CORPORATE GOVERNANCE JUNE 2008 SUGGESTED ANSWERS AND EXAMINER S COMMENTS

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1 IMPORTANT NOTICE CORPORATE GOVERNANCE JUNE 2008 S AND EXAMINER S COMMENTS When reading these answers, please note that they are not intended to be viewed as a definitive model answer, as in many instances there are several possible answers/approaches to a question. These answers indicate a range of appropriate content that could have been provided in answer to the questions. They may be a different length or format to the answers expected from candidates in the examination. SECTION A (Compulsory answer all parts of this question) 1. (a) Outline the content of the Association of British Insurers (ABI) principles for executive remuneration. Since the Greenbury Report (1995) there has been significant attention focused on developing policies for executive remuneration. The ABI has made recommendations now on board responsibilities in this area. Boards are responsible for adopting remuneration policies and practice as follows: Boards are responsible for adopting remuneration policies and practices that promote the success of the company by creating value in the longer-term. Remuneration policies and practices should be clearly aligned with corporate objectives and business strategy, and should be reviewed regularly. Remuneration committees should maintain a constructive and timely dialogue with the company's major institutional shareholders and with the ABI on matters relating to senior executive remuneration. Executive remuneration should be set at levels that retain and motivate, but benchmarks used for setting targets and rewards should be used with caution. Executive remuneration should be linked to individual and corporate performance through graduated targets that align the interests of the executives with those of shareholders. Shareholders will not support alignment that entitle executives to rewards that are not justified by performance. From a theoretical perspective, these guidelines help the company to reduce the agency problems arising between company management and their shareholders. Page 1 of 10

2 (b) Explain the importance of training programmes for directors. Since the Cadbury Report (1992) there have been a series of recommendations on training both for executive and non-executive directors. The idea of a 'learning board' has become important, with boards being expected to keep up-to-date with the latest developments. The ICSA study text (2007) discusses the induction process for new directors, and explains the need for training and professional development. For good corporate governance and transparency, regular training is essential. The Combined Code (2006) states that: "The board should be supplied in a timely manner with information in a form and of a quality appropriate to enable it to discharge its duties. All directors should receive induction on joining the board and should regularly update and refresh their skills and knowledge" (A5, p.8). The Combined Code emphasises the need for companies to provide resources to directors for developing and updating their knowledge and capabilities. For example, directors should have access to independent professional advice at the company's expense where they judge it necessary to discharge their responsibilities. (c) Outline the role of the nomination committee in ensuring good corporate governance practice. For boards to act in an accountable and transparent way, the appointments process needs to be transparent. Since Cadbury, listed companies have been recommended to set up a nomination committee which assists the board in appointing new directors. It is comprised of a majority of non-executive directors. The ICSA study text (2007) discusses the role of the nomination committee, and raises issues relating to weaknesses in the system of board nominations. The Combined Code (2006) states: "There should be a formal, rigorous and transparent procedure for the appointment of new directors to the board" (A.4, p.7). The Combined Code outlines the need for a nomination committee which will lead the process for board appointments and make recommendations to the board. The nomination committee should evaluate the balance of skills, knowledge and experience on the board. It should then prepare a description of the role and capabilities required for each appointment. (d) Discuss the corporate governance recommendations which have been made in the area of board performance evaluation and appraisal. The Combined Code (2006) makes recommendations on board performance evaluation and appraisal as follows: Page 2 of 10

3 "The board should undertake a formal and rigorous annual evaluation of its own performance and that of its committees and individual directors"(a6, p.9). Further, the Chairman should act on the outcome of the performance evaluation by acknowledging strengths and weaknesses among board members and, where appropriate, proposing new members/seeking resignations. The Combined Code (provision A.6.1) states that: "The board should state in the annual report how performance evaluation of the board, its committees and its individual directors has been conducted. The non-executive directors, led by the senior independent director, should be responsible for performance evaluation of the Chairman, taking into account the views of executive directors". The Higgs Report (2003) recommended that boards should undergo evaluation of their corporate governance performance. Recent evidence suggests that increasingly companies are starting to bring in an external facilitator to helping the process of board performance appraisal. Furthermore, there is a growing quantity of disclosure on board performance and self-evaluation in annual reports. (e) Distinguish between the roles of Chairman and Chief Executive. A company's Chief Executive Officer (CEO) is primarily responsible for executive management, and for setting the company's strategic position. The Chief Executive should lead and direct the executive management of the company. The CEO is accountable to the board of directors for the way in which the company is run, and for its performance. It is the Chairman's role to steer the company by managing the board of directors and setting its agenda. Since the Cadbury Report (1992) best practice guidelines in the UK and around the world (except until recently in the US) have recommended the roles of Chairman and Chief Executive to be held by different people. This is to avoid unfettered power being held by an individual, and to allow two individuals to devote the necessary time and effort to the very different work of the two 'job descriptions'. The Combined Code (2006) states: "There should be a clear division of responsibilities at the head of the company between the running of the board and the executive responsibility for the running of the company's business. No one individual should have unfettered powers of decision" (A.2, p.4). (f) How do the principal features of the South African King Reports I and II differ from those of the UK Combined Code? Chapter 13 of the ICSA study guide (2007) deals with international aspects of corporate governance. In this chapter there is a discussion of the two King Reports, and their significance for corporate governance. Page 3 of 10

4 The reports differ significantly from other corporate governance codes and sets of principles, for example the Combined Code, by focusing more specifically on issues relating to responsibility. In addition, the Reports distinguish between responsibility and accountability. There is a far greater emphasis on the importance of stakeholders to corporate governance in the South African principles than in those of other countries. In this way, the South African approach to corporate governance may be seen to be ahead of its time. (g) Analyse the ways in which narrative reporting contributes to corporate transparency. Narrative reporting contributes to corporate transparency by providing coverage of nonfinancial, as well as financial, aspects of performance for stakeholders. Furthermore, narrative reporting makes (or should if properly produced) financial information more accessible to a wider range of users. In addition, narrative reporting provides the opportunity for companies to discuss their performance in a forward-looking manner rather than the traditionally historical approach to financial reporting. A statutory requirement for a Business Review has now been introduced into UK law as a result of an EU directive. This, in some respects, has replaced the operating and financial review (OFR), which was originally encapsulated in the modern company law review as a mandatory statement, but was dropped in (h) Explain what constitutes a stakeholder engagement programme, and why some companies have broadly adopted such an approach. The needs and requirements of stakeholders have become increasingly important in corporate governance in recent years as views of corporate governance have moved away from a solely shareholder-centric approach towards a more stakeholder-centric approach (Solomon, 2007, for example). One of the ways in which companies learn about their stakeholders' needs and engage directly with different stakeholder groups is to hold focus group meetings and to develop a programme of stakeholder engagement. Further details on the role of stakeholders in corporate governance are available in the ICSA study text (2007). (i) Outline ICSA's guidelines on electronic communications with shareholders. Transparency is one of the cornerstones of good corporate governance. Where information asymmetry exists naturally between companies and their shareholders, any means of improving communications should be embraced. It has been argued that such communications could be enhanced by the greater use of electronic methods such as and websites. Page 4 of 10

5 Students should have outlined the ICSA guidelines on electronic communications with shareholders. For full marks they should have commented on why improved dialogue between companies and their shareholders is desirable and important, showing how electronic communications can help to achieve this. They may have referred to the Combined Code's emphasis on improving dialogue. (j) Briefly outline the types of risk which commonly affect listed companies. The treatment of risk through an efficient system of internal control is an essential component of good corporate governance. The categories of risk which commonly affect businesses may be summarised as follows: Business risks: risk of demand/sales falling, obsolescence risk, market risk (competition). Financial risks: interest rate risk, currency risk, credit risk. Legal risks: compliance risk, regulatory risk. Reputational risk: social and environmental risks, governance risk. EXAMINER S COMMENTS Section A was a good indicator of the likely quality of the rest of the paper in most, though not all, cases. Question 1(b) on training and Question 1(g) on narrative reports were poorly answered by all but the best candidates. Question 1(d) on board evaluation resulted in many candidates mentioning the remuneration committee and the measures for paying bonuses or share options, rather than answering the question set. Question 1(h) was read as 'shareholders' by far too many candidates, and the Code requirement putting onus on institutional shareholders was therefore frequently referred to. SECTION B (Answer THREE questions from this section) 2. John Walker is a well-known entrepreneur who has spent the last 15 years building up his own publishing business. From a small start, publishing the work of friends and family, John has managed to expand his company so that it has become a competitive publishing house. Until now, the company has remained private. John has identified several opportunities for the company to expand and become more international, but has realised that he needs substantial external funding. He has therefore decided to go public, and has managed to obtain a full listing on the London Stock Exchange. However, John is having problems adjusting to running a company which has external shareholders and non-executive directors (NEDs), and which has to comply with the Combined Code. In a recent radio interview, John said: "I'm an entrepreneur. My head is bursting with ideas for developing my business. When I have an inspirational idea, I need to get on with implementing it straightaway. All this corporate governance 'stuff', and Page 5 of 10

6 having to fill my boardroom with independent NEDs, is tearing the soul out of my company. It is slowing down decision-making". John has asked you, as the new Company Secretary to the organisation, to highlight the benefits of several important governance mechanisms. Write a report for John and the board explaining the benefits of a substantial proportion of the board being independent NEDs. (20 marks) A common problem expressed by entrepreneurial business leaders (for example, Richard Branson) is that corporate governance codes of practice result in slowing down decisionmaking. The processes and mechanisms required to ensure accountable boards of directors mean that snap decisions cannot be implemented as easily as perhaps they could have been before the Cadbury Report in By gaining a listing, a company suddenly has to comply with corporate governance codes of practice, and must take account of the needs of shareholders and stakeholders alike. This question required the candidates to explain the reasons why non-executive directors contribute to boardroom decision-making, and to provide a persuasive argument for their usefulness as monitors and advisors to boards. As explained by the Higgs Report, and the Combined Code, NEDs have a multiple function. They have to assist the board in strategic decision-making, by providing an independent and hopefully objective viewpoint on major strategic decisions. They also have to assist in scrutinising the work of the board. They have an important 'people' role in the nomination and remuneration committees, respectively. In these committees they determine the remuneration policy and the remuneration of the executive directors, and they ensure a fair process for recruiting directors onto the board. NEDs also play an important role in risk management within the company, being involved at the heart of the internal control system on the internal audit committee and any risk committee the company may have. In the words of the Combined Code (2006, p.3): "As part of their role as members of a unitary board, non-executive directors should constructively challenge and help develop proposals on strategy. Non-executive directors should scrutinise the performance of management in meeting agreed goals and objectives and monitor the reporting of performance. They should satisfy themselves on the integrity of financial information and that financial controls and systems of risk management are robust and defensible. They are responsible for determining appropriate levels of remuneration of executive directors and have a prime role in appointing, and where necessary removing, executive directors, and in succession planning" For NEDs to carry out their roles effectively it is important that they are independent, in that for example they do not hold shares in the company and do not have any familial ties with directors on the board. Candidates needed to summarise the need for, and characteristics of, independence in order to obtain a clear pass. The Higgs report recommended (2003) the appointment of a Senior Independent Director (SID) to act as a conduit for institutional investor concerns, a champion for Page 6 of 10

7 shareholders, effectively. Candidates should have mentioned this important recommendation, and explained that a SID can help to align the interests of shareholders and management, thus reducing agency problems and their associated costs. The issue for students to highlight was that now the company has external shareholders in significant proportion, given its new listing on the LSE, then accountability to these shareholders becomes essential. Although it is clear that the roles of strategy, scrutiny, people and risk are extremely 'invasive' from the point of view of executive management, they are necessary to provide objective decision-making which is in the interests of shareholders and shareholder wealth maximisation. In this way, NEDs help to align the interests of shareholders and management in order to reduce agency costs. EXAMINER S COMMENTS Poor candidates assumed compliance with the Combined Code was a given fact, whereas better candidates addressed why complying with the Code was desirable. Too many answers unfortunately did not contain advice for John Walker, and merely made comparisons between him and Robert Maxwell and Asil Nadir. The best candidates addressed their answers to the required audience i.e. John Walker and the board of directors, whereas poor answers merely provided a general history of corporate governance. Almost all candidates assumed that the first sentence of the final paragraph required an answer of a page or more, highlighting "the benefits of several important governance mechanisms". In order to obtain a good mark in this question, candidates needed to concentrate on the question requirement i.e. a report on the benefits of NEDs. 3. Explain the ways in which minority shareholders may be treated inequitably by companies. (20 marks) Minority shareholders are those whose combined shareholdings are insufficient to affect resolutions by the company in a general meeting. The level of protection afforded to minority shareholders by law differs between countries. The UK has strong legal protection for minority investors, but many emerging market economies have lower levels of investor protection. Research has shown the existence of minority shareholder wealth expropriation by majority shareholders (often founding family members). Difference classes of shares instituted by majority shareholders imply that minority shareholders can have fewer rights to dividends and to voting. The ICSA study text (2007) provides an excellent case example examining the need for equitable treatment of minority shareholders (Case 6.6). The OECD Principles (2004) stress the need to treat all classes of shareholders equitably. The European Union is currently examining ways of improving shareholder Page 7 of 10

8 rights within EU states, as many countries have different classes of shareholder with unequal rights, for example voting rights being far removed from 1 share: 1 vote. EXAMINER S COMMENTS Question 3 was not well answered on the whole, and much detail was provided on institutional shareholders, either as the subject or in contrast to retail shareholders who were seen as the minority shareholders. Many candidates forgot, or took as given, the legal protection of equality for transfers, dividends, pre-emption rights and takeovers. 4. You have applied for the position of Company Secretary in a large listed company. As part of the interview process, you have been asked to prepare a 20-minute presentation, which you will give to the board, entitled "How I will ensure that Company X meets the Governance Challenge". Provide a summary of this presentation for distribution to the board. (20 marks) The Company Secretary's role in corporate governance has been emphasised in the Combined Code and in the South African King II Report. The Combined Code states that the Company Secretary is responsible for: Ensuring good information flows within the board and its committees, and between executive management and non-executive directors (NEDs). Advising the board (through the Chairman) on all corporate governance matters. Being available to give advice and support to individual directors. A list of the Secretary's tasks and responsibilities are given in the study text as follows: To assist the Chairman of the board with preparing for, conducting and reporting the outcome of board meetings and general meetings of the company, taking minutes at the meetings. Some involvement in counting proxy votes from shareholders for AGMs as all results are sent to the Company Secretary. The Secretary is responsible for assisting the Chairmen of the committees of the board. The Secretary may have some involvement with external and internal auditors, and should be able to offer advice on risk management issues. The Secretary may be responsible for arranging insurance cover. EXAMINER S COMMENTS The answers to Question 4 were disappointing, and approximately half of the answers only included a general outline of corporate governance. Very few candidates managed to do more than duplicate the ICSA list of corporate governance duties. Page 8 of 10

9 5. Although an increasing number of companies are now producing separate social and environmental reports, sustainability reports, or some form of corporate social responsibility report, there are still many listed companies which do not disclose this type of information separately. You are the Secretary of a listed company in the mining industry. Until now, your company has chosen not to produce a separate report covering environmental, social and governance (ESG) information, and has only included ESG information in the annual report. The board has now decided to move to preparing a separate sustainability report which will disclose this type of information. It has asked you to write a paper summarising the optimum structure and content of this new report. (20 marks) The study text provides useful information on the optimum content of social and environmental reports based on current examples of best practice, as well as on guidelines for example the Global Reporting Initiative (GRI). There have been many attempts in the literature and in practice to develop a system of reporting, or a framework, which accommodates social and environmental reporting. One of these is the concept of the triple bottom line (TBL). The Association of British Insurers (ABI) produced guidelines on ESG reporting in As well as providing useful guidance for companies, this set of guidelines demonstrates a significant user demand for information on ESG issues. In a free market, such as that in the UK, such a demand needs to be met by corporate disclosures. Although companies produce a range of non-standardised, voluntary disclosures in both the annual report and in separate reports on corporate social responsibility information, the ABI, inter alia, have produced guidelines on the contents of reporting in these areas. However, companies tend to try and disclose information on social, ethical and environmental issues which relate to their business activity specifically, and which represent material risks according to the internal control system of risk assessment. It is therefore difficult to be prescriptive about content as every company has an individual risk profile, especially in relation to 'soft', qualitative, non-financial risks such as climate change risks. Despite the difficulties in prescribing content, the ABI guidelines, originally produced in 2001 and republished in 2007, have been taken up broadly by listed companies. The latest version of the guidelines requires ESG reporting in three areas: ESG risk assessment by the board. ESG risk: policies and procedures. Remuneration and ESG issues. Page 9 of 10

10 EXAMINER S COMMENTS In general, the answers to Question 5 were poor. Very few candidates referred to the details of the question to illustrate their answers, i.e. the mining situation, and provided little detail beyond a few references to wasting assets. 6. Describe the characteristics and mechanisms required for a company to operate a sound system of internal control. (20 marks) A company's system of internal control is paramount to the success of the company in avoiding unnecessary or excessive risks. It is possible that the materialisation of significant risk could wipe out a company's profitability and liquidity. It is essential that companies analyse the risks which they are susceptible to, and assess the potential impact of these risks in order to construct an effective risk management system with appropriate risk management tools. It is also essential for companies to monitor and evaluate the effectiveness of their risk management systems. All these stages of internal control were described in full in the Turnbull Report, which represented the first attempt to make implicit systems of internal control explicit. The basis of the Turnbull Report was to provide a framework, based on best practice in UK listed companies, of effective internal control which could be modified and implemented by individual listed companies. The revised Turnbull Report (2005) changed little of substance from the original, but placed more focus on the evaluation of risk management systems and on the disclosure of information relating to the company's system of internal control. This issue was rather overlooked in the first version of the Turnbull Report. EXAMINER S COMMENTS A large number of candidates listed the SPAMSOAP, and perhaps one or two other points, without providing an explanation of, for example, the audit committee or the independent external auditors. However, the remainder of the candidates generally gave reasonable answers to obtain a pass mark. The scenarios included here are entirely fictional. Any resemblance of the information in the scenarios to real persons or organisations, actual or perceived, is purely coincidental. Page 10 of 10