TOPICS

IN
ACTUARIAL AND CORPORATE GOVERNANCE

STAPLE INN HALL

26 NOVEMBER 2002

ALAN FROST
MALCOLM LEWIS
NICK TAYLOR

TOPICS IN ACTUARIAL AND CORPORATE GOVERNANCE

26 NOVEMBER 2002
INTRODUCTION
1.
These three short papers cover a number of topics in Actuarial and Corporate
Governance and are intended to set the scene for a discussion.
2.
The first paper discusses Actuarial Governance including the role of the
Appointed Actuary, the proposed Actuarial Function, and the role of the actuary as both
an executive and non-executive director.
3.
The second paper covers general Board dynamics - types of Board, Constitution,
Operation and Controls.
4.
The third paper examines Corporate Governance in the context of value and
behaviour.
5.
Both Actuarial and Corporate Governance are currently being considered in
depth. This is as a result of financial scandals, recommendations by the DTI and FSA,
and significant new legislation in the USA.

Alan Frost
Malcolm Lewis
Nick Taylor

ACTUARIAL GOVERNANCE
Introduction
1.
This paper concentrates on Actuarial Governance as it relates to life offices
although the position of Friendly Societies is very similar. The Appointed Actuary role
is currently under discussion following an issue of a consultation paper by the FSA.
2.
Passing reference is made to the role of Scheme Actuaries in pensions but this is
unfamiliar territory to the author.
3.
As there is no formal actuarial role in general insurance, except at Lloyd's, this
area is not specifically covered.
Development Of Actuarial Role In Life Offices
4.
The Life Assurance Companies Act 1870 introduced the requirement for
periodical valuation of the liabilities. The Assurance Companies Act 1909 changed the
requirement to quinquennial valuations by an actuary who also had to prepare a report.
5.
There were Insurance Companies Acts in 1958, 1974, 1980 and 1982. The last
of these is the one we have now operated under for 20 years and has effectively been
carried forward to the new Financial Services and Markets Act regime. However it was
the 1974 Act which introduced the role of the Appointed Actuary. This was followed
by the first Guidance Note issued by the profession - GN1 - on 1 May 1975.
6.
Until 1974 the role of General Manager and Actuary - a combined role - was
familiar particularly in mutual offices. The specific responsibilities of the Appointed
Actuary led to most offices splitting the role.
The Appointed Actuary
7.
Essentially the 1974 Act required a nominated person to act as Appointed
Actuary, the main responsibility being to certify the mathematical reserves.
8.
Over the years the Regulatory Authorities, advised by the Government Actuary's
Department, together with the profession, have developed the role leading to both
formal Regulations and to amendments to GN1. It is worth noting that the FSA
employs its own actuaries having taken most of the life office team from the GAD.

9.
The Appointed Actuary advises on solvency, the exercise of discretion including
bonus rate recommendations, reassurance and premium rates.
10.
The Appointed Actuary has to certify that professional guidance - notably GN1
and GN8 - have been followed. The profession believes that it was the first time formal
Regulations required professional guidance to be followed. An advantage of this is that
following the due process for changing professional guidance is much quicker than
issuing new Regulations.
11.
The Appointed Actuary is concerned that Policyholders' Reasonable
Expectations are being met and there is a professional duty to advise on the
interpretation of this.
12.
The profession used to consider that the Appointed Actuary was the
policyholders' champion. However the profession and Appointed Actuaries are not
perceived to have taken a robust stand over pensions misselling or mortgage
endowments nor are they seen to have done a particularly good job over guaranteed
annuity options.
Influences On The Role Of The Appointed Actuary
13.
The influences on the role of the Appointed Actuary are similar to those which
have affected the life assurance industry.
14.
Going back to the introduction of the Appointed Actuary role in 1974, this was a
time when most of the senior positions were held by actuaries. As already mentioned
most of those who held the joint role of General Manager and Actuary split this.
15.
The most important long running influence has been the development of the role
following the discussions between the Regulators and the Profession. This has made
the role considerably more technical, at the expense of executive responsibilities. In
1974 Appointed Actuaries were generally part of the senior executive team. New
Appointed Actuaries now seem to be treated as technicians and no longer have general
management responsibilities.
16.
The development of unit linked business which really took off in the 1960's
brought a new culture of powerful direct selling to the life assurance industry.
17.
The newly formed unit linked offices had multi-disciplinary executive teams
thus knocking actuaries off their traditional perch. No longer did you need to be an FIA
or FFA to run a life office.

18.
A third major influence has been the increased demands of shareholders. Thirty
years ago shareholders took their share of the surplus quietly but this is no longer the
case.
19.
Appointed Actuaries have lost executive power in the office and at the same
time are under pressure to satisfy shareholders as well as policyholders.
FSA Position
20.
The FSA believes that Directors should demonstrate that they take full
responsibility for both the financial position, and bonus policy where applicable. They
believe that Directors have been too inclined to delegate to the Appointed Actuary and
thus do not fully understand the position of their office. Even in with-profits offices,
where Directors are responsible for declaring the bonus, the decision has often been
effectively delegated to the Appointed Actuary.
21.
The FSA is also concerned that the Appointed Actuary's work has not been
subject to either peer review or formal audit.
22.
Finally the FSA are concerned about the lack of transparency particularly on
with profit funds.
FSA Proposals
23.
The FSA's proposals can be divided into five areas namely the Board, Actuaries,
With Profit business, Financial Information and Disclosure.
Board
24.
The Board should take full responsibility for the financial position of the office
and should sign off the valuation of the liabilities in the Annual Returns. They should
also take full responsibility for bonus declarations in with profit offices.
25.
In addition it should be their responsibility to produce an annual Financial
Condition Report - currently the responsibility of the Appointed Actuary under GN2
although this is not mandatory.

Actuaries
26.
The Appointed Actuary role will cease except with regard to advising on with
profit business. There will be a new Required Function - the Actuarial Function. The
individual appointed to head this function will advise the Board and calculate the
liabilities. The auditors will confirm that it is not unreasonable for the Directors'
Certificate to be signed. The head of the Actuarial Function has been referred to as the
Valuation Actuary in some quarters which suggests a lower level of responsibility.
27.
The Appointed Actuary and the Head of the Actuarial Function can be the same
person. However neither may be Chairman, Chief Executive nor hold any post which
might involve a conflict of interest.
With Profit Business
28.
The office must publish a statement of Principles and Practices of Financial
Management. This must be backed up with a statement of compliance in the regulatory
returns.
29.
A With Profit Fund Committee must be formed with non-executive directors and
external committee members.
Financial Information
30.
The with profit liabilities must be disclosed on a realistic basis. It is acceptable
to use either a retrospective asset share basis or a prospective bonus reserve valuation.
31.
Full disclosure of investment returns, guarantees, expense levels, reassurance
arrangements and any financial engineering must be given.
32.
It is hoped that the Annual Returns can be simplified and eventually be made
available on the FSA website.
Disclosure
33.
The FSA is keen on a tiered approach to disclosing information. Core
information would be made available automatically with additional information
available on request.

Response Of The Profession

34.
It might have been expected that the profession would argue for preserving the
status quo. However our actual response was that we believed change was necessary
taking into account the current environment and the FSA's views on corporate
governance.
35.
It is important to note that, as a profession, it is our responsibility to put the
public interest first above any self interest or commercial interest of the members. We
are not a trade body.
36.
We believe that we should work with the FSA to make sure that the Actuarial
Function is properly specified and thus works effectively to look after not just
policyholders' interests but the interest of other stakeholders as well. We will thus draw
up appropriate Guidance Notes and lay down CPD requirements.
37.
In addition both the profession itself and the actuaries - certainly actuarial
firms - will have a role in making sure that directors better understand the actuarial role
within their offices.
38.
The profession has expressed concern that the role of the With Profit Fund
Committee is not wide enough and needs to cover other areas of discretion such as
management charges, mortality and morbidity costs. It may be better to have an
Actuarial Committee of the Board.
39.
One area which is taxing the profession is that currently the Appointed Actuary
signs off the reserves and is concerned predominantly with policyholders' interests, even
if under a certain amount of shareholder pressure. Under the FSA's proposals, it is the
Directors who will sign these off and their responsibility, in a proprietary office, is
primarily to the shareholders. This is going to be a difficult area to regulate although
Directors will almost certainly have to state that they have paid due regard to advice
from the Actuarial Function. There may also be a statutory duty on the Actuarial
Function to report any breaches of regulation to the FSA - whistleblowing.

Some Comments
40.

At this stage I would like to add a few personal comments.

41.
The profession has been slow to react to the changes in the environment in
which the Appointed Actuary operates. We have been too proud of the special position
occupied by the Appointed Actuary. We did not even believe it was necessary for the
Appointed Actuary's work to be subject to peer review or audit although this changed
following the problems at the Equitable and the recommendations of the Corley
Committee.
42.
Old established offices promoting staff internally, and thus not obtaining outside
exposure, have preserved a management culture which is not necessarily correct.
43.
I must say that the FSA's proposals are very much in line with views I expressed
when the profession was taking soundings earlier in the year. However I believe that
there is no need to have an Appointed Actuary even in with profit offices. A properly
constituted With Profit Fund Committee, or preferably Actuarial Committee, would
provide proper protection and would be more in line with the FSA's views on corporate
governance.
44.

I am pleased that the profession has accepted the need for change.

45.
It is my view that the new responsibilities placed on Directors, together with the
Actuarial Function, will give increased prominence to actuarial advice. The actuarial
position will be strengthened and this should lead to more protection for policyholders.
46.
There is one very important consideration and that is the need for actuaries to
communicate effectively. Directors will no longer be able to say that is all too difficult
and so delegate to the Appointed Actuary. They will need to understand exactly what
the actuaries have done before taking any decision.
The Actuary As A Life Office Executive Director
47.
Whether there is only one actuary as an Executive Director or several, and
whether or not there are non-executive actuary directors, the position at present is that
there should be a shared responsibility for what the Appointed Actuary puts forward.
This will continue to be the position when the Actuarial Function comes into being.
48.
The actuary as an Executive Director must be absolutely familiar with any
actuarial matters which come to the Board and should preferably have discussed the
papers in detail before any meeting. Hopefully support will be given to what is put
forward but there must always be a right to disagree.

The Actuary As A Life Office Non-Executive Director

49.
Under the FSA's proposals the role of Non-Executive Actuary Directors will
become very exposed. As with all Boards the other Directors will look to the experts in
any subject to take the lead. In a subject perceived as difficult - actuarial matters - this
will be particularly the case.
50.
As mentioned above, with regard to Executive Actuary Directors, careful
preparation is needed and it may be necessary to seek a briefing from the Actuarial
Function.
51.
There is also the role of the non-executive actuaries on the With Profit Fund
Committee or Actuarial Committee, where again careful preparation will be needed.
52.
There is likely to be an increased demand for non-executive actuaries both to sit
on the Board or the Committee. However having noted that the Equitable is suing its
former Directors, it is clear that such roles not only require a high degree of professional
input but can also have unwelcome side effects.
Scheme Actuary
53.
The key role of the Scheme Actuary is to monitor funding - to carry out regular
valuations and to provide various certificates and documents. The Scheme Actuary
needs to be notified about certain events such as sales and acquisitions, wind ups and
scheme mergers. There is also a statutory duty to report any breaches of regulations, in
this case to OPRA - whistleblowing again.
54.
The Scheme Actuary may get a new statutory duty of care to scheme members
when new legislation is put forward. If so the profession will need to give appropriate
guidance. We must await the promised Green Paper for further details.
The Actuary As Pension Trustee
55.
The role of the actuary as Pension Trustee is very similar to that of an actuary
sitting as a non-executive director on the Board of a life office with the addition of legal
responsibilities as a trustee. The Scheme Actuary cannot also be a trustee unlike an
Appointed Actuary who can be a Director of the life office.
56.
It is generally considered that a higher duty of care is expected from professional
trustees than those who do not come from such backgrounds.

Actuarial Governance In Wider Fields

57.
As well as being asked to sit on Boards in the more traditional areas actuaries
also get asked to sit on other Boards, Committees and charities because of their
perceived financial skill.
58.
The prime warning here is to take care as the financial controls will not
necessarily be anything like as stringent as those in the environment where you usually
operate. There may not be any controls at all! However, if things go wrong, you are
accountable. This is worth bearing in mind however much satisfaction the role might
give.
Conclusion
59.
Although I have not covered the subject in depth I trust that I have provided
sufficient information to provoke an interesting discussion.

N H Taylor

CORPORATE GOVERNANCE AN INTRODUCTION

1.
I remember well the first Board I attended as a Director. I had attended Boards
as a member of a management team but never in my own right. I was very ill prepared,
had had no briefing from anyone, and although I was representing a company with a
significant stake in the enterprise felt totally out of my depth.
2.
I came across a useful book by Geoffrey Mills15 in 1986 which proved a useful
handbook. He describes the different types of Board:
a.
b.
c.
d.
i.
ii.
iii.
e.
f.
g.
i.
ii.
iii.
iv.
v.
vi.

Holding Boards
Private Companies
Divisional Boards
Subsidiary Boards
Minorities
Joint Ventures
Associate Companies
Funnies (subsidiaries based in the British Virgin Islands or the Dutch
Antilles!)
Nationalised Industries (showing how old the book is!)
To this list we may add other governance bodies to which we may be
invited:
Charities
Pension Fund Trustees
Housing management companies
Parochial Church Councils
Quangos of all description
Many others

3.
Not all of these require modern governance mechanisms. From experience it is
likely that they need to be run effectively and the role of Chairman1 is paramount
however trivial the cause. Davies3 suggests minimum criteria for governance:
a.
The identity of the body
b.
Definition of its purpose
c.
How the purpose is to be achieved
d.
Membership criteria (both explicit, such as shared interests and implicit, for
example, shared values
e.
How the body is to be administered
f.
How the body relates externally
g.
How success is measure
h.
Termination arrangements
1

Use of the male gender in this note implies the opposite and vice versa

10

4.
These days the term stakeholder is used frequently in a governance context.
Davies points out that the role of stakeholders has not been part of strategic planning to
date. He refers to Kendall & Kendall15 who propose an expansion of the strategy
process to include stakeholder analysis. Their five-step process is as follows:
a.
Internal analysis (resources, value chain, strengths/weaknesses, culture and
so on)
b.
External analysis (business environment, markets, competitors, actual and
potential customers and so on)
c.
Stakeholder analysis (customers, employees, owners, suppliers, community)
d.
Confirm or change goal (strengths, weaknesses, opportunities, threats +
stakeholder input)
e.
Formulating strategy (evaluating strategic options, choosing and planning
implementation)
5.
Having established the type of the Board it is next relevant to review the types of
director (trustee, member etc.). Mills gives us an amusing preface with his description
of;
a.
The Chairman
b.
The Chief Executive
c.
Associates and alternates
d.
The old retainer
e.
The family
f.
The maverick
g.
The court jester
As a separate group he describes non-executive directors including what he calls the
professional director. This is a little misleading because presumably some of the
above are professional and Ive certainly met some non-executive court jesters in my
time.
6.
More modern competency based thinking breaks directors into different groups
most of which are self-explanatory. As with teams built along Belbin lines it is
assumed that directors are capable of adopting different roles according to different
circumstances. The theory assumes that a board will recruit a combination of nonexecutive directors who fit best the particular needs of a company at a particular point in
time. The weakness of the theory is that those requirements will probably change over
time. The types described are:
h.
Builder
a.
Organiser
i.
Lateral thinker
b.
Focuser
j.
Conscience
c.
Challenger
k.
Summariser
d.
Probe
l.
Mentor
e.
Discloser
m.
Ambassador
f.
Honest broker
n.
Bulldog
g.
Architect

11

7.
The governance framework has evolved continually over the last 10 years with a
succession of public reviews:
a.
Cadbury (1992)
b.
Greenbury (1995)
c.
Hampel (1998)
d.
Turnbull (1999)
Development has emerged from other bodies also.
e.
The Stock Exchange Combined Code lists requirements for quoted
companies
f.
The Compact Law Review (2001) will eventually have an impact some of it
helpful to smaller companies.
g.
The Financial Services Authority has also suggested developments specific
to Life Assurance Companies.
h.
The government is reviewing the role of non-executive directors in the light
of recent scandals (The Higgs Review).
8.
The developments in paragraph 7 have led in larger and quoted companies to a
committee structure in which audit processes and risk management has much greater
prominence than hitherto. Some have suggested that we are now in a box-ticking
environment, which is unproductive. This is clearly not so. Ticking off processes and
reports are essential as the first step in corporate governance. What is more important is
having an holistic approach to governance that recognises not just the detail but an
overall approach to management of institutions that can avoid the excesses of the past.
9.
The composition of the board is still a crucial feature in avoiding excesses. The
old boy network has been criticised for perpetuating bad practices. The criticism may
be well founded. A modern nominations committee may still use the old boy network
to source candidates but is likely to be rigorous in final selection. The danger is
recruiting a group of like-minded people with little diversity in thought or experience.
10.
The role of non-executives has come under very close scrutiny. The days of
turning up for the meeting and a nice lunch, having read the papers on the train, are one
hopes long past. The spotlight has fallen on non-executives. Regulators and
government are looking closely at their role and effectiveness.
11.
The biggest change required is a cultural one As long as managers see risk
management processes as a chore and not as a tool there will be little progress.
12.
Communication between different stakeholders is also the key to company
survival. Whether this is between Board and shareholders, boards and policyholders,
boards and management or all the other combinations it is essential that expectations are
correctly set and reported on.

12

13.
Finally, the link with executive incentives is a topical and emotive issue. Public
opinion is probably as good a judge as any into how we should react to excessive
remuneration. Meanwhile, the International Corporate Governance Network (ICGN)
has produced a code of practice on executive remuneration with ten key
recommendations including:
a.
Transparency in reporting
b.
Careful use of options
c.
The role of remuneration committees
d.
Opposition to cash transaction bonuses
e.
Investing institutions should spend more time analysing company reports.

Alan Frost

Selected bibliography. The following works are a useful introduction to the topic. The
publications by the Institute of Directors are excellent reading for those about to take on a Board
role
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.

BLAKE, Allan, Dynamic Directors (Macmillan, 1999)

COMPANY LAW REVIEW STEERING GROUP, THE, Modern Company Law (HMSO, July
2001)
DAVIES, Adrian, A Strategic Approach to Corporate Governance (Gower, 1999)
DEMB, Ada & NEUBAUER, F.-Friedrich, The Corporate Board Confronting the Paradoxes
(Oxford, 1992)
DUNNE, Patrick, Directors Dilemmas Tales from the Frontline (Kogan Page, 2000)
DUNNE, Patrick, Running Board Meetings How to get the most from them (Kogan Page,
1999)
EGON ZEHNDER INTERNATIONAL, A Practical Guide for Non-Executive Directors (1999)
EGON ZEHNDER INTERNATIONAL, Corporate Governance and the Role of the Board of
Directors (2000)
GARRATT, Bob, The Fish Rots from the Head (HarperCollins, 1996)
INSTITUTE OF DIRECTORS (Ed. Pierce, Chris), The Effective Director (Kogan Page, 2001)
INSTITUTE OF DIRECTORS, Standards for the Board (Kogan Page, 2001)
INSTITUTE OF DIRECTORS, The Independent Director (Kogan Page, 1999)
INSTITUTE OF DIRECTORS, The Company Directors Guide (Kogan Page, 2001)
KENDALL, Nigel and Arthur, Real-World Corporate Governance (Pitman Publishing, 1998)
MILLS, Geoffrey, On the Board (Allen & Unwin, 1985)

13

GOVERNANCE IN THE CONTEXT OF VALUE AND BEHAVIOUR

Introduction
1.
This paper concentrates on some of the key attitudes and behaviours that the
author feels managers of organisations should exhibit and how, by adopting a value
mindset, it would significantly improve the way in which the managers govern.
2.
The key components of this view on Governance are from a synthesis of ideas
derived and developed from a combination of sources, a sample of which are set out in
the bibliography.
Background
Setting The Scene
3.
The mind-set of the corporate executive (Executive) has always been bombarded
with issues that need to be taken into consideration, since the time when funds were
being risked for reward, in businesses run by others.
4.
During the period of the early 18th Century we saw greed and opportunism rife
in the states of France and England, when spectacular fortunes were capable of being
made by trading in pieces of paper, better known as company shares. It was a game in
which nobody could lose, even the less well off.
5.
This mania for gambling and the obtaining of easy wealth had been fuelled by
the idea of a National Lottery in England, first launched in 1694 with tickets selling for
10 each and a first prize of 1,000 for sixteen years. The lottery of the day was not a
quite, as we know it today since nobody could lose!! Anybody who bought a ticket was
guaranteed an annuity from the government at a fixed rate of interest. In addition, if
they won they also had the chance for the greater prizes. For gamblers the lottery was
popular as it is today and a number of these schemes were set up.
6.
For Governments of the time, who were burdened with massive National Debts
as a result of lengthy wars, the attraction of quick cash flow to get or keep the wheels of
Government turning, was too good to be true, even if at some point in the future it might
turn out to be a very expensive solution. Paying back the money may well turn out to
be somebody elses problem.

14

7.
The effect of these lotteries was a feeling of invincibility causing a dramatic rise
and then subsequent fall of both the Mississippi Company in France and the South Sea
Companies in England. Both were ideas that promised great returns from the fortunes
that lay overseas in those far off lands. In France, people became what became known
as millionaires in very short periods of time. In one month the Mississippi share
values rose by some 1,000%. In England the 190 South Sea share schemes set for
trading with South America raised some 220m, a very substantial amount especially if
converted into current money terms.
8.
It was then in 1720 that the bubble burst on these schemes, when it was finally
realised that nothing really underpinned or supported these perceived share values
except expectation. The result was a run on the shares with their value subsequently
crashing to some 15% of their face value.
9.
Riches turned to rags with leading land-owning families brought to their knees
in bankruptcy.
10.
The same happened with the French Mississippi Company, directed by a
Scotsman called John Law, an outlaw of England having escaped prison after being
sentenced for killing somebody in a dual.
11.
As a result of the bubble bursting on the 190 English trading businesses, the
English Parliament passed the South Sea Bubble Act of 1720 that effectively outlawed
companies, except by Act of Parliament or Royal Assent. This limited the size of
companies to six owners with no right of share transfer and unlimited liability for the
business's debts. The aim of this Government action was an attempt to maintain
confidence in the Government by protecting the general investor from the risks of the
unscrupulous company tricksters or profiteers who might be thinking of promoting
companies that might make extravagant claims of future riches, for it to actually turn
out to be no more than a scurrilous way of effectively defrauding people out of their
money. It wasnt until 1844 that companies were given actually given a separate legal
personality and not until 1855, nearly 135 years after the South Sea bubble, when
limited liability status was allowed for the shareholders.
12.
Markets havent really seen such hysterical investor behaviour like that of the
1720s until the DOTCOM mania of 1999-2000, when basic logic as to what might
justify or support the share prices being quoted, again went to the four winds.

15

The Effects Of These Share Price Escalations

13.
For Governments, part of their survival and continued existence relates, in part,
to the protection of their voters from unscrupulous promoters. Having voters losing
substantial sums of money, let alone their life savings, is not something Governments
can afford to be seen to condone, especially if the schemes being put forward are not in
reality what they pretend to be.
14.
However, in a Free-Market economy, care is always needed to ensure that
Governments are not seen to be too interfering. Everybody has the freedom to make
money as well as lose it, provided it is done on an even playing field.
15.
Confidence though in the financial markets in which companies are attempting
to raise these finances, requires that investors have a suitable level of information and
sufficient trust that they feel they can look after their own interests. Therefore, the
balancing act for Governments is to take on a role that is on the one hand arms-length
whilst at the same time sufficiently marshalling of private enterprises; ensuring that
there is enough transparency as to what is going on inside these enterprises in terms of
the actions and strategies relating to both their past and future potential.
16.
Over the last some 160 years this investor protection has principally been
monitored through the Companies Acts. The provision of financial information for
public scrutiny was, however, slow in coming since it was not until 1929 that both
balance sheets and profit and loss accounts were required to be submitted and not until
1981 that accounts needed to be in a prescribed format.
A Dilemma Facing Organisational Management
17.
Traditionally, the information being supplied under the statutory requirements of
the Companies Acts has been historical in nature, implying a rear view mirror
approach to driving the business car. The facts disclosed are after the event and may
only give a rough indication of what might be about to happen in the future.
18.
Consequently, to produce information in a Companies Acts format that is
historically backward looking, many corporate teams believe that by adopting these
performance measures as their dashboard indicators for future operating, they must be
behaving in a manner in line with best practice. In other words, by viewing information
in a balance sheet and profit and loss will adhere to the principals of corporate
Governance. If it is satisfactory for the statutory requirements then it must be fine for
the day-to-day and future management decision-making processes.

16

19.
The problem with this view though is that nowadays, Executives have the
dilemma of facing an ever-changing and uncertain future in relation to all aspects of
their businesses. Trying to understand where and how they should be applying their
management skills to this uncertain and paradoxical future has become ever harder and
more fraught, especially when from a financial perspective, it is attempted by looking at
the past results and then extrapolating them into the future, with various adjustments for
future expectations.
20.
Recent 2002 scandals such as Enron, WorldCom, Andersens, Tyco etc could be
considered to be attempts by management teams to maintain the expected improvements
in value growth through the manipulation of financial data and perceived facts. In part
this must have been driven by executive greed and stock market pressure to be seen to
be delivering results that justified the expectations.
21.
Numerous accusations have been made that there have been serious breaches in
the trust relationship between the Executive and the organisational stakeholders that
they are supposed to be interfacing with, with the result that various reviews on the
issue of Governance have been undertaken. The fat cat Executive, who is demonised
as putting himself in front of the people he represents, the shareholders, has caused great
concern and stirred up the shareholder activist. This activist behaviour, which has
originated from the USA, has been awoken in an attempt to make managers at least
accountable to shareholders, the owners of these entities. Hermes have taken the lead in
this role by putting the Chairman / CEO / CFO of organisations under severe scrutiny to
explain what they are doing to manage the value of their businesses. At this point in
time, in the UK, activists do not have any specific powers, except those of a large
institutional shareholder who can show their disapproval if they feel the management
are going off course. This type of presence is though starting to have good effects.
22.
It would appear that the world has become rather paradoxical since management
must consider their competitors to be potential alliance partners; investment will be
crucial to keep ahead of the competition but then will almost immediately be
outdated; staff will be your most crucial future value generating asset, with caring for
them essential for optimal performance but in highlighting their potential, possibly
causing them to leave for greener pastures. Failing to plan will leave organisations open
to possible failure, but any plan once formed will quickly become outdated. In short,
the trend identified by Tom Peters in his 1993 book Thriving on Chaos, is now
starting to move into warp drive.

17

The Key Issues Facing The World Of Corporate And Personal Governance
23.
In general, the corporate world is under attack for the way in which it manages
itself, especially with the recent corporate accounting scandals; however, over the last
10 years there has been a succession of public reviews on this issue of Governance,
namely Cadbury (1992), Greenbury (1995), Hampel (1998), Turnbull (1999) and the
Commonwealth Association of Corporate Governance. All have been trying to identify,
and in some way prescribe, how Executives should behave.
24.
The problem with this approach is that it is dealing with the smoke rather than
the fire; saying what teams ought and ought not to be doing rather than dealing with
the problem of the way should be doing along with how they think.
25.
For the most part, excepting those needing to meet the basic needs of life, people
behave as a result of the mental models that they hold about life. The way that we each
interact in relationships and situations is very much dependent upon the way that these
mental models, which we have built up during our life, supply us with output
information as a result of the input data. By changing the underlying formulae that
make up these mental models, it is likely that the output information will change and as
a consequence the resulting behaviour. The formulae that make up these models are
mainly derived from the lifetime experiences and the values that we hold important.
26.
This is the crux of the authors arguments. By adopting a more appropriate
mental business model, which is supported by meaningful values, many of the
difficulties faced by Executives on the governance front would disappear.
How Can Valuation Techniques Help To Improve The Way Executives Govern
And The Behaviours They Exhibit In This World Of Uncertainty?
Positioning The Techniques
27.
Much can be learned from the mindset one needs to adopt when looking at the
issues of corporate valuation.
28.
Corporate valuation has always been an important aspect in the free market
world since access to capital flows to finance the corporate engine, at an appropriate
risk / return, is essential.
29.
The sophistication of valuation techniques that attempt to surround and trap this
illusive creature called value has grown considerably over the last twenty years.
Unfortunately one will never capture the value creature, although from time to time one
might catch glimpses of it.

18

30.
The techniques vary from those based around historical accounting data, with
more of a rear view mirror approach through to more economic and future orientated
approaches that attempt to look through the front windscreen.
31.
A few of the historical methods are techniques such as Earnings per Share
(EPS), Dividend Yield, Price to Earnings (P/E), Price to Book (P/B), Price to Sales
(P/S), EBITDA multiples, Total Shareholder Return (TRS) and the Price Earnings
Growth (PEG) of Jim Slater and the Zulu Principal.
32.
The future economic approaches centre on the discounted cash flow (DCF)
techniques of Free Cash Flow (FCF) and Shareholder Value Analysis (SVA) as put
forward by Alfred Rappaport, Roger Mills and Aswath Damodaran. Other techniques
that are extremely powerful are Cash Flow Return on Investment (CFROI), a
trademarked method of Holt Associates, Cash Value Added (CVA) and Total Business
Return (TBR).
33.
Hybrids of these two generalised approaches, which are from the Residual
Income family, is Economic Value Added (EVA), a trademarked method of Stern
Stewart as well as Enterprise Value Added (EV+), developed by Paul James of
Sharevaluer.com.
34.
Over the last 15 years these various approaches have been given the title
Shareholder Value techniques.
35.
However, this is not a paper on valuation techniques but rather what we can
learn from these approaches in order to develop a more appropriate Governance model
or mental paradigm.
36.
In Corporate Finance the underlying premise that is put forward is that the core
objective of management is to maximise the value of the enterprise for the benefit of its
shareholders. Whilst this may be a starting point, it is not totally wholesome attitude
since it implies that the other stakeholders are not important. This point was recognised
by the Institute of Chartered Accountants in England and Wales (ICAEW) where they
renamed their approach to Shareholder Value, Enlightened Shareholder Value to show
that an appreciation of other stakeholders is essential to achieving growth in equity
values.
37.
In reality, many of the inputs to these valuation models require the support of
other stakeholders other than shareholders such as employees, customers, suppliers,
community and government. To ignore these other parties runs the risk of losing their
goodwill and the long-term benefits of their committed involvement.

19

The Main Benefits Of Adopting A Value Mindset To Running An Organisation

1. Executives must try to look more through the front windscreen of the
business car by using future economic models, only glancing in the rear view
mirror at historical information to understand where an organisation has come
from and what may be coming up quickly. Looking ahead to attempt to see what
may be coming in the future is critical to survival. All value is in the future.
2. Leadership is about knowing and inspiring people to go where one needs to
go. This is different to management which is simply the exercise of doing the
things that will get you to where the leaders have suggested will be an exciting
future vision. In value terms it means deciding the levels of value one wishes to
achieve by a defined time. For the bank Lloyds TSB, they have stated that they
wish to double their share value every three years. The key here is to adopt the
Stephen Covey habit of starting with the end objective in mind.
3. The future is always changing and at a rate that is almost too difficult to keep
up with or comprehend, as highlighted Gary Hamel in his book, Leading the
Revolution. Failure to continually look forward and to maintain clarity is almost
suicidal in a business car that is getting faster and faster.
4. Creating value is about taking positive risks not just trying to avoid
negative ones. Without taking risks one cannot expect to get returns, but then
unfortunately as soon as you do start to make returns you will notice competitors
in your rear view mirror. Future cash flows will always carry varying degrees of
risk depending upon the strategy being adopted to generate them. A new product
launch in a new market is likely to be far more risky when compared with an
existing product that is pushed within an existing market. Managing the downside
risks is only one part of the risk Governance function. Taking risks must the
other.
5. Creating profit is simply about obtaining revenues greater than the costs.
Creating value is about generating cash flow returns greater than the cost of the
finance needed to support those cash flows. Included in the cost of the finance is
also the opportunity cost of the money and this must appropriately reflect the risks
associated with generating those cash flows. Putting high-octane debt fuel in the
car will make it go faster, but the added risk is that with a winding trading road,
there is every chance of missing a bend if we look behind us.

20

6. Investing appropriately in the future is imperative since product and service

life cycles are shortening all the time. Attempting to guess where the bends in the
road are going to come up is about experience and judgement. Knowing where
your financing and new product idea refuelling stops are located to regenerate
the organisation must figure strongly in the mindset of the Executive driver.
7. Growing the enterprise and showing the ability to accelerate will attract
much higher premiums than a company with a steady progression. Investment in
the potential of the future will give the business car the ability to accelerate should
competitors try to come up and overtake.
8. Most important for the high performance Executive driver is care for the
team effort and not just their own self-importance. The co-drivers (managers)
need to have trust and confidence that the driver cares about everybody,
including the mechanics (employees), the owners (shareholders), the engine
manufacturers (suppliers), the spectators who may actually risk their lives
watching (community). Without trust that the Executives have integrity, are
looking forward for potential dangers, understand the risk/reward profiles of those
involved and work for the Team, those drivers will not be retained however,
exciting their potential and ruthlessness. Jack Welsh, the former CEO of GE, is
credited with saying that the toughest decisions you can make are around high
performing individuals who have the wrong values
9. Managing for value is not just about past performance but the potential
expectations of the future. The former is clearly important though it is very
possible to show good performance but destroy potential. Professor David Allen
states that current progress is equal to past performance plus/minus future
potential. Short-term views to improve profitability but which destroy the longerterm opportunities are generally penalised by the market. However, Executives
seem to continually believe that it is only about growing short term Earnings per
Share (EPS). Clearly growing EPS is a good sign, but not if potential future cash
flow is being negatively affected.

21

10. If value is the perception of the future cash flow generating capability of the
business, then the key is to understand the drivers of those cash flow engines. In
our uncertain world, the level of cash flow generated from intangible as opposed
to tangible assets is ever increasing, although allowance needs to be made for the
state of the current markets. In the book Cracking the value Code it is stated
that in 1978 the difference between the market value and the book value of the
Standard and Poor 500 was only 5%. By 1998 the difference stood at 72%. For
accountants this is simply put down as goodwill, however, for the Executive
responsible for managing the overall market value of a business, looking after the
intangible value element represented by brands, people, intellectual property and
knowledge management is extremely important. Dealing effectively and
sympathetically with these soft issues is fast becoming the main issue for
Executive Teams.
11. Leading for value is about an attitude of mind that considers everything
within a corporate whole. The perception of whether somebody trusts the
Executives as well as the figures and strategies put in front of me by them, is
critical to the way one considers the risk premiums and inputs to the value models
used.
Concluding Comments
38.
Governance is about being proactive and looking into the future, not just the
past. It requires that a holistic approach be used to ensure that an appropriate balance is
kept within the various parts of the system. Balancing the soft and the hard aspects will
increase the likely value outputs.
39.
Linking value with values is a useful mental paradigm for managing the value
model. Being transparent about the information we supply to stakeholders is key to
building trust and belief in the future potential. Extraordinary growth needs to be
supported by logical facts as well as a powerful emotional belief in what is being
created. Creating something that is not meaningful is unlikely to be passionately
pursued.
40.
In July 2001, the final report of the DTI on the Modern Company Law - For a
competitive economy was published which proposes a dramatic re-write of the last 160
years of Company Law. This formed the basis of the Governments white paper
Modernising Company Law, published 12 months later with comments still being
sought up until 29th November 2002.

22

41.
This review is a significant rethink of the way companies are going to be
expected to operate in the future, with organisations being expected, and encouraged, to
become more open, transparent and pro-active towards disclosing what they are
attempting to do. This contrasts with the laws previously, which were aimed at
preventing Executives from behaving in a certain way.
42.
Now, Governance should be about encouraging Executives to create a
meaningful future for all stakeholders, without spending too much time on the past.

Malcolm Lewis

Selected bibliography. The following works may be a useful introduction to this topic.
16.
17.
18.
19.
20.
21.
22.
23.
24.
25.
26.
27.
28.
29.
30.
31.
32.
33.
34.

BALEN, Malcolm, A very English deceit (Fourth Estate, London 2002)

BLAKE, Allan, Dynamic Directors (Macmillan, 1999)
COMPANY LAW REVIEW STEERING GROUP, The Modern Company Law (HMSO, July
2001)
COVEY, Stephen, The Seven Habits of Highly Effective People Powerful lessons in personal
change (Simon & Schuster 1992)
DAMODARAN, Aswath, The dark side of Valuation (FT Prentice Hall 2001)
DAVIDSON, Hugh, The Committed Enterprise How to make vision and values work
(Butterworth Heinmann 2002)
DAVIES, Adrian, A Strategic Approach to Corporate Governance (Gower, 1999)
DUNNE, Patrick, Directors Dilemmas Tales from the Frontline (Kogan Page, 2000)
ECCLES, Robert; HERZ, Robert; PHILLIPS, David, The Value Reporting Revolution Moving
beyond the Earnings Game (Wiley 2001)
HAMEL, Gary, Leading the Revolution (HBS Press 2000)
KUNDE, Jesper, Corporate Religion (FT Prentice Hall, 2002)
McCONNELL, Carmel, Change Activists Make big things happen fast ( Pearson Education
2001)
METCALF, Jim, An OFR you cant refuse (CIMA - Financial Management Nov 2002)
MILLS, Roger, The Dynamics of Shareholder Value- The principles and practices of strategic
value analysis (Mars, 1998)
READ, Cedric; ROSS, Jacky; DUNLEAVY, John; SCHULMAN, Donniel; BRAMANTE,
James, eCFO Sustaining value in the new corporation (Wiley 2001)
ROBERT, Michael, The Power of Strategic Thinking-Lock in markets, Lock out competitors
(McGraw-Hill, 1998)
SLATER, Jim, Beyond the Zulu principle Extraordinary Profits from Growth shares (Orion
Business Books, 1998)
WARREN, Richard, Corporate Governance and Accountability (Liverpool Academic press
2000)
ZOHAR, Danah, Rewiring the corporate brain Using the new science to rethink how we
structure and lead organisations (Berrett Koehler 1997)

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