Professional Documents
Culture Documents
Chapter 6
Governance
(Shareholders Portion)
Organization
Agency Theory
Agency Theory
‘Agency’ occurs when one party (Principal) employs another party (Agent) to perform a task on their behalf. In
most companies, there is separation of ownership and control. Shareholders own the company and directors run
the company on behalf of the shareholders.
▪ Agent: Directors (as they run the company on behalf of the shareholders)
Conflict of Interest
Directors have a fiduciary duty to act in the best interests of shareholders. ‘Conflict of interest’ means that
director’s ‘personal’ interest surpasses the interest of the shareholders, i.e. directors lose their independence,
integrity and objectivity. Directors must solely work for the best interest of shareholders and avoid their personal
interest at all times (or disclose).
Accountability: The agent is fully accountable to the principal. Directors, individually and collectively, have a duty
under corporate governance to run the company in the best interest of the shareholders and to be held
accountable of the results and outcomes. . Directors can be held accountable in following ways:
▪ Scrutiny of their performance by NEDs
▪ Linking directors’ remuneration with performance
▪ Non-appointment of director upon completion of tenure
Costs of Agency
Agency cost is a cost incurred by the Principal (shareholders) to monitor the Agents (directors). Agency cost can
be classified in two categories:
▪ Monitoring cost (e.g. remuneration of directors, cost of monitoring, audits, attending AGMs, NEDs, etc.)
▪ Residual loss (cost beyond remuneration of directors, e.g. where there is conflict of interest by directors
leading to a loss to business / shareholders)
Board of Directors
Introduction
Every company is led by a Board of Directors, which is collectively responsible for achieving the objectives and
long-term success of the company. The board should have appropriate
▪ Size
▪ Knowledge, Skills and Experience KISSE(D)
▪ Independence
Non-Executive Directors (NED) are part-time outside directors ‘independent’ of the company i.e. they are not
employee of the company.
▪ Completeness: Provide complete picture, disclosures should meet minimum statutory obligations
▪ Accuracy: Correct facts and figures, no errors, inspire confidence
▪ Regularly: Regular, timely communication CART
▪ Transparency: Open and fair disclosure of information, no concealment
Board Meetings
▪ Meeting should be held regularly
▪ Minimum quorum to be present
▪ Agenda:
Decided by Chairman
Include both short-term and long-term issues
Circulate in advance so that Directors can prepare
▪ Chairman to direct meetings and encourage debates
Role of NEDs
▪ Strategy: discuss strategies, bring external experience and leadership
▪ Performance: scrutinize the performance of Executive directors
▪ Risk: ensuring effective internal control and risk management systems are in place and financial
reporting is accurate and reliable
▪ People: nomination, remuneration and succession planning of executive directors and senior
executives, providing added comfort to shareholders
Advantages of NEDs
▪ Brings independence to the Board (i.e. no conflict of interest)
▪ Adds confidence to shareholders
▪ Have external experience and wider perspective
▪ Scrutinize / challenge performance of executive directors and the company
▪ Employees can discuss confidential or sensitive matter with NED directly (whistle-blowing)
▪ Company can comply with Regulatory / Listing requirements
Disadvantages of NEDs
▪ Difficult in finding an appropriate NED with relevant experience and willing to work at a small fee
▪ May lack independence
▪ May face resistance from executive directors
▪ May find it hard to enforce their views
▪ May not give sufficient time to business
▪ Smaller remuneration as compared to executive directors
Independence of NEDs
▪ No business or financial relationship with the company for last 3 years
▪ Not an employee of the company for last 5 years
▪ Not an NED in same company for more than 9 years
▪ Not have close family ties or friendship with executive directors
▪ Not a significant customer or supplier of the company for last 3 years
▪ No family members working in the company in senior position
▪ Not an auditor of the company for last 3 years
▪ Not have a cross-directorship with another executive director
▪ No share in profit or having share options of the company
▪ NEDs should be allowed to seek independent expert advice on any professional matter, if required
Number of NEDs
There is no fixed number of NEDs. Different jurisdictions have different rules:
▪ UK: Sufficient number of NEDs so that their views carry significant weight
▪ NY Stock Exchange: NEDs should be > 50% of the total board size (i.e. in majority)
▪ Singapore: Atleast one third of the board
▪ One of the NEDs run a specialist consultancy company. She has received separate fees from her
consultancy company for providing consultancy advice to the company in which she is NED
▪ Two of the NEDs have permanently retired and use the income they get from being NEDs to
supplement their living
Board Committees
Key Board Committees
3- Audit Committee: Reviewing accounts and internal controls, liasoning with external auditors and
supervising internal audit function
Risk Committee
The Risk Committee is responsible for oversight of the risks which the company faces and ensuring that a sound
system of risk management and internal controls exists to deal with those risks. Risk Committee comprises of
majority of NEDs with some Executive directors, as specialist expertise of Executive directors can benefit the
committee.
Long term incentive: e.g. share options (covered below), long term bonus
Bonus payout is based on financial performance of the company, mainly profitability. Non-
financial targets can also be there, e.g. customer satisfaction, market sharer, etc.
▪ Retention options:
Attractive package
Loyalty bonus (e.g. if you stay with Company for 5 years, you will get Rs XXX bonus)
Share options
Share options are long term incentives scheme whereby directors are allotted company shares which they can
only sell after 3-5 years (exercise date). Share prices should increase over time due to growth and profitability of
the company. This motivates directors to stay with the company and focus on creating long term shareholder
wealth.
2- Management Board
▪ It is appointed by Supervisory Board and lead by the CEO
▪ Consists of CEO and executive directors
▪ Responsible to implement strategies approved by Supervisory Board
▪ Focuses more on operational and day-to-day management
▪ Management board does not have any voting rights
Unitary Board:
In this approach, there is just one board in the company:
▪ Single board having Executive directors as well as Non-Executive directors
▪ Executive directors focus more on day to day management (similar to Management Board under Two
Tier approach)
▪ Non-Executive directors focus more on advice and protecting shareholder interests (similar to
Supervisory Board under Two Tier approach)
▪ However, all directors have equal voting rights
Advantage Disadvantage
Methods of CPD
▪ External trainings
▪ In-house trainings
▪ Attending conferences and seminars
▪ Professional courses and certifications
▪ Reading / writing relevant books
▪ Mentoring and coaching
Advantage of CPD
▪ Maintain professional knowledge and skills of directors
▪ Keeps directors up to date with latest topics and developments
▪ Enhance director’s competence
▪ Improves board’s effectiveness
▪ Demonstrate director’s commitment to their profession and company
Advantages of Diversity
▪ Wider pool of talent
▪ Broader range of ideas and knowledge
▪ More representative of the community
▪ Enhanced reputation and outlook of organization
▪ Compliance with listing regulations
Issues of Diversity
▪ May lead to sub-groupings within the board
▪ Board may ignore the views of diversified members
▪ Diversified members may not feel motivated to contribute
Appointment of Directors
Directors can be appointed in the following manner:
▪ By resolution from Shareholders – usually in Annual General Meeting (AGM)
▪ By resolution following directions from Govt / State – intervention under certain circumstances
Leaving of Directors
Following are the circumstances in which directors leave office
▪ Retirement at the end of the term
▪ Removal:
Resignation anytime during the term
Disqualification anytime during the term
Removal by shareholders anytime during the term
Retirement by Rotation
Directors contract are limited to a specific time period, after which he / she automatically retires by default. Then
the director offers himself / herself for re-election (retire by rotation). In UK, director’s contract is for 1 year for
large listed companies and 3 years for other companies.
Service contracts is the director’s employment contract which covers the terms and conditions of director’s
employment with the company. In UK, a service contract is for 1 year for large listed company and for 3 years for
all other companies.
Removal of Directors
A director may leave or maybe removed from office before his / her term expires. There are many possible
reasons:
▪ Resignation by director – a director can resign on his own by giving formal notice period
▪ Disqualification of Director
Disciplinary offence
Fraud
Absent for more than 6 months
Disability / Death
Bankruptcy
Corporate Governance
Corporate Governance
▪ Is a system by which companies are configured, coordinated and controlled in the interest of the
shareholders and other stakeholders? Agency relationship is the foundation of corporate governance as
there is separation between the ownership and control
▪ The objective of a corporate governance is to improve corporate performance and accountability in order
to create long term shareholder value
▪ Corporate governance is less of an issue in small companies or partnership business where the business
is managed directly by the shareholders / owners
1. Independence (no conflict of interest, no wrong motives, fact based, no bias, no undue influence)
2. Probity (integrity, honesty, straight forward, truthfulness, not conceal anything wrong)
3. Transparency (disclose all material matters to shareholders, open relationship with shareholders)
Institutional Investors
Definition
Shares in listed companies are held by a range of individuals and institutions. Institutional shareholders are
organizations which have large amount of money to invest. They include pension funds, insurance companies,
investment & unit trusts, mutual funds, etc. Accordingly, the number of shares held is much higher than
number of shares held by an individual shareholder. Hence institutional shareholders have a much higher
influence than an individual shareholder. Institutional investors employ Fund Managers to manage the
investment portfolio with the aim to benefit the individual member of the funds.
Exercise: Identify the differences between individual investor and institutional investor
Outsider Dominated Business is one in which the controlling shareholding is held by a large number of
shareholders, e.g. a listed company. Shares could also be held by Institutional Investors. Since these are listed
companies, they are subject to higher regulations / corporate governance requirements.
▪ None or few NEDs with weak position ▪ Significant NEDs having strong position
▪ Less focus on internal audit and risk ▪ High focus on internal audits & risk management
management
▪ Lower agency problems and cost (as family is ▪ Higher agency problems and cost (as directors run
running the business directly) the business on behalf of the shareholders)
Benefit Problem
Based on the concept of “comply OR explain” whereby the directors explain to shareholders the reasons for
not complying with any particular code and if the shareholders are not satisfied, they can hold the directors
accountable. Hence the decision regarding degree of compliance is in the hands of the shareholders rather
than the regulators.
Example
Which one is rule based approach and which one is principle based approach?
Advantage: Advantage:
▪ Clear regulations – no subjectivity ▪ Shareholders decide to what extent compliance
▪ Standard rules across the board needs to be done
Disadvantage: Disadvantage:
▪ Inflexible ▪ Subjective
▪ Unable to address exceptional situations ▪ Not suited for non-knowledgeable shareholders
▪ High cost of compliance ▪ Lack of consistency across industry
OECD Principles
OED principles were developed in 1998 and revised in 2004 and grouped into 5 broad areas:
ICGN Principles
ICGN report was issued in 2005 and revised in 2009 to provide practical guidance on OECD principles. It emphasis
on the following matters:
1. Shareholders (create long term value, protect their rights, fair treatment)
2. Directors (board structure, skills, term, remuneration, election, evaluation)
3. Corporate culture (ethics, integrity, bribery/anti-corruption, whistle blowing)
4. Risk management (analyze, manage, risk appetite)
5. Remuneration of Senior Management (link with performance)
6. Audits (external, internal, relationships)
7. Disclosures and transparency (material financial & non-financial info)
Practice Questions
P1 – Jun 2010 Q2: Remuneration Committee | Reward Package (Tomato Bank)
P1 – Jun 2012 Q4: Insider Business | Induction & CPD | Two Tier Board (Lum Co)
P1 - Dec 2013 Q4: Director Leaving | Technology Risk | Professional Ethics (Lobo Co)
P1 – Dec 2014 Q3: Role of CEO | Benefits of NED | Conflict of Interest (New Ideas)