CORPORATE GOVERNANCE [MBA]

STUDY NOTES

WRITTEN BY

BORNAPART SIBANDA

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Table of Contents
1 Corporate Governance Issues ......................................................................................................... 3
2 External Governance-Law and Regulation .................................................................................... 11
3 Codes of Best Practice and Norms of Behaviour .......................................................................... 19
4 Boards of Directors: The Lynchpin ................................................................................................ 25
5 Internal Controls and Accountability ............................................................................................ 31
6 Risk Management ......................................................................................................................... 38
7 Financial Market –Supervision and Control .................................................................................. 42
8 Governance and Financial Market Economics .............................................................................. 48
9 External Reporting Need versus Delivery ..................................................................................... 54
10 Definition Inconsistency and system improvement ................................................................. 59
11 Reality in the face of prescription ............................................................................................. 63

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 1 Corporate Governance Issues

1.1 Introduction
 This module will introduce the issues that make corporate governance important,
the concepts about governance that distinguish it from other areas of management
study, and the domains that are relevant to it.

1.2 External & Internal governance of Group Activities

 External corporate governance: is the set of mechanisms that regulate, oversee,
direct and control human behaviour with the intent of ensuring that collective and
individual behaviour within a group meets the norms of the society.
 Internal corporate governance: is the set of rules, guidance and controls that
determine the course of individual actions within a collective group.
 External governance limits the autonomy of any collective enterprise, both in its
organisation and in the activities of individuals operating within it.
 Internal governance limits the autonomy of the individuals who form the collective
enterprise.
 In the absence of internal governance, group activities fail while in the absence of
external governance; collective groups fail to meet the community’s expectation.

1.3 Feudal Economies and Financial Markets

 In a feudal economy, the capital needs of government and religious institutions are
met through taxations, donations or booty obtained in war.
 In this economy, the capital needs of commerce and industry are met locally and
most business activities are financed with cash flow.

1.3.1 Financial Need Stimulates Market development

 The growth of industry and commerce has resulted in the growth of capital needs
hence capital markets and financial institutions. This has marked the transition
from a feudal to an industrial market economy.
 A thriving trade in valuables during the 1700s resulted in the emergence of the
Goldsmiths who took deposits of valuables such as gold, silver and jewels. Banks in
London were later established by these Gold Smiths. The bank of England was one
of the establishments.

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1.4 Embryonic Corporate Governance Mechanisms
 By the end of the 17th Century, the practice of holding and moving physical
valuables was replaced by a new concept: depositing valuables and issuing banking
orders/or drafts.
 These drafts permitted someone else besides the depositor to draw upon the
valuables.
 This allowed the movement of capital represented by financial instruments, in
place of the movement of gold, silver and other valuables.

1.4.1 Individualised Internal governance mechanisms

 The use of a banker’s draft to draw some else’s valuables resulted in a number of
significant risks.
 This required banks to ensure that individuals deposited valuables which they
actually owned.
 The bank was also expected to have a secure place.
 The bank had to be trustworthy as a depository, reliable with its inventory
management and accounting and safe from theft.
 At first, each bank determined its own processes to manage deposits, drafts and
the risk which was created.

1.4.2 Evolution towards external Mechanisms

 The public was assured by good reputation of individual organisations. However,
bad behaviour of the few affected other banks.
 Risks that threatened public institutions resulted in government involvement in the
solutions.
 Initial external corporate governance mechanisms were developed by the
government and from solutions of institutions themselves e.g development of
membership rules by the London stock exchange.

1.5 Foundations of the corporate governance Framework

 Understanding the social, political and economic importance of land in Europe is
critical as the corporate governance framework used around the world today
appears to have evolved from the external and internal governance system used in
this land owning system.

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1.5.1 Ownership as life estate-A deed settlement
 A legal structure of land ownership developed in England. It was called the strict
settlement. It allowed title of property to be established so that the successor
generations of land owner only owned a tenancy for their lifetime and operated
under legal and social constraints.

1.5.2 Under strict settlement, the land belonged to the estate, not the squire.

1.5.3 Landed Estate Administration

 Estates had a resident agent responsible for farms, negotiating leases, ensuring the
husbandry covenants were kept (e.g crop rotation of crops), recommending and
supervising improvements and for the collective disbursement and accounting of
estate revenues and expenditures.
 The prime Accounting records were usually running statements of cash received
and paid out.

1.5.4 Estate Accounting System

 The estate accounting system developed in the 16th century.
 All accounts of the receivers were brought into the central office for audit
purposes
 Accounting reports showed the source of net cash revenues and expenditure

1.5.5 Adoption by Canals and railroads

 The estate accounting system was later adopted by canals and railroads
 These were financed by the issuance of shares and the shareholders would see that
the amount was used to cover operating expenses through the capital account.
 The capital intensive nature of railroads resulted in the recognition of depreciation
during the 1840s.
 To the aristocrat, an accounting statement told him how much cash he had
available from his estate, how much had already been remitted and how much was
still in hand and thus provided a guide to consumption and to estimating estate
cash flows.

1.5.6 Directors and their duties

 The history of the 1st board of directors is lost in the units of time.
 By 1600, the concept of board of directors was written into the charters of English
joint stock companies.

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  Directors chose how to full fill their duties until the 19 century where the debate
of whether a director was an agent or trustee took place.
 As an agent, the directors were seen as standing in the same position vis a vis the
shareholders as steward stands in relation to his lord of the Estate.
 As trustees, directors of limited liability companies were seen as the successors of
directors of unregistered companies which were created as trusts under a deed of
settlement.
 Whichever analysis was used to determine the duties of the director, it was
decided by the courts from duties arising from and developed by the aristocratic
estates.

1.6 External governance mechanisms to facilitate Economic

development
 In London and other cities such as Paris and Vienna, coffee house developed into
embryonic capital markets.
 These coffee house capital markets were gathering places where men with money
met and engaged in both social discourse and financial business.
 This led to the emergence of jobbers who facilitated transactions in these coffee
houses. They organised the transfer of assets by matching buyers with money with
the sellers of assets.
 At this point, capital markets faced challenges as they needed a better legal form
for enterprise organisation.
 These problems were solved 1stly by the development of a liability company called
a joint stock company.

1.7 Protecting the Providers of Capital and Society

 Adam Smith, the author of “wealth of Nations” was concerned not only about the
creation of wealth, but also about its equitable distribution.
 As a result of his investigation, Smith concluded that the corporate form of
organization, which limits the owners’ risk to the amount of their investment, has
inherent problems that are dangerous to society.
 Smith was worried that unlimited life permits organizations to outlive their original
purpose and grow their capital until they gain excessive power and mismanage
their assets.

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1.7.1 Effect on Organizational Forms and Capital Formation

 The speculative bubble of South Sea resulted in the corporate form being only
obtained through parliament
 After Smith’s expression of his concern, the use of corporate form was rare
 Despite the limited floatation’s after the collapse of South Sea, market activities
continued with jobbers continuing with their roles
 Partnerships were the prominently used form of organization though with
challenges emanating from the limited resources of partners and their finite lives.

1.7.2 World dependence on the financial markets

 During the second half of the 20th Century, companies were organized as limited
liabilities and accessed their capital requirements from public markets.
 Today most economies are dependent on financial markets as organizations in
those economies are directly or indirectly dependent on the capital markets.

1.7.3 World dependence on the financial markets

 With Economies growing, financial need stimulated the development of capital and
retail financial markets.
 Where there arose efficiency, administrative or behavior control problems, these
led to the development of governance solutions.
 The bubble act passed by the UK parliament in June 1720 was an early attempt at
external governance purportedly intended to protect the providers of capital by
prohibiting the raising of capital in the public markets, except by charted joint
stock companies.
 The evolving nature of external governance solutions was a result of continued
emergence of problems.
 These solutions were either public or private solutions.
 Stock markets created rules
 Problems with behavior of management led to the development of accounting,
which in turn supported internal decision making.
 Auditing and accounting standards developed as a means to provide consistent and
reliable information reporting externally.

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1.8 Listed Company behavior-on (off) the agenda

 During 1970s, the Japanese economy boomed while the West economies were
stagnant.
 Reagan and Thatcher reforms changed the economic systems in the US and UK.
However, after 1986, there was a new climate of greed.
 In 1987, the Asian markets crashed and then slowly other major markets caught
this economic Asian flu, an indication of interdependencies of major industrial
economies. The US market crashed in 1987 and the UK market followed in 1989.
 A number of large listed companies failed in the US between late 1980 and early
1990s, leading to the establishment of the Tread way Commission.
 Some of the UK failures in the UK that outraged the public were those of Polly Peck
and a massive £10 billion fraud at BCCI, resulting in the establishment of the card
bury Committee.

1.9 Market Madness, excess and Trust Lost

 The second half of 1990 was characterized by increased company earnings which
saw their values increasing and the CEO remunerations also skyrocketing.
 There were celebrity CEOs of companies such as GE, Tyco and Vivenda who
embarked on expansions through acquisitions.
 The public increasingly participated in the markets, analysts touted unknown and
untried managers.
 Year 2001 marked the turn of events in the US.
 Companies such as Enron during year 2002 restated their earnings. WorldCom
restated its earnings, having manipulated it by $3,8 billion
 The CEOs had perks that ran into millions
 High flying companies crashed because of some of the following reasons:
- Accounting manipulation
- Boardroom breakdown
- CEO performance-related departures with large payoffs
- Corporate fraud
- Insider trading
- Misuse of corporate resources
- Risk management failures

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  By the end of 2003, belief in the efficacy of companies and investment institutions
had sunk

1.10 A fundament requirements in economic relations

 Trust is fundamental in the functioning of capital markets

 Buying and selling of shares and debt in capital markets requires trust.
 The beliefs necessary to make financial markets viable include the belief that:
- Those issuing debt or equity investments have the ability and the intent to
fulfill their obligations
- The financial instruments are valid and are what they purport to be.
- Sellers will deliver what they agreed to sell at the time and place agreed.
- Purchasers will pay the price at the time, place and in the form agreed.
- All relevant information is available to all parties to the transactions.

1.11 The Domains of corporate governance

 The corporate governance controls have been focused on achieving trust by

addressing the classic principal agent problem
 Trust requires reliable external control and good quality performance reporting
 The explicit aim of most recent corporate governance reforms has been to improve
trust by improving the reliability of performance reporting through accounting
standards, audit practice and legal sanctions for faulty reporting
 Company reliability through the supervision of management undertaken by the
board of directors.
 Other governance systems to have received attention have been the auditors and
to a limited extent, company executives
 Recent domains: Auditors, Board, executive
 Sources: Society, government, profession.

1.11.1 Many external governance influences

 It is difficult to have efficient and reliable markets if the external control of

companies in general and reported performance in particular is unreliable.
 External governance encompasses many domains: these are areas where public
policies, rules and behavioral norms govern corporate activity.
 Some governance mechanisms are explicit while others are tacit

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  Exposures by journalists have frequently led to public distrust.

1.11.2 1 Corporate governance is external guidance

 Internal governance mechanisms that guide, direct and control individual behavior
within a corporate setting are also as important as the diverse external sources of
the guidance, direction and controls that signal society’s expectations about what
is achieved by the enterprise and how it should achieve it.

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 2 External Governance-Law and Regulation

2.1 Introduction

 An external corporate governance framework provides the rules, guidance and

control arising outside an organization that are intended to influence the decision,
actions and behavior that occur within it.
 The framework is made up of 4 complex, interrelated and independent elements
namely: law, regulation, codes of best practice and social norms.

2.2 External Mandates

 External corporate governance requirements have existed for many years than
there have been legal structures governing the association of men.
 The degree to which the mandatory elements of an external governance framework
traditionally have prescribed the workings of the internal governance systems of
organisations vary significantly from jurisdiction to jurisdiction.
 Until recently, British law has been virtually silent on how limited liability
companies are organised and governed internally.
 Every internal governance system must be guided by law and regulations.
 As a result, anyone who is interested in or responsible for an internal governance
system needs to understand the relevant external governance Frameworks

2.3 Legal systems

 Countries have different legal systems within their external governance framework
 There are 3 classifications of legal systems, namely, Civil law, Common law and
religious law.
 The most widespread legal families in countries with well-developed financial
markets are civil and common law.

2.3.1 Civil law

 A civil law system uses comprehensive statutes and codes to order legal material
and legal scholars to formulate the detailed rules that must be followed and also
interpret them.
 Civil law is highly systematised and structured and so it is often called codified.
 The 3 sub-families of Civil law are French, German and Scandinavian.

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2.3.2 Common Law
 Common law is distinct from Civil law, in that, the body of law is created by
legislation and by judges who resolve disputes and interpret laws
 Within a common law system, judicial precedents are created by the decisions of
judges and add to the body of law.
 Judicial decisions interpret statutes and add to the body of law. A system of
judicial precedence means that decisions of higher courts bind those of the lower
courts.
 In common law, judges have significant power. This is a major difference that
distinguishes common law from civil law.

2.3.3 Cross system Influences-Mixed legal systems and anomalies

 Legal theories developed in one family of law have been adopted in countries that
have legal systems belonging to another family of law
 Ecuador illustrates this. It has a French inspired civil law system, but when Ecuador
revised its company law in 1977, it incorporated many elements of common law in
its new legal framework

2.4 Evolutionary Development of legal and regulatory frameworks

 History has demonstrated that, as the economies and markets develop, new issues
inevitably arise and these lead to the creation of further policy solutions e.g. An
English bankruptcy law was passed in 1542 before being revised in 1570 to provide
relief to prisons which were now congested due to the earlier law which sent
debtors to Prison.

2.4.1 Foundations of company Law

 A limited liability company is the most used form of company ownership used
 Prior to 1855, limited liability companies were only available through an act of
parliament in most jurisdictions
 Increased demand for capital led to the formation of the deed of settlement
company
 Someone who needed capital would divide his interest in a business property into
shares and using a deed transfer title of shares in the property to investors who
along with the founder were now trustees.
 This form of organisation laid the ground work for modern UK and Irish law by
emphasizing the contractual nature of the relationship between a company and its
shareholders.

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  The joint stock companies act of 1844 created a general form of company with
freely transferable shares, but the owners where not protected from liability.
 The limited liability act of 1855 introduced the notion of limited liability for
shareholders of a company.
 By 1914, there were 65 000 limited companies registered in England and Wales.

2.4.2 Development of a legal context for companies

 Early company laws placed few restrictions on company actions in other words,
they permitted a wide scope in corporate behaviour and as a result, there were
periodic scandals involving limited company fraud and problems with investor
protection.
 This led to the development of law and amendment of the companies Act,
insolvency Act and Financial services Act.

2.4.3 Associations formed as partnerships governed separately

 Most partnerships are governed by a contract between the partners.
 In the UK, the partnership Act was passed in 1890.
 Unlike the limited company, external governance of partnership has attracted very
little attention.
 However, some countries now have limited liability partnerships. It is taxed like a
partnership but has limited liability.
 The UK passed the limited liability partnership Act 2000.
 The US also permits an entity called a limited partnership.

2.5 Contemporary Company law

 A company is considered a juristic person
 The implication of this is that it owns assets and is responsible for its liabilities.
 In other words, the company controls itself. As a result, a company is required to
account for its own revenue and expenses and to pay tax on its net earnings just as
any individual is required to do.

2.5.1 Types of companies

 Private unlimited company – There is no limit to the members’ liability
 Private company limited by shares – The members’ liability is limited to any
amount unpaid on shares they hold
 Private company limited by guarantee – The members’ liability is limited to the
amount they have agreed to contribute to the company’s assets if it is wound up

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  Public limited company (PLC) – The company shares may be offered for sale to the
general public, and members’ liability is limited to the amount unpaid on shares
held by them; however, there are detailed rules about share capital that must be
followed

2.5.2 Member Agreements at Formation

 The ‘persons’ who create a company ‘subscribe’ to a set of agreements, including
an agreement to contribute capital in exchange for shares in the company
 The Certificate of Incorporation is the document by which a government grants or
charters a company.
 The other two documents are, in effect, contracts among the members and the
company that they are forming. These are called the Memorandum of Association
and the Articles of Association

2.5.3 External Governance Requires internal structures at Company Formation

 Company law in most jurisdictions requires the incorporators of a company to apply
corporate governance mechanisms at the time a company is formed. In other
words, the external governance framework specifies internal governance
mechanisms that must (or may) be in place in a company
 The memorandum of Association is mandated to set out the following:
- The company name
- Where it is registered
- The company objects (the purpose for which it has been created)
- The extent of the liability that the members assumed
- The total amount of capital and the division of that capital into shares.
 Articles of Association: The articles of association are a contract between the
members (shareholders, subscribers) and the organization and among the members
themselves. It sets out the rights and duties of directors (e.g director’s expenses,
powers, remuneration, gratuities and pensions) and shareholders individually and in
meetings. Certain statutory clauses (such as those dealing with allotment, transfer,
and forfeiture of shares) must be included; the other clauses are chosen by the
stockholders to make up the bylaws of the organization

2.5.4 Complex jurisdictional differences

 Countries have different rules that are complex and also look similar
 American corporation law is more prescriptive when compared to the British and
Irish laws

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  Rules in French civil law make forming a company in France more complex than it
is in the UK where common law has been adopted.
 Jurisdictional differences within a country also occur e.g while England and Wales
can accept a company director who is less than 16 years, such is not allowed in
Scotland.
 In the US, a limited company is called a corporation, while unlike in the UK, a
company refers to a limited liability

2.5.5 Type of company limits actions and determines various requirements

 Different forms of business have to meet different requirements in terms of
ownership, information disclosure e.t.c
 A private company may have one director while a public company should at least
have two directors.
 A secretary of a private company does not have to be qualified, while that of a
public company should have professional qualifications.

2.5.6 Choice of Domicile (i.e location of charter or formation)

 The choice of a domicile lies with shareholders in many jurisdictions.
 However, management tends to make decisions about domicile because of
practical limitations in the shareholder resolution process.
 Companies have recently been shopping for domiciles and incorporating themselves
in places such as Bermuda where they can operate tax free. However, Bermuda
favours management and severely limits shareholder rights.
 States like Delaware have the following advantages
- Very limited disclosure requirements
- No minimum capital requirements
- State courts reputed to interpret the corporation laws favourable to companies
- No state corporation Income tax

2.6 Mandates on stewardship and Accountability

2.6.1 Company Officer

 In the UK, the officer of a company include the directors, senior managers and
secretary

2.6.2 Legal control-Shareholders

 The legal control and ownership of a limited company resides in the shareholders
and they exercise this responsibility at general shareholder meetings

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  The minimum shareholder rights provided in the company laws may be
strengthened by the addition of shareholder friendly provision to the articles of
association

2.6.3 The board of Directors

 The board of directors is elected by shareholders
 Directors can either be executive or non-executive. The former are employees of
the company while the later play a supervising role. However, under the UK law,
these directors have equal rights and responsibilities.

2.6.4 Accountability requirements

 External accountability is required of every company by law in every modern
jurisdiction and company directors are responsible for providing it.
 The external accountability may come in the form of financial statements
disclosures, information about company officers and secretaries etc.

2.6.5 Accounting Standard Convergence

 One of the greatest challenges for listed companies, investors and regulators is
performance reporting.
 Countries have different GAAP standards that have resulted in the differences of
evaluating performance. In 1993, Daimler made a profit under German GAAP while
it made a loss under the US GAAP.
 Countries have made attempts to create one standard.
 The attempt has been made by the European countries. They have been however,
the emergence of International Accounting Standards that has also been adopted
by the EU. However, there is still fragmentation with very few countries using the
IAS.

2.6.6 Legal Provision that apply to companies and directors

 The Companies Act 1985 – This sets down the requirements for company
formation such as the names a company may use, its powers, share capital
requirements accounting and auditing requirements, the qualifications, duties and
responsibilities of directors and company secretaries, enforcement of fair dealing
by directors, company member protections, and investigations of company
misdeeds.
 The Companies Act 1989 – Provides amendments to the Companies Act 1985

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  Theft Act 1968 – This law contains provisions to address fraudulent accounting,
false statements by company officers, and director responsibilities for illegal acts
by the company.
 Company Directors Disqualification Act 1986 – Reasons for and the process by
which individuals become ineligible to serve as company directors
 Insolvency Act 1986 – This statute contains the provisions by which the activities
of a company are ended, whether voluntarily or involuntarily, and its debts are to
be settled
 Criminal Justice Act 1993 – A section of this Act covers insider dealing in the
shares of UK listed companies.
 The Financial Services Act 1986 as amended by the Financial Services and
Markets Bill of 1998 – These Acts establish the consolidated supervisory regime for
companies in the banking, insurance and investment businesses, and for the stock
exchanges and listed companies.

2.7 Winds of change

 There is continued change in company law, with consequences for companies
whose internal governance systems results in them breaching the external
governance framework.
 In the UK, following the Cardbury code, there has been a movement of separating
the role of the chairman from that of the CEO.

2.7.1 Recent Legal developments

 The enterprise Act passed by the UK parliament in 2002 focused on consumer law
and insolvency legislation.
 For example, the act makes individual participation in hard-core cartels a criminal
offence, streamlines appeal mechanisms and establishes new product procedures
for tackling trading practices that harm consumers.
 Another area of law that is changing relates to rules about corporate manslaughter.
This new law defines certain actions by a company’s personnel in relation to work
related death as a criminal behaviour that is committed by the company.
 The most recent legal development occurred during 2002 in the US. Following the
collapse of Enron and World com, the US Congress passed the Sarbanes-Oxley Act
that made fundamental changes in the nature of the audit and company reporting
and the responsibilities of reporting irregularities.

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2.7.2 Expect more rules due to continuing International corporate scandals
 Continued corporate scandals will continually result in the emergence of new
rules/laws and regulations.
 Some of the scandals include the following: Ahold, a Dutch company that
overstated its profits by $500 million, Parmalat, an Italian company that lied that it
had $6.55 billion in Bank of America.

2.8 Barriers to Improvement

2.8.1 Accounting Harmonisation

 There has been continued attempt to integrate financial services and financial
markets across Europe.
 The international Accounting Standards Committee (later restructured to
International Accounting Standard Board) made a historic agreement with the
International Organisation of Securities Commissions (IOSCO) in 1995 when it
delivered a set of accounting standards in late 1999, IOSCO endorsed them for use
by companies listed on its member stock exchanges.
 IAS 39 introduced fair value reporting for many financial instruments and this
contradicted with the EU directives, though, the EU finally adopted this standard.
 In May 2000, the EU required all companies to adopt IAS
 Now some countries outside the EU such as Singapore have adopted the IAS
standard.

2.8.2 Problems with Complex Webs of law and External oversight

 There are many sources of external regulations, hence problems and issues arise
due to the complexity in the framework of external governance e.g In the UK,
there are 5 authorised professional accountancy bodies, each of which has
different qualification programme and professional supervision regime.
 Other sources include the parliament, Government, European commission,
Financial reporting Council, Stock exchange etc.
 The problem is that, the precise role of each player in the external governance
system is not clear.

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 3 Codes of Best Practice and Norms of Behaviour

3.1 Introduction
 The previous module examined the formal mandates of law and regulation while
this module explores the other two elements in the external framework: Codes of
best practice and Social Norms.
 A code of best practice is a set of non-binding principles, standards and practices
which have been recommended by a distinguished body and relate to the internal
governance of companies.
 Codes of best practice are an explicit public policy written to address company
concerns such as honesty, accountability, risk management, influence and politics
of profit and executive compensation.
 It focuses on the director’s role and corporate accountability
 The best known codes are : Treadway and Cadbury
 In contrast to the other elements of an external corporate governance framework,
norms of behaviour are implicit rather than explicit and occur naturally in a social
context.

3.1.1 Public Interest in Corporate Oversight

 During the late 1980s and 1990s, there were company failures which shook the
public trust. These resulted from dis-honesty of boards, directors and trustee of
pension funds.
 Fraudulent financial reporting in the US resulted in the establishment of the
Treadway Commission in 1985. Following the collapse of Polly Peck and BCCI in the
UK, the Cadbury Committee was appointed in 1991.

3.2 External Pronouncement about Internal governance Practices

3.2.1 The Tread way Report

 The Commission of Sponsored Organisations (COSO) sponsored a study group called
the National Commission of Fraudulent Financial reporting Chaired by James C
Treadway Jr.
 The commission sought to improve external company reporting by focusing on the
internal controls of a company.
 The three identified objectives of internal control were:
- Efficient and Effective operations
- Accurate Financial reporting
- Compliance with laws and regulation
 The report set out the components needed to achieve an effective internal control
system:
- Control environment – The foundation for the internal control system
providing discipline and structure.

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 - Risk assessment – The identification and analysis by management, not
internal audit, of the relevant risks threatening achievement of an
organisation’s intended objectives.
- Control activities – The policies, procedures and practices that ensure
management objectives are achieved and risk mitigation is carried out.
- Information and communication – Support for other control components by
communicating control responsibilities to employees and by providing
information in a form and time frame that allows people to execute their
duties.
- Monitoring – The external oversight of internal controls by management and
others who are outside the process; or the application of independent
methodologies, such as customised procedures or standard checklists, by
employees within a process.

3.2.2 The Cadbury Report

 The Cadbury committee was setup in 1991 following the collapse of BCCI.
 It was setup by the London stock exchange, financial Reporting council and the
UK’s professional accounting bodies.

3.2.3 Cadbury Contributions

 It focused on the following main areas affecting the board and directors:
- Board of Directors - The board should meet regularly, retain full and effective
control over the company and monitor the executive management. There should
be a clearly accepted division of responsibilities at the head of a company, which
will ensure a balance of power and authority, such that no one individual has
unfettered powers of decision. Where the chairman is also the chief executive, it is
essential that there should be a strong and independent element on the board,
with a recognised senior member. Besides, all directors should have access to the
advice and services of the company secretary, who is responsible to the Board for
ensuring that board procedures are followed and that applicable rules and
regulations are complied with.
- Non-Executive Directors - The non-executive directors should bring an
independent judgement to bear on issues of strategy, performance, resources,
including key appointments and standards of conduct. The majority of non-
executive directors should be independent of management and free from any
business or other relationship which could materially interfere with the exercise of
their independent judgment, apart from their fees and shareholding.
- Executive Directors - There should be full and clear disclosure of directors’ total
emoluments and those of the chairman and highest-paid directors, including

20
 pension contributions and stock options, in the company's annual report, including
separate figures for salary and performance-related pay.
- Financial Reporting and Controls - It is the duty of the board to present a
balanced and understandable assessment of their company’s position, in reporting
of financial statements, for providing true and fair picture of financial reporting.
The directors should report that the business is a going concern, with supporting
assumptions or qualifications as necessary. The board should ensure that an
objective and professional relationship is maintained with the auditors so as to
provide to all a true and fair view of company's financial statements

3.2.4 Rules vs Principles

 The Cadbury report made it clear that boards and individuals should follow the
code in the context of the particular circumstances. It is a principles approach to
internal compliance with external governance.

3.2.5 The system of Internal Control-Not internal Financial Control

 The Cadbury committee looked beyond the financial control system and
recommended that the board of directors should report on the effectiveness of the
entire systems of internal control, not just the system internal financial control.

3.3 The theory behind Best Practice recommendations

3.3.1 Agency relationships

 Best practice recommendations seek to overcome what is known as the principal
agent problem.
 For a company, the agent is management and the principal is the shareholder
 Investors delegate the day to day management of the company to management.

3.3.2 Divergence of Interests

 The interests of organisation owners and managers do not always coincide

3.3.3 Divergence ad Agency Costs

 Managers can use the firm’s assets for personal gain at the expense of adding
economic value to the company
 Divergence in risk appetites creates another agency cost.

3.3.4 Information Asymmetries

 It is always difficult for a principal to understand and resolve misalignment with
managers due to information asymmetry.

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  Information asymmetry results from the fact that managers know more about
company activities than the principal/shareholders

3.3.5 The director’s role in Theory (often a long way to practice)

 The directors should look after the interest of shareholders
 In theory, the board selects management, however in practice; managers tend to
influence the selection of the board of directors.

3.4 Best practice corporate governance reform-Narrow Focus

 The majority of the best practice recommendations has been on the board of
directors

3.4.1 Evolution in external prescriptions about Best Practice

 Previously the key focus of these codes has been on the board of directors
 However, over time, the focus has been evolving
 There has been an apparent link between the contents of best practice reports and
public pressure.
 The green bury report addressed issues on executive remunerations in line with
revelations by journalists.

3.4.2 Some recommendations Morph into legal mandates

 Best practice recommendations are at times converted into legally binding
regulation
 However, the most common action is to comply or explain
 After the Cadbury report, companies listing on the London stock exchange had to
report on their compliance with the report

3.5 Around the world-Inconsistences’ in reports

 By 2002, the 15 member countries of the EU had issued more than 32 codes
 Best practice codes and recommended practices have been published in countries
with very diverse cultures, legal systems and financial traditions

3.5.1 Variation in definitions for corporate governance

 A number of reports around the world do not define the term corporate
governance, assuming that there is an agreed definition
 Those defining the term do not agree on the definition

3.5.2 Variation in views on the purpose of the company

 Corporate governance reports also often reflect differences in emphasis
 Preda report from Italy has maximising shareholders returns as the primary
objective of company
 In contrast, the Peters reports from Netherlands ask for a good balance between
the shareholders who provide the risk capital and other stakeholders.
 The OECD takes a pan-national approach and states that, the corporate governance
framework should recognise the rights of stakeholders as established by law and

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 encourage the active co-operation between corporations and stakeholders in
creating wealth, jobs and sustainability of financially sound enterprises.

3.5.3 Variation in Aims of the recommendations

 Some reports advocate for transparency e.g. the Belgian Dual Code & Swedish
shareholder Association.
 Others are unique e.g. the Kings Report in South Africa integrate corporate
governance with racial and social justice

3.6 Norms, Expectations and Behaviours

 Some governance mechanisms are explicit and unambiguous; others are implicit
and arise from a tacit understanding of the accepted way that something is done.
 A public outcry can result in implicit norms being made explicit
 If mandatory requirements fail to achieve desired results, they may be abandoned.

3.6.1 Dynamics of the debate about short-termism

 A heated debate took place in the early 1990s-concern was about short-termism in
British and American companies
 Companies focused on the short term Investment rather than long-term and the
popular verdict was that, the capital markets placed excessive weight on short
term performance
 As the debate continued, public opinion came to accept that financial markets
were myopic and forced a short sighted outlook on corporate managers.

3.6.2 Little evidence to support the popular view about short-termism

 As much as the market responds to short term signals, reviews of research on the
effect on the market of announcements about earnings, research and
development, changes in accounting practices, capital funding issues and
acquisitions suggest that the markets are generally efficient and correctly discount
the long-term as well as the short-term implications of these announcements
 So, rather than being short-term oriented, quite the contrary: academic research
suggests that the markets react positively to investments in the future such as
research and development.

3.6.3 Alternative Explanations for short-termism

 Some academics have concluded that, because of the self-belief of managers that
the markets are short-termist, many act upon those beliefs.

3.6.4 Share-options to solve short-termism

 Share-options were identified as one of the ways to curb short-termism
 Meanwhile, unknown to the market, a new problem was developing. By and large,
American CEOs were running their boards of directors and their committees
including the compensation committee.

3.7 Stimuli for changes in external governance

 Money tends to influence behaviour in interesting ways

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3.7.1 Lost Money Stimulates reforms
 The public gets outraged about corporate behaviours involving lost money-personal
money belonging to the public and lost through the acts of corporate entities
 The public reaction leads to public debate, policy action and the development of
controls.
 The public outrage at the Enron incident in the US led to the passage of the
Sarbanes-Oxley Act
 In the UK, reform is still focused on the boardroom with Higgs (i.e.
recommendations on the effectiveness of non-executive directors) and Smith
(guidance for Audit Committees)

3.7.2 Before the fall-behaviours and Stimuli

 Contrary to the fact that agents are always motivated by self-interest, most of the
CEOs did not follow corporate governance principles in an attempt to match the
performance of companies who were manipulating their financials, resulting in
higher performance reports.
 Those CEOs who did not deliver did not last long in their jobs, hence the pressure
to manipulate reports.

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 4 Boards of Directors: The Lynchpin

4.1 Introduction
 The boards of many companies have failed to carry out their duties e.g Enron,
Marconi and world com. These boards failed the shareholders, creditors and
employees
 A better understanding of the role of the board and its place as the lynchpin
between the external governance framework and internal governance system help
those who want to see boards move beyond formulaic compliance with the external
rules.

4.2 The basis for the board of Directors

 To understand the framework that underlies the structure and practices expected
from the board of directors, one must understand its legal basis. To understand the
legal basis, it helps to see it in its historical perspective.

4.2.1 An early board and the role of the directors

 A royal charter created the British India Company in 1600
 Its assets were overseen by a governor and directors
 After the company acquired control of Bengal in 1757, it grew and started to
influence policies of India and also abused its influence leading to the passage of
the regulating Act 1773
 The company was ultimately controlled by the government in an attempt to curb
its continued influence
 During the time, the main role of the board was to hire and fire top management

4.2.2 Club Control in the boardroom

 There were few shareholders during the 20th century in both the UK and US
 The network of boardroom of directors was also exclusive
 Governance within these self-regulating clubs was based upon personal integrity

4.2.3 Being a Director

 Historically, the ability to get along was a good quality of a director
 Conflict in the boardroom was viewed as an indication of failure

4.3 Shaking the foundations of the Established order

 The idea of a code of conduct for boards of Directors began to form when a series
of scandals shook the foundations of this long established role in the corporate
governance system
 The 1st failure was that of Roll-Royce which was due to mismanagement. The next
one was the collapse of BCCI with losses exceeding $10 billion. BCCI insiders called
their board of directors RAF, meaning rent a face. The company was also involved
in money laundering and bribery of officials
 The BCCI scandal was followed by the death of Robert Maxwell who had plundered
the pension funds of the 2 UK listed companies that he controlled. The board of
directors failed to protect the pensions and investors who lost in shares of Maxwell

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 Communication. $400 million in authorised loans was diverted to Maxwell’s private
companies due to concentrated control.

4.3.1 Changing the Role of the board-forever

 The 1st step towards a change in boardroom practice occurred in 1991, when
the Cadbury Committee was appointed by the London Stock Exchange and given
the task of examining the financial aspects of corporate governance.
 First it appeared to seek to improve the accountability of all of the members of
a board of directors to the owners of the company
 Second, it appeared to seek to improve the rule of law within companies and to
do so through the board of directors.

4.4 Legal Responsibilities of Directors

 The duties and responsibilities undertaken by directors arise from statute law,
regulation and in common law, decisions by Judges

4.4.1 Sources of the legal Mandate on the duties of UK Directors

 The UK statutory is rather short on details as the UK has relied upon norms of
behaviour.
 Lack of specificity within the law means that the UK courts have had to interpret
what is intended

4.4.2 Legal liabilities for Directors

 Duties of Care- Diligence should be exercised when carrying out company duties
and reasonable competence and a higher standard is expected
 Fiduciary duties of the company: Company resources should only be used to
carryout company responsibility and conflicts of interest should be avoided
 Restricted Transactions with the company: No loan advancement by the company
and company assets should not be taken without permission
 Administration: keeping of company records such as accounting statements,
minutes of meetings etc. Directors must protect creditors’ interests should the
company become insolvent
 Financial interests: directors must disclose all their interest in the company, be it
shares or debts

4.5 Who are the Directors

 In the UK, someone who is bankrupt or disqualified by a court from holding a
directorship may not serve as a director unless given leave to act in respect of a
particular company or companies.
 In the case of a PLC and its subsidiaries, someone over 70 years of age or reaching
70 years of age while serving as a director may not serve, unless appointed or re-
appointed by resolution of the shareholders in a general meeting of which special
notice has been given of the election.
 There is no minimum age limit in the Companies Act for a director to be appointed
in England and Wales

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4.6 Expected Boardroom Practices
 The Green bury followed the Cadbury and its principal recommendations was the
need for regulating compensation to directors
 The Hampel Report of 1998 consolidated the two reports into the combined code
 The combined code emphasized a number of areas of boardroom practice. These
areas are given below:

4.6.1 Better director Training

 Training and development is important and all directors should have appropriate
training

4.6.2 Balancing the board

 There should be a balance between independent non-directors and executive
directors
 Non-directors should constitute at least a 3rd of the board.

4.6.3 Splitting the roles of chairman and chief executive

 Cadbury has been unequivocal in observing that the concentration of too much
power in one person has been a key enabler in many corporate failures e.g BCCI,
Polly Peck, WorldCom, Tyco and Maxwell.

4.6.4 Improved Information for the Board

 All directors should be properly briefed by management on all matter relevant to
their roles and responsibilities to enable them to function properly

4.6.5 Open Process of Board Appointments

 The combined code requires all but the smallest companies to setup a nominating
committee to oversee appointment of the board.
 The majority members of this committee should be non-directors.

4.6.6 Director Remuneration

 Remuneration should be sufficient to attract and retain directors, but should not
be more than necessary
 There should be a remuneration committee made up of fully independent non-
executive directors

4.6.7 Relations with shareholders

 Shareholders should vote and their voting should be considered carefully
 Companies should dialogue with institutional shareholders
 Reports on votes by those in attendance and non-attendance should be made
available.

4.6.8 Accountability and Audit

 The board of directors is responsible for presenting a balanced and understandable
assessment of the company’s position and prospects
 It should report on internal controls and risk including financial, operational and
compliance controls and risk management.
 It should also establish an Audit committee, the committee should review the
scope and results of the audit, objectively and independence of auditors

27
4.7 Follow on Recommendations and Mandates

4.7.1 Turnbull on Internal Control (September 1999)

 The report aimed to create a risk based approach to the establishment of internal
control.
 In assumed that directors undertook vigorous risk assessments and risk based
decision making

4.7.2 Smith Audit Committees (January 2003)

 The report provided guidance on Audit committee practice
 The report however codified what was already being done by companies
 It identified the following roles and responsibilities of an audit committee
- Monitor the integrity of the financial statements of the company
- Review the company’s internal financial control system
- Unless addressed by a separate risk committee or by the board itself,
review the risk management systems
- Monitor and review the effectiveness of the company’s internal audit
function
- Make recommendations to the board in relation to the appointment of the
external auditor
- Approve the remuneration and terms of engagement of the external auditor
following appointment by the shareholders in general meeting

4.7.3 Higgs on Non-Executive Directors

 The UK Department of Trade and Industry commissioned an Investment banker
Derek Higgs to review the non-executive director role
- The number of meetings of the board and its main committees and the
attendance of individual directors should be published in the annual report;
- A chief executive should not become the chairman of the same company;
- Non-executive directors should meet at least once a year without the
chairman or executive directors present, and the fact that such meetings
have occurred should be disclosed in the annual report;
- A senior independent director should be available to meet with shareholders
‘if they have concerns that have not been resolved through the normal
channels of contact with the chairman or chief executive’;
- The pool of director candidates is too restricted and needs to be
broadened;

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 - New non-executive directors should receive a comprehensive induction;
- Board performance should be evaluated at least once a year;
- The chairman should address the developmental needs of the board;
- A non-executive director should serve no more than two three-year terms.
 There was however criticism of these recommendations:

- What makes a non-executive director suddenly cease to be useful after six

years?
- What will be accomplished by a once-a-year meeting of the non-executive
directors without the chairman present?
- What is it about having been employed previously by a company that makes
someone a poor chairman for it?
- Academic research looking for links between boardroom composition and
shareholder returns is inconclusive.

4.7.4 A new UK combined Code

The new Combined Code took effect in November 2003. Companies were required to
report on their compliance in their annual report. The new Code did not include all of
Higgs’ proposals. The principal differences from the previous Code were:

 Board balance
- At least half the members of the board should be independent non-executive
directors, with an exception for smaller companies
- Listed companies (i.e. those outside the FTSE 350) need include only two such
independent non-executive directors
 Chairman and the chief executive
- The same individual should not act as both chairman and chief executive
- The chief executive should not become chairman of the same company
- The chairman should hold regular meetings with the non-executive directors
without the executives present
- A senior independent director should be available to receive shareholders’
concerns that cannot be resolved through the normal channels of contact with the
chairman, chief executive or finance director
 Appointment and tenure
- The nomination committee should consist of a majority of independent non-
executive directors

29
 - Any term beyond six years for a non-executive director should be subject to
rigorous review. Executive directors should not take on more than one non-
executive directorship in a FTSE 100 company nor become chairman of such a
company

No individual should be appointed to a second chairmanship of a FTSE 100 company

4.7.5 A rules Based Approach-SarBox

 Despite many codes of practice being principle based, In contrast, post Enron
legislation in the US is rules based
 The Sarbanes Oxley Act of 2002 is a set of new and enhanced standards for all US
public company boards, management and public accounting firms
 As a result of SOX, top management must certify the accuracy of financial
information
 In addition, penalties for fraudulent activities are now severe
 The Act also requires the Audit committee to have a member who is a financial
expert e.g., someone who understands GAAP and its application, someone who has
experience in preparing, auditing and analysing or evaluating financial statements
 It also addressed the issue of conflict of interest of Auditors and Analysts.

4.8 The State of Play in the Boardroom

 Most of the board rooms are controlled by CEOs as shown by World Com’s board
which approved a $50 million loan to its CEO after a 5 minutes conversation with
the compensation committee
 However with many recommendations coming through, what exists today is a
boardroom in transition.

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5 Internal Controls and Accountability
5.1 Introduction
 The module explores internal governance and some of the principal governance
mechanisms used within organisations.
 Corporate governance prescription and theory have just began to address the
connection between internal governance and the achievement of the intended
objectives of external governance.
 The domains of internal governance are given below:

5.2 Foundations of enterprise accountability and control

 Pacioli provided the first known description of double entry bookkeeping.

5.2.1 Accounting for the landed Estates

 The accounting system used by many British estates was charge/discharge
Accounting (CDA)
 There was a charge (receipt) on the left hand or debit and a discharge on the right
hand or credit side of each page or statement.
 The key feature of a CDA systems were that it was a form of responsibility
accounting and that it emphasized cash transactions rather than asset and liability
 It was a system of control meant to ensure that the behaviour of the steward and
his sub agents was proper.
 James Loch, agent of the Duke of Sutherland recommended double entry, capital
accounting and breakeven accounts.
 Capital accounts included articles and machinery and depreciation.
 Estates accounts were separate from household accounts

5.2.2 The genesis of modern cost accounting

 Josiah wedgewood was faced with a drop in demand for his products during the
1772 depression
 In an attempt to remain viable, he examined the costs of material and labour and
understanding the relationship between fixed costs and volume.

31
  As a result, he was able to calculate the cost of producing different products and
adopting differential pricing.

5.2.3 Modern Cost Accounting

 The 18th Century was characterised by increased manufacturing in America and Eli
Whitney’s invention of the cotton gin influenced economic growth.
 Accounting became increasingly important to management when setting prices and
cost management and activity control.
 Carniege steel developed a voucher system for materials of labour and cost sheets
by operational area leading to its better understanding of cost structure and
performance.

5.2.4 Modern Internal Control-Pierre DuPont, Donaldson Brown and Alfred Sloan
 DuPont Powder Company was bought by cousins who exchanged shares with
existing owners for bonds.
 The cousins developed fixed asset accounting which enabled them to use a return
on investment (ROI)
 DuPont later on acquired General Motors
 They developed an advanced flexible budgeting system and created uniform
performance criteria
 They also created performance linked incentive and profit sharing plans in order to
motivate people to achieve the budgeted results.
 One of the important aspects of GM board was a continuous audit of the business.

5.2.5 Implications of reliance on potentially outmoded internal governance

 Today the system designed at General Motors provides the fundamental
architecture for the internal governance systems used by many large organisations
e.g budgets
 Views about human resources have however changed.

5.3 Information and decisions- A theoretical model of control

 The word control has some unpleasant connotations such as domination and
manipulation
 However it can also have a positive meaning such as moderate, influence or guide

5.3.1 Notions about Control

 The second notion of control is the domain of corporate governance.

5.3.2 The Theoretical Model

 The theoretical model of control requires 4 conditions to exist in order for a
process to be in control.

32
  The theoretical model of control requires four conditions to exist in order for a
process to be in ‘control’.
i. Objectives must exist because, without a purpose, control has no meaning.
ii. The output must be measurable, and those measures must be comparable
to the objectives.
iii. A predictive model of the process that is controlled must exist, so that
failure to meet an objective can be ascertained and proposals for corrective
action can be evaluated.
iv. It must be possible to take corrective action to reduce the deviation of
actual from desired performance

5.4 From theory to application

 An example of the application of a predictive model, is a thermostat controlled
room
 In the case of a thermostat breaking, the room might be out of control until the
problem is fixed.

5.4.1 The Human Dimension

 Human beings have variable capabilities and personal objectives that may operate
independently from that of the company resulting in them sabotaging control
activities to achieve their objectives e.g. getting someone fired by not following
instructions in order to get his/her position.

5.4.2 Achieving control requirements objectives

 With a heating system, the objective is the desired room temperature
 In many businesses, the objective is the generation of profit for the owners.

33
5.4.3 Measurable output comparable with objectives
 The second requirement of the theoretical control model is that actual
performance must be measured and compared with quantified performance
objectives established within a predictive model of the process.
 At times the impact of the actual performance cannot be ascertained until it is too
late to take corrective action, hence the need of surrogate performance objectives
that are measurable as the activity progresses.

5.5 Internal Predictive Models-Informed and formal mechanisms

 In practice, managers may not use formal predictive models (e.g budgets) to
assess performance decisions, instead they may rely on informal models which are
based on experience and intuition

5.6 External Recommendations about internal control

 Recommendations and mandates found in the external governance framework
about internal governance practice often diverge from theory e.g Treadway
 Report on internal control risks confusion because it is not about mechanisms that
fit the theoretical control model; instead, it recommends a number of internal
governance mechanisms it calls internal control.

5.7 Internal Governance-Guide support, control and account for

decisions
 The reason why big organisations with many branches across the globe and
thousand workers are able to function is that they have created a diverse set of
mechanisms used to guide, influence, co-ordinate, constrain and control the
behaviour of its people.
 These mechanisms range from social influence (e.g. shared norms and values,
bullying, role models) and informal guidelines (i.e. understanding about ‘the way
things are done here’) through training (i.e. skills development), to formal rules
and procedures and training on procedures and rules (which are meant to restrict
behaviour) through to performance measurement and measurement-linked
incentives.
 Examples of internal governance mechanisms include budgets, quality sampling,
implementation plans, and task limitations, skills testing training, peer approval
and punishment.

34
5.8 The human Dimension-Unexpected response
 The purpose of internal governance mechanisms is to guide individual behaviour
towards the desired organisational objectives

5.8.1 Explaining governance mechanisms

 Internal governance mechanisms can encourage behaviour that is not consistent
with the organisation’s objectives e.g systems that encourage competition among
employees may result in them sabotaging each other.
 Various theories have attempted to explain human behaviour e.g
Cognition: Behaviour is seen as an organism’s mental process
Behaviour Analysis: behaviour is seen as a function of an organism’s
environment

5.8.2 Gap between theory and Practice

 Understanding human behaviour is expected to enable organisations to create
governance mechanisms that can deliver the behaviour and performance needed.
 At times people may have a negative attitude towards a mechanisms e.g a review
process may be perceived as adding unnecessary delay to the implementation of a
strategy.

5.9 Gaming and manipulation

 People at times try to buffer themselves during good times in order to have
resources available when times are more difficult.
 Alternatively, they may manipulate the data in an attempt to hide problems or
poor performance.

5.10 Budgets up close

 In some companies, a manager can lose a job if he misses a budget

5.10.1 Multiple use of a budget


forecasting and planning;
- authorisation for resource use;
- coordination of diverse organisational areas;
- communication of plans;
- decision support analytics;
- motivation for teams;

35
 - motivation of individuals who have responsibility for specific areas or
activities;
- performance evaluation;
- determination of rewards

5.10.2 Budgeting in Context

 In 1952 a study reported on budget-related dysfunctional behaviours in four mid-
sized American companies (Argyris, 1952). It proposed that pressure to deliver
budget performance caused hierarchical conflict between budget holders and their
bosses, cross-boundary conflict between units, a strong departmental focus to the
detriment of the organisation, and job-related tension.
 However, budgets should not be viewed in isolation from the organisational context
e.g. a budget acts as a mechanism for expenditure authorisation. This makes it
part of the system for the distribution of authority and responsibility within an
organisation.

5.10.3 The paradox of budgets

 Budgets can have a positive motivational effect on employees only if they have a
challenging target that is achievable but which carries a risk that it may not be
achieved
 But if a budget is used as a control mechanism or to forecast outcomes, it will need
to provide a good estimate of likely outcomes and be sensitive in its measurement
 A budget may not be suitable as a forecasting method in a model as it would need
to be an accurate estimation of outcomes
 The use of a budget as a decision support tool in a control model maybe
inconsistent with its use as a human performance motivator and assessment.

5.10.4 Budgeting as a political Process

 Given limited resources, setting budgets between budget holders often involves
political negotiation and resolution of differences.
 The more complex an organisation, the more political the budget process maybe.
 During budget negotiations, budget holders with influence usually win in the
allocation process over those without influence, regardless of their proposals

5.11 A lesson about governance mechanisms

 The implications for budgets are obvious. No budget system, irrespective of how
well it has been designed can be viewed independently of the whole organisation
system
 This lesson applies beyond budgets, it is applicable to all.

36
 A corporate governance system needs to be understood and managed as a whole;
the existence of guideline documents does not guarantee implementation.

37
 6 Risk Management
6.1 Introduction
 Risk has always existed even during historical times when people mastered the risk
of fire
 Risk presents both opportunities as well as hazards
 Risk can be classified into 4 types:
i. Hazards: these include fire, injury, death etc.
ii. Financial Risk: This is the possibility that the cost or benefit underlying a
financial asset, liability or transaction will change.
iii. Operational and strategic risk: these are part of the fabric of an
organisation. These are risks that arise directly from internal processes and
management decisions
 Risks are not always negative. There may be just as many positive (upside) risks as
there are downside risks.

6.2 How the understanding of risks developed

 Before the development of mathematical techniques that routinely could help
people to understand risk, measure it and evaluate the consequences of alternative
choices, the future could be understood only be reference to the past.
 The development of risk followed the work of Paciolli which led people like Pascal
and Fermat to study “probability” in gambling (the game of dice)
 By 1725, various mathematicians were devising tables of life expectations and the
British government had begun to use the sale of life annuities as a financing
mechanism.
 Abraham de Moive observed and wrote about the normal curve of distribution and
developed the concept of standard deviation.
 In 1875, a cousin of Charles Darwin by the name Galton observed and wrote about
the tendency of data observations to regress towards the mean.

6.3 Implications of risk-Sudden shift in value

 Risk is important because it can have significant effect on the value of companies
 In a study carried out on 100 0 firms, it was found that, the majority of a positive
value shifts appeared to be related to strategic alliances, mergers and acquisitions
or confidence in the management’s ability to execute core business process or
investment research.
 The majority of sudden negative values shifts appeared to relate to failures to
adapt to changes in the business environment, customer mismanagement and poor
investor relations.

6.4 The multiple dimensions of risk

 The world is full of uncertainty about future outcomes.
 The concept of risk is a way of expressing the nature and likelihood of those
uncertainties often expressed in economic terms.
 Risk presents both danger and opportunity

38
6.4.1 Downside risk
 This type of risk creates a negative cash flow
 Insurance can be used to manage this risk

6.4.2 Upside Risk

 This type of risk creates positive cash flow e.g. new product innovation

6.5 Deep Muddy waters

 Risk management is not as straight forward as other areas of management
 In organisations, there are two competing approaches to risk management, thus
quantitative and qualitative
 Quantitative uses mathematical methods while qualitative uses judgement

6.5.1 Uncertain sources, types and magnitude

 Risks are everywhere

6.5.2 Arbitrary Risk classifications

6.6 Risk Management-like holding Eels

6.6.1 Jurisdictional Issues
 Specific risks can emerge where responsibilities for risk management are shared
across borders or boundaries. One example is the crisis that emerged during 1995
when US regulators discovered that the New York branch of the Japanese Daiwa
Bank had lost heavily on US government bonds. Over more than a decade, more
than $1.1 billion in bonds had disappeared to cover speculation on US Treasury
bonds while the bank was under joint supervision by Japan and American
regulators.

39
6.6.2 Confusing tight control and bureaucracy with risk Management
 Concern about management fraud, criminal and terrorist laundering has resulted in
a host of new laws and regulations around the organisation, e.g the US Patriot Act
anti-money laundering rules, Basel 2 etc.
 The need for the provision of new information and adhering to these rules has
resulted in bureaucratic processes.

6.6.3 Ineffective Risk management leadership

 Companies use their resources to manage risk in order to attain their objective.
 CEOs lead the process and their leadership capability is tested when there is a
crisis

 An example of a poorly managed crisis is that of Coke during year 1999. There were
claims of rat poison, fungicides and carbon dioxide leaks in its cans. The company
was defensive, claiming that these impurities were not a risk. As a result, it lost
control of the crisis and had to ultimately recall 17 million cases of branded soft
drinks and as a result of this scandal, its share price fell heavily.

6.6.4 Effective Risk management leadership

 If handled well, a crisis can strengthen a brand
 Johnson and Johnson successfully managed its crisis of Tylenol medicine when 7
people died in Chicago after taking it. The company immediately recalled 31
million bottles and took responsibility. After an investigation showed that the
death were due to cyanide added into the bottles at retail level, the medicine was
re-introduced with a triple seal. The company was able to regain its reputation.

6.7 Risk in the strategic context

 The Tread way report proposed that a risk assessment is the identification and
analysis by management, not internal audit, of the relevant risk threatening
achievement of an organisation’s intended objectives
 This suggests that the Treadway is referring to downside risk only and its relevance
to internal control

6.7.1 Often struggle between upside and down risk objectives

 There is always a conflict between risk managers and line managers
 Risk managers may always want to minimise the downside risk while line managers
see opportunities in the upside risk e.g. Marketing employees may want to push
products and innovations into the market to up sales while risk managers and
compliance officers attempt to protect the company from risky customers and risky
innovations.

6.7.2 Overlaid Risk controls

 Each regulatory creates demand for data management and improved systems and
processes.
 Collective application of many compliance requirements can overwhelm an existing
operating system

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6.7.3 Understanding risk in the strategic context
 Risk is difficult to understand unless it is understood in the broader context of a
company’s strategy
 Risks, both upside and down side need to be identified, assessed and then a risk
strategy should be implemented.
 If a strategy is poorly formulated and articulated, it may be difficult to identify,
assess manage and obtain the benefits of the upside risks and keep the downside
risks under control.

6.8 Being real and prepared

 Risk is a vital characteristic of life and it affects every aspect of living
 There are downside risks such as pollution, threats to worker health and safety and
upside risks such as the opportunity presented by an innovative new product or
recognition of a market need.
 Finding ways to reduce costs or improve efficiency or effectiveness are examples of
capitalising on upside risk

6.8.1 Understanding risk tolerance

 Assessing risk tolerance can be tricky. It is the question both of how much risk can
be afforded and of how much risk can be tolerated emotionally
 What is an affordable level of risk depends mainly on the total available resources
and on the time horizon until the resources that will be put at risk will be needed
for another use.
 Determining how much risk can be tolerated – the temperamental tolerance for risk
is more difficult to quantify. It depends on each individual’s attitude towards risk.

6.8.2 Explicitly assumed and lay off risks

 Companies can evaluate options of whether to assume risk or transfer it. It may not
be worthwhile to take insurance for risk that can be absorbed by the company.

6.8.3 Crisis management and continuity

 Companies need to be prepared for the eventuality that they will experience a
crisis
 Many companies do not have a crisis management plan.

6.8.4 Paradoxes and Challenges

 There is more information about downside risks than about upside
 Being pro-active in managing risk can save a company potential costs
 Risk based models can be used to improve operations

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 7 Financial Market –Supervision and Control
7.1 Introduction
 It is important to understand the financial system vis-a vis the external governance
frameworks, as the framework either explicitly or explicitly relates to money
 The domains of external governance of financial markets are Financial Markets,
banks , analysts and investors

7.2 The money system-Financial markets

 Before money developed, economies used barter trade
 Money was later on developed to facilitate transactions in goods and services
 However, money has value only if there is belief in the financial strength,
efficiency and honesty of those who back it. Without this trust, money would be
worthless

7.2.1 The Financial system-Money markets

 Prior to the stock exchange, individuals with money and those with capital needs
met at coffee houses to transact
 The London stock exchange was a result of transactions in Jonathan’s coffee House
 During the same period, Goldsmiths began to take deposits and then lend funds
thereby becoming banks
 Specialists services started to emerge with jobbers making markets in securities,
brokers intermediating transactions and insurance companies being formed to
manage cargo risks

7.2.2 Deregulation or at least re-regulation

 The initial financial market system was expensive and inefficient with high barriers
of entry
 The Stock exchanges had their own rules, working practices and commissioned
rates which excluded many individuals
 Only exchange members could own brokerage companies
 Realising the under capitalisation of the stock exchange, London experienced a big
bang when the UK mandate required the abolishment of the stock exchange rules
 As a consequence of many regulatory changes, the demarcation within the financial
system segments began to blur
 The big Bang marked the introduction of electronic trading
 Individuals no longer deposited their money in banks, but could also buy and sell
shares

7.3 Understanding the City-Capital Markets

 The city is a term used in London and New York to refer to institutions at the heart
of the domestic financial system

7.3.1 New Money Flowing into the Financial Markets

 Bank deposits are the main source of new short term capital

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  The primary source of new-long-term capital used by the government and private
sector consists of savings by private individuals that come through pensions,
insurance companies or unit trusts, building societies etc.

7.4 Capital Market Functions- What they are for and how they do it
 Capital markets exists to provide a public forum for the raising and investing of
money and as an exit mechanism for those who have participated in the raising of
this capital
 An appreciation of the functions that capital markets fulfil is necessary to
understand why corporate governance is so important to the health of these
markets

7.4.1 Primary and secondary Markets

 A primary market is one where new debt or equity issues are arranged
 Holders of equity and debt instruments trade them in the secondary market. This is
the exit route for someone who no longer wants to hold a financial instrument

7.4.2 Market Liquidity

 When there are enough buyers and sellers in a financial market so that they can
buy and sell at will, it is liquid
 Liquidity in the secondary market makes primary transactions more attractive to
investors by providing them with an exit route for their investment

7.4.3 Private equity and debt

 Many primary market transactions take place in informal markets, thus directly
between investors and those seeking capital
 A limitation of private debt or equity investment is that, it is difficult to sell,
should the need to do so arise
 Lack of liquidity makes raising large amounts of capital from private sources
difficult

7.4.4 Financial Instruments

 Financial Instruments mainly constitute of debt for an example bonds or equity
(shares)
 The distinction between debt and equity is essential as only after all debt is
satisfied, do shareholders receive the remaining assets if any remain

7.4.5 Derivatives
 A derivative is a financial instrument that derives its value form the value of
another asset
 Derivatives are mechanisms for managing risk, interest rates, currency exchange
rates, commodity prices etc.
 Derivative instruments include options, futures, forwards and swaps

7.4.6 The Market Mechanisms

 There are multiple capital markets for the exchange of funds for financial
instruments

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  The main capital markets are: the stock exchanges where shares and bonds are
traded, the banking and money markets which trade short –term credit instruments
and the Euromarkets

7.5 Markets- derivatives, Regulations …..What is the relevance

 Financial Markets are important to the health of a modern economy because the
financial markets play a major role in fulfilling society’s key economic needs.
These include:
 Funding government, local production and commerce and international trade
 facilitating investment for those with excess funds above their immediate needs
 Expediting development of large infrastructure projects
 permitting the conversion of investments in financial instruments into cash
 Providing mechanisms to exchange one currency for another
 Offering mechanisms to offset the risks that underlie economic activities

7.6 Financial regulation-solutions to perceptions of market problems

7.6.1 Rationale for financial market regulation
 The regulation is as a result of 3 problems
- Systematic risk-refers to the risk to the whole system arising from the failure of
one or more of its parts. The evidence suggests that stable financial system can
improve economic growth, however left to itself a financial system is prone to
periods of instability
- Asymmetric information- differences in information known to various financial
market participants, for an example insider trading
- Bad money-money that has been illegitimately obtained can crowd out good
money in markets-money laundering by criminal syndicates

7.6.2 Self-regulation and social norms

 before the 20th century, financial market participants organised themselves in order
to help provide investors with confidence

7.6.3 Regulation to provide consumers protection and economic stability

 After the 1929 stock market crash, many financial laws were developed.
 In 1933 and 1934 in the US, legislation which made it compulsory for companies to
publish audited financial statements was passed
 Over time, additional controls were added such as setting brokerage commission
and licensing for various market participants
 By 1950, most countries had a substantial body of law and regulation specific to
the financial markets with the purpose to provide macro-economic stability and to
protect individuals

7.6.4 Economic health: Through market efficiency

 During the economic stagnation which took place in the 1970s, there were debates
about the effect of financial regulation on economic growth
 It was argued that regulations caused inefficiencies

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  Deregulations then followed and saw the removal of interest rate ceilings,
reduction of the level of required financial investments and elimination of many
foreign investments restrictions
 Deregulated financial markets were able to allocate capital and risk better
 The efficiency of the market resulted in reduced cost of capital for the most
promising projects and thereby economic growth was stimulated

7.6.5 The strategic challenge for every participant after the Big Bang
 Deregulation resulted in the development of different business models with banks
being skilled to manage the risks of physical handling and accounting for other
people’s money and evaluating their creditworthiness
 Regulators had the ability to manage experienced market participants but had
little experience in managing inexperienced market participants
 The second problem was that, regulation was fragmented with many regulating
bodies’ regulating different sections of the market

7.7 The simple lesson about strategic change

 Both external and internal governance must be fit for purpose and strategic
execution method.
 Strategic change usually requires new governance system guidance and
capabilities.

7.8 A new focus for financial market governance

 The massive $10 billion shortfall that caused the collapse of BCCI in 1991 took
place under the noses of the banking regulators on every continent.

7.8.1 A focus on crime

 BCCI was able to hide its activities through banking havens, layering of corporate
structure and back to back documentation with controlled entities.
 The company also used kickbacks and bribes
 Its complex structure frustrated any attempt to understand its operations.
 A US senate report published in 1992 criticised other governments and the UK for
refusing to co-operate in the investigation of BCCI
 Countries such as Switzerland that offer strict bank secrecy have also been
criticised

7.8.2 Pressure for change-Crime prevention and liquidity through trust

 The US has been pressuring for aggressive and coordinated regulation and an
international regime for sharing of financial information among governmental
entities
 The need to ensure that the confidence of the market is there, always requires
that investors become aware of each other, hence disclosure of information.

7.9 Current National Models of Financial supervision

 Historically, each sector had its own supervisory authority
 Advocates of regulator integration argue that savings could be achieved by pooling
expertise and basic administration activities

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  It would provide a single point of authority for granting authorisations, thus
allowing one regulator to keep track of all of the problems caused by any company
or individual
 Recently there has been moves in a number of countries to integrate some or all
financial supervision into a financial service authority

7.10 Supra-national Authorities

 There are many international entities with varying degrees of authority and
influence that are relevant to financial supervision and the stability of the financial
system.
 The Bank of International Settlements (BIS):
- Provides a forum for central bank co-operation
- It conducts and publishes research that contribute to monetary and financial
stability and formulates recommendations
- It performs traditional banking functions for international organisations
 G8 working group on Financial crime
 Committee of European Securities
 The European Union: The EU intends to integrate the financial markets across its
member nations.

7.11 Design of an integrated Regulator-The UK Financial Services

Authority
 In year 2000, the UK parliament abandoned the earlier attempts which were based
upon sector specific self-regulation and created the financial services authority.

7.11.1 Responsibility allocation

 Financial Services Authority- it is responsible for regulation of the financial services
industry in the UK, including supervising exchanges, listed companies, clearing and
settlement houses and other market infrastructure providers, conducting market
surveillance and transaction monitoring.
 Bank of England: Interest rate setting, banking supervision and lender of last resort
to banks
 DTI: Company law and insolvency matters and investigations and prosecutions
under the various companies act.

7.11.2 The Financial Services Authority

 Its objectives are:
- maintaining confidence in the financial system;
- promoting public understanding of the financial system;
- securing appropriate protection for consumers;
- Reducing the extent to which it is possible for a business carried on by a
regulated person to be used for a purpose connected with financial crime.
 The main new features of the FSA regime, when compared with the previous
market supervision, include:
- single authorisation, supervision and enforcement powers across financial
service markets;

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 - a single compensation system and single ombudsman – to manage the
process of complaints and reparation;
- prosecution power for firms failing to maintain money laundering controls

7.11.3 New regulatory responsibilities created

 Mutual society registration
 Unfair terms in consumer contracts
 The code of market conduct
 General insurance and mortgage lending
 Recognised overseas investment changes

7.11.4 Setting a strategy-FSA

 The main aim of the strategy devised by the FSA is to identify, prioritise downside
risks to its four statutory requirements

7.11.5 Implementing strategy-setting up the authority

 The FSA identified downside risks to its statutory objectives
 The sources of information were firms being supervised, contacting consumers,
market research, discussions with a wide range of stakeholders
 Performance measurements were designed to access where it was meeting its
objectives.

7.11.6 Separating of Duties within the agency

 The enabling legislation requires the investigation and recommendation functions
of the FSA to be carried out separately from taking of decisions and issuing
statutory notices.

7.11.7 Quality Assurance and Internal Audit (QA/IA)

 This department within the FSA uses independent reviews to provide objective
assurance to the FSA board and executive that a sound robust, fit for purpose risk
management framework is maintained and operated by management.

7.11.8 Training and competences

 The securities institute is an examining, training and professional membership body
for the UK financial services industry.

7.11.9 Setting the agenda for regulated firms

 In January 2000, the FSA published a proposed approach to future regulation. It
named a goal to maintain efficient, orderly and clean financial markets and help
consumers achieve a fair deal.

7.11.10 Headlines and More change

 Regulators were criticised over the unexpected collapse of Equitable life in 2000
 Thousands of UK pensions were affected
 FSA chairman had his bonus cut

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 8 Governance and Financial Market Economics
8.1 Introduction
 By the dawn of the 21st Century, the financial sector had transformed.
 Many banks and capital market intermediaries were now globally operational
 The markets in which they operate are sensitive to information and communication
 External governance in these markets affect the structure of these markets
 This module examines structural variation in financial markets of concern to
economists and policy makers

8.2 Financial Market Economics: Structural variation

 There are structural differences in markets which include relative size, turnover
and number of companies, market liquidity and ownership concentration.

8.2.1 Variation in market size, liquidity and breath

 The US and japan have the two largest equity markets.
 The US market is highly liquid while that of Japan is less liquid
 The UK leads in the number of firms that are listed
 A much smaller percentage of large German companies are listed on its exchanges
and there is much lower liquidity within those markets.

8.2.2 Differences in share ownership and patterns

 Corporate share ownership patterns are substantial across OECD.
 German is at one extreme with 64% of its listed companies controlled by a small
group of shareholders
 In the UK and US, ownership is fragmented and there is little concentration

8.2.3 Variation in shareholder involvement in corporate decisions and monitoring

 In Germany, where there are concentrated holdings, shareholders with large stakes
also tend to be active shareholders.
 In the UK and US, where ownership is dispersed, shareholders maintain a more
arm’s length relationship with companies in which they have an interest.

8.2.4 Radically different markets for corporate control

 There are also differences in the market for corporate control
 In the UK and the US, hostile takeovers by way of purchase of shares in the open
market are common.
 In continental Europe, such transactions are rare
 In Germany, a takeover has never succeeded

8.3 Research and debate about governance effects on capital markets

 Academic research has sought to explain structural differences by finding links
between local legal, regulatory and best practices regimes.

8.3.1 Generic approaches to solving the principal agent problem

 Acquiring a controlling stake in the company and use boardroom power to signal
preferences, advice on strategic decisions to oust poorly performing management

48
  Arm’s length approach: Uses mechanisms to ensure that management commits to
efficient operation and maximising intervention in company decisions.
 External mechanisms such as corporate takeover, court law or shareholder
resolution. This approach requires good external reporting to shareholders and a
market with enough information.

8.4 Trade-offs in supervision-choices for investors, companies and

society
 When shareholding is fragmented, investors don’t have an influence on
management and therefore diversify their investments to minimise risk.

8.4.1 Trade-off in courts of supervising approaches

 Diversified ownership have higher monitoring costs of a greater risk that
management will use company assets in-efficiently or for its own benefits and
thereby fail to maximise shareholder returns
 In contrast concentrated shareholding make it easier and less costly for
shareholders to guide management and monitor its performance
 Markets with concentrated ownership are usually illiquid
 Shareholders can be incentivised to own more or controlling shares through
rent(thus, giving them higher returns than minority shareholders)
 Companies have trade-offs and make choices that affect supervision and market
structures: A privately held firm seeking funding can approach a private investor to
get the benefit of gaining wise counsel, strategic advice and greater efficiency
against the cost of giving up the personal benefits and privileges they can achieve
without close supervision.
 On the other hand, while listing on an exchange has governmentally imposed
restrictions and listing costs, it avoids the potential for interference associated
with close monitoring by controlling shareholders

8.4.2 Potential Associates between supervision and liquidity

 Trading in shares of closely held companies is less liquid than in those of widely
held companies
 When different classes of the same shares are compared, low voting shares are
usually more liquid
 Supervisory regimes that encourage concentrated ownership may improve oversight
of management but may constrain market liquidity hence constrain economic
growth

8.4.3 Observed and speculated upon trade-offs

 Where there is limited government intervention, markets are large and more
liquid, ownership is dispersed, turnover is high and hostile take-overs are easier
 External directors and regulators also play an important role
 One good result is sacrificed for another desirable outcome for an example greater
government control ensures market trust but reduces liquidity
 So when public policy is considered, every trade-off requires careful consideration
of the costs and benefits

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8.5 Corporate supervision-Legal Context variation
 company laws that pertain to corporate insiders, members and offices, relations
between the company and outsiders exist in a number of countries

8.5.1 Differences in natural Systems of Corporate supervision

 There are variations in company requirements which arise with countries such as
Austria, Denmark and Germany allowing two-tier boards while Belgium, Finland and
France allow unitary boards.

8.5.2 Significant variation in Law: employer Representation

 The UK, US and many other countries do not require employee representation on
boards, Germany, Austria, Denmark and Sweden do require that large companies
have employee representative on the supervisory board
 In France if employee ownership exceed 3%, they generally have the right to
nominate some directors
 In Germany, companies with more than 500 employees should allow employee
representation

8.5.3 Significant variation in Law: shareholders Right

 The rights of shareholders depend on the jurisdiction where the companies has
been incorporated
 In other countries, there is one share one vote, while in others the type of
shareholding determines the number of votes.
 In general within the EU, a shareholder vote is required to amend the company’s
articles of association, approve new share issues, approve the selection of Auditor,
while in some countries including Portugal, Spain and the UK, the incorporation
articles can restrict these basics shareholder rights.

8.6 Supervisory approach-Answers not clear Cut from practise

 People always have a way to circumvent rules

8.6.1 A Range of supervision approached

 The two approaches are market based supervision and enterprise oriented
supervision though many countries lie in the middle of the spectrum

8.6.2 UK and US –market based external supervision of companies

 In the UK and US the supervisory systems permit capital markets to play a leading
role in company discipline
 Implicitly, this assumes that the capital market provides objective valuations of
financial instruments and poor management performance can be subject to take
over.
 To ensure fair evaluation, securities regulators tend to get involved in issues such
as disclosures, accounting standards, auditing and the regulation of market
participants as they seek to make this mechanism effective
 In this type of system, the board of directors is viewed as crucial to successful
external control of companies
 A problem which can arise in this system is the conflict of interest

50
8.6.3 Germany enterprise oriented supervision of companies
 Emphasis is not on the role of the markets, but is on controlling the enterprise
itself
 As a result, employee representation is required in large firms, there is a two tier
board consisting of a supervisory board and a management board
 Unlike in the UK and the US, German shareholders are well represented at
shareholder meetings.

8.6.4 Is one supervision approach better than the other?

 When the reality of practice is considered, both approaches have short comings,
for example most Anglo-American boards have members representing or being
influenced by management.
 Sometimes controlling shareholders influence the appointment of some directors
 Employees, suppliers and the communities hardly have representatives on the
board, hence this reduces the quality of boardroom oversight
 Poor oversight also occurs in countries with some enterprise oriented system of
corporate supervision, for example German investors were shocked by the collapse
of the Kirch Gruppe Media enterprise

8.6.5 Supervisory Board |structure-Perhaps Not as big and influence as it appears

 More jurisdictions in the EU with unitary structures do not have large liquid capital
markets
 however on average , the type of boards do not matter

8.6.6 Variation within countries may be as great

 A comparison of company laws indicate country variations
 Evidence form a study of boardroom showed that a few boards are linked closely to
the internal control systems.

8.6.7 Area of significant variation: supervisory Board meeting frequency

 In 2001, German boards met 5 times, Spain 10 times, Italy 12 times, UK 9 times
 In the UK, unitary boards appeared to be like two tier boards with executive
directors meeting frequently and the full board less frequently

8.6.8 Mixed Approaches to the external supervision of companies

 Many countries have mixed systems for an example Netherlands and Sweden
 Belgium and France have been making changes to their legal systems
 For more than 25 years, the French government has been trying to open up its
capital markets. Tax incentives have been used to attract …..investors to the
equity markets
 Company disclosure requirements, accounting standards and compliance takeover
rules have been implemented and constantly reviewed

8.7 Contextual Influence in markets

 It has been argued that shortcomings in a legal system lead naturally to
concentrated ownership of listed companies
 Whether countries with such a system offer effective dispute resolution
mechanisms for minority shareholders is open to debate

51
  One society can be comfortable with a set of governance mechanisms very
different from what another society considers appropriate

8.7.1 Gaps in regulatory coverage

 There are also gaps in regulatory coverage e.g derivatives are traded both on
formal exchanges and off exchanges.
 Off exchange transactions are not as regulated as those that take place at the
formal exchanges.

8.7.2 Influence from and evolution of the context that affects choices
 Many choices made by investors, issuers and market intermediaries involve trade-
offs affecting concentration of ownership interest and trading liquidity for financial
instruments.
 The relationship between liquidity and capital market structure and the laws,
regulations and recommended ‘best practices’ governing the markets is not as
obvious as suggested by the theoretical arguments proposed about such links.
 Evolution in the legal system results from choices made by participants who are
influenced by that system and the context surrounding the system.

8.7.3 Successful and unsuccessful reform efforts

 There has been attempts by the EU to harmonise the operations of the capital
markets of its member states by standardising the corporate governance
framework
 However, one of the primary impediments to convergence has been incompatibility
between the systems of rules that enhance market liquidity and constrain
concentrated control.
 As a result, the objective of total EU capital market harmonisation has been scaled
down to subsidiary principles, which means setting standards but leaving the
specific regulation to the member countries.

8.8 A lesson from the Economic failures

8.8.1 Why have the economic experiments failed?
 There has been a lot of aid channelled into Africa, but despite this, Africa is still
lagging behind in terms of development.
 Perhaps the reason for the failure of economic reform is that the market-based
policies upon which many aid initiatives have been based are flawed – they assume
that economic reforms can create efficient markets without an accompanying
reform of the external governance framework and political institutions in those
countries.
 Without limits on the acts of governments and a guarantee of property rights and
individual liberty, ‘efficient markets’ may be difficult to create.

8.8.2 Market functioning requires the enforcement of rights

 The efficient functioning of markets requires that contracts and property rights be
enforceable

52
  It is probable that solving the economic and market failures in underdeveloped
countries requires political and social institutions that limit the discretion and
authority of government and of individual actors favoured by government.

8.9 Power, culture, Cycles, Psychology

8.9.1 Power balance in a system of governance
 In the absence of checks on power, abuse can and will occur.
 As much as there is no recipe for limiting power, governance mechanisms should
ensure that power is not concentrated.
 Various participants can also be incentivised to police one another’s actions
 A secondary way to limit power is federalism, in which different levels of
governance limit one another.

8.9.2 Governance mechanisms include cultural influences

 Cultural differences are relevant to the governance system. For example, Japan
has historically been regarded as having a debt as opposed to an equity financial
system
 In Japan there are no legal requirements on companies to take the interests of
suppliers, creditors or employees into special consideration, yet they do. It is a
cultural expectation that causes this corporate behaviour in Japan.
 While it is arguable that Germany’s system is based on legal mandates and Japan’s
on cultural expectations, in the late 1980s and early 1990s they produced similar
longer-term, investment-oriented behaviour by companies.

8.9.3 Psychology and Market Cycles

 Psychology in human behaviour drives financial markets, management behaviour
and the underlying economy as well. For example, optimism triggers spending,
which stimulates the economy; in contrast, pessimism can lead to cautious
managers and economic decline. It has also led managers to ‘cook the books’ when
they were unable to meet market performance expectations: this, in turn, drove
the markets to unrealistic heights.

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 9 External Reporting Need versus Delivery
9.1 Introduction
 In one single aspect of the corporate governance system given most attention over
the years is probably external corporate reporting
 This has led to the development of the auditing industry.
 Auditing developed as a private means than a public policy tool to help keep the
inaccuracy of financial reporting within acceptable bounds.
 However, there is still a possibility of managers collaborating with accountants
 Accurate information is essential to many stakeholders

9.2 The need for accounting-Birth of a profession

 The origin of auditing has been lost in the mist of time
 In 1314, the English established an office of the Auditor of the Exchequer.
 Auditors were employed to control disbursements by government officials
 In its early form, the word audit in England referred to the periodic settlement of
the accounts between the landlord and his tenants.

9.2.1 Beginning of a profession

 The work of the accountants started to expand in the 18th century
 The companies Act of 1844 established the incorporation of businesses in the UK by
a formal registration process and required the annual appointment of auditors, to
examine the accounts and balance sheet of public companies
 William Deloitte opened his London based firm in 1845. William cooper started his
in1849
 The early practitioners began to form professional groups.

9.2.2 The cooper brothers

 William was later on joined by his 3 brothers.

9.2.3 Similar American developments

 The development of the accounting profession in the US was a bit slow with 14
accountants in 1850.
 Railroads resulted in the need for heavy investment and need for financial control
 Public concern about abuse by railroad monopolies when they set rates resulted in
the government mandating them to use a uniform accounting system
 The accounting profession began to grow in the US as it had earlier in the UK.

9.2.4 The International heavy weights

 The big 8 in the 1960s were made up of: Auther Andersen, Ernst and Ernst, Haskins
and Sells, Lybrand, Ross Bros and Montogomery, Peat Marwick, Price water house,
touché Ross, Authur young

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9.3 A drive towards standardisation
 After the stock market crash in 1929 and the depression that followed, it was found
that the stock market crash was a result of corporate fraud and financial mischief
and resulted in the legislation requiring audited reporting by all listed companies
 However in the 20th century, investors complained that the balance sheet and
income statement did not provide adequate disclosure.
 There was a drive for the need for standardisation of reporting which resulted in
the addition of the cash flow statement as part of the required sets of financial
statements
 Globalisation resulted in the need for internationally comparable accounts and led
to the formation of the International accounting standards board

9.4 External Accountability Today: GAAP Financial Statements

 The elements assembled into a set of financial statements involve conventions and
principles that are at best, approximations of past reality.
 GAAP is an accrual method that seeks to match income and expenses and record
them in the period in which the claim or right originates.

9.4.1 Representation of the Past-Not a projection into the future

 Financial statements are formal, summarised presentations of the financial data
accumulated in a company’s accounting records
 Financial Accounting standards provide the guidance on how to represent various
types of financial transactions.

9.4.2 Balance sheet, statements of Income and funds flow statement

 A balance sheet is meant to reflect the financial position of an entity as at a point
in time.
 An income statement seeks to reflect the activities that occurred with the assets
owned by the entity during a period of time.
 A statement of changes in financial position or funds flow statement seeks to
explain, or link, the balance sheet at the beginning of the period covered by the
income with the balance sheet at the end of the period.

9.4.3 Relative importance of components

 The income statement is subsidiary to the balance sheet from an accounting point f
view
 In the UK, emphasis is on the balance sheet while in in US, it’s on the income
statement
 The UK and US financial presentations can be confusing if an individual is only
familiar with one of them, even though they give the same output.

9.5 Accounting and reporting-Its use and Purpose

 Users differ in the information they want from accounting reports because of their
different needs.
 Investors want one type of information, creditors another. Governments have
needs that are different from those of investors and creditors, and employees
often want information that is of little interest to the others.

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  The presentation of these statements therefore differs across countries. In
countries where there are many government enterprises, the statements are
standardised, while there is little disclosure of information where enterprises are
owned by wealth families. Where funds are mostly obtained from banks,
accounting is more likely to be creditor oriented.

9.6 Auditing the financial Accounts

 The audit of the accounts of a company by an independent accountant has become
a key feature of the corporate accountability required in most external governance
frameworks.
 An audit is defined by the UK Auditing Practices Board as ‘an independent
examination of, and expression of an opinion on, the financial statements of an
enterprise’.

9.6.1 Who performs audits

 Audits are performed by registered accountants

9.6.2 Evolution in Audit approach

 The early audits performed by Broaker only reconciled receipts with what was
reported and did not involve the accounting inventory
 When it was disclosed that Mckesson Robbins had cooked their inventory records,
as auditing standard was developed requiring auditors to confirm the existence of
inventory
 In the 1960s, the audit process evolved. An audit team mapped all of the financial
processes used by the company and then determined by testing them that the
documented control procedures were followed by the client
 A sample of transactions would be taken and only material balances confirmed with
third parties.

9.6.3 Risk based Financial Audit methodologies

 By the beginning of the 21st century many of the major accounting firms were
using what they called a risk based audit.
 In a traditional audit methodology the auditor tested to find errors, to look for
malfeasance and for evidence of process failure; if no such evidence was found,
they concluded that the business process was operating effectively, and the
information it produced was reliable.
 With a risk-based approach, the auditor looks at how management determines that
key organisational processes involved in financial transactions and accounting are
operating effectively, and then undertakes to corroborate that by examining the
risk areas.
 A risk-based methodology makes several assumptions. First, it assumes that
management has designed the business processes to ensure that the functions are
performing as expected (e.g. sales orders are filled, cash is collected, vendors are
paid).
 Second, it assumes that, by designing processes to ensure that the activities of the
business are executed properly, accurate financial information should be produced.
 Evidence that the business process is working properly is obtained by determining
how management knows that its processes are working properly.

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9.7 The Audit committee-Overseer of the Auditors
 The main role of the audit committee is to monitor the integrity of the financial
statements of the company, and to review the company’s internal financial control
system; its role may, or may not, include risk management and non-financial
control systems.
 It should also give recommendations where it finds flaws.

9.8 The many kinds of Audit

9.8.1 External Financial Audit
 Examination of financial statements by an independent public accountant and
intended for the outsider
 This is done with the objective of expressing an opinion on the truth and fairness of
the financial statements.

9.8.2 Internal Auditing

 An internal Audit is a continuous review of the financial, accounting and or
operational processes of a company, performed by employees.
 Internal Audits can reduce the cost of external audits
 It helps management by ensuring that internal financial control is effective.

9.8.3 Auditing for standards, compliance, improvements or ……

 The different types of audit are:
- Financial Audit
- Operational Audit: Also known as performance or management audit. It
measures and evaluates administrative control against standards set by
management e.g budgets.
- Compliance audit
- Investigative audit: Performed to investigate incidents of fraud or
misappropriation of assets
- Information assurance: Address the security and internal control
environment of automated information processing systems and how people
use those systems. It includes data protection
 Purpose of an Audit
- Benchmarking
- Fraud detection
- Risk assessment
- Improvement planning
- Trust

9.8.4 Evolution in the purpose of source audits

 The original role for audits was to ensure appropriate control of assets
 Today, audits are important as they ensure operational control and act as input to
strategic planning
 There has also been changing legal requirements and pressure as a result of
pronouncements in best practice codes
 The need for protecting the environment has also resulted in environment audits.

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9.9 Patterns in Frauds and Accounting Manipulator
 An earnings restatement in effect rewrites a company’s history. Typically, when a
company announces that it has restated or intends to restate its financial
statements, events happen in rapid succession – the share price collapses, earnings
forecasts are lowered, managers leave, often outside auditors are changed, and
lawsuits are filed.
 Restatements are done after consulting with Auditors or regulators and arise at
times as a result of: misinterpreting accounting rules, dividend distributions,
discontinued operations, mergers and acquisition, change of accounting period etc.

9.9.1 US restatements during 11 years ending 1997

 A study by COSO revealed that, between 1987 & 1997, 300 companies had
fraudulent financial statements.
 There was evidence that many were under financial stress before they engaged in
the fraudulent financial reporting.
 Thus the subsequent frauds may have been designed to hide downward trends for
some companies and to preserve the appearance of an upward trend for others.
 When considered together, 83% of the cases named one or both the CEO and the
CFO.
 Most companies did not have audit committees and those which did, the Audit
committee members did not have experience.
 40% of the boards had no directors who could be considered independent
 The SEC named the auditors in 29% of the reports for participation in the fraud or
for negligent auditing.

9.9.2 Restatements between 1997 and 2001 in the US

 Many companies rested their earnings between 1998-2008 due to accounting
misrepresentation, irregularities, fraud and errors.

9.9.3 Trends and recent data

 Prior to year 2001, the largest amount of restatement was $1.1 billion reduction by
Waste Management. WorldCom now holds that dubious record with a $7.68 billion
downward adjustment.

9.10 Is one Audit methodology superior to another

 A naïve analysis of the data would suggest that the new risk based auditing method
could be contributing to the trends in accounting restatements
 In a risk based method, the auditor tests an assumption that management has
determined that the business processes are working properly and seeks evidence
that the financial information generated as a by-product of those business
processes is properly recorded.
 This is radically different from the earliest auditing methods, where the auditor
checked that every transaction was properly recorded and the numbers were added
correctly
 Enron, world Com and Tyco used risk based audit methodology while BCCI, Maxwell
and Barrings were audited with the previous generation of audit methodologies.

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 10 Definition Inconsistency and system improvement

10.1 Introduction
 The term ‘corporate governance’ is commonly used today, but it has no generally
accepted definition, and the definitions that have been proposed are inconsistent.
 Although there does seem to be tacit agreement that corporate governance is
about imposing the will of society on corporate entities, there is little agreement
on the specifics of what kinds of corporate entity, or how and for whom this is to
be achieved. As a result there is confusion about what corporate governance is and
how it should be achieved.

10.2 The term corporate governance

 This term was first used by Robert Tricker in 1976
 However, until the late 1980s the term was used rarely. When the term was used,
most often it was in publications intended for company secretaries that addressed
issues relevant to both private and listed companies.
 The spectacular corporate failures at BCCI in 1991, Maxwell in 1992 and Barings in
1995 thrust the term ‘corporate governance’ into mainstream usage, first in the UK
and then in the United States and elsewhere.
 In its initial formation, the term was aimed at addressing the role and activities of
directors.

10.3 Corporate governance-An inconsistent Notion

 According to Robert Tricker, corporate governance is concerned with the way that
corporate entities are governed, as distinct from the way businesses with those
companies are managed. Corporate governance addresses the issues facing boards
of directors, such as the interaction with top management, and relationships with
the owners and others interested in the affairs of the company…
 Corporate: refers to a group or association of people, usually authorised by some
form of agreement, acting as an individual (i.e. the group) especially in business
and civic activities.
 Governance: is the act, manner or functioning of the rules, guidance and controls
which determine a course of action through an intended or emergent system of
processes

10.3.1 Emerging variation in definitions: International differences

 A host of reports with varying definitions have been published since Cadbury
 Cadbury in the UK appears to encompass both the external governance framework
and internal governance used in companies in its definition: The system by which
companies are directed and controlled…
 The Belgium Federation elected to focus its definition of ‘corporate governance’ on
internal governance only: … [Corporate governance is the] organisation of the
administration and management of companies.

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  The Peters Report from the Netherlands also has a definition that limits ‘corporate
governance’ to internal governance.
 The Berlin Initiative, define ‘corporate governance’ as the mandatory, but not the
voluntary, elements in the external governance framework: [Corporate
governance] describes the legal and factual regulatory framework for managing
and supervising a company.

10.3.2 Differences in Purpose of the company and the importance of shareholders

 The Peters report from the Netherlands asks for a ‘good balance’ between
shareholders who provide the risk capital and other stakeholders.
 Italy’s Preda report holds maximising shareholder returns as the primary objective
of a company.

10.3.3 Variation in definitions-National Differences

 Not only are they variations in international differences but also in materials that
has been developed.

10.3.4 Most uses of the term are without an explicit definition

 The majority of those who write and speak about corporate governance do not
bother to define the term at all.

10.4 The challenge of definitional ambiguity

 The lack of an agreed, generally accepted definition of ‘corporate governance’
means that individuals are left to develop their own understanding of what
corporate governance means, or else try to find an implicit meaning from the
context in which the term is used.

10.4.1 Inferring a definition from the context

 Definitions can be inferred in some reports.

10.4.2 Developing a Common mental Model?

 The variation in definition can be compared to the familiar fable about the blind
men and the elephant.
 Each blind man sees a different aspect of the elephant and forms a mental model
about the beast called an elephant from that aspect alone.

10.4.3 Testing for the Elephant Problem

 The elephant problem has been tested using a number of professionals (Directors,
Senior Managers and regulators). The outcome was varying definitions of corporate
governance.
 Clearly, there is confusion among knowledgeable people about what corporate
governance is.

10.5 Variation in Domain, Aspect and specificity

 Despite the definition inconsistencies, they all address that that can be improved
in order to benefit the business. These include strategic and operational guidance
and control mechanisms.

 Domain refers to a territory or area under rule or influence.

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  Aspect refers to the way in which something may be viewed or regarded; a
category.
 Specificity refers to the degree to which instructions are given.

10.6 Does variation in definitions really matter

 The variation in definitions does matter.
 Corporate governance efforts guided by different definitions will address very
different problems compared with improvement efforts.

10.7 Guiding corporate governance analysis

 Consistency in the use of definitions will help someone to recognise and respond to
problems of understanding, such as those created by the use of implied, imprecise
and inconsistent definitions (i.e. the ‘elephant’ problem). However, consistency is
not enough.
 In order to be useful for improvement, the study of corporate governance needs to
be guided by a working understanding encompassing the source of the problems
that need to be improved. If the focus is too narrow and misses the source of a
problem, it is unlikely that the effort will produce useful solutions.
 Ideally, a working definition should enable knowledgeable people to improve the
standard of governance performance, both from a regulatory and from a company
practice perspective, although someone could choose to concentrate on one or the
other.

10.8 Rethinking Governance System improvement

 Human beings organise themselves with a set of evolving norms, policies,
procedures and processes that guide individual decision-making and thereby
behaviour.
 As a result, internal and external mechanisms evolve to govern their behaviour.

10.8.1 System vs Individual assumptions

 A system approach provides an alternative paradigm to when considering
governance reforms – that most of the variation in performance is produced by
system factors, not by the individuals who operate within that system. As a
consequence, it opens the system itself to analysis, not just the decision-making by
individuals.

10.8.2 Viewing governance from a system orientation

 To describe a system, it is necessary to describe both the separate functions and
their method of interconnection. With corporate governance, this has never been
done.

10.8.3 The Dynamics of a system

 Not all systems are dynamic, but many are.
 Dynamic systems can change with the passage of time as their parts interact to
create a series of evolving system conditions.
 Clearly an elephant is dynamic; it is born, grows, matures and then ages overtime.

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10.8.4 Observed properties of organisational systems
 The conditions existing in a system at a particular point in time influence both the
decision-making and the behaviour of the individuals who are operating within that
system at that time.
 Deming, the man who developed modern quality management, argued that poor
quality in a manufacturing or service setting is the result of problems with the
system, not with the people working within it.
 How can employees do the job right if the incoming material is wrong, the
machines are in poor repair, or the measuring instruments are not capable of
producing an accurate measurement each time they are used? (cf. Deming, 1986).
 Humans operate in a circular environment, where each action affects conditions
and the changed conditions become the basis for future actions in an unending
cycle. Because people are interconnected, the cycles are intertwined.

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 11 Reality in the face of prescription
11.1 Introduction
 One bad apple (company) has the potential to spoil a whole barrel of fruit.
 It is essential to differentiate symptoms and causes in corporate governance issues
 There is general agreement that more needs to be done to prevent, detect and
expose financial fraud, but the current focus has been on stopping symptoms such
as fraudulent individual decisions by senior management and bad acts by auditors,
on the system of financial reporting, audit practice and management practice that
underpins company reporting to the capital markets.

11.2 Lack of trust-symptom or problem

 The 2002 events resulted in the lack of trust developing in the market.
 The period was characterised by financial statements restatements which eroded
the trust of the public.
 Restatements can be a result of fraud, errors, change in accounting standards etc.

11.3 Policy response-Punish the individual

 The most notable of the American additions to the new external governance
mandates for listed companies was the Sarbanes Oxley Act.

11.3.1 A very long Sarbox to do list

 The act specified responsibilities for management, audit committees and everyone
involved in the preparation of financial statements.
 The law also specifies criminal penalties to punish those who fail to do what is
mandated.

11.3.2 Limited view on Trust and Sarbox changes

 During the research that led to the Sarbanes Act, respondents of the survey which
was undertaken indicated that, improved communication, management of
stockbrokers and Investment banks will be necessary to restore trust and they were
also of the opinion that the act will help to do that.

11.4 Policy response-Tinker with the board

 In response to the 2002 crisis, the UK reforms saw the compilation of the Higgs and
Smith reports and the revision of the UK combined code. These reports focused on
the board.
 None of the changes adopted by the various jurisdictions appears to have been a
redesign. Rather they were prescriptive and additive to the external governance
framework and focused primarily on boardroom independence and external
reporting process.

11.4.1 New requirements for Independence

 Detailed proposals to improve the independence of boards were tabled with the
NYSE requiring the majority of the board to be independent.
 The UK, Higgs report was prescriptive, recommending that companies either
comply or explain.

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  It even went further and recommended that the CEO should not move to a
chairman position.
 The NYSE now requires listed companies to have nominating, corporate governance
and compensation committees composed of 3 or more independent directors.
 While the Australian stock exchange guidelines were not quite as restrictive as
those proposed by Higgs and the NYSE, there is concern expressed by
commentators in each jurisdiction that this will put pressure on the pool of
available directors.

11.5 Independence-reality from the individual perspective

 In the UK, most board members are employees of the company, while the opposite
is true in the US.
 This does not however mean that the US board is more independent than the UK
 Often, outside directors will include long-time friends and associates of the
chairman or individuals
 Focusing on independence results in the risk of overlooking quality

11.6 The different assumptions in a system paradigm

 The historic approach to corporate governance reform has assumed that individual
matters
 A system approach adopts an alternative paradigm-that most of the variation in
performance is produced by system factor, not by individuals who operate that
system.

11.7 Statistical evidence on the governance system

 Deming recommended the use of statistical analysis (variance analysis) to identify
problems in a system.

11.7.1 Independence and performance

 Researchers have not found any correlation between the proportion of outsiders
who appear to be independent in a boardroom and company performance, though
this does not mean that boards should be dominated by outsiders
 Research has however shown that, if these directors are made owners, they start
to vigorously represent the firm
 Such directors can even cap CEO packages and terminate contracts of non
performing directors

11.7.2 Data on reporting quality

 Additional useful data can be found in the GAO study, undertaken for the Senate
banking committee. This study reveals that, restatements between 2001-2003
where mainly due to irregularities

11.7.3 Inference from the data

 Sampling from a population of approximately 6 000 listed companies in the US
disclosed 919 instances of reporting output failure
 There was no sampling method, only those companies that had been reported to
the SEC were examined
 However, this data is indicative of the wide spread of the problem.

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11.7.4 An acceptable failure rate
 No one has debated an acceptable failure rate in company reporting. There was an
outcry in 1997 when there were 92 restatements and there was a similar out cry in
2001 when there were 225 restatements.

11.8 Bottom-up Exploration of the reporting process

 A bottom up approach of identifying a problem has been used in manufacturing and
the approach provides a different way of thinking for corporate governance

11.8.1 Business Activity and Transaction Management

 The majority of data used for the preparation of financial statements is gathered
from different business activities and form the input for the process that lead to
the compilation of financial statements

11.8.2 Legitimate difference between MIS and Financial statements

 Management accounts may serve a different purpose and therefore arise from a
different source (e.g. statistical allocations rather than actual transactions).
 Structural differences may exist (e.g. different cut-off periods; unit business
organisational boundaries may be different from legal boundaries).
 Management accounts may be prepared using different accounting principles (e.g.
German GAAP, IAS, cash basis, tax-basis, regulator mandated).
 There may be different judgements (e.g. more prudent or more aggressive reserve
calculations).
 Confidential information may exist that should not be known by the accounting
staff (e.g. litigation or redundancy reserves)

11.8.3 Accounting judgements and management within the reporting system

 Many judgements go into the reporting of financial data.
 This may include provision for bad debts or returns which many be different from
the actual debts or returns

11.8.4 Symptoms and issues in the Finance function

 High staff turn over
 Slow closes-books taking long to be closed. This can be due to accounting
manipulations
 Poor management structures or a weak financial officer provide the unscrupulous
plenty of opportunity for mischief etc.
 Unexplained changes in cash flow or unexpected earnings adjustment can be
indicative of hidden problems
 Use of spread sheets to prepare financial statements can create problems, because
such spread sheet can have logic or arithmetic errors
 High consultancy spend can be an indication of management problems e.g
underperformance by management
 When management fails to respond to questions with timely and logical answers

11.9 Illegitimate differences-Financial statement “Black magic”

 Differences in the MIS and financial statement data maybe due to various sources
which might be called black magic. They include:

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 - Management adjustment to either the MIS of financial accounts in-
appropriately
- Manipulation of data intended to disguise operational reality
- Failure to book legitimate transactions

11.9.1 Seeking comfort that Black magic is within acceptable bounds

 Due to limited resources, Auditors focus on areas where black magic might happen
 This may mean focusing on input transactions due to the fact that the current IT
systems are difficult to alter
 Time pressure provides an opportunity for major items to be overlooked or for
management to use the pressure to avoid the auditors detecting or discussing
suspect accounting entries

11.9.2 Locating black magic for real

 This is done by Auditors, and most recently, using the risk based methodology audit
methodology
 This method scrutinises the processes and identifies the risk areas ,thus areas of
potential black magic and then scrutinises them

11.10 Boardroom functions in company reporting

 The next level up in the hierarchy of the reporting process is the audit committee
which is part of the board of directors

11.10.1 Choosing and developing the board room

 The majority of non-executive directors have been recruited without having a
formal interview and induction.
 In the UK survey of 101 company directors in 2001, it was found that the majority
of directors where ignorant of personal liability of directors where personal liability
of directors and legal issues which arose from potential solvency

11.10.2 Consensus cultures maybe the board room norm

 In the US, the CEO is normally the chairman of the board
 These boards have tended to be self-selecting and their information, procedures,
agenda and meetings have been controlled by the CEO. This is the individual who is
responsible for the activities that the board is supposed to monitor.
 Such boards are rarely involved in voting and the norm is a group of similarly
minded people operating in a consensus culture

11.10.3 Diversity in boardroom

 The Higgs review reported that only 7 per cent of non-executive directors (NEDs) in
UK listed companies are non-British nationals, only 6 per cent are women, and only
1 per cent are from a British ethnic minority. Many chairmen insist that the
directors on their boards have previous experience in the boardroom or top
management of large companies. This precludes considerable talent from
elsewhere.

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11.11 Disconnects from the internal system
 Enron was able to fool a lot of people and hence received great reviews for its
operations

11.11.1 The Enron Record

 Until its collapse, Enron reported gross sales that reached $200 billion and assets of
$60 billion
 Management was able to fool the board and everyone else
 When sales started to decline due to market saturation, the management started
manipulating records

11.11.2 Best practice failure

 Enron scored well on best practice governance recommendations
 Its audit committee appeared to have the required financial expertise and
experience
 The board followed the rules laid by regulators
 However the audit committee and board failed to respond to warning signs that led
to the collapse of the company
 Other governance failures includes Marconi and equitable life and My Travel

11.11.3 Evidence from Boardrooms

 Failures of boards can be attributed to the disconnect between internal corporate
governance and board level activities
 Many boards rely on: (a) Material from external Auditors (b) reports received via
normal chains of command (c) financial performance indicators
 Boards with the least contact with the internal governance process are more
confident with their companies
 The other reason of failure is the failure by the board to react on time when there
is a decline in performance

11.11.4 Implications and Policy challenge

 Effective risk control may not be achieved by a board that appears to be
following best practice corporate governance, if they rely on the auditors for the
mandated evaluation of internal control
 This is because Auditors are concerned with financial risk more than operating
risk
 There are few boards who conduct broad operational reviews
 Internal audit do not support the board to the extent it should
 Information from formal channels is susceptible to manipulation
 Internal corporate governance mechanisms appears to be most effective in firms
where they are updated routinely as market conditions, strategy and company
operations change
 The recent best practice recommendations could be a prescription for future
problems

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