"Corporate Governance is the system by which companies are directed and controlled". It ensures good management of the company and promotes transparency and accountability. "The challenge of good corporate governance is to find a way in which the interest of shareholders, directors and other interest groups can be sufficiently satisfied". The way companies run and their management determines the country's economic position. Therefore, it is important for companies be able to exercise freedom on how they operate in compliance with a required set of rules. Misuse of corporate assets by the directors and lack of effective control over and accountability of directors' action contributed to a number of financial scandals in the UK and in the world in general. These scandals illustrate was happens when corporate governance is weak and when check and balances are ineffective  .
Corporate governance and scandals
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Conflict between the two parties who run the company, shareholders and directors, such as directors acting for their own interests without the consent of the shareholders, can lead to company's failure. The Companies Acts do not mention how power should be distributed between the two parties and this is left to the company's articles, which often leaves too much power to the directors and sometimes they abuse it. For example in Enron the Chief Executive Officer (CEO) of the company acted to benefit their own interest and breached their obligation to promote the company's interest which led to the company's failure  . Usually internal controls within the company prevent this from happening such as the existence of an internal auditing. However, lack of independence can still lead to conflict of interests and so accounts may not be prepared properly such as in Polly Peck and Coloroll which eventually collapsed  .
Collapses and bankruptcies of large corporations affected the whole world and a general ill-feeling appeared from the society. In 1995 Baring Bank collapsed due to lack of effective internal control; in 2001 Enron constituted one of the largest bankruptcies in the history of the US due to misconduct from the audit committee and the absence of independent non-executive directors (NEDs); in 2003 Parmalat, an Italian company, suffered loses, due to the board's lack of independence; in 2004 the China Aviation Oil also suffered losses because of an over-powerful CEO who took decisions again the company's best interest. Finally, in 2009 the Satyam Computer Science, Indian's fourth largest technology group, suffered several losses due to an over-powerful chairman and large directors' remuneration packages  . These are only a few examples of corporate governance scandals in the last years.
As we can see the major scandals in recent years were caused because senior executives acted on behalf of their own interest, due to lack of internal controls and close relationship that led to conflict of interest. Even though it is in a director's duties to make decisions in the company's best interest there was nobody to ensure this and many directors shown to be of poor moral character. Unfettered power in the hand of the CEO is an obvious problem and separation of the chairman and the CEO's role is essential. The function of NEDs was weak in most of the companies, as they could not detect any fake accounts through their audit function. Also the board adopted remuneration systems which gave large amount of money to directors in contrast with their performance.
These failures demonstrated a need to improve corporate governance mechanisms in order to prevent such collapses happening again and restore investor confidence. The response of the US was the introduction of the Sarbanes-Oxley Act 2002, a piece of strict legislation. However, the UK government decided to carry out different reports to find out how to make the board of directors more effective, how to stop the scandals and how to stop directors overpaying themselves.
Review of Corporate Governance and the Committees
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The introduction of UK's corporate governance codes was to create more transparency and accountability and restore investor confidence but also because the foreign corporate failures raised questions about the efficacy of the British system of corporate governance  . The review committees, appointed by the government, usually included "prominent respected figures from business and industry, representatives from the investment community and professional bodies"  . The UK's Combined Code in 1998 embodied the findings of a trilogy of Codes; the Cadbury report (1992), the Greenbury report (1995) and the Hampel report (1998).
The Cadbury report was created due to lack of confidence after the BCCI and Maxwell scandals and a committee chaired by Sir Adrian Cadbury was set up. The recommendations would apply to all listed companies on a 'comply or explain' basis. Its main recommendations related to the importance of the division of the responsibilities at the head of the company and the role of the NEDs. The publication of the Cadbury report represented the first attempt to formalize corporate governance best practice in a written document  . Later the Greenbury report was created after the British Gas case, as a response for the concerns for the amount of directors' remuneration. The recommendations aimed to strengthen accountability and proposed the creation of a remuneration committee comprised by independent NEDs. Finally, the Hampel report was set up to review the recommendations made by the previous reports. The report emphasized the importance of institutional investors who should be more interested in the company's management and take any opportunity given to them to control the actions of those in charge.
The review did not stop there. There were still important issues which needed to be addressed. Therefore, several reports were created for particular problems. The Turnbull report addressed the issue of internal control and the Myners review analyzed the importance of institutional investors. Particularly important were the Higgs (2003) and Smith (2003) reports which were the foundation for the Combined Code reform in 2003 after the Enron scandal. Higgs report reviewed the role of NEDs in the UK and recommended that the position of the CEO and chairman should not be retained by the same person. Also there should be training programs for the director's job. Finally the Smith review, established by the Financial Services Authority (FSA) responsible for the content of the Combined Code on Corporate Governance, defined the role of the audit committee and the need to be satisfied that an appropriate system of controls exists within the company.
The Corporate Governance Code (formerly known as Combined Code)
The Combined Code of 2003 incorporated the substance of the Higgs and Smith reviews and applied to all public limited companies (plcs). This is because if this type of company fails it affects a wider part of the public. The redrafting of the Code in 2003 was referred to as "the biggest shake-up of boardroom culture in more than a decade  ". There were more reforms of the Code in 2006, 2008 and 2010 and they addressed several important aspects.
Firstly, there must be a clear division between the running of the board (chairman) and the executive responsibility for the running of the company's business (CEO), otherwise one person would have too much power like in the Polly Peck scandal. Secondly, the codes on corporate governance aim to restrict the number of executive directors in the board by require an analogous proportion of NEDs  so that no individual or small group can dominate the board's decision-making. The appointment of NEDs was considered the most important and effective corporate governance initiative  . Thirdly, there should be a formal and transparent procedure for the appointment of new directors to the board. Fourthly, an independent audit committee should be established, to avoid scandals such as Enron, which will help to ensure that the accounts show a fairer view and "that the interests of shareholders are properly protected in relation to financial reporting and internal control"  . An increase in disclosure of information can help determine if a company is operating correctly and how is producing its financial statements. Finally, a remuneration committee should be established controlled by independent NEDs. This will prevent executive directors from setting their own remuneration levels in excessive amounts like in the Tyco scandal.
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Most of the reviews were made by individuals who already worked in large corporations, as for example the CEOs of Marks & Spencer were part of the Greenbury committee. It is like the industry itself realized problems and attempted to regulate it. Yet, this is like "the inmates are running the asylum" as Alan Dignam  said. How effective can be letting people from the inside control regulation and review? On the other hand, who can be more suitable to bring change which will be accepted by both the industry and the society. Corporate Governance requires knowledge and expertise that only someone working in the field can acquire. At the time, it seemed that they were the most appropriate to make the reforms.
A big debate developed was whether NEDs are a good solution for the problems. Their role is mainly to control executive directors and ensure that no person exercises undue influence on the board. NEDs should be selected through an impartial formal process. They should be independent, meaning that they should not be affected by any relationships or circumstances in their judgment. However, even though the shareholders decide who is going to be selected, the selection is from a number of individuals proposed by the executives. So again it is the executives who chose the NEDs and there may still be the possibility for conflict of interest since they may not be independent.
Another issue that has caused controversy is the value of shareholders. "It is sometimes noted that shareholders are the 'missing link' in corporate governance  ." In the past the importance of the shareholder has been ignored but new rules introduced are aimed at putting shareholders' interests at hearts such as the Code which encourages shareholder involvement. "Shareholders are enhanced in a number of ways including greater use of electronic communications more information, enhanced proxy rights and provision regarding the circulation emphasis on shareholders' responsibilities with encouragement for institutional shareholders to be more active and to disclose how they have voted"  .
Generally compliance with the codes is voluntary and non-binding since it is still applied on a 'comply or explain' basis. Companies with a Premier Listing have "the requirement to provide a 'comply or explain' statement in the annual report"  . The rule obliges companies either to follow it or to explain to their shareholders why they are not doing so  since they should be able to monitor matters related to the Code and protest if the company does not have an appropriate reason. This was reinforced by the UK Stewardship Code, according to which "institutional investors report on their policies for monitoring and engaging with the companies in which they invest"  . The rule recognizes that sometimes it is appropriate to allow a degree of flexibility because the needs of each company are different. Yet, there are worries from investors that there may be poor quality of explanations and other disclosures provided by some companies.
It is difficult to define and determine which is the best method of governance; self-regulation or government legislation. Self-regulation is important to help determine what standards are required but is it enough to stop the scandals? When this method fails then there is no choice but for the law to intervene. Compliance with legislation can help improve a company's reputation and helps to boost investor confidence. If everything was put into statute then there would be consistency. But is it better to have consistency or flexibility? Besides the way the code is today it gives the opportunity to companies to deny compliance but non-compliance can damage a company's image, imply that there is no transparency or that there is misconduct. So impliedly compliance with the code is necessary.
The new laws in the US are thought to be heavy handed and financially costly in contrast with UK's 'soft' law. The UK approach combines high standard of corporate governance with relatively low associated costs  and is a market-based approach that enables the board to retain flexibility in the way it organizes itself and exercises responsibilities"  . So does really the UK Code improves the effectiveness of corporations and their accountability? The Cadbury report recognized that no system can eliminate the possibility of fraud (Maxwell scandal) without controlling completely a company but that excessive control prevents directors to actually do their work and take risks.
"In most countries the basic responsibilities of the company's board are set out in regulation which will also include sanctions where those responsibilities are not met"  . A few years back Morrisons announced that they would comply with the Code but not with sections regarding remuneration and shareholders relationship because it would affect the company's management. That was all needed to satisfy the 'comply or explain' rule. The only sanction in this case was a two-page article in a newspaper. Therefore, it seems that there are no real sanctions in the UK and therefore companies have nothing to fear legally. The worst that they might suffer is damage of their reputation. This is one of the biggest differences between the Code and the strict law in the US since the Sarbanes-Oxley Act 2002 offers civil and criminal sanctions.
Continuous updating of corporate governance codes and systematic review of corporate governance checks and balances are necessary to avoid other Enrons in the future  . Even though it cannot prevent unethical activity from happening, it can at least detect it before it is too late. The main reason behind corporate governance scandals is the corruption within organisations. Also an issue was the absence of shareholders' involvement which has been emphasized in the reforms. Governance is an important issue which affects the business world and will continue play an important role in the future. It is more than just enforcing power and legislation; it is about effectively managing a corporation with the cooperation and mutual involvement of its members to ensure fair and efficient operations  . So maybe what is necessary is to keep this 'soft' law policy with no over-regulation but insert more sanctions available for misconduct.