It's time to make companies more accountable

David Pitt-Watson, one of the authors of a new book on citizen investors, The New Capitalists, gives an alternative take on the key events of the past year

Over the past generation, millions of people have become the owners of our large companies. Nearly two-thirds of Britain's adult population directly and indirectly through the institutions managing pensions and life insurance policies own shares in our major companies. Take those shareholdings together, and we, "the new capitalists", own the majority of most British companies.

That poses a fundamental question. If we all own these companies, how come they don't seem to be run in our interests?

In part it is because the boards and financial institutions who are employed on our behalf simply aren't asked to behave that way. The business news often focuses on doing deals and trading shares. Larger issues of ownership or the integrity of the financial markets are often relegated to the small print. As a result, companies are not managed as well as they might. That means billions of pounds are lost to our savings.

Here is an alternative review of the past year from a different perspective.

THE SCANDALS OF 2006

Dr Who would have made a great City trader. He could have gone back in time, bought shares at low prices, and sold them today. Of course, that's impossible, because you can't travel through time. At least until now.

During 2006, it was discovered that a number of American boards had issued share options to their executives which could be "backdated". Now plenty of companies grant executives options. Essentially they give the executive the right to buy shares at today's price. So if the company does well, and the share price rises, the executive exercises the option and makes a profit. It's a powerful incentive to manage the company well.

Backdated options are different. They allow the executive to choose the day in the past when the option price is struck. So the executive chooses a day when the price was low, and cleans up. Not much incentive there.

Yet these option schemes were approved by boards of directors who by law, should be acting in shareholders interests. They didn't. The system failed.

Uniquely, it was in America that boards became so corrupted. This is not surprising, since America has some of the least democratic corporate practices in the world. In particular, US shareholders do not have the right to nominate or vote down directors.

Contrast the UK. Not only do directors stand for election, in recent years they have also had to have their remuneration approved by a shareholder vote. Not that this has solved everything. But it is difficult to believe UK institutions would have approved backdating. Nor would they approve ridiculous severance contracts such as the €15m payoff enjoyed by the CEO of Germany's Volkswagen when he was fired.

But before we congratulate ourselves too much, we should perhaps recognise our own problems. This year, in Germany, the trial of members of the board of Mannesmann came to an end. Some of Germany's most senior business figures were in court to explain why they took payments from Vodafone when it took over their company. How could that not be viewed as a conflict? Fines were paid, reputations were damaged. But no one asked about the Vodafone directors. They also received large bonuses for the deal. The Mannesmann purchase, and others like it, lost Vodafone huge amounts of money. Indeed this year Vodafone reported the largest ever loss in British history, as it wrote down the value of its overpriced acquisitions.

Today the financial press is reporting a wave of acquisitions. I wonder, will there be another British company that will pour your savings away on ill-thought-out purchases? Arguably, Vodafone lost its shareholders more than £100bn. Will the financial institutions that allowed this to happen be more careful with your money when the next wave of acquisitions takes place?

LAWS AND REGULATIONS

Hank Paulson is the Republican Secretary for the Treasury, and former head of Goldman Sachs. This year he praised financial regulation in the UK, much of it put in place by a Labour Government. This is particularly noteworthy when you consider that most UK company boards face a much stricter regime of accountability than their American counterparts. For example, in Britain boards stand for election and shareholders can remove them with a simple vote. The board has a constitution giving specific roles to its members, and protecting their independence. American boards feel no such constraints.

Mr Paulson favours the UK regime because although it is more accountable, it has much less regulation. In Britain, the bedrock of the law is the Companies Act (a new one was passed this year). Beyond this, there is a voluntary "Combined Code", to which large quoted companies subscribe. The spirit of these rules is that companies are accountable to their shareholders. The sanction is that their directors will be removed.

In America, there is no Companies Act - or rather there are 50 of them, one for every state. So the federal government has had to regulate the buying and selling of shares. And the clever investment bankers and lawyers find ways round these regulations, and the federal government passes more regulation to close the loopholes. All companies are therefore stuck complying with reams of regulation.

That is one reason why the City of London is now overtaking Wall Street, and why, to date, Britain has avoided scandals like Enron, Worldcom, Tyco and Hollinger. That is why the UK will push through a special law protecting stock exchange regulation, even if the exchange itself is sold to the Americans.

For once, it seems, Britain got things right. And Mr Paulson may find it very difficult to emulate us, because the American Constitution stands in his way.

ENVIRONMENTAL COMPANIES?

This year we all read about the Stern report. Our use of fossil fuels is unsustainable, and could destroy the planet. New regulation is needed to stop carbon dioxide pollution.

Britain produces about 2 per cent of the world's CO2. But its companies mine or drill for 10 per cent of the world's carbon. You might think that they would lobby against the Stern report. But quite the reverse. Britain's carbon producers have already told the Government that they believe their operations to be potentially unsustainable and want better regulation of them. Furthermore, these companies believe, quite rightly, that such regulation will be in their shareholders' interest. That is because there shareholders are like you and me. It makes no sense for us to encourage companies to make a profit which involves a social cost which we have to bear. Further, the companies argue, if we act now, they have the technology to do something about carbon emissions. In 20 years it may be too late.

The big question is whether US companies can be persuaded to follow a similar logic. If they were run for their shareholders, they certainly should. So here is a new year resolution for you. Contact your pension fund manager and ask them to write to the board of Exxon. Remind them that they should be running the company for their millions of shareholders, and ask why they continue to fund groups which deny that climate change is taking place.

TRADE UNIONS IN THE CITY

This year, the SEIU trade union was trying to recruit bus drivers in the US. But it felt it was being stopped by dirty trick tactics of the employers.

It turns out that those employers were subsidiaries of First Group. And the shareholders of First Group were respectable City institutions, who had promised their pension fund clients they would ensure that the companies they owned were at least neutral in response to trade unions. So rather than going on strike, the American trade unions contacted pension trustees on both sides of the Atlantic. They didn't want special favours, they just wanted the right to recruit. Rather than protesting outside head office, the trade unions proposed a shareholder resolution. Fund managers were invited into the boardroom. First Group acted honourably, promising a proper code of conduct, and that the union could recruit and be recognised if it could show it had enough support.

So this year, trade unions were not just the representatives of organised labour. They were also the representatives of organised capital.

THE BATTLE FOR THE SOUL OF ACCOUNTANCY

This year, we came within a hair's breadth of accepting the accounting rules which gave us Enron. And it happened almost by accident.

Accounting is important. It is the accountant who is the shareholders' eyes and ears, who investigates and signs off the company's financial statements as a "true and fair" view of the company's affairs. Without this assurance, it would be impossible for us to trust our money to companies about which we know relatively little.

For some years there has been a project to standardise accounting practices around the world. This is a good idea, but the devil is in the details. In particular, in America, accounting standards are based on the information necessary to trade shares, whereas in most of the rest of the world, they are about what owners need to know. Ninety-nine per cent of the time these are the same. The problem is that the other 1 per cent is often associated with misconduct. So, for example, if the CEO has got his hand in the till for small amounts, then this doesn't affect the share price. But it sure is something the owner would want to know.

In the back offices in Brussels, Eurocrats began to frame legislation to "harmonise" global rules. Its effect became apparent during the drafting of the Companies Act, which seemed to have lost the provision that UK accounts give a "true and fair" view of company affairs. Why? Because that didn't accord with the new standards which would fit the US model.

The fightback has began. It was "a battle for the soul of accountancy", declared Ann Simpson, head of the International Corporate Governance Network.

UN PRI

At the start of trading on the New York Stock Exchange, someone rings a bell. If you are a big business person selling your company, you're often given that privilege. But in April, the bell was rung by Kofi Annan, the secretary general of the United Nations. Why? Behind him stood 20 besuited fund managers, representing $3 trillion of pension fund savings. They had just signed the UN-sponsored Principles for Responsible Investment (PRI). In it they agreed that, as the representatives of the owners of companies, they took some responsibility for the performance of the companies in which they invested. That included social as well as financial performance.

One statement doesn't change the world. But the statement is a first. In the past, if companies behaved badly, fund managers just sold the shares. They were traders, not owners. Last year a significant number promised to act as owners. A first step, but a fundamental one.

David Pitt-Watson is chairman of Hermes Equity Ownership Services and co-author of The New Capitalists: How Citizen Investors are Reshaping the Corporate Agenda

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