Chapter 2: Development of corporate governance

Chapter learning objectives

Upon completion of this chapter you will be able to:

• describe and critically evaluate the reasons behind the development and use of codes of practice in corporate governance (acknowledging national differences and convergence)
• explain and briefly explore the development of corporate governance codes in principles-based jurisdictions.

1 Influences on corporate governance

Governance theory concludes that there are two major factors affecting organisational operation:

• Agency theory leads to shareholder pressure and shareholder activism.
• Stakeholder theory leads to stakeholder lobbying and concerns over social responsibility.

In addition:

• company law provides a framework within which operations occur
• audit and auditors impact on governance and are covered in depth in internal control and risk sections of the syllabus
• codes of governance are developed by government, operate as a prerequisite to membership of stock exchanges, maybe grounded in legislation, and guide individual professional bodies.

This chapter is about the development of these codes of best practice.

2 Development of corporate governance codes

There is no requirement under the syllabus to be conversant with any particular country's codes of governance, except for that of Sarbanes-Oxley (SOX) from the US. However, the development of such codes is closely associated with the UK and hence this is a good model to use in discussing general, global best practice requirements.

Background: Factors leading to the Cadbury Report

The impetus for the Cadbury Report arose from a number of events including:

• Black Monday, 19 October 1987, when the US stock market lost one quarter of its value in a few hours,
• the subsequent downturn in economies and trust in business,
• the collapse of BCCI in 1991, and
• the UK's own corporate responsibility scandal relating to the Mirror Group and its owner, Robert Maxwell.

3 The UK Corporate Governance Code

The latest edition of the UK Corporate Governance Code was issued in June 2010 by the Financial Reporting Council (FRC) following the financial crisis which came to a head in 2008-2009. This triggered a widespread reappraisal, locally and internationally of the governance systems which might have alleviated it.

In the UK, Sir David Walker was asked to review the governance of Banks and other financial institutions, and the FRC decided to bring forward the code review so that corporate governance in other listed companies could be assessed at the same time.

Two principal conclusions were drawn by the FRC from its review.

• First, that much more attention needed to be paid to following the spirit of the Code as well as its letter.
• Secondly, that the impact of shareholders in monitoring the Code could and should be enhanced by better interaction between the boards of listed companies and their shareholders.

To this end, the FRC has assumed responsibility for a stewardship code that will provide guidance on good practice for investors. However, overall, the FRC agreed that the fundamental principles of the previous Combined Code were sound and 'fit for purpose'

The Main Principles of the Code are divided into five areas

• Section A: Leadership
• Section B: Effectiveness
• Section C: Accountability
• Section D: Remuneration
• Section E: Relations with Shareholders

Each area has a set of principles of good governance followed by a series of provisions that detail how the principle might be achieved.

These will be discussed in more detail in subsequent chapters.

Additional detail: The main principles of the UK Corporate

THE MAIN PRINCIPLES OF THE CODE

Section A: Leadership

• Every company should be headed by an effective board which is collectively responsible for the long-term success of the company.
• There should be a clear division of responsibilities at the head of the company between the running of the board and the executive responsibility for the running of the company's business. No one individual should have unfettered powers of decision.
• The chairman is responsible for leadership of the board and ensuring its effectiveness on all aspects of its role.
• As part of their role as members of a unitary board, 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 to enable them to discharge their respective duties and responsibilities effectively.
• There should be a formal, rigorous and transparent procedure for the appointment of new directors to the board.
• All directors should be able to allocate sufficient time to the company to discharge their responsibilities effectively.
• 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 in a form and of a quality appropriate 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.
• All directors should be submitted for re-election at regular intervals, subject to continued satisfactory performance.

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 in achieving its strategic objectives. The board should maintain sound risk management and internal control systems.
• The board should establish formal and transparent arrangements for considering how they should apply the corporate reporting and risk management and internal control principles and for maintaining an appropriate relationship with the company's auditor.

Section D: Remuneration

• Levels of remuneration should be sufficient to attract, retain and motivate directors of the quality required to run the company successfully, but a company should avoid paying more than is necessary for this purpose. A significant proportion of executive directors' remuneration should be structured so as to link rewards to corporate and individual performance.
• There should be a formal and transparent procedure for developing 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.

4 Governance codes

Reasons for developing a code

• It should reduce instances of fraud and corruption improving shareholder perception and market confidence.
• There is statistical evidence that poor governance equates to poor performance.
• Management consultancy, McKinseys, found that global investors were willing to pay a significant premium for companies that are well governed.
• The existence of good governance is a decision factor for institutional investors.
• Even if it does not add value, it reduces risk and huge potential losses to shareholders.

Practical problems with a governance code

• The process is reactionary rather than proactive, responding to major failures in governance rather than setting the agenda.
• The impact varies depending on the nature of the company and the global viewpoint.
• Directors complain that it restricts or even dilutes individual decision-making power.
• It adds red tape and bureaucracy in the use of committees and disclosure requirements.
• Adherence to governance requirements harms competitiveness and does not add value.
• It cannot stop fraud.

5 Chapter summary

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