Corporate governance refers to the way in which companies are governed, and to what purpose. It is concerned with practices and procedures for trying to ensure that a company is run in such a way that it achieves its objectives.

This module has been developed from ICSA Professional Development Series: Corporate Governance, Third edition, Brian Coyle, ICSA Publishing Ltd, 2005. www.icsapublishing.co.uk

Corporate governance refers to the way in which companies are governed, and to what purpose. It is concerned with practices and procedures for trying to ensure that a company is run in such a way that it achieves its objectives. This could be to maximise the wealth of its owners (the shareholders), subject to various guidelines and constraints and with regard to the other groups with an interest in what the company does. Guidelines and constraints include behaving in an ethical way and in compliance with laws and regulations.

Other groups with an interest in how the company acts include employees, customers and the general public.

Some other definitions that have been provided are as follows:

‘Corporate governance is the system by which companies are directed and controlled. The shareholders’ role in governance is to appoint the directors and the auditors and to satisfy themselves that an appropriate governance structure is in place.’ (Cadbury Report, 1992).

‘If management is about running businesses, governance is about seeing that it is run properly. All companies need governing as well as managing’ (Professor Bob Tricker, 1984).

Corporate governance is, then, concerned with how powers are shared and exercised by different groups to ensure that the objectives of the company are achieved. Aspects of corporate governance are:

• the rights of shareholders and other interest groups such as the employees

• how powers are shared and exercised by the directors

• how the holders of power in a company should be held accountable for what they do.

Other factors to take into account are that:

• A company is a legal entity or ‘legal person’. As a person, it is able to enter into contracts and make business transactions. It can own assets and owe money to others, and it can sue and be sued in law. Human beings have to make decisions and arrange transactions in the company’s name.

• The members of a company are its owners, the ‘equity’ shareholders. However, membership changes continually as investors buy and sell the company’s shares.

• Shareholders have relatively few powers, which are restricted mainly to certain voting rights. Power is in the hands of the board of directors, or perhaps just one or two individual directors on the board.

To appreciate what corporate governance is, it is helpful to be aware of what it is not:

• Corporate governance is not primarily concerned with day-to-day management of operations by business executives. The powers of executive managers to direct business operations are one aspect of governance, but management skills are not.

• Similarly, corporate governance is not concerned with formulating business strategy, although the responsibility of the board of directors and executive managers for taking strategic decisions is.

Why is corporate governance important?

A company should have objectives. Some of these, such as the reasons for its existence, may be set out in its written constitution. (In the UK the written constitution of a company is contained in its Memorandum and Articles of Association.) Other objectives may be implied or assumed, rather than clearly documented. A company should be governed in a way that moves it towards the achievement of its objectives.

However, although a company exists as a legal person, in reality it is the organised, collective effort of many different individuals. It is controlled by a board of directors, in the interests of its owners, the shareholders. The interests of the board and the shareholders ought to coincide, but in practice they may be at odds with each other.

The challenge of good corporate governance is to find a way in which the interests of shareholders, directors and other interest groups can all be sufficiently satisfied.

Corporate governance is a matter of much greater importance for large public companies, where the separation of ownership from management is much wider than for small private companies. Public companies raise capital on the stock markets, and institutional investors hold vast portfolios of shares and other investments. Investors need to know that their money is reasonably safe. Should there be any doubts about the integrity or intentions of the individuals in charge of a company, the value of the company’s shares will be affected and the company will have difficulty raising any new capital should it wish to do so.

Whilst the focus on corporate governance has been primarily on the commercial sector, it is also of importance for the public and voluntary sectors. Many of the issues are the same but there are some that are of specific importance to these sectors:

• Accountability. This is fundamental to the corporate governance of public bodies, and in recent years, the voluntary sector with regard to both the proper stewardship of public and donated funds and the increasing demand for service users to be involved in decision-making.

• Stakeholders. Whilst commercial companies are primarily accountable to the shareholders, organisations in the public and voluntary sectors are accountable to a wide range of stakeholders, including service users, the general public, funders and national government. Issues of accountability are not clear-cut and conflicts can arise, e.g. charity trustees have a legal duty to act in the interests of their beneficiaries, but if the charity is a membership body this may conflict with the wishes of members.

• Openness and transparency. There is a demand for open government and a distrust of decisions taken ‘behind closed doors’. Voluntary organisations also face calls for transparency.

• Governance/board structures. The unitary board is not common in these sectors. Boards, or their equivalent, may be directly elected or appointed, and are often volunteer-based.

• Monitoring performance. In recent years a major emphasis in the public sector has been on performance measurement and evaluation. Increasingly voluntary organisations are beginning to look at ways of measuring outcomes.

Corporate governance in the public sector

A key development for the corporate governance of the UK public sector was the Nolan Committee on Standards in Public Life. The Committee was set up in 1995 in response to concerns that the conduct of some politicians was unethical and, in particular, allegations of MPs taking cash for putting parliamentary questions.

Whilst the Committee focused on MPs, its remit included the civil service, non-departmental public bodies (NDPBs) and the NHS. Its early recommendations also had a wider impact on the public and voluntary sectors, and its seven principles of public life have been widely adopted.

The Nolan Seven Principles of Public Life Selflessness: Holders of public office should take decisions solely in terms of the public interest. They should not do so to gain financial or other material benefits for themselves, their family or their friends. Integrity: Holders of public office should not place themselves under any financial or other obligation to outside individuals or organisations that might influence them in the performance of their duties. Objectivity: In carrying out public business, including making public appointments, awarding contracts or recommending individuals for rewards and benefits, holders of public office should make choices on merit. Accountability: Holders of public office are accountable for their decisions and actions to the public and must submit themselves to whatever scrutiny is appropriate to their office. Openness: Holders of public office should be as open as possible about the decisions and actions that they take. They should give reasons for their decisions and restrict information only when the wider public interest clearly demands. Honesty: Holders of public office have a duty to declare any private interests relating to their public duties and to take steps to resolve any conflicts arising in a way that protects the public interest. Leadership: Holders of public office should promote and support these principles by leadership and example.

In 2004 the Independent Commission for Good Governance in Public Services, chaired by Sir Alan Langlands was set up and supported by the Office for Public Management (OPM) and the Chartered Institute of Public Finance and Accountancy (CIPFA), in partnership with the Joseph Rowntree Foundation. Through two rounds of consultation, the Commission drew on the views of a wide range of people with experience of governance, and of service users and citizens, to produce the Good Governance Standard for Public Services that was published in January 2005.

The Standard presents six principles of good governance that are common to all public service organisations and are intended to help all those with an interest in public governance to assess good governance practice. It shows how these should be applied if organisations are to live up to the Standard and provides a basis for the public to challenge sub-standard governance.

Many functions in the public sector are managed by public bodies to which the Standards can apply. Examples include public corporations; NHS bodies; NDPBs or quangos and nationalised industries. They operate at arm’s length from government departments, although ministers remain accountable for their performance and actions, and are responsible for appointments to them.

Good Governance Standards According to the Standards good governance in public life is: focusing on the organisation’s purpose and on outcomes for citizens and service users performing effectively in clearly defined functions and roles promoting values for the whole organisation and demonstrating the values of good governance through behaviour taking informed, transparent decisions and managing risk developing the capacity and capability of the governing body to be effective engaging stakeholders and making accountability real.

In contrast to such public bodies, UK local government is founded on a system of representatives elected by and of the public. These elected members set policy and are accountable for actions taken on their behalf. Traditionally, local authorities were managed via committees, but the Local Government Act 2000 heralded new forms of governance. The cabinet system has now become more common, with councillors either acting as part of the executive, or sitting on scrutiny committees. A number of local authorities now have directly elected mayors with executive powers.

This shift away from traditional methods of public governance has also occurred in the NHS, with a move towards the private sector unitary board model. NHS Trust boards comprise both executive and non-executive directors.

There has also been a gradual erosion of the boundary between the public, voluntary and commercial sectors. There now are a large number of charities and private companies that perform public functions and receive government funding. As they are not technically part of the public sector they often sit outside the mechanisms for accountability and control.

Corporate governance and the UK voluntary sector

This includes a wide range of organisations, from charities to not-for profit bodies, and mutual self-help groups. It is characterised by its variety of legal forms. For example, charities can take the form of trusts; unincorporated associations; charitable companies limited by guarantee; chartered bodies; or Industrial and Provident Societies.

Corporate governance developments in other sectors have impacted on voluntary organisations, with many of the recommendations of Cadbury, Nolan and Turnbull being adapted for the sector. For example, the National Council of Voluntary Organisations (NCVO) adapted Nolan’s seven principles of public life into a code of conduct for charity trustees; the Charity Commission’s Statement of Recommended Practice requires larger charities to include a statement on risks in their annual report.

Corporate governance also developed in response to sector-specific issues, including:

• The increase in size and importance of the sector, particularly as a result of the contracting out of public service to voluntary organisations.

• A perception of a decline in public confidence in charities.

• Greater competitions for funding.

• A lack of clarity about the duties of voluntary board members, and in particular concerns about the liabilities of charity trustees.

• A growing demand for accountability to service users and beneficiaries.

Demands for greater transparency on how charities spend donated income, and in particular the proportion spent on administration.

This has resulted in:

• A change in the methods of recruitment and selection of board members. Whilst this is still predominately by word of mouth, the use of advertisements and open recruitment procedures have increased.

• Greater clarity about governance structures, with more organisations having documented policies, procedures and control mechanisms.

• The tightening of regulatory regimes and more stringent reporting requirements.

In addition, there have been initiatives to improve governance across the sector. The Charity Commission has greatly increased the scope of guidance it provides to charities. In 1993 the National Council for Voluntary Organisations set up a Trustee Services Unit to provide support and advice to its members. A survey on trends in charity governance it carried out in 1999 showed that external initiatives to improve governance were having an effect. However, the impact was concentrated on medium and large charities, with a growing gap between large and small charities.

Concerns about corporate governance have grown over time. The recognition of a need for changes in the way that public companies are governed began with a number of spectacular and well-publicised corporate failures. In the US, many organisations in the savings and thrift industry had to be rescued from financial collapse in the 1980s. In the UK, a number of companies collapsed unexpectedly in the 1980s and 1990s. These included Polly Peck International, the Bank of Credit and Commerce International, British and Commonwealth, the Mirror Group News International and Barings Bank. In each case, there appeared to be serious accounting or financial reporting irregularities and/or inadequate internal controls and risk management. In some cases, ‘creative accounting’ and inadequate financial regulation were seen as the cause of the corporate failure. In other cases, such as the collapse of Barings Bank due to the losses of a rogue trader, inadequate controls were a key factor.

When questions were asked about how the corporate collapse could happen to such well-established companies without warning, some common themes emerged:

• Investors were not kept informed about what was really going on in the company

• The published financial statements were misleading.

• External auditors did not appear to spot the warning signs.

• The self-seeking activities of powerful company chiefs, their apparent lack of personal and business ethics were seen as a major cause of failure – the antics of Robert Maxwell being a prime, but not unique, example.

• The inability of the board to restrain the powerful company chiefs from acting improperly.

• In addition, it was recognised that the risk of financial collapse can be prevented by adequate risk management, and that in the case of most of the companies concerned, the financial controls had been inadequate or ineffective.

A brief history

And God made Cadbury … and saw it was good

The main impetus for better practices in corporate governance began in the UK in the late 1980s and early 1990s. The Report of the Committee on the Financial Aspects of Corporate Governance (the ‘Cadbury Report’) was published in 1992, and was later described as ‘a landmark in thinking on corporate governance’. The Report included a Code of Best Practice, and UK listed companies came under pressure from City institutions to comply with the requirements of the Code. The Cadbury Code was appended to the Stock Exchange Listing Rules in 1993.

In 1995, a working group was set up to look into the relationship between companies and institutional investors. It was chaired by Mr Paul Myners, who was then chairman of Gartmore plc, and produced the Myners Report, which made a variety of recommendations about how the relationship between institutional investors and company management should be conducted. The Report included suggestions for improving the communications between companies and institutional investors and for the conduct of annual general meetings. The significance of the Myners Report is that it urged institutional investors to reassess their role as shareholders and their responsibilities for ensuring good corporate governance and the success of the companies in which they invested. When a company is performing badly, institutional investors should try to do something to put matters right, instead of selling their shares and washing their hands of the company. Mr Myners went on to argue that unless institutional investors voluntarily became more active in the governance of companies and exercised their rights more forcibly, they should be compelled to do so by legislation. Representative bodies of the institutional investor organisations, such as the Institutional Shareholders Committee, the Association of British Insurers and the National Association of Pension Funds, have responded by issuing guidelines for members on corporate governance issues, and principles of corporate governance.

And out of Cadbury came Greenbury

On the recommendation of the Cadbury Committee, another committee was set up to review progress on corporate governance in UK listed companies. This committee issued the Greenbury Report in 1995, which focused mainly on directors’ remuneration. At the time, the UK press was condemning ‘fat cat’ directors, particularly those in newly privatised companies. The Greenbury Report issued a Code of Best Practice on establishing remuneration committees, for disclosures of much more information about the remuneration of directors and remuneration policy, and for more control over notice periods in directors’ service contracts and compensation payments in the event of early termination of contracts.

And Cadbury and Greenbury begat Hampel

A Committee on Corporate Governance, chaired by Sir Ronald Hampel, was set up in 1995 to review the recommendations of the Cadbury and Greenbury Committees. The final report of the Hampel Committee was published in 1998. Its Report covered a number of governance issues, such as the composition of the board and role of directors, directors’ remuneration, the role of shareholders (particularly institutional shareholders), communications between the company and its shareholders, and financial reporting, auditing and internal controls.

And lo! The Combined Code was born

The Hampel Report also suggested that its recommendations should be combined with those of the Cadbury and Greenbury Committees into a single code of corporate governance. This suggestion led to the publication of the original 1998 Combined Code, which applied to all UK listed companies.

And from the Combined Code sprang Turnbull

A significant element of the Combined Code was the requirement for directors to review the system for internal controls – financial, operational, compliance and risk management. The formal guidance on how to interpret and implement this recommendation was made in a report in 1999 – The Turnbull Committee Report. This came from came a working party established by the Institute of Chartered Accounts in England and Wales (ICAEW) chaired by Nigel Turnbull.

And the good work continues

Corporate governance issues have also been addressed by changes in UK company law. New regulations in 2002 were introduced for greater disclosures of directors’ remuneration by listed companies, replacing similar regulations that were included in the Listing Rules from 1995. (See How should Directors’ Remuneration be Structured? for more details.) Listed companies are now required to publish a directors’ remuneration report each year, and invite shareholders to vote on the report at the company’s annual general meeting.

Corporate governance issues remained in the spotlight in the UK, and two influential reports were produced in January 2003. The Higgs Report, commissioned by the Department of Trade and Industry, considered the role and effectiveness of non-executive directors. The Smith Report, commissioned by the Financial Reporting Council, provided guidance for audit committees. The responsibility for the Combined Code was transferred to the Financial Reporting Council in 2003, and a revised Combined Code was issued, which incorporated many of the Higgs and Smith recommendations.

The Combined Code covers most areas of corporate governance, and is made up of:

• Main principles.

• Supporting principles: as their name suggests these are principles that supplement and support the main principles. Most main principles have one or more supporting principles.

• Provisions: these are specific measures that companies are expected to take.

Further developments are continuing with the advent of the OFR (Operating and Financial Review) regulations that came into effect in April 2005 (see Operating and Financial Review) and potentially a requirement for a statutory statement of directors’ duties – putting common law duties into statute law.

Comply or explain

The Listing Rules include an obligation to disclose the extent of their compliance with the Combined Code, and the ‘comply or explain’ rule for listed companies applies to all provisions of the Code. Under this rule a company is not under a formal obligation to comply with best practice as indicated by the Code. However, the obligation to disclose the extent of compliance enables company shareholders (and others) to monitor the extent to which a company does comply with the Code and consider the merits of any explanations for non-compliance. Shareholders who are not satisfied with a board’s compliance can express this through their votes at the AGM.

A largely separate, although interconnected, development has been a growing awareness on the part of large companies of the potential risks to their reputation and long-term success from failures to comply with laws and regulations or to act in an ethical way. Many companies have also claimed to recognise the potential long-term benefits from acting in a socially responsible manner.

A stakeholder in a company is someone who has an interest or ‘stake’ in it, and is affected by what the company does. Each stakeholder or stakeholder group can, therefore, expect the company to behave or act in a particular way, with regard to the stakeholders’ interests. A stakeholder might also expect to have some say in some of the decisions a company takes and some of the actions it takes. The balance of power between different stakeholder groups, and the way in which power is exercised, are key issues in corporate governance.

A public company has a number of different stakeholder groups:

• Its members or equity shareholders are the owners. In a small company, the owners may also be directors. In a large public company, the directors may own some shares, but are not usually the largest shareholders. The interests of the shareholders are likely to be focused on the value of their shares and dividend payments. However, the powers of shareholders in large public companies are usually fairly restricted and shareholders have to rely on the board of directors to act in their best interests.

• A different situation arises when there is a majority shareholder or a significant shareholder. A shareholder with a controlling interest is able to influence decisions of the company through an ability to control the composition of the board of directors. When there is a majority shareholder, the interests of minority shareholders may be disregarded.

• The board of directors has the responsibility for giving direction to the company. It delegates most executive powers to the executive management, but reserves some decision-making powers to itself, such as decisions about raising finance, paying dividends and making major investments. Executive management is also held accountable to the board for their performance.

• A board of directors is made up of both executives and non-executives. Executive directors are individuals who combine their role as director with their position within the executive management of the company. Non-executive directors perform the functions of director only, without any executive responsibilities. Executive directors combine their stake in the company as a director with their stake as a fully paid employee, and their interests are, therefore, likely to differ from those of the non-executives.

• The board may take decisions collectively, but it is also a collection of individuals, each with his or her personal interests and ambitions. Some individuals are more likely to dominate the decisions by a board and to exert strong influence over their colleagues. In particular, the most influential individuals are likely to be the chairman and the chief executive officer (CEO). The chairman is responsible for the functioning of the board. The CEO is the senior executive director, and is accountable to the board for the executive management of the company. The term ‘CEO’ derives from the US, but is now widely used in the UK (where the term ‘managing director’ is also used). The main interest of individual executive directors is likely to be power and authority, a high remuneration package and a wealthy life-style.

• Management is responsible for running the business operations and is accountable to the board of directors (and more particularly to the CEO). Individual managers, like executive directors, may want power, status and a high remuneration. As employees, they may see their stake in the company in terms of the need for a career and an income.

• Employees have a stake in their company because it provides them with a job and an income. They too have expectations about what their company should do for them, and these could be security of employment, good pay and suitable working conditions. Some employee rights are protected by employment law, but the powers of employees are generally limited.

• Lenders and other creditors have an indirect interest in a company, because they expect to be paid what they are owed. If they deal with the company regularly, or over a long time, they will expect the company to do business with them in accordance with their contractual agreements. If the company becomes insolvent, unpaid creditors will take a more significant role in its governance, depending on the insolvency laws in the country, for example by taking legal action to take control of the business or its assets.

• Representatives of investment institutions have some influence over public companies whose shares are traded on a stock market. Representative bodies include the Association of British Insurers (ABI) and National Association of Pension Funds (NAPF) in the UK, and the International Corporate Governance Network, an association of ‘activist’ institutional investors around the world. These bodies may try to coordinate the activities of their members, for example, by encouraging them to vote in a particular way on resolutions at the annual general meetings of companies in which they are shareholders. These bodies represent the opinions of the investment community generally.

• The general public are also stakeholders in large companies, often because they rely on the goods or services provided by a company to carry on their life. For example, households expect utility companies to provide an uninterrupted supply of water, electricity or gas to their homes, or a reliable telephone connection. Commuters expect a rail company to be under an obligation to provide a convenient and reliable transport service to and from work, and at a reliable price. Pressure groups, such as environment protection groups, sometimes try to influence the decisions of companies.

A large company has a large number of stakeholders and has to balance the demands and needs of each of them. Although some stakeholder groups have power to decide or influence actions by the company, others do not have much influence and rely on the ‘enlightenment’ of the company’s managers (primarily the directors) to take decisions that are in their interests and beneficial for them.

Often, there will be a conflict of interests between different stakeholder groups. For example, employees may want higher salaries, which their company cannot afford without cutting dividends to shareholders.

A major concern with corporate governance is the conflict of interests between the board of directors (and its individual directors) and other stakeholder groups, particularly the shareholders and employees. When the directors take decisions that are in their personal best interests, and regardless of the interests of other stakeholders, should this be allowed or how can it be prevented? The directors, particularly executive directors, have greater access to the information systems of their company and so know more about what is going on. They are also often in a position to control or manipulate the information that is released to the shareholders or employees.

Shareholders have to rely on the board of directors to govern their company competently and in their best interests. They are able to monitor the performance of the company (and, by implication, its directors), primarily through the company’s annual report and accounts. They make their decisions to invest in the company’s shares and hold on to them, largely on the basis of information supplied by the directors in the company’s name. Their only reassurance that the information they are supplied is correct is the honesty of the directors and the assertion by the company’s auditors that the published accounts give a true and fair view of the company’s profitability and financial position.

The problem has been well expressed by the OECD, the international organisation established to help governments deal with global economic, social and governance issues:

‘What makes corporate governance necessary? Put simply, the interests of those who have effective control over a firm can differ from the interests of those who supply the firm with external finance. The problem, commonly referred to as a principal-agent problem, grows out of the separation of ownership and control and of corporate outsiders and insiders. In the absence of the protections that good governance supplies, asymmetries of information and difficulties of monitoring mean that capital providers who lack control over the corporation will find it risky and costly to protect themselves from the opportunistic behaviour of managers and controlling shareholders.’

The relationship between the shareholders and the board of directors is at the centre of many of the problems that arise in corporate governance. Many of the guidelines in the codes of conduct for corporate governance and codes of best practice are directed towards reducing the potential for conflict, by seeking to put some restraints on individual directors, particularly the CEO and other executive directors, and by trying to reconcile the interests of the two stakeholder groups.

At the heart of the debate about corporate governance lie the conflicts of interest, or potential conflicts of interest, between shareholders and either the board of directors as a whole or individual board members. The directors may be tempted to take risks and make decisions aimed at boosting short-term performance. Many shareholders are more concerned about the longer term, the continuing survival of their company and the value of their investment. If a company gets into financial difficulties, professional managers can move on to another company to start all over again, whereas shareholders suffer a financial loss.

Issues in corporate governance where a conflict of interests might be apparent are:

• financial reporting and auditing

• directors’ remuneration

• company–stakeholder relations

• risk-taking

• effective communication between the directors and shareholders.

Financial reporting and auditing

(See Reporting to Shareholders and The Audit Committee and the External Audit for more detail.)

The directors may try to disguise the true financial performance of their company by ‘dressing up’ the published accounts and giving less than honest statements. ‘Window-dressed’ accounts make it difficult for investors to reach a reasoned judgement about the financial position of the company. Concerns about misleading published accounts provided an early impetus in the 1980s and early 1990s to the movement for better corporate governance in the UK. Accounting irregularities in a number of companies led to a tightening of accounting standards, although the problems of window dressing are unlikely ever to disappear completely.

Concerns about financial reporting in the US emerged with the collapse of energy corporation Enron in 2001, which filed for bankruptcy after ‘adjusting’ its accounts. This was followed by similar problems at other US companies, such as telecommunications group WorldCom (which admitted to fraud in its accounting), Global Crossing and Rank Xerox. Problems emerged in some European companies, for example, at the Italian group Parmalat at the end of 2003. A corporate governance issue was the question of the extent to which the directors were aware in each case of the impending collapse of their company and, if they knew the problems, why shareholders were not informed much sooner. As further cases unfold, this question remains relevant.

When the annual financial statements of a company prove to have been misleading, questions are inevitably raised about the effectiveness of the external auditors. There are two main issues relating to the external audit of a company. One is whether it should be the job of the auditors to discover financial fraud and material errors. The second is the problem of the relationship between a client company and its auditors, and the extent to which the auditors are independent and free from the influence of the company’s management. If auditors are subject to influence from a client company, they might be persuaded to agree with a controversial method of accounting for particular transactions, which shows the company’s performance or financial position in a better light. Arthur Andersen, which collapsed in 2002, appears to have lacked independence from major clients such as Enron.

Directors’ remuneration

Directors may reward themselves with huge salaries and other rewards, such as bonuses, a generous pension scheme, share options and other benefits. Institutional shareholders do not object to high remuneration for directors. However, they take the view that rewards should depend largely on the performance of the company and the benefits obtained for the shareholders. The main complaint about ‘fat cat’ directors’ remuneration is that when the company does well, the directors are rewarded well, which is fair enough, but when the company does badly, the directors continue to be paid just as well.

Interest in arguments about directors’ pay has varied in the past between different countries. In the UK, concerns led to the establishment of the Greenbury Committee in the 1990s and the production of the Greenbury Report. Directors’ remuneration has remained a contentious issue ever since. In 2002 company law was changed by the Directors’ Remuneration Report Regulations 2002, requiring listed companies to produce a directors’ remuneration report annually and to invite shareholders to vote on the report at the company’s AGM.

For more detail go to How should Directors’ Remuneration be Structured?.

Company–stakeholder relations

Most decision-making powers in a company are held by the board of directors. The corporate governance debate has been about the extent to which professional managers, acting as board directors, exercise those powers in the interests of their shareholders and other stakeholders in the company, and whether the powers of directors should be restricted.

This aspect of corporate governance is about:

• the structure of the board of directors and the role of independent non-executive directors

• the powers of shareholders under company law and whether these should be extended by corporate law reform – for example, by giving shareholders the right to approve the company’s remuneration policy or its remuneration packages for board members (see How should Directors’ Remuneration be Structured? for more details)

• whether shareholders actually make full use of the powers they already have, for example by voting not to re-elect directors.

For more detail go to Relations with Institutional Shareholders.

Corporate governance and risk management

As a general rule, investors expect higher rewards to compensate them for taking higher business risks. If a company makes decisions that increase the scale of the risks it faces, profits and dividends should be expected to go up. Another issue in corporate governance is that the directors of companies might take decisions intended to increase profits without giving due regard to the risks. In some cases, companies may continue to operate without regard to the changing risk profile of their existing businesses.

When investors buy shares in a company, they have an idea of the type of company they are buying into, the nature of its business, the probable returns it will provide for shareholders and the nature of its business and financial risks. To shareholders, investment risk is important, as well as high returns. Directors, on the other hand, are rewarded on the basis of the returns the company achieves, linked to profits or dividend growth, and their remuneration is not linked in any direct way to the risk aspects of their business. Risk management is now recognised, particularly in the UK, as an ingredient of sound corporate governance.

Takeovers can also be a contentious matter. A company’s board of directors may try to grow their company by buying up target companies, almost regardless of the price they have to pay. The results of a successful large takeover bid at an excessive price are likely to be:

• more power and higher status for the company’s board and individual directors (justifying higher salaries)

• a good deal for the shareholders in the target company

• a loss of wealth for the company’s own shareholders when the takeover fails to achieve the expected effect on the company’s profits and the share price eventually falls.

A common denominator in past corporate failures has been a lack of effective control over the company and the absence of risk management procedures and systems. The problem with corporate collapse could be dishonest management finally being exposed, but is much more likely to be the consequence of a well-intentioned board of directors failing to carry out its duties adequately. The duties of the board of directors must include ensuring that there is an operative and effective system of risk management. Shareholders should feel confident that the board is aware of the risks faced by the company, and that a system for monitoring and controlling them is in place.

For more detail go to Risk Management and Internal Control and The Audit Committee and the External Audit.

Information and communication

Another issue in corporate governance is communication between the board of directors and the company’s shareholders. Shareholders, particularly those with a large financial investment in the company, should be able to voice their concerns to the directors and expect to have their opinions listened to. Small shareholders should at least be informed about the company, its financial position and its intentions for the future, even if their opinions carry comparatively little weight.

The responsibility for improving communications rests with the companies themselves and their main institutional shareholders. Companies can make better use of the annual report and accounts to report to shareholders on a range of issues and the policies of the company for dealing with them. The annual report and accounts should not be simply a brief directors’ report and a set of financial statements. The company should explain its operations and financial position (in an [Operational and Financial Review) and report on a range of governance issues such as directors’ remuneration, internal controls and risk management and policies on health, safety and the environment. Many companies now use their web-site to report on such matters. A company can also try to encourage greater shareholder attendance and participation at annual general meetings as a method of improving communications and dialogue. Electronic communications, including electronic voting, should also be considered. Electronic voting could, for example, encourage institutional investors to use their votes more ‘proactively’. In addition, institutional investors should develop voting policies, and apply these in general meetings. Where necessary, they can vote against the board to alert the directors to the strength of their views.

For more detail go to [Reporting to Shareholders, Relations with Institutional Shareholders and Making Constructive Use of the AGM.

The extent of corporate governance legislation

Companies are constrained or limited by the law in what they can do. For example, laws regulate the way in which companies deal with other people, giving rights to creditors and customers, and provide some protection for employees and for society at large. They are also subject to various regulations and codes of practice from external bodies, such as the national listing authority (e.g. in the UK, the FSA (Financial Services Authority) is UK Listing Authority, which issues rules for listed companies whose shares are traded on the main London Stock Exchange).

Issues to consider, therefore, are:

• the extent to which corporate governance practices should be forced on companies by legislation

• how much should be left to regulation by the stock market regulators

• how much corporate governance should be a matter for companies to decide for themselves, perhaps within a published framework of best practice guidelines.

In the UK, for example:

• Company law provides some framework for corporate governance, but arguably not enough.

• The law is reinforced for listed companies (i.e. companies whose shares are on the UK Official List and are traded on the main market of the London Stock Exchange) by regulations in the UK Listing Rules. These rules require companies to comply with certain aspects of corporate governance, but does not provide a comprehensive statutory regime.

• The UK Listing Rules give support to a code of principles and best practice for corporate governance: the Combined Code. Although pressure is brought to bear on companies to persuade them to apply the best practice measures that are recommended, the Combined Code is voluntary.

In practice, however, although corporate governance is voluntary rather than compulsory, the risk of disrupting relations with shareholders is usually enough to persuade companies to comply with guidelines and codes of practice.

The US has taken a statutory rather than a voluntary principles-based approach to corporate governance. Following the financial scandals at corporations such as Enron and WorldCom, statutory rules on corporate governance were introduced by the Sarbanes–Oxley Act of 2002. It remains to be seen whether the voluntary or regulatory approach will be more successful.

Ethical issues

Ethical considerations are at the root of many perceived problems with corporate governance in practice. Individuals are expected to behave in an ethical way. Companies may be aware of the need to maintain a culture of corporate ethics, providing a code of conduct that all directors and employees are expected to follow.

In addition, the perception of ethical issues by external pressure groups may affect the reputation of a company, or the way it is run. An activist external group may regard itself as having a vested interest in the activities and operations of a company, particularly those involved in areas of advanced scientific research.

There has been considerable debate about what the objectives of sound corporate governance should be. The different views can be divided into three broad approaches:

1. the shareholder value approach

2. the enlightened shareholder approach

3. the stakeholder or pluralist approach.

The shareholder value approach

A well-established view, supported by company law in advanced economies, is that the board of directors should govern their company in the best interests of its owners, the shareholders. This could mean that the main objective of a company should be to maximise the wealth of its shareholders, in the form of share price growth and dividend payments, subject to conforming to the rules of society as embodied in laws and customs. The directors should be accountable to their shareholders, who should have the power to remove them from office if their performance is inadequate. The OECD, in the introduction to its principles of corporate governance, states that from a company’s perspective, corporate governance is about:

‘maximising value subject to meeting the corporation’s financial and other legal and contractual obligations. This inclusive definition stresses the need for boards of directors to balance the interests of shareholders with those of other stakeholders – employees, customers, suppliers, investors, communities – in order to achieve long-term sustained value.’

The strength of this approach to corporate governance is its general acceptance. Many people hold the view that public companies are in business to earn profits for the benefit of their shareholders. Successful companies are perceived as those paying dividends to shareholders and whose share price goes up. Within the broad objective of maximising shareholder values, the board of directors will also act fairly in the interests of employees, customers, suppliers and others with an interest in the company’s affairs.

The stakeholder approach

An alternative view is that the aim of sound corporate governance is not just to meet the objectives of shareholders, but also to have regard for the interests of other individuals and groups with a stake in the company, including the public at large. The OECD argues that there is a public policy perspective towards corporate governance, as well as a corporate perspective.

‘From a public policy perspective, corporate governance is about nurturing enterprise while ensuring accountability in the exercise of power and patronage by firms. The role of public policy is to provide firms with the incentives and discipline to minimize the divergence between private and social returns and to protect the interests of stakeholders.’

From a ‘stakeholder view’, corporate governance is concerned with achieving a balance between economic and social goals and between individual and communal goals. Sound corporate governance should recognise the economic imperatives companies face in competitive markets and should encourage the efficient use of resources through sound investment. It should also require accountability from the board of directors to the shareholders for the stewardship of those resources. Within this framework, the aim should be to recognise the interests of other individuals, companies and society at large in the decisions and activities of the company.

A problem with the stakeholder approach is that company law gives certain rights to shareholders, and there are some legal duties on the board of directors towards their company. The interests of other stakeholders, however, are not reinforced by company law. In the UK, there is currently a requirement that the directors should ‘have regard in the performance of their functions’ to the interests of the company’s employees in general as well as to the interests of the shareholders (Companies Act 1985, section 309). In practice, however, this provision of the Act has had little, if any, effect, because it is not specific and is presumably open to wide interpretation.

Supporters of a stakeholder approach (or pluralist approach) to corporate governance argue that there would have to be company legislation giving it support. A pluralist approach is that cooperative and productive relationships will be optimised only if the directors are permitted or required to balance shareholder interests with the interests of other stakeholders who are committed to the company. Changes in company law would be required to introduce such an approach in practice. If the law were to be changed in this way, it is much more likely that directors would be permitted to have regard for the interests of stakeholders other than the shareholders in particular circumstances, but would not be required to do so.

It is important to remember that although shareholder interests are not well protected by company law, extensive protection is provided by other aspects of law such as employment law, health and safety legislation and environmental law.

The enlightened shareholder approach

The enlightened shareholder approach to corporate governance is that the directors of a company should pursue the interests of their shareholders, but in an enlightened and inclusive way. The directors should look to the long term, not just to the short term, and they should also have regard to the interests of other stakeholders in the company, not just the shareholders. Managers should be aware of the need to create and maintain productive relationships with a range of stakeholders having an interest in their company.

A UK Company Law Review Steering Group issued a consultative document in 1998, in which it commented that UK company law currently does not embrace the enlightened shareholder approach, and if this approach was desirable, suitable changes in the law would need to be considered. Enlightened change, it felt, would not come voluntarily, but (like a pluralist approach) would need the backing of the law.

A criticism of the enlightened shareholder view is that most shareholders do not fit the image of enlightened investors. Most shares in public companies are owned by institutional investors, who are themselves relatively unaccountable to their beneficiaries. However, the role of institutional investors in corporate governance is likely to evolve in the future, with institutions expected to be more ‘proactive’ in promoting the rights and interests of shareholders. In the UK (and the US), where trust law applies, pension fund trustees look after financial investments for the beneficiaries of the pension funds. The trustees are legally obliged to further the long-term interests of the fund’s beneficiaries. In the past, this obligation has been interpreted narrowly to mean that trustees must protect the long-term financial interests of the beneficiaries. This interpretation has now been challenged. In the UK, pressure group PIRC (Pensions, Investment and Research Consultants Limited) argues that shareholder voting rights are also an asset of the pension fund beneficiaries, and these too should be given due care and attention by trustees. Trustees should, therefore, be obliged to vote at company meetings in the interests of their beneficiaries.

The King Reports: an integrated approach to corporate governance

The King Reports, published in South Africa, take an integrated approach to corporate governance. In 1992, the Institute of Directors in South Africa established the King Committee, which produced its first report in 1994. This was followed by a second report in 2002. The reports take the view that a company has a wide range of stakeholders whose views should be considered, and there should be a participative corporate governance system, applied with integrity.

King made a distinction between the accountability and responsibility of the board of directors:

• Accountability is the liability to render account to someone else. A director is accountable to the shareholders, at common law or by statute, and the company’s annual report and accounts, for example, should be presented to the shareholders for approval. The King Committee rejected the stakeholder concept that the board of directors should be accountable to other stakeholder groups, arguing that if a board of directors is accountable to everyone, the result would be accountability to no one.

• Responsibility is the liability of a person to be called to account when that person is responsible. The King Committee suggested that a board of directors, whilst being accountable to the shareholders only, should be responsible to other stakeholder groups as well as the shareholders.

A board of directors should be allowed to govern the company in the way it considers best, showing enterprise and flair. Accountability to all stakeholder groups would restrict enterprise. However, an inclusive approach to corporate governance, as recommended by King, would make the board of directors responsible to other stakeholders. The 2002 Report comments:

‘The inclusive approach recognises that stakeholders such as the community in which the company operates, its customers, its employees and its suppliers, need to be considered when developing the strategy of a company. The relationship between a company and these stakeholders is either contractual or non-contractual. The inclusive approach requires that the purpose of the company should be defined, and the values by which the company will carry on its daily life should be identified and communicated to all stakeholders. The stakeholders relevant to the company’s business should also be identified. These three factors must be combined in developing the strategies to achieve the company’s goals. The relationship between the company and its stakeholders should be mutually beneficial. A wealth of evidence has established that this inclusive approach is the way to create sustained business success and steady long-term growth in shareholder value.’

The King Report argued in favour of a balance in corporate governance between allowing the directors to run the company in the way they considered best for the stakeholders, while providing stakeholders with some protection against a board of directors that ignores its responsibilities and is not held properly accountable.

There are three ‘corporate sins’: sloth, greed and fear:

1. Sloth is the unwillingness to take risks and initiatives. It results in a loss of flair and enterprise, and the creation of a slow-moving bureaucracy to manage the company.

2. Greed is the desire of executive managers to get the best for themselves out of their company. It leads to short-term decision-making, without proper regard for the long-term future. Decisions are often based on the wish to drive up the share price and so the value of the directors’ own share options.

3. Fear arises when executives worry about what their shareholders (or the investment community) will say or do, so that decisions are taken that will keep shareholders content. Fear, like sloth, leads to an erosion of enterprise.

The Report suggested that concerns about corporate governance arose out of investor concerns about excessive powers in the hands of greedy professional executive managers. However, protecting investors against greed runs the risks of sloth and fear. Hence the need for a proper balance within a sound system of governance.

Which approach is likely to apply?

In practice, the shareholder value approach to corporate governance is the generally accepted view, but questions about the merits of the other approaches were raised in a consultation document published by the UK Company Law Review Steering Group in 1998. This group was set up to carry out a broad review of corporate law in the UK.

In discussing the interests that a company should be required to serve, the document stated that:

‘A case is recognised for ensuring that company managers have regard, where appropriate, to the need to ensure productive relationships with a range of interested parties and have regard to the longer term.’

The relative merits of the enlightened shareholder concept and the pluralist concept should, therefore, be considered.

In its response to the consultation document, the Company Law Committee of the Law Society in England and Wales stated that it did not accept the pluralist approach and that company law should not be used to implement social and cultural changes. In its view, there is already scope and flexibility in the existing law to apply pluralist or enlightened shareholder concepts, and that most boards of directors do take into account the interests of stakeholders in the decisions they make. It argued that the pluralist approach could damage share values, since actions to further the interests of other stakeholders might reduce returns to shareholders.

It seems unlikely, in view of current attitudes, that a pluralist approach will replace the shareholder value approach.

Achieving best practice in corporate governance

It is debatable whether a single set of rules of best practice in corporate governance could be drawn up that would apply properly to all public companies. Circumstances differ, and what is best for one company is not necessarily best for another.

Even assuming that a consensus can be reached about what is best practice in corporate governance, there could be disagreement about whether best practice should be recommended as a voluntary code or enforced through regulation, for example by company law.

• Corporate governance is concerned with the way companies are governed. Fundamentally, it is about what the objectives of a company should be. In the case of large public companies, it is also concerned with how powers are exercised by the directors and the accountability of the directors to the company’s owners, the equity shareholders.

• Concerns about governance practices arose partly out of corporate scandals and financial collapses and partly from the growing awareness of the need for good practice to attract investment capital.

• An issue in corporate governance is the relationship between stakeholders in the company, and their different interests, rights and powers. Stakeholders include the shareholders, board of directors, management, other employees, suppliers, customers, government and the general public (including pressure groups).

• Major developments in corporate governance have included, in the UK, the Cadbury Report, Myners Report, Greenbury Report, Hampel Report the 1998 Combined Code, the Higgs Report, the Smith Report and the 2003 revised Combined Code.

• On an international level there have been the Commonwealth Association Principles and the OECD Principles. At a national level, major developments outside the UK have included the King Report (South Africa) and the Sarbanes–Oxley Act (US). Some countries rely mainly on voluntary codes of practice, whereas others rely more on legislation and compulsion.

• Key issues in corporate governance, for which codes of best practice have been developed, are financial reporting and auditing, directors’ remuneration, the balance of power on the board of directors, risk management and communications between company and shareholders. Personal and business ethics underlie all these key issues.

• The best-established approach to corporate governance is the shareholder value concept. A move to an enlightened shareholder approach or a stakeholder approach would require changes in the law to be effective. However, there is growing awareness of the need for companies to act in a socially responsible way.

• Corporate governance issues apply not only to large public companies, but also to other companies, state-run industries, government departments and agencies and not-for-profit organisations.

:www.icsa.org.uk Institute of Chartered Secretaries and Administrators for a variety of resources relating to corporate governance

:www.icsapublishing.co.uk ICSA Publishing Ltd providing additional corporate governance resources

www.fsa.gov.uk/pages/Doing/UKLA/pdf/lr_comcode2003.pdf for the text of the 2003 Combined Code

www.opm.co.uk/ICGGPS/download_upload/Standard.pdf for the Good Governance Standards for Public Services

www.governance.co.uk Governance is a newsletter concerning international corporate governance issues.

www.icgn.orgInternational Corporate Governance Network aiming to raise corporate governance standards internationally.

www.asb.org.uk/corporate Financial Reporting Council responsible for publishing the Combined Code.

www.iia.org.uk Institute of Internal Auditors.

www.icaew.co.uk/cbp/index.cfm?aub=tb2I_6242 Guidance from ICAEW on the Combined Code. 

www.nacdonline.org/ National Association of Corporate Directors, US-based not-for-profit organisation dedicated to the needs of corporate boards and individual board members

www.boardmember.com Website of the Corporate Board Member magazine

www.spencerstuart.com Global executive search consultancy also offering corporate governance services

www.cacg-inc.com Commonwealth Association for Corporate Governance

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There is no one right answer, however, whatever definition you arrived at it should have at its core the notion that governance is about the proper conduct of a business or organisation and ensuring the proper controls are in place and operating to ensure that proper condu