APPROACHES TO CORPORATE GOVERNANCE

The major driving forces behind corporate governance development include among other things:

  • Globalization;
  • Treatment of investors; and
  • Major corporate scandalse.g Enron, Parmalat, WorldCom etc

Driving forces of governance code development

The main drivers have been:

  1. Increasing internationalization and globalization – move for investors to invest outside their home countries. The King report of South Africa highlights the role of free movement of capital commenting that investors are promoting governance in their own interests.
  2. Investor concerns – this comes as a result of differential treatment of domestic and foreign investors both in terms of reporting and associated rights/dividends. It was also aimed at addressing the excessive influence of majority shareholders. Hence, investors called for parity of treatment in order to protect their interests.
  3. Quality of Accounts – most of the reports (financial) were not meeting minimum acceptable standards which were leading to increasing debates and litigation. Shareholders were not satisfied with the reporting. Hence, shareholder confidence was eroded in what was being reported. Whilst corporate governance development isn’t about better financial reporting requirements, the regulation of practice such as off-balance sheet financing has led to greater transparency and a reduction in risks faced by investors. See Enron scandal reports on off-balance sheet financing.
  4. National differences – characteristics of individual countries may have a significant influence in the way corporate governance has developed. The King report, for instance, emphasizes the qualities that are important to the South African culture such as: collectiveness, consensus, fairness, consultation, and religious faith in the development of best practice.
  5. Increasing Corporate scandals – an increasing number of high profile corporate scandals such as the collapses of organizations such as; BCCI, Maxwell Communications Corporations, Enron, Parmalat, to mention a few prompted the development of governance codes in the early 1990s.

Arising from the above, there has been development in corporate governance codes. Codes of best practice in many jurisdictions were developed to combat these problems. The problem of overbearing individuals dominating a company has been countered by recommendations in many codes recommending that the role of CEO and Board Chairman be separate i.e CEO should not at the same time be the Board Chairperson.

The development of codes of best practice has been promptedin order to meet the lacuna in law or clarify ambiguities in the law. It was also to raise a higher standard of behavior than provided in most local legislation requirements. In addition, codes were developed to ensure that local companies comply with international best practice.

Principles of Governance

These are based on a number of codes worldwide.

  1. Ensure adherence to and satisfaction of the strategic objectives of the organization, thus aiding effective management.
  2. Convey and reinforce the requirements relating to governance in local status and listing rules.
  3. Assist companies in minimizing risk, especially financial, legal and reputation risk, by ensuring appropriate systems of financial control, for monitoring risk and ensuring compliance with the law are in place.
  4. Promote ethical behavior with integrity, meaning straightforward dealing and completeness, being particularly important.
  5. Underpin investor confidence, partly in response to the driving forces highlighted above.
  6. Fulfill responsibilities to all stakeholders and to minimize potential conflict of interest between owners, managers, and a wider stakeholder community.
  7. Establish clear accountability at senior levels within within an organization. Boards, however, must not become too closely involved with day to day issues and fail to delegate responsibility to management.
  8. Maintain independence of those who scrutinize the behavior of the organization and its senior executive managers. Of great import is that non-executive directors, internal and external auditors.
  9. Provide accurate and timely reporting of trustworthy/independent financial and operational data to both management and owners/members of the organization, to give them a true and balanced picture of what is happening in the organization.
  10. Encourage more involvement of owners in the effective management of the organization through recognizing their responsibilities of oversight and input to decision making processes via voting or other mechanisms.
  11. Direct behavior

Principles versus Rules

The biggest question is whether the guidance should be predominately in the form of principles or detailed laws/regulations. The UK guidance has suggested that a voluntary code coupled with disclosure would prove more effective than a statutory code in promoting the key principles of openness, integrity, and accountability.Nevertheless the UK guidance has also gone beyond broad principles and has provided some specific guidelines aimed at promoting an understanding of directors’ responsibilities and openness about the ways they have been discharged. Specific standards also help in raising standards of financial reporting and business conduct, aiming to remove the need for statutory regulation.

Principle Based Approach

Characteristics of a principles based approach

a)Focus of aims

b)Flexibility

c)Breadth of application

d)Comply or explain

e)Role of capital markets

Focus of aims – the approach focuses on objectives( e.g. fair treatment of minority shareholders) rather than mechanisms by which these objectives will be achieved. Principles are ideally easier to integrate into strategic planning.

Flexibility –the approach lay stress on elements of corporate governance to which rules cannot be easily applied.Areas such as the requirement to maintain sound systems of internal control, organizational culture, and maintain good relationship with shareholders and other stakeholders.

Breadth of application–can easily be applied across different legal jurisdictions rather than being founded the legal requirements of one country e.g the OECD guidelines that is applied internationally (to be covered in details later).

Comply or explain – where the principles-based approaches have been established in the form of corporate governance codes, the specific requirements that the code make have been enforced on a comply or explain basis.

Role of capital markets – principles-based approaches have been adopted in jurisdictions where the governing bodies of stock markets have had the rime role in setting standards for companies to follow.

Advantages of principles based approach

a)Avoid legislation - it avoids the need for inflexible legislation that companies have to comply with even though the legislation is not appropriate.

b)Less costly – less burdensome in terms of time and expenditure. In many countries there are continual pressures from businesses for governments to ‘reduce the burden of red-tape.’ A principle based approach can avoid the need for excessive information provision, management and reporting costs, and complex monitoring and support structures.

c)Appropriate for company – approach allows companies to develop their own approach to corporate governance that is appropriate for their circumstances within the limits laid down by the stock exchanges. For instance, it may be excessive to impose on companies in lower risk industries the same mandatory reporting requirements that companies in higher risk industries face.

d)Flexibility – approach allows for transitional arrangements and unusual circumstances. If one director leaves the board suddenly, there may be period of technical non-compliance until the director is replaced. Most shareholders would be satisfied provided the non-compliance is explained.

e)Emphasis on explanation –enforcement on a comply or explain basis means that businesses can explain why they have departed from the specific provisions if they feel it is appropriate.

f)Emphasis on investor decisions – a principles based approach accompanied by disclosure requirements puts the emphasis on investors making up their minds about what businesses are doing (and whether they agree departures from the codes are appropriate.)

Criticisms of principles-based approach

a)Broadness of principles – principles may be so broad that they fail to give best guide to corporate governance practice.

b)Misrepresents companies attitudes;

c)Consistency between companies–application of principles may not be consistent between companies. Clear rules could be better as the standards apply to all directors. Principles just promote a ‘level playing field’ preventing companies from gaining unfair competitive advantage over others.

d)Confusion over rules – companies may not be sure of which rules are mandatory and which are not.

e)Inadequate explanation – some companies may perceive a principles-based approach as non-binding and fail to comply without giving adequate reasons or explanations.

f)Investor misunderstanding – non-specialist shareholders may not interpret the significance of disclosure correctly.

The Hampel report of all corporate governance reports came out the strongest in favor of principles-based approach. The committee preferred to relax the regulatory burdens on companies and was against treating corporate governance codes as sets of rules, judging companies by whether they have complied (‘box-ticking’). The report recognizes that there are guidelines which will normally be appropriate but the differing circumstances of companies meant that sometimes there are valid reasons for exceptions.

‘Good corporate governance is not just a matter of prescribing particular corporate structures and complying with a number of hard and fast rules. There is a need for broad principles. All companies should then apply these flexibly and with commonsense to the varying circumstances of individual companies. Companies’experience of the codes has been rather different. Too often they believe that the codes have been treated as sets of prescriptive rules. The shareholders or their advisors would only be interested in whether the letter of the rule has been complied with.’

Rules-based approach

Characteristics of rules based approaches

a)Emphasis on achievements

b)Compulsory compliance

c)Visibility of compliance

d)Limitations of rules

e)Criminal sanctions

Emphasis on achievements – approach place more emphasis on definite achievements than underlying factors and control systems. Due to this there may be little motivation to achieve more than is required by the rules.

Compulsory compliance – approach allow no leeway. It’s either you have or have not complied with the rules. They offer no flexibility for varying circumstances, for organizations of varying size or in different stages of development.

Visibility of compliance–it should in theory be easy to see if there is compliance with the rules. Comparison between companies should be straight forward. However,, that depends on whether the rules are unambiguous, and the clarity of evidence of compliance or non-compliance.

Limitations of rules–enforcers of rules based approach (regulators, auditors) may find it difficult to deal with questionable situations that are not covered sufficiently in the rulebook. This was the problem with Enron - the company kept a number of financial arrangements off its balance sheet. Although this apporaoch can be seen as not true and fair, Enron could use it because it did not breach any accounting rules in existence then in America. Keeping legislation up-to-date to keep loopholes closed is a reactive and probably costly process.

Criminal sanctions – theseapproaches tend to corporate governance tend to be found in jurisdictions and culture that lay great emphasis on obeying the letter of the law rather than the spirit. Serious breaches will be penalized by criminal sanctions. They often take the form of legislation themselves e.g the Sabanese-Oxley Act (yet to be discussed.) This may give rise to significant compliance costs.

Insider systems (Family companies)

This is where companies listed on stock exchange are controlled by a small number of major shareholders, such as members of company’s founding families, banks, other companies etc.

Family companies are the best examples of insider structures. Agency issues are not common since families have direct involvement in running of company.

Individual behavior may other than being influenced by corporate ethical codes, be also influenced by family’s ethical beliefs. The family companies’ existence depends on how long families want to invest and an on maintenance of family unity. If family unity breaks down, governance may become difficult.

Advantages of insider systems

  • Easy to establish ties between owners and managers due to participation of owners in management;
  • Agency problem and agency costs are reduced due to owner involvement in management;
  • Smaller shareholder base establishes flexibility about when profits are made. Access to longer term capital may be easier;

Disadvantages

  • There may be discrimination against minority shareholders;
  • Controlling families may not be effectively monitored by banks or other shareholders;
  • Lack of formal governance structures until problems arise that may call for their establishment e.g succession planning problems.
  • Reluctance to employee outsider in influential positions;
  • May be unwilling to appoint non-executive directors;
  • May not give adequate disclosure of financial information and may be prone to misuse of funds;
  • Succession issues may be a major problem. Vibrant members may be succeeded by other family members who are less competent.

Outsider systems (Anglo-Saxon regimes)

This involves companies where shareholding is more widely dispersed.

There is manager-ownership separation.

Advantages

  • Separation of ownership and management provides for development of more robust legal and governance regimes to protect shareholders;
  • Shareholders have voting rights that they can use to exercise control;
  • Hostile takeovers are rare as interests of shareholders are guarded, especially minority shareholders’ interest.

Disadvantages

  • More prone to agency problem and huge agency costs;
  • Larger shareholders may have short-term priorities. Hence, in event that company is not doing fine, they would rather sell their shares than pressurize management to change strategies.

Corporate governance codes

Cadbury Report (1992)

Following various financial scandals and collapses (e.gColoroll and Polly peck) and a perceived general lack of confidence in the financial reporting of many UK companies, the Financial Reporting Council, the London Stock Exchange, and the accountancy profession established the Committee on the Financial Aspects of corporate Governance in May 1991. After the committee was set up, the scandals at BCCI and Maxwell happened, and as a result, the Committee interpreted its remit more widely and looked beyond the financial aspects to corporate governance as a whole. The committee was chaired by Sir Adrian Cadbury and, when the committee reported in December 1992, the report became widely known as ‘the Cadbury Report.’

The recommendations covered;

the operation of the main board;

the establishment, composition, and operation of key board committees;

the importance of, and contribution that can be made by, non – executive directors;

the reporting and control mechanisms of business.

The Cadbury Report recommended a Code of Best Practice with which the boards of all listed companies registered in the UK should comply, and utilized a ‘comply or explain’ mechanism. This mechanism means that a company should comply with the code but, if it cannot comply with any particular aspect of it, then is should explain why it is unable to do. This disclosure gives investors detailed information about any instances of non–compliance and enables them to decide whether the company’s non- compliance is justified.

The main recommendations are discussed below beginning with the board of directors.

Cadbury Report’s Code of Best Practice:

1.The Board of Directors

The board should meet regularly, retain full and effective control over the company, and monitor the executive management.

There should be a clearly accepted division of responsibilities at the head of a company, which will ensure a balance of power and authority, such that no one individual has unfettered powers of decision. (Where the chairman is also the chief executive, it is essential that there should be a strong and independent element on the board, with a recognized senior member.)

The board should include non- executive directors of sufficient caliber (competence) and number for their views to carry significant weight in the board’s decisions.

The board should have a formal schedule of matters specifically reserved to it for decision to ensure that the direction and control of the company is firmly in its hands.

There should be an agreed procedure for directors in the furtherance of their duties to take independent professional advice if necessary, at the company’s expense.

All directors should have access to the advice and services of the company secretary, who is responsible to the board for ensuring that board procedures are followed and that applicable rules and regulations are complied with.

Any question of the removal of the company secretary should be a matter for the board as a whole.

2. Non – executive Directors

Non-executive directors should bring an independent judgment to bear on issues of strategy, performance, resources, including key appointments, and standards of conduct.

The majority should be independent of management and free from any business or other relationship which could materially interfere with the exercise of their independent judgment, apart from their fees and shareholding. Their fees should reflect the time which they commit to the company.

Non – executive directors should be appointed for specified period and re-appointment should not be automatic.

All None-executive directors’ appointments and reappointments should be through a formal process involving the entire board.

3.Executive Directors

Directors’ contracts should not exceed three years without shareholders’ approval.

There should be full and clear disclosure of directors’ total emoluments and those of the chairman and highest – paid UK director, including pension contributions and stock options. Separate figures should be given for salary and performance – related elements and the basis on which performance is measured should be explained.

Executive director’s pay should be subject to the recommendations of a remuneration committee made up wholly or mainly of non- executive directors.

4.Reporting and Controls

It is the board’s duty to present a balanced and understandable assessment of the company’s position.