General Principles of Corporate Governance

Question 1

Why is corporate governance more significant for large companies than for small private companies?

Answer 1

The separation of ownership from management is much wider in larger companies than smaller companies.

Question 2

What is the difference between governance and management?

Answer 2

Powers to manage the company are given to the board of directors (mostly to CEO/MD then delegated further to exec directors and exec managers).

BOD should retain some powers/responsibilities with certain matters being reserved for board decision rather than delegated to management.

BOD responsible for performance of management team BUT not responsible for day-to-day management.

BOD responsible for governing the company. Responsibilities for governance go beyond management.

Question 3

CASE STUDY: Maxwell Corporation

Answer 3

Robert Maxwell - Chairman and CEO. Position of dominant power on BOD.

Domineering personality mixed with a weak BOD. Able to run his companies in whatever way he liked. No clear distinction between privately-owned companies and the public Maxwell Corporation.

Early 90’s companies hit serious financial difficulties. Following his death in 1991 it emerged he had accumulated debts of £4BN and an unauthorised hole of over £400M existed in the pension fund of Mirror Group Newspapers.

Question 4

CASE STUDY: 7 Main Enron Issues

Answer 4

1. Misleading transactions in accounts with approval of executives (recording expenses as assets);
2. Audit committee approved fraudulent accounts;
3. Auditors (Arthur Andersen) and others employed by Enron profited from transactions with Enron;
4. Ineffective board, lots of NEDs, dominated by majority executives;
5. Board ignored whistleblowers;
6. Inappropriate remuneration and rewards for directors; and
7. Unethical business practices.

Question 5

6 examples of bad corporate governance

Answer 5

1. BOD that fails to perform its duties properly (dominated by 1 or more individuals or fails to carry out tasks);
2. Misleading financial reporting to shareholders/investors;
3. Poor relationship between board and main shareholders;
4. Ineffective systems of risk management (exposure to errors and fraud due to inadequate internal controls);
5. Inappropriate remuneration and reward systems for directors and senior execs;
6. Unethical business practices.

Question 6

CASE STUDY: Naibu (Chinese Sportswear)

Answer 6

Listed its shares on London’s AIM in 2012.

October 2014 - restated details in its 2013 FS revising reported profits down due to typographical error (an expense item for factory machinery had been stated as 2.6M renminbi rather than 26M renminbi).

Share price fell from 124p per share to 11.5p per share.

Shares suspended in January 2015 pending clarification of its financial position.

UK NEDs admitted they had lost contact with Chairman and CEO (thought to be somewhere in China) and were therefore not in a position to assess company’s financial performance.

Raised serious questions re corporate governance standards - behaviour of Chairman and CEO, failings by NEDs and company’s auditors (Clark Crowe Whitehall).

Questions raised about the reputation of the AIM market and whether it might deter investors from investing in companies with an AIM listing.

Question 7

Influence of “major shareholders”

Answer 7

In the UK, most companies do not have a very large influential shareholder.

A major shareholder in a listed company is likely to hold less than 5% of the shares. Individually they can meet with the company to express views but to have significant influence they must act collectively and express shared views to the BOD.

In other countries, majority shareholders in listed companies are not uncommon.

Question 8

What are agency costs and what are the 3 main elements of agency cost?

Answer 8

Costs for having an agent making decisions on behalf of a principal.

1. COSTS OF MONITORING - e.g. requirement for directors to produce annual report and accounts to shareholders.
2. BONDING COSTS - e.g. incentives to directors/managers to act in best interests of shareholders (remuneration package).
3. RESIDUAL LOSS - e.g. loss to shareholders when managers take decisions not in shareholders’ best interests but themselves.

Question 9

What are the 4 agency conflicts?

Answer 9

1. MORAL HAZARD - manager seeks benefits from position. Status, company car, sports events. Incentive is higher when they have no or few shares. Growth through acquisitions/takeovers to benefit themselves.
2. LEVEL OF EFFORT - low effort if no or few shares held. Lack of effort may lead to lower share price/profits.
3. EARNINGS RETENTION - director/manager remuneration often linked to company size not profits. Incentive to reinvest profits in order to expand rather than pay out dividends. Over-priced takeover bids.
4. TIME HORIZON - shareholders long-term (share price based on long-term expectations), managers short-term (annual bonus, short contract).

Question 10

How are agency costs minimised?

Answer 10

Improving the monitoring of management and/or providing management with incentives to align their interests closer to those of the shareholders.

Remuneration packages based on profits (lower profits, lower pay) and long-term interests (share option schemes)

Question 11

What are the main differences between the shareholder and pluralist approaches to corporate governance?

Answer 11

Shareholder Value Approach - well-established, supported by company law, BOD to govern company in best interests of its shareholders. Directors accountable to shareholders who have power to remove them.

Pluralist Approach - directors required to balance shareholder interests with the interests of other stakeholders committed to the company.
Achieve balance between economic and social goals and individual & communal goals. Stakeholder rights not reinforced to any great extent by company law.

Question 12

According to King IV Code, why should governing bodies adopt a stakeholder-inclusive approach to corporate governance?

Answer 12

Governing body gives parity to all sources of value creation (not just financial capital).

Balances the needs, interests and expectations of stakeholders over time by way of prioritising and in some cases trading interests. Decisions of how to do this are made on a case-by-case basis but always with best interests of the organisation over the longer term.

Question 13

In what ways do personal ethics differ from corporate ethics?

Answer 13

PERSONAL - closely associated with morality. Right vs wrong. Laws may establish this to some extent. Standard of behaviors are determined by social attitudes of morality and good conduct more than rules.

Associated with integrity and transparency.

CORPORATE - standards of business behaviors by companies. Employees’ actions strongly influenced by employer’s expectations. Can affect the company’s dealings with stakeholders.

Connected closely with approach to corporate governance adopted by the company.

Question 14

What are typical contents of a code of corporate ethics?

Answer 14

No rules, however, Consultative Committee of Accounting Bodies (CCAB) guidance suggests the following may be relevant:

Mission statement;
Statement of high-level values;
Clear ethical principles;
Internal policies (linked to values and ethical principles where appropriate); and
Implications of breaches of the code.

Reference to guidance to aid understanding and compliance.

Question 15

CASE STUDY: Hewlett-Packard (HP)

Answer 15

2011 - paid $11BN to acquire UK software company Autonomy. Following the acquisition, HP wrote down the value of the acquisition by half to $5.5BN.

HP claimed misleading reporting by Autonomy in its 2010 FS as the reason. This was denied by Autonomy’s former directors.

2014 - with the help of its US auditors, EY, HP filed re-stated financial results for Autonomy for 2010 and cut its profits by 81%.

Autonomy’s former UK auditors denied that there was anything wrong with the original figures in the 2010 FS.

This argument raised questions fundamental to good governance. Were the FS true and fair and transparent? Were EY independent or effective?

Question 16

CASE STUDY: Tesco Plc

Answer 16

2014 - admitted to overstating its half-year profits and questions were raised about the composition of the company’s BOD and the use of inappropriate accounting policies.

Tesco’s BOD had no NEDs with retail experience until the appointment of 2 new NEDs in October 2014. Suggested that this weakness in retail knowledge meant that the board lacked the necessary expertise to raise appropriate questions with execs.

Tesco’s 1st half figures for 2014 prematurely recognised income and anticipated cost savings. The issue came to light following an employee questioning the accounting treatment used. The company estimated the overstatement at £250M.

Tesco then reported that profits had been overstated by £263M and that this was a result of incorrect recognition of income over a number of years.

The Chairman, Sir Richard Broadbent, said he would step down as part of this announcement.

At the end of October 2014, the UK’s Serious Fraud Office accounted the launch of a criminal investigation into the alleged accounting irregularities at Tesco, which is continuing.

In 2016, 3 former execs were charged by the SFO with Fraud and False Accounting. The case is ongoing.

Question 17

List 6 key issues in corporate governance.

Answer 17

1. Financial reporting and auditors;
2. Remuneration of directors and senior execs;
3. Company-stakeholder relations;
4. Risk-taking and management of risk;
5. Effective communication between the directors and shareholders; and
6. Ethical conduct and CSR.

Question 18

What are the arguments for and against the application of corporate governance codes of practice to large companies?

Answer 18

FOR: eliminate the risk of misleading/false financial reporting. Prevent companies from being dominated by self-seeking CEOs or Chairmen.

Protect investors through preventing risks of corporate scandals and promoting fairness, accountability, responsibility and transparency.

Argument that companies that comply with best practice in corporate governance are more likely to achieve success.

Leads to strong reputation and therefore less exposed to reputation risk.

Encourages investors to hold shares for the longer term rather than short-term profits.

AGAINST: for many companies/institutional investors, compliance with a code is a box-ticking exercise (i.e. adopt procedures/systems without considering potential benefits).

Far too extensive and burdensome for their potential benefits.

Costly in terms of time and money in achieving compliance.

Companies that are obliged to comply with corporate governance regulations or best practice are at a competitive disadvantage to rival companies from countries where the regulation is weaker.

Connection between good governance and good financial results has not been proven or demonstrated.

Question 19

1. What is the relevance of the law on insider dealing to corporate governance?
2. What is the relevance of money laundering to good corporate governance practice?

Answer 19

1. Often carried out by a director or professional adviser of a company.

It is a criminal offence. (UK - Criminal Justice Act 1993).

2. Companies often used for the purpose of money laundering. It is a criminal offence of most countries. Owners/directors of the companies are are often involved in the money laundering themselves.

Question 20

Identify 2 of the main requirements of SOX 2002 in relation to corporate governance in corporations registered with the SEC in the US.

Answer 20

1. Publish an internal audit report with the annual financial statements.
2. Legal protection for whistleblowers

Question 21

What is the difference between principles and provisions in a code of corporate governance?

Answer 21

Consist of main principles which have supporting provisions to indicate how a principle should be applied in practice.

Listed companies MUST apply the main principles of governance.

Listed companies are NOT required to comply with provisions, however, they must explain their non-compliance.

The Listing Rules in the UK require listed companies with a premium listing to apply all the main principles of the UK Code, without exception and report to the shareholders (in Annual Report) with how they have done so.

Question 22

In the UK, how does the ‘comply or explain’ rule apply to foreign companies with a premium listing?

Answer 22

Required to disclose in their annual report and accounts whether they comply with the corporate governance code of their country of incorporation, and the significant ways in which their corporate governance practices differ from the provisions in the UK Corporate Governance Code.

Question 23

Explain the disadvantages of rules-based approach to corporate governance, compared with a principles-based approach.

Answer 23

1. Rules-Based: Difficult to devise a set of rules that should apply to all companies in all circumstances VS. Principles-Based: Allows them to breach the guidelines if it seems appropriate and sensible.
2. Voluntary code of best practice can be targeted at largest co’s and smaller co’s able to choose whether they want to model their own governance systems on PARTS of the code for listed co’s.
3. Excessive regulation may DETER companies from becoming listed. Particularly if the rules for listed co’s are stricter than those of private co’s.

Question 24

Which body is responsible for the UK Corporate Governance Code?

Answer 24

Financial Reporting Council

Question 25

5 Sections of the UK Corporate Governance Code 2018

Answer 25

1. Board Leadership and Company Purpose
2. Division of Responsibilities
3. Composition, Succession and Evaluation
4. Audit, Risk and Internal Control
5. Remuneration

Question 26

7 Principles of the UK Stewardship Code

Answer 26

1. Publicly disclose policy on how they will discharge their stewardship responsibilities;
2. Robust policy on managing conflicts of interest in relation to stewardship which should be publicly disclosed;
3. Monitor their investee companies;
4. Establish clear guidelines on when and how they will escalate their stewardship activities;
5. Should be willing to act collectively with other investors where appropriate;
6. Should have a clear policy on voting and disclosure of voting activity;
7. Should report periodically on their stewardship and voting activities.

Question 27

What are the 6 aspects of corporate governance covered by the G20/OECD Principles?

Answer 27

1. Ensuring the basis for an effective corporate governance framework;
2. The right and equitable treatment of shareholders and key ownership functions;
3. Institutional investors, stock markets and other intermediaries;
4. The role of stakeholders in corporate governance;
5. Disclosure and transparency;
6. The responsibilities of the board.

Question 28

List 6 rights of shareholders in the G20/OECD Principles

Answer 28

1. Secure methods of ownership registration;
2. Transfer shares;
3. Obtain relevant info about the company on a timely and regular basis;
4. Participate and vote in general meetings of the company;
5. Elect and remove directors;
6. Share in the profits of the company.

Question 29

What approach and framework do the G20/OECD Principles set out for institutional investors?

Answer 29

Disclose their corporate governance and voting policies with respect to their investments;
Votes should be cast by custodians or nominees in line with the directions of the beneficial owner of the shares;
Disclose how they manage material conflicts of interest that may affect the exercise of key ownership rights re their investments;
Framework should require that proxy advisors and analysts disclose and minimise conflicts of interest that might compromise the integrity or their advice/analysis;
Insider trading and market manipulation should be prohibited with applicable rules enforced;
Companies listed in a jurisdiction other than of their incorporation, applicable corporate governance laws/regulations should be clearly disclosed;
Stock markets should provide fair and efficient price discovery as a means to help promote effective corporate governance.

Question 30

What do the G20/OECD Principles state about the role of stakeholders in corporate governance?

Answer 30

Framework should recognize the rights of stakeholders established by law or through mutual agreements and should encourage active co-operation between corporations and stakeholders in creating wealth, jobs and the sustainability of financially sound enterprises.

Mechanisms for employee participation should be allowed to develop. Access to relevant, sufficient and reliable info on a timely/regular basis.

Freely communicate concerns about illegal or unethical practices to the board and to the competent public authorities and their rights should not be compromised for doing this.

Corporate governance should be complimented by an effective, efficient insolvency framework and the effective enforcement of creditors’ rights.

Question 31

According to the G20/OECD Principles, what are the benefits of a strong disclosure regime?

Answer 31

It is central to shareholders’ ability to exercise their shareholder rights on an informed basis.

Can be a powerful took for influencing the behaviour of companies and for protecting investors.

Can help attract capital and maintain confidence in the capital markets.

Multinational companies - helps improve the understanding of the local populations about the company, activities and policies with respect to environmental and ethical standards and relationships between the company and communities it operates in.

Question 32

CASE STUDY: Sema Group Plc (LHS Acquisition)

Answer 32

Sema - IT Services Company (listed on LSE and Paris SE)

March 200 - acquired LHS (Atlanta-based telecoms software company) for £3BN which represented a 75% premium to its current share price. Founder and major shareholder of LHS, Herr L, became a NED of Sema. Strategic move for Sema to enter into the US market.

Investors became uneasy when Sema’s interim results were announced in September 2000 which had little to say about the acquisition or US expansion plans. Analysts regarded the results to be window dressed (it had included a £14.3M refund from its Swedish pension fund in its profits). Without this one-off operational item, profits would have been much lower.

Share price fell by 17% the week that the results were announced.

Herr L had started selling his shares in Sema the week leading up to the announcement of the interim results (1.8M for £24M). 3 transactions through a German bank.

These sale transactions were in breach of the Model Code requirement for UK listed companies - directors should not deal in the shares of their company in a closed period i.e. 2 months before announcement of company results. Herr L then sold a further 800K shares for £9M on the day of the results.

Sema’s Co Sec was reported to have said that he learned of the sales on 11 October after being contacted by an investment bank.

As part of the acquisition, Herr L was to hold onto his LHS shares until after the acquisition with an option to exchange them for Sema shares from January 2000. The investment bank informed the Co Sec that Herr L had exercised his option over part of his stake, ahead of schedule and without notifying anyone at Sema.

The Co Sec tried to obtain details of the share deals by Herr L (transaction dates, shares sold, price received) in order to make an announcement to the stock market. The Co Sec found Herr L to be obstructive and unhelpful taking 2 weeks to provide the info. Sema subsequently informed the UK FSA.

Herr L stated that he made the transactions in all honesty, misunderstanding the stock exchange rules. Investors were skeptical due to LHS already being a listed entity on the NASDAQ so directors should have been familiar with the restrictions on director share dealings.

A further problem to Sema was the poor trading performance of LHS following the acquisition (sales slumped from £42M in Q1 to £36M in Q2 to £24M in Q3). Profits warning issued on 25 November (market suspected that Sema were aware of the problem long before the issuance).

Share price fell 44% on the day of the profits warning and a further 10% the following Monday. Herr L resigned on 29 November.

Question 33

List 15 corporate governance responsibilities that could be given to a company secretary.

Answer 33

1. Establishing a formal schedule of matters reserved for decision making by the board;
2. Establishing a formal division of responsibilities between the chairman and CEO;
3. Scheduling board meetings and providing high quality information in a timely manner to enable the board to discharge its duties;
4. Ensuring appropriate insurance cover is arranged in respect of any legal action against directors (D+O);
5. Ensuring board committees are constituted in compliance with the UK Code and have the appropriate balance of skills, experience, independence and knowledge of the company;
6. Planning and organising director induction programmes;
7. Planning and organising director training and development programmes;
8. Arranging for major shareholders to be offered the opportunity to meet new directors;
9. Facilitating good info flows between board members, committees and senior management as well as NEDs;
10. Establishing procedures to allow directors to take independent professional advice at the company’s expense if required;
11. Develop proactive relationship with board members, providing a source of info and advice;
12. Act as primary contact for NEDs;
13. Supporting the process for the board to undertake formal annual evaluation of its own performance and that of its committees and individuals;
14. Assisting the board in the preparation of the annual review of the effectiveness of the risk management and internal controls;
15. Ensuring board keeps in touch with shareholder opinion on a continuing basis.

Question 34

What is the meaning of ‘conscience of the company’?

Answer 34

Acting in accordance with conscience means acting in a way that seems ethical.

The Co Sec should speak out against bad governance and unethical practice and remind the board and senior execs of the appropriate course of conduct and the principles of good governance that they should apply.

The Co Sec must be independent-minded and should not be under the influence of any other individual (i.e. Chairman/CEO).

Question 35

Why is it important that a company secretary should be independent and how can this independence be protected?

Answer 35

ICSA Guidance Note “reporting lines of the company secretary” - BOD have the right to expect their Co Sec to give impartial advice and act in best interests of the company. BOD should ensure that Co Sec is in a position to do so by ensuring that they are not subject to undue influence of 1 or more of the BOD. The establishment of appropriate reporting lines for the Co Sec will normally be a crucial factor in establishing that protection.

Co Sec should, though Chairman, be accountable to the BOD as a whole;

If Co Sec has additional executive responsibilities to their core role, they should report to the CEO or appropriate exec director on such matters; and

The Co Sec’s remuneration should be set (or at least noted) by the board as a whole, or by the remuneration committee of the board on the recommendation of the Chairman or CEO.

The UK Code: The appointment/removal of the Co Sec should be a matter for the board as a whole.

King IV: board should appoint/remove the Co Sec and empower the individual to enable them to fulfill their duties properly. The Co Sec should have an ‘arms length relationship’ with the board, emphasising the requirement for independence.

Question 36

Why is it inappropriate to give corporate governance responsibilities to an individual who acts as the company’s in-house lawyer?

Answer 36

The independence is a critical aspect of the corporate governance role of the Co Sec.

In their legal work, an in-house lawyer must at times consider the specific interests of the company and individual directors and may be required to advise them on the most appropriate way of dealing with legal issues that arise. In performing this role, the lawyer will often have to take sides to represent a particular interest. This would be inconsistent with the requirement to remain independent when advising on governance issues.

A trained/qualified individual as a professional lawyer could be a suitable candidate to act as a Co Sec or take on corporate governance responsibilities within the company, but only if the following are applied:

1. The qualified lawyer does no legal work for the company; and
2. The independence of the individual can be protected in the same way as for a company secretary, with the board as a whole responsible for appointing and dismissing them and deciding their remuneration.