WHAT IS CORPORATE GOVERNANCE?

CADBURY REPORT 1992

‘THE SYSTEM BY WHICH COMPANIES ARE

DIRECTED AND CONTROLLED’
 Governance & Management
Governance Function Management

Approval of Plans Planning Preparation of plans

Providing overall Leading Leading those who

leadership implement plans

Arranging Organizing Tasks division &

resources resource usage

Controlling managers Controlling Controlling employees

2
 Governance
 Strategic
 Setting Objectives
 Devising plans to achieve these objectives
 Setting rules or parameters
 Not directly concerned with routine affairs
 Protection of Interests of all stakeholders
 Management
 Current Affairs
 Implementing the Plans
 Developing Suggestions and Alternatives
 Operational Matters

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 AGENCY THEORY
SEPARATION BETWEEN OWNERSHIP AND CONTROL

PRINCIPAL
E.G. SHAREHOLDERS

EMPLOYEES ACCOUNTABLE TO

AGENT
ON BEHALF OF E.G. DIRECTORS

TO PERFORM

TASK
E.G. MANAGING THE
COMPANY
AGENCY THEORY AND CORPORATE
GOVERNANCE
COMPANIES OWNED AND MANAGED BY SAME PEOPLE

EXPANSION REQUIRED INVESTROS(SHAREHOLDERS-LIMITED

LIABILITY)

DELEGATED RUNNING OF COMPANY TO MANAGERS

(AGENTS)

SEPARATION OF GOALS

AGENCY PROBLEMS
 Key concepts of AGENCY
THEORY
• Affect or affected by the policies
STAKEHOLDERS • It may be any person or group

AGENT • High salary

OBJECTIVES • Large bonus and status for a director

PRINCIPAL • Wealth maximisation

OBJECTIVE
 Key concepts of AGENCY
THEORY
• Employed by a principal
AGENT • To carry out a task on their behalf

AGENCY • Relationship between a principal and their agent

AGENCY COSTS • Principal will pay to agent

• Accountable to the principal who hired them.

ACCOUNTABLE

FIDUCIARY • Directors have a responsibility to the shareholders

RESPONSIBILITY • According to company law as ‘operating in the best interests of the
shareholders’.
 The cost of agency relationships
Agency cost
 Incentive schemes and remuneration
 Costs of management providing annual report data such as
I. Committee activity
II. Risk management analysis
III. Cost of principal reviewing this data
 Cost of meetings with financial analysts and principal shareholders
 The cost of accepting higher risks
 Cost of monitoring behavior e.g. management audit procedures
 Person’s MORAL STANCE
Probity/honesty Responsibility Accountability

• Honesty in • Willingness to • Accounting for

financial/positional accept liability for business position as
reporting. the outcome of a result of
• Internal and governance acceptance of
external decisions. responsibility
stakeholders. • Clarity in the • Communication
• A foundation definition of roes channels with
ethical stance in and responsibilities internal and
both principles- for action. external
and rules-based • Know how about stakeholders.
systems. business and • Development and
personal behavior. maintenance of
risk management
and control
systems.
 Person’s MORAL STANCE

Reputation Judgment Integrity

• Developing and • Meaningful • Steadfast adherence

sustaining personal conclusions to a strict moral or
reputation through • The ability to weigh ethical code. High
other moral virtues. numerous issues and moral virtue.
• Developing and give each due • The highest
sustaining the moral consideration standards of
stance of the • The skill with which professionalism and
organization. management make probity.
• Moral stance of the decisions which will • A prerequisite within
accounting improve the agency relationships.
profession. wealth/prosperity of
the organization
 STAKEHOLDER THEORY
employees MANAGEMENT
customers

shareholders
suppliers

Future generations
STAKEHOLDERS
Creditors

Animal species
Community

General
Environment public/world
society Government
mendelow model of
stakeholder management

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 Advantages of Stakeholder Analysis
• Get to know stakeholders better:
– Relative importance, power and interests
– Better managed relationships
– Risks identified
• Make better strategies and decisions
 Disadvantages of Stakeholder Analysis
• Best done on continuous basis. Gets outdated
quickly
• hard to categorize stakeholders in real life
situations
– Focus on most important stakeholder
– Stakeholders can work together and form
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pressure groups
 Codes of conduct

 The Combined Code for Corporate

Governance adopted by the Financial
Services Authority (FSA) in the UK.
 OECD code on ethics. (organization
for economic cooperation and
development)
 Sarbanes Oxley act. (U.S)
 Code of Corporate Governance 2012
Amended July 2014 (Pakistan)
institutional shareholder

A type of shareholder is the

institutional shareholder. This is
an organisation, rather than an
individual, and accordingly, the
number of shares held is usually
much higher than individual
‘private’ shareholders hold.
 They include pension funds,
insurance companies, and
investment trusts.
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 institutional shareholder
 In recent years, institutional shareholders
have become much more active for the
following reasons:
 Corporate governance regulations has
encouraged them to use their votes wisely.
 Many institutional investors have seen that
improved governance leads to increased
share prices.
 Those whose funds they are investing are
putting more pressure on them to act.
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 When should institutional shareholders
intervene?
 the company’s performance is consistently poor;
 the company is engaged in unethical practices or has
a poor reputation;
 there is excessive risk taking or perhaps not enough
risk taking;
 there is a breakdown of communication between
directors and shareholders;
 there is consistent fail in the company’s systems or
repeated fraud.
 The NEDs are ineffective
 There are inappropriate remuneration policies
17

 Law and regulations are not being followed

Non-executive
directors(NED)
 areengaged part time by the
organisation, bring relevant
independent, external input and scrutiny
to the board, and typically occupy
positions in the committee structure.
 Theboard should consist of a balance of
executive and non-executive directors
and should be of sufficient size that
there is a balance of skills and
experience in order to effectively
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manage the company.

Roles of NEDs
 Strategy: as part of the board, they assist with
determining the strategy of the company.
It is likely that this is led by the
executive directors but NEDs are
involved in this process by challenging
strategy and questioning other options
before the strategy is implemented.
 Performance: NEDs should scrutinize the
performance of the executive directors
in meeting goals and objectives. The
NEDS lead the process of replacing and
recruiting directors through the
nomination committee. 19
Roles of NEDs
 Risk:NEDs should satisfy themselves that
the financial information is accurate and
the financial controls and risk
management systems are effective. They
play a role in ensuring that the
company’s systems of financial reporting,
internal control and risk management are
operating satisfactorily through the audit
committee.
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Roles of NEDs
 People role:
 a) Directors and managers: NEDS are
responsible for determining appropriate
levels of remuneration for executives
and are key figures in appointment and
removal of senior managers and
succession planning
 b) Shareholders: should take
responsibility for shareholders concerns
and attend regular meetings with
shareholders.
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 Independence of NEDS
 • should not have been an employee within the last 5
22
years.
 They should not have had any business relationships
with the company in the last three years.
 They should not have any family members in senior
positions at the company.
 Any NED who has been on a board for more than nine
years is assumed to no longer be independent.
(Directors’ appointments are voted on by shareholders
on a three-yearly cycle, so nine years is relevant as it
gives three terms as a director).
 NEDs are only remunerated with a fee for director
duties – no profit share or share options.
 They cannot hold cross-directorships This term is used
to explain a potential relationship between the
executive directors of two companies.
NEDs with experience from
the same industry -
 higher technical knowledge of
issues in that industry
 a network of contacts
 an awareness of what the
strategic issues are within the
industry
 might reduce the NED’s ability to
be objective
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NEDs with experience from a
different industry
 a fresh pair of eyes to a given problem
-

 a lack of previous material business

relationships will usually mean that a
NED will not have any previous alliances
or prejudices that will affect his or her
independence
 they will be lesser biased towards
people, policies and practices in that
industry
 Less knowledge of that sector

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Disadvantages of NEDS
 High caliber NEDs may go to best run companies
rather than the ones which are in more need of
input from good NEDs
 As they do not work full time for the company,
they may only spend limited time there. It is
debatable how much they actually know about the
company and how much they can add value.
 They can damage company performance by
weakening board unity, stifling entrepreneurship
and concentrating on matters other than
maximization of financial performance.
 Having additional directors increases the size of
the board of directors as at least half of the board
must be independent non executives. This
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Chairman’s responsibilities

With regard to protecting shareholders’

interest
 The chairman represents the company to
investors and other outside
stakeholders/constituents.
 communication with shareholders. This
occurs in a statutory sense in the annual
report (where, in many jurisdictions, the
chairman must write to shareholders each
year in the form of a chairman’s statement)
and at annual and extraordinary general
meetings. 26
With regards to BOD’s
effectiveness
 ensure there is a balance in the board (
between the number of EDs and NEDs
excluding the Chairman and in the skills
of the board)
 ensurethe existence and effective
composition of the four sub-committees
 facilitating
good relationships between
executive and non-executive directors
 Lead in board development
27

 Facilitating board appraisal

 With regards to BOD’s
communication
 setting the board’s agenda and ensuring that
board meetings take place on a regular
basis.
 Internally, the chairman ensures that
directors receive relevant information in
advance of board meetings so that all
discussions and decisions are made by
directors fully apprised of the situation
under discussion
 Ensure no dominant individual dominates the
discussions. 28
 CEO's responsibilities
 29To
develop and implement policies and strategies
capable of delivering superior shareholder value and
to assume full responsibility for all aspects of the
company’s operations
 implement the decisions of the board. This means
that the various divisions and/or departments in the
organisation must work out the strategies agreed,
and the CEO must configure and co-ordinate the
business to achieve these.
 Manage the financial and physical resources of the
company
 Monitor results: the CEO has to analyse the
performance of all parts of the business in terms of
each one’s contribution to strategy and its fit with
the rest of the organisational structure
 CEO's responsibilities
 –Ensure that effective operational and risk
controls are in place
 Overseeing the management team, co-
ordinating the interface between the board
and the other employees in the company
 Relate to a range of external parties
including the company’s shareholders,
suppliers, customers and state authorities

30
Reasons for splitting the role
 'A clear division of responsibilities must exist at the
head of the company. No individual should have
unfettered power of decision.'
 Representation: the chairman is clearly and solely a
representative of shareholders with no conflict of
interest having a role as a manager within the firm.
 The chairman provides a channel for the concerns of
non-executive directors
 The chief executive can fully concentrate on the
management of the organisation without the
necessity to report to shareholders

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Reasons against splitting the
role
 Unity: the separation of the role creates
two leaders rather than the unity
provided by a single leader.
 Ability: both roles require an intricate
knowledge of the company. It is far
easier to have a single leader with this
ability rather than search for two such
individuals.
 Human nature: there will almost
inevitably be conflict between two high
powered executive offices.
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NOMINATION COMMITTEE-ROLES
 All members must be NEDS
 Oversees board appointments to maintain a
balance in the board.
 Establishes desirable size of the
board(bearing in mind the current and
planned size and complexity of the
operations
 It needs to consider a balance between
executives and independent NEDs
 skills, knowledge and expertise of the
current board
 It considers the need to attract board
members from diverse backgrounds
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(diversity in the board)

NOMINATION COMMITTEE-
ROLES
 Succession planning: It acts to meet the
needs for continuity and succession
planning, especially among the most senior
members of the board.
 CEO succession: The search for a potential
replacement CEO begins immediately after
a new CEO is appointed!)
 Arranges induction training of all directors
 Arranges CPD activities for all directors
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OUTSIDER SYSTEM
 An outsider system is one where those that
own the company are separate from those
that run the company.
 There is a clear gap between those who
run the company and those who own it,
hence the agency problem.
 They have more formal organizational and
reporting structures and systems for
accountability to external shareholders.
 generally, larger companies (public
companies in particular) are more highly
regulated and have more stakeholders to
manage than privately owned, smaller
35

family businesses.
INSIDER SYSTEM
 Aninsider system is one where there are
strong links between those that run the
company and major stakeholders.
 The major shareholders may also feature
on the board, for example bankers or
institutional shareholders employees may
have representatives on the board.
 Familydominated companies often
have a similar structure with family
members sitting on the board.
36
Family dominated companies pros:
 lower agency costs associated with insider-dominated
businesses because fewer agency trust issues. Less
monitoring is usually necessary because the owners are
often also the managers
 Ethics – it could be said that threats to reputation are
threats to family honour and this increases the likely
level of ethical behaviour.
 Fewer short-term decisions – the longevity of the
company and the wealth already inherent in such
families suggest long-term growth is a bigger issue.
 Decision making may be quicker as there are relatively
lesser number of people and they are likely to have the
same mindset 37
 Cons
 Minority shareholders and non-included
stakeholders may lack protection from the
dominant insiders as they have little
representation within the company.
 There is a potential lack of transparency as
information is kept inside the company.
 There are relatively lesser formal governance
structure, systems, policies and procedures.
 ‘Gene pool’ and succession issues are
common issues in family businesses.
 ‘Feuds’ and conflict resolution can be major
governance issues in an insider-dominated
38

business.
REMUNERATION COMMITTEE-ROLES

 1. Determines remunerations policy on

behalf of the board and the
shareholders(pay scales applied to
directors’ packages, the proportions of
different types of reward within the
overall package and the periods in which
performance related elements become
payable)
 2. Makes individual director’s packages
(ensure fair but not excessive-Contents
of the package have been discussed
39

separately later)
REMUNERATION COMMITTEE-ROLES
 3. It reports to the shareholders on the outcomes
of their decisions, usually in the corporate
governance section of the annual report (usually
called Report of the Remunerations Committee).
This report, which is auditor reviewed, contains a
breakdown of each director’s remuneration and a
commentary on policies applied to executive and
nonexecutive remuneration.
 4. They may also be asked to make severance
packages.
 5. Where appropriate and required by statute or
voluntary code, the committee is required to be
seen to be compliant with relevant laws or codes
40

of best practice.
Components of an ED’s remuneration package
 Basic salary: When setting a director’s salary, the
remuneration committee should consider hi past
experience, performance and responsibilities. It
should not be related to performance of company.
Another aspect to consider is what others
companies are willing to pay ( Market rate)
 Performance-related elements: Bonuses are often
given for increased profits, increased market
share, increased sales, reduced costs, increased
margins and so on. However, bonuses could also be
given for non-financial measures, for example,
reducing employee turnover or better customer
service or environmental targets such as reducing
pollution. This may avoid the focus on inflating
short-term profits. 41
Components of an ED’s remuneration package
Share options :Share options are contracts that allow the
executive to buy shares at a fixed price or exercise price. -
If the stock rises above this price the executive can sell the
shares at a profit. – they give the executive the incentive to
manage the firm in such a way that share prices increase,
therefore share options are believed to align the managers'
goals with those of the shareholders.
Benefits in kind: transport, health provisions, holidays,
loans
Retirement benefits: The Combined Code suggests that
only a director’s basic salary is pensionable.
A retirement benefit such as lifetime use of the company
plane/car or a sizeable pension payout could be awarded.
The company makes payments into directors’ pension
schemes so on retirement the director will have an income
42
Should corporate governance provisions
vary by country?
YES
 Some countries have more insider structures than
outside because of which accountability relationship is
different
 Developing countries may not want incur compliance
and monitoring costs
 Developing countries might not have enough skilled
people and formal systems
 Some governments may have more flexible governance
to attract international companies and hence improve
their economic climate ( when SOX was enforced in the
USA, some companies delisted from the NYSE and got
themselves listed on the London stock exchange)
43
Should corporate
governance provisions vary
by country? NO
 Regardless of the culture, standardized
corporate governance provisions will
ensure that minority interest is protected
 Countries with poor reputation in terms
of corruption and fraud need a strict
standardized governance structure
 Investor confidence is greater in
countries where good governance
structures are followed.
44
 Rules based approach
 In a rules-based approach to corporate governance,
provisions are made in law and a breach of any
applicable provision is therefore a legal offence. This
means that companies become legally accountable
for compliance and are liable for prosecution in law
for failing to comply with the detail of a corporate
governance code or other provision.
 It is the judiciary rather than investors which
monitors and punishes transgression
 In a rules-based approach such as Sarbanes-Oxley
,the legal enforceability of the Act requires total
compliance in all details. This places a substantial
compliance cost upon affected companies .45


 Principles based approach
 principles-based approach works by (usually) a stock
market making compliance with a detailed code a
condition of listing.
 If a company is unable to comply in detail with every
provision of a code, the listing rules state that the
company must explain, usually in its annual report,
exactly where it fails to comply and the reason why it is
unable to comply. The shareholders, and not the law,
then judge for themselves the seriousness of the breach.

 If the shareholders are not satisfied with the explanation

for lack of compliance, they can punish the board by
several means including holding them directly
accountable at general meetings, by selling shares
(thereby reducing the value of the company) or by direct
46

intervention if a large enough shareholder.

Against principles based For principles based
Some companies may present weak or Flexibility:. A principles-based
untrue explanations justifying their approach is flexible and allows
actions. companies to develop their own
approach, perhaps with regard to the
demands of their own industry or
shareholder preferences. e.g, why
companies in lower risk industries
should be constrained by the same
internal control reporting
requirements as companies in higher
risk industries.
Without the law to back it up, It enables the policing of compliance
corporate governance becomes harder by those who own the entity and have
to enforce. a stronger vested interest in
compliance

There may be confusion over what is By requiring explanations of non-

compulsory under law and what is
principles-driven under listing rules.
compliance, companies are required
to think carefully about
47 their reasons
for not complying and this may make
them decide to follow the code after
Against rules based For rules based

Rigidity of law-companies will try to Clarity in terms of what you must do

look for loopholes.

Compliance is seen to be an inflexible Standardization for all companies

‘box ticking’ exercise and this can If the law is good then it will give
sometimes mean that companies lose shareholders assurance that a
perspective of what are the most company is being run effectively
important aspects of governance

substantial proportion of this cost Minimizes chances of going against

adds very little value to the rule as non-compliance results in
shareholders, especially in small penalties.
companies, and resources are
diverted to demonstrating minor
areas of compliance which could be
used more effectively elsewhere (such
as in company operations) 48
Sarbanes Oxley Act(SOX)

 In 2002, following a number of corporate

governance scandals such as Enron and
WorldCom, tough new corporate
governance regulations were introduced
in the US by SOX.
 SOX is extremely detailed and carries the
full force of the law.
 It includes requirements for the
Securities and Exchange Commission
(SEC) to issue certain rules on corporate
governance. 49
 Key points of SOX
 SOX requires the Chief Executive Officer and Chief
Financial Officer to personally attest to the accuracy
of the annual report, quarterly reports, and to the
effectiveness of internal control systems. If
subsequently it is discovered that the accounts are
not accurate and have to be restated, any bonuses
paid to those directors have to be repaid.
 SOX has very detailed requirements on internal
control. Companies must have a sound system of
internal control and they must also have suitable
documentation in place to provide evidence that the
system is working.
 The auditors have to provide a report to say they
have checked the internal control systems over
financial reporting and give their opinion as to
whether they are working or not 50
Key points of SOX
 SOX has a ban on auditors providing a range of
other services to their audit clients.
 Under SOX, no loans can be made by a public
company to its directors or other senior
executives.
 In SOX there is greater protection of
whistleblowers. A whistleblower is someone who
reports bad practice
 This was the case in Enron and WorldCom.
(Sherron Watkins)
 Must have an audit committee
 Complete disclosure of off-balance sheet
transactions.
 SOX makes audit partner rotation the law (after 7
51

years)
 Transaction cost theory
 A theory accounting for the actual cost of outsourcing
production of products or services including transaction costs,
contracting costs, coordination costs, and search costs. The
inclusion of all costs are considered when making a decision
and not just the market prices.
 It is in the interests of management to internalize
transactions as much as possible, to remove these costs and
the resulting risks and uncertainties about prices and quality.
 Transaction costs can be further impacted by the following:
 Bounded rationality: our limited capacity to understand
business situations, which limits the factors we consider in the
decision.

52
 Transaction cost theory
 Opportunism: actions taken in an individual's
best interests, which can create uncertainty in
dealings and mistrust between parties.
 The significance and impact of these criteria will
allow the company to decide whether to expand
internally (possibly through vertical integration)
or deal with external parties.
 Managers become more risk averse seeking the
safe ground of easily governed markets.
 Transaction cost theory and agency theory
essentially deal with the same issues and
problems. Where agency theory focuses on the
individual agent, transaction cost theory focuses
53

on the individual transaction.

Example
 To illustrate, suppose Bob purchases
100 shares of XYZ stock from his broker, Jack.
He pays $200 for the shares at $2 per share.
Jack originally purchased the shares for a total
of $180, incurring a $20 spread charged to Bob.
In addition, Jack charges a base $20 brokerage
commission. Bob pays Jack a total of $220 even
though the actual cost of the shares was $180.
 For investors with a finite amount of money to
spend on investment activities, transaction
costs need to be carefully considered since
they diminish the number of securities that
may be purchased.
54