CORPORATE GOVERNANCE

JUNE 2007

SUGGESTED ANSWERS AND EXAMINER’S COMMENTS

IMPORTANT NOTICE

When reading these suggested answers please note that the answers are intended as an
indication of what is required rather than a definitive “right” answer. In many cases there are
several possible answers/approaches to a question. Please be aware also that the length of
the suggested answers given here may be somewhat exaggerated from what might be
achieved in the reality of an unseen, time constrained examination.

EXAMINER’S GENERAL COMMENTS

• Corporate governance has wide ranging objectives, including probity in business activity,
compliance with law and regulation, the securing of reputation and confidence towards
the attraction of inward investment and corporate accountability to a broad range of
stakeholders. The discipline is both practical and theoretical. Its application is not an
exact science, and there are in many cases more than one valid response to questions
set.
• For the Chief Examiner and marking team this means assessing the candidate's answer
for evidence of general understanding and relevance to the question set, and awarding
marks for demonstrating the minimum required standard. Higher marks are awarded for
success in coping with greater breadth, depth and sophistication in application. Being at
ICSA Professional Programme II Stage, no question is set to seek description alone, but
should be answered in a critical and evaluative manner.
• Where multi-part questions contain an indication of the marks awarded, they are for
candidate guidance on relative weighting and the use of time.

SECTION A
(Compulsory – answer all parts of this question)

1. (a) Outline the importance of the company secretary's role in corporate

governance. (4 marks)

SUGGESTED ANSWER

The company secretary's role in corporate governance has been emphasised in the
Combined Code and in the South African King II Report. The Combined Code states that
the company secretary is responsible for:

• ensuring good information flows within the board and its committees, and
between executive management and non-executive directors (NEDs);

Page 1 of 13
© ICSA, 2007
• advising the board (through the chairman) on all corporate governance matters;
• being available to give advice and support to individual directors.

ICSA has also provided guidance on the company secretary's corporate governance role
which students should refer to, to gain good marks.

Students should identify some of the specific corporate governance tasks and
responsibilities of the company secretary. For example, the company secretary has been
identified by the FSA as the appropriate person to deal with whistleblowing. Students
should also mention the need for the company secretary to be independent from undue
influence or pressure from senior board members.

Students should discuss the role of the company secretary critically, providing
arguments for why the company secretary's corporate governance role is important.

EXAMINER’S COMMENTS

On the whole this question was not answered well. Given the nature of the question and
its specific relevance to the role of the secretary in corporate governance, it is a
standard question for the course, so this was surprising

(b) Who should sit on a nomination committee? Outline the corporate

governance role played by the nomination committee. (4 marks)

SUGGESTED ANSWER

The nomination committee, established by the board, should contain a majority of

members who are independent non-executive directors (NEDs), and a committee
chairman who is either the board chairman or an independent NED.

The Combined Code specifies the need for a formal, rigorous and transparent process
for appointing new directors. The Higgs “Suggestions for Good Practice” summarise the
principle duties of the nomination committee. The corporate governance role of the
committee is to search for new directors, and then to consider new appointments to the
board and make recommendations to the full board. However, only the full board, not
the nomination committee, has the authority to make new appointments. The NEDs
introduce independence into succession decisions, and should ensure that the
appointments process is not dominated by the company chairman.

Mention should be made of potential conflicts of interest, such as the need to keep the
chairman of the board out of discussions on chairman succession. The way in which
appointments are made and the way in which the committee makes its
recommendations should be discussed in detail.

EXAMINER’S COMMENTS

This question was answered reasonably well, and in no case did candidates fail to
provide an answer.

Page 2 of 13
© ICSA, 2007
(c) In what ways should the recommendation of the Higgs Report for
large companies to nominate a senior independent director (SID) lead
to more effective corporate governance? (4 marks)

SUGGESTED ANSWER

SID is an independent non-executive director, recognised as the senior individual

amongst the NEDs.

The main reason for promoting the role of a SID in corporate governance was to create
a go-between for companies and their institutional investors. This is especially useful
where there may be disagreement between a company and its shareholders. In this
way, a SID has been viewed as a champion of shareholder interests. The SID acts as a
corporate governance mechanism when normal communication channels between
shareholders and company boards fail.

A discussion should be included of the role of the SID, mentioning that the chairman
should render a SID unnecessary, and that SIDs have been seen as divisive for boards.

EXAMINER’S COMMENTS

Candidates' responses to this question focused more on the general role of NEDs rather
than specifically on the role of the SID. However, candidates generally knew that the
recommendation came from the Higgs Report and commented on the importance of the
SID as a representative of shareholder interests.

(d) Explain why ensuring equitable treatment of shareholders and

protecting shareholders' rights are important issues in corporate
governance. (4 marks)

SUGGESTED ANSWER

The OECD Corporate Governance Principles (1999 and 2004) emphasised the need for
companies to treat all their shareholders equally and to protect their rights. The main
reason for this focus arises from the need to provide corporate governance principles for
a wide range of countries, some of which have developing stock markets and
economies, and many of which are not characterised by Anglo-Saxon style corporate
governance. Shareholder property rights, for example, are not consistent internationally.
The OECD Principles insist that shareholders' property rights be protected. Shareholders'
voting rights also need to be protected. The need for companies to treat all
shareholders equally has arisen from cases of unfair treatment. For example, in a
takeover negotiation, major shareholders may be offered better terms by a bidder than
smaller shareholders.

Students should comment on the need to follow the OECD principles in order to
encourage cross-border investment, and to nurture trust in corporations among
shareholders internationally.

Page 3 of 13
© ICSA, 2007
EXAMINER’S COMMENTS

This question received varied answers, but most focused on the OECD principles. Every
student attempted the question

(e) Explain the need for the ICSA Guidelines on Best Practice for
Electronic Communications with Shareholders. (4 marks)

SUGGESTED ANSWER

Transparency is one of the cornerstones of good corporate governance. Where

information asymmetry exists naturally between companies and their shareholders, any
means of improving communications should be embraced. It has been argued that such
communications could be enhanced by a greater use of electronic methods, such as
email and websites.

Students should outline the ICSA guidelines on electronic communications with

shareholders, and should comment on why improved dialogue between companies and
their shareholders is desirable and important, showing how electronic communications
can help to achieve this. They may refer to the Combined Code's emphasis on improving
dialogue.

EXAMINER’S COMMENTS

This question was well-answered in general, although answers lacked detailed reference
to the ICSA guidelines.

(f) Explain the ways in which corporate governance reform has addressed
issues concerning directors' remuneration. (4 marks)

SUGGESTED ANSWER

Since the publication of the Greenbury Report (1995), transparency in relation to the
setting of directors' remuneration has been a focus of corporate governance reform in
the UK and elsewhere. The Combined Code states that "Levels of remuneration should
be sufficient to attract, retain and motivate directors of the quality required to run the
company successfully, but a company should avoid paying more than is necessary for
this purpose".

It also states that a significant proportion of executive directors' remuneration should be

structured so as to link rewards to corporate and individual performance.

Students should explain that directors should not be rewarded for corporate
underperformance, and that companies now disclose graphs of corporate performance
in relation to the market, as well as directors' salaries. Shareholders can vote on
remuneration policy (although not salaries directly).

Page 4 of 13
© ICSA, 2007
The role of remuneration committee in setting executive remuneration should be
discussed.

EXAMINER’S COMMENTS

This question was answered well on the whole. It is a broad question and some
candidates struggled to keep their answers concise

(g) In what ways should the Tyson Report improve the effectiveness of
non-executive directors (NEDs)? (4 marks)

SUGGESTED ANSWER

The Higgs Report performed an evaluation of the effectiveness of NEDs, and studied the
UK population of NEDs. The Higgs Report commented that the gene pool for the
selection of NEDs should be widened. The Tyson Report picked up on this conclusion,
and examined it in detail looking for ways in which could do this. The resulting Tyson
report found that diversity in backgrounds, skills and experience of non-executive
directors enhanced board effectiveness by bringing a wider range of knowledge and
viewpoints to bear on issues relating to corporate performance, strategy and risk.
Further, the report indicated that greater boardroom diversity improved relationships
with corporate stakeholders, such as customers, employees and shareholders. These
groups would welcome broader board membership as it would imply that boards have a
better understanding of stakeholder needs, and their importance to corporate success.

EXAMINER’S COMMENTS

Candidates generally did not appear to have knowledge of the Tyson Report and the
majority confused it with the Higgs Report. Only a small number of answers made
reference to issues of diversity.

(h) Identify the ways in which risk reporting has evolved in recent years.
(4 marks)

SUGGESTED ANSWER

Non-financial reporting has become increasingly important in recent years with studies
showing at least half of the content of annual reports is now devoted to narrative rather
than financial disclosures. Non-financial reporting is an essential element in
communications with shareholders and other report users. In the UK, one of the main
recommendations for improving aspects of non-financial reporting is to provide
companies with the opportunity to make forward-looking disclosures. From a corporate
governance perspective, the key issue from a corporate governance perspective is that
an OFR should improve the communications between a company and its shareholders,
and make the affairs and the prospects of the company more transparent and
understandable to shareholders. This should be done, however, without disclosing
confidential information that would benefit rival companies.

Page 5 of 13
© ICSA, 2007
If adopting a UK perspective, students could discuss the contents of an OFR and the
current state of play on the OFR and Business Review. They could mention the findings
of the Radcliffe Committee which highlighted the need for an OFR to discuss
reputational risk issues and the interests of other stakeholders, for example. They
could also mention that the new version of the Turnbull guidance makes
recommendations for better risk reporting. If they choose to focus on a country other
than the UK they should refer to any relevant developments in reporting in that country.

EXAMINER’S COMMENTS

Answers to this question were generally quite weak. Usually there was some reference
made to the Turnbull Report, but very little detail about its recommendations

(i) How can a Code of Ethical Conduct improve a company's corporate

governance? (4 marks)

SUGGESTED ANSWER

The essential contribution that ethics makes to corporate governance effectiveness is

raised in the study text. The need for a code of ethics arises from the need to bolster
corporate governance guidelines, the law and regulations with ethical behaviour. A lack
of ethical behaviour can (as in the case of Enron) lead to corporate failure, no matter
how many corporate governance mechanisms are in place in a company. As stated in
the study text, the New York Stock Exchange (NYSE) has recommended that all listed
companies should publish a code of ethics. Students should list the types of issues that
should be included in a corporate code of ethics.

EXAMINER’S COMMENTS

Most candidates provided a reasonably good answer to this question, and nearly all
referred to the NYSE listing requirement for a code.

(j) In what ways do the South African King Reports (I and II) seek to
integrate stakeholder responsibility into corporate governance?
(4 marks)

SUGGESTED ANSWER

The corporate governance initiatives by South Africa represent the more far-reaching
attempts worldwide to integrate issues of corporate social responsibility and stakeholder
responsibility (note not accountability) into their code of best practice. This is mainly
due to the particular nature of the country and the social responsibility problems
associated with it. These include HIV reporting issues and human rights (racial) abuses.

EXAMINER’S COMMENTS

Answers to this question were generally good, with most candidates being aware of the
importance of the King Reports in the area of stakeholder accountability.

Page 6 of 13
© ICSA, 2007
 SECTION B
(Answer THREE questions from this section)

2. You are employed as the company secretary of a company which is listed at

present on a minor European stock exchange, but is seeking a listing on the
London Stock Exchange. You have performed an evaluation of the company's
compliance with the Combined Code in preparation for the listing. Generally,
your evaluation indicates that your company complies with the Combined
Code. However, there is one area where you anticipate a problem.

For many years, the roles of chairman and chief executive have been carried
out by the same person, and you do not expect him to welcome standing
down from either position. There is clearly pressure for the company to
change this situation, and you know you will have to address the issue with
the board. At preliminary, informal discussions with members of the board,
you were met with some opposition. Comments included one director using a
well-known phrase:

"If it ain't broke, don't fix it."

Another board member said:

"Well, why on earth should we change something that has worked so well for
our company for so long?"

Following these brief conversations, you are asked to prepare a detailed

report that:

• outlines how the Financial Reporting Council's guidance on internal

control recommends that companies establish and maintain a sound
system of internal control; and
• explains the benefit of split roles, and why split roles improve
corporate governance. (20 marks)

SUGGESTED ANSWER

The first part of this question requires the students to outline the main elements of the
guidance following the Turnbull Committee Report on Internal Control (1999). As
discussed in the study text, the framework recommended by the Turnbull Guidance
involves the board setting appropriate policies on internal control, seeking regular
assurance to satisfy itself that the system is operating effectively, and ensuring that the
internal control system is effective in management risks in the same way that it has
approved. The risk management framework should involve assessing the nature and
extent of the company's risks, the potential impact of these risks and the likelihood they
may materialise. The company must then devise an appropriate risk management
strategy, costing for the risk management tools employed. Students should mention the
elements of an effective internal control system as laid out by the Turnbull Guidance,

Page 7 of 13
© ICSA, 2007
 and should comment on the importance of a dynamic internal control system whereby
the company evaluates the effectiveness of its internal control system on a regular
basis.

The Cadbury Report recommended split roles, as this would diminish the unfettered
control held by a chairman/chief executive position at the top of the company. Following
the Hampel Report, the Combined Code went further by stipulating that the positions
could not be held by the same person. Where this was unavoidable, the company must
explain why in its annual report.

Students should discuss the arguments for and against this issue. They may mention
that this is one of the areas where corporate governance in the US differs substantially
from UK corporate governance, although the US is starting to embrace split roles
gradually (e.g. Disney). There should also be a discussion of the very different roles
played by the chairman and chief executive, and what the responsibilities and function
of each person should be. The best answers should incorporate some real life examples.
They should also be written in report style for maximum marks.

EXAMINER’S COMMENTS

Candidates who answered this question did it well. They generally provided a full and
accurate answer to both parts on internal control and on split roles.

3. The Cadbury Report (1992) stated that, "Given the weight of their votes, the
way in which institutional shareholders use their power to influence the
standards of corporate governance is of fundamental importance". How are
institutional investors currently encouraged to practice shareholder activism?
(20 marks)

SUGGESTED ANSWER

Shareholder activism can be defined as "A term that refers to (1) the considered use by
institutional investors of their rights as shareholders, by voting against the board of
directors at general meetings (or threatening to vote against the board); and (2) active
dialogue with the boards of companies to influence decisions by the board".

The Cadbury Report and the Combined Code have focused attention on the corporate
governance role of institutional investors.

Students should discuss guidelines on activism produced by the ISC, the NAPF, the ABI
and the ICGN.

Answers should address the two primary areas of shareholder activism with relatively
equal importance, namely voting and engagement/dialogue. They should discuss the
importance of voting by institutional investors, and the improvements in electronic
voting encouraged by the 2004/2005 reports by Paul Myners, should be mentioned.

Page 8 of 13
© ICSA, 2007
 For full marks, students should critically discuss the need for institutional investors to
avoid voting in line with management, but rather to use their votes in a considered,
responsible way.

In relation to engagement and dialogue, students should outline the recommendations

made in the successive corporate governance codes of practice and policy
documentation, and any evidence concerning the level of engagement at present
(Myners Committee, for example).

EXAMINER’S COMMENTS

Answers to this question were quite disappointing on the whole. Although most
candidates did discuss voting and engagement, they provided little evidence to suggest
that they had read around the subject, and demonstrated a narrow reliance on the
course text. There was little critical discussion in most scripts about the growing
importance and relevance of relationship investing.

4. (a) What are the main issues covered by the OECD Principles of Corporate
Governance? (12 marks)

SUGGESTED ANSWER

The first set of internationally acceptable standards of corporate governance was

produced by the Organisation for Economic Co-operation and Development (OECD,
1999). The OECD is an international organisation, based in Paris and its membership
comprises 29 countries from all around the world.

The OECD Principles represented a lowest common denominator of principles for ‘good’
corporate governance. Many of the principles displayed similarities to the Cadbury Code
(1992), and covered such issues as the equitable treatment of shareholders, shareholder
responsibilities, transparency and disclosure in terms of corporate reporting and audit,
the role and responsibilities of company boards of directors and the importance of non-
executive directors. For the purposes of the OECD Principles, corporate governance was
defined as, ‘that structure of relationships and corresponding responsibilities among a
core group consisting of shareholders, board members and managers, designed to best
foster the competitive performance required to achieve the corporation’s primary
objective’ (IMF, 2001). As we can see from this definition, the OECD attempted to
describe corporate governance in the broadest terms in order to embrace as many
different forms of corporate governance system as possible.

(b) Evaluate their potential to contribute to the development of an agreed

world-wide agenda for best practice in corporate governance.
(8 marks)
SUGGESTED ANSWER

One of the problems with the OECD Principles and Code of Practice was their
impotence, as they have no legislative power. Nevertheless, their impact has been
substantial, and countries have used them as a reference point for self-assessment and

Page 9 of 13
© ICSA, 2007
for developing their own codes of best practice in corporate governance. In 1999
ministers representing the 29 countries in the OECD voted unanimously to endorse the
OECD Principles. The World Bank has researched many countries around the world to
assess the extent to which they have complied with the OECD principles, and all of
these country assessments are available on the Internet.

In 2004, the OECD issued a revised set of principles on Corporate Governance. The
OECD has expanded to include 30 members, with the accession of the Slovak Republic
in December 2000. The OECD Principles (2004) stated that the 1999 Principles provided
specific guidance for legislative and regulatory initiatives in OECD member countries, but
also in non-member states. The 1999 Principles have been thoroughly reviewed in order
to take account of recent developments and experiences in both OECD member and
non-member countries.

In reviewing the 1999 Principles, the OECD drew on the findings of a comprehensive
survey of how member countries addressed a variety of corporate governance
challenges. The revised Principles have maintained the spirit of a non-binding and
principles-based approach, which recognised the need to adapt implementation to
varying economic, legal and cultural situations.

The revised Principles cover the following areas:

(i) Ensuring the basis for an effective corporate governance framework.

(ii) The rights of shareholders and key ownership functions.
(iii) The equitable treatment of shareholders.
(iv) The role of stakeholders.
(v) Disclosure and transparency.
(vi) The responsibilities of the board.

It seems that stakeholders have been given greater weight in the redrafted version of
the Principles.

Students should discuss the strengths and weaknesses of the OECD Principles as a
framework for companies internationally. The strengths are mainly that the OECD
principles are general enough to apply to countries around the world. However, in being
so general, they are, as mentioned earlier, a lowest common denominator. In this sense
they do not push corporate governance as far as they could. Other codes, such as South
Africa's King II Report, are stronger on stakeholder issues and CSR, and the US
approach is stronger in terms of audit and financial reporting. Nevertheless, the OECD
principles represent the first bold attempt to provide international standards of
corporate governance. Their success is evident in the large number of countries who are
applying the principles even though they are not in the OECD.

EXAMINER’S COMMENTS

This question was answered well on the whole. However, candidates tended to answer
the first part of the question better than the second. Students described the OECD
Principles in detail, but were less able to critically discuss the international trend towards

Page 10 of 13
© ICSA, 2007
 harmonisation of corporate governance standards, and the role of the OECD in this
movement.

5. You are the company secretary of a large UK company listed on the London
Stock Exchange. Your company, over the last two years, established a call
centre in an East Asian country. In the past week, you have been visited by
an employee who has received an email from a group of human rights
activists, suggesting that employees in the call centre are not being treated
correctly. The employee is extremely concerned about the situation and has
asked you to address the matter urgently. According to her information,
details of maltreatment include:

• Employees being allowed only one toilet break in 6 hours.

• Derogatory comments from management concerning ethnic dress
worn by employees.
• General verbal abuse of employees by managers on the floor.

You have had a quiet word with a member of the board, to discuss this highly
sensitive issue. He has requested that you prepare a report overnight,
explaining the situation in terms of reputation risk to the company and the
potential for material impact. In your report, you have been asked to address
a number of issues:

• Why corporate social responsibility is an important corporate

governance issue. (8 marks)

• How companies in your situation should handle reputation risk arising

from evidence of human rights abuses. (8 marks)

• The extent to which the company's institutional investors may be

interested in breaches of corporate social responsibility such as this.
(4 marks)

SUGGESTED ANSWER

The answer should cover issues relating both to CSR and reputation risk, as well as the
impact of reputational risk issues on institutional shareholders. The study text discusses
the need for companies to take social responsibility into account, and the importance of
CSR as a reputation risk. The type of CSR breach alluded to in this question will
demonstrate a serious lack of CSR policy and strategy, if the allegations are founded in
truth. A full investigation is required. If the company survives this type of information
becoming public knowledge, it will have to start taking CSR issues extremely seriously.
This could be the line taken in the company secretary's report. Not only does immediate
action need to be taken, but also company CSR strategy over the medium to long-term
needs to be radically reformed to avoid this type of situation arising in the future.

Page 11 of 13
© ICSA, 2007
 This question should also highlight the important role that the company secretary plays
in communicating with directors on an individual basis, as well as advising the whole
board on corporate governance issues.

High marks were given where students succeeded in integrating the discussion of CSR
as a reputation risk within a company's internal control system. There should have been
a full discussion of both of these aspects, bringing them together within a company's
risk management system. The increasing importance that institutional investors are
beginning to give to issues of social responsibility should have been emphasised,
especially regarding the consideration of 'environmental, social and governance factors'.
Credit was awarded to students who wrote the report in a report style, addressed to the
board as advice from the company secretary.

EXAMINER’S COMMENTS

This question generally seemed to inspire candidates into providing good answers. They
were usually in report form, and allowed them to use their imagination in developing the
scenario. Weaknesses tended to be in a lack of knowledge about why there is a strong
link between CSR and corporate performance, as well as little understanding in many
cases of CSR issues.

6. (a) Why does external audit make an important contribution to good

corporate governance? (12 marks)

(b) In what ways may external auditor independence be threatened, and

how may these threats be avoided? (8 marks)

SUGGESTED ANSWER

The purpose of the audit function is to ensure that the financial statements are objective
and reliable for the benefit of the users of the published financial statements, and for
those making decisions based on management accounts and other internal reports. The
external auditors report to the audit committee of a company. The audit committee is a
committee of the board consisting of independent NEDs, at least one of whom should
have recent, relevant financial experience. Typically, the audit committee has at least
three members. At least once a year, the external auditors have to report to the audit
committee in the absence of management.

The external auditors are appointed by shareholders, but on the basis of board
recommendation. The role of the audit is described in detail in the study text, which also
mentions the audit report.

The Smith Report in the UK and the Sarbanes Oxley Act in the US have focused on
improving the independence of the internal and the external audit. The Sarbanes-Oxley
Act especially, has broadened the remit of the external audit, in order to incorporate a
far more detailed audit of internal control and risk management systems.

Page 12 of 13
© ICSA, 2007
 Threats to auditor independence involve such issues as the rotation of auditors and
provision of consultancy services, as well as the problem of management capture of the
audit function.

Students should discuss the audit report, and the various arguments surrounding
auditor independence critically, and in-depth.

EXAMINER’S COMMENTS

Candidates generally performed well on this question and seemed to provide more
detailed and thorough answers to part (b). I would however say that answers were very
much based on the course text, and seldom displayed any attempt to read around the
subject. However, this comment applies to many of the answers to most questions on
the exam paper.

The scenarios included here are entirely fictional. Any resemblance of the information in
the scenarios to real persons or organisations, actual or perceived, is purely coincidental.

Page 13 of 13
© ICSA, 2007