Institutional and private investors Essay
The concept of corporate governance involves the development of clear systems to ensure that all business entities are managed and controlled in a way that ensures the best interests of the shareholders (the owners) are protected. As a concept, corporate governance came into prominence during the 1970s and ‘80s particularly in the developed world due to the increased level of globalization and internationalisation that led to shareholders and investors demanding for a more transparent and regulated approach to organisational management and the reporting of entity performance.
Its significance was also brought to light following the high profile corporate scandals and collapses that plagued the business world, which severely eroded investor confidence in how their companies were being directed by the board and management. These scandals over the last 25 years highlighted the need for some clear guidance to tackle the various risks and problems that can arise in organisations’ systems of governance.
This prompted the development of various corporate governance codes of conduct providing companies with a framework of best practice guidelines to follow to ensure better supervision, improved corporate performance and protection against the misuse of company resources. These codes of conduct have been in the form of corporate governance reports
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the corporate world and the increased adoption of corporate governance best practices by business entities the world over. It will also analyse the impact these reports on corporate governance are having on companies today and how it has altered the way companies are governed and managed. 2. What is Corporate Governance? Corporate Governance could be defined as the overall system by which organisations are directed and controlled. It is concerned with systems, processes, controls, accountability and decision making within an entity i. e. how managers execute their authority and responsibilities and how they account for it.
Although this area is discussed mostly in relation to large quoted companies, governance is an issue relevant to all corporate bodies, commercial as well as not-for-profit. Having good corporate governance i. e. a proper system in place to ensure the entity is managed and controlled in line with corporate best practices to ensure that the interests of all stakeholder groups are protected and power is not abused, is essential for companies in order to achieve the following. ? To minimise financial, legal and reputation risk; by requiring compliance with accepted good practices of financial control and conformity to law
? To ensure focus on achievement of strategic objectives ? To fulfil responsibilities to all stakeholders and minimise potential conflicts of interest between parties ? To establish clear accountability at senior levels within the entity ? To maintain the independence of those who scrutinise the behaviour of entity and its management (non-executive directors, internal and external auditors) ? To ensure provision of accurate and timely reporting of trustworthy financial and operating data to stakeholders showing a true and fair view ? To promote integrity and ethical behaviour within the entity
These are achieved through the creation of a framework of control for companies’ executive management so that they are answerable to all stakeholders who have an interest in the company. 3. Corporate Governance Today Over the last three decades, corporate governance issues have come into prominence throughout the developed world. This increased demand for the development of governance was driven by the increasing level of globalisation and internationalisation, which has meant that investors, both private and institutional can invest anywhere and required companies to operate in an acceptable fashion and report performance fairly.
Also a number of very public and high-profile corporate scandals such as Enron, Poly Peck International, World com, BCCI and Maxwell Communications Corp have adversely affected investor confidence and has led to a demand for better governance and measures to enforce it. Apart from these factors, another element that has driven the need for more transparent controls on organisational management is the issues that have risen concerning the reliability of financial reporting. Grey areas such as off balance sheet financing, manipulation of financial results through deferring of expenses predating of income, burying debt etc.
have been brought into the spot light through some of the above scandals and have got shareholders demanding for better financial regulation and corporate governance. The traditional dependence on the board of directors and external auditors for the assurance that an appropriate governance structure exists was no longer sufficient and as a result of this rising need for a more structured and transparent approach towards corporate governance, a number of countries have commissioned different committees to develop reports on corporate governance best practices that can be adopted by companies.
These reports have brought awareness to a number of areas related to governance, which will be discussed in detail in the following chapters. 4. Reports on Corporate Governance A number of reports have been produced in various countries aimed at identifying and presenting corporate best practices that can be adopted by business entities in order to address the risks and problems caused due to poor governance in different areas. There are three countries have made significant contributions to improving governance of business entities by the publication of reports on corporate governance.
They are the United Kingdom (UK), the United States of America (USA) and South Africa. The reports produced by each of these countries are summarised below. United Kingdom There were three significant corporate governance reports published in the UK during the 1990s. ? Cadbury Report – general corporate governance issues ? Hampel Report – general corporate governance issues ? Greenbury Report – Remuneration of Directors The recommendations of these three reports were merged into a Combined Code in 1998, with which companies listed in London Stock Exchange are required to comply.
Since the publication of the Combined Code a number of reports in the UK have been published about specific aspects of corporate governance. ? Turnbull Report – Risk management and Internal control ? Smith Report – Role of internal audit ? Higgs Report – Role of the non-executive director United States of America The United States’ legislators passed the Sarbanes-Oxley Act in 2002 defining guidelines on how US companies should be governed.
Also changes made to the listing rules that need to be fulfilled by companies quoted on the Wall Street is another method used by the states to enforce good corporate governance. South Africa South Africa’s contribution to the corporate governance debate has been the publication of the King Report, which highlights seven characteristics of good corporate governance and reviews some of the best practices published in other reports. This was first published in 1994 and updated in 2002 to take account of developments in South Africa and elsewhere in the world.
5. Areas of governance highlighted by Corporate Governance Reports There are a number of areas highlighted as important for the establishment of a system of good corporate governance within organisations according to the reports mentioned above. They are as follows. ? Role of the Board of Directors ? Attributes of the Board of Directors ? Composition of the Board of Directors ? Remuneration for the Board of Directors ? Internal Control and Risk management ? Relations with Shareholders and other Stakeholders ? Reporting on Corporate Governance and Disclosures
Each of these areas will be discussed together with the recommendations for each of them as described in the Corporate Governance reports. 5. 1 Role of the Board of Directors The Board of Directors are the group of individuals appointed by the shareholders (owners) of a business to run it on behalf of them, while preserving the interests of all stakeholder groups. They are also required to report the performance of the company to the shareholders. These directors have a significant role to play in ensuring the development of good corporate governance within organisations.
The King Report provides a summary of the role of the board of Directors as follows. “To define the purpose of the company and the values by which the company will perform its activities and to identify the stakeholders relevant to the business of the company. The board must then develop a strategy to combine these three factors and ensure management implements that strategy. ” As such it is the board that bears ultimate responsibility for the functioning of the business entity, and who is ultimately accountable to the stakeholders of the entity.
Some of the key tasks that have to be performed by the Board of Directors according to the Cadbury and King Reports are as follows. ? Undertaking the making of certain crucial policy and strategic decisions pertaining to the company’s operations ? Monitoring the Chief Executive Officer ? Overseeing strategy ? Monitoring significant risks and control strategies ? Monitoring key human capital aspects and corporate social responsibility ? Ensuring the effective communication of the entity’s strategic plans both internally and externally
By getting the board of Directors more involved in the company, some level of restraint can be exerted on the executive management of the company who are charged with running the business. 5. 2 Attributes of the Board of Directors In order to effectively carry out its role, the Board of Directors should have the following attributes. ? Relevant expertise in governance, the industry and the different functional areas of the business ? A suitable balance between executive (involved in the management of the business) and independent non-executive directors within the board
? A mix of individuals from diverse backgrounds with different skills, areas of expertise and knowledge ? A transparent Nominations committee to oversee the process for board appointments ? Access to relevant financial and non-financial information directly when making decisions and for the monitoring of company performance ? A system of appraisal to assess the performance of the board once a year and to provide relevant training if required These essential features that a typical board should possess have been high lighted by the UK’s Higgs Report 5. 3 Composition of the Board of Directors
Another area highlighted by the corporate governance reports published is the composition of the board i. e. how the board of directors should be made up. All reports acknowledge the importance of having a division of responsibilities as the head of an organisation. As such they require the roles of Chairman of the Board and Chief Executive Officer to be held by two different individuals. However, the Cadbury report and the Smith report qualify this requirement by suggesting that if there is a strong independent element on the Board in the form of a Non Executive director, the posts can be held by one individual.
Apart from this, another key area addressed is the inclusion of non-executive directors to the board. Non-Executive Directors(NEDs) have no management responsibilities within the organisation and are expected to provide a balancing influence within the board and reduce the conflicts of interest between management (including executive directors) and other stakeholders by exercising independent judgement on all issues. The Cadbury Report provides an indication as to the number of NEDs needed on the board.
“The board should include non-executive directors of sufficient character and number for their views to carry significant weight” The New York stock exchange (NYSE) rules how ever give more prescriptive guidelines as to the number of NEDs needed. It requires listed companies to have a majority of NEDs on their boards. Further to this, the reports on corporate governance have highlighted various safeguards that can be taken to ensure that the NEDs remain independent so as to provide reassurance to shareholders that management is acting in the best interests of the organisation. They include;
? NEDs having no business, financial or other connections with the company apart from fees and shareholdings o The UK’s Higgs report has widened the scope of ‘business connections’ to include anyone who has been employed or had a material business relationship over the last few years, or served on the board for more than 10 years ? NEDs shouldn’t take part in share option schemes and should not be entitled to a pension ? Appointments of NEDs should be for a specified term and reappointment not automatic ? Access to independent advice from external parties for NEDs if required 5.
4 Remuneration for the Board of Directors Directors of major corporate entities have been known to pay themselves excessive “fat cat” salaries and bonuses which are not in line with their obligation to function in the best interests of shareholders. In order to cut down on this corporate abuse, the various reports on corporate governance have introduced a number of provisions to address this. The Greenbury report identified a number of principles that have to be adhered to when determining remuneration for directors. They include;
? Directors’ Remuneration should be determined by a remuneration committee comprising of Non-executive directors ? Any form of bonus paid to directors should be related to measurable performance or enhanced shareholder value ? There should be full transparency of Directors’ remuneration including pension provisions in the published annual accounts The remuneration offered to directors should be sufficient to attract, retain and motivate the right calibre of individuals whilst ensuring that it isn’t adverse to the interests of shareholders.
The target is to use the remuneration package as a means of aligning management interests with those of share holders. Long term share option schemes, performance related pension schemes, and renewable short term service contracts are some of the modern elements of an executive director’s remuneration package used to encourage him/her to work in the company’s best interests. Corporate governance reports have also provided guidelines as to the level of disclosures on remuneration arrangements to be included in the published final accounts.
The idea is to create transparency so that outside parties and shareholders know how much is being paid to executives and can raise questions if they feel that the results don’t justify the reward. Some of the necessary disclosures in line with the UK’s combined code on corporate governance include; ? Remuneration policy o Remuneration levels, main components of remuneration, performance criteria and measurement, pension provision, contracts of service, compensation for loss of office etc. ? Arrangements for individual directors
o A break-up of each director’s basic salary, benefits-in-kind, bonuses and long-term incentives(share options, pensions etc) Apart from this the Greenbury report followed by the Combined Code requires companies to get shareholders to vote on the Remuneration Statement and on the different elements of the remuneration packages of individual directors. 5. 5 Internal Control and Risk management Another very significant area addressed by the different reports on corporate governance is how a business entity should manage the risks it faces and develop systems to ensure proper controls are in place to mitigate these risks.
It is the responsibility of the Board of Directors to regularly review the processes of risk management and internal control within the entity and disclose the results to stakeholders. The UK’s Turnbull Report suggests that review of internal controls should be an integral part of a company’s operations and that the board should pay significant attention to control issues. The Cadbury Report explains the need for an Audit Committee to liaise with the external auditors, supervise internal audit and review the annual accounts and internal controls.
This Audit committee will purely focus on creating a climate of discipline and control within the entity, protecting the independence of external auditors and strengthening the position of internal auditors. The final target is increasing public confidence in the credibility and objectivity of financial statements. According to the Cadbury Report, the main duties of the Audit committee include; ? Review of both quarterly and annual financial statements ?
Review of the Financial reporting system and Budgeting systems o Evaluating the effectiveness of performance indicators, variance analysis and budgetary control ? Acting as the intermediary with external auditors o Helping them obtain the information required, protecting their independence, and addressing the areas of concern they identify ? Review of internal Audit o Reviewing the scope, methods used, resources available, reporting arrangements and results of the Internal audit function ?
Review of Internal control and Risk management systems o Monitoring the adequacy of systems, ensuring legal compliance and reviewing the risk management policy ? Supervision of any investigations undertaken The UK’s Smith Report defines the composition of the Audit committee. “The audit committee should consist entirely of independent NEDs (excluding the chairman), and should include at least one member with significant and recent financial experience” The New York Stock Exchange (NYSE) has made it compulsory for all its listed companies to have an Audit committee.
The USA’s Sarbanes-Oxley Act also requires the Board of Directors to disclose to the Auditors and the audit committee, deficiencies in the operation of internal controls and to assess, evaluate and comment upon the effectiveness of these controls in the annual report. 5. 6 Relations with Shareholders and other Stakeholders Shareholders are the owners of the business and as such the Board of Directors are accountable to them. It is the shareholders who appoint directors at the Annual General Meeting (AGM) and as such directors perform a stewardship function, managing the business on behalf of them.
In order to ensure that directors continue to perform in the interest of shareholders, a number of measures have been introduced by the different reports on corporate governance. They include; ? Requiring all directors to submit themselves for re-election regularly (at least once every three years) ? Requiring shareholders (particularly institutional shareholders) to actively participate in policy formation at AGMs and to use their votes to communicate with the board The UK’s Hampel Report provides recommendations on how the AGM could be used to enhance communications with shareholders.
Providing sufficient notice to shareholders prior to the meeting, including a question-and-answer session for shareholders to raise any concerns, developing a system whereby shareholders can vote on different issues separately rather than as a bundle are some of the recommendations made. With regard to the interests of other stakeholders apart from shareholders; the level to which directors are responsible is under debate. The Hampel Report claims that making directors responsible to other stakeholders would mean that there was no clear yardstick for judging directors’ performance.
However the OECD (Organisation for Economic Co-operation and Development) guidelines on Corporate Governance places a wider importance on the importance on other stakeholder groups, saying that the competitiveness and ultimate success of a corporation depends on the contributions of different stakeholders such as employees, creditors and suppliers and recommends that; “The corporate governance framework of a company should ensure that respect is given to the rights of stakeholders that are protected by law, which include rights under labour law, business law, contract law and insolvency law”
It also recommends improving stakeholder participation in governance through employee representation on the board, employee share option and profit sharing schemes etc. The King Report of South Africa draws a clear distinction between the responsibility a company has towards stakeholders and the accountability it has towards its shareholders, saying that it is not possible for a company to be accountable to everyone. 5. 7 Reporting on Corporate Governance
With regard to reporting on corporate governance, there are a number of requirements specified by the combined code on corporate governance. In accordance with the combined code, the London Stock Exchange requires the following disclosures. ? A narrative statement of how the company applied the corporate governance principles set out by the combined code ? A statement as to whether on not the company complied with the provisions in the combined code during the last accounting period, and if not reasons for non-compliance
Apart from these general disclosures, there are a number of other statements on corporate governance expected to be included in the Annual Report of a company. ? Information about the Board of Directors, its composition, its responsibilities, its performance etc ? A brief report on the Remuneration, audit and nomination committees ? Information about relations with External auditors ? A statement on the effectiveness of internal controls and risk management ? A statement on relations and dialogue with shareholders
? A statement on the company as a ‘going concern’ ? A Sustainability Report o This will look at the nature and extent of social, ethical , safety, health and environmental management policies and practices – King Report ? An Operating and Financial Review (OFR) o This will include the directors’ analysis of the business, its finances and operations so as to provide investors with a historical and prospective analysis of the company through the eyes of the management – UK’s Accounting Standards Board
All these reports and statements are aimed at providing shareholders and all external parties with a transparent picture of the company and its operations. 6. Impact of these reports on the increasing significance of Corporate Governance As explained above the different reports published on corporate governance have shed light on a number of areas regarding the board of directors (its role, remuneration, its composition) internal control, internal audit, disclosures, reporting etc
These reports have contributed in no insignificant terms to the development of corporate governance through the introduction of principles and guidelines as to the best practices business entities should follow so as to ensure good corporate governance and the preservation of interests of all stakeholders including shareholders. Most stock exchanges throughout the world have made adherence to the corporate governance principles and guidelines outlined in these reports compulsory for all listed companies.
The purpose of this is to provide investors with some level of security and guarantee that their money is in good hands and will not be manipulated. As such, these reports have also contributed towards increasing the level of investor confidence by providing investors with some level of assurance that their companies will be managed and governed in a transparent way that protects and adds value to their investment. This, in an age of globalisation and high capital mobility, is a vital requirement if institutional and private investors are to invest overseas.
In addition, these reports on corporate governance have opened doors to active debate on corporate governance, which until recently has remained a secondary issue in most forums. It has helped open eyes towards the criticality of having a system in place to protect the interests of the parties outside the company who have the most to lose. The different reports published have been updated, revised and amended over the last few years to reflect new findings and improvements to existing guidelines and principles.
As a result, corporate governance continues to evolve and adapt to changes arising in the business environment and so continues to remain relevant and timely in the ever changing landscape of 21st century business. Therefore, in summary, it could be said that the different reports published on corporate governance over the last fifteen years have made a very big change in the level of awareness and understanding of the philosophy of corporate governance, whilst also contributing towards the development of systems of best practices that are commonly acceptable to the majority as the way in which companies should be managed.