Chapter 6 G o v e r n ac e (Shareholders Portion) Organization Share Holders (B1) Stake Holders (B2) Introduction Agency Theory Board of Directors Stakeholder Mapping Model by Mendelow Corporate CSR Governance Reporting to Stakeholders: Integrated Reporting Environment and Social Reporting EMAS & ISO 14000 Public Sector Governance Agency Theory Agency Theory ‘Agency’ occurs when one party (Principal) employs another party (Agent) to perform a task on their behalf. In most companies, there is separation of ownership and control. Shareholders own the company and directors run the company on behalf of the shareholders. Principal: Shareholders (as they are owners of the company) Agent: Directors (as they run the company on behalf of the shareholders) Page 1 Problems With Agency Arrangement Conflict of interest (covered below) Oversight (e.g. directors maybe negligent or miss something) Lack of integrity and honesty (e.g. directors doing frauds) Lack of transparency (e.g. inaccurate reporting) Ethical violations (e.g. directors may deviate from the values and ethics of the shareholders) Conflict of Interest Directors have a fiduciary duty to act in the best interests of shareholders. ‘Conflict of interest’ means that director’s ‘personal’ interest surpasses the interest of the shareholders, i.e. directors lose their independence, integrity and objectivity. Directors must solely work for the best interest of shareholders and avoid their personal interest at all times (or disclose). E.g. of conflict of interest include: Sub-contracting company’s work to close family members Focusing on short term profit to maximize their own bonus for the year Negotiating high / unjustified remunerations Accepting any personal benefit from third party Fiduciary Duty and Accountability Fiduciary Duty: Fiduciary duty means duty of utmost good faith towards the principal. This means that directors should act in the best interest of shareholders and avoid any conflict of interest (or disclose). This duty can be legal or ethical. Accountability: The agent is fully accountable to the principal. Directors, individually and collectively, have a duty under corporate governance to run the company in the best interest of the shareholders and to be held accountable of the results and outcomes. . Directors can be held accountable in following ways: Scrutiny of their performance by NEDs Linking directors’ remuneration with performance Non-appointment of director upon completion of tenure Page 2 Costs of Agency Agency cost is a cost incurred by the Principal (shareholders) to monitor the Agents (directors). Agency cost can be classified in two categories: Monitoring cost (e.g. remuneration of directors, cost of monitoring, audits, attending AGMs, NEDs, etc.) Residual loss (cost beyond remuneration of directors, e.g. where there is conflict of interest by directors leading to a loss to business / shareholders) Board of Directors Introduction Every company is led by a Board of Directors, which is collectively responsible for achieving the objectives and long-term success of the company. The board should have appropriate Size Knowledge, Skills and Experience KISSE(D) Independence Executive Directors are full time employees of the company. Non-Executive Directors (NED) are part-time outside directors ‘independent’ of the company i.e. they are not employee of the company. Functions of the Board of Directors Overall the Board has to act in the best interest of the shareholders, which includes: Maximize shareholder wealth Provide entrepreneurial leadership and strategic management Monitor business performance Monitor performance of CEO and management team Establish effective risk management process Ensure that effective internal controls and financial accounting / reporting systems are in place Safeguard company assets Ensuring legal compliance Page 3 Communication with shareholders and stakeholders Take major decisions such as borrowing, lending, fixed assets, financing, major projects, etc. Duties of Individual Directors Fiduciary duty and accountability Avoid conflict of interest Remain within the powers given by the Board & Articles of Association Treat all shareholders equally Principles of professional ethics Integrity Objectivity Professional competence and due care Confidentiality Professional behavior Communication & Disclosure with Shareholders Following are the general principles which the Board of Directors should follow in communication and disclosures to their shareholders: Completeness: Provide complete picture, disclosures should meet minimum statutory obligations Accuracy: Correct facts and figures, no errors, inspire confidence Regularly: Regular, timely communication CART Transparency: Open and fair disclosure of information, no concealment Composition & Balance of the Board Page 4 Composition of the Board The Board should consist of: Chairman CEO Executive directors Non-executive directors Balance of the Board Board Size should be appropriate Board should have right amount of Knowledge, Skills and Experience Balanced between Executive and NEDs (Independence) Any one person should not be able to Dominate the Board Split role between Chairman and CEO Diversity in the board (covered below) Board Meetings Meeting should be held regularly Minimum quorum to be present Agenda: Decided by Chairman Include both short-term and long-term issues Circulate in advance so that Directors can prepare Chairman to direct meetings and encourage debates Chairman & CEO Role & Responsibilities of Chairman Main role: Running the Board Link between company and shareholders / stakeholders Page 5 KISSED+SD Communication with shareholders (e.g. Annual Report) Protect shareholder interests and increase long term shareholder wealth Lead board of directors and ensure smooth running of board, such as: Appropriate size, knowledge, skills, experience, and independence of directors Balance between executive and non-executive directors Effective functioning of Board Committees Regular meetings Directors’ nomination, performance and remuneration Role & Responsibilities of CEO Main role: Running the Company Propose strategies to the board Implement decisions of the Board Monitor day to day running of business and all departments Manage resources effectively and efficiently Risk management and internal control systems Timely and accurate reporting Legal and regulatory compliance Interact with external parties, such as Government, key customers, key suppliers, Stock Exchanges Splitting of Roles Between Chairman & CEO The Chairman runs the Board. The CEO runs the company. The running of the Board should be separate from the running of the Company. Hence the role of Chairman and the role of CEO should not be performed by one person, as this concentrate excessive power in the hand of one person. The Chairman should be independent just like a NED. Advantages of Splitting the Role: Segregation of duty leading to improved governance Higher shareholder confidence as Chairman is normally a NED Able to challenge CEOs views and performance Directors can communicate with Chairman if they have concerns relating to CEO Page 6 CEO can concentrate on running the business without spending time to manage board activities Disadvantages of Splitting the Role: Separation creates two leaders rather than unity provided by one leader Chances of disagreement or clash between Chairman and CEO Chairman may not have in-depth knowledge of business Non-executive directors (NEDs) NEDs are part-time outside directors who are ‘independent’ i.e. they are not employee of the company. They bring independence, external perspective and scrutiny. They add to the confidence to shareholders by occupying key positions in various Board Committees. They get a fixed fee for being NEDs and are not entitled to any bonus or share options as it will create conflict of interest and threaten their independence. Role of NEDs Strategy: discuss strategies, bring external experience and leadership Performance: scrutinize the performance of Executive directors Risk: ensuring effective internal control and risk management systems are in place and financial reporting is accurate and reliable People: nomination, remuneration and succession planning of executive directors and senior executives, providing added comfort to shareholders Advantages of NEDs Brings independence to the Board (i.e. no conflict of interest) Adds confidence to shareholders Have external experience and wider perspective Scrutinize / challenge performance of executive directors and the company Employees can discuss confidential or sensitive matter with NED directly (whistle-blowing) Company can comply with Regulatory / Listing requirements Page 7 Disadvantages of NEDs Difficult in finding an appropriate NED with relevant experience and willing to work at a small fee May lack independence May face resistance from executive directors May find it hard to enforce their views May not give sufficient time to business Smaller remuneration as compared to executive directors Independence of NEDs No business or financial relationship with the company for last 3 years Not an employee of the company for last 5 years Not an NED in same company for more than 9 years Not have close family ties or friendship with executive directors Not a significant customer or supplier of the company for last 3 years No family members working in the company in senior position Not an auditor of the company for last 3 years Not have a cross-directorship with another executive director No share in profit or having share options of the company NEDs should be allowed to seek independent expert advice on any professional matter, if required Number of NEDs There is no fixed number of NEDs. Different jurisdictions have different rules: UK: Sufficient number of NEDs so that their views carry significant weight NY Stock Exchange: NEDs should be > 50% of the total board size (i.e. in majority) Singapore: Atleast one third of the board Exercise – Independent or Not? Most of the NEDs have been in their present role since the company was listed 12 years ago One of the NEDs run a specialist consultancy company. She has received separate fees from her consultancy company for providing consultancy advice to the company in which she is NED Page 8 Two of the NEDs have permanently retired and use the income they get from being NEDs to supplement their living Board Committees Key Board Committees 1- Nomination Committee: Recommends appointments of new directors 2- Remuneration Committee: Recommends remuneration policy for executive directors 3- Audit Committee: Reviewing accounts and internal controls, liasoning with external auditors and supervising internal audit function 4- Risk Committee: Overseeing risk management process Advantages (Importance) of Having Board Committees More focused and specialized More time can be spent by committees as full board has limited time Higher involvement by NEDs (e.g. in audit or remuneration committees) Board can focus more on strategic and business matters Increases shareholder confidence Nomination Committee (Majority NEDs) The Nomination Committee makes recommendation of appointments of directors to the Board, with the objective of maintaining balance. This Committee consists of majority of NEDs. The procedures for nominating directors should be formal, rigorous and transparent. Roles of the Nomination Committee: Determine right Size of the board KISSED Page 9 Ensure board contains the required Knowledge, Skill and Experience Balance between executive directors and NEDs (Independence) Diversity in the board (covered below) Identify and attract competent directors to fill any vacancy Induction training and continued professional development (covered below) Succession planning of directors Page 10 How to Recruit New Director Personal connection / word of mouth of directors and senior management Executive search companies Advertisement Professional forums and networks Remuneration Committee (100% NEDs) The Remuneration Committee recommends remuneration policy for the directors with the purpose of attracting, retaining and motivating directors to achieve long-term returns for the shareholders. Committee comprises of 100% NEDs so that committee can be independent while determining the remuneration of CEO and executive directors. An appropriate portion of the package should be linked with performance. Roles of the Remuneration Committee: Determine remuneration policy in order to attract, retain and motivate Ensure that a portion of the package is linked with performance as well as linked with long term Decide remuneration for CEO and all Executive Directors Report remuneration policy and packages to shareholders (through Remuneration Report) Audit Committee (100% NEDs) The Audit Committee is responsible to ensure that financial reporting is accurate, internal audit function is effective and external auditors remain independent. All members are NEDs with atleast one NED having recent expertise in financial reporting and audit. This is to ensure that shareholders receive independent and accurate financial information of the company. Roles of the Audit Committee: Financial statements and reporting: Ensuring accuracy and integrity of financial statements and regulatory filings Review accounting policies Review internal controls relating to financial reporting Compliance with relevant laws and regulations Monitoring internal audit function: ….. Page 11 Ensure independence and objectivity of internal audit Appoint internal auditor and monitor his/her performance Approve annual internal audit plan Ensure effectiveness and efficiency of internal audit function Ensure that internal audit recommendations are implemented timely Managing External Auditors: Recommendation appointment, re-appointment or removal of external auditor Approve terms of engagement / audit scope Approve auditor’s remuneration Ensuring independence and objectivity of external auditor Review any non-audit services provided by external auditors (e.g. tax consultancy) Audit closure meetings, including discussing issues and weaknesses identified during audit Provide Whistleblowing arrangements to prevent fraud and mis-reporting (Covered in more detail in Section F – Organizational Control & Audit) Risk Committee The Risk Committee is responsible for oversight of the risks which the company faces and ensuring that a sound system of risk management and internal controls exists to deal with those risks. Risk Committee comprises of majority of NEDs with some Executive directors, as specialist expertise of Executive directors can benefit the committee. Roles of the Risk Committee: Relating to Risk Management Process Implement formal risk management process / ERM framework Advice board on risk appetite and ALARP levels Embed risk management in organization culture Identify key risks and recommend risk management procedures and controls Monitor overall risk exposure of the company and ensure it remains within limits set by the board Ensure risk management procedures and controls are effective ….. Page 12 Informing board and shareholders of any significant change to company’s risk profile Monitor performance of Risk Manager Relating to Internal Controls Review and implement internal control systems, policies and procedures Assess effectiveness of internal controls Review Internal Controls Report sent to Shareholders Provide early warning to the board of emerging weakness in the internal control system (Covered in more detail in Section D – Risk Management) Remuneration & Rewards of Directors General Principles Remuneration should be sufficient to attract, retain and motivate competent directors Remuneration to be in line with market rates, industry norms and close competitors Remuneration should have following components: Fixed pay Variable / Performance based incentives: Short term incentives (e.g. bonus) Long term incentives (e.g. share options) Consider difference in experience levels of directors Director cannot approve his own remuneration – to be done by Remuneration Committee (NEDs) Full transparency to shareholders (e.g. disclosures in annual accounts) Components of a Remuneration Package Basic salary – should be comparable to market and salaries of other similar directors in the company Benefits / perks – comparable with market practices (e.g. car, club membership) Retirement benefits / Pensions – only basic salary pensionable, has to be in line with the law Performance Related Pay: helps to ensure that directors’ actions are aligned with shareholders’ interests: Short term incentive: e.g. annual bonus ….. Page 13 Long term incentive: e.g. share options (covered below), long term bonus Bonus payout is based on financial performance of the company, mainly profitability. Nonfinancial targets can also be there, e.g. customer satisfaction, market sharer, etc. Retention options: Attractive package Loyalty bonus (e.g. if you stay with Company for 5 years, you will get Rs XXX bonus) Long term bonus (performance based) Share options Share options are long term incentives scheme whereby directors are allotted company shares which they can only sell after 3-5 years (exercise date). Share prices should increase over time due to growth and profitability of the company. This motivates directors to stay with the company and focus on creating long term shareholder wealth. Factors Influencing Level of Reward of CEO and Directors Size of company (small company normally pays less) Pubic sector or private sector (public sector pays less) Profile and experience of the CEO and directos Commercial organization or not-for-profit organization Company’s performance and target achievement Market rates: Benchmarking with similar companies / competitors in the industry Board Structures: Unitary and Two-Tier Board Having a single board have some problems, especially if the CEO is dominating and powerful and NEDs are suppressed. Hence there are two approaches to structure the Board. Two Tier Board: In this approach, there are two boards in a company: ….. Page 14 1- Supervisory Board It is appointed by Shareholders and led by a Chairman Consists of mostly NEDs and senior directors Focuses more on long term strategies Responsible for legal and regulatory compliance All voting rights vested in this board Supervises the Management Board (see below) 2- Management Board It is appointed by Supervisory Board and lead by the CEO Consists of CEO and executive directors Responsible to implement strategies approved by Supervisory Board Focuses more on operational and day-to-day management Management board does not have any voting rights Unitary Board: In this approach, there is just one board in the company: Single board having Executive directors as well as Non-Executive directors Executive directors focus more on day to day management (similar to Management Board under Two Tier approach) Non-Executive directors focus more on advice and protecting shareholder interests (similar to Supervisory Board under Two Tier approach) However, all directors have equal voting rights Advantages & Disadvantages of a Two-Tier Board: Advantage Separation between strategic and operational roles Disadvantage Slower decision making ….. Page 15 Greater independence leading to higher investor confidence Isolation of supervisory board from operational matters Voting rights in hand of NEDs and senior directors Management board demotivated due to limited CEO cannot dominate the board Information sharing by management board involvement in strategic matters might be poor Induction of New Directors Induction is a process of orientation and familiarisation of new directors with the company, so that the new director has some know-how about the company. This will help the new director in settling down and becoming productive quickly. The Chairman has to ensure that new directors receive formal induction on joining the board. If a NED joins, the company should invite major shareholders to meet the new NED. What Aspects Are Covered In Induction Introduction to company and its operations Role & responsibilities of directors Professional, legal and ethical values which a director must follow Board procedures and committees Details of all directors, major shareholders and key employees Strategies and business plans Organizational values, culture and structure Key customers, suppliers, banks, auditors, stakeholders, etc. Advantages (& Importance / Purpose) of Induction Makes new director familiar with the company, its operations and core strategies Helps in understanding the norms and culture of the organization Build working relationships with fellow directors and key executives Reduces settling in time and speeds up the productivity and learning curve ….. Page 16 Continued Professional Development of Directors CPD is systematic maintenance and improvement of knowledge and skills necessary for execution of duties throughout an individual’s professional career. The Chairman has to ensure that all directors undertake regular CPD in order to fulfil their duties. Methods of CPD External trainings In-house trainings Attending conferences and seminars Professional courses and certifications Reading / writing relevant books Mentoring and coaching Advantage of CPD Maintain professional knowledge and skills of directors Keeps directors up to date with latest topics and developments Enhance director’s competence Improves board’s effectiveness Demonstrate director’s commitment to their profession and company ACCA’s Processional Development Matrix (Features of Effective CPD Planning) Planning: Individual should identify competencies required in the current role and develop CPD plan Action: Undertake actual CPD Results: Assess whether CPD achieved the objectives and desired competency level Reflection: Examine evolving nature of the role and continuously plan CPD for future needs Diversity in the Board Diversity means having variety of people in the board, normally based on demographics prevailing in that society. Diversity is based on age, gender, educational / professional background, experience, ethnicity, etc. ….. Page 17 Advantages of Diversity Wider pool of talent Broader range of ideas and knowledge More representative of the community Enhanced reputation and outlook of organization Compliance with listing regulations Issues of Diversity May lead to sub-groupings within the board Board may ignore the views of diversified members Diversified members may not feel motivated to contribute How Regulators Encourage Diversity By specifying in law minimum diversity requirements, e.g. 40% of board to be females By mandatory disclosures in Annual Accounts relating to diversity measures taken by the company Appointment of Directors Directors can be appointed in the following manner: By resolution from Shareholders – usually in Annual General Meeting (AGM) By resolution from Directors (temporary appointment)– the Article of Association of a company empowers Board to appoint a director to fill an unexpected vacancy in the board. This normally happens if any director leaves in between or becomes disqualified. But this appointment is only valid until the next AGM, when the shareholders will appoint / approve the new Board. By resolution following directions from Govt / State – intervention under certain circumstances Leaving of Directors Following are the circumstances in which directors leave office Retirement at the end of the term Removal: Resignation anytime during the term ….. Page 18 Disqualification anytime during the term Removal by shareholders anytime during the term Retirement by Rotation Directors contract are limited to a specific time period, after which he / she automatically retires by default. Then the director offers himself / herself for re-election (retire by rotation). In UK, director’s contract is for 1 year for large listed companies and 3 years for other companies. Importance / Benefits of Retirement by Rotation Directors need to perform well in case they want to get re-elected Gives an opportunity to shareholders to get rid of directors who are not performing Reduces cost of termination of non-performing directors Opportunity to replace the Board over a period of time whilst maintaining continuity and stability Service contracts is the director’s employment contract which covers the terms and conditions of director’s employment with the company. In UK, a service contract is for 1 year for large listed company and for 3 years for all other companies. Removal of Directors A director may leave or maybe removed from office before his / her term expires. There are many possible reasons: Resignation by director – a director can resign on his own by giving formal notice period ….. Page 19 Disqualification of Director Disciplinary offence Fraud Absent for more than 6 months Disability / Death Bankruptcy Removal by Shareholders – usually through a general meeting giving 28 days’ notice Performance Appraisal of the Board The performance of the Board should be reviewed on an annual basis. The performance of the Board as a whole, Committees and individual directors are reviewed. The performance evaluation is led by the Chairman and Chairman’s performance is evaluated by NEDs. Board’s & Committees’ performance is assessed against: Maximizing long-term shareholder’s wealth Achievement of financial and non-financial targets Risk management, internal controls and financial reporting Compliance with regulations Communications with shareholders and stakeholders and problem solving Corporate governance and management of board (conduct of meetings, working of the committees, quality of documentation) Individual director’s performance is assessed against: Achieving of individual performance targets Contribution to the strategies and problem solving Principles of professional ethics (integrity, honesty, professional competence and due care, confidentiality and professional behavior) Active participation in board activities (meetings, preparedness, committees, etc.) Any unethical behaviour (insider trading, , unfair dealing, conflict of interest) ….. Page 20 CPD Advantage of Performance Evaluation Enforces high performance Identifies low performing directors Identifies training needs Forms basis for bonus payouts Insider Trading / Dealing Insider trading / dealing means buying or selling of company shares by its own directors or senior executives based on information which is not publicly available as yet. Directors often have access to market-sensitive information beforehand and they can benefit significantly if they buy or sell company shares based on confidential information. Why Insider Trading is Unethical / Illegal Directors have to act in the primary interest of shareholders and not to make personal gains Directors have to maximize ‘long’ term value of the organization. If insider trading is allowed, then it is likely that directors would be tempted to take short term decisions to make personal gains Insider trading can damage the reputation and integrity of the capital markets of the country Cost of capital might increase as investors would expect a higher return to cover higher risk if insider trading prevails ….. Page 21 Corporate Governance Corporate Governance Is a system by which companies are configured, coordinated and controlled in the interest of the shareholders and other stakeholders? Agency relationship is the foundation of corporate governance as there is separation between the ownership and control The objective of a corporate governance is to improve corporate performance and accountability in order to create long term shareholder value Corporate governance is less of an issue in small companies or partnership business where the business is managed directly by the shareholders / owners Principles of Corporate Governance 1. Independence (no conflict of interest, no wrong motives, fact based, no bias, no undue influence) 2. Probity (integrity, honesty, straight forward, truthfulness, not conceal anything wrong) 3. Transparency (disclose all material matters to shareholders, open relationship with shareholders) 4. Fairness (even dealings with all stakeholders) 5. Reputation (board carries a reputation, moral stance, must enjoy confidence of key stakeholders) 6. Responsibility (clear roles) 7. Accountability (answerable for results) 8. Judgment (ability to make sound decision) 9. Skepticism (questioning mind, critical evaluation) AIR-DRIFTS Features of Strong Corporate Governance Environment Role of Chairman and CEO is segregated Sufficient NEDs on the Board Formal board committees Risk management framework Focus on strong internal controls Transparent and factual reporting Rewards linked with performance ….. Page 22 Internal and external audits Focus on integrity, objectivity and avoidance of conflict of interest by directors Institutional Investors Definition Shares in listed companies are held by a range of individuals and institutions. Institutional shareholders are organizations which have large amount of money to invest. They include pension funds, insurance companies, investment & unit trusts, mutual funds, etc. Accordingly, the number of shares held is much higher than number of shares held by an individual shareholder. Hence institutional shareholders have a much higher influence than an individual shareholder. Institutional investors employ Fund Managers to manage the investment portfolio with the aim to benefit the individual member of the funds. Exercise: Identify the differences between individual investor and institutional investor Characteristics of Institutional Investors Higher dominance as power is concentrated in few hands Higher ‘Shareholder Activism’: Active participation in key strategies and decisions Paying attention to the Board composition, Committees and NEDs Making active use of voting rights Critical review of remuneration policy and perks Dictating risk appetite Problems of Institutional Investors Tend to focus on short term profits Higher interference in business due to dominance of power Minority / individual shareholder interests may be ignored ….. Page 23 Institutional Investor Intervention Institutional investor may intervene in the affairs of an organization under following circumstances: Concerns about business strategies Major acquisition or disposal Deteriorating performance & results Excessive directors’ remuneration Non-compliance with laws and codes Weak NEDs Major internal control failure Unethical issue Agency Complication in Institutional Shareholders Agency problems are more complex in institutional shareholders. Institutional shareholders gather a large pool of funds from members (e.g. pension fund or mutual funds) and then employ Fund Managers to invest these funds into numerous listed companies on the stock exchange. As the Fund owns shares on behalf of its members, the final shareholders are the members. Hence there is the added layer of middleman (i.e. Fund Manager) between the members and the listed company. Hence no individual member has a direct voice or communication with the listed company. Insider And Outsider Dominated Business Definitions Insider Dominated Business is one in which the controlling shareholding is held by a small number of dominant individuals. Mostly these are family owned businesses and are generally not listed on stock exchange. Hence, they are subject to lessor level of regulations / corporate governance requirements. Outsider Dominated Business is one in which the controlling shareholding is held by a large number of shareholders, e.g. a listed company. Shares could also be held by Institutional Investors. Since these are listed companies, they are subject to higher regulations / corporate governance requirements. Difference Between Family Owned and Public / Listed Companies Family Owned Business Public / Listed Companies Owned by family members Owned by individuals or institutional investors Mostly private limited Mostly public limited / listed company Lessor regulations and CG requirements Stringent regulations and CG requirements Freedom of taking decisions Decisions based on majority shareholder or voting ….. Page 24 None or few NEDs with weak position Significant NEDs having strong position No Board Committees Formal Board Committees Focus on long term returns Less focus on internal audit and risk Focus on short / medium term returns High focus on internal audits & risk management management Lower agency problems and cost (as family is running the business directly) Generation change leads to problems Higher agency problems and cost (as directors run the business on behalf of the shareholders) Good succession planning in place Advantages and Disadvantages of Family Owned Business Benefit Problem Greater involvement in management Discrimination against minority shareholders Lower agency problems and cost High chances of dispute between major Focus on long term strategies Higher level of ethical behavior due to shareholder groups Conflict of interest Weak corporate governance / NEDs reputational risk Improved communication and coordination between shareholders EXTRA / STRONGER INTERNAL CONTROLS IN A LISTED COMPANY Chairman and CEO roles are split NEDs Board Committees / Risk committee Internal Audit Whistle blowing arrangement ….. Page 25 Corporate Governance Scope & Approaches Rule Based Approach Vs Principle Based Approach Rule Based Approach Rule based approach focus on clear cut regulations and controls. Full compliance is expected by all companies at all times without any exception. Any non-compliance is a legal offence and organization will be prosecuted and punished. This approach is adopted in USA, e.g. Sarbanes Oxley Act. Principle Based Approach It’s a framework-based approach setting out guiding principles aiming to create a culture of responsible and ethical behavior. If the reason for noncompliance is justified, then it may not be deemed as a legal offence. This approach is taken in UK and other European countries. Based on the concept of “comply OR explain” whereby the directors explain to shareholders the reasons for not complying with any particular code and if the shareholders are not satisfied, they can hold the directors accountable. Hence the decision regarding degree of compliance is in the hands of the shareholders rather than the regulators. Example Which one is rule based approach and which one is principle based approach? Advantage and Disadvantage Rule Based Principle Based ….. Page 26 Advantage: Clear regulations – no subjectivity Standard rules across the board Punishment acts a deterrent Advantage: Shareholders decide to what extent compliance needs to be done Flexible / Can be adopted according to industry, company size and nature of risk Provides a level playing field for all industries and Able to address exceptional situations companies Suited for non knowledgeable shareholders Lower cost of compliance Disadvantage: Disadvantage: Inflexible Subjective Unable to address exceptional situations Not suited for non-knowledgeable shareholders High cost of compliance Lack of consistency across industry Code of Corporate Governance A Code of Corporate Governance is a document issued by Regulatory Authorities or Stock Exchanges and covers all matters of corporate governance, including role of the Board, risk management, internal controls, remunerations, reporting, etc. The purposes of Codes of Corporate Governance are: Specify behavior of corporate governance Ensure companies are well run in line with shareholder’s interest Boost confidence of investors Reduce frauds Encourage best practices Bring consistency across companies Governance Codes For Multiple Jurisdictions Two organisations have published corporate governance codes intended to apply to multiple national jurisdictions. These organisations are: Organization for Economic Cooperation and Development (OECD); and International Corporate Governance Network (ICGN) ….. Page 27 OECD Principles OED principles were developed in 1998 and revised in 2004 and grouped into 5 broad areas: 1. Rights of shareholders (voting, electing/removing directors, access to information) 2. Equitable treatment of all shareholders (minority / overseas shareholders) 3. Rights and protection of stakeholders (access to information, protection against fraud) 4. Timely/accurate disclosures of material matters (transparency) 5. Responsibility of the board (i.e. work in best interest of the company, treat all stakeholders fairly, etc) ICGN Principles ICGN report was issued in 2005 and revised in 2009 to provide practical guidance on OECD principles. It emphasis on the following matters: 1. Shareholders (create long term value, protect their rights, fair treatment) 2. Directors (board structure, skills, term, remuneration, election, evaluation) 3. Corporate culture (ethics, integrity, bribery/anti-corruption, whistle blowing) 4. Risk management (analyze, manage, risk appetite) 5. Remuneration of Senior Management (link with performance) 6. Audits (external, internal, relationships) 7. Disclosures and transparency (material financial & non-financial info) Common Themes Amongst All Codes Shareholders Stakeholders Directors Auditors and Audit Committee Disclosures and Transparency Risk Management, Ethics & Culture Objectives of Governance Codes for Multiple Jurisdictions Helps in globalization of investments, i.e. cross border investments Increases comfort level of investors Global consistency ….. Page 28 Limitations of Governance Codes for Multiple Jurisdictions Represents lowest common denominator Regional differences in culture, legal structures, economy, capital / financing structures, openness / maturity of stock market, insider vs outsider system, development stage of the country, etc. Cost of following a global standard may be high Practice Questions P1 – Jun 2010 Q2: Remuneration Committee | Reward Package (Tomato Bank) P1 – Jun 2012 Q4: Insider Business | Induction & CPD | Two Tier Board (Lum Co) P1 - Dec 2013 Q4: Director Leaving | Technology Risk | Professional Ethics (Lobo Co) P1 – Dec 2014 Q3: Role of CEO | Benefits of NED | Conflict of Interest (New Ideas) ….. Page 29