Definitions and Issues in CG

Question 1

What are the 2 main theories of CG?

Answer 1

1. Shareholder primacy theory (agency theory) = shareholder value approach to CG
2. Stakeholder theory = stakeholder approach to CG

Question 2

What is the focus of the shareholder primacy theory of CG?

What are the 2 main criticisms?

Answer 2

= maximising value to shareholders before considering other corporate stakeholders such as employees, customers, suppliers, and society as a whole

1. Inappropriate stewardship = changes in ownership structure has led to ownerless companies where no single investor has a large enough stake in a company to act as the responsible owner
2. Short-termism = a tendency for management to take actions that maximise short term earnings at the expense of shareholders’ long-term objectives

Question 3

When does an agent-principal relationship exist?

What are the 2 challenges associated with agency theory?

What is the criticism of agency theory?

Answer 3

= in companies where there is a separation of ownership and control

1. Agency conflicts = agents and principles have differing interests.
   Shareholders want long-term income (dividends).
   Managers want short-term annual bonuses.
2. Agency costs = costs associated with maintaining the agent-principal relationship
   a. Bonding costs = costs of paying directors
   b. Monitoring costs = costs of monitoring their performance
   c. Residual loss costs = costs to shareholders associated with directors’ actions which in the long-run turn out not to be in the best interests of the shareholders (e.g. major acquisition or disposal)

Argued that agency theory focuses on maintaining value for shareholders which has led to short-termism because many shareholders are looking for short-term gains = shareholders invest in shares often as a tradable commodity for short term gain and consider investment in the business second

Question 4

What are the 4 areas of agency conflict that Jensen and Meckling identified?

How can a company manage or avoid conflicts of interest between shareholders and directors and managers? (2)

Answer 4

1. Moral Hazard = Managers have an interest in receiving benefits from their position e.g. company car
2. Level of Effort = Managers may work less hard than they would if they were the owners of the company
3. Earnings Retention = Director’s remuneration is often related to the size of the company (measured by annual sales revenue) rather than its profits
   = Managers have an incentive to increase the size of the company (reinvest profits), rather than pay dividends
4. Time Horizon = Shareholders are concerned about long-term financial prospects of their company. Directors and managers might only care about the short-term for annual bonuses

Agency theory = companies should use CG practices
1. use long-term incentive share award or stock option schemes
2. Adopt policies on conflicts of interest and related party transactions

Question 5

What does the stakeholder theory of CG say the purpose of CG should be?

How does this apply to decision-making?

How does this apply to financial and non-financial objectives?

How should companies act?

Who should companies be accountable to?

Answer 5

= purpose of CG should be to meet the objectives of everyone that has an interest in the company

Boards should balance the interests of different stakeholder groups, deciding on a case-by-case basis which interest take priority.

Non-financial objectives, such as employee relations or limiting environmental impact, should be considered equal to the financial objectives, such as the return on investment

Companies should act as good corporate citizens and take into account the impact on society and the environment.

Companies should be accountable to society and should conduct their activities to the benefit of society
(Forms the basis for arguments in favour of corporate, social, and environmental responsibility)

Question 6

What is the shareholder value approach to CG?

What is the main objective?

Who should the directors be accountable to?

What is the criticism?

Answer 6

= board of directors should govern their company in the best interests of its owners, the shareholders

Main objective = maximise shareholder’s wealth through share price growth and dividend payments

Directors should only be accountable to shareholders with power to appoint and remove from office for poor performance.

Not sustainable in the long term as companies need to interact with different stakeholder groups.

Question 7

What is the stakeholder (AKA pluralist) approach to CG?

Where is it mostly adopted?

What is the criticism?

Answer 7

= companies should have regard to the views of all stakeholders, not just shareholders, and balance all their interests when making decisions

Mostly adopted in civil law countries = France, Germany, Japan, and China

Argued that if companies were to take into account all stakeholders’ conflicting views, they would never come to a decision

Question 8

What is the inclusive stakeholder approach to CG?

How does this affect the board’s decision-making?

Where was it introduced and in which country does the approach reflect the needs and culture?

Answer 8

= boards should consider the legitimate interests and expectations of key stakeholders on the basis that this is in the best interests of the company

Legitimate interests and expectations of key stakeholders should be included in board’s decision-making and traded off against each other on a case-by-case basis in the best interests of the company

Introduced by King Reports
Approach reflects African needs and culture = incorporates sustainability and good citizenship into the definition of CG to fight corruption, poverty, and health issues

Question 9

What is the enlightened shareholder value approach to CG?

How is it different from the stakeholder approach and the inclusive stakeholder approach?

Which duty does it link to under the CA2006?

What are the 2 challenges to the duty in practice?

Which regulation seeks to address these challenges by providing guidance?

Answer 9

= boards should look to the long term as well as short term and consider the views of and impact on other stakeholders when considering actions to maximise shareholder value

Different because other stakeholder views are only considered in so far as it would be in the interests of shareholders to do so (stakeholder approaches = boards balance the conflicting interests of stakeholders in the best interests of the company)

S.172 CA2006 imposes a statutory duty on directors to promote the success of the company for the benefit of its members as a whole and have regard to 6 factors

2 challenges in practice:
1. No provision in CA2006 to enforce the duty = members are the only stakeholder with enforcement rights through a derivative action
2. No guidance as to how directors should take other stakeholder interests into account = Boards in reality still focus on shareholder interests only

The Companies (Miscellaneous Reporting) Regulations 2018

Question 10

What are 5 main differences between a shareholder primacy approach (SPA) and a company/stakeholder focused approach (C/SA) to CG?

Answer 10

1. Functions of the company
   * SPA = Maximise wealth for shareholders
   * C/SA = Provide goods and services; provide employment; create opportunities for investment; drive innovation
2. Purpose of the company
   * SPA = Maximise wealth for shareholders
   * C/SA = Is set by the Board
3. Responsibility to society
   * SPA = None
   * C/SA = Fulfil business purpose and act as a good corporate citizen
4. Ethical standards
   * SPA = Whatever shareholders want or obey the law
   * C/SA = Obey law and follow society’s ethical standards
5. Nature of shareholders
   * SPA = Undifferentiated, self-interested wealth maximisers
   * C/SA = Diverse, with differing objectives, incentives, time horizons and preferences

Question 11

Trends today support the convergence of the shareholder value approach and the stakeholder approach:

What is the company centred approach to CG as further developed in 2017 by J. Bower and L. Paine?

Why should shareholders not take primacy over other stakeholder groups? (3)

Answer 11

Recognises companies are independent entities in law with the potential for indefinite life –> company’s leadership have a duty to sustain it in the long-term = make decisions in the best interests of the company not in the interests of one of more stakeholder groups

Shareholders should not take primacy over other stakeholder groups:
1. Shareholders have no legal duty to protect or serve the companies whose shares they own

2. Shareholders often have differing interests = generally invest for short-term return on investment pressurising management to focus on the short-term rather than long-term projects in the better interests of the company’s sustainability
3. Companies have power over billions of people’s lives so should serve the societies and markets they operate in over the longer-term = should create value for multiple stakeholders as well as shareholders

Question 12

What is stakeholder capitalism?

Why is it becoming important?

Where was the concept introduced globally? Why?

Answer 12

Seeks to create shareholder returns by creating value for society as a whole
= Is about aligning their interests to grow the pie for the benefit of all

Important = growing view that the most important assets in an organisation are not tangible but are intangible i.e. access to talent and reputation

Introduced globally at WEF Davos 2020 meeting = Governments and companies are realizing the importance of ESG considerations for long-term success

Question 13

Who does the ‘Responsibility’ principle of CG refer to?

How can organisations help with this?

How does responsibility link to accountability?

Answer 13

a person or group of people having authority over something, and therefore liable to be held accountable for the exercise or lack of exercise of that authority

Organisations should make sure procedures are in place so people know their responsibilities and what they are accountable for

Mismanagement of authority should be penalised = responsibility goes in hand with accountability

Question 14

What does the ‘Accountability’ principle of CG refer to?

Who should accountability be to?

What are the 2 challenges?

What does CG best practice say about how to overcome these?

Answer 14

requirement for a person or group of people in a position of responsibility to justify, explain or account for the exercise (or not) of their authority

Accountability should be to the person or group of people from whom the authority is derived
Challenges = decide how they should be made accountable and over what time period

CG best practice requires an organisation to set out clearly who is accountable for what and over what time period

Question 15

What does the ‘Transparency’ CG principle refer to?

What should an organisation do? (3)

Answer 15

the ease with which an outsider is able to make a meaningful analysis of an organisation and its actions, both financial and non-financial

Organisations should:
1. Be open = builds trust between the organisation and its stakeholders

2. Ensure that disclosure is timely and accurate on all material matters = so those interested in the organisation can make informed decisions
3. Have policies in place about the disclosure of information – e.g. what information should be public /private

Question 16

What does the ‘Fairness’ CG principle refer to?

What should an organisation do to enforce this? (3)

Answer 16

the principle that all key stakeholders should be treated fairly when decisions are made or actions taken by the organisation

Organisations should:
1. provide effective redress for violations, e.g. to minority shareholders when they have been treated unfairly

2. have policies and procedures in place to ensure key stakeholder views are considered without bias
3. apply fair practices when dealing with stakeholders

Question 17

What is reputation?

What can a bad reputation do?

What must an organisation do to manage reputational risk?

What are 5 benefits of effective reputational management?

Answer 17

= defines an organisation as well as the individuals associated with that organisation

The destruction of a reputation can lead to the end of the organisation = Arthur Anderson was destroyed in 2002 by the damage of its involvement in the Enron affair

Organisations must have structures, policies and processes in place to manage reputational risk

J Larkin = benefits of effective reputational management:

1. Improve relationship with shareholders
2. Recruiting and retaining the best employees
3. Attracting best business partners, suppliers, and customers
4. Minimising threats of litigation and stringent regulation
5. Reinforcing the organisation’s credibility and trust for stakeholders

Question 18

What is the rules-based approach to CG laws, regulations, standards, and codes?

What is an example?

What happens if fail to obey?

Critics argue it only works when? (2)

What are 3 disadvantages?

What is the benefit of the system?

What are 2 advantages?

Answer 18

= consists of a mandatory set of laws, regulations, standards and codes
E.g. Sarbanes-Oxley Act 2002

Failure to obey = company sanctions and/or fines and directors in breach may also be fined, imprisoned, and/or disqualified

Critics argue it only works where:
1. Challenges the company face are similar, justifying a common approach to common problems
2. The rules and their enforcement effectively prevent the behaviours they are aimed at affecting

Disadvantages:
1. Rigid
2. Lack of discretion
3. Enforcement in many countries is weak

Benefits of system = sends a message to owners, potential investors, and other stakeholders that the country takes their protection from mismanagement seriously

Advantages:
1. Readily enforceable
2. Civil or criminal sanctions

Question 19

What is the principles-based approach to CG laws, regulations, standards, and codes?

What is an example?

What are the advantages? (2)

What are the disadvantages? (2)

Answer 19

= a voluntary set of best practices usually contained in a code of best practice

E.g. UK Corporate Governance Code 2018
Advantages:
1. Flexibility = Recognises that noncompliance may sometimes be in the organisation’s best interests
2. Comply or explain

Disadvantages:
1. Lack of enforceability = for it to work, institutional investors have to take an active role in the governance of the companies they invest in
2. No sanctions

Question 20

What is the comply or explain approach to a principles-based approach to CG laws, regulations, standards, and codes?

Who assesses this?

Which code uses this?

Answer 20

Comply or explain = company is asked to comply with a voluntary principles-based code of best practice and the company must explain to shareholders why it has not if it thinks it’s not in its best interests to.

The company’s shareholders and shareholder representative bodies are then expected to assess whether the explanation is acceptable or not.

UK CG Code adopts this

Question 21

What is the apply and explain approach to a principles-based approach to CG laws, regulations, standards, and codes?

When was it introduced?

Which code has adopted it?

Answer 21

Apply and explain = apply each principle by considering them within the company’s context and then explain how they have addressed them in their governance practices

Introduced by King IV in 2016

Adopted by The Wates Corporate Governance Principles for Large Private Companies (2018)

Question 22

How should a CG framework be implemented through assimilation of CG practices?

What happens if there is an inappropriate infrastructure?

Answer 22

Organisational purpose –> Compliance (structure + policies + procedures + people) –> governance –> culture –> organisation success

1. Based on the organisational purpose, the cosec can advise the board on the appropriate CG requirements for the organisation
2. Compliance answers the ‘what is required’ question = leads to an organisation adopting the appropriate structures, policies and procedures
3. Governance answers the ‘how do we make this effective’ question = Co sec needs to ensure the infrastructure is appropriate for the organisation = people work well together, resources used effectively, and information flows smoothly = decisions made effectively = successful organisation

○ Inappropriate infrastructure = anticipated cultures will not be developed

People will develop their own cultures and if not being managed lead to bad practices = threatens the performance and long-term sustainability of the organisation

Question 23

What are 6 benefits of adopting good governance practices?

Answer 23

1. Long-term sustainability
2. Reduced risk of corporate crisis and scandals
3. Effective decision making
4. Improved oversight, monitoring, and evaluation
5. Succession planning
6. Ethical behaviour = an anti-corruption tool

Question 24

What are 3 consequences of weak governance practices?

Answer 24

Weak governance leads to:
1. Failing companies (Parmalat 2003)

2. Reputational problems (Sports Direct 2017)
3. Excessive regulation = laws in response to scandals

Question 25

Why is Transparency a core principle of corporate governance? (3)

How can it aid Accountability? (2)

Answer 25

Important:
1. Transparency is needed in order for shareholders to be able to assess a company’s Board and how it operates

2. Transparency and openness helps to create trust between the company and its shareholders and other stakeholders
3. Transparency can drive better behaviour by companies because they are being judged by the behaviours that are disclosed

Aid Accountability:
1. The provision of information can help stakeholders to hold companies to account

2. It requires companies to set out who is accountable for what so that stakeholders are clear who should be held responsible

Question 26

What is a company’s purpose?

Why is it important? (5)

Answer 26

= the reason that the company is in business

1. Everything a company does should stem from its organisation’s purpose because its purpose sits at the top of its corporate governance framework.
2. Helps the Board to make decisions about its strategic goals and its consideration of risk
3. Helps to set the organisation’s governance framework of policies and procedures.
4. It gives clarity of purpose for the Board, management, employees and investors.
5. UK CG Code = culture and remuneration needs to be aligned with purpose