IRM ERM M1U6.1 Corporate governance Flashcards
History of Corporate Governance Code
In the UK, the Financial Reporting Council (FRC) introduced the first corporate governance code in 1992, originally called the Cadbury Code of Best Practice.
The code was later updated by the Turnbull Report in 1999, which focused on helping directors of listed companies establish effective risk management and internal control systems to achieve their objectives.
The most recent update to the Code, in 2018, is known as the UK Corporate Governance Code. It still defines corporate governance as ‘the system by which companies are directed and controlled’.
This Code emphasizes the importance of good corporate governance for long-term sustainable success.
Corporate governance definition
The UK Corporate Governance Institute (2022)
Corporate governance is essentially about how companies are run and for what purpose. It defines who holds power and responsibility, and who makes decisions.
Think of it as a toolbox that helps management and boards tackle the challenges of running a company more effectively.
By ensuring there are proper decision-making processes and controls in place, corporate governance aims to balance the interests of all stakeholders: shareholders, employees, suppliers, customers, and the community.
The main features of the UK Corporate Governance Code are:
Leadership – Every company should be headed by an effective board which is collectively responsible for the long-term success of the company.
Division of Responsibilities – There should be a clear division of responsibilities between the leadership of the board and the executive leadership of the company’s business.
Composition, Succession and Evaluation – The board and its committees should have a combination of skills, experience, and knowledge. Annual evaluation of the board should consider its composition, diversity and how effectively members work together to achieve objectives.
Audit, Risk, and Internal Control – The board should establish procedures to manage risk, oversee the internal control framework, and determine the nature and extent of the principal risks the company is willing to take to achieve its long-term strategic objectives.
Remuneration – Remuneration policies and practices should be designed to support strategy and promote long-term sustainable success. Executive remuneration should be aligned to company purpose and values and be clearly linked to the successful delivery of the company’s long-term strategy.
Section 4 of the Code. Principle O:
Section 4 of the Code are the most relevant from a risk management perspective, notably Principle O:
“The board should establish procedures to manage risk, oversee the internal control framework, and determine the nature and extent of the principal risks the company is willing to take in order to achieve its long-term objectives”.
The Code defines principal risks noting that they ‘should include, but are not necessarily limited to, those that could result in events or circumstances that might threaten the company’s business model, future performance, solvency or liquidity and reputation’.
Materiality
it is difficult to define the term materiality, because it is used in different contexts and the interpretation of the term differs in different parts of the world.
Fundamentally, something is financially material if it has the potential to affect the bottom line in a meaningful manner
2018, FRC ‘The Wates Corporate Governance Principles for Large Private Companies’.
These principles aim to enhance transparency and accountability in organizational actions, particularly concerning their impact on stakeholders such as the workforce, suppliers, and customers.
The FRC reviewed the application of the Wates Principles in early 2022, stating that their analysis “showed that companies are grasping the spirit of the Wates Corporate Governance Principles. However, overall, there is room for improvement in reporting.”
Two main approaches to the enforcement of governance
Comply or explain / principles based
Comply and sign / prescriptive based / Fully comply - exceptions are not acceptable
Corporate governance requirements that are ‘wanted’ are usually referred as principles based. In this case, organisations are expected to comply with the principles set out, but it is not mandatory to do so. However, they do not comply with any of the principles, they must explain why. Principles based corporate governance is also referred to as ‘comply or explain’.
Corporate governance requirements that are ‘compulsory’ are usually referred to as prescriptive based. In this case, organisation must comply with the principles set out, and there are penalties for non-compliance. Prescriptive based corporate governance is also referred to as ‘comply and sign’.
The approach to corporate governance is typically set at a national level. For example, in the UK a principles-based approach to corporate governance is used and is supported by the relevant rules and regulations, whereas in the US (United States), a prescriptive based approach is used.
Subcommittees of the board
Audit
Risk
Remuneration
Disclosure
The principles-based approach
Compliance with the code is not legally mandated, but companies must disclose any non-compliance and reasons for it in their annual report and accounts.
The principles-based approach encourages organizations to tailor their application of requirements to their specific circumstances, rather than merely checking boxes.
Companies should avoid a ‘tick-box’ approach and operate under the ‘comply or explain’ or ‘principle-based’ regime.
The prescriptive-based approach
The prescriptive-based approach is legally binding, with penalties like fines or imprisonment for non-compliance, especially for directors of publicly listed organizations.
This approach often emerges in response to major corporate failures, as seen with Sarbanes-Oxley in the US after the Enron and WorldCom scandals.
Prescriptive governance offers clarity and uniformity in compliance, applying one set of rules to all listed organizations.
Penalties for non-compliance incentivize adherence to regulations, but it may lead to a ‘box-ticking’ mentality rather than genuine improvement in governance and reportin
Aim of corporate governance
Good governance improves decision-making quality, fosters ethical practices, and enhances long-term value creation for sustainable businesses.
At a corporate level, governance involves setting and pursuing objectives within the social, regulatory, and market context.
Aimed at ensuring companies achieve their objectives while maintaining stakeholders’ confidence.
