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Over the past decade, the governance of companies has attracted much attention. Following a number of high profile corporate collapses, such as HIH insurance and One.Tel in Australia, and Enron and WorldCom in the United States (US), a number of regulatory changes aimed at improving corporate governance have been implemented. In the US, the Sarbanes-Oxley Act 2002 (SOX), also known as the Public Company Accounting Reform and Investor Protection Act 2002, regulates boardroom accountability and provides the Securities and Exchange Commission with an enhanced policing role in corporate governance matters (De Nicolo, Laeven and Ueda 2008; Dignam 2007). While SOX introduced formal regulation, many other countries chose to adopt a more flexible approach by way of formal guidelines or recommendations based on the 'comply or explain' principle. The German Corporate Governance Code and the Swiss Code of Best Practice are two examples. In Australia, two major corporate governance reforms were implemented: the Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Act 2004 and the Australian Securities Exchange (ASX) Corporate Governance Council's Principles of Good Corporate Governance and Best Practice Recommendations (ASX Corporate Governance Principles).
Definition of Corporate Governance
The most common definition which can be found in the Australian community is the one provided by the ASX council which reads as follows:
'Corporate governance is 'the framework of rules, relationships, systems and processes within and by which authority is exercised and controlled in corporations'. It encompasses the mechanisms by which companies, and those in control, are held to account.'
This is quite different from the wording provided by the Organization for Economic Cooperation and Development (OECD) which views Corporate Governance as a set of relationships between a company's management, its board, its shareholders and other stakeholders. However, it fundamentally means the same thing. Corporate governance in essence influences how the objectives of the company are set and achieved. It also directs how risk is monitored and assessed, and how performance is optimized both in the short and long term. Effective corporate governance structures thusly encourage companies to create value, through entrepreneurialism, innovation, development and exploration, and provide accountability and control systems commensurate with the risks involved. As owners of the company, the shareholders elect the directors to oversee the operation and performance of the business on their behalf. The directors are accountable to the body of shareholders that elect them (Tirole, 2006) and this represents the concept of fiduciary responsibility of company directors towards the owners of the company. More recently, investors are increasingly demanding from companies that investments have regard to ESG (Environmental, Social and Governance) factors. Good corporate governance should facilitate effective monitoring and provide proper incentives for the board and management to follow objectives that are in the interests of the company and its shareholders (OECD, 2004).
Timeline for CG Reforms in Australia
The following depicts a small resume of all the major events in the Australian CG environment. It is by no means exhaustive but nevertheless encompasses the key turning point in the history of the country:
Corporate Law Economic Reform Program
The Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Act 2004 (the CLERP 9 Act) legislated certain governance requirements for Australian companies. Amendments were made to the Corporations Act 2001 in four key areas: executive remuneration; financial reporting; continuous disclosure; and shareholder participation (CLERP 9 2007). As stated in the explanatory memorandum to the CLERP 9 Bill, the objective underlying these amendments was to: 'improve the operation of the market by promoting transparency, accountability and shareholder activism' (Brown & G'rgens, 2009). A range of provisions designed to encourage shareholder participation and improve compliance with the continuous disclosure regime were also introduced. These amendments strengthened the continuous disclosure regime by imposing personal liability on individual responsibility for a failure to disclose; and also by giving ASIC the power to issue infringement notices (Clarke et al. 2007; CLERP 9 2002). A few years later, the ASX Corporate Governance Council was formed and provided a streamlined and refined guidelines/recommendations for companies to adopt.
The ASX Corporate Governance Council
The ASX Corporate Governance Council was formed in August 2002 as a central reference point for companies to understand stakeholder expectations and to promote and maintain investor confidence. It has been chaired by the Australian Securities Exchange (ASX) since its inception. The Council is a remarkably diverse body, bringing together 21 businesses, investment and shareholder groups. Its ongoing mission is to ensure that the principles-based framework it developed for corporate governance continues to be a practical guide for listed companies, their investors and the wider Australian community. Its purpose was and remains to develop Principles and Recommendations which reflect international good practice. The Council's diverse range of voices is one of its strengths. Its striving for consensus is consistent with maintaining balance in regulatory and reporting affairs. The ASX Corporate Governance Council includes representatives of various parties .
'If not ' why not' Approach
The Recommendations what the name suggests: recommendations. That is, they are not to be regarded as iron-clad rules or LAW which are enforceable. They are guidelines, designed to produce an outcome that is effective and of high quality and integrity. These recommendations are suggestions for practices designed to optimize corporate performance and accountability in the interests of shareholders and the broader economy. If any one company considers that a Recommendation is inappropriate to its particular circumstances, it has the flexibility not to adopt it ' a flexibility tempered by the requirement to explain the reasons behind not adopting the same ' the 'if not, why not' approach. However, there is an exception regarding audit committees . It applies to companies comprising the S&P All Ordinaries Index. The ASX Listing Rules mandate the establishment of audit committees by those companies and require that the composition, operation and responsibility of the audit committee of companies in the top 300 of that Index comply with the Council's Recommendations. Top 300 companies is a reference made in Listing Rule 12.7 to the Top 300 companies listed in the S&P All Ordinaries Index at the beginning of the company's financial year. The proposed amendments are likely to come into effect at the end of 2007. The ASX Corporate Governance Council encourages companies to use the guidance provided by this document as a focus for re-examining their corporate governance practices and to determine whether and to what extent the company may benefit from a change in approach, having regard to the company's particular circumstances. The ASX Corporate Governance Council supports companies seeking to meet the 'spirit' of the Principles through whatever means they believe are most appropriate to their business. Nothing in the Principles and Recommendations precludes a company from following an alternative practice to that set out in a particular Recommendation, provided it explains its approach. This explanation of the alternative approach is the essence of 'if not, why not' reporting. The ASX Corporate Governance Council considers that a well-reasoned 'if not, why not' explanation from a company is a valid response to a particular Recommendation. Effective 'if not, why not' reporting practices involve:
' identifying the Recommendations the company has not followed
' explaining why the company has not followed the relevant Recommendation
' explaining how its practices accord with the 'spirit' of the relevant Principle, that the company understands the relevant issues and has considered the impact of its alternative approach.
The ASX Corporate Governance Council considers the 'if not, why not' reporting platform offers Australian companies a robust and flexible structure for governance disclosure and balances the genuine governance interests of public capital markets. The ASX Corporate Governance Council encourages companies to make use of the 'if not, why not' approach, and other market participants to support this approach.
Under ASX Listing Rule 4.10.3, companies are required to provide a statement in their annual report disclosing the extent to which they have followed the Recommendations in the reporting period. Where companies have not followed all the Recommendations, they must identify the Recommendations that have not been followed and give reasons for not following them. Annual reporting does not diminish the company's obligation to provide disclosure under ASX Listing Rule 3.1. It is only where a Recommendation is not followed or where a disclosure requirement is specifically identified that a disclosure obligation is triggered. Each Recommendation is clearly identified as a disclosure obligation and the disclosure obligation is contained in the Guide to reporting at the end of each Principle. The Commentary that follows each Recommendation does not form part of the Recommendation and does not trigger a disclosure obligation. It is provided to assist companies to understand the reasoning for the Recommendation, highlight factors which may be relevant to consider, and make suggestions as to how to implement the Recommendation. The Guide to reporting which follows each Principle sets out what and where disclosure is required. In some cases the company is required to set out the relevant disclosure in a separate corporate governance statement in its annual report. Where the Corporations Act requires particular information to be included in the directors' report, the company has the discretion to include a cross-reference to the relevant information in the corporate governance section of the annual report rather than duplicating the information. For more general information, there are requirements to make information publicly available, ideally on the company website. This information should be clearly presented in a separate corporate governance information section of the website. The corporate governance statement in the annual report should contain references or links or instructions to navigate the website to enable shareholders to gain access to this information readily.
The change in the reporting requirement applies to the company's first financial year commencing on or after 1 January 2008. Accordingly, where a company's financial year begins on 1 January, disclosure will be required in relation to the financial year 1 January 2008 ' 31 December 2008 and will be made in the annual report published in 2009. Where a company's financial year begins on 1 July, disclosure will be required in relation to the financial year 1 July 2008 ' 30 June 2009 and will be made in the annual report published in 2009. Companies are encouraged by the ASX CG Council to make an early transition to the revised Principles and Recommendations and companies are requested to consider reporting by reference to the Principles and Recommendations in their corporate reporting for the 2007' 2008 year.
The Principles and Recommendations
Please see Appendix 2 for the complete list of Principles and associated recommendations as provided by the ASX CG Council. The principles can be organized into three types: structural principles, behavioral principles and disclosure principles.
The structural principles assume that corporate governance mechanisms matter for the performance of the firm and the achievement of the firm's goals. These principles dictate the ideal composition of the board of directors and separation of roles on the board, for the existence and structure of board committees and the operation of annual general meetings. The underlying assumption that governance structures matter for firm performance has been dismissed by most financial economists (for example, Bhagat and Black, 1998). The weight of empirical evidence shows that board structure (such as a majority of independent non-executive directors) and/or that separation of board roles (such as between the chair and CEO positions) is unrelated to better average financial performance, other things being equal. There is, however, evidence that the operation of boards improves around important events (such as poor performance, CEO dismissal) and on certain key decisions-making issues (such as CEO remuneration, auditor appointment) when the board has a majority of independent non-executive directors. The number of non-executive directors in Australia are positively associated with the likelihood of CEO dismissal and negatively associated with excess CEO remuneration (Fleming and Stellios, 2002). Thus, it cannot at least be expected to observe better financial outcomes for equity and debt holders as a result of adopting the principles on structure alone. Behavioral change is also necessary as a matter of fact.
Behavioral principles form the majority of the Council's recommendations. The behavioral approach assumes that adherence to structure in itself (a compliance oriented 'box-ticking') does not necessarily lead to better governance. They are designed to influence the behavior of the management of major listed firms and generate positive spillovers in terms of changes in behavior to all firms. The setting of principles to influence behavior (to achieve compliance in spirit as well as in the letter of the law) draws upon the theory associated with 'expressive law' ' that by expressing a desired behavior one can encourage the occurrence of that behavior (see Cooter, 1998). Firms adopting the new principles will encourage a move to a new set of behavior by management of 'non-adopters'. Thus, a compliance culture is transaction cost minimizing; even more so when non-compliance may require greater resources being devoted to explain the case for opting-out, or lead to falls in the firm's share price as investors exit.
Each of the 8 ASX principles has an associated disclosure principle, which outlines how the firm is to communicate corporate governance information to the stock market. The assumption behind the disclosure principles is that more information is better than less, and the operation of an efficient stock market requires material information to be disclosed in a timely fashion. This is consistent with the operation of the continuous disclosure rules since they were adopted in 1996. It is not the case that all market participants are equal in their ability to comprehend the implications of new information on corporate governance practices for the value of the firm.
Major Corporate Collapses
It doesn't make any doubts nowadays that bad corporate governances were at the heart of major Australian company failures, not unlike familiar global companies like ENRON and Worldcom. HIH Insurance had one of the largest liquidation in Australia's history back in 2001. Major concerns surrounded the breakdown of regulations like unsupervised delegation of authority, under pricing, reserve problems, false reports, reckless management, incompetence, & fraud (The following section will give more insights into this case). That same year saw another colossal collapse: Harris Scarfe, which was a retail & household goods department store. The latter had their assets re-valued above market level to conceal losses. Still in 2001, the 4th largest telecommunications company, One. Tel, falsified its financial information and lured investors spotting unrealistic expectations of returns which eventually led to the downfall of the company shortly after. In 2002, Ansett Australia, an airline for flights both domestic and to Asia observed high costs of operations with a highly overpaid staff and ageing fleet. The company also suffered from maintenance difficulties and increased competition with start-up companies. It went bust shortly after.
HIH as a major Corporate Governance failure
The company was the second largest insurance company in Australia. Because of the collapse, a large number of Australian businesses were left uninsured. The Government was eventually forced to step in with a rescued package for policy holders.
In 1968 the company Payne Liability Agencies Pty Ltd was funded by Ray Williams and Michael Payne. Ray Williams was at the time one of the directors and its Chief Executive Officer. Due to their experience and connections, they soon got the business rolling. In 1971 the company was acquired by the UK listed Company CE Health PLC. Williams secured a seat on the UK Parent company's board. In a turn of event in 1992, the parent company decided to dispose of the Australian firm. Williams used his influence to ensure that his two most trusted executives along with himself be allocated 11 % of the shares in the newly listed company, HIH (Health International Holdings). In 1995, Williams went into negotiations with the Swiss giant insurance company Winterthur. There were already concerns then in that the company was run for the benefit of the executives instead of the shareholders. This was in direct breach of the nowadays corporate governance fundamental rule in which directors have a fiduciary responsibility towards the owners of the company. Winterthur ended up controlling 51% of HIH but chose not to exercise control and remained minority on the board. Eventually the Swiss giant decided to sell its shares and Williams acquired control over 10% block of shares. The latter expanded the Australian business by purchasing another listed company FAI without conducting any due diligence exercise. By the time of the collapse in 2001, the total losses amounted between AU$ 3,5 billion and AU$ 5,3 billion. Williams used HIH insurance policies to cover the his high risk personal investments and those of his fellow trusted executives. There were fundamentally no differences between his own personal funds and the company's funds.
In this case, the Federal Government had the power to legislate and the Corporation Act of 2001 was the prime piece of legislation. Assisting legislations of that time were the CLERP of 1991 and ASIC: compliance with the CA. The Federal Government announced that a Royal Commission was required to conduct a review of the collapse. In terms of Agency problems, the controlling block of shares combined with executive power was the major concern. HIH was also found to suffer from poor management skills and lack of accountability from the directors. The stock 'blockholders' were exercising executive control over large listed companies. In 2003: Australian Securities and Investment Commission filed criminal charges against former officers of FAI (reinsurance contracts). The latter helped FAI show a pre-tax operating profit instead of a significant loss. The New South Wales Court of Appeal upheld civil charges and penalties against Ray Williams for breaching his duty as director. The latter had to pay a compensation of USD 5.4 million and he was eventually jailed and banned to act as director for 10 years.
Support for Australia's approach is reflected in the continued high level of reporting against the Council's Principles and Recommendations by the more than 2,000 entities listed on ASX. Overall reporting levels of corporate governance practice ' the aggregate of adoption of recommended practices and of 'if not, why not' reporting ' have risen in each of the three years the Principles and Recommendations have been in operation prior to this revision. This is good news for investors. The more transparent listed entities are about their corporate governance practices, the better placed investors will be to make informed investment decisions.
The revised document of 2007 however cannot be the final word. The ASX CG Council offered it as guidance and will be most probably reviewed again to reflect the ongoing changing environment related to the business world, and to ascertain better practices towards corporate governance. Nor is it the only word. Good corporate governance practice is not restricted to adopting the Council's Recommendations. The arrangements of many entities differ from the Recommendations but amount equally to good practice. What matters is disclosing those arrangements and explaining the governance practices considered appropriate to an individual company's circumstance. The thread that runs through each of the Principles and Recommendations is invariably linked to the preservation of investor confidence. The wording can change, as necessary, from time to time, but that underlining theme will remain.
Corporate governance reforms such as those provided by the Principles of the ASX Corporate Governance Council are welcome additions to the rules and regulations that form the legal boundaries to firm behavior. But the important policy implication is that management of firms should not be expected to alter governance structures and behavior overnight. Such an expectation is unrealistic given that structural change in itself will not lead to better outcomes for shareholders, debt holders or other stakeholders of the firm. Behavioral change is a longer term process. One unfortunate side-effect of the focus on corporate governance is that market participants (such as large institutional investors) and policy makers are calling for a faster response to the apparent failures.
Appendix 1: Representatives of the ASX Corporate Governance Council
Association of Superannuation Funds of Australia Ltd
' Australasian Investor Relations Association
' Australian Council of Superannuation Investors
' Australian Financial Markets Association
' Australian Institute of Company Directors
' Australian Institute of Superannuation Trustees
' Australian Securities Exchange
' Australian Shareholders' Association
' Business Council of Australia
' Chartered Secretaries Australia
' CPA Australia Ltd
' Financial Services Institute of Australasia
' Group of 100
' Institute of Actuaries of Australia
' The Institute of Chartered Accountants in Australia
' Institute of Internal Auditors Australia
' Investment and Financial Services Association
' Law Council of Australia
' National Institute of Accountants
' Property Council of Australia
' Securities & Derivatives Industry Association
Appendix 2: the principles and Recommendations
Principle 1 Lay solid foundations for management and oversight
'Companies should establish and disclose the respective roles and responsibilities of board and management.'
Recommendation 1.1 Companies should establish the functions reserved to the board and those delegated to senior executives and disclose those functions.
Recommendation 1.2 Companies should disclose the process for evaluating the performance of senior executives.
Recommendation 1.3 Companies should provide the information indicated in the Guide to reporting on Principle 1
Principle 2 Structure the board to add value
'Companies should have a board of an effective composition, size and commitment to adequately discharge its responsibilities and duties.'
Recommendation 2.1 A majority of the board should be independent directors.
Recommendation 2.2 The chair should be an independent director.
Recommendation 2.3 The roles of chair and chief executive officer should not be exercised by the same individual.
Recommendation 2.4 The board should establish a nomination committee.
Recommendation 2.5 Companies should disclose the process for evaluating the performance of the board, its committees and individual directors.
Recommendation 2.6 Companies should provide the information indicated in the Guide to reporting on Principle 2.
Principle 3 Promote ethical and responsible decision-making
'Companies should actively promote ethical and responsible decision-making.'
Recommendation 3.1 Companies should establish a code of conduct and disclose the code or a summary of the code as to:
' the practices necessary to maintain confidence in the company's integrity
' the practices necessary to take into account their legal obligations and the reasonable expectations of their stakeholders
' the responsibility and accountability of individuals for reporting and investigating reports of unethical practices.
Recommendation 3.2 Companies should establish a policy concerning trading in company securities by directors, senior executives and employees, and disclose the policy or a summary of that policy.
Recommendation 3.3 Companies should provide the information indicated in the Guide to reporting on Principle 3.
Principle 4 Safeguard integrity in financial reporting
'Companies should have a structure to independently verify and safeguard the integrity of their financial reporting.'
Recommendation 4.1 The board should establish an audit committee.
Recommendation 4.2 The audit committee should be structured so that it:
' consists only of non-executive directors
' consists of a majority of independent directors
' is chaired by an independent chair, who is not chair of the board
' has at least three members.
Recommendation 4.3 The audit committee should have a formal charter.
Recommendation 4.4 Companies should provide the information indicated in the Guide to reporting on Principle 4.
Principle 5 Make timely and balanced disclosure
'Companies should promote timely and balanced disclosure of all material matters concerning the company.'
Recommendation 5.1 Companies should establish written policies designed to ensure compliance with ASX Listing Rule disclosure requirements and to ensure accountability at a senior executive level for that compliance and disclose those policies or a summary of those policies.
Recommendation 5.2 Companies should provide the information indicated in the Guide to reporting on Principle 5.
Principle 6 Respect the rights of shareholders
'Companies should respect the rights of shareholders and facilitate the effective exercise of those rights.'
Recommendation 6.1 Companies should design a communications policy for promoting effective communication with shareholders and encouraging their participation at general meetings and disclose their policy or a summary of that policy.
Companies should provide the information indicated in the Guide to reporting on Principle 6.
Principle 7 Recognise and manage risk
'Companies should establish a sound system of risk oversight and management and internal control.'
Companies should establish policies for the oversight and management of material business risks and disclose a summary of those policies.
The board should require management to design and implement the risk management and internal control system to manage the company's material business risks and report to it on whether those risks are being managed effectively. The board should disclose that management has reported to it as to the effectiveness of the company's management of its material business risks.
The board should disclose whether it has received assurance from the chief executive officer (or equivalent) and the chief financial officer (or equivalent) that the declaration provided in accordance with section 295A of the Corporations Act is founded on a sound system of risk management and internal control and that the system is operating effectively in all material respects in relation to financial reporting risks.
Companies should provide the information indicated in the Guide to reporting on Principle 7.
Principle 8 Remunerate fairly and responsibly
'Companies should ensure that the level and composition of remuneration is sufficient and reasonable and that its relationship to performance is clear.'
Recommendation 8.1 The board should establish a remuneration committee.
Recommendation 8.2 Companies should clearly distinguish the structure of non-executive directors' remuneration from that of executive directors and senior executives.
Recommendation 8.3 Companies should provide the information indicated in the Guide to reporting on Principle 8.