Corporate Governance System in the United Kingdom - Term Paper Example

Corporate Governance System in the United Kingdom Corporate governance has come to be widely defined as the policies and broad guidelines on the basis of which a company is being administered. It also defines the relationship which the corporation will share with its stakeholders, namely the customers, share holders, the employees as well as the suppliers. A good corporate governance model must provide satisfactory powers to the shareholders. The board of directors and the governing body must display efficiency and integrity of character. The dealings of the organization with all the stakeholders must be based on sound ethics, with a provision of adequate disclosure of its operations. This can be ensured only when strict internal control and internal check are introduced in the organizations. Also every stakeholder should be given proper opportunity to safeguard their interest in the organization.  History of Corporate Governance in UK Although various practices for safeguarding the interest of the stakeholders in the British organizations were present in the past, the term corporate governance came into vogue only in the 1990’s with the publication of the Cadbury report. This report though was on the governance aspects in the financial sector, a list for the code of best practices were also added to it. The recommendation of this report was later on adopted by many companies as a model code for good governance. Then in 1995, the Greenbury report was introduced which contained the principles regarding director’s remuneration, so as discourage them from the practice of declaring arbitrary salaries for themselves, which was quite common in those days. Another report published in 1998 called the Turnbull report, provided guidelines to deal with the risk management and development of the internal control system in the companies. After the Enron and the Worldcom scandals in the US, the government of UK appointed a committee under Derek Higgs to prepare a report on corporate governance. Government then established Financial Reporting Council (FRC), a body consisting of eminent members from the commerce, industry and service fields to study the Higgs Report in 2003. FRC produced a much toned down version of the same report as the new code on corporate governance in 2003. This code was first updated in 2006 and then again in 2008. Also added to this was a review of the workings of the audit committees and recommendations to improve the same, as mentioned in another seminal study conducted by Sir Robert Smith. (“A history of corporate governance” 2007) Current Scenario The combined code, adopted since 2003, has taken a so-called comply or explain approach. Only the companies which have been listed in the London Stock Exchange are supposed to report on this code. The kind of reporting consists of how they have complied with the various codes and wherever they have failed to do so then reason has to be provided for the same. Although these provisions apply only to the companies listed on the London Stock Exchange but many such parallel provisions are emerging which now has to be followed even by the unlisted as well as the nonprofit entities.   For the companies whose shares are quoted on the exchange, reporting on the application of the various codes is necessary duty under the listing rules provided by the UK listing authority (UKLA). Any company which fails to do so will be penalized for the same. The key issues which the codes wish to highlight are that of the composition of the board and its structure, management of the board, remunerations payable to the directors, financial controls employed by the company, its accountability and audit and the relation with the shareholders (IOD n.d.). Thus the aim of corporate governance is to provide for the profitability of the company considering the welfare of all the stakeholders. Business organizations are commercial organizations formed to carry out business and earn profits for its members. But the same has to be undertaken only after ensuring the working of the top executives as reflected in the performance of the company has been within the ethical framework and in the best interest of all the members of the society (fact sheet).   The key Aspects The key aspects of the corporate governance in UK as defined by the code includes a single board of directors who will be together responsible for the performance of the company. Also the impartiality of the directors in performance of the duties has to be ensured. Constant evaluation of the functioning of the boards and the committees has to be done at regular intervals. There must be transparency in their appointment and declaration of remuneration and no such appointments can be made without the consent of the shareholders. An independent committee has to be set up with an advisory vote of the shareholders so as to decide the remuneration of the directors. The remuneration of the directors must be linked with their performance and their engagements. Further effective rights of the shareholders have to be preserved and enhanced. Most importantly proper check and balance have to be provided. This can be done by essentially separating the posts of the Chairman and the chief executive officer of the company. It is also desirable to maintain a good balance between the executive and non executive directors in the board. It has been decided that for big companies at least half of the board of directors should consist of independent non executive directors and the smaller ones should have at least two such directors.  There has to be a provision for internal audit and audit committee set up with independent directors having necessary experience and which must be allowed to function independently.  Models of corporate governance It has been argued that essentially there are two models of corporate governance. First model is the “market oriented” model that is in vogue in the countries like the USA and the UK. Under this model the share holders are the “outsiders” and they take small part in management, hence instead of holding on to shares for a long time, they trade actively in the share market, i.e selling them when they are not satisfied with the management practices and buying the shares of those companies with whose working practices they are in tune with. The share holders in these markets mitigate their risks by spreading them among shares of many companies. Thus instead of voicing their opinions the general meetings, shareholders in these countries wish to show their pleasure and displeasure by buying and selling the shares respectively. The spread in their portfolio do not allow any particular shareholder to get a decent number of shares, hence there are large in number but do not hold sufficient stakes to make their voices heard. Thus disposal of shares of a loss making company is considered a better option than the long term route of helping in the rescue attempt. Still the appointment of the non executive directors and the auditors is done by the shareholders, the government and its designated agencies are also kept engaged to ensure the rights of the share holders. On the contrary the share holders in the countries like Japan and Germany enjoy an insider relationship. Share holding is mainly institutional like that of the market oriented countries but the difference lies in the fact that the main share holders includes the banks which provides loans, and also those firms which are the customers or the suppliers of the company. Hence active trade in shares in these countries is much less than the market counterparts and the tendency is to have shares in a few companies and to hold the same for a much longer time period. Germany even provides for a two tier board so as to give representation to an equal number of shareholders and employees. It has been argued that many a times the banks which are the principle loan givers force these companies to take excess loans. Also the top executives are not always looking for the increasing the shareholders value rather they work for increasing the market share of these companies through intense competition so as to satisfy the objectives of the top management. Thus positive and negative sides exist in both these models. (Ricketts, 2007, pp.332-334)  Essentials of Superior Corporate Governance It is widely believed that the more a company adopts to the corporate governance norms, less scrutiny will be required to be done in its case and higher will be its reputation and more effective will be its performance. Aim of the corporate governance measures as envisaged in the Financial Reporting council (FRC) is to provide high standards of corporate governance along with low implementation costs for the same. This is possible because in UK the rules regarding governance are principle based rather than being based on rule. Thus business companies can adopt these rules according their own conditions and thus avoid unnecessary checks on the functioning of the enterprise. These laws and provisions have been developed in such a way so as to be able to deal with a wide array of exigencies. Care has been taken to establish prominent relationship between the shareholders and the company and not within the company and the regulator. This is because the shareholders are the actual owners of the company and it is in accordance to their discretion that the management of the company has to function. Regulations are only to provide management with the basic guidelines. The regulations encourage the board and the share holders to engage in discussions about corporate governance, so that the board can educate the shareholders on the same. The shareholders have been further empowered on account of their voting rights and the right to information act, to know about any questionable decisions of the board. An essential feature of such governance should be that it must not be too cumbersome so as to hamper the proper functioning of the organization. Proper governance should ensure the security of the capitals of the creditors as well as the owners of the company and help to improve their long term profitability. Therefore the corporate governance norms has to be flexible, so that it can be implemented universally regardless of the size, ownership pattern or the industry in which it is engaged. To make the system effective it is very important to provide the shareholders with adequate information so that they can make conscious judgments.   Virtues of Corporate Governance in UK The corporate governance system developed in the UK is based on the market based approach of the USA, which provides enough flexibility to the board members to function, while ensuring the safeguard of the shareholder’s interest. Under the law in UK shareholders have voting rights on wide ranging subjects. These include rights to appoint and remove the directors from their posts, to call extra ordinary general meeting if required. They also have an advisory vote on the director’s remuneration which is decided by a separate committee. The board also has to provide the share holders with the board review which mentions the uncertainties and risks if any which the company is currently facing. The listing rules also work in favor of the share holders by decreeing that all the major transactions of the company has to be put to vote and certain other declarations which has to be made in the public.       Studies have proved that the UK is ahead of most of the countries in terms of maintaining high standards of corporate governance. A report published in 2005 by FTSE ISS corporate governance index and another one by Government Metrics International has ranked UK at the topmost position among all the countries surveyed. Compliance costs in UK are also less than those countries which are following the same level of standards. A paper published by Oxera for London Stock Exchange has mentioned that better corporate governance environment of the UK is a major reason due to which many companies decide to list their companies in UK before doing so in the US. (Financial Reporting Council 2006)         The virtues of the corporate governance system of UK are many. The most important such virtues are that UK takes into account the virtues of the US system after excluding the excesses. The process of information disclosure is also quite advanced in UK. Along with this it follows reliable auditing and accounting standards by taking into account the substance over form principles. Since the publication of the Cadbury report there has been an increase in the separation of the roles of the chairman and that of the Chief Executive Officer. The chairman’s involvement in day to day running of the corporations has largely been curtailed. Institutional investors who were always strong in UK are now taking active interest in the management of the affairs of the company and in keeping the management informed of their views.  Still as compared to other countries in Europe, in UK workers participation in the management of the company affairs is virtually unknown (Becht and Mayer, n.d.). Though there is a provision in UK regarding this, it has not been made essential. Just before failure of the RBS bank, its management has issued new shares in which the workers were encouraged to participate. As no representatives of the workers were part of the company’s management, they were unaware of the financial condition of the bank. Due to this many of the employees suffered once the bank went into liquidation.  Shortcomings It is widely believed that the reason of failure of banking sector has to be blamed entirely on the failure to implement the corporate governance norms in the sector. This has led to bonus payments without any ostensible link with the performance. Also many cases of weakness like the negligence by the board and use of unsatisfactory risk management measures has never been reported. The increase in pay structure of the top executives was not based on profit but on the risk taken by them over the investors and depositors wealth. (Kennyl, 2009) Unlike the US, in UK institutional investors play a vital role in company’s management and the directors and the top executives do not take decisions arbitrarily. But the bankruptcy of the Royal Bank of Scotland has again brought the issues of corporate governance to the fore. The failure of RBS is very similar to those of its American counterparts with the Chairman and the CEO taking arbitrary decisions without caring to keep the shareholders informed. Many researchers have expressed deep concerns regarding the success of corporate governance in the companies. The reason attributed to this is that the main problem is not about making the financial statements in tune with the governance measures; rather it is about how to bring the quality of human decisions in line with these measures.  (Bruce, 2009) Many research works have shown that companies incorporating better corporate governance measures have been more successful, while some others have cry hoarse on the cost and the involvement of manpower to undertake the same. Among these, one thing is certain that the shareholders are now a much more educated and enlightened lot. Nearly all the reports and recommendations of the British government have been undertaken only after the objections made by the shareholders. Also the business houses are now facing relentless pressure from the unions, government agencies, media and the shareholders, who are all demanding efficient and ethical governance on the part of the companies References 1. “A history of corporate governance” (2007), Out-Law.com, available at: http://www.out-law.com/page-8213 (accessed on June 5, 2009) 2. Becht, M. and Mayer, C. (n.d.) Corporate Governance in Europe. Available at: http://www.sbs.ox.ac.uk/NR/rdonlyres/0B017B7F-BAE4-4242-BA9E-941954BEEF29/2961/CorporateGovernanceinEurope4.pdf (accessed on June 4, 2009) 3. Bruce, R. (2009) Corporate governance: Live and learn - problems with the global banking culture, Financial Director, available at: http://www.financialdirector.co.uk/financial-director/comment/2239014/live-learn-4522186 (accessed on June 5, 2009) 4. Financial Reporting Council (2006) The Combined Code on Corporate Governance, June, available at: http://www.frc.org.uk/documents/pagemanager/frc/Combined%20Code%20June%202006.pdf (accessed on June 5, 2009) 5. IOD (n.d.) Corporate governance in the UK, Factsheet, available at: http://www.iod.com/intershoproot/eCS/Store/en/pdfs/ukcorporategovernance.pdf (accessed on June 5, 2009) 6. Kennyl, J. (2009) Corporate governance failure driving banking crisis, FT Advisor, available at: http://www.ftadviser.com/InvestmentAdviser/Investments/AssetClass/Equities/News/article/20090225/2d2a7d74-034c-11de-a6db-00144f2af8e8/Corporate-governance-failure-driving-banking-crisis.jsp (accessed on June 5, 2009) 7. Rickets, M.J. (2007) Economies of business enterprise: An introduction of business enterprise, Edward Elgar Publishing Read More