Definitions and issues in corporate governance

Question 1

Describe the case of Polly Peck 1990

Answer 1

Nadir was acting as chair and CEO = too much power = decisions were not fully discussed with the board. He said he would take the company private and then abandoned that plan as he was in substantial debt. Share prices dropped and Polly Peck went into administration. Nadir was charged with theft and false accounting.

Question 2

What is the definition of CG as defined by the Cadbury Committee 1992?

Answer 2

= the system by which companies are directed and controlled

Question 3

What is CG and what does it do as defined by The Organisation for Economic Co-operation and Development (OECD) (1999)?

Answer 3

= relationships between a company’s management, board, shareholders and other stakeholders.

Provides the structure for object setting and the means of achieving those objectives and monitoring performance

Question 4

What is CG as defined by King IV Report on Corporate Governance for South Africa (2016)?

What are the 4 outcomes?

Answer 4

= 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

Question 5

How does the 2018 UK CG Code differ from the 2016 Code in terms of its CG definition?

What is the purpose of CG as defined in the 2016 code?

What is it based on?

What does the 2018 Code say about CG and succeeding in the long-term?

Answer 5

2018 Code expands on the 2016 definition of CG and recognizes that companies don’t exist in isolation.

2016 Code = ‘the purpose of CG is to facilitate effective, entrepreneurial and prudent management that can deliver the long-term success of the company.

the definition of CG from the Cadbury Report

2018 Code = ‘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.’

Question 6

What are the 2 main theories of CG?

Answer 6

1. Shareholder primacy theory (agency theory) = shareholder value approach to CG
2. Stakeholder theory = stakeholder approach to CG

Question 7

What is the focus of the shareholder primacy theory of CG?

What are the 2 criticisms?

Answer 7

= maximising the value to shareholders before considering other corporate stakeholders such as employees, customers, suppliers and society as a whole.

Criticisms:
1. Inappropriate stewardship
○ changes in shareholder structure has led to ownerless companies = where no single investor has a large enough stake in a company to act as the responsible owner
○ Shareholder representative bodies focus on executive pay and board composition not decision making of the board/ management

2. Short-termism
   ○ = a tendency for management to take actions that maximise short term earnings and stock prices at the expense of shareholders’ objectives of long-term company performance.
   ○ Shareholders invest in shares often as a tradable commodity for short term gain and consider investment in the business second.

Question 8

When does an agent-principal relationship exist?

What are the 2 challenges associated with agency theory?

What is the criticism of agency theory?

Answer 8

An agent-principal relationship exists in companies where there is a separation of ownership and control.

Challenges:
1. Agency conflict = agents and principals have differing interests
• Shareholders want want long-term income = looking for dividends
• Directors and managers look short-term to annual bonuses
• 4 areas identified by Jensen and Meckling

2. Agency costs = the costs associated with maintaining the agent–principal relationship
   • Bonding costs = cost of paying directors and executive management
   • Monitoring costs = costs of monitoring their performance
   • Residual loss costs = costs to shareholders associated with directors’ actions which in the long run turn out not to be in the interests of the shareholders (e.g. a major acquisition or disposal)

Criticism:
Argued that agency theory focuses on maintaining value for shareholders which has led to short-termism because many shareholders are looking for short-term gains

Question 9

What are the 4 areas of agency conflict that Jensen and Meckling identified?

How can a company manage or avoid conflicts of interest between shareholders and directors and managers? (2 examples)

Answer 9

1. Moral Hazard = Managers have an interest in receiving benefits from their position e.g. company car
2. Level of Effort = Managers may work less hard than they would if they were the owners of the company
3. Earnings Retention = Director’s remuneration is often related to the size of the company (measured by annual sales revenue) rather than its profits

= Managers have an incentive to increase the size of the company (reinvest profits), rather than pay dividends

4. Time Horizon = Shareholders are concerned about long-term financial prospects of their company. Directors and managers might only care about the short-term for annual bonuses

Agency theory = companies should use CG practices
1. use long-term incentive share award or stock option schemes
2. Adopt policies on conflicts of interest and related party transactions

Question 10

What does the stakeholder theory of CG say the purpose of CG should be?

How does this apply to decision-making?

How does this apply to financial and non-financial objectives?

How should companies act?

Who should companies be accountable to?

Answer 10

= purpose of CG should be to meet the objectives of everyone that has an interest in the company

Boards should balance the interests of different stakeholder groups, deciding on a case-by-case basis which interest take priority.

Non-financial objectives, such as employee relations or limiting environmental impact, should be considered equal to the financial objectives, such as the return on investment

Companies should act as good corporate citizens and take into account the impact on society and the environment.

Companies should be accountable to society and should conduct their activities to the benefit of society
(Forms the basis for arguments in favour of corporate, social, and environmental responsibility)

Question 11

What is the main difference between the agency and stakeholder theories?

Answer 11

Agency theory deals with the relationship between shareholders and directors where there is a separation of ownership. Challenges include conflicts of interest and the costs associated with avoiding/managing those conflicts

The stakeholder theory = the purpose of CG should be to meet the objectives of everyone that has an interest in the company

Question 12

How do agency and stakeholder theories affect the objectives of the companies?

Answer 12

Agency theory = company focuses on creating and maintaining shareholder value
1. Focus on financial objectives
2. Objectives tend to be short-term

Stakeholder theory = boards balance the interests of the different stakeholders when making decisions
1. Non-financial objectives are equal to financial objectives
2. Objectives tend to be longer-term

Question 13

What are the 4 main approaches to CG?

Answer 13

1. Shareholder value approach
2. Stakeholder approach (AKA Pluralist approach)
3. Inclusive stakeholder approach
4. Enlightened shareholder value approach

Question 14

What is the shareholder value approach to CG?

What is the main objective?

Who should the directors be accountable to?

What is the criticism?

Answer 14

= board of directors should govern their company in the best interests of its owners, the shareholders

Main objective = maximise shareholder’s wealth through share price growth and dividend payments

Directors should only be accountable to shareholders with power to appoint and remove from office for poor performance.

Not sustainable in the long term as companies need to interact with different stakeholder groups.

Question 15

What is the stakeholder (AKA pluralist) approach to CG?

Where is it mostly adopted?

What is the criticism?

Answer 15

= companies should have regard to the views of all stakeholders, not just shareholders, and balance all their interests when making decisions

Mostly adopted in civil law countries = France, Germany, Japan, and China

Argued that if companies were to take into account all stakeholders’ conflicting views, they would never come to a decision

Question 16

What is the inclusive stakeholder approach to CG?

How does this affect the board’s decision-making?

Where was it introduced and in which country does the approach reflect the needs and culture?

Answer 16

= boards should consider the legitimate interests and expectations of key stakeholders on the basis that this is in the best interests of the company

Legitimate interests and expectations of key stakeholders should be included in board’s decision-making and traded off against each other on a case-by-case basis in the best interests of the company

• Introduced by King Reports
• Approach reflects African needs and culture = incorporates sustainability and good citizenship into the definition of CG to fight corruption, poverty, and health issues

Question 17

What is the enlightened shareholder value approach to CG?

How is it different from the stakeholder approach and the inclusive stakeholder approach?

Which duty does it link to under the CA2006?

What are the 2 challenges to the duty in practice?

Which regulation seeks to address these challenges by providing guidance?

Answer 17

= boards should look to the long term as well as short term and consider the views of and impact on other stakeholders when considering actions to maximise shareholder value

• Different because other stakeholder views are only considered in so far as it would be in the interests of shareholders to do so (stakeholder approaches = boards balance the conflicting interests of stakeholders in the best interests of the company)

S.172 CA2006 imposes a statutory duty on directors to promote the success of the company for the benefit of its members as a whole and have regard to 6 factors

2 challenges in practice:
1. No provision in CA2006 to enforce the duty = members are the only stakeholder with enforcement rights through a derivative action
2. No guidance as to how directors should take other stakeholder interests into account = Boards in reality still focus on shareholder interests only

The Companies (Miscellaneous Reporting) Regulations 2018

Question 18

Which approaches to CG see boards taking a longer-term view in decision-making?

Answer 18

Enlightened shareholder value, stakeholder, and inclusive stakeholder approaches tend to take a longer-term view than the shareholder value approach

Question 19

Which approaches to CG put shareholders first?

Answer 19

The shareholder value and enlightened shareholder value approaches

Question 20

What are 5 main differences between a shareholder primacy approach (SPA) and a company/stakeholder focused approach (C/SA) to CG?

Answer 20

1. Functions of the company
   • SPA = Maximise wealth for shareholders
   • C/SA = Provide goods and services; provide employment; create opportunities for investment; drive innovation
2. Purpose of the company
   • SPA = Maximise wealth for shareholders
   • C/SA = Is set by the Board
3. Responsibility to society
   • SPA = None
   • C/SA = Fulfil business purpose and act as a good corporate citizen
4. Ethical standards
   • SPA = Whatever shareholders want or obey the law
   • C/SA = Obey law and follow society’s ethical standards

5.Nature of shareholders
• SPA = Undifferentiated, self-interested wealth maximisers
• C/SA = Diverse, with differing objectives, incentives, time horizons and preferences

Question 21

Trends today support the convergence of the shareholder value approach and the stakeholder approach:

What is the company centred approach to CG as further developed in 2017 by J. Bower and L. Paine?

Why should shareholders not take primacy over other stakeholder groups? (3)

Answer 21

• Recognises companies are independent entities in law with the potential for indefinite life –> company’s leadership have a duty to sustain it in the long-term = make decisions in the best interests of the company not in the interests of one of more stakeholder groups

• Shareholders should not take primacy over other stakeholder groups:
1. Shareholders have no legal duty to protect or serve the companies whose shares they own

2. Shareholders often have differing interests = generally invest for short-term return on investment pressurising management to focus on the short-term rather than long-term projects in the better interests of the company’s sustainability
3. Companies have power over billions of people’s lives so should serve the societies and markets they operate in over the longer-term = should create value for multiple stakeholders as well as shareholders

Question 22

What is stakeholder capitalism?

Why is it becoming important?

Where was the concept introduced globally? Why?

Answer 22

• Seeks to create shareholder returns by creating value for society as a whole
= Is about aligning their interests to grow the pie for the benefit of all

Important = growing view that the most important assets in an organisation are not tangible but are intangible i.e. access to talent and reputation

Introduced globally at WEF Davos 2020 meeting = Governments and companies are realizing the importance of ESG considerations for long-term success

Question 23

What are the 4 principles of corporate governance?

Answer 23

1. Fairness
2. Accountability
3. Responsibility
4. Transparency

Question 24

Who does the ‘Responsibility’ principle of CG refer to?

How can organisations help with this?

How does responsibility link to accountability?

Answer 24

• a person or group of people having authority over something, and therefore liable to be held accountable for the exercise or lack of exercise of that authority

• Organisations should make sure procedures are in place so people know their responsibilities and what they are accountable for

Mismanagement of authority should be penalised = responsibility goes in hand with accountability

Question 25

What does the ‘Accountability’ principle of CG refer to?

Who should accountability be to?

What are the 2 challenges?

What does CG best practice say about how to overcome these?

Answer 25

• requirement for a person or group of people in a position of responsibility to justify, explain or account for the exercise (or not) of their authority

• Accountability should be to the person or group of people from whom the authority is derived

• Challenges = decide how they should be made accountable and over what time period

• CG best practice requires an organisation to set out clearly who is accountable for what and over what time period

Question 26

What does the ‘Transparency’ CG principle refer to?

What should an organisation do? (3)

Answer 26

• the ease with which an outsider is able to make a meaningful analysis of an organisation and its actions

Organisations should:
1. Be open in = builds trust between the organisation and its stakeholders

2. Ensure that disclosure is timely and accurate on all material matters = so those interested in the organisation can make informed decisions
3. Have policies in place about the disclosure of information – e.g. what information should be public /private

Question 27

What does the ‘Fairness’ CG principle refer to?

What should an organisation do to enforce this? (3)

Answer 27

• the principle that all key stakeholders should be treated fairly when decisions are made or actions taken by the organisation

Organisations should:
1. provide effective redress for violations, e.g. to minority shareholders when they have been treated unfairly

2. have policies and procedures in place to ensure key stakeholder views are considered without bias
3. apply fair practices when dealing with stakeholders

Question 28

What is reputation?

What can a bad reputation do?

What must an organisation do to manage reputational risk?

What are 5 benefits of effective reputational management?

Answer 28

= defines an organisation as well as the individuals associated with that organisation

• The destruction of a reputation can lead to the end of the organisation = Arthur Anderson was destroyed in 2002 by the damage of its involvement in the Enron affair

• Organisations must have structures, policies and processes in place to manage reputational risk

• J Larkin = benefits of effective reputational management:
1. Improve relationship with shareholders
2. Recruiting and retaining the best employees
3. Attracting best business partners, suppliers, and customers
4. Minimising threats of litigation and stringent regulation
5. Reinforcing the organisation’s credibility and trust for stakeholders

Question 29

What 8 things make up an organisations’ corporate governance framework?

Answer 29

1. Applicable laws
2. regulations
3. standards
4. codes
5. Organisation’s constitution
6. Structures
7. Policies
8. Procedures

Question 30

What are the 3 approaches to CG laws, regulations, standards, and codes?

Answer 30

1. Rules- based
2. Principles- based
3. Hybrid

Question 31

What is the rules-based approach to CG laws, regulations, standards, and codes?

What is an example?

What happens if fail to obey?

Critics argue it only works when? (2)

What are 3 disadvantages?

What is the benefit of the system?

What are 2 advantages?

Answer 31

• = consists of a mandatory set of laws, regulations, standards and codes
• E.g. Sarbanes-Oxley Act 2002

• Failure to obey = company sanctions and/or fines and directors in breach may also be fined, imprisoned, and/or disqualified

• Critics argue it only works where:
1. Challenges the company face are similar, justifying a common approach to common problems
2. The rules and their enforcement effectively prevent the behaviours they are aimed at affecting

• Disadvantages:
1. Rigid
2. Lack of discretion
3. Enforcement in many countries is weak

• Benefits of system = sends a message to owners, potential investors, and other stakeholders that the country takes their protection from mismanagement seriously

• Advantages:
1. Readily enforceable
2. Civil or criminal sanctions

Question 32

What is the principles-based approach to CG laws, regulations, standards, and codes?

What is an example?

What are the advantages? (2)

What are the disadvantages? (2)

Answer 32

• = a voluntary set of best practices usually contained in a code of best practice

• E.g. UK Corporate Governance Code 2018

• Advantages:
1. Flexibility = Recognises that noncompliance may sometimes be in the organisation’s best interests

2. Comply or explain

• Disadvantages:
1. Lack of enforceability = for it to work, institutional investors have to take an active role in the governance of the companies they invest in

2. No sanctions

Question 33

What is the comply or explain approach to a principles-based approach to CG laws, regulations, standards, and codes?

Who assesses this?

Which code uses this?

Answer 33

Comply or explain = company is asked to comply with a voluntary principles-based code of best practice and the company must explain to shareholders why it has not if it thinks it’s not in its best interests to.

The company’s shareholders and shareholder representative bodies are then expected to assess whether the explanation is acceptable or not.

UK CG Code adopts this

Question 34

Why was an apply or explain approach to a principles-based approach to CG laws, regulations, standards, and codes adopted in South African King Code III? (2)

Answer 34

Adopted in South African King Code III for 2 reasons:

1. allows non listed entities to tell a story of how CG is being adopted in their organisations
2. To avoid a tick box approach to CG

Question 35

What is the apply and explain approach to a principles-based approach to CG laws, regulations, standards, and codes?

When was it introduced?

Which code has adopted it?

Answer 35

Apply and explain = apply each principle by considering them within the company’s context and then explain how they have addressed them in their governance practices

Introduced by King IV in 2016

Adopted by The Wates Corporate Governance Principles for Large Private Companies (2018)

Question 36

What is the hybrid approach to CG laws, regulations, standards, and codes?

Give an example of each within the UK.

Answer 36

= a mix of rules based and principle-based approaches

• UK = some elements of corporate governance are contained in:
○ Laws: Disclosure of directors’ remuneration

○ Regulations: UK Listing Rules and DTRs

○ Standards: International Financial Reporting Standards (IFRS).

○ Voluntary codes of best practices: UK CG Code

Question 37

What is an organisation’s constitution?

What topics does it usually cover? (5)

Answer 37

= Sets out how an organisation is to conduct itself within the laws, regulations, standards, and codes adopted by the company

Usually covers:
1. shareholders’ rights,

2. the appointment, powers and duties of directors,
3. board proceedings,
4. the appointment, power, and duties of the company secretary,
5. provisions for winding up the company

Question 38

What 5 factors will an organisation’s structure depend on?

What are 5 examples of types of structures that could be put in place?

Answer 38

Organisation’s:
1. Type
2. Applicable laws and regulations
3. Strategic objectives
4. Risks associated with its operations
5. People

• Examples of types of structures that could be put in place:
1. Audit committee
2. Risk committee
3. Nominations committee
4. Remuneration committee
5. Role profiles for the chair, CEO, and NEDs

Question 39

What 2 factors will an organisation’s policies depend on?

What are 5 examples of types of policies that could be put in place?

Answer 39

1. Type of organisation
2. Sector it operates in

Examples of policies:
1. Code of conduct / ethics
2. Bribery
3. Conflicts of interest
4. Whistleblowing
5. Insider trading

Question 40

Why do organisations establish procedures?

What are 5 examples of types of procedures and processes that could be put in place?

Answer 40

= to utilise the resources available to them and implement their policies and strategies effectively and efficiently

• Examples of procedures and processes:
1. Strategic planning
2. Risk management
3. Health and safety
4. Recruitment
5. Business continuity

Question 41

What 3 things should be considered by an organisation when considering the implementation of an appropriate governance framework?

Answer 41

1. The organisation’s purpose = the reason the organisation is in business
2. The assimilation of CG practices
3. What constitutes success for the organisation? = define critical success factors, to measure and revisit governance practices if not met

Question 42

Why is it important for an organisation to know its purpose? (4)

Answer 42

1. Everything stems from it = vision, mission, strategic goals and governance framework
2. Efforts and resources and can be focused effectively
3. Clarity for stakeholder = employees know what they are working towards, investors know what they are investing in etc.
4. Helps cosec set up governance framework of structures, policies and procedures

Question 43

How should a CG framework be implemented through assimilation of CG practices?

What happens if there is an inappropriate infrastructure?

Answer 43

Organisational purpose –> Compliance (structure + policies + procedures + people) –> governance –> culture –> organisation success

1. Based on the organisational purpose, the cosec can advise the board on the appropriate CG requirements for the organisation
2. Compliance answers the ‘what is required’ question = leads to an organisation adopting the appropriate structures, policies and procedures
3. Governance answers the ‘how do we make this effective’ question = Co sec needs to ensure the infrastructure is appropriate for the organisation = people work well together, resources used effectively, and information flows smoothly = decisions made effectively = successful organisation

○ Inappropriate infrastructure = anticipated cultures will not be developed
People will develop their own cultures and if not being managed lead to bad practices = threatens the performance and long-term sustainability of the organisation

Question 44

What is the difference between compliance and governance?

Is compliance bad on its own?

Describe the case of Enron (2001)

Answer 44

• Compliance answers the ‘what is required’ question = leads to an organisation adopting the appropriate structures, policies and procedures
• Governance answers the ‘how do we make this effective’ question = cosec needs to ensure the infrastructure is appropriate for the organisation

○ Compliance on its own, it is a pure box-ticking exercise

Enron (2001) = board approved a Code of Ethics but leadership were not committed so neither were the employees and unethical behaviour became the norm. A whistle-blower disclosed dubious accounting practices and the share price collapsed so Enron went bankrupt. CEOs and CFO were convicted of financial crimes

Question 45

What are 6 benefits of adopting good governance practices?

Answer 45

1. Long-term sustainability
2. Reduced risk of corporate crisis and scandals
3. Effective decision making
4. Improved oversight, monitoring, and evaluation
5. Succession planning
6. Ethical behaviour = an anti-corruption tool

Question 46

What are 3 consequences of weak governance practices?

Answer 46

• Weak governance leads to:
1. Failing companies (Parmalat 2003)

2. Reputational problems (Sports Direct 2017)
3. Excessive regulation = laws in response to scandals

Question 47

What is the difference between governance and management according to Bob Tricker?

Who is responsible for the governance of the organisation?

Who has the power to manage the day-to-day affairs?

What are the 2 ways this delegation happens?

Answer 47

management is about running businesses, governance is about seeing that it is run properly.

• Board is responsible for the governance e.g. setting up the structures, policies and procedures

• Powers to manage the day-to-day affairs = delegated to CEO and executive management team

• 2 ways this happens:
1. Authority to manage is passed to the CEO with the power to sub-delegate = board can hold CEO accountable

2. Authority is passed to several executives depending on the nature of their responsibilities. e.g. CFO given authority for financial affairs