Scope of corporate governance

We start this Text by discussing corporate governance, a fundamental topic in this
paper. You have encountered corporate governance already in your law and auditing
studies, but this syllabus requires a deeper understanding of what has driven the
development of corporate governance codes over the last 15 years.
We start by looking at the principles that underpin corporate governance codes. Some
will be familiar from what you have learnt about ethics in auditing. We shall examine
ethics in detail in Part C of this Text, but you’ll find that certain ethical themes recur
throughout this book.
In Section 2 we show how corporate governance has partly developed in response to
the problem of agency – the difficulty of ensuring that shareholders are able to
exercise sufficient control over directors and managers, their agents. In Section 3 we
consider the interests of other stakeholders in corporate governance. As we shall see
in later chapters, a key issue in the development of corporate governance is how
much, if at all, directors/managers have a responsibility to consider the interests of
stakeholders other than shareholders. The examiner has stressed the need for
understanding that business decisions are affected by, and can affect, many people
inside and outside the business.
In the last section we introduce other major corporate governance issues. We shall
see how corporate governance guidelines address these in the next two chapters.

Study guide

    Intellectual level
A1 The scope of governance  
(a) Define and explain the meaning of corporate governance. 2
(b) Explain and analyse the issues raised by the development of the joint stock company as the dominant form of business organisation and the separation of ownership and control over business activity. 3
(c) Analyse the purpose and objectives of corporate governance in the public and private sectors. 2
(d) Explain and apply in the context of corporate governance the key underpinning concepts. 3
(e) Explain and assess the major areas of organisational life affected by issues in corporate governance. 3
(f) Compare and distinguish between public, private and non-governmental organisations (NGOs) with regard to the issues raised by, and the scope of, governance. 3
(g) Explain and evaluate the roles, interests and claims of the internal parties involved in corporate governance. 3
(h) Explain and evaluate the roles, interests and claims of the external parties involved in corporate governance. 3
(i) Analyse and discuss the role and influence of institutional investors in corporate governance systems and structures, for example the roles and influences of pension funds, insurance companies and mutual funds. 2
A2 Agency relationships and theories  
(a) Define and explore agency theory. 2
(b) Define and explain the key concepts in agency theory. 2
(c) Explain and explore the nature of the principal-agent relationship in the context of corporate governance. 3
(d) Analyse and critically evaluate the nature of agency accountability in agency relationships. 3
(e) Explain and analyse the following other theories used to explain aspects of the agency relationship: Transactions cost theory and Stakeholder theory. 2
A7 Corporate governance and corporate social responsibility  
(b) Discuss and critically assess the concept of stakeholder power and interest using the Mendelow model and how this can affect strategy and corporate governance. 3

Exam guide

You may be asked about the significance of the underlying concepts in Section 1, or to analyse a corporate governance scenario in terms of the agency responsibilities directors or auditors have towards various stakeholders, given the claims the stakeholders have on the organisation. Questions may also examine the roles of other participants in corporate governance. Questions will not always be about listed companies. They will also cover public sector organisations and charities. The issues highlighted in the last section could well be important problems in a scenario question. To quote the examiner: ‘Most questions will involve some focus on, or connection with, the stakeholders and how their agents act on their behalf. Students will have to identify the relevant stakeholders primarily by assessing their power and interest.’

                                1 Definitions of corporate governance     12/12, 12/14, 6/15

Corporate governance, the system by which organisations are directed and controlled, is based on a number of concepts, including transparency, independence, accountability and integrity.


1.1 What is corporate governance?

Corporate governance is the system by which organisations are directed and controlled. (Cadbury report)

Corporate governance is a set of relationships between a company’s directors, its shareholders and other stakeholders. It also provides the structure through which the objectives of the company are set, and the means of achieving those objectives and monitoring performance, are determined. (OECD)

Key term


Exam focus         An exam question on corporate governance might start by asking you to define what corporate point           governance is.

A number of comments can be made about these definitions of corporate governance.

  • The management, awareness, evaluation and mitigation of risk are fundamental in all definitions of good governance. This includes the operation of an adequate and appropriate system of control.
  • The notion that overall performance is enhanced by good supervision and management within set best practice guidelines underpins most definitions.
  • Good governance provides a framework for an organisation to pursue its strategy in an ethical and effective way and offers safeguards against misuse of resources, human, financial, physical or intellectual.
  • Good governance is not just about externally established codes; it also requires a willingness to apply the spirit as well as the letter of the law.
  • Good corporate governance can attract new investment into companies, particularly in developing nations. It should mean that shareholders can trust those responsible for running and monitoring the company.
  • Accountability is generally a major theme in all governance frameworks, including accountability not just to shareholders but also to other stakeholders, and accountability not just by directors but by auditors as well.  
  • Corporate governance underpins capital market confidence in companies and in the government/regulators/tax authorities that administer them. It helps protect the value of shareholders’ investment.

1.1.1 History of governance

Governance focuses on ownership because ownership, and therefore financing, results in businesses being formed and expanded. Different systems of governance are seen as best practice in different countries, as we shall see later in this text. However, much of the governance debate has been seen in the context of the so-called Anglo-Saxon model where ownership and management are separate, and companies can obtain a listing on a stock exchange where their shares are bought and sold.

1.1.2 Governance in companies and non-governmental organisations

Although mostly discussed in relation to large quoted companies, governance is an issue for all corporate bodies, commercial and not for profit, including public sector and non-governmental organisations. There are certain ways in which companies might differ from other types of organisation, such as their ownership (principals), their mission and the legal/regulatory environment within which they operate.

Public sector organisations are organisations that are controlled by one or more parts of the state. Their functions are often to implement government policy in secretarial or administration areas. Some are supervised by government departments (for example hospitals or schools). Others are devolved bodies, such as local authorities, nationalised companies (majority or all of the shares owned by the Government), supranational bodies or non-governmental organisations.

These organisations are in the public sector because the control over a particular public service, utility or public good is seen as so important that it cannot be left to the profit-motivated sector, which may for example seek to close socially vital loss-making services, such as bus routes.

Objectives will be determined by the political leaders in line with government policy. They are likely to focus on value for money and service delivery objectives, possibly underpinned by legislation. The level of control may be high, leading to accusations of excess bureaucracy and cost.

In many countries there are thousands of charities and voluntary organisations that exist to fulfil a particular purpose, maybe social, environmental, religious or humanitarian. Funds are raised to support that purpose. Charities are not owned as such, but will be primarily responsible to the donors of funds and the beneficiaries (those who receive money or other aid) out of the charities’ resources. Charities will be subject to their own legal regime that grants privileges (for example tax concessions) but imposes requirements on how funds can be spent and the charities’ assets managed.

As well as being crucial to passing P1, you also need to be able to demonstrate your contribution to effective and appropriate governance in your area of responsibility in order to fulfil performance objective 4 of your PER.

1.2 Corporate governance concepts

One view of governance is that it is based on a series of underlying concepts.

1.2.1 Fairness

The directors’ deliberations and also the systems and values that underlie the company must be balanced by taking into account everyone who has a legitimate interest in the company, and respecting their rights and views. In many jurisdictions, corporate governance guidelines reinforce legal protection for certain groups, for example minority shareholders. It should mean the company deals even-handedly with others.

                                 1.2.2 Transparency                              12/07, 12/08, 6/11, 6/13, 6/14
Transparency means open and clear disclosure of relevant information to shareholders and other stakeholders, as well as not concealing information when it may affect decisions. It means open discussions and a default position of information provision rather than concealment.
Key term

Disclosure in this context obviously includes information in the financial statements, not just the numbers and notes to the accounts but also narrative statements such as the directors’ report and the operating and financial or business review. It also includes all voluntary disclosure; that is, disclosure above the minimum required by law or regulation. Voluntary corporate communications include management forecasts, analysts’ presentations, press releases, information placed on websites and other reports such as standalone environmental or social reports.

The main reason why transparency is so important relates to the agency problem that we shall discuss in Section 2, the potential conflict between owners and managers. Without effective disclosure the position could be unfairly weighted towards managers, since they have far more knowledge of the company’s activities and financial situation than the owner/investors. Avoidance of this information asymmetry requires not only effective disclosure rules but also strong internal controls that ensure the information that is disclosed is reliable. Information also needs to be published in sufficient detail to meet the needs of shareholders/owners. Publication of abbreviated information may be counter-productive and may give the impression of concealment rather than openness.

Linked with the agency issue, publication of relevant and reliable information reassures investors and underpins stock market confidence in how companies are being governed and thus significantly influences market prices. International accounting standards and stock market regulations based on corporate governance codes require information published to be true and fair. Information can only fulfil this requirement if adequate disclosure is made of uncertainties and adverse events. It is therefore clear that financial data will be insufficient without supporting explanation.

Circumstances where concealment may be justified include discussions about future strategy (knowledge of which would benefit competitors), confidential issues relating to individuals and discussions leading to an agreed position that is then made public.



Ethics guru Chris Macdonald has raised a number of issues with the concept of transparency.

  1. The requirement of transparency to check how directors (agents) are doing indicates a big problem with governance. If shareholders had complete confidence in directors, there would be no concern about transparency.
  2. Transparency assumes that those who receive information are well informed but problems may arise through misinterpretation. The example quoted was a hospital executive being criticised for having the perk of expensive membership of an exclusive private club. However, if the executive was responsible for fundraising, the club would provide networking opportunities with members who could make large donations to the hospital.
  3. In the context of directors’ remuneration (discussed in Chapter 3) evidence suggests that full transparency can ratchet up average reward. A chief executive, seeing how much other chief executives in their sector are earning, may want their rewards to match theirs. A remuneration committee may regard the fact that its chief executive is earning below average remuneration as poor publicity for the chief executive and the company.
  4. Full transparency of rewards of one type may lead to those in positions of trust to seek less visible, and perhaps more costly, rewards. For example, the 2009 scandal about excessive expenses being claimed by UK Members of Parliament was linked to the political unacceptability of increasing MPs’ salaries significantly. To head off a revolt by members, the Conservative Government in the 1980s introduced a big increase in members’ expense allowances, with the minister responsible allegedly telling MPs ‘go out boys and spend it.’


Weighing up transparency against confidentiality may be difficult and hence the examiner tests it regularly. Remember that sometimes there may be valid commercial reasons for keeping information away from those who may use it against the company. On the other hand, greater transparency and providing a full explanation for controversial actions can be an effective means of responding to critics.
Exam focus point
1.2.3 Innovation

The concept of innovation in the approach to corporate governance recognises the fact that the needs of businesses and stakeholders can change over time. It also has an impact on how organisations respond to meeting the ‘comply or explain’ requirement contained in various codes of corporate governance that are currently in effect.

1.2.4 Scepticism

The UK Corporate Governance Code, under the heading of ‘Leadership’, encourages non-executive directors (NEDs) to adopt an air of scepticism so that they can effectively challenge management decisions in their role of scrutiny. Applying professional scepticism is also an important part of the role of auditors and audit committees. ISA 200 defines professional scepticism as: ‘An attitude that includes a questioning mind, being alert to conditions which may indicate possible misstatement due to error or fraud, and a critical assessment of audit evidence.’ This does not mean that all management decisions and evidence have to be approached with suspicion or mistrust; but rather that an open and enquiring mind must always be employed. A healthy corporate culture and environment is one that encourages and enables such scepticism to thrive.

1.2.5 Independence
Independence is the avoidance of being unduly influenced by vested interests and free from any constraints that would prevent a correct course of action being taken. It is an ability to stand apart from inappropriate influences and be free of managerial capture, to be able to make the correct and uncontaminated decision on a given issue.

Independence is a quality that can be possessed by individuals and is an essential component of professionalism and professional behaviour.      

Key term

An important distinction generally with independence is independence of mind and independence of appearance.

  • Independence of mind means providing an opinion without being affected by influences compromising judgement.
  • Independence of appearance means avoiding situations where an informed third party could reasonably conclude that an individual’s judgement would have been compromised.

Independence is an important concept in relation to directors; in particular, freedom from conflicts of interest. Corporate governance reports have increasingly stressed the importance of independent nonexecutive directors, directors who are not primarily employed by the company and who have very strictly controlled other links with it. They should be in a better position to promote the interests of shareholders and other stakeholders. Freed from pressures that could influence their activities, independent nonexecutive directors should be able to carry out effective monitoring of the company and its management in conjunction with equally independent external auditors on behalf of shareholders.

Non-executive directors’ lack of links and limits on the time that they serve as non-executive directors should promote avoidance of managerial capture – accepting executive managers’ views on trust without analysing and questioning them.

As you will remember from Paper F8, the independence of external auditors from their clients is also important in corporate governance (covered further in Chapter 10). As the auditor is acting on behalf of the shareholders and not the client, close friendship with the client may influence the external auditor’s judgement, and mean that the external auditor is not effectively representing the shareholders’ interests.   Internal auditors also need to be independent of the colleagues whom they are auditing (discussed in Chapter 8).

A complication when considering independence is that there are varying degrees of independence, lying between total independence (no knowledge/connection with the other party) and zero independence

(inability to take a decision without considering the effect on the other party). In real-life situations the two extremes are unlikely, but in most situations independence should be as near to total independence as possible.



Question   External auditor independence
Why is the independence of external auditors so important?  


  • Shareholders and other stakeholders need a trustworthy record of directors’ stewardship to be able to take decisions about the company. Assurance provided by independent auditors is a key quality control on reliability.
  • An unqualified report by independent external auditors on the accounts should give them more credibility, enhancing the appeal of the company to investors.
  • A lack of independence may mean that an effective audit is not done. Thus the shareholders are not receiving value for the costs of the audit.
  • A lack of independence may lead to a failure to fulfil professional requirements. Failure to do this undermines the credibility of the accountancy profession and the standards it enforces.


1.2.6 Probity/honesty

Hopefully this should be the most self-evident of the principles. It relates to not only telling the truth but also not misleading shareholders and other stakeholders. Lack of probity includes not only obvious examples of dishonesty, such as taking bribes, but also reporting information in a slanted way that is designed to give an unfair impression.

Guidance in the UK charitable sector has defined probity in terms of receipt of gifts or hospitality by trustees. The Code stresses that all gifts should be clearly recorded, and trustees should not accept gifts with a significant monetary value or lavish hospitality. They should certainly not accept gifts or hospitality which may seem likely to influence their decisions.

1.2.7 Responsibility

Responsibility means management accepting the credit or blame for governance decisions. It implies clear definition of the roles and responsibilities of the roles of senior management.

The South African King report stresses that, for management to be held properly responsible, there must be a system in place that allows for corrective action and penalising mismanagement. Responsible management should do, when necessary, whatever it takes to set the company on the right path.

King states that the board of directors must act responsively to, and with responsibility towards, all stakeholders of the company. However, the responsibility of directors to other stakeholders, both in terms of to whom they are responsible and the extent of their responsibility, remains a key point of contention in corporate governance debates. We shall discuss the importance of stakeholders later in this chapter.

The limits of responsibility and how responsibility is enforced will be a recurring theme throughout this text, developed further in:

  • Chapters 2-3, on corporate governance
  • Chapters 4-8, covering directors’ responsibilities in respect of risk management and internal control
  • Chapters 9-10, covering accountants’ responsibilities to clients and society
  • Chapter 11, covering corporate social responsibility
                                 1.2.8 Accountability                                                                     12/12
Corporate accountability refers to whether an organisation (and its directors) is answerable in some way for the consequences of its actions.
Key term

Directors being answerable to shareholders have always been an important part of company law, well before the development of the corporate governance codes. For example, companies in many regimes have been required to provide financial information to shareholders on an annual basis and hold annual general meetings. However, particularly because of the corporate governance scandals of the last 30 years, investors have demanded greater assurance that directors are acting in their interests. This has led to the development of corporate governance codes, which we shall consider in the next chapter.

Making accountability work is the responsibility of both parties. Directors, as we have seen, do so through the quality of information that they provide whereas shareholders do so through their willingness to exercise their responsibility as owners, which means using the available mechanisms to query and assess the actions of the board.  Public sector accountability

The accountability relationship will be different for bodies owned or run by national or central government. The nature of the relationship may be clear – that government determines objectives. How accountability is demonstrated and enforced may depend though on how coherent the objectives are. The main problem will often be where the body’s main objectives are non-economic, but the Government also wishes to limit the amount it spends on the body.

As with responsibility, one of the biggest debates in corporate governance is the extent of management’s accountability towards other stakeholders, such as the community in which the organisation operates. This has led on to a debate that we shall discuss in Chapter 10 about the contents of accounts themselves.

In the context of public service, the UK Nolan Committee on Standards in Public Life commented that holders of public office are accountable for their decisions and actions to the public, and must submit themselves to whatever scrutiny is appropriate for their office.

A wider issue with the extent of accountability in the public sector is the extent of accountability towards different groups in society. For example, politicians can be seen as being accountable to the body of taxpayers as a whole – it is their interests that parliamentary bodies have been established to represent. However, politicians are also accountable to a group within the category of taxpayers – the voters who voted for them. This raises the issue of what happens if the actions politicians take advantage their voters, but disadvantage other taxpayers. More controversially, there is the issue of the extent to which politicians should be accountable to donors who pay significant sums to finance their political activities.

The examiner has commented:

‘When I say accountability, I mean companies to investors, professionals to their values, business systems to their stakeholders and so forth.’

These comments emphasise that accountability, like responsibility, is a topic that underpins much of the rest of this text and will be a key feature in many exam questions. The comments indicate that it is possible to be accountable to an abstract set of values. However, much of the discussion about accountability focuses on the extent of accountability to stakeholders, particularly when stakeholder interests differ.

Exam focus point
Reputation                  6/14

Reputation is determined by how others view a person, organisation or profession. Reputation includes a reputation for competence, supplying good quality goods and services in a timely fashion, and also being managed in an orderly way. However, a poor ethical reputation can be as serious for an organisation as a poor reputation for competence.

The consequences of a poor reputation for an organisation can include:

  • Suppliers’ and customers’ unwillingness to deal with the organisation for fear of being victims of sharp practice
  • Inability to recruit high-quality staff
  • Fall in demand because of consumer boycotts
  • Increased public relations costs because of adverse stories in the media
  • Increased compliance costs because of close attention from regulatory bodies or external auditors
  • Loss of market value because of a fall in investor confidence


Over the past few years the American retail giant Wal-Mart has made efforts to improve its reputation in various ways. These have included improving its labour and healthcare records, donating to not for profit organisations and promoting the case that it helps economic growth and provides healthy groceries. This has partly been for strategic purposes, as the company has sought to open stores in cities in face of local hostility, due to the adverse effect on other local retailers.

Unfortunately Wal-Mart’s attempts to portray itself as more ethical have been undermined by a recent bribery scandal, as we shall see in Chapter 10.


We shall see later on in this Text how risks to an organisation’s reputation depend on how likely other risks are to crystallise.

In the context of governance, reputation also means personal and professional reputation, and the moral reputation of the accountancy profession as a whole. All are influenced by the extent to which individuals or members of the profession demonstrate the other underlying concepts we have discussed.

                                 1.2.10 Judgement                                                                           6/14

Judgement means the board making decisions that enhance the prosperity of the organisation. This means that board members must acquire a broad enough knowledge of the business and its environment to be able to provide meaningful direction to it. This has implications not only for the attention directors have to give to the organisation’s affairs, but also on the way the directors are recruited and trained.

As you will see when you come to study Paper P3, the complexities of senior management mean that the directors have to bring multiple conceptual skills to management that aim to maximise long-term returns. This means that corporate governance can involve balancing many competing people and resource claims against each other. Although, as we shall see, risk management is an integral part of corporate governance, corporate governance isn’t just about risk management.

                                 1.2.11 Integrity                                                                   6/10, 06/13

Key term     Integrity means straightforward dealing and completeness. What is required of financial reporting is that

it should be honest and that it should present a balanced picture of the state of the company’s affairs. The integrity of reports depends on the integrity of those who prepare and present them.’ (Cadbury report)

Integrity (means that) holders of public office should not place themselves under any financial or other obligation to outside individuals or organisations that might influence them in the performance of their

official duties.                                      UK Nolan Committee Standards on Public Life

Integrity can be taken as meaning someone of high moral character, who sticks to strict moral or ethical principles no matter the pressure to do otherwise. In working life this means adhering to the highest standards of professionalism and probity. Straightforwardness, fair dealing and honesty in relationships with the different people and constituencies whom you meet are particularly important. Trust is vital in relationships and belief in the integrity of those with whom you are dealing underpins this.

Integrity is an underlying principle of corporate governance. All those in agency relationships should possess and exercise absolute integrity. To fail to do so breaches the relationship of trust. The Cadbury report definition highlights the need for personal honesty and integrity of preparers of accounts. This implies qualities beyond a mechanical adherence to accounting or ethical regulations or guidelines. At times accountants will have to use judgement or face financial situations which aren’t covered by regulations or guidance, and on these occasions integrity is particularly important.

Integrity is an essential principle of the corporate governance relationship, particularly in relationship to representing shareholder interests and exercising agency (discussed in Section 2). Monitoring and hence agency costs can be reduced if there is trust in the integrity of the agents. In addition, we have seen that a key aim of corporate governance is to inspire confidence in participants in the market and this significantly depends on a public perception of competence and integrity.

Integrity is also one of the fundamental principles discussed in the IESBA code of ethics (see Chapter 10). It provides assurance to those with whom the accountant deals of good intentions and truthfulness.

Exam focus               The Pilot Paper asks for an explanation of what integrity is, and its importance in corporate governance.

point                       The December 2007 exam asked about the significance of transparency. The June 2013 exam had a question about the importance of integrity and transparency. You may be asked similar questions about other principles.

2 Corporate governance and agency theory 6/08, 6/09, 6/10


Agency is extremely important in corporate governance, as the directors/managers are often acting as agents for the owners. Corporate governance frameworks aim to ensure directors/managers fulfil their responsibilities as agents by requiring disclosure and suggesting they be rewarded on the basis of performance.

2.1 Nature of agency 12/14, 6/15

Key term Agency relationship is a contract under which one or more persons (the principals) engage another

person (the agent) to perform some service on their behalf that involves delegating some decision-making

authority to the agent.                                                               (Jensen and Meckling)

You will have encountered agency in your earlier studies, but a brief revision will be helpful. There are a number of specific types of agent. These have either evolved in particular trades or developed in response to specific commercial needs. Examples include factors, brokers, estate agents, bankers and auctioneers.

Agency in the context of director-shareholder relationships is discussed below. However, there are many other types of agency relationships. Corporate governance guidance is concerned with the shareholderauditor agency relationship as well as the shareholder-manager relationship. The auditors act as the shareholders’ agents when carrying out an audit, and thus the shareholders wish them to maintain their independence of the management of the company being audited. The problems auditors have when attempting to maintain their independence is dealt with in governance guidance.

Exam focus        Question 1 in June 2009 asked about the agency relationship between a bank and the trustees of a point      pension fund that invested in the bank. However, not all organisations have private shareholders/investors. June 2010 Question 1 examined the agency situation in a nationalised company wholly owned by the home country government. Not only the Government but also the taxpayers are principals there. Managers running a charity will be acting as agents for the trustees who represent the principals (donors and recipients of aid). In December 2013 there was a question requiring a definition of agency in the context of corporate governance.

2.2 Accountability and fiduciary responsibilities

2.2.1 Accountability

Key term                In the context of agency, accountability means that the agent is answerable under the contract to their principal and must account for the resources of their principal and the money they have gained working on their principal’s behalf.

Two problems potentially arise with this.

  • How does the principal enforce this accountability (the agency problem, see below)? As we shall see, the corporate governance systems developed to monitor the behaviour of directors have been designed to address this issue.
  • What if the agent is accountable to parties other than their principal – how do they reconcile possibly conflicting duties (for the stakeholder view see Section 3)?
                                 2.2.2 Fiduciary duty                                                                      06/13
Fiduciary duty is a duty of care and trust which one person or entity owes to another. It can be a legal or ethical obligation.     

In law it is a duty imposed on certain persons because of the position of trust and confidence in which they stand in relation to another. The duty is more onerous than generally arises under a contractual or tort relationship. It requires full disclosure of information held by the fiduciary, a strict duty to account for any profits received as a result of the relationship, and a duty to avoid conflicts of interest.


Key term

Under English law company directors owe a fiduciary duty to the company to exercise their powers bona fide in what they honestly consider to be the interests of the company. This duty is owed to the company and not generally to individual shareholders. In exercising the powers given to them by the constitution the directors have a fiduciary duty not only to act bona fide but also only to use their powers for a proper purpose. The powers are restricted to the purposes for which they were given.

Clearly the concepts of fiduciary duty and accountability are very similar though not identical. Where certain wider responsibilities are enshrined in law, do directors have a duty to go beyond the law, or can they regard the law as defining what society as a whole requires of them?

                                 2.2.3 Fiduciary relationship with stakeholders                           12/07

Evan and Freeman have argued that management bears a fiduciary relationship to stakeholders and to the corporation as an abstract entity. It must act in the interests of the stakeholders as their agent, and it must act in the interests of the corporation to ensure the survival of the firm, safeguarding the long-term stakes of each group. Adoption of these principles would require significant changes to the way corporations are run. Evan and Freeman propose a ‘stakeholder board of directors’, with one representative for each of the stakeholder groups and one for the company itself. Each stakeholder representative would be elected by a stakeholder assembly. Company law would have to develop to protect the interests of stakeholders.

Exam focus        Question 4 in December 2007 asked students not only to explain what fiduciary responsibility was but also point    to argue the case in favour of extending it. This illustrates that the examiner does not regard fiduciary duty as a legal concept set in stone, but one that can be used flexibly. A question in June 2013 asked for a description of fiduciary duty in the context of the case presented in the question.

2.2.4 Performance

The agent who agrees to act as agent for reward has a contractual obligation to perform their agreed task. An unpaid agent is not bound to carry out their agreed duties. Any agent may refuse to perform an illegal act.

2.2.5 Obedience

The agent must act strictly in accordance with their principal’s instructions provided that these are lawful and reasonable. Even if they believe disobedience to be in their principal’s best interests, they may not disobey instructions. Only if they are asked to commit an illegal act may they do so.

2.2.6 Skill

A paid agent undertakes to maintain the standard of skill and care to be expected of a person in their profession.

2.2.7 Personal performance

The agent is presumably selected because of their personal qualities and owes a duty to perform their task themselves and not to delegate it to another. But they may delegate in a few special circumstances, if delegation is necessary, such as a solicitor acting for a client would be obliged to instruct a stockbroker to buy or sell listed securities on a stock exchange.

2.2.8 No conflict of interest

The agent owes to their principal a duty not to put themselves in a situation where their own interests conflict with those of the principal. For example, they must not sell their own property to the principal (even if the sale is at a fair price).

2.2.9 Confidence

The agent must keep in confidence what they know of their principal’s affairs even after the agency relationship has ceased.

2.2.10 Any benefit

Any benefit must be handed over to the principal unless they agree that the agent may retain it. Although an agent is entitled to their agreed remuneration, they must account to the principal for any other benefits. If they accept from the other party any commission or reward as an inducement to make the contract with him, it is considered to be a bribe and the contract is fraudulent.

2.3 Agency in the context of the director-shareholder relationship 6/08

Agency is a significant issue in corporate governance because of the dominance of the joint-stock company, the company limited by shares as a form of business organisation. For larger companies this has led to the separation of ownership of the company from its management. The owners (the shareholders) can be seen as the principal, the management of the company as the agents.

Although ordinary shareholders (equity shareholders) are the owners of the company to whom the board of directors is accountable, the actual powers of shareholders tend to be restricted. They normally have no right to inspect the books of account, and their forecasts of future prospects are gleaned from the annual report and accounts, stockbrokers, journals and daily newspapers.

The day-to-day running of a company is the responsibility of the directors and other managers to whom the directors delegate, not the shareholders. For these reasons, therefore, there is the potential for conflicts of interest between management and shareholders.

December 2013 Question 2 asked students to explain agency in the context of corporate governance.
Exam focus point

2.4 The agency problem

The agency problem in joint stock companies derives from the principals (owners) not being able to run the business themselves and therefore having to rely on agents (directors) to do so for them. This separation of ownership from management can cause issues if there is a breach of trust by directors by intentional action, omission, neglect or incompetence. This breach may arise because the directors are pursuing their own interests rather than the shareholders’ or because they have different attitudes to risk taking to the shareholders.

For example, if managers hold none or very few of the equity shares of the company they work for, what is to stop them from working inefficiently, concentrating too much on achieving short-term profits and hence maximising their own bonuses, not bothering to look for profitable new investment opportunities, or giving themselves high salaries and perks?

One power that shareholders possess is the right to remove the directors from office. But shareholders have to take the initiative to do this and, in many companies, the shareholders lack the energy and organisation to take such a step. Ultimately they can vote in favour of a takeover or removal of individual directors or entire boards, but this may be undesirable for other reasons.

2.5 Agency costs

To alleviate the agency problem, shareholders have to take steps to exercise control, such as attending AGMs or ultimately becoming directors themselves. However, agency theory assumes that it will be expensive and difficult to:

  • Verify what the agent is doing, partly because the agent has available more information about his activities than the principal does
  • Introduce mechanisms to control the activities of the agent

The principals therefore incur agency costs, which are the costs of the monitoring that is required because of the separation of ownership and management.   Common agency costs include:

  • Costs of studying company data and results
  • Purchase of expert analysis
  • External auditors’ fees
  • Costs of devising and enforcing directors’ contracts
  • Time spent attending company meetings
  • Costs of direct intervention in the company’s affairs
  • Transaction costs of shareholding

To fulfil the requirements imposed on them (and to obtain the rewards of fulfilment) managers will spend time and resources proving that they are maximising shareholder value by, for example, providing increased disclosure or meeting with major shareholders.

Agency costs can be expensive for shareholders only holding shares in a few companies. For larger-scale investors, holding a portfolio containing the shares of many different companies, agency costs can be prohibitive. This illustrates the importance of minimising agency costs by aligning the interests of shareholders and directors.

Exam focus         Your syllabus stresses the significance of agency problems in public listed companies.  point

2.6 Resolving the agency problem: alignment of interests

Agency theory sees employees of businesses, including managers, as individuals, each with their own objectives. Within a department of a business, there are departmental objectives. If achieving these various objectives leads also to the achievement of the objectives of the organisation as a whole, there is said to be alignment of interests.

Key term                Alignment of interests is accordance between the objectives of agents acting within an organisation and the objectives of the organisation as a whole. Alignment of interests is sometimes referred to as goal congruence, although goal congruence is used in other ways, as you will see in your P3 studies.

Alignment of interests may be better achieved and the ‘agency problem’ better dealt with by giving managers some profit-related pay, or by providing incentives that are related to profits or share price. Examples of such remuneration incentives are:

  • Profit-related/economic value-added pay

Pay or bonuses related to the size of profits or economic value-added.

  • Rewarding managers with shares

This might be done when a private company ‘goes public’ and managers are invited to subscribe for shares in the company at an attractive offer price. In a management buy-out or buy-in (the latter involving purchase of the business by new managers, the former by existing managers), managers become joint owner-managers.

  • Executive share option plans (ESOPs)

In a share option scheme, selected employees are given a number of share options, each of which gives the holder the right after a certain date to subscribe for shares in the company at a fixed price. The value of an option will increase if the company is successful and its share price goes up, therefore giving managers an incentive to take decisions to increase the value of the company, actions congruent with wider shareholder interests.

Such measures might merely encourage management to adopt ‘creative accounting’ methods which will distort the reported performance of the company in the service of the managers’ own ends.

An alternative approach is to attempt to monitor managers’ behaviour; for example, by establishing ‘management audit’ procedures, to introduce additional reporting requirements, or to seek assurances from managers that shareholders’ interests will be foremost in their priorities. The most significant problem with monitoring is likely to be the agency costs involved, as they may imply significant shareholder engagement with the company.

2.7 Other agency relationships

2.7.1 Shareholder-auditor relationship

The shareholder-auditor relationship is another agency relationship on which corporate governance guidance has focused. The shareholders are the principals, the auditors are the agents and the audit report the key method of communication.

2.7.2 Shareholder-auditor relationship in public companies

An agency problem with auditors is that auditors may not be independent of the management of the companies that they audit. They become too close to management or are afraid that management will not give them non-audit work.

Corporate governance codes have sought to address this problem. However, the shareholder-auditor relationship in public companies imposes its own complexities. The auditors are acting as shareholders’ agents in monitoring the stewardship of directors. However, as we shall see in Chapter 8, the (nonexecutive) directors, who are on the audit committee, effectively also act as shareholders’ agents in monitoring the auditors. They are responsible for recommending the appointment and removal of the external auditors, fixing their remuneration, considering independence issues and discussing the scope of the audit.

The implication perhaps in most governance guidance is that the external auditors and non-executive directors are ‘on the same side’, with conflicts most likely to arise in tensions with executive directors (hence the possibility being raised in governance guidance of the external auditors and audit committee meeting without executive management being present). The situation breaks down if there is conflict between auditors and non-executive directors. Auditors then have the right to qualify their audit reports and make statements if they resign, but this is clearly a sign of problems that may require stakeholder intervention, time and cost.

2.7.3 Agency costs of external audit

Direct costs are obviously the audit fee. In addition, there will be the time spent by management and employees dealing with the information and preparing information for the auditors.

The amount of audit costs is not solely determined by the shareholders, but also influenced by the professional institutes to which the auditors belong and national and international government bodies. These institutions can influence audit fees directly, for example through rules on low-balling (fees that are too low). They can also impose requirements that indirectly add to the costs of audit. For example, institutes and standard-setting bodies lay down requirements that auditors must fulfil, impacting on the quality of work and the costs to be recovered. Governments, too, can take measures that will affect costs. For example, recent EU proposals (discussed further in Chapter 10) would require compulsory rotation of auditors every few years. This would most probably increase audit costs over time because new auditors would incur set-up costs when they started acting for a new client.

This in turn raises the issue of the extent to which influences other than shareholder opinions should determine audit work and audit costs. One argument might be that the audit fee is effectively a cost of risk management which reduces the earnings available to shareholders. If the shareholders are happy with the audit fee being low and hence the audit work carried out being limited, this implies that they are happy to accept increased risk in return for lower audit costs and higher earnings – it is fundamentally a risk-return decision. Well-informed potential investors and markets will take a similar view.

Critics of this view would argue that the impact of a company that has been inadequately audited falling into difficulties is potentially severe and goes well beyond the loss of shareholders’ investment. Employees, customers and suppliers can all be adversely affected and the wider economy may also be damaged if the company is large enough.

2.7.4 Other relationships

Other significant agency relationships include directors themselves acting as principals to managers/employees as agents. It is of course a significant responsibility of directors to make sure that this agency relationship works by establishing appropriate systems of performance measurement and monitoring (discussed in Chapter 8). In turn managers will act as principals to employees. There is also the relation between directors/managers and creditors, where creditors are seeking the payment of invoices on a timely basis.

Concerns over strategies and risks 

A major concern in practice is likely to be if the shareholder is concerned about the strategies being adopted or the level of risks being taken, either too high or low. Arguably, if the shareholder is dissatisfied it can sell its shares and invest in companies whose strategies it trusts and whose risk appetites it shares. However in practice transaction costs plus the risk of not realising the full potential value from a sale may mean the shareholder is reluctant to sell.

Lack of communication by company  

If the company does not, or is unwilling to, communicate proactively what shareholders wish to know, shareholders will need to find other means of obtaining information or make efforts to express their dissatisfaction. One thing acknowledged by the boards of companies that have been recently involved in controversy over executive pay (discussed further in Chapter 3) has been the need to communicate better with shareholders about directors’ remuneration.

Inadequacy of governance arrangements    

The shareholder may need to spend more effort monitoring what the company is doing if it feels the corporate governance arrangements are inadequate. Particular concerns might be a very powerful chief executive and a lack of a strong non-executive director presence on the board.

Conflicts with other shareholders  

The shareholder may have to incur costs and time if other, more powerful shareholders do not appear to share the shareholder’s concerns about the company in which they have invested. A common criticism in recent years is that institutional shareholders have given boards an easy ride, and failed to use the power their large shareholdings gives them to press the concerns of small shareholders without much influence.


2.8 Agency and public sector organisations

Public sector organisations also incorporate an agency relationship between the principals (the political leaders and ultimately the taxpayers/electors) and agents (the elected and executive officers and departmental managers). Because the taxpayers and electors have differing interests and objectives, establishing and monitoring the achievement of strategic objectives, and interpreting what is best for the principals, can be very difficult.

The agency problem in public services is also enhanced by limitations on the audit of public service organisations. In many jurisdictions the audit only covers the integrity and transparency of financial transactions and does not include an audit of performance or fitness for purpose.

2.9 Agency and charities

The agents in a charity are those responsible for spending donations and grants given. They include the directors and managers of the charitable services. Controls are needed to ensure that the interests of the principals (donors and recipients of charitable services) are maintained, and that funds are used for the intended purpose and not embezzled or used for self-enrichment.

Charities ensure that the agency problem is reduced and the goodwill of donors maintained by having a board of directors to run the charity, but also trustees to ensure that the board is delivering value to donors and to ensure that the charity’s aims are fulfilled. The trustees generally share the values of the charity and act like non-executive directors of public companies (discussed in Chapter 3). The trustees are likely to have the power to recruit and dismiss directors.

Agency problems in charities may not just arise from managers’ activities. An ambiguous relationship between the aims of the charity and commercial requirements may cause difficulty. Trustee prejudices may also hinder the relationship, particularly if they are trying to represent donors and beneficiaries who are largely silent. A lack of commercial knowledge and an unwillingness to change attitudes by the trustees may make the relationship problematic.

Publication of information about the contribution that the charity makes can help resolve the agency problem in charities. An annual report that clearly states how the charity is run and how it has delivered against its stated terms of reference and objectives can increase the confidence of donors, beneficiaries and regulators. A comprehensive audit of this information will reinforce its usefulness.

2.10 Transaction costs theory

Transactions cost theory is based on the work of Cyert and March and broadly states that the way the company is organised or governed determines its control over transactions. Companies will try to keep as many transactions as possible in-house in order to reduce uncertainties about dealing with suppliers, and about purchase prices and quality. To do this, companies will seek vertical integration (that is, they will purchase suppliers or producers later in the production process).

Transaction cost theory also states that managers are also opportunistic ie organise their transactions to pursue their own convenience. They will also be influenced by the amounts that they personally will gain, the probability of bad behaviour being discovered and the extent to which their actions are tolerated or even encouraged in corporate culture.

A further aspect of the theory is that managers will behave rationally up to a point, but this will be limited by the understanding of alternatives that they have. 

The implications of transaction cost theory are that management may well play safe, and concentrate on easily understood markets and individual transactions they can easily control. This may mean that the company runs efficiently and, in its way, effectively. However, a focus on low-risk activities may discourage potential investors who are looking for a large return. Alternatively, shareholders dissatisfied with low profits may seek greater involvement in governance.

Internally senior managers will need to assess the impact of opportunistic issues, since this should determine the degree of monitoring that is needed over the activities of operational managers.     

Thus despite differences of emphasis, transaction cost theory and agency theory are largely attempting to tackle the same problem, namely to ensure that managers effectively pursue shareholders’ best interests.

                                 3 Types of stakeholders    12/07, 6/08, 12/08, 6/10

Directors and managers need to be aware of the interests of stakeholders in governance; however, their responsibility towards them is judged.


3.1 Stakeholders

Key term                Stakeholders are any entity (person, group or possibly non-human entity) that can affect or be affected by the achievements of an organisation’s objectives. It is a bi-directional relationship. Each stakeholder group has different expectations about what it wants and different claims on the organisation.

                                 3.1.1 Stakeholder claims                                                              12/12

The definition above highlights the important point for both business ethics and strategy, that stakeholders do not only just exist but also have claims on an organisation. Some stakeholders want to influence what the organisation does. Others are mainly concerned with how the organisation affects them and may want to increase or decrease this effect. However, there is the problem that some stakeholders do not know that they have a claim against the organisation, or know that they have a claim but do not know what it is.

A useful distinction is between direct and indirect stakeholder claims.

  • Stakeholders who make direct claims do so with their own voice and generally do so clearly. Normally stakeholders with direct claims themselves communicate with the company.
  • Stakeholders who have indirect claims are generally unable to make the claims themselves because they are for some reason inarticulate or voiceless. Although they cannot express their claim directly to the organisation, this does not necessarily invalidate their claim. Stakeholders may lack power because they have no significance for the organisation, have no physical voice (animals and plants), are remote from the organisation (suppliers based in other countries) or are future generations.

We shall discuss further the legitimacy of stakeholder claims and direct and indirect stakeholders later in this section.

Exam focus        If you are asked to describe and assess a claim in the exam, remember that the fact that some point   stakeholders have no voice does not invalidate their claims. Sometimes their claims may be the most powerful of all.


                                 3.1.2 Importance of recognition of stakeholder claims              12/12

Knowledge of who stakeholders are and what claims they make is a vital part of an organisation’s risk assessment, since the claims made by the stakeholder can affect the achievement of objectives.

Stakeholders also have influences over the organisation. It is important to identify what these are and how significant they are, since it may determine the organisation’s decision if it has to decide between competing stakeholder claims. We discuss the assessment of the influence of stakeholders in terms of their power and interest below. An organisation also needs to know where likely areas of conflict and tension between stakeholders may arise.

3.1.3 Misinterpretation of stakeholder claims

As we shall see later in this chapter, assessment of stakeholder claims is potentially a difficult, subjective process. Organisations may also misinterpret the claims that stakeholders have or are making. This can mean that organisations take wrong or unnecessary actions, or fail to take the right actions, to deal with stakeholder concerns. It also may distort organisational priorities. There is possibly also an increased chance of conflict between the organisation and some stakeholders, as stakeholders who have strong grounds for feeling that their concerns are not being addressed properly take action.

Exam focus

point                       December 2012 Question 4 required students to identify and describe stakeholders and stakeholder claims in a scenario.

                                3.2 Stockholder theory (shareholder theory)                12/08

The theory that focuses on the interests of shareholders is known as stockholder theory, since it is mostly discussed in American literature.

Stockholder theory states that shareholders alone have a legitimate claim to influence over the company. It uses agency theory to argue that shareholders (as principals) own the company. Hence directors as agents have a moral and legal duty only to take account of shareholders’ interests. As it is assumed that shareholders wish to maximise their returns, then directors’ sole duty is to pursue profit maximisation.

This is the view of the pristine capitalist category defined by Gray, Owen and Adams that we shall consider further in Chapter 11.

3.3 Problems with stockholder view

Modern corporations have been seen as so powerful, socially, economically and politically, that unrestrained use of their power will inevitably damage other people’s rights. For example, they may blight an entire community by closing a major factory, inflicting long-term unemployment on a large proportion of the local workforce. They may use their purchasing power or market share to impose unequal contracts on suppliers and customers alike. They may exercise undesirable influence over government through their investment decisions. There is also the argument that corporations exist within society and are dependent on it for the resources they use. Some of these resources are obtained by direct contracts with suppliers but others are not, being provided by government expenditure.

Exam focus

point                       Remember in the exam that the stockholder view isn’t just an economic argument. Behind it is an ethical argument of fairly rewarding those who supply the company with its capital.

                                 3.4 Stakeholder theory                                             12/08, 6/09

Stakeholder theory proposes corporate accountability to a broad range of stakeholders. It is based on companies being so large, and their impact on society being so significant, that they cannot just be responsible to their shareholders. There is a moral case for a business knowing how its decisions affect people both inside and outside the organisation. Stakeholders should also be seen not as just existing, but as making legitimate demands on an organisation. The relationship should be seen as a two-way relationship. There is much debate about which demands are legitimate, as we shall discuss below.

What stakeholders want from an organisation will vary. Some will actively seek to influence what the organisation does and others may be concerned with limiting the effects of the organisation’s activities on themselves.

Relations with stakeholders can also vary. Possible relationships can include conflict, support, regular dialogue or joint enterprise.

Exam focus

point                       If you’re asked to argue in favour of the stakeholder perspective in the exam, you’re likely to have to consider a number of different groups of stakeholders. December 2008 Question 1 required students to assess an ethical decision from the wider stakeholder perspective.



To what extent do you believe that animals should be considered as stakeholders? This is more than just a hypothetical question.

  • Vegetarians do not eat meat because they believe that eating meat is wrong. Animals are ends in themselves, and do not exist just for our pleasure.
  • Some anti-vivisection campaigners, such as The Body Shop, a cosmetics retailer, state they are against ‘animal testing’.
  • Even if animals are to be eaten, some cultures require them to be treated well, according to humane standards, as animals are capable of suffering.
  • The moral status of particular species of animals varies from culture to culture. Pigs are ‘unclean’ in Judaism and Islam. Beef is forbidden to Hindus. British people do not eat ‘horse’, although horses are eaten in other European countries. Similarly, eating dogs is perfectly acceptable in some cultures, but is totally unacceptable elsewhere. Guinea pigs are a food staple in the Andean countries, but are school pets in Britain. In some cultures, insects are eaten, in others, not.
  • How would your views differ if you believed, as is the case in some religions, that animals contain the reincarnated souls of dead people?
  • How would your view change if you believed that, like humans, some animal species are able to ‘learn’, exhibit altruistic behaviour, and that our sense of right and wrong results from evolutionary adaptation of the social behaviour patterns of our primate ancestors? (De Waal, 2001)


3.5 Instrumental and normative view of stakeholders

Donaldson and Preston suggested that there are two motivations for organisations responding to stakeholder concerns.

3.5.1 Instrumental view of stakeholders

This reflects the view that organisations have mainly economic responsibilities (plus the legal responsibilities that they have to fulfil in order to keep trading). In this viewpoint fulfilment of responsibilities towards stakeholders is desirable because it contributes to companies maximising their profits or fulfilling other objectives, such as gaining market share and meeting legal or stock exchange requirements. Therefore a business does not have any moral standpoint of its own. It merely reflects whatever the concerns are of the stakeholders it cannot afford to upset, such as customers looking for green companies or talented employees looking for pleasant working environments. The organisation is using shareholders instrumentally to pursue other objectives.

3.5.2 Normative view of stakeholders

This is based on the idea that organisations have moral duties towards stakeholders. Thus accommodating stakeholder concerns is an end in itself. This suggests the existence of ethical and philanthropic responsibilities as well as economic and legal responsibilities and organisations focusing on being altruistic.

The normative view is based on the ideas of the German philosopher Immanuel Kant. We shall discuss these in detail in Chapter 9. For now, Kant argued for the existence of civil duties that are important in maintaining and increasing the net good in society. Duties include the moral duty to take account of the concerns and opinions of others. Not to do so will result in breakdown of social cohesion leading to everyone being morally worse off, and possibly economically worse off as well.

A question issued by the examiner required students to apply these two views of stakeholders to viewpoints expressed by directors.

Exam focus point

3.6 Classifications of stakeholders

Stakeholders can be classified by their proximity to the organisation.

Stakeholder group Members
Internal stakeholders Employees, management
Connected stakeholders Shareholders, customers, suppliers, lenders, trade unions, competitors
External stakeholders The Government, local government, the public, pressure groups, opinion leaders

There are other ways of classifying stakeholders.

3.6.1 Legitimate and illegitimate stakeholders
Stakeholder group  Members
Legitimate stakeholders Those who have valid claims on the organisation
Illegitimate stakeholders Those whose claims on the organisation are not valid

This is possibly the most subjective distinction of all, depending as it does on views of which stakeholders should have a claim against the organisation. However, it is also the most important. A number of bases have been suggested for determining legitimacy.

  • A contractual or exchange basis
  • Different types of claim including legal, ownership or the firm being responsible for their welfare
  • Stakeholders having something at risk as a result of investment in the firm or being affected by the firm’s activities
  • Moral grounds; that the stakeholders benefit from or are harmed by the firm, or that their rights are being violated or not respected by the firm

Ultimately how the legitimacy of each stakeholder’s claim is viewed may well depend on the ethical and political perspective of the person judging it. The stockholder view for example would make the distinction solely on whether the stakeholder has an active economic relationship with the organisation. Stakeholders who might be difficult to categorise in this way include pressure groups and charities. However, others would argue for a wider definition, maybe including distant communities, other species, or future generations.

The problem of perception can result in conflict between stakeholders and the organisation. Stakeholder may claim legitimacy wrongly or management views of legitimacy may not be the same as stakeholders’ own perceptions.      

3.6.2 Direct and indirect stakeholders
Stakeholder group Members
Direct stakeholders Those who know they can affect or are affected by the organisation’s activities – employees, major customers and suppliers
Indirect stakeholders Those who are unaware of the claims they have on the organisation or who cannot express their claim directly – wildlife, individual customers or suppliers of a large organisation, future generations

This classification links to the discussion above about direct and indirect claims. It demonstrates a potential problem; that stakeholders who have the largest claim on an organisation may not be aware of its activities and its impact on them. A further issue is that indirect stakeholders’ claims have to be interpreted by someone else in order to be directly expressed. How can we tell what future generations would say? Do environmental pressure groups fairly interpret the needs of the natural environment?

3.6.3 Recognised and unrecognised stakeholders
Stakeholder group  Members
Recognised stakeholders Those whose interests and views managers consider when deciding on strategy
Unrecognised stakeholders Those whose claims aren’t taken into account in the organisation’s decisionmaking – likely to be very much the same as illegitimate stakeholders
                                3.6.4 Narrow and wide stakeholders                                             6/09
Stakeholder group Members
Narrow stakeholders  Those most affected by the organisation’s strategy – shareholders, managers, employees, suppliers, dependent customers
Wide stakeholders  Those less affected by the organisation’s strategy – government, less dependent customers, the wider community

One implication of this classification might appear to be that organisations should pay most attention to narrow stakeholders, less to wider stakeholders.

Question 1 in June 2009 asked students to identify three narrow stakeholders and assess the impact of the events described in the scenario on them.

Exam focus point

3.6.5 Primary and secondary stakeholders
Stakeholder group Members
Primary stakeholders  Those without whose participation the organisation will have difficulty continuing as a going concern, such as shareholders, customers, suppliers and government (tax and legislation)
Secondary stakeholders  Those whose loss of participation won’t affect the company’s continued existence, such as broad communities (and perhaps management)

Clearly an organisation must keep its primary stakeholders happy. The distinction between this classification and the narrow-wide classification is that the narrow-wide classification is based on how much the organisation affects the stakeholder. The primary-secondary classification is based on how much the stakeholders affect the organisation.

3.6.6 Active and passive stakeholders
Stakeholder group Members
Active stakeholders Those who seek to participate in the organisation’s activities. Active stakeholders include managers, employees and institutional shareholders, but may also include other groups that are not part of the organisation’s structure, such as regulators or pressure groups
Passive stakeholders  Those who do not seek to participate in policy making, such as most shareholders, local communities and government

Passive stakeholders may nevertheless still be interested and powerful. If corporate governance arrangements are to develop, there may be a need for powerful passive shareholders to take a more active role. Hence, as we shall see below, there has been emphasis on institutional shareholders who own a large part of listed companies’ shares actively using their power as major shareholders to promote better corporate governance.  

3.6.7 Voluntary and involuntary stakeholders
Stakeholder group  Members
Voluntary stakeholders Those who engage with the organisation of their own free will and choice, and who can detach themselves from the relationship – management, employees, customers, suppliers, shareholders and pressure groups
Involuntary stakeholders  Those whose involvement with the organisation is imposed and who cannot themselves choose to withdraw from the relationship – regulators, government, local communities, neighbours, the natural world, future generations
3.6.8 Known and unknown stakeholders
Stakeholder group  Members
Known stakeholders Those whose existence is known to the organisation
Unknown stakeholders Those whose existence is unknown to the organisation (undiscovered species, communities in proximity to overseas suppliers)

This distinction is important if you argue that an organisation should seek out all possible stakeholders before a decision is taken. The implication of this view is that the organisation should aim for its policies to have minimum impact.

The examiner may ask you in your exam to identify the stakeholders mentioned in a case scenario, using stockholder and stakeholder perspectives.

Exam focus point

3.7 Assessing the relative importance of stakeholder interests

Apart from the problem of taking different stakeholder interests into account, an organisation also faces the problem of weighing shareholder interests when considering future strategy. How, for example, do you compare the interest of a major shareholder with the interest of a local resident coping with the noise and smell from the company’s factory?

Power and interest

One way of weighing stakeholder interests is to look at the power they exert and the level of interest they have about its activities.

Mendelow classifies stakeholders on a matrix whose axes are power held and likelihood of showing an interest in the organisation’s activities. These factors will help define the type of relationship the organisation should seek with its stakeholders and how it should view their concerns. Mendelow’s matrix represents a continuum, a map for plotting the relative influence of stakeholders. Stakeholders in the bottom right of the continuum are more significant because they combine the highest power and influence.

  • Key players are found in Segment D. The organisation’s strategy must be acceptable to them, at least. An example would be a major customer.
  • Stakeholders in Segment C must be treated with care. They are capable of moving to Segment D.

They should therefore be kept satisfied. Large institutional shareholders might fall into Segment C.

  • Stakeholders in Segment B do not have great ability to influence strategy, but their views can be important in influencing more powerful stakeholders, perhaps by lobbying. They should therefore be kept informed. Community representatives and charities might fall into Segment B.
  • Minimal effort is expended on Segment A.

Stakeholder mapping is used to assess the significance of stakeholders. This in turn has implications for the organisation.

  • The framework of corporate governance and the direction and control of the business should recognise stakeholders’ levels of interest and power.
  • Companies may try to reposition certain stakeholders and discourage others from repositioning themselves, depending on their attitudes.
  • Key blockers and facilitators of change must be identified.
  • Stakeholder mapping can also be used to establish future priorities.
3.8.1 Using Mendelow’s approach to analyse stakeholders

Power means who can exercise most influence over a particular decision (though the power may not be used). These include those who actively participate in decision-making (normally directors, senior managers) or those whose views are regularly consulted on important decisions (major shareholders). It can also in a negative sense mean those who have the right of veto over major decisions (creditors with a charge on major business assets can prevent those assets being sold to raise money). Stakeholders may be more influential if their power is combined with:

Legitimacy: the company perceives the stakeholders’ claims to be valid 

Urgency: whether the stakeholder claim requires immediate action

Level of interest reflects the effort stakeholders put in to attempting to participate in the organisation’s activities, whether they succeed or not. It also reflects the amount of knowledge stakeholders have about what the organisation is doing.



Goaway Hotels is a chain of hotels based in one country. Ninety per cent of its shares are held by members of the family of the founder of the Goaway group. None of the family members is a director of the company. Over the last few years, the family has been quite happy with the steady level of dividends that their investment has generated. Directors are encouraged to achieve high profits by means of a remuneration package with potentially very large profit-related bonuses.

The directors of Goaway Hotels currently wish to take significant steps to increase profits. The area they are focusing on at present is labour costs. Over the last couple of years, many of the workers they have recruited have been economic migrants from another country, the East Asian People’s Republic (EAPR). The EAPR workers are paid around 30% of the salary of indigenous workers, and receive fewer benefits. However, these employment terms are considerably better than those that the workers would receive in the EAPR. Goaway Hotels has been able to fill its vacancies easily from this source, and the workers from the EAPR that Goaway has recruited have mostly stayed with the company. The board has been considering imposing tougher employment contracts on home country workers, perhaps letting the number of dismissals and staff turnover of home country workers increase significantly.

In Goaway Hotels’ home country, there has been a long period of rule by a government that wished to boost business and thus relaxed labour laws to encourage more flexible working. However, a year ago the opposition party finally won power, having pledged in their manifesto to tighten labour laws to give more rights to home country employees. Since their election the new Government has brought in the promised labour legislation, and there have already been successful injunctions obtained, preventing companies from imposing less favourable employment terms on their employees.

An international chain of hotels has recently approached various members of the founding family with an offer for their shares. The international chain is well known for its aggressive approach to employee relations and the high demands it makes on its managers. Local employment laws allow some renegotiation of employment terms if companies are taken over.


Using Mendelow’s matrix, analyse the importance of the following stakeholders to the decision to change the employment terms of home country’s workers in Goaway Hotels.

  • The board of directors
  • The founding family shareholders
  • The trade unions to which the home country workers belong
  • Migrant workers



Remember that we are talking about one specific decision so we need to focus on that decision.

The board of directors

Power: Low, surprisingly perhaps. However, the new employment legislation appears to limit significantly directors’ freedom to reduce labour costs by changing contractual terms. The directors also have little say over the decision of shareholders to sell shares. (This demonstrates that you cannot take anyone’s role for granted.)

Level of interest: High, as this is a major decision, integral to the directors’ plans for the future of the Goaway hotel chain. It may also have a significant effect on their remuneration.


Power: High, because the shareholders are currently in a position to sell their shares if they feel that they have received a good offer. If they do, unions and employees may find that the international company is able to take a much tougher approach.

Level of interest: Low, as none of them participate actively in Goaway’s decision-making. Their main concern is whether to continue to take dividends or realise a capital gain from their investment.

Trade unions 

Power: High. This is because they have the economic power to take legal action to prevent Goaway from changing their members’ employment terms. 

Level of interest: High. This is because they wish to protect their members.

Migrant workers 

Power: Low. This is because replacement workers can be recruited easily from the home country.

Level of interest: Low. The migrant workers seem quite happy with their current employment terms, even though these are not as favourable as the home country’s workers.


3.8.2 Problems with stakeholder mapping

There are however a number of issues with Mendelow’s approach:

  • It can be very difficult to measure each stakeholder’s power and influence.
  • The map is not static. Changing circumstances may mean stakeholders’ positions move around the map. For example, stakeholders with a lot of interest but not much power may improve their position by combining with other stakeholders with similar views.
  • The map is based on the idea that strategic positioning, rather than moral or ethical concerns, should govern an organisation’s attitude to its stakeholders.
  • If there are a number of key players, and their views are in conflict, it can be very difficult to resolve the situation, hence there may be uncertainties over the organisation’s future direction.
  • Mendelow’s matrix considers power and influence but fails to take legitimacy into account. Legitimacy is a distinct concept from power. For example, minority shareholders in a company controlled by a strong majority may not have much power, but law in most countries recognises that they have legitimate rights which the company must respect. Mitchell, Agle and Wood argue that legitimacy is a desirable social goal, dependent on more than the perception of individual stakeholders.
Please remember that Mendelow’s grid is a tool to be applied to help you understand the importance of different stakeholders. It is not something to be discussed every time you see the word stakeholder.

The examiner’s report for the December 2007 exam complained that, when the question asked students to explain the importance of identifying stakeholders, this did not mean, as many students thought it did, describing the Mendelow matrix or each stakeholder’s position on the Mendelow matrix.

Exam focus point

3.9 Reconciling viewpoints of different stakeholders

Jensen argued that enlightened long-term value maximisation offers the best and fairest method of reconciling the competing interests of stakeholders. Enlightened long-term value maximisation means pursuing profit maximisation, but with regard to business ethics and the social consequences of the organisation’s actions. It is like the expedient stance identified by Gray, Owen and Adams, which we shall cover in Chapter 11. Jensen argued that the problem with traditional stakeholder theory is that it gave no indication of how to trade off competing interests. Lacking measurable targets, managers are therefore left unaccountable for their actions.

4 Roles of stakeholders


Governance reports have emphasised the role of institutional investors (insurance companies, pension funds, investment houses) in directing companies towards good corporate governance.

4.1 Roles of stakeholders in corporate governance

Corporate governance reports worldwide have concentrated significantly on the roles, interests and claims of the internal and external stakeholders involved.

4.2 Directors

The powers of directors to run the company are set out in the company’s constitution or articles.

Under corporate governance best practice there is a distinction between the role of executive directors, who are involved full time in managing the company, and the non-executive directors, who primarily focus on monitoring. However, under company law in most jurisdictions the legal duties of directors and responsibility for performance, controls, compliance and behaviour apply to both executive and nonexecutive directors.

The role of directors in corporate governance is obviously central. In future chapters we shall examine what happens when directors fail to exercise proper supervision.

4.3 Company secretary

Company legislation in many countries requires companies to appoint a company secretary as a condition of registration. The secretary is seen as an important figure in ensuring compliance with legal and other regulatory frameworks. Legislation makes reference to certain specific duties of the company secretary but does not provide a general definition of what the company secretary should do. The secretary’s precise duties will vary according to the size of company. The most important duties, however, will be in the following areas.

  • Arranging meetings of shareholders and the board of directors

Duties include giving notice of the meeting, issuing the agenda in advance, attending the meeting and ensuring that proper procedures are followed, drafting and circulating the minutes. Importantly the secretary may be responsible for communicating the decisions to the staff of the company or to outsiders. The secretary may also advise the board about their regulatory and legal responsibilities and duties.

  • Signing, authentication and maintenance of documents and registers

The secretary will normally be responsible for completing and signing the annual return of the company and delivering various other statutory documents, including the annual accounts, to the authorities. The secretary is also responsible for maintaining the statutory registers.

  • General administrative duties

The secretary may act as the general administrator and head office manager. Tasks include ensuring compliance with the company’s constitution and other statutory and regulatory requirements, such as the Listing Rules. The secretary may also be responsible for maintaining the accounting records required by law, corresponding with legal advisers, tax authorities, trade associations, etc and administering the office.

4.3.1 Independence and competence of the secretary

Whatever the duties of the secretary, their ultimate loyalty must be to the company. This may mean the secretary coming into conflict with, for example, a director or even the chief executive. If one of the directors has a clear conflict of interest between their duties to the company and their personal interests, the company secretary should ensure that the board minutes reflect the conflict. If the conflict prevents a director from voting and being counted in the quorum at the board meeting, the proper procedure should be followed.

Because of the legal knowledge that the secretary needs to have, in many countries the secretary of a listed or public company is required to be a member of an accountancy or company secretarial body.

4.3.2 Statement of best practice

ICSA, the Institute of Chartered Secretaries and Administrators, has published a Statement of Best Practice on reporting lines for the company secretary.

  • The company secretary is responsible to the board, and should be accountable to the board through the chairman on all matters relating to their duties as an officer of the company (the core duties).
  • If the company secretary has other executive or administrative duties beyond the core duties, they should report to the chief executive or such other director to whom responsibility for the matter has been delegated.
  • The company secretary’s salary, share options and benefits should be settled by the board or remuneration committee on the recommendation of the chairman or chief executive.

ICSA has argued strongly in favour of the importance of the role its members undertake. ICSA has campaigned, unsuccessfully, against the removal of the requirement in UK law for a private company to be required to appoint a company secretary. Public companies in the UK are still required to appoint a secretary.

ICSA has highlighted the following contributions that a secretary can make.

  • Probity of the company

A company secretary is responsible for protecting the probity of a company. They are a guard against the directors acting in their own interests rather than those of the company. An important aspect of the role is to remind directors of their responsibilities. The secretary also acts to protect the interests of third-party shareholders and other stakeholders, and is also responsible for interpreting the decisions of the board and ensuring they are implemented throughout the company.

  • Legal compliance

Under companies’ legislation, the secretary (as an officer of the company) is held responsible for numerous breaches of law. Directors’ priorities and areas of expertise may not be in the areas of governance and compliance.

  • Governance

ICSA argues that, if a secretary is appointed when a company is formed, this should mean that the principles of compliance and good governance are embedded in the company’s procedures from the start. These aspects will be of critical importance as the company grows towards listing.

4.4 Sub-board management

Their interests are similar to the directors in many respects, and they may be concerned with corporate governance from the viewpoint of being potential main board directors. They will also be interested in how corporate governance decisions impact on their current position (how much decision-making will be delegated to them and in what areas? What parameters will they be obliged to follow?). As employees, managers will also have interests in pay and working conditions as described below.

Although sub-board management does not have ultimate responsibility for decision-making within a company, its role in corporate governance is vital. In order to function effectively the board needs to be supported by a strong senior management team, responsible for implementing strategy and controlling and co-ordinating activities. The management team will be responsible for:

  • Helping to set the tone of the company (we discuss this in Chapter 5)
  • Supervising the implementation of control and risk management procedures (discussed in Chapter 7)
  • Providing information that directors need to make decisions about strategy, risk management and control (discussed in Chapter 8)

Shortcomings in any of these areas could seriously undermine the effectiveness of governance.

4.5 Employees

Employees of course play a vital role in the implementation of strategy. They need to comply with the corporate governance systems in place and adopt appropriate culture. Their commitment to the job may be considerable, involving changes when taking the job (moving house), dependency if in the job for a long time (not just financial but in utilising skills that may not be portable elsewhere) and fulfilment as a human being (developing a career, entering relationships).

Employees will focus on how the company is performing, and how the company’s performance will impact on their pay and working conditions. UK company law has required the directors to have regard to the interests of the company’s employees in general as well as the interests of its members. Other European jurisdictions have gone further in terms of employee participation.

Employees also have information requirements. Surveys suggest that the most interesting information for employees is information concerned with the immediate work environment and which is futureorientated. There are a number of ways in which this information can be provided.

  • An organisation-wide employee report
  • Organisation-wide information on financial results, information on personnel or sales at a unit level
  • Statements by managers on their individual activities
  • Separate inserts about each division

Employees’ contribution to corporate governance is to implement the risk management and control procedures. As we shall see in Chapter 5, the company’s culture will impact significantly on this, so that if enforcement measures are lax or employees do not have the skills or knowledge necessary to implement procedures, governance will be undermined.

Employees also have a role in giving regular feedback to management and of whistleblowing serious concerns. Again, poor communication, perhaps because employees are scared to raise issues or management won’t listen, will impact adversely on governance.

The role of employees as informants was tested in the Pilot Paper Question 4. Staff demonstrating a lack of awareness of risk was an issue in December 2007 Question 2.
Exam focus point

                                 4.6 Trade unions                                                                       6/10

Trade unions exist to protect employee interests, so will be interested in the pay, prospects and working conditions of their members. They may be concerned about aspects of poor corporate governance; for example, failure by directors to communicate with employees or failure to protect whistleblowers. Trade unions will also be concerned about a lax control and risk environment, which may jeopardise health and safety or which permits bullying or discrimination by managers or other employees. However, they may also be concerned with an environment that is excessively controlling and which curtails their members’ privacy at work. Their influence will depend on the percentage of employees that are members. Trade unions can distribute information to employees or ascertain their views.

A good relationship with trade unions can have many benefits for a company. Union members will often have similar objectives for the organisation to senior management and share management’s values. The trade unions can harness this and help ensure that the workforce is committed to implementing strategy. Unity between management and unions will appeal to those who do business with the company. A good relationship can help maximise productivity by a contented workforce.

Trade union influence can also act as a balancing factor in corporate governance, highlighting abuses by management which would also concern shareholders.

Trade unions are also exercising their influence through pension funds, pressing for change by use of voting rights. The strength of trade unions varies from country to country. In France, where union rights are extended to all employees, unionisation has a greater impact on corporate decision-making than it can do in the UK where only union members benefit from collective bargaining agreements.

In some jurisdictions trade unions will have a formal role in governance, possibly on a two-tier board which we shall look at later on. Trade unions may play a role that is supportive of governance or hostile to it. For example, management attempts to encourage whistleblowing of other employees’ poor practice may meet with resistance.

4.7 Suppliers

Major suppliers will often be key stakeholders, particularly in businesses where material costs and quality are significant. Supplier co-operation is also important if organisations are trying to improve their management of assets by keeping inventory levels to a minimum. They will need to rely on suppliers for reliability of delivery. If the relationship with suppliers deteriorates because of a poor payment record, suppliers can limit or withdraw credit and charge higher rates of interest. They can also reduce their level of service, or even switch to supplying competitors.

4.8 Customers

Customers have increasingly high expectations of the goods and services they buy, both from the private and public sectors. These include not just low costs, but value for money, quality and service support.

In theory, if consumers are not happy with their purchases, they will take their business elsewhere next time. With increasingly competitive markets, consumers are able to exercise increasing levels of power over companies.

More sophisticated analysis of consumer behaviour has also enhanced the importance of consumers. Dissatisfied customers are more likely to make their views known than satisfied customers. Moreover, businesses now believe that normally the costs of retaining existing customers are significantly less than those of obtaining new customers.

Consumers are increasingly evaluating goods and services not just on the basis of how they will satisfy their immediate material needs but also on how they will satisfy their deeper moral needs. For example, a shopper may prefer one brand of baked beans not for its taste but because the manufacturer supports a good cause of which the consumer approves.

4.8.1 Public sector requirements

Public sector governance requirements stress the need for assessing the effectiveness of policy and arrangements for dialogue with users of services. The UK Good Governance Standard for Public Services points out that organisations can use a range of methods to find out the views, and promote the involvement of service users, including citizens’ juries and community time banks (mutual volunteering by members of the public working alongside service providers to support their neighbours).

4.9 External auditors

The external audit is one of the most important corporate governance procedures. It enables investors to have much greater confidence in the information that their agents, the directors/managers, are supplying. The main focus of the external audit is on giving assurance that the accounts give a true and fair view but external auditors can provide other audit services such as social and environmental audits (discussed in Chapter 11). They can also highlight governance and reporting issues of concern to investors. External auditors are employed to scrutinise the activities of the managers, who are the shareholders’ agents. Their audit fees can be seen as an agency cost. As discussed above, this means that external auditors are also the shareholders’ agents. Auditors are also acting on behalf of regulators and the government, and perhaps other stakeholders.

Because of the significance of the external audit, the external auditors must be independent.

A balance is required between working constructively with company management and at the same time serving the interests of shareholders. The balance can be attained by companies establishing audit committees and the accounting profession developing effective accounting standards.

4.10 Regulators

Regulation can be defined as any form of interference with the operation of the free market. This could involve regulating demand, supply, price, profit, quantity, quality, entry, exit, information, technology, or any other aspect of production and consumption in the market.
Key term

This category includes government bodies, such as health and safety executives, and regulators, such as the financial services authorities, utility regulators and charity commissioners, among many others relevant to specific types of industry. Regulator approval will be required before the organisation is allowed to operate and receive the benefits of action; for example, favourable tax status for charities or being able to offer financial advice for financial services institutions.

4.10.1 Methods of regulation

Legislators and regulators affect organisations’ governance and risk management. They establish rules and standards that provide the impetus for management to ensure that risk management and control systems meet minimum requirements. They also conduct inspections and audits that provide useful information and recommendations regarding possible improvements. Regulators will be particularly interested in maintaining shareholder-stakeholder confidence in the information with which they are being provided.

In specific situations regulators may have other actions available.



Competition authorities are responsible for ensuring diversity wherever possible, but sometimes the industry is a natural monopoly.

The two main methods used to regulate monopoly industries are as follows.

  • Price control

The regulator agreeing the output prices with the industry. Typically, the price is progressively reduced in real terms each year by setting price increases at a rate below that of inflation. This has been used with success by regulators in the UK but can be confrontational.

  • Profit control

The regulator agreeing the maximum profit that the industry can make. A typical method is to fix maximum profit at x% of capital employed. However, this does not provide any incentive to make more efficient use of assets. The higher the capital employed, the higher the profit will be. In addition, the regulator will be concerned with:

  • Actively promoting competition by encouraging new firms in the industry and preventing unreasonable barriers to entry
  • Addressing quality and safety issues and considering the social implications of service provision and pricing


4.10.2 Costs of regulation

The potential costs of regulation include the following.

  • Enforcement costs

Regulation can only be effective if it is properly monitored and enforced. Direct costs of enforcement include the setting up and running of the regulatory agencies – employing specialist staff, monitoring behaviour, prosecuting offenders (or otherwise ensuring actions are modified in line with regulations). Indirect costs are those incurred by the regulated (eg the firms in the industry) in conforming to the restrictions.

  • Regulatory capture

This refers to the process by which the regulator becomes dominated and controlled by the regulated firms, such that it acts increasingly in the firm’s interests, rather than those of consumers. This is a phenomenon that has been observed in the US (where economic regulation has always been more widespread).

  • Unintended consequences of regulation

An example is the so-called ‘Aversch-Johnson effect’. This refers to the tendency of rate of return (profit) regulation to encourage firms to become too capital intensive and therefore minimise their return on capital. Companies try to maximise their asset base so that their return on capital employed is low. It appears to be a concern in the telecommunications industry. In other words, firms regulated in this way have an incentive to choose a method of production that is not leastcost, because it involves too high a ratio of capital to labour.

4.10.3 Regulation and stakeholders

Where privatisation has perpetuated monopolies over natural resources, industry regulatory authorities have the role of ensuring that consumers’ interests are not subordinated to those of other stakeholders, such as employees, shareholders and tax authorities. The regulator’s role may be ‘advisory’ rather than statutory. It may extend only to a part of a company’s business, necessitating a fair allocation of costs across different activities of the company.



Benston (2000) provides six reasons for the regulation imposed to protect consumers of banking, securities and insurance. Regulations are imposed to:

  • Maintain consumer confidence in the financial system
  • Ensure that a supplier on whom consumers (eg of a major utility) rely does not fail
  • Ensure that consumers receive sufficient information to make ‘good’ decisions and are dealt with


  • Ensure fair pricing of financial services
  • Protect consumers from fraud and misrepresentation
  • Prevent invidious discrimination against individuals


4.10.4 Regulators and corporate governance

Regulators will also be concerned with how corporate governance guidance affects the way organisations deal with changing circumstances.



A good example of a major change requiring a different approach to regulation has been the liberalisation of the activities by financial institutions in many countries. The traditional separation of financial institutions into banks, insurance companies, brokers and investment companies has been abolished and financial institutions engage in all these activities. The risks to which a multiproduct financial institution is exposed can be significantly different to the risks that each of the individual component parts eg the banking division are exposed.

In practice, the task of keeping regulation up to date and relevant is made more challenging by the pace of innovation in financial products and the development of financial markets and institutions and by globalisation.

The question that arises is: How much regulation should there be? And is there perhaps an optimal level of regulation?

According to McMenamin in Financial Management – An Introduction, ‘regulation is essentially a question of balance … too little or ineffective regulation leaves the markets open to abuse, too much regulation makes markets rigid, costly to operate and uncompetitive’.

As a result of the problems in the banking sector over the last few years, the distinction between regulation of banks’ retail activities (operations concerned with customer deposits, business lending and the transmission of money) and investment activities has been much debated.

In June 2010 the Independent Commission on Banking in the UK (the Vickers Commission, chaired by economist Sir John Vickers) was set up by the incoming Coalition Government. It produced its final report in September 2011. The report recommended that UK banks’ domestic retail operations (operations concerned with customer deposits, business lending and the transmission of money) should be ringfenced from their wholesale and investment operations. Retail banking activities should be carried out by separate subsidiaries within banking groups, with the ringfenced part of the bank having its own board and being legally and operationally separate from the parent bank.  Retail banks should have equity capital of 10% of risk-weighted assets and UK banking groups should have primary loss-making capacity of at least 17-20% – equity, bonds and cocos (contingent convertible notes) – to act as a safety buffer.

Non-retail parts of banking groups should be allowed to fail. The report anticipated that this would mean that their cost of capital went up. However, the lack of guaranteed government support for investment activities should mean that banks were less likely to take excessive risks in this area.

Banks were given until 2019 to implement these requirements fully, a period felt by some commentators to be very lengthy. The time period was set to coincide with the international capital requirements changes being introduced by the Basel regulators.

In May 2012 the UK Government set out details of a banking reform bill, giving the UK Treasury the power to ringfence the retail operations of large banks from their investment divisions, and to ensure that depositors recover their money before unsecured creditors if a bank becomes insolvent.


4.10.5 Regulators and charities

As previously mentioned, charities receive favourable regulatory treatment but in return they must demonstrate their benevolent purposes and apply for recognition by the country’s charity commission or equivalent.

4.11 Government

Most governments do not have a direct economic/financial interest in companies (except for those in which they hold shares). However, governments often have a strong indirect interest in companies’ affairs, hence the way they are run and the information that is provided about them.

  • Governments raise taxes on sales and profits and on shareholders’ dividends. They also expect companies to act as tax collectors for income tax and sales tax. The tax structure might influence investors’ preferences for either dividends or capital growth. Economic policies such as deregulation may be influenced by the desire for economic growth and increased efficiency.
  • Governments pass and enforce laws, and also establish and determine the overall regulatory and control climate in a country. This involves exertion of fiscal pressure, and other methods of state intervention. Governments also determine whether the regulatory framework is principles or rules based (discussed later in the text).
  • Governments may provide funds towards the cost of some investment projects. They may also encourage private investment by offering tax incentives.
  • In the UK, the Government has made some attempts to encourage more private individuals to become company shareholders, by means of:
    • Attractive privatisation issues (such as in the electricity, gas and telecommunications industries)
    • Tax incentives, such as ISAs (Individual Savings Accounts), to encourage individuals to invest in shares
  • Governments also influence companies, and the relationships between companies, their directors, shareholders and other stakeholders.
4.11.1 Objectives of public sector organisations

One problem, which we discussed in the context of agency, is that objectives of public sector organisations have to be established in the light of political pressures, caused by varying taxpayer demands. Some taxpayers may want a public sector organisation to do much more, others may want it to do less or cease to exist with a resultant tax saving. Control mechanisms such as audit can test the integrity and transparency of transactions, but may not cover performance or fitness for purpose.         4.11.2 Privatisation

Privatisation means that the Government attempts to establish an accurate market value for a stateowned enterprise and then sell shares in that enterprise on the country’s stock exchange.
Key term

Privatisation has been an instrument of policy used by a number of governments over recent years in industries such as energy, water, transport and minerals. The privatised organisation is no longer controlled by the state. Instead it is subject to company law and listing rules. The company may be exposed to a competitive market for the first time, requiring a different skill set from its directors and a large internal culture change.

4.11.3 Nationalisation
Nationalisation involves the Government taking a business from its shareholders into public ownership.
Key term

During the second half of the 20th century the governments of many developed countries moved away from nationalisation, taking many companies out of public ownership and into the private sector. Nationalised industries have been more important in developing countries.

However, recent developments in the financial sector, such as the UK Government nationalising the Northern Rock bank, have focused attention on nationalisation and its implications, including implications for governance and stakeholders.

Key issues here are the reasons for nationalisation and the length of time for which businesses will be nationalised. The UK Government stated when Northern Rock was nationalised that nationalisation would be a temporary measure. The precedent may have been the purchase of the Johnson Matthey bank by the Bank of England under a short-term rescue package in the 1980s, with Johnson Matthey subsequently trading profitably.

However, the purchase of Northern Rock and intervention in other banks could be seen as helping to guarantee the country’s financial infrastructure. This might otherwise be undermined by a lack of confidence and result in economic recession or collapse. Other infrastructure investments (for example Network Rail in the UK) have tended to be for the longer term.

Northern Rock’s nationalisation must also be seen in the context of other UK Government measures to boost the economy, including encouragement of bank lending. This raises the issue of how far the Government should intervene in the operations of the bank, so that the bank’s lending decisions clearly reflect government objectives.

This uncertainty of motivation means that there is also a lack of clarity over the significance of different stakeholders in the bank’s operations.

  • The Government presented the nationalisation in terms of it acting as agents for the taxpayers, who were effectively the new shareholders. The decision to nationalise was portrayed as the best economic decision in the circumstances. The Government rejected two rescue bids by Virgin and the bank’s management on economic grounds.
  • However, government intervention has also served the interests of the depositors in the banks, who would otherwise have risked losing some of their savings.
  • The position with regard to borrowers is complex. If the bank is to be sold on as a going concern, over-generous packages to borrowers will not increase its attractiveness to potential purchasers.

Traditionally, however, ideas of equity and fairness have been applied in public sector organisations – how do they relate to borrowers here?

Exam focus

point                       As nationalisation is currently a topical issue, the issues raised by having government and taxpayers as principals rather than shareholders will be examinable.

4.12 Stock exchanges

Stock exchanges provide a means for companies to raise money and investors to transfer their shares easily. They also provide information about company value, derived from the supply of, and demand for, the shares that they trade. Stock exchanges list companies whose shares can be held by the general public (called public companies in many jurisdictions). Many such companies have a clear separation between ownership and management.

Stock exchanges are important because they provide regulatory frameworks in principle-based jurisdictions. In most countries, listing rules apply to companies whose shares are listed on the stock exchange. Stock exchange regulation can therefore have a significant impact on the way corporate governance is implemented and companies report. The UK is a good example of this, with the comply or explain approach being consistent with the approach of self-regulation of London institutions. In America, by contrast, a more legalistic and rules-based approach has been adopted, in line with the regulatory approach that is already in place.

                                 4.13 Institutional investors                                     12/10, 6/14

Institutional investors have large amounts of money to invest. They are covered by fewer protective regulations, on the grounds that they are knowledgeable and able to protect themselves. They include investors managing funds invested by individuals. The term also includes agents employed on the investors’ behalf.
Key term

Institutional investors are now the biggest investors in many stock markets but they might also invest venture capital, or lend directly to companies. UK trends show that institutional investors can wield great powers over the companies in which they invest.



Before looking at the following paragraph, see if you can list the major types of institutional investor in the UK.


The major institutional investors in the UK are:

  • Pension funds
  • Insurance companies
  • Investment and unit trusts (set up to invest in portfolios of shares)
  • Venture capital organisations (investors particularly interested in companies that are seeking to expand)

Their funds will be managed by a fund manager who aims to benefit investors in the funds or pension or policy holders. Although fund managers will use lots of different sources of information, their agency costs will be high in total because they have to track the performance of all the investments that the fund makes.

4.13.1 Advantages and disadvantages of institutional investment

In some respects the institutional investor fulfils a desirable role. People should ideally be in pensionable employment or have personal pension plans, and the funds from which their pensions will be payable should be held separately from the companies by whom they are employed. Similarly, investors should have the opportunity to invest through the medium of insurance companies, unit trusts and investment trusts.

However, the dominance of the equity markets by institutional investors has possibly undesirable consequences as well.

  • Excessive market influence

For capital markets to be truly competitive there should be no investors who are of such size that they can influence prices. In the UK, transactions by the largest institutions are now on such a massive scale that considerable price movements can result.

  • Playing safe

Many institutions tend to avoid shares which are seen as speculative as they feel that they have a duty to their ‘customers’ to invest only in ‘blue chip’ shares (ie those of leading commercially sound companies). As a result, the shares of such companies tend to be relatively expensive.

  • Short-term speculation

Fund managers are sometimes accused of ‘short-termism’ in that they will tend to seek short-term speculative gains or simply sell their shares and invest elsewhere if they feel that there are management shortcomings. Pension fund trustees are also accused of being over-influenced by short-term results because of the lack of time they have to go into the company’s performance in detail. However, arguably, institutional investors have become so influential that they are less able to divest from companies without suffering a substantial loss in order to liquidate their holdings. They have therefore been forced to adopt a more long-term outlook.

  • Lack of power of investors

Investors in investment and pension funds cannot directly influence the policy of the companies in which their funds invest, since they do not hold shares themselves and cannot hold the company accountable at general meetings.

4.13.2 Role of institutional investors

UK guidance has placed significant emphasis on the role of institutional investors in promoting good corporate governance. The UK Corporate Governance Code states that shareholders should enter into a dialogue with companies based on the mutual understanding of objectives, taking into account the size and complexity of the companies and the risks they face. Their representatives should attend company annual general meetings and make considered use of their votes.

UK guidance stresses that institutional investors should consider, in particular, companies’ governance arrangements that relate to board structure and composition. They should enter a dialogue about departures from the Code if they do not accept the companies’ position.

4.13.3 Statement of best practice

The UK Corporate Governance Code refers to guidance in the UK Stewardship Code, published in July 2010 and revised in September 2012. The Stewardship Code states that institutional investors should:

  • Disclose how they will discharge their responsibilities
  • Operate a clearly disclosed policy for managing conflicts of interest
  • Monitor performance of investee companies to gain assurance on the operation of the board and its committees by attending meetings of the board and the AGM and should be particularly concerned with departures from the UK Corporate Governance Code, and also seek to identify threats to shareholder value at an early stage
  • Establish clear guidelines on when they will actively intervene, when they are concerned about strategy and performance, governance or approach to risk
  • Be willing to act collectively with other investors, particularly at times of significant stress or when the company’s existence appears to be threatened
  • Operate a clear policy on voting and disclosure of voting activity; they should not necessarily support the board
  • Report to their clients on their stewardship and voting activities; they should consider obtaining an independent audit opinion on their engagement and voting processes.

As well as this guidance, the Myners report on proxy votes and the role of owners in administering them is also relevant to the role of institutional investors and their fund managers (see Chapter 3).

4.13.4 Means of exercising institutional investors’ influence

A number of different methods may be effective.

  • One to one meetings

These discuss strategy, whether objectives are being achieved, how the company is achieving its objectives and the quality of management. However, new information cannot be divulged to any single analyst or investor in these meetings, as it would give that investor an information advantage over others.

  • Voting

Generally institutional investors would prefer to work behind the scenes and to avoid voting against the board if possible. If they were intending to oppose a resolution, they should normally state their intention in advance. Most corporate governance reports emphasise the importance of institutional investors exercising their votes regularly and responsibly.

  • Focus list

This means putting companies’ names on a list of underperforming companies. Such companies’ boards may face challenges.

  • Contributing to corporate governance rating systems

These measure key corporate governance performance indicators such as the number of nonexecutive directors, the role of the board and the transparency of the company.  

4.13.5 Intervention by institutional shareholders

In extreme circumstances the institutional shareholders may intervene more actively, by for example calling a company meeting in an attempt to unseat the board. The UK Institutional Shareholders’ Committee has identified a number of reasons why institutional investors might intervene.

  • Fundamental concerns about the strategy being pursued in terms of products, markets and investments
  • Poor operational performance, particularly if one or more key segments has persistently underperformed
  • Management being dominated by a small group of executive directors, with the non-executive directors failing to hold management to account
  • Major failures in internal controls, particularly in sensitive areas such as health and safety, pollution and quality
  • Failure to comply with laws and regulations or governance codes
  • Excessive levels of directors’ remuneration
  • Poor attitudes towards corporate social responsibility



The response by institutional investors in the UK to the Vickers report on the banking sector discussed above raised questions about their attitudes towards wider stakeholder concerns. The Telegraph in the UK reported in September 2011 that a ‘secret’ meeting between the leading investors and members of the Treasury Select Committee had taken place. At this meeting investors had apparently demanded that the provisions of the Vickers report should be watered down, stating that they would prevent the market value and return on equity of banks improving from unacceptably low levels. Investors alleged that the proposals would put UK banks at a significant disadvantage compared with competitors in America and Europe.

Concerns were also expressed by those working within the banking sector. On the morning of 14 September 2011 Carsten Kengeter, the head of UBS’s investment bank, voiced concerns about the costs of ringfencing retail banking operations from investment banking activities. Hours later he was being briefed on a very large alleged rogue trading scandal at UBS (discussed further in Chapter 6), a scandal which some commentators suggested vindicated proposals for separating different banking functions.


The publication of guidance recently has made intervention by institutional shareholders a topical area. Question 1 in December 2010 asked students to consider what might prompt intervention and at what point it should happen.
Exam focus point

4.14 Small investors

The Organisation for Economic Co-operation and Development suggested that a key principle of corporate governance is that all shareholders should be treated equally. However, if institutional investors become more influential, they may be treated better by company managers.

Small investors include shareholders who hold small numbers of shares in companies, trusts and funds. They may not have the same ease of access to information that institutional investors possess, or the level of understanding of experts employed by institutional investors. Their portfolios are likely to be narrower and they may be less able to diversify risk away. These problems can handicap their position.

4.15 Stakeholders in the not for profit sector

In many countries there are thousands of charities and voluntary organisations that exist to fulfil a particular purpose, maybe social, environmental, religious or humanitarian. In most countries they are allowed tax privileges and reduced legal requirements. Charities will be accountable to those who supply them with donations. Transparency, particularly as regards who receives aid and the reasons for expenditure for non-charitable purposes, will be significant.

4.15.1 Primary stakeholders

Primary stakeholders of charities include not only donors and regulators but also grant providers, service users and the general public.

4.15.2 Representing stakeholder interests

As previously discussed, some stakeholders may not have their own voice (for example animals benefiting from the work of animal charities) and it will be up to trustees to represent their interests as best they can.

A number of issues will influence trustees’ decisions.

  • Prioritisation of resources

Depending on how widely the charity’s purposes are defined, there is likely to be a variety of uses to which the charity’s resources can be put. These will have varying impacts, direct and indirect, short and long term. Animal charities spending considerable sums of money on publicity campaigns may help educate the public and, over the longer term improve the treatment of animals and change society’s basic values. However, they will have no direct impact on animals that are currently suffering.

  • Taking over government roles

There may be some tasks in society that charities take over because government is not providing a particular service or not providing it very well. For example in some countries animal charities have taken over stray control services, carrying out a range of humane actions rather than the brutal, undiscriminating, catch and kill activities of public sector animal catchers.

Charity trustees may have to answer criticism from donors and other stakeholders if they do this. Some supporters may argue that the task has to be done and it is in line with the charity’s purposes. Others may argue that the charity should not be supplying services that governments should provide, and it takes resources away from other, important, charitable activities. There may also be a conflict between a desire to co-operate with government when providing a service and a campaigning desire to expose government shortcomings.

  • Best interests

Trustees may face conflicting opinions about what the best interests of animals are. One distinction in the context of animal charities is the difference between animal welfare and animal liberation. Animal welfare is often defined as the desire to prevent unnecessary suffering and ensure a good quality of life and humane death, while not being opposed in principle to the use of animals. By contrast most animal liberationists are fundamentally opposed to the use or ownership of animals by humans. Liberationists would claim that many of the situations accepted by animal welfarists would inevitably compromise the wellbeing of the animal and its ability to live in accordance with its natural needs.

4.15.3 Conflicts between stakeholders

There may be a conflict between the objectives of different stakeholders, arising partly from a lack of clarity on how far commercial objectives can be pursued without compromising a charity’s mission. Some stakeholders have demanded that charities should be run on more commercial lines, attempting to make the most of resources and with chief executives drawn from the private sector. Other stakeholders (volunteers, some donors) have objected that this has meant charities moving too far away from their charitable objectives. Trustees have often struggled to resolve these conflicts and change historical ways of operation, particularly if they themselves lack commercial skills or understanding.

4.15.4 Disclosure by charities

In some jurisdictions charities face a light disclosure regime which allows them to provide minimal financial detail. Charities have been criticised for this and some have responded by making fuller disclosures than required by law.

The strategy for dealing with stakeholders set out in Good Governance: A Code for the Voluntary and Community Sector is that trustees should ensure that they identify those with a legitimate interest in their work. They need to ensure there is a strategy for regular and effective communication with them about the organisation’s achievements and work, including the board’s role and the organisation’s objectives and values.

The Code sees openness and accountability as follows.

  • It means ensuring stakeholders have the knowledge and opportunity to hold trustees to account.
  • It means demonstrating that the charity learns from mistakes and errors, for example by having clear and effective complaints procedures and using the feedback to learn and improve performance.
  • It means ensuring the principles of equality and diversity are applied, and that information and meetings are accessible to all sectors of the community.
  • It means keeping membership records up to date, seeking members’ views and encouraging members to participate in governance.
  • It means acting on broader responsibilities towards communities, wider society and the environment. Some charities demonstrate that they are delivering value to donors and users of the service by measuring and publishing the contribution they make. Some use a social or environmental reporting framework (discussed further in Chapter 11). This includes details of how the charity is run and how it delivers against its terms of reference and its objectives. This can demonstrate accountability and transparency and increase the confidence of primary stakeholders.

4.16 Stakeholder and agency theory

Quinn and Jones argued that agency theory does not allow managers to avoid their normal moral obligations, particularly avoiding harm to others, respecting the autonomy of others, telling the truth and honouring agreements. Only after fulfilling these can they maximise shareholder wealth. The agencyprincipal relationship can only be meaningful if managers attend to the moral principles.

The opposite view was forcefully argued by Milton Friedman. Friedman claimed that managers are responsible to owners who generally are aiming to make as much money as possible. If managers are argued to have social responsibilities, then they have to act in some ways that are not in the interest of the owners, their principals, and they will be spending money for purposes other than those authorised. They are not therefore acting properly as agents. Instead they are in effect raising taxes and deciding how these taxes should be spent, which is the proper function of government, not agents.

4.17 Stakeholder theory and company law

Although company law reforms in various countries have attempted to place some emphasis on ethical and social responsibility, a key foundation of company law in most jurisdictions remains the fiduciary and legal obligations that managers have to maximise shareholder wealth. Therefore under law, if managers are to fulfil responsibilities to a wider stakeholder base, there must, according to capitalist thinking, be a business profit case for doing so (Freidman’s argument above).

Some commentators have tried to reconcile stakeholder and agency theory by arguing that managers are stakeholders, responsible as agents to all other stakeholders. Although stakeholders have divergent interests that may be difficult to reconcile, that does not absolve management from at least trying to reconcile their interests. Managers are, after all, certainly responsible to all shareholders and different shareholders have divergent interests.

Exam focus        The examiner has commented that the issue of stakeholders lies at the heart of most discussions of point                ethics. Being able to identify the stakeholders mentioned in a case scenario and describing their claims on the organisation is an important skill for P1 candidates to develop.

5 Major issues in corporate governance

FAST FORWARD            Key issues in corporate governance reports have included the role of the board, the quality of financial reporting and auditing, directors’ remuneration, risk management and corporate social responsibility.

We shall expand on these issues in the next two chapters, but for now let’s examine the major areas that have been affected by corporate governance.

5.1 Duties of directors

The corporate governance reports have aimed to build on directors’ duties as defined in statute and case law. These include the fiduciary duties to act in the best interests of the company, use their powers for a proper purpose, avoid conflicts of interest and exercise a duty of care.

5.2 Composition and balance of the board

A feature of many corporate governance scandals has been boards dominated by a single senior executive or ‘small kitchen cabinet’ with other board members merely acting as a rubber stamp.

Sometimes the single individual may bypass the board to action their own interests. The report on the UK Guinness case suggested that the Chief Executive, Ernest Saunders, paid himself a £3 million reward without consulting the other directors.

Even if an organisation is not dominated by a single individual, there may be other weaknesses in board composition. The organisation may be run by a small group centred round the chief executive and chief financial officer, and appointments may be made by personal recommendation rather than a formal, objective process.

As we shall see, the board must also be balanced in terms of skills and talents from several specialisms relevant to the organisation’s situation and also in terms of age (to ensure senior directors are bringing on newer ones to help succession planning).

5.3 Reliability of financial reporting and external auditors

Issues concerning financial reporting and auditing are seen by many investors as crucial because of their central importance in ensuring management accountability. They have been the focus of much debate and litigation. While focusing the corporate governance debate solely on accounting and reporting issues is inadequate, the greater regulation of practices such as off-balance sheet financing has led to greater transparency and a reduction in risks faced by investors.

External auditors may not carry out the necessary questioning of senior management because of fears of losing the audit, and internal auditors do not ask awkward questions because the chief financial officer determines their employment prospects. Often corporate collapses are followed by criticisms of external auditors, such as the Barlow Clowes affair where poorly planned and focused audit work failed to identify illegal use of client monies.

5.4 Directors’ remuneration and rewards

Directors being paid excessive salaries and bonuses has been seen as one of the major corporate abuses for a large number of years. It is inevitable that the corporate governance codes have targeted this issue.

5.5 Responsibility of the board for risk management and internal control systems

Boards that meet irregularly or fail to consider systematically the organisation’s activities and risks are clearly not fulfilling their responsibilities. Sometimes the failure to carry out proper oversight is due to a lack of information being provided, which in turn may be due to inadequate systems being in place for the measurement and reporting of risk.

5.6 Rights and responsibilities of shareholders

We saw in Section 3 how shareholders’ rights and the role of shareholders, particularly institutional shareholders, has been the subject of much debate. Shareholders should have the right to receive all material information that may affect the value of their investment and to vote on measures affecting the organisation’s governance.

5.7 Corporate social responsibility and business ethics

The lack of consensus about the issues for which businesses are responsible and the stakeholders to whom they are responsible has inevitably made corporate social responsibility and business ethics an important part of the corporate governance debate.

                     5.8 Public and non-governmental bodies corporate governance                                                                                    6/11

Many of the principles that apply to company corporate governance also apply to government bodies or other major entities such as charities. Boards will be required to act with integrity, to supervise the body’s activities properly and to ensure appropriate control and risk management and reporting systems are being maintained. However, governance arrangements will also reflect the strategic purpose of the organisation. Governance should always ensure that income is being used to optimal effect and that operations are being run efficiently.

5.8.1 Composition of boards

This may be determined by regulation or may be tailored by the body’s constitution. There may be more than one board. There could be an executive board for overseeing operations, and a supervisory board of trustees. For charities, trustees should ensure that the objectives and policies reflect its fiduciary purposes. The supervisory board may also include representatives of all major stakeholder groups, to ensure stakeholder interests are being represented.

The supervisory board will also need to consider the composition of the executive board and whether to recruit directors from the private sector to run the organisation.

5.8.2 Conduct of directors

Directors may be subject to organisation or sector-specific controls to ensure that they act in the public interest. In charities trustees may be particularly concerned that the salaries and benefits that the directors receive are reasonable given the purposes of the charity and also the need to reward the directors fairly for the responsibilities that they undertake.

5.8.3 Compulsory regulations vs voluntary best practice

Certain guidelines that are voluntary best practice in the corporate sector may be compulsory for some other sorts of organisation, for example maintenance of an internal audit department.



The UK Good Governance: A Code for the Voluntary and Community Sector illustrates the variety of obligations that charities have to regulators. The Code requires trustees to ensure compliance with:

  • The governing document
  • Regulators’ requirements, particularly as regards submission of information 
  • Maintenance of records and production of accounts

Areas of legislation with which some or all charities may have to comply include:

  • Charity
  • Company
  • Trust
  • Industrial and provident society
  • Employment
  • Health and safety
  • Data protection
  • Equality
  • Other relevant legislation, including fundraising, protection of children and vulnerable adults, provision of health or care services, provision of financial advice, housing and tenancy law

The guidance states that the board must also act prudently to protect the reputation, assets and property of the organisation, and to ensure that assets and property are only used to deliver stated aims.


5.8.4 Disclosure of internal control

Central government bodies in the UK are an example of bodies that are required to make disclosures about specific controls, such as risk registers, training, key performance indicators and reporting systems.

We end each chapter by including questions that require you to think widely about what you’ve just covered. Sometimes they’ll involve comparisons between material in different parts of this chapter.

For this chapter, consider the concepts discussed in Section 1. Which of them do you think corporate governance guidance may address most effectively? Which of them do you think that governance codes do not cover very well?

With these questions, there is no right answer, and often we shall do no more than give our own opinions.

Certainly most governance guidance covers transparency quite thoroughly and is reinforced by the requirements of financial reporting standards. However, this has been because lack of transparency has been a major issue of concern in various governance scandals, notably in Enron. Is guidance on transparency essentially reactive?

You may feel, having read Section 3, that directors might have most difficulty applying the concept of fairness. Most governance guidance has done no more than address this topic in general terms, leaving directors to decide how to give shareholders’ interests appropriate priority, and decide between the competing interests of other stakeholders. Probably the South African King report goes furthest in addressing this issue.

‘Stakeholders such as the community in which the company operates, its customers, its employees and its suppliers need to be considered when developing the strategy of a company.’

However, the King report does not accept the full concept of accountability to all legitimate stakeholders.

‘The stakeholder concept of being accountable to all legitimate stakeholders must be rejected for the simple reason that to ask boards to be accountable to everyone would result in their being accountable to no one. The modern approach is for a board to identify the company’s stakeholders, including its shareowners, and to agree policies as to how the relationship with those stakeholders should be advanced and managed in the interests of the company.’


Chapter Roundup

Corporate governance, the system by which organisations are directed and controlled, is based on a number of concepts including transparency, independence, accountability and integrity.
Agency is extremely important in corporate governance, as often the directors/managers are acting as agents for the owners. Corporate governance frameworks aim to ensure directors/managers fulfil their responsibilities as agents by requiring disclosure and suggesting they be rewarded on the basis of performance.
Directors and managers need to be aware of the interests of stakeholders in governance; however, their responsibility towards them is judged.
Governance reports have emphasised the role of institutional investors (insurance companies, pension funds, investment houses) in directing companies towards good corporate governance.
Key issues in corporate governance reports have included the role of the board, the quality of financial reporting and auditing, directors’ remuneration, risk management and corporate social responsibility.

Quick Quiz

  • Corporate governance focuses on companies’ relationships with all stakeholders, not just shareholders.



  • Name five concepts that underlie corporate governance.
  • Fill in the blank:

…………………………………. means straightforward dealing and completeness.

  • Why is agency a significant issue in corporate governance?
  • Fill in the blank:

…………………………………. means that persons owe a duty to others because of the position of trust and confidence they hold in relation to those others.

  • Name three methods of rewarding management that can help to ensure alignment of interests.
  • Which of the following is not generally classified as an institutional shareholder?
    • Pension funds C             Central government
    • Investment trusts D             Venture capitalists
  • What are the main fiduciary duties of directors?

Answers to Quick Quiz

  • True
  • Any five of:

Fairness, Openness/Transparency, Independence, Probity/Honesty, Responsibility, Accountability, Reputation, Judgement and Integrity

  • Integrity
  • Because of the separation of ownership (principal) from management (agent)
  • Fiduciary
  • Profit-related/economic value-added pay, shares, executive share option plans
  • C Central government
  • Acting in the best interests of the company, using their powers for a proper purpose, avoiding conflicts of interest, the duty of care



Number Level Marks Time
Q1 Examination 25 49 mins


02 Approaches to corporate governance

Having described the underlying principles and issues behind the development of
corporate governance in
Chapter 1, in this chapter we discuss how corporate
governance codes have developed. In Section 1 we see the development of many
codes in the context of a desire to develop principles-based guidance and also as
a function of the share ownership patterns of the economies to which the codes
relate. In Section 2 we discuss briefly the main codes that have been developed
worldwide, both in individual countries and for a number of jurisdictions (the
OECD and ICGN reports).
Because of its differing approach to regulation generally, and also specifically
because of the fallout from the collapse of Enron, America has developed a more
prescriptive approach to corporate governance, the Sarbanes-Oxley Act. We cover
this legislation in Section 3. We give more detail about it than other
regulations/guidance, since the examiner has emphasised its importance as the
most influential corporate governance instrument of recent times, influencing
practice globally because of the international significance of American business.
In Section 4 we discuss the very important topic of corporate social responsibility,
the concepts that lie behind it and how it has influenced the development of
corporate governance. Corporate social responsibility ideas are significant in Part
E of the syllabus, which we shall cover in
Chapters 9 to 11.
Finally in Section 5 we look at the public sector and the specific governance issues
that affect different types of public sector organisations.

Study guide

    Intellectual level
A6 Different approaches to corporate governance  
(a) Describe and compare the essentials of rules- and principles-based approaches to corporate governance, including discussion of comply or explain. 3
(b) Describe and analyse the different models of business ownership that influence different governance regimes (eg family firms vs joint stock company-based models). 2
(c) Describe and critically evaluate the reasons behind the development and use of codes of practice in corporate governance (acknowledging national differences and convergence). 3
(d) Explain and briefly explore the development of corporate governance codes in principles-based jurisdictions (impetus and background, major corporate governance codes, effects of). 2
(e) Explain and explore the Sarbanes-Oxley Act as an example of a rules-based approach to corporate governance (impetus and background, main provisions/contents, effects of). 2
(f) Describe and explore the objectives, content and limitations of corporate governance codes intended to apply to multiple national jurisdictions (OECD, ICGN). 2
A7 Corporate governance and corporate social responsibility  
(a) Explain and explore social responsibility in the context of corporate governance. 2
(b) Discuss and critically assess the concept of stakeholder power and interest using the Mendelow model and how this can affect strategy and corporate governance. 3
(c) Analyse and evaluate issues of ownership, property and the responsibilities of ownership in the context of shareholding. 3
A9 Public sector governance  
(a) Describe, compare and contrast public sector, private sector, charitable status and non-governmental (NGO and quasi-NGO) forms of organisation, including purposes and objectives, performance, ownership and stakeholders (including lobby groups). 2
(b) Describe, compare and contrast the different types of public sector organisations at subnational, national and supranational level. 2
(c) Assess and evaluate the strategic objectives, leadership and governance arrangements specific to public sector organisations as contrasted with private sector. 3
(d) Discuss and assess the nature of democratic control, political influence and policy implementation in public sector organisations including the contestable nature of public sector policy. 3
(e) Discuss the obligations of public sector organisations to meet the economy, effectiveness, efficiency (3 Es) criteria and promote public value. 3

Exam guide

You may well have to discuss the implications of basing governance guidance on principles. The examination team has stated that knowledge of the main features and advantages and disadvantages of codes in general is important, but line by line knowledge isn’t required.

As regards specific codes, the main themes of Sarbanes-Oxley may be tested. The examination team has stressed that, although the UK Corporate Governance Code sets out good practice (and students from anywhere in the world would do well to have some knowledge of UK practice), answers based on the students’ local codes of practice would be equally acceptable. Students in countries without detailed codes could use UK or international codes to underpin their answers.

The existence of wider social responsibilities is likely to be a theme in many questions.

                                  1 Basis of corporate governance guidance                                                  12/14, 6/15

Globalisation, the treatment of investors and major corporate scandals have been major driving forces behind corporate governance developments.

Many governance codes have adopted a principles-based approach allowing companies flexibility in interpreting the codes’ requirements and to explain if they have departed from the provisions of the code.

Insider systems are where listed companies are owned by a small number of major shareholders.

Outsider systems are where shareholdings are more widely dispersed, and the management-ownership split is more of an issue.


1.1 The driving forces of governance code development

Corporate governance issues came to prominence in the US during the 1970s and in the UK and Europe from the late 1980s. The main, but not the only, drivers associated with the increasing demand for the development of governance were:

  • Increasing internationalisation and globalisation

This has meant that investors, and institutional investors in particular, began to invest outside their home countries. The King report in South Africa highlights the role of the free movement of capital, commenting that investors are promoting governance in their own self-interest.

  • Investor concerns

The differential treatment of domestic and foreign investors, both in terms of reporting and associated rights/dividends, and the excessive influence of majority shareholders in insider jurisdictions caused many investors to call for parity of treatment.

  • Quality of accounts

Issues concerning financial reporting were raised by many investors and were the focus of much debate and litigation. Shareholder confidence in what was being reported in many instances was eroded. While corporate governance development isn’t just about better financial reporting requirements, the regulation of practices such as off-balance sheet financing has led to greater transparency and a reduction in risks faced by investors.

  • National differences

The characteristics of individual countries may have a significant influence in the way corporate governance has developed. The King report emphasises the importance of qualities that are fundamental to the South African culture, such as collectiveness, consensus, helpfulness, fairness, consultation and religious faith in the development of best practice.

  • Scandals

An increasing number of high profile corporate scandals and collapses including Polly Peck International, BCCI and Maxwell Communications Corporation prompted the development of governance codes in the early 1990s. However, other scandals since then have raised questions about further measures that may be necessary.

1.2 Development of corporate governance codes

To combat these problems, codes of best practice were developed in many jurisdictions. Some of the main provisions of codes have been clear attempts to deal with difficult situations. The problem of an overbearing individual dominating a company has been countered by recommendations in many codes that different directors occupy the positions of a company of chief executive officer and chairman at the head of a company.

The development of codes has also been prompted by the need to clarify ambiguities in the law, or require a higher standard of behaviour than local legislation requires. Codes have also been developed to ensure local companies comply with international best practice.

1.3 Principles of governance

Whether or not the detailed guidance is mostly in the form of principles or rules, there are a number of underlying principles that underpin most codes worldwide, based on what the codes are meant to achieve. This list is based on a number of reports:

  • Ensure adherence to and satisfaction of the strategic objectives of the organisation, thus aiding effective management
  • Convey and reinforce the requirements relating to governance in local statutes and listing rules
  • Assist companies in minimising risk, especially financial, legal and reputational risks, by ensuring appropriate systems of financial control for monitoring risk and ensuring compliance with the law are in place
  • Promote ethical behaviour with integrity, meaning that straightforward dealing and completeness are particularly important
  • Underpin investor confidence, partly in response to the driving forces behind governance discussed above
  • Fulfil responsibilities to all stakeholders and to minimise potential conflicts of interest between owners, managers and the wider stakeholder community
  • Establish clear accountability at senior levels within an organisation; however, one danger may be that boards become too closely involved with day-to-day issues and do not delegate responsibility to management
  • Maintain the independence of those who scrutinise the behaviour of the organisation and its senior executive managers; independence is particularly important for non-executive directors and internal and external auditors
  • Provide accurate and timely reporting of trustworthy/independent financial and operational data to both the management and owners/members of the organisation, to give them a true and balanced picture of what is happening in the organisation
  • Encourage more proactive involvement of owners/members in the effective management of the organisation through recognising their responsibilities of oversight and input to decision-making processes via voting or other mechanisms
  • Use direct behaviour, as the importance of ensuring that boards take specific actions will influence the amount of detailed requirements within codes
                                  1.4 Principles or rules?                 6/08, 12/11, 12/12, 12/13

A continuing debate on corporate governance is whether the guidance should predominantly be in the form of principles, or whether there is a need for detailed laws or regulations.

UK guidance has generally suggested that a voluntary code coupled with disclosure would prove more effective than a statutory code in promoting the key principles of openness, integrity and accountability.

Nevertheless the UK guidance has also gone beyond broad principles and provided some specific guidelines. These have aimed to promote an understanding of directors’ responsibilities and openness about the ways they have been discharged. Specific guidelines also help in raising standards of financial reporting and business conduct, aiming to remove the need for statutory regulation.



A principles-based approach to regulating the behaviour of motorists might say that motorists should drive safely having regard to traffic and road conditions whereas a rules-based approach might specify that motorists should not drive at speeds in excess of 100 km/h.

This example of motoring regulation indicates a basic weakness with both types of regime. Using a principles-based approach, what criteria can be used to determine when a motorist is not driving safely? The motorist being involved in an accident perhaps, but the accident may have been due to other factors. One problem with a rules-based approach is that attention is focused on whether the rules have been broken, and not perhaps on more relevant factors. For example, a motorist driving on a motorway at 100 km/h on a day where the motorway was seriously affected by snow might be obeying the law, but would clearly be driving at an undesirably fast speed.


                                   1.5 Characteristics of a principles-based approach  12/11
  • Focus on aims

The approach focuses on objectives (for example the objective that shareholders holding a minority of shares in a company should be treated fairly) rather than the mechanisms by which these objectives will be achieved. Possibly therefore principles are easier to integrate into strategic planning.

  • Flexibility

A principles-based approach can lay stress on those elements of corporate governance to which rules cannot easily be applied. These include overall areas, such as the requirement to maintain sound systems of internal control, and ‘softer’ areas, such as organisational culture and maintaining good relationships with shareholders and other stakeholders.

  • Breadth of application

Principles-based approaches can be applied across different legal jurisdictions rather than being founded on the legal regulations of one country. The OECD guidelines, which we shall cover later in this chapter, are a good example of guidance that is applied internationally.

  • Comply or explain

Where principles-based approaches have been established in the form of corporate governance codes, the specific recommendations that the codes make have been enforced on a comply or explain basis.

  • Role of capital markets

Principles-based approaches have often been adopted in jurisdictions where the governing bodies of stock markets have had the prime role in setting standards for companies to follow.

Listing rules include a requirement to comply with codes but, because the guidance is in the form of a code, companies have more flexibility than they would if the code was underpinned by legal requirements.


In 2010, when the Combined Code was amended and renamed the UK Corporate Governance Code, there appeared to be increased emphasis on the spirit of the Code and the principles, encouraging boards to think about how to apply the principles. The comply or explain approach was covered in a separate section, which emphasised that non-compliance may be justified so long as the code principles were followed and the justification for non-compliance explained in the annual report. This was in response to criticisms that were raised during the consultation on the amendments, that many investors appeared to want to just see compliance (tick-box) and would not take into account whether the reasons for noncompliance were acceptable.

A new version of the UK Code published in September 2012 gave more guidance on the explanations required. A company should demonstrate that what it was doing was consistent with the underlying governance principles, contributed to good governance and promoted delivery of business objectives. It should set out the background, provide a clear rationale for the action it was taking, and describe actions taken to address any additional risks and maintain conformity with the relevant principle. The explanation should indicate whether the deviation from the Code’s detailed provisions was limited in time and, if so, when the company intended to return to conformity with the Code’s provisions.

Other codes have moved away from talking in terms of comply or explain. The United Nations Code has used an adopt or explain approach. The Netherlands code and the South African King report have used an apply or explain approach. King comments that directors may conclude that following a recommendation may not be in the best interests of the company. The board could decide to apply the recommendation differently, or apply another practice and still achieve the most important principles of governance. Explaining how the principles and recommendations were applied, or the reasons for non-application, results in compliance.


1.6 Characteristics of a rules-based approach
  • Emphasis on achievements

Rules-based systems place more emphasis on definite achievements rather than underlying factors and control systems. The EMAS environmental management system (discussed further in Chapter 11) is a good example of a system based on rules, with requirements for targets to be set and disclosure requirements of whether or not targets have been achieved. However, there may be little incentive to achieve more than is required by the rules.

  • Compulsory compliance

Rules-based approaches allow no leeway. The key issue is whether or not you have complied with the rules. There is no flexibility for different circumstances, for organisations of varying size or in different stages of development.

  • Visibility of compliance

It should in theory be easy to see whether there has been compliance with the rules. Comparison between companies should be straightforward. However, that depends on whether the rules are unambiguous, and the clarity of evidence of compliance or non-compliance).

  • Limitations of rules

Enforcers of a rules-based approach (regulators, auditors) may find it difficult to deal with questionable situations that are not covered sufficiently in the rulebook. This was a problem with Enron. The company kept a number of its financial arrangements off its balance sheet. Although this approach can be seen as not true and fair, Enron could use it because it did not breach the accounting rules then in existence in America. Keeping legislation up to date to keep loopholes closed is a reactive and probably costly process.

  • Criminal sanctions

Rules-based approaches to corporate governance tend to be found in legal jurisdictions and culture that lay great emphasis on obeying the letter of the law rather than the spirit. Serious breaches will be penalised by criminal sanctions. They often take the form of legislation themselves, notably the Sarbanes-Oxley Act which we shall discuss later in this chapter as the most relevant example of a rules-based approach. The amount of legislation for businesses in these jurisdictions may give rise to significant compliance costs.  

1.7 Advantages of a principles-based approach

Possible advantages of basing corporate governance codes on a series of principles are as follows.

  • Avoids legislation

It avoids the need for inflexible legislation that companies have to comply with even though the legislation is not appropriate.

  • Less costly

It is less burdensome in terms of time and expenditure. Although governments have not been directly involved in many of the bodies that have established corporate governance practice, they clearly have a major interest and have made their views known. In many countries there are continual pressures from businesses for governments to ‘reduce the burden of red-tape.’ A principles-based approach can avoid the need for excessive information provision, management and reporting costs, and complex monitoring and support structures.

  • Appropriate for company
    • principles-based approach allows companies to develop their own approach to corporate governance that is appropriate for their circumstances within the limits laid down by stock exchanges. For example, it may be excessive to impose on companies in lower risk industries the same mandatory reporting requirements that companies in higher risk industries face. It should suffice that shareholders are happy with the extent of reporting in lower risk industries.
  • Flexibility
    • principles-based approach can allow for transitional arrangements and unusual circumstances.

If one of the directors leaves the board suddenly, there may be a period of technical noncompliance until the director is replaced. However, most shareholders should generally be satisfied, provided the non-compliance is explained.

  • Emphasis on explanations

Enforcement on a comply or explain basis means that businesses can explain why they have departed from the specific provisions if they feel it is appropriate. In many instances now, the departures from best practice described in reports are of a minor or temporary nature.

Explanations of breaches have generally included details of how and when non-compliance will be remedied.

  • Emphasis on investor decisions
    • principles-based approach accompanied by disclosure requirements puts the emphasis on investors making up their own minds about what businesses are doing (and whether they agree departures from the codes are appropriate).
1.8 Principles-based approach in action: The Hampel report

Of the major corporate governance reports, the Hampel report (1998) in the UK came out the strongest in favour of a principles-based approach. The committee preferred relaxing the regulatory burden on companies and was against treating the corporate governance codes as sets of rules, judging companies by whether they have complied (‘box-ticking’). The report states that there may be guidelines which will normally be appropriate but the differing circumstances of companies mean that sometimes there are valid reasons for exceptions.

‘Good corporate governance is not just a matter of prescribing particular corporate structures and complying with a number of hard and fast rules. There is a need for broad principles. All companies should then apply these flexibly and with common sense to the varying circumstances of individual companies. Companies’ experience of the codes has been rather different. Too often they believe that the codes have been treated as sets of prescriptive rules. The shareholders or their advisers would only be interested only in whether the letter of the rule has been complied with.’

The issue of box-ticking was still being raised when the UK Code was being reviewed in 2009. The UK Financial Reporting Council highlighted disclosure as a particular issue, seeing a need for rationalisation of disclosures and development of disclosures that investors found informative, rather than companies being forced to comply with requirements that were not necessary for their circumstances.

1.9 Criticisms of a principles-based approach

There are a number of problems with a principles-based approach that were highlighted when the Hampel report was debated and have been raised since.

  • Broadness of principles

Principles may be so broad that they are of very little use as a guide to best corporate governance practice. For example, the suggestion that non-executive directors from a wide variety of backgrounds can make a contribution is seen as not strong enough to encourage companies away from recruiting directors by means of the ‘old boy network’ (relying on their current business and social contacts).

  • Misrepresents company attitudes

Comments about box-ticking are incorrect for two reasons. Firstly, shareholders do not apply that approach when assessing accounts. Secondly, it is far less likely that disasters will strike companies with a 100% compliance record since they are unlikely to be content with token compliance, but will have set up procedures that contribute significantly to their being governed well.

  • Consistency between companies

Investors cannot be confident of consistency of approach. Clear rules mean that the same standards apply to all directors. A principles-based approach promotes a ‘level playing field’, preventing individual companies gaining competitive or cost advantages with lower levels of compliance.

  • Confusion over rules

There may be confusion over what is compulsory and what isn’t. Although codes may state that they are not prescriptive, their adoption by the local stock exchange means that specific recommendations in the codes effectively become rules, which companies have to obey in order to retain their listing.

  • Inadequate explanation

Some companies may perceive a principles-based approach as non-binding and fail to comply without giving an adequate or perhaps any explanation. Not only does this demonstrate a failure to understand the purpose of principles-based codes but it also casts aspersions on the integrity of the companies’ decision-makers. A rules-based approach, particularly if backed by criminal sanctions, may give shareholders more confidence that the company and its directors are complying.

  • Investor misunderstanding

A principles-based approach depends on markets understanding the seriousness of noncompliance and revaluing shares appropriately. However, non-specialist shareholders may not interpret the significance of disclosures correctly.

  • Shareholder rights

It’s been suggested that a principles-based approach requires a regime where shareholders have meaningful rights in law, such as being able to vote individual directors off the board.

Exam focus        June 2008 Question 4 asked whether a rules-based approach or principles-based approach should be point               applied in a developing country. In December 2012 and December 2013 there was a question on the difference between rules-based and principles-based approaches to corporate governance.

1.10 Application of principles-based approaches by investors

In practice comply or explain has not led to lots of companies treating compliance as voluntary. Analysts and investors have taken breaches, particularly by larger listed companies, very seriously. The reputation of companies has been adversely affected if they have tried to justify non-compliance on the grounds of excessive trouble or cost. However, the value of smaller or recently quoted companies has been less affected by non-compliance. Stock markets have effectively allowed these companies more latitude even though they have breached the governance codes.  

1.11 Influence of ownership

A key distinction that has been drawn between the corporate governance systems worldwide in different regimes has been between the insider and outsider models of ownership, although in practice most regimes fall somewhere in between the two.

                                 1.12 Insider systems (family companies)                         6/10

Insider or relationship-based systems are where most companies listed on the local stock exchange are owned and controlled by a small number of major shareholders. The shareholders may be members of the company’s founding families, banks, other companies or the Government.

The reason for the concentration of share ownership is the legal system. There tends to be more diverse shareholder ownership in jurisdictions such as the UK that have strong protection for minority shareholders.

Family companies are perhaps the best example of insider structures. Agency is not really an issue with families because of their direct involvement in management. Individual behaviour may be influenced not only by corporate ethical codes but also by the family’s ethical beliefs. Family companies may wish to invest for the long term. However, their longevity depends on the willingness of family members to continue to be actively involved. Family companies also depend on the maintenance of family unity. If this breaks down, governance may become very difficult.

Exam focus

point                       The scenario in June 2008 Question 3 concerned a family-dominated company with various governance issues.

1.12.1 Advantages of insider systems
  • It is easier to establish ties between owners and managers. In particular controlling families often participate in the management of companies.
  • The agency problem and costs of monitoring are reduced if the owners are also involved in management.
  • Even if the owners are not involved in management, it should be easier to influence company management through ownership and dialogue.
  • A smaller base of shareholders may be more flexible about when profits are made and hence more able to take a long-term view. Accessing longer-term capital may be easier.
1.12.2 Disadvantages of insider systems
  • There may be discrimination against minority shareholders as regards, for example, availability of information and ultimately expropriation of the wealth of minorities.
  • Evidence suggests that controlling families tend not to be monitored effectively by banks or by other large shareholders.
  • Insider systems often do not develop more formal governance structures until they need to, for example as a forum for resolving family disagreements or dealing with controversial issues such as succession planning. If they do not develop, then arguments between the controlling directors can undermine personal and professional relationships and company performance.
  • Insider firms, particularly family firms, may be reluctant to employ outsiders in influential positions and may be unwilling to recruit independent non-executive directors.
  • Evidence suggests that insider systems are more prone to opaque financial transactions and misuse of funds.
  • For capital markets to be truly competitive there should be no investors who are on their own of such size that they can influence prices. As we have already seen in many capital markets, transactions by the largest shareholders are now on such a massive scale that considerable price movements can result.
  • As previously discussed, many large shareholders (particularly financial institutions) tend to avoid shares that are seen as speculative and invest only in ‘blue chip’ shares (ie those of leading commercially sound companies). As a result, the shares of such companies tend to be relatively expensive.
  • Succession issues may be a major problem. A vigorous company founder may be succeeded by other family members who are less competent or dynamic.
June 2010 Question 4 looked at a scenario where one family member appeared to be defrauding others.

Exam focus point

Sir Adrian Cadbury, chairman of the committee that produced the seminal Cadbury report in the UK, was also responsible for a report in 2000: Family Firms and their Governance: Creating Tomorrow’s Company from Today’s. In the report Cadbury discussed the stages of establishing corporate governance structures in a family firm, from a family assembly through to a board of directors including members from outside the family. Cadbury commented that establishing a formal board was the key stage of progressing from an organisation based on family relationships to an organisation based on business relationships, and that the establishment of a board provided necessary clarification of responsibilities and the process for taking decisions.

Cadbury commented that in order to manage growth successfully family firms had to:

  • Be able to recruit and retain the very best people for the business
  • Develop a culture of trust and transparency
  • Define logical and efficient organisational structures


1.13 Outsider systems

Outsider systems are ones where shareholding is more widely dispersed, and there is the managerownership separation. These are sometimes referred to as Anglo-American or Anglo-Saxon regimes.

1.13.1 Advantages of outsider systems
  • The separation of ownership and management has provided an impetus for the development of more robust legal and governance regimes to protect shareholders.
  • Shareholders have voting rights that they can use to exercise control.
  • Hostile takeovers are far more frequent, and the threat of these acts as a disciplining mechanism on company management.
1.13.2 Disadvantages of outsider systems
  • Companies are more likely to have an agency problem and significant costs of agency.
  • The larger shareholders in these regimes have often had short-term priorities and have preferred to sell their shares rather than pressurise the directors to change strategies.
Although the British and American systems can both be classified as outsider systems, don’t necessarily assume that exam scenarios will always be about such systems. Some questions may well be set on insider systems, and focus on the implications for corporate governance of operating within insider systems.

Exam focus point

2 Corporate governance codes 6/13
Major governance guidance includes the UK Corporate Governance Code, the South African King report and the Singapore Code of Corporate Governance. International guidance includes the OECD principles and the ICGN report.


2.1 Major governance codes – UK
2.1.1 The Cadbury report

The Cadbury committee in the UK was set up because of the lack of confidence perceived in financial reporting and in the ability of auditors to provide the assurances required by the users of financial statements. The main difficulties were considered to be in the relationship between auditors and boards of directors. In particular, the commercial pressures on both directors and auditors caused pressure to be brought to bear on auditors by the board and the auditors often capitulated. Problems were also perceived in the ability of the board of directors to control their organisations.

  • Corporate governance responsibilities

The roles of those concerned with the financial statements are described in the Cadbury report, published in 1992.

  • The directors are responsible for the corporate governance of the company.
  • The shareholders are linked to the directors via the financial reporting system.
  • The auditors provide the shareholders with an external objective check on the directors’ financial statements.
  • Other concerned users, particularly employees (to whom the directors owe some responsibility) are indirectly addressed by the financial statements.
  • Code of Best Practice

The Code of Best Practice included in the Cadbury report and subsequently amended by later reports was aimed at the directors of all UK public companies, but the directors of all companies were encouraged to use the Code.

2.1.2 The Greenbury code

In 1995, the Greenbury committee published a code which established principles for the determination of directors’ pay and detailing disclosures to be given in the annual reports and accounts.

2.1.3 The Hampel report

In 1998, the Hampel committee followed up matters raised in the Cadbury and Greenbury reports, aiming to restrict the regulatory burden on companies and substituting principles for detail whenever possible. Under Hampel:

  • The accounts should contain a statement of how the company applies the corporate governance principles
  • The accounts should explain their policies, including any circumstances justifying departure from best practice
2.1.4 Combined Code and UK Corporate Governance Code

The London Stock Exchange subsequently issued a combined corporate governance code in 1998, which was derived from the recommendations of the Cadbury, Greenbury and Hampel reports.

Since the publication of the Combined Code a number of reports in the UK have been published about specific aspects of corporate governance.

  • The Turnbull report (1999, revised 2005) focused on risk management and internal control.
  • The Smith report (2003) discussed the role of audit committees.
  • The Higgs report (2003) focused on the role of the non-executive director.

We shall discuss some of the detailed provisions of these codes later in this Text.

The Combined Code was revised a number of times after its original publication in 1998. The May 2010 revision changed the name of the code to the UK Corporate Governance Code. The latest Code (September 2012) is summarised in an Appendix to Chapter 3 of this Text.

Although you can quote from local or international codes when answering questions, the examiner has recommended that all P1 students read the UK Corporate Governance Code.

Exam focus point

2.2 Major governance codes – South Africa

South Africa’s major contribution to the corporate governance debate has been the King report, first published in 1994 and updated in 2002 and 2009 to take account of developments in South Africa and elsewhere in the world.

The King report differs in emphasis from other guidance by advocating an integrated approach to corporate governance in the interest of a wide range of stakeholders – embracing the social,

environmental and economic aspects of a company’s activities. The report encourages active engagement by companies, shareholders, business and the financial press and relies heavily on disclosure as a regulatory measure.

2.3 Singapore Code of Corporate Governance

The Singapore Code (published 2001, revised 2005, with consultations on further revisions in 2011) of Corporate Governance takes a similar approach to the UK Corporate Governance Code with the emphasis being on companies giving a detailed description of their governance practices and explaining any deviation from the Code. Some guidelines, particularly on directors’ remuneration, go beyond that of the UK. Revisions to the Code in 2005 reflected recent concerns. They included expanding the role of the audit committee, requiring companies to have procedures in place for whistleblowing and the separation of substantive motions in general meetings.

2.4 Effects of corporate governance reports

The OECD report (see below) emphasises that codes may leave shareholders and other stakeholders with uncertainty concerning their status. Market credibility therefore requires that their status in terms of coverage, implementation, compliance and sanctions should be clearly specified.  

As far as the UK Codes are concerned, a survey of institutional investors carried out in 2000, two years after the Combined Code was first issued, suggested that provisions of the Codes had had varying impacts. There had been effective implementation of proposals relating to board structure, non-executive directors and board committees. However, the reports had only had a limited effect on director remuneration levels, though there had been greater compliance with guidance relating to length of directors’ service contracts and severance arrangements.

2.5 Convergence of international guidance

Because of increasing international trade and cross-border links, there is significant pressure for the development of internationally comparable practices and standards. Accounting and financial reporting is one area in which this has occurred. Increasing international investment and integration of international capital markets has also led to pressure for standardisation of governance guidelines, as international investors seek reassurance about the way their investments are being managed and the risks involved.

Unsurprisingly the convergence models that have been developed lie between the insider/outsider models and between profit-orientated and ethical stakeholder approaches.

2.6 OECD guidance

The Organisation for Economic Co-operation and Development (OECD) has carried out an extensive consultation with member countries, and developed a set of principles of corporate governance that countries and companies should work towards achieving. The OECD has stated that its interest in corporate governance arises from its concern for global investment. Corporate governance arrangements should be credible and understood across national borders. Having a common set of accepted principles is a step towards achieving this aim.

The OECD developed its Principles of Corporate Governance in 1998 and issued a revised version in April 2004. They are non-binding principles, intended to assist governments in their efforts to evaluate and improve the legal, institutional and regulatory framework for corporate governance in their countries.

They are also intended to provide guidance for stock exchanges, investors and companies. The focus is on stock exchange listed companies, but many of the principles can also apply to private companies and state-owned organisations.

The OECD principles deal mainly with governance problems that result from the separation of ownership and management of a company. Issues of ethical concern and environmental issues are also relevant, although not central to the problems of governance.

2.6.1 The OECD principles

The OECD principles are grouped into five broad areas.

  • The rights of shareholders

Shareholders should have the right to participate and vote in general meetings of the company, elect and remove members of the board and obtain relevant and material information on a timely basis. Capital markets for corporate control should function in an efficient and timely manner.

  • The equitable treatment of shareholders

All shareholders of the same class of shares should be treated equally, including minority shareholders and overseas shareholders. Impediments to cross-border shareholdings should be eliminated.

  • The role of stakeholders

Rights of stakeholders should be protected. All stakeholders should have access to relevant information on a regular and timely basis. Performance-enhancing mechanisms for employee participation should be permitted to develop. Stakeholders, including employees, should be able to freely communicate their concerns about illegal or unethical relationships to the board. 

  • Disclosure and transparency

Timely and accurate disclosure must be made of all material matters regarding the company, including the financial situation, foreseeable risk factors, issues regarding employees and other stakeholders and governance structures and policies. The company’s approach to disclosure should promote the provision of analysis or advice that is relevant to decisions by investors.  

  • The responsibilities of the board

The board is responsible for the strategic guidance of the company and for the effective monitoring of management. Board members should act on a fully informed basis, in good faith, with due diligence and care and in the best interests of the company and its shareholders. They should treat all shareholders fairly. The board should be able to exercise independent judgement. This includes assigning independent non-executive directors to appropriate tasks.

This summary is worth remembering for the exam because it incorporates many key ideas from corporate governance codes around the world.

Exam focus point

2.7 ICGN report

The International Corporate Governance Network (ICGN) issued a report (published in 2005, revised in 2009) aiming to enhance the guidance produced by the OECD. The purpose is to provide practical guidance for boards to meet expectations so that they can operate efficiently and compete for scarce capital effectively. The ICGN believes that companies will only achieve value in the longer term if they manage effectively their relationships with stakeholders such as employees, customers, local communities and the environment as a whole.

The ICGN guidance emphasises the following points in particular.

2.7.1 Sustainable value

The objectives of companies should be to generate sustainable shareholder value over the long term. This means that companies have to manage effectively the governance, social and environmental aspects of the activities as well as the financial.

2.7.2 Board
  • The structure of boards will depend on national models. Boards should be responsible for guiding corporate strategy, monitoring performance and the effectiveness of corporate governance arrangements, dealing with succession issues, aligning remuneration with the company’s interests, ensuring the integrity of systems and overseeing disclosure. Boards need to generate effective debate and discussion about current operations, potential risks and proposed developments.
  • Directors should have appropriate skills, competence, knowledge and experience, and a diversity of perspectives. They should demonstrate independent judgement and fulfil their fiduciary duties to shareholders and the company. All directors need to allocate sufficient time to the company.

They should have appropriate knowledge of the company and access to its operations and staff. (c)                Directors should be re-elected at least once every three years.

  • The board’s chair should not be the current or former Chief Executive Officer. Corporations should establish audit, compensation and nomination/governance committees.
  • There should be a formal process for evaluating the work of the board and individual directors.
2.7.3 Corporate culture
  • The board should promote an ethical corporate culture, with a focus on integrity.
  • Companies should take steps to ensure that ethical standards are adhered to, including developing an organisation-wide code of ethics.
  • Areas codes should cover include bribery and corruption, employee share dealing and compliance with laws.
  • Companies should have whistleblowing channels in place for employees, suppliers or stakeholders to raise issues of non-compliance.
2.7.4 Risk management
  • Companies need to take risks but should also have proper risk management procedures in place.
  • The board must ensure that effective and dynamic processes are in place for analysing and managing risks. It should ensure that the company’s risk-bearing capacity and the tolerance levels for key risks mean that the company does not exceed an appropriate risk appetite. Boards should disclose sufficient information about risk management to reassure shareholders.
2.7.5 Remuneration
  • Senior managers’ remuneration should be aligned with value-creation drivers over an appropriate time period. Pay structures should align manager and shareholder interests, reinforce corporate culture and not reward the taking of inappropriate risks.
  • Companies should clearly disclose remuneration policies and structures, particularly performance metrics. Disclosure should also include justification of annual awards in the context of annual performance. Shareholders should be able to vote annually on remuneration packages and policies.
2.7.6 Audit
  • A robust and independent annual audit is an essential part of a company’s checks and balances. Its scope should be prescribed by law, but the audit committee should also ensure that it is sufficient for the company’s purposes. Shareholders should have the right to expand the scope of the audit.
  • Companies should establish an effective internal audit function or explain why they have not done so. The audit committee should oversee the company’s relationship with the external auditor.
2.7.7 Disclosure and transparency
  • Companies should openly communicate their aims, challenges, achievements and failures on a timely basis, affirming annually the accuracy of financial accounts. Reporting of relevant and material non-financial information is an essential part of disclosure.
  • Companies should also disclose appropriate data about major shareholders and relationships within the corporate group.
2.7.8 Shareholders
  • Companies should act to protect shareholders’ rights to vote. Divergence from shareholders having one vote for each share they own should be justified. Shareholders should be able to vote on removing individual directors and auditors.
  • Major changes affecting the equity, economic interests or share ownership rights of existing shareholders should not be made without prior shareholder approval.
  • Institutional shareholders should be able to discharge their fiduciary duties to vote. They should be able to consult with management.
  • Shareholders should be able to take action against inequitable treatment.
2.7.9 Shareholder responsibilities
  • Shareholders should act in a responsible way that is aligned with the objective of long-term value creation. Institutional shareholders should recognise their responsibilities to beneficiaries, savers and pensioners. They should take account of governance risk factors and the riskiness of a company’s business model.
  • Shareholders should actively vote in a considered manner at general meetings. Institutional shareholders should publicly disclose their voting policies and practices.
2.8 Significance of international codes

Codes such as the OECD code have been developed from best practice in a number of jurisdictions. As such, they can be seen as representing an international consensus. They stress global issues that are important to companies operating in a number of jurisdictions. The OECD code for example emphasises the importance of eliminating impediments to cross-border shareholdings and treating overseas shareholders fairly.

Although the OECD code is non-binding, its principles have been incorporated into national guidance by a number of countries including Greece and China. The OECD principles have also been used by such organisations as the World Bank as a basis for assessing the corporate governance frameworks and practices in individual countries. These assessments are used to determine the level of policy dialogue with, and technical assistance given to, these countries.

The fact that the local codes of different countries are based on the same international code means that compliance costs for companies who are operating in many jurisdictions will be reduced. It also gives investors some confidence about the application of governance rules.

The development of international codes should also be seen in the context of the development of robust financial reporting rules, since investors’ concerns with unreliable accounting information has meant that they have questioned corporate governance arrangements. Developments in international accounting standards aim to promote greater international harmony in accounting practice, and international convergence on governance is consistent with this.

2.9 Limitations of international codes

A number of problems have been identified with international codes.

  • International principles represent a lowest common denominator of general, fairly bland, principles.
  • Any attempt to strengthen the principles will be extremely difficult because of global differences in legal structures, financial systems, structures of corporate ownership, culture and economic factors.
  • As international guidance has to be based on best practice in a number of regimes, development will always lag behind changes in the most advanced regimes.
  • The codes have no legislative power.
  • The costs of following a very structured international regime (such as one based on SarbanesOxley) may be very burdensome for companies based in less developed countries, who are not operating worldwide.
2.10 Contribution of corporate governance codes

However the individual provisions of the codes are viewed, they have undoubtedly made a number of contributions to the corporate environment.

  • The reports have highlighted the contributions good corporate governance can make to companies.
  • The codes have emphasised certain dangers that have contributed to corporate governance failure, for example individuals having too great an influence.
  • The provisions have provided benchmarks that can be used to judge the effectiveness of internal controls and risk management systems.
  • The guidelines have promoted specific good practice in a number of areas, for example nonexecutive directors, performance-related pay and disclosure.
  • The recommendations have highlighted the importance of basic concepts and highlighted how these can be put into practice, for example accountability through recommendations about organisation-stakeholder relationships and transparency by specifying disclosure requirements.
2.11 Impact of corporate governance codes

A survey by McKinsey in 2002 suggested that investors were prepared to pay a premium to invest in a company with good corporate governance. Important signs of good corporate governance for investors included boards with a majority of independent non-executive directors, significant director share ownership and share-based compensation, formal director evaluation and good responsiveness to shareholder requests for information.

As far as company performance is concerned, surveys suggest that firms with strong shareholder rights had higher firm value, higher profits, higher sales growth and also lower capital expenditure and fewer acquisitions. The reason may be that active shareholders give managers less scope to take risks or be negligent about internal control systems. On the other hand, there appears to be little evidence that leadership structure and board composition have much impact on corporate performance. 



The UK Corporate Governance Code is a London Stock Exchange requirement for listed companies. It is recommended for other companies. Some argue that the code should be mandatory for all companies.


  • Discuss the benefits of the UK Corporate Governance Code to shareholders and other users of financial statements.
  • Discuss the merits and drawbacks of having such provisions in the form of a voluntary code.



(a)      Benefits of the UK Corporate Governance Code


Of key importance to the shareholders are the suggestions that the UK Corporate Governance Code makes in respect of the annual general meeting. In the past, particularly for large listed companies, AGMs have sometimes been forbidding and unhelpful to shareholders. The result has been poor attendance and low voting on resolutions.

The UK Code requires that separate resolutions are made for identifiably different items which should assist shareholders in understanding the proposals laid before the meeting.

It also requires that director members of various important board committees (such as the remuneration committee) be available at AGMs to answer shareholders’ questions.

Internal controls

Another important area for shareholders is the emphasis placed on directors’ monitoring and assessing internal controls in the business on a regular basis. While it is a statutory requirement that directors safeguard the investment of the shareholders by instituting internal controls, this additional emphasis on quality should increase shareholders’ confidence in the business.

Directors’ re-election

The requirements of the code also make the directors more accessible to the shareholders. They are asked to submit to re-election every three years. They are also asked to make disclosure in the financial statements about their responsibilities in relation to preparing financial statements and going concern.

Audit committee

Lastly, some people would argue that the existence of an audit committee will lead to shareholders having greater confidence in the reporting process of an entity.

Other users

The key advantage to other users is likely to lie in the increased emphasis on internal controls as this will assist the company in operating smoothly and increasing viability of operations, which will be of benefit to customers, suppliers and employees.

(b)      Voluntary code

Adherence to the UK Corporate Governance Code is not a statutory necessity, although it is possible that in the future such a code might become part of company law.


The key merit of the code being voluntary for most companies is that it is flexible. Companies can review the code and make use of any aspects which would benefit their business.

If they adopt aspects of the code, they can disclose to shareholders what is being done to ensure good corporate governance, and which aspects of the code are not being followed, with reasons.

This flexibility is important, for there will be a cost of implementing such a code, and this cost might outweigh the benefit for small or owner-managed businesses.


Critics would argue that a voluntary code allows companies that should comply with the code to get away with non-compliance unchallenged.

They would also argue that the type of disclosure made to shareholders about degrees of compliance could be confusing and misleading to shareholders and exacerbate the problems that the code is trying to guard against.


3 Sarbanes-Oxley

The Sarbanes-Oxley legislation requires directors to report on the effectiveness of the controls over financial reporting, limits the services auditors can provide and requires listed companies to establish an audit committee. It adopts a rules-based approach to governance.


3.1 The Enron scandal

The most significant scandal in America in recent years has been the Enron scandal, when one of the country’s biggest companies filed for bankruptcy. The scandal also resulted in the disappearance of Arthur Andersen, one of the Big Five accountancy firms, who had audited Enron’s accounts. The main reasons why Enron collapsed were overexpansion in energy markets, too much reliance on derivatives’ trading which eventually went wrong, breaches of federal law, and misleading and dishonest behaviour. However, enquiries into the scandal exposed a number of weaknesses in the company’s governance.

3.1.1 Lack of transparency in the accounts

This particularly related to certain investment vehicles that were kept off balance sheet. Various other methods of inflating revenues, offloading debt, massaging quarterly figures and avoiding taxes were employed.

3.1.2 Ineffective corporate governance arrangements

The company’s management team was criticised for being arrogant and overambitious. The Economist suggested that Enron’s Chief Executive Officer, Kenneth Lay, was like a cult leader with his staff and employees fawning over his every word and following him slavishly. The non-executive directors were weak, and there were conflicts of interest. The chair of the audit committee was Wendy Gramm. Her husband, Senator Phil Gramm, received substantial political donations from Enron.

3.1.3 Inadequate scrutiny by the external auditors

Arthur Andersen failed to spot or question dubious accounting treatments. Since Andersen’s consultancy arm did a lot of work for Enron, there were allegations of conflicts of interest.

3.1.4 Information asymmetry

Information asymmetry is the agency problem of the directors/managers knowing more than the investors. The investors included Enron’s employees. Many had their personal wealth tied up in Enron shares, which ended up being worthless. They were actively discouraged from selling them. Many of Enron’s directors, however, sold the shares when they began to fall, potentially profiting from them. It is alleged that the Chief Financial Officer, Andrew Fastow, concealed the gains he made from his involvement with affiliated companies.

3.1.5 Executive compensation methods

These were meant to align the interests of shareholders and directors, but seemed to encourage the overstatement of short-term profits. Particularly in the US, where the tenure of chief executive officers is fairly short, the temptation is to inflate profits in the hope that share options will have been cashed in by the time the problems are discovered.

3.2 The Sarbanes-Oxley Act 2002

In the US the response to the breakdown of stock market trust caused by perceived inadequacies in corporate government arrangements and the Enron scandal was the Sarbanes-Oxley Act 2002. The Act applies to all companies that are required to file periodic reports with the Securities and Exchange Commission (SEC). The Act was the most far-reaching US legislation dealing with securities in many years and has major implications for public companies. Rule-making authority was delegated to the SEC on many provisions.

Sarbanes-Oxley shifts responsibility for financial probity and accuracy to the board’s audit committee, which typically comprises three independent directors, one of whom has to meet certain financial literacy requirements (equivalent to non-executive directors in other jurisdictions).

Along with rules from the Securities and Exchange Commission, Sarbanes-Oxley requires companies to increase their financial statement disclosures, to have an internal code of ethics and to impose restrictions on share trading by, and loans to, corporate officers.

3.3 Detailed provisions of the Sarbanes-Oxley Act
3.3.1 Oversight Board

The Act set up a new regulator, The Public Company Accounting Oversight Board (PCAOB), to oversee the audit of public companies that are subject to the securities laws.

The Board has powers to set auditing, quality control, independence and ethical standards for registered public accounting firms to use in the preparation and issue of audit reports on the financial statements of listed companies. In particular the board is required to set standards for registered public accounting firms’ reports on listed company statements on their internal control over financial reporting. The board also has inspection and disciplinary powers over firms.

3.3.2 Auditing standards

Audit firms should retain working papers for at least seven years and have quality control standards in place, such as second partner review. As part of the audit they should review internal control systems to ensure that they reflect the transactions of the client and provide reasonable assurance that the transactions are recorded in a manner that will permit preparation of the financial statements in accordance with generally accepted accounting principles. They should also review records to check whether receipts and payments are being made only in accordance with management’s authorisation.

3.3.3 Non-audit services

Auditors are expressly prohibited from carrying out a number of services including internal audit, bookkeeping, systems design and implementation, appraisal or valuation services, actuarial services, management functions and human resources, investment management, legal and expert services. Provision of other non-audit services is only allowed with the prior approval of the audit committee.

3.3.4 Quality control procedures

There should be rotation of lead or reviewing audit partners every five years and other procedures such as independence requirements, consultation, supervision, professional development, internal quality review and engagement acceptance and continuation.

3.3.5 Auditors and audit committee

Auditors should discuss critical accounting policies, possible alternative treatments, the management letter and unadjusted differences with the audit committee.

3.3.6 Audit committees

Audit committees should be established by all listed companies.

All members of audit committees should be independent and should therefore not accept any consulting or advisory fee from the company or be affiliated to it.At least one member should be a financial expert.

Audit committees should be responsible for the appointment, compensation and oversight of auditors. Audit committees should establish mechanisms for dealing with complaints about accounting, internal controls and audit.

3.3.7 Corporate responsibility

The chief executive officer and chief finance officer should certify the appropriateness of the financial statements and that those financial statements fairly present the operations and financial condition of the issuer. If the company has to prepare a restatement of accounts due to material non-compliance with standards, the chief finance officer and chief executive officer should forfeit their bonuses.

3.3.8 Off-balance sheet transactions

There should be appropriate disclosure of material off-balance sheet transactions and other relationships (transactions that are not included in the accounts but that impact on financial conditions, results, liquidity or capital resources).

3.3.9 Internal control reporting (the Section 404 requirement)

S 404 of the Act states that annual reports should contain internal control reports that state the responsibility of management for establishing and maintaining adequate internal control over financial reporting. Annual reports should contain an assessment of the effectiveness of the internal control over financial reporting, and a statement identifying the framework used by management to evaluate the effectiveness of the company’s internal control over financial reporting.

External auditors should report on this assessment, having carried out independent testing of the control system.

To carry out their review effectively, management is likely to have to rely on internal audit work on the control systems. Internal auditors’ work would include:

  • Identifying controls at an entity and operational level
  • Reviewing the completeness of documentation
  • Testing controls
  • Advising on the contents of the statement of effectiveness of the internal control system and the disclosure of material weaknesses

Companies should also report whether they have adopted a code of conduct for senior financial officers and the content of that code.

3.3.10 Whistleblowing provisions

Employees of listed companies and auditors will be granted whistleblower protection against their employers if they disclose private employer information to parties involved in a fraud claim.

3.4 Impact of Sarbanes-Oxley in America

The biggest expense involving compliance that companies are incurring is fulfilling the requirement to ensure their internal controls are properly documented and tested, and there is better communication about controls to shareholders. US companies had to have efficient controls in the past, but they now have to document them more comprehensively than before, and then have the external auditors report on what they have done. This has arguably resulted in greater market confidence in American companies.

The Act also formally stripped accountancy firms of almost all non-audit revenue streams that they used to derive from their audit clients, for fear of conflicts of interest. The Act makes clear that there needs to be distance between companies and external auditors. External auditors’ position has also been strengthened by the requirement for listed companies to operate effective audit committees.

For lawyers, the Act strengthens requirements on them to whistleblow internally on any wrongdoing they uncover at client companies, right up to board level.

3.5 International impact of Sarbanes-Oxley

The Act also has a significant international dimension. About 1,500 non-US companies, including many of the world’s largest, list their shares in the US and are covered by Sarbanes-Oxley. There were complaints that the new legislation conflicted with local corporate governance customs and, following an intense round of lobbying from outside the US, changes to the rules were secured. For example, German employee representatives who are non-management can sit on audit committees, and audit committees do not have to have board directors if the local law says otherwise, as it does in Japan and Italy.

In addition, as America is such a significant influence worldwide, arguably Sarbanes-Oxley may influence certain jurisdictions to adopt a more rules-based approach.

3.6 Criticisms of Sarbanes-Oxley

Monks and Minnow have criticised Sarbanes-Oxley for not being strong enough on some issues, for example the selection of external auditors by the audit committee, and at the same time being over-rigid on others. Directors may be less likely to consult lawyers in the first place if they believe that legislation could override lawyer-client privilege.

In addition, Monks and Minnow allege that a Sarbanes-Oxley compliance industry has sprung up focusing companies’ attention on complying with all aspects of the legislation, significant or much less important. This has distracted companies from improving information flows to the market and then allowing the market to make well-informed decisions. The Act has also done little to address the temptation provided by generous stock options to inflate profits, other than requiring possible forfeiture if accounts are subsequently restated.

Most significantly perhaps there is recent evidence of companies turning away from the US stock markets and towards other markets, such as London. The number of initial public listings fell in New York after the introduction of Sarbanes-Oxley and rose in stock exchanges allowing a more flexible, principles-based approach. An article in the Financial Times suggested that this was partly due to companies tiring of the increased compliance costs associated with Sarbanes-Oxley implementation and allegedly reduced flexibility and corporate risk-taking.

In particular, directors of smaller listed companies have been unhappy with the requirement for companies to report on the effectiveness of their internal control structure and procedures for financial reporting. They have argued that gathering sufficient evidence for auditors on the internal controls over financial reporting is expensive and less important for small companies than for large ones. In addition, the nature of the regulatory regime may be an increasingly significant factor in listing decisions. A rules-based approach means compliance must be absolute. The comply or explain choice is not available.



The following summary compares the main points of UK and US guidance.

  UK guidance  US guidance 
Scope  All types of internal control including financial, operational and compliance Internal control over financial reporting
Audit committee Smith report states this should consist of independent non-executive directors, at least one having relevant and recent financial experience Should consist of independent directors, one of whom should be a financial expert
Audit rotation Ethical guidance states lead audit partner should be rotated at least every five years, other key audit partners at least every seven years Rotation of lead partner required every five years
Non-audit services  Audit committee should review non-audit services provided by auditor to ensure auditor objectivity and independence is safeguarded. Accountancy bodies state that executing transactions or acting in management is not compatible with being an objective auditor. Other services cast doubts on objectivity Auditors forbidden by law from carrying out a number of non-audit services including internal audit, bookkeeping, systems design/implementation, valuation, actuarial, management, expert services
Reports on internal control  Accounts to include statement of responsibility of management for internal controls. Also disclosure that there is a process for identifying, evaluating and managing risks and how board has reviewed this Accounts should include statement of responsibility of management for internal controls and financial reporting and accounts should also include audited assessment of financial reporting controls
Code of ethics No equivalent guidance Companies should adopt a code of ethics for senior financial officers
Certification by directors  Under UK legislation directors are required to state in directors’ report that there is no relevant audit information that they know and that auditors are unaware Certification of appropriateness and fair presentation of accounts by chief executive and chief finance officer


In his 2008 article on corporate governance, the examiner emphasised the importance of students understanding that the form and enforcement of corporate governance guidelines is an important part of corporate activity, as these systems underpin investor confidence. Students need to realise that SarbanesOxley has been, and continues to be, an important influence on international corporate governance.
Exam focus point

                                  4 Corporate social responsibility                 6/15

FAST FORWARD             Debates on organisations’ social responsibilities focus on what these responsibilities are, how organisations should deal with stakeholders and what aspects of an organisation’s environment, policies and governance are affected.

                                  4.1 Pressures on organisations                                         12/10

Organisations face a number of pressures from different directions to be socially responsible.

4.1.1 Governance requirements

The 2009 update of the South African King report emphasised the importance of sustainability, linking it with the value of ethics and improved ethical standards. The King report stresses that sustainability is a business opportunity to eliminate or minimise adverse consequences for the company, on the community and on the environment and to improve the impact of the company’s operations on the economic life of the community. The triple bottom line (economic, social and environmental responsibilities) enables a company to be relevant to society and the natural environment.

Stakeholder expectations

Pressures on organisations to widen the scope of their corporate public accountability come from increasing expectations of stakeholders and knowledge about the consequences of ignoring such pressures. The King report stresses the importance of engagement with external stakeholders, and individual workers and stakeholders being able to communicate openly.

Stakeholders include communities (particularly where operations are based), customers (product safety issues), suppliers, supply chain participants and competitors. Issues such as plant closures, pollution, job creation and sourcing can have powerful social effects on these stakeholders.

4.1.3 Reputation risk

We shall discuss the importance of loss of corporate reputation in later chapters. Increasingly a business must have the reputation of being a responsible business that enhances long-term shareholder value by addressing the needs of its stakeholders. 

4.2 Significance of corporate social responsibility

Businesses, particularly large ones, are subject to increasing expectations that they will exercise corporate social responsibility. Carroll’s model of social responsibility suggests there are four levels of social responsibility.

4.2.1 Economic responsibilities

Companies have economic responsibilities to shareholders demanding a good return, to employees wanting fair employment conditions and customers who are seeking good-quality products at a fair price. Businesses are set up to be properly functioning economic units and so this responsibility forms the basis of all others.

4.2.2 Legal responsibilities

Since laws codify society’s moral views, obeying those laws must be the foundation of compliance with social responsibilities. Although in all societies corporations will have a minimum of legal responsibilities, there is perhaps more emphasis on them in continental Europe than in the Anglo-American economies where the focus of discussion has been on whether many legal responsibilities constitute excessive red tape.

4.2.3 Ethical responsibilities

These are responsibilities that require corporations to act in a fair and just way even if the law does not compel them to do so.

4.2.4 Philanthropic responsibilities

According to Carroll, these are desired rather than being required of companies. They include charitable donations, contributions to local communities and providing employees with the chance to improve their own lives.

4.3 Corporate social responsibility and stakeholders

Inevitably discussion on corporate social responsibilities has been tied in with the stakeholder view of corporate activity, the view that as businesses benefit from the goodwill and other tangible aspects of society, that they owe it certain duties in return, particularly towards those affected by its activities.

As discussed in Chapter 1 organisations need to identify and classify stakeholders systematically and decide on how they will respond to stakeholder claims. The Mendelow model is one method of assessing the power and interest of stakeholders.

4.3.1 Problems of dealing with stakeholders

Whatever the organisation’s view of its stakeholders, certain problems in dealing with them on corporate social responsibility may have to be addressed.

  • Collaborating with stakeholders may be time consuming and expensive.
  • There may be culture clashes between the company and certain groups of stakeholders, or between the values of different groups of stakeholders with companies caught in the middle.
  • There may be conflict between the company and stakeholders on certain issues when they are trying to collaborate on other issues.
  • Consensus between different groups of stakeholders may be difficult or impossible to achieve, and the solution may not be economically or strategically desirable.
  • Influential stakeholders’ independence (and hence ability to provide necessary criticism) may be compromised if they become too closely involved with companies.
  • Dealing with certain stakeholders (eg public sector organisations) may be complicated by their being accountable in turn to the wider public.
4.4 Impact of corporate social responsibility on strategy and corporate governance

Social responsibilities can impact on what companies do in a number of ways.

4.4.1 Objectives and mission statements

If the organisation publishes a mission statement to inform stakeholders of strategic objectives, mention of social objectives is a sign that the board believes that they have a significant impact on strategy.

4.4.2 Ethical codes of conduct

As part of their guidance to promote good corporate behaviour among their employees, some organisations publish a business code of ethics. We shall look at these in Chapter 10.

4.4.3 Corporate social reporting and social accounts

We shall see in Chapter 11 how organisations, as part of their reporting on operational and financial matters, report on ethical or social conduct. Some go further, producing social accounts showing quantified impacts on each of the organisation’s stakeholder constituencies.

4.4.4 Corporate governance

Impacts on corporate governance could include representatives from key stakeholder groups on the board, or perhaps even a stakeholder board of directors. It also implies the need for a binding corporate governance code that regulates the rights of stakeholder groups.

4.5 Ownership and corporate social responsibility

Having talked about the social responsibilities of companies, we also need to consider the responsibilities of shareholders in companies. This is complicated by the nature of ownership of shares. Shareholders are not buying something tangible that they can use as they please and regulate how others use it. Instead shareholders are buying a right to participate in risks and rewards from a separate legal entity.

One view is that shareholders have responsibilities arising directly out of their rights, particularly the rights to vote in an annual general meeting. The argument is that they should use the voice they have at the annual general meeting. If they own a large block of shares, they should make the most of the influence this gives them to ensure good corporate governance and accountability for decisions made.

A wider view is that shareholders, by buying shares in the hope of an opportunity of greater returns than they could achieve from a safe investment, also have a responsibility to society in the same way as they would be responsible for controlling tangible property that they owned. They should be insisting that those managing the company carry out a policy that is consistent with the public welfare. Institutional investors can help achieve this by having publicly-stated policies that they will only invest in companies that demonstrate corporate social responsibility.

One of the main problems with this view in relation to large corporations is the wide dispersion of shareholders. This means that shareholders with small percentage holdings have negligible influence on managers. In addition the ease with which shareholders can dispose of shares on the stock markets arguably loosens their feeling of obligation in relation to their property. This then raises the question of why the speculative (and possibly short-term) interests of shareholders should prevail over the longerterm interests of other stakeholders.

In corporate governance discussions, the idea of ownership responsibilities has had a significant influence because of the importance of institutional shareholders. Not only do they have the level of shareholdings that can be used as a lever to pressure managers, but they themselves have fiduciary responsibilities as trustees on behalf of their investors.

In the exam you may have to bring these ideas in when discussing the role of institutional shareholders. 
Exam focus point

If you were writing a corporate governance code, would you employ a principles-based or rules-based approach?

In the end it would depend on the society in which you lived and what you were trying to achieve in the code.

A society with an emphasis on obeying a strict legal code would probably be most comfortable with a governance framework that reflected this and was very much rules-based. Similarly a society with an active legal profession in pursuit of any loopholes they can find probably needs some watertight rules. You would also probably prefer a governance framework that was rules-based if your objectives were fairly narrow, if you were concerned with specific abuses rather than all-round corporate governance. In effect you would be developing a framework similar to many accounting standards, which in recent years have aimed to narrow (or eliminate) choices in accounting practice.

A society where the emphasis was on being a ‘sound’ corporate citizen (a good member of the Stock Exchange club perhaps) and which focused on following best practice with limited law or regulations in support would probably be most happy with a principles-based approach. You would also have to use that approach if your code covered governance best practice over a wide spectrum, since many aspects of governance cannot be easily defined in terms of following simple rules.

You may have taken the compromise position, that the code should be a combination of general principles with some specific provisions, for example requiring all listed companies to have an audit committee. The risk with doing this may be that companies focus on complying with the specific provisions, and neglect the governance areas covered by the vaguer, more general principles. However, research suggests that companies that happily comply with specific provisions in codes also have a good compliance record with the more general recommendations.

 5 Public sector governance  12/14

FAST FORWARD             The public sector is different from the private sector in a number of ways but in general the main differences are in the aims and purposes of the public sector, its sources of funding and accountability.

5.1 Forms of organisations
5.1.1 Public sector

In a mixed economy the public sector delivers those goods and services that cannot or should not be provided by private sector companies or the business sector. The public sector provides services for the population either free of charge or for a cost. The services provided may be on a national level, such as a national health service, or on a local level, such as libraries. The public sector may be funded from local taxation, from central government grants, or from a combination of the two.

Public services are funded by taxpayers and are administered by elected officials at national level

(Members of Parliament) or at local level (local councils or municipalities). See also Chapter 1, Section 2.8 for a discussion of agency arrangements in the public sector.

5.1.2 Private sector

This comprises a large variety of organisations with the principal aim of, in simple terms, making a profit for the benefit of individual owners or shareholders who provide the capital or funding for commercial activity.

5.1.3 Charities

These are organisations set up for not for profit purposes, funded from donations.

5.1.4 Non-governmental organisations (NGOs) and quasi-autonomous nongovernmental organisations (QUANGOs)

QUANGOs are bodies set up by central government to carry out functions similar to government but with non-elected executive members. The UK Cabinet Office’s definition of a QUANGO is:

‘… a body which has a role in the processes of national government, but is not a government department, or part of one, and which accordingly operates to a greater or lesser extent at arm’s length from Ministers.’

The following table shows the main characteristics of these types of organisation.

  Public sector Private sector Charitable status NGOs/quasi NGOs
Purposes and objectives Public service Profit Relief of poverty, research, etc As defined by owners
Performance Central regulation Financial reporting standards SORP Set outcomes
Ownership Government Partners/shareholders Donors Government
Stakeholders (including lobby groups) The public, central government, service users Shareholders, regulators, taxation authorities Service users Government, lobbying groups

Lobbying groups are those that come together with a common interest, with a view to influencing government policy. They may come under criticism if they are seen to have sufficient power to influence policy in their favour.

5.2 Levels of public sector organisations
  • Subnational

A division of government below central level, for example a state, county or province

  • National

Central government, normally based in the capital city of a country

  • Supranational

Above individual national governments, for example the European Union

5.3 Public and private sector arrangements
  • Strategic objectives

Private sector companies’ reasons for existing are set out in the Memorandum and Articles of Association or similar document. Strategic objectives are set by the board of directors and are monitored against specific targets, such as increase in profit or market share.

In the public sector objectives are determined by the funding body in the first instance although institutions may have a level of autonomy in how they operate and may be able to set local targets to meet specific needs.

  • Leadership

In the private sector leadership is provided by the board of directors and decisions are in some cases (eg appointing the external auditor) ratified by a majority of shareholders. Leadership in the public sector is founded on high standards of behaviour and leading by example.

In the UK, leadership is one of the seven principles of public life as determined by the Nolan committee in 1995, the other six being selflessness, integrity, objectivity, accountability, openness and honesty.

  • Governance arrangements

Public sector organisations must have arrangements in place to demonstrate that public money is being used appropriately and that specified objectives are being met in the provision of public services. Audit or inspection regimes may be in place to report on success in achieving objectives.

5.4 Characteristics of public sector governance
  • Nature of the state

The characteristics of a state vary considerably depending on whether it is a democracy, whether it has a formal constitution and so on. The UK, for example, is a constitutional monarchy where the monarch is the head of state (a largely ceremonial role) and the Prime Minister is the head of the Government. Most states require the following four ‘organs of state’ in order to function.

(a) Legislature – makes the laws (b) Judiciary – interprets the law

  • Executive – government departments headed by cabinet ministers
  • Secretariat – the administration or ‘civil service’
  • Nature of democratic control

In a democracy the Government is answerable ultimately to the electorate. This may be at national or local level.

  • Policy implementation

At central government level policy implementation is the responsibility of the Ministers in charge of government departments. In local government the Council conducts its affairs through officers who head the various service departments in the local authority.

  • Accountability and reporting

Public entities generally need to demonstrate that they have used public money for the purposes intended and have obtained value for that money. One way of measuring this is to evaluate performance against the three ‘Es’:

Economy – obtaining inputs of the appropriate quality at the lowest price available

Efficiency – delivering the service to the appropriate standard at minimum cost, time and effort

Effectiveness – achieving the desired objectives as stated in the entity’s performance plan

This is a new topic in the P1 syllabus, examinable from December 2014. You are strongly advised to read the two articles on this area written by the P1 examining team; these articles are called ‘Public Sector

Governance – Part 1’ and ‘Public Sector Governance – Part 2’ and can be accessed via the ACCA website. 

Exam focus point



Chapter Roundup




Globalisation, the treatment of investors and major corporate scandals have been major driving forces behind corporate governance developments.

Many governance codes have adopted a principles-based approach allowing companies flexibility in interpreting the codes’ requirements and to explain if they have departed from the provisions of the code.

Insider systems are where listed companies are owned by a small number of major shareholders.

Outsider systems are where shareholdings are more widely dispersed, and the management-ownership split is more of an issue.

Major governance guidance includes the UK Corporate Governance Code, the South African King report and the Singapore Code of Corporate Governance. International guidance includes the OECD principles and the ICGN report.
The Sarbanes-Oxley legislation requires directors to report on the effectiveness of the controls over financial reporting, limits the services auditors can provide and requires listed companies to establish an audit committee. It adopts a rules-based approach to governance.
Debates on organisations’ social responsibilities focus on what these responsibilities are, how organisations should deal with stakeholders and what aspects of an organisation’s environment, policies and governance are affected.
The public sector is different from the private sector in a number of ways, but in general the main differences are in the aims and purposes of the public sector, its sources of funding and accountability.

Quick Quiz

  • True
    Box-ticking is a major criticism of a principles-based approach to corporate governance.


  • Fill in the blank:

Countries where most listed companies are owned and controlled by a small number of major shareholders are known as …………………………………. systems.

  • Which UK report concentrated on establishing principles for the determination of directors’ pay and disclosures about directors’ remuneration in the accounts?
    • The Cadbury report C             The Hampel report B          The Greenbury report               D             The Turnbull report
  • What are the five major areas covered by the OECD principles?
  • Which major corporate scandal primarily prompted the development of the Sarbanes-Oxley rules?
  • Which of the following types of work are external auditors allowed to carry out for audit clients under the Sarbanes-Oxley rules?
    • Internal audit      C             Taxation advice
    • Systems design and implementation             D             Investment management
  • Sarbanes-Oxley requires accounts to include an assessment of the effectiveness of the internal control structure and the procedures for financial reporting.



  • What were the four levels of corporate social responsibility suggested by Carroll?

Answers to Quick Quiz

  • Box-ticking is a major criticism of a rules-based approach.
  • Insider systems
  • B The Greenbury report
  • Rights of shareholders, equitable treatment of shareholders, role of stakeholders, disclosure and transparency, responsibilities of the board
  • Enron
  • C Taxation advice (although the approval of the client’s audit committee is required)
  • True
8                   Economic          Ethical
                      Legal          Philanthropic



Number Level Marks Time
Q2 Examination 25 49 mins


03 Corporate governance practice and reporting

In this chapter we see in more detail how corporate governance reports have tried to
address the issues we’ve discussed in the first two chapters, particularly the last
section of
Chapter 1. A quick glance at the contents of this chapter reveals that a
properly functioning board is central to good corporate governance, hence we spend
a lot of time discussing who should be on the board and what they should be doing.
Section 3 deals with the perennially controversial area of directors’ remuneration.
In the last two sections we deal with the areas of relationships with shareholders and
stakeholders. Section 4 focuses on methods of communication, particularly general
meetings. Section 5 deals with what is reported to shareholders. Remember that one
aspect of the principal-agent problem is information asymmetry, agents
(directors/managers) being in possession of more information than principals
(shareholders). The disclosure provisions in legislation and corporate governance
reports aim to address this issue.
In this chapter we have tried to mix and match codes with issues, mentioning
specific codes such as the UK Corporate Governance Code that contain particularly
important governance provisions. However, the examiner has stressed that
worldwide convergence has meant that similar codes operate in many jurisdictions,
and that it will be acceptable to refer to
relevant provisions of your local code or
international codes when answering questions.

Study guide

    Intellectual level
A3 The board of directors  
(a) Explain and evaluate the roles and responsibilities of boards of directors. 3
(b) Describe, distinguish between and evaluate the cases for and against unitary and twotier structures. 3
(c) Describe the characteristics, board composition and types of directors (including defining executive and non-executive directors). 2
(d) Describe and assess the purposes, roles and responsibilities of non-executive directors. 3
(e) Describe and analyse the general principles of the legal and regulatory frameworks within which directors operate on corporate boards. 2
(f) Define, explore and compare the roles of the chief executive and company chairman. 3
(g) Describe and assess the importance, and execution, of induction and continuing professional development of directors on boards of directors. 3
(h) Explain and analyse the frameworks for assessing the performance of boards and individual directors (including NEDs) on boards. 2
(i) Explain the meanings of diversity and critically evaluate issues of diversity on boards of directors. 3
A4 Board committees  
(a) Explain and assess the importance, roles and accountabilities of board committees in corporate governance. 3
(b) Explain and evaluate the role and purpose of the following committees in effective corporate governance: remuneration committee, nominations committee, risk committee, audit committee. 3
A5 Directors’ remuneration  
(a) Describe and assess the general principles of remuneration. 3
(b) Explain and assess the effect of various components of remuneration packages on directors’ behaviour. 3
(c) Explain and analyse the legal, ethical, competitive and regulatory issues associated with directors’ remuneration. 3
A8 Governance: reporting and disclosure  
(a) Explain and assess the general principles of disclosure and communication with shareholders. 3
(b) Explain and analyse best practice corporate governance disclosure requirements. 2
(c) Define and distinguish between mandatory and voluntary disclosure of corporate information in the normal reporting cycle. 2
(d) Explain and explore the nature of, and reasons and motivations for, voluntary disclosure in a principles-based reporting environment (compared with, for example, the reporting regime in the USA). 3
(e) Explain and analyse the purposes of the annual general meeting and extraordinary general meetings for information exchange between the board and shareholders. 2
(f) Describe and assess the role of proxy voting in corporate governance. 3

Exam guide

The exam is likely to include many questions like Question 1 in the Pilot Paper, requiring assessment of the strength of corporate governance arrangements in a particular organisation. This chapter provides the benchmarks against which arrangements can be assessed. You may also see quite specific part questions on aspects of corporate governance, such as the role of non-executive directors.

                                1 Role of the board                                12/14, 6/15

The board should be responsible for taking major policy and strategic decisions.

Directors should have a mix of skills and their performance should be assessed regularly.

Appointments should be conducted by formal procedures administered by a nomination committee.


1.1 Definition of board’s role

If the board is to act effectively, its role must be defined carefully.



The South African King report provides a good summary of the role of the board.

‘To define the purpose of the company and the values by which the company will perform its daily existence and to identify the stakeholders relevant to the business of the company. The board must then develop a strategy combining all three factors and ensure management implements that strategy.’

The King report stresses that the board is responsible for assets and for ensuring the company follows its strategic plan. For management to be held properly responsible, there must be a system in place that allows for corrective action and penalising mismanagement. Responsible management should do, when necessary, whatever it takes to set the company on the right path. The UK Corporate Governance Code provides an alternative definition.

‘The board is collectively responsible for promoting the success of the company by directing and supervising the company’s affairs.

The board’s role is to provide entrepreneurial leadership of the company, within a framework of prudent and effective controls which enable risk to be assessed and managed.

The board should set the company’s strategic aims, ensure that the necessary financial and human resources are in place for the company to meet its objectives and review management performance.

The board should set the company’s values and standards and ensure that its obligations to its stakeholders and others are understood and met.’

For governmental organisations, the UK’s Good Governance Standard for Public Services defines the primary functions of the governing body as:

  • Establishing the organisation’s strategic direction and aims, in conjunction with the executive
  • Ensuring accountability to the public for the organisation’s performance  Ensuring that the organisation is managed with probity and integrity This involves:
  • Constructively challenging and scrutinising the executive
  • Ensuring that the public voice is heard in decision-making
  • Forging strategic partnerships with other organisations


1.2 Scope of role

To be effective, boards must meet frequently. The Singapore Code of Corporate Governance emphasises the need for boards to meet regularly and as warranted by circumstances. Companies should amend their constitutions to provide for telephonic and videoconference meetings. The ICGN guidelines emphasise the importance of the non-executive directors meeting in the absence of the executive directors as often as required and on a regular basis.

Directors should have sufficient time to fulfil their responsibilities. The UK Corporate Governance Code states that the boards should not agree to a full-time executive director taking on more than one nonexecutive directorship in a FTSE 100 company nor the chairmanship of such a company. The time commitment for non-executive directors should be set out when they are appointed, and they should undertake to have sufficient time to discharge their role.

1.2.1 Matters for board decision

The board should have a formal schedule of matters specifically reserved to it for decision at board meetings. Some would be decisions such as mergers and takeovers that are fundamental to the business and therefore should not be taken solely by executive managers. Other decisions would include acquisitions and disposals of assets of the company or its subsidiaries that are material to the company, investments, capital projects, bank borrowing facilities, loans and foreign currency transactions, all above a set size (to be determined by the board).

1.2.2 Other tasks
  • Monitoring the chief executive officer
  • Overseeing strategy
  • Monitoring risks, control systems and governance
  • Monitoring the human capital aspects of the company eg succession, morale, training, remuneration, etc
  • Managing potential conflicts of interest
  • Ensuring that there is effective communication of its strategic plans, both internally and externally



For the voluntary sector, the UK’s Good Governance: A Code for the Voluntary and Community Sector lays much the same requirements on trustees that governance codes lay on boards of directors. Even though trustees are acting in an unpaid capacity, they are still accountable for their organisation performing well and upholding its values. The code stresses the importance of the board being well organised and the board, subcommittees and offices having clear responsibilities. The code also contains various ethical requirements, including integrity, avoidance of conflicts of interest, responsiveness and accountability. The Code stresses the board of trustees’ role in ensuring compliance with the objects, purposes and values of the organisation and with its governing document.

The Code also lays more stress than the governance codes targeted at listed companies on trustees focusing on the strategic direction of their organisation and not becoming involved in day-to-day activities. The chief executive officer should provide the link between the board and the staff team, and the means by which board members hold staff to account.

Other areas in the Code which go beyond the requirements for companies are for trustees to uphold and apply the principles of equality and diversity, and for the organisation to be fair and open to all sections of the community in all its activities.

For the public sector, the Good Governance Standard for Public Services stresses the need to focus on the organisation’s purpose and on outcomes for service users and the rest of the community when making decisions. These decisions should be informed and transparent.  


1.3 Attributes of directors

In order to carry out effective scrutiny, directors need to have relevant expertise in industry, company and functional area and governance. The board as a whole needs to contain a mix of expertise and show a balance between executive management and independent non-executive directors. The South African King report, reporting within a racially mixed region, stresses the importance of also having a good demographic balance. 

1.3.1 Moral attributes

The King report lists five moral attributes that individual directors should have:

  • Conscience – acting with intellectual honesty and independence of mind in the best interests of the company and its stakeholders, avoiding conflicts of interest
  • Inclusivity – taking into account the legitimate interests and expectations of stakeholders
  • Competence – having the knowledge and skills required to govern a company effectively
  • Commitment – diligently performing duties and devoting enough time to company affairs
  • Courage – having the courage to take the necessary risks and to act with integrity
1.3.2 Possession of necessary information

As we have seen in the last chapter, in many corporate scandals, the board was not given full information. The UK’s Higgs report stresses that it is the responsibility both of the chairman to decide what information should be made available and of directors to satisfy themselves that they have appropriate information of sufficient quality to make sound judgements. The South African King report highlights the importance of the board receiving relevant non-financial information, going beyond assessing the financial and qualitative performance of the company and looking at qualitative measures that involve broader stakeholder interests.



Corporate governance expert Professor Richard Leblanc commented that good boards ‘are independent, competent, transparent, constructively challenge management and set the ethical tone and culture for the entire organisation.’ In organisations where there were corporate misdeeds or ethical failures, there were generally also board problems. Common defects included ‘undue influence, bullying, poor design, lack of industry knowledge and directors who are not engaged.’


                                 1.4 Diversity                                                                            12/13
Diversity is the variation of social and cultural identities among people existing together in a defined

employment or market setting.                                                                                                        (Cox)

Primary categories of diversity include age, race, ethnicity and gender while secondary categories of diversity include education, experience, marital status, beliefs and background.

Key term

The UK Corporate Governance Code states that, when directors are appointed, the board should have due regard for the benefits of diversity on the board, including gender diversity. In its 2011 green paper the European Commission stated that a diversity of expertise and backgrounds is essential if the board is to function efficiently. The Commission highlighted a variety of professional backgrounds, national or regional backgrounds and gender diversity as the most significant considerations when assessing diversity.

An earlier UK report, the 2003 Tyson report on the recruitment and development of non-executive directors, highlighted the benefits that diversity can bring:

  • Talent

A company committed to diversity has the best chance of finding and employing the best available talent rather than artificially limiting itself.

  • Broad range of knowledge

No one individual director can be knowledgeable and informed about all aspects of business given the information and expertise necessary for boards to govern listed companies effectively.

Management literature suggests that groups make better decisions if the available information is more diverse, provided the group understands who knows what and takes advantage of the knowledge. One example is having foreign nationals on the board, which should enhance knowledge of the global environment within which most listed companies operate. Diverse boards should avoid the ‘group-think’ that can occur when boards have similar backgrounds.

  • Greater range of constituencies

Diverse boards can reach out more effectively to a broader range of constituencies to help them deal with problems. They can also send positive signals to different stakeholder groups and contribute to a better understanding of the stakeholder groups that underpin commercial success.

  • Independence and judgement

A board with a broad range of experience is more likely to develop independence of mind and a probing attitude. It can also enhance corporate decision-making by having sensitivity to a wider range of risks to its reputation.

(e)       Corporate citizen

Greater diversity can enhance a company’s reputation as a corporate citizen that understands its community. Following from that, a company can have the objective of its board reflecting the make-up of the society within which it operates, in order to maximise its strategic fit with the community. Fairly reflecting the community can also be seen as strengthening the social contract between a company and its stakeholders.

However, some studies have found that diversity can result in lower cohesion and trust unless members are trained to work together and boards are effectively led.  1.4.1 Gender diversity

Much of the debate about diversity has focused on the issue of the proportion of women on boards.

The Davies report on women on boards in the UK in 2011 highlighted the following arguments in favour of  greater female representation.

  • Improving performance

Studies suggest that female non-executive directors contribute more effectively than male nonexecutives, preparing more conscientiously for board meetings and being more prepared to ask awkward questions and to challenge strategy. Studies also suggest that a gender-balanced board is more likely to pay attention to managing and controlling risk.

  • Accessing the widest talent pool

In Europe and the US women account for approximately six out of ten university graduates and in the UK women make up almost half the labour force. Businesses will not perform to their maximum capability if they do not utilise this pool of talent effectively.

  • Being more responsive to the market

Surveys suggest that in the UK women hold almost half the wealth and are responsible for about 70% of household purchasing decisions. As women are often the customers of the company’s products, having more women directors can improve understanding of customer needs. Large companies in consumer-facing industries have a higher proportion of women on their boards than big companies in other sectors.

  • Achieving better corporate governance

Studies have shown that boards with a significant number of women on them demonstrated better governance behaviour in a number of ways. A Canadian study provided evidence that genderbalanced boards were more likely to measure and monitor strategy, adhere to ethical guidelines and ensure better communication with a focus on non-financial performance measures such as employee and customer satisfaction, diversity and corporate social responsibility. There is evidence from the UK that balanced boards are better at focusing on succession planning and new director training and induction. UK evidence suggests that balanced boards are also more likely to carry out effective reviews of the whole board’s skills, knowledge and experience, and of board performance.

The Davies report made a number of recommendations which, it was hoped, would promote an increase in the number of female directors:

  • FTSE 350 companies setting out the percentage of women they aimed to have on their boards, with larger companies aiming for a minimum 25%
  • Quoted companies being required to disclose the proportion of women on their boards, in senior executive positions and female employees in the whole organisation
  • Listed companies establishing a policy concerning boardroom diversity, including measurable objectives for implementing the policy
  • Disclosures in the corporate governance report about progress in achieving diversity and also the work of the nomination committee in promoting diversity; investors should pay close attention to what boards are doing
  • Other recommendations included advertising non-executive positions and search firms drawing up a code of conduct; recruitment should utilise not only executives within the corporate sector but also women from outside the corporate mainstream, including entrepreneurs, academics, civil servants and women with professional service backgrounds, with training opportunities being provided as required

Elsewhere some countries have introduced quotas backed by legislation or regulation. In Norway legislation required all private listed companies to raise the proportion of women on their boards to 40% by 2008. Other countries include promotion of gender diversity as part of the comply or explain requirements. However, in some leading countries, for example Japan and Brazil, the proportion of women on boards has remained low and static.

The year after the Davies report was published saw the biggest ever increase in the UK in the percentage of women on boards, compared with numbers plateauing in the three years before the report’s publication. At a similar rate of increase, FTSE 100 boards should achieve the target of having a minimum of 25% women directors by 2015. However, the number of female non-executive directors was increasing at a much faster rate than executive directors, indicating that companies were not appointing many of their female executives as directors.

1.4.2 Quotas

An issue currently under discussion at national and EU level is whether diversity, particularly gender diversity, should be imposed by mandatory quotas.

Arguments in favour of quotas include the following.

  • Effectiveness

Quotas backed by legal sanctions can achieve results quicker than voluntary action. Norway achieved full compliance when it imposed a gender quota, whereas other European countries have seen much slower progress.

  • Disappearance of barriers

Quotas force firms to deal with issues holding underrepresented groups back.

However, a number of arguments have been raised against quotas.

  • Excessive regulation

A number of business leaders have argued that it is not up to governments to lay down regulations on the composition of boards. Composition needs to be determined by companies recruiting on merit according to their needs.

  • Tokenism

If a candidate was believed to be appointed primarily because they belonged to the right underrepresented group, their contribution might not be taken seriously. Critics of this argument however claim that if candidates are appointed purely on a token basis, this is due to poor work by the nomination committee.

  • Need to address other issues first

The Davies report suggested that a key barrier to more diverse recruitment was a lack of flexibility in work-life balance. Writing in the Financial Director, Shima Barakat suggested that a lack of family-friendliness in work policies was a significant issue for both sexes. Other issues that companies needed to address to improve the pool of future candidates were tailored development programmes, increasing the visibility of high-performer role models and external recruitment.

  • Multiple directorships

If the recruitment pool from the underrepresented group is small, the same people may end up holding multiple directorships, limiting their contribution to individual companies. Critics have highlighted a group of around 70 women in Norway who hold a number of directorships each.

  • Other methods

The response to the UK Davies report suggests that other methods to encourage companies can achieve some improvements.



An article in The Wall Street Journal in January 2010 highlighted the potential problems with diversity, and possible solutions to these issues.


Initial stereotyping

Existing directors may scrutinise new board members carefully and may easily stereotype them quickly as, for example, ‘Activist’ or ‘Typical accountant’. This risk is greater if, at the first board meetings the newcomer attends, the new director asks basic questions or takes a different perspective from the rest of the board. The newcomer may be dismissed as clueless.

Lasting impressions

Having created a (misleading) impression in their own minds about the new director, long-serving directors may use subsequent evidence about the newcomer to reinforce their initial views, remembering anything that gives further support to the stereotype they have formed and blocking information that doesn’t fit.


If a new director comes from a business or organisational environment with a different culture, the existing directors may react adversely if the newcomer behaves in a way that would be accepted in their normal environment, but is not accepted in their company. The newcomer may come from a background where interruptions are encouraged, but this may not be the way the board that the new director has joined is used to operating.

Confirmation from others

Like-minded board members may compare notes on a new colleague and support each other’s impressions.

Reinforcing behaviour

If existing directors take an adverse view of newcomers, they may start reacting to them in an unfriendly manner and exclude them from informal discussions. This may result in the newcomer becoming defensive or oversensitive. Current directors may combine against the newcomer or the board may split into factions.



When recruiting new members, nomination committees should consider personalities of candidates carefully. In particular they should assess whether potential directors realise how they come across to others and their ability to disagree constructively. A newcomer’s lack of basic knowledge may result in the newcomer asking questions that the existing directors should still be asking, but have not done for a long time.

Assist newcomers      

The chairman should ensure that newcomers are welcomed and have a chance to make a favourable first impression. Particularly at their first few board meetings, the chairman should aim to draw out the contribution of newcomers.

Be prepared for dissension  

Boards should be able to cope with constructive and civil discussion. If board members feel inhibited from expressing their views because of fears of conflicts, or dissenting views are not reconciled, the board will not be effective. The chairman must encourage directors to express vague concerns. It is also useful for boards to have a devil’s advocate figure, but this role should be filled by different directors at different times. Having the same director act the role the whole time, particularly if the director is perceived as representing a minority viewpoint, may lead to the director being stereotyped as a cynic and the director’s views ignored.


                                1.5 Role and function of nomination committee          6/08, 12/13

In order to ensure that balance of the board is maintained, corporate governance codes recommend that the board sets up a nomination committee, made up wholly or mainly of independent non-executive directors, to oversee the process for board appointments and make recommendations to the board. The nomination committee needs to consider:

  • The balance between executives and independent non-executives
  • The skills, knowledge and experience possessed by the current board
  • The need for continuity and succession planning
  • The desirable size of the board
  • The need to attract board members from a diversity of backgrounds

The nomination committee should ensure that appointments to the board are made using objective criteria. However, the criteria should not be so restrictive that it limits too greatly the number of candidates.



It is also very important for charities to ensure that trustees have a suitable range of skills. The Good Governance: A Code for the Voluntary and Community Sector stresses the importance of trustees having the diverse range of skills, experience and knowledge necessary to run the organisation effectively.

The collective experience of trustees should ideally cover the following areas.

  • Providing effective strategic leadership and working as a team
  • Direct knowledge of the organisation’s beneficiaries and users, and of their needs and aspirations
  • Governance, general finance, business and management
  • Human resources and diversity
  • The operating environment and the risks that exist for the organisation
  • Other specific knowledge such as fundraising, health, social services, property or legal


Codes stress that, as well as considering these issues when appointments are made, the nomination committee should regularly review the structure, size and composition of the board, and keep under review the leadership needs of the company.

It should also consider whether non-executive directors are spending enough time on their duties and other issues relating to re-election and reappointment of directors and membership of board committees.


One area of concern is whether individual directors are exercising disproportionate influence on the company. For example, Boots prohibited the chairman of the remuneration committee from serving on the audit committee and vice versa.


The UK Corporate Governance Code emphasises that the procedures for recruiting directors must be formal, rigorous and transparent. To help ensure this a majority of committee members should be independent non-executive directors. The UK Code recommends that an external search consultancy and open advertising should be used, particularly when appointing a non-executive director or chairman. The UK Higgs report made a number of suggestions about possible sources of non-executive directors.

  • Companies operating in international markets could benefit from having at least one non-executive director with international experience.
  • Lawyers, accountants and consultants can bring skills that are useful to the board.
  • Listed companies should consider appointing directors of private companies as non-executive directors.
  • Including individuals with charitable or public sector experience but strong commercial awareness can increase the breadth of diversity and experience on the board.
                                 1.6 Induction of new directors                                          12/09

The UK Higgs report provides detailed guidance on the development of an induction programme tailored to the needs of the company and individual directors.

Build an understanding of the nature of the company, its business and its markets •      The company’s culture and values

•      The company’s products or services

•      Group structure/subsidiaries/joint ventures

•      The company’s constitution, board procedures and matters reserved for the board

•      The company’s principal assets, liabilities, significant contracts and major competitors

•      Major risks and risk management strategy

•      Key performance indicators

•      Regulatory constraints

Build a link with the company’s people •      Meetings with senior management

•      Visits to company sites other than headquarters, to learn about production and services, meet employees and build profile

•      Participating in board’s strategy development

•      Briefing on internal procedures

Build an understanding of the company’s main relationships including meetings with auditors •      Major customers

•      Major suppliers

•      Major shareholders and customer relations policy

1.7 Continuing professional development of board

The Higgs report points out that to remain effective, directors should extend their knowledge and skills continuously. The report suggests that professional development of potential directors ought to concentrate on the role of the board, obligations and entitlements of existing directors and the behaviour needed for effective board performance.

For existing directors, significant issues that professional development should cover on a regular basis include:

  • Strategy
  • Management of human and financial resources
  • Audit and remuneration issues
  • Legal and regulatory issues
  • Risk management
  • The effective behaviour of a board director such as influencing skills, conflict resolution, chairing skills and board dynamics
  • The technical background of the company’s activities so that directors can properly appreciate the strategic considerations (for example in fast-evolving fields such as financial services or technology)

The Higgs report suggests that a variety of approaches to training may be appropriate, including lectures, case studies and networking groups.

1.8 Performance of board

Appraisal of the board’s performance is an important control over it, aimed at improving board effectiveness, maximising strengths and tackling weaknesses. It should be seen as an essential part of the feedback process within the company and may prompt the board to change its methods and/or objectives. The UK Corporate Governance Code recommends that performance of the board, its committees and individual directors should be formally assessed once a year. Ideally the assessment should be by an external third party who can bring objectivity to the process.

In order to be conducted effectively, the appraisal of the whole board will need to include:

  • A review of the board’s systems (conduct of meetings, work of committees, quality of written documentation)
  • Performance measurement in terms of the standards it has established, financial criteria, and nonfinancial criteria relating to individual directors
  • Assessment of the board’s role in the organisation (dealing with problems, communicating with stakeholders)

If the review is carried out internally, board members may be asked to assess performance using a questionnaire based on the best practice of an effective board. The questionnaire may be supplemented by interviews.

The Higgs report provides a list of the criteria that could be used.

  • Performance against objectives
  • Contribution to testing and development of strategy and setting of priorities
  • Contribution to robust and effective risk management
  • Contribution to development of corporate philosophy (values, ethics, social responsibilities)
  • Appropriate composition of board and committees
  • Responses to problems or crises
  • Are matters reserved for the board the right ones?
  • Are decisions delegated to managers the right ones?
  • Internal and external communication
  • Board fully informed of latest developments
  • Effectiveness of board committees
  • Quality of information
  • Quality of feedback provided to management
  • Adequacy of board meetings and decision-making
  • Fulfilling legal requirements

Parker suggests that a key aspect of board appraisal is whether the board focuses on long-term issues and vision, or spends too much time on day-to-day management matters.


Corporate Governance: A Practical Guide published by the London Stock Exchange and the accountants RSM Robson Rhodes suggests that board evaluation needs to be in terms of clear objectives. Boards ought to be learning lessons from specific decisions they have taken. (Did they receive adequate information? Did they address the main issues well?)

Considering how the board is working as a team is also important. This includes such issues as encouragement of criticism, existence of factions and whether dominant players are restricting the contribution of others. The guidance suggests involving an external facilitator to help discover key issues.

The guide also compares the working of an effective board with other types of board and suggests that boards should consider which unsuccessful elements they demonstrate.

Type of board Strengths Weaknesses
Effective board •      Clear strategy aligned to capabilities

•      Vigorous implementation of strategy

•      Key performance drivers monitored

•      Effective risk management

•      Focus on views of City and other stakeholders

•      Regular evaluation of board performance

The rubber stamp •      Makes clear decisions

•      Listens to in-house expertise

•      Ensures decisions are implemented

•      Fails to consider alternatives

•      Dominated by executives

•      Relies on fed information

•      Focuses on supporting evidence

•      Does not listen to criticism

•      Role of non-executives limited

Type of board Strengths Weaknesses
The talking shop •      All opinions given equal weight

•      All options considered

•      No effective decision-making process

•      Lack of direction from chairman

•      Failure to focus on critical issues

•      No evaluation of previous decisions

The number crunchers •      Short-term needs of investors considered

•      Prudent decision-making

•      Excessive focus on financial impact

•      Lack of long-term, wider awareness

•      Lack of diversity of board members

•      Impact of social and environmental issues ignored

•      Risk averse

The dreamers •      Strong long-term focus

•      Long-term strategies

•      Consider social and environmental implications

•      Insufficient current focus

•      Fail to identify or manage key risks

•      Excessively optimistic

The adrenaline junkies •      Clear decisions

•      Decisions implemented

•      Lurch from crisis to crisis

•      Excessive focus on short term

•      Lack of strategic direction

•      Internal focus

•      Tendency to micro-manage

The semi-detached •      Strong focus on external environment

•      Intellectually challenging

•      Out of touch with the company

•      Little attempt to implement decisions

•      Poor monitoring of decision-making


1.9 Performance of individual directors

Separate appraisal of the performance of the chairman and the CEO should be carried out by the nonexecutive directors, but all directors should have some form of individual appraisal. Criteria that could be applied include the following.

  • Independence – free thinking, avoids conflicts of interest
  • Preparedness – knows key staff, organisation and industry, aware of statutory and fiduciary duties
  • Practice – participates actively, questioning, insists on obtaining information, undertakes professional education
  • Committee work – understands process of committee work, exhibits ideas and enthusiasm
  • Development of the organisation – makes suggestions on innovation, strategic direction and planning, helps win the support of outside stakeholders
10 Legal and regulatory frameworks

When defining the scope of their role, boards must comply with the legal and regulatory framework of the jurisdiction(s) within which they operate. These affect not just the scope of the board’s role, but also the appointment and removal of directors. You will have covered key aspects of the framework in your company law studies, but we include a brief reminder of the main elements of the law in most jurisdictions. The directors must also comply with the company’s constitution (articles in the UK); we discuss below some common provisions in these internal regulations.

1.10.1 Legal rights

Directors are entitled to fees and expenses as directors according to the company’s constitution, and emoluments and compensation for loss of office in line with their service contracts (discussed below).

1.10.2 Legal responsibilities

Directors have a duty of care to show reasonable competence and may have to indemnify the company against loss caused by their negligence. Directors are also said to be in a fiduciary position in relation to the company. They must act honestly in what they consider to be the best interest of the company and in good faith.

The UK Companies Act 2006 sets out seven statutory duties of directors.

  • Act within their powers
  • Promote the success of the company
  • Exercise independent judgement
  • Exercise reasonable skill, care and diligence
  • Avoid conflicts of interest
  • Do not accept benefits from third parties
  • Declare an interest in a proposed transaction or arrangement
1.10.3 Duty to act within powers

The directors owe a duty to act in accordance with the company’s constitution, and only to exercise powers for the purposes for what they were conferred. They have a fiduciary duty to the company to exercise their powers bona fide in what they honestly consider to be the interests of the company.

In exercising the powers given to them by the articles the directors have a fiduciary duty not only to act bona fide but also only to use their powers for a proper purpose. The powers are restricted to the purposes for which they were given. They should also act in accordance with decisions reached at board and company meetings and in compliance with the law.

1.10.4 Duty to promote the success of the company

An overriding theme of the Companies Act 2006 is the principle that the purpose of the legal framework surrounding companies should be to help companies do business. Their main purpose is to create wealth for the shareholders.

In essence, this principle means that the law should encourage a long-term outlook and regard for all stakeholders by directors and that stakeholder interests should be pursued in an enlightened and inclusive way.

The requirements of this duty are difficult to define and possibly problematic to apply, so the Act provides directors with a list of issues to keep in mind. When exercising this duty directors should consider:

  • The consequences of decisions in the long term
  • The interests of their employees
  • The need to develop good relationships with customers and suppliers
  • The impact of the company on the local community and the environment
  • The desirability of maintaining high standards of business conduct and a good reputation
  • The need to act fairly as between all members of the company

This list identifies areas of particular importance and modern day expectations of responsible business behaviour; for example, the interests of the company’s employees and the impact of the company’s operations on the community and the environment.

The Act does not define what should be regarded as the success of a company. This is down to a director’s judgement in good faith. This is important, as it ensures that business decisions are for the directors rather than the courts. No guidance is given for what the correct course of action would be where the various duties are in conflict.

1.10.5 Duty to exercise independent judgement

Directors should not delegate their powers of decision-making or be swayed by the influence of others. Directors may delegate their functions to others, but they must continue to make independent decisions.

1.10.6 Duty to exercise reasonable skill, care and diligence

Directors have a duty of care to show reasonable skill, care and diligence.

Section 174 provides that a director owes a duty to their company to exercise the same standard of ‘care, skill and diligence that would be exercised by a reasonably diligent person with:

  • The general knowledge, skill and experience that may reasonably be expected of a person carrying out the functions carried out by the director in relation to the company; and
  • The general knowledge, skill and experience that the director has.’ There is therefore a reasonableness test consisting of two parts.
  • Did the director act in a manner reasonably expected of a person performing the same role?

A director, when carrying out their functions, must show such care as could reasonably be expected from a competent person in that role. If a ‘reasonable’ director could be expected to act in a certain way, it is no defence for a director to claim, for example, lack of expertise.

  • Did the director act in accordance with the skill, knowledge and experience that the director actually has?

The duty to be competent extends to non-executive directors, who may be liable if they fail in their duty.

                                 1.10.7 Duty to avoid conflict of interest                                      12/10

A conflict of interest in the context of directors’ duties most often means a situation where directors face influences that tempt them not to act in the best interests of the company.

As agents, directors have a general duty to try to avoid a conflict of interest. In particular:

  • The directors must retain their freedom of action and not fetter their discretion by agreeing to vote as some other person may direct.
  • The directors owe a fiduciary duty to avoid a conflict of duty and personal interest.
  • The directors must not obtain any personal advantage from their position as directors without the consent of the company for whatever gain or profit they have obtained.

Any action against a director in connection with a conflict of interest will normally be taken by the company. The type of remedy will vary with the breach of duty.

  • The director may have to account for a personal gain.
  • If they contract with the company in a conflict of interest the contract may be rescinded by the company. However, the company cannot both affirm the contract and recover the director’s profit.
  • The court may declare that a transaction is ultra vires or unlawful.

The company’s constitution may not allow directors to have any contracts with the company. If it allows contracts, then directors are likely to have to disclose their interest to the rest of the board. Legal provisions may reinforce or be stricter than the constitution, prohibiting certain transactions (for example loans to directors) and only allowing some transactions if they are ratified by a shareholder vote (transactions above a certain size). Directors of listed companies may face stricter legal requirements.

Conflicts of interest are discussed further in Chapter 10.

1.10.8 Duty not to accept benefits from third parties

This duty prohibits the acceptance of benefits (including bribes) from third parties conferred by reason of them being a director, or doing (or omitting to do) something as a director.

1.10.9 Duty to declare interest in proposed transaction or arrangement

Directors are required to disclose to the other directors the nature and extent of any interest, direct or indirect, that they have in relation to a proposed transaction or arrangement with the company.

                                 1.10.10 Insider dealing/trading                                                     6/11

In most regimes it is a criminal offence for directors and others to use inside information that they have to gain from buying or selling shares in a stock market. Inside information has been defined as information that is specific and precise, has not yet been made public, and if made public would have a significant effect on the share price (it is price-sensitive information).

For directors, an obvious example would be using the advance knowledge they have of the company’s results to make gains before the information is released to the market. Rules in many countries therefore include prohibition in directors dealing in shares during a close period, defined as a specific period (60 days for example) before the publication of annual or period results.

As well as being a criminal offence, it is also an abuse of directors’ roles as agents, a clear instance of directors using the superior information they have for their benefit, rather than putting shareholders’ interests first. It also undermines the capital markets by deterring investors who do not have access to privileged information and therefore feel that market distortions will result in insufficient returns for the risks that they face.


Company directors are not the only persons who may be accused of insider trading. In 2012 Cheng Yi Liang, a long-serving employee of the US Food and Drug Administration (FDA), was found guilty of misusing confidential information and sentenced to five years in prison. The FDA is responsible for drug approval in the US. Not only does it receive confidential information about companies, but the status of an application is itself highly price-sensitive information, since the public announcement of approval of a drug can have a huge impact on share price.

Ethics guru Chris Macdonald highlighted that Cheng Yi Liang did not breach ethical obligations to corporate shareholders – he had none. Instead he undermined the principles of exchange of information on which a free market is based.


1.11 Leaving office 12/13
1.11.1 Departure from office  6/09

A director may leave office in the following ways.

  • Resignation (written notice may be required)
  • Not offering themselves for re-election when their term of office ends  Failing to be re-elected
  • Death
  • Dissolution of the company
  • Being removed from office
  • Prolonged absence meaning that director cannot fulfil duties (may be provided in law or by company constitution)
  • Being disqualified (by virtue of the constitution or by the court)
  • Agreed departure, possibly with compensation for loss of office
1.11.2 Time-limited appointments

Under the company’s constitution or the director’s service contract, some roles, particularly those of chief executive or chairman, may be for a fixed period. Ordinary directors may have to retire from the board on reaching a retirement age and may or may not be able to seek re-election.

In addition, some corporate governance guidelines suggest that non-executive directors should hold their post for a limited length of time. The UK Corporate Governance Code suggests that a non-executive director should normally serve for six years. Value may be added in exceptional circumstances by a nonexecutive director serving for longer, but the reasons need to be explained to shareholders. Higgs suggests that after nine years on the board non-executive directors should face annual re-election.

                                1.11.3 Retirement by rotation                                                        6/08

Directors are often required to retire from the board and seek re-election. In many jurisdictions it is once every three years, although UK guidance has reduced the period to one year for large listed companies (discussed below). Managing directors may be exempt from the provisions about re-election of directors. The provisions may be enshrined in law, but in most jurisdictions, the company’s constitution or articles prescribe the rules on rotation. Directors will generally be entitled to seek re-election if they have retired by rotation and the provisions may assume that the retiring directors are deemed to be reappointed. However, retirement by rotation provisions allow shareholders a regular opportunity to vote directors out of office.

Retirement by rotation has the following benefits for companies.

  • Shareholder rights

Retirement gives shareholders their main chance to judge the contribution of individual directors and deny them re-election if they have performed inadequately. It is an important mechanism to ensure director accountability.

  • Evolution of the board

Compulsory retirement of directors forces directors and shareholders to consider the need for the board to change over time. The fact that only some directors retire each year means that, if board changes are felt to be necessary, they can happen gradually enough to ensure some stability.

  • Costs of contract termination

By limiting the length of service period, the compensation paid to directors for loss of office under their service contracts will also be limited. Contracts may well expire at the time the director is required to retire and if then the director is not re-elected, no compensation will be payable.

In June 2008 students came up with a number of incorrect definitions of retirement by rotation.

•              Doing different jobs in the same company

•              Finding a successor to replace you as a director

•              Having to wait to leave the board, if too many directors want to leave at the same time

Exam focus point

1.11.4 Re-election of directors

In May 2010 the UK Corporate Governance Code introduced the requirement for directors of FTSE 350 companies (the biggest listed companies) to face re-election every year. Directors of smaller listed companies should face re-election every three years.

Reaction to this new provision has been mixed. Sir David Walker, author of the Walker Review into banking governance, welcomed the new provision because it would introduce more discipline into boardrooms.

‘Provision for annual election of the chairman and other board members should introduce welcome additional encouragement and discipline to both shareholders and board members in seeking to promote the best possible long-term performance in the intensely competitive environment in which so many UK companies now operate.’

However, Richard Lambert, director-general of the Confederation of British Industry (CBI), took the opposite view.

‘It could promote a focus on short-term results, make boards less stable and discourage robust challenges in the boardroom.’

In July 2010 representatives of three institutional shareholders wrote to the Financial Times stating their opposition to the new provisions. They did not believe that the new provisions would increase accountability. Instead they claimed the provisions would result in a short-term culture, with boards being distracted by short-term voting outcomes. They felt the requirement was detrimental to building long-term relationships with boards, and ran counter to the Stewardship Code for Institutional Investors (covered in Chapter [1]). The investors said they would support boards who gave valid and reasonable explanations for continuing to re-elect directors every three years.

1.11.5 Removal from office

The company’s constitution may allow for a director’s removal from office for a variety of reasons. These could include absence from board meetings for a long time, mental health problems or bankruptcy. The constitution or the directors’ service contract may allow for removal for disciplinary reasons or on grounds of incompetence, although incompetence may be difficult to prove.

Local law or the company’s constitution may also allow removal of directors by board vote, or by a shareholder vote, perhaps in a company meeting convened for that purpose.

1.11.6 Disqualification

Directors may be legally disqualified by the court or government action. Depending on the regime, possible grounds for disqualification may include failing to keep proper accounting records, not filing accounts, returns or other statutory documents and trading when their company is insolvent.

Disqualification is likely to mean that a person cannot be a director of any company and that the person cannot act as if they are a director or influence a board in other ways.


UK law provides that a director may be removed from office by an ordinary resolution (75% vote in favour) passed in general meeting. Company articles may contain additional provisions, such as allowing removal by a resolution of the board of directors. These provisions permit a company to dismiss a director without observing the formalities of the statutory procedures. However, if the director also has a service agreement, they may still be entitled to compensation for its breach by their dismissal.

In addition to any provisions of the articles for removal of directors, a director may be removed from office under statute by ordinary resolution (50+% vote in favour) of which special notice (28 days) to the company has been given by the person proposing it.

This statutory power of removal overrides the articles and any service agreement (but the director may claim damages for breach of the agreement). The power is, however, limited in its effect:

  • A member who gives special notice to remove a director cannot insist on the inclusion of their resolution in the notice of a meeting unless they qualify by representing sufficient members.
  • A director may be irremovable if they have ‘weighted’ voting rights and can prevent the resolution from being passed.

In reality the combination of the company law requirements and the provisions of a director’s service contract may make it difficult to remove a director until their term of office is complete.


the required minimum period of notice (a rolling contract). There may be other provisions connected with departure, including termination without notice, payment in lieu of notice, whether the director can be placed on gardening leave and restrictions on subsequent employment (for example joining competitors).

Legal provisions in many regimes have tended to focus on requirements for companies to keep contracts and make them available for shareholder inspection. In many countries, it has been corporate governance codes that have dealt with the most controversial issues, including remuneration, the term of the contract and payments on termination of contract.

Some governance guidance states that the notice period on the contracts should be one year or less. If the director has to be given a longer period at first in order to secure agreement to join, the initial period should subsequently be reduced.

2 Board membership and roles

FAST FORWARD              Division of responsibilities at the head of an organisation is most simply achieved by separating the roles of chairman and chief executive.

Independent non-executive directors have a key role in governance. Their number and status should mean that their views carry significant weight. 

2.1 Board membership

Key issues for consideration are:

  • Size – with greater size can come greater opportunities for representation of varied views.

However, this can be at the expense of ease of operation and coherence of decision-making.

  • Inside/outside mix – what proportion should be executive decision-makers whose main employment is by the company and what proportion should be outsiders?
  • Diversity – the issues here include male/female mix, representation from ethnic minorities and representatives from professions other than business (for example academia).
2.2 Chairman and CEO

Ultimate leadership of the organisation consists of a number of strands, most importantly:

  • Leading the board of directors – the chairman
  • Leading the management team at and below board level – the chief executive officer or CEO
                                 2.2.1 Role of chairman                                            12/07, 6/09, 12/09

The UK Higgs report provides a thorough analysis of the role of the chairman. Higgs comments that the chairman is ‘pivotal in creating the conditions for overall board and individual director effectiveness, both inside and outside the boardroom’. The chairman is responsible for:

  • Running the board and setting its agenda

The chairman should ensure the board focuses on strategic matters and takes account of the key issues and the concerns of all board members. He should ensure the contributions of executives and non-executives are co-ordinated and good relationships are maintained.

  • Ensuring the board receives accurate and timely information

We shall discuss this further later in the Text, but good information will enable the board to take sound decisions and monitor the company effectively.

  • Ensuring effective communication with shareholders

The chairman should take the lead in ensuring that the board develops an understanding of the views of major investors. The chairman is often the public face of the company as far as investors are concerned.

  • Ensuring that sufficient time is allowed for discussion of controversial issues

All members should have enough time to consider critical issues and not be faced with unrealistic deadlines or decision-making.

  • Taking the lead in board development

The chairman is responsible for addressing the development needs of the board as a whole and enhancing the effectiveness of the whole team, also meeting the development needs of individual directors. The chairman should ensure that the induction programme for new directors is comprehensive, formal and tailored.  

  • Facilitating board appraisal

The chairman should ensure the performance of the whole board, board committees and individuals is evaluated at least once a year.

  • Encouraging active engagement by all the members of the board

The chairman should promote a culture of openness and debate, by, in particular, ensuring that non-executive directors make an effective contribution to discussions.

  • Reporting in and signing off accounts

Financial statements in many jurisdictions include a chairman’s statement that must be compatible with other information in the financial statements. The statement provides an opportunity for the chairman to demonstrate that they are acting in the shareholders’ best interests, and to provide an independent view of the company’s affairs. The statement can also explain how the chairman is exercising their role and highlight other aspects of corporate governance that might be of concern to the shareholders.

The chairman may also be responsible for signing off the financial statements.

Higgs goes on to provide a description of an effective chairman, who:

  • Upholds the highest standards of integrity and probity
  • Leads board discussions to promote effective decision-making and constructive debate
  • Promotes effective relationships and open communication between executive and non-executive directors
  • Builds an effective and complementary board, initiating change and planning succession
  • Promotes the highest standards of corporate governance
  • Ensures a clear structure for, and the effective running of, board committees
  • Establishes a close relationship of trust with the CEO, providing support and advice while respecting executive responsibility
  • Provides coherent leadership of the company
As you can see above, the examiner emphasised the importance of the role of the chairman by examining it in both the 2009 papers.

Exam focus point

                                 2.2.2 Role of CEO                                                                  6/09, 6/11

The CEO is responsible for running the organisation’s business and for proposing and developing the group’s strategy and overall commercial objectives in consultation with the directors and the board. The CEO is also responsible for implementing the decisions of the board and its committees, developing the main policy statements and reviewing the business’s organisational structure and operational performance. 

The CEO is the senior executive in charge of the management team and is answerable to the board for its performance. They will have to formalise the roles and responsibilities of the management team, including determining the degree of delegation.

A guidance note that used to supplement the UK Combined Code suggests that the major responsibilities of the CEO will be as follows.

  • Business strategy and management

The CEO will take the lead in developing objectives and strategy having regard to the organisation’s stakeholders, and will be responsible to the board for ensuring that the organisation achieves its objectives, optimising the use of resources.

  • Investment and financing

The CEO will examine major investments, capital expenditure, acquisitions and disposals and be responsible for identifying new initiatives.

  • Risk management

The CEO will be responsible for managing the risk profile in line with the risk appetite accepted by the board. They will also be responsible for ensuring that appropriate planning, operational and control systems and internal controls are in place and operate effectively. The CEO has ultimate ownership of the control systems and should take the lead in establishing the control environment and culture.

  • Establishing the company’s management

The CEO will provide the nomination committee with their view on the future roles and capabilities required of directors, and make recommendations about the recruitment of individual directors. They will also be responsible for recruiting and overseeing the management team below board level.

  • Board committees

The CEO will make recommendations to be discussed by the board committees on remuneration policy, executive remuneration and terms of employment.

  • Liaison with stakeholders

Like the chairman, part of the CEO’s role will be to deal with those interested in the company. The chairman’s focus, however, will often be on dealing with shareholder concerns, whereas the CEO will also be concerned with other major stakeholders who impact on the company’s operations, for example its most important customers.

Question 1 in June 2009 required discussion of how a chief executive had failed to oversee internal controls effectively.

Exam focus point

                                 2.3 Division of responsibilities                             12/07, 12/11

All governance reports acknowledge the importance of having a division of responsibilities at the head of an organisation to avoid the situation where one individual has unfettered control of the decision-making process.

The simplest way to do this is to require the roles of chairman and CEO to be held by two different people, for the following reasons.

  • Demands of roles

It reflects the reality that both jobs are demanding roles and ultimately the idea that no one person would be able to do both jobs well. The CEO can then run the company. The chairman can run the board and take the lead in liaising with shareholders.

  • Authority

There is an important difference between the authority of the chairman and the authority of the chief executive, which having the roles taken by different people will clarify. The chairman carries the authority of the board whereas the chief executive has the authority that is delegated by the board. Separating the roles emphasises that the chairman is acting on behalf of the board, whereas the chief executive has the authority given in their terms of appointment. Having the same person in both roles means that unfettered power is concentrated into one pair of hands. The board may be ineffective in controlling the chief executive if it is led by the chief executive.

  • Conflicts of interest

The separation of roles avoids the risk of conflicts of interest. The chairman can concentrate on representing the interests of shareholders.

  • Accountability

The board cannot make the CEO truly accountable for management if it is led by the CEO.

  • Board opinions

Separation of the roles means that the board is more able to express its concerns effectively by providing a point of reporting (the chairman) for the non-executive directors.

  • Control over information

The chairman is responsible for obtaining the information that other directors require to exercise proper oversight and monitor the organisation effectively. If the chairman is also chief executive, then directors may not be sure that the information they are getting is sufficient and objective enough to support their work. The chairman should ensure that the board is receiving sufficient information to make informed decisions, and should put pressure on the chief executive if the chairman believes that the chief executive is not providing adequate information.

  • Compliance

Separation enables compliance with governance best practice and hence reassures shareholders.

That said, there are arguments in favour of the two roles being held by the same person.

  • Creation of unity

Having a single leader creates unity within the company. Having two leaders that disagree can create deadlock.

  • Acquisition of knowledge

The holders of both posts need considerable knowledge of the company. A non-executive chairman may struggle to acquire this knowledge due to constraints on his time.

The UK Corporate Governance Code also suggests that the CEO should not go on to become chairman of the same company. If a CEO did become chairman, the main risk is that they will interfere in matters that are the responsibility of the new CEO and thus exercise undue influence over them.


The issue of separation of duties was highlighted by the testimony of Paul Moore, former head of the group regulatory risk at HBOS, to the UK House of Commons’ Treasury Select Committee. Moore’s evidence to the Treasury Select Committee on HBOS (and other banks) stated:

‘There has been a completely inadequate “separation” and “balance of powers” between the executive and all those accountable for overseeing their actions and “reining them in” ie internal control functions such as finance, risk, compliance and internal audit, non-executive Chairmen and Directors, external auditors, the FSA, shareholders and politicians.’

We shall return to Paul Moore’s evidence later in this text.


In July 2011 the international media conglomerate, News Corporation, faced a scandal arising from allegations of phone hacking at the UK paper, the News of the World. A public inquiry headed by judge Sir Brian Leveson and police investigations sought to establish what had happened and who may have been responsible for any dubious conduct.

The scandal also, however, pointed a spotlight on other aspects of News Corporation’s affairs, including its corporate governance arrangements. Rupert Murdoch was both Chief Executive Officer and Chairman of the Board at News Corporation, as well as being its most significant shareholder. This meant that he was able to run board meetings and control the information flow. How independent the independent nonexecutive directors were and how much ability they had to debate what was going on was considered questionable.

This was not the first time that concerns had been raised about the corporate governance of companies controlled by Rupert Murdoch. Rupert Murdoch bought The Times and The Sunday Times in the UK in the early 1980s. The board of Times Newspapers also included National Directors, independent national figures of stature whose role it was to protect the editorial independence of the newspapers from interference by the owner. One of Rupert Murdoch’s first actions was to appoint two new National Directors, without first seeking the approval of the existing National Directors. Agendas were not circulated to directors ahead of board meetings, and board meeting dates were often changed at short notice, meaning some directors could not attend. In 1985 Murdoch informed the National Directors by fax of his intentions to appoint Charles Wilson as editor of The Times without consulting them in advance.

Eventually Rupert Murdoch asked the National Director who had been most critical, the historian Hugh Trevor-Roper, to leave the board. Trevor-Roper agreed but commented: ‘For an “independent” director to be asked by the chairman to resign with only a weekend’s notice, and without time to consult those whom he ought to consult, does look rather peremptory.’

[1] .11.7 Service contracts

Service contracts set out terms and conditions of directors’ appointment, including duties, remuneration, constraints on activities while acting as a director, the duration of the appointment (fixed-term contract) or

Alternative arrangements

UK guidance recommends that if the posts were held by the same individual, there should be a strong independent element on the board with a recognised senior member. A senior independent nonexecutive director should be appointed who would be available to shareholders who have concerns that have not been resolved through the normal channels.


A good illustration of how sensitive an issue the same person acting as chief executive and chairman can be was the experience of Marks & Spencer in the UK in 2008. Sir Stuart Rose had been group chief executive for a number of years, and was considered generally to have been successful in this role. In March 2008 the group proposed that Sir Stuart take on the role of executive chairman as well as being chief executive. This clearly breached the guidance in the Combined Code that the same person should not be both chief executive and chairman, and that the chief executive should not go on to become chairman. Marks & Spencer’s justification for non-compliance with the Combined Code was that it would allow the company extra time to find a new chief executive within the company.

However a number of institutional investors objected to this arrangement. In spite of meeting with Marks and Spencer board representatives, Legal & General maintained its objections, stating that it did not support the dilution of corporate governance standards, particularly in leading UK companies. Peter Chambers, Chief Executive of Legal & General Investment Management, commented: ‘We believe we have a moral responsibility to uphold corporate ethics in the UK and believe bellwether companies in the UK share this responsibility . . . We don’t think they [M&S] should be explaining why they are not complying – they should be complying.’ Richard Buxton of Schroders, another investor in Marks & Spencer, commented: ‘For such a household name to do this sets an appalling precedent.’

Marks & Spencer proposed a number of concessions to alleviate investor concerns. These included:

  • Sir Stuart standing for re-election every year at the company’s annual general meeting, starting in July 2008
  • His pay remaining unchanged
  • Two new non-executive directors being appointed
  • M&S reverting to having a separate chairman and chief executive once Sir Stuart’s tenure as executive chairman ended

In early 2010, Marc Bolland took over from Stuart Rose as chief executive, but Stuart Rose continued as non-executive chairman until the end of 2010.


Exam focus        Be careful, if you’re asked about the role of the chief executive or chairman, to see whether you are point              supposed to cover specific aspects of the role. For example, if you were asked about the chief executive’s role in internal control, you should not write about their role in developing strategy.

                                 2.4 Board committees                                                            6/15

Many companies operate a series of board sub-committees responsible for supervising specific aspects of governance. Operation of a committee system does not absolve the main board of its responsibilities for the areas covered by the board committees.

However, good use of committees seems to have had a positive effect on the governance of many companies. Higgs found evidence that committees had given assurance that important board duties were being discharged rigorously.

The main board committees are:

  • Audit committee – arguably the most important committee, responsible for liaising with external audit, supervising internal audit and reviewing the annual accounts and internal controls. The audit committee’s work is discussed further in Chapter 8.
  • Nomination committee – responsible for recommending the appointments of new directors to the board. We have discussed their work above.
  • Remuneration committee – responsible for advising on executive director remuneration policy and the specific package for each director (discussed in Section 3).
  • Risk committee – responsible for overseeing the organisation’s risk response and management strategies (discussed in Chapter 5).

Corporate governance guidance has concentrated on the work of the audit, remuneration and nomination committees. The Higgs report recommends that no one individual should serve on all committees. Most reports recommend that the committees should be staffed by non-executive directors and preferably independent non-executive directors. We shall now consider the role of non-executive directors to see why their role is deemed to be so significant.

2.5 Non-executive directors 12/08, 12/09, 06/13
Non-executive directors have no executive (managerial) responsibilities.  
Key term

Non-executive directors should provide a balancing influence, and play a key role in reducing conflicts of interest between management (including executive directors) and shareholders. They should provide reassurance to shareholders, particularly institutional shareholders, that management is acting in the interests of the organisation.

Exam focus        The P1 exams so far have demonstrated the importance of non-executive directors as central figures in point                corporate governance. You need a good understanding of who non-executive directors are, what they do, why they are of benefit to the organisation, and the problems that exist in relation to them.

                                 2.6 Role of non-executive directors                                 12/07

The UK’s Higgs report provides a useful summary of the role of non-executive directors.

  • Strategy

Non-executive directors should contribute to, and challenge the direction of, strategy. They should use their own business experience to reinforce their contribution. The Walker review on corporate governance in UK banks and other financial institutions highlighted the challenge stage as an essential part of board discussions: ‘The most critical need is for an environment in which effective challenge of the executive is expected and achieved in the boardroom before decisions are taken on major risk and strategic issues.’

  • Scrutiny

Non-executive directors should scrutinise the performance of executive management in meeting goals and objectives and monitor the reporting of performance. They should represent the shareholders’ interests to ensure agency issues don’t arise to reduce shareholder value.

  • Risk

Non-executive directors should satisfy themselves that financial information is accurate and that financial controls and systems of risk management are robust. (These may include industryspecific systems, such as in the chemical industry.)

  • People

Non-executive directors are responsible for determining appropriate levels of remuneration for executives and are key figures in the appointment and removal of senior managers and in succession planning.

The UK Higgs report suggests that non-executive directors have ‘an important and inescapable relationship with shareholders’. Higgs recommends that one or more non-executive directors should take direct responsibility for shareholder concerns, and should attend regular meetings with shareholders. One method of enhancing the contribution of non-executive directors is to appoint one of the independent non-executive directors as senior independent director to provide a sounding board for the chairman and to serve as an intermediary for the other directors and shareholders if they have concerns they cannot resolve through other channels.

The examiner sees the contribution of non-executive directors as centred on these four elements. Question 1 in December 2007 not only required discussion of these four roles, but discussion of the tensions between them.  
Exam focus point

For the public sector, the Good Governance Standard for Public Services defines the role of non-executive directors as:

  • Contributing to strategy by bringing a range of perspectives to strategic development and decisionmaking
  • Making sure that effective management arrangements and an effective team are in place at the top level of the organisation
  • Delegating decisions not reserved for the governing body
  • Holding executives to account through purposeful challenge and scrutiny
  • Being extremely careful about getting involved in operational detail for which responsibility is delegated to the executive
2.6.1 Advantages of non-executive directors

Non-executive directors can bring a number of advantages to a board of directors.

  • Experience and knowledge

They may have external experience and knowledge which executive directors do not possess. The experience they bring can be in many different fields. They may be executive directors of other companies, and have experience of different ways of approaching corporate governance, internal controls or performance assessment. They can also bring knowledge of markets within which the company operates.

  • Perspective

Non-executive directors can provide a wider perspective than executive directors who may be more involved in detailed operations.  

  • Reassurance

Good non-executive directors are often a comfort factor for third parties such as investors or creditors. 

  • Contribution

The English businessman Sir John Harvey-Jones pointed out that there are certain roles nonexecutive directors are well suited to play. These include ‘father-confessor’ (being a confidant for the chairman and other directors), ‘oil-can’ (intervening to make the board run more effectively) and acting as ‘high sheriff’ (if necessary taking steps to remove the chairman or chief executive). (e) Dual roles

The most important advantage perhaps lies in the dual nature of the non-executive director’s role. Non-executive directors are full board members who are expected to have the level of knowledge that full board membership implies.

At the same time, they are meant to provide the so-called strong, independent element on the board. This should imply that they have the knowledge and detachment to be able to monitor the company’s strategy and affairs effectively. In particular they should be able to assess fairly the remuneration of executive directors when serving on the remuneration committee, be able to discuss knowledgeably with auditors the affairs of the company on the audit committee and be able to scrutinise strategies for excessive risks.

In addition, of course, appointing non-executive directors ensures compliance with corporate governance regulations or codes.

2.6.2 Problems with non-executive directors

Nevertheless there are a number of difficulties connected with the role of non-executive director.

  • Lack of independence

In many organisations, non-executive directors may lack independence. There are in practice a number of ways in which non-executive directors can be linked to a company, as suppliers or customers for example. Even if there is no direct connection, potential non-executive directors are more likely to agree to serve if they admire the company’s chairman or its way of operating.

  • Prejudice

There may be a prejudice in certain companies against widening the recruitment of non-executive directors to include people proposed other than by the board or to include stakeholder representatives.

  • Preferences of best directors

High-calibre non-executive directors may gravitate towards the best-run companies, rather than companies which are more in need of input from good non-executives.

  • Enforcing views

Non-executive directors may have difficulty imposing their views on the board. It may be easy to dismiss the views of non-executive directors as irrelevant to the company’s needs. This may imply that non-executive directors need good persuasive skills to influence other directors. Moreover, if executive directors are determined to push through a controversial policy, it may prove difficult for the more disparate group of non-executive directors to oppose them effectively.

  • Prevention of problems

Sir John Harvey-Jones has suggested that not enough emphasis is given to the role of nonexecutive directors in preventing trouble, in warning early on of potential problems. Conversely, when trouble does arise, non-executive directors may be expected to play a major role in rescuing the situation, which they may not be able to do.

  • Time available

Perhaps the biggest problem which non-executive directors face is the limited time they can devote to the role. If they have valuable experience, they are also likely to have time-consuming other commitments. In the time they have available to act as non-executive directors, they must contribute as knowledgeable members of the full board and fulfil their legal responsibilities as directors. They must also serve on board committees. Their responsibilities mean that their time must be managed effectively, and they must be able to focus on areas where the value they add is greatest. However, expectations of non-executive directors are increasing. The 2009 Walker review of UK financial institutions recommended that a minimum expected annual time commitment of 30 to 36 days to a major board should be clearly indicated in letters of appointment.

  • Weakening board unity

Some commentators have suggested that non-executive directors can damage company performance by weakening board unity and stifling entrepreneurship. Agrawal and Knoeber suggested that boards are often expanded for political reasons, to include stakeholder representatives with concerns other than maximisation of financial performance.

2.7 Number of non-executive directors

Most corporate governance reports acknowledge the importance of having a significant presence of nonexecutive directors on the board. The question has been whether organisations should follow the broad principles expressed in the Cadbury report:

‘The board should include non-executive directors of sufficient character and number for their views to carry significant weight.’,

or whether they should follow prescriptive guidelines. New York Stock Exchange rules now require listed companies to have a majority of non-executive directors (ie more than half the board). Other codes, such as the Singapore code, suggest at least a third of the board should be independent (non-executive) directors.

                                 2.8 Independence of non-executive directors              12/10

Although non-executive directors can fulfil the roles described above even if they are not independent, the presumption in governance reports is that non-executive directors’ contribution is enhanced if they are independent. Various safeguards can be put in place to ensure that non-executive directors remain independent. Those suggested by the corporate governance reports include:

  • Connections

Non-executive directors should have no business, financial or other connection with the company. Recent reports have widened the scope of business connections to include anyone who has been an employee or auditor, or had a material business relationship (such as being a supplier or significant customer) over the last few years, or served on the board for more than nine years.

  • Cross-directorships

This is where an executive director of Company A is a non-executive director of Company B, and an executive director of Company B is a non-executive director of Company A. These are a particular threat to independence, often increased by cross-shareholdings. The problem is that non-executive directors will sit in judgement on executive directors when, for example, they consider their remuneration. Having one director sit in judgement on another who in turn is sitting in judgement on them is an obvious conflict of interest, with directors being concerned with their own interests rather than shareholders’.

  • Share options

They should not take part in share option schemes and their service should not be pensionable, to maintain their independent status. This is intended to help ensure non-executive directors’ detachment from executive directors, and means that they can offer advice and scrutiny that is not influenced by an interest in the company’s share price in the short term.

  • Appointment terms

Appointments should be for a specified term (often three years) and reappointment should not be automatic. The board as a whole should decide on their nomination and selection.

  • Advice

Procedures should exist whereby non-executive directors may take independent advice, at the company’s expense if necessary. This helps the non-executive directors gain outside, objective advice on areas of concern.

However, the requirements do vary jurisdiction by jurisdiction, reflecting different approaches to the drafting of codes of governance. In some jurisdictions factors that impair independence are stressed; others emphasise positive qualities that promote independence. Ultimately, as the ICGN guidelines point out, all definitions come down to non-executive directors being independent-minded, which means exercising objective judgement in the best interests of the corporation whatever the consequences for the director personally.

2.8.1 Maintaining independence of non-executive directors

One way of increasing independence of the non-executive directors as a whole is to recruit non-executive directors from outside the industry in which the company operates. Networks threatening independence can build up within industries as staff move between companies and collaborate on industry bodies. Nonexecutive directors from within the industry may also be influenced by the assumptions and prejudices of the industry.

However, the disadvantage of recruiting non-executive directors from outside the industry is that they may lack strategic awareness of industry issues, technical knowledge and a network of contacts. In practice the effectiveness of many boards is probably maximised by including a mixture of non-executives from within the industry with technical expertise, and industry outsiders with wider regulatory, political or social insight.

Whenever a question scenario features non-executive directors, watch out for threats to, or questions over, their independence. These could include personal or business relationships. The examiner highlighted the independence of non-executive directors in an article about independence published in August 2011, so it is very likely to be examined in future.

Exam focus point

2.9 Characteristics of non-executive directors

The UK Higgs report summed up the characteristics of the effective non-executive director.

  • Upholds the highest ethical standards of integrity and probity
  • Supports executives in their leadership of the business while monitoring their conduct
  • Questions intelligently, debates constructively, challenges rigorously and decides dispassionately
  • Listens sensitively to the views of others inside and outside the board
  • Gains the trust and respect of other board members
  • Promotes the highest standards of corporate governance and seeks compliance with the provisions of the Code wherever possible

Higgs suggests that the following issues should be considered when appraising the performance of nonexecutive directors.

  • Preparation for meetings
  • Attendance level
  • Willingness to devote time and effort to understand the company and its business
  • Quality and value of contributions to board meetings
  • Contribution to development of strategy and risk management
  • Demonstration of independence by probing, maintaining own views and resisting pressure from others
  • Relationships with fellow board members and senior management
  • Up to date awareness of technical and industry matters
  • Communication with other directors and shareholders
                                 2.10 Multi-tier boards                                                          12/09

Some jurisdictions take the split between executive and other directors to its furthest extent.

2.10.1 Corporate governance arrangements in Germany

Institutional arrangements in German companies are based on a dual board.

  • Supervisory board
    • supervisory board has workers’ representatives and stakeholders’ management representatives including banks’ representatives. The board has no executive function, although it does review the company’s direction and strategy and is responsible for safeguarding stakeholders’ interests. It must receive formal reports of the state of the company’s affairs and finance. It approves the accounts and may appoint committees and undertake investigations. The board should be composed of members who, as a whole, have the required knowledge, abilities and expert experience to complete their tasks properly and are sufficiently independent.
  • Management board
    • management or executive board, composed entirely of managers, will be responsible for the day-to-day running of the business. The supervisory board appoints the management board. Membership of the two boards is entirely separate.
2.10.2 Corporate governance arrangements in Japan

In Japan there are three different types of board of director.

  • Policy boards – concerned with long-term strategic issues
  • Functional boards – made up of the main senior executives with a functional role
  • Monocratic boards – with few responsibilities and having a more symbolic role

Perhaps unsurprisingly, one of the main features of this structure is that decision-making is generally thorough but slow. This has been considered acceptable in a culture where the stress is on long-term decisions. Directors are supposed to continue to promote the interests of employees once they join the board, in line with corporate culture. Entry of executives onto the board is controlled by the chairman, who may seek the advice of others (frequently bankers).

2.11 Unitary boards vs multi-tier boards
2.11.1 Advantages of unitary boards
  • Common legal responsibility

All participants in the single board have equal legal responsibility for management of the company and strategic performance. This implies a more active approach by those directors who are not executive directors and therefore act in an independent and ‘supervisory’ capacity.

  • Inclusion in decision-making

If all the directors attend the same meetings, the independent directors are less likely to be excluded from decision-making and given restricted access to information. Boards that take all views into account in decision-making may end up making better decisions.

  • Questioning

The presence of non-executive directors with different viewpoints to question the actions and decisions of executive directors as they are taking place should lead to better decisions being made.

  • Maintenance of better relationships

The relationship between different types of directors may be better as a single board promotes easier co-operation.

2.11.2 Disadvantages of unitary boards
  • Objectivity of monitoring

Non-executive directors’ primary role is to monitor decision-making by executive directors. They may find it very difficult to monitor objectively if they are also significantly involved in decisionmaking themselves.

  • Time requirements

The time requirements on non-executive directors may be onerous, both in terms of the time spent in board meetings and the commitment required to obtain sufficient knowledge about the company to properly fulfil their monitoring role.

  • Entrenchment of divisions with employees

In some jurisdictions, for example the UK, the unitary board can be seen as emphasising a division between directors and employees who are not represented on the board. 

  • Relationships with shareholders

Similarly the unitary board also emphasises the divide between the shareholders and the directors. Shareholder representatives cannot be included on the board other than as directors. However, if shareholder representatives are appointed as directors, it means that they may face a conflict between promoting the interests of the shareholder group they represent, and acting in the interests of the company as a whole. If shareholder representatives are not on the board, then the general meeting may be the only time that shareholder grievances or concerns can be raised effectively.

2.11.3 Advantages of multi-tier boards
  • Separation of duties

The main argument in favour of multi-tier boards is the clear and formal separation between the monitors and the executive directors being monitored.

  • Guarding role

The supervisory/policy board has the capacity to be an effective guard against management inefficiency or worse. Indeed its very existence may be a deterrent to fraud or irregularity in a similar way to the independent audit.

  • Interests of stakeholders

The supervisory/policy board should take account of the needs of stakeholders other than shareholders, specifically employees, who are clearly important stakeholders in practice. The system actively encourages transparency within the company, between the boards and, through the supervisory board, to the employees and the shareholders. It also involves the shareholders and employees in the supervision and appointment of directors.

  • Role of strategic board

If the split of the board is on strategic/operational lines, a small strategic board may be able to act more quickly and decisively than a larger board that includes everyone with operational responsibilities.

2.11.4 Disadvantages of multi-tier boards
  • Lack of clarity

Confusion over authority and therefore a lack of accountability can arise with multi-tier boards. This criticism has been particularly levelled at Japanese companies where the consequence is allegedly often over-secretive procedures.

  • Ineffectiveness of supervisory board

In practice, the supervisory/policy board may not be as effective as it seems in theory. The executive management board may restrict the information passed on to the supervisory board and the boards may only liaise infrequently.

  • Lack of independence

The supervisory board may not be as independent as would be wished, depending on how rigorous the appointment procedures are. In addition, members of the supervisory board can be and indeed are likely to be shareholder representatives. This could detract from legal requirements that shareholders don’t instruct executive directors how to manage if the supervisory board was particularly strong.

  • Limitations of strategic board

Exclusion of board members, particularly those with operational responsibilities from important strategic discussions, may result in decisions that do not take full account of all the important factors. Directors who are not consulted may not support the decisions, particularly if they regard them as unworkable.

Question 1 of the Pilot Paper included a good illustration of the sort of requirement you might face. It asked for students to construct a case for (argue in favour of) the company in the scenario adopting a unitary board structure. This meant that students had to use their knowledge of the features of different board structures and appreciate why the company in the scenario should adopt a unitary structure.

Exam focus point

2.11.5 The future global position

Proposals to introduce two (or more) tier boards have been particularly criticised in the UK and US. Critics claim that moves to increase the involvement of non-executive directors (influenced ironically by Sarbanes-Oxley) are a step on the slippery slope towards two-tier boards. The German and Japanese models also appear to be coming under pressure to change as a result of globalisation of capital markets and cross-border mergers and acquisitions.  

                                3 Directors’ remuneration

FAST FORWARD            Directors’ remuneration should be set by a remuneration committee consisting of independent nonexecutive directors.

Remuneration should be dependent on organisation and individual performance.

Accounts should disclose remuneration policy and (in detail) the packages of individual directors.

3.1 Purposes of directors’ remuneration

Clearly adequate remuneration has to be paid to directors in order to attract and retain individuals of sufficient calibre. Remuneration packages should be structured to ensure that individuals are motivated to achieve performance levels that are in the company and shareholders’ best interests as well as their own personal interests.



In November 2008 Peter Wuffli, former chief executive of the Swiss bank UBS, revealed that he had handed back SFr 12 million (£6.7 million) in bonus entitlements in sympathy with its plight. The decision contributed to pressure on other UBS directors and directors of other banks to renounce incentive payments gained through past performance.


3.1.1 Need for guidance

However, directors being paid excessive salaries and bonuses has been seen as one of the major corporate abuses for a large number of years. It is inevitable that the corporate governance provisions have targeted it. However, this is not necessarily to the disadvantage of the high-performing director, since guidance issued has been underpinned by a distinction between reasonable rewards that are justified by performance, and high rewards that are not justified and are seen as unethical.

The Greenbury committee in the UK set out principles which are a good summary of what remuneration policy should involve.

  • Directors’ remuneration should be set by independent members of the board.
  • Any form of bonus should be related to measurable performance or enhanced shareholder value.
  • There should be full transparency of directors’ remuneration, including pension rights, in the annual accounts.
                                3.2 Role and function of remuneration committee       6/10

The remuneration committee plays the key role in establishing remuneration arrangements. In order to be effective, the committee needs to determine both the organisation’s general policy on the remuneration of executive directors and specific remuneration packages for each director.

The UK Corporate Governance Code suggests measures to ensure that the committee is independent, including requiring the committee to be staffed by independent non-executive directors, ensuring that executive directors do not set their own remuneration levels. Measures to ensure independence include stating that the committee should have no personal interests other than as shareholders, no conflicts of interest and no day-to-day involvement in running the business.

Guidance from the Association of British Insurers stresses the importance of remuneration committees bringing independent thought and scrutiny to the development and review process, together with an understanding of the drivers of the business that contribute to shareholder value. The Financial Stability

Forum emphasises the importance of committee members having sufficient risk measurement expertise.

They must also have the ability to make fair decisions about how remuneration should vary during periods of loss.

3.3 Remuneration policy

Issues connected with remuneration policy may include the following.

  • The pay scales applied to each director’s package
  • The proportion of the different types of reward within each package
  • The period within which performance related elements become payable
  • What proportion of rewards should be related to measurable performance or enhanced shareholder value, and the balance between short- and long-term performance elements
  • Transparency of directors’ remuneration, including pension rights, in the annual accounts
3.3.1 Positioning of company

When establishing remuneration policy, the remuneration committee has to take into account the position of its company relative to other companies. The UK Greenbury report highlighted a number of factors which the remuneration committee should consider.

  • Recruitment and retention difficulties
  • The behaviour of others in the sector
  • Level of competition
  • Risks, challenges, complexity, diversity and international spread of the business
  • Special expertise and understanding required

Use of an external consultant can help the committee objectively determine the other companies that should be used as benchmarks and avoid using a skewed sample for comparison. However, the UK Corporate Governance Code points out the need for directors to treat such comparisons with caution, in view of the risk of an upward ratchet in remuneration levels with no corresponding improvement in performance. Guidance from the Association of British Insurers suggests that companies need to provide justification for paying directors salaries above median levels and points out that paying salaries below median levels gives more scope for performance-related incentives. The emphasis needs to be on remuneration committees asking searching questions about the data they are given.

  • How appropriate are the comparator companies and should a broader cross-section be used?
  • How widely dispersed are remuneration levels within the comparator group of companies and would removing one or two companies significantly affect the mean or range?
  • How reliable and up to date is the data?

A further question is how big a part comparisons should play, in particular in determining salary levels, and how much should remuneration also be influenced by individual responsibilities, internal relativities and job security.



The German Corporate Governance Code suggests that criteria for determining the appropriateness of remuneration of individual directors include tasks the directors do, personal performance, the economic situation, the performance and outlook of the enterprise and internal and external comparisons of common levels of remuneration. Monetary remuneration should include fixed and variable elements, with variable elements based on a multi-year assessment. Remuneration arrangements should not encourage the directors to take unnecessary risks.


3.3.2 Performance measures

A key issue in determining remuneration policy is over which performance measures are used to determine the remuneration of directors. There are a number of potential problems with this decision.

  • Simply, the choice of the wrong measure, achieving performance that does not benefit the company significantly and does not enhance shareholder value
  • Excessive focus on short-term results, particularly annual financial performance (which can also be manipulated)
  • Remuneration operating with a time delay, being based on what happened some time ago rather than current performance

Other issues the remuneration committee have to consider include:

  • The potentially complex relationships with a variety of strategic goals and targets (including cost of capital, return on equity, economic value added, market share, revenue and profit growth, cost containment, cash management, compliance goals, revenue and environment goals)
  • The differentials at management/director level (difficult with many layers of management)
  • The ability of managers to leave, taking clients and knowledge to a competitor or their own new business
  • Individual performance and additional work/effort

UK guidance also suggests that remuneration should be assessed by non-financial metrics and designed to allow voluntary elements to be reclaimed in the event of misstatement or misconduct.

3.4 Elements of remuneration packages  12/07, 6/09, 6/10, 12/11, 06/13

Packages will need to attract, retain and motivate directors of sufficient quality, while at the same time taking shareholders’ interests into account as well.

However, assessing what the levels of executive remuneration should be in an imperfect market for executive skills may prove problematic. The remuneration committee needs to be mindful of the implications of all aspects of the package as well as the individual contributions and additional work effort  made by each director. Important factors to take into account include:

  • The market rate – the transfer value if a director was to move to a comparable position in another company
  • Legal, fiscal or regulatory constraints such as a compulsory multiple between the highest and lowest paid in an organisation
  • Previous performance in the job and the outcome of performance reviews
  • Stakeholder opinion and ethical considerations
3.4.1 Basic salary

Basic salary will be in accordance with the terms of the directors’ contract of employment, and is not related to the performance of the company or the director. Instead it is determined by the experience, performance and responsibilities of the director, and also what other companies might be prepared to pay (the market rate).

3.4.2 Performance-related bonuses

Directors may be paid a cash bonus for good (generally accounting) performance. To guard against excessive payouts, some companies impose limits on bonus plans as a fixed percentage of salary or pay.

Transaction bonuses tend to be much more controversial. Some chief executives get bonuses for acquisitions, regardless of subsequent performance, possibly indeed further bonuses for spinning off acquisitions that have not worked out.

Alternatively loyalty bonuses can be awarded merely to reward directors or employees for remaining with the company. Loyalty bonuses have been criticised for not being linked to performance. Sometimes they are granted for past loyalty without the director guaranteeing that they will remain with the company. There have been examples of directors leaving their company a short time after receiving a loyalty bonus.

The link between remuneration and company performance is particularly important. Recent UK guidance has stressed the need for the performance-related elements of executive directors’ remuneration to be stretching and designed to align their interests with those of shareholders and promote the long-term success of the company. Remuneration incentives should be compatible with risk policies and systems.

Governance guidance has also suggested that short-term bonuses should be partially deferred, providing scope for companies to reclaim variable bonuses if subsequent results are disappointing.



Writing in the UK Guardian newspaper in 2012, distinguished commentator Sir Simon Jenkins argued that bonuses for directors should be banned. Sir Simon argued that many directors were already exceptionally well paid. Bonuses were an unjustified appropriation of profits that rightly belonged to those who owned the company, the risk-bearing shareholders. Any monies that shareholders wanted distributed within the company should be shared equally between directors and staff. Bonuses had nothing to do with incentive and instead were regarded as an entitlement. The same often applied to the public sector where the criteria on whether a senior employee would receive a bonus would be subjective and overwhelmingly influenced by the individual concerned. Jenkins summed up:

‘I cannot see what is so special in the psychology of a senior executive that makes him respond to a financial incentive, when the same mechanism apparently has no effect on lesser mortals.’



Directors may be awarded shares in the company with limits (a few years) on when they can be sold in return for good performance.

3.4.4 Share options

Share options give directors the right to purchase shares at a specified exercise price over a specified time period in the future. If the price of the shares rises so that it exceeds the exercise price by the time the options can be exercised, the directors will be able to purchase shares at lower than their market value.

Share options can be used to align management and shareholder interests, particularly options held for a long time when value is dependent on long-term performance. The UK Corporate Governance Code states that shares granted or other forms of remuneration should not vest or be exercisable in less than three years. Directors should be encouraged to hold their shares for a further period after vesting or exercise. Grants should be phased rather than being in one block.

The performance criteria used for share options are a matter of particular debate. Possible criteria include the company’s performance relative to a group of comparable companies.

There are various tricks that can be used to reduce or eliminate the risk to directors of not getting a reward through stock options. Possibilities include grants that fail to discount for overall market gains, or are cushioned against loss of value through compensatory bonuses or repricing. 

The UK Corporate Governance Code states that non-executive directors should not normally be offered share options, as options may impact on their independence.

3.4.5 Benefits in kind

Benefits in kind could include transport (eg a car), health provisions, life assurance, holidays, expenses and loans. The remuneration committee should consider the benefit to the director and the cost to the company of the complete package. The committee should also consider how the directors’ package relates to the package for employees. Ideally perhaps the package offered to the directors should be an extension of the package applied to the employees.

Loans may be particularly problematic. Recent corporate scandals have included a number of instances of abuses of loans, including a $408 million loan to WorldCom Chief Executive Officer Bernie Ebbers. Using corporate assets to make loans when directors can obtain loans from commercial organisations seems very doubtful, and a number of jurisdictions prohibit loans to directors of listed companies.

3.4.6 Pensions

Many companies may pay pension contributions for directors and staff. In some cases, however, there may be separate schemes available for directors at higher rates than for employees. The UK Corporate Governance Code states that as a general rule only basic salary should be pensionable. The Code emphasises that the remuneration committee should consider the pension consequences and associated costs to the company of basic salary increases and any other changes in pensionable remuneration, especially for directors close to retirement.

The Walker report on UK financial institutions responded to concerns raised about aspects of pension arrangements. It recommended that no executive board member or senior executive who leaves early should be given an automatic right to retire on a full pension – that is, through enhancement of the value of their pension fund.

3.5 Remuneration packages

As well as considering the magnitude of different elements, remuneration committees need to view the overall remuneration package for each director, and assess whether the relative weightings of each element are appropriate, particularly the balance between basic rewards and incentive. A well-balanced package should aim to reduce agency costs by ensuring that directors’ (agents’) interests are aligned with those of shareholders (principals). This means the package should reward directors who meet targets that further the interests of shareholders. The committee will need to take into account the following factors when deciding what weightings are appropriate.

3.5.1 Strategic objectives

Remuneration packages need to be consistent with the business’s strategies. Guidance from CIMA in a 2010 discussion paper stresses the need for executive pay policies to be aligned with a clear link to business strategy, with proportionate bonuses linked to performance and risk. This implies the need for clear determination of business objectives (discussed further in Chapter 5) and careful design of packages. There should be a match between long-term business objectives and remuneration methods, such as share incentive plans, and short-term objectives and remuneration, particularly bonuses.

Of course one strategic objective may be maintaining reputation as a good corporate citizen. This may lead companies to be cautious about the maximum levels of remuneration directors are given, or be  particularly concerned about headline-grabbing elements of directors’ packages, for example bonuses.



According to BP’s remuneration report, bonuses were determined not only by operating cash flows and level of total shareholder return compared with other major oil companies, but also other strategic imperatives including reserve replacement, process safety and rebuilding trust.


3.5.2 Risk

The Financial Stability Forum stresses the importance of packages reflecting the risks companies face. The Forum suggests that compensation must be symmetric with risk outcomes, meaning that the bonus component should be as variable downwards in response to poor performance as it is upwards in response to good performance. It must reflect risk time horizons, with payments not being made in the short term when risks are realised over the longer term. The Forum suggests that the mix of different elements within the package must be consistent with risk alignment and will vary by director and employee.

The remuneration committee’s influence can be particularly important here. The committee should be able to review what directors are doing to achieve the targets they have been set, and be able to penalise directors if it has evidence that they are taking excessive risks to achieve their targets.

3.5.3 Balancing of different elements

In order to achieve a fairly balanced package, the remuneration committee needs to consider how the package is balanced in different ways.

  • Fixed and variable elements

A pay package that is designed to retain directors, for example when there is a very active market for executives, is likely to include a high fixed element. As discussed above, however, most governance reports stress the importance of reward depending to a significant degree on corporate and individual performance. That said, too high a weighting towards variable, performance-related elements, particularly if the targets set are tough, may disincentivise directors.  

  • Immediate and deferred elements

Most governance guidance stresses that a part of remuneration ought to be deferred in order to ensure that directors are not rewarded excessively for gains in performance that turn out to be temporary. The remuneration committee will need to consider the period for deferment of bonuses, the minimum vesting period for stock options and shares and whether some or all shares granted should be retained until the end of employment.   

  • Long-term and short-term elements

The UK Corporate Governance Code stresses the need for reward packages to be designed to promote the success of companies over time, with a bias towards longer-term elements. However, remuneration committees cannot completely ignore the views of influential shareholders who strongly desire short-term success.             

  • Cash and noncash elements

This can include balancing salaries and bonuses with benefits and pensions, depending on the requirements and needs (for example tax efficiency) of individual directors. Most governance codes here concentrate on the balance between cash and share-balanced rewards, which also links into the immediate/deferred and short-term/long-term considerations described above.    

The Pilot Paper asked how the different elements of packages can be used as a control mechanism to align directors and shareholders’ interests, and help resolve the agency problem. December 2007 Question 2 asked about the role of performance-role pay and for an assessment of a director’s remuneration package. June 2009 Question 3 asked students to criticise an unsatisfactory package. June 2010 Question 2 required discussion of another controversial package and also inadequate scrutiny by the remuneration committee. Undoubtedly future exams will also contain scenarios where directors’ remuneration is an important issue, since controversies about excessive remuneration are regularly reported.

Exam focus point

3.6 Service contracts and termination payments

Length of service contracts can be a particular problem. If service contracts are too long, and then have to be terminated prematurely, the perception often arises that the amounts paying off directors for the remainder of the contract are essentially rewards for failure. Most corporate governance guidance suggests that service contracts greater than 12 months need to be carefully considered and should ideally be avoided. A few are stricter. Singapore’s code suggests that notice periods should be six months or less.

Some companies have cut the notice period for dismissing directors who fail to meet performance targets from one year to six months. Other solutions include continuing to pay a director to the end of their contract, but ceasing payment if the director finds fresh employment, or paying the director for loss of office in the form of shares.

3.7 Remuneration of non-executive directors

The International Corporate Governance Network (ICGN) issued guidance on the remuneration of nonexecutive directors in 2010 and produced further draft guidance in 2012.

The ICGN focuses on recommending methods that preserve the independence of non-executive directors. It suggests that an annual fee or retainer should be the preferred method of cash remuneration. Fees can vary according to the responsibilities that non-executive directors have and the demands made on their time. Non-executive directors who are members of board committees could be reasonably paid higher fees, with chairs of board committees being given additional amounts.

Alternatively the ICGN allows non-executive directors to be paid in shares that vest in them immediately. These shares should come with requirements about long-term ownership and holding attached, with directors holding the shares for a specified period after they retire from the board.

The ICGN believes that all non-executive directors should hold an amount of equity in the company that is significant to them. This should help ensure that their interests are aligned with shareholders. It would be best if these holdings were bought by the directors out of their own pockets, but giving shares to them as part of their remuneration is an acceptable alternative. The guidance prohibits transactions or arrangements that reduce the risks of share ownership for non-executive directors.

The guidance states, however, that non-executive directors should not receive shares on a deferred basis, share options or performance-based remuneration, as these might compromise their independence. Non-executive directors should also not receive:

  • Attendance fees in addition to their basic fees – attendance at meetings is a primary duty of nonexecutive directors
  • Severance fees
  • Rights to participate in defined benefit retirement schemes, since non-executive directors are elected representatives of shareholders and not employees
3.7.1 Determining remuneration of non-executive directors

To avoid the situation where the remuneration committee is solely responsible for determining its own remuneration, the UK Corporate Governance Code states that the board or the shareholders should determine the remuneration of non-executive directors within the limits prescribed by the company’s constitution.

3.8 Remuneration disclosures

In order for readers of the accounts to achieve a fair picture of remuneration arrangements, the annual report would need to disclose:

  • Remuneration policy
  • Arrangements for individual directors

UK regulations emphasise the importance of detailed disclosure of performance conditions attached to remuneration packages, such as the reasons for choosing those conditions and the methods used to determine whether the conditions have been met. A key comparison required by regulations is a line graph showing the total shareholder return on the company’s shares over a five year period and the total shareholder return on a holding of a portfolio of shares over the same period representing a named broad equity market index.

Other disclosures that may be required by law or considered as good practice include the duration of contracts with directors, and notice periods and termination payments under such contracts. Details of external remuneration consultants employed by the remuneration committee to advise on determining remuneration should be provided.


Good examples of where specific country disclosure requirements have gone further are the provisions in the Singapore Code of Corporate Governance which also prescribes disclosure of:

  • The remuneration packages of the top five key executives who are not directors
  • Details of the remuneration of employees who are immediate family members of the directors


3.9 Voting on remuneration

Along with disclosure, the directors also need to consider whether members need to signify their approval of remuneration policy by voting on the remuneration statement and elements of the remuneration packages, for example long-term incentive schemes. Any vote could be binding on the company or advisory. The legal impediment to voting on the overall remuneration of individual directors is the employment contract between the company and its directors. The shareholders cannot force the company to commit a breach of contract. 


Votes on remuneration and their consequences were very frequently in the news in the UK and other countries in Spring 2012.

Citigroup Shareholders rejected the chief executive’s £9.4 million pay package for a year in which its shares fell by 44%. This was the first vote against a pay package in America since the say on pay legislation was introduced. Citigroup responded by saying it would look at a more formula-based method for setting pay.
Central Rand Gold 75% of shareholders voted against the remuneration report. The chief executive subsequently resigned.
Capital Shopping Centres Almost 30% of shareholders voted against pay policies. In response the chairman of the remuneration committee promised to carry out a review of remuneration policy, focusing on areas including ‘providing value for shareholders by rewarding executives primarily for results and aligning [rewards] with best practice’.
AstraZeneca The chief executive and chairman resigned ahead of the annual general meeting after pressure from shareholders and non-executive directors.
Barclays Nearly a third of voting shareholders failed to back remuneration policies, including the chief executive’s £17 million pay package. This vote came after concessions from the chief executive and finance director about performance conditions attached to bonuses. Revelations later in 2012 about alleged fixing of the LIBOR rate resulted in the departure of the chairman and chief executive of Barclays, and Alison Carnwath, chair of the remuneration committee, also resigned.
Man Group 33% of the shareholders failed to support Alison Carnwath’s re-election as director, apparently because of her failure to take a strong enough line on executive pay in her role as chair of the remuneration committee of Barclays.
Trinity Mirror The chief executive resigned after leading shareholders, who disliked her £1.7 million pay package, put pressure on the rest of the board, threatening to vote against their re-election. During her ten years as chief executive, the publisher’s market capitalisation fell from more than £1bn to £80m, and its share price fell by over 90% to 30p. During that period, her total remuneration was more than £14 million.

Following her decision to resign, almost 50% of shareholders failed to back the remuneration report at the company’s annual general meeting.

Aviva The chief executive resigned after shareholders rejected the remuneration report. However, although the company’s share price fell by 60% during his tenure, it was reported that he would leave the company with a £1.75 million pay-off.
William Hill Almost half the shareholders opposed the chief’s new pay package, including a £1.2 million retention bonus.

There are a number of issues arising from these examples of shareholder activism.

  • The greater willingness of shareholders to intervene came after the UK Government announced proposals in January 2012 for a shareholder vote on the remuneration report to be binding.
  • There was also systematic pressure on representatives of institutional investors, particularly from pension funds and shareholder advisory bodies such as PIRC and ISS.
  • Communication by shareholders with the board before the annual general meeting proved to be very influential means of putting pressure on directors. For example, the chief executive of Trinity Mirror resigned before the AGM after shareholder criticism. Boards have acknowledged that more communication with shareholders is needed and remuneration committees need to be more proactive in explaining to shareholders what is happening on executive pay and why.
  • Shareholders seemed to prefer to vote against the remuneration report rather than against the reelection of directors. However, the proportion of shareholders voting against reappointment has increased, particularly against chairs of remuneration committees who have failed to curb executive pay.
  • There were a number of instances where directors who had left boards prematurely received settlements under their service contracts that were criticised for being excessive. This is an aspect of director reward that may receive greater attention from shareholders in future when the terms are granted, rather than when the director leaves the company.

 4 Relationships with shareholders and stakeholders


The board should maintain a regular dialogue with shareholders, particularly institutional shareholders.

The annual general meeting is the most significant forum for communication.

How much organisations consider the interests of other stakeholders will depend on their legal responsibilities and the extent to which they view stakeholders as partners.

4.1 Rights of shareholders

The OECD guidelines stress the importance of the basic rights of shareholders. These include the right to secure methods of ownership registration, convey or transfer shares, obtain relevant and material information, participate and vote in general meetings and share in the profits of the company. Under the OECD guidelines shareholders should also have the right to participate in, and be sufficiently informed on, decisions concerning fundamental changes such as amendments to the company’s constitution.

The guidelines also stress the importance of treating all shareholders of the same class equally, particularly protecting minority shareholders against poor treatment by controlling shareholders.

4.2 Relationships with shareholders

A key aspect of the relationship is the accountability of directors to shareholders. This can ultimately be ensured by requiring all directors to submit themselves for regular re-election (the corporate governance reports suggest once every three years is reasonable).

The need for regular communication with shareholders is emphasised in most reports. Particularly important is communication with institutional shareholders, such as pension funds who may hold a significant proportion of shares. The UK Corporate Governance Code states that non-executive directors, in particular the senior independent director, should maintain regular contact with shareholders. The board as a whole should use a variety of means for ascertaining major shareholders’ opinions, for example face to face contact, analysts or brokers’ briefings and surveys of shareholders’ opinions.

                                 4.3 General meetings                                                              6/11
4.3.1 Annual general meetings

The annual general meeting is a statutorily protected opportunity for members to have a regular discussion about their company and its management. It allows the board to discuss the results of the company and explain the future outlook. Shareholders vote on the appointment of directors and auditors and the level of dividends to be paid.

The annual general meeting is the most important formal means of communication with shareholders. Governance guidance suggests that boards should actively encourage shareholders to attend annual general meetings. UK guidance has included some useful recommendations on how the annual general meeting could be used to enhance communication with shareholders, by giving shareholders an opportunity to ask questions and use their votes.

  • Notice of the AGM and related papers should be sent to shareholders at least 20 working days before the meeting.
  • Companies should consider providing a business presentation at the AGM, with a question and answer session.
  • The chairs of the key sub-committees (audit, remuneration) should be available to answer questions.
  • Shareholders should be able to vote separately on each substantially separate issue. The practice of ‘bundling’ unrelated proposals in a single resolution should cease.
  • Companies should propose a resolution at the AGM relating to the report and accounts.
  • The UK Stewardship Code 2012 emphasises the importance of institutional shareholders attending annual general meetings and using their votes, to translate their intentions into practice. Institutional shareholders should provide their clients with details of how they’ve voted.
  • Codes with international jurisdiction, such as the OECD principles, emphasise the importance of eliminating impediments to cross-border voting.

The most important document for communication with shareholders is the annual report and accounts, covered in Section 5 below. 

4.3.2 Other general meetings

General meetings may also be convened to discuss issues that cannot wait until the next annual general meeting. In some jurisdictions company meetings that are not annual general meetings are called extraordinary general meetings, although this term is no longer used in English law.

Local legislation will impose conditions on the power to call other general meetings. Directors may be given power under the articles to call a meeting at any time they see fit. Under English law for public companies, members requisitioning a general meeting must hold at least 10% of the paid up share capital holding voting rights.

Often other general meetings are called to authorise a major strategic move, such as a large acquisition or to respond to a significant strategic threat. Shareholders may requisition a general meeting if they have urgent concerns about how the company is being run. In Chapter 1 we discussed circumstances in which institutional shareholders may intervene in a company, such as major failings in internal control. Ultimately institutional shareholders may intervene by requisitioning a general meeting.

General meetings can help reassure shareholders by allowing a two-way discussion between themselves and directors. On the other hand, they can be a means of holding directors to account and ultimately passing a vote of no confidence.

Proxy votes            12/11
A proxy is a person appointed by a shareholder to vote on behalf of that shareholder at company meetings.
Key term

Under most regimes a member of a company, who is entitled to attend and vote at a meeting of the company, has a statutory right to appoint an agent, called a ‘proxy’, to attend and vote for them. There may be rules governing how many proxies a member can appoint, whether the proxy has to be a member, whether the proxy has a right to speak and when the proxy can vote.

Proxy forms can allow the shareholder either to instruct the proxy how to vote on some or all motions, or nominate someone attending the meeting (often a director) to exercise the shareholders’ vote at their discretion. This is particularly relevant when the board’s view is carried by proxy votes (including proxies which the board has the discretion to exercise), despite the feeling of the meeting being against the board on the motion.

Also, unless a standard proxy card is very elaborately worded, it cannot anticipate all the possible amendments to the resolution(s) set out in the notice of the meeting. If a substantial amendment is carried, the proxy’s authority to vote is unaffected – but they no longer have instructions as to how they should vote. They should exercise their discretion in whatever fashion they honestly believe is likely to reflect the wishes of the shareholder.

4.4.1 Advantages of proxy voting
  • Attendance

Institutional shareholders often hold shares in hundreds of companies. It is impractical to expect their representatives to attend every annual general meeting. Even if they could, the associated agency costs would be considerable and the usefulness of being present would be limited if all the votes were routine. Using a proxy means that their votes can be exercised, in accordance with best practice.It also gives smaller shareholders who cannot attend meetings in person the chance to have some influence over the company’s strategies and policies.

  • Representative of shareholders’ views

If only those who attend the annual general meeting are allowed to vote and only a small number of shareholders attend, the votes taken may not be representative of the views of the shareholder body as a whole. Proxies mean that the views of those not attending the annual general meeting are reflected in the general meeting votes and the votes should thus be more representative of shareholder opinion.

4.4.2 The Myners report

The Myners report in the UK Review of the Impediments to Voting UK Shares (2004) aimed to address concerns about problems in administering proxy votes and the beneficial owners not taking sufficient interest in the votes. The report makes a number of recommendations.

  • Beneficial owners

Beneficial share owners should ensure that their agreements with investment managers and custodians who are accountable to them should include voting standards, establish a chain of responsibility and an information flow on voting and require reports by investment managers on how they have discharged their responsibilities. Investment managers should decide a voting policy and stick to it.

  • Electronic voting

The report recommends the adoption of electronic voting to enhance the efficiency of the voting process and to reduce the loss of proxy votes.

  • Stock lending

Stock lending is a temporary transfer of shares or other securities, from a borrower to a lender, with agreement by the borrower to return the securities to the lender at a prearranged time. The report comes down against stock lending on the grounds that voting rights are effectively transferred, and lending sometimes takes place specifically to transfer voting rights. Myners recommends that stock should be recalled if there are votes on contentious issues.

  • Investment managers

Investment managers should report to their clients how they have exercised their voting responsibilities.

  • Procedures at meetings

Myners addresses the situation where votes at company meetings are decided on a show of hands, with one vote per member present, unless a poll is called. Myners suggests that a poll should be called on all resolutions. The report also recommends that proxy forms should include a vote withheld box, to identify the extent to which shareholders are consciously abstaining. The report also recommends giving the right to speak and the right to vote on a show of hands to anyone who has been appointed to act as a proxy by a member (an alternative to filling in a proxy form).

4.5 Relationships with stakeholders

How much the board is responsible for the interests of stakeholders other than shareholders is a matter of debate. The Hampel committee claimed that, although relationships with other stakeholders were important, making the directors responsible to other stakeholders would mean there was no clear yardstick for judging directors’ performance.

However, the OECD guidelines see a rather wider importance for stakeholders in corporate governance, concentrating on employees, creditors and the Government. Companies should behave ethically and have regard for the environment and society as a whole.

The OECD guidelines stress that the corporate governance framework should therefore ensure that respect is given to the rights of stakeholders that are protected by law. These rights include rights under labour law, business law, contract law and insolvency law.

The OECD guidelines also state that corporate governance frameworks should permit ‘performanceenhancing mechanisms for stakeholder participation’. Examples of this are employee representation on the board of directors, employee share ownership, profit-sharing arrangements and the right of creditors to be involved in any insolvency proceedings.

The UK Hermes Principles emphasise that companies should support voluntary and statutory measures that minimise the externalisation of costs to the detriment of society at large.

5 Reporting on corporate governance


Annual reports must convey a fair and balanced view of the organisation. They should state whether the organisation has complied with governance regulations and codes. It is considered best practice to give specific disclosures about the board, internal control reviews, going concern status and relations with stakeholders.

5.1 Importance of reporting

The Singapore Code of Corporate Governance summed up the importance of reporting and communication rules:

‘Companies should engage in regular, effective and fair communication with shareholders … In disclosing information, companies should be as descriptive, detailed and forthcoming as possible, and avoid boilerplate disclosures.’

Good disclosure helps reduce the gap between the information available to directors and the information available to shareholders, and addresses one of the key difficulties of the agency relationship between directors and shareholders.

5.2 Principles vs compulsory

The emphasis in principles-based corporate governance regimes is on complying or explaining. Companies either act in accordance with the principles and guidelines laid down in the code or explain why and specifically how or in what regard they have not done so.

The London Stock Exchange requires the following general disclosures.

  • A narrative statement of how companies have applied the principles set out in the UK Corporate Governance Code, providing explanations which enable their shareholders to assess how the principles have been applied.
  • A statement as to whether or not they complied throughout the accounting period with the provisions set out in the UK Corporate Governance Code. Listed companies that did not comply throughout the accounting period with all the provisions must specify the provisions with which they did not comply, and give reasons for non-compliance.


The Catlin Group disclosed examples of non-compliance in a couple of areas.

The Company complies with the UK Corporate Governance Code other than in respect of the following.

  • Until 30 June, one member of the Compensation Committee (Michael Eisenson) was not ‘independent’ due to his affiliation with a shareholder. Since 30 June, all members of the

Compensation Committee are independent, so membership is now compliant with the Code.

  • Certain directors’ appointment letters, originally issued some years ago, do not specify a minimum time commitment. The affected individuals have been directors for at least five years, and over that time each has demonstrably devoted sufficient time and attention to their responsibilities.


Beyond these basic requirements disclosure guidelines in principles-based regimes tend to be based on the ideas of providing balanced and detailed information that enables shareholders to assess the company’s potential. They acknowledge that judgement is important in deciding what to disclose.

                                 5.3 Reporting requirements                                    12/08, 6/14

The corporate governance reports suggest that the directors should explain their responsibility for preparing accounts. They should report that the business is a going concern, with supporting assumptions and qualifications as necessary.

In addition, further statements may be required depending on the jurisdiction, such as:

  • Information about the board of directors: the composition of the board in the year, information about the independence of the non-executives, frequency of, and attendance at, board meetings, how the board’s performance has been evaluated; the South African King report suggests a charter of responsibilities should be disclosed
  • Brief reports on the remuneration, audit, risk and nomination committees covering terms of reference, composition and frequency of meetings
  • An explanation of directors’ and auditors’ responsibilities in relation to the accounts and any significant issues connected with the preparation of accounts, for example changes in accounting standards having a major impact on the accounts
  • Information about relations with auditors, including reasons for change and steps taken to ensure auditor objectivity and independence when non-audit services have been provided
  • An explanation of the basis on which the company generates or preserves value and the strategy for delivering the objectives of the company
  • A statement that the directors have reviewed the effectiveness of internal controls, including risk management
  • A statement on relations and dialogue with shareholders
  • A statement that the company is a going concern
  • Sustainability reporting,defined by the King report as including the nature and extent of social, transformation, ethical, safety, health and environmental management policies and practices
  • A business review or operating and financial review (OFR)

Furthermore, the information organisations provide cannot just be backward-looking. The King report points out that investors want a forward-looking approach and to be able to assess companies against a balanced scorecard. Companies will need to weigh the need to keep commercially sensitive information private with the expectations that investors will receive full and frank disclosures. They should also consider the need of other stakeholders.

5.3.1 The Operating and Financial Review/Management commentary

The UK’s Accounting Standards Board summarised the purpose of such a review:

‘The Operating and Financial Review (OFR) should set out the directors’ analysis of the business, in order to provide to investors a historical and prospective analysis of the reporting entity “through the eyes of management”.’

In the UK guidance about the OFR was first published in 1993. The implementation of the 2006 Companies

Act meant that the OFR was abolished in 2008, but most of the content originally recommended by the Accounting Standards Board should be now included in an expanded business review contained within the directors’ report.

In December 2010, the International Accounting Standards Board issued an IFRS Practice Statement Management Commentary, which is the international equivalent of the Operating and Financial Review. The IASB stated that management commentary should follow these principles:

  • To provide management’s view of the entity’s performance, position and progress;
  • To supplement and complement information presented in the financial statements;
  • To include forward-looking information; and
  • To include information that possesses the qualitative characteristics described in the Conceptual Framework.

The Practice Statement says that to meet the objective of management commentary, an entity should include information that is essential to an understanding of the following elements.


Element User needs
Nature of the business The knowledge of the business in which an entity is engaged and the external environment in which it operates.
Objectives and strategies To assess the strategies adopted by the entity and the likelihood that those strategies will be successful in meeting management’s stated objectives.
Resources, risks and relationships A basis for determining the resources available to the entity as well as obligations to transfer resources to others; the ability of the entity to generate long-term sustainable net inflows of resources; and the risks to which those resource-generating activities are exposed, both in the near term and in the long term
Results and prospects The ability to understand whether an entity has delivered results in line with expectations and, implicitly, how well management has understood the entity’s market, executed its strategy and managed the entity’s resources, risks and relationships
Performance measures and indicators The ability to focus on the critical performance measures and indicators that management uses to assess and manage the entity’s performance against stated objectives and strategies
                                 5.4 Voluntary disclosure                             12/08, 12/11, 6/14

Voluntary disclosure can be defined as any disclosure above the mandated minimum. Examples include a chief executive officer’s report, a social/environmental report, additional risk or segmental data.

Disclosing information voluntarily, going beyond what is required by law or listing rules can be advantageous for the following reasons.

  • Wider information provision

Disclosures covering wider areas than those required by law or regulations should give stakeholders a better idea of the environment within which the company is operating and how it is responding to that environment. This should enable investors to carry out a more informed analysis of the strategies the company is pursuing, reducing information asymmetry between directors and shareholders and perhaps attracting investment.

  • Different focus of information

Voluntary information can be focused on future strategies and objectives, giving readers a different perspective to compulsory information that tends to be focused on historical accounting data.

  • Assurance about management

Voluntary information provides investors with further yardsticks to judge the performance of management, improving accountability. Its disclosure demonstrates to shareholders that managers are actively concerned with all aspects of the company’s performance.

  • Consultation with equity investors and other stakeholders

The voluntary disclosures a company makes can be determined by consultations with major equity investors such as institutional shareholders on what disclosures they would like to see in the accounts. There can also be consultation with other stakeholders if they are influential.

The UK Government has set out principles that are useful for voluntary disclosure in general.

  • The process should be planned and transparent, and communicated to everyone responsible for preparing the information.
  • The process should involve consultation within the business, and with shareholders and other key groups.
  • The process should ensure that all relevant information should be taken into account.
  • The process should be comprehensive, consistent and subject to review.
December 2008 Question 1 asked about compulsory and voluntary disclosures, and how voluntary disclosures enhanced accountability. December 2011 Question 1 asked about the significance of disclosure on environmental risk management for shareholders.  
Exam focus point


  Listed companies Charities
Purpose Maximisation of returns for shareholders Beneficial purpose for which the organisation is set up and which the law regards as charitable
Requirements Company law

Corporate governance reports

Accounting standards

Charity law (although if charity is company limited by guarantee it will need to comply with relevant company legislation as well)

Accounting requirements applicable to charities

Stakeholder requirements Profit maximisation


Supply of goods and services

Fair treatment

Fulfilment of charity’s benevolent purposes
Governance Board of directors

Inclusion of non-executive directors

Board of trustees

Inclusion of donor and beneficiary representatives

Separate executive board possibly



Discuss how the main measures recommended by the corporate governance codes should contribute towards better corporate governance.

Recommendations of corporate governance codes

Clearly, a company must have senior executives. The problem is how to ensure as far as possible that the actions and decisions of the executives will be for the benefit of shareholders. Measures that have been recommended by various corporate governance codes include the following.


  • A listed company is required by the UK Corporate Governance Code to appoint independent nonexecutive directors. The non-executives are intended to provide a check or balance against the power of the chairman and chief executive.
  • The posts of chairman and CEO should not be held by the same person, to prevent excessive executive power being held by one individual.
  • Non-executive directors should make up the membership of the remuneration committee of the board, and should determine the remuneration of executive directors. This is partly to prevent the executives deciding their own pay, and rewarding themselves excessively. Another purpose is to try to devise incentive schemes for executives that will motivate them to achieve results for the company that will also be in the best interests of the shareholders.

Risk assessment

The requirement in many codes for a risk audit should ensure that the board of directors is aware of the risks facing the company, and have systems in place for managing them. In theory, this should provide some protection against risk for the company’s shareholders.

Dialogue with shareholders 

The UK Corporate Governance Code encourages greater dialogue between a company and its shareholders. Institutional investor organisations are also encouraging greater participation by shareholders, for example in voting.

However, the onus is on shareholders to use this power. In early 2008 there were a number of stories in the UK press about shareholder concerns about excessive levels of directors’ remuneration, although these generally did not translate into shareholders voting down the remuneration report, possibly the most effective sanction. They may though have encouraged remuneration committees to impose tougher conditions in future.


The audit committee of the board is seen as having a major role to play in promoting dialogue between the external auditors and the board. Corporate governance should be improved if the views of the external auditors are given greater consideration, since implementing their feedback should improve control systems.


Chapter Roundup



The board should be responsible for taking major policy and strategic decisions.

Directors should have a mix of skills and their performance should be assessed regularly.

Appointments should be conducted by formal procedures administered by a nomination committee.



Division of responsibilities at the head of an organisation is most simply achieved by separating the roles of chairman and chief executive.

Independent non-executive directors have a key role in governance. Their number and status should mean that their views carry significant weight.



Directors’ remuneration should be set by a remuneration committee consisting of independent nonexecutive directors.

Remuneration should be dependent on organisation and individual performance.

Accounts should disclose remuneration policy and (in detail) the packages of individual directors.



The board should maintain a regular dialogue with shareholders, particularly institutional shareholders.

The annual general meeting is the most significant forum for communication.

How much organisations consider the interests of other stakeholders will depend on their legal responsibilities and the extent to which they view stakeholders as partners.

  Annual reports must convey a fair and balanced view of the organisation. They should state whether the organisation has complied with governance regulations and codes. It is considered best practice to give specific disclosures about the board, internal control reviews, going concern status and relations with stakeholders.  
Quick Quiz
  • List the ways in which a director can leave office.
  • What are the main features of the induction programme recommended by the Higgs report?
  • Fill in the blank:

According to UK guidance boards should have a …………………………………. to define their responsibilities.

  • How can an organisation ensure that there is a division of responsibilities at its highest level?
  • What according to the Greenbury report were the key principles in establishing a remuneration policy?
  • The UK Corporate Governance Code recommends that a remuneration committee should be staffed by executive directors.



  • Which of the following is not a recommendation of UK guidance in relation to annual general meetings?
    • Notice of the AGM should be sent to shareholders at least 20 working days before the meeting.
    • To simplify voting, the key proposals made at the AGM should be combined in one resolution.
    • Companies should propose a resolution at the AGM relating to their report and accounts.
    • Institutional shareholders should provide their clients with details of how they’ve voted at Annual General Meetings.
  • Fill in the blank:
    • …………………………………. is a person appointed by a shareholder to vote on behalf of that shareholder at company meetings.

Answers to Quick Quiz

  •  Resignation
    • Not offering himself for re-election when his term of office ends
    • Failing to be re-elected
    • Death
    • Dissolution of the company
    • Being removed from office
    • Prolonged absence meaning that director cannot fulfil duties (may be provided in law or by company constitution)
    • Being disqualified (by virtue of the constitution or by the court)
    • Agreed departure
  •  Building an understanding of the nature of the company, its business and markets
    • Building a link with the company’s people
    • Building an understanding of the company’s main relationships
  • A formal schedule of matters reserved for their decision. (This schedule should include such decisions as approval of mergers and acquisitions, major acquisitions and disposals of assets and investments, capital projects, bank borrowing facilities, major loans and their repayment, foreign currency transactions above a certain limit.)
  •  Splitting the roles of chairman and chief executive
    • Appointing a senior independent non-executive director
    • Having a strong independent element on the board with a recognised leader
  •  Directors’ remuneration should be set by independent members of the board
    • Any form of bonus should be related to measurable performance or enhanced shareholder value
    • There should be full transparency of directors’ remuneration including pension rights in the annual accounts
  • The remuneration committee should be staffed by independent non-executive directors.
  • B The guidance recommends that shareholders should be able to vote separately on each substantially separate issue.
  • Proxy


Number Level Marks Time
Q3 Examination 25 49 mins


Appendix to Chapter 3

1 UK Corporate Governance Code 2012

A Leadership

A1 Role of the board

All listed companies should be led by an effective board, responsible for providing entrepreneurial leadership, within a framework of prudent and effective controls, enabling risk to be assessed and managed. The board is responsible for setting strategic aims, ensuring sufficient resources are available, setting values and standards and ensuring obligations to shareholders. The board should meet regularly, with a formal schedule of matters reserved for it. The annual report should explain how the board operates, and give details of members and attendance.

A2  Division of responsibilities

A clear division of responsibilities should exist so that there is a balance of power, and no one person has unfettered powers of decision. The roles of chairman and chief executive should not be exercised by one person.

A3 The chairman

The chairman is responsible for leading the board and ensuring its effectiveness. The chairman should establish the board’s agenda, and ensure there is adequate time for discussion, particularly of strategic matters. The chairman should promote openness and debate, help non-executive directors contribute effectively and promote constructive relations between executives and non-executives. The chairman should ensure that the board receives accurate, timely and clear information and should ensure communication with shareholders is effective. The chairman should meet the independence criteria for non-executive directors. A chief executive should not go on to become chairman.

A4 Non-executive directors

Non-executive directors should scrutinise management’s performance and constructively challenge strategy. They should obtain assurance about the integrity of financial information and that financial controls and risk management systems are robust and defensible. Other important tasks include determining executive remuneration and playing a significant role in decisions about board changes. One of the independent non-executives should be appointed as senior independent director, to act as an intermediary with other directors and shareholders. The chairman should hold meetings with the nonexecutives without the executives being there, and the non-executives should meet without the chairman to appraise the chairman’s performance. Directors should ensure that concerns they have that cannot be resolved are formally recorded.

B Effectiveness

B1 Composition of the board

The board and its committees should have a balance of skills, experience, independence and knowledge of the company. The board should be of sufficient size to operate effectively, but not so large as to be unwieldy. The board should have a balance of executive and non-executive directors so that no individual or small group is dominant. Decisions on committee membership should take into account the need to avoid undue reliance on particular individuals. At least half the board of FTSE 350 companies should be independent non-executive directors. Smaller listed companies should have at least two independent non-executive directors.


B2 Appointments to the board

There should be a clear, formal procedure for appointing new directors. A nomination committee should make recommendations about all new board appointments. The majority of members of this committee should be independent non-executives. Directors should be appointed on merit, against objective criteria, and with consideration to the value of diversity, including gender diversity. The annual report should include a section on the board’s policy on diversity and its success in achieving those policy objectives. There should be an orderly succession process in place.

B3 Commitment

Directors should allocate sufficient time to the company to discharge their duties effectively. In particular, the nomination committee should assess the time commitment expected of the chairman, and the chairman’s other commitments should be disclosed to the board and shareholders. Non-executives’ letters of appointment should set out the expected time commitment and non-executives should undertake to have sufficient time to fulfil their responsibilities. Their other significant commitments should be disclosed to the board. A full-time executive director should not take on more than one non-executive directorship of a FTSE 100 company, nor the chairmanship of a FTSE 100 company.

B4 Development

All directors should be properly inducted when they join the board and regularly update their skills and knowledge. The chairman should agree training and development needs with each director.

B5 Information and support

The board should be promptly supplied with enough information to enable it to carry out its duties. Information volunteered by management will sometimes need to be supplemented by information from other sources. The chairman and secretary should ensure good information flows. Directors should be able to obtain independent professional advice and have access to the services of the company secretary. The company secretary is responsible for advising the chairman on all governance matters. The whole board should be responsible for appointing and removing the company secretary.

B6 Evaluation

There should be a vigorous annual performance evaluation of the board as a whole, individual directors (effective contribution and commitment) and board committees. Evaluation of the board of FTSE 350 companies should be externally facilitated at least once every three years. The chairman should take action as a result of the review, if necessary proposing new board members or seeking the resignation of directors.

B7 Re-election

All directors should submit themselves for re-election regularly, and at least once every three years.  Directors of FTSE 350 companies should be subject to annual election by shareholders.

C Accountability

C1 Financial and business reporting

The board should present a fair, balanced and understandable assessment of the company’s position and prospects in the annual accounts and other reports, such as interim reports and reports to regulators. The board should ensure that narrative sections of the annual report are consistent with the financial statements and the assessment of the company’s performance. The directors should explain their responsibility for the accounts, and the auditors should state their reporting responsibilities. The directors should explain the basis on which the company generates or preserves value and the strategy for delivering the company’s longer-term objectives. The directors should also report on the going concern status of the business.

C2 Risk management and internal control

The board is responsible for determining the nature and extent of the significant risks it is willing to take to achieve objectives. Good systems of risk management and control should be maintained. The directors should review effectiveness annually and report to shareholders that they have done so. The review should cover all controls including financial, operational and compliance controls and risk management.

C3 Audit committee and auditors

There should be formal and clear arrangements with the company’s auditors, and for applying the financial reporting and internal control principles. Companies should have an audit committee consisting of independent non-executive directors. One member should have recent and relevant financial experience. The committee should monitor the accounts, review internal financial controls and also other internal controls and risk management systems if there is no risk committee. The audit committee should make recommendations for the appointment and remuneration of the external auditor, and consider the auditor’s independence and objectivity, the effectiveness of the audit process and whether the external auditor should provide non-audit services. FTSE 350 companies should put the external audit contract out to tender at least every ten years. The audit committee should also review internal audit’s work. If there is no internal audit function, the audit committee should consider annually whether it is needed. The audit committee should also review ‘whistleblowing’ arrangements for staff who have concerns about improprieties. Audit committees should report to shareholders on how they have carried out their responsibilities, including on how they have assessed the effectiveness of the external audit process.

D Directors’ remuneration

D1 Level and components of remuneration

Remuneration levels should be sufficient to attract directors of sufficient calibre to run the company effectively, but companies should not pay more than is necessary. A proportion of remuneration should be based on corporate and individual performance. Comparisons with other companies should be used with caution. When designing performance-related elements of remuneration, the remuneration committee should consider annual bonuses and different kinds of long-term incentive schemes. Targets should be stretching. Levels of remuneration for non-executive directors should reflect time commitment and responsibilities, and should not include share options or performance-related options.

Boards’ ultimate objectives should be to set notice periods at one year or less. The remuneration committee should consider the appropriateness of compensation commitments included in the contracts of service.

D2 Procedure

Companies should establish a formal and clear procedure for developing policy on executive remuneration and for fixing the remuneration package of individual directors. Directors should not be involved in setting their own remuneration. A remuneration committee, staffed by independent nonexecutive directors, should make recommendations about the framework of executive remuneration, and should determine remuneration packages of executive directors and the chairman. The board or shareholders should determine the remuneration of non-executive directors.

E Relations with shareholders

E1 Dialogue with shareholders

The board should keep up a dialogue with shareholders, particularly major (institutional) shareholders. The board should try to understand issues and concerns, and discuss governance and strategy with major shareholders.

E2 Constructive use of the AGM

The AGM should be a means of communication with investors. Companies should count all proxies and announce proxy votes for and against on all votes on a show of hands, except when a poll is taken. Companies should propose a separate resolution on each substantially separate issue, and there should be a resolution covering the report and accounts. The chairmen of the audit, nomination and remuneration committees should be available to answer questions at the AGM. Papers should be sent to members at least 20 working days before the AGM.

Compliance with the Code

The UK Corporate Governance Code requires listed companies to include in their accounts:

  • A narrative statement of how they applied the principles set out in the UK Corporate Governance Code. This should provide explanations which enable their shareholders to assess how the principles have been applied.
  • A statement as to whether or not they complied throughout the accounting period with the provisions set out in the UK Corporate Governance Code. Listed companies that did not comply throughout the accounting period with all the provisions must specify the provisions with which they did not comply, and give reasons for non-compliance.

Revised guidance for directors on the Combined Code* (Turnbull report)

1 Introduction
The importance of internal control and risk management

The internal control systems have a key role in managing the risks linked with a company’s business objectives, helping to safeguard assets and the shareholders’ investment. The control system also aids the efficiency and effectiveness of operations, the reliability of reporting and compliance with laws and regulations. Effective financial records, including proper accounting records, are an important element of internal control.

A company’s environment is constantly evolving and the risks it faces are constantly changing. To maintain an effective system of internal control, the company should regularly carry out a thorough review of the risks it faces.

As profits are partly the reward for risk taking in business, the purpose of internal control is to help manage risk rather than eliminate it.

Objectives of guidance

The guidance is designed to reflect good business practice by embedding internal control in a company’s business processes, remaining relevant in the evolving business environment and enabling each company to apply it to its own circumstances. Directors must exercise judgement in determining how the Combined Code has been implemented. The guidance is based on a risk-based approach, which should be incorporated within the normal management and governance processes, and not be treated as a separate exercise.

Internal control requirements of the Combined Code*

This guidance aims to provide guidance for the directors on the requirements of the Combined Code relating to:

  • Maintaining a sound system of internal control
  • Conducting an annual review of internal control  Reporting on this review in the annual report
2 Maintaining a sound system of internal control

The board is responsible for the system of internal control, for setting policies and seeking assurance that will enable it to satisfy itself that the system is functioning effectively, in particular in managing risks.

In determining what the system of controls should be, the board should take account of the following.

  • The nature and extent of risks facing the company
  • The extent and categories of acceptable risks
  • The likelihood of the risks materialising
  • The company’s ability to reduce the impact of risks
  • The costs versus the benefits of internal controls

Management is responsible for implementing board policies on risk and control. Management should identify and evaluate the risks faced by the company for board consideration, and design, implement and monitor a suitable internal control system. All employees have some responsibility for internal control as part of their accountability for achieving business objectives. They should have the knowledge, skills, information and authority to operate the system of internal control effectively.

Elements of internal control systems

The control system should facilitate a company’s effective and efficient operation by enabling it to respond to risks effectively. It should help ensure the quality of reporting by ensuring that the company maintains proper accounting records and processes that generate the necessary information. The system should also help ensure compliance with laws and regulations, and internal policies.

Control systems reflect the control environment and organisational structure. They include control activities, information and control processes and monitoring the continuing effectiveness of internal control systems. The systems should be embedded in the company’s operations and form part of its culture, be able to respond quickly to evolving risks and include procedures for reporting immediately to management.

Control systems reduce rather than eliminate the possibility of poor judgement in decision-making, human error, control processes being circumvented, management override of controls and unforeseeable circumstances. They provide reasonable but not absolute assurance against risks failing to materialise.

3 Reviewing the effectiveness of internal controls

Reviewing control effectiveness is an essential part of the board’s responsibilities. Management is responsible for monitoring the system of internal control and providing assurance to the board that it has done so. Board committees may have a significant role in the review process. The board has responsibility for disclosures on internal control in the annual report accounts.

A reliable system of internal control requires effective monitoring, but the board cannot just rely on monitoring taking place automatically. The board should regularly review and receive reports on internal control and should undertake an annual assessment for the purposes of making its report on internal controls.

The reports from management should provide a balanced assessment of the significant risks and the effectiveness of the internal controls in managing those risks. Reports should include details of control failings and weaknesses, including their impact and the action taken to rectify them.

When reviewing reports during the year, the board should consider what the risks are and how they have been identified, evaluated and managed. It should assess the effectiveness of the internal controls, consider whether any actions are being taken to remedy weaknesses and consider whether more effective monitoring is required.

The board should also carry out an annual assessment, considering what has been reported during the year plus any other relevant information. The annual assessment should consider the changes in the significant risks and the company’s ability to respond to changes in its environment. It should also cover the monitoring of risks, the internal control and audit systems, the reports regularly given to the board, the significance of control failings and weaknesses, and the effectiveness of reporting.

4 The board’s statement on internal control

The annual report and accounts should include appropriate high-level information to aid shareholders’ understanding of the main features of the company’s risk management and internal control processes. The minimum disclosure should be that a process of risk management exists, it has been in place for the whole period, the board has reviewed it and it accords with the provisions in the Turnbull report. The board should acknowledge its responsibility for internal controls and that the system is designed to manage rather than eliminate the risk of failure. It should disclose details of its review process and what actions have been taken to deal with weaknesses and related internal control aspects.

*The Turnbull guidance was issued before the Combined Code was renamed the UK Corporate Governance Code.

UK Stewardship Code

Seven principles

Institutional investors should:

  • Publicly disclose their policy on how they will discharge their stewardship responsibilities
  • Have a robust policy on managing conflicts of interest in relation to stewardship which should be publicly disclosed
  • Monitor their investee companies
  • Establish clear guidelines on when and how they will escalate their stewardship activities
  • Be willing to act collectively with other investors where appropriate
  • Have a clear policy on voting and disclosure of voting activity  Report periodically on their stewardship and voting activities
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