Rt. Hon. Jacqui Smith MP

TOMORROW'S COMPANY EVENT

This morning you have asked yourselves some hard questions. You have been looking closely at what you have called “the Investors’ balancing act”, in terms of the relationship between risk, cost, and profitability. These questions are not new, but they are very timely and relevant given the events of recent years.

We all know what happens when things go wrong. Corporate collapse means trust is lost – people lose their jobs, their investments, their pensions. But when standards are high, confidence in our companies attracts investment, and creates the foundation for enterprise, innovation, competitiveness and employment.

150 years ago, we created the joint stock limited liability company. Since then, the whole purpose of corporate law has been to provide a framework for investment and enterprise by limiting liability whilst also providing investors with a transparent view of the business. Our predecessors began with this important principle of enabling the market, rather than the state, to be the primary means of regulating corporate behaviour.

For this reason, we have always seen corporate governance as about more than the protection of shareholders and creditors. Its fundamental purpose is to encourage and enable companies to create the internal structures and controls- the dynamic, in fact, that will promote trust and transparency - and lead to better performance.

But this doesn’t mean that there is no role for Government. The role should be to provide the underpinning legal framework - the infrastructure on which business relationships depend. It provides the means of accountability for the exercise of corporate economic power - and the safeguards and remedies for abuses of that power.

But the corporate collapses we have seen remind us that we live in fast-changing times, and the legal framework, no matter how flexible, requires updating. In Government, we ask ourselves three questions when considering new proposals for corporate governance or company law.

· Will change promote enterprise, investment and the free flow of capital in support of growth and innovation?
· Will change maintain the right balance between oversight by shareholders and the directors’ ability to drive the business?
· Will we enable the market to reward strong performers and punish those who do not serve investors’ interests, or will the regulatory authorities become, de facto, the judges of performance?

Our clear goal is to ensure that enterprise continues to flourish, that the capital markets remain effective, and that people have trust and confidence in business. We see the role of the state as being to enable the market - and more particularly shareholders - to judge performance, not stand in its place. Giving shareholders the opportunity, and the means, to make their own judgements and hold management to account is at the heart of our approach.

This is a rather more ambitious set of objectives than that of “protection of shareholders and creditors”. Indeed, talk of “protection” implies that those who own companies and those who run them are on opposite sides. But institutional investors, who own, on behalf of their clients, the large majority of shares, depend on companies to provide their returns. And companies need investment from shareholders who are committed in the long-term - shareholders who are prepared to work with them to improve performance. So, our practice in the UK has been to work not in opposition, but in partnership.

It is through partnership that the UK Combined Code on corporate governance has been created. The key underpinning of the Code is that companies follow its principles and either comply with its provisions or explain why not - explain not to a regulator, but to the shareholders. This is the key means by which we have enabled the market to judge the actions of a business in the light of the specific circumstances of that business. A code is working when people give good explanations just as much as when they comply with normal requirements.

The Code was developed in the course of the 1990s by a series of committees set up by market participants, chaired by leading company directors, and with membership drawn from companies, investors and their advisors. As market practices and expectations have changed, companies and investors have recognised the need to raise standards, and have worked together to do so.

The process is evolution of standards, not incremental regulation. To maintain that evolution, we have now set up a mechanism for continuing development and monitoring of corporate governance standards through the Financial Reporting Council. The Council and its Corporate Governance Committee include leading figures from business, the investment community and their professional advisors. Its decisions are made by people who intimately understand the markets. And, in explaining those decisions, it has a head start in securing a market response because many of the markets’ and professions’ leading figures are involved by the Council at all stages, they own its conclusions and want to make them work.

Our preference, as I have said, is for joint evolution of standards and we have adopted the same partnership approach in developing our proposal to introduce the Operating and Financial Review into the accounts of quoted companies.

The problem – or arguably the market failure – that we seek to address here is the tendency of markets to take an overly short-term view of performance.

It is neither possible nor desirable to mandate a long term view, but it is the role of government to put in place structures that focus directors on a wider range of material factors, and longer term risks and opportunities for their business and to facilitate investor involvement in the thinking and planning in response to these factors.

The OFR, then, will provide a view of the direction and strategy of the business and a wider range of information on matters that in the view of the directors are necessary to understanding the company.

We have taken care in developing our proposals to adopt a proportionate approach. Responses to the public consultation argued that a rigid OFR framework would result in a compliant response rather than a real change in behaviour. We have listened and changed our draft regulations accordingly. Again, we want to foster enterprise and innovation, not to burden it.

The OFR goes to the heart of what we want to achieve by way of effective dialogue between companies and shareholders. That effective dialogue implies good companies, companies which:

· provide quality information and
· are properly equipped to engage with their stakeholders and explain the thinking behind their corporate strategies and decision-making.

But effective dialogue also needs good owners, those who take their ownership responsibilities seriously, those who:
· really get to understand the business and develop long term relationships with the board,
· have the skills, knowledge and business expertise to sustain that relationship
· work with other owners to tackle the key issues, but without trying to micro manage the business.

I have to say that taken as a whole, there remain weaknesses in the way that owners, particularly pension funds and institutional shareholders, exercise their responsibilities. Pension fund trustees need greater expertise to carry out their role more effectively. Institutional owners and fund managers have sometimes been slow to engage with companies on questions of company leadership, performance or strategy. Partly as a result, poor company performance has not been tackled early enough. Pressure on management has therefore continued to come from the share price or from the threat of takeover.

There also remains a lack of transparency in information flows, hampering the ability of principals to hold agents accountable. Taken together, these weaknesses reflect the complex nature of the relationships between pension fund trustees and insurance companies, fund managers operating on their behalf and the ultimate beneficiaries.

Finally, directors are still drawn from a restricted pool; not enough consideration is given to developing and recruiting from a wider range of talent. The challenge is to ensure that companies make best use of that talent. This means thinking more systematically - more dynamically - about the effectiveness of their boards and their recruitment processes; Boards that do not do this will not be in a position to grasp new opportunities for the company - and reap the rewards. Effective boards improve company performance, leading to better returns for shareholders.

There are some key issues that I believe confront us now:

· How to raise awareness of ownership responsibilities amongst principals, especially pension fund trustees.
· How to enable principals to hold fund managers to account
· How to improve communications between companies and individual shareholders and between pension funds and beneficiaries.
· How to get companies to think more systematically - more dynamically - about the effectiveness of their boards;

The Government has taken, and is taking, substantial action to strengthen the way this investment chain works. But there is more to be done to improve the standard of knowledge and information throughout the chain.

I’ve laid out my view of the government role in corporate governance and argued the broad case, as others will have done over these two days. But your focus this morning has been on whether corporate governance really works. Is there a measurable link between good governance and profitability?

Over the last few years there has been growing interest in the effects of changes in corporate governance regimes on the choice of strategy, management control and performance evaluation systems both in the private and the public sector. There has also been increasing research into the relationship between corporate governance and capital markets. And we have seen the development of databases and empirical studies, mostly in the US, which attempt to quantify corporate governance changes.

While there are significant caveats - problems of correlation and causality, difficulties in measuring levels of shareholder engagement - there is both strong theoretical justification for corporate law and governance changes in general terms and growing evidence to support interventions designed to ensure more effective company reporting and improved transparency.

However, I believe there is a clear need for more comprehensive and more rigorous analysis of recent corporate law and governance reform in the UK. I am also sure that the development of better metrics and better research has an important part to play in growing responsible owners by helping to show them that their participation really does make a difference.

I’d like to end by thanking you for giving me the opportunity to contribute to the important debate going on at this conference.

For corporate governance to work, we all have our part to play, as investors, as businesses and as individuals. We need to be clear about what more needs to happen to enable us all to fulfil these roles effectively. As a government, we need a clear view of our objectives, but also of the limitations of blunt regulation. Where regulation is necessary, we must ensure that it is proportionate and promotes a thriving economy and investment community.

This debate is timely and the prize is great. By getting our corporate governance right, we are well on the way to supporting good companies and to boosting our prosperity – and with that our levels of public and private investment, our jobs, our pensions and our economic future.