Corporate Governance - Introduction PDF

Corporate Governance Introduction Corporate governance and accountability Book by J. Solomon 2020  Learning Outcome By the end of this lecture you should be able to: define corporate governance in a variety of way...

Corporate Governance Introduction Corporate governance and accountability Book by J. Solomon 2020  Learning Outcome By the end of this lecture you should be able to: define corporate governance in a variety of ways explain the different theoretical approaches to corporate governance appreciate why corporate governance is an increasingly important issue for business at a global level Introduce the UK corporate governance codes of practice and policy documents Introduce latest UK Corporate Governance Code main principles and provisions Why are we studying corporate governance?  Why are we studying corporate accountability? UK – Robert Maxwell (1991) UK – Barings Bank (1995) US – Enron (2001) US – Worldcom (2002) UK – Northern Rock (2007) US – Lehman Brothers (2008) US – American International Group (AIG) (2008) US- Silicon Valley What’s the problem? Toxic False Assets Bonuses Accounting Bail- Corporations Fraud outs Loop- Greed holes Deception What’s the problem? ‘The directors of companies, being the managers of other people’s money rather than their own, cannot be expected to watch over it with the same anxious vigilance with which (they) watch over their own.’ (p.6) (Adam Smith, 1776, cited in Tricker, 2012) Why is Corporate Governance Important? Weaknesses in corporate governance can lead to corporate failure (as seen from previous examples) The 2007-09 financial crisis has emphasised the need for good corporate governance Corporate governance can affect corporate financial performance Corporate governance can affect social welfare Company ownership and control Defining Corporate Governance? Due to the evolving and dynamic nature of corporate governance there is no single, accepted definition. The Cadbury Report (1992) defines it as ‘the way in which companies are directed and controlled’ The Walker Review (2009) defines it as ‘to protect and advance the interests of shareholders through setting the strategic direction of a company and appointing and monitoring capable management to achieve this.’ Defining Corporate Governance? Existing definitions fall along a spectrum ranging from narrow (shareholder-oriented) to broad (stakeholder-oriented) Solomon (2013) defines CG as ‘The system of checks and balances, both internal and external to companies, which ensures that companies discharge their accountability to all their stakeholders and act in a socially responsible way in all areas of their business activity’ (p.7). The business case for governance Increased accountability of management and maximising sustainable wealth creation Better financial performance and more attractiveness to the investors Leading to increase in share price and value of the company Socially responsible company is more attractive to customers, therefore increase in revenue Purpose and objectives of corporate governance Basic purpose: monitor those parties within a company which control the resources owned by investors Primary objective: contribute to improved corporate performance and accountability in creating long-term shareholder value Key concepts The foundation to governance is the action of the individual. These actions are guided by a person’s moral stance. Fairness Openness/transparency Independence Probity/honesty Responsibility Accountability Reputation Judgement Activity Fred is a certified accountant. He runs his own accountancy practice from home, where he prepares personal taxation and small business accounts for about 75 clients. Fred believes that he provides a good service and his clients generally seem happy with the work Fred provides. At work, Fred tends to give priority to his business friends that he plays golf with. Charges made to these clients tend to be lower than others – although Fred tends to guess how much each client should be charged as this is quicker than keeping detailed time records. Fred is also careful not to ask too many questions about clients affairs when preparing personal and company taxation returns. His clients are grateful that Fred does not pry too far into their affairs, although the taxation authorities have found some irregularities in some tax returns submitted by Fred. Fortunately the client has always accepted responsibility for the errors and Fred has kindly provided his services free of charge for the next year to assist the client with any financial penalties. Required: Discuss whether the moral stance taken by Fred is appropriate. Overall, it can be argued that Fred is providing a professional service in accordance with the expectations of his clients. However, the moral stance taken by Fred can be queried as follows. The guessing of the amounts to charge clients implies a lack of openness and transparency in invoicing and has the effect of being unfair. Friends may be charged less than other clients for the same amount of work. If other clients were aware of the situation, they would no doubt request similar treatment. The lack of questioning of clients about their affairs appears to be appreciated. However, this can be taken as a lack of probity on the part of Fred – without full disclose of information Fred cannot prepare accurate taxation returns. It is likely that Fred realises this and that some errors will occur. However, Fred does not have to take responsibility for those errors; his clients do instead. While Fred does appear to be acting with integrity in the eyes of his clients, the lack of accuracy in the information provided to the taxation authorities eventually will affect his reputation, especially if more returns are found to be in error. In effect, Fred is not being honest with the authorities. Fred may wish to start ensuring that information provided to the taxation authorities is of an appropriate standard to retain his reputation and ensure that clients do trust the information he is preparing for them. Theoretical Frameworks Agency theory Transaction cost theory Stakeholder theory Agency Theory Relationship between the shareholder (the principal) and the directors (the agents). Directors – maximise personal gains sometimes detrimental to shareholders. Motivating one party (the agents), to act in the best interests of another (the principal) rather than in his own interests. Costly to monitor. Agency costs Agency costs arise largely from principals monitoring activities of agents, and may be viewed in monetary terms, resources consumed or time taken in monitoring. E.g. Incentive schemes and remuniration packages Cost of annual report data such as committee, activty and risk management analysis Cost of meetings with financial analysts Cost of accepting higher risks Cost of monitoring behaviour Residual loss https://youtu.be/7g_d-phoUrU Agency problem resolution measures Meetings between the directors and key institutional investors Voting rights at the AGM in support of or against resolution Accepting takeover Divestment of shares Need for corporate governance If the shareholder activities are not enough to monitor the company then some form of regulation is needed. Codes of conduct and recommendations issued by governments and stock exchanges E.g. the UK Corporate Governance Code (2018) issued by Financial Services Authority (FSA). Stakeholder Theory Began in 1970s developed by Freeman (1984). Hold a ‘stake’ not solely a ‘share’ in companies shareholders employees suppliers customers creditors local communities the environment animal species future generations Stakeholder theory by Freeman https://youtu.be/bIRUaLcvPe8 Stakeholder versus Agency Can companies maximize shareholder wealth AND satisfy a broad range of stakeholder needs? Problems of balancing needs of stakeholders Often different groups have diverse and contradictory needs and concerns Hill, C. and Jones, T. (1992) STAKEHOLDER- AGENCY THEORY, Journal of Management Studies, Vol.29, pp.131–154. Why do Business exists? to earn profit to serve purpose For shareholders For Society (customers, employees,..) The Enlightened Shareholder approach is based on a growing belief that: maximising stakeholder welfare/wealth leads to long- term value maximisation creating value for stakeholders is synonymous with creating financial value for shareholders ignoring the needs of stakeholders can lead to lower financial performance and even corporate failure – LOOK AT BP and the Gulf of Mexico! corporate social, ethical and environmental performance are indicators of management quality Corporate Social Responsibility There is an urgent need for all society to address stakeholder issues: Human rights Treatment of employees treatment of customers Climate change  Companies are pervasive in their impact on society and on the environment They have to be called to account for their actions They have to be accountable to society They have to behave responsibly Things are changing but is the change happening quickly enough?  Corporate Governance is about improving companies’ ACCOUNTABILITY to shareholders and to non-shareholding stakeholders Sustainable, accountable companies are the only means of ensuring a safe global environment for the future The Global Financial Crisis The collapse of banks around the world has been attributed partly to bad corporate governance excessive remuneration encouraging the taking of excessive risks poor understanding of risks by board members Inadequate risk management systems and systems of internal control More causes: Bad boardroom ethics Lack of personal integrity Excessive greed among boardroom members Inadequate risk disclosures Lack of linkage between audit, internal audit, board Who Suffers from Bad Corporate Governance? EVERYONE! People with savings People who hold shares People who have borrowed People who own houses People who pay taxes People who lose their jobs People who are retired University students, lecturers, schools Hospitals and patients Carillion’s collapse The demise of Carillion was the UK's biggest corporate failure in decades, affecting hundreds of thousands of people across the country: More than 3,000 jobs were lost at the company, and the collapse affected 75,000 people working in its supply chain. It failed with debts of £7bn, more than its annual sales of £5.2bn. Some of the biggest failings! UK – Robert Maxwell (1991) UK – Barings Bank (1995) US – Enron (2001) UK – Northern Rock (2007) (Case Study) US – American International Group (AIG) (2008) UK – RBS, HBOS and Lloyds TSB (2009) UK- Thomas Cook (2019) UK-Carillion (2022) US- Silicon Valley There are many more!! 33 The Maxwell Affair 1991 Biggest fraud of the 20th century Maxwell Communication Corporation and Mirror Group Newspapers Stole £727 million from the pension funds of the two public companies, as well as from the companies' assets £1 billion was lost from shareholder value after the public companies crashed 34 Corporate governance problems in this case Lack of segregation of positions of power, Robert Maxwell was both chief executive and chairman of Maxwell Communication Corporation Chairman and chief executive in MacMillan Publishers Non-executive directors did not appear to perform an independent function Audit function did not perform effectively Pension fund trustees failed to examine Maxwell's financial activities in sufficient detail Pension fund regulators failed to investigate and control Maxwell's activities 35 Corporate Governance problems in Enron Unregulated power in the hands of the chief executive Non-executive directors ineffective Poor moral character of directors Lack of understanding of risk and derivatives used 36 Ethics and Corporate Governance Corporate governance is wrapped up with the ethics of individuals. No matter how many mechanisms are in place to ensure that companies are run in an accountable manner, people at the top can act unethically. 37 The Global Financial Crisis What was global financial crisis? https://youtu.be/bx_LWm6_6tA The banking sector worldwide has collapsed due to bad corporate governance and risk management ‘ACCA believes that the credit crunch can therefore be viewed, in large part, as a failure in corporate governance’ (Moxey and Berendt, 2008, p.4) 38 Corporate governance weaknesses contributing to the credit crunch A failure in institutions to appreciate and manage the interconnection between the inherent business risks and remuneration incentives. Remuneration structures/bonuses that encouraged excessive short-termism. This neither supports prudent risk management nor works in the interests of long-term owners. Risk management departments in banks that lacked influence or power. Weaknesses in reporting on risk and financial transactions. A lack of accountability generally within organisations and between them and their owners. 39 Further contributory factors Over-complexity of products and lack of understanding by management of the associated risks Excessive reliance on leverage in banks' business models Inter-connectedness of financial institutions Misalignment between the interests of originators of, and investors in, complex financial products 40  Failure to appreciate cultural and motivational factors, a rigidity of thinking, a lack of desire to change, an attitude of 'it is not my problem', inappropriate vision/drivers and, human greed Lack of training to enable senior management and board members to understand underlying business models and products, leading to poor oversight by senior executives and a lack of rigorous challenge by independent non-executive directors Complacency after a prolonged bull market LACK of BOARDROOM ETHICS 41 The first report on Corporate Governance The Cadbury Report - 1992 Arose out of concern that business was out of control Sir Adrian Cadbury (Cadbury Schweppes) chaired panel 'Revolutionary' agenda involved Direct response, esp. to Maxwell affair Separate roles of chairman and chief executive Raised profile of board and non-executive directors, as opposed to management Enhanced role for audit Statement required under London Stock Exchange listing rules 'Comply or explain' Development of corporate governance in the UK Development of corporate governance in the UK The Greenbury Report 1995 A second report was created in response to public shareholder concerns about directors’ remuneration. British Gas Fat Cats – related to directors paying themselves huge remuneration packages that aren’t deserved! This report was designed to link directors’ salaries and their performance. 45 The Combined Code, revised 2003 Incorporated Higgs and Smith recommendations into the code Higgs approach somewhat watered down Still 'comply or explain’ 2005 Update of Turnbull guidance 2006 Code revisited, allowing independent chairmen to sit on nomination committees 2008 Minor revisions 2009 Walker Review of governance in financial services 2010 Another look at the Combined Code – learning from Walker? UK CGC 2018 Latest edition of UK CGC was issued in 2018 Issued by Financial Reporting Council (FRC) No significant changes since the review in 2010 following the financial crisis of 2008-2009. Review conducted by Sir David Walker. Two principal conclusions were drawn: Much more attention needed to be paid to following the spirit of the code Better dialogue between listed companies and their shareholders UK CGC 2018 Comply or explain Not rules but principles and provisions Reporting to shareholders – how the code is followed? If a particular provision is not followed, clear rational should be provided E.g. some provisions may be less relevant to the new companies; some provisions do not apply to FTSE 350 companies UK Corporate Governance Code 2018 (UK CGC 2018) Section A: Leadership Section B: Effectiveness Section C: Accountability Section D: Remuneration Section E: Relationship with shareholders Section A: Leadership Every company should be headed by an effective board which is responsible for the long-term 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. Nomination committee 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 should be sufficient to attract, retain and motivate directors of the quality required to run the company successfully But should 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 Remuneration committee 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 Board Structure 58 Two-tier Board 59 One-Tier model UK & USA 3 mechanisms for improving corporate governance in boards Splitting chairman/chief executive position Improve effectiveness of NEDs Curb excessive executive remuneration 60 Advantages and disadvantages of two-tier board Advantages Clear separation between governance and management Shareholder involvement Wider stakeholder involvement Independence Direct power over management, e.g. right to appoint the management board Disadvantages Isolation of supervisory board through non-participation in management meetings Added bureaucracy and slower decision making Advantages of unitary board NED expertise Wide view points suggests better decision making Reduction of fraud, malpractice Improved investor confidence 61 Reasons for and against splitting the role 62 Chairman and Chief Executive Chairman Pivotal role in helping the board to achieve its potential Responsible for leading the board, setting the board agenda and ensuring board effectiveness Like a ‘conductor of an orchestra’ Chief Executive Determines corporate strategy Manages day to day running of business 63 Splitting the Role of Chairman and Chief Executive: one-tier boards (Research) According to academic literature, splitting the roles  Can reduce agency problems and result in improved corporate performance because of more independent decision making (Donaldson & Davies, 1994).  Significantly higher financial performance (Peel & O’Donnell, 1995).  However, not enough evidence to prove these points (Daily & Dalton, 1997). 64 NEDs and the Credit Crunch Deficiencies in NEDs role within financial institutions contributed to current global financial crisis FT article during financial crisis said companies need to: improve the qualifications and on-going training for NEDs pay more attention to the relevant experience and competence when recruiting NEDs Increase the time commitment given by NEDs 65 Diversity on board Boardroom diversity could contribute to board effectiveness McKinsey & Company (2007) conclude that companies with a larger proportion of women on boards perform better than those with fewer. Joy et al (2007) found that boards with a higher proportion of women outperform their rival companies. Further research shows positive links between gender diversity and corporate financial performance. However, some studies find no positive relationship. Norway have introduced quotas. 66  The Tyson Report (2003): Widening the 'Gene Pool' NEDs criticized as "Pale, stale and male“ Higgs also suggested NEDs should come from more diverse backgrounds Tyson Report explored greater diversity:  background  skills  experience of members  race  gender  nationality  age The power of diversity by Lord Michael Hastings, Global head of citizenship, KPMG International: https://youtu.be/Hel9oc5so5w 67 Women on Boards Davies Review Annual Report 2015 Women on board report 2015: https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/415454/bis-15-134- women-on-boards-2015-report.pdf Why female representation on the board is necessary? The FRC’s specific issues with the low percentages of women directors are rooted in three concerns about board effectiveness:  that a lack of diversity around the board table may weaken the board by encouraging “group think”;  that such low percentages of women on boards may demonstrate a failure to make full use of the talent pool; and  that boards with no, or very limited, female membership may be weak in terms of connectivity with, or understanding of, customers and workforce and offer little encouragement to aspiration among female employees. 68 Performance evaluation At least once a year, the performance of the board as whole, its committees and its members should be evaluated 69 Main Board Committees Nomination committee Majority non-executives Structure of the board, new executives Remuneration committee 100% non-executive Pay and other benefits of executives Risk committee Majority non-executives Company risk exposure and strategy Audit committee 100% non-executive Controls, internal audit and external audit Note: we will explore the role of nomination committee in this lecture. Remaining committees will be covered later in the course. 70 Nominations committee 71