West vs Leroi

1 At an academic conference, a debate took place on the implementation of corporate governance

practices in developing countries. Professor James West from North America argued that one of
the key needs for developing countries was to implement rigorous systems of corporate
governance to underpin investor confidence in businesses in those countries. If they did not, he
warned, there would be no lasting economic growth as potential foreign inward investors would
be discouraged from investing.

2 In reply, Professor Amy Loi, herself from a developing country, reported that many developing
countries are discussing these issues at governmental level. One issue, she said, was about
whether to adopt a rules-based or a principles-based approach. She pointed to evidence
highlighting a reduced number of small and medium sized initial public offerings in New York
compared to significant growth in London. She suggested that this change could be attributed to
the costs of complying with Sarbanes-Oxley in the United States and that over-regulation would
be the last thing that a developing country would need. She concluded that a principles-based
approach, such as in the United Kingdom, was preferable for developing countries.

3 Professor Loi drew attention to an important section of the Sarbanes-Oxley Act to illustrate her
point. The key requirement of that section was to externally report on – and have attested
(verified) – internal controls. This was, she argued, far too ambitious for small and medium
companies that tended to dominate the economies of developing countries.

4 Professor West countered by saying that whilst Sarbanes-Oxley may have had some problems, it
remained the case that it regulated corporate governance in the ‘largest and most successful
economy in the world’. He said that rules will sometimes be hard to follow but that is no reason
to abandon them in favour of what he referred to as ‘softer’ approaches.

Required:
(a) Describe the essential features of a rules-based approach to corporate governance.
(3 marks)
 (b) Construct the argument against Professor West's opinion, and in favour of Professor
Leroi’s opinion that a principles-based approach would be preferable in developing
countries. Your answer should consider the particular situations of developing countries.
(10 marks)
Study Guide
B3(b) Compare rules versus principles based approaches to governance and when they may be
appropriate.

Marking scheme

(a) 1 mark for each essential feature of a rules-based

approach, briefly described 3 marks
Up to a maximum (for part (a)) of 3 marks

(b) 1 mark for each relevant point made on the advantage

of principle-based approach to governance, up to a 4 marks
maximum of 4
Up to 2 mark for each relevant point about the 6 marks
suitability of a principle-based approach for
developing countries, up to a maximum of 6
Up tp a maximum (for part (b)) of 10 marks 10 marks
 Top tips. Perhaps the most important point to mention in (a) is the lack of flexibility in rules-
based approaches as this leads into (b). It is no use including rules that companies cannot
comply with because of a lack of local infrastructure.

The suggested solution also highlights the point that a principles-based approach encourages
governance to develop as the companies expand, and addresses the issue of international
investor confidence by pointing out that there are globally recognised international codes that
are principles-based.

It is important that you understand which of the professors is advocating which approach, in
order to focus your argument in (b) correctly. In effect, (b) is asking: what are the arguments
against rules-based approaches, and in favour of principles-based approaches, in developing
countries. Make sure you focus specifically on these points; not, for example, on a more
general discussion of the points for and against each approach.

Also, the reference to developing countries is mentioned twice in the requirement, and it is
vital that you consider the arguments specifically in this context.

Answers:
a.
Rules-based approach
Rules-based approach is implementing rigorous systems to corporate governance which clearly
define rules and standards.

Company has no freedom in varying interpretation of rules and standards but to comply
obediently.

It is easy to identify whether the company has complied with the rules and standards that stated.

b.
Lack of resources
Rules-based approach will only be suitable to adapt if the country has sufficient resources. The
principles-based approach will be more adaptable for developing countries since the rules and
standards are more flexible. For example, it will be difficult for the company in developing
countries that follow rules-based approaches which the company needs to change their audit
partner every five years since it may lead the company to the capital problem.

Facilitate Economic Development

Principles-based approach can facilitate economic development of a developing country because
of its flexibility which increases the number of small and medium-sized initial public offerings.
Professor Leroi pointed to evidence highlighting a significant growth in London compared to
New York (P2L4-5) in which she concluded that principles based approach was preferable in
developing countries.

Cost-benefit
The cost of complying with Sarbanes-Oxley legislation in the United States will be more costly
as they need to obey the rules and standards that are set by the government. (P2L6-7) However,
the company in developing countries using a principles-based approach does not need to obey
the rules and standards strictly since it is more flexible than a rules-based approach. Therefore,
cost-benefit will be achieved under principles-based approach.

OECD principles
It can gain more confidence from investors by using the principles-based approach rather than
rules-based approach. OECD code is a benchmark for developing good corporate governance
practices. This can ensure that the company has appropriate disclosure and transparency on their
financial statements and performance. The shareholders' confidence will increase as OECD
codes can also protect and facilitate the shareholders rights.