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Fundamentals of Ethics, Corporate Governance and Business Law
Module: 03
Corporate Governance, Codes and CSR
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1. Governance
In early 2001, one of the world's major energy companies based in Houston,
Texas, was enjoying annual revenues of $111 billion, a stock price of $90 per
share, and seemed almost unstoppable in its capacity to expand indefinitely. Even
Forbes named them the 'Most Innovative Company' right up until 2000.
By the end of 2006, the former CEO and CFO of the company were serving
prison sentences, whilst the former chairman and founder died of a heart
attack week after being sentenced.
That's a dramatic turn of events.
Well, by now you may have guessed that the company in question is Enron,
who filed for bankruptcy in late 2001 after evidence started to emerge of a
huge accounting and corporate fraud scandal. But how did they manage to
keep it going for so long?
Let's start with Kenneth Lay, the founder and chairman of Enron. He was
also the CEO (Chief Executive Officer) for a period, too. So, we have one of
the world's largest companies under the command of one man. This is rarely
good a when the CEO and chairman are different people, they help check
each other so policies are fully scrutinised before being enacted. When they
are the same person this is less likely to happen.
Then we have the other key players: Jeffrey Skilling and Andrew Fastow.
Skilling is the former president, CEO and COO (Chief Operating Officer) again,
a lot of power for one person. Fastow was the CFO (Chief Financial Officer).
Between them, these guys managed to construct one of the biggest cases of
corporate fraud in global financial history.
They lied about revenue by recognising income in unorthodox ways and
covered it up with creative accounting and a close relationship with their
auditor.
But the really important question is: How did they get away with it for so
long? How could a handful of businessmen have enough power and authority
to control one of the world’s most successful companies? Who was keeping
tabs on them?
The answer, in part, is because there was a lack of good corporate
governance.
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Definition
Corporate governance is the way organisations are directed,
administered and controlled, with the aim of ensuring that the
organisation is run in a way that is right for all stakeholders, in particular
the shareholders.
Corporate governance therefore includes:
• Managing the relationships with stakeholders.
• Managing the organisation’s goals and strategies.
A stakeholder is anyone who has an interest in the performance of the company.
There are many stakeholders, such as shareholders, management, employees,
suppliers, customers, banks and other lenders, regulators, the environment and
the community at large. Governance is about ensuring the business is run in a
way that looks after the needs of all stakeholder groups.
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2. Agency theory
The agency problem
Let's say you're a millionaire with a really expensive car (lucky you!) and a
chauffeur driving you everywhere you want (even luckier you!) Here we have
a conflict – you own the car, but she drives it. You might want it driven well, be
well looked after, and there for you at all times, but you've put someone else
in charge and you've got no idea what your chauffeur is doing when you're
not there! Where are they going? How are they driving? Who are they driving
with?
This problem; the conflict between the wants of you, the owner, and the
manager, the chauffeur, is an example of the agency problem. In agency
theory the chauffeur is your agent – the person you've given responsibility to
for looking after the car and driving it for you. Her needs might not always
align with yours though and the temptation to take it for a quick spin with
friends when you're not around may just get too much! And there lies the problem. The needs of the agent and the owner may differ.
So how does this theory relate to business, and governance in particular?
In business the owner are the shareholders (who are known as the
principal), and they are in charge of employing the directors (who are the agent) to run the business on their behalf.
Now, although the directors should be running the business in the
shareholders' interests (they have a responsibility to do so – this is their
job), it is inevitable that their own personal interests will be considered too
– just like with your expensive car and your chauffeur! This conflict is the
agency problem.
For instance, when it comes to salaries paid, the directors are going to be
pushing for as high a salary as possible, whilst the shareholders will want to
set appropriate salaries that don't incur enormous costs for the business.
Information asymmetry
One issue with the agency problem is information asymmetry. The
directors have more information about the company than the
shareholders, and as a result the shareholders are not always able to fully
hold directors accountable for decisions made. In our example, the
chauffeur probably has more information about the car than you do, so you
need to trust that she will keep you suitably informed.
In business, the CEO will have access to lots of internal information
and specific data relating to the performance of the company. They will
also have a fairly close relationship with the chief financial officer
(CFO), and this will put them in a powerful position. You have to trust
them to use their informed position well and indeed to present to you all the
relevant data you need as an investor. But can shareholders trust them?
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Well sometimes yes, but other times no – which corporate disasters such
as Enron, WorldCom and Lehman Brothers clearly demonstrate.
We can show the relationships diagrammatically:
Agency and corporate governance
So, what, if anything, can be done about the agency problem? Firstly, there's
the legal duty of directors to run the business on behalf of shareholders:
this is known as the fiduciary duty.
Fiduciary duty is powerful, but it is not always enough and so on top of that
we have corporate governance regulation which aims to overcome the
agency problem by finding ways of reducing the bias of directors,
demanding accountability and disclosing relevant information.
Agency cost
An agency cost is the idea that there are measurable time and financial`
commitments in ensuring that an agent is acting appropriately on behalf
of the principal.
Let's return to our chauffeur. You could perhaps monitor where and how she
drives using GPS tracking. That system has a cost, and this cost is called an agency cost.
Take any company and there will almost certainly be some 'cost' to the
principal in making sure that the agent acts in their interest. The standard
costs for shareholders/the board in hiring directors come in the form of
bonus payments, incentive schemes, share-based payments which
should align the shareholders interests with the directors. The salaries of
non- executive directors who are responsible for monitoring and controlling
the executive directors are another. The costs of financial reporting and
auditing are agency costs too.
Obviously, these costs reduce the total amount of return that comes back to
the shareholders, and so a balance needs to be struck between an
acceptable expense in managing the directors effectively and maintaining
reasonable returns from the investment.
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Key terms
Okay, so we've raced through a number of key terms, so let's take a second
to make sure we know what they mean and how they fit into corporate
governance:
What it means
How it relates to corporate
governance
Agents
The person(s) who
manages something on
behalf of a principal.
The agents are the directors,
who must run the business in
the interest of the
shareholders.
Principals
The person(s) who
delegates responsibility of
management to an agent.
The principals are the
shareholders, who hire
directors to run the business
on their behalf.
Agency
The act of providing a
service on behalf of
another.
The agency between directors
and shareholders can lead to
conflicts of interest, known as
the agency problem.
Accountability
The extent to which
someone is to blame for an
action.
Directors are to be held
accountable for their actions
in running the business.
Fiduciary duty A legal duty to act solely in
another party's interests.
The directors have a fiduciary
duty to shareholders.
Agency cost
The cost associated with
ensuring agents behave
appropriately
The cost of agency has to be
weighed up against the
benefits.
The need for governance
In recent years, there has been significant interest in the corporate
governance practices of modern corporations, particularly in relation to
accountability, since the high-profile collapses of a number of large
corporations.
In the UK, the Cadbury report was produced in 1992 after the collapses of
BCCI, the Mirror Group and Polly Peck, whilst in the U.S., there was
increasing focus from 2001 after scandals including Enron and WorldCom.
Their demise was quickly followed by the U.S. government passing the Sarbanes-Oxley Act (2002) which imposed strict governance standards in
US companies.
So, we have a number of instances where companies have been found to be
misleading shareholders, fixing the books, and lots of generally fraudulent
and dishonest behaviour. And the response to this has been a number of acts
and laws being passed by global governments to prevent these things from
happening again. Let's take a look at what those key acts and laws are all
about.
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3. Principles of corporate governance
What we are going to do now is take a look at these key principles that form the
basis of the acts that have been passed in recent years. These are the foundations of corporate governance, and they are designed to make the
business-world more responsible and accountable.
The core principles which most contemporary discussions of corporate
governance refer to were raised in three documents released since 1990:
• The Cadbury Report (UK, 1992).
• The Principles of Corporate Governance (OECD, 1998 and 2004).
• The Sarbanes-Oxley Act (US, 2002).
The Cadbury and OECD reports present general principles around which
businesses are expected to operate to assure proper governance. As these are
in general terms only and are not compulsory or legislated, they are known as principle-based approaches to governance.
The Sarbanes-Oxley Act, informally referred to as Sarbox or SOX, is an attempt by the federal government in the United States to legislate several of
the principles recommended in the Cadbury and OECD reports. In
governance terms SOX is what is known as a rules-based approach that being
one that
is legislated and sets out in significant amounts of detail exactly what must (and
must not) be done.
In the UK, a new code has taken the place of the Cadbury report, and what we now have is the UK Code of Corporate Governance, which is updated a
regular interval and relevant to UK companies listed on the stock market. It is
largely based on the same principles as the Cadbury report, but it's worth
noting that we will only be concerned with this new UK Code. This is also a principle-based approach.
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The Five Key Principles
Generally, we can boil a lot of the ideas contained within corporate
governance down to 5 key principles:
Rights and equitable treatment of shareholders
Organisations should respect the rights of shareholders and help
shareholders to exercise those rights. They can help shareholders exercise their rights by openly and effectively communicating information and by
encouraging shareholders to participate in general meetings.
For example, an organisation will hold an AGM. This stands for Annual
General Meeting, which is a meeting held once a year with the board of
directors and the shareholders in attendance where a number of key issues
are discussed and then put to the vote. This gives shareholders the ability to
voice any concerns, and vote on relevant matters.
It's very important to make sure that shareholders are given the opportunity to
have a voice in the company. After all, they are the owners of the company!
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Interests of other stakeholders
Organisations should recognise that they have legal, contractual, social, and market driven obligations to non-shareholder stakeholders, including
employees, investors, creditors, suppliers, local communities, customers, and
policy makers.
For instance, with regard to employees, an organisation has a number of
legal requirements to ensure that their staff are being given appropriate
training, resources, holiday entitlement, health and safety training, etc. Even
though the employees don't necessarily hold shares in the company, it's clear
that they are an important factor in the performance of the business and a
moral duty of care is owed to them.
Other important stakeholders would be creditors or investors. A company has
obligations to repay or provide returns on any capital attained from these
stakeholders. If an organisation fails to do this they will find it hard to negotiate
more capital which is essential to long term success.
Role and responsibilities of the board
The board needs sufficient relevant skills and understanding to review and
challenge management performance. It also needs to be of a suitable size
and have appropriate levels of independence and commitment. There is
no point in a small company having a huge board of directors, but also a
large company needs enough people to be able to provide sufficient
expertise. Also if the board is not independent, then it will be open to bias
which may have a detrimental effect on strategy.
Members of the board should also be appointed based on their skills and
experience, rather than their connections in the business-world. Nepotism
(giving preference to a family member) or cronyism (appointing friends to
positions of authority without regard to their qualifications) is drastically
reduced when formal and rigorous procedures are put in place for
appointing members of the board.
Integrity and ethical behaviour
Integrity should be a fundamental requirement in choosing corporate
officers and board members. Organisations should develop a code of
conduct for their directors and executives that promotes ethical and
responsible decision making.
Integrity means an individual should behave fairly and always 'do the right
thing' acting in a professional manner considering the wider impact of all
decisions made on others. As we have seen, there have been numerous cases
of chief executives and other top level members of organisations engaging in
morally dubious behaviour. Directors should be chosen who show the highest
of moral standards to avoid these situations occurring.
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Disclosure and transparency
Organisations should make the roles and responsibilities of their board and
management clear and publicly known in order to provide stakeholders
with a level of accountability. They should also implement procedures to
independently verify and safeguard the integrity of the company's financial
reporting. Disclosure of material (i.e. significant and relevant) matters
concerning the organisation should be timely and balanced to ensure that all
investors have access to clear, factual information.
One way that this is done is in the company's annual report where a whole
range of both financial and non-financial information is disclosed. Most
annual reports will contain a section on the governance of the business
including details of executive and non-executive directors of an
organisation, with a breakdown of their key responsibilities and roles. This
gives interested parties the ability to identify an individual, or group of
individuals, who have responsibility of a particular aspect of the managing of
the business. Coca-Cola is an example of a company which produces very
clear and accessible annual reports.
Disclosure of business operations are also required by law to prevent
unlawful conduct. For example, in November 2015 amendments were made
to the Human Trafficking and Exploitation Act regarding information which
could reveal hidden human trafficking and modern slavery.
Board Structures
All boards have executive and non-executive directors. Executives are
employees who are involved in the day to day running of the business
and will have positions such as CEO, or senior manager. Non-executive
directors (NEDs) are more like consultants, they do not have position in
the company other than their role on the board. They will be experts in
any fields that the company is involved in.
Boards can be split into two broad categories, unitary boards and two-tier
boards:
Unitary
Most UK companies have a unitary model. Unitary boards have both
executives and non-executives and usually make decisions together as a
single unit.
A Unitary board can be either majority executive or majority non-
executive. The first consists of mostly executives and the other of mostly
non-executives.
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Two-tier
These are mainly used in France and Germany. They consist of a lower tier
which is known as the Management board and an upper tier known as the
Supervisory board.
The management board is in charge of the day to day running of the
business and usually formed of mostly executives such as CEO's.
The supervisory board supervises, advises and decides who is
appointed to the management board. Supervisory board members are
usually non- executives and are nominated by shareholders.
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4. The UK Code of corporate governance
To whom does it apply?
The UK Corporate Governance Code is a set of principles of good corporate
governance aimed at companies listed on the London Stock Exchange.
Public listed companies are required to disclose how they have
complied with the code, and explain where they have not applied the
code – in what the code refers to as 'comply or explain'.
Note that this means that there is no legal obligation to actually follow the
rules of the code, with the aim of providing the Directors with the flexibility to
diverge from the code where they feel it is in the stakeholders' best interests.
Full disclosure where they do not comply and the reasons for this should
enable shareholders to raise objections if they do not agree.
For example, in defiance of combined code rules, Stuart Rose became the
Executive Chairman (i.e. both Chairman and CEO) of Marks and Spencer in
2008, as the directors believed it was best for the company. Following
significant shareholder protests and negative media coverage, he stepped
down from this role in 2010.
Private companies are also encouraged to conform; however there is no
requirement for disclosure of compliance in private company accounts.
Since many smaller companies are owned and managed by the same person,
there is less call for accountability for private companies as they are not
listed. Shareholders in listed companies are members of the public, so the
government has a greater need to protect public interests. Private
companies are privately owned so there is less of a need to protect the
public from them.
A principles-based approach
The Code adopts a principles-based approach. This means that it
provides general guidelines of best practice rather than highly detailed rules.
There is also no legal obligation to adopt the principles. This contrasts with
a rules-based approach which rigidly defines exact provisions that must
be adhered to (as is used in SOX).
Contents of the UK combined
code Section A: Leadership
1. Every company should be headed by an effective board which is collectively
responsible for the long-term success of
the company.
An effective board is one that is able to
make a difference to the organisation.
They will have regular meetings, clear
lines of communication, and clearly
defined roles.
2. There should be a clear division of responsibilities at the head of the
company between the running of the board (Chairman) and the executive
responsibility for the running of the company’s business (CEO). No one
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individual should have unfettered powers of decision-making.
This is to make sure that no one individual has too much power within the
organisation. The CEO and Chairman of the board need to be different to
make sure there is some tension between directors at the top of the
company. This ensures a sufficient level of scrutiny is applied to any
proposed ideas and strategies.
3. The chairman is responsible for the leadership of the board and
ensuring its effectiveness on all aspects of its role. They are responsible for
organising and directing the focus of the non-executive directors, who are
the members of the board who are not managers of the company. This role
ensures that the non-executives are effective in their role.
4. As part of their role as members of a board, non-executive directors should constructively challenge and help develop proposals on
strategy. This ensures that there is an element of tension between the
executive and non-executive directors. The executives will have to convince
the board of any ideas or plans they have for the business, and extreme
ideas will be scrutinised.
Section B: Effectiveness
1. The board and its committees should have the appropriate balance of skills,
experience, independence and
knowledge of the company to enable
them to discharge their respective duties
and responsibilities effectively.
This ensures that members of the board are
properly qualified for their position and can
perform their job effectively.
2. There should be a formal, rigorous and transparent procedure for the
appointment of new directors to the board. This can be done by a
Nomination Committee.
This makes the recruitment process fair and comprehensive; ensuring that
only the most suitable candidates are appointed to the board. This measure
reduces the risk of nepotism and cronyism.
3. All directors should be able to allocate sufficient time to the company
to discharge their responsibilities effectively.
Often, the non-executive directors (NEDs) will be part-time employees of the
company, and perhaps only work directly for the company a few hours per
week. In this situation, it's important that individuals are giving the
organisation their full attention, regardless of their engagement with other
business.
4. All directors should receive induction on joining the board and should
regularly update and refresh their skills and knowledge.
To be really effective, the board need to be trained in the specifics of the
organisation and the industry in which they operate.
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If, for example, they are working at an energy company, they will need to
know about both that particular company, e.g. its strategy, objectives,
procedures, culture, customers, suppliers, financial position. They will also
need to know about the energy industry at large, such as competitors,
industry growth rates, and technological trends, to play an effective role on
the board.
5. The board should be supplied in a timely manner with information in a
form and of a quality appropriate to enable it to discharge its duties.
Much like the previous point, directors need adequate information to make
decisions. If the company is planning to expand into a new industry, the
board need to be given appropriate information on that industry in order to
make an effective decision about any expansion.
6. The board should undertake a formal and rigorous annual evaluation
of its own performance and that of its committees and individual directors.
Self-evaluation is important to make sure that the board are aware of its own
performance, and think critically about their role and responsibilities at the top
of the organisation.
7. All directors should be submitted for re-election at regular intervals,
subject to continued satisfactory performance.
This ensures directors are replaced when they aren't performing effectively.
Shareholders can chose to remove any poorly performing directors by taking
a vote, and this also reduces the costs associated with firing a director such
as having to pay off a long term contract.
Section C: Accountability
1. The board should disclose a balanced and understandable assessment of the
company’s position and prospects.
This makes sure that the board are
communicating honestly about the reality of
the business, and that they aren't concealing
information from stakeholders.
2. The board is responsible for determining the nature and extent of the significant risks it is willing to take in
achieving its strategic objectives. The board should maintain sound risk
management and internal control systems.
Therefore, the board must be responsible for identifying risks that the
company may face, and putting systems in place to avoid or reduce the
impact of these risks.
3. The board should establish formal and transparent arrangements for
considering how they should apply the corporate reporting, risk
management, and internal control principles, and also for maintaining an
appropriate relationship with the company’s auditor.
So, it should be made clear exactly how the board are choosing to implement
any principles of corporate governance, so that these choices are justified. Most organisations will use an Audit Committee, which is made up
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of members of non-executive directors who are tasked with making
decisions regarding choosing an auditor.
Section D: Remuneration
1. Levels of remuneration should be sufficient to attract, retain and
motivate directors of the quality required to run the company successfully,
but a company should avoid paying more than is necessary for this
purpose. Remuneration is the money paid for
service i.e. salary.
A significant proportion of executive
directors’ remuneration should be structured
so as to link rewards to corporate and
individual performance, with an increasing
emphasis on long term performance.
2. There should be a formal and transparent
procedure for developing policy on
executive remuneration and for fixing the remuneration packages of
individual directors. No director should be involved in deciding his or her
own remuneration.
Directors' pay is a contentious issue, and so the procedure by which a salary
figure is arrive at should be transparent to ensure that the process is fair and reasonable. Most organisations will use a Remuneration Committee
made up of non-executive directors who are tasked with making decisions
regarding remuneration.
Section E: Relations with Shareholders
1. There should be a dialogue with shareholders based on the mutual
understanding of objectives. The board as a
whole has responsibility for ensuring that a
satisfactory dialogue with shareholders takes
place.
It is important for the shareholders to
communicate their views and objectives and
also have an ability to hold the board directly
responsible for business decisions.
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2. The board should use the Annual General Meeting (AGM) to
communicate with investors and to encourage their
participation.
The code most commonly used in the case study exam
As a good, general set of principles it is also the one you should most
commonly use in the case study exams (which you will need to take later
in the course!) as an example of good principles, even if that organisation is
not obligated to use it.
There are other codes of governance however that are used in other
countries that mostly fulfil the same principles such as the Kings III report
(South Africa) and Sarbanes Oxley (USA).
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5. Governance committees
As part of the UK's combined code they recommend a number of committees
on which the non-executive directors sit. In this section we bring together all
the key committees and give you a little more detail on them.
The major board committees are:
Audit committee
The main responsibilities for the audit committee are as follows:
• Monitoring the integrity of the financial statements and any formal announcements relating to financial performance.
• Reviewing internal financial controls and, unless there is a separate board risk committee, reviewing the company’s internal control and
risk management systems.
• Monitoring and reviewing the effectiveness of the internal audit function.
• Making recommendations to the board in relation to the appointment, re-appointment and removal of the external auditor
and approve the remuneration and terms of engagement of the
auditor.
• Reviewing the auditor’s independence and objectivity.
• Developing and implementing the non-audit services policy (with the aim that auditor independence is not compromised by significant non- audit fees).
The audit committee should be staffed by independent, non-executive
directors (NEDs) to bring independence to this key oversight role.
Remuneration committee
Directors' pay is a contentious issue, and so the procedure by which a salary
figure is arrived should be transparent to ensure that the process is fair and reasonable. Most organisation will use a Remuneration Committee, made
up of non-executive directors who are tasked with making decisions
regarding remuneration.
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Levels of remuneration should be sufficient to attract, retain and
motivate directors of the quality required to run the company successfully,
but a company should avoid paying more than is necessary for this
purpose.
A significant proportion of executive directors’ remuneration should be
structured so as to link rewards to corporate and individual performance,
with an increasing emphasis on long term performance.
There should be a formal and transparent procedure for developing policy
on executive remuneration and for fixing the remuneration packages of
individual directors. No director should be involved in deciding his or her own
remuneration.
Nomination committee
In a well governed and effective board there should be a formal, rigorous and transparent procedure for the appointment of new directors to the board.
This makes the recruitment process fair and comprehensive; ensuring that only
the most suitable candidates are appointed to the board. This measure
reduces the risk of nepotism and cronyism.
This task is appointed to the nominations committee, which is made up of
mostly NEDs and make decisions on the structure of the board and appoint
new directors.
Benefits of NEDs
We can relate the advantages of NEDs to these committees as an easy way
to learn then:
• Independent review of risk and reporting (audit committee)
• Independence in dealing with the auditors (audit committee)
• Fair pay (not too high or low) for directors (remuneration committee)
• Fair appointment for new directors on merit (nomination committee).
And we might also add:
• Support the development of board decisions and strategy by bringing an independent perspective.
• Be a representative of shareholders and other stakeholders to ensure their needs are met.
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6. IFAC's drivers for sustainable organisational success
We all want to be successful and we want to stay successful, but how can
we achieve this? If only there was some list to help guide us on how to be
successful from a reliable source. Luckily IFAC has kindly provided such a
list!
Remember, IFAC is the International Federation of Accountants, and is the
global organisation for the accountancy profession.
If you want a really successful company, then your governance will go
beyond ticking off lists showing your compliance with regulations. It will
seek to improve the running of your organisation. In other words, good
governance should breed good performance.
IFAC's drivers for sustainable organisational success are key areas where
better governance can lead to vast improvements:
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7. CIMA's proposals for better reporting on corporate governance
A governance report is usually included in financial statements. Most
commonly this shows how the organisation has complied with governance
regulations.
CIMA have proposed that improvement to the reporting of governance could
be made in 3 ways:
Chairman's Message
A Chairman's message is encouraged by the UK Corporate Governance
Code. It's supposed to cover how the parts of the Code on leadership and
effectiveness have been followed. It's usually a dull statement of how
seriously governance is taken.
CIMA propose that they should talk about how leadership has been
shown to be effective in relation to key corporate events and
according to the organisation's values.
Narrative reporting and governance reporting
The governance report should widen it's remitting to include reports made
by managers about its market environment, the priorities of its strategy,
business model and risks. This is Narrative reporting and it enables
readers of the accounts to get a broader view of the organisation's
performance.
Compliance reporting separate from governance reporting
CIMA proposes separating wider reporting of governance issues and
governance compliance (i.e. how the company complies with regulation)
so the report will have a section on governance and a section on compliance to
ensure both sections are clearly distinguishable to readers.
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Corporate Codes and CSR
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1. Codes and guidelines
There is a saying, when in Rome do as the Romans do. This phrase was born
out of the fact the people do things differently in other places. It was first
penned by St Ambrose who was explaining that to avoid conflict he followed
different customs of the Christian church depending on where he was. This
may not surprise you, but people have fought and died over differing views on
when to celebrate Easter or when to fast. Well, a similar philosophy should
be followed with regards to international corporate governance. Of course, I
mean the “when in Rome” philosophy, not the “fight and die” one!
Much like many aspects of regulations and conceptual frameworks,
corporate governance principles and codes have been developed in a
range of different countries.
As a rule, compliance with these governance recommendations is not
mandated by law, although the codes linked to stock exchange listing
requirements may have a coercive effect. This means that although there is
no legal obligation, it is a condition of being a listed company. Many
companies, therefore, will need to adopt these policies if they want to be
listed on a stock exchange.
For example, companies quoted on the London, Toronto and Australian Stock
Exchanges formally need not follow the recommendations of their respective codes. However, they must disclose whether they follow the
recommendations in those documents and, where not, they should provide
explanations concerning divergent practices. Such disclosure
requirements exert a significant pressure on listed companies for
compliance.
The organisation for economic co-operation and development (OECD)
principles
One of the most influential guidelines to international corporate
governance has been the 1999 OECD Principles of Corporate
Governance. This was revised in 2004. The principles were created to
assist OECD and non-OECD governments in their efforts to evaluate and
improve the legal, institutional and regulatory framework for corporate
governance in their countries, and to provide guidance and suggestions for
stock exchanges, investors, corporations, and other parties that have a role
in the process of developing good corporate governance.
Whilst these principles may focus primarily on publicly traded
companies, both financial and non-financial (like the UK code of
governance) they are, to some extent applicable and useful for
improving the corporate governance in non-traded companies, for
example, privately held and state-owned enterprises.
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The six principles in the OECD framework are as follows:
Lets take a look at these in a little more detail:
Ensuring the basis for an effective corporate governance framework
The corporate governance framework should promote transparent and
efficient markets, be consistent with the rule of law and clearly articulate the
division of responsibilities among different supervisory, regulatory and
enforcement authorities.
The rights of shareholders and key ownership functions
The corporate governance framework should protect and facilitate the
exercise of shareholders’ rights. Basically this means that directors should
always act in the best interests of the shareholders.
The equitable treatment of shareholders
The corporate governance framework should ensure the equitable treatment
of all shareholders, including minority and foreign shareholders. All
shareholders should have the opportunity to obtain effective redress for
violation of their rights. In short, all shareholders big and small deserve the
right to have their voice heard and be invited to the AGM etc.
The role of stakeholders in corporate governance
The corporate governance framework should recognise the rights of
stakeholders established by law or through mutual agreements and
encourage active co-operation between corporations and stakeholders in
creating wealth, jobs, and the sustainability of financially sound
enterprises.
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Disclosure and transparency
The corporate governance framework should ensure that timely and
accurate disclosure is made on all material matters regarding the
corporation, including the financial situation, performance, ownership, and
governance of the company.
The responsibilities of the board
The corporate governance framework should ensure the strategic guidance
of the company, the effective monitoring of management by the board, and
the board’s accountability to the company and the shareholders.
US Code – Sarbanes Oxley
Sarbanes–Oxley, Sarbox or SOX, is a United States governance law for all
U.S. public company boards, management and public accounting firms.
It is named after sponsors Paul Sarbanes and Michael G. Oxley.
Rules-based approach
SOX is a rules-based approach which is mandated by law, and it is,
therefore, more restrictive than many principle-based approaches like
OECD and the UK code of Governance.
Debate continues over the perceived benefits and costs of SOX. Opponents
of the bill claim it has reduced America's international competitive edge
against foreign financial service providers, saying SOX has introduced an
overly complex regulatory environment into U.S. financial markets.
On the other side, proponents of the measure say that SOX has improved the
confidence of fund managers and other investors with regard to the veracity of
corporate financial statements.
Key elements of SOX
Sarbanes–Oxley contains 11 titles that describe specific mandates and
requirements for financial reporting. The key elements you need to know
for this exam are:
Public Company Accounting Oversight Board (PCAOB)
Title I establishes the Public Company Accounting Oversight Board, to
provide independent oversight of public accounting firms providing audit
services ("auditors"). Essentially, the PCAOB audit the auditors.
The PCAOB also creates a central oversight board tasked with registering
auditors, defining the specific processes and procedures for compliance
audits, inspecting and policing conduct and quality control, and enforcing
compliance with the specific mandates of SOX.
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Auditor Independence
Title II establishes standards for external auditor independence in order to
limit conflicts of interest. It also addresses new auditor approval
requirements making sure that new auditors meet the minimum
requirements, audit partner rotation making sure that the same auditors
aren't always working with the same entity to prevent any vested interests forming, and auditor reporting requirements. It restricts auditing
companies from providing non-audit services, such as consulting, for the
same clients.
Corporate Responsibility
Title III mandates that senior executives take individual responsibility for the
accuracy and completeness of corporate financial reports. It defines the
interaction of external auditors and corporate audit committees, and
specifies the responsibility of corporate officers for the accuracy and validity
of corporate financial reports.
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2. Corporate social responsibility (CSR)
Meet Bob! Bob is the owner of Bob's Lunchbox a company based in anytown
committed to making quality sandwiches, filled with local organic produce.
Now, imagine if Bob simply dumped his food waste into the Anytown river!
Well, apart from being illegal, it would be an irresponsible thing to do. It
would encourage rats and probably poison the fish and other animals living in
the river. He would be a very bad neighbour.
Now, imagine the law said it was actually legal to dump up to 20kg of food
waste per week into local rivers. Should Bob take advantage? It would now
be legal, but it would still be highly irresponsible, because the ill effects of the
activity would still apply, even if he only dumped 1kg. That, in a nutshell, is
the concept of Corporate Social Responsibility. It's about doing what's right
for all stakeholders, even when it goes beyond mere compliance with
laws and regulations.
Corporate Social Responsibility is a company's responsibility to the
society in which it operates. This means considering all stakeholders as
part of the decision making process – not just the “key players”.
CSR policies cover issues such as environmental policy and sustainability,
health and safety, treatment of staff, charitable work and contribution, and
supporting local communities.
Benefits to business of good CSR
Brand differentiation and reputation
Now you might be tempted to look upon CSR as a compliance issue: a cost of doing business that must be borne. It's actually better to see it as an
investment in something that brings multiple returns! In crowded
marketplaces, companies strive for a unique selling proposition that can separate them from the competition in the minds of consumers. CSR can
play a vital role in building customer loyalty based on distinctive ethical
values. Several major brands, such as The Co-operative Group, The
Body Shop and American Apparel are built on ethical values.
A good CSR policy and approach can create a good long-term
reputation for the firm, which supports the development of a strong, well
recognised and well-respected brand.
Avoiding regulation
Corporations are keen to avoid interference in their business through taxation or regulations. By taking substantive voluntary steps, they can
persuade governments and the wider public that they are taking issues such
as health and safety, diversity, or the environment seriously as good
corporate citizens with respect to labour standards and impacts on the
environment. This will help avoid having standards imposed by law.
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For example, a few years ago, a media scare emerged over parabens, a type
of preservative stabiliser used in many personal care products such as
moisturiser. No hard data existed to prove its danger, but to avoid regulatory
intervention in their industry, manufacturers began voluntarily removing the
ingredient. What they quickly discovered was that the removal could be
turned into a selling point and products emerged that boasted "paraben free"
as a benefit. As a result, the media scare ended there, with no further
investigation by the regulatory bodies.
Carroll's Pyramid of Corporate Social Responsibility
So how do you keep track of all the areas you need to work on? Carroll
devised a four-part model for CSR and argued that any organisation wishing
to implement CSR would need to satisfy each of the following levels:
Economic responsibility
The organisation has a primary responsibility to stay in business, return
value to shareholders, pay its employees and deliver quality to customers.
Today public feeling may find the pursuit of cash distasteful, but this is the
primary purpose of a profit-making entity and a necessity for non-profits if
they wish to continue to operate.
For example, a company that spent all its money developing clean energy
systems and then couldn't afford to pay its staff would be operating
irresponsibly. So keeping the company afloat and generating cash comes
first.
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Legal responsibility
The organisation also has a primary responsibility to operate within
the law in each country of operation. It's not just about staying out of jail:
the law provides a baseline for acceptable behaviour. So when it comes to
developing CSR policies, the legal requirements provide a starting point and
a minimum licence to do business. Most large companies and particularly
multinational companies will have someone working purely on compliance.
For example, in 2012, the UK Advertising Standards Authority referred
Groupon to the Office of Fair Trading, a regulatory authority, after the
company was found to have broken UK advertising regulations more than 50
times in less than a year. That wasn't just illegal it was not good social
responsibility.
Ethical responsibility
The top half of Carroll’s pyramid looks at discretionary responsibilities. In
theory these responsibilities are optional because the organisation
may not be held legally accountable. In practice, however, they are not
really optional, since unethical practices will eventually create a bad
reputation and threaten the primary responsibility of generating wealth.
Ethical responsibility is about going beyond compliance and doing what is
right and fair.
For example, Tesco, the UK supermarket, came under media criticism for its
use of private label food brands such as Willow Farms and Boswell Farms.
Critics said this gave the impression that the food was sourced from local
British farms but in reality no farms of that name existed and most of the
food was produced abroad. Legally, Tesco can call its brands what it likes
and there is no suggestion that it broke any laws. But critics felt the ploy
was unethical and misleading.
Ethics vary from person to person, some think it is unethical to eat meat
whereas others do not. Therefore, it is up to companies to try to maintain
ethics that will coincide with those of the society in which they operate.
Philanthropic responsibility
This is about discretionary acts of corporate citizenship: making a
contribution to the wider good of society. These are the things that no one expects
you to do and no one will require you to do, but you do them anyway.
For example, in an effort to provide better technological support for
governments that are slow to embrace technology, Google provides Code for
America, a charity, with an annual gift of $3 million to develop civic technological solutions. There's no direct benefit to Google, it's just something the
company believes would make the world a better place.
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Example: Bob's Lunchbox
So let's look at our example company and see how it might go about
implementing Carroll's Pyramid.
1. Economic. Bob takes care to negotiate the best deal he can on his inputs
and eliminate unnecessary cost in his operations, so that he can make the
best return possible on his business so he can pay his staff and source food
responsibly without concern for price.
2. Legal. Bob is strict about only using suppliers that have a recognised food
safety certification and recent audits in place. He understands that a single
breach of food safety law could shut down his business. He uses a CIMA-
qualified accountant to help prepare his financial statements and tax so he
can be sure to be operating within the law.
3. Ethical. Bob trades on the claim that he uses only local organic
ingredients. He could get a better price by using industrial suppliers, but
that would be unethical, given the claims he makes.
4. Philanthropic. Bob's sandwich store donates food each week to a
homeless charity. It also sponsors a number of nutritional and healthy living
non-governmental organisations (NGOs). These acts don't directly benefit
Bob's business, but they do benefit the wider community in which his
business operates, and they support the overarching vision of his company.
Ethical stances
So how far should Bob go? How will he know when he's done enough? It
depends on which ethical stance his company is going to adopt. Johnson,
Scholes and Whittington claim there are four stances, which determine “the
extent to which an organisation will exceed its minimum obligations to
stakeholders”. Here are those stances:
Short-term Shareholder Interest
This is a stance designed to maximise returns in the current financial
year. Companies with this stance believe anything above legal minimum set
by governments is not profitable.
For example, a factory that releases carbon emissions just below the legal
maximum is not breaking the law. It could invest in new machinery and
process redesign to reduce emissions to close to zero, but that would not be in
the short-term interest of shareholders, since the investment is not
necessary.
Longer-term Shareholder Interest
This stance takes a slightly longer view of things and recognises that money
spent now on corporate responsibility can enhance the organisation's
reputation and bring returns later.
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Walmart tried this argument with its shareholders when some asked the
company to justify spending on sustainability. Ultimately, the spending had to
be sold as a long-term investment in cost-reduction through renewable
energy before it was agreed.
Multiple stakeholder obligation
Organisations taking this stance recognise an obligation to a wider group of
stakeholders than simply shareholders. It is not a simple case of
“government legislates” responsibility, but more “society dictates” it. It
involves recognising a purpose beyond financial.
The food industry launched a global, cross-industry initiative to end reliance on
palm oil, which is responsible for deforestation. This has no financial benefits
for any manufacturer, it is simply a recognition of responsibility to a wider set of
stakeholders, such as the producing communities, environmental NGOs and
the planet as a whole, which needs better forest management to slow climate
change.
Shaper of society
An organisation taking this stance sees its purpose in society as its ultimate
driver, so financial interests are subordinate to performing its role in/for society.
An example might be the John Lewis Partnership (which includes the
Waitrose supermarket). Its radical mission is the happiness of its employees,
which its commercial activity supports. In JLP's model, all staff are joint
owners of the business and the collective employs its directors to run the
business in trust, returning shares in the profit to all partners. The directors
are, therefore, accountable to the workforce and can be removed.
Sustainability
Let's say you want to manufacture a chemical, but your process uses fossil
fuels and causes long-term toxic waste to be leaked into the local area. It's
profitable, so it satisfies Carroll's first level of CSR. But is it sustainable?
Well, no. It can't be sustained indefinitely as a business, because there is
only so much fossil fuel left on Earth. Once it's gone you have no business
model. Secondly, the activity itself damages the environment that future
generations will need to survive in.
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That's the notion of sustainability in a nutshell. It's using resources in such
a way that we don't compromise the needs of future generations. It's
about challenging short-termism in the way we operate our activities, both
internally and externally and focusing on the long-term sustainability of both
the business and its environment.
Cost savings through sustainable development
Ironically, focusing on long-term sustainable development can bring
short-term profitability increases through cost-savings. For example,
harvesting rain water instead of turning on the taps will bring long-term
environmental benefits, but will also save on your water bill. The same is
true of solar energy to generate electricity, or natural lighting in stores.
Corporations looking for investments from shareholders and banks to fund
their sustainability programmes soon realised that selling the story that way
achieved better buy-in.
Building CSR into the organisation
So, coming back to Bob and his food waste. Bob should carry on as he is and
just hire a CSR expert to implement this, right? You guessed it. Wrong! CSR
is far too important to leave it to one function or division of your
company to implement and will only lead to conflicts of interest within
the organisation. To be effective, CSR needs to be built into the decision-
making process for the whole organisation. There are a variety of ways of
doing that. Let's look at them:
Mission and objectives
Inclusion of CSR values within the mission statement has become
common practice, they help to ensure that CSR is considered within all
strategies and that objectives are achieved without compromising the
company’s CSR policies.
Creating focused CSR objectives with clear plans for achievement also helps
focus CSR activity, particularly when these are linked to managerial
performance and reviewed regularly.
CSR Policies
A CSR policy is an internal statement of rules and expectations on
CSR issues to be applied within the organisation. It sets out the
organisations
values and clear rules to be followed in relation to many ethical and social issues.
So for example, Bob could set a policy of never paying less than market rate
for produce, or of never setting unfair production targets that made it
economically impossible for producers to continue supply sustainably. When
Bob's business expands and he no longer directly oversees procurement, his
policies will set out the rules for his staff to follow.
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Benchmarking
Benchmarking enables comparison of CSR performance against other
organisations. It involves reviewing competitor CSR initiatives, as well as
measuring and evaluating the impact that those policies have on society and
the environment, as well as how customers perceive competitor CSR strategy. After a comprehensive study of competitor strategy and an
internal policy review has been performed, a comparison can be drawn
and a strategy developed for CSR initiatives.
So for example, Bob could take a look at what his main competitor, does as
a corporate citizen and aim to close the gap between his policies and theirs.
Social accounting, auditing, and reporting
Social accounting involves accounting for and reporting the social and
environmental effects of a company's economic actions.
A number of reporting guidelines or standards have been developed to serve
as frameworks for social accounting, auditing and reporting including:
Global Reporting Initiative's Sustainability Reporting Guidelines
The ISO 14000 environmental management standard
In some nations, legal requirements for social accounting, auditing and
reporting exist although there is little international agreement on what
constitutes meaningful measurement of social and environmental
performance.
Problems of Supply
You may run your company perfectly ethically, but if one of your
suppliers is not so ethical then you and your company are guilty by
association.
Apple got in trouble for this when it was discovered that the Chinese
company that they had outsourced production to was subjecting its staff to
inhumane working conditions, resulting in several suicides.
You even need to consider the distances travelled. Food miles for example.
The environment is a key focus at the moment so if tons of greenhouse gases
are being pumped into the air for you to transport food such as beef from
South America to the UK when there is perfectly good beef in Britain you
may suffer a public backlash. Both from environmentalists and also those
concerned about the state of the British beef industry.
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3. Regulations and business/government relations
If you live in the UK you may recall the time Russell Brand was fired from the
BBC for making abusive phone calls during his radio show. This was the
result of a large number of complaints being made to OFCOM on the grounds
that the content of his show was deemed to be offensive! OFCOM is the
Office of Communications and is responsible for regulating and monitoring
broadcasting, telecommunications and postal services. After an investigation
OFCOM affirmed the complaints were against public standards and the BBC
fired him. This is an example of the power of a regulatory body.
Regulations and regulatory bodies
Regulations are often set by regulatory bodies. In the UK examples are
OFCOM (telecoms) and OFGAS (gas) which aim to promote fair competition
between companies whilst protecting the public.
Regulations create limits, constraints or allocate a responsibility. Their
purpose is usually to protect the public good in some way. For example, by
ensuring the safety and quality of the products or services that businesses in
the industry provide.
Impact on business
Businesses must comply with rules and regulations governing the market
place, or face the consequences. These may be anything from a slap on the
wrist and disappointed stares from the public, to an indictment.
Ineffective and overly oppressive regulations have been found to
discourage business development which in turn may have a negative effect
on the economy. As a result governments, regulatory bodies and businesses
will often meet to discuss new regulations ensuring the right balance of
protection, fairness, room for innovation etc.
Corporate political activity (CPA)
Corporate political activity is essentially the process of businesses getting
involved in political activity in order to influence decisions and to react
quickly to change.
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Buffering
There are two broad types of buffering:
• Lobbying – this involves an organisation attempting to influence government through debate and discussion with them. One
example of this can be seen in America in regard to gun laws. Gun
lobbyists will use their power and number of supporters to put
pressure on government to protect gun rights. In the UK, the
Confederation of British Industry (CBI) will lobby on business related
matters to put the 'business perspective' across to the UK
government.
• Donations – many organisations will make donations to political parties. Many people see this as a form of bribery, although it is not
technically classed as such.
In developing countries Corporate Political Activity is commonplace and
some governments or government officials are more readily willing to
change laws or regulations based on lobbying activities, or even bribery.
Bridging
This refers to companies working their way around new rules and
regulations in order to avoid legal action when new laws are passed. For
example, a perfume company finding out that a key ingredient in one of their
fragrances could be banned in the next year because it can damage skin.
This allows them extra time to formulate an alternative before the law comes
into affect, avoiding any legal repercussions.
Diploma in Business Ethics and Corporate Governance - Level 3 copy_1.pdfModule 3 Corporate Governance, Codes and CSR.pdf