Chapter 19 Corporate governance
Learning objectives Understand the importance of corporate governance as a system by which companies are directed and controlled, and describe the impact on stakeholders when corporate governance fails. Explain the difference between a broad concept of corporate governance on behalf of many stakeholders, compared to the UK narrow focus of corporate governance on behalf of shareholders. Evaluate the role of corporate governance as an ex-ante mechanism to monitor corporate behaviour compared to ex-post external audit monitoring. Appreciate different models of corporate governance. Describe and discuss the recommendations included in the in the UK Corporate Governance Code. Appreciate balance on the board, board committees and current developments relating to UK corporate governance. Understand the reporting entity s obligation to disclose corporate governance practice and appreciate the purpose of comply or explain disclosures. Describe and discuss the recommendations of the UK Stewardship Code and evaluate the likelihood of investors effectively monitoring boards of directors. Appreciate that governance mechanisms operate in different types of entity, including in audit firms. 2
Corporate Governance: Definition Corporate governance is the system by which companies are directed and controlled. Boards of directors are responsible for the governance of their companies. The shareholders role in governance is to appoint the directors and the auditors and to satisfy themselves that an appropriate governance structure is in place. The responsibilities of the board include setting the company s strategic aims, providing the leadership to put them into effect, supervising the management of the business and reporting to shareholders on their stewardship. The board s actions are subject to laws, regulations and the shareholders in general meeting (UK Corporate Governance Code, 2012, p. 1). 3
Two mechanisms for monitoring Corporate governance is one mechanism for monitoring an agent s (director s/management) progress in meeting the needs of shareholders to ensure company management is acting in the best interests of their principals; this is known as ex-ante monitoring. Auditing is also a mechanism for monitoring corporate activity at the end of a defined period of time, once several executive decisions have been implemented; this form of monitoring is sometimes referred to as ex-post monitoring, which refers to assessing the quality of the results once the executive decisions have been taken and their effects realized. 4
Models of corporate governance In broad terms, good governance refers to the framework of rules and practices by which those who control a company or organization ensure that they act with integrity and are accountable, fair and transparent to stakeholders who have a relationship with the entity. For all models and concepts, it is important always to remember that for corporate governance mechanisms to be effective, their role is to oversee the executive and therefore must be separate from the day to day operational management of the entity. The systems by which companies are directed and controlled will vary depending on the type of the organization and the jurisdiction in which it operates. Different jurisdictions have different legal, political and cultural systems which will determine how corporate governance is explicitly or implicitly regulated. 5
UK Model of Corporate Governance The UK model is based on the underlying concepts of accountability, transparency, probity and focus on the long term success of the company. Over two decades, the FRC in the UK has published a number of evolving iterations of its corporate governance code. The Code is not a rigid set of rules. It consists of principles (main and supporting) and provisions. The listing rules require companies to apply the main principles and report to shareholders on how they have done so. The principles are the core of the Code and the way in which they are applied should be the central question for a board as it determines how it is to operate according to the Code. The UK model of corporate governance has at its roots, the enduring underlying approach of comply or explain. 6
Comply or explain In practice, an alternative course of action to that of following a provision of the Code may be justified where the Board assess that good governance can be achieved. Where this is the case, the directors are required to explain to shareholders, in the annual report and accounts, the circumstances and rationale for not following the provision and illustrate how the alternative practice is consistent with the related principle of the Code and will contribute to good governance. This comply with the Code or explain to shareholders approach is seen as a flexible way of ensuring good corporate governance. 7
UK v US Corporate Governance Current UK Code provides that roles of chairman of the Board and CE should not be exercised by the same person. In US, role of CE has retained a powerful influence over direction and control of companies. US response to corporate collapses such as Enron, was statutory regulation through the Sarbanes-Oxley (SOX) Act (2002), which focuses on strict ex-post audit monitoring of USlisted companies, plus legislation by SEC to scrutinize and monitor executive remuneration more closely. But, after the recent financial crisis, the US has reacted with a further wave of legislation and more SEC proposals. But separation of chairman and CE is now encouraged by SEC and is now required for certain US entities that received state assistance in the aftermath of the financial crisis. 8
International models of corporate governance EU legislation requires EU listed companies to identify the CG code used and to adopt a comply or explain approach to CG disclosures. But, in 2013, the EU Commission initiated a roadmap: Enhancing the EU Corporate Governance Framework, and identified an evaluation of the functioning of the comply or explain principle revealed considerable shortcomings OECD has issued CG principles intended to assist national governments and regulators in developing effective CG guidance: Ensuring the basis for an effective CG framework The rights of shareholders and key ownership functions The equitable treatment of shareholders The role of stakeholders in corporate governance Disclosure and transparency, and The responsibilities of the board. 9
UK CG Code: Types of company officer Board of directors (BoD) Chair of the board or chairman or chairperson Chief Executive (CE) Officer (CEO) Non-executive director (NED) Independent non-executive director (ined) Company secretary 10
The UK CG Code, main principles (1) Leadership There are four main principles (A.1. to A.4.) that focus on developing governance mechanisms to ensure: The board is focused on the long-term success of the company. The board should not be controlled by one individual; the chairman of the board and the CEO should not be held by the same individual. The chairman is responsible for leadership and effectiveness of the board. The role of NEDs includes challenging and contributing to strategy development 11
The UK CG Code, main principles (2) Effectiveness There are seven (B.1. to B.7.) main principles that focus on developing governance mechanisms to ensure: Board have the necessary skills, experience, independence and knowledge to do their duties and meet their responsibilities. Appointment of directors to the board is subject to a formal, rigorous and transparent procedure. Directors are given sufficient time to discharge their duties. Directors should undergo induction training when appointed and keep up-to-date with their knowledge and skills. Information is supplied timeously to the board. There should be annual performance evaluation of the board, its committees and the directors. Re-election of directors should be subject to continued satisfactory performance. 12
The UK CG Code, main principles (3) Accountability There are three (C.1. to C.3.) main principles that focus on developing governance mechanisms to ensure: The board presents a fair, balanced and understandable assessment of the company s position and prospects. Risk management and internal control mechanism are put in place by the board and significant risks to achieve strategic objectives are identified. The board maintains an appropriate relationship with the company s auditor 13
The UK CG Code, main principles (4) Remuneration There are two (D.1. and D.2.) main principles that focus on developing governance mechanisms to ensure that director s remuneration is: Designed to promote the long-term success of the company and elements of performance-related pay are communicated to the board Subject to formal and transparent procedures where no individual director influences their own pay 14
The UK CG Code, main principles (5) Relations with shareholders There are two (E.1. and E.2.) main principles that focus on developing governance mechanisms to ensure: There is two-way communication between the board and the shareholders, ensuring that concerns/issues of major shareholders are communicated to the board. The board and board committee should use the AGM to communicate with investors and to encourage their participation. 15
Non-executive directors B.1.1: BoD considers following to assess NED independence: has been an employee of company or group within last 5 years has, or has had within last 3 years, a material business relationship with the company, either directly, or as a partner, shareholder, director or senior employee of a body that has such a relationship with the company has received or receives additional remuneration from the company apart from a director s fee, participates in the company s share option or a performance-related pay scheme, or is a member of the company s pension scheme has close family ties with any of the company s advisers, directors or senior employees, holds cross-directorships or has significant links with other directors through involvement in other companies or bodies represents a significant shareholder has served on the board for more than 9 years from the date of their first election 16
Duties of NEDs are wide Constructively challenge and help develop strategy Scrutinize performance of management and reporting of company performance Determine remuneration of executive directors Take a prime role in appointing, removing and succession planning of executive directors Appoint a senior ined who acts as an intermediary between the chair of the board and the NEDs Evaluate the performance of the chairman Make recommendations to the board about appointing the external auditor, in their independent capacity on the audit committee 17
Other recommendations affecting NEDs They, like executive directors, should have access to legal advice at the company expense and to the advice and guidance of the company secretary. This will increase effectiveness Fees of NEDs should reflect the time that they commit to the company. This will help to ensure their objectivity is not threatened by large payments not related to the work that they perform. 18
Audit Committee: Role and Responsibilities (1) To monitor integrity of financial statements and any formal announcements relating to the company s financial performance, reviewing significant financial reporting judgements contained in them. To review company s internal financial controls and, unless expressly addressed by a separate board risk committee composed of independent Directors, or by the board itself, to review company s internal control and risk management systems. To monitor and review effectiveness of the company s internal audit function. To make recommendations to the board, for it to put to the shareholders for their approval in general meeting, in relation to the appointment, re-appointment and removal of the external auditor and to approve the remuneration and terms of engagement of the external auditor. 19
Audit Committee: Role and Responsibilities (2) To review and monitor the external auditor s independence and objectivity and the effectiveness of the audit process, taking into consideration relevant UK professional and regulatory requirements. To develop and implement policy on the engagement of the external auditor to supply non-audit services, taking into account relevant ethical guidance regarding the provision of non-audit services by the external audit firm; and to report to the board, identifying any matters in respect of which it considers that action or improvement is needed and making recommendations as to the steps to be taken. To report to the board on how it has discharged its responsibilities. 20
ACTIVITY 19.6 From your understanding of the audit process, suggest how the audit committee might be involved in overseeing the effectiveness of the audit process, from audit engagement through to audit reporting. 21
Audit Committee and external auditor effectiveness: FRC guidance Audit committee s/b in close communication with external auditors to: Review external audit planning, including consideration of materiality levels, scope of audit and skills, seniority and expertise of the audit team. Review findings of audit, including: discussing major audit issues and their resolution with the auditors; evaluating key audit judgements; review errors identified by external audit and ascertain how they have been resolved or why they might have remained unadjusted. Review management representation letters and judge if the information is accurate and complete. Review management letter and monitor the management s responses to the external audit findings and recommendations is appropriate. Review the audit process at the end of audit cycle, to assess effectiveness and whether agreed audit plan, and necessary changes met See also ISA 260 Communication with those charged with governance. 22
ACTIVITY 19.7 Take a look at the list of duties of audit committees and: a) Form a view as to whether they appear to be reasonable in the context of corporate governance. b) Decide whether they could be carried out by individuals employed as non-executive directors on a part-time basis. c) Explain how you think that an audit committee of three non-executive directors could carry out the work of the committee effectively. 23
The FRC Guidance on Audit Committees (2012) recommends that: Audit committee should review its own scope and effectiveness annually, recommending required changes to the BoD. The committee should report annually to the board on how it has discharged its responsibilities, including: The significant issues that it considered in relation to the financial statements and how these issues were addressed; Its assessment of the effectiveness of the external audit process and its recommendation on the appointment or reappointment of the external auditor; Any other issues on which the board has requested the committee s opinion Following on from that, each year the board should also review the effectiveness of the audit committee. 24
The nominations committee The code provides that there should be a nominations committee, constituted by a majority of ineds, to set and appoint directors to the board, and ensure the board has an appropriate balance of skills, experience, knowledge and independence. The nomination committee should have regard to diversity, particularly gender, on the board and should fix NED terms of appointment, not normally more than six years. This committee should also ensure the directors have sufficient time to discharge their responsibilities effectively. 25
Remuneration Committee: Code Principles 1. Levels of remuneration should be sufficient to attract, retain and motivate directors of the quality required to run the company successfully, but a company should avoid paying more than is necessary for this purpose. A significant proportion of executive directors remuneration should be structured so as to link rewards to corporate and individual performance. 2. There should be a formal and transparent procedure for setting the policy on directors remuneration and for determining the remuneration package for individual directors. ACTIVITY 19.8 There is a school of thought regularly reported in the media, that it is necessary to pay high remuneration for top executives to retain their services and discourage them from seeking employment elsewhere. Do you think this argument holds true? 26
Table 19.4 Principles of Stewardship Code To protect and enhance the value that accrues to the ultimate beneficiary, institutional investors should: 1. Publicly disclose their policy on how they will discharge their stewardship responsibilities. 2. Have a robust policy on managing conflicts of interest in relation to stewardship, which should be publicly disclosed. 3. Monitor their investee companies. 4. Establish clear guidelines on when and how they will escalate their stewardship activities. 5. Be willing to act collectively with other investors where appropriate. 6. Have a clear policy on voting and disclosure of voting activity. 7. Report periodically on their stewardship and voting activities. 27
Directors statement of responsibilities In 1992 the Cadbury Report stated that the directors should explain their responsibility for preparing the accounts next to a statement by the auditors about their reporting responsibilities. Such statements are now being included in the reporting package of companies. The responsibilities of auditors are stated in the audit report itself and reference is made to the statement of directors responsibilities. These steps were considered important in the context of corporate governance to make clear that the directors have primary responsibility for preparing financial statements that give a true and fair view (see chapter 16). 28
Internal control Internal Control: Guidance for Directors (FRC, 2005) sets out best practice on risk management and internal control for UK listed companies, and assists in applying section C.2 (see Table 19.2) of the Code. The FRC guidance emphasizes the importance of internal control and risk management and then provides three sections providing guidance focusing on: 1. maintaining a sound system of internal control; 2. reviewing the effectiveness of internal controls; 3. the board s statement on internal controls. 29
Maintaining a sound system of internal control The guidance outlines the elements of a sound system of internal control as: Assisting in achieving corporate objectives by being able to respond to important business, financial and compliance risks. Assisting in ensuring the quality of internal and external reporting. Assisting in ensuring compliance with appropriate laws and regulations and also the operations of corporate policies concerned with the conduct of the business (paragraph 19). 30
Reviewing effectiveness of internal control (1) When the board reviews the internal control reports during the year they should: Consider what are the significant risks and assess how they have been identified, evaluated and managed. Assess the effectiveness of the related system of internal control in managing the significant risks, having regard to any significant failings or weaknesses in internal control that have been reported. Consider whether necessary actions are being taken promptly to remedy any significant failings or weaknesses. Consider whether the findings indicate a need for more extensive monitoring of the system of internal control (para. 29). 31
Reviewing effectiveness of internal control (2) When conducting their annual assessment of the effectiveness of internal controls the board should consider: Changes in the nature of significant risks since the previous annual assessment. The extent and effectiveness of the monitoring of the risks, the system of internal control and of the internal audit function. How often and the extent of communication of the results of the monitoring to the board. Whether any important failings or weaknesses in the control systems have been identified during the year. The effectiveness of the public reporting processes of the company (para. 31). 32
The board s statement on internal control The board is required to state in the annual report that they are responsible for the system of internal control and reviewing its effectiveness. The board should also state that there is a process of risk management in place, which identifies, evaluates and manages important risks. The statement should give details of the process they used to review the effectiveness of the internal control systems and state what actions have been taken or are in the process of being taken to remedy significant weaknesses. Finally the statement should outline the process by which the board has evaluated the effectiveness of the system of internal control and that the system only manages the risks rather than eliminates them. 33
Audit Firm Corporate Governance The Audit Firm Governance Code (FRC and ICAEW, 2010) sets a benchmark of good practice for audit firms and is currently mandatory for 7 audit firms that together audit about 95% of companies listed on the main market of the London Stock Exchange and other audit firms may adopt it on a voluntary basis. The Code is similar in structure to the UK Corporate Governance Code and comprises principles and provisions around the themes of: Leadership; Values; Independent non-executives; Operations; Reporting; and Dialogue. The purpose of the Code is to assist in promoting continuing confidence and choice in the market for audit of listed companies and should be relevant to everyone who sees audit as playing a vital role in a market economy. The Code also declares that, in addition to its main aim, compliance with the Code will enrich firms transparency reports. Refer to Figure 3.3 for a suggested a structure of an audit firm to enhance ethical behaviour. 34
Concluding remarks: corporate governance The UK Corporate Governance Code is now an accepted part of corporate life for listed companies in the UK. The limited changes made to the Code suggests that users and producers are reasonably satisfied with the present requirements of the Code. Further evidence is the extent to which UK principles of corporate governance have been adopted in other countries throughout the world, in particular adopting a comply or explain approach and separating chairman/chief executive responsibilities at the top of corporate entities. The principles-based approach in the UK, avoiding burdensome rules and putting onus on directors of companies to explain how they have complied with the Code, is regarded as a success (Monks and Minow, 2004). Others are more circumspect; e.g. Arcot et al (2010) question the effectiveness of the comply or explain process, as does the European Commission (2013). Despite the accepted success of the Code, we have seen severe criticism of the way in which corporate entities have been governed, particularly those operating in the banking sector after the financial crisis. 35