Corporate governance

1. What is corporate governance

● Cadbury report: The system by which companies are directed and controlled
● The aim (2014 Code): To facilitate effective entrepreneurial and prudent management to
deliver the long-term success of the business
● Updated definitions of purpose of CG:
○ To protect and advance the interests of shareholders through setting the strategic
direction of a company and appointing and monitoring capable management to
achieve this. (Walker Review, 2009)
○ To facilitate effective, entrepreneurial and prudent management that can deliver the
long-term success of the company. (FRC, 2014)
○ To detail on how shareholders’ wealth has been/will be created and protected.
○ To preserve and enhance shareholders’ investment (Hampel Report)

2. Theories associated with corporate governance

Agency theory underpins UK views on CG and has dominated the framing of guidance to date.
The acknowledgement of potential misalignments and the need to control the potential for
self-interested behaviour of the directors is the foundation of CG concerns.

● Agency theory, stewardship and principal-agent problem

○ The directors are accountable to the investors and are expected to provide them with
open and honest reports about the direction in which the company is being taken, and
whether they are discharging their duties properly
○ Separation of ownership and control can result in conflicts of interests/goals
○ The principal–agent problem assumes that the directors will pursue their own personal
objectives - due to information asymmetry

● Hence the need for good CG:

○ Investors need reassurance that their money is well invested with a satisfactory return
potential and that there is no fraud
○ Transparency and disclosure are key solutions to maintain trusts
○ Reporting and auditing - support transparency and the flow of reliable information
between management, boards, shareholders, regulators and other stakeholders - and
hold directors being properly accountable
○ Financial reporting systems that produce high quality financial statements - aids
accountability, but more information is needed
3. Consequences of ineffective corporate governance

• Case of Maxwell - fraudulent activities - transfer of pension funds to prop up the empire
• Case of Enron - aggressive and fraudulent earning managements - bankruptcy
• Credit crisis - lack of effective control mechanisms to curb excessive risk-taking by financial
institutions
• Investors’ trust eroded by corporate collapses and scandals e.g. Enron
• Impact on society - huge government support to bail out banks e.g. EBS, Lloyds, TSB
• Redefinition of companies’ responsibilities through tighter companies regulations e.g. UK
Company Law Act, CG codes revisions, USA’s Sarbanes Oxley Act after Enron scandal

4. Financial reporting’s role in corporate governance

● Ensure shareholders have trust in the directors - from the directors being properly
accountable to the shareholders - through reporting
● Financial reporting systems that produce high quality financial statements are part of this
system of accountability
● Reporting and auditing - support transparency and the flow of reliable information
between management, boards, shareholders, regulators and other stakeholders.

5. The UK ​Corporate Governance Code​ (2016)

● Sets out corporate governance principles and recommendations (described as provisions)
● The context of the Code:
○ CG is the system by which companies are directed and controlled.
○ Boards of directors are responsible for the governance of their companies.
○ Shareholders’ role in governance: to appoint the directors and the auditors and ensure
an appropriate governance structure is in place.
○ Board’s responsibilities: 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.

● Leadership
○ Company must be headed by an effective unitary board (EDs & NEDs) which is
collectively responsible for the long-term success of the company.
○ Directors must act in the best interests of the company and for the good of society at
large - good CG is part of wider CSR
 ○ There should be a clear division of responsibilities - leading the board (NED) vs running
of the company’s business (ED). No individual should have unfettered powers of
decision.
○ The chairman (NED) is responsible for leadership of the board and ensuring its
effectiveness on all aspects of its role.

● Effectiveness
○ Structure and composition of the Board
1. Size - at least half should be independent NED (FTSE 350 companies)
2. Each sub-committee (audit, remuneration, nomination) comprising at least 3
independent NED
3. Diversity - balance of skills, experience, independence, knowledge of company,
gender
4. BOD must be committed - allocate sufficient time to company

○ The role of NEDs and sub-committees - effective monitors of management

1. Act in advisory capacity
2. Contribute expertise and objectivity
3. Constructively challenge and help develop proposals on strategy
4. Scrutinise performance of executive management
5. Ensure integrity of financial information
6. Ensure systems of risk management are robust and defensible
7. Determine remuneration levels for executives
8. Appoint/remove executives

● Remuneration
○ EDs’ remuneration should be designed to promote the long-term success of the
company.
○ Remuneration committee must set & implement directors’ remuneration policy. No
director should be involved in deciding his/her own remuneration.
○ Stress on transparency in directors’ remuneration - require extensive directors’
remuneration report
○ Remuneration should be sufficient to attract, retain and motivate directors with
qualities required to run the company
○ Performance-related elements should be in line with company’s objectives and risk
policies
○ If options are used as long-term incentive scheme - should not be exerciseable for at
least 3 years
○ Balance between fixed and variable elements of remuneration
Question 5, 2017
Agency theory suggests that there will be conflict between shareholders and directors unless
the executive directors are closely monitored. The independent non-executive directors of a
public listed company play a key role in corporate governance in general, which may include
‘keeping the peace’ between the executive directors and the shareholders.

Required:
Assess the main areas for potential conflict of interest between the shareholders of a listed
company and its executive directors and discuss the role independent non-executive directors
play in dealing with these issues.

An independent non-executive director is a person who has no connection with the company
other than as a non-executive director. An independent non-executive director should be able
to give an independent opinion on the affairs of the company, without influence from any other
director or shareholder or other stakeholder the director is representing. Non-executive
directors with close relationships to executive directors would not be independent. Each
committee of the board of directors addresses a leading area of conflict of interest.

Conflicts of interest and how they are dealt with

A potential conflict of interest can occur when the executive directors of a company take
decisions that would not be in the interests of the company’s shareholders. Although there are
several areas where a conflict of interest could arise, the most difficult areas are ​remuneration
of the directors and senior managers, financial reporting and nominations of new board
members.

Remuneration
If executive directors decide their own remuneration, they could pay themselves as much as
possible, without having to hold themselves to account or justify their high pay. If executive
directors can devise incentive schemes for themselves, these may be linked to achieving
performance targets that are not necessarily in the shareholders’ interests. For example,
rewarding directors with a bonus for achieving profit growth is of no value to shareholders if
the result is higher business risk and a lower share price.

Remuneration committee
The UK’s Combined Corporate Governance Code 2014 calls for a remuneration committee of
the board to be established to decide on directors’ pay, including incentive schemes. The
committee’s members should all be independent non-executive directors. The remuneration
committee should have delegated responsibility for setting remuneration packages for all
executive directors and the chairman, including pension rights and any compensation
payments. The committee should also recommend and monitor the level and structure of
remuneration for senior management. The non-executive directors should be able to devise fair
remuneration packages that include an incentive element where the performance targets align
the objectives of the executive directors into line with those of the shareholders.

Financial reporting
A second problem area is financial reporting. The executive directors may be tempted to distort
the results of the company, to present the financial results in a way that reflects better on
themselves and their achievements.

Audit committee
The UK’s Combined Corporate Governance Code 2014 requires the board to establish an audit
committee, consisting of non-executive directors, whose task should be to consider issues
relating to financial reporting and financial control systems. This committee should be
responsible for liaising regularly with the external and internal auditors. The board should
satisfy itself that at least one member of the audit committee has recent and relevant financial
experience.

Nominations to the board

A third potential area for conflict is nominations to new board members. A powerful chairman
or chief executive officer could be tempted to appoint their supporters or ‘yes’ men or women
to the board, and so strengthen their position on the board.

Nomination committee
The UK’s Combined Corporate Governance Code 2014 recommends that the board should
establish a nomination committee of the board, manned by non-executive directors. The
committee should oversee recruitment, keep the balance of the board under review and
consider longer term succession planning.

There could be other areas of potential conflict of interest other than those discussed above
(which students may include) such as strategy development, shareholder engagement, etc. In
such areas the non-executive directors should still be able to provide a counter balance to
self-interested views of executive directors.