UK Walker Review: Tougher Than the Rest

July 23, 2009

On 16 July 2009, Sir David Walker, Senior Adviser at Morgan Stanley International, who has been commissioned by the UK Secretary of State for Business, Enterprise and Regulatory Reform and HM Treasury to undertake an independent review of corporate governance of the UK banking industry, published his consultation document – A Review of Corporate Governance in UK Banks and Other Financial Industries. Whilst some bankers have labelled the Review as bureaucratic and populist, views from other commentators are that the recommendations are "feeble" and uncontroversial. As for Walker himself, he believes that the proposals on pay are "tougher than anything to be found anywhere in the world". Wherein lies the truth? 


The rationale for a special review into the industry stems from the view that banks and other financial institutions which are systemically significant are vulnerable due to substantial amounts of leverage. The failure of such institutions gives rise to public interest externalities, and as such, financial regulators are interested in maintaining confidence in these institutions. The ability to generate return over time to shareholders is part of securing the ongoing confidence in these institutions and it is for this reason that the effective governance of the banks has been on the priority list for the UK government.

The Review sets out 39 recommendations which are proposed as governance best practice. Sir David however is not prescriptive in his Review as to how his recommendations are to be translated in practice. The recommendations do not envisage the promulgation of any new primary legislation. To the great relief of seasoned UK market participants, Sir David firmly endorses the "comply or explain" approach to guidance which has long been a hallmark of UK corporate governance initiatives. Accordingly, the majority of the recommendations, if adopted, are capable and are likely to be accommodated within the existing UK corporate governance code, the Combined Code on Corporate Governance (the "Combined Code") issued by the Financial Reporting Council ("FRC") and will build upon the existing Statement of Principles of the Institutional Shareholders Committee ("ISC"). Some of the recommendations however would necessitate a change in practice of the UK Financial Services Authority ("FSA"). One of the recommendations would result in the creation of a Code of Conduct for Remuneration Consultants. Sir David envisages that each of these "codes" or "statements of principle" will require amplification and amendment together with better observance, but he does not envisage anything more extensive at this stage.

The Review invites the FRC and FSA to work out the details as to how to accommodate the Recommendations and unfortunately in a number of areas, also leaves the FRC to fill in the blanks!

Timing & Scope

The Review, which is now open for public comment until 1 October 2009, is to close with the publication of final conclusions in November 2009. Following the completion of the initial consultation phase in October, it will then be for the UK government, FSA and the FRC to determine implementation in practice.

The original terms of reference for the Review was extended from examination of corporate governance in the UK banking industry to identifying recommendations which were applicable both to banks and other financial institutions ("BOFIs").

One of the criticisms of the Review is that it fails to clearly identify the precise application of its recommendations. Sir David acknowledges in the Review that there is no definition of "other financial institutions" but due to time constraints, the Review’s focus has ended up being "larger financial institutions, particularly those which are listed". The Review identifies 17 BOFIs drawn from the FTSE 100, but as illustrative examples of the possible scope of the enhanced system of corporate governance. The Report also notes that in some areas, the recommendations have wider relevance to non-financial UK companies. This is one key area which the FRC will need to give more detailed consideration and clearer guidance to companies.

The 39 Steps

Some of the recommendations of the Review are relatively prescriptive in form. The majority, however, set parameters within which there is a need for the exercise of judgement and some flexibility by the members of the board of BOFIs. The Recommendations fall within five categories, the key proposals of which are highlighted below.

Board size, composition and qualification

The proposals in this area are based on the general premise and assessment that the deficiencies in BOFI boards have related much more to patterns of behaviour within these boards, rather than to their form or organisation. Hence, the Review is quick to conclude that the UK corporate governance principles that boards should act primarily in the best interests of shareholders, and not for other stakeholders, is upheld and reinforced; as is the unitary board system over the two-tier board system that is the feature of a number of Continental European companies.

Sir David, however, sees the challenge in trying to change the nature of engagement of non-executive directors ("NEDs") on the boards of BOFIs; to encourage an environment in which constructive challenge is expected and encouraged. On reading the Review, one cannot help but be drawn to the conclusion that much of the anecdotal narrative and assessment of areas of deficiencies have been focussed on a handful of major bank failures; the Royal Bank of Scotland ("RBS") under the "reign" of Sir Fred Goodwin, being a key driver.

With the aim of encouraging a healthy, challenging board environment, the Review recommends that the BOFI board should provide dedicated support for NEDs on any matter on which they may require separate advice (Rec. 2). Sir David says that NEDs on BOFI boards should be expected to give a greater time commitment than has been normal in the past – a minimum of 30 to 36 days in year and that this requirement should be embodied in the NED’s letter of appointment (Rec. 3). Sir David also believes that the FSA should be playing a more proactive role in this area as directors of BOFIs perform a "controlled function", and any NED proposed for a BOFI board must be approved by the FSA.  Sir David recommends that, as part of its ongoing supervisory process, the FSA should give close attention to the balance of the board of BOFIs in relation to risk strategy, but also taking into account the relevant experience and qualities of directors and an assessment of relevant industry experience (Recs. 4 & 5). The Review notes that one of the possible deficiencies in BOFI boards to-date has been the lack of sufficient NEDs with relevant financial industry experience and independence of mind.

Functioning of the board and evaluation of performance

The Review is notable in its repeated emphasis of the enhanced role of the NEDs of BOFI boards. The report goes into great detail about the expectations of NEDs on BOFI boards and the need of such boards to emphasise the NEDs proactive responsibilities. The proposals, however, in this area are far from clear and have been categorised as "wishy washy". With respect to the Chairman of the BOFI board, Sir David is clear in his recommendation that one of the two "desirable conditions" for a successful chairman of a major bank is for that person to be able to draw on substantial relevant financial industry experience. It is interesting to note in this regard that two of the major UK banks which have faced deep turmoil in the financial crisis (RBS and HBOS) were chaired by non-bankers. Walker accordingly recommends that the chairman of BOFI board should bring a combination of relevant financial industry experience and a track record of leadership capability in a significant board position (Rec. 8). How one is to measure the second of these limbs is not clear. The Review recommends that the chairman of a BOFI board should be proposed for election on an annual basis (Rec. 10) and given the key role played by the chairman, he or she should expect to commit a substantial proportion of their time, probably not less than two-thirds, to the business of the entity (Rec. 7).

The role of institutional shareholders: communication and engagement

The Review is "generous" in its apportionment of blame for the current crisis, attributing the "widespread acquiescence by institutional shareholders and the market in the gearing up of banks’ balance sheets". Sir David takes the view that the various board and director shortcomings in some of the dysfunctional BOFI boards would have been tackled more effectively had there been more vigorous scrutiny and persistence by major investors acting as owners.

In what many regard as Walker overstepping the mark in the area of shareholder responsibility, the Review includes recommendations encouraging major long-only investors to undertake collective shareholder activist type strategies to pressurise boards of BOFIs on matters of collective concern (Rec. 21)! The report encourages these investors to enter into a memorandum of understanding to govern their proposed interventionist strategies.

Of a less contentious nature, the Review also recommends that the "Statement of Principles – the Responsibilities of Institutional Shareholders and Agents (2007)" (which is a series of basic principles promulgated by the Institutional Shareholders Committee (ISC) setting out best practice for institutional shareholders or agents in relation to their responsibilities in respect of investee companies e.g. encouraging publication of their investment policy and strategy for intervention and monitoring of performance) be endorsed and monitored by the FRC (Recs. 16 - 18). The thinking behind this recommendation is to elevate these principles, by converting them into an industry code falling under the remit of the FRC and to promote greater commitment to these best practice principles. Walker also believes the FSA has a role to play in promoting institutional shareholder responsibility by encouraging commitment to the Principles as a matter of best practice on the part of all institutions that are authorised to manage assets for others and requiring (as part of the authorisation process) disclosure against these principles on a "comply or explain" basis (Rec. 20).

Governance of risk

Walker‘s recommendations around the issue of monitoring and management of risk in a BOFI are the most specific of the recommendations and, if adopted, will require real change in the governance of the majority of  BOFIs.

Walker is of the view that BOFIs, due to their distinct need to mitigate financial risk, not just as a set of controls (which is also the case with non- financial institutions), but as part of their core strategy and product offering, will require a dedicated risk unit. Deloitte’s research into FTSE 250 BOFIs (2008) drew out the fact that there were only three BOFI companies which had disclosed the existence of specific risk or risk oversight board committees!

Walker recommends that the board of a BOFI should establish a board risk committee separately from the audit committee, which has responsibility for oversight and advice to the board on the current risk exposures of the entity and its future risk strategy (Rec. 23). The board risk committee should report on an annual basis to shareholders by inclusion in the Annual Report & Accounts of a report describing the strategy of the entity in a risk management context (Rec. 27). Further, in support of board-level risk governance, a BOFI board should be served by a Chief Risk Officer ("CRO") who should participate in the risk management and oversight process at the highest level, with direct access to the chairman and an entrenched position, meaning that they cannot be removed unless the whole board consents (Rec. 24).


Last, but by no means least, Walker addresses the need for remuneration practices to be constructed in such a way as to provide incentives for sustainable performance. The recommendations around remuneration reform has attracted the greatest deal of public and press comment. In particular, the recommendation that the annual report of the Remuneration Committee should disclose detail of "high-end" executives whose total remuneration exceeds the executive board median total remuneration, in bands indicating on a no-name basis the numbers of executives in each band and the main elements of the remuneration package (Rec. 31).

Walker recommends that the remit of the Remuneration Committee should extend to oversight of packages of such high-end executives, even though they may not have a formal board position (Rec. 29). The report also recommends the deferral of incentive payments – incentives, says Walker, should be balanced so that at least one half of the variable remuneration offered in any one year, is in the form of a long-term scheme with vesting subject to a performance condition, with half of the award vesting after not less than three years and the reminder, after five years (Rec. 33). As a form of "name and shame" proposal, Walker recommends that if less than 75% of total votes cast by shareholders on the annual advisory resolution to adopt the Remuneration Committee report, the chairman of the Remuneration Committee must resign (Rec. 36).

The last of the Walker Review recommendations centres around the creation of a new industry code for remuneration consultants – who were also apportioned with blame for the escalation in BOFI remuneration packages which had a disproportionate dependence on short term performance. Walker recognises that, due to the increasing complexity of incentive and remuneration packages, many BOFI boards/Remuneration Committees resort to the external advice of remuneration consultants. Unfortunately, self-interest on the part of these consultants has led to a lack of suitable packages and a lack of clarity in the remuneration process. Walker recommends that a code of conduct for remuneration consultants be drawn up and these firms should forma professional body to adopt and authorise the code going forward (Rec. 38).

Practical Implications

Although we are some months away from the Walker recommendations being translated into the UK corporate governance structure, the implications of some of the recommendations are already quite clear.

There is inevitably going to be an increase in the costs of corporate governance of BOFIs – with a new Risk Committee in place, being serviced by a new officer (the CRO) and the requirement to produce a report on an annual basis. Although not mandated to do so, Walker firmly encourages BOFI boards to access remuneration consultants in drawing up remuneration packages. The enhanced disclosure on boards and the expected increase in the use by NEDs of external advice and support in discharging their "enhanced" roles on BOFI boards, will also add to the cost of compliance with the new corporate governance regime.

The increased scope of responsibility and time commitment required by NEDs, the senior independent advisers and the chairmen on the boards of BOFIs, will put pressure on boards to increase the fees of such board members, otherwise there would be a real concern that a dearth of willing volunteers for the role of a BOFI board member will result.

Not to be forgotten, of course, is the series of recommendations which have an impact on institutional shareholders. If the Principles of Stewardship are properly adhered to and the other recommendations implemented, these shareholders will be facing new and increased costs of disclosure and increased need for legal and other advice in pursuing any interventionist strategy.

What the Critics Say

Many other City doyens who may have wanted to take up the mantle of the Review for the Government are now looking with relief in the aftermath of the publication of the Walker Review.  

Many in the banking community have hit back at the report for its bureaucratic proposals which they fear will lead to the slowing down of day- to- day processes by non-executives who are used to operating on a month-to- month basis. This fear has been echoed in part by other industry bodies, such as the Association of British Insurers, who fear the extension of the remit of NEDs into areas which should properly be performed by management.

As for the proposal on remuneration, Walker is no one’s friend. The idea of a City insider (Walker being the former Chairman of Morgan Stanley International) being tasked with devising recommendations to rectify "faults that were their own industry’s making" is described by some as astonishing. Many feel that the recommendations on remuneration do not go far enough.  Walker may have shot himself in the foot with his recommendation on disclosure of "high-end" executive remuneration. The proposal lacks rigour and purpose; as Walker states that his concern is not about the size of the packages (and indeed there are no proposals to cap remuneration packages and claw backs are only to restricted to limited circumstances), but rather on their longer-term incentive focus. If this is indeed the case, then why disclose any detail at all and fuel the frenzy of the public cries of excess? Not surprisingly, there are complaints in other quarters that the "crackdown on City pay" in the Review is "manifestly unreasonable and unfair" and London risks "seeing some of [its] star traders and dealmakers leaving the country".

There are, in addition, many unanswered questions in the recommendations, and a number of gaps in terms of how some of the proposals are to be implemented, policed and enforces. The voluntary code for remuneration consultants has come in for some of the harshest criticism. Many regard it as perverse to leave the code of conduct to be drafted by these consultants themselves!

The government, however, is at the present time ignoring the swathe of criticism. Prime Minister Gordon Brown has said that Walker had produced "clear recommendations" which he believed would be adopted and which promise a new era of openness and professionalism in the way banks are managed.

Tough enough, too tough, not tough at all? …. The debate has just begun.

  Gibson, Dunn & Crutcher LLP

Gibson, Dunn & Crutcher LLP lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn attorney with whom you work or Selina Sagayam (+44 20 7071 4263, [email protected]) in the firm’s London office.  

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