Corporate Governance - Development of the Combined Code

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An overview of the development of the UK Combined Code and the Cases involved.

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Corporate Governance - Development of the Combined Code

  1. 1. Corporate Governance DEVELOPMENT OF THE UK CODE OF CORPORATE GOVERNANCEWritten byJason Cates
  2. 2. © Jason Cates, 2012Reproduction for the following uses is authorised provided the source is acknowledged inline with the Copyright, Designs and Patents Act 1988;Private and research study purposes, performance, copies or lending for educationalpurposes, criticism and news reporting, incidental inclusion and copies and lending bylibrarians. Further details of authorised use under the above Act is available from the UKCopyright Service.This publication may be made available online at SlideShare.net/AdrJasonCates for publicuse no earlier than 09:00hrs (GMT) on 21 January 2013 as deemed appropriate by theacknowledged source.This paper has referenced appropriate sources in line with Harvard Referencing.Any queries regarding this publication should be sent to:AdrJasonCates@GoogleMail.com orLinkedIn.com/in/AdrJasonCatesTo be delivered to the University of Hertfordshire on or by26 November 2012Ordered by Jason Cates to be printed21 November 2012Printed in the United Kingdom 1
  3. 3. ‘Encouraging transparency, accountability and long-term stability will promote healthy long- term growth and help UK industry gain public trust’ (Financial Reporting Council 2010)Part I: Explain how the corporate collapses of the 1990s and early 2000s led to thepublication of the first Combined Code in 2003. (70%)Part II: With reference to the above quotation evaluate whether or not the Code in itscurrent format is adequate for protecting the interests of stakeholders in public limitedcompanies (30%) 2
  4. 4. ContentsIntroduction ................................................................................................................................ 4Part I ........................................................................................................................................... 5 Case Studies ........................................................................................................................................ 5 Maxwell ........................................................................................................................................... 5 Polly Peck ........................................................................................................................................ 5 BCCI ................................................................................................................................................. 6 Barings ............................................................................................................................................ 6 WorldCom and Enron ...................................................................................................................... 7 Publishing of the UK Corporate Governance Code ............................................................................. 8 Chairman and CEO .......................................................................................................................... 8 Board of Directors ........................................................................................................................... 8 Auditing and Whistle-blowers ......................................................................................................... 9 Internal Control ............................................................................................................................. 10 Conclusion ..................................................................................................................................... 10Part II ........................................................................................................................................ 11 Healthy Growth vs. High Growth ...................................................................................................... 11 Public Trust ....................................................................................................................................... 12 Conclusions ....................................................................................................................................... 12 Recommendations ............................................................................................................................ 13Part III ....................................................................................................................................... 14 Signatories......................................................................................................................................... 14 References ........................................................................................................................................ 15 3
  5. 5. IntroductionThis paper will analyse and evaluate the adequacy of the 2003 Combined Code to promote“transparency, accountability and long-term stability”. This will include considering how theCombined Code was initially developed in the context of the corporate collapses of the 1990’s andearly 2000’s, these being Polly Peck, Maxwell, Barings, BCCI, Enron and WorldCom. In addition, this paper will evaluate the role of the combined code in the modern businesscontext and its role in recent failures in corporate governance. Once completed, this paper will makeappropriate recommendations in light of these failures and other relevant findings. 4
  6. 6. Part ICase StudiesMaxwell Robert Maxwell owned the publisher Pergamon Press and later bought the Mirror group in1984 for £90m. This fulfilled a lifelong ambition of his of “controlling a major UK newspaper”.Maxwell would then go on to pledge funds from his company’s pension fund to fuel this ambitionand purchase further publishing companies, both in the UK and abroad. In total, Maxwell “stole”£400m from the pension fund of Mirror Group in order to fuel this ambition. (Wearing, R., 2005) Maxwell was also renowned for settling disputes through the courts and suing those whowould criticize him or his business practices in public. This led to many potential whistle-blowersbeing afraid to criticize him in public, thus helping him to keep his business activities under wraps.(Wearing, R., 2005)Polly Peck Asil Nadir owned 24% of Polly Peck and was both Chairman and CEO. Polly Peck went intoadministration in 1990 with debt levels totalling £1.3bn which was largely secured against shares inthe company. When creditors became concerned about Polly Peck’s ability to repay its debt, theywent on to sell their shares causing a significant decline in Polly Peck’s share price. Furthermore,Nadir with the aid of the Swiss based broker Jason Davies ran a share-buying operation in order tohelp bolster Polly Pecks share price. This was with the aim of increasing the company’s ability toobtain further debt finance secured against Polly Peck’s shares. (Wearing, R., 2005) These cases raise the issue of concentration of power and the need to separate the roles ofChairman and CEO. 5
  7. 7. BCCI For BCCI, there were concerns relating to its ability to repay its debt, this led to leadingfigures at BCCI falsifying its accounts in order to hide losses. In addition, false documentation wasprovided to the auditors Price Waterhouse in order to further cover us these losses. Onceuncovered, Price Waterhouse raised its concerns to the Bank of England and was aided byinformation provided by a whistle-blower. However, these concerns were largely brushed aside bythe Bank. In addition, Price Waterhouse also acted as a management consultant to BCCI, thusleading to a possible conflict of interest in its role as auditor. (Wearing, R., 2005) This case raises the issue of whistleblowing, potential conflicts of interest for auditors andthe role played by regulators such as the Bank of England.Barings For Barings, the derivatives trader Nick Leeson was allowed to put at risk £742m, twice thereported capital of Barings unchecked. This led to Barings making loses of £830m in 1995 withLeesons losses being hidden in a dormant error account. These losses weren’t picked up on due toLeeson himself accounting for these trades in the “back office”. Simply speaking, there was a lack ofinternal controls to check over Leesons work and ensure adequate accounting procedures wereenforced. This was in spite of multiple managers having concerns regarding Leesons tradingactivities. Leeson then went on to fool the external auditors Coopers and Lybrand with falsifiedletters from clients to further cover his tracks. (Wearing, R., 2005) This case highlights the need for adequate internal control systems facilitating internalaccountability. 6
  8. 8. WorldCom and Enron At WorldCom, expenses were misrepresented as capital expenditure in the accounts. Thiswas aimed at improving Enron’s profit figures in addition to improving the asset figures as shown inthe company’s balance sheet. This activity was picked up on by Cynthia Cooper, an internal auditorat WorldCom who informed WorldCom’s Audit Committee of her concerns, but was largely ignored.This issue was again overlooked by WorldCom’s external auditors Arthur Anderson. Anderson werelater unable to explain how they missed such an overstatement in corporate cash flows totalling$3.8bn. (Wearing, R., 2005) For Enron, the issue was its use of Special Purpose Vehicles which were established with theintention of hiding debt. Moreover, those involved in these SPV’s were paid significant remunerationwith the CFO Andrew Fastow making $30m for his role in establishing these partnerships. (Wearing,R., 2005) Furthermore, the independence of Enron’s audit committee was put into question. Thisincluded one committee member being a paid consultant for Enron. Sherron Watkins, an accountantat Enron, raised her concerns by sending an anonymous email to CEO Ken Lay. Her concerns wereinvestigated, but the independence of this investigation could also be questioned. (Wearing, R.,2005) These cases raise the need to appoint adequate and independent auditors, both internallyand externally. In addition, the need for an appropriate policy regarding whistleblowing has alsobeen raised by these two above cases. 7
  9. 9. Publishing of the UK Corporate Governance Code This paper will now discuss how the above cases led to the combined Code of 2003. This willbe carried out by discussing how the specific aspects of the code were developed and their role inthe wider business context.Chairman and CEO A recurring theme in the above cases was the concentration of power. This coupled with aninsufficient system of accountability had considerable ramifications in these cases. This issue relatesspecifically to Pergamon and Polly Peck where power was concentrated around a single individual.(Wearing, R., 2005) This issue was raised in the Cadbury Report which stated the role of chairman should beseparate from that of CEO. (Cadbury, 1992) This allows the chairman to “stand sufficiently back fromthe day-to-day running of the business”. This led the Combined Code to state “there should be aclear division of responsibilities at the head of the company” and “no one individual should haveunfettered powers of decision”. (FRC, 2003) This is to help ensure appropriate accountability at the highest levels of the corporate ladderwith no one individual going unquestioned or unchallenged, whatever their role may be.Board of Directors The issue of directors again relates specifically to the cases of Maxwell and Polly Peck andthe concentration of power. In order to counterbalance the power of the executive directors, thecombined code states that at least half the board, excluding its chairman, should be non-executives.Thus helping to ensure the majority of the board are appropriately independent. (FRC, 2003) A nomination committee should be established consisting mainly of non-executive directorswith the role of recommending appointments to the board of directors. This committee should“evaluate the balance of skills, knowledge and experience on the board” and make appointments as 8
  10. 10. appropriate. Thus, the knowledge and experience of the board should be as broad and varied aspossible ensuring the board’s long-term effectiveness. (FRC, 2003) The board should also establish a Remuneration committee consisting of at least 3 non-executive directors. Moreover, no executive directors are permitted to sit on this committee in linewith the Greenbury and Cadbury reports. (Greenbury, 1995) (Cadbury, 1992) The role of theremuneration committee is to determine the “remuneration for all executive directors and thechairman”. Furthermore, this remuneration should largely be linked to individual performance andconsidered relative with other companies. (FRC, 2003) Simply speaking, the board of directors should be appropriately independent with no singleindividual having overriding control of the company. Additionally, issues such as remuneration andappointments to the board should be largely handled by the non-executive directors. This is toensure remuneration is kept appropriate and nominations independent, thus preventing powergravitation towards a single individual. (FRC, 2003)Auditing and Whistle-blowers In regards to the audit function, this issue specially relates to the WorldCom and Enron casesand the need for adequate independence in relation to external auditors. In addition, the issue offraud and how this should be handled was a prominent feature of the BCCI and Enron cases. As such,the Combined Code states that the audit committee should be responsible reviewing the company’sinternal control and risk management systems. Thus helping to prevent and mitigate fraud withinthe organisation. Additionally, the committee is responsible for monitoring the external auditor’sindependence with a focus on the supply of non-audit services and its implications on independence.(FRC, 2003) The issue of whistle-blowing was a prominent issue in the BCCI, WorldCom and Enron cases.In light of these cases, the code states that arrangements should be reviewed as to allow staff inconfidence to “raise concerns about possible improprieties” within the organisation. In addition, the 9
  11. 11. audit committee should act upon this information with systems allowing for appropriateinvestigation and follow-up action. As such, information provided in this fashion should not be“overlooked” or ignored as was the issue in the above cases. (FRC, 2003)Internal Control Continuing on from this, internal controls should be established to “safeguard shareholders’investment and the company’s assets”. This issue relates specifically to Barings where the internalcontrol systems failed to pick up and prevent Leesons trading activities leading to the companiescollapse. This issue was highlighted in the Turnbull report which provided guidance on managing riskand providing adequate disclosure in the annual report. (Turnbull, 1999) These controls weredesigned to help facilitate the internal auditing process and help prevent fraud andmisrepresentation of the organisations financial information. Thus, this advice can be viewed asbeing a direct result of the failures of companies such as Barings. (FRC, 2003) In addition, the combined code states that these controls should be reviewed on an annualbasis and reported to the shareholders as appropriate. This includes reviewing the organisationscompliance with the combined code and providing shareholders with appropriate explanation ininstances of non-compliance. (FRC, 2003)Conclusion In conclusion, specific aspects of the code appear to have been developed with the casesdiscussed directly in mind. This includes being designed to help prevent or at least reduce thechances of such failures from arising again in the future. However, the recent banking crisis bringsthe suitability and vigour of the combined code into question. 10
  12. 12. Part IIHealthy Growth vs. High Growth It can be argued that growth cannot be consistently high, yet remain healthy. This issue washighlighted in the recent banking crises where the financial services industry experienced significantgrowth, but was built on unstable foundations which later led to its collapse. (BBC, 2009) These unstable foundations included a lack of transparency and understandability of theactivity undertaken by these financial institutions which led to significant risk-taking. In relation tothe combined code, this issue relates specifically to internal controls and how they failed to preventsuch significant risk-taking. Simply, during times of high economic growth, as business confidencewas growing, companies such as banks were more willing to take on risk. However, this confidencewas to be unfounded when debtors soon started to default on their loans. (BBC, 2009) Hence, notonly do internal controls need to be developed, but they need to be appropriately enforced in orderto be effective. This was highlighted at UBS where the trader Kweku Adoboli lost the bank £1.4bnand in total risked loses reaching £7.5bn. In this case, it wasn’t the lack of internal controls, but thefact that they weren’t adequateky enforced by “senior managers”. Furthermore, fraudulentbehaviour by Adoboli allowed him to further hide his loses. (BBC, 2012) However, it can be argued that this “boom and bust” is a natural part of the economic cycleand cannot be prevented, merely its effects mitigated. Simply, corporate collapses will continue tooccur, regardless of how effective the combined code is made. Therefore, any alterations to thecombined code should focus on mitigation rather than on prevention. This may include requiringcompanies to be in a position to withstand extreme economic and financial pressures. An examplewould be requiring companies to hold a greater level of capital in reserve. This will bring thecombined code in line with the policies of the European Banking Authority which now requires banksto hold 9% of their assets in capital reserves. Although this type of policy may hinder economic 11
  13. 13. growth in the short-to-medium term, future economic growth could be considered “healthier”, thuscreating long-term stability. (EBA, 2012)Public Trust In terms of public trust, this paper looks toward the Scandinavian economic model. TheScandinavian model sees greater cooperation between organisations and stakeholders. Thisfacilitates greater transparency, protects stakeholders and builds public trust. This trust can becomesignificant in times of economic uncertainty when companies need the support of stakeholders suchas employees and investors. This is compared to the liberal model of Anglo-Saxon countries wherethere is significant distrust between companies and stakeholders such as trade unions. (Euroframe,2007) Therefore, the combined code needs to consider and gain inspiration from such alternativeeconomic models in order to allow organisations to gain public trust. This may, for example, includehaving representatives of major stakeholders on a company’s board of directors. This will helpencourage greater transparency and cooperation, while at the same time provide companies theflexibility they need in times of greater uncertainty. (Euroframe, 2007)Conclusions To conclude, the “boom and bust” and cyclical nature of the economic cycle cannot beprevented, only its effects mitigated. Therefore, this should be the main focus of any alterations tothe combined code. The combined code should encourage companies to be in a position towithstand extreme economic stresses, thus reducing the risk of corporate collapse. Additionally,internal controls should be tailored to encourage greater consistency in regards to risk-taking. This iscompared to the current system where risk-taking is strongly correlated with the economic cycle.Furthermore, in regards to protecting stakeholders, the combined code should use the Scandinavianmodel as a basis for future standards in corporate governance. This will help facilitate greatercooperation between organisations and stakeholders and help build public trust. (BBC, 2009) 12
  14. 14. Recommendations In light of the recent banking crises, as well as the fraud highlighted at UBS and the findingsof this paper, we make the following recommendations to the combined code. Theserecommendations are aimed at mitigating the effects of corporate governance failures andfacilitating greater engagement with major organisational stakeholders.  Auditors should ensure internal controls are adequately and consistency enforced by all levels of senior management, thus implementation of internal controls should remain consistent throughout the economic cycle.  Companies should hold adequate capital reserves to withstand severe failures in corporate activity. This may include, but not exclusively, fraud, regulatory failures and/or significant economic uncertainty.  Specific directors should be appointed to the board based on their relationship with major stakeholders such as employees and local communities. This will facilitate greater cooperation with major stakeholders and help build public trust. 13
  15. 15. Part IIISignatoriesI commend this paper to the University of Hertfordshire to be delivered on or by 26 November 2012.Jason Cates ___________ Mail: AdrJasonCates@GoogleMail.com Portfolio: SlideShare.net/AdrJasonCates LinkedIn: LinkedIn.com/in/AdrJasonCates 14
  16. 16. References(In line with Harvard Referencing)BBC (2009) Timeline: Credit crunch to downturn. [Online] Available at:http://news.bbc.co.uk/1/hi/business/7521250.stm [Accessed: 21st November 2012]BBC (2012) Kweku Adoboli jailed for fraud over £1.4bn UBS loss. [Online] Available at:http://www.bbc.co.uk/news/uk-20338042 [Accessed: 20th November 2012]Cadbury (1992) The Financial Aspects of Corporate Governance. [Online] Available at:http://www.icaew.com/~/media/Files/Library/subjects/corporate%20governance/financial%20aspects%20of%20corporate%20governance.pdf [Accessed: 1st November 2012]Euroframe (2007) European Socio-Economic Models: Experiences and Reform Perspectives. [Online]Available at:http://www.euroframe.org/fileadmin/user_upload/euroframe/efn/autumn2007/Annex3_WIFO.pdf[Accessed: 19th November 2012]European Banking Authority (2012) Final report on the implementation of Capital Plans following theEBA’s 2011 Recommendation on the creation of temporary capital buffers to restore marketconfidence. [Online] Available at:http://eba.europa.eu/capitalexercise2012/Finalreportrecapitalisationexercise.pdf [Accessed: 19thNovember 2012]Financial Reporting Council (2003) Combined Code 2003. [Online] Available at:http://www.frc.org.uk/Our-Work/Codes-Standards/Corporate-governance/UK-Corporate-Governance-Code.aspx [Accessed: 14th October 2012]Greenbury (1995) Directors Remuneration. [Online] Available at:http://www.ecgi.org/codes/documents/greenbury.pdf [Accessed: 1st November 2012]Turnball (1995) Internal Control. [Online] Available at: http://frc.org.uk/getattachment/5e4d12e4-a94f-4186-9d6f-19e17aeb5351/Turnbull-guidance-October-2005.aspx [Accessed: 1st November2012] 15

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