Fundamentals of Ethics, Corporate · 2018. 10. 14. · Fundamentals of Ethics, Corporate Governance and Business Law Module: 03 Corporate Governance, Codes and CSR. 2 1. Governance

Fundamentals of Ethics, Corporate Governance and Business Law

Module: 03

Corporate Governance, Codes and CSR

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1. Governance

In early 2001, one of the world's major energy companies based in Houston,

Texas, was enjoying annual revenues of $111 billion, a stock price of $90 per

share, and seemed almost unstoppable in its capacity to expand indefinitely. Even

Forbes named them the 'Most Innovative Company' right up until 2000.

By the end of 2006, the former CEO and CFO of the company were serving

prison sentences, whilst the former chairman and founder died of a heart

attack week after being sentenced.

That's a dramatic turn of events.

Well, by now you may have guessed that the company in question is Enron,

who filed for bankruptcy in late 2001 after evidence started to emerge of a

huge accounting and corporate fraud scandal. But how did they manage to

keep it going for so long?

Let's start with Kenneth Lay, the founder and chairman of Enron. He was

also the CEO (Chief Executive Officer) for a period, too. So, we have one of

the world's largest companies under the command of one man. This is rarely

good a when the CEO and chairman are different people, they help check

each other so policies are fully scrutinised before being enacted. When they

are the same person this is less likely to happen.

Then we have the other key players: Jeffrey Skilling and Andrew Fastow.

Skilling is the former president, CEO and COO (Chief Operating Officer) again,

a lot of power for one person. Fastow was the CFO (Chief Financial Officer).

Between them, these guys managed to construct one of the biggest cases of

corporate fraud in global financial history.

They lied about revenue by recognising income in unorthodox ways and

covered it up with creative accounting and a close relationship with their

auditor.

But the really important question is: How did they get away with it for so

long? How could a handful of businessmen have enough power and authority

to control one of the world’s most successful companies? Who was keeping

tabs on them?

The answer, in part, is because there was a lack of good corporate

governance.

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Definition

Corporate governance is the way organisations are directed,

administered and controlled, with the aim of ensuring that the

organisation is run in a way that is right for all stakeholders, in particular

the shareholders.

Corporate governance therefore includes:

• Managing the relationships with stakeholders.

• Managing the organisation’s goals and strategies.

A stakeholder is anyone who has an interest in the performance of the company.

There are many stakeholders, such as shareholders, management, employees,

suppliers, customers, banks and other lenders, regulators, the environment and

the community at large. Governance is about ensuring the business is run in a

way that looks after the needs of all stakeholder groups.

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2. Agency theory

The agency problem

Let's say you're a millionaire with a really expensive car (lucky you!) and a

chauffeur driving you everywhere you want (even luckier you!) Here we have

a conflict – you own the car, but she drives it. You might want it driven well, be

well looked after, and there for you at all times, but you've put someone else

in charge and you've got no idea what your chauffeur is doing when you're

not there! Where are they going? How are they driving? Who are they driving

with?

This problem; the conflict between the wants of you, the owner, and the

manager, the chauffeur, is an example of the agency problem. In agency

theory the chauffeur is your agent – the person you've given responsibility to

for looking after the car and driving it for you. Her needs might not always

align with yours though and the temptation to take it for a quick spin with

friends when you're not around may just get too much! And there lies the problem. The needs of the agent and the owner may differ.

So how does this theory relate to business, and governance in particular?

In business the owner are the shareholders (who are known as the

principal), and they are in charge of employing the directors (who are the agent) to run the business on their behalf.

Now, although the directors should be running the business in the

shareholders' interests (they have a responsibility to do so – this is their

job), it is inevitable that their own personal interests will be considered too

– just like with your expensive car and your chauffeur! This conflict is the

agency problem.

For instance, when it comes to salaries paid, the directors are going to be

pushing for as high a salary as possible, whilst the shareholders will want to

set appropriate salaries that don't incur enormous costs for the business.

Information asymmetry

One issue with the agency problem is information asymmetry. The

directors have more information about the company than the

shareholders, and as a result the shareholders are not always able to fully

hold directors accountable for decisions made. In our example, the

chauffeur probably has more information about the car than you do, so you

need to trust that she will keep you suitably informed.

In business, the CEO will have access to lots of internal information

and specific data relating to the performance of the company. They will

also have a fairly close relationship with the chief financial officer

(CFO), and this will put them in a powerful position. You have to trust

them to use their informed position well and indeed to present to you all the

relevant data you need as an investor. But can shareholders trust them?

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Well sometimes yes, but other times no – which corporate disasters such

as Enron, WorldCom and Lehman Brothers clearly demonstrate.

We can show the relationships diagrammatically:

Agency and corporate governance

So, what, if anything, can be done about the agency problem? Firstly, there's

the legal duty of directors to run the business on behalf of shareholders:

this is known as the fiduciary duty.

Fiduciary duty is powerful, but it is not always enough and so on top of that

we have corporate governance regulation which aims to overcome the

agency problem by finding ways of reducing the bias of directors,

demanding accountability and disclosing relevant information.

Agency cost

An agency cost is the idea that there are measurable time and financial`

commitments in ensuring that an agent is acting appropriately on behalf

of the principal.

Let's return to our chauffeur. You could perhaps monitor where and how she

drives using GPS tracking. That system has a cost, and this cost is called an agency cost.

Take any company and there will almost certainly be some 'cost' to the

principal in making sure that the agent acts in their interest. The standard

costs for shareholders/the board in hiring directors come in the form of

bonus payments, incentive schemes, share-based payments which

should align the shareholders interests with the directors. The salaries of

non- executive directors who are responsible for monitoring and controlling

the executive directors are another. The costs of financial reporting and

auditing are agency costs too.

Obviously, these costs reduce the total amount of return that comes back to

the shareholders, and so a balance needs to be struck between an

acceptable expense in managing the directors effectively and maintaining

reasonable returns from the investment.

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Key terms

Okay, so we've raced through a number of key terms, so let's take a second

to make sure we know what they mean and how they fit into corporate

governance:

What it means

How it relates to corporate

governance

Agents

The person(s) who

manages something on

behalf of a principal.

The agents are the directors,

who must run the business in

the interest of the

shareholders.

Principals

The person(s) who

delegates responsibility of

management to an agent.

The principals are the

shareholders, who hire

directors to run the business

on their behalf.

Agency

The act of providing a

service on behalf of

another.

The agency between directors

and shareholders can lead to

conflicts of interest, known as

the agency problem.

Accountability

The extent to which

someone is to blame for an

action.

Directors are to be held

accountable for their actions

in running the business.

Fiduciary duty A legal duty to act solely in

another party's interests.

The directors have a fiduciary

duty to shareholders.

Agency cost

The cost associated with

ensuring agents behave

appropriately

The cost of agency has to be

weighed up against the

benefits.

The need for governance

In recent years, there has been significant interest in the corporate

governance practices of modern corporations, particularly in relation to

accountability, since the high-profile collapses of a number of large

corporations.

In the UK, the Cadbury report was produced in 1992 after the collapses of

BCCI, the Mirror Group and Polly Peck, whilst in the U.S., there was

increasing focus from 2001 after scandals including Enron and WorldCom.

Their demise was quickly followed by the U.S. government passing the Sarbanes-Oxley Act (2002) which imposed strict governance standards in

US companies.

So, we have a number of instances where companies have been found to be

misleading shareholders, fixing the books, and lots of generally fraudulent

and dishonest behaviour. And the response to this has been a number of acts

and laws being passed by global governments to prevent these things from

happening again. Let's take a look at what those key acts and laws are all

about.

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3. Principles of corporate governance

What we are going to do now is take a look at these key principles that form the

basis of the acts that have been passed in recent years. These are the foundations of corporate governance, and they are designed to make the

business-world more responsible and accountable.

The core principles which most contemporary discussions of corporate

governance refer to were raised in three documents released since 1990:

• The Cadbury Report (UK, 1992).

• The Principles of Corporate Governance (OECD, 1998 and 2004).

• The Sarbanes-Oxley Act (US, 2002).

The Cadbury and OECD reports present general principles around which

businesses are expected to operate to assure proper governance. As these are

in general terms only and are not compulsory or legislated, they are known as principle-based approaches to governance.

The Sarbanes-Oxley Act, informally referred to as Sarbox or SOX, is an attempt by the federal government in the United States to legislate several of

the principles recommended in the Cadbury and OECD reports. In

governance terms SOX is what is known as a rules-based approach that being

one that

is legislated and sets out in significant amounts of detail exactly what must (and

must not) be done.

In the UK, a new code has taken the place of the Cadbury report, and what we now have is the UK Code of Corporate Governance, which is updated a

regular interval and relevant to UK companies listed on the stock market. It is

largely based on the same principles as the Cadbury report, but it's worth

noting that we will only be concerned with this new UK Code. This is also a principle-based approach.

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The Five Key Principles

Generally, we can boil a lot of the ideas contained within corporate

governance down to 5 key principles:

Rights and equitable treatment of shareholders

Organisations should respect the rights of shareholders and help

shareholders to exercise those rights. They can help shareholders exercise their rights by openly and effectively communicating information and by

encouraging shareholders to participate in general meetings.

For example, an organisation will hold an AGM. This stands for Annual

General Meeting, which is a meeting held once a year with the board of

directors and the shareholders in attendance where a number of key issues

are discussed and then put to the vote. This gives shareholders the ability to

voice any concerns, and vote on relevant matters.

It's very important to make sure that shareholders are given the opportunity to

have a voice in the company. After all, they are the owners of the company!

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Interests of other stakeholders

Organisations should recognise that they have legal, contractual, social, and market driven obligations to non-shareholder stakeholders, including

employees, investors, creditors, suppliers, local communities, customers, and

policy makers.

For instance, with regard to employees, an organisation has a number of

legal requirements to ensure that their staff are being given appropriate

training, resources, holiday entitlement, health and safety training, etc. Even

though the employees don't necessarily hold shares in the company, it's clear

that they are an important factor in the performance of the business and a

moral duty of care is owed to them.

Other important stakeholders would be creditors or investors. A company has

obligations to repay or provide returns on any capital attained from these

stakeholders. If an organisation fails to do this they will find it hard to negotiate

more capital which is essential to long term success.

Role and responsibilities of the board

The board needs sufficient relevant skills and understanding to review and

challenge management performance. It also needs to be of a suitable size

and have appropriate levels of independence and commitment. There is

no point in a small company having a huge board of directors, but also a

large company needs enough people to be able to provide sufficient

expertise. Also if the board is not independent, then it will be open to bias

which may have a detrimental effect on strategy.

Members of the board should also be appointed based on their skills and

experience, rather than their connections in the business-world. Nepotism

(giving preference to a family member) or cronyism (appointing friends to

positions of authority without regard to their qualifications) is drastically

reduced when formal and rigorous procedures are put in place for

appointing members of the board.

Integrity and ethical behaviour

Integrity should be a fundamental requirement in choosing corporate

officers and board members. Organisations should develop a code of

conduct for their directors and executives that promotes ethical and

responsible decision making.

Integrity means an individual should behave fairly and always 'do the right

thing' acting in a professional manner considering the wider impact of all

decisions made on others. As we have seen, there have been numerous cases

of chief executives and other top level members of organisations engaging in

morally dubious behaviour. Directors should be chosen who show the highest

of moral standards to avoid these situations occurring.

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Disclosure and transparency

Organisations should make the roles and responsibilities of their board and

management clear and publicly known in order to provide stakeholders

with a level of accountability. They should also implement procedures to

independently verify and safeguard the integrity of the company's financial

reporting. Disclosure of material (i.e. significant and relevant) matters

concerning the organisation should be timely and balanced to ensure that all

investors have access to clear, factual information.

One way that this is done is in the company's annual report where a whole

range of both financial and non-financial information is disclosed. Most

annual reports will contain a section on the governance of the business

including details of executive and non-executive directors of an

organisation, with a breakdown of their key responsibilities and roles. This

gives interested parties the ability to identify an individual, or group of

individuals, who have responsibility of a particular aspect of the managing of

the business. Coca-Cola is an example of a company which produces very

clear and accessible annual reports.

Disclosure of business operations are also required by law to prevent

unlawful conduct. For example, in November 2015 amendments were made

to the Human Trafficking and Exploitation Act regarding information which

could reveal hidden human trafficking and modern slavery.

Board Structures

All boards have executive and non-executive directors. Executives are

employees who are involved in the day to day running of the business

and will have positions such as CEO, or senior manager. Non-executive

directors (NEDs) are more like consultants, they do not have position in

the company other than their role on the board. They will be experts in

any fields that the company is involved in.

Boards can be split into two broad categories, unitary boards and two-tier

boards:

Unitary

Most UK companies have a unitary model. Unitary boards have both

executives and non-executives and usually make decisions together as a

single unit.

A Unitary board can be either majority executive or majority non-

executive. The first consists of mostly executives and the other of mostly

non-executives.

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Two-tier

These are mainly used in France and Germany. They consist of a lower tier

which is known as the Management board and an upper tier known as the

Supervisory board.

The management board is in charge of the day to day running of the

business and usually formed of mostly executives such as CEO's.

The supervisory board supervises, advises and decides who is

appointed to the management board. Supervisory board members are

usually non- executives and are nominated by shareholders.

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4. The UK Code of corporate governance

To whom does it apply?

The UK Corporate Governance Code is a set of principles of good corporate

governance aimed at companies listed on the London Stock Exchange.

Public listed companies are required to disclose how they have

complied with the code, and explain where they have not applied the

code – in what the code refers to as 'comply or explain'.

Note that this means that there is no legal obligation to actually follow the

rules of the code, with the aim of providing the Directors with the flexibility to

diverge from the code where they feel it is in the stakeholders' best interests.

Full disclosure where they do not comply and the reasons for this should

enable shareholders to raise objections if they do not agree.

For example, in defiance of combined code rules, Stuart Rose became the

Executive Chairman (i.e. both Chairman and CEO) of Marks and Spencer in

2008, as the directors believed it was best for the company. Following

significant shareholder protests and negative media coverage, he stepped

down from this role in 2010.

Private companies are also encouraged to conform; however there is no

requirement for disclosure of compliance in private company accounts.

Since many smaller companies are owned and managed by the same person,

there is less call for accountability for private companies as they are not

listed. Shareholders in listed companies are members of the public, so the

government has a greater need to protect public interests. Private

companies are privately owned so there is less of a need to protect the

public from them.

A principles-based approach

The Code adopts a principles-based approach. This means that it

provides general guidelines of best practice rather than highly detailed rules.

There is also no legal obligation to adopt the principles. This contrasts with

a rules-based approach which rigidly defines exact provisions that must

be adhered to (as is used in SOX).

Contents of the UK combined

code Section A: Leadership

1. Every company should be headed by an effective board which is collectively

responsible for the long-term success of

the company.

An effective board is one that is able to

make a difference to the organisation.

They will have regular meetings, clear

lines of communication, and clearly

defined roles.

2. There should be a clear division of responsibilities at the head of the

company between the running of the board (Chairman) and the executive

responsibility for the running of the company’s business (CEO). No one

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individual should have unfettered powers of decision-making.

This is to make sure that no one individual has too much power within the

organisation. The CEO and Chairman of the board need to be different to

make sure there is some tension between directors at the top of the

company. This ensures a sufficient level of scrutiny is applied to any

proposed ideas and strategies.

3. The chairman is responsible for the leadership of the board and

ensuring its effectiveness on all aspects of its role. They are responsible for

organising and directing the focus of the non-executive directors, who are

the members of the board who are not managers of the company. This role

ensures that the non-executives are effective in their role.

4. As part of their role as members of a board, non-executive directors should constructively challenge and help develop proposals on

strategy. This ensures that there is an element of tension between the

executive and non-executive directors. The executives will have to convince

the board of any ideas or plans they have for the business, and extreme

ideas will be scrutinised.

Section B: Effectiveness

1. The board and its committees should have the appropriate balance of skills,

experience, independence and

knowledge of the company to enable

them to discharge their respective duties

and responsibilities effectively.

This ensures that members of the board are

properly qualified for their position and can

perform their job effectively.

2. There should be a formal, rigorous and transparent procedure for the

appointment of new directors to the board. This can be done by a

Nomination Committee.

This makes the recruitment process fair and comprehensive; ensuring that

only the most suitable candidates are appointed to the board. This measure

reduces the risk of nepotism and cronyism.

3. All directors should be able to allocate sufficient time to the company

to discharge their responsibilities effectively.

Often, the non-executive directors (NEDs) will be part-time employees of the

company, and perhaps only work directly for the company a few hours per

week. In this situation, it's important that individuals are giving the

organisation their full attention, regardless of their engagement with other

business.

4. All directors should receive induction on joining the board and should

regularly update and refresh their skills and knowledge.

To be really effective, the board need to be trained in the specifics of the

organisation and the industry in which they operate.

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If, for example, they are working at an energy company, they will need to

know about both that particular company, e.g. its strategy, objectives,

procedures, culture, customers, suppliers, financial position. They will also

need to know about the energy industry at large, such as competitors,

industry growth rates, and technological trends, to play an effective role on

the board.

5. The board should be supplied in a timely manner with information in a

form and of a quality appropriate to enable it to discharge its duties.

Much like the previous point, directors need adequate information to make

decisions. If the company is planning to expand into a new industry, the

board need to be given appropriate information on that industry in order to

make an effective decision about any expansion.

6. The board should undertake a formal and rigorous annual evaluation

of its own performance and that of its committees and individual directors.

Self-evaluation is important to make sure that the board are aware of its own

performance, and think critically about their role and responsibilities at the top

of the organisation.

7. All directors should be submitted for re-election at regular intervals,

subject to continued satisfactory performance.

This ensures directors are replaced when they aren't performing effectively.

Shareholders can chose to remove any poorly performing directors by taking

a vote, and this also reduces the costs associated with firing a director such

as having to pay off a long term contract.

Section C: Accountability

1. The board should disclose a balanced and understandable assessment of the

company’s position and prospects.

This makes sure that the board are

communicating honestly about the reality of

the business, and that they aren't concealing

information from stakeholders.

2. The board is responsible for determining the nature and extent of the significant risks it is willing to take in

achieving its strategic objectives. The board should maintain sound risk

management and internal control systems.

Therefore, the board must be responsible for identifying risks that the

company may face, and putting systems in place to avoid or reduce the

impact of these risks.

3. The board should establish formal and transparent arrangements for

considering how they should apply the corporate reporting, risk

management, and internal control principles, and also for maintaining an

appropriate relationship with the company’s auditor.

So, it should be made clear exactly how the board are choosing to implement

any principles of corporate governance, so that these choices are justified. Most organisations will use an Audit Committee, which is made up

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of members of non-executive directors who are tasked with making

decisions regarding choosing an auditor.

Section D: Remuneration

1. Levels of remuneration should be sufficient to attract, retain and

motivate directors of the quality required to run the company successfully,

but a company should avoid paying more than is necessary for this

purpose. Remuneration is the money paid for

service i.e. salary.

A significant proportion of executive

directors’ remuneration should be structured

so as to link rewards to corporate and

individual performance, with an increasing

emphasis on long term performance.

2. There should be a formal and transparent

procedure for developing policy on

executive remuneration and for fixing the remuneration packages of

individual directors. No director should be involved in deciding his or her

own remuneration.

Directors' pay is a contentious issue, and so the procedure by which a salary

figure is arrive at should be transparent to ensure that the process is fair and reasonable. Most organisations will use a Remuneration Committee

made up of non-executive directors who are tasked with making decisions

regarding remuneration.

Section E: Relations with Shareholders

1. There should be a dialogue with shareholders based on the mutual

understanding of objectives. The board as a

whole has responsibility for ensuring that a

satisfactory dialogue with shareholders takes

place.

It is important for the shareholders to

communicate their views and objectives and

also have an ability to hold the board directly

responsible for business decisions.

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2. The board should use the Annual General Meeting (AGM) to

communicate with investors and to encourage their

participation.

The code most commonly used in the case study exam

As a good, general set of principles it is also the one you should most

commonly use in the case study exams (which you will need to take later

in the course!) as an example of good principles, even if that organisation is

not obligated to use it.

There are other codes of governance however that are used in other

countries that mostly fulfil the same principles such as the Kings III report

(South Africa) and Sarbanes Oxley (USA).

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5. Governance committees

As part of the UK's combined code they recommend a number of committees

on which the non-executive directors sit. In this section we bring together all

the key committees and give you a little more detail on them.

The major board committees are:

Audit committee

The main responsibilities for the audit committee are as follows:

• Monitoring the integrity of the financial statements and any formal announcements relating to financial performance.

• Reviewing internal financial controls and, unless there is a separate board risk committee, reviewing the company’s internal control and

risk management systems.

• Monitoring and reviewing the effectiveness of the internal audit function.

• Making recommendations to the board in relation to the appointment, re-appointment and removal of the external auditor

and approve the remuneration and terms of engagement of the

auditor.

• Reviewing the auditor’s independence and objectivity.

• Developing and implementing the non-audit services policy (with the aim that auditor independence is not compromised by significant non- audit fees).

The audit committee should be staffed by independent, non-executive

directors (NEDs) to bring independence to this key oversight role.

Remuneration committee

Directors' pay is a contentious issue, and so the procedure by which a salary

figure is arrived should be transparent to ensure that the process is fair and reasonable. Most organisation will use a Remuneration Committee, made

up of non-executive directors who are tasked with making decisions

regarding remuneration.

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Levels of remuneration should be sufficient to attract, retain and

motivate directors of the quality required to run the company successfully,

but a company should avoid paying more than is necessary for this

purpose.

A significant proportion of executive directors’ remuneration should be

structured so as to link rewards to corporate and individual performance,

with an increasing emphasis on long term performance.

There should be a formal and transparent procedure for developing policy

on executive remuneration and for fixing the remuneration packages of

individual directors. No director should be involved in deciding his or her own

remuneration.

Nomination committee

In a well governed and effective board there should be a formal, rigorous and transparent procedure for the appointment of new directors to the board.

This makes the recruitment process fair and comprehensive; ensuring that only

the most suitable candidates are appointed to the board. This measure

reduces the risk of nepotism and cronyism.

This task is appointed to the nominations committee, which is made up of

mostly NEDs and make decisions on the structure of the board and appoint

new directors.

Benefits of NEDs

We can relate the advantages of NEDs to these committees as an easy way

to learn then:

• Independent review of risk and reporting (audit committee)

• Independence in dealing with the auditors (audit committee)

• Fair pay (not too high or low) for directors (remuneration committee)

• Fair appointment for new directors on merit (nomination committee).

And we might also add:

• Support the development of board decisions and strategy by bringing an independent perspective.

• Be a representative of shareholders and other stakeholders to ensure their needs are met.

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6. IFAC's drivers for sustainable organisational success

We all want to be successful and we want to stay successful, but how can

we achieve this? If only there was some list to help guide us on how to be

successful from a reliable source. Luckily IFAC has kindly provided such a

list!

Remember, IFAC is the International Federation of Accountants, and is the

global organisation for the accountancy profession.

If you want a really successful company, then your governance will go

beyond ticking off lists showing your compliance with regulations. It will

seek to improve the running of your organisation. In other words, good

governance should breed good performance.

IFAC's drivers for sustainable organisational success are key areas where

better governance can lead to vast improvements:

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7. CIMA's proposals for better reporting on corporate governance

A governance report is usually included in financial statements. Most

commonly this shows how the organisation has complied with governance

regulations.

CIMA have proposed that improvement to the reporting of governance could

be made in 3 ways:

Chairman's Message

A Chairman's message is encouraged by the UK Corporate Governance

Code. It's supposed to cover how the parts of the Code on leadership and

effectiveness have been followed. It's usually a dull statement of how

seriously governance is taken.

CIMA propose that they should talk about how leadership has been

shown to be effective in relation to key corporate events and

according to the organisation's values.

Narrative reporting and governance reporting

The governance report should widen it's remitting to include reports made

by managers about its market environment, the priorities of its strategy,

business model and risks. This is Narrative reporting and it enables

readers of the accounts to get a broader view of the organisation's

performance.

Compliance reporting separate from governance reporting

CIMA proposes separating wider reporting of governance issues and

governance compliance (i.e. how the company complies with regulation)

so the report will have a section on governance and a section on compliance to

ensure both sections are clearly distinguishable to readers.

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Corporate Codes and CSR

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1. Codes and guidelines

There is a saying, when in Rome do as the Romans do. This phrase was born

out of the fact the people do things differently in other places. It was first

penned by St Ambrose who was explaining that to avoid conflict he followed

different customs of the Christian church depending on where he was. This

may not surprise you, but people have fought and died over differing views on

when to celebrate Easter or when to fast. Well, a similar philosophy should

be followed with regards to international corporate governance. Of course, I

mean the “when in Rome” philosophy, not the “fight and die” one!

Much like many aspects of regulations and conceptual frameworks,

corporate governance principles and codes have been developed in a

range of different countries.

As a rule, compliance with these governance recommendations is not

mandated by law, although the codes linked to stock exchange listing

requirements may have a coercive effect. This means that although there is

no legal obligation, it is a condition of being a listed company. Many

companies, therefore, will need to adopt these policies if they want to be

listed on a stock exchange.

For example, companies quoted on the London, Toronto and Australian Stock

Exchanges formally need not follow the recommendations of their respective codes. However, they must disclose whether they follow the

recommendations in those documents and, where not, they should provide

explanations concerning divergent practices. Such disclosure

requirements exert a significant pressure on listed companies for

compliance.

The organisation for economic co-operation and development (OECD)

principles

One of the most influential guidelines to international corporate

governance has been the 1999 OECD Principles of Corporate

Governance. This was revised in 2004. The principles were created to

assist OECD and non-OECD governments in their efforts to evaluate and

improve the legal, institutional and regulatory framework for corporate

governance in their countries, and to provide guidance and suggestions for

stock exchanges, investors, corporations, and other parties that have a role

in the process of developing good corporate governance.

Whilst these principles may focus primarily on publicly traded

companies, both financial and non-financial (like the UK code of

governance) they are, to some extent applicable and useful for

improving the corporate governance in non-traded companies, for

example, privately held and state-owned enterprises.

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The six principles in the OECD framework are as follows:

Lets take a look at these in a little more detail:

Ensuring the basis for an effective corporate governance framework

The corporate governance framework should promote transparent and

efficient markets, be consistent with the rule of law and clearly articulate the

division of responsibilities among different supervisory, regulatory and

enforcement authorities.

The rights of shareholders and key ownership functions

The corporate governance framework should protect and facilitate the

exercise of shareholders’ rights. Basically this means that directors should

always act in the best interests of the shareholders.

The equitable treatment of shareholders

The corporate governance framework should ensure the equitable treatment

of all shareholders, including minority and foreign shareholders. All

shareholders should have the opportunity to obtain effective redress for

violation of their rights. In short, all shareholders big and small deserve the

right to have their voice heard and be invited to the AGM etc.

The role of stakeholders in corporate governance

The corporate governance framework should recognise the rights of

stakeholders established by law or through mutual agreements and

encourage active co-operation between corporations and stakeholders in

creating wealth, jobs, and the sustainability of financially sound

enterprises.

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Disclosure and transparency

The corporate governance framework should ensure that timely and

accurate disclosure is made on all material matters regarding the

corporation, including the financial situation, performance, ownership, and

governance of the company.

The responsibilities of the board

The corporate governance framework should ensure the strategic guidance

of the company, the effective monitoring of management by the board, and

the board’s accountability to the company and the shareholders.

US Code – Sarbanes Oxley

Sarbanes–Oxley, Sarbox or SOX, is a United States governance law for all

U.S. public company boards, management and public accounting firms.

It is named after sponsors Paul Sarbanes and Michael G. Oxley.

Rules-based approach

SOX is a rules-based approach which is mandated by law, and it is,

therefore, more restrictive than many principle-based approaches like

OECD and the UK code of Governance.

Debate continues over the perceived benefits and costs of SOX. Opponents

of the bill claim it has reduced America's international competitive edge

against foreign financial service providers, saying SOX has introduced an

overly complex regulatory environment into U.S. financial markets.

On the other side, proponents of the measure say that SOX has improved the

confidence of fund managers and other investors with regard to the veracity of

corporate financial statements.

Key elements of SOX

Sarbanes–Oxley contains 11 titles that describe specific mandates and

requirements for financial reporting. The key elements you need to know

for this exam are:

Public Company Accounting Oversight Board (PCAOB)

Title I establishes the Public Company Accounting Oversight Board, to

provide independent oversight of public accounting firms providing audit

services ("auditors"). Essentially, the PCAOB audit the auditors.

The PCAOB also creates a central oversight board tasked with registering

auditors, defining the specific processes and procedures for compliance

audits, inspecting and policing conduct and quality control, and enforcing

compliance with the specific mandates of SOX.

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Auditor Independence

Title II establishes standards for external auditor independence in order to

limit conflicts of interest. It also addresses new auditor approval

requirements making sure that new auditors meet the minimum

requirements, audit partner rotation making sure that the same auditors

aren't always working with the same entity to prevent any vested interests forming, and auditor reporting requirements. It restricts auditing

companies from providing non-audit services, such as consulting, for the

same clients.

Corporate Responsibility

Title III mandates that senior executives take individual responsibility for the

accuracy and completeness of corporate financial reports. It defines the

interaction of external auditors and corporate audit committees, and

specifies the responsibility of corporate officers for the accuracy and validity

of corporate financial reports.

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2. Corporate social responsibility (CSR)

Meet Bob! Bob is the owner of Bob's Lunchbox a company based in anytown

committed to making quality sandwiches, filled with local organic produce.

Now, imagine if Bob simply dumped his food waste into the Anytown river!

Well, apart from being illegal, it would be an irresponsible thing to do. It

would encourage rats and probably poison the fish and other animals living in

the river. He would be a very bad neighbour.

Now, imagine the law said it was actually legal to dump up to 20kg of food

waste per week into local rivers. Should Bob take advantage? It would now

be legal, but it would still be highly irresponsible, because the ill effects of the

activity would still apply, even if he only dumped 1kg. That, in a nutshell, is

the concept of Corporate Social Responsibility. It's about doing what's right

for all stakeholders, even when it goes beyond mere compliance with

laws and regulations.

Corporate Social Responsibility is a company's responsibility to the

society in which it operates. This means considering all stakeholders as

part of the decision making process – not just the “key players”.

CSR policies cover issues such as environmental policy and sustainability,

health and safety, treatment of staff, charitable work and contribution, and

supporting local communities.

Benefits to business of good CSR

Brand differentiation and reputation

Now you might be tempted to look upon CSR as a compliance issue: a cost of doing business that must be borne. It's actually better to see it as an

investment in something that brings multiple returns! In crowded

marketplaces, companies strive for a unique selling proposition that can separate them from the competition in the minds of consumers. CSR can

play a vital role in building customer loyalty based on distinctive ethical

values. Several major brands, such as The Co-operative Group, The

Body Shop and American Apparel are built on ethical values.

A good CSR policy and approach can create a good long-term

reputation for the firm, which supports the development of a strong, well

recognised and well-respected brand.

Avoiding regulation

Corporations are keen to avoid interference in their business through taxation or regulations. By taking substantive voluntary steps, they can

persuade governments and the wider public that they are taking issues such

as health and safety, diversity, or the environment seriously as good

corporate citizens with respect to labour standards and impacts on the

environment. This will help avoid having standards imposed by law.

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For example, a few years ago, a media scare emerged over parabens, a type

of preservative stabiliser used in many personal care products such as

moisturiser. No hard data existed to prove its danger, but to avoid regulatory

intervention in their industry, manufacturers began voluntarily removing the

ingredient. What they quickly discovered was that the removal could be

turned into a selling point and products emerged that boasted "paraben free"

as a benefit. As a result, the media scare ended there, with no further

investigation by the regulatory bodies.

Carroll's Pyramid of Corporate Social Responsibility

So how do you keep track of all the areas you need to work on? Carroll

devised a four-part model for CSR and argued that any organisation wishing

to implement CSR would need to satisfy each of the following levels:

Economic responsibility

The organisation has a primary responsibility to stay in business, return

value to shareholders, pay its employees and deliver quality to customers.

Today public feeling may find the pursuit of cash distasteful, but this is the

primary purpose of a profit-making entity and a necessity for non-profits if

they wish to continue to operate.

For example, a company that spent all its money developing clean energy

systems and then couldn't afford to pay its staff would be operating

irresponsibly. So keeping the company afloat and generating cash comes

first.

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Legal responsibility

The organisation also has a primary responsibility to operate within

the law in each country of operation. It's not just about staying out of jail:

the law provides a baseline for acceptable behaviour. So when it comes to

developing CSR policies, the legal requirements provide a starting point and

a minimum licence to do business. Most large companies and particularly

multinational companies will have someone working purely on compliance.

For example, in 2012, the UK Advertising Standards Authority referred

Groupon to the Office of Fair Trading, a regulatory authority, after the

company was found to have broken UK advertising regulations more than 50

times in less than a year. That wasn't just illegal it was not good social

responsibility.

Ethical responsibility

The top half of Carroll’s pyramid looks at discretionary responsibilities. In

theory these responsibilities are optional because the organisation

may not be held legally accountable. In practice, however, they are not

really optional, since unethical practices will eventually create a bad

reputation and threaten the primary responsibility of generating wealth.

Ethical responsibility is about going beyond compliance and doing what is

right and fair.

For example, Tesco, the UK supermarket, came under media criticism for its

use of private label food brands such as Willow Farms and Boswell Farms.

Critics said this gave the impression that the food was sourced from local

British farms but in reality no farms of that name existed and most of the

food was produced abroad. Legally, Tesco can call its brands what it likes

and there is no suggestion that it broke any laws. But critics felt the ploy

was unethical and misleading.

Ethics vary from person to person, some think it is unethical to eat meat

whereas others do not. Therefore, it is up to companies to try to maintain

ethics that will coincide with those of the society in which they operate.

Philanthropic responsibility

This is about discretionary acts of corporate citizenship: making a

contribution to the wider good of society. These are the things that no one expects

you to do and no one will require you to do, but you do them anyway.

For example, in an effort to provide better technological support for

governments that are slow to embrace technology, Google provides Code for

America, a charity, with an annual gift of $3 million to develop civic technological solutions. There's no direct benefit to Google, it's just something the

company believes would make the world a better place.

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Example: Bob's Lunchbox

So let's look at our example company and see how it might go about

implementing Carroll's Pyramid.

1. Economic. Bob takes care to negotiate the best deal he can on his inputs

and eliminate unnecessary cost in his operations, so that he can make the

best return possible on his business so he can pay his staff and source food

responsibly without concern for price.

2. Legal. Bob is strict about only using suppliers that have a recognised food

safety certification and recent audits in place. He understands that a single

breach of food safety law could shut down his business. He uses a CIMA-

qualified accountant to help prepare his financial statements and tax so he

can be sure to be operating within the law.

3. Ethical. Bob trades on the claim that he uses only local organic

ingredients. He could get a better price by using industrial suppliers, but

that would be unethical, given the claims he makes.

4. Philanthropic. Bob's sandwich store donates food each week to a

homeless charity. It also sponsors a number of nutritional and healthy living

non-governmental organisations (NGOs). These acts don't directly benefit

Bob's business, but they do benefit the wider community in which his

business operates, and they support the overarching vision of his company.

Ethical stances

So how far should Bob go? How will he know when he's done enough? It

depends on which ethical stance his company is going to adopt. Johnson,

Scholes and Whittington claim there are four stances, which determine “the

extent to which an organisation will exceed its minimum obligations to

stakeholders”. Here are those stances:

Short-term Shareholder Interest

This is a stance designed to maximise returns in the current financial

year. Companies with this stance believe anything above legal minimum set

by governments is not profitable.

For example, a factory that releases carbon emissions just below the legal

maximum is not breaking the law. It could invest in new machinery and

process redesign to reduce emissions to close to zero, but that would not be in

the short-term interest of shareholders, since the investment is not

necessary.

Longer-term Shareholder Interest

This stance takes a slightly longer view of things and recognises that money

spent now on corporate responsibility can enhance the organisation's

reputation and bring returns later.

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Walmart tried this argument with its shareholders when some asked the

company to justify spending on sustainability. Ultimately, the spending had to

be sold as a long-term investment in cost-reduction through renewable

energy before it was agreed.

Multiple stakeholder obligation

Organisations taking this stance recognise an obligation to a wider group of

stakeholders than simply shareholders. It is not a simple case of

“government legislates” responsibility, but more “society dictates” it. It

involves recognising a purpose beyond financial.

The food industry launched a global, cross-industry initiative to end reliance on

palm oil, which is responsible for deforestation. This has no financial benefits

for any manufacturer, it is simply a recognition of responsibility to a wider set of

stakeholders, such as the producing communities, environmental NGOs and

the planet as a whole, which needs better forest management to slow climate

change.

Shaper of society

An organisation taking this stance sees its purpose in society as its ultimate

driver, so financial interests are subordinate to performing its role in/for society.

An example might be the John Lewis Partnership (which includes the

Waitrose supermarket). Its radical mission is the happiness of its employees,

which its commercial activity supports. In JLP's model, all staff are joint

owners of the business and the collective employs its directors to run the

business in trust, returning shares in the profit to all partners. The directors

are, therefore, accountable to the workforce and can be removed.

Sustainability

Let's say you want to manufacture a chemical, but your process uses fossil

fuels and causes long-term toxic waste to be leaked into the local area. It's

profitable, so it satisfies Carroll's first level of CSR. But is it sustainable?

Well, no. It can't be sustained indefinitely as a business, because there is

only so much fossil fuel left on Earth. Once it's gone you have no business

model. Secondly, the activity itself damages the environment that future

generations will need to survive in.

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That's the notion of sustainability in a nutshell. It's using resources in such

a way that we don't compromise the needs of future generations. It's

about challenging short-termism in the way we operate our activities, both

internally and externally and focusing on the long-term sustainability of both

the business and its environment.

Cost savings through sustainable development

Ironically, focusing on long-term sustainable development can bring

short-term profitability increases through cost-savings. For example,

harvesting rain water instead of turning on the taps will bring long-term

environmental benefits, but will also save on your water bill. The same is

true of solar energy to generate electricity, or natural lighting in stores.

Corporations looking for investments from shareholders and banks to fund

their sustainability programmes soon realised that selling the story that way

achieved better buy-in.

Building CSR into the organisation

So, coming back to Bob and his food waste. Bob should carry on as he is and

just hire a CSR expert to implement this, right? You guessed it. Wrong! CSR

is far too important to leave it to one function or division of your

company to implement and will only lead to conflicts of interest within

the organisation. To be effective, CSR needs to be built into the decision-

making process for the whole organisation. There are a variety of ways of

doing that. Let's look at them:

Mission and objectives

Inclusion of CSR values within the mission statement has become

common practice, they help to ensure that CSR is considered within all

strategies and that objectives are achieved without compromising the

company’s CSR policies.

Creating focused CSR objectives with clear plans for achievement also helps

focus CSR activity, particularly when these are linked to managerial

performance and reviewed regularly.

CSR Policies

A CSR policy is an internal statement of rules and expectations on

CSR issues to be applied within the organisation. It sets out the

organisations

values and clear rules to be followed in relation to many ethical and social issues.

So for example, Bob could set a policy of never paying less than market rate

for produce, or of never setting unfair production targets that made it

economically impossible for producers to continue supply sustainably. When

Bob's business expands and he no longer directly oversees procurement, his

policies will set out the rules for his staff to follow.

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Benchmarking

Benchmarking enables comparison of CSR performance against other

organisations. It involves reviewing competitor CSR initiatives, as well as

measuring and evaluating the impact that those policies have on society and

the environment, as well as how customers perceive competitor CSR strategy. After a comprehensive study of competitor strategy and an

internal policy review has been performed, a comparison can be drawn

and a strategy developed for CSR initiatives.

So for example, Bob could take a look at what his main competitor, does as

a corporate citizen and aim to close the gap between his policies and theirs.

Social accounting, auditing, and reporting

Social accounting involves accounting for and reporting the social and

environmental effects of a company's economic actions.

A number of reporting guidelines or standards have been developed to serve

as frameworks for social accounting, auditing and reporting including:

Global Reporting Initiative's Sustainability Reporting Guidelines

The ISO 14000 environmental management standard

In some nations, legal requirements for social accounting, auditing and

reporting exist although there is little international agreement on what

constitutes meaningful measurement of social and environmental

performance.

Problems of Supply

You may run your company perfectly ethically, but if one of your

suppliers is not so ethical then you and your company are guilty by

association.

Apple got in trouble for this when it was discovered that the Chinese

company that they had outsourced production to was subjecting its staff to

inhumane working conditions, resulting in several suicides.

You even need to consider the distances travelled. Food miles for example.

The environment is a key focus at the moment so if tons of greenhouse gases

are being pumped into the air for you to transport food such as beef from

South America to the UK when there is perfectly good beef in Britain you

may suffer a public backlash. Both from environmentalists and also those

concerned about the state of the British beef industry.

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3. Regulations and business/government relations

If you live in the UK you may recall the time Russell Brand was fired from the

BBC for making abusive phone calls during his radio show. This was the

result of a large number of complaints being made to OFCOM on the grounds

that the content of his show was deemed to be offensive! OFCOM is the

Office of Communications and is responsible for regulating and monitoring

broadcasting, telecommunications and postal services. After an investigation

OFCOM affirmed the complaints were against public standards and the BBC

fired him. This is an example of the power of a regulatory body.

Regulations and regulatory bodies

Regulations are often set by regulatory bodies. In the UK examples are

OFCOM (telecoms) and OFGAS (gas) which aim to promote fair competition

between companies whilst protecting the public.

Regulations create limits, constraints or allocate a responsibility. Their

purpose is usually to protect the public good in some way. For example, by

ensuring the safety and quality of the products or services that businesses in

the industry provide.

Impact on business

Businesses must comply with rules and regulations governing the market

place, or face the consequences. These may be anything from a slap on the

wrist and disappointed stares from the public, to an indictment.

Ineffective and overly oppressive regulations have been found to

discourage business development which in turn may have a negative effect

on the economy. As a result governments, regulatory bodies and businesses

will often meet to discuss new regulations ensuring the right balance of

protection, fairness, room for innovation etc.

Corporate political activity (CPA)

Corporate political activity is essentially the process of businesses getting

involved in political activity in order to influence decisions and to react

quickly to change.

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Buffering

There are two broad types of buffering:

• Lobbying – this involves an organisation attempting to influence government through debate and discussion with them. One

example of this can be seen in America in regard to gun laws. Gun

lobbyists will use their power and number of supporters to put

pressure on government to protect gun rights. In the UK, the

Confederation of British Industry (CBI) will lobby on business related

matters to put the 'business perspective' across to the UK

government.

• Donations – many organisations will make donations to political parties. Many people see this as a form of bribery, although it is not

technically classed as such.

In developing countries Corporate Political Activity is commonplace and

some governments or government officials are more readily willing to

change laws or regulations based on lobbying activities, or even bribery.

Bridging

This refers to companies working their way around new rules and

regulations in order to avoid legal action when new laws are passed. For

example, a perfume company finding out that a key ingredient in one of their

fragrances could be banned in the next year because it can damage skin.

This allows them extra time to formulate an alternative before the law comes

into affect, avoiding any legal repercussions.

Diploma in Business Ethics and Corporate Governance - Level 3 copy_1.pdfModule 3 Corporate Governance, Codes and CSR.pdf