Governance Guide (Part 1)
- 22 May, 2011 21:13
Corporate governance – how companies are run at the management level – has evolved enormously since the early days of its codification. It has developed from an ad hoc set of guidelines into a corporate discipline in its own right.
For CFOs in particular, the emphasis must be on efficient board operation, clear risk management and properly aligned executive and non-executive voices. The CFO plays a central role in ensuring good corporate governance lies at the heart of the company operations.
But what is corporate governance? How should boards approach it, and how does the regulatory framework act to enforce best practice?
Internal Governance: What is it?
"Corporate Governance": relationship among various participants in determining the direction and performance of corporations. The primary participants are (1) the shareholders, (2) the management (led by the chief executive officer), and (3) the board of directors," according to the definition by Monks, Robert A.G. and Nell Minow, Corporate Governance
Put simply, internal corporate governance covers how businesses run themselves in order to comply with the regulations put in place to protect stakeholders. Staff, shareholders, investors, suppliers and financial backers (principally the banks) are entitled to expect that company boards follow well-established procedures in protecting the company’s assets and future. It also requires management to encourage participation of stakeholders in the company’s future, and to allow those stakeholders a voice in the direction the company takes.
The composition and effective functioning of management boards is one of two or three most important factors in a company’s financial success. Clear alignment of goals, effective communication and efficient reporting structures all contribute to the success of a business.
Internal governance best practice requires directors to follow a set of guidelines that in theory should ensure that standards are maintained. Corporate governance rules largely cover how the board is administered. For example, procedures cover how committees vote, how executive power is balanced and checked by non-executive voices (see part II) and how reporting structures should be designed in order to clearly communicate important information upwards and downwards throughout the organisation.
Key Principles
The most important aspects of corporate governance can be summarised as:
• Internal controls
• Audit
• Reporting and transparency
• Renumeration policy
• Nomination of directors and their removal from the board
Of these, control and reporting tend to come to the fore in most discussions of good (and bad) governance procedures. The key element in all this is the clear accountability of the board to its stakeholders. Transparency in corporate reporting is crucial, and the Financial Reporting Council (FRC) as well as academics and professional service firms have led the way in encouraging companies to publish and explain only the most meaningful and material aspects of their corporate performance.
Endless pages of meaningless information is of less use than no information at all, so boards are now expected to highlight in a concise way the business’s strategy, the key risks it faces and how it proposes to address those challenges.
Central to best practice in this area is the issue of engagement. Allowing stakeholders a say is critical, and the Code steers companies towards using the annual general meeting, informal channels and investor roadshows as ways of engaging with stakeholders. By doing that management get a ‘sense check’ of their strategy and get the opportunity to answer any criticism that stakeholders may have. In recent years, the issue of renumeration has become perhaps the hottest topic.
The UK Corporate Governance Code (formerly the Combined Code) sets out how boards should be rewarded and goes to great pains to lay out how board performance and reward should be aligned with shareholder interests. It is not always easy to reconcile the two sides, but there do exist companies that have demonstrated a clear commitment to addressing this issue.
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According to the Chartered Institute for Personnel and Development there are a number of key principles that companies must adhere to:• The design of remuneration plans should be clear, appropriately simple and relevant
• The mix of fixed and variable remuneration should be commensurate with each executive’s role and level in the organisation. They should not lead to inappropriate risk-taking, for example incentives that drive inappropriate behaviours such as revenue growth to the detriment of profit (see below, ‘When corporate governance fails’)
• Incentives should reward outcomes that lead to, and reflect, sustainable and measurable value creation.
• Remuneration committees should act independently
• When agreeing remuneration decisions, remuneration committees should have the discretion to exercise judgement and take the broader context of an organisation into account alongside its performance, as appropriate.
External Governance
Who are the regulators?
Corporate governance rules are influenced by a number of bodies. The government sets the framework with its primary legislation. The Companies Act 2006 set out the general rules for companies. Within that, principle responsibility for policing corporate governance lies with the FRC, a body made up of industry experts and professional regulators. Part-funded by the government, the FRC works with corporates as well as the users of company reports (investment funds, pension funds and so on) to lay down appropriate rules for board composition and corporate governance.
Every few years, the regulators update the guidance relevant to the latest events and developments. That has been a regular occurrence since the first publication of the Cadbury Report back in 1992. Since then, there have been numerous updates to the Combined Code. The last, which occurred in 2009, revealed a corporate constituency broadly happy with the current guidelines. According to the FRC, “All FTSE 100 participants and the majority of those from FTSE 250 and Small Cap companies considered that the Combined Code had had a broadly beneficial effect and remained fit for purpose, and its relative lack of prescription [ie a principles-based approach] was seen as a strength.”
Interestingly, however, the further down the food chain to the smaller companies the FRC went, the lower the satisfaction levels. Smaller listed companies in particular registered their unhappiness with the burden imposed by corporate governance principles. There have been calls for an adapted code for smaller entities, though a separate set of principles has yet to emerge.
The FRC has had its position strengthened by the new government and now sits unchallenged at the head of the corporate governance pyramid.
How corporate scandals have shaped governance
For PLCs, the rules on corporate governance have been refined in the last decade to reflect the various scandals and business failures. In the US, the collapse of Enron and the scandals that followed at Tyco and elsewhere led to a change in corporate governance and reporting rules principally through the introduction of the US Sarbanes-Oxley Act.
The UK and Europe follow a principles-based approach, which lays down the basic principles companies should follow. This is in direct contrast to the US approach which holds to a rules-based prescriptive system which lays down directly what company boards must and must not do. This is a similar approach to US accounting rules and can be partly explained by the heavily litigious nature of US corporate life.
Principles versus Rules
However in the UK there remains a ‘comply or explain’ culture that sets out how it should be done and allows directors to explain why a certain guideline has not been followed. This principle is enshrined in most corporate and accounting law in the UK.
However, there are fears that the rush to regulate in the wake of the banking crisis might lead to a significant increase in the rules covering corporate governance, and a serious increase in the amount of regulations. So far that hasn’t happened.
In the UK, the FRC was quick to react to the market’s demand for greater clarity on corporate governance by updating its Code of Practice. The latest iteration came out in 2010 and represented a stock taking exercise of the current rules.
The Financial Reporting Council reviewed the Code in 2009 and set out a number of changes to the rules. The review was instigated by the continuing downturn, which was placing undue strain on many businesses.
Responses to the Combined Code update
“We believe that the UK has one of the best governance regimes in the world. The comply or explain approach is effective and flexible. It is up to companies and shareholders to fulfill their roles conscientiously in order to make the process work more effectively.” [Aviva Investors]
Meanwhile Odgers Berndtson, executive headhunters and corporate consultants summarised the support among external stakeholders for the principles-based approach.
“We engage daily with the key people responsible for creating effective boards – chairmen, executive and non-executive directors, and company secretaries. The Code is an essential reference tool in these conversations … The principles-based approach, as opposed to a more prescriptive rules-based regime, is an essential part of what makes the Code valuable, allowing companies to devise for themselves a governance structure and processes that are most relevant.”
Clearly, the corporate community in the UK accepts that the Code, while not perfect in all cases, does largely get the balance right between oversight and allowing board discretion.