The basics of Corporate Governance - YouTube

Let's have a look at corporate governance.

Why we need it?

What exactly it is?

And what constitutes best practice?

Corporate governance is required because of a divorce between ownership and control.

Shareholders own a business and they have their own objectives.

What they would like the directors to do in the business is to work to ensure that their

own objectives are met, to make sure the shareholders objectives are met.

But, directors have their own objectives too.

And they may on occasion differ from what the shareholders want.

So, for example if the directors are being paid a bonus based on profits produced for

this year, it's no surprise that directors will work hard to produce profits for this

year.

That's not necessarily the same as producing long term shareholder wealth.

I could increase my profits this year by cutting back on training, by cutting back on research

and development, by cutting corners.

And I would make a profit this year and a bonus but it wouldn't necessarily be good

for the business.

So, what corporate governance does is seek to try and ensure that the directors behave

in such a way as to insure the shareholders objectives are met.

Now, corporate governance is fairly big picture, is to do with the structure of the board,

the roles of the directors on the board and the subcommittee's on that board and how the

board works basically, internal controls and trickles down from there.

So, once you've got the governance structures right in the first place, internal controls

then follows.

So, corporate governance is the method by which organizations are directed and controlled.

Is to do the board structure composition and roles.

Now, starting off with board structure, there are various alternatives around the world

for ways in which corporate governance structures are decided upon at a senior level.

At some jurisdictions have what's known as a multi tier system, where they'll have a

supervisory board?

Which is the senior board on which non-executive directors sit?

So, everyone on that board has no executive responsibilities within the business, no operational

responsibilities.

And reporting into that supervisory board, we have a management board and this is where

all the executives sit.

They are the people that have operational responsibilities in the business.

So, your head of Finance, your head of HR, your head of IT will sit on the management

board and report up to the supervisory board.

Keeping those two separate has lots of advantages.

It means that you get, the supervisory board are not in any way encumbered or threatened

potentially by the executive directors being in the same meeting.

But it does mean that you have lots of separate meetings going on and you don't have all the

brains in the room at the same time when you're making key decisions.

So, it's also a relatively expensive way to set it up because of all the meetings and

the communication that's required between the two boards.

The much more usual approach is for to have a unitary board structure, which just means

the organization has one board.

And on that board there are the executive directors and the executive directors of people

with operational responsibilities in the business and the non-executive directors, the people

are there purely to ensure the business is being run on behalf of the shareholders.

We're going to focus most of our attention on the unitary board that side of things because

it is most common in the real world.

Now, corporate governance as a regulatory sort of environment can take one of two forms.

We can either have a rules based approach and a rules based approach is where you have

typically some legislation like in the USA we have the Sarbanes-Oxley Act, sometimes

shortened to SAR box.

And that's a legal requirement for companies to follow, the rules laid down in the Sarbanes-Oxley

Act.

And if you don't comply with the requirements of that act, then there are legal consequences,

you can be taken to court, you could potentially be sent to prison.

That is relatively rare; it's a relatively sort of strict legally enforceable regime.

The usual approach is to go for a more principles based approach, which is a little bit more

flexible in its application.

One of the issues the rules-based approach is that it's very difficult to come up with

rules that suit every single set of circumstances.

So with the principles based approach, you lay out best practice principles that can

be applied flexibly in different term, in different circumstances.

So, the principles based approach is outlined best practice and we'll come on to what that

best practice generally is in a minute.

And it's normally required to be implemented on what's known as a complier explained basis.

This is slightly different from saying it's a voluntary code just because it's best practice.

So, for example, in the UK, if you're a listed business, listed company on the stock exchange

then by virtue of being listed, you agree to apply the UK code on corporate governance

on a complier explained basis.

Which means, you need to state in your financial statements whether you fully comply with that

code or if you don't, the way in which you don't and why you don't?

And provided, you've disclosed the way in which you don't comply then you're covered

as far as the listing rules are concerned.

And that means then the investors have all the information they need to then help them

decide whether or not they're happy with your lack of compliance.

And sort of in the background here is the thought that there could be a perfectly good

reason why you don't or can't comply with one elements of the corporate governance code.

And it's up to then the investors to decide whether or not they're happy with that.

One of the advantages it's often quoted for the principles based approach is that the

judgments are being made by the owners of the business here, the investors, as opposed

to a rules based approach where judgment is being made by the courts.

So, it's not voluntary.

It's best practice.

It's not voluntary, if you're a listed business.

So, you need to apply it on a complier explained basis.

Now, as far as international rules are concerned with corporate governance, generally speaking

corporate governance is a very jurisdiction or country specific thing.

But there are codes out there that are espousing general and best practice.

And probably, the best known is the OECD code, which is quite a high-level sort of code that

talks about the rights of shareholders and so on the obligations of directors and the

International Corporate Governance Network, the ICGN, took the OECD framework and made

it much more sort of applicable.

So, it's kind of guidance notes to help people understand how to apply the principles in

their own businesses.

So, the ICGN report is really the best we have for international best practice as far

as corporate governance is concerned.

That said, that its jurisdiction specific.

As you go round the different jurisdictions in principles based approaches, they are all

very similar and there's a lot of things that flow through them all and let's have a look

at what constitutes best practice now.

So, for a unitary board, first of all, we have at least half the board made up of non-executive

directors or Ned's as they're known for short.

These people have no operational responsibilities on the board.

They are typically part-timers, they're usually paid a salary, they're often very experienced

business people and they are there to represent the needs of the shareholder.

And the reason why we say we have at least 50% of the board being Ned's is that it means

it's any decisions cannot be dominated by people with operational responsibilities within

the business.

So, if you get the finance director for example, who is an executive director because he's

also head of finance, dominating decisions they might be sidetracked or compromised by

what's going on in their own department rather than thinking of the business as a whole.

And to try and stop that from happening we have a majority or said we would don't have

a majority of executive directors, we have at least half the people in the room being

non executives and maybe there'll be a majority.

So, the four roles of a non-executive director, you can learn with this list of forwards SSRP,

Strategy Scrutiny Sisk in People.

So, they are there to contribute to the strategy of the business and they are there to scrutinize

the executive directors and to make sure that the decisions the executive directors make

is in the best interests of the shareholders.

Now, they are to ensure that risk management processes are in place and operating.

And on the people side of things, that they're to make sure that the board has the right

number of people on it, the right types of people on it, they've got the right sorts

of roles and that last one, people tends to get sorted out through the various committees

that we'll talk about in a moment.

Another key principle of best practice is that the chair person, who runs the board

and the CEO, the chief executive officer, who is the manager of the executives in the

business should be separate roles, there should be two separate people.

If you have one person doing both those roles, first of all it's a lot of work for one person

to do and you'd have to question whether they can do both roles well.

Secondly, it puts an awful lot of power into one pair of hands which might be a concern

for shareholders and for the business.

And it also means that the chair and the CEO can keep their respective responsibilities

completely apart.

So the chairperson runs the board, the CEO runs the business.

And yes, the two couldn't sort of bounce ideas off each other.

And hopefully, we get better answers as a result.

But keeping the role separate ultimately should mean that the board and the executive function

in the business operates a little bit more independently and a little bit better.

And then, at various board subcommittees, the majority of best practice codes say there

should be three boards subcommittees, the audit committee, the nominating committee,

and the remuneration committee.

The audit committee reviews the financial statements.

It is the clearance point for internal and external audit.

And the reason for that is that the audit committee is made up of typically three non-executive

directors, independent non-executive directors, at least one of which needs to have relevant

and recent financial experience.

So they know what they're, where they're, what they're doing when they're reading a

set of financial statements.

And they are relatively independent which means an internal audit cleared to them, internal

auditor therefore independent and if external audit clear to them, that helps make their

all a little bit easier.

Because you don't want for example external audit to be clear into the finance director,

if the external audit team have got something to say about the way the finance department

is run.

So, they clear internal audit, external audit, review the financial statements.

And then also, if there isn't a separate risk committee, will come on to the risk committee

in a minute.

They'll also take responsibility for ensuring that there is a risk management process in

place and operating.

The nomination committee is to do with who is on the board.

So, nomination naming, so who is named as directors on the on the board and they'll

consider things like the structure of the board, how big it needs to be?

Whether we should have more internally promoted people or bring people in from the outside.

Now, consider issues like diversity and so on and make recommendations for approval.

The remuneration committee looks at how directors are paid.

So, they'll look at things like the proportion of fixed salary to a bonus or performance-related

pay.

If the performance-related pay, they'll make sure it's sufficient to motivate directors

but not so excessive that it causes them to take silly risks, and they'll make sure that

it's structured in such a way as to encourage the directors to work towards the long term

goals of the shareholders.

So they'll set the pay effectively for the executive directors in the business.

It's also becoming increasingly common these days for there to be a fourth committee, the

risk committee to take the responsibility off the audit committee and give risk management

a bit of specific focus.

Now, that's good in many ways.

Not only does it give it specific focus, it also means that we can get some executive

directors involved.

Because remember, the audit committee is made up of non-executive directors.

So, if the audit committee you're looking after risk, then there won't be any executive

directors involved directly in looking after risk.

So, the risk committee gives it a bit of separate consideration to make sure that risk management

is given the profile that it needs and the focus that it needs to operate well within

the business.

So, they're the general sort of principles of best practice that you'll see with corporate

governance.

There are various others, but that's the main ones.

Now, let's cope with governance codes, this is based only on the UK code but this would

be the same for any codes really around the world.

Right, focus on these five areas.

So, they'll look at leadership, so they'll look at the role of the chairman and the role

of the CEO and make sure those roles are separate and how they work and make sure they work

together well, and the effectiveness of the board, so making sure for example that directors

have sufficient time to do their job, they have sufficient information given to them

in sufficient time before meetings to enable them to come to well reasoned decisions and

they ensure accountability of the board and clarify accountability of the different members

of the board, they've got the different subcommittees there but also to clarify that the board of

directors are responsible for the performance and operations of the business as a whole,

to ensure that directors are remunerated in an appropriate way, to encourage them to think

like shareholders and to behave how shareholders would want them to behave.

And also, to ensure they maintain relationships with those shareholders.

So, for example not seeing the annual general meeting as purely legal administrative exercise

but using the AGM as a way to communicate with shareholders and to get shareholders

involved in making key decisions in the business.

It's also increasingly common to identify particular non-executive directors, sometimes

called a senior non-executive director, to give them as a point of contact for shareholders

to contact if they have any questions throughout the year to try and improve relations with

shareholders.

There's a general point to finish on for the exam.

Although, there is a lot of sort of ideas and concepts surrounding corporate governance,

if you imagine being a shareholder and you're employing somebody else to look after your

business for you.

If you think about the kind of things that you would worry about and how you'd make yourself

feel better about those things, those are the control mechanisms you'd put in place.

You usually find that what you're actually doing is describing the corporate governance

code.

So they have they have an underlying logic to them which helps us in exams.

Thanks for listening.