L5

The Regulatory Framework

Learning Outcomes:
To understand
o legislation, regulation and corporate governance codes
o corporate regulation in the USA
o corporate regulation in the UK
o company codes
o principles or rules based: the governance debate

Boards have to ensure that the company follows Legislation, regulation and CG Codes:
§ Company law
§ Legislations (such as Health and safety, Consumer protection, environmental
standards)

These legislations evolve rapidly.

- UK Bribery Act (2010)
- UK Enterprise and Regulatory reform Act (2013) on Intellectual property
- Regulations on environment and human rights (EU)
- Regulation on taxation, import/export, employee working conditions etc.

Other regulations include:

§ Accounting standards both GAAP and IFRS
§ Stock exchange rules if not followed can result in delisting
§ Corporate Governance codes
- Country
- International
§ Codes by institutional investors
§ Company’s own governance code

 Limited liability companies depend on company law for their existence,

continuity and winding-up
 Companies must follow the company law of the jurisdiction in which they are
incorporated, and the laws of other places where they do business.
 Penalties for failure to obey company law can be heavy on the company, its
directors, and its officers = both fines and/or prison
 Company laws in tax havens can be lax
 In the UK companies can be charged with manslaughter
 Directors are liable if they do not follow regulations – taxation, import-export,
employee working conditions, accounting standards, corporate governance
codes etc.
 Listed companies have to follow stock exchange rules otherwise they can be
delisted.
L5

Corporate Regulation in the UK:

In the UK, Companies incorporated at the national level must follow UK Companies Act
(2006)
 Clarifies under statute law the duties of director and role and
responsibilities towards stakeholders
 Reporting on risk, opportunities, CSR
 Improved shareholder involvement
 Offence for providing misleading material in the audit report

§ The UK Cadbury Report (1992), responding to a series of corporate failures,

produced the world’s first corporate governance code
§ Entitled 'The financial aspects of corporate governance', it was not intended to be a
comprehensive review of the subject
§ The code was discretionary (‘comply or explain’), UK listed companies must report
that they have complied with the code or, if not, explain why

Cadbury Report on financial aspects of CG (1992):

 The wider use of independent non-executive directors
 The introduction of an audit committee of the board having a minimum of three
non-executive directors with a majority of them independent
 The division of responsibilities between the chairman of the board and the chief
executive. If the roles are combined, the board should have a strong independent
element
 The use of a remuneration committee of the board to oversee executive rewards
 The introduction of a nomination committee with independent directors to propose
new board members
 Adherence to a detailed code of best practice

Corporate governance codes:

Subsequently, the UK has published more reports than any other country
1. Cadbury Report (1992)
2. Greenbury Report (1995)
3. Hampel Report (1998)
4. UK Combined Code (1998)
5. Turnbull (1999)
6. Myners (2001)
7. Higgs (2003)
8. Smith (2003)
9. Tyson (2003)
10. Revised UK Combined Code (2003)
11. Davies report (2011)
12. Stewardship Code (2012)
L5

Greenbury Report on
directors’ remuneration
(1995):
- companies’
remuneration
committees should
be comprised
solely of
independent non-
executive
directors
- chairman
UK Combined Code of
(1998): remuneration
- committee
Hampel In 1998–the
report
should
review of
respond
Cadbury, to
Cadburyshareholders’
(1998):
Greenbury
- questions
good corporate and
Hampel at the
proposals
governance needs
AGM
were
broadconsolidated
principles
- annual
into thereports
UK
not
should prescriptive
include
Combined
rules; Code,
Turnbulldetails
Report
which of
was all
(1999): =
- compliance
director rewards
Internal annexed
Controls to
should be the -
& Risk
flexible
Issues naming
Stock each
Exchange
and
- director. relevant
Elaborated onto
listing
each rules
company’s
-- directors’
putting
Thus into place
compliance
individual
contracts
appropriate
became
circumstances, ashould
run for nocontrols.
internal
requirement more for
-- than
and that
internala year to
controls
all
Higgs Report companies
governance
(2003): =
avoid
in excessive
financial,
listed on the
should
Non Executive
golden
operational,not be
Directors
London
reduced
- handshakes.
Besides Stock
to what
compliance
Exchange =
and
the report
reaffirming called a
- Ariskgolden
Although
‘box-ticking’
handshak
managementthe code
- eprevious
is ano
Risk
had clause
assessment
direct in an
exercise
guidelines
Mynersexecutive
(2001)
was & (Pg.
vital this127
Smith
legal
- Report:
That
report standing
the unitary in
(2003) employment
in Barclays contr
2019
terms
board
recommendedof
isreport)
totally
- actThe Myners
that
annual provides
enforcement,
accepted
-- the
That directorinonthe it
Report (2001)
executive
Reporting with
formed
UK.
recruitment part of
aaddressed
significant
internal
the overall
the
controls
- severance
That
should
became thebe
responsibilitiesboard
anpackage is
of
regulatory
accountable to
inrigorous,
institutional
the case
integral
framework
formal
part thatof
for
the
and company’s
transparent
investors
the executive (mutual
the corporate
companies
shareholders.
- their
That executive in loses
the
funds, job
governance pension
UK
-- Share
That
directors
funds,
process. self- should
SWFs).
options =
to
regulation
not hold
Sovereign
be linked to long moreis the
wealth
preferred
thanperformance
funds
term one non-
approach
executive
of firm to
corporate
directorship
- The Smith Report of a
governance.
FTSE 100
(2003)
company
strengthened the
- role
Boards should
of audit
evaluate
committee. theSir
performance
Robert Smith of
L5

Davies Report (2011) on

Board Diversity:
- FTSE 100
companies should
be aiming for a
minimum of 25%
female board
member
- quoted
Corporatecompanies
governance codes:
should
Followingdisclose
the global financial crisis, beginning in 2007, the FRC - Financial Reporting Council
annually
(which took over the
the proportionresponsibility
of from the Stock Exchange Listing Rules) reviewed the UK
CombinedwomenCode, and renamed it the UK Corporate Governance Code (2010)
on the
board, in senior
The main executive
principles are:
§ Section A: Leadership
positions and in
§ Section B:
the whole Effectiveness
§ Section C: Accountability
organisation;
§ - Section D: Remuneration
Hampton-
§ Section E: Relations
Alexander review with Shareholders
(2016-18): FTSE
Section A:350
Leadership
boards to
 Every company
target 33%women should be headed by an effective board which is responsible for the
long-term
by 2020 success of the company
 A clear division of responsibilities between the running of the board and executive
responsibility for running the business
 No one individual should have unfettered powers of decision
 The chairman is responsible for leadership of the board and ensuring its
effectiveness
 Non-executive directors should constructively challenge and help develop
proposals on strategy

Section B: Effectiveness
 The board and its committees should have the appropriate balance of skills,
experience, independence and knowledge of the company
 A formal, rigorous and transparent procedure for the appointment of new
directors
 All directors to allocate sufficient time to the company
 All directors should receive induction on joining the board and should regularly
update and refresh their skills and knowledge
 The board should be supplied in a timely manner with information to enable it to
discharge its duties
 The board should undertake a formal and rigorous annual evaluation of its own
performance and that of its committees and individual directors
L5

Section C: Accountability
 The board should present a balanced and understandable assessment of the
company’s position and prospects
 The board is responsible for determining the nature and extent of the significant
risks it is willing to take
 The board should maintain sound risk management and internal control systems
 The board should establish formal and transparent arrangements for corporate
reporting and risk management and for maintaining an appropriate relationship
with the company’s auditor

Section D: Remuneration
 Levels of remuneration sufficient to attract, retain and motivate directors of the
quality required to run the company successfully
 avoid paying more than is necessary for this purpose
 A significant proportion of executive directors’ remuneration link rewards to
corporate and individual performance
 A formal and transparent policy on executive remuneration and for fixing the
remuneration packages of individual directors
 No director should be involved in deciding his or her own remuneration

Section E: Relations with Shareholders

 There should be a dialogue with shareholders based on the mutual understanding
of objectives
 The board as a whole has responsibility for ensuring that a satisfactory dialogue
with shareholders takes place
 The board should use the AGM to communicate with investors and to encourage
their participation

The Regulators (UK) since 2013: (Who are they)

FRC (Financial Reporting Council) became part of regulatory body in the UK besides:
- PRA (Prudential Reporting Authority) whose objective is to promote the
financial stability of the UK financial system (by ensuring banks hold enough
capital and liquidity to withstand shocks unaided).
- FCA (Financial Conduct Authority) whose objective is to protect consumers,
financial markets and improve competition.

Corporate regulation in the USA:

§ Companies incorporated within state not federally
§ Each state in the United States has its own companies’ law
§ Federal oversight of companies is provided by the Securities and Exchange
Commission (SEC)
§ The SEC’s mission is to protect investors, to maintain fair, orderly, and efficient
markets, and to facilitate capital formation
§ To achieve protection for investors, SEC requires public companies to disclose
information that is then publicly available
§ The SEC oversees securities exchanges, securities brokers and dealers, investment
advisors, and mutual funds
L5

§ The SEC developed an extensive corporate governance regime for companies listed
in the USA
§ Widely believed that US financial regulation was a model for the rest of the world
§ Then in 2001 came the collapse of Enron, WorldCom, Tyco, Waste Management and
the ‘big five’ auditor Arthur Andersen

Sarbanes Oxley Act (2002):

 The response from the US government was the Sarbanes Oxley Act (2002), now
known as SOX
 emphasises that the regulation of corporate governance should be under the law,
not through discretionary codes
 SOX :
- required certification of internal auditing
- increased financial disclosure
- applied criminal and civil penalties on directors for non-compliance

 Created Public Company Oversight Board (PCOB) - oversees public accounting firms
and issues accounting standards
 Listed companies must have audit committee with entirely independent outside
directors
 Management to produce an “internal control report” (financial controls,
operational controls and compliance controls) - the responsibility of management
for establishing and maintaining and assessing effectiveness of an adequate internal
control structure and procedures.
 Independent outside auditors must attest to managers' internal control
assessment, pursuant to SEC rules
 High cost of compliance
 Regulation of auditors
- one year cooling off before employment of audit staff or partner of auditor
- rotate audit partner every 5 years
 Restrictions on non-audit work: management, investment, legal services
 All firm-related work will be audited
 Disclosure of all fees paid to auditor
What is the role of internal audit?
o Internal audit is an independent appraisal activity within an organisation. It acts as a
form of control.
o Its function is to check the functioning and the adequacy of other controls.
o The controls that are checked by internal audit are mainly internal controls, which
are categorised by the Turnbull guidelines into financial controls, operational
controls and compliance controls. Internal controls are part of the system of internal
control.
o Financial controls are controls over accounting procedures, to try to ensure that
accounts and financial statements are „accurate‟, to help to protect the
organisation‟s assets, and to prevent or detect fraud.
o Operational controls are controls within operational systems and procedures to
prevent or detect failures due to operational error, such as human or technical error.
L5

o Compliance controls are controls to ensure that the organisation is complying with
key regulations, such as health and safety regulations.
o There is no statutory requirement for internal audit, but the work of internal audit
can help the directors of a company to monitor and report on the effectiveness of
the company‟s system of internal control.
o Internal auditors may also do other audit checks, such as value for money audits and
special investigations (such as IT audits).
o Internal auditors are often employees, and so report to a senior line manager such as
the Finance Director. However, it is a requirement of good governance that the
internal auditor should have ready access to the Chairman of the board and the
audit committee.
o It would also be relevant to state that internal auditors may be involved in the risk
management assessment process within an organisation.

SEC require US Exchanges to reflect SOX (2003):

- Board must have majority independent outside directors
- Establish corporate governance committee (to develop CG principles and ensure
board and director evaluation)
- Require compensation (remuneration) committee to ensure CEO rewards aligned
with corporate objectives
- Require audit committee to produce and disclose CG guidelines and codes of
business conduct and to review external auditor’s reports on internal controls

Dodd-Frank Wall Street Reform and Consumer Protection Act (2010):

§ The global financial crisis 2007 led to the collapse and bail-out of some major
financial institutions by the US government
§ The Dodd-Frank Wall Street Reform and Consumer Protection Act (2010) enacted to
improve American financial regulation and the governance of the US financial
services industry
- creates a more effective regulatory structure, fills a host of regulatory gaps,
additional funding for the SEC to hire more examiners
- brings greater public transparency and market accountability to the financial
system and
- gives investors important protections and greater input into corporate
governance.
- established a whistle-blower program

Some of the requirements were

- Liquidation fund in case of receivership
- Break up too big to fail banks to avoid systemic risk
- Capital requirements
- Easier for consumers to understand Mortgages, credit card and debit
cards
- Volcker rule – separate investment and retail bank; no involvement in
hedge funds
- Regulate derivatives
- Exchange available for swaps
L5

- SEC office for credit ratings

- Aid whistle-blowers
Changes were made by Trump to ease these rules

Governance debate:
Principles based or rules based approach - a governance debate
Many commentators refer to ‘Anglo-American’ approach to CG
§ unitary board, with both executive and non-executive directors
§ common law jurisdictions
Contrasted with Continental European approach
§ two tier, supervisory board and executive board
§ civil law jurisdictions
But a schism has emerged within the Anglo-Saxon approach
§ In the US, corporate governance now enforced by regulation and the rule of
law. (SOX)
§ In the UK and many other jurisdictions corporate governance is by self-
regulation and voluntary compliance with CG codes

Principles-based approach to governance in UK:

Advantages
 Not so rigid, allows for different circumstances.
 Allows companies to go beyond the minimum required.
 Less of an admin burden.
 Can develop own specific CG and Internal controls (For example physical controls
over cash will be vital to some businesses and less relevant or not applicable to
others).
Disadvantages
 The principles are so broad that they are of very little use as a guide to best
corporate government practice
 It may be difficult for the directors to see whether they have met the specific
requirements of the Code.
VS
Rules based approach followed by the US:
Advantages
 Clarity
 Standardisation
 Penalties are a deterrent against bad CG
 Easier compliance with the rules, as they are unambiguous, and can be evidenced

Disadvantages
 Can create just a "box-ticking" approach
 Not suitable to all possible situations.
 Creates unnecessary administration burden on some companies
 One size does not necessarily fit all.
 Expensive