Contents and Objectives of each Reports of CG in UK

The Cadbury report focused on the role and structure of the board of directors, audit and accountability and the relationship with institutional investors. Companies should provide a note in the annual report that they had complied or to explain what provisions had not been complied with.

In subsequent years, the Greenbury report was published (1995) which covered director remuneration after concerns that directors remuneration was becoming uncontrolled.

In 1998 the Hampel report was published, which updated Cadbury and Greenbury and amalgamated them into the Combined Code. This is a single code containing guidance on corporate governance. The Hampel report had reviewed the two reports amid concerns that corporate governance compliance was a box-ticking exercise, so aimed to make the code principles based. This meant that companies had to consider if they met the spirit of the code’s principles.

Further reports on corporate governance have included Turnbull (1999) which reviewed internal control; Higgs (2003) focusing on non-executive directors; Tyson (2003) covering recruitment of non-executive directors; and Smith (2003) which looked at auditors and audit committees.

Corporate Governance Development in UK

1. The Combined Code developed after corporate failures in the late 1980s and early 1990s that caused government focus on listed companies and corporate governance.
2. The Combined Code developed from a number of different reports looking into different areas of corporate governance. 
3. This started with the Cadbury code of best practice in 1992 and was added to in 1995 with the Greenbury report arising from concerns about directors’ remuneration. In 1998 the Hampel report looked at the effectiveness of the Cadbury and Greenbury reports and whether the recommendations were working. 
4. The three reports became the Combined Code.
5. Later, in 1999, the Turnbull Guidance was published on internal controls and 
6. In 2003 in the aftermath of Enron, two separate committees were set up to look at the role of NEDs (Higgs report) and the role of audit and audit committees (Smith report).

PROBLEMS BETWEEN PRINCIPAL AND AGENT

PROBLEMS BETWEEN PRINCIPAL AND AGENT

As discussed above, due to the existence of large companies with many small shareholders it can be difficult for shareholders to have a voice. However, it is important to understand that directors have a duty to act in the shareholder’s best interests. This is known as their fiduciary duty which means the directors should act in the utmost good faith to the shareholders and should not place themselves in a position where their own interests conflict with this duty. In other words, the directors are accountable to the shareholders.

Problems between principal and agent occur when there is conflict in the relationship. In many cases the objectives of the two parties are in conflict. Shareholders may want capital growth or dividend growth. Directors, who may not be shareholders, may seek to maximise their own wealth in terms of pay and bonuses. Many bonuses are paid based on profits and therefore they wish to maximise profits in the short term. This will not necessarily achieve the shareholders’ objectives.

One way of dealing with this problem is to align the objectives of shareholders and directors, often by including long-term benefits in a director’s bonus structure. For this reason, many directors are given share options that are exercisable at a future date so they will consider the long-term perspective of the company as well as the short term, thus aligning the interests of both parties.

Other problem-solving measures include:

• Attending the AGM and voting for or against the proposed resolution;
• Meetings between institutional investors and directors;
• Proposing resolutions to be heard at the AGM;
• Divesting shares.

BARINGS BANK

BARINGS BANK

Barings Bank was a very old traditional British bank. In the 1980s and early 1990s the banking industry was going through a period of change as a result of deregulation. British banks had previously been very tightly controlled but gradually the British government allowed British banks to enter into new markets.

In the early 1990s, Barings expanded into “new” products such as options and futures trading. Nick Leeson, a British banker, was given the new Singapore branch to manage.

In trading operations, the bank has a front office where the trades are organised and a back office, where the trades are recorded and accounted for. There should always be segregation of duties between those trading and those accounting for the trades. This should stop fraudulent traders doing one thing and recording another.

However, at Barings, Leeson had total control of both the front office and the back office. He controlled how his trades were being recorded.

When members of Leeson’s team made a few mistakes, Leeson did not want his staff to be blamed so he hid their mistakes in an account (88888). He could do this because of the lack of segregation of duties which allowed him to trade and then to record those trades. Additionally, there was a lack of understanding of the trades being entered into both by the UK directors and the auditors.

Leeson used the bank’s money to gamble on the markets, making speculative trades. The 88888 account was used to hide any losses. By the end of 1994, losses in that account amounted to more than £200 million.

The bank allowed him more money to continue trading, although it was unlikely they knew what he was doing.

The fraud reached a climax in January 1995 when he gambled that the Japanese stock exchange, the Nikkei, would not move significantly overnight. Unfortunately the Kobe earthquake hit Japan and the stock exchange fell significantly. Leeson aimed to recoup losses by betting that the stock exchange would recover quickly. It didn’t and Leeson knew that millions were going to be lost and he fled. By the time the bank understood the position he had created it was too late and he had created a massive loss exceeding £800m. This was big enough to wipe out Barings bank. The bank was eventually sold for £1.

The bank was wiped out by one trader because the directors didn’t understand the business they were in or what Leeson was doing. There was a serious lack of internal control over the operations. Again, there was too much control in one person’s hands and to some extent the auditors failed to properly understand the situation at the bank.

ENRON CASE

ENRON

The collapse of Enron is probably the most famous example of a company failure due to fraudulent accounting.

Enron was one of the top 10 American companies in 2001. It filed for bankruptcy in December 2001 as a result of accounting scandals that rendered the financial statements worthless.

THE ACCOUNTING SCANDAL

Enron was an energy company based in Houston, Texas, formed by bringing together two other operations and was run by the chairman, Kenneth Lay. He was highly regarded as a businessman as Enron had performed so well.

Enron provided energy and also started to look at new ways of making money by developing energy derivatives such as options and futures. The problem was that Enron needed to borrow a lot of money to continue to finance its operations. It was aware that high levels of debt made the company’s financial position look weaker so instead of borrowing the money in the Enron companies it set up special purpose entities (SPEs), who borrowed the money on Enron’s behalf and then channelled the funds in to Enron.

At the time, American accounting standards were set up in such a way that if these SPEs were set up carefully enough, the liabilities would not appear in the Enron accounts. This is called ‘off-balance sheet’ financing as the debts belong to Enron but are not shown in that company’s balance sheet/statement of financial position.

Many of the hidden debts were backed by the Enron share price. If the share price continued to rise, the debts did not need to be repaid. However, if the share price fell, the debts had to be settled. This had an adverse impact on cash flow, which then had a negative effect on the share price thus requiring more debts to be settled and so on.

Enron had massively under reported just how debt they had. The financial statements showed profits when in reality the company was hiding huge debts and losses in the SPEs. When the Enron share price reached its highest level in August 2001, Enron senior executives started to sell their own shares, whilst still encouraging investors to buy shares in Enron. As large numbers of shares were offloaded by Enron executives who knew the true financial position of the company, the share price started to fall. By the end of November 2001, the news of the financial losses and mounting debts was made public and the company filed for bankruptcy in December 2001. The share price had dropped from a high of US$90 to being worthless.

WHAT WENT WRONG?

There were a number of problems at Enron. Whilst some of the accounting was strictly within the American rules, some of it contravened accounting standards. Far too much information and control was in the hands of a very small number of dominant individuals who were too involved in the day to day running of the business.

There was a lack of internal control and poor risk management. Whilst Enron did have non-executive directors they did not appear to understand what was happening and clearly did not question the executive directors sufficiently.

There was a serious failure in the audit function as the auditors, Arthur Andersen, were aware of what Enron was doing. The role of the auditor is to report to the shareholders on the accuracy of the financial statements and yet Andersen was so close to the directors that they were not fulfilling their obligations. There are allegations that they assisted Enron in committing some of the illegal accounting. Arthur Andersen collapsed as a result of this scandal.

Andersen earned a large audit fee as well as a huge amount of fees for non-audit work. There has always been an opinion in the accountancy profession that if the auditors perform many other services in addition to the external audit it could compromise their opinion about the accuracy of the financial statements, as they do not want to upset the directors and risk losing the (usually) more lucrative non-audit work.

As a result of Enron’s bankruptcy, the American government responded by issuing the Sarbanes-Oxley Act in July 2002. This was American corporate governance backed by law. It is a very tough piece of legislation with strict rules about the director’s responsibility for the financial statements, auditor independence and internal control. It aims to ensure that such public accounting scandals cannot happen again.

MAXWEL AFFAIRS

MAXWELL AFFAIRS

Robert Maxwell ran a vast publishing empire, which included the Mirror Group of newspapers and various other newspapers and media companies. Maxwell was a very dominant person.

Maxwell’s group of companies had significant debts and there were many rumours about the level of debts and his dishonesty in business. As early as 1971, the Department of Trade and Industry reported that he could not be relied upon to exercise proper stewardship of a public company as he had tried to mislead an investor wishing to takeover one of his companies.

Maxwell borrowed millions of pounds from the Mirror Group pension scheme to help shore up some of the other businesses that were in trouble. This was illegal. By 1991, there was increasing public suspicion of the treatment of the pension scheme funds as the company had not met its statutory reporting requirements.

After his death IN 1991, it became apparent that he had used hundreds of millions of pounds from the pension funds to finance corporate debts. Thousands of employees lost their pensions.

Many questions were asked after this scandal; the primary question being how this money could have been taken out of the pension scheme. Why would the pensions fund trustees, who were responsible for running the pension scheme, not question this? It could be that they allowed it to happen, as Maxwell was so dominant. Additionally, perhaps the auditors should have picked this up as an issue or the other board members should have challenged Maxwell.

Yet again, one person was allowed to do what they wanted as they were in total control. This highlighted the problem of a single dominant individual at the head of a company.

PRINCIPLES OF TRANSACTION COST THEORY

Transaction cost theory originated from the 1930s, when the economist Ronald Coase was investigating the reasons companies exist and why they were growing so large.

Transaction costs are incurred in spending time researching, negotiating and agreeing a transaction. Transaction cost theory examines the theory that directors would rather enter into agreements for their sources of goods and services as this reduces uncertainty as they have everything they need for the foreseeable future. By doing this the time and expense of sourcing materials is avoided.

Coase believed that, on average, directors would prefer to lose the flexibility of searching for inputs in order to have the certainty of predicting what would happen with their business in the future. Whilst committing to long-term agreements and contracts avoids uncertainty and is easier to control, it could mean that better opportunities may be missed.

Coase’s concern was that directors were making their own life easier at the expense of opportunities that would improve shareholder wealth. However, if directors are not concerning themselves with constantly sourcing and renegotiating resources, they have more time to spend on longer-term strategy issues.

Transaction cost theory explains why companies are getting bigger. Transaction cost theory says that in order to reduce uncertainty and to increase control, a company should tie itself up in more agreements and this therefore means more staff, more assets, more contracts and a larger company.

Alternatively, a board of directors who are worried about the security of their supplies may choose to buy the company that supplies them. This is called vertical integration. The downside to vertical integration is that supplies will always come from that one company and there may be better quality or prices to be had elsewhere.

This helps to explain why the agency problem is getting worse. A larger company means the gap between shareholders and directors gets bigger.

In Summary:

1. Directors are likely to prefer to own things, or at least have long-term contracts in place, because it makes their lives easier through increased control and certainty over the future.
2. As such, they are likely to create larger and larger organisations/companies. This may be good for them, but may not result in the best decisions for shareholders or other stakeholders as:

• the organisation may grow larger than is efficient;
• by agreeing long term contracts, the ability to take advantage of good deals in the future may be lost;
• because directors will get to know company staff, assets etc. very well (because they are internal), they may simply renew contracts without looking at outside options.

COMPARISON OF RULES-BASED AND PRINCIPLES-BASED SYSTEMS

RULES BASED

1. As it is rules based, compliance will be 100%.
2. Non-compliance is punishable by law including fines, de-listing and imprisonment of directors.
3. If the law is good then it will give shareholders assurance that a company is being run effectively.
4. It lacks flexibility as laws are slow to change.
5. In making the rules law and the penalties high, companies can overdo their corporate governance. This is costly and time consuming.

PRINCIPLES BASED SYSTEM

1. It is flexible so companies of different sizes, nature or stages of development can comply.
2. Companies can comply with spirit of principles rather than just ‘ticking boxes’.

Rule-bases and Principles-based Corporate Governance Approach

Characteristics of Rule Based Approach

1. prescribed set of cg requirements
2. quick way of ensuring compliance
3. adopts a checklist approach
4. clear distinction between compliance and non-compliance
5. easy to see that entity is complying
6. reduction of flexibility on the part of management and auditors
7. difficult to set rules to cover all situations
8. possible to misinterpret rules
9. same rules apply to all, whatever their size

Characteristics of Principles Based Approach

1. activities of entities must address major principles set out in codes of best practice
2. not simply a box ticking exercise
3. more difficult to avoid than a rules based approach
4. easy to see that entity is complying
5. directors required to work in the entity's best interests
6. more flexible, and therefore better able to deal with new situations
7. easier justification for apparent breach of principles
8. but principles may be interpreted differently

Underlying Concepts of Corporate Governance

These are the fundamental concepts behind how companies (and more importantly those involved with companies, primarily directors) should behave. These concepts are very individual in nature; remember, it is the individual who decides how to act, and therefore corporate governance is as important to the individual as it is to the company that the individual represents.

1 FAIRNESS

All people affected by decisions (stakeholders) should be treated with equal consideration. Fairness implies an open and even handed approach without bias.

2 OPENNESS/TRANSPARENCY

All information should be made available to stakeholders, and in a clear manner. This may suggest companies should not just follow disclosure rules, but also add voluntary disclosures if it adds to transparency. The greater the level of transparency in decision making and reporting to shareholders, the lower the agency cost.

3 INDEPENDENCE

All those in a position of monitoring should be independent of those/what they are monitoring:

• Non-executive directors should be independent of the executive directors, and of company operations as their role is to monitor performance.
• External auditors should be independent of the company, especially its accounting department and processes.
• Internal auditors should be independent of the company, as they are likely to be involved in monitoring systems throughout the company’s operations.

4 PROBITY/HONESTY

This is not just telling the truth, it also means finding out the truth, not ignoring it and not ‘turning a blind eye’.

In a company scenario honesty is required in financial reporting and should be embedded in the culture of the organisation.

5 RESPONSIBILITY

Directors should understand and accept their responsibility to shareholders and other stakeholders. They should act in their best interests and be willing to accept the consequences if they fail in this responsibility.

6 ACCOUNTABILITY

Directors must be willing to be held accountable for their actions so they must accept responsibility for the roles entrusted to them. They are accountable to the shareholders as the company’s owners and shareholders cannot exercise their own responsibility (as owners) unless they receive relevant information from the directors.

 7 REPUTATION

Directors must protect their own reputation, and that of the company they run, as damage to either is likely to lead to more widespread damage to the company. Accountants should protect their own reputation as well as that of the professional body to which they belong.

This raises an interesting debate about whether a director’s private life is in fact private – since a bad personal reputation is likely to affect their business reputation and hence that of the company.

8 JUDGEMENT

Directors must ensure they have all the necessary information and understanding in order to be able to make sensible business decisions that improve the prosperity of the company.

9 INTEGRITY

This is quite a general term and has a crossover with some of the other terms above. Integrity means honesty, fair-dealing, presenting information without any attempt to bias opinion and in a more general sense ‘doing the right thing’.