Corporate Governance Is the Way a Public Limited Company - Essay Example

Corporate Governance is the way a public limited company Contents Introduction 3 Discussion 4 Conclusion 13 References 15 Introduction In the modern world, it has been recognized that the focus on governance issues has increased in a significant manner. The main approaches of corporate governance are considered as institutional approach and functional approach. Institutional approach refers to the examination of existing institutions in producing services in a more efficient manner. In this regard, institutions refer to the financial, legal and regulatory framework that is there in the governance system. There also has been an increasing focus on legal institutions to strengthen such institutions in an attempt to protect investors against frauds that are there in the corporate system. In contrast, functional approach refers to the functioning of various institutional arrangements in differing ways. It recognizes the fact that there are numerous ways of addressing governance concerns that are similar in nature. It is considered to be an open-minded approach which examines the existence of various possibilities. There are mainly two systems in the literature of corporate governance such as outsider system and insider system of corporate governance. The outsider system which is also known as dispersed system of governance is characterised by shareholder protection and dispersed ownership and is considered to be largely associated with the US and the UK. The insider system which is also known as concentrated system is characterised by weaker protection to shareholders and concentrated ownership and is considered to be mainly associated with European governance systems. The corporate governance of the UK is considered to have high standards associated with relatively low costs. The report by Governance Metrics International in the year 2009 showed the UK in the second position with regard to average governance performance by organizations in various countries. Discussion The UK’s corporate governance process has its basis in a series of scandals and corporate collapses in the 1980s and early 1990s. This led to the need of UK business communities of putting its house in a proper and orderly manner. In this regard, Sir A. Cadbury set up a committee in the year 1991 which made a series of recommendations in the year 1992. The report is known as the Cadbury Report (Tirole, 2001, pp 1-6). The Cadbury Report addressed numerous factors such as reporting based on internal control, role of non-executive directors, and the relationship between chief executive and the chairman. The companies listed on the London Stock Exchange need to follow these recommendations and also have to explain their position if they are found to be not complying with the recommendations (Clarke, 2004, p.35). The recommendations of the Cadbury Report have been continuously modified since the year 1992. The UK introduced Combined Code for Corporate Governance in the year 1998 (Crane and Matten, 2010, p. 81). It is largely considered as an international benchmark for practices of sound corporate governance. It offers flexibility to organizations with regard to compliance with their principles and also to provide explanation for not complying with a certain regulation. In this regard, it can be considered to be in stark contrast to mandatory systems (Jones and Pollitt, 2009, pp. 162-167). This has led to encouragement of organizations with regard to adoption of the spirit of the Code. The mandatory systems in this regard had an approach which is considered as “box-ticking” which failed to allow sound deviations from the rule and as such were not able to generate the trust of investors (Parkinson and Kelly, 2010, pp. 101-107). The model of “Comply or Explain” led to a better governance system in the UK and the basic premise of such a model has been adopted by other countries such as Germany and Austria (Hooghiemstra, 2000, pp. 55-68). It has been considered that the Code facilitated compliance. For instance, the Code facilitated appointment of independent non executive directors for a service contract of 12 months in place of executive directors (Hancock, 2005, p. 49). A large number of organizations incorporated in FTSE350 were seen to be in compliance with the Code at the end of the year 2004 (Vogel, 2005, p. 71). But the picture can be considered as not that good when it is considered with regard to those organizations that were not complying with the provisions of the Code (Jalilvand and Malliaris, 2013, p. 63). These organizations also explained themselves in a very poor manner for not complying with the Code. There were also some organizations that did not provide any explanation for their incompliance (Levy and Kaplan, 2009, p. 41). In this regard, if there is any explanation provided by such organizations for their incompliance, it fails to justify the reasons for their incompliance with the Code (Moir, 2001, pp. 16-22). Organizations tend to continue with their poor explanations till they start to comply with the Code. This is representative of the fact that organizations failed to use the flexibility of the Code to adjust their governance issues with the ever changing business circumstances (Baron, 2001, pp. 7-11). In this regard, it could be said that organizations tend to make fundamental choices between non-compliance and compliance. Shareholders in this regard tend to be indifferent to the quality of explanation that is provided by an organization for its non-compliance (Kallifatides and Ekwall, 2010, p. 55). The provision for explanations by organizations is considered to be a strategy to identify good investments rather than simply a tool which focuses solely on compliance. It is also important to take a note of the fact that the returns on portfolios of organizations that are considered as compliers do not significantly differ from that of non-compliers. But the returns of organizations that are considered as non-compliers tend to significantly differ with their quality of explanations (Plessis, Plessis, Bagaric and Hargovan, 2011, p. 51). In this regard, the Code could be significantly strengthened with higher potential benefits as follows: I) In the year 2004, it was found that provisions relating to minimum percentages of independent non executive directors and non executive directors have a high rate of compliance, above 95%. In this regard, it can be said that the organizations that are considered as non-compliant are most likely to provide no explanation and also the least likely to search for specific justifications. The revision of the Code in this regard made such provisions more stringent (Riley, 2006, p. 59). This will have a significant bearing on the compliance levels of organizations. But it remains to be seen whether there is any improvement in the quality of justification for non-compliance (Tricker and Tricker, 2012, p. 69). Another alternative route in this regard could be to make such provisions compulsory for those organizations that are already not complying and also not explaining much. II) The ways for enhancing the attention of shareholders with regard to explanations have to be found. In this regard, the inclusion of a specific provision could prove to have potential significant benefits (Griseri and Seppala, 2010, p. 87). The message that is to be conveyed is that full compliance may not be possible but the organization has to provide explanations to prove the fact that incompliance is in fact a better way of governing a company. The Combined Code remained in operation from the year 1998 to the year 2004. The provisions in this regard are summarised as follows: I) CEO and Chairman: The key task of the top management of an organization is to run the operations of the board and to successfully conduct the organization’s business (Heath, 2006, pp. 533-537). The division of responsibilities should be very clear such as to facilitate a balance of authority and power. In this regard, it is important to note that no one person should have unfettered decision making power. II) Senior Non-executive Director: The inclusion of an independent and strong non-executive element is highly desirable on the board of an organization excluding the chairman such that concerns could be addressed to such a person (Ruggie, 2004, pp. 499-501). III) Independent non-executive Directors: The non-executive directors of an organization should be free from the purview of management and also from any other relationship or business which could have a significant influence on their abilities to exercise independent judgement (Laufer, 2003, pp. 253-261). IV) Non-executive Directors: The non-executive directors of an organization should comprise persons from the board and it should not be less than one third. V) Service contracts: It is of utmost importance that the contract periods or notice should be set at one year or less. VI) Nomination committee: Every organization must have a nomination committee which will make recommendations to the board relating to all new appointments by the board (Maxwell, Lyon and Hackett, 2000, pp. 513-516). Non-executive directors should constitute the majority in such a committee. VII) Remuneration committee: Every organization should have a transparent and formal procedure for policies such as remuneration of individual directors and executive remuneration. There should be no involvement of directors with regard to decide remuneration (Bendell and Murphy, 2002, p. 77). Independent non-executive directors should constitute the remuneration committee. VIII) Audit committee: The board of an organization should construct an audit committee comprising at least three non-executive directors with written terms of condition. The written terms should deal clearly with the duties and authorities of the audit committee. The level of compliance of organizations in the UK is being communicated through the use of the following graphs: (Grimaud, Arcot and Bruno, 2005, p.4) The sample has maximum 10,288 numbers of instances of compliance. It is found that there are 8,712 cases of compliance in actual which results in a compliance level of 84.7%. From the above graph, it is seen that there is an increase in the compliance level of companies each year although full compliance had not been achieved by all organizations in this regard. 44% of companies had not complied in the year 2004 with respect to at least one of the principles as compared to 90% in the year 1998 (Financial Reporting Council, 2010). There were 14% of companies that had not complied with respect to more than two principles while 5% of companies had not complied on more than three principals in the year 2004. (Grimaud, Arcot and Bruno, 2005 , p.7) The above graph shows the compliance levels of organizations on each principle at the beginning of the period of December 1998-June 1999 and also at the end of the period of July 2003-June 2004 (Urip, 2010, p. 31). It is seen from the above graph that the average overall compliance level per principle had increased from 76.7% in the year 1998 to 91.4% in the year 2004. It is also observed that the compliance level had increased for all principles excepting audit committee which had remained at approximately the same level. The principles such as senior non executive director and service contracts had the maximum increase in compliance levels over the period of study (Financial Reporting Council, 2013). The principle of service contracts had increased from 35% to 80% during the period whereas the principle of non executive director had increased from 57% to 92% during the same period. The quality of explanations that are provided by organizations operating in the UK is communicated through the use of the following graphs: (Grimaud, Arcot and Bruno, 2005 , p.8) The absence of explanations by organizations for not complying with the Code is certainly not very desirable. It is also considered not to be in the spirit of the Code. From the above graph, it is seen that the absence of explanations by organizations is a common factor in the sample (CBI, 2013). The organizations had chosen not to provide any explanation in almost one out of five cases of non-compliance. On an average the percentage can be considered as 17% which had remained fairly constant during the period of the study though there was a slight decrease at the end of the period. (Grimaud, Arcot and Bruno, 2005 , p.9) The above graph shows two contrasting trends. First it can be said that three principles such as requirement of one third of non executive directors, remuneration committee comprising only independent non executive directors, and the requirement of majority of independent non executive directors had a non-compliance level of 25% which is not explained. Second, the deviations from two principles such as the requirement of a majority of independent non executive directors on the nomination and audit committees had been explained in more than 90% of cases (London Stock Exchange, 2012). But it may be concluded that each and every principle suffers from absence of explanations to some extent. (Grimaud, Arcot and Bruno, 2005 , p.12) The classification of explanations can be termed as general and specific. From the above graph, it is seen that there is existence of time trend in the evolution of quality of explanations. There is an existence of inflexion point in the above graph after the year 2001. From that point, there is a decrease in general explanations and an increase in the specific explanations (Rayton and Cheng, 2004). It can be considered that increase in compliance level in a significant way during the period of study resulted in the decreasing level of non-compliances during the period. (Grimaud, Arcot and Bruno, 2005 , p.13) The above graph gives the average percentages of general, no explanations, and specific with regard to each and every principle. The provision of senior non executive director had performed best in the sample. The explanations for non compliance in this regard are considered to be the best. This provision had the lowest percentage with regard to general explanations and also had a very low percentage with regard to no explanations (Grimaud, Arcot and Bruno, 2005). For other principles, the percentage of good explanations can be considered as approximately 20% excepting nomination committee where good explanations account for 14% of the cases. These results must be considered from the view point that there are very small numbers of companies that are not complying with the provisions of remuneration committee, nomination committee, and relating to audit as compared to the provisions of service contracts and senior non executive director. Conclusion The development of a market based approach by the UK enables the organizations which are operating in the UK to adopt a more flexible approach with regard to their organization of themselves and discharging their responsibilities while at the same time making sure that they are accountable to their shareholders in a proper manner. This is largely achieved by the Corporate Governance Code of UK which is handled by the FRC. The Code functions on the principle of ‘comply or explain’. The companies listed on the London Stock Exchange need to follow these recommendations and also have to explain their position if they are found to be not complying with the recommendations. The Code has identifiable sound practices of governance relating to internal control and risk management but organizations can choose to adopt a different strategy if it suits their circumstances in a suitable manner. In this regard, they have to explain their shareholders that the approach that has been taken is the best one with regard to performance of the company. The shareholders must give their agreement in this regard as an indication of their contentment. References Baron, D., 2001. Private Politics, Corporate Social Responsibility, and Integrated Strategy. Journal of Economics & Management Strategy, Vol.10 (1), pp. 7-11. Baron, D., 2001. Private Politics, Corporate Social Responsibility, and Integrated Strategy. Journal of Economics & Management Strategy, Vol.10 (1), pp. 7-15. Bendell, J. and Murphy, D., 2002. The Greening of Business in Developing Countries: Rhetoric, Reality and Prospects. London: Zed Books. CBI. 2013. Corporate governance. 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Vogel, D., 2005. The Market for Virtue: The Potential and Limits of Corporate Social Responsibility. Brookings Institution. Read More