Firstly, I’d like to thank the Institute of Directors for hosting this afternoon’s event. I’d also like to applaud the Institute of Business Ethics for nearly 30 years of excellent work. Its mission statement is to “promote high standards of business practice based on ethical values”. The need for this has never been more true; just look at the loss of public trust in business and other institutions.
Importantly, the Institute of Business Ethics recognised that espousing such values was not just about public perception, but about underpinning the long-term performance of companies.
With my background and the obvious relevance of this subject to banks you may be expecting me to talk exclusively about the financial services sector. I don’t want to do that – these issues are important for all companies – but I will start with a quote from Sir Richard Lambert’s recent Banking Standards Review:
“The overriding responsibility for improving the behaviour of banks must lie with the leadership of the institutions themselves, operating within the framework set out by the regulators. It is for them to define the values and purpose of the banks which they lead, to appoint and promote people who are aligned with its values, to decide which types of business they are happy to accept and which to turn away, and to do everything in their power to make sure that the tone set at the top reaches all the way down through these often very large organisations.”
Replace “banks” with “companies” and this quote remains true. Richard has got it spot on by saying that it is ultimately down to the leadership of companies to deal with the issue.
Of course bodies like the FRC, and the PRA/FCA in the case of financial institutions, have a role. Regulators can and should make it clear when certain behaviours are totally unacceptable and then punish any breaches. Codes and standards do spread best practice that makes bad behaviour less likely to occur; and public reporting can make it harder to conceal such behaviour. But that does not prevent bad behaviour or inappropriate strategies or decisions. Only the company, or rather people, can do that.
Companies must not think of ethics and culture as some sort of compliance exercise. Getting appropriate processes and controls in place is important, but will not by themselves embed the right values and culture. That requires vigilance by the board, and a lot of thought. The IBE paper is a helpful prompt for that.
It is essential that boards lead by example and set the tone at the top in order to influence the behaviour of management and staff. That leadership must come, in particular, from the Chairman and Chief Executive, who need to be seen to live the values they espouse and to be very clear about any practices for which there is zero tolerance. The CEO, with the support of the executive team, has responsibility for setting an example to the company’s employees, and communicating to them the expectations of the board in relation to the company’s culture, values and behaviours.
Communicating those expectations from the board outwards is the easy part. Much more difficult is establishing whether they have been understood and acted on throughout the company. Boards have little direct visibility of what is going on in the depths of the organisation, and it is always tempting to hide bad news from them – the same is true at all levels. It is important that board identify indicators that might suggest problems. A lack of openness, for example, is often a tell-tale sign.
Where bad behaviour is identified, it is essential the boards deal with it in a way that sends an unambiguous signal to the rest of the company that it will not be tolerated.
In this context I can cite the example of my immediate past experience as Chairman of Lloyds Banking Group. That bank’s exposure to Payment Protection Insurance (PPI) claims and restitution is well-known. PPI selling was stopped before I got there in September 2009. But since then there have been cases of inappropriate selling behaviour at the retail level or enquiries in the LIBOR or Foreign Exchange area. As much top-down (which in a way is the easier bit) as well as bottom-up the board and Antonio Horta-Osario, Lloyd’s Chief Executive, had to change attitudes and practices. So much so that in the Annual Report for 2013 Lloyds actually signposted ‘conduct risk’ as a separate item and stated – and I quote:
“The Group has no appetite for systemic unfair customer outcomes arising from any of its activities: through product design, sales or other sales processes. This appetite is reviewed and approved annually by the Board. To achieve this, the Group has policies, processes and standards which provide the framework for businesses and colleagues to operate in accordance with the laws, regulations and voluntary codes which apply to the Group and its activities.”
While the board must lead, it does not act alone. I have already mentioned the role of regulators including the FRC. The FRC has been instrumental in increasing the influence of shareholders, both directly and through the work of external auditors – examples include annual election of directors, now adopted by almost all FTSE 350 companies, and enhanced auditor and audit committee reports.
But, reflecting on what I said about change needing to come from within the company itself, we have perhaps not placed enough emphasis on governance below board level and the important role played by, for example, internal audit in providing assurance to the board.
Don’t panic – I am not proposing a new code on internal governance! There are others better placed than the FRC to advise on good practice, such as the Chartered Institute of Internal Auditors who have recently produced a report on the role of internal audit in promoting the right culture. Philippa Foster Back from the IBE provided the foreword to that report, and I quote her:
“Internal audit… can provide confidence that there is a strong commitment to good conduct and that it is actually being translated into everyday behaviours, but also, more importantly, where it is not.”
It is difficult to talk about ethics and trust in business without talking about directors’ remuneration. We are getting to the end of the first AGM season and have experienced the enhanced voting rights for shareholders introduced by the Government last year. We have seen a few votes lost and high levels of dissent in many others. Hopefully companies will heed these signals and take care to ensure that they demonstrate a clear link between the performance of their directors and the pay they receive.
The level and structure of remuneration can also have an important effect on behaviour, and needs careful thought if it is to create the right incentives. This is true at all levels, not just at the board. Remuneration and incentives that encourage people to cut corners or prioritise short-term gains over long-term prosperity, or which leave some groups of employees feeling unfairly treated compared to others, can have a destructive effect.
The danger of sending equivocal signals is something we have experienced with the UK Corporate Governance Code. For many years the section of the Code dealing with directors’ remuneration has opened with the words:
“Levels of remuneration should be sufficient to attract, retain and motivate directors of the quality required to run the company successfully”
On the face of it, that is hard to argue with. However we have found that some companies have cited that phrase to justify what many would consider excessive pay and large golden handshakes – choosing to ignore the rest of the sentence, which reads “but a company should avoid paying more than is necessary for this purpose”.
For this reason, we have recently consulted on changing the Code to replace the current wording with a simple statement that “Executive directors’ remuneration should be designed to promote the long-term success of the company. Performance-related elements should be stretching and rigorously applied.”
It is a small but nuanced change and one that hopefully sends an unambiguous message that the interests of the company rather than the interests of the employee should have priority.
We are considering responses now to that consultation, but I am sure some change to remuneration philosophy will end up in the final text.
That is the beauty of the Code – it is an organic document, that is subject to revision every two years and that can adapt to concerns and issues in the market. It will always be important to highlight such concerns to see if they should be incorporated into the Code. It is for this reason, in particular, that I applaud the workings of the IBE.
Thank you again to the IBE for inviting me to speak today, and thank you for listening.