A6-Different approaches to corporate governance

Approaches to Corporate Governance

SMEs and stakeholder interests
Development and use of codes of practice in CG
Sarbanes Oxley (SOX)

Approaches to Corporate Governance

There are 2 possible systems for trying to get companies to have good corporate
governance
These are:
1. Rules based
2. Principle based

Rules-based system

In the rules-based system, companies adhere to the rules or pay penalties.

ADVANTAGES
1.
2.
3.
4.

Clarity
Standardisation
Penalties are a deterrent against bad CG
Easier compliance with the rules, as they are unambiguous, and can
be evidenced

DISADVANTAGES
1.
2.
3.
4.
5.

Can create just a "box-ticking" approach

Not suitable to all possible situations.
Creates unnecessary administration burden on some companies
One size does not necessarily fit all.
Expensive

Principles-based System (Comply or explain)

In the principles system, companies adhere to the spirit of the rule, or

explain why it hasnt.
This does not mean the company has a choice not to adhere.
It just means it can TEMPORARILY explain why it has not.
The punishment for this non-adherence will be judged by investors.

ADVANTAGES

1.
2.
3.
4.

Not so rigid, allows for different circumstances.

Allows companies to go beyond the minimum required.
Less of an admin burden.
Can develop own specific CG and Internal controls (For example physical
controls over cash will be vital to some businesses and less relevant or
not applicable to others.

DISADVANTAGES
1. The principles are so broad that they are of very little use as a guide to
best corporate government practice
2. Not easier compliance as with the rules, as they are ambiguous, and can
not be evidenced
Principles v Rules More Detail
A. Principles
The principle of comply or explain means that companies have to take
seriously the general principles of relevant corporate governance codes.
Compliance is required under stockmarket listing rules but non-compliance is
allowed based on the premise of full disclosure of all areas of non-compliance.
It is believed that the market mechanism is then capable of valuing the extent
of non-compliance and signalling to the company when an unacceptable level of
compliance is reached.
On points of detail companies could be in non-compliant as long as they made
clear in their annual report the ways in which they were non-compliant and,
usually, the reasons why.
This meant that the market was then able to punish non-compliance if
investors were dissatisfied with the explanation (ie the share price might fall).
In most cases nowadays, comply or explain disclosures in the UK describe
minor or temporary non-compliance.
Some companies, especially larger ones, make full compliance a prominent
announcement to shareholders in the annual report, presumably in the belief
that this will underpin investor confidence in management, and protect market
value.
Remember though that companies are required to comply under listing rules
but the fact that it is not legally required should not lead us to conclude that
they have a free choice.

The stock market takes a very dim view of most material breaches, especially in
larger companies.
Typically, smaller companies are allowed (by the market, not by the listing
rules) more latitude than larger companies.
This is an important difference between rules-based and principles-based
approaches.
Smaller companies have more leeway than would be the case in a rules-based
jurisdiction, and this can be very important in the development of a small
business where compliance costs can be disproportionately high.
B. Rules
Rules-based control is when behaviour is underpinned and prescribed by
statute of the countrys legislature.
Compliance is therefore enforceable in law such that companies can face legal
action if they fail to comply.
US-listed companies are required to comply in detail with Sarbox provisions.
Sarbox compliance can also prove very expensive.
The same detailed provisions are required of SME's as of large companies, and
these provisions apply to each company listed in New York.
National differences
Developing countries
In developing economies - there are normally many SMEs. For these companies
extra regulations would be very costly
So, perhaps for them the option to comply or explain is better.
This would allow those who seek foreign investment to comply more fully than
those who don't want it and are prepared to explain why
Developing countries may not have all resources that are needed for full
compliance (auditors, pool of NEDs, professional accountants, internal auditors,
etc).
To help compliance, international standards help nations become competitive.
The OECD (Organisation for Economic Cooperation & Development) was
established in 1961.

It is made up of the industrialised marketeconomy countries, as well as some

developing countries, and provides a forum in which to establish and coordinate
policies.
The ICGN (International Corporate Governance Network) was founded in 1995 at
the instigation of major institutional investors, represents investors, companies,
financial intermediaries, academics and other parties interested in the
development of global corporate governance practices

SMEs and stakeholder interests

Here, often, shareholders are not different from directors
Differences to a listed company
1.
2.
3.
4.

Often Family owned

Often no separation between management and owners
Little differences between owner and director objectives
Smaller number of shareholders - who are often in contact with the company
- so conflict less likely

In a listed Company it's different..

1.
2.
3.
4.
5.

Objectives of shareholders and directors may be different

Asymmetry of information
Shareholders get less info than directors, making monitoring harder
A separation between ownership and control
Shareholders and directors are different people

Development and use of codes of practice in CG

Corporate governance issues came about during the 1970s in the USA and in the
late 1980s in the UK.
The main reasons (but not exclusively), for the demand in the development
of corporate governance were:

Increasing internationalisation and globalisation

Differential treatment of domestic and foreign investors
Issues around financial reporting
The different characteristics amongst different countries
High profile corporate scandals

In addition, the need to develop a set of codes was driven to clarify uncertainties in
the law, or to set a higher standard of conduct than local legislation may require.
What Is a code And what is it for?

In most countries, financial accounting to shareholders is underpinned by company

law and International Financial Reporting Standards
Some of the other activities of directors are not, and it is in this respect that
countries differ in their approaches.
Codes are intended to specifically guide behaviour where the law is ambiguous.
UKs Cadbury Code
One of the major recommendations was that the two most senior jobs in a company
(CEO and chairman) should be held by separate individuals.
Other codes followed as it became clear that behaviour, other than financial,
needed to be provided for.

Sarbanes Oxley (SOX)

Came about in 2002 following corporate scandals such as Enron
Main features
1. Companies sign certificate stating accuracy of financial statements
2. If accounts are re-stated due to non-compliance with standards - CEO
forgoes previous 12month bonus
3. Non- audit work restrictions on auditors
4. Senior audit partner changed every 5 years
5. Directors cannot sell shares at sensitive times
Effects of SOX

Keep your feet warm

Personal liability for directors
Improved investor confidence
Improved internal control
Improved use of audit committees
Increased costs
Reduced responsiveness of companies
Reduced risk taking