Development of the UK Corporate Governance Code - Assignment Example

Department of Accounting and Finance FINANCIAL ACCOUNTING 2 (AAF005-2) Development of the UK Corporate Governance Code by Student Name & Number An assignment submitted in partial fulfilment of the assessment for the Financial Accounting 2 unit Date of submission TABLE OF CONTENTS 1.0 INTRODUCTION The UK has a highly liquid listed company sector with dispersed ownership and a system of corporate governance that has developed significantly over the last two decades. Prior to 1992, the corporate governance of UK companies was regulated by customs and practice. According to Mullerat and Brennan (2010, p. 51), company law together with some stock requirements laid down only basic rules concerning boards of directors, financial reporting and audit. The Cadbury review was established in 1991 in response to a series of financial scandals. The Cadbury Report which was released in 1992 began the process of greater codification of corporate governance norms and as Mallin (2007, p. 22) points out, the report was the first to set out recommendations regarding the structure of boards of directors and companies’ accounting systems in the UK. Following on from the Cadbury Report, there have been a number of subsequent reviews to the corporate code made by committees led by Sir Richard Greenbury (1995), Sir Ronnie Hampel (1998), Nigel Turnbull (1999), Sir Derek Higgs and Sir Robert Smith (2003), and Sir David Walker (2009) (Bain & Barker, 2010, p. 267; Blowfield & Murray, 2008, p. 216; Brown & Snyder, 2012, p. 299). The reviews covered various aspects of corporate governance including executive remuneration, internal control, non-executive directors (NEDs) and audit committees. The recommendations made in all these reviews are incorporated in the UK Corporate Governance Code 2010. The standards laid out in this code are not legally enforceable and thus, it is a voluntary code for the directors of UK companies. However, companies with a premium listing on the London Stock Exchange (LSE) are required to apply the code on a ‘comply and explain’ basis. According to Mallin (2007, p. 22), the code has relevance to most companies and organisations irrespective of their size and whether they are quoted or not and in many instances, the code has been a source of deterrence to financial irregularities. This report reviews the development of the UK corporate development code from 1992, explaining its effectiveness as a source of deterrence to financial irregularities. 2.0 THE REVOLUTION OF THE CORPORATE GOVERNANCE IN THE UK SINCE 1992 2.1 The Cadbury Review As noted earlier, the review on corporate governance practice in UK was initially sparked by the prevalence of financial scandals and corporate collapses as in the cases of Coloroll and Polly Peck (Solomon, 2007, p. 152). As well, the move was driven by lack of credibility in the contents of financial reports of most UK companies. In response, the LSE, the UK Financial Reporting Council (FRC), and the organisation of accountancy professionals formed a committee on the Financial Aspects of Corporate Governance led by Sir Adrian Cadbury in 1991. The Cadbury committee issued its report in December 1992 (Mallin, 2007, p. 22). The recommendations of this review covered various areas such as boards’ operations, effective procedures for the establishment of board committees, and composition and operations of the key committees (Mallin, 2007, p. 30-31). It also reviewed the importance of independent NEDs in a company’s board as well the efficient reporting and control mechanisms of a business. Listed companies in the LSE are required to comply with the code (Davidson, 2010, p. 57). If a company cannot comply with any particular aspect of the code, it is required to be in a position to explain why it is unable to do so (Frederikslust & Ang, 2008, p. 347). This particular provides shareholders and potential investors with useful information on the instances where a company has or has not complied with the code. Where it fails to comply, investors are able to decide whether the failure is justified. Despite the Cadbury recommendations, there was continued discontent regarding directors’ remuneration fees and their defective and inconsistent disclosure of vital information in companies’ annual reports. This led to the setting up of Greenbury review. 2.2 The Greenbury Report of 1995 A committee which was chaired by Sir Richard Greenbury came up with comprehensive recommendations in 1995 regarding disclosure and director’s remuneration packages. The Greenbury Report recommendations generally focused on increasing accountability of directors and enhancing their performances. First, the report suggested that a company’s remuneration committee need to be composed of independent NEDs who would fully advice the shareholders every year regarding the company’s executive compensation policy as well as full disclosure of the contents of individual directors’ remuneration (Spedding, 2008, p. 352) Secondly, the report proposed the adoption of the performance measures that will effectively link rewards to the individual performance of directors. The purpose of this was to enhance greater congruence between the wishes of shareholders and the interests of directors. According to Vinten (2001, p. 4), the disclosure of director’s remuneration has become quite significant in UK company accounts since the release of the Greenbury Report. As the Greenbury committee published its report, another committee chaired by Sir Ronnie Hampel was set up to look at how such voluntary codes were being implemented. 2.3 The Hampel Report of 1998 The Hampel committee reported in 1998. The report found that a number of companies did not implement the recommendations of the Cadbury Report for various reasons. Further, there had been numerous concerns regarding the extent to which companies should give consideration to the concerns of various stakeholders, for instance shareholders, employees, customers, suppliers, creditors and the community. The report emphasised on the importance of good governance in ensuring that the interests of stakeholders are fully incorporated in organisational operations. The report stated that directors were in charge of relations with the various stakeholders and were accountable to shareholders (Ogilvie, 2007, p. 23). The report also called for companies to embrace the recommendations laid out in the report to prevent malpractices and frauds. At the same time that Hampel committee was reporting, an idea of the LSE whose purpose was to merge the ideas in the Cadbury, Hampel, and Greenbury Reports, referred to as the Combined Code, was published. 2.4 The Combined Code of 1998 The Combined Code released in 1998 combined together the recommendations provided in the three earlier reports. The report incorporates all the issues covered in the earlier reports including remuneration, audit, stakeholder relations and disclosure among others. According to Great Britain H.M. Treasury (2010, p. 39), the report details are appended to the Listing Rules of LSE. The report reinforces the ‘comply and explain’ principle of reporting which was first mentioned by the Cadbury Report. It added weight to the requirement of the report for any deviation from the code, especially for LSE listed companies. The Turnbull Report, which was published in 1999, guides directors on how to carry out an adequate review of companies’ financial statements before they are incorporated into annual report. 2.5 Turnbull Report of 1999 This report was issued by a review committee under the chairmanship of Nigel Turnbull, which was established by the Institute of Chattered Accountants in England and Wales (ICAEW). This report provided guidance on how the Combined Code could be implemented to make companies’ internal control systems efficient (Short, 1999, p. 57; Spira, 2001, p. 739). It emphasised the role of directors in ensuring that companies have strong and sound internal control systems and that all controls are working as they should (Sikka, 2008, p. 998). Importantly, the report suggested that directors should assess companies’ internal control systems and report on their status in annual reports. It also suggested that organisations were subject to new risks from external environment and also from the decisions made by directors in relation to their strategies and procedures (Zaman, 2001, p. 5). In the managing of the risks, the report proposed that directors should assess the weaknesses and vulnerabilities of the internal control system and make relevant changes in order to manage internal and external risks effectively. Thus, the Turnbull Report outlined the existing procedures in earlier reports and then made recommendations for improving internal control systems. 2.6 The Myners Report of 2001 This report was published in 2001 and it focuses more on trustees’ legal requirements as well as the relationship between trustees and investors, and promotes greater involvement of investors (Davies, 2002, p. 14). The report suggested that shareholders should be more active in taking actions against leadership of companies with less than satisfactory performances (Mallin, 2007, p. 26). Since the report was released, a lot of investors in various companies in the UK have shown an increase in their willingness to react against irregularities or underperformances (Davies, 2002, p. 14). 2.7 The Higgs Review of 2003 The 2003 Higgs review, under the chairmanship of Derek Higgs, focused on the importance of NEDs in companies’ boards. The report that was published gave support for the recommendations of the Combined Code (1998) with a few additional adjustments (Hand et al, 2004, p. 230). It touched on the role and effectiveness of NEDs and suggested that half of companies’ board should be comprised of independent NEDs. Further, the report suggested that NEDs should be paid at a rate corresponding with additional responsibility (Harper, 2007, p. 207). Thus, the Higgs review helped to inform the Combined Code, though it opposed some of the recommendations made in it. While the Higgs Committee was sitting, the UK Government asked the FRC to consider the particular role of audit committees within the governance framework and the relationship that they should have with the company’s external auditor. In the case of Maxwell’s Companies a decade earlier, the company had received a clear or ‘unqualified’ audit in the financial year before its collapse and it was clear that the audit committee had failed despite the fact that the chair of audit committee was a chattered accountant. This informed the appointment of a committee by FRC to review the role of the audit committee within the overall board structure, led by Sir Robert Smith. 2.8 The Smith Report of 2003 The Smith Report in 2003 focused on the role of audit committee. The report noted that while all company directors had a task to take action in the firm’s interest, the audit committee had a particular role to act independently from the executive to ensure that the interests of shareholders are appropriately protected in regard to internal control and financial reporting (FRC, 2003, p. 7). The report suggested that a strong audit committee is crucial to an effective internal control system but proposed that it should not monitor itself. Thus, the Smith Report gave a high-level overview of the responsibilities of audit committee. 2.9 The Combined Code of 2003 In light of the reports of Myners, Higgs and Smith, the 1998 Combined Code was revised to take account of various the recommendations and published in July 2003 (Solomon, 2007, p. 96). It thus incorporated the combined views of these earlier reports. One difference of the Combined Code from the previous one is that it states there should be no sole reliance on particular individuals while the previous Code stated that NEDs should not sit in all board committees (Tomasic, 2011, p. 7). On top of this, the revised Code further emphasised the responsibilities of a company’s chairman and the senior independent director. It also proposed a formal and thorough annual assessment of companies’ boards and the committees as well as evaluation of individual directors’ performances (Tomasic, 2011, p. 7). 2.10 Revised Turnbull Guidance A revised version of the Turnbull Report (1999) was issued in 2005 with a few changes. The report encourages directors to review their application of guidance regularly and to be more keen while review financial statements. The report suggested that it would be useful to assure investors that the internal control system is effective and both internal and external risks are well managed. On the basis of this report, directors of listed companies are required to inform shareholders on the status of the internal control system in the annual report and disclose and explain any noteworthy failings or flaws in the system, which they have or have not dealt with (Oxelheim & Wihlborg, 2008, p. 5). 2.11 The Combined Code of 2006 This is an updated version of the Combined Code issued in 2003 and has three major changes. The first change was meant to have the chairman of the board of directors serving on the reward committee but not acting as its chairman (FRC, 2006, p. 14; Pass, 2006, p. 467). Secondly, the Code provides for a ‘vote withheld’ option on proxy appointment and gives shareholders power to withhold their votes during any resolution. The third recommendation states that corporations should publish on their websites information about proxies lodged at general conferences where voting was conducted through a show of hands (Handley-Schachler, Juleff & Paton, 2007, p. 623). 2.12 The Combined Code on Corporate Governance 2008 The Combined Code was revised again in 2008 following the findings of a review document that was issued by the FRC (Pass, 2008, p. 291). The Code builds on the previous codes and remains a well crafted document and contains the main principles of good governance. The months preceding the issue of this revised Code had seen a significant increase in business failures. As well, there had been increased exposure of possible shortcomings in the governance arrangements within certain companies. According to the Institute of Directors Staff (2010, p. 63), this was a result of failures in the application of the Code’s principles, not with the principles themselves. Minor changes were made to this Code which allowed a board chairperson to have membership to the audit committee but not to be its chairman (FRC, 2008, p. 3). 2.13 The Walker Review of 2009 Following the 2008 financial crisis and the collapse of Northern Rock Company, a committee led by Sir David Walker was established to examine the trend of corporate governance in banks and other financial organisations in the UK. The Walker Report that was issued in 2009 made recommendations for all companies (Brown, 2009, p. 92; Ross & Crossan, 2012, p. 112; Chapman, 2012, p. 78). It noted that the crisis was partly sparked by the lack of a ‘challenge’ step in board decision making. This was followed by a review by the FRC, resulting into a new Code- the UK Corporate Governance Code (FRC, 2010, p. 1; Walker Review, 2009, p. 2; FRC, 2012). 2.14 Audit Firm Governance Code of 2010 In January 2010, the Audit Firm Governance Code was issued which sets a benchmark for good governance of audits firms that audit companies listed in the LSE. It is a voluntary code which firms that are not listed in the LSE may adopt wholly or partly (The Stationery Office, 2011, p. 63). The Code operates on the ‘comply or explain’ basis and proposes that the governance structure of audit firms should be comprised of independent non-executives. 2.15 Stewardship Code for Institutional Investors (2010) In a review of the Combined Code in 2009, the FRC found that there were numerous concerns regarding the effectiveness and quality of engagement between directors of listed firms and investors (Organisation for Economic Co-operation and Development 2011, p. 128). Subsequently, the FRC released a voluntary stewardship code in July 2010 comprising of seven principles which encourage getting more involved in corporate change through the use votes. 2.16 AIC Code of Corporate Governance In October 2010, the Association of Investment Companies (AIC) issued a revised Code of the Corporate Governance Code and an updated corporate governance guide for listed corporations (Smith, 2010). The contents of the Code reflect the principles of the Governance Code and consequently, it was endorsed by FRC as an alternative Code for investment firms. 2.17 UK Corporate Governance Code (2010) (The “Governance Code”) The UK Corporate Governance Code (2010) forms the primary source of corporate standards in the UK (Smith, 2010). It was issued in June 2010 by the FRC resulting from minor amendments to the Combined Code. Some of the changes contained in the Governance Code reflect the recommendations made in the Walker Report (Smith, 2010). The report applies to all companies listed in the LSE and is effective from 29 June 2010. 3.0 CASE STUDIES 3.1 Associated British Foods Plc Associated British Foods Plc governance practices demonstrate how effective the UK Corporate Code is in serving its intended purpose. The board of directors for Associated British Foods Plc is composed of 8 members comprising the chairman, Charles Sinclair, two executive and five NEDs (Associated British Foods Plc, 2011). Prior to the resignation of Galen Weston as a non-executive director in December 2011, all the other NEDs were fully independent of both the management and activities that would interfere with exercise of independent judgement (Associated British Foods Plc, 2011). Following his relationship with Wittington Investments Limited, Galen Weston was not regarded as an independent non-executive director and according to Associated British Foods Plc (2011), Weston had not been publicly appointed. Thus, the company’s board was compliant with the relevant Code provisions related to appointment of NEDs except on one point: it did not comply with section B .3.2 the Governance Code’s which requires the appointment of all NEDs to be made public (FRC, 2010, p. 15). The company’s board explained that the reason for lack of formal appointment was due to the Galen’s relationship with Wittington Investments Limited. However, Galen Weston’s resignation in December 2011 increased the board’s compliance with the standards of the Governance Code. According to Associated British Foods Plc (2011), the chairman of the company’s board, Charles Sinclair is also the chairman of the Remuneration Committee. This contravenes section D. 2.1 of the UK Corporate Governance Code which stipulates that the chairman of the board should not chair the remuneration committee (FRC, 2010, 23). However, the board of Associated British Foods Plc gives explanation that Charles Sinclair is best suited to chair both the company and the remuneration committee due to his experience. The cases of Galen Weston and Charles Sinclair show that the board of Associated British Foods Plc is compliant with the UK Corporate Governance Code. It is compliant with most of the principles laid out in the Code and where it does not, it provides a suitable explanation for non-compliance. Thus, the board implements the ‘comply or explain’ approach laid down in the Governance Code (FRC, 2010, p. 7). The resignation of Galen Weston shows that Associated British Foods Plc‘s board is ready to comply as much as possible with the provisions of the code. Charles Sinclair’s case shows that the ‘comply or explain’ approach provides flexibility for a company’s board and gives a chance for the board to make informed appointments and to maintain robust governance. 3.2 Barclays Bank Similar to Associated British Foods Plc, the Barclays bank is compliant with the principles laid out in the UK Corporate Governance Code. The board is currently composed of the chairman, two executive directors and ten NEDs (Barclays, 2011). The board size has reduced from 18 directors in 2007. According to Barclays (2011), the purpose of the reduction in board size is to allow constructive group discussion and enable all directors to contribute effectively. This step enhances compliance with section B.1 of the Governance Code which stipulates that the board’s membership should be of ample size to meet the needs of the company and that alterations to the composition of the board and/or its committees can be implemented without unwarranted disturbance; and does not have to be too big as to be unmanageable (FRC, 2010, p. 12). Section B.6 of the Code states that a company’s board should conduct evaluation of its overall performance, the performance of individual directors and that of board’s committees (FRC, 2010, p. 16). According to Barclays (2011), the board of Barclays Bank conducts an annual review which helps to increase the board’s effectiveness. Further, section D.1 of the Governance Code suggests that the director’s remuneration should reflect company’s performance in the long-term and should be structured in a way that it effectively links rewards to individual and corporate performance (FRC, 2010, p. 12). In regard of this principle, the CEO of Barclays Bank, Bob Diamond has not received his two years bonus as a result of the recent financial problems facing the company. Generally, the corporate governance practices of Barclays Bank are highly compliant with the principles laid down in the Governance Code. This demonstrates the effectiveness of the Governance Code in serving its purpose. However, in light of the above cases and the continued financial irregularities in UK, there is need for improvement of the Code in the future. 4.0 CONCLUSION, COMMENTS AND RECOMMENDATIONS The development of the UK Corporate Governance Code can be traced back to the early 1990s after the issue of a Cadbury Report. The revolution was sparked by the rise in financial irregularities and corporate collapses of UK companies. Continued dissatisfaction over irregularities and perceived lack of willingness by corporations to respond to poor performance, among other reasons elicited the need for more reviews of corporate governance in UK companies, leading to more revisions to the code. Numerous reviews to the Code resulted into the UK Corporate Governance Code, which is effective from 29 June 2010. Conformity with the stipulations of the Code is voluntary. However, compliance with the Code is a must for UK companies which are listed in the LSE, but on a ‘comply or explain’ basis. As demonstrated in the case of Associated British Foods Plc, the UK’s approach to corporate governance since the issue of the Cadbury report in 1992 has been characterised by avoidance of prescriptive rules. Brennan and Solomon (2008, p. 895) explain that different organisations require different governance approaches depending on business activities, size, ownership structure and operating environment. Thus, one solution may not be optimal for all organisations in all circumstances. For this reason, the Governance Code has no statutory force but the companies which are listed to the LSE are required to comply with the code. Where they fail to do so, they are required to produce reasons for non-compliance. As noted in the case of Associated British Foods Plc, under the “comply or explain” regime, corporations have no statutory obligation to all of the recommendations laid down in the Code. The Code states that the ‘comply or explain’ policy is the epitome of UK corporate governance (FRC, 2010, p. 4). This component has been in operation since the issue of the 1992 Cadbury Report and it forms the foundation of the Code’s flexibility (Organisation for Economic Co-operation and Development, 2011, p. 128). However, this does not mean that the Code encourages poor corporate governance. To minimise irregularities, the disclosure obligation gives shareholders the ability to monitor the extent to which organisations are compliant, review the reasons advanced by directors for non-compliance with any part of the code and if they feel dissatisfied, and express their concerns during annual general meetings through their voting behaviour. The ‘comply or explain’ provision thus gives an allowance for an organisation to adopt optimal corporate governance practices as demonstrated in the case of Associated British Foods Plc board chairman, Sir Charles Sinclair. Time will tell if there will be need to introduce statutory compliance but, as illustrated in the case of Associated British Foods Plc, the Code’s is more effective when it is voluntary in nature. However, there is one concern regarding the power of appointment and removal and performance evaluation vested on companies’ boards. From time to time, shareholders are dissatisfied with boards’ performance and call for particular directors to be removed (Brennan & Solomon, 2008, p. 895). However, this is not a straightforward thing and requires close attention to details. In the UK, according to Brennan and Solomon (2008, p. 895), there are requirements to give notice of such intentions, allowing the company time to develop strategies to thwart such a move. In practice, as illustrated in the case of Associated British Foods Plc, the appointment and removal of directors is much a decision of the incumbent board and the wishes of institutional investors are accommodated within that framework. Certainly, there is a feeling that investors should play a bigger role in this area and few company boards would act against the desires of such organisation. As far as private shareholders are concerned, their powers to influence corporate behaviour are limited, and to be effective, this would require a level of concerted action that is beyond the will of most investors. This can be achieved, for instance, through additional provisions in the Governance Code that increase the power of investors’ and shareholders’ vote in the appointment and removal of directors. As demonstrated in the case of Barclays Bank, company boards are responsible for evaluation of their performances, their committees and the performances of individual directors. Certainly, with the increased financial irregularities in the UK, there is a possibility of a biased evaluation. It is thus advisable for such evaluation to be conducted by a third party who will give an independent view, free from bias. 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