ACCA P1 Governance, Risk and Ethics - 2010 - Study text

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Chapter 5: Directors’ remuneration

A trade union spokesman (the Trades Union Congress general secretary) is reported

to have commented: ‘It is hard not to conclude that this further huge rise in

executive pay is more about greed than performance…. The stratospheric levels of

directors' pay compared to average wages mean that executives now live in a class

apart, even from employees in their own companies. It is not just socially divisive,

but bad for the economy.’

4.4 Remuneration and competition issues

Although there might be ethical reasons for arguing that directors’ remuneration is

too high, there are competitive reasons for explaining the increase.

Directors’ remuneration has risen because there appears to be a shortage of

individuals who are considered to have the ability to lead major stock market

companies. Given a shortage in the supply of talented individuals, general levels of

remuneration for top executives have risen.

4.5 Remuneration and shareholder attitudes

Shareholders, particularly institutional investors, have shown a strong interest in

remuneration as an issue in corporate governance. The views of insurance

companies and pension funds are most often expressed by their trade associations,

the Association of British Insurers (ABI) and the National Association of Pension

Funds (NAPF), which provide guidance to their members and may sometimes co-

ordinate their activities.

The Association of British Insurers has issued guidelines for its members on

executive remuneration. These are consistent with the principles and provisions of

the Combined Code, but are more specific in detail. The guidelines are directed at

both:

 remuneration committees, because they indicate the aspects of remuneration

that their shareholders will consider

 their members, by indicating what they should consider when deciding whether

or not to show their approval of the remuneration policy of any company in

which they invest.

Institutional investors do not argue in favour of lower remuneration. They believe

that:

 directors should be paid a fair remuneration, but not excessive amounts

 a large part of a directors’ remuneration package should consist of incentives

 performance targets for incentives should be relevant and challenging.

The ABI’s guidelines on executive remuneration are about 10 pages long. A few

guidelines are shown below, to illustrate the approach that institutional investors

take to the assessment of remuneration policy.

 Remuneration committees should communicate their policy on base salaries to

shareholders. If it seeks to pay salaries at the median (average) level or above,

the committee should provide a justification.

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 When a director is paid a bonus for achieving a performance target, the

directors’ remuneration report should give a full analysis of which performance

targets were met.

 If performance is subsequently found to have been over-stated by management,

the remuneration committee should have the right to reduce or reclaim the

bonus payments to executives.

 When preparing the contract for a director, the remuneration committee should

calculate the likely cost of any severance payment on dismissal, and whether this

is acceptable.

 Where companies have share-based incentive schemes, executives should be

encouraged to build up ‘meaningful’ holdings of shares in the company.

The significance of shareholder attitudes

Shareholder views on remuneration packages can be important. Institutional

investors might act together and use their votes at general meetings.

The power of individual shareholders in large companies is usually restricted. Even

the largest shareholders usually do not own a large proportion of the shares in their

company, and it can be very difficult for shareholders to act together to obtain a

majority of votes at any general meeting of the company.

However, institutional investors are increasingly active, and remuneration

committees need to be aware that proposed incentive schemes, or the remuneration

package of a senior executive such as the CEO, may arouse strong opposition.

Shareholders can express their displeasure with remuneration policy and

remuneration packages by voting collectively in any of the following ways:

 to vote against a proposed new incentive scheme

 to vote their disapproval of the directors’ remuneration report

 to vote against the re-election of a director who is retiring by rotation,

particularly if the director is a member of the remuneration committee or is a

beneficiary of a generous remuneration package.

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CHAPTER

Different approaches to

corporate governance

Contents

1 Rules-based and principles-based approaches

2 Brief history of corporate governance in the UK

3 International codes and principles of corporate

governance

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Rules-based and principles-based approaches

 Reasons for the development of corporate governance codes

 Corporate governance codes and different models of corporate ownership

 Rules-based approach to corporate governance

 The rules-based approach in the US: Sarbanes-Oxley Act 2002

 Main governance aspects of Sarbanes-Oxley

 Principles-based approach to corporate governance

1 Rules-based and principles-based approaches

1.1 Reasons for the development of corporate governance codes

Codes of corporate governance, in different forms, have been developed in most

countries where there is a stock exchange. The main reason for codes of good

corporate governance is to help and protect investors.

 Investors need reliable information about companies, to decide whether to invest

in shares or (if they already hold shares) whether to sell them. Financial

reporting by companies and external auditing should therefore be reliable.

Investors should also be given other information to help them make their

investment decisions, such as information about future prospects of the

company, internal control and risk management and directors’ remuneration.

 Investors need to be protected against unethical or dishonest behaviour by

company management. For example, there must be strict laws against insider

dealing, to prevent managers from making personal profits at the expense of

other investors.

Many investment institutions invest in the stock markets of many different

countries. They can choose which markets to invest in, and can choose to avoid

stock markets where they believe that governance practices are poor and investors

are treated badly.

Countries have developed corporate governance codes and practices because they

want to attract and keep investment capital, especially from global institutional

investors. This is because investment capital helps the country’s economy to

develop and its companies to prosper. Pressure for better corporate governance has

come mainly for two reasons:

 The collapse of major stock market companies in a major financial centre, where

investors have lost substantial amounts of money and the cause of the collapse

has been largely attributable to bad corporate governance.

 Pressure from institutional investors in countries with well-developed corporate

governance codes or rules.

The International Corporate Governance Network (ICGN) is an entity formed in

1995, whose members consist of major institutional investors, companies, banks and

other interested groups. Its aim is to encourage the development of good corporate

Chapter 6: Different approaches to corporate governance

practices worldwide. It has published a statement on global corporate governance

principles (revised 2005), which gives an indication of why corporate governance

matters so much to institutional investors.

The statement commented that the governance of a corporation is one of the key

factors that investors consider when they decide where to allocate their investment

capital. ICGN members considering making investment decisions also consider the

market’s governance profile.

Ethics and company performance

Other reasons for encouraging the development of good corporate governance are

that:

 Good corporate governance practices are an application of good business ethics.

 It might be argued that good corporate governance contributes to the efficiency

and effectiveness of a company’s leadership and management. If this view is

correct, well-governed companies will be more successful in the long term than

badly-governed companies. However, this has not yet been proved, one way or

the other.

1.2 Corporate governance codes and different models of corporate

ownership

Codes of corporate governance are applied to major stock market companies. Laws

and regulations on corporate governance issues are also mainly applied to stock

market companies. This is not surprising, as the main reason for codes of

governance is to help and protect investors.

Other companies can normally decide what system of corporate governance they

want, and they are not required to comply with any established principles or rules.

However, these companies might decide to apply these principles or rules because

they think that:

 it is ethically correct to do so, or

 it will improve the performance of the company.

Examples

In the UK, the London Stock Exchange has a stock market for smaller companies, the

Alternative Investment Market (AIM). There are fewer regulations for companies in

this market, and AIM companies are not required to comply with the Combined

Code of corporate governance. However, an unofficial code of governance for AIM

companies has been developed, and AIM companies are encouraged to adopt this

code.

The board of a family-owned company might be dominated by some of the family

members who are also the company’s senior executives. The company might decide

to appoint a non-executive director to represent the interests of family shareholders

or other shareholders who are not on the board. (The director would not be

independent, but the appointment of a NED to represent the interests of smaller

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shareholders might help to ensure that the company is governed in the interests of

all the shareholders, not just the owner-directors.)

1.3 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 by some other form of 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.

There are some advantages with a rules-based approach:

 Companies do not have the choice of ignoring the rules.

 All companies are required to meet the same minimum standards of corporate

governance.

 Investor confidence in the stock market might be improved if all the stock

market companies are required to comply with recognised corporate governance

rules.

There are disadvantages with a rules-based approach.

 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.

Corporate governance rules: practical applications

Every country with a stock market should have some rules of corporate governance.

The UK for example, which is associated with a principles-based approach to

corporate governance, has some statutory rules.

Examples of statutory rules in the UK are as follows.

 With some exemptions, mainly for small and medium-sized companies,

companies are required to submit a directors’ report and financial statements to

the shareholders each year. This is a key aspect of accountability of the directors

to the company’s owners.

 The financial statements should be audited.

 Quoted companies (companies whose shares are traded on a stock exchange)

must prepare a directors’ remuneration report each year, and present this to the

shareholders.

 The Companies Act 2006 specifies duties that the directors owe to their

company.

Chapter 6: Different approaches to corporate governance

The difference between countries that take a rules-based approach and those that

take a principles-based approach to corporate governance is mainly one of

emphasis. Some countries have more rules than others, and rely more on the

enforcement of rules to achieve the required standard of governance.

The country most associated with a rules-based approach is the USA.

1.4 The rules-based approach in 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 recognised 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-publicised 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 analysing 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.

1.5 Main governance aspects of Sarbanes-Oxley

The Sarbanes-Oxley Act introduced corporate accountability legislation. It includes

some specific requirements. In addition, it required the financial markets regulator,

the Securities and Exchange Commission (SEC) to issue rules to implement some

parts of the legislation. The Act is very long. Some of its provisions are described

below.

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.

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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, recognised 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

Chapter 6: Different approaches to corporate governance

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. (There was a debate in

2007 about a member of the audit committee who used the company’s corporate

membership of an expensive country club to play golf at the club. Did this mean

that he was not properly independent?)

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 book-

keeping 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.)

1.6 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.

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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.

 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.

In the UK, the Combined Code is the relevant code of corporate governance for

listed companies. All UK listed companies must comply with rules known as the

Listing Rules, which are issued and enforced by the financial markets regulator (the

Financial Services Authority or FSA). One of the Listing Rules is that companies

must comply with al the detailed provisions of the Combined Code, or explain their

non-compliance, in an annual corporate governance statement to shareholders. This

statement is included in the annual report and accounts.

Which is more effective: a rules-based approach or a principles-based

approach?

The advantages and disadvantages of a principles-based approach to corporate

governance are the opposite of those for a rules-based approach. There is no

conclusive evidence to suggest that one approach is better than the other.

It has been suggested that the burden of the detailed rules in the US, especially the

requirements of section 404, has made the US an unattractive country for foreign

companies to trade their shares. As a result, many foreign companies have chosen to

ACCA P1 Governance, Risk and Ethics - 2010 - Study text - Emile Woolf Publishing

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