Tricker, Chapter 5 PDF

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Ch. 5

Tricker: The Regulatory Framework

Legislaon, Regulaon, and Corporate Governance Codes Being a creaon of the law, limited-liability companies depend on company law for their existence, connuity, and winding-up Company Law

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Defines the way in which they are incorporated, how their directors are appointed, and how shareholder relaons need to be run, as well as lays down disclosure and filing requirements

Companies must stay within the company law of the jurisdicon in which they are incorporated and the laws of other places where they do business Company laws vary from very specific and demanding (many US states, the UK, most other advanced economies) to the quite undemanding (some offshore tax havens)

Companies, their directors, and their officers can also find themselves exposed to other legislaon, such as health and safety, consumer protecon, and environmental standards → Directors need to ensure that they have the necessary systems and advice to minimize the risk of breaking the law: company secretary Corporate Regulaons -

Extend and amplify the law

For example: taxaon regulaons, import/export regulaons, and employee working condions Boards should ensure that the necessary safeguards are in place Accounng standards apply to the specific jurisdicon in which the company is reporng (GAAP, IFRS)

Stock Exchange’s Rules

Must be followed by listed companies

→ All of the above menoned are mandatory: They must be followed if penales are to be avoided (also: Discreonary Corporate Governance Codes)

Corporate Regulaon in the US -

Each state in the US has its own companies’ law Federal company oversight is provided by the Securies and Exchange Commission (SEC) Its mission is to protect investors, maintain fair, orderly, and efficient markets, facilitate capital formaon SEC requires companies to disclose financial and other informaon and oversees key parcipants in the security world The SEC developed an extensive corporate governance regime for the US listed companies Widely believed that US financial regulaon was a model for the rest of the world

Sarbanes-Oxley Act (SOX) of 2002 -

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Response of US government aer collapses of massive companies in

Probably the most influenal piece of company legislaon in the world to date, not least because it emphasised the US belief that the regulaon of CG should be under law, not through discreonary codes Requires: Cerficaon of internal auding, increased financial disclosure, applied criminal and civil penales on directors for non-compliance Applied to all US and non-US companies listed in the US: now required to submit an annual report about their internal accounng controls to the US SEC

Tricker: The Regulatory Framework

Secon 302 Secon 404

Set of internal procedures designed to ensure accurate financial disclosure that have to be signed off Report on the company’s internal controls as part of the annual report, affirming “the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporng”; it must also “contain an assessment of the effecveness of the internal control structure and procedures” → Independent external auditors must also aest to management’s internal control assessment → expensive requirements → cricism

SOX also established: - New standards for boards and audit commiees - New independence standards for external auditors - A new Public Company Accounng Oversight Board (PCAOB) to oversee accounng firms and to issue accounng standards overseen by the SEC -

SOX has forced massive concentraon on corporate governance in the US In addion to the costs of compliance, SOX brought significant fees to legal and accounng firms, and spawned a new corporate governance advisory and training industry Due to costs, many companies based overseas delisted or dropped plans to list Many US companies reported benefits from SOX compliance, including beer accountability of individuals, reduced risk of financial fraud, and improved accuracy in financial reports

Dodd- Frank Wall Street Reform and Consumer Protecon Act of 2010 - Enacted aer the financial crisis to improve American financial regulaon and the governance of the US financial service industry - This law creates a new, more effecve regulatory structure, fills a host of regulatory gaps, brings greater public transparency and market accountability to the financial system, and gives investors important protecons and greater input into corporate governance Treadway Commission (1985) - Created to consider fraudulent corporate financial reporng - Led to creaon of Commiee of Sponsoring Organisaons (COSO) , a private-sector iniave aiming to encourage management and board towards more effecve business acvies - COSO is dedicated to guiding execuve management and governance enes toward the establishment of more effecve, efficient, and ethical business operaons on a global basis - It offers frameworks and guidance based on in-depth research, analysis, and best pracces The Business Roundtable (BR) - An associaon of CEOs of leading US companies comprising nearly a third of the total value of the US stock markets - Published a statement on corporate governance, followed by Principles of Corporate Governance in 2002 - Believes that US has the best CG, financial reporng, and securies markets systems in the world - These systems work because of the adopon of best pracces by public companies within a framework of laws and regulaons that establish minimum requirements while affording companies the ability to develop individualized pracces that are appropriate for them - Each corporaon should look to these principles as a guide in developing structures, pracces, and processes that are appropriate for it in light of its needs and circumstances -

BR principles are intended to assist corporate boards of directors and management in their individual

Ch. 5

Ch. 5

Tricker: The Regulatory Framework

effort to implement best pracces of corporate governance If a company’s governance pracces diverge from common pracce, it should disclose the reasons for this and why its pracces are appropriate, consistent with its size, industry, culture, and other factors BR’s CG principles emphasize the importance of the role of execuve management, with the board providing oversight rather than involvement -

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Management responsibilies: - Under the oversight of board, to develop and implement the corporaon’s strategic plans, and to idenfy, evaluate, and manage the risks and risk profile - Under the oversight of the audit commiee and the board, to produce financial statements …, and to make mely disclosures investors need …

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Board responsibilies: - Through its audit commiee, to engage an independent accounng firm to audit the financial statements prepared by management, as well as to oversee the corporaon’s relaonships with the outside auditor - Through its corporate governance commiee, to play a leadership role in shaping the CG of the corporaon and the composion of the board – the commiee should regularly assess the skills and experience of the board and its members, and engage in succession planning for the board - Through its compensaon commiee, to adopt and oversee the implementaon of compensaon policies, establish goals for performance-based compeon, and determine compensaon

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Corporaon responsibilies: - Engage with long-term shareholders in a meaningful way - Deal with its employees, customers, suppliers, and other constuencies

→ These responsibilies and others are crical to the funconing of the modern public corporaon and the integrity of the public markets → No law or regulaon can be a substute for the voluntary adherence to these principles by corporate directors and management in a manner that fits the needs of their individual corporaons

The Naonal Associaon of Corporate Directors (NACD) (1977) - A naonal organisaon for directors: Network for director development, strengthening board pracces, and influencing opinion on corporate governance issues - Challenged what it believed was the accepted corporate governance paradigm: “Management is accountable to the board, and the board is accountable to shareholders” - BUT “the board does more than mechanically link those who manage the corporaon and those who own it; the board is at the very centre of corporate governance itself” - Emphasized the need for director professionalism: Only if each member of the board understands and all members agree upon - their joint responsibilies as directors, can the enre board truly fulfil its role

The American Law Instute (ALI) (1923) - Seeks to clarify American common law - Business Judgement rule: Court will not intervene even though a board decision has been wrong, provided that it was made in good faith

Tricker: The Regulatory Framework

Council of Instuonal Investors (CII) - A non-profit associaon represenng a diverse array of public, pension union, and corporate employees - In 2002, CII published a set of corporate governance policies, which suggested goals and guidelines for the effecve governance of publicly traded corporaons - Believes that the promoon, adopon, and effecve implementaon of guidelines for the responsible conduct of business and business relaonships are consistent with the fiduciary responsibility of protecng long-term investment interests The CII CG principles are not binding, but are designed to provide guidelines: 1. All directors should be elected annually by confidenal ballots 2. At least two-thirds of a corporaon’s directors should be independent 3. A corporaon should disclose informaon necessary for shareholders to determine whether each director qualifies as independent, whether or not the disclosure is required by state or federal law 4. Companies should have, audit, nominang, and compensaon commiees; all members of these commiees should be independent 5. A majority vote of shareholders should be required to approve major corporate decisions concerning sale or pledge of corporate assets that would have a material effect on shareholder value

New York Stock Exchange corporate lisng standards NYSE Euronext (NYX) published its report in 2010 and outlines with it some core principles, as follows: - The boards fundamental objecve should be to build long-term sustainable growth in shareholder value - Successful CG depends on successful management of the company - Good CG should be integrated with the company’s business strategy - Shareholders have responsibility and long-term economic interest to vote their shares in reasoned and responsible manner - CG issues are best solved through collaboraon and market-based reforms - Crical of CG is transparency: Appropriate disclosure policies and pracces (same for investors) - The commission supports requirement of a majority of independent directors, but also addional dependent directors (appropriate range and mix of experse, diversity, and knowledge) - Proxy advisory firms need to be held to appropriate standards of transparency and accountability - SEC should work with exchanges to ease burden of proxy vong, while encouraging greater parcipaon by individual investors in the proxy-vong process New York Stock Exchange listed company manual lays down requirements that listed companies must fulfil to be listed: - Listed companies (LC) must have a majority of independent directors - To empower non-management directors, they must meet at regularly scheduled execuve sessions without management - LC must have a nominang/CG commiee of independent directors only - This commiee must have a wrien charter - LC must have a compensaon commiee of independent directors only - This commiee must have a wrien charter - LC must have an audit commiee - This commiee must have a minimum of three members who are independent - This commiee must have a wrien charter - Shareholder must be able to vote on all equity-compensaon plans - LC must adopt and disclose CG guidelines - LC must adopt and disclose a code of business conduct and ethics for directors, officers, and employees - LC must have a publically accessible website

Ch. 5

Ch. 5

Tricker: The Regulatory Framework

Corporate Regulaon in the UK -

In the UK, companies are incorporated at the country level and have to abide by the UK Companies Acts UK produced world’s first corporate governance report in 1992, leading to a formal CG code

The Cadbury Report (1992)

Produced in response to corporate failures in the UK and not intended to be a comprehensive review of subject

This code is discreonary: UK listed companies were required to report that they had complied with the code of, if they had not, the reasons:  Wider use of independent non-execuve directors  Introducon of an audit commiee (min. 3 non-execuve directors and majority of them independent)  Division of responsibilies between Chairman and CEO (If not, strong independent element in the board necessary)  Use of remuneraon commiee of the board  Use of a nominaon commiee  Adherence to detailed code of best pracces

The Greenbury Report (1995)

Addressed issues of directors’ remuneraon

The Hampel Report (1998)

Response to suggeson in Cadbury and Greenbury reports that a review should be undertaken aer a few years’ experience

→ The three codes menoned were essenally voluntary and mainly for listed companies

The UK Combined Code (1998) Consolidated the above menoned proposals and was incorporated into the London Stock Exchange’s lisng rules -

Sets out standards of good pracce on maers such as board composion, director remuneraon, accountability, and audit in relaon to shareholders UK listed companies were required to report compliance with the principles Although the Code had no legislave basis and enforcement, failure to meet its requirements could lead to delisng from the Exchange Formal de-lisng, however, would tend to disadvantage the very shareholders whom the corporate governance codes were designed to protect, so delisng was a last resort The Stock Exchange rather tends to rely on informal guidance to companies

Turnbull Report (1999)

Elaborated that companies should have appropriate internal controls

→ Recognized that risk assessment was vital and recommended that reporng on internal controls became an integral part of the corporate governance process; thus two new dimensions of CG were added: Enterprise Risk Management and Internal Management Controls Myners Report (2001)

Addressed responsibilies of instuonal investors

Higgs Report (2003)

Re-examined CG in Brish companies 10 years aer Cadbury and sharpened the requirements in previous codes

→ At least half the board should be INEDs, all members of the audit and remuneraon commiee and

Tricker: The Regulatory Framework

most of the nominaon commiee should be INEDs, and role of CEO and Chairman should be separated The Smith Report (2003) Looked at audit commiees: Should only have INEDs, at least one of whom was financially literate and up to date, main role in annual report and shareholders’ general meeng The Tyson Report (2003)

Focused on recruitment and development on non-execuve directors (NEDs)

UK Combined Code was revised in 2003 and in 2006 and CG requirements were grouped under four headings:  Independence  Diligence  Professional development  Board performance evaluaon Listed companies were now required under Stock Exchange Lisng Rules to report how they applied the Combines Code (sll discreonary)

The main principles of the UK CG Code are as follows:  -

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Secon A: Leadership Company should be headed by an effecve board that is collecvely responsible for long-term success Clear division of responsibilies at the head of the company between the running of the board and execuve responsibility for the running of the company’s business; no one individual should have unfeered powers of decision Chairman is responsible for leading the board and ensuring its effecveness on all aspects of its role In a unitary board, NEDs should construcvely challenge and help developing proposals on strategy Secon B: Effecveness The board and its commiees should have the appropriate balance in skills, experience, independence, and knowledge of the company There should be a formal, rigorous, and transparent procedure for appointment of new directors All directors should be able to allocate sufficient me to the company All directors should receive inducon on joining the board and update their knowledge and skills Board should be supplied in a mely manner with informaon Board should undertake formal and rigorous annual evaluaon of its own performance (and commiees) All directors should be submied for re-elecon at regular intervals

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Secon C: Accountability Board present a balanced and understandable assessment of company’s posion and prospects Board is responsible for determining nature and extent of risks it is willing to take Board should establish formal, transparent arrangements of how it applies corporate risk management and internal control; maintaining appropriate relaonship with auditor

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Secon D: Remuneraon Levels of remuneraon should be sufficient to aract, retain, and movate directors to run the company at quality required (link rewards to corporate performance) Formal and transparent procedure for policies of execuve remuneraon no director should be involved in his or her own remuneraon

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Ch. 5

Ch. 5

Tricker: The Regulatory Framework

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Secon E: Relaons with shareholders There should be a sasfactory dialogue with shareholders Board should use AGM to communicate with investors

The UK Companies Act 2006 Companies Act was the largest UK Act ever and some new measures were introduced for public firms: - Clarified directors’ dues for the first me in statute law → act in interest of shareholders and must pay regard to the longer-term interests of employees, suppliers, consumers, and the environment - Encouraged narrave reporng by companies (forward-looking, idenficaon of risks and opportunies, environmental maers, employees, and social and community issues) - Promoted shareholder involvement in governance (makes it easier for indirect investors to be informed and to exercise governance rights) - Included new offence for recklessly of knowingly including misleading, false, or decepve maers in an audit report - Enabled auditors to agree a limit on their liability with their audit clients, subject to shareholder approval Also introduced some measures for private firms: - New model arcles of associaon - Dropping need for a company secretary - Dropping need for AGM

Women on Boards -

Top 300 European companies have 9.7% of women in their boards (2008), 25% of companies an enrely male board Regulatory quotas haven been suggested as a way of increasing gender diversity Quotas force nominaon commiees to cast a wider net, although some women directors object to quotas because they suggest that women cannot succeed on their own Some research studies shows that corporate performance improves with women on the board Board diversity and effecveness are closely linked Diversity widens the perspecve brought to bear on decision-making, avoids too great a similarity of atude, and helps companies understand their customers and workforce A board with too few woman on it risks a...