Chapter 16Governance and social responsibility

Chapter OutlineResponsibility to ALL stakeholder, not just

shareholders

CORPORATE GOVERNANCE CORPORATE SOCIAL RESPONSIBILITY

SEPARATION OF OWNERSHIP AND CONTROL

Mechanisms to improve corporate governance:

- NEDs- Remuneration committee

- Audit committee- Public oversight

STAKEHOLDER NEEDS ANALYSIS

Triple bottom line reporting:

-Financial results- Social performance

- Environment performance

Separation of ownership and control

People who own the company (shareholders) do not control the company (board of directors)e.g. in limited company

Decision-makers do not bear a major share of the wealth effects of their decisions

In a small company, directors are also likely to own all the shares in the company => no separation of ownership and control

In large companies there is likely to be a large number of external shareholders who play no role in the day-to-day running of the company => separation of ownership and control and potential for conflict of interests

Reasons for the separation of ownership and control Specialist management can run the business better

than those who own the business Original shareholders cannot personally contribute

all the capital needed to run the business => external capital from people who are not interested in the day-to-day operations

Win-win situation for both parties; Managers can get on with full-time management of the

business Shareholders are interested in ROI and do not have the

skills, time or inclination to deal with day-to-day matters

Reasons for the separation of ownership and control

Shareholder want safeguards to ensure that managers run the business in the interests of all the stakeholders fairly, not just in the managers’ own interests

=> Agency problem Managers have to act in the best interests of the

company as a whole E.g. directors voting themselves huge salaries, bonus

shares and golden parachutes

Test your understanding

The ‘separation of ownership and control’ refers to the situation where the owners of a company are always different people to the directors of the company.

True or false. Explain.

Other perspectives on governance Stewardship theory

Management of an organisation are the stewards of its assets, charged with their employment and deployment in ways consistent with the overall strategy of the organisation

Agency theory (discussed) Stakeholder theory

More ‘organic’ view of the organisation Development of notion of stewardship, stating that

management has a duty of care, not just to the owners but also to the wider community

Governance principles Minimise risk Ensure adherence to and satisfaction of strategic objectives Fulfil responsibilities to all stakeholders and to minimise potential

conflicts of interest Establish clear accountability Maintain independence of those who scrutinise the behaviour of the

organisation and its senior executives Provide accurate and timely reporting of trustworthy/independent

financial and operational data Encourage more proactive involvement of owners/members in

effective management Promote integrity, that is straightforward dealing and completeness

Meaning of corporate governance Corporate governance is the set of processes and policies by

which a company is directed, administered and controlled. It includes the appropriate role of the board of directors and of the auditors of a company.

Definitions: ‘Corporate governance is the system by which companies

are directed and controlled.’ (Cadbury Report, 1992) ‘Corporate governance involves a set of relationships

between a company’s management, its board, its shareholders and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined.’ (OECD Principles of Corp. Governance, 2004)

Meaning of corporate governance

Key issues Membership of the board of directors – both executive and non-

executive directors (NEDs) Role of the BOD – purely to make money for shareholders or

are there wider responsibilities How directors’ remuneration is decided and disclosed Role of both internal audit and external audit

Driving forces of governance development

Increasing internationalisation and globalisation Differential treatment of domestic and foreign investors Issues concerning financial reporting Characteristics of individual countries Increasing number of high profile corporate scandals

Features of poor corporate governance

Domination by a single individual Lack of involvement of board Lack of adequate control function (lack of internal audit, lack

of adequate technical knowledge) Lack of supervision (lack of segregation of key roles) Lack of independent scrutiny Lack of contact with shareholders Emphasis on short-term profitability Misleading accounts and information

Risks of poor corporate governance

Ultimately making such large losses that bankruptcy becomes inevitable.

The organisation may also be closed down as a result of serious regulatory breaches, for examples misapplying investors’ monies.

Meaning of corporate social responsibility (CSR)

‘CSR is the continuing commitment by business to behave ethically and contribute to economic development while improving the quality of life of the workforce and their families as well as of the local community and society at large.’ (WBCSD, 1998)

CSR refers to the idea that a company should be sensitive to the needs and wants of all of the stakeholders in its business operations, not just the shareholders

Meaning of corporate social responsibility (CSR) The stakeholders of a company are all those who are

influenced by, or can influence, the company’s decisions and actions.

Examples of shareholder groups: Shareholders - Suppliers Directors - Government Other employees - Lenders of funds Customers Community organisation, esp. in local neighbourhood

Sustainable development: companies should make decisions based not only on financial factors, but also on the social and environmental consequences of their actions

Meaning of corporate social responsibility (CSR) WBCSD:

CORPORATE RESPONSIBILITY(SUSTAINABLE DEVELOPMENT)

CORPORATE FINANCIAL

RESPONSIBILITY

CORPORATE ENVIRONMENTAL RESPONSIBILITY

CORPORATE SOCIAL

RESPONSIBILITY

Corporate social responsibility (CSR)

Key issues in the CSR debate: Employee rights, e.g. laws to prohibit ageism and

other discrimination at work Environmental protection, e.g. reducing factory

emissions of poisons and pollutants Supplier relations Community involvement

Importance of CSR to an organisation’s success

Traditional view (losing support): CSR offers no business benefits and destroys

shareholder value by diverting resources away from commercial activity

Companies should operate solely to make money for shareholders and it’s not company’s role to worry about social responsibilities

Companies pay taxes to govt, and it is govt and charities that should are responsible for social matters

Importance of CSR to an organisation’s success Modern view:

Coherent CSR strategy can offer business benefits by enabling a company to:

Monitor changing social expectations Manage operational risks Identify new market opportunities Retain key employees

Alignment of firm’s core values and values of society can lead to better reputation and ensure long-term future

Costs of CSR initiatives should be thought of as an investment in an intangible strategic asset rather than as an expense

Impact of corporate governance and CSR on the organisation

Enhanced performance reporting methods Balanced scorecard Triple bottom line reporting

Balanced scorecard approach

Balanced scorecard approach

Only by succeeding in all 4 perspective can a company flourish in the long-term

Look at: Financial perspective: annual profits, earning per

share Customer perspective: number of complaints

received per month Internal perspective: percentage of units requiring

reworking Innovation perspective: percentage of revenues

from recently-introduced products

Triple bottom line reporting

Expands the reporting framework to include not just financial outcomes but also environmental and social performance

PEOPLE, PLANET, PROFIT

Non-executive directors (NEDs)

Company law refers only to ‘directors’ in general However, 2 types of directors have emerged

Executive directors: involved in the day-to-day execution of management decisions

NEDs: Attend primarily board meetings (and

meetings of board committees) Should be ‘independent’ Oversight role

Non-executive directors (NEDs)

Being independent is similar to auditor independence, such as: Not acting for a prolonged period of time Having enough time to carry out the role properly Having no links to the executives

Non-executive directors (NEDs)

Recommendations: At least half the board (excluding the chairman)

should comprise independent NEDs A smaller company should have at least 2

independent NEDs One of the independent NEDs should be

appointed to be the ‘senior independent director’ – available to be contacted by shareholders who wish to raise matters outside the normal executive channels of communication

Test your understanding

Mrs X retires from the post of finance director at AB plc. The company is keen to retain her experience, so invite her to become a NED of the company.

Can she qualify as an independent non-executive?

Remuneration committees Principle of most codes of corporate governance

that no director should be involved in deciding the level of their own remuneration => remuneration committee with 3 (2 in smaller firms) independent NEDs

Responsible for setting the remuneration of all the executive directors and the chairman, incl. pension rights and any compensation payments

Whole BOD should determine the remuneration of the NEDs, or the board could delegate this responsibility to a committee of the board

Advantages and disadvantages of having a remuneration committee

Advantages: Avoids the agency problem of directors deciding

their own levels of remuneration Leaves the board free to make strategic decisions

about the company’s future

Disadvantages: Danger of ‘you scratch my back, I’ll scratch yours’

(high remuneration for director, high for NEDs) Cost involved in preparing for and holding

committee meetings

Audit committees

INTERNAL AUDITORS

EXTERNAL AUDITORS

AUDIT COMMITTEE

FULL BOARD OF DIRECTORS

Audit committees

Consists of independent NEDs who are responsible for monitoring and reviewing the company’s internal financial controls and the integrity of the financial statements

Acts as an interface between the full board of directors and internal and external auditors

Audit committees Auditors have problem that the people they report to and

liaise with (the board) are often the people whose activities they report on.

Can cause major problems: External auditors become too close to the executive directors External auditors are not comfortable reporting errors,

frauds, etc to the very people who have done them! Internal auditors are not comfortable reporting systems

weaknesses to the very people who designed the systems! Board might have internal auditors to keep up appearance –

but then ensure they don’t come anywhere close to areas with mistakes or frauds

Audit committees

Is a subset of the main board Should comprise at least independent 3 NEDs (2 in smaller

firms), one member must have recent relevant financial experience

Company’s Annual Report should describe the work of the audit committee

Should act as the first point of contact for both internal and external auditors, doing the following:

Audit committees Being available for internal and external auditors Requiring executive directors to attend as necessary Reviewing accounting policies and financial statements as a

whole to ensure that they are appropriate and balanced Reviewing systems of internal controls Agreeing agenda of work for the internal audit dept. Receiving results of internal audit work Shortlisting firms of external auditors when a change is

needed Reviewing independence of external audit firm Considering extent to which external auditors should be

allowed to tender for ‘other services’

Advantages and disadvantages of audit committees

Advantages: Improved independence and overall quality of

internal and external audit functions

Disadvantages: Audit committees add another tier/level to

decision-making by directors => this could slow a company’s activities down

Test your understanding

Why are the members of an audit committee required to be NEDs rather than executive directors?

Nomination committee

To find suitable applicants to fill board vacancies, to oversee the process for board appointments and make recommendations to the board for approval.

Factors to consider: Balance between executives and NED Skills possessed by the board Need for continuity Desirable size of the board Recently diversity of backgrounds of board members

Public oversight of corporate governance

Public is a legitimate stakeholder in a large company and has therefore a ‘right to know’ how such a company is being governed and a right to be involved in the governance process

Publication of Annual Report and Accounts (incl. description of work of audit and remuneration committee)

Growth in power of NEDs Companies discuss future plans with representatives of

various stakeholder groups incl. journalists and local politicians

Corporate GovernanceThe system by which companies are

directed and controlledUK – Combined Code is principles based,

company must ‘comply or explain’USA – Sarbanes Oxley is rules based (i.e.

law) with personal liability of company officers

Stakeholder needs analysis

Can be carried out to bring some structure to the implementation of a CSR programme

Analysis involved doing research to determine: Who are the key stakeholders in the business? What are their needs?

Possible methods Questionnaires Focus groups Direct interviews or interviews with representatives

Stakeholder needs analysis

To some stakeholders, the company owes obligations arising from the law (pay salaries to employees)

Other obligations arise voluntarily due to the company’s commitment to CSR (discuss plans with interested pressure groups before a particular plan is adopted)

Stakeholder needs analysis Example: Stakeholders of 888.com (internet gambling site listed

on London Stock Exchange) operating under licence granted by Govt of Gibraltar: Shareholders (listed thus compliance with rules of exchange

incl. adopting Combined Code on Corporate Governance) Employees (good employer to all staff members) Customers (to offer fair, regulated and secure environment in

which to gamble) Govt (to comply with terms of its licence granted in Gibraltar) The public (sponsoring sports teams to strengthen brand;

also addressing public concerns about negative aspects of gambling, e.g. compulsive gamblers)

Chapter summaryDefinition of corporate

governance

Systems by which companies are directed and controlled

Separation of ownership and control in large companies

means that rules on corporate governance are required to reduce agency problems.

Codes on governance typically refer to:

- NEDs- Remuneration

- Audit committee- Public oversight

Definition of corporate social responsibility

Idea that a company should be sensitive to the needs of all its

stakeholder, not just shareholders.

Possible expanded methods of performance reporting:

- Balanced scorecard (4 perspectives)

- Triple bottom line reporting (People, Planet, Profit)