ACCA P1 Governance, Risk and Ethics - 2011 - Study text - Emile Woolf Publishing
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Paper P1: Governance, risk and ethics
154 © Emile Woolf Publishing Limited
The reasons for voluntary disclosures
Companies are not required to provide voluntary disclosures, but there are several
reasons why they choose to do so.
Some voluntary information might be provided as a public relations or
marketing exercise, to present ‘good news’ about the company to investors and
other users of the company’s published reports. For example, this might be the
purpose of a chairman’s report. It could be argued that social and environmental
reporting has been used by some companies to promote their ‘green’ image and
strengthen their reputation with customers.
Providing information on a voluntary basis might persuade the government or
financial service regulator that compulsory disclosures and regulation are not
necessary.
Companies might publish social and environmental reports out of a genuine
ethical and cultural belief in the responsibilities of the company to society and
the environment. If a company believes that it has social and environmental
responsibilities, publishing a report on these issues is a way of making itself
accountable.
A company might use voluntary disclosures as a way of improving
communications with its shareholders. By giving more disclosures to
shareholders, companies might encourage shareholders to respond, and enter
into a dialogue with the company about its strategies and plans for the future.
2.4 Narrative reports: business reviews and interim management
statements
As mentioned earlier, there is a view that companies should provide information in
a narrative form about their financial performance and prospects for the future, in
addition to providing financial statements. This view is based on the belief that
narrative reports can be much easier to understand than financial statements and
notes to the financial statements.
There is also a demand from investors for non-financial information, in addition to
financial information.
Many major companies have provided narrative reports on a voluntary basis,
usually in a chairman’s report or an operating and financial review. However, these
voluntary statements have limitations. The main limitations are that:
the company can decide what to include in the report and what to leave out
the information is often presented in a very positive form, as public relations for
investors, and might not be entirely reliable.
Business review
The demand for narrative reporting and the limitations of voluntary narrative
reporting have led to mandatory narrative reporting in some countries. In the
European Union, the Accounts Modernisation Directive introduced a requirement
for companies to include a business review in their annual report and accounts.
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Example: UK requirement for a business review
The legal requirement for a business review was introduced in the UK by the
Companies Act 2006 (section 417). The Act states that the purpose of the business
review is to inform shareholders and help them to assess how the directors have
performed their legal duty to promote the success of the company.
The business review should contain:
- a fair review of the company’s business, and
- a description of the main risks and uncertainties facing the company.
The review should provide a ‘balanced and comprehensive analysis’ of:
- the development and performance of the company’s business during the
year and
- the position of the company’s business at the end of the year.
With the exception of small companies (which are not required to prepare a
business review at all) and medium-sized companies, the business review must
include:
an analysis of key financial performance indicators (KPIs), and
where appropriate, other key performance indicators including KPIs relating to
environmental matters and employee matters.
In addition, quoted companies are required to include in their business review,
information about:
the main trends and factors likely to affect the future development and
performance of the company’s business
environmental matters (including the impact of the company’s business on the
environment), the company’s employees and social and community issues
‘persons with whom the company has contractual or other arrangements which
are essential to the business of the company’ – unless disclosure of this
information would, in the opinion of the directors, be seriously prejudicial to
that person or against the public interest.
The Act gives some exemption from the requirement to provide this information.
Disclosures of ‘impending developments or matters in the course of negotiation’ do
not have to be disclosed if this would be prejudicial to the interests of the company.
Interim management statements (IMSs)
The demand for more and better transparency and disclosures by listed companies
has also led to a requirement in the European Union for major stock market
companies to issue an interim management statement (IMS) each year. This is a
requirement of the EU Transparency Directive, which came into force from January
2007.
An IMS is required in addition to the company’s interim financial statements for the
first six months of the financial year. The purpose of an IMS is to explain material
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events and transactions that have taken place in the (six-month) period, and their
financial effect. It must also include a description of the principal risks and
uncertainties that the company will face for the remaining six months of the year.
In the UK, the Financial Services Authority issued guidance to companies about the
new rules, which stated that they believe that companies will meet the IMS
requirements based on the content of performance reports, trading statements and
other such similar formats with no extra information, if those reports or statements
include the required information under the Disclosure and Transparency Rules.
This means that the IMS must outline the material events and transactions for the
IMS’s relevant period and their impact on the financial position of the company and
provide a general description of the financial position of the company.
(Note: The Disclosure and Transparency Rules, like the Listing Rules, are rules that
all UK listed companies must comply with.)
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Dialogue with shareholders: general meetings
The need for dialogue between companies and their shareholders
Shareholder activism
General meetings of the company and voting by shareholders
Problems with the use of voting rights
3 Dialogue with shareholders: general meetings
3.1 The need for dialogue between companies and their shareholders
Constructive dialogue between the board of directors and the main shareholders of
the company should help to improve the quality of corporate governance. Dialogue
between the directors and the main shareholders should reduce the problems in the
principal-agent relationship between them.
Through dialogue, the shareholders can tell the directors what they are hoping
the company will achieve or any concerns they might have (for example, about
the risks faced by the company, about the dividends they hope to receive or
about the succession for the position of chairman or CEO, and so on).
Similarly, the directors can explain their plans and intentions in more detail than
through formal reports.
The need for dialogue is recognised in various codes of corporate governance and
statements of corporate governance principles. For example, the UK Combined
Code includes the following principles.
The board is responsible for having a satisfactory dialogue with shareholders
‘based on the mutual understanding of objectives’.
In addition, institutional shareholders have a responsibility to enter into a
dialogue with companies, also ‘based on the mutual understanding of
objectives’.
For a company, most of the dialogue with its shareholders is conducted by the
chairman, the CEO and the finance director. These are the individuals, for example,
who normally make presentations about the company to institutional investors. The
UK Combined Code states that in his discussions with major shareholders, the
chairman should discuss, amongst other things, governance and strategy.
It is the responsibility of the chairman to make sure that other members of the board
are informed about the views and concerns of the major shareholders.
The UK Combined Code states that major shareholders should be given the
opportunity to meet with the company’s non-executive directors, if they wish to do
so. However, with the exception of the senior independent director, it is unlikely
that institutional investors will want to meet a company’s NEDs, simply because
their time can be used better in other ways.
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Senior independent director (SID)
A role of the senior independent non-executive director is to listen to the concerns of
shareholders, when shareholders have concerns that have not been resolved
through their normal channel of communication with the chairman, CEO or finance
director. The senior independent director might then be asked to discuss the
concerns of the shareholders with the rest of the board – in effect, to challenge the
views of the chairman and CEO.
In order to perform this role, the senior executive director must be known to the
major shareholders. Some meetings between the SID and shareholders is therefore
desirable.
3.2 Shareholder activism
When a shareholder is dissatisfied with the performance of a company, he can sell
his shares. There is no requirement for a shareholder to continue investing in a
company. This is probably a reasonable description of the ‘traditional’ approach of
institutional investors to the companies in which they invested.
An alternative approach to selling shares in under-performing companies is to:
monitor companies closely
enter into a dialogue with a company when it is under-performing, and express
the concerns that the shareholder has about the company
use voting rights to put pressure on a company’s management.
This approach is called shareholder activism or shareholder engagement.
Purpose of shareholder activism
The purpose of shareholder activism is to try to improve the performance of under-
performing companies. This purpose is explained in a Statement of Principles of the
Institutional Shareholders Committee (ISC), a joint body in the UK representing all
institutional investor associations. The ISC Principles state:
‘The policies of activism … do not constitute an obligation to micro-manage the
affairs of … companies, but rather relate to procedures designed to ensure that
shareholders derive value from their investments by dealing effectively with
concerns about under-performance.’
The Principles also state that although institutional investors are encouraged to
become ‘active’ investors, they should still use their right to sell their shares, if this
is what they would prefer to do in the case of some companies.
The nature of shareholder activism
Shareholder activism consists of the following activities.
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Shareholders should monitor the companies in which they invest. Effective
monitoring requires an active dialogue between the shareholder and the
company. The ISC Principles state that institutional shareholders should
‘endeavour to identify problems at an early stage to minimise any loss in
shareholder value. If they have any concerns and do not propose to sell [their
shares], they will seek to ensure that the … company’s board are made aware of
them.’
Shareholders should have a policy about when they will intervene in a company
by expressing their concerns. Concerns may relate to the company’s strategy,
operational performance, ineffectiveness of the company’s independent NEDs,
failures in the company’s internal controls, directors’ remuneration packages or
the company’s social and environmental policies.
Shareholders should then assess the effectiveness of their intervention.
If the company is still concerned, and dissatisfied with the company’s response
to the concerns, the shareholder should consider using his vote against the board
of directors on selected matters at the company’s next general meeting.
Institutional investors are encouraged to practice ‘responsible voting’.
Responsible voting can be defined as taking informed decisions about how to
vote at company general meetings, within the framework of a well-considered
corporate governance policy.
3.3 General meetings of the company and voting by shareholders
A general meeting of the company is a meeting of the company’s owners
(shareholders) to discuss and vote on certain items. The company’s board also
attends general meetings, and the auditors and company advisers might also attend.
There are two types of general meeting:
The annual general meeting (AGM) which is held each year to vote on ‘routine’
proposals.
An extraordinary general meeting (EGM) is any general meeting that is not an
AGM. An EGM might be called to consider specific issues, such as a proposal to
approve a major takeover of another company.
The voting rights of shareholders
In a well-governed company all ordinary shareholders should have equal voting
rights. In principle, this means one share, one vote.
The matters that shareholders have the right to vote on are fairly limited. They
include votes on:
the election or re-election of directors
the re-appointment of the company’s auditors for another year
approving a dividend proposed by the directors
in the UK, approval of the directors remuneration report
approval of new share incentive schemes
approval of proposed major transactions, such as a takeover.
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Shareholder activism and voting rights
In principle, shareholders can use their votes against the board of directors when
they have concerns about the company and they are not satisfied with the response
from the board of directors. Shareholders might therefore:
vote against the re-election of a director whose conduct or opinions they dislike
vote against the proposal to approve the directors remuneration report, for
example when they have concerns about the remuneration policy of the
company or about the remuneration packages of directors..
Votes against the board of directors at a general meeting will attract press comment
and adverse opinion from investors. The company’s board of directors, after
suffering defeat in a vote at a general meeting, or wishing to avoid the risk of defeat,
might make concessions and do something to deal with the concerns that the
shareholders have expressed.
3.4 Problems with the use of voting rights
Although shareholders can use their voting rights, or threaten to use their voting
rights, to put pressure on a board of directors, there are limitations and problems
with the use of voting.
Individual shareholders, even major shareholders, might own only a small
proportion of the company’s shares. In the UK for example, the stock market
considers any shareholder to be ‘significant’ if it owns more than 3% of the
shares in a company. To win a vote at a general meeting requires a majority of
the votes (and sometimes even more). Many shareholders need to organise
themselves to use their votes in concert to have any chance of obtaining a
majority of the votes.
Some institutional shareholders might fail to use their votes in a responsible
way. There are several reasons for this:
- An institutional investor might own shares, but hand the management of the
shares to a different organisation (a fund manager). It might be difficult for
the institutional shareholder to give instructions to a fund manager on how
to vote at a general meeting of each company in which it holds shares.
- Institutional shareholders might engage in stock lending. Stock lending
involves lending shares to another entity for an agreed period of time, in
return for a fee. The benefit of stock lending is that it increases income from
shares. A disadvantage of stock lending is that during the time that stock is
being lent, the borrower has the voting rights, not the lender. The practice of
stock lending makes it more difficult for institutional investors to vote,
because they do not always know how many shares they currently hold.
- Many shareholders, including some institutional shareholders, might
arrange for the company chairman to vote on their behalf at the general
meeting, as a ’proxy’. A shareholder can instruct a proxy on how to cast its
votes on each specific proposal at the meeting. However, many shareholders
give the chairman their proxy votes, and allow the chairman to decide how
to use the votes. Giving proxy votes to the chairman can therefore make the
chairman – and so the board as a whole – a very powerful voting force in a
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general meeting. It is then very difficult to vote successfully against any
proposal from the board of directors.
- In some countries, there are restrictions on the ability of foreign shareholders
to vote at general meetings of the company. Global investors are often unable
to use their shares to vote on proposals at general meetings, for example
because of restrictions on proxy voting.
These problems with voting are well recognised, and some measures have been
taken to reduce them.
Institutional investors might be advised on voting by their association. In the UK
for example the Association of British Insurers issues advice to its members to
vote against a particular proposal by a company at a general meeting to be held
in the near future. These warnings, known as red tops, are normally issued
when the institutional investors have concerns about specific governance
matters, such as the remuneration of the company’s executives.
Associations such as the ICGN (the International Corporate Governance
Network) continue to argue in favour of more voting rights for foreign
shareholders, and the removal of laws or rules in a company’s constitution that
make it difficult for foreign shareholders to exercise their voting rights.
In some countries, including the UK, there have been initiatives to remove some
of the inefficiencies and difficulties in voting for institutional investors.
The Myners Report
In the UK, the institutional investor organisations established a Shareholder Voting
Working Party. In 2004, a report was prepared for the Working Party entitled:
‘Review of the Impediments to Voting UK Shares’. It is more commonly known as
the Myners Report, after the name of its author.
The Myners Report identified the problems faced by institutional investors in using
their voting rights in UK companies, and it made several recommendations,
including the following.
The institutions that own shares should give proper attention to using their
voting rights and the responsible use of their votes. Since it is impractical for
many institutional shareholders to attend all general meetings of companies in
which they invest, they should use proxy voting.
Institutions that put their shares into the hands of a fund manager should make
sure that the fund manager votes is accountable for the use of the voting rights
and uses the votes as instructed.
Institutional investors should be careful about lending their shares and voting
on contentious issues at a general meeting. ‘The Report commented: ‘When a
resolution is contentious, I start from the position that the lender should
automatically recall the [lent shares], unless there are good economic reasons for
not doing so.’
The voting system at the time was largely paper-based. Myners recommended
the use of electronic voting. With electronic voting, a shareholder submits his
voting instructions to the company by electronic means. This is a form of proxy
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voting, and the company will include the electronic proxy votes in any poll vote
at the general meeting.
A feature of voting at general meetings in UK companies is that the chairman
can decide whether a vote should be taken by a show of hands of the
shareholders present at the meeting, or by a ‘poll vote’. With a show of hands, a
majority vote means the vote of more than one half of the shareholders present
at the meeting, regardless of how may shareholders attend the meeting and how
few shares they hold between them. A poll vote is a count of all votes submitted,
including proxy votes, on the basis of one share, one vote. Myners argued that in
order to encourage proxy voting, all decisions at general meetings should be
made by a poll vote, not a shown of hands. Companies should also disclose in
their website the results of all the poll votes at general meetings.
Proxy voting forms allowed a shareholder to indicate how to vote his shares, for
or against a proposed resolution. Myners recommended that a third option
should be added to proxy voting forms – the option to ‘consciously withhold
the votes’. In other words, shareholders should be allowed to abstain from
voting, and indicate to the company that this is a conscious decision, not a
failure to vote at all. Abstaining from voting is a sensible option where a
shareholder disapproves of a proposal but the disapproval is not strong enough
for the shareholder to want to vote against the board of directors.
Progress has been made in the UK towards adoption of the Myners proposals.
Nearly all large companies now permit electronic voting. Company chairman are
much more conscious of the need to take proxy votes into consideration: although
most decisions are still taken by a show of hands (for convenience and to save time
at the meeting), the chairman usually announces the total numbers of votes
submitted as proxy votes, for and against the proposal and as abstentions. The
option to make a conscious decision to withhold a vote has been adopted.
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Corporate social responsibility
Definition of corporate social responsibility (CSR)
Principles of CSR
CSR and stakeholders in the company
The effect of CSR on company strategy
CSR reporting
CSR and institutional investors
4 Corporate social responsibility
4.1 Definition of corporate social responsibility (CSR)
Corporate social responsibility refers to the responsibilities that a company has
towards society. CSR can be described decision-making by a business that is linked
to ethical values and respect for individuals, society and the environment, as well as
compliance with legal requirements.
CSR is based on the concept that a company is a citizen of the society in which it
exists and operates.
As a corporate citizen of society, it owes the same sort of responsibilities to
society at large that other citizens should owe.
There is a social contract between a company and the society in which it
operates. As the owner or user of large amounts of property and other resources,
companies as corporate citizens also owe a duty to society to use its property
and resources in a responsible way. In return, society allows the company to
operate and remain in existence.
Corporate Social Responsibility is related to the idea that as well as their
responsibilities to shareholders, boards of companies are also responsible to the
general public and other stakeholder groups. There are two key areas of
responsibility:
(i) general responsibilities that are a key part of the board’s duties which need to
be completed in order to succeed in their industry and/or are regulatory/legal
requirements that are imposed on them
(ii) duties that are seen by some people feel go beyond these general
responsibilities.
4.2 Principles of CSR
Corporate social responsibility has five main aspects. For any company, some of
these aspects might be more significant than others.