Impact of Sarbanes Oxley Act on the GlaxoSmithKline United Kingdom - Essay Example

Impact of Sarbanes Oxley Act, 2002 on GlaxoSmithKline UK What is Corporate Governance The term corporate governance basically covers the systems and processes which are established by the corporate entities for ensuring proper accountability. Corporate governance ensures the establishment of relationships and their maintenance among both controlling and minority shareholders, the Board of Directors and other external stakeholders of the corporate entities. The basic principles on which the corporate governance functions include transparency, public accountability, fairness, and responsibility founded upon the concept of disclosure (Adam Dowdney). The objective of the observance of such principles is to encourage the necessary trust and confidence of shareholders. Globally, several legislative and administrative requirements in the form of new accounting standards, requirements as to detailed disclosures in financial statements and stricter enforcement of regulations on securities exchanges have been prescribed to ensure that governance of corporate entities is maintained at levels that are beneficial to themselves as well as to the people dealing with such bodies corporate. In the past, corporate governance had been used to protect the interests of company stockholders. However 'Corporate Governance' has assumed a new dimension in the post 'Enron' and 'Post Globalisation' scenario as almost every major developed and developing nation ensures some sort of promotion and protection of corporate governance principles. Conflicting Views of Corporate Governance The basic conceptual framework of the study of Corporate Governance deals with the relationship among the various internal stakeholders like owners, directors, and managers. The corporate governance structure of a corporation in a given country is determined by the following factors among other things: The legislative and regulatory framework outlining the roles and responsibilities of all the parties involved in the practice of corporate governance The de facto realities of the corporate environment in the respective country and the The articles of association of the respective companies However there are certain basic views or models that describe the corporate governance practices universally. According to Tricker (1996) "Stewardship theory, stakeholder theory and agency theory are all essentially ethnocentric" Tricker (1996) observes although there is no change in the underlying ideologies there are conflicting theories of corporate governance established on the basis of the perceptions and expectations of the respective roles of individual, enterprise and the state. The basic principles of the different theories depend largely on the relationships that exist between these agencies. The conflicting views on the corporate governance are presented below: The Agency Model Hawley & William (1996) state the emphasis of corporate governance lies in constructing rules and incentives in the form of implicit or explicit contracts for the purpose of aligning the behaviour of managers being the agents with the expectations of the owners being the principals. Under the agency theory of corporate governance it is assumed that the ownership of the firms is dispersed as the American 'modern' corporation. The main consequence of such a form of dispersed ownership is that there exists a gap between the owners representing the 'principals' of the firm and those who are responsible for the running the day to day operations of the firm who are known as 'agents'. Thus as Shelifer and Vishny (1997) state, "agency theorists aim to understand how investors get the mangers to give them back their money and hence minimize agency costs." According to Jensen & Meckling (1976) since the relationship between the owners and managers of a corporation is that of a pure agency relationship, the issues associated with the 'separation of ownership and control' in the modern ownership corporation are also mostly agency based. The Stewardship Model In the stewardship model, "managers are good stewards of the corporations and diligently work to attain high levels of corporate profit and shareholders returns" (Donaldson & Davis 1994). Being the critics of the agency theory they disagree with the basic assumption that the managers cannot be trusted that they will maximize the profits for the owners. They opine that the managers are good stewards of the corporation and will work diligently to achieve high level of corporate success in the form of shareholders' returns. As against the agency theory stewardship theory considers that the organisational wealth maximization is to be attempted with a view to distribute the wealth and power among the various interest groups of the organization. This necessitates that all the groups of people connected with the organization have a definite role to play in the functioning of the organization. The theory further assumes that the organisational success can be achieved through the coalition and partnership of the people concerned. In such cases the institutional owners would participate in the organizational process by exercising their voices. The Stakeholder Model The Stakeholder theory has been defined by Clarkson (1994) as "The 'firm' is a system of stake holders operating within the larger system of the host society". The function of the stakeholders is to provide the necessary legal and market infrastructure which will facilitate the efficient discharge of the firm's activities. Blair (1995) supported this view by stating the endeavour of the management and the board of directors is to maximise the total wealth creation by the firm. For this purpose Porter (1992) advised the creation of a board of directors consisting of "significant customers, suppliers, financial advisers, employees, and community representatives". However Williamson (1985) does not favour the idea of porter for the representation of the stakeholder constituencies in the unitary, as he is of the view that it may work out counterproductive. Based on the work of Jensen & Meckling (1976) Hill & Jones (1992) have worked on a new model that takes into account the relationships in an organisation. This framework considers the relationship which is both contractual and also relates to implicit and explicit factors. model known as 'Stakeholder-agency theory' takes into account the relationship between a firm and its strategic shareholders. UK Response to Application of Corporate Governance Principles The evolution of corporate governance in the UK can be traced back to the early 20th century which saw a significant development when the public companies started listing their shares in the stock exchanges. In the year 1972 the European Economic commission issued the fifth draft directive proposing a two-tier board as being practiced in Germany and Holland. However the idea of two tier board was not accepted by the UK. The country was in favour of the unitary board approach which comprise of both executive and non-executive directors that was made responsible for the day to day running of the business. The UK's response was the formation of a committee chaired by Lord Bullock. This committee recommended the continuation of the unitary board with worker representative board which was also not well received in the Britain's corporate quarters. The Corporate Governance issues in the UK have passed through the era of many committees and their reports in respect of the governance of the public listed companies during the 90's. In the year 1991, the Financial Reporting Council, the London Stock Exchange, and the various Accountancy Bodies set up the Cadbury Committee. The Cadbury committee recommended that in order to continue with the listing in the stock exchanges the public companies should be forced to comply with a code of best corporate practice as a precondition The Cadbury committee report was followed by the Greenbury committee in the year 1995 and its recommendations, except those relating to share options, long-term incentive schemes ad pension entitlements were included in the listing requirements, making it a compulsory listing precondition. The Hampel Committee formed in the year 1998 supplemented the recommendations made by the Cadbury and the Greenbury committees by contributing improvements over their recommendations. The London Stock Exchange, based on the Hampel report, brought out a general code of good practice entitled 'The Combined Code' which was made compulsory for all companies proposing to become listed after 31st December 1998. Despite the fact that it is a code, non-compliance with the code may entail a listed company in a fine or in some cases refusal to list. The year 1999 witnessed the submission of Turnbull Report which prescribed: The evaluation of risks facing the company in the responsibilities of the board of directors Ensuring that effective safe guard mechanisms and internal control systems are in place to prevent or reduce the risk Internal controls to include a transparent annual assessment of risks. The Aftermath of the Enron scandal necessitated publication of the Higgs Report and a 'Revised Combined Code' with the main emphasis on collective responsibility of the board of directors. The recommendations of the Higgs report did not approve the French and German models of board structure but preferred the existing UK unitary structure. The Higgs report advocated a greater involvement of non-executive directors basing its recommendation on the Revised Combined Code. Corporate Governance in the United States The corporate governance in the context of United States is regulated predominantly by legislation in the form of Sarbanes - Oxley Act, 2002 (SOX) and the detailed regulations drawn by the Securities and Exchange Commission (SEC), the New York Stock Exchange (NYSE) and NASDAQ based on the provisions of SOX. The approach to corporate governance in the UK varies significantly from that in the US as the UK takes a 'comply or explain' approach in almost all instances. In the US although the 'comply or explain' method is used in a few instances, in a majority of cases the US regulation relies on the regulation (SOX) and penalties in the form of penalties and imprisonments for any violation of the SOX provisions. Comparison of SOX Provisions with the UK Equivalent The important provisions of SOX and the equivalent legislation can be presented in the form of a table as shown below: Important Provisions of SOX Equivalent Legislation in the UK Establishment of the Public Company Accounting Oversight Board (PCAOB) with the express authority to oversee the audit of all the companies which are subject to US Securities Law; There is the obligation on the part of the auditors of these companies to register with the PCAOB. Under the Companies (Audit, Investigations, and Community) Enterprises Act, 2004 the Financial Reporting Review Panel has been given the power to require the companies, officers, employees and also the auditors to provide the required information for carrying out any investigation into the accounts of any company. Measures to enhance the independence of the audit committees and the effectiveness of such committees There are similar provisions under the Combined Code and the Smith Guidance. Certification by the CEO/CFO about the contents of the periodic reports (false certifications will be viewed as criminal offence) From 6th April 2005 a similar obligation is placed on the directors under the 2004 Act - any false certification will attract criminal proceedings Certification by the CEO/CFO of the quarterly/annual reports and also the assurance that there is an effective internal control system is in operation Combined Code and Turnbull Guidance insist on such a certification as a measure of best practice, although there is no legal compulsion Section 404 of the Sarbanes - Oxley Act, 2002 places a requirement on the publicly traded companies to establish and maintain internal control systems that take care of the processes of financial reporting. Section 404 (a) requires the management to disclose any material weaknesses in the financial reporting by the companies. PCAOB Auditing Standard No2 identifies three classes of deficiencies in the internal control system. In order to ensure the implementation of the provisions of the SOX a 'Committee of Sponsoring Organizations' (COSO was formed in the year 1985 with the sponsorship of five major professional accounting bodies in the United States. The COSO board issued guidance in 2007which is effective for monitoring all the three internal control weaknesses including the financial reporting objective which is applicable to the public reporting under SOX. Similar the internal control guidelines COSO issued in 2006 for smaller public companies focused on two basic elements: The monitoring system should ensure whether all the components of internal control are in effective operation and The weakness in internal control systems should be brought to the attention of all concerned including the management and the boars so that timely corrective actions can be initiated. Applicability of SOX Provisions to GlaxoSmithKline UK Under the new corporate standards adopted by the New York Stock Exchange on November 2003, which are applicable to foreign companies GlaxoSmithKline (GSK) has to comply with the domestic requirement of US with respect to the corporate governance. The following are some of the requirements that GSK has to fulfill and the difference between the UK compliance and the requirement in the US Context: (1) As per the regulation in the US listed companies must have a majority of independent directors - GSK complies with the equivalent domestic requirement under the Combined code. (2) The US listed companies must have nominating/corporate governance committee composed entirely of independent directors. There are similar provisions for compensation committee and audit committee - GSK complies with these provisions under the Combined Code Apart from the requirements of NYSE section 404 (a) requires an assessment as at the end of the most recent fiscal year, the effectiveness of the internal control structure, and of the internal control procedures. The Act requires the existence of a suitable framework that can provide the process procedures and evaluation criteria for the effectiveness of the internal control. Turnbull Guidance as in practice in the UK is identified as one of such frameworks, by Footnote 68 to SEC Rule 33-8238. The Turnbull guidance covers the review of the effectiveness of the internal control system in operation and also the identification of the weaknesses of the system. Paragraph 28 of the guidance specifies that the internal controls 'should include all types of controls including those of an operational and compliance nature, as well as internal financial controls'. Therefore the requirement of S 404 (a) which deals with the internal control over financial reporting is fully covered by the Turnbull Guidance. In fact Turnbull guidance deals exhaustively with the internal control systems and its evaluation. While the Turnbull guidance can be considered as a suitable framework for the purposes of Section 404 (a) of SOX there are no provisions in the guidance which reduces the obligations of the companies (to be registered with the SEC) to comply with the US laws and regulations concerning the internal control systems and the reporting thereon. Hence GSK has to comply with the provisions of Sec 404 (a) of the SOX, 2002 (FRC). Potential Benefits of SOX When the UK companies listed in the US Stock Exchanges review the internal control systems as per the requirement of SOX in addition to the Turnbull guidance, there would be a thorough evaluation of the internal control system. In view of the strict guide lines and reporting requirements of SOX as well as Turnbull guidance the companies are doubly secured to find out any weaknesses or deficiencies in the internal control systems sufficiently in advance so that there can not be any surprises from the control perspective. This would improve the process efficiency and thereby would lead to higher competitive edge. Most importantly this would satisfy the significant requirement of the corporate governance in increasing the trust of the stakeholders and investors who rely on the financial statements of the corporations for various purposes. Potential Problems The duplication of the work in the form satisfying the requirements of the Turnbull guidance as well as the Section 404 (a) of the SOX Act would entail additional efforts in terms of time and money for the companies attracted by both the provisions. However the UK companies would have already spent considerable time and efforts in preparing the compliance as per the Turnbull guidance. Hence it may not pose a problem for these companies. It must however be mentioned that satisfying two legislative requirements in respect of same fundamental function would lead to complexity in the control processes and additional workload which definitely would cost the companies both money and the number of people involved to comply with the requirements. References Adam Dowdney 'Corporate Governance in the UK and US Comparison' The Metropolitan Corporate Counsel Clarkson, M.B.E., (1994), A Risk Based Model of Stakeholder Theory, The Centre for Corporate Social Performance & Ethics, University of Toronto. Corporate Governance 'History of Management Thought' Series (Ashcroft Publishing) p1 COSO (2007) "Internal Control - Integrated Frameworks: Guidance on Monitoring Internal Control Systems' Discussion Paper September 2007 Donaldson, L. & Davis, J.H. (1994), 'Boards and Company Performance - Research challenges the Conventional Wisdom', Corporate Governance: An International Review, vol. 2, no. 3, pp. 151-60. FRC (2004) 'The Turnbull guidance as an evaluation framework for the purposes of Section 404(a) of the Sarbanes-Oxley Act' Shleifer, A. & Vishny, R.W. (1996), 'A Survey of Corporate Governance' National Bureau of Economic Research, Working Paper 5554, Cambridge, MA. Tricker, R.I. (1996), 'Pocket Director' The Economist Books, London. Williamson, O.E. (1985), The Economic Institutions of Capitalism, Free Press, New York. Read More