Corporate Governance – principles, policies and practices

1. Corporate Governance – principles, policies and practices Corporate Governance – Principles, Policies and Practices 3e Chapter 1 Corporate Governance: A Subject Whose Time Has Come

2. Corporate Governance: A Subject Whose Time Has Come • All corporate entities need governing • Corporate governance is old, only the phrase is new • The early days – merchants and monopolists • The invention of the limited-liability company • The separation of ownership from operations • Developments in the 1970s • Developments in the 1980s – corporate collapses • Developments in the 1990s – corporate governance codes arrive • Developments early in the 21st century - yet more collapses • Corporate governance implications of the global financial crisis • New frontiers for corporate governance.

3. The evolution of corporate governance All corporate entities need a governing body • Profit-orientated companies, public and private • Joint ventures • Co-operatives • Partnerships • Not-for-profit organizations • voluntary and community organizations • charities • academic institutions • governmental corporate entities • Quangos.

4. The evolution of corporate governance • Corporate governance concerns the way power is exercised over corporate entities - Corporate governance is different from management • Executive management is responsible for running the enterprise: the governing body ensures that it is running in the right direction and being run well - Directors are responsible for setting the organization’s direction, formulating strategy and policy making. The board is also responsible for supervising management and being accountable.

5. The evolution of corporate governance Chaucer (c1343 -1400), the English writer, philosopher, and courtier, used the word, governance (although he could not decide how to spell it (gouernance, governaunce) But the phrase ‘corporate governance’ did not come into use until the 1980s.

6. The evolution of corporate governance Nothing new about corporate governance except the phrase ‘corporate governance’ Shakespeare Merchant of Venice Act 1 Scene 1 Merchant Antonio: In sooth, I know not why I am so sad. It wearies me, you say it wearies you, but how I caught it, found it or came by it, I am to learn Salerio: Your mind is tossing on the ocean, there where your argosies, with portly sail, do overpeer the petty traffikers that curtsey to them …

7. The evolution of corporate governance • Corporate entities always need governing • Corporate governance is necessary whenever ownership or membership is separated from management control • 16th century traders and joint ventures • 17th/18th century trading companies • East India Company • Hudson Bay Company • 19th century limited liability company.

8. The evolution of corporate governance The governance agency dilemma arises whenever ownership or membership is separated from executive management control. "The directors of companies, being the managers of other people's money rather than their own, cannot well be expected to watch over it with the same anxious vigilance with which (they) watch over their own. - Adam Smith, The Wealth of Nations, 1776.

9. The evolution of corporate governance • The joint stock, limited liability company • A brilliant concept of the 19th century • Incorporate a legal corporate entity • Separate from its owners, but with similar legal rights - to buy and sell own assets • - to employ people • - to contract and incur debts • - to sue and be sued • Companies have an existence independent of owners • Shares can be transferred, traded • Liability of shareholders for company debts limited • Directors stewards for shareholders • - directors’ fiduciary duty to act on their behalf.

10. The evolution of corporate governance Owner managers Other employees Owner-managed entity Owners Managers Employees Separate legal entity

11. Owners (shareholders) Board of Directors Managers Employees Limited liability company The evolution of corporate governance

12. The evolution of corporate governance In the United States 19th century legislation in some states allowed incorporation of companies In New York, Wall Street financial institutions financed and traded shares of companies formed to build railways and develop industry following Civil War (1861 – 1865) Legislators suspicious of limiting shareholders’ liability for companies’ debts. Objectives and life span of each company defined. One company could not own another. Gradually state constitutions amended and laws re-written to give more power to companies.

13. The evolution of corporate governance In the early days, limited-liability companies were relatively small and simple Shareholders drawn from wealthier classes and could attend shareholder meetings In those days there were no chains of financial institutions, pension funds, hedge funds, brokers, or agents between the investor and the boardroom But some companies became large and complex. Their shareholders numerous, geographically spread, with different needs and expectations.

14. The evolution of corporate governance 1930s US problems Berle and Means (USA) Securities and Exchange Commission 1970s EU/UK, two tier boards Bullock Report (UK) Stakeholder ideas Watkinson & Nader 1980s collapses, Maxwell (UK) Bond (Australia) Nomura (Japan) Burnham Drexall/Boesky (USA) 1990s calls for codes of best practice

15. The evolution of corporate governance The rise of the modern corporation has brought a concentration of economic power which can compete on equal terms with the modern state - economic power versus political power, each strong in its own field. The state seeks in some aspects to regulate the corporation, while the corporation, steadily becoming more powerful, makes every effort to avoid such regulation… Berle and Means 1932, revised 1967

16. The evolution of corporate governance Developments in the 1970s 1972 US SEC requires listed companies to create board audit committees, comprised of independent outside directors 1977 UK c all for audit committees (Conduct of Directors white paper) but concept of independent directors not recognized 1972 European Economic Commission call for German style two-tier boards- not acceptable in countries with unitary boards Debates in US and UK on companies’ wider stakeholder responsibilities beyond duty to shareholders (not yet called corporate social responsibility)

17. The evolution of corporate governance Developments in the 1980s Problems of governance domination and corporate collapse

18. The evolution of corporate governance Problems of governance domination and corporate collapse In US Ivan Boesky, Michael Levine and Michael Milken • junk bond financed, insider information deals through Drexal, Burnham, and Lambert In UK Guinness case and Robert Maxwell In Australia Alan Bond, Laurie Connell of Rothwells, and the Girvan Corporation In Japan Nomura Securities

19. The evolution of corporate governance 1985 US Treadway Commission formed to consider fraudulent corporate financial reporting. Their first report (1987) led to the creation of the Committee of Sponsoring Organizations of the Treadway Commission (COSO), private-sector initiative to encourage executive management and boards towards more effective business activities

20. The evolution of corporate governance Developments in the 1990s Corporate governance codes arrive 1992 Cadbury Report based on recognized good practice • wider use of independent non-executive directors, the introduction of an audit committee of the board with independent members • division of responsibilities between the chairman of the board and the chief executive • a remuneration committee of the board to oversee executive rewards • a nomination committee to propose new board members • reporting publicly that the corporate governance code had been complied with or, if not, explaining why.

21. The evolution of corporate governance Codes of best practice Subsequent UK codes • Cadbury (1992) • Greenbury (1995) • Hampel (1998) • Turnbull (1999) • Myners (2001) • Higgs (2003) • Smith (2003) • Tyson (2003) • UK Combined Code (1998 and 2003)

22. The evolution of corporate governance Codes of best practice around the world Australia (1993) Canada (1994) Holland (1997) Hong Kong, Italy, India, Japan (1998) Russia (2001) Codes from international agencies OECD/World Bank, Commonwealth (1999) Codes from institutional investors CalPERS, PIRC, Hermes …

23. The evolution of corporate governance 1997 US Business Roundtable Statement on Corporate Governance listed guiding principles of sound corporate governance: • The paramount duty of the board of directors of a public corporation is to select a Chief Executive Officer and to oversee the CEO and other senior management in the competent and ethical operation of the corporation on a day-to-day basis • The corporation has a responsibility to deal with its employees in a fair and equitable manner.

24. The evolution of corporate governance Despite the principles and codes problems persist Enron (USA) HIH Insurance (Australia) Independent Insurance (UK) Parmalat (Italy) Tyco (USA) Tomkins (UK) Vodphone Mannesmann (Germany) Waste Management (USA) Worldcom (USA) Sarbanes Oxley Act (USA 2002)

25. The evolution of corporate governance The global financial crisis Western world lending and asset bubble massive liquidity lax monetary policies cheap money Companies used low interest loans to leverage their financial strategies World trade boomed - some countries facing vast trade imbalances Personal borrowing soared.

26. The evolution of corporate governance The global financial crisis 2007 in US - After decade of substantial growth house prices fell - Some owners in negative equity - Worse, many loans were to poor credit risks, the so-called sub-prime market - Foreclosures escalated - House prices fell further.

27. The evolution of corporate governance Global crisis financial institutions fail In US - Bear Stearns (bailed out by Government) - Fannie Mae and Freddie Mac (Government guarantees) - AIG Insurance (Government loan facility) - Lehman Brothers (allowed to become bankrupt after 158 years).

28. The evolution of corporate governance Global crisis - financial institutions fail In UK Northern Rock bank (nationalised) RBS (Royal Bank of Scotland) (nationalised) HBOS (nationalised) Lloyds Bank (major government stake) In Iceland All three banks and stock market collapsed (supported by IMF).

29. The evolution of corporate governance CG responses to global financial crisis US SEC changes to regulatory procedures for listed companies • obligatory (though non-binding) shareholder votes on top executive remuneration • annual election of directors • creation of board-level committees to focus on enterprise risk exposure • separation of the CEO role from that of the board chairman suggested.

30. The evolution of corporate governance UK Combined Code re-named the Corporate Governance Code Main changes: 2010 • Annual re-election of chairman or the whole board • New principles on the leadership of the chairman, and the roles, skills and independence of non-executive directors • Board evaluation reviews to be externally facilitated every three years • Regular personal performance and development reviews by the chairman with each director • New principles on the board’s responsibility for risk management • Performance-related pay aligned with strategy and risk policy • Companies to report on their business model and financial strategy.

31. The evolution of corporate governance Frontiers for corporate governance Some key issues remain: Should the CEO ever also be chairman of the board? Should a retiring CEO go on as chairman? Can outside directors be genuinely independent? Should shareholders be able to nominate directors? Should institutional investors exercise more power? Are external auditors really independent? How should directors’ remuneration be determined? How should new complex, dynamic, and often global corporate entities be governed? Are governance processes around the world converging? Are rules for governance of listed companies appropriate to family companies, small firms, partnerships, or not-for-profit entities?

32. Corporate Governance: A Subject Whose Time Has Come We have seen how corporate governance has evolved • all corporate entities need governing • corporate governance is old, only the phrase is new • the early days – merchants and monopolists • the invention of the limited-liability company • the separation of ownership from operations • developments in the 1970s, 80s and 90s • corporate collapses • corporate governance codes arrive • developments early in the 21st century - yet more collapses • corporate governance and the global financial crisis • new frontiers for corporate governance.