Corporate Governance on the London Stock Exchange

Question 1

Why has corporate governance emerged as a key focus in the last 30 years? 4

Answer 1

It is now part of everyday speech
•The rise of the term is linked to crises
•ride ranging impact not just on company
•Corporate governance is everyone’s concern

Question 2

Examples from the UK on SE ? Period: late 80s/early 90s 4

Answer 2

•Polly Peck International

•Bank of Credit and Commerce International

•Maxwell

Question 3

Summary of Polly Peck International 6

Answer 3

•Rapid rise to status as top-100 listed company
•Holding company for global conglomerate
•Debt secured against company’s shares
•Stock market slide exposed problems
•Investigators discovered lack of internal controls
•CEO able to transfer funds unchecked

Question 4

Summary of BCCI 5

Answer 4

•Organisation used banking secrecy rules to cover its involvement in criminal activity
•Concerns arose from mid-80s after heavy losses on global markets
•Bank of England ultimately requested an audit report
•Report revealed serious problems
•BCCI shut down by Bank of England

Question 5

Summary of Maxwell 6

Answer 5

•Large publishing group
•Debts secured against shares
•Sale of shares by creditors affected price which impacted remaining security
•Used money from pension funds to cover business (and personal) expenses
•Concern among regulators by 1991
•Bankruptcy in 1992

Question 6

Common features - causes 4

Answer 6

•Failure of corporate governance
•Lack of internal controls
•Failure of auditors to spot problems early
•Ability of powerful executives to abuse position

Question 7

Common features effects 8

Answer 7

•Bankruptcy or severe financial problems
•Losses for shareholders
•Losses for creditors
•Redundancies
•Problems for pensioners
•Problems for auditors
•Problems for markets
•Problems for other companies seeking equity capital

Question 8

Responses regulation ?

Answer 8

UK (1992-2008)
•Progressive development of the Combined Code on Corporate Governance
•A self-regulatory response
•Based on principles

Question 9

Reports based on the responses? 6

Answer 9

Cadbury Report on the Financial Aspects of Corporate Governance (1992)
•Greenbury Report on Directors’ Remuneration (1995)
•Hampel Report (1998) (emergence of Combined Code)
•Turnbull Report on Internal Control (1999)
•Smith Report on Audit Committees (2003)
•Higgs Report on Independent Directors (2003)

Question 10

Combined code section 1? 4

Answer 10

Section 1 COMPANIES
•A Directors
•B Remuneration
•C Accountability and Audit
•D Relations with Shareholders

Question 11

Combined code section 2? 1

Answer 11

Section 2 INSTITUTIONAL SHAREHOLDERS
• E Institutional Shareholders

Question 12

What is combined code? 9

Answer 12

Contains main and supporting principles and provisions
•LSE Listing Rules require a listed company to make a two-part disclosure statement in relation to the Code:
1.how it applies the principles in the Code
2.confirm that it complies with the Code’s provisions or – where it does not – provide an explanation

Expectation is that companies will comply with Code principles most of the time
•Recognised that departure may be justified ‘in particular circumstances’
•Company ‘must review each provision carefully’
•Company must ‘give a considered explanation if it departs from the Code provisions’
•Recognised that smaller companies may judge some provisions ‘disproportionate’

Question 13

Quotes about combined code 4

Answer 13

shareholders have every right to challenge companies’ explanations if they are unconvincing’
•but ‘they should not be evaluated in a mechanistic way and departures from the Code should not be automatically treated as breaches’
•‘institutional shareholders should carefully consider explanations given for departure from the Code and make reasoned judgements in each case…’
•‘…and be prepared to enter a dialogue if they do not accept the company’s position’

Question 14

A.1. The board main principle? 1

Answer 14

Main Principle
•Every company should be headed by an effective board, which is collectively responsible for the success of the company.

Question 15

A.1 The Board
•Supporting Principles 2

Answer 15

The board’s role is to provide entrepreneurial leadership of the company within a framework of prudent and effective controls which enables risk to be assessed and managed. The board should set the company’s strategic aims, ensure that the necessary financial and human resources are in place for the company to meet its objectives and review management performance. The board should set the company’s values and standards and ensure that its obligations to its shareholders and others are understood and met.

As part of their role as members of a unitary board, non-executive directors should constructively challenge and help develop proposals on strategy. Non-executive directors should scrutinise the performance of management in meeting agreed goals and objectives and monitor the reporting of performance. They should satisfy themselves on the integrity of financial information and that financial controls and systems of risk management are robust and defensible. They are responsible for determining appropriate levels of remuneration of executive directors and have a prime role in appointing, and where necessary removing, executive directors, and in succession planning.

Question 16

What is code provisions 2

Answer 16

Code Provisions
•A.1.1 The board should meet sufficiently regularly to discharge its duties effectively. There should be a formal schedule of matters specifically reserved for its decision. The annual report should include a statement of how the board operates, including a high level statement of which types of decisions are to be taken by the board and which are to be delegated to management.

•A.1.2 The annual report should identify the chairman, the deputy chairman (where there is one), the chief executive, the senior independent director and the chairmen and members of the nomination, audit and remuneration committees. It should also set out the number of meetings of the board and those committees and individual attendance by directors.

Question 17

Combined code a.1.3 and a1.4

Answer 17

A.1.3 The chairman should hold meetings with the non-executive directors without the executives present. Led by the senior independent director, the non-executive directors should meet without the chairman present at least annually to appraise the chairman’s performance…and on such other occasions as are deemed appropriate.

•A.1.4 Where directors have concerns which cannot be resolved about the running of the company or a proposed action, they should ensure that their concerns are recorded in the board minutes. On resignation, a non-executive director should provide a written statement to the chairman, for circulation to the board, if they have any such concerns…

Question 18

A.2 Chairman and chief executive 1

Answer 18

Main Principle
•There should be a clear division of responsibilities at the head of the company between the running of the board and the executive responsibility for the running of the company’s business. No one individual should have unfettered powers of decision.

Question 19

A.3 Board balance and independence

Answer 19

Main Principle
•The board should include a balance of executive and non-executive directors (and in particular independent non-executive directors) such that no individual or small group of individuals can dominate the board’s decision taking.

Question 20

•A.4 Appointments to the Board

Answer 20

•Main Principle
•There should be a formal, rigorous and transparent procedure for the appointment of new directors to the board.

Question 21

A.5 Information and professional development
•Main Principle

Answer 21

•The board should be supplied in a timely manner with information in a form and of a quality appropriate to enable it to discharge its duties. All directors should receive induction on joining the board and should regularly update and refresh their skills and knowledge.

Question 22

A.7 Re-election

Answer 22

Main Principle
•All directors should be submitted for re-election at regular intervals, subject to continued satisfactory performance. The board should ensure planned and progressive refreshing of the board.

Question 23

B.1 The Level and Make-up of Remuneration

Answer 23

Main Principles
•Levels of remuneration should be sufficient to attract, retain and motivate directors of the quality required to run the company successfully, but a company should avoid paying more than is necessary for this purpose. A significant proportion of executive directors’ remuneration should be structured so as to link rewards to corporate and individual performance.

Question 24

B.2 Procedure

Answer 24

•Main Principle
•There should be a formal and transparent procedure for developing policy on executive remuneration and for fixing the remuneration packages of individual directors. No director should be involved in deciding his or her own remuneration.

Question 25

C.1 Financial Reporting supporting and main? 2

Answer 25

Main Principle
•The board should present a balanced and understandable assessment of the company’s position and prospects.

•Supporting Principle
•The board’s responsibility to present a balanced and understandable assessment extends to interim and other price-sensitive public reports and reports to regulators as well as to information required to be presented by statutory requirements.

Question 26

Code Provisions C1 ? (2)

Answer 26

•C.1.1 The directors should explain in the annual report their responsibility for preparing the accounts and there should be a statement by the auditors about their reporting responsibilities.

•C.1.2 The directors should report that the business is a going concern, with supporting assumptions or qualifications as necessary.

Question 27

•C.2 Internal Control main principle and code provision? (2’

Answer 27

•Main Principle
•The board should maintain a sound system of internal control to safeguard shareholders’ investment and the company’s assets.

•Code Provision
•C.2.1 The board should, at least annually, conduct a review of the effectiveness of the group’s system of internal controls and should report to shareholders that they have done so. The review should cover all material controls, including financial, operational and compliance controls and risk management systems.

Question 28

C.3 Audit Committee and Auditors main (1)

Answer 28

Main Principle
•The board should establish formal and transparent arrangements for considering how they should apply the financial reporting and internal control principles and for maintaining an appropriate relationship with the company’s auditors.

Question 29

D.1 Dialogue with Institutional Shareholders main (1)

Answer 29

Main Principle
•There should be a dialogue with shareholders based on the mutual understanding of objectives. The board as a whole has responsibility for ensuring that a satisfactory dialogue with shareholders takes place.

Question 30

D.2 Constructive Use of the AGM main (1)

Answer 30

•Main Principle
•The board should use the AGM to communicate with investors and to encourage their participation.

Question 31

E.1 Dialogue with companies main and supporting? (2)

Answer 31

Main Principle
•Institutional shareholders should enter into a dialogue with companies based on the mutual understanding of objectives.

•Supporting Principles
•Institutional shareholders should apply the principles set out in the Institutional Shareholders’ Committee’s “The Responsibilities of Institutional Shareholders and Agents – Statement of Principles”, which should be reflected in fund manager contracts.

Question 32

E.2 Evaluation of Governance Disclosures main (1)

Answer 32

Main Principle
•When evaluating companies’ governance arrangements, particularly those relating to board structure and composition, institutional shareholders should give due weight to all relevant factors drawn to their attention.

Question 33

E.3 Shareholder Voting main (1)

Answer 33

Main Principle
•Institutional shareholders have a responsibility to make considered use of their votes.

Question 34

Combine code summary ? 6

Answer 34

Monitoring by institutional investors and their intervention as necessary is essentially the enforcement mechanism envisaged by the Code.

•What characteristic of listed companies does the Combined Code in essence try to deal with and indeed take advantage of?

•Assumption is that inherent in the market will be a desire to ensure optimum governance…

•…But does this happen?

•Who or what ensures that the institutional investors actually behave in this way?

Govt has taken powers under Companies Act 2006 to compel publication of voting activity by institutional investors. Unless they do so voluntarily, it will regulate.

Question 35

Critique summary (2)

Answer 35

The Combined Code was well established before the banking crisis struck in 2008
•But had already been subject to detailed criticism by that point…

Question 36

Critique on CC by market? (2)

Answer 36

The market’s view was positive
•This ‘comply or explain’ approach has been in operation for over ten years and the flexibility it offers has been widely welcomed both by company boards and by investors. It is for shareholders and others to evaluate the company’s statement.
(Financial Reporting Council, Preamble to Combined Code 2006)

Question 37

Critique on CC by government ? (2)

Answer 37

The government’s view was positive
•‘Our system of principles and risk-based regulation provides our financial services with a huge competitive advantage and is regarded as the best in the world’
(Ed Balls, then Economic Secretary to the Treasury, October 2006)

Question 38

Critique on CC by independent observers ? (5)

Answer 38

Independent observers were less enthusiastic
•There was significant non-compliance as far as the full Code is concerned (<50%)
•But does this mean that:
•the flexible approach was working well?
or
•the market was not really concerned

Question 39

Why did CC raise doubt (2)

Answer 39

Analysis of appliance and compliance statements (by McNeil and Li 2006) indicates that reasons for non-compliance were often ‘brief and uninformative’
•This raised ‘serious doubt’ about whether investors could carry out the assessment the Code presupposes

Question 40

Critique of cc summary (6)

Answer 40

So what was the market actually doing?
•Perhaps assessing the merits of non-compliance in another way?
•McNeil and Li found a strong correlation between acceptance of non-compliance and strong share-price performance
•The approach was thus not ‘comply or explain’…
•…but ‘comply or perform’
•Can anyone spot the problem?

Question 41

What do critics propose? (4)

Answer 41

Since ‘comply or explain’ was not working, the Combined Code should become part of company law
•This would give shareholders a say over any derogation from the Code ex ante in the context of general meetings
•In other words, there should be a shift away from principles and towards rules
•These are issues we will consider further in the second part of the course