ACCA P1 Corporate Governance

Corporate

Governance

Chapter 1: the scope of governance of 50

Meaning Corporate governance is the system by which companies are directed and controlled.

Governance should not be confused with management.

• Management is concerned with running the business operations of a company.

• Governance is about giving lead to the company and monitoring and controlling management decisions, so as to ensure that the company achieves its intended purpose and aims.

Professor Bob Tricker, 1984: ‘If management is about running business, governance is about seeing that it is run properly’

The term corporate governance means governance of companies.

What CG is not? Corporate governance is not about management activities, and management skills and

techniques. Corporate governance is not about formulating business strategies for the company.

When the problems for corporate governance arises o The separation of ownership and control. o Company has many different shareholders, and there is no majority shareholder.

The separation of ownership from control can affect the quality of governance in non-corporate entities.

The main areas covered by codes of CG o The role and responsibility of the board of directors. o The composition and balance of the board of directors. o Financial reporting, narrative reporting and auditing. o Directors’ remuneration. o Risk management and internal controls. o Shareholders’ rights.

Governance issues in public sector entities and in government Six core principles for good corporate governance in public sector companies:

1. Focusing on the organization’s purpose and on outcome for citizens and service users.

2. The responsibilities of executive management and governing body (board) should be clear.

3. Integrity and ethical behaviour. 4. Risk management and responsibility of the governing body for the internal

controls. 5. Composition and balance of the board. 6. Engaging stakeholders and making accountability real.

o Constructive dialogue should exist between the governing body and the general public and particular interest group.


Concepts of good governance

1. Fairness o All shareholders should receive fair treatment from directors. o One vote per share and the right to receive same dividend per share.

2. Openness/transparency o Openness and transparency means ‘not hiding anything’. o Intentions should be clear and information should not be withheld from

individuals who ought to have a right to receive it. o Transparency means clarity. Providing information about what the company

has done, what it intends to do in the future, and what risks it faces.

3. Independence o Independence means freedom from the influence of someone else. o A principle of the CG is that substantial number of the directors should be

independent, which means that they are able to make judgments and give opinion that are in the best interest if the company, without bias or pre-conceived ideas.

4. Honesty and integrity o Honesty should be an essential quality for directors and their advisers. o An individual who is honest, and who is known to be honest, is beloved by

others and is therefore more likely to be trusted.

5. Responsibility and accountability o The boars is responsible for:

Setting the strategic objective of the company, and To monitor the decisions of executive management.

o With responsibility, comes accountability. The BOD should be accountable to shareholders.

6. Reputation o A large company is known widely by its reputation or character. o A reputation may be good or bad, it depends on:

o Combination of several qualities, including: Commercial success, and Management competence.

7. Judgment o All directors are expected to have sound judgment and to be objective in

making their judgments (avoiding bias and conflicts of interest).


Nolan’s Seven Principles of Public Life

These were issued in the UK by Nolan Committee (1995) on standards of public life. The committee was formed to report on the standards of behaviour amongst politicians and in the civil service and other public sector bodies.

1. Selflessness 2. Integrity 3. Objectivity 4. Accountability 5. Openness 6. Honesty 7. Leadership

Chapter 2. Agency relationships and theories of 50

Agency Theory:

1. The law of agency

An agent is a person who acts on behalf of another person, the principal, in dealing with other people.

The agent acts on the name of the principal, and commits the principal to agreement and transactions.

In company law, the directors act as agents of the company. The board of the directors as a whole, and individual director, have the authority to bind the company to contractual agreements with other parties.

Directors set the objectives and strategies of the company.

Fiduciary duties of directors

A fiduciary duty of the director is a duty of trust.

A director must act in on behalf of the company in total good faith, and must not put his personal interest before the interests of the company.

In case of breach he could be held liable in law. Legal action by company would normally be taken by the rest of the bods, or possible, a majority of shareholders acting in the name of the company.

Agency law and challenging the actions of the directors

It is very difficult for shareholders to use the law to challenge the actions and decisions of the company’s directors. Their ability to challenge them is restricted.

• The shareholders can vote to remove any director but this requires majority of votes by shareholders, which might be difficult to obtain.

• In the court of law it is up to the shareholder to demonstrate that director is in the breach of his duty.

In summary, although there is the legal relationship between the BODs and their company, the shareholders cannot easily use the law to control the decisions or actions of the directors take on behalf of the company.

2. Concepts in agency theory: the agency relationship

The theory of agency deals with the relationship between:

• a company’s owners and

• its managers (directors).


Agency is based on the idea that when a company is first established, its owners are usually also its managers. As a company grows, the owners appoint managers to run it.

The owners expect the managers to run the company in the best interest of its owners; the agency relationship arises.

Major lenders also have interest in the activities of the company; how the company is being managed, because they have concerns about the ability of the company to repay the debt with interest.

The agency relationship

This theory was developed by Jensen and Meckling (1976). They suggested how the governance of the company is based on the conflicts of the interest between:

o the company’s owners(shareholders) o its managers o and major providers of debt finance.

• Shareholders Increase their income and wealth Dividends and capital growth Concerned about long-term profitability and financial prospects

• Managers (Directors) They are employed to run the company on behalf of the shareholders. Managers have an employment contract and earn a salary. Their main interests are likely to be the size of their remuneration package and their

status as company managers.

• Major providers of debt finance 1. Have interest in sound financial management by the company’s managers.

3. Agency Conflicts

Agency conflicts are differences in the interests of a company’s owner and managers.

• Moral Hazards. Interest of manager in receiving benefits from his status. Car, chauffer, company airplane and so on. Jenson and Meckling: Manager’s incentive to obtain these benefits is higher if he has no shares, or only few shares.

• Effort level. Managers may work less hard than they would if they were the owners of the company. This problem exists in the middle as well as senior level of management. Different pay incentives to senior and middle management.

• Earnings retention. Remuneration of directors is related to the size of the company, rather than its profits. In order to grow the company managers might invest in the projects where the expected profitability is quite small, rather than pay out dividends.

• Risk aversion. Executive directors and senior management usually earn most of their income from the company they work for. They are therefore interested in the stability of the company. This means that management might be risk averse, and reluctant to invest in higher-risk projects.

• Time horizon. Managers might only be interested in the short-term. This is partly because they expect annual bonuses based on short-term performance and partly


because they might not expect to be with the company for more than a few years. They want the ROI and ARR to increase while shareholders have greater interest in long-term value as measured by NPV.

4. Agency costs

• Agency costs are the costs of having an agent to make decisions on behalf of a principal.

• Agency costs are the costs that the shareholders incur by having managers to run the company instead of running the company themselves.

• Agency costs are potentially very high in large companies, where there are many different shareholders and large professional management.

• Agency costs can therefore be defined as the ‘value loss’ to shareholders that arises from the divergence if interest between the shareholders and the company’s management.

There are three aspects of agency costs:

1. Monitoring costs are costs of measuring, observing and controlling the behavior of management. Sometimes are imposed by law (annual accounts, annual audit) and some arise from compliance with codes of corporate governance.

2. Bonding Costs are costs of arrangements that help to align the interest of the shareholders and managers. For example, agency costs arise when a company’s directors decide to acquire a new subsidiary, and pay more for the acquisition than it is worth.

3. Residual losses are losses occur for the owners, such as the losses arising from a lower share price, because the managers take decisions and actions that are not in the best interest of the shareholders. Monitoring costs and bonding costs will not prevent some residual loss from occurring.

5. Reducing the agency problem

• Incentives should be provided to management to increase their willingness to take ‘value-maximizing decisions’.

• Align the interest of directors through: I. PRP (performance related pay)

Their salaries and commission are dependent on profit. They work for ROCE. Example; teacher hired on per hour basis.

II. Share option schemes Offer shares to managers. They will not only be the employees of the company, they would become the shareholders of the company. Sense of ownership will force them to work for the share price, EPS etc.

III. Executive share option scheme (ESOS) Members of BOD are offered shares with certain conditions of time. For e.g. After 3 years X number of shares.

• Choosing between agency cost and alignment of interest is based on cost benefit analysis.

Providers of debt

The problems of the agency relationship are bigger in companies that are profitable but have low growth in profits. these companies generate a large amount of free cash flow.


Shareholders would wish that free cash flow should be either:

o Invested in projects that will earn a high return (+npv) o Paid to the shareholders as dividends.

One way of reducing this problem is would be to have high proportion of debt in to the capital structure of the company. Interest must be paid on debt, and this reduces the free cash flow. Management must also make sure that new investments are profitable so and the company would be able to pay interest on debt capital.

Board of Directors

A different way of reducing the agency problem is to make the board of directors more effective at monitoring the decisions of the executive management.

• The board will be ineffective if dominated by CEO.

• CEO and chairman should not be the one person.

• The board must consist largely of independent non-executive directors. Because they are not the full-time employees of the company.

• Non-executive directors should be responsible for the remuneration packages for executive directors and senior management.

Jensen argued that board becomes less effective if it grows in size. Large board makes slow decisions.

6. Accountability of agents

Agents should be accountable to their decisions and actions. Agent should disclose every action to the principal.

7. Ethics and agency theory

There is an ethical aspect to agency theory. The theory is based on the view that individuals cannot be trusted to act in any way that it is not in their own best interest.


Transaction cost economics theory

This theory explains the relationship between the owners of a company and its management as the resolution of a conflict of interest, although it is an economic theory. It is closely associated with the work of Oliver Williamson.

1. Costs of the firm: production costs and transaction costs

The operations of a business entity can be performed either through market transactions or by doing the work by in-house.

Market Transactions: o Obtaining raw material form external supplier (outside) o Hiring full time employees o Selling finished goods through retail organizations

In-house: o Making raw material itself o Hiring self-employed contractors to do work o Selling finished goods directly to the end user

According to the theory of transaction cost economics, the structure of a firm and the relationship between the owners of a firm and management depends on the extent to which transactions are performed internally.

Total costs are the sum of production costs and transaction costs.

Production costs: o Costs incurred in ideal economic market, to make and sell goods of the firm. o In ideal economic market production costs are minimized.

Transaction Costs: o Additional costs incurred whenever the ‘perfect’ situation is not achieved.

For example: Unavailability of the cheap supplier, because organization was not aware of the existence of the cheap supplier. For example: Selling goods to the customers not knowing that the receivable will become a bed debt.

Transaction costs are sometimes higher when transaction is arranged in the market, and they are sometimes higher when the transaction is done ‘in-house’.

Carrying out the transaction in-house rather than arranging contracts externally is called vertical integration.

Total costs are minimized when transition costs are minimized.

Performing transactions in-house removes all the risks and:

o Uncertainties about the future prices of products and about product quality o Costs of dealing with external suppliers.


2. Assumptions in transaction cost economics (TCE)

Traditional economic theory is based on the assumptions that all behavior is rational and that profit maximization is the rational objective of all businesses.

Transaction cost economics changes these assumptions, by trying to allow for human behavior, and the fact that individuals do not always act rationally.

Williamson assumptions about behavior:

Bounded rationality, and Opportunism.

Bound rationality

It is assumed in TCE that humans act rationally, but only within certain limits if understanding. For example that the manger of a company will in theory act rationally in seeking to maximize the value of the company for its shareholders, but their bounded rationality might make them act differently.

It is impossible to predict with certainty what will happen, because there are too many factors and too many possibilities to consider.

When uncertainty is high, or when a situation is very complex, there is a greater tendency to carry out transaction ‘in-house’ and to have vertical integration.

Opportunism

o People will not always be honest and truthful about their intentions. o ‘An effort to realize individual gains through a lack of candor or honesty is

transactions.’ –Williamson o However managers are opportunistic by nature. Given the opportunity, they will

take advantage of available ways of improving their on benefits and privileges. o Problems with opportunism:

• External parties such as contractors can not always be trusted to at honestly.

• There is also risk that by taking control of transactions internally, managers will have opportunities to take decisions and actions that are in their own personal interest.

3. The variables in transaction costs economics

There are three variables which determine the extent to which a firm does the work itself.

Frequency of transactions Uncertainty Asset specification

Frequency of transactions when goods are purchased very frequently, or services are used frequently, there is a much stronger case for vertical integrations and bringing the work ‘in-house’ because the


transaction costs should be lower. For example, a company will rarely ever want to establish its own department for management consultancy.

Uncertainty

Uncertainty creates problems partly because of bounded rationality. As a general rule, greater uncertainty makes it more likely that the transactions will be done in-house. For example, Ski instructor for the customers on its winter skiing holidays.

Asset specification

When an asset has only one specific use, transaction costs are likely to be reduced by vertical integration. For example, a professional football club will use a football stadium for its football matches.

4. Comparison of transaction cost economics with agency theory

Transaction cost economics

Management behavior is determined by bounded rationality and opportunism.

Due to both factors mangers will act in their own self interest when opportunities arise.

Self interest behavior should be controlled.

Agency theory Agency theory uses the

conflict of interest between shareholders and managers.

Managers will often try to increase the size of their company, even though it is not in the best interest of the shareholders.

Managers benefit personally from the growth in the size of the company.


Stakeholder theory

1. Stakeholders approach to corporate governance

The stakeholder view is that the purpose of corporate governance should be to achieve, as far as possible, the aims of all key stakeholders- employees, investors, major creditors, customers, major suppliers, the government, local communities and the general public.

Govt should design its policies in such a way that it provides firms incentives and discipline to maintain the interest of all the stakeholders.

The OECD Principles themselves recognize the role of stakeholders in corporate governance and state that the corporate governance framework should:

Recognise the right of stakeholders that are recognized in law or through mutual agreements, and also

Encourage active co-operation between corporation and stakeholders in creating wealth, jobs and the sustainability of financially sound enterprises.

2. Definition of stakeholder theory

Company managers should take decisions that take into consideration the interests of all the stakeholders, not only shareholders.

Stakeholder theory can be seen as a mix of a variety of discipline which provides a blend of sociological and organizational ideas.

3. Rights for stakeholders

According to the stakeholder approach of corporate governance, significant power within the framework of CG is held by senior management, directors and shareholders.

A stakeholder approach to CG can therefore be implemented only by:

Negotiation and co-operation between management and employees, and Legislation giving to stakeholders or protecting stakeholder rights.

4. Stakeholder theory and agency theory

Stakeholder theory

Company has obligation to other stakeholders in addition to shareholders.

Agency theory

Manager should act in the best interest of the shareholders.

Chapter 2. Agency relationships and theories of 50 Both the approaches to CG (or ethical theory) are not necessarily inconsistent. Companies and their managers can act in the best interest of the shareholders and at the

same time attempt to satisfy the interest of other stakeholders. For example, society and environment concerned stakeholder.

In other words, best practice in corporate governance and corporate social responsibility might be consistent with each other

Chapter 3. The board of directors of 50

The role of the board

1. Introduction

The BOD is an executive committee with governing powers and administration. They attract investment, raise finance from the public/shareholder.

When a country has a code of CG, the code applies only to major stock market companies. Private companies or subsidiaries within a group might choose voluntarily to comply with.

2. Delegation of power within a company

The delegation of power within a company may vary form company to company.

The role of the board of directors is not to manage the company. This is the role of the management.

3. Corporate governance codes on the role of the board

The combined code in the UK states that ‘every company should be headed by an effective board, which is collectively responsible for the success of the company.’ It then goes on to state that the board is responsible for:

Strategy setting or strategic decisions Acquisition of assets Borrowing loans Raising finance Any special transaction (forex) Appointment of CEO Monitoring of CEO Risk management

4. Decision making and monitoring roles

The role of the board of the directors is a combination of decision-making and monitoring.

A board should retain certain responsibilities, and should make decision in these areas itself.

After delegating the responsibilities to executive management it should monitor the performance if management. For e.g. CEO.

In addition the board should monitor the system of internal controls that management has put in place.

The board should accountable to shareholders for its performance in carrying out these twin roles of decision-making and monitoring.

Chapter 3. The board of directors of 50 5. Unitary board and two-tier board structures

In most countries, companies have a unitary board. This means there is a single board of directors, which is responsible for performing all the functions of the board.

Two-tier boards

In some countries (such as Germany and the Netherlands), all or most large companies have a two-tier board. A two-tier board consists of:

A management board, and A supervisory board.

The management board is responsible for the oversight of management and business operations. It consists entirely of executive directors, and its chairman is the company’s CEO.

The supervisory board is responsible for the general oversight of the company and the management board. It consists entirely of non-executive directors, who have no executive management responsibilities in the company. Its chairman is the chairman of the company, who is the most significant figure in the corporate governance structure.

The function of the chairman is to work closely with the CEO. As chairman of the management board, CEO reports to the chairman of the company. If there is a good relationship between the CEO and the chairman, the chairman will speak to the company’s management at meetings of the supervisory board.

Directors on the supervisory board normally include:

Representatives of major shareholders of the company Representatives of the employees or the major trade union Former executive managers of the company, possibly former members of the

management board who have now retired form the company.

In large companies, the supervisory board can be quite large, in order that it can represent sufficient number of different stakeholder interest.

Comparison of unitary and two-tier boards

Unitary board

Healthy debate between NED and ED

Faster communication Cost effective Better co-ordination within

members and good relationships.

Work towards a common purpose.

Disadvantage: minority interest may be overlapped.

Two-tier board

Fraud chances will be reduced Check will increase Accountability of the board will

increase. NED will have more time to

analyze the issues. Disadvantage: NED will have

more powers and autonomy situation may arise.


Composition of the board

1. Composition and size of the board

1. Chairman 2. Deputy chairman(sometimes) 3. CEO 4. EDs 5. NEDs

The board should not be so large as to be unwieldy (unable to use the power).

2. Executive and non-executive directors

(Note: UK listed companies may be required to include non-executive directors on their board. Other companies are not required to appoint non-executive directors, but might do so voluntarily.)

Executive Directors are directors who also have executive management responsibilities in the company. They are normally full time employees of the company. Examples are CEO, CFO/Finance directors.

Non-executive Directors or NEDs are directors who do not have executive management responsibilities in the company. (They might be an executive director in a different company.)

o NEDs are not employees of the company. o They are not full-time employees. When they are appointed there should be

clear understanding about how much time they would spend discussing company’s affairs (monthly or yearly).

However, the status of ED and Ned, as directors, is exactly the same.

3. Independence

Independence means reaching opinions, expressing them and not necessarily agreeing with everything that fellow directors say. All directors should show the independence of character. In corporate governance, however, ‘independence’ means something much more specific than having an independent mind.

4. Independent directors

An independent director is the one who:

• has no link to a special interest group or stakeholder group. For e.g. management, other employees of the company, major shareholder, a supplier or a major supplier or customer of the company.

• has no significant personal interest in the company, such a significant contractual relationship with the company.


This is impossible for an executive director to be independent, because he/she has a direct link with executive management. Only NED can be independent. However all NEDs are not independent.

Definitions of ‘independent director’ vary between countries and codes. In Singapore the definition is less strict than in the UK.

According to UK CCG a director is not independent when he:

1. has been an employee with in past five years. 2. has (or has had within the previous three years) a material business relationship

with the company. For e.g. shareholder, director or senior employee. 3. receives remuneration in addition the fees as NED. For e.g. participant in share

incentive scheme, PRP, pension. 4. close family ties with a director, senior employee or professional advisor the

company. 5. has significant links with the other directors through involvement in other

companies or entities. 6. Represents a major shareholder 7. Has served on the board for more than nine years since the date of his election as

director.

5. Board balance and independent directors

A board should consist of directors with a suitable range of skills, experience and expertise. However, there should also be a ‘balance of power’ on the board, so that no individual or small group of individuals can dominate decision-making by the board. Example:

• The Maxwell Communication Corporation (Robert Maxwell). Misappropriated £900 million form pension fund, using the fund in the expansion of the company and to support the group companies that were in financial difficulty in 1992.

• Polly Peck International (Asil Nadir)

• Both the companies collapsed in the early 90s.

The UK CC states: ‘The board should include a balance of EDs and NEDs (and in particular independent NEDS) such that no individual or small group of individuals can dominate the board’s decision-taking.’

Further it states that: ‘To ensure the power and information are not concentrated in one or twp individuals, there should be a strong presence on the board of both EDs and NEDs.’

The CC specifies that:

o At least 50% of the board, excluding the chairman, should consist of independent NEDs, except for smaller listed companies. (It is usual for the chairman of a UK listed company to be independent.)

o In smaller listed companies, there should be at least two independent NEDs. o In Singapore CCG states that independent directors should make up at least one-

third of the board. Because codes vary form country to country.


The role of chairman, CEO and NEDs

1. Separation of the roles of chairman and CEO

The UK CC states that:

The roles of chairman and CEO should not be held by the same person. CEO should not go on to be the chairman of the company.

However, there should be a good working relationship between the chairman and the CEO.

The idea behind the provision of the Code that the CEO should not go to be the chairman is that a CEO who ‘sets up’ to become the company chairman might seek to dominate or influence his successor as CEO. However, sometimes CEO is offered a part-time role as chairman, this happens when the CEO decides to do something different, a company might be able to retain his experience and knowledge in that case..

2. Role of the CEO

o The CEO is responsible for the executive management of the company’s operations. o He is the leader of the management team, and all senior executive managers report

to the CEO. o If there is an executive management committee for the company, the CEO should

be the chairman of this committee. o Other executive directors may sit on the board of directors, the CEO reports to the

board on the activities of the entire management team, and is answerable to the board for the company’s operational performance.

3. Role of the board chairman

If the companies comply with the CC, a chairman will therefore be both independent and NED.

o He is the leader of the board of directors. o He is responsible for managing the board. o The UK CC identifies the following are the responsibilities for the chairman:

Setting the agenda for the board discussions. Ensuring that all directors receive accurate, timely and accurate information.

This is important for NED particularly, because he relies on the information provided by the chairman.

Communication between company and shareholders. Ensuring that NEDs contribute effectively to the work of the board. Ensuring co-operative relationship between the NEDs and Eds.

o Higgs Suggestions: Run the board and set the agenda (agenda for strategic matters not details

of management). Makes sure that enough time is allowed for the full discussion of complex

and controversial issues.


Arranges the induction programmers for new directors with the assistance of the company secretary.

Organize the performance evaluation of the board, its main committees and its individual directors.

Encourage the active participation in the board’s affairs by all directors.

The chairman represents the company in its dealings its shareholders and (usually) the media. He is the ‘public face’ of the company.

Comparison of the roles of CEO and chairman

CEO

1) Executive Director. Full time employee.

2) All executive managers report, directly or indirectly to the CEO.

3) The CEO reports to the chairman (as leader of the board) and to the board generally.

4) Head of the executive management team.

5) To draft proposed plans, budget and strategies for board approval.

6) To implement decisions of the board

Chairman

1) Part –time. Usually independent. 2) No executive responsibilities. Only the

company secretary and the CEO report to the chairman directly, on matters relating to the board.

3) The chairman reports to the company’s shareholders, as leader of the board.

4) Leader of the board, with responsibility for its effectiveness.

5) To make sure that the board fulfils its role successfully.

6) To ensure that all directors contribute to the work of the board.

4. Role of NEDs

The reason for having the NEDs on a board:

o To give the board the better balance. o To reduce the possibility of dominance of once individual or small group of

individuals.(one man show= Robert Maxwell, Asil Nadir)

The four roles for NEDs identified by Higgs Guidance:

1) Strategy. NEDs should challenge constructively and help to develop proposals on strategy.

2) Performance. Monitor the performance of executive management. 3) Risk. NEDs should satisfy themselves about the integrity of the financial info

provided by the company and should also satisfy themselves about the company’s risk management system and internal controls.

4) People. NEDs should be responsible for deciding the remuneration of the EDs and other senior managers, and should have a major role in the appointment of new directors and in the ‘succession planning’ for the next chairman and CEO of the company.

These roles suggest that NEDs have complex tasks in unitary board. They act as colleagues of the EDs and at the same time they are monitoring them also. They act as


colleagues in discussing the strategies and helping to develop strategy. However they act as ‘policeman’ on monitoring their performance.

Note: the function of the independent NEDs is to reduce the agency costs arising from the conflict of interests between shareholders and management.

Senior Independent Director (SID)

The UK CC suggests that one of the independent NEDs should be appointed as senior independent director (SID).

Roles of the SID:

o Act as a leader for the other independent NEDs. For e.g. calling meetings for NEDs away from EDs.

o Expected to act in usual circumstances, when corporate governance is not functioning. For example:

A disagreement between major shareholder and chairman. The SID might be required to argue with the chairman or CEO in a

situation where the company is failing to apply proper standards of corporate governance.

5. The appointment of non-executive directors

It is generally accepted that the board of directors should collectively possess a suitable combination of experience and skills. The Tyson Report (2003) reached several conclusions.

The effectiveness of the board would be improved by having a board consisting of directors with a range of experiences, knowledge and backgrounds, rather than a aboard whose NEds all come from the same type of background.

Companies should have a formal system of appointing new NEDs to the board. NEDs should be recruited from wider range of different backgrounds. Other sources of NEDs should be individuals in private sector companies,

‘professional’ (accountants, solicitors) and business consultants, and individuals working on the public sector or the non-commercial private sector.

Keeping the board refreshed

There is a need to keep a board refreshed by appointing new directors regularly, to bring fresh experience and skills to the board.

As a company grows the experience required by the directors might change. Over time, the independence of a NED is likely to diminish. Tats why NEDs should be

replaced after the certain number of years. Changes to the board, to keep it refreshed, affect NEds rather than EDs. This is

because EDs are the employees of the company. They remain EDs as long as their job is retained.

Chapter 3. The board of directors of 50 6. Criticism of NEDs

Lack of knowledge Insufficient time with the company Accepting the views of EDs.


Directors and the law

Corporate law varies between countries. Directors have certain right and duties; if they fail to carry out their duties they could become liable for their failure.

1. The powers and rights of directors

In UK law, individual company directors have implied power to make legally bound contracts for the company, even if their powers have not been specified actually (actual authority).

Service contracts

A service contract for an executive director is a legally-binding contract of employment. It includes:

o entitlement to remuneration o pension rights o a minimum notice period for termination of office.

The service contract of an ED should specify his role as an executive manager of the company, but might not include any reference to his role as a company director. If the director is asked to resign from the board, it is generally –accepted practice that he is dismissed from the post of executive manager. Director is given rights by law to wrongful or unfair dismissal by the company.

Fixed term contracts

• NEDs are usually appointed for fix period.

• In UK, normally Ned is appointed for 3 years.

• After 3 years, reappointment might be renewed with the approval of S/H.

• This cycle of 3 years continues till the NED’s retirement.

2. Appointment, election and removal of directors

When a vacancy occurs during the course of the year, BOD nominates an individual and then appoints him.

At the next AGM (also called shareholders meeting), the directors stands for election. In UK, the director is elected if he obtains 50% votes of the s/h.

As the appointment of NEDs is for three years. o In UK, most companies include in their AOA a requirement that one-third of

directors should retire each year by rotation. o And stand for re-election.

It is usual for directors who retire by rotation and stands for re-election to be re-elected by a very large majority.

Directors are removed from the office when they have failed. Chairman removes them. Their removal is based on their bad performance.

UK company law allows shareholders (with at least a specified minimum holding of shares in the company) to call the company meeting to vote on the proposal to remove the director/ a director can be removed by a simple majority vote of the s/h.


When a director is removed form office, he retains his contractual rights, as specified in his contract of employment. This could involve a very large payment.

3. Duties and legal obligations of directors

In the UK, the Companies Act 2006, statutory duties for directors are to:

act within their powers promote the success of the company for the benefit of its shareholders exercise independent judgment executrices reasonable skill, care and diligence (show care and effort) avoid conflicts of interest not to accept benefits form third party declare any interest in a proposed transaction with the company

Conflicts of interest

A director would be in breach of his fiduciary duty to the company, for e.g. if he puts his own interests first, ahead of the interests of the company.

Disclosure of interests

A breach of fiduciary duty would also occur if a director has an interest in a contract with the company but fails to disclose this interest to the rest of the board and obtains their approval. For e.g.

o David is a director in company A and also a major share in another company (say company B)

o And company A is going to enter into a supply contract with company B. o Then David must disclose his interest as soon as possible to the rest of the board of

company A, and obtain their approval. o In case of failure he would become liable and all his secret profits will be handed

over to the company A. o In the UK, it is criminal offence (not to disclose an interest), punishment is FINE.

Share dealings by directors

It is common practice that directors of listed companies have some shares in their company. They work inside the company and this is common for them to have information about company (or other company). That information is confidential and if it is made public, it is likely that it will affect the share price.

Taking advantage of price-sensitive information about a company to buy or sell shares, or to encourage anyone else to buy or sell shares, is a criminal offence, known as insider dealing.

If the director is found to have carried out insider dealing or insider trading, he has committed a criminal offence and face a fine/imprisonment or he might be found liable in civil law to the individual at whose expense he has made profit.

In UK all listed companies are required to apply THE MODEL CODE, or a code that is no less strict.


THE MODEL CODE:

• Directors must not deal in shares of their company during a ‘close period’.

• CLOSE PERIOD means the period before the announcement to the stock market of the company’s interim and financial results.

• A director must not deal in shares of the company that he has the price-sensitive information.

• A director must obtain the prior permission from the chairman before dealing in the company’s shares at any time.

5. Disqualification of directors

In the UK the law allows a court to disqualify an individual from acting as a director in a variety of circumstances. These include:

• when a director is bankrupt

• when a director is suffering from mental disorder

• when a director is found guilty of crime such as the misappropriation of company funds).


Induction, training and performance evaluation of directors

1. Induction for new directors

Induction is a form of training. Its purpose is to make a new person familiar with what the company does, how it

operates, how it is organized, who the senior managers are and so on. NEDs and EDs both need the induction training. EDs should know more about the company than the EDs. Knowing more does not mean that they know everything about the company that

they should know. The UK combined code recognizes the importance of induction and states that all

directors should receive induction on joining the board, and the chairman with the help of company secretary should ensure that new directors receive a full, formal and tailored induction on joining the board.

Induction to gain familiarity with company induction to gain familiarity with being a director of the company An induction programme might therefore include:

o visits to important sites/locations of operations o demonstrations of the company’s products o meetings with senior managers and staff o possibly, meetings with professional advisers of the company o possibly, meetings with major shareholders(if shareholders wish to)

a new director should be given: o information about what the board does o guidance on insider dealing/trading o copies of minutes of recent board meetings o a schedule of dates for future board meetings o details of the committees of the board, and their responsibilities.

2. Training and professional development for directors

The UK combined states that:

All directors should regularly update and refresh their skills and knowledge. The chairman should ensure that directors regularly update their skills and the

knowledge. The company should provide the necessary resources for developing and updating

its directors’ knowledge and capabilities.

Subject areas for training and development might include formal training in business strategy, corporate governance issues or developments in financial reporting.

Chapter 3. The board of directors of 50 3. Performance Evaluation

The board is accountable to the shareholders, and it might therefore be argued that the performance of the board should be judged by the shareholders. However, in practice this would be difficult to achieve.

In some countries codes of corporate governance include a requirement that the performance of the board and its individual directors should be reviewed regularly, and the review should be carried out by the board itself. The chairman should have the responsibility for the performance evaluation.

Chapter 4. Board committees of 50

The need for the board committees

1. The nature of the board committees

The board committee is a committee set up the board, and consisting of selected directors, which is given responsibility for monitoring a particular aspect of the company’s affairs for which the board has reserved the power of decision making.

A committee is not given the decision making powers. Its role is to monitor an aspect of the company’s affairs, and:

Report back to the board, and Make recommendations to the board.

Board committee is not a substitute for executive management and board committee does not have executive powers.

2. The main Board committees

1. A remuneration committee 2. An audit committee 3. A nomination committee 4. A risk management committee

3. The reason for having board committees

Saves time of the board and effective utilization of resources. To avoid a conflict of interest between EDs (management) and its shareholders.

Board committee should consist wholly or largely of independent non-executive directors.


The audit committee

Audit committee is a sub committee of board comprises of NEDs or sometimes majority of NED. In large listed companies there should be at least three members of the committee (and in smaller companies at least two members).

Singapore CCG states that the audit committee should consist of at least three members, all of them should be NEDs. There should be 1 financial expert in the committee. Singapore recommendation is 2 financial experts

Role and function:

Advisor to the BOD Appraisal of the board Liaison between internal and

external auditor To review and monitor the

independence and objectivity of the external auditor

Review F/S before authorization of board.

Review the company’s internal financial controls

Review the company’s internal control and risk management systems(if there is no risk management committee)

Review the effectiveness of the IA dept

Review the effectiveness of the audit process Develop and monitor the use of the external auditor to perform non-audit work for the

company Approve the remuneration and terms of the engagement of the external auditor In USA (NYSC) all the listed companies must have an audit committee as per SOX The audit committee reports to the board, and board takes the decision. If case of conflict

between board and committee, committee report to shareholders.

Advantages

Financial statements become more reliable Provide check on the risks of misleading reporting Reduce the possibility of fraud Management letter by external auditor is provided to audit committee then board.

Disadvantages

Delay in issuance of F/S If not expert, wastage of time and resources.


The remuneration committee

A remuneration committee comprises of independent NEDs negotiates and recommends remuneration packages for executive directors or senior managers. Independent NEDs do not have a personal interest in the remuneration structure for senior executives, because they are not remunerated in the same manner as executives. They receive a fixed annual salary.

The need for remuneration committee: o In the past directors set their own salaries. This was a misuse of shareholders’

resources. They rewarded themselves fat cat salary (inequitable salaries). o It was required by means of good corporate governance that there should be

equitable salaries. o Equitable salary means salary on the basis of talent/ competence of directors. o Good corporate governance required REMUNERATION COMMITTEE. Let the salary

be set by neutral people (independent NEDs).

Composition of Remuneration Committee: o Remuneration committee is comprises of solely independent NEDs.

Remuneration of NEDs o Remuneration of Ned is set by board and approved by shareholder in AGM. Their

salary is set according to the felt rate normally. This should be disclosed in the annual report. This enhances the degree of transparency.

o Disclose the salary of EDs in annual report also. o Describe the salary of NEDs in the constitution of the company (AOA). This enhances

the degree of openness.

How to motivate EDs o All the directors should not be treated in the same way. Good corporate governance

emphasizes the point of fairness. Treatment should be equitable. o Remuneration packages should be attractive to attract knowledgeable, skilled and

competitive persons. o The remuneration should be set in such a way that keeps the existing directors

attracted in order to retain them and it has the ability to attract new directors. o The directors’ contract or remuneration should be limited to one year (combined

code), sometimes two years, or 3 years; it depends upon the relationship b/w Company and directors or past history of the directors.

Main duties of the remuneration committee The Higgs Guidance suggested the following duties:

o The committee should agree with the main board, chairman, CEO and other executive directors on the policy for remuneration. The role of the CEO is advisory.

o For PRP, committee should decide the target for performance. o Committee should decide the pension arrangements for each ED. o Committee should design approve the design of any new share incentive plan.


The nominations committee A nomination committee makes recommendations about new appointments to the board. It Comprises of NEDs and Sets the desirable size and the balance of the board.

The need for nomination committee o The process for filling the vacancy on the board or succession planning takes time.

The board should delegate the task to a committee to save the time and resources. o The UK Combined Code states that ‘there should be a formal, rigorous and

transparent procedure for the appointment of new directors to the board’. Such transparency can be established by setting up a nomination committee.

Main duties of nomination committee o To consider skills and knowledge of the members o To consider the diversity (age, sex and skin) of the board o To consider the need of leadership in the company o To consider the need of induction programmes, contracts between directors o To consider the need of succession planning o It has specified role.

Succession planning o Planning in advance for the eventual replacement of key members of the board

when they eventually retire (or in the event of dismissed). o Succession planning applies in particular to:

• the board chairman

• the CEO, and

• possibly, the finance director.


The risk committee

The work of the risk committee should be to satisfy itself that executive management have a suitable system of risk management and internal control in place, and that these systems function effectively. This is another check on executive management.

Risks that a company faces: o Business risks, strategic risks, operating risks o Errors, frauds, losses

Responsibility of board for risk management and risk control: o Make sure that internal controls exist and they are working effectively o Protecting the company and its resources from the risk of external events

Such as damage to assets from fire, flooding, theft, natural disasters etc.

Risk management and internal control should therefore be: o Planned and implemented by management o Monitored by the board

The role of the board and board committees on risk:

Accountable Accountable

Planned and Monitored/Maintained implemented

INTERNAL CONTROLS

>In addition to the internal controls:

Shareholder Board Executive mgt

Internal controls

The board should: >conduct review of internal controls at least once a year. >report to shareholders about review > review should include: --all material controls, financial, operational and compliance controls. --risk mgt system

Internal controls Financial controls

Operational controls

Compliance controls

Risk management

Chapter 4. Board committees of 50 Board responsibilities for the internal control system and risk management:

o The responsibility to review the company’s internal controls and risk management should be carried out by:

• the audit committee, or

• the full board, or

• risk committee, consisting of independent NEDs entirely. o The Combined Code does not suggest the specific way to way to review the internal

controls and risk management. o The guidelines in the Singapore code of corporate governance are similar to the

provisions in the UK Code:

• The audit committee should review the adequacy of internal controls and risk management of the company.

• The audit committee should ensure that review is carried out at least once a year.

• The board should include the comment on the adequacy of the internal controls and the risk management system in its annual report and accounts.

Chapter 5. Directors’ remuneration of 50

Principles of directors’ remuneration

NEDs are paid an annual fee for their services. o Usually a fixed amount. o Based on the estimated number of days that the director will spend with the

company during the year. E.g. attending board and board committees meetings.

Components of remuneration package of EDs: o Remuneration package for ED is part of the director’s service contract. o Remuneration is reviewed regularly each year. o Package is set through the negotiation between individual director and

remuneration committee. o Negotiation occurs when the director first join the company. o Package might be re-structures subsequently at any time. o Package includes:

Salary Bonuses Share option Schemes Pension right Often:

• Free medical insurance

• A company car

• A company aero plane, helicopter and so on.

The amount that a company must offer its directors depends on: o What other companies are paying, and o How many suitable candidates are available.

Remuneration package structures: 1. Basic salary 2. Short- term incentives: bonus 3. Long- term incentives: shares plans 4. Pensions

1. Basic Salary: • The purpose of basic salary is to give a director a guarantees minimum amount of

pay.

• The size of the salaries varies between companies, and directors.

• A lower salary might be acceptable to a director who expects to receive large amount cash bonuses or equity awards.

2. Short-term incentives: Bonus:

• An annual cash bonus for meeting or exceeding target performance levels.

• The nature and potential size of annual bonuses can drive the behavior of senior executives.

• Executives will possibly be much more concerned about short-term targets and annual cash bonuses than about longer-term share incentives and bonuses.


3. Long-term incentives: Share plans:

• Long-term incentives schemes usually are: o Share options or o Fully-paid shares in the company.

• Share options: o A share option gives its holders the right, at a future date, to buy shares in

the company at a fixed price. Buy 20,000 shares in the company at an exercise price of

$6.40. o Share option schemes for senior executives might be the responsibility of

the remuneration committee. o In the UK, the earliest time for that share option can be exercised is three

years after they have been awarded; this is why share options are long term incentives.

o The exercise price for the share options should not be lower than the market price of the shares at the time the share options were awarded.

• Under water share options If the share price falls below the exercise price of the, the options are said to be ‘out-of-the-money’ or ‘under water’. However share options are replaced when they are under water.

Arguments: If the share options are awarded, with the rise in share price both the directors and shareholders benefit. And if it goes down both suffers at the same time. If share options are replaced when they are under water, the directors benefit from the rise in the price but do not suffer when the share price goes down. Conflict of interest arises. The executives are protected against the bad situations.

• Fully-paid shares in the company: o An alternative to share options is the award of fully paid shares in the

company. o This avoids much of the problem of a fall in the share price. o Whereas share options under water have no value at all, fully-paid share

retain some value, even when the share price falls. o In order to award free fully-paid share to executives, the company will buy

its own shares.

• Share plans and performance targets o The award of share options should be conditional on the director or senior

executive meeting certain performance targets. 4. Pensions:

Executives may be members of a company pension scheme. In addition, there may be ‘unfunded’ pension arrangements for individual directors.


Performance- related incentive schemes

Incentives should link rewards for executives with benefits for the company and its shareholders.

Problems: o Profits in the current year might be improved by deferring much-needed capital

expenditure, or by deciding not to invest in new research or development work. o An executive might have much less concern for the long term performance of the

company, partly because short-term incentives are usually paid in cash and partly because the director might not expect to remain with the company for the long term.

o Executive are often protected against the ‘downside’. For e.g. under water share options.

o Reward for the new executive might be due to the decisions taken in the past by the executive’s predecessor. Or vice versa.

o Incentives are criticized for rewarding an executive for doing something that ought to be a part of his normal responsibilities. (Executive recommending the successor to the nominations committee).

A proposed new long-term incentive scheme should be submitted to the shareholders for approval. <The UK Combined Code>

Performance Targets: o Annual Bonuses:

An annual bonus scheme may be the award of a bonus on achieving or exceeding an annual target.

Higher profits do not necessarily mean higher dividends or a higher share price.

If profits are obtained, but investors consider the company to face much higher risks, the share might fall.

The remuneration committee might recommend that bonus should be based on TSR.

TSR (Total shareholder return) is simply the sum of the dividends to the shareholders plus the increase in the share price during the period (or minus the fall in the price of the share.

o Personal Targets: Within an incentive scheme for senior executives, each individual may be

given ‘personal’ non-financial targets for achievement. o Long-Term Incentives:

Long-term incentives schemes for executives may set a target for profitability, possibly over a period of three years.

Why share options an expense: o The award of fully-paid shares in the company is an expense because the company

pays the money to buy the shares, and this spending is for the benefits of its executive directors.

o This is an employment cost. o Employment cost should be reported as an expense in the income statement.

Chapter 5. Directors’ remuneration of 50 Legal Issues:

o It should be a principle of corporate governance that the shareholders of a company should be given full information about the remuneration of the company’s directors.

o The requirement to publish remuneration details varies between countries. o In the UK quoted companies are required by law (the Companies Act) to prepare a

directors’ remuneration report each year.

Chapter 6. Different approaches to corporate governance of 50

Rules-based and principles-based approaches

The main reason for codes of good corporate governance is to help and protect investors. o Investors need reliable information about companies to decide whether to invest in

shares or to sell them. o Investors need to be protected against unethical or dishonest behavior by company

management.

Countries have developed corporate governance codes and practices because they want to attract and keep investment capital, especially from global institutional investors.

o Investment capital helps the country’s economy to develop and its companies to prosper.

o Pressure for better corporate governance has come mainly for two reasons: The collapse of major stock market companies in a major financial centre. Pressure form the institutional investors in the countries with well

developed corporate governance codes or rules.

ICGN – The International Corporate Governance Network: o Formed in 1995 o Members are major institutional investors, companies, banks and other interested

groups. o Its aim is to encourage the development of good corporate governance worldwide. o ICGN commented that governance of a corporation is the key factor which investors

consider when they decide to invest.

Ethics and company performance: o Good corporate governance practices are an application of good business ethics. o Good corporate governance contributes to the efficiency and effectiveness of the

company.

Codes of CG: o Are applied to major stock market companies. o Laws and regulations on CG issues are also mainly applied to stock exchange

companies. o Other companies can normally decide what system of CG they want to comply with,

but they are not required to comply with any established principles or rules.

Rule-based approach: o A rule based approach to CG is based on the view that companies must be required

by law to comply with established principles of good CG. o ADVANTAGES:

Companies don’t have choice of ignoring the rules. All companies are required to meet the same minimum standards of CG. Confidence of the investor might be increased.

o DISADVATAGES: Same rules might not be suitable for every company. Some aspects of CG cannot be regulated easily. E.g. negotiating the

remuneration of directors.

Chapter 6. Different approaches to corporate governance of 50 UK is associated with principles-based approach to CG.

Examples of statutory rules in the UK:

• Mainly small and medium sized companies are required to submit directors’ report and FS to the shareholders each year.

• Audit of FS

• Quoted companies must prepare a director’s remuneration report each year and present to shareholders.

o USA is most associated with rules based approach.(Sarbanes Oxley Act 2002)

SARBANES OXLEY ACT (2002) – SOX: o The SOX introduced corporate accountability legislation. o It required the financial markets regulator and SEC to issue rules to implement some

parts of legislation. o PROVISIONS:

PCAOB • Law set up a regulator (public company accounting oversight

board). The role of the regulator is to inspect and monitor the accounting firms.

• It can take disciplinary action against the accounting firms. For example. Working papers: a firm should maintain W/P for at least 7 years.

CEO/CFO certification (sec 302 of the Act) • All listed companies in the US are required to include in their annual

and quarterly accounts a certificate to SEC. This certificate should be signed by CEO and CFO.

• CEO and CFO should certify the appropriateness of the FS. In case of material misstatements (inaccuracy) all the bonuses awarded to CEO/CFO will be forfeited.

Assessment of internal controls (sec 404 of the Act) • Management and directors are responsible for establishing and

maintaining adequate internal controls.

• Auditors are required to prepare an ‘attestation report’ on the company’s assessment of its internal control system.

• Companies must disclose any material weakness in their internal control system. If more than one material weakness exists, a company is not allowed to conclude that its internal control system is adequate.

• A report on internal control must be included in the company’s annual report to shareholder.

Loans to executives • The Act prohibits companies (other than banks) from lending money

to any directors or senior executives. Insider dealing

• Very strict on insider dealing.

• Directors or senior executives are not allowed to trade in shares of their company during any ‘black-out period’.

Audit committees • Listed companies must have an audit committee, consisting entirely

of independent NEDs.


Non-audit work by auditors • Non audit services are prohibited.

• For example, book keeping for the client, valuation services or any management functions for the company.

Protection for whistleblowers • A whistle blower is an employee of the company who reports,

through a channel of communication other than his direct supervising manager, suspected fraud or illegal activities in the company.

• The Act provides protection for that employee preventing company from taking action against employee, such as terminating his employment. For e.g. Enron

Rotation of partners (audit firm) at least 5 years. Firm should ensure quality of audit (quality control procedures).

MAJOR DRAW BACKS OF ACT • It is very rigid. Major draw back is its nature as rules based

approach.

• Many companies moved to LSE except other companies which were attracted by its discipline. On the whole it ended up in loss.

• Relationship between auditor and client got worse. Due to the limitation of non audit services provided by the audit firm.

• Overcame only some rules based on ENRON scandal, other fraud situations were not covered.

• Controls over financial reports only.

• Code of ethics especially for finance directors.

Principles-based approach o It is based on the view that a single set of rules is inappropriate for every company.

Circumstances and situations differ between companies. The circumstances of the same company can change over time.

o It is therefore argued that CG should be applied to all major companies but code should consist of principles not rules.

o This approach is sometimes called comply or explain. Either the company has complied with all the provisions or explains their non-compliance with any specific provision.

o ADVANTAGES Flexibility Differences can be

understood. There is no best way. Contingency approach.

Bureaucracy reduces Effective utilization of

resources Requires no revision Room for explanation

o DISADVANTGES Companies do not follow

because not mandatory. Subjectivity issues Lack of comparability

unavailability of benchmark.

Directors are not matured.

Insider system and outsider system


Insider system

Company is owned and controlled by a small number of major shareholders. Family companies are perhaps the best example of insider structures. Agency is not really an issue with families because of their direct involvement in management. Family companies also depends on family unity, this breaks down, governance may become very

difficult.

Advantages

No agency problems. Agency cost will be reduced. Immediate decisions. Better understanding due to less diversification.

Disadvantages

Lack of accountability (self review, apna ehtisab khud karna) Poor corporate governance Lack of skills Violation of rights of minority

Outsider system

Where shareholding is widely dispersed and there is the manager-ownership separation.

Advantages

Shareholders have voting rights that they can use to exercise control. More governance, minority shareholders are protected.

Disadvantages

Agency problems and significant cost of agency. More diversification It takes time to make decision


Brief history of corporate governance in the UK

THE CADBURY CODE (1992) Best practices

The Cadbury committee in the UK was set up because of:

o Lack of the trust of shareholders in FS o Globalization (trading in local and international stock markets) o Scandals and collapses o Difficulties in the relationship between auditors and board of directors.

Cadbury focuses on:

o BOD o Auditors o Shareholders o Other stakeholders (indirectly)

Corporate governance responsibilities

o The directors are responsible for the preparation of FS. o Auditors provide a check on particular FS, in short provide external objective check

on FS o Shareholders are informed/linked with company via FS(direct link) o Other stakeholders are indirectly linked with company via FS o CCCG encourages directors to adopt these provisions/ rules in the company.

Provisions

o The board should meet regularly. o There should be at least three NEDs on the board, a majority of whom should be

independent. o The major matters (acquisition and disposals of assets, mergers) should be referred

to the board. o Responsibility and powers of CEO and chairman should be separated. o Audit committee (key board committee) should be formed. It provides liaison

between internal/external auditor and the board. The committee should also review half yearly and annual statements.

o Directors’ service contract should be disclosed in the annual report. o Balance and understandable assessment of the company’s going concern and the

effectiveness of its internal controls should be disclosed and mentioned in the annual report.


THE GREENBURY CODE (1995) Directors remuneration

The directors’ remuneration should be set by the remuneration committee, comprises of solely independent NEDs, and it should be disclosed in the annual report.

Directors’ service contract should be limited to one year. It is advisable. Salary of ED is set by remuneration committee (NEDs). Salary of NEDs should be decided by full board through flat rate and should be subject to

shareholders approval.

THE HAMPEL REPORT (1998) Best practices

It puts a more emphasis on principles based approach. There should be a room for explanation in case of any non-compliance with the

code/principle. Every company should disclose/present/report its corporate governance structure in the

annual report.

THE TURNBULL REPORT (1999) Risk mgmt & internal controls

Established by ICAEW Risk management and effective internal controls are the responsibility of the board. The board should take measures for the future significant risks Risk and controls should be reviewed regularly Shareholders should be informed about risks and the system for managing risk (i.e. risk

management) The internal controls should be:

o embedded in the operations of the company and should form part of its culture o Should be able to respond quickly to changing risks to the business from factors

within the company and its business environment. The sound system of internal controls reduces, but cannot eliminate, the possibility of:

o Poor judgment in decision making o Human error o Management overriding controls o Unforeseen events and circumstances o Control processes being deliberately circumvented by employees and others.

Chapter 7. Governance: reporting and disclosures of 50

THE HIGGS REPORT (2003) Non-Executive Directors

Its title was ‘review of the role and effectiveness of the NEDs’ At least one half of the board should consist of independent NEDs The chairman should be independent at the time of his appointment A CEO should not go on to become chairman of the company One independent NED should be appointed as senior independent director NED should have suitable skills and experience NED should spend the proper time at the board as required by them All new NEDs should be given induction after their appointment.

THE SMITH REPORT (2003) Audit committee

Established by FRC (financial reporting council) Purpose was to make audit committees effective Liaison b/w internal auditor and external auditor Review FS before the authorization of the board One or two members in the audit committee should financial expert.

THE REVISED COMBINED CODE (2003) UK (LSE) The code is consisting of:

1) Cadbury (1992) Best practices 2) Greenbury (1995) Directors’ remuneration 3) Hampel (1998) Best practices 4) Turnbull (1999) Risk management and internal controls 5) Higgs (2003) NEDs 6) Smith (2003) Audit committee

The Higgs report and Smith report early in 2003, a revised version of the Combined Code

was published later in the same year. The Code now consists of:

1) Main principles 2) Supporting principles 3) Detailed provisions

The code is now reviewed regularly by the financial reporting council.


International codes and principles of corporate governance

1) The OECD Principles of Corporate Governance 2) The ICGN Statement of Global Corporate Governance Principles

The main aim of the international statements of principles is to raise standards in the ‘worst’ country towards the standards that already exist in the ‘best’ country.

The result of encouraging better standards of corporate governance should be that:

Better governance will attract more investment form global investors Companies will benefit from more investment finance, to increase their profits National economies will benefit form having strong and profitable companies.

The OECD Principles

The OECD Principles are published by the Organization for Economic Co-operation and Development

Members of the OECD are governments of 30 economically-developed countries

Objectives:

To develop the world economy To assist government of countries to improve the legal and regulatory and institutional

framework for corporate governance To provides guidance to stock exchanges, investors and companies on how to

implement best practices

Contents:

1) Rights of the shareholders 2) Equitable treatment of shareholders 3) Rights of stakeholders 4) Disclosure and transparency 5) Responsibilities of the board

1) Rights of the shareholders

Right to transfer the ownership of their shares Right to receive regular and relevant information about the company Right to vote at general meetings Right to receive share in the company’s profits Right to remove the directors from the board.

2) Equitable treatment of shareholders Equitable treatment of all shareholders, including minority and foreign

shareholders Within the same class of shares, all shares should carry the same rights


Minority shareholders should be protected against unfair actions taken by majority shareholders

Insider trading should be illegal Restrictions on cross-border voting should be eliminated Directors should disclose their personal interests in the transactions with

company. 3) Rights of the stakeholders

Shareholders interest should be protected and they should have right to access relevant information.

There should be co-operation between companies and their stakeholders ‘in creating wealth, jobs and the sustainability of the financially sound enterprise’.

4) Disclosures and transparency Openness Financial, non-financial, relevant and material information should properly be

disclosed (voluntary or mandatory) in the annual report. 5) Responsibilities of the board

To take the strategic decisions, direction of the company (to set the vision) and making policies

To protect the rights of shareholders and other stakeholders To provide relevant information to shareholders and stakeholders.

OECD is not solely the corporate governance; it is the one of the pillars of the corporate governance.

Chapter 7. Governance: reporting and disclosures of 50 The ICGN Principles

It is the voluntary association of major institutional investors, companies, financial intermediaries and other organizations

Its aim is to improve corporate governance practices around the world. It is consistent with the OECD but it is more specific about the issues that investors will take

into account in deciding how (and where) to invest It gives more emphasis than the OECD to the right of investor to participate actively in

corporate governance in the companies they invest.

Contents:

1) Role of the board 2) Shareholders 3) Audit and accounts 4) Ethics and stakeholders

1) Role of the board

The board structure should be dependent on national model o National model: according to the law and culture of the country. Principles

based approach. Chairman and CEO should be separated Former CEO should not become chairman immediately Rotation of directors after every 3 years Relevant skills, knowledge and experience of the directors Formal appraisal of the board.

2) Shareholders Rights to remove or/and elect directors Right to receive the information In case of inequitable treatment they can take actions.

3) Audit and accounts They must excel and foster. They should move towards more truth and fairness They should compare the financial statements with the industry benchmark Audit committee should review accounts.

4) Ethics and stakeholders Rights of the stakeholders should be protected Company should maintain a long term and productive relationship with its

stakeholders Code of ethics (there should be statement of code of ethics for company

employees).

Limitations of international codes or principles:

It is not mandatory, then why to waste resources Based on the development of the society and not easy to implement in developing

societies Culture specific (UK and USA have different cultures).


General principles of disclosure

1) Transparency and disclosure Transparency

Transparency in stock markets and other financial markets mans that information about conditions in the markets is clear and well understood.

Disclosure Disclosure means making information available, so that there is transparency.

2) Principles of disclosure and communication

The information should be : o reliable o understandable o timely o equally available to all investors o made available by convenient channels of communication

The opportunities for exploiting confidential information to make a personal profit should be minimized.

Corporate governance reporting There is no best practice of corporate governance which suits all companies. It’s a principle based approach and vary from organization to organization and country to country.

Every company describes its corporate governance style in its annual report under the statement of compliance.

Statement of compliance includes:

The board o Size o Balance

About the directors Vision and mission Internal audit Audit committee

o Size o Balance

Training programmes Meetings

o Regularity External auditors Reporting


Corporate social responsibility CSR

Definitions:

CSR is the Obligation of the organization to satisfy the expectations of the society. CSR is a commitment to improve community well being through discretionary business

practices and contribution of corporate personnel.

CSR is based on the concept that company is a citizen of the society in which it exists and operates.

As a corporate citizen of society, it owes the same sort of responsibility to society at large that other citizens should owe.

There is social contract between a company and society in which it operates.

Principles:

CSR has five main aspects.

1) A company should operate in an ethical way and with integrity. 2) A company should treat its employees fairly and with respect. 3) A company should demonstrate respect for the basic human rights.

o Non-tolerance for Child labour 4) A company should be a responsible corporate citizen in its community.

o Invest in local communities, such as local schools or hospitals 5) A company should do what it can do for the sustainability of the environment for future

generations. o Reducing pollution of air, land or rivers and seas o Recycling waste materials.

CSR and stakeholders

A company has responsibilities not only to its shareholders, but also to its employees, all its customers and suppliers, and to society as a whole.

CSR impact on company strategy

There has been a significant increase in public awareness if environmental problems, such a global warming, pollution, energy consumption and the potential for natural disasters. To remain successful in business, companies must respond to changes in the expectations of its customers.

Company’s steps to implement CSR:

It should: 1) decide its code of ethical values, and possibly publish these as code of ethics. 2) establish the current CSR position and future CSR position. 3) develop realistic targets and strategies of CSR. 4) implement these strategies 5) identify key stakeholders (employees, pressure groups, customers) 6) communicate the CSR achievements to the key stakeholders. This is the main purpose of CSR

reporting.

Chapter 7. Governance: reporting and disclosures of 50 CSR reporting / Social and environmental reporting / Sustainability reporting

In some countries, listed companies have published annual reports on their CSR. These reports have been voluntary. Published separately from annual report and accounts. The purpose is to inform key stakeholders about CSR policy achievements. CSR reports includes:

o Health and safety issues o Environmental issues o Employee issues o Social issues o Educational issues o Investments by company in local community projects

CSR and institutional investors

There are some ‘ethical investor’, including some investment institutions that choose to invest only in companies that meet certain minimum standards of social and environmental behavior.

In UK, the National Association of Pension Funds (NAPF) stated that CSR is not the part of CG but it is issue for the management of a company rather than its governance.

Why to be socially responsible?

Increases sales and market share Strengthen brand positioning (how customer sees our product) Enhance corporate image (how labour sees our organization) Increase ability to attract, motivate and retain employees Decrease operating cost (govt reliefs, tax reliefs, advertising expenses reduce due to open

marketing) Increase appeal to investors and financial analysts.

Arguments against CSR

It is the responsibility of directors to act in the best interest of the shareholders. If the directors are not acting in the best interest of the shareholders it is the theft of agency

cost. The company pays corporation tax, rest of the things are the responsibility of govt. Company has to reduce its profitability and sometimes company has to shut down its

profitable operations. o For e.g. raw material changed due to marine life/health problems.

Accountability problems CSR activities are non-profit activities. Managers/directors are not accountable for expenses

incurred in CSR activities. Accountability of directors is reduced. It can arise the chances of manipulation.

Chapter 7. Governance: reporting and disclosures of 50 Strategies of CSR

Different companies have deferent strategies.

Pro-active It always starts with the person who is standing in the mirror. Taking step by own before complain of society.

Reactive Taking steps after complain of society. Sometimes society claims, sometimes govt. (so motto actions)

Defense Justify actions wrong actions. What you have done, society is not benevolent.

Accommodation Compensating for what we have done wrong by providing alternatives.

ACCA P1 Corporate Governance

Business

Transcript of ACCA P1 Corporate Governance