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Corporate Governance November 2011

Suggested answers and examiner’s comments

Important notice When reading these answers, please note that they are not intended to be viewed as a definitive „model‟ answer, as in many instances there are several possible answers/approaches to a question. These answers indicate a range of appropriate content that could have been provided in answer to the questions. They may be a different length or format to the answers expected from candidates in the examination. Examiner’s general comments Some answers for this examination session were of a high order of excellence, but many candidates did not perform as well. Before looking at the suggested answers to the questions in the November 2011 examination, it may therefore be useful to suggest why some candidates did not achieve a pass standard and how most candidates might have performed better than they did. There seem to be four main reasons for poor performance in the examination. Some of them are unique to Corporate Governance and three of them were commented on in the Suggested Answers and Examiner‟s Comments for the June 2011 examination. (i) To achieve a satisfactory standard in the Corporate Governance examination, it is essential to

study the syllabus topics in some detail and to have some understanding of the nature of the topic. It is difficult to write an answer to a 25 mark question without having some basic knowledge and understanding. Unfortunately, many candidates demonstrated a lack of understanding. Even though they may have studied the subject, they did not appear to have understood fully what they had read. For example, some candidates did not appear to have given much thought to the nature of boards of directors and how they operate, yet the leadership of companies and the effectiveness of boards are core subjects in corporate governance.

(ii) The requirements of each question should be set out clearly. Each question in the November paper was divided into two or more parts, and in most cases each part of the question was in several parts. The questions therefore offered the structure for an answer, but many candidates did not appear to recognise this and did not answer the questions in full.

(iii) The Suggested Answers and Examiner‟s Comments for the June 2011 examination included the observation that: “A number of candidates did not allocate time between the questions as efficiently as they should have done. A few candidates answered only three questions. More candidates made a hasty attempt at a fourth question, but were clearly running out of time. It is very difficult to pass an examination when 25% of the questions have not been answered or have been answered much too hastily.” Exactly the same problem arose in November 2011.

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Some candidates succeeded in spite of what appeared to be a very hasty fourth answer, but not many.

(iv) Problems in „real life‟ corporate governance are often kept hidden from the press, or are reported in the financial press, well out of the notice of most individuals. As a result, many candidates appeared to lack an awareness of some elements of corporate governance. One problem is uncertainty about how relations between shareholders and company boards might „work‟ in practice: some candidates seemed to think that active shareholders are able to „force‟ boards of directors to accept their views. In practice, institutional investors may hold only a small proportion of the shares of large listed companies and it is therefore difficult for any individual institution to bring heavy pressure to bear when they disapprove of the board‟s policies or intentions. Another common problem is a view that the chairman is a „Clint Eastwood‟ type of character, who single-handedly can sort out governance problems. Chairmen are leaders of boards, but not dictators. The comments on Question 1 include the rather naïve views that were provided about corporate social responsibility and the benefits that it may provide for companies.

Candidates who avoided these pitfalls in general performed reasonably well, although there were other common weaknesses that kept marks lower than they might otherwise have been: (i) Some candidates prepared an answer plan before starting to write their answer. This is

commendable, especially when thought has gone into the ideas sketched out in the answer plan. Unfortunately, some answer plans did not contain relevant points – it is essential to answer the question that has been set, not what you would like the question to be about. In some cases, answer plans were very long and would have taken much too long to prepare.

(ii) Another problem is one that has been referred to in feedback on previous examinations. Some candidates show a tendency to present points in a list of very brief bullet points. A comment on the June 2011 examination was: “The presentation of answers in a list of bullet points is perfectly acceptable but the points must be complete. A short note of three of four words is insufficient because it requires the marker to assume or guess at the point that was intended. Candidates are at risk of not earning marks for what are probably valid points but which have not been clearly explained.” This comment applies to the November 2011 examination as well.

(iii) Some candidates appeared to have studied the syllabus at length and were familiar with much of the detail in the syllabus. This is commendable. Unfortunately, other candidates included a large number of factual errors in their answers. Although errors are not marked down, they do not help the candidate to earn points either.

1. Leek Corporation is a global pharmaceuticals company that develops and markets a

range of health drugs and medicines. The board of directors is planning a two-day meeting at a remote location to discuss various issues for which there is insufficient time at normal board meetings. An item on the agenda for the meeting is the company‟s corporate social responsibility (CSR) policy and CSR reporting. Some board members are not fully convinced of the benefits of CSR policies, and believe that the company demonstrates social responsibility sufficiently through the products that it manufactures. Other board members argue that the company should recognise the importance of having a sustainable business and should report regularly on this subject to shareholders and other groups. They argue in favour of introducing triple bottom line reporting, based on the guidelines of the Global Reporting Initiative. They also argue that CSR policies are desirable not only for ethical and public relations reasons, but also for the commercial benefits that they can bring to the company.

As company secretary, you have been asked to write a paper for the board members on CSR, sustainability and CSR reporting. This will be used as a starting point for discussions about these issues at the planned board meeting. Required

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Write a paper for the board that covers the following issues: (a) The implications of CSR policies for corporate governance and the relevance of

CSR policy objectives to the enlightened shareholder and the stakeholder theories of governance.

(5 marks) (b) The potential public relations and commercial benefits for Leek Corporation from

actively pursuing CSR policies. (8 marks) (c) The nature of sustainable business and the purpose, format and content of

reporting on environmental, social and governance issues (ESG reporting). Your paper should end with recommendations to the board about next steps that should be taken to develop CSR policies and ESG reporting for the company.

(12 marks) Suggested answer To: The board of directors From: Company secretary Date: November 2011 Subject: CSR, sustainability and triple bottom line reporting

(a) Introduction: CSR policies and corporate governance CSR policies are directed towards objectives for a range of social and environmental issues. They recognise that the company has obligations not only to its shareholders but also to its employees and other stakeholders and to the preservation of the environment. Traditionally, it has been assumed that the objective of public companies is the maximisation of shareholder wealth and that governance is concerned with the principal-agent relationship between the board of directors and shareholders. By recognising the need for CSR policies, companies (and their boards of directors) accept that this traditional view is inappropriate. CSR policies imply either an enlightened shareholder approach or a stakeholder approach to governance. An enlightened shareholder approach to corporate governance takes as its basic assumption that although the principal aim of a company should be to satisfy the aims of its shareholders, these must be compromised to some extent by satisfying or protecting the expectations of other stakeholders. Alternatively, companies that pursue CSR policies may have a stakeholder approach to corporate governance. With a stakeholder approach, the board of directors recognises the interests and expectations of a number of different stakeholder groups, and pursues policies (including CSR policies) that attempt as far as possible to satisfy these differing (and often conflicting) expectations.

Examiner’s comments In general, this part of the question was answered well, although some candidates provided one or two definitions but did not answer the question. This was the only question which required the answer to be presented in the format of a board paper and a large proportion of the candidates answering the question did present this format, some more professionally than others. A few answers were exceptionally long, and far too long for a question that offered at most five marks.

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(b) Public relations benefits and commercial benefits of CSR policies CSR policies may be adopted for ethical or commercial reasons, or both. The public relations aspect of CSR policies is that companies can try to publicise their CSR-related activities to promote the reputation of the company, particularly with customers, the general public and investors. Some investment institutions are committed to socially-responsible investment policies, and will prefer to invest in companies with a good reputation for social and environmental responsibility. Reputation risk A company may promote its CSR policies in order to develop its reputation. Alternatively, CSR policies could be used to protect or repair a damaged reputation. As an example, the oil company BP announced in 2010 that all cash bonus incentives for its employees in the fourth quarter of the year would be based exclusively on health and safety issues, rather than financial issues, and that the company would be reviewing the basis on which it rewarded employees in the future. This initiative was part of an attempt by the company to restore its damaged reputation following the large oil spillage at its deep water well in the Gulf of Mexico. One aspect of CSR for pharmaceuticals companies such as Leek Corporation should be the safety aspects of the drugs and medicines that it sells. If a new drug is insufficiently tested, and proves to have damaging side effects for its users, the publicity could be potentially damaging for the company. Company policy on strict testing of new products may therefore help to protect it against the risk of negative publicity. Leek Corporation could try to gain public relations benefits from its CSR policies. Public relations may be seen as a cheap form of advertising. However, opportunities to gain favourable publicity may be rare. Potential commercial benefits CSR policies can also deliver significant commercial benefits to some companies. It has been argued that improvements in a company‟s reputation will persuade more customers to buy the company‟s products and services, although there is a lack of conclusive evidence in support of this view. Other commercial benefits are more tangible and measurable, in terms of a reduction in waste in production or in clean-up costs, a reduction in fines and penalties for breaches of regulations, and profits from the development of new environmentally-friendly products. Companies may try to develop products or services that use fewer materials and create less waste in production. Pharmaceuticals companies have high levels of material waste, and policies directed towards waste reduction would create cost savings. The provision of cheap drugs and medicines is an important social issue for developing countries, in order to improve standards of health in the population. A pharmaceuticals company might decide on a policy of offering its medicines at low prices to customers in developing countries. For example, in 2009 GlaxoSmithKline announced a policy of providing cheap drugs to developing countries, and an undertaking to invest a proportion of its profits into spending on hospitals and clinics in those countries. In the short-term, the effect of this policy would be to reduce profits. However, in the longer term the economic growth of developing countries should create expanding markets for the company‟s products, perhaps eventually at full price, and success in selling their drugs to developing countries would help a large pharmaceuticals company to compete against the providers of cheaper generic drugs. For some companies, CSR policies may be necessary for long-term survival, as „traditional‟ raw materials become scarcer and so more expensive. In industries such as pharmaceuticals, CSR

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policies to develop safer products may also help the industry to defer or avoid even stricter legislation and regulation, for which compliance could be costly. It may be argued that a company with CSR policies is more likely to attract long-term investment in its shares from institutional investors with socially responsible investment policies. If so, these investors may become long-term shareholders, and this may help to maintain or support the company‟s share price. In some cases, CSR policies may benefit a pharmaceuticals company by attracting employees with talent. Talented employees are more likely to be innovative or entrepreneurial, or to demonstrate other capabilities that might help to improve the company‟s performance. An example of this was the decision by pharmaceuticals company Merck in the 1990s to begin a policy of giving away free, to anyone who wanted it, a drug that cures river blindness, a common affliction in West Africa. At the time Merck justified the decision in terms of its effect in attracting talented employees who would want to work for an ethical drugs company. Commercial benefits, rather than ethical or PR motives, are likely to be the strongest motivator for companies to pursue enlightened CSR policies since the interests of society, the environment and profitability are satisfied simultaneously. A company can take a leadership position in its markets by differentiating its products through CSR: this should be an important consideration in driving the board‟s policy on CSR. The board should also be aware that developing CSR policies and pursuing CSR objectives will create commercial opportunities in the future, and will contribute to the longer-term development of the company. Examiner’s comments The weakest answers to part (b) were those that lacked realism. Far too many candidates made the assumption in answers that CSR policies would make customers extremely loyal and would increase sales demand and give the company a competitive advantage. It may be useful to consider whether you feel loyal to a particular pharmaceuticals company because of its CSR policies. Probably most of us don‟t so is it realistic to suggest in the exam that consumers value these policies in this way?. (c) Sustainable business and ESG reporting Sustainable business for an organisation is business that enables the organisation to succeed and survive, without compromising the interests of future generations. A sustainable business must therefore be profitable, because without profits it cannot survive. However, the business must also be capable of continued existence into the future, without the risk of coming to an end for either social or environmental reasons. The purpose of ESG reporting is to provide transparent disclosures about the company‟s policies and targets for achieving sustainability and its progress towards the achievement of those targets. There are several aspects to sustainability: economic, environmental and social, and ESG reporting provides disclosures about each of these aspects of performance. In addition, it should provide information about governance of the company. A company‟s annual financial statements provide much of the economic information that is relevant to sustainability (profits, financial position, cash flows and so on), and these economic aspects of performance need not be repeated in ESG reporting. Unlike financial statements, there are no standard formats for ESG reporting. This is because the key factors for sustainability vary widely between companies, due to differences in the nature of their businesses. However, users of reports on ESG issues make comparisons between different companies; therefore, some similarities in reporting are desirable. The Global Reporting Initiative (GRI) guidelines for sustainability reporting provide a common basis for reporting that makes comparisons and benchmarking more practicable.

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For each area of performance (economic, environmental, social, governance), a company should identify those aspects that are key to the sustainability of the business. The GRI guidelines provide aspects of performance that might be „key‟ for a company, and suggest key performance indicators for each aspect that might be used for reporting purposes. Performance might be measured either qualitatively or quantitatively. Quantitative measures are probably preferable, but are not essential and might not be practicable. Qualitative measures should be capable of verification, so that companies are able to demonstrate success (or failure) in performance. Reports may also state targets as well as actual performance, and compare achievements to date with targets. For example, a pharmaceuticals company may decide that reducing waste in production is a key factor for long-term financial success and also sustainability of the environment. It might therefore set as a target a reduction in waste materials (or an increase in recycled materials) as a percentage of the total amount of materials used, by a given date in the future. A sustainability report can then show both actual performance and also progress towards the target. Social reporting might focus on aspects of performance relating to employee policy, community policy, or human rights. For example, many CSR reports provide information about company policy on matters such as employee training and development, providing equal opportunities, and its anti-discrimination and diversity policies. They may also cover issues such as working conditions, health and safety at work, and whistleblowing policies. Recommendation The board should consider developing CSR policies and providing information to its stakeholders about the application of those policies. The board might decide to create a CSR committee to consider these issues and report back to the board. An issue that the committee should consider would be the content of CSR policies for the company, including objectives for each policy and key performance indicators for setting targets and monitoring performance. The committee may also wish to consider risk issues in CSR policies, including the risks of failing to establish policies or achieve policy targets. It is also recommended that the committee should give consideration to sustainability of the company‟s business, and also to the potential commercial benefits from some of the CSR policies the company might adopt. The committee should also make recommendations about how the company should report on its CSR policies and performance. A voluntary annual CSR report might be appropriate, but the committee should consider the content of such a report, and systems that would need to be introduced by management for monitoring and measuring progress towards policy objectives. It would also need to consider how this report would add to the information provided by disclosures in its annual report and accounts. Consideration should also be given for further assurance systems and reporting by auditors who offer CSR and sustainability assurance services. Examiner’s comments Some answers to this question confused ESG reporting with CSR policies. Part (c) was about reporting, not about CSR policies themselves. This part of the question had many different elements. It asked about: (i) the nature of sustainable business, (ii) the purpose, (iii) the format and (iv) the content of reporting on ESG issues, (v) recommendations about the next steps to develop CSR policies, and (vi) ESG reporting. With so many elements to the question, fairly short comments would have been sufficient. However, many candidates did not answer all these elements. Some answers also confused ESG with triple bottom line reporting (SEE).

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2. Potter Company is a well-established retailing company. It is a UK listed company and is included in the FTSE 350. In compliance with the requirements of the UK Corporate Governance Code, it recently conducted an annual performance review of the board, its committees and its directors, with the assistance of external consultants. Acting on the findings and recommendations of the consultants, the board chairman has arranged a meeting with the chairman of the nomination committee and you, as company secretary. At this meeting, he reveals that the consultants were very critical of the board as a whole and the nomination committee in particular, because of a lack of succession planning and a failure to review the size and composition of the board.

There are ten directors on the board: the chairman, four other non-executive directors and five executive directors, including the Chief Executive Officer (CEO) and finance director. All four non-executive directors, excluding the chairman, are considered to be independent, and the chairman was considered independent when he was first appointed. There have been no changes to the board during the past four years. The board chairman, Mike Berry („Mike‟), reveals at the meeting that he is considering retirement in one year‟s time, and before he leaves the company he wants to make sure that he will leave behind a strong and effective board of directors. However, he is aware that the CEO wants to be appointed as the next chairman of the company. This is something Mike has decided to strongly oppose, even if it results in the CEO leaving the company if he is refused the appointment. Mike asks the chairman of the nomination committee to call a meeting of the committee to review succession planning and the size and composition of the board. He suggests that you, as company secretary, may be able to offer assistance and advice on these matters. Required (a) Recommend measures that should be taken by the nomination committee to

establish succession planning for the senior positions on the board. (10 marks)

Suggested answer Succession planning for a board of directors is planning for the eventual replacement of board members, and it is particularly important that there should be long-term succession planning for the most important board positions, particularly the positions of board chairman, CEO and finance director. Succession planning is necessary to ensure that the board remains effective. The chairman intends to retire in one year‟s time, but the external consultants have criticised the board and the nomination committee for a lack of succession planning, suggesting that nothing has yet been done. The nomination committee should begin a process of identifying a potential new chairman who would be acceptable to the board, the shareholders and the investment community in general. The UK Corporate Governance Code („the UK Code‟) states that the board chairman should be independent on first appointment. This means that the chairman is free from any material relationships with the company and it may be appropriate to make the appointment from the existing pool of independent non-executive directors (NEDs) or as an external appointee. A current employee (such as the CEO) would not be considered independent. Some companies do not comply with this provision of the UK Code and instead explain their non-compliance in the report and accounts. Since the chairman may be appointed from outside the company, the nomination committee should initiate a search. To do this it may appoint a firm of head-hunters, whose task would be to identify a small number of potential candidates for consideration. (The nomination committee might advertise the position or might conduct its own private search. If it does not use external consultants or advertising, it must explain its reasons.) Alternatively, the nomination committee

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may consider the appointment of an existing independent NED as successor to the chairmanship, if a suitable candidate exists who is able to take on the role. A new chairman should be acceptable to the shareholders as well as to the board. Choosing a new chairman is a very sensitive issue for a public company, but the nomination committee chairman should seek the opinions of shareholders about the type of person the board should be seeking to appoint, without discussing specific individuals. Potter Company is a retailing company and a suitable candidate for the chairmanship may be an individual with experience with a large company in the retailing industry or other customer-focused industry. It would also be beneficial if the person appointed has had experience in the past of running a large organisation. When the nomination committee eventually identifies a preferred candidate, who would be willing to accept the position of chairman, it should make a recommendation to the board. The board has the power to appoint a chairman from outside the company, although the person appointed should subsequently seek election as a director by the shareholders at the next AGM. If a suitable candidate is identified fairly quickly, the board may consider appointing the individual as deputy chairman until the current chairman retires, and provide suitable induction in the next year so that he is better prepared to take on the position when the time eventually comes. The nomination committee should also consider succession planning for other positions on the board. There is a risk that if the CEO is not appointed as the new chairman, he might resign from the company. His successor may be appointed from inside or outside the company, and the nomination committee may use a firm of head-hunters to carry out a search, and also consider the merits of existing executive directors. There is a risk that when internal candidates apply for the position of CEO and are not successful, they often leave the company shortly afterwards. The company may therefore lose one or more executive directors, as well as the CEO, as a consequence of the chairman‟s retirement. The nomination committee needs to plan for this eventuality and have a workable succession plan in place. The nomination committee may consider the need to give priority to some issues before others. The chairman plans to retire within a year, and the search for a successor should be the most urgent consideration. Given the risk that the CEO may resign at about the same time, equal priority should be given to considering potential successor for this position too. The size and composition of the board should also be addressed, but this matter is probably less urgent. Examiner’s comments A large number of answers mixed up points that were relevant to part (a) with points that were relevant to part (b), and these answers were marked as a single one-part answer. Comments on both parts of the question are given at the end of the suggested answer to part (b). (b) Describe proposals that might be recommended to the board by the nomination

committee for changing or refreshing the composition of the board of directors and reviewing the size of the board.

(15 marks)

Suggested answer At the moment Potter Company, as a UK listed company in the FTSE 350, is not compliant with the provision of the UK Code that at least one half of the board, excluding the chairman, should consist of independent NEDs. To comply with the UK Code, there should be an additional independent NED, or one of the executive directors should resign from the board. The committee should review the balance on the board between executive directors and NEDs, and may recommend that a there should be a larger proportion than 50% of NEDs on the board.

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The UK Code also states that the board should be of sufficient size that the needs of the business can be met and that changes to the membership of the board and its committees can be managed without undue disruption. However, the board should not be so large as to be unwieldy. The nomination committee should review the size of the board, with reference to any comments in the report of the external consultants. The UK Code also states that undue reliance should not be placed on any individuals in deciding the chairmanship and membership of the board committees. The nomination committee should therefore review the current membership of the board committees and assess whether there is excessive reliance on one or more NEDs and whether an additional appointment of an independent NED to the board might be appropriate, to spread the membership of the board committees more widely. The composition of the board should be consistent with the future strategy of the company. Changes may be appropriate so that the board members, particularly the NEDs, have the range of knowledge and experience to oversee and challenge the strategy that has been set by the executive directors. The lack of suitable experience and knowledge on the board may be a reason why the size and composition of the board was criticised by the consultants. Another principle in the UK Code is that the search for new board candidates should be made on merit, against objective criteria and with due regard to the benefits of diversity on the board, including gender, and that there should be „progressive refreshing‟ of the board. A provision of the UK Code is that the re-appointment of a NED for a term beyond six years should be subject to rigorous review, and with regard to the need for continual refreshing of the board. The nomination committee appears to have failed in this task so far, and it should give urgent attention to the composition of NEDs on the board and the need for a programme of continual change and refreshment. There has been no change in board membership for four years, which might suggest that one or more of the NEDs has already served for nearly six years or longer than six years. The committee should consider recommending that these individuals are not offered a renewal to their contracts when their existing three-year term comes to an end. A search for replacements, in compliance with the requirements of the UK Code, should begin. A firm of head-hunters may be used, or the positions advertised, and the nomination committee should recommend candidates that it has vetted for appointment by the board. It should not be a one-off exercise to review the composition of the board. The nomination committee needs to plan continually for the future, and the committee chairman should report to shareholders on its work, including its policies and plans, each year in the governance section of the annual report.

Examiner’s comments On the whole this question was answered comparatively well, although candidates who mixed up their answers to the two parts sometimes repeated a point in part (b) that they had already made in part (a). There were also some noticeable weaknesses in many answers: (i) Many candidates wrote an answer in general terms about succession planning and the

role of the nomination committee, without much reference to the details in the scenario of the question.

(ii) Some candidates either did not refer to requirements of the UK Code, or confused UK requirements with the King Code.

(iii) A surprising number of candidates stated that there must be an equal number of executive directors and NEDs on the board. This statement contains two inaccuracies. The UK Code states that at least one half of the board should consist of independent NEDs.

(iv) Many candidates suggested that the CEO in the scenario could become the chairman when the current chairman retired. Institutional shareholders need a lot of persuading that

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this would be acceptable, and candidates did not appear to realise how much such a move would be resisted.

(v) Some candidates discussed succession planning as an activity that takes place after a vacancy on the board has occurred. Planning is a proactive forward-looking activity, not a reactive measure.

(vi) Many candidates wrote at great length about induction and training for new directors, the qualities required of a chairman or the characteristics that are used to assess the independence of directors, which lost sight of the requirements of the question.

3. You are the company secretary of a UK listed company. You have been discussing the audit committee‟s review of the effectiveness of the internal control system with the head of the internal audit department, Jon Adams („Jon‟). Before joining the company, Jon worked for several years in the internal audit department of a US corporation, and he therefore has experience of both the UK principles-based approach and the US rules-based approach to monitoring internal control systems. His preference is for a principles-based approach. However, he tells you that he admires the COSO Framework for an internal control system that was defined by the Treadway Commission in 1992 in its report „Internal Control – Integrated Framework‟. This identified five components that should combine to produce an effective internal control system: these five components are control environment, risk assessment, control activities, information and communication, and monitoring.

As an internal auditor, Jon‟s concern is mainly with monitoring, and he noticed a comment by COSO in the Introduction to its 2009 report „Guidance on Monitoring Internal Control Systems‟ that “unmonitored controls tend to deteriorate over time”. Jon believes that a permanent internal audit function is an essential requirement in large companies for this reason, and that there should be regular internal audit testing to assess the effectiveness of internal controls.

Required (a) Explain the difference between the UK principles-based and the US rules-based

approach to monitoring the effectiveness of internal control systems, and the benefits to a company of using a principles-based approach.

(7 marks)

Suggested answer A requirement for good corporate governance is that a company should have an effective system of internal control. In the UK there is no specific legislation about internal control systems. The principles-based UK Corporate Governance Code („the UK Code‟) states that the board should maintain a sound system of internal control and at least annually it should conduct a review of the effectiveness of the system and report to shareholders that it has done so. The UK Code also states that a function of the audit committee should be to review the internal financial controls and (unless a risk committee of the board or the full board carries out the task) should review the whole internal control system. The UK approach therefore provides guidelines, but does not provide specific rules; for example, the Turnbull Guidance on internal control and reviewing effectiveness. In contrast, the US has statutory rules on internal control, based on section 404 of the Sarbanes-Oxley Act. This Act requires companies registered with the SEC to produce an internal control report each year which contains an assessment of the effectiveness of the company‟s internal control system. The assessment must be carried out with the involvement of the chief executive officer and chief finance officer and the framework on which the assessment is based must be a recognised framework (such as the COSO Framework). Companies must also retain evidence to provide reasonable support for their assertions about the effectiveness of the internal control system. Management must also disclose any material weakness in the company‟s internal

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control system for financial reporting. Companies are required to demonstrate compliance with the regulations, by creating evidence through documentation. The external auditors must also issue an attestation report on management‟s assessment of the internal control over financial reporting. An internal audit section, if one exists in the company, is part of the internal control system. The principles-based approach in the UK Code allows companies to consider the value of an internal audit function as part of the internal control system. The regulatory framework in the US does not provide the same flexibility for the inclusion of such reviews in the assessment of internal control. In summary, the UK approach is based on principles in the UK Code supported by the Turnbull Guidelines, whereas the US approach is to impose statutory requirements, including the use of a recognised framework for conducting the assessment of internal control effectiveness. However, both approaches have the same objective, which is that the board or management must recognise their responsibility for the effectiveness of internal control and report to shareholders annually on this subject. It can be argued that there are greater benefits with a principles-based approach. For example: (i) A principles-based approach means that the review of internal control does not have to

follow strict rules, and does not become a box-ticking exercise to ensure compliance with the law.

(ii) By providing some flexibility, the system is likely to be less burdensome on companies in terms of time and cost to carry out the annual review. (When the Sarbanes-Oxley Act requirements were first implemented, there were widespread complaints about the administrative burden and costs of compliance.)

(iii) Companies are also able to develop internal controls that are applicable to their specific circumstances.

Examiner’s comments Candidates who showed awareness of some of the detail of this topic earned good marks. The weakest answers focused entirely on the UK principles-based approach without mentioning the US approach. Some answers did not mention internal control systems, although approaches to monitoring the effectiveness of internal control systems was the subject of the question.

(b) Describe briefly the five components of an internal control system, as defined in the

COSO Framework, and the contribution of each of these components to an effective internal control system.

(10 marks)

Suggested answer

(i) The control environment refers to the culture within the company and accepted norms and attitudes towards risk and risk management. An effective internal control system should have a culture of risk awareness, with strong lead provided and an example set by the board and senior management. A strong control culture creates an awareness of risks among the management and work force, and an understanding of the need to ensure that controls are properly applied and effective.

(ii) Assessment refers to the requirement for an internal control system to monitor continually

the risks that the company faces, and changes in those risks. The significance of each risk should be assessed, and control measures should be devised for the risks that are considered material. The continual assessment of risks is essential because circumstances change: new risks emerge and existing risks change in character. It is important to look for changes in the nature of risks, so that new controls can be introduced or existing controls amended.

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(iii) Internal controls are the controls that are devised and implemented to prevent risk events

from occurring or identifying and correcting control failures that occur. Controls are fundamental to any control system, and they must be well designed and properly applied.

(iv) Information must be produced about risks, controls and control failures, and this

information must be communicated to the relevant people, including senior management. People within an organisation need to be made aware of the risks and the controls that should be applied to manage the risks. They should also be informed when there are failures in risk control. Information, including feedback about failures, is essential to a control system.

(v) Monitoring refers to the requirement to review and check the effectiveness of the other

components of the internal control system. The control system and the effectiveness of controls should be monitored regularly, to ensure that the system remains effective and that measures are taken to remove any weaknesses that are identified (including weaknesses in risk assessment and in internal controls).

All five components of the internal control system must function for an effective internal control system. A serious failure or weakness in any component will make the system ineffective and inadequate.

Examiner’s comments The question included the five components of the COSO Framework and candidates were required to explain what each element was. The weakest answers did not refer to the five elements given in the question. Most candidates appeared to recognise the requirement to write about each of the five elements, but a number of answers were incorrect, appeared confused and did not demonstrate understanding of some of the five components.

(c) Explain why “unmonitored controls tend to deteriorate over time” and how an

internal audit function might contribute to the maintenance of an effective internal control system.

(8 marks)

Suggested answer If internal controls are not monitored regularly, they are likely to become less effective over time. This is for two reasons. First, the nature of the risk may change so that a control that was established to deal with the risk may no longer be appropriate and so fail to fulfil its intended purpose. Second, there may be a tendency over time to ignore controls and circumvent them, unless compliance is regularly monitored. Monitoring has the effect of helping to ensure that internal controls remain relevant and are applied effectively, or to identify control weaknesses where the controls are no longer appropriate or no longer applied. When weaknesses in the system are identified through monitoring, measures can be taken to deal with them. An internal audit function can contribute to the monitoring of the internal control system by conducting tests of the effectiveness control. At a detailed level, this will involve audits into specific aspects of operations to check whether financial, operational and compliance controls are properly applied and to identify control weaknesses where existing internal controls do not deal adequately with the significant risks. Internal control is not the only way in which the effectiveness of an internal control system may be monitored. The audit committee can obtain reports from management and the external auditors about controls and control weaknesses or control failures. Supervisors may be given responsibilities for checking the effectiveness of controls within their area of operations. There may also be reporting measures embedded in the management reporting system that will signal possible control failures that occur.

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To contribute effectively to monitoring of internal control, internal auditors must be individuals with appropriate capabilities, objectivity and authority. The information they produce needs to be persuasive about weaknesses or failings in key controls, and their reports and recommendations must be acted on by the management responsible for the operations. Examiner’s comments Candidates who appeared to know what an internal audit was performed reasonably well in answering part (c). There was some difficulty with explaining why controls deteriorate over time if unmonitored. Very few candidates made the direct point that internal audit can be used to monitor controls, which reduces the likelihood that the audited controls will deteriorate.

4. Winston Barr („Winston‟) is the chairman of a listed UK company that has experienced

severe problems at board level in the past few years. Three years ago, the company suffered heavy losses on its operations and came close to insolvency and collapse. The entire board of directors resigned, and Winston was subsequently appointed as the chairman of a new board. The company‟s lawyers have recently informed him that there are strong grounds for taking legal action against the former members of the board for negligence and a serious lack of care in the performance of their duties. They have suggested that the board should take action against all these board members to recover as much as possible of the losses that were incurred at the time. Just over one year ago, the new Chief Executive Officer (CEO) was paid a large cash bonus on the basis of excellent reported performance by the company in the previous financial year. This year, it has been discovered that the reported profits were incorrect and that the company had only made a small profit in the year. Several major shareholders are demanding that the CEO should be told to repay the bonus that he was wrongly paid. So far the CEO has refused to do so. The company will be announcing its half year results in two weeks‟ time, but an executive director has just informed Winston that for personal financial reasons he must sell a quantity of shares that he owns in the company. When Winston informed the director that this was not permitted by the Model Code, the director replied that he had no choice because he needed the money urgently. If he was instructed not to sell the shares, he would demand to take professional advice on the matter at the company‟s expense, to find out whether a ban on selling the shares would be a breach of his contractual rights. Winston has asked you, as company secretary, for your advice on each of these problems. Required (a) Discuss the issues that the board should consider in deciding whether to take legal

action against the former board members for negligence and a failure to act with due care and diligence.

(7 marks)

Suggested answer Several factors should be considered by the board:

(i) The probability of success in the legal action should be considered. The board has been

informed that there are strong grounds for legal action, and has been advised by its lawyers to initiate an action. However, the legal advice and opinion is not a „guarantee‟ of success. If the board decides to initiate legal action, it must recognise that the company

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will incur costs without any certainty of a successful outcome. It may be appropriate to ask for a further legal opinion, from a lawyer who specialises in the relevant aspect of the law.

(ii) Even if the legal action is successful, it is doubtful whether the company would benefit

financially. Unless the former directors are very wealthy it is doubtful whether they would have the money or assets to afford any payments to the company that the court may award. The costs of the legal action may therefore exceed the potential benefits.

(iii) The board should also consider the potential effect on the company‟s reputation of a legal

action against the former directors. Any such legal action would probably be widely publicised in the financial media. There may be adverse publicity arising from the past failures and near-insolvency of the company, and the details of the failures and mistakes would emerge in court and would be reported in the press. On the other hand, failure to take action against the former directors may damage the reputation of the current board, as a body that cannot take „tough‟ decisions.

(iv) The attitudes of major shareholders may also be relevant. The board may be more inclined

to initiate legal action if shareholders are demanding it, or if a group of shareholders are threatening to initiate a derivative action against the former directors in the name of the company.

(v) Having reached its decision about whether or not to initiate legal action, the board should

announce the decision, and the reasons for it. This is a matter in which openness and transparency is advisable, so that the board is seen to have taken a considered and rational decision in the perceived best interests of the company.

Examiner’s comments This question posed the greatest difficulty for candidates. In the question, the company‟s lawyers had stated that there are strong grounds for taking legal action. Part (a) asked what issues the board should consider, having been given this legal advice. The question was asking for a broad view of the issues the organisation should consider when deciding whether to take legal action or not. Many candidates wrote instead about the statutory duties of directors and whether these had been breached. Some candidates wrote about insolvency law, even though the company had not become insolvent.

(b) Explain whether the company has the right to demand repayment of the cash bonus

from the CEO, and what measures Winston should take to try to deal with the problem and minimise the risk of it happening again.

(10 marks) Suggested answer This is a difficult problem for Winston to deal with. The large bonus payment to the CEO was based on incorrect financial information, but it is not clear who was responsible for producing the information and who was aware of the error before it was eventually discovered and revealed. The CEO would have been involved in the finalisation of the financial statements for the year in question, but he may not have been aware of the error. Even if he did know about the error in the reported profit, this may be difficult to „prove‟. The audit committee should initiate an investigation into why the incorrect financial information was produced. It should liaise with the remuneration committee about the findings of this investigation and the two committees should work together to resolve the issues relating to the bonus payment. The remuneration committee should be asked to check the details of the incentive arrangement with the CEO. This may include a provision that there should be some clawback, i.e. that cash bonuses are repayable if it is subsequently discovered that the size of the bonus was calculated

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on incorrect figures. In the absence of such a term in the agreement, the CEO may be legally entitled to retain the bonus. If the incorrect financial information was produced in error rather than fraudulently, the board may have to accept the situation that has occurred. The remuneration committee should also review whether the incorrect financial information has also resulted in inappropriate bonus payments to other senior executives, and deal with this problem in a similar way. Winston may therefore have to resort to influence and persuasion, and ask the CEO to repay some or all of the bonus payment voluntarily. He can use arguments such as shareholder anger at the misreported profit figure and the bonus payment, and could suggest that unless the bonus is repaid the CEO may lose the confidence of his board colleagues and make it difficult for him to remain as CEO of the company. If the CEO is due to stand for re-election at the next AGM, the possibility that the shareholders will vote against his re-election may also persuade the CEO to repay some or all of the money. If the CEO will be standing for re-election at the AGM, Winston should consider whether the behaviour of the CEO may be raised by shareholders as an issue at the meeting. This may be an additional factor to discuss with the CEO. The board should expect the chairman to achieve some success in obtaining a full or partial repayment of the bonus. Winston should also ask the remuneration committee to ensure that a similar situation cannot arise again in the future, by including a suitable provision for bonus repayments in the incentive agreements of all the senior executives of the company. In particular, Winston should also consider clawback provisions in directors‟ service contracts. If there is no provision in remuneration agreements for the full or partial repayment of bonuses in the event that payments are made on the basis of incorrect information, he should discuss with the chairman of the remuneration committee, or the board as a whole, the need to include such provisions in the future. Examiner’s comments This question was in two parts. The first part was about whether the company had the right to demand repayment of the cash bonus. The second part was about measures to deal with the problem and the risk that it might occur again. For the first part of the question, some answers reached the wrong conclusion in assuming that the financial statements must have been prepared fraudulently by the CEO, without anything in the question stating that this was the case, and so made suggestions about the criminality of the CEO and the need to dismiss him. Good answers recognised that the views of shareholders may be relevant and some answers even identified the common sense idea that the CEO could be asked to repay voluntarily some of the excessive bonus. For the second part of the question, some candidates suggested that the problem was incorrect financial reporting or poor auditing, although the question did not indicate any reason why the financial statements were misstated. Candidates who focused on financial reporting and auditing did not address the more specific problem of over-payment of bonuses. Some candidates suggested that the solution would be to offer directors long-term incentives such as share options. This suggestion did not recognise the fact that remuneration packages commonly include both short-term and long-term incentives, and suggestions about long-term incentives were therefore not relevant to the question.

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(c) With regard to the executive director‟s requests about selling shares and seeking advice at the company‟s expense, advise Winston on the courses of action the board might take.

(8 marks) Suggested answer UK listed companies are required by the Listing Rules to have rules about share dealings by the directors that are no less stringent than the rules in the Model Code. The purpose of the rules is to give assurance to investors in the stock market that the directors of a company are not able to abuse their position (of access to undisclosed information about their company) and deal in shares of their company for personal benefit. The Model Code requires that directors should not be permitted to deal in shares of their company during a close period, which includes the period two months before publication of the company‟s half-year and full year financial results. If the director was to sell his shares in the company now, before publication of the company‟s results, this would appear to be a breach of the Model Code. It is also possible that if the director is aware of any price-sensitive information, he might be guilty of insider dealing if he was to sell his shares now but this does not appear to be the situation in this scenario, especially if the company will be reporting results that are in line with market expectations. However, the Model Code allows exceptions to the general rule and permits clearance to be given to a director to sell shares during a close period where the director has a pressing financial commitment or would suffer financial hardship if unable to deal. The decision in this case should be taken by the shares and dealings committee of the board (or by the board as a whole). Clearance may be given to the director to sell the shares, but it should first be satisfied that the director‟s financial reasons for wanting to sell the shares are genuine and reasonable. However, in practice, it is very unlikely that a director would be allowed to sell his shares during a close period, because the director is likely to have inside information; consequently, dealing in shares would breach the law on insider trading. A listed company must disclose all directors‟ dealings in its shares via Stock Exchange Announcements, which are monitored by investors. Dealing by a director during the close period should be made public, as a matter of good governance, and the reputation of the individual director would be affected. The director should be made aware of this and that his share dealings would be seen by investors as an indication of his sentiment towards the company. Winston should respond to the director‟s assertion that he would seek legal advice at the expense of the company if he were refused permission to sell the shares. The UK Corporate Governance Code states that directors should have access to professional advice at the company‟s expense where they judge it necessary in order to carry out their duties as a director. In this situation, the director‟s concern is with his personal right to sell shares, which is not connected to the performance of his role as a director. He should therefore be told that he has misunderstood the „rules‟ and cannot seek legal advice at the company‟s expense to resolve a personal matter. Examiner’s comments The quality of answers to part (c) was variable, and some candidates did not mention the law against insider trading. Insider trading is illegal. If the director were to sell his shares, he might be accused of insider trading. Since proof in criminal cases may be hard to establish, and since the stock market needs to demonstrate that investors will not be treated unfairly by insiders, the Listing Rules requires companies to apply the Model Code or something more rigorous to their directors, even though the insider trading law exists. A high proportion of answers did not recognise that both sets of rules apply and so many did not mention the law. The second part of the question (on whether the director was entitled to legal advice at the company‟s expense) was answered correctly by most candidates, but by no means all.

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5. The newly-appointed chairman of your company‟s audit committee, Angela Reid („Angela‟), has asked for your advice. Although she is a professionally-qualified accountant with industrial experience, she has only a limited knowledge of auditing. Angela tells you that, in the past, she has been doubtful about the benefits of external audit but accepts that it is a legal requirement. Her immediate concern is with the committee‟s responsibility for monitoring the independence of the auditors, and she wants advice on how the committee should perform this „independence check‟.

Angela is also aware that the independence of the auditors may be threatened by the large amount of non-audit work they do for the company in addition to the external audit. In recent months, the company‟s auditors have installed a new IT system for accounting and management reporting, provided tax advice and advice on the company‟s accounting policies, and carried out a financial investigation into another company that was the target for a takeover bid. Angela also knows that the company chairman would like the audit firm to help with promoting a new share issue that the company plans to make in the next few months. The company does not have a clear policy on giving non-audit work to the audit firm, and Angela believes that this is an issue that the committee needs to consider. Required (a) Explain the role of the external auditors in providing an effective system of

corporate governance and the nature of threats to the independence of external auditors. Recommend checks that the audit committee should carry out to assess whether the auditors remain sufficiently independent.

(13 marks)

Suggested answer When there is separation of ownership from control in a company, accountability is an important aspect of good corporate governance. The board of directors should be accountable to the shareholders for their stewardship of the company‟s assets and for the way in which they have exercised their powers. It is therefore a legal requirement that companies should submit an annual report and accounts to the shareholders, so that the shareholders can make an assessment of the company‟s performance and financial position. For the annual report and accounts to provide accountability, it is essential that the information they contain should be reliable. In the past, misleading financial statements have often been a factor in major financial scandals and the collapse of major companies. It is most unusual that the auditors of the company in this scenario should have been involved in the installation of a new IT system for accounting, as it could compromise their independence. External auditors check the financial statements and the way in which they have been prepared, and provide an independent professional opinion to the shareholders about whether the financial statements give a true and fair view. Shareholder confidence in the financial statements, including the statement by the board about the going concern status of the company, therefore depends on the independent opinion of the auditors. If the external auditors lose their independence from a client company, the reliability of their audit opinion may become doubtful and the accounting profession considers independence to be a professional ethical requirement of auditors. Five types of threats to auditor independence can be identified: (i) Self-interest threats – which arise in situations where it is in the auditor‟s own interests to

accept the views and opinions of the client‟s management and not to challenge them vigorously. The auditors in the scenario carry out a lot of non-audit work for the company, and this may create a self-interest threat. This is because the audit firm may be reluctant to lose the non-audit work and fee income, and so may be less rigorous than it should be in the conduct of the external audit.

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(ii) Self-review threats – which arise when the auditors are required to check the validity of work that has previously been carried out by employees of the audit firm. Auditors might be reluctant to report failures in the work of their own staff.

(iii) Familiarity threats – which can develop as members of the audit team become more

familiar with a client company and its management, and so become more willing to accept the accuracy and validity of their opinions and what they do.

(iv) Advocacy threats – which arise when the audit firm actively promotes the interests of a

client company, for example, in a legal dispute between the company and another party. In the question scenario, the auditors should not be asked to promote the share issue because of the advocacy threat that this would create.

(v) Intimidation threats – which arise when the auditors accept the views of a client‟s

management because of threats or domineering personalities.

The UK Corporate Governance Code („the UK Code‟) states that the audit committee should review the independence and objectivity of the external auditors, and the effectiveness of the audit process (Provision 3.2). The audit committee should therefore monitor the external auditors and actively consider their independence. The committee may gather evidence from a number of sources: (i) The reports prepared by the auditors for management and the audit committee/board may

indicate the extent to which the auditors challenge management views and identify control system weaknesses. The audit committee should meet at least once a year with the head of the audit team, and discuss the issues that arose during the audit. The information obtained from this meeting, and the auditor‟s letter to management about control weaknesses, should provide useful evidence about the auditors‟ judgement.

(ii) The audit committee should seek assurances from the audit firm about the procedures that

the firm has in place for monitoring the continuing independence of its audit team. For example, the audit committee should seek assurance that none of the audit team is a significant holder of the company‟s shares, or is related to a senior manager in the client company.

(iii) If the company has an internal audit department, reports by internal auditors on control

system weaknesses may help with an assessment of the opinions of the external auditors. (iv) It is unusual for the auditors of a listed company to write a qualified audit report, or to

challenge the going concern statement by the board of directors. However, any such disputes between the auditors and the board (and management) should be an indication of auditor independence.

Examiner’s comments This question had three parts and asked about: (i) the role of the external auditors in corporate governance, (ii) threats to auditor independence, and (iii) checks that the audit committee should carry out on auditor independence. Many candidates answered this question well. The most popular suggestion for monitoring auditor independence was a proposal for regular audit partner rotation (which the accounting profession has accepted) and audit firm rotation (which is not yet established practice). These are measures designed to protect independence rather than monitor it, but candidates were given credit for these suggestions.

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(b) Advise the audit committee chairman about the responsibilities of the committee with regard to non-audit work by the audit firm. Recommend an approach that the committee should take to deciding which items of non-audit work, and how much work, might be awarded to the firm.

(12 marks)

Suggested answer The UK Code states that the audit committee should develop and implement policy on using the external audit firm to carry out non-audit work. The committee should report to the board on this policy and, in doing so, identify any matters where improvements or action is necessary and make recommendations about what should be done. An important consideration should be that, by taking on non-audit work, the audit firm risks compromising its independence due to threats such as self-interest threats (the threat of losing fee income for non-audit work), self-review threats and familiarity threats. It is acceptable for an audit firm to provide tax advice to a client. In addition, it is part of the responsibility of the external auditor to provide advice on the acceptability of accounting policies or due diligence in corporate transactions. The main concern of the audit committee should be with the non-audit work carried out by the audit firm. The committee should understand that non-audit work can be given to other firms, and there is no requirement or obligation to offer this work to its firm of auditors. In developing policy on non-audit work and the external auditors, the committee should take into consideration relevant ethical guidance. The accountancy professional bodies issue guidance to their members, including guidance on certain types of non-audit work that must not be undertaken for a client company, and other types of work where the threat to independence should be monitored carefully. The company‟s policy should be that non-audit work should not be given to the audit firm if it breaches the ethical guidelines of the profession. For example, prohibited non-audit work should include helping a company to promote a new share issue, because of the advocacy threat involved. The other items of non-audit work mentioned by the chairman of the audit committee are not prohibited, and providing advice on accounting policies is work that the auditors should be expected to perform as part of the regular annual audit. The committee should also recognise that there will be a threat to auditor independence if too much non-audit work is given to the audit firm; therefore its policy may include a limit on the amount of non-audit work that is awarded to the audit firm in any year. There may also be a policy on types of non-audit work that should not be awarded, and a requirement that contracts worth above a stated amount should be submitted for board approval before they are awarded to the audit firm. The audit committee consists of non-executive directors, and so should be involved in policy issues only, and compliance with policy. It should not be expected to make the decisions about giving non-audit work to external firms of accountants. The responsibility of the committee should therefore be to submit policy guidelines to the board for approval, and monitor compliance by management with the approved guidelines. The board as a whole should be aware that investors routinely monitor the ratio of non-audit fees to audit fees paid to the audit firm of the company, and use this as an indicator of the auditors‟ independence. Shareholders may not support the re-appointment of the auditors at the AGM if they consider that the ratio of non-audit work to audit work is too high. Examiner’s comments Although some answers were expressed in very general terms and did not address the requirements of the question, the general standard of answers was reasonable. It appeared that candidates often guessed whether some the items of non-audit work mentioned in the question

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should be allowable or not, as work for the audit firm. Apparent guesses were probably 50% correct and 50% incorrect, but this showed a commendable intention to deal with the detail in the question scenario.

6. Tom Loft („Tom‟) and Kitty Loft („Kitty‟) run a private company in the UK, „Green Sun

Homes‟, that specialises in the installation of solar panels for homes. The company was established about 30 years ago as a construction company specialising in family houses, but has moved into solar panelling because of the enthusiasm of Tom and Kitty for environmental protection. They have been married for 30 years and have a son and a daughter. The daughter is working for a major law firm and the son is the company secretary of a listed company. Tom and Kitty are joint owners of 85% of the shares in the company, their son owns 5% (even though he is not involved in the company‟s business) and the remaining 10% are owned by employees of the company. The company‟s profits have been falling during the last three years, partly because of the economic conditions but also because Tom and Kitty have decided to reduce the prices for their work in order to encourage more people to buy solar panels and thereby protect the environment. In their view, the environment matters more than money.

Tom and Kitty have been talking with their son and daughter about the company and their aspirations for the future. The son said that he was enjoying his job and had been spending a lot of time reviewing the corporate governance policies of the company that he works for. When Tom replied that he did not know what corporate governance was, the son said that governance was different in publicly-quoted companies compared with family-controlled businesses, and gave an explanation of the main issues with corporate governance. The son then went on to say that he was ambitious and would like to be the director of a publicly-quoted company one day. Tom and Kitty said that they would be delighted to bring both their son and daughter into their company, and would be willing to plan for it to become a quoted company. They said that the son could be involved in the management of the business, and the daughter would be able to combine the roles of company lawyer and company secretary on a part-time basis. The son replied that if they were serious about taking the company on to the stock market, Tom and Kitty would have to consider a wide range of issues and plan to make substantial changes in the company. Required (a) Explain, with reference to Green Sun Homes, how corporate governance differs

between large quoted companies and family-run companies, and identify the major corporate governance challenges that family-run companies may face.

(10 marks)

Suggested answer The main theories of corporate governance are based on publicly-quoted companies, where there is separation of ownership from control, and a key issue is the relationship between the board of directors and the shareholders (and other stakeholder groups). In family-controlled companies, there is no separation (or relatively little separation) between ownership and control. As a consequence, governance issues relating to accountability and audit, remuneration and transparency and disclosure are not particularly relevant to family-controlled companies although they are major concerns for stock market companies. Although the boards of directors of all companies should consider the long-term interests and long-term objectives of their company, they are often under pressure from fund managers to earn reasonable profits in the short-term, with growth in earnings per share and dividends each year. In family-controlled companies, including the example of Green Sun Homes in the question, maximising short-term profitability is not the main objective, and even over the longer

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term other objectives may be considered as important as (or more important than) profit. Tom and Kitty, for example, seem to be willing to operate with lower profits in order to attract more orders for solar panels because of their personal concerns about the environment. Family-owned businesses have governance problems that are not found in larger organisations. An important issue is often ownership succession. In the case of Green Sun Homes, the owners have two children but neither of these seems to want involvement in the business, even though the son owns some of the shares. Eventually, the owners may be forced to seek a third party buyer for the business, or wind up the business, if they cannot persuade one or both of their children to take over the management. Some family-run companies, including Green Sun Homes, award some shares to employees, who are a minority interest in the ownership of the company. This gives rise to issues concerning the rights of minority shareholders. The majority owners need to consider the interests of the minority shareholders when making decisions for the company, for example, about strategic direction and dividend payments. Listed companies should be led by an experienced and effective board of directors, which collectively is able to set objectives for the company and lead it towards their achievement. With small family-controlled businesses, the board of directors is smaller and (usually) less experienced and so may not have the ability to develop the company beyond a certain limit. In the case of Green Sun Homes, for example, the board may consist of just Tom and Kitty, who do not appear to have plans for growing the business. Examiner’s comments Answers to this part of the question were variable in quality. Candidates who identified the separation of ownership and control in large companies, and the agency problem, generally answered the entire question well. Answers were too general if they explained the difference between family-owned companies and large quoted companies in terms simply of differences in regulations and codes of governance. A few candidates did not answer the question in part (a) and instead addressed the requirements of part (b) in both parts of their answers. (b) Discuss the matters that would have to be considered by the owners of Green Sun

Homes if they wanted to turn the company into a publicly-quoted company. (15 marks)

Suggested answer From the information available, it would appear that Green Sun Homes is a long way from becoming a publicly-quoted company. It is extremely difficult for small and medium-sized companies to obtain a stock market quotation and get access to public capital. The company will need to transform its business plan, its financial performance and its governance. In the UK, if a company is able to meet the requirements for a stock market quotation, it may seek admission to AIM first, as a step towards obtaining a main stock market listing at a later date. Corporate culture and objectives The company‟s board of directors (currently Tom and Kitty) must change the objectives and culture of the company. A publicly-quoted company has a large number of shareholders, and the objective of the company should be primarily to create value for shareholders. It may also be appropriate to have regard to the concerns of other stakeholders in the company, but a balance needs to be found between profitability and environmental concern. The current policy of selling their products at a low price for environmental reasons appears to be unsustainable. The company will need to give more attention to profits. (To meet the requirements for a stock market quotation, the company will have to meet certain financial performance criteria anyway. It

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will also have to plan for substantial growth in the business to meet these requirements, including growth in profits.) Board of directors In order to develop a business plan for the development of the business and its profitability, the company needs a board with a broader range of skills and knowledge than Tom and Kitty possess themselves. The size and composition of the board will need to change. It may be appropriate to strengthen the representation of executive management on the board, and the son may have suitable skills to be an executive director. However, the company will also need to find some independent non-executive directors who can help with the development of the business strategy and with the progression of the company towards the stock market. The company might benefit from the experience of a non-executive director with knowledge of the financial services industry. Tom and Kitty cannot expect to run the company as a family-controlled business if it succeeds in attaining stock market status. They should give serious consideration to succession planning, in particular for the roles of chairman and chief executive officer. In the future, the company will need to ensure continuity of leadership for the board and also develop a professional management team. Risk management and internal control The board of the company will also need to give far more attention to risk management and internal control than it has probably done so far. There should be a clear policy on business risk and the risk appetite of the company, as part of the business development plan. Any future shareholders will want to understand the risk as well as the potential returns in any investment they make in the company. It will also be necessary to develop an effective internal control system: investors will expect the board of a publicly-quoted company to give assurances about the effectiveness of the internal control system, because this is important for the protection of their investment. Regulatory compliance The board will need to be aware that if the company attains stock market status, it will be required to meet more rigorous regulatory requirements, for example, in relation to the external audit and also to transparency and disclosures of information. Family-controlled private companies can operate with relative secrecy, but this is not possible for a quoted company. Remuneration issues As the company progresses toward a position where it is able to meet the requirements for stock market entry, other issues will have to be considered. These include the remuneration of directors and senior executives. The company will need to develop a policy on remuneration that is transparent and acceptable to investors. It could mean that Tom and Kitty will have to accept lower remuneration in the future. Other issues The board will also have to consider ways of bringing the company to the attention of potential investors, and at some stage this will mean finding a sponsor who is prepared to support the application for admission to the stock market, and help to find investors who are willing to invest capital in the company. At some stage, dialogue with potential investors should be initiated. Tom and Kitty should be advised that it may be inappropriate to appoint their daughter as both company secretary and company lawyer. The two roles are different and should not be combined. The company secretary, amongst his other duties, is required to act as the conscience of the company and to advise the company on ethical and governance requirements.

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A company lawyer is responsible for protecting the legal interests of the company, which could require a different approach to dealing with problems that may arise. These potential conflicts need to be managed, for example, by appointing external legal advisers in certain situations. Conclusion In summary, it is by no means clear that Green Sun Homes will be able to develop its business to the point where it meets the requirements for a stock market quotation. To do so, the company must grow the business, with a focus on profitability. The company will also have to change its culture and transform its governance practices. Examiner’s comments The suggested answer includes some of the major points that could have been included in an answer, but some candidates made other points that were treated on their merits. In general, the requirements of the question were dealt with well. The weakest answers were those that appeared to have been written in a hurry, as the final answer in the examination, and those that focused on the legal and regulatory procedures for obtaining public company status (or a listing, although this was not mentioned in the question), without any mention of governance issues.

The scenarios included here are entirely fictional. Any resemblance of the information in the scenarios to real persons or organisations, actual or perceived, is purely coincidental.