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Chapter 5 Corporate Governance

Chapter learning objectives: Lead Component Indicative syllabus content

A3. Ways of managing risk

(a) Roles and responsibilities.

• Role of board and others in the organisation for identifying and managing risks

• Risk mitigation including TARA – transfer, avoid, reduce, accept

• Assurance mapping • Risk register • Risk reports and responses • Ethical dilemmas associated with

risk management

B3. Explain governance risks

(a) Explain the role of board and its committees in managing strategic risk. (b) Explain failure of governance and its impact on strategy.

• Separation of the roles of CEO and chairman

• Role of non-executive directors • Roles of audit committee,

remuneration committee, risk committee and nomination committee

• Directors’ remuneration

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1. CORPORATE GOVERNANCE Corporate governance is the system by which companies are directed and controlled.

• The system covers the following:

• The role of the company directors.

• The authenticity of the company accounts.

• The relation between the company and the auditors.

• The shareholders’ interest in the company.

The importance of corporate governance • Companies are required to follow local governance rules to qualify for stock exchange

listing.

• Corporate governance codes have been developed from the UK governance codes.

• The UK follows a principles-based approach whereas the US follows a legislative (rules-based) approach.

• Corporate governance helps reduce risk.

• Corporate governance gained high importance after a series of sudden corporate collapses. The most publicised failures were: the Maxwell Communications Corporation, Enron, Barings Bank and Worldcom.

• Several reasons were identified for these failures:

• Unified role of chairman/CEO.

• Decisions made in the personal interest of directors rather than those of the shareholders.

• Lack of director expertise/knowledge.

• Poor control systems.

• Lack of independence of auditors.

• Lack of interest by the key investing institutions.

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Benefits of good corporate governance • Greater fairness and openness of directors.

• Greater public confidence in companies.

• Reduced risk for investors and other stakeholders.

• Lower risk of strong CEO domination.

• Transparency, more timely and clear communication of information.

• Improves performance and leadership by the board.

Limitations of corporate governance: • It does not prevent company failure or collapse.

• It cannot prevent companies failing to achieve their objectives.

2. Principles of good corporate governance Good governance principles put forward by the Organisation for Economic Co-operation and Development (OECD):

• Rights of shareholders, e.g. one share equals one vote for all shareholders.

• Equitable treatment of shareholders, e.g. protection of minority interests.

• Equitable treatment of all stakeholders.

• Accurate and timely information for users of published information.

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The principles of the UK Governance Code:

Comply or explain rule

• The code has no force in law and is enforced on listed companies through the Stock Exchange.

• Listed companies are expected to “comply or explain’’; this approach is the trademark of corporate governance in the UK.

• Listed companies have to state that they have complied with the code or else explain to shareholders why they have not.

• This allows some flexibility, and non-compliance might be acceptable in some circumstances.

3. Board Leadership and company purpose • The board of directors leads the company.

• The chairman provides leadership for the board.

• No one person should have autonomous decision-making authority.

• The roles of chairman and CEO should be held by separate individuals.

• The non-executive directors (NEDs) should form half the board.

• The NEDs serve to interrogate the decisions of executive directors beyond doubt.

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Role of the Chairman Role of the CEO

• Runs the boards. • Sets out the vision for the company. • Provides leadership for the board. • Sets out the composition and structure of

the board. • Plans and decides on the agenda of board

meetings. • Chairs all meetings. • Encourages NEDs to present their ideas to

the board. • Chairs AGM and other meetings with

shareholders. • Presents the shareholders’ opinions to the

board. • Acts as a bridge between shareholders and

directors. • Arranges communication at AGM of

shareholders with the remuneration, nomination and audit committees.

• Runs the company. • Represents the company to stakeholders. • Provides the link between employees and

the board. • Implements the strategy decided by the

board. • Holds accountability for all company

operations. • Puts together a coordinated management

team. • Arranges and manages resources for

company operations. • Monitors and controls operations and

budgets. • Helps select board members.

Non-Executive Directors (NEDs) Roles: Responsibilities:

• They appoint/remove executive directors.

• They decide on the remuneration of the executive directors.

• They provide independent criticism of the decisions of executive directors.

• They review the performance of the management.

• They assist in strategy development.

• They evaluate the financial and control systems of the organisation.

• Foster a relationship of trust with the executive directors.

• Be knowledgeable about the company and the industry.

• Keep themselves abreast of changes in business and industry.

• Make sure to receive timely, accurate and sufficient information before meetings.

• Promote high ethical and governance standards.

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Independence:

• There should be as many NEDs as executive directors.

• The main responsibility of the NEDs is to oversee the shareholders’ interests.

• One senior NED should be available for shareholders’ concerns or sensitive issues.

• While hiring an NED, need to balance industry experience with independence.

• It is likely that, with greater experience, their independence may be compromised.

• It is more effective to hire NEDs with a range of fields of experience.

Why NEDs need to be independent:

• To provide objectivity in company decisions.

• To bring in a variety of experience and knowledge to decision making.

• To give voice to shareholders’ concerns in the board.

• To reduce risk arising from the personal interests of executive directors.

Threats to NED independence: A person cannot be an independent NED if:

• He is a major shareholder.

• He has family ties with a director.

• He is entitled to some other compensation in addition to remuneration as a director.

• He has had material business dealing with the company in the past three years.

• He has been an employee of the company in the past five years.

• He has been on the board for more than nine years.

• He is a director in another company.

BOARD EFFECTIVENESS The board works effectively when:

• There is a variety of skill, experience and knowledge among the members.

• There is a formal appointment procedure for the directors.

• The directors have enough time to dedicate to company matters.

• The directors have formal induction training on appointment.

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• The directors keep updating their knowledge and skills according to industry changes.

• All directors are submitted for re-election annually.

BOARD ACCOUNTABILITY • The board should present the company’s status and future prospects.

• The board decides on the strategy to achieve its objectives.

• The board decides how risk-averse or risk-taking the company will be.

• The board is responsible for developing and implementing risk management and internal control systems.

• The board should review and report on internal control and risk management systems annually.

Nominations committee • Evaluates the structure and composition of the board.

• Makes sure that the board is sufficiently diverse.

• Reviews the proportion of NEDs on the board.

• Prevents any one individual from asserting dominance.

• Is responsible for succession planning.

• Recommends applicants for any vacancies that arise.

• Nominates members for re-appointment.

• Should be independent from the board.

Audit committee • The board forms the audit committee.

• It consists of 2-3 independent NEDs.

• At least one member should have financial experience.

• The committee reviews the reliability of the financial statements.

• It reviews and affirms the soundness of internal and financial controls.

• It assesses the efficiency of the internal audit department.

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• It suggests (for shareholders to decide) external auditors and their remuneration.

• It scrutinises the objectivity and effectiveness of the external auditors.

• It generates policies regarding non-audit work from external auditors.

• Its role and responsibilities are mentioned in the annual report.

• If the board disregards any suggestion made by the committee, this is mentioned in the annual report.

• The audit committee should set up a procedure to address any confidential staff concerns (whistleblowing).

• It should also set up formal investigation procedures for such matters.

Responsibilities of an audit committee:

• Review of the financial statements (interim included).

• Review of the internal controls system.

• Dialogue with external auditors on significant matters.

• Making recommendations on the appointment of the external auditors and their fee.

• Review of the audit report and other audit documents.

• Ensuring that the whistleblowing system is in place.

Remuneration committee • Consists of 2-3 independent NEDs.

• Decides on the remuneration of executive directors.

• Director remuneration consists of:

• Basic salary.

• Performance bonus or share options.

• Pension contributions.

• Benefits in kind, e.g. conveyance, medical expenses.

• Remuneration should be:

• High enough to motivate directors.

• High enough to compensate their effort.

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• Comparable to similar companies.

• There should be a performance-related portion to ensure the long-term success of the company.

• Considers pension and other compensation payments for directors.

• Also recommend compensation for senior management.

• The shareholders recommend the remuneration of the NEDs.

• Remuneration for NEDs should not be performance-related (this would compromise independence).

• The roles, responsibilities and authority of the committee should be set out in a statement.

Share options as compensation for directors: • Prevent directors from focusing on short-term profit.

• Promote a long-term focus on company performance.

• Other factors influence the share price apart from company success.

• These other factors include:

• The overall business environment in the country. • The business environment of the specific industry. • The fashion trends of the time.

• Share options align the directors’ personal goals with company success.

• Share options give the directors a financial incentive to make sure the company performs well.

4. Internal controls and governance

INTERNAL RISK REPORTING • The board is responsible for maintaining and appraising controls.

• Identifying risk areas is the responsibility of the management.

• Developing them is also the management’s responsibility.

• The management monitors the control systems and reports to the board.

• The board appraises the systems through reports on how risks have been managed.

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• If a failure is identified, the development norms of the control systems are reviewed.

• The annual report includes information on risk management procedures and internal controls.

• The annual report includes the board’s acknowledgement of responsibility for these.

• It should also include the review process for these systems.

EXTERNAL RISK REPORTING

Turnbull Report The Turnbull Report forms part of the UK Corporate Governance Code (before it is was called the Combined Code).

The requirements of the Turnbull Report include:

• Use a risk-based approach to develop internal controls.

• Identify objectives.

• Determine the risks involved.

• Ascertain controls to deal with the risks.

• Implement a control system to prevent risks materialising.

• Monitor and review controls regularly.

• Review should be conducted for:

• The control environment. • Control activities. • Risk assessment procedures. • Information/communication. • Monitoring.

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5. Sarbanes-Oxley Act (SOX) • Developed as a result of high profile collapses in the US economy (Enron, Worldcom).

• It is detailed legislation for US-based companies.

• It differs from the UK code on two points:

• SOX is rules-based rather than principles-based, and

• SOX demands more detailed documentation for internal controls and their audit.

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6. Chapter summary