Module-4: Developments in Corporate Governance in UK

 

Sir Adrian Cadbury (1992) defined corporate governance as ‘the whole system of controls, both financial and otherwise, by which a company is directed and controlled’

The OECD (1999) defined it as ‘a set of relationships between a company’s board, its shareholders and other stakeholders. It also provides the structure through which the objectives of the company are set, and the means of attaining those objectives, and monitoring performance are determined’.

 Corporate governance refers to control of corporations and to systems of accountability by those in control. It is about ensuring that executives and boards are accountable to shareholders while managing risks and enhancing competitiveness on a corporate and national level. The idea of corporate governance was originally developed in 1962 as a way of ensuring that investors receive a fair return on their investment by having a certain protection against management abuse or poor use of their investment capital (Arsalidou and Wang, 2005). There have been several critical events that occurred over the past two centuries that have mandated a drastic change in corporate governance. Not only did these acts establish best practices, but also enable major changes in accounting, auditing, shareholder investments, and business processes in general. 

Factors that led to speed up the Developments in Corporate Governance in the UK

There have been a number of key drivers to increased attention to corporate governance in the UK:

  • Firstly, collapses of prominent business, both in the financial and  non-financial sectors, such as Polly Peck, BCCI, and later Barings; led to increased emphasis on controls to safeguard assets
  • Secondly, the changing pattern of share ownership, particularly in the US and UK, which led to a greater concentration of share ownership in the hands of institutional investors, such as pension funds and insurance companies.  In the UK, for example, institutional investors own around 80% of the UK stock market (see below for further detail).  In the US, the figure is less, but institutional investors are very powerful in absolute terms.
  •  Thirdly, institutional investors are increasingly seeking to diversify their portfolios and invest overseas.  They then look for reassurances that their investment will be protected.
  •  Fourthly, with technological advances in communications and markets generally, ideas can be disseminated more widely and more quickly, and institutional investors globally are talking to each other more and forming common views on key aspects of investment such as corporate governance.
  •  Fifthly, given that businesses as diverse as family owned firms and state owned enterprises are increasingly seeking external funds, whether that is from domestic sources or international sources, corporate governance takes on an increasingly important role in helping to provide confidence in those companies and hence help to obtain external funding at the lowest cost possible.
  •  Finally, within a country (as opposed to a company or individual         business), good corporate governance helps to engender confidence in the stock market and hence in the economic environment as a whole, creating a more attractive environment for investment.

(Source: Mallin, C., Mullineux, A., & Wihlborg, C. (2004). The Financial Sector and Corporate Governance: Lessons from the UK.)

The Committee on the Financial Aspects of Corporate Governance, better known as the Cadbury Committee, was set up in May 1991 to address the concerns increasingly voiced at that time about how UK companies dealt with financial reporting and accountability and the wider implications of this. The Committee was sponsored by the London Stock Exchange, the Financial Reporting Council and the accountancy profession. It published its final report and recommendations in December 1992. The terms of reference for this committee, which Sir Adrian Cadbury himself drew up, were: ‘To consider the following issues in relation to the financial reporting and accountability and to make recommendations on good practice:

a)      The responsibilities of executive and non-executive directors for the reviewing and reporting on performance to shareholders and other financially interested parties; and the frequency, clarity and form in which information should be provided;

b)      The case for audit committees of the board, including their composition and role;

c)      The principal responsibilities of auditors and the extent and value of audit;

d)     The links between shareholders, boards, and auditors;

e)      Any other relevant matters.’

Source: (Cadbury Report, 1992, Appendix 1, p.61)

The main recommendations of the Cadbury report were:

•        A division of responsibilities at the head of the company to ensure that no one individual has powers of decision

•        A majority of non-executive directors to be independent

•        At least three non-executives on the audit committee

•        A majority of non-executives on the remuneration committee

•        Non-executives should be selected by the whole board

Central to these was a Code of Best Practice and the requirement for companies to comply with it or to explain to their shareholders why they had not done so. The recommendations and the Code provided the foundation for the current system of corporate governance in the UK and have proved very influential in corporate governance developments throughout the world.

Thus UK have seen the Cadbury Report (1992), Greenbury Report (1995), Hampel Report (1998) and Turnbull Report (1999) to name but four.

The Higgs Review and the Smith Review reported simultaneously on 20th January 2003 (Higgs, 2003, and Smith, 2003) with the CGAA reporting on 29th January (CGAA, 2003). The final Higgs report contains a large number of recommendations relating to:

  1.         The structure of the board
  2.         The role and other commitments of the chair
  3.         The role of the non-executive director
  4.         The recruitment and appointment procedures to the board
  5.         Induction and professional development of directors
  6.         Board tenure and time commitment
  7.         Remuneration
  8.         Resignation procedures
  9.         Audit and remuneration committees
  10.         Board liability
  11.         Relationships with shareholders

The comparison of these directly with the Higgs Review conclusions in Table 1 below.

Table 1. Summary of key areas recommendations of each investigation

Key issues in  Governance

CADBURY REPORT

HIGGS REVIEW

Chair

No one person with power of decision

Chair, of only one company, not ex or current CEO

Compliance

Listing rules Comply or explain

Listing rules Comply or explain

Independent Non-exec directors (INEDs)

Majority NEDs to be independent

Narrow definition independent NEDs (INEDs)

Audit and Remuneration Committees

At least 3 NEDs on Audit Committee, majority NEDs on Remuneration

Committee At least 3 INEDs on Remuneration Committee

Nomination Committee

Selection of NEDs matter for whole board

Wider recruitment, chaired by INED, majority INEDs

Process

-

Codes of Best Practice

Relationship with Shareholders

-

Senior independent director

Director development

-

Induction, appraisal, training

Sources: Cadbury Report (1992, pp.58-59), Higgs Review (2003, pp.5-10)

Higgs recommended that the Financial Reporting Council (FRC) and Financial Services Authority process his review’s proposals rapidly. The government endorsed this urgency. The FRC announced that it was to take forward the recommendations of both the Higgs and the Smith reports for changes to the Combined Code on Corporate Governance by 1 July 2003

Some nine years later, in 2001, the collapse of Enron sent shockwaves through the US market. As a result of the Enron collapse and various other high profile scandals in the years since its occurrence, the US is examining its own corporate governance structures and provisions to determine how these might be improved and help avoid another Enron. The EU similarly is developing principles and legislation to improve corporate governance, and scandals such as Royal Ahold and Parmalat have helped drive further governance reforms

The Cadbury Report issued in the UK in 1992 laid the foundations of a set of corporate governancecodes, not just in the UK but in countries as diverse as Russia and India, which have incorporated its main principles into their own corporate governance codes


In the US there wasswift government action via the Sarbanes-Oxley legislation in mid 2002 and the new NYSE listing rules also in mid 2002, and there have been prosecutions of many of those operating at top levels in the failed companies such as Enron, starting in November 2001. In this environment the UK Government has wanted to be seen to react quickly to the crisis but also to head-off the potential consequences of US regulation and legislation for companies of British origin that are listed on the NYSE. It seems probable that there has been behind the scenes negotiation at an inter-governmental level to determine the extent to which the US measures should apply to the UK and other foreign owned companies


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