Chapter 1c - The Corporate Governance framework

Question 1

What does the Corporate Governance Framework consist of?

Answer 1

The frame work consists of:

1. Applicable laws, regulations, standards and codes
2. Organisation’s constitution
3. Structures - how are boards and committees are structured
4. Policies - directors share dealings, etc.
5. Procedures - whistleblowing

Question 2

Under Applicable laws, regulations, standards and codes countries have adopted what are the 3 main approaches?

Answer 2

1. Rules based approach - Sarbanes Oxley. You need to do it.
2. Principles-based approach - UK Corporate governance code. Not based on legislation.
3. Hybrid approach - CA 2006. i.e reporting on remuneration and the code. UK uses the hybrid approach

Question 3

What is the rules based approach?

Answer 3

Consists of a mandatory set of laws, regulations, standards and codes.

Failure to obey in a rules-based system may result in a company suffering sanctions or fines.

Directors of companies in breach of rules may also be fined, imprisoned or disqualified from holding the position of director for a period of time.

Question 4

What are the critics of rules-based approach?

Answer 4

Critics of rules-based approach argue that it only works where:

a. The challenges faced by companies under the purview of the regulation are substantially similar, justifying a common approach to common problems.

b. The rules and their enforcement efficiently and effectively direct, modify or preclude the behaviours they are aimed at affecting.

Question 5

Benefits of a rules based approach?

Answer 5

The benefits of a rules based approach is that it sends a message out to owners, potential investors and other stakeholders that the country takes seriously their protection from immoral practices by those managing and overseeing the organisations they are investing in or dealing with.

Question 6

What is a Principles based approach?

Answer 6

Consists of a voluntary set of best practices usually contained in a code of best practice example: UK Corporate Governance Code 2018. The codes shareholder and potential investors.

Based on the assumption that shareholders will self-regulate the companies within which they invest.

With the codes being voluntary they adopt a ‘comply or explain’ and ‘apply and explain’ approach.

Question 7

What does the Principle based approach allow companies to do?

Answer 7

The principles-based approach allows companies and their shareholders to choose which principles and practices of the corporate governance they believe is appropriate to 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 companies lifecycle, be in the organisations best interest.

For principals-based approach to work institutional shareholders need to take a more active role in the governance of those companies in which they invest

Those they hold funds on behalf of individuals such as trust funds pension funds etc, they have a responsibility on behalf of those individuals to make sure that the boards of directors of the companies which they invest are made properly accountable and govern their company’s responsibility.

Question 8

What is the Hybrid approach?

Answer 8

Many countries are now adopting a hybrid approach combining mandatory laws and regulations with voluntary principles-based codes of best practice.

For example, in the UK some elements of corporate governance are contained in:

• Laws: company, insolvency, directors’ disqualification and disclosures of directors remuneration.
• Regulations: listing authority rules, such as UK Listing Rules and Disclosure and Transparency.

Concepts of:

• ‘comply or else’,
• ‘comply or explain’, and
• ‘apply or explain’

Question 9

What is meant by comply or else?

Answer 9

Comply or else means:

A company’s obligation to abide with a mandatory rules-based system of corporate governance. Failure to abide with the rules, usually results in some form of sanction for the company or directors.

Question 10

What is meant by comply or explain?

Answer 10

Refers to a system where companies are asked to comply with a voluntary principles based code of best practice.

Where the company believes that it is not in its best interest to ‘comply’ with a provision of the code, it is required to ‘explain to shareholders why they have not complied.

Shareholders and shareholder representative bodies are to assess whether the explanation is acceptable of not. The UK Corporate Governance works on a comply or explain regime.

Question 11

What is meant by apply or explain?

Answer 11

Apply or Explain:

Avoids ‘tick box’ mentality and focusses organisations to apply principle and explain how e.g. King IV, and Wates code.

The term was adopted in the South African King code III for two reasons:

1. The code for the first time, applied to all types of entities regardless of their form of establishment or incorporation. These entities under a ‘comply or explain’ regime would only have had to the option of complying or not. As many of the entities were not listed companies, which the corporate governance practices was originally designed for, it was felt that the regime would put off many entities from adopting a good corporate governance.

Asking them how they were ‘applying’ the principles with the code was a less harsh way of reporting on what they were doing as they did not have to give a yes or no answer, they could tell a story of how corporate governance was being adopted in their organisations.

2. There was a felling amongst many stakeholders that the ‘comply and explain’ regime was leading to companies adopting a tick-box approach to corporate governance, adopting the provisions without considering whether they were suitable for their companies or not.

This requires organisations to apply the good governance outcomes set out in South African King IV and explain how they have done so.

Question 12

Q1. What are the pros and cons of a rules-based approach vs a principles based approach to corporate governance?

Answer 12

Critics of the rules-based approach argue that it only works:

1. Where the challenges faced by companies under the purview of the regulation are substantially similar, justifying a common approach to common problems and
2. If the rules are their enforcement efficiently and effectively direct, modify or preclude to the behaviours they are aimed at affecting.

The benefits of this system sends a message out to owners, potential investors and other stakeholder that the country takes seriously their protection from immoral practices by those managing and overseeing the organisation’s they are investing in or dealing with.

The enforcement of the rules to achieve this in many countries are weak.

Question 13

Q2. What is the ‘comply or explain rule for listed companies?

Answer 13

‘Comply or explain’ refer to the system whereby a company is asked to comply with a voluntary principles-based code of best practice.

Where the company believe that is not in its best interests to ‘comply’ with a provision of the code it is required to explain to shareholders why they have not complied.

The company’s shareholder and shareholder representative bodies are then expected to assess whether the explanation is acceptable or not. The UK Corporate governance code works on the premise of a ‘comply or explain’ code.

Question 14

How does ‘comply or explain differ from the ‘apply and explain’ rule in King IV?

Answer 14

The term ‘apply or explain’ was adopted in the South African King Code for two main reasons.

1. The code first the first time, applied to all types of entities regardless of their form of establishment or incorporation. These entities under a ‘comply or explain’ regime would only have had to the option of complying or not. As many of the entities were not listed companies, which the corporate governance practices was originally designed for, it was felt that the regime would put off many entities from adopting a good corporate governance.

Asking them how they were ‘applying’ the principles with the code was a less harsh way of reporting on what they were doing as they did not have to give a yes or no answer, they could tell a story of how corporate governance was being adopted in their organisations.

2. To avoid a ‘mindless response’ to the corporate governance recommendations contained within the code. There was a felling amongst many stakeholders that the ‘comply and explain’ regime was leading to companies adopting a tick-box approach to corporate governance, adopting the provisions without considering whether they were suitable for their companies or not.

Question 15

What is the Organisation’s constitution?

Answer 15

The organisation’s constitution is also known as the Articles of Association, bylaws, charters or trust deeds.

It sets out how an organisation is to conduct itself with the laws, regulations, standards and codes adopted y the country within which it operates.

It usually covers:

Shareholder’s rights to have a share in profits, to attend meetings, voting, appointment, powers and duties of the directors, structures and policies etc.

Question 16

What things do you need to consider when Implementing a governance framework?

Answer 16

When considering implementation of the appropriate governance framework, the company secretary or governance professional should consider:

• The organisations purpose
• The assimilation of corporate governance practices
• What constitutes success for their organisation

Question 17

What do we mean by the organisations purpose?

Answer 17

It’s the reason why the company is in business and is set out in the memorandum of association. Knowing the purpose is very important as everything stems from it such as the vision, mission, strategic goals etc.

In knowing the purpose and focusing its efforts and resources on achieving that purpose that organisations can be successful in the long run.

If an organisation has clarity of the purpose then its employees know what they are working toward, investors know what they are investing in and management know how to focus their resources and manage their risks.

Question 18

What do we need to think about when we say Assimilation of corporate governance practices?

Answer 18

Based on the organisational purpose, the company secretary / governance professional can advise the board on the appropriate corporate governance requirements for the organisation.

They should ensure that the organisation puts in place the structures, policies and procedures required to meet the organisation’s specific needs, manage its risk ad comply with the appropriate laws and regulations, standards and codes that apply.

The assimilation of the corporate governance framework is what governance is all about. It requires engagement with the people who work for the organisation to create cultures of good practice.

Question 19

What is meant by Organisational success?

Answer 19

Organisational success is when an organisation gets its governance right then it reaps the benefits of success.

To ensure that this is happening an organisation should define what its critical success factors are so these can be measured. This is usually done as part of the strategic planning process.

Question 20

Q1. Why is knowing your purpose important for an organisation?

Answer 20

Knowing the organisational purpose is very important as everything stems from it: its vision, mission, strategic goals, and governance framework including risk management.

It is only through knowing the purpose and focusing efforts and resources on achieving that purpose that organisations can be successful in the long run.

If an organisation has clarity of the purpose then its employees know what they are working to, investors know what they are investing in and management know how to focus their resources and manage their risks.

For the company secretary / governance professional knowing the organisational purpose helps set up the organisation’s governance framework of structures, policies and procedures.

Question 21

Q2. What is the difference between compliance and governance?

Answer 21

Compliance answers ‘what is required’. It leads to an organisation adopting the appropriate structures, policies and procedures. On its own its purely a box-ticking exercise.

Governance answers ‘how do we make this effective’. The company secretary should ensure that the infrastructure is appropriate for the organisation, that people are focused and work well together, resources are used effectively and information flows smoothly.

Decisions are then made effectively, and this all contributes to a successful, sustainable organisation.

If the infrastructure is not appropriate for the organisation, then the anticipated ‘cultures’ will not be developed.

Those within the organisation will develop their own cultures which may not be managed and often leads to bad practices, such as failure to follow policies, the misuse of resources, breakdown of important relationships, etc.

This threatens the performance and long-term sustainability of the organisation.

Question 22

Q3. How can a business ensure it assimilates corporate governance practices into its culture?

Answer 22

If an organisation gets its governance right, then it reaps the benefits of success.

To ensure this is happening an organisation should define what its critical success factors are so these can be measured. This will usually be done as part of the strategic process.

Question 23

Explain the following:

1. Comply or else
2. Comply or explain
3. Apply and explain

Answer 23

1. ‘Comply or else’

Failure to comply with mandatory rules results in sanction. E.g. Sarbanes Oxley in US

2. ‘Comply or explain’(‘Apply or explain’)
   Where the company believes that it is not in its best interests to ‘comply’ with a provision of the code, it is required to ‘explain’ to shareholders why they have not complied e.g. UKCG Code
3. ‘Apply and explain’
   Avoids ‘tick box’ mentality and focusses organization to apply principle and explain how. e.g. King IV, Wates

Question 24

Importance of adopting good CG?

Answer 24

1. Long-term sustainability
2. Improved access to external financing
3. Lower cost of capital
4. Improved operational performance
5. Increased firm valuation
6. Improved share performance
7. Reduced risk of corporate crisis and scandals
8. Effective decision making
9. Improved oversight, monitoring and evaluation

Question 25

Consequences of weak governance practices

Answer 25

Corporate failure:

1. Accounting fraud
2. Lack of knowledge skills and experience on the board, e.g. Barings Bank
3. Dominant personalities, e.g. Maxwell
4. Failure to understand and manage risk, e.g. global financial crisis, Carillion

Reputational problems:

1. Unethical business practices, e.g. Volkswagen ‘Dieselgate
2. Lack of transparency and disclosure, e.g. Olympus
3. Poor relationship between the board and shareholders, e.g. Sports Direct
4. Inappropriate remuneration and reward systems for directors and senior executive, e.g. Enron, Carillion

Question 26

Consequences of weak governance practices for industry

Answer 26

1. Excessive regulation – many of the laws, regulations, standards and codes introduced globally have been in response to the scandals that have resulted from weak governance practices
2. Lack of investment in capital markets – evidence shows that investors place importance on good governance practices when investing in companies. A lack of those practices can therefore lead to a lack of investment.
3. The development of shareholder representative bodies, such as the Investment Association or functions within some of the larger institutional shareholders specifically for monitoring the corporate governance practices of the companies they invest in, e.g. Hermes, CalPERS.
4. A focus on regulating and disclosing senior executive pay.
5. The establishment of powerful regulators such as the US Securities and Exchange Commission.

Question 27

Governance v Management

Answer 27

Governance:

• The system by which a company is directed and controlled.
• Ensuring that the business of a company is conducted properly.
• Establishing its structures, policies and procedures.
• Board of directors are responsible for governance. For listed companies, a majority may be Non Executive Directors.

Management:

• Running the business.
• Led by the executive directors with delegation to a management team.