Part One, Chapter 1 - Definitions and Issues In Corporate Governance

Question 1

What was The Cadbury Report and its purpose?

Answer 1

The Cadbury Report was the first corporate governance code in the world. It contained a number of recommendations to raise standards in corporate governance. Its purpose was to encourage honesty and accountability of listed companies by establishing principles for them to follow.

Question 2

The Cadbury Report covered which eight topics?

Answer 2

The topics covered by the Cadbury Report included:

1. Board effectiveness
2. The roles of the chair and the non-executive directors
3. Access to independent professional advice
4. Directors’ training
5. Board structures and procedures
6. The role of the company secretary
7. Directors’ responsibilities
8. Internal financial controls and internal audit

Question 3

Who chaired the committee that led to The Cadbury Report being published?

Answer 3

Sir Adrian Cadbury.

Question 4

What did The Cadbury Committee (1992) define corporate governance as?

Answer 4

The Cadbury Committee (1992) defined corporate governance as ‘the system by which companies are directed and
controlled’.

Question 5

True or false? There is no one definition of corporate governance.

Answer 5

True!

Question 6

What did The Organisation for Economic Co-operation and Development (OECD) define corporate governance as?

Answer 6

‘A set of relationships between a company’s management, its board, its shareholders and other stakeholders … also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined’.

Question 7

What did The UK Corporate Governance Code 2016 state was the purpose of corporate governance?

Answer 7

According to the 2016 Code, ‘the purpose of corporate governance is to facilitate effective, entrepreneurial and prudent management that can deliver the long-term success of the company’.

Question 8

What does The 2018 UK Corporate Governance Code recognise?

Answer 8

The 2018 UK Corporate Governance Code recognises that companies do not exist in isolation: ‘To succeed in the long-term, directors and the companies they lead need to build and maintain successful relationships with a wide range of stakeholders.’

Question 9

There are no agreed definitions or approaches to corporate governance. There is, however, agreement on four
concepts of corporate governance. List them.

Answer 9

1. Accountability
2. Responsibility
3. Transparency
4. Fairness

Question 10

Who benefits from corporate governance?

Answer 10

Corporate governance benefits organisations of all sizes across all three sectors, public, private and not for profit.

Question 11

What are the two main theories that form the basis for corporate governance practices?

Answer 11

1. Shareholder primacy theory which forms the basis of the shareholder value approach to corporate governance.
2. Stakeholder theory which forms the basis of the stakeholder approach to corporate governance.

Question 12

What does the shareholder primacy theory of corporate governance focus on?

Answer 12

The shareholder primacy theory of corporate governance focuses on maximising the value to shareholders before considering other corporate stakeholders, such as employees, customers, suppliers and society as a whole.

Question 13

Who developed the shareholder primacy theory?

Answer 13

Milton Friedman and Henry Manne

Question 14

According to the shareholder primacy theory, what is the purpose of directors, managers, and employees in a company?

Answer 14

The shareholder primacy theory is based on the premise that shareholders own companies and that directors, managers and employees are engaged by the company for the purpose of maximising shareholder wealth.

Question 15

What is the contrary view advocated by supporters of the stakeholder approach?

Answer 15

The contrary view advocated by supporters of the stakeholder approach to corporate governance is that shareholders
don’t actually own the company as the company is a separate legal entity in and of itself.

Question 16

Why has shareholder primacy as a governance model come under criticism? List two reasons.

Answer 16

1. Inappropriate stewardship - It is argued that changes in shareholder structure from direct investment by individual shareholders to wealth invested under management (asset managers, pensions, insurance) has led to what are often referred to as ‘ownerless companies’, where no single investor has a large enough stake in the company to act as the responsible owner, checking the performance and behaviour of the board and management of the
   company.
2. Short termism - Defined by the Kay Report (2012) as both ‘a tendency to under-investment, whether in physical assets or in intangibles such as product development, employee skills and reputation with customers, and as a hyperactive behaviour by executives whose corporate strategy focuses on restructuring, financial re-engineering or mergers and acquisitions at the expense of developing the fundamental operational capabilities of the business’.

Question 17

What did the agency theory criticise company directors for?

Answer 17

The theory argues that company directors were not likely to be as careful with other people’s money as their own.

Question 18

When is an agent-principal relationship established?

Answer 18

The agent–principal relationship exists when an agent represents the principal in a particular transaction and is expected
to represent the best interests of the principal above their own.

Question 19

Who are the parties involved in an agent-principal relationship, and under what condition does this relationship exist?

Answer 19

Jensen and Meckling argued that the agent–principal relationship existed in companies where there was a separation of ownership and control. The shareholders played the part of the principal and the directors and managers played the part of the agent.

Question 20

Conflict arises in an agent–principal relationship when agents and principals have differing interests. Provide two examples of the main conflicts between shareholders and managers.

Answer 20

1. Shareholders usually want to see their income and wealth grow over the long term so will be looking for long-term
   year-on-year increases in dividends and share prices.
2. Directors and managers, on the other hand, will be looking more short-term to annual increases in their remuneration and bonuses.

Question 21

Jensen and Meckling identified four areas of conflict between shareholders and managers. List and define them.

Answer 21

1. Moral hazard - A manager has an interest in receiving benefits from his or her position in the company (use of a company car, plane, house, events etc). Jensen and Meckling suggested that a manager’s incentive to obtain these benefits is higher when they have no shares, or only a few shares, in the company.
2. Level of effort - Managers may work less hard than they would if they were the owners of the company. The effect of
   this lack of effort could be smaller profits and a lower share price.
3. Earnings retention - The remuneration of directors and senior managers is often related to the size of the company (measured by annual sales revenue and value of assets) rather than its profits. This gives managers an incentive to increase the size of the company, rather than to increase the returns to the company’s shareholders.
4. Time horizon. Shareholders are concerned about the long-term financial prospects of their company, because the value of their shares depends on expectations for the long-term future. In contrast, managers might only be interested in the short term. This is partly because they might receive annual bonuses based on short-term performance, and partly because they might not expect to be with the company for more than a few years.

Question 22

Agency theory says that companies should use corporate governance practices to avoid or manage conflicts.
Provide two examples of how companies can achieve this.

Answer 22

1. The use of long-term incentive share award or stock option schemes based on total shareholder return to align
   the interests of shareholders and management.
2. Adoption of conflict of interest and related party transaction policies.

Question 23

Define ‘agency costs’.

Answer 23

Agency costs are the costs associated with maintaining the agent–principal relationship.

Question 24

Provide examples of agency costs expected to be paid in a company.

Answer 24

1. Bonding costs – The cost of paying directors and executive management.
2. The costs of monitoring the performance of the board and executive management - These will include the cost of
   general meetings and of the production and distribution of shareholder information such as annual reports and
   financial statements. It could be argued with the introduction of electronic communications that the cost of the latter
   has been reduced in recent years.
3. Residual loss - This relates to the costs to shareholders associated with actions by the directors and executives which in
   the long run turn out not to be in the interests of the shareholders, for example a major acquisition or disposal, fraud
   or foray into a new business line.

Question 25

According to the stakeholder theory, what is the purpose of corporate governance and who should it benefit?

Answer 25

Stakeholder theory, in direct contrast to shareholder primacy theory, states that the purpose of corporate governance should be to meet the objectives of everyone that has an interest in the company.

Question 26

Define 'stakeholders'

Answer 26

Individuals and groups that have an interest in a company.

Question 27

Provide examples of key stakeholders.

Answer 27

Key stakeholder groups are investors, employees (often represented by unions), suppliers, customers, government, regulators, creditors, local communities and the general public.

Question 28

According to the stakeholder theory, what should companies take into account when making decisions?

Answer 28

Stakeholder theory also states that companies should act as good corporate citizens when making decisions and carrying out their activities, taking into account the impact these will have on society and the environment. Companies should be accountable to society and should conduct their activities to the benefit of society.

Question 29

There are four main approaches to corporate governance. List them.

Answer 29

1. Shareholder value approach 2. Stakeholder approach 3. Inclusive stakeholder approach 4. Enlightened shareholder value approach

Question 30

What is the shareholder value approach to corporate governance?

Answer 30

The shareholder value approach to corporate governance states that the board of directors should govern their company in the best interests of its owners, the shareholders.

Question 31

What does the shareholder value approach focus on?

Answer 31

This approach focuses on protecting investors and the value of their shareholding in the company.

Question 32

Why is a pure shareholder value approach not sustainable in the long term?

Answer 32

Because companies have to interact with different stakeholder groups, the interests of which they will have to consider if they are going to be successful and sustainable in the long run.

Question 33

What is the stakeholder or pluralist approach to corporate governance?

Answer 33

The stakeholder or pluralist approach to corporate governance states that companies should have regard to the views of all stakeholders, not just shareholders, and try to balance the interests of all company stakeholders.

Question 34

Where is the stakeholder approach to corporate governance predominantly adopted?

Answer 34

The stakeholder approach to corporate governance is predominantly adopted in civil law countries, such as France and Germany, and in Japan and China where companies are often required to take account of the social and financial interests of employees, creditors and consumers in their decision-making.

Question 35

What is the inclusive stakeholder approach to corporate governance?

Answer 35

This approach believes that the board of directors should consider the legitimate interests and expectations of key stakeholders on the basis that this is in the best interests of the company. The legitimate interests and expectations of key stakeholders should be included in the board’s decision-making process and traded off against each other on a case-by-case basis in the best interests of the company.

Question 36

Where is the inclusive stakeholder approach most commonly used and why?

Answer 36

Africa, as the approach best reflects African needs and culture. It incorporates ethics and corporate social responsibility into the definition of corporate governance as part of the fight against corruption, poverty and health issues such as TB, malaria and HIV/AIDS.

Question 37

What is the enlightened shareholder value approach to corporate governance?

Answer 37

The enlightened shareholder value approach proposes that boards, when considering actions to maximise shareholder value, should look to the long term as well as the short term, and consider the views of and impact on other stakeholders in the company, not just shareholders.

Question 38

How does the enlightened shareholder value approach differ to the stakeholder approach and stakeholder inclusive approach?

Answer 38

The enlightened shareholder approach considers the view of other stakeholders, so far as it would be in the interests of shareholders to do so. This differs from the stakeholder and stakeholder inclusive approaches where boards balance the conflicting interests of stakeholders in the best interests of the company.

Question 39

Which UK law introduced the enlightened shareholder value approach?

Answer 39

The enlightened shareholder value approach was introduced in the UK by the Companies Act 2006 (CA2006), which imposed a statutory duty on directors to ‘promote the success of the company for the benefit of its members as a whole'.

Question 40

There are two main challenges in practice with how the enlightened shareholder value approach has been adopted in the UK. Define and explain the two main challenges.

Answer 40

1. There is no provision in CA2006 to enforce the duty of directors to consider the interests of a wider stakeholder group. The only stakeholder with enforcement rights within CA2006 are those for members through a derivative action. 2. There is no guidance as to how directors should take other stakeholder interests into account, particularly conflicting ones. Boards, therefore, in reality still focus on shareholder interests only, perhaps as these are the only enforceable ones.

Question 41

List some of the main differences between a shareholder primacy approach and a company/stakeholder focused approach.

Answer 41

The shareholder primacy approach: - Looks to maximise wealth for shareholders - Has no responsibilities to society - Have no ethical standards - Directors obey whatever the shareholders want - Shareholders have authority over the business - Shareholders are self-interested - Shareholder's have agents to manage over the company - Directors are agents or representatives of the shareholders - Returns are made to the shareholders The company stakeholder approach: - Looks to provide goods and services; provide employment; create investment opportunities; and drive innovation - Have responsibilities to society - be a good corporate citizen - Follows ethical standards and obeys the law - Shareholders are suppliers of capital and have defined rights and responsibilities - Shareholders are diverse instead of purely self-interested wealth maximisers - Directors are fiduciaries for the company and its shareholders - Management want to sustain the performance of the company - Returns are made to all stakeholders: achievement of company value, quality of goods and services, employee well-being, returns to shareholders

Question 42

Why should companies create value for multiple stakeholders?

Answer 42

Companies have power over billions of people’s lives, to transform societies and to impact the environment, they should serve the societies and markets within which they operate over the longer -term. They should, therefore, create value for multiple stakeholders, for instance, employees, customers, and suppliers in addition to its shareholders.

Question 43

What does stakeholder capitalism seek to create?

Answer 43

Stakeholder capitalism seeks to create shareholder returns by creating value for society as a whole, i.e. customers, employees, suppliers, communities, and the environment. It is about aligning their interests to benefit all.

Question 44

True or false? Stakeholder capitalism views the most important assets in an organisation as intangible (not physical).

Answer 44

True! Stakeholder capitalism views intangible assets as the most important. For example, access to talent, intellectual property, reputation and the license to operate.

Question 45

Not everyone is on board with stakeholder capitalism. Why?

Answer 45

Countries have been adopting their own forms of stakeholder governance for many years and these are still preferred as they are embedded in how organisations in those countries do business.

Question 46

List the four principles of corporate governance.

Answer 46

1. Responsibility 2. Accountability 3. Transparency 4. Fairness

Question 47

Define 'responsibility'.

Answer 47

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

Question 48

Define 'accountability'.

Answer 48

Accountability refers to the requirement for a person or group of people in a position of responsibility to account for the exercise (or not) of the authority they have been given. Accountability should be to the person or group of people from whom the authority is derived.

Question 49

Define 'transparency'.

Answer 49

Transparency refers to the ease with which an outsider is able to make a meaningful analysis of an organisation and its actions, both financial and non-financial. It also refers to the clarity of process in making decisions and carrying them out.

Question 50

Define 'fairness'.

Answer 50

Fairness refers to the principle that all key stakeholders should be treated fairly when decisions are made or actions taken by the organisation. The organisation should provide effective redress for violations, for example to minority shareholders when they have been unfairly treated.

Question 51

In addition to responsibility, accountability, transparency, and fairness, what is the other principle regarded as important within corporate governance?

Answer 51

Reputational management

Question 52

What does good reputation attract?

Answer 52

Good reputation attracts and motivates employees, customers and investors, and also assists in raising cash.

Question 53

True or false? The destruction of a reputation can lead to the end of the organisation.

Answer 53

True!

Question 54

Provide five benefits of effective reputational management.

Answer 54

1. Improving relations with shareholders. 2. Creating a more favourable environment for investment and access to capital. 3. Recruiting and retaining the best employees. 4. Attracting the best business partners, suppliers and customers. 5. Reducing barriers to development in new markets. 6. Securing premium prices for products and/or services. 7. Minimising threats of litigation and of more stringent regulation. 8. Reducing the potential for crises. 9. Reinforcing the organisation’s credibility and trust for stakeholders.

Question 55

What does an organisation’s corporate governance framework consists of?

Answer 55

1. Applicable laws, regulations, standards and codes 2. Organisation’s constitution 3. Structures 4. Policies 5. Procedures

Question 56

In developing the framework of laws, regulations, standards and codes of best practice relating to corporate governance countries have adopted what three main approaches?

Answer 56

1. Rules-based approach 2. Principles-based approach 3. Hybrid approach

Question 57

What does a rules-based approach to corporate governance consist of?

Answer 57

A rules-based approach to corporate governance consists of a mandatory set of laws, regulations, standards and codes.

Question 58

List two consequences of failing to obey in a rules-based system.

Answer 58

1. The company may suffer sanctions and/or fines. 2. Directors of companies in breach of the rules may also be fined, imprisoned and/or disqualified from holding the position of director for a period of time.

Question 59

Name one advantage and one disadvantage of a rules-based system.

Answer 59

Advantage - a rules-based system sends a message out to owners, potential investors and other stakeholders that the country takes seriously their protection from nefarious practices by those managing and overseeing the organisations they are investing in or dealing with. Disadvantage - In reality, it is the enforcement of the rules that achieves this and in many countries, enforcement is weak.

Question 60

What does a principles-based approach to corporate governance consist of?

Answer 60

A principles-based approach to corporate governance comprises a voluntary set of best practices usually contained in a code of best practice.

Question 61

Provide an example of a principles-based approach.

Answer 61

The UK Corporate Governance Code 2018

Question 62

Provide advantages of a principles-based approach.

Answer 62

1. The principles-based approach is flexible. It allows companies and their shareholders to choose which principles and practices of corporate governance they believe are appropriate for their company at a particular time. 2. The principles-based approach allows for discretion based on the circumstances of the company.

Question 63

A principles-based approach uses codes of practice to govern corporate governance. What method do the codes often adopt?

Answer 63

The codes adopt a ‘comply or explain’ or ‘apply and explain’ approach.

Question 64

True or false? A Principles-based approach is not self-regulating.

Answer 64

False! They are based on the presumption that shareholders will self-regulate the companies within which they invest.

Question 65

What is the main concern surrounding a principles-based approach?

Answer 65

The concern is that, with limited resources and time, are UK investors going to be devoting their energies to monitoring the corporate governance performance of UK-listed companies? Evidence has also shown that in addition to time and resource, overseas investors face practical barriers to direct engagement with UK companies. Neither of these developments bode well for a future self-regulating system for the UK market.

Question 66

What does the hybrid approach combine together to govern corporate governance?

Answer 66

The hybrid approach combines mandatory laws and regulations with voluntary principles-based codes of best practice.

Question 67

What elements of corporate governance can be found within a hybrid approach?

Answer 67

1. Laws: company, insolvency, directors’ disqualification and disclosure of directors’ remuneration. 2. Regulations: listing authority rules, such as UK Listing Rules and Disclosure and Transparency Rules. 3. Standards: International Financial Reporting Standards (IFRS). 4. Voluntary codes of best practices: UK Corporate Governance Code, Good Governance: A Code for the Voluntary and Community Sector.

Question 68

Define 'comply or else'.

Answer 68

‘Comply or else’ refers to a company’s obligation to abide with a mandatory rules-based system of corporate governance. Failure to abide with the rules usually results in some form of sanction for the company and/or its directors.

Question 69

Define 'comply or explain'.

Answer 69

‘Comply or explain’ refers to the system whereby a company is asked to comply with a voluntary principles-based code of best practice. Where the company believes that it is not in its best interests to ‘comply’ with a provision of the code, it is required to ‘explain’ to shareholders why they have not complied.

Question 70

True or false? The UK corporate governance code works on the premise of a ‘comply or explain’ regime.

Answer 70

True!

Question 71

Why was 'apply or explain' adopted in Africa?

Answer 71

1. To ensure all types of entities, regardless of their form of establishment or incorporation, were applying corporate governance codes. 2. To avoid a ‘mindless response’ to the corporate governance recommendations contained within the code (e.g. adopting the provisions without considering whether they were suitable for their companies or not).

Question 72

Define 'organisation’s constitution'.

Answer 72

The organisation's constitution sets out how an organisation is to conduct itself within the laws, regulations, standards and codes adopted by the country within which it operates.

Question 73

What is the most common type of organisational constitution?

Answer 73

The most common are articles of association, bylaws, charters or trust deeds.

Question 74

What should an organisation's constitution cover?

Answer 74

1. Shareholders’ rights (including the right for shareholders to share in profits and to attend general meetings and vote). 2. The appointment, powers and duties of the directors and chief executive officer. 3. Board proceedings, appointment, powers and duties of the company secretary. 4. Matters to do with accounts and audit and provisions for winding up the entity.

Question 75

An organisation should consider the structures that are appropriate to it. This will depend on what things?

Answer 75

1. The type of organisation it is, for example a listed company. 2. The laws and regulations applicable to the type of entity. 3. The strategic objectives of the organisation. 4. The risks associated with the operations conducted by the organisation. 5. The people who work for the organisation.

Question 76

Provide examples of the types of structures that can be put in place for an organisation.

Answer 76

1. A board with a charter and delegated authorities. 2. An audit committee. 3. A risk committee. 4. A governance and nominations committee. 5. A remuneration committee. 6. Role profiles for the chair, chief executive officer, non-executive directors etc. 7. Executive committee or senior management team. 8. Organisational structure including employee job descriptions.

Question 77

What are 'policies'?

Answer 77

Policies are used to govern how an organisation conducts their operations.

Question 78

Provide five examples of policies.

Answer 78

1. Sexual harassment 2. Code of conduct or ethics 3. Bribery 4. Conflicts of interest 5. Whistleblowing 6. HR 7. Risk 8. IT 9. Disclosure of information 10. Gifts

Question 79

Why do organisations establish procedures and processes? Provide two reasons.

Answer 79

1. Procedures and processes enable organisations to utilise the resources available to them to operate their business. 2. They allow organisations to implement the policies and strategies they have adopted effectively and efficiently.

Question 80

Provide examples of procedures and processes.

Answer 80

1. Strategic planning 2. Business continuity 3. Risk management and internal controls 4. Computer data and security 5. Managing information 6. Health and safety 7. Procurement 8. Recruitment

Question 81

In considering the implementation of the appropriate governance framework for an organisation, the company secretary/ governance professional should also consider what three things?

Answer 81

1. The organisation’s purpose 2. The assimilation of corporate governance practices 3. What constitutes success for their organisation

Question 82

What is directly affected by an organisation's purpose?

Answer 82

1. Vision 2. Mission 3. Strategic goals and governance framework 4. Risk management

Question 83

What does the assimilation of corporate governance practices ensure?

Answer 83

The assimilation of the corporate governance framework into an organisation is what governance is all about. It requires engagement with the people who work for the organisation to create cultures of good practice.

Question 84

How can organisations promote company success?

Answer 84

By defining what its critical success factors are so these can be measured. If these critical success factors are not being met the board may have to revisit the governance practices of the organisation, not just its strategic planning.

Question 85

The adoption of good governance practices by organisations leads to a successful company. Provide some examples.

Answer 85

1. Long-term sustainability 2. Improved access to external financing, whether through listing or from banks 3. Lower cost of capital 4. Improved operational performance 5. Increased firm valuation 6. Improved share performance 7. Reduced risk of corporate crisis and scandals 8. Effective decision making 9. Improved oversight, monitoring and evaluation 10. Succession planning 11. Ethical behaviour – an anti-corruption tool

Question 86

From a wider economic perspective, what can weak corporate governance practices bring?

Answer 86

1. Excessive regulation – many of the laws, regulations, standards and codes introduced globally have been in response to the scandals that have resulted from weak governance practices. It has meant that regulation in some cases has been reactive to a particular circumstance and although well intended has been poorly conceived. 2. Lack of investment in capital markets – evidence shows that investors place importance on good governance practices when investing in companies. A lack of those practices can therefore lead to a lack of investment. 3. The development of shareholder representative bodies. 4. A focus on regulating and disclosing senior executive pay. 5. The establishment of powerful regulators such as the US Securities and Exchange Commission.

Question 87

What is the difference between governance and management?

Answer 87

Bob Tricker stated 'whereas management is about running businesses, governance is about seeing that it is run properly’.

Question 88

Who is responsible for the 'governance' of the organisation and what does this include?

Answer 88

The board of directors is responsible for the ‘governance’ of the organisation: setting up the structures, policies and procedures within which the business of the organisation is conducted and ensuring that they operate effectively.

Question 89

Who is responsible for the day-to-day affairs of the company?

Answer 89

The powers to manage the day-to-day affairs of the company are usually delegated to the CEO and their executive management team.

Question 90

Describe the two ways in which powers to manage the day-to-day affairs of a company is delegated to the CEO.

Answer 90

1. The authority to manage is passed to the CEO with the power to sub-delegate as they think fit to either individual members of management or to an executive committee. 2. The authority is passed to several executives depending on the nature of their responsibilities. The chief finance officer would therefore receive authorities direct from the board in relation to the financial affairs of the business.