The subject of this report is to get an understanding of what is corporate governance and, in the UK context, critically discuss its regulation. In order to achieve this, we will firstly look at the academic definitions of corporate governance and then analyse what were the impacts and reasons of the improvements over time. We shall also analyse the recommendations coming from the different codes established over time to improve the corporate governance including the main mitigation in place i.e. the principal – agent model.
2. What do you understand by the term corporate governance?
Depending on the source, we can find different but not conflicting academic definitions of corporate governance. I listed here three definitions coming from three different worlds: audit, OECD corporate governance scope and finance.
The International Standards for the Professional Practice of Internal Auditing (Standards) define governance as: “the combination of processes and structures implemented by the board to inform, direct, manage, and monitor the activities of the organization toward the achievement of its objectives.” (Chartered Institute of Internal Auditors 2010)
The OECD Principles were originally released in 1999 and revised in 2003-2004, they also are one of the 12 key standards of the Financial Stability Forum. These principles are addressing key areas of corporate governance e.g. shareholders, stakeholders, board accountability, transparency, disclosure, etc… (OECD 2004)
From a financial perspective: “Corporate governance is a term that refers broadly to the rules, processes, or laws by which businesses are operated, regulated, and controlled. The term can refer to internal factors defined by the officers, stockholders or constitution of a corporation, as well as to external forces such as consumer groups, clients, and government regulations.” (SearchFinancialSecurity.com 2010)
At the end of the day what is important to take away from these is that it is about accountability and to close the gap of the principal – agent problem.
3. With reference to the UK, critically discuss the way in which corporate governance is regulated.
As explained by Brian Coyle (2005) different committees have been reported in The UK to improve the corporate governance of companies listed on the London Stock of Exchange.
In the UK, after companies’ failures in the 80’s, the London Stock of Exchange established a commission chaired by Sir Adrian Cadbury in 1992. They developed a code aiming to raise the corporate governance standards and the financial reporting. The recommendations were mainly already spread best practices. They better defined the relationship between executive and non-executive directors and their independence with shareholders. The code stresses also the responsibilities of the board members individually and as a whole and also the relationship with external auditors. This code was on a voluntary basis but the London Stock of Exchange brought pressure on all listed companies to comply.
After this first report was implemented, another report took place, the Greenbury report in 1995, to tackle the issue of directors making money in amounts unrelated to the companies’ results. The committee recommended to implement a remuneration committee made of non-executive directors to define remuneration of the executive directors; review the notice for directors; recommendations to disclose the remuneration policies including the one of the directors.
In 1996 the Hampel committee has been set-up to review both Cadbury and Greenbury reports. In 1998, the output is to publish principles in general terms more than a tick in the box exercise. The recommendations are about the board of directors’ composition and the processes to compose it, another main topic is about the directors’ remuneration. The report also delivers recommendations on how to best manage the communication with the shareholders and also about accountability and audit as already treated by Cadbury.
After this, in 2002, the law was altered to enforce listed companies to provide the details of the remuneration policies and annual reports. Right was also given to shareholders to vote on remuneration policy for directors.
Other influential reports in the UK include Rutteman Report 1994, Myners report 2001 and Tyson report 2003 (Chartered Accountants Ireland 2010). Most of these reports have been reactive to inappropriate practices by companies which resulted into financial losses e.g. Smith report in 2003 as a result of the collapse of Arthur Anderson, Enron and WorldCom in 2002.
Sir David Walker and Lord Turner both did review corporate governance in UK banks and other financial organisations after the latest financial crisis in 2009. Walker`s review (2009) delivered 39 recommendations in different areas like effective risk management at board level including the incentives in remuneration policy to manage risk effectively; the balance of skills; experience and independence required on the boards of UK bank institutions; effectiveness of Board`s practices and the performance of audit, risk, remuneration and nomination committee; the role of institutional shareholders in engaging effectively in companies and monitoring of boards and whether UK approach is consistent with international practices and how national and international best practices can be promulgated. On the other hand, Turner`s recommendations (Financial Services Authority 2009) were based on analysing the origins of the crisis, assessing whether deficiencies in the regulation contributed to it and making recommendations for change. The FRC (Financial Reporting Council 2010) agreed to implement these recommendations through revision to the code which will apply after June 2010. Although, the recommendations have been implemented and are more or less prescriptive, the organisations need some flexibility and use of their judgement in making some decisions.
4. The principal – agent model and the differing objectives of the principals and agents.
As we could read in the previous paragraphs, to ensure better corporate governance, it is important to properly manage the relationship between the shareholders and the board of directors.
In order to improve the corporate governance, one of the models is the principal – agent that will resolve the problem of ownership versus control by having a contract in place that will ensure the managers’ or directors’ goals (agents) are aligned with the ones of the shareholders (principal).
As described by Sloman and Wride (2009) this model generates a problem, the asymmetric information as shareholders and managers may have different aims. The shareholders are looking for profit maximisation while the managers might be more attracted by salary, status, prestige, bonus, etc…. Dutta (1999) defines that this problem “arises when non-economic agent – the agent – takes an action that affects another economic agent – the principal.”.
This situation of potential asymmetric information can be mitigated in different ways. Sloman (2008) and others like Milgrom and Roberts (1992) came with solutions to this problem by implementing two major principles, the monitoring and setting up of an incentive programme. Using these two appropriately will decrease the gap between the agent and the principal goals and align them better. On the one hand, the monitoring will mainly happen through the AGM (Annual General Meeting) where the performance of the board can be assessed. The incentive programmes, on the other hand, are focusing on how to best remunerate the agents e.g. the board members according to their performance via bonuses, shares, etc….
So the better the principal – agent problem is being handled, the better the corporate governance will be but let’s see in the next topic whether it means that it does influence the companies’ overall performance.
5. In conclusion, why are the governance structures identified in the Codes believed to produce good governance and therefore better performance?
The main reason why there is such a belief is that these codes has been put in place in a reactive way and intend to bring solution to the past crisis root causes. This is the reason why there had multiple reviews over time to “fine-tune” existing recommendations or develop new ones.
There are no convincing empirical evidences that the codes have improved the performance of the UK listed companies. As an evidence of this, each of the codes described is reactive to proven bad governance e.g. ENRON, Arthur Andersen, etc… i.e. even with all the recommendations made, bad performance – behaviours still persist. Win Hornby (2009) also confirms that most of the governance-performance studies have been inconclusive.
On the other hand though, as Davies (2006) mentions, in two surveys (1997 and 2000) from Business Week magazine, companies with the highest rankings in terms of governance are the ones showing the highest financial returns. Is good governance enough to have high financial returns? It cannot be the only one but it is one of the most important factors as corporate governance encompasses all processes and controls in place to operate the business. This also means that the influence of the codes in the composition of the board of directors, the way it interacts internally and externally and also gets remunerated is key to align the goals of the shareholders and the managers (directors) and deliver a win-win for all stakeholders.
In the UK unlike in the US only little has been turned into laws. So concerns about corporate governance is still there as not all companies will comply. The risks coming from bad governance are not fully mitigated yet and may thus lead to another set of reports and codes in the future or law amendments to even go further in best practices enforcement.
6. References / Bibliography:
CHARTERED ACCOUNTANTS IRELAND, 2010. The UK Corporate Governance Code. [online]. Dublin, Ireland: Chartered Accountants Ireland. Available from: http://www.charteredaccountants.ie/Members/Technical1/Corporate-Governance/Featured-Content/ [Accessed 30 October 2010].
CHARTERED INSTITUTE OF INTERNAL AUDITORS, 2010. PA 2110-1: Governance: Definition. London: Chartered Institute of Internal Auditors.
COYLE, B., 2005. Risk awareness and corporate governance. Canterbury: IFS.
DAVIES, A., 2006. Best Practice in Corporate Governance: Building Reputation And Sustainable Success. Aldershot, UK: Gower Publishing.
DUTTA, P., 1999. Strategies and Games: Theory and Practice. Cambridge, USA: The MIT Press.
FINANCIAL REPORTING COUNCIL, 2010. The UK Corporate Governance Code and associated guidance. [online]. London: The Financial Reporting Council Limited. Available from: http://www.frc.org.uk/corporate/ukcgcode.cfm [Assessed 30 October 2010]
FINANCIAL SERVICES AUTHORITY, 2009. The Turner Review A regulatory response to the global banking crisis. London: The Financial Services Authority.
HORNBY, W., 2009. 2009_Business_Objectives.ppt. Unpublished.
MILGROM, P. R. and ROBERTS, J., 1992. Economics, organization, and management. London, UK: Prentice-Hall.
OECD, 2004. OECD Principles of Corporate Governance. Paris, France: OECD Publications.
SEARCHFINANCIALSECURITY.COM, 2010. Definitions. [online]. US: Searchfinancialsecurity.com. Available from: http://searchfinancialsecurity.techtarget.com/sDefinition/0,,sid185_gci1174602,00.html [Accessed 22 October 2010].
SLOMAN, J and WRIDE, A., 2009. Economics. 7th ed. Harlow, England: Pearson Education Limited.
WALKER, D., 2009. A review of corporate governance in UK banks and other financial industry entities – Final recommendations. London: The Walker review secretariat.