Week 3

Landmarks in the Emergence of

Corporate Governance
 
• Corporate Governance Committees
• World Bank on Corporate Governance
• OECD Principles
• McKinsey Survey of Corporate Governance
• Sarbanes-Oxley Act, 2002
The Committees(UK).
 The Cadbury Committee on Corporate
Governance, 1992
 The Paul Ruthman Committee
 The Greenbury Committee, 1995
 The Hampel Committee 1995
 The Combined code 1998
Events that led to the formation of Cadbury committee

It is important to appreciate the environment

surrounding the establishment of the
Committee.The Committee was appointed in
the aftermath of the “scandalous” collapse of
several prominent UK companies during the
later 1980s and early 1990s, including
Ferranti International PLC, Colorol Group,
Pollypeck International PLC, Bank of Credit
and Commerce International (BCCI) and
Maxwell Communication Corporation
The Cadbury Committee

 The Cadbury Committee was then appointed

by the Conservative Government (Thatcher) of
the United Kingdom (UK) in May 1991 with
a broad mandate to “help raise the standards
of corporate governance and the level of
confidence in Financial reporting and auditing
by setting out clearly what it sees as the
respective responsibilities of those involved
and what it believes is expected of them.”
The committee’s work resulted in the form of a
Code of Best Practices , Which included 19
recommendations pertaining to the following

 The Board of Directors

 The non-executive directors
 The executive directors
 Reporting and controls
1. The Board of directors
 The Board should meet regularly, retain full
and effective control over the company and
monitor the executive management.

 Balance of powered should be ensured. For e.g.

The CEO and the chairman of a company
should, preferably, not be the same person.

 In case of companies where chairman is also

the CEO , there should be a strong and
independent member on the board, who
should be a recognized senior member.
 The board should include Non-executive directors of
sufficient caliber and number, so that their views carry
significant weight in the board's decisions.

 The Board should have a formal schedule of matters

specifically reserved to it for decisions to ensure that the
direction and control of the company is firmly in its hands

 In discharge of their duties the directors should have access

to independent professional advice, if necessary, at the
company’s expense.

 All directors should have access to the company’s secretary,

who is responsible to the board and who ensures that board
procedures are followed and that applicable rules and
regulations are complied with. Only Board can remove the
secretary
2. The Non-executive directors
 Non-executive directors should exercise independent judgment
to bear on issues of strategy, performance, resources, including
key appointments and standards of conduct.

 The majority should be independent of the management and

free from any business or other relationship, which could
materially interfere with the exercise of their independent
judgment. Apart from their fees and shareholding

 Non-executive directors should be independent for specified

terms and reappointment should not be automatic

 Non-executive director should be appointed through a formal

process and their appointment should be a matter for the
board as a whole
3. The Executive directors
 Directors service contracts should not exceed
without shareholders’ approval.
 There should be full and clear disclosure of their

total emoluments and those of the chairman,

including pensions contributions and stock options.
 Separate figures should be given for salary and

performance related elements and the basis on

which performance measured should be explained .
 Executive directors’ pay should be subject to the

recommendations of a remuneration committee

made up wholly of or mainly non-executive
directors.
4. Reporting and Controls
 It is the boards duty to present a balanced and
understandable assessment of the company’s
position
 The board should ensure that an objective and
professional relationship is maintained with the
auditors.
 The board should form an audit committee of at
least three non-executive directors with written
terms of reference, which clearly mentions its
authority and duties.
 The directors should report on the effectiveness
of the company’s system of internal control.
 In 1994, these recommendations were
appended to the Listing Rules of the London
Stock Exchange, and it was stipulated that
companies need not comply with the
principles, but had to explain to the stock
market why not if they did not.
 That was a bit of lax mode of implementation

of the recommendations, probably because

privatization of public sector companies was
underway.
The controversial clause of the
Cadbury Code and The Paul
Ruthman Committee
 The most controversial requirement proposed
by the Cadbury Committee was that “The
directors should report on the effectiveness
of the company’s system of internal control.”
 This went beyond the system of internal

control pertaining to financial matters

 The Paul Ruthman committee rejected this

recommendation on grounds of practicality

and restricted the reporting requirement to
internal financial controls only.
The Greenbury Committee, 1995
Focused on directors remunerations
 Aimed to address general concerns about the

accountability and level of directors’ pay.

 Argued against statutory control and for

strengthening accountability by the proper

allocation of responsibility for determining
directors remuneration.
 Code of best practice in this regard was

produced. The recommendations of which

can be divided into the following sections
 ◦ Remuneration committee
◦ Disclosures
◦ Remuneration Policy
◦ Service Contracts and compensation

 The Hampel Committee 1995

◦ Further developed the Cadbury report
◦ Recommended that
 Auditors should report on internal control to the directors,
but privately.
 The directors should maintain and review all and not just
financial controls
 Companies currently not having internal audit function
should periodically review their need for one.
 Consolidated the recommendations of the previous
committees
The Combined code 1998
 The combined code was derived from Ron
Hampel Committee’s Final Report, Cadbury
report and the Green Burry report.
 It was appended to the listings rules of the

London stock exchange

 Compliance of the code is mandatory for all

listed companies in UK.

The Turnbull Committee, 1999
 Basically gave recommendations on how to
implement the combined code.
◦ It was setup by ICAEW (institute of chartered
accountant of England & Wales) in 1999.
World Bank On Corporate Governance

 Interested because its both an international

bank and an institution involved in equitable
and sustainable economic development
worldwide.
 Was one of the earliest organizations to study
the issue of corporate governance.
 Appreciates the complexity of the concept and
focuses on principles such as
◦ Transparency
◦ Accountability
◦ Fairness & Responsibility
OECD Principles
OECD was one of the earliest organizations to have
worked on and spell out principles and practices that
should govern corporations. These principles are as
much trend setters as were the committees reports.
The corporate governance principles laid out, and
adopted by its member countries, are as follows
 The rights of shareholders: For e.g. voting rights,

disclosure rights ( financial statements) etc

 Equitable treatment of shareholders: Minority

shareholder protection from management directors &

majority shareholders.
 The role of stakeholders in corporate governance
 Disclosure & transparency
 The responsibilities of the Board: overlooking

executive compensation and performance,

risk management.
McKinsey Survey on Corporate
Governance
 McKinsey is International Management
consultant Organization
 Responded to questions like whether there is

any quantifiable connection between good

corporate governance and market valuation
of a company?
 And it responded by conducting a survey
 Survey sample included 188 companies from

6 emerging markets i.e. India, Malaysia,

South Korea, Taiwan and Turkey
 The result showed a positive connection.
 It was established that good corporate

governance increase market value in the

following ways.
◦ Increasing financial performance
◦ Transparency, thereby reducing conflict of interest.
◦ Increasing investor confidence.
The survey rated the performance on corporate
governance on the following parameters.
◦ Accountability: Board size, transparent ownership,
board accountability
◦ Disclosure and transparency of the Board:
Independent directors for e.g.
◦ Shareholder equality: 1 share 1 vote
The survey results are as follows
◦ Companies with good corporate governance
showed high price-book value.
◦ Investors are willing to pay a premium of as much
as 28% for shares of companies which adhere to
best corporate governance practices.
◦ Emerging markets companies often claim that
western standards of corporate governance do not
apply to them. How the study revealed that
investors all over the world , including those from
the emerging markets look for high standards of
good governance.
Sarbanes Oxley Act 2002
 Important provisions contained in the SOX Act
are as follows
◦ Establishment of Public Company Accounting
Oversight Board (PCAOB)
 Will consist 5 members out of which 2 will be certified
public accountants. Or CPAs.
 All accounting firms must register with PCAOB
 Should submit information like the following to PACOB
 Fee received from clients for both audit & non-audit services
 Firms financial information
 Staff details who participates in audits
 Quality control policies
  Information on civil , criminal and disciplinary proceedings
against the firm
 PCAOB will conduct annual inspections of firms that audit
more than 100 public companies and once in three years in
other cases.
 The PCAOB will establish rules governing audit quality control,
independence , ethics and other standards.
 The Board will report to SEC annually. Which will be forwarded
by SEC to congress.
◦ On Audit Committee
 The audit committee of the company will include directors
from the board of directors. However all directors will be
independent
 Will be responsible for appointment, fixing fees and the
oversight of the work of independent auditors
 Responsible for handling audit complaints from affected
parties
 Will review the procedures for receipt, treatment of accounts
and internal control
  Public accounting firms will report to audit committee
on all critical accounting issues , policies and practices

◦ Conflict of Interest:
 A Public accounting firm is not allowed conduct audit
of such publicly traded company(ies) if the CEO, CFO,
Controller, Chief accounting officer or any other officer
of the company was employed by such firm and
participated in the audit of that company during 1 year
period prior to the date of initiation of audit.

◦ Audit Partner rotation:

 Rotation of lead audit or co-ordinating partner and the
partner reviewing audit once every 5 year is a must.
◦ Improper influence on conduct of Audits
 Fraudulent influence, coercion, manipulation or
misleading of any auditor engaged in audit by
executives of the company was made unlawful.

◦ Prohibition of non-audit services:

 Auditors are prohibited from providing non-auditing
services concurrently with audit financial services.
 Non Audit services include:
 Book-keeping
 Financial information system, design and implementation
 Appraisals or valuation services
 Internal audit outsourcing services
 Management functions or human resources
 Brokerage, investment advisor or banking services.
 Legal services or expert services
  Any other service that the board of the company determines
as impermissible according by regulations
 However the board has the power to grant exemptions
 Engagement in providing tax services allowed.

◦ CEOs, CFOs required to affirm financials

 If the financials have to be restated due to material non-
compliance “ as a result of misconduct” of CEO or CFO
then any incentives and bonuses received by such CEO
or CFO shall be returned to the company.
 This applies to equity based compensation received
during the first 12 months of IPO.

◦ Loans to Directors:
 Both US and Foreign companies , with securities traded
in US are prohibited from making or arranging from
third party any type of personal loan to directors.
◦ Attorneys:
 Those dealing with publicly traded companies are
required to report evidence of material violation of law
to the CEO.
 And if the CEO doesn’t respond then to the audit
committee or Board of directors.
◦ Securities analyst
 Brokers and dealers of securities are prohibited from
penalizing an analyst employed by them for producing
any adverse, negative or unfavorable research report
on a public company .
 Disclosures of conflict of any conflict interest must be
made frequently. For e.g. The analyst has investments
or debt in the company he is reporting on.
◦ Penalties:
 CEO or CFO providing a certificate knowing that it does
not meet the criteria stated may be fined upto$1
million
 And /or 10 years imprisonment
 Those doing it willfully can face upto $5 million in
fines and upto 20 years imprisonment.