Corporate governance
Introduction
A company is a corporate enterprise, established with the purpose to pursue a common object and also to obtain profits for the persons who established it. Upon incorporation, a company becomes a legal entity separate from the persons who established it. Although an artificial entity, companies has have power to own assets, trade, incur debts and enforce claims.
Due to this artificial nature, the company cannot act on its own behalf and must do so through other persons, notably its directors, and hence, corporate governance is necessary.
Corporate governance is somewhat a flexible term. It covers a wide range of academic debate from who should own and control the company to the relationship between shareholders and directors. In short, corporate governance is simply defined as the process and system in which a company is directed and controlled in order to achieve its objectives. Governance is used to monitor whether the outcomes are in accordance with the plans and motivate the organization to be more fully informed in order to maintain or alter organizational strategy.
Before we explore in depth into the issue of control of the company and the relationship of shareholders and directors, it is important to first understand the theories underlying the principle of corporate governance, as seen today.
A brief history of corporate governance
In the 18th and 19th century, the most common form of business is unincorporated associations, where individual owners were also the controllers. Such forms of businesses are called the traditional enterprise model.
The turn of the 18th century showed a shift in circumstances. The emergence of large scale projects such as transport and communications technology resulted in more statutory companies being formed. Such companies were by no means ordinary businesses but were special ventures which were granted the advantages of incorporation by the State because of the public needs and interests in such infrastructures.
For such companies, the importance of the State in granting corporate status in central. The fiction theory asserts that the legal person has no substantial reality, no mind, no will and it exists only in law. Corporations are simply legal fictions, created and sustained by the State.
The state is central to its existence and the company therefore only exists and is legitimised because if serves the public good. This theory makes it relatively easy to justify the imposition of corporate regulations aimed at promoting the public interest. This theory’s dominance parallels the time when grants of chartered status were relatively unusual occurrences confined to the privileged few who had both a public interest venture and the influence to obtain a grant of chartered status. However, the weakness of the concession or fiction theory is that it has very little say on the issue of individuals behind the corporations.
With the increase of wealth amassed by people, companies became the preferred method of doing business as they were able to facilitate large scale investment with minimum risk. As such, more companies were being formed and as a result. These companies are those where ownership is separate from control
As time goes by, more wealth were amassed by the largely untaxed middle lasses and companies became a preferred method of doing businesses as they were able to facilitate large scale investment with minimal risk.
Registered companies provided these traditional enterprises with access to incorporated status. Other theories have emerged to challenge the dominance of concession and fiction theories which were beginning to lose their applicability.
One of the theories which are arisen to contradict the fiction theory is the aggregate theory. Originated from the Roman law theory surrounding the Roman Societas, this theory states that a company is no fiction but has real existence; formed by an aggregate of private individuals who pull their investments together, on a set of terms they all agree upon. As such, the focus of company’s accountability will be on the shareholders, and shareholders’ wealth maximisation now becomes the sole corporate interest of the company.
This theory in turn has difficulty explaining the concept of separate legal entity and ownership of property. As such, the corporate realism theory emerged to offer an explanation to the newer managerial types of companies. Originated from 19th century German theorists, the corporate realism theory seems to be of the fact that a company has a ‘real’ separate existence from the members. The company is a real entity with its own interest and objectives that are defined by its managers. As such, the focus of the company is no longer limited to shareholders’ wealth maximisation. However, this theory still does not state the issue of accountability.
Until the late 1960s, the tangible success of managerial companies and the ability of these companies to behave as corporate citizens meant that corporate realism was the dominant theory. However, by the 1980s, a change was occurring in the way shareholders were behaving. Reform in the state pension and health care funding had pushed enormous amounts of money into the equity markets through institutional investors like pension funds, investment funds and insurance companies, and at the same time, barriers to capital inflows and outflows were removed in many countries that resulted in international investment funds operating in both the London and New York markets.
In all, the institutional investor emerged as a dominant force in those markets, holding nearly 80% of the shares in the UK market and 60 - 70% of the shares in the US market by the late 1980s. While institutional investors preferred to remain largely passive investors for the most part, they did favour market mechanisms in order to promote shareholder wealth maximisation. Thus, share options share price as a measure of performance and the non-executive director emerged as a monitoring mechanism on management.
Along with this change came a challenge to corporate realism from the work of economists who provided evidence that managerial self-interest was a dominant feature of managerial corporations. Aggregate theory (now called the nexus of contracts theory), with its emphasis on the shareholder as a monitoring mechanism, was revitalised by economic theory and remains the dominant theory today.
While it remains largely a reformulation of aggregate theory, this nexus of contracts theory provided the additional tools, based around economic efficiency, mainly to provide an attack to managerial firms. In nexus of contracts analysis, the firm is reduced to contracts and markets, and thus the firm is not in any sense a real person. Therefore, it has no interest of its own into which one can place corporate social responsibility.
Chapter 2
Introduction
In this chapter, specific UK corporate governance debate will be examined, together with the response by the Government and the industry.
The background of the UK corporate governance debate
An analysis done by Berle and Means (1932) following the crisis of 1929, showed that the problem of governance of managers arose from the separation of ownership and control , in which ideally, ownership, including supervision, should be the prerogative of shareholders, while control, including decision making function, should be the prerogative of the managers or directors. However, this separation could only be achieved in larger companies with broad shareholder base, where managers do not have significant shareholding in the company.
The emergence of the Berle and Means Corporation in the UK in the late 1960s lead to the rise in the issue of managerial accountability. Unlike the US where shareholders were given the primacy, UK sought to limit the discretion of the management of the company by increasing the power of the employees.
Change however, came rapidly with the election of Margaret Thatcher as the Prime Minister in 1979. With the US free market as an example, reforms to the UK public sector soon began. Privatizations of public sectors industries such as British Telecom, water and electricity, the reform of pension provision, health care and social welfare; the removal of barriers to capital inflow and outflow and the removal of the employment protection changed the nature of the corporate governance tremendously.
Events in the last 15 years have turned the spotlight on liability of auditors for their reports. Claims were usually brought by the liquidator or administrator of the failed company. There were numerous corporate scandals around to provide the basis for these actions, Barlow Clowes, Maxwell, Polly Peck to name a new. Some of these claims were huge, the largest was probably the action brought by the liquidators of Bank of Credit and Commerce International (BCCI) against Price Waterhouse and Ernst & Whinney . The broadsheet press popularly attributed these failures to weak governance systems, lax board oversight and vesting the control in the hands of a single top executive.
Jay Dahyaa, corresponding author, Cardiff Business School in his article entitled The Cadbury Committee, Corporate Performance and Top Management Turnover , stated that statistics have shown that historically, executive directors have very much dominated the board of directors in most UK companies. Statistics also show that historically, executive directors have very much dominated the board of directors in the UK companies.
For example, a survey done in 1988 showed that there were only 21 companies of the Financial Times 500 where non-executive directors comprise a majority of the board, when the boards were ranked according to the fraction of non-executive board members. In comparison however, the board of directors for 387 of the Fortune 500 U.S. companies comprised of majority of outsiders.
Concerns were also expressed as to how an auditor with statutory responsibility to company’s shareholders can handle a commercial relationship with the company’s management and remain impartial . As a result of the Enron case , the statutory dispositions of the profession have strengthened quickly for a better independence necessity, achieved in the USA by the Sarbannes- Oxley Act .
On the other hand, the auditing firms themselves have come up with the same conclusion such as the rotation of auditors, the splitting of their businesses
(non audit services and audit work), the powers of the audit committees.
However, in the light of all these reports we have to note that some problems remain unsolved. This is not a unique issue. The auditors, like solicitors, have to work under rules adopted by the profession. However, transparency by companies management and auditors firms is important to ensure impartiality in an audit process, especially where auditors supply other activities.
The Cadbury Report
It was because of these corporate scandals and the exposed legal position of statutory auditors prompted the reconsideration of the adequacy of corporate governance mechanisms and that the Cadbury Committee was set up on May 1991 by the Financial Reporting Council, the London Stock Exchange and the accountancy profession to examine the financial aspects of corporate governance.
The committee issued a draft report of its recommendations for public comment on May 27, 1992. Between then and December 1, 1992, the committee accepted comments and issued its final report on December 1, 1992. The Cadbury Report, Report of the Committee on the Financial Aspects of Corporate Governance, reviewed the structure and responsibilities of board of directors, the role of auditors and the rights and responsibilities of shareholders.
In order to achieve its aim of an improvement in the quality of corporate governance, the Cadbury Report dealt with the problems from different angles, with the overall objective of changing the environment in which companies operate. Three approaches can be identified :
a. Structural and functional alterations designed to spread the balance of power;
b. Increases in assumptions of responsibility;
c. Enhanced quality of disclosure.
Some of the key recommendations of the Report was designed to ensure that power is spread around within the governance structure of the company, and not concentrated in one person, or one small group. The Report recommended that committee structure should be put in place to improve accountability of the appointment of directors, the remuneration of directors, and audit process. Therefore, a listed company should have 3 sub-committees of the Board to cover appointments, remunerations and audit.
The accountability process would be ensured by having non-executive directors on each of the sub-committees. The remuneration committee in particular was to be made up wholly or mainly of non-executive directors .
The cornerstone of the report is ‘The Code of Best Practice’ and the key recommendation was to introduce non-executive directors to the main Board; the idea was that these non-executive directors would bring some objectivity to the main Board .
The Committee was also concerned with ensuring that people within the governance structure knew where their responsibilities began and ended, and also that these responsibilities were carried out or discharged properly. As such, there was a recommendation that there should be a statement of the directors’ responsibilities for the accounts and a counterpart statement by the auditors about their auditing responsibilities.
Much of the Report was focused on enhancing the quality of financial information being disclosed by companies, as such information is regarded as an important regulatory tool. If the information disclosed is accurate, it enables the market to react appropriately and is thought to result in an accurate valuation of the company’s securities . The Report proposed measures to increase the effectiveness and objectivity of the audit, which it saw as important external check on the way in which financial statements are prepared and presented, and regarded to annual audit as one of the cornerstones of corporate governance, an essential part of the checks and balances required.
The majority of the Cadbury Committee recommendations were implemented by the London Stock Exchange. However, they were not implemented as enforceable listing rules but rather by the odd mechanism of appending them to the listing rules. As such, compliance is voluntary. However, this method of implementation does have its advantage. Although there were no penalties for non-compliance, the Report explicitly recognised that legislation would likely follow if companies do not comply and since June 1993, a statement is required of each company, with an explanation why it had not complied. That explanation should also be reviewed by the auditor. In essence, it left it up to companies to decide for themselves what to do as no external scrutiny was given to the explanations for non-compliance.
This informal method of implementation however, turned out to be effective. By 1998, all companies in the Financial Times 100 and over 90% of all firms on the Official List of the London Stock Exchange were in compliance with the key provisions of the Code.
Cadbury Committee however left some key issues incomplete. First, it had never actually defined independence and so companies continued to appoint friends of management, ex-managers and managers of other companies to the board as non-executives.
Second, it did not specify that non-executives be a majority on the main board and allowed executive managers to sit on the sub-boards which made it very difficult for non-executives to be effective. This problem first manifested itself in the continuing upward spiral of directors’ pay despite the new mainly non-executive remuneration committee.
Chapter 3
Greenbury Report
Although Cadbury Report proposed that the remuneration committee is to be made up of wholly or mainly non-executive directors, it however did not provide for any further clarification on the issue of directors’ remuneration itself. This has led to the growing concern regarding the issue of director’s remuneration, since there are a number of well-recorded instances where directors have awarded themselves substantially increased salaries and benefits for doing essentially the same job. Although there is always a possibility that these revised levels of remuneration commensurate with the changed responsibilities and liabilities, the fact however remains that these increases have seldom been handled appropriately and with adequate explanation. A good example is when British Gas announced a massive salary increase for the Managing Director and at the same time announced 2,000 redundancies .
The high salary of these Executive Directors also has the effect of widening the gap between the earnings of those who direct large companies and those who carry out their instructions.
It would therefore be better if companies could adopt a standard multiplier or scale of payment of such Executive Directors. In response to the public debate and media reports on excessive remuneration of directors, the Confederation of British Industry has set up a Study Group on Directors’ Remuneration, chaired by Sir Richard Greebury.
The resultant Greenbury Report in July that year contained in a Code of Best Practice for Directors’ Remuneration. The Code reinforced the Cadbury Committee’s ideas relating to the establishment of remuneration committees and contained a requirement for the audit committee to submit a full report to shareholders each year, explaining the company’s approach to remuneration. It also requires much more detail about the remuneration package of each director than was required by the law existing at that time.
Greenbury identified that there is an inherent conflict of interest in directors deciding their own pay. As such, it was recommended that there should be no executive directors in the remuneration committees and that the remuneration committee should take into account the wider economic scene inside and outside the company when deciding on the executive salary.
There were also recommendations that share options should be replaced by a long term (3 years) performance related criteria which were to be forwarded to the shareholders. Share options were considered a problem because once granted, it was impossible for the company to tell how much the shares would be worth in the future leaving the company open to criticism for overpaying the executives. Share price may also be an inappropriate measure of performance both encouraging directors to make short term share price maximizing decisions and giving only a general market view of the company’s prospects not the individual director’s performance.
The Report also proposed that there should be higher levels of salary disclosure in the annual accounts. This would enable closer scrutiny of directors’ salaries. Ideally directors should have 1 year rolling contracts but 2 years may be acceptable. This would allow directors to be dismissed easier without having to pay off the remainder of their long term contracts.
However, as with Cadbury, the recommendations of the Greenbury Committee were adopted by the London Stock Exchange in the same non-binding manner. Unfortunately, the open disclosure regime recommended by the Greenbury Committee only succeeded in providing a reference to higher salaries in other similar companies to justify their own pay claims. The issue of excessive directors’ pay still rumbles on today with little sighs of any resolution of the issue.
Hampel Report
The Cadbury Report recommended the appointment of a new committee by the end of June 1995 to examine the compliance, and to update on the Cadbury Code of Best Practice. However, before companies were able to comply fully with the recommendations of Cadbury and Greenbury, another committee, headed by Sir Ronald Hampel, has been set up to examine and effectiveness and implementations of the Cadbury and Greenbury recommendations.
In their report, the Hampel Committee stated firstly, that it was too early to judge the effectiveness of the Cadbury and Greenbury recommendations, although its primary task was to do so, and secondly, that corporate governance could not be accomplished by mere mechanical compliance to checklists, but rather, it requires the company’s commitments to its principles as well as practice. The Hampel Report was not well received by many, as many were of the view that there were sufficient recommendations on corporate governance and more recommendations could affect the growth of the company.
The Hampel Report states that smaller companies should not enjoy a lighter corporate governance code. The Committee is of the opinion that the principles should be the same for all businesses, especially as shareholders often need more assurance about smaller companies.
With regards to directors the Committee generally supports performance-related remuneration but rewards should not be ‘excessive’. The Committee does not recommends that non-executive directors should participate in share-option schemes, but does not consider that the payment of non-executive remuneration by means of shares would compromise their independence.
There is agreement with Greenbury in that companies should aim to reduce the term of directors’ contracts to one year or less. Directors’ service contracts should include detailed provisions regarding early termination rather than relying on directors making claims for damages.
The Committee also endorses the setting up of remuneration committees and is of the view that these should consist solely of independent non-executive directors. The determination of the remuneration of non-executive directors should be delegated to a sub-committee of the full board. However, it was suggested that a more simplified method of disclosure of individual remuneration packages in the annual report and accounts, combined with a more informative statement about the general principles of the company’s remuneration policy. Finally, the Committee agrees that shareholders approval should be sought for new long-term incentive plans but not necessarily for the remuneration committee’s report.
In June 1998 the key elements of the Hampel Report were incorporated in the Stock Exchange Rules, governing all companies listed on the Stock Market. Although the development of a code for corporate governance was a step forward, Hampel’s Report failed to meet with universal accord. Critics said that little was new; that the committee comprised businessmen and their advisers who therefore had a vested interest; that it provided no real accountability and consisted of broad principles which would be hard to put into detailed practice.
Margaret Beckett, the Minister then in charge of the DTI, agreed with the criticisms, particularly in the areas of accountability and transparency, and hinted that she might be prepared to propose legislation in the field of Corporate Governance. As recently as February 1999 a report in the Financial Times suggested that Stephen Byers, Secretary for Trade and Industry, wanted the Stock Exchange to change its rules so that companies would have to put their pay plans to shareholders every year for approval.
This essay has been written by a student and kindly submitted in order to help you with your studies.
If you would like your own custom written law essay then you can find out more here...
Was this useful to you?
Did you find this article useful? Was the content up-to-date or do you have something to add? Give us your feedback and we'll make this site even better for you to use!
