Corporate Governance

June 2010

Suggested answers and examiner’s comments

Important notice

When reading these answers, please note that they are not intended to be viewed as a definitive
„model‟ answer, as in many instances there are several possible answers/approaches to a question.
These answers indicate a range of appropriate content that could have been provided in answer to the
questions. They may be a different length or format to the answers expected from candidates in the
examination.

Examiner’s general comments

The following general comments have mostly been made before in suggested answers and
examiner‟s comments for previous sittings of the Corporate Governance paper. Many candidates
continue to make the same mistakes or use the same poor exam technique, so the comments need to
be repeated. The comments do not apply to all candidates, but they do apply to a fairly large
proportion of candidates, sufficient to justify comment here.

(i) The ten questions in Section A are worth a maximum of 40 marks. Each of the ten questions is
worth just four marks each. In Section B, each question is worth 20 marks. Many candidates
clearly did not manage their time efficiently, and most of the pages of their exam scripts (and so
presumably most of their time) was spent on Section A. Some answers to Section A questions
covered one or even two pages, whilst the answers to Section B questions were no longer than
this, and in some cases, were shorter. This is very poor exam technique. Candidates should
allocate their time sensibly, with about 1.5 minutes for each mark, giving 30 minutes for reading
time and answer-planning time on Section B questions and about 6 minutes for Section A
questions.

(ii) When time is short in an exam, it may be tempting to write answers in the form of short „bullet
point‟ style notes. Short notes in a list do not convey much meaning to the reader, or convey no
meaning at all. Candidates must try to make sure that the points they make in an answer are
sufficiently clear. In commenting on previous examinations in November 2008 and November
2009, I wrote: “Lists are acceptable as long as the answers present the points sufficiently clearly
and completely for the marker to understand the point. If candidates make „bullet points‟ that fail
to explain sufficiently the point they are trying to make, and leave it to the reader to „fill in the
gaps‟, they will not get credit and will not earn marks.” This comment still applies for the June
2010 session.

(iii) A few candidates provided answers as a series of questions, without any further comment or
explanation. The same problem arises with short bullet points. A list of questions without further
comment is unlikely to convey much information to the reader, and so will get very little credit.

© ICSA, 2010 Page 1 of 18

(iv) A very popular word in answers was „ensure‟. Not much in business life is certain, and using the
word „ensure‟ usually suggests a lack of realism, good sense and good judgement.

Of the Section B questions, Questions 3, 4 and 6 were most popular. Unfortunately, candidates did not
always seem to know enough about the topics covered by these questions. The standard of answers
in Question 6 indicated that many candidates did not know as much as they should about internal
audit and its relevance to corporate governance. A surprising number of candidates appeared to know
very little about board performance reviews and so did not provide good answers to Question 4. There
is quite a lot to learn in the Corporate Governance syllabus, and candidates need to put in time and
effort to learn and understand the subject.

Section A
1. (a) What is auditor rotation, and how does rotation contribute to good corporate
governance? (4 marks)

Suggested answer

(i) A distinction can be made between rotation of audit firms and rotation of audit partners.
(ii) Rotation of audit firms means that a company should change its firm of external auditors
on a regular basis, at least every given number of years.
(iii) Rotation of audit partners means that the audit engagement partner responsible for the
audit of a particular client company should be changed on a regular basis, for example,
every five or seven years. (Other partners involved in an audit may also be rotated
regularly.)
(iv) It is possible to have audit partner rotation without audit firm rotation.
(v) It is argued that rotation allows a „fresh view‟ to be brought to a company‟s annual audit,
which may help to maintain audit quality.
(vi) It is also argued that rotation reduces the risk that the auditor‟s independence will be
threatened by over-familiarity with the client.
(vii) It may be argued that rotation reduces the quality of governance by reducing auditing
standards. When there is rotation, a loss of efficiency occurs due to an incoming auditor
needing to learn about the company and an outgoing auditor needing to prepare for the
succession of a new auditor.

Examiner’s comments

Many candidates answered this question well. Some candidates did not make a distinction
between audit firm and audit partner rotation, but the nature and purpose of auditor rotation
appeared to be generally understood.

(b) Explain the provisions of the UK Combined Code regarding the composition and
chairmanship of a nomination committee, and suggest why these provisions are
considered necessary for good corporate governance. (4 marks)

Suggested answer

The provisions of the Combined Code on Corporate Governance (Combined Code) are as
follows.

(i) A majority of the nominations committee should be independent non-executive directors

(NEDs).
(ii) The chairman of the board may be chairman of the committee. Otherwise, an independent
NED should be the chairman of the committee.
(iii) However, the chairman should not chair the nomination committee when it is discussing
the appointment of a successor to the chairmanship.

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 Why the provisions are necessary:

 In a well-governed company, there should be a formal, rigorous and transparent procedure

for appointing new directors to the board. Unless there is a majority of independent NEDs
on the committee, there may be some risk that nominations will be controlled (with a lack
of transparency) by the executive directors or an all-powerful chief executive officer (CEO).
 However, representation on the committee of executive directors is desirable for
appointments to executive director positions.

Examiner’s comments

Many candidates provided a good answer to this question. A common error was to include in
answers that the committee should consist of a majority of „independent‟ NEDs. Some
candidates also stated that the committee must consist entirely of independent NEDs.

(c) Describe the four roles of a non-executive director. (4 marks)

Suggested answer

The Higgs Report (2003) stated that the role of NEDs should have four elements, and NEDs are
perhaps better placed to fulfil these roles than executive directors:

 Strategy – NEDs should contribute to the formulation and review of business strategies by
the board. They should challenge strategy proposals in a constructive way and they should
also contribute to the development of strategy proposals.
 Performance – NEDs should scrutinise the performance of the executive directors and
other senior executives, by receiving reports on management performance and checking
whether agreed objectives and targets have been achieved.
 Risk – NEDs should satisfy themselves about the integrity of the financial information
produced by the company and should also satisfy themselves that there are robust
systems of internal control and risk management.
 People – NEDs are responsible for deciding the remuneration of executive directors (and
possibly other senior executives) and they should have a major role in the appointment
(and removal) of directors and in succession planning.

Examiner’s comments

The question asked about „the‟ four roles of NEDs, and it was hoped that candidates would
identify the Higgs Report as a framework for an answer. Many candidates did not do so, and
commented on how NEDs bring „independence‟, „skills and experience‟ or „contacts‟ to the
board, or create a „balanced board‟. However, these are not „roles‟.

(d) With regard to the functioning and effectiveness of the board committees, what
should be the responsibilities of a company secretary? (4 marks)

Suggested answer

The company secretary:

 Should assist the chairmen of the board committees by ensuring the smooth running of
committee meetings, for example, by organising meetings, issuing papers for the
meeting and taking minutes.
 Should ensure good communication flows between the board and its committees and,
where appropriate, between committees.
 May also, occasionally, be required to prepare papers for discussion at committee
meetings, such as papers on new regulations or on governance issues.
 May assist the committee chairman with the preparation of their reports for inclusion in
the annual report and accounts.
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  May serve a committee by carrying out certain tasks on their behalf, such as liaising with
external remuneration consultants (on behalf of the remuneration committee), head
hunter firms (on behalf of the nominations committee) or the internal or external auditors
(on behalf of the audit committee).
 Acting as secretary to the committees, can remind the committees of the principles and
guidelines of the Combined Code.

Other suggestions may have been acceptable.

Examiner’s comments

In general, candidates answered this question reasonably well, although some answers were
restricted to suggesting what a company secretary might do as secretary to the committees and
nothing else. A few candidates wrote about the company secretary and the main board, and did
not mention board committees at all, and therefore did not answer the question.

(e) Outline four of the main provisions on the design of performance-related

remuneration for executive directors, as set out in an appendix to the UK
Combined Code. (4 marks)

Suggested answer

The following points are taken from Schedule A of the Combined Code.

(i) The remuneration committee should consider whether directors should be eligible for
annual bonuses. If so, performance conditions should be relevant and stretching, and
designed to enhance shareholder value. Upper limits should be set for bonuses, and these
should be disclosed.
(ii) The remuneration committee should consider whether directors should be eligible for
benefits under long-term incentive schemes. In normal circumstances, shares granted
should not vest and share options should not become exercisable in less than three years.
(iii) Any new long-term incentive schemes should be approved by the shareholders. The total
of potential awards should not be excessive. Payouts or grants under all long-term
schemes should be subject to challenging performance criteria.
(iv) The award of shares or options should be phased rather than made in one block.
(v) Normally, only basic salary should be pensionable.
(vi) The remuneration committee should consider the pension consequences of any increase
in basic salary, particularly for directors approaching retirement.

Examiner’s comments

This question called for a good understanding of the requirements of the Combined Code, and
specifically Schedule A to the Code. Many candidates did not appear to know the answer, but
managed to mention one or two relevant points, for which they were given due credit. Some
candidates wrote (sometimes at length) what they appeared to know about provisions on
directors‟ remuneration, but mentioned nothing that was relevant to the actual question.

(f) What is the nature of accountability, and how is it applied within a system of
corporate governance? (4 marks)

Suggested answer

(i) The general concept of accountability relates to any situation where one person is given
power and authority by another. The person who is given the authority has a responsibility
to exercise his power in the manner intended, and should be held accountable to the
person who gave him the authority.

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 (ii) This is evident in the agency relationship between the board of directors and the equity
shareholders of a company. The directors should be accountable to the shareholders for
their stewardship of the company‟s assets and for the performance of the company.
(iii) Accountability in corporate governance means that shareholders should be given the
opportunity to review the performance of the board of directors by comparing actual
achievements against objectives, and to ask for explanations of unsatisfactory
performance. Where performance is unsatisfactory, the shareholders may demand the
resignation of directors or may vote against their re-election.
(iv) For accountability to operate in practice, there must be a method of measuring
performance. Quantified targets should be set and actual performance should be
measured and compared with those targets.
(v) Accountability in corporate governance is applied largely through the presentation of the
annual report and accounts to shareholders, the comparison of actual results with
expected performance and discussion of the accounts at the AGM.

Examiner’s comments

Many candidates answered this question adequately but not well. The main problems were an
inability to explain accountability properly, and not answering the second part of the question.
Some candidates recognised that one way in which the board is made accountable to
shareholders is through the requirement to prepare and present the annual report and accounts.
Some candidates referred to the „financial report and accounts‟ or did not mention the annual
report at all (only the accounts). At this stage of the examinations, candidates should be more
exact in their knowledge.

(g) How does a supervisory board in a company with a two-tier board structure, such
as a public company in Germany, differ from a unitary board, such as a board of
directors in a UK public company? (4 marks)

Suggested answer

 In a two-tier board structure, the supervisory board consists entirely of NEDs. This differs
from a unitary board, where members consist of both executive and non-executive
directors.
 Where two-tier boards operate, notably in Germany, there is often a large number of
members on the supervisory board. In unitary board structures, the number of NEDs is
generally much less.
 In supervisory boards, many of the NEDs are not independent. Some may represent the
interests of employees or trade unions. Others may be representatives of major
shareholders. Others may be former senior executives who have now retired. In a unitary
board structure, it is usual for most NEDs of quoted companies to be independent.
 A supervisory board has separate responsibilities from the management board. These
include oversight of the management board and the appointment and dismissal of
members of the management board. In a unitary board structure, it is good governance
practice to delegate certain board responsibilities to board committees consisting entirely,
or of a majority, of independent NEDs.
 In a unitary board structure, all directors have the same legal duties and may be held liable
by the company or its shareholders for a failure to comply with their duties. In a two-tier
structure, the directors on the supervisory board and directors on the management board
have different responsibilities, and so are not potentially liable in the same way.

Other points may have been acceptable for this question.

Examiner’s comments

Many candidates appeared to know about the two-tier board structure and described it
adequately. Answers invariably compared the different structures of the supervisory and unitary
boards, and some made a comparison of the independence of directors within each system.
© ICSA, 2010 Page 5 of 18
 Not many candidates compared the functions and responsibilities of the two types of board. Any
comment would have been acceptable based on the fact that in a two-tier structure, governance
responsibilities are split between the two boards, whereas in a unitary board system, the same
board has all the governance responsibilities.

(h) Explain the limitations of the Annual General Meeting of a large listed public
company for the exercise of their rights by the equity shareholders. (4 marks)

Suggested answer

The key issues for comment are that the AGM is a means by which shareholders can:

 Vote on certain issues, and indicate confidence in the board through those votes.
 Ask questions to the board and obtain information.

The AGM, therefore, arguably provides only limited opportunities for exercising shareholder
rights.

(i) It is usual for votes at AGMs to be on routine issues such as approval of the final dividend,
re-appointment of the auditors, election or re-election of directors and (in the UK) approval
of the directors‟ remuneration report. These provide only limited opportunities for holding
the directors accountable for their performance.
(ii) The matters voted on at an AGM are normally all proposed by the directors. When this is
the case, shareholders can exercise their rights only by voting against the directors, and
not making proposals of their own.
(iii) A group of shareholders may be able to organise themselves and include their own
proposal in the agenda for an AGM, but this is difficult to organise in practice, especially
when the company is big and has a large number of shareholders.
(iv) Attendance at AGMs is often low. It is usual for most shareholders (if they do vote) to vote
on proposals by proxy. In practice, the board of directors are often given support by proxy
voters, and therefore are guaranteed a majority in any poll vote called at the AGM.
(v) Because attendance at AGMs is often low, not many shareholders are able to hold the
board to account by asking challenging questions about performance.
(vi) The shareholders have no right to vote for a higher final dividend than the amount
proposed by the directors, and can only vote to reduce the proposed dividend.
(vii) Votes against the proposals of directors at an AGM may damage the interests of the
dissident shareholders, because „shareholder unrest‟ in a company may have a harmful
effect on the share price, in the short term.
(viii) However, the AGM provides an opportunity for small shareholders to ask questions directly
to directors of the company and, in this respect, gives shareholders a valuable opportunity
to exercise rights as owners of the company.

Examiner’s comments

A surprising number of candidates did not write much in answer to this question. Too many
candidates wrote about the voting power of minority interests, which is not a limitation of AGMs.
It would be a much greater concern if minority interests could out-vote the majority. A few
candidates did not appear to know the meaning of „equity shareholders‟, which is surprising at
this stage of the professional examinations.

© ICSA, 2010 Page 6 of 18

 (i) What information about risks needs to be contained in a narrative report to
shareholders (such as a business review as required of quoted companies within
the European Union)? Why may this information be of value? (4 marks)

Suggested answer

 A report such as a business review should provide a review of the company‟s business,
and, in addition, should describe the principal risks and uncertainties facing the company.
 The risks described are much more likely to be business risks rather than internal control
risks.
 Business risks include risks in the business environment of the company, such as risks
from political or regulatory change, legal issues, technological developments, social
change, or environmental issues. In addition, business risks and uncertainty will relate to
competition and the markets in which the company operates.
 A well-written business review will discuss how the various risks may have an impact on
future company performance.
 Information about risk and uncertainty is useful to various stakeholders in a company, but
is particularly useful to shareholders and potential investors. This is because an investor is
interested in the future and the reasons why future events may not turn out as expected.
An understanding of risk should help the investor to make a well-informed investment
decision, by comparing the expected return with the business risks involved and other risks
in the company where they have made a financial investment. By providing information to
assist with decision-making, information about risk has a value.

Examiner’s comments

This question did not require a broad range of points for a satisfactory answer. A large number
of candidates appeared to assume that the question expected much more in the answer than
was actually the case, and wrote about requirements for disclosures about risk that were
incorrect. Another common problem was for candidates to write about all the disclosure
requirements for a business review, but this was failing to answer the actual question.

(j) Explain briefly the main reasons why a company may adopt a corporate code of
ethics. (4 marks)

Suggested answer

 A corporate code of ethics is authorised and approved by the board of directors of the
company. Its purpose is to inform employees and external stakeholders in the company
that the directors expect the company to behave in ways that are consistent with ethical
standards set out in the code.
 Managers and employees are required to comply with the standards specified in the code,
and unethical behaviour by any employee should be subject to disciplinary action.
 A code of ethics should provide guidance on the treatment of employees, relationships
with suppliers (and ethical standards required from suppliers, such as prohibiting the use
of child labour or slave labour), relationships with customers, and responsibilities to the
community and wider society.
 Having a published code of ethics may enhance the general reputation of the company,
with government, suppliers, customers and the public generally.
 External stakeholders, such as customers and suppliers, are able to challenge the
company if they consider that it has failed to comply with the ethical standards of
behaviour that it has set for itself.
 By producing and publishing a code of ethics, and expressing their continued support for
the code, the board of directors can give clear ethical direction to the company.
 A breach of the ethical code by an employee may be treated as a disciplinary offence;
therefore, the code can be used as a way of controlling unethical behaviour.

© ICSA, 2010 Page 7 of 18

 Examiner’s comments

There were some excellent answers to this question. However, far too many candidates took a
simplistic approach and stated that a code of ethics „ensures‟ that the company‟s employees will
comply with the law, that more investors will want to buy shares in the company, that the
company‟s reputation will certainly be enhanced with the public and the company‟s profits and
share price will rise. A useful check on such assertions may be to ask yourself how many
companies you know that have codes of ethics. Some candidates took a cynical view that codes
of ethics are produced as a marketing tactic, to increase competitiveness compared with
companies that do not have a code of ethics. A useful check on such assertions may be to ask
yourself whether you actually believe this and can you think of any examples from „real life‟?

Section B
2. The Wigwam Investment Fund (WIF) monitors the performance of all the quoted
companies in which it holds equity shares. Decisions about buying, holding or selling
shares are based partly on reports by its analysts. The head of department is meeting a
newly-appointed analyst to explain the aspects of a company’s performance that are of
particular interest. He says that it is obviously important to look at all financial reports
issued by the company, including the financial statements in its annual report and
accounts, and it is also important to look for information about the company’s business
strategies and future prospects.

He then adds that WIF attaches great importance to corporate governance, and would be
inclined to avoid investing in companies with unsatisfactory corporate governance. The
newly-appointed analyst replies that he was not required to consider governance issues
in his previous job as credit analyst for a commercial bank, and he wants to know more
about what aspects of governance should be included in the reports that he prepares on
companies for his superiors.

Identify the corporate governance issues that should be of interest to an institutional

investor in equities, and explain why these issues may be of particular interest to the
fund managers of WIF. (20 marks)

Suggested answer

(i) An institutional investor should have a general interest in governance issues, in the
expectation that a company may perform better if it is well-governed than if there are
weaknesses in governance. The analyst should, therefore, look at the company‟s
governance history, to find out whether there have been any particular problems, such as
a large shareholder vote at a general meeting against a proposal by the board of directors.

(ii) Any investor should be interested in the quality of leadership and governance within the
company, and should look for reassurance that the company does have good leadership
and will continue to do so in the future. Items of particular interest may be management
changes and succession planning for the roles of chairman and CEO, because changes in
senior management and the board may affect the quality of leadership. The investor is
also likely to be concerned about companies where the same individual holds the position
of CEO and chairman, or where a CEO goes on to become the chairman. These
companies will probably be monitored closely for signs of excessive dominance by a
powerful individual.

(iii) Institutional investors expect to receive information about the financial performance of the
company (and non-financial aspects of performance). An important source of such
information is the annual report and accounts. Investors need to have confidence in the
information provided, and that the financial statements provide a true and fair view of the
financial performance and financial position of the company. Concerns about corporate
© ICSA, 2010 Page 8 of 18
 governance have arisen in the past from unreliable and misleading financial reporting.
Investors recognise the need for accounts to be audited by independent external auditors.
Governance issues relating to the independence of the external auditors should, therefore,
be a matter of some concern.

(iv) In the past, institutional shareholders have taken a leading role in demanding suitable
remuneration policies and practices for executive directors and other senior executives. It
is argued that in order to improve company performance, senior management should be
motivated to act in the interests of the shareholders, and motivation can be provided
through well-constructed remuneration schemes. A substantial proportion of the
remuneration package for an executive director should consist of short-term and long-term
incentives, and the incentives should be based on targets or objectives that are beneficial
to shareholders. However, remuneration should not be excessive and there should be no
„rewards for failure‟. Excessive payments to executives reduce the profits available to
shareholders, and excessive grants of shares may dilute the earnings per share
significantly. An institutional investor should, therefore, monitor the remuneration
arrangements of senior executives and consider whether they are paid appropriately.

(v) Investors buy shares in companies in the expectation of a certain return on investment. In
making an investment, there will be some investment risk. Investment risk relates to any
factors that may result in a fall in company profits and dividends, or a fall in market price.
This includes risks resulting from losses caused by fraud and error. Equity investors
should, therefore, have an interest in systems of risk management and internal control
within a company, and should be satisfied that these systems are effective and do not
contain material weaknesses. They need reassurance that business strategies are not
excessively risky (and that business risks are suitably controlled) and that there is no
material risk of unexpected losses from fraud or error. If the company does not have an
internal audit function, an investor should look at the reasons why the board of directors
does not see the need for one.

(vi) Institutional investors with a large investment in a company‟s equity will often wish to
maintain an effective dialogue with the company‟s board, through its chairman. They
should be interested in having meetings and discussions with company representatives,
and in the content and quality of reporting by the company.

(vii) An institutional investor may have concerns about social and environmental matters, and
may have a policy of investing only in companies with acceptable standards of corporate
social responsibility (CSR). These investors will, therefore, be interested in the company‟s
reporting of its CSR policies and achievements, in its annual business review or in its CSR
reporting.

Examiner’s comments

This question called for candidates to identify a number of different issues in corporate
governance and then explain why these issues might be of interest to an institutional
shareholder. A common weakness was to write about the principles or provisions relating to a
number of different aspects of corporate governance, without considering why institutional
shareholders should be interested in these matters. Answers that did not consider „why‟, were
not answering an important part of the question.

© ICSA, 2010 Page 9 of 18

3. Luke Graves (Luke) is the long-serving Chief Executive Officer (CEO) of Hornbill plc, a UK
listed company. He had a meeting with the newly-appointed chairman of the company,
Ross Plank (Ross), who happens to be married to Luke’s sister. A number of different
items were on the agenda for discussion.

Luke said that he had recently had a meeting with two institutional shareholders in the
company, who together held 5% of the equity shares. He had discussed the company’s
performance over the past few months and they had been pleased by the profit forecasts
that he had given them. The company’s results would be announced to the stock market
within the next two weeks. He had also discussed the company’s main business
strategies with these shareholders and had informed them that he intended to establish a
strategy committee within the company, consisting of the executive directors and other
senior executives.

They then went on to discuss the retirement and re-election of board directors at the
AGM. Luke said there was a problem with one of the directors, who would be retiring by
rotation this year, who had been an independent non-executive director for almost nine
years. He was very experienced and had contributed enormously to the work of the
board. He was considered to be too valuable to lose from the board, but there was now a
problem with his independent status. Luke felt that he was still as independent now as he
was when he first joined the board.

Luke also informed Ross that he had arranged for additional training for two board
directors: one of the non-executive directors and also the marketing director.

(a) Analyse the evident weaknesses in the company’s corporate governance

practices. For each weakness that you identify, recommend what the appropriate
practice of governance should be. (10 marks)

Suggested answer

The following weaknesses in corporate governance are evident:

(i) The newly-appointed chairman, as brother-in-law of the CEO, has a close family
connection with an existing board member. The chairman cannot, therefore, be considered
independent on appointment. This lack of independence should be disclosed in the annual
report and accounts. Investors may ask for the chairman to resign.

(ii) The CEO has broken stock market regulations (disclosure rules) by giving financial
information to the shareholders that has not been made publicly available. In addition, it
appears that the information he has given the shareholders includes „inside information‟. If
the shareholders now buy or sell shares in the company before the announcement of the
annual results, they would be criminally liable for insider dealing. They must be informed
that they are insiders and should not deal in shares of the company until the information
becomes public knowledge. The board will have to consider Luke‟s breach of the rules.

(iii) The board of directors as a whole should have responsibility for deciding business
strategy, and it should not delegate this responsibility to executive management. Executive
management should implement the strategies decided by the board. It is not clear what
Luke means by establishing a strategy committee, but it should not be for the purpose of
deciding strategies. It would also have been appropriate to discuss his intentions with his
board colleagues before announcing them to a few shareholders. The chairman has
already expressed his possible opposition to the CEO‟s plan. (Any comment would have
been acceptable if it mentioned that the board as a whole should be responsible for
deciding strategy and for deciding whether any new board committee should be set up.)

(iv) The board chairman has responsibility for induction and training of directors, particularly
NEDs, although the task of arranging induction and training may be delegated to the

© ICSA, 2010 Page 10 of 18

 company secretary. It is inappropriate that an executive director such as the CEO should
decide on training requirements for an NED. (It may be appropriate for the CEO to arrange
technical training for another executive director.)

(v) In general, the CEO is taking on too many roles outside his proper area of responsibilities
and there is a risk that the board of the company will be dominated by a single individual.
This risk is increased because of the family connection between the CEO and chairman.

(b) Discuss the problem facing the company concerning the long-serving non-
executive director, and recommend what the company should do to resolve it.
(10 marks)

Suggested answer

The problem facing the company is that the board may wish to retain the services of the NED
beyond a nine-year term. It is generally considered that an NED who remains with the company
for more than nine years after first being elected is no longer independent. This is included in the
provisions of the Combined Code.

It is also a requirement of the Combined Code that the majority of the board of directors should
consist of independent NEDs. If the NED remains on the board and is no longer considered
independent, the membership of the board may have to be changed (possibly by having to
appoint two more independent NEDs.)

The board, on advice from the nominations committee, should consider the continuation of the
NED as a board member, and decide whether his services are still required. If the board decides
that the NED should continue in office, it should explain its decision to shareholders in the
annual report and accounts.

The most suitable part of the annual report to make this disclosure would be in the section
dealing with compliance with the Combined Code. The company should state that it has not
complied with the Combined Code, and give an explanation (under the „comply or explain‟ rule in
the Listing Rules).

Alternatively, it may be argued that the NED is still independent. The nine-year „rule‟ is actually
only guidance and the board may argue that in this particular case the NED has retained his
independence. Therefore, the provisions of the Combined Code have not been breached. If this
course of action is taken, the situation should be kept under continual review.

Examiner’s comments

This was a popular question, and the standard of answers varied considerably. There were
several common problems. Many candidates explained correctly that the chairman could not be
considered independent on appointment, but then did not make a recommendation about what
to do about the problem. A few candidates suggested that the CEO might not be independent
too: an executive director cannot be considered independent.

A few candidates suggested that it was bad governance practice for the chairman and CEO to
meet in private and discuss issues. This is not the case. It would be bad practice if they kept
matters hidden from the rest of the board that should be disclosed or where information should
be shared. But there is nothing wrong with meeting and discussing problems – this happens in
business all the time, from board level down.

Some candidates mixed up the Model Code rules for directors (and not dealing in the company‟s
shares in a close period) with the law on insider dealing. Inside information should not be passed
to another person, and if this happens, that other person becomes an insider – at any time of the
year, not just around results time. Many candidates did not make a recommendation about what
to do.

© ICSA, 2010 Page 11 of 18

 Many candidates also discussed the NED with nine years on the board as part of their answer to
part (a), but this is not a weakness of corporate governance in the company, unless questions
are raised about the adequacy of succession planning.

Part (b), in general, was answered quite well, although some candidates took a very narrow view
of the situation (and argued that the director must resign, without considering the issue more
broadly). Some candidates did not include the need for the board to agree whether the director
should be asked to/allowed to stand for re-election again, and the need to persuade
shareholders to vote for him if this happens.

4. You are the secretary of a medium-sized listed company. The chairman of the board of
directors has asked for your opinion or advice about performance reviews.

At the moment, the company does not have any system of annual review of the
performance of the board and its directors. He wants to introduce such a system, and
recognises that it is recommended best practice for corporate governance. However, he
has no previous experience with performance reviews and is not sure how they should be
done. He knows that there is a need to review the performance of individual directors,
each of the board committees and the board as a whole, but does not know what he
should be looking for in order to judge performance. In addition, he is not sure how his
own performance should be assessed, or whether this is necessary. He thinks that the
most appropriate solution may be to delegate the responsibility for performance reviews
to the nomination committee.

Taking account of the relevant provisions in the UK Combined Code of Corporate

Governance:

(a) Suggest, with reasons, the aspects of performance that should be measured and
reviewed, in order to make an assessment of the individual directors, the
individual board committees and the board as a whole. (8 marks)

Suggested answer

(i) In reviewing the performance of individual directors, the chairman should look at their
work for the board and the board committees, and on other board duties:

 The contribution of an individual can be monitored by the extent to which the

individual contributes to board discussions and the apparent quality of those
contributions.
 A directors‟ continuing commitment to the role can be monitored by attendances at
meetings (and the number of apologies for absence), and by the amount of time
spent with the company (compared with the time commitment that the individual has
promised). This is particularly the case with NEDs, who are not full time with the
company and who may have agreed to a minimum time commitment in their contract
of appointment.

(ii) The performance of the board as a whole should be assessed by considering the various
responsibilities of the board and how well or badly these have been carried out.
Responsibilities such as strategy formulation, monitoring the effectiveness of internal
control and risk management systems, and communications with executive management
should be considered.

(iii) The performance of the board committees can be considered in a similar way, by
considering the responsibilities of each committee and how well these have been carried
out. In addition, the effectiveness of each committee in communicating with the main board
should be assessed.

© ICSA, 2010 Page 12 of 18

 (iv) The board and each committee should be assessed for the composition of their
membership, and whether their composition complies with best governance practice.

(v) Other suggestions would have been acceptable, such as an assessment of the way in
which the board responded to an unusual event or „crisis‟ during the year.

(b) As company secretary, make practical recommendations to the chairman about

how he should set about introducing annual performance reviews. (12 marks)

Suggested answer

Note: This answer is written in the context of the Combined Code on Corporate Governance,
and not the UK Corporate Governance Code, issued in June 2010.

(i) The chairman should inform his board colleagues of his intention to carry out annual
performance reviews, so that they are aware of his intentions.

(ii) He should decide when the review will be conducted, and announce this to the rest of the
board.

(iii) He should decide how the performance review should be conducted. He may wish to do
most of the appraisals himself, with the assistance of the company secretary. Alternatively,
he may hire external specialists in board performance reviews. The experts can offer
practical advice and may also be asked to do some of the appraisals.

(iv) For carrying out a performance review, the chairman must decide what matters to look at.
He may refer to lists of items to consider in the Higgs Guidance on Performance
Evaluation. Having prepared a list of questions or matters to consider, the chairman should
implement the review.

(v) For the performance review of individuals, the chairman may have meetings where
performance is discussed, and in cases where weaknesses are identified, ways of
improving performance may be agreed (for example, extra training, or a commitment to
attend more board or committee meetings). For subsequent years, the chairman should try
to agree performance targets with the individual.

(vi) The performance review of board committees may be discussed with the chairman of the
committee (if this is not the company chairman himself). Similarly, the review of the
performance of the board as a whole may be discussed with all the board members.
Reasons for weak performance may be identified, with a view to making improvements: for
example, poor performance by the board may be attributable to a failure to provide
relevant, timely and accurate information to board members.

(vii) The chairman should also ask the senior independent director to organise a performance
review for himself, and accept the feedback that this review provides.

(viii) After the reviews have been carried out, the chairman should consider the need for
changes and improvements. This may include reaching a decision that certain directors
(particularly NEDs) should no longer serve on the board, or that new board members are
required. These findings should be discussed with the nominations committee.

(ix) For the annual report, the chairman should include a statement of how the performance
review has been conducted.

© ICSA, 2010 Page 13 of 18

 (x) The review process should be an annual event, although the method of carrying out the
review (for example) with or without the assistance of external consultants) may vary from
one year to the next.

Examiner’s comments

There were some weaknesses in answers and many candidates did not appear to have studied
this topic in any detail. Several candidates assumed that the annual performance review was
linked to remuneration and annual bonuses, which is not the case. Similarly, the annual review
of executive directors‟ performance by the CEO is not a part of the annual review of board
performance.

Many candidates stated incorrect facts. The Combined Code states that the board should
undertake an annual performance review of itself, its committees and individual directors. The
review is generally carried out by the chairman, not by the nomination committee and not by the
CEO.

In answer to part (a), candidates were able to suggest aspects of performance of individual
directors that might be appraised, but did not make any suggestions about appraisal of the board
and its committees.

5. The newly-appointed secretary of a UK listed company was previously a company

secretary working for a large company in South Africa. He has commented to the board of
directors that, in his opinion, the company does not give enough attention to its
corporate social responsibility (CSR). In comparison with South Africa, he believes, UK
companies do not sufficiently understand the need to act as responsible corporate
citizens and this is a weakness in the UK Combined Code on Corporate Governance,
compared with the King Report.

In response to his suggestion that the company should publish a Social and
Environmental Report every year, the chairman replied that this is no longer necessary
because of the statutory requirement for quoted companies to include social and
environmental information in their annual business review.

(a) Explain the differences between the UK Combined Code on Corporate

Governance and the King Report with regard to corporate social responsibility
and, on the basis of these differences, give your assessment of the opinions and
comments of the company secretary. (10 marks)

Suggested answer

Note: This answer is based on the content of the King II Report, which was examinable in June
2010, and not the King III Report issued in 2009.

The Combined Code contains no principles or provisions relating directly to corporate social
responsibility. There are some statutory requirements for disclosures about social and
environmental issues (in a business review) and many large listed companies publish voluntarily
an annual CSR report.

In comparison, the King II Report includes a number of provisions relating to ethics and CSR:

(i) The company secretary is required to provide a central source of guidance on ethical
issues as well as on governance matters.

(ii) Companies are required to report on their policies, procedures and systems for, and their
commitment to, CSR issues: social, ethical, safety, health and environment issues. The
King II Report also refers to stakeholder reporting.

© ICSA, 2010 Page 14 of 18

 (iii) The King II Report states that specific consideration should be given to a number of
issues: safety and occupational health issues/objectives (including HIV/AIDS);
environmental reporting and choosing the options with the least environmental impact;
social investment policies, including black economic empowerment, and human capital
development, such as training and opportunities for women.

(iv) The King II Report states that there is a need for a code of ethics for all stakeholders and
companies should demonstrate their commitment to their code of ethics. Directors should
disclose their opinion on the extent to which ethical standards are met. Entities should also
continuously review their relationships with other entities whose ethical standards are
lower.

The views of the company secretary are debatable, and it is possible to agree or disagree with
him. There are major differences between conditions in South Africa and the UK, and between
the aims of the Combined Code and the King II Report:

(i) South Africa is still a developing country in comparison with the UK and the national
economy faces considerable problems with resource shortages, low standards of living,
low standards of general education, and health. The country‟s population may expect
companies to act much more as „corporate citizens‟ and display much more corporate
social responsibility than in the UK. There may also be a history of unethical business
practice in South Africa which the King II Report was intended to combat.

(ii) The King II Report was written for public sector enterprises and government departments
as well as listed companies and financial institutions. It may, therefore, be expected that it
will have more concern for social issues.

(iii) It may be argued that there is no need for the Combined Code to be concerned with CSR,
because many large companies are already aware of their responsibilities.

(b) Discuss the view of the company chairman that an annual Social and
Environmental Report is not necessary, because of the social and environmental
information in the annual business review. (10 marks)

Suggested answer

(i) The business review is a part of the annual report and accounts of a company and so is
written primarily for the equity shareholders. A Social and Environmental Report is a
voluntary report, written for a wider audience of stakeholders.

(ii) By producing a Social and Environmental Report, a company is recognising that it has
certain responsibilities to stakeholders other than its shareholders. The report may,
therefore, be an ethical „statement‟.

(iii) Company law provides only limited details about the social and environmental information
that a business review should contain. It should provide information about environmental
matters (including the impact of its business on the environment), company employees
and social and community issues. There should be disclosures about company policy on
these matters and their effectiveness. Where appropriate, the review should include key
performance indicators on environmental or employee matters (for comparing target with
actual achievements).

(iv) A company may choose to include extensive social and environmental information in the
business review. Alternatively it may provide only limited information. A Social and
Environmental Report, in contrast can be a large document and so should contain much
more extensive information about CSR issues.

© ICSA, 2010 Page 15 of 18

 (v) Institutional investors such as the ABI in the UK continue to want these reports to be
produced, since they are under an obligation to report their own investment performance in
these areas.

(vi) In conclusion, a Social and Environmental Report is not „necessary‟ in the sense that it is
not a legal requirement. However, producing a Social and Environmental Report probably
demonstrates a greater commitment to CSR objectives and concerns that the inclusion of
social and environmental issues in a business review. For this reason, the chairman is
probably wrong in his view.

Examiner’s comments

This was not a popular question, possibly because a fairly detailed knowledge of the King II
Report was needed to provide a high quality answer to part (a).

6. Brakefoot plc is a small UK listed company. The chairman of the board of directors has
asked the chairman of the audit committee and the company secretary for information or
advice on two matters.

The company does not have an internal audit function at the moment, and the audit
committee will be carrying out a review of the need for one. The chairman is not familiar
with the work of internal auditors, and wants to learn more before the audit committee
presents its report.

The company set up a whistle-blowing procedure four years ago, following the arrest and
criminal prosecution of an executive director for fraud. Whistle-blowers are asked to
report their concerns to the company secretary, who then decides whether the matter
should be referred to the board of directors. Since the procedure was established, there
have been only three instances of whistle-blowing, and in one of these the whistle-blower
was dismissed for making false allegations. The other two whistle-blowers resigned from
the company several months after making their allegations. The chairman believes that
the whistle-blowing procedure is not working as intended, but is not sure why.

(a) Describe the responsibilities that an internal audit function may be given if it is
established, and suggest with reasons:

(i) who should decide the tasks or projects for internal audit; and
(ii) who the senior internal auditor should report to within the company.
(10 marks)

Suggested answer

The broad responsibilities of an internal audit function should be approved by the board of
directors. The responsibilities of an internal audit function may be as follows:

 An internal audit function would be required to review the internal control system through a
continuous series of investigations. A review of internal control should include reviews of
the systems for identifying and assessing risks, and for monitoring the effectiveness of
controls. However, the internal auditor‟s work would consist of investigations into the
effectiveness of internal controls in certain parts of the business.

 Reviews of internal controls may include financial controls, operational controls and
compliance controls, or may be limited to financial controls only. Material weaknesses in
internal controls would be reported to management, and possibly also to the board or audit
committee.

© ICSA, 2010 Page 16 of 18

  Internal auditors may be required to carry out similar reviews of the systems for business
risk management.

 Internal auditors may be required to carry out special investigations into various parts of
the business. These investigations may be called systems audits, value for money audits
or IT audits. All such investigations should have the objective of testing the robustness of
systems and their controls.

 The internal auditors may be asked to carry out risk assessments, such as measuring the
probability of an adverse event and the impact of the event if it were to occur. This would
be a form of special investigation.

Different individuals or committees may decide the tasks or projects for internal audit. Internal
audits may be planned by a senior person in accounts and finance, such as the finance director.
The internal auditors must have line reporting and executive control; this is often provided by the
finance director.

Audits may also be carried out at the specific request of a departmental manager or divisional
manager. In addition, internal auditors may be asked to carry out projects or investigations for
the board or the audit committee.

The senior internal auditor will usually, therefore, be required to report to a variety of different
people. He should report to the person who gives him a project: this may be the finance director,
a departmental or divisional manager (with reports copied to the finance director), the audit
committee or the board.

Since there may be a large number of requests for the assistance of the internal auditors, their
work programme should be planned in advance.

As a matter of good corporate governance, the chief internal auditor should be able to access
the board or audit committee directly, without going through a line manager.

In addition, the audit committee or board may ask the chief internal auditor to attend meetings, to
report on internal control or risk management issues.

(b) From the information provided, identify the apparent problems with the whistle-
blowing procedure, and suggest reasons why it may not be functioning as it was
originally intended. (10 marks)

Suggested answer

An apparent weakness with the whistle-blowing procedure is that not enough individuals have
made use of it to „blow the whistle‟. This may possibly be because there are no instances of
misbehaviour within the company, or all instances of misbehaviour are reported through normal
reporting lines (subordinate to boss), but this is unlikely.

It seems more likely that the procedure is not used because employees do not have faith in its
effectiveness, and may be concerned about victimisation by colleagues.

Of the three whistle-blowers in four years, one was dismissed for making unfair allegations. This
disciplinary action may have been justified, but other employees would have noticed the event.

The two other whistle-blowers left soon after making their allegations. We do not know whether
the allegations were justified, and we do not know the reasons, but both left the company soon
afterwards. They may well have suffered from hostility by work colleagues to the action they had
taken.

© ICSA, 2010 Page 17 of 18

 Employees may also have little confidence in the reporting system. Reports are made initially to
the company secretary, which could be appropriate. However, the company secretary then
reports the allegation to the board of directors, which will include the operational director for the
department where the alleged wrongdoing has occurred. As a result, the allegation may not be
given the independent review that it should be given. For example, a more suitable procedure
may be for the company secretary to refer the allegations of whistle-blowers, if they seem
serious, to an independent external investigator, such as a firm of lawyers.

It is also possible that the procedure is not working as intended because not enough employees
know about it. If so, there should be a programme of familiarisation so that employees are made
much more aware of the procedure and how they will be protected in the event that they make
an allegation.

Note: Other points or suggestions may have been relevant and acceptable.

Examiner’s comments

This was a popular question but the general standard of answers was disappointing.

In part (a), many candidates did not describe correctly the responsibilities of an internal audit
function. Many candidates stated that the internal auditors had executive control over the
implementation of internal controls, or that they „ensure‟ that the control system is effective. This
is not the case. They check and then report on their findings, often making recommendations for
improvements. Their reports ought to be acted on where appropriate, but the internal auditors do
not „ensure‟ anything: they are an additional control within the overall control system, and they
give advice.

Some candidates wrote about the review by the audit committee of the need for internal audit if
the company does not yet have an internal audit function, but this was not relevant to the
question.

There was a lot of confusion about who should be responsible for deciding the tasks or projects
for internal audit, and who the senior internal auditor should report to. Many candidates stated
that the tasks for an internal audit function must be decided by the board or the audit committee.
It is certainly true that some projects may be given to internal audit by the board or audit
committee, such as providing assistance with the review of the effectiveness of the internal
control system for the purpose of the annual report. However, if an internal audit function is set
up as a full-time operation, it will carry out more investigations than those required by the board
or audit committee. Also, it is most unlikely that an audit committee will have the time, skill or
knowledge of the company‟s operating systems and control systems to specify tasks for internal
audit in detail or to assess the findings of their audit investigation.

Similarly, independence is an important issue for the senior internal auditor, but as a full-time
employee, he or she ought to report normally to a full-time executive manager – the finance
director perhaps, or the CEO. Independence can be protected by giving the senior internal
auditor an additional reporting line to the board or audit committee, and expecting the audit
committee to meet with the senior internal audit from time to time, without any executive director
present at the meeting.

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.

© ICSA, 2010 Page 18 of 18