Approaches TO Corporate Governance PDF

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CHAPTER 2 APPROACHES TO CORPORATE GOVERNANCE RULES BASED AND PRINCIPLES BASED APPROACHES There are two basic approaches to developing a code of corporate governance. These include; -a rules-based approach -a principles-based approach Rules-based approach to corporate governance A rules-based approach to corporate governance is based on the view that companies must be required by law or compulsory regulation to comply with established principles of good corporate governance. The rules might apply only to some types of company, such as major stock market companies. However, for the companies to which they apply, the rules must be obeyed and few (if any) exceptions to the rules are allowed. Advantages - Companies do not have the choice of ignoring the rules. - No interpretation is required because of the clarity of the legal term - It promotes uniformity of compliance for all companies - Regulatory compliance enhances greater confidence of stakeholders - Awareness of sanction for non-compliance serves as a deterrent to transgression Disadvantages - The same rules might not be suitable for every company, because the circumstances of each company are different. A system of corporate governance is too rigid if the same rules are applied to all companies. - There are some aspects of corporate governance that cannot be regulated easily, such as negotiating the remuneration of directors, deciding the most suitable range of skills and experience for the board of directors, and assessing the performance of the board and its directors. - Available loopholes in the law may be exploited - The rules may be overloaded and this may lead to increased business cost - There is limitation for improvement or going beyond the minimum level Principles-based approach to corporate governance A principles-based approach to corporate governance is an alternative to a rules-based approach. It is based on the view that a single set of rules is inappropriate for every company. Circumstances and situations differ between companies. The circumstances of the same company can change over time. This means that: -the most suitable corporate governance practices can differ between companies, and -the best corporate governance practices for a company might change over time, as its circumstances change.

It is therefore argued that a corporate governance code should be applied to all major companies, but this code should consist of principles, not rules and; -The principles should be applied by all companies. -Guidelines or provisions should be issued with the code, to suggest how the principles should be applied in practice. - As a general rule, companies should be expected to comply with the guidelines or provisions. - However, the way in which the principles are applied in practice might differ for some companies, at least for some of the time. Companies should be allowed to ignore the guidelines if this is appropriate for their situation and circumstances. - When a company does not comply with the guidelines or provisions of a code, it should report this fact to the shareholders, and explain its reasons for non-compliance. Comply or explain This approach is sometimes called comply or explain. It applies in the UK, for example. With a comply or explain approach, stock market companies should be required to present a corporate governance statement to their shareholders in which they state that: - They apply the principles in the code of corporate governance (the code that applies to companies in that stock market), and - Either the company has: - complied with all the provisions or guidelines in the code for applying the principles in practice, or - explain their non-compliance with any specific provision or guideline.

Advantages of principles based approach -Principle based approach take into consideration the culture of the Company by allowing it develop its own approach to Corporate Governance that is within the specification stock exchange. -It saves time and money on the part of government. -It allows company to explain reasons why they have not comply with a specific provision. -It provides choice for investors to determine the company they want to invest in. -It obviate the need to comply with rigid legislation that company have to comply with even where it is glaring that such legislation is not appropriate. Disadvantages of principle based approach -Lack of consistent approach put down the confidence of the investors. -Since principle base approach has to be within specification of the exchange then it is not totally autonomous, if companies are to be listed.

-Companies may fail to give adequate explanation for not complying with certain principle on code of corporate governance.

EXAMPLE OF RULES-BASED APPROACH: THE US SARBANES OXLEY ACT 2002 In the US, corporate governance was not regarded as important until the collapse of several major companies in 2001 and 2002, and large falls in the stock market prices of shares of all companies. This major setback for the US stock exchanges damaged investor confidence. It was recognized fairly quickly that one of the reasons for the unexpected collapse of several companies (‘corporations’) was poor corporate governance. Enron and WorldCom were the two most notorious examples, but there were others too. There were several well-publicized cases where: - A company in serious financial difficulties was dominated by a chief executive and a small number of other senior executives, who appeared to be running the company in their own interests, without concern for the interests of shareholders (other than themselves). - Financial reporting was misleading. - Financial controls were weak and inadequate to prevent the misleading reporting, and to prevent fraudulent activities by some executives. Politicians soon became involved in analyzing the problems in the stock market and the collapse of companies such as Enron and WorldCom. This involvement of politicians soon led to new legislation to improve standards of corporate governance. This was the Sarbanes-Oxley Act 2002, which was named after its two main sponsors in the US Congress.

Main governance aspects of Sarbanes-Oxley The Sarbanes-Oxley Act introduced corporate accountability legislation. It includes some specific requirements. Specific requirements and key provisions of the Act  CEO/CFO certifications (section 302 of the Act) The Act requires all companies in the US with a stock market listing (both US companies and foreign companies) to include in their annual and quarterly accounts a certificate to the SEC. This certificate should be signed by the chief executive officer and the chief financial officer (finance director) and should confirm the accuracy of the financial statements. The CEO and CFO are therefore required to take direct personal responsibility for the accuracy of the company accounts.  Assessment of internal controls (section 404 of the Act) Section 404 is possibly the most notorious part of the Sarbanes-Oxley Act. The Act required the SEC to establish rules that require companies to include an internal control report in each annual statement. This internal control report must: - ‘state the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting; and

contain an assessment … of the effectiveness of the internal control structure and procedures of the [company] for financial reporting.’ The SEC issued rules to implement this requirement of the Act. The management of companies registered with the SEC (stock market companies in the US), with the CEO and CFO, must evaluate the effectiveness of the company’s internal control over financial reporting. The rule states that: ‘The framework on which management’s evaluation of the … internal control over financial reporting is based must be a suitable, recognized control framework.’ -

Companies are required to maintain evidence, including documentary evidence, to provide reasonable support for management’s evaluation of the internal control system. (One of the criticisms of section 404 has been the large amount of work necessary to collect and maintain all this evidence.) Companies must disclose any material weakness in their internal control system. If more than one material weakness exists, a company is not allowed to conclude that its internal control system is adequate. A report on internal control must be included in the company’s annual report to shareholders. In addition, the external auditors are required to prepare an ‘attestation report’ on the company’s assessment of its internal control system. The consequence of section 404 is that companies in the US or foreign companies whose shares are traded on a US stock market must undertake a review of their internal control system for financial reporting every year, and to maintain evidence to support the assessment of the control system that management gives in its annual report to the shareholders. The criticism of section 404 has been mainly that the requirements create a very large amount of work, that it costly in terms of management time and other resources, as well as auditors’ costs.  Loans to executives The Act prohibits companies (other than banks) from lending money to any directors or senior executives.  Forfeit of bonuses Another requirement of the Act is that if a company’s financial statements have to be re-stated due to non-compliance with accounting standards and rules, any bonuses paid to the CEO and CFO in the previous 12 months must be paid back to the company.  Insider dealing The Act introduced stricter rules to prevent insider dealing by directors and senior executives. They are not allowed to trade in shares of their company during any ‘black-out period’.  Audit committees Companies with a stock market listing must have an audit committee consisting entirely of members who are independent of the company.  Non-audit work by auditors The Act restricted the types of non-audit work that the company’s auditors can perform for the company. Auditors are not allowed, for example, to do bookkeeping work for an audit client, or provide valuation services or perform any management functions for the company.

 Protection for whistleblowers A whistleblower is an employee of the company who reports, through a channel of communication other than his or her direct supervising managers) suspected fraud or illegal activities in the company. The Act provides protection for any employee who ‘blows the whistle’ on activities in the company, and prevents the company from taking action against the employee, such as terminating his or her employment. (This was what Enron did to an employee who acted as a whistleblower when she suspected fraudulent activities in the company.)  Audit standards Audit firms must have quality control standards in place and retain working papers for at least seven years. Auditors must review internal control systems as part of the audit to ensure they reflect client transactions. The auditors must also provide reasonable assurance that transactions are recorded in a manner that will permit the preparation of GAAP-compliant financial statements. International codes and principles of corporate governance The key international statements of corporate governance principles that have been issued are: - the OECD Principles of Corporate Governance - the ICGN Statement on Global Corporate Governance Principles - the Principles for Corporate Governance in the Commonwealth (the CAGC Guidelines). Organization for Economic Cooperation and Development (OECD) • Established in 1961, the OECD is an international organization composed of the industrialized market economy countries, as well as some developing countries, and provides a forum in which to establish and co-ordinate policies. Objectives of the OECD principles • The principles represent the first initiative by an intergovernmental organization to develop the core elements of a good corporate governance regime. • The principles are intended to assist OECD and non-OECD governments in their efforts to evaluate and improve the legal, institutional and regulatory framework for corporate governance in their countries and to provide guidance and suggestions for stock exchanges, investors, corporations, and other parties that have a role in the process of developing good corporate governance. • The principles focus on publicly-traded companies, both financial and non-financial. However, to the extent that they are deemed applicable, they might also be a useful tool for improving corporate governance in non-traded companies, e.g. privately-held and state-owned enterprises. • The principles represent a common basis that OECD member countries consider essential for the development of good governance practices. • The principles are intended to be concise, understandable and accessible to the international community. • The principles are not intended to be a substitute for government, semi-government or private sector initiatives to develop more detailed ‘best practice’ in corporate governance.

Content of the OECD Principles (revised 2015) There are six main principles in the OECD, but each of the main principles has a number of supporting principles (OECD Principles of Corporate Governance – 2015 Edition, © OECD 2015); Principle I- Ensuring the basis for an effective corporate governance framework Principle II- The rights of shareholders and key ownership functions Principle III- The equitable treatment of shareholders Principle IV- The role of stakeholders in corporate governance Principle V- Disclosure and transparency Principle VI- The responsibilities of the board. ICGN Global Corporate Governance Principles (revised 2009) • ICGN, founded in 1995 at the instigation of major institutional investors, represents investors, companies, financial intermediaries, academics and other parties interested in the development of global corporate governance practices. Objectives of the ICGN principles • The ICGN principles highlight corporate governance elements that ICGN-investing members take into account when making asset allocations and investment decisions. • The ICGN principles mainly focus on the governance of corporations whose securities are traded in the market – but in many instances the principles may also be applicable to private or closely-held companies committed to good governance. • The ICGN principles do, however, encourage jurisdictions to address certain broader corporate and regulatory policies in areas which are beyond the authority of a corporation. • The ICGN principles are drafted to be compatible with other recognized codes of corporate governance, although in some circumstances, the ICGN principles may be more rigorous. • The ICGN believes that improved governance should be the objective of all participants in the corporate governance process, including investors, boards of directors, corporate officers and other stakeholders as well as legislative bodies and regulators. Therefore, the ICGN intends to address these principles to all participants in the governance process. Content of the ICGN principles: • corporate objective – shareholder returns • disclosure and transparency • audit • shareholders’ ownership, responsibilities, voting rights and remedies • corporate boards • corporate remuneration policies • corporate citizenship, stakeholder relations and the ethical conduct of business

• corporate governance implementation. Limitations of international codes or statements of principles - All codes are voluntary and are not legally enforceable unless enshrined in statute by individual countries. - Local differences in company ownership models may mean parts of the codes are not applicable. - Because they apply to all countries, they can only state general principles. They cannot give detailed guidelines, and so are not specific. Since they are not specific, they are possibly of limited practical value. - Their main objective is to raise standards of corporate governance in the ‘worst’ countries. They have less relevance for countries where corporate governance standards are above the minimum standard. Governance in non-profit and public sector Organizations Governance in public sector organizations Public sector organizations Public sector organizations are those that are directly controlled by one or more parts of the state and exist to implement specified tasks which serve government policy for example in areas like health care, education and defense. The public sector delivers services and goods that either cannot, or should not, be provided by private sector businesses, for example, Hospitals, Schools, Defense and police forces, Refuse collection, Local government authorities, Prisons and court systems, nationalized companies e.g. nuclear power stations, or a national railway, other non-governmental organizations (NGOs). The size of the public sector varies in different countries. In some countries government might retain control of industries which the government deems to be of key national interest. Of course governments view on this might change leading to the privatization of formally government owned entities. This would require a valuation of the entity for sale to the investment community. The opposite could also occur with a government deciding that an industry should be taken into government ownership (nationalisation). Public sector organizations exist at: - National level e.g. a national health service - Subnational (local) level e.g. a local library - Supranational level e.g. the European Union, NAFTA, ECOWAS The public at large are a key stakeholder in public sector entities both from a funding perspective (through the payment of local and/or national taxes) and a ‘customer’ perspective (as a user of the services). Their focus is likely to be on value for money rather than the achievement of profits. The public are often concerned that public sector organizations are over-bureaucratic and unnecessarily costly. Public services are administered (managed) by elected officials who serve a role similar to a board of directors in a company. Elected officials typically include: - Members of parliament at the national level; and - Councilors within local councils/municipalities. Two other types or organizations to mention are:

- Non-governmental organizations (NGOs); and - Quasi-autonomous non-governmental organizations (QUANGOs). NGOs and QUANGOs are bodies set up by central government to perform functions similar in nature to government. However, the governance teams who run the NGO or QUANGO are nonelected executive members. The ‘Good Governance Standard’ In the UK, a Good Governance Standard was published by the Independent Commission for Good Governance in Public Service. This sets out six core principles of good corporate governance for public service corporations. 1. ‘Good governance means focusing on the organization’s purpose and on outcomes for citizens and service users’. This means having a clear understanding of the purpose of the organization, and making sure that users of the service receive a high-quality service and that taxpayers (who pay for the service) get value for money. 2. ‘Good governance means performing effectively in clearly defined functions and roles’. The governing body of the organization is comparable to the board of directors in a company. It must be clear about what its responsibilities are, and it should carry these out. The responsibilities of executive management should also be clear, and the governing body is responsible for making sure that management fulfills its responsibilities properly. 3. ‘Good governance means promoting values for the whole organization and demonstrating the values of good governance through behavior’. Integrity and ethical behavior are therefore seen as core governance issues in public sector entities. 4. ‘Good governance means taking informed, transparent decisions and managing risk’. Risk management and the responsibility of the governing body for the internal control system is as much a core feature of governance in public sector entities as in companies. 5. ‘Good governance means developing the capacity and capability of the go...