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Public Confidence in Corporate Regulation

13th March 2003

Mr. Jonathan Djanogly (Huntingdon): I am grateful to have been called to participate in this debate on an important issue for companies, their corporate governance and public confidence in corporate financial regulation.

In general, much of the report is worthy of consideration. It adds to what should be an ongoing review of corporate governance procedures. However, I stress that the process has long been ongoing. It has not been started and it will not end with this report. Therefore, I take issue with the warning in the report against dangerous complacency, and with the Financial Secretary's warning about complacency in her speech to the National Association of Pension Funds yesterday. I have advised boards on corporate governance issues for more than a decade, and I declare an interest as noted in the Register of Members' Interests. I have seen an enormous change in the whole area of corporate reporting, independence and accountability, not least through the Cadbury, Greenbury and Hampel reports and the guidelines of the NAPF, Hermes Pensions Management and the Pensions and Investments Research Consultants. Therefore, I, among others, suggest that the use of the word "complacency" is clearly inappropriate. Furthermore, I do not wish to rubbish many of the valuable points made in the Smith and Higgs reports, and I acknowledge that we have had no UK Enron, but I have been somewhat surprised at the amount of time spent so far, not only in the House but by the professions and the business community, on the overall question of corporate governance in recent months. Other much more directly relevant issues, such as the weakness of the Government's manufacturing strategy and the impact of tax and regulations on British companies, are hardly ever mentioned. Those issues have much more to do with the success of UK companies than the subject considered in the report.

Why are the Government now being so forthright on corporate governance? Perhaps we could have a debate on that. Is it to keep up with the Joneses in America, who have started from a much weaker position than we have in this country, or is it to divert attention from the Government's failings? Some Members might see the irony when I recall that the Government were recently seen kicking and screaming against Conservative proposals to split the chief executive and chairman roles on the new UK Competition Commission under the Enterprise Act 2002.

In that regard, however, as the hon. Member for Dumbarton (Mr. McFall) made clear, the report made one very important recommendation in paragraphs 42 to 44 in its section on "Other Matters". It highlighted the lack of progress on implementation of the company law review, which was launched as far back as 1998. A thorough rewrite of the Companies Acts is more urgently required than an update of the combined code on corporate governance.

Dr. Palmer : I want to establish how much complacency the hon. Gentleman is advocating. Is he saying that there is no need for a change in corporate governance, or that there is a need for change but that it is not very urgent?

Mr. Djanogly : It is a question of priorities. I did not say that there was no need to examine corporate governance; I specifically said that it has evolved, is evolving and will evolve in the future. It is not something that we need not consider, but I suggest that the Government's priorities are currently wrong. If we look at what is happening in the stock markets in this country and around the world at the moment, we see that chief executives and chairmen have other things on their minds than dealing with corporate governance. The Government are clearly taking the alternative view. They will deal with corporate governance and then start to look at the Companies Acts. They have got it the wrong way round. I note that the Government's response to the report says that the precise timing of Companies Acts legislation will depend on the parliamentary timetable. I suggest to the Financial Secretary that that is not an acceptable response to every company in this country that is affected by those Acts and that, for the most part, will be assisted by new legislation. I ask her again: when will we have the Bill?

Paragraph 31 of the report states that the Committee is

"generally opposed to the use of share options as a significant source of remuneration in public companies."

However, I was somewhat bemused that the hon. Member for Dumbarton equated stock options with a life of luxury, because the rate of remuneration is dependent on the success or otherwise of the company concerned. I note that the Government response did not address that point.

Mr. McFall : On stock options, I used the words of Sir David Tweedie, the president of the International Accounting Standards Board. They were not my words. He said that stock options were used by executives, who get a cheap price, inflate the share option and profit themselves while the health and welfare of the company is disadvantaged in the medium and longer term. He warned us that that practice is widespread in the United States, and that we should not have it in the United Kingdom. I quoted an eminent authority.

Mr. Djanogly : Sir David may well have said that, but I doubt that he meant it to apply to every single company that issues stock options. Of course, like any other aspect of corporate governance, share options can be abused, and I admit that they have been abused in certain cases. That does not mean that stock options are, per se, the wrong means of remuneration. I note, however, that the Government did not respond to the report's point about that.

Mr. Mark Field : Does my hon. Friend accept that there is a very important role for stock options, both to incentivise staff at all levels-not just directors-and as a means of growing a business? The small and medium-sized business sector will be the main vehicle for jobs growth in the decades ahead. In such companies, stock options can be a very good way of keeping valuable and innovative young employees on board for the long term.

Mr. Djanogly : My hon. Friend makes an important point, with which I totally agree. There have been many surveys over the years on alternatives to stock options. None came up with a scheme as flexible or as consistently useful as the issuing of stock options.

The only evidence in the report for the position that stock options are a bad idea is the statement that in the United States "people could get most of their remuneration in share payments 'and even pay suppliers in share options'".

However, those points simply do not follow. Paying directors in shares is an established practice in this country. It is completely different from issuing stock options to directors and has even been recommended as good practice in previous corporate governance reviews.

Existing statutes ban directors from buying tradeable options in their own companies, and existing corporate governance rules disapprove of non-executive directors holding stock options in their own companies. Will the Financial Secretary tell us whether there are any proposals to change current practice as a result of the report? I have not heard of any such proposals, but I would be interested to know whether there are any.

It is important to keep in mind that the size of companies may be very relevant. My hon. Friend alluded to that in his intervention. As a non-executive in an alternative investment market company-I accept that such companies are not subject to the combined code on corporate governance-you can be issued with stock options, as they are often offered as part of the overall reward for becoming involved in what may be a much riskier type of company.

Mr. Deputy Speaker : Order. I have never in my life been offered stock options. The hon. Member is again using the word "you".

Mr. Djanogly : I apologise, Mr. Deputy Speaker.

In that instance, the company may prefer to promise future shares rather than give up its cash. Finally, there is sometimes an assumption that share options are some sort of cheap giveaway. The hon. Member for Dumbarton alluded to that in his contribution.

Mr. McFall : Stock options are part of aggressive earnings management and must be stamped out, although I take the hon. Gentleman's point that they may be useful for some companies. I quote Sir David Tweedie:

"The whole question of aggressive earnings management is one of the big problems we are facing. If you can hold the share price for three or four years so you will be so rich that your family will be taken care of for generations to come, you can see what the temptations are going to be of just ramping the profit figures. That is why we are absolutely convinced that the way to deal with this sort of situation is to be pretty brutal . . . share options should be charged, if you control a special purpose entity you should consolidate it. Let us forget the exceptions, that is it. We will hear special pleading, 'We're different' but you soon learn that the world is a special case after a while in this job."

We must knock down such aggressive management and charge stock options as expenses.

Mr. Djanogly : With the greatest respect, I must point out to the hon. Gentleman that Sir David Tweedie was referring to the tax treatment of share options. He was not discussing whether they should be issued. Indeed, their tax position is being addressed.

Mr. Howard Flight (Arundel and South Downs): May I put it to my hon. Friend that the problem with Sir David Tweedie's proposals is that they are intended to stop the abuse of share option schemes such as no doubt occurred in the United States? The tragedy is that the proposals would also kill off the highly beneficial and widely spread employee share schemes, which have been a great success in this country in spreading wealth, encouraging employee participation and improving productivity. Companies issue shares at a discount under the employee share schemes introduced by previous Governments and this Government. The companies would be forced to account for them in the profit and loss statement, and that would be wholly inappropriate in principle. The main objection to the proposal is that it has taken a draconian stance towards abuse and forgotten about the good things that it would also kill off.

Mr. Djanogly : I thank my hon. Friend for that helpful contribution, with which I absolutely agree. It is also important to make the point that, historically, stock options in America have been issued in a very different way from those in the United Kingdom-most specifically in relation to the time for which such options can be exercised, and the conditions of issue. I shall finish my remarks on stock options on that point.

Mr. Nigel Beard (Bexleyheath and Crayford): Let me return to the quotation from Sir David Tweedie cited by my hon. Friend the Member for Dumbarton (Mr. McFall). Sir David Tweedie was talking about the perverse financial incentives that can be obtained. He was not talking about tax, but about the corruption of the purposes of people who receive such stock options. I heard the hon. Member for Arundel and South Downs (Mr. Flight) say that they were used widely for ordinary employees. Employee share schemes are used widely, but not stock options. Those are a different kettle of fish altogether.

Mr. Deputy Speaker : Order. We have had some interventions that are bordering on becoming mini-speeches. Can we keep interventions short?

Mr. Djanogly : Thank you, Mr. Deputy Speaker. I have to say that I welcome interventions. They make for an interesting debate.

Mr. Deputy Speaker : Order. So do I, but they should be interventions.

Mr. Djanogly : I take the point, Mr. Deputy Speaker.

Mr. McFall : I shall be very brief, and this is my last word on the subject. Sir David Tweedie was speaking about the accounting treatment of stock options. That is the issue. In reference to the point made by the hon. Member for Arundel and South Downs (Mr. Flight), it is interesting to note that many US companies, including those with all-employee schemes, such as Wal-Mart, are moving to expense share options. That is the trend that Sir David Tweedie was considering when saying that there are lessons for the UK.

Mr. Djanogly : Indeed, that is so, and this country is moving in that direction. I have no problem with that point, but it is very different from saying that issuing share options is wrong.

The other key issue regarding share options is the conditions which they are issued. That process can be carried out responsibly or irresponsibly. An effective remuneration committee will carefully consider the conditions under which share options are to be issued, which will normally be directly related to the future success of the company, the individual's performance, or indeed, a combination of the two. As with the other issues that we are discussing, that process can be handled in a responsible or an irresponsible manner.

Mr. Mark Field : Although I take on board the concerns raised by the hon. Member for Dumbarton (Mr. McFall), there is a risk that if we berate stock options-the press would inevitably make that into a big issue-we would encourage the short-termism that would blight smaller, growing companies. Although I recognise the abuses, I hope that my hon. Friend will agree that we need to encourage stock options in the general sense, particularly for relatively low-paid employees and middle management staff who aspire to a long-term career with a company.

Mr. Djanogly : I thank my hon. Friend for that contribution, and I absolutely agree with him. Stock options will be used in different companies for different purposes. Larger companies will be concerned that executives do not have as large a financial stake in the company as in the capital. The companies will therefore want to incentivise their managers and make them feel part of the future success of the company. On the other hand, smaller companies may not be able to afford to pay the significant salaries that will enable them to recruit competitive staff, who will otherwise go to large companies. The use of stock options can be an effective way of binding such people in. It is difficult to say that one size fits all, and that is the beauty of the use of stock options. As things stand, stock options are probably the most adaptable way of incentivising staff.

Paragraphs 38 to 41 of the Select Committee's report deal with the implications for directors. I was somewhat surprised at how little time the report gave to that issue, even though the hon. Member for Dumbarton made it the centrepiece of his speech. Unfortunately, the report to some extent justified the Government's response by saying little about the implications for directors. Following the Higgs report, more will come out and I have a feeling that we will discuss the subject again. I will not dwell too much on that issue at present; instead, I will address the content of the report and particularly recommendation (q), which states:

"there is a good case for an audit committee composed of non-executive directors, rather than the board as a whole, to be responsible, in the case of quoted companies"-

I assume that that means fully listed quoted companies-

"for selecting the firm of auditors...and for fixing the auditors' remuneration."

The Government did not respond to that part of the report and I would be interested to hear the Financial Secretary's views on the matter.

The proposals should be treated with caution. They tie in directly with one of the main problems that has been identified with the Higgs report, which the hon. Member for Dumbarton addressed. Taken together, the proposals will create a split between executives and non-executives on a board. Not only does the Higgs report say that non-executives should not sit on an audit committee, but it says that the chairman should not sit on it either because, by way of that appointment, he is deemed to be non-independent. I see good reason for audit committees to review who is the right auditor and how much the auditor is to be paid, and to question boards' decisions if they feel that those decisions are wrong. However, the final decision should be a full board decision, with the board acting and answerable as one.

As with several other proposed measures coming out of Higgs and Smith, there are serious implications for non-executives. They will bear a greater responsibility and there could be negative implications, which could go against Higgs's desire to encourage people and to have a wider pool of non-executives. There could also be higher cost implications for the companies, which may have to pay more to those who are prepared to take on the extra responsibilities.

Finally, I support the Select Committee's findings that considerable improvements in the governance of companies can be brought about by greater shareholder interest in their affairs. More to the point, much more emphasis should be placed on that issue, which relates to matters such as how information is disseminated to the market, how brokers' reports are produced, how banks market their client shares and how institutions vote their shares and involve themselves in the corporate governance of the companies in which they have invested. That issue has been much more thoroughly reviewed in the Untied States, and we could usefully take a closer look at it in the UK. However, since the report was produced, the institutional shareholders committee has produced welcome new guidelines on institutional activism. That is a move in the right direction, but it is a matter on which we should concentrate further.

3.24 pm

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