Chapter 16 Governance and social responsibility

1. Chapter 16 Governance and social responsibility

2. Chapter Outline Responsibility to ALL stakeholder, not just shareholders CORPORATE GOVERNANCE CORPORATE SOCIAL RESPONSIBILITY SEPARATION OF OWNERSHIP AND CONTROL STAKEHOLDER NEEDS ANALYSIS • Mechanisms to improve corporate governance: • NEDs- Remuneration committee- Audit committee- Public oversight • Triple bottom line reporting: • Financial results- Social performance - Environment performance

3. Separation of ownership and control • People who own the company (shareholders) do not control the company (board of directors) e.g. in limited company • Decision-makers do not bear a major share of the wealth effects of their decisions • In a small company, directors are also likely to own all the shares in the company => no separation of ownership and control • In large companies there is likely to be a large number of external shareholders who play no role in the day-to-day running of the company => separation of ownership and control and potential for conflict of interests

4. Reasons for the separation of ownership and control • Specialist management can run the business better than those who own the business • Original shareholders cannot personally contribute all the capital needed to run the business => external capital from people who are not interested in the day-to-day operations • Win-win situation for both parties; • Managers can get on with full-time management of the business • Shareholders are interested in ROI and do not have the skills, time or inclination to deal with day-to-day matters

5. Reasons for the separation of ownership and control • Shareholder want safeguards to ensure that managers run the business in the interests of all the stakeholders fairly, not just in the managers’ own interests => Agency problem • Managers have to act in the best interests of the company as a whole • E.g. directors voting themselves huge salaries, bonus shares and golden parachutes

6. Test your understanding • The ‘separation of ownership and control’ refers to the situation where the owners of a company are always different people to the directors of the company. • True or false. Explain.

7. Other perspectives on governance • Stewardship theory • Management of an organisation are the stewards of its assets, charged with their employment and deployment in ways consistent with the overall strategy of the organisation • Agency theory (discussed) • Stakeholder theory • More ‘organic’ view of the organisation • Development of notion of stewardship, stating that management has a duty of care, not just to the owners but also to the wider community

8. Governance principles • Minimise risk • Ensure adherence to and satisfaction of strategic objectives • Fulfil responsibilities to all stakeholders and to minimise potential conflicts of interest • Establish clear accountability • Maintain independence of those who scrutinise the behaviour of the organisation and its senior executives • Provide accurate and timely reporting of trustworthy/independent financial and operational data • Encourage more proactive involvement of owners/members in effective management • Promote integrity, that is straightforward dealing and completeness

9. Meaning of corporate governance • Corporate governance is the set of processes and policies by which a company is directed, administered and controlled. It includes the appropriate role of the board of directors and of the auditors of a company. • Definitions: • ‘Corporate governance is the system by which companies are directed and controlled.’ (Cadbury Report, 1992) • ‘Corporate governance involves a set of relationships between a company’s management, its board, its shareholders and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined.’ (OECD Principles of Corp. Governance, 2004)

10. Meaning of corporate governance • Key issues • Membership of the board of directors – both executive and non-executive directors (NEDs) • Role of the BOD – purely to make money for shareholders or are there wider responsibilities • How directors’ remuneration is decided and disclosed • Role of both internal audit and external audit

11. Driving forces of governance development • Increasing internationalisation and globalisation • Differential treatment of domestic and foreign investors • Issues concerning financial reporting • Characteristics of individual countries • Increasing number of high profile corporate scandals

12. Features of poor corporate governance • Domination by a single individual • Lack of involvement of board • Lack of adequate control function (lack of internal audit, lack of adequate technical knowledge) • Lack of supervision (lack of segregation of key roles) • Lack of independent scrutiny • Lack of contact with shareholders • Emphasis on short-term profitability • Misleading accounts and information

13. Risks of poor corporate governance • Ultimately making such large losses that bankruptcy becomes inevitable. • The organisation may also be closed down as a result of serious regulatory breaches, for examples misapplying investors’ monies.

14. Meaning of corporate social responsibility (CSR) • ‘CSR is the continuing commitment by business to behave ethically and contribute to economic development while improving the quality of life of the workforce and their families as well as of the local community and society at large.’ (WBCSD, 1998) • CSR refers to the idea that a company should be sensitive to the needs and wants of all of the stakeholders in its business operations, not just the shareholders

15. Meaning of corporate social responsibility (CSR) • The stakeholders of a company are all those who are influenced by, or can influence, the company’s decisions and actions. • Examples of shareholder groups: • Shareholders - Suppliers • Directors - Government • Other employees - Lenders of funds • Customers • Community organisation, esp. in local neighbourhood • Sustainable development: companies should make decisions based not only on financial factors, but also on the social and environmental consequences of their actions

16. Meaning of corporate social responsibility (CSR) • WBCSD: CORPORATE RESPONSIBILITY(SUSTAINABLE DEVELOPMENT) CORPORATE FINANCIAL RESPONSIBILITY CORPORATE ENVIRONMENTAL RESPONSIBILITY CORPORATE SOCIAL RESPONSIBILITY

17. Corporate social responsibility (CSR) • Key issues in the CSR debate: • Employee rights, e.g. laws to prohibit ageism and other discrimination at work • Environmental protection, e.g. reducing factory emissions of poisons and pollutants • Supplier relations • Community involvement

18. Importance of CSR to an organisation’s success • Traditional view (losing support): • CSR offers no business benefits and destroys shareholder value by diverting resources away from commercial activity • Companies should operate solely to make money for shareholders and it’s not company’s role to worry about social responsibilities • Companies pay taxes to govt, and it is govt and charities that should are responsible for social matters

19. Importance of CSR to an organisation’s success • Modern view: • Coherent CSR strategy can offer business benefits by enabling a company to: • Monitor changing social expectations • Manage operational risks • Identify new market opportunities • Retain key employees • Alignment of firm’s core values and values of society can lead to better reputation and ensure long-term future • Costs of CSR initiatives should be thought of as an investment in an intangible strategic asset rather than as an expense

20. Impact of corporate governance and CSR on the organisation • Enhanced performance reporting methods • Balanced scorecard • Triple bottom line reporting

21. Balanced scorecard approach

22. Balanced scorecard approach • Only by succeeding in all 4 perspective can a company flourish in the long-term • Look at: • Financial perspective: annual profits, earning per share • Customer perspective: number of complaints received per month • Internal perspective: percentage of units requiring reworking • Innovation perspective: percentage of revenues from recently-introduced products

23. Triple bottom line reporting • Expands the reporting framework to include not just financial outcomes but also environmental and social performance • PEOPLE, PLANET, PROFIT

24. Non-executive directors (NEDs) • Company law refers only to ‘directors’ in general • However, 2 types of directors have emerged • Executive directors: involved in the day-to-day execution of management decisions • NEDs: • Attend primarily board meetings (and meetings of board committees) • Should be ‘independent’ • Oversight role

25. Non-executive directors (NEDs) • Being independent is similar to auditor independence, such as: • Not acting for a prolonged period of time • Having enough time to carry out the role properly • Having no links to the executives

26. Non-executive directors (NEDs) • Recommendations: • At least half the board (excluding the chairman) should comprise independent NEDs • A smaller company should have at least 2 independent NEDs • One of the independent NEDs should be appointed to be the ‘senior independent director’ – available to be contacted by shareholders who wish to raise matters outside the normal executive channels of communication

27. Test your understanding • Mrs X retires from the post of finance director at AB plc. The company is keen to retain her experience, so invite her to become a NED of the company. • Can she qualify as an independent non-executive?

28. Remuneration committees • Principle of most codes of corporate governance that no director should be involved in deciding the level of their own remuneration => remuneration committee with 3 (2 in smaller firms) independent NEDs • Responsible for setting the remuneration of all the executive directors and the chairman, incl. pension rights and any compensation payments • Whole BOD should determine the remuneration of the NEDs, or the board could delegate this responsibility to a committee of the board

29. Advantages and disadvantages of having a remuneration committee Advantages: • Avoids the agency problem of directors deciding their own levels of remuneration • Leaves the board free to make strategic decisions about the company’s future Disadvantages: • Danger of ‘you scratch my back, I’ll scratch yours’ (high remuneration for director, high for NEDs) • Cost involved in preparing for and holding committee meetings

30. Audit committees INTERNAL AUDITORS AUDIT COMMITTEE FULL BOARD OF DIRECTORS EXTERNAL AUDITORS

31. Audit committees • Consists of independent NEDs who are responsible for monitoring and reviewing the company’s internal financial controls and the integrity of the financial statements • Acts as an interface between the full board of directors and internal and external auditors

32. Audit committees • Auditors have problem that the people they report to and liaise with (the board) are often the people whose activities they report on. • Can cause major problems: • External auditors become too close to the executive directors • External auditors are not comfortable reporting errors, frauds, etc to the very people who have done them! • Internal auditors are not comfortable reporting systems weaknesses to the very people who designed the systems! • Board might have internal auditors to keep up appearance – but then ensure they don’t come anywhere close to areas with mistakes or frauds

33. Audit committees • Is a subset of the main board • Should comprise at least independent 3 NEDs (2 in smaller firms), one member must have recent relevant financial experience • Company’s Annual Report should describe the work of the audit committee • Should act as the first point of contact for both internal and external auditors, doing the following:

34. Audit committees • Being available for internal and external auditors • Requiring executive directors to attend as necessary • Reviewing accounting policies and financial statements as a whole to ensure that they are appropriate and balanced • Reviewing systems of internal controls • Agreeing agenda of work for the internal audit dept. • Receiving results of internal audit work • Shortlisting firms of external auditors when a change is needed • Reviewing independence of external audit firm • Considering extent to which external auditors should be allowed to tender for ‘other services’

35. Advantages and disadvantages of audit committees • Advantages: • Improved independence and overall quality of internal and external audit functions • Disadvantages: • Audit committees add another tier/level to decision-making by directors => this could slow a company’s activities down

36. Test your understanding • Why are the members of an audit committee required to be NEDs rather than executive directors?

37. Nomination committee • To find suitable applicants to fill board vacancies, to oversee the process for board appointments and make recommendations to the board for approval. • Factors to consider: • Balance between executives and NED • Skills possessed by the board • Need for continuity • Desirable size of the board • Recently diversity of backgrounds of board members

38. Public oversight of corporate governance • Public is a legitimate stakeholder in a large company and has therefore a ‘right to know’ how such a company is being governed and a right to be involved in the governance process • Publication of Annual Report and Accounts (incl. description of work of audit and remuneration committee) • Growth in power of NEDs • Companies discuss future plans with representatives of various stakeholder groups incl. journalists and local politicians

39. Corporate Governance • The system by which companies are directed and controlled • UK – Combined Code is principles based, company must ‘comply or explain’ • USA – Sarbanes Oxley is rules based (i.e. law) with personal liability of company officers

40. Stakeholder needs analysis • Can be carried out to bring some structure to the implementation of a CSR programme • Analysis involved doing research to determine: • Who are the key stakeholders in the business? • What are their needs? • Possible methods • Questionnaires • Focus groups • Direct interviews or interviews with representatives

41. Stakeholder needs analysis • To some stakeholders, the company owes obligations arising from the law (pay salaries to employees) • Other obligations arise voluntarily due to the company’s commitment to CSR (discuss plans with interested pressure groups before a particular plan is adopted)

42. Stakeholder needs analysis • Example: Stakeholders of 888.com (internet gambling site listed on London Stock Exchange) operating under licence granted by Govt of Gibraltar: • Shareholders (listed thus compliance with rules of exchange incl. adopting Combined Code on Corporate Governance) • Employees (good employer to all staff members) • Customers (to offer fair, regulated and secure environment in which to gamble) • Govt (to comply with terms of its licence granted in Gibraltar) • The public (sponsoring sports teams to strengthen brand; also addressing public concerns about negative aspects of gambling, e.g. compulsive gamblers)

43. Chapter summary Definition of corporate governance Systems by which companies are directed and controlled Definition of corporate social responsibility Idea that a company should be sensitive to the needs of all its stakeholder, not just shareholders. Separation of ownership and control in large companies means that rules on corporate governance are required to reduce agency problems. • Codes on governance typically refer to: • NEDs- Remuneration- Audit committee- Public oversight • Possible expanded methods of performance reporting: • Balanced scorecard (4 perspectives)- Triple bottom line reporting (People, Planet, Profit)