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Governance in different countries and organisations

UK COMBINED CODE OF BEST PRACTICE

Corporate Governance in the UK is covered by the Combined Code, a document that developed over a number of years. The Code is kept up to date by the UK Financial Reporting Council (FRC).

 

History of the Combined Code

This is not a history exam! However, the Code includes the results of a number of individual Reports, and it would be reasonable for the P1 Examiner to expect you to recognise the names.

Following a series of high profile corporate collapses in the late 1980s and early 1990s, Sir Adrian Cadbury was asked to look into UK corporate governance. In 1992, the Cadbury Code was created.

In 1995, following a series of concerns about excessive director pay, the Greenbury Report was issued, giving recommendations on how to better align director rewards with those of shareholders.

In 1998, soon after the Cadbury Code had been in use for 5 years, the Hampel Report reviewed how well the Cadbury Code was working, and made recommendations for change.

Important Issues

There was a concern that the Cadbury Code was too close to a box-ticking approach, and was not making companies think enough about the principles involved. As such, Hampel advocated a more principles-based code.

The London Stock Exchange operates a Comply or Explain approach. All listed companies are expected to follow all provisions of the Combined Code … or explain in their Annual Reports which provisions they have not followed, and why.

In 1999, the Turnbull Report was issued. Turnbull gives detail on how to create an effective Internal Control System, which is an essential part of good risk management.

In late 2001, Enron collapsed. Whilst Enron was primarily a US company, its operations were international … and it was felt that UK corporate governance may be able to learn some lessons as well.

In 2002/2003, two reports were issued as a result of post-Enron analysis, and both of these reports now form part of the Combined Code in the UK. The Higgs Report looked into improving the effectiveness of directors, especially NEDs. The Smith Report focussed on the role of Audit Committees.
The Combined Code was updated again in 2006, but has not changed much in the last 4 years.

 

Comply or explain

The “Comply or Explain” approach is NOT the same as saying the Code is Voluntary.

The expectation is that listed companies will follow the Combined Code in full, and that non-compliance (and hence explanations) will be rare.

Having “Comply or Explain”, rather than having corporate governance law (as in the US), would seem to have some advantages and disadvantages:

Advantages

  • The ability of companies not to comply with the standard provisions recognises that not all company situations are the same, and that some flexibility is therefore welcome
  • Laws can appear to be heavy-handed, and often do not therefore get the support of the business community. It is hoped that by avoiding laws, businesses will be more willing to contribute to the ongoing corporate governance debate
  • By requiring explanations of non-compliance, companies are required to think carefully about their reasons … and this may make them decide to follow the Code after all!

Disadvantages

  • Some companies may use the ability not to comply in order to avoid some provisions of the Code, and then present weak (or untrue) explanations justifying their actions
  • Without the law to back it up, corporate governance becomes harder to enforce

 

SARBANES-OXLEY ACT (SARBOX, SOX)

After the collapse of Enron, WorldCom, and a series of other American corporate frauds and failures, the US Government was keen to act quickly and firmly.

On 30 July 2002, the Sarbanes-Oxley Act was passed (it is named after the 2 US politicians who sponsored it through Congress). It was not long before it became known as Sarbox … or SOX.

There are many differences between SOX and the UK Combined Code:

  • SOX is law, with strict penalties for non-compliance. The Combined Code is Best Practice, not law
  • SOX makes audit partner rotation the law, whereas in the UK such matters are covered by the profession’s Codes of Ethics
  • SOX has a ban on auditors providing a range of “other services” to their audit clients. In the UK, very few “other services” are banned, but are instead considered within the objectivity area of Ethics.
  • SOX requires the CEO and CFO to personally attest to the accuracy of the Annual Report, Quarterly Reports, and to the effectiveness of Internal Control Systems. In the UK, there are general assurances in the Directors’ Report and Annual Report, but no personal certification is required
  • Under SOX, the auditors must attest the Internal Controls statement. Auditors do not make any such statement in the UK
  • Under SOX, if laws have been broken (e.g. accounting standards), the CEO and CFO forfeit some of their remuneration (e.g. their bonuses). There are no such rules in the UK
  • Under SOX, no loans can be made by a public company to its directors or other senior executives. Whilst the same rules apply in UK law, there is a de minimus limit and there are some exemptions



In many ways, SOX and the Combined Code are very similar, but in many other ways SOX is much more strict, and of course is backed up by the US law.

The main areas in which SOX is tough are directors, auditors, and internal controls – which is hardly surprising giving many blame Enron’s collapse on a failure in those 3 areas.

 

GOVERNANCE IN OTHER COUNTRIES

Corporate Governance varies around the World, largely due to different history and cultures.

In the UK and US, the model is aimed primarily at the rights of shareholders.

In Germany and much of continental Europe, and also in Japan, banks play a more prominent role, often holding shares and having Board members. Such governance models tend to be more inclusive, ensuring that the rights of workers, customers and suppliers (and maybe the community) are represented at Board level.

In Japan, many major company structures were traditionally based around banks. Large groups of companies from many industries would all be financed, and part-owned by a major bank, which would create a strong financial alliance. Cross-shareholdings between companies were common, and in many cases the companies in the “group” would all supply each other.

In South America, Italy, Spain, and large parts of East Asia (e.g. Indonesia) the focus is more on family ownership, with a large % of the biggest companies owned and controlled by a small number of the most powerful families in the country.

 

Unitary and two-tier boards

In countries where there is greater inclusivity in decision-making, or where there is a strong family dominance, it is possible that a 2-tier board will exist.

A Management Board will run the day to day operations of the company, but will be monitored by a higher level Supervisory Board. In UK terms, this is similar to having the NEDs on a top board, with the Executive Directors on a separate lower Board.

The 2-tier system may also operate with family dominated companies, with family members having their own top-level private Board which has controlling voting rights (and therefore where the true decision-making power rests).

To an extent, schools in the UK may be seen to have a 2-tier system, with the Head / Principal and a small number of senior teachers on a management board, with the School Governors in a more supervisory role.

Of course, schools naturally have a lot of stakeholders (parents, teachers etc.) so would seem well-suited to this structure.

Advantages of 2-tier boards

  • Where there is a large Board, splitting into 2 may make discussion and decision making easier.
  • The existence of 2 Boards allows for more stakeholders to be involved.
  • By separating NEDs from the Executive Directors, the independence of the NEDs is likely to be improved.

Disadvantages of 2-tier boards

  • If one board is clearly senior to the other, it may lead to conflict.
  • It may be better for NEDs to be present during Executive Director discussions, rather than receiving a report of what was said.
  • It is likely to lead to slower decisions.
  • Senior management are now 2 steps away from a final decision, which may demotivate them.
  • In many countries (e.g. UK) all directors have equal legal status, whether Executive or NED. This may make it necessary for all to sit on a single Board.

 

GOVERNANCE OUTSIDE LISTED COMPANIES

The rise in the importance of governance has been fuelled by fraud and corporate collapses, primarily among large listed companies.

But can other companies, and other organizations, learn from corporate governance?

 

Charities

Consider the following issues:

  • Could a Charity suffer from fraud?
  • Does a Charity need to manage risks?
  • Does a Charity need a strategy and effective leadership?



The answer to all of these questions is of course yes!

In the UK, charities are regulated and monitored by The Charities Commission, whose principles demand:

  • Sound governance
  • Effective controls
  • A Board that is competent and independent
  • A Board that monitors its own performance
  • Training for Board members
  • All Board members to identify any conflicts of interest
  • Good risk management system.



Of course, charities are typically not companies, and may not be used to behaving in a “corporate” manner, because:

  • They are often run by volunteers, who may have minimal business experience.
  • They are often much smaller than companies, so are less likely to have the need (or resources) for things like Board Committees.
  • Often the founder of the charity leaves rules in place to ensure future decisions are still made according to his original intentions.
  • It may seem “harsh” to forcibly rotate a volunteer off a charity’s Board.
  • It may be that as volunteers, there are no Board remuneration issues (other than reclaimed expenses).

 

Public sector – e.g. councils

Traditionally, councils were seen as full of faceless officials, inefficiently spending the public’s money.

Many would not associate a council with words such as accountability or responsibility, assuming that decisions were often made for political reasons, or because you knew someone on the council and were able to persuade them to get you what you wanted.However, Councils have also taken many aspects of governance to heart. Consider Harrow Borough Council in London, whose website includes sections on:

  • Sustainability
  • The councilors, and how elections operate
  • How council decisions are made
  • Budgets and spending plans
  • Council strategy
  • Council performance.



Clearly many aspects of corporate governance do not have such importance in a council, but equally there are other areas which do.

Haringey Borough Council seem to go even further – the following pages are taken from:

www.haringey.gov.uk/index/council/ourstandards/ethicalgovernance.htm