Prepared for ICSA's annual conference, London, March 2012 If installing Fred Goodwin as Knight Bachelor in 2004 “for services to banking” was unwise, the decision by the previously (and subsequently) obscure Honours Forfeiture Committee to recommend that Her Majesty annul the appointment achieved a whole new low. While he was, self-evidently, ultimately not a successful CEO, Goodwin does not belong in the same circle of Inferno as Robert Mugabe or Nicolae Ceausescu, whose previous honours the Committee had also dispatched.
The decision came in the wake of the report by the Financial Services Authority into the failure of the Royal Bank of Scotland in December 2011. The FSA report is a weighty tome at 450+ pages. It does not make gripping reading. However, outside the Financial Reporting Council (of which more in a moment), reviews of governance are usually personal affairs; official reviews are all-too-rare. The 30 page section in the RBS report on ‘Management, Governance and Culture’, therefore, deserves close attention. Here, let’s focus solely on the governance aspects.
Specifically, what can we learn from the RBS experience for governance about:
- the assumption of a ‘unitary board’?
- governance roles around risk for non-financial firms?
- the roles of company secretaries?
The role of NEDs in a ‘unitary board’
The emphasis the RBS report places on role of non-executive directors to provide ‘rigorous testing, questioning and challenge’ is a recurring theme of reviews of governance within financial services and other sectors alike.
In a speech in May 2009, the FSA’s CEO, Hector Sants, noted that NEDs would need to have “relevant and diverse expertise, have a willingness to challenge, independence of thought and the ability to avoid the ‘herd mentality’”. This, he contended, would require “a different calibre of NED, with a different mindset” from previous appointments. In that speech, Sants also addressed the dilemma of the potential conflict in the roles of executive and non-executive directors. In his 2003 review of the role of NEDs, Sir Derek Higgs had said:
"We do not want to set up NEDs as a competing governance mechanism against the executive. It is more about making both much more effective. We therefore continue to support the ‘unitary board’ model, but it must be recognised that such a structure runs the risk of encouraging the herd instinct, both in the sense of encouraging ‘follow the leader’ behaviour and in the sense of the reluctance to ‘break away from the pack’ and express an independent view."
In its analysis of the relationship between executive directors and NEDs, the FSA’s report on RBS makes much of the ‘herd instinct’ – the failure to challenge. Like the Walker review, Higgs review and FRC analysis of the Combined Code (now UK Corporate Governance Code) before it, the FSA’s report on RBS is uncontroversial to the point of ignoring the obvious. The mythology of the ‘unitary board’ is unhelpful; frequent repetition does not make it so. In reality, firms typically have four types of directors:
- a director who is chief executive, who reports to the board
- director(s) who report(s) to the chief executive
- directors who are not executives, . . .
- . . . one of whom will be chairman with an expectation of considerable time commitment
While formally, legally, these roles are broadly equivalent, once evaluation moves beyond the formal, structural settings of the board to its behaviour and to improving its performance, clarity over such distinctions is vitally important. Only through such clarity can we understand differences in motivations and inhibitions in expression and propensity to action. Behaviourally, the differences in power, authority, knowledge, access to information and commitment to existing or proposed course of action will all have a significant impact on ‘willingness to challenge’. And, when dealing with what is primarily a social system, as is a board of directors, conventional wisdom on formal and structural issues is inadequate for the task; behavioural issues are paramount.
If we are to make effective use of board evaluation, strengthened by the FRC review and emphasized in the FSA’s review of RBS, we need to be more mature about how boards work behaviourally. Persisting with the assumption behaviourally – as opposed to legally – that all board members are equal is unhelpful and inhibits improvement; evaluation simply creates another box to tick.
NEDs and risk in non-financial firms
In November 2009, the Walker review advocated increased time commitment by non-executive directors in banks and other financial institutions, with much of that time dedicated to risk review. The RBS report seems to accept this proposition. However, to me it seems unrealistic – even in financial firms; NEDs are valuable precisely because they are not wrapped up in the day-to-day work of the business.
While Walker’s logic on separating a forward-looking risk committee from the historically-focused audit committee was impeccable, the question remains, at both committee and full board level, what elements of risk should the board focus on as distinct from management? Regardless of sector, it seems clear to me that the board should focus its attention on the development of and assurance over the operation of the firm’s risk system – its framework elements, risk tolerances and follow-up on ‘exceedences’ (breaking limits) – rather than on specific levels of risk exposure. Poring over details of risks, whether in underwriting reports, credit exposure reports or risk registers is not what boards generally or NEDs specifically are there to do. Such activities should be pushed back to executives.
The board’s process of review of the risk system or of major risk issues – such as an acquisition (a key focus of the RBS recommendations) – must allow NEDs to contribute effectively and robustly, without the extensive detail or, possibly, technical knowledge available to executives. Focus on detail and ‘numbers’ is where many boards and business-people more generally feel comfortable and where they feel they have grounds for ‘objective’ judgement and decision-making. It allows technically-competent and financially-literate NEDs or executives to apply and demonstrate their expertise. Relatively few NEDs or executives are trained or skilled in understanding behavioural systems – often lazily referred to as ‘soft skills’. Recent research suggests there may even be widespread neurological biases in favour of attention to such detail and away from impressionist, non-linear or integrative systems.
In building and operating a board which has a different function from an executive group, it is essential that a broader set of experiences and skills be assembled and given the opportunity – through broader agenda-setting – to contribute to examining the behavioural or ‘cultural’ elements of a firm. This will not occur without conscious attention to where the attention of the board is to be focused. That is clearly a role for the company secretary advising the chairman.
Should the trend of risk committees spread more broadly? Commentators have been quick to underscore that Walker is focused only on the financial services sector and to distance corporate sectors from such debates. However, the logic is unassailable: the role of the audit committee is backward-looking; risk is a forward-looking issue. The two focuses should not be confused; risk oversight should not be conflated with control oversight. Concerning board structure: draw your own conclusions!
One of Walker’s key recommendations was to require financial firms to create chief risk officer roles, “reporting (sic) to the board risk committee, with direct access to the chairman of the committee in the event of need”. Just like an internal audit director! However, Walker did not accept ICSA’s suggestion that the same provision should be made for corporate secretaries: that they should report jointly to the Chairman with similar provisions for independence and remuneration. It is a report on which the RBS report is silent.
I believe that is a lost opportunity; it is an idea that is both sensible and necessary in that it provides a direct and clear path for non-executive directors to access information and support that is being denied them by senior executives. It would remove the inevitable (even if innocently intended) filter of executive preview of assurance and would provide conditions under which NEDs could pose penetrating questions independently of executive management and expect robust responses. While it would alter the intensity and focus of the secretarial role, this cycle is an essential element of independent challenge of management assumptions by non-executive directors. It is an idea whose time has come; its dangers are usually grossly overplayed.
If – when – the ICSA proposal were adopted, combined with the Walker CRO recommendations and existing provisions for internal audit directors, the financial services sector would have a triumvirate of ‘governance officer’ roles: the secretary reporting jointly to the CEO and Chairman, the CRO reporting jointly to the CEO and chair of the risk committee (forward-looking risk) and the director of internal audit with a joint reporting line to the chair of the audit committee (backward-looking risk). This would provide a far more coherent and effective assurance base for non-executive directors and the board than is available currently.
The ‘triumvirate’ governance officer structure is just as valid in non-financial sector firms; without a risk committee, where risk is a focus for the whole board, the CRO position should report to the chairman or his or her designated NED(s) – but not to the chair of the audit committee; risk is not and must not be treated as a compliance issue.
By addressing these critical areas – the acknowledgement of different types of directors in governance reviews, refocusing the board’s attention to system-level issues in risk and establishing a triumvirate of governance officers with direct board relationships – we would increase firm’s governance performance and reduce the tick-box emphasis in risk systems and governance reviews. The focus of the FSA’s RBS report, like so many before it, was more steeped in governance ‘orthodoxy’. Recent events have been far from orthodox; the solutions we seek must be also.