P1 Syllabus A: GOVERNANCE AND RESPONSIBILITY A1: The scope of governanceSyllabus A1a) Define and explain the meaning of corporate governance.

Corporate governance“is the system by which organizations are directed and controlled”

It can be internal:

1. Board giving direction

2. Risk analysis

3. Internal Controls

It can be external

1. Law and regulations

2. Notion of social responsibility

A sound system of corporate governance is capable of reducing company

failures in a number of ways:

it addresses issues of management

This reduces the agency problem and makes it less likely that management will

promote their own self-interests above those of shareholders.

it helps to identify and manage the wide range of risks

These might arise from changes in the internal or external environments

it specifies a range of effective internal controls

that will ensure the effective use of resources and the minimization of waste,

fraud, and the misuse of company assets.

Internal controls are necessary for maintaining the efficient and effective

operation of a business

it encourages reliable and complete external reporting of financial data

By using this information, investors can establish what is going on in the

company and will have advanced warning of any problems

it underpins investor confidence

gives shareholders a belief that their investments are being responsibly

managed

it encourages and attract new investment

make it more likely that lenders will extend credit and provide increased loan

capital if needed

Syllabus A1b) Explain, and analyses 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 business activity.

A ‘ joint stock company’  “is a company which has issued shares”

Shareholders delegate control to

1. professional managers,

2. the board of directors

to run the company on their behalf.

Separation of ownership and control leads to a potential conflict  of 

interests  between  directors  and  shareholders.

The purpose of Corporate GovernanceIs to:

monitor those who control the resources owned by investors Contribute to improved corporate performance and

accountability in creating long-term shareholder value.

Public vs Private sector

The ways in which the companies might differ:

their ownership (principals), their mission and the legal/regulatory environment within which they operate.

Public sector organisations are organisations that are controlled by one or more parts of the state.

Their functions are often to implement government policy in secretarial or administration areas.

Some are supervised by government departments (for example hospitals or schools).

Others are devolved bodies such as local authorities, nationalised companies (majority or all of the shares owned by the government).

These organisations are in the public sector because the control over a particular public service, utility or public good is seen as so important that it cannot be left to the profit motivated sector, which may for example seek to close socially vital loss-making services such as bus routes.

Objectives will be determined by the political leaders in line with government policy.

They are likely to focus on value for money and service delivery objectives, possibly underpinned by legislation.

The level of control may be high.

In many countries there are thousands of charities and voluntary organisations that exist to fulfil a particular purpose, maybe social, environmental, religious or humanitarian.

Funds are raised to support that purpose.

Charities are not owned as such, but will be primarily responsible to the donors of funds and the beneficiaries (those who receive money or other aid) out of the charities’ resources.

Key Underpinning Concepts of Corporate GovernanceSo what’s all this nonsense about then hey?? Well, for a company to be run well, and in the best interests of its shareholders, is a bit like all good relationships. They are built on solid foundations of trust and so on… so that’s my little heartwarming story over… back to the boring stuff… oh but please remember these need memorising as they are a common question!

These are the underpinning concepts....

Fairness

Respecting the rights and views of any groups with a legitimate interest.

This means a lack of bias. This is especially important where personal feelings are involved.

Responsibility Willingness to accept liability for the outcome of governance

decisions. Clarity in the definition of roles and responsibilities. Conscientious business and personal behaviour.

Accountability

Answerable for the consequences of actions.

Providing clarity in communication channels with internal and external stakeholders.

Development and maintenance of risk management and control systems.

Honesty/Probity

Not simply telling the truth but also not being guilty of issuing misleading statements or presenting information in confusing or distorted way.

Truthful Not misleading

Integrity

A person of high moral virtue. Adheres to a strict moral or ethical code despite other pressures.

It is an underlying principle of corporate governance and it is vital in all agency relationships.

Straightforward dealing.

Importance of integrity in corporate governance:

Codes of ethics do not capture all ethical situations. Any profession (such as accounting) relies upon a public perception of

competence and integrity. It provides a basic ethical framework to guide an accountant’s

professional and personal life. It underpins the relationships that an accountant has with his or her

clients, auditors and other colleagues. Trust is vital in the normal conduct of these relationships and

integrity underpins this. Transparency/ Openness

Means openness (say, of discussions), clarity, lack of withholding of relevant information unless necessary.

Disclosure, including voluntary disclosure of reliable information.

Importance of transparency:

Gains trust with investors and authorities. Underpins market confidence in the company through truthful and

fair reporting. Helps manage stakeholder claims. Reasons for secrecy/confidentiality include the fact that it may be

necessary to keep strategy discussions secret from competitors. And yet when I wore my transparent lecturing suit when lecturing

they said it “wasn’t appropriate”. Meh ;-) Independence

Independence of NEDs. Independence of the board from operational involvement. Independence of directorships from purely personal motivation.

Reputation Personal reputation for moral virtues. Organisation reputation for moral virtues. Accountancy profession reputation for moral virtues.

Innovation ability of company to transfer local knowledge and ideas in the new

products/processes that will create value Scepticism

especially in the meaning of professional scepticism – being challenging, scrutinise management by questioning, not just accepting their explanations

Judgment taking decisions enhancing organisation’s performance

The major areas of organizational lifei. Duties of Directors &Functions of the Board

Duties of Directors are:

to carry out their fiduciary duties to act in the best interest of the company

to use their powers in the appropriate way grounded according to statute and case law

to avoid conflicts of interests to exercise a duty of care.

ii. The composition and balance of the board (and board committees)

The balance of the board is very important to the success of the company.

There are various ways boards can be made up from single tier, two or even three tier, but the board must be balanced in terms of skills, knowledge, experience, skills, and in some specialist areas gender and ethnicity also need to be considered.

iii. Relevance and reliability of corporate reporting and external auditing.

Important factors to investors are issues around financial reporting and external auditing, as they provide indicators to the importance of management accountability.

Issues around reporting can be twofold:

Internal auditors may not wish to ask difficult questions as they are asking these questions to people who provide their employment.

External auditors may not wish to ask awkward questions as they do not want to lose the contract.

iv. Directors’ remuneration and rewards.

It has been reported in the media about ‘fat cat ‘salaries, and the abuse of the corporate world in paying these salaries.

Strong corporate governance can help to stem these issues.

v. Responsibility of the board for risk management systems and internal control.

It is the boards responsibility to ensure that they meet regularly, and if they do not then they are failing to fulfil their responsibilities, and therefore are not in the position to manage risk appropriately.

There needs to be robust reporting systems so that adequate systems are in place to measure and report risk.

vi. The rights and responsibilities of shareholders, including institutional investors

All shareholders, and investors have the right to all relevant material that may have an effect on their investment.

They should also have the right to vote on any measures that affect the management and governance of the organisation.

vii. Corporate social responsibility and business ethics.

Corporate social responsibility and business ethics may not seem an important part of corporate governance, but it is.

Inclusive corporate social responsibility can be a way to create solid business success, as the relationship between a company and its stakeholders become jointly beneficial.

NON-CORPORATE’ CORPORATE GOVERNANCEPublic sector organisations

Public sector organisations are state controlled. They can be parts of government departments (eg. hospitals and schools), or

local government authorities, nationalised companies and non-governmental organisations (NGOs)

Their aim is to implement parts of government policy. Government likes to keep control over such parts, as it is deemed so

important it cannot be trusted to private shareholders and their profit motive alone.

For a nationalised rail service, for example, some loss-making route services may be retained in order to support economic development in a particular region.

Such service delivery objectives are often underpinned by legislation.

Agency relationship in the Public Sector

In private companies, the owner/manager split creates an agency problem - this still exists within the public sector.

Management serve the interests of the taxpayer who, though, are likely to seek objectives other than long run profit maximisation.

This causes a problem however. The taxpayer/electorate does not have one simple goal (like shareholders have that of profit maximisation).

So public servants, elected and non-elected, try to interpret the taxpayers’ best interests

So there will be a problem of establishing strategic objectives and monitoring their achievement.

The millions of taxpayers and electors in a given country are likely to want completely different things from public sector organisations.

Some will want them to do much more while others, perhaps preferring lower rates of tax, will want them to do much less or perhaps not to exist at all.

This can be called the problem of ‘fitness for purpose”. It is normal to have a limited audit of public sector organisations to ensure

the integrity and transparency of their financial transactions, but this does not always extend to an audit of its performance or ‘fitness for purpose’.

Many nationalised companies have recently been privatised.

Moving from state control to having to comply with company law and relevant listing rules, in the process creating large new companies in industries such as energy, water, transport and minerals.

This change means competition. It changes the skills needed by executive directors, so is usually accompanied by a substantial internal culture change

Charities and voluntary organisations

There is often a third sector, charities and voluntary organisations, the first two being business and the state.

These exist for a particular social, environmental, religious, humanitarian or similar benevolent purpose and often enjoy tax privileges and reduced reporting requirements.

In exchange, a charity must demonstrate its benevolent purpose and apply for recognition by the country’s charity commission or equivalent.

Then there is the agency problem between the donors and the charity. Will the donations be used fully for the purpose? Hence the need for very strong regulation Some charities voluntarily provide full financial disclosures and this places

increased pressure on others to do the same. A common way to help to reduce the agency problem is to have a board of

directors overseen by a committee of trustees (sometimes called governors). The trustees here act in a similar way to NEDs, and will generally share the

values of the charities purpose Charities can exhibit their effectiveness by using a social or environmental

audit-type framework, including a regular and transparent report on how the charity is run and how it has delivered against its stated objectives.

This increases the confidence and trust of all of the main stakeholders: service users, donors, regulators and trustees and reduces the agency problem

Purpose Agents Principals Typical governance arrangements

Public listed companies

Maximisation of long-term shareholder returns

Directors Shareholders Executive board monitored by non- executive directors and non-executive chairman.

Public sector

Implementation of

Various layers of service and

Ultimately, taxpayers

Complex political structures seeking to

government policy

departmental managers

and, in a democracy, voters (the two are often similar)

interpret the wishes of taxpayers and the best way to deliver services

Charities and voluntary organisations

Achievement of benevolent purposes

Directors and service managers

Donors and other supporters provide the resources. Service users or consumers benefit from charities.

Ideally, an executive board accountable to independent trustees. Open to interpretation and abuse in some jurisdictions, however.

Directors Rights and DutiesThese are:

1. Rights

The first thing to understand is that directors do not  have unlimited power. They are limited by:

Articles of associationThese prescribe how directors operate including the need to be re-elected every 3 years

Shareholder resolutionThis can stop the directors acting for them

Provisions of lawEg health and safety or the duty of care.

Board decisionsBoards make decisions in the interests of shareholders not directors

2. Fiduciary Duties Act in good faith: 

as long as directors’ motives are honest Duty of skill and care

This is a legal requirement.

The amount of skill expected depends on your expertise and experience

3. Penalties for acting without due skill and care Any contract made by the director may be void Directors may be personally liable for damages if negligent May be forced to restore company property at their own expense

The composition and balance of the boardIn the UK listed companies have to state in their accounts that they comply with the following regulations:

1. Separate MD & chairman2. Minimum 50% non executive directors (NEDs)3. Independent chairperson4. Maximum one-year notice period5. Independent NEDs (three-year contract, no share options)

Directors in Corporate GovernanceThese are the most prominent group in corporate governance (and often the most annoying).

Seriously though they have a massive part to play in making sure the company is well run and directed (hence the name!)

Executive or non-executive

The numbers and split of executives to NEDs will partly depend upon the regulatory regime of the country.

NEDs are independent and are not involved in the day to day running of the business

Non executives

Investors and regulators prefer there to be more NEDs, due to their independent scrutiny of the company.

Remember that the execs should be working in the best interests of the shareholders and it’s partly the NEDs job to ensure they do

Legal responsibilities

So here we are looking at the legal side of what they need to do to help run and direct the company well (corporate governance)

In a unitary board structure (the one where there’s just one board - see later sections), all directors share legal responsibility for company activities and all are accountable to the shareholders.

Notice that directors are all responsible for each others decisions - this is important - it means everyone is looking to ensure each other does the job well (see collective responsibility below)

In most countries, all directors are subject to retirement by rotation, where they either step down or offer themselves for re-election (by the shareholders) for another term in office.

This gives shareholders a chance to not re-elect rubbish directors!

Collectively responsible

Directors are collectively responsible for the company’s performance, controls, compliance and behaviour.

So there’s no hiding place for them hopefully

Board roles

They must comply fully with relevant regulatory requirements that will include legal, accounting and governance frameworks.

The board of directors must discuss and agree strategies to maximise the long-term returns to the company’s shareholders.

Company secretaryCompulsory

In most countries, the appointment of a company secretary is a compulsory condition of company registration.

This is because the company secretary has important responsibilities in compliance, including the responsibility for the timely filing of accounts and other legal compliance issues.

So as well as making sure her nails are well manicured it is his/her legal responsibility to ensure all the admin that comes with PLCs are adhered too.

Even though I joke about this - it is actually a vital role. The legal frameworks are there to try and protect the stakeholders

Advises legal responsibilities

The company secretary often advises directors of their regulatory and legal responsibilities and duties.

Loyal to company

His or her primary loyalty is always to the company. In any conflict with another member of the company (such as a director), the

company secretary must always take the side most likely to benefit the company

Technical knowledge

In many countries’ he (get me being all modern!) must be a member of one of a list of professional accountancy or company secretary professional bodies

Major roles include:

1. Maintaining the statutory registers2. Ensuring the timely and accurate filing of audited accounts and other

documents to statutory authorities3. Providing members (eg shareholders) and directors with notice of

relevant meetings4. Organising resolutions for and minutes from major company meetings

(like the AGM)

Sub-board management Sometimes referred to (ambiguously) as ‘middle’ management, managers

below board level are a crucial part of the governance system. It is the employees, led by sub-board management, that implement

strategies, meet compliance targets and collect the information and data on which board-level decisions are made.

Effectiveness

Depends on the extent to which organisational activities are controlled and coordinated.

‘Strategic drift’ can occur, especially in large organisations, when this vital control and coordination is ineffective.

It is the sub management which can prevent the strategic drift by making sure the policies decided by the board are actually followed through

Employee representatives

Trade unions represent employees in a workplace; membership is voluntary and its influence depends on how many of the

workforce are members

Corporate Governance role

Trade unions are able to ‘deliver’ the compliance of a workforce. If a strategy needs a high level of commitment, a union can help to

unite the workforce behind the strategy and ensure everybody is committed to it.

How do they do this?

1. United front This can also mean that management and workforce are seen as

united by external stakeholders; making the achievement of strategies more likely.

2. Keeps management abuses at bay A trade union can be a key actor in the checks and balances of power

within a corporate governance structure. This can often work to the advantage of shareholders, especially when

the abuse has the ability to affect productivity.3. Help effectiveness of company

Unions are often good at highlighting management abuses such as fraud, waste, incompetence and greed

Help to control the employees Where a good relationship exists between union and employer, then

productivity of employees tends to increase

Syllabus A1h,i)

h) Explain and evaluate the roles, interests and claims of, the external parties involved in corporate governance.i) Shareholders (including shareholders’ rights and responsibilities)

i) Analyse 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.

Shareholders and other investorsNow time for the big boys… the most important external actors in corporate governance.

They do, after all, own the business that we are looking to run and direct properly.

“Other Investors” include fixed-return bond-holders

Shareholders have the right to . . .

1. Elect representatives to the board of directors at the annual shareholder meeting

2. Recall board members who are not doing their job3. Recommend amendments or propose policy to the Board4. Call special meetings5. Request shareholder education/training programs

Shareholders have the responsibility to . . .

1. Attend the annual meeting, and other important shareholder meetings2. Vote competent representatives to the board of Directors3. Take a turn serving on the Board, if elected

Agency relationship

The shareholders are the principals. They expect agents (directors) to act in their best economic interests

An agency relationship is one of trust between an agent and a principal which obliges the agent to meet the objectives placed upon it by the principal.

As one appointed by a principal to manage, oversee or further the principal’s specific interests, the primary purpose of agency is to discharge its fiduciary duty to the principal

Agency costs

Shareholders incur agency costs in monitoring the agents (directors).

If they didn’t have to keep checking the managers then there would be agency costs.

When a shareholder holds shares in many companies, the total agency costs can be prohibitive;

shareholders therefore encourage directors’ rewards packages to be aligned with their own interests so that they feel less need to continually monitor directors’ activities.

So let’s look at some examples of costs of monitoring and checking on directors’ behaviour

1. Attending relevant meetings (AGMs and EGMs)2. Studying company results3. Making direct contact with companies

Types of Investor

1. Small investors

Individuals who hold shares in unit trusts, funds and individual companies.

They typically buy and sell small volumes and tend to have fewer sources of information than institutional investors.

They also often have narrower portfolios, which can mean that agency costs are higher, as the individuals themselves study the companies they have invested in for signs of changes in strategy, governance or performance.

2. Institutional investors The biggest investors in companies, dominating the share volumes on

most of the world’s stock exchanges. Examples include Pension funds, insurance companies and unit trust

companies each fund being managed by a fund manager. Fund managers have some influence over the companies so need to be

aware of the performance and governance of many companies in their funds, so agency costs can be very large indeed.

When should institutional investors intervene in company affairs?

Concerns over strategy Consistent underperformance (without explanation) NEDs not doing their job properly Internal Controls persistently failing Failure to comply with laws and regulations Inappropriate remuneration policies Poor approach to social responsibility (reputation risk)

AuditorsThe most obvious role of audit in corporate governance is to report to shareholders that the accounts are accurate (‘a true and fair view’ is the term used in some countries.

A qualified audit report is an important signal to markets about the company.

Other services

These sometimes include social and environmental advice and audit.

Regulators and governments

This usually applies to companies or sectors involved in areas considered strategically or politically important by governments

Examples

The control of monopolies

The supply of water or energy

Stock exchangesShares are bought and sold through stock exchanges.

Each keeps an index of the value of shares on that exchange; In London, for example, the FTSE All Share (Financial Times Stock Exchange) index is a measure of all of the shares listed in London.

In New York, it is the Dow Jones index and in Hong Kong, it is the Hang Seng index.

Role in Corporate Governance

Listing rules are sometimes imposed on listed companies often concerning governance arrangements not covered elsewhere by company law.

In the UK, for example, it is a stock exchange requirement that listed companies comply with the Combined Code on Corporate Governance

Procedure for obtaining a listing on an international stock exchange

Normally, obtaining a listing consists of three steps:

1. legal2. regulatory3. compliance

Steps:

1. In the UK a firm seeking listing must register as a public limited company.This entails a change in its memorandum and articles agreed by the existing members at a special meeting of the company.

2. The company must then meet the regulatory requirements of the Listing Agency which, in the UK, is part of the Financial Services Authority (FSA).These requirements impose a minimum size restriction on the company and other conditions concerning length of time trading.

3. Once these requirements are satisfied the company is then placed on an official list and is allowed to make a public offering of its shares.

4. Once the company is on the official list it must then seek the approval of the Stock Exchange for its shares to be traded.In principal it is open to any company to seek a listing on any exchange where shares are traded.

5. The London Exchange imposes strict requirements and invariably the applicant company will need the services of a sponsoring firm that specialises in this type of work.

The advantages of seeking a public listing

1. It opens the capital market to the firm2. It offers the company access to equity capital from both institutional

and private investors and the sums that can be raised are usually much greater than can be obtained through private equity sources.

3. Enhances its credibility as investors and the general public are aware that by doing so it has opened itself to a much higher degree of public scrutiny than is the case for a firm that is privately financed.

The disadvantages of seeking a public listing

1. A distributed shareholding does place the firm in the market for corporate control increasing the likelihood that the firm will be subject to a takeover bid.

2. There is also a much more public level of scrutiny with a range of disclosure requirements.

3. Financial accounts must be prepared in accordance with IFRS or FASB and with the relevant GAAP as well as the Companies Acts.

4. Under the rules of the London Stock Exchange companies must also comply with the governance requirements of the Combined Code