Corporate Governance Study Text PDF

The Chartered Governance Qualifying Programme Corporate Governance Study text First published 2019 Published by CGI Publishing Limited Saffron House, 6–10 Kirby Street London EC1N 8TS © CGI Publishing Limited, 2021 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form, or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior permission, in writing, from the publisher. Typeset by Paul Barrett Book Production, Cambridge Edited by Benedict O’Hagan Cover designed by Anthony Kearney British Cataloguing in Publication Data A catalogue record for this book is available from the British Library. ISBN 978-1-86072-824-2 As with all legislation, the provisions of the Companies Acts and related legislation are open to interpretation and must be assessed in the context of the particular circumstances at hand, the articles of association of the company in question, and any relevant shareholders’ agreement or other pertinent ancillary agreements. While every effort has been made to ensure the accuracy of the content of this book, neither the author nor the publisher can accept any responsibility for any loss arising to anyone relying on the information contained herein. ii cgi.org.uk Corporate Governance Contents Contents Part One Corporate governance – principles and issues 1 1 Definitions and issues in corporate governance 3 1. Introduction 3 2. The origins of the term corporate governance 3 3. Definitions of corporate governance 4 4. Theories of corporate governance 5 5. Approaches to corporate governance 8 6. Principles of corporate governance 12 7. Reputational management 13 8. The corporate governance framework 14 9. Implementation of a governance framework 18 10. The importance of adopting good corporate governance practices 21 11. Consequences of weak governance practices 22 12. Governance and management 24 2 Corporate governance in the UK 26 1. Introduction 26 2. History of corporate governance in the UK 26 3. UK law and governance 29 4. UK Listing Regime 31 5. UK Corporate Governance Code 2018 32 6. FRC guidance 33 7. Guidance from investors 34 8. QCA Corporate Governance Code 2018 34 9. Corporate governance and unlisted companies 34 3 Role of the company secretary in governance 38 1. Introduction 38 2. The company secretary and corporate governance 38 3. The requirements for a company secretary 39 4. The role of the company secretary 39 5. The company secretary as the ‘conscience of the company’ 45 6. The Company Secretary: Building trust through governance 46 7. Qualifications and skills 47 8. Position in the organisation 49 9. Independence of the company secretary 50 10. Liability of the company secretary 52 11. In-house versus outsourced company secretary 53 iii cgi.org.uk Corporate Governance Contents 4 Other governance issues 55 1. Introduction 55 2. Corporate governance outside the UK 55 3. The US and Sarbanes-Oxley Act 2002 55 4. South Africa and the King Codes 57 5. Corporate governance frameworks in Germany 58 6. Corporate governance frameworks in Japan 59 7. Corporate governance frameworks in China 61 8. Corporate governance frameworks in Scandinavia 61 9. Corporate governance frameworks in the Netherlands 62 10. Governance in other sectors 62 11. Governance for family-controlled companies 64 12. Global principles of corporate governance 65 13. Key issues in corporate governance 66 14. Corporate governance issues in developing and emerging markets 70 Part Two The board of directors and leadership 73 5 Directors’ duties and powers 75 1. Introduction 75 2. Powers of directors 75 3. General duties of directors under the Companies Act 2006 77 4. Duty to act within powers and for proper purposes 79 5. Duty to promote the success of the company 81 6. Duty to exercise independent judgement 83 7. Duty to exercise reasonable skill, care and diligence 84 8. Duty to avoid conflicts of interest 86 9. Duty not to accept benefits from third parties 89 10. Duty to declare interests in transactions 89 11. The Wates Corporate Governance Principles for Large Private Companies 91 12. Who can bring an action for a breach of the general duties 91 13. Fraudulent and wrongful trading 92 14. Directors’ and officers’ insurance 93 6 Role and membership of the board of directors 96 1. Introduction 96 2. Role of the board 96 3. Matters reserved for the board 99 4. Composition of the board 101 5. Role of the chair 103 6. Role of the chief executive officer 106 7. Separation of the roles of chair and chief executive 106 8. Role of other executive directors 109 9. Non-executive directors – role and independence 110 iv cgi.org.uk Corporate Governance Contents 10. Non-executive directors – effectiveness 112 11. Senior independent director 114 12. Board committees and NEDs 115 13. Role of the company secretary 117 7 Board composition and succession planning 120 1. Introduction 120 2. Board size 120 3. Balance of skills, knowledge and experience 124 4. Diversity 126 5. Nomination committee 132 6. Appointments to the board 134 7. Accepting an offer of appointment 135 8. Succession planning 136 9. Refreshing board membership 139 10. Annual re-election 140 11. The Wates Corporate Governance Principles for Large Private Companies 141 8 Board effectiveness 143 1. Introduction 143 2. FRC Guidance on Board Effectiveness 143 3. Regular meetings 144 4. Decision-making processes 144 5. Supply of information 147 6. Board portals, electronic board papers and virtual meetings 150 7. Use of social media by boards 151 8. Corporate culture 151 9. Business ethics 154 10. The role of the company secretary in building an ethical culture 155 11. Independent professional advice 160 12. Performance evaluation 161 13. Induction and professional development 164 Part Three Disclosure, corporate social responsibility and stakeholders 168 9 Financial reporting to shareholders and external audit 170 1. Introduction 170 2. Financial reporting 171 3. Requirements for financial reporting 172 4. Investor confidence in financial reporting 174 5. The role of the board in financial reporting 176 6. Role of the company secretary in financial reporting 176 7. Audit committee requirements 177 8. Role and responsibility of the audit committee 178 9. Meetings of the audit committee 180 v cgi.org.uk Corporate Governance Contents 10. Audit committee relationship with the board 180 11. Audit committee relationship with shareholders 181 12. Audit committee report 181 13. Role of the company secretary in relation to the audit committee 182 14. External auditor 182 15. Role of the external auditor 184 16. Auditor independence 185 17. Non-audit services 187 18. Auditor rotation 188 19. The Report of the Independent Review into the Quality and Effectiveness of Audit 2019 (the Brydon Review) 189 20. Audit and FRC reform 192 21. ‘Restoring trust in audit and corporate governance’ 193 22. Role of the company secretary in relation to the external auditors 195 10 Corporate social responsibility and stakeholders 197 1. Introduction 197 2. Definition of corporate social responsibility 197 3. History of CSR 198 4. The business case for CSR 200 5. Categories of CSR activity 203 6. CSR frameworks 205 7. CSR benchmarking 211 8. Integrated thinking 212 9. Advising the board on being socially responsible 212 10. Engagement with stakeholders 213 11. The Wates Corporate Governance Principles for Large Private Companies 216 12. Impact of Section 172 duty to promote the success of the company on stakeholder engagement 216 13. Role of the governance professional in stakeholder engagement 217 11 Reporting on non-financial issues, including Corporate responsibility 220 1. Introduction 220 2. Non-financial reporting 220 3. CSR reporting and the law 223 4. Drivers for voluntary CSR reporting 225 5. Triple bottom line reporting 226 6. Integrated reporting 227 7. Global Reporting Initiative 230 8. Sustainability Accounting Standards Board 232 9. IIRC integrated reporting framework 232 10. The Corporate Reporting Dialogue 233 11. Climate change reporting 234 12. Moves to single reporting standard 234 13. External assurance 235 14. Environmental Profit & Loss Accounts 235 15. The company secretary’s role in CSR reporting 236 vi cgi.org.uk Corporate Governance Contents Part Four Risk management and internal control 238 12 Systems of risk management and internal control 240 1. Introduction 240 2. Corporate governance, risk and internal controls 240 3. Risk 242 4. Internal controls 245 5. Elements of a risk management and internal control system 246 6. Developing a risk management system 248 7. Benefits of risk management 253 8. The role of the board in risk management and internal control 253 9. Common failures of boards 255 10. Long-term viability statement 258 11. Sustainability 259 12. Advising the board on planning for sustainability 259 13 Risk structures, policies, procedures and compliance 262 1. Introduction 262 2. Structures 262 3. Governance players 267 4. Policies and procedures 270 5. Whistleblowing 272 6. Cybersecurity 275 7. Governance of information 276 8. Disaster recovery plans 277 9. The UK Bribery Act 2010 278 10. Conflict prevention and resolution 280 11. Senior executive remuneration and risk 281 Part Five Shareholder rights, shareholder engagement and directors’ remuneration 283 14 Shareholders’ rights and engagement 285 1. Introduction 285 2. Definitions 285 3. Separation of ownership and control 286 4. Powers and rights 287 5. Common abuses of shareholder rights 290 6. Anonymity of shareholders 297 7. Institutional shareholder responsibilities 297 8. UK Stewardship Code 300 9. Shareholder representative bodies 310 10. Responsible investment versus socially responsible investment 311 vii cgi.org.uk Corporate Governance Contents 15 Board engagement with shareholders 315 1. Introduction 315 2. Shareholder engagement 315 3. Annual general meetings 316 4. Electronic communication 320 16 Remuneration of directors and senior executives 322 1. Introduction 322 2. Remuneration as a corporate governance issue 322 3. Elements of remuneration for executive directors and senior executives 324 4. UK Corporate Governance Code principles and provisions on remuneration 329 5. Remuneration committee 331 6. Wates Principles for private companies on remuneration 335 7. Directors’ remuneration report 335 8. Directors’ remuneration policy 336 9. Annual remuneration report 338 10. Compensation for loss of office and rewards for failure 341 11. Listing Rule provisions on long-term incentive schemes 343 12. Non-executive remuneration 343 13. Other guidance on remuneration 345 Test yourself answers 351 Directory of web resources 394 Glossary 395 viii cgi.org.uk Corporate Governance How to use these study materials How to use these study materials These study materials have been developed to support the Corporate Governance module of the Institute’s Chartered Governance Qualifying Programme and includes a range of navigational, self-testing and illustrative features to help you get the most out of the support materials. The sections below show you how to find your way around the text and make the most of its features. Introductory and reference materials The introductory materials include a full contents list and the aims and learning outcomes of the qualification, as well as a list of acronyms and abbreviations. The reference materials include a range of additional guidance, a glossary of key terms and a directory of web resources. The texts themselves The texts are grouped into five main parts, with each part further divided into chapters, which cover the key topics from this area. Each part opens with an overview of what will be covered, and learning outcomes for the part. Every chapter opens with a list of the topics covered and an introduction specific to that chapter. The study materials are structured to allow students to break the content down into manageable sections for study. Each chapter ends with a summary of key content to reinforce understanding. Features The study materials are enhanced by a range of illustrative and self-testing features to assist understanding and to help you prepare for the examination. You will find answers to the ‘test yourself’ questions in a separate document. Each feature is presented in a standard format, so that you will become familiar with how to use them in your study. These features are identified by a series of icons. The study materials also include tables, figures and other illustrations as relevant. ix cgi.org.uk Corporate Governance How to use these study materials Corporate Governance Chapter 1 | Definitions and issues in corporate governance related party transactions; whistleblowing; disclosure of information; Case studies sexual harassment; insider trading; risk; IT policies; HR including a remuneration policy; gifts, entertainment and gratuities; and Short, illustrative fair competition and business practices. 8.6 Procedures case studies that link Organisations also establish procedures and processes to enable them to utilise the resources available to them to operate their business and implement the policies and strategies they have adopted effectively and efficiently. theory to real-world Examples of procedures and processes are: strategic planning; examples. business continuity; risk management and internal controls; Stop and think computer data and security; managing information; health and safety; ‘Stop and think’ boxes procurement; and recruitment. encourage you to Stop and think 1.1 reflect on how your Does the organisation I work for have or need any of the above policies and procedures? Does my organisation have other policies or procedures not mentioned above? Corporate Governance own experiences or Chapter 1 | Definitions and issues in corporate governance 9. Implementation of a governance framework common business In considering the implementation of the appropriate governance framework for an organisation, the company secretary/ scenarios relate governance professional should also consider: the organisation’s purpose; the assimilation of corporate governance practices; and to the topic under what constitutes success for their organisation? governance laws, regulations, standards and codes adopted globally today. The topics covered by the Cadbury Report included: board effectiveness, the roles of the chair and the non-executive directors, access to independent professional advice, directors’ training, board structures and procedures, the role of the company secretary, directors’ discussion. 9.1 The organisation’s purpose The first thing to consider when implementing a governance framework is the organisation’s purpose. An organisation’s responsibilities, internal financial controls and internal audit. We will see later in this book that each of these topics has, over the years since 1992, been developed further as best practice and thinking on the subject has evolved in response to subsequent events to where we are today. purpose is the reason the organisation is in business, its raison d’être. Sometimes, it is set out in an objects clause in the company’s memorandum of association. If not, the board should ensure that it is defined in the governance documents of the organisation. Knowing the organisation’s purpose is very important as everything stems from it: the organisation’s Case study 1.1 Polly Peck was a UK listed company which was placed into administration in October 1990. Its share price fell 75% from the beginning of August 1990 to 20 September 1990 when its shares were suspended from trading on the London Stock Exchange. The chair and chief executive of 18 cgi.org.uk Polly Peck was Asil Nadir, a charismatic and hard-working businessman. It is argued that the fact that Nadir was chair and CEO of Polly Peck meant that the concentration of too much power in the hands of one individual may have meant that important decisions were not fully discussed by the Corporate Governance Part 1_Ebook.indd 18 04/08/2021 07:48 board of directors. Nadir had acquired 58% of Polly Peck in 1980 at a cost of £270,000. Under his management Polly Peck experienced unprecedented growth, with Nadir’s investment valued at just over £1 billion by 1990. The growth was achieved through diversification into other product lines and expansion internationally, both of which were deemed to be high-risk strategies by market analysts. In August 1990, Nadir – frustrated with Polly Peck’s low price-earnings ratio, i.e. the relationship between its share price and reported profits before dividends (earnings) – announced that he was to bid for the company and take it private. Corporate Governance Five days later he abruptly changed his mind and dropped the plan. This caused the share price to fall substantially. As the company went into administration, it issued a statement stating that Chapter 1 | Definitions and issues in corporate governance a combination of the fall in share price and negative publicity associated with it, had caused the company’s liquidity problems. Nadir had claimed that he could shore up the company with his own personal wealth, which at the time was thought to be about £1 billion. However, it turned out that he and his other companies were in substantial debt. Unfortunately, many of the banks were holding Polly Peck shares as collateral against these loans. Following the collapse, Nadir was charged with theft and false accounting. Nadir was found guilty in 2012 and sentenced to 10 years in prison, he was transferred from his UK prison to Turkey in 2016 and released after one day in prison there. employee relations or limiting environmental impact, should be considered equal to the financial objectives, such as the return on investment, usually associated with maximising shareholder value. Stakeholder theory also states that companies should act as good corporate citizens when making decisions and carrying out their activities, taking into account the impact these will have on society and the environment. Companies 3. Definitions of corporate governance should be accountable to society and should conduct their activities to the benefit of society. This aspect of the There is no one definition of corporate governance. stakeholder theory forms the basis for arguments in favour of corporate social and environmental responsibility discussed in more detail in Chapter 11. In 1984 Bob Tricker stated: ‘If management is about running business, governance is about seeing that it is run properly. All companies need governing as well as managing.’ Since then corporate governance has been defined in many ways. For example: Test yourself 1.1 The Cadbury Committee (1992) defined corporate governance as ‘the system by which companies are directed and 1. What is the main difference between the agency and stakeholder theories? controlled’. 2. How do they affect the objectives of companies? The Organisation for Economic Co-operation and Development (OECD) published its Corporate Governance Principles in 1999 (revised in 2004) and defined corporate governance as involving ‘a set of relationships between 3. How can a company manage conflicts of interest between shareholders and directors and a company’s management, its board, its shareholders and other stakeholders … also provides the structure managers? through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined’. Test yourself 5. Approaches to corporate governance There are four main approaches to corporate governance, the first two of which have as their basis the theoretical frameworks discussed above. These are: 4 cgi.org.uk Short, revision-style shareholder value approach; stakeholder approach; Corporate Governance Part 1_Ebook.indd 4 04/08/2021 07:47 questions to help inclusive stakeholder approach; and enlightened shareholder value approach you recap on key 5.1 Shareholder value approach The shareholder value approach to corporate governance states that the board of directors should govern their company information and core in the best interests of its owners, the shareholders. The main objective is to maximise the wealth of a company’s shareholders through share price growth and dividend payments, while conforming to the rules of society as embedded in laws and customs. The directors should only be accountable to the shareholders, who should have the power to concepts. Answers appoint them and remove them from office if their performance is inadequate. This approach focuses on protecting investors and the value of their shareholding in the company. It was historically adopted in listed companies where there was a separation of ownership and control. However, private companies are now also adopting this approach. are to be found Non-corporates can also adopt an investor value approach to their governance. Investors in not-for-profit and public sector organisations can expect a ‘social impact’ as value for their investment. For example, in developing economies an towards the end of investor in private sector agribusiness will expect value for money from the activities undertaken by the organisations in which they invest. the text. It is argued that a pure shareholder value approach is not sustainable in the long term as companies are not islands and have to interact with different stakeholder groups, the interests of which they will have to consider if they are going to be successful and sustainable in the long run. 5.2 Stakeholder approach The stakeholder or pluralist approach to corporate governance states that companies should have regard to the views of all stakeholders, not just shareholders. This would include the public at large. When taking decisions, boards of companies should try to balance the interests of all the company’s stakeholders. 8 cgi.org.uk Corporate Governance Part 1_Ebook.indd 8 04/08/2021 07:47 x cgi.org.uk Corporate Governance About the authors About the authors Mrs.Alison Dillon Kibirige is a global expert on corporate governance. She is the Founding Director of AMDK Consultancy & Training Services Limited (AMDK), a business she set up in early 2007, which focuses on improving corporate governance practices in all sectors globally. Her work at AMDK has taken her throughout Africa, the Caribbean, the Middle East and Asia working for organisations across all three sectors, Corporate Governance Institutes, Institutes of Directors and other bodies involved in corporate governance. Alison has served as a member of boards, committees and industry working groups since the early 1980s. Alison has worked for the IFC/Global Corporate Governance Forum on projects in Africa, Asia and Eastern Europe. She developed the IFC Corporate Secretaries Toolkit and Handbook and a series of workshops for IFC for Directors of Banks in Nigeria and for SME Governance. She was formerly a member of the ICSA (Institute of Chartered Secretaries and Administrators) UKRIAT Division Committee, the Company Secretary of aBi Trust and aBi Finance Limited, Director of the Leadership Team Uganda Ltd, Chair of ICSA Uganda and a member of the ICSA’s Professional Standards Committee. She is a lawyer and a Fellow of ICSA. Alison was awarded the 2013 ICSA President’s Medal for Meritorious Service, the inaugural ICSA Company Secretary of the Year award in 2005 and has also won awards globally for her work with shareholders. Andrew has worked as a Partner of The Mentor Partnership, a consultancy specialising in company secretarial practice, publishing and training. He writes and lectures widely on company secretarial and legal issues, document retention and document management. Andrew is the author of two books with ICSA, The Law and Practice of Company Meetings and The ICSA Guide to Document Retention. He is also an Editor of the ICSA’s Company Secretarial Practice manual, and its weekly email newsletter. xi cgi.org.uk Corporate Governance Acronyms and abbreviations Acronyms and abbreviations ABI Association of British Insurers ACCA Association of Chartered Certified Accountants AGM Annual General Meeting AIFS Alternative Investment Funds AIM Alternative investment market AoA Articles of Association BCP Business Continuity Plan BEIS Business Energy and Industrial Strategy BHS British Home Stores BIS Bank of International Settlement BITC Business in the Community BREXIT British Exit from the European Union CA2006 Companies Act 2006 CalPERS California Public Employees Retirement System CBI Confederation of British Industry CDSB Climate Disclosure Standards Board CEO Chief Executive Officer CFO Chief Financial Officer CIMA Chartered Institute of Management Accountants CIPD Chartered Institute of Personnel and Development CIPE Centre for International Private Enterprises CIPFA Chartered Institute of Public Finance and Accountancy CMA Capital Markets Authority CNPC China National Petroleum Corporations COSO Committee of Sponsoring Organisations CRO Chief Risk Officers CSR Corporate Social Responsibility CS Company Secretary DTR Disclosure and Transparency Rules DFID Department of International Development DJSI Down Jones Sustainability Indexes DSEP Dove Self-esteem Project DTI Department of Trade and Industry E&Y Earnest & Young EBITDA Earnings before interest, taxation, depreciation and amortisation ECGI European Corporate Governance Institute EcoDA European Confederation of Directors Associations EEA European Economic Area EP&L Environment Profit & Loss Account EPS Earnings per share xii cgi.org.uk Corporate Governance Acronyms and abbreviations EPS Equator Principles ESG Environment, Social and Governance EU MAR European union Market Abuse Regulation EU European Union FCA Financial Conduct Authority FRC Financial Reporting Council FSMA Financial Services and Markets Act 2000 FTSE Financial Times Stock Exchange GAAP Generally Accepted Accounting Principles GBP Great British Pound GP Governance Professional GDPR General Data Protection Regulation GHG Green House Gas GMI Global Measures International GSSB Global Sustainability Standards Board HIV Human immune deficiency virus HR Human Resources HSBC Hong Kong and Shanghai Banking Corporation IA Investment Association IAS International Accounting Standards IBE Institute of Business Ethics ICAEW Chartered Accountants of England and Wales ICGN International Corporate Governance Network ICSA Institute of Chartered Secretaries and Administrators IEA International Energy Agency IFAC International Federation of Accountants IFC International Finance Corporation IFRS International Financial Reporting Standards IIRC International Integrated Reporting Council IMA Investment Management Authority IOD Institute of Directors ISO International Organisation for Standardisation IT Information Technology JSE Johannesburg Stock Exchange KPIs Key performance Indicators LPDT Listing Prospectus and disclosure and Transparency Rules LR Listing Rules LTIPs Long-term incentive plans M&A Mergers & Acquisitions MENA Middle East and North Africa MSC Marine Stewardship Council NAPF National Association of Pension Funds xiii cgi.org.uk Corporate Governance Acronyms and abbreviations NASDQ Nasdaq NCA National Crime Agency NEDS Non-executive Directors NGOs Non-Governmental Organisations NIS Network and Information System NYSE New York Securities Exchange OECD Organisation for Economic Co-operation and Development OES Operations of Essential Services OHSAS Occupational Health and Safety Assessment Specification PBIT Profit before interest and taxes PCA Principle Component Analysis PCAOB Public Company Accounting Oversight Board PDMR Person discharging managerial responsibilities PIE Public Interest Entity PIN Personal Identification Number PIRC Pensions and Investments Research Consultants PLSA Pensions and Life Savings Association PWC Price Water Coopers RCG Remuneration Consultants Group RDS Royal Dutch Shell RDSP Relevant Digital Service Providers RIS Regulatory Information Service ROCE Return on Capital Employed ROSC Reporting on Observations of Standards and Codes SAIL Single alternative inspection location SASB Sustainability Accounting Standards Board SAYE Save as you earn SDGs Sustainable Development Goals SEC Securities and Exchange Commission SID Senior Independent Director SIGMA Sustainability – Integrated Guidelines for Management SMEs Small and Medium Enterprises SOX Sarbanes Oxley Act 2002 SRI Socially Responsible Investment SYSC Senior Management Arrangements, Systems and Controls QCA Quoted Companies Alliance TCFD Task Force on Climate-related Financial Disclosure TIAA-CREF The Teachers Insurance and Annuity Association – College Retirement Equities Fund TSR Total Shareholder Return UBS Union Bank of Switzerland UKLA UK Listing Authority UN United Nations xiv cgi.org.uk Corporate Governance Acronyms and abbreviations VaR Risk at Value VCT Voluntary Counselling and Testing VMF Value for Money VW Volkswagen WWF World Wildlife Fund xv cgi.org.uk Part One Corporate governance – principles and issues Overview Part 1 of this study text examines the nature and scope of corporate governance, its importance to the long- term success of all types of organisations and the role of the company secretary at its heart. Chapter 1 tries to define the term ‘corporate governance’ and looks at the different approaches to, and theoretical frameworks for, corporate governance. It describes the four principles of corporate governance: responsibility, accountability, transparency and fairness. It then looks at the corporate governance framework, discussing the differences between the rules-based and principles-based approaches to corporate governance regulation and the difference between compliance and governance. Finally, it looks at the benefits of good corporate governance to an organisation versus the consequences of poor governance. Chapter 2 looks at how corporate governance has developed in the UK, the laws and regulations that govern it for companies with listings on the London Stock Exchange and for unlisted private companies. Chapter 3 examines the importance of the company secretary to governance within an organisation. It discusses the role of the company secretary in governance and compliance and as an advisor and communicator. It considers the importance of the company secretary having strong interpersonal skills and commercial and business acumen. It looks at why the independence of the company secretary is essential to good governance and how an organisation can take steps to preserve that independence. Finally, the chapter considers the pros and cons of outsourcing the company secretary role and the challenges of combining it with another role in the organisation such as the in-house lawyer. Chapter 4 looks at the international aspects of corporate governance, and how other countries have established their corporate governance frameworks. It examines how governance has been adopted outside of the corporate sector in the public and not-for profit sectors. It also discusses the key corporate governance issues facing companies today. Corporate Governance Learning outcomes Part 1 should enable you to: explain the different approaches to corporate governance that are adopted throughout the world; understand why there are different approaches to corporate governance globally; describe the difference between a rules-based approach to corporate governance and a principles- based approach; distinguish between compliance and governance; demonstrate the importance of the role of the company secretary within the corporate governance framework; explain the importance of applying the principles of corporate governance: responsibility, accountability, transparency and fairness within your organisation for its long-term success and sustainability; appreciate the difference between good and bad governance practices, and the impact they have on the performance and long-term sustainability of the organisation; understand why it is important for boards to consider the impact of decisions on a wider stakeholder group including employees, customers and suppliers — not just on shareholder value differentiate between the role of the board and the role of management, understanding the importance of the board to the organisation; and understand why the governance role of the organisation should be kept separate from that of compliance-based roles, for example that of the in-house lawyer. 2 cgi.org.uk Corporate Governance Chapter 1 | Definitions and issues in corporate governance Chapter 1 Definitions and issues in corporate governance CONTENTS 1. Introduction 2. Origins of the term corporate governance 3. Definitions of corporate governance 4. Theories of corporate governance 5. Approaches to corporate governance 6. Principles of corporate governance 7. Reputational management 8. The corporate governance framework 9. Implementation of a governance framework 10. The importance of adopting good corporate governance practices 11. Consequences of weak governance practices 12. Governance and management 1. Introduction This chapter introduces you to corporate governance, what it is and what it is not, why it is important and the consequences of not practising good governance. It discusses the different approaches to, and theoretical frameworks of, corporate governance and how they have developed over the years. It looks at what makes up a corporate governance framework and how this might be implemented in an organisation. 2. The origins of the term corporate governance English dictionaries define ‘governance’ as the way that organisations or countries are managed at the highest level, and the system for doing this. Bob Tricker first used the term ‘corporate governance’ in an article, ‘Perspectives on corporate governance: Intellectual influences in the exercise of corporate governance’, which was published in a 1983 collection of essays edited by Michael Earl. Tricker had realised in the 1970s that ‘governance’ was different from ‘management’ – a topic which had been written about extensively. The term corporate governance was picked up and used by Sir Adrian Cadbury when he was asked to chair a committee established in May 1991 by the Financial Reporting Council (FRC), the London Stock Exchange, and the accountancy profession due to an increasing lack of investor confidence in the honesty and accountability of listed companies. This followed the sudden financial collapses of two companies, Coloroll and Polly Peck, both of which had apparently healthy published accounts. While the committee was in session, there were two further scandals at the Bank of Credit and Commerce International (BCCI) and the Mirror Group News International. The recommendations from the Committee were published in 1992 in ‘The Report of the Committee on the Financial Aspects of Corporate Governance: The Code of Best Practice’ (the Cadbury Report) and underpin many of the corporate 3 cgi.org.uk Corporate Governance Chapter 1 | Definitions and issues in corporate governance governance laws, regulations, standards and codes adopted globally today. The topics covered by the Cadbury Report included: board effectiveness, the roles of the chair and the non-executive directors, access to independent professional advice, directors’ training, board structures and procedures, the role of the company secretary, directors’ responsibilities, internal financial controls and internal audit. We will see later in this book that each of these topics has, over the years since 1992, been developed further as best practice and thinking on the subject has evolved in response to subsequent events to where we are today. Case study 1.1 Polly Peck was a UK listed company which was placed into administration in October 1990. Its share price fell 75% from the beginning of August 1990 to 20 September 1990 when its shares were suspended from trading on the London Stock Exchange. The chair and chief executive of Polly Peck was Asil Nadir, a charismatic and  hard-working businessman. It is argued that the fact that Nadir was chair and CEO of Polly Peck meant that the concentration of too much power in the hands of one individual may have meant that important decisions were not fully discussed by the board of directors. Nadir had acquired 58% of Polly Peck in 1980 at a cost of £270,000. Under his management Polly Peck experienced unprecedented growth, with Nadir’s investment valued at just over £1 billion by 1990. The growth was achieved through diversification into other product lines and expansion internationally, both of which were deemed to be high-risk strategies by market analysts. In August 1990, Nadir – frustrated with Polly Peck’s low price-earnings ratio, i.e. the relationship between its share price and reported profits before dividends (earnings) – announced that he was to bid for the company and take it private. Five days later he abruptly changed his mind and dropped the plan. This caused the share price to fall substantially. As the company went into administration, it issued a statement stating that a combination of the fall in share price and negative publicity associated with it, had caused the company’s liquidity problems. Nadir had claimed that he could shore up the company with his own personal wealth, which at the time was thought to be about £1 billion. However, it turned out that he and his other companies were in substantial debt. Unfortunately, many of the banks were holding Polly Peck shares as collateral against these loans. Following the collapse, Nadir was charged with theft and false accounting. Nadir was found guilty in 2012 and sentenced to 10 years in prison, he was transferred from his UK prison to Turkey in 2016 and released after one day in prison there. 3. Definitions of corporate governance There is no one definition of corporate governance. In 1984 Bob Tricker stated: ‘If management is about running business, governance is about seeing that it is run properly. All companies need governing as well as managing.’ Since then corporate governance has been defined in many ways. For example: The Cadbury Committee (1992) defined corporate governance as ‘the system by which companies are directed and controlled’. The Organisation for Economic Co-operation and Development (OECD) published its Corporate Governance Principles in 1999 (revised in 2004) and defined corporate governance as involving ‘a set of relationships between a company’s management, its board, its shareholders and other stakeholders … also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined’. 4 cgi.org.uk Corporate Governance Chapter 1 | Definitions and issues in corporate governance In 2004, The New Partnership for African Development (NEPAD) Declaration on Democracy, Political, Economic and Corporate Governance defined corporate governance as being ‘concerned with ethical principles, values and practices that facilitate the balance between economic and social goals and between individual and communal goals. The aim is to align as nearly as possible the interests of individuals, corporations and society within the framework of sound governance and the common good.’ In 2015, the G20/OECD issued a new set of corporate governance principles which stated that corporate governance practices should ‘help build an environment of trust, transparency and accountability necessary for fostering long-term investment, financial stability and business integrity, thereby supporting stronger growth and more inclusive societies’. In 2016, the King IV Report on Corporate Governance for South Africa defined corporate governance as: ‘The exercise of ethical and effective leadership by the governing body towards achievement of the following governance outcomes: – ethical cultures – good performance – effective control – legitimacy The UK Corporate Governance Code 2016 stated that ‘the purpose of corporate governance is to facilitate effective, entrepreneurial and prudent management that can deliver the long-term success of the company’. It refers back to the definition of corporate governance from the Cadbury Report, and states that the 2016 Code is still set within the context of this definition: ‘Corporate governance is therefore about what the board of a company does and how it sets the values of the company. It is to be distinguished from the day to day operational management of the company by full-time executives.’ The 2018 UK Corporate Governance Code expands the definition, recognising that companies do not exist in isolation: ‘To succeed in the long-term, directors and the companies they lead need to build and maintain successful relationships with a wide range of stakeholders.’ Originally referring to the governance in large listed companies, evidence is growing that corporate governance can deliver benefits to other types of organisations of all sizes across all three sectors, public, private and not for profit. As we will see in Chapter 4, codes of best practice have been developed for the public, voluntary and health sectors, for sports bodies, and for academy schools, among others. 4. Theories of corporate governance There are two main theories that form the basis for corporate governance practices. These are the shareholder primacy theory (and related to this, agency theory), which forms the basis of the shareholder value approach to corporate governance, and the stakeholder theory, which forms the basis of the stakeholder approach to corporate governance. These two approaches to corporate governance are discussed later in this chapter. 4.1 Shareholder primacy theory The shareholder primacy theory of corporate governance focuses on maximising the value to shareholders before considering other corporate stakeholders, such as employees, customers, suppliers and society as a whole. It was developed in the 1960s by economists, such as Milton Friedman and Henry Manne, out of the legal arguments propounded by Berle and Means in agency theory. The shareholder primacy theory is based on the premise that shareholders own companies and that directors, managers and employees are engaged by the company for the purpose of maximising shareholder wealth. The contrary view advocated by supporters of the stakeholder approach to corporate governance is that shareholders don’t actually own the company as the company is a separate legal entity in and of itself. Companies, like individuals, are therefore citizens of the countries in which they operate and should therefore comply with societal norms for that country, which includes complying with all laws and regulations and taking into consideration how they impact other citizens and the environment. 5 cgi.org.uk Corporate Governance Chapter 1 | Definitions and issues in corporate governance Since the 2008 global financial crisis, the focus by many companies on shareholder primacy as a governance model has come under criticism for the following reasons: Inappropriate stewardship. It is argued that changes in shareholder structure from direct investment by individual shareholders to wealth invested under management (asset managers, pensions, insurance) has led to what are often referred to as ‘ownerless companies’, where no single investor has a large enough stake in the company to act as the responsible owner, checking the performance and behaviour of the board and management of the company. Even where the asset managers, pensions and insurance companies group together under shareholder representative bodies such as the Investment Management Association and the Pensions and Lifetime Savings Association (formerly National Association of Pension Funds), their focus tends to be on issues such as executive pay and board composition rather than the decision making of the board and management team. Short termism, defined by the Kay Report (2012) as both ‘a tendency to under-investment, whether in physical assets or in intangibles such as product development, employee skills and reputation with customers, and as a hyperactive behaviour by executives whose corporate strategy focuses on restructuring, financial re-engineering or mergers and acquisitions at the expense of developing the fundamental operational capabilities of the business’. A report in 2016 from Tomorrow’s Company, an independent non-profit think tank, found that UK companies were not allocating capital to tackle the major challenges faced by the UK in infrastructure and research and development. Instead companies are choosing to pay out more of their cash to shareholders by way of dividends or share buy- back programmes. Furthermore, there is evidence that there has been a decline in the average holding periods of shares in both the UK and the US from around six years in 1950 to six months in 2010 (Haldane 2010). It is argued that this demonstrates that shareholders are investing in shares more often as a tradable commodity for short-term gain, with investment in the business itself of secondary importance. 4.1.1 Agency theory Agency theory was developed in 1932 by Berle and Means, although it has been argued by Letza, Sun and Kirkbride (2004) that Adam Smith in his book the Wealth of Nations (1772) first pointed out the principal–agent relationship between shareholders and directors when he argued that company directors were not likely to be as careful with other people’s money as their own. Further work to understand how the relationship between agents and principals played out in corporates was carried out by Jensen and Meckling (1976). The agent–principal relationship exists when an agent represents the principal in a particular transaction and is expected to represent the best interests of the principal above their own. Jensen and Meckling argued that the agent–principal relationship existed in companies where there was a separation of ownership and control, the shareholders playing the part of the principal and the directors and managers playing the part of the agent. Where separation of ownership and control in a company exists, the challenges associated with the agent–principal relationship also occur. These relate to conflicts of interest and the costs associated with avoiding/managing those conflicts. Agency conflict Conflict arises in an agent–principal relationship when agents and principals have differing interests. The main conflict between shareholders and managers is as follows: Shareholders usually want to see their income and wealth grow over the long term so will be looking for long-term year-on-year increases in dividends and share prices. Directors and managers, on the other hand, will be looking more short-term to annual increases in their remuneration and bonuses. Jensen and Meckling identified four areas of conflict: Moral hazard. A manager has an interest in receiving beneﬁts from his or her position in the company. These include all the beneﬁts that come from status, such as a company car, use of a company plane, a company house or ﬂat, attendance at sponsored sporting events and so on. Jensen and Meckling suggested that a manager’s incentive to obtain these beneﬁts is higher when they have no shares, or only a few shares, in the company. For example, 6 cgi.org.uk Corporate Governance Chapter 1 | Definitions and issues in corporate governance senior managers may pursue a strategy of growth through acquisitions, in order to gain more power and ‘earn’ higher remuneration, even though takeovers might not be in the best interests of the company and its shareholders. Level of effort. Managers may work less hard than they would if they were the owners of the company. The effect of this lack of effort could be smaller proﬁts and a lower share price. Earnings retention. The remuneration of directors and senior managers is often related to the size of the company (measured by annual sales revenue and value of assets) rather than its proﬁts. This gives managers an incentive to increase the size of the company, rather than to increase the returns to the company’s shareholders. Management are more likely to want to reinvest proﬁts in order to expand the company, rather than pay out the proﬁts as dividends. When this happens, companies might invest in capital investment projects where the expected proﬁtability is quite small, or propose high-priced takeover bids for other companies in order to build a bigger corporate empire. Time horizon. Shareholders are concerned about the long-term ﬁnancial prospects of their company, because the value of their shares depends on expectations for the long-term future. In contrast, managers might only be interested in the short term. This is partly because they might receive annual bonuses based on short-term performance, and partly because they might not expect to be with the company for more than a few years. Agency theory says that companies should use corporate governance practices to avoid or manage these conflicts. Examples of how companies can achieve this are as follows: The use of long-term incentive share award or stock option schemes based on total shareholder return to align the interests of shareholders and management. Adoption of conflict of interest and related party transaction policies. Agency costs Agency costs are the costs associated with maintaining the agent–principal relationship. In companies, these costs are: Bonding costs – the cost of paying directors and executive management. The costs of monitoring the performance of the board and executive management. These will include the cost of general meetings and of the production and distribution of shareholder information such as annual reports and financial statements. It could be argued with the introduction of electronic communications that the cost of the latter has been reduced in recent years. Residual loss relates to the costs to shareholders associated with actions by the directors and executives which in the long run turn out not to be in the interests of the shareholders, for example a major acquisition or disposal, fraud or foray into a new business line. Evidence shows that applying good corporate governance practices helps to minimise both the potential for conflict and the costs associated with the separation of ownership and control in corporates. It is argued that agency theory appears to focus exclusively on maintaining value for the shareholders and this in turn has led to short-termism at the expense of long-term performance as many shareholders are looking for short-term gains. Blair (1995) goes on to argue that ‘what is optimal for shareholders often is not optimal for the rest of society. That is, the corporate policies that generate the most wealth for shareholders may not be policies that generate the greatest total social wealth’. 4.2 Stakeholder theory Stakeholder theory, in direct contrast to shareholder primacy theory, states that the purpose of corporate governance should be to meet the objectives of everyone that has an interest in the company. Individuals and groups that have an interest in a company are known as stakeholders. Key stakeholder groups are investors, employees (often represented by unions), suppliers, customers, government, regulators, creditors, local communities and the general public. When making decisions, boards should balance the interests of these different stakeholder groups, deciding on a case-by-case basis which interests should take priority in a particular circumstance. This means that non-financial objectives, such as 7 cgi.org.uk Corporate Governance Chapter 1 | Definitions and issues in corporate governance employee relations or limiting environmental impact, should be considered equal to the financial objectives, such as the return on investment, usually associated with maximising shareholder value. Stakeholder theory also states that companies should act as good corporate citizens when making decisions and carrying out their activities, taking into account the impact these will have on society and the environment. Companies should be accountable to society and should conduct their activities to the benefit of society. This aspect of the stakeholder theory forms the basis for arguments in favour of corporate social and environmental responsibility discussed in more detail in Chapter 11. Test yourself 1.1 1. What is the main difference between the agency and stakeholder theories? 2. How do they affect the objectives of companies? 3. How can a company manage conflicts of interest between shareholders and directors and managers? 5. Approaches to corporate governance There are four main approaches to corporate governance, the first two of which have as their basis the theoretical frameworks discussed above. These are: shareholder value approach; stakeholder approach; inclusive stakeholder approach; and enlightened shareholder value approach 5.1 Shareholder value approach The shareholder value approach to corporate governance states that the board of directors should govern their company in the best interests of its owners, the shareholders. The main objective is to maximise the wealth of a company’s shareholders through share price growth and dividend payments, while conforming to the rules of society as embedded in laws and customs. The directors should only be accountable to the shareholders, who should have the power to appoint them and remove them from office if their performance is inadequate. This approach focuses on protecting investors and the value of their shareholding in the company. It was historically adopted in listed companies where there was a separation of ownership and control. However, private companies are now also adopting this approach. Non-corporates can also adopt an investor value approach to their governance. Investors in not-for-profit and public sector organisations can expect a ‘social impact’ as value for their investment. For example, in developing economies an investor in private sector agribusiness will expect value for money from the activities undertaken by the organisations in which they invest. It is argued that a pure shareholder value approach is not sustainable in the long term as companies are not islands and have to interact with different stakeholder groups, the interests of which they will have to consider if they are going to be successful and sustainable in the long run. 5.2 Stakeholder approach The stakeholder or pluralist approach to corporate governance states that companies should have regard to the views of all stakeholders, not just shareholders. This would include the public at large. When taking decisions, boards of companies should try to balance the interests of all the company’s stakeholders. 8 cgi.org.uk Corporate Governance Chapter 1 | Definitions and issues in corporate governance The stakeholder approach to corporate governance is predominantly adopted in civil law countries, such as France and Germany, and in Japan and China where companies are often required to take account of the social and financial interests of employees, creditors and consumers in their decision-making. This approach is also reflected in the New Partnership for Africa’s Development’s definition of corporate governance, which states that corporate governance is concerned with achieving a balance between economic and social goals and between individual and communal goals. Opponents of the stakeholder approach argue that if companies were to take into account all stakeholders’ conflicting views, they would never come to a decision. However, there is no direct evidence that one approach is superior to the other in terms of the success of the organisation. 5.3 Inclusive stakeholder approach The South African King Reports, developed by the Institute of Directors in South Africa, introduced a third approach to corporate governance, the inclusive stakeholder approach. This approach differs in its emphasis from the shareholder value and stakeholder approaches in that its supporters believe that the board of directors should consider the legitimate interests and expectations of key stakeholders on the basis that this is in the best interests of the company. The legitimate interests and expectations of key stakeholders should be included in the board’s decision-making process and traded off against each other on a case-by-case basis in the best interests of the company. In the inclusive approach, the shareholder does not have any predetermined precedence over other stakeholders. The best interests of the company are defined by the Institute of Directors for Southern Africa, King Code of Governance for South Africa 2009, King IV, not in terms of maximising shareholder value, but ‘within the parameters of the company as a sustainable enterprise and the company as a corporate citizen’. The inclusive stakeholder approach reflects African needs and culture. It incorporates the concepts of sustainability and ‘good citizenship’ (ethics and corporate social responsibility) into the definition of corporate governance as part of the fight against corruption, poverty and health issues such as TB, malaria and HIV/AIDS. The concepts of ethics and corporate social responsibility are often seen in the shareholder value approach as complementary disciplines. 5.4 Enlightened shareholder value approach The enlightened shareholder value approach proposes that boards, when considering actions to maximise shareholder value, should look to the long term as well as the short term, and consider the views of and impact on other stakeholders in the company, not just shareholders. The views of other stakeholders are, however, only considered in so far as it would be in the interests of shareholders to do so. This differs from the stakeholder and stakeholder inclusive approaches where boards balance the conflicting interests of stakeholders in the best interests of the company. The enlightened shareholder value approach was introduced in the UK by the Companies Act 2006 (CA2006), which imposed a statutory duty on directors to ‘promote the success of the company for the benefit of its members as a whole, and in doing so have regard (among other matters) to: the likely consequences of any decision in the long term; the interests of the company’s employees; the need to foster the company’s business relationships with suppliers, customers and others; the impact of the company’s operations on the community and the environment; the desirability of the company maintaining a reputation for high standards of business conduct; and the need to act fairly as between members of the company. Interestingly, the interests of creditors are not included within this list. CA2006 specifically states that the duty imposed on directors to promote the success of the company overrides any laws or regulations requiring the director to act in the interests of creditors of the company. 9 cgi.org.uk Corporate Governance Chapter 1 | Definitions and issues in corporate governance There are two main challenges in practice with how the enlightened shareholder value approach has been adopted in the UK. Although directors now have a duty to consider the interests of a wider stakeholder group, there is: 1. No provision in CA2006 to enforce the duty. The only stakeholder with enforcement rights within CA2006 are those for members through a derivative action. It could be argued, however, that there is redress for non-shareholder stakeholders through other aspects of law, e.g. employment law, health and safety legislation and environmental law. 2. No guidance as to how directors should take other stakeholder interests into account, particularly conflicting ones. Boards, therefore, in reality still focus on shareholder interests only, perhaps as these are the only enforceable ones. The Companies (Miscellaneous Reporting) Regulations 2018 seek to address these challenges by providing guidance and reporting requirements on how directors are taking into account in their decision making the interests of employees and fostering relationships with customers, suppliers and others. More information on this is provided in Chapter 2. 5.5 Main differences between a shareholder primacy approach and a company/stakeholder focused approach The main differences between a shareholder primacy approach and a company/stakeholder focused approach are set out in Table # below. Table #: Main differences between a shareholder primacy approach and a company/stakeholder focused approach Shareholder Primacy Approach Company (stakeholder focused) Approach Functions of the company Maximise wealth for shareholders Provide goods and services; provide employment; create opportunities for investment; drive innovation Purpose of the company Maximise wealth for shareholders Business purpose set by the particular company’s Board Responsibilities to society None Fulfil business purpose and act as a good corporate citizen Ethical standards Whatever shareholders want or Obey law and follow ethical standards generally obey the law and avoid fraud and accepted by society in which operates collusion Role of shareholders Owners of the company with Owners of shares; suppliers of capital with defined authority over its business rights and responsibilities Nature of shareholders Undifferentiated, self-interested Diverse, with differing objectives, incentives, time wealth maximisers horizons and preferences Role of directors Shareholder’s agents, delegates, Fiduciaries for the company and its shareholders or representatives Role of management Shareholder’s agents Leaders of the organisation; fiduciaries for the company and its shareholders Management’s objective Maximise returns to shareholders Sustain the performance of the company Management’s timeframe Present/near term Established by the board; potentially indefinite, requiring attention to the near, medium and long- term Management performance Single: Returns to shareholders Multiple: among them, company value, achievement metrics of strategic goals, quality of goods and services, employee well-being, returns to shareholders Source: Joseph L. Bower and Lynn S. Paine, The Error at the Heart of Corporate Leadership, Harvard Business Review May-June 2017 10 cgi.org.uk Corporate Governance Chapter 1 | Definitions and issues in corporate governance 5.65 Convergence of approaches to corporate governance Proponents of each of the approaches to corporate governance have traditionally been very protective of their approach, seeing the shareholder value and stakeholder approaches as being diametrically opposed. However, trends today seem to support convergence of the two main approaches to corporate governance: the shareholder value approach and the stakeholder approach. As we saw in Africa, where many countries follow the common law system, ‘in the best interests of the shareholders’ is being redefined as ‘the long-term sustainability of the company’, which appears to resemble more closely the stakeholder approach, rather than being ‘in the best interests of shareholders’. This is not seen as at odds with being in the shareholders’ best interests. This company centred approach was further developed in 2017 by Joseph L Bower and Lynn S. Paine. It recognises that companies are Independent entities in law with the potential for indefinite life. It is the duty of a company’s leadership to sustain it in the long-term and thus make decisions in the best interests of the company not in the interests of one or more stakeholder group. Shareholders should not take primacy over other stakeholder groups as they have no legal duty to protect or serve the companies whose shares they own, they can normally buy and sell shares without restriction, and are protected by the doctrine of limited liability from responsibility for the companies’ debts and misdeeds. They are also often not one cohesive group but have differing interests. They generally invest expecting a shorter-term return on their investment which pressurises management to focus on short or medium -term projects rather than longer-term projects that could be in the better interests of the company’s longer-term sustainability. Companies have power over billions of people’s lives, to transform societies and to impact the environment, they should serve the societies and markets within which they operate over the longer -term. They should, therefore, create value for multiple stakeholders, for instance, employees, customers, and suppliers in addition to its shareholders. Figuring out how to maintain the relationships with key stakeholders and manage the trade-offs between them in the best long-term interests of the company should be the focus of management and not maximising value for shareholders. In civil law countries, pressure is being exerted to give priority to the interests of shareholders. For example, in France, the Marini Report criticised the concept of company interest, since it brought the danger of having management act primarily in its own interests. In Japan, corporate governance principles suggest on the one hand that a balance of various interests must be drawn, but on the other hand that the providers of capital are at the core of corporate governance. Whichever approach to corporate governance is adopted, one of the underlying issues corporate governance attempts to deal with is conflicts of interest (potential or actual) between shareholders, members of the board as a whole, or as individual members and stakeholders. Directors may be tempted to take risks for short-term benefit whereas shareholders and many stakeholders will be looking to the long term. If a company gets into financial difficulty, directors can usually move on to another company with limited or no financial loss, leaving the shareholders and other stakeholders to suffer the fallout and loss. 5.7 Stakeholder capitalism Stakeholder capitalism seeks to create shareholder returns by creating value for society as a whole, i.e. customers, employees, suppliers, communities, and the environment. It is about aligning their interests to grow the pie for the benefit of all – Professor Alex Edmans of the London Business School stated in his 2020 book ‘Grow the Pie’. The view that the most important assets in an organisation are not tangible ie physical but are intangible i.e. access to talent, intellectual property, reputation and the license to operate has been growing. Larry Fink, the Chairman and CEO of Blackrock, the world’s largest asset manager with USD 8.6 trillion in assets under management as of January 2021, in January 2019 sent a letter to the CEO’s of companies in the Blackrock portfolio requesting that they focus on societal purpose alongside their visions, missions and reasons for being in business. This was followed in August 2019 with the US Business Roundtable which includes 200 of America’s most influential business leaders committing to lead their companies for the benefit of all stakeholders. The concept of stakeholder capitalism was introduced globally at the World Economic Forum (WEF) Davos 2020 meeting. According to the WEF, the technological, environmental, geopolitical, and socioeconomic transformations over 11 cgi.org.uk Corporate Governance Chapter 1 | Definitions and issues in corporate governance the last 20 years are driving a re-examination of the traditional models of corporate governance. Governments and companies around the world are realizing the importance of economic, social and governance (ESG) considerations to the long-term financial performance and resilience of organisations. The focus of the 2021 Davos meeting was also Stakeholder Capitalism. Not everyone is on board with stakeholder capitalism. The reason for this is that outside of the US, countries, as we have seen above, have been adopting their own forms of stakeholder governance for many years and these are still preferred as they are embedded in how organisations in those countries do business. There is also an acceptance that you cannot dismantle 50 years of shareholder primacy in a day or a year especially when it appears that companies in capitalist countries are still winning by the old rules. Test yourself 1.2 1. What are the differences between the shareholder primacy and company/stakeholder focused approaches to corporate governance? 2. What is the difference between the enlightened shareholder value and inclusive stakeholder approaches to corporate governance? 3. Which approaches see boards taking a longer-term view in decision-making? 4. Which approaches put shareholders first? 6. Principles of corporate governance Despite there being no agreed definition of corporate governance, there are four agreed principles underlying the development of corporate governance. These principles can be found operating to different degrees in all types of organisations whichever sector they are in: private, public or not-for-profit. These principles are: responsibility; accountability; transparency; and fairness. 6.1 Responsibility This refers to a person or group of people having authority over something, and who are, therefore, liable to be held accountable for the exercise or lack of exercise of that authority. Those given authorities should accept full responsibility for the powers that they have been given and the authority they exercise. They should understand what their responsibilities are, and should carry them out ethically with honesty, probity and integrity. Organisations should ensure that procedures and structures are in place so that people know what they are responsible for and thus liable to account for. This will help people to minimise, or avoid completely, potential conflicts of interest that could arise in the exercise or lack of exercise of their authority. Mismanagement of authority should be penalised, and therefore responsibility goes hand in hand with accountability. 6.2 Accountability This refers to the requirement for a person or group of people in a position of responsibility to account for the exercise (or not) of the authority they have been given. Accountability should be to the person or group of people from whom the authority is derived. 12 cgi.org.uk Corporate Governance Chapter 1 | Definitions and issues in corporate governance Those providing accountability should provide ‘honest’ information and not manipulate facts or ‘spin’ them to their or their organisation’s advantage. Accountability applies to all the different ‘players’ within an organisation, whether they are the owners of the organisation, the governing body, the management or the employees. The challenge is in deciding how the person or group of people should be made accountable, and over what time period. Corporate governance best practice requires an organisation to set out clearly who is accountable for what and over what time period so that an organisation’s stakeholders are clear whom they should hold responsible for what. The sophistication of how this is set out will again depend on the size and complexity of the organisation and can range from a few lines to a large manual as the organisation becomes more complex. 6.3 Transparency This refers to the ease with which an outsider is able to make a meaningful analysis of an organisation and its actions, both financial and non-financial. It also refers to the clarity of process in making decisions and carrying them out. Transparency builds trust between the organisation and its stakeholders: those with whom it interacts or who have an interest in the organisation. Organisations should: be open in all of their actions, relationships, processes and decision-making – this includes tenders, recruitment and disclosures about business performance and risks; and ensure that disclosure is timely and accurate on all material matters, including: the financial situation, performance, ownership and corporate governance. It does not include commercially sensitive information, for example, the Coca- Cola Company would not be required to disclose the recipe for the Coca-Cola drink. Those interested in the organisation need to know about it in order to make informed decisions when dealing with it. Information disclosure needs to be timely to be of benefit to its recipients. It can be delivered through press releases, market releases, annual reports and an organisation’s website. Organisations should have policies in place about the disclosure of information – what information should be public and what information should be kept secret, who has authority to disclose what information and when, and so on. They should also have a policy and process on how information should be kept confidential once it has been classified as confidential information. 6.4 Fairness This refers to the principle that all key stakeholders should be treated fairly when decisions are made or actions taken by the organisation. The organisation should provide effective redress for violations, for example to minority shareholders when they have been unfairly treated. Again, organisations should have policies, structures and procedures in place to ensure that the organisation and the people within consider key stakeholder views with justice and avoidance of bias or vested interests. Fair practices should be applied in an organisation’s dealings with stakeholders. These dealings should also adhere to the spirit, not just the letter, of all rules and regulations that govern the organisation. An example of this would be where an organisation outsources to lower cost suppliers in emerging or developing markets who achieve the lower costs through less favourable working practices such as sweat shops and child labour. The organisation hopes to benefit through higher profits and the senior executives through higher bonuses. 7. Reputational management In addition to the above principles, many corporate governance experts now see reputational management as an important issue within corporate governance. We saw above how in the UK, directors now have as part of their statutory duties under CA2006 ‘the desirability of the company maintaining a reputation for high standards of business conduct’. 13 cgi.org.uk Corporate Governance Chapter 1 | Definitions and issues in corporate governance Reputation defines an organisation as well as the individuals associated with that organisation. A good reputation attracts and motivates employees, customers and investors, and also assists in raising cash. The destruction of a reputation can lead to the end of the organisation. For example, the global accounting firm Arthur Andersen was destroyed in 2002 by the damage of its involvement in the Enron affair in the USA. Organisations must have structures, policies and processes in place to manage reputational risk. Judy Larkin (2002) identified the benefits of effective reputational management, which can be summarised as follows: improving relations with shareholders; creating a more favourable environment for investment and access to capital; recruiting and retaining the best employees; attracting the best business partners, suppliers and customers; reducing barriers to development in new markets; securing premium prices for products and/or services; minimising threats of litigation and of more stringent regulation; reducing the potential for crises; and reinforcing the organisation’s credibility and trust for stakeholders. 8. The corporate governance framework An organisation’s corporate governance framework consists of the following: applicable laws, regulations, standards and codes organisation’s constitution structures policies procedures 8.1 Applicable laws, regulations, standards and codes In developing the framework of laws, regulations, standards and codes of best practice relating to corporate governance countries have adopted three main approaches: rules-based approach principles-based approach hybrid approach Rules-based approach A rules-based approach to corporate governance consists of a mandatory set of laws, regulations, standards and codes. An example is the US, Sarbanes-Oxley Act 2002. Failure to obey in a rules-based system may result in a company suffering sanctions and/or fines. Directors of companies in breach of the rules may also be fined, imprisoned and/or disqualified from holding the position of director for a period of time. Critics of the rules-based approach argue that it only works where: the challenges faced by companies under the purview of the regulation are substantially similar, justifying a common approach to common problems; and the rules and their enforcement efficiently and effectively direct, modify or preclude the behaviours they are aimed at affecting. 14 cgi.org.uk Corporate Governance Chapter 1 | Definitions and issues in corporate governance The benefits of such a system is that it sends a message out to owners, potential investors and other stakeholders that the country takes seriously their protection from nefarious practices by those managing and overseeing the organisations they are investing in or dealing with. In reality, it is the enforcement of the rules that achieves this and in many countries, enforcement is weak. Principles-based approach A principles-based approach to corporate governance comprises a voluntary set of best practices usually contained in a code of best practice. An example of such a code is the UK Corporate Governance Code 2018. These codes of best practice, which were developed originally for listed companies, protect shareholders and potential investors. They are based on the presumption that shareholders will self-regulate the companies within which they invest. The codes being voluntary often adopt a ‘comply or explain’ or ‘apply and explain’ approach, discussed later in the chapter. The principles-based approach allows companies and their shareholders to choose which principles and practices of corporate governance they believe are appropriate for their company at a particular time. The approach recognises the need for flexibility due to the diversity of circumstances and experiences within companies, and the fact that non- compliance may, at that time in a company’s lifecycle, be in the organisation’s best interests. It was also hoped that the approach would restrict the regulatory burden on companies. For the principles-based approach to work, institutional shareholders have to take a more active role in the governance of those companies in which they invest. It is argued that institutional shareholders, such as pension funds, unit trusts and life assurance companies, hold funds on behalf of many individuals and are therefore investing indirectly on behalf of those individuals. They thus have a responsibility on behalf of those individuals to make sure that the boards of directors of the companies in which they invest are made properly accountable and govern their companies responsibly. Many business leaders say a principles-based approach, allowing for discretion based on the circumstances of the company, is far preferable to what is perceived as a rigid rules-based approach. They claim that evidence suggests that long-term economic development is best achieved when business leaders are permitted to exercise judgement. However, the catalogue of business scandals over the last 20 years seems to indicate that some sort of regulation may be needed to ensure that good governance prevails in organisations, and stakeholders and stakeholder interests are protected. Even in the UK, questions are being asked as to whether current market structures, which are very different from those in place in the early 1990s, are still able to regulate listed companies in the way envisaged. The concern is that, with limited resources and time, are UK investors going to be devoting their energies to monitoring the corporate governance performance of UK-listed companies? Evidence has also shown that in addition to time and resource, overseas investors face practical barriers to direct engagement with UK companies. Neither of

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