Chapter 6

Governance
(Shareholders Portion)

Organization

Share Holders (B1) Stake Holders (B2)

Agency Theory Introduction
Board of Stakeholder Mapping Model by
Directors Mendelow CSR
Corporate Governance Reporting to Stakeholders:
Integrated Reporting
Environment and Social
Reporting EMAS & ISO 14000
Public Sector Governance

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.

 Principal: Shareholders (as they are owners of the company)

 Agent: Directors (as they run the company on behalf of the shareholders)
Problems With Agency Arrangement
 Conflict of interest (covered below)
 Oversight (e.g. directors maybe negligent or miss something)
 Lack of integrity and honesty (e.g. directors doing frauds)
 Lack of transparency (e.g. inaccurate reporting)
 Ethical violations (e.g. directors may deviate from the values and ethics 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).

E.g. of conflict of interest include:

 Sub-contracting company’s work to close family members

 Focusing on short term profit to maximize their own bonus for the year
 Negotiating high / unjustified remunerations
 Accepting any personal benefit from third party

Fiduciary Duty and Accountability

Fiduciary Duty: Fiduciary duty means duty of utmost good faith towards the principal. This means that
directors should act in the best interest of shareholders and avoid any conflict of interest (or disclose). This
duty can be legal or ethical.

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
 Knowledge
 Independence
 Size
 Skills KISSE(D)
 Experience

Executive Directors are full time employees of the company.

Non-Executive Directors (NED) are part-time outside directors ‘independent’ of the company i.e. they are not
employee of the company.

Functions of the Board of Directors

Overall the Board has to act in the best interest of the shareholders, which includes:
 Maximize shareholder wealth
 Provide entrepreneurial leadership and strategic management
 Monitor business performance
 Monitor performance of CEO and management team
 Establish effective risk management process
 Ensure that effective internal controls and financial accounting / reporting systems are in place
 Safeguard company assets
 Ensuring legal compliance
 Communication with shareholders and stakeholders
 Take major decisions such as borrowing, lending, fixed assets, financing, major projects, etc.
Duties of Individual Directors
 Fiduciary duty and accountability
 Avoid conflict of interest
 Remain within the powers given by the Board & Articles of Association
 Treat all shareholders equally
 Principles of professional ethics
 Integrity
 Objectivity
 Professional competence and due care
 Confidentiality
 Professional behavior

Communication & Disclosure with Shareholders

Following are the general principles which the Board of Directors should follow in communication and
disclosures to their shareholders:

 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

Composition & Balance of the Board

Composition of the Board
The Board should consist of:
 Chairman
 CEO
 Executive directors
 Non-executive directors
 Balance of the Board
 Board Size should be appropriate
 Board should have right amount of Knowledge, Skills and Experience
 Balanced between Executive and NEDs (Independence)
 Any one person should not be able to Dominate the Board
KISSED+SD
 Split role between Chairman and CEO
 Diversity in the board (covered below)

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

Chairman & CEO

Role & Responsibilities of Chairman
Main role: Running the Board
 Link between company and shareholders / stakeholders
 Communication with shareholders (e.g. Annual Report)
 Protect shareholder interests and increase long term shareholder wealth
 Lead board of directors and ensure smooth running of board, such as:
 Appropriate size, knowledge, skills, experience, and independence of directors
 Balance between executive and non-executive directors
 Effective functioning of Board Committees
 Regular meetings
 Directors’ nomination, performance and remuneration
Role & Responsibilities of CEO
Main role: Running the Company
 Propose strategies to the board
 Implement decisions of the Board
 Monitor day to day running of business and all departments
 Manage resources effectively and efficiently
 Risk management and internal control systems
 Timely and accurate reporting
 Legal and regulatory compliance
 Interact with external parties, such as Government, key customers, key suppliers, Stock Exchanges

Splitting of Roles Between Chairman & CEO

The Chairman runs the Board. The CEO runs the company. The running of the Board should be separate from
the running of the Company. Hence the role of Chairman and the role of CEO should not be performed by one
person, as this concentrate excessive power in the hand of one person. The Chairman should be independent
just like a NED.

Advantages of Splitting the Role:

 Segregation of duty leading to improved governance
 Higher shareholder confidence as Chairman is normally a NED
 Able to challenge CEOs views and performance
 Directors can communicate with Chairman if they have concerns relating to CEO
 CEO can concentrate on running the business without spending time to manage board activities

Disadvantages of Splitting the Role:

 Separation creates two leaders rather than unity provided by one leader
 Chances of disagreement or clash between Chairman and CEO
 Chairman may not have in-depth knowledge of business
 Non-executive directors (NEDs)
NEDs are part-time outside directors who are ‘independent’ i.e. they are not employee of the company. They
bring independence, external perspective and scrutiny. They add to the confidence to shareholders by
occupying key positions in various Board Committees. They get a fixed fee for being NEDs and are not entitled
to any bonus or share options as it will create conflict of interest and threaten their independence.

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

Exercise – Independent or Not?

 Most of the NEDs have been in their present role since the company was listed 12 years ago

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

1- Nomination Committee: Recommends appointments of new directors

2- Remuneration Committee: Recommends remuneration policy for executive directors

3- Audit Committee: Reviewing accounts and internal controls, liasoning with external auditors
and supervising internal audit function

4- Risk Committee: Overseeing risk management process

Advantages (Importance) of Having Board Committees

 More focused and specialized
 More time can be spent by committees as full board has limited time
 Higher involvement by NEDs (e.g. in audit or remuneration committees)
 Board can focus more on strategic and business matters
 Increases shareholder confidence

Nomination Committee (Majority NEDs)

The Nomination Committee makes recommendation of appointments of directors to the Board, with the
objective of maintaining balance. This Committee consists of majority of NEDs. The procedures for nominating
directors should be formal, rigorous and transparent.

Roles of the Nomination Committee:

 Determine right Size of the board
 Ensure board contains the required Knowledge, Skill and Experience
 Balance between executive directors and NEDs (Independence)
KISSED
 Diversity in the board (covered below)
 Identify and attract competent directors to fill any vacancy
 Induction training and continued professional development (covered below)
 Succession planning of directors
How to Recruit New Director
 Personal connection / word of mouth of directors and senior management
 Executive search companies
 Advertisement
 Professional forums and networks

Remuneration Committee (100% NEDs)

The Remuneration Committee recommends remuneration policy for the directors with the purpose of
attracting, retaining and motivating directors to achieve long-term returns for the shareholders. Committee
comprises of 100% NEDs so that committee can be independent while determining the remuneration of CEO
and executive directors. An appropriate portion of the package should be linked with performance.

Roles of the Remuneration Committee:

 Determine remuneration policy in order to attract, retain and motivate
 Ensure that a portion of the package is linked with performance as well as linked with long term
 Decide remuneration for CEO and all Executive Directors
 Report remuneration policy and packages to shareholders (through Remuneration Report)

Audit Committee (100% NEDs)

The Audit Committee is responsible to ensure that financial reporting is accurate, internal audit function is
effective and external auditors remain independent. All members are NEDs with atleast one NED having
recent expertise in financial reporting and audit. This is to ensure that shareholders receive independent and
accurate financial information of the company.

Roles of the Audit Committee:

Financial statements and reporting:
 Ensuring accuracy and integrity of financial statements and regulatory filings
 Review accounting policies
 Review internal controls relating to financial reporting
 Compliance with relevant laws and regulations
Monitoring internal audit function:
 Ensure independence and objectivity of internal audit
 Appoint internal auditor and monitor his/her performance
 Approve annual internal audit plan
 Ensure effectiveness and efficiency of internal audit function
 Ensure that internal audit recommendations are implemented timely

Managing External Auditors:

 Recommendation appointment, re-appointment or removal of external auditor
 Approve terms of engagement / audit scope
 Approve auditor’s remuneration
 Ensuring independence and objectivity of external auditor
 Review any non-audit services provided by external auditors (e.g. tax consultancy)
 Audit closure meetings, including discussing issues and weaknesses identified during audit

Provide Whistleblowing arrangements to prevent fraud and mis-reporting

(Covered in more detail in Section F – Organizational Control & Audit)

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.

Roles of the Risk Committee:

Relating to Risk Management Process
 Implement formal risk management process / ERM framework
 Advice board on risk appetite and ALARP levels
 Embed risk management in organization culture
 Identify key risks and recommend risk management procedures and controls
 Monitor overall risk exposure of the company and ensure it remains within limits set by the board
 Ensure risk management procedures and controls are effective
 Informing board and shareholders of any significant change to company’s risk profile
 Monitor performance of Risk Manager
Relating to Internal Controls
 Review and implement internal control systems, policies and procedures
 Assess effectiveness of internal controls
 Review Internal Controls Report sent to Shareholders
 Provide early warning to the board of emerging weakness in the internal control system

(Covered in more detail in Section D – Risk Management)

Remuneration & Rewards of Directors

General Principles
 Remuneration should be sufficient to attract, retain and motivate competent directors
 Remuneration to be in line with market rates, industry norms and close competitors
 Remuneration should have following components:
 Fixed pay
 Variable / Performance based incentives:
 Short term incentives (e.g. bonus)
 Long term incentives (e.g. share options)
 Consider difference in experience levels of directors
 Director cannot approve his own remuneration – to be done by Remuneration Committee (NEDs)
 Full transparency to shareholders (e.g. disclosures in annual accounts)

Components of a Remuneration Package

 Basic salary – should be comparable to market and salaries of other similar directors in the company
 Benefits / perks – comparable with market practices (e.g. car, club membership)
 Retirement benefits / Pensions – only basic salary pensionable, has to be in line with the law
 Performance Related Pay: helps to ensure that directors’ actions are aligned with shareholders’ interests:

 Short term incentive: e.g. annual bonus

 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)

 Long term bonus (performance based)

 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.

Factors Influencing Level of Reward of CEO and Directors

 Size of company (small company normally pays less)
 Public sector or private sector (public sector pays less)
 Profile and experience of the CEO and directos
 Commercial organization or not-for-profit organization
 Company’s performance and target achievement
 Market rates: Benchmarking with similar companies / competitors in the industry

Board Structures: Unitary and Two-Tier Board

Having a single board have some problems, especially if the CEO is dominating and powerful and NEDs are
suppressed. Hence there are two approaches to structure the Board.

Two Tier Board:

In this approach, there are two boards in a
company: 1- Supervisory Board
 It is appointed by Shareholders and led by a Chairman
 Consists of mostly NEDs and senior directors
 Focuses more on long term strategies
 Responsible for legal and regulatory compliance
 All voting rights vested in this board
 Supervises the Management Board (see below)
 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

Advantages & Disadvantages of a Two-Tier Board:

Advantage Disadvantage

 Separation between strategic and operational roles  Slower decision making

 Greater independence leading to higher
investor confidence
 Voting rights in hand of NEDs and
senior directors
 CEO cannot dominate the board
 Isolation of supervisory board from
operational matters
 Management board demotivated due to
limited involvement in strategic matters
 Information sharing by management
board might be poor
 Induction of New Directors
Induction is a process of orientation and familiarisation of new directors with the company, so that the new
director has some know-how about the company. This will help the new director in settling down and
becoming productive quickly. The Chairman has to ensure that new directors receive formal induction on
joining the board. If a NED joins, the company should invite major shareholders to meet the new NED.

What Aspects Are Covered In Induction

 Introduction to company and its operations
 Role & responsibilities of directors
 Professional, legal and ethical values which a director must follow
 Board procedures and committees
 Details of all directors, major shareholders and key employees
 Strategies and business plans
 Organizational values, culture and structure
 Key customers, suppliers, banks, auditors, stakeholders, etc.

Advantages (& Importance / Purpose) of Induction

 Makes new director familiar with the company, its operations and core strategies
 Helps in understanding the norms and culture of the organization
 Build working relationships with fellow directors and key executives
 Reduces settling in time and speeds up the productivity and learning curve

Continued Professional Development of Directors

CPD is systematic maintenance and improvement of knowledge and skills necessary for execution of duties
throughout an individual’s professional career. The Chairman has to ensure that all directors undertake regular
CPD in order to fulfil their duties.

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

ACCA’s Processional Development Matrix (Features of Effective CPD Planning)

 Planning: Individual should identify competencies required in the current role and develop CPD plan
 Action: Undertake actual CPD
 Results: Assess whether CPD achieved the objectives and desired competency level
 Reflection: Examine evolving nature of the role and continuously plan CPD for future needs

Diversity in the Board

Diversity means having variety of people in the board, normally based on demographics prevailing in that society.
Diversity is based on age, gender, educational / professional background, experience, ethnicity, etc.

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

How Regulators Encourage Diversity

 By specifying in law minimum diversity requirements, e.g. 40% of board to be females
 By mandatory disclosures in Annual Accounts relating to diversity measures taken by the company
 Appointment of Directors
Directors can be appointed in the following manner:
 By resolution from Shareholders – usually in Annual General Meeting (AGM)

 By resolution from Directors (temporary appointment)– the Article of Association of a company

empowers Board to appoint a director to fill an unexpected vacancy in the board. This normally
happens if any director leaves in between or becomes disqualified. But this appointment is only valid
until the next AGM, when the shareholders will appoint / approve the new Board.

 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.

Importance / Benefits of Retirement by Rotation

 Directors need to perform well in case they want to get re-elected
 Gives an opportunity to shareholders to get rid of directors who are not performing
 Reduces cost of termination of non-performing directors
 Opportunity to replace the Board over a period of time whilst maintaining continuity and stability
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

 Removal by Shareholders – usually through a general meeting giving 28 days’ notice

Performance Appraisal of the Board

The performance of the Board should be reviewed on an annual basis. The performance of the Board as a
whole, Committees and individual directors are reviewed. The performance evaluation is led by the Chairman
and Chairman’s performance is evaluated by NEDs.

Board’s & Committees’ performance is assessed against:

 Maximizing long-term shareholder’s wealth
 Achievement of financial and non-financial targets
 Risk management, internal controls and financial reporting
 Compliance with regulations
 Communications with shareholders and stakeholders and problem solving
 Corporate governance and management of board (conduct of meetings, working of the committees,
quality of documentation)
Individual director’s performance is assessed against:
 Achieving of individual performance targets
 Contribution to the strategies and problem solving
 Principles of professional ethics (integrity, honesty, professional competence and due care,
confidentiality and professional behavior)
 Active participation in board activities (meetings, preparedness, committees, etc.)
 Any unethical behaviour (insider trading, , unfair dealing, conflict of interest)
 CPD

Advantage of Performance Evaluation

 Enforces high performance
 Identifies low performing directors
 Identifies training needs
 Forms basis for bonus payouts

Insider Trading / Dealing

Insider trading / dealing means buying or selling of company shares by its own directors or senior executives
based on information which is not publicly available as yet. Directors often have access to market-sensitive
information beforehand and they can benefit significantly if they buy or sell company shares based on
confidential information.

Why Insider Trading is Unethical / Illegal

 Directors have to act in the primary interest of shareholders and not to make personal gains
 Directors have to maximize ‘long’ term value of the organization. If insider trading is allowed, then it is
likely that directors would be tempted to take short term decisions to make personal gains
 Insider trading can damage the reputation and integrity of the capital markets of the country
 Cost of capital might increase as investors would expect a higher return to cover higher risk if insider
trading prevails
 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

Principles of Corporate Governance

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)

4. Fairness (even dealings with all stakeholders)

AIR-DRIFTS
5. Reputation (board carries a reputation, moral stance, must enjoy
confidence of key stakeholders)

6. Responsibility (clear roles)

7. Accountability (answerable for results)

8. Judgment (ability to make sound decision)

9. Skepticism (questioning mind, critical evaluation)

Features of Strong Corporate Governance Environment
 Role of Chairman and CEO is segregated
 Sufficient NEDs on the Board
 Formal board committees
 Risk management framework
 Focus on strong internal controls
 Transparent and factual reporting
 Rewards linked with performance
 Internal and external audits
 Focus on integrity, objectivity and avoidance of conflict of interest by directors

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
Characteristics of Institutional Investors
 Higher dominance as power is concentrated in few hands
 Higher ‘Shareholder Activism’:
 Active participation in key strategies and decisions
 Paying attention to the Board composition, Committees and NEDs
 Making active use of voting rights
 Critical review of remuneration policy and perks
 Dictating risk appetite

Problems of Institutional Investors

 Tend to focus on short term profits
 Higher interference in business due to dominance of power
 Minority / individual shareholder interests may be ignored

Institutional Investor Intervention

Institutional investor may intervene in the affairs of an organization under following circumstances:

 Concerns about business strategies  Major acquisition or disposal

 Deteriorating performance & results  Excessive directors’ remuneration
 Non-compliance with laws and  Weak NEDs
codes
 Unethical issue
 Major internal control failure

Agency Complication in Institutional Shareholders

Agency problems are more complex in institutional shareholders. Institutional shareholders gather a large
pool of funds from members (e.g. pension fund or mutual funds) and then employ Fund Managers to invest
these funds into numerous listed companies on the stock exchange. As the Fund owns shares on behalf of
its members, the final shareholders are the members. Hence there is the added layer of middleman (i.e.
Fund Manager) between the members and the listed company. Hence no individual member has a direct
voice or communication with the listed company.
 Insider And Outsider Dominated Business
Definitions
Insider Dominated Business is one in which the controlling shareholding is held by a small number of
dominant individuals. Mostly these are family owned businesses and are generally not listed on stock
exchange. Hence, they are subject to lessor level of regulations / corporate governance requirements.

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.

Difference Between Family Owned and Public / Listed Companies

Family Owned Business Public / Listed Companies

 Owned by family members  Owned by individuals or institutional investors

 Mostly private limited  Mostly public limited / listed company

 Lessor regulations and CG requirements  Stringent regulations and CG requirements

 Freedom of taking decisions  Decisions based on majority shareholder or voting

 None or few NEDs with weak position  Significant NEDs having strong position

 No Board Committees  Formal Board Committees

 Focus on long term returns  Focus on short / medium term returns

 Less focus on internal audit and  High focus on internal audits & risk management
risk management

 Lower agency problems and cost (as family  Higher agency problems and cost (as directors
is running the business directly) run the business on behalf of the shareholders)

 Generation change leads to problems  Good succession planning in place

 Advantages and Disadvantages of Family Owned Business

Benefit
 Greater involvement in management
 Lower agency problems and cost
 Focus on long term strategies
 Higher level of ethical behavior due
to reputational risk
 Improved communication and
coordination between shareholders
Problem
 Discrimination against minority shareholders
 High chances of dispute between
major shareholder groups
 Conflict of interest
 Weak corporate governance / NEDs

EXTRA / STRONGER INTERNAL CONTROLS IN A

LISTED COMPANY
 Chairman and CEO roles are split

 NEDs

 Board Committees / Risk committee

 Internal Audit

 Whistle blowing arrangement

Corporate Governance Scope & Approaches

Rule Based Approach Vs Principle Based Approach
Rule Based Approach
Rule based approach focus on clear cut regulations and controls. Full compliance is expected by all
companies at all times without any exception. Any non-compliance is a legal offence and organization will
be prosecuted and punished. This approach is adopted in USA, e.g. Sarbanes Oxley Act.

Principle Based Approach

It’s a framework-based approach setting out guiding principles aiming to create a culture of responsible
and ethical behavior. If the reason for noncompliance is justified, then it may not be deemed as a legal
offence. This approach is taken in UK and other European countries.
 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 and Disadvantage

Rule Based Principle Based

Advantage:
 Clear regulations – no subjectivity
 Standard rules across the board
 Punishment acts a deterrent
 Provides a level playing field for all industries and
companies
 Suited for non knowledgeable shareholders
 Advantage:
 Shareholders decide to what extent compliance
needs to be done
 Flexible / Can be adopted according to industry,
company size and nature of risk
 Able to address exceptional situations
 Lower cost of compliance

Disadvantage: Disadvantage:
 Inflexible  Subjective
 Unable to address exceptional situations  Not suited for non-knowledgeable shareholders
 High cost of compliance  Lack of consistency across industry

Code of Corporate Governance

A Code of Corporate Governance is a document issued by Regulatory Authorities or Stock Exchanges and
covers all matters of corporate governance, including role of the Board, risk management, internal controls,
remunerations, reporting, etc.
The purposes of Codes of Corporate Governance are:
 Specify behavior of corporate governance
 Ensure companies are well run in line with shareholder’s interest
 Boost confidence of investors
 Reduce frauds
 Encourage best practices
 Bring consistency across companies

Governance Codes For Multiple Jurisdictions

Two organisations have published corporate governance codes intended to apply to multiple national
jurisdictions. These organisations are:

 Organization for Economic Cooperation and Development (OECD); and

 International Corporate Governance Network (ICGN)

OECD Principles
OED principles were developed in 1998 and revised in 2004 and grouped into 5 broad areas:

1. Rights of shareholders (voting, electing/removing directors, access to information)

2. Equitable treatment of all shareholders (minority / overseas shareholders)
3. Rights and protection of stakeholders (access to information, protection against fraud)
4. Timely/accurate disclosures of material matters (transparency)
5. Responsibility of the board (i.e. work in best interest of the company, treat all stakeholders fairly, etc)

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)
Common Themes Amongst All Codes
 Shareholders
 Stakeholders
 Directors
 Auditors and Audit Committee
 Disclosures and Transparency
 Risk Management, Ethics & Culture

Objectives of Governance Codes for Multiple Jurisdictions

 Helps in globalization of investments, i.e. cross border investments
 Increases comfort level of investors
 Global consistency

Limitations of Governance Codes for Multiple Jurisdictions

 Represents lowest common denominator
 Regional differences in culture, legal structures, economy, capital / financing structures, openness /
maturity of stock market, insider vs outsider system, development stage of the country, etc.
 Cost of following a global standard may be high.

Practice
Questions
P1 – Jun 2010 Q2: Remuneration Committee | Reward Package (Tomato Bank)
P1 – Dec 2014 Q3: Role of CEO | Benefits of NED | Conflict of Interest (New