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REVIEW MATERIAL for ACCA P1 Governance, Risk and Ethics

Carl R. Burch

4/26/2012

I put together these P1 notes when studying for the exam. Thought that it would be good to share them with you. Good luck with your Exam. If you have comments or questions you can reach me at the following email addess: carl.burch@hocktraining.com

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Table of Contents

A. Governance and Responsibility .................................................................................... 1

1. THE SCOPE OF GOVERNANCE............................................................................................................... 1 2. AGENCY RELATIONSHIP AND THEORIES ............................................................................................... 7 3. THE BOARD OF DIRECTORS ............................................................................................................... 13 4. BOARD COMMITTEES ......................................................................................................................... 23 5. DIRECTORS REMUNERATION ............................................................................................................. 26 6. DIFFERENT APPROACHES TO CORPORATE GOVERNANCE .................................................................... 29 7. CORPORATE GOVERNANCE AND CORPORATE SOCIAL RESPONSIBILITY ............................................... 39 8. GOVERNANCE: REPORTING AND DISCLOSURE .................................................................................... 41

B. Internal Control and Review ...................................................................................... 47

1. MANAGEMENT CONTROL SYSTEMS IN CORPORATE GOVERNANCE ...................................................... 47 2. INTERNAL CONTROL, AUDIT AND COMPLIANCE IN CORPORATE GOVERNANCE ................................... 55 3. INTERNAL CONTROL AND REPORTING ................................................................................................ 62 4. MANAGEMENT INFORMATION IN AUDIT AND INTERNAL CONTROL ..................................................... 64

C. Identifying and Assessing Risk ................................................................................... 67

1. RISK AND THE RISK MANAGEMENT PROCESS ...................................................................................... 67

2. CATEGORIES OF RISK ......................................................................................................................... 68 3. IDENTIFICATION, ASSESSMENT AND MEASUREMENT OF RISK ............................................................. 74

D. Controlling and Managing Risk ................................................................................. 79

1. TARGETING AND MONITORING OF RISK .............................................................................................. 79 2. METHODS OF CONTROLLING AND REDUCING RISK ............................................................................. 80 3. RISK VOIDANCE, RETENTION AND MODELING .................................................................................... 82

E. Professional Values and Ethics .................................................................................. 86

1. ETHICS THEORIES .............................................................................................................................. 86

2. DIFFERENT APPROACHES TO ETHICS AND SOCIAL RESPONSIBILITY .................................................... 89 3. PROFESSIONS AND THE PUBLIC INTEREST ........................................................................................... 93 4. PROFESSIONAL PRACTICE AND CODES OF ETHICS ............................................................................... 96

5. CONFLICTS OF INTEREST AND THE CONSEQUENCES OF UNETHICAL BEHAVIOR ................................... 98 6. ETHICAL CHARACTERISTICS OF PROFESSIONALISM .......................................................................... 105

7. SOCIAL AND ENVIRONMENTAL ISSUES IN THE CONDUCT OF BUSINESS AND ETHICAL BEHAVIOR. ..... 106

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A. Governance and Responsibility

1. The Scope of Governance

a) Define and explain the meaning of corporate governance.

Definition:

The OECD says corporate governance is a:

set of relationships between a companys directors, its shareholders and other stakeholders.

structure through which the objectives of the company are set, and the means of obtaining these objectives and monitoring performance.

The IIA says governance is:

the system by which a company is controlled and directed. Governance includes the rules and procedures for making decisions on corporate affairs to ensure success while

maintaining the right balance with stakeholders interest.

Governance is the leadership and direction given to a company so that it can achieve the objectives of its existence.

Note: Important points are boxed.

Cadbury Report of 1992 said:

Corporate Governance is the system by which organizations are directed and controlled.

Explain the meaning of governance:

Governance is the leadership and direction given to a company so that it achieves the objectives of its existence.

Management is about making business decisions: governance is about monitoring and controlling decisions.

Governance is not about formulating business strategy for the company. However, the responsibility of the board and senior managers for deciding strategy is an aspect of governance.

Benefits to having GOOD corporate governance processes:

The company will have improved risk management system.

There will be clear accountability for executive decision making.

It focuses management attention on introducing appropriate systems of internal control.

It encourages ethical behavior and a CSR (Corporate Social Responsibility) perspective.

It can help safeguard the organization from the misuse of assets and possible fraud.

It can help to attract new investment into a company.

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Seeks to put limits on excessive director remuneration.

Downside to governance:

It could develop an excessively risk adverse culture amongst mangers.

There could be too much reporting and not enough time to seek and pursue profit making activities.

It could damper entrepreneurial activities.

There could be too much excessive supervision, red tape and bureaucracy.

The cost of operating internal controls exceeds any possible benefits.

There is the possibility that the focus on meeting different stakeholder expectations will confuse management as to their corporate responsibilities.

b) Explain, and analyze the issues raised by the development of the joint stock company as the dominant form of business organization and the separation of ownership and control over the business activity.

Joint stock companies have multiple shareholders. The shareholders own the company but generally do not run the company. There is a separation of ownership and control. In order to maintain control over the company, shareholders elect a board of directors who have oversight authority. The board then hires the CEO who is then responsible for putting together the management team to run the company.

Since management does not have a vested interest in the company, they might not care as much whether the objectives of the company are met.

c) Analyze the purposes and objectives of corporate governance.

Purpose of Governance:

The purpose of corporate governance is to facilitate the effective, entrepreneurial and prudent management that can deliver the long-term success of the company.

Good corporate governance should contribute to better company performance by helping a board discharge its duties in the best interest of the shareholders. If it is ignored, the consequences may well be vulnerability or poor performance. Good governance should facilitate efficient, effective and entrepreneurial management that can deliver shareholder value over the longer term.

d) Explain, and the apply in context of corporate governance, the key underpinning concepts of:

i. Honestly/probity Be honest that statements about the company are truthful. Not putting a spin on the facts.

ii. Accountability The emphasis is the managers accountability to the shareholders, but also accountable to other possible stakeholders.

iii. Independence The emphasis is making sure that there are truly non-executive directors on the board who are free to critique the job performance of management. Independence is not having a conflict of interest issue.

iv. Responsibility The board has a responsibility to oversee the work on management. The board should also retain responsibility for certain key

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decisions, such as setting strategic objectives and approving critical capital investments.

v. Decision making / judgment All directors are expected to have sound judgment and to be objective in making their judgments. The OECD says the board should be able to exercise judgment on corporate affairs independent, in particular, from management.

vi. Reputation A companys reputation, if good, is built on success and management competence. However, it might take years for a company to gain its reputation and only a day for it to get ruined. Companies that are badly governed can be at risk of losing goodwill from investors, employees and customers.

vii. Integrity This is similar to honestly, but it also means behaving in accordance with high standards of behavior and a strict moral or ethical code of conduct. This means doing the right thing. Being a straight shooter.

viii. Fairness This means that all shareholders should receive fair treatment from the directors (one share one vote). This also means taking into account the other stakeholders of the company, such as suppliers, creditors, employees, local community, etc.

ix. Transparency / openness This means not hiding anything. Transparency means clarity. This involves full disclosure of material matters which could influence the decisions of stakeholders.

Note: A good way to remember the key concepts of corporate governance is to think of the mnemonic HAIRDRIFT.

e) Explain and assess the major areas of organizational life affected by issues in corporate governance.

i. Duties of directors and functions of the board (including performance measurement). Directors have a fiduciary duty to act in the best interest of the company. They need to use their powers for proper purpose, avoid conflicts of interest and exercise a duty of care.

ii. The composition and balance of the board (and board committees). Boards must be balanced in terms of skill and talents from several specialisms relevant to the organizations situation and also in terms of age (to ensure senior directors are brining on newer ones to help succession planning).

iii. Reliability of financial reporting and external auditing. The reliability of the financial reports is crucial to ensuring that management is held accountable. External auditors need to make sure that they are getting the right information in order to verify the reliability of the financial reports. External auditors cannot be fearful of asking awkward questions because of fear of losing the audit.

iv. Directors remuneration and rewards. Directors remuneration has to be seen as being fair. Excessive salaries and bonuses has been seen as one of the major corporate abuses for a number of years.

v. Responsibility of the board for risk management systems and internal control. Boards should meet regularly as to provide proper oversight for risk management and internal control systems. Without proper oversight, the organization may have inadequate systems in place for measuring and reporting on risks.

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vi. The rights and responsibilities of shareholders, including institutional investors. Shareholders should have the right to receive all material information that may affect the value of their investment and to vote on measures affecting the organizations governance.

vii. Corporate social responsibility and business ethics. Corporate social responsibility and business ethics is an important part of the corporate governance debate. At this point, there is not any real consensus about these issues.

The South African King report commented that The relationship between a company and its stakeholders should be mutually beneficial. This inclusive approach is the way to create sustained business success and steady long-term growth in corporate value.

However, the Hampel report emphasized responsibility towards shareholders and states that it is impractical for boards to be given lots of responsibilities towards the wider stakeholder community.

f) Compare, and distinguish between public, private and non-governmental organizations (NGO) sectors with regard to the issues raised by, and scope of, governance. THESE ANSWERS MIGHT NEED EXPANDING.

Public Sector Governance requirements stress the need for assessing the effectiveness of policy and arrangements for dialogue with users of services.

Private The private sector is concerned with the continued existence of the company. Therefore, having good governance processes is of vital importance.

NGOs Non-governmental organizations provide services which are not normally provided by either public or private organizations. Therefore, they need governance processes which can ensure that they are providing the best service possible.

g) Explain and evaluate the roles, interests and claims of, the internal parties involved in corporate governance.

i. Directors Have an operational role in running the company, developing strategies, etc. Concerning corporate governance, directors have the role to act responsibly; to act with honesty; be accountable, etc. (HAIRDRIFT).

ii. Company Secretaries Company secretaries are an officer of the company and as such they have an operational role in the company. For example, company secretaries might sign some contracts, or declare some relevant matters to the proper authorities. They also have role to play in corporate governance by making sure that the directors are complying with corporate governance.

Some of the functions / responsibilities of the company secretary are listed below:

Should be responsible for providing relevant, reliable and timely information to all directors, so that they are able to make well-informed judgments in contributing to decision-making by the board.

Should be an expert on the regulations and corporate governance, so that he can advise the board on any matters in which a governance issue should be considered.

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Although the chairman should be responsible for induction of new directors and continuing professional development of established directors, the company secretary is likely to be given the responsibility for organizing induction and, where appropriate, CPD for directors.

The chairman is also responsible for the performance appraisal of the board, board committees and individual directors.

The company secretary should be the first point of contact for any NED wanting assistance or information from the company.

iii. Sub-board management If a manager is not on the board, then he or she is considered to be part of sub-board management. This person might be the purchasing agent, human resource manager, etc. Concerning operational roles, directors develop strategies to achieve some objective, and it will be the sub-board managers who have to take the strategy and develop the tactics to achieve the objectives of the organization.

iv. Employees Employees have an operational role to carry out the tactical plans of the sub-board management. As far as corporate governance, the employees have the responsibility to comply with the corporate governance systems in place and adopt appropriate culture. They need to implement the risk management and control procedures and to report back if controls are not working as they should.

v. Unions Unions have a responsibility to protect the interest of the employees. As such, the ability of management to alter its working practices, for example, may depend on obtaining the cooperation and support of the trade unions.

h) Explain and evaluate the roles, interest and claims of, the external parties involved in corporate governance.

i. Shareholders (including shareholders rights and responsibilities) The role of governance is to protect the rights of all shareholders, including the right to vote for board members, etc.

ii. External Auditors Auditors try to influence to the company to present reliable and accurate financial statements. Auditors can also influence by recommending ways to improve the strength of internal controls within the company. They can also provide other audit services such as social and environmental audits. They can also highlight governance and reporting issues of concern to investors.

iii. Regulators Regulators (i.e., SEC, etc.) have a role of making sure that public companies financial information is transparent, reliable and accurate. Regulation can be defined as any form of interference with the operation of the free market. This could involve regulating supply, price, profit, quantity, entry, exit, information, technology, or any other aspect of production and consumption in the market.

iv. Government Like regulators, the government has a role to make sure that regulators are doing their job in making sure that public companies are abiding by the laws and regulators of the country.

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v. Stock exchanges Public companies list their shares on regulated stock exchanges, such as New York Stock Exchange, NASDAQ, American Stock Exchange, London Stock Exchange, and many others. Stock exchanges are privately owned and thus they need to protect their reputation. Stock exchanges are regulated and thus require listed companies to abide by governmental regulations.

Stock exchanges are important because they provide regulatory frameworks in principles-based jurisdictions. Stock exchange regulation can therefore have a significant impact on the wary corporate governance is implemented and companies report.

vi. Small investors (and minority rights) The role of governance is to protect the interest of the minority shareholders; to make sure that their voices are heard and that they are treated equally.

vii. Institutional investors (Analyze and discuss the role and influence of institutional investors in corporate governance systems and structures, for example, the roles and influences of pension funds, insurance companies and mutual funds) - Institutional investors manage funds of individual investors. They are organizations which pool large sums of money and invest those sums in security, real property and other investment assets. They can also include operating companies which decide to invest its profits to some degree in these types of assets.

Major institutional investors are:

Pension funds.

Insurance companies.

Investment and unit trusts.

Venture capitalist organizations.

Institutional investors will have a lot of influence in the management of corporations because they will be entitled to exercise the voting rights in a company. They can actively engage in corporate governance. Furthermore, because institutional investors have the freedom to buy and sell shares, they can play a large part in which companies stay solvent, and which go under. Influencing the conduct of listed companies, and providing them with capital are all part of the job of investment management.

Intervention by institutional shareholders:

Under extreme circumstances, the institutional shareholders may intervene more actively, by, for example, calling a company meeting in an attempt to unseat the board. Reasons why institutional investors might intervene:

Concern about the strategy in terms of product, markets and investments.

Poor operational performance.

Management is dominated by a small group of executive directors, with NEDs failing to hold them accountable.

Major failure of internal controls, particularly in the area such as health and safety, pollution or quality.

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Failure to comply with laws and regulations or governance codes.

Excessive levels of directors remunerations.

Poor attitudes towards corporate social responsibility.

2. Agency Relationship and theories

a) Define and explore agency theory.

Agency theory is a theory of the relationship between the principal and an agent.

In limited companies, the directors and senior managers act as agents of the shareholders, who own the company.

Agency theory is based on the view that when an agent represents a principal, the self-interest of the agent is different from the interests of the principal. Without suitable controls and incentives, the agent will make decisions and actions that are in his or her own interest rather than those of the principal.

Agency theory is relevant to corporate governance because many of the measures recommended for good governance are concerned with controls and incentives that will persuade agents to act in the shareholders best interest.

o For example, controls are applied through accountability and incentives are given in remuneration packages.

b) Define and explain the key concepts in agency theory:

i. Agents The agents are the directors and senior management of the company. They are selected and hired to run the company in the best interest of the shareholders.

ii. Principals The principals are the shareholders. They elect the board and the board hire the CEO who is in charge of putting the management team together.

iii. Agency An agency relationship arises when one or more persons (the principals) engage another person (the agent) to perform some service on their behalf that involves delegating some decision making authority to the agent (Jensen and Meckling).

iv. Agency costs Agency costs are the costs of having an agent make decisions are behalf of a principal. Applying this to corporate governance, agency costs are the costs that the shareholders incur by having managers run the company instead of running the company themselves. There are three costs associated with agency costs:

Cost of monitoring. The owners of the company have to establish systems to monitor the actions and performance of management, to try to ensure the management is acting in the best interest of the company.

Bonding costs. These are costs to provide incentives to managers to act in the best interest of the company.

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Residual loss. Costs to the shareholders of management decisions that are not in the best interest of the shareholders (but in the interest of the managers themselves).

Agency costs = monitoring costs + bonding costs + residual costs.

v. Accountability Agents should be held accountable for their decisions and actions. Accountability means:

Having to report back to the principal to give an account of what has been achieved.

Having to answer questions from the principals about the performance and achievements.

Having the power to reward or punish the agent for good or bad performance.

Greater accountability should reduce agency problems because it provides management with an incentive to achieve performance which is in the best interest of the shareholders. However, incentives should not be excessive where the cost of the incentive is greater than the benefit that the monitoring provides.

vi. Fiduciary responsibilities Fiduciary duty is a duty of the agent to act for the good of the company. A person with fiduciary duty is in a position of trust.

However, the existence of fiduciary duty is not sufficient to insure that there is good corporate governance.

Evan and Freeman argued that management bears a fiduciary relationship to stakeholders and to the corporation as an abstract entity. It must act in the interests of the corporation to ensure the survival of the firm, safeguarding the long-term stakes of each group.

The main fiduciary duties of directors are:

o Act in the best interest of the company.

o Avoiding conflict of interest.

o Using powers of proper purpose.

o Having a duty of care.

vii. Stakeholders Stakeholders are parties (both internal and external) who have an interest in well-being of the company. The different stakeholders include: management, shareholders, vendors, creditors, board of directors, employees, regulators, pressure groups (like PETA, Green Peace, etc.), auditors, and the local community.

c) Explain and explore the nature of the principal-agent relationship in the context of corporate governance.

Jensen and Meckling defined the agency relationship as a form of contract between the companys owners and its managers, where the owners appoint an agent to manage the company on their behalf.

The owners expect the agents to act in the best interest of the owners. Ideally, the contract between the owners and managers should be sure that he managers always act in the between interest of the owners. However, it is impossible to arrange the perfect contract, because decisions by the

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managers affect their own personal welfare as well as the interest of the owners.

This raises a fundamental question. How can managers, as agents of their company, be induced or persuaded to act in the best interests of the shareholders?

d) Analyze and critically evaluate the nature of agency accountability in agency relationships.

In the context of agency, accountability means that the agent is answerable under his contract to his principal and must account for the resources of his principal and the money he has gained working on his principals behalf.

Two issues with the idea of agents being held accountable:

1) How does the principal enforce this accountability?

2) What if the agent is accountable to parties other than his/her principal? How does he/she reconcile possible conflicting duties.

e) Explain and analyze the following other theories used to explain aspects of the agency relationship.

i. Transaction costs theory.

Transaction cost theory was developed by Coase and Williamson is an economic theory. Is based on the idea that companies have to decide which activities are needed to be performed in house and which activities it can buy from external sources. It attempts to provide an explanation of the actions and decisions of managers that are not consistent with rationality and profit maximization.

Williamson argued that the actions and decisions of managers are based on a combination of bounded rationality and opportunism.

Bounded rationality means that the manager will have limited understanding of alternatives. This may imply that they will play it safe and concentrate only on safe markets.

Opportunism means that managers make decisions based on their own personal interests.

Conclusion: Managers should be controlled to prevent them from acting in their own interests rather than in the best interest of the shareholders.

This theory is consistent with agency theory and provides a theoretical justification for the need for rules or principles of good corporate governance.

Need to make sure that the objectives of management and the shareholders are congruent.

ii. Stakeholder theory.

Companies provide not only wealth to the shareholders, but they provide jobs to a employees and contribute the national and local economies.

Companies are corporate citizens and thus they have a responsibility to society.

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There is a close link between stakeholder theory and CSR.

In addition to providing returns to shareholders, companies have a responsibility to its employees, customers, governments, communities, suppliers, lenders and the general public.

Accountability is an important aspect of responsibility. This means that companies not only should report to its shareholders, but also provide information to its stakeholders, either by producing more reports or by including more information in its annual reports. This might explain the publication by some companies of an annual sustainability report and employee reports for the benefit of the companys employees.

Mendelows power/interest matrix. Interest is horizontal, and power is vertical.

Four quadrants Ignore, Keep informed, Keep satisfied, and Key Players.

Level of Interest

Po

we

r

Low High

Weak

Ignore Keep Informed

Strong Keep Satisfied Key Players

Ignore quadrant Stakeholders who are in this category can be ignored by the company. In this quadrant might be the government, or some shareholders, or employees who really dont have any power or interest. However, this does not take into account any moral or ethical considerations. It is simply the stance to take if strategic positioning is the most important objective.

Keep Informed Most shareholders would fall into this quadrant. You need to keep shareholders informed of whats going on (e.g., annual report), but they dont exert much power. However, stakeholders in this quadrant can increase their overall influence by forming coalitions with other stakeholders in order to exert a greater pressure and thereby make themselves more powerful.

Keep Satisfied In this quadrant the stakeholder doesnt have much interest but does have strong power over the company. All these stakeholders need to do to become influential is to re-awaken their interest. This will move them across to the right and into the high influence sector, and so the management strategy for these stakeholders is to keep satisfied.

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Key players Key players are those who have the greatest influence on the company. This question here is how many competing stakeholders reside in that quadrant of the map. If there is only one (e.g., management) then there is unlikely to be any conflict in a given decision-making situation. If there are several, then there are likely to be difficulties in decision-making and ambiguity over strategic direction.

Different categories of Stakeholders:

As far as stakeholders, have to understand the differences on how to categorize stakeholders. Including:

Internal and external stakeholders. This is probably the easiest distinction between stakeholders.

o Internal stakeholders will typically include employees and management.

o External stakeholders will include customers, competitors, suppliers, and so on.

Some stakeholders might be more difficult to categorize, such as trade unions that may have elements of both.

Narrow and wide (Evans and Freeman).

o Narrow are those that are most affected by the org. policies and will usually include shareholders, management, employees, suppliers, and customers who are dependent upon the organizations output.

o Wide are those not so much affected, including government, less-dependable customers, the wider community, etc.

The Evans and Freeman model may lead some to conclude that an organization has a higher degree of responsibility and accountability to its narrower stakeholders.

Primary vs. secondary (Clarkson).

o A primary stakeholder is one without whose continuous participation the corporation cannot survive as a going concern. So primary are those that do influence the company and those that do not (i.e. shareholders, customers, suppliers and government (tax and legislation)).

o Secondary are those that the org. does not directly depend upon for its immediate survival (e.g. broad communities and perhaps management, since management can be replaced.

Active and passive stakeholders (Mahoney).

o Active stakeholders are those who seek to participate in the organizations activities. These stakeholders may or may not be part of the formal structure. Management and employees obviously fall into this active category, but so may some parties from outside an organization, such as regulators, environmental pressure groups, and possibly large investors (i.e. institutional investors).

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o Passive stakeholders are those who do not normally seek to participate in an organizations policy making. This is not to say that passive stakeholders are any less interested or less powerful, but they do not seek to take an active part in the organizations strategy. Passive stakeholders will normally include most shareholders, government, and local communities.

Voluntary vs. involuntary.

o Voluntary include the employees (those with transferable skills), most customers, suppliers and shareholders.

o Involuntary are those who do not chose to be stakeholders, but are so nevertheless, for example, local communities, future generations, and most competitors.

Legitimate vs. illegitimate.

o This one is more difficult and it might depend on your viewpoint. While those with an active economic relationship with an organization will almost always be considered legitimate, others that make claims without such a link, or that have no mandate to make a claim, will be considered illegitimate by some.

o While a terrorist would be considered illegitimate, there is more debate on the legitimacy of the claims of lobby groups, campaigning organizations, and non-governmental/charitable organizations.

Recognized vs. unrecognized.

o This categorization follows on from the debate over legitimacy. If an organization considers a stakeholders claim to be illegitimate, then the organization would not recognize the stakeholders claim when making a decision.

Known and unknown.

o Finally, some stakeholders are known about by the organization in question and others are not. This means, of course, that it is very difficult to recognize whether the claims of unknown stakeholders (e.g., nameless sea creatures, communities in close proximity to overseas suppliers, etc.) are considered legitimate or not. Some say that it is a moral duty for organizations to seek out all possible stakeholders before a decision is taken and this can sometimes result in the adoption of minimum impact policies. For example,, even though the exact identify of a nameless sea creature is not known, it might still be logical to assume that low emissions can normally be better for such creatures than high emissions.

Instrumental and normative motivations of stakeholder theory.

o The instrumental viewpoint is that organizations only take shareholder opinions into account only insofar as they are consistent with the economic objectives of the company.

o The normative viewpoint takes a more moral stand. Based on the moral philosophy of Immanuel Kant (1724-1804) who believed the each of us has a moral duty to account for each others concerns and opinions.

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Kant talked about the civil duty, which he believed important in maintaining and increasing overall good in society.

3. The Board of Directors

a) Explain and evaluate the roles and responsibilities of boards of directors.

The board should be responsible for making major policy and strategic decisions. Directors should have a mix of skill and their performance should be assessed regularly. Boards are collectively responsible for:

Promoting the success of the company

Providing leadership and direction.

Managing risks and instituting the appropriate systems of internal controls.

Supervising lower levels of management and employees.

Setting the strategic goals and targets of the company.

Ensuring that the necessary financial and human resources are in place.

Reviewing managerial performance.

Other responsibilities are:

Monitoring the CEO.

Overseeing the implementation of corporate strategy.

Monitoring risks, control systems and systems of CG.

Monitoring HR issues like succession planning, training, remuneration, etc.

Ensuring the effective communication of strategic plans to stakeholders.

It was suggested by UK Cadbury report that, as a principle of good corporate governance, there should be a formal list of matters reserved for collective decision-making by the board. These matters include:

Strategy approving long-term objectives, deciding commercial strategy, approving budgets, oversight of operational performance.

Investments approving major capital investments, major contracts, acquisitions and disposals.

Decisions on capital structure and financing.

Decisions on major organization and management re-organization.

Review of the effectiveness of internal controls and risk management systems. This function might be delegated to internal auditing, if the company has an internal auditing function.

Communication with shareholders.

Remuneration of executive directors and other senior executive managers.

Appointments to the board.

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Company policies.

Proposing dividends.

b) Describe, distinguish between and evaluate the cases for and against, unitary and twotier board structure.

In most countries, companies have a single board of directors (unitary board). This board would consist of executive and non-executive directors, with a chair and a CEO.

Some countries have a 2-tier board structure (Germany and Netherlands), consisting of:

A management board of executive directors (headed by the CEO or managing director).

o The management board reports to the supervisory board.

o Is responsible for day-to-day running of the business.

A supervisory board of NED (headed by the chair of the company).

o This board has no executive function; however it may review the companys direction and strategy. It is meant to safeguard shareholder interest.

o Receives formal reports of the state of the companys affairs and finance.

o It approves the accounts and may appoint committees and undertake investigations.

In a 2-tier company board structure:

Membership of the two boards is entirely separate.

The effectiveness of this type of structure will depend on the relationship between the chair and CEO. In public companies:

It is usual in a unitary board for most non-executive directors (NEDs) to be classified as independent.

Most NEDs in a supervisory board would not be regarded as independent. In a 2-tier board structure, NEDs on the supervisory groups often are:

o Represent interest groups (e.g., employees or major shareholders), or

o Former executive directors of the company, possibly former members of the management board who have now retired form the company.

2-tier board

Advantages Disadvantages

Responsibilities for management and

governance are clearly separated.

Supervisory board can be very large.

Supervisory board membership recognizes

interests of stakeholders groups.

Decision-making might be slower than with a

unitary board.

Executive directors and NEDs have different

responsibilities and duties.

Might be the risk of conflict between the two

boards.

Risk of conflict between interest groups on the

supervisory board

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Unitary board

Advantages Disadvantages

Unitary boards can be small in size because

there are no requirements to appoint directors

who represent stakeholder interest groups.

Can also get too large if not careful.

It is easier for the NEDs and the executive

directors to work co-operatively.

If there is a conflict between chair and CEO, this

can negatively affect the company.

Unitary boards work towards a common goal,

which is what the board considers to be in the

best interest of the shareholders and others.

As with any board, there not be a consensus of

what the goals are.

c) Describe the characteristics, board composition and types of, directors (including defining executive and non-executive directors (NED).

The Combined Code states that at least one half of the board members should be independent non-executive directors, with a minimum of 3 NEDs. There has to be a balance between EDs and NEDs.

The Combined Code also states that a former CEO of a company should not move on to become the company chairman. The Combined Code argues that the power of chairman and CEO should not be held by one individual because it gives too much power on the board to that individual.

Board composition:

A chairman, who may be any executive director but is usually a NED.

Sometimes a deputy chairman.

A chief executive officer, who an executive director.

Other executive directors, possibly including the CFO, COO, and others.

Other NEDs.

Balance of Power:

The board should contain a suitable balance of power in order to prevent one person or group of people from dominating the decision making of the board.

When there are several independent minded individuals on the board, it is more likely that the interest of the shareholders, and possibly also other stakeholders in the company will be properly represented.

Several ways to achieve suitable balance:

o The same individual should not hold the position of CEO and chairman at the same time.

o The roles of the CEO and chairman should be specified formally so that one individual is not able to take responsibilities away from the other. There needs to be a written charter.

o There needs to be the presence of independent non-executive directors on the board. The Combined Code states that for large stock market companies, a majority of the board should be independent NEDs (50%).

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o There should be a senior NED with sufficient strength of character to challenge both the chairman and CEO if this seems necessary. This person needs to be able to ask hard questions.

o The NEDs must be effective in their roles. They need to be able to give sufficient time to the company.

o Some decision making should be delegated to the board committees to remove decision making from directors in cases where there is a conflict of interest, or to act as a check on some of the activities of executive directors (for example the audit committee).

Executive and NEDs:

Executive directors are directors who also have executive management responsibilities in the company. They are normally full-time employees.

NEDs are directors who do not have any executive management responsibilities.

o They are not employees of the company.

o They are not full-time. When they are appointed, there should be a clear understanding about how much time (each month or each year) the NED will probably be required to give to the companys affairs.

d) Describe and assess the purposes, roles and responsibilities of NEDs.

The Higgs report commented that the role of the NED is frequently described as having two main elements: (1) monitoring executive activity and (2) contributing to the development of strategy.

Higgs identified four roles for NEDs.

1) Strategy. Should contribute development of the companys business strategy.

2) Scrutinizing performance. The NEDs need to scrutinize the performance of management.

3) Risk management/Internal control. NEDs should satisfy themselves that financial information produced by management is reliable. They need to satisfy themselves that financial controls and systems of risk management are robust and defensible.

4) People. They should be involved in the people side of running the company, including their roles on the nomination committee and remuneration committees. NEDs are responsible for deciding the level of remuneration of executive directors. They also have a prime role in appointing and removing senior management, and in succession planning.

Cross-directorship is a situation where the executive director of one company (company A) sits on the board of another company (company B). At the same time, a executive director of company B, sits on the board of company A. When this situation exists, the NEDs involved might be reluctant to criticize each other.

In practice, many companies do not allow cross-directorships.

Some of the problems that can occur with the appointment of NEDs:

Lack of independence if appointed by the NED.

Lack of authority to impose their views.

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Often confined to represent the views of the stakeholders.

A limited amount of time they can devote to the board.

May be a difficulty in recruiting good NEDs limited supply.

Ways to ensure independence:

Not involved in share scheme.

Their service should not be pensionable.

Should be for a specific period.

The NED should not have any business, financial or other connection with the company-apart from fees and shareholdings.

Re-appointment should not be seen to be automatic.

The full board should decide on their selection and appointment.

NED must be able to take external professional advice where necessary and the costs of same have to be borne by the company.

e) Describe and analyze the general principles of legal and regulatory frameworks within which directors operate on corporate boards.

Duties while in office:

Legal rights and responsibilities. Directors are entitled to fees and expenses according to the companys constitution. Directors have a duty of care to show reasonable competence and may have to indemnify the company against loss caused by their negligence. Directors are also said to be in a fiduciary position in relation to the company.

Duty to act within powers. Directors have to operate in accordance with the companys constitution and only to exercise powers for the purpose for what they were elected for.

Duty to promote the success of the company. The law should encourage long-termism and regard for all stakeholders by directors and that stakeholder interests should be pursued in an enlightened and inclusive way.

Duty to exercise independent judgment. This means that directors should not delegate their powers of decision-making or be swayed by the influence of others.

Duty to exercise reasonable skill, care and diligence. Directors have the duty of care to show reasonable skill, care and diligence.

Duty to avoid conflict of interest. A director is an agent of the company. A director would be in breach of fiduciary duty to the company, for example, if he puts his or her own interests first, ahead of the interests of the company. A breach of fiduciary duty would also occur if a director has an interest in a contract with the company but fails to disclose this interest to the rest of the board and obtain their approval.

Duty not to accept benefits from third parties. This duty prohibits the acceptance of benefits (including brides) from third parties conferred by reason of them being a director, or doing, (or omitting to do) something as a director.

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Duty to declare interest in proposed transaction or arrangement. Directors are required to disclose to the other directors that nature and extent of any interest, direct or indirect, that they have in relation to a proposed transaction or arrangement with the company.

Insider dealing / trading.

o An insider is someone who has business connection with an entity as a result of which they may acquire relevant information.

o Insider dealing is where a person with inside information buys or sells shares or securities in an entity.

o An insider in possession of unpublished price sensitive information should not deal.

o An offense is also committed if the insider encourages another person to deal.

o The person dealing as a result of that encouragement, and believing the source to be an insider, is also committing an offense.

o Disclosure of insider information, other than in the proper course of employment to an authorized person, is also an offense.

Leaving Office:

Departure from office. A director may leave office in the following ways:

o Resignation.

o Not offering him or herself for reelection.

o Death.

o Dissolution of the company (e.g. bankruptcy).

o Being removed from office.

o Prolonged absence (generally more than 6 months).

o Being disqualified.

o Agreed departure.

Time limited appointments. Ordinary directors may have to retire from the board on reaching a retirement age or may not be able to seek reelection.

o Time-limited appointments. Existing directors are required to stand for re-election at regular intervals.

o Fixed term contracts. NEDs are usually appointed for a fixed term. In the UK, normal practice is for 3-years. At the end of this term, the appointment might be renewed for a further 3-years.

Retirement by rotation. It is usual for directors who retire by rotation and stand for re-election to be reelected by a very large majority. In the UK, most companies include in their constitution a requirement that one-third of directors should retire each year by rotation and stand for re-election. This means that each director stands for re-election every three years. (this is why appointments of NEDs are for periods of 3-years.)

Service contracts. Executive directors have service contracts with the company. A service contract includes terms such as entitlement to

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remuneration including pension rights, and a minimum notice period for termination of office.

Removal. When a director performs badly, it should be expected that he or she will be asked by the board or the company chairman to resign. This is the most common method by which directors who have failed are removed from office. When a director is removed from office, he or she retains contractual rights, as specified in his or her contract of employment. This could involve a very large payment.

Disqualification. The corporate law of a company might provide for the disqualification of any individual acting as a director of any company, where the individual is guilty of behavior that is totally unacceptable from a director. This could include:

o When a director is bankrupt.

o Director is suffering from a mental disease.

o Director has been found guilty of a crime in connection with the formation or management of a company.

f) Define, explore and compare the roles of the CEO and the board chairman.

Role of the CEO:

The CEO is responsible for the executive management of the company operations.

The CEO is the leader of the management team, and all senior managers report to the CEO.

If there is an executive management committee for the company, the CEO should be the chairman of this committee.

The CEO reports to the board on the activities of the entire management team, and is answerable to the board for the companys operational performance.

Risk management. The CEO is responsible to manage the companys risk profile.

Liaison with stakeholders. The CEO need to deal with those interested in the company.

Role of the Chairman:

The chairman must act as the spokesperson of the board.

Is the conduit of communication between the CEO and the shareholders.

Ensuring that the board as a whole and also individual directors contribute effectively to the work of the board.

o Sets the agenda for the board meetings.

o Provides suitable information before each board meeting.

o At board meetings, encourages open dialogue between members of the board.

o Helps non-executive directors to contribute effectively to the company.

The chairman is responsible for the effectiveness of the board. He is therefore responsible for:

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o The induction of all new directors, and

o The annual performance review of the board, board committee and individual directors.

Also sets the tone at the top.

Should be the advocate of ethical behavior in the company.

An effective chairman should establish a close working relationship with the CEO and should ensure that all decisions by the board are implemented.

He or she should promote best practice in corporate governance and high standards of ethical conduct by the company and its employees.

He or she should provide leadership for the company are represent its views with external stakeholders, including the shareholders.

Summary of the roles of CEO and Chairman

CEO

Executive director. Full time employee

Chairman

Part-time. Usually independent.

Reporting Lines

All executive managers report, directly or indirectly, to the CEO.

The CEO reports to the Chairman and to the board generally.

Reporting Lines

No executive responsibilities. Only the company secretary and the CEO report to the chairman directly, on matters relating to the board.

Main responsibilities

Head of the executive management team.

Business strategy development and leadership.

Make financing and investment decisions.

Managing the companys risk profile.

Implement board decisions.

Involvement with certain board committees.

Main responsibilities

Leader of the board, with responsibility for its effectiveness.

To make sure that the board fulfills its role successfully.

To ensure that all directors contribute to the work of the board.

Division of responsibilities: The role of the CEO and chairman should be separated. The CEO runs the company and the chairman runs the board. Reasons to separate:

The separation of roles avoids any conflicts of interest.

It is difficult to make the CEO accountable if there is no one senior to him or her.

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The board can make the CEO more accountable for management of the company if there is a separate Chairman of the board.

The UK 2nd Combined Code suggests that the retired CEOs should not become Chair of the same company. The main concern is that he or she would interfere too much in the running of the company by the new CEO.

The Cadbury report stated that if the roles were combined, there should be a strong independent element to the board with NEDs. Higgs states that one senior member of the NEDs should be appointed who would be available to shareholders who had concerns that could not be resolved through normal channels.

g) Describe and assess the importance and execution of, induction and continuing professional development of directors on boards of directors.

The UK Higgs report provides guidance on the development programs.

Induction of new directors:

When directors are appointed to the board of a company, they are expected to bring the benefits of their knowledge, skill and experience to the discussions of the board.

Directors need to build an understanding of the nature of the company, its business and its markets. This includes:

o The companys culture and values.

o The companys products and/or services.

o The structure of the company/subsidiaries/joint ventures.

o Major risks and risk management strategy.

o Key performance indicators.

o Regulatory constraints.

Build a link with the companys people.

o Meet with senior management.

o Visit company sites.

o Participate in the boards strategy development.

o Briefing on internal procedures.

Build an understanding of the companys main relationships including meeting with auditors.

o Major customers.

o Major suppliers.

o Major shareholders.

Continuing Professional Development:

CPD is necessary to make sure that directors remain up to date on their relevant professional knowledge.

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Higgs report suggests that CPD of potential directors should concentrate on the role of the board, obligations and entitlements of existing directors and the behaviors need for effective board performance.

Topics for professional development would include financial management training, HR issues, CG developments, risk management updates on legal and regulatory issues, audit practice and procedures, financial reporting and strategic planning.

h) Explain and analyze the frameworks for assessing the performance of boards and individual directors (including NEDs) on boards.

Performance of the board:

Aim is to improve board effectiveness, maximizing strengths and tackling weaknesses.

Performance of individual directors and the board as a whole needs to be appraised regularly. In the UK there is a requirement for an annual performance review. Ideally, the assessment should be by an external third party who can bring objectivity to the process.

Performance of the whole board needs to include:

o A review of the boards systems (conducting meetings, work of committees, quality of written documentation).

o Performance measurement in terms of standards it has established, financial criteria, and non-financial criteria relating to individual directors.

o Assessment of the boards role in the organization (dealing with problems, communicating with stakeholders).

Higgs Report lists a number of criteria that can be used to monitor the effectiveness of boards.

o Performance against objectives.

o Contribution to strategic development.

o Contribution to risk management.

o Contribution to the development of corporate culture.

o Appropriate composition of the board and committees.

o Effectiveness of responses to crises and problems.

o The proper delegation of matters to lower levels and the reservation of matters for board decision.

o Effectiveness of internal and external communications.

o The extent to which the board is kept appraised of developments.

o The effectiveness of the board committees.

o The quality of information supplied to board members.

o The number of board meetings held.

o The extent to which the board has met all legal, financial reporting, regulatory and CG requirements.

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Performance of individual directors: Need to use the following criteria when judging the performance of the individual director.

Independence: This means avoiding conflict of interest.

Preparedness: The director knows the key staff, organization structure, industry and regulatory background.

Practice: The director participates in board meetings, questions, insists on obtaining information, and undertakes CPD.

Committee work: The director participates fully in audit, risk and nominations committees (remunerations for NEDs).

Development: The director makes suggestions as to strategic choice and direction.

If the director considers performance to be unsatisfactory, he should consider ways of encouraging directors to improve their performance.

4. Board Committees

a) Explain and assess the importance, roles and accountabilities of, board committees in corporate governance.

A board committee is a committee set up by the board, and consisting of selected directors (both executive and non-executive), which is given responsibility for monitoring a particular aspect of the companys affairs for which the board has reserved the power of decision-making.

The role of a committee is to monitor an aspect of the companys affairs, and:

Report back to the board, and

To make recommendations to the board.

The full board should make a decision based on the committees recommendations. If a board was to reject the recommendations of a committee, then the board needs to give a very good reason for doing so.

A board committee needs to meet with sufficient frequency to enable it to carry out its responsibilities. It is important to remember, however, that a board committee is not a substitute for executive management and a board committee does not have executive powers. A committee might monitor activities of executive managers, but it does not take over the job of running the company from management.

b) Explain and evaluate the role and purpose of the following committees in effective corporate governance.

i. Remuneration committees.

The Remuneration Committee deals with the remuneration of executive directors and senior managers.

Some believe that the remuneration of directors should be linked to company performance.

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Level of remuneration should be sufficient to attract and retain and motivate directors to do a good job, but should not pay them more than is necessary for this purpose.

There should be a final and transparent procedure for developing policy on executive remuneration and for fixing the remuneration package of individual directors.

No director should be involved in deciding his or her own remuneration.

There should be limited contracts of service periods, ideally for one year.

The committee should be made up of independent NEDs.

ii. Nominations committees.

The Nominations Committee has the responsibility to identify and recommend individuals for appointment to the board and executive director. The committee should play an active role in the companys succession planning.

This means planning for the eventual retirement of the:

CEO,

The board chairman, and

Possibly the finance director.

In addition, the NC should consider:

The desirable size of the board.

The skills of the board members. Combined code recommends at least one NED have financial experience (aka qualified accountant).

The need to attract board members from a diversity of backgrounds.

The balance between ED and NEDs. The combined code says that there should be a balance with a minimum of 3 NEDs.

iii. Risk committees.

There needs to be a way for companies to manage their risk. Risks include:

Business and strategic risks, and

Risk of errors, fraud, losses, breakdowns, etc.

This board would have oversight responsibility for risk and internal control.

Typical roles of the Risk Committee:

To agree with the RM strategy.

Receive and review RM reports from all operational departments.

Monitor overall exposure and specific risks.

Assess the effectiveness of the RM strategy.

Provide guidance to the main board.

Work with the AC on designing and monitoring ICs for the mitigation and management of risk.

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Prepare reports on risks and draft the RM strategy note for the annual accounts.

To assist in determining a companys risk appetite. The board will determine the level of risk the company is willing and able to take on.

iv. Audit committees.

The audit committee is considered to be the most important board committee. The UK Cadbury report emphasized the importance of internal audit having unrestricted access to the audit committee.

The board should establish an AC of at least three, or in the case of smaller companies, two, independent NEDs.

The board should be satisfied that at least one member of the AC has recent and relevant financial experience.

The AC needs to ensure that the external auditors are completely independent of the company and its subsidiaries, and that they are working in the best interests of the shareholders. The audit committee should ensure that the company complies with all laws and regulations applying to it, and that the necessary reports are filed with the authorities.

The AC needs to review and discuss with management and the external auditor the effects of changes in accounting standards, and the implications of these proposed changes.

Needs to ensure that both the external and internal auditors have sufficient resources to carry out their defined roles.

Needs to act as a mediator between management and auditors when there is a difference of opinion.

Needs to recommend on the appointment or replacement the external auditor, who shall report directly to the Audit Committee. If the board does not accept the ACs recommendation, it should include the reasons in the annual report.

Needs to be directly responsible for the compensation and oversight of the work of the external auditor.

Role and responsibilities of the Audit Committee:

An AC of independent NEDs should liaise with external audit, supervise internal audit and review the annual accounts and internal controls.

To monitor the integrity of the financial statements of the company, and any formal announcements relating to the companys financial performance, reviewing significant financial reporting judgments contained in them.

To review the companys internal financial controls, and unless expressly addressed by a separate board risk committee composed of independent directors, or by the board itself, to review the companys internal control and risk management systems.

To monitor and review the effectiveness of the companys 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-

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appointment and removal of the external auditor and to approve the remuneration and terms of the external auditor.

o The external auditor reports directly to the audit committee.

To review and monitor the external auditors 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.

There are several reasons why an audit committee is beneficial to an organization. 1) Independence of the external auditors. The committee selects the

external auditor and thus can eliminate some pressure that the executive management might try to apply.

2) Competence of the external auditor. The committee also assesses the competence of the external auditor.

3) Providing an assessment of the financial statements and audit process. The committee reports to the board on matters that they consider relevant, with regard to financial statements and audit process. Its responsibility is to ensure that the statements are reliable.

4) Independence of the internal auditor. The committee helps to ensure the independence of the internal audit function by having the IAF functionally report to the committee and not to someone in management.

5) Increase public confidence.

5. Directors remuneration

a) Describe and assess the general principles of remunerations.

i. Purposes. There are two purposes of any remuneration package:

1) The package should be designed to attract qualified people to the company; however, it should not be more than necessary,

2) It should provide incentive for the director. The amount that the company will pay will depend upon:

o What other companies are paying, and

o How many suitable candidates are available.

ii. Components. When a remuneration package is designed for a director or senior manager, it should consider:

o Each separate element in the package, and also

o All the elements in the package as a whole.

The components include both short-term and long-term incentives, between cash and equity and between current pay and pension rights.

For example, a director may be paid an average basic salary, but may receive a generous pension entitlement and an attractive long-term incentive scheme.

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Another director might receive a low basic pay, but a very attractive short-term bonus incentive scheme.

iii. Links to strategy. Any directors remuneration package should be linked to the company achieving its long-term objectives. This could entail the company giving the directors the right to purchase shares at a specified exercise price over a specified time period in the future. This provides incentive for the directors to do what they have to do to raise the price of the shares.

iv. Links to labor market conditions. Any remuneration package has to be linked to local market conditions. Again, every company needs to be able to attract and retain qualified personnel, but companies need to make sure that they are not over compensating its directors.

b) Explain and assess the effect of various components of remuneration packages on directors behavior.

i. Basic salary will be in accordance with the terms of the directors contract of employment, and is not related to the performance of the company or the director.

Instead it is determined by the experience of the director and what other companies might be prepared to pay for the directors service (the market rate).

ii. Performance related bonuses. Directors may be paid a cash bonus for good (generally accounting) performance. To guard against excessive payouts, some companies impose limits on bonus plans as a fixed percentage of salary or pay.

o There is also something called Transaction bonuses which is where the CEO get a bonus for acquisitions, regardless of subsequent performance, possibly indeed further bonuses for spinning off acquisitions that have not worked out.

iii. Shares and share options (share schemes). Share schemes are used to provide long-term incentive which gives the executives a personal interest in the performance of the companys share price over a period of several years. Since they have an incentive, they will do (or should do) what they can to improve the financial performance and longer-term prospects.

Problems with these share schemes are:

o Executives might be motivated by short-term targets and cash bonuses than by longer term targets and share awards.

o If share price falls because of a general decrease in the market, the options might be worthless, therefore, not providing much incentive for the executive to perform.

o Share schemes are often for a three year period. The executive receives an award of fully-paid shares, or is able to exercise share options after three years. If the executive sells the shares, his or her interest in the company comes to an end.

(The UK 2nd Combined Code states that non-executive directors should not normally be offered share options, as options may impact upon their independence).

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iv. Loyalty bonuses are intended to get directors to stay with the company for an extended period of time. For example, if a directors contract expires, the director may be paid a bonus for extending the contract.

v. Benefits in kind could include transportation (e.g., a car), health provisions, life assurance, holidays, expenses and loans.

The remuneration committees should consider the benefit to the director and the cost to the company of the complete package.

Also, the committee should consider how the directors package relates to the package for employees. Ideally, perhaps, the package offered to the directors should be an extension of the package offered to the employees.

vi. Pension benefits. Many companies offer pension contributions for directors and staff. In some cases, however, there may be separate schemes available for directors at higher rates than for employees.

The Combined Code states that as a general rule, only basic salary should be pensionable.

The Code emphasizes that the remuneration committee should consider the pension consequences and associated costs to the companys basic salary increases and any other changes in pensionable remuneration, especially for directors close to retirement.

c) Explain and analyze the legal, ethical, competitive and regulatory issues associated with directors remuneration.

It needs to be a principle of corporate governance that the shareholders of the company be given the full information about the remuneration of the companys directors. This information is important so they understand the link between the directors remuneration and company performance.

In the UK, quoted companies are required to publish a directors remuneration report each year. The report must contain extensive disclosures about directors remuneration. It is general practice to include the report in the annual report and accounts.

Some of the information in the remuneration report must be audited by the companys auditors. Other parts of the report are not subject to an audit.

Shareholders must vote at the companys annual general meeting on a resolution to approve the report. This is an advisory vote only, and the shareholders do not have the power to reject the report or amend the remuneration of any director or senior executive.

Information that is subject to audit includes:

The remuneration for the year for each director, analyzed into salary and fees, bonuses, expenses received, compensation for loss of office and other severance payments, and non-cash benefits.

For each director, details of interests in share options, including details of options awarded or exercised during the year, options that expired during the year without being exercised, and any variations to the terms and conditions relating to the award or exercise of options.

For options exercised during the year, the market price of the shares when the options were exercised should also be shown.

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For options have not been exercised, the report should show the exercise price, the date from which the options may be exercised and the date they expire.

For each director, details should be given of pension contributions or entitlements.

Details should also be provided of any large payments made during the year to former directors of the company.

Ethical issues about remuneration.

There are some well-recognized ethical issues that affect the reputation and public perception of companies. The ethical issues include:

The rate of increase in the directors pay has been much greater than the rate of increase in the pay of other employees.

A survey conducted by KPMG (2005) found that bonus payments to senior executives had risen at a fast rate, but the pay rate increase was not linked to long-term strategy of the company and the shareholder value.

o This meant that directors were paid large bonuses but were not adding value to the company.

Research by Income Data Service in the UK in 2006 stated that directors were now earning almost 100 times as much in annual remuneration than other full-time workers, compared with about 40 times as much in 2010. This gap is continuing to increase.

6. Different approaches to corporate governance

a) Describe and compare the essentials of rules and principles based approaches to corporate governance. Includes discussion of comply or explain.

An example of a rules based approach to corporate governance is Sarbanes-Oxley. An example of a principles based approach to corporate governance is the UK Combined Code.

Rules-based approach to corporate governance is based on the view that companies must be required by law to comply with established principles of good corporate governance.

There are advantages with a rules-based approach:

Companies do not have a choice of ignoring the rules.

All companies are required to meet the same minimum standards of corporate governance.

Investors confidence in the stock market might be improved if all the stock market companies are required to comply with recognized corporate governance rules.

Disadvantages are:

The same rules might not be suitable for every company, because the circumstances of each company are different. A system of corporate governance is too rigid if the same rules are applied to all companies.

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There are some aspects of corporate governance that cannot be regulated easily, such as negotiated the remuneration of directors, deciding the most suitable range of skills and experience for the board of directors, and assessing the performance of the board and its directors.

A principles-based approach to corporate governance is an alternative to a rules-based approach. It is based on the view that a single set of rules is inappropriate for every company. Circumstances and situations differ between companies. The circumstances of the same company can change over time. This means that:

The most suitable corporate governance practices can differ between companies, and

The best corporate governance practices for a company might change over time, as its circumstances change.

In the UK, the Combined Code is the relevant code of corporate governance for listed companies. All UK listed companies must comply with rules known as the Listing Rules, which are issued and enforced by the financial markets regulator.

Advantages of principles-based:

It avoids the need for inflexible legislation that companies have to comply with even though the legislation might not be appropriate.

It is less burdensome in terms of time and expenditure.

A principles-based approach allows companies to develop their own approach to corporate governance that is appropriate for their company.

Enforcement on a Comply or Explain basis which means that companies can explain why they are not in compliance with a specific provision.

A principles-based approach accompanied by disclosure requirements put the emphasis on investors making up their own minds about what businesses are doing.

Criticism of principles-based approach:

Criticized as so broad that they are of very little use as a guide to best corporate governance practice.

Hampel report comments about tick-boxing are incorrect.

Investors cannot be confident of consistency of approach. Clear rules mean that the same standards apply to all directors.

Which is more effective. It has been suggested that that the burden of the detailed rules in the US, especially the requirements of section 404, has made the US an unattractive country for foreign companies to trade their shares. As a result, many foreign companies have chosen to list their shares in countries outside the US, such as the UK.

Comply or Explain

The comply or explain approach is the trademark of corporate governance in the UK. 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.

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It is recognized that an alternative to following a provision may be justified in particular circumstances if good governance can be achieved by other means. If a company is in breach of the Code then the reason for the breach should be clearly and carefully explained to shareholders. In providing an explanation, the company should aim to illustrate how its actual practices are both consistent with the principle to which the particular provision relates and contribute to good governance.

In their responses to explanations, shareholders should pay due regard to companies individual circumstances and bear in mind, in particular, the size and complexity of the company and the nature of the risks and challenges it faces. While shareholders have every right to challenge companies explanations if they are unconvincing, they should not be evaluated in a mechanistic way and departures from the Code should not be automatically treated as breaches. Shareholders should be careful when responding to the statements from companies in a manner that supports the comply or explain process and bearing in mind the purpose of good corporate governance.

Smaller companies may judge that some of the provisions are disproportionate or less relevant in their case. Some of the provisions do not apply to companies below the FTSE 350. However, such companies may nonetheless consider that it would be appropriate to adopt the approach in the Code and they are encouraged to do so.

b) Describe and analyze the different models of business ownership that influence different governance regimes (e.g., family firms versus joint stock company-based models).

Insider structures This is where a company listed on a stock exchange is owned and controlled by a small number of major shareholders. The shareholders may be members of the companys founding family, banks, other companies or the government.

o Family companies are perhaps the best example of insider structures. In this case, agency problems are not really an issue because there is no separation between management and owners theyre one and the same.

Advantage of insider system:

o Easier to establish ties between owners and managers.

o Agency problem is reduced and costs of monitoring is also reduced, if management is involved in management.

o Even if owners are not involved in management, it should be easier to influence company management through ownership and dialogue.

o A smaller base of shareholders may be more flexible about when profits are made and hence more able to take a long-term view.

Disadvantage:

o May be discrimination against minority shareholders.

o Evidence suggests that controlling families tend not to monitor effectively by banks or by other large shareholders.

o Insider systems do not develop more formal governance structures until they need to.

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o Insider firms, particularly family firms, may be reluctant to employ outsiders in influential positions and may be unwilling to recruit independent NEDs.

o Succession issues may be a major problem. A vigorous company founder may be succeeded by other family members who are less competent or dynamic.

Outsider systems Outsider systems are ones where shareholding is more widely dispersed, and there is the manager-ownership separation. Sometimes called Anglo-Saxon regimes.

Advantages of outsider systems:

o Provides an impetus for the development of more robust legal and governance regimes to protect shareholders.

o Shareholders have voting rights that they can use to exercise control.

o Hostile takeovers are far more frequent, and the threat of these acts as a disciplining mechanism.

Disadvantages:

o Companies are more likely to have an agency problem and significant costs of agency.

o The larger shareholders in these regimes have often had short-term priorities and have preferred to sell their shares rather than pressurize the directors to change strategies.

c) Describe and critically evaluate the reasons behind the development and use of codes of practice in corporate governance (acknowledging national differences and convergence).

The international guidelines include the OECD principle and ICGN report.

These guidelines came about because of the increase in international trade and cross-border links leads to increased pressure for the internationally comparable practices and standards.

o This is particularly true for accounting and financial reporting.

o Increasing international investment and integration of international capital markets has also led to pressure for standardization of governance guidelines, as international investors seek reassurance about the way their investments are being managed and risks involved.

Not surprisingly, convergence models that have been developed lie between the insider/outsider models, and between profit-orientated and ethical stakeholder approaches.

The result of encouraging better standards of CG should be that:

o Better governance will attract more investment from global investor.

o Companies will benefit from more investment finance, to increase their profits.

o National economies will benefit from having strong and profitable companies.

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Disadvantages of international codes of CG:

These international codes can often represent an attempt to find the lowest common denominator.

Attempts to find global solutions can be difficult because of differences in legal systems, financial systems, cultures, economies and structures of CG.

International guidelines will be based on practice in a number of regimes; accordingly it may lag behind changes in the more advanced regimes.

These international guidelines have no legal status.

d) Explain and briefly explore the development of corporate governance codes in principles-based jurisdictions.

i) Impetus and background:

Principles-based is based on the view that a single set of rules is inappropriate for every company. The UK Cadbury report suggested that a voluntary code coupled with disclosures would prove to be more effective than a statutory code in promoting the key principles of openness, integrity, and accountability.

The development of CG practices in the UK is interesting because it helps to show how different aspects of CG emerged whenever problems with CG became known. In other words, codes of CG are reactive, not proactive.

ii) Major corporate codes:

The Cadbury report (1992). This was the first CG code in the UK. It was a reaction to several financial scandals involving listed UK companies. The main problems were considered to be in the relationship between auditors and boards of directors. There was thought that commercial pressures on both directors and boards caused pressure to be exerted on auditors, and too often, auditors gave in (capitulated). Problems were also perceived in the ability of the board to control their organizations.

CG responsibilities:

o Directors are responsible for CG. o Shareholders are linked to the directors through the financial reporting

system. o Auditors provide shareholders with an external opinion on the

directors financial reports. o Other concerned users, particularly the employees are indirectly

addressed by the financial statements. Code of best practice: The primary aim was to all UK listed companies, but the directors of all companies were encour