The Effectiveness of Governance Regulation in the UK - Research Paper Example

The development and effectiveness of governance regulation in the UK since the beginning of the 1990s to the present (Corporate Governance Issues) A corporation is a collection of internal and external stakeholders namely employees, shareholders (investors), customers, suppliers, financial institutions, and the society at large. A corporation has to be fair in all its transactions. It is rather a compulsion than choice to organizations especially, in the epoch of globalization where they need to pool resources from across the globe and win the confidence of the global people. These corporations are therefore governed by a set of code of values and principals. Top management responsibilities, especially those of the CEO, involve getting things accomplished through and with others in order to meet the corporate objectives (Wheelen and Hunger, 2007). So, good governance is wholly and solely the responsibility of the top management and for that the concept of corporate governance can play an optimal role. Corporate governance is about ethical conduct in business. Ethics concerned with the code of values and principals that enables a person to choose between the right and wrong and therefore select from alternative course of action. Corporate governance refers to the processes, rules or the laws in which the businesses are controlled, regulated and operated. This term usually refers to the internal factors which are usually defined by the constitution, stockholders and the officers as well as the external forces like clients, consumer groups and the governmental regulations. Well defined corporate governance offers a structure which usually works for the benefit of all people who are concerned by making sure that the entire enterprise does adhere to best practices and ethical standards as well as the formal laws. Corporate governance is generally a relationship that exists between the stakeholders which is used in controlling and examining the performance and the direction of the organization. Although, various definitions of corporate governance exist, the widely accepted one and importantly, which acted as the catalyst for the evolution of Corporate Governance in United Kingdom (UK) was given in the Cadbury Report. It describes corporate governance as “the system by which companies are directed and controlled” (qtd. in Kumar 2008). Adrian Cadbury in the Global Corporate Governance Forum, held under the auspices of the World Bank, further added to this definition by stating, "Corporate Governance is concerned with holding the balance between economic and social goals and between individual and communal goals. The corporate governance framework is there to encourage the efficient use of resources and equally to require accountability for the stewardship of those resources." (qtd in Heritage Institute). This neatly summarises the reason for the institution of corporate governance. Modern businesses have a variety of stakeholders whose interests may conflict; however, the control of the organisation is skewed heavily towards a single subset of this group, top management team. Therefore, a system of checks and balances is required to safeguard the rights of all stakeholders. In that direction, the corporate governance as a key management necessity started developing in UK in 1990s. When key scandals erupted among the UK institutions in early 1990s, it pushed the UK business community to put the house in order by coming up with various initiatives. Thus, this paper will trace the development and effectiveness of governance regulation in the UK since the beginning of the 1990s to the present. Much of the current framework of corporate governance legislation and regulations in UK had its origins in the various financial scandals and high profile corporate collapses, and the resultant findings reports. That is, when it is found that some insufficiency or large loopholes only led to the financial scandals, business leaders and lawmakers typically respond by changing governance requirements. Therefore, it is necessary to be familiar with the specifics of the particular corporate failures that inspired them. This part of the paper will discuss that in the UK, the failures of Polly Peck, BCCI and the various holdings of Robert Maxwell were the key triggers that led to the origination of corporate governance as a key necessity for organisational functioning. “The development of corporate governance in the UK has its roots in a series of corporate collapses and scandals in the late 1980s and early 1990s, including the collapse of the Polly Peck, BCCI bank and the Robert Maxwell pension funds scandal, both in 1991.” (Financial Reporting Council 2006). Wearing (2005) adds to this perspective by stating all the above mentioned cases have some common elements: powerful leaders, rapid and unsustainable growth, overly optimistic market assessments and very complex organisational structures. For example, Polly Peck, a small textile company in UK which suddenly grew exponentially in 1980s, only to be caught in corporate fraud and collapse in early 1990s. The first key point is, the Chairman and CEO of Polly Peck were the same man – Asil Nadir. Nadir, after acquiring a controlling interest in Polly Peck in early 1980s, developed it into a major conglomerate. However, from 1987 till the end of 1990, Polly Peck funds were pilfered by Nadir and also on his behalf, as there was no controlling mechanism to check. Large sums were used to finance the “covert purchases of Polly Peck shares by Nadirs private businesses, taking his stake in the business well beyond the disclosed 25% interest, with other sums allegedly spent on personal interest such as paying a tax bill, buying a Mercedes for Nadirs ex-wife, and providing a windfall for his son Birol.”( Bowers 2012). When the Polly Peck pressurized Nadir to share the details about the financial transfers and take responsibility for it, he refuses and he even dismisses the financial controller appointed to check the loopholes and improve the management of funds. These dubious actions of Nadir and due to the lack of strong controlling mechanism, the Polly Peck collapses in October 1990. That is, although concerns were raised about the financial reporting systems used by Polly Peck or in particular Nadir, no stakeholder pursued the doubts. The other key scandal, which led to the origination of Corporate governance in UK is the BCCI bank scandal. The Bank of Credit and Commerce International (BCCI), an international bank established by a Pakistani financier Agha Hasan Abedi in 1972, became one of the largest private banks on the basis of assets in 1980s. However, it came under the scrutiny of not only financial regulators but also intelligence due to its shady management of funds. That is, it was involved in massive money laundering exercises (even helping Islamic terrorists) and also various other financial crimes, which it carried out without detection by operating under bank secrecy jurisdictions without the purview of centralized regulatory. With a complicated corporate structure and shoddy record keeping, regulatory review, and audits, the complex BCCI family of entities created was able to evade ordinary legal restrictions on the movement of capital and goods as a matter of daily practice and routine. (Matyjewicz and Blackburn). However, when all these came under the scanner of the authorities, it was locked down, causing it to collapse with high financial liabilities and importantly necessitated the formation of corporate governance code. The scandal involving Maxwell Holdings and its then Chairman plus CEO, Robert Maxwell also played a role in the development of corporate governance in UK in 1990s. Maxwell indulged in heavy borrowings particularly from employees’ pension funds in order to expand his media empire, and when it did not work out on expected lines, it led to huge debts and the eventual failure. “Media mogul Robert Maxwell borrowed from employees’ pension funds and from banks as he tried to keep his empire alive. Eventually it failed and pensioners lost half of their pensions.”( Matyjewicz and Blackburn). As in the earlier case, the key corporate governance deficiency found in Maxwell’s functioning was Robert Maxwell held both the positions of Chairman and CEO, without any strong regulatory mechanism to judge his decisions. “The lack of separation of these roles led to the concentration of power which facilitated the fraudulent activities.” (Maier 2005). In addition, The Department of Trade and Industry had categorically rejected Maxwell’s ‘fitness’ to run a public company as early as 1971 – but he continued to do so until his death twenty years later. During that time he gave trusteeship of a pension fund to his sons, and misappropriated the funds. Maxwell’s contempt for non-executive directorial independence was also criticized. Thus, all the major scandals in late 1980s and early 1990s created a major impact in the business, political as well as in the social circles. To prevent such scandals from happening, steps were initiated and that led to the development of the first framework for corporate governance, which is the Cadbury Report, prepared by Sir Adrian Cadbury in 1992. “Initial corporate governance developments in the UK began in the late 1980s and early 1990s in the wake of corporate scandals such as Polly Peck, BCCI and Maxwell.” (Kingston City Group). The existence of a comprehensive UK code regarding best practice in corporate governance dates from the publication of the Cadbury Report. The Cadbury Committee was initially established after the failure of Polly Peck, but was able to observe the failures of BCCI and Robert Maxwell prior to publishing its recommendations and so the final report was broad in scope and had the advantage of these three examples of poor corporate governance. In an attempt to address concerns relating to overly complex financial statements and fraud, the resultant report established the principle of “comply or explain”, which is the essence of the principles-based approach. (Solomon 2010). In 1991, the Committee on the Financial Aspects of Corporate Governance was established and was chaired by Sir Adrian Cadbury. The series of recommendations made by this committee in 1992 were only constituted as the Cadbury Report as a two-page code of best practice. Drawing heavily from the corporate governance related work of the Treadway Commission in the USA, this report was mainly aimed at the Listed companies and whether their functioning is in line with ethical behaviour. So, the report mainly focused on the delineation of roles in an organization’s top management, the role of non-executive directors and also how the finances has to be managed with strong internal controls. “The resulting Cadbury Report published in 1992 outlined a number of recommendations around the separation of the role of an organisation’s chief executive and chairman, balanced composition of the board, selection processes for non-executive directors, transparency of financial reporting and the need for good internal controls.” (Kingston City Group). Focusing on the top management functioning, the report specifically asked for the separation due to the dubious role played by Nadir and Maxwell in the above discussed cases. With separation of leadership roles, Cadbury wanted to actualize an environment, where undue power is not in the hands of a single individual, thus preventing him/her from acting unilaterally and negatively without any restriction. In addition, with optimal role for non-executive directors, the report wanted the chairman to allow the non-executive directors to perform their allocated roles. “It is for chairman to make certain that their non-executive directors receive timely, relevant information tailored to their needs, that they are properly briefed on issues arising at board meetings, and that they make an effective contribution as board members in practice.” (Matyjewicz and Blackburn). As far as the internal controls are concerned, the report wanted the setting up of effective audit committees within the organization, as well as part of external consultant framework, so that effective and ethical decisions are taken without the leader influencing it. The report got strong validation when it was adopted by the City and the Stock Exchange as the basic benchmark for organization’s ethical functioning. “A requirement was added to the Listing Rules of the London Stock Exchange that companies should report whether they had followed the recommendations or, if not, explain why they had not done so (this is known as comply or explain).” (Financial Reporting Council 2006). After the path breaking Cadbury Report, series of reports came out through the 1990s, incorporating various updated or new provisions related to governance, which further strengthened corporate governance framework. The first initiative was the ‘Working Group on Internal Control’, which was mainly established to provide the needed guidance for the organizations on how to fulfil the Principle 4.5 of the Cadbury Code, which is regarding the “reporting on the effectiveness of the company’s system of internal control”. (Cadbury Report 1992). This in turn led to the release of the Rutteman Report in 1994 titled ‘Internal Control and Financial Reporting’, which provided apt guidelines to the organizations to actualize effective internal controls. In mid 1990s, concerns were raises about chairman and other directors’ pay and share options based on the dubious actions of Nadir. To manage this concern the Greenbury committee was set up in 1995 by the United Kingdom Confederation of Business and Industry. The committee came up with a report, which recommended “extensive disclosure in annual reports on remuneration and recommended the establishment of a remuneration committee comprised of non-executive directors.” (Kingston City Group). Like in the case of the Cadbury report, this report and its recommendation was also were endorsed by the Listing Rules. As an extension of both these reports, the Hampel Committee was set up. That is, “in January 1996, the Hampel Committee was established to review the extent to which the Cadbury and Greenbury Reports had been implemented and whether the objectives had been met.” (Kingston City Group). The Hampel Report came up with validations and certain suggestions, and all this were combined to create the Combined Code of Corporate Governance, the precursor to the current UK Corporate Governance Code, in 1998. This Code formed on the basis of all the reports was an all encompassing framework, as it covered all the areas in organizational functioning, which is susceptible to unethical and fraudulent activities. That is, the code covered “areas relating to structure and operations of the board, directors’ remuneration, accountability and audit, relations with institutional shareholders, and the responsibilities of institutional shareholders.” (Kingston City Group). The key component of this code is that, it applied to all the listed companies and importantly mandated those companies to come up annual report, which included a narrative statement of how they have followed or applied the Code and if they are not able to follow it, they were stipulated to give the reasons for it. Then, importantly, the Turnbull Committee was set up in 1998 by the Institute of Chartered Accountants in England & Wales (ICAEW) to provide guidance to the companies on how to implement and follow the Combined code. The committee came up with a report titled, “Internal Control: Guidance for Directors on the Combined Code” in 1999, and it provide detailed guidance to the companies on how to manage any financial risk. Thus, all these committees led to the development of a stronger corporate governance framework. “In 1998 the Cadbury and Greenbury reports were brought together and updated in the Combined Code, and in 1999 the Turnbull guidance was issued to provide directors with guidance on how to develop a sound system of internal”( Financial Reporting Council 2006) However, in the early 2000s, with major changes happening both in UK as well as in world business environment, particularly the scandals in USA like Enron Scandal, more changes or updates were done to the Corporate governance code, leading to the formation of the current UK Corporate Governance Code. That is, in 2002, the Department of Trade and Industry (DTI) and HM Treasury initiated a review of the Combined Code, particularly due to the changes in the company law. For that purpose, the Higgs committee was set up. The Higgs report was an all encompassing one, as it provided detailed and in-depth guidelines and regulations for the companies for effective corporate government. Some of the key recommendations were Definition of ‘independence’ and the proportion of independent non-executive directors on the board and its committees An expansion on the role of the senior independent director to provide an alternative channel to shareholders and lead evaluations on the chairman’s performance Added emphasis on the process of nominations to the board through a transparent and rigorous process and evaluation of the performance of the board, its committees and individual directors (Kingston City Group). At the time of this key report in 2003, the Financial Reporting Council came up with the Smith Report titled “Guidance on Audit Committees” and the DTI came up with the Tyson Report focusing on the recruitment and development of non-executive directors commissioned. The Enron and WorldCom scandals in the US had repercussions in the UK, with the Higgs Review and Smith Report in 2003 aiming to increase public confidence in the independence of non-executive directors. In contrast to the United State’s legislative response, the Higgs’ Review remained in favour of the “comply or explain” approach. For example, this is section 1.14 from the Higg’s Review: “…this Review builds on the “comply or explain” approach established by Sir Adrian Cadbury a decade ago. Listed companies have to report on how they apply the Code’s principles and to state whether they comply with the detailed provisions and, if not, why not. This approach has worked well.” (Practising Law Institute 2003) All these led to the formulation of the UK Corporate Governance Code in July 2003, which applied to all the listed companies in the primary market of the London. The key document detailing good practices of corporate governance in the UK is the UK Corporate Governance Code (formerly the Combined Code). Responsibility for this document lies with the Financial Reporting Council (FRC). All companies with a Premium Listing of equity shares in the UK are statutorily required to explain how they have applied the UK Corporate Governance Code in their annual report and accounts (FSA handbook). This area is currently regulated by the Financial Services Authority, but reform in the area of financial regulation, following the recent financial crisis, means that its responsibilities are being divided among other public bodies. When a firm presents its report in a format not explicitly set by the FRC as being good practice, it has to justify its decisions with reference to the overarching principles of the Code. Thus, it has been said that the UK’s approach to corporate government is “principles based”, as it permits individual firms to derive their own accounting and governance procedures if desired, provided they conform to the spirit of recognised good corporate governance. From these developments of corporate governance, it is clear that it has provided all the organizations of today a strong framework. Organizations’ main duty is to identify ways of ensuring that the all the decisions are made in an effectual manner. In the modern business world, corporate governance is used in establishing order between the company’s owner and the top managers who might be affected by conflict of interest. In the resent years, the area of corporate governance has received a lot of attention due to the high profiled scandals which involves abuse of the corporate power as well as criminal activities by the corporate managers or officers. An imperative part of an efficient corporate governance system includes the provisions for the criminal or civil prosecution of the persons who does conduct the illegal and unethical acts in the name of some enterprise. The main aspect, the above discussed frameworks particularly the Smith committee, focused is regarding the role of board of directors and this of key relevance in the current times. With the superior power in the hands of the Chairman without any decentralization leading to a slew of scandals in the early 1990s, the current focus on directors augurs well. The boards of directors are individuals who are responsible of representing the owners of the firms through monitoring the top level managers and their strategic decisions. (Wheelen, Hunger and Rangarajan 2007). The responsibility and the role of the board of directors vary depending on the firm. The board’s activities are usually determined by the duties, powers as well as the responsibilities that are delegated by them by the authority outside itself. The duties of the board of directors include governing the firm through establishment of objectives and policies, appointing, selecting and reviewing the performance of the executives, ensuring that there are enough financial services, approving of all the budgets and setting the salaries as well as the compensation. They protect the assets of the shareholders and ensure that there is a decent return on the investment. They direct the affairs of the firm; they reward and punish the managers, protect the rights and the interests of the shareholders and ensure maximization of wealth. The board of the directors is the uppermost governing authority in the management structure of any trading company. It is the role of the board to evaluate, select and approve the necessary compensation of the company’s CEO, recommend the stock splits, pay the dividends, approve the financial statement of the company among others. An effective board of directors should protect the principals from opportunism such as that found in General Motors which led to its bankruptcy. How the board members operate the firm’s resources determines the success or the loss of the company. Good governance is essential for the success of any firm. The board members play an imperative role in serving their communities and their causes and in bringing commitment as well as passion including the skills and the experience in the firms they lead. (Monks and Minow 1985) They offer long term vision and ensure good reputation as well as the values of the organization are protected. The board members needs to have effective policies and procedures in place and need to work as a team ensuring that there is good relationship within the firm. For this to happen, the board members should offer strong leadership, increase accountability, enhance their decision making among others. Corporate governance is vitally important to the economic well being of a modern capitalist economy. In complex organisations with variety of interested parties and many potential conflicts of interest, corporate governance can inform these parties about the organisation’s activities and also protects stakeholder’s rights through monitoring and control. Organizations should ensure that all its stakeholders enjoy equal rights and keep them informed about all the major decisions. This can be ensured by encouraging them to participate in general body meetings. Understanding the legal obligations on part of the organization is essential and also the right mix of people at various levels of hierarchy should be members of the board and also a rotation policy for the chairperson and the CEO is recommended. When important appointments are made it has to be transparent. Ethical decision making guarantee good public relations and more importantly eliminate legal risk and bad image in the eyes of the media and its various publics. Proper monitoring by the board of directors of all important areas of the company especially matters concerning finance is essential. (Hunger and Rangarajan, 2007, p.37). Corporate governance results in proper functioning of the organization and hence would result in profitability to the delight of its investors and its financial publics and provide for better socio economic growth. So good governance will result in all round benefit to those directly and indirectly concerned. The activities related to corporate governance has a direct influence on the financial health of the corporate entities and thus has tremendous significance. Today corruption is an all embracing phenomena in many parts of the globe; as a result suspicion has become an inherent quality of those concerned with the corporate. Winning the trust of its employees, customers, bankers, and the society is imperative to do business. As the world become borderless and cross border business has become the order of the day, ensuring ethical and accepted way of doing business will ensure goodwill and profits to organizations. References Bowers, S., 2012. Asil Nadir and Polly Peck: timeline, [Online] Available at http://www.guardian.co.uk/business/2012/jan/23/asil-nadir-polly-peck- timeline(Accessed on May 8, 2012) Cadbury Report., 1992. Financial Aspects of Corporate Governance Financial Reporting Council., 2006. 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