Corporate Governance – Principles, Policies and Practices 3e

1. Corporate Governance – Principles, Policies and Practices 3e Chapter 5 The Regulatory Framework

2. The regulatory framework - in which we consider: - legislation, regulation and corporate governance codes - corporate regulation in the USA - corporate regulation in the UK - corporate regulation in other countries - world-wide corporate governance codes - codes from institutional investors - company codes -codes for the public and voluntary sectors • the importance of compliance – corporate governance reports - principles or prescription - the governance debate.

3. The regulatory framework Legislation, regulation and CG Codes • Being a creation of the law, limited liability companies depend on company law for their existence, continuity and winding-up • Companies must follow the company law of the jurisdiction in which they are incorporated, and the laws of other places where they do business • Penalties for failure to obey company law can be heavy on the company, its directors and its officers • both fines and/or prison • in China the penalty can be death for corruption or other major corporate infractions.

4. The regulatory framework Corporate regulation in the USA • Each state in the United States has its own companies’ law • Federal oversight of companies is provided by the Securities and Exchange Commission (SEC) • The SEC’s mission is to protect investors, to maintain fair, orderly, and efficient markets, and to facilitate capital formation • To achieve this protection for investors, the SEC requires public companies to disclose information that is then publicly available • The SEC oversees the key participants in the securities world, including securities exchanges, securities brokers and dealers, investment advisors, and mutual funds.

5. The regulatory framework The SEC developed an extensive corporate governance regime for companies listed in the USA Widely believed that US financial regulation was a model for the rest of the world Then in 2001 came the collapse of Enron, WorldCom, Tyco, Waste Management and the ‘big five’ auditor Arthur Andersen.

6. The regulatory framework • The response from the US government was the Sarbanes Oxley Act (2002), now know as SOX or Sarbox, • Influential company legislation emphasizing the US belief that the regulation of corporate governance should be under the law, not through discretionary codes • SOX : • required certification of internal auditing • increased financial disclosure • applied criminal and civil penalties on directors for non-compliance • required annual report on internal accounting controls to the SEC.

7. Corporate governance codes • Sarbanes-Oxley Act (SOX) 2002 • Created Public Company Oversight Board • Listed companies must have audit committee with entirely independent outside directors or an entirely outside board • Regulation of auditors – one year cooling off before employment of audit staff or partner of auditor • rotate audit partner every 5 years • Restrictions on non-audit work: management, investment, legal services • No work that will be audited • Disclosure of all fees paid to auditor.

8. Corporate governance codes Section 404 SOX • Management to produce an “internal control report” • Report affirms “the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting”  • Report must also “contain an assessment of the effectiveness of the internal control structure and procedures of the issuer for financial reporting” • Independent outside auditors must attest to managers' internal control assessment, pursuant to SEC rules • High cost of compliance.

9. Corporate governance codes SEC require US Exchanges to reflect SOX (2003) • Board must have majority independent outside directors • Establish corporate governance committee (to develop CG principles and ensure board and director evaluation) • Require compensation (remuneration) committee to ensure CEO rewards aligned with corporate objectives • Require audit committee to produce and disclose CG guidelines and codes of business conduct and to review external auditor’s reports on internal controls.

10. The regulatory framework • The global financial crisis came, starting in 2007 led to the collapse and bail-out of some major financial institutions by the US government • The Dodd-Frank Wall Street Reform and Consumer Protection Act (2010) was enacted to improve American financial regulation and the governance of the US financial services industry • Mary L. Schapiro, Chairman of the SEC explained: • “This law creates a new, more effective regulatory structure, fills a host of regulatory gaps, brings greater public transparency and market accountability to the financial system and gives investors important protections and greater input into corporate governance.”

11. The regulatory framework • The Treadway Commission was created in 1985 to consider fraudulent corporate financial reporting • Their first report (1987) created the Committee of Sponsoring Organizations (COSO), a private-sector initiative to encourage executive management and boards towards more effective business activities • COSO supports executive management and boards to establish more effective, efficient, and ethical business operations • COSO offers frameworks and guidance based on in-depth research, analysis, and best practices, including • Enterprise Risk Management — an integrated framework (2004) • Guidance on Monitoring Internal Control Systems (2009).

12. The regulatory framework Corporate regulation in the UK • In the UK, companies must follow UK Companies Acts • The UK Cadbury Report (1992), responding to a series of corporate failures, produced the world’s first corporate governance code . • Entitled 'The financial aspects of corporate governance', it was not intended to be a comprehensive review of the subject • The code was discretionary, UK listed companies must report that they have complied with the code or, if not, explain why.

13. Corporate governance codes • Subsequently, the UK has published more reports than any other country • Cadbury Report (1992) • Greenbury Report (1995) • Hampel Report (1998) • UK Combined Code (1998) • Turnbull (1999) • Myners (2001) • Higgs (2003) • Smith (2003) • Tyson (2003) • Revised UK Combined Code (2003)

14. Corporate governance codes Cadbury Report on financial aspects of CG (1992) • The wider use of independent non-executive directors • The introduction of an audit committee of the board having a minimum of three non-executive directors with a majority of them independent • The division of responsibilities between the chairman of the board and the chief executive. If the roles are combined, the board should have a strong independent element • The use of a remuneration committee of the board to oversee executive rewards • The introduction of a nomination committee with independent directors to propose new board members • Adherence to a detailed code of best practice.

15. Corporate governance codes Greenbury Report on directors’ remuneration (1995) • That companies’ remuneration committees should be comprised solely of independent non-executive directors • That the chairman of the remuneration committee should respond to shareholders’ questions at the AGM • That annual reports should include details of all director rewards - naming each director • And that directors’ contracts should run for no more than a year to avoid excessive golden handshakes.

16. Corporate governance codes Hampel report – review of Cadbury (1998) • That good corporate governance needs broad principles not prescriptive rules; that compliance with sound governance practices, such as the separation of board chairmanship from chief executive, should be flexible and relevant to each company’s individual circumstances, and that governance should not be reduced to what the report called a ‘box-ticking’ exercise • That the unitary board is totally accepted in the UK. There is no interest in alternative governance structures or processes such as two tier boards • That the board is accountable to the company’s shareholders. There is no case for redefining directors’ responsibilities to other stakeholder groups • That self-regulation is the preferred approach to corporate governance. There was no need for more company legislation.

17. Corporate governance codes UK Combined Code (1998) • In 1998 the Cadbury, Greenbury and Hampel proposals were consolidated into the UK Combined Code, which was annexed to the Stock Exchange listing rules • Thus compliance became a requirement for all companies listed on the London Stock Exchange • Although the code had no direct legal standing in terms of enforcement, it formed part of the overall regulatory framework for companies in the UK.

18. Corporate governance codes Turnbull Report (1999) • Elaborated on the call in the Hampel Report for appropriate internal controls. • Risk assessment was vital • Reporting on internal controls became an integral part of the corporate governance process.

19. Corporate governance codes The Higgs Report (2003) • At least half the board should be independent, non-executive directors • All members of the audit and remuneration committees, and a majority of the nomination committee, should be independent non-executive directors • That the role of chief executive should always be completely separate from that of chairman • That director recruitment should be rigorous, formal and transparent • That executive directors should not hold more than one non-executive directorship of a FTSE 100 company • Boards should evaluate the performance of directors and board committees annually • Boards should have a senior non-executive director to liaise with shareholders.

20. Corporate governance codes The Higgs Report (2003) • Commissioned by the Labour Government, rather than the financial institutions, to see how “more independent and more active non-executives, drawn from a wider pool of talent, could play their part in raising productivity” • Derek Higgs’ initial proposals was contentious • Proposals that were not accepted included: • a ban on chief executives moving into the chair of their own company • a ban on chairmen heading the nomination committee of their own board • a ban on anyone being chairman of more than one FTSE 100 company • and a call for regular meetings between the senior independent director and shareholders.

21. Corporate governance codes • The Myners Report (2001) addressed the responsibilities of institutional investors • The Smith Report (2003) looked at audit committees. Sir Robert Smith called for: • A strengthening of the role of the audit committee • All members of the audit committee to be independent • At least one member should have significant, recent, and relevant financial experience • The audit committee to recommend the selection of the external auditor • An audit committee report to be included in the annual report to shareholders, with the chairman of the committee attending to answer questions.

22. Corporate governance codes The Tyson Report (2003) • On the recruitment and development of non-executive directors • More professionalism and transparency in recruitment • Director induction and training • Outside directors could be recruited from the ‘marzipan layer’ of senior executives, those just below board level, and from unlisted companies, consultancies, and organisations in the non-commercial sector.

23. Corporate governance codes Revised UK Combined Code • Published by the Financial Reporting Council having taken over the responsibility from the Stock Exchange Listing Rules • Four principle requirements for governance of listed companies: • Independence • Diligence • Professional development • Performance evaluation • Also sections on remuneration committees and audit committees (increasing its role in monitoring the integrity of the published financial statements and reinforcing the independence of the outside auditor).

24. Corporate governance codes Following the global financial crisis, beginning in 2007, the FRC reviewed the UK Combined Code, and renamed it the UK Corporate Governance Code (2010) This code set out standards of good practice in relation to • board leadership and effectiveness • remuneration • accountability and relations with shareholders.

25. Corporate governance codes The UK Corporate Governance Code contains broad principles, plus some more specific provisions. The main principles are: • Section A: Leadership • Section B: Effectiveness • Section C: Accountability • Section D: Remuneration • Section E: Relations with Shareholders.

26. Corporate governance codes Section A: Leadership • Every company should be headed by an effective board which is responsible for the long-term success of the company • A clear division of responsibilities between the running of the board and executive responsibility for running the business • No one individual should have unfettered powers of decision • The chairman is responsible for leadership of the board and ensuring its effectiveness • Non-executive directors should constructively challenge and help develop proposals on strategy.

27. Corporate governance codes • Section B: Effectiveness • The board and its committees should have the appropriate balance of skills, experience, independence and knowledge of the company • A formal, rigorous and transparent procedure for the appointment of new directors • All directors to allocate sufficient time to the company • All directors should receive induction on joining the board and should regularly update and refresh their skills and knowledge • The board should be supplied in a timely manner with information to enable it to discharge its duties • The board should undertake a formal and rigorous annual evaluation of its own performance and that of its committees and individual directors.

28. Corporate governance codes Section C: Accountability • The board should present a balanced and understandable assessment of the company’s position and prospects • The board is responsible for determining the nature and extent of the significant risks it is willing to take • The board should maintain sound risk management and internal control systems • The board should establish formal and transparent arrangements for corporate reporting and risk management and for maintaining an appropriate relationship with the company’s auditor.

29. Corporate governance codes Section D: Remuneration • Levels of remuneration should be sufficient to attract, retain and motivate directors of the quality required to run the company successfully • But should avoid paying more than is necessary for this purpose • A significant proportion of executive directors’ remuneration link rewards to corporate and individual performance • A formal and transparent policy on executive remuneration and for fixing the remuneration packages of individual directors • No director should be involved in deciding his or her own remuneration.

30. Corporate governance codes Section E: Relations with Shareholders • There should be a dialogue with shareholders based on the mutual understanding of objectives • The board as a whole has responsibility for ensuring that a satisfactory dialogue with shareholders takes place • The board should use the AGM to communicate with investors and to encourage their participation.

31. Peters (Holland) 1997 SE Hong Kong 1998, 2005 Deutsche Bundestag (Germany) 1998 Italy 1998 Japan 1998 Malaysia 1999 Brazil 1999 Singapore 1999 Russian IoD 2001 Codes in other countries • Hilmer (Australia) 1993 • Toronto SE (Canada) 1994 • King (S. Africa) 1994, rev 2002 • Swedish Academy of Directors 1994 • Viénot (France) 1995 • USA Business Round Table 1996/7/2002

32. Corporate governance codes Codes from international agencies OECD (1999/2003) (Organisation for Economic Co-operation and Development) Principles of Corporate Governance Commonwealth Association for Corporate Governance Principles for Corporate Governance(1999) World Bank/OECD Forum United Nations Development Program (corporate governance papers and conferences) IOSCO International Organisation of Securities Commissions Regulators from>50 countries, representing 98% of world securities traded.

33. Corporate governance codes • OECD Principles of Corporate Governance • The rights of shareholders • The equitable treatment of shareholders • The role of stakeholders in corporate governance • Disclosure and transparency • The responsibilities of the board • - to act in good faith, diligently, and with care • - to treat all shareholders fairly • - to ensure compliance with the law • - to review and guide corporate strategy • - to select, compensate, and monitor key executives • - to monitor governance practices • - to ensure integrity of accounting and financial • systems

34. Corporate governance codes • Commonwealth Principles • for Corporate Governance • Board appointments • Strategy and values • Company performance • Compliance and conformance • Accountability to shareholders • Relationships with stakeholders • Balance of powers, and internal procedures • Board performance assessment • Management appointments, and technology • Risk management • Annual review of future solvency

35. Corporate governance codes • Codes from Institutional Investors • CalPERS – California Public Employees’ Retirement System • (>US$155 billion in assets) 1997 onwards • International Corporate Governance Network • (>US$6 trillion in assets) • Teachers Insurance and Annuity Association-College Retirement Equities Fund (TIAA-CREF) • Hermes Fund Manager principles 2002, 2008.

36. Corporate governance codes Many listed companies now publish their own corporate governance policies and codes (explore company web sites for examples or view a selection of codes on this textbook’s Online Resource Centre at http://www.oxfordtextbooks.co.uk/orc/tricker3e/).

37. Corporate governance codes • Corporate Governance Guidelines for Individual Directors • Guidelines for Directors • - IoD UK, Canada, Australia etc. • Code of Practice for the NED – IoD UK • NED understands the company and its finances • NED is truly independent (defined) • Conflicts of interest identified • NED’s role to improve decision making of board • - expand horizons of board and monitor executive performance

38. Corporate governance codes Codes for the public and voluntary sectors • Now widely recognized that all corporate entities need to be governed, as well as managed • This applies to not-for-profit as to profit-orientated entities • charities • trusts • mutual societies • sports associations • cultural organizations • public authorities • non-government organizations • other entities in the public and voluntary sectors.

39. Corporate governance codes Differences between governance of the not-for-profit and the profit-orientated sectors • Their governing bodies have a variety of names – e.g. council, committee, board of governors • They usually have different constituencies to satisfy, with multiple objectives and measures of performance, rather than profit • Often the governing body is all non-executive with executives attending but not voting.

40. Corporate governance codes Principles or prescription a governance debate Many commentators refer to ‘Anglo-American’ approach to CG • unitary board, with both executive and non-executive directors • common law jurisdictions Contrasted with Continental European approach • two tier, supervisory board and executive board • civil law jurisdictions But a schism has emerged within the Anglo-Saxon approach • In the US, corporate governance now enforced by regulation and the rule of law. (SOX) • In the UK and many other jurisdictions corporate governance is by self-regulation and voluntary compliance with CG codes.

41. The regulatory framework We have considered - legislation, regulation and corporate governance codes - corporate regulation in the USA and the UK - corporate regulation in other countries - world-wide corporate governance codes - codes from institutional investors - company codes - codes for the public and voluntary sectors - the importance of compliance – corporate governance reports - principles or prescription - the governance debate.