Corporate governance from the inside out
This article explains that effective corporate governance has both internal and external drivers.
Although directors and managers of companies may have little influence over the external regulatory framework, they can and must play their part in ensuring effective internal governance and compliance from deep within their own organisations.
This should extend beyond external financial reporting and corporate governance structures into more operational areas of business management. By promoting deep-rooted corporate governance ideals within their own organisations, a culture of stakeholder focus and individual and corporate responsibility, for the common good, can flourish.
This article first briefly introduces agency theory and the agency problem, which recognises that the interests of the shareholders and of the board of directors may sometimes conflict and how issues relating to this problem brought about the need for corporate governance codes in the first place. It then examines the traditional stewardship concept that underlies conventional corporate governance within an external financial reporting framework.
The article then compares ‘rules’ versus ‘principles’ based codes and the implementation of governance within organisations. It argues that a broader and longer-term view of agency theory, such as applies to a wider group of stakeholders can engender a better team spirit that will help promote a culture of pro-stakeholder behaviour and positive attitudes at all levels of the organisation. The important links between corporate governance and corporate culture and values are also highlighted.
Under the narrowest of perspectives the principal objective of a company has traditionally been to maximise profits and thereby add to the wealth of its shareholders. However, the degree to which the pursuit of profit and wealth dominates depends upon the society's view of ‘agency theory’. The questions to ask are; who discharges responsibility; who is accountable and what particular structure of relationships and potential conflicts exist between ‘principals’ and their ‘agents’.
In business the stakeholder is known as the ‘principal’ and the officers of the company or the directors are known as the ‘agents’. The extent to which boards of directors act in the interests of shareholders and in the pursuit of fiduciary interests such as wealth maximisation is determined by which of the seven perspectives is taken on corporate social responsibility; Gray, Owen and Adams (1996).
The stewardship concept
Generally it is accepted that the rights of shareholders and other stakeholders connected with the company should be protected and promoted by ‘stewards’ of these stakeholders and their interests, Argenti (1997) and Campbell (1997).
In theory, agents should be held responsible and accountable for balancing the conflicting interests of a whole range of stakeholders of the company.
The traditional ‘pristine capitalist’ view of ‘stewardship’ implies that the rights of the shareholders and the pursuit of their wealth are of paramount importance (Sternberg 1998). However, the banking crisis and spectacular corporate failures such as Enron and World Com would indicate that even the narrower interests of owners can often be neglected or ignored, along with those of a much wider group of stakeholders, including the general public.
The separation of ownership and control
The introduction of the limited company as a legal entity was a great advance from the private solely owned business or the partnership in that it greatly increased the supply of long-term funds to industry and commerce, and contributed to the creation of far more wealth within the global economy. The concepts of shareholdings and limited liability encouraged many more people of moderate means to invest their disposable income in businesses and at much lower risk than would hitherto have been possible within unincorporated organisations. With many more investors, many of whom have little or no business acumen, came the need to divorce ownership and control for practical purposes, and to introduce a ‘court’ or board of directors, as the ‘agents’ of this disparate group. This is the basis of what became the public limited company, a separation of ownership and control. This is a normal arrangement these days and it is hardly ever questioned.
‘The trade of a joint stock company is always managed by a court of directors. This court, indeed, is frequently subject, in many respects, to the control of a general court of proprietors. But the greater part of those proprietors seldom pretend to understand anything of the business of a company…’
Adam Smith (1776), p408
The separation of ownership and control, and the disparity and inexperience of shareholders in business and financial matters, as Adam Smith recognised, would be problematic unless some system of external governance was imposed to safeguard the interests of these owners. The separation of ownership and control, and the potential divergence of the interests of owners and managers, is the main reason why there is a need for a system of corporate governance.
Adam Smith also recognised the problem of the separation of control and ownership interests within companies:
‘….The directors of such companies, however, being the managers rather of other peoples money rather than their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own…. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company’
Adam Smith (1776), p408
Clearly it was recognised as long ago as 1776 that the ‘agency’ model within the corporate context would not naturally work to the advantage of the principals without some intervention.
The legal and professional framework
Successive Companies Acts throughout the world from 1844 in the UK, have laid down increasingly complex layers of legislation about the constitution, the format, the minimum disclosure requirements, about the use of reserves, the maintenance of capital, and the general protection of creditors. In addition there has been a legal requirement for an ‘independent’ external audit of the financial disclosures of a company’s affairs on a periodic basis to be carried out by competent and qualified professionals.
One of the major responsibilities of company directors is to ensure that the financial reports of companies are relevant and faithfully represent the affairs of the company and that stakeholders can make rational decisions based on the qualitative characteristics of the reports that are published (they are a ‘true and fair’ representation of the state of the company’s finances at a given point in time). Auditing is mainly concerned with the faithful representation aspect of financial information.
Companies in most countries are by law required to have their accounts audited at the end of every financial period. A major aspect of most external corporate governance codes is about ensuring that the role of the auditor is effective and the relationship between the auditors and directors has integrity and is independent and objective. The issues to consider here are who should appoint the auditors, how long should the same firm of auditors be used repeatedly, and should firms of auditors, or even their subsidiaries or associates be providing consulting services to their clients?
Corporate governance can be seen as having internal and external sources, where external corporate governance consists of mandatory and voluntary codes, reports and frameworks such as company law, stock market listing rules and accounting and auditing standards. Internal corporate governance is how such external governance is complied with and embedded within the culture and values of the organisation and how sound governance is implemented and works in practice.
The corporate governance framework can play its part in providing a structure for governing the behaviour of companies and their officers, but external rules, regulations, and codes of practice are not effective unless a climate of compliance within organisations is promoted to support such structures and mechanisms at all levels through such mechanisms as corporate and ethical codes of behaviour and values. There also needs to be a deeper culture embedded within companies, recognising the responsibilities and duties of management with regard to the legitimate rights of their stakeholders and shareholders.
Effective corporate governance is about promoting this climate of transparency, scepticism and objectivity; by creating systems, procedures, and internal structures, aimed at complying with external requirements, but also pre-empting and dissuading anti-stakeholder behaviour from deep within the organisation. Internal corporate governance (or the corporate culture) should therefore be instrumental in reducing the ‘expectations gap’ between the interests and motivations of the ‘agent’ and those of the ‘principal’; thereby addressing the agency problem at all levels within the organisation.
Principles or rules-based codes of corporate governance
Corporate governance structures can be voluntarily complied with and any departures from best practice can be explained in the notes to the accounts. The main benefit of this ‘principles based’ approach is that full compliance is often difficult for companies in specific situations or in special circumstances. ‘Rules-based’ compliance is a ‘one size fits all’ (box ticking) approach where full compliance is required by law and where departures can entail legal sanctions. This approach, such as adopted in the USA, is felt to be more effective because it doesn’t rely as heavily on the integrity of the boards of directors to interpret and comply or explain openly and objectively.
Corporate governance is based on voluntary control in many countries, such as in the UK and is often a requirement for stock exchange listing. It is based on the adoption of specific board sub-committees and structures with clear recommendations relating to sound internal financial and operational controls and the promotion of high quality financial information to strengthen the accountability of boards of directors to their shareholders.
The Cadbury Code, (1992) was designed to concentrate on the essential internal control mechanisms to support this need for greater transparency and accountability to shareholders, which at the time was felt to be deficient. This voluntary report highlighted the ways in which companies could better underpin a company’s legal and regulatory obligations to its shareholders through accountability and control, viewing the role of the non-executive director (NED) as being critical from an independence perspective.
The recommendations of the Cadbury Report emphasised higher standards of corporate governance through improvements in the quality of financial reporting. This aspect has also been supported by accounting standards bodies nationally and internationally, striving to provide more consistency, relevance, and understandability within the process of accounting for financial transactions and for reporting income, assets and liabilities. The Cadbury report (1992) and others, were eventually enforced as listing rules on many stock exchanges.
The Cadbury Report recommended that external auditing should be more independent and closely monitored through the introduction of audit committees composed of a minimum number of non-executive directors (NEDs). However, where corporate governance was to have most impact was through the introduction of robust internal control mechanisms and a system of internal audit where the design and control of processes and continuous monitoring of transactions and decision-making can help safeguard assets and prevent and detect anti-stakeholder behaviour within the organisation. The concept of internal control was to be based on promoting continuous vigilance by management in preventing financial loss through fraud, error, inefficiency or incompetence.
There are many corporate governance codes, published around the world focusing on such matters as the role of the boards of directors and on how they are constituted. These include various recommendations on the procedures to appoint directors, the qualifications of directors, the proportion and independence and effectiveness of non-executive directors (Higgs 2003) and their diversity (Tyson 2003), and on the need for additional and independent board committees such as audit (Smith 2008), nomination, risk and remuneration committees. Indeed many corporate scandals (pre-Enron) tended to revolve around inappropriate or unjustified pay increases or bonuses for executives, seemingly regardless of performance, leading to so called ‘fat cat’ scandals. Both the Greenbury Report (1995), and the Hampel Report (1998), have focused their attention on directors' remuneration, rather than upon broader and more significant financial, performance or governance issues, because it was seen as being such a problem.
The main recommendations of the above committees were subsequently incorporated by the Turnbull Committee into the original Combined Code of the Committee on Corporate Governance in 1999, but this code also emphasised the broader responsibility of companies with respect to safeguarding shareholders’ interests.
‘The board should maintain a sound system of internal control to safeguard shareholders' investment and the company's assets’
Principle D.2 – Combined Code May 1999
The combined code has been revised since 1999, and in 2010 it included several new recommendations. Eventually various versions of the UK Corporate Governance Code were published (FRC, 2014). These various iterations of the combined codes include the requirement for the company chairman to be re-elected annually and to encourage greater diversity (specifically gender diversity) of the board. The revised code also requires more emphasis on the board of directors’ performance in the larger companies being independently reviewed on a regular basis. It requires disclosure of the business model and responsibilities relating to risk; such as how much risk the company can accept and how much it will need to avoid, reduce or transfer. These new requirements link well with new proposals for a broader corporate reporting framework relating to integrated reporting <IR> (IIRC, 2013).
The revised combined code also makes new recommendations about the need to align remuneration of directors to longer-term performance metrics and having a closer interface between non-executive directors and the executive directors. The changes also include the chairman’s responsibility relating to identifying the training and development needs of directors and around more effective external communications with shareholders, including institutional investors.
More effective company law, listing rules, regulations, accounting and auditing standards and corporate governance codes have clearly provided a better structure and basis for the governance of companies' behaviour in relation to the original agency problem. Whether these governance structures are principles or rules-based, the essential agency problem still seems to remain, as highlighted by continuing evidence of director failings and further corporate failures.
Reliance on voluntary codes, professional standards, and even on legislation may not provide an adequate safeguard against governance failure unless boards of directors, on behalf of stakeholders, set a clear ‘tone from the top’ and actively create a culture of transparency, honesty, and integrity within their organisations at all levels.
Corporate governance and cultural values
For corporate governance to be effective and for the interests of stakeholders to be properly safeguarded, a climate should be created where those working for the stakeholders and on behalf of them, are conscious of the ultimate economic, social and ethical consequences of their decisions and behaviour (at whatever level).
Directors should therefore promulgate and inculcate within their organisations a climate of responsibility, accountability, and transparency. This can be achieved by the use of formal structures such as audit and remuneration committees, by appointing effective and independent non-executive directors, and by tightening up on auditing regulations, but it is mainly achieved by having a sustainable, longer-term and broader perspective and by encouraging all to act ethically.
Companies can encourage such behaviour by designing appropriate corporate codes of ethics and behaviour within organisations, supported by a system of cultural values which are themselves linked to individual performance appraisal and professional development.
For example, promoting consonance between the aims of primary stakeholders and those of other stakeholders can create a team spirit where all perceive they are working for a common purpose or goal. This common purpose can also be reinforced by having a clear corporate mission and setting strategic aims and objectives which are coherent and sustainable and which can be broken down into meaningful and measurable departmental and team objectives that all within the organisation can buy into and relate to.
This kind of climate is promoted by such instruments as:
- equitable productivity and bonus schemes
- transparent recruitment and promotion policies
- good staff welfare and reward systems
- effective environmental policies, and
- good customer relations.
All of these are based on an overriding quality culture, where effectiveness and efficiency are promoted and every aspect of the organisations activities are considered to be important at all levels, where people of all levels are valued and respected and where the impact of all decisions on the interests of stakeholders is always recognised and anticipated.
Good governance therefore must, by implication, extend beyond basic compliance with external reporting and auditing requirements, to such areas as internal control, performance measurement and management, budgetary control systems, quality management, staff recruitment, training and development, and to reward and promotion systems within a business organisation.
A business that embraces the underlying principles as well as ‘being seen’ to be compliant with corporate governance codes is better placed to protect the interests of its stakeholders, including the public interest, from a more sustainable and longer-term perspective.
This wider view of agency theory is in stark contrast to the narrower ‘stewardship’ perspective, but whichever perspective is taken, corporate governance and all it entails is an essential framework within which the rights, responsibilities, and rewards available to the principals and their agents is best balanced.
The development of an informal corporate culture and of ethical values to underpin and support formal corporate governance structures is essential. This approach reduces the risk of negative behaviours such as, wastefulness, inefficiency, idleness, greed, fraud, deception, bribery or theft occurring or being tolerated.
Such a business culture can sustainably meet and balance the needs of shareholders, lenders, employees, suppliers, customers, and the general public, recognising their respective interests as being entirely compatible over the longer term.
This balance can only be realistically achieved if effective acceptance of corporate social responsibility, rather than compliance with governance structures alone, becomes part of the ‘mindset’ of all those working in business organisations; so that accountability and responsibility to all stakeholders is delivered from the inside out.
- Argenti, J (1997) Stakeholders: The Case Against Long Range Planning, 30(3), 442-445
- Cadbury Committee, (1992), Report of the Committee on the Financial aspects of Corporate Governance, London, Gee
- Campbell A, (1997), Stakeholders: The Case in Favour of Long Range Planning. Long Range Planning, International Journal of Strategic Management, (30)3, 446-449
- Financial Reporting Council (2010), Revisions to the UK Corporate Governance Code UK (formerly the Combined Code), FRC
- Financial Reporting Council (2014), UK Corporate Governance Code, FRC
- Gray, R., Owen, D. and Adams, C. (1996) Accounting and Accountability; Changes and Challenges in Corporate Social and Environmental Reporting, Harlow: Prentice Hall Europe
- Greenbury Committee, (1995), ‘Directors’ Remuneration – Report of a Study Group’, chaired by Sir Richard Greenbury
- Hampel Committee, (1998), Committee on Corporate Governance – Final Report, London, Gee
- Higgs (2003), ‘Review of the Role and Effectiveness of Non-executive Directors’
- IIRC, ‘The International <IR> Framework’ (Dec 2013), published by the IIRC
- Smith A, (1776), ‘An Inquiry into the Nature and Causes of the Wealth of Nations’, Feedbooks
- Smith Committee (2008), Consultation on Proposed Changes to Guidance on Audit Committees, (The Smith Guidance)
- Sternberg, E (1998) Corporate Governance: Accountability in the Marketplace, Hobart, Paper 137, Institute of Economic Affairs
- Turnbull Committee, (1998), Combined Code – Principles of Good Governance and Code of Best Practice
- Turnbull Committee, (1999), Internal Control – Guidance for Directors on the Combined Code
- Tyson Report (2003)
Adapted from an article originally written by a member of the P1 examining team