INDEPENDENCE AS A CONCEPT IN CORPORATE

GOVERNANCE

This article explores the theory of independence, and discusses why it’s vital in many contexts relating to corporate governance and professional behaviour

The concept of independence occurs at several points in the Paper P1 Study Guide. It is listed as one of the key underpinnings of corporate governance in Section A1d, it is a crucial quality possessed by both internal and external auditors (Sections B2b and B2c), and it is included in Section E5c as an ethical quality.

In corporate governance, independence is therefore important in a number of contexts. It is vital that external auditors are independent of their clients, that internal auditors are independent of the colleagues they are auditing, and that non-executive directors have a degree of independence from their executive colleagues on a board. But what do we mean by ‘independence’ as a concept?

Independence is a quality that can be possessed by individuals and is an essential component of professionalism and professional behaviour. It refers to the avoidance of being unduly influenced by a vested interest and to being free from any constraints that would prevent a correct course of action being taken. It is an ability to ‘stand apart’ from inappropriate influences and to be free of managerial capture, to be able to make the correct and uncontaminated decision on a given issue.

If, for example, an auditor is a longstanding friend of a client, the auditor may not be sufficiently independent of the client. Given that it is an auditor’s job to act on behalf of shareholders and not the client, the friendship with the client may compromise the auditor’s ability to effectively represent the interests of the shareholders. The auditor may not be as thorough as he ought to be, or he may be influenced to give the benefit of a doubt to the client when he should not be doing so.

The same could apply to non-executive directors (NEDs). In some countries, NEDs are referred to as independent directors to emphasise this very point. NEDs are appointed by shareholders in order to represent their interests on company boards. The primary fiduciary duty that NEDs owe is, therefore, to the company’s shareholders. This means that they mustn’t allow themselves to be captured or unduly influenced by the vested interests of other members of the company such as executive directors, trade unions or middle management.

DEGREES OF INDEPENDENCE

A common problem in many organisational situations is ensuring independence where it could represent an ethical threat if absent. In real-life situations, friendships and networks build up over many years in which relationships exist at a number of different levels of intensity. Audit engagement partners can get to know clients very well over many years, for example, and serving together on boards can cement friendships between NEDs and executive members of a board.

Clearly then, there are varying degrees of independence. I find the use of continua helpful when describing a variable such as this. A continuum is a theoretical construct describing two extremes and a range of possible states between the two extremes. In the case of the continuum in Figure 1, the left-hand extreme describes the ‘total independence’ extreme. At this point, the parties in the relationship have no connection with each other, may not know the identity of each other and, therefore, have no reason at all to act other than with total dispassionate independence. On the other extreme on the right-hand side – the ‘zero independence’ end – the two parties are so intimate with each other they are incapable of making a decision without considering the effect of that decision on the other party.

Figure 1

Of course, in real-life situations, the actual degree of independence is likely to be somewhere between the two extremes, but it is clearly desirable in most situations that the real position should be as near to the left of the continuum as possible.

Any of the five main ethical threats can undermine or reduce a person’s independence (self-interest, self-review, familiarity, advocacy, intimidation).

In some situations, company law or corporate governance codes make provisions to reduce threats to independence. It is often required, for example, to rotate engagement partners every so many years in an audit situation. Independence is also very important for NEDs, however, and it is to this that I now turn.

INDEPENDENCE AND NON-EXECUTIVE DIRECTORS

So looking in a bit more detail at the roles of NEDs in particular, what are the specific benefits of NED independence? We have already discussed the fact that the primary fiduciary duty of a NED is to the company’s shareholders. In order to increase NED independence, some shareholders prefer to bring new NEDs in from outside the industry in which the company competes. This is because a number of independence-threatening informal networks can build up within an industry over the years as staff move between competitor companies and as they collaborate in industry ‘umbrella’ bodies from time to time.

There is a debate about the pros and cons of appointing NEDs that have some industry experience compared to appointing NEDs from outside the industry in which the company in question competes. Previous industry involvement brings with it a higher technical knowledge of issues in that industry (which might be important), a network of contacts and an awareness of what the strategic issues are within the industry. While these might be of some benefit to a NED’s contribution, the prior industry involvement might also reduce the NED’s ability to be objective and uncontaminated by previously held views: in other words, they can make the NED less independent.

Accordingly, it is sometimes easier to demonstrate independence when NEDs are appointed from outside the industry. In addition to the benefits of the ‘new broom’ effect of bringing a fresh pair of eyes to a given problem, a lack of previous material business relationships will usually mean that a NED will not have any previous alliances or prejudices that will affect his or her independence.

In practice, many companies employ a mix of NEDs, and it is often this blend of talents and areas of expertise that is what makes a non-executive board effective. Technical input can be given by some NEDs, while wider political or regulatory insights might be provided by others. In large and highly visible companies, NEDs able to bring a social or political perspective to board deliberations can be strategically important. They may have retired senior government ministers or former chairmen of other large companies on their boards to give these insights. The fact that such people usually have no previous material business relationship with the company is seen as important in ensuring that they are materially independent.

MEASURES TO INCREASE NED INDEPENDENCE

In order to enhance the independence of non-executive directors, a number of provisions are made in company law and in corporate governance codes. The nature of these provisions and their enforceability in law also varies with jurisdiction.

First, it is usually the case that NEDs should have – and have had – no business, financial or other connections with the company during the past few years (again, the period varies by country). This means that, for example, the NED should not have been a shareholder, an auditor, an employee, a supplier or a significant customer.

Second, cross-directorships are usually banned. This is when an executive director of Company A serves as a NED in Company B and, at the same time, an executive director of Company B serves as a NED at Company A. Such a relationship is considered to make the two boards too intimately involved with each other and potentially reduces the quality of the scrutiny that the two NEDs involved in the cross-directorship can bring.

Third, restrictions or total bans on share options for NEDs are often imposed. These are intended to help ensure that NEDs are able to stand slightly apart from the executive board and offer advice and scrutiny that are unhampered by vested interests such as short-termism on the company’s share price.

Fourth, NED contracts sometimes allow them to seek confidential external advice (perhaps legal advice) on matters on which they are unhappy, uncomfortable or uncertain. This should be at the company’s expense and helps the NED to gain outside, objective advice on the issue he or she is concerned about. Finally, NEDs are usually time-limited appointments (typically three years) and the number of terms that a NED can serve is also often limited, perhaps to two consecutive terms.

In conclusion, then, independence is an essential quality in a number of situations in corporate governance and in professional behaviour. Independence is sometimes enhanced and underpinned by regulation and legislation, but over and above that, it is expected of every professional person and of every professional accountant.

Written by a member of the Paper P1 examining team

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This article introduces the idea of stakeholders and stakeholding. It starts with definitions of the relevant terms, explains the nature of stakeholder ‘claims’, and then goes on to use the Mendelow framework to explain how stakeholding is linked to influence. Finally, it covers the different ways in which stakeholders are categorised and how they are distinguished from each other. The second article in this series will be published in the February 2008 issue of student accountant.

DEFINITIONS AND EXAMPLESThe subject of stakeholders features in several areas of the Paper P1 syllabus. It is central to any understanding of the subject of business and organisational ethics. The purpose of this – and the next – article is to bring all aspects of the subject together so that students new to the field can gain an understanding of what the subject means and how it is constructed as far as ethics is concerned.

Any definition of a stakeholder must take into account the stakeholder–organisation relationship. The best definition of this is by Freeman, who in 1984 defined a stakeholder as: ‘Any group or individual who can affect or [be] affected by the achievement of an organisation’s objectives’. This definition shows the important bi-directionality of stakeholders – that they can be both affected by – and

all about stakeholders – part 1relevant to ACCA Qualification Paper P1

can affect – an organisation. Of course, some stakeholders will be in both camps.

When we think of stakeholders, it is possible to list many examples, but the ones that usually come to mind are shareholders, management, employees, trade unions, customers, suppliers, and communities. However, larger and more complex organisations can have many more stakeholders than these. Compare, for example, the different complexities of a small organisation, such as a corner shop or street trader, with a large international organisation such as a major university or ACCA. The first important aspect of stakeholder theory is, therefore, to recognise that stakeholders exist and that the complexity and range of stakeholders relevant to an organisation will depend on that organisation’s size and activities.

STAKEHOLDER ‘CLAIMS’The reason why stakeholders are important in both business ethics and in strategic analysis is because of the notion of stakeholder ‘claims’. A stakeholder does not simply exist (as far as the organisation is concerned) but makes demands of it. This is where understanding stakeholding can become more complicated.

Essentially, stakeholders ‘want something’ from an organisation. Some want

stakeholdersto influence what the organisation does (those stakeholders who want to affect) and others are, or potentially could be, concerned with the way they are affected by the organisation and may want to increase, decrease, or change the way the activities of the organisation affect them. One of the problems with identifying stakeholder claims, however, is that some stakeholders may not even know that they have a claim against an organisation, or may know they have a claim but are unaware of what it is. This brings us to the issue of direct and indirect stakeholder claims.

Direct stakeholder claims are made by those with their own ‘voice’. These claims are usually unambiguous, and are often made directly between the stakeholder and the organisation. Stakeholders making direct claims will typically include trade unions, shareholders, employees, customers, suppliers and, in some instances, local communities.

Indirect claims are made by those stakeholders unable to make the claim directly because they are, for some reason, inarticulate or ‘voiceless’. Although this means they are unable to express their claim direct to the organisation, it is important to realise that this does not invalidate their claim. Typical reasons for this lack of

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expression include the stakeholder being (apparently) powerless (eg an individual customer of a very large organisation), not existing yet (eg future generations), having no voice (eg the natural environment), or being remote from the organisation (eg producer groups in distant countries). This raises the problem of interpretation. The claim of an indirect stakeholder must be interpreted by someone else in order to be expressed, and it is this interpretation that makes indirect representation problematic. How do you interpret, for example, the needs of the environment or future generations? What would they say to an organisation that affects them if they could speak? To what extent, for example, are environmental pressure groups reliable interpreters of the needs (claims) of the natural environment? To what extent are terrorists reliable interpreters of the claims of the causes and communities they purport to represent? This lack of clarity on the reliability of spokespersons for these stakeholders makes it very difficult to operationalise (to include in a decision-making process) their claims.

UNDERSTANDING THE INFLUENCE OF EACH STAKEHOLDER (MENDELOW)In strategic analysis, the Mendelow framework is often used to attempt to understand the influence that each stakeholder has over an organisation’s objectives and/or strategy. The idea is to establish which stakeholders have the most influence by estimating each stakeholder’s individual power over – and interest in – the organisation’s affairs. The stakeholders with the highest combination of power and interest are likely to be those with the most actual influence over objectives. Power is the stakeholder’s ability to influence objectives (how much they can), while interest is the stakeholder’s willingness (how much they care).

Influence = Power x Interest

There are issues with this approach, however. Although it is a useful basic framework for understanding which stakeholders are likely to be the most influential, it is very hard

to find ways of effectively measuring each stakeholder’s power and interest. The ‘map’ generated by the analysis of power and interest (on which stakeholders are plotted accordingly) is not static; changing events can mean that stakeholders can move around the map with consequent changes to the list of the most influential stakeholders in an organisation.

FIGURE 1: THE MENDELOW FRAMEWORK

The organisation’s strategy for relating to each stakeholder is determined by the part of the map the stakeholder is in. Those with neither interest nor power (top left) can, according to the framework, be largely ignored, although this does not take into account any moral or ethical considerations. It is simply the stance to take if strategic positioning is the most important objective. Those in the bottom right are the high-interest and high-power stakeholders, and are, by that very fact, the stakeholders with the highest influence. The question here is how many competing stakeholders reside in that quadrant of the map. If there is only one (eg management) then there is unlikely to be any conflict in a given decision-making situation. If there are several and they disagree on the way forward, there are likely to be difficulties in decision making and ambiguity over strategic direction.

Stakeholders with high interest (ie they care a lot) but low power can increase their overall influence by forming coalitions with other stakeholders in order to exert a greater

The subject of stakeholders features in several areas of the Paper P1 syllabus. It is central to any understanding of the subject of business and organisational ethics.

pressure and thereby make themselves more powerful. By moving downwards on the map, because their power has increased by the formation of a coalition, their overall influence is increased. The management strategy for dealing with these stakeholders is to ‘keep informed’.

Finally, those in the bottom left of the map are those with high power but low interest. All these stakeholders need to do to become influential is to re-awaken their interest. This will move them across to the right and into the high influence sector, and so the management strategy for these stakeholders is to ‘keep satisfied’.

HOW TO CATEGORISE STAKEHOLDERSThe Freeman definition is something of a ‘catch all’ and many writers in the field have found it helpful to develop other ways of distinguishing one type of stakeholder in an organisation from another.

Internal and external stakeholdersPerhaps the easiest and most straightforward distinction is between stakeholders inside the organisation and those outside. Internal stakeholders will typically include employees and management, whereas external stakeholders will include customers, competitors, suppliers, and so on. Some stakeholders will be more difficult to categorise, such as trade unions that may have elements of both internal and external membership.

Narrow and wide stakeholders (Evans and Freeman)Narrow stakeholders are those that are the most affected by the organisation’s policies and will usually include shareholders, management, employees, suppliers, and customers who are dependent upon the organisation’s output. Wider stakeholders are those less affected and may typically include government, less-dependent customers, the wider community (as opposed to the local community) and other peripheral groups. The Evans and Freeman model may lead some to conclude that an organisation has a higher degree of responsibility and accountability to its narrower stakeholders.

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Primary and secondary stakeholders (Clarkson)According to Clarkson: ‘A primary stakeholder group is one without whose continuing participation the corporation cannot survive as a going concern’. Hence, whereas Evans and Freeman view stakeholders as being (or not being) influenced by an organisation, Clarkson sees the important distinction as being between those that do influence an organisation and those that do not. Secondary stakeholders are those that the organisation does not directly depend upon for its immediate survival.

Active and passive stakeholders (Mahoney)Mahoney (1994) divided stakeholders into those who are active and those who are passive. Active stakeholders are those who seek to participate in the organisation’s activities. These stakeholders may or may not be a part of the organisation’s formal structure. Management and employees obviously fall into this active category, but so may some parties from outside an organisation, such as regulators (in the case of, say, UK privatised utilities) and environmental pressure groups.

Passive stakeholders, in contrast, are those who do not normally seek to participate in an organisation’s policy making. This is not to say that passive stakeholders are any less interested or less powerful, but they do not seek to take an active part in the organisation’s strategy. Passive stakeholders will normally include most shareholders, government, and local communities.

Voluntary and involuntary stakeholdersThis distinction describes those stakeholders who engage with the organisation voluntarily and those who become stakeholders involuntarily. Voluntary stakeholders will include, for example, employees with transferable skills (who could work elsewhere), most customers, suppliers, and shareholders. Some stakeholders, however, do not choose to be stakeholders but are so nevertheless. Involuntary stakeholders include those affected by the activities of large organisations, local communities and ‘neighbours’, the natural environment, future generations, and most competitors.

Legitimate and illegitimate stakeholdersThis is one of the more difficult categorisations to make, as a stakeholder’s legitimacy depends on your viewpoint (one person’s ‘terrorist’, for example, is another’s ‘freedom fighter’). While those with an active economic relationship with an organisation will almost always be considered legitimate, others that make claims without such a link, or that have no mandate to make a claim, will be considered illegitimate by some. This means that there is no possible case for taking their views into account when making decisions.

While terrorists will usually be considered illegitimate, there is more debate on the legitimacy of the claims of lobby groups, campaigning organisations, and non-governmental/charitable organisations.

Recognised and unrecognised (by the organisation) stakeholdersThe categorisation by recognition follows on from the debate over legitimacy. If an organisation considers a stakeholder’s claim to be illegitimate, it is likely that its claim will not be recognised. This means the stakeholder’s claim will not be taken into account when the organisation makes decisions.

Known about and unknown stakeholdersFinally, some stakeholders are known about by the organisation in question and others are not. This means, of course, that it is very difficult to recognise whether the claims of unknown stakeholders (eg nameless sea creatures, undiscovered species, communities in close proximity to overseas suppliers, etc)are considered legitimate or not. Some say that it is a moral duty for organisations to seek out all possible stakeholders before a decision is taken and this can sometimes result in the adoption of minimum impact policies.

For example, even though the exact identity of a nameless sea creature is not known, it might still be logical to assume that low emissions can normally be better for such creatures than high emissions.

David Campbell is examiner for Paper P1

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In this second article on stakeholders and stakeholding, Paper P1 examiner David Campbell concludes his discussion of these important themes.

THE STAKEHOLDER/STOCKHOLDER DEBATEThe stakeholder/stockholder (or stakeholder/shareholder) debate is at the heart of the ethical consideration of stakeholders and is central to the discussion as it separates people into political and ethical ‘camps’. The term ‘stockholder’ rather than ‘shareholder’ was used more in American literature that discussed these issues and has been the more commonly used term to describe the belief that shareholders are the only stakeholder with a legitimate claim to influence. Essentially, proponents of the stockholder theory argue that because organisations are ‘owned’ by their principals, the agents (directors) have a moral and legal duty to only take account of principals’ claims when setting objectives and making decisions. Hence, for a joint‑stock business such as a public company, it may be assumed that because principals (shareholders) seek to maximise their returns, the sole duty of agents is to act in such a way as to achieve that. Stakeholder theorists, in contrast, argue that because a business organisation is a citizen of society, enjoying its protection, support and benefits, it has a duty to recognise a plurality of claims in the same way that an individual might act as

who’s whoa ‘responsible citizen’. In effect, this means recognising claims in addition to those of shareholders when reaching decisions and deciding on strategies.

INSTRUMENTAL AND NORMATIVE MOTIVATIONS OF STAKEHOLDER THEORyAnother debate, from an ethical perspective, is why organisations do or do not take account of stakeholder concerns in their decision making, strategy formulation, and implementation. A parallel can be drawn between the ways in which organisations view their stakeholders and the ways in which individual people consider (or do not consider) the views of others. Some people are concerned about others’ opinions, while other people seem to have little or no regard for others’ concerns. Furthermore, the reasons why individuals care about others’ concerns will also vary.

In attempting to address this issue, Donaldson and Preston described two contrasting motivations: the instrumental and the normative.

The instrumental view of stakeholdersThe instrumental view of stakeholder relations is that organisations take stakeholder opinions into account only insofar as they are consistent with other, more important, economic objectives (eg profit maximisation, gaining market share, compliance with a corporate governance standard). Accordingly, it may be that a business acknowledges

stakeholders only because acquiescence to stakeholder opinion is the best way of achieving other business objectives. If the loyalty or commitment of an important primary or active stakeholder group is threatened, it is likely that the organisation will recognise the group’s claim because not to do so would threaten to reduce its economic performance and profitability. It is therefore said that stakeholders are used instrumentally in the pursuit of other objectives.

The normative view of stakeholdersThe normative view of stakeholder theory differs from the instrumental view because it describes not what is, but what should be. The most commonly cited moral framework used in describing ‘that which should be’ is derived from the philosophy of the German ethical thinker Immanuel Kant (1724–1804). Kant’s moral philosophy centred around the notion of civil duties which, he argued, were important in maintaining and increasing overall good in society. Kantian ethics are, in part, based upon the notion that we each have a moral duty to each other in respect of taking account of each others’ concerns and opinions. Not to do so will result in the atrophy of social cohesion and will ultimately lead to everybody being worse off morally and possibly economically.

Extending this argument to stakeholder theory, the normative view argues that organisations should accommodate stakeholder concerns not because of what

all about stakeholders - part 2relevant to ACCA Qualification Paper P1

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the organisation can instrumentally ‘get out of it’ for its own profit, but because by doing so the organisation observes its moral duty to each stakeholder. The normative view sees stakeholders as ends in themselves and not just instrumental to the achievement of other ends.

SEVEN POSITIONS ALONG THE CONTINUUM: GRAy, OWEN AND ADAMSThe stakeholder/stockholder debate can be represented as a continuum, with the two extremes representing the ‘pure’ versions of each argument. But as with all continuum constructs, ‘real life’ exists at a number of

points along the continuum itself. It is the ambiguity of describing the different positions on the continuum that makes Gray, Owen and Adams’s ‘seven positions on social responsibility’ so useful.

Pristine capitalistsAt the extreme stockholder‑end is the pristine capitalist position. The value underpinning this position is shareholder wealth maximisation, and implicit within it is the view that anything that reduces potential shareholder wealth is effectively theft from shareholders. Because shareholders have risked their own money to invest in a business, and it is they who are

The issue of stakeholders lies at the heart of most discussions of ethics and accordingly, is very important for ACCA Qualification Paper P1. Being able to identify the stakeholders mentioned in a case scenario, and describing their individual claims upon an organisation, is likely to be an important skill for Paper P1 candidates to develop.

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the social contractarians in recognising that (regardless of the views of society), business has a social and environmental footprint and therefore bears some responsibility in minimising the footprint it creates. An organisation might adopt socially and/or environmentally responsible policies not because it has to in order to be aligned with the norms of society (as the social contractarians would say) but because it feels it has a responsibility to do so.

SocialistsIn the context of this argument, socialists are those that see the actions of business as those of a capitalist class subjugating, manipulating, and even oppressing other classes of people. Business is a concentrator of wealth in society (not a redistributor) and so the task of business, social, and environmental responsibility is very large – much more so than merely adopting token policies (as socialists would see them) that still maintain the supremacy of the capitalist classes. Business should be conducted in a very different way – one that recognises and redresses the imbalances in society and provides benefits to stakeholders well beyond the owners of capital.

Radical feministsLike the socialists, radical feminists (not to be confused with militants, but rather with a school of philosophy) also seek a significant re‑adjustment in the ownership and structure of society. They argue that society and business are based on values that are usually considered masculine in nature such as aggression, power, assertiveness, hierarchy, domination, and competitiveness. It is these emphases, they argue, that have got society and environment in the ‘mess’ that some people say they are in. It would be better, they argue, if society and business were based instead on values such as connectedness, equality, dialogue, compassion, fairness, and mercy (traditionally seen as feminine characteristics). This would clearly represent a major challenge to the way business is done all over the world and hence would require a complete change in business and social

the legal owners, only they have any right to determine the objectives and strategies of the business. Agents (directors) that take actions, perhaps in the name of social responsibility, that may reduce the value of the return to shareholders, are acting without mandate and destroying value for shareholders.

ExpedientsThe expedient position shares the same underlying value as that of the pristine capitalist (that of maximising shareholder wealth), but recognises that some social responsibility expenditure may be necessary in order to better strategically position an organisation so as to maximise profits. Accordingly, a company might adopt an environmental policy or give money to charity if it believes that by so doing, it will create a favourable image that will help in its overall strategic positioning.

Social contract positionThe notion of social contract has its roots in political theory. Democratic governments are said to govern in a social contract with the governed. This means that a democratic government must govern broadly in line with the expectations, norms and acceptations of the society it governs and, in exchange, society agrees to comply with the laws and regulations passed by the government. Failure by either side to comply with these terms will result in the social contract being broken. For businesses, the situation is a little more complex because unlike democratic governments, they are not subject to the democratic process.

The social contract position argues that businesses enjoy a licence to operate and that this licence is granted by society as long as the business acts in such a way as to be deserving of that licence. Accordingly, businesses need to be aware of the norms (including ethical norms) in society so that they can continually adapt to them. If an organisation acts in a way that society finds unacceptable, the licence to operate can be withdrawn by society, as was the case with Arthur Andersen after the collapse of Enron.

Social ecologists Social ecologists go a stage further than

culture. This theory relates to Hofstede’s ‘cultural dimensions’ introduced in the Paper F1 syllabus.

Deep ecologistsFinally, the deep ecologists (or deep greens) are the most extreme position of coherence on the continuum. Strongly believing that humans have no more intrinsic right to exist than any other species, they argue that just because humans are able to control and subjugate social and environmental systems does not mean that they should. The world’s ecosystems of flora and fauna, the delicate balances of species and systems are so valuable and fragile that it is immoral for these to be damaged simply (as they would see it) for the purpose of human economic growth.

There is (they argue) something so wrong with existing economic systems that they cannot be repaired as they are based on completely perverted values. A full recognition of each stakeholders’ claim would not allow business to continue as it currently does and this is in alignment with the overall objectives of the deep ecologists or deep greens.

CONCLUSIONThe issue of stakeholders lies at the heart of most discussions of ethics, and, accordingly, is very important for Paper P1. Being able to identify the stakeholders mentioned in a case scenario, and describing their individual claims upon an organisation, is likely to be an important skill for Paper P1 candidates to develop.

In addition, being able to identify the ethical viewpoints of people in a case scenario, perhaps with regard to stakeholder/stockholder perspectives, or using Gray, Owen and Adams’s positions, is also important. The various ways of categorising stakeholders is helpful for any stakeholder analysis but a general appreciation that business decisions are affected by and can affect many people and groups both inside and outside of the business itself, is fundamental to an understanding of the importance of stakeholders.

David Campbell is examiner for Paper P1

Corporate governance is a process and a system – and as with any system, it has many parts. The Paper P1 Study Guide recognises this in two parts (A1g and A1h) and the Paper P1 exam could ask about any of these. While each one has a role, they are not all a part of a company’s internal structure. Both internal and external actors can have a role in governance. Study Guide section A1g is concerned with internal actors; section A1h is more concerned with external actors.

Internal actors (and employee representatIves)directorsThe most prominent group of actors in corporate governance are the company’s directors. They can be either executive or non‑executive directors (NEDs); the numbers and split of executives to NEDs will partly depend upon the regulatory regime of the country. It is generally the case that investors and regulators prefer there to be more NEDs, as their independent scrutiny of the company, its controls and strategies, provide a more robust governance structure. In a unitary board structure, all directors share legal responsibility for company activities and all are accountable

to the shareholders. In most countries, all directors are subject to retirement by rotation, where they either step down or offer themselves for re‑election (by the shareholders) for another term in office.

Directors are collectively responsible for the company’s performance, controls, compliance and behaviour. This means that the board of directors must discuss and agree strategies to maximise the long‑term returns to the company’s shareholders. They must also comply fully with relevant regulatory requirements that will include legal, accounting and governance frameworks.

company secretaryIn most countries, the appointment of a company secretary is a compulsory condition of company registration. This is because the company secretary has important responsibilities in compliance, including the responsibility for the timely filing of accounts and other legal compliance issues. In addition to this responsibility for compliance with relevant laws and regulatory frameworks, the company secretary often advises directors of their regulatory and legal responsibilities and duties. His or her primary loyalty

is always to the company. This means that in any conflict with another member of the company (such as a director), the company secretary must always take the side most likely to benefit the company (rather than any single director).

Technical knowledge is therefore an important part of this role. Because of this, many countries’ company law mandates that for a public company, the postholder must be a member of one of a list of professional accountancy or company secretary professional bodies (which includes ACCA). The major roles include:¤ maintaining the statutory

registers (such as the share register)

¤ ensuring the timely and accurate filing of audited accounts and other documents to statutory authorities (eg government companies’ agencies and tax authorities)

¤ providing members (eg shareholders) and directors with notice of relevant meetings

¤ organising resolutions for and minutes from major company meetings (like the AGM); keeping records from these and other meetings.

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sub-board managementSometimes referred to (ambiguously) as ‘middle’ management, managers below board level are a crucial part of the governance system. It is the employees, led by sub‑board management, that implement strategies, meet compliance targets and collect the information and data on which board‑level decisions are made.

The effectiveness of sub‑board management as part of a governance system is partly based on the extent to which organisational activities are controlled and coordinated. Value‑adding synergies arise when specialists work to achieve organisational objectives in their own departments and are coordinated by an effective board of senior managers and directors. There is ample scope for ‘strategic drift’, especially in large organisations, when this vital control and coordination is ineffective.

employee representatives (trade unions)The most common way of providing employee representation (to the board) is through a trade union. Trade unions represent employees in a workplace; membership is voluntary and the influence of the union is usually proportional to the percentage of the workplace that are members.

Although often assumed to be in an adversarial relationship with management, trade unions can play a very helpful role in corporate governance. The adversarial assumption is probably unhelpful in many situations, as union members often share the same objectives for the organisation, and share professional and ethical values with management in carrying out the organisational strategy.

In terms of governance, trade unions are able to ‘deliver’ the compliance of a workforce. If a strategy needs a high level of commitment, a union can help to unite the workforce behind the strategy and ensure everybody is committed to it. This can also mean that management and workforce are seen as united by external stakeholders; this can make the achievement of strategies more likely. By collective bargaining over pay and th

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conditions, agreement usually signifies that the workforce ‘buys in’ to the agreed strategy or activity.

A trade union can be a key actor in the checks and balances of power within a corporate governance structure. Where management abuses occur, it is often the trade union that provides the first and most effective reaction against it; this can often work to the advantage of shareholders, especially when the abuse has the ability to affect productivity. Unions are often good at highlighting management abuses such as fraud, waste, incompetence and greed, all of which are unhelpful traits in board members.

Linked to the above, trade unions help to maintain and control one of the most valuable assets in an organisation, the employees. Where a helpful and mutually constructive relationship is cultivated between union and employer, then an optimally efficient industrial relations climate exists, thus reinforcing the productivity of human resources in the organisation. In defending members’ interests and negotiating terms and conditions, the union helps to ensure that the workforce is content and able to work with maximum efficiency and effectiveness.

internal actorsgovernance:

student accountant 08/2009

external actorsshareholdersShareholders and other investors (eg fixed‑return bond‑holders) are usually considered the most important external actors in corporate governance. In the agency relationship that exists between shareholders and directors, the shareholders are the principals. They have the right to expect agents (directors) to act in their best economic interests and to observe a fiduciary duty towards them.

Shareholders incur agency costs in monitoring the activities and actions of agents (directors). These are the costs of monitoring and checking on directors’ behaviour. Examples of agency costs are attending relevant meetings (AGMs and EGMs), studying company results and analysts’ reports, and making direct contact with companies through investor relations departments. When a shareholder holds shares in many companies, the total agency costs can be prohibitive; shareholders therefore encourage directors’ rewards packages to be aligned with their own interests so that they feel less need to continually monitor directors’ activities.

The Paper P1 Study Guide considers two types of shareholder: small investors and institutional investors. Small investors are individuals who hold shares in unit trusts, funds and individual companies. They typically buy, hold or sell small volumes and tend to have sh

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y.fewer sources of information on companies than institutional investors. They also often have narrower and less robust portfolios, which can mean that agency costs are higher, as the individuals themselves study the companies they have invested in for signs of changes in strategy, governance or performance.

Institutional investors are by far the biggest investors in companies, and they dominate the share volumes on most of the world’s stock exchanges. Pension funds, insurance companies, unit trust companies and similar financial institutions hold large numbers of shares in individual funds with each fund being managed by a fund manager. Individuals, either directly or through investment products (such as pensions or endowments) buy into investment funds that are then managed, by selectively buying, holding or selling shares and other investments. When the fund grows or reduces in value, the member gains or loses value as a result. Fund managers do have some influence over the companies that they hold shares in, with greater influence obviously being associated with higher proportionate holdings. Fund managers need to be aware of the performance and governance of many companies in their funds, so agency costs can be very large indeed. To reduce these, they make use of information from several sources on the companies and also

seek to have directors’ benefit packages aligned with their own interests as much as possible.

stock exchangesShares are bought and sold through stock exchanges. Each of the main international stock exchanges keeps an index of the value of shares on that exchange; this is the most frequently quoted ‘number’, referring to the total value of the shares on that exchange. In London, for example, the FTSE All Share (Financial Times Stock Exchange) index is a measure of all of the shares listed in London. In New York, it is the Dow Jones index and in Hong Kong, it is the Hang Seng index.

The value of any share on a stock exchange is calculated continuously, based on the demand and supply of that share. Demand for shares is driven by the expected future returns on that share which, in turn, is driven by expected company performance. Information suggesting an increase in performance will tend to increase demand for a given share; anything suggesting a deterioration in performance will cause fewer shares to be demanded. The price of a share rises and falls with supply and demand until the equilibrium price is achieved (when the same number of shares is supplied and demanded). Any change in supply or demand will then move the equilibrium price (ie the share price on the stock exchange).

technIcal

In addition to listing, pricing and transacting share buying and selling, stock exchanges can also have a role in the governance of the companies listed on the exchange. Listing rules are sometimes imposed on listed companies and in many cases, listing rules concern governance arrangements not covered elsewhere by company law. In the UK, for example, it is a stock exchange requirement that listed companies comply with the Combined Code on Corporate Governance: not a legal requirement but a stock exchange requirement. Other listing rules concern reporting behaviour. In a rules‑based jurisdiction, the law underpins corporate governance and reduces the need for stock market listing rules.

auditorsMost Paper P1 candidates will know about the role of auditors from studying Paper F8. The most obvious role of audit in corporate governance is to report to shareholders that, having audited the company’s accounts, the accounts are accurate (‘a true and fair view’ is the term used in some countries). Audit is also a legal requirement in compliance with company law as a condition of company registration and the granting of limited liability.

In addition to a normal audit, however, auditors perform a vital service to shareholders in highlighting issues in the governance and reporting of the company. A qualified audit report, while being a serious matter for a company, is also an important signal to markets about the company. Some auditors also offer additional services to clients and these sometimes include social and environmental advice and audit.

regulators and governments In addition to company law and listing rules, some companies and industrial sectors are subject to further external control by government‑appointed regulators or by governments themselves. This usually applies to companies or sectors involved in areas considered strategically or politically important by governments; these include the control of monopolies or the supply of utilities (such as water or energy). In some countries,

this also applies to military equipment and medical supplies. When this is the case, regulation typically applies to pricing and supply contracts.

In some countries, many large companies are owned, directly or indirectly, wholly or partially, by the host government. Nationalised companies are part of the economic fabric of many developing countries but tend to feature less prominently in more developed countries. It is generally believed that the profit motive, created by the agency relationship in a conventional shareholder–director arrangement, creates and stimulates greater economic efficiency than in nationalised companies.

Governments control corporate governance through the imposition of legislation and the enforcement (through a judiciary) of common and statute laws. Although governments usually have a range of political and social objectives in mind when controlling business, they also rely heavily on tax revenues levied on company profits and, where relevant, sales and other transaction taxes. One reason for the deregulation of much economic activity is the need to increase tax revenues and create employment by gaining the economic efficiencies offered by competition and executive reward packages that are aligned to added shareholder value.

David Campbell is examiner for Paper P1g

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student accountant 08/2009

'NON-CORPORATE' CORPORATE GOVERNANCEThis article considers two broad types of non-corporate organisation: public sector organisations and charitable/voluntary organisations

Much of the material written about the governance of organisations concerns ‘corporate’ governance, ie the governance of corporate limited and usually listed companies. There are very good reasons why this is an important area to study and understand as this is linked to the agency problem and the need for investors to trust and support the directors put in place as the ‘stewards’ of their investments.

The health of capitalist systems, the value of equities and the security of long-term shareholder value are all dependent on effective and robust systems of corporate governance and so it is right that these are at the centre of the Paper P1 Study Guide and in most of the textbooks on which the Paper P1 Study Guide draws. The Paper P1 Study Guide also covers governance in family and insider-dominated organisations (section A6b).

Governance issues also apply to a range of other organisational types, however. These types of organisation are important for different reasons to those for business organisations. In each case, an agency gap exists which governance systems can be used to address, but it is interesting to look at the nature of the principals in these agency relationships and how different types of organisations configure their governance arrangements.

In this article, I will consider two broad types of non-corporate organisation: public sector organisations and charitable/voluntary organisations. The purpose of this is to clarify and expand on the Paper P1 Study Guide section A1f.

PUBLIC SECTOR ORGANISATIONS

Public sector organisations are those that are directly controlled by one or more parts of the state. In the usual composition of a state (executive/government, legislature, judiciary and secretariat/administration) public sector bodies are usually found implementing parts of executive (government) policy in the secretariat or administration. This does not mean that they are all parts of government departments, however (although they might be, such as some hospitals and schools). They can alsobe devolved government bodies such as local government authorities, nationalised companies (where the majority of shares are owned by the government), supranational bodies, or one of a number of ‘arms-length’ bodies such as non-governmental organisations (NGOs).

The size of the public sector varies in different countries. In some countries, many of the largest companies are state-controlled, for example. In others, business activity is largely private, but the state may control public services such as education and health.

In terms of strategic purpose, public sector organisations exist to implement one or more aspects of government policy. The control over a particular public service, utility or public good is seen as so important that it cannot be left to the profit motive and the demands for returns from private shareholders. Organisational objectives will, therefore, be determined by the political leaders of the country at that time in line with government policy. For a nationalised rail service, for example, some loss-making route services may be retained in order to support economic development in a particular region.

The way in which these organisations are regulated and controlled is different from most business organisations. The focus is likely to be on value for money rather than the achievement of profits, and the level of control from central or local government can be very high, giving rise to criticisms that public sector organisations are over-bureaucratic and unnecessarily costly. They are likely to have service delivery objectives underpinned by legislation.

Despite their contrasts with business organisations, public sector organisations also incorporate an agency relationship. Their management, sometimes comprising a mix of elected and executive officers, serve the interests of their principals but the principals, as discussed, are likely to seek objectives other than long run profit maximisation. In public sector organisations, the ultimate principal is the taxpayer and elector (in a democracy) in that it is he or she that pays for the service and the organisations exist for their benefit.

Because taxpayers and electors are diverse and heterogeneous, different layers of public servants, elected and non-elected people seek to interpret taxpayers’ best interests, a task that is sometimes fraught with difficulty.

A typical problem in the governance of public sector organisations is establishing strategic objectives and monitoring their achievement. The millions of taxpayers and electors in a given country are likely to want completely different things from public sector organisations. Some will want them to do much more while others, perhaps preferring lower rates of tax, will

want them to do much less or perhaps not to exist at all. Interpreting these varying demands is affected by politics. It applies at all levels of state activity from the local, to the national to the supranational. It is normal in most countries to have a limited audit of public sector organisations to ensure the integrity and transparency of their financial transactions, but this does not always extend to an audit of its performance or ‘fitness for purpose’.

In recent years, a number of national governments have privatised some of their state-owned organisations. This means that they attempt to gain an accurate market value for a state-owned enterprise and then sell newly issued shares in that company on the country’s stock exchange. In doing this, the privatised organisation goes from state control to having to comply with company law and relevant listing rules. In liberalising their economies, many countries have undergone widespread privatisation programmes in recent years, creating large new companies in industries such as energy, water, transport and minerals, that were formerly state-owned. This change places the organisation in a potentially competitive market for the first time and changes the skills needed by executive directors to some extent. It is usually accompanied by asubstantial internal culture change as the new company adjusts to its new strategic situation.

CHARITIES AND VOLUNTARY ORGANISATIONS

In many countries, there is a sizeable ‘third’ sector (the first two being business and the state). In some countries there are tens of thousands of charities and voluntary organisations that exist, usually, for a particular social, environmental, religious, humanitarian or similar benevolent purpose. In most countries, this benevolent purpose is recognised by the state in that they enjoy tax privileges and reduced reporting requirements.

In exchange for favourable regulatory treatment, however, a charity must demonstrate its benevolent purpose and apply for recognition by the country’s charity commission or equivalent. It is not just regulatory authorities that a charity is accountable to, however. It also needs to raise funds to pursue its benevolent aims and so it needs donations. These usually come from individuals and organisations that share the charity’s benevolent aims and ethical values.

This opens up an interesting accountability relationship: how do donors giving to charities know that their donations will be used for the intended purpose and not wasted, misdirected or embezzled? In some jurisdictions, regulation is very light and some charities have taken advantage of this by very partial disclosure and minimal financial reporting. This, in turn, has led to criticism and calls for more rigorous corporate governance regulation of charities in some countries. Some charities voluntarily provide full financial disclosures and this places increased pressure on others to do the same. There have been many reports, however, of recipients of charitable donations misusing funds, sometimes for self-enrichment. This is clearly a breach of the trust placed in the charities.

A common way to help to reduce the agency problem is to have a board of directors overseen by a committee of trustees (sometimes called governors). In this case, the board manages the charity and the trustees act as a control on the board to ensure that the board is delivering value to the donors and are acting towards the stated and agreed benevolent aims. This protects the goodwill of the donors and ensures the efficient delivery of charitable services. The trustees are typically people who share the values of the charity and act in a similar way to independent or non-executive directors in a public company. Some schools and universities are run along these lines, for example. The trustees also have the power to recruit and remove senior executives in the charity.

One of the recent developments in seeking to maximise the effectiveness of charities, and hence deliver value to donors and users of the charitable service, is to measure and then publish the contribution the charity makes. Using a social orenvironmental audit-type framework, including a regular and transparent report on how the charity is run and how it has delivered against its stated terms of reference and objectives can greatly aid accountability and increase the confidence andtrust of all of the main stakeholders: service users, donors, regulators and trustees.

Written by a member of the Paper P1 examining team

April 2008 student accountant 39

technical

This article introduces some of the main themes in relation to the control of corporate governance and discusses how this control differs by country. In particular, the aim is to clarify the features and characteristics of rules-based and principles-based approaches to corporate governance, how each type of system is regulated, and to examine some of the associated benefits and drawbacks.

WhAT Is A ‘code’ And WhAT Is IT for?The regulation of corporate governance is not new. It has been an important part of company law for many decades and we should not assume that corporate governance did not exist before the various codes were drawn up. The importance of shareholders being able to hold directors to account was a key part of the design of the joint stock company, and company law has always provided for various aspects of this accountability relationship. It has traditionally been a condition of the granting of limited liability, for example, that companies should provide certain minimum information to their shareholders on an annual or half-yearly basis, in addition to general meetings and so on.

Furthermore, there have, unfortunately, always been corporate governance ‘scandals’ where company directors have acted illegally or in bad faith towards their shareholders. Bad corporate governance didn’t start with Enron. It has always been important for investors to have a high level of assurance that directors will act in the shareholder’s best interests and this need continues to this day. Part of the debate, however, is about the best mechanism to underpin the activities of directors in helping to achieve this. While in most countries, financial accounting to

corporate governance codes

shareholders is underpinned by company law and International Financial Reporting Standards, some of the other activities of directors are not, and it is in this respect that countries differ in their approaches.

‘Codes’ of corporate governance are intended to specifically guide behaviour where the law is ambiguous, or where a higher level of behavioural prescription is needed than can be provided for in company legislation. The Bangladesh Code of Corporate Governance (2004) explains this well:

‘The obvious function of a Code of Corporate Governance… is to improve the general quality of corporate governance practices. The Code does this by defining best practices of corporate governance and specific steps that organisations can take to improve corporate governance. The Code, thereby, begins to raise the quality and level of corporate governance to be expected from organisations; in some areas the Code specifies more stringent practices than is required by Bangladeshi law, but it should be emphasised that these additional requirements are in keeping with international best practices.’

The development of codes has, however, been essentially reactionary. A sense that ‘something must be done’ in response to certain corporate failures or serious breaches of faith by directors towards their shareholders, has tended to stimulate the production of codes to reduce the likelihood of reoccurrence. One of the earliest attempts to ‘code’ corporate governance behaviour was the UK’s Cadbury Code, issued in 1992. In response to a small number of cases linked to the dominance of a board by a single, overbearing combined CEO and chairman, one of the major Cadbury recommendations was that the two most

senior jobs in a company (CEO and chairman) should be held by separate individuals.

Other codes followed as it became clear that behaviour, other than financial, needed to be provided for. Codes appeared in countries other than the UK as investors sought additional assurance from corporate boards. The issue then arose as to whether and how these requirements should be policed and enforced.

rules And prIncIples-bAsed ApproAchesMany countries, including the UK and many Commonwealth countries, adopted what became known as a ‘principles-based’ approach to the enforcement of the provisions of corporate governance codes. Importantly, this meant that for publicly-traded companies, the stock market had to recognise the importance of the corporate governance provisions. By including the requirement to comply with codes within the listing rules, companies were able to adopt a more flexible approach to code provisions than would have been the case had compliance been underpinned by law.

The principle of ‘comply or explain’ emerged. This meant that companies had to take seriously the general principles of the relevant corporate governance codes (the number of codes increased throughout the 1990s and beyond) but on points of detail they could be in non-compliance as long as they made clear in their annual report the ways in which they were non-compliant and, usually, the reasons why. This meant that the market was then able to ‘punish’ non-compliance if investors were dissatisfied with the explanation (ie the share price might

rules, principles and Sarbanes–Oxleyrelevant to ACCA Qualification Paper P1technical

40 student accountant April 2008

technical

fall). In most cases nowadays, comply or explain disclosures in the UK describe minor or temporary non-compliance. Some companies, especially larger ones, make ‘full compliance’ a prominent announcement to shareholders in the annual report, presumably in the belief that this will underpin investor confidence in management, and protect market value.

It is important to realise, however, that compliance in principles-based jurisdictions is not voluntary in any material sense. Companies are required to comply under listing rules but the fact that it is not legally required should not lead us to conclude that they have a free choice. The requirement to ‘comply or explain’ is not a passive thing – companies are not free to choose non-compliance if compliance is too much trouble. Analysts and other stock market opinion leaders take a very dim view of most material breaches, especially in larger companies. Companies are very well aware of this and ‘explain’ statements, where they do arise, typically concern relatively minor breaches. In order to reassure investors, such statements often make clear how and when the area of non-compliance will be remedied.

As an example, here is a recent compliance statement from Aviva plc, a large UK-based company. The area of non-compliance describes a slight technical breach concerning two directors’ notice periods. Section B1.6 of the Combined Code specifies that notice periods of directors ‘should be set at one year or less’, and Section B1.5 explains that ‘the aim [of this is] to avoid rewarding poor performance’: ‘The Company has complied fully throughout the accounting period with the provisions set down in… the Combined Code except that, during the period, two executive directors had contracts with notice periods which exceeded 12 months.’

In contrast, Barclays plc issued an unqualified compliance statement for the year to 2006, as follows: ‘For the year ended 31 December 2006, we have complied with the provisions set out in… the UK Combined Code on Corporate Governance.’

BAE Systems plc (formerly British Aerospace) took a very direct approach in its 2006 report, directly quoting from the Combined Code and then detailing how the company had complied in detail with each important section. Visit http://production.

investis.com/investors/corpgov/introduction/ to see this approach online.

The idea of the market revaluing a company as a result of technical non-compliance tends, importantly, to vary according to the size of the business and the nature of the non-compliance. Typically, companies lower down the list in terms of market value, or very young companies, are allowed (by the market, not by the listing rules) more latitude than larger companies. This is an important difference between rules-based and principles-based approaches. Because the market is allowed to decide on the allowable degree of non-compliance, smaller companies have more leeway than would be the case in a rules-based jurisdiction, and this can be very important in the development of a small business where compliance costs can be disproportionately high.

The influence of the British system, partly through the Commonwealth network, has meant that principles-based systems have become widely operational elsewhere in the world. A quite different approach, however, has been adopted in the US.

sArbAnes–oxley And The ‘rules-bAsed’ ApproAchAfter the high-profile collapses of Enron and Worldcom in the US, the US Congress passed the Sarbanes–Oxley Act 2002 (usually shortened to ‘Sarbox’ or ‘Sox’). Unlike in the UK and in some Commonwealth countries, Congress chose to make compliance a matter of law rather than a rule of listing. Accordingly, US-listed companies are required to comply in detail with Sarbox provisions. This has given rise to a compliance consultancy industry among accountants and management consultants, and Sarbox compliance can also prove very expensive.

One of the criticisms of Sarbox is that it assumes a ‘one size fits all’ approach to corporate governance provisions. The same detailed provisions are required of small and medium-sized companies as of larger companies, and these provisions apply to each company listed in New York even though it may be a part of a company listed elsewhere. Commentators noted that the number of initial public offerings (IPOs) fell in New York after the introduction of Sarbox, and they rose

on stock exchanges allowing a more flexible (principles-based) approach.

An example of a set of provisions judged to be inordinately costly for smaller businesses are those contained in Sarbanes–Oxley Section 404. This section requires companies to report on the ‘effectiveness of the internal control structure and procedures of… financial reporting’. The point made by some Sarbox critics is that gathering information on the internal controls over financial reporting (ICFR) in a systematic and auditable form is very expensive and, arguably, less important for smaller companies than for larger ones. Accordingly, Section 404 has been criticised as being an unnecessary burden on smaller companies, and one which disproportionately penalises them because of the fixed costs associated with the setting up of ICFR systems. Advice in 2007 issued by the United States Securities and Exchange Commission (which, among other things, monitors Sarbox compliance) introduced a small amount of latitude for smaller companies, but the major criticisms of Section 404 remain.

relevAnce To pAper p1A substantial part of the Paper P1 Study Guide concerns matters of corporate governance. The manner in which corporate governance provisions are provided and enforced is an important part of corporate activity in each country because it is these systems that underpin investor confidence. Candidates for the Paper P1 exam need to have a sound knowledge and understanding of each aspect of the Paper P1 Study Guide, and the rules versus principles debate is a key part of this. Sarbox has been, and continues to be, an important influence on corporate governance and is specifically mentioned in the Paper P1 Study Guide for that reason.

useful lInKs The European Corporate Governance

Institute offers an excellent online resource, containing links to all of the major codes, at www.ecgi.org/codes

The Sarbanes–Oxley Act (2002) is available online at www.sarbanes-oxley.com

david campbell is examiner for paper p1

After the high-profile collapses of Enron and Worldcom in the US, the US Congress passed the Sarbanes–Oxley Act 2002 (usually shortened to ‘Sarbox’ or ‘Sox’).