ACCA P1 Governance, Risk and Ethics - 2011 - Study text - Emile Woolf Publishing
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Paper P1: Governance, risk and ethics
124 © Emile Woolf Publishing Limited
Three-year notice periods are now rare in the UK. Pressure was exerted on listed
companies by the UK codes of corporate governance. The current UK Combined
Code specifies that notice periods should be set at one year or less.
Even so, when a director is dismissed the payment on termination of employment
can be very high, since it might include one year’s base salary, pension entitlements,
shares and bonuses that the director might be entitled to under the terms of his
various incentive schemes.
Compensation on loss of office
In the UK, institutional investors have stated their expectation that companies will
seek limit payments of compensation on loss of office of a director or senior
executive. Since a director is protected legally by the terms of his (or her) service
contract, it is therefore essential that the remuneration committee should negotiate
contract terms with a new director that will limit the potential size of compensation
payments.
The UK Combined Code states that when a remuneration committee negotiates the
terms of a service contract with a new director, it should consider what the
compensation payments might be in the event that the individual is dismissed. The
committee should seek to avoid agreeing terms of employment that would reward a
director for poor performance and dismissal. The committee should therefore take a
‘robust line on reducing compensation to reflect departing directors’ obligations to
mitigate loss’.
A director dismissed by a company should be required, by the terms of his service
contract, to try to mitigate the losses he suffers as a result of the dismissal. He can do
this, for example, by finding new employment as soon as possible. A service
contract may therefore provide for the total compensation on loss of office to be
payable in several stages (instead of in full at the time of dismissal) and for these
payments to be stopped if the individual finds a new job.
4.3 Ethical issues about remuneration
There is an ethical aspect to directors’ remuneration, which has attracted some
publicity as the rate of increase in directors’ pay has been much greater than the rate
of increase in the pay of other employees.
A Survey of Directors’ Compensation 2005 in the UK by KPMG found that
bonus payments to senior executives had risen at a fast rate, but were hardly
ever linked to the long term strategy of the company and the shareholder value.
This meant that executives were not adding to the value of the company but
were being paid large bonuses. Executives in too many companies are being
paid for achievements meeting targets with very little relevance to corporate
strategy and the value proposition it puts to shareholders.
Research by Income Data Services in the UK in 2006 stated that directors were
now earning almost 100 times as much in annual remuneration than other full-
time workers, compared with about 40 times as much in 2000. The gap between
the remuneration of the most highly-paid and the remuneration of the least well
paid, in percentage terms, was continuing to increase.
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A trade union spokesman (the Trades Union Congress general secretary) is reported
to have commented: ‘It is hard not to conclude that this further huge rise in
executive pay is more about greed than performance…. The stratospheric levels of
directors' pay compared to average wages mean that executives now live in a class
apart, even from employees in their own companies. It is not just socially divisive,
but bad for the economy.’
4.4 Remuneration and competition issues
Although there might be ethical reasons for arguing that directors’ remuneration is
too high, there are competitive reasons for explaining the increase.
Directors’ remuneration has risen because there appears to be a shortage of
individuals who are considered to have the ability to lead major stock market
companies. Given a shortage in the supply of talented individuals, general levels of
remuneration for top executives have risen.
4.5 Remuneration and shareholder attitudes
Shareholders, particularly institutional investors, have shown a strong interest in
remuneration as an issue in corporate governance. The views of insurance
companies and pension funds are most often expressed by their trade associations,
the Association of British Insurers (ABI) and the National Association of Pension
Funds (NAPF), which provide guidance to their members and may sometimes co-
ordinate their activities.
The Association of British Insurers has issued guidelines for its members on
executive remuneration. These are consistent with the principles and provisions of
the Combined Code, but are more specific in detail. The guidelines are directed at
both:
remuneration committees, because they indicate the aspects of remuneration
that their shareholders will consider
their members, by indicating what they should consider when deciding whether
or not to show their approval of the remuneration policy of any company in
which they invest.
Institutional investors do not argue in favour of lower remuneration. They believe
that:
directors should be paid a fair remuneration, but not excessive amounts
a large part of a directors’ remuneration package should consist of incentives
performance targets for incentives should be relevant and challenging.
The ABI’s guidelines on executive remuneration are about 10 pages long. A few
guidelines are shown below, to illustrate the approach that institutional investors
take to the assessment of remuneration policy.
Remuneration committees should communicate their policy on base salaries to
shareholders. If it seeks to pay salaries at the median (average) level or above,
the committee should provide a justification.
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When a director is paid a bonus for achieving a performance target, the
directors’ remuneration report should give a full analysis of which performance
targets were met.
If performance is subsequently found to have been over-stated by management,
the remuneration committee should have the right to reduce or reclaim the
bonus payments to executives.
When preparing the contract for a director, the remuneration committee should
calculate the likely cost of any severance payment on dismissal, and whether this
is acceptable.
Where companies have share-based incentive schemes, executives should be
encouraged to build up ‘meaningful’ holdings of shares in the company.
The significance of shareholder attitudes
Shareholder views on remuneration packages can be important. Institutional
investors might act together and use their votes at general meetings.
The power of individual shareholders in large companies is usually restricted. Even
the largest shareholders usually do not own a large proportion of the shares in their
company, and it can be very difficult for shareholders to act together to obtain a
majority of votes at any general meeting of the company.
However, institutional investors are increasingly active, and remuneration
committees need to be aware that proposed incentive schemes, or the remuneration
package of a senior executive such as the CEO, may arouse strong opposition.
Shareholders can express their displeasure with remuneration policy and
remuneration packages by voting collectively in any of the following ways:
to vote against a proposed new incentive scheme
to vote their disapproval of the directors’ remuneration report
to vote against the re-election of a director who is retiring by rotation,
particularly if the director is a member of the remuneration committee or is a
beneficiary of a generous remuneration package.
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Paper P1
Governance,riskandethics
CHAPTER
6
Different approaches to
corporate governance
Contents
1 Rules-based and principles-based approaches
2 Brief history of corporate governance in the UK
3 International codes and principles of corporate
governance
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Rules-based and principles-based approaches
Reasons for the development of corporate governance codes
Corporate governance codes and different models of corporate ownership
Rules-based approach to corporate governance
The rules-based approach in the US: Sarbanes-Oxley Act 2002
Main governance aspects of Sarbanes-Oxley
Principles-based approach to corporate governance
1 Rules-based and principles-based approaches
1.1 Reasons for the development of corporate governance codes
Codes of corporate governance, in different forms, have been developed in most
countries where there is a stock exchange. The main reason for codes of good
corporate governance is to help and protect investors.
Investors need reliable information about companies, to decide whether to invest
in shares or (if they already hold shares) whether to sell them. Financial
reporting by companies and external auditing should therefore be reliable.
Investors should also be given other information to help them make their
investment decisions, such as information about future prospects of the
company, internal control and risk management and directors’ remuneration.
Investors need to be protected against unethical or dishonest behaviour by
company management. For example, there must be strict laws against insider
dealing, to prevent managers from making personal profits at the expense of
other investors.
Many investment institutions invest in the stock markets of many different
countries. They can choose which markets to invest in, and can choose to avoid
stock markets where they believe that governance practices are poor and investors
are treated badly.
Countries have developed corporate governance codes and practices because they
want to attract and keep investment capital, especially from global institutional
investors. This is because investment capital helps the country’s economy to
develop and its companies to prosper. Pressure for better corporate governance has
come mainly for two reasons:
The collapse of major stock market companies in a major financial centre, where
investors have lost substantial amounts of money and the cause of the collapse
has been largely attributable to bad corporate governance.
Pressure from institutional investors in countries with well-developed corporate
governance codes or rules.
The International Corporate Governance Network (ICGN) is an entity formed in
1995, whose members consist of major institutional investors, companies, banks and
other interested groups. Its aim is to encourage the development of good corporate
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practices worldwide. It has published a statement on global corporate governance
principles (revised 2005), which gives an indication of why corporate governance
matters so much to institutional investors.
The statement commented that the governance of a corporation is one of the key
factors that investors consider when they decide where to allocate their investment
capital. ICGN members considering making investment decisions also consider the
market’s governance profile.
Ethics and company performance
Other reasons for encouraging the development of good corporate governance are
that:
Good corporate governance practices are an application of good business ethics.
It might be argued that good corporate governance contributes to the efficiency
and effectiveness of a company’s leadership and management. If this view is
correct, well-governed companies will be more successful in the long term than
badly-governed companies. However, this has not yet been proved, one way or
the other.
1.2 Corporate governance codes and different models of corporate
ownership
Codes of corporate governance are applied to major stock market companies. Laws
and regulations on corporate governance issues are also mainly applied to stock
market companies. This is not surprising, as the main reason for codes of
governance is to help and protect investors.
Other companies can normally decide what system of corporate governance they
want, and they are not required to comply with any established principles or rules.
However, these companies might decide to apply these principles or rules because
they think that:
it is ethically correct to do so, or
it will improve the performance of the company.
Examples
In the UK, the London Stock Exchange has a stock market for smaller companies, the
Alternative Investment Market (AIM). There are fewer regulations for companies in
this market, and AIM companies are not required to comply with the Combined
Code of corporate governance. However, an unofficial code of governance for AIM
companies has been developed, and AIM companies are encouraged to adopt this
code.
The board of a family-owned company might be dominated by some of the family
members who are also the company’s senior executives. The company might decide
to appoint a non-executive director to represent the interests of family shareholders
or other shareholders who are not on the board. (The director would not be
independent, but the appointment of a NED to represent the interests of smaller
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shareholders might help to ensure that the company is governed in the interests of
all the shareholders, not just the owner-directors.)
1.3 Rules-based approach to corporate governance
A rules-based approach to corporate governance is based on the view that
companies must be required by law (or by some other form of compulsory
regulation) to comply with established principles of good corporate governance.
The rules might apply only to some types of company, such as major stock market
companies. However, for the companies to which they apply, the rules must be
obeyed and few (if any) exceptions to the rules are allowed.
There are some advantages with a rules-based approach:
Companies do not have the choice of ignoring the rules.
All companies are required to meet the same minimum standards of corporate
governance.
Investor confidence in the stock market might be improved if all the stock
market companies are required to comply with recognised corporate governance
rules.
There are disadvantages with a rules-based approach.
The same rules might not be suitable for every company, because the
circumstances of each company are different. A system of corporate governance
is too rigid if the same rules are applied to all companies.
There are some aspects of corporate governance that cannot be regulated easily,
such as negotiating the remuneration of directors, deciding the most suitable
range of skills and experience for the board of directors, and assessing the
performance of the board and its directors.
Corporate governance rules: practical applications
Every country with a stock market should have some rules of corporate governance.
The UK for example, which is associated with a principles-based approach to
corporate governance, has some statutory rules.
Examples of statutory rules in the UK are as follows.
With some exemptions, mainly for small and medium-sized companies,
companies are required to submit a directors’ report and financial statements to
the shareholders each year. This is a key aspect of accountability of the directors
to the company’s owners.
The financial statements should be audited.
Quoted companies (companies whose shares are traded on a stock exchange)
must prepare a directors’ remuneration report each year, and present this to the
shareholders.
The Companies Act 2006 specifies duties that the directors owe to their
company.
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The difference between countries that take a rules-based approach and those that
take a principles-based approach to corporate governance is mainly one of
emphasis. Some countries have more rules than others, and rely more on the
enforcement of rules to achieve the required standard of governance.
The country most associated with a rules-based approach is the USA.
1.4 The rules-based approach in the US: Sarbanes-Oxley Act 2002
In the US, corporate governance was not regarded as important until the collapse of
several major companies in 2001 and 2002, and large falls in the stock market prices
of shares of all companies. This major setback for the US stock exchanges damaged
investor confidence.
It was recognised fairly quickly that one of the reasons for the unexpected collapse
of several companies (‘corporations’) was poor corporate governance. Enron and
WorldCom were the two most notorious examples, but there were others too. There
were several well-publicised cases where:
A company in serious financial difficulties was dominated by a chief executive
and a small number of other senior executives, who appeared to be running the
company in their own interests, without concern for the interests of shareholders
(other than themselves).
Financial reporting was misleading.
Financial controls were weak and inadequate to prevent the misleading
reporting, and to prevent fraudulent activities by some executives.
Politicians soon became involved in analysing the problems in the stock market and
the collapse of companies such as Enron and WorldCom. This involvement of
politicians soon led to new legislation to improve standards of corporate
governance. This was the Sarbanes-Oxley Act 2002, which was named after its two
main sponsors in the US Congress.
1.5 Main governance aspects of Sarbanes-Oxley
The Sarbanes-Oxley Act introduced corporate accountability legislation. It includes
some specific requirements. In addition, it required the financial markets regulator,
the Securities and Exchange Commission (SEC) to issue rules to implement some
parts of the legislation. The Act is very long. Some of its provisions are described
below.
CEO/CFO certifications (section 302 of the Act)
The Act requires all companies in the US with a stock market listing (both US
companies and foreign companies) to include in their annual and quarterly accounts
a certificate to the SEC. This certificate should be signed by the chief executive
officer and the chief financial officer (finance director) and should confirm the
accuracy of the financial statements. The CEO and CFO are therefore required to
take direct personal responsibility for the accuracy of the company accounts.
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Assessment of internal controls (section 404 of the Act)
Section 404 is possibly the most notorious part of the Sarbanes-Oxley Act. The Act
required the SEC to establish rules that require companies to include an internal
control report in each annual statement. This internal control report must:
‘state the responsibility of management for establishing and maintaining an
adequate internal control structure and procedures for financial reporting; and
contain an assessment … of the effectiveness of the internal control structure and
procedures of the [company] for financial reporting.’
The SEC issued rules to implement this requirement of the Act. The management of
companies registered with the SEC (stock market companies in the US), with the
CEO and CFO, must evaluate the effectiveness of the company’s internal control
over financial reporting. The rule states that: ‘The framework on which
management’s evaluation of the … internal control over financial reporting is based
must be a suitable, recognised control framework.’
Companies are required to maintain evidence, including documentary evidence, to
provide reasonable support for management’s evaluation of the internal control
system. (One of the criticisms of section 404 has been the large amount of work
necessary to collect and maintain all this evidence.)
Companies must disclose any material weakness in their internal control system. If
more than one material weakness exists, a company is not allowed to conclude that
its internal control system is adequate.
A report on internal control must be included in the company’s annual report to
shareholders.
In addition, the external auditors are required to prepare an ‘attestation report’ on
the company’s assessment of its internal control system.
The consequence of section 404 is that companies in the US or foreign companies
whose shares are traded on a US stock market must undertake a review of their
internal control system for financial reporting every year, and to maintain evidence
to support the assessment of the control system that management gives in its annual
report to the shareholders. The criticism of section 404 has been mainly that the
requirements create a very large amount of work, that it costly in terms of
management time and other resources, as well as auditors’ costs.
Loans to executives
The Act prohibits companies (other than banks) from lending money to any
directors or senior executives.
Forfeit of bonuses
Another requirement of the Act is that if a company’s financial statements have to
be re-stated due to non-compliance with accounting standards and rules, any
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bonuses paid to the CEO and CFO in the previous 12 months must be paid back to
the company.
Insider dealing
The Act introduced stricter rules to prevent insider dealing by directors and senior
executives. They are not allowed to trade in shares of their company during any
‘black-out period’.
Audit committees
Companies with a stock market listing must have an audit committee consisting
entirely of members who are independent of the company. (There was a debate in
2007 about a member of the audit committee who used the company’s corporate
membership of an expensive country club to play golf at the club. Did this mean
that he was not properly independent?)
Non-audit work by auditors
The Act restricted the types of non-audit work that the company’s auditors can
perform for the company. Auditors are not allowed, for example, to do book-
keeping work for an audit client, or provide valuation services or perform any
management functions for the company.
Protection for whistleblowers
A whistleblower is an employee of the company who reports, through a channel of
communication other than his or her direct supervising managers) suspected fraud
or illegal activities in the company. The Act provides protection for any employee
who ‘blows the whistle’ on activities in the company, and prevents the company
from taking action against the employee, such as terminating his or her
employment. (This was what Enron did to an employee who acted as a
whistleblower when she suspected fraudulent activities in the company.)
1.6 Principles-based approach to corporate governance
A principles-based approach to corporate governance is an alternative to a rules-
based approach. It is based on the view that a single set of rules is inappropriate for
every company. Circumstances and situations differ between companies. The
circumstances of the same company can change over time. This means that:
the most suitable corporate governance practices can differ between companies,
and
the best corporate governance practices for a company might change over time,
as its circumstances change.