Chapter 6: Corporate governance approaches

Chapter learning objectives

Upon completion of this chapter you will be able to:

  • describe and compare the essentials of 'rules-' and 'principles-' based approaches to corporate governance, and discuss the meaning of 'comply or explain'
  • describe and analyse the different models of business ownership that influence different governance regimes (e.g. family firms versus joint stock company-based models)
  • explain and explore the Sarbanes-Oxley Act 2002 (SOX) as an example of a rules-based approach to corporate governance
  • describe and explore the objectives, content and limitations of, corporate governance codes intended to apply to multiple national jurisdictions.

1 Rules and principles based approaches to corporate governance

There are different approaches to the communication, management and monitoring of codes.

  • A rules-based approach instils the code into law with appropriate penalties for transgression.
  • A principles-based approach requires the company to adhere to the spirit rather than the letter of the code. The company must either comply with the code or explain why it has not through reports to the appropriate body and its shareholders.

The UK model is a principles-based one, although since adherence is part of stock exchange listing requirements it cannot be considered to be voluntary for large companies.

The US model is enshrined into law by virtue of SOX. It is, therefore, a rules-based approach.

Choice of governance regime

The decision as to which approach to use for a country can be governed by many factors:

  • dominant ownership structure (bank, family or multiple shareholder)
  • legal system and its power/ability
  • government structure and policies
  • state of the economy
  • culture and history
  • levels of capital inflow or investment coming into the country
  • global economic and political climate.

Comply or explain

A principles-based code requires the company to state that it has complied with the requirements of the code or to explain why it could not do so in its annual report. This will leave shareholders to draw their own conclusions regarding the governance of the company.

Illustration 1 – Marks & Spencer

On 10 March 2008, Marks & Spencer announced Board and senior management changes.

The announcement stated that “Lord Burns will stand down as Chairman with effect from 1 June 2008” and that “Sir Stuart Rose is appointed Executive Chairman from the same date”.

This action meant that Sir Stuart Rose would become CEO and chairman and, in allowing one individual to hold both positions, Marks & Spencer would not be in compliance with the UK Corporate Governance Code. Furthermore (and also in contravention of the code), the directors had not fully consulted major shareholders in advance of this announcement.

In their corporate governance statement for the year ended 29 March 2008, Marks & Spencer stated that they had complied with all the provisions of the code with the exception of the two noted above and went on to explain the non compliance. A letter was also written to the shareholders (dated 3 April 2008) explaining in full the reasons for the departure.

Arguments in favour of a rules-based approach (and against a principles-based approach)

Organisation's perspective:

  • Clarity in terms of what the company must do – the rules are a legal requirement, clarity should exist and hence no interpretation is required.
  • Standardisation for all companies – there is no choice as to complying or explaining and this creates a standardised and possibly fairer approach for all businesses.
  • Binding requirements – the criminal nature makes it very clear that the rules must be complied with.

Wider stakeholder perspective:

  • Standardisation across all companies – a level playing field is created.
  • Sanction – the sanction is criminal and therefore a greater deterrent to transgression.
  • Greater confidence in regulatory compliance.

Arguments against a rules-based approach (and in favour of a principles-based approach)

Organisation's perspective:

  • Exploitation of loopholes – the exacting nature of the law lends itself to the seeking of loopholes.
  • Underlying belief – the belief is that you must only play by the rules set. There is no suggestion that you should want to play by the rules (i.e. no 'buy-in' is required).
  • Flexibility is lost – there is no choice in compliance to reflect the nature of the organisation, its size or stage of development.
  • Checklist approach – this can arise as companies seek to comply with all aspects of the rules and start 'box-ticking'.

Wider stakeholder perspective:

  • 'Regulation overload' – the volume of rules and amount of legislation may give rise to increasing costs for businesses and for the regulators.
  • Legal costs - to enact new legislation to close loopholes.
  • Limits – there is no room to improve, or go beyond the minimum level set.
  • 'Box-ticking' rather than compliance – this does not lead to well governed organisations.

Refer to the Examiner's article published in Student Accountant in April 2008 “Rules, principles and Sarbanes-Oxley”.

2 Sarbanes-Oxley (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 a rules-based approach to governance.
  • SOX is extremely detailed and carries the full force of the law.
  • SOX includes requirements for the Securities and Exchange Commission (SEC) to issue certain rules on corporate governance.
  • It is relevant to US companies, directors of subsidiaries of US-listed businesses and auditors who are working on US-listed businesses.

Illustration 2 – Enron

On 2 December 2001, Enron, one of US top 10 companies filed for Chapter 11 bankruptcy protection. The size of the collapse sent shock waves around the world and 'Enronitus' spread through investors and boards of directors shaking confidence in the markets and continued global economic prosperity.

Measures introduced by SOX

Measures introduced by SOX include:

  • All companies with a listing for their shares in the US must provide a signed certificate to the SEC vouching for the accuracy of their financial statements (signed by CEO and chairman).
  • If a company's financial statements are restated due to material non-compliance with accounting rules and standards, the CEO and chief finance officer (CFO) must forfeit bonuses awarded in the previous 12 months.
  • Restrictions are placed on the type of non-audit work that can be performed for a company by its firm of auditors.
  • The senior audit partner working on a client's audit must be changed at least every five years (i.e. audit partner rotation is compulsory).
  • An independent five-man board called the Public Company Oversight Board has been established, with responsibilities for enforcing professional standards in accounting and auditing.
  • Regulations on the disclosure of off-balance sheet transactions have been tightened up.
  • Directors are prohibited from dealing in the shares of their company at 'sensitive times'.

Internal control statement (s404)

Sarbanes-Oxley Act section 404 requires management and the external auditor to publish a statement for external usage that reports on the adequacy of the company's internal control over financial reporting. This is the most costly aspect of the legislation for companies to implement, as documenting and testing important financial manual and automated controls requires enormous effort.

The cost of complying with s404 impacts smaller companies disproportionately, as there is a significant fixed cost involved in completing the assessment.

The requirement is that a company's published annual report should include an internal control report of management that contains:

(1) A statement of management's responsibility for establishing and maintaining adequate internal control over financial reporting for the company. This will include reference to the fact that an effective system of internal control is the responsibility not just of the CFO but the CEO and the senior executive team as a whole.

(2) A statement identifying the framework used by management to conduct the required evaluation of the effectiveness of the company's internal control over financial reporting.

(3) Management's assessment of the effectiveness of the company's internal control over financial reporting as of the end of the company's most recent fiscal year, including a statement as to whether or not the company's internal control over financial reporting is effective. The assessment must include disclosure of any “material weaknesses” in the company's internal control over financial reporting identified by management. Management is not permitted to conclude that the company's internal control over financial reporting is effective if there are one or more material weaknesses in the company's internal control over financial reporting.

(4) A statement that the audit firm that audited the financial statements included in the annual report has issued an attestation report on management's assessment of the company's internal control over financial reporting.

More will be discussed on s404 in the internal controls and audit chapters later in this text.

Key effects of SOX

  • personal liability of directors for mismanagement and criminal punishment
  • improved communication of material issues to shareholders
  • improved investor and public confidence in corporate US
  • improved internal control and external audit of companies
  • greater arm's length relationships between companies and audit firms
  • improved governance through audit committees.

Negative reactions to SOX

  • Doubling of audit fee costs to organisations
  • Onerous documentation and internal control costs
  • Reduced flexibility and responsiveness of companies
  • Reduced risk taking and competitiveness of organisations
  • Limited impact on the ability to stop corporate abuse
  • Legislation defines a legal minimum standard and little more.

Test your understanding 1

The ASD company is based in a jurisdiction which has strong principles of corporate governance. The directors realise that if the rules of governance are broken, then there are financial penalties on them personally. However, the rules that must be followed are clear and the directors follow those rules even though they may not agree with them.

Recently, one director has noted that if one of the reports required under corporate governance is simply placed into the postal system, then it is deemed to have been received by the shareholders. However, with a significant percentage of items being 'lost in the mail' this provides the company with a good excuse for non-receipt of the report – the director even went so far as to suggest privately that the report should not be produced.


(a)Briefly explain the principles - and rules - based approaches to corporate governance.

(b)Contrast the advantages and problems of the system of corporate governance in ASD company's jurisdiction with the alternative approach to governance.

3 Divergent governance

The committees and codes of practice in the UK are implemented through the Financial Services Authority (FSA) and adherence is a requirement of listing on the stock exchange.

Corporate governance also impacts on other types of organisational structure:

  • non-governmental organisations (NGOs)
  • smaller limited companies
  • US companies (see earlier in this chapter - SOX)
  • private or family companies (see later in this chapter)
  • global organisations (see later in this chapter).


Governance issues for NGOs are similar to those raised for public sector organisations since both are not-for-profit (NFP) structures (discussed in chapter 1).

In general, there is a need for increased commercialisation in operations, the need to run the charity as a business for the benefit of all. Reasons for the movement towards a more commercially run operation include:

  • the need to be seen to run resource efficiently by stakeholders
  • the need to get the most out of budgets, gifts, grants in service provision
  • the increased use of directors drawn from the private sector to run NFPs
  • increased awareness and skills among employees in relation to business management techniques.

The shift in terms of increased accountability and performance measure is not without its cost. The culture clash between serving a social need and running a business often leads to a dilution of resolve:

  • Boards are councils or governing bodies.
  • Managers are administrators or organisers.
  • Boards struggle to find a method or function which is not at odds with their association's configuration and philosophy.

Key reasons for this are:

  • dormant or silent patrons
  • the anti-industry bias/culture
  • the discretionary nature of the sector, using volunteers
  • the ambiguity of mission and commercial imperative
  • historical mode of operation/custom and precedence
  • lack of commercial skills in senior management
  • unwillingness of directors to move beyond their parental, devotional view.

Smaller limited companies

There is a duty on all organisations to operate within the law and, for those of any given size, to produce audited accounts. In governance terms, the agency problem does not tend to arise in private limited companies since shareholding is restricted and those with shares tend to have a direct involvement with the running of the firm.

Particular problems arise due to the limited size of such concerns:

  • role and numbers of NEDs
  • size of the board
  • use of audit and nomination committees.

Despite this there is generally a perception that all companies should comply and, like all other companies, in order to foster the key need for improved communication, should either comply or explain through the Business Review.

4 Governance structures

A wider world view of governance requires consideration of the nature of ownership, power and control.

Illustration 3 – Share ownership analysis

La Porta 1999 analysed company structures in 49 countries and found that 24% of large companies have a wide share ownership compared to 35% being family controlled (Walmart, Barclays, Cadbury).

  • Families tend to have control rights in excess of their cash flow rights in terms of preferential share voting rights.
  • Controlling families tend to participate in the management of their firms.
  • Other large shareholders are usually not there to monitor controlling shareholders.

Family structures (as opposed to joint stock)

A family structure exists where a family has a controlling number of shares in a company. This has potential benefits and problems for the company, and the other shareholders involved.

Benefits that arise include:

  • Fewer agency costs – since the family is directly involved in the company there are fewer agency costs.
  • 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.

Problems include:

  • Gene pool – the gene pool of expertise in owner managers must be questionable over generations.
  • Feuds – families fight, and this is an added element of cultural complexity in the business operation.
  • Separation – families separate and this could be costly in terms of buying out shareholding and restructuring.

Insider-dominated structures (as opposed to outsider-dominated)

This is an extension of the same idea. Insider-dominated structures are where the listed companies are dominated by a small group of shareholders. These:

  • may be family owned
  • may be banks, other companies or governments
  • predominate in Japan and Germany.

The close relationship suggests benefits including:

  • fewer agency problems and costs
  • lower cost of capital
  • greater access to capital
  • less likelihood of suffering short-termism
  • greater, stable expert input to managerial decisions.

Problems include:

  • lack of minority shareholder protection (unlike protection in law in outsider-dominated structures)
  • opaque operations and lack of transparency in reporting
  • misuse of power
  • the market does not decide or govern (shareholders cannot exit easily to express discontent).

National differences

The insider/outsider model deals with the issue of national differences. These tend to lie in the nature of the legal system and the degree of recourse investors (minority investors) have.

Little recourse leads to insider dominated structures.

  • Insider orientation: termed the French structure because of its origin.
  • Outsider orientation: Anglo-American structure because of its origin.

The global diffusion of such governance standards tends to be initially led by Anglo-Saxon countries because of the agency problems and similarity between legal systems from the UK origin.

Chapter two described developments in corporate governance regulation in the UK. Similar developments have occurred in other countries. This section considers other international developments, in particular the development of corporate governance guidelines in the Commonwealth and European Union

Corporate governance and the European Union

In May 2003, the EU Commission presented a Communication entitled” Action Plan on Modernising Company Law and Enhancing Corporate Governance in the European Union”. The aim of this report was to put forward recommendations designed to lead to greater harmonisation of the corporate governance framework for EU listed companies in all countries in the EU.

The recommendations in the report included measures such as;

  • An EU directive requiring listed companies to publish an annual statement on corporate governance, including a 'comply or explain' regulation
  • Another directive on collective board responsibilities for the disclosure of certain key financial and non-financial information.

On 5 April 2011, the EU Commission launched a public consultation on possible ways forward to improve existing corporate governance mechanisms. The objective of the Green Paper is to have a broad debate on the issues raised and allow all interested parties to see which areas the Commission has identified as relevant in the field of corporate governance.

However, new EU Directives or amendments to existing Directives will have to be incorporated into the national law of all the member states of the EU.

Corporate governance and the Commonwealth Countries

Concern for the need to establish good corporate governance practice has led to an initiative from the Commonwealth countries, which began with the first King report in 1994.

Many commonwealth countries have emerging economies and some such as South Africa have developing Stick markets. Good corporate governance is seen as essential to the further development of national economies and the growth of the capital markets in those countries.

The work of the first King report lad to the setting up in 1998 of the Commonwealth Association for Corporate Governance (CACG). It produced a set of Corporate Governance guidelines in 1999.

The CACG guidelines put forward a list of fifteen principles of corporate governance. These are fairly similar of the corporate governance guidelines of other organisations it is useful to view them from the 'emerging markets' viewpoint.

Corporate governance in Japan

Some new corporate governance provisions were introduced into the Japanese Commercial Code in 2003, including provisions for US-Style board committees. However not many Japanese listed companies have yet decided to adopt this new system.

5 International convergence

The competitiveness of nations is a preoccupation for all governments.

  • Harmonisation and liberalisation of financial markets mean that foreign companies now find it easy to invest in any marketplace.
  • This has led to a drive towards international standards in business practices to sit alongside the global shift in applying International Accounting Standards (IASs).

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

  • the Organisation for Economic Cooperation and Development (OECD) and
  • the International Corporate Governance Network (ICGN).

Organisation for Economic Cooperation and Development (OECD)

What is it?

  • Established in 1961, the OECD is an international organisation composed of the industrialised market economy countries, as well as some developing countries, and provides a forum in which to establish and co-ordinate policies.

Objectives of the OECD principles

  • The principles represent the first initiative by an intergovernmental organisation to develop the core elements of a good corporate governance regime.
  • The principles are intended to assist OECD and non-OECD governments in their efforts to evaluate and improve the legal, institutional and regulatory framework for corporate governance in their countries, and to provide guidance and suggestions for stock exchanges, investors, corporations, and other parties that have a role in the process of developing good corporate governance.
  • The principles focus on publicly-traded companies, both financial and non-financial. However, to the extent that they are deemed applicable, they might also be a useful tool for improving corporate governance in non-traded companies, e.g. privately-held and state-owned enterprises.
  • The principles represent a common basis that OECD member countries consider essential for the development of good governance practices.
  • The principles are intended to be concise, understandable and accessible to the international community.
  • The principles are not intended to be a substitute for government, semi-government or private sector initiatives to develop more detailed 'best practice' in corporate governance.

The OECD principles were updated and republished in 2004.

Content of the OECD principles:

  • ensuring the basis for an effective corporate governance framework
  • the rights of shareholders and key ownership functions
  • the equitable treatment of shareholders
  • the role of stakeholders in corporate governance
  • disclosure and transparency
  • the responsibilities of the board.

International Corporate Governance Network (ICGN)

What is it?

  • ICGN, founded in 1995 at the instigation of major institutional investors, represents investors, companies, financial intermediaries, academics and other parties interested in the development of global corporate governance practices.

Objectives of the ICGN principles

  • The ICGN principles highlight corporate governance elements that ICGN-investing members take into account when making asset allocations and investment decisions.
  • The ICGN principles mainly focus on the governance of corporations whose securities are traded in the market – but in many instances the principles may also be applicable to private or closely-held companies committed to good governance.
  • The ICGN principles do, however, encourage jurisdictions to address certain broader corporate and regulatory policies in areas which are beyond the authority of a corporation.
  • The ICGN principles are drafted to be compatible with other recognised codes of corporate governance, although in some circumstances, the ICGN principles may be more rigorous.
  • The ICGN believes that improved governance should be the objective of all participants in the corporate governance process, including investors, boards of directors, corporate officers and other stakeholders as well as legislative bodies and regulators. Therefore, the ICGN intends to address these principles to all participants in the governance process.

Content of the ICGN principles:

  • corporate objective – shareholder returns
  • disclosure and transparency
  • audit
  • shareholders' ownership, responsibilities, voting rights and remedies
  • corporate boards
  • corporate remuneration policies
  • corporate citizenship, stakeholder relations and the ethical conduct of business
  • corporate governance implementation.


  • All codes are voluntary and are not legally enforceable unless enshrined in statute by individual countries.
  • Local differences in company ownership models may mean parts of the codes are not applicable.

6 Chapter summary

Test your understanding answers

Test your understanding 1

(a) Rules- and principles-based approaches to corporate governance

A rules-based approach to corporate governance instils the code into law with appropriate penalties for transgression. The code therefore has to be followed, and if it is not followed then the directors are normally liable to a fine, imprisonment or both.

A principle-based approach requires the company to adhere to the spirit rather than the letter of the code. The company must either comply with the code or explain why it has not through reports to the appropriate body and its shareholders. However, in many principles-based jurisdictions, the code has to be followed in order to obtain a listing on the relevant stock exchange. This means that the code is not quite 'voluntary'.

(b) In the example, the ASD company is in a rules based jurisdiction.

Benefits of the rules based approach

There is clarity in terms of what the company and directors must do to comply with the corporate government regulations. In this instance, clarity simply means that the requirements must be followed; there is no option to comply or explain why the requirements have not been followed as there is in a principles-based system.

Even though ASD is a medium-sized company, there is one set of rules to be followed. This has the effect of limiting uncertainty regarding the standard of corporate governance which can be a problem with a principles-based approach (which rules were actually complied with?).

There are criminal sanctions for non-compliance which means that there is a greater likelihood that the regulations will be followed. In a principles-based approach, although there may be the threat of de-listing, there is no penalty on the directors meaning that there can be less incentive to actually follow the code.

Problems with the rules based approach

The fact that the regulations are statutory tends to lead to methods of avoiding the 'letter of the law' – that is loopholes will be found and exploited. A principles-based approach provides the guidelines which can then be applied to any situation, effectively avoiding this problem.

The rules are simply there; agreement with the rules is not required, only compliance. In principles-based systems, there is the underlying belief that the principles are accepted. In other words compliance is more likely simply because companies and directors want to follow them to show good corporate governance.

Companies and directors must follow the rules that have been set – there is no incentive to improve on the basic minimum standard, for example, in terms of providing additional disclosure. A principles-based system allows interpretation of the minimum standards and in effect encourages additional disclosure where necessary as this complies with the 'spirit' of the regulations.

Created at 5/24/2012 12:29 PM  by System Account  (GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London
Last modified at 8/15/2012 11:08 AM  by System Account  (GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London

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