In theory, the need for corporate governance rests on the idea that when separation exists between the ownership of a company and its management, executives have the opportunity to take actions that benefit themselves (known as the agency problem), leading to insider abuse with shareholders and other stakeholders often bearing the cost of these actions (agency costs). As a result, shareholders play an important role in providing oversight of management. But in cases where the separation between ownership and management is blurred, particularly in family businesses, greater protections are needed.
The agency problem can be most obvious, and agency costs the highest, in the sale or acquisition of a company. In this scenario, shareholders are dependent on management to obtain the best possible price for the equity they own in the company. If the corporate governance framework of a company doesn’t address the agency problem, instead of agreeing the best deal for the company, management might be tempted to agree to the deal that most benefits them leaving the shareholders with little recourse against spurious agency costs (such as diminished investment value).
A common form of control for the agency problem, introduced almost unanimously by corporate governance frameworks across the globe, is the provision of independent decision-making at board level. The reason for this is that decisions made by a director who is independent are, in theory, free from any constraint or ulterior considerations that would prevent the correct decision to be made.
There is flexibility in how independent decision-making might be obtained, depending on the regulation your company is subject to and cultural norms of the country in which your company resides. In the UK, listed companies should have a majority of independent directors on their boards. Where the directors are conflicted in a particular transaction, an independent committee is often formed to advise the board and provide comfort to shareholders.
Although independent board membership is not mandated for private businesses in the UK, it certainly is best practice and is becoming more common. Having the benefit of flexibility, private businesses might take inspiration from foreign entities on how to introduce independence mechanisms that are consistent with business models and regulatory constraints. For example, Japanese boards typically have few independent directors those that are non-executive are typically representatives of the lead bank or a major supplier or customer.
To protect against the lack of independent oversight leading to insider abuse, the board of a global car manufacturer developed a set of committees to provide advisory or monitoring services to the board. The company convenes an “International Advisory Board (IAB) that includes external advisors with backgrounds in politics, economics, environmental issues and business providing an independent viewpoint on issues that are critical to the company’s long term strategy.
UK family businesses bosses might find they have a similar business ownership model to those of the Japanese, with tightly knit ownership and management and little by way of independence on its board. It is likely that the Japanese company convened its IAB knowing that stakeholders are weary of a perceived lack of independence. Indeed, recent studies show that family-controlled private business groups can bring greater risk due to the lesser extent of independent oversight and as a result typically enjoy less foreign investment.
Private businesses can overcome this scepticism through a variety of means, such as the voluntary adoption of the Corporate Governance Code’s guidance on appointment of independent board members, or by seeking formal advice from independent external advisors. Or, for example, by adopting a private equity hybrid model. According to it, a private holding company is family-controlled and actively involved in protecting the long term interests of the business, and a public listing in which the family holding company has a controlling stake then provides access to capital and an important external feedback.
Whichever path is chosen, ensuring the board is provided with independent advice guarantees credibility to stakeholders, and should be seen as vital to the success of any private business seeking external investment or expansion. Furthermore, although independent board membership is not currently a requirement for private business, 2016 saw noteworthy attention given to private business governance and board membership in the UK and is anticipated to be an area of reform in 2017.
Joan Medland is senior associate and Matt Timmons is a director in PwC‘s entity governance and compliance team