KCP Revision - SLIDE DECK 1 - Definition and Issues Flashcards
What is the definition of Corporate Governance?
There is no one definition of Corporate Governance.
The definitions of Corporate Governance have evolved over time in line with emergent themes and principle.
This started with the Cadbury Committee in 1992, at the point when Corporate Governance standards were introduced. ‘The system by which companies are directed and controlled’ The Cadbury Committee 1992
Through time, these have evolved to include stakeholders in addition to objectives.
In 2004, the OECD defined Corporate Governance as ‘a set of relationships between a company’s management, its board, its shareholders and other stakeholders…. Also provides the structure through which objectives of the company are set, and the means of attaining those objectives and monitoring performance’
This has further evolved to include trust, transparency, accountability, integrity, ethical culture, values, whilst re iterating the relationship with wider range of stakeholders.
The G20 / OECD in 2015 issued a new set of principles which stated ‘Corporate Governance was to help build an environment of trust, transparency and accountability necessary for fostering long-term investment, financial stability and business integrity, thereby supporting stronger growth and more inclusive societies’.
The UK Corporate Governance Code issued in2016 and revised in 2018 states ‘Corporate governance is therefore about what the board of a company does and how it sets the values of the company (UK Corporate Governance Code 2016)
‘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.’ (UK Corporate Governance Code 2018)
What are two main theories of Corporate Governance and give a brief overview of both.
- SHAREholder primacy theory
- STAKEholder theory
- Shareholder primacy theory.
Focuses on maximising value to shareholders before considering other stakeholders.
“The business of business is business.”
Based on doctrine of Milton Friedman whose theory of business ethics states that “an entity’s greatest responsibility lies in the satisfaction of the shareholders.” - Stakeholder theory
Believes shareholders don’t actually own companies - company is separate legal entity and should conform to societal norms for the country in which they operate and how their behaviour impacts others.
Criticism of shareholder primacy since 2008 based on short termism, executive behaviour, risk.
Related to shareholder primacy theory is the AGENCY theory, Summarise this.
Developed in 1932 by Berle and Means, agency theory sets out how the agent - principal relationship exists and explains the concepts of separation between ownership and control.
The theory explains the concept that an agent represents the principal in a particular transaction and is expected to represent the best interests of the principal above their own.
Further work to understand how the relationship between agents and principals (in particular agency conflict) was carried out by Jensen and Meckling in 1976.
Their agency conflict work examined the manager’s interest is in receiving benefits from their position, which will be higher when they have no stake in ownership. This may drive behaviours not in the best interest of the owners. E.g short-termism
Related to shareholder primacy theory is the AGENCY theory, Summarise this.
Developed in 1932 by Berle and Means, agency theory sets out how the agent - principal relationship exists and explains the concepts of separation between ownership and control.
The theory explains the concept that an agent represents the principal in a particular transaction and is expected to represent the best interests of the principal above their own.
Further work to understand how the relationship between agents and principals (in particular agency conflict) was carried out by Jensen and Meckling in 1976.
Their agency conflict work examined the manager’s interest is in receiving benefits from their position, which will be higher when they have no stake in ownership. This may drive behaviours not in the best interest of the owners. E.g. short-termism
Jensen and Meckling identified 4 areas of conflict in the agency conflict theory. Summarise these.
- Moral Hazard
A manager’s incentive to obtain benefits is higher when they have no shares on the company and may act in a way in order to gain more power and earn a high remuneration through take overs and acquisitions even though it may not be in the best interest of the company. - Lack of Effort
Managers could be less hard working than they would be if they owned the company therefore lack of effort = smaller profits = lower share price. - Earnings Retention
As earnings are often related to the size of the company, there is the incentive to increase the size of the company rather than increase returns to company’s shareholders. Management may also want to reinvest profits to grow company rather than pay out dividends to shareholders. - Time Horizon
Managers may only be interested in short term performance of the company vs. long term growth of shareholders. This could be because managers receive short term incentives and bonus based on performance and may not stay with the company for more than a few years.
SOLUTION = Corporate Governance practices can be used to align interests of shareholders and management.
PREVIOUS EXAM QUESTION - JUNE 2022
The agency theory of corporate governance states that the agent and principal may have conflicting interests. Explain these conflicting interests, using examples.
(5 marks)
Developed in 1932 by Berle and Means, agency theory sets out how the agent - principal relationship exists and explains the concepts of separation between ownership and control. The theory explains the concept that an agent represents the principal in a particular transaction and is expected to represent the best interests of the principal above their own.
Further work to understand how the relationship between agents and principals (in particular agency conflict) was carried out by Jensen and Meckling in 1976.
Jensen and Meckling identified 4 areas of conflict in the agency conflict theory.
- Moral Hazard
A manager’s incentive to obtain BENEFITS is higher when they have no shares on the company and may act in a way in order to gain more power and earn a high remuneration through take overs and acquisitions even though it may not be in the best interest of the company. - Lack of Effort
Managers could be less hard working than they would be if they owned the company therefore lack of effort = smaller profits = lower share price. - Earnings Retention
As earnings are often related to the size of the company, there is the incentive to increase the size of the company rather than increase returns to company’s shareholders. Management may also want to reinvest profits to grow company rather than pay out dividends to shareholders. - Time Horizon
Managers may only be interested in short term performance of the company vs. long term growth of shareholders. This could be because managers receive short term incentives and bonus based on performance and may not stay with the company for more than a few years.
SOLUTION = Corporate Governance practices can be used to align interests of shareholders and management.
Shareholder and Stakeholder theories are broken down into a further 4 approaches. Summarise these.
- Shareholder Value Approach
The board of directors should govern their company in the best interest of its owners - Enlightened Shareholder Approach
In considering actions to maximise shareholder value, the board should look to the long term as well as the short term and consider the views of and impact on other stakeholders in the company. The views of other stakeholders are, however, only considered in so far as it would be in the interests of shareholders to do so. - Inclusive Stakeholder Approach
The board should consider the legitimate interests and expectations of all key stakeholders on the basis that this is in the best interests of the company. - Stakeholder Approach (pluralist approach)
Should have regard to the views of all stakeholders. When taking decisions… should balance the interests of all stakeholders.
Why has the Enlightened Shareholder Approach came about and what should a director consider when applying this approach?
The Enlightened Shareholder Approach
S172 CA2006 imposed a statutory duty on directors to ‘promote the success of the company for the benefit of its members as a whole’, and in doing so have regard to:
the likely consequences of any decision in the long term;
the interests of the company’s employees;
the need to foster the company’s business relationships with suppliers, customers and others;
the impact of the company’s operations on the community and the environment;
the desirability of the company maintaining a reputation for high standards of business conduct; and
the need to act fairly as between members of the company.
Summarise Stakeholder Capitalism.
Stakeholder capitalism seeks to create SHAREHOLDER RETURNS by CREATING VALUE FOR SOCIETY AS A WHOLE i.e. customers, employees, suppliers, communities, and the environment. Aligning interests to grow the pie for the benefit of all.
The view that the most important assets in an organisation are not tangible but rather are intangible i.e. access to talent, intellectual property, reputation.
Larry Fink, the Chairman and CEO of Blackrock, the world’s largest asset manager, in January 2019 sent a letter to the CEO’s of companies in the Blackrock portfolio requesting that they focus on SOCIETAL PURPOSE alongside their visions, missions and reasons for being in business.
This was followed in August 2019 with the US Business Roundtable which includes 200 of America’s most influential business leaders committing to lead their companies for the benefit of all stakeholders.
The concept of Stakeholder Capitalism was introduced globally at the WEF Davos 2020 although not everyone is on board as various forms of corporate governance are adopted in various countries.
PREVIOUS EXAM QUESTION
Explain how the enlightened shareholder value approach, in section 172 of the Companies Act 2006, attempts to reconcile the shareholder value and stakeholder approaches to corporate governance.
(5 marks)
The Shareholder Value Approach provides that the board of directors should govern their company in the best interest of its owners.
In contrast, the Stakeholder Approach provides that directors should have regard to the views of all stakeholders. When taking decisions they should balance the interests of all stakeholders.
S172 CA2006 imposed a STAUTORY DUTY on directors to ‘promote the success of the company for the benefit of its members as a whole’, and in doing so have regard to:
the likely consequences of any decision in the long term;
the interests of the company’s employees;
the need to foster the company’s business relationships with suppliers, customers and others;
the impact of the company’s operations on the community and the environment;
the desirability of the company maintaining a reputation for high standards of business conduct; and
the need to act fairly as between members of the company.
Therefore, S172 of the companies act, provides an Enlightened Shareholder Approach by COMBINING the shareholder value approach and the stakeholder approach.
It CONSIDERS actions to maximise shareholder value, by looking to the long term as well as the short term and considering the views of and impact on other stakeholders in the company. HOWEVER, the views of other stakeholders are, only considered in so far as it would be in the interests of shareholders to do so.
WHAT are the 4 PRINCIPLES of good corporate governance and summarise these.
REMEMBER RAFT.
- Responsibility
Those given authorities should accept full responsibility for the powers that they have been given and the authority they exercise. They should carry them out ethically with honesty, probity and integrity.
(NB goes hand in hand with accountability) - Accountability
This refers to the requirement for a person or group of people in a position of responsibility to account for the exercise (or not) of the authority they have been given. They should provide ‘honest’ information and not manipulate or spin facts. - Fairness
This refers to the principle that all key stakeholders should be treated fairly when decisions are made or actions taken by the organisation. - Transparency
This refers to the ease with which an outsider is able to make a meaningful analysis of an organisation and its actions.
Give examples of HOW good corporate governance can be put in place for each of the 4 principals.
- Responsibility
Set out procedures and structures so people know what they are responsible for and liable to account for. this will minimise confusion, avoid potential conflicts of interest and arise in the exercise or lack of authority,
Procedures for mismanagement of authority should also be established and penalised where necessary, - Accountability
Set of procedures and structures around who is accountable for what and over what time period so that stakeholders are clear who is responsible.
Ranges and becomes more complex as organisation size grows. - Fairness
Policies, procedures and structures should be in place to ensure that organisations consider key stakeholders and avoid bias or vested interests.
Fair practices should be applied in spirit and not just in letter of the law (think of child labour and directors bonuses) - Transparency
Be open in actions, processes and decision making. Inc. tenders, recruitment and disclosures etc.
Ensure that information is shared which is accurate and timely.
Ensure that there are policies in place around the disclosure of information - what should be made public to who and when.
PREVIOUS EXAM QUESTION
Accountability and transparency are core principles of corporate governance. Explain why transparency is one of the core principles and how it can aid accountability.’
(5 marks)
Transparency is a core principle of corporate governance because:
- Transparency is needed in order for SHAREHOLDERS to be able to ASSESS a
company’s Board and how it operates. - Transparency and openness helps to CREATE TRUST between the company
and its shareholders and other stakeholders. - Transparency can DRIVE BETTER BEHAVIOURS by companies because they are
being judged by the behaviours that are disclosed. - TIMELY AND ACCURATE DISCLOSURE is needed in order for a fair market to
operate in the securities of traded companies.
Transparency can aid accountability because:
- The provision of information can help stakeholders to hold companies to
account. - It requires companies to set out who is accountable for what so that
stakeholders are clear who should be held responsible.
Why should directors consider reputational management as an important issue within corporate governance?
Experts now see reputational management as an important issue within corporate governance.
The CA2006, under s172 statutory duties, includes ‘The desirability of the company for maintaining a reputation for high standards of business conduct’.
Reputation defines an organisation as well as the individuals associated with that organisation. When this goes wrong, it can lead to the destruction of an organisation and end of the company. Example - Arthur Andersen was destroyed in 2002 by the damage of its involvement ion the Enron affair.
Some benefits of effective reputation management are:
1. Improving relations with shareholders
2. Creating a more favourable environment for investment and access to capital
3. Recruiting and retaining the best employees
4. Attracting the best business partners, suppliers and customers;
5. Reducing barriers to development in new markets
6. Securing premium prices for products and/or services;
7. Minimising threats of litigation and of more stringent regulation
8. Reducing the potential for crises
9. Reinforcing the organisation’s credibility and trust for stakeholders.
What should be included in a company framework for Corporate Governance?
REMEMBER SOAPP
- Structures
- Organisation’s constitution
- Applicable laws, regulations, standards and codes
- Policies
- Procedures
