Corporate Culture and the Role of Boards

This post is based on a report produced by the United Kingdom’s Financial Reporting Council.

The FRC’s mission is to promote high quality corporate governance and reporting to foster investment. The UK has a good reputation in this field which has underpinned a substantial amount of business success, but it is by no means perfect.

There are valid questions about how effectively existing corporate governance arrangements address the board’s responsibilities to stakeholders other than shareholders, as envisaged in the Companies Act 2006. The framework of corporate governance in the UK is based on a shareholder primacy and value model of equity capitalism. There is a continuing debate about what this means. One view is that it necessarily involves a short-term focus since shareholders are most interested in the certainty of more immediate financial returns. This inevitably has consequences in terms of the decisions and actions which companies and investors take. Short-termism can drive poor business behaviours and conduct, for example: inappropriate incentives, market-rigging, poor customer service, low levels of investment and opaque financial structures and arrangements.

The view of the FRC is that the UK governance model remains an efficient and effective means of meeting the objectives of, and arbitrating between, the many stakeholders in the market. The combination of legislation, regulation and codes provides a flexible framework for companies and their stakeholders to pursue their objectives and achieve long-term success. Success depends, however, on the spirit with which companies and investors apply the principles and use the flexibility they have.

The FRC embarked on this project to gain a better understanding of how boards are currently addressing culture, to encourage discussion and debate, and to identify and share good practice to help companies. This report seeks to address how boards and executive management can steer corporate behaviour to create a culture that will deliver sustainable good performance. This report looks at the increasing importance which corporate culture plays in delivering long-term business and economic success—an issue very much to the fore this year. In doing so it focuses on the role of the board in shaping, monitoring and overseeing culture.

With the help of our partners in the project, the Chartered Institute of Management Accountants (CIMA), the City Values Forum, the Chartered Institute of Personnel and Development (CIPD), the Institute of Business Ethics (IBE) and the Chartered Institute of Internal Auditors (IIA), we focused on broad aspects of company culture—the role of the board in delivering sustainable success, engagement with employees, customers, shareholders and other stakeholders, how to embed the desired culture, and how to assess culture. Our partners have published separate reports on each of these aspects, listed in Appendix 2 [available here].

This report was informed by an extensive literature review, the submissions from our partners in the coalition, interviews with FTSE chairmen and chief executives, surveys of heads of internal audit, chairmen and company secretaries, and many roundtables and discussions with investors, a range of professionals working in companies, and organisations with expertise and experience in company culture.

The FRC is very grateful to all those who responded to our invitation to participate, and would particularly like to thank our partners for their contribution and guidance throughout the project. We would also like to thank Independent Audit Limited for their invaluable work in surveying and interviewing chairmen, chief executives and company secretaries.

The following post is designed to stimulate thinking around the role of boards in relation to culture, and encourage boards to reflect on what they are currently doing. Over the next year we will be monitoring reporting on culture by companies and investors.

Executive Summary

Culture in a corporate context can be defined as a combination of the values, attitudes and behaviours manifested by a company in its operations and relations with its stakeholders. These stakeholders include shareholders, employees, customers, suppliers and the wider community and environment which are affected by a company’s conduct.

Key Observations

From our discussions with chairmen, chief executives, investors and a broad range of stakeholders and professional organisations we make the following observations about corporate culture:

Demonstrate Leadership

Leaders, in particular the chief executive, must embody the desired culture, embedding this at all levels and in every aspect of the business. Boards have a responsibility to act where leaders do not deliver.

Recognise The Value of Culture

A healthy corporate culture is a valuable asset, a source of competitive advantage and vital to the creation and protection of long-term value. It is the board’s role to determine the purpose of the company and ensure that the company’s values, strategy and business model are aligned to it. Directors should not wait for a crisis before they focus on company culture.

Be Open and Accountable

Openness and accountability matter at every level. Good governance means a focus on how this takes place throughout the company and those who act on its behalf. It should be demonstrated in the way the company conducts business and engages with and reports to stakeholders. This involves respecting a wide range of stakeholder interests.

Embed and Integrate

The values of the company need to inform the behaviours which are expected of all employees and suppliers. Human resources, internal audit, ethics, compliance, and risk functions should be empowered and resourced to embed values and assess culture effectively. Their voice in the boardroom should be strengthened.

Assess, Measure and Engage

Indicators and measures used should be aligned to desired outcomes and material to the business. The board has a responsibility to understand behaviour throughout the company and to challenge where they find misalignment with values or need better information. Boards should devote sufficient resource to evaluating culture and consider how they report on it.

Align Values and Incentives

The performance management and reward system should support and encourage behaviours consistent with the company’s purpose, values, strategy and business model. The board is responsible for explaining this alignment clearly to shareholders, employees and other stakeholders.

Exercise Stewardship

Effective stewardship should include engagement about culture and encourage better reporting. Investors should challenge themselves about the behaviours they are encouraging in companies and to reflect on their own culture.

Business, Society and the Corporate Governance Framework

Companies do not exist in isolation. They need to build and maintain successful relationships with a wide range of stakeholders in order to prosper. These relationships will be successful and enduring if they are based on respect, trust and mutual benefit.

Business’ reputation is still recovering from the impact of the global financial crisis and continuing examples of poor corporate behaviour. As we have seen, cultural failures damage reputation and have a substantial impact on shareholder value. Intangible assets such as intellectual property, customer base and brand now account for over 80 per cent of total corporate value, compared to under 20 per cent 40 years ago. [1] This shift magnifies the impact on total value when a reputational crisis occurs. This is a challenge for boards, which must find ways to understand and influence the factors which affect culture and behaviours.

The debate about the role of business in society is directly linked to the way in which companies create and sustain long-term value for the benefit of a wide range of stakeholders. From the outset of our work the FRC has been clear that we wish to offer constructive observations which have practical application. We are not suggesting changes to the current flexible framework of corporate governance. While legislation, regulation and codes influence individual and corporate behaviour, they do not ultimately control it.

The Companies Act 2006 makes it clear that in pursuit of the overarching duty to promote the success of the company for the benefit of the members as a whole, directors should take account of a range of stakeholders in making decisions. Inevitable conflicts will arise between the interests of different sets of stakeholders but where there is a broad alignment between their objectives, a focus on how business is conducted and how stakeholders are treated will create opportunities for value creation that have mutually reinforcing benefits for all.

UK Companies Act 2006, Section 172.

(1) A director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole, and in doing so have regard (amongst other matters) to:

  1. the likely consequences of any decision in the long-term,
  2. the interests of the company’s employees,
  3. the need to foster the company’s business relationships with suppliers, customers and others,
  4. the impact of the company’s operations on the community and the environment,
  5. the desirability of the company maintaining a reputation for high standards of business conduct, and
  6. the need to act fairly as between members of the company.

The UK Corporate Governance Code (the Code) ascribes to boards a responsibility for setting the company’s values and standards (supporting principle A.1), while the preface to the Code states:

‘One of the key roles for the board includes establishing the culture, values and ethics of the company. It is important that the board sets the correct “tone from the top”. The directors should lead by example and ensure that good standards of behaviour permeate throughout all levels of the organisation. This will help prevent misconduct, unethical practices and support the delivery of long-term success.’ [2]

Culture is closely linked to risk and risk appetite and the Code asks boards to look at the risks which might affect the company and its long-term viability.

Chairmen and chief executives recognise the relevance of major shifts in the broader environment in which business operates. Acceptable behaviour evolves over time so culture has to be adjusted for the context and the times in which the company is operating. For example, consumers are far more concerned with the environmental impact of companies and of their own behaviour than they were 30 years ago. Well-chosen values typically stand the test of time, but need to be tested for continuing relevance as society changes and business adapts.

Purpose, Strategy and the Business Model

Several chairmen told us that a clear purpose—why the company exists and what it is there to do—is the starting point for a successful company and closely tied to culture. In an increasingly complex business environment, boards and executive teams need to have a good understanding of the company and how it makes money—its business model—in order to have a clear line of sight between the decisions they take and how these impact on the company’s culture and deliver its purpose.

Companies are recognising the value in defining and communicating a broader purpose beyond profit which generates wealth and delivers benefits to society as a whole. This can help create shared goals, motivate employees and build trust with customers. As organisations become less hierarchical, and flexible working more prevalent, many companies are finding that common purpose is helping to bind organisations together.

Chairmen felt strongly that there is no ‘one-size-fits-all’ when it comes to culture. What matters is that the culture is appropriate for the context in which the company is operating and that there is internal alignment between company purpose, values, strategy and business model(s). Aligning business decisions with purpose and values and focusing on how financial targets will be achieved, will over the long-term lead to more sustainable value creation. One example of a framework that can help boards to achieve alignment has been developed by the City Values Forum. [3]

FTSE chairmen and chief executives interviewed strongly agreed that culture is integral to everything they do and features implicitly or explicitly in discussions about strategy, and in particular how to achieve that strategy.

Chairmen also report that culture impacts the strategy that is chosen, for example:

  • Which international markets should the company operate in?
  • Can the desired culture be maintained in particular markets?
  • How quickly should the company expand?
  • Will rapid growth affect the culture in a harmful way?

For most chairmen, culture is the enabler, the differentiator and a source of competitive advantage. The importance of culture to the successful operation of the firm is amplified still further when the capital of the firm is vested primarily in the quality of its people.

Chief executives we interviewed told us that culture is an intrinsic part of how the business is managed and an output of how the business is run. Key enablers for achieving strategic targets include the business model(s), employee behaviour, processes and management. Many chief executives agreed that, in normal circumstances, what works best for many companies is making sure behavioural considerations are a prominent, consistent part of everything they do.

Investors echoed much of this sentiment, pointing out that they gain a good deal of insight into the culture of a company through its articulation of its business model and the attitude to employees.

For most large organisations, the business model comprises a complex and connected series of relationships, activities, processes and stakeholders, drawing on a range of inputs and resources to achieve the stated purpose. For boards to have the capability to assess whether its culture is aligned with its purpose, a business model framework can be used to support board discussion and to assist in understanding this complexity. One example of such a framework has been developed by the Chartered Institute of Management Accountants (CIMA). [4]

At a strategic level, the board’s focus will be on setting and monitoring the company’s culture, in terms of the values and behaviours which best deliver value creation over the short, medium and long-terms and the incentives which support this.

At an operational level the focus will be on obtaining assurance that the company’s operations are aligned with its culture. In this way, boards and executive management can ensure that decisions around value creation and values are fully integrated.

View from the boardroom

Chairmen and chief executives agreed overwhelmingly that boards must have a responsibility for culture and must exercise oversight in this area. The board can influence culture in many ways. The board is responsible for appointing and removing the chief executive. Cultural change may take a long time to bed in; and boards can provide continuity. Boards also find it easier to be objective since they are not immersed in the day to day running of the business.

Strong governance is essential for a healthy culture. As well as the processes and practices in the boardroom, governance needs to focus on the substance of what boards do, who they engage with, what information they are given and what questions they ask. Boards should see that good governance runs through all areas of the business, including the executive committee and the layers of middle management. This will deliver improved decision-making and better outcomes.

Shareholders rely on the board to oversee a healthy culture that is compatible with the business model, steers the executive and delivers the strategy. Boards must be actively engaged in the business of shaping, overseeing and monitoring culture and holding the executive to account where they find misalignment with company purpose and values.

It can be difficult for non-executive directors (NEDs) to obtain sufficient knowledge of business operations to challenge management effectively. It is important for the chairman to set the tone in the boardroom so that NEDs are empowered to raise concerns where they have doubts.

The key challenge for boards is to understand what in practice drives the behaviour of employees and management and to shape and influence those drivers in a way that will foster greater sustainability and improved performance over time.

The inherent difficulty in understanding and measuring intangibles such as behaviour and culture, means that boards need to start by defining their purpose and values and setting out clearly the desired culture and behaviours, against which they can benchmark actual behaviour throughout the organisation. They then need to develop frameworks and tools to assess behaviours and culture to guide management and board decisions.

People on the board must never accept something that they don’t understand. This applies to established members as much as new members. If something is not clear, the board must ask the question even if it seems a stupid one. They must have the confidence to admit that they don’t understand.

Anthony Habgood, Chairman, RELX Group

* * *

The complete report, including appendices, is available here.

Endnotes:

[1] Ocean Tomo LLC, 2015. Intangible asset market value study. S&P500, http://www.oceantomo.com/2015/03/04/2015-intangible-asset-market-value-study/
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[2] FRC, 2016. UK Corporate Governance Code, https://www.frc.org.uk/Our-Work/Publications/Corporate-Governance/UK-Corporate-Governance-Code-April-2016.pdf
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[3] City Values Forum and Tomorrow’s Company, 2016. Governing culture: risk and opportunity—a guide to board leadership in purpose values and culture
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[4] CIMA, 2016. Financial Management—Rethinking the business model, http://www.cimaglobal.com/Thought-leadership/Research-topics/Budgeting-and-planning/Rethinking-the-business-model 
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