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This article is about Corporate Governance: why we need it, what exactly it is and what constitutes best practice.
CIMA’s view on governance can be summarised in terms of whether the following desired outcome is achieved:
Boards should be focused on the long-term sustainability of their business. They should be confident that their business models will deliver this – with appropriate risk mitigations as necessary - and that performance indicators and incentives reinforce the desired behaviours.
The need for good governance is an integral part of the CIMA syllabus. We can see that this topic is mostly present in BA4 paper, but there are some bits in E1 and P3. Also, let's not forget about the case studies - it's one of the favourite topics there!
If you would like to go through some free ethics questions, you can check our BA4 free package. There are 25 questions on Business Ethics.
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Let's have a look at corporate governance.
Why we need it?
What exactly it is?
And what constitutes best practice?
Corporate governance is required because of a divorce between ownership and control.
Shareholders own a business and they have their own objectives.
What they would like the directors to do in the business is to work to ensure that their own objectives are met, to make sure the shareholders objectives are met.
But, directors have their own objectives too.
And they may on occasion differ from what the shareholders want.
So, for example if the directors are being paid a bonus based on profits produced for this year, it's no surprise that directors will work hard to produce profits for this year.
That's not necessarily the same as producing long term shareholder wealth.
I could increase my profits this year by cutting back on training, by cutting back on research and development, by cutting corners.
And I would make a profit this year and a bonus but it wouldn't necessarily be good for the business.
So, what corporate governance does is seek to try and ensure that the directors behave in such a way as to insure the shareholders objectives are met.
Now, corporate governance is fairly big picture, is to do with the structure of the board, the roles of the directors on the board and the subcommittee's on that board and how the board works basically, internal controls and trickles down from there.
So, once you've got the governance structures right in the first place, internal controls then follows.
So, corporate governance is the method by which organizations are directed and controlled.
Is to do the board structure composition and roles.
Now, starting off with board structure, there are various alternatives around the world for ways in which corporate governance structures are decided upon at a senior level.
At some jurisdictions have what's known as a multi tier system, where they'll have a supervisory board? Which is the senior board on which non-executive directors sit?
So, everyone on that board has no executive responsibilities within the business, no operational responsibilities.
And reporting into that supervisory board, we have a management board and this is where all the executives sit.
They are the people that have operational responsibilities in the business.
So, your head of Finance, your head of HR, your head of IT will sit on the management board and report up to the supervisory board.
Keeping those two separate has lots of advantages.
It means that you get, the supervisory board are not in any way encumbered or threatened potentially by the executive directors being in the same meeting.
But it does mean that you have lots of separate meetings going on and you don't have all the brains in the room at the same time when you're making key decisions.
So, it's also a relatively expensive way to set it up because of all the meetings and the communication that's required between the two boards.
The much more usual approach is for to have a unitary board structure, which just means the organization has one board.
And on that board there are the executive directors and the executive directors of people with operational responsibilities in the business and the non-executive directors, the people are there purely to ensure the business is being run on behalf of the shareholders.
We're going to focus most of our attention on the unitary board that side of things because it is most common in the real world.
Now, corporate governance as a regulatory sort of environment can take one of two forms.
We can either have a rules based approach and a rules based approach is where you have typically some legislation like in the USA we have the Sarbanes-Oxley Act, sometimes shortened to SAR box.
And that's a legal requirement for companies to follow, the rules laid down in the Sarbanes-Oxley Act.
And if you don't comply with the requirements of that act, then there are legal consequences, you can be taken to court, you could potentially be sent to prison.
That is relatively rare; it's a relatively sort of strict legally enforceable regime.
The usual approach is to go for a more principles based approach, which is a little bit more flexible in its application.
One of the issues the rules-based approach is that it's very difficult to come up with rules that suit every single set of circumstances.
So with the principles based approach, you lay out best practice principles that can be applied flexibly in different term, in different circumstances.
So, the principles based approach is outlined best practice and we'll come on to what that best practice generally is in a minute.
And it's normally required to be implemented on what's known as a complier explained basis.
This is slightly different from saying it's a voluntary code just because it's best practice.
So, for example, in the UK, if you're a listed business, listed company on the stock exchange then by virtue of being listed, you agree to apply the UK code on corporate governance on a complier explained basis.
Which means, you need to state in your financial statements whether you fully comply with that code or if you don't, the way in which you don't and why you don't?
And provided, you've disclosed the way in which you don't comply then you're covered as far as the listing rules are concerned.
And that means then the investors have all the information they need to then help them decide whether or not they're happy with your lack of compliance.
And sort of in the background here is the thought that there could be a perfectly good reason why you don't or can't comply with one elements of the corporate governance code.
And it's up to then the investors to decide whether or not they're happy with that.
One of the advantages it's often quoted for the principles based approach is that the judgments are being made by the owners of the business here, the investors, as opposed to a rules based approach where judgment is being made by the courts.
So, it's not voluntary.
It's best practice.
It's not voluntary, if you're a listed business.
So, you need to apply it on a complier explained basis.
Now, as far as international rules are concerned with corporate governance, generally speaking corporate governance is a very jurisdiction or country specific thing.
But there are codes out there that are espousing general and best practice.
And probably, the best known is the OECD code, which is quite a high-level sort of code that talks about the rights of shareholders and so on the obligations of directors and the International Corporate Governance Network, the ICGN, took the OECD framework and made it much more sort of applicable.
So, it's kind of guidance notes to help people understand how to apply the principles in their own businesses.
So, the ICGN report is really the best we have for international best practice as far as corporate governance is concerned.
That said, that its jurisdiction specific.
As you go round the different jurisdictions in principles based approaches, they are all very similar and there's a lot of things that flow through them all and let's have a look at what constitutes best practice now.
So, for a unitary board, first of all, we have at least half the board made up of non-executive directors or Ned's as they're known for short.
These people have no operational responsibilities on the board.
They are typically part-timers, they're usually paid a salary, they're often very experienced business people and they are there to represent the needs of the shareholder.
And the reason why we say we have at least 50% of the board being Ned's is that it means it's any decisions cannot be dominated by people with operational responsibilities within the business.
So, if you get the finance director for example, who is an executive director because he's also head of finance, dominating decisions they might be sidetracked or compromised by what's going on in their own department rather than thinking of the business as a whole.
And to try and stop that from happening we have a majority or said we would don't have a majority of executive directors, we have at least half the people in the room being non executives and maybe there'll be a majority.
So, the four roles of a non-executive director, you can learn with this list of forwards SSRP, Strategy Scrutiny Sisk in People.
So, they are there to contribute to the strategy of the business and they are there to scrutinize the executive directors and to make sure that the decisions the executive directors make is in the best interests of the shareholders.
Now, they are to ensure that risk management processes are in place and operating.
And on the people side of things, that they're to make sure that the board has the right number of people on it, the right types of people on it, they've got the right sorts of roles and that last one, people tends to get sorted out through the various committees that we'll talk about in a moment.
Another key principle of best practice is that the chair person, who runs the board and the CEO, the chief executive officer, who is the manager of the executives in the business should be separate roles, there should be two separate people.
If you have one person doing both those roles, first of all it's a lot of work for one person to do and you'd have to question whether they can do both roles well.
Secondly, it puts an awful lot of power into one pair of hands which might be a concern for shareholders and for the business.
And it also means that the chair and the CEO can keep their respective responsibilities completely apart.
So the chairperson runs the board, the CEO runs the business.
And yes, the two couldn't sort of bounce ideas off each other.
And hopefully, we get better answers as a result.
But keeping the role separate ultimately should mean that the board and the executive function in the business operates a little bit more independently and a little bit better.
And then, at various board subcommittees, the majority of best practice codes say there should be three boards subcommittees, the audit committee, the nominating committee, and the remuneration committee.
The audit committee reviews the financial statements.
It is the clearance point for internal and external audit.
And the reason for that is that the audit committee is made up of typically three non-executive directors, independent non-executive directors, at least one of which needs to have relevant and recent financial experience.
So they know what they're, where they're, what they're doing when they're reading a set of financial statements.
And they are relatively independent which means an internal audit cleared to them, internal auditor therefore independent and if external audit clear to them, that helps make their all a little bit easier.
Because you don't want for example external audit to be clear into the finance director, if the external audit team have got something to say about the way the finance department is run.
So, they clear internal audit, external audit, review the financial statements.
And then also, if there isn't a separate risk committee, will come on to the risk committee in a minute.
They'll also take responsibility for ensuring that there is a risk management process in place and operating.
The nomination committee is to do with who is on the board.
So, nomination naming, so who is named as directors on the on the board and they'll consider things like the structure of the board, how big it needs to be?
Whether we should have more internally promoted people or bring people in from the outside.
Now, consider issues like diversity and so on and make recommendations for approval.
The remuneration committee looks at how directors are paid.
So, they'll look at things like the proportion of fixed salary to a bonus or performance-related pay.
If the performance-related pay, they'll make sure it's sufficient to motivate directors but not so excessive that it causes them to take silly risks, and they'll make sure that it's structured in such a way as to encourage the directors to work towards the long term goals of the shareholders.
So they'll set the pay effectively for the executive directors in the business.
It's also becoming increasingly common these days for there to be a fourth committee, the risk committee to take the responsibility off the audit committee and give risk management a bit of specific focus.
Now, that's good in many ways.
Not only does it give it specific focus, it also means that we can get some executive directors involved.
Because remember, the audit committee is made up of non-executive directors.
So, if the audit committee you're looking after risk, then there won't be any executive directors involved directly in looking after risk.
So, the risk committee gives it a bit of separate consideration to make sure that risk management is given the profile that it needs and the focus that it needs to operate well within the business.
So, they're the general sort of principles of best practice that you'll see with corporate governance.
There are various others, but that's the main ones.
Now, let's cope with governance codes, this is based only on the UK code but this would be the same for any codes really around the world.
Right, focus on these five areas.
So, they'll look at leadership, so they'll look at the role of the chairman and the role of the CEO and make sure those roles are separate and how they work and make sure they work together well, and the effectiveness of the board, so making sure for example that directors have sufficient time to do their job, they have sufficient information given to them in sufficient time before meetings to enable them to come to well reasoned decisions and they ensure accountability of the board and clarify accountability of the different members of the board, they've got the different subcommittees there but also to clarify that the board of directors are responsible for the performance and operations of the business as a whole, to ensure that directors are remunerated in an appropriate way, to encourage them to think like shareholders and to behave how shareholders would want them to behave.
And also, to ensure they maintain relationships with those shareholders.
So, for example not seeing the annual general meeting as purely legal administrative exercise but using the AGM as a way to communicate with shareholders and to get shareholders involved in making key decisions in the business.
It's also increasingly common to identify particular non-executive directors, sometimes called a senior non-executive director, to give them as a point of contact for shareholders to contact if they have any questions throughout the year to try and improve relations with shareholders.
There's a general point to finish on for the exam.
Although, there is a lot of sort of ideas and concepts surrounding corporate governance, if you imagine being a shareholder and you're employing somebody else to look after your business for you.
If you think about the kind of things that you would worry about and how you'd make yourself feel better about those things, those are the control mechanisms you'd put in place.
You usually find that what you're actually doing is describing the corporate governance code.
So they have they have an underlying logic to them which helps us in exams.
Thanks for listening.