ICSA
CSQS: Corporate Governance
Course Notes
(1H /2019)
TABLE OF CONTENTS
Introduction to ICSA CSQS Corporate Governance .............................................................. iii
Corporate Governance Syllabus ............................................................................................ ix
SECTION 1: Concepts in Corporate Governance ................................................................. 1
Achievement Ladder Step 1 ............................................................................................... 28
SECTION 2: Governance: Principles v Rules ....................................................................... 29
SECTION 3: The Board of Directors ..................................................................................... 52
SECTION 4: Governance Practice ....................................................................................... 81
Achievement Ladder Step 2 ............................................................................................. 107
Section: Extra: Revision ...................................................................................................... 108
SECTION 5: Remuneration ................................................................................................ 114
SECTION 6: Reporting ....................................................................................................... 133
SECTION 7: Shareholders .................................................................................................. 171
Achievement Ladder Step 3 ............................................................................................. 190
SECTION 8: Internal Control .............................................................................................. 191
SECTION 9: Risk Management .......................................................................................... 209
SECTION 10: Corporate Social Responsibility ................................................................... 233
Achievement Ladder Step 4 ............................................................................................. 257
APPENDIX 1: Readings ...................................................................................................... 258
APPENDIX 2: Answers to Lecture Examples ..................................................................... 287
i
INTRODUCTION
ii
INTRODUCTION TO ICSA CSQS CORPORATE
GOVERNANCE
1 Resources
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Important course dates
Syllabus & Course notes
Exam questions and quiz at the end of some sections
1st course mock exam
2nd course mock exam
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Final mock exam is only revealed close to the final mock date.
2 The Course Notes
Please note that "This study material contains material copyright ICSA"
These course notes are designed to be used both in the classroom and outside the
classroom to help with your home study acting as a framework to add your own
notes.
They are not a precis of the ICSA study text, this is an integrated course of study,
which together with the study text, MyStudy recording, practice and revision kit, mock
exams and past exam papers forms a comprehensive assistance to learning,
understanding and then finally attempting the actual ICSA exam.
During each Section there are Lecture Examples, these have been designed to assist your
learning, please attempt them.
There are also a few areas to “complete” from the descriptions provided by your tutor during
the class, so please listen, ask questions and annotate the notes provided.
Some Sections have a Quick Quiz at the end, with answers provided. There are also some
longer answer questions. Don’t cheat and look at the answers before you try the questions!
Some of the questions in the Quick Quiz may require use of the text book to look up further
information.
It is vital that the major part of your learning is practising old exam questions. Just making
notes and reading is not enough to ensure a pass, question practice is essential.
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Sections roughly follow the order of chapters in the study text, however the final
chapter in the study text (other!) is integrated into various different sections of the
notes.
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Essentials that you must know
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Quiz & questions for home study use
iii
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Followed in class, with lecture examples throughout
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A few home study sections
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Answers to lecture examples in Appendix 2
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Reading material in Appendix 1
ICSA suggest that you will need a minimum of 150 hours of study to successfully complete
and pass this course. You will need to develop effective study techniques, just reading the
notes or copying out the study text is not an effective technique. However there are effective
techniques and one of these is using your own mind maps.
Lecture example 1: Reading: Mind Maps
Please read the short article in appendix 1
3 The Study Text
The recommended text book:
Brian Coyle and Trina Hill
ICSA Study Text Corporate Governance
ICSA Publishing
As many students never get to the end of the study text book until it is too late! below is a list
of useful information that is in the appendices in the study text:
The appendices of the study text are very useful!!
Appendix 1: The UK Governance Code (replaced: please download the new 2018
version from FRC website)
Appendix 2: The G20 / OECD Principles
Appendix 3: FRC code and other guidance
Appendix 4: FRC guidance board effectiveness (replaced: please download the new
version from FRC website)
Appendix 5: FRC guidance on Audit Committees
iv
Appendix 6: FRC guidance on Risk Management, Internal Control and Related
Reporting (formally the Turnbulll Guidance)
Appendix 7: The UK Stewardship Code
Appendix 8: FRC Corporate Culture and The Role of Boards
Appendix 9: King Code IV
Glossary of terms
Directory of further reading
4 The exam
As with all ICSA CSQS exams the structure is as follows:
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3 hours 15 minutes exam with a 50% pass mark
The first 15 minutes is reading time, you may write on the exam question paper only
There will be a choice of 6 questions, 4 must be attempted, each worth 25 marks.
All questions are long answer style, and may be divided into sub sections.
Each question will also have a small scenario associated with it.
5 Extra reading
It is important that you are reasonably up to date with new developments in Corporate
Governance as it is a constantly evolving subject. This is noted by the examiner in the
comments shown below. A useful website for guidance on corporate governance issues is
ICSAs own website
www.icsa.org.uk
ICSA publish a wide range of guidance notes on this subject, the study text does reproduce
some of the guidance in the text, but you should download some of the more important
guidance material for extra reading. The examiner often refers to specific ICSA guidance in
exam model answers.
6 Exam issues
Examiner comments
In answering the questions candidates need to show good analytical ability in discussing the
issues raised by the questions and how these issues applied to the case study.
Weaker answers are usually were either short of ideas or lacked common sense and
judgement.
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Points that are made in an answer should be explained. It is not sufficient to make a
statement without justifying it or explaining your reasoning. Corporate governance should not
be a box-ticking exercise, but a large number of candidates write answers in a box-ticking
style, and fail to earn as many marks as they otherwise might do.
Bullet points?
A point that has been made in the past is that many candidates use brief lists of bullet points,
and their answers read like a hasty list of incomplete notes.
Comments from other exam reports on this topic have included
“Lists are acceptable as long as the answers present the points sufficiently clearly and
completely for the marker to understand the point. If candidates make „bullet points‟ that fail
to explain sufficiently the point they are trying to make, and leave it to the reader to „fill in the
gaps‟, they will not get credit and will not earn marks.”
Candidates who may think they „got the answer right‟ might well have earned inadequate
marks by failing to make their points sufficiently full and clear.
Structure answers
There is considerable time pressure on candidates in the exam. Even so, some candidates
might have scored higher marks if they had taken a short time to think about how to answer
a question and to plan the points they could make. Without some answer planning, there
may be a tendency to become repetitive, or to present rambling answers that lack structure.
Some additional comments from a previous examiner of this paper that echo the ones
above:
Stay on track
Take time to read the question carefully and to plan your answer to address the points
raised, not just cover the topic generally – or, worse still, waffle at length and at random.
Good candidates, and all those achieving merit or distinction, showed ability to analyse
problems and to set out the issues involved in a particular topic clearly, often giving points
both in favour and against the proposition. The better candidates showed awareness of
current debates in corporate governance, especially in their own country.
Very basic exam technique makes marking less stressful!
7 Model answers
Due to the nature of this subject there are often various “right” answers to a question,
therefore the answers suggested may be slightly different to the answer you have written,
that does not mean your answer is incorrect.
vi
The length of the suggested answers is also often somewhat exaggerated from what might
be achieved in the reality of an unseen three hour examination. Each answer explores
several areas that might be covered, but is intended as an indication of what is required
rather than as a definitive “right” answer.
At this level, candidates are expected to reason and to apply their varied experience to date
to the issues raised. Please do not be discouraged. Shorter answers, with less narrative but
clear evidence of knowledge, understanding and analytical ability, are well rewarded if
relevant points are covered adequately and the question set is addressed.
Course mock exams
Course mock exams general information
Please start each question on a new sheet of paper, write on both sides of the paper in blue
or black ink only, however if you are going to scan your answers then it may be better to
write on one side as it will be a clearer scan.
Complete all the detail on the front sheet, i.e. Name, return address, then detach it and
attach it to your answers,(you keep the questions), then send to BPP.
Typed answers, unless with prior permission, are NOT acceptable.
Return completed exams by due date, you can scan & covert to pdf and then email, but this
must be legible, if it is not it may not get marked.
Email address: Jerseyenquiries@bpp.com
Postal address:
ICSA Administration, BPP Professional, Whiteley Chambers, 39, Don Street St Helier,
Jersey, Channel Islands, JE2 4TR
Course exam 1
The exam is 1 hour and 40 minutes (1 hour 30 minutes writing, 10 minutes reading time)
There are two compulsory questions
You can use your notes / study text
Course exam 2
The exam is 2 hours and 30 minutes including 15 minutes reading time
There are three compulsory questions
You can use your notes / study text
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Final Mock exam
The exam is 3 hours 15 minutes with 15 minutes reading time at the start of the exam and
then 3 hours writing. You may write on the exam paper only in the reading time.
Candidates should attempt FOUR QUESTIONS ONLY from the choice of six, all of which
carry 25 marks each.
The exam should be completed under exam conditions, for “Face to Face” students this will
be at BPP offices.
NO BOOKS or NOTES should be used
viii
CORPORATE GOVERNANCE SYLLABUS
Module outline and aims
The aim of the Corporate Governance module is to equip the Chartered Secretary with the
knowledge and key skills necessary to act as adviser to governing authorities across the
private, public and voluntary sectors. The advice of the Chartered Secretary will include all
aspects of the governance obligations of organisations, covering not only legal duties, but
also applicable and recommended standards of best practice.
The module will enable the development of a sound understanding of corporate governance
law and practice in a national and international context. It will also enable you to support the
development of good governance and stakeholder dialogue throughout the organisation,
irrespective of sector, being aware of legal obligations and best practice.
Learning outcomes
On successful completion of this module, you will be able to:
 Appraise the frameworks underlying governance law and practice in a national and
international context.
 Advise on governance issues across all sectors, ensuring that the pursuit of strategic
objectives is in line with regulatory developments and developments in best practice.
 Analyse and evaluate situations in which governance problems arise and provide
recommendations for solutions.
 Demonstrate how general concepts of governance apply in a given situation or given
circumstances.
 From the perspective of a Chartered Secretary, provide authoritative and professional
advice on matters of corporate governance.
 Assess the relationship between governance and performance within organisations.
 Apply the principles of risk management and appraise the significance of risk
management for good governance.
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 Compare the responsibilities of organisations to different stakeholder groups, and
advise on issues of ethical conduct and the application of principles of sustainability
and corporate responsibility.
Syllabus content
Candidates will be required to discuss in detail statutory rules and the principles or
provisions of governance codes, and apply them to specific situations or case studies.
Candidates will also be expected to understand the role of the company secretary in
providing support and advice regarding the application of best governance practice.
Although the syllabus presents governance issues mainly from the perspective of
companies, candidates may be required to apply similar principles to non-corporate entities,
such as those in the public and voluntary sectors.
Governance is a continually developing subject, and good candidates will be aware of any
major developments that have occurred at the time they take their examination.
The detailed syllabus set out here has a strong UK emphasis, and it is expected that UK
corporate governance will be the focus of study for most candidates. A good knowledge of
the principles and provisions of the UK Corporate Governance Code will therefore be
required, together with any supporting Guidance on the Code published from time to time by
the Financial Reporting Council. However, a good knowledge and understanding of the code
of corporate governance in another country will be acceptable in answers, provided that
candidates indicate which code they are referring to in their answer.
The UK Corporate Governance Code (‘the Code’; formerly ‘the UK Combined Code’) is
subject to frequent review and amendment by the Financial Reporting Council. You are
advised to check the student newsletter and student news area of the ICSA website to find
out when revisions to the Code will first be examined.
Candidates will not be required to learn in detail codes of governance in countries other than
the UK, although they will be given credit for referring to the code in their own country
outside the UK. Similarly they will not be required to learn in detail codes of governance for
unquoted companies, public sector bodies or not-for-profit organisations. However they must
be prepared to discuss governance issues in these organisations, and be aware of how
these issues differ from corporate governance in listed companies.
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General principles of corporate governance – weighting 10%
The nature of corporate governance and purpose of good corporate governance
 Separation of ownership and control
 Agency theory and corporate governance
 Stakeholder theory and corporate governance
Key issues in corporate governance
 Leadership and effectiveness of the board; accountability; risk management and
internal control; remuneration of directors and senior executives; relations with
shareholders and other stakeholders; sustainability
Principles of good corporate governance
 OECD Principles of Corporate Governance
Framework of corporate governance
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Legal framework
Rules-based and principles-based approaches
Codes of corporate governance and their application: UK Corporate Governance
Code
Concept of ‘comply or explain’
Governance and ethics
Potential consequences of poor corporate governance
The board of directors and leadership – weighting 10%
Role of the board
Division of responsibilities on the board
Matters reserved for the board
Role and responsibilities of the board chairman
Role and responsibilities of the Chief Executive Officer
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Role and responsibilities of non-executive directors
Independence and non-executive directors
Role of the Senior Independent Director
Statutory duties of directors
Rules on dealing in shares by directors: insider dealing; Model Code
Liability of directors: directors’ and officers’ liability insurance
Unitary and two-tier boards
Effectiveness of the board of directors – weighting 15%
Role of the company secretary in governance
Size, structure and composition of the board: board balance
Board committees
Appointments to the board: role of the Nomination Committee; succession and board
refreshment
Induction and development of directors
xii
Information and support for board members
Performance evaluation of the board, its committees and individual directors
Re-election of board members
Governance and accountability – weighting 10%
Financial and business reporting and corporate governance
The need for accountability and transparency
The need for reliable financial reporting: true and fair view, going concern statement
Responsibility for the financial statements and discovery of fraud
Role of the external auditors
Auditor independence; threats to auditor independence; auditors and non-audit work
The Audit Committee: roles, responsibilities, composition; FRC Guidance
Reporting on non-financial issues: narrative reporting; strategic report
Remuneration of directors and senior executives – weighting 10%
Principles of remuneration structure: elements of remuneration
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Remuneration policy
Elements of a remuneration package and the design of performance-related remuneration
 Candidates will not be required to discuss performance targets in detail, but need to be
aware of short-term incentives (e.g. cash bonuses) and longer term bonuses (share
grants, share options).
 Difficulties in designing a suitable remuneration structure
Role of the Remuneration Committee
Compensation for loss of office
Disclosures of directors’ remuneration
 Candidates will be expected to show an awareness of issues relating to the disclosure
of directors’ remuneration in the annual report and accounts, but not the detail (e.g. not
the detail of the directors’ remuneration report)
Shareholder approval of incentive schemes and voting rights with regard to remuneration
The recommendations or guidelines of institutional investor groups on matters relating to
directors’ remuneration
Relations with shareholders – weighting 10%
The equitable treatment of shareholders; protection for minority shareholders
Rights and powers of shareholders
Dialogue and communications with institutional shareholders (companies) or major
stakeholders
Role of institutional investor organisations (or major stakeholders)
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 In the UK, the role of the ABI and PLSA and the relevance for corporate governance
 UK Stewardship Code
Constructive use of the annual general meeting
Shareholder activism
Candidates will be required to have an awareness of the benefits of electronic
communications between companies and their shareholders, but will not be required to know
the detailed law and regulations on electronic communications.
Risk management and internal control – weighting 15%
The nature of risks facing companies and other organisations: categories of risk
 The difference between ‘business risk’ and ‘governance risk’ (internal control risk)
 Internal control risks: financial, operational and compliance risks
 Elements in an internal control system: FRC guidance
Risk and return; identifying, monitoring and reporting key risk areas; risk appetite and risk
tolerance; responsibility of the board of directors
Responsibilities for risk management and internal control: board of directors, executive
management, audit committee, internal and external auditors
 Risk Committees of the board
 Risk management committees
 Role of internal audit within an internal control system
Disaster recovery plans
Whistle-blowing policy and procedures
 ICSA best practice on whistle-blowing procedures
Reviewing and reporting on the effectiveness of the risk management and internal control
systems
xv
Corporate social responsibility and sustainability – weighting 10%
The nature of sustainability
The nature of corporate responsibility and corporate citizenship
Corporate responsibility and stakeholders
 Internal and external stakeholders
Elements of corporate social responsibility: employees, the environment, human rights,
communities and social welfare, social investment, ethical conduct
Reputation risk: placing a value on reputation
Formulating and implementing a policy for corporate social responsibility
Reporting to stakeholders on sustainability and corporate social responsibility issues
 Voluntary social and environmental reporting
 Sustainability reporting: triple bottom line; GRI Guidelines
 Integrated reporting
Other governance issues– weighting 10%
International aspects of corporate governance
Governance problems for large global groups of companies
Corporate governance: unquoted companies and small quoted companies
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Governance in the public sector
Governance in the not-for-profit sector
End of introduction
xvii
COURSE NOTES
xviii
SECTION 1: Concepts in Corporate Governance
SECTION 1: CONCEPTS IN CORPORATE
GOVERNANCE
Lecture Example 1a: Class Exercise/Discussion: Corporate Governance?
Required
Brainstorm the following: What is Corporate Governance?
You may want to think about the origins of governance including scandals, risk, reputation,
regulation, principles, and ethics.
What Is
Corporate
Governance?
Governance?
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SECTION 1: Concepts in Corporate Governance
1 Introduction
The subject of corporate governance leapt into the global news limelight from obscurity after
a string of collapses and scandals involving high profile companies. In the early 90’s in the
UK these were companies such as the Mirror Group and Barings Bank.
Some leading figures recognised the rising importance of corporate governance:
“The proper governance of companies will become as crucial to the world economy as the
proper governing of countries”
James Wolfensohn – Former President of the World Bank
The Economist 2nd January 1999
Then later in the USA, Enron, the Texas based energy giant, and WorldCom, so dominant in
the U.S. telecom industry, shocked the business world with both the scale and age of their
unethical and illegal operations.
The subject has stayed firmly on the front pages with the financial difficulties in 2007 of
Lehman Brothers with the resulting world-wide repercussions. More recently the problems at
News International and other newspapers show that it is not just financial considerations that
are part of the subject, business ethics being also an important element.
2 The Enron Issues
The Enron scandal illustrates some of the poor governance issues that will be dealt with in
more detail in the course:
1. Misleading transactions in accounts with approval of executives
2. Audit committee approved fraudulent accounts
3. Auditors and others employed by Enron profited from transactions with Enron.
4. Totally ineffective board, lots of non-executives, but most not independent and
dominated by executives
5. Board ignored whistleblowers
6. Inappropriate remuneration and rewards for directors
7. Unethical business practices
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SECTION 1: Concepts in Corporate Governance
Lecture example 1b: reading: Scandals
Please read the articles in appendix 1
The subject has become part of everyday language, so much so that it now features in Pub
Quizzes…………….
Lecture example 2: Class Exercise / Discussion: Pub Quiz
The Pub Quiz
1) Which executive chairman disappeared off his boat in 1991?
2) Which company, listed on AIM (the alternative investment market) had an issue with
fraud concerning its accounts in 2018?
3) What job did Sir Adrian Cadbury of the Cadbury report have at Cadbury Schweppes
and Sir Richard Greenbury of the Greenbury report have at M&S?
4) What is a golden parachute?
5) What is retirement by rotation?
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SECTION 1: Concepts in Corporate Governance
3 Definitions of corporate governance
“Governance” refers to the way “something” is governed. This could include a vast range of
“something’s” from a country to a local council, a charity, a school to a Parish Church.
Therefore the concepts of Governance cover a vast range of organisations from those firmly
in the profit making sector to those in the not for profit areas and public service domains.
General definition
A more general definition by Sir Adrian Cadbury, Chairman of the Cadbury Committee, 1992
which features some of the principles of corporate governance:
“Corporate Governance, the system by which organisations are directed and controlled, is
based on concepts of transparency, independence, accountability and integrity”
Local Government
The Chartered Institute of Public Finance and Accountancy (CIPFA) adapted the Cadbury
definition for the local government sector. It defines corporate governance as
“the systems and processes, the cultures and values, by which local government bodies are
directed and controlled and through which they account to, engage with and, where
appropriate, lead their communities”.
Governance of companies
The governance of companies tends to dominate the subject so a definition with regards to
this area is below
Corporate governance can be defined as:
A set of relationships between a company’s directors, its shareholders and other
stakeholders. It also provides structure through which the objectives of the company
are set, and the means of obtaining these objectives and monitoring performance are
determined.
At a basic level, governance is a fundamental internal control system, consisting of the
culture of the company and the policies and procedures operating within that culture,
ensuring the best interests of the company are serviced in the most effective manner.
Lecture example 3: Class Exercise (exam standard): Benefits & Drawbacks
Required
Assess the benefits and drawbacks to a business of applying a framework for corporate
governance.
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SECTION 1: Concepts in Corporate Governance
Solution
Benefits
Drawbacks
For corporate governance to be effective it must be a feature of the inherent business
culture, i.e. the way business is conducted. However the challenge is to find a way in which
the interests of shareholders, directors and other stakeholders can be sufficiently satisfied.
4 Stakeholders in corporate governance
A definition
Stakeholders are people, groups or organisations that can affect or be affected by the
actions or policies of an organisation. Each stakeholder group has different expectations
about what it wants, and therefore different claims upon the organisation.
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SECTION 1: Concepts in Corporate Governance
5 Classifying Stakeholders
Stakeholders can be classified in various ways,
Proximity
The method shown below is based on proximity to the organisation
Financial
Another method of grouping stakeholders is based on their financial interest in the
organisation.
Financial stakeholders with a direct financial stake in the organisation would be shareholders
and providers of loan capital such as banks and bond holders. All other stakeholders would
be classified as non-financial.
Shareholders: sub divisions
Institutional shareholders can be long term or short term investors. Short term investors such
as hedge funds are mainly looking for short term profit. There are various organisations that
act in the interests of the investment market.
The Association of British Insurers (ABI)
The Pension and Lifetime Savings Association (PLSA) (formerly The National Association of
Pension Funds (NAPF))
Pensions Investment Research Consultants Limited PIRC (www.PIRC.co.uk) an
independent investors advisory body and pressure group
A worldwide organisation:
The International Corporate Governance Network (ICGN)
6 How powerful are stakeholder groups?
A useful mapping tool for the analysis of stakeholder power and interest in an organisation is
the Mendelow matrix.
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SECTION 1: Concepts in Corporate Governance
Mendelow classifies stakeholders on a matrix [below] whose axes are power held and
likelihood of showing an interest in the organisation’s activities. These factors will help define
the type of relationship the organisation should seek with its stakeholders, and how it should
view their concerns.
Stakeholder theory proposes corporate accountability to a broad range of stakeholders. It is
based on companies being so large, and their impact on society being so significant that
they cannot just be responsible to their shareholders. Stakeholders should be seen not as
just existing, but as making legitimate demands upon an organisation. The relationship
should be seen as a two-way relationship FORWARD
What stakeholders want from an organisation will vary. Some will actively seek to influence
what the organisation does and others may be concerned with limiting the effects of the
organisation's activities upon themselves.
There is considerable dispute about whose interests should be taken into account. The
legitimacy of each stakeholder's claim will depend on your ethical and political perspective
on whether certain groups should be considered as stakeholders.
The OECDs (The Organisation for Economic Co-operation and Development) principles of
corporate governance specifically recognises the rights and roles of stakeholders.
Provision 5 of the UK Corporate Governance Code 2018 now makes it a requirement for
boards to understand the views of stakeholders, in particular employees. It states
The board should understand the views of the company’s other key stakeholders and
describe in the annual report how their interests and the matters set out in section 172 of the
Companies Act 2006 have been considered in board discussions and decision-making.
The board should keep engagement mechanisms under review so that they remain effective.
For engagement with the workforce, one or a combination of the following methods should
be used:
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SECTION 1: Concepts in Corporate Governance
• a director appointed from the workforce;
• a formal workforce advisory panel;
• a designated non-executive director.
If the board has not chosen one or more of these methods, it should explain what alternative
arrangements are in place and why it considers that they are effective.
Lecture example 4: Exam standard question: Stakeholders
Corporate governance reports worldwide have concentrated significantly on the roles,
interests and claims of the internal and external stakeholders involved in a publically listed
company.
Required
List some of these stakeholders and their claims on the organisation
Solution
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SECTION 1: Concepts in Corporate Governance
7 Instrumental and normative views of stakeholders
Donaldson and Preston suggested that there are two motivations for organisations
responding to stakeholder concerns.
8 Instrumental view of stakeholders
This reflects the view that organisations have mainly economic responsibilities (plus the legal
responsibilities that they have to fulfil in order to keep trading). In this viewpoint fulfilment of
responsibilities towards stakeholders is desirable because it contributes to companies
maximising their profits, or fulfilling other objectives such as gaining market share or meeting
legal or stock exchange requirements. Therefore a business does not have any moral
standpoint of its own. It merely reflects whatever the concerns are of the stakeholders it
cannot afford to upset, such as customers looking for green companies or talented
employees looking for pleasant working environments. The organisation is using
shareholders instrumentally to pursue other objectives.
9 Normative view of stakeholders
This is based on the idea that organisations have moral duties towards stakeholders in
addition to the economic ones. Thus accommodating stakeholder concerns is an end in
itself. This suggests the existence of ethical and philanthropic responsibilities as well as
economic and legal responsibilities.
10 Theoretical frameworks of Governance
We have already dealt with stakeholder theory as a frame work of corporate governance;
however there are two other frameworks that should be considered
11 Agency Theory (Jensen and Mekling)
Agency theory is used to study the problems of motivation and control when a principal
needs the help of an agent to carry out activities. Agency theory would describe the
shareholders in a company as the principals, with the board their agents who are
empowered to act in their interests.
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SECTION 1: Concepts in Corporate Governance
In practice the powers of shareholders tend to be very restricted. They normally have no
right to inspect the books of account, and forecasts of future prospects are gleaned from the
annual report and accounts, stockbrokers’ reports and media sources.
There is an information asymmetry; the agent has more information than the principal.
The diagram below illustrates how agency works in practice:
Agency theory assumes that agent and principal act in their own self-interest. These
interests may conflict. The separation of ownership from management can cause issues if
there is a breach of trust by directors either by intentional action, omission, neglect, or
incompetence.
Lecture example 5 Class discussion: Shareholder concerns
Required
Briefly suggest some reasons why shareholders might become concerned about the
management of an organisation in which they hold an investment.
Solution
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SECTION 1: Concepts in Corporate Governance
12 The agency solution
One power that shareholders possess is the right to remove the directors from office. But
shareholders have to take the initiative to do this, and in many companies, the shareholders
lack the energy and organisation to take such a step. Ultimately they can vote in favour of a
takeover or removal of individual directors or entire boards, but this may be undesirable.
Shareholders can take steps to exercise control, but such action will be expensive, time
consuming and difficult to manage because it is difficult to:
(a) Verify what the board is doing, partly because the board has access to more information
about its activities than the principal does; and
(b) Introduce mechanisms to control the activities of the board, without preventing it from
functioning effectively.
Any steps taken by shareholders are likely to incur agency costs.
Lecture example 6 Exam question: Controlling the board
Required
Suggest some ways in which shareholders can monitor and control a board of directors.
(and likely to incur agency costs in doing so)
Solution
Monitoring systems
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SECTION 1: Concepts in Corporate Governance
Controls
13 Exam practice question analysis
Briefly explain agency theory, and how it relates to corporate governance. (5 marks)
Question analysis:
The question is in 2 parts: Briefly explaining (making clear) a theory and then explaining how
it is connected to governance.
Should be answered in two sections, so two distinct paragraphs.
Marking scheme: 3 marks can be awarded for each section, but maximum 5 marks for the
question.
Time: 5 marks x 1.8 minutes a mark = 9 minutes max
Typical Answer
Agency theory (as applied to companies) was developed by Jensen and Meckling. The
theory is based on the concept of the separation of ownership of companies (equity
shareholders) from control (executive management or the board of directors). With the
managers/directors being the agents of the principals, the shareholders.
In the context of corporate governance, agency theory defines the relationship between
directors and the shareholders. It clearly illustrates that both expressed and implied authority
is given to the board to deal with any third party. Such actions should always be conducted
in the manner of promoting the success of the company in best interests of the shareholders.
14 Approaches to Corporate Governance
There has been considerable debate about what the objectives of sound Corporate
Governance should be. The different views can be divided into 3 broad approaches:
a)
Shareholder value approach

Traditional approach
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


b)
Directors should run companies with the maximisation of shareholder wealth as their
principle focus
Shareholders should have the power to remove directors if this isn’t achieved
In pursuit of wealth maximisation, directors will act fairly in the interests of other
stakeholders.
Stakeholder approach (pluralist approach)



c)
Public policy perspective: directors should be permitted or required to balance the
interests of shareholders and stakeholders.
The balance social and economic goals
Problem: company law biased towards shareholder rights. However there are many
other aspects of law protecting the rights a various stakeholders groups
Enlightened shareholder approach





Directors should pursue the interests of their shareholders, but in an enlightened and
inclusive way.
Look L/T not S/T
Create and maintain dialogue with other stakeholder groups
Shareholders as ‘enlightened’ investors?
Institutional investors will need to listen more to their beneficiaries
15 The King Reports
The South African King Reports (King 2, 2004, King 3, 2009 & King IV 2015) reject the
enlightened shareholder approach in favour of the stakeholder approach, stating that the
shareholders do not have predetermined position above the other stakeholder groups.
The King Report defined the following two terms:
Accountability:
the liability to render account to someone else.
Responsibility:
the liability of a person to be called to account when he is responsible.
Main points:
Directors should only be accountable to shareholders
Accountable to too many groups would restrict enterprise and flair.
Directors should be responsible to other stakeholders.
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16 Principles of good corporate governance
The following diagram illustrates the 9 core principles that underlie good corporate governance
16 Brief definitions of these principles









Integrity: Straightforward dealing and completeness; high moral character; honesty.
Fairness: Respecting the rights and views of any group with a legitimate interest.
Judgement: Making decisions that enhance the organisation’s prosperity.
Independence: Having only limited or strictly controlled links to the organisation.
Openness: Disclosure, including voluntary disclosure of reliable information.
Probity: Truthful and not misleading.
Responsibility: Systematic correction of errors, failures or mismanagement.
Accountability: Answerable for the consequences of actions.
Reputation: Stakeholders perception or expectations. A valuable asset of the
organisation.
17 Ethics and governance
Ethics is concerned with right and wrong and how conduct should be judged to be good or
bad. It is about how we should live our lives and, in particular, how we should behave
towards other people. It is therefore relevant to all forms of human activity.
Business life is a fruitful source of ethical dilemmas because its whole purpose is material
gain, the making of profit. Success in business requires a constant, avid search for potential
14
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advantage over others and in business, people are under pressure to do whatever yields
such advantage.
It is important to understand that if ethics is applicable to corporate behaviour at all, it must
therefore be a fundamental aspect of mission, since everything the organisation does flows
from that. Managers responsible for strategic decision making cannot avoid responsibility for
their organisation's ethical standing. They should consciously apply ethical rules to all of
their decisions in order to filter out potentially undesirable developments. The question is
however what ethical rules should be obeyed. Those that always apply or those that hold
only in certain circumstances?
Ethical assumptions underpin all business activity as well as guiding behaviour. The
continued existence of capitalism makes certain assumptions about the 'good life' and the
desirability of private gain, for example.
Managing stakeholders: Corporate ethical codes
Organisations have responded to wide and varied pressures from external stakeholders to
be seen to act ethically by publishing ethical codes, actually a requirement of Sarbanes
Oxley in the USA
Ethical codes contain a series of statements setting out the organisation's core values and
explaining how it sees its responsibilities towards its stakeholders. They cover specific areas
such as gifts, anti-competitive behaviour and so on.
The typical features of an ethical code could be as follows:





Guidance on acceptable and unacceptable behaviour
Specific examples of company expectations
Links to the organisation's mission and objectives
Clear guidance on consequences and sanctions
Standards for the ethical treatment of suppliers, customers, employees
A corporate code of ethics has no value unless it has the full support of the board of
directors and senior management.
To reinforce this, the company secretary should ensure the board reviews the code of ethics
regularly and that it is issued annually to all employees to remind them of its requirements. It
might also be appropriate for the managers to sign up to the code annually to confirm their
observance and that it is being followed in their areas.
If it is fully supported by the board and senior management, a code of ethics has several
potential benefits to a company:
(i) It establishes policies for conduct and behaviour within an organisation that all employees
know they are expected to observe. A code should set out clearly what forms of behaviour
are, or are not, required.
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(ii) It helps to ensure compliance with laws and regulations: this is important because noncompliance could result in legal action against the company, resulting possibly in additional
costs and loss of reputation
(iii) A code of ethics should also ensure that a high quality of service is provided to external
stakeholders, particularly suppliers and customers. This should help to improve the
company’s dealings with them and may, in the longer term, give it a strong reputation and
help to attract customers. In addition, if suppliers are made aware the existence of the code
of ethics, they should be discouraged from attempting unethical/illegal behaviour.
(iv) Following a code of ethical behaviour should also help manage stakeholder relations
with employees and shareholders. Ethical conduct by management in their dealings with
employees and employee representatives may help to improve industrial relations within the
company. Ethical conduct in relations with shareholders, including openness and
transparency, should help to reinforce the accountability of the board to its shareholders, and
so improve the quality of corporate governance.
(v) Although there is no conclusive evidence, it could be argued that a strong code of ethics
helps to create an organisation with a strong sense of values, and that this in the long term
will help to promote its commercial success.
Home Study: For further information on various aspects of ethics, please read chapter
1 in study text
18 Key issues in Corporate Governance
The scope of corporate governance is vast and we shall expand on the following key issues
during this course of study.
Major issues pertaining to corporate governance, that could arise in an exam question, are
illustrated below.
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19 The History of Corporate Governance
Corporate governance issues came to prominence in the UK and Europe In the late 1980s.
One of the main drivers for improvement was an increasing number of high profile corporate
scandals and collapses including Polly Peck International, BCCI, and Maxwell
Communications Corporation
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20 Other counties response to governance issues
.
21 South Africa and the King Reports
South Africa's major contribution to the corporate governance debate has been the King
report, first published in 1994. The King report differs in emphasis from other guidance by
advocating an integrated approach to corporate governance in the interest of a wide range
of stakeholders – embracing the social, environmental and economic aspects of a
company's activities. The report encourages active engagement by companies,
shareholders, business and the financial press and relies heavily on disclosure as a
regulatory measure.
22 The Singapore Code
The Singapore Code (published 2001, revised 2005 and again 2018) of Corporate
Governance takes a similar approach to the UK Corporate Governance Code, comply or
explain why not. Some guidelines, particularly on directors' remuneration, go beyond what is
in UK guidance.
23 The USA and The Sarbanes-Oxley Act 2002
In the US the response to the breakdown of stock market trust caused by the Enron scandal
and others was the Sarbanes-Oxley Act 2002. The Act applies to all companies that are
required to file periodic reports with the Securities and Exchange Commission (SEC),
effectively any company in the world listed on the New York Stock Exchange. SOX is a rule
based regime and rule-making authority was delegated to the SEC on many provisions.
24 Governance in the public sector
In addition to the high profile corporate scandals in the early 90’s such as Polly Peck and
BCCI, there were also various scandals involving people in public life such as that revealed
by the Guardian Newspaper in 1994 of MP’s taking bribes to ask questions in the House of
Commons.
This prompted the Prime Minister, John Major, to set up The Committee on Standards in
Public Life headed by Chairman Lord Nolan in 1995. The Committee still meets as it is a
standing committee, generally monthly throughout the year
The committee reported the following year, publishing a set of seven principles
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SECTION 1: Concepts in Corporate Governance
25 The Seven Principles of Public Life (The Nolan Principles)







Selflessness – Holders of public office should act solely in terms of the public
interest. They should not do so in order to gain financial or other benefits for
themselves, their family or their friends.
Integrity – Holders of public office should not place themselves under any financial
or other obligation to outside individuals or organisations that might seek to influence
them in the performance of their official duties.
Objectivity – In carrying out public business, including making public appointments,
awarding contracts, or recommending individuals for rewards and benefits, holders of
public office should make choices on merit.
Accountability – Holders of public office are accountable for their decisions and
actions to the public and must submit themselves to whatever scrutiny is appropriate
to their office.
Openness – Holders of public office should be as open as possible about all the
decisions and actions they take. They should give reasons for their decisions and
restrict information only when the wider public interest clearly demands.
Honesty – Holders of public office have a duty to declare any private interests
relating to their public duties and to take steps to resolve any conflicts arising in a
way that protects the public interest.
Leadership – Holders of public office should promote and support these principles
by leadership and example.
The committee then published a wide variety of reports concerning specfic areas from Local
Public Spending Bodies, to Local Government and Standards of Conduct in Executive
NDPBs,(Non Departmental Public bodies) and NHS Trusts. Its remit was extended in 1997
to political parties.
There are major differences between corporate governance in the private sector and public
sector, the main one is the public sector is non profit making and accountable to different
stakeholders, there are no shareholders in the public sector.
26 Stakeholders in the not-for-profit sector (example charities)
Primary stakeholders of charities include not only donors and regulators, but also grant
providers, service users and the general public. There may be a conflict between the
objectives of these different stakeholders. Some stakeholders have demanded that charities
should be run on more commercial lines, attempting to make the most of resources and with
chief executives drawn from the private sector. Other stakeholders (volunteers, some
donors) have objected that this has meant charities moving too far away from their charitable
objectives
27 Disclosure by charities
In some regimes charities face a light disclosure regime which allows them to provide
minimal financial detail. Charities have been criticised for this and some has responded by
making fuller disclosures than required by law.
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Good Governance: A Code for the Voluntary and Community Sector was written in 2005 by
representatives from all over the sector, supported by the charities commission in 2005,
Trustees should:



Identify those stakeholders with a legitimate interest in their work.
Have a strategy for regular and effective communication with them about the
organisation's achievements and work.
Communicate planned developments, account for feedback and complaints, and
report performance, impacts and outcome.
The Code sees openness and accountability as meaning:





Being clear about what information is available and what must remain confidential
Complying with reasonable outside requests for information
Being open about the organisation's governance and its strategic reviews
Ensuring stakeholders have the knowledge & opportunity to hold trustees to account
Ensuring the principles of equality and diversity are applied, and that information and
meetings are accessible to all sectors of the community
Some charities demonstrate that they are delivering value to donors and users of the service
by measuring and publishing the contribution they make. Some use a social or
environmental reporting framework, this includes details of how the charity is run and how it
delivers against its terms of reference and its objectives. This can demonstrate
accountability and transparency and increase the confidence of primary stakeholders.
A governance code for charities: Basic principles
The main principles of a good governance code for charitable organisations should set out
the ways in which the board of directors or trustees provide leadership to the organisation.

Members of the board should understand their role and responsibilities, both
collectively and individually. They must understand their legal duties and their
responsibilities with regard to the governing document of the charity. As trustees,
they have a duty to act in the best interests of the beneficiaries of the trust, and all
the trustees must have a clear idea of who are the intended beneficiaries of the
charity.

The trustees of a charity should ensure that the organisation delivers its purpose or
aim. To do this, they must ensure that the purpose remains valid and that this is
delivered by means of a long-term strategy, an agreed operational budget and
monitoring of outcomes and performance.

The board of trustees should work effectively both as individuals and as a team.
There should be arrangements for identifying and recruiting new trustees.

Once appointed, trustees should be given induction so that they understand what the
charity does, how it operates and how it is funded. Where necessary, trustees should
also be given on-going training in relevant issues. A good governance code for
charities should also require that directors or trustees are subject to regular
performance reviews into their effectiveness.
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SECTION 1: Concepts in Corporate Governance

The trustees should exercise effective control over the charity, and ensure that it
complies with all legal and regulatory requirements, has good financial and
management controls, identifies the major risks facing the charity and has a good risk
management system in place to deal with them. The trustees should also ensure that
authority is delegated to management, committees or volunteers and that the charity
is operating effectively.

The board of a charity should behave with integrity and promote the integrity of the
charity. A charity should also be open and accountable, both internally and
externally. This requirement includes open communications, informing people about
the charity and its work.
Governance away from the public sector and listed companies
Reading: Governance in Unlisted and Private companies
Please read the section in the study text at the end of chapter 5 and the principles suggested
by the Institute of Directors
The BHS scandal
BHS was originally listed and in the FTSE 100, but was purchased outright in 2000 by Sir
Philip Green and taken private, so it became a private limited company again, but a rather
large one.
The business failed, and left a large deficit in the company pension fund, the resulting
scandal concerning how this had occurred meant the Government decided that large limited
companies needed to improve their corporate governance.
They engaged James Wates CBE, who was head of one of the largest privately owned
construction companies in UK. Formed a committee to look at governance of large private
companies and published proposals in July 2018, with the FRC publishing Large Ltd code in
December 2018.
Based on a comply or explain basis, basic governance requirements were suggested for
large limited companies
On 11 June 2018 The Companies (Miscellaneous Reporting) Regulations 2018
were laid in Parliament
This new reporting requirement will apply to financial years beginning 1 January 2019 with
reporting to start in 2020.
Companies will be able to apply the Wates Corporate Governance Principles for Large
Private Companies and meet the requirement.
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SECTION 1: Concepts in Corporate Governance
It will require private companies of a significant size to disclose their corporate governance
arrangements in their directors’ report and on their website, including whether they follow a
formal code such as the Wates Corporate Governance Principles.
The following criteria apply
•
(i) more than 2,000 employees; or
•
(ii) turnover above 200 million pounds ($267 million) and a balance sheet of more
than 2 billion pounds.
•
Where companies meet these criteria they must publish a statement of their
corporate governance arrangements in their directors' report and website.
The Six Wates Principles were as below:

Purpose – An effective board promotes the purpose of a company, and ensures that
its values, strategy and culture align with that purpose.

Composition – Effective board composition requires an effective chair and a balance
of skills, backgrounds, experience and knowledge, with individual directors having
sufficient capacity to make a valuable contribution. The size of a board should be
guided by the scale and complexity of the company.

Responsibilities – A board should have a clear understanding of its accountability
and terms of reference. Its policies and procedures should support effective decisionmaking and independent challenge.

Opportunity and Risk – A board should promote the long-term success of the
company by identifying opportunities to create and preserve value and establish
oversight for the identification and mitigation of risk.

Remuneration – A board should promote executive remuneration structures aligned
to sustainable long-term success of a company, taking into account pay and
conditions elsewhere in the company.

Stakeholders – A board has a responsibility to oversee meaningful engagement with
material stakeholders, including the workforce, and have regard to that discussion
when taking decisions. The board has a responsibility to foster good relationships
based on the company’s purpose.
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SECTION 1: Concepts in Corporate Governance
Summary
Key areas

Introduction

Definitions of corporate governance

Stakeholders

Agency theory

Approaches to corporate governance

Principles of governance

Ethics and governance

History of governance

The public sector

Governance of charities

The private sector
23
SECTION 1: Concepts in Corporate Governance
Quick Quiz
1. Name five principles that underlie corporate governance.
2. Fill in the blank, using one of the principles you named above.
........................................ means straightforward dealing and completeness
3. In one sentence “Why is agency a significant issue in corporate governance?”
Longer questions
4 Summarise the main features of agency theory in relation to corporate governance.
(6 marks)
24
SECTION 1: Concepts in Corporate Governance
5 What do you understand by ‘fairness’ in a corporate governance context? (4 marks)
25
SECTION 1: Concepts in Corporate Governance
Answers to Quick Quiz
1 Any five of:
Fairness, Openness/Transparency, Independence,
Accountability, Reputation, Judgement and Integrity
Probity/Honesty,
Responsibility,
2. Integrity
3 Because of the separation of ownership (principal) from management (agent), the
information asymmetry between them and resultant lack of goal congruence.
Answers to longer questions
4 Summarise the main features of agency theory in relation to corporate governance.
(6 marks)
Agency theory may be summarised as follows:

In large companies, ownership is separated from control of the company. Control is
exercised by managers, who act as agents on behalf of the shareholders.

Managers should therefore act in the interests of shareholders, but are actually
driven by self-interest.

Conflicts of interest therefore arise between managers and shareholders, and
managers cannot be relied on to act in the best interests of shareholders, without
controls or incentives.

These problems create costs to shareholders (agency costs). These might be costs
of monitoring (for example, costs of external audits), costs of incentivising
management (bonuses etc.) or costs arising from the fact that managers take some
decisions in their self-interest anyway.

An aim of corporate governance should be to minimise these agency costs.
Credit was given to any mention of the originators of agency theory, Jensen and Mekling.
EXAMINER’S COMMENTS
It is difficult to explain a theory briefly within a short answer, and candidates were given
credit for displaying an awareness of the various key issues. Some candidates, however, did
not know what agency theory was, although this did not prevent them writing at length about
something completely different, such as the shareholder approach to corporate governance.
26
SECTION 1: Concepts in Corporate Governance
5 What do you understand by ‘fairness’ in a corporate governance context? (4 marks)
Fairness in a corporate governance context requires giving equal consideration to each
shareholder and ensuring that the rights of minorities are protected. This involves the
provision of information to all shareholders and providing access to general meetings and
voting arrangements.
Examiner’s comments
This question was often better answered by students outside the UK. Perhaps long tradition
and legislation in the UK has made equal treatment of all investors the natural thing to do?
27
Achievement Ladder Step 1
ACHIEVEMENT LADDER STEP 1
You have now covered the topics that will be assessed in Step 1 of your Achievement
Ladder.
You should now attempt and pass Step 1 of the Achievement Ladder on the online
VLE platform BEFORE moving on to the next part of the course.
It is vital in terms of your progress towards 'exam readiness' that you attempt this Step in the
near future.
You will receive feedback on your performance, and you can use the ongoing BPP support
to help address any improvement areas. This will help you to tailor your learning exactly to
your own individual requirements
Achievement ladder Step 1
10 multiple choice questions
Followed by
Debrief of questions
28
SECTION 2: Principles v Rules
SECTION 2: GOVERNANCE: PRINCIPLES V RULES
1 Development of corporate governance codes
To combat governance problems many jurisdictions have developed voluntary codes of best
practice. Some of the main provisions of codes have been clear attempts to deal with difficult
situations. For example: An individual dominating a company has been countered by
recommendation that different directors occupy the positions of CEO and chairman.
However in certain jurisdictions, notably the USA, the voluntary approach did not seem to be
successful, and in response to the Enron scandal and others, in a move to promote
confidence among investors and the markets, the USA went down the regulatory route. The
Sarbanes-Oxley Act became statute in 2002.
2 Principles or rules?
A continuing debate on corporate governance is whether the guidance should predominantly
be in the form of principles, or whether there is a need for detailed laws or regulations.
The UK Cadbury report suggested that a voluntary code coupled with disclosure would
prove more effective than a statutory code in promoting the key principles of openness,
integrity and accountability.
The Cadbury report also acknowledged the need for codes to go beyond broad principles
and provide some specific guidelines.
Lecture Example 1: Class Exercise/Discussion: Principles or rules
Many international companies are listed on both a US stock exchange (with a rules based
approach) and a European stock exchange (with a principles based approach).
Briefly bullet point a list of the issues facing such a company. (Use the table on the next
page comparing principles v rules to assist)
Solution


29
SECTION 2: Principles v Rules


3 A comparison of the two approaches
30
SECTION 2: Principles v Rules
Although the UK is a principles based regime, there are some aspects of governance that
are regulated, a few examples of these regulations are found in:
a) UK Company law
Powers and duties of directors
Disclosure of directors remuneration
b) EU Directives concerning UK company law
Shareholder rights
Requirement to have an audit committee
c) Insolvency Law and directors liability
Fraudulent trading (CA2006)
Wrongful Trading (IA1986)
d) Criminal Law
Insider dealing (CJA 1993)
Money Laundering
4 Characteristics of a principles-based approach
(a) The approach focuses on objectives (for example: shareholders holding a minority of
shares in a company should be treated fairly) rather than the mechanisms by which these
objectives will be achieved.
(b) A principles-based approach can lay stress on those elements of corporate governance
to which rules cannot easily be applied, such as the requirement to maintain sound systems
of internal control.
(c) Principles-based approaches can applied across different legal jurisdictions rather being
founded in the legal regulations of one country. The OECD guidelines, which we shall cover
later in this section, are a good example of guidance that is applied internationally.
(d) Where principles-based approaches have been established in the form of corporate
governance codes, the recommendations are generally enforced on a comply or explain
basis. However some countries have adopted an apply or explain basis, stating that it will
31
SECTION 2: Principles v Rules
lead to companies applying the principles rather than box ticking. King Code 3 specifically
mentions this issue.
(e) Principles-based approaches have often been adopted in jurisdictions where the
governing bodies of stock markets have had the prime role in setting standards for
companies to follow. Listing rules include a requirement to comply with codes, but because
the guidance is in a form of a code, companies have more flexibility than they would if the
code was underpinned by legal requirements.
The UK governance code states that any explanations given should be adequate and clear:
‘It is recognised that an alternative to following a provision may be justified in particular
circumstances if good governance can be achieved by other means. A condition of doing
so is that the reasons for it should be explained clearly and carefully to shareholders …
In providing an explanation, the company should aim to illustrate how its actual practices
are consistent with the principle to which the particular provision relates, contribute to good
governance and promote delivery of business objectives.’
5 The UK Corporate Governance Code
The origins of the current Code stem from the report of the Committee on the Financial
Aspects of Corporate Governance (the Cadbury Report, 1992) to which was attached a
Code of Best Practice.
It became the Combined Code in 1998, and in 2010 a revised code was published and
renamed The UK Governance Code. There were various revisions notably 2014 and 2016,
then after much consultation the Financial Reporting Council, (FRC has responsibility for the
code), published a very heavily revised code in 2018.
The Code is divided into main principles and provisions. For the main principles a company
has to state how it applies those principles. In relation to the Code provisions a company has
to state whether they comply with the provisions or – where they do not – give an
explanation.
The FRC has also published a revised Guidance on Board Effectiveness document to back
up the code.
Lecture example 1a Reading: Highlights of the 2018 UK Governance Code by
FRC in appendix 1
There are 5 main sections, with 18 principles and 41 provisions, examples of a principle and
some of the provisions are shown below from each section.
1 Board Leadership and Company Purpose
Principles A to E and Provisions 1 to 8
Principle A. A successful company is led by an effective and entrepreneurial board, whose
role is to promote the long-term sustainable success of the company, generating value for
shareholders and contributing to wider society.
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SECTION 2: Principles v Rules
Provision 1. The board should assess the basis on which the company generates and
preserves value over the long-term. It should describe in the annual report how opportunities
and risks to the future success of the business have been considered and addressed, the
sustainability of the company’s business model and how its governance contributes to the
delivery of its strategy.
2 Division of Responsibilities
Principles F to I and Provisions 9 to 16
Principle F. The chair leads the board and is responsible for its overall effectiveness in
directing the company. They should demonstrate objective judgement throughout their
tenure and promote a culture of openness and debate. In addition, the chair facilitates
constructive board relations and the effective contribution of all non-executive directors, and
ensures that directors receive accurate, timely and clear information.
Provision 9. The chair should be independent on appointment when assessed against the
circumstances set out in Provision 10. The roles of chair and chief executive should not be
exercised by the same individual. A chief executive should not become chair of the same
company. If, exceptionally, this is proposed by the board, major shareholders should be
consulted ahead of appointment. The board should set out its reasons to all shareholders at
the time of the appointment and also publish these on the company website.
Provision 10. The board should identify in the annual report each non-executive director it
considers to be independent. Circumstances which are likely to impair, or could appear to
impair, a non-executive director’s independence include, but are not limited to, whether a
director:
• is or has been an employee of the company or group within the last five years;
• has, or has had within the last three years, a material business relationship with the
company, either directly or as a partner, shareholder, director or senior employee of a body
that has such a relationship with the company;
• has received or receives additional remuneration from the company apart from a director’s
fee, participates in the company’s share option or a performance-related pay scheme, or is a
member of the company’s pension scheme;
• has close family ties with any of the company’s advisers, directors or senior employees;
• holds cross-directorships or has significant links with other directors through involvement in
other companies or bodies;
• represents a significant shareholder; or
• has served on the board for more than nine years from the date of their first appointment.
Where any of these or other relevant circumstances apply, and the board nonetheless
considers that the non-executive director is independent, a clear explanation should be
provided.
Provision 11. At least half the board, excluding the chair, should be non-executive
directors whom the board considers to be independent.
3 Composition, Succession and Evaluation.
Principles J to L and Provisions 17 to 23
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SECTION 2: Principles v Rules
Principle J. Appointments to the board should be subject to a formal, rigorous and
transparent procedure, and an effective succession plan should be maintained for board and
senior management. (Meaning exec committee or 1st layer below board level inc. co. sec.)
Both appointments and succession plans should be based on merit and objective criteria.
(Ref. equality Act 2010), and, within this context, should promote diversity of gender, social
and ethnic backgrounds, cognitive and personal strengths.
Provision 17. The board should establish a nomination committee to lead the process for
appointments, ensure plans are in place for orderly succession to both the board and senior
management positions, and oversee the development of a diverse pipeline for succession.
A majority of members of the committee should be independent non-executive directors. The
chair of the board should not chair the committee when it is dealing with the appointment of
their successor.
Provision 18. All directors should be subject to annual re-election. The board should set out
in the papers accompanying the resolutions to elect each director the specific reasons why
their contribution is, and continues to be, important to the company’s long-term sustainable
success.
Provision 19. The chair should not remain in post beyond nine years from the date of their
first appointment to the board. To facilitate effective succession planning and the
development of a diverse board, this period can be extended for a limited time, particularly in
those cases where the chair was an existing non-executive director on appointment. A clear
explanation should be provided.
4 Audit, Risk and Internal Control
Principles M to O and Provisions 24 to 31
Principle M. The board should establish formal and transparent policies and procedures to
ensure the independence and effectiveness of internal and external audit functions and
satisfy itself on the integrity of financial and narrative statements (includes interim reports)
Provision 24. The board should establish an audit committee of independent non-executive
directors, with a minimum membership of three, or in the case of smaller companies, two.
(below FTSE 350 throughout the year prior to the reporting year i.e. all of 2019 if reporting
year is 2010) The chair of the board should not be a member. The board should satisfy itself
that at least one member has recent and relevant financial experience. The committee as a
whole shall have competence relevant to the sector in which the company operates.
5 Remuneration
Principles P to R and Provisions 32 to 41
Principle P. Remuneration policies and practices should be designed to support strategy
and promote long-term sustainable success. Executive remuneration should be aligned to
company purpose and values, and be clearly linked to the successful delivery of the
company’s long-term strategy.
Provision 32. The board should establish a remuneration committee of independent nonexecutive directors, with a minimum membership of three, or in the case of smaller
companies, two. In addition, the chair of the board can only be a member if they were
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SECTION 2: Principles v Rules
independent on appointment and cannot chair the committee. Before appointment as chair
of the remuneration committee, the appointee should have served on a remuneration
committee for at least 12 months.
Provision 33. The remuneration committee should have delegated responsibility for
determining the policy for executive director remuneration and setting remuneration for the
chair, executive directors and senior management. It should review workforce remuneration
and related policies and the alignment of incentives and rewards with culture, taking these
into account when setting the policy for executive director remuneration.
Provision 34. The remuneration of non-executive directors should be determined in
accordance with the Articles of Association or, alternatively, by the board. Levels of
remuneration for the chair and all non-executive directors should reflect the time
commitment and responsibilities of the role. Remuneration for all non-executive directors
should not include share options or other performance-related elements.
6 The OECD principles
The Organisation for Economic Co-operation and Development (OECD) developed a set of
principles of corporate governance in 1999 and a revised version in April 2004. These were
reviewed again in 2015 and have been adopted as one of the Financial Stability Board’s Key
Standards for Sound Financial Systems and also endorsed by the G20. It is interesting to
note that there are only principles and no detailed guidance provisions.
The code can be found in the study text appendices
The code arose from its concern for global investment. With the idea that corporate
governance arrangements should be understood across national borders
They are non-binding principles, intended to assist governments in their efforts to evaluate
and improve the legal, institutional and regulatory framework for corporate governance in
their countries.
They are also intended to provide guidance to stock exchanges, investors and companies.
The focus is on stock exchange listed companies, but many of the principles can also apply
to private companies and state-owned organisations.
The OECD principles deal mainly with governance problems that result from the separation
of ownership and management of a company. The OECD principles are grouped into five
broad areas, with a jurisdictional over rider as the first principle, making six in total.
The first principle is: 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.
(a) The rights of shareholders
Shareholders should have the right to participate and vote in general meetings of the
company, select and remove members of the board and obtain relevant and material
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SECTION 2: Principles v Rules
information on a timely basis. Capital markets for corporate control should function in an
efficient and timely manner.
(b) The equitable treatment of shareholders
All shareholders of the same class of shares should be treated equally, including minority
and overseas.. Impediments to cross-border shareholdings should be eliminated.
(c) The role of stakeholders
Rights of stakeholders should be protected. All stakeholders should have access to relevant
information on a regular and timely basis. Performance-enhancing mechanisms for
employee participation should be permitted to develop. Stakeholders, including employees,
should be able to freely communicate their concerns about illegal or unethical relationships
to the board.
(d) Disclosure and transparency
Timely and accurate disclosure must be made of all material matters regarding the company,
including the financial situation, foreseeable risk factors, issues regarding employees and
other stakeholders and governance structures and policies. The company's approach to
disclosure should promote the provision of analysis or advice that is relevant to decisions by
investors.
(e)Role of the board
The board should be responsible for the strategic guidance of the company, the effective
monitoring of management by the board, and the board should be accountable to the
company and the shareholders.
7 ICGN Guidance
Internal Corporate Governance Network (ICGN) Report published in 2005 and revised in
2009. Provides practical guidance to companies and effectively acts as a “how to Guide” to
the OECD principles




Board structure, membership and operation
Shareholders' rights and equitable treatment
Audit and accounts
Ethics and stakeholders, including corporate social responsibility
Promotes communication between investors and companies to stimulate economic growth
and success
Lecture example 2: Exam standard question: the goal of the OECD?
Required
“The goal of international codes of corporate governance should be the development of a
universal set of rules.” Evaluate this attitude towards corporate governance.
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SECTION 2: Principles v Rules
Evaluate
For “international codes should be developing universal rules”
Against “international codes should be developing universal rules”
8 The role of the Company Secretary in Corporate Governance
The company secretary's role in corporate governance has been emphasised in the UK
governance Code and in the South African King Report. The UK Governance Code states
that the company secretary is responsible for:
• ensuring good information flows within the board and its committees, and between
executive management and non-executive directors (NEDs);
• advising the board (through the chairman) on all corporate governance matters;
• being available to give advice and support to individual directors. The ICSA has produced a
guidance note listing the responsibilities of the company secretary.
Lecture example 3: Readings: Guidance notes
On the ICSA website are numerous guidance notes that the examiner often refers to in exam
answers. There is a list of these in appendix 1
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SECTION 2: Principles v Rules
9 Responsibilities for statutory compliance and CSR
The company secretary is responsible for ensuring statutory compliance with:
CA2006
Listing rules
Rules of FCA concerning prospectuses etc.
Disclosure to stock market (directors share dealings etc.)
Compliance with MAR (market abuse regulations) ensuing directors share dealings comply
As regards CSR the company secretary has to ensure that all stakeholders are considered
when the board makes decisions, particularly with regards to employees
NAPF (now PLSA) has a particular emphasis on CSR, and illustrates the importance of the
company secretary and the Board responsibility for oversight of CSR policy.
10 Independence of the company secretary
The company secretary also has responsibility as to the business ethics adopted by the
company, perhaps advising the directors against unethical practices. Therefore they have to
be seen as independent, and not influenced by any particular entity such as the CEO.
Lecture example 4: exam standard question: safeguarding
How may the independence of the company secretary be safeguarded?
Solution (Please answer with 4 bullet points)

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SECTION 2: Principles v Rules



Therefore how the secretary is appointed and removed is of particular importance.
If the company secretary is also a qualified lawyer, this could in certain circumstances result
in challenges to their independence; to avoid this they should avoid any specific legal work
for the company as this would compromise their independence, as it may involve “taking
sides”.
Whatever the duties of the secretary, the secretary's ultimate loyalty must be to the
company. This may mean the secretary coming into conflict with, for example, a director or
even the chief executive. One particular area is the requirement for directors to report
conflicts of interest.
11 Reporting lines
(a) The company secretary is responsible to the board, and should be accountable to the
board through the chairman on all matters relating to his duties as an officer of the company
(the core duties).
(b) If the company secretary has other executive or administrative duties beyond the core
duties, he should report to the chief executive or such other director to whom responsibility
for the matter has been delegated.
(c) The company secretary's salary, share options and benefits should be settled by the
board or remuneration committee on the recommendation of the chairman or chief
executive.
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SECTION 2: Principles v Rules
Lecture example 5: Exam question: Role of secretary
This question is analysed and debriefed as a separate recording on the website. If you don’t
feel you are suitably prepared for a complete question yet, please leave it until later.
You are professionally qualified and the company secretary of a large private company. Its
strategic plans expect to introduce outside capital within the next three years, either by listing
on a major stock exchange or bringing in major outside investors. The directors are aware
that UK private companies are no longer required to employ a professionally qualified
company secretary.
The Chairman and Managing Director have failed to inform you of various executive and
committee meetings. They have also been transferring some of the traditional
responsibilities of the company secretary to clerical staff elsewhere in the organisation.
Given these changes, you are concerned that the board may remove you as company
secretary.
Required
What would you do to try to convince the board that it is in the interest of the
company to continue to retain you? In answering this question, you should
consider what the key attributes of a company secretary are, the contribution that
the secretary makes to the governance of the company and why it should be a
professionally qualified company secretary that performs these roles.
(25 marks)
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SECTION 2: Principles v Rules
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SECTION 2: Principles v Rules
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SECTION 2: Principles v Rules
Summary
Key areas

Development of corporate governance codes

Principles v rules

The UK Corporate Governance Code

The OECD principles

The role of the Company Secretary in Corporate Governance
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SECTION 2: Principles v Rules
Quick quiz
1 Which of the following statement best describes a principles based approach to corporate
governance?
A It works on a comply or explain basis
B Allows no leeway or deviation
C Easier compliance as things can be easily evidenced
D Places emphasis on definite achievements rather than control systems
2 Which is the correct chronological order for the publishing of UK corporate governance
reports?
A Cadbury – Hampel - Greenbury - Turnbull
B Greenbury – Cadbury – Hampel - Turnbull
C Cadbury – Greenbury – Hampel - Turnbull
D Cadbury – Greenbury – Turnbull - Hampel
3 Explain agency theory, and how it relates to corporate governance. (2 marks)
4 Identify six of the core principles of corporate governance
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SECTION 2: Principles v Rules
Longer question
5 Briefly discuss the impact of the following factors on the development of corporate
governance codes, rules and laws in recent years. (10 marks)
Globalisation, foreign investment, financial reporting, local culture, corporate scandals.
Solution
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SECTION 2: Principles v Rules
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SECTION 2: Principles v Rules
Quick Quiz Answers
1A
A principles based approach to corporate governance works on a comply or explain or apply
and explain basis This means that should a company have just reasons not to comply fully
with corporate governance principles and practice, it can deviate from them provided it can
explain the rationale and this is accepted by the shareholders.
2C
The correct chronological order for the publishing of UK corporate governance reports is:
Cadbury 1992 – Greenbury 1995 – Hampel 1998 - Turnbull 1998.
3 Agency theory involves the relationship between a Principal and an Agent
In the context of corporate governance, agency theory defines the relationship between
directors and the shareholders. It clearly illustrates that both expressed and implied authority
is given to the board. Actions should always be conducted to promote the success of the
company in the best interests of the shareholders
The protection afforded by the fiduciary duty is required because the agent has more
information than the principal and unless checked will be inclined to act in their own selfinterest.
4 The 9 core principles of corporate governance are:
Integrity
Fairness
Judgement
Independence
Openness
Probity
Responsibility
Accountability
Reputation
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SECTION 2: Principles v Rules
5 Briefly discuss the impact of the following factors on the development of corporate
governance codes, rules and laws in recent years. (10 marks)
Globalisation, foreign investment, financial reporting, local culture, corporate scandals.
Answer
(a) Increasing globalisation meant that investors and institutional investors in particular,
began to invest outside their home countries. The King report in South Africa highlights the
role of the free movement of capital, commenting that investors are promoting governance in
their own self-interest.
(b) The differential treatment of domestic and foreign investors, both in terms of
reporting and associated rights/dividends, also the excessive influence of majority
shareholders in jurisdictions with many family owned and controlled companies, caused
many investors to call for parity of treatment.
(c) Issues concerning financial reporting were raised by many investors are the Enron
scandal and were the focus of much debate and litigation. Shareholder confidence in what
was being reported in many instances was eroded.
(d) The characteristics of individual countries may have a significant influence in the way
corporate governance has developed. The first King report emphasised the importance of
qualities that are fundamental to the South African culture such as collectiveness,
consensus, helpfulness, fairness, consultation and religious faith in the development of best
practice.
(e) An increasing number of high profile corporate scandals and collapses including Polly
Peck International, BCCI, and Maxwell Communications Corporation prompted the
development of governance codes in the early 1990s. Enron and Worldcom prompted the
development of SOX. The financial banking crisis of 2007, resulted in the Walker Review of
2009, and the revision of the UK Governance Code.
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SECTION 2: Principles v Rules
Extract From the UK Governance Code 2018 Overseen by the FRC
The first version of the UK Corporate Governance Code (the Code) was published in 1992
by the Cadbury Committee. It defined corporate governance as ‘the system by which
companies are directed and controlled. Boards of directors are responsible for the
governance of their companies. The shareholders’ role in governance is to appoint the
directors and the auditors and to satisfy themselves that an appropriate governance
structure is in place.’ This remains true today, but the environment in which companies, their
shareholders and wider stakeholders operate continues to develop rapidly.
Companies do not exist in isolation. Successful and sustainable businesses underpin our
economy and society by providing employment and creating prosperity. To succeed in the
long-term, directors and the companies they lead need to build and maintain successful
relationships with a wide range of stakeholders. These relationships will be successful and
enduring if they are based on respect, trust and mutual benefit. Accordingly, a company’s
culture should promote integrity and openness, value diversity and be responsive to the
views of shareholders and wider stakeholders.
Over the years the Code has been revised and expanded to take account of the increasing
demands on the UK’s corporate governance framework. The principle of collective
responsibility within a unitary board has been a success and – alongside the stewardship
activities of investors – played a vital role in delivering high standards of governance and
encouraging long-term investment. Nevertheless, the debate about the nature and extent of
the framework has intensified as a result of financial crises and high-profile examples of
inadequate governance and misconduct, which have led to poor outcomes for a wide range
of stakeholders.
At the heart of this Code is an updated set of Principles that emphasise the value of good
corporate governance to long-term sustainable success. By applying the Principles, following
the more detailed Provisions and using the associated guidance, companies can
demonstrate throughout their reporting how the governance of the company contributes to its
long term sustainable success and achieves wider objectives.
Achieving this depends crucially on the way boards and companies apply the spirit of the
Principles. The Code does not set out a rigid set of rules; instead it offers flexibility through
the application of Principles and through ‘comply or explain’ Provisions and supporting
guidance. It is the responsibility of boards to use this flexibility wisely and of investors and
their advisors to assess differing company approaches thoughtfully.
Reporting on the Code
The 2018 Code focuses on the application of the Principles. The Listing Rules require
companies to make a statement of how they have applied the Principles, in a manner that
would enable shareholders to evaluate how the Principles have been applied. The ability of
investors to evaluate the approach to governance is important. Reporting should cover the
application of the Principles in the context of the particular circumstances of the company
and how the board has set the company’s purpose and strategy, met objectives and
achieved outcomes through the decisions it has taken.
It is important to report meaningfully when discussing the application of the Principles and to
avoid boilerplate reporting. The focus should be on how these have been applied,
articulating what action has been taken and the resulting outcomes. High-quality reporting
will include signposting and cross-referencing to those parts of the annual report that
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SECTION 2: Principles v Rules
describe how the Principles have been applied. This will help investors with their evaluation
of company practices.
The effective application of the Principles should be supported by high-quality reporting on
the Provisions. These operate on a ‘comply or explain’ basis and companies should avoid a
‘tick-box approach’. An alternative to complying with a Provision may be justified in particular
circumstances based on a range of factors, including the size, complexity, history and
ownership structure of a company. Explanations should set out the background, provide a
clear rationale for the action the company is taking, and explain the impact that the action
has had. Where a departure from a Provision is intended to be limited in time, the
explanation should indicate when the company expects to conform to the Provision.
Explanations are a positive opportunity to communicate, not an onerous obligation.
In line with their responsibilities under the UK Stewardship Code, investors should engage
constructively and discuss with the company any departures from recommended practice. In
their consideration of explanations, investors and their advisors should pay due regard
to a company’s individual circumstances. While they have every right to challenge
explanations if they are unconvincing, these must not be evaluated in a mechanistic way.
Investors and their advisors should also give companies sufficient time to respond to
enquiries about corporate governance.
Corporate governance reporting should also relate coherently to other parts of the annual
report – particularly the Strategic Report and other complementary information – so that
shareholders can effectively assess the quality of the company’s governance arrangements,
and the board’s activities and contributions. This should include providing information that
enables shareholders to assess how the directors have performed their duty under section
172 of the Companies Act 2006 (the Act) to promote the success of the company. Nothing in
this Code overrides or is intended as an interpretation of the statutory statement of directors’
duties in the Act.
The Code is also supported by the Guidance on Board Effectiveness (the Guidance). We
encourage boards and companies to use this to support their activities. The Guidance does
not set out the ‘right way’ to apply the Code. It is intended to stimulate thinking on how
boards can carry out their role most effectively. The Guidance is designed to help boards
with their actions and decisions when reporting on the application of the Code’s Principles.
The board should also take into account the Financial Reporting Council’s Guidance on
Audit Committees and Guidance on Risk Management, Internal Control and Related
Financial and Business Reporting.
Application
The Code is applicable to all companies with a premium listing, whether incorporated in the
UK or elsewhere. The new Code applies to accounting periods beginning on or after 1
January 2019.
For parent companies with a premium listing, the board should ensure that there is adequate
co-operation within the group to enable it to discharge its governance responsibilities under
the Code effectively. This includes the communication of the parent company’s purpose,
values and strategy.
Externally managed investment companies (which typically have a different board and
company structure that may affect the relevance of particular Principles) may wish to use the
Association of Investment Companies’ Corporate Governance Code to meet their obligations
under the Code. In addition, the Association of Financial Mutuals produces an annotated
version of the Code for mutual insurers to use.
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SECTION 2: Principles v Rules
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SECTION 3: The board of directors
SECTION 3: THE BOARD OF DIRECTORS
1 Is Governance and Management the same?
“If management is about running businesses, governance is about seeing that it is run
properly. All companies need governing as well as managing” – Professor Bob Tricker 1984
Governance of a company is a function of the board of directors, and this should not be
confused with the day to day management of a company which is a function of managers.
Directors who are also executive managers should recognise that they have board functions,
such as determining long term strategy, that are not related to management, i.e. the
implementation of operations to support that strategy.
The governing functions are those that provide the essential direction, resources and
structure to meet specific needs in the organisation. These include for example:




Strategic Direction: setting a direction for the organisation that reflects its objectives.
Resource Development: developing financial resources that support the objectives
Financial Accountability: Overseeing reporting concerning resources that ensure
honesty and cost-effectiveness.
Leadership Development: developing the human resources that lead the organisation
today and in the future.
The management functions are those that implement business activities and support to
accomplish the goals of the organization. These usually include:


Program Planning and Implementation _ taking the strategic direction to the next level
of detail and putting it into action.
Administration _ ensuring the effective management of the details behind activities to
achieve the objectives
2 The role of the board
The board roles:
(a) Collectively responsible for promoting the success of the company by directing and
supervising the company’s affairs.
(b) Provides entrepreneurial leadership of the company, within a framework of prudent and
effective controls, which enable risk to be assessed and managed.
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SECTION 3: The board of directors
(c) Should set the company’s strategic aims, ensure that the necessary financial and human
resources are in place for the company to meet its objectives and review management
performance.
Lecture example 1: Classroom discussion: Role of the BOD
(Extract from UK Corporate Governance Code)
Principle A. A successful company is led by an effective and entrepreneurial board, whose
role is to promote the long-term sustainable success of the company, generating value for
shareholders and contributing to wider society.
Required
Discuss the characteristics and roles that might be demonstrated by an effective board of
directors.
Solution
The South African King report provides a good summary of the role of the board.
'To define the purpose of the company and the values by which the company will perform its
daily existence and to identify the stakeholders relevant to the business of the company. The
board must then develop a strategy combining all three factors and ensure management
implements that strategy.'
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SECTION 3: The board of directors
For governmental organisations, the UK Good Governance Standard for Public Services
defines the primary functions of the governing body as:



Establishing the organisation’s strategic direction and aims, in conjunction with the
executive
Ensuring accountability to the public for the organisation’s performance
Ensuring that the organisation is managed with probity and integrity
This involves:



Constructively challenging and scrutinising the executive
Ensuring that the public voice is heard in decision-making
Forging strategic partnerships with other organisations
3 Matters for the board
The board is the main decision making body of the company, therefore to make this effective
the board should have a formal schedule of matters specifically reserved to it for decision at
board meetings.




Mergers and takeovers that are fundamental to the business and hence should not
be taken solely by executive managers.
Acquisitions and disposals of assets of the company or its subsidiaries that are
material to the company.
Investments, capital projects,
Bank borrowing facilities, loans and their repayment, foreign currency transactions,
all above a certain size (to be determined by the board).
Other board tasks






Monitoring the Chief Executive Officer
Overseeing strategy
Monitoring risks, control systems and governance
Monitoring the human capital aspects of the company e.g. succession, morale,
training, remuneration etc.
Managing potential conflicts of interest
Ensuring that there is effective communication of its strategic plans, both internally
and externally
Reading: ICSA guidance note
Please download the ICSA guidance note “ICSA guidance on matters reserved for the
board" from the ICSA website
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SECTION 3: The board of directors
Lecture example 2: Reading: Types of boards
1) Please read Types of Boards in appendix 1
2) Then read the case study concerning Morgan Stanley below and decide the type of
board
Morgan Stanley Case Study
Phil Purcell became CEO at Morgan Stanley, in 1998, Morgan Stanley was one of the
largest investment banking companies in the US. Purcell assumed the role of CEO of the
company after the merger of Morgan Stanley with Dean Witter and went on to fill the
company's governing board with his loyalists, as a result his aggressive strategies were
rarely challenged at board level. Purcell was severely criticised for the way he handled
people in Morgan Stanley which led to the exodus of talented employees.
During his tenure as the CEO, Morgan Stanley got involved in several costly legal
problems. The poor governance under Purcell's regime had an adverse effect on Morgan
Stanley's stock, which slipped by 39% between 2000 and 2005.
A group of former Morgan Stanley executives started campaigning against Purcell and
succeeded in ousting him from the company in 2005
4 Multi-tier boards
The USA and UK have a unitary board structure, with both the executives and nonexecutives sitting on the same board.
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SECTION 3: The board of directors
However some jurisdictions take the split between executive and other directors to its
furthest extent.
5 Corporate governance arrangements in Germany
Institutional arrangements in German companies are based on a dual board. Membership
of the two boards is entirely separate.
(a) Supervisory board
A supervisory board has many stakeholder representatives for example workers'
representatives and banks' representatives.
The board has no executive function, although it does review the company's direction and
strategy and is responsible for safeguarding stakeholders' interests. It must receive formal
reports of the state of the company's affairs and finance. It approves the accounts and may
appoint committees and undertake investigations.
(b) Management board
A management or executive board, composed entirely of managers, will be responsible for
the day-to-day running of the business. The supervisory board appoints the management
board.
Lecture example 3: Exam standard question: For & against
Evaluate the case for and against operating a two-tier board structure. (8 marks)
Solution
For
Against
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SECTION 3: The board of directors
6 Directors’ powers
Directors’ powers are derived from the Articles, and the laws of agency. The Companies
(Model Articles) Regulations 2008 provide that directors may delegate their powers to other
executives and board committees and that the board of directors may exercise ‘all the
powers of the company’, though this power is given to the board, not individual directors.
Ultimately if the members of the company are unhappy with the actions of the directors, they
can remove these by ordinary resolution with special notice or alter the Articles of
Association by special resolution to change the powers of the directors.
7 Directors’ duties
Directors have various duties under common law and statute, but to whom are these duties
owed?
Lecture Example 4: Who are the duties owed to?
Do the directors owe the duty to the company or to the shareholders? After all it is the
shareholders who approve the appointment of the directors and can remove the directors at
General Meeting. Please read the case details below before you decide.
Case: Percival v Wright (1902)
P, a director, wished to sell his shares, and the other directors (also shareholders) bought
these at P’s valuation. The other directors (not telling P) had been negotiating to sell the
company at a higher price. P asked the Court for the purchase to be set aside for nondisclosure of these negotiations, as he said they were in breach of their duty to him as a
shareholder by non-disclosure.
Required
Your decision based on the facts above and therefore to whom are the duties
owed?
8 Directors’ general duties
The CA 2006 has codified directors’ duties into a set of seven general duties. Company’s
constitution
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SECTION 3: The board of directors
1) Use powers for proper purpose (s171 CA2006)
Directors have a duty to act in accordance with the company’s constitution, and to exercise
his powers for the purposes conferred.
What constitutes proper purpose is defined by the circumstances under consideration with a
good example being the allotment of new shares. In these instances directors must exercise
their powers for a proper purpose per:

not to facilitate a takeover – Howard Smith v Ampol Petroleum[1974]
Case details:
Howard Smith v Ampol Petroleum [1974]
Directors issued new shares to persons seeking to launch a takeover bid
to help it succeed. Even though the directors honestly thought that the
takeover was in the best interests of the company it was held to be
unconstitutional to issue shares for this purpose.(the power to issue
shares is supposed to raise capital, the votes that go with shares are just
a shareholder right)
2) Promote the success of the company (s172 CA2006)
A director has a duty to act in a way he considers, in good faith, would be most likely ‘to
promote the success of the company for the benefit of its members as a whole’.
Unfortunately the CA 2006 does not define what ‘promote the success’ means and although
it is felt to relate to improving the long-term returns to shareholders it is only in time via case
law that a true definition will emerge.
In exercising this duty directors must have regard to the following factors:
a) the likely consequences of any decision in the long term,
b) the interests of the company’s employees,
c) the need to foster the company’s business relationships with suppliers, customers
and others,
d) the impact of the company’s operations on the community and the environment,
e) the desirability of the company maintaining a reputation for high standards of
business conduct, and
f)
the need to act fairly as between members of the company.
3) Independent judgment (s173 CA2006)
Directors must exercise their powers independently, however he is allowed to delegate his
functions (though not his powers) to a third party.
The model articles forbid delegation to anyone but a fellow director in matters connected
with:
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SECTION 3: The board of directors
a) the taking of decisions by directors
b) the appointment or termination of a director
c) the declaration of a dividend
4) Reasonable skill, care and diligence (s174 CA2006)
A director has a duty to his company to exercise reasonable skill, care and diligence and this
is judged by two ‘tests’:
a) has he exercised the knowledge, skill and experience reasonably expected of a
director in that position
And
b) the knowledge, skill and experience of that particular director
In essence therefore a director is firstly expected to act as a reasonable person would,
though if they possess any particular skills or experience he will be expected to exercise
those per Dorchester Finance v Stebbing [1989]
Case details
Dorchester Finance Co v Stebbing [1989]
Money lending company had 3 directors S and Parsons and Hamilton. S worked full time, P
and H paid little attention to the company and came to the premises rarely. H and P were in
the habit of signing blank cheques at S’s request. No board meetings were held and S used
the cheques to make illegal loans. All these were held liable to make good the company’s
losses on grounds (amongst others) that H and P were experienced in accountancy and
signing blank cheques was negligent.
5) Avoid conflicts of interest (s175 CA2006)
Directors had traditionally faced a very strong fiduciary duty not to benefit personally from
any commercial opportunities that came their way as a result of their directorship. In such
cases the directors would have required permission of shareholders before proceeding:

Regal (Hastings) Ltd v Gulliver [1967] – failure to gain permission of the Company
Regal (Hastings) Ltd v Gulliver [1967]
Opportunity arose for the company to acquire two more cinemas through a subsidiary.
Company could not proceed alone because it had insufficient funds. The directors
subscribed for new shares in the subsidiary and the shares in the two companies were
sold on at a profit. The new controlling shareholder sued the directors to recover the
profit. It was held that, whilst the directors had no ulterior motive, they were still liable to
account for the profit made.
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6) Benefits from third parties (s176 CA2006)
Directors are forbidden from accepting benefits from third parties, including bribes. This duty
cannot be overridden by board authorisation as per conflict transactions above.
7) Interest in a transaction (s177 CA2006)
At any point a director becomes aware that they have any interest in a contract with the
company this must be disclosed to the full board at the next board meeting.
9 Directors common law duty of care
For over 70 years, the analysis of a judge in Re City Equitable Fire Insurance Co Ltd
[1925] provided an unchallenged template for standards of skill and care, but this old
common law judgement was clearly aimed at directorship being the part time job of a
gentleman.
This was revised by the judgement in Re D'Jan of London Ltd [1994] and incorporated into
s174 CA2006.
1) Re D'Jan of London Ltd [1994]
Without reading it, Mr D'Jan signed a change to an insurance policy which was erroneously filled
out by his insurance broker. He did not read it before he signed, and it contained a mistake, which
was that the answer 'no' was given to the question of whether in the past he had 'been director of
any company which went into liquidation'. The insurance company, refused to pay up when a fire
at the company’s premises destroyed £174,000 of stock. The company had gone into insolvent
liquidation by the time Mr D'Jan realised that the form had been incorrectly completed. The
liquidators sued Mr D'Jan to recoup the lost funds on behalf of the company's creditors. They
alleged both negligence and misfeasance under s 212 of the Insolvency Act 1986.
It was held that failing even to read the form was negligent, even though it may be common
practice. ‘People often take risks in circumstances in which it was not necessary or reasonable to
do so.’ Though some documents may be reasonable not to read, for instance ones ‘running to 60
pages of turgid legal prose on the assurance of [a] solicitor’ (because then of course the solicitor
may be sued) this one was not. It was short.
There is a minimum attention to one’s tasks that must be implicit in the job of a company director.
As a director, though one need not make no mistakes of judgment, one may only make mistakes
of judgment when one has thought about the issue and decided to make a mistake of judgment.
However, Mr D’jan had acted honestly and reasonably and therefore was partly relieved from
liability by the Court under s 727 of the Companies Act 1985, (now s 1157 under the Companies
Act 2006).
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10 Consequences of a breach of duty
S170 CA2006 makes it clear that directors owe their duties to the company not the
members. This means that the only company itself can take action against a director who
breaches them. However, it is possible for a member to take a derivative action against the
director on behalf of the company
If however the members absolve the director or ratify the action then the director is
effectively forgiven.
Common ratification items include

Power to allot shares.

Power to borrow

Power to give security

Power to refuse to register a transfer of shares

Power to call general meetings

Power to circulate information to shareholders
Under s239 CA2006, any resolution which proposes to ratify the acts of a director which are
negligent, in default or in breach of duty or trust regarding the company must exclude the
director or any members connected with them from the vote.
Should any breach of duty (general or specific) occur the directors may be liable in the
following ways:
a) Fined – failure to comply can be a criminal offence
b) Removed from office – for breach of their service contract
c) Indemnify the company – for any losses suffered as a result of breach of duty
11 Board membership and roles
Key issues for consideration for board membership are:
a) Size – the balance needs to be struck between the benefits of having varied views and
opinions, alongside the need for coherence of decision-making.
(b) Inside/outside mix – the split between executive decision-making directors and nonexecutive directors. Independent non-executive directors have a key role in governance.
Their number and status should mean that their views carry significant weight.
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(c) Diversity mix in terms of gender, ethnicity, backgrounds, experience, etc.
Division of responsibilities at the head of an organisation is most simply achieved by
separating the roles of chairman and chief executive.
The chairman of a listed company should be independent when first appointed. The UK
Code states:
Provision 9. The chair should be independent on appointment when assessed against the
circumstances set out in Provision 10. (A list of challenges to independence). The roles of
chair and chief executive should not be exercised by the same individual. A chief executive
should not become chair of the same company.
If, exceptionally, this is proposed by the board, major shareholders should be consulted
ahead of appointment. The board should set out its reasons to all shareholders at the time of
the appointment and also publish these on the company website.
Provision 19. The chair should not remain in post beyond nine years from the date of their
first appointment to the board. To facilitate effective succession planning and the
development of a diverse board, this period can be extended for a limited time, particularly in
those cases where the chair was an existing non-executive director on appointment. A clear
explanation should be provided.
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SECTION 3: The board of directors
Lecture Example 5: Exam standard question: CEO & Chairman
a) Assess the benefits of the separation of the roles of chief executive and chairman
(10 marks)
and
b) Explain how ‘accountability to shareholders’ is increased by the separation of these
roles. (2 marks)
Solution
Assessment of benefits. (needs 5 points)
1)
2)
3)
4)
5)
Accountability to shareholders
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The Marks & Spencer case study illustrates the sensitivity of the markets to these issues
concerned unfettered power with one individual
The UK Cadbury report recommended that if the posts were held by the same individual,
there should be a strong independent element on the board with a recognised senior
member.(now known as a SID (senior independent director))..
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The UK Higgs report suggested that a senior independent non-executive director should be
appointed who would be available to shareholders who have concerns that have not been
resolved through the normal channels.
12 Composition of a board of directors
As an example the full board of British Petroleum, numbering 13 individuals, (July 2011)
consists of the following:
Chairman
Group CEO
CEO Refining and Marketing
CFO
And nine NEDS
There is also an executive management committee (“Our executive management team is
responsible for the day to day running of the company”) .consisting of
Group CEO, CEO Refining and Marketing, CFO (same individuals as on the full board)
And 9 other executives
(It is noticeable that there is only 1 woman (a NED) on the Board and no women at all on the
executive management committee)
At least half the board should be independent non-executive directors (NEDS), not counting
the chairman. Smaller companies outside the FTSE 350 used to be excluded from this, but
the 2018 UK code revised the requirements
UK Governance code
Provision 11. At least half the board, excluding the chair, should be non-executive directors
whom the board considers to be independent.
13 Non-Executive Directors
Non-executive directors (NEDs) have no executive (managerial) responsibilities, but bring
judgement and experience to the board. They do need to have an understanding of the
business but may be draw from a broad range of talent in the commercial and noncommercial sectors
For example: Executives of other companies, NEDS in other companies, Professionals
(lawyers, doctors etc.), politicians and civil servants.
14 The roles of NEDS
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SECTION 3: The board of directors
NEDs have a key role in reducing conflicts of interest between management (including
executive directors) and shareholders by providing balance to the board. They bring an
independent viewpoint as they are not full time employees.
The role of non-executive directors as illustrated in the Higgs Report 2003 & 2006 includes:
(a) Strategy. contributing to, and challenging the direction of, strategy.
(b) Scrutiny. NEDs should scrutinise the performance of management in meeting goals and
objectives, monitor the reporting of performance. They should represent the shareholders'
interests to ensure agency issues don't arise to reduce shareholder value.
(c) Risk. NEDs should satisfy themselves that financial information is accurate and that
financial controls and systems of risk management are robust.
(d) People. NEDs are responsible for determining appropriate levels of remuneration for
executives, and are key figures in the appointment and removal of senior managers and in
succession planning.
(e) NEDs act as chairmen of the audit, remuneration and nomination committees.
(f) One NED is appointed as senior independent director, SID, whose role includes:

In normal times, acting as a sounding board for the chairman and supporting the
chairman.

Leading the annual review by the NEDs of the performance of the board chairman.

When the board is undergoing a period of stress, working with the chairman, other
directors, and/or shareholders to resolve significant problems.

The senior independent director may also take responsibility for an orderly
succession process for the chairman.

Attending sufficient meetings with major shareholders, to listen to their views and
obtained a balanced view of their concerns.
(g) NEDs are expected to hold meetings with the board chairman without executive directors
present. This should help to maintain an appropriate balance of power and influence on the
board.
(h) All NEDs are expected to develop an understanding of the views about the company of
the major shareholders.
The main advantages of bringing NED's onto a board are as follows:





external expertise
wider perspective
independent view
compliance with corporate governance codes
assurance to 3rd parties. (Investors etc.)
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SECTION 3: The board of directors
After the financial crises of 2007 the perceived failings of NEDS was well broadcast, and had
been highlighted in the Myners report in 2002. These problems tend to centre on two areas

Lack of true independence

Lack of effectiveness.
Lecture example 6: Class Discussion The effectiveness of NEDS
a) Explain why NED's may not be sufficiently independent or effective.
b) Suggest ways in which organisations can attempt to overcome these problems.
Solution
Challenges to independence
Challenges to effectiveness
Solutions
The Walker Report on the governance of banks in 2009 commented that NEDS should have
material input to decisions on strategy and oversight of implementation. Their major role is to
challenge executives, and have the strength of character to be able to achieve this.
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The Higgs review had a number of suggestions concerning the characteristics of NEDs and
assessment of their contribution.
The Myners Report in 2002 highlighted many problems concerning NEDS
These included: (please complete from slide or study text)
1
2
3
4
5
Lecture example 7: Readings: Higgs on NEDS and ICSA on SIDS
Please read the short summary in appendix 1 concerning Higgs report and the
recommendations on NEDS.
Please also read the ICSA Corporate Governance study text by Brian Coyle Chapter 4
section 10 on Senior Independent Directors (SIDS)
15 NEDS & Board Committees
The board operates with a series of sub committees composed of board members. These
deal with particular specialised areas, and enable the NEDS to contribute
The UK has no statutory requirement for nomination, or remuneration committees these are
just recommended by the Governance Code. However following the EU statutory audit
directive in 2008, quoted companies need an audit committee. The risk committee seems to
be an increasingly common feature of many large public companies.
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SECTION 3: The board of directors
Composition of committees required by UK code
Nomination Committee (UK Code Provision 17)
Majority of members should be independent NEDS. (executives can be a member, but not
chair or dominate). Chair should be board chairman or an independent NED. The chair of
the board should not chair the committee when it is dealing with the appointment of their
successor.
Remuneration Committee (UK Code Provision 32)
All members should be independent NEDS Minimum 2 in companies outside FTSE 350
(smaller companies), minimum 3 in companies inside FTSE 350.(larger companies). The
chairman of the board if independent on appointment can sit in committee, but not chair it.
Before appointment as chair of the remuneration committee, the appointee should have
served on a remuneration committee for at least 12 months.
Audit Committee
All members should be independent NEDS Minimum 2 in companies outside FTSE 350
(smaller companies), minimum 3 in companies inside FTSE 350.(larger companies). The
committees are covered in more detail later in the notes.
UK Governance code
Provision 24. The board should establish an audit committee of independent non-executive
directors, with a minimum membership of three, or in the case of smaller companies, two.
The chair of the board should not be a member. The board should satisfy itself that at least
one member has recent and relevant financial experience. The committee as a whole shall
have competence relevant to the sector in which the company operates.
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SECTION 3: The board of directors
Summary
Key points

Is Governance and Management the same?

The role of the board

Matters for the board

Multi-tier boards

Directors’ powers

Directors’ duties

Consequences of a breach of duty

Board membership and roles

Non-Executive Directors

NEDS & Board Committees
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Quick Quiz
1)
Which of the following is the responsibility of the Chairman of the board rather than
the Chief Executive Officer?
A Business strategy
B Risk management
C Communication with shareholders
D Investment and financing
2)
Identify FOUR roles of non-executive directors.
Longer question
3)
In the interest of good corporate governance, discuss the level and method of
remuneration for non-executive directors. (4 marks)
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SECTION 3: The board of directors
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SECTION 3: The board of directors
Exam standard question
In the exam you have 1.8 minutes a mark (100 marks / 180 minutes) therefore writing the
answer should take you no longer than 20 minutes. (22 minutes for 12 marks, however you
will need time to read your answer and plan it) Remember examiner model answers may be
much longer and more detailed than you could possibly do in a time constrained exam. It is
vital that you look at the marks available for each part of the question and organise your
answer to suit.
4 (a) How do unitary and two-tier boards differ? (4 marks)
(b) What are the arguments for and against two-tier boards? (8 marks)
Solution
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Answers to Quick Quiz
1)
C The Chairman of the board is responsible for communication with shareholders,
as this role encompasses all aspects of board management.
2) The role of non-executive directors includes

Contributing to, and challenging the direction of, strategy.

Scrutinising the performance of management in meeting goals and objectives,
monitor the reporting of performance. They should represent the shareholders'
interests to ensure agency issues don't arise to reduce shareholder value.

Satisfy themselves that financial information is accurate and that financial controls
and systems of risk management are robust.

Determining appropriate levels of remuneration for executives, and are key figures in
the appointment and removal of senior managers and in succession planning.
Longer question
In the interest of good corporate governance, discuss the level and method of remuneration
for non-executive directors. (4 marks)
Suggested Answer
The basic fee paid to non-executive directors should be sufficient for the proper time that
should be devoted to meetings, committee participation and visits to the company’s
operation. The chairman, chairmen of committees and those serving on the standing
committees may receive larger fees than those who only serve on the main board. Fees
should not be so large as to discourage resignation when appropriate.
Fees paid partly or fully in shares are acceptable, especially where these must be held until
the individual ceases to be a director, although there may be practical issues about
settlement of the related tax bills. However, fees for non-executive directors should not
include any performance-related elements to preserve independence and encourage
challenge to strategic decisions.
For an independent NED, fees should not include any element of consultancy for specific
services rendered as that could affect the relationship with management and might impair
independence.
Examiner’s comments
The quality of the answer to this question was a good indicator of each candidate’s overall
performance. Poorer candidates missed the reference to ‘non-executive’ and wrote, some at
extreme length, about the composition and work of the remuneration committee.
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SECTION 3: The board of directors
Types of board model answer
This is a model answer to an exam standard question (please note that this answer may be
much longer than could be attempted in a time constrained exam). Notice the bullet points,
remember that is an answer scheme, it is suggested that you limit the use of bullet points.
3. (a) How do unitary and two-tier boards differ?
(4 marks)
Suggested Answer
• Unitary board is a single board of directors, with both executive and non-executive
directors in the case of most public companies.
• Common in most countries, especially those under UK or US influence.
• The unitary board makes all the decisions of the company that are reserved for the
directors as a board;
• Board makes decisions as a unified group.
Two-tier board structure consists of a supervisory board and a management board beneath
it.
Management board:
• Consists exclusively of executives;
• Makes decisions about operational matters of major importance;
• Its head is the CEO.
Supervisory board:




Deals with other issues at board level, chiefly strategic;
Has oversight of the management board;
Its chairman is non-executive and is the chairman of the company;
All supervisory board members are non-executives, (though not
necessarily independent) as supervisory boards often include a
significant number of employee representatives, representatives of
major shareholders and the wider community and so may tend to
adopt a stakeholder approach to corporate governance.
(b) What are the arguments for and against two-tier boards?
(8 marks)
Suggested Answer
The effectiveness of the two-tier board structure depends on an excellent working
relationship between the chairman of the supervisory board and the CEO (head of the
management board). This may be a strength or a weakness depending on the calibre of the
individuals concerned and the quality of their working relationship.
For a two-tier board structure, it can be argued that:
• Helps to promote a stakeholder approach to corporate governance;
• No confusion between the responsibilities of executive directors as directors of the
company and their responsibilities as executive managers of the company;
• Executive management is accountable to the supervisory board.
Against a two-tier board structure, it can be argued that:
• The supervisory board consists entirely of non-executives, who might not have a proper
understanding of the company
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SECTION 3: The board of directors
• On a typical two-tier board, especially in many countries in Europe, many nonexecutives are not independent. Supervisory directors include staff and trade union
representatives, those from major shareholders or other companies where there are
cross-shareholdings and often former executives of the company. These nonindependent board members might promote the interests of the ‘faction’ they
represent. Confidentiality may also be an issue; in Germany, breaches of
confidentiality by supervisory board members has been made a criminal offence.
• The shareholder approach to corporate governance may be subordinated to the
stakeholder approach.
Examiner’s comments
This was the most popular question. Most candidates dealt satisfactorily with (a). I was
pleased to see that many candidates referred to strategy as a key role for the board. The
quality of the answers to (b) was more variable but mostly adequate.
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SECTION 3: The board of directors
UK Governance Code
1. Board Leadership and Company Purpose
Principles
A. successful company is led by an effective and entrepreneurial board, whose role is to
promote the long-term sustainable success of the company, generating value for
shareholders and contributing to wider society.
B. The board should establish the company’s purpose, values and strategy, and satisfy itself
that these and its culture are aligned. All directors must act with integrity, lead by example
and promote the desired culture.
C. The board should ensure that the necessary resources are in place for the company to
meet its objectives and measure performance against them. The board should also establish
a framework of prudent and effective controls, which enable risk to be assessed and
managed.
D. In order for the company to meet its responsibilities to shareholders and stakeholders, the
board should ensure effective engagement with, and encourage participation from, these
parties.
E. The board should ensure that workforce policies and practices are consistent with the
company’s values and support its long-term sustainable success. The workforce should be
able to raise any matters of concern.
Provisions
1. The board should assess the basis on which the company generates and preserves value
over the long-term. It should describe in the annual report how opportunities and risks to the
future success of the business have been considered and addressed, the sustainability of
the company’s business model and how its governance contributes to the delivery of its
strategy.
2. The board should assess and monitor culture. Where it is not satisfied that policy,
practices or behaviour throughout the business are aligned with the company’s purpose,
values and strategy, it should seek assurance that management has taken corrective action.
The annual report should explain the board’s activities and any action taken. In addition, it
should include an explanation of the company’s approach to investing in and rewarding its
workforce.
3. In addition to formal general meetings, the chair should seek regular engagement with
major shareholders in order to understand their views on governance and performance
against the strategy. Committee chairs should seek engagement with shareholders on
significant matters related to their areas of responsibility. The chair should ensure that the
board as a whole has a clear understanding of the views of shareholders.
4. When 20 per cent or more of votes have been cast against the board recommendation for
a resolution, the company should explain, when announcing voting results, what actions it
intends to take to consult shareholders in order to understand the reasons behind the result.
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SECTION 3: The board of directors
An update on the views received from shareholders and actions taken should be published
no later than six months after the shareholder meeting. The board should then provide a final
summary in the annual report and, if applicable, in the explanatory notes to resolutions at the
next shareholder meeting, on what impact the feedback has had on the decisions the board
has taken and any actions or resolutions now proposed
5. The board should understand the views of the company’s other key stakeholders and
describe in the annual report how their interests and the matters set out in section 172 of the
Companies Act 2006 have been considered in board discussions and decision-making. (The
Companies (Miscellaneous Reporting) Regulations 2018 require directors to explain how
they have had regard to various matters in performing their duty to promote the success of
the company in section 172 of the Companies Act 2006) The board should keep
engagement mechanisms under review so that they remain effective. For engagement with
the workforce, one or a combination of the following methods should be used:
• a director appointed from the workforce;
• a formal workforce advisory panel;
• a designated non-executive director.
If the board has not chosen one or more of these methods, it should explain what alternative
arrangements are in place and why it considers that they are effective.
6. There should be a means for the workforce to raise concerns in confidence and – if they
wish – anonymously. The board should routinely review this and the reports arising from its
operation. It should ensure that arrangements are in place for the proportionate and
independent investigation of such matters and for follow-up action.
7. The board should take action to identify and manage conflicts of interest, including those
resulting from significant shareholdings, and ensure that the influence of third parties does
not compromise or override independent judgement.
8. Where directors have concerns about the operation of the board or the management of
the company that cannot be resolved, their concerns should be recorded in the board
minutes. On resignation, a non-executive director should provide a written statement to the
chair, for circulation to the board, if they have any such concerns.
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SECTION 4: Governance Practice
SECTION 4: GOVERNANCE PRACTICE
1 Background
The Financial Reporting Council (FRC) has produced a guidance note on Board
Effectiveness in March 2011 to assist companies in applying the principles of the UK
Corporate Governance Code. It replaces ‘Good Practice Suggestions from the Higgs Report’
(known as “the Higgs Guidance”), which was last issued in 2006.
The guidance relates primarily to Sections A and B of the Governance Code on the
leadership and effectiveness of the board.
After the financial crises of 2007, in June 2009 ICSA engaged Sir David Walker to produce a
discussion document on Boardroom Behaviours.
This report concludes that:
• Appropriate boardroom behaviours are an essential component of best practice corporate
governance; and that the absence of guidance on appropriate boardroom behaviours
represents a structural weakness in the current system;
• Had that guidance been available and, more importantly, observed, some of the
consequences of the current crisis might have been less severe and that, in any case,
prevention of a recurrence of the events of the last year is at least partly dependent upon
guidance on appropriate boardroom behaviours being incorporated in the Code; and
• better articulation of the business case for best practice corporate governance, and more
focus on directors’ responsibilities and potential liabilities, should incentivise directors to
exhibit appropriate boardroom behaviours.
Reading: Appendix 1: FRC report on corporate culture & the role of boards
Please read the main headlines from the executive summary in appendix 1
Lecture example 1: Class discussion boardroom practices
What would you consider to be “Best practice boardroom behaviour”?
Solution
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SECTION 4: Governance Practice
2 Factors that influence boardroom practices
The degree to which these behaviours can be delivered is shaped by a number of key
factors:
• The character and personality of the directors and the dynamics of their interactions;
• The balance in the relationship between the key players, especially the chairman and CEO,
the CEO and the board as a whole, and between executive and non-executive directors;
• The environment within which board meetings take place; and
• The culture of the boardroom and, more widely, of the company.
ICSA has published a code concerning best boardroom practice, its main points are
summarised below:
1)
2)
3)
4)
5)
6)
7)
Written and monitored board procedures
Adequate induction of new directors
Information provision to all directors
Matters for the board should be reserved for board approval before the event
Chairman should decide the agenda
Company secretary should administer the board meetings, and minutes etc.
Board committees should be responsible to and supervised by the whole board
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SECTION 4: Governance Practice
3 Basic requirements for effective boardroom practice:

The board should have the right character, this effectively means “challenging”
This issue is illustrated by a quote from Warren Buffet (the famous American investor)
“The problem with corporate boards is the “boardroom atmosphere,” the desire of most
people in a group to get along with one another. Directors are aggressive and tenacious in
their normal jobs, but may become more passive when thrown together with their peers on a
board of directors. They have difficulty asking the tough questions at board meetings on
issues such as CEO compensation, risk, governance strategy, and board/CEO
performance……… to question a CEO mega-grant of share options would be “like belching
at the dinner table.””




Regular board meetings
Agenda should consist of matters reserved for the board
Information provided in an understandable and timely fashion
Support for directors, i.e. legal, accounting advice
Lecture example 2: Exam standard question: The facility fee
Gilt Ltd
Gilt Ltd is a small company in a niche market, with an issued share capital of 100,000 £1
shares held by 100 members.
One of the members, Bill, holds a considerable shareholding, but not a majority, and has
many years of business experience. Since Bill semi-retired he has taken it upon himself to
“help out” as the company reminds him of when he started out, so he regularly attends board
meetings, advising the board on various issues. This advice is considered extremely
valuable by the other directors as Bill is a highly regarded non-executive of Itt plc, a much
larger company in a similar field to Gilt Ltd. However his attendance is never recorded at
Bills request, as his wife thinks he is playing golf at the time and would not approve!!
Harry, the managing director of Gilt Ltd, has been approached by Itt plc in respect of its
making a takeover bid for Gilt Ltd. Itt plc has given Harry what is described as a facility fee of
£50,000 for ensuring that the takeover is successful.
At the next board meeting Harry, with the considerable help of Bill, convinces the other
directors that the takeover bid is in the long-term interest of Gilt Ltd, but they are concerned
that the holders of the majority of the issued share capital will not approve of the takeover.
In order to ensure the success of the takeover, the directors of Gilt Ltd agree that they
should allot sufficient new shares to Itt plc to ensure that a new majority of members will
support the takeover.
After the allocation of the shares to Itt plc a general meeting is called to consider the
takeover and it is approved, with Itt plc voting in favour.
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SECTION 4: Governance Practice
May, a substantial shareholder in Gilt Ltd, has subsequently found out about the actions of Itt
plc, Harry and the other directors, and has also discovered via her son who works for the
company, about the board meetings with Bill in attendance.
Required
May has asked you to analyse the situation, what is your analysis?
Please plan your answer in bullet point form only
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SECTION 4: Governance Practice
4 Appointments to the board
In order to carry out effective scrutiny, directors need to have relevant expertise in industry,
company, functional area (e.g. finance for CFO) and governance. The board as a whole
needs to contain a mix of expertise and show a balance between executive management
and independent non-executive directors. The South African King report, reporting within a
racially-mixed region, stresses the importance also of having a good demographic balance.
5 The nomination committee
In order to ensure that balance of the board is maintained, corporate governance codes
recommend the board should set up a nomination committee, made up wholly or mainly of
independent non-executive directors, led by the Chairman or a senior NED, to oversee the
process for board appointments and make recommendations to the board.
The nomination committee needs to consider:

The balance between executives and independent non-executives

The skills, knowledge and experience possessed by the current board

The need for continuity and succession planning

The desirable size of the board

The need to attract board members from a diversity of backgrounds
The nomination committee should ensure that appointments to the board are made using
objective criteria. However the criteria should not be so restrictive that it limits too greatly
the number of candidates.
The recruitment of “directors” is not just an important issue in the commercial sector, it is
also an issue in the voluntary sector as the case study below illustrates:
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The UK Corporate Governance Code emphasises that the procedures for recruiting directors
must be formal, rigorous and transparent.
The UK Code recommends that an external search consultancy and open advertising
should be used, particularly when appointing a non-executive director or chairman.
The UK Higgs report made a number of suggestions about possible sources of nonexecutive directors:

Companies operating in international markets could benefit from having at least one
non-executive director with international experience

Lawyers, accountants and consultants can bring skills that are useful to the board

Listed companies should consider appointing directors of private companies as nonexecutive Directors

Including individuals with charitable or public sector experience but strong
commercial awareness can increase the breadth of diversity and experience on the
board
Increasing diversity: The reports
The Davies Report 2011 and the Hampton-Alexander Review 2016
In 2011 Lord Davies released a ‘Women on Boards’ report which aimed to push the issue of
gender equality forward and promote the cause amongst UK companies. In the report Lord
Davies set the voluntary target of 25% women on the boards of FTSE 100 companies by the
end of 2015.
The target of 25% was met and in 2016 Lord Davies released his five-year summary of the
report as the Hampton-Alexander Review raising the target to 33% by 2020 on FTSE 350
boards.
Its general argument in favour of greater diversity was that diverse and balanced boards ‘are
more likely to be effective boards.
The Parker Report into the Ethnic Diversity of UK Boards 2016
The Parker Review report recommendations included that each FTSE 100 Board should
have at least one director of colour by 2021, and each FTSE 250 Board the same by 2024
The Review made three recommendations:
1 Increase the ethnic diversity of UK boards.
2 Develop candidates for the pipeline and plan for succession.
3 Enhance transparency and disclosure.
Points 2 and 3 were common with the Davies report, confirming the view that lack of
succession planning was a recurring issue.
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The UK Governance Code provisions concerning diversity
Principle J. Appointments to the board should be subject to a formal, rigorous and
transparent procedure, and an effective succession plan should be maintained for board and
senior management. Both appointments and succession plans should be based on merit and
objective criteria, and within this context, should promote diversity of gender, social and
ethnic backgrounds, cognitive and personal strengths.
Provision 23. The annual report should describe the work of the nomination committee,
including:
• the process used in relation to appointments, its approach to succession planning and how
both support developing a diverse pipeline;
• how the board evaluation has been conducted, the nature and extent of an external
evaluator’s contact with the board and individual directors, the outcomes and actions taken,
and how it has or will influence board composition;
• the policy on diversity and inclusion, its objectives and linkage to company strategy, how it
has been implemented and progress on achieving the objectives; and
• the gender balance of those in the senior management and their direct reports.
Lecture example 3: Exam question: class discussion: succession planning
Required
How should a board plan for an orderly succession, specifically indicate the two most
important positions?
(4 marks)
Solution
Lecture example 4: class discussion: Knowledge question: Goodbye?
Required
How can directors depart from office?
Solution
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Reading: ICSA guidance note: the role of the nomination committee
Please download the ICSA guidance note concerning the role of nomination committee from
the icsa website: www.icsa.org.uk
6 Retirement by rotation
Directors of public companies (in the model articles for plc’s) are required to retire from the
board and seek re-election, once every three years, although managing directors (CEO) may
be exempt from these provisions. Directors will generally be entitled to seek re-election if
they have retired by rotation and the provisions may assume that the retiring directors are
deemed to be reappointed. However, retirement by rotation provisions allow shareholders a
regular opportunity to vote directors out of office.
The UK Corporate Governance Code introduced the requirement for directors of FTSE 350
companies to face re-election every year, and in 2018 this was extended to all companies
that have to comply with the UK code.
Provision 18. All directors should be subject to annual re-election. The board should set out
in the papers accompanying the resolutions to elect each director the specific reasons why
their contribution is, and continues to be, important to the company’s long-term sustainable
success.
Retirement by rotation has the following benefits for companies:
(a) Shareholder rights
Retirement gives shareholders their main chance to judge the contribution of individual
directors and deny them re-election if they have performed inadequately. It is an important
mechanism to ensure director accountability.
(b) Evolution of the board
Compulsory retirement of directors forces directors and shareholders to consider the need
for the board to change over time. The fact that only some directors retire each year means
that if board changes are felt to be necessary, they can happen gradually enough to ensure
some stability.
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(c) Costs of contract termination
By limiting the length of service period, the compensation paid to directors for loss of office
under their service contracts will also be limited. Contracts may well expire at the time the
director is required to retire and if then the director is not re-elected, no compensation will be
payable.
Lecture Example 5: Class discussion: Controversial or not?
In May 2010 the UK Corporate Governance Code introduced the requirement for directors of
FTSE 350 companies (the biggest listed companies) to face re-election every year. Directors
of smaller listed companies should face re-election every three years. (since changed to
every year as well) This has been slightly controversial.
Required
Please put forward arguments for and against this provision
Solution
For
Against
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7 Induction of new directors and CPD
The UK Higgs Report provided detailed guidance on the development of an induction
programme tailored to the needs of the company and individual directors.
To remain effective, directors should extend their knowledge and skills continuously.
Significant issues that professional development should cover on a regular basis include:
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8 Board Appraisal
An appraisal of the board's performance is an important control over it, aimed at improving
board effectiveness, maximising strengths and tackling weaknesses. In the UK the directors
have to undergo a formal review every year
The UK code states that there should be an external formal evaluation every 3 years of
FTSE companies, and the board should state if the consultants are in any way connected to
the company. The review should involve the whole board and the board committees.
It can also be used to justify and measure performance, assisting the setting of the
remuneration policy.
All directors should be also be individually appraised; criteria that could be applied include:
Boards as a whole need to be appraised
Lecture example 6 Class discussion Board appraisal: Criteria?
Briefly suggest some criteria that you would use to determine the effectiveness of the whole
board of directors of a large listed plc (not using any of those on the spider diagram above!!)
Solution
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9 The Ethical Boardroom
Ethical business is part of corporate governance, and the behaviour of directors is an
important part of this as it sets the culture of the whole company. Enron is a good example of
failure in the area.
10 Directors share dealings
Directors often own shares in their own company, however they are effectively the ultimate
insider, therefore knowing perhaps when to buy or sell the shares.
There are a number of restrictions on when they can trade in shares.
11 Insider dealing
Insider dealing has been defined as a criminal offence by The Criminal Justice Act 1993
(CJA 93).
In essence it is using unpublished information to buy/sell securities in order to make a gain
or avoid making a loss.
The securities are purchased or sold on a regulated market.
12 Definitions
a) Insider - anyone who is in receipt of ‘inside information’, including:

directors, employees, or shareholders

anyone else who has access to inside information via their office or profession (e.g.
auditors)

anyone who gains information from any of the above
b) Inside Information – information that is price sensitive, being:

related to specific securities

is specific or precise

has not been made public

is likely to have a significant effect on the price of the securities
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c) Dealing – the defendant either:

was an insider who dealt using inside information in price-affected securities

encouraged other(s) to deal

disclosed the inside information to anyone else
However as this is a criminal offence it is difficult to secure a conviction as the offence has to
be proved beyond reasonable doubt.
Lecture example 7: Reading: Insider dealing or not?
Please read the brief article in appendix 1
13 MAR
Up to July 2016 the Model Code was the UKLA’s model share dealing code for listed
companies. Under the Listing Rules, listed companies required directors and certain other
employees to comply with the Model Code (or a code which is more rigorous).
The law is now governed by the new 2014 EU Regulation, the Market Abuse Regulation
(MAR) becoming law in the UK in July 2016.
It covers a wide range of market abuse, which is defined as conduct that adversely affects a
financial market and falls below the standards expected by the regular user of that market.
The Financial Conduct Authority (FCA) can enforce disciplinary action against those who
commit such abuses.
MAR provides for two very broad types of civil offence concerning market abuse, these
being insider dealing and market manipulation. Insider dealing is also a criminal offence
under the CJA 1993, and market manipulation is as well, under the Financial Services Act
2012, but it is very difficult to obtain a conviction.
MAR sets out restrictions on directors, connected persons and certain staff from dealing in
the company’s securities. This prevents dealing during certain "prohibited periods" being 30
calendar days before the announcement of an interim financial report or a year-end report..
The restrictions mean that the director or member of staff concerned may not be able to
deal, even when he/she is not in possession of inside information. Under MAR, directors and
certain employees are also required to ensure compliance in relation to certain persons
"connected" with them.
MAR requires companies to draw up “insider lists” a list of all persons who have access to
inside information, by employment, services provided etc. and this has to be kept up to date.
Companies must retain an insider list for a period of at least five years after it is drawn up or
updated. MAR also places requirements on regulators and companies to be able to receive
information via whistleblowing of any potential breaches.
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The requirements are as follows




Directors must not deal in shares of their company during a closed period and
permission cannot be given during this time, unless it would exceptionally cause
financial hardship (e.g. pressing debt)
A director must not deal at any time that they are privy to price-sensitive information.
A director must seek clearance from the chairman (or another designated director)
before dealing in the company’s shares. The CEO and Chairman can give clearance
to each other.
A director must ensure that none of his connected persons,(spouse and children,
plus companies where the director controls over 20% of the shares) deals without
clearance.
MAR reporting requirements
Companies must report any of the following:




Suspicious transaction and order reports (STORs).
Persons discharging managerial responsibilities (PDMRs).
Any delays of disclosure of inside information.
Under MAR Article 10, ‘PDMRs must notify details of dealings by themselves and
‘connected persons’ in shares of the company, once the total for the year is over
5,000 euros.
Lecture example 8: Class discussion: Arabella
Mary, the CFO of Airline Catering plc, a listed company, meets with Henry and his new
girlfriend Arabella for dinner, Henry is a director of a new sub division of the company. After
dinner, and a few drinks, he shows Mary the draft accounts for the subsidiary company that
will be discussed at the full board meeting of Airline Catering plc the next day, mentioning
that he is delighted that the profits have soared and that the share price is bound to rise
dramatically when the accounts are published the following month. Arabella, while
pretending she is not really interested, overhears the whole conversation and fully
understands the significance of the results. The next day Arabella persuades her friend Tom
to contract to sell her £50,000 worth of his shares in Airline Catering plc.
Has she committed an offence?
A. Yes. The information is obtained from a person connected with the company, and
she has dealt in order to obtain a profit. This is insider dealing.
B. No. The shares were not dealt on a recognised regulated market.
C. Yes. Although this was a private purchase, all public company share dealings are
potentially subject to the Criminal Justice Act 1993.
D. No. Arabella is not herself connected with the company, and could only be liable if
she had deliberately obtained the information.
Answer:
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As listed companies in the UK have to disclose own company share dealing by directors and
connected persons and this is notified to the Regulator Information Service (RIS) Many
traders on the market follow this information, using it to make investment decisions. For
more information see this website
http://followthedirectors.co.uk/1-introduction/
Investors using this information take the view:
Quoting from the website
“What directors do with their own money, that sends the real message about how investable
their company is. Actions speak louder than words.”
Home study: Liability of Directors
Please read the study text Chapter 5
Summary
Key areas

Factors that influence boardroom practice

The nomination committee

Retirement by rotation

Induction of new directors and CPD

Board Appraisal

Insider dealing

MAR
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Quick Quiz
1) List the ways in which a director can leave office.
2) What are the main features of the induction programme recommended by the Higgs
report?
3) How can an organisation ensure that there is a division of responsibilities at its
highest level?
Longer questions
4) Who should sit on a nomination committee? Outline the corporate governance
role played by the nomination committee. (4 marks)
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5) Outline two matters which a prospective director should disclose to the
company whose board he or she is to join, and explain why they should be
disclosed. (4 marks)
6) Why might stock markets wish to control the times at which directors deal in
the shares of their companies? (4 marks)
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Answers to Quick Quiz
1)









Resignation
Not offering himself for re-election when his term of office ends
Failing to be re-elected
Death
Dissolution of the company
Being removed from office
Prolonged absence meaning that director cannot fulfil duties (may be
provided in law or by company constitution)
Being disqualified (by virtue of the constitution or by the court)
Agreed departure
2)



Building an understanding of the nature of the company, its business and
markets
Building a link with the company's people
Building an understanding of the company's main relationships



Splitting the roles of chairman and chief executive
Appointing a senior independent non-executive director
Having a strong independent element on the board with a recognised leader
3)
4) Who should sit on a nomination committee? Outline the corporate governance
role played by the nomination committee. (4 marks)
SUGGESTED ANSWER
The nomination committee, established by the board, should contain a majority of members
who are independent non-executive directors (NEDs), and a committee chairman who is
either the board chairman or an independent NED.
The UK Governance Code specifies the need for a formal, rigorous and transparent process
for appointing new directors. The Higgs “Suggestions for Good Practice” summarise the
principle duties of the nomination committee, now contained in FRC guidance. The corporate
governance role of the committee is to search for new directors, and then to consider new
appointments to the board and make recommendations to the full board. However, only the
full board, not the nomination committee, has the authority to make new appointments. The
NEDs introduce independence into succession decisions, and should ensure that the
appointments process is not dominated by the company chairman.
Mention should be made of potential conflicts of interest, such as the need to keep the
chairman of the board out of discussions on chairman succession. The way in which
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appointments are made and the way in which the committee makes its recommendations
should be discussed in detail.
EXAMINER’S COMMENTS
This question was answered reasonably well, all candidates attempted it
5) Outline two matters which a prospective director should disclose to the
company whose board he or she is to join, and explain why they should be
disclosed. (4 marks)
SUGGESTED ANSWER
Disclosure of interests is a mechanism to make sure that a director acts in the best interests
of the company and its shareholders.
Interests to be declared include a director’s shareholding in the company; any other interests
in the company’s securities (e.g. warrants, options, pension investments); holdings or offices
held by director or his/her immediate family in subsidiaries or investments of the company.
This is a legal requirement in many countries and a regulatory one for most quoted markets.
This allows both the board in its deliberations and outsiders dealing with the company to be
aware of these other forms of interest in the company. Views differ about the extent to which
the alignment of a director’s interest with that of the shareholders is desirable. Owning a
modest shareholding is generally viewed as encouraging proper consideration of the position
of the ordinary shareholder, but a major interest, or even more a representative interest
when also a director of a large shareholder, may be seen as impairing independence.
Interests in any holdings of securities or offices held by director or his/her immediate family
in major suppliers, customers, competitors or a regulator and cross shareholdings with other
directors should also be declared. These interests may influence a director’s view of
decisions relating to the other party. If a matter for decision affects one of these interests, it
may be appropriate for the director to abstain from voting on it, to absent himself from the
debate or for the board to agree that he may participate fully. The Articles of Association or
bye-laws of the organisation may contain rules governing these matters. Later, if a director is
a ‘related party’ to a purchase or special deal under consideration, not only do the above
constraints apply, but there may also be requirements, under the UKLA Rules, to advise
shareholders or to seek their consent before entering into a contract. Common law has long
demanded that someone in a fiduciary position should not make a ‘secret profit’ from their
position.
6) Why might stock markets wish to control the times at which directors deal in
the shares of their companies? (4 marks)
SUGGESTED ANSWER
Directors often own shares in the companies on whose boards they serve. In many
countries, this is encouraged by the provision of share option and other share incentive
schemes, especially for executive directors. However, the directors of a public company are
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likely to know more about the financial position of the company, and about other plans or
threats that could influence its share price, than other investors. In the past, it was not
unusual for directors to take advantage of this inside knowledge by buying or selling shares
before the information that would affect the share price reached the market generally.
Markets therefore introduce rules to restrict the times at which directors and connected
persons can deal in their own company’s shares to those periods when they are least likely
to be in possession of price sensitive information. This helps to ensure that all shareholders
are operating on similar bases and minimises the making of unfair profits..
Disclosure rules relating to directors’ share dealings help to police any rules relating to
insider dealing and the misuse of price sensitive information. In addition, even at times when
dealings are permitted under the rules, the information that one or more directors many be
trading in the company’s shares provides the market generally with some indication of the
directors’ view of their company. A single trade may be insufficient information – the person
concerned may be buying a new house, paying school fees or even just the tax on the
shares earned under an incentive scheme.
Directors’ shareholdings are also an indication of the alignment of their interests with those
of shareholders. For example, the AIM in London requires the directors (and staff with more
than 5% of the share capital) of a newly-quoted stock to sign ‘lock-in agreements’ that forbid
them to sell shares or securities in the company for the first twelve months on the market
and often constrain dealings for an even longer period without consultation with the
regulators.
EXAMINER’S COMMENTS
Most candidates made the point about insider dealing but failed to mention much else. It did
not require very specific examples of the current statutory regulation, but a more general
answer, it is important candidates look at the command word being used in the question and
read the question carefully.
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UK Corporate Governance Code
2 Division of Responsibilities
Principles
F. The chair leads the board and is responsible for its overall effectiveness in directing the
company. They should demonstrate objective judgement throughout their tenure and
promote a culture of openness and debate. In addition, the chair facilitates constructive
board relations and the effective contribution of all non-executive directors, and ensures that
directors receive accurate, timely and clear information.
G. The board should include an appropriate combination of executive and non-executive
(and, in particular, independent non-executive) directors, such that no one individual or small
group of individuals dominates the board’s decision-making. There should be a clear division
of responsibilities between the leadership of the board and the executive leadership of the
company’s business.
H. Non-executive directors should have sufficient time to meet their board responsibilities.
They should provide constructive challenge, strategic guidance, offer specialist advice and
hold management to account.
I. The board, supported by the company secretary, should ensure that it has the policies,
processes, information, time and resources it needs in order to function effectively and
efficiently.
Provisions
9. The chair should be independent on appointment when assessed against the
circumstances set out in Provision 10. The roles of chair and chief executive should not be
exercised by the same individual. A chief executive should not become chair of the same
company. If, exceptionally, this is proposed by the board, major shareholders should be
consulted ahead of appointment. The board should set out its reasons to all shareholders at
the time of the appointment and also publish these on the company website.
10. The board should identify in the annual report each non-executive director it considers to
be independent. Circumstances which are likely to impair, or could appear to impair, a nonexecutive director’s independence include, but are not limited to, whether a director:
• is or has been an employee of the company or group within the last five years;
• has, or has had within the last three years, a material business relationship with the
company, either directly or as a partner, shareholder, director or senior employee of a body
that has such a relationship with the company;
• has received or receives additional remuneration from the company apart from a director’s
fee, participates in the company’s share option or a performance-related pay scheme, or is a
member of the company’s pension scheme;
• has close family ties with any of the company’s advisers, directors or senior employees;
• holds cross-directorships or has significant links with other directors through involvement in
other companies or bodies;
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• represents a significant shareholder; or
• has served on the board for more than nine years from the date of their first appointment.
Where any of these or other relevant circumstances apply, and the board nonetheless
considers that the non-executive director is independent, a clear explanation should be
provided.
11. At least half the board, excluding the chair, should be non-executive directors whom the
board considers to be independent.
12. The board should appoint one of the independent non-executive directors to be the
senior independent director to provide a sounding board for the chair and serve as an
intermediary for the other directors and shareholders. Led by the senior independent
director, the non-executive directors should meet without the chair present at least annually
to appraise the chair’s performance, and on other occasions as necessary.
13. Non-executive directors have a prime role in appointing and removing executive
directors. Non-executive directors should scrutinise and hold to account the performance of
management and individual executive directors against agreed performance objectives. The
chair should hold meetings with the non-executive directors without the executive directors
present.
14. The responsibilities of the chair, chief executive, senior independent director, board and
committees should be clear, set out in writing, agreed by the board and made publicly
available. The annual report should set out the number of meetings of the board and its
committees, and the individual attendance by directors.
15. When making new appointments, the board should take into account other demands on
directors’ time. Prior to appointment, significant commitments should be disclosed with an
indication of the time involved. Additional external appointments should not be undertaken
without prior approval of the board, with the reasons for permitting significant appointments
explained in the annual report. Full-time executive directors should not take on more than
one non-executive directorship in a FTSE 100 company or other significant appointment.
16. All directors should have access to the advice of the company secretary, who is
responsible for advising the board on all governance matters. Both the appointment and
removal of the company secretary should be a matter for the whole board.
3 Composition, Succession and Evaluation
Principles
J. Appointments to the board should be subject to a formal, rigorous and transparent
procedure, and an effective succession plan should be maintained for board and senior
management. Both appointments and succession plans should be based on merit and
objective criteria and, within this context, should promote diversity of gender, social and
ethnic backgrounds, cognitive and personal strengths.
K. The board and its committees should have a combination of skills, experience and
knowledge. Consideration should be given to the length of service of the board as a whole
and membership regularly refreshed.
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L. Annual evaluation of the board should consider its composition, diversity and how
effectively members work together to achieve objectives. Individual evaluation should
demonstrate whether each director continues to contribute effectively.
Provisions
17. The board should establish a nomination committee to lead the process for
appointments, ensure plans are in place for orderly succession to both the board and senior
management positions, and oversee the development of a diverse pipeline for succession.
A majority of members of the committee should be independent non-executive directors. The
chair of the board should not chair the committee when it is dealing with the appointment of
their successor.
18. All directors should be subject to annual re-election. The board should set out in the
papers accompanying the resolutions to elect each director the specific reasons why their
contribution is, and continues to be, important to the company’s long-term sustainable
success.
19. The chair should not remain in post beyond nine years from the date of their first
appointment to the board. To facilitate effective succession planning and the development of
a diverse board, this period can be extended for a limited time, particularly in those cases
where the chair was an existing non-executive director on appointment. A clear explanation
should be provided.
20. Open advertising and/or an external search consultancy should generally be used for the
appointment of the chair and non-executive directors. If an external search consultancy is
engaged it should be identified in the annual report alongside a statement about any other
connection it has with the company or individual directors.
21. There should be a formal and rigorous annual evaluation of the performance of the
board, its committees, the chair and individual directors. The chair should consider having a
regular externally facilitated board evaluation. In FTSE 350 companies this should happen at
least every three years. The external evaluator should be identified in the annual report and
a statement made about any other connection it has with the company or individual
directors.
22. The chair should act on the results of the evaluation by recognising the strengths and
addressing any weaknesses of the board. Each director should engage with the process and
take appropriate action when development needs have been identified.
23. The annual report should describe the work of the nomination committee, including:
• the process used in relation to appointments, its approach to succession planning and how
both support developing a diverse pipeline;
• how the board evaluation has been conducted, the nature and extent of an external
evaluator’s contact with the board and individual directors, the outcomes and actions taken,
and how it has or will influence board composition;
• the policy on diversity and inclusion, its objectives and linkage to company strategy, how it
has been implemented and progress on achieving the objectives; and • the gender balance
of those in the senior management and their direct reports.
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106
Achievement Ladder Step 2
ACHIEVEMENT LADDER STEP 2
You have now covered the topics that will be assessed in Step 2 of your Achievement
Ladder.
You should now attempt and pass Step 2 of the Achievement Ladder which is the first
course mock exam
It is vital in terms of your progress towards 'exam readiness' that you attempt this Step in the
near future and complete it by the due date
You will receive feedback on your performance, and you can use the ongoing BPP support
to help address any improvement areas. This will help you to tailor your learning exactly to
your own individual requirements
Achievement ladder Step 2
First course mock exam to be completed by due date
Followed by
Debrief of exam
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SECTION: EXTRA: REVISION
Lecture example 1: Revision question: LL
LL is a listed company based in the country of Tyne. The corporate governance code in
Tyne, enforced by Tyne’s stock exchange, is based on the OECD principles of corporate
governance.
Robert Ferris, the Chairman of LL, has recently returned from a meeting with Thelma
Chambers, who is the representative of Elm Lodge International bank, the institutional
investor with the largest shareholding in LL. He discussed the results of the meeting with
Terrance Collier, LL’s chief executive. Robert told Terrance that he had mentioned to
Thelma that LL may try to expand its operations into America and he wondered whether LL
should therefore seek a stock market listing in America. Thelma said that, in her opinion, this
would be a very good idea, as it would force LL to comply with the Sarbanes-Oxley
legislation and meet higher standards of corporate governance than the regime in Tyne,
which she considered too lax. Terrance however commented that this was another example
of the ‘dreaded Thelma’s interference’. From what he could tell Sarbanes-Oxley took a ‘one
size fits all’ approach and would involve lots of useless bureaucracy.
Required
Evaluate Thelma’s suggestion that it would be better if LL had to comply with the Sarbanes-Oxley
legislation. (8 marks)
Solution
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Lecture example 2: Revision question: Ding Dong
Sam Mesentery was appointed a director of Ding Company in October this year taking on
the role of financial controller. He had moved himself and his family to a new country to take
up the post and was looking forward to the new challenges. When he arrived he learned that
he was on the ‘operating board’ of Ding Company and that there was a ‘corporate board’
above the operating board that was senior to it. This surprised him as in the companies he
had worked for in his own country, all directors in the company were equal.
The corporate board at Ding was small, with five directors in total, while the operating board
was larger, with ten members.
After a few days in the job he received an e-mail requiring him to report to Annette Hora, the
managing director. She said that she had regretfully received two complaints from another
senior colleague about Sam’s behaviour. First, Sam had apparently made a highly
inappropriate remark to a young female colleague and second, his office was laid out in the
wrong way. Not only was his desk positioned in breach of fire regulations but also, he was
told that it was normal to have the desk facing towards the door so that colleagues felt more
welcomed when they went in. ‘It’s company policy’ she said abruptly. Sam remembered the
conversation with the young female colleague but was unaware of anything inappropriate in
what he had said to her. He said that he positioned his desk so he could get the best view
out of the window when he was working.
It was a month later that Sam first met with Arif Zaman, Ding’s non-executive chairman. After
Arif asked Sam how he was settling in, Sam asked Arif why he preferred a two-tier board
structure and Arif replied that actually it was Annette’s idea. He said that she prefers it that
way and because he is a non-executive member doesn’t feel able to challenge her opinion
on it. Because ‘it seems to work’ he had no plans to discuss it with her. He went on to say
that he was an old friend of Annette’s and was only in post to satisfy the corporate
governance requirements to have a non-executive chairman. He said that he saw his role as
mainly ceremonial and saw no need to take any direct interest in the company’s activities.
He said that he chaired some board meetings when he was available and he sometimes
wrote the chairman’s statement in the annual report.
Required
(a) Explain the content of a director’s induction programme and assess the advantages of
such a programme for Sam. (8 marks)
(b) Assess Arif Zaman’s understanding of his role as non-executive chairman. (9 marks)
(Total = 17 marks)
Solution
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SECTION: Extra: Revision
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SECTION: Extra: Revision
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SECTION: Extra: Revision
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SECTION 5: Remuneration
SECTION 5: REMUNERATION
1 Introduction
Directors being paid (or paying themselves as perceived by many of the public) excessive
salaries and bonuses has been seen as one of the major corporate abuses for a large
number of years. It is inevitable that the corporate governance provisions have targeted it.
However this is not necessarily to the disadvantage of the high-performing director, since
guidance issued has been underpinned by a distinction between reasonable rewards that
are justified by performance, and high rewards that are not justified and are seen as
unethical.
The “problem” of excessive remuneration has a long history in corporate governance, the
privatisation of the UK utilities in the 1990, and the resulting large salary increases awarded
to the directors, with the CEO of British Gas as a particular case study
Lecture example 1 Case study: reading: British Gas
Please read: Cedric Brown, “fat cat in the dog house “published by the Independent in
appendix 1
At the time of the financial crisis of 2007 to 2009 the phrase “Rewards for Failure” became a
very popular description used by politicians and the media to describe the various
remuneration packages and pension arrangements of the directors of the failed banks and
other companies.
However in an exam answer it is important that you remain dispassionate about this subject.
It is important to recognise that there may be some senior executives that have behaved
unethically showing “greed”, however there is a reasonable aspiration of executives to be
well rewarded for the work they do. A balanced, but perhaps high reward package
encouraging high performance is justified, what is not is high rewards despite poor
performance.
Lecture example 2 Case study reading: Rewards for Failure
Please read “Rewards for failure debate follows BP boss into retirement” published by the
Guardian in appendix 1
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2 Purposes of Directors remuneration
Clearly adequate remuneration has to be paid to directors in order to attract and retain
individuals of sufficient calibre. Remuneration packages should be structured to ensure that
individuals are motivated to achieve performance levels that are in the company and
shareholders' best interests as well as their own personal interests.
The Greenbury Committee (1995) in the UK set out principles which are a good summary of
what remuneration policy should involve.

Directors' remuneration should be set by independent members of the board

Any form of bonus should be related to measurable performance or enhanced
shareholder value

There should be full transparency of directors' remuneration, including pension rights,
in the annual accounts
3 Remuneration policy
Issues connected with remuneration policy may include the following:

The pay scales applied to each director's package

The proportion of the different types of reward within each package

The period within which performance related elements become payable

What proportion of rewards should be related to measurable performance or
enhanced shareholder value, and the balance between short and long-term
performance elements

Transparency of directors' remuneration, including pension rights, in the annual
accounts (Directors Remuneration Report Regulations 2002 , now part of the
Companies Act 2006)
When establishing remuneration policy, boards have to take account the position of their
company relative to other companies. However the UK Corporate Governance Code points
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out the need for directors to treat such comparisons with caution, in view of the risk of an
upward ratchet in remuneration levels with no corresponding improvement in performance
4 What performance measures to use?
There are a number of issues with this decision:

Simply, the choice of the wrong measure, achieving performance that does not
benefit the company significantly and does not enhance shareholder value

Excessive focus on short-term results, particularly annual financial performance
(which can also be manipulated)

Remuneration operating with a time delay, being based on what happened some
time ago rather than current performance. So potentially the perception of rewards
for failure if the reward was earning a long time in the past
5 Who decides the directors remuneration?
Prior to Greenbury, one of the major issues was directors setting their own pay, so
Greenbury recommended the creation of a remuneration committee.
Composition (UK Code)
All independent NEDS, in large companies at least 3, smaller companies 2. The company
chairman can also be a member, if considered independent, but not chair it. Higgs
suggested that the company secretary should be the secretary.
Frequency of Meeting (from ICSA guidance)
It must meet close to the year end to review the directors' remuneration report which quoted
companies must now submit to shareholders for approval at the AGM. We would
recommend that the committee should meet at least twice a year in order to discharge its
responsibilities properly.
Responsibility (UK Code)
Setting the remuneration for all executive directors and chairman, in addition recommend
remuneration of senior management
Shareholder input
Shareholders should be able to vote, approving long term incentives recommended by
committee and board.
Lecture example 3: class discussion: Main duties
In the light of the information above, what are the duties of the remuneration committee?
Solution
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SECTION 5: Remuneration
As an annex to the question
Who sets the pay of the NEDs?….some of them form the remuneration committee!!
Solution
6 The remuneration package
A well-balanced package should aim to reduce agency costs by ensuring that directors’
(agents) interests are aligned with shareholders’ (principals). This means the package
should reward directors who meet targets that further the interests of shareholders, for
example by including a bonus based on achievement of targets that are consistent with
enhanced shareholder value.
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The remuneration committee should also be able to review what the director is doing to
achieve the targets set, and be able to penalise the director if it has evidence that the
director is taking excessive risks to achieve the targets.
UK Code suggests the following concerning the policy:
Provision 40: When determining executive director remuneration policy and practices, the
remuneration committee should address the following:
• clarity – remuneration arrangements should be transparent and promote effective
engagement with shareholders and the workforce;
• simplicity – remuneration structures should avoid complexity and their rationale and
operation should be easy to understand;
• risk – remuneration arrangements should ensure reputational and other risks from
excessive rewards, and behavioural risks that can arise from target-based incentive plans,
are identified and mitigated;
• predictability – the range of possible values of rewards to individual directors and any
other limits or discretions should be identified and explained at the time of approving the
policy;
• proportionality – the link between individual awards, the delivery of strategy and the longterm performance of the company should be clear. Outcomes should not reward poor
performance; and
• alignment to culture – incentive schemes should drive behaviours consistent with
company purpose, values and strategy.
Lecture example 4 Class Discussion: The benefits of pay
Discuss these various components of directors remuneration packages: Explain what the
element is, then indicate an argument for and perhaps against the particular element.
Remember: The purpose of directors’ remuneration is to be sufficient to:
(a) Attract and retain individuals of sufficient calibre, and
(b) Motivate them to achieve performance levels that are in the shareholders’ best interests
as well as their own personal interests.
Solution
Basic Salary
Performance Related Pay & transaction bonuses
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Benefits in kind
Pensions
Shares
Share Options
7 Remuneration report
UK quoted companies are required by Companies Act 2006 to prepare a directors
remuneration report that is published in the Annual Report and therefore sent to all
shareholders. It has to be approved by the board and signed. Part of the report is audited by
the external auditors, mainly the specific numerical items.
The initial Greenbury recommendations concerning reporting have become more detailed
over time, becoming law in 2002, and part of the companies act in 2006. . In October 2013
the reporting requirements became even more detailed for quoted companies on a main
exchange such as the LSE, but the changes did not apply to AIM listed companies
A directors' remuneration report must contain:



A statement by the remuneration committee chairman
The company's policy on directors' remuneration
An implementation report, containing information about how the remuneration policy
was implemented during the financial year.
The remuneration policy should set out:
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


How the company proposes to pay directors, including every detail of remuneration.
The details on remuneration for newly-appointed directors, and on 'loss of office
payments'.
Remuneration for NEDs as well as executive directors.
The UK rules on directors' remuneration give power to shareholders

Shareholders have a binding vote on remuneration policy at least every three years,
and must be informed annually about the implementation of remuneration policy.
The UK Code requires the annual report to contain the following information about the work
of the remuneration committee:
UK Code Provision 41. There should be a description of the work of the remuneration
committee in the annual report, including:
• an explanation of the strategic rationale for executive directors’ remuneration policies,
structures and any performance metrics;
• reasons why the remuneration is appropriate using internal and external measures,
including pay ratios and pay gaps;
• a description, with examples, of how the remuneration committee has addressed the
factors in Provision 40;
• whether the remuneration policy operated as intended in terms of company performance
and quantum, and, if not, what changes are necessary;
• what engagement has taken place with shareholders and the impact this has had on
remuneration policy and outcomes;
• what engagement with the workforce has taken place to explain how executive
remuneration aligns with wider company pay policy; and
• to what extent discretion has been applied to remuneration outcomes and the reasons why.
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Lecture example 5: Exam standard question: Bonus schemes for NEDS?
Exam technique
In the exam you have 1.8 minutes a mark (100 marks / 180 minutes) therefore writing this
answer should take you no longer than 15 minutes. (18 minutes for 10 marks, however you
will need time to read your answer and plan it) .
Remember examiner model answers may be much longer and more detailed than you could
possibly do in a time constrained exam. It is vital that you look at the marks available for
each part of the question and organise your answer to suit.
The question: Bonus schemes for NEDS
Bonus schemes are normally designed to motivate full-time employees who have no other
employment and are wholly dependent upon the organisation for their income. Part-time
employees and short-term employees might not be included. A particular problematic area
are non-executive directors who are part-time, remunerated by fees under contracts for a
fixed number of years and required by corporate governance codes to maintain
independence.
Required
Describe and advise on the possible features of bonus schemes which are designed
to motivate non-executive directors, but not compromise the role of the non-executive
director (10 marks)
Solution
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SECTION 5: Remuneration
8 Compensation for loss of office
Directors usually have service contracts with the company, so the payments for loss of office
will be contractual.
The issue with these payments is they may be perceived as a reward for failure if the
director is leaving for poor performance. The UK governance code has in line with most
corporate governance guidance around the world suggested that service contracts greater
than 12 months need to be carefully considered and should ideally be avoided. A few are
stricter. Singapore's code suggests that notice periods should be six months or less.
It also recommends that when negotiating contracts the remuneration committee should be
mindful of potential rewards for failure
Investor organisations ABI and NAPF (now PLSA) produced a joint statement on this issue
in February 2008
Readings: Institutional shareholders
1) Please read the ABI and NAPF (PLSA) statement in Appendix 1
2) Please read Chapter 6 concerning Institutional shareholders views on directors
remuneration in the study text
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SECTION 5: Remuneration
Summary
Key areas

Purposes of Directors remuneration

Remuneration committee

Remuneration policy

The remuneration package

Remuneration report

Compensation for loss of office
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SECTION 5: Remuneration
Quick Quiz
1)
The UK Corporate Governance Code recommends that a remuneration committee
should be staffed by executive directors.
True
False
2)
In compliance with the reporting requirement on director’s remuneration, which of the
following does not have to be disclosed in the annual report and accounts?
A The duration of director’s contracts together with notice periods
B Summarised information for individual directors
C Performance conditions attached to individual packages
D The overall remuneration policy
3)
The audit committee does not assume which of the following responsibilities?
A Review of the adequacy internal control systems
B Consider the recommendations of the external auditors in the management letter
C Review of financial statements
D Setting of remuneration and reward packages for all directors
4)
Exam standard question: The Board of directors
Required
You are required to write a bullet pointed brief report to the board of directors of a new listed
company, which outlines the following areas.
(a) The role of the non-executive directors
(b) The role of the remuneration committee
(c) The role of the nomination committee
(25 marks)
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SECTION 5: Remuneration
Solution
125
SECTION 5: Remuneration
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SECTION 5: Remuneration
Answers to Quick Quiz
1)
False. The remuneration committee should be staffed by independent non-executive
directors.
2)
B Summarised information for individual directors does not have to be disclosed in
the annual report and accounts; this is because detailed disclosures of the remuneration
package of all directors must be published.
3)
D The audit committee is responsible for many things, however it is the role of the
remuneration committee to set remuneration and reward packages for all directors.
The Board of directors: long answer
(8 Marks for each section, 1 mark for report heading)
REPORT
To: Board of directors
From: Consultant
Date: December X4
Subject: Board of directors and committees
Non-executive directors
The board should include a balance of executive and non-executive directors and the role of
the nonexecutive directors should include the following elements.

Being independent in judgement and possessing an inquiring mind

Being well informed about the company and the environment within which it operates

Having a strong command of issues relevant to the business

Constructively challenging proposals on strategy and helping to develop such
proposals

Scrutinising the performance of management and monitoring reports on that
performance

Ensuring that sufficient, accurate, clear and timely information is provided to the
board in advance of meetings

Satisfying themselves of the integrity of the financial controls and information

Satisfying themselves that the risk management systems are robust and defensible

Determining appropriate levels of remuneration for executive directors
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
Playing an important role in the appointment and removal of directors and in
succession planning

Understanding the views of major investors
Remuneration committee
The remuneration committee should be made up of non-executive directors as it is
responsible for setting the remuneration for all executive directors, the chairman and the
company secretary.
As well as this basic responsibility the remuneration committee has other duties.

To determine targets for any performance related pay schemes

To determine the policy for pension arrangements for executive directors

To ensure that any contractual terms on termination and payments made are fair
both to the company and the individual

To determine the total individual remuneration package for each executive director
including bonuses, incentive payments and share options

To agree the policy for authorising expense claims from the chief executive and
chairman

To ensure that all required disclosures for remuneration matters are fulfilled
Nomination committee
The UK Governance Code requires that there should be formal, rigorous and transparent
procedures for the appointment of new directors to the board. The nomination committee,
made up of a majority of independent non-executive directors, can carry out this role. The
main duties of this committee are to:

Evaluate the current balance of skills, knowledge and experience on the board and
with this in mind to prepare a description of the role and capabilities required for a
particular appointment

Consider candidates from a wide range of backgrounds

Review the time required from a non-executive director annually

Assess whether the non-executive directors are spending enough time to fulfil their
duties

Consider succession planning and in particular what skills and expertise are needed,
given the challenges and opportunities facing the company

Prepare a statement for the annual report including the process used for
appointments and explains if external advice or advertising has been used. The
statement should also state the membership of the committee, and the number of
committee meetings attended over the year.
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UK Corporate Governance Code
5 Remuneration
Principles
P. Remuneration policies and practices should be designed to support strategy and promote
long-term sustainable success. Executive remuneration should be aligned to company
purpose and values, and be clearly linked to the successful delivery of the company’s longterm strategy.
Q. A formal and transparent procedure for developing policy on executive remuneration and
determining director and senior management10 remuneration should be established. No
director should be involved in deciding their own remuneration outcome.
R. Directors should exercise independent judgement and discretion when authorising
remuneration outcomes, taking account of company and individual performance, and wider
circumstances.
Provisions
32. The board should establish a remuneration committee of independent non-executive
directors, with a minimum membership of three, or in the case of smaller companies, two. In
addition, the chair of the board can only be a member if they were independent on
appointment and cannot chair the committee. Before appointment as chair of the
remuneration committee, the appointee should have served on a remuneration committee
for at least 12 months.
33. The remuneration committee should have delegated responsibility for determining the
policy for executive director remuneration and setting remuneration for the chair, executive
directors and senior management.12 It should review workforce13 remuneration and related
policies and the alignment of incentives and rewards with culture, taking these into account
when setting the policy for executive director remuneration.
34. The remuneration of non-executive directors should be determined in accordance with
the Articles of Association or, alternatively, by the board. Levels of remuneration for the chair
and all non-executive directors should reflect the time commitment and responsibilities of the
role. Remuneration for all non-executive directors should not include share options or other
performance-related elements.
35. Where a remuneration consultant is appointed, this should be the responsibility of the
remuneration committee. The consultant should be identified in the annual report alongside
a statement about any other connection it has with the company or individual directors.
Independent judgement should be exercised when evaluating the advice of external third
parties and when receiving views from executive directors and senior management.
36. Remuneration schemes should promote long-term shareholdings by executive directors
that support alignment with long-term shareholder interests. Share awards granted for this
purpose should be released for sale on a phased basis and be subject to a total vesting and
holding period of five years or more. The remuneration committee should develop a formal
policy for post-employment shareholding requirements encompassing both unvested and
vested shares.
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37. Remuneration schemes and policies should enable the use of discretion to override
formulaic outcomes. They should also include provisions that would enable the company to
recover and/or withhold sums or share awards and specify the circumstances in which it
would be appropriate to do so.
38. Only basic salary should be pensionable. The pension contribution rates for executive
directors, or payments in lieu, should be aligned with those available to the workforce. The
pension consequences and associated costs of basic salary increases and any other
changes in pensionable remuneration, or contribution rates, particularly for directors close to
retirement, should be carefully considered when compared with workforce arrangements.
39. Notice or contract periods should be one year or less. If it is necessary to offer longer
periods to new directors recruited from outside the company, such periods should reduce to
one year or less after the initial period. The remuneration committee should ensure
compensation commitments in directors’ terms of appointment do not reward poor
performance. They should be robust in reducing compensation to reflect departing directors’
obligations to mitigate loss.
40. When determining executive director remuneration policy and practices, the
remuneration committee should address the following:
• clarity – remuneration arrangements should be transparent and promote effective
engagement with shareholders and the workforce;
• simplicity – remuneration structures should avoid complexity and their rationale and
operation should be easy to understand;
• risk – remuneration arrangements should ensure reputational and other risks from
excessive rewards, and behavioural risks that can arise from target-based incentive plans,
are identified and mitigated;
• predictability – the range of possible values of rewards to individual directors and any other
limits or discretions should be identified and explained at the time of approving the policy;
• proportionality – the link between individual awards, the delivery of strategy and the longterm performance of the company should be clear. Outcomes should not reward poor
performance; and
• alignment to culture – incentive schemes should drive behaviours consistent with company
purpose, values and strategy.
41. There should be a description of the work of the remuneration committee in the annual
report, including:
• an explanation of the strategic rationale for executive directors’ remuneration policies,
structures and any performance metrics;
• reasons why the remuneration is appropriate using internal and external measures,
including pay ratios and pay gaps;
• a description, with examples, of how the remuneration committee has addressed the
factors in Provision 40;
• whether the remuneration policy operated as intended in terms of company performance
and quantum, and, if not, what changes are necessary;
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SECTION 5: Remuneration
• what engagement has taken place with shareholders and the impact this has had on
remuneration policy and outcomes;
• what engagement with the workforce has taken place to explain how executive
remuneration aligns with wider company pay policy; and
• to what extent discretion has been applied to remuneration outcomes and the reasons why.
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SECTION 5: Remuneration
132
SECTION 6: Reporting
SECTION 6: REPORTING
1 Corporate reporting
The annual report and accounts of a company is the principle way that the directors (agents)
provide information concerning their stewardship of the company assets to the shareholders
(principals).
In fact accounting can be defined as “the process of identifying, measuring and
communicating economic information to permit informed judgements and decisions by users
of the information” American Accounting Association (1966)
Taking this vague definition slightly further and placing a governance slant on it, “The
objective of accounting is to provide financial information regarding an enterprise for use in
making decisions. The objective of accounting to investors is to provide financial information
regarding an enterprise for use in making investment decisions, investors include owners
and creditors.” Staubus (2000)
To be useful to all users the accounting information that is published needs to show various
characteristics:
Lecture example 1: Class discussion: Qualitative characteristics
Required:
Please list the 7 characteristics that accounting information should show to be useful to all
users of the information?
Solution
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SECTION 6: Reporting
2 Validity
The role of these seven characteristics is to ensure that the information contained in different
financial reports is equally valid, in theory to all the potential users of the information.
However all these attributes are not simultaneously achievable and so a conflict can develop
between the various characteristics. This may result in a compromise or trade-off between
the various characteristics depending on the user group and the context in which the
information is being used. A good example is the reliability and completeness of the
published financial information, but to be useful it must be produced within a suitable time
period.
As indicated above, various stake holding groups have an interest in the financial statements
of an organisation such as a large listed plc
Lecture example 2: Class discussion: stakeholders and financial statements
Required:
List some stakeholders of a large listed plc and indicate their particular interest in the
financial statements of a listed plc
Solution
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SECTION 6: Reporting
3 Reliable reporting
The reliability of the annual reports relies on several factors:
The care of the directors producing the financial information
The opinion of the external auditors
The accounting policies of the company, are they honest or attempting to hide the real
position and “window dress” the figures
The Cadbury Committee was established in 1991 as a direct result of concerns about the
reliability of financial statements of UK companies after various scandals had dented
investor confidence, such as Polly Peck and Mirror Group
If financial statements are produced to deliberately mislead shareholders and the markets
generally then this is fraudulent and a crime. There is however perhaps a fine line between
very aggressive accounting policies that may be permitted by accounting standards, and so
maybe approved of by the auditors, and fraudulent accounts. The overall intention is to show
the financial situation of the company in the best light, even though this may only be in the
short term.
This has been a feature of many of the governance scandals at various companies around
the world, the most infamous being Enron and Worldcom, however it seems most
jurisdictions around the world are not immune.
Lecture example 3: Reading: Horie and Livedoor in Japan
Please read the article in appendix 1
4 How to “window dress” financial statements
There are various methods that a company may use to show its financial position in a better
light.
1)
Overstatement of revenues.
Revenues should be related to the relevant accounting period and there are various
methods of boosting these revenues. If you have received a lump sum payment that
covers several years of services, you can inflate your sales by stating the entire amount
to the sales for the current year. If the contrast contract is for say five years, the correct
accounting treatment is to apportion the sales over five years in the process called
amortization.
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SECTION 6: Reporting
A second and common way of inflating revenues is to make large shipments of
products to distribution channels towards the end of the year. The entire shipment is
booked as sales for the current year even though distributors are free to return any
unsold goods. The correct accounting would be to show the amount as stock only
accounting for sales as and when the products are actually sold. For contracting
companies, it is easy to inflate revenue by accounting for excess profits on contracts
that have not yet been completed
2) Deferring or understating expenses.
For example, a company may regard marketing expenses or brand building
expenses as long-term expenses and show them as a capital expenditure. This will
result in the amount being shown in the balance sheet where it can be amortized
over a number of years rather than in the profit loss account, where it should be
shown, As a result, the profit for the year will be inflated by this figure. Another
example is not to create provisions from profit is to cover pay-outs for legitimate
claims against the company.
3) Off-balance-sheet items.
Avoiding showing significant items of capital expenditure on the balance sheet by
leasing them and arranging to buy them back at the end of the lease period. Only the
lease rental that is payable at periodic intervals is shown as an expense. Once the
asset has been taken off the balance sheet, neither the asset nor the buyback liability
is disclosed on the accounts. Similarly creating a network of subsidiaries and
associate companies and, because these are separate legal entities, their financial
position need not be incorporated into the financial position of the parent.
5 Principles of Corporate Governance: Transparency and openness
There should be transparency in reporting by companies, so stakeholders can assess the
true financial position of the company and make judgements about future prospects.
The UK Governance code states the annual report as well as containing accurate financial
information it should also explain:

The basis on which the company generates revenue and makes a profit from
operations

The overall financial strategy of the company
Lecture example 4: Exam standard question: worldwide minerals
Please read the following scenario and then answer the question
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SECTION 6: Reporting
WM is a large listed multinational company that deals with natural minerals that are
extracted from the ground, processed and sold to a wide range of industrial and construction
companies. In order to maintain a consistent supply of minerals into its principal markets, an
essential part of WM’s business strategy is the seeking out of new sources and the
measurement of known reserves. Investment analysts have often pointed out that WM’s
value rests principally upon the accuracy of its reserve reports as these are the best
indicators of future cash flows and earnings. In order to support this key part of its strategy,
WM has a large and well-funded geological survey department which, according to the
company website, contains ‘some of the world’s best geologists and minerals scientists’. In
its investor relations literature, the company claims that:
‘our experts search the earth for mineral reserves and once located, they are carefully
measured so that the company can always report on known reserves. This knowledge
underpins market confidence and keeps our customers supplied with the inventory they
need. You can trust our reserve reports – our reputation depends on it!’
At the board meeting, the head of the geological survey department, Ranjana Tyler, reported
that there was a problem with the latest report because one of the major reserve figures had
recently been found to be wrong. The mineral in question, mallerite, was WM’s largest
mineral in volume terms and Ranjana explained that the mallerite reserves in a deep mine in
a certain part of the world had been significantly overestimated. She explained that, based
on the interim minerals report, the stock market analysts were expecting WM to announce
known mallerite reserves of 4·8 billion tonnes. The actual figure was closer to 2·4 billion
tonnes. It was agreed that this difference was sufficient to affect WM’s market value, despite
the otherwise good results for the past year.
Vanda Monroe, the finance director, said that the share price reflects market confidence in
future earnings. She said that an announcement of an incorrect estimation like that for
mallerite would cause a reduction in share value. More importantly for WM itself, however, it
could undermine confidence in the geological survey department.
The board discussed the options open to it. The chairman, who was also a qualified
accountant, was Tim Blake. He began by expressing serious concern about the over
estimation and then invited the board to express views freely. Gary Howells, the operations
director, said that because disclosing the error to the market would be so damaging, it might
be best to keep it a secret and hope that new reserves can be found in the near future that
will make up for the shortfall. He said that it was unlikely that this concealment would be
found out as shareholders trusted WM and they had many years of good investor relations to
draw on.
Vanda Monroe, the finance director, reminded the board that the company was bound to
certain standards of truthfulness and transparency by its stock market listing. She pointed
out that they were constrained by codes of governance and ethics by the stock market and
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that colleagues should be aware that WM would be in technical breach of these if the
incorrect estimation was concealed from investors.
Finally, Martin Chan, the human resources director, said that the error should be disclosed to
the investors because he would not want to be deceived if he were an outside investor in the
company. He argued that whatever the governance codes said and whatever the cost in
terms of reputation and market value, WM should admit its error and cope with whatever
consequences arose.
The WM board contains three non-executive directors and their views were also invited. One
of them questioned the internal audit and control systems, and whether they were adequate
in such a reserve-sensitive industry. In response WM’s chairman, Tim Blake, said that he
intended to write a letter to all investors and analysts in the light of the mallerite problem
which he hoped would address some of the issues raised.
Required:
Define ‘transparency’ and evaluate its importance as an underlying principle in
corporate governance and in relevant and reliable financial reporting. Your answer
should refer to the case as appropriate. (10 marks)
Solution
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6 Directors duties regarding reporting
Directors have a duty to prepare accounts, a directors' report and (for quoted companies) a
directors' remuneration report, and a number of subsidiary and associated responsibilities in
relation to those.
The annual accounts must be approved by the board and the company balance sheet must
be signed on their behalf by a director (s414 CA2006).They must not approve accounts,
unless they are satisfied that they give a true and fair view of the assets, liabilities, financial
position and profit or loss of the company
The directors' report must contain strategic report that replaced the business review from
October 2013. This is not part of the directors report and is a separate section.
The strategic report must contain

a fair review of the company's business
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

A description of the principal risks and uncertainties facing the company.
A review of how the company's business has performed during the financial year and
the position of the company as at the end of the year.
To enable understanding of this development there should also be:

Analysis using financial key performance indicators (KPIs) and non-financial KPIs
concerning environmental and employee issues.

The main trends and factors affecting the future development of the company's
business

Information about the company's policies on
-
Environmental matters,
The company's employees
Social, community and human rights issues
For quoted companies, the strategic report should also contain:


A description of the company's strategy and business model
A gender breakdown: the number of persons of each sex at the end of the financial
year who were directors, senior managers and employees of the company. (as a
result of the Davies report)
The directors of quoted companies are required to prepare a directors' remuneration report
(s420 CA 2006), which must provide certain narrative disclosures about remuneration policy
and numerical disclosures concerning the remuneration of individual directors.
They should also make a going concern statement as per the UK governance code
recommendations, however this was revised in 2014 to include a statement identifying any
material uncertainty.
7 The UK Governance Code
The UK Governance Code has requirements as regards reporting, this is shown below:
Principle N. The board should present a fair, balanced and understandable assessment of
the company’s position and prospects.
Provision 27. The directors should explain in the annual report their responsibility for
preparing the annual report and accounts, and state that they consider the annual report and
accounts, taken as a whole, is fair, balanced and understandable, and provides the
information necessary for shareholders to assess the company’s position, performance,
business model and strategy.
Provision 30. In annual and half-yearly financial statements, the board should state whether
it considers it appropriate to adopt the going concern basis of accounting in preparing them,
and identify any material uncertainties to the company’s ability to continue to do so over a
period of at least twelve months from the date of approval of the financial statements.
Provision 31. Taking account of the company’s current position and principal risks, the
board should explain in the annual report how it has assessed the prospects of the
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company, over what period it has done so and why it considers that period to be appropriate.
The board should state whether it has a reasonable expectation that the company will be
able to continue in operation and meet its liabilities as they fall due over the period of their
assessment, drawing attention to any qualifications or assumptions as necessary.
8 Directors responsibilities under US law
Section 302 of Sarbanes Oxley Act 2002 states that CEO and CFO have personal
responsibilities for the accuracy of the company’s financial statements. They have to sign the
SEC statement affirming this.
9 External Audit
External auditors are from accountancy firms and their primary role is to scrutinise
accounting records so as to report on the truth and fairness of the financial statements to
shareholders
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An independent external auditor’s report is considered an essential tool when reporting
financial information to users of that information. Companies rely on auditor reports to certify
their information in order to attract investors, obtain loans, and improve public appearance.
Some have even stated that financial information without an auditor’s report is “essentially
worthless” for investing purposes.
10 Responsibilities
11 The Directors of the company are responsible for the Financial
Statements
The directors of a company have the responsibility for maintaining adequate accounting
records and of preparing proper financial statements for the use of shareholders and
creditors. Even though the financial statements are sometimes constructed and produced in
the auditors' office, primary responsibility for the statements remains with the directors.
Therefore it is the directors responsibility to detect fraud via their internal control systems, it
is not the prime responsibility of the auditors, however if they find it they should report it to
the directors.
The auditors' product is their report. It is a separate document from the client's financial
statements, although the two are closely related and transmitted together.
12 The auditors responsibility
The word audit when applied to financial statements means that the balance sheet,
statements of income and retained earnings, and statement of cash flows are accompanied
by an audit report prepared by independent public accountants, expressing their professional
opinion as to the fairness of the company's financial statements.
The goal is to determine whether these statements have been prepared in conformity with
generally accepted accounting principles (GAAP) and comply with the law.
13 Negligence by the auditors?
The Companies Act 2006 has introduced new rules concerning auditors liability for
negligence. Shareholder can vote to limit the liability of auditors in a liability Limitation
agreement. (LLA) The CA 2006 also introduction 2 crimes associated with audit concerned
with recklessness
1) To recklessly include any matter that is misleading, false or deceptive
2) To recklessly omit a statement from an audit report that is required by the Act
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Lecture example 5: Auditors duty owed to………….????
Please read the details of this case
Caparo Industries plc v Dickman [1990]
Fidelity plc, manufacturers of electrical equipment, was the target of a takeover bid by
Caparo Industries plc. Fidelity was performing badly and in March 1984 Fidelity issued a
profit warning, which had halved its share price.
In May 1984 Fidelity's directors made a preliminary announcement in its annual profits for
the year up to March. This confirmed the position was poor and the share price fell again. At
this point Caparo had begun purchasing large numbers of shares. In June 1984 the annual
accounts, which were done with the help of the accountant Dickman, were issued to the
shareholders, which now included Caparo.. Caparo reached a shareholding of 29.9% of the
company, at which point it made a general offer for the remaining shares, as the City Code's
rules on takeovers required. But once it had control, Caparo found that Fidelity's accounts
were in an even worse state than had been revealed by the directors or the auditors. It sued
Dickman for negligence in preparing the accounts and sought to recover its losses. This was
the difference in value between the company as it had and what it would have had if the
accounts had been accurate.
Were the auditors liable?
Solution
14 The Auditors Report
The Auditors' Unqualified (now called unmodified) Report
The standard unqualified report is where the auditor has made no exceptions and inserts no
qualifications in the report. An unqualified opinion can only be expressed when the
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independent auditor has formed the opinion on the basis of an examination made in
accordance with generally accepted accounting principles, applied in a consistent basis and
includes all informative disclosures necessary to make the statements not misleading.
The standard unqualified report consisting of three paragraphs and is addressed to the
persons who retained the auditors.
The Introductory Paragraph
The introductory paragraph emphasizes that the client company is primarily responsible for
the financial statements and that the auditors render a report on the financial statements, not
on the accounting records.
The Scope Paragraph
The scope paragraph describes the nature of the audit and that it was conducted in
accordance with generally accepted auditing standards providing reasonable assurance that
the financial statements are free of material misstatement.
The Opinion Paragraph
In the opinion paragraph, the auditors are expressing nothing more than an informed
opinion. They do not guarantee or certify that the statements are accurate.
An example of a report is shown in the study text
Other types of report (called modified reports)
Other types of report are unusual and may indicate serious financial problems
Qualified Opinions
Qualifications with respect to an auditor's opinion may be broadly classified into two
categories; those qualifications which relate to the scope of the examination, and those
qualifications with respect to the fairness of presentation in accordance with generally
accepted accounting principles consistently applied. A qualified opinion restricts the auditors'
responsibility for fair presentation in some areas of the financial statements. The opinion
states that except for the effects of some deficiency in the financial statements, or some
limitation in the scope of the auditors' examination, the financial statements are presented
fairly. All qualified reports include a separate explanatory paragraph before the opinion
paragraph disclosing the reasons for the qualification.
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Adverse Opinions
An adverse opinion is the opposite of an unqualified opinion; it is an opinion that the financial
statements do not present fairly the financial position, results of operations, and cash flows
of the company, in conformity with generally accepted accounting principles.
The auditors should express an adverse opinion if the statements are so lacking in fairness
that a qualified opinion would not be warning enough. Whenever the auditors issue an
adverse opinion, they should disclose in a separate paragraph of the report the reasons for
the adverse opinion and the principal effects on the financial statements of the matters
causing the adverse opinion.
Disclaimer of Opinion
A disclaimer of opinion is no opinion. In an audit engagement, a disclaimer is required when
substantial scope restricts or other conditions preclude the auditors' compliance with
generally accepted auditing standards.
15 Ethics and Auditors
Lecture example 6: Arthur Andersen
Please read the following article (an extract from Wikipedia’s article on the Enron scandal)
Arthur Andersen
Case: Arthur Andersen LLP v. United States
Arthur Andersen, Enron’s auditors, was charged with, and found guilty of, obstruction of
justice for shredding the thousands of documents and deleting e-mails and company files
that tied the firm to its audit of Enron. Although only a small number of Arthur Andersen's
employees were involved with the scandal, the firm was effectively put out of business; the
SEC is not allowed to accept audits from convicted felons.
The firm surrendered its CPA license on August 31, 2002, and 85,000 employees lost their
jobs. The conviction was later overturned by the U.S. Supreme Court due to the jury not
being properly instructed on the charge against Andersen. The Supreme Court ruling
theoretically left Andersen free to resume operations. However, the damage to the Andersen
name has been so great that it has not returned as a viable business even on a limited scale
and currently only employs 200 people in Chicago dealing with the over 100 lawsuits
outstanding.
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16 Independence (and conflicts of interest) concerning auditors
Threats to independence of action and conflicts of interest include:

Self-interest

Self-review

Advocacy

Familiarity

Intimidation
17 Self-interest threat
As summarized by the diagram below:
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Safeguards in these situations might include:
(a) Discussing the issues with the audit committee of the client
(b) Taking steps to reduce the dependency on the client
(c) Consulting an independent third party such as an accounting body
(d) Maintaining records such that the firm is able to demonstrate that appropriate staff and
time are spent on the engagement
(e) Compliance with all applicable audit standards, guidelines and quality control procedures
18 Self-review threat
Self-review threat is where an audit firm provides services other than audit services to an
audit client (i.e. providing multiple services).
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19 Advocacy threat
An advocacy threat arises in certain situations where the audit firm assume the client’s part
in a dispute or somehow acting as their advocate. The most obvious instances of this would
be when a firm acts as an expert witness in a court case.
Relevant safeguards might be:
(a) Using different departments in the firm to carry out the work
(b) Making full disclosure to the client’s audit committee
(c) Withdrawal from an engagement if the risk to independence is considered too great.
20 Familiarity threat
Familiarity threat is where independence is jeopardised by the audit firm and its staff
becoming over familiar with the client and its staff. We have already discussed this as
familiarity threat arises in conjunction with a self-interest threat.
21 Intimidation threat
An intimidation threat arises when members of the audit team have reason to be intimidated
by client staff. These are also examples of self-interest threats, largely because intimidation
may only arise significantly when the audit firm or its employees has something to lose.
Situations which might create intimidation threats include:
(a) Threats of dismissal.
(b) Threats of litigation.
(c) Pressure to reduce fees or the extent of work performed.
Lecture example 7: Class discussion: Threats
Required
For each of the following situations, identify the threat to independence and suggest
potential remedies.
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(a) A bank has requested a reference from the firm about a client that is seeking additional
funding. The client promises to be a very valuable client if the business succeeds in raising
extra funds.
(b) The client has told the firm that it has received a cheaper quote from a rival for
conducting the annual audit and that it is considering changing auditor next year.
(c) The firm has been asked to conduct an internal audit for the client of the effectiveness of
a recent IT investment. The IT investment was project managed by the consulting division of
the accounting practice.
(d) A partner at the office conducting the audit holds 20% of the equity of the client.
(e) The Managing Partner and the Chairman of the client often play golf together.
Solution
Further EU regulations have been introduced concerning the performance of non-audit work
by auditors. The 2014 EU Audit Directive and Regulation came into force in June 2016 and
applies mainly to listed companies in the EU.
It covers:

Restricting the amount of non-audit work that audit firms can undertake to no more
than 70% of the average fees from audit work over the previous three financial years

It also imposes a ban on audit firms conducting certain types of non-audit work,
including: tax advice; services involving management/decision-making for the client;
book-keeping; and designing or implementing internal controls relating to financial
information.
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22 USA: Sarbanes-Oxley Act 2002
Public Oversight Board
The Act set up a new regulator, The Public Company Accounting Oversight Board (PCAOB),
to oversee the audit of public companies that are subject to the securities laws.
The Board has powers to set auditing, quality control, independence and ethical standards
for registered public accounting firms to use in the preparation and issue of audit reports on
the financial statements of listed companies. In particular the board is required to set
standards for registered public accounting firms' reports on listed company statements on
their internal control over financial reporting.
The board also has inspection and disciplinary powers over firms.
Auditing standards
Audit firms should retain working papers for at least seven years, have quality control
standards in place such as second partner review. As part of the audit they should review
internal control systems
Non-audit services
Auditors are expressly prohibited from carrying out a number of services including internal
audit, bookkeeping, systems design and implementation, appraisal or valuation services,
actuarial services, management functions and human resources, investment management,
legal and expert services.
Provision of other non-audit services is only allowed with the prior approval of the audit
committee.
23 The Audit Committee
Role and function of the audit committee
The Cadbury report summed up the benefits that an audit committee can bring to an
organisation
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Cadbury had some warnings concerning audit committee failings
(a) Must not act as a 'barrier' between the external auditors and the main board.
(b) Must not allow the main board to 'abdicate its responsibilities with regard to financial
statements’
(c) The audit committee must also avoid falling under the influence of a dominant board
member.
(d) Need members with financial experience
24 Composition of the audit committee
The UK Code states
Provision 24. The board should establish an audit committee of independent non-executive
directors, with a minimum membership of three, or in the case of smaller companies, two.
The chair of the board should not be a member. The board should satisfy itself that at least
one member has recent and relevant financial experience. The committee as a whole shall
have competence relevant to the sector in which the company operates.
The Singapore code suggests that at least two members should have accounting or related
financial management expertise.
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Legal requirements
EU Statutory Audit Directive 2008: UK listed companies must have an audit committee
SOX: NYSE prohibited from listing companies without an audit committee
25 Role of audit committee
Review of financial statements and systems

The committee should review interim (if published) and annual accounts

Review the financial reporting and budgetary systems especially systems that allow
monitoring of the most significant business and financial risks
Liaison with external auditors
The audit committee's tasks here will include:

Being responsible for the appointment or removal of the external auditors as well as
fixing their remuneration.

Considering whether there are any other threats to external auditor independence. In
particular the committee should consider non-audit services provided by the external
auditors, paying particular attention to whether there may be a conflict of interest.

Discussing the scope of the external audit prior to the start of the audit. This should
include consideration of whether external audit's coverage of all areas and locations
of the business is fair, and how much external audit will rely on the work of internal
audit.

Acting as a forum for liaison between the external auditors, the internal auditors and
the finance director.

Helping the external auditors to obtain the information they require and in resolving
any problems they may encounter.

Dealing with any serious reservations which the external auditors may express either
about the accounts, the records or the quality of the company's management.
Review of internal audit (Covered in a later section)




Standards
Scope
Resources,
Reporting arrangements
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
The head of internal audit should have direct access to the audit committee.
Review of internal control

Monitor the control environment, management's attitude towards controls and overall
management controls.

The audit committee's review should cover legal compliance and ethics, for example
listing rules or environmental legislation.

The committee should also address the risk of fraud and ensure whistleblowing
mechanisms are in place.

Review the company's statement on internal controls prior to its approval by the
board.
The committee should consider the recommendations of the external auditors

Review of risk management

The audit committee can play an important part in the review of risk as recommended
by the Turnbull report

Confirm that there is a formal policy in place for risk management and that the policy
is backed and regularly monitored by the board

The extent of their work may depend on whether there is a separate risk
management committee
Investigations

The committee will also be involved in implementing and reviewing the results of oneoff investigations.

The Cadbury report recommended that audit committees should be given specific
authority to investigate matters of concern
Reading: FRC Guidance concerning Audit Committees
The FRC’s Guidance on Audit Committees 2016 is not compulsory and Is only guidance to
assist in complying with the UK Governance Code. It is part of the recommended reading in
the introduction to the course notes and is included in the appendices at the end of the study
text.
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26 Non-Financial reporting
Some stakeholders have an interest in other aspects of the company, in addition to its
financial performance and position. Non-financial information that may interest includes
information about:
(i) Business strategy and what the company is hoping to achieve in the future.
(ii) Risk, because the value of their investment depends not only on the financial returns of
the company but also its exposures to risk.
(iii) Corporate governance and compliance (or non-compliance) with the applicable corporate
governance code; shareholders may consider that compliance is an indication of a wellgoverned company.
(iv) Social and ethical policies and performance by the company; these issues are
particularly important to investors with a socially responsible investment policy.
Some groups of stakeholders other than shareholders also have an interest in non-financial
aspects of a company’s policies and performance. For example, employees are likely to be
interested in the employment policies of their company, and the public (and the government)
may be interested in aspects of social and environmental performance, such as issues
relating to human rights and environmental protection.
The purpose of providing non-financial information is to satisfy the information needs of
these groups. In addition, the company itself will have its own purposes for providing the
information:
(i) The company may also see potential for enhancing its reputation by providing information
on social and environmental issues. A good reputation may provide positive commercial
benefits.
(ii) The board of directors may have a genuine concern for environmental, social and
governance issues, and may therefore want to publish information about these matters, as a
matter of principle.
Narrative reporting
ICSA has a guidance note entitled Contents list for the annual report of a UK company
Of particular relevance to this exam is, for example:
Corporate governance statement
•
introduction by chairman including governance overview and diversity statement
•
statement of compliance with UK Corporate Governance Code, or other applicable
code, and meaningful explanations of any non-compliance information on
governance/risk management structures
•
report on board responsibilities, activities, attendance etc.
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•
report on board evaluation and outcomes
•
report on each committee including letter from committee chairman, committee
responsibilities, activities, attendance etc, and reporting by the audit committee on
judgements taken on significant issues, their assessment of the performance of the
external audit process; and impairment assumptions.
Reading: Narrative reporting
Please download the ICSA guidance note entitled “Contents list for the annual report of a UK
company” and “Good practice for annual reports” from the ICSA website.
And
Home study: Please read the study text chapter 7 section 7
Lecture example 8: Exam standard question: Neirum Engineering
Instructions
Please read the scenario as you would in the real exam, writing on the question paper
only for 4 minutes.
Then attempt the question
Part a is worth 10 marks and so should take no longer than 18 minutes
Part b is worth 5 marks so should take no longer than 9 minutes
You can use your notes if required
The scenario
Ken Masters is Managing Director of a medium-sized engineering company. His company
has carried out a couple of projects over the last year for Nerium Engineering, a recently
listed company. The board of Nerium Engineering has subsequently contacted Ken about
becoming a non-executive director of the company.
Nerium's board has told Ken that his responsibilities as a director would include being a
member of Nerium's audit and remuneration committees.
The audit committee has only just been established and its terms of reference have yet to be
finally agreed. Ken is unsure what such a role might involve and, as an engineer without a
finance qualification, he is also unsure as to whether he is the right person for such a
committee.
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The remuneration committee has by contrast been established for just over two years. Ken
understands the main role of the remuneration committee but is worried about the
responsibilities that he will be taking on. In particular he is concerned about widespread
condemnation of 'fat cat' salaries and rewards, and criticisms of situations where senior
executives have been forced to resign when their company has performed very badly but
have taken a large pay-off when they leave. He is worried that in some cases, non-executive
directors on remuneration committees have been accused of failing to do their job properly
by allowing excessive remuneration packages.
He has been pondering the following quote from the UK Corporate Governance Code:
‘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.’
Historically Nerium Engineering has rewarded its directors largely on the basis of the
earnings the company has achieved. The directors have received quite a small basic salary,
but a large profit-related bonus.
Required
(a) Explain the possible role and responsibilities of the audit committee and the main
qualities that a member of such a committee should possess. Refer to the case as
appropriate. (10 marks)
(b) Describe the basic principles that should be applied to test the acceptability of a
performance measure. (5 marks)
Solution
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References
American Accounting Association: Committee to Prepare a Statement of Basic Accounting
Theory. (1966). A Statement of basic accounting theory. Sarasota,
Florida. American
Accounting Association.
Staubus G. (2000). The Decision Usefulness Theory of Accounting : A Limited History (New
Works in Accounting History). New York. Garland Publishing
Summary
Key areas

Corporate reporting

Validity of information

Reliable reporting

How to “window dress” financial statements

Transparency and openness

Directors duties regarding reporting

The UK Governance Code 2010

External Audit

The Auditors responsibilities

The Auditors Report

Independence (and conflicts of interest) concerning Auditors

USA: Sarbanes-Oxley Act 2002
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Quick quiz
Exam question
1(a) Explain what a ‘going concern statement’ is.
(5 marks)
(b) Describe the responsibilities of the directors of a listed company in respect of financial
reporting under the Companies Act 2006 and the UK Corporate Governance Code.
(14 marks)
(c) Discuss the division of responsibility between company directors and external auditors in
respect of the prevention and detection of fraud.
(6 marks)
(Total: 25 marks)
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Quick quiz answers
1 (a) Explain what a ‘going concern statement’ is.
(5 marks)
Suggested answer
Going concern is a key accounting concept and the UK Corporate Governance Code
includes a provision (30) that the directors of a company should report in the Annual and
Interim Reports that the company is a going concern. The going concern statement
expresses a view, of the directors, that the company will continue in trade for the foreseeable
future (at least the next 12 months). The financial statements are prepared on a going
concern basis and the company’s assets are valued accordingly (in comparison to how they
would be valued on a break-up/liquidation basis).
(b) Describe the responsibilities of the directors of a listed company in respect of
financial reporting under the Companies Act 2006 and the UK Corporate Governance
Code.
(14 marks)
Suggested answer
A company’s directors are responsible for the preparation and content of the financial
statements. The directors of a company have certain legal duties under the Companies Act
2006 in respect of financial reporting, which are as follows.





To prepare annual company accounts, which must be approved by the board and
signed by a director.
To prepare a directors’ report which must also be approved by the board and signed
by a director or the company secretary. Unless the company is subject to the small
companies’ regime, the directors’ report must also contain a business review.
In a listed company, to prepare a directors’ remuneration report which must be
approved by the board and signed by a director in addition to being approved by the
shareholders (in an advisory vote).
In a public company, the reports and accounts must be laid before the shareholders
in a general meeting.
To file with the Registrar of Companies a copy of the annual accounts, directors’
report, the auditors’ report and (for listed companies) the directors’ remuneration
report.
A common misconception is that the auditors are responsible for the ‘true and fair view’ in
the financial statements. The directors are responsible for the financial statements; they
prepare the financial statements and have primary responsibility for the information they
contain to be reliable and accurate. The directors of a company are responsible for
identifying and correcting any errors within the financial statements and for providing the
external auditors with reasonable assurances that there are no errors. The auditors then
provide a professional opinion to the shareholders.
Under the UK Corporate Governance Code the directors of a company should prepare the
annual report and accounts to be fair, balanced and understandable in order to provide the
shareholders with the necessary information to assess the company’s business model and
strategy, performance and prospects, including a going concern statement. The board’s
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responsibility extends to interim and other price-sensitive public reports and reports to
regulators as well as to information required as part of statutory reporting requirements.
Principle N. The board should present a fair, balanced and understandable assessment of
the company’s position and prospects.
Provision 27. The directors should explain in the annual report their responsibility for
preparing the annual report and accounts, and state that they consider the annual report and
accounts, taken as a whole, is fair, balanced and understandable, and provides the
information necessary for shareholders to assess the company’s position, performance,
business model and strategy.
Provision 30. In annual and half-yearly financial statements, the board should state whether
it considers it appropriate to adopt the going concern basis of accounting in preparing them,
and identify any material uncertainties to the company’s ability to continue to do so over a
period of at least twelve months from the date of approval of the financial statements.
Provision 31. Taking account of the company’s current position and principal risks, the
board should explain in the annual report how it has assessed the prospects of the
company, over what period it has done so and why it considers that period to be appropriate.
The board should state whether it has a reasonable expectation that the company will be
able to continue in operation and meet its liabilities as they fall due over the period of their
assessment, drawing attention to any qualifications or assumptions as necessary.
Under the Companies Act 2006 the directors of a company are potentially liable for any
errors or misleading information in the annual report and accounts. Any person (for example,
an investor) suffering a loss as a result of an error of misstatement in the report and
accounts may make a claim against the company. The company can then take legal action
against the directors to recover any damages it has paid in respect of such claims.
(c) Discuss the division of responsibility between company directors and external
auditors in respect of the prevention and detection of fraud.
(6 marks)
Suggested answer
Fraud and errors can result in the incorrect use of accounting policies; omissions of fact; or
misinterpretation of fact. Whilst both can lead to incorrect figures being provided within
financial statements if they have not been detected, errors are unintentional, whereas fraud
is intentional and a criminal offence.
It is not the auditor’s responsibility to detect fraud or errors. The board is responsible for
preventing fraud or detecting it where it occurs though a system of internal control and the
monitoring of the system’s effectiveness. Auditors assess the risk that fraud or errors may
have occurred and their audit procedures should be so designed to enable them to make
this assessment and provide reasonable assurance that such errors have not occurred.
Where the auditors discover that fraud has taken place, they have a responsibility to report
this to the directors.
The Companies Act 2006 introduced provisions to offer some protection for auditors against
liability for negligence or breach of duty through the use of Limited Liability Agreements.
Examiner’s comments
Question 2 was quite a popular question but was not generally answered very well.
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In part (a), most candidates were able to provide an explanation of the going concern
statement, although many made no mention of it being a key accounting concept. Other
candidates incorrectly stated that it was a statement made by a company’s auditors.
Part (b) specifically related to financial reporting but many candidates covered non-financial
reporting such as corporate governance and corporate social responsibility, which were not
relevant. In general candidates seemed to struggle to identify and/or distinguish between the
responsibilities of directors for financial reporting under the Companies Act 2006 and the UK
Corporate Governance Code. Again, confusion arose over the responsibilities of directors
and auditors.
A number of candidates extended their answers, and gained further marks, by commenting
on the liability of directors for errors or misleading information in a company’s accounts and
the possibility of legal action being taken.
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UK Corporate Governance Code
The following covers Sections 6, 8 and 9 of the course notes
Section 4 Audit, Risk and Internal control
Principle M. The board should establish formal and transparent policies and procedures to
ensure the independence and effectiveness of internal and external audit functions and
satisfy itself on theintegrity of financial and narrative statements.
Footnote: The board’s responsibility to present a fair, balanced and understandable
assessment extends to interim and other price-sensitive public records and reports to
regulators, as well as to information required to be presented by statutory instruments.
Principle N. The board should present a fair, balanced and understandable assessment of
the company’s position and prospects.
Principle O. The board should establish procedures to manage risk, oversee the internal
control framework, and determine the nature and extent of the principal risks the company is
willing to take in order to achieve its long-term strategic objectives.
Provisions
Provision 24. The board should establish an audit committee of independent non-executive
directors, with a minimum membership of three, or in the case of smaller companies, two.
The chair of the board should not be a member. The board should satisfy itself that at least
one member has recent and relevant financial experience. The committee as a whole shall
have competence relevant to the sector in which the company operates.
Provision 25. The main roles and responsibilities of the audit committee should include:
• monitoring the integrity of the financial statements of the company and any formal
announcements relating to the company’s financial performance, and reviewing significant
financial reporting judgements contained in them;
• providing advice (where requested by the board) on whether the annual report and
accounts, taken as a whole, is fair, balanced and understandable, and provides the
information necessary for shareholders to assess the company’s position and performance,
business model and strategy;
• reviewing the company’s internal financial controls and internal control and risk
management systems, unless expressly addressed by a separate board risk committee
composed of independent non-executive directors, or by the board itself;
• monitoring and reviewing the effectiveness of the company’s internal audit function or,
where there is not one, considering annually whether there is a need for one and making a
recommendation to the board;
• conducting the tender process and making recommendations to the board, about the
appointment, reappointment and removal of the external auditor, and approving the
remuneration and terms of engagement of the external auditor;
• reviewing and monitoring the external auditor’s independence and objectivity;
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• reviewing the effectiveness of the external audit process, taking into consideration relevant
UK professional and regulatory requirements;
• developing and implementing policy on the engagement of the external auditor to supply
non-audit services, ensuring there is prior approval of non-audit services, considering the
impact this may have on independence, taking into account the relevant regulations and
ethical guidance in this regard, and reporting to the board on any improvement or action
required; and
• reporting to the board on how it has discharged its responsibilities.
Provision 26. The annual report should describe the work of the audit committee, including:
• the significant issues that the audit committee considered relating to the financial
statements, and how these issues were addressed;
• an explanation of how it has assessed the independence and effectiveness of the external
audit process and the approach taken to the appointment or reappointment of the external
auditor, information on the length of tenure of the current audit firm, when a tender was last
conducted and advance notice of any retendering plans;
• in the case of a board not accepting the audit committee’s recommendation on the external
auditor appointment, reappointment or removal, a statement from the audit committee
explaining its recommendation and the reasons why the board has taken a different position
(this should also be supplied in any papers recommending appointment or reappointment);
• where there is no internal audit function, an explanation for the absence, how internal
assurance is achieved, and how this affects the work of external audit; and
• an explanation of how auditor independence and objectivity are safeguarded, if the external
auditor provides non-audit services.
Provision 27. The directors should explain in the annual report their responsibility for
preparing the annual report and accounts, and state that they consider the annual report and
accounts, taken as a whole, is fair, balanced and understandable, and provides the
information necessary for shareholders to assess the company’s position, performance,
business model and strategy.
Provision 28. The board should carry out a robust assessment of the company’s emerging
and principal risks. The board should confirm in the annual report that it has completed this
assessment, including a description of its principal risks, what procedures are in place to
identify emerging risks, and an explanation of how these are being managed or mitigated.
Footnote: Principal risks should include, but are not necessarily limited to, those that could
result in events or circumstances that might threaten the company’s business model, future
performance, solvency or liquidity and reputation. In deciding which risks are principal risks
companies should consider the potential impact and probability of the related events or
circumstances, and the timescale over which they may occur.
Provision 29. The board should monitor the company’s risk management and internal
control systems and, at least annually, carry out a review of their effectiveness and report on
that review in the annual report. The monitoring and review should cover all material
controls, including financial, operational and compliance controls.
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Provision 30. In annual and half-yearly financial statements, the board should state whether
it considers it appropriate to adopt the going concern basis of accounting in preparing them,
and identify any material uncertainties to the company’s ability to continue to do so over a
period of at least twelve months from the date of approval of the financial statements.
Provision 31. Taking account of the company’s current position and principal risks, the
board should explain in the annual report how it has assessed the prospects of the
company, over what period it has done so and why it considers that period to be appropriate.
The board should state whether it has a reasonable expectation that the company will be
able to continue in operation and meet its liabilities as they fall due over the period of their
assessment, drawing attention to any qualifications or assumptions as necessary.
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SECTION 7: SHAREHOLDERS
1 Types of Shareholder
a). Institutional Shareholders
Institutional shareholders own a large part of the share capital of publicly quoted companies
and consequently have a duty to act in the best interests of their clients. This includes
maintaining effective channels of communication with the board to understand the
company's aims and objectives and to support the board by positive voting.
There is a report from the Institutional Shareholders Committee - the Responsibilities of
Institutional Shareholders in the UK and the Stewardship Code which both outline key
principles of good corporate governance which institutional shareholders should work to.
b) Individual Shareholders
Individual shareholders i.e. private persons, each hold a very small percentage of shares in
listed companies, and so tend to be very much minority shareholders. In fact individuals hold
12% (2014) of the shares of UK listed companies, which is actually more than some
categories of institutional investors. However millions of persons, particularly through
pensions are beneficiaries from the returns on shares, the shares being held by institutional
investors.
c) Joint holders of shares
Subject to the Articles, a company may register a transfer of shares into the joint names of
any number of persons, but normally limited to four. The model Articles of a private company
provide for Directors to refuse to register any transfer and the Articles for a public company
limit the number to four transferees.
- only one certificate may be issued to joint holders
- all joint holders are jointly and severally liable to pay all calls if the shares are partly paid
- if one of the joint holders dies, the shares pass automatically to the surviving joint holder
- dividend warrants, notices and communications are sent to the 'senior' (first-named) joint
holder
- the signature of all joint holders is required on a transfer of shares
2 Members rights, duties and liabilities
Usually defined by both the Companies Act and the Articles as follows:
- can inspect and request copies of statutory books, records, directors' service contracts,
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the company's Articles, the annual accounts, Notice of general meetings, minutes of
general meetings
- have the right to attend general meetings, ask questions of directors, vote on any
resolution and appoint a proxy.
Other rights include



A derivative action for negligence, breach of duty, default or breach of trust by the
directors under s 260
A derivative action in respect of unfairly prejudicial conduct by the majority under s
994
To petition the court for the company to be wound up on the grounds that it is just
and equitable to do to so
Members have no right to be paid a dividend, unless recommended by the Board, to have
access to Board minutes or accounting records or to be consulted on business issues.
Duties of members
Disclose interest in shares s793 CA 2006
Notify the company if there holding goes above 3% of the co.’s voting rights or then falls
below 3%
Members are liable to contribute to the assets of the company in respect of any amounts
outstanding on the shares held at a winding-up (contributories) and to pay any amounts that
are unpaid on the shares if called on by the company
The register of members
S113 CA 2006 states every company must keep a register of members
Summary of Shareholder rights
Under the Companies Act 2006 shareholders have the right to:







receive annual report and accounts;
attend, vote and speak at general meetings;
pre-emption on share issues;
approve long-term incentive schemes;
elect/re-elect directors and auditors;
approve the remuneration policy (at least every three years); and
share in the profits of the company (by way of dividends).
Powers bestowed on shareholders include:




voting at general meetings;
requisitioning a general meeting (minimum 5% holding);
proposing a matter in the business of an AGM (minimum 5% holding); and
making derivative claims where directors have breached duties/acted illegally.
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3 Shareholder communications
The directors legal duties are owed to the company, but the shareholders are the owners, so
they should be kept informed of what the company is doing, with the directors engaging with
them.
The UK code suggests that communication can be done by
Dialogue with shareholders
Constructive use of the AGM
Shareholder dialogue and constructive use of the AGM
Shareholder activism can mean that shareholders group together to engage in active
dialogue with the boards of companies to influence their decisions. Also, institutional
investors can use their rights as shareholders to vote against the board of directors at
general meetings. The threat or implication that such action may take place also counts as
shareholder activism.
With regard to engagement with shareholders, the UK Corporate Governance Code (‘the
Code’) states (in E.1.1) that the chairman should ensure that the views of shareholders are
communicated to the board as a whole and that the chairman should discuss governance
and strategy with major shareholders.
Non-executive directors should be given the opportunity to attend scheduled shareholder
meetings and should attend if particularly requested to by a shareholder. The Senior
Independent Director should take a more active role in attending meetings with major
shareholders in order to ascertain their views and help develop a balanced understanding of
their issues and concerns.
The Code (E.1.2) suggests that an understanding of major shareholders’ views can be
developed through direct face-to-face contact, analysts’ or brokers’ briefings and surveys of
shareholder opinion.
The Code’s main principle is that the board as a whole has a responsibility for ensuring that
a satisfactory dialogue with shareholders takes place. As a supporting principle, the Code
states that the board should keep in touch with shareholder opinion in whatever ways are
most practical and efficient.
4 Role of the company secretary
Regulators are keen that ‘price sensitive’ information is promptly disclosed to shareholders,
other investors and the ‘market’ in general to avoid the creation of a ‘false market’ in a
companies shares and decrease the period in which ‘inside’ information is not available to all
market participants.
Companies listed on the London Stock Exchange are subject to continuing obligations to
make routine disclosures to shareholders, including the publication of interim and preliminary
results and dividend declarations.
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They are also required to make non-routine disclosures about proposed changes in the
corporate and financial structure of the company, for example, rights issues, mergers and
acquisitions.
Other important material information such as changes in board membership.
5 The forms of communication
Due to the change in the default position for shareholder communication by the Companies
Act 2006, communications can now be delivered electronically rather than by hard copy
(paper).
In order to take advantage of electronic communication, the shareholders need to approve,
and the company’s articles should permit. Shareholders must have the option to provide
their email address or request that all further communications are sent via hard copy. Those
that do not respond are “deemed” to have consented to electronic communication
Lecture example 1: What are the advantages of electronic communication?
Required
Please list some advantages of electronic communication with shareholders rather than
sending them hard copy
Solution
6 The AGM
The UK Corporate Governance Code states that a company should use the AGM to
communicate with shareholders and to encourage their participation. The chairmen of the
audit, remuneration and nominations committees should attend the AGM, so that they are
available to answer questions from shareholders.
Companies are encouraged to send out the notice of the AGM well in advance of the
meeting (with at least 20 working days’ notice) so that more shareholders will have time to
plan their attendance.
The chairman should give shareholders an opportunity to ask questions, and questions
should be answered honestly and openly.
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There should be a separate resolution and vote on each substantial different issue, and
shareholders should be able to indicate their choice to abstain on any resolution, as well as
being able to vote ‘for’ or ‘against’. The company should also disclose the proxy votes when
resolutions are agreed on a show of hands of those present at the meeting.
A well-managed AGM can be used by the board to provide constructive communication with
shareholders, by presenting an informative view of the company’s performance and
aspirations, including the board’s views on risk and future prospects, and also the company’s
CSR policies. The chairman should also encourage questions and comments from
shareholders at the meeting, and give responses to their concerns.
In some circumstances, the AGM has value in providing an opportunity for shareholders to
demonstrate their concerns through voting. Votes against the remuneration report of the
company or votes against the re-election of a board member (such as a committee
chairman) may have the effect of prompting a positive response from the board on the
matter that is the cause of concern.
However, the AGM may be of limited value in promoting standards of corporate governance,
except when there are matters about which the shareholders disapprove of the company
policy or the proposals of the board.
The resolutions on which shareholders vote at an AGM may be limited to ‘standard’ items
such as approval of the proposed final dividend payment, re-appointment of the company’s
auditors and re-election of the directors. The chairman or finance director may give a short
presentation about the company’s financial performance and position. If all these matters do
not arouse controversy, shareholders may be indifferent and attendance at the AGM may be
low.
An AGM can be much more useful when there are disagreements between some
shareholders and the policies of the company, such as poor financial performance or a
controversial remuneration policy with large bonuses for senior executives. Shareholders
who are opposed to a proposed resolution by the board should have time to organise proxy
votes against the resolution, especially if they win the support of one or more institutional
investor representative organisations.
In a well-governed company, however, serious disagreements between the board and
shareholders should be uncommon.
There are many large companies and investors are unlikely to commit resources to attending
every AGM. The cost in terms of time to travel and attend could exceed the potential
benefits.
Shareholder activism
In recent years shareholders have become increasingly active in voicing their disagreement
with what is seen as excessive executive remuneration. This increased activism encouraged
by the Stewardship Code is now reflected in the UK Governance Code
Reading: BT hit by shareholder revolt over outgoing chief's £2.3m pay
Please read the article in Appendix 1 from the Guardian newspaper from July 2018
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The vote by the BT shareholders would now require action from the board under Provision 4
of the UK code as below.
UK Corporate Governance Code
Principle D. In order for the company to meet its responsibilities to shareholders and
stakeholders, the board should ensure effective engagement with, and encourage
participation from, these parties.
Provision 3. In addition to formal general meetings, the chair should seek regular
engagement with major shareholders in order to understand their views on governance and
performance against the strategy.
Committee chairs should seek engagement with shareholders on significant matters related
to their areas of responsibility. The chair should ensure that the board as a whole has a clear
understanding of the views of shareholders.
Provision 4. When 20 per cent or more of votes have been cast against the board
recommendation for a resolution, the company should explain, when announcing voting
results, what actions it intends to take to consult shareholders in order to understand the
reasons behind the result. An update on the views received from shareholders and actions
taken should be published no later than six months after the shareholder meeting. The board
should then provide a final summary in the annual report and, if applicable, in the
explanatory notes to resolutions at the next shareholder meeting, on what impact the
feedback has had on the decisions the board has taken and any actions or resolutions
now proposed.
Footnote: Details of significant votes against and related company updates are available on
the Public Register maintained by The Investment Association
www.theinvestmentassociation.org/publicregister.html
7 The role of the stewardship code
The Stewardship Code states that major shareholders should try to attend the AGM, but
recognises that this may not be possible.
The Stewardship Code (2012 version) refers to the stewardship responsibilities of investors.
This is referencing the responsibilities of institutional investors towards their beneficiaries i.e.
their customers who invest in the pension funds. The basic premise being that the
institutional investor should engage with the companies that they invest in on behalf of their
beneficiaries.
8 Debt capital
Listed companies have increased their use of debt capital (corporate bonds) and in many
cases reduced their equity capital through share buy-backs. As a result, investors in debt
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capital should also have responsibilities for stewardship and monitoring companies in which
they invest. Bond investors do not attend AGMs, but companies with large amounts of debt
capital should be giving serious consideration to ways of communicating and engaging with
them.
Making constructive use of the AGM is therefore an area of governance where only limited
benefits may be obtained. Nevertheless, chairmen should make sure that directors are well
briefed on all aspects of the company’s business that could be questioned by shareholders
and the company secretary must make sure that the meeting is properly convened,
constituted and conducted. A poor performance at the AGM would result in negative publicity
which harms the company’s reputation and has a negative impact on business.
9 The stewardship code
The main objective of the UK Stewardship Code ('the Code’) is to promote the concept of
active share ownership: shareholders should be prepared to act when they believe that the
board of directors is not serving their best interests. The Code was written for UK institutional
investors although it may also be adopted by foreign institutional investors
10 The seven principles
The main requirements of the Code may be explained in terms of the seven principles of the
Code that institutional investors should apply:

They should disclose their policies on engagement with the companies in which they
invest, including their policies on voting and considering non-compliance of
companies with the requirements of the UK Corporate Governance Code.

They should have a robust policy for dealing with any conflicts of interest in their
investments.

They should monitor the companies in which they invest in order to decide when it is
necessary to enter into dialogue with their board of directors. They should meet with
company chairmen and attend the general meetings of companies in which they
have a large shareholding.

They should have clear guidelines about how they will escalate their activities in the
event that they are dissatisfied with a company’s response to their concerns.

They should be willing to act collectively with other investors where appropriate.

They should have a clear policy on voting and should disclose their voting record.

They should report to their clients periodically about their stewardship and voting
activities: this will make them more accountable to their clients for their contribution to
corporate governance.
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11 Difficulties for institutional investors
Institutional investors may hold shares in a large number of companies, but may hold them
through fund managers rather than directly as shareholders themselves. They may also be
large organisations.
This can make the administrative process of monitoring companies difficult:


For institutions that hold shares through fund managers, it may not be possible to
engage directly in dialogue with the boards of companies.

It may also be difficult to achieve effective communication between individuals
responsible for monitoring the corporate governance of companies with the
individuals who represent the institutions in discussions with companies.

Institutions may not have sufficient resources to monitor all companies or to send
representatives to their general meetings. Even when they have a substantial
shareholding, they may have only limited time for meetings with company chairmen.
Institutions may choose instead to follow the voting recommendations of their
investor association without investigating.

Institutions do not always have the same views. When their opinions differ, they will
not be willing to act collectively. They may also give conflicting opinions to the
companies they engage with.

Institutions may have good intentions about applying the Code, but do not
understand enough about the strategies and objectives of the companies in which
they invest.
The FRC recognised that there would be difficulties with implementation of the Code, and it
proposes to conduct regular reviews into the effectiveness of its implementation.
Reading: PLSA (NAPF) Corporate Governance Policy and Voting Guidelines
Institutional investor associations such as the PLSA (Formerly NAPF) provide voting
guidance to their members. This is often guidance on particular issues such as remuneration
and corporate social responsibility.
Please read the study text concerning institutional investors voting guidance at the end of
chapter 8 in the Study Text.
Also
Download the ICSA guidance note: ‘Enhancing Stewardship Dialogue’ from the ICSA
website.
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12 Takeovers and mergers
The purpose of a takeover is the acquisition by one company of the whole or majority of the
share capital of another in exchange for an issue of shares, cash payment or a combination
of the two.
The main types of takeover are:

Purchase by public offer - This is the most common form of takeover, where an offer
is made to the shareholders of a company to acquire all, or a proportion of, their
holdings.

The City Code on Takeovers and Mergers should be carefully observed if the
company is listed.

Purchase by acquisition of individual blocks of shares, i.e. stake-building - This is
used to build a base from which to launch a takeover for all the shares.

Purchase by formal agreement with individual shareholders - This is only practicable
where there are only a few shareholders in the company to be acquired.

Arrangements and reconstructions - covered by CA 2006, Part 26.
13 The City Code on Takeovers and Mergers
The City Code on Takeovers and Mergers (the Code) sets out regulations for the acquisition
of shares in listed companies.
Whether a listed company is defending or making a bid, professional financial advisers will
need to be retained to advise on the merits of the bid. Although these advisers will take the
Code into consideration, it is necessary for the company secretary to be familiar with it as he
will form part of the team preparing documentation which will be issued to the shareholders
of the target company.
The Code is intended to ensure fair and equal treatment of all shareholders during a
takeover. It does not set out to deal with the financial implications. Its provisions apply when
a bidder increases their shareholding to 30 per cent or more.
The general principles of the Code are:
1. All shareholders of the offeree must be given equivalent treatment.
2. The shareholders of the offeree must have enough information to make an informed
decision on the bid and enough time to consider it.
3. The board of the offeree must act in the interests of the company as a whole and must
not deny shareholders the chance to decide on the merits of the bid.
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4. False markets must not be created in the shares of the offeree, the offeror or any other
company concerned by the bid.
5. An offeror must ensure that they can meet any cash consideration in full before
announcing a bid.
6. An offeree company must not be hindered in the conduct of its affairs for longer than is
reasonable by a bid for its securities.
These six principles are supported by 38 extensive rules and provisions.
14 Summary of the principal rules
1. Any offer must first be made to the board of the company offeree or to its advisers
disclosing the identity of the offeror (rule 1).
2. When any firm intention to make an offer is notified to a board from a serious source, the
board must publicise it by a press notice without delay, regardless of whether the board
approves the offer.
3. In the period prior to the announcement of an offer, it is essential that absolute
confidentiality is maintained; company secretaries should be responsible for the
arrangements (rule 2.1).
4. The boards of both companies must obtain competent independent advice and the
substance of such advice should be made known to shareholders (rule 3).
5. Any information, including particulars of shareholders, given to an offeror company
should on request be given promptly to a less welcome but bona fide potential offeror (rule
20.2).
6. Any document or advertisement addressed to shareholders in connection with an offer
must be prepared with the same standards of care regarding statements made as if it were a
prospectus (rule 19).
7. Rules 24-27 contain detailed provisions covering the content of announcements and offer
documents. There are also requirements regarding the timetable of an offer to ensure that all
shareholders are given a fair opportunity to consider it (rules 30-4).
15 Compulsory acquisition of shares
s.s974-989 CA2006 protects the rights of a minority to resist compulsory acquisition
following a takeover to ensure no less fair treatment than those who have accepted an offer.
If the acquiring company has control over at least 90% of the target company, notice of
compulsory acquisition can be given to any outstanding shareholders.
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Unless the shareholder applies to cancel or vary the order within 6 weeks and the court
agrees, the bidding company acquires the shares on the original terms of the offer.
Appropriate payment is then made with share transfer documentation.
16 Schemes of arrangement
A different type of takeover situation arises when a new holding company is created to take
over two companies with a view to merging their operations. Alternatively a scheme of
arrangement under the Companies Act can achieve a takeover whereby members agree to
a compromise or arrangement.
Court approval is required and resolutions of the members or creditors require a 75%
approval rather than the 90% for compulsory acquisition.
The company is restructured and shares are not transferred but cancelled by court order
without any stamp duty liability.
17 Annual information update
Under the prospectus rules for listed companies, each year the company must prepare an
annual information update.
This update contains all information that has been released to the regulatory information
service or published as required by the Companies Act during the previous twelve months,
including filings with the Registrar of Companies.
A short description of the information is required and details of where the information can be
obtained.
A listed company must file the update with the FCA by releasing it to an RIS within 20
working days after the publication of its annual report and accounts.
The company secretary is responsible for maintaining an adequate system for a full and
accurate record of all information released and made public by the listed company.
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Summary
Key areas

Types of Shareholder

Members rights, duties and liabilities

Shareholder communications

Role of the company secretary

The forms of communication

The AGM

The role of the stewardship code

Difficulties for institutional investors

Takeovers and mergers

Annual information update
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Quick quiz questions
1) Bailey plc (‘Bailey’) is a listed company due to hold its annual general meeting (AGM) in
four weeks. At the previous year’s AGM, a shareholder, Monk Nominees Ltd (‘Monk’), voted
against the re-appointment of the Chairman, David Ryan, as part of a poll vote.
In the period leading up to the end of the financial year, the company’s registrars reported
that Monk has increased its shareholding in Bailey to 10% of the issued share capital. The
registrars have also advised that a large number of other minority shareholders have
submitted proxy forms which appoint a representative of Monk as their proxy.
David has requested a meeting with you, as Company Secretary, to discuss a number of
issues ahead of the AGM.
Required
Prepare a briefing note for David in which you:
(a) Describe and explain how the rights and powers of shareholders and proxies
relate to the situation regarding Monk.
(8 marks)
b) Explain how Bailey can improve engagement and dialogue with major
shareholders, including with Monk, both prior to and at this AGM.
(6 marks)
Total 14 marks
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SECTION 7: Shareholders
184
SECTION 7: Shareholders
185
SECTION 7: Shareholders
Quick quiz answers
1) Bailey plc (‘Bailey’) is a listed company due to hold its annual general meeting (AGM) in
four weeks. At the previous year’s AGM, a shareholder, Monk Nominees Ltd (‘Monk’), voted
against the re-appointment of the Chairman, David Ryan, as part of a poll vote.
In the period leading up to the end of the financial year, the company’s registrars reported
that Monk has increased its shareholding in Bailey to 10% of the issued share capital. The
registrars have also advised that a large number of other minority shareholders have
submitted proxy forms which appoint a representative of Monk as their proxy.
David has requested a meeting with you, as Company Secretary, to discuss a number of
issues ahead of the AGM.
Required
Prepare a briefing note for David in which you:
(a) Describe and explain how the rights and powers of shareholders and proxies
relate to the situation regarding Monk.
(8 marks)
Suggested answer
Bailey plc – Briefing note
.
In respect of the recent events regarding Monk, the following points are noted:

Monk owns 10% of the issued share capital of Bailey and therefore has the required
holding to requisition a resolution for consideration at the AGM. The timescale for
activating this power is at least 6 weeks before the AGM.

Monk’s AGM is due to be held in 4 weeks and, therefore, Monk will not be able to
propose any matters of business at the AGM.

Monk holds a sufficient percentage of the company’s issued share capital to enable it
to demand a poll at the AGM, in addition to it also holding a large number of proxies
for other minority shareholders.

An understanding of the reasons for Monk’s vote against the re-appointment of the
Chairman at the previous year’s AGM is required.
b) Explain how Bailey can improve engagement and dialogue with major
shareholders, including with Monk, both prior to and at this AGM.
(6 marks)
Suggested answer
Monk is attempting to influence the governance of Bailey through shareholder activism. Such
activism can be constructive where it involves discussion and dialogue. If the board fails to
respond appropriately to shareholders’ concerns and issues, Monk may use their powers at
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SECTION 7: Shareholders
the AGM to vote against the re-appointment of David Ryan again. Bailey and its board need
to consider the possibility of the press being in attendance at the AGM and their interest in
and reporting of any contentious issues.
This could result in negative publicity and have an impact on Bailey’s reputation. It is
important, therefore, for Bailey’s board to take the necessary steps to try and resolve the
issue ahead of the AGM.
It may be worth considering arranging a meeting between David (or perhaps the Senior
Independent Director) and Monk prior to the AGM to discuss the issues further and how
these might be resolved if possible.
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SECTION 7: Shareholders
UK Corporate Governance Code
1 Board Leadership and Company Purpose
Principle D. In order for the company to meet its responsibilities to shareholders and
stakeholders, the board should ensure effective engagement with, and encourage
participation from, these parties.
Provision 3. In addition to formal general meetings, the chair should seek regular
engagement with major shareholders in order to understand their views on governance and
performance against the strategy.
Committee chairs should seek engagement with shareholders on significant matters related
to their areas of responsibility. The chair should ensure that the board as a whole has a clear
understanding of the views of shareholders.
Provision 4. When 20 per cent or more of votes have been cast against the board
recommendation for a resolution, the company should explain, when announcing voting
results, what actions it intends to take to consult shareholders in order to understand the
reasons behind the result. An update on the views received from shareholders and actions
taken should be published no later than six months after the shareholder meeting. The board
should then provide a final summary in the annual report and, if applicable, in the
explanatory notes to resolutions at the next shareholder meeting, on what impact the
feedback has had on the decisions the board has taken and any actions or resolutions now
proposed.
Footnote: Details of significant votes against and related company updates are available on
the Public Register maintained by The Investment Association
www.theinvestmentassociation.org/publicregister.html
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SECTION 7: Shareholders
189
Achievement Ladder Step 3
ACHIEVEMENT LADDER STEP 3
You have now covered the topics that will be assessed in Step 3 of your Achievement
Ladder.
You should now attempt and pass Step 3 of the Achievement Ladder on the online
VLE platform BEFORE moving on to the next part of the course.
It is vital in terms of your progress towards 'exam readiness' that you attempt this Step in the
near future.
You will receive feedback on your performance, and you can use the ongoing BPP support
to help address any improvement areas. This will help you to tailor your learning exactly to
your own individual requirements
Achievement ladder Step 3
20 multiple choice questions
Followed by
Debrief of questions
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SECTION 8: Internal Control
SECTION 8: INTERNAL CONTROL
Lecture example 1: Barings
Please read the article in appendix 1
Lecture example 2 class discussion: what is internal control?
What Is
Internal
Control?
Governance?
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SECTION 8: Internal Control
1 Internal control frameworks
Definition: Internal control is a process effected by an entity’s board of directors,
management and other personnel, designed to provide reasonable assurance regarding the
achievement of objectives. (COSO)
Another definition supplied by the Institute of Internal Auditors
“An internal control is any action taken by management to enhance the likelihood that
established objectives and goals will be achieved. Management plans, organises and directs
the performance of sufficient actions to provide reasonable assurance that objectives and
goals will be achieved. Control is the result of proper planning, organising and directing by
management”
The two main sources of guidance on internal controls are contained in COSO (The
Committee of Sponsoring Organisations of the Treadway Commission) and Turnbull (The
Turnbull Report).
COSO has the support of the Securities and Exchange Commission (SEC) which is the body
in charge of implementing and enforcing the Sarbanes Oxley (SOx) legislation in the USA. It
is therefore most relevant to those companies following the SOx rules on internal controls.
The UK Turnbull Report was commissioned in order to give guidance to companies so they
can follow the principles of the UK’s Corporate Governance Code.
This is now covered in FRC guidance
The UK Corporate Governance Code states in Principle O. The board should establish
procedures to manage risk, oversee the internal control framework, and determine the
nature and extent of the principal risks the company is willing to take in order to achieve its
long-term strategic objectives.
Provision 28. The board should carry out a robust assessment of the company’s emerging
and principal risks. The board should confirm in the annual report that it has completed this
assessment, including a description of its principal risks, what procedures are in place to
identify emerging risks, and an explanation of how these are being managed or mitigated.
Provision 29. The board should monitor the company’s risk management and internal
control systems and, at least annually, carry out a review of their effectiveness and report on
that review in the annual report. The monitoring and review should cover all material
controls, including financial, operational and compliance controls.
Provision 31. Taking account of the company’s current position and principal risks, the
board should explain in the annual report how it has assessed the prospects of the
company, over what period it has done so and why it considers that period to be appropriate.
The board should state whether it has a reasonable expectation that the company will be
able to continue in operation and meet its liabilities as they fall due over the period of their
assessment, drawing attention to any qualifications or assumptions as necessary.
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SECTION 8: Internal Control
2 Internal control risks
Internal control risks arise because of weakness in systems and procedures
Lecture example 3: Internal control risks
Internal control risks can be broadly placed into 3 categories. Please suggest some
examples of these risks
Solution
Financial risks
Operational risks
Compliance risks
Turnbull also indicates that even a highly effective internal control system will not be able to
mitigate all these risks and it only reduces but does not eliminate the possibilities of losses
arising from poorly-judged decisions, human error, deliberate circumvention of controls,
management override of controls and unforeseeable circumstances.
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SECTION 8: Internal Control
Systems will provide reasonable (not absolute) assurance that the company will not be
hindered in achieving its business objectives and in the orderly and legitimate conduct of its
business, but won't provide certain protection against all possible problems.
Lecture example 4: Class discussion: internal control at M&S
Assess the importance of effective internal controls to different stakeholder groups for a
large retail organisation such as M&S.
Solution
Shareholders
Debt providers
Employees
Customers
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Government, regulatory and other bodies
3 Objectives of internal control
COSO and Turnbull give broadly similar objectives for internal control systems. The Turnbull
objectives are listed below.
More practically, internal controls should help organisations to counter risk, maintain the
quality of financial reporting and ensure compliance with law and regulation
They provide reasonable assurance that organisations will achieve their objectives.
4 Characteristics of internal control systems
Turnbull suggests the characteristics of an effective internal control system are
• Be embedded in the operations of the company and form part of its culture
• Be capable of responding quickly to evolving risks within the business
• Include procedures for reporting immediately to management significant control failings
and weaknesses together with control action being taken
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5 The framework
The internal control framework comprises the control environment and control procedures
Control or internal environment –
The overall context of control, in particular the culture, infrastructure and architecture of
control and attitude of directors and managers towards control
Control procedures –
The detailed controls in place such as recruitment procedures
6 Control environment factors

The philosophy and operating style of the directors and management The entity's
culture, whether control is seen as an integral part of the organisational framework,
or something that is imposed on the rest of the system

The entity's organisational structure and methods of assigning authority and
responsibility (including segregation of duties and supervisory controls)

The directors' methods of imposing control, including the internal audit function, the
functions of the board of directors and personnel policies and procedures

The integrity, ethical values and competence of directors and staff
7 The UK Turnbull report:
environment.
elements of a strong control

Clear strategies for dealing with the significant risks that have been identified

The company's culture, code of conduct, human resource policies and performance
reward systems supporting the business objectives and risk management and
internal control systems

Senior management demonstrating through its actions and policies commitment to
competence, integrity and fostering a climate of trust within the company

Clear definition of authority, responsibility and accountability so that decisions are
made and actions are taken by the appropriate people

Communication to employees what is expected of them and scope of their freedom
to act

People in the company having the knowledge, skills and tools to support the
achievements of the organisation's objectives and to manage its risks effectively.
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SECTION 8: Internal Control
8 Control procedures
You may find internal controls classified in different ways, the study text classifies them into
financial, operational and compliance
Corporate, management, business process and transaction controls
This classification is based on the idea of a pyramid of controls from corporate controls at
the top of the organisation, to transaction controls over the day-to-day operations.

Corporate controls include general policy statements, the established core culture
and values and overall monitoring procedures such as the internal audit committee

Management controls encompass planning and performance monitoring, the
system of accountabilities to superiors and risk evaluation

Business process controls include authorisation limits, validation of input, and
reconciliation of different sources of information

Transaction controls include complying with prescribed procedures and accuracy
and completeness checks
The UK Auditing Practices Board's SAS 300 Accounting and internal control systems and
risk assessments lists some specific control procedures.

Approval and control of documents

Controls over computerised
environment

Checking the arithmetical accuracy of the records

Maintaining and reviewing control accounts and trial balances

Reconciliations:
applications
and the information technology
Comparing the results of cash, security and stock counts with accounting records

Comparing internal data with external sources of information

Limiting direct physical access to assets and records
The old UK Auditing Practices Committee's guideline Internal controls gave a useful
summary that is often remembered as a mnemonic, SPAMSOAP.
Segregation of duties
Physical
Authorisation and approval
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SECTION 8: Internal Control
Management
Supervision
Organisation
Arithmetical and accounting
Personnel
This can be used to create a list of control procedure, such as higher level management
procedures, below are some examples of higher level internal controls.
9 Higher level internal controls
(a) Segregation of duties. For example, the chairman/Chief Executive roles should be split.
(b) Physical. These are measures to secure the custody of assets, e.g. only authorised
personnel are allowed to move funds on to the money market.
(c) Authorisation and approval. All transactions should require authorisation or approval by
an appropriate responsible person; limits for the authorisations should be specified, e.g. a
remuneration committee is staffed by non-executive directors to decide directors' pay.
(d) Management should provide control through analysis and review of accounts, e.g.
variance analysis, provision of internal audit services.
(e) Supervision of the recording and operations of day-to-day transactions. This ensures
that all individuals are aware that their work will be checked, reducing the risk of falsification
or errors, e.g. budgets, managers' review, exception or variance reports.
(f) Organisation: identify reporting lines, levels of authority and responsibility. This ensures
everyone is aware of their control (and other) responsibilities, especially in ensuring
adherence to management policies, e.g. avoid staff reporting to more than one manager.
(g) Arithmetical and accounting: to check the correct and accurate recording and
processing of transactions, e.g. reconciliations, trial balances.
(h) Personnel. Attention should be given to selection, training and qualifications of
personnel, as well as personal qualities; the quality of any system is dependent upon the
competence and integrity of those who carry out control operations, e.g. use only qualified
staff as internal auditors.
Lecture example 5: reading: RBS
Please read the case study in appendix 1
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SECTION 8: Internal Control
Lecture example 6: M&S purchase?
Suppose M&S were considering the purchase of an overseas retailer based in the USA (as
they did in the late 1980s when they purchased Brooks Brothers).
Required
Identify and briefly discuss suitable controls over this strategic decision.
Solution
10 Elements of internal control/enterprise risk management
COSO and Turnbull both identify various elements of internal control / enterprise risk
management. COSO is more systematic in its recognition of those elements.
COSO uses a diagram called the COSO Enterprise Risk Management (ERM) cube to
describe how the elements of the framework, the objectives of the framework and the levels
of an organisation fit together.
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SECTION 8: Internal Control
The COSO Framework for an internal control system identifies the following five basic
elements, simplified from the original version.
(i) A control environment. This describes the awareness of, and attitude to, internal
controls in the organisation, shown by directors, management and employees. It is
determined by the example given by the company’s leaders to control and their expectations
that employees should also be risk conscious.
(ii) Risk identification and assessment through a system or procedure for identifying the
risk facing the company, how these are changing and assessing their significance.
(iii) Control activities by using internal controls devised and implemented to eliminate,
reduce or control risks.
(iv) Information and communication being provided to employees who are responsible for
the management of risk, to enable them to fulfil their role and tasks. Communication within
an internal control system also includes the existence and use of a whistleblowing
procedure.
(v) Monitoring the effectiveness of the internal control system on a regular basis. Internal
audit is one method of doing so, but responsibility also lies with executive management,
external auditors (as part of their annual audit) and the board of directors.
Lecture example 7 class discussion: Potential problems for Arlo?
The board of Arlo plc has decided to outsource some of its manufacturing operations to a
supplier based on a different continent, in order to save costs. Arlo plc has always tightly
controlled its manufacturing processes that are located in its own country, with an emphasis
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SECTION 8: Internal Control
on producing what customers require, rigorous quality control and close monitoring of
employees to ensure they produce what is required.
Why might Arlo plc have difficulty maintaining the same level of control over the activities of
its overseas supplier?
Solution
11 Responsibilities for internal control
Reporting on internal control
The reports the board provides will depend on the stock exchange rules. Two major
jurisdictions with differing requirements reflecting a differing approach to corporate
governance are the UK and the USA.
UK requirements
The board should disclose, as a minimum, in the accounts the existence of a process for
managing risks, how the board has reviewed the effectiveness of the process and that the
process accords with UK guidance.
The board should also include:

An acknowledgement that they are responsible for the company's system of internal
financial control and reviewing its effectiveness

An explanation that such a system is designed to manage rather than eliminate the
risk of failure to achieve business objectives, and can only provide reasonable, and
not absolute, assurance against material misstatement or loss
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SECTION 8: Internal Control

A summary of the process that the directors (or a board committee) have used to
review the effectiveness of the system of internal financial control and consider the
need for an internal audit function if the company does not have one. There should
also be disclosure of the process the board has used to deal with material internal
control aspects of any significant problems disclosed in the annual accounts

Information about those weaknesses in internal financial control that have resulted in
material losses, contingencies or uncertainties that require disclosure in the financial
statements or the auditor's report on the financial statements.
12 USA requirements
Under the Sarbanes-Oxley requirements, annual reports should contain internal control
reports that state the responsibility of management for establishing and maintaining an
adequate internal control structure and procedures for financial reporting. Annual reports
should also contain an assessment of the effectiveness of the internal control structure and
procedures for financial reporting, additionally disclosures of any material weaknesses in
internal control. Auditors should report on this assessment.
13 Internal control monitoring systems
Internal audit
The Turnbull report in the UK stated that listed companies without an internal audit function
should annually review the need to have one, and listed companies with an internal audit
function should review annually its scope, authority and resources.
Turnbull states that the need for internal audit will depend on:
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SECTION 8: Internal Control
Internal audit is a form of control put in place by the board in order to help achieve the
company’s objectives.
Internal audit is an important part of the internal control system and it can therefore be
regarded as having the same objectives as the rest of the internal control system: i.e.
safeguarding assets; economy, efficiency & effectiveness of operations; reporting; and
compliance.
The internal audit department reports to the audit committee who will carry out an annual
review of the internal audit function covering:
(a) scope of work;
(b) authority;
(c) independence;
(d) resources.
As well as the objectives listed above the scope of the work performed by internal audit can
include:
(a) Risk management processes;
(b) Value for money audits;
(c) Attainment of company goals and objectives.
To ensure the internal audit department has sufficient authority, the audit committee will
consider whether the terms of reference of the internal audit department are sufficiently
broad and whether the reports produced by the internal audit department have been reviewed
and action taken.
The FRC states that listed companies without an internal audit function should annually
review the need to have one.
The audit committee are responsible for ensuring the independence of the internal audit
department. This will include receiving their reports but also managing the appointment or
removal of the head of the department. They will need to ensure that internal audit are not
being asked to carry out any operational roles and that other safeguards are in place to
maintain their independence.
Often the internal auditor will report on operational matters to the finance director, but on
reporting matters to the audit committee. Removal of the head of internal audit should be
only performed by the audit committee.
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SECTION 8: Internal Control
The audit committee will need to ensure that the internal audit department is adequately
resourced in terms of hours, physical resources and appropriate knowledge, skills and
experience.
14 Whistleblowing
'Whistleblowing' is the name commonly given to workers making a disclosure of wrongdoing
(usually) by their employer.
The need for whistleblowing arises when normal procedures and internal controls will not
reveal the illicit activity, due to the individuals responsible for the activity somehow being
able to ignore or circumvent the normal controls. Illicit or illegal behaviour should be
uncommon and, therefore, whistleblowing should be an occasional event.
Lecture example 8 Reading: Whistleblowing cases
Please read the detail concerning two whistleblowing cases in appendix 1
15 Why is whistleblowing
governance?
a
relevant
issue
for
corporate
The problems facing whistle-blowers relate to weaknesses in corporate governance. If an
employee has a genuine, honest concern about something happening within an
organisation, which he or she believes to be dishonest or improper, there should be a
mechanism for these concerns to be brought to the attention of management and dealt with
in a constructive way. Having such a system in place and making staff aware of how to use it
(and how not to use it maliciously) should be part of an effective risk management system.
Diligent employees can act as an early warning of serious malpractice that might damage
the company, including financial loss in the case of fraud, exposure to severe penalties in
breach of law or regulations and damage to the firm’s reputation.
16 Potential concerns and problems concerning whistleblowing
Concerns about whistleblowing have increased in recent years for a number of reasons,
including:
Individual employees prepared to investigate matters further prior to reporting any
allegations may discover information that they are not officially supposed to be aware of.
Companies have become aware that they could be liable for information held as email
messages in the files of employees.
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SECTION 8: Internal Control
Whistleblowers run the risk of retaliation and it would appear that they are more likely to be
dismissed than rewarded, particularly where information is passed to someone outside the
company, such as the media.
Whistleblowers may put their jobs, and even their careers, at risk. An employer taking action
may claim that dismissing the employee was not related to the allegations made, or claim
that the employee was dismissed because their statements were vindictive and untrue.
Whistleblowers are protected by legislation in the UK called the Public Interest Disclosure
Act 1998, which inserted a number of new provisions in the Employment Rights Act 1996.
Note that the legislation does not impose an obligation to whistle blow, rather it protects
individuals who choose to do so, whether as a matter of conscience or ethics or because
they are following internal rules and procedures.
This protection is afforded to workers generally (and not just to ‘employees’) and there is no
requirement as to age or length of service. The protection means that any worker who is
victimised or sacked in breach of the Act can present a complaint to an employment tribunal
that he has been subjected to a detriment in contravention of the statutory provisions.
Some suggested solutions in respect of the above problems could include:

The company and its senior management being committed to the policy and
procedures.

Instilling a culture of honesty and integrity and the company enabling employees to
report allegations externally where appropriate. There are some official
whistleblowing channels that provide a way of reporting concerns to someone
outside the employer organisation, which can be set up or outsourced by an
employer to provide a confidential service to employees.
The company taking any allegations seriously and investigating them in an
appropriate manner before taking relevant action.


The company having external advisers in place to deal with investigations
(particularly where allegations are being made against senior executives/directors).
Following a recommendation in the Smith Report on audit committees, the 2003 Combined
Code included a provision making it a responsibility of the audit committee to ‘review
arrangements’ whereby staff may, in confidence, raise concerns about possible improprieties
within the company. This is now reflected in the UK Governance Code.
Provision 6. There should be a means for the workforce to raise concerns in confidence and
– if they wish – anonymously. The board should routinely review this and the reports arising
from its operation. It should ensure that arrangements are in place for the proportionate and
independent investigation of such matters and for follow-up action.
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SECTION 8: Internal Control
17 Whistleblowing procedures
A whistleblowing system should encourage employees to report illegal or unethical
behaviour but should also discourage malicious and unfounded allegations.
The BSI’s Whistleblowing Arrangements Code of Practice suggests that the main features of
a whistleblowing policy should include:










That it is documented and a copy should be given, or made available, to every
employee.
Key aspects of the procedure, including the person to whom employees should
report their suspicions or concerns (for example, the company secretary or internal
audit).
A statement that the company takes malpractice or misconduct very seriously.
A statement that the company is committed to a culture of transparency where
employees can report legitimate concerns without fear of penalty or punishment.
Details of the types of misconduct for which employees should use the procedure
and the level of proof that is required.
A clear statement that no employee will be victimised for raising a genuine concern.
Victimisation for raising a qualified disclosure should be a disciplinary offence.
Details of the procedure that will be followed to investigate an allegation.
Details of the internal reporting procedures to follow and an alternate external
reporting route.
An undertaking that, as far as possible, whistleblowers will be informed about the
outcome of their allegations and the action that has been taken.
A statement that whistleblowers will be promised confidentiality as far as is possible.
It is also recommended (by the BSI’s Code) that employee representatives should be
involved in establishing the procedure and monitoring the implementation.
18 Sarbanes-Oxley: risk management and internal control
Please read study text chapter 13
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SECTION 8: Internal Control
Summary
Key areas

Internal control frameworks

Internal control risks

Objectives of internal control

Characteristics of internal control systems

Control environment factors

The UK Turnbull report

Control procedures

Elements of internal control / enterprise risk management

Responsibilities for internal control

USA requirements

Internal control monitoring systems

Whistleblowing

Sarbanes-Oxley: risk management and internal control
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SECTION 8: Internal Control
208
SECTION 9: Risk Management
SECTION 9: RISK MANAGEMENT
Lecture example 1: Why the differences? Compare AAA to SSS
AAA Group was a private UK company established 30 years ago by a high-profile and
popular entrepreneur, Mr X. During 30 years of growth AAA developed into a business that
included telephones and home media, airlines, rail transport, and financial services. Most
shares were held by Mr X although some were held by rich personal friends of his.
At his retirement Mr X sold the company to SSS, a US listed corporation, that owns
railroads. The management of SSS has been totally astonished to find an almost complete
absence of risk management methods in AAA such as very few formal budgetary systems, a
willingness to invest considerable sums of money in business ideas with only sparse
business plans, or on just a whim and a history of failed business ideas amongst the small
number of really very successful ventures.
Identify reasons for the different management attitudes to risk between AAA and SSS.
Solution
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SECTION 9: Risk Management
1 Risk and risk appetite
Risk is a condition in which there exists a quantifiable dispersion in the possible results of an
activity.
Risk appetite is a measure of a company's capacity to accept different risks.
A hazard is the impact on the organisation if the risk materialises.
Lecture example 2: Class discussion Daily risks?
Required
Suggest some reasons why organisations face risks on a daily basis.
Consider why organisations might seek to increase the risk they face.
Solution
I
2 Stakeholder responses to risk
Stakeholder groups are not necessarily risk averse. They are likely to react adversely if a
company does not conform with their expectations.
The attitude of some stakeholder groups to risk could have an influence on the company’s
strategy. These groups are:
(a) Shareholders;
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SECTION 9: Risk Management
(b) Debt providers;
(c) Employees;
(d) Customers;
(e) Government, regulatory and other bodies.
Lecture example 3: Stakeholders reaction to M&S taking risks
Different stakeholder groups can affect or be affected by the risk management strategy at
M&S, a major UK retailer
Required
For each stakeholder group evaluate their attitude towards risk-taking by the company.
Solution
Shareholders
Debt providers
Employees
Customers
Government, regulatory and other bodies
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SECTION 9: Risk Management
3 Embedding risk awareness
Risk awareness should be embedded in the company’s:
(a) Systems and procedures;
(b) Culture and values.
Lecture example 4: Class discussion: Embedding risk
Required
Suggest some practical ways in which risk awareness can be embedded in an organisation
at different levels.
Solution
4 Risk management responsibilities
The board has overall accountability for risk management as part of its corporate
governance responsibilities.
The board may choose to delegate responsibility to line management or a separate risk
management function.
A risk committee could also be set up, and can include both executive and non-executive
directors.
If there is no risk committee, the audit committee will take responsibility for risk
management.
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SECTION 9: Risk Management
5 Risk Identification
(ii) Risk identification and assessment
through a system or procedure for
identifying the risk facing the company,
how these are changing and assessing
their significance.
This diagram is to remind you how risk identification fits into the COSO framework as an
example of a risk management framework
Risk identification is a continuous process. Risks once identified can be included within the
risk register and kept under review.
Lecture example 4a) Sources of risk
ICSA suggest the following are sources of risk, give an example under each source.
Reputation risk.
Competition risk.
Business environment risks.
Risks from external events.
Liquidity risk.
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6 Risk events
A key aspect of risk identification emphasised in the COSO Enterprise Risk Management
Framework is identification of events that could impact upon implementation of strategy or
achievement of objectives.
Such events could include:
(a) External events such as economic changes, political developments or technological
advances;
(b) Internal events such as equipment problems, human error or difficulties with products;
(c) Trends and root causes;
(d) Escalation triggers, certain events happening or levels being reached that require
immediate action;
(e) Event interdependencies. Identifying how one event can trigger another and how events
can occur concurrently.
7 Categorising risk
This is part of the identification process, risks can be categorised by scope or function.
8 Risk categories by scope
An advantage of analysing risks by scope, separating them into strategic and operational
risks is to ensure they are considered by the most appropriate level of management. Some
organisations choose to maintain separate risk registers for strategic and operational risks.
An advantage of categorising risk by function is that they can be analysed and managed by
managers with appropriate technical expertise. For example legal risks will be managed by a
legal department.
9 Strategic risks
Strategic risks are those risks that relate to the fundamental long term decisions that
directors take about the future of an organisation.
The most significant risks are focused on the impact they would have on the company's
ability to survive in the long term.
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Lecture example 5 : class discussion: strategic risks
Give an example of the following 'strategic' risks:
Solution
Technology
Competition
Product
Investment
Resources
Reputation
10 Operational risk
This is the risk of loss from a failure of internal business and control processes and will affect
day to day operations.
Operational risk includes losses arising from
(a) Internal control/audit inadequacies
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(b) IT failures
(c) Human error
(d) Loss of key-personnel
(e) Fraud
(f) Business interruption.
The main difference between strategic and operational risks is that strategic risks relate to
the long term and are derived in part from the external environment. Operational risks are
what could go wrong on a day-to-day basis, and are internally focused.
11 Classification of risk by function
There are many different types of risks faced by organisations, particularly those with
commercial or international activities.
Lecture example 6: Class discussion: Types of risk
Explain the following types of risk using an example if appropriate.
Currency risk, credit risk, environmental risk, probity risk, knowledge management risk,
outsourcing risk.
Solution
The nature of these risks can be classified under the several key headings, as illustrated
below. You could be expected to identify a broad range in an exam question.
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12 Risk evaluation
The company will perform an analysis on the identified risks, looking at the likelihood of the
risk event occurring and the impact of the event if it does occur.
Risk profiling
Having assessed the risk it can be mapped onto a grid of impact and likelihood
The risk tolerance boundary reflects the company’s risk appetite.
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The risk profile allows the company to prioritise its treatment of different risks. It may choose
to spend less on managing one risk in order to release funds to manage another more
effectively.
Risk quantification
Risks that require more analysis will be quantified, where possible results and losses are
considered.
Techniques for carrying out risk quantification include sensitivity analysis and accounting
ratios.
13 Risk management
In order to deal with risk, organisations will consider:
Risk Transfer
Risk Avoidance
Risk Reduction
Risk Acceptance
The likelihood/consequences matrix below is a means of matching a suitable strategy to a
given risk. This is the 'TARA' model.
Accept / Tolerate. Accept the risk, because it is not significant or they are risks the
organisation has no control over.
Transfer: Move some or all of the risk to someone else, for example by entering joint
ventures to share risk or by purchasing insurance against risk events.
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Reduce / Trim. Take suitable measures to reduce the risks – by reducing the likelihood of
an adverse risk event or by reducing the impact if a risk event occurs. Internal controls can
have the greatest effect here, see SPAMSOAP later in this section for ideas.
Avoid / Terminate. Avoid the risk entirely, by withdrawing from the area of business
operations where the risk exists.
Lecture example 7: Disaster
Define the key elements of a disaster recovery plan.
(8 marks)
Solution
14 Risk control and review
Senior management needs to develop systems to monitor and record risk, adapting to
changing circumstances.
A Risk Register is a Risk Management tool, a central repository for all risks identified by
organisation and, for each risk, includes information such as risk probability, impact,
management measures, risk owner.
Typically a risk register contains:



A description of the risk
The impact should this event actually occur
The probability of its occurrence
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


Risk Score (the multiplication of Probability and Impact)
A summary of the planned response should the event occur
A summary of the mitigation (the actions taken in advance to reduce the probability
and/or impact of the event)
The risks are often ranked by Risk Score so as to highlight the highest priority risks to all
involved.
Risk and remuneration
There is a relationship between risk appetite and the remuneration policy of a company.
Remuneration policies must be consistent with effective risk management. If the
remuneration policy is not aligned with effective risk management it is likely that employees
will have incentives to act in ways that might undermine effective risk management
The aim should be to ensure that companies have risk-focused remuneration policies, which
are consistent with and promote effective risk management and do not expose them to
excessive risk. They should cover all aspects of remuneration that could have a bearing on
effective risk management including wages, bonus, long term-incentive plans, options, hiring
bonuses, severance packages and pension arrangements.
Communication
The board must make sure that staff abilities and attitudes are suitable, and that everyone
has access to appropriate organisational information.
15 The Risk Committee
The risk committee may include executive and non-executive directors. It is often chaired by
the company’s CEO.
Lecture example 8: Risk committee
Construct an argument for setting up a risk committee that:
(a) is staffed by executive directors
(b) is staffed by NED's.
Solution
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Roles of a risk committee include





Assess risks
Review risk register
Advise board
Review findings of internal audit
Ensure risk management system exists
Some companies employ a specific risk manager
A risk manager needs to combine technical skills in credit, market and operational risk with
leadership and persuasive skills.
COSO lists their responsibilities as:
(a) leadership of enterprise risk management;
(b) establishing and promoting enterprise risk management;
(c) developing polices;
(d) common risk management policies
(e) establishing a common risk language;
(f) dealing with insurance companies;
(g) implementing risk indicators, (i.e. designing early warning systems);
(h) allocation of resources based on risk;
(i) reporting to the CEO.
Lecture example 9: Exam standard question: Doctors practice
A doctors' practice, with six doctors and two practice nurses, has decided to increase its
income by providing day surgery facilities. The existing building would be extended to
provide room for the surgical unit and storage facilities for equipment and drugs. The aim is
to offer patients the opportunity to have minor surgical procedures conducted by a doctor at
their local practice, thus avoiding any unfamiliarity and possible delays to treatment that
might result from referral to a hospital. Blood and samples taken during the surgery will be
sent away to the local hospital for testing but the patient will get the results from their doctor
at the practice. It is anticipated that the introduction of the day surgery facility will increase
practice income by approximately 20 per cent.
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Required
(a) Describe the additional risks that the doctors' practice may expect to face as a
consequence of the introduction of the new facility. (9 marks)
(b) Explain the meaning of the term 'risk appetite' and discuss who should take
responsibility for defining that appetite in the context of the scenario outlined above. (5
marks)
Solution
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16 FRC Guidance on risk management and internal control
In 2014, the FRC published a guidance document called ‘FRC Guidance on Risk
Management, Internal Control and Related Financial and Business Reporting’.
This links Turnbull guidance on internal control with good practice for risk management, as
reflected in the conclusions of previous FRC reports as below:
The guidance 'aims to bring together elements of best practice for risk management; prompt
boards to consider how to discharge their responsibilities in relation to the existing and
emerging principal risks faced by the company; reflect sound business practice, whereby risk
management and internal control are embedded in the business process by which a
company pursues its objectives; and highlight related reporting responsibilities.'
The board has responsibility to:

Ensure systems for identifying the risks facing the company are in place and these
enable the board to make a ‘robust assessment’ of those risks;

Identify the nature and extent of the principal risks facing the company and those
risks that the company is willing to take to achieve its strategic objectives.

Embed the appropriate culture and reward systems throughout the company;
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
Determine how the principal risks should be managed or mitigated to reduce the
probability of occurrence and impact

Review the effectiveness of the risk management and internal control systems.

Ensure that there are sound processes for internal and external communications on
risk management and internal control.
The role of management is implementing board policies on risk and control:
This would include
(a) identifying and evaluating risks;
(b) operating the system of internal control;
(c) monitoring the effectiveness of the system of internal control.
The board need to make sure management




understands the risks;
implements appropriate policies and controls;
monitors the controls; and
provides the board with timely information so that it can fulfil its own responsibilities.
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Summary
Key areas

Risk and risk appetite

Stakeholder responses to risk

Embedding risk

Risk management responsibilities

Risk Identification

Classification of risk

Risk evaluation

Risk management

Risk control and review

The Risk Committee
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Quick quiz
Jill Root is the newly appointed non-executive director (NED) of Loran plc (‘Loran’), a listed
company in the retail sector. Following recent events concerning a competitor, Jill wants a
critical review to be made of the risk management systems within the company.
Jill is due to chair the next meeting of Loran’s risk committee and has asked you as
Company Secretary to produce a briefing note to assist her in preparing her opening
presentation.
Required
Prepare a briefing note for Jill in which you:
(a) Identify the principles set out in the UK Corporate Governance Code in respect of
risk management.
(8 marks)
(b) Discuss the differences between strategic risk and operational risk, and describe
the general risk areas, with examples as relevant to Loran.
(9 marks)
(c) Define the key elements of a disaster recovery plan.
(8 marks)
(Total: 25 marks)
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Quick quiz answers
1. Jill Root is the newly appointed non-executive director (NED) of Loran plc (‘Loran’), a
listed company in the retail sector. Following recent events concerning a competitor, Jill
wants a critical review to be made of the risk management systems within the company.
Jill is due to chair the next meeting of Loran’s risk committee and has asked you as
Company Secretary to produce a briefing note to assist her in preparing her opening
presentation.
Required
Prepare a briefing note for Jill in which you:
(a) Identify the principles set out in the UK Corporate Governance Code in respect of
risk management.
(8 marks)
Suggested answer
Loran – Briefing note
Risk management systems
The UK Corporate Governance Code states in Principle O. The board should establish
procedures to manage risk, oversee the internal control framework, and determine the
nature and extent of the principal risks the company is willing to take in order to achieve its
long-term strategic objectives.
Provision 28. The board should carry out a robust assessment of the company’s emerging
and principal risks. The board should confirm in the annual report that it has completed this
assessment, including a description of its principal risks, what procedures are in place to
identify emerging risks, and an explanation of how these are being managed or mitigated.
Provision 29. The board should monitor the company’s risk management and internal
control systems and, at least annually, carry out a review of their effectiveness and report on
that review in the annual report. The monitoring and review should cover all material
controls, including financial, operational and compliance controls.
Provision 31. Taking account of the company’s current position and principal risks, the
board should explain in the annual report how it has assessed the prospects of the
company, over what period it has done so and why it considers that period to be appropriate.
The board should state whether it has a reasonable expectation that the company will be
able to continue in operation and meet its liabilities as they fall due over the period of their
assessment, drawing attention to any qualifications or assumptions as necessary.
(b) Discuss the differences between strategic risk and operational risk, and describe
the general risk areas, with examples as relevant to Loran.
(9 marks)
Suggested answer
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Differences between strategic and operation risks and general risk areas
There is a clear distinction between strategic (or external) and internal operational risks.
Strategic risks may include those concerned with reputation, competition, the business
environment and finance and are determined by the strategies that a company pursues.
Operational risks will be more specific to the industry in which a company operates.
The Basel Committee (for banking supervision) defines operation risk as “the risk of losses
resulting from inadequate or failed internal processes, people and systems, or external
events”.
The general areas of business risk can be defined as financial, operational, strategic and
compliance.
For Loran, depending on which retail environment it trades in, strategic risks could include:




demand for new products higher or lower than expected and the effect this would have
on actual profits;
competitors taking market share;
bad publicity or losing customer loyalty; and
changes in compliance regulations making the sale of a particular product more difficult.
For Loran, within the retail industry, operational risks could include:




shrinkage (loss of products through employee/customer pilfering/theft);
breakdown of IT systems (for example, stock control, tills);
failure of logistics systems; and
availability of land/premises for retail stores.
(c) Define the key elements of a disaster recovery plan.
(8 marks)
Suggested answer
Disaster recovery plans
The purpose of a disaster recovery plan is to have a plan of action in the event of an
extreme disaster that is unconnected with the business of the company and is outside the
control of management.
The main components of a disaster recovery plan may include:





Specification of essential operations in the business that must be maintained.
Identification of computers or networks to which the IT system can be transferred in the
event of damage to the main system.
Specification of a location that operations could be transferred to in the event of access
not being available to the usual location.
Identification of key personnel who are needed to maintain operations.
Identification of an executive to be responsible for dealing with any press/media
attention.
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Disaster recovery plans should be constantly maintained and should develop with a
business. They should be reviewed at least annually as part of the review of the
effectiveness of internal controls undertaken by the audit committee or board as part of an
organisation’s risk management processes.
Examiner’s comments
This question was the second most popular question on the paper, but again was not
answered well.
Part (a) sought to test candidates’ knowledge of the UK Corporate Governance Code in
respect of risk management. Most candidates provided a reasonable explanation of the
principles but answers were often a little too general, without sufficient detail of the board’s
responsibility. Many candidates made reference to the audit or risk committees and their role
in risk management which was not relevant to the question.
Distinguishing between the different types of risks was problematic for many candidates,
with confusion arising between strategic and operational. Some answers detailed the COSO
framework, which was not relevant to the question.
Some candidates did not correctly identify the general areas of risk (financial, operational,
strategic and compliance) and this then impacted on their ability to provide relevant
examples of risks faced by Loran.
In general candidates provided good examples of general risks, but opportunities to gain
further marks were missed where candidates did not provide any specific examples of risks
faced by Loran.
Tutorial Note: This question illustrates the examiners focus on the learnt details of the UK
Governance Code, together with very specific sections of the study text (reproduced word for
word in the disaster recovery plan answer). It is also yet another format.
However there is also some practical application in the specific risks for Loran in the retail
sector, which is difficult to find in the brief scenario, and suggests the use of a good
imagination, along with justification of your suggestions in your answer, will gain you marks
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SECTION 10: Corporate Social Responsibility
SECTION 10: CORPORATE SOCIAL RESPONSIBILITY
1 Definition of CSR
Definition: CSR is
•
Having regards to the impact of a company’s actions on society
•
Requiring a manager to consider his acts in terms of a whole social system, and
holds him responsible for the effects of his acts anywhere in that system
Corporate social responsibility is a concept whereby organisations consider the interests of
society by taking responsibility for the impact of their activities on wider stakeholders.
This obligation can be seen to extend beyond statutory obligations to comply with legislation.
2 Carroll’s model of CSR
Carroll's model of social responsibility suggests there are four levels of social responsibility.
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Economic responsibilities
Companies have economic responsibilities to shareholders demanding a good return, to
employees wanting fair employment conditions and customers who are seeking good-quality
products at a fair price.
Businesses are set up to be properly functioning economic units and so this responsibility
forms the basis of all others.
Legal responsibilities
Since laws codify society's moral views, obeying those laws must be the foundation of
compliance with social responsibilities. Although in all societies corporations will have a
minimum of legal responsibilities, there is perhaps more emphasis on them in continental
Europe than in the Anglo-American economies where the focus of discussion has been
whether many legal responsibilities constitute excessive red tape.
Ethical responsibilities
These are responsibilities that require corporations to act in a fair and just way even if the
law does not compel them to do so.
Philanthropic responsibilities
According to Carroll, these are desired rather than being required of companies. They
include charitable donations, contributions to local communities and providing employees
with the chances to improve their own lives.
Lecture example 1 Statements
Classify the following statements using the Carroll model.
(a) ‘We believe in giving something back to the community providing the firm can afford
it’.
(b) ‘Our CSR statement is just something to attract the customers that care about those
things’.
(c) ‘We are proud that our new factory, as well as cutting our costs, has allowed us to
give decent housing and education to families in a developing country’.
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Solution
3 Corporate social responsibility and stakeholders
Inevitably discussion on corporate social responsibilities has been tied in with the
stakeholder view of corporate activity, the view that as businesses benefit from the goodwill
and other tangible aspects of society, that they owe it certain duties in return, particularly
towards those affected by its activities.
Lecture example 2 Exam standard question Problems of dealing with
stakeholders?
Whatever the organisation's view of its stakeholders, certain problems in dealing with them
on corporate social responsibility may have to be addressed.
Required
What may these problems be? (8 marks)
Solution
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SECTION 10: Corporate Social Responsibility
Lecture example 3: related to lecture example 2: a different angle!
Proponents of CSR argue that there is a strong business case for considering stakeholders,
whereas critics argue that CSR distracts from the fundamental economic role of businesses.
Required
Suggest some arguments for both for and against CSR. (You may want to consider what
might motivate an interest in CSR.)
Solution
4 Critiques of corporate social responsibility
Corporate social responsibility has been attacked for introducing concepts that are counter
to good order in the free market. The underlying idea is that economic self-interest and
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allocative efficiency ensure maximum economic growth and hence maximum social
welfare.
Milton Friedman, in his book, Capitalism and Freedom, argues that:
There is one and only one social responsibility of business—to use its resources and
engage in activities designed to increase its profits so long as it stays within the rules of the
game, which is to say, engages in open and free competition without deception or fraud.
5 CSR and Sustained Development initiatives world wide
There are a number of projects and initiatives that are shaping the goals and principles of
corporate social responsibility and sustainable development, such as:
OECD (Organization for Economic Cooperation and Development) is an international
organization with 35 industrialized countries as participants, which account for 76 per cent of
the world trade. The themes that this organization addresses include environmental, human
rights, labour issues, and information disclosure.
United Nations' Global Compact was established in 1999 by United Nations' Secretary Kofi
Annan as a voluntary international initiative. Participant companies are asked to demonstrate
their support to ten different international principles of human and labour rights, anticorruption and environmental protection, to seek solutions to the challenges of globalization
and promote responsible corporate citizenship. The initiative has more than 2,500 business
participants from 90 countries around the world.
Kyoto Protocol was agreed on in 1997 to reduce greenhouse gas emissions by 2012. A total
of 1968 countries and the EEC have ratified the protocol (envroliteracy.org, 2007).
6 Corporate citizenship
Much of the debate in recent years about corporate social responsibility has been framed in
terms of corporate citizenship, particularly mentioned in the King 3 Code. This is partly
because of unease about using words like ethics and responsibility in the context of
business decisions.
Matten et al have suggested that there are three perspectives or corporate citizenship.
Limited view
This is based on voluntary philanthropy undertaken in the business's interests. The main
stakeholder groups that the corporate citizen engages with are local communities and
employees. Citizenship in action takes the form of limited focus projects.
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Equivalent view
This is based on a wider general definition of corporate social responsibility that is partly
voluntary and partly imposed. The organisation focuses on a broad range of stakeholders
and responds to the demands of society. Self-interest is not the primary motivation, instead
the organisation is focused on legal requirements and ethical fulfilment.
Extended view
This view is based round a partly voluntary, partly imposed view of active social and political
citizenship.
Corporations must respect citizens' rights, particularly as governments have failed to provide
some of the safeguards necessary for their society's citizens. Again the focus is on a wide
range of stakeholders, with a combination of self-interest promoting corporate power and
wider responsibility towards society.
Under the extended view, organisations will promote:



Social rights of citizens by provision (for example provision of decent working
conditions
Civil rights, by intervening to promote citizens' individual rights themselves or to
pressurize governments to promote citizens' rights
Political rights by channelling (allowing individuals to promote their causes by using
corporate power)
Lecture example 4: which view is this?
What view of corporate citizenship does the following requirement in the 2006 UK
Companies Act (s 172) promote:
A director of a company must act in the way he considers … would be most likely to promote
the success of the company for the benefit of its members as a whole, and in doing so have
regard to:
(a) The likely consequences of any decision in the long-term
(b) The interests of the company’s employees
(c) The need to foster the company’s business relationship with suppliers, customers and
others
(d) The impact of the company’s operations on the community and the environment
(e) The desirability of the company maintaining a reputation for high standards of business
conduct
(f) The need to act fairly between members of the company
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Solution
The UK Governance Code
In its introduction to the UK code the FRC place emphasis on the position of a company in
society as below:
Companies do not exist in isolation. Successful and sustainable businesses underpin our
economy and society by providing employment and creating prosperity. To succeed in the
long-term, directors and the companies they lead need to build and maintain successful
relationships with a wide range of stakeholders. These relationships will be successful and
enduring if they are based on respect, trust and mutual benefit. Accordingly, a company’s
culture should promote integrity and openness, value diversity and be responsive to the
views of shareholders and wider stakeholders.
This is then reflected in the first part of the code as below:
Principle A. A successful company is led by an effective and entrepreneurial board, whose
role is to promote the long-term sustainable success of the company, generating value for
shareholders and contributing to wider society.
Principle D. In order for the company to meet its responsibilities to shareholders and
stakeholders, the board should ensure effective engagement with, and encourage
participation from, these parties.
Principle E. The board should ensure that workforce policies and practices are consistent
with the company’s values and support its long-term sustainable success. The workforce
should be able to raise any matters of concern.
And in particular
Provision 5. The board should understand the views of the company’s other key
stakeholders and describe in the annual report how their interests and the matters set out in
section 172 of the Companies Act 2006 have been considered in board discussions and
decision-making. The board should keep engagement mechanisms under review so that
they remain effective.
Provision 5 then details in particular the importance of engagement with the workforce, this
has perhaps been prompted by various scandals including one involving Sports Direct.
Please read the BBC article: https://www.bbc.co.uk/news/uk-england-derbyshire-36855374
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7 Sustainability
Sustainability means limiting the use of depleting resources to a level that can
be replenished.
The most commonly quoted definition of sustainable development is from the Brundtland
report (published by the UN in 1987)
"Sustainable development is development that meets the needs of the present without
compromising the ability of future generations to meet their own needs."
When considering sustainability a number of questions need to be considered:
A key issue here is generational equity, ensuring that future generations are able to enjoy
the same environmental conditions, and in social terms per capita welfare is maintained or
increased.
The two approaches to the idea of sustainability relate to their supporters’ views of the
extent, causes and solutions. These are:
(a) Weak sustainability believes that the focus should be on sustaining the human species
and the natural environment can be regarded as a resource. The weak sustainability
viewpoint tends to dominate discussion within the Western economic viewpoint
(b) Strong sustainability stresses the need for harmony with the natural world; it is
important to sustain all species, not just the human race. They see a requirement for
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fundamental change, including a change in how man perceives economic growth (and
whether it is pursued at all).
Lecture example 5: Ford and sustainability
Please read the short article on Ford in appendix 1
8 CSR and corporate strategy
A distinction must be made between charity and CSR. Charity refers to a company’s efforts
to donate money or resources to an organization or a cause, promoting and allowing
employees to volunteer in the community, and the establishment or endorsement of
foundations.
CSR is a concept that involves a company taking into consideration the different
stakeholders involved when making a business decision.
The OECD defines CSR to be an integral part of a company’s value system and strategy
For a company to fully integrate CSR, top management must integrate social responsibility
into the strategic level of the decision-making process in order to develop a framework for
economic decisions made at different levels of the organization’s hierarchy.
The problem that a company will encounter if CSR is not integrated into the organization
strategy is that management and employees could bypass social responsibility
considerations and CSR becomes personal ethics rather than CSR.
To adopt a CSR strategy the organization needs to take the following steps according to
business for social responsibility www.bsr.org
(a)
(b)
(c)
(d)
Define CSR for their particular business.
Understand motivations underlying its commitment.
Establish policies and goals to achieve CSR.
Establish measures to monitor their accomplishments in CSR
9 Benefits of CSR
Risk management
Managing risk is a central part of many corporate strategies. Reputation risk is the principal
risk concerned here. Scandals can draw unwanted attention from regulators, courts,
governments and media.
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Brand differentiation
Companies strive for a unique selling proposition that can separate them from the
competition in the minds of consumers. CSR can play a role in building customer loyalty
based on distinctive ethical values, major brands, such as The Co-operative Group, The
Body Shop are built on ethical values.
Human resources
A CSR programme can be an aid to recruitment and retention of employees particularly with
regards to graduates. CSR can also help improve the perception of a company among its
staff, particularly when staff can become involved
Regulators
Avoiding interference 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.
10 Disadvantages of CSR policies
A possible disadvantage of active pursuit of CSR is the accusation by critics that overt CSR
activity is a cost for doubtful public relations benefit, for example, one oil company has been
accused (fairly or not) of spending more on its PR budget for environmental protection than it
spends on environmental protection itself.
Lecture example 6: Linkages
Please read the article in appendix 1
Then answer this question
Class discussion: How can companies attempt to limit the CSR reputation damage caused
by forward and backward linkages?
Solution
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11 Organisations & CSR reporting
Supporters of CSR argue that corporate social responsibility and reporting can be extended
to illuminate inequalities in distribution in society and limitations of traditional
accounting methods.
Reporting has a major role in making organisations more visible and transparent.
Social accounting, auditing and reporting
Taking responsibility for one's actions means in the first instance accounting for actions.
Social accounting is a concept describing the communication of social and environmental
effects of a company's economic actions to stakeholders.
A number of reporting guidelines have been developed to serve as frameworks e.g.




ISO 14000 Environmental Management Standard
Global Report Initiative (GRI) sustainability reporting guidelines.
AA1000 Standard – based on triple bottom line (3BL) reporting
FTSE4 Good index
Lecture example 7 The Triple bottom line
Triple bottom line accounting clearly describes the goal of CSR.
Required
Suggest some areas that a company might report on under the headings below.
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SECTION 10: Corporate Social Responsibility
Solution
People
Planet
Profit
12 Environmental management systems
Eco-Management and Audit Scheme (EMAS)
EMAS is a voluntary scheme that emphasises targets and improvements, on-site inspections
and requirements for disclosure and verification.
Requirements for EMAS registration
(a) An environmental policy containing commitments to comply with legislation and achieve
continuous environmental performance improvement
(b) An on-site environmental review
(c) An environmental management system that is based on the review and the company’s
environmental policy
(d) Environmental audits at sites at least every three years
(e) Audit results to form the basis of setting environmental objectives and the revision of the
environmental policy to achieve those objectives
(f) A public environmental statement validated by accredited environmental verifiers
containing detailed disclosures about policy, management systems and performance in
areas such as pollution, waste, raw material usage, energy, water and noise
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ISO 14000
ISO 14000 provides a general framework on which a number of specific standards have
been based (the ISO family of standards).
ISO 14001 prescribes that an environmental management system must comprise:
(a) An environmental policy statement, which should be the basis for future action. It needs
therefore to be based on reliable data, and allow for the development of specific targets.
(b) Assessment of environmental aspects and legal and voluntary obligations.
(c) A management system ensuring effective monitoring and reporting on environmental
compliance.
(d) Internal audits and reports to senior management.
(e) A public declaration that ISO 14001 is being complied with.
Environmental reporting
The arguments in favour of environmental reporting, promote the need for transparency and
openness, disclosing all matters of concern to investors and other stakeholders. These
should be generally presented in a balanced dispassionate and understandable way.
Lecture example 8: Benefits
Identify the business benefits of an organisation achieving external accreditation for its CSR
activities.
Solution
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SECTION 10: Corporate Social Responsibility
13 Social and environmental audits
Social audit is the process of checking whether an organisation has achieved set targets.
General social audits will involve:
(a) Establishing whether the organisation has a rationale for engaging in socially responsible
activity.
(b) Identifying that all current environment programmes are congruent with the mission of the
company.
(c) Assessing objectives and priorities related to these programmes
(d) Evaluating company involvement in such programmes past, present and future
An environmental audit is a systematic, documented, periodic and objective evaluation of
how well an entity, its management and equipment are performing, with the aim of helping to
safeguard the environment by facilitating management control of environmental practices
and assessing compliance with entity policies and external regulations.
In practice environmental audits may cover a number of different areas including:
(a) Environmental Impact Assessments
(b) Environmental surveys
(c) Environmental SWOT analysis
(d) Environmental Quality Management (EQM)
(e) Eco-audits
(f) Eco-labelling
(g) ISO 14000
(h) Supplier audits
14 Integrated Reporting <IR>
<IR> is a process that results in a periodic integrated report by an organization about value
creation over time and related communications regarding aspects of value creation.
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“An integrated report is about how an organization’s strategy, governance, performance and
prospects, in the context of its external environment, lead to the creation of value in the
short, medium and long term.” (http://www.theiirc.org/)
It differs from other forms of reporting focusing on the process not the product, its uses a
series of capitals to illustrate the creation of value for all stakeholders, not just shareholders:
There are seven guiding principles that <IR> requires to be seen as meaningful:
(i) Strategic and forward-looking
(ii) Connectivity across all relationships that create value
(iii) Stakeholder relationships and how they work to create value
(iv) Materiality, disclosing those matters that substantially affect value creation
(v) Reliability and completeness, avoiding any bias
(vi) Conciseness (to encourage people to read about <IR>)
(vii) Consistent and comparable presentation with other organisations and over time.
15 How the King Report relates to corporate social responsibility
and sustainability issues.
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The King Code requires integrated reporting by companies, which means that company
reports should combine financial issues with sustainability aspects. An example of this being
the 6 capitals model of integrated reporting (IR)
The King Code has 3 main themes:

Leadership means that companies should have effective leadership illustrated by
ethical values and the principles of fairness, accountability, responsibility and
transparency.

Sustainability means that the company should conduct its business in a way that
does not consume excessive natural resources or threaten / damage the
environment.

Corporate citizenship means that the company should be aware of its position in
society and that it has a responsibility as a ‘citizen’ to contribute to the well-being of
society.
Companies should have a stakeholder-inclusive approach, which means taking into
consideration the concerns and interests of internal and external stakeholders, not just
shareholders. Companies should establish ethical standards and disclose, measure, assess,
and monitor these standards.
16 Problems associated with CSR reporting
Environmental issues and sustainable business have undoubtedly become more important
for companies and investors, and many companies provide large quantities of information
about their social and environmental policies and achievements. However, a cynical investor
might wonder how much to believe about the information that companies present.
Companies may exaggerate their CSR credentials and when reputation damaging events
occur, the whole basis of their CSR credentials are called into question, An example of this
is BP and the Gulf of Mexico oil spill.
Companies can have problems in making CSR information either meaningful or convincing
to their stakeholders.
There are a number of reasons for this:
(1) Companies can decide what information to include and what to keep out of their
reports. There may be a suspicion that companies report the favourable aspects of
performance and do not report the unfavourable ones.
(2) Environmental issues vary widely between industries, and companies in different
industries will therefore choose to report about different matters. It is therefore
difficult or impossible to achieve standardisation in the content of reports.
(3) Information is often presented in narrative format. Narrative reports take longer to
read and are not as easy to refer to as quantitative reports.
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(4) Quantitative measures of social and environmental performance can be achieved,
but these will differ between industries, and companies within the same industry may
choose to present different quantitative measures.
(5) Quantitative measures that are used in reports may not have a clear meaning or
significance to readers of the reports.
(6) The quantitative measures in social and environmental reports are probably not
audited by independent environmental auditors. Un-audited information is unlikely to
be perceived as reliable as audited information.
(7) Some companies may provide only limited information about social and
environmental issues because of the cost of gathering it.
17 CSR and Institutional Investors
The National Association of Pension Funds (NAPF) now called The Pensions and Lifetime
Saving Association, ‘PLSA’, produced a Responsible Investment Guide in 2013. This
referenced that ESG factors Environmental, Social or Governance should be taken into
account by investors, due to their significant impact on long term value.
It recognises the following ESG issues

Environmental risks e.g. climate change;

Social risks e.g. human rights & health and safety:

Governance risks e.g. Board independence & succession planning;
Ethical investing and socially responsible investing (SRI)
PLSA (formerly NAPF) defines ethical investing as:
Refusing to invest in ‘unethical’ companies, because the activities of the company are
inconsistent with the investor’s ethical, moral or religious beliefs
It defines socially responsible investing (SRI) as:
Ethical investing plus encouraging companies to develop CSR policies and objectives, and
using shareholder power where required to further those ends.
ABI and disclosure
The ABI (Association of British Insurers) has issued guidelines on environmental, social and
governance (ESG) disclosures that companies should make,
These follow 3 themes
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SECTION 10: Corporate Social Responsibility

The ESG risk assessment by the board (or whether it has not carried out such an
assessment)

Information about significant ESG risks and the company’s policies for managing
these risks,

Does the remuneration policy consider ESG issues when setting the remuneration of
senior executives?
Summary
Key areas

Definition

Carroll’s model of CSR

CSR and stakeholders

Critiques of CSR

CSR and Sustained Development initiatives world wide

Corporate Citizenship

Sustainability

CSR and corporate strategy

Benefits of CSR

Disadvantages of CSR

Reporting
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Quick Quiz
1) For each of the following aspects of a company’s operations, suggest the
most appropriate form of <IR> capital that could be used to monitor it.
2) Gurney’s is an old company which now operates globally. It has a long history and was
originally founded by a man of strong religious principles, who used his business to promote
the consumption of non-alcoholic fruit cordials. Gradually the business developed away from
cordials towards confectionary.
Although it has been a global enterprise for many years there are strong bonds of affection
and loyalty from its local home community. These strong ties are partly the result of the
charitable work done by the Gurney Foundation, a body involved in workers’ welfare,
education and prison reform among other things. The Gurney Foundation was created by
the Gurney family, who retain ties to the confectionary company (Albert Gurney is the
chairman of the board), part of the assets of the foundation remain shares in Gurney’s.
However control of the company passed out of family hands many years ago when the
company was listed on the stock market. As well as its links to charitable works Gurney’s
Sweets are an iconic brand in their home country.
James Bright, a management accountant at Gurney’s, has recently carried out detailed work
on the best use of the company’s resources. He has concluded that all production should be
transferred from the home country to South America and most resources should be targeted
at expanding the firm’s activities in South America and Asia. The iconic brands, like the
Gurney Gobstopper, should no longer be produced or sold by Gurney’s (although held in
high affection the market for gobstoppers was restricted to Gurney’s home country and has
been dwindling for some time). Gurney’s will sell these brands (they have already received
an offer which James has assessed as being far in excess of their value to the company).
On the basis that James Bright’s recommendations will maximise shareholder value, the
board has decided unanimously to adopt them. The excess cash generated by the sale of
the brands will be paid to the shareholders as an extra dividend. As the biggest single
shareholder the Gurney Foundation’s share of this dividend will be approximately $300
million, the next largest dividend payment being $3 million.
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Required
Identify, with evidence, which of the 3 main theories of governance that Gurney’s now
seems to be following (10 marks)
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SECTION 10: Corporate Social Responsibility
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SECTION 10: Corporate Social Responsibility
Answer to quick quiz
2 Gurney’s is an old company which now operates globally. It has a long history and was
originally founded by a man of strong religious principles, who used his business to promote
the consumption of non-alcoholic fruit cordials. Gradually the business developed away from
cordials towards confectionary.
Although it has been a global enterprise for many years there are strong bonds of affection
and loyalty from its local home community. These strong ties are partly the result of the
charitable work done by the Gurney Foundation, a body involved in workers’ welfare,
education and prison reform among other things. The Gurney Foundation was created by
the Gurney family, who retain ties to the confectionary company (Albert Gurney is the
chairman of the board), part of the assets of the foundation remain shares in Gurney’s.
However control of the company passed out of family hands many years ago when the
company was listed on the stock market. As well as its links to charitable works Gurney’s
Sweets are an iconic brand in their home country.
James Bright, a management accountant at Gurney’s, has recently carried out detailed work
on the best use of the company’s resources. He has concluded that all production should be
transferred from the home country to South America and most resources should be targeted
at expanding the firm’s activities in South America and Asia. The iconic brands, like the
Gurney Gobstopper, should no longer be produced or sold by Gurney’s (although held in
high affection the market for gobstoppers was restricted to Gurney’s home country and has
been dwindling for some time). Gurney’s will sell these brands (they have already received
an offer which James has assessed as being far in excess of their value to the company).
On the basis that James Bright’s recommendations will maximise shareholder value, the
board has decided unanimously to adopt them. The excess cash generated by the sale of
the brands will be paid to the shareholders as an extra dividend. As the biggest single
shareholder the Gurney Foundation’s share of this dividend will be approximately $300
million, the next largest dividend payment being $3 million.
Required
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SECTION 10: Corporate Social Responsibility
Identify, with evidence which of the 3 main theories of governance that Gurney’s now
seems to be following (10 marks)
Suggested answer
The board seem to be following the shareholder value approach which is the traditional
approach with the directors running the company with the maximisation of shareholder
wealth as their principle focus
The most influential piece of data in reaching their decision seems to have been the report
from the management accountant. This has presumably included appraisal of the investment
using standard techniques which incorporate conventions like the time value of money. If
past profitability has been assessed this will have been done based on financial accounting
conventions like going concern and the accruals concept. The decision about the payment of
the future dividend will have also been based on financial accounting conventions and on
projected cash flows maximising the benefit to the shareholders.
One of the most significant ways in which the decision will have been based on the
shareholder value approach will have been in which costs (and which benefits) were
included or excluded from the assessments. So for instance the costs associated with the
loss of jobs for the local community will have been borne by the state through benefits and
by local businesses through a decline in the local economy. These costs will not have been
incorporated into the decision making process. The decision may also have implications for
the company’s carbon emissions if their logistics have changed substantially. This may be
an improvement or a decline in carbon emissions but it is likely again to have been excluded
from the decision.
The assessment of costs has developed to a certain extent and there are companies who
will adopt a triple bottom line or full cost accounting approach, which would include some of
the costs which are often excluded. There is no evidence that the board took this wider view
into consideration in making their decision.
The board also apply values which may arise from established conventions in deciding the
extent and scope of the board’s agency responsibility. The narrow view supported by the
legal position, and consequently the dominant convention within the shareholder value
approach, is to view the board’s responsibility being solely to maximise shareholder wealth.
This traditional view seems to be the position adopted by the board and not a wider view of
the board’s responsibility and regard it as having wider obligations to all stakeholders.
Examiner note: Details of the specific accounting methods, or even the names of those
methods, mentioned in the second paragraph of the model answer are not required to gain
maximum marks in this question as they are beyond the scope of the corporate governance
syllabus, but are provided to give a complete answer, as they may have been added by
students who have studied the financial CSQS modules or equivalent.
End of course notes
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Achievement Ladder step 4
ACHIEVEMENT LADDER STEP 4
You have now covered the topics that will be assessed in Step 4 of your Achievement
Ladder.
You should now attempt and pass Step 4 of the Achievement Ladder which is the
second course mock exam
It is vital in terms of your progress towards 'exam readiness' that you attempt this Step in the
near future and complete it by the due date
You will receive feedback on your performance, and you can use the ongoing BPP support
to help address any improvement areas. This will help you to tailor your learning exactly to
your own individual requirements
Achievement ladder Step 4
Second course mock exam to be completed by due date
Followed by
Debrief of exam
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APPENDIX 1: READINGS
Introduction lecture example 1: Mind maps
It is vital that you construct your own mind maps, and not one created by someone else.
That way you will be able to recall the map in the exam.
Characteristics of mind maps




-Subject consolidated in a central image
-Main themes radiate from central image as branches
-Key word or image used on branches
-Branches connect all information
A rather complex example is shown below, but note that pictures are involved as well, as
they will help you recall information and the map.
Advantages of Mind Mapping
Study time is saved by:

noting only relevant words
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APPENDIX 1: Readings





reading only relevant words
Key words visually arranged
Enhancing recall and concentration on real issues
The brain finds it easier to accept and remember visually stimulating mind maps
Encourages continuous and potentially endless flow of thought
Make it better
Make words interesting, and use pictures as triggers
BIG
small
King Code IV (South African Governance Code)
Mind map tips
1 Break mental blocks



Add blank lines –challenge your brain to fill them in
Ask questions –challenge your brain to think
Add images –additional triggers for memory trace
2 Reinforce

Review your mind map

Do quick mind map checks
3 Prepare

Prepare your mental attitude -be positive; uses images; be absurd! It does not matter
how ridiculous they are as only you are seeing this!

Make your mind map as beautiful as possible

Section 1: Lecture example 1b : readings
Tutor note: don’t quote from scandals in exam answers unless the examiner
specifically asks for examples
Case Study 1 - Court rules on Parmalat settlement
FINANCIALTIMES[FEBRUARY2007]
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APPENDIX 1: Readings
By Adrian Michaels
Deloitte secured a court ruling on Tuesday which allows its $149m settlement with Parmalat
to go ahead. But a New York judge at the same time handed other groups being sued by the
Italian dairy company a significant bargaining chip.
Deloitte, the audit firm, agreed to pay the money as part of efforts by new management at
Parmalat to recover billions of dollars from groups it alleges helped prolong fraud at the
company before its collapse in 2003. Deloitte did not admit any wrongdoing.
Deloitte could have walked away from the deal unless it was given protection from the court
against some categories of further claims. That protection was granted on Tuesday, but the
judge said the amount the audit firm was paying would have to figure in calculations in any
future apportionment of blame at trial.
The judge's opinion could be a blow to Enrico Bondi, Parmalat's chief executive, who is
perceived to have allowed Deloitte to settle for a relatively small amount while still hoping to
recoup billions of dollars from institutions such as Bank of America and Citigroup.
Bank of America, legal experts said on Tuesday, may be more inclined to go to trial rather
than settle. Even if the bank were to be found guilty of wrongdoing, which it contests, then
the amount of liability would be influenced by the amount Deloitte paid and the percentage of
blame for the wrongdoing attributed to Deloitte.
Equally, the experts said, Bank of America and others could still seek to settle, but for
considerably less than Mr Bondi has been seeking.
Bank of America called the Deloitte judgment a "fair and equitable ruling that comports with
established legal practice".
Another challenging recommendation is that the incentives to misstate financial information
should be reduced.
Mr Buffett memorably characterised this problem as one in which "managers who always
promise to 'make the numbers' will at some point be tempted to 'make up the numbers'." We
recommend that companies refrain from providing the market with forecasts of profits that
assume unrealistic precision. No business operates in the sort of tranquil and entirely
predictable world where pinpoint accuracy can be either promised or achieved.
Although the issues that need to be dealt with in order to regain public trust are wider than
just audit, there is undoubtedly a strong case to be made for improving the quality of audit.
Much can be done within audit firms – for example, sending clear messages from the top
that quality matters to the firm more than anything else.
Backed up by strengthened review processes to make sure audit partners are still doing the
job properly and a stronger and more open relationship with the audit committee - including
the subject of independence - the issue of quality will return to the heart of every audit.
Public trust will not be regained by financial reporting until there is a widespread belief in the
honesty and transparency of all participants in the financial reporting process.
Quite simply, publicly available codes of conduct for financial analysts, lawyers and
investment banks and public relations companies must be developed, covering their
involvement in financial reporting, and their application must be monitored. The duty of all
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these participants to ensure that public reporting presents information fairly should override
all other duties of the individuals and firms concerned.
Here are two examples of what this would mean in practice.
First, where a lawyer takes a position of advocacy, that advice should include a summary of
the significant issues raised so that the board can sensibly evaluate that advice.
Second, credit agencies should be required to disclose their criteria and their evaluation
processes as well as the quality control procedures they adopt.
The taskforce sets a challenging agenda for reform. Even in countries such as the UK,
where many of our recommendations are already best practice, there is more to do; and we
must support the adoption of these provisions across the world.
Failure to tackle these issues will perpetuate the current loss of faith in financial reporting,
add to the cost of capital and continue to reduce our economic productivity. There is too
much at stake for us to allow this to happen.
Case study 2: An industry still skulking in the shadow of Enron
FINANCIALTIMES[JULY2006]
By Barney Jopson
The long shadow of Enron lingers over the accountancy profession. The energy trader
dragged down Andersen; which sold it a racy mix of audit and consulting services; and in
doing so focused attention on the profit-seeking instincts of accountants.
A backlash against commercial conflicts of interest soon followed in 2002, but the UK audit
watchdog revealed this month [July 2006] that the big four accountancy firms have failed to
prove they can control them. The comments from the Financial Reporting Council struck at
the heart of a perceived tension between accountants' twin goals of optimising earnings and
doing rigorous audits.
The FRC focused on problems inside the audit divisions of PwC, Ernst & Young, KPMG and
Deloitte. Others are concerned about links between audit and non-audit work, which have
become sensitive again as the firms move back into consulting.
Arthur Wyatt, a former veteran of Andersen in the US, sees the issues as part of a deeper
historical shift. Surveying four decades of change in a 2003 speech, he said: "Just as greed
appears to have been the driving force at many of the companies that have failed or had
significant restructurings, greed became a force to contend with in the accounting firms. The
cultures of the firms had gradually changed from a central emphasis on delivering
professional services in a professional manner to an emphasis on growing revenues and
profitability."
Such comments lead some to ask whether accountancy firms in their current form; a series
of profit-making partnerships that do auditing alongside more lucrative non-audit work; are
best placed to guarantee the accuracy of financial statements.
The FRC avoided such fundamental questions as it presented the results of its second
annual inspections, but it was blunt in its criticism of the big four. They had made only limited
progress in restraining "profit-seeking", it said, in spite of instructions to reorder their
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APPENDIX 1: Readings
priorities last year. Sir John Bourn, chairman of the FRC's professional oversight board, said
that while senior accountants talked the talk on audit quality, "the emphasis
isn't always underlined at the working level".
Some firms had not included clear quality performance indicators in their appraisal systems
and others had failed to ensure individual partners were assessed against them, the FRC
said. Remuneration and partner promotions were not linked to audit quality measures, but to
commercial objectives.
The conclusions did not surprise Laurie Young, an author, consultant and former PwC
partner. "I think this is institutional rather than individual," he says. "Most auditors will err on
the side of integrity, but there is an institutional bias towards maintaining the ludicrously high
earnings of this oligopoly."
The big four posted profits per partner in their most recent financial years that ranged from
£545,000 at KPMG to £702,000 at Deloitte.
As PwC, KPMG and Ernst & Young move back into consulting; Deloitte never left; they say
the provision of non-audit services to audit clients is becoming a thing of the past.
But the FRC said it had found evidence of non-audit services being sold to audit clients in
contravention of the regulator's ethical guidelines. Sir John said he was concerned that a 25year-old auditor seeking to please his or her boss could best do so by fostering a client's
interest in a new service line rather than offering an exemplary piece of auditing.
Big four partners reject the suggestion of an inherent conflict between their commercial goals
and their public interest responsibilities. Richard Bennison, head of UK audit at KPMG,
defends the need for high profits and
salaries. "I believe the best quality audits are done by highly motivated, intelligent people,
and for that you need to enable partners to share in the success of the whole firm," he says.
Peter Wyman, head of professional affairs at PwC, says: "It's been PwC's long-term policy to
differentiate ourselves with the quality of our people and the work we produce. That brings in
clients and fees and the commercial side will then look after itself."
Sceptics have proposed nationalising auditing, or ditching it entirely and asking companies
to insure their financial statements instead. Sir John is not entertaining such possibilities.
Indeed, he agreed that quality and commercialism could be "two sides of the same coin”. But
in a telling echo of one of Mr Wyatt's phrases, the FRC report said "cultural changes" were
needed within the firms. If cultures won't change, it is the structure of the audit system that
must
Case study 3
Taken from Wikipedia (not a very good academic source, but useful for general knowledge)
The Olympus scandal was precipitated on 14 October 2011 when British-born Michael
Woodford was suddenly ousted as chief executive of international optical equipment
manufacturer, Olympus Corporation he had been company president for six months, and two
weeks prior had been promoted to chief executive officer, when he exposed "one of the
biggest and longest-running loss-hiding arrangements in Japanese corporate history".
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APPENDIX 1: Readings
The board chairman, Kikukawa, who had appointed Woodford to these positions, again
assumed the title of CEO and president. The incident raised concern about the endurance of
corporate governance in Japan.
Apparently irregular payments for acquisitions had resulted in very significant asset
impairment charges in the company's accounts, and this was exposed in an article in a
Japanese financial magazine and had come to Woodford's attention. Japanese press
speculated on a connection to Japanese organised crime syndicates) Olympus defended
itself against allegations of impropriety.
Despite Olympus' denials, the matter quickly snowballed into a scandal over concealment of
more than 117.7 billion yen ($1.5 billion) of investment losses and other dubious fees and
other payments dating back to the late 1980s On 26 October, Kikukawa was replaced by
Shuichi Takayama as chairman, president, and CEO. On 8 November 2011, the company
admitted that the company's accounting practice was "inappropriate" and that money had
been used to cover losses on investments dating to the 1990s. The company blamed the
inappropriate accounting on former president Tsuyoshi Kikukawa, auditor Hideo Yamada
and executive vice-president Hisashi Mori.
By 2012 the scandal had developed into one of the biggest and longest-lived lossconcealing financial scandals in the history of corporate Japan, it led to the resignation of
much of the board, investigations across Japan, the UK and US, the arrest of 11 Japanese
directors, senior managers, auditors, and bankers of Olympus for alleged criminal activities
or cover-up and raised considerable turmoil and concern over Japan's prevailing corporate
governance and transparency and the Japanese financial markets. Woodford received a
reported £10 million ($16 m) in damages from Olympus for defamation and wrongful
dismissal in 2012around the same time, Olympus also announced it would shed 2,700 jobs
(7% of its workforce) and around 40 percent of its 30 manufacturing plants by 2015.
Section 2: Lecture example 1a) Highlights of UK Code 2018 by FRC
Revised UK Corporate Governance Code 2018 highlights by FRC
Code content
Broadens the definition of governance and emphasises the importance of:
• Positive relationships between companies, shareholders and stakeholders.
• A clear purpose and strategy aligned with healthy corporate culture.
• High quality board composition and a focus on diversity.
• Remuneration which is proportionate and supports long-term success.
Designed to:
• Set higher standards of corporate governance to promote transparency and integrity in
business.
• Attract investment in the UK for the long term, benefitting the economy and wider society.
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APPENDIX 1: Readings
Detailed changes
Stakeholders
• Emphasis on improving the quality of the board and company’s relationships with a wider
range of stakeholders.
• Taking effective action when receiving significant shareholder votes against resolutions
and reporting back more promptly.
• Board responsibility for workforce policies and practices which reinforce a healthy culture.
• Engaging with the workforce through one, or a combination, of a director appointed from
the workforce, a formal workforce advisory panel and a designated non-executive director, or
other arrangements which meet the circumstances of the company and the workforce.
• The ability for directors and the workforce to be able to raise concerns and for effective
enquiry of these concerns.
The boardroom
• Emphasis on importance of independence and constructive challenge of the boardroom.
• Strengthening consideration of ‘overboarding’.
• A focus on diversity, the length of service of the board as a whole, and effective board
refreshment.
• ‘Comply or explain’ provision for a maximum nine-year length of service, allowing flexibility
to extend “to facilitate effective succession planning and the development of a diverse
board… particularly in those cases where the chair was an existing non-executive director
on appointment”.
• Nomination committee responsibility for more effective succession planning that develops a
more diverse pipeline. Reporting on the gender balance of senior management and their
direct reports.
• Higher quality external board evaluations, emphasising the importance of the evaluator’s
direct contact with the board and individual directors.
Remuneration
• More demanding criteria for remuneration policies and practices.
• Clearer reporting on remuneration, how it delivers company strategy, long-term success
and its alignment with workforce remuneration.
• Directors exercising independent judgement and discretion on remuneration outcomes,
taking account of wider circumstances.
• Remuneration committee chair should have served on a remuneration committee for at
least 12 months.
Code structure and reporting
The Code does not set out a rigid set of rules; instead it offers flexibility through the
application of Principles and through ‘comply or explain’ Provisions and supporting guidance.
It is the responsibility of boards to use this flexibility wisely and of investors and their
advisors to assess differing company approaches thoughtfully.
The 2018 Code:
• is shorter and sharper;
• “Supporting Principles” have been removed; and
• has fewer Provisions.
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Renewed focus on the Principles
• By reporting on the application of the Principles in a manner that can be evaluated,
companies should demonstrate how the governance of the company contributes to its longterm sustainable success and achieves wider objectives
• The statement should cover the application of the Principles in the context of the particular
circumstances of the company, how the board has set the company’s purpose and strategy,
met objectives and achieved outcomes through its decisions
• High-quality reporting will include signposting and cross-referencing to other relevant parts
of the annual report.
The effective application of the Principles should be supported by high-quality reporting on
the Provisions
• The Provisions establish good practice on a ‘comply or explain’ basis.
• Companies should avoid a ‘tick-box approach’. An alternative to complying with a Provision
may be justified in particular circumstances based on a range of factors, including the size,
complexity, history and ownership structure of a company.
• Explanations should set out the background, provide a clear rationale for the action the
company is taking, and explain the impact that the action has had.
• Where a departure from a Provision is intended to be limited in time, the explanation
should indicate when the company expects to conform to the Provision.
• Explanations are a positive opportunity to communicate, not an onerous obligation.
The role of investors and their advisors is very important
• Investors should engage constructively and discuss with the company any departures from
recommended practice.
• When considering explanations, investors and proxy advisors should pay due regard to a
company’s individual circumstances.
• Proxy advisors have every right to challenge explanations if they are unconvincing, but
explanations must not be evaluated in a mechanistic way.
• Investors and proxy advisors should also give companies sufficient time to respond to
enquiries about corporate governance reporting.
.Section 2: Lecture Example 3: Readings Guidance notes
The examiner suggests that the guidance notes are essential reading, and they are in fact
an easy way for the examiner to structure a new exam question, use a guidance note as the
basis for it.
Examiner comments:
Whilst the ICSA Study Text is the recommended study material for this examination,
candidates should consider opportunities to widen the scope of their reading. Examples of
many of the reports and documents referenced within the Study Text can easily be obtained
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through an internet search. In addition, in many areas, the ICSA produces guidance notes
which aim to provide a practical approach to dealing with corporate governance issues and
procedures. For candidates not currently working within company secretarial or governance
fields, such materials and resources can greatly assist in providing a better understanding of
the topic as a whole and in being able to analyse issues and apply principles to real-life and
hypothetical (examination) situations.
Examples of ICSA guidance notes
You can find these on the ICSA website, just search for them after you have signed in, as
some are only available to members. They are continually updated, so this is not a
prescriptive up to date list. www.icsa.org.uk
• Duties and reporting lines of the company secretary
• Terms of Reference – Audit, Risk, Remuneration, Nomination and Executive Committees
• Matters reserved for the board
• Directors’ duties to exercise care skill and diligence
• Induction of directors
• Joining the right board – due diligence for prospective directors
• Roles of the Chairman, Chief Executive and Senior Independent Director
• Directors remuneration report
• Directors general duties
ICSA Guide to Enhancing Stewardship Dialogue
FRC UK Corporate Governance Code
FRC Guidance on Board Effectiveness
Quoted Companies Alliance and EcoDa/ IOD Governance Codes
Section 3 lecture example 2: Case study: Types of Boards
“Corporate governance a practical guide” published by the London Stock Exchange and the
accountants RSM Robson Rhodes
This study suggests that board evaluation needs to be in terms of clear objectives. Boards
ought to be learning lessons from specific decisions they have taken (Did they receive
adequate information? Did they address the main issues well?)
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Considering how the board is working as a team is also important. This includes issues such
as encouragement of criticism, existence of factions, whether dominant players are
restricting the contribution of others. The guidance suggests involving an external facilitator
to help discover key issues. The guide also compares the working of an effective board with
other types of board and suggests that boards should consider which unsuccessful elements
they demonstrate.
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Section 3 lecture example 7: Higgs on NEDS
The UK Higgs report summed up the characteristics of the effective non–executive director:
Even though Higgs has now been superseded by FRC guidance, the report provided a very
useful basic short “exam” list to learn, so it is reproduced here:

Upholds the highest ethical standards of integrity and probity

Supports executives in their leadership of the business while monitoring their conduct

Questions intelligently, debates constructively, challenges rigorously and decides
dispassionately

Listens sensitively to the views of others inside and outside the board

Gains the trust and respect of other board members

Promotes the highest standards of corporate governance and seeks compliance with
the provisions of the Code wherever possible
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Higgs suggested that the following issues should be considered when appraising the
performance of non-executive directors:

Preparation for meetings

Attendance level

Willingness to devote time and effort to understand the company and its business

Quality and value of contributions to board meetings

Contribution to development of strategy and risk management

Demonstration of independence by probing, maintaining own views and resisting
pressure from others

Relationships with fellow board members and senior management
Section 4: FRC Report on corporate culture on the role of boards
Headlines from the executive summary
RECOGNISE THE VALUE OF CULTURE
A healthy corporate culture is a valuable asset, a source of competitive advantage and vital
to the creation and protection of long-term value. It is the board’s role to determine the
purpose of the company and ensure that the company’s values, strategy and business
model are aligned to it. Directors should not wait for a crisis before they focus on company
culture.
DEMONSTRATE LEADERSHIP
Leaders, in particular the chief executive, must embody the desired culture, embedding this
at all levels and in every aspect of the business. Boards have a responsibility to act where
leaders do not deliver.
BE OPEN AND ACCOUNTABLE
Openness and accountability matter at every level. Good governance means a focus on how
this takes place throughout the company and those who act on its behalf. It should be
demonstrated in the way the company conducts business and engages with and reports to
stakeholders. This involves respecting a wide range of stakeholder interests.
EMBED AND INTEGRATE
The values of the company need to inform the behaviours which are expected of all
employees and suppliers. Human resources, internal audit, ethics, compliance, and risk
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functions should be empowered and resourced to embed values and assess culture
effectively. Their voice in the boardroom should be strengthened.
ALIGN VALUES AND INCENTIVES
The performance management and reward system should support and encourage
behaviours consistent with the company’s purpose, values, strategy and business model.
The board is responsible for explaining this alignment clearly to shareholders, employees
and other stakeholders.
ASSESS, MEASURE AND ENGAGE
Indicators and measures used should be aligned to desired outcomes and material to the
business. The board has a responsibility to understand behaviour throughout the company
and to challenge where they find misalignment with values or need better information.
Boards should devote sufficient resource to evaluating culture and consider how they report
on it.
EXERCISE STEWARDSHIP
Effective stewardship should include engagement about culture and encourage better
reporting. Investors should challenge themselves about the behaviours they are encouraging
in companies and to reflect on their own culture.
The whole report and many case studies are available from:
https://www.frc.org.uk/Our-Work/Corporate-Governance-Reporting/Corporategovernance/Corporate-Culture-and-the-Role-of-Boards.aspx
Section 4: Lecture Example 7: Case example – Tarmac
This the share price of Tarmac plc during the last few months of 2000
Several directors of Tarmac built up their holding over a couple of weeks including Chief
Executive, Roy Harrison, who bought 25,000 shares at 398p and Finance Director, Chris
Bunker who invested in a total of 17,403 shares. Another director Sir A Gill purchased
30,000 shares
The share price had been depressed due to fears over interest rates, but the day after the
final purchase, the price rocketed by 34.5% due to a possible bid offer.
The sequence of purchases by the directors, followed by the sudden rise in share price,
prompted an investigation by the London Stock Exchange.
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So had the directors committed the offence of insider dealing?
The LSE investigation uncovered no insider dealing. The directors maintained they knew
nothing of the bid until the day after the last purchase.
While directors do run some risk, examples such as this are quite rare.
Here, both the directors and the bid offeror recognised that Tarmac shares were
undervalued by the market, but the directors saw it first.
Section 5: Lecture example 1 Case study: reading: British Gas
“Cedric Brown, fat cat in the dog house”
So why all the fuss about Cedric Brown and his massive
salary?
VICKY WARD The Independent
Monday, 13 March 1995
(With minor edits for the readers of today)
In a contest to decide the Least Popular Man in Britain, there would be politicians and peers
jostling for position with villains and the odd soap character, but Cedric Brown would be
running as the short- priced favourite. Few people have the power to excite the combined
outrage of tabloid headline writers, broadsheet columnists, Home Counties matrons and the
Prime Minister, but the chief executive of British Gas - the man with the 900 per cent salary
increase - has managed, albeit unwittingly, to unite the nation.
The tabloids are out to get him because he is prospering at a time when the economic
certainties of the Eighties have long been flushed down the avocado toilet suite. The middle
classes dislike him for earning too much money and then squandering it. The Establishment
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wants the fellow blackballed: aside from not having the right address, he is the man most
likely to lose the Tories the next election. The Labour party like the idea of Mr Brown only in
so far as he will help do for Mr Major. And Mr Major himself is painfully aware that Cedric
Brown, a man earning five times his own salary, has all the timing and sense of occasion of
the gas man who comes to investigate a leak with a match as a light.
Most of all, the tabloids have got it in for Mr Brown for living the very lifestyle that the majority
of their readers aspire to. Mr Brown is the boy next door made too good ("fat" in tabloid talk),
the Yorkshire lad who has grafted 44 years with British Gas and its predecessors to reach
the top, and, having got there, is reaping what he considers to be his reward (or "market
value" as he would say). That reward comprises a salary of £475,000 (47 times that of your
average Joe at British Gas), a £600,000 incentive deal, £1m worth of share options, a
£180,000 annual pension on his retirement in five years' time and, of course, that "mansion"
in suburban Bucks.
No wonder Mr Brown's secure and cushy suburban home life is the envy of Express and
Sun readers alike. "As long as these swine have freedom to bury their toffee-noses in the
trough," the People thundered, "they will swallow as much silver as their bloated bellies can
carry."
Immediately before privatisation in 1986, the chief executive of British Gas (Brown's current
position) earned £50,000; that salary has risen 900 per cent since then, vastly above the rate
of inflation and little to do with British Gas, a monopoly in private hands, having become 900
per cent more efficient. This was the magic of Thatcherism working for Cedric Brown and his
ilk.
However history is very often ignored, Mr Brown's trough is not really very different in weight
from that earned by the great public- spirited captains of industry of, say, 60 years ago. Mr
Brown has been criticised by politicians of both sides of the House for earning 47 times as
much as British Gas showroom staff; yet, Frank Pick, chief executive of the London
Passenger Transport Board from 1933-40 (when he shaped what was the world's finest
integrated urban public transport system) earned £10,000 a year, 43 times as much as a bus
driver, and in 1935 London bus drivers were among the best-paid workers in Britain.
Prime ministers found him as admirable and as daunting as they find Cedric Brown
insensitive and suburban, unfortunately for the rather dull Cedric Harold Brown his pay rise
was just badly timed to the extreme and that in this world of insatiable tabloids is fatal and to
the slaughter he goes.
Section 5: Lecture example 2 Case study: reading: Rewards for Failure
Rewards for failure debate follows BP boss into retirement


Browne tops list with £1m a year despite bonus loss
Incomes linked to salary for board, but not workers
By Phillip Inman, The Guardian, Thursday 30th August 2007
The former BP chief executive, Lord Browne of Madingley, topped the executive pension
league in 2006 with a retirement package worth more than £1m a year.
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Close behind was Lawrence Fish, the head of Royal Bank of Scotland's US operations. Mr
Fish, 62, has so far accumulated an annual pension entitlement of £992,081.
A roll call of executives from Britain's best-known large companies - Shell, Cadbury,
Unilever, GlaxoSmithKline and Tesco - bulk out the rest of the list, showing that a final salary
pension from a blue chip employer is still the best route to a financially secure retirement.
Bob Diamond, the high-flying head of Barclays' investment banking business, who heads the
annual directors' pay league in the Guardian/RTF pay survey, fails to appear on the list
because he squirrels away income made in Britain into a private pension plan in his native
US. After 12 years on an investment banker's wages, Mr Diamond would be expected to be
somewhere in the top 10, but the omissions in the government's rules on pay and pension
disclosure allow many of the highest paid to sidestep divulging all of their remuneration.
Trade unions have campaigned against excessive pension bonuses paid to senior
executives at a time of cuts in pension rights for shop floor and office workers.
The majority of workers are now members of occupational schemes that pay retirement
incomes based on stock market returns rather than on a guarantee offered by their
employer. Most executives in the FTSE 100 continue to enjoy guaranteed plans linked to
their final salaries.
Richard Harvey, the former chief executive of insurer Aviva who retired last year to do
charity work in Africa, took an £11.6m transfer value payment from his fund in order to
generate an annual income.
Questions about the link between pay and performance have dogged the debate around
executive pensions. Lord Browne's performance at BP was singled out by some who felt that
after building the company into one of the largest and most profitable oil majors, he had
begun to undermine its future.
Lord Browne announced his decision to quit this year after the company faced strong
criticism for its safety record in the US following a fire at its Texas City refinery which killed
several employees in 2005. It drew further criticism when pipes at its Alaskan oilfields were
found to be leaking.
Lord Browne's reign finally came to an end earlier than planned after he lied in court during
an attempt to block tabloid revelations about his personal life. He lost some £15m in
potential bonuses due as part of his retirement package, but kept the pension.
Cadbury Schweppes boss Todd Stitzer is another top executive to profit from accelerated
pension benefits. If he retires tomorrow he can count on a pension of £737,000 a year.
His pension will be unaffected by criticism that his current plan to break up the company is
born of his failure to integrate the business and that, like Lord Browne, he took his eye off
health and safety issues. A salmonella outbreak at a factory making some of Britain's best
loved chocolate bars damaged the company's reputation .
Like Lord Browne, Mr Stitzer may yet lose some of his bonus entitlements, but his and all
other executive pensions remain untouchable.
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Section 5 reading: severance pay
Best Practice On Executive Contracts and Severance - A Joint Statement By The
Association Of British Insurers And The National Association Of Pension Funds (now
The Pensions and Lifetime Savings Association, ‘PLSA’)
1. Introduction
1.1 Our two organisations, whose members are leading institutional investors in UK markets,
are publishing an updated statement of best practice on contract and severance policy for
directors.
1.2 This statement is aimed at assisting Boards and their Remuneration Committees with the
design and application of contractual obligations for senior executives. Shareholders have
an expectation that Boards will consider the risks of negotiating inappropriate executive
contracts that can lead to situations where failure is rewarded.
1.3 Institutional shareholders believe executives of listed companies should be appropriately
rewarded for the value they generate. However, they are also concerned to avoid situations
where departing executives are rewarded for under-performance. For many years the ABI
and NAPF have considered this to be a matter of good governance and it is clearly
addressed in the FRC’s UK Corporate Governance Code
2. Principles
2.1 The responsibility for setting directors’ contracts lies primarily with the Remuneration
Committee.
2.2 In line with the UK Corporate Governance Code, contracts should be set with reasonable
notice periods.
2.3 Boards should ensure that executives show leadership by aligning their financial
interests with those of the company.
2.4 The level of remuneration received by senior executives already factors in the risk
associated with their role. Boards should ensure that contracts do not include any additional
financial protection in the event of poor performance leading to termination.
2.5 The Remuneration Committee should carefully consider what commitments (including
pension contributions and all other elements) their directors’ terms of appointment would
entail in the event of early termination.
2.6 Directors’ contracts should ensure that severance payments arising from poor corporate
performance should not extend beyond basic salary.
2.7 Companies should clearly disclose key elements of directors’ contracts on their website
and summarise them in the Remuneration Report.
2.8 Companies should fully disclose in their Remuneration Report the constituent parts of
any severance payments and justify the total level and elements paid.
3. Guidance
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3.1 This Guidance is intended to emphasise certain aspects of the UK Corporate
Governance Code and where appropriate provide guidance as to shareholders’
expectations.
3.2 Contract policy including terminations and the approach to mitigation should be clearly
explained in the Remuneration Report. Also, corporate objectives set for executives by the
Board should be clear. The more transparent and understandable the objectives, the easier
it is to determine how an executive has performed and therefore prevent payment for failure.
Wherever possible, objectives against which performance will be measured should be made
public.
Contract Terms
3.3 Remuneration Committees should ensure that the policy and objectives on directors’
contracts are clearly stated in the Remuneration Report. Shareholders will take account of
contracts and the way they are implemented in considering their vote on the Remuneration
Report and the re-election of members of the Remuneration Committee.
3.4 When contracts are being negotiated, boards should consider and avoid the reputational
risk of being obliged to make large payments to executives who have failed to perform.
Contracts should be reviewed periodically and Remuneration Committees should consider
whether the contract provisions are in line with their policy and this Statement.
Notice Periods
3.5 The UK Corporate Governance Code states that under normal circumstances directors
should be retained on contracts of one year or less. However we believe that a one-year
notice period should not be seen as a floor, and we would strongly encourage boards to
consider contracts with shorter notice periods. Compensation for risks run by senior
executives is already implicit in the absolute level of remuneration, which mitigates the need
for substantial contractual protection.
3.6 If it is necessary to offer executives longer notice periods, for example for incoming
executives at companies in difficulties, we would expect the length of the contract to be
justified. In that case the termination provisions attached should be fully disclosed and the
length of the contract should reduce on a rolling basis in line with the recommendations
contained in this Guidance.
Severance Payments
3.7 Remuneration Committees should have the leeway to design a policy appropriate to the
needs and objectives of the company, but they must also have a clear understanding of their
responsibility to negotiate suitable contracts and be able to justify severance payments to
shareholders.
3.8 From the outset, Boards should establish a clear policy to ensure any non-contractual
payments are linked to performance. No director should be entitled to discretionary
payments in the event of termination of their contract arising from poor corporate
performance. Remuneration Committees should consider retaining their discretion to reclaim
bonuses if performance achievements are subsequently found to have been significantly
miss-stated.
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3.9 Contracts should not provide additional compensation for severance as a result of
change of control.
3.10 Remuneration Committees should ensure that full benefit of mitigation is obtained. This
includes the legal obligation on the part of the outgoing senior executive to mitigate the loss
incurred through severance by seeking other employment and reducing the need for
compensation. Phased payments are generally appropriate for fulfilling compensation on
early termination. The ABI and NAPF are not supportive of the liquidated damages approach
which involves agreement at the outset on the amount that will be paid in the event of
severance.
Pensions
3.11 Pension entitlement or contributions on severance can represent a large element of
cost to shareholders. Remuneration Committees should identify, review and disclose in the
Remuneration Report any arrangements that guarantee pensions with limited or no
abatement on severance or early retirement. These pension arrangements are no longer
regarded as acceptable, except where they are generally available to all employees. Where
opportunities arise, existing contracts should be amended. Such conditions should not be
included in new contracts.
Inspection Arrangements
3.12 Directors’ contracts and any side letters relating to severance terms and pension
arrangements should be readily available for shareholder inspection.
4. Conclusion
4.1 It is unacceptable that poor performance by senior executives, which detracts from the
value of an enterprise and threatens the livelihood of employees, can result in excessive
payments to departing directors. Boards have a responsibility to ensure that this does not
occur.
Section 6: Lecture example 3: Fall from grace
by Julian Ryall
ACCA accounting and business magazine
01 Jun 2006
Never before has a home-grown Japanese entrepreneur fallen so far and so fast as
Takafumi Horie, chief of the Livedoor empire. Julian Ryall reviews the case and asks
whether Japan Inc should now expect tougher financial regulatory controls as a
result of the scandal
Six months ago, Takafumi Horie bestrode Japan’s business world, his empire
encompassing interests as diverse as a used car dealership, energy drinks and an on-line
travel agency, but all rooted in his purchase of internet service provider Livedoor in
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November 2002.
Released on bail from the Tokyo Detention Centre on 27 April, 33-year-old Horie cut a very
different figure. Visibly thinner after four months behind bars, he is likely to spend the next
couple of years fighting through the courts to clear his name of accounting fraud and
securities law violations. The first date ringed in his diary was 26 May, when four of his
closest confidantes at Livedoor were due to appear before the Tokyo District Court.
The hearing, as well as those for Horie, who is being tried separately as he intends to plead
not guilty, will inevitably hold the attention of an industry that has found itself in the firing line
from both the media and the public, fielding accusations of being at least negligent and, at
worst, collusive.
“We have to respond to the public’s expectations and rebuild their confidence in the
accounting profession,” said Tsuguoki Fujinuma, chairman and President of the Japan
Institute of Certified Public Accountants (JICPA). “We are aware that the public is watching
how we respond to this matter and, while we have already taken many steps, they still
expect more from us.”
Horie was arrested on 23 January, and has been charged with falsification of Livedoor’s
financial report for the year to 30 September 2004, by conspiring to add ¥5.34bn (£25.55m)
in sales to the firm’s consolidated earnings results. Consequently, instead of a pretax profit
of ¥5.03bn (£24.07m) in the reporting period, the company actually had a pretax loss of
¥312.78m (£1.50m).
At their peak, individual Livedoor stocks were valued at ¥800 (£3.83); they were delisted
from the Tokyo Stock Exchange on 14 April after sinking to ¥94 (45p).
“The Livedoor case is quite unique and we believe that, first and foremost, it was a case of
market manipulation followed by the financial scandal,” said Fujinuma. “They apparently
used a series of techniques such as stock-splits, share takeovers and investment funds, to
conceal merger and acquisition transactions, and while individually these procedures may
not break any laws, prosecutors say that, combined, they were illegal.
“Horie was a man driven by his ambitions who was great in finding loopholes in the capital
market rules.”
The chicanery has also revealed some serious flaws in accountancy standards in Japan, he
admits. “Even before the Livedoor case, we received a lot of enquiries from our members
concerning the use of special purpose entities - such as those that Enron Corp set up in the
US in that case - because they are new here and they did not know how to handle them,” he
said. “We asked the Accounting Standards Board of Japan to set detailed standards, but
they are still working on them.”
A first tranche of rules is expected at any time, while regulations on more complicated issues
are due out within the next 12 months.
Many people are also questioning auditors’ independence from their clients’ management,
Fujinuma agrees, so one immediate self-regulatory step that the JICPA introduced in April is
adopting the US approach to rotating audit partners by reducing the rotation period from
seven years to five years.
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In addition, the institute is stepping up its quality control campaign by obliging members to
undergo a minimum of 40 hours of education a year. Prior to April, two hours of the total was
dedicated to ethics, but that has now been doubled to four hours each year. Inspections are
also being stepped up of the JICPA’s 440 member audit firms, with Japan’s Big Four outfits,
which audit 80% of public companies, being examined every two years and the remainder
every three years. Plans are also under way for a training centre for listed auditing firms, and
companies that are negligent in a case such as Livedoor will, in the future, not be able to
hide behind privacy regulations and will be identified.
At the government level, the Financial Services Agency (FSA) on 26 April set up a CPA
system deliberation group to examine the causes and effects of the Livedoor and other
scandals, with the intention of strengthening regulations and amending the relevant laws,
although Fujinuma points out that existing legislation, some of which is based on SarbanesOxley, is already reflected in the revised CPA law, such as rules concerning the
independence of auditors.
Section 7: Reading: BT hit by shareholder revolt over outgoing chief's £2.3m
pay
The Guardian 11th July 2018
BT has been hit by a significant shareholder rebellion over its outgoing chief executive Gavin
Pattersons £2.3m Pay Packet.
At its annual meeting in Edinburgh, 34.2% of investors voted against the telecoms group’s
remuneration report, including the payout to Patterson.
The AGM result will lead to BT being placed on a public register of firms in which more than
20% of shareholders have voted against an executive pay resolution.
Patterson’s 2017 pay package was revealed in May, only weeks after he unveiled a new
strategy for the embattled company, including job cuts to slash costs. The payout included a
performance bonus of £1.3m for the year to the end of March.
In June, BT announced that Patterson was leaving, after a backlash from shareholders over
the company’s poor performance and concerns that Patterson was not the right person to
lead the company through an ambitious restructuring plan. He is due to step down later this
year after a replacement is appointed.
Overall BT’s top management pocketed £21.5m in pay, bonuses and share awards last year,
23.5% more than the previous 12 months.
BT said: “We are naturally disappointed with the lower level of support received for our
remuneration report for the year ending 31 March 2018.” It added that it was mostly related
to the annual bonus payment to Patterson.
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The company said it had been been talking to its main shareholders over the past two weeks
to discuss their concerns and vowed to do more to listen to investors.
BT said: “During the remainder of 2018 we will engage further with our shareholders and
proxy advisers to understand in full detail the reasons for their concerns and whether we
should consider any changes to our longer-term approach to remuneration.”
Several shareholder advisory groups, including ISS and Pirc, had urged investors to oppose
the payout to BT’s chief executive.
Pirc said: “The company’s recent poor share performance, the decision to cut 13,000 jobs in
order to deal with losses and the losses brought about by BT Italy’s accounting practices are
not reflected in the CEO’s remuneration.”
The company is under pressure for its poor performance, including an accounting scandal in
Italy which led to a £530m writedown and a big fall in its share price last year. The scandal
resulted in Patterson’s pay being cut by £4m to 1.34m in 2016-17.
There have been a number of shareholder rebellions this year at companies ranging from
AstraZeneca to the turnaround specialist Melrose.
Royal Mail could also face an investor revolt over executive pay at its annual meeting in
Sheffield on 19 July.
It has been criticised by two investor advisory groups, ISS and Glass Lewis, for its decision
to pay its new chief executive, Rico Back, a higher salary than his predecessor. ISS is also
concerned that the outgoing CEO, Moya Greene, will leave with a payoff of more than
£900,000.
In a statement, Royal Mail said: “We recognise that executive remuneration is a sensitive
issue in the current economic environment. Our remuneration approach remains to recruit,
retain and motivate executives of a high calibre that have the experience and expertise to
lead our very large and complex company through a period of intensive change.
“We have sought to ensure that Rico Back and Moya Greene’s overall fixed cash
remuneration – their base salary, pension entitlements and benefits – are broadly the same.
So Rico’s annual salary is higher than Moya’s to compensate for the halving of the cash
pension allowance he would have received were this the same as the pension allowance
Moya received. It is worth noting that the potential increase in Rico’s variable pay is subject
to meeting stringent performance conditions.”
Footnote
The royal mail shareholder revolt occurred with over 70% voting against
https://www.bbc.co.uk/news/business-44884828
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Section 8: lecture example 1: Barings
From www.wikipedia.com (not a good academic source but useful for general knowledge)
Some of the accuracy of the following article could be argued, and you should not quote
from scandals in your exam, as it just takes too much time, usually looking vague and
general, which examiners don’t like, plus it is most often not at all relevant to the question.
However, read with due regard to those caveats, the events detailed below are an important
piece of background reading.
Barings was brought down in 1995 due to unauthorized trading by its head derivatives trader
in Singapore, Nick Leeson.
At the time of the massive trading loss, Leeson was supposed to be arbitraging, seeking to
profit from differences in the prices of Nikkei 225 futures contracts listed on the Osaka
Securities Exchange in Japan and the Singapore International Monetary Exchange. Such
arbitrage involves buying futures contracts on one market and simultaneously selling them
on another at a higher price. Since everyone tries to take advantage of a price difference on
a publicly traded futures contract, the margins on arbitrage trading are small or even wafer
thin. Consequently, the volumes traded by arbitrageurs must be very large to gain any
meaningful profit. In arbitrage, one is buying something at one market while selling the same
goods in another market at about the same time. Consequently, almost all risks are hedged
and the strategy is not very risky.
However, instead of buying on one market and immediately selling on another market for a
small profit, the strategy approved by his superiors, Leeson bought on one market then held
on to the contract, gambling on the future direction of the Japanese markets. If one uses the
above example, one could buy $100 million worth of Nikkei futures contracts then hope that
the contract price goes up in future. In this instance, even a percentage change of the price
would create 1 million dollar worth of profit or loss.
According to Eddie George, Governor of the Bank of England, Leeson began doing this at
the end of January 1995. Due to a series of internal and external events, his unhedged
losses escalated rapidly.
Internal auditing
Under Barings Futures Singapore's management structure through 1995, Leeson doubled
as both the floor manager for Barings' trading on the Singapore International Monetary
Exchange and head of settlement operations. In the latter role, he was charged with
ensuring accurate accounting for the unit. The positions would normally have been held by
two different employees. By allowing Leeson, as trading floor manager, to settle his own
trades, Barings short-circuited normal accounting and internal control/audit safeguards. In
effect, Leeson was able to operate with no supervision from London—an arrangement that
made it easier for him to hide his losses. After the collapse, several observers, including
Leeson himself, placed much of the blame on the bank's own deficient internal auditing and
risk management practices.
People at the London end of Barings were all so know-all that nobody dared ask a stupid
question in case they looked silly in front of everyone else.
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—Nick Leeson, Rogue Trader (1996)
Some people raised eyebrows about Leeson's activities but were ignored.
Awaiting breakdown from my buddy Nick … (once they creatively allocate the numbers).
—Brenda Granger, Head of Futures and Options Settlements in London, January 1995
internal e-mail
Corruption
Because of the absence of oversight, Leeson was able to make seemingly small gambles in
the futures arbitrage market at Barings Futures Singapore and cover for his shortfalls by
reporting losses as gains to Barings in London. Specifically, Leeson altered the branch's
error account, subsequently known by its account number 88888 as the "five-eights
account", to prevent the London office from receiving the standard daily reports on trading,
price, and status. Leeson claims the losses started when one of his colleagues bought
contracts when she should have sold them, costing Barings £20,000.
By December 1994, Leeson had cost Barings £200 million. He reported to British tax
authorities a £102 million profit. If the company had uncovered his true financial dealings
then, collapse might have been avoided as Barings still had £350 million of capital. [8]
Kobe earthquake
Using the hidden five-eights account, Leeson began to aggressively trade in futures and
options on the Singapore International Monetary Exchange. His decisions routinely resulted
in losses of substantial sums, and he used money entrusted to the bank by subsidiaries for
use in their own accounts. He falsified trading records in the bank's computer systems, and
used money intended for margin payments on other trading. As a result, he appeared to be
making substantial profits. However, his luck ran out when the Kobe earthquake sent the
Asian financial markets into a tailspin. Leeson bet on a rapid recovery by the Nikkei, which
failed to materialize.
Discovery
On 23 February 1995, Leeson left Singapore to fly to Kuala Lumpur. Barings Bank auditors
finally discovered the fraud around the same time that Barings' chairman, Peter Baring,
received a confession note from Leeson. Leeson's activities had generated losses totalling
£827 million (US$1.3 billion), twice the bank's available trading capital. The collapse cost
another £100 million. The Bank of England attempted an unsuccessful weekend bailout.[10]
Employees around the world did not receive their bonuses. Barings was declared insolvent
on 26 February 1995 and appointed administrators began managing the finances of Barings
Group and its subsidiaries. The same day, the Board of Banking Supervision of the Bank of
England launched an investigation led by Britain's Chancellor of the Exchequer and their
report was released on 18 July 1995.
Aftermath
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ING, a Dutch bank, purchased Barings Bank in 1995 for the nominal sum of £1 and
assumed all of Barings' liabilities, forming the subsidiary ING Barings.
Section 8 lecture example 5: RBS
Case - FSA inquiry into RBS purchase of ABN Amro
THETELEGRAPH[AUGUST2009]
By Rowena Mason and Jamie Dunkley
The Financial Services Authority has launched an official review into Royal Bank of
Scotland's debt-laden acquisition of ABN Amro the year before it had to be bailed out by the
taxpayer.
The regulator notified RBS in April of its intention to conduct the review, which will scrutinise
the bank's capital raising last year. It is understood that the review will look into the "whys
and wherefores" of RBS's battle with Barclays to buy the investment bank for €71bn (£63bn)
at the top of the market. It is likely to include a close look at what due diligence was
performed.
The FSA's supervisory review was revealed in the notes of RBS's half-year results last
month. The acquisition of ABN Amro has been widely blamed for heaping RBS with debt and
depleting its capital resources so that it was badly placed to withstand the credit crisis.
The bank, which was the largest to be propped up by the Treasury, reported a record £40bn
loss for 2008 in February – the biggest in UK corporate history. A large part of its writedowns were related to the ill-fated decision to buy the investment bank.
Stephen Hester, the chief executive of RBS, who joined after its part-nationalisation, said in
April that the bank will take at least three to five years to recover from the attempted
integration of ABN Amro assets that were instrumental in damaging the bank's balance
sheet.
RBS, which is now 70pc owned by the state, has unveiled a sweeping restructuring plan. As
many as 20,000 jobs could be lost after the bank said it planned to cut costs by £2.5bn. A
spokesman for RBS would only say that the bank is co-operating fully with the regulator's
review.
Section 8 lecture example 8: readings: Two whistleblowing cases
1. Fernandes v Netcom (2000)
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Causation: Complaints about whistleblower were a smokescreen
Fernandes was finance officer for a UK subsidiary of a US telecoms company. In 1997 when
Fernandes had told his contact in the US about large and suspect expenses claims made by
his CEO, he was told to turn a blind eye. In late 1999 when the CEO’s expenses had
exceeded £300,000, Fernandes raised his concerns with the US Board. He immediately
found himself under pressure to leave and when he refused to resign, he was disciplined
and dismissed for authorising the CEO’s expenses.
Fernandes brought a PIDA claim. The CEO remained in post until Fernandes had won his
claim for interim relief.
At the full hearing ET decided that the complaints about Fernandes were a smokescreen
and that he had been sacked for whistleblowing.
As Fernandes was 58 and unable to secure similar work, the award was £293,000
2
Gulwell v Consignia (2002)
Good faith: Where purpose was to secure his own way by bullying tactic, disclosure was not
made in good faith.
Gulwell, who was seeking promotion a role as a sales adviser, had a challenging and
impertinent approach to both colleagues and managers. He decided to monitor and record
the time off, holidays and sick leave of all in his office. He made a series of disclosures and
claimed that these caused him to be denied promotion. ET held that Gulwell was making the
disclosures “to achieve his own ends to be appointed as sales adviser and as a crude form
of bullying tactics” and “to secure his own way in relation to other fellow employees that he
believed should have been disciplined”. Held the disclosures were not made in good faith
and that there had been no detriment.
Section 10: lecture example 5: Ford and Sustainability
Ford to develop 'sustainability strategy'
F INANCIALT IMES[ A PRIL2 0 0 7 ]
By John Reed
Ford Motor has promoted an executive to a top-level environmental remit in another
reflection of green issues' elevation to the top of the US car industry's agenda.
Susan Cischke will be responsible for establishing a "long-range sustainability strategy" and
environmental and safety policy for the company, reporting to Alan Mulally, Ford's president
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APPENDIX 1: Readings
and chief executive. Ms Cischke formerly reported to Ford's head of corporate affairs as
head of Ford's environmental and safety engineering.
Europe's main carmakers mostly already have board-level executives with environmental
responsibilities.
The Detroit-area carmakers are stepping up their environmental efforts amid a shift in
political and public opinion in the U.S. on the issues of global warming and energy security.
Mr Mulally, a former senior executive at Boeing, said he believed that the "vast majority of
data" pointed to "global warming… that comes from greenhouse gases."
"In the court of public opinion, we've moved to the place that we all agree this is an issue
and we all want to do something about it," he said.
Ford is also a leading carmaker in Europe, where lawmakers recently agreed to hold the car
industry to much tighter carbon dioxide emissions standards by 2012. Ford said Ms Cischke
would be charged with ensuring that Ford's products "meet or exceed all safety and
environmental regulations worldwide. "
Green groups have criticised Ford, along with General Motors and DaimlerChrysler's
Chrysler unit of making too many gas-guzzling, high-emission large vehicles and lagging
behind Japanese and European competitors in developing cleaner cars. Some of Ford's
current vehicles do not meet US fuel-efficiency standards.
Alongside tightening environmental regulations, alternative-fuel cars are becoming a topdrawer business issue for the industry as they develop competing technologies involving
hybrid engines, hydrogen, or biofuels. Ms Cischke said she would work closely with Derrick
Kuzak, head of Ford's global product development, and others to help build "sustainable
technologies."
All of the new technologies have disadvantages, and entail large research and development
costs. Ford, which is in the midst of a radical downsizing and restructuring plan, has resisted
cutting its research and development budget despite record financial losses.
Section 10 lecture example 6: Linkages
From http://www.globalenvision.org
Posted on July 8, 2004
Responsible corporate policies make for good global neighbours.
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APPENDIX 1: Readings
"When I decided to join Gap Inc. in the fall of 2002," writes
Paul Presser, President and CEO of the clothing giant
behind the Gap, Old Navy, and Banana Republic brands,
"one of the first things my teenage daughter asked was,
'Doesn't Gap use sweatshops?'"
This question, effectively pushed into consumer
consciousness by an aggressive global movement for
workers' rights, has haunted Gap for nearly a decade. In
May, the company released its first Social Responsibility
Report, providing an important window into how far that
movement has come-and highlighting challenges that
continue to confront apparel workers in an industry where
"remaining competitive" fuels a search for ever-cheaper production.
Gap's 40-page report attempts to take the sweatshop issue head on. The result of a
collaboration with several "social investment" and corporate responsibility organizations,
such as the Calvert Group and the Interfaith Center on Corporate Responsibility (ICCR), the
document provides data on conditions in 3,010 factories in over 50 countries were the
company's garments are made. "Few factories, if any, are in full compliance all of the time"
with Gap's code of conduct, the report states.
The report has earned Gap genuine, if measured, praise from a variety of leading antisweatshop organizations. "We've had our differences with Gap in the past, and we may in
the future," says Bruce Raynor, President of UNITE, the textiles and needletrades union. But
he cites the report as a move to "create positive change for workers."
Then 3 years later……………………….
From www.cnn.com
October 29, 2007
Clothing retailer Gap Inc. has fired an Indian company accused of using child labour to make
clothes, the company's president said.
"It's deeply, deeply disturbing to all of us," Gap President Marka Hansen said Sunday after
watching a video of children at work in a New Delhi, India, sweatshop.
"I feel violated and I feel very upset and angry with our vendor and the subcontractor who
made this very, very, very unwise decision," Hansen said.
Hansen blamed the alleged abuse on an unauthorized subcontractor for one of its Indian
vendors and said the subcontractor's relationship with the Gap had been "terminated."
She said the garments allegedly produced by the children represented a small portion of a
single order placed with the vendor and that the clothes would not be sold in stores.
"We strictly prohibit the use of child labour," Hansen said in a statement. "Gap has a history
of addressing challenges like this head-on, and our approach to this situation will be no
exception.
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APPENDIX 1: Readings
"In 2006, Gap Inc. ceased business with 23 factories due to code violations. We have 90
people located around the world whose job is to ensure compliance with our Code of Vendor
Conduct."
The report first appeared Sunday in Britain's Observer newspaper. Watch how children
worked as virtual slaves
The Observer spoke to children as young as 10 who said they were working 16 hours a day
for no pay. The paper described the workplace as a "derelict industrial unit" where the
hallways were flowing with excrement from a flooded toilet.
One 10-year-old boy told the paper he was sold to the company by his parents.
"'I was bought from my parents' village in [the northern state of] Bihar and taken to New
Delhi by train," The Observer quoted the boy as saying. "The men came looking for us in
July. They had loudspeakers in the back of a car and told my parents that, if they sent me to
work in the city, they won't have to work in the farms. My father was paid a fee for me, and I
was brought down with 40 other children."
Another boy, 12, said he worked from dawn until 1 a.m. and was so tired he felt sick,
according to the paper. But if any of the children cried, he told The Observer, they would be
hit with a rubber pipe or punished with an oily cloth stuffed in their mouths.
The children were producing hand-stitched blouses for the Christmas market in the United
States and Europe at Gap Kids stores, according to the newspaper. The blouses were to
carry a price of about $40, The Observer reported.
The Gap faced criticism for similar practices in 2000, when a BBC documentary uncovered
young girls producing Gap products at a Cambodian factory. But since then, Hansen said,
the company has developed comprehensive policies to prevent abuse and protect workers'
rights. Hansen said violations of those policies are now "extremely rare."
She said she does not support closing any factories in India in response to the allegations
because it would deprive those working in proper conditions of their income.
The Gap also operates Banana Republic and Old Navy stores. It has 3,100 stores around
the world.
End of Appendix 1 Readings
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APPENDIX 2: Answers to lecture examples
APPENDIX 2: ANSWERS TO LECTURE EXAMPLES
Section 1 Lecture example 2: The Pub Quiz Answers
1) Which executive chairman disappeared off his boat in 1991?
Robert Maxwell
2) Which company, listed on AIM (the alternative investment market) had an issue with
fraud concerning its accounts in 2018?
Patisserie Valerie
3) What job did Sir Adrian Cadbury of the Cadbury report have at Cadbury Schweppes
and Sir Richard Greenbury of the Greenbury report have at M&S?
Executive chairman
4) What is a golden parachute?
A payment to leave the company
5) What is retirement by rotation?
In the public company model articles every year a third of the directors put
themselves up for re-election by the shareholders at the AGM
Section 1 Lecture example 3: Exam standard question: Answer
Benefits
(a) Improved risk management. The reduction of downside risk will reduce business losses.
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(b) Overall business performance is enhanced by management focusing attention on areas
of critical importance.
(c) Defines clear accountability for executive decision making.
(d) It provides both an appropriate and adequate system of internal control, which permeates
the organisation from top to bottom.
(e) Best practice guidelines are applied by management, who therefore strive to improve
their performance.
(f) Encourages ethical behaviour and corporate social responsibility.
(g) Safeguards the firm from misuse of business assets, both tangible and intangible.
(h) Can attract new investment, particularly in developing countries.
Drawbacks
(a) It is expensive to implement
(b) May slow business decision making, resulting in missed opportunities, especially when
compared to other business operating in a jurisdiction with less onerous governance
principles/regulation.
(c) May be perceived as window dressing by some stakeholders
(d) Overly transparent reporting may result in a competitive disadvantage
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APPENDIX 2: Answers to lecture examples
Section 1 Lecture example 4: exam standard question: Answer
Corporate governance reports worldwide have concentrated significantly on the roles,
interests and claims of the internal and external stakeholders involved.
(a) Directors: The powers of directors to run the company are set out in the company’s
constitution or articles. Under corporate governance best practice there is a distinction
between the roles of executive directors, who are involved full-time in managing the
company, and the non-executive directors, who primarily focus on monitoring. However
under company law in most jurisdictions the legal duties of directors apply to both executive
and non-executive directors.
(b) Employees play a vital role in an organisation in the implementation of strategy; they
need to comply with the corporate governance systems in place and adopt appropriate
culture. Their commitment to the job may be considerable involving changes when taking the
job (moving house), dependency if in the job for a long time (not just financial but in utilising
skills that may not be portable elsewhere) and fulfilment as a human being (developing a
career, entering relationships).
(c) Suppliers. Major suppliers will often be key stakeholders, particularly in businesses
where material costs and quality are significant. Supplier co-operation is also important if
organisations are trying to improve their management of assets by keeping inventory levels
to a minimum; they will need to rely on suppliers for reliability of delivery. If the relationship
with suppliers deteriorates because of a poor payment record, suppliers can limit or withdraw
credit and charge higher rates of interest. They can also reduce their level of service, or
even switch to supplying competitors.
(d) Customers have increasingly high expectations of the goods and services they buy, both
from the private and public sectors. These include not just low costs, but value for money,
quality and service support. In theory, if consumers are not happy with their purchases, they
will take their business elsewhere next time. With increasingly competitive markets,
consumers are able to exercise increasing levels of power over companies as individuals.
(e) External auditors. The external audit is one of the most important corporate governance
procedures; it enables investors to have much greater confidence in the information that
their agents, the directors/managers are supplying. However, the main focus of the external
audit is on giving assurance that the accounts give a true and fair view. Because of the
significance of the external audit, the external auditors must be independent.
(f) Regulators. A key interest of regulators in corporate governance is maintaining
shareholders stakeholder confidence in the information with which they are being provided.
Section 1 Lecture example 5: exam standard question: Answer




Decline in profitability
Lack of disclosures in annual accounts
Fall in share price
Adverse commentary by analysts
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APPENDIX 2: Answers to lecture examples


Change in business environment
Change in key personnel
Section 1 Lecture example 6: exam standard question: Answer
Monitoring systems
Increase numbers of Non-Executive Directors (NEDs)
Request formation of committees
Employ consultants
Attend AGM and question board
Controls
Performance related pay
Bonuses
Share options
Section 2 – Lecture Example 1: Class Exercise/Discussion: Principles or rules
(a) The company will have to comply with the US rules or face fines, delisting and director
prosecutions. The rules will therefore establish a bare-minimum that the company will have
to achieve.
(b) The company must comply with the principles of the European system, or explain why
not. If there is a conflict between the US rules and European principles then they will comply
with the US rules using this as an explanation for their departure from the principles.
(c) If the European principles go further than the US rules (without contradicting them) the
company may be encouraged by their European investors to apply the European principles.
(d) A company listed in both the US and Europe is likely to be very highly regarded by
investors since it will have a basic guaranteed level of corporate governance established by
Sarbanes Oxley, supplemented by the principles of (for example) the UK’s Corporate
Governance Code.
Section 2 – Lecture Example 2: OECD goals
For
The benefits of international codes of corporate governance include
(a) It provides a standardised approach helping multi-national companies to enforce
consistent codes across their operations.
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APPENDIX 2: Answers to lecture examples
(b) It gives investors the understanding and confidence to invest in global capital markets.
(c) It makes it easier for countries to implement corporate governance codes since they are
not having to produce their own codes from scratch.
(d) It ensures a minimum level of corporate governance.
Against
A number of problems have been identified with international codes of corporate
governance.
(a) International principles represent a lowest common denominator of general, fairly banal
and meaningless principles.
(b) Any attempt to strengthen the principles will be extremely difficult because of global
differences in legal structures, financial systems and structures of corporate ownership,
culture and economic factors.
(c) As international guidance has to be based on best practice in a number of regimes,
development will always lag behind changes in the most advanced regimes.
(d) The codes have no legislative power.
Section 2 – Lecture Example 4: Exam question
How may the independence of the company secretary be safeguarded?
(4 marks)
Suggested Answer
In order to expect impartial advice from the company secretary, boards should ensure that
the secretary is in a position to be impartial.
As an officer, he or she should report through the chairman to the board as a whole in
respect of the duties as secretary to the company.
Where the person concerned holds any additional executive responsibilities, then he or she
should report to the chief executive or appropriate executive directors on such matters.
The secretary’s remuneration should be settled (or at least noted) by the board as a whole or
by the remuneration committee on the recommendation of the chairman or chief executive.
Examiner’s comments
This was often poorly answered. Far too many candidates confused the independence of the
secretary with the criteria for an independent NED – some of which criteria would be absurd
for an officer who is often an employee of the company. The best candidates raised the
issue of the secretary who is also a director
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Section 2:Lecture example 5: Exam question Company Secretary
You are professionally qualified and the company secretary of a large private company. Its
strategic plans expect to introduce outside capital within the next three years, either by listing
on a major stock exchange or bringing in major outside investors. The directors are aware
that UK private companies are no longer required to employ a professionally qualified
company secretary.
The Chairman and Managing Director have failed to inform you of various executive and
committee meetings. They have also been transferring some of the traditional
responsibilities of the company secretary to clerical staff elsewhere in the organisation.
Given these changes, you are concerned that the board may remove you as company
secretary.
Required
What would you do to try to convince the board that it is in the interest of the
company to continue to retain you? In answering this question, you should consider
what the key attributes of a company secretary are, the contribution that the secretary
makes to the governance of the company and why it should be a professionally
qualified company secretary that performs these roles.
(25 marks)
SUGGESTED ANSWER
Key attributes a company secretary must possess include:
• Domain expertise
• Broad based knowledge
• Specialised training in essential laws and regulations with which the company needs to
comply
• Sufficient character and presence to be able to work alongside board members
• Ability to advise board of directors
• A mediator at meetings
• A record/minute keeper
Key role of company secretary:
• stems from statutory, contractual and common law obligations
• acts as the coordinator of information flow in the company
• responsible for keeping and maintaining the requisite records of the company
• coordinating the preparation of calling all meetings, including the AGM • usually also the
secretary of various board committees and so is privy to much information
• involved in preparation of annual reports
• coordinate between external auditors, internal audit and audit committee
• compliance with requisite disclosure of the company and ensuring compliance with all
licence and regulatory requirements required by government authorities
• oversee the company's insurance requirements to ensure that the company and its officers
are adequately protected
Corporate Governance role of the Company Secretary
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APPENDIX 2: Answers to lecture examples
• Ensuring the smooth running of the board's and board committees' activities by helping the
chairman to set agendas, preparing papers and presenting papers to the board and board
committees, advising on board procedures and ensuring the board follows them.
• Keeping under close review all legislative, regulatory and corporate governance
developments that might affect the Company's operations, and ensuring the board is fully
briefed on these and that it has regard to them when taking decisions.
• Ensuring that the concept of stakeholders (particularly employees - see Companies Act
2006) is in the board's mind when important business decisions are being taken.
Keeping in touch with the debate on Corporate Social Responsibility and stakeholders, and
monitoring all developments in this area and advising the board in relation to its policy and
practices with regard to Corporate Social Responsibility and its reporting on that matter.
• To act as a confidential sounding board to the chairman, non-executive Directors and
executive Directors on points that may concern them, and to take a lead role in managing
difficult inter-personal issues on the board e.g. the exit of the Directors from the business.
• To act as an additional enquiring voice in relation to board decisions which particularly
affect the Company, drawing on his/her experience and knowledge of the practical aspects
of management including law, tax and business finance.
• To act as the "Conscience of the Company".
• To ensure, where applicable, that the standards and/or disclosures required by the UK
Governance Code annexed to the UK Listing Rules are observed and, where required,
reflected in the Annual Report of the Directors - the Secretary usually takes the lead role in
drafting the Annual Report, including the Remuneration disclosures and agreeing these with
the board and board committees.
• Compliance with the continuing obligations of the Listing Rules e.g. ensuring publications
and dissemination of Report and Accounts and interim reports within the periods laid down in
the Listing Rules; dissemination of Regulatory News Announcements such as Trading
Statements to the market; ensuring that proper notification is made of Directors' dealings
and the acquisition of interests in the Company's incentive arrangements.
• Managing relations with investors, particularly institutional investors, with regard to
corporate governance issues and the board's practices in relation to corporate governance.
• To induct new Directors into the business and their roles and responsibilities.
• As regards offences under the Financial Services and Markets Act 2000(e.g. s395),
ensuring that the board is fully aware of its responsibility to ensure that it does not mislead
the market by putting out or allowing the release of misleading information about its financial
performance or trading condition, or by omitting to state information which it should state, or
by engaging in a course of conduct which could amount to misleading the market.
• Ensuring compliance with all statutory filings Annual Returns, filing of resolutions adopted
at Annual General Meetings/new Articles of Association and any other filings required to be
made with Companies House. Also other statutory obligations such as Data Protection Act
and Credit Licence registration.
• Making arrangements for and managing the whole process of the Annual General Meeting
and establishing, with the board's agreement, the items to be considered at the AGM,
including resolutions dealing with governance type matters, e.g. the vote on the
Remuneration Report and votes on special incentive schemes involving directors.
Information about proxy votes etc.
Is it essential for a professionally qualified company secretary to perform the above
roles?
• Depends on type of company
• Smaller outfits, say a two-person company or an owner-managed one, may be able to do
so.
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• But the big private companies need the expertise for compliance and, especially with plans
for outside investors, an independent person managing the preparations for and recording of
directors and shareholders meetings is strongly preferred by most outside investors.
• Public companies are required by UK law to have a properly qualified secretary; those
quoted on stock markets are also expected to comply, or to justify and explain noncompliance, with good corporate governance practice, in which a well-qualified company
secretary is both recommended good practice and of great help in ensuring compliance
generally.
The various duties already outlined are most effectively performed by someone with proper
training to identify which laws, regulations and codes apply, understand these requirements
and to assist the board in ensuring compliance for the benefit of the company, its reputation
and its shareholders.
Steps that a company secretary could take in the case of the company on the facts
given in the question:
• Realistically, many company secretaries will find it difficult to take much action.
• Check one’s employment contract, especially if appointed directly to the post, rather than
promoted over time informally.
A proactive approach would consider the following options:
• Gently persuade the chairman and management to involve the company secretary;
• Take stock of the situation to ensure that nothing is remiss either with one’s own
performance or within the conduct of the company’s business; if under threat because you
may light upon misdemeanours, consider the possible need for whistleblowing;
• Try to emphasise your value to the company, especially of the role in the light of plans for
future external investment.
• The UK Governance Code does not yet apply to this company as it is at present a private
company. However, it will apply if the Company lists in the future, and best practice requires
all the board to be involved in appointment and dismissal of secretary
Section 3 – Lecture Example 1: Role of the BOD
(a) Leadership
(b) Independence (an appropriate balance of executive and non-executive directors)
(c) A suitable balance of skills and experience
(d) Diverse backgrounds in order to represent different stakeholder groups.
(e) Integrity, probity and fairness in order to manage any conflicts of interest.
(f) Good communications between members and to stakeholders.
(g) Equal participation in robust discussions.
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Section 3 – Lecture Example 3: Exam standard question: for & against
Advantages of multi-tier boards
(a) The clear and formal separation between the monitors and those being monitored.
(b) The supervisory/policy board has the capacity to be an effective guard against
management inefficiency or worse. Its existence may act as a deterrent to fraud or
irregularity in a similar way to the independent audit.
(c) The supervisory board system should take account of the needs of stakeholders other
than shareholders, specifically employees, who are clearly important stakeholders in
practice.
(d) The system actively encourages transparency within the company, between the boards
and, through the supervisory board, to the employees and the shareholders. It also involves
the shareholders and employees in the supervision and appointment of directors.
Disadvantages of multi-tier boards
(a) Confusion over authority and therefore a lack of accountability can arise with multi-tier
boards. This criticism has been particularly levelled at Japanese companies where the
consequence is allegedly often over-secretive procedures.
(b) The management board may restrict the information passed on to the supervisory board
and the boards may only liaise infrequently.
(c) The supervisory board may not be as independent as would be wished, depending on
how rigorous the appointment procedures are. In addition, members of the supervisory
board can be, indeed are likely to be, shareholder representatives; this could detract from
legal requirements that shareholders don't instruct directors how to manage if the
supervisory board was particularly strong.
Section 3: Lecture Example 4: Who are the duties owed to?
The duties are owed to the company.
The management of a corporation does not owe a fiduciary duty to shareholders to avoid
misusing corporate information for its own benefit - their only duty was to the company.
Section 3 – Lecture Example 5: CEO & Chairman
(1) Separating the roles ensure that there is not a single individual with unfettered power.
The principle that the roles should be separated was established following the frauds carried
out by Robert Maxwell at Mirror Group Newspapers in the early 1990s.
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(2) The CEO can then run the company; the chairman can run the board. Separation of the
roles allows them both to be given suitable focus. The chairman should be looking to the
interests of the shareholders; the CEO is concerned implementing the board’s strategy.
(3) It reflects the reality that both jobs are demanding roles. In particular in large companies
(e.g. FTSE100 companies) it would be too demanding for one person to carry out both
functions.
(4) Having two different people in the role brings two different perspectives, two sets of
experience and skills and therefore improves decision making.
(5) The separation of roles avoids the risk of conflicts of interest. The CEO’s remuneration
will contain performance related bonuses. He may be inclined to take unacceptable risks to
make sure that he earns his bonus.
Accountability to shareholders
(a) The board cannot make the CEO truly accountable for management if it is led by the
CEO.
(b) Separation of the roles means that the board is more able to express its concerns
effectively by providing a joint channel of reporting (the chairman) for the non-executive
directors.
[Note: The UK Cadbury report recommended that if the posts were held by the same
individual, there should be a strong independent element on the board with a recognised
senior member. The UK Higgs report suggested that a senior independent non-executive
director should be appointed who would be available to shareholders who have concerns
that were not resolved through the normal channels. The UK Corporate Governance Code
also suggests that the CEO should not go on to become chairman of the same company. If a
CEO did become chairman, the main risk is that he or she will interfere in matters that are
the responsibility of the new CEO and thus exercise undue influence over him or her]
Section 3 – Lecture Example 6: Class Discussion The effectiveness of NEDS
Independence
Length of service (UK code and King III suggest 9 years)
Cross-directorships
Inflated pay or pay based on financial performance of company
Share options or large shareholding
Family members are employees
Only employment
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Effectiveness
Quality
Experience
Number
Availability
Ways of overcoming problems
Service contracts
Disclosure
Training
Market rates of pay
Induction to organisation
Section 4 – Lecture Example 1: Boardroom Practices
Best practice boardroom behaviour may be characterised by:
• a clear understanding of the role of the board;
• the appropriate deployment of knowledge, skills, experience, and judgment;
• independent thinking;
• the questioning of assumptions and established orthodoxy;
• challenge which is constructive, confident, principled and proportionate;
• rigorous debate;
• a supportive decision-making environment;
• a common vision; and
• the achievement of closure on individual items of board business.
Section 4: lecture example 2: The facilty fee
Basics of the answer

Bill would be considered a shadow director
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



The non-recording of his presence at meetings means the minutes are not a
complete record of the meeting
The allotment of new shares is a misuse of directors powers, they are not being used
for proper purpose, the power to issue shares is for raising capital.
The facility fee is a benefit from a third party, and therefore a bribe. The director
could be removed from office by the other directors or by the shareholders.
The share issue would be valid, but the vote would have to be taken again, the
interested parties would be excluded from the vote.
Full answer (much too detailed to be reproduced in a Corporate Governance exam!)
Bill is a shadow director and therefore will be liable as a properly appointed director
The minutes could be challenged as incomplete records of the meetings
There are two other particular issues that emerge from the problem scenario. The first
relates to the fact that Harry has taken a facility fee from Itt plc and the second relates to the
fact that the board of directors has used its general power to allot shares to pursue the
particular end of assuring the successful takeover of their company.
These issues will be considered in turn below.
(i) Harry’s facility fee
The rule that directors should not allow a conflict of interest to arise was strictly enforced by
the courts in the United Kingdom and it can be clearly stated that directors were forbidden
from entering into any arrangement which would involve, even the possibility of, a conflict
between their personal interests and the interests of their company. The simplest statement
of the rule
is that directors were not permitted to profit personally from their position without full
disclosure and the prior approval of the company (Regal (Hastings) v Gulliver (1942) and
Boardman v Phipps (1967)).
There can be no clearer instance of a conflict of interest than the situation of a director taking
a bribe. it is a benefit from a third party, Itt plc, to induce Harry to use his influence as a
director to further the merger. As a result he has breached his duty to Gilt Ltd and not only
will he be liable to be dismissed from the board by a simple majority vote but he may also be
required to pay any money received to Gilt Ltd.
(ii) The allotment of shares to Itt plc
Long-standing common law rule that directors’ powers should be used only for the purposes
for which they were conferred.
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This rule is known as the ‘proper purposes doctrine’ and was developed by the courts in
order to ensure that directors use their powers for the purpose for which those powers were
given to them and not for any ulterior or improper purpose. Most of the cases on this point
have related to the exercise by directors of their power to issue new shares in an attempt to
assist or, alternatively to prevent, potential takeover bids for their companies. Thus in
Howard Smith v Ampol Petroleum (1974) directors preferred one takeover bid as opposed to
another, which was supported by the majority shareholding. In order to defeat the bid they
disliked, the directors issued new shares, effectively reducing the existing majority to a
minority holding in the company, incapable of blocking their preferred takeover bid. This was
clearly an abuse of the directors’ powers and a breach of their duty to act bona fide in the
interests of the company (See also Hogg v Cramphorn (1966) and Bamford v Bamford
(1969)).
Another aspect of this general fiduciary duty is that directors must not act in such a way as
will fetter the exercise of their discretion in relation to decisions that affect the operation of
the company. For example, directors might enter into a contractual agreement with some
outsider to use their vote in a particular way at board meetings. Once again, such an
agreement is a clear breach of their fiduciary duty, although it must be recognised that if
directors enter into contract on behalf of the company, which they genuinely consider to be
in the company’s best interests, then they may bind themselves to vote in favour of any
subsequent resolutions necessary to achieve the successful completion of the contract.
Applying the above to the facts of the problem, it is apparent that the board of directors have
used their power to allot shares, not for the primary purpose of raising capital for their
company, but for the ulterior purpose of facilitating the take-over. As a result, although their
exceeding their powers could be ratified by a vote at a subsequent general meeting,
nonetheless without that ratification, May could apply to the court to have the share
allocation declared invalid and Itt plc’s use of those shares to vote in favour of the takeover
bid would also be invalidated. In any subsequent vote to ratify the improper use of the
directors’ powers, Itt plc would not be permitted to vote.
Section 4: Lecture example 3: Exam question: class discussion: succession
planning
How should a board plan for an orderly succession?
(4 marks)
Suggested Answer
Orderly board succession is vital to the stability and success of a company. It is usually the
responsibility of the nominations committee to make recommendations to the board
regarding succession. Any gaps in the skills or experience on the board need to be
identified. The retirement cycle for non-executive directors and any forthcoming retirements
of executive directors should be taken into account. The recruitment process for any
forthcoming vacancy should be rigorous and transparent.
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The key positions on the board of chairman and chief executive are of particular importance.
Ideally, the succession for the CEO should be planned well in advance. The strategic
priorities of the company may suggest that either an external or internal appointment would
be more appropriate. When a new chairman is sought, the out-going chairman should stand
down from the nominations committee, if he/she is currently a member. For both these
posts, sufficient time should be allowed for an orderly handover, without too long an overlap.
If an appointment is likely to be controversial – as, for example, the promotion of the chief
executive to the role of chairman – then it would be wise to consult major shareholders as
part of the process.
Examiner’s comments
Generally well answered, especially by stronger candidates.
Section 4: Lecture example 4: Knowledge question: Goodbye?
A director may leave office in the following ways:

Resignation (written notice may be required)

Not offering himself for re-election when his term of office ends

Failing to be re-elected

Death

Dissolution of the company

Being removed from office

Prolonged absence meaning that director cannot fulfil duties (may be provided in
law or by company constitution)

Being disqualified (by virtue of the constitution or by the court)

Agreed departure, possibly with compensation for loss of office
Section 4: Lecture Example 5: Class discussion: Controversial or not?
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In May 2010 the UK Corporate Governance Code introduced the requirement for directors of
FTSE 350 companies (the biggest listed companies) to face re-election every year. Directors
of smaller listed companies should face re-election every three years.
Reaction to this new provision has been mixed.
For
Sir David Walker, author of the Walker Review into banking governance, welcomed the new
provision would introduce more discipline into boardrooms.
'Provision for annual election of the chairman and other board members should introduce
welcome additional encouragement and discipline to both shareholders and board members
in seeking to promote the best possible long-term performance in the intensely competitive
environment in which so many UK companies now operate.'
Against
However Richard Lambert, director-general of the Confederation of British Industry (CBI)
took the opposite view:
'It could promote a focus on short-term results, make boards less stable and discourage
robust challenges in the boardroom.'
In July 2010 representatives of three institutional shareholders wrote to the Financial Times
stating their opposition to the new provisions. They did not believe that the new provisions
would increase accountability. Instead they claimed the provisions would result in a shortterm culture, with boards being distracted by short-term voting outcomes. They felt the
requirement was detrimental to building long-term relationships with boards, and ran counter
to the Stewardship Code for Institutional Investors. The investors said they would support
boards who gave valid and reasonable explanations for continuing to re-elect directors every
three years.
Section 4: Lecture Example 6: Class discussion Board appraisal: Criteria?
The UK Higgs report suggested a list of the criteria that could be used to appraise the
performance of a board:
(a) Performance against objectives
(b) Contribution to testing and development of strategy and setting of priorities
(c) Contribution to robust and effective risk management
(d) Contribution
responsibilities)
to
development
of
corporate
(e) Appropriate composition of board and committees
(f) Responses to problems or crises
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philosophy
(values,
ethics,
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(g) Are matters reserved for the board the right ones?
(h) Are decisions delegated to managers the right ones?
(i) Internal and external communication
(j) Board fully informed of latest developments
(k) Effectiveness of board committees
(l) Quality of information
(m) Quality of feedback provided to management
(n) Adequacy of board meetings and decision-making
(o) Fulfilling legal requirements
Section 4: Lecture Example 8: Arabella
The correct answer is B - S 52(3) Criminal Justice Act 1993. The securities were not
dealt on a regulated market.
The definition of insider dealing given in Option A is accurate as far as it goes but not
complete. Option C is untrue, and the reason given in Option D is wrong; Arabella's lack of
connection with the company is irrelevant, as she obtained the information from a person
who is connected with it.
Section Extra: Lecture example 1: Revision question LL
Advantages of compliance with Sarbanes-Oxley
Enforcement of key provisions
From Thelma’s viewpoint, adherence to Sarbanes-Oxley means that LL must comply with
certain important features of corporate governance, rather than being allowed to explain
non-compliance. One example is the audit committee. Sarbanes-Oxley requires all listed
companies to establish an audit committee consisting of independent directors, one of whom
should be a financial expert.
Internal controls
Sarbanes-Oxley is stronger than most principles-based codes in requiring accounts to
include an audited assessment of financial reporting controls. Most principles-based codes
require disclosures about risk management and board review, but not assessment of
effectiveness.
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Accountability
Sarbanes-Oxley enforces director accountability by requiring the chief executive and chief
finance officer to provide certification of the appropriateness and fair presentation of the
accounts. If the accounts later have to be restated, these individuals forfeit their bonuses.
Ethics
Sarbanes-Oxley promotes corporate ethics by requiring companies to report on whether they
have adopted a code of ethics for senior financial officers. This should help ensure that the
right ‘tone’ is established at the top of the organisation.
Disadvantages of compliance with Sarbanes-Oxley
Extra bureaucracy
Terrance’s observation that Sarbanes-Oxley has resulted in increased demands appears to
have been borne out in practice, with the US stock markets becoming less popular as a
place for initial public listings. High compliance costs appear to be significant factors in these
decisions.
Costs of multiple compliance
As well as compliance with Sarbanes-Oxley, LL will still need to provide evidence of its
compliance with its own local governance regime. This will involve the company incurring the
costs of compliance with two regimes, without perhaps giving some investors much, if any,
extra assurance.
Over-focus on compliance
The emphasis in the Sarbanes-Oxley regime has been on compliance with all aspects of the
legislation. This can distract companies’ attention from issues that are not closely regulated
by Sarbanes-Oxley, but are important to investors like Elm Lodge bank, such as
improvement in information flows.
Inflexibility
Sarbanes-Oxley requirements do not allow any leeway or judgement in a number of areas,
for example forbidding auditors from carrying out specified non-audit services. A principlesbased regime can emphasise the importance of auditor independence, but leave it to
companies’ audit committees’ judgement on how this may best be achieved.
Section Extra: Lecture example 2: Revision question Ding dong
(a) Build an understanding of the company
The induction programme should ensure that the new director has a sufficient understanding
of the company’s products or services, major risks and board operations. Induction will
help Sam understand the complex environment in which Ding is operating and the nature
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of Ding’s resource markets. It should also help Sam understand why the board is
constituted as a two-tier board, and what that means for the way it operates.
Develop relations with colleagues
Induction should help new directors establish relations with their colleagues by personal
meetings and by setting out how colleagues are expected to work together. It should
prevent early clashes which could permanently damage relationships.
Here it seems that Sam’s relationship with Annette was not established properly at the
start and the fact that their first significant meeting was when Annette admonished Sam may
impair their future relationship. Proper induction could have meant that Sam avoided the
misunderstandings that have led to Annette rebuking him.
Develop relationships with external parties
Induction should give new directors the chance to start developing relations with the key
external stakeholders with whom they will be dealing.
Here it should mean that Sam has an early opportunity to meet Ding’s auditors and
establish how they operate and the significance of differences in auditing practices in
this country compared with the country in which Sam has previously been based. He should
also be introduced to Ding’s main finance providers.
Promote understanding of practices and culture
Induction should also allow new directors to gain an understanding of the company’s
practices and culture, ‘our way of doing things’. This could include how directors conduct
themselves in their dealings with others and practical operating matters.
Early problems have arisen as a result of Sam failing to receive proper induction. An
induction process would have demonstrated to Sam how expectations in dealings with
others differed in this country compared with his previous base, and made it less likely that
he would make an inappropriate remark. He would also have been briefed on the practical
policies with which he must comply, such as the positioning of his desk.
(b) Ceremonial nature of role
Arif’s view that the role of the chairman is ceremonial seriously underestimates its
importance. The chairman should be responsible for overseeing the functioning of the
board. As such he should not simply defer to Annette’s views on board structure. This
means also that the chairman should ensure that the board receives reliable and timely
information and that sufficient time is allowed for discussion of controversial issues. That
does not seem to be happening here and as a result key directors are being excluded from
discussions.
Compliance with corporate governance requirements
Arif’s view of compliance with corporate governance guidance is also misguided. When they
recommend that the roles of chairman and chief executive be split, corporate governance
codes require more than the roles be held by different people. They seek a division of
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responsibilities with the chief executive running the company, but the chairman being able to
hold the chief executive to account and express the concerns of other non-executive directors
and shareholders.
Role of non-executives
Arif’s inability to challenge Annette’s opinions demonstrates that he is ineffective as a
chairman and nonexecutive director. One of the roles of non-executive directors according to
the Higgs report is to contribute to, and challenge, the strategy that the chief executive
and other executives are promoting. As chairman Arif should be taking the lead in this.
Independence of chairman
It seems that Arif’s friendship with Annette was a significant factor in his appointment and he
appears to feel indebted to her. However the expectations of shareholders, whose interests
the chairman represents, is that the chairman should be objective.
Commitment to role
Arif’s view of the level of commitment required as chairman again demonstrates he totally
misunderstands its importance. One reason why governance reports recommend splitting
the roles of chairman and chief executive is that both should be demanding jobs. Arif cannot
effectively be leading the board if he does not attend many of its meetings. His lack of
direct interest in Ding does mean that he will find it difficult to hold Annette to account.
His lack of involvement also may mean that the chairman’s statement that he writes cannot
provide any assurance to shareholders.
Section 5: Lecture example 3: class discussion: Main duties
The Higgs Report 2003 had number of suggestions for good practice concerning the
remuneration committee

Determine and agree with the board the framework or broad policy for the
remuneration of the company’s chief executive, chairman, the executive directors,
the company secretary and other members of the executive management

The policy shall encourage enhanced performance and are, in a fair and responsible
manner, rewarded for their individual contributions to the success of the company

Approve the design of, and determine targets for, any performance related pay
schemes and the total annual payments

Review the design of all share incentive plans for approval by the board and
Shareholders.


Determine the policy for, and scope of, pension arrangements for each executive
director and other senior executives

Ensure that contractual terms on termination, and any payments made, are fair to the
individual, and the company, that failure is not rewarded and that the duty to mitigate
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loss is recognised

In consultation with the chairman and/or chief executive, determine the total
individual remuneration package of each executive director and other senior
executives including bonuses, incentive payments and share options or other share
awards
Have regard to legal requirements, the UK Corporate Governance Code and the UK Listing
Authority’s Listing Rules

review and note annually the remuneration trends across the company or group

Oversee any major changes in employee benefits structures throughout the company
or group


Agree policy for authorising claims for expenses from the chief executive and
Chairman

Ensure that all provisions regarding disclosure of remuneration are fulfilled

Responsible for establishing the selection criteria, selecting, appointing, of any
remuneration consultants

Obtain reliable, up-to-date information about remuneration in other companies.
Annex to lecture example
Who sets the pay of the NEDs….some of them form the remuneration
committee!!

The remuneration of non-executive directors shall be a matter for the chairman and
the executive members of the board (or maybe the shareholders if provided for in the
articles)

No director or manager shall be involved in any decisions as to their own
remuneration
Section 5 Lecture example 4 The benefits of pay
(a) Basic salary will be in accordance with the terms of the directors’ contract of
employment, and is not related to the performance of the company or the director. Instead it
is determined by the experience of the director and what other companies might be prepared
to pay (the market rate).
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(b) Performance related bonuses. Directors may be paid a cash bonus for good (generally
accounting) performance. To guard against excessive pay-outs, some companies impose
limits on bonus plans as a fixed percentage of salary or pay. The measure used may be
wrong or subject to manipulation. Transaction bonuses tend to be much more
controversial. Some chief executives get bonuses for acquisitions, regardless of subsequent
performance, possibly indeed further bonuses for spinning off acquisitions that have not
worked out.
(d) Directors may be awarded shares in the company with limits (a few years) on when they
can be sold in return for good performance. Makes them shareholders! However may not be
an incentive if only allowed to sell years later, or may manipulate results to boost price if
allowed to sell earlier
(e) Share options give directors the right to purchase shares at a specified exercise price
over a specified time period in the future. If the price of the shares rises so that it exceeds
the exercise price by the time the options can be exercised, the directors will be able to
purchase shares at lower than their market value. [The UK Corporate Governance Code
states that non-executive directors should not normally be offered share options, as options
may impact upon their independence.] Underwater options are not an incentive. Liable to
results manipulation and short termism
(f) Benefits in kind could include transport (e.g. a car), health provisions, life assurance,
holidays, expenses and loans. The remuneration committees should consider the benefit to
the director and the cost to the company of the complete package. Also the committee
should consider how the directors’ package relates to the package for employees; ideally
perhaps the package offered to the directors should be an extension of the package applied
to the employees.
(g) Pensions. Many companies may pay pension contributions for directors and staff. In
some cases however, there may be separate schemes available for directors at higher rates
than for employees. The UK Corporate Governance Code states that as a general rule only
basic salary should be pensionable. The Code emphasises that the remuneration committee
should consider the pension consequences and associated costs to the company of basic
salary increases and any other changes in pensionable remuneration, especially for
directors close to retirement. Fred Goodwin of RBS is a good example of problems with
pensions.
Section 5 Lecture example 5: Exam standard question: Bonus schemes for
NEDS?
Top tips: Think about the key issue of independence for NEDs. As long as the features you
suggest do not compromise independence or suggest awarding too generous bonuses you
will be earning marks.
Bonus schemes for non-executive directors (NEDs)
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The design of bonus schemes for NEDs is problematic. If the bonus is too small the NEDs
may not be motivated to do anything more than the minimum required to collect their fees. If
the bonus is too generous they may stop acting in the best interests of shareholders for fear
of incurring the displeasure of the executive directors and thereby jeopardizing their bonus
payments.
A bonus scheme for NEDs will therefore need to include the following features.
(i) It should ensure that high quality and motivated NEDs are recruited, thereby ensuring that
shareholders will benefit from the appointment of the NEDs.
(ii) The bonus should be paid either in cash or in the companies' shares.
(iii) The bonus scheme could be linked to the long-term performance of the company, rather
than simply to the financial performance of the current period. A balanced range of
performance measures such as increase in market share or stock market valuation in
relation to competitors over a certain period of time (depending on the NEDs' length of
contract) and so on should encourage NEDs to take a broader view of corporate
governance.
(iv) It is important that good corporate governance is seen to be maintained. Shareholders'
prior approval of any bonus scheme should be obtained to avoid any impression that NEDs'
bonuses are being offered as a quid pro quo for the executive directors' remuneration.
(v) Any bonus scheme should be designed to provide an incentive for the NED to achieve
specific objectives or complete specific tasks outside his normal duties as a NED. Bonuses
are justified for tasks such as carrying out competitor reviews or designing staff
remuneration schemes, which will enhance the NED's understanding of the business without
compromising his independence.
(vi) Any goal-oriented bonuses should be paid immediately following the work to which they
relate. Rolling up of bonus payments may silence any criticism from the NED as the payment
date approaches.
The UK code should be borne in mind when designing, but remember these are provisions,
so explanations for non-compliance can be given, with all the caveats of the comply or
explain regime. So it is very important that shareholders' prior approval of any bonus
scheme should be obtained.
UK Code Provision 34 The remuneration of non-executive directors should be determined
in accordance with the Articles of Association or, alternatively, by the board. Levels of
remuneration for the chair and all non-executive directors should reflect the time
commitment and responsibilities of the role. Remuneration for all non-executive directors
should not include share options or other performance-related elements.
Section 6 Lecture example 1: Class discussion: Qualitative characteristics
Required:
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Please list the 7 characteristics that accounting information should show to be useful to all
users of the information?
Solution
Relevance: Information that has the ability to influence the economic decisions of users
through its predictive or confirmatory value.
Understandability: Ensures users’ with a reasonable knowledge of business, accounting
and a willingness to study the information provided can perceive the significance of the
information concerned.
Reliability: The information faithfully represents what it purports to represent, being free
from bias and material errors
Completeness: The information should provide a rounded view of the total economic
activities of the reporting entity. This may mean that the report is a highly complex
document.
Objectivity: The information provided should meet all proper users’ needs and be neutral in
that it is not biased towards any particular user group.
Comparability: In addition to providing recent data, similar information from the same entity
from different time periods or from other entities for the same time period should also be
provided.
Timeliness: Publication of the accounting disclosure should be reasonably soon after the
financial year-end so as to give meaningful new information that is “up to date” and useful for
making economic decisions.
Section 6 Lecture example 2: Class discussion: stakeholders and financial
statements
Financial statements are intended to be understandable by readers who have "a reasonable
knowledge of business and economic activities and accounting and who are willing to study
the information"
Financial statements may be used by stakeholding groups for different purposes:
Directors require financial statements to make strategic business decisions that affect its
continued operations. Financial analysis is then performed on these statements to provide
management with a more detailed understanding.
Directors remuneration may also be determined by the figures
Employees also need these reports in wage negotiations and promotion prospects. Also to
provide reassurance concerning job security and rankings.
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Prospective investors make use of financial statements to assess the viability of investing in
a business. Financial analysis is often used by investors, thus providing them with the basis
for making investment decisions.
Financial institutions (banks and other lending companies) use them to decide whether to
grant a company with fresh working capital or extend debt securities (such as a long-term
bank loan or debentures)
Government and tax authorities require financial statements to ascertain the amount of taxes
and other duties declared and paid by a company.
Vendors who extend credit to a business require financial statements to assess the
creditworthiness of the business.
Media and the general public are also interested in financial statements.
Section 6 Lecture example 4: Exam standard question: worldwide minerals
Transparency and its importance at WM
Define transparency
Transparency is one of the underlying principles of corporate governance. As such, it is one
of the ‘building blocks’ that underpin a sound system of governance. In particular,
transparency is required in the agency relationship. In terms of definition, transparency
means openness (say, of discussions), clarity, lack of withholding of relevant information
unless necessary and a default position of information provision rather than concealment.
This is particularly important in financial reporting, as this is the primary source of information
that investors have for making effective investment decisions.
Evaluation of importance of transparency
There are a number of benefits of transparency. For instance, it is part of gaining trust with
investors and state authorities (e.g. tax people). Transparency provides access for investors
and other stakeholders to company information thereby dispelling suspicion and
underpinning market confidence in the company through truthful and fair reporting. It also
helps to manage stakeholder claims and reduces the stresses caused by stakeholders (e.g.
trade unions) for whom information provision is important. Reasons for
secrecy/confidentiality include the fact that it may be necessary to keep strategy discussions
secret from competitors. Internal issues may be private to individuals, thus justifying
confidentiality. Finally, free (secret or confidential) discussion often has to take place before
an agreed position is announced (cabinet government approach).
Reference to case
At Worldwide Minerals, transparency as a principle is needed to deal with the discussion of
concealment. Should a discussion of possible concealment even be taking place? Truthful,
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APPENDIX 2: Answers to lecture examples
accurate and timely reporting underpins investor confidence in all capital-funded companies
including WM. The issue of the overestimation of the mallerite reserve is clearly a matter of
concern to shareholders and so is an example of where a default assumption of
transparency would be appropriate.
Section 6 lecture example 5 Auditors duty owed to………….????
The House of Lords decided that no duty was owed at all, either to existing shareholders or
to future investors by a negligent auditor. The purpose of the statutory requirement for an
audit of public companies under the Companies Act 1985 was the making of a report to
enable shareholders to exercise their class rights in general meeting. It did not extend to the
provision of information to assist shareholders in the making of decisions as to future
investment in the company.
Therefore the defendants owed no duty of care to potential investors in the company who
might acquire shares in the company on the basis of the audited accounts.
The lords also suggested that although it was not necessary to decide the matter, it would
seem unlikely that shareholders independently would have any right of action against the
auditors for negligently prepared accounts even if they chose to dispose of their shares on
the basis of those accounts. The company itself would have a right of action for any loss it
suffered as a result of those accounts being negligently prepared.
Section 6 lecture example 7: Threats
(a) Advocacy threat but also possibly self-interest. The reference could be biased to help
the client to get the funding. The reference could be externally reviewed or the relationship
disclosed to the bank (which presumably they realise already).
(b) Intimidation threat and also self-interest. The present audit and future audits may be
‘soft’ to keep client happy or superficial to save costs and so allow a competitive fee to be
charged. Stay with original audit plan and give clear account for time spent to client.
Consider review of audit plan for next year.
(c) Self-review threat: if it can be shown that there is not proper independence from the
consulting division. Check independence or decline request.
(d) Self-interest threat: the partner and their staff should be excluded from the audit
process and not allowed to see the papers or report.
(e) Familiarity threat: however this does not appear to be a significant problem (assuming
the Managing Partner has no connection with the audit) for now, so no action needed.
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Section 6 lecture example 8: Neirum engineering
(a) (i) Role and responsibilities
Monitoring accounts
One of the main roles of the audit committee is to monitor the integrity of the financial
statements of the company. This will mean that the audit committee should review the
significant financial reporting issues and judgements made in connection with the
preparation of the financial statements that are prepared by the company. The audit
committee should also review the clarity and completeness of disclosures in the financial
statements.
Review of control systems
The audit committee should review the company's internal financial control system and,
unless addressed by a separate risk committee or by the board itself, risk management
systems. The audit committee should assess the scope and effectiveness of the systems
established by management to identify, assess, manage and monitor financial and nonfinancial risks.
Whistleblowing arrangements
The audit committee should review arrangements by which staff of the company may, in
confidence, raise concerns (whistleblow) about possible improprieties in matters of financial
reporting, financial control or any other matters.
Monitoring internal audit
The audit committee also has responsibilities for the internal audit function and should
monitor and review the effectiveness of the company's internal audit function. If there is no
internal audit function, the audit committee should consider whether there is a need for one
each year and make recommendations to the board.
Maintaining relations with external auditors
In general terms the audit committee is responsible for overseeing the company's relations
with the external auditor. The audit committee has primary responsibility for making
recommendations on the appointment, reappointment and removal of the external auditors.
The audit committee should assess the qualification, expertise, resources, effectiveness and
independence of the external auditors annually. The audit committee should approve the
terms of engagement and the remuneration to be paid to the external auditor. The audit
committee should also recommend to the board the policy in relation to the provision of nonaudit services by the external auditor, to ensure that the provision of such services does not
impair the external auditor's independence or objectivity.
(ii) Knowledge of company and its environment
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All new audit committee members should be given an induction programme and all
members should receive training on an ongoing basis.
Independence
Corporate governance reports such as the UK Corporate Governance Code require all
members of the audit committee to be independent non-executive directors.
Independence means having no financial or other connection with the company other than
receiving directors' fees and possibly owning shares. The UK Corporate Governance Code
suggests that non-executive directors may not be independent if during the last three years
they have had a material business relationship with the company, so this suggests Ken may
not be considered independent
Financial experience
Ken does not need to have an accountancy qualification to serve on an audit committee.
Governance reports require that at least one member of the audit committee should have
significant, recent and relevant financial experience, for example as an auditor or finance
director of a listed company. Ideally this person should have a relevant professional
qualification.
Financial literacy
However given the role and responsibilities of the audit committee, governance reports
suggest there is a need for some degree of financial literacy amongst the other members
of the audit committee.
This will vary according to the nature of the company. Ken’s experience as Managing
Director should mean he has probably has sufficient knowledge to fulfil this requirement, but
would not have enough knowledge to be the chairman. This may be more of a problem if
Nerium is involved in significant specialist financial activities.
Overview of business
Individual members of the audit committee should have an overview of the company's
business and be able to identify the main business and financial dynamics and risks.
Clearly Ken would have the requisite knowledge as Managing Director of an engineering
company.
(b)Performance measures
A performance measure should follow a number of basic principles.
Link with strategy
The measure should be clearly linked to the strategic goals of the company.
Individual performance
A performance measure for an individual should, as far as possible, reflect the contribution
of that individual to achieving the performance.
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Interests of shareholders
The performance measure should be identifiable with the interests of shareholders and
the wider stakeholder community.
Flexibility
The measure should require the minimum of adjustment to ensure consistency in the light
of any strategic and operational changes that occur.
Difficult to distort
The measure should not be able to be manipulated easily, nor should there be incentive or
opportunity to manipulate it. Possibly manipulation is less likely if the performance measure
is one of a number of different qualitative and quantitative, financial and non-financial
measures, a sort of balanced scorecard.
Section 7 Lecture example 1: What are the advantages of electronic
communication?
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

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

offer substantial savings on print and postage costs
provide security by reducing postal interception and lost documentation
are environmentally friendly because of reduced paper volumes
allow for more targeted and tailored communications
give shareholders choice to suit their requirements
now deemed best practice.
Section 8 Lecture example 3 : Internal control risks
Financial risks
Error or fraud in accounting systems leading to incorrect reporting
Loss of financial assets
Exposure to interest rate fluctuations/ currency exchange rate fluctuations
Incorrect pricing of goods
Poor invoicing credit control
Operational risks
Security access to buildings resulting in loss of assets / damage
Computer systems failure resulting in loss of data
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Loss of company confidential information
Compliance risks
Lack of compliance with law and regulation
Fines, legal action from stakeholders
Section 8: lecture example 4: Internal Controls at M&S
(a) Shareholders want to ensure that their investment is protected. The benefit of internal
controls for them is that they will reduce the incidence of fraud and error. Controls will also
manage risks faced by the company thus reducing the overall risk faced by investors.
However controls cost money to design, implement and monitor and this will reduce the
value of the shareholders’ investment. They therefore want an appropriate balance of
controls, so more controls over high risk areas and fewer over areas where they are less
exposed.
(b) Debt providers want to protect the capital they have put into the company and to receive
interest. They will want to make sure that controls are adequate to protect their investment.
They will be less concerned with controls being costly unless the cost is so great as to put
the whole company at risk and thereby expose any creditors to risk.
(c) Employees are concerned about job security so will want to see controls that are
adequate to protect the future of the company. Employees were particularly badly affected
by the Mirror Group corporate failure where Robert Maxwell misappropriated pension funds.
Employees are therefore concerned to see adequate controls over their pension funds. They
also have a stake in the reputation of the company and therefore in how reputation risk is
managed. Employees have to operate controls and will therefore not want them to add an
unnecessary burden to their work. They will want controls that protect them against any
perceived threats.
(d)Customers will want to their dealings with the company to be pleasant and hassle free.
They will be unhappy about controls that are overly intrusive (M&S traditionally had a
reputation for no quibbling over returns and gained Christmas sales from people buying
presents that could be returned.) On the other hand customers will want to be assured of the
safety (and recently the ethical provenance) of the products they are buying and will expect
adequate controls in this area.
(e) Government, regulatory and other bodies will want to assure that adequate controls exist
to cover statutory compliance. They may audit this themselves (VAT and PAYE compliance)
or respond when there is a breach (health and safety).
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Section 8 lecture example 5: M&S purchase….
Controls over the purchase of an overseas subsidiary
(a) There should be full and frank discussion about the potential acquisition in full board
meetings
(b) NEDs should take particular steps to satisfy themselves about the business case for
acquiring the subsidiary
(c) The NEDs may wish to discuss the potential acquisition without the presence of the
executive directors. The chairman should ensure that all their views are communicated to
the full board.
(d) The decision to make the purchase should be approved by the whole board of directors
and recorded in the board minutes.
(e) Due diligence checks should be carried out on the company to be acquired. This could
be done by independent consultants not involved in the transaction in any other way.
(f) There could be separation between the person driving the strategic decision to make the
purchase and the person negotiating the purchase.
(g) The person selected to run the newly acquired subsidiary should be selected by the
Nomination Committee.
The controls would need to ensure that the decision to make the purchase was made in the
best interests of (in the example M&S’s) shareholders. This would mean the most
independent and careful scrutiny of the decision possible.
Once the proposal was to proceed, controls would be needed to ensure that the company
did not pay too much for the acquisition, hence the due diligence work.
Section 8 lecture example 7 : Arlo
Possible difficulties include:

Cultural difficulties; management structures and attitudes may differ in the overseas
supplier, also attitudes to quality

Arlo plc does not have direct control over the suppliers’ workers as they are
employed by the supplier

Quality review; does Arlo plc incur costs through sending its own staff out to review
the supplier’s activities, or does it rely on the quality procedures operated by its
supplier

Communication problems; the supplier may be unwilling to give Arlo plc bad news
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Section 9 Lecture example 1: risk
(a) The personal views and influence of Mr X will have determined AAA's attitude to risk and
he is an entrepreneur who is willing to take risks. SSS has shareholders who would punish a
board that took too many risks and had too many failed business ventures. The SSS board
members will be cautious, in order to ensure they remain on the board.
(b) Different shareholder requirements. AAA’s shareholders are obviously risk seeking
because they know and support Mr X. SSS’s shareholders, by purchasing railroad stock,
have shown a preference for an established industry.
(c) Organisational influences. AAA is smaller and it has diverse businesses. It has a history
of growth by trial and error. Risk taking is in its culture and reflected in its lack of control
systems.
(d) Cultural influences. AAA has been characterised by an individualist culture based on Mr
X. SSS is more likely to operate a hierarchist culture.
(e) National influences. SSS is subject to strict US codes on corporate governance and
internal control.
Section 9 Lecture example 2: daily risks

Changing business environment e.g. PEST factors/5 forces

Individual employees at all levels making decisions

Control failures/bypassed

Unexpected hazards

Reasons to embrace more risk?

Greater demands from stakeholders (customers, suppliers and shareholders)

Market environment becoming more competitive
Section 9 Lecture example 3: Stakeholders reaction to M&S taking risks
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(a) Shareholders are not necessarily risk averse, but they will expect higher returns from
high risk companies. They may well have acquired their shares to fit into a balanced
portfolio. They will be concerned if there is an unexpected change in the company’s risk
appetite and may choose to invest elsewhere. Many of M&S’s small private investors do so
out of loyalty and might be expected to prefer a low risk investment. The second biggest
investor is Legal & General who will hold M&S shares as part of a balanced portfolio.
(b) Debt providers are most concerned about the risk of non-payment and they can take
various actions with potentially serious consequences such as:

Denial of credit

Higher interest charges,

Applying restrictive covenants

Requiring security (e.g. mortgage)

Putting the company into liquidation.
(c) Employees will be concerned about threats to their job prospects (money, promotion,
benefits and satisfaction) and ultimately threats to the jobs themselves. The variety of
actions employees can take include:

Pursuing of their own goals rather than shareholder interests

Industrial action

Refusal to co-operate

Resignation
(d) Customers will be concerned with threats to their getting the goods or services that they
have been promised, or not getting the value from the goods or services that they expect.
The risk to the firm is that they could take their business elsewhere. M&S built its reputation
as a good value brand and suffered in the 1990s when there was a perceived fall in quality.
(e) Governments, regulatory and other bodies will be particularly concerned with risks
that the organisation does not act as a good corporate citizen, implementing for example,
poor employment or environmental policies. A number of the variety of actions that can be
taken could have serious consequences.
(f) Government can impose tax increases or regulation or take legal action. Pressure
groups tactics can include publicity, direct action, sabotage or pressure on government or
other stakeholders.
Section 9 Lecture example 4: Class discussion: Embedding risk
Training
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APPENDIX 2: Answers to lecture examples
Workshops
Monitoring
Shadowing
Ethical codes
Good leadership
Set up compliance/risk management department
Build risk identification into job descriptions
Create risk register
Section 9: Lecture example 4a) Sources of risk
ICSA suggest the following are sources of risk, give an example under each source.
Reputation risk. Reputation lies with the organisations stakeholders, so any other risk
occurring may damage that reputation. The risk of loss in customer loyalty or customer
support following an event that damages the company’s reputation.
Competition risk. The risk that business performance will differ from expected performance
because of actions taken (or not taken) by business rivals.
Business environment risks. These are risks of significant changes in the business
environment from political and regulatory factors, economic factors, social and
environmental factors and technology factors.
Risks from external events. These are risks that financial conditions may change, with
adverse changes in interest rates or exchange rates.
Liquidity risk. This is the risk that the company will have insufficient ready cash to settle all
its liabilities on time, and so may be declared insolvent and forced into winding up. The
board of directors should monitor this risk at least annually when they prepare the going
concern statement for the annual report and accounts
Section 9: Lecture example 5 : class discussion: strategic risks

Lack of investment in IT (Technology)

Product failure/recall (Product)

Lack of availability of staff (Resources)

Fall in share price (Investment)

Adverse PR/press (Reputation)
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
New entrant (Competition)

Failed project (Product/Competition/Reputation/Investment/Technology/Product)
Section 9: lecture example 6: Types of risk
Currency risk: Exposure to adverse movements in exchange rates making sales less
valuable or increasing costs.
Credit risk Lack of necessary assets/reputation to obtain financing.
Environmental risk: Risk of damaging environment through business activities.
Probity risk: Risk of dishonest or unethical behaviour in an organisation
Knowledge management risk: Loss or lack of access to necessary information.
Outsourcing risk: Lock in to unsuitable supplier
Section 9: Lecture example 7: Disaster
Define the key elements of a disaster recovery plan.
(8 marks)
Suggested answer
Disaster recovery plans
The purpose of a disaster recovery plan is to have a plan of action in the event of an
extreme disaster that is unconnected with the business of the company and is outside the
control of management.
The main components of a disaster recovery plan may include:
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Specification of essential operations in the business that must be maintained.
Identification of computers or networks to which the IT system can be transferred in the
event of damage to the main system.
Specification of a location that operations could be transferred to in the event of access
not being available to the usual location.
Identification of key personnel who are needed to maintain operations.
Identification of an executive to be responsible for dealing with any press/media
attention.
Disaster recovery plans should be constantly maintained and should develop with a
business. They should be reviewed at least annually as part of the review of the
effectiveness of internal controls undertaken by the audit committee or board as part of an
organisation’s risk management processes.
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Section 9: lecture example 8: risk committee
Executive directors

Knowledge of company

Risk – key concern

Remuneration can be linked to risk management

Supports strategic planning
Non-executive directors

Independence/objectivity

External experience

No financial gains linked to decision
Section 9: lecture example 9: Doctors Practice
(a) Additional risks
A number of additional risks arise from the introduction of the new facility, including the
following.
Operational risks
(1) Surgical equipment failure
The practice may face threats to its income through failures of its surgical equipment,
meaning that it cannot provide surgical procedures whilst the equipment is unavailable.
(2) Storage facilities failure
Environmental failures in the storage facilities for equipment and drugs may also lead to a
loss of income if surgical procedures cannot be provided. The practice may also face the
costs of replacing the equipment and drugs that have been contaminated.
(3) Security
The additional equipment and drugs stored may make the practice more vulnerable to theft.
(4) Transportation risks
The blood and samples taken may be contaminated by storage facilities problems at the
surgery, and also by deterioration during transportation. This may result in misdiagnosis of
illness and hence the costs of giving patients the wrong treatment.
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(5) High demand
High demand at certain times of the year may mean that the practice loses income through
being unable to meet the demand, or incurs increased costs through having to pay for extra
medical and nursing care.
You would also have scored marks if you discussed the following operational risks.
(1) Hospital delays
The practice may lose income through not being able to provide care because of delays in
testing blood and samples at the local hospital.
(2) Staff
Existing staff may not have the collective skills necessary to operate the new unit. If new
staff are employed, there may be a risk of staff dissatisfaction and hence retention problems
with existing staff if new staff are employed on better terms.
(3) Effect on existing care
The resources required by the new facilities may mean less resources are available for
existing work; hence the areas of care currently provided may suffer and income from these
be threatened.
Legal risks
Providing more procedures may increase the risk of problems arising during treatment, and
hence losses through the costs of fighting or settling negligence claims.
Regulatory risks
If shortcomings arise in the treatment provided, the practice's regulatory body may intervene
and prevent the practice providing the surgical procedures it currently wishes to offer.
Financial risks
The new facilities will have to be financed. The practice may face problems in meeting any
finance costs that it has to incur, particularly if the return on investment is not as good as
forecast. Financing the investment may mean funds are lacking when required for other
purposes, such as buying out a retiring partner.
Reputation risks
The practice may not achieve the income growth expected if the standard of treatment is
believed to be lower than would be available in the hospital, or if because of operational
difficulties patients were forced to wait longer for treatment than they would in a hospital.
(b) Risk appetite
Risk appetite is the amount of risk that the practice is prepared to accept in exchange for
returns (the clientele effect). The new arrangements here are expected to increase income,
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and the risk appetite defines what risk levels will be acceptable in exchange for the
increased income. Risk appetite also infers that the practice is willing to accept that risk has
a downside as well as an upside, and the consequences of both are culturally acceptable.
Risk appetite decisions
In this situation, one of the senior partners in the practice would act as the risk manager and
be responsible for analysing risk and recommending what acceptable risk levels might be
in the changed circumstances for each of the major risks. However as the decision results
from a major change in practices, the recommendations should certainly be approved by a
majority of the doctors, and preferably be unanimous.
The practice may also have to act within constraints imposed by government or regulator,
which effectively limit the maximum amount of risk the practice can bear.
Section 10 Lecture example 1: statements
(a) Philanthropic
(b) Economic
(c) Philanthropic
Section 10 Lecture example 2: problems with stakeholders
4 points from the following: 2 marks a point made and explained
(a) Collaborating with stakeholders may be time-consuming and expensive.
(b) There may be culture clashes between the company and certain groups of
stakeholders, or between the values of different groups of stakeholders with companies
caught in the middle.
(c) There may be conflict between company and stakeholders on certain issues when
they are trying to collaborate on other issues.
(d) Consensus between different groups of stakeholders may be difficult or impossible to
achieve, and the solution may not be economically or strategically desirable.
(e) Influential stakeholders' independence (and hence ability to provide necessary criticism)
may be compromised if they become too closely involved with companies.
(f) Dealing with certain stakeholders (e.g. public sector organisations) may be complicated
by their being accountable in turn to the wider public.
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Section 10 lecture example 3: related to lecture example 2: a different angle!
Business case for CSR
– Builds reputation
– Attracts investors/employees/customers
– Can be a source of competitive advantage
– Can tie into branding
– Pre-empts legislation
– Unregulated therefore easy to incorporate
Business case against CSR
Organisations are responsible to shareholders CSR is 'stealing' their funds
– Benefits do not outweigh costs
– Time consuming
– Seen as PR only (many stakeholders will be cynical)
Section 10 Lecture example 4: which view?
This provision has been the subject of some debate. One view is that the key phrase is
benefit of its members, implying a limited view of citizenship. However some critics have
argued that the section lists so many factors to consider that it effectively implies an
equivalent view.
Section 10: Lecture example 7: The Triple bottom line
People – Employee benefits
Charitable donations
Planet – Waste management
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Profit – Benefits brought to local community for example via education schemes, community
projects
Section 10: Lecture example 8: Benefits
– Good PR
– Credibility
– Receive advice and support
End of lecture example answers
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