Corporate Governance + Reading

Question 1

Corporate Governance

Answer 1

The system by which organisations are directed and controlled by the board.

Question 2

Good corporate governance

Answer 2

• Risk management (Combined code 2024)
• Good supervision and effective management (by having information)
• Framework to pursue ethica (Post Office Case) and effective strategies
• Clear lines of accountability
• Willingness to apply spirit of governance (not just rules)

Question 3

The aim of corporate governance

Answer 3

• Create framework of executive control
• Raise standards of controls (E.g. internal auditing)
• Organisations answerable to stakeholders
• Ensure behaviour is socially responsible
• Protect investors

Question 4

Why corporate governance may fail

Answer 4

• Autocratic leadership (Weak board and chairman - e.g. Royal Bank of Scotland Fred Goodwin)
• Disregard of rules
• Ignoring the interests of stakeholders
• Too few controls including audit
• Accounting & reporting lapses

Question 5

History of Corporate Governance (in UK)

Answer 5

Cadbury Report (1992)
The report sought to create a balance of power between executive and non-executive directors, strengtheninginternal monitoring mechanisms, thereby reducing the potential for managerial self-interest at the expense of shareholders.

The Higgs Report of 2003 expanded on the Cadbury and Greenbury reports by advocating for more non-executive directors on boards to limit CEO power and enhance corporate governance. This aimed to boost board independence and oversight, reducing the risk of managerial misconduct. Overall, these UK reports promote transparency, accountability, and board independence to mitigate agency problems and enhance risk management.

Greenbury Report (1995)
focused on aligning director remuneration with company performance to address the agency problem. It recommended employee stock ownership plans for executive directors but not for non-executive directors (NEDs). This recommendation aimed to ensure that directors’ incentives were aligned with shareholders’ interests, as there was previously a lack of transparency regarding director compensation. By establishing a clear relationship between share price and director performance, the report sought to mitigate conflicts of interest and improve risk management.

Question 5

Turnbull Report (1999)

Answer 5

Elements of CG ‘best practice’:
- Robust system of internal controls
- Annual review of controls
-> Shareholders activity (shareholders should be more active - e.g. UK is less active as most of the big investors were pension funds and insurance companies which tend to be more relaxed)
-> Review - cover all controls
-> Disclose risks
- Risk management
-> Collective responsibility of the Board
- Regular evaluation of risks
-> Reported to Board
- Review need for Internal Audit department

Recommendations:
Forward-looking risk process
Open system
- Disclosure to shareholders
Does not seek to eliminate risk
Highlighted importance of ERM
Governance a strategic issue driven by business objectives

Question 5

CG Code Requirements

Answer 5

Directors
- balancing ED and NED
- regular reviewing every 3 years

Directors remuneration
- link rewards to corporate and individual performance
- include details of remuneration of each director in annual report

Relations with shareholders
- Encourage participation and communicate with investors

Accountability and Audit
- Audit committee made up at least 3 NEDs
- Should be formal and transparent arrangements.
- Internal audit is an integral part of good governance and helps minimise operational & strategic risks

Question 5

Non-Executive directors

Answer 5

Key control of Corporate Governance
- Use of independent non-executive directors

Roles include:
- Challenging and helping develop strategies
- Performance monitoring of Company (Audit Committee) - based on an agency theory perspective
- Review of risk management and internal controls
- Determine executives pay (Remuneration Committee)
- Appointing executives (Nominations Committee)

Independence is key

Role arose due to:
- Need for no conflicts of interest amongst Executives / Non-Executives
- Countering powerful CEOs

Independence precluded by:
- Previous employment
- No recent links with the business - Material business relationship in previous 3 years
- Personal or financial links with company
- Long service on Board (>9yrs)

Recent research (e.g., in JAE) emphasises the performance-effects of functional attributes of directors such as:
- financial qualifications
- firm/industry experience
- other business commitments
In some jurisdictions (e.g., Norway) board composition is influenced by statute (e.g., gender diversity)

Question 5

Asymmetric information

Answer 5

Good corporate governance promotes transparency and disclosure of relevant information, including risks faced by the organisation. This transparency enables stakeholders to make informed decisions and helps to build trust with investors, regulators, and other stakeholders.

Heart of agency problem and lie behind the market failures and the associated corporate scandals.

Has it become more of an issue than before?

Emergence of large scale business with complex organisational forms have increased lack of transparency within corporations, resulting in greater informational asymmetry between investors and management.

Technological progress, more information is now available, causing information overload making it difficult to extract information that is relevant and important.

Question 5

Solving agency problem

Answer 5

When decision-making authority is delegated, this can lead to some loss of efficiency and consequent potential loss.

To mitigate agency costs, managers may receive incentives tied to accounting performance, such as a portion of the company’s profits or bonuses.

Despite receiving share of profits, managers are expected to provide accurate information about the organisation’s performance. Highlighting the assumption that managers are motivated to act in the best interests of the firm and its stakeholders. However, ensuring that managers provide accurate information involves incurring certain costs, known as bonding costs. These are the costs associated with ensuring that managers fulfil their responsibilities and provide accurate information to mitigate the risk of managers providing misleading or inaccurate information.

If managers are predicted to prepare a FS, then there would be a need for monitoring. Otherwise managers, motivated by self-interest, might attempt to inflate profits to boost their share of earnings.