A Comparative Survey of Corporate Governance Between the UK &

A Comparative Survey of Corporate Governance Between the UK &
the US: What Lessons Should China Learn?∗
RAO Yulei SHENG Hu
Business School, Central South University, P.R.China, 410083
[email protected]
Abstract Comparing to the US’s violent revolution from flexible corporate governance tradition to a
more descriptive and legislative form, the UK has been conducting a way of evolution with steady steps,
wide-ranging influence groups, self regulation, and deep engagement of institutional investors. This
paper analyses the corporate governance in the UK from the perspective of comparison with that in the
US. Since China has transplanted the system from that of common law countries, the comparison
between two countries gives a template for China to make it clear what should we learn and what should
not. This paper then gives some suggestions to improve the corporate governance in China.
Keywords Corporate Governance, the UK, the US
1 Introduction
The Cadbury Report issued in the UK in 1992 laid the foundations of a set of corporate governance
codes, not only in the UK but in countries all over the world. Following a series of corporate scandals as
Enron, corporate governance has gained a much higher profile. China has mainly transplanted the civil
law system (the Continental European or Japanese system), but also referenced many from that of
common law countries (Anglo-American system, including the UK and the US).
It has long been known that there are great differences on corporate governance system between
common law and civil law countries. It is argued that common law which puts much more trust in law
enforcers and gives much greater discretion to the courts is better placed to protect shareholders with
significantly stronger shareholders’ rights. However, reaction to corporate scandals in the US has
promoted legislators to be more prescriptive through legislation by quickly introducing the stringent
Sarbanes-Oxley Act. The Act has had a positive effect on corporate governance issues, but it has
imposed a substantial increase in compliance cost, particularly in the short term. Ribstein (2005)
summarized that the Act was ineffective and unnecessary.”[1] Evidence indicates that excessive
legislative prescription can impede the development of broad and liquid capital markets. It was asked
that whether regulation had gone so far that foreign companies had decided against listing in the US.
Some European companies that were considering a listing on NASDAQ or the NYSE were having
second thought of listing on LSE [2,3].
While people focused on the distinction of civil law and common law, the comparative work
between the UK and the US had been neglected. Recently, a number of studies have begun to explore
those differences. The legal nature of the corporation is distinctly different in the UK from that in the US.
Miller (2000) examined takeover law in the UK and the US, and found that there are several salient
differences between two countries. He argued that the UK has a more robust and less regulated takeover
market, while the US is more permissive towards derivative litigation[4]; Toms & Wright (2005)
compared the systems of business organization and corporate governance of the US and the UK during
1995-2000, and indicated that “there are also differences that have not been fully investigated.” [5]
Aguilera et al (2006) examined differences by evaluating institutional investor composition and modes
of action in the two markets, and by exploring the implications of such differences for the varying
importance of “corporate responsibility” issues within the two countries. [6]
The failure of corporate governance in the US, the overreaction of the legislation by
Sarbanes-Oxley Act and the current debate about the corporate governance between the UK and the US
caused the motivation of reviewing the evolution of corporate governance in the UK and rethinking
∗
Supported by National Science Foundation of China (No. 70672106 and 70272045).
351
what lessons could be learnt.
2 The Differences of Corporate Governance in the UK and the US
2.1 Revolution or Evolution?
Comparing to the US’s response to the scandals with a revolution on corporate governance with the
feature of “Severe law comes out of trouble time”, the UK conducted a quiet and steady evolution which
is somewhat as “Soft fire makes sweet malt”.
The corporate governance framework in the UK operates at several levels: Firstly, through
legislation of Company Law Reform Bill; secondly, through regulations and listing rules for listed
companies, which are enforced by the Financial Services Authority; finally and most importantly,
through the Combined Code which is the responsibility of the Financial Reporting Council. Over the
past years, the UK has initiated a series of investigations into ways to improve the corporate governance.
In forming the current corporate governance code, the Combined Code(1998) and the Revised
Combined Code(2003), the committees to some certain issues, and the reports coming out of these
committees, include chronologically the Cadbury Report(1992), the Greenbury Report(1995), the
Hampel Report(1998), the Turnbull Guidance(1999), Myners Review(2001), the Higgs Report(2003),
the Smith Report(2003), and the Tyson Report(2003), played great important roles.
From the start of the evolution of corporate governance after great scandals in early 1990’s to the
Revised Combined Code in 2003, we can clearly see that every step of improvement on corporate
governance relied mainly on how a committee works. The procedure of the evolution makes UK
corporate governance stands as the most open and transparent system in the most industrialized
countries. The UK is now ahead of the US in terms of the quality of the investing environment on the
basis of the governance practices of the firms they are most likely to invest in.
2.2 Enforcement or Self-regulation?
The most important innovation of the governance in the UK was introducing a voluntary code
which was different from a statutory code and established best practice. Instead of being prescriptive
and legislative like the Sarbanes-Oxley Act, The UK government used a “comply or explain” approach
when facing the failures, which was introduced for the first time in 1992 by the Cadbury Report1. Most
of the conventions and rules started as “self-regulation”, but have been subsequently supported by the
force of law. It is legally mandatory under the Financial Services and Markets Act (2000) to explain
such divergences. The “comply or explain” approach is preferable to statutory measures because it does
not commit companies to a “one size fits all”, and thus diminishes the risk of complying with the letter
rather than the spirit of the code; whereas a more statutory regime would lead to a “box-ticking”, which
would fail to allow for sound deviations from the rule and would not foster investors’ trust.
Some empirical research proved that the Combined Code is for encouraging compliance but fails to
encourage informative explanations. After investigated 245 non-financial UK companies over the period
of 1998-2004, Arcot & Bruno (2005) found that there was a clearly increasing trend in the percentage of
companies complying, which increases from 10% in 1998-1999 to 56% in 2003-2004 [7]. However, the
analysis of the explanations highlights drawbacks in the system. Their evidence shows that companies
prefer to comply rather than change their explanation. Arcot, Bruno & Faure Grimaud, (2005)
investigated non financial constituents of the FTSE350 at the end of 2004, and found that companies
that didn’t comply tended to stick with the same explanation until they directly jump to compliance[8].
This suggests that companies do not use the flexibility of the Code to fine-tune their governance to their
changing circumstances.
3.3 The Equity Based Compensation
The ostensible purpose of equity-based compensation is to align the CEO’s and senior managers’
1
See Cadbury, A. (1992) Report of the Committee on Financial Aspects of Corporate Governance (http://
www.ecgi.org/codes/documents/cadbury.pdf).
352
interest with those of shareholders, to create clear incentives for management to focus primarily on the
creation of shareholder value. But evidence revealed both in the UK and US that there was no
discernible link between pay increases and company performance. The large awards of compensation
seem to be far greater than would have been necessary to retain and motivate those CEOs. In turn, this
sometimes lavish component of equity-based compensation created a perverse incentive for senior
managers to manipulate and smooth accounting earnings. Firms are under enormous pressure to sustain
a high stock price, which in effect promotes unethical behaviors, tempting managers to manipulate
earnings statements in order to defend their position. Boards found it difficult to monitor these
accounting manipulations and tended to place limited restrictions but allowing the managers to cash
their options at any time. However, the UK government started a procedure of solving the problem by
designing the mechanisms of link between the compensation and the performance of executives.
Conyon and Murphy (2000) document the differences in CEO pay and incentives in the US and the UK
for 1997, and demonstrate that CEO pay and stock-based incentives in the US are much higher than in
the UK, with 45% higher cash compensation and 190% higher total compensation[9].
2.3 The External Control Mechanism of Institutional Investors
It has long been said that there is a sharp contrast between the shareholder dispersion in
Anglo-Saxon countries and block shareholding in Civil Law countries. But recent researches show that
it is far more overstated. Mallin et al. (2005) argued that institutional investors controlled about 80% of
the UK equity market, and close to 60% of the US equity market in 2003[10]. The ownership is
considered equally in the UK & the US. But their roles in corporate governance of the institutional
investors in two countries are quite different.
Since the Cadbury Report in 1992, and with further impetus from the Myners Review in 2001, the
UK institutional investors have been encouraged to play a more active role in the governance of
portfolio companies. The Combined Code established principles applicable to institutional investors,
including that “institutional shareholders should enter into a dialogue with companies based on the
mutual understanding of objectives”, and that they should make “considered use of their votes”. Thus
insurance companies and pension funds which dominate the UK equity market have long-term payout
obligations and might more readily adopt a long-term perspective on the risks and opportunities
presented by portfolio companies. The UK pattern of ownership and control is in some respects more
shareholder friendly than that of the US, combined with the mandatory shareholder powers. It means
that a few institutions are in a position at any time to threaten the board and thus exercise control. British
pension fund trustees are legally independent. Dialogues between shareholders and firms take place in
the context of the “nuclear option”, the right of shareholders of calling an extraordinary general meeting
within three weeks with 10% of votes. Hence British boards of directors are more exposed to investor
pressure on such issues as the composition of the board, the appointment of new directors, and executive
pay. The standard default constitution confers a power on the general meeting to give directions to the
board on any matter by qualified majority. Therefore, the residual power over the firm resides with the
general meeting, not with the board as in the US. Shareholders are clearly in the driving seat, with
boards as contractual agents of the general meeting. Institutional investors in the UK engage in matters
such as corporate strategy, board effectiveness, executive remuneration and CEO succession. They act as
an “early warning system” on important strategic and governance issues, and, increasingly, are
evaluating social and environmental risks facing the company [11].
In the US, however, the largest institutional investors pre-dominate by investment companies
(mutual funds) and investment advisors (money management firms). The relationship between
institutional investors and portfolio companies is characterized less by collaborative pursuit of the
long-term health of the company, but more by scripted communications between analysts and corporate
investor relations departments to meet securities analysts’ quarterly financial projections. Consequently,
institutional investors in the US do not play the strategic consulting role. The rights of shareholders are
severely constrained between annual general meetings, making it difficult for institutional investors to
gain access to the board if it doesn’t wish to cooperate. Many of the US institutional investors are asset
management divisions of large financial institutions that conduct business with the firms concerned, and
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are therefore reluctant to antagonize the management of those firms. Collectively, the board maintains
the power to change the articles and by-laws in many circumstances, and to approve or reject
shareholder-initiated changes. The board can ignore resolutions of the firm’s general meeting on
ordinary business proposals. In fact, shareholders have only very limited power to interfere with the
course of the company between general meetings, as for example, they cannot demand an extraordinary
general meeting or table proposals to the board outside the general meeting. The only residual right that
remains in this case is to organize a very expensive proxy contest.
2.4 The Responsibilities of the Board of Directors
The independence of the board of directors is a precondition of the efficiency of the function of the
board, while it can conduct the function of monitoring as well as advisor. However, the monitoring
function could not be brought into action if both the board of directors and the executive affairs are
controlled by only one person, that could cause the over powered of executives. It is not uncommon in
the US that the system of outside directors is conducted more in letters rather than in spirits. For
example, there were 15 out of 17 outside directors in Enron’s board, including some well known people.
But the complex relationship among directors turned the board to a club, which was mostly controlled
by the executives. However, In the UK, the Code on corporate governance attached great importance on
the system of non-executive directors.
The greater amount of constraint on the exercise of CEO power in the UK versus the US became
one of the divergences areas of the corporate governance. From the beginning of the evolution of
corporate governance, the recommendations on how to improve the efficiency of the board of directors
are eternal issues, which mainly focus on the separation of the roles of chairman of the boards and the
CEOs. Splitting the two roles was first suggested by the Cadbury Committee and was incorporated into
the Combined Code (2003)2, which states “there should be a clear division of responsibilities at the head
of the company between the running of the board and the executive responsibility for the running of the
company’s business. No one individual should have unfettered powers of decision.” The CEO’s exercise
of power in the UK may be further constrained by the Higgs Review’s structural suggestion that firms
appoint a “senior independent director”. This change seems likely to spread the power at the top of the
firm by enhancing the power of the board of directors to operate independent of management and
effectively monitor executive action. The effect of these reports was to enhance the role and visibility of
non-executive directors. Higgs Report indicated that 90% of the UK’s largest companies follow a dual
strategic leadership pattern, but approximately 80% of US companies’ CEO is also the Chairman of the
Board3. It is not uncommon for the chief executive, who is usually also the chairman, to be the only
full-time manager on the board in the US.
3 What Lessons Should China Learn?
Since1995, China has started to research and practice the reform of corporate governance. In 2000,
Shanghai Stock Exchange issued the Guidance of Corporate Governance of Listed Companies,
following this step, in 2002, China Securities Regulatory Commission (CSRC) issued the Rules of
Corporate Governance of Listed Companies, which set up a series of regulatory provisions.
Investigation shows that comparing with 2005, in 2006, Chinese listed companies’ corporate governance
standard has shown an overall improvement, which is mainly due to the uplifted standards of mandatory
regulations. The inconsistent pace of corporate governance improvement between mandatory areas and
self-conscious areas indicates that Chinese listed companies’ improvement on corporate governance is
mainly compelled by the pressure from monitoring authorities4. Thus, it still remains areas to be
2
See Combined Code on Corporate Governance (2003), Available at http://www.fsa.gov.uk/pubs/
ukla/lr_comcode2003.pdf
3
See Higgs, D. (2003) Review of the Role and Effectiveness of Non-Executive Directors
(http://www.ecgi.org/codes/documents/higgsreport.pdf).
4
See Chinese Centre for Corporate Governance of the Chinese Academy of Social Sciences and the Faculty of
Business of the City University of Hong Kong, The Corporate Governance Assessment Report of the 100 Top
Chinese Listed Companies in 2006. http://www.iwep.org.cn/cccg/20060616/contents.htm
354
improved, but in this paper, I would like to focus on what we could learn from the comparison between
the UK and the US.
3.1 Provoke the Influence Groups’ Wide Range Awareness
From the UK’s successful procedure, we can learn that we need more and wide-ranging participants
in the process of improving corporate governance. In China, there is a lack of broad awareness and
extensive influence from different organizations and participants. Some academic institutions like
Nankai Centre of Corporate Governance, Corporate Governance Centre of Chinese Academy of Social
Science, have made out the corporate governance index to evaluate the level of governance for Chinese
listed companies and issued the evaluation report every year, which greatly increased the common
awareness of corporate governance. But it is far less than enough. The improvement of corporate
governance needs more diversification of participants and involvements from companies’ initiatives,
shareholders, stakeholders, some sorts of non-profitable investor protection associations, professional
institutions, media, public feelings, etc.
3.2 The Role of Institutional Investors
China has conducted the share trading reform, with the prospect that original non-tradable shares
may gradually be held by some present institutional investors, who could be incentive to conduct the
right of large shareholders. From the failure of market mechanism of the US and the increasingly
positive effect on corporate governance of institutional investors in the UK, we realize that with the
domain of concentration of ownership, institutional investors in Chinese listed companies may be
encouraged to become greatly involved in the corporate governance affairs in their portfolio companies.
Although Chinese corporate governance primarily modelled on the Anglo-American external
market-based system, China has not yet fostered a mature market mechanism as the US does5, given that
Chinese banks are also not yet actively participated in their monitoring and control governance function
as banks in Germany and Japan do. It may have few alternatives but to develop and modify the current
insider-based model. The most feasible solution is to advocate the institutional investor’s important role
in corporate governance.
3.3 Avoid Extra Agency Cost of CEO’s Equity Based Compensation
We are adopting the reform of privatizing on state-owned enterprises and share reform on listed
companies, while executive incentives by holding stock shares or options are currently hot debate way
and means. Taking into account the experience of the last decade and the most recent studies of the link
between pay, motivation and performance in the US and the UK, further researches are needed on the
design of Chinese remuneration packages for senior executives. We need clearly definite and identify by
both legislations and regulations on the limitation of managers transformation of the risk of holding
shares and options to those of investors. To do so, the most important thing is to emphasise the
transparency of the compensation schedules and the limitation of the transactions of CEO held shares in
short terms to avoid particular agency cost of CEO’s equity based compensation. If there is no limitation
for managers to transfer the risk of holding the shares to the corporate or investors, the schedule of
executive stock options will increase the agency cost rather than link the interest between the executives
and that of investors.
3.4 Forster an Environment of Companies’ Self-regulation
The newly amended Company Law has shown improvement in strengthening company’s
self-governance, and provided legal support to enterprises for self-reformation of corporate governance.
However, competition of capital market, particularly competition in financing, is required to boost up
management initiatives to improve corporate governance by self-discipline. Only when it is fully
recognized that capital markets are important sources for enterprises’ financing and corporate
5
Actually, as we mentioned, some of the market mechanisms such as the over-liquidity of the transactions of
capital assets and M&A, the links between stock price and CEO’s equity-based compensations are proved to some
part have a negative effect on corporate governance.
355
governance as an instrument for capital marketing, will enterprises have the initiative to improve
corporate governance by self-discipline, and to learn the best corporate governance practices from
outstanding enterprises.
3.5 Improve the Efficiency of the Board of Directors
In China, it is regulated that all listed companies are required to establish an independent board of
directors, with no less than one-third independent directors out of the total members. But the current
system, which is run by a board of supervisors, usually big shareholders, isn’t working. Directors are
mainly nominated by major shareholders and elected to the board by the shareholders general meeting.
Insider control and the conflicts of interest may arise when managers and directors are the same people.
This has seriously hampered the interests of small and medium-sized investors. The perfect design and
detailed provisions about the system of non-executive directors in the UK give us a good template for
reference. China needs to clarify the precise meaning and responsibilities implied by each type of
directors and to clarify their legal duties and objectives, to accelerate the awareness the directors’ loyalty
to the company, and their conscientious fulfillment of responsibilities and appropriate expertise.
Meanwhile, the functions, responsibilities, remuneration and legal liability of non-executive directors
should be more clearly defined, and the importance and exact definition of independence be discussed.
4 Conclusion
By comparing the corporate governance system between the UK and the US, we found that
although they are under the same common law system, which has a strong shareholder rights and good
protection for investors, there exists a great deal of distinctions. Compared to the US’s violent revolution
of the corporate governance from flexible tradition to a more descriptive and legislative form, the UK
tends to improve the corporate governance by a way of steady steps and large-ranging influence groups,
with the permanent direction of self regulation of “comply or explain”. Meanwhile, the institutional
investors in the UK are greatly encouraged, contrast to that in the US, to engage in the corporate
governance affairs as real shareholders to supervise the performance of their portfolio companies. Since
China has transplanted the system from that of common law countries, such as the adoption of
independent directors and the implementation of equity-based compensations, It is important to compare
the differences between the UK and the US to learn from the experience of their failure and success. The
paper suggests that to improve the corporate governance, China should widely provoke the awareness of
influence groups, encourage institutional investors to play important roles in corporate governance,
avoid the probability of by-producing extra agency cost of CEO’s equity based compensation, foster an
environment of companies’ self-regulation, and improve the efficiency of the board of directors.
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