworks.

• The PRA framework does not include conduct risks as this will be covered by the Financial Conduct Authority.

• The new framework includes “potential impact” on the stability of the system. This is a welcome change, ensuring that firms are not viewed in isolation from the financial system as a whole.

• Finally the new framework also includes “resolvability” which is linked to impact. It makes perfect sense to ensure that if a firm does get into trouble it is resolvable without significant harm to customers or the wider economy.

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24. Each of these changes is welcome in the context of the regulatory restructure. What is missing however is a reference to the softer side of operations mitigation in terms of corporate culture, behaviours and governance. Provision for these softer elements were included in the previous FSA risk assessment framework under management governance and culture and it is concerning to see that such a crucial factor in guiding the decision making processes of firms is not given specific reference in the new regulatory scorecard.

25. The PRA approach to regulation documents (published last year for insurance and banking) explicitly state that supervisors will not have any ‘right culture’ in mind when making assessments about firms. Rather, supervisors will only expect a board to reconsider its culture in the wake of a failure to meet other regulatory requirements.

26. This approach to regulation flies in the face of an earlier speech made by Hector Sants in October 2010 during which he noted the importance and feasibility of regulating culture and set out a number of methods for doing it. He stressed that “regulators have a central role to play, which should be to ensure firms have the right culture for their business model – the right ethical framework – to facilitate the right decisions and judgements and we should intervene when we find those frameworks are lacking”6.

27. In our view, a judgement based approach to supervision that fails to adequately consider behavioural aspects is wrongly skewed towards indicators of a firm’s financial soundness which often only show signs of trouble once bad decisions have already been made. As we argued in a paper published in June 2011, a proactive understanding of a firm’s management culture can help to forewarn regulators that businesses are likely to take unnecessary risks or make bad decisions7. Regulators must reintroduce a specific provision for corporate governance and culture under the new framework. In turn, they must find ways to both identify examples of good corporate practise and promote it where possible.

Q4 What type of corporate culture should financial services firms seek to foster? In what ways can this be encouraged?

28. Professional bodies such as the CII can play a key role in fostering a corporate culture within firms which is suitably forward looking and aligned with the needs of consumers. As the leading professional body for insurance and financial services, the CII is committed to protecting the public interest by guiding practitioners in the sector towards higher professional standards. We use three core indicators to assess the progress being made by our members in attaining higher professional standards. These include:

• Qualifications: Improvements in qualifications raise the level of knowledge and understanding of practitioners.

• Continuing professional development (CPD): By undertaking continuous learning, practitioners are able to keep their knowledge and understanding up to date as the world continues to change around them.

• Ethics: A commitment to act in the interests of consumers helps to ensure fair and honest business practises.

29. Professionalism does not, however, just refer to the characteristics of individual advisers, brokers or underwriters. Firms as a whole can make a commitment to professionalism of which characteristics can include:

• Corporate experience and expertise: management that has the necessary experience and expertise to ensure that the business model is sustainable and implemented effectively;

• Corporate systems and controls: including corporate governance that exerts appropriate levels of control over the running of the business including risk

6 Hector Sants (Oct 2010) “Can culture be regulated? Speech to Mansion House Conference on Values and Trust” 7 CII (June 2011) “A New Approach to Financial Regulation: Embedding Professionalism”, Papers in Professionalism 8

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management, maintaining adequate capital, record keeping, training and competency programmes and developing a culture that encourages the fair treatment of customers; and

• Employee professional support: encouragement of professional standards for employees through supporting technical training and development and encouraging appropriate behaviour.8

Evidencing professional corporate culture through verifiable standards

Chartered firms

30. We award the title “Chartered” to individual practitioners that demonstrate and maintain the highest professional standards. Chartered status, granted by the Privy Council, gives insurers and financial planners parity with other professional firms and distinguishes the Chartered title holders from competitors. We also award the Corporate Chartered title to firms demonstrating best practice at an organization-wide level.

31. To become Chartered, firms must ensure staff members acquire and retain the necessary knowledge and skills to deliver the highest quality services and advice to their customers. They must also work in an ethical manner that places clients’ interests at the heart of the services they provide.

32. For example, Chartered broking firms must meet a number of key requirements including:

• A minimum of one of the board’s members must personally hold the CII Chartered Insurance Broker title.

• One of the firm’s board or highest management team (who, as an individual, holds the Chartered Insurance Broker title), must take on the role of Responsible Member.

• The entire board or highest management team together with a minimum of 90% of customer facing staff must be members of the CII.

• Access to a Chartered Insurance Broker must be available to customers.

• Firms must have a professional development programme in place.

• Firms must have core values that align with the CII’s Code of Ethics.

33. A corporate Chartered title is therefore a commitment to an overall standard of excellence and professionalism. A firm which holds each of these elements is one whose strategy is focused on delivering high standards to the consumer for the long-term – epitomised through the achievement of rigorous learning and development for employees and a proven commitment to ethical practice. While the concept is still a relatively new one, it is rapidly gaining support as it offers an option to developing professional standards at a firm rather than individual level. There are currently over 500 Chartered firms.

Aldermanbury Declaration

34. In co-operation with leading figures in the general insurance market, the CII formed a task force in 2009 to raise professional standards in general insurance. The result was the Aldermanbury Declaration published in March 2010 calling on the sector to commit to a common framework of professional standards for its practitioners. The Declaration is a voluntary industry-led initiative that seeks to deliver the following benefits:

• Better outcomes for customers.

• Improved standards of risk management.

• A more confident, trusted profession.

• More talented people attracted to a career in insurance.

• Increasingly rewarding careers for those within insurance. 8 Each of these characteristics were identified in a CII report (2007) entitled “Professionalism and Reputation”

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• Reinforcing the reputation of the London wholesale insurance market.

35. By the first anniversary of the Declaration, 200 firms including all major insurers had signed up to this commitment. We believe these proposals are ambitious but realistic and have called on all firms signing up to implement the changes by December 2013.

36. In our view, professional bodies like the CII will become an ever important channel for reinforcing good standards of behaviour and decision making by individual practitioners and increasingly by organisations as a whole. The success of our two initiatives referred to above, demonstrates that firms are willing to make voluntary commitments to higher standards of behaviour in financial services. As the new regulators seek to foster an environment where firms act prudently and in the interest of their customers, they must look to examples such as these of industry best practise in order to understand how to identify and promote good corporate culture under the new regulatory regime.

Conclusion

37. The near failure of a number of systemically important firms in 2007 and 2008 can, in part, be explained by poor standards of corporate governance and culture.

38. In particular, good standards of risk management at board level were lacking. Evidence suggests that certain boards were not competent enough to understand the risks facing their businesses, whilst in other organisations there was a pervasive culture that prevented effective understanding and communication of risk.

39. There have been numerous reviews of corporate governance in light of the crisis – most notably the Walker Review in 2009. Most recommendations from these reviews have focused on changing structural incentives to reduce risk taking and to foster stronger risk management functions.

40. Under the current regulatory restructure which seeks to disband the FSA, the new prudential regulator (PRA) is likely to remain focused on ‘hard factors’ like leverage ratios rather the ‘softer factors’ like the skills and experiences of board members and the risk cultures of organisations which are also vitally important in determining outcomes.

41. This trend must be reversed – cultures and behaviours must be given more prominence. In the early stages of reforming the tripartite structure it appeared as though the FSA was considering developing a framework for assessing the culture and behaviour of firms. For example, in a speech given by Hector Sants in October 2010 he proclaimed that regulators “cannot avoid judging culture”. The FSA has since backtracked on this stance to the extent that the new prudential regulator will not have “any right culture in mind” when making judgments about firms.

42. We believe it is possible to develop a framework for measuring organisation-wide commitments to best practise in terms of cultures, behaviours and competencies and we provide two examples of CII initiatives in this area. These initiatives demonstrate that firms in certain parts of the financial services sector are making voluntary commitments to improving standards in the wider public interest.

43. Regulators need to signpost examples such as this where firms act beyond minimum compliance. While identifying and promoting the ‘right corporate culture’ is difficult to lock into a regulatory approach, such an effort will be a vital part of shifting towards a more proactive regulatory regime.

May 2012

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Written evidence submitted by Unite the Union (CGR 11)

This response is submitted by Unite the Union. Unite is the UK’s largest trade union with 1.5 million members across the private and public sectors. The union’s members work in a range of industries including financial services, manufacturing, print, media, construction, transport, local government, education, health and not for profit sectors. Unite is the largest trade union in the finance sector representing some 130,000 workers in all grades and all occupations, not only in the major English and Scottish banks, but also in investment banks, the Bank of England, insurance companies, building societies, finance houses and business services companies. Executive Summary

• The Boardroom is the starting point in creating a corporate culture based upon fairness and respect. Unite would recommend the promotion of good working practices which treat workers fairly; giving them a voice on the direction of the organisation at a strategic level and providing appropriate and equitable reward;

• Changes in corporate culture are required which encourage diversity, promote equality

and fairness, and are seen to act beyond the interests of shareholders to take account of the demands of the real economy.

• The performance based and target driven reward system has led to an intensification of

the working environment which is driven by sales over service and some would argue quantity before quality;

• Unite would argue this macho management style together with pressurised sales

techniques has created a vicious cycle of negative corporate culture across the sector;

• Unite has called for employee representation on remuneration committees to provide a pragmatic approach to the pay systems that contributed to the financial crisis;

• Unite supports positive action to increase diversity in the boardroom and in other senior

level roles. This would include ensuring unbiased training takes place in recruitment and selection interviews as well as at performance appraisals;

• Increasing the diversity and representative structure of remuneration committees will go

some way to strengthen accountability and re-engage the sector with the real economy;

• Employers must provide high quality, socially responsible and rewarding work, which reflects the values and ethics of the organisation and not a bullying and highly pressurised culture which encourages profits at any price.

Introduction Unite welcomes the opportunity to respond to this Inquiry and will focus on three specific issues: corporate culture, remuneration, and diversity and background. This response is based primarily on the content of the Unite document – “A Finance sector for the Real Economy” - which seeks to offer the union’s position on a number of key issues in the sector.

Corporate culture

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What type of corporate culture should financial services firms seek to foster? In what way can this be encouraged? How effective are Boards at shaping corporate culture within their institutions?

1. Unite believes it is vital that the outcome of the recent financial and economic crisis is the creation of a domestic and global financial system which is reconstructed around values which support a long-term outlook that is sustainable, transparent and fair, that meets the needs of society and the real economy.

2. To achieve this, changes in corporate culture are required which encourage diversity,

promote equality and fairness, and are seen to act beyond the interests of shareholders to take account of the demands of the real economy.

3. The corporate culture expected of any institution, and perhaps even more so in financial

services, is honesty, integrity and probity. Unite would argue that the finance sector fell well below expectations on all accounts.

4. One way to instigate change would be to replace the existing reward system with one

based upon fairness and to lead by example from the top down. The performance based and target driven reward system has led to an intensification of the working environment which is driven by sales over service and some would argue quantity before quality.

5. This is overseen by overworked, increasingly pressurised and in some cases, inadequately

trained managers. As these individuals move up through the ranks of the business they are subjected to more aggressive and pressure driven styles of leadership. This method of management then becomes the norm.

6. However, the workforce left in the wake of such management styles are themselves

over-worked, highly stressed and often suffering the effects of stress related illness. Unite would argue this macho management style together with pressurised sales techniques has created a vicious cycle of negative corporate culture across the sector.

7. This is evidenced by a stress survey undertaken jointly by Unite and Accord, in a large

bank which highlighted that 84.8% of respondents suffer from stress, 76.4% report suffering from symptoms caused by stress including depression and anxiety attacks. They also identified long working hours and unremitting pressure to perform well as causes of stress.

8. The Boardroom is the starting point in creating a corporate culture based upon fairness

and respect. Unite would recommend the promotion of good working practices which treat workers fairly; giving them a voice on the direction of the organisation at a strategic level and providing appropriate and equitable reward are other ways to encourage and promote a corporate culture which acts to support a sustainable, transparent and successful business. Evidence suggests this is also more likely to improve morale and increase productivity. It need not be a race to the bottom.

Remuneration

What role should institutional investors, remuneration consultants, employees and others play with respect to remuneration in the financial services sector?

Is there a case for introducing still greater transparency for senior executives with respect to remuneration in the financial services sector?

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Should there be further reform of the remuneration arrangements of senior executives in the financial services sector? Should this extend to those highly paid individuals who sit below executive level?

9. Unite believes there is a fundamental failing in the regulatory process as there remains an over-representation of shareholder and corporate interests over public, employee or wider social interests which is weakening effective oversight. Unite supports a stronger regulatory framework, including the involvement of trade unions, as well as independent and academic experts to improve industrial democracy.

10. Project Merlin was set up by the UK Government to curb excessive bonuses and encourage the UK’s five largest banks to increase lending to small businesses and improve transparency in remuneration. This year, while those banks that have signed up to Project Merlin will publish the pay packages of their five highest-paid executives below board level, they do not have to publish the pay of investment specialists who do not have management responsibility, despite some of them being paid salaries in the millions. Furthermore, while the executives' pay will be revealed, their names will not.

11. In its response to the recent HM Treasury consultation on bank executive remuneration disclosure, Unite expressed its disappointment that:

“HM Treasury has limited its focus on improving disclosure in remuneration to the naming of the eight highest paid senior executive officers and not taken account of the fundamental issues that are evident within the pay system which have created pay inequality and unfairness; namely that of exaggerated pay levels and excessive bonus payments for senior employees and executives and a culture of competitive macho management driven from the boardroom down.”

12. Unite has frequently raised concerns over an earnings culture which rewards high risk

strategies and failure at executive level, while dispensing severe penalties for ‘failure’ to those lower down the organisation. It is necessary to tie pay and bonus structures to sustainable and long-term performance which are non-biased, fair and encourage and motivate the workforce.

13. Unite also believes that incentives increase the risks of mis-selling by employees in a drive to meet often unrealistic and unattainable targets, which does little for consumer confidence and does little to motivate the workforce. As the Unite survey previous mentioned highlighted, this type of selling is responsible for increasing stress, lowering morale and can also lead to a conflict of interest where inappropriate sales may be made by some individuals in order to avoid the disciplinary process.

14. Unite seeks open and transparent pay systems where decent pensionable pay is delivered

to all workers.

This would be based upon:

− Pay decisions which are objective, rather than subjective; − Principles which are explicit, clear and straightforward; − Systems which are free of favouritism and treats all staff in the same way, regardless of

gender, ethnicity, age, grade and so on; − Outcomes that can be measured.

15. For too long decisions have been made by select groups with a vested interest in

maintaining the status-quo, and have avoided involving employee representatives on key agencies, boards and committees. Unite has called for employee representation on

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remuneration committees to provide a pragmatic approach to the pay systems that contributed to the financial crisis.

Diversity and background

What is the relationship, if any, between Board diversity and company performance in the financial service sector?

16. According to Boardwatch in 2012 women made up only 16% of the members of the corporate boards of FTSE 100 companies. This was up from 9.4% in 2004. 1

17. This is unacceptably slow progress and while voluntary methods for achieving a more representative group bringing differing talents, abilities and behaviours, has so far failed, Unite would argue that if systems were put in place which provided equal opportunities for advancement without penalising individuals then many more women may see a career path open to them on an equal basis to their male colleagues.

18. The take up of flexible working arrangements can however be viewed by some employers, as well as some colleagues, as showing less commitment; as not being part of the ‘team’ and not playing a full part in the company’s development. Part time workers in particular, which are mostly women, are often seen as less committed to the aims of the organisation and therefore less likely to be promoted over their male colleagues.

19. Quotas are often suggested as one method to improve diversity. However the imposition of quotas is controversial, not least by the business community, but also by many women. Nevertheless legislation has been put in place in countries like Belgium, Canada, France and Norway to increase gender diversity by stipulating a quota. This ranges from 33% to 50% Women Board Directors. Other countries have introduced regulation to improve the gender balance: Australia, Denmark, Germany and the US 2 have all put in place stricter regulatory requirements on gender disclosure.

20. Indeed even the Prime Minister, David Cameron has stated that he wishes to see more women on the boards of firms "preferably without having quotas" but said he would not rule them out "if we cannot get there by other means".

21. Unite however would prefer to opt for positive action to increase diversity in the boardroom and in other senior level roles. This would include ensuring unbiased training takes place in recruitment and selection interviews as well as at performance appraisals. As well as this it is important to provide training opportunities which can lead to career progression and through actively encouraging, and publicly supporting the take up of flexible work arrangements to those at more senior management levels.

The Future – a finance sector for the real economy

22. The finance sector needs to change and through the introduction of robust regulation built around values which reflect the needs of society and which are sustainable, transparent and fair, it can change. The potential does exist to create a working environment which delivers an increased commitment by the workforce, boosting morale, increasing confidence and sustainable performance resulting in a finance sector which can better serve the real economy.

23. Unite believes that it is vital to ensure that employees have a voice at a strategic level

and that employers enter into dialogue with trade unions at every opportunity in order to re-engage with the workforce to ensure the delivery of a successful finance sector by confident and dedicated employees.

1 http://www.boardsforum.co.uk/boardwatch.html 2 Catalyst, Increasing Gender Diversity on Boards: Current Index of Formal Approaches (November, 2011).

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24. Increasing the diversity and representative structure of remuneration committees, including employee representation, will go some way to strengthen accountability and re-engage the sector with the real economy.

25. The concerns raised in this response regarding the reward systems in the sector have

been made by Unite and predecessor unions over a long period. However it would appear from the responses to the Unite stress survey and despite the huge costs to the industry from the mis-selling of PPI, that sales based on targets continues to be a key feature in profit generation. Furthermore, the latest Financial Ombudsman annual review indicates that notwithstanding PPI, while banking complaints fell by one per cent the numbers of upheld complaints in key areas such as current accounts increased 31 per cent. 3 There is still work to be done to treat customers fairly.

26. The sector has a responsibility to its customers, the workforce and society to deliver

financial services that serve the needs of consumers, are transparent, relevant and importantly based upon need. The workforce in the sector is highly skilled and qualified to provide a professional service to customers based upon knowledge and experience. They shouldn’t feel pressured into selling products to meet targets forced upon them without their input.

27. Finally, employers must provide high quality, socially responsible and rewarding work,

which reflects the values and ethics of the organisation and not a bullying and highly pressurised culture which encourages profits at any price. Good work practices associated with fairness, transparency and trust can deliver successful and profitable companies as well as the kind of workplace people want to work in and the kind of organisation consumers want to be associated with.

May 2012

3 FOS – Annual Review 2011-2012

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Written evidence submitted by the Financial Services Authority (FSA) (CGR 11)

1. We welcome the opportunity to submit this memorandum to the Treasury Committee as

part of its inquiry into Corporate Governance and Remuneration. In this memorandum we seek to clarify the FSA’s remit in this area. We also set out our views on a number of issues raised in the Committee’s terms of reference, including:

• board structure and effectiveness;

• board diversity;

• FSA approval process for Significant Influence Functions;

• the role of the regulator in incentivising the right behaviour and culture;

• the impact of previous reviews and new regulatory developments;

• the role of shareholders; and

• the future approach of the Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA) to corporate governance and risk management.

Executive summary 2. Our comments in this memorandum are primarily driven by our understanding of what

happened to the systemically important financial institutions during the financial crisis. We have previously acknowledged that a number of regulatory factors contributed to the crisis. However, the decisions made by firms’ boards and senior management, within their corporate governance frameworks, were key drivers of the crisis. Ensuring good governance is a key element in increasing the probability that good decisions will be made whilst poor governance is a strong indicator of more significant problems.

3. As various FSA reports have demonstrated, including the FSA Board Report into the Failure

of the RBS1, some of the causes of the crisis were deeply rooted in behavioural and cultural issues. These issues resulted in actions and decisions that, with the benefit of hindsight, were clearly not right.

4. Analysis of the firms that failed during the crisis shows that one or more of five key

indicators were evident:

• an ineffective board2;

• a domineering CEO;

• key posts held by individuals without the required technical competence;

• inadequate ‘four-eyes’ oversight of risk; and

• an inadequate understanding of the aggregation of risk. 5. Our approach to governance and risk management issues aims to strike the right balance

between relying on those who manage the firm’s affairs, and their shareholders, to put in place an effective governance framework; and regulatory intervention, where appropriate, to ensure the public interest is protected.

1 http://www.fsa.gov.uk/static/pubs/other/rbs.pdf 2 An effective board is defined in the Financial Reporting Council’s Guidance on Board Effectiveness: http://www.frc.org.uk/images/uploaded/documents/Guidance%20on%20board%20effectiveness%20FINAL6.pdf

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6. In response to the financial crisis, we instigated a more intensive approach to supervision.

This approach involves the presumption that supervisors will intervene if they believe that the firm’s judgment is at variance to the regulator’s objectives. In his speech3 in April 2012, Hector Sector, the FSA’s Chief Executive, reinforced to firms the importance of good risk management and encouraged them to introduce improvements to their risk management frameworks.

7. We take a proportionate approach to the regulation of firms. While the governance and

management of all regulated firms is considered on a periodic basis, this memorandum describes the intensive approach we take to corporate governance and risk management issues in the systemically important institutions. There are a number of ways in which the FSA does impact a firm’s governance arrangements. These include:

• assessing board effectiveness, using tools such as effectiveness reviews and supervisory discussions;

• influencing the composition of management through our authorisation process for Significant Influence Functions;

• influencing remuneration policies to ensure they are consistent with effective risk management through implementation of the Remuneration Code;

• influencing the training and competence regime; and

• deterring poor behaviour through our enforcement regime.

8. Putting our role into the wider UK context, the Financial Reporting Council (FRC) and the Department for Business, Innovation and Skills (BIS) have overall responsibility for setting the regulatory and legislative framework for governance in the UK. Since the financial crisis, the FRC has revised the Combined Code and issued it as the Corporate Governance Code and the UK Stewardship Code to help company boards become more effective and more accountable to their shareholders. The FSA, in its role as Listing Authority, is responsible for making rules governing firms’ disclosure of information in line with the FRC’s Codes. BIS has ultimate responsibility for enforcing and policing the Companies Act.

Board Structure 9. The financial crisis exposed significant shortcomings in the governance and risk

management of firms and the culture which underpins them. This reflected a failure in behaviour, attitude and, in some cases, competence. While some systemically important financial institutions have implemented improvements to their governance and risk management frameworks since the crisis, other firms have made insufficient progress in this area.

10. An effective board structure is essential to support robust governance and risk

management, to determine a firm's strategy and risk appetite and to enable timely monitoring, decision-making and challenge. In our view, there are three key components to an effective board.

11. Firstly, the board needs to set the direction and maintain a suitable culture throughout the

firm. An effective board is one which understands the circumstances under which their firm would fail and constantly asks the ‘what if’ questions. To do this well, a board needs to

3 http://www.fsa.gov.uk/library/communication/speeches/2012/0424-hs.shtml

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understand its business model, understand and focus on material risks and challenge the executive on the execution of the strategic plan.

12. Secondly, the Chairman should construct and manage a board that has the skills and

experience to enable it to function effectively. These skills should enable the board collectively to understand and address the breadth of the business and non-executive directors (NEDs) should have the right character and values. The structure needs to be clear and transparent to staff at group and subsidiary levels. Diversity of skills, experience and background is also essential.

13. Thirdly, the board should sign off the strategic plan and ensure that the executive team

execute to that plan. To do this effectively the board needs to see and demand relevant information that demonstrates how well the plan is being delivered. This needs to be comprehensive, timely, forward looking, where possible, and showing sensitivity to different assumptions and scenarios to enable the right decisions and challenges to be made.

14. While the issue of good governance is primarily for firms and shareholders to address,

regulators clearly have a role to play to ensure the public interest is protected. Since the crisis, society and Parliament have made it clear that they expect regulators to have a view on governance at firms and be willing to intervene. We have responded by instigating a more intensive and rigorous approach to supervision, centred on taking forward-looking judgments about firms. This approach involves the presumption that supervisors will intervene if they believe that the firm’s judgment is at variance to the regulator’s objectives.

15. The FSA assesses effectiveness on a continuous basis, using a range of supervisory tools.

Our approach includes undertaking reviews of board effectiveness governance and risk management, as well as regular supervisory discussions with the Chairman, key executives and NEDs. The FSA’s analysis of these reviews and ongoing supervisory discussions highlight potential triggers for further work or focus on emerging areas of concern.

16. Our supervisory approach does not advocate a particular board structure but aims to ensure

that the management and governance is appropriate to the sector and the business model. We have no view as to whether a unitary board, as is predominantly found in the UK, or a two-tier structure, common in some other European countries, might be more appropriate. This is for a firm's board and management to decide on, in the context of their firm's circumstances and activities.

Board diversity 17. We are not in a position to draw a direct correlation between board diversity and company

performance. A set of personal characteristics does not on its own determine an outcome. However, firms ultimately fail because of the decisions taken by management within its corporate governance framework. The crisis exposed significant shortcomings in the governance and risk management of firms and the culture and ethics which underpin them. This is not principally a structural issue, but more an issue of failure in behaviours, attitudes and culture.

18. Therefore, the relationship between board diversity and performance is better positioned in

relation to good governance. To have greater diversity on boards, it is important to look at the broader issues of culture, recruitment strategies and development at both board level and across the organisation. The FSA looks at these issues within our equality duties for the sector.

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19. We believe that a diverse board encourages creativity and is more likely to avoid the dangers of ‘group think’ and ‘herd mentality’. An effective boardroom should bring together a depth of experience, viewpoint and skills. To ensure the right balance of skills and experience is achieved at board level, it is vitally important that firms look towards the future and seek to cultivate and develop those skills from within their workforce. This needs to involve ensuring the firm recruits from the widest pool, has an inclusive culture and provides an environment where all staff can progress and develop without barriers.

FSA approval process for Significant Influence Functions 20. Under the Financial Services and Markets Act 2000 (FSMA), authorised firms are required to

seek approval from the FSA for individuals undertaking Significant Influence Functions (SIF), which are roles that exercise material influence over the running of a firm. Our assessment of whether individuals are ‘fit and proper’ for these roles is a continuous process. However, in reality authorisation is the crucial decision point and the main gateway of regulation.

21. The core objective of our SIF process is to work with firms to ensure a balanced and

effective board and senior executive team. The FSA does this by ensuring a robust and rigorous appointment process is undertaken by the firm and by assessing the suitability of a candidate to undertake a role. This assessment takes into account the overall composition of the board as well as the individual’s knowledge and competence.

22. As we observed prior to the crisis, the FSA was not, in any meaningful way, seeking to

make these judgements. The authorisation process was a register and the judgements being made prior to individuals being placed on it were solely based on probity. There was no pretence that the FSA was looking at competency or the blend of individuals on the board.

23. As a result of the financial crisis, which revealed that many senior executives and NEDs in

key board positions lacked the technical expertise to manage the risks in their firms, we sought to address this problem by enhancing our SIF process. Our more intrusive approach included the introduction of interviews for those candidates moving into key roles4 within firms which are assessed as posing the highest risk to the FSA’s objectives, particularly in relation to a firm’s safety and soundness and to its fair treatment of customers. Interviews outside key roles may be undertaken on an exceptional basis, but only where there is a clearly defined, risk-driven reason for doing so. Where firms provide evidence of a robust recruitment and assessment process, the regulator may grant approval without the need to interview.

24. The rationale for the new intensive process is clear and the impact is apparent. Since the

introduction of the enhanced SIF process, approximately 10% of applications have been withdrawn by firms following concerns identified by the FSA interview panel. It is therefore clear that the process is having an impact. Candidates also benefit from early engagement with the regulator. Interviews provide the opportunity for them to consider their motivation for a role and what they plan to achieve. This aids their understanding of the regulator’s expectations of them as an Approved Person. A further positive outcome has been the raising of the recruitment standards, with firms themselves undertaking more robust assessments of applicants.

4 Key Control Functions: Chairman, Chief Executive Officer, Senior Independent Director, Chief Finance Officer, Chief Risk Officer, Chairs of Audit, Risk or Remuneration Committees.

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25. The introduction of an assessment by the regulator means that it is inevitable that the length of time to appoint is greater. We have made improvements to our process and have seen significant reduction in timelines as a result. We also recognise that many of the individuals we need to see are very senior and experienced in their field and, not unreasonably, expect to be evaluated by their peers. We have therefore taken on a group of similarly experienced and highly-regarded senior advisors to support us in such interviews.

26. As part of our SIF approval process, we are not always looking for financial services

experience. However, we are looking for clear thought to have been given to what skills are needed on the board as a whole and consideration to which individuals are best placed to provide them.

27. Some people have challenged whether our SIF process may be a contributory factor as to

why so few women apply for roles in financial services. It is difficult for us to determine why so few applications are received but our statistics suggest that female candidates are actually more successful at being approved following an interview, albeit based on relatively small numbers.

28. Under the new regulatory framework, we anticipate that the SIF process will be largely

unchanged in that a single process will remain for both the PRA and FCA. The PRA will run the process in respect of key roles in dual regulated firms. The FCA will be involved in those interviews with the right to veto, and will also lead the process for all other approved roles.

The role of the regulator in incentivising the right behaviour and culture 29. Ensuring individuals have the right skill set and the board has the right balance does not in

itself ensure good governance. Central to effective governance is a firm’s culture. It should spring from the nature of the firm’s activities and also be focused on the firm delivering the right long-term obligations to society. The right cultures are rooted in strong ethical frameworks and the importance of individuals making decisions in relation to principles rather than just short-term commercial considerations. Reward structures should not encourage short-term gain and excessive risk taking. While a regulator should not prescribe what the right culture is, a firm’s culture is of legitimate interest to us where that culture poses a potential risk to our statutory objectives. Our regulatory focus is on identifying poor culture and behaviours and on being ready to intervene in those cases which have the potential to lead to poor outcomes and impact on our statutory objectives.

Remuneration 30. We recognise the high level of interest in remuneration in the financial services sector. Our

remit in this area is to make sure that pay practices in the firms we regulate do not encourage inappropriate risk-taking and that firms do not pay out more than they can afford. We are not looking to limit individual levels of pay, as that is not our mandate, but we believe that firms must have remuneration policies that are consistent with sound risk management. Our work in this area is primarily through our responsibility for the implementation of the Remuneration Code (the ‘Code’).

31. The revised Code came into operation in January 2011 to implement the changes required

by the Capital Requirements Directive 3 (CRD3) which aimed to align remuneration principles across the EU. The Code applies to around 2700 firms, including all banks, building societies and Capital Adequacy Directive (CAD) investment firms, and is applied proportionately relative to the size and significance of the firm. Its primary purpose is to

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align remuneration with risk and covers governance, controls, risk adjustment, bonus structures and disclosure. CRD3 and the Code are also consistent with the Financial Stability Board’s (FSB) Remuneration Principles and Standards.

32. The Code is wide in its application as it covers senior management, risk takers and staff

engaged in control functions. It also covers any employee receiving total remuneration that takes them into the same remuneration bracket as senior management and risk takers, whose professional activities have a material impact on the firm’s risk profile. The largest firms covered by the Code are subject to an annual review by the FSA which includes a detailed statement from the firms of their remuneration proposals, meetings with the Chairs of Remuneration Committees and extensive discussion about the application of risk adjustment and other factors. The FSA will only sign off a firm’s proposal when it is satisfied it is compliant with the Code’s requirements.

33. Compliance with the Code’s key principles has improved significantly since it was

introduced and it has had a measurable impact on the eradication of multi-year guarantees, the deferral of variable remuneration and improvements in governance at the largest firms. We believe this reflects strong progress whilst recognising that more needs to be done in certain areas, in particular in the application of risk adjustment techniques to remuneration.

34. A number of issues can be traced back to the measures on which the board focuses.

Incentives have been set that have made it rational for the executive to focus on increasing revenue, profit, assets and leverage rather than on capital, liquidity and asset quality. Senior executives’ annual remuneration in the past has tended to be heavily influenced by operating profit, earnings per share (EPS) growth and return on equity as distinct from return on assets and prudent management of leverage. Significant progress has already been made in this area but, as the Financial Policy Committee (FPC) has highlighted, there is still room for improvement.

35. There has also been less regard to non-financial performance measures. We would

encourage firms to do more to give greater weight to non-financial metrics, particularly fair treatment of customers, in determining an individual’s compensation.

36. It is likely that the Capital Requirements Directive IV (CRD IV), which is currently under

negotiation, will strengthen the EU regulatory regime further, including through the application of regulatory technical standards in certain areas. The European Banking Authority (EBA’s) guidelines for data collection on remuneration, including high earners, which will come into force later this year, will also increase transparency relating to remuneration payouts. However, we believe that any new initiatives should be consistent with work to increase capital and liquidity standards and improve firms’ resilience in stressed circumstances. They should not generate inconsistency between national or European remuneration regimes and the FSB’s Principles and Standards, as this could create an unlevel playing field and damage global competitiveness.

The risk return trade-off for bank executives 37. Our Chairman’s foreword to the FSA’s Report on the Failure of RBS5 addressed the fact that

no enforcement action was taken against the bank’s management and asked whether this implies the rules should be changed for the future. Lord Turner noted some examples of changes that could be made, including:

5 http://www.fsa.gov.uk/static/FsaWeb/Shared/Documents/pubs/other/rbs-foreword.pdf

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• the introduction of a ‘strict liability’ for bank directors and executives, which should increase the likelihood of a successful enforcement case in the event of a bank failure; and

• automatic incentives, whereby a bank’s failure automatically (and without any need to establish personal culpability) results in some negative consequence for its management, such as a ban from the industry, or forfeiture of a significant proportion of past remuneration.

38. Both of these options should more closely align the personal interests of a bank’s

management with the fate of the firm, and therefore encourage more prudent behaviour. There is clearly a need to find a better balance between encouraging those running banks to focus more on downside risks, and the need to ensure banks can attract high quality individuals and can deliver the levels of financial intermediation needed by the real economy. We look forward to contributing to the public debate on these matters.

Impact of previous reviews and new regulatory developments EU regulatory engagement with corporate governance issues 39. We continue to play an active role influencing various EU initiatives concerning corporate

governance measures, including the European Commissions’ proposals to amend CRD IV, its 2010 and 2011 Green Papers on corporate governance, and the ongoing Solvency II negotiations. We are also fully involved with, and contributing to, the governance related work of the three European Supervisory Authorities.

40. We are fully in favour of enhancing and improving corporate governance across the EU in areas where there is clear evidence of failings, shortcomings or improvements that need to be made. There is an open question, which is not for the FSA to answer, as to whether enhancing corporate governance standards should be done at EU level, the national level, or whether a mix of the two is indicated in line with the principle of subsidiarity.

41. Whichever route is taken, enhancing effective corporate governance has been shown to be

quite difficult to achieve. A single one size fits all approach is least likely to succeed, so we encourage an EU approach of flexibility, with the right mix of formal regulation and 'comply or explain' provisions.

42. In the area of financial services, such an approach can lead to significant benefits, including

the introduction of minimum standards across European countries or different sectors, often implementing uniformly international standards. Such standards include the updated Basel Committee for Banking Supervision guidance on enhancing corporate governance for banking organisations and the International Association of Insurance Supervisors 'Core Principles on Corporate Governance'. However, applying higher standards at the national level may become more challenging in future as the EU is beginning to regulate more in the governance area.

Impact of the Walker Review

43. The Walker Review included 22 recommendations ranging from board size, composition, qualification and functions to remuneration and the governance of risk, with each individual recommendation detailing a number of important proposals. These recommendations highlighted the importance of good corporate governance and identified a number of measures that can be implemented to improve the effectiveness of corporate governance.

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44. We generally expect regulated firms to have given consideration to the relevant recommendations of the Walker Review. While there has been progress in this area, it is our view that insufficient progress has been made.

45. The boards for our Very High Impact Firms (VHIFs), essentially high street banks, building

societies and large insurers, are aware of and familiar with the Walker Report and have taken some steps to change. Notable examples are:

• On the Walker recommendations on risk, all VHIFs now have separate Risk and Audit committees, although some boards have struggled to distinguish between the two. Reporting lines of Chief Risk Officers (CROs) vary; some report to the CEO, whereas others report to the Board Risk committee. The position of CROs also varies; two are board members, others are not. Some CROs are present throughout board meetings; whereas others only attend during ‘risk related’ items. While we expect CROs to report to a very senior executive level in the firm, the key issue is that it is clear that the CRO has primary accountability to the board.

• On the Walker recommendations on board size composition and qualification, succession planning and training are dealt with well in some firms but not in others. NEDs time commitment is also an issue. Some are surprised by the time required and many struggle with this in practice, although for new NEDs it is an issue we address during the approval process.

46. Although progress has been made since the Walker Review, it is important to recognise that structure alone is not sufficient. It is also vital that board members, particularly NEDs, receive relevant and timely management information to enable the right decisions and challenges to be made and to ensure the key risks are taken into consideration.

Independent Commission on Banking 47. The report of the Independent Commission on Banking (ICB) made a series of

recommendations for ring-fencing (RF) banks, including recommendations around governance arrangements. Since publication of the report, the FSA has provided HM Treasury with technical advice. We have noted that in order to achieve the ICB objectives, the majority of RF bank NEDs should be able to act objectively, critically and with independence of character and judgment.

48. Any legislative or PRA provision implementing the duty to maintain the integrity of the RF,

and to ensure the RF principles are followed, should be legally certain. A director should know what it is that he or she must do or not do in order to comply.

The Role of Shareholders 49. The overall framework of, and standards for, corporate governance for listed issuers is set

by the UK Corporate Governance Code, the content of which is the responsibility of the FRC. However, the UK Listing Authority (UKLA), which is part of the FSA, is responsible for making the Listing Rules governing admission to listings, the continuing obligations of issuers and enforcement of these obligations. The Listing Rules require, for premium listed issuers, the inclusion of a ‘comply or explain’ statement in an issuer’s annual financial report. Additional corporate governance requirements, flowing from EU company law and applicable to issuers with securities admitted to trading on regulated markets, are contained in the Disclosure and Transparency Rules.

50. We keep the Listing Rules under continuous review to ensure that they properly reflect

changes in market practice and so allow the UKLA to meet its objectives. In January 2012,

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we published a consultation paper6 that, amongst largely technical proposed changes, sought views on whether there were any enhancements to the Listing Rules that might be desirable to provide additional protection to investors and minority shareholders. This consultation ended on 26 April 2012. We are currently considering the responses and what, if any, proposals for rule changes we might want to consult on later in the year.

51. We await the outcome of the Kay Review into UK Equity Markets. However, when

considering the role of shareholders, there are a few points to note. A precondition for success in equity markets is a strong, active shareholder base. While long-term shareholders have an economic interest in the performance of a company, short-term shareholders will be more inclined to sell their shares in response to poor corporate governance. In addition, there are a range of retail tracker funds where investors are not making active decisions to buy or sell stocks. It is also important to recognise that greater shareholder engagement will incur costs that will fall on the end investor.

52. The current EU legislation for investment funds – the UCITS Directive - requires managers to

develop adequate and effective strategies for determining when and how voting rights on their holdings are to be exercised. We expect a similar requirement to be part of the Alternative Investment Fund Managers Directive. This would cover hedge funds but not sovereign wealth funds.

Future approach of the PRA and FCA to corporate governance and risk management 53. In early 2013, the regulatory architecture will change with the creation of the PRA and the

FCA. The FSA is already operating a ‘twin peaks’ style regulation and the new regulatory bodies will continue to build on the FSA’s work to ensure that firms’ governance and risk management frameworks are effective.

The PRA 54. Given the PRA's general safety and soundness objective, its key focus will be whether or not

a board is effective in delivering a firm that is prudentially robust. Crucially, it will understand the circumstances in which the firm would fail and constantly ask the 'what if' questions. The PRA will therefore continue to assess board effectiveness on an ongoing basis, using a variety of supervisory tools. The initial approval of individuals will remain the crucial decision point regarding the suitability of candidates for roles on firms’ boards. The PRA will continue to assess the robustness and rigour of the appointment process undertaken by the firm and to interview candidates for the key board roles that will be influential in delivering the PRA's objectives. It will not approve a candidate unless it is satisfied that (s)he is suitable for the role.

55. The PRA will also place a key emphasis on assessing a firm’s culture, in terms of both

the enablers that are in place and the outcomes that it delivers. A firm's remuneration structure is a key enabler, so the PRA’s focus will continue to be on the risk that remuneration structures pose to the regulator’s objectives. As for outcomes, a key manifestation of a firm's culture is its business model, the assessment of which will be a cornerstone of the PRA's supervisory approach. Where the PRA detects an inappropriate culture (e.g. through excessive risk taking or an unsustainable business model), it will take decisive steps to ensure the board remedies the issue.

6 http://www.fsa.gov.uk/static/FsaWeb/Shared/Documents/pubs/cp/cp12_02.pdf

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56. The PRA will place an increased emphasis on communicating directly with the boards of the firms it supervises. On an annual basis it will, after assessing a firm, write to the Chairman and then, for the most significant firms, hold a meeting with the board to ensure that the PRA’s views are fully understood by all members of the board, and not just the executives. The PRA will also be ready to engage in other communication with boards and board members.

The FCA 57. To achieve the FCA’s single strategic objective and its three operational objectives, the

FCA’s approach has been designed to be more judgment-based, bold and pre-emptive than previously. The framework has been structured so that it will be easier to communicate to boards and senior executives, which will help firms align good business with good regulatory practice.

58. The FCA will place the responsibility for setting, embedding and maintaining both effective

governance arrangements and the firm’s culture on the firm’s governing body. However, where the FCA considers that a firm’s governance arrangements or culture are inadequate to enable the firm to identify and manage conduct risks, the FCA may increase the scope of the firm assessment, undertake a thematic review or require it to strengthen its systems and controls.

59. One of the features of the FCA’s approach will be to focus on addressing the underlying

causes of problems, not just the symptoms. This is where the FCA’s assessment of firm culture will be important. Culture is considered a potential root cause of poor outcomes for both retail and wholesale participants and is a strong indicator as to how a firm approaches its regulatory obligations.

60. The new framework for supervision will focus much more clearly on the main drivers of

conduct risk at the firm and include both firm-based assessments and comprehensive market, sectoral and product chain analysis. The intensity of the application of the framework will depend on the FCA’s categorisation of the regulated firms.

61. As with the PRA, the approval of individuals will remain the crucial decision point to assess

the suitability of candidates for the key board roles that will be influential in delivering the FCA’s objectives.

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Written evidence submitted by the Financial Services Practitioner Panel (CGR 12)

Introduction The Financial Services Practitioner Panel (‘the Panel’) was set up under the Financial Services and Markets Act to represent the interests of regulated firms in the work of the Financial Services Authority (FSA). It consists of 13 members drawn from a wide cross section of the larger regulated firms. The Chairman of the Smaller Businesses Panel sits on the Practitioner Panel to ensure that the interests of smaller firms are also considered. The Panel strongly supports robust and effective regulation of the financial services sector, and recognises the importance of effective corporate governance in firms. As such, we welcome the Inquiry into this topic by the Treasury Select Committee, and have provided our contribution to selected questions below.

3. Does the UK approach to regulation and supervision of financial services incentivise Boards to perform their role effectively? Is more intrusive regulation a substitute or complement to effective corporate governance? Is a "comply or explain" approach an effective framework for governance?

The Panel believes that the FSA plays an important part in ensuring that firms have appropriate processes and structures in place for effective corporate governance, but we consider the impact of regulation on behaviour and culture to be far more important. We recognise that the FSA’s new intrusive and intensive approach to supervision means greater regulatory interventions and involvement in both the day-to-day operations of the firm, and in the questioning of firm strategy and decisions than has perhaps been the case in the past. If approached in the right way this can be a positive development where the regulator more pro-actively locates weaknesses in governance procedures and processes. This would complement the work of a firm’s Board and should be welcomed. However, there are concerns in the industry that the new intrusive approach to regulation and specifically corporate governance may entail excessive involvement of regulators in the management of the firm. For example, the FSA is now regularly asking to attend firm Board meetings. We are aware these requests are now becoming more common, and believe such a regulatory approach to monitoring corporate governance could become counter-productive. A regulator’s presence in Board meetings can stifle frank discussion and lead to a situation where Board members are discouraged from airing issues of concern or highlighting potential risks. This could result in the opposite of what the regulator should set out to achieve in this sphere, by lowering internal transparency and oversight of risks, and therefore also hindering the development of prompt intervention and mitigation plans. The extent to which this happens will, of course, depend on the frequency of attendance, the way in which it is conducted and followed up on and the reaction of the firms. It also raises a broader question regarding the line between the regulator inputting into a firm’s governance procedures, and the extent to which it ends up being a participant in the running of a firm. Although we believe it has an important role in the former, it is key to emphasise that the running of a firm still remains the responsibility of that firm’s executives and ultimately the Board. Failing to clearly recognise this point would entail risks to both the regulator and the firm, and pose the question: if the FSA plays a larger

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role in the running of a firm, would it also take on greater responsibility for that firm failing, for example, by becoming a ‘shadow director’? The Panel is broadly supportive of the UK’s ‘comply or explain’ approach to governance.

9. Is the existing FSA approval process for significant influence functions (SIF), including non-executive directors, effective?

Industry is supportive of the FSA’s role in assessing the competence of certain specific directors and function holders, provided the FSA has the appropriate skills and expertise available to do this. The FSA process for approving Significant Influence Functions plays a valuable role in avoiding downside risk and ensuring key office holders within a firm are appropriately qualified. The Panel is supportive of regulator involvement at this stage, and we believe this can add value to the firm’s own recruitment and selection procedures. However, the Panel does have certain concerns around the current process, and believes there are a number of areas for improvement. Key among those concerns is the amount of time the SIF process currently takes. The process for approving a SIF has increased from an average of 102.4 days in Q1 2011 to 118.2 days in Q1 20121. This represents both very high absolute levels and also a significant increase. In practice, this means that firms now have to wait on average almost four months after they have done their own recruitment, assessment and negotiation with a suitable candidate, to receive FSA sign-off. The Panel recognises that firms have a responsibility in ensuring that the FSA receives accurate information, that the increase in the past year is partly driven by firms taking longer to respond to information requests and that the FSA has improved some of its processes. However, the FSA also has a part to play in ensuring firms are aware of the type of data required, that it communicates this appropriately to firms and that the volume and complexity of information requests are proportionate to the role. As an industry, we have both positive and negative examples of engagement with the FSA SIF approval process. On the one hand, there have been concerns from firms in instances where potential SIF candidates have been blocked, and firms believe the FSA has not clearly communicated on what grounds. As a result of such experiences, we are aware of instances where firms have chosen not to nominate individuals who they believe are good candidates, due to a lack of certainty that the FSA will appreciate this. We are also aware that the SIF approval process is deterring some potentially suitable non-executive directors from putting their names forward. This is an area where perceptions are as important as reality, and may be due solely to a lack of adequate communication from the regulator. However, we would also like to emphasise that this process can only continue to remain valuable if the FSA ensures it has the right people in place to conduct SIF assessments. We would also like to note that firms benefit from having senior staff with a variety of skills. This should be taken into account in the SIF process – for instance, it may be that a potential SIF has an excellent knowledge of the firm’s treasury, hedging or other markets activities or retail customer needs, but may not have a detailed understanding of UK regulation (e.g. as a result of being recruited from abroad.) If a firm’s Board overall can still demonstrate it has strong expertise across all relevant areas, it should not preclude the recruitment of an individual who may have a different and specific set of valuable skills. On the same note, we have observed that the SIF process can often be

1 Source: The Financial Services Authority

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focused on ensuring that the candidate has a highly technical understanding of issues, even at very senior levels. The focus in such interviews should remain relevant to the role, and regulatory knowledge should be balanced against ensuring the individual has suitable leadership skills. A further industry concern in this area has been the perception of a move towards interviewing a greater number of office holders. Although the FSA process can add value, it is important that resources are directed towards the areas where they will make the most difference. Given especially the delay that greater involvement of the FSA implies for the process, this should be reserved for roles where the individual will demonstrably have a significant influence on the running of the firm. It is not useful or efficient for the regulator to replicate the firm’s recruitment work at more junior levels, where staff are less likely to be able to influence the firm’s overall direction and strategy. On the more positive side, we are also aware of instances where the FSA has provided extremely useful input to the ongoing recruitment process, and where the firm has appreciated and agreed with the FSA’s assessment of a candidate not being of a suitable calibre for a SIF. Instances such as this demonstrate the clear benefit involvement of the regulator may bring for the long-term stability of a firm. As such, although we remain supportive of the process as a whole and appreciate much of the FSA’s work, there remain clear areas for improvement in respect of timing, setting the criteria for SIF approval and communicating this to firms, and more precisely defining which functions or roles are subject to the process.

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Written evidence submitted by the Institute of Chartered Accountants of Scotland (ICAS)

(CGR 13)

1 Executive Summary 1.1 Our key messages are:

• The intended corporate governance outcomes in financial services firms should be the same as other organisations but should also include adequate protection of customers and effective engagement and co-operation with the regulator;

• The unitary board structure used in the UK is the most effective governance model;

• We strongly advocate that it is the role of the chairman to ensure that a board has a balanced membership;

• Given the size of financial institutions relative to the UK economy, it is essential to develop an effective regulatory structure. As part of this structure there is a significant need for regulators to pay more attention to accumulated market wide risks and to facilitate a more co-ordinated and effective response to these risks. Additionally, we support stronger, more effective integration between the regulator and auditors to achieve better risk and performance evaluation of these institutions at both organisation and sector level. We offer a comparative approach from another highly regulated sector for consideration by the Committee;

• We strongly support the ‘comply or explain’ approach to corporate governance; • It is the role of Boards to instil and cascade an appropriate corporate culture

based on the principles of ethical behaviour, fair and proper business practices, sustained performance and seeking to act in the long-term interests of the shareholders; and

• We support greater stakeholder engagement on pay matters and transparency of remuneration arrangements through appropriate disclosure.

2 Introduction 2.1 The Institute of Chartered Accountants of Scotland (ICAS) welcomes this opportunity

to provide written evidence to the above inquiry. Our CA qualification is internationally recognised and respected. We are a professional body for over 19,000 members who work in the UK and in more than 100 countries around the world. Our members represent different sizes of accountancy practice, financial services, industry, the investment community and the public sector. Almost two thirds of our working membership work in business, many leading some of the UK’s and the world’s great companies.

2.2 Our Charter requires ICAS to act primarily in the public interest, and our responses to enquiries are therefore intended to place the public interest first.

3 Board structure and composition 3.1 What outcomes should corporate governance in the financial services sector

seek to achieve?

3.2 The intended outcomes should be the same as those for other non-financial institutions i.e. to ensure that the company is run in the long-term interests of shareholders but also to provide adequate protection for customers (depositors, loan holders etc.) and effective risk management, especially given the comparative size of banking within the UK economy.

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3.3 For those financial entities which are systemically important, this role also extends to seeking to ensure that such entities properly co-operate and assist financial regulators in their oversight of the UK economy.

3.4 Are Board structures effective? For example, should UK financial institutions consider adopting alternatives to the unitary Board structure?

3.5 We are firm supporters of the unitary board structure and see no evidence that would support the need for change. Banks failed across the globe and there is no evidence that any one board structure was more complicit than any other in this respect. The key is undoubtedly for a company to ensure that it has a balanced board (please refer to our comments at paragraph 10.2). The responsibility for this objective rests with the company chairman. We have also sought views from members who have experience of sitting on Boards which operate a “Supervisory Board” structure and the views expressed all indicate that the unitary board model works better in practice.

3.6 Does the UK approach to regulation and supervision of financial services incentivise Boards to perform their role effectively? Is more intrusive regulation a substitute or complement to effective corporate governance? Is a “comply or explain” approach an effective framework for governance?

3.7 Undoubtedly, in the lead up to the financial crisis mistakes were made by UK supervisory bodies. Those mistakes have been acknowledged both by the Financial Services Authority (FSA) and by the Governor of the Bank of England. It is therefore at least questionable whether the previous system did appropriately incentivise Boards to perform their role effectively. On a global basis, those jurisdictions which appear to have emerged from the financial crisis best placed are those which are regarded as having good supervisory structures in place e.g. Canada, Singapore and Hong Kong. The FSA has recognised the mistakes that were made in its light touch approach to oversight and has made great efforts to change the manner in which it conducts its supervisory role. We are also aware that in the near future a new regulatory structure will be implemented within the UK which will result in the FSA being disbanded.

3.8 There is a need however to recognise that in the first instance there was a failure in macro-prudential supervision, i.e. the failure to respond globally/nationally to changing risks such as those which emerged in the US mortgage market, the expansion of credit derivatives, the over-reliance on ratings agencies which were unregulated, the expansion of complex structures such as collateralised debt obligations and the use of monoline insurers etc. Secondly, there was a failure to effectively regulate individual institutions. Post crisis, there has been considerable focus placed on the latter, and there is clearly a need for regulators to be prepared to intervene in individual companies, but there is also a significant need for regulators to pay more attention to accumulated market wide risks and co-ordinate an effective response as appropriate.

3.9 Whilst there is clearly a need for regulators to be more interventionist in the supervision of individual firms, regulators need to avoid undermining the board and the effective governance of firms by excessive intervention. This is obviously a difficult balancing act. There is a risk that boards take false comfort from regulators and therefore potentially do not focus enough on fulfilling their own responsibilities in considering the remaining risks of the business. Indeed, in the past, some boards appear to have taken comfort from complying with inadequate capital and liquidity rules. On the other hand, there is also a risk that excessive regulation will stifle innovation and economic growth. Therefore, regulatory intervention in the governance of individual firms needs to be measured and not overly risk averse to avoid stifling growth and innovation.

3.10 We view more intrusive regulation as a complement to corporate governance and not a substitute and we believe that this approach has already been adopted by the FSA and will be continued by its successor. One of the welcome changes that has been

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put in place post crisis has been the re-establishment of regular meetings between the regulator and the auditors of the banks. The establishment of such meetings was one of the key features of the Banking Act 1987 which fell into disuse. We note that the House of Lords Economic Affairs Committee1 also lamented the demise of such regular dialogue and called for the reintroduction of such a framework in early course.

3.11 We are pleased to see that the benefit of such meetings has been recognised and once again a mechanism has been put in place to facilitate regular such meetings. We very much see such meetings as being beneficial in both directions i.e. for the regulator but also for the auditor in relation to helping them get a greater understanding of the wider economy in which banks operate and any significant matters of relevance across the industry, therefore placing the auditor in a better position to risk assess, plan the audit and assess the bank’s actual performance.

3.12 We support the best practice approach recommended by the FSA in their “Code of practice for the relationship between the external auditor and the supervisor2” for bilateral (auditor-regulator) and trilateral meetings where the third member from the regulated firm (or client) should be independent i.e. the Chair of the Audit Committee or an alternate independent non-executive director. In our experience, success is contingent on transparency and a willingness to communicate. A forum where there is the opportunity for open discussion between the regulator and the auditor, without management present, facilitates this.

3.13 A comparative is offered for consideration from another highly regulated sector. A similar approach is taken to make sure that scrutiny is better targeted and more proportionate to identified risks in Scottish public sector bodies3. This example goes a step further than current FSA guidance4 as joint plans and reports are routinely produced between the auditor and regulator.

3.14 In this example, an annual Assurance and Improvement Plan is prepared and published for each council, which captures jointly agreed areas of risk and the resulting scrutiny response for each body. It is the primary planning document for scrutiny bodies. This is the result of discussions between the auditors and the various inspection/regulatory bodies that have involvement with the council e.g. Education Scotland, Care Inspectorates, Housing Regulator, Inspector of Constabulary etc. The nature of these discussions is to compare the different scrutiny bodies’ views of the risks facing the council and to draw up a scrutiny plan and response which makes best use of the scrutiny bodies’ combined resources. This helps to reduce the burden on firms of multiple inspections/audits and results in a more informed comprehensive assessment of risks.

3.15 There are also bilateral discussions between scrutiny bodies about public bodies generally or about specific cases. The audited body would not always be present and in some cases may not know that the meeting has taken place until after the event. In some cases joint reports are produced with some of the other scrutiny bodies. These may be on a particular risk area or as part of a routine work programme. Both result in an improvement plan which is followed up and monitored.

3.16 This example may offer a starting point which FSA guidance, using powers under the Financial Services and Markets Act 2000 (sections 165-1665) could build on to develop into an appropriate framework for financial institutions.

1 http://www.publications.parliament.uk/pa/ld200910/ldselect/ldeconaf/999/ceac160310ev1.pdf (page 34) 2 http://www.fsa.gov.uk/pubs/guidance/fg11_09.pdf May 2011 (see principle 1 & 2) 3 http://www.audit-scotland.gov.uk/work/scrutiny/index.php 4 http://www.fsa.gov.uk/pubs/guidance/fg11_09.pdf 5 Section 165/166 of FSMA 2000 give the supervisory authority the power to commission reports by skilled persons to provide an independent assessment of a regulated firm

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3.17 More effective integration and co-ordination between the regulator and auditor is especially important in a complex and significant industry to strengthen both audit and supervision, as well as to facilitate the spread of best practice and improve consistency of risk identification and evaluation. We believe that consideration should be given to formalising arrangements for more integrated working at the national, global and organisational levels. This aims to improve the quality and effectiveness of supervision to deliver more informed assessments and a joined up response. Banks operate in a global market and a framework would facilitate more co-ordinated responses to national and global intelligence.

3.18 It is widely recognised that the operation of corporate governance regimes in certain financial institutions was found to be deficient in light of the evidence which has emerged from the credit crisis, and that a number of areas of governance needed to be revised and improved to reduce the likelihood of another such crisis. The UK took steps towards this by commissioning and publishing the Walker Report in November 2009 which focussed on the corporate governance of UK banks and other financial sector entities. It was also recognised in the UK that the corrective measures needed were not suitable or indeed necessary for all non-financial companies and there was a clear distinction in the actions and remedies that were required solely for businesses that operated in the financial sector. We were supportive of this approach. We have also recommended that the European Commission (EC) should ensure that they adopt a similar position and to be mindful that each Member State will have their individual set of unique market drivers and patterns of shareholder behaviour which they will have to take account of. This is a matter that must be resolved at Member State and not Commission level.

3.19 The follow up to the publication of the Walker Report as mentioned above, along with the post crisis revisions and impending revisions to the UK Corporate Governance Code and the new Stewardship Code for institutional shareholders, has enhanced the UK’s position as a global leader in proactive corporate governance. At the heart of this is the “comply or explain” regime which is used in assisting companies to engage with the compliance aspects of the Code whilst allowing them freedom to explain any instances where they feel this is not appropriate in their particular situation.

3.20 The Financial Reporting Council (FRC) report6 a high level of compliance with the 'comply or explain' regime contained in the Corporate Governance Code. We are firm supporters of this approach although we do recognise that on occasion, explanations offered by companies could be improved. This was highlighted by Grant Thornton in its recent research publication7. We are therefore supportive of the recent announcement by the FRC of its proposal to provide greater guidance as to what constitutes an acceptable explanation when a company decides not to follow the requirements of a specific principle of the Code.

4 Corporate culture

4.1 What type of corporate culture should financial services firms seek to foster? In what way can this be encouraged? How effective are Boards at shaping corporate culture within their institutions?

4.2 The type of corporate culture should be the same as that of non-financial services firms. This should be focussed on placing strong ethics and corporate governance at the heart of an organisation and its tone from the top should reflect this. It is not enough to make statements to that effect; the appropriate tone must be set at the top and cascaded down throughout the organisation. One only has to look at the recent bribery allegations made against Wal-Mart in the US, which resulted in its share price

6 http://www.frc.org.uk/press/pub2709.html 7 http://www.grant-thornton.co.uk/pdf/corporate_governance.pdf (page 7)

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falling 5% in opening trading, to highlight the importance of proper governance, ethical behaviour and the resulting impact on shareholders’ interests.

4.3 There is evidence to suggest that Boards have been successful in shaping corporate culture within their institutions. Unfortunately, as hindsight illustrates, the corporate culture that was developed in certain banks was not conducive to the long term sustainability of the business. From the outside it would appear as though certain banks threw out the most basic principle of banking i.e. the ability of only lending money to those who would be able to repay, in search of increasing sales and profits of such loans. Therefore, we would reiterate that the key is for Boards to set and instil appropriate cultures within their organisation which should be based on ethical behaviour, fair and proper business practices (including treating the customer fairly), sustained performance and seeking to act in the long-term interests of the shareholders. These principles should underpin decision-making.

5 Impact of previous reviews and new regulatory developments 5.1 What difference would the proposals in the Independent Commission on

Banking’s report on the Boards of ring-fenced banks make to corporate governance in these institutions?

5.2 This should have no impact on the principles and objectives of corporate governance as stated above. However, there is the possibility that some potential conflicts and challenges may be created by the proposed governance regime for ring-fenced banks i.e. a potential conflict between the directors’ duties under the Companies Act to act in the long-term interests of the Company and any specific narrower duty imposed as regards the operation of the ring-fence. We do appreciate that in theory, the differences should be minimal but in practice we can see potential confusion as to the directors’ primary duty in difficult circumstances.

5.3 There may also be practical implications in relation to attracting sufficient numbers of independent directors of satisfactory skill and experience, to service the requirements of ring-fenced banks given the potential complexities highlighted above.

5.4 What benefits, if any, come from EU regulatory engagement with corporate governance issues?

5.5 We firmly believe that the UK is at the forefront of developments in corporate governance. The introduction of the landmark Cadbury Code (forerunner to the UK Corporate Governance Code) in the early 1990s was seen as a global benchmark and through various revisions over the years has, in our view, maintained the UK at the leading edge of developments in this area. In our view we therefore would welcome the EU seeking to replicate the UK model across all member states, although we do appreciate that this may not be possible, or indeed appropriate, in all member states i.e. due to their state of development and also their historical business environment where a two-tier board structure may be seen as the preferred model. Therefore, we believe that the EU should establish high level principles designed to promote good corporate governance but should leave the detail to member states to best serve the needs of the companies and stakeholders in those countries.

5.6 What impact has the Walker Review (2009) had on corporate governance and corporate behaviour in financial services?

5.7 We believe that this has had a positive impact. Please also refer to our comments at paragraphs 3.18 and 3.19.

6 Non-Executive Directors

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6.1 Should non-executive directors bear greater liabilities than under current law? Should executives in FTSE 100 companies be able to hold non-executive positions in other firms?

6.2 We do not believe that non-executives should bear greater liabilities than under current law. The unitary board structure renders all board members equally liable for the activities of an entity.

6.3 We believe that executives of FTSE 100 companies should be able to hold non-executive positions in other firms. We are aware that the current knowledge held by executives is valued and much sought after by other companies seeking to ensure that they have the most appropriate non-executives for their particular boards. However, constraints on the time of those in executive positions has led to a situation where it is proving harder for companies to obtain the services of FTSE 100 executives to serve as non-executives on other boards.

6.4 Is the existing FSA approval process for significant influence functions (SIF), including non-executive directors, effective?

6.5 The key to corporate governance is in ensuring that every company has a balanced board. It is widely recognised that the boards of certain financial institutions pre crisis did not appear to be appropriately balanced and some banks lacked appropriate banking skills on the board. This undoubtedly led to the FSA introducing its approval process which appears to have merit, particularly in relation to the appointment of non-executives to smaller financial institutions. However, we do question whether this may actually work on occasion against the notion of a “balanced and diverse” board on the grounds that the expertise in financial institutions held by board members may be very narrow. Care is required to ensure that the pendulum does not swing too far the other way i.e. specialist expertise becomes a barrier which prevents the appointment of very well qualified non-executive directors who do not have specific knowledge in a highly specialised area. As an example, with the introduction of Solvency 2, feedback affirms that the expectations regarding non-executive directors’ technical knowledge are a challenge to fulfill.

7 The role of shareholders 7.1 Should shareholders be required to exercise a stronger role in systemically

important financial institutions? What are the key barriers to greater shareholder activism by institutional investors in financial institutions? What risks are associated with it?

7.2 We believe that the role of shareholders is the same in such entities. We do however believe that such entities should be subject to greater scrutiny from regulators than other non-financial institutions.

7.3 Is it realistic to expect sovereign wealth funds and hedge funds to undertake a more active role?

7.4 We are not convinced that in the shorter-term this is a realistic expectation. Our view appears to be supported by the low level of engagement from such entities following the introduction of the FRC’s Stewardship Code.

8 Remuneration 8.1 What role should institutional investors, remuneration consultants, employees

and others play with respect to remuneration in the financial services sector?

Remuneration Committee

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8.2 The Remuneration Committee is responsible for and the best informed to make decisions on remuneration packages which are then confirmed by the full Board.

Shareholders 8.3 We support stronger shareholder responsibility, engagement and say on executive

remuneration (see our response to the BIS consultation in April 20128). The UK Stewardship Code9 (FRC) provides institutional shareholders with good practice on how to engage with companies, using the “comply or explain” approach.

8.4 A combination of safeguards provide the opportunity for shareholders to express their views on a company's executive remuneration policy, these include:

(i) the advisory vote introduced in 2003 (which ensures there is a strong reputational risk inherent in the remuneration report being defeated); and

(ii) the FRC’s UK Corporate Governance Code 201010 requirement for annual re-election of directors (where shareholders could register dissatisfaction via voting against the re-appointment of the Chairman of the Remuneration Committee or directors who do not appear to be performing.

8.5 In addition for banks, building societies and investment firms:

(iii) the FSA Handbook and Listing Rules create binding obligations on firms11. Updates from 2011 include remuneration principles which require firms to establish a remuneration policy which is aligned with areas such as business strategy and the long-term interests of the firm and its shareholders, promotes sound risk management and ensures performance pay is assessed on the overall business performance as well as the individual’s, and based on longer-term performance12. This provides an extra layer of preventative measures to encourage best practice.

8.6 Generally, good practice principles on remuneration apply across all sector types. However, following the crisis in 2008, additional Listing Rules for the banking and investment sector were introduced to reflect some of the learning points, as per paragraph (iii) above. This includes a response to avoid incentivising risk-taking which exceeds the firm’s agreed tolerance level. We support this, however we do not have any evidence to date suggesting the need for fundamentally different roles for the group identified in the question above regarding remuneration.

Employees 8.7 We do not see a practical role for employees regarding remuneration. There are also

practical difficulties with proposals to enhance their role. For example:

• Having employee representatives on the remuneration committee would mean co-opting non board members to serve on board committees which we believe undermines the much respected UK unitary board approach;

• Selecting candidates who are representative of the workforce would not be easy, particular with overseas operations; and

8 http://icas.org.uk/Businss_Issues/Submissions/ 9http://www.frc.org.uk/images/uploaded/documents/UK%20Stewardship%20Code%20July%2020103.pdf (see also principles – page 8) 10 http://www.frc.org.uk/documents/pagemanager/Corporate_Governance/UK%20Corp%20Gov%20Code%20June%202010.pdf 11 http://www.fsa.gov.uk/pages/Handbook/readers_guide.pdf (page 23) 12 http://fsahandbook.info/FSA/html/handbook/SYSC/19A/3

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• The specific employee(s) may fear action being taken against them in retaliation for being outspoken on a particular matter. Therefore, to protect such individuals there would be a need to introduce appropriate employment legislation.

8.8 Is there a case for introducing still greater transparency for senior executives

with respect to remuneration in the financial services sector?

8.9 We are supportive of transparent remuneration policies that align executive remuneration with the long-term risks of the business; these are particularly relevant in the financial services sector.

8.10 The Companies Act 2006 (S421) as enacted through SI 2008/41013 currently focuses disclosure requirements on directors within the Remuneration Report, as do the Listing Rules14. However, some companies (such as RBS15 & HSBC16) are already voluntarily providing additional details of the highest paid senior executives who are not on the main board as well as the fixed and variable pay elements, as proposed by the HM Treasury consultation paper in December 201117.

8.11 Given that the highest paid individuals in an organisation may not necessarily be board directors, it is not unreasonable to extend disclosure to this group in the Remuneration Report. There is a precedent for this in Scottish local authorities18 whose Remuneration Reports include (the equivalent of) directors as well as those earning above a certain threshold (in this case £150,000) whose name and post are disclosed. There is also a table of general disclosure by pay band in multiples of £5,000 of the aggregate numbers of staff earning above certain thresholds (being £50,000). The thresholds have been set for a particular sector and do not indicate a recommendation for financial services.

8.12 We believe that the overall objective should be seen as providing sufficient disclosure on the structure of pay (fixed/variable elements), the spread of the highest paid individuals and to demonstrate that remuneration policies and structures within an organisation do not incentivise excessive risk.

8.13 Should there be further reform of the remuneration arrangements of senior executives in the financial services sector? Should this extend to those highly paid individuals who sit below executive level?

8.14 Please refer to our comments in paragraphs 8.9 to 8.12.

8.15 The Chairman of the Financial Services Authority has argued that there may be a case for changing the personal risk return trade-off for bank executives. He has suggested either a ‘strict liability legal sanctions or an automatic incentives based approach. What are the merits and drawbacks of these proposals? Are there other ways to achieve the same objective?

8.16 We are supportive of the intention to moderate excessive risk taking behaviour within banks given their significant role in the UK economy. We believe that a strict liability legal sanction is not desirable in practice as it is likely to act as a deterrent to potential bank executives due to the risk of large personal liability. This is consistent with the FSA report19 assessment in their 2011 report on RBS. Banks need to be able to attract

13 http://www.legislation.gov.uk/uksi/2008/410/pdfs/uksi_20080410_en.pdf 14 http://fsahandbook.info/FSA/html/handbook/LR/9/8 15 http://www.investors.rbs.com/download/report/Annual_Report_2011.pdf (pg 294) 16 http://www.hsbc.com/1/PA_esf-ca-app-content/content/assets/investor_relations/hsbc2011ara0.pdf 17 http://www.hm-treasury.gov.uk/consult_merlin_remuneration_disclosure.htm 18 http://www.legislation.gov.uk/ssi/2011/64/pdfs/ssi_20110064_en.pdf 19 http://www.fsa.gov.uk/pubs/other/rbs.pdf (page 9)

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the best candidate for the position, particularly given their significant role in the UK economy. To counter the risk of liability, there may be an expectation from candidates for a commensurate increase in remuneration however this would contradict current public opinion and policy direction on levels of executive pay.

8.17 For sustainable improvement, our preference is an incentives based approach, building on an appropriate corporate culture (please refer to our comments in paragraphs 4.2 – 4.3) where key principles such as effective risk management, appropriate risk tolerances, ethical behaviour, long-term interests of the organisation and shareholders etc. are embedded within decision making, performance and remuneration frameworks. We welcome the recent revisions to the Listing Rules20 which better align remuneration principles with risk management and risk tolerances.

9 Governance of risk 9.1 Has the management of risk in firms improved since the financial crisis?

9.2 We believe that the management of risk has improved since the financial crisis. The

Board is responsible for the management of risk and for establishing a company’s risk appetite. There is no doubt that risk now features higher on any board agenda.

9.3 Boards have needed to consider whether the introduction of a separate risk committee

is required. There is however, no one size fits all solution and whilst in certain companies a risk committee may be necessary, in other companies such matters might be appropriately dealt with by the audit or other committee.

10 Diversity and background 10.1 What is the relationship, if any, between Board diversity and company

performance in the financial service sector?

10.2 We believe that Board diversity in the broadest sense is a very important issue (to achieve a balanced board, not just purely gender diversity). We have no evidence to support any claims either way of any relationship that may exist between Board diversity and company performance, specifically in the financial services sector but would point to the citations in the EU report21 and the Lord Davies report (February 2011)22 for wider research conclusions on the benefits.

24 May 2012

20 http://fsahandbook.info/FSA/html/handbook/SYSC/19A/3 21 Women in Economic Decision Making in the EU: A Progress Report (2012) 22 http://www.bis.gov.uk/assets/biscore/business-law/docs/w/11-745-women-on-boards.pdf

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Written evidence submitted by Board Intelligence (CGR 14)

Board Intelligence

• Board Intelligence provides services to boards and executive committees to drive board effectiveness and improve the quality of decision making. We specialise in improving the scope and quality of the information that board directors receive and around which they formulate their judgement and challenge.

• We have reviewed over 80 board packs in the past year alone from a range of sectors (including, but not limited to financial services). We observe board meetings to help us tailor our solutions to the specific needs of each client and as such we have considerable exposure to current practice within the boardroom.

• We welcome the opportunity to participate in the Treasury Select Committee’s consultation process

surrounding corporate governance best practice in the financial services industry.

Response Summary

We have limited our consultation response to those issues upon which we feel qualified to comment: 1. What outcomes should corporate governance in the financial services sector seek to

achieve? [Qu.1]

• Corporate governance outcomes should be in line with whatever the company’s stakeholders deem to be acceptable given their appetite for risk. Where the stakeholder is ‘society’ the regulator has a crucial role to play to represent their interests. However, where the stakeholders are perfectly able to represent themselves and where the firm in question is not ‘systemically important’, they should be at liberty to adopt whatever system of governance they deem desirable - no matter how risky that system may be.

2. Are Board structures effective? Should UK financial institutions consider alternatives to unitary Boards? [Qu.2]

• We believe boards are over-reliant on board meetings as the main mechanism through which to

fulfill their role; to steward and supervise effectively we propose that boards engage in a much broader set of activities.

• In the board meetings of many of the UK’s largest organisations, time could be used to better effect: board agendas regularly feature upwards of over 20 agenda items, prohibiting meaningful discussion and creating a tone that is more administrative than strategic, adding little value as a result.

• Finally, we observe the challenge that the unitary board structure presents for the non-executive,

given the very people they are there to supervise are peers of equal status.

• However, assuming the unitary board remains in favour, we propose a simple measure to transform its effectiveness: namely empowering the board by improving the scope and quality of the information directors receive. Many boards are blindfolded by inadequate information. By helping board directors to see quickly and clearly what really matters both inside and outside of their organisation, all directors are then equipped with the tools they need to contribute effectively on matters of both assurance and strategy.

3. Should there be reform of the remuneration arrangements of senior executives in

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financial services? [Qu.14]

• Given the ‘shareholder spring’ and public sentiment as expressed in the media, reform would seem inevitable whether self-imposed or required by the regulator. Our view is that this reform should not try to forge stronger links between executive pay and share price performance for two reasons: firstly the market is often a poor proxy for long-term value creation; and secondly, if most organisations claim to be concerned with creating value for more than just shareholders, why do we seek to reward executives for their performance against short-term financials and share price alone?

Full Response

1. What outcomes should corporate governance in the financial services sector seek to achieve? [Qu. 1]

1.1. Corporate governance describes the way a company is run: in essence, the way decisions are

taken and the style in which business is conducted. The right outcome from corporate governance, for any organisation in any sector (financial or otherwise), is the outcome that is aligned with the expectations of the company’s stakeholders.

1.2. In those financial services firms where society is a major stakeholder, their system of governance should limit risk of failure - especially where society bears disproportionate downside risk. Such a system should involve rigorous checks and balances and other protocols to counter recklessness, human fallibility and decision making bias. On the other hand, there are financial services firms where society is not a major stakeholder and where high-risk stakes are both affordable and attractive to the participants; should they so wish, they should be at liberty to adopt a ‘riskier’ system of governance.

1.3. As such, the right outcome for a system of governance is the one that achieves the appropriate

balance between risk and return; and it is for an organisation’s stakeholders to determine what is ‘appropriate’ and not just its shareholders. This requires that each firm correctly identifies its stakeholders, clearly communicates their system of governance and that the stakeholders are empowered to respond. In the case of shareholders, this may be done through divestment of the stock or by voting; in the case of society at large, the regulator has a role to play and must have appropriate powers at their disposal to protect the interests of those without a voice.

2. Are Board structures effective? Should UK financial institutions consider alternatives to the

unitary Board? [Qu. 2]

2.1 We believe there are a number of serious flaws in the structure of UK boards. We do not claim to have all of the answers but below we have set out our observations as stimulus for further thought and discussion:

2.2 Over-reliance on board meetings: Given the board’s duty to supervise and steward, we believe too much emphasis is placed on board meetings and that, whilst necessary, they are insufficient for the job at hand. From the confines of the boardroom a director cannot hope to gain a firm grasp on the culture of a business, the calibre of its management or the opportunities and threats it is facing. And yet most boards seek to fulfill their role principally through attending a series of board meetings (notwithstanding the occasional away day and office or branch tour). We would advocate the board draw on a wider set of tools beyond the board meeting and re-weight the time directors spend in board meetings vs the time spent in the business (perhaps by work-shadowing), speaking to external stakeholders and participating in more board away days.

2.3 Use of time in board meetings: It is not uncommon for the board of a FTSE 350 to regularly

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endure over 20 items on their board meeting agenda, turning the board into a highly administrative forum with no time for substantive discussion of each item. In our experience, most boards have an appetite to reduce the burden on their agenda but they feel constrained (rightly or wrongly) by what they believe are the expectations of the regulator. We would encourage The Treasury (together with the FSA and the FRC) to initiate a conversation around which items do and do not need to be dealt with at a board meeting and those that may be dealt via alternative channels (e.g. secure digital forums, conference calls or sub-committees). This would enable the board meeting to be reserved for serious, in-depth discussion on the future of the organisation, free from the distractions of minor issues and operational details.

2.4 Challenging the sanctity of the unitary board structure: The unitary board is considered one

of the great strengths of UK governance. In our opinion, there are flaws to the unitary board structure (as set out below) and we welcome this question being posed. However, given the general support in the UK that we believe the unitary structure enjoys, we do not expect major change. We have therefore proposed a means of redressing (although not eliminating) a key weakness, rather than an overhaul of the unitary board structure per se.

2.4.1 The flaws in the unitary board structure:

2.4.1.1 Taking first the board’s role as ‘supervisor’: We wonder whether the unitary structure may be

an obstacle to the board’s fulfillment of its role as supervisor. The board seeks to supervise the executive who number among them - as such, the non-executives are supervising their peers. In most other walks of life (and for good reason), supervision is embedded within a clear hierarchy to empower the supervisor. The challenge of supervising a peer in the unitary board structure is aggravated by the asymmetry of information between executives and non-executives: with knowledge comes power and given the time they spend in the business, the executive holds the balance. Regardless of the ideals of the unitary board, power amongst directors is far from evenly spread, making supervision still harder.

2.4.1.2 Taking next the board’s role as ‘steward’: The unitary principles would make good sense for the purpose of formulating the strategy - were it actually the case that this was what boards do. In reality, board meetings allow little time for a meaningful discussion of strategy, and away days tend to occur only once a year (and often address more than just strategy). A series of snatched conversations at board meetings and one-day immersion in the topic is inadequate for the development of a robust strategy, especially for a major multinational. When the board engages with strategy it does so to challenge and ratify rather than originate and develop. In effect, the board engages with strategy as a ‘supervisor’ rather than steward. And in this regard, non-executives face the same challenges as those described above.

2.4.2 Recommendation

2.4.2.1 Other board structures (apart from the continental two-tiered structures) provide food-for-

thought, most notably the system of governance adopted by NHS Trusts and Network Rail whereby secondary governance bridges the gap between external stakeholders and the board. However, if the unitary structure is to remain broadly unchanged (which we suspect it will) then we would recommend the following:

2.4.2.2 The scope and quality of the information that boards (and their non-executives) receive can have a profound effect on their impact. We work with the boards of some of the UK’s largest companies (usually at the behest of an executive team that has an appetite to empower their board) where the quality of the conversation has been transformed by equipping the board with the very best tools possible to do their job. With the right scope and quality of information, presented in a concise and readable fashion, we have observed that the board is demonstrably more effective. They are much better placed to supervise and ask the pertinent questions about

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the things that really matter. And when it comes to strategy, they have the requisite stimulus around which to add their judgment and experience.

2.4.2.3 A survey published by Korn/Ferry Whitehead Mann & KPMG earlier this year revealed that one in five non-executives felt out of depth in boardroom discussions because of the inadequate briefing materials, further distorting the balance of power between the executives and non-executives. We have spent the past four years focused on nothing but how to equip the board with effective board packs and we would like to see board information be given greater prominence in the governance debate.

3. Should there be further reform of the remuneration arrangements of senior executives in

financial services? Should this extend to those highly paid individuals who sit below executive level? [Qu. 14]

3.1. Yes – we believe there should be further reform of the remuneration arrangements.

3.2. Before setting out our position, we would like to distinguish between two very separate issues that we feel have become rather muddled in the media. The first is whether it is ever acceptable for executives to be paid so much more than their workforce (irrespective of the value they have created) for fear that the growing divergence between rich and poor may undermine the health of society. The second, quite separate issue, is how to reward executives in proportion to the value they have created, and above all, avoid executive pay rising whilst value (especially latent long-term value) is destroyed. It is this second question that we seek to address below.

3.3. Most attempts at creating a stronger link between remuneration and long-term value have

focused on how to align pay to shareholder value creation. This strikes us as curious on two counts: firstly, as we all know, share prices often fail to reflect fair value because they are susceptible to the caprices of short-termist shareholders and to external market influences (and TSR peer groups are rarely a satisfactory solution). Secondly, most organisations claim to be concerned with creating value for more than just their shareholders (in line with the spirit of the 2006 Companies Act). So why are we rewarding executives for their performance against share price alone?

3.4. We propose that a company identifies the principal sources of value it seeks to create (with

financial value firmly on the list) and if, for example, customer satisfaction and employee engagement number among them, then they too should feature in the performance criteria, provided reasonable measures can be found. As well as providing a better reflection of performance aligned with the company’s purpose, many of these measures may also prove to be a better lead indicator of future financial prospects than share price.

3.5. Quite apart from market distortions of the share price, in many of our largest organisations

where CEO tenure averages 5 years, it can take almost that long (if not longer) for a CEO’s efforts to filter down to the bottom line. In theory the share price should factor in a good strategy but in reality, share based pay will reward or penalise executives based less on their own stewardship and more on that of their predecessor. Encouraging a broader set of indicators may better reflect both the lead indicators of financial value creation and the value the company is creating in forms beyond the financial.

3.6. The question remains, however, as to whether reform should be driven by the regulator or

whether shareholders and public sentiment will be a sufficient driving force.

Jennifer Harris Managing Director 28 May 2012

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Written evidence submitted by ShareSoc (the UK Individual Shareholders Society)

(CGR 15) Board Structure and Composition 1. Corporate governance in companies should seek to set standards that uphold certain moral principles and commonly judged best practice to ensure that the interests of various stakeholders in the company are best pursued. 2. It is clear to us that the existing arrangements for board structure, and particularly the nomination of directors, create major problems. In practice directors solely determine who will be appointed as directors (i.e. they appoint themselves), and also determine their own pay (via Nomination Committees and Remuneration Committees that are not independent but solely consist of the same directors). We would prefer to see shareholders have a lot more say in these matters and have suggested that a system of Shareholder Committees consisting of various stakeholders, similar to that in use in Sweden, would provide a much better basis - this is described in a note on our web site here (see bottom right of page): www.sharesoc.org/policies.html It is also clear to us that the concept of having a number of non-executive directors and a non-executive Chairman has been ineffective in properly supervising the activities of the executives of financial institutions. There are multiple reasons why this is so. For example the executives have dominant control of information resources. Whether a non-unitary board structure would help to control this problem is however debatable. It would perhaps make more sense to examine the reasons for the failings in non-executive directors before coming to any conclusion on that matter. 3. It is surely recognised that the “light-touch” regulation of financial services that was introduced into the UK over the last 15 years was one cause of the crisis in the banking sector. More intrusive regulation, particularly of financial services which are very important to the health of the UK economy in general, is necessary because there is a recognition that market forces otherwise are insufficient to prevent abuses. Corporate governance is no substitute for external regulation, and typically can only deal with some basic standards about the way the board and certain aspects of the company operate. However, the “comply and explain” approach to corporate governance does seem to have been generally effective in the UK. Corporate Culture 4. Corporate culture is indeed exceedingly important. Unfortunately the whole financial services sector has become riddled by a culture of high rewards for high risk in recent years. Major contributors to this problem are the generally high levels of pay, short periods of tenure, and aggressive bonus schemes with bonuses providing much too high a proportion of total remuneration. The latter encourages excessive risk taking. Indeed we said this in our submission to the recent BIS consultation on remuneration: “We suggest that bonus schemes, LTIPs, and share options as elements of total pay have become grossly excessive in recent years and the addition of these schemes, and their complexity has concealed the impact of the growth of total pay. Although we support the concept that executives should share in the rewards generated by a company, and agree that they should be able to build a stake in the company so that their interests are aligned with shareholders, we are doubtful that these provide significant incentives to senior management – at least not in the timescale that is likely to be relevant. We therefore strongly support the simplification of remuneration packages and the reduction in the percentage

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of total pay that is represented by performance related elements”. We have argued that remuneration schemes need to be simplified and performance related pay should be no more than 50% of base salary. Impact of previous reviews and new regulatory developments 5. 6. and 7. We do not feel qualified to comment on these points. Non-Executive Directors 8. There is a general problem in UK company law that it has become ineffective in enforcing adequate standards of behaviour by company directors. This is not specific to non-executive directors (all directors are in essence equally responsible in law). Although the Companies Act lays down the duties of directors (and were clarified in the 2006 Act), it has never lately proved to be practical to pursue any action for breach of duty against the directors of large companies. In addition, there is no concept of “fraud on the market” as is available in the USA which can be used by shareholders to pursue errant directors, nor litigation funding arrangements that would make such cases viable. In addition the fragmentation of the share ownership of large FTSE companies makes co-ordinating any action by shareholders, who might provide some discipline on directors, to be very difficult in recent times. Regulations are ineffective in controlling abusive activity, and even when the law is broken, directors are unlikely to be pursued. The law and market regulations are too weak and the regulators are not forceful enough and are under-resourced to pursue many of the issues that arise. Even if actions are practical, the costs of litigation are now so high that only the wealthiest institutions could risk an action against a public company, and most fund managers have no incentive to pursue such claims. Similarly, if the financial accounts of a company have been misleading to shareholders due to failures by the company auditors, the shareholders have no claims that can be pursued in law and more and more obstructions to possible claims against auditors have been put in place over the last few years. Likewise other professionals involved in promoting or regulating companies (brokers, merchant banks, company promoters, etc) are ever more protected from their own failings. In essence the legal system which acts as the framework for companies has been watered down in the interests of company directors and their professional advisors over the last 50 years, to the detriment of shareholders interests and to that of the wider community. We would like to see a substantial reform of company law to tackle some of these problems. Our only comment on the question of whether executives should hold non-executive positions in other companies is that generally in FTSE-100 companies we think it is unwise because of the limited time that such executives might be able to devote to such roles. It is hard to see how a non-executive director of a large financial institution can perform a proper and effective governance role, without devoting a substantial proportion of their time to that task. 9. We have no comments on the FSA approval process for directors of financial institutions. The Role of Shareholders 10. We certainly support a more active role for shareholders in the supervision of companies, which is typically now termed “engagement”. We have pointed out above how we would like to see Shareholder Committees involved in selecting directors and setting their remuneration and they might have a wider role in addition. There are many complex barriers to greater shareholder

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activism by institutional investors however. Some of these might be capable of being tackled by regulation but the issue of investors not wanting to become “insiders” is a particular problem that needs examining. It means that they are reluctant to ask for information that is essential to exercise proper stewardship. But we see no risks in more shareholder activism – indeed the opposite is surely the case – the lack of effective activism and engagement generates risks. 11. Sovereign wealth funds and hedge funds can indeed take a more active role, although some hedge funds steer clear of public engagement because they fear that the media are prejudiced against them. Remuneration 12. We see investors as having a key role in setting more reasonable pay policies, but there needs to be an appropriate regulatory framework in place to support them. We suggest there are 5 key elements of a comprehensive solution to the problem of excessive remuneration: A. A binding and forward looking vote on pay at AGMs via a special resolution. B. Remuneration and nomination committees should become “shareholder committees”, i.e. the members should be shareholder representatives with some role for individual shareholders who are more likely to take an independent stance. C. Improved pay reporting with a national body producing comparative data needs to be introduced, so that everyone can see comparative data not just the board’s remuneration consultants and a few major institutions. D. The role of institutional investors and their lack of engagement needs to be tackled. E. The disenfranchisement of individual shareholders needs fixing where most do not or cannot vote due to the use of nominee accounts. There are some aspects of the role of remuneration consultants which are clearly unsatisfactory at present. In practice the Remuneration Committee, as currently constituted, effectively relies on a secret report from their consultants, who may well have a vested interest in raising general remuneration levels. The report is not disclosed to shareholders so they can verify what it says, or form a different view based on the data provided. We do not see that involving employees will assist to moderate pay – they also may have a vested interest in raising general pay levels, to the disadvantage of shareholders. 13. It is certainly the case that Remuneration Reports are overly-complex, excessive in length and often confuse the reader as much as they enlighten. Simplifying the structure of remuneration and having a single comparative figure for the individual remuneration of all directors (combining the various elements of pay) which is being studied by the FRC at present would certainly assist. 14. We do not believe the reform of remuneration arrangements has gone nearly far enough. Although we do not wish to see direct Government intervention in setting pay, we suggest there could be much tougher approaches than we have seen to date, as suggested above. 15. Proposals for “strict liability” legal sanctions or automated incentive arrangements rather beg the question. Liability for what exactly? General incompetence? Such arrangements only work in criminal law (which seems to be what is being proposed, or regulations with the force of law), when there are well defined rules and those rules are clearly broken. We are sceptical that such

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an approach would be workable in practice or lead to fair and reasonable outcomes when issues requiring finer judgement arise. Governance of Risk 16. We have no comments on whether the management of risk has improved since the financial crisis. Diversity and background 17. There is no evidence that we are aware of that relates board diversity to company performance in the financial services sector. The merit of board diversity is surely more related to other social and moral arguments that no large public companies should be dominated by a small group of like-minded individuals, and the perception that past failures have arisen from “group-think” by boards which more diversity might avoid. But diversity by itself is not helpful except where it enables people with somewhat different backgrounds, but with good knowledge of the financial services sector, to become members of boards. We would be opposed to the recruitment of directors solely on the ground of their diverse sexual, ethnic or other backgrounds as opposed to their basic competence to act as a director of a FTSE-100 company. Further information To quote two points from our manifesto which echo some of the comments above, we suggest: The legal framework for companies should be changed to improve accountability. Directors and auditors should have a duty to, and be legally accountable to shareholders. The legal concept of “fraud against shareholders” should be introduced in a new law to cover such matters as issuing false or misleading information to the market or the prejudicing of minority shareholders, and provide a basis for legal actions. The legal system should be reformed so that shareholders can pursue grievances at reasonable cost. In addition the penalties for fraud should be increased. Excessive pay of directors needs restraining. The pay of directors and senior managers in some companies has become excessive and should be controlled by ensuring that shareholders both set and approve board pay in advance (via a Shareholder Committee and vote in general meeting) and not by solely allowing the directors to determine their own pay with retrospective approval by shareholders. Roger W. Lawson Chairman 23 May 2012

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Written evidence submitted by the CBI (CGR 16)

1. The CBI is the UK's leading business organisation, speaking for some 240,000 businesses

that together employ around a third of the private sector workforce. Our membership includes corporate businesses and investors, so we represent both sides of the corporate governance debate.

2. The CBI believes that good corporate governance is about enhancing the quality of decision

making in companies so they are well run. Corporate governance is primarily about behaviours and values, so is best addressed through principles-based codes, supported by a “comply or explain” disclosure framework that recognises individual business circumstances and promotes shareholder engagement.

3. The UK’s model of corporate governance is highly regarded around the world; various

reviews since the financial crisis have recognised this and sought to build on the strengths of the UK model.

4. The CBI has previously noted that where there were failings of corporate governance during

the financial crisis these were largely a failure of execution, rather than the corporate governance framework itself.

5. In this submission, the CBI argues that:

• The structure and composition of Boards should promote the long-term success of the company

• The Board plays a critical role in setting the culture of the organisation

• Corporate governance reviews and regulatory developments should be well targeted and build on the strengths of the UK governance model

• Shareholders must have the right information and powers to hold Boards to account

• The role of remuneration should be to align the interests of Boards with shareholders and the long-term interests of the company

The structure and composition of Boards should promote the long-term success of the company 6. The aims and objectives of corporate governance in the financial services sector should be

no different to that in other companies: to ensure that decisions are taken in the best interests of shareholders and to promote the long-term interests of the company.

The unitary board structure is the right approach for the UK… 7. The CBI does not believe that adopting a different Board structure in financial institutions in

the UK would lead to better governance. No single board structure was resistant to the financial crisis, with unitary, two-tier and alternative Board structures all having the potential to fail.

8. The unitary board structure promotes collective responsibility for decision-making, and non-

executive directors can challenge and develop proposals on strategy. We believe that two-

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tier boards are susceptible to a lack of consistency, communication gaps and slow decision-making.

Regulation and supervision is not a substitute for governance… 9. The UK’s principles-based approach to corporate governance, underpinned by its “comply

or explain” approach and strong shareholder engagement is the best way to influence Board behaviour.

10. Regulation should complement, rather than substitute, effective governance. Effective

supervision by regulators is important for oversight for the financial system and regulation should determine appropriate capital and liquidity levels, which are essential ingredients for financial stability. But they should work hand-in-hand with good governance, which sets the culture and behaviours in individual institutions. A move towards a more prescriptive, rules-based approach to governance would introduce a “box ticking” mentality that would not be effective in influencing behaviour.

Diverse boards help to promote a customer perspective and effective challenge in the boardroom… 11. The CBI believes that there is an unquestionable business case for increasing gender

diversity in the boardroom. Our report “Room at the Top” set out the benefits of diverse boards, which include a challenge to “group think” mentality, access to the best available talent, diverse thinking to help drive innovation, a better reflection of a firms’ customer base and helping to promote a more positive corporate image.

12. The most effective way to promote boardroom diversity is through companies reporting

against internally-set targets and the actions they are taking to reach those targets.

The Board plays a critical role in setting the culture of the organisation 13. The Board plays a critical role to play in setting the culture and behaviours of the

organisation, which should then cascade through the organisation through effective management.

14. For financial services firms, a culture that encourages awareness and effective management

of risks, seeks robust challenge across all levels of the firm, and one that keeps the interests of customers and shareholders at the forefront of decision making is appropriate.

Corporate governance reviews and regulatory developments should be well targeted and build on the strengths of the UK governance model Reforms put in place since the financial crisis have emphasised effective risk management… 15. There has been a renewed emphasis placed on understanding and managing risk in firms

since the financial crisis, and in particular “low probability, high impact” risks. This focus has in part been driven by the reforms suggested by the Walker Review and through the Basel Committee. Reforms to further strengthen risk management are ongoing through the CRD IV and Solvency II reforms for the banking and insurance sectors respectively.

INSERT Any EU involvement in corporate governance should focus on promoting good practice and risk oversight…

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16. It is important that the approach to corporate governance respects the differing systems of company law and shareholder profiles that exist in Member States. Corporate governance codes now exist in every Member State of the EU. So we see the role of the EU to highlight best practice in governance rather than to set prescriptive regulatory interventions.

17. The G20 set out a global approach to improving risk management specifically for financial

institutions, and this is being implemented for systemically important financial institutions in the EU through the CRD IV and Solvency II directives.

There are potential pros and cons to corporate governance within a ring-fenced banking structure as proposed by the Independent Commission on Banking… 18. The Independent Commission on Banking recommends that a separate retail bank operate

with an independent board and governance structure. This should help to promote an independent controlling mind and focus on the specific risks relating to the retail entity within the ring-fence, which is positive. But on the other hand, it will be important that the Board of the ring-fenced entity does not operate in a “silo” and its actions are informed by a broader understanding of the strategy, issues and risks facing the wider Group.

Shareholders’ role is to hold Boards to account, but not micro-manage 19. Shareholders have an important role to play in the corporate governance of financial

institutions. As the Corporate Governance Code stipulates, their role is to appoint the directors and the auditors and to satisfy themselves that an appropriate governance structure is in place.

20. To carry out this role effectively, it is important the shareholders have the right information

and powers to hold Boards to account, but their role should not extend to micro-management or involvement in the day-to-day decision making of the company.

21. With the increasingly international nature of shareholding in UK listing companies, including

financial institutions, it is important to promote engagement with international shareholders. The new Stewardship Code for Institutional Investors is designed, in part, to address this. International engagement should include ownership by Sovereign Wealth Funds, though it is unrealistic to expect engagement from hedge funds.

The role of remuneration should be to align the interests of Boards with shareholders and the long-term interests of the company Executive reward must be squarely linked to performance… 22. The approach to remuneration in the financial services sector should follow that of other

private sector organisations, so that remuneration is used to align the interests of Boards with shareholders and the long-term interests of the company.

23. The CBI is clear that executive remuneration must always be squarely linked to performance,

with high pay only ever justified by outstanding performance. The link between pay and performance must be strong, clear and stand up to scrutiny.

Remuneration is principally a matter for shareholders and Boards… 24. Remuneration is principally a matter for shareholders and Boards, so institutional investors

have an important role to play in holding Boards to account over remuneration both through ongoing dialogue as well as their formal vote at the AGM.

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25. The CBI believes it would be inappropriate and ineffective for employees to play a formal

role in setting remuneration. The UK corporate governance code already requires that the remuneration committee should be “sensitive to pay and employment conditions elsewhere in the group, especially when determining annual salary increases”, which we believe is appropriate.

26. The CBI also does not support a role for regulators in setting pay, for example through a

cap or ratio, which we believe would have unintended consequences and erode the link between pay and performance.

Transparency and disclosure are important in remuneration… 27. The CBI supports transparency and disclosure in remuneration. In particular, we believe the

nature of the links between performance and reward, the measures used and the results on which reward has been calculated should be spelled out in remuneration reports, subject to commercial sensitivity.

28. Where remuneration committees choose to use remuneration consultations to help inform

their thinking over pay strategy, it is important that the process of appointing, use of and fees paid to remuneration consultants are properly disclosed.

29. Regulations set out in CRD III and the FSA remuneration code already require higher levels

of disclosure for financial institutions than in is the case for other listed businesses. CRD III requires the remuneration arrangements of senior management and risk-takers, staff engaged in control functions and any employee whose total remuneration takes them into the same remuneration bracket as senior management and risk takers. The FSA’s code similarly requires disclosure for those members of staff whose activities have a material impact on the institution’s risk profile. The CBI believes that these additional levels of disclosure for financial institutions are appropriate and sufficient.

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Written evidence submitted by Simon Prior-Palmer (CGR 17)

BOARD STRUCTURE AND COMPOSITION

1. What outcomes should corporate governance in the financial services sector seek to achieve?

1.1 The UK should aim to have the world’s most respected Corporate Governance structure and track record. This will help to attract businesses and jobs in the UK, as it has done in the past.

1.2 The UK already has a more effective corporate governance structure than the USA because of the clearer distinction between Executive and non-Executive, in particular at the level of Chairman. The UK system is also widely considered more effective than the two tier European structure.

1.3 Until the catastrophic failures of RBS, HBOS and certain mortgage banks the UK’s corporate governance track record was demonstrably better over the last two decades than that of either the USA or Europe. There have been relatively few failures in corporate governance among the UK’s non-bank industrial and commercial listed enterprises.

1.4 The primary goal therefore must be to restore the reputation of the UK as a location of excellence in the corporate governance of financial institutions, particularly in relation to large banks.

1.5 One way to contribute to the goal may be to make an example, in some way, of those who failed in the corporate governance of large, collapsed banks. In the absence of the breaking of any legal or regulatory rule in the collapsed banks, it is easy for any sanctions on the Boards to be avoided. This may suggest it is possible to be a Director of a collapsed bank and proceed onwards as an individual virtually unscathed. Further comments relevant to corporate governance of large, complex banks are attached at Appendix I.

2. Are Board structures effective? For example, should UK financial institutions consider adopting alternatives to the unitary Board structure?

2.1 The Board structure established in the UK through (i) companies legislation (ii) the combined code and (iii) the inputs of many reports, which over two decades have contributed to the combined code and to general practice, is effective. The Walker Report: “A review of corporate governance in UK banks and other financial industry entities – Final recommendations” – 26 November 2009, is an excellent statement of the principle and practice of corporate governance and should stand as a global benchmark for the future.

2.2 There are no superior alternatives to the unitary Board structure either in the USA, Europe or the rest of the World. The US system combines the role of Chairman and Chief Executive which dilutes the distinction between executive and independent non-executive. In Europe the two tier structure involving an executive Board and a Supervisory Board comprising non-executives and employee representatives is flawed in that it inhibits the operation of a free market in corporate control and grants one group of stakeholders, namely employees, an excessively strong position in relation to both

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shareholders and possible alternative owners. The UK should maintain its existing unitary system. Canada, Australia and many other countries practice the same system.

2.3 A. As highlighted in the House of Commons Treasury Committee: Banking Crisis: reforming corporate governance and pay in the City, published 15th May 2009, at least three flaws in non-executive practice are identified as follows:

i) lack of sufficient time devoted to the non-executive role in complex large banks ii) too many banking non-executives lack the relevant banking or financial

experience, and iii) the banks need to access a broader talent pool to create greater diversity.

B. Commenting on each of these three:

i) For a bank non-executive there should be a requirement to explain to the CEO of the regulator how other Directorships will be accommodated without impairing effectiveness as a non-executive of a bank

ii) The concept of diversity of expertise as applied to complex banking institutions is flawed and should be replaced by a preference, for a majority of the non-executives on a bank Board, to have relevant experience of complex banks or other complex financial institutions.

iii) The concept of diversity in respect of gender, or other categories of diversity, is a laudable goal subject to the overarching priority of expertise as explained in ii) above.

3. Does the UK approach to regulation and supervision of financial services incentivise Boards to perform their role effectively? Is more intrusive regulation a substitute or complement to effective corporate governance? Is a "comply or explain" approach an effective framework for governance?

3.1 Generally, the interface between a financial services firm and its regulator is one of constructive tension. This is true worldwide and in the UK. The firm seeks to follow the rules and keep the regulator content at minimum cost in terms of staff costs and senior management time. The regulator presses for greater transparency and detail over time.

3.2 Unsurprisingly post the 2007-2008 financial crisis Boards are dedicated to ensuring that their executives comply in all respects with regulatory requirements. Before the crisis Boards, executive and non-executives acting in unison, were inclined to promote an all-consuming lack of transparency in their relationships with regulators. For their part regulators were wholly incapable of penetrating the obfuscation.

3.3 With the recent examples of catastrophic failures of large banks, such as RBS and HBOS, still fresh, for a time at least the shockwaves will incentivise Boards to perform effectively.

3.4 In the longer term the discipline of ensuring sufficient expertise amongst non-executives as indicated in 2.3 B (ii) above, and regulatory sanctions on Directors of failed financial institutions, should together provide some measure of additional safety relative to the past when combined with revised rules on capital, liquidity and other aspects.

3.5 More intrusive regulation is a complement to effective corporate governance. It is not a substitute. The Board should have access to all current data in real time while the

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regulator is both one step removed and one or more steps in time behind the leading edge of the analysis of the evolving situation. Thus the Board, comprising the Executives, the Chairman and non-Executives, has a position of overwhelming importance in the outcomes for a complex bank.

3.6 “Comply or explain” is an effective framework for some aspects of governance that are not mandatorily required either by company law or by the central tenets of the Combined Code, or its constituent reports. In the future there will be greater need for banks to comply, rather than not comply and then explain, given their track record. The elements of governance that are capable of being dealt with on a “comply or explain” basis are relatively few in number and, separately, non-compliance is a relatively infrequent occurrence.

CORPORATE CULTURE

4. What type of corporate culture should financial services firms seek to foster? In what way can this be encouraged? How effective are Boards at shaping corporate culture within their institutions?

4.1 Banks and other financial services firms need to trend back towards an era when (i) their employees’ remuneration was more in line with other professions (ii) where the customer’s interests always came first and (iii) where remuneration was only marginally linked to individual, unit, division or whole firm performance.

4.2 Both the steps taken by regulators, and the move towards greater action on the part of institutional shareholders and associations of small shareholders, will have a major impact over time on achieving the objectives set out in 4.1 above.

4.3 Banks in particular have been ineffective at shaping corporate culture within their institutions. RBS and HBOS are classic examples.

Since the 2007-2008 financial crisis some banks have demonstrated greater difficulty than others in establishing an improved corporate culture.

Boards are critical to reshaping corporate culture and the Boards of many banks have been effective in repositioning culture since the financial crisis

Lower revenues and reduced profits mean that there is less money available for extra-ordinary compensation, fewer jobs available and many jobs nearly at risk. These considerations have helped to drive improvements in culture.

The opprobrium from the general public towards poor culture and excessive remuneration levels in banks has helped to concentrate the minds of Boards on the importance of cultural change. This opprobrium has been expressed by a wide range of politicians across the political spectrum and voiced in parliaments and by governments in UK and Europe and in Congress in North America.

The opprobrium has also been widely aired in all categories of media.

In these contexts it is unlikely that any Board is not treating the issue as a priority.

IMPACT OF PREVIOUS REVIEWS AND NEW REGULATORY DEVELOPMENTS

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5. What difference would the proposals in the Independent Commission on Banking's report on the Boards of ring-fenced banks make to corporate governance in these institutions?

5.1 The ICB report (“Vickers”) ensures greater future protection for UK taxpayers by removing the riskiest trading businesses into separately capitalised entities (these may still be owned by the same holding company which owns the sister ring fenced bank).

5.2 One effect of ring fencing will be to concentrate the focus of the holding company Board on the individual risks in each entity. In the past different risks have been conflated and consequently each individual risk category lacked clear identification, as exemplified in the cases of RBS and HBOS.

5.3 Separately, there is a fundamental flaw in Vickers which, while not undermining the benefits outlined in 5.1 and 5.2 above, may have the dis-benefit of possibly creating a false sense of future security for the taxpayer:

For example by far the greatest losses at RBS and HBOS were in the area of standard corporate lending rather than in the securities trading areas. In particular, at the time of RBS’s collapse the great majority of losses on securities businesses were already known in the market place and, to a great extent, already accounted for both in the financial statements and in the share price.

The issue that brought RBS down was the wholesale markets’ gradual, then total, loss of confidence in the quality of the loan assets on the bank’s balance sheet.

RBS therefore failed as a result of a classic loss of depositor’s confidence in the quality of the bank’s assets and the visibly inadequate amount of capital available to absorb impending loan losses. This loss of confidence, first gradual then total, led to a classic run on the liquidity in the wholesale markets which would have spread instantly to retail depositors in the absence of government intervention to acquire the collapsed carcass.

5.4 The actions recommended in the Vickers report make little difference to reducing the possibility of ring fenced retail banks again destroying their balance sheets with bad loans in the future. New regulatory rules on capital and liquidity are the key tools designed to reduce the risk of a re-occurrence of the collapse of large banks. The ICB report adds little further protection: the removal of the securities trading businesses is in essence a peripheral event which, while slightly reducing the risk to ring fenced banks, does not add significantly to the avoidance of bad lending on a large scale in the future.

6. What benefits, if any, come from EU regulatory engagement with corporate governance issues?

6.1 Virtually none. European regulatory intervention tends to be guided by political motivations in respect of London as a global financial centre as much as any other motivations. For example, while the central tenets of Basle III are adjusted to avoid too many European banks running out of capital, at the same time multiple regulatory assaults on London continue in a myriad of areas with the unspoken, underlying purpose of reducing London’s pre-eminence as a financial centre. This topic has received mostly accurate coverage in the financial media.

7. What impact has the Walker Review (2009) had on corporate governance and corporate behaviour in financial services?

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7.1 The Walker Report is a world standard statement of corporate governance principles. It will stand as a text book for practitioners and students alike for many years to come. As a result of existing and new managements committing themselves and their employees to these principles, the Walker Report will have a positive effect on improving corporate governance and corporate behaviour today and in the future.

NON–EXECUTIVE DIRECTORS

8. Should non-executive directors bear greater liabilities than under current law? Should executives in FTSE 100 companies be able to hold non-executive positions in other firms?

8.1 Non-Executive Directors (NEDs) of collapsed financial institutions should in future suffer the sanction of being denied admittance to further Boards in the financial services sector. The sanction is sensible because in law it is almost impossible to prove that a NED has been negligent or incompetent. Unless the NED has committed an actual, provable mistake or fraud, a bank or other institution can collapse without any sanction or punishment of the Chairman or NEDs whatsoever. This is the situation of respect to the NEDs at RBS and HBOS, and of the mortgage banks that collapsed.

8.2 Therefore, in the future it makes sense for the regulator to be in a position to apply the sanction of being denied admittance to further Boards in the financial sector across the full spectrum of Chairman, NEDs and Executives. The impact of the opprobrium in the market place will then determine whether other non-executive positions are available to these individuals on Boards in the non-financial sector.

8.3 It is not practical to impose the recommendations set out in 8.1 and 8.2 above by changes to corporate law because in this event few citizens would be willing to become a NED of a financial institution.

8.4 Subject to the constraint set out in 2.3 B (i) above, a NED of a financial institution may have more than one NED position subject to explaining to the CEO of the regulator that he has sufficient time to devote to the non-executive position at the financial institution.

9. Is the existing FSA approval process for significant influence functions (SIF), including non-executive directors, effective?

9.1 In part, no. The significant influence function (SIF) process is effective for middle-management positions, in the majority of cases. In the case of senior management or Board positions, CEOs, Chairman and NEDs, it is less effective because the interviewers are not of the interviewees’ peer group and may not have the equivalent knowledge or experience to make a fully effective assessment. On a few exceptional occasions the CEO of the regulator may be available for the SIF interviews of a senior person. In this instance the SIF process may be deemed effective. (Before the creation of the FSA the Governor of the Bank of England maintained direct relationships with the leaders of large banks and made his own judgements. The bureaucratisation of this feature into a process at the FSA destroyed any meaningful assessment of bank leaders).

THE ROLE OF SHAREHOLDERS

10. Should shareholders be required to exercise a stronger role in systemically important financial institutions? What are the key barriers to greater shareholder activism by institutional investors in financial institutions? What risks are associated with it?

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10.1 Yes. The performance of shareholders in the cases of RBS and HBOS and the collapsed mortgage banks was pathetic at best. The TSC 9th Report into the Banking Crisis (15th May 2009) indicates that L & G alone made a serious attempt to effect a change of Chairman and CEO at RBS. Even this attempt was not followed through with either rigour or in coordination with other shareholders.

10.2 The key barrier is that detailed governance is a near tertiary priority for most institutional investors because

(i) their primary focus is managing the investments, by analysis and by effecting views via sales and purchases of shares

(ii) their secondary focus is informing their analysis by maintaining regular contact with investee companies at pre-scheduled meetings and, less often, in private meetings with the Chairman, CEO, CFO or senior independent NED, and

(iii) their tertiary focus is corporate governance because it is expensive to employ qualified staff in an area not directly productive of revenue; additionally, it is difficult to find staff with the depth and breadth of experience to do the job effectively given the appropriately wide latitude accorded to Directors by company law, the combined code and standard practice. It is also challenging to identify what is really going on in a vast complex financial institution such as a bank. It is the role of the Chairman and NEDs on the Board to know.

11. Is it realistic to expect sovereign wealth funds and hedge funds to undertake a more active role? 11.1 Some present day institutional investors such as hedge funds and sovereign wealth

funds are not interested in raising their heads above the parapet on corporate governance. Hedge funds are concerned primarily with making money for their investors by rapid sale and purchase decisions. Hedge funds can be pro-active when they choose and, for example, put a company “into play” to attract a takeover bid. A good example is The Children’s Investment Trust (“TCI”) and its investment in ABN Amro (only RBS fell into the mousetrap).

Sovereign Wealth funds are reluctant to become publicly involved in foreign jurisdictions, either through a lack of knowledge of the local context or through fear of actions that might be perceived as impairing sensitive political and diplomatic relations.

11.2 In today’s world the traditional UK insurance company and pension fund investors

constitute a smaller percentage of the ownership of any large company, as compared to the last century, and are therefore less powerful.

11.3 However, the current, still nascent, activism on remuneration demonstrates that, if

shareholders make the effort, change is achievable. 11.4 The principal risk with greater shareholder activism is that fewer top quality, fully

experienced candidates will be willing to put forward their names as candidates to be NEDs or Chairmen, given the potentially toxic cocktail of increased risk of liability, regulatory sanctions, public opprobrium, unfair and ill-informed media coverage and reduced remuneration.

11.5 On balance it is likely that a sufficiently large pool of talent is available in the UK

notwithstanding the risks outlined in 10.6

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REMUNERATION

12. What role should institutional investors, remuneration consultants, employees and others play with respect to remuneration in the financial services sector?

12.1 The capitalist system depends on differentiated incentives to achieve optimal allocation of scarce physical assets and human resources.

12.2 Shareholders, the owners of companies, should be the central players in determining the remuneration of executives and Boards. Remuneration consultants provide data and advice on pay packages but are powerless to affect the outcome if shareholders intervene. Human nature will ensure that employees will seek maximum available compensation in their contracts. It is the role, sequentially, of senior management, Boards and shareholders to determine the outcome.

12.3 Shareholders have been lazy in participating in the determination of remuneration but are rapidly becoming less lazy.

12.4 UK has many world class banks, financial institutions and industrial and commercial companies. It is difficult, if not impossible, in a globally transparent market place for senior managers, Boards and shareholders to award remuneration packages below world scale levels without compromising on the quality of the person hired.

12.5 Another key issue is the mechanisms for linking pay with performance. The individual corporate culture of the bank in each context will be a major determinant in the quality of outcome, for all stakeholders, of the remuneration policies selected.

13 Is there a case for introducing still greater transparency for senior executives with respect to remuneration in the financial services sector?

13.1 Yes, so long as bank compensation practices remains materially out of line with other industries. Otherwise lack of transparency may ultimately contribute to financial institutions being considered socially unacceptable when in fact they play critical roles in facilitating growth in economies.

14 Should there be further reform of the remuneration arrangements of senior executives in the financial services sector? Should this extend to those highly paid individuals who sit below executive level?

14.1 Current reforms have made substantial inroads towards transparency. Improved corporate cultures are improving behavioural outcomes. The reforms could be extended to individuals who sit below executive level for the reason stated in 13.1 above. However, such change is unlikely to alter the level of remuneration of these individuals and, since they are not in senior management or governance roles, the extension of reforms may be more an issue of identifying a level of transparency acceptable to society as a whole rather than a governance issue.

15. The Chairman of the Financial Services Authority has argued that there may be a case for changing the personal risk return trade-off for bank executives. He has suggested either a 'strict liability legal sanctions or an automatic incentives based approach. What are the merits and drawbacks of these proposals? Are there other ways to achieve the same objective?

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15.1 The withdrawal of past compensation, as suggested by the Chairman of the FSA, is an additional sanction that may be imposed by the regulator on management and Directors of financial institutions. This is a reasonable step in the case of a financial institution that deteriorates soon after paying out large remuneration.

15.2 Good quality corporate governance at Board level should be able to prevent the collapse of financial institutions regardless of the quantum and nature of remuneration paid to executives.

15.3 In the case of RBS the Board lamentably failed to reign in a dominant CEO. The role

remuneration played in his actions is difficult to gauge though the publicity in relation to the level of the CEO’s pension following his bank’s collapse may have a bearing on the question. The core point however is that the Board failed to check the CEO’s actions, linked or not to remuneration.

15.4 In non-financial industrial and commercial companies, collapse almost never occurs as a

result of excessive remuneration levels. In most cases a weakening business is sold before it collapses and the share incentives are often worthless as a result. In the case of banks there is a well-known difference of category in that only the government is big enough to take on the collapsing institution. In the context of bank failure the share incentives also become worthless.

15.5 To repeat, top quality corporate governance is the only substantive way to ensure that remuneration packages do not adversely influence the management of the business.

15.6 In the future shareholders, the owners of companies, are likely to become more significant determinants of the levels of remuneration which will in turn impact the remuneration of the next level of management.

16. Has the management of risk in firms improved since the financial crisis?

16.1 Yes, but large losses will continue to appear in lending and securities businesses as a regular part of the financial landscape. Losses are an essential feature of the business of financing risk. However, the recent, May 2012, multi-billion dollar loss announced by JP Morgan illustrates that giant losses may still be made if any part of the holy grail of corporate governance is transgressed. In the case of JP Morgan the event may illustrate a case (the dominant CEO of RBS being another) of an over-powerful, dominant CEO with a personalised chain of command over a trading area that was segregated from the bank’s standard business lines and as a result was either supervised differently or partially unsupervised because of the CEO’s direct involvement. The case of UBS’s $2.3 billion trading losses in 2011 illustrates the risks of complex principal positions traded by junior executives whose supervisors are barely able to comprehend the risk.

17. What is the relationship, if any, between Board diversity and company performance in the financial service sector?

17.1 This question has been answered at 2.3 B (ii) and (iii) above.

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APPENDIX 1

FURTHER COMMENT RELEVANT TO CORPORATE GOVERNANCE IN FINANCIAL INSTITUTIONS

A.1 Given the goal set out in 1.1 to promote the UK as a benchmark for corporate governance, the TSC may wish in the case of the world’s largest bank collapse, RBS, to censure publicly the Chairman and NEDs in the absence of any other legal or regulatory sanctions being appropriate. The same may apply in the case of HBOS. This would set a precedent for the future in terms of the reputational fate awaiting the Boards of significant, collapsed financial institutions and remind the world that the UK takes these matters seriously.

A.2 In the FSA report “The failure of the Royal Bank of Scotland”, published December 2011, the parts most directly relevant to corporate governance (though the entire report reflects a gross failure of corporate governance) are paras 24 – 27 of the Executive Summary (pp 26 – 27) and the Section 2.2 Management, Governance and Culture paras 569 – 667 (pp 220 – 252). The approach to this topic in the Report is to ask questions which in the main cannot be answered in the Report on account of the need for qualitative judgements and assertions on topics where evidence is virtually impossible to divine. The inputs of the lawyers acting for RBS and the Directors, both acting generally and specifically through the maxwellisation process, are likely to have ensured that the section is an inadequate response, by any reasonable measure in relation to the scale of the catastrophe that occurred, to the particular questions posed in the Report and to the wider corporate governance issues being debated by the TSC.

A.3 One step the TSC might take is to ask the FSA in relation to RBS to release under parliamentary privilege the transcripts of all interviews (some interviews are referred to in para 860 on p 346 of the FSA Report) with senior management, with Executive and non-Executive Directors of the Boards, with shareholders and with the Bank of England, both (i) during the original enforcement investigation in 2009-10 and (ii) in 2011 in relation to the preparation of the report into the Failure of RBS, published in December 2011 and discussed by the TSC in January 2012. TSC may as a result of reviewing these inputs be in a position, for example, to determine the level of constructive contribution by Board interviewees during the compiling of the various reports and in the investigations.

A.4 The Committee may also wish to request sight of (i) The Price Waterhouse documents (referred to in Part 3 of the FSA Report, para 2 p 348) prepared for the FSA enforcement division’s investigation into RBS, focusing explicitly on the Global Banking and Markets Division (GMB, the acquisition of ABR Amro and the investment circulars, (ii) Project Snow, an internal audit report prepared within RBS during the summer of 2008, and (iii) various other documents relevant to the main Report into the failure of RBS that may be useful to the TSC‘s review of Corporate Governance.

A.5 The public Interest in unlikely to be meaningfully served by TSC commissioning a further more comprehensive review of the failure of RBS. The combination of (i) the explanation of the generic failures in the market place in the Turner Review: “A regulatory response to the global banking crisis,” report of March 2009, (ii) the Walker Report: “A review of corporate governance in UK banks and other financial industry entities”, 26th November 2009, and (iii) the FSA report on the Failure of RBS, December 2011, (the latter overseen by two external reviewers appointed by the TSC), constitute a sufficient analysis for most people of the generic failures and the failure of RBS in particular. Substantive regulatory changes are being implemented globally through Basle III and in parallel the FSA has reformed its methods of supervision.

A.6 As a result of the FSA finding no breach at RBS of rules or of law amongst any of the executives or the Board, the Chairman or NEDs, all of these individuals have escaped public censure. Many

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professional observers and widespread comments on twitter indicate that the general public may think that this is an unacceptable finishing point.

A.7 Corporate Governance is in the last analysis an issue of human competence. This is the greatest factor in the collapse of the banks, together with capital, asset quality and liquidity. The latter are capable of careful measurement as set out in Part 2, Section 1, of the FSA Report on the Failure of RBS, “Factors contributing to RBS’s failure and the FSA’s regulatory and supervisory response”. Section 2 of Part 2, “Management, Governance and Culture,” may be considered by TSC to be a weaker part of the report because it is self-evidently heavily censored in a maxwellisation process by lawyers for RBS and for the Executive and non-Executive Directors as indicated in A.2 above.

For the same reasons, it may be assumed, it is noticeable that the “Factors” section named above barely touches on the incompetence of the Board in respect of the catalogue of failures to oversee capital, liquidity and asset quality.

A.8 On 9th March 2012 the FSA enforcement division published a short report (37 pages plus annex) identifying a breach of Principle 3 of the FSA’s Principles for Business (“Principle 3”). Principle 3 is the requirement that “a firm must take reasonable care to organise and control its affairs responsibly and effectively with adequate risk management systems.”

The report refers throughout to HBOS (“Bank of Scotland plc”) as “the Firm” without any explicit reference to the Board of HBOS, comprising the Chairman, the NEDs and the Executive Directors. It is not clear whether the FSA is currently engaged on a larger report on HBOS. If the FSA is so engaged the section on management, governance and culture is likely to entail the same deficiencies as the RBS report and for the same reasons as set out in A.2 above.

A.9 Para 135 (Page 49) of House of Commons Treasury Committee: Banking Crisis: reforming corporate governance and pay in the City, published 15th May 2009, quotes PIRC who urged that:

“consideration is given to the role and responsibility of the Boards of banks. Too much commentary on the banking crisis has overlooked or underplayed the primary responsibility that the Boards of banks have for their own failures. Whilst it is of course right to consider the role of regulators and central banks, the Board members of the banks that have run into difficulties must take their full responsibility too. They approved the business strategies and products that have caused such damage after all.”

A.10 Lord Turner’s observation at para 1461 that, while 20 years ago the boards of major banks “were stuffed with a random bit of the non-relevant great and the good”, today this phenomenon is no longer the case. This is not accurate in that the major banks have manifestly not appointed NED’s who have the relevant technical skills. A look at the composition of the Boards of RBS and HBOS at the time of their collapse will illustrate that Lord Turner’s suggestion is wide of the mark. A new generation of the “great and good” may have replaced the old generation. Nowhere to be seen on the Board are the experienced derivatives traders, for example. Most people from non-financial industries, from the Chairman to the receptionist, can understand the simple core of banking, namely deposits and loans made with deposits. Hence, the configuration of the Chairman and NEDs on the Boards of RBS and HBOS, replete with experience from non-financial companies, was patently unfit for the purpose of governing large, complex, systemically important banks.

                                                            1 House of Commons Treasury Committee: Banking Crisis: reforming corporate governance and pay in

the City: published 15th May 2009  

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A.11 Equally inaccurate is Lord Stevenson’s statement (Chairman of HBOS) at para 1442 that it was “very difficult to get non-executives with banking experience on boards.” This is simply not true. It reflects only the point that the executive search firms (“headhunters”) put forward as candidates for the bank Boards individuals drawn from the new generation of the “great and the good” having senior non-financial industrial and commercial backgrounds. The candidates understood extremely little about complex banks. Gifted and experienced retired bond traders, for example, from the senior management ranks of top banks who understood every detail of complex financial instruments, and the relevant remuneration processes and management’s challenges related thereto, were missing from the Boards.

The executive search industry earns little from NED searches. The resource-efficient solution for them is to cross-fertilize the great and the good, most often with proper regard to relevant expertise, but in relation to the large banks clearly a totally failed exercise in the past because experts from senior management of complex banks were not recruited.

A.12 Stephen Hester’s comment at para 1453 is insightful, relevant and accurate.

He thought “all companies struggle with the non-executive balance” and that it was important to have executive directors in place that wanted to be strongly challenged, but that it was equally important that non-executives understood that their role involved challenging the executive. He went on to say that: “Helping the company succeed does not always mean saying, yes, to the chief executive, it can mean a challenge, constructive challenge, but I have to tell you, I am not sure this is an issue of process. I think it is, unfortunately, an issue of humans and their behaviour.”

A.13 The Governor of the Bank of England’s observation at para 1484 saying “the fact that there is a crisis is in itself not evidence that the individuals in charge of those institutions necessarily failed” is laughable. The decisions taken by senior management and the Board at RBS would have been demonstrated, without a financial crisis and in most economic scenarios, as appalling.

A.14 In the same para 1485, Lord Turner is quoted as saying, probably rightly, that the crisis 10 years hence will be decreased in severity because of regulatory changes “a better system of capital adequacy, a counter-cyclical system of capital adequacy, more robust and effective policies on liquidity.”

However, the TSC may wish to reconsider Lord Turner’s suggestion that the regulatory changes “are more likely to decrease the likelihood of overall systems problems in 10 years’ time, more likely to do it than operating through the competence of the executives or the non-executives of specific institutions.” This assertion may be thought to underplay “the issue of humans and their behaviour” suggested in A.12 and wrongly diminish the critical, central role of corporate governance in outcomes.

A.15 Peter Chambers (L & G) summarises as follows at para 1756

“of all outside people the regulators have the first line of sight in seeing what goes on in the banks. They have information that is not accessible by the rest of us as investors in the public domain. The other group of people who have line of sight are the banks themselves and their executive directors and above that the non-executive directors. One would have to conclude

                                                            2 IBID 3 IBID 4 IBID 5 IBID 6 IBID 

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12  

that the non-executive directors were not effective in controlling the activities of the executive directors; otherwise, we would not be where we are now.”

A.16 In conclusion, if the goal is to re-establish the UK as the pre-eminent global context for best practice corporate governance of financial institutions, in order to assist attracting businesses and jobs to the country, then it follows directly that shortfalls in corporate governance on the scale of RBS and HBOS should be fully aired in the highest halls of democracy so as to be seen in the UK and worldwide to emphasize and underline both the seriousness with which these issues are considered in the UK and the attention paid to following through on lessons learned and to highlighting examples.

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Written evidence submitted by Gavin Palmer (CGR 18)

Submission from an experienced private investor of over 30 years active corporate Governance

since 1991

. My responses are outlined below and I would ask that the committee refer to the ShareSoc

Nomination Committee and also Nomination Committee with new adapted proposals as

the best and most suitable solution that would create a lasting economic benefit to

workers, Board Directors in focusing on the business matters at hand rather than politics

and power, the manufacturing businesses and the UK tax system.

. Board structure and composition

. What outcomes should corporate governance in the financial services sector seek to

achieve? A reasonable balanced return.10-20% ROE. Allowance for the 3% of loans that

default each year and a service to the business and retail customers. Playing of nil sum

games, high leverage should be minimized as unproductive use of the countrys intellectual

and banking capital. Financial weapons of mass destruction with only the employees always

gaining.

. Are Board structures effective? For example, should UK financial institutions consider

adopting alternatives to the unitary Board structure? Yes a Shareholder lead Nomination to

the AGM committee would align the incentive to make money with the caution over losing

the entire investment as happened with RBS of the owners. Only the largest owners have

the incentive for the company to outperform the markets rivals over the next 30 years far

longer than a CEOs term of office or non executives influence. Life is ruled by incentives and

only the owner can rightly balance talent vs cost, teamwork vs individuals, retaining capital

vs cash draining, bonus vs the cost of finding or training equivalent replacements, tax

avoidance vs declarable public profits.

The non executive committee system was intended to act like a Shareholders

Nomination to the AGM committee however the law of unintended consequences has

failed with no executive now being directly held to account for the pay awarded to

themselves but excused by other committees, consultants. The Non executives have

gradually gone ‘native’ and are ineffective eg The two Non execs removed by EMAP PLC

when they rightly disagreed with the CEOs plans.

. Does the UK approach to regulation and supervision of financial services incentivize Boards

to perform their role effectively? With a self appointing board lead by a strong chairman

the UK approach has lead to a disaster. It must change. (institutional investors have

diversified their holdings so much they have difficulty in coordinating a >50% voting

response because all institutions default is to support the management because others

demand that they always vote.) The Bank of England or FSA supervisors should maintain

their role in ensuring that shrinking capital ratios and insurance fiddles are avoided. (failure

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RBS) There is currently no stick for boards members – payoff of a broken contract, large

guaranteed pensions only by hard negotiation at the start to puff the pension higher. The

annual proposal for re election of Directors would allow the Shareholder lead Nomination to

the AGM committee to gradually change the composition of the board over time. The

board would also spend less time politically fighting and more time serving the businesses

that they run. A far better use of the cream of talent available with perhaps an increase of 10-30% of the executives time. Excellent value. Selection based on talented ability and teamwork vs loyalty to the appointment committee and it Chairman.

.

. Is more intrusive regulation a substitute or complement to effective corporate governance?

Complement. Shareholders do not know what is truly going on inside a business although

they try to employ auditors to do that for them to check on the management. Once the

leaders attitude is changed and positive leaders are protected and rewarded the followers

below also change. However structural problems e.g. a ruthless merchant banking takeover

executive is too much of a match for a retail relationship banker in the hierarchy of PLCs. A

split is needed. The culture does not serve the retail service side that is so needed from

banks in the country

. Is a "comply or explain" approach an effective framework for governance? It generally moves

the companys along and does allow differences when well argued to remain in place.

Afterall everything we do currently was once untested and new and needing explanation.

.

. Corporate culture

. What type of corporate culture should financial services firms seek to foster? Mildly

innovative, honesty, integrity, trustworthiness, my word is my bond, respectable, balanced.

In what way can this be encouraged? By firing those who are not, sending to

Coventry/isolating firms which are not and allowing them to go bankrupt. Banning

individuals from practicing and interference in reappointment. How effective are Boards at

shaping corporate culture within their institutions? Currently very effective with Friday

morning beatings by RBS distorting the attitudes and behaviours in all functions of the

bank. (see Fines, etc in all sections of the bank)

.

. Impact of previous reviews and new regulatory developments

. What difference would the proposals in the Independent Commission on Banking's report on

the Boards of ring-fenced banks make to corporate governance in these institutions? The

investment banking side would have to work harder to try and get at the retail banking

assets and relationships’. The senior management would still come from the Merchant

banking side as they are more ruthless and manipulative by the nature of their training and

career.

. What benefits, if any, come from EU regulatory engagement with corporate governance

issues? The encouragement of more women would have an effect. However the balance of

time available vs the number to be involved with is too many for the small Corporate

Governance Departments of large institutions with over 2,000 investments.

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. What impact has the Walker Review (2009) had on corporate governance and corporate

behaviour in financial services? I looked but I did not find.

.

. Non Executive Directors

. Should non-executive directors bear greater liabilities than under current law? They are all

Directors. However the auditors should have far greater liabilities than at present. Should

executives in FTSE 100 companies be able to hold non-executive positions in other firms?

Yes as I proposed in 1991 to the BP AGM the executives only have 24hours in the day and

should devote most of their efforts to BP and that these non-executive roles should be a

maximum of 3.

. Is the existing FSA approval process for significant influence functions (SIF), including non-

executive directors, effective? No idea, however once approved, what happens when they

fail? Culture and attitude cause the results not whether they have a piece of paper in their

hand. However it might deter or make further levels of disguise more likely. Only by

punishing the culture and behaviour and thus risking a person career whilst rewarding those

of the ethical persuasion over time is an approval process most likely to succeed. Fellow

employees do not want to be tarred by the same brush.

.

. The role of shareholders

. Should shareholders be required to exercise a stronger role in systemically important financial

institutions? YES by directly being elected to sit around a table and sort out the best

management for the business in the current situation. What are the key barriers to greater

shareholder activism by institutional investors in financial institutions? Directors cannot be

forcibly removed other than by a vast effort and only then by an advisory vote to then hope

for a resignation eg Aviva. The Chairman controls the nomination committee and thus the

boards appointees. Analysts and large shareholders are black balled and restricted in

information or denied interview time with Directors punishing those speaking out by

increasing the perceived risk and uncertainty about the companys activities. Analysts also

want to win the Analyst awards which require special insight and recommendations not

normally forthcoming except by the Directors personal guidance. What risks are associated

with it? There is the occasional risk as happened once in Sweden of an activist fund

persuading a higher risk set of appointments to the board however after a time the change

back to more sensible management was smooth when it was apparent of the mistake. The

activist holder could not outvote his other three shareholders plus Chairman.

. Is it realistic to expect sovereign wealth funds and hedge funds to undertake a more active

role? They already do in Abu Dhabi. However hedge funds on leveraged amounts are likely

to only be involved to further their narrow interests and shorter term horizons vs pension

and insurance based shareholders.

.

. Remuneration

. What role should institutional investors, remuneration consultants, employees and others play

with respect to remuneration in the financial services sector? The largest investors should be

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together actively selecting the best talent for the senior roles. The remuneration consultant

firms and others would be able to advise but not have the final vote as only the shareholder

is in a position to offset and balance the competing interests between Directors, employee,

consultants, headhunters, unions and the businesses need to rapid growth or safety.

. Is there a case for introducing still greater transparency for senior executives with respect to

remuneration in the financial services sector? Makes little difference other than bragging

rights as to who is the most highly paid alpha male in the industry. However change the

situation to “he who pays the gold makes the rules” (Shareholder lead nomination to the

AGM committee) and the norms and ‘rules’ will change. The total board pay and bonus

should be clearly displayed next to the profits to make easy comparison of the twos

differing success.

. Should there be further reform of the remuneration arrangements of senior executives in the

financial services sector? Face to face with the shareholders representatives in one room.

Then once the shareholders’ are agreed the committee chairman can put forward the

collective view without fear of members being picked off by the Directors one by one. The

best reform is to put the shareholders back in the driving seat directly involved in the

selection and interview of candidates and their attitudes. The Shareholder Nomination to

the AGM committee proposal by ShareSoc and also by myself Gavin Palmer is most suitable

, historic and proven.

. Should this extend to those highly paid individuals who sit below executive level? The largest

shareholders should be aware of the number and responsibilities of these as a large amount

of their capital is at risk from their activities. Eg RBS Global Capital markets headed up by

Mr Hourican. Otherwise the whole picture of Barings Bank and Nick Leeson would not be

revealed.

. The Chairman of the Financial Services Authority has argued that there may be a case for

changing the personal risk return trade-off for bank executives. He has suggested either a

'strict liability legal sanctions or an automatic incentives based approach. What are the

merits and drawbacks of these proposals? Merits :that Directors weigh up a downside

rather than having a company paid insurance policy to back them up. By far the best

deferent is to be fired and lose their job being replaced by someone else like their junior.

This proposal would probably only lead to an escalation of fees to offset the higher risks

with more money diverted into insurance policies and pre contract negotiations rather than

leading and driving the business forward. Self serving suggestion not worthy of the

Chairman representing the publics interest. Nothing should be automatic for incentives.

. Are there other ways to achieve the same objective? Have the largest shareholders face

Directors face to face and fire them. Director loses credibility and possibly even an entire

career in that industry. Far better and more effective and what the city used to do to punish

behavior, the rest of the city refused to trade with the offending party causing the offenders

to be severely punished in the course of business and firing most of the employees and

losing years of reputation for all those affected.

.

. Governance of risk

. Has the management of risk in firms improved since the financial crisis? Overstaffed

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investment banking in RBS is appalling. That is a cash risk to the banks position of too high

costs. Selling off for pittance of valuable parts of RBS deplorable eg stockbroking. Lloyds is

doing the right thing as they had the right culture to start with. RBS is mildly out of control.

.

. Diversity and background

. What is the relationship, if any, between Board diversity and company performance in the

financial service sector? A predominance of men on boards increases the desire for high

risk, high reward type activities. Women are proven to develop longer term relationships

with a better long term performance (fewer transactional costs and failures). The challenge

is biologically/psychologically there is no reward for women to break into the top highest

risk positions however for the business as a whole women’s long term stronger relational

aspect would be very beneficial on financial services boards.

Any further comments relevant to corporate governance in financial institutions would be welcomed. Those who have supplied the capital by original subscription and by retained profits have now due to clever salami slicing of their rights, ability to contact each other, far smaller average % shareholding and mechanisms via the Directors control of the Nominations Committee lost the ability to control, intimidate or even attempt to bully boards into accepting reasonable, responsible Corporate Governance practices. When reforms were suggested Murphys Law prevailed with the Law of Unintended Consequences Eg Compulsory voting meant more automatic voting in managements favour because of lack of time of the proxy voting departments, so instead of abstaining and not voting which would increase the voting power of those that did vote and read up on an issue the Institutions voted regardless in favour of the management. Eg A private nominee almost got elected until the Directors realized and called round shareholders to change their votes to go against the candidate. Currently not even the capital of shareholders is enough for large trading desks of massive banks RBS and now capital is drawn from the Governments and the ordinary taxpayers. All to fund an activity which in too many cases is a nil sum gain for the both the country and the shareholders over time but is always in the interest of the employees concerned. Only by putting the largest shareholders back into the position of being the ones to choose and select the Board of Directors and the Chairman without fear of retribution, withholding and contempt can the Boards regain their respect for their owners instead of paying lip service. I commend these proposals to the committee 24 May 2012

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Written evidence submitted by UK Policy Governance Association (CGR 19)

BOARD STRUCTURE AND COMPOSITION What outcomes should corporate governance in the financial services sector seek to achieve? 1) A good two-way connection with shareholders. 2) A comprehensive and explicit set of policies for governing the strategic direction, prudence and ethics of their entity. 3) Assurance of performance against its policies. Are Board structures effective? The Chair and Chief Executive roles should not be combined into one role. Ideally, executives should not operate as full board members. At the very least, their participation should be governed by strict conflict-of-interest policies set by non-executive board members. Does the UK approach to regulation and supervision of financial services incentivise Boards to perform their role effectively? See below. Is more intrusive regulation a substitute or complement to effective corporate governance? Organisations do NOT exist to be regulated so it can only ever be a complement. Regulation exists for the public benefit because the public gives organisations licences to operate in our society. Organisations exist to achieve their owners’ intent not regulators’ intent. Is a "comply or explain" approach an effective framework for governance? Yes CORPORATE CULTURE What type of corporate culture should financial services firms seek to foster? Honest and transparent. In what way can this be encouraged? By the board being honest and transparent itself and requiring honesty and transparency of those who report directly to it. How effective are Boards at shaping corporate culture within their institutions? They can set a tone and require honest and transparent reporting from those who report directly to it. They can also require that their direct reports ensure the same throughout the organisation. Important to separate accountability from blame. IMPACT OF PREVIOUS REVIEWS AND NEW REGULATORY DEVELOPMENTS – no comments of this section NON EXECUTIVE DIRECTORS Should non-executive directors bear greater liabilities than under current law? All directors should have the same liabilities.

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Should executives in FTSE 100 companies be able to hold non-executive positions in other firms? Yes Is the existing FSA approval process for significant influence functions (SIF), including non-executive directors, effective? It would be helpful for the FSA to comment on this now it has been running for a while. There is a danger that the FSA end up taking responsibility for those going through the SIF interviews as being ‘suitable’. Would it not be better for the FSA to publish its principles for recruitment of SIF and then hold firms to account that they recruit to these principles. THE ROLE OF SHAREHOLDERS Should shareholders be required to exercise a stronger role in systemically important financial institutions? The shareholders of “the system” are presumably the public and so I would assume that the onus for care in relation to “systemic importance” should fall on the government as representative of the public rather than on the shareholders of the financial institution. What are the key barriers to greater shareholder activism by institutional investors in financial institutions? Lack of board interest or skill in encouraging shareholder activism. Having sufficient methodologies and knowledge for seeking to legitimise board positions on behalf of those they represent? Being able to balance the interests of those whose interests are fully represented with the interests of those whose interests are not fully represented. It is the board’s job to do this balancing – investors cannot be expected to do it for themselves. What risks are associated with it? Distorting proper balance in terms of the best interests of ALL shareholders. Is it realistic to expect sovereign wealth funds and hedge funds to undertake a more active role? Only if they can do so without distorting proper balance in terms of best interests of ALL shareholders. REMUNERATION What role should institutional investors, remuneration consultants, employees and others play with respect to remuneration in the financial services sector? Demanding transparency and complaining when decisions do not align with the best interests of ALL shareholders, including when they are damaging to the organisation’s reputation. Is there a case for introducing still greater transparency for senior executives with respect to remuneration in the financial services sector? Not a matter for legislation. Boards should decide in shareholders’ best interests. Should there be further reform of the remuneration arrangements of senior executives in the financial services sector? Should this extend to those highly paid individuals who sit below executive level? Not a matter for legislation. Boards should decide in shareholders’ best interests. The Chairman of the Financial Services Authority has argued that there may be a case for changing the personal risk return trade-off for bank executives. He has suggested either a 'strict liability legal sanctions or an automatic incentives based approach.

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3

What are the merits and drawbacks of these proposals? Are there other ways to achieve the same objective? Not a matter for legislation. Boards should decide in shareholders’ best interests. GOVERNANCE OF RISK Has the management of risk in firms improved since the financial crisis? Although it seems that more time and focus is being given to risk at the Board level. There still appears to be a lack of clarity how improving risk management should be achieved at a Board level. With the adoption of ERM (Enterprise Risk Management) systems the management of risk within organisations has likely improved. However we are not clear that the board’s governance of risk has improved i.e. the board's ability to set and monitor the risk criteria under which the organisation operates. DIVERSITY AND BACKGROUND What is the relationship, if any, between Board diversity and company performance in the financial service sector? Ability to more accurately reflect the diversity of the shareholders. Avoidance of group-think. Any further comments relevant to corporate governance in financial institutions would be welcomed. We need a common and robust theory of governance and a holistic approach to its implementation. The continuing confusion between governance and management continues to impede our ability to hold all the players to account in a clear and fair manner. About the UK Policy Governance Association The UK Policy Governance Association (UKPGA) is a non-profit organisation committed to promoting owner-accountable, ethical and effective governance using the Carver Policy Governance®1 model. Caroline Oliver Chair 23 May 2012

1 1Policy Governance® is the registered service mark of John Carver. Used with permission. The ® after Policy Governance is a symbol used to protect the integrity of the principles and practices that make up the Policy Governance model. Its use does not imply any financial obligation to the service mark owner. The authoritative website for the Policy Governance model can be found at www.carvergovernance.com

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Written evidence submitted by Hermes Equity Ownership Services Board structure and composition 1. What outcomes should corporate governance in the financial services sector seek to achieve? The duty of directors of UK incorporated companies is clearly laid out in the Companies Act 2006, as to promote the success of the company for the benefit of its members as a whole. Too often boards believe that their role is simply to generate shareholder value, but the good sense of the Companies Act is to require something broader and more long-term than that is often understood to be. The Companies Act (section 172) goes on to set out how the success of the company can best be promoted, in an articulation commonly referred to as ‘enlightened shareholder value’, which encompasses running the business with a full consciousness that it will only succeed if it considers the interests of customers, suppliers, employees, the community and the environment – and seeks to maintain a reputation for high standards of business conduct. Corporate governance is not an end in itself. It is a framework to enable boards and directors individually to deliver on their duties to promote the success of the company. The outcome that good governance seeks to achieve must be this articulation of directors’ duties. While a number of companies relevant to the Committee’s inquiry are not incorporated in the UK, we nonetheless believe that this same outcome of governance must apply to them as well. We fundamentally believe that this articulation of directors’ duties is the right one, and so firmly support boards which seek to establish non-standard governance structures to enable them effectively to deliver upon it. 2. Are Board structures effective? For example, should UK financial institutions consider adopting alternatives to the unitary Board structure? Boards are groups of individuals. The structures within which they operate matter less than the way those individuals interact with each other, either formally or informally, with the proviso that individuals need to know how to make best use of the structures within which they interact. We believe therefore that encouraging alternative board structures would not be a productive avenue to pursue, not least because the majority of directors of UK companies are most experienced with unitary boards and therefore are most likely to make them work most effectively. The current Companies Act permits banks and other companies to choose alternative structures, but we believe that – because of directors’ familiarity with the unitary board structure – any requirement to use alternative structures might lead to less effective decision-making for a period of time. Unitary boards face the risk that there can be excessive cosiness between the non-executive and executive directors, but they have the advantage that non-executive directors can have more direct access and insight into the business. The strictures of the Corporate Governance Code are ways of mitigating these risks and encouraging the right forms of behaviour in the boardroom. All board structures require directors

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to act effectively, carry out their duties with diligence and avoid the risks of groupthink. We favour a focus on these behavioural aspects rather than the structural issues; using structural methods to address behaviour is less likely to produce a good outcome than focusing on the behaviour itself. 3. Does the UK approach to regulation and supervision of financial services incentivise Boards to perform their role effectively? Is more intrusive regulation a substitute or complement to effective corporate governance? Is a "comply or explain" approach an effective framework for governance? We are strong supporters of the comply or explain approach. This creates an opportunity for flexibility where the circumstances of the business make that necessary or appropriate. We also believe that it builds in a basis for challenge and debate, such that there is a dynamic of discussion around governance between the company and its shareholders. This does require shareholders to step up and fully play their role in this process – something we discuss further below – but this dynamism is of real importance. Good governance is not a fixed point; it needs energy and to be lived in practice. We are concerned that the FSA may be stepping beyond an appropriate level of supervision to excessive intrusion. One bank director recently commented to us that the level of direction (the example given was asserting the appropriate level of pay for a relatively junior compliance officer) risked exposing the FSA to charges of being a shadow director. This disquiet reflects our concern that the regulator’s actions may be overstepping the mark. We are also concerned by the FSA’s requests to attend board meetings of regulated entities, and have encouraged those banks which have declined to welcome FSA staff into their boardrooms; we do not believe that this sort of activity will provide a benefit. The level of supervision of financial institutions prior to the crisis is widely accepted to have been inappropriately low but we fear that the swing of the pendulum has gone too far and there may now be excessive intrusion. It risks disempowering boards and making them less effective rather than more so. The risk is that rules will inevitably lead to formal, legal compliance with the letter rather than the spirit of the law or regulation. In turn this leads to behaviour that is focused on formal, defensive compliance (which easily drifts into a gaming of the system) rather than the sort of culture and approach that we seek, which is a dynamic of seeking improvement within appropriate risk parameters rather than mere compliance. We believe that it is this culture which is more likely to secure the successful future of the banking industry and limit the risks of future failures. Regulation which bolsters the principle of fiduciary duty – both in terms of the duties of directors and in terms of the duty to clients (discussed further below) – is more likely to be effective than detailed and prescriptive rule-based regulation. Corporate culture 4. What type of corporate culture should financial services firms seek to foster? In what way can this be encouraged? How effective are Boards at shaping corporate culture within their institutions?

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The corporate culture of every financial services firm must be to focus first on the interests of its clients. By delivering value to clients, the firm will prosper for the long run. It is also the nature of much of the financial services industry that it acts in a fiduciary capacity, stewarding money on behalf of its beneficial owners. It concerns us the extent to which much of the financial services industry fails to consider fully the implications of the fiduciary duties which apply to it – too few firms state that they put clients’ interests first, and fewer still have the structures and practices in place to deliver on such assertions. We believe that there would be considerable value in reassessing and perhaps reasserting the understanding of fiduciary duty such that it is more fully at the forefront of the minds of every individual within the financial services industry. The board’s role in instilling corporate culture can only be limited; as with many issues the primary role must be for the executives, with the whole board’s role limited to: (i) ensuring the heads of the organisation have the right cultural approach, (ii) calling management to account in respect of the issue, and (iii) agreeing the culture and playing a role in setting the tone from the top of the organisation. The board can agree what the culture ought to be, and certainly can ensure that individuals with the wrong cultural approach are not at the heads of organisations, but shaping and delivering on that agreed culture is the responsibility of the executive team. The non-executive directors can examine, critique and discuss their performance in delivering this – just as can other parties, not least the shareholders and regulators. Impact of previous reviews and new regulatory developments 5. What difference would the proposals in the Independent Commission on Banking's report on the Boards of ring-fenced banks make to corporate governance in these institutions? We are firm supporters of the Independent Commission’s proposal for banks to ring-fence their retail operations. We believe that one of the fundamental reasons why banks have tended to take on inappropriate risk is because capital is fungible between investment banking and other risky activities and the banks’ less risky operations. We believe that unless and until different banking activities face specifically appropriate costs of capital there is in effect a cross-subsidy to the high risk businesses from less risky activities. Without the appropriate costs of capital being applied the risks of activities are not appropriately priced in, and banks will continue to make mistaken assessments as to the risk/reward trade off of certain activities. We believe that because of this clear enhancement to the clarity of the application of capital, the governance of banks under the ring-fencing proposals will be significantly enhanced. 6. What benefits, if any, come from EU regulatory engagement with corporate governance issues?

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We believe that the EU’s current focus in respect of corporate governance – which is less about the governance of the corporation and more about the role of shareholders and issues in the investment chain – is appropriate for the current state of the market. We believe that the failure in the chain of accountability, which in one crucial sense is what governance standards are seeking to ensure, is less within companies – which have made significant positive changes over the past several years – than it is within the investment chain. Above we note that the culture of any financial institution including and perhaps especially institutional investors needs to be based on an initial focus on its clients’ interests. This focus needs to be present throughout the investment chain such that it works more effectively in the interests of its underlying beneficiaries, something that is often not demonstrably delivered. 7. What impact has the Walker Review (2009) had on corporate governance and corporate behaviour in financial services? It is still early days for the Walker Review recommendations to have had an impact by working fully through the system, but the early signs are positive. The Walker recommendations fell into 4 categories: professionalising NEDs and enabling more effective board dynamics; making engagement between shareholders and companies more effective; enhancing the governance of risk; and enhancing the oversight and accountability around remuneration. Given that these four categories appear to have driven the structure of the Committee’s following questions, we consider the impact of Walker in each individual area below. Non Executive Directors 8. Should non-executive directors bear greater liabilities than under current law? Should executives in FTSE 100 companies be able to hold non-executive positions in other firms? We do not believe that it would be productive in terms of the quality of available non-executives nor in terms of the quality of board debate for the level of liability that individuals face to be increased. In our experience, many of the most productive and proactive non-executive directors are also executives at other companies. We believe that their non-executive roles also help improve their effectiveness in their own boards. While we would be uncomfortable about such an individual holding multiple non-executive director roles, we firmly believe that it would be a marked negative were a ban to be introduced on executives holding any non-executive positions. With regard to the Walker recommendations we believe that these have been positive in making clear the professional role and standards expected of non-executive directors. They have served to bring the minimum standards closer towards the level of best practice. The recommendations on the role of the chair and on the approach of the board are more behavioural and will inevitably involve a greater time-lag such that their success will be harder to judge. The recommendations are right and appropriate and we believe the right steps are being taken by most boards; the

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recommendation which perhaps needs most ongoing attention is the effectiveness of the board evaluation process. 9. Is the existing FSA approval process for significant influence functions (SIF), including non-executive directors, effective? It certainly appears effective in discouraging candidates from putting themselves forward and in weeding out individuals from among those proposed. Whether the right individuals are discouraged or barred we simply do not know. We fear that some good candidates do not come forward at all. Our dialogue with non-executive directors indicates that they take the FSA approval meetings extremely seriously and feel them to be tough. However, they are not always convinced that the focus of the discussions is in the right areas. The role of shareholders 10. Should shareholders be required to exercise a stronger role in systemically important financial institutions? What are the key barriers to greater shareholder activism by institutional investors in financial institutions? What risks are associated with it? At present the greatest threat to increased shareholder involvement in the governance of financial institutions is that they are crowded out by the close involvement of the FSA and other regulators. The approval process for directors limits the scope for shareholders to impose themselves in the nominations process and makes it harder for investors to seek the removal of individuals that they see as failing to perform in their role. The FSA seems indifferent to investor views on director quality, preferring its own judgements to those of others – its response to attempts at communication have been unwelcoming at best. The situation is even more extreme with regards to remuneration, where the detailed prescription on pay structures and levels set by the FSA and other regulators mean that the role for investors risks being extremely limited. Where we disagree with the approach of the regulators, our voice is inevitably ignored. We do not think that shareholders should be required to exercise a stronger role, but we do think that they should do so, and further we fundamentally believe that it is in their interests for them to do so – certainly it is in the interests of their underlying beneficiaries that they should do so. Perhaps the most radical and welcome element of the Walker recommendations was in this area, requiring the establishment of a Stewardship Code in the UK and its oversight and regular review by the FRC. The introduction of the Code has had some impact, and many fund managers have asserted their compliance with it; however, the extent to which this is genuinely delivered in practice is open to question. The unwillingness of the industry to encompass the Stewardship Code in fund management mandates is perhaps the strongest indicator that there may be less delivery in practice than is asserted in theory. An industry delivering fully on its fiduciary duties to customers would be more active in taking forward stewardship responsibilities.

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11. Is it realistic to expect sovereign wealth funds and hedge funds to undertake a more active role? While generalisations in the field of hedge funds are difficult, we do not believe that it is in the nature of the majority of hedge funds to take a close interest in the stewardship of companies in which they invest – indeed most hedge funds would not regard themselves as investors in companies at all, but traders in financial instruments. A handful of hedge funds have explicit activist strategies, but beyond these we do not see this class of investors taking a more active role. Sovereign wealth funds, however, are long-term investors and therefore have a strong financial interest in fostering the long-term well-being of the companies and markets in which they invest. In the past, they have been wary of exercising this role because of some unfortunate negative media coverage suggesting that they might act as arms of public policy for their nations. We believe that this concern is eroding and that sovereign wealth funds are now more actively considering how to exercise their role as stewards. This is clearly a positive step for stewardship and the accountability of companies to their owners. Remuneration 12. What role should institutional investors, remuneration consultants, employees and others play with respect to remuneration in the financial services sector? We note our significant concerns with regards to the level of regulatory intervention in the area of remuneration. One director has suggested to us that the FSA risks becoming a shadow director in banks given the detail of its prescriptions. It certainly risks crowding out the role of shareholders. Nonetheless, we naturally believe that shareholders have an important role to play in the area of remuneration, and we actively seek to call remuneration committees to account for their decisions both in relation to senior management and throughout the highest paid individuals in financial institutions. We believe that this is a necessary role to preserve and enhance value over time in the companies in which our clients invest. The question also asks about the role of remuneration consultants. We believe that the Walker recommendations regarding such consultants were well-judged and necessary. We do not yet have full confidence that remuneration consultants have lived up to the implications of developing a code of conduct which sets and enhances the approach of the industry, nor do we have significant faith in its industry body in which independent influence is minimal. Neither do we yet see remuneration committees consistently and fully taking control of the relationship with their consultants rather than the consultants’ relationships being more with the executive side of the business.

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13. Is there a case for introducing still greater transparency for senior executives with respect to remuneration in the financial services sector? We do not believe that additional data is necessary. We have made various proposals to the Department of Business Information and Skills in reflection on its recent consultation on pay to suggest ways in which disclosures can be enhanced so that there is more information value in company disclosures and investors can more clearly and straightforwardly understand the data provided. 14. Should there be further reform of the remuneration arrangements of senior executives in the financial services sector? Should this extend to those highly paid individuals who sit below executive level? Simply put, the financial services sector pays excessive remuneration. Compensation ratios – the level of staff pay compared to revenues – are too high across the banking industry. We believe that these ratios are unsustainably high especially in the new world of higher capital requirements and lower returns on that capital, as they do not leave sufficient returns to the shareholders who are putting their capital at risk. The market’s general concern about this issue can be seen in the low valuations on banks at present and the unwillingness to invest new equity capital. Simply put, shareholders are not convinced that they will get an appropriate return on any capital that they invest – principally because too much of the reduced pie continues to be paid to the staff. We believe that more banks are incorporating an appropriate cost of capital in assessing the performance of staff, and considering risk-adjusted returns rather than simple returns. But we believe that the industry still has further to go in these regards. These are necessary steps to assess properly what sort of performance needs to be rewarded and to what extent. The industry also needs to be better at assessing individual performance and be willing not to award significant bonuses (or indeed inflated fixed pay) to underperformers. 15. The Chairman of the Financial Services Authority has argued that there may be a case for changing the personal risk return trade-off for bank executives. He has suggested either a strict liability legal sanctions or an automatic incentives based approach. What are the merits and drawbacks of these proposals? Are there other ways to achieve the same objective? These options are considered in the chair’s introduction to the FSA report on the failure of the Royal Bank of Scotland, and even the author suggests that there are significant problems with either proposal. Most importantly, both approaches risk making it considerably harder to attract the high quality individuals that we need to have on bank boards. Unless we have the highest quality boards available to us we risk failing to deal with the next crisis as we focus on learning the lessons of the last. In particular, Lord Turner acknowledges the significant problems around a strict liability model – not least the potential for injustice and the complex legal issues around the burden of proof. This seems to us unworkable and not worth further consideration.

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Under the headline of the incentives approach, he makes two separate proposals – automatic bans for the directors of failed banks and pay in deferred shares which would have to be held for the long term. We believe that these ideas are worth some active consideration, though we do not believe that either requires a significant change from the current approach. The key directors of the failed banks have largely removed themselves from relevant boards, even though (with a single exception) there have been no outright regulatory bans. Shareholders have made it reasonably clear that they would not welcome the presence of these individuals on relevant boards. Extending this approach from the key directors to all risks some injustice, and perhaps shareholders are best placed to mark the divide between these two categories. The idea of directors holding shares for the long-term is one which we are actively promoting not just within the banking sector but more generally as we see this as the way most likely to be effective in avoiding payments for failure and linking pay to appropriate long-term performance. We are attaching a discussion paper on executive remuneration which considers this as a key way forwards in this respect generally. There is perhaps in addition one simple way of dealing with the problems which sparked the demise of Royal Bank of Scotland – apart from wiser and more effective shareholders acting fully in their clients’ interests – which would be for regulators to bar hostile bids in the banking sector, something which Lord Turner’s introduction hints at but does not make explicit. Clearly also the tougher capital requirements which are coming into force would have limited the risks. Governance of risk 16. Has the management of risk in firms improved since the financial crisis? This is something which, unfortunately, is not as apparent to shareholders as it might be. We have had active dialogue with the chief risk officers or equivalents at a number of the leading banks – something which was not made available prior to the crisis – and we have been able to gain some assurances as to their reporting lines and scope of action. These seem now to be established in the appropriate way for the risk team to operate effectively, which we have welcomed and supported. However, whether risk management is fully delivered in practice is less clear to shareholders, and can really only be tested through the failures to manage risk effectively – which unfortunately still seem to be occurring. We believe that the Walker recommendations in this area were appropriate and broadly accepted by the industry (they reflected contemporary best practice), and from what we have seen they have been implemented effectively. Diversity and background 17. What is the relationship, if any, between Board diversity and company performance in the financial service sector? Boards are most effective if they provide debate and challenge, and a degree of discomfort for the executive team – while at the same time supporting management in the delivery of the company’s strategy. This is a difficult balance to strike, and it is

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the role of the chair to ensure that the right balance of challenge and support is felt within the boardroom and more broadly in the interactions of the non-executive and executive directors. Diversity’s value is in increasing the number of perspectives around the boardroom table, reducing the risk of groupthink and making it more likely that a range of difficult and challenging discussions occur. It is not a panacea – the boards of some companies that have failed were significantly diverse – but it can be an important element in making boards more likely to succeed. Any further comments relevant to corporate governance in financial institutions would be welcomed. We make such comments under three headings:

• Remuneration and regulation – proposed next steps • Accounting issues; and • Auditor dialogue with regulators

Remuneration and regulation – proposed next steps We attach two documents which articulate our positions with regards to financial institutions:

1. Banking remuneration principles 2. Rewriting the rules of the banking sector

We also attach a discussion paper that we produced regarding pay more generally – the discussion paper being our commentary compiled ahead of a seminar we held which brought together the remuneration committee chairs or their representatives from 44 FTSE 100 companies with their underlying owners in the firm of trustees and executives from leading pension schemes. We believe that each of these three documents is relevant to the Committee’s inquiry and may be helpful in your deliberations. Accounting issues The allegation is sometimes raised by various parties that fair value accounting played a role in the crisis, and this question will no doubt be raised once again to you. We are not convinced that this is the case and so feel it is appropriate to discuss this complex issue briefly. It is worth stepping back to consider what the purpose of the reported accounts is. Under English law, this is to communicate corporate performance and the current position to the current shareholders. The communication enables shareholders to understand the performance of their company, and just as importantly it forms a basis for shareholders to hold management and the board to account for their stewardship of the company's assets. So our test for whether accounting for banks is appropriate is whether it best serves this underlying purpose – providing the information that shareholders need to assess performance and where necessary to call management and boards to account. We see no practical alternative to fair value accounting for financial instruments; while this offers no more than a snapshot which will not remain representative of

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values even a short time after the snapshot is taken, it is necessary to have a basis on which to call management to account. Without fair values JP Morgan would not yet have needed to reveal its recent $2 billion loss, limiting shareholders’ opportunity to discipline management over such a significant issue. The fact that the loss may well be greater when the positions are finally liquidated does not mean that we do not welcome knowing of the existence of the $2 billion now. The other area criticised under the headline of fair value accounting is with regards to the impairment of debt. IFRS was clearly wrong about this, and we welcome the IASB’s agreement to move to an expected loss approach rather than a incurred loss model. It is unfortunate that this change to the far more appropriate expected loss approach is being delayed and we are encouraging the IASB to accelerate this key change. We have also in recent times been encouraging banks to make more disclosures around impairments such that it is possible for investors to understand what the expected losses might be even though the new standard is not yet in place. But we are not convinced that the incurred loss model is correctly called fair value accounting – at least one academic points out that the expected loss approach can much more accurately be considered to be the fair value of the debt. Having highlighted these two specific areas, there is a more general issue. One key allegation with regard to fair value accounting is its procyclicality – boosting performance in the upswing of markets and making the downswing much more painful. Procyclicality is clearly unhelpful but we are not sure that fair value accounting was the biggest driver of procyclical behaviour in the run-up to the crisis. Rather, money was too cheap (in the form of consistently low interest rates, lowered every time there was a chance the long boom – laughably then considered the ‘great moderation’ – showed signs that the bubble might have sprung a leak); regulators acted in a procyclical manner, rather than countercyclically, by relaxing supervision and regulations and basing capital requirements on banks’ flawed internal models; and all of us were sucked into believing that the prices in markets were reflections of reality rather than leveraged gambles that prices would continue to rise. For there were an awful lot of real transactions in those unreal markets, particularly in terms of property and securitisation. In many ways, securitisation is simply a way for banks to turn illiquid assets into realised profits. There is no question of whether an asset should be valued at mark-to-market or mark-to-model, or held on the books at historic cost, when it has been sold in an open market transaction. Accounting can never be a substitute for common sense, whether on the part of investors, directors, auditors or regulators. It can never be a substitute for effective regulation and supervision. All parties need to think and to act in a countercyclical manner. The irony is that in the aftermath of the crisis almost all of these parties are continuing to act in a procyclical manner by tightening standards and their approaches in the downswing. It is perhaps no more than human nature. Auditor dialogue with regulators We share the disappointment felt by the House of Lords Select Committee on Economic Affairs that the practice of active dialogue between auditors and regulators fell into disuse. We welcome the fact that these discussions appear to be happening

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again, though we are clear that this needs to be a two-way dialogue in order for it to be most effective in limiting systemic risks and safeguarding value for shareholders. 24 May 2012

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Written evidence submitted by Legal & General Group Plc This response is submitted on behalf of Legal & General Group Plc. Legal & General is a leading FTSE 100 company and provider of risk, savings and investment management products. Established in 1836, the Group has over seven million customers in the UK for life assurance, pensions, investments and general insurance plans. Our fund management arm, Legal & General Investment Management (LGIM) is one of Europe’s largest institutional asset managers and a major global investor. LGIM manages £371 billion in assets for more than 3,300 clients (as at 31 December 2011), and is recognised for its active approach to corporate governance issues. LGIM is a long term investor and seeks to engage on both performance and corporate governance related topics with the aim of creating sustainable long term shareholder value. Summary

• Good corporate governance underpins the long term success of a company. • Shareholders have an important role to play in setting new and higher standards of

stewardship and engagement with the companies in which they invest. • We strongly support the ‘comply or explain’ principle as we believe it acknowledges

that a “one size fits all” approach is inappropriate. • Excessive regulation risks hampering the activities of company management and may

lead to a decline in growth and the creation of shareholder value. • A balance between prescriptive corporate governance requirements, guidance and

voluntary codes which preserves flexibility for companies to operate to their individual circumstances whilst providing shareholders with the ability to assess companies’ corporate governance arrangements is desirable.

• Good corporate governance is ultimately about the right behaviours and culture within an organisation. In our view no amount of prescriptive rules can guarantee this behaviour. This can only be encouraged, not prescribed.

• Changes in culture and behaviours take time and the amendments to the corporate governance framework introduced since the financial crisis should be given a period to embed before further action is taken. Any case for further change needs to consider whether measures already introduced have had the desired effect of changing behaviours.

Our feedback on selected questions in the terms of reference follows. Board structure and composition 1. What outcomes should corporate governance in the financial services sector seek to

achieve? Corporate governance is about achieving the right behaviours within financial services companies, encouraging the right culture, promoting shareholder and consumer confidence in individual companies and the financial services sector as a whole, and ensuring that the interests of all stakeholders, including shareholders and customers, are appropriately represented and aligned. This is not an outcome unique to the financial services sector, although the financial crisis severely impacted confidence in that sector. As such, corporate governance outcomes are of particular importance for financial services companies and their stakeholders to support a rebuilding of lost confidence. 2. Are Board structures effective? For example, should UK financial institutions

consider adopting alternatives to the unitary Board structure? UK financial services company board structures are effective. Recent corporate governance changes including encouraging greater diversity in board membership represent further steps towards enhanced board effectiveness. LGIM has been very active in this area and is a

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member of the 30% Club1. We see no compelling case for alternative board structures. There was no evidence that supervisory boards fared better in the crisis or that they were more effective than unitary boards. The effectiveness of boards comes down to the calibre of the individuals, who must have a clear understanding of their role and responsibilities and the tools necessary to discharge their responsibilities effectively. Many initiatives, including the Walker Review, the March 2011 FRC Guidance on Board Effectiveness, together with various FSA publications including the Statements of Principle and Code of Practice for Approved Persons, and the FSA's expectations of non-executive directors in ensuring effective corporate governance have helped the directors of financial services companies to better understand the expectations of their role and responsibilities and the tools they should employ to effectively discharge their responsibilities. 3. Does the UK approach to regulation and supervision of financial services incentivise

Boards to perform their role effectively? Is more intrusive regulation a substitute or complement to effective corporate governance? Is a "comply or explain" approach an effective framework for governance?

Regulator engagement with firms very much complements effective corporate governance, in the same way that shareholder engagement with their investee companies encourages companies to improve standards and behaviours. The approach to regulation and supervision can assist in providing assurance that a firm has appropriate processes and structures in place for effective corporate governance. If focused on material issues and undertaken in a balanced way by suitably qualified professionals, the regulator’s input is likely to be welcomed and considered a valued contribution. However, this may not be the case where supervision lacks focus on matters of materiality or relevance to the regulator’s objectives. Further, intrusive regulation is unlikely to be productive where engagement is with a changing group of junior personnel who lack understanding of the firm’s business and have insufficient experience compared with that of the often senior and very experienced individuals who sit on the boards of financial services companies. The more intrusive regulatory approach does risk FSA becoming excessively involved in the management of firms, at the extreme potentially becoming shadow directors, undermining FSA’s own ‘senior management responsibility’ principle and could risk regulatory judgment substituting board decision making. As discussed by Baroness Hogg at the Sarasin Conference on 6 October 2011, it is crucial that regulators do not usurp the role of boards, or of shareholders, thereby threatening the chain of accountability. Increasing intrusiveness may also be counterproductive. With increasing requests for FSA to attend board meetings, FSA’s presence could in fact inhibit board discussion and discourage frank debate, thereby undermining board effectiveness. It also raises questions about the regulator's role if there are failings at a firm where FSA has been a regular attendee at board meetings. We believe the ‘comply or explain’ approach does provide an effective framework for governance in the UK. 6. What benefits, if any, come from EU regulatory engagement with corporate

governance issues?

1 Fundamentals – “Healthy Debate” – November 2011 - http://www.lgim.com/_resources/pdfs/about-lgim/Fundamentals_November%202011.pdf

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Engagement to ensure consistency in corporate governance requirements across the EU is desirable. However, we believe that prescriptive requirements imposed at EU level and which are not considered necessary for the UK should be avoided. By way of example, Lord Davies recently commented that the progress made in increasing the number of women on FTSE company boards following the Davies Report is evidence that UK business is taking board diversity seriously, working to bring about change voluntarily. It would be undesirable for a slower pace of change at EU level to result in the Commission introducing compulsory quotas for the UK as may be the outcome of the current EU consultation on the gender imbalance on EU boards. In addition, the culture and structure of European companies differ greatly from that of those in the UK. For example, the general level of transparency and disclosure of corporate governance arrangements in European companies are not as advanced as UK Plc. Therefore, the ‘comply or explain’ approach works well in the UK but a more prescriptive, rules based system may work better in the rest of Europe. 7. What impact has the Walker Review (2009) had on corporate governance and

corporate behaviour in financial services? The Walker Review made a significant contribution in promoting increased corporate governance standards in financial institutions in the wake of the financial crisis, in particular through providing greater clarity specifically for financial services companies and their directors on corporate governance behaviours and outcomes expected of the sector. These have since largely been translated into expectations for listed companies of all sectors. The Walker Review has also increased the focus on the ‘risk culture’ of companies and improving systems internally to ensure the stability and health of financial organisations. 8. Should non-executive directors bear greater liabilities than under current law?

Should executives in FTSE 100 companies be able to hold non-executive positions in other firms?

Executive and non-executive directors have the same duties under company law and the concept and practice of the unitary board would be undermined by any statutory distinction in legal accountability. There is also a risk that the already limited pool of non-executive director candidates for financial services companies would be further limited. We see no case for differentiation – indeed, effective decision making could be undermined through a limitation on the pooling of executive and non-executive capabilities in decision taking. We believe it adds to the breadth of experience of executive directors to be able to hold one non-executive position at another firm, subject to the time commitment not interfering with the discharge of their executive responsibilities. By allowing an executive director to participate in another board they gain valuable insight and experience including understanding the wider macroeconomic environment and issues outside the financial services sector, and corporate governance practices, processes and behaviours that may promote or undermine an effective board. This is important experience to bring back to their executive role. 9. Is the existing FSA approval process for significant influence functions (SIF),

including non-executive directors, effective? The FSA approval process is now more intensive than previously, and it does promote greater rigour in the firm’s own appointment process. It is not clear, however, whether this will translate into more effective boards. . The focus on corporate governance and board effectiveness by financial institutions themselves has influenced companies’ approach to defining the specification for a new appointment, such as pursuing greater board diversity and reflecting the enhanced guidance on the role and responsibilities of non-executive directors.

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We would caution that the FSA approval criteria for significant influence functions does significantly limit the pool of candidates available to financial services companies. With FSA’s expectations as to knowledge and competencies of the firm’s business, market environment, risk management and the regulatory framework, it is in practice difficult for financial services companies to put forward candidates from outside the financial services sector for board appointments. We have also experienced FSA seeking information as part of their approval process on the other candidates considered for the appointment and an explanation of why candidate X was preferred over candidate Y. There is a risk this intrusiveness leads to FSA usurping the role of the board in deciding the best person for the role. 10. Should shareholders be required to exercise a stronger role in systemically

important financial institutions? What are the key barriers to greater shareholder activism by institutional investors in financial institutions? What risks are associated with it?

11. Is it realistic to expect sovereign wealth funds and hedge funds to undertake a more active role?

The introduction of the Stewardship Code in July 2010 recognises that alongside the focus on company corporate governance practices and behaviour, there also needs to be a reciprocal focus on the need for shareholders, and in particular institutional investors, to engage actively with companies on issues as part of exercising their stewardship role. The Stewardship Code already obliges institutional shareholders to engage in dialogue with the companies in which they invest on a ‘comply or explain’ basis and we would question whether additional prescription would increase meaningful dialogue. Engagement gives investors the opportunity to learn about a company’s strategy, operations, financials and external challenges and opportunities, all of which are essential to be able to exercise their stewardship duty in the most effective way. More importantly, engagement means investors can voice concerns before voting at general meetings and allows an exchange of ideas with the company. Engagement in a collaborative environment can achieve significant changes if shareholders are unified on their approach and a regular and consistent approach to engagement is vital in order for it to be successful. Therefore, we would question the case for creating a two tier approach for shareholders as regards the financial services and non-financial services companies in which they invest. This may have unintended consequences including reducing the investment case of financial services companies as shareholders move away from the sector to avoid the costs and burden of prescribed increased stewardship obligations over and above the non-financial services companies they invest in. 12. What role should institutional investors, remuneration consultants, employees and

others play with respect to remuneration in the financial services sector? 13. Is there a case for introducing still greater transparency for senior executives with

respect to remuneration in the financial services sector? 14. Should there be further reform of the remuneration arrangements of senior

executives in the financial services sector? Should this extend to those highly paid individuals who sit below executive level?

Executive and senior management remuneration in all companies, not just the financial services sector, is currently an area of intense focus. Issues relating to executive remuneration and transparency are not confined to the financial services sector. We would be concerned by any move to prescribe specific reform for the financial services sector.

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Remuneration questions have been, and continue to be, a focus from the Walker Review to the FSA remuneration code, and most recently the BIS consultations on the future of narrative reporting and enhanced shareholder voting rights over executive remuneration and discussion paper on executive pay. It is crucial that changes already introduced and those proposals that are currently being consulted on are given time to embed. Changes in behaviour do take time and any case for further reform needs to consider if the measures already introduced have had the desired effect of changing behaviours. Layering change upon change without due consideration of whether the initial changes have had the desired impact is likely to cause confusion, could lead to unintended consequences and risks shifting focus away from changing behaviours to a tick box approach. We also believe that like good narrative reporting, transparency on executive pay and a clear link between pay and performance will become a differentiator between companies. The combination of peer company practice, media focus and governance changes already introduced is likely to bring about remuneration reform with no need for further prescriptive reform. 16. Has the management of risk in firms improved since the financial crisis? Risk management in financial services companies has taken on much greater prominence since the financial crisis. As noted by the FRC in their September 2011 report on “Boards and risk”, there has been a step change in the board's focus on risk in the last few years, reflecting the emphasis in the revised UK Corporate Governance Code on the board's responsibility for strategic risk decision-making. There have also been significant changes to firms’ risk management frameworks, including the establishment of board risk committees with responsibility for oversight and advice to the board on risk exposure and risk strategy and the recommendation that all financial services companies should be served by a Chief Risk Officer. 17. What is the relationship, if any, between Board diversity and company performance

in the financial service sector? Board diversity contributes to greater board effectiveness through diversity of background and experience leading to greater diversity of thought and point of view around the board table. As noted above, the FSA approval criteria for significant influence functions does limit the ability of financial services companies to achieve greater board diversity through significantly limiting the pool of available candidates. It is uncertain at this time as to how in practice financial services companies will achieve greater board diversity notwithstanding that diversity is recognised as contributing to enhanced board effectiveness. As highlighted in our response to question 2, LGIM has done a lot of work in this area and has applied this to all companies. 24 May 2012

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Written evidence submitted by the Financial Services Consumer Panel

Introduction

1. The Financial Services Consumer Panel has a statutory role in financial services regulation which will continue under the new regulatory regime with the Financial Conduct Authority (FCA). Consequently, we take a close interest in issues which have a significant impact on consumers of financial services such as this.

2. Effective corporate governance is of paramount importance given what

we have learned the implications can be for ordinary consumers when those charged with the responsibility fall short of what is required. The Panel therefore supports the opening-up of the debate on how to improve corporate governance in systemically important financial institutions. We have a particular interest in improving the consumer input at Board level, ensuring that the consumer interest is taken into account in all areas of a firm’s business, while of course noting how important it is that any proposed interventions are proportionate and do not impede the sound recovery of the financial services sector. Given that there have been at least 3 other similar such reviews of corporate accountability undertaken in the last 15 years we hope that the recommendations which are taken forward in the course of this inquiry can implement real positive change.

3. In the course of the text below we have only produced answers to

those questions where we have sufficient knowledge. On other questions we have no evidence to submit.

Executive summary We have set out in this evidence our responses to the questions asked by the Committee and the key points are summarised below:

4. Good corporate governance requires delivery of an agreed strategy, a clear understanding of the related risk appetite and the establishment of a robust control framework. Structures, controls and processes should be operated by individuals with appropriate experience, be supported by a strong culture and, critically, be incentivised in a way which is in the best interests of consumers.

5. One structural improvement we believe should be made, given the

benefit for all stakeholders in rebuilding customers’ trust in banks, would be to strengthen representation of the consumer interest on the boards of major firms.

6. The FSA has long been calling for the principle of Treating Customers

Fairly (TCF) to become part of the corporate culture of authorised firms. We have always supported this approach and see our proposal

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to strengthen representation of the consumer interest on the boards of major firms as a natural development of that, with a nominated member of the board taking a proactive role in ensuring that this is taken into account in all areas of a firm’s business.

7. Systemically important institutions would also potentially benefit from

improving the diversity on their Boards – given that the pool from which these individuals is drawn from is probably shrinking as liability risks increase.

8. In terms of corporate governance there would need to be distinct

arrangements and different cultures in place if UK retail subsidiaries were to be legally, economically and operationally separated from the rest of the banking groups to which they belonged. Independent governance would be essential if it were to be ensured that those who managed a ringfenced bank were to have appropriate incentives to act in the interests of that bank.

9. We believe there is definite merit in exploring the impact requiring

executive directors to bear greater liabilities than under current law could have on both firms and consumers.

10. We also believe there is justification in considering more fully the case

for a specific new criminal offence of ‘serious financial recklessness’ for executive directors. This would hold to account publicly those who have acted irresponsibly and may, quite reasonably, be a more effective deterrent than fines or bans.

Board structure and composition   What outcomes should corporate governance in the financial services sector seek to achieve?

11. We believe that good corporate governance can only manifest itself through the effective interaction of a firm’s board and executive. Through delivery of an agreed strategy, a clear understanding of the related risk appetite and the establishment of a robust control framework it should be possible to manage risk effectively across the business. Associated structures, controls and processes should be operated by people with appropriate experience, be supported by a strong culture and, critically, be incentivised in a way which is in the best interests of consumers.

Are Board structures effective? For example, should UK financial institutions consider adopting alternatives to the unitary Board structure?

12. It is self-evident that during the crisis governance failings contributed to excessive risk-taking in the financial sector and that non-executive directors (NEDs) failed to give an appropriate degree of challenge. We doubt, though, whether that was specifically an issue of Board structure

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given that different banks operating in the same financial and market environment and under the same structures and regulatory arrangements generated such massively different outcomes. This can only be fully explained in terms of differences in the way they were run. Therefore we see no obvious alternatives to a unitary Board structure.

13. One structural improvement we believe could be made, given the

benefit for all stakeholders in rebuilding customers’ trust in banks, would be to strengthen representation of the consumer interest on the boards of major firms. It is our view that the largest systemically important firms should be required to assign responsibility at Board level for the role of consumer advocate or champion, accountable for ensuring that the consumer interest is embedded throughout the organisation and reporting on performance in this area. The Panel would not expect this to be a discrete role – in many ways responsibility could rest fairly easily within the remit of the marketing division of a firm – but care would have to be taken to ensure that firms did not feel that they could ‘tick the consumer box’ simply by taking this step.

Does the UK approach to regulation and supervision of financial services incentivise Boards to perform their role effectively? Is more intrusive regulation a substitute or complement to effective corporate governance? Is a “comply or explain” approach an effective framework for governance?  

14. During the crisis it is arguable whether senior management in some firms were complying with their existing obligations under the FSA’s rules, which are set out clearly in the Statements of Principle and Code of Practice for Approved Persons, (APER). In addition the FSA’s ‘light touch’ approach manifested itself in the form of inadequate supervision and enforcement of these rules, of which we are still seeing the implications in the form of the PPI fallout. Clearly then the UK approach to regulation at that time definitely did not incentivise Boards to perform their role effectively.

15. Arguably, the FSA is now quite rightly demanding higher levels of

compliance and showing greater intent to take tough action where rules are broken. This cannot, though, ever be a substitute for effective corporate governance given that the FSA’s powers are not infinite. Even a toolkit which empowers the regulator to take action where significant risk is emerging can only work as a complement to effective corporate governance. In order to deliver better and fairer outcomes for consumers both need to work hand in hand.

Corporate culture   What type of corporate culture should financial services firms seek to foster? In what way can this be encouraged? How effective are Boards at shaping corporate culture within their institutions?

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16. Evidently, Boards have not been particularly successful in shaping the right type of corporate culture within their institutions or we would not have seen such widescale mis-selling of PPI. The culture which seems to have engendered such mis-selling appears to have been one of excessive profits and bonuses rather than one of high standards of customer service. One potential antidote to this would be for firms to embrace greater diversity when considering who to appoint as a NED. In the past candidates have often tended to come from a small pool of individuals with close inter-connections. Widening the search might have a positive impact on culture in particular.

17. The FSA has long been calling for the principle of Treating Customers

Fairly (TCF) to become part of the corporate culture of authorised firms. We have always supported this approach and see our proposal to strengthen representation of the consumer interest on the boards of major firms as a natural development of that, with a nominated member of the board taking a proactive role in ensuring that this is taken into account in all areas of a firm’s business. This would be entirely separate from ensuring that the firm is complying with the principle of TCF, where ultimate responsibility would rest with the member(s) of the senior management team/executive team with compliance oversight.

18. As an additional condition we also think it would encourage better

behaviour were a statement to be required in the annual reports of these large firms setting out which Board member(s) has/have responsibility for consumer issues and the steps that the firm has taken to ensure that TCF has been embedded throughout the organisation. It could work in a way similar to chairing the audit committee which is usually a non-executive function.

19. Another positive cultural characteristic which Boards should help

engender is one of reviewing and appraising performance on a regular basis. NEDs themselves should be subject to effective induction and ongoing performance appraisal processes but it is not clear that this is always the case. Ensuring that these processes are adhered to at Board level sets a healthy example for the rest of the organisation.

Impact of previous reviews and new regulatory developments   What difference would the proposals in the Independent Commission on Banking’s report on the Boards of ring-fenced banks make to corporate governance in these institutions?

20. The Panel welcomes the Independent Commission on Banking’s intention to improve the stability of banks’ retail operations, given their fundamental importance to millions of ordinary customers. In terms of corporate governance there would need to be distinct arrangements and different cultures in place if UK retail subsidiaries were to be legally, economically and operationally separated from the rest of the banking groups to which they belonged. Independent governance

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What benefits, if any, come from EU regulatory engagement with corporate governance issues?

21. MiFID II, CRD IV, PRIPS and IMD all include proposals on corporate governance and will form the blueprint for the future in this regard. The Panel welcomes any such regulatory engagement with corporate governance issues, at an EU or UK level, if it can be proven to increase standards and lead to better outcomes for UK consumers

22. One such example which we support is the MiFID II Directive proposal

to impose a diversity obligation on boards with respect to composition. This section of the Directive sets out a new template for board governance which we believe, in principle, is the type of reinforcement of good board practice which the EU should be promoting and fits with our recommendations under Corporate Culture above.

What impact has the Walker Review (2009) had on corporate governance and corporate behaviour in financial services?

23. We welcomed the majority of the proposals in the Walker Review. However, despite its increased scrutiny on governance and non-executive roles in ensuring effective risk management, it has yet to be proved whether the more intrusive approach has been widely adopted. Equally, despite some of the recent activity, it is unproven whether shareholders have, indeed, taken a more robust approach moving away from their usual timid collective stance.

Non Executive Directors   Should non-executive directors bear greater liabilities than under current law? Should executives in FTSE 100 companies be able to hold non-executive positions in other firms?

24. NEDs require sufficient financial industry capability and critical perspective to provide independent challenge. However, we believe there is definite merit in exploring the impact requiring NEDs to bear greater liabilities than under current law could have on both firms and consumers. In the foreword to the FSA’s Report into the failure at RBS Lord Turner suggested that the personal risk-return trade off for executives could be changed by either introducing a ‘strict liability’ of executives and Board members for the adverse consequences of poor decisions, or taking an incentives based approach. The latter could see senior executives and directors of failing banks banned from future positions of responsibility or have a significant proportion of their remuneration deferred in the event of failure. We would like to see such options given greater consideration by Government and regulator alike.

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25. We would like to draw the distinction here between executive and non-

executive directors. Although their legal responsibilities are the same it is more important for any sanctions against reckless directors to apply to those with executive responsibility. NEDs should be taking a strategic view of the business but are not responsible for detailed operational decisions. In order to widen the pool of NEDs – as we suggest should be done in our answers to the questions on Corporate Culture – then it has to be avoided making it a completely poisoned chalice.

Is the existing FSA approval process for significant influence functions (SIF), including non-executive directors, effective?

26. Currently, the FSA only approves individuals through a formal SIF interview when they are newly appointed to undertake specific functions at a firm. The individual has to prove he or she is fit and proper but the FSA does not have to reapprove an individual if the complexity of the job they enter changes significantly as a result of changes at the firm.

27. Legislation could be changed, so that where the nature of an

individual’s role changes significantly as a result of the growth of the firm, or a significant increase in their responsibilities within the firm, then they have to reapply to become an approved person holding a SIF role and prove they are competent to occupy the enhanced role. Another option would be to change legislation so that approval for certain SIF roles is time limited, requiring individuals to reapply after a fixed time. We think there is merit in considering these options in greater detail.

The role of shareholders   Should shareholders be required to exercise a stronger role in systemically important financial institutions? What are the key barriers to greater shareholder activism by institutional investors in financial institutions? What risks are associated with it?

28. Given the ‘shareholder spring’ – the movement among shareholders in recent months to push back loudly and forcibly against the companies in which they have invested to protect their interests – we believe there is a definite role to be played in this regard by shareholders of systemically financial institutions. The recent example of Aviva is a potent one, where shareholders failed to endorse the insurer's pay policies including packages for senior executives.

Remuneration   

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Should there be further reform of the remuneration arrangements of senior executives in the financial services sector? Should this extend to those highly paid individuals who sit below executive level?

29. We believe that senior executives’ remuneration packages should be more closely aligned to long term goals, which deliver real value for firms and their customers, rather than short term profits. Given the recent developments on CRD IV – where Parliament is considering capping bonuses to a year’s salary – and also the ‘shareholder spring’ there is potential for further positive change in this regard.

The Chairman of the Financial Services Authority has argued that there may be a case for changing the personal risk return trade-off for bank executives. He has suggested either a ‘strict liability legal sanctions or an automatic incentives based approach. What are the merits and drawbacks of these proposals? Are there other ways to achieve the same objective?

30. We outline above in our answers on NEDs that we would like to see such options given greater consideration by Government, in particular with regards to executive directors. In both instances the case against requiring bank executives to take on greater personal liabilities has already been widely made – the idea that it would potentially distort the incentives for directors to join the boards of banks relative to other financial services firms and UK banks relative to non-UK banks.

31. However, we believe the case for change with regards to executive

directors is rather more persuasive. A more conservative approach to risk would certainly be one likely impact and it would also be more likely to keep previously irresponsible individuals away from the industry. Furthermore, we believe there is also justification to consider more fully the case for a specific new criminal offence of ‘serious financial recklessness’ for executive directors. This would hold to account publicly those who have acted irresponsibly and may, quite reasonably, be a more effective deterrent than fines or bans.

Annex: about the Financial Services Consumer Panel

32. The Panel is an independent statutory body, set up to represent the interests of consumers in the development of policy for the regulation of financial services. It works to advise and challenge the FSA from the earliest stages of its policy development to ensure they take into account the consumer interest. The Panel also takes a keen interest in broader issues for consumers in financial services where it believes it can help achieve beneficial change/outcomes for consumers.

33. Members of the Panel are recruited through a process of open

competition and encompass a broad range of relevant expertise and experience. There are sixteen members of the Consumer Panel. Current members have experience of consumer advice, campaigning, communications, market research, journalism, the law, financial

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services industry, financial inclusion, European issues, financial regulation and compliance and later life issues.

25 May 2012

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Written evidence submitted by Pensions & Investment Research Consultants Ltd (PIRC)  

INTRODUCTION  We welcome the opportunity to submit evidence to the inquiry. Pensions & Investment Research Consultants Ltd (PIRC) has been an  independent adviser to pension funds and other  institutional investors for over 20 years. PIRC’s clients have combined assets in excess of £1.5 trillion and include some of  the  largest pension  funds, asset management companies and  insurance companies  in  the UK and overseas. Together, they comprise a diverse group of  institutional  investors with  long‐term liabilities and broad fiduciary duties.   PIRC  undertakes  company  research  on  corporate  governance  and  corporate  social  responsibility issues at public companies, and provides advice to clients on proxy voting strategies and other active shareowner  initiatives. Our  comments  are  based  on  two  decades  of  practical  experience, which inform our views on  the  strengths and weaknesses of disclosures, governance  structures, and  the interaction of statute, regulation and codes of practice.   PIRC’S RESPONSE TO THE INQUIRY  Response to specific questions  Please note we have only answered those questions where we have a particular view.  Board structure and composition  What outcomes should corporate governance in the financial services sector seek to achieve?    We believe that John Kay has identified the appropriate focus for such firms in the light of the global financial crisis:   “The purposes of equity markets are to generate returns for savers and to improve the performance of companies.  In the  long run, returns to savers will be equal to the returns earned by companies, less  the  costs  of  intermediation.  There  is  a  fundamental  alignment  between  the  success  of companies and the returns to savers.”   In this context we believe that financial services firms should be considered in a similar framework in that  their public company status  requires  them  to behave as  if  the  long  term  really mattered and that  their  responsibilities  to  shareholders  entail  appropriate  obligations  to  their  clients  and customers.    Are Board  structures  effective?  For  example,  should UK  financial  institutions  consider  adopting alternatives to the unitary Board structure?   There  is a danger that the UK oversells the benefits of a unitary board, as two‐tier boards seem to work perfectly well for many non‐UK companies. However it is also clear  that companies with two‐tier boards have failed in the crisis.   Perhaps the best lesson that the UK can learn in this respect is to acknowledge that other models are valid, and that convergence on the model of the  unitary board, and no stakeholder representation, is neither a given nor  inherently desirable. The nature of  stakeholder  representation  through  the two‐tier board structure in different markets is particular (for example between the German  model, 

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the  Dutch  model  and  the  Danish  model)  and  therefore  continued  study  through  comparative analysis should be requested by HMT and BIS.   Does  the UK  approach  to  regulation  and  supervision  of  financial  services  incentivise Boards  to perform  their  role  effectively?    Is  more  intrusive  regulation  a  substitute  or  complement  to effective  corporate  governance?  Is  a  "comply  or  explain"  approach  an  effective  framework  for governance?  Again we  note  that much  commentary  from within  the UK’s  governance  community  asserts  the value of  ‘comply or explain’  in contrast to regulation, though typically with  little or no evidence to back  this. PIRC has publicly  stated  that we believe  that certain elements of corporate governance might be better dealt with through regulatory intervention than market oversight, particularly where there is clear agreement.    What benefits, if any, come from EU regulatory engagement with corporate governance issues?  Whilst we note  that many  in  the UK have a negative attitude  towards  the EU’s  involvement,  it  is worth noting that  in some areas more searching questions have been asked by the EC than  in the various  analyses provided by bodies  in  the UK, where  such  analysis has been  conducted  (eg  FSA reports). We  would  particularly  highlight  the  EU  consultation  on  audit  quality,  which  proposed interventions that go significantly further on issues relating to auditor independence than have been entertained  by UK  policymakers. We  believe  that  the UK has  been  particularly weak  in  this  area historically, and European intervention may deliver positive benefits for shareholders.       What impact has the Walker Review (2009) had on corporate governance and corporate behaviour in financial services?   The Review essentially worked within  the existing  framework of UK governance and has strengths and  weaknesses  because  of  it.  Whilst  the  recommendations  on  remuneration  disclosure  – particularly below board  level  ‐ were welcome, PIRC believes  it missed the opportunity to dig  into the questions of scale of reward, and the motivational value of performance pay.  Similarly,  the  Review’s  consideration  of  other  approaches  to  governance,  such  as  some  level  of stakeholder representation, was rather perfunctory. Such a study is overdue.    The Review played an  important role  in highlighting  the role of shareholders  in  the governance of financial  institutions,  and ultimately  led  to  the development of  the  Stewardship Code. Whilst we consider that the Code has weaknesses, we believe it has in general been a positive development.   Non Executive Directors  Should non‐executive directors bear greater liabilities than under current law?   We believe that an  independent assessment of the role of directors following the passage of the section  of  the  Companies  Act  2006  relating  to  directors  duties  would  help  contribute  to  the question of whether greater legal liabilities are required.   Should executives in FTSE 100 companies be able to hold non‐executive positions in other firms?  In our experience executive directors  facing multiple active directorships  (in both corporate and non‐corporate) organisations suffer from a lack of focus in their principal responsibilities at some 

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time or other.  It would be a prudent requirement to  limit membership by executive directors to one other FTSE100 company board as a non‐executive.   The role of shareholders  Should  shareholders  be  required  to  exercise  a  stronger  role  in  systemically  important  financial institutions? What are the key barriers to greater shareholder activism by institutional investors in financial institutions? What risks are associated with it?  We believe  that shareholder oversight of systemically  important  financial  institutions continues  to face  challenges.   At  the end of 2009, PIRC undertook  an  analysis of  voting  trends  amongst  asset managers  invested  in  the UK‐listed banks. This was based on  the voting data publicly disclosed by asset  managers.  We  found  that  shareholder  challenge,  as  expressed  in  votes  against  and abstentions, was limited prior to the crisis, although there was evidence of change in 2009.  In  the  course  of  responding  to  the  inquiry, we  have  undertaken  some  further  analysis  of  voting trends looking at the period from 2008 to 2011. Some surprising findings included that –  •  In 2011, there was an increase in support for banks’ remuneration reports from the sample of asset managers analysed. The level of opposition was only lower in 2008.   •  There were five asset managers that voted for all the banks’ remuneration reports in 2011, compared to four in 2010 and none in 2009.  •  Looking at 2011, we were able to identify two abstentions and one vote against a director of a bank facing re‐election, out of a total of 709 voting decisions captured.   •  In comparison in 2009, we were able to identify seven abstentions and eleven votes against a director of a bank facing re‐election, out of a total of 692 voting decisions captured.      •  In the four year period we were only able to indentify two instances of votes against the re‐appointment of the auditor, out of a total 313 voting decisions by 20 asset managers captured. Both cases involved the same manager opposing auditor appointments in 2011.  The  apparent  increase  in  support  for  bank  remuneration  policies,  at  least  within  the  sample analysed,  is  consistent  with  some  anecdotal  market  feedback.  PIRC  believes  that  some  asset managers were wary of “bank bashing”, and accepted the argument made by the banks themselves that too much shareholder pressure on remuneration might be counterproductive.  Looking at the limited challenge to incumbent directors in 2011 compared to 2009, this might in part be explained by  the  fact  that new management  teams had been established, and  investors were wary of destabilising them. These findings should also be seen in a context of an extreme reluctance on the part of asset managers to vote against directors generally.   The  lack  of  challenge  to  audit  firms  is  puzzling,  since  the  firms  that were  reappointed without challenge had typically signed off the accounts of the banks on a ‘going concern’ basis in 2008, only for those banks to require recapitalisation to survive a few months later.   We note that the committee’s previous inquiry into corporate governance and pay in the City stated: “We are perturbed that the process results in ‘tunnel vision’, where the big picture that shareholders want to see is lost in a sea of detail and regulatory disclosures.”   

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 PIRC believes shareholders must take a more active role in audit and accounting issues, and that the absence of such investor involvement at the banks pre‐crisis was a significant failure of oversight.   More generally, events so far in 2012 suggest that in the current AGM season a number of UK asset managers have  toughened  their voting stance at UK companies,  including  the banks. Barclays saw significant votes against both its remuneration report and the chair of its remuneration committee. It  is not  immediately apparent what has caused this upsurge  in dissent, but political pressure must have at  least  some  role.  In addition,  it  is worth noting  that  the  so‐called  ‘shareholder  spring’ has gained prominence because investors have begun to use their voting rights more assertively.  PIRC  therefore  believes  that  it  is  important  that  the Government,  and  bodies  such  as  the  select committee, continue to focus on the role shareholders can play, and the importance of them using their voting rights effectively.  Is it realistic to expect sovereign wealth funds and hedge funds to undertake a more active role?  Yes, we believe  there  is nothing  inherent  in  the nature of either sovereign wealth  funds or hedge funds that would prevent them playing a more active role. Indeed in our own experience have found that both  types of  investor can provide a more critical perspective.  It  is unfortunate  that  the UK’s corporate  governance  community  has  been  dominated  by  traditional  institutions  and  their  trade bodies which have historically exhibited a very passive attitude to ownership issues.       Remuneration  What  role  should  institutional  investors,  remuneration  consultants,  employees  and  others  play with respect to remuneration in the financial services sector?   Presuming  that  there  is no desire  for  further  regulatory  intervention  in  respect of  remuneration, then  the  only  other  two  groups  likely  to  provide  effective  oversight  of  remuneration  in  public companies are their shareholders   or their employees. In the UK governance model employees are not  currently afforded any  specific  role, although PIRC has  long  supported  that  they  should have representation on remuneration committees.  As such it must fall to shareholders to be the principal groups exercising oversight.   Unfortunately in recent history most asset managers as the largest group of those owning shares in UK companies have been very reluctant to oppose all but a small minority of remuneration‐related proposals. The  large votes  in favour that most financial  institutions have received have served only to  legitimise  rent capture by  the executives  running  them. Of particular concern  is  the attitude of some  asset  managers  which  downplay  the  value  of  voting,  and  which  often  vote  in  favour  of controversial proposals whilst expressing concerns privately. PIRC believes such an approach  is still employed by  some houses,  and has  the  effect of distorting  the  signalling  function of  voting.  The market receives the impression that all is well even when there are concerns.   Therefore  we  believe  an  important message  that  the  Government  and  others  can  send  is  that shareholder voting rights are valuable, and must be used to challenge companies where there are concerns.  It  should  be  a  simple  principle  that  if  shareholders  disagree with  a  proposal  then  the assumption will be that they will vote against it, unless there are very compelling reasons not to do so. It is regrettable that such a basic principle requires articulation, but nonetheless we believe that the promotion of such an attitude would be beneficial.   

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In  respect  of  remuneration  consultants,  it must  be  clear  that  they  work  for  the  remuneration committee, not for the company, and the firm employed should not undertake other work for the company  or  company  employees.  In  addition  we  would  favour  remuneration  consultants  being subject to a shareholder approval vote, as is the case with audit firms.      Is  there  a  case  for  introducing  still  greater  transparency  for  senior  executives with  respect  to remuneration in the financial services sector?   We are not opposed  to  further  transparency, but  it  is  important  to be  realistic about what  it may achieve.  It  should  not  be  assumed  that  further  disclosure  of  remuneration  arrangements,  for example  below  board  level  or  further  down  the  organisation,  will  necessarily  lead  to  more accountability  (for  example  to  shareholders).  However  such  disclosure may  be  a  public  good  in making more transparent the level of reward available within one particular sector of the economy.   Should  there  be  further  reform  of  the  remuneration  arrangements  of  senior  executives  in  the financial  services  sector?  Should  this  extend  to  those  highly  paid  individuals  who  sit  below executive level?  We agree with the proposal in the Walker Review that below board level remuneration should also be  more  transparent,  particularly  where  individuals  working  in  particular  business  units  are generating significant proportions of a financial services firm’s income, eg proprietary trading desks.   However there is a danger that the post‐crisis reform effort puts too much emphasis on the design and structure of remuneration as opposed to its scale and motivational value. PIRC believes that the excessive emphasis on performance‐related pay adds to complexity, which makes it both harder for shareholders to exercise oversight and  less  likely that recipients will be motivated by the schemes. All  parties  in  corporate  governance  agree  that  too  much  time  and  resource  is  devoted  to remuneration  issues,  yet  this  is  an  inevitable  consequence  of  numerous  attempts  to  redesign rewards.  PIRC  is  increasingly  sceptical  that  performance‐related  pay  has  provided  benefits  to  either shareholders or companies, and we note that opinion within the remuneration consulting industry is moving  in  this direction  too.    The one  reform we would  advocate  is  radical  simplification of pay schemes – stripping back remuneration to salary and at most one, simple, incentive scheme.     What  is  the  relationship,  if  any,  between  Board  diversity  and  company  performance  in  the financial service sector?  We believe that this area of study is considerably under researched. We commend the TSC to call for independent evidence from the BIS on this matter.    28 May 2012 

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Written evidence submitted by the Company Law Committee of the Law Society of England and Wales

(CGR 28) I am writing to you in my capacity as Chairman of the Company Law Committee of the Law Society of England and Wales in relation to the above terms of reference. The Law Society is the representative body for over 145,000 solicitors in England and Wales. The Society negotiates on behalf of the profession, and makes representations to regulators and Government in both the domestic and European arenas. The Company Law Committee of the Law Society made up of senior and specialist corporate lawyers. Our comments in this letter are supported by the Law Reform Committee of the Bar. Question 2 Are board structures effective? For example, should UK financial institutions consider adopting alternatives to the unitary board structure? We believe that the view has previously been taken in Government in connection with the introduction of the European Company (Societas Europea) that two tiered boards were not incompatible with English corporate law. However English law imposes the same duties on all directors — so, in that sense, the unitary board structure is embedded in English law and is reflected in numerous provisions throughout the body of our corporate legislation, including in the Companies Act 2006. We assume that the purpose behind a two-tiered board would be to allocate different functions and responsibilities to the different tiers and it would be a radical shift in English law to make the necessary changes to allow for this. So the legal implications of effecting any such change should not be underestimated. The merits of a unitary board are that it provides an effective forum for executive and nonexecutive directors to exchange views regarding the direction and management of the company and for non-executive directors to be able to challenge the assumptions and views of management. The Combined Code requires a “supervisory” dimension but within a unitary board framework. This structure has the beneficial effect of ensuring that all directors have access to equal information whereas the supervisory/management board structure does not guarantee this. if any change to the unitary board structure were proposed, it would be important to identify what specific benefits the proposed alternative structure carried and take into account any benefits offered by the current unitary structure which may be lost as a result. In addition, if such a fundamental change were thought to be worth making for financial institutions, it is not clear why it should be limited to that type of organisation, particularly given the issues that would arise in trying to define the scope of entities it should apply to (bearing in mind that organisations can change their businesses over time). These issues mean that the implications of any such change could be very far reaching. Question 3 Does the UK approach to regulation and supervision of financial services incentivise Boards to perform their role effectively? is more intrusive regulation a substitute or complement to effective corporate governance? is a "comply or explain" approach an effective framework for governance?

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We do not think more intrusive regulation is a substitute or necessarily a complement to corporate governance. Regulation draws a clear line as to behaviour that is required or prohibited. Corporate governance codes can set standards at a higher level than could be the case if legislation were to be passed. in practice, adherence to the code can increase over a period of time as more companies come to see the benefits of a particular practice. We think that a comply or explain approach to corporate governance is an effective framework. It provides flexibility for different companies of different sizes. It also requires companies to explain their reasons for noncompliance to shareholders, who are the owners of the company and who can decide whether to take action and, if so, what form this should take. Question 8 Should non-executive directors bear greater liabilities than under current law? Liabilities arise from a failure to perform obligations or duties and it is not clear whether this question is contemplating that non-executive directors should have more onerous obligations or duties than executive directors or that the duties/obligations of all directors should be increased or that a higher standard of care and skill should be expected of directors. It is a longstanding principle of English law that the duties placed on directors apply equally to executive and non-executive directors. It would represent a major change to English law to move from this principle. In any event it would seem inappropriate to contemplate imposing greater liabilities on non-executive directors than on executive directors. As for the position of directors of UK companies generally, their basic duties were codified in the Companies Act 2006 after considerable scrutiny during the passage of the Companies Bill through Parliament and in the earlier debates about directors’ duties at the time of the Company Law Review and the initial draft bill which was issued as a White Paper. We would question the wisdom of reviewing this area when such a short time has elapsed since the implementation of the Act. In any case there seems little doubt that, with the marked increase in regulation over recent years, the responsibilities of individuals who take on the position of directors have become significantly greater in the last decade (taking into account, for example, certain strict liability offences which have been imposed on directors and the increased expectations that the law and society have placed on directors). In addition the statutory derivative action which was introduced by the Companies Act 2006 provides a statutory route for claims to be brought against directors. Indeed the committee is aware that, with all these burdens on and risks for directors, there is serious concern, at least in some quarters, that many excellent candidates who could make a valuable contribution to companies are deterred by the potential liability which the current law places on them from becoming directors. As regards the standard of care required of directors, the Companies Act 2006 requires a director to exercise the care, skill and diligence which would be exercised by a reasonably diligent person with (a) the general knowledge, skill and experience that may reasonably be expected of a person carrying out the functions carried out by the director in relation to the company and (b) the general knowledge, skill and experience that the director has. The benefit of this formulation is that the standard can be adapted to take into account the size and nature of the company concerned (with a higher standard being generally expected from the director of a major, international company than from a director of a small, regional company) and will change over time to reflect changes in the reasonable expectations of the business world. We hope that you find the above comments helpful. We would of course be happy to discuss these issues further with you. Richard Ufland

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24 May 2012

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Written evidence submitted by Quoted Companies Alliance INTRODUCTION The Quoted Companies Alliance is an independent membership organisation that champions the interests of small and mid-size quoted companies. Their individual market capitalisations tend to be below £500m. The Quoted Companies Alliance is a founder member of EuropeanIssuers, which represents over 9,000 quoted companies in fourteen European countries. The Quoted Companies Alliance Corporate Governance Committee has examined your proposals and advised on this response. A list of committee members is at Appendix A. RESPONSE We welcome the opportunity to respond to this consultation regarding corporate governance in systemically important financial institutions. It is notable that whilst the objective of the inquiry is stated to relate only to corporate governance in systemically important financial institutions, the terms of reference go far beyond that. Whilst we represent small and mid-size quoted companies, we are quite concerned by the likelihood of far-reaching proposals that will seriously impact our sector. This may be an unintentional outcome, but the potential consequences could create further burdens on small and mid-size quoted companies. We feel that there is no evidence of widespread poor behaviour in this sector. Corporate governance and the duties of directors were considered and debated at length in 2006. In 2009, the financial institutions’ corporate governance had been discussed in depth under the Walker Review. We do not believe it is appropriate to seek to reopen this body of law at this stage when matters such as the BIS consultation on Long Termism in Corporate Britain, the EU Corporate Governance Green Paper and company law review remain outstanding. It is also important to emphasise that the relationship between shareholders and directors is crucial when discussing good corporate governance. The trust between the two parties is the basis of a successful company. A lack of trust between the two, leads only to a greater demand for regulation. To engender greater trust between the shareholders and directors, there needs to be plenty of feedback from the shareholders to the directors. We have seen in the recent months there have been numerous occasions where shareholders have taken action against their directors without having to rely on regulation. The shareholder reaction to some proposed by the largest companies remuneration policies and the increase media coverage on appointing more women to boards, will serve to change behaviours and therefore require less regulatory and legislative change. Board structure and composition

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1. What outcomes should corporate governance in the financial services sector seek to achieve?

There should be no difference in the outcomes of corporate governance between sectors: Corporate governance principles should be the same and be consistently applied, regardless of the sector. We consider any proposal to impose differential treatment is both dangerous and counterproductive. We do believe though, that if there is to be a change in treatment (which is something that we would be vocal against) then a proportionate approach with regards to small and mid-size quoted companies would be appropriate.

2. Are Board structures effective? For example, should UK financial institutions consider adopting alternatives to the unitary Board structure?

We see no evidence for the need for any material change to the current standard board structure or to directors duties, the latter of which are now essentially codified in section 172 et seq. Companies Act 2006. To make any changes in a piecemeal fashion without identifying any specific issues to be addressed would be imprudent and potentially counterproductive. The effectiveness of a board structure hinges upon the dynamics within that board, the personalities concerned and the manner in which a chairman manages his board. The structures within which boards operate matter less than the substance of how individuals on the board interact with each other, either formally or informally, with the proviso that board members should understand and optimise the corporate governance structure in which they operate as a matter of best practice. We believe therefore that encouraging alternative board structures would not be a productive avenue to pursue, not least because:

• the majority of directors of UK companies are most experienced and familiar with unitary boards and it would seem sensible to allow directors to use existing, familiar structures to effectively “bed down” recent and significant developments in corporate governance ; and

• the legal basis for anything other than a unitary board under English company law would be unclear and untested, and require significant time and resources to develop without any clear, defined benefit.

3. Does the UK approach to regulation and supervision of financial services

incentivise Boards to perform their role effectively? Is more intrusive regulation a substitute or complement to effective corporate governance? Is a "comply or explain" approach an effective framework for governance?

We believe that the combination of a clear legal regime, together with a renewed focus on good governance provides an appropriate and sufficient incentive for boards to effectively perform their role. We would welcome supportive and tailored supervision (for example, thematic reviews and engagement with directors and boards) by

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regulators within existing provisions, rather than incremental intrusive or aggressive, enforcement led regulation. Intrusive regulation is no substitute for effective corporate governance in the first instance, although we recognise there is a role for accountability and regulation where governance has failed. We strongly support the “comply or explain” approach to the implementation of corporate governance principles by companies and to the adherence to the principles for stewardship by investors. Good governance is an attitude of mind which must distil not only through a board, but through a whole organisation and therefore it cannot be best applied by either regulation or blind code compliance. It is, therefore, important for companies and investors to find governance solutions that are best suited for their business model, structure and organisational culture. We suggest, however, that the descriptor “comply or explain” be changed to “apply and explain”. Once again we believe that the need for a proportionate response to corporate governance for small and mid-size quoted companies is essential. The large banks were unable to manage certain systemic risk within the financial system and a number of large institutions were unable to protect themselves from such risks, leading to much hype about corporate governance, which ultimately should not disproportionately penalise small and mid-size quoted companies. Corporate Culture

4. What type of corporate culture should financial services firms seek to foster? In what way can this be encouraged? How effective are Boards at shaping corporate culture within their institutions?

The corporate culture that every financial services firm should seek to foster is a clear focus on integrity, long-termism and serving the interests of its clients. Cultural leadership from the top of a firm is essential as senior management set and shape the cultural tone of a firm. Therefore, boards have a vital role in shaping the corporate culture of their respective organisations and should encourage an open and engaged culture where decisions are made and both challenge and ideas are encouraged without fear. It is also the board’s role to ensure that individuals with the wrong cultural approach are appraised with this in mind as an important performance factor, and not in unchecked, senior management positions within their organisations. This can be encouraged by considering measures to drive more positive and substantive disclosure about corporate governance, and commitment by shareholders to engage about the issue given their stewardship responsibilities. Impact of previous reviews and new regulatory developments

5. What difference would the proposals in the Independent Commission on Banking's report on the Boards of ring-fenced banks make to corporate governance in these institutions?

We have no comment on this question.

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6. What benefits, if any, come from EU regulatory engagement with corporate governance issues?

The benefits of EU regulatory engagement on corporate governance issues are significant as they filter through to, and add consistency to, a breadth of EU countries. It is therefore vitally important for EU member States to consider questions of corporate governance together to deliver constantly improving practice. The European institutions are currently drawing together their conclusions following the Corporate Governance Green Paper of July 2011. The UK should wait and evaluate the conclusions from this process before pursuing alternatives which may confuse the picture further. Whilst we support EU regulatory engagement as described above, we note that the “comply or explain” approach to corporate governance was a concept developed in the UK which has gained currency across the EU as a more effective and more immediate way to deliver appropriate best practice, rather than strict procedural legal obligations.

7. What impact has the Walker Review (2009) had on corporate governance and corporate behaviour in financial services?

We have no comment specifically on the financial services sector. Non-Executive Directors

8. Should non-executive directors bear greater liabilities than under current law? Should executives in FTSE 100 companies be able to hold non-executive positions in other firms?

In general, liabilities should be appropriate to the role being discharged, and the first question should be answered with the benefit of a legal analysis of the different roles between executives and non-executives. We feel it is inappropriate for us to comment on how the FTSE 100 companies should have to comply, however we do stress that we do not want any proposals to filter down inappropriately to small and mid-size quoted companies. We emphasise that if there is any prospective legislation, then it must offer a proportionate approach for small and mid-size quoted companies.

9. Is the existing FSA approval process for significant influence functions (SIF), including non-executive directors, effective?

We have no comment in relation to this, save to say that the formal approval process must be viewed in the context of the wider due diligence and selection process of a new director. The role of shareholders

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10. Should shareholders be required to exercise a stronger role in systemically important financial institutions? What are the key barriers to greater shareholder activism by institutional investors in financial institutions? What risks are associated with it?

We believe it is important to encourage a greater number of traditional long-term investors to act as responsible owners through the exercise of voting rights and engagement with investee companies, including systemically important financial institutions. While we do not think that shareholders can or should be required to exercise a stronger role, it is certainly in the interests of their clients (where applicable) that they do so. In this context, we see the UK Stewardship Code as an important driver in broadening the base of active shareholders, although more needs to be done to encourage institutional investors (both asset owners and their investment managers) to exercise stewardship of their investee companies. While shareholder engagement is critical for effective oversight of the governance practices of financial institutions, we believe it is important to be realistic about what shareholder engagement can achieve in view of the “asymmetry of information” available to the management of financial institutions, supervisory authorities and the market. Higher transparency of financial institutions and more meaningful disclosure on governance, risk (including non-financial risks) and internal controls would help improve quality of shareholder engagement. However, shareholders cannot be expected and should not attempt to micromanage.

11. Is it realistic to expect sovereign wealth funds and hedge funds to undertake a more active role?

We have no comment on this question. Remuneration

12. What role should institutional investors, remuneration consultants, employees and others play with respect to remuneration in the financial services sector?

We have no comment specifically on the financial services sector.

13. Is there a case for introducing still greater transparency for senior executives with respect to remuneration in the financial services sector?

We have no comment specifically on the financial services sector.

14. Should there be further reform of the remuneration arrangements of senior executives in the financial services sector? Should this extend to those highly paid individuals who sit below executive level?

We have no comment specifically on the financial services sector.

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15. The Chairman of the Financial Services Authority has argued that there

may be a case for changing the personal risk return trade-off for bank executives. He has suggested either a 'strict liability legal sanctions or an automatic incentives based approach. What are the merits and drawbacks of these proposals? Are there other ways to achieve the same objective?

We have no comment specifically on the financial services sector. Governance of risk

16. Has the management of risk in firms improved since the financial crisis? We have no comment specifically on the financial services sector. Diversity and background

17. What is the relationship, if any, between Board diversity and company performance in the financial service sector?

We have no comment specifically on the financial services sector. If you would like to discuss this in more detail, we would be pleased to attend a meeting. Tim Ward Chief Executive June 2012

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APPENDIX A

QUOTED COMPANIES ALLIANCE CORPORATE GOVERNANCE COMMITTEE

Edward Beale Western Selection Plc Tim Bird Field Fisher Waterhouse Dan Burns McguireWoods Anthony Carey Mazars LLP Richard Chin Oriel Securities Limited Louis Cooper Crowe Clark Whitehill LLP Madeleine Cordes Capita Registrars Ltd Edward Craft Wedlake Bell LLP Kate Elsdon PricewaterhouseCoopers LLP Nicola Evans Hogan Lovells International LLP David Fuller CLS Holdings PLC Clive Garston DAC Beachcroft LLP Tim Goodman Hermes Equity Ownership

Services Nick Graves Burges Salmon David Isherwood BDO LLP Kate Jalbert The Quoted Companies Alliance Colin Jones UHY Hacker Young Dalia Joseph Oriel Securities Limited Derek Marsh China Food Company PLC Claire Noyce Hybridan LLP James Parkes CMS Cameron McKenna LLP Anita Skipper Aviva Investors Julie Stanbrook Hogan Lovells International LLP Jacques Sultan The Quoted Companies Alliance Eugenia Unanyants-Jackson F&C Investments Melanie Wadsworth Faegre Baker Daniels LLP Tim Ward The Quoted Companies Alliance Cliff Weight MM & K Limited

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APPENDIX B

THE QUOTED COMPANIES ALLIANCE (QCA) An independent organisation funded by its members, the Quoted Companies Alliance champions the interests of small and mid-cap size companies, their advisors and investors. It was founded in 1992, originally known as CISCO. The Quoted Companies Alliance is governed by an elected Executive Committee, and undertakes its work through a number of highly focussed, multi-disciplinary committees and working groups of members who concentrate on specific areas of concern, in particular:

taxation legislation affecting small and mid-cap quoted companies corporate governance employee share schemes trading, settlement and custody of shares structure and regulation of stock markets for small and mid-cap quoted companies; political liaison – briefing and influencing Westminster and Whitehall, the City and

Brussels accounting standards proposals from various standard-setters

The Quoted Companies Alliance is a founder member of European Issuers, which represents quoted companies in fourteen European countries. Quoted Companies Alliance’s Aims and Objectives The Quoted Companies Alliance works for small and mid-cap quoted companies in the United Kingdom and Europe to promote and maintain vibrant, healthy and liquid capital markets. Its principal objectives are: Lobbying the Government, Brussels and other regulators to reduce the costing and time consuming burden of regulation, which falls disproportionately on smaller quoted companies Promoting the smaller quoted company sector and taking steps to increase investor interest and improve shareholder liquidity for companies in it. Educating companies in the sector about best practice in areas such as corporate governance and investor relations. Providing a forum for small and mid-cap quoted company directors to network and discuss solutions to topical issues with their peer group, sector professionals and influential City figures. Small and mid-cap quoted companies’ contribute considerably to the UK economy: There are approximately 2,000 small and mid-cap quoted companies They represent around 85% of all quoted companies in the UK They employ approximately 1 million people, representing around 4% of total private

sector employment Every 5% growth in the small and mid-cap quoted company sector could reduce UK

unemployment by a further 50,000 They generate:

- corporation tax payable of £560 million per annum

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- income tax paid of £3 billion per annum - social security paid (employers’ NIC) of £3 billion per annum - employees’ national insurance contribution paid of £2 billion per annum

The tax figures exclude business rates, VAT and other indirect taxes.

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Written evidence submitted by the Local Authority Pension Fund Forum

 

T he Local Authority Pension Fund Forum was established in 1991 and is a voluntary association of 55 local authority pension funds based in the UK. It exists to promote the investment interests of local authority pension funds and to maximise

their influence as shareholders to promote corporate social responsibility and high standards of corporate governance amongst the companies in which they invest. The Forum’s members currently have combined assets of over £100 billion. 1 Summary LAPFF has been arguing consistently that effective financial governance – on which the rest of governance depends - is dependent on properly audited accounting information. The Cadbury Committee, on which the existing Combined Code was founded, was actually called “The Financial Aspects of Corporate Governance” and focussed on accounting and auditing practice. The banking crisis has clearly identified problems with the accounting standards (International Financial Reporting Accounting Standards, “IFRS”) used by banks, as concluded by the Economic Affairs Committee of the House of Lords (May 2011). The Head of Financial Stability at the Bank of England has questioned whether banks need different accounting standards. Clearly if the Bank of England, as a contingent creditor, cannot rely on the audited accounts intended for the shareholders of banks, it is difficult to see how the shareholders can either. LAPFF has also been concerned that the governance of the Financial Reporting Council is deeply flawed, and gave specific examples which included:-

a board led by a person who has been setting auditing standards for 26 years, whilst acting as defence lawyer for large accounting firms,

senior appointments made without open advertising of posts,

aims and objects that differ to those of the law, which is that accounts are focussed on stewardship and capital maintenance, which the FRC approved accounting standards do not deliver.

Whilst aspects of the Financial Reporting Council, around the code, have been strong, there is a sense that a good deal of effort has been expended in deflecting attention from defective accounting standards and defective audits. LAPFF takes this opportunity to submit its “Banks Post Mortem” which was published in December 2011. It identifies how the capital adequacy regime of the FSA, had relied on the defective accounting regime applicable under IFRS, which was, unusually, rolled out in a similar fashion in both the UK and Eire, as the FRC’s accounting standard setting function covers both states. LAPFF also notes that the Financial Reporting Council, despite setting accounting standards on which profits can be unreal, or even unrealisable, had not identified the

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inappropriateness of pay schemes based on faulty accounting. LAPFF also notes the unacceptable but growing practice of company auditors being hired as remuneration consultants for their audit clients. 2 Response to Chair’s Comments The Chair rightly identifies that shareholders and taxpayers have shared the losses but with whom? It is not clear that creditors or indeed directors have shared the losses (other than a small number of high profile departures such as Fred Goodwin at RBS). On paper, the limited liability structure should mean that both directors AND auditors are liable. We seem to have arrived at limited liability for auditors without a single company having changed their articles to take advantage of the powers afforded them under the 2006 Act to introduce proportionate liability. 3 Response to Specific Questions The Forum has taken the opportunity below to provide our view on those issues which we consider relevant to our activities. Board structure and composition 1. What outcomes should corporate governance in the financial services sector

seek to achieve? Corporate governance shouldn’t seek to eliminate financial risk but rather to ensure that shareholders are protected from disproportionate liability. 2. Are Board structures effective? For example, should UK financial institutions

consider adopting alternatives to the unitary Board structure? Whilst it is important to consider alternatives, it should be noted that financial institutions with two tier boards also failed, Dexia being a case in point. The failure of financial institutions was less a board structure issue and more a case of imprudent regulation and the outcome of a mindset amongst directors who had made it to the top table having an uncritical reliance on advice from firms (accountants, lawyers and corporate finance advisors). These firms had business models that conflicted with the directors’ fiduciary duties to their shareholders. 3. Does the UK approach to regulation and supervision of financial services

incentivise Boards to perform their role effectively? Is more intrusive regulation a substitute or complement to effective corporate governance? Is a "comply or explain" approach an effective framework for governance?

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Comply or explain has proved to be a poor method of protecting shareholders from director’s incompetence. Company Law ties shareholder rights into a legal framework that depends on prescribed disclosures which allow shareholders to exercise their rights. There is a danger that this will be sacrificed in favour of convenience. This can be seen at a broad structural level. For example, it would be cheaper and more convenient for companies with international revenue and presence, if the legal structure of a company was no longer tied to a particular nation’s company law. This is already happening with SE’s (Societas Europaea, a public EU company). The approach can also be seen at a more parochial level. For example, changes to Company Law in the UK have ceded traditional shareholder rights in favour of permissive rights for the board. For example, shareholders no longer have a right to vote on a name change. Corporate culture 4. What type of corporate culture should financial services firms seek to foster?

In what way can this be encouraged? How effective are Boards at shaping corporate culture within their institutions?

The corporate culture ought to be shaped by the purpose of the company. Some financial institutions were no longer fit for purpose because they could no longer lend. To the extent that these organisations could no longer function under a single purpose they were too big to succeed. Impact of previous reviews and new regulatory developments 6. What benefits, if any, come from EU regulatory engagement with corporate

governance issues? International companies and their advisers have an unambiguous, well resourced process for delivering their narrative to regulators at a European level. This contrasts sharply with the multi-faceted often conflicting views of investors. Put simply, it is too easy for companies to lobby out investor initiatives aimed at improving governance on investor terms. There is a danger that European regulation settles for the lowest common denominator and aims to avoid those “awkward” national differences. For example the T2S development (a platform for securities settlement) threatens a perfectly good piece of UK regulation in the form of s793 of the Companies Act. We cannot see a good reason why companies should not have the power to find out who their investors are. 7. What impact has the Walker Review (2009) had on corporate governance and

corporate behaviour in financial services? The most damaging aspect of Walker has been that it gives legitimacy to deferral of bonus over a multi-year period. Bonuses that are accrued but not paid immediately is appropriate if the bonus is subsequently cancelled if performance dips in subsequent years. The question is whether this actually happens in practice. Accrued liabilities should be declared, but the problem is they are being deliberately hidden and this is not being challenged by auditors.

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The complexity that this adds to disclosure reinforces one of the main obstacles to shareholder action to restrain executive pay in the face of poor performance, namely lack of transparency. Unless outcomes of all prior year awards are analysed over multiple years, each year ahead of the AGM, the pay vote common in most European markets is limited to an opinion on policy in the year ahead. Executive pay concerns are principally the result of “skimming” or taking money out of the company on the basis of selective performance over a selected period designed to avoid the downside. Deferral frustrates attempts to put a stop to this, and the personal tax arrangements used by executives has ensured this is enthusiastically supported by boards. Non Executive Directors 8. Should non-executive directors bear greater liabilities than under current law? The chances of a director, either executive or non-executive, becoming liable beyond the limit of their D&O liability cover are remote. The degree to which non-executives are now no longer facing personal financial loss breaks a key premise upon which governance is based, namely that shareholders and directors interests are aligned. The role of shareholders 10. Should shareholders be required to exercise a stronger role in systemically

important financial institutions? What are the key barriers to greater shareholder activism by institutional investors in financial institutions? What risks are associated with it?

Beneficial owners’ tolerance of reasonable comparative return despite poor absolute return for the level of fee paid to investment managers means that institutions do not have an incentive to be active. A regulatory duty to inform beneficial owners and to resource the provision of this information by reference to a fixed relationship with managers fees, would help create upward pressure for institutional activism. Prescribed reporting formats for investment manager quarterly reports could also make underperformance in absolute terms more transparent. 11. Is it realistic to expect sovereign wealth funds and hedge funds to undertake a

more active role? The question assumes that sovereign wealth funds and hedge funds are not active. However recent regulatory intervention on shorting demonstrates the opposite. Sovereign wealth funds and hedge funds have very different constituencies to satisfy, and demanding long term relationship building with companies from a fund that has a short term gain mandate from its investors seems to miss the point. Remuneration

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12. What role should institutional investors, remuneration consultants, employees

and others play with respect to remuneration in the financial services sector? Institutional investors should use their voting rights. The election of directors who have benefitted from a disproportionate share of profits should not be assured regardless of the presence of a say on pay vote on the meeting agenda. Remuneration consultants should be prevented from acting in any other capacity for a company and should not conduct engagement with investors on executive pay issues. An elected employee representative presence on the remuneration committee would have a positive influence. 13. Is there a case for introducing still greater transparency for senior executives

with respect to remuneration in the financial services sector? 14. Should there be further reform of the remuneration arrangements of senior

executives in the financial services sector? Should this extend to those highly paid individuals who sit below executive level?

Yes there are strong cases to be made both for greater transparency and for further reform. However, greater transparency is not synonymous with more disclosure. Fundamental reform of remuneration for senior executives is clearly needed throughout the FTSE 100, not just in the financial services sector. Numerous recent pay awards have borne no relation to company performance or to returns to investors. The membership of remuneration committees must be opened up to include a significant number of staff and customer/user representatives and the practice of senior executives awarding each other excessively generous packages through their membership of remuneration committees needs to be ended. A useful reform might to be require remuneration committees to approve pay settlements for all staff, not just executives. In particular, LAPFF considers disclosure from financial institutions should cover how shareholders, directors and taxpayers have shared the trading surplus over recent years and provide projections going forward. In doing this, share values should be shown. In addition, companies should be forced to disclose total executive pay, including bonuses which have been accrued but not yet paid and to compare this with dividend and profit performance and the pay settlement for the remainder of their staff. The Forum also supports proposals for reports on future remuneration policy which should provide more details on how approved LTIPs will operate for directors in the forthcoming year. This would require shareholder approval for any scheme changes such as changes to performance criteria and allocation of maximum awards under these schemes. 15. The Chairman of the Financial Services Authority has argued that there may be

a case for changing the personal risk return trade-off for bank executives. He has suggested either a 'strict liability legal sanctions or an automatic incentives based approach. What are the merits and drawbacks of these proposals?

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There is a danger of encouraging pay schemes which reward bank executives as if they were entrepreneurs and misaligning pay schemes with the fundamental purpose of the institution. June 2012

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Written evidence submitted by HSBC

Dear Andrew

I am writing in response to your request for written evidence for your inquiry into corporate governance and remuneration. These are clearly important issues in the overall reform agenda for the financial services industry, both in the UK and worldwide, and we are pleased to be able to provide our contribution.

Our comments draw on our experiences not only in the UK but also elsewhere in the world. HSBC is listed and headquartered in the UK but we are also listed in Hong Kong, New York, Paris and Bermuda with shares in HSBC Holdings held by 220,000 shareholders in 132 countries and territories. We also have a structure of separately capitalised and funded, locally regulated banks in many jurisdictions and, as a result, a large number of subsidiary boards with outside non-executive directors – at present, there are over 100 such directors across the Group. As a result, we have considerable experience of governance issues relevant for systemically important financial institutions.

These are important issues and, in recognition of that, I have discussed this letter with the Board of HSBC Holdings plc which has endorsed its contents.

1. BOARD STRUCTURE AND COMPOSITION

(i) What outcomes should corporate governance in the financial services sector seek to achieve?

(ii) Are Board structures effective? For example, should UK financial institutions consider adopting alternatives to the unitary Board structure?

(iii) Does the UK approach to regulation and supervision of financial services incentivise Boards to perform their role effectively? Is more intrusive regulation a substitute or complement to effective corporate governance? Is a "comply or explain" approach an effective framework for governance?

In terms of outcomes, effective corporate governance should ensure the institution is both sustainable and productive and is managed in the long term interest of its stakeholders. At its simplest, this entails that the bank obtains, sustains and retains the resources and expertise, physical, financial, intellectual and human, to provide the essential functions of the bank. It can then take deposits and keep them safe, provide payments systems at home and abroad, efficiently allocate credit to households and businesses to support economic growth and help these customers manage their risks and needs over time – at appropriate prices, effectively risk managed and capitalised, with an appropriate reward to the shareholders in order to attract the capital which enables the bank to operate.

In considering whether board structures are effective at achieving that objective, it is important to consider not only the structure and governance of the Board itself but also

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the various reporting structures and committees which underpin the Board and the relationship with shareholders which sit above it. Also important is the Board dynamic itself, the conduct of meetings, the participation of individual directors and the role of the Chairman in facilitating all this. All of these are integral parts of the governance process, allowing, on the one hand, in-depth consideration of specific areas and, on the other, creating the necessary checks and balances on the overall direction of the firm.

We believe that the principal corporate governance role of the Board for any bank within the Group is to ensure that its bank has the right executive leadership and depth in its executive team, from HSBC Holdings itself downwards, that the balance between executive delegation and reserved powers is appropriate and that there is sufficient reliable information made available to the Board to review and challenge the performance of the executive management. The terms of reference of HSBC Holdings Board have recently been refreshed and are attached. These of course address a much wider range of responsibilities than simply corporate governance.

Against this background, it seems to us that either a unitary or two-tier board can be effective depending on the way in which governance is established in the jurisdictions in which they operate and provided that there are clear responsibilities for the members of the relevant boards and effective communication between the various bodies. Generally, however, we believe that the unitary Board structure is a better structure. A two-tier board can be effective depending on the way in which governance is established. But we think that examples of such structures in Germany or Switzerland do not suggest that it is a better structure or that it would be more suitable for financial institutions than the unitary board where directors have shared responsibilities. There is no evidence also to suggest that a particular model of Board structure performed better than others in the recent crisis.

The UK has a sound framework for corporate governance, in some cases, more developed than in other jurisdictions; for example, where the role of Chairman and Chief Executive are combined. Recognising that individual circumstances can influence the design of the most effective overall structure, the UK’s "comply or explain" model is very effective – it establishes a clear baseline for actions but allows firms to adopt a different position when this is not appropriate for their circumstances, having first given the matter due and careful consideration and being prepared to explain that decision. The diversity of listed companies in the UK, in terms of size, type of business, international spread, is considerable – one size cannot fit all of them.

An enhanced level of regulation and supervision can support governance by adding a further line of challenge but it cannot substitute for effective corporate governance. The role of the Board in governance is much broader than that of a regulator given its responsibility to a wider range of stakeholders. It is true that although boards and regulators have different objectives (the former is about long term success of company and the latter is about the safety and soundness of the financial system) these objectives should be complementary, or at least mutually supportive. Successful banks need a sound financial system, and a sound financial system needs commercially profitable banks. The problem with intrusive regulation is not so much that it diverts management's attention from a 'broader agenda', but that it heightens the risk that roles and accountabilities will be confused - regulators may seek to take decisions which properly belong to boards and management, reducing the scope for the proper

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exercise of discretion and undermining effective governance, as well as exposing regulators to various risks e.g. of making themselves shadow directors. This may be even more of a concern when monetary policy, macro prudential policy and financial supervision are all within one institution. The move to more intrusive regulation has, however, been healthy and rather overdue - it has forced banks, including HSBC, to focus more intently on risk management , and to ask questions which might not have been quite so front of mind in the past etc - but there is a real risk that the pendulum will swing too far. There must be a real concern now about regulatory overload - a rather separate issue, which is about trying to do too much, too soon, with stretched resources : this leads to massive inefficiencies both in the regulators and in banks - we see that all the time, in part, through the proportion of Board time on regulatory design issues.

2. CORPORATE CULTURE

(i) What type of corporate culture should financial services firms seek to foster? In what way can this be encouraged? How effective are Boards at shaping corporate culture within their institutions?

Culture is critical to norms of behaviour in all firms and we believe especially so in the financial services area where a coherent approach to risk in its many forms, and with its various consequences, is of such importance. On top of a clear statement of the risk appetite and risk boundaries of an organisation, tone from the top is crucial, as is evidence as to how core values are incorporated into training and development and how adherence to such values is rewarded and, where not adhered to, punished.

Since the crisis, HSBC has revisited training in this area and is rolling out a programme designed to help us “lead with courageous integrity” and be “Dependable, Open and Connected” in our actions. The course lasts two days and 1,393 of our top 4,000 leaders in the UK have now been on it. On a five point scale where 1 is 'outstanding' and 5 is 'poor', it has scored 1.54 overall, with recent courses regularly reaching 1.23 - making it one of our most effective courses in the Group as judged by participants. The programme is now being replicated throughout the Group.

The "theme" of the course is that we make values-led decisions in our personal lives but at work there is a risk that pressures could lead us to compromise our values. Hence we need to become more aware of how we make our decisions, so that we make better ones. Management is expected to lead by example and adherence to 'values' is an entry gate in performance appraisal for reward – if values are compromised there is no eligibility for a performance reward. The Board has supported this initiative which has been led by the Group Chief Executive.

A copy of the Group’s Values as approved by the Board is attached. The core of the programme can be summed up as follows:

"HSBC has a long, proud history of doing the right thing: by our people, our customers and our shareholders. With unprecedented levels of scrutiny within our industry, standing firm for what is right – regardless of pressure to act differently – is more important than ever. Our values and principles provide a framework to help us make the right commercial decisions and mitigate the

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risk of doing the wrong thing, in order to drive long-term, sustainable gains for our organisation."

3. IMPACT OF PREVIOUS REVIEWS AND NEW REGULATORY DEVELOPMENTS

(i) What difference would the proposals in the Independent Commission on Banking's report on the Boards of ring-fenced banks make to corporate governance in these institutions?

(ii) What benefits, if any, come from EU regulatory engagement with corporate governance issues?

(iii) What impact has the Walker Review (2009) had on corporate governance and corporate behaviour in financial services?

In respect of the ICB's ring-fencing proposals, we do see some potential conflicts and challenges created by the proposed governance regimes for ring-fenced banks. In particular, we are concerned about a conflict between the directors’ duties under the Companies Act to act in the long term interests of the Company and any specific narrower duty imposed as regards the operation of the ring-fence. In theory, the differences should be minimal but in practice we can see potential confusion as to directors’ primary duty in difficult circumstances. We also foresee additional practical implications in attracting sufficient numbers of independent directors of satisfactory skill and experience, to service the requirements of both ring-fenced banks and other financial institutions. The pool of directors is already limited by the technical qualities which are required to understand modern banking (particularly if serving on certain committees such as Risk or Remuneration) and the additional responsibilities and scrutiny as a director of a ring-fenced bank will exacerbate this.

We welcome all engagement designed to improve corporate governance standards and no one model or regime has unique superiority. High standards of corporate governance are essential if failures and contagion are to be avoided in the future. While the standards need to be consistently high, a single code for Europe would not readily accommodate different national laws and corporate structures.

A principles-based approach with code provisions (the "comply or explain" approach) has demonstrated its value even though it has not prevented some egregious failures. The principles of good governance could have broad application across all jurisdictions, with each country learning from its neighbour; take the best and adjust as necessary for national differences.

A description of how an institution has applied these principles is of far more value than simple adherence to a code (ticking the box). That is not to suggest that codes do not have an important influence far beyond mere compliance. A code sets standards for behaviour – a baseline - but this codification lacks inherent flexibility. Companies, whether domestic or international, vary in size, age and stage of development and operate diverse types of business with different objectives and risk profiles. Comply or explain, if applied honestly by the company and intelligently by stakeholders can accommodate all of these differences.

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Furthermore, national corporate governance codes can be adapted to changing circumstances far more swiftly than an international code or even national legislation and regulation. The EU should set out to influence national codes and not usurp national authority.

From an HSBC perspective, the recommendations of the Walker Review were seen as highly constructive and were subject to careful consideration by our Board of Directors. Those recommendations not already in place, aspects of the governance of risk and remuneration, are now an established part of our corporate governance practices. Furthermore, the Walker Review recommendations in respect of board size, composition and qualification and the functioning of the board and evaluation of performance were beneficial to clarifying our thinking about the optimal structure of the Board.

4. NON-EXECUTIVE DIRECTORS

(i) Should non-executive directors bear greater liabilities than under current law? Should executives in FTSE 100 companies be able to hold non-executive positions in other firms?

(ii) Is the existing FSA approval process for significant influence functions (SIF), including non-executive directors, effective?

We believe that our non-executive directors play a critical role in the governance of HSBC Holdings plc and its underlying banks. These directors sit alongside the executive directors and, in the case of the directors of the UK entities, take the same level of responsibility for the actions of their respective firms. In these circumstances, we find it difficult to see why non-executive directors should take any greater responsibility than at present; the Companies Act already holds Directors to a sufficiently high standard of responsibility. It seems the intent would be to hold non-executives responsible in some way for the failure of an institution. The danger of such an intent, even if capable of definition, is that the increased risks would dissuade individuals from taking non-executive roles or being excessively risk averse, to the detriment of the system as a whole.

The FSA approval process for the appointment of non-executive directors has been a useful addition in terms of highlighting areas where non-executives might need more training or induction to better discharge their responsibilities. We should be wary, however, of this creating a scenario where only bankers, accountants and ‘the like’ are considered for positions on bank boards. This must create a risk of 'group-think' when instead, on occasions, challenge and different perspectives are what are needed. Within HSBC, we have benefitted considerably from having on the boards within the Group, talented individuals with a commercial or industrial background, rather than in the financial sector, whose experience and perspective can be very valuable and complementary.

We have seen benefits when executive directors of HSBC also act as non-executive directors on the boards of other major companies. Insights are gained and given into different industry practices and perspectives which can be useful for both parties. In addition, a different prism through which to observe economic trends is helpful. If the

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source of the question was with regard to the necessary time commitment to take on an NED role as well as serving as an executive on a bank board, we agree appointment to an NED role needs careful consideration, given the increasing commitment required in terms of time and also the potential conflicts of interest which can be created.

5. THE ROLE OF SHAREHOLDERS

(i) Should shareholders be required to exercise a stronger role in systemically important financial institutions? What are the key barriers to greater shareholder activism by institutional investors in financial institutions? What risks are associated with it?

(ii) Is it realistic to expect sovereign wealth funds and hedge funds to undertake a more active role?

Shareholders are an important part of any governance process and we have a very active engagement process with our shareholders. Information is critical to shareholders being able to exercise their influence on the executive management properly and I believe that we are strong in this respect. We publish comprehensive annual and interim reports and increasingly detailed interim management statements. We are now providing an annual update on our strategy implementation, the latest of which was on 17 May 2012. We supplement this with presentations on various aspects of our business at roadshows and conferences – we did over 30 of these in 2011 - all published on our website, along with a full financial report and accounts for each of the main underlying subsidiaries, such as HSBC Bank plc in the UK.

In addition to these publications by HSBC, we have an active investor relations function to ensure that analysts for both buy and sell-side institutions are able to talk to management in developing their analysis of the Group and we think that this is helpful to ensuring a diverse range of widely available analysts’ materials.

We also talk directly to our larger shareholders during the year, creating an opportunity for them to improve their understanding of the Group and to address any questions or concerns they may have. Within these arrangements, there is often a specific discussion on remuneration. For smaller shareholders this is usually dealt with in writing or face to face at the Annual General Meeting in London and the Informal Shareholders Meeting in Hong Kong each year. Ultimately, shareholders express their opinions through their votes at the Annual General Meeting. In addition, an integral part of the role of the Senior Independent Director is to be available to talk to institutions to discuss any shareholder concerns as well as keeping in regular routine contact.

Included in the Annual Report and Accounts is a 57 page section on corporate governance and remuneration which, we feel, gives a comprehensive overview of how the firm is managed and the managers rewarded. A copy is attached for completeness.

By giving shareholders full information and platforms to express their views, we believe we have done much to remove any barriers which may exist to shareholders expressing their views and engaging with HSBC. The most significant shareholder leverage is through the annual election of directors and we believe it is through selecting directors,

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both executive and non-executive, that shareholders can exert governance most effectively.

It is not clear how shareholders could be required to exercise a stronger role, particularly when they reserve the right to the ultimate sanction of selling their shares. Indeed, we have observed first hand that activism is often concentrated on creating short term gains in share prices, sometimes from restructuring which may not be in the long term interests of the business. It can also be highly diversionary of management attention as the challenge from activism often seeks answers to questions of intent that the activist knows cannot be answered under Stock Exchange rules; for example ‘will you consider disposing of subsidiary A or buy Company B?’. In the years before the crisis, a number of shareholders suggested that HSBC could take a more aggressive stance to capital, liquidity and funding, and we are glad we gave greater weight to the longer term stability which our traditional approach offered, rather than follow the activists’ suggestions. I am not sure that promoting participation by any one group of shareholders is a solution as each has different views and perspectives. For example, in general, some sovereign wealth funds may take a longer term perspective whilst some hedge funds are focused on shorter term results but it is not possible to generalise. A balanced approach to shareholder engagement is required and to attach a greater responsibility to a particular set of shareholders would be wrong.

At the same time, there have been suggestions, for example in the recent consultation undertaken by the Department of Business, Innovation and Skills that shareholder votes on key issues such as remuneration should be binding. We will always respect the wishes of the majority of shareholders – they are, after all, the owners of the business – but any move to towards binding votes on these issues will need to reflect the legal framework and the different jurisdictions in which a Group such as HSBC operates, in terms of the responsibilities imposed on the directors, and should be undertaken in conjunction with shareholders. We would not support binding votes where these are delivered by less than a majority representing more than 50% of the issued share capital.

6. REMUNERATION

(i) What role should institutional investors, remuneration consultants, employees and others play with respect to remuneration in the financial services sector?

(ii) Is there a case for introducing still greater transparency for senior executives with respect to remuneration in the financial services sector?

(iii) Should there be further reform of the remuneration arrangements of senior executives in the financial services sector? Should this extend to those highly paid individuals who sit below executive level?

(iv) The Chairman of the Financial Services Authority has argued that there may be a case for changing the personal risk return trade-off for bank executives. He has suggested either a 'strict liability legal sanctions or an automatic incentives based approach. What are the merits and

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drawbacks of these proposals? Are there other ways to achieve the same objective?

Overall, the focus on remuneration and how various stakeholders can play a role in determining the remuneration strategy for a firm should apply for all companies including those in the financial services sector.

In addressing this question for HSBC, institutional shareholders play an important role in how we shape our remuneration strategy, policy and award structures. As an example, our long term incentive plan, the Group Performance Share Plan (“GPSP”) launched in 2011 was developed through nearly two years of consultation with our largest shareholders which helped to influence the final design of the award, how performance underpinning the awards should be assessed and the level of disclosure that would be most helpful to shareholders. All of this was undertaken to ensure the terms of the awards were better aligned to shareholders interests. This dialogue/consultation continues to be an evolving process and helps to promote transparency and provide clarity regarding application of our policies to our shareholders.

We are supportive of full transparency, save where details might be competitively sensitive, and believe we are a leader in this regard already. We already provide detailed disclosure of remuneration for senior staff below Board level and will work with shareholder and public policy bodies to improve clarity and comparability. In terms of scope of application for HSBC, the remuneration disclosure regime already extends to cover 320 individuals in the Group, so-called Code Staff who are senior executives and risk-takers, and it is not clear that any benefit would be achieved by extending this.

The role of remuneration consultants needs to be carefully controlled but properly targeted they can assist companies on a number of fronts. These include market insights on remuneration for specific roles, benchmarking a company’s remuneration strategy against competitors within the same industry and providing comparability with those outside. They can also provide an independent assessment of the effectiveness of reward structures and provide assistance how they could be designed to meet the remuneration strategy to attract, motivate and retain the ‘best-in-class’ employees that an organisation requires. We believe that Remuneration Committees should not however delegate responsibility for remuneration policy and design to external parties. HSBC engages with remuneration consultants to a limited degree principally for the purposes of benchmarking and technical updates. HSBC’s Remuneration Committee has not used external remuneration consultants since 2010 and indeed the new long term incentive plan referenced above was developed internally.

HSBC has undertaken progressive steps to ensure that we provide greater transparency and detail on how we remunerate our employees through our disclosures in our Directors Remuneration Report, Pillar 3 reporting and through our continued discussions on remuneration with our investors. As an example, in this year’s report, we disclosed our variable pay funding methodology which considers the relationship between capital, dividends and variable pay and provides assurance that the distribution of post tax profits between these three elements is considered appropriate. We also provided detailed disclosures on the metrics used for our GPSP arrangements,

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how the Remuneration Committee arrived at their determinations of performance and our variable pay pools. We believe the emphasis should not simply be on increasing the level of disclosure, but the aim should be to ensure that all companies are providing a consistent level of disclosures to allow comparability and a level playing field for external stakeholders who review our accounts.

On the question of further reform of the remuneration arrangements for senior executives, this has to be undertaken in the context of international competitiveness. There is a need for an international policy on remuneration to be conformed before new approaches can be considered locally, lest those who move away from international norms will be competitively disadvantaged. Only when these elements have settled down and the goals of any policies are clear and stable should consideration be given to further reforms.

A growing problem for subsidiaries of HSBC operating in local markets such as Latin America and Asia is how to compete for talent in terms of reward when competitors are not subject to the same constraints on structure and quantum of reward. This is caused by the extra-territorial application of EU legislation and FSA policy on remuneration as outlined in Capital Requirement Directive (“CRD”) III and those outlined in the draft CRD IV. Applying EU regulation on pay to subsidiaries of EU based firms in local markets outside the EU diminishes the attraction of the EU as a headquarters location given the competitive distortions created.

We believe that the risk and return trade-off for our senior executives has been appropriately addressed and so do not see any further benefits from the ideas put forward by the Chairman of the FSA; all of our variable pay plans reflect the requirements of CRD III, including clawback arrangements (which we have exercised in certain cases over the last year). In addition, the GPSP plan (referenced above) for our most senior management, also has elements which are unique to HSBC and which are intended to bind together the outcomes for management, the firm, and shareholders over the long-term. In particular, under our GPSP we require that any shares which are awarded, in addition to being subject to clawback for a period of five years from date of award, may not be sold until the retirement of the relevant executive.

A strict liability legal sanction framework for personal liability would in our view be impossible to define to distinguish personal accountability from market based consequences and would undoubtedly make the UK unattractive as a financial services centre versus other leading locations without such a regime. There exist already within UK law adequate tools to address personal wrongdoing and the deferral and clawback arrangements now in force complement these importantly.

7. GOVERNANCE OF RISK

(i) Has the management of risk in firms improved since the financial crisis?

Management of risk has undoubtedly improved and as important, the emphasis on specifying risk appetite has increased dramatically since the crisis.

Following the establishment of a Group Risk Committee in February 2010 in response to the Walker review recommendations, non-executive oversight of risk management

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and internal controls is stronger and more intensely focused. The Group Risk Committee is responsible for advising the Board on high-level risk-related matters and risk governance. This, in turn, has led to an increased risk-focused approach by the Board itself, most notably through it requesting increased levels of risk analysis in the management information and proposals it receives. In line with the Walker Review recommendations, the Committee also provides guidance to our Group Remuneration Committee on risk adjustments to be applied to performance objectives set in the context of incentive packages and liaises with the Remuneration Committee on calibrating performance reward to ensure full regard is given to the risk management control exercised by individuals with risk taking mandates.

We wholeheartedly support the increased risk focus that the Walker Review and other recent corporate governance changes have advocated, as this is very much in line with the approach HSBC has traditionally followed to its operations.

8. DIVERSITY AND BACKGROUND

(i) What is the relationship, if any, between Board diversity and company performance in the financial service sector?

We believe that risk management is enhanced through diversity of perspective within the management team and the Board but do not believe that any conclusions can be drawn that imply a strict relationship between Board diversity and company performance.

In recruiting individuals for boards across our organisation, we place most emphasis on individuals who have the skills and experience to contribute to the broad range of matters being discussed on those boards. Some may lack a specific knowledge of banking and its technicalities but offer a more general perspective on, for example, countries, customer segments, technology or general economic trends..

It is in this context that we see the value of diversity; based on knowledge and experience which embraces race, gender and age but does not seek to engineer quotas based on specific criteria. Against this background, we feel that diversity has increased in recent years, at Holdings Board level. We currently have 17directors of which four are women and 8 are not British or hold dual nationality.

9. OTHER COMMENTS

In addition to the comments made above, we have also contributed to a report by the G30 entitled "Toward effective governance of financial institutions", a copy of which is attached, which we would commend to the Committee.

In considering the current state of remuneration policy and corporate governance and any further developments, we believe there are a number of factors to be taken into consideration:

(i) to consider whether the regulatory and supervisory framework going forward has the necessary status and reward structures to attract, retain and motivate the talent it needs;

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(ii) to consider the governance and reward structures of critical new elements of the financial services architecture such as central clearing counterparties, where risk is now to be concentrated;

(iii) the need for comparability between the UK and European regimes and indeed internationally; and

(iv) the impact on UK headquartered firms if regulations on governance and reward are applied extra-territorially to other jurisdictions,

I trust this is helpful. I would be glad to appear before your Committee to give evidence in person on this important issue and I look forward to hearing from you in due course.

Yours sincerely

D J Flint

June 2012

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Written evidence submitted by the institute of chartered accountants in England and Wales

INTRODUCTION

1. We welcome the Treasury Select Committee’s inquiry into corporate governance and remuneration in systemically important financial institutions. Below we offer some comments in response to your questions on corporate culture, the impact of previous reviews and new regulatory developments, governance of risk, and remuneration.

WHO WE ARE

2. ICAEW is a world-leading professional accountancy body supporting over 136,000 members in more than 160 countries. With a Royal Charter, we work in the public interest with governments, regulators and industry to maintain the highest business and ethical standards. We are also a founding member of the Global Accounting Alliance with over 775,000 members worldwide.

3. Our members operate across a wide range of areas in business, practice and the

public sector. They provide financial expertise and guidance based on the highest professional, technical and ethical standards. They are trained to provide clarity and apply rigour, and so help create long-term sustainable economic value. There are over 25,000 ICAEW members working in the financial services sector and there are currently 80 ICAEW members on FTSE 100 company boards.

4. ICAEW has played an active role developing corporate governance in the UK and internationally, and continues to contribute to its evolution today. Our Financial Services Faculty was established in 2007 to become a world class centre for thought leadership and guidance on issues and challenges facing the financial services industry. It draws together professionals from across the financial services sector.

MAJOR POINTS

CORPORATE CULTURE

Good governance depends on people acting appropriately

5. The behaviour and competence of individuals are often thought to be the most important factors in determining the success or failure of a business and the same is true of governance. Governance is about people; those who make decisions, those who challenge the decisions of others and those who oversee how others implement decisions and manage related risks. In order for corporate governance to function effectively, shareholders as well as the board of a company need to effectively undertake their respective responsibilities.

6. It is widely acknowledged that in the financial crisis, there were failures of

governance in individual institutions. However, while some institutions failed, some survived, and others came out relatively unscathed, despite there being similarities in governance structures between these institutions. So while it is important to have suitable corporate and governance structures in place, we suggest that the crisis was

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more about human failings related to corporate culture, dominance by key executives, or seemingly ineffective challenge by non-executives, rather than a systemic failure of the UK’s corporate governance framework.

7. Behaviour can be difficult to control using regulation. Education and lessons from

experience may be better tools. ICAEW recently published guidance on this, ‘Enhancing the dialogue between bank auditors and audit committees’1, aimed at strengthening governance by improving the relationships between auditors, audit committees and executive management.

8. The Financial Reporting Council (FRC) should continue to keep the UK corporate

governance framework under regular review, making improvements when identified. These and other changes, such as those brought about by the review by Sir David Walker (noted in paragraph 10, below) need time to be effectively implemented by all concerned. They should then be evaluated to see how they are working in practice.

IMPACT OF PREVIOUS REVIEWS / GOVERNANCE OF RISK Effectiveness can only be judged over a cycle

9. Crises test the effectiveness of corporate governance. The effectiveness of governance is as much about people and behaviours as structures. For that reason, we think the effectiveness of governance often improves in the aftermath of crises, because it focuses attention on it. Weakness in governance can develop during periods of economic stability, then only become apparent when businesses run into difficulties – or during an economic downturn.

10. There have been a number of regulatory and non-regulatory developments with

respect to governance in banks over the last few years: • The trend towards having independent board risk committees that started pre-crisis

and followed-up in the review by Sir David Walker2 in response to an increased awareness in the complexity of board oversight of risk in a complex financial institution;

• The role of chief risk officers in many institutions being given greater authority and prominence;

• Risk departments in some institutions becoming involved, for example, at the design stage of product development, rather than their previous role of being given a more limited right of veto at the final decision stage; and

• The Independent Commission on Banking proposed some structural reforms aimed at strengthening governance.

11. Together, these regulatory and non-regulatory measures seem to improve corporate

governance. But they need to work over the whole economic cycle, under stressed and non-stressed situations.

REMUNERATION

1 http://www.icaew.com/~/media/Files/Technical/Financial-services/tecplm11129-webaudit-banks.ashx 2 http://webarchive.nationalarchives.gov.uk/+/http://www.hm-treasury.gov.uk/walker_review_information.htm

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Remuneration issues are about incentives

12. The issue of executive remuneration has attracted a high level of shareholder and public attention, with widespread criticism of perceived weak links between pay and performance. ICAEW has been supportive of the Government’s initiatives on this, such as simplifying the disclosure of directors’ pay arrangements in annual reports to facilitate a meaningful dialogue between the board and shareholders.

13. Remuneration policy can be useful in aligning the incentives of individuals and the

strategic objectives of the organisation. This works most effectively when the incentives of individuals are aligned to their own performance and areas under their control. At board level, this can include the performance of the organisation as a whole. To be an effective incentive for people below board level, it needs to be based at a more granular level.

14. But linking pay too strongly to individual performance can create mismatches in the

incentives. An organisation may have a series of objectives, with a balance between different objectives. Incentives based on just one of these objectives may lead to excessive risk-taking. For example, in its Retail Distribution Review the Financial Services Authority will prohibit commission-based sales by independent financial advisers, because they fear commission leads to mis-selling when advisers are driven to earn the highest commission, rather than pick the most appropriate product for their client. There may be a role for regulation in preventing a company’s remuneration policy from incentivising individuals to take excessive risks.

15. We suggest that the role of shareholders in executive remuneration should be

considered in the wider context of corporate governance. Fresh and innovative thinking is needed when looking at the ways in which market participants seek to incentivise boards, managers and each other to act in the interests of those that they are meant to serve.

June 2012

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Written evidence submitted by the Association of British Insurers

1. The ABI is the voice of insurance, representing the general insurance, investment and long-term savings industry. It was formed in 1985 to represent the whole of the industry and today has over 300 members, accounting for some 90% of premiums in the UK.

2. Introduction

2.1 During the course of the financial crisis, it emerged that allowing the collapse of a number of imperilled financial institutions would have calamitous consequences for the UK and for the wider financial system. To preserve financial stability, vast sums of taxpayer money were dedicated to preventing their failure. In the following analysis and debate, these firms have become referred to variously as “too big to fail” or “systemically risky”.

2.2 Although it is entirely proper to scrutinise whether shortcomings in governance arrangements contributed to the failure of these firms (and if so in what way), it is vital to bear in mind that the primary and over-riding need is to ensure that such firms are in the future allowed to fail (in an orderly manner that protects consumers and taxpayers), and that appropriate regulatory processes and structures are in place to enable this. Whilst arrangements that permitted excessive and reckless risk-taking should most certainly be reviewed, a reactionary response that introduces crippling restrictions could also have devastating effects on the wider economy at an extremely challenging time.

2.3 Above all, the objective of policy-making in response to the “SIFI” problem must not be to eliminate the possibility of failure, but the ensure that the impact of failures is containable; otherwise reckless behaviour will be encouraged rather than deterred and a hugely restrictive regime will be required, the cost of which will ultimately result in overly large premiums for customers.

2.4 The terms of reference for the inquiry suggest the risk and remuneration relationship holds particular importance for systemically risky institutions. Inappropriate remuneration arrangements can clearly drive inappropriate risk-taking. However, those financial institutions which have failed have done so due to their chosen business strategy, and inappropriate risk and governance processes in the boardroom. It was not a result of poorly structured remuneration arrangements.

2.5 Risk-taking itself is inherent to enterprise, and the impact of inappropriate risk-taking may be greater in a firm whose failure could have a systemic reach - however the principles of governance that should provide adequate checks and balances to the strategy of a firm (including the alignment of incentive arrangements with long-term goals) should be consistent across all firms.

2.6 The ABI is also concerned that these terms of reference refer generically to “financial institutions” or “financial services” but in many places where it is clear that the reference is applicable only to a narrow subset of entities (usually banks). This perhaps arises from the fact that currently the only institutions to have been identified as systemically risky are all banks. Processes to establish whether other financial institutions could pose a systemic risk are still on-going and, in the case of insurers, the International Association of Insurance Supervisors have yet to determine whether or not any insurance company merits this categorisation.

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2.7 In considering this topic, the ABI urges the Committee to be clear throughout where consideration is being given to the financial sector as a whole, and where the Committee are considering only a subset. Also it is important that in proposing any new measures, careful consideration should be given to the impact on all the institutions that they could affect – and where possible should be appropriately targeted to avoid imposing unnecessary burdens on firms in whose structure and processes the crisis did not expose any significant flaws.

3. Board structure and composition

3.1 What outcomes should corporate governance in the financial services sector seek to achieve? We believe that corporate governance in the financial services sector should ensure that UK leadership standards of corporate governance can be successfully applied to what is a critical sector of the UK economy in employment, GDP and global significance, to promote confidence in and within the financial services sector and in the financial system generally.

3.2 Are Board structures effective? For example, should UK financial institutions consider adopting alternatives to the unitary Board structure? The greatest challenge in designing effective oversight of listed companies in general, but in particular for banks and other complex business entities, is to ensure sufficient knowledge of the business and expertise among the independent non-executives such that they are able to hold management to account. It is plausibly the case that the unitary board structure will have greater relative advantages to others when it comes to such entities since the independent non-execs will be closer to the active decision-making organs of the business. In any case we see no evidence that other structures, such as supervisory boards, would have worked better in the Banking Crisis. Indeed, European countries with a supervisory board structure also had to support financial institutions, such as Aegon and ING in the Netherlands and Fortis in Belgium. Accordingly, we believe that the unitary board structure, as adopted throughout the UK corporate structure, is fit-for-purpose for financial services companies too. The UK Corporate Governance Code highlights the importance of board effectiveness and evaluation. Institutional shareholders pay particular attention to the quality of disclosures that are provided in this area. The ABI published a report on the issue of board effectiveness in September 2011 entitled Board Effectiveness – Highlighting best practice: encouraging progress, which drew together recommendations for maximising the performance of company boards. Highlighting the variety of ways leading companies currently implement diversity, succession planning strategies and board evaluations. We focused on these areas as we felt they were fundamental to improving board effectiveness. We felt that highlighting best practice would encourage progress and improve board effectiveness and provide an important input into a firm’s wider corporate governance. This will improve the development and execution of strategy and ultimately contribute to the continued long term success of the company. Please see Board Effectiveness Report.

3.3 Does the UK approach to regulation and supervision of financial services incentivise Boards to perform their role effectively? Is more intrusive regulation a substitute or complement to effective corporate governance? Is a “comply or explain” approach an effective framework for governance? The reforms to the UK regulatory system currently going through Parliament will introduce a more judgement-led approach. This will build on changes to the

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regulatory philosophy which the FSA has introduced over the past few years. The intention is that this approach should allow regulators to become more focused on the major risks facing firms (and the risks involved in the failure of a firm) rather than reliance on assessing detailed compliance with rules.

In principle, a judgement-led approach is welcome as it will involve greater engagement by senior regulatory staff in assessing the risks facing firms and the actions taken to mitigate these risks and less reliance on a mechanistic, rules-based approach. However, there are dangers to the approach as it could give rise to inconsistent, and possibly arbitrary, decisions by supervisors in respect of individual firms. In the worst case it could lead to supervisors second-guessing management decisions (which would appear to be a situation which the regulators accept will arise given they have described the approach as ‘judgements on judgements’) and potentially even acting as a shadow director. It is unclear, therefore, how the move to a judgement-led approach can be reconciled to the Board having sole responsibility for the management of the business. The FSA has also in public statements accepted that they will sometimes make the wrong judgements. It is unclear under such circumstances how responsibility for any customer detriment that might arise from such an error will be apportioned. There is a danger that where this situation arises the Board will be left to take the blame for decisions made by the regulator. Once again this potential situation would call into question whether the Board of a firm can operate effectively under the proposed regulatory approach. In order to try and mitigate these concerns it is essential that the PRA and FCA maintain sufficient checks and balances to prevent such outcomes. This must include robust arrangements to enable firms to challenge regulatory decisions - we are not, therefore, in favour of the proposed limits in the Financial Services Bill on the ability of firms to challenge PRA decisions at the Upper Tribunal. Corporate governance cannot be substituted by regulation; good corporate governance should supplement the regulation of financial services firms. Our members are strong believers of the comply or explain framework, and feel that it remains appropriate in the financial services sector. The benefit of this approach is that it leads to engagement on the issues surrounding good governance. If a company believes that a principle of governance is not appropriate in their individual circumstances the company can provide an explanation of why this is the case. It is then up to shareholders to take account of the individual firm’s circumstances and judge the quality and appropriateness of the explanation. If shareholders have concerns with the reasons for deviating from the Code or if the explanation is inappropriate or insufficient in detail, shareholders can then engage with the company. Shareholders are in the best place to make these judgements on what is appropriate for the company its individual circumstances. We do not believe that there is any evidence to suggest that any other approach to corporate governance would have been more effective in the crisis.

4. Corporate culture

4.1 What type of corporate culture should financial services firms seek to foster? In what way can this be encouraged? How effective are Boards at shaping corporate culture within their institutions?

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One of responsible risk-taking in which sustainable shareholder value creation, including through the value of service provided to the entities clients, is the embedded objective of all, where reward can be high but only where performance justifies it, in which risk management systems are well-built and operate effectively, and where responsible employees can be confident that concerns they may have can be raised and addressed without career-limiting implications.

5. Impact of previous reviews and new regulatory developments

5.1 What difference would the proposals in the Independent Commission on Banking’s report on the Boards of ring-fenced banks make to corporate governance in these institutions? We see the main advantages of ring-fencing as relating more to separate capitalisation of different business activities than in creating different structures of governance oversight including separate boards populated by different individuals. The critical point, however, is that individuals serving on boards of ring-fenced banks should, when serving as such, owe their duties to the company in question, and they in turn need to ensure that the governance arrangements for the entity are sound.

5.2 What benefits, if any, come from EU regulatory engagement with corporate governance issues? In view of the recent financial crisis, it is right that all law makers, at all levels, make a thorough examination of existing corporate governance legislation. With EU company law Directives and existing Recommendations the EU also has a role to play. However, in doing so a balance must be struck. A number of key factors must be considered, and fundamental principles of corporate governance should not be undermined. Any regulatory action must be duly considered and target any clearly identified needs for change rather than for bringing in regulation for regulation sake. In recent months, there has been considerable positive attention given to the role of shareholders during the ‘shareholder spring’, and Commissioner Barnier has expressed his intention to work on supporting this at the EU level, including the development of a binding shareholder votes.

Certainly, we believe that shareholder’ interests will be best served if the Commission focus on means of developing tools that will equip and strengthen shareholders’ ability to hold Boards to account cross-border.

At the present time, our primary concern is that while policy-makers express support for role of shareholder engagement during the shareholder spring, these same policyholders’ action on the ground is paradoxically taking powers away from shareholders. The most apt example of this at the moment is CRDIV.

The Capital Requirements Directive IV is currently progressing through the European legislative framework, we have concerns with a number of the proposals including imposing ratios between fixed and variable pay, which is likely to increase fixed pay, removing the link of pay for performance, we also highlight concerns, with the directive imposing caps on the number of directorships an individual may hold, and the imposition of quotas on the diversity of the board. We are concerns that a number of these proposals are taking powers away from shareholders and being given to the competent regulatory authority. It is important that shareholders have sufficient tools to carry out their stewardship responsibilities and can engage with the companies on a number of issues and hold boards to account. Some of the proposals under CRD IV take corporate governance issues outside the sphere of company law and into a banking compliance world. We maintain there needs to be a certain degree of flexibility, and a certain degree of oversight by shareholders otherwise there is a risk

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of complete disengagement. Furthermore, there will be no incentive for banks to take any notice of their shareholders.

This highlights why real care and attention is needed in this field. The results of unintended consequences could be severe.

In a broader sense, any EU developments need to recognise that there are different shareholder models in different member states. This is a challenge, as member states have different approaches to corporate governance, their systems of governance are at different stages of development and there are a number of different corporate, legal and shareholder structures across Europe. So any European Corporate Governance regime will need to fit within all these parameters and needs to provide enough flexibility to ensure that it is compatible with the most developed governance regimes such as current comply and regime in the UK.

5.3 What impact has the Walker Review (2009) had on corporate governance and corporate behaviour in financial services? Corporate behaviours in the sector have improved and the Walker Review has been a landmark in the formalisation of improved governance and more robust structures and processes but it is difficult to prove the counterfactual. The response of relevant listed entities to the Banking Crisis would have involved learning and improvement.

6. Non Executive Directors

6.1 Should non-executive directors bear greater liabilities than under current law? Should executives in FTSE 100 companies be able to hold non-executive positions in other firms? It is a core principle that directors are collectively and individually responsible for the decisions, actions and omissions of the Board. This is a key attribute of the unitary board which enshrines collegiality while respecting, indeed making a virtue of, diversity of role, expertise and qualities of independence. In practical terms the liabilities that non-executives might bear are ultimately a matter for the courts in any particular circumstances and the courts will be guided by previous case law. How statutory provisions should be framed was considered both during parliamentary deliberation on what is now the Companies Act 2006 as well as during public consultation during the review of company law which preceded the Bill’s introduction to Parliament. No major changes were made. Given the events in the financial system since the Act it is not unreasonable to wish to assess whether the conclusions remain sound but we believe they are. For an executive director of significant enterprises such as companies with a main market listing, in which ABI Members have significant investments, that role must be their primary responsibility and their ability to take on outside interest will be accordingly constrained. However, it is potentially in the interest of both giving and receiving company as well as the individual concerned that their expertise can be shared and developed and broader perspectives brought to bear in their primary role. In practice it is unlikely that an executive director of one company would be able to take on more than one outside directorship or to take on the chairmanship of a major board committee though we do not think it would be helpful to codify such a restriction. It is a matter for judgment for boards and nomination committees who should also be sensitive to, and where appropriate be proactive in soliciting, the views of shareholders on whether individuals can be spared from exclusive focus on the primary role in their working life.

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6.2 Is the existing FSA approval process for significant influence functions (SIF), including non-executive directors, effective? We have a number of concerns about the current SIF approval process. In order for the approval process to be effective, those conducting the interviews need to be of sufficient seniority to be credible to the interviewees and have had sufficient experience of financial services and boardrooms in order to ask pertinent questions. Based on feedback we have received from Members we remain concerned that the interviews are not being conducted at a sufficiently senior level by the FSA. We are also concerned about the length of time that the approval process may take – once again our Members have expressed concern that the approval process can take an excessively long period. The problems with this process are of particular concern in the recruitment of non-executives. Given the important role that non-executives play, particularly in relation to their role representing the interests of shareholders, and the fact that good non-executives are much in demand, we believe that the interview and approval process should be expedited. Ultimately there is a risk that many suitable candidates will not accept appointment at financial services firms. We are also concerned that the current proposals for the approval of SIF’s in the Financial Services Bill will exacerbate this situation. We are concerned that the proposed process for approving holders of controlled functions appears unnecessarily complex and is not yet fully thought through. It is unclear from the drafting which regulator will be responsible for designating and approving some functions. We would continue to suggest that it would be more appropriate for there to be a joint responsibility on the part of PRA and FCA to approve holders of significant influence functions for dual-regulated firms. Whatever system is put in place it is important that it is run as efficiently as possible to ensure that the approval process is undertaken quickly and with the minimum of overlap. Candidates should only have to put forward one application and attend a joint interview. In order to ensure this it would be appropriate, as with authorisations, for either PRA or FCA to take the lead in processing applications consulting the other as necessary.

7. The role of shareholders

7.1 Should shareholders be required to exercise a stronger role in systemically important financial institutions? What are the key barriers to greater shareholder activism by institutional investors in financial institutions? What risks are associated with it? As with (non-executive) directors we believe it would be inappropriate, and potentially, dangerous to create different expectations of responsibilities of shareholders. It is also critical to remember that the practical ability of shareholders to exercise stewardship responsibilities also relates to their rights which fundamentally relate to the votes they cast in general meeting. It is evident, in particular from experience during the years immediately preceding the Banking Crisis, that the ability of institutional shareholders to exercise suasion over powerful boards that do not choose to respect their views can be very limited. Our assessment is that shareholders in systemically-important financial institutions, both individually and collectively, already devote more time and resources to their responsibilities as shareholders in such companies than they might otherwise be expected to do by reference to criteria such as current value of the shareholdings. It would be important not to ratchet expectations in this area and more specifically to ensure that the investment case for bank equity is not to be further reduced.

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Ultimately, it is the responsibility of Boards to ensure that they have appropriate corporate governance systems in place.

7.2 Is it realistic to expect sovereign wealth funds and hedge funds to undertake a more active role? Historically, UK institutional investors have been the investors that have upheld their stewardship responsibilities. Sovereign Wealth Funds and Hedge Funds have been unlikely to take a more active role unless they derive value from Stewardship. A key concern is that given the role of UK institutional investors have historically and continue to take there is too much temptation to free ride and derive value without committing any resource to stewardship. Given the FSA requirement for Investment Managers to comply or explain their compliance with the Stewardship Code we have seen a number of hedge funds sign up to the Code, but we have yet to see this lead to greater increase in stewardship activity by these types of institutions. There is currently a significant gap, with no Sovereign Wealth Funds having signed up to the Stewardship Code, although some have shown their support for it. However, over the medium term it is reasonable to expect some Sovereign Wealth Funds, could take a stronger role.

8. Remuneration

8.1 What role should institutional investors, remuneration consultants, employees and others play with respect to remuneration in the financial services sector? Like all listed companies, our members believe that it is the role of the Board and the Remuneration Committee to set the remuneration policy and make decisions on what individuals should be paid. Shareholders expect the Remuneration Committee to protect and promote their interests in setting executive remuneration and to have to scrutinise but not micro-manage this important part of the Non Executive Directors’ responsibilities. These responsibilities are clearly set out in the UK Corporate Governance Code and are critical to the successful handling of difficult remuneration issues. Investors have been increasingly critical in recent years of the judgements of many Remuneration Committees and have welcomed the recently introduced power to have an annual vote on the election of non-executive directors, including the Chair of the Remuneration Committee. One aspect of shareholders holding Remuneration Committee’s to account is engagement between investors and the Remuneration Committee. For many years, the ABI has helped to facilitate collective engagement between our members and the Board’s and Remuneration Committee of companies. A recent example of this is the follow-on for our letter to the UK bank Chairman (see question 14), our members met collectively under the auspices of the ABI to engage with the Chairman and Remuneration Committee Chairman to discuss the structure of bank pay. Remuneration Consultants should be hired by the Remuneration Committee to provide appropriate independent advice on remuneration structures. The consultant’s relationship should be analogous to audit Committees and auditors. We believe that Companies should disclose all fees paid to remuneration consultants including details of related work for the company such as the provision of employee tax compliance, human resource consultancy or board evaluation. The annual report should also set out how the remuneration consultant was appointed and on what terms that appointment was made. We do not believe that employees in any company including financial service companies should have an explicit role in the setting or approving remuneration. Our members support the UK Corporate Governance Code which states that the

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Remuneration Committee should be sensitive to pay and employment conditions elsewhere in the Group. The ABI principles of Remuneration state that “it is the role of the Board which are appointed by shareholders to run companies and act in their interests. They have a fiduciary duty to act in the best interests of their shareholders when determining remuneration. It is their responsibility to promote the long-term success of the Company, taking into account the interests of employees, suppliers, customers, community, the environment and society.” In addition, the guidance to the principles state the following on the pay for employees below board level.

“The Remuneration Committee should be cognisant of pay and conditions elsewhere in the Group and take them into account when determining executive remuneration.

The Committee may have a role in determining pay or having oversight of remuneration at below board level. This is of particular relevance where the levels of remuneration or the risks associated with the activities involved are material to the Group’s overall performance.”

8.2 Is there a case for introducing still greater transparency for senior executives with

respect to remuneration in the financial services sector? With regard to the disclosure of the remuneration paid to senior executives in the financial services sector. The requirements to disclose aggregate senior executive and Code staff remuneration and the recent requirements from the HM Treasury to introduce disclosure of the eight highest paid individuals is sufficient at the current time for senior executives. In our response to HM Treasury consultation on Bank Executive Remuneration Disclosure: Consultation on Draft Regulations, we made the following observation: the senior executives, will not always be the individuals who carry the greatest systemic risk to the organisations nor will they be the highest paid individuals below board level. Indeed, many of the highest paid employees in investment banks operate significantly below board level. It is our view that an increased focus on these individuals might force institutions to look more closely at the risk/reward systems that they have in place for such individuals. We recommend that the government should require the disclosure of the ‘highest paid individuals’ below board level irrespective of whether they hold a managerial position.

8.3 Should there be further reform of the remuneration arrangements of senior executives in the financial services sector? Should this extend to those highly paid individuals who sit below executive level? In December 2011, the ABI wrote to the five UK listed banks – See attached letter. In this letter we highlight our members concern with remuneration across the banking sector. Whilst we recognise that each bank has different characteristics, in terms of business focus, geographical reach and performance, this letter sets out our view that all banks need to fundamentally restructure their remuneration practices. As bank remuneration is currently structured, our members are concerned about the level of returns that shareholders receive compared to the returns given to employees. Members believe that in recent years this balance has been inequitable, with too much value being delivered to employees in contrast to the dividends paid to shareholders. The attached data shows how total employee costs and dividend payments have changed over the last 10 years, at the five UK listed banks, all this data has been collected from the Annual Reports of the Banks. At Barclays, for example total staff

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costs have risen from £3.755 billion in 2002 to £11.407 billion in 2011. Over the same time period total dividends fell from £1.206 billion in 2002 (dividend per share of 18.35p) to total dividends of £653 million in 2011 (dividend per share of 5.5p). Likewise at HSBC, total staff costs have increased from US$ 8.609 billion in 2002 to US$ 21.166 billion in 2011. Over this time period, dividend payments have increased from US$ 5.001 billion (dividend per share of 53 cents) in 2002 to US$7.324 billion in 2011 (dividend per share of 39 cents). In neither case has the payout to shareholders kept pace with the payouts to employees. ABI members continue to engage with all UK banks to improve the investment case for the banks by improving the remuneration structure. ABI members are supportive of the principle of pay for performance; members are supportive of individuals being rewarded for exceptional performance, but importantly only if it is in the context of an appropriate capital allocation balance. It is important that any structural reforms, if required, should extend to key decision-makers below board level who put significant shareholder value at risk, and to guard against any perverse incentive not to promote such individuals to the appropriate level of responsibility including board level. We believe that any performance measures used to assess the company’s performance for employment remuneration should be risk adjusted measures, so the profit or returns measures used for remuneration should be on a risk adjusted basis. This process is dependent on a robust process of risk adjustment. In addition, ABI members are not in favour of banks using contingent capital to reward or defer remuneration. This is particularly the case when there is no transparent market in the instrument. It is our belief that deferred remuneration should be included on the balance sheet.

8.4 The Chairman of the Financial Services Authority has argued that there may be a case for changing the personal risk return trade-off for bank executives. He has suggested either a ‘strict liability legal sanctions or an automatic incentives based approach. What are the merits and drawbacks of these proposals? Are there other ways to achieve the same objective? Out of the two approaches presented by Lord Turner, our members believe that automatic incentives based approach would be the one which has the most productive results. We believe that the automatic incentives approach will require executives and Boards to automatically face the downside consequences of bank failure. There obviously needs to be appropriate recourse for Directors to appeal or demonstrate that they were seeking to rectify the failure. But members believe that personal reputation of individual directors is a strong motivator. Annual re-election of directors has only recently been implemented into the UK Corporate Governance Code and we have found that the personal reputational risk of facing a significant negative vote is starting to have an impact of Director behaviour, as the individuals can see the negative consequences that a negative vote could have on their reputation with shareholders and companies more generally. The large degree of deferral will ensure that Directors have exposure to the share price and will be affected by falls in the share price. Therefore, they will have money at risk which will be based on the decisions they make. The Executive Directors should also be subject to clawback of awards which made on the basis of misstated financial information. Non-Executive Directors should not participate in incentive

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schemes, but could be required to purchase shares at the market price out of their fee. They will then be subject to holding period for the time that they are a Non-Executive Director. Non-Executive Directors should not be subject to clawback, but their exposure to the share price is likely to be a motivator to their behaviour. We agree with Lord Turner, that the options to ensure that Bank Executives and Boards place greater weight on avoiding downside risks merits careful debate.

9. Governance of risk

9.1 Has the management of risk in firms improved since the financial crisis? Insurance is about the management of risk and, therefore, insurance firms have always devoted considerable resources to risk management. Likewise the UK insurance regulatory system has adopted a risk-based approach for a number of years: insurers are supervised against their risk-based Individual Capital Assessment. The success of this can be seen in the performance of insurers during the financial crisis – no UK insurers became insolvent or required public funds. However, insurers understand that further improvements in risk management are necessary. The forthcoming implementation of the Solvency II directive (which is due to come into force at the beginning of 2014) will further enhance risk management within firms. Insurers will be required to have separate risk and actuarial functions and governance arrangements will require the Board to have a clear understanding of the risks faced by the firm and the measures in place to mitigate these (in practice, as noted above, these will simply reinforce existing developments).

10. Diversity and background

10.1 What is the relationship, if any, between Board diversity and company performance in the financial service sector? Board diversity is an essential driver of board effectiveness. The ABI believe that ensuring the board is composed of members from different backgrounds, with a wide range of skills and experiences, introduces a diversity of perspective that will help to promote the company’s long term success. This is due to the fact that board members with diverse perspectives are more likely to challenge previously held assumptions and break down the tendency towards ‘group-think’ that can arise where a board is composed solely of like-minded individuals – as happened during the recent financial crisis. The evidence base for the relationship between board diversity and company performance in the financial services sector is growing, however some findings differ and it is difficult to determine cause and effect. The 2003 Tyson Report highlighted a number of benefits from board diversity for companies which should ultimately benefit their shareholders. These included benefits to company reputations, enhanced sensitivity to company risks from a healthy mix of backgrounds and perspectives and better management of key constituencies such as shareholders and employees. More specifically, in the case of gender diversity, McKinsey’s Women Matter 2010 report found that companies with a higher proportion of women in their executive committees have better financial performance. A further recent Thomson Reuters report, Women in the Workplace, indicates share prices at companies that open job opportunities to women may fare better in volatile or falling markets. It is our view that as companies grow in size and complexity and increase their business activities in the global arena, the significance of boardroom diversity, on

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various levels, is increased. In order to achieve long-term success in a competitive international environment, companies need to draw upon a diverse range of perspectives and competencies that are relevant in a globalised business world. A diverse board, therefore, sends a robust and positive signal to investors that companies are confronting this challenge by ensuring they have the guidance needed in the boardroom to steer them through every stage of their development. This will help to promote the company’s long-term success. Economic benefits are achieved by having a well-balanced and carefully selected board. However, the needs of companies vary considerably according to the nature of business, its size and many other factors; therefore there cannot be a ‘one size fits all’ approach to diversity and consequently board appointments. There is need to ensure that companies have a sufficient degree of flexibility. May 2012

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Written evidence submitted by The City of London Law Society

Written evidence from the Company Law Committee of the City of London Law Society

The City of London Law Society represents approximately 14,000 City lawyers through individual and corporate membership including some of the largest international law firms in the world. These law firms advise a variety of clients from multinational companies and financial institutions to Government departments, often in relation to complex, multi-jurisdictional legal issues. The CLLS responds to a variety of consultations on issues of importance to its members through its 17 specialist committees. This submission has been prepared by the Company Law Committee.

The Treasury Select Committee’s inquiry has a broad scope and includes some questions that go to the heart of corporate governance of UK companies. It is not within our remit to respond to the specific focus of the inquiry but we wish to draw the Committee’s attention to the important distinction between the role and objectives of the company law framework that regulates the governance of UK companies generally and the role and objectives of the regulatory framework that governs financial institutions.

We believe that this distinction is important. It is right that financial institutions should be subject to special rules because of the systemic risks to which they expose the wider community. But we do not think it is appropriate to modify the corporate governance framework that applies to companies generally and which is designed to ensure that all companies, including financial institutions, are run in a way that promotes their success for the benefit of their shareholders. Altering this core statutory obligation of directors in relation to systemically important financial companies will create unhelpful confusion of responsibilities. If it is right that special considerations apply to systemically important financial institutions, we suggest any additional constraints should be imposed as part of the regulatory regime (enforced by a regulator with a close supervisory relationship with the companies concerned) and not by changes to the governance framework.

The two specific questions in the terms of reference on which our concerns are focussed are Question 2 (Are board structures effective?), Question 3 (Is more intrusive regulation a substitute or complement to effective corporate governance? Is a "comply or explain" approach an effective framework for governance?) and Question 8 (Should non-executive directors bear greater liabilities than under current law?).

Question 2

Are board structures effective? For example, should UK financial institutions consider adopting alternatives to the unitary board structure?

The UK corporate governance framework allows considerable flexibility in the way companies organise their boards. Among public companies this ranges from boards that are broadly balanced between non-executive and executive directors to those that are preponderantly non-executive with one or two executives. Each approach has its proponents and companies are free to decide, after appropriate engagement with their shareholders, which will be most effective for them. The question seems to suggest that the Treasury Select Committee may want to go further and consider whether a dual

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board structure would be appropriate for SIFIs. That would be a step that would require a major re-engineering of the governance framework for those institutions, including defining the duties and responsibilities of each board. No doubt in considering this question the Treasury Select Committee will seek evidence of how other governance systems work and whether they proved more effective in the recent financial crisis compared to unitary boards; and in assessing that evidence we would urge the Treasury Select Committee to recognise that any corporate governance framework is a complex system of checks and balances: the perceived effectiveness of dual board structures within a different legal and cultural framework would not necessarily be replicated in the UK.

Question 3

Is more intrusive regulation a substitute or complement to effective corporate governance? Is a "comply or explain" approach an effective framework for governance?

We do not believe more intrusive regulation should be a substitute for, or a complement to, effective corporate governance. The “comply or explain” approach to corporate governance is applied against a regulatory background that sets certain minimum standards. The comply or explain approach allows companies to preserve operational flexibility and to work out their own optimal arrangements in dialogue with their investors. This gives flexibility where a standard imposes a particular burden on smaller companies or, for some reason ( which may be temporary) is thought not to be appropriate for a particular company. Regulations, which are slow to adapt, are invariably crafted in order to achieve a political consensus. We believe regulations are likely to result in lower standards being set than a “comply or explain” approach which can set higher aspirational standards (because companies can choose to explain if they do not comply) and can evolve more quickly than regulations in the light of changing conditions and investor expectations. By way of example, the UK Corporate Governance Code not only expresses broad principles, but also includes a number of concrete guidelines. Recent work by the Financial Reporting Council demonstrates that when new higher standards of corporate governance have been introduced companies have been relatively quick to adopt the new standards (for example in relation to putting all directors up for annual election) even though initially there was not consensus about the new requirement. The FRC has also shown that there is high compliance with the Code and generally the quality of explanations is good and that companies and investors are working together to enhance the quality of disclosure in other cases of non-compliance. More intrusive regulation could make companies less willing to strive to meet the higher standards that emerge under a “comply or explain” approach and would also impose a greater burden on smaller companies less able to meet the higher standards at an early stage (or where the higher standards may not be appropriate for their particular situation). There is a risk that more intrusive regulation could result in an approach that involves more box-ticking and boilerplate disclosure: a race to the bottom, rather than encouraging companies to engage with investors and the benefits of adopting the Code provisions.

While there is certainly a role for regulation in constraining corporate behaviour that could increase systemic risk and harm the wider public (e.g. regulation requiring banks to hold minimum levels of capital having regard to their risk-weighted assets; regulation protecting the environment), more intrusive regulation of a company’s governance arrangements would shift responsibility from companies and their owners to the

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regulator, undermining the role of shareholders as responsible owners and create a confusion of responsibilities on the part of the directors.

Question 8

Should non-executive directors bear greater liabilities than under current law?

We do not understand why the question focuses on non-executive directors. If it is concerned with general legal duties (rather than specific regulatory obligations) we think the distinction is misconceived. We do not believe that imposing additional liabilities on directors will achieve any desired improvement in the stewardship of their companies. The standards of conduct and assurance required by the Companies Act are high. More onerous standards would expose directors to liability without fault which we do not believe can be justified. It would add a very real and substantial disincentive for individuals to accept appointment to boards and if, as we suggest is the case, good governance is as much about having the right people as the design of the legal framework, this proposal would be counter- productive.

May 2012

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Written evidence submitted by Cevian Capital (UK) LLP Basis for Views Cevian Capital is the largest dedicated active ownership investor in Europe, managing c. EUR 5 billion for c. 250 primarily institutional clients. Cevian’s senior team members have been focused exclusively on active ownership since 1996, and this strategy has generated attractive long-term returns for Cevian’s clients. Cevian invests in the equity of listed companies. It does not short, hedge or use leverage1. The majority of Cevian’s clients irrevocably commit their capital to Cevian for 3-5 years, enabling Cevian to take a long-term view. Cevian’s average term of investment is 3-4 years, though it has often owned stakes in companies for much longer. Cevian actively seeks to invest in companies whose performance is below potential, and then works constructively to improve these companies, including governance changes. Cevian has been particularly successful investing in financial institutions and working to improve their governance. This experience includes important financial institutions in the UK, Germany, Sweden and Denmark. Cevian’s team members have served on the boards of companies listed in Sweden, Finland, Norway, Germany, Switzerland, the US and the UK. In total, Cevian senior team members have held approximately 35 board seats in listed companies. This provides a strong basis to discuss corporate governance and other related matters. The chairman of Cevian Capital UK is Lord Myners, who has extensive experience with UK companies from virtually every relevant perspective: investor, CEO, board director, chairman, Treasury Minister, regulator, and member of various commissions and studies. As a government minister 2008-2010, he had deep involvement in the restructuring of the UK banking sector and was given rare insight into the governance problems that led to issues with the UK banks. A founding partner of Cevian Capital is Christer Gardell, who was a partner of McKinsey & Co and a member of McKinsey’s Financial Services European leadership team. In November 2011, Cevian Capital UK submitted a response to the Kay Review Call for Evidence.2 A copy of this submission is attached.

                                                            1 Non-Euro currency exposure is occasionally hedged, and limited leverage may be used on occasion for bridging purposes 2 This current submission draws on the Kay Review submission, and in places repeats text used in that submission.  

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Introduction We welcome the Treasury Select Committee’s Inquiry into the critical area of corporate governance and remuneration in systemically important financial institutions. While there has been progress in some areas since publication of Sir David Walker’s Review on BOFIs, we are concerned that little seems to have been done to address the fundamental governance issues at BOFIs – particularly governance within the board room and the link between the board and owners. Our submission focuses entirely on these areas. Overview – The Fundamental Flaw in the System Walker Review: “The essential “challenge” …. appears to have been missed in many board situations and needs to be unequivocally clearly recognised and embedded for the future. The most critical need is for an environment in which effective challenge of the executive is expected and achieved in the boardroom before decisions are taken on major risk and strategic issues.” The essence of this submission is that the current nomination process for non-executive directors (“NEDs”) of UK listed companies is fundamentally flawed and, consequently, it should not be surprising that the boards of many UK companies – particularly financial institutions – have failed in their overall task of being good stewards for owners, other stakeholders, and society as a whole. In the UK, the nomination process for NEDs is typically controlled by company chairmen, and the shareholder approval vote is almost always an empty formality. Consequently, chairmen effectively select their own NEDs. Human nature means most chairmen will avoid selecting “natural challengers,” and most NEDs – having been given their job by the chairmen – are uncomfortable making waves. When chairmen select NEDS who are not natural challengers, and when the NEDs are uncomfortable “rocking the boat” , the result is a lack of challenge in the boardroom. This leads to poor decision-making, limited accountability and improper alignment of interests. The challenges (and consequences) are particularly grave in the financial sector – where the job of a NED is especially difficult – given that relative to part-time NEDs, executive directors have a huge informational advantage and benefit asymmetrically from risk-taking. Involving large shareholders directly in the nomination process would directly address the fundamental flaws in the current system. As radical as this may sound, in Swedish, Norwegian and (most large) Finnish companies, large shareholders already play a direct role in the nomination process, including for banks. Interviews of chairmen, NEDs, executives, owners, and regulators underscore how well this system works. Although there are other factors at play, it is striking that the financial institutions in these countries generally avoided the excesses of UK, US and many other

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European banks, and compensation for executives is not the problem that it has been in the UK. Consequences of Poor Board Behaviour Poorly functioning, out-of-touch, non-accountable boards display many symptoms that are damaging for stakeholders and society, particularly in the case of systemically important financial institiutions. These include: • Inappropriate risk-taking, strategic errors, poor acquisitions and capital management –

arising from insufficient control over ambitious management teams, who often have asymmetric incentives and a desire to expand their domains;

• Weak governance – chairmen, NEDs and executives who perform “well enough” to keep their seats, but are not compelled to drive a company to its potential; poorly managed succession processes;

• Executive remuneration – Plans with targets that are too low, purely financial, and

poorly aligned with the interests of shareholders and wider stakeholders; inappropriate benchmarks and structures; and unreasonably high levels of compensation;

• Corporate underperformance – arising from un-ambitious, unchallenging and inappropriate target setting;

• Lack of diversity – A lack of diversity within the board, resulting from managed nomination processes that lack transparency and objectivity, and that favour the “old boys’ network.”

Shareholders, other stakeholders and policy makers have limited time and resources. Much effort is expended on trying to address individual issues – such as executive remuneration. It would be more efficient, and more effective, if attention were focused primarily on comprehensively improving board behavior, which would address many symptoms at one time (including risk-taking and executive remuneration). What is the Root Cause of Poor Board Behavior? The root cause of poor board behavior is that shareholders have abdicated their responsibility for appointing board members, and, in practice, today it is the boards themselves (led by the chairmen) who appoint their own members. Board candidates are put forward for election and re-election by the nomination committee of the board -- almost invariably headed and controlled by the chairman. Institutional shareholders do now regularly vote on director elections (and for many, the act of voting is held out as a demonstration of their responsible ownership). However, in most instances the shareholder vote has become an empty formality, as the easiest, least costly and therefore routine thing for institutional owners to do is to vote “for” all the candidates. This is evidenced by the fact that not a single director candidate put forward by a FTSE 350 board has been voted

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down by shareholders in at least the last five years. (According to unpublished data for all elections 2006-2010, prepared by PIRC).3 This behavior is especially disappointing as appointing directors is the shareholders’ single most powerful tool of ownership, and by failing to exercise it, they are failing to fulfill their “primary role in promoting the accountability of management and boards for the performance of their businesses.”4 Leaving board appointments entirely to the discretion of chairmen and their nomination committees results in dynamics which can be damaging: Yes, there are good chairmen who seek to fill their board with natural “challengers” – but, in our experience, it is common for chairmen to favour directors who are quite the opposite; people who will not “rock the boat.” Furthermore, once chosen, non-executive directors understandably feel primarily beholden to the chairmen who have given them their seat (and only secondarily to shareholders, whose approval was always certain and only a formality). In addition, non-execs are well aware that developing a reputation as a “trouble-maker” within the board is certain to limit the number of board invitations they receive in the future.5 6 At the same time, NEDs – other than the chairmen and, occasionally, senior independent directors- rarely meet with shareholders. Thus the only information that comes to them about shareholder views and perceptions is intermediated – by the chairmen and executives themselves (whom they are supposed to challenge), by corporate brokers (who may have their own agendas), and to some extent through sell-side research. The result of these dynamics is a subjugation of accountability to shareholders, as well as a reduction of challenge within the boardroom. Without internal challenge, and without a real sense of its own accountability to shareholders, the non-executives on the board, individually and collectively, are likely to fail in one of the most important duties – the exercise of corporate control and accountability. With insufficient control and accountability, a range of poor outcomes are likely, particularly in areas where conflicts of interest may exist with management objectives. 7

                                                            3 There have been approximately 10 instances of candidates being withdrawn by companies, probably as a result of back-room actions by large shareholders.  4  Text in italics taken from the background information provided by the Kay Review along with the call for evidence. 5 It is important to note the particularly high demands placed on non-executives in the unitary board system, since they are expected to challenge fellow members of the board (the executives) who are engaged with the company on a full-time basis and shape or control much of the information going to the board. Meanwhile, the average non-executive, at best, spends 2-3 days a month focused on the company, and has little or no information about the company and its industry, other than what is provided through board channels. 6 UK companies and the search firms who support them have become much better over the years at identifying candidates whose CVs look appropriate for the task. However, as we make clear, that alone doesn’t make someone a good board director. 7 We accept that in some rare companies may thrive without boardroom challenge because of the unique “benevolent dictator” characteristics of their leadership. However, policy should not be built on such exceptions.

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Shareholder Involvement in Board Nominations We believe that the most tangible and realistic way to comprehensively addressing poor board performance is to directly involve shareholders in the company’s board nomination process for non-executive directors. This system operates well in Sweden (as well as in Norway and at most large companies in Finland) and benefits all – shareholders, companies, directors and society at large. While it would be inappropriate to simply take the Swedish system and apply it to the UK, there are important lessons that can be drawn from the Swedish experience. We would be happy to comment on these matters. Why would Shareholders in Nominating Committees be more effective? There are three primary reasons:

1. Involving shareholders in nominating committees would directly address the root causes of poor board behavior, and result in an improvement in the range of areas where board behaviour is damaging for shareholders, other stakeholders and society. This includes risk-taking and executive pay.

2. Getting risk-taking and executive pay right is very complex, and requires detailed study of large amounts of information (some of which is confidential) and a delicate balancing of various objectives. It is not clear that shareholders, with limited resources and working from the outside, are in a position to do this work well.

The economic cost of such efforts, or need for it, would reduce significantly if shareholders had more confidence in their NEDs. In our view, current compensation schemes are driven to be more formulaic and quantitative precisely because shareholders are not willing to trust the qualitative judgement of directors. The process of nominating non-executive directors is also complex, but on balance suits the skill set of institutional shareholders much better than analyzing pay. Having put in place non-executive directors who feel true accountability to a company’s owners and stakeholders, shareholders can effectively and reliably charge these non-executives to appropriately set pay levels.

3. Experience in other countries has demonstrated that involving shareholders directly in the board nomination process has led to a marked increase, over time, in their true engagement with the companies. As one Swedish pension fund CEO we spoke with said (this has been paraphrased): “When we became responsible for board nominations, we knew that society would blame us if the companies didn’t perform. So we realized we had to take this work seriously. We didn’t want to do it, but we felt forced to. Over time, we realized how valuable it was for us, as our work in nominations committees gave us a better appreciation of our companies, a

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longer-term view, and made it natural to collaborate with other large shareholders.”

In closing, we would like to re-emphasise that we have consciously chosen to submit a very focused response, rather than to respond comprehensively to every issue and sub-issue on which views were invited. We suggest encourage the Treasury Select Committee to give serious consideration to measures which address the broad issue of poor board performance, rather than focusing on symptoms of this problem. June 2012

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Written evidence submitted by Barclays

Board structure and composition 1. What outcomes should corporate governance in the financial

services sector seek to achieve? 1.1 Good corporate governance is fundamental to building a sustainable

economy, alongside a wider focus on strategy, behaviour and regulation. It is an important element in creating and sustaining shareholder value and ensuring that behaviour is ethical, legal and transparent. However, it cannot, and arguably should not be expected to prevent failure. Nor can it guarantee success. Financial services firms must be allowed to take and manage risk if they are to support the economy effectively.

1.2 A well-governed and well-run company engenders trust, which in turn

builds confidence in that company’s ability to create sustainable returns for its owners and to support the needs of its wider stakeholders, including, in the case of financial institutions such as Barclays, those regulatory bodies that are tasked with ensuring financial stability.

1.3 Effective corporate governance supports the delivery of the company’s

strategic priorities. It should help ensure that the company is well-managed; that its risks are identified and mitigated; that its income is generated in a sustainable way; that costs are properly managed; that there is a robust control environment in place and that people are rewarded for performance and are not incentivised to take inappropriate risks.

2. Are board structures effective? For example, should UK financial

institutions consider adopting alternatives to the unitary board structure?

2.1 The board is fundamental to effective corporate governance, and we

believe that the current structures used by UK public companies are effective. A board’s role is to set the overall strategic direction and to take steps to satisfy itself that management is acting in accordance with that authority and within an appropriate framework of controls to deliver the strategy.

2.2 Barclays is not aware of any evidence to suggest that the unitary board

structure contributed to the financial crisis or that two-tier board structures weathered the storm better. As the Walker Review observed, the key issue in practice is not formal board structure but the comparative effectiveness of boards functioning under the two different approaches.

2.3 A unitary board, when properly run and performing effectively, can be

more successful than a two-tier structure. Decisions are taken collectively in one forum where executive and non-executive Directors share the same

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responsibilities and are able to exchange views and challenge each other. In the two-tier model, there is no opportunity for such interaction, which is widely regarded as value-adding for effective decision-making.

2.4 Board effectiveness is more than a question of structure. The essential

factors are behaviours, style and tone in the boardroom; ensuring that the board is comprised of suitably experienced individuals; creating a culture where challenge is both expected and welcomed and ensuring that the board receives the right information at the right time. The overall quality and effectiveness of corporate governance is much more dependent on behavioural issues and style rather than process and structure.

2.5 The role of the Chairman (which we set out in our Charter of

Expectations1) is at the heart of this cultural and behavioural approach to ensure:

• a Chief Executive does not become too dominant;

t

ors.

• all non-executive Directors contribute effectively as individuals, whilscritically, aiming to get the best out of the Directors collectively; and,

• the promotion of effective communication between executive and non-executive Direct

2.6 Training and induction are critical to ensure Directors can perform

effectively as individuals and collectively. However, while training and induction can address areas of technical development, depth of experience, sound judgment and independence of thought cannot be acquired through training.

2.7 An effective process for non-executive Director recruitment is therefore also

crucial: the board must fully identify the skills and experience it requires, must have a thorough and transparent search and selection process and must have an established way of evaluating Directors’ individual as well as collective performance. Director evaluation is an important part of the process of ensuring an effective board.

3. Does the UK approach to regulation and supervision of financial

services incentivise boards to perform their role effectively? Is more intrusive regulation a substitute or complement to effective corporate governance? Is a “comply or explain” approach an effective framework for governance?

3.1 Companies must create a strong culture of corporate governance in a way

that is appropriate and relevant to their own particular circumstances and challenges.

1 Charter of Expectations

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3.2 Achieving regulatory certainty in a stable public policy environment is vitally important to allow the financial services industry to focus on delivering on behalf of all its stakeholders and help to foster economic growth.

3.3 UK-specific regulation must ensure that UK banks are able to compete on fair terms in European and global markets. It is vital that any UK regulatory measures are assessed in the context of their implications for the wider economy.

3.4 We appreciate that regulators have a vested interest in, and can contribute

to, good corporate governance, but this should complement rather than act as a substitute for the corporate governance practices implemented by management in line with the best practice recommendations of the UK Corporate Governance Code. We do not support any measures that would blur the distinction between the responsibilities of supervisors and management.

3.5 A greater role for supervisors in corporate governance runs the risk that

supervisors become de facto management, who are then responsible for assessing or monitoring their own performance. An effective supervisor must retain a degree of distance and independence from the management of the company.

3.6 It is essential to retain flexibility around how companies apply corporate

governance practices that are relevant to their business. In this regard, we are strongly supportive of the “comply or explain” regime.

3.7 “Comply or explain” allows companies to explain to their shareholders why

they have not complied with best practice principles or provisions. It is up to the company and its shareholders to engage on matters of non-compliance and the responsibility of shareholders to put their views to the company if they do not accept the explanation provided.

3.8 “Comply or explain” is fundamentally sound: it can and does work well

and is rightly held up as a model for other jurisdictions. There is no evidence that alternative corporate governance structures and processes fared better or worse during the financial crisis. While the design and operation of corporate governance structures and processes are important, behaviours, including values, style and tone, matter much more.

3.9 Also see response to Question 9.

Corporate culture 4. What type of corporate culture should financial services firms seek

to foster? In what way can this be encouraged? How effective are boards at shaping corporate culture within their institutions?

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4.1 As the ICB recognised, “corporate culture cannot directly be regulated”. Barclays believes that shaping corporate culture is the responsibility of both boards and management and should be a constant focus.

4.2 There should be a culture in the boardroom that creates the environment

for Directors to demonstrate appropriate values and effective behaviours in their stewardship of the company, a culture where challenge and review is expected and accepted.

4.3 However, once clear decisions on policy or strategy are made, management must be fully empowered to implement those decisions in the best interests of shareholders, customers and employees.

4.4 The culture and values set by the board and reinforced by management

should foster good behaviour throughout the organisation from the top down.

4.5 At Barclays, our purpose is to help individuals, communities, businesses and

economies to progress and grow. Citizenship is one of our four execution priorities and fundamental to this agenda is ‘the way we do business’: maintaining integrity in the way that we govern and manage our business, with robust controls supported by clear business principles. By behaving with the highest levels of integrity we aim to retain, or regain, the trust of our customers, shareholders, other external stakeholders and employees.

Impact of previous reviews and new regulatory developments 5. What difference would the proposals in the Independent

Commission on Banking’s report on the boards of ring-fenced banks make to corporate governance in these institutions?

5.1 The Companies Act 2006 includes the requirement to promote the success

of the company in the long term and to act fairly between shareholders, which in the case of the ring-fenced bank, means the parent company.

5.2 The board of a UK retail subsidiary would apply the same generally

accepted principles in a way that is appropriate for its own circumstances and challenges, while still operating within the overall governance and control framework set by the parent company for its operations.

5.3 As the ICB recognised, it will be essential to maintain lines of

communication between the ring-fenced company and the parent to ensure delivery of the overall group strategy.

5.4 As with many banks, Barclays has subsidiaries that are either wholly or

partially owned. Some of these subsidiaries have their own Board structures, with effective corporate governance, in place already. Therefore, the ICB proposals for ring-fenced subsidiaries already have structural and governance precedent on which to be based.

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5.5 Existing international standards for corporate governance can, and should, be used to design the requirements of the ring-fenced entity. We note the need to address the potential conflict for directors sitting on both the ring-fenced entity board and the holding company/parent board and how this conflict can be overcome. This will depend on the detail of how the ICB proposals will be implemented. We would urge that such implementation should take into account the need for clarity in the arena of corporate governance and directors’ duties and should strike a balance between regulatory requirements, cost and administrative burden.

5.6 We set out our proposals for the governance of the ring-fenced entity in

our response to the ICB report, which included: • the ring-fenced entity will require a separate board which does not

preclude membership of other company boards (given the insufficient pool of qualified non-executive Directors to meet existing bank board places);

• the ring-fenced entity should not be fully independent of the parent; nor should it have unique board audit or remuneration committees but a separate Chief Risk Officer (CRO) and board risk committee may be considered; and,

• a defined resolution event would trigger the resignation from the parent board of a director who also sits on the ring-fence entity board so as to avoid any potential conflict of interest in resolution.

6. What benefits, if any, come from EU regulatory engagement with

governance issues? 6.1 Like some other Member States, the UK is well-advanced in its review of

corporate governance issues arising from the financial crisis, implementing proposals on: board composition; board oversight of risk management; institutional shareholder engagement; remuneration (Walker Review); UK Corporate Governance Code; the Stewardship Code; FRC’s Guidance on Board Effectiveness; and the FSA Code on Remuneration.

6.2 A significant number of best practice developments have been

implemented in the UK and, to a large extent, are already in practice at Barclays. In contrast, some Member States are starting from a different base and moving at a slower pace.

6.3 Whilst no “one size fits all” approach can be taken, we would welcome an

EU-wide harmonisation of approach, with full recognition of the value of a principles-based approach.

6.4 The lowest common denominator should not be set as the benchmark and

there should be scope for Member States to reflect their differing circumstances.

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7. What impact has the Walker Review (2009) had on corporate governance and corporate behaviour?

7.1 The Walker Review is an excellent example of how best practice standards

can be rapidly developed and implemented, largely without recourse to legislation.

7.2 Barclays welcomed and supported the criteria given priority in the Walker

Review. 7.3 By taking a principles-based approach, flexibility was maintained that

allows companies to implement the recommendations in a way that is appropriate for their business model.

7.4 The Walker Review recommendation for a board risk committee has been

in place at Barclays since 1999 elevating the importance of risk oversight and management.

7.5 In line with Walker’s recommendations, Barclays remuneration policy was

revised in 2008 to accentuate risk management and the role of behaviours in the determination of remuneration, creating a direct and recognisable alignment between the rewards and risk exposure of shareholders and employees, in particular, executive Directors and senior management.

7.6 While many of the recommendations in the Walker Review were already in

place at Barclays, Barclays made a number of changes in response to the Review, including enhancing the role and status of the Chief Risk Officer (CRO). Other measures we have implemented include:

• Formalising the records of non-executive Director training

programmes; • Reviewing and revising non-executive Director role profiles and

the role profiles for the Chairman and the

e); al report;

Board on significant

e Board Risk Committee considers the

neration

isers for the Board

it in reviewing the risk

expected time commitment; • Reviewing and revising

Senior Independent Director; • Submitting all Directors for annual re-election by shareholders (as

subsequently recommended by the UK Corporate Governance Cod• Including an annual Board Evaluation statement in the annu• Increasing the frequency of reports to the

movements in the shareholder register; • Formalising the way in which th

macro-economic environment; • Introducing a dotted reporting line for the CRO to the Chairman of

the Board Risk Committee and ensuring that the CRO’s remuis specifically covered by the Board Remuneration Committee;

• Setting up a retained panel of independent advRisk Committee, who can be called on if required;

• Extending the Board Risk Committee’s remaspects of due diligence on strategic transactions;

200

• Enhancing the report of the Board Risk Committee in the annual report;

• Providing input from the Risk Function and the Board Risk Commito

ttee the Board Remuneration Committee’s discussion of remuneration,

y risk adjustments to be made to remuneration.

iabilities than under current law? Should executives in FTSE 100 companies be able to

t exercise the same degree of skill, care and attention. We see no argument

s.

.2 We agree with the Walker Review conclusion that there would be no

lp at executive with different perspectives, experience and

knowledge, which ultimately benefits the company, as best practice is

on one non-executive Directorship in a FTSE-250 company and no

executive Director should take on the chairmanship of a FTSE-250

e is

be able to meet the time commitment we expect of them that the additional role will not impact

. Is the existing FSA approval process for significant influence

.1 We broadly support the FSA’s approach to significant influence functions,

specifically on an

Non Executive Directors 8. Should non-executive directors bear greater l

hold non-executive positions in other firms? 8.1 In UK law, all Directors have the same responsibilities and duties and mus

for increasing the legal liabilities to be borne by non-executive Director 8

benefit in a statutory separation of Directors’ responsibilities. 8.3 Allowing an executive to serve on another listed company board can he

provide th

shared. 8.4 Best practice already dictates that no executive Director should take

more than

company. 8.5 Our executive Directors may take up only one FTSE 100 non-executiv

directorship and are obliged to obtain authorisation prior to doing so. It their responsibility to ensure that they will

their effectiveness as a Barclays Director. 9

functions (SIF), including non-executive directors, effective? 9

ensuring appropriate Directors are appointed. 9.2 We welcome the recent comments by Hector Sants that, except in rare

circumstances, the FSA will not interview non-executives unless they intendto occupy senior non-executive roles, that the FSA does not expect all nonexecutives to b

-

e technical experts in financial services and that it does not expect every member of the board to have the same degree of technical knowledge.

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9.3 We have raised concerns in the past around the potential impact of thenew, more intrusive approach to the “fit and proper” test. In part

icular, it

is important that the FSA is adequately and appropriately resourced to

elves forward as candidates and therefore be to the detriment of achieving the required diversity of skills,

dge on the board.

e key barriers to greater shareholder activism by institutional investors in

nd s

lders have a responsibility to act as responsible owners regardless of the nature of the

e varies by type of investor. Inevitably, smaller

and mid-sized institutions are more resource-constrained than principal

der. Companies cannot force institutional investors to engage with them: that pressure can

aking decisions and expressing their views through their votes. Engagement with

e

shareholder believes it is acting in the long-term interests of the company

interview and approve proposed candidates in a timely manner. 9.4 Despite recent assurances from the FSA about the interview process, the

process and the required competencies may continue to deter potential non-executive Directors from putting thems

experience and knowle The role of shareholders 10. Should shareholders be required to exercise a stronger role in

systemically important financial institutions? What are th

financial institutions? What risks are associated with it? 10.1 We share the UK Stewardship Code’s aims of improving dialogue a

transparency between investors and companies, and believe that this needto become firmly embedded as a behaviour. Shareho

business of the company in which they own shares. 10.2 Engagement varies significantly through time and according to the natur

of the issue or topic. It also

institutional shareholders. 10.3 The key questions to address are the cost to institutional shareholders of

engagement and ensuring that such investors are adequately resourced toundertake appropriate engagement activity: and secondly, the relationship of the institutional investor with the underlying sharehol

only come from the underlying shareholders, as clients. 10.4 Constructive and effective engagement between investors and companies

is paramount to ensuring investors are adequately informed when m

companies should be seen as a necessary part of good ownership. 10.5 We believe that shareholder engagement should not normally be played

out in public, but should be a matter for a company and its owners. In suchcircumstances, we see little risk from shareholder activism, provided th

and is engaging appropriately with the company to express its views. 10.6 The designation of an individual institution as globally systemically

important is for regulatory purposes on the basis that such firms will be

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subject to stricter standards than other firms. It is not at all clear what implications this would have for the role of the owners of such a firm nhow such implications could be translated into mandatory requirementhe owners of those firms. We do not believe that shareholders can or should be viewed as a complement, let alone a substitute, for robust regulation. That said, we would expect enhanced regulatory standards (whether through more intensive scrutiny or higher requirements, such ascapital) for globally systemically important fi

or ts for

rms to naturally prompt higher

levels of scrutiny from shareholders and, therefore, the Board, to ensure

1. Is it realistic to expect sovereign wealth funds and hedge funds to

ors will have different strategies depending upon their resources, risk appetite and desired return, which will dictate their

do not actively engage with companies. In fact, our large sovereign owners

vely

wealth funds and hedge funds and other types of investor and our comments in response to question 10 apply equally to all

estor.

nal investors, remuneration consultants, employees and others play with respect to remuneration in the

ers, regulators and employees. This is a challenging process,

which independent board remuneration committees are best placed to

isted companies to listen to institutional investors views and discuss remuneration with them through a variety of

e chairmen and company chairmen typically meet with institutional investors and with shareholder representative bodies to

that firms can still meet their expectations. 1

undertake a more active role? 11.1 Different types of invest

behaviour as investors. 11.2 It should not be assumed that sovereign wealth funds and hedge funds

take an active interest in how their investment is performing. 11.3 Institutions that hold significant voting rights in companies already acti

engage with management. We do not see any need to distinguish between sovereign

types of inv Remuneration 12. What role should institutio

financial services sector? 12.1 Remuneration decisions involve making complex judgements, which

require careful balancing of the interests of many stakeholders, includingsharehold

manage. 12.2 It is current practice for many UK l

different means of engagement. 12.3 Remuneration committe

discuss remuneration.

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12.4 The advisory shareholder vote on a company’s remuneration report at the AGM is a highly influential means for all shareholders, including institutional investors, to have their “say”. We anticipate the dialogue and

k

n and emerging

regulatory and governance requirements. The advice provided by external

actored into remuneration decision-making. Employee representative bodies (such

h

tion Code has had a fundamental impact on how remuneration is managed and governed in

13. there a case for introducing still greater transparency for senior vices

on Report Regulations, which require full disclosure of executive directors’

re and ch we support:

s’ closure (2010).

eration. (Many UK firms including Barclays have – in

engagement between financial services firms and institutional investors on remuneration to develop much further in 2012 and beyond.

12.5 In making their decisions, remuneration committees often choose to see

advice from independent professional consultants and internal specialists. Their input typically includes: market remuneration data; intelligence odevelopments in market practice; and advice on existing

remuneration consultants is one of a number of factors used to assist remuneration committees to make informed decisions.

12.6 We do not feel it is appropriate that employees sit on board remuneration

committees as this would create an inherent conflict of interest. Board remuneration committees are independent of those whose pay the committee makes decisions about, so it is counter-intuitive to include an employee representative, regardless of which part of the business they were drawn from. Employees have a “voice”, for example, through company-wide employee opinion surveys which are typically shared with executive management and with remuneration committees and f

as unions and works councils) also play an important role in working witmany companies in a number of areas relating to remuneration.

12.7 Regulators also have a key role in remuneration in the financial services

sector. In the UK for example, the FSA’s Remunera

the UK financial services sector and the FSA has active input throughout the year on companies’ remuneration processes.

Isexecutives with respect to remuneration in the financial sersector?

13.1 In addition to the long standing Directors’ Remunerati

remuneration, there have been significant developments in disclosutransparency in the last two years whi

• The “Merlin 5” top five highest paid senior executive officer

remuneration dis• In 2010 the FSA also introduced disclosure of FSA “Code Staff”

remuneration on the structure and quantum of Code Staff remuneration.

• HM Treasury draft “executive remuneration report” regulations (2011), expected to introduce in 2012 still greater transparency on senior executive remun

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the interests of early and transparent disclosure – voluntarily mad“top eight” remuneration disclosures ahead of t

e the he Treasury regulations

becoming law).

reater shareholders on remuneration. Barclays, for example,

provided a detailed breakdown of total incentive awards in our results for

3.3 We recognise that the process is a journey but, given the extensive change

there be further reform of the remuneration arrangements f senior executives in the financial services sector? Should this

inciples for sound compensation practices and the Capital Requirements Directive. These reforms have led to material changes in the

ion Code nd the

tive

“clawback”). The use of multi-year guaranteed bonuses has also been

4.3 Given the wide ranging reforms to date, we do not feel that further reform to

uggested either a ‘strict liability legal sanctions or an automatic incentives based approach. What are the

• We also expect further developments in executive remuneration disclosure both from the UK and from the EU.

13.2 Some companies are already doing more voluntarily to provide g

transparency to

2011. This disclosure significantly exceeded the legal disclosure requirements.

1

underway in disclosure of senior executive remuneration, we do not see a strong case for introducing still greater reform at this time.

14. Should

oextend to those highly paid individuals who sit below executive level?

14.1 Internationally, there has been significant reform of executive remunerationover the last three years, including as a result of implementation of the FSB’s pr

remuneration arrangements of senior executives in the financial services sector.

14.2 In the UK specifically, the implementation of the FSA’s Remunerat

has resulted in material changes to the structure of remuneration aalignment of remuneration and risk, including: increased levels of incendeferral; increased use of equity; and, enhancements in the “risk adjustment” of remuneration (for example, “malus” provisions or

eliminated. For UK listed companies, the FSA’s Remuneration Code applies globally and extends to all employees (not only senior executives).

1

is necessary at present. Time is required to allow the reforms introduced date to bed down and for their full impact to be seen.

15. The Chairman of the Financial Services Authority has argued that

there may be a case for changing the personal risk return trade-off for bank executives. He has s

merits and drawbacks of these proposals? Are there other ways to achieve the same objective?

205

15.1 We appreciate that in the event of a material failure in a financial services

irectors’ conduct.

,

s. A

osts).

to incentives is appropriate. Malus provisions that are currently in place do not apply

but are operated based on the careful judgment of the remuneration committee. We believe that it is important that the

overnance of risk

an s. To keep risk management at

the centre of the executive agenda, it is embedded in the everyday management of the business. Barclays Board Risk Committee, which is

ing

report in 2008 entitled “Observations on Risk

Management Practices during the Recent Market Turbulence”, which critical

fying firm-wide exposures (1999); a Group-wide risk appetite framework (2003); Group-wide stress testing (2006); and a detailed

isk

crisis.

firm, shareholders and other stakeholders will rightly expect executive management to be held to account. However, adequate sanctions arealready in place to exert real influence on D

15.2 We believe that the continuing efforts to improve and refine the existing

regulatory and controls framework is the correct approach to take in addressing any concerns with the system.

15.3 We do not believe that imposing strict liability on Directors is a suitable

response and may have both unintended and unwelcome consequencestrict liability approach would hold Directors liable irrespective of intent, fault or negligence and would not take into account the particular circumstances of the case or of the individual. It would create a material imbalance in UK Directors’ legal liabilities relative to other jurisdictions making senior executive roles in UK financial services firms unattractive tomany potential candidates globally, (driving up the remuneration cWe would also question whether an “automatic” approach

“automatically”,

remuneration committee continues to have that flexibility. G 16. Has the management of risk in firms improved since the financial

crisis? 16.1 Risk management is a fundamental part of Barclays business activity and

essential component of its planning proces

comprised of independent non-executive Directors, provides monitorand oversight of all Barclays risk activities.

16.2 The Senior Supervisors Group, including FSA, BaFin and the Federal

Reserve, issued a

concluded that firms that had weathered the crisis had “exercisedjudgment and discipline” and had an “adaptive” approach to risk management.

16.3 Even before the crisis, Barclays had introduced: a framework for

quanti

“Mandate and Scale” framework which sets out specific limits per each rtype in 2007. These controls all certainly helped us through the financial

206

16.4 In the last few years, we have seen increased use by regulators of Stress

Testing, which is an important risk management tool and part of a broader ale

e to our Board Remuneration Committee. Also, all line managers throughout the

the firm’s risk control frameworks.

governance cannot, and arguably should not be expected to prevent failure.

ween diversity and economic benefits or improved company performance.

rd,

maintaining a competitive advantage. A truly diverse board will include

ence, as

kground and those with broad commercial experience. A board needs both types of experience to be able to take

rder

t boards give due weight to the benefits of diversity, such as gender or ethnicity, but all board appointments must

tive.

input into risk appetite alongside our Risk Appetite and Mandate and Scframeworks

16.5 A major change within Barclays has been the much greater role of risk

input into remuneration analysis, with a detailed review of the risk profile (and how it has changed) being sent from the Board Risk Committe

bank are required to include in their performance review of their staff the need to show compliance with

16.6 As per question 1, good

Diversity and background 17. What is the relationship, if any, between board diversity and

company performance in the financial services sector? 17.1 It can be difficult to demonstrate a direct causal relationship bet

Having a board comprised of high-calibre individuals is clearly key to boardeffectiveness, and a wide talent pool is clearly a positive goal.

17.2 Barclays recognises and embraces the benefits of having a diverse boa

and sees increasing diversity at board level as an essential element in

and make good use of differences in the skills, regional and industry experience, background, race, gender and other qualities of Directors.

17.3 We believe that a board needs a diverse range of skills and experi

well as financial services experience, to be fully effective. Bank boards should have an appropriate balance between those Directors with a banking/financial bac

good decisions; it requires that diversity of skills and background in oto be fully effective.

17.4 We would not be supportive of any measures to enforce quotas for

diversity on a board. It is right tha

be made on merit in the context of the skills and experience that board asa whole requires to be effec

207

ific industry experience, non-executive Directors need to be able to ask the right questions and challenge

gement effectively. It is these personal qualities that are essential elements for an effective board.

ay 2012

17.5 We have adopted a Board Diversity Policy2 that sets out our approach to board diversity at Barclays.

17.6 Ultimately, regardless of their spec

mana

M

2 Board Diversity Policy, 19 April 2012

208

Written evidence submitted by the Trade Union Congress

Introduction

1.1 The TUC welcomes this opportunity to submit evidence to the Treasury Committee inquiry into corporate governance and remuneration in systemically important financial institutions. The TUC represents over six million workers in 54 unions, including approximately 200,000 workers in the finance sector. Our members are also consumers of financial services and have also been affected, along with the entire UK population, by the financial crisis that was created in part by mistakes made by the leaders of financial institutions.

2.1 Board structure and composition

1. What outcomes should corporate governance in the financial services sector seek to achieve?

2.1 The TUC believes that the broad aims of corporate governance are consistent across all sectors. At the broadest level, corporate governance aims to provide:

• appropriate structures and procedures for effective board-level decision making that reflects directors’ legal duties under section 172 of the Companies Act; and

• a monitoring and supervisory function sufficient to ensure that decisions are questioned and challenged where appropriate.

Breaking these two broad aims down further, corporate governance should seek to achieve the following outcomes:

• effective long-term strategic leadership of the company;

• good succession planning;

• ensure that stakeholder interests (including those of shareholders, workers, suppliers and local communities) and environmental impacts are taken into account effectively in decision-making;

• promote positive, long-term stakeholder relationships based on trust;

• ensure vigilant risk-management;

• ensure an appropriate degree of transparency and integrity in reporting;

• manage board recruitment to ensure that the board constitutes a sufficient range of skills, knowledge, experience and backgrounds to facilitate an appropriate degree of challenge and input into decision-making and strategic direction;

• devise and implement an effective remuneration policy.

While we believe that these broad aims and outcomes apply regardless of sector, we recognise that appropriate arrangements to secure such outcomes will vary from company to company, with sector being an important factor in their determination. In the context of systematically important financial institutions we recognise the critical importance of risk management and ensuring that risks to the organisation and its stakeholders (including investors) and risks to the wider economic system are both managed effectively with a high degree of scrutiny.

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2. Are Board structures effective? For example, should UK financial institutions consider adopting alternatives to the unitary Board structure?

2.2 The TUC believes that the two-tier board system offers important benefits, some of which are particularly relevant in the context of the financial sector.

2.3 It has been recognised in the UK since the Cadbury Report of the 1990s that non-executive directors have an important monitoring function in relation to executive directors on UK boards. One of the factors that contributed to poor decision-making in financial companies in the run-up to the financial crisis was the domination of boards by powerful chief executives who were subject to insufficient challenge from other board members. In some cases, the chief executive had had considerable influence over nomination procedures, thus weakening the capacity of the board for effective challenge.

2.4 The separation of the executive and the supervisory functions in a two-tier board structure make the supervisory function much more explicit. It is also much harder for non-executives to be ‘out-gunned’ by the executives, because the executives are generally in a minority on the supervisory board (in the German system, for example, the only executive member of the supervisory board is the Chief Executive). Some may suggest that this separation of structures can slow down decisionmaking, but we would argue that making the right decisions is much more important than making decisions quickly. If the decision-making process at RBS over buying ABM Amro could have been slowed down, it is highly likely that this disastrous purchase would not have gone ahead, and RBS would not have needed such high levels of Government support to avoid collapse.

2.5 A key attribute of two-tier boards is that workers and in some cases shareholders generally have either direct representation or nomination rights on boards. The interests of workers are well-correlated with the long-term interests of the company, and the TUC believes that having workers represented on UK boards would help boards to prioritise the long-term interests of the company in decision making, rather than being distracted by short-term financial engineering, as occurred in the run-up to the financial crisis. Workers also bring with them in-depth knowledge of how the company operates in practice and are well-placed to contribute to the need to foster positive stakeholder relationships, as set out in section 172 of the Companies Act.

2.6 In relation to shareholder representation, in many of the countries where this occurs, share ownership is much more concentrated than is generally the case in the UK, and many companies have one or two shareholders who own a significant proportion of shares. The TUC recognises that in cases where share ownership is concentrated shareholder board representation can work well. Given the absence of high levels of share concentration, it not clear whether shareholders in the UK would have the capacity or inclination to sit on company boards.

3. Is more intrusive regulation a substitute or complement to effective corporate governance?

2.7 The TUC believes that more intrusive regulation is not a substitute for effective corporate governance; the two should complement each other. Corporate governance is about ensuring appropriate structures, procedures, cultures, incentives and

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supervision to promote effective decision making. Regulation is about setting out legal minimum standards which are enforced by the State rather than by shareholders.

2.8 It is particularly important that systemic risk is addressed by regulatory requirements and that law enforcement agencies are responsible for the enforcement of measures in this area. It is not viable to leave the monitoring of systemic risk to individual financial institutions and their shareholders, as there may be times when the short-term interests of an individual financial organisation and the interests of the financial system as a whole diverge. In addition, it is essential that systemic risk is addressed on a systemic basis, by an organisation that is responsible for supervising the system as a whole. It is not realistic to leave this broader responsibility to shareholders of individual institutions, although clearly the latter should still seek to be vigilant against systemically-risky behaviour at individual organisations as far as is practicable.

Is a "comply or explain" approach an effective framework for governance?

2.9 Comply and explain has a mixed record in corporate governance. It is most effective where there is widespread agreement over the principle in question, but different companies may either require different lengths of time to implement it or may have particular circumstances at a given point in time that lead them to choose to diverge from the principle. An example here would be the Corporate Governance Code principle on separation of the roles of Chair and Chief Executive: over the years since this principle was adopted, the proportion of companies complying has steadily grown. Companies at times still choose to go against the principle, but need to convince shareholders that they have valid reasons for doing so or run the risk of shareholder action (as occurred, for example, at Marks & Spencer in 2009). In this case, the “comply and explain” approach can be seen to have been effective in securing gradual change over time.

2.10 To give a contrasting example, the Corporate Governance Code also includes, again on a “comply or explain” basis, the following principle: “Remuneration Committees should be sensitive to pay and employment conditions elsewhere in the group, especially when determining annual salary increases”. This principle has been widely flouted, with companies neither reflecting pay and employment conditions in the rest of the company in their decisions on directors’ remuneration, nor explaining why they have not done so in their remuneration reports. Arguably, this is because there was not a broad consensus in support of the principle, especially among those who were meant to be applying it. In this example, the “comply or explain” approach has failed.

3.1 Corporate culture

4. What type of corporate culture should financial services firms seek to foster? In what way can this be encouraged? How effective are Boards at shaping corporate culture within their institutions?

3.1 The TUC believes that all companies should seek to foster a culture in which decision-making is focussed on strategies for the long-term success of the company; which fosters long-term relationships based on respect and trust with its workforce and other stakeholders; which encourages workers to contribute ideas and views and allows them to report problems without fear of reprisals; and has high standards of ethical behaviour at its heart.

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3.2 Ethics are an important component of a desirable corporate culture at all businesses, but are particularly important in the financial services sector because of the imbalance in information and knowledge between consumers and those within the industry. There is also the issue that with financial services, unlike the majority of consumer products, flaws in a product are not always immediately apparent, and may only come to light after a considerable time. The scope for mis-selling has unfortunately been illustrated by one mis-selling scandal after another. Our affiliate Unite, which represents workers in the finance industry, told an earlier Treasury Committee inquiry that “targets are often imposed on employees, not agreed through two-way dialogue and there is little opportunity to challenge them. Targets and the pressure placed on our members to reach them can result in a situation where inappropriate products may be sold to customers.1” Unite calls for an end to sales-based targets and argues that pay for workers in the financial sector should be focussed on decent pensionable salaries based on fair pay for a fair day’s work, rather than sales-based target driven pay. The TUC fully supports this call.

4.1 Impact of previous reviews and new regulatory developments

5. What difference would the proposals in the Independent Commission on Banking's report on the Boards of ring-fenced banks make to corporate governance in these institutions?

4.1 We do not believe that the Independent Commission on Banking’s (ICB) report would necessarily have a direct impact on corporate governance in these institutions, as according to our understanding the same board would still be responsible for the different parts of the bank. It is possible that as the ICB’s recommendations are implemented, boards will develop new mechanisms of corporate governance to reflect the separation of functions.

7. What impact has the Walker Review (2009) had on corporate governance and corporate behaviour in financial services?

4.2 We believe that it is too early to give an informed response to this question.

5.1 Non-Executive Directors

8. Should non-executive directors bear greater liabilities than under current law? Should executives in FTSE 100 companies be able to hold non-executive positions in other firms?

5.1 The TUC believes that it is essential that all those responsible for both executive and non-executive functions have sufficient time to carry out their responsibilities effectively. This principle must be given very careful consideration when determining the number of board roles that any one individual carries out.

5.2 In addition, the TUC believes that there is a strong case for greater diversity of board members. The tendency of companies to appoint non-executive directors (NEDs) who are executive directors of other companies means that board members are generally drawn from a very narrow pool of people with similar backgrounds and experience. This can contribute to the problem of ‘group think’ on boards.

1 Unite submission to Treasury Committee evidence session on incentive structures

and executive remuneration in the banking sector, November 2008

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5.3 The TUC strongly supports the appointment of NEDs who are drawn from a wider range of backgrounds, and believes that this would make a valuable contribution to improving the effectiveness of boards. A first step towards this would be for all NED positions to be publicly advertised, rather than using head-hunting firms as is currently the case. Drawing NEDs from a wider range of backgrounds would also address the issue alluded to in the question, namely whether executive directors have time to carry out additional non-executive director roles effectively.

9. Is the existing FSA approval process for significant influence functions (SIF), including non-executive directors, effective?

5.4 It is clear that prior to the financial crisis such procedures were ineffective. An earlier report from the Treasury Committee2 noted that: “Some banks’ management and boards have failed their shareholders and created concerns for their customers and this failure has had devastating consequences for the UK’s private and public finances.” Widespread failures at board level (including non-executives) were identified at RBS, HBOS and Northern Rock.

5.5 As argued above, the TUC is supportive of a diversity of experience and backgrounds at board level. However, there is a case that some non-executive directors should have relevant qualifications and technical competence in areas such as risk-management to ensure that non-executives as a whole have sufficient knowledge and expertise to challenge executive directors effectively.

6.1 The role of shareholders

10. Should shareholders be required to exercise a stronger role in systemically important financial institutions? What are the key barriers to greater shareholder activism by institutional investors in financial institutions? What risks are associated with it?

6.1 The TUC believes that there is an important distinction between the role of shareholders and regulators in relation to systemically important financial institutions. We believe that matters concerning systemic risk should be monitored by regulators rather than shareholders. This is in part because we do not believe that shareholders’ oversight is sufficiently effective to take on this critical responsibility (please also see comments in 2.9 above).

6.2 It should be remembered that one of the most significant errors in the run-up to the financial crisis – the RBS takeover of ABM Amro - was voted on by RBS shareholders and overwhelmingly approved. It is also the case that shareholders were generally supportive of the approach of RBS, HBOS and Northern Rock in the pre-financial crisis period, despite the major risks that each was running up. Indeed, Lloyds, which (until its takeover of HBOS) was less highly leveraged and less exposed to risky assets than some of the other banks, had come under pressure from some shareholders for not making sufficient use of leverage and being ‘boring’ in its approach. Shareholder involvement is not a panacea, and as submissions to John Kay’s current Review into Equity Markets and Long-Term Decision Making have illustrated, shareholders can at times put pressure

2 Banking Crisis: dealing with the failure of the UK banks’, Seventh Report of

session 2008-09.

http://www.publications.parliament.uk/pa/cm200809/cmselect/cmtreasy/416/416.pdf

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on boards to generate short-term results at the expense of strategies for long-term, sustainable success.

6.3 One of the key barriers to more effective engagement between investors and companies is the dispersion of shares. Share ownership patterns have changed rapidly over recent decades. In the 1960s, the majority of shares in UK companies were owned by individuals, many of whom took a reasonable level of interest in the companies whose shares they owned. By the 1980s, the majority of shares were owned by UK institutional investors such as pension funds and insurance companies. Today, this has changed again, and recent figures from the Investment Managers’ Association (IMA) suggest that pension funds and insurance companies now hold around 13% of UK equities each, with an additional 14% held by other UK institutional investors3. ONS figures show that at the end of 2008, 41.5 per cent of UK-listed shares were owned by investors from outside the UK, and individuals held just over ten per cent, the lowest percentage since the survey started in 19634.

6.4 These changes have great significance for the quality of engagement between fund managers and companies. It will clearly be harder for overseas investors to develop the kind of engaged relationships with UK companies that are envisaged by the UK’s corporate governance system. Language, culture, proximity and availability of information all make engagement much more straightforward within a national context in comparison with engaging with companies abroad. This is reflected in responses to the TUC’s Fund Manager Voting Survey: in the 2011 Survey, 21 respondents said they voted all their UK shares, while just ten voted all their overseas shares, although a further seven indicated that they voted the large majority, or a large proportion of their overseas holdings5. The UK’s corporate governance system was not designed on the basis that the largest single share ownership block would be investors from outside the UK.

6.5 In contrast to individuals who tend to own shares in a limited number of companies whose progress they follow closely, institutional investors generally own shares in hundreds or even thousands of companies. Just as an increasing proportion of UK shares are held by investors from outside the UK, an increasing proportion of equity holdings of UK institutional investors are global, rather than UK equities. The sheer number of companies whose shares they hold poses major practical challenges to the ability of institutional investors to carry out their corporate governance responsibilities effectively. If UK institutional investors are to engage effectively on an informed and consistent basis with all the companies whose shares they own, this would require a very significant deployment of resources, considerably above the levels that most currently devote to engagement.

6.6 The TUC’s Fund Manager Voting Survey asks each year about how many people fund managers have working on corporate governance and responsibility issues. With five exceptions - two teams of 30 or more, two teams of twenty or more and one with twelve people – all other respondents have less than ten staff working on these issues6. 3 IMA, Asset Management in the UK 2009 – 2010, July 2010

4 Available at http://www.statistics.gov.uk/cci/nugget.asp?id=107

5 TUC Fund Manager Voting Survey 2011

6 ibid

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However skilled and dedicated such staff may be, it cannot be possible for them to engage effectively with all the companies whose shares they hold over all the issues for which shareholders are ultimately responsible.

6.7 The IMA has made it clear that its members are wary of too weighty expectations being placed on their governance role: ‘The fact that UK investors now own a smaller proportion of UK companies has implications for the corporate engagement role that investment managers play in the governance of companies. There is concern amongst investment managers that there should not be unrealistic expectations of what they can achieve through engagement.’7

6.8 As Sir David Walker pointed out in his report on UK bank governance, competition between institutional investors and the fact that the gains generated by effective engagement are enjoyed by investors across the board rather than flowing directly to the investors who have carried out the engagement, reduce the incentives for institutional investors to devote sufficient resources to enable them to engage effectively with all the companies whose shares they hold.

6.9 To conclude on this point, equity markets have become increasingly global, with over 40 per cent of the shares of UK companies now owned by investors overseas. At the same time, UK institutional investors hold increasingly diversified portfolios, with a smaller proportion of total assets being held in equities and an increasing proportion of the equities they do hold being in overseas markets. The geographical and numerical spread of their company’s shareholders creates significant challenges for a board’s ability to engage effectively across their shareholder base. At the same time, UK institutional investors have increasingly diversified equity holdings, which creates challenges for their ability to engage effectively with the companies whose shares they own. Shareholdings are simply spread too thinly to facilitate committed, engaged relationships between institutional investors and companies.

6.10 In addition to the practical difficulties that diversified shareholding presents for both investors and companies in terms of developing long-term, engaged relationships, there is a still more fundamental challenge to corporate governance created by the changing nature of share ownership. The convergence of interests between shareholders and other stakeholders and also, crucially, between the interests of shareholders and the long-term success of the company itself, breaks down if shareholders are taking a short-term perspective. The interests of short-term shareholders cannot be taken as a proxy for the long-term success of the company and its other stakeholders, as if the long-term impact is discounted it is possible to slash investment, lower wages and squeeze suppliers in a way that may generate short-term returns, although it will undermine the company’s potential for future success. In the context of the financial sector, short-term shareholders, whose strategies are based on share trading rather than long-term share ownership, can benefit from risky and unsustainable strategies, if these have the effect of boosting the company’s share price in the short-term. While the proportion of shares owned by alternative investment managers across the stock market as a whole remains fairly low, the ability of alternative investment managers to buy and sell large numbers of shares in a particular company over a short period of time magnifies their influence in the market.

7 IMA, op cit

215

6.11 The TUC believes that this creates a major challenge to the UK’s corporate governance system that has to date been insufficiently acknowledged by policy makers. The TUC believes that directors’ duties should be reformed so that directors are required to promote the long-term success of the company as their primary aim. In so doing, they should be required to deliver sustainable returns to shareholders, promote the interests of employees, suppliers and customers, and have regard to community, environmental and reputational impacts. This would have the effect of rebalancing the interests of shareholders and others stakeholders, but all their interests would be secondary to those of long-term success of the company.

11. Is it realistic to expect sovereign wealth funds and hedge funds to undertake a more active role?

6.12 Sovereign wealth funds are usually long-term holders of equities, but do not generally develop engaged relationships with the companies whose shares they own. The TUC does not believe that this is likely to change. Indeed, it should be remembered that a few years ago there was concern expressed in some quarters about the so-called political risks of allowing sovereign wealth funds unfettered access to our equity markets. This makes is less likely that sovereign wealth funds will be inclined to take an active role in the affairs of UK companies. The Sovereign Wealth Fund of Qatar has been the largest shareholder in Barclays since 2008 and this has not lead to any major changes in corporate governance performance.

6.13 The term ‘hedge funds’ is a very broad term used to describe asset managers who use widely diverging strategies for generating returns. For the majority of hedge funds, it is unlikely that they will have the desire to play an active role in the corporate governance of the companies whose shares they hold. The average holding period of equities is far lower for hedge funds than institutional investors and so they are less likely to be concerned about longer term issues. In addition, active engagement is often seen to increase the costs of holding an equity, something that hedge funds usually try to minimise.

6.14 However, some hedge funds adopt extremely activist positions, deploying strategies of buying large numbers of shares in particular companies in order to force through particular changes. For example, in February 2011, the Chair of F&C Asset Management was ousted following a campaign by the hedge fund Sherborne. Sherborne had built an 18 per cent stake in F&C since August 2010, for the specific purpose of forcing change at F&C.

6.15 The influence of activist hedge funds is not always beneficial; for example, the process which led to the disastrous take-over of ABN Amro by RBS was kick-started by hedge fund TCI, acquiring a stake in ABN and arguing publically that it should be sold8.

7.1 Remuneration

12. What role should institutional investors, remuneration consultants, employees and others play with respect to remuneration in the financial services sector?

8 Hedge fund TCI seeks ABN Amro breakup, Reuters, February 2007.

http://uk.reuters.com/article/2007/02/21/abnamro-hedgefund-idUKNOA13599520070221

216

7.1 Institutional investors should take a much tougher approach to remuneration than they do at present and in particular should make much greater use of their powers to reject remuneration reports. Investors have had an advisory vote on company remuneration reports since 2003. Between 2003 and the end of 2011, just 18 remuneration reports had been defeated at company AGMs out of the thousands of votes that have taken place over that time. While the recent increase of investor activism on remuneration is both welcome and long overdue, it should be remembered that this year to date there have been just four remuneration report defeats. This is still below the peak of five remuneration report defeats in 2009, which was followed by just three in each of 2010 and 2011. Whether what we are currently witnessing is a permanent trend towards greater shareholder activism on pay or just a blip is too early to say.

7.2 The TUC believes that workers should be represented on remuneration committees and believes that this would bring important benefits.

• Workers would bring a fresh perspective and common sense approach to discussions on remuneration, in contrast to the current culture that presides on remuneration committees.

• The Government has acknowledged the importance of taking into account both company pay differentials and consulting with workers about directors’ pay. The best way to ensure that these issues are considered properly in decision- making is for workers to be represented on remuneration committees.

• Workers’ interests are inextricably linked to the long-term success of their company; they are therefore well placed to contribute to discussions on an appropriate remuneration strategy to serve the long-term interests of the company.

• Including workers on remuneration committees would engender a higher degree of buy-in from employees on pay arrangements at their company. This should contribute to employee engagement, which is shown to be linked to higher company productivity and performance.

• Research has shown that worker representation does help to curb directors’ remuneration. One study showed that, among the largest 600 European companies, the presence of board level worker representation is correlated with lower CEO pay and a lower probability of stock option plans. A second study showed that, within large German companies, stronger worker representation on the board led to lower CEO pay and less use of stock-based remuneration9.

• There is clear academic evidence that high wage disparities within companies harm productivity and company performance10. Combined with evidence (cited above) that

9 Board Level Employee Representation, Executive Remuneration And Firm Performance

In Large European Companies, Sigurt Vitols, March 2010; and Arbeitspapier 163,

Beteiligung der Arbeitnehmervertreter in Aufsichtsratsausschüssen, Auswirkungen auf

Unternehmensperformanz und Vorstandsvergütung, Studie im Auftrag der Hans-Böckler-

Stiftung, Sigurt Vitols 2008; both available from the TUC

10 See, for example, Pedro Martins, Dispersion in Wage Premiums and Firm

Performance, Centre for Globalisation Research Working Paper No. 8 April 2008;

Olubunmi Faleye, Ebru Reis, Anand Venkateswaran, The Effect of Executive-Employee

217

worker representation on remuneration committees is associated that lower rates of CEO pay, this makes a strong case for the inclusion of worker representatives on remuneration committees.

7.3 In relation to the financial services industry, it is particularly important that excessive executive remuneration is addressed, given the damage done to the rest of the economy caused by mistakes made within this sector and the extremely high levels of reward that continue to be paid to directors and senior executive in the industry.

7.4 The TUC believes that remuneration consultants have played a significant role in designing increasingly complicated remuneration structures that have paid out excessive amounts for mediocre and at times poor performance. The TUC is very concerned about the conflicts of interests that are created when remuneration consultants are also carrying out other work for the company, and believes that this should be prohibited. It is also important that remuneration consultants are appointed by and report to the remuneration committee only and not the executive directors.

13. Is there a case for introducing still greater transparency for senior executives with respect to remuneration in the financial services sector?

14. Should there be further reform of the remuneration arrangements of senior executives in the financial services sector? Should this extend to those highly paid individuals who sit below executive level?

7.5 The TUC would support mandatory disclosure of the number of people within each firm whose total remuneration exceeds £1 million, preferably in bands of £1 million to £2 million, £2 million to £3 million and so on.

15. The Chairman of the Financial Services Authority has argued that there may be a case for changing the personal risk return trade-off for bank executives. He has suggested either a 'strict liability legal sanctions or an automatic incentives based approach. What are the merits and drawbacks of these proposals? Are there other ways to achieve the same objective?

7.6 There is evidence that the lack of personal liability has encouraged excessive risk taking at financial institutions in the past. The current Executive Director for Financial Stability at the Bank of England has gone much further than the Chairman of the FSA and questioned the whole notion of limited liability in respect to banks11. In 2009, it was noted that Hoare’s Bank, which is still structured as a traditional partnership with the owners bearing the risk, had weathered the crisis (and previous crises) much better than limited liability banks12.

Pay Disparity on Labor Productivity, EFMA, Jan 2010; and Douglas M. Cowherd and

David I. Levine, Product Quality and Pay Equity Between Lower-Level Employees and

Top Management: An Investigation of Distributive Justice Theory, Administrative

Science Quarterly, Vol. 37, No. 2, Special Issue: Process and Outcome: Perspectives

on the Distribution of Rewards in Organizations June 1992

11 Andrew Haldane, ‘The Doom Loop’, LRB, February 2012.

http://www.lrb.co.uk/v34/n04/andrew-haldane/the-doom-loop

12 South Sea Bubble Survivor Says Dismantle RBS, Lloyds, Bloomberg, March 2009.

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aANXHOD12Q2A&refer=news

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7.7 The TUC does not support the current emphasis on performance-related remuneration. There is ample evidence that performance-related pay has not been effective in rewarding good performance, as noted by the BIS Discussion Paper on executive remuneration launched in September 2011. There is also convincing academic evidence that performance-related pay does not generate higher levels of motivation or performance13. We believe that there should be a greater focus on annual salary, with performance-related pay limited to a much smaller proportion of total remuneration than is currently the case14.

7.8 Where performance-related pay does exist, we are supportive of calls that bonus payments should be subject to ‘claw-back’ in the event of trades or deals turning bad. The current structure of much remuneration in the financial sector means that individuals face a different risk/reward trade-off from that of the institutions they work for. They are personally financially rewarded when a trade or deal works and face little or no personal financial liability if the trade/deal goes wrong. This misalignment of incentives can lead to excessive risk taking.

7.9 Some have argued that a stronger alignment of individual risk/reward trade-offs with institutional risk reward trade-offs would lead to banks and other financial institutions not taking ‘enough risks’ and ultimately to slower growth. This is unlikely to be the case, and in fact an argument can be made that if banks engaged in less high risk/high reward behaviour they would be able to deploy more of their balance sheet in ‘traditional’ activities (such as retail and commercial banking) which are often more supportive of growth.

8.1 Governance of risk

16. Has the management of risk in firms improved since the financial crisis?

8.1 We believe that it is too early to assess this.

9.1 Diversity and background

17. What is the relationship, if any, between Board diversity and company performance in the financial service sector?

9.1 See comments in 5.2 above.

June 2012

13See, for example, The False Promise of Pay for Performance: Embracing a Positive

Model of the Company Executive, James McConvill, 2005; The Upside of Irrationality:

The Unexpected Benefits of Defying Logic at Work and at Home, Dan Ariely, 2010; Not

Just for the Money: Economic Theory of Motivation, Bruno Frey, 1997; The Hidden

Costs of Reward: New Perspectives on the Psychology of Human Motivation, Mark R.

Lepper & David Greene, 1979

14 For more discussion on this, please see TUC, Treasury Committee Inquiry into

corporate governance in systemically important financial institutions, November

2011

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Written evidence submitted by Towers Watson

1.1. Towers Watson welcomes the opportunity to respond to this consultation. We are a leading global human resource consulting firm and have been providing executive remuneration advice to major UK listed companies for over 40 years. Over the course of these 40 years or so we have acted as the appointed remuneration committee adviser to many of the UK’s largest firms in both financial services and general industry.

1.2. We have limited our comments to those areas where we feel best qualified to offer our views.

1.3. As a broad observation we note however the plethora of initiatives, regulatory developments and legislation that is being brought to bear on the issue of pay and risk in financial services (as well as executive remuneration more broadly). We have for example since 2009 witnessed the introduction of:

CRD III and the current FSA remuneration code and the likely evolution of the code via CRD IV.

Solvency II which is aimed specifically at the insurance sector and which will in all probability lead to a similar set of pay rules and guidelines around pay and risk that are already applied to firms covered by CRD III (and IV).

Alternative Investment Management Funds Directive, again with similar provisions around remuneration as currently applied under CRD III.

Advisory voting by shareholders on the Directors’ Remuneration Reports of listed UK firms and the prospect for binding votes on for example future pay policy.

Increased disclosure on remuneration levels and structure under the Project Merlin agreement that covers major UK banks.

Increased disclosure on remuneration levels and structure more broadly under Pillar 3 in respect of other major financial institutions that are not UK listed companies or subscribers to Project Merlin.

1.4. The focus of many of these initiatives has resulted in a rule-based or legislative-based framework which shapes both pay policy and disclosure. In Asia Pacific the approach has been more principles based whilst in the United States the recent FDIC guidelines on pay and risk fall someway between the two.

1.5. We suggest that any further changes to the current governance and remuneration provisions for the UK financial services sector need to take into account the extent to which firms are already required to liaise and consult with shareholders, structure and

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deliver pay as well as the regulatory oversight and provisions applied in other major global financial centres outside of Europe.

1.6. We also believe that the industry will undergo some form of structural shift directly as a result of regulatory interventions that are already in play. By way of example, Basel III will require firms to hold increased levels of capital as a buffer to financial shocks. Retaining more cash as capital in the business will mean that on a like for like basis there will be less flexibility for firms to allocate to discretionary spend in the form of dividends to shareholders or, more likely, variable pay pools.

1.7. The need to hold higher levels of capital will make investment banking and capital markets activities in particular less profitable with a resulting decrease in variable pay spend. Such a change is likely to be a structural rather than temporary change in the underlying economic model.

1.8. The EU is currently debating whether to require financial institutions to implement remuneration policies that will limit the proportion of variable pay as a percentage of fixed pay. We understand the proposals as they stand would limit firms to paying variable pay at no more than 100% of fixed pay or a 1:1 ratio.

1.9. In short, we urge the Government to be wary of the unintended consequences of further regulatory interventions since Government, regulators and shareholders already have at their disposal a variety of ways in which to influence executive remuneration.

2. The role of shareholders

Should shareholders be required to exercise a stronger role in systemically important financial institutions? What are the barriers to greater shareholder activism by institutional investors in financial institutions? What risks are associated with it?

2.1. Shareholder empowerment is a sound objective in principle. UK institutional investors however, have limited resources to engage actively across their whole portfolio. We also know from our own meetings that as a matter of policy some focus more on key investment decisions rather than monitoring the details of a company’s executive remuneration policy.

2.2. In addition, in respect of many major companies across all sectors a significant proportion of investors are based overseas. In the case of Barclays for example, around 32% of shares are held by UK investors (both institutional and retail) while the respective figure for Standard Chartered is 35%. Other institutions judged to be systemically important within the UK may be wholly or partly listed on overseas exchanges with only a small proportion of shares held by UK investors. Whilst “say on pay” and active shareholder engagement are well-established in the UK such an environment is not necessarily found in many other countries. Here a willingness or ability to engage with firms in respect of executive pay may be limited or non-existent.

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2.3. The influence of those organisations offering voting advisory services and particularly the influence of those organisations offering voting advice on UK PLCs to overseas investors is already significant. Our analysis shows a strong correlation between a recommendation to vote against a report and the actual outcome of the vote for companies with a large overseas investor base.

2.4. Forthcoming proposals under the Business Innovations and Skills consultation process on shareholders voting rights may well lead to a binding vote on future remuneration policy of all UK-listed companies and this in itself ought to provide shareholders with a stronger role on remuneration policy.

2.5. In conclusion, systemically important financial institutions operating in the UK could be drawn from both UK and overseas listed firms with different standards of corporate governance and engagement with say on pay, producing an uneven playing field in respect of corporate governance standards and shareholder engagement. Voting agencies already apply different standards to US and UK companies in terms of voting recommendations on remuneration and given the proportion of shares held in UK firms by overseas investors it could also be argued that a small number of voting advisory firms have an undue influence on the votes cast on UK remuneration policies and which would be exacerbated further if a binding vote on future remuneration policy is introduced for UK-listed companies.

Is it realistic to expect sovereign wealth funds and hedge funds to undertake a more active role?

2.6. Given that a number of overseas investors are sovereign wealth funds please see our comments under paragraphs 2.1 through 2.5 above.

2.7. With regard to hedge funds we would assume that basic investment strategy would preclude investors from actively engaging with management and even if they did it would not be on a longer-term basis so any engagement is likely to be tactical rather than focused more towards longer-term strategic investment decisions, remuneration policies or quality of management etc.

3. Remuneration

What role should institutional investors, remuneration consultants, employees and others play with respect to remuneration in the financial services sector?

3.1. The question is relevant for all listed companies. We are not clear as to why such a question should be aimed only at the financial services sector.

Institutional investors

3.1. We urge Government to resist any temptation to encourage shareholders to micro-manage pay in companies. The current advisory vote on the Directors’ Remuneration Report already gives shareholders an effective tool for influencing pay decisions. Companies now engage much more frequently with their key institutional investors on important executive pay matters and companies that have experienced a

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significant low vote or a failed resolution will often invest considerable resources in rehabilitating their pay arrangements with shareholders. In those cases where shareholders consider that a remuneration committee has taken insufficient account of their views on directors’ pay, shareholders already have a binding vote on the annual re-election of each director as a further means for signalling their objections.

3.2. If investors are to continue to have an advisory vote on past remuneration decisions as well as a binding vote on future remuneration policy, investors will have more than ample opportunity to provide either guidance or direction to the remuneration committee and company management as to the shape and structure of remuneration policy for executives.

3.3. In addition to being subject to a vote by shareholders, remuneration policy and structures in many major institutions are already subject to the FSA’s remuneration code. However, in respect of certain aspects of detail investor guidelines are in direct contrast to guidance being provided by the FSA. For example, many institutional investors have a strong preference for the use of relative TSR as a performance measure used to determine the vesting of long-term incentive awards. However, the FSA is not generally supportive of relative TSR (or EPS) as a performance measure.

3.4. As a result, the role played by institutional investors can be at odds with rules and guidance on remuneration provided by regulators.

Remuneration consultants

3.5. Our role is to help companies make sound business decisions that will help create shareholder value whilst taking account of regulatory and best practice guidelines as well as well considered remuneration design principles. We provide information, data, analytics and advice based on experience to help companies arrive at decisions on remuneration - we rarely if ever are asked to recommend how much an executive should be paid.

3.6. Unlike appointed auditors or actuaries, remuneration consultants can only advise and influence; we do not have the power to sanction decisions or provide formal approval to proposals. Decision-making should never in our view be “out-sourced” to consultants.

3.7. We are co-founders and members of the Remuneration Consultants’ Group Code of Conduct. Key objectives of the Code are to support the integrity and objectivity of advice provided to remuneration committees by their advisors and to minimise the potential for conflicts of interest.

Employees

3.8. There are examples of European countries that require employee representation across all industries and in our experience there are cases where this is effective. However, we would like to stress that the governance structures around these arrangements are very different to those in place in the UK. In Germany for example the employee representative has full membership of the supervisory board and

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contributes to any discussions on remuneration with the same duties and information on the company as other supervisory board members.

3.9. In the UK, having an employee representative on the remuneration committee, without being a board member, would undermine our current corporate governance structure of a unitary board with all members being directors, and all committee members having a collective responsibility for the long-term success of the company.

3.10. We note that an employee representative on the committee would favour employees over other stakeholders when the statutory duty of directors is to promote the success of the company for the benefit of members, having regard to the interests of the company’s employees as well as other stakeholders.

3.11. Remuneration committees already have a duty to consider the broader pay and employment conditions across the company when making decisions on executive pay and in our experience committee members are increasingly aware of how decisions on executive pay compare to those being made elsewhere for the broader employee population. An employee vote on remuneration would place employees in a potentially more influential position than other stakeholders.

3.12. Employees are able to vote on directors’ remuneration as shareholders and a greater encouragement of employee shareholding might provide an additional source of feedback to remuneration committees. Most leading financial services companies provide for some form of all-employee share purchase plan and participants are already likely to have the opportunity of casting votes based on any vested shares employees have retained.

3.13. In summary we do not support the notion that employees should sit on the remuneration committee of any listed company irrespective whether it is a financial services company or not.

3.14. If there is an overwhelming view that remuneration committees should take account of employee views then we would suggest that the most efficient route is to encourage (but not require) remuneration committees to seek those views using the same approach that may already be in use in conducting employee engagement surveys. The challenge would be ensuring that employees are fully informed before giving their opinion.

Is there a case for introducing still greater transparency for senior executives with respect to remuneration in the financial services sector?

3.15. It is our experience over a number of years and in a number of countries that one unintended consequence of increased disclosure is that it has led to an increase in executive pay levels. We believe it to be likely that there will be a similar outcome for senior executive pay levels within larger banks if there is greater pay disclosure, particularly given the focus the industry has on relative pay levels across firms and especially for top talent. Disclosure of below-board pay levels may have the consequence of making the UK a less attractive employment destination for executives who might fall into this new disclosure category. We made a similar observation in our submission to the BIS consultation on executive remuneration,

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when the question of extending disclosure within UK listed companies beyond the board was raised. We think that the Government is right not to have carried forward disclosure of pay beyond the board for UK listed companies generally.

3.16. If increased disclosure is intended to restrain executive pay we believe that the intention is misguided – we would argue that increased disclosure has the opposite effect.

3.17. The banking sector remains a key element of the British economy and when these regulations are added to other increases in the regulatory, taxation and media pressure for banks and their executives, the question arises as to whether the UK can remain an attractive location when compared to other global financial centres.

Should there be further reform of the remuneration arrangements of senior executives in the financial services sector? Should this extend to those highly paid individuals who sit below executive level?

3.18. There is already an EU-led framework in place which has been implemented in the UK as the FSA remuneration code as well as other related frameworks that broadly follow the thrust of the principles that underpin the code. Further regulation is likely to follow for the insurance sector and alternative investment management sector.

3.19. For the largest and most complex firms the code sets out in a relatively prescriptive manner the way in which pay can be structured and delivered to Code Staff. As a result we have seen firms revise their remuneration policies to provide for:

Increased levels of deferred pay;

Claw-back features including malus like provisions;

Risk-adjusted performance measures to determine variable pay spend; and

Improved performance management processes that seek to reflect broader contribution rather than simply financial performance.

3.20. Via CRD IV there are further proposals to limit variable pay as a proportion of fixed pay for covered firms in EU member states such that maximum levels of variable pay might be capped at 100% of fixed pay or a ratio of 1:1.

3.21. In addition to these frameworks, remuneration of executives of UK-listed companies is subject to the current advisory vote on the Directors’ Remuneration Report (which will evolve into both advisory and binding votes under the BIS proposals).

3.22. Given the level of prescription already in place in major firms and the fact that remuneration policy for executive directors will soon be subject to a binding shareholder vote we do not see a case for further reform. Indeed, we might argue to the contrary in that regulations around pay in EU member states places UK firms at a competitive disadvantage in many key overseas markets and that the current framework itself ought to be relaxed somewhat.

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The Chairman of the Financial Services Authority has argued that there may be a case for changing the personal risk return trade-off for bank executives. He has suggested either a strict liability legal sanctions or an automatic incentives based approach. What are the merits and drawbacks of these proposals? Are there other ways to achieve the same objective?

3.23. We are unclear as the precise meaning of this question but assuming that the thrust is in respect of the balance of risk and reward we make the following comments.

3.24. Pay structures in banks have undergone, and continue to undergo, significant change such that the way in which remuneration is delivered in banks is now significantly different to that in general industry or even in the insurance sector. In simple terms, executives now receive a lower proportion of variable pay in cash, a higher proportion in equity (or similar instruments) which vests over an extended timeframe, typically three years. Non-vested awards are also subject to claw-back provisions based on subsequent financial performance, personal performance and risk. Taken together the risk-return trade-off for bank executives has changed significantly over the last three years.

3.25. It could be argued that deferral into equity may encourage some excessive risk-taking where for example the share price has fallen significantly over a deferral period and an individual seeks to inflate the share price through risky business decisions in order to make good the short-fall. We believe this to be an unlikely scenario however since there are too many variables that may come into play to make individuals make conscious decisions outside of the relevant approved risk management framework or guidelines.

3.26. Further change may also be possible. We have already noted that there is a strong possibility that via CRD IV variable pay may well be limited to 100% of fixed pay - significantly changing the risk-return arrangements further. If such an approach is implemented by regulators then the resulting “pay mix” for senior executives will be more conservative than we would typically observe in some of the UK’s other largest companies for executives sitting on the Executive Board or Management Committee.

3.27. One alternative approach would be to require deferral into bond or fixed income type instruments rather than equity. Such instruments by their very nature are significantly less elastic in value compared to equity, thus providing significantly less upside in terms of any potential pay-out.

Yours sincerely Katharine Turner Practice Leader, Executive Compensation Andrew Marshall Director, Executive Compensation June 2012

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Written evidence submitted by Legal & General Investment Management (CGR.37)

Board Structure and composition  

1. What outcomes should corporate governance in the financial services sector seek to achieve? 

 Corporate Governance aims to protect all stakeholders, align management with their shareholders to whom they are accountable and maximise the creation of value in the business over the long term. This is in reference to all companies, not just financial institutions.  We recognise the systemic importance of financial institutions to the economy (in terms of growth, GDP, employment etc). Therefore, regulation in the financial industry should aim to be complemented with corporate governance to protect the integrity of the UK economy.  

2. Are Board structures effective? For example, should UK financial institutions consider adopting alternatives to the unitary Board structure? 

 The role of the Board is to protect shareholders and ensure that they receive a return on their investment. Underpinning this is improving the underlying performance of the company and ensuring long term sustainable growth. The Board of Directors are the business brain of the company. Good decision making is dependent on the discussions and debates in the boardroom. In addition, they should be actively engaged with shareholders and be in tune with market views.  We believe the unitary board structure works well and is fit for purpose. Ultimately, the quality of the Board comes down to the calibre of the directors (both executives and non‐executives). It is the role of the Nominations Committee to ensure the Board is working well and is effective. This is highlighted in the UK Corporate Governance Code. Furthermore, formal Board processes and procedures are necessary for a unitary Board to work effectively.  In order for the Board to function effectively, we also think it is important that Non‐Executives should not take on too many roles and other directorships. Depending on the size of the company and type of industry they operate in, Non‐Executives need sufficient time to understand the business and make the time to engage with shareholders. In relation to financial institutions which are global and have a high complexity in the business, this may be greater and require a larger amount of individual director’s time commitment.   Furthermore, there should be good disclosure on Board evaluations and a statement of the action points that have been carried out to improve performance.  LGIM believes the constant refreshment of Boards and succession planning as being vital for the long term sustainable performance of a company. LGIM also supports diversity in boardrooms to enhance its functioning and to stimulate debates. It is important that Boards are flexible and adapt just like a company has to adjust to market conditions. 

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 3. Does the UK approach to regulation and supervision of financial services incentivise 

Boards to perform their role effectively? Is more intrusive regulation a substitute or complement to effective corporate governance? Is a “comply or explain” approach an effective framework for governance? 

 LGIM believes that the overall approach in UK corporate governance has worked successfully in comparison to our international peers. The ‘comply or explain’ framework from the UK Corporate Governance Code is an essential catalyst for discussions between companies and investors. In addition, it provides companies with the flexibility to operate without having to adhere to rigid regulation.  Regulation can assist  in providing assurance  that a  firm has appropriate processes and  systems  in place  for  effective  corporate  governance.  However,  too  many  prescriptive  rules  and  intrusive regulation may be counter productive. For example, increasing requests for the FSA to attend board meetings  would  inhibit  board  discussion  and  discourage  open  debate.  This  undermines  board effectiveness which  is crucial  in the UK Corporate Governance Code.  It also raises questions about the regulator's role if there are failings at a firm where the FSA has been a regular attendee at board meetings.  

Corporate culture  

4. What type of corporate culture should financial services firms seek to foster? In what way can this be encouraged? How effective are Boards at shaping corporate culture within their institutions? 

 The aim of corporate governance is to foster a culture within an organisation which mitigates risk and creates value for all stakeholders. In relation to a financial institution, the maintenance of a ‘risk‐controlled’ culture throughout the organisation is important to its long term health.  LGIM views the Board of Directors as providing leadership and oversight to the whole organisation. Therefore, when examining culture and behaviours, its dynamics are important to understand how strategic decisions are being made and whether it creates long term value or places the Company at greater risk. In addition, their actions are correlated with the Company’s reputation in the market and how they deal with stakeholder issues. This is then fed further down through the chain of command to all employees in the firm.  Another important area that is connected with corporate culture is incentive arrangements. These are attached to strategic decisions made at Board level which drives the performance of the Company. More detail is given in the Remuneration section of this consultation. 

 

Impact of previous reviews and new regulatory developments  

5. What difference would the proposals in the Independent Commission on Banking’s report on the Boards of ring‐fenced banks make to corporate governance in these institutions? 

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 It remains to be seen what the effects on the Boards of ring‐fenced banks would have on the corporate governance arrangements within these institutions. The arguments surrounding separating different banking activities and capitalisation is more visible as they relate to the economic performance of the Company. In relation to the effect at Board level, ring‐fenced banks should have an independent board which may or may not lead to the creation of a different governance structure within the firm. Nevertheless, it is important that directors are unified and work efficiently for the stability of the Company as a whole.  

6. What benefits, if any, come from EU regulator engagement with corporate governance issues? 

 We are aware that due to the systemic risk that financial institutions pose to the international economy, it is desirable that there is international collaboration and consistency with regards to policies from regulators. This includes harmonised guidelines for corporate governance.  However, we believe that the prescriptive requirements imposed at EU level are not considered necessary for the UK and should be avoided. For example, in relation to Corporate Governance, the culture and structure of European companies differ greatly from those in the UK. The level of transparency in public documents and willingness to engage with investors is also different due to the shareholding structure in the market.   Therefore, when examining the proposals by European regulators, it is important to take in to account whether they would actually work in the UK or have an opposite effect.  

7. What impact has the Walker Review (2009) had on corporate governance and corporate behaviour in financial service? 

 The Walker Review has improved corporate behaviours in the sector as a whole by placing emphasis on risk‐related issues and making Boards reassess their own performance. Furthermore, there has been increased focus on the business models of financial institutions and where there are weaknesses in their internal systems which are vital for the stability and health of financial organisations. 

 Non‐Executive Directors (NEDs)  

8. Should Non‐Executive Directors bear greater liabilities than under current law? Should executives in FTSE 100 companies be able to hold non‐executive positions in other firms? 

 Since the financial crisis, we have seen the role of NEDs being strengthened given that they play a crucial role in the dynamics of the Board and the oversight of management actions. NEDs are probing deeper in to a company’s financial affairs and are spending more time working with companies in order to take in to account the risks to a business model.  

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As mentioned in Question 2, LGIM expects NEDs to have sufficient time to carry out their duties efficiently. The amount of time an NED spends in the business is determined by the size of the corporation, the complexity of the business and its product and the risks involved. In relation to financial institutions, these features are often large and therefore an NED should be fully committed to his/her role.   It is important for an NED to have a broad range of experience and technical knowledge in order to contribute effectively in the boardroom. Furthermore, having up to date executive experience is also positive and plays an important part in the performance of the individual director. Therefore, they should be able to hold executive/non‐executive positions in other firms as their expertise can be shared and developed improving the performance of the Board. We do not believe that there is any benefit for NEDs to bear greater liabilities than under current law. There is also a risk that this would further restrict the pool of NED candidates for financial services companies.   

9. Is the existing FSA approval process for significant influence functions (SIF), including non‐executive directors, effective? 

 In our experience, the FSA approval process has become more intensive than ever when considering the appointment of a director for a financial institution. Although we acknowledge the need for a thorough process to be held in order to select the correct candidate and ensure that they are competent for that role, there is evidence that this has limited the pool of candidates and deterred good quality nominees from applying for the position.  For example, the recent search for the Chairman of Prudential Plc was found to be difficult because of the regulatory burden going forward and additional time‐commitment. This has deterred well known and respected ‘external’ candidates from accepting the job.  

The role of shareholders  

10. Should shareholders be required to exercise a stronger role in systemically important financial institutions? What are the key barriers to greater shareholder activism by institutional investors in financial institutions? What are the risks associated with it? 

 LGIM believes that the two‐way dialogue between companies and investors is vital. Without robust discussions and direct communication with shareholders, companies are unable to ascertain the views of their actions within the marketplace. In addition, without institutional investors engaging with companies, shareholders are unable to understand management decisions.  The Stewardship Code highlights the importance of engagement both individually and collectively in taking  ownership  of  companies.  LGIM  believes  that  engagement  gives  the  opportunity  to  learn about a company’s strategy, operations, financials and external challenges and opportunities, all of which are essential  in order  for an  investor  to exercise  their ownership duty  in  the most effective way. This  is also mentioned  in  the  recent  ‘Interim Report on  the Kay Review’ which  is  seeking  to empower asset managers.  

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More  importantly, engagement means LGIM can voice concerns before voting at general meetings and  allow  an  exchange  of  ideas  with  the  company.  Doing  engagement  in  a  collaborative environment also aids this process and can achieve significant changes if shareholders are unified on their approach. As LGIM  is  largely a  long term shareholder  in  its equity  investments, a regular and consistent approach to engagement is vital in order for it to be successful.   

 11. Is it realistic to expect sovereign wealth funds and hedge funds to undertake a more active 

role?  The reduction in the proportion of UK equities held by UK investors, and corresponding increase in holdings by international investors has inevitably resulted in reduced influence by UK long‐term institutions over company management.  Due to LGIM’s size, we are able to engage with overseas investors to have more influence. We contact the large players and are able to enter in to dialogue due to our reputation and confidentiality approach to meetings. This makes us a common ally with other investors on specific issues.  The Kay Review has also expressed its interest in the involvement of overseas investors in the UK market on corporate governance and LGIM is supportive of any action taken to collaborate.  Therefore, LGIM believes that it is realistic to expect sovereign wealth funds and hedge funds to undertake a more active role in corporate governance issues.  

Remuneration  

12. What role should institutional investors, remuneration consultants, employees and others play with respect to remuneration in the financial services sector? 

 13. Is there a case for introducing still greater transparency for senior executives with respect 

to remuneration in the financial services sector?  

14. Should there be further reform of the remuneration arrangements of senior executives in the financial services sector? Should this extend to those highly paid individuals who sit below executive level? 

 15. The Chairman of the FSA has argued that there may be a case for changing the personal 

risk return trade‐off for bank executives. He has suggested either a ‘strict liability legal sanctions or an automatic incentives based approach. What are the merits and drawbacks of these proposals? Are there other ways to achieve the same objective? 

 It is clear that discontent over Directors remuneration has been a main focal point for investors during the year so far with reference to a “Shareholder Spring” occurring. As with all companies in which we invest, we examine executive remuneration structures in great detail and come to a decision on whether we feel that award levels are appropriate and there is a link between pay and 

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performance. There are 3 basic principles on executive pay which we feel is important for companies to consider:  

1. SIMPLICITY – Executive pay needs to be simplified and focused on long‐term value creation rather than short‐term performance. A single figure on remuneration would also be helpful however the industry should be given guidance on how this is calculated. It should be noted that Legal & General Group Plc attempted to do this in this year’s remuneration report. This is in line with best practice. 

 2. TRANSPARENCY – Pay and other remuneration must be transparent; performance targets 

should be clear and explicit, as should the level of award an Executive Director would receive if these targets were achieved, and how the reward will be paid should also be disclosed e.g. pay/bonus/share options/ restricted share awards. 

 3. ALIGNMENT – Pay and especially bonuses need to be aligned to the long‐term interests of 

investors and executives themselves. Executive Directors should have meaningful ownership of shares, not just options. Clawback mechanisms and deferral of awards in to the future should be considered to further link pay and performance. 

 Caution should be taken when deciding remuneration in the wider financial sector. This is because different financial businesses do not all pose the same systemic risk to the economy, they are culturally structured differently and organisations are unique in their strategy, make‐up and operations.  In relation to remuneration consultants, we have found on occasion that a company’s reliance on remuneration advisors has left the Board to: (a) not exercising their own common sense on what is appropriate; and (b) using consultants to devise benchmarks that are totally inappropriate and only serve to increase executive pay. LGIM believes that more transparency is required about the use of remuneration advisors and the information they provide to the Company. The Remuneration Committee Chairman should be able to demonstrate a clear understanding of the proposals being put to shareholders without the help of their Advisor.  LGIM has been heavily engaged with Business Innovations and Skills (BIS) regarding remuneration in the UK market. We also put forward our views and specific improvements that can be made in our recent submission.  Given the intense focus on remuneration with the FSA Remuneration Code, Walker Review, HMT Consultation on Remuneration Disclosure and BIS consultation on Executive Pay, we do not believe that any prescriptive reforms should be introduced at this current time. It is crucial that changes being proposed undergo a proper consultation process and given a period to be embedded and carefully examined to ensure that they have had the desired effect.    

Governance of Risk  

16. Has the management of risk in firms improved since the financial crisis?  

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LGIM believes the management of risk has been improved since the financial crisis. In particular, Risk Committees are being increasingly separated from the Audit function by being more specialised and more emphasis is being placed on their independence from executive management. For example, the important role of the Chief Risk Officer has risen in organisations. This ensures that risks inherent in business activities are adequately assessed, understood and managed by the Board, thereby minimising risk exposure.   

Diversity and background  

17. What is the relationship, if any, between Board diversity and company performance in the financial services sector? 

 LGIM believes that board diversity contributes to effective risk oversight and is critical to improving the quality of decision making on company boards. We have been very active in this area and are members of the 30% Club. A thought-piece expressing our views can be found at: http://www.lgim.com/_resources/pdfs/about-lgim/Fundamentals_November%202011.pdf  It is important that regulation does not over burden and restrict the appointment of directors as this makes it difficult to recruit candidates with different and diverse backgrounds. Although having financial acumen is important for accepting a role in a financial institution, too many prescriptive rules may deter individuals with international experience in different markets which may be important for a Company aiming to increase its global footprint.  31 May 2012

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Written evidence submitted by the UK Shareholders Association Board structure and composition

1. What outcomes should corporate governance in the financial services sector seek to achieve?

The objectives of corporate governance in the financial sector should be the same as those in other sectors.

A Long term survival of the business:

Long term is difficult to define but emphasises the need (inter alia) to look at continuity, to seek to avoid the tyranny of quarterly reporting, to recognise that investment in new products and services may take time, to encourage well founded persistence in such developments, to recognise that risks can take a long time to appear, and to ensure that the company takes full account of the changes which will inevitably occur in the business, political and environmental world.

B The proper recognition of responsibility and a willingness to ensure that those with the responsibility for the running of the business are held to account both for their successes and, importantly, their failures;

C The proper recognition of the businesses’ owners- the shareholders- whether those be institutional or personal:

This needs to go with an acknowledgement that dealing with private shareholders will be both more difficult than with institutional but also more beneficial in that those private shareholders will offer both a different view and one more geared to the concept of stewardship and the achievement of long term survival.

2. Are Board structures effective? For example, should UK financial institutions consider adopting alternatives to the unitary Board structure?

A key issue in corporate governance is the balance which has to be struck between having a board which is not adequately critical of its executives and one which is overly so. The concept of “friendly” criticism is difficult to maintain. Boards can often fail to adequately review the plans and polices of management in the interest of both “not rocking the boat” and avoiding the inevitable personal discomfort of a board where the management feel persecuted or not properly valued. Unless there is immediate pressure to act for some reason it is easier for non-executives to suppress doubts than to express them.

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There is therefore a case for a supervisory board where this sense of antagonism might be avoided. However UKSA has little experience of the way in such supervisory boards actually operate and cannot comment on them in detail.

Whilst audit committees have the advantage that they allow time for greater consideration of accounting and auditing matters there is, on occasion, a sense in which the full board can feel detached from crucial decisions in this area for which the full board is, and must be, collectively responsible.

3. Does the UK approach to regulation and supervision of financial services incentivise Boards to perform their role effectively?

To the extent that a number of financial institutions failed one can only conclude that any incentive arising from regulation was ineffective. It is in any case arguable as to whether regulation in itself either is or should be the prime driver (possibly however a necessary one) but acceptance of the outcomes listed above to the first question in section 1 would be more effective. The main incentive to boards to perform effectively is for such boards to know that if they are ineffective their company will fail. There must be no possibility of a business being “too big to fail” and thus having the implicit guarantee of a taxpayer funded bailout. The consequence of this is that efforts have to be made to ensure that no business is “systemically important, however that is defined.

Is more intrusive regulation a substitute or complement to effective corporate governance?

Certainly not a substitute for. The evidence from the 2008 collapse was that the then regulator, the FSA, failed to prevent the disaster. There is an inevitable tendency for regulators to become “box tickers”, unwilling or unable to ask the most fundamental questions. Even if such a tendency were to be avoided problems then arise as to who is really running the business. As previously suggested boards have and must have full responsibility for the company. If this is in doubt responsibility will fall between two stools. Moreover there is a risk, if not a likelihood, that the regulators become shadow directors and acquire the responsibility and liabilities of that role. Thus regulation can only be and must only be a complement to effective corporate governance. Is a “comply or explain” approach an effective framework for governance?

In principle yes. There will always be circumstances which are not envisaged by regulations. If there is an explanation as to why a regulation has not been complied with then those treating with the company as investors, debtors or creditors can make their own decisions as to whether they are happy with the failure to comply. However some companies have been able to develop a style of governance reporting that satisfies the letter of this requirement without providing any real explanation. Without teeth, ‘comply or explain’ is neutered. There should be an opportunity for shareholder scrutiny, for example by a non-binding vote at the AGM.

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Corporate culture

4. What type of corporate culture should financial services firms seek to foster?

The first requirement is to distinguish those firms offering service to a client from those dealing with a customer. The concern, quite rightly, has been to seek to protect depositors with and clients of firms dealing with the affairs of those clients. The culture in these cases clearly has to be one in which the interests of the client come first. This has both a long term financial benefit to the business, in that a well-treated client is more likely to return, and a benefit to society in that it protects the interests of the clients who may not have the resources to protect themselves. In firms which seek to deal in financial matters on their own account the culture can and probably should be different. Such businesses should have a culture of profit maximisation in the interests of their owners. Historically such businesses were often partnerships and thus the risk decisions were taken directly by those who stood the risks unlike the present situation. If these businesses are to be public limited companies the need is to have a form of regulation which makes clear to all, the risks and potential rewards involved. The difficulty is in drawing distinctions between the two types of businesses but this has been done before. (See e.g. Glass-Steagall Act 1933 USA)

In what way can this be encouraged?

There is no one culture to be encouraged. It is up to the respective boards to set incentives (if they feel those are needed) in ways designed to achieve their differing objectives for the cultures of their businesses.

How effective are Boards at shaping corporate culture within their institutions?

The culture should come from the board led by the chairman. However, a forceful CEO can often effectively create the culture he wants. How in practice cultures develop UKSA cannot comment on.

Impact of previous reviews and new regulatory developments

5. What difference would the proposals in the Independent Commission on Banking’s report on the Boards of ring-fenced banks make to corporate governance in these institutions?

This is presumably a reference to the proposal that “ ring fenced “ banks shall have a majority of non-executive directors of whom one will be the chair and that they are to report as if they were an independent PLC. UKSA believes that this would certainly help if those boards fully accepted the guidelines laid out in the replies to question 1 above

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6. What benefits, if any, come from EU regulatory engagement with corporate governance issues?

UKSA believes that relatively little benefit comes from EU regulatory involvement. This is for two reasons:

A The UK financial services industry represents by far the largest part of the EU financial services

B Any advantages from common standards would be minimal as the EU cannot influence those standards outside the EU, for example in countries such as Switzerland, USA and Hong Kong.

7. What impact has the Walker Review (2009) had on corporate governance and corporate behaviour in financial services?

No comment.

Non Executive Directors

8. Should non-executive directors bear greater liabilities than under current law?

It is not clear what is being envisaged here. Under UK company law all directors have the same responsibilities and liabilities. UKSA is not aware of any arguments in favour of such a suggestion and thus has no view on this point.

Should executives in FTSE 100 companies be able to hold non-executive positions in other firms?

UKSA believes that the main advantage of executives holding non-executive positions in other firms is that it broadens their experience. Clearly each board must be happy that such use of executive time is not at the cost of their own company.

9. Is the existing FSA approval process for significant influence functions (SIF), including non-executive directors, effective?

No comment.

The role of shareholders

10. Should shareholders be required to exercise a stronger role in systemically important financial institutions?

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UKSA would wish to see explicit recognition of the role of private shareholders as against institutional and an acknowledgement that the two groups of shareholders can, and often do, have very different approaches.

Shareholders presumably look to protect their own position as owners of the company. Those investors acting for principals e.g. pension schemes and insurance companies have a responsibility to do their best to protect the interest of their principals. Given the preponderance of institutional shareholders it is important that they are active in discharging their responsibilities. There is evidence that they have sought to do this more by selling shares rather than being proactive. That is easier, less time consuming1 and less confrontational than working for changes in a company. However just recently (E.g. Barclays, HSBC, Standard Life, BP and National Grid) there is some evidence of change here. It is difficult to see what obligations to act would be effective. It is also encouraging that by December 2011, 175 firms in investment management had signed up to The UK Stewardship Code published by the FRC in 20102

However private shareholders can normally be expected to act more directly and UKSA believes that using this approach could help if such private shareholders were properly empowered.

The particular problem of effective disenfranchisement caused by the insistence on nominee accounts urgently needs to be addressed.

UKSA has for some years been advocating the use of Shareholder Committees for this purpose and believes that all companies, not just those deemed systemically important, could benefit from the idea.( See interim report of the Kay review: article by Alistair Blair in the Investors Chronicle- 21 March 2012: private member’s bill by William Cash, MP 2009: Walker Report Para 5.17).

In the meantime, the Financial Reporting Council should reintroduce to its Corporate Governance Code of Conduct a requirement that all votes at general meetings be taken first on a show of hands, to give private investors in attendance the opportunity to show their opinions in the most visible way, which will often have a salutary effect even though the institution- dominated proxy votes may determine the issue. Denying those who have their own money invested the chance to demonstrate their opinion has been wholly counter-productive.

What are the key barriers to greater shareholder activism by institutional investors in financial institutions?

1 A recent poll of asset managers found that they have, on average, holdings in 450 businesses. Fewer than half claim to engage with all their investee companies.((Economia (ICAEW magazine) May 2012 page 47)). 2 Economia, May 2012, Page 48

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The barriers have been outlined above: effort, time, the avoidance of confrontation in a narrow pool of people, conflicts of interest, prevalence of index-tracking and/or fund performance measurement relative to an index making absolute performance irrelevant, cheaper (and more profitable) to sell or short the stock instead of engage to improve performance, commission on sales all of which constitute the agency problem, much compounded by the practice of stock lending.

What risks are associated with it?

No comment.

11. Is it realistic to expect sovereign wealth funds and hedge funds to undertake a more active role?

Sovereign wealth funds are reluctant to be seen as “interfering”. Presumably hedge funds can be expected to act in a manner similar to the institutions.

Remuneration

12. What role should institutional investors, remuneration consultants, employees and others play with respect to remuneration in the financial services sector?

UKSA assumes that this question is still addressed to those businesses which remain systemically important. It assumes that those which deal on their own account with appropriate disclosures of risks are not included.

Institutional investors have an important role here if they are willing to undertake it. It has been commented above that they have found it easier not to get involved but this may be changing.

UKSA believes there should be little or no role for remuneration consultants. They have a clear incentive to seek to maximise pay. They can become a way for a board to attempt to slough off responsibility for pay levels to someone else. The UKSA manifesto states “Remuneration consultants must be made accountable to the shareholders, their reports made available to the shareholders and their reappointment sanctioned at each AGM.”

UKSA cannot see how employees could be involved in such decisions unless there were either two level boards with employee representation (EG Germany) or some sort of formal structure for workers’ councils.

Once again, Shareholder Committees as suggested above should have a role to play here. It also supports the government’s approach for binding votes, (but as ordinary resolutions), as suggested by the recent BIS consultation. UKSA’s response to this consultation is attached.

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13. Is there a case for introducing still greater transparency for senior executives with respect to remuneration in the financial services sector?

UKSA would wish to see the remuneration of senior executives brought into the proposed provisions of the BIS consultation as well as executive directors. It is essential that the ‘performance’ incentives of directors and senior employees are subject to independent scrutiny – not necessarily as to quantum but definitely as to structure. ‘One way’ incentives such as stock options and threshold triggers reward volatility and therefore incentivise risk-taking.

14. Should there be further reform of the remuneration arrangements of senior executives in the financial services sector? Should this extend to those highly paid individuals who sit below executive level?

See reply to 13

15. The Chairman of the Financial Services Authority has argued that there may be a case for changing the personal risk return trade-off for bank executives. He has suggested either a ‘strict liability legal sanctions or an automatic incentives based approach. What are the merits and drawbacks of these proposals? Are there other ways to achieve the same objective?

See reply to 13 Governance of risk

16. Has the management of risk in firms improved since the financial crisis?

UKSA has no evidence on this point.

Diversity and background

17. What is the relationship, if any, between Board diversity and company performance in the financial service sector?

No comment.

Any further comments relevant to corporate governance in financial institutions would be welcomed. R A Collinge F.C.A Head of Corporate Governance Group, UKSA June 2012