Introduction: The Wates Principles (Wates) are the UK’s pyramid of large company governance. Increasingly, Wates is being applied to private and public companies alike. Indeed, Wates is viewed on the global stage as a clear summary of best practices. In three parts, I would like to examine Wates in the context of recent business events as well as in view of peer guidance for corporate governance.
The pinnacle principle is Leadership and Purpose. One imagines that leadership drives governance and purpose flows down. Yet, one might also consider that a pyramid is only as sound as its base. In this spirit, I would like to discuss leading from the base: how this supports the whole and gives meaning to purpose.
The Base: “Specific Matters” are the weighty foundation: #4 Opportunity & Risk, #5 Remuneration, and #6 Stakeholder Relationships & Engagement.
Let’s work from Principle #6:
“Directors should foster effective stakeholder relationships aligned to the company’s purpose. The board is responsible for overseeing meaningful engagement with stakeholders, including the workforce, and having regard to their views when taking decisions.”
To the chagrin of Friedmanites everywhere, Stakeholder relationships have expanded well beyond shareholders. Milton Friedman spurred a move from a 1960’s Great Society version of capitalism to his own interpretation of “invisible hand” capitalism. Friedman’s Theory of Shareholder Value left moral decisions to the individual shareholders whilst management maximized profits. The market would make everything workout well for society. But, everything hasn’t worked out for the better over the past forty years. Taking into account the increase of homelessness in rich countries, climate change and a myriad of other issues, neither the invisible hand nor corporate social responsibility helped as expected. For most stakeholders, corporate performance, wages, quality of life, the environment and much more are worse today than when Friedman was at his apogee.
Wates represents a revival of “stakeholder” capitalism. Now, the Board of Directors has to balance shareholder rights against the needs of stakeholders including customers, employees, government, environment, and society. The list of stakeholders is deliberately nebulous. One company’s stakeholders may be very different from another’s. How does the company, under the guidance of the board, engage? Customer and employee engagement is quite clear. But, the other stakeholders?
The old adage, “don’t be part of the problem, be part of the solution” seems to be a good stakeholder mantra. Many aspects of social engagement are being assigned to the sustainability column. We have seen this in Larry Fink’s CEO letters. Boards need to demonstrate positive actions to address sustainability whether poverty alleviation, social justice, or climate change.
UAE based real estate developer Majid Al Futtaim issued green bonds. This was not a fluke, but part of a process. In 2011, the company (MAF) initiated a sustainability strategy. MAF issued a Green Finance Framework in April 2019. Working in the MENA region, MAF has embraced the United Nations’ Sustainable Development Goals. Drive to a MAF shopping center, the carpark is shaded by solar arrays. The indoor water feature aerates gray water to be used for landscaping.
Principle #5 is going to be increasingly linked to Principle #6 as compensation affects stakeholders very directly:
“A board should promote executive remuneration structures aligned to the long-term sustainable success of a company, taking into account pay and conditions elsewhere in the company.”
We are already seeing increased questioning of the gap between executive and worker pay. Whether it was the Trump tax cut, offshoring or simple greed, in the United States, CEO pay is 278 times that of workers average wages. When wages are cut and jobs are offshored, who gets the money? Executives are happy to keep it! The UK gap may be less egregious than the US, yet the principle is that excessive compensation schemes for leadership are typically incentives for leaders to maximize their personal benefit over other stakeholders. Board members need to take into account the types of incentives that CEOs and other corporate officers enjoy that do not promote productivity, worker well being, supply chain health, and local communities.
One would imagine that Principle #4 Opportunity & Risk is the bread and butter of board duties:
“A board should promote the long-term sustainable success of the company by identifying opportunities to create and preserve value, and establishing oversight for the identification and mitigation of risks.”
Audit and enterprise risk management (ERM) are distinct. Audit emphasizes financial integrity. ERM is looking at the horizon of risks from operations to online engagement. ERM is looking out for both white and black swans.
The board audit committee (AC) is responsible for evaluating the financial integrity of the business. Part of this role is straight forward: are the financial statements accurate? Is the company exposed to fraud? What are the risks that could impinge on financial integrity? As one analyzes each of these, it becomes clear that the AC has a mandate to examine corporate wide policies, procedures and controls. The AC determines their effectiveness, points out weaknesses, and monitors revisions. When controls are sound, a company is less susceptible to financial fraud, and should make better financial decisions.
At NMC Health, the UAE firm under administration, the AC failed in its primary duties. First, the AC erringly validated the financial integrity of the company. How could the company have USD 4 billion of hidden debt? Even if the debt had been known, the AC had a duty to know the purpose of the debt and where the money went. Second, the AC failed to discover if any fraud had taken place. Controls were clearly absent. On the one hand, it is true that managements can hide many things from the board. On the other hand, the board, in particular, the AC, has an obligation to make sure that controls are in place. The AC is heavily armed and dangerous as it can challenge management, insist on controls, and perform its reviews. Moreover, the AC is in a position to challenge the external auditors as much as it is to coordinate with them. When it doesn’t, cases like NMC, Thomas Cook, WorldCom and PollyPeck arise.
An enterprise risk management committee (ERMC) provides risk oversight of operational activities at a granular level. If one were to create a corporate or committee hierarchy, the audit committee checks the work of the ERMC. There are boards that have a joint audit and risk committee. But, this creates a risk that one or both of the functions are not performed to standard: The volume is too great for the combined committee to handle.
In some enterprises, ERMC is a joint management-board committee which reflects the operational aspects of ERMC compared to the oversight aspects of the audit committee. The ERMC should agree with management and full board on a risk appetite statement, this sets the tone from the top and helps to define a composite risk picture. The ERMC traditionally uses a dashboard approach. More advanced methods look at risk over time. All approaches need to reward what the National Association of Corporate Directors (USA) calls balkanized risks: many yellow flags, none of which appear serious, aggregate into a red flag. This means that the ERMC needs to be able to know when a crisis is looming, and when it has arrived.
Risks are commonly divided between market risks, operational risks, cyber risks and liquidity risks. For a commodity trading firm, market risks might be the most important. For a financial institution, liquidity risks rank highest. And, for operating companies, operational risk is greatest. Cyber is now significant for all businesses.
Digital risk runs from web presence, social media engagement, and cyber security to reputation management:
- Toys R Us outsourced their web presence to Amazon in the early 2000s. Toys R US online failure was the harbinger of the demise of many bricks & sticks retailers. This is online presence risk.
- In 2017, hackers gained access to the data of 140 million Equifax customers in one of the worst breaches of consumer data ever. This is pure cyber security risk.
- More recently, Amazon has suffered from continuous social media debacles following its proposal to have the public contribute to a relief fund for Amazon’s workers, and then besmirching and firing an employee who led a strike over worker conditions during the COVID-19 pandemic. These separate events blend social media engagement with reputational risk.
Under the Wates Principles, the board owns these types of failures as it is responsible for strategy including web presence, security including cyber, and reputation.
The outbreak of COVID-19, the white swan of 2020, pushed many companies to their business continuity plans. Many service businesses have been able to shift to remote work plans. But, for manufacturing and others, COVID-19 has meant broken supply chains and restrictions on operations so that laborers are properly distanced. In the travel, hospitality and dining segments, COVID-19 risks a total shutdown of operations with the knock-on effects of laid off workers, unpaid rents and mortgages, and so on.
If one looks at airlines, during the past ten years some enjoyed annual profits in the billions of dollars. Failing to heed the biblical story of Joseph, they bought back their own stock and depleted their cash reserves. Having had a shutdown in 2001, a fuel spike in 2008 followed by a significant slowdown, one would have thought that airline ERMCs would have contemplated the necessity of high cash reserves to weather future risks. The AC for its part ought to have highlighted the danger of not sustaining sufficient cash in the business for high probability contingencies like fuel spikes, cyclical downturns, and less likely business interruption events. The ERMC should have anticipated these types of risks, and held management to plan appropriately.
In contrast, Ford Motor Company was a stunning example of fiscal probity when Alan Mulally took over in 2006. The firm was in a poor financial condition and needed working capital as well as capital expenditure. Mulally addressed the liquidity situation by raising USD 46 billion in 2006/7 including 23.6 billion of secured funds 90 days after he joined. As a result, Ford didn’t need a 2009 bailout, but took government funds to be on level footing with GM & Chrysler which fell into bankruptcy — the very thing that Mulally’s board approved financial prudence prevented.
Wates expresses accountability in Principle #4. The board owns the selection of strategy, and opportunities, the definition and embrace of risk, and oversight of financial and risk management. At the operational level, management is the sole proprietor.
Principles #4 Opportunity & Risk, #5 Remuneration and #6 Stakeholder Relationships & Engagement are universal. Whatever leadership defines, no matter the purpose is agreed, the foundational principles assure that the business is sustainable in a 360 degree manner: stakeholders, management and risk.
The Middle: Principles #2 Board Composition and #3 Director Responsibilities are called The Characteristics of Governance. At the the middle of the pyramid, these are complementary principles. Principle #2 states:
“Effective board composition requires an effective chair and a balance of skills, backgrounds, experience and knowledge, with individual directors having sufficient capacity to make a valuable contribution. The size of a board should be guided by the scale and complexity of the company.”
Building Board Composition is increasingly a delicate art. There are the catch words like diversity. And, there are the skills: finance, human capital, technology,… Each speaks to having the most suitable board for one’s business. The California State Teachers’ Retirement System (CALSTRS) offers advice on the best practices in board composition. The leadoff is independent leadership, meaning the chair of the board. CALSTRS does not want the CEO to be chair because the duties conflict. On the one hand, the roles are distinct with the board providing oversight of management. How, logically, does the CEO as chair perform oversight of the CEO as manager. On the other hand, the board, not the CEO should control the agenda, which sometimes includes firing the CEO.
Wates goes a step further in encouraging more independence across the board. Indeed, this is the global trend. Independence links well with diversity and stakeholder engagement. The CFA Institute believes that the majority of a board should be independent because:
“An independent majority on the board is more likely to consider the best interests of shareowners first. It also is likely to foster independent decision-making and to mitigate conflicts of interest that may arise.”
Diversity might seem like a light touch. Yet, diversity reflects our stakeholders. We no longer live in a monochrome world with one gender at work, another at home. CALSTRS adds that diversity broadens the perspectives and expertise that makes a board most effective. Independent boards are more likely to push management to be more rigorous and better prepared. And, they may well assure that all stakeholders are identified and their needs addressed.
Composition must embrace chemistry. This is challenging because the group who will form a board have different specialities, skills, experiences. If we have embraced diversity, they will have different shades, ages and experiences. Independents should be clear headed with just enough distance to see what management and connected directors can’t or don’t wish to see. They must then bring it up. That is where chemistry comes in. Without it, an insight over a business challenge may be seen as a challenge to management. Indeed, chemistry may allow for diplomacy and an easing of tension before conflict erupts. Conscious Governance shares some good examples of this from the CEO to board perspective.
Size matters in the sense that it is relevant to the purpose and size of the business. Smaller, private businesses, start-ups may not require more than three to five directors. But, larger and regulated businesses require larger boards. Complexity drives size. Financial and cyber expertise are now indispensable. Business area expertise must always be present. Each layer of engagement, the transition from private to public, expansion across borders are among the many factors that drive board formulation.
Board evaluations assess board effectiveness. They often show what directors do not see in their day to day roles.
A wonderful view of a leader is that she knows when to follow. Directors are typically accomplished and have frequently run a business. A director has worn the leadership shoes. Yet, directorship now means knowing to follow, or to lead by example.
Principle #3 Director Responsibilities states:
“The board and individual directors should have a clear understanding of their accountability and responsibilities. The board’s policies and procedures should support effective decision-making and independent challenge.”
This principle is more like three. A director has a duty of loyalty to the firm. Whether this is captured in law or not, there is no point in acting as a director if one is not loyal to the firm. By itself, this is complex. Who or what is the firm: Management? A visionary CEO? A business legacy? Shareholders? Does loyalty mean that one has to know when the firm has come to its natural end?
The second is law. In the UK, the law has become much more strict. Directors, even non-executives and independents, now share the same accountability as management, and with it particular responsibilities. One would not like to be an independent director of the recently failed Thomas Cook.
The third is policy and procedure (P&P). How do these enshrine effective decision making and independent challenges? In my career as an independent director, I have observed how two horrific realities have framed P&P. The first is that many companies are happy for a global firm, perhaps one of the big four audit firms, to write their P&P. This creates a clear problem that managers and staff may not have enough input. The P&P are a box ticked, not a realistic rulebook and road map. The second is that managers might think that P&P belong to the audit or corporate governance department. Either way, the people, who should rely on them and know best what is happening, are not invested in the P&P. When operational teams do not own their P&P, the board can be sure that controls are not well observed.
Principles #2 and #3 seem intangible. Yet, their density is a powerful load. A poorly composed board will not be able to challenge, guide, or engage with management. A board of cronies, or unplugged mono-chrome retirees, a board disconnected from stakeholders is a balsa frame supporting a marble capstone. It cannot fulfill its duties.
The Capstone & Conclusion: Principle #1 is the capstone, or Wates’ North Star: Purpose & Leadership:
“An effective board develops and promotes the purpose of a company, and ensures that its values, strategy and culture align with that purpose.”
Realistically, most directors inherit a purpose. Their duty is to serve that purpose, or determine that it requires a change. If not, they must consider whether or not they should resign.
Even if the board informs the values and culture of a company, the employees see these every day in the behavior of management. The board, however, must hold the management accountable to the values and culture that foundational. Ernst & Young states this well:
“Responsibility for defining the right culture for the company and embedding it within daily operations falls to management, but the board must oversee and hold management to account on how it is defining, aligning (to purpose and strategy), embodying and reporting on culture.”
A friend of mine, a coach, puts it, “Culture is how we do things around here.” Culture matters in a world that values human capital as much or more than tangible assets. Culture is the DNA that defines how human capital and tangible assets create value.
The board will not decree the strategy, it will evaluate management’s proposed strategy and engage with management to approve or adapt the strategy. PWC offers insights to the board’s role in strategy:
Challenge management’s assumptions;
Analyze the risks embedded in a strategy and discuss with management;
Make sure that management sees beyond the short term;
Verify that management has thought about disruption: being the disruptor or being disrupted;
Keep the strategy discussion alive throughout the board calendar;
Hold management accountable; and
Keep shareholders in the loop.
To the last point, regulated companies are obliged to keep their regulator aware of their strategies and changes.
Leadership is not the general atop a horse giving commands. Modern corporate leadership is a form of dynamic engagement. The director is a member of a leadership team. And, that team in the Wates view embraces stakeholders, takes ownership of oversight, and dialogues with management. Wates is not merely prescriptive, but proscriptive. Boards must reflect both their stakeholders and the nature and complexity of the business. As Wates has written it, Principle#1 ingrains elements of each of the five principles holding it up.
The six principles, promoted by the UK’s Financial Reporting Council, are broad enough to leave gaps. This is a strength as flexibility allows diverse and robust approaches to the governance. As we see in nature, diversity enhances an ecosystem. In 2008, we suffered from a lack of diversity in financial institutions. This resulted in systemic collapse.
The Wates Principles are clear enough to establish the foundation of best practices for corporate governance. Presented for large private corporations, the principles are widely being adopted by smaller enterprises. In the UK, the transparency promoted by the Wates Principles is meant to guide boards to build stakeholder trust. This trust is meant to be the foundation of greater commercial sustainability.
The principles go beyond merely fulfilling their legal duties. The author of the principles is hopeful that widespread adoption of the principles will improve governance and accountability whilst reducing the risks of failure. Lest a director think otherwise, the principles do not reduce a director’s significant duties, they give context.