The Corporate Governance framework

Question 1

The Corporate Governance framework?

Answer 1

The frame work consists of:

1. Applicable laws, regulations, standards and codes
2. Organisation’s constitution
3. Structures
4. Policies
5. Procedures

Question 2

Applicable laws, regulations, standards and codes

Answer 2

Applicable laws, regulations, standards and codes
In developing laws, regulations, standards ad codes of best practices relating to corporate governance,
countries have adopted three main approaches:

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

Question 3

Rules based approach?

Answer 3

Rules based approach

Consists of a mandatory set of laws, regulations, standards and codes.

Failure to obey in a rules-based system may result in a company suffering sanctions or fines
Directors of companies in breach of rules may also be fined, imprisoned or disqualified from holding the position of director for a period of time.

Question 4

Critics of rules-based approach argue?

Answer 4

Critics of rules-based approach argue that it only works where:

a. The challenges faced by companies under the purview of the regulation are substantially similar, justifying a common approach to common problems
b. The rules and their enforcement efficiently and effectively direct, modify or preclude the behaviours they are aimed at affecting.

The benefits of such a system is that it sends a message out to owners, potential investors and other stakeholders that the country takes seriously their protection from immoral practices by those managing and overseeing the organisations they are investing in or dealing with.

Question 5

Principles based approach?

Answer 5

Principles based approach

Consists of a voluntary set of best practices usually contained in a code of best practice example: UK Corporate Governance Code 2018. The codes shareholder and potential investors.

Based on the assumption that shareholders will self-regulate the companies within which they invest.
With the codes being voluntary they adopt a ‘comply or explain’ and ‘apply and explain’ approach.

The principles-based approach allows companies and their shareholders to choose which principles and practices of the corporate governance they believe is appropriate to their company at a particular time.

the approach recognises the need for flexibility due to the diversity of circumstances and experiences within companies, and the fact that non compliance may, at that time in a companies lifecycle, be in the organisations best interest.

The approach should restrict the regulatory burden on companies.

For principals-based approach to work institutional shareholders need to take a more active role in the governance of those companies in which they invest.

Those they hold funds on behalf of individuals such as trust funds pension funds etc, they have a responsibility on behalf of those individuals to make sure that the boards of directors of the companies which they invest are made properly accountable and govern their company’s responsibility.

Question 6

Hybrid approach?

Answer 6

Hybrid approach

Many countries are now adopting a hybrid approach combining mandatory laws and regulations with voluntary principles-based codes of best practice. For example, in the UK some elements of corporate governance are contained in:

• Laws: company, insolvency, directors’ disqualification and disclosures of directors renumeration
• Regulations: listing authority rules, such as UK Listing Rules and Disclosure and Transparency

Concepts of

• ‘comply or else’,
• ‘comply or explain’, and
• ‘apply or explain’

Question 7

Comply or else?

Answer 7

Comply or else:

A company’s obligation to abide with a mandatory rules-based system of corporate governance. Failure to abide with the rules, usually results in some form of sanction for the company or directors.

Question 8

Comply or explain?

Answer 8

Comply or explain

Refers to a system where companies are asked to comply with a voluntary principles based code of best practice.

Where the company believes that it is not in its best interest to ‘comply’ with a provision of the code, it is required to ‘explain to shareholders why they have not complied.

Shareholders and shareholder representative bodies are to assess whether the explanation is acceptable of not. The UK Corporate Governance works on a comply or explain regime.

Question 9

Apply or explain?

Answer 9

The term was adopted in the South African King code III for two reasons:

1. The code for the first time, applied to all types of entities regardless of their form of establishment or incorporation. These entities under a ‘comply or explain’ regime would only have had to the option of complying or not. As many of the entities were not listed companies, which the corporate governance practices was originally designed for, it was felt that the regime would put off many entities from adopting a good corporate governance.

Asking them how they were ‘applying’ the principles with the code was a less harsh way of reporting on what they were doing as they did not have to give a yes or no answer, they could tell a story of how corporate governance was being adopted in their organisations.

2. To avoid a ‘mindless response’ to the corporate governance recommendations contained within the code. There was a felling amongst many stakeholders that the ‘comply and explain’ regime was leading to companies adopting a tick-box approach to corporate governance, adopting the provisions without considering whether they were suitable for their companies or not.

This requires organisations to apply the good governance outcomes set out in South African King IV and explain how they have done so.
King 1V says:

‘the required explanation allows stakeholder to make an informed decision as to whether or not the organisation is achieving the…good governance outcomes required by King IV’

Question 10

Reputational management?

Answer 10

Reputational management is now see as important to corporate governance.

Directors now have as part of their statutory duties under CA2006 ‘the desirability of the company maintaining a reputation for high standards of the business conduct’.

Reputation defines an organisation as well as the individuals associated with that organisation.

Good reputation attracts and motivates employees, customers and investors, etc. The destruction of a reputation can lead to the end of the organisation.
Organisations must have structures, policies and processes in place to manage reputational risk.

Question 11

Benefits of effective reputational management:?

Answer 11

The benefits of reputational risk:

1. Improving relations with shareholders
2. Recruiting and retaining the best employees
3. Securing premium prices for products and or services
4. Reducing the potential for crises
5. Reinforcing the organsations credibility and trust for stakeholders
6. Attracting the best business partners, suppliers and customers
7. Reducing barriers to development in new markets

Question 12

Principles of corporate governance?

Answer 12

Principles of corporate governance:

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

Question 13

what does Fairness mean?

Answer 13

Fairness:

Stakeholders should be treated fairly when decisions are made, or actions taken by the organisation.

Organisations should provide corrective actions for violations for example to minority shareholders when they have been unfairly treated.

Policies and procedures in places to ensure that the organisation and the people within it consider key stakeholder views with justice and avoidance of bias and vested interest.

Question 14

What does Responsibility mean?

Answer 14

A person or group of people having authority over something, and who are therefore liable to be held accountable for the exercise or lack of exercise of that authority.

Those given authorities should accept full responsibility for the powers that have been given and the authority that they exercise.

They should understand what their responsibilities are, and should carry them out ethically with honesty, morally, and with integrity.

To avoid potential conflicts of interest that could arise I the exercise or lack of exercise of authority companies should ensure that procedures ad structures are in place so that people know what they are responsible and accountable for.

Question 15

What does Accountability mean?

Answer 15

accountability means:

Relates to a person or group of people in a position of responsibility to be accountable for the exercise of the authority they have been given.

Those providing accountability should provide ‘honest’ information and not manipulate facts or ‘spin’ them to their or their organisations advantage.

Corporate governance best practices require an organisation to set out clearly who is accountable for what and over what time period so that an organisation’s stakeholders are clear whom they should hold responsible for what.

Question 16

What does Transparency mean?

Answer 16

Transparency means?

The ease with which an outsider is able to make a meaningful analysis of a organisation and its actions, both financial and non-financial. It refers to the ‘clarity’ of process in making decisions and carrying out them.

Transparency builds trust between the organisation and its stakeholders and those with whom the organisation interacts with or has an interest in the organisation.

Oranisations should:

• Be open in all of their actions, relationships, processes and decision making – this includes tenders, recruitment and disclosures about business performance and risks and
• Ensure that disclosures are timely and accurate on all material matters, including: the financial situation, performance, ownership and corporate governance.

Those interested in the organisation need to know about it in order to make informed decisions when dealing with it.

Information disclosure needs to be timely to benefit its recipients. It can be delivered through press releases, market releases, annual reports, and an organisations website.

Policies should be in place about disclosure information, what information should be public and what information should be kept secret, who has the authority to disclose, etc.

Question 17

What is the difference between the Enlighted shareholder value and the inclusive stakeholder approaches to corporate governance?

Answer 17

The difference between the Enlighted shareholder value and the inclusive stakeholder approaches are:

Enlightened Shareholder Value approach:

The enlightened shareholder value approach proposes that boards, when considering actions to maximise shareholder value, should look to the long term as well as the short term, and considers the views of and impact on other stakeholders in the company, not just shareholders.

Stakeholder approach:

The views of stakeholders are only considered in the interests of when shareholders choose to do so.
This differs from the stakeholder and stakeholder inclusive approaches where boards balance the conflicting interests of stakeholders in the best interests of the company

Question 18

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

Answer 18

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

Question 19

Which approaches put shareholders first?

Answer 19

The shareholder value and enhanced shareholder value approaches put shareholders first.

Question 20

Distinction between stakeholder (pluralist) & inclusive shareholder theory?

Answer 20

The distinction between stakeholder (pluralist) theory and the inclusive shareholder theory is that:

a. Stakeholder (pluralist) theory has all the interest of the stakeholders
b. Inclusive Shareholder theory has the best interest of the company

Question 21

Challenges of the Enlightened Shareholder value approach?

Answer 21

Challenges in the Enlightened Shareholder Value approach are:

2 main challenges in practice with how the enlightened shareholder value approach has been adopted in the UK.

Although directors now have a duty to consider the interests of a wider stakeholder group there is:

a. no provision in CA2006 to enforce the duty.
b. No guidance as to how directors should take other stakeholder interest into account, particularly conflicting ones.

The companies (miscellaneous reporting) regulations 2018 seeks to address these challenges by providing guidance and reporting requirements on how directors are taking into account their decision making the interests of employees and fostering relationships with customers, suppliers and others.

Question 22

Who are stakeholders?

Answer 22

a. Investors
b. Employees
c. Suppliers
d. Customers
e. Government
f. Regulators
g. Creditors
h. Local communities and general public

Question 23

What do we mean by Agency Costs?

Answer 23

Agency Costs

1. Bonding costs – the costs associated with maintaining the agent principal relationship. i.e.
   a. The costs of monitoring the performance of the board and executive management (includes cost of general meetings, annual reports and financial statements). Although argued that electronic communications have reduced costs
   b. Residual loss i.e. the costs to shareholders associated with actions by the directors and executives which in the long run turns out not to be in the best interest of shareholders i.e. major acquisition or disposal, fraud or foray of new businesses

Applying good corporate governance practices helps to minimise conflict and costs associated with the separation of ownership and control in companies.
It is argued that the agency theory focuses exclusively on maintain value for the shareholders, in return leading to short-termism at the expense of long term performance (shareholders looking for short term gains).

Blair (1995) argues that ‘what is optimal for shareholders is often not optimal for the rest of society. Meaning that policies that generate the most wealth for shareholders may not be policies that generate the greatest total social wealth.

Question 24

What do we mean by Agency conflict?

Answer 24

Agency conflict

Conflict arises in an agent – principal relationship when agents and principals have differing interests. The main conflict between shareholders and managers are:

1. Shareholders usually want to see their income and wealth grow over the long term so will be looking for long term year on year increases in dividends and share prices
2. Directors and managers, on the other hand, will be looking more short term to annual increases in their remuneration and bonuses.

Question 25

Jensen and Meckling identified 4 areas of conflict?

Answer 25

1. Moral Hazard
2. Earning retention
3. Level of effort
4. Time horizon

Question 26

Moral Hazard?

Answer 26

Moral Hazard:

A manager has an interest in receiving benefits from his or her position in the company. These include all the benefit that come from status, such as company car, house or flat, etc.

Manager’s incentive to obtain these benefits is higher when they have no shares or a few shares, in the company. For example, managers may peruse a strategy of growth through acquisitions, in order to gain more power and ‘earn’ higher remuneration, even though takeovers might not be in the best interest of the company and its shareholders.

Question 27

Earning retention?

Answer 27

Earning retention:

The remuneration of directors and senior managers is often related to the size of the company (measured by annual sales revenue and value of assets) rather than its profits. This gives managers an incentive to increase the size of the company, rather than to increase the returns to the company’s shareholders.

Question 28

Level of effort?

Answer 28

Level of effort:

Managers may work less hard then they would if they were the owners of the company. The effect of the this lack of effort could be smaller profits and lower share price.

Question 29

Time horizon?

Answer 29

Time Horizon?

Shareholders are concerned about the long-term financial prospects of their company, because the value of their shares depends on expectations for the long term future. In contrast, managers might only be interested in the short term. This is partly because they might receive annual bonuses based on short term

performance, and partly because they might not expect to be with the company for more than a few years.

Agency theory suggests that companies should use corporate governance practices to avoid or manage these conflicts.