1 - Definitions and issues in CG Flashcards
UKCG Code - purpose of CG (previous definition)
To facilitate effective, entrepreneurial and prudent management that can deliver the long-term success of the company
Cadbury Committee definition of CG
The system by which companies are directed and controlled
2 key theories to CG
- Shareholder primacy theory (shareholder value approach / agency theory)
- Stakeholder theory (stakeholder approach)
Focus of shareholder primacy theory to CG
Maximising value to shareholders before considering other corporate stakeholders
Opinion of shareholder primacy view of those opposing theory
Shareholders don’t actually own the company as it is a separate legal entity in itself - it should therefore comply with societal norms of its country, such as considering impact on other citizens and the environment
2 reasons why shareholder primacy governance has come under increased criticism from 2008 global financial crisis
- Inappropriate stewardship
- Short termism
Briefly, what is meant by inappropriate stewardship
No shareholders taking responsibility for checking performance and behaviour of board and management
Briefly, what is meant by short termism
Not enough focus on developing fundamental operational capabilities of the business, or allocating capital to tackle major challenges faced by UK such as infrastructure, research and development
When does the principal-agent relationship exist?
Agent represents the principal in a particular transaction and is expected to represent the best interests of the principal above their own
Which relationship underpins agency theory?
Principal-agent relationship
What is the key conflict in principal-agent relationship? ‘Agency conflict’
Shareholders usually want to see income and wealth grow over the long term, while directors and managers will be looking for more short-term increases in their remuneration and bonuses
4 areas of agency conflict identified by Jensen and Meckling
- Moral hazard - managers have interest in receiving remuneration, and this is more so the case if they have no or few shares
- Level of effort - managers work less hard than if they were owners
- Earnings retention - remuneration is often linked to revenue, so managers often take decisions to increase revenue rather than profits
- Time horizon - Shareholders concerned about long-term whereas managers may only be interested in the short-term
What does agency theory say on CG?
CG practices should be used to avoid or manage agency conflict(s)
What are agency costs?
Costs associated with maintaining the principal-agent relationship
3 types of agency costs
- Bonding costs - costs of paying directors and management
- Performance monitoring costs (including GMs, annual reports)
- Residual losses - relating to actions of directors/execs not in interests of companies
Focus of stakeholder theory to CG
Meeting the objectives of all stakeholders. Boards should balance their various interests (inc. non-financial) when making decisions.
4 key approaches to CG
- Shareholder value approach
- Stakeholder approach
- Inclusive stakeholder approach
- Enlightened shareholder value approach
Inclusive stakeholder approach to CG
Developed by South Africa - similar to stakeholder approach but incorporates ethics and CSR
Enlightened shareholder value approach to CG
Board should look to the long term as well as the short term when maximising shareholder value. Views of other stakeholders considered but only insofar as it is in the interests of the shareholders to do so
ie. ‘promoting the success of the company’
2 reasons why directors still very much primarily favour interests of shareholders
- No provision in CA2006 to enforce duty, only stakeholder having rights are members through derivative action
- No guidance as to how directors should take other stakeholder interests into account, particularly conflicting ones
Convergence of approaches to CG, briefly
Newer approaches of enlightened shareholder value and inclusive stakeholder are closer than older approaches which were considered diametrically opposed.
Shareholder focus ‘in the best interests of the shareholders’ is being redefined as ‘long-term sustainability of the company’, which is far closer to the stakeholder focus
4 agreed principles underlying development of CG
Responsibility
Accountability
Transparency
Fairness
Explain responsibility as principle of CG
Those in authority should accept responsibility for powers they have been given authority to exercise
Explain accountability as principle of CG
Those responsible should be able to honestly account for exercise (or non-exercise) of their authority to those from whom it is derived
Explain transparency as principle of CG
The ease with which an outsider can make a meaningful analysis
Explain fairness as principle of CG
All stakeholders should be treated fairly when decisions made or actions taken
An emerging issue in CG, in addition to 4 key principles
Reputational management - maintaining reputation for high standards of business conduct
5 elements of a company’s CG framework
- Applicable laws, regulations, standards and codes
- Organisation’s constitution
- Structures
- Policies
- Procedures
3 main approaches to developing framework of applicable laws, regulations, standards and codes
- Rules-based approach
- Principles-based approach
- Hybrid approach
Rules-based approach to CG
Consists of mandatory set of laws, regulations, standards and codes
2 criticisms of rules-based approach to CG
- Only works if challenges faced by companies are substantially similar
- Only works if rules and their enforcement direct, modify or preclude behaviours they aim to affect
Benefit of rules-based approach to CG
Statement that country takes seriously their protection from nefarious practices.
In reality, this is dependent on enforcement of laws, which is often weak.
Principles-based approach to CG
Consists of voluntary set of best practices contained in code of best practice, requiring more active role of institutional shareholders
Benefit of principles-based approach
Many claim that long-term econ dev is best achieved when business leaders are permitted to exercise judgement
Criticism of principles-based approach
Catalogue of business scandals over last 20 years indicate more stringent CG regulation may be beneficial
What is the hybrid approach to CG?
Combing mandatory laws and regulations with voluntary principles-based codes of best practice
What is meant by ‘comply or else’?
Obligation to abide by mandatory rules-based system of CG - failure usually results in some form of sanction
What is meant by ‘comply or explain’?
Voluntary principles-based code of best practice - company need not comply but must explain why they haven’t to shareholders who can assess explanation
Under which concept does UKCG Code operate?
Comply of explain
What is meant by ‘apply or explain’?
No need to comply in full, but explain how principles were applied if they were
2 reasons for introduction of ‘apply or explain’
- To not put off entities that did not have to comply under previous ‘comply or explain’ - seems less harsh
- To avoid compliance through box-ticking as it was thought was happening under ‘comply or explain’
What is meant by ‘apply and explain’?
Companies must apply principles and explain how they have done so
How do Wates CG Principles define their ‘apply and explain’ system?
Companies should ‘apply each principle by considering them individually within the context of company’s specific circumstances. They should be able to explain in their own word how they have addressed them in their governance practices’
5 examples of types of structures that may be appropriate to a company
- Audit committee
- Risk committee
- Remunerations committee
- Exec committee and senior management team
- Board with a charter and statement of reserved powers or delegated authorities
What is the purpose of an organisation’s policy?
A policy governs how an organisation conducts its operations
5 examples of policy
- Bribery
- Conflicts of interest
- Whistleblowing
- Insider trading
- Gifts, entertainment and gratuities
What is the purpose of an organisation’s procedures/processes
Enable organisation to utilise resources available to operate business and implement policies and strategies effectively and efficiently
5 examples of procedures/processes
- Strategic planning
- Risk management and internal controls
- Managing information
- Business continuity
- Recruitment
3 key considerations when implementing an organisation’s CG framework
- Org’s purpose
- Assimilation of CG practices
- What constitutes success
4 advantages to having clarity of org’s purpose (for different stakeholders)
- Employees know what they are working towards
- Investors know what they are investing in
- Boards/management know how to focus resources and manage risks
- CoSec has more direction in setting up CG framework
5 elements of CG framework (in order)
1 - Org purpose
2 - Compliance (what is required)
3 - Governance (how do we make this effective)
4 - Culture
5 - Org success
What is the difference between compliance and governance?
Compliance is what is required, while governance is the practice of making the compliance practices effective for the organisataion
4 of the ways CG practices can be assimilated into corporate culture
- Demonstrating leadership
- Openness and accountability
- Aligning values
- Exercising stewardship
5 of the many benefits of effective CG
- Long-term sustainability
- Improved operational performance
- Reduced risk of crisis and scandals
- Improved oversight, monitoring and evaluation
- Improved share performance
2 primary consequences of weak governance
- Failing companies
- Reputational problems
4 causes of failing companies
- Accounting fraud
- Lack of knowledge or skills on board
- Dominant personalities
- Failure to understand and manage risk
4 causes of reputational problems for companies
- Unethical business practices
- Lack of transparency and disclosure
- Poor relationship between board and shareholders
- Inappropriate remuneration and reward systems for directors, senior execs
5 consequences of weak CG from wider econ perspective
- Excessive regulation
- Lack of investment
- Development of shareholder rep bodies
- Focus on regulating and disclosing exec pay
- Establishment of powerful regulators
