There is no single, accepted definition of what the expression ‘corporate governance’ means, but the majority of the definitions relate to “control” of the company.
This factsheet discusses what corporate governance is, the legal framework, plus the origins, purpose and main principles of the UK Corporate Governance Code.
What is corporate governance?
It is important to note that there is no single, accepted definition of what the expression ‘corporate governance’ means.
The majority of the definitions employed by corporate practitioners relate corporate governance to “control” of the company. “Corporate governance is the system by which businesses are directed and controlled.”(Cadbury Report, UK).
Another related theme common to definitions of corporate governance focuses upon the “supervision” of the company or of management. In addition, a number of definitions relate corporate governance to a legal framework, rules and procedures and private sector conduct. Finally, some practitioners talk of governance as encompassing relationships between shareholders, boards and managers.
Perhaps the most comprehensive definition of corporate governance is set out by the Organisation for Economic Co-operation and Development (OECD): “Corporate governance is one key element in improving economic efficiency and growth as well as enhancing investor confidence. 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. Good corporate governance should provide proper incentives for the board and management to pursue objectives that are in the interests of the company and its shareholders and should facilitate effective monitoring.” (OECD Principles, 2004, Preamble)
In other words, corporate governance means rigorous supervision of the management of a company; it means ensuring that business is done competently, with integrity and with due regard for the interests of all stakeholders. Good governance is, therefore, a mixture of legislation, non-legislative codes, self-regulation and best practice, structure, culture, and board competency.
The board and the individuals comprising it are at the heart of the company. They are the link between those who provide the capital and to whom they are accountable, and those, who carry out the policies and decisions they make and who are therefore accountable to the board. Corporate governance exists to provide a framework within which these regulations can operate effectively and the board can fulfil its key purpose.
The origins of the UK Corporate Governance Code
The origins of the current Code stem from the report of the Committee on the Financial Aspects of Corporate Governance, or the Cadbury Report, 1992, to which was attached a Code of Best Practice.
This was further developed through a series of reworkings including those of the Greenbury Committee, culminating in the Directors’ Remuneration – Report of a Study Group chaired by Sir Richard Greenbury, or the Greenbury Report, 1995 with its recommendations on executive pay and a Code of Best Practice.
It was then decided that previous governance recommendations should be reviewed and brought together in a single code. The work was carried out under the chairmanship of Sir Ronald Hampel and the ensuing Final Report: Committee on Corporate Governance, or the Hampel Report, 1998, with its Combined Code on Corporate Governance, which had a number of provisions relating to internal control.
However it gave little guidance on internal controls’ scope and extent. Consequently the Institute of Chartered Accountants in England and Wales, backed by the Stock Exchange formed a working party to study the matter of internal control, which resulted in the Turnbull Report, 1999.
In 2002, the Department of Trade and Industry (DTI) asked Derek Higgs to look at the role and effectiveness of non-executive directors. The ensuing report, known as Higgs Review, 2003, also suggested amendments to the Combined Code. At the same time as Higgs was reporting, the Financial Reporting Council (FRC) had asked a group chaired by Sir Robert Smith to issue Combined Code guidance for audit committees. In July 2003 the revised Combined Code, taking account of both the Higgs Review and the guidance for audit committees was published, and took effect for reporting periods beginning on or after 1 November 2003.
The Code is now called the UK Corporate Governance Code and has been updated at regular intervals since 2003. The latest revisions in April 2016 took effect for reporting periods beginning on or after 17 June 2016.
The Code begins with the words “The purpose of corporate governance is to facilitate effective, entrepreneurial and prudent management that can deliver the long-term success of the company.”It goes on to say that “Corporate governance is therefore about what the board of a company does and how it sets the values of the company. It is to be distinguished from the day to day operational management of the company by full-time executives.”
The purpose of the Code
All the UK reports and codes have taken the ‘comply or explain’ approach.
Only quoted companies (those with a premium listing on the London Stock Exchange, whether they are incorporated in the UK or elsewhere) are obliged to report how they apply the Code principles and whether they comply with the Code provisions and, where they do not, explain their departures from them.
The Code has also had a noticeable wider impact on governance of organisations outside the commercial corporate sector where parallel codes of governance are emerging. For a quoted company reporting on its application of the Code is one of its continuing obligations under the Listing Rules published by the UK Listing Authority (UKLA). If quoted companies ignore the Code, then there will be penalties under the Listing Rules.
The Code is divided into main principles, supporting principles and provisions. For both main principles and supporting principles a company has to state how it applies those principles. In relation to the Code provisions a company has to state whether they comply with the provisions or – where they do not – give an explanation. It is the Code provisions that contain the detail on matters such as separation of the role of chairman and chief executive, the ratio of non-executive directors and the composition of the main board committees.
The first principle of the Code states that: “Every company should be headed by an effective board.” The board’s effectiveness is widely regarded as a prerequisite for sustained corporate success. The quality and effectiveness of directors determines the quality and effectiveness of the board. Formal processes for appointment, induction and development should be adopted.
Effectiveness of the board and its individual members has to be assessed. The Code states that no one individual should have unfettered powers of decision-making. It sets out how this can be avoided by splitting the roles of chairman and chief executive, and specifies what the role of the chairman should be. The Code offers valuable guidance on the ratio of non-executive to executive directors and definitions of independence.
Main principles of the Code
The text of the Code can be found at the FRC's website and we do not set it out in full here.
For many non-quoted companies and other organisations the main principles of the Code form a useful starting point for reviewing their governance structures and processes, these are set out below.
a - Leadership
- The role of the board Every company should be headed by an effective board which is collectively responsible for the long-term success of the company.
- Division of responsibilities There should be a clear division of responsibilities at the head of the company between the running of the board and the executive responsibility for the running of the company’s business. No one individual should have unfettered powers of decision.
- The chairman The chairman is responsible for leadership of the board and ensuring its effectiveness on all aspects of its role.
- Non-executive directors As part of their role as members of a unitary board, non-executive directors should constructively challenge and help develop proposals on strategy.
b - Effectiveness
- The composition of the board The board and its committees should have the appropriate balance of skills, experience, independence and knowledge of the company to enable them to discharge their respective duties and responsibilities effectively.
- Appointments to the board There should be a formal, rigorous and transparent procedure for the appointment of new directors to the board.
- Commitment All directors should be able to allocate sufficient time to the company to discharge their responsibilities effectively.
- Development All directors should receive induction on joining the board and should regularly update and refresh their skills and knowledge.
- Information and support The board should be supplied in a timely manner with information in a form and of a quality appropriate to enable it to discharge its duties.
- Evaluation The board should undertake a formal and rigorous annual evaluation of its own performance and that of its committees and individual directors.
- Re-election All directors should be submitted for re-election at regular intervals, subject to continued satisfactory performance.
c - Accountability
- Financial and business reporting The board should present a fair, balanced and understandable assessment of the company’s position and prospects.
- Risk management and internal control The board is responsible for determining the nature and extent of the principal risks it is willing to take in achieving its strategic objectives. The board should maintain sound risk management and internal control systems.
- Audit committee and auditors The board should establish formal and transparent arrangements for considering how they should apply the corporate reporting and risk management and internal control principles and for maintaining an appropriate relationship with the company’s auditors.
d - Remuneration
- The level and components of remuneration Executive directors’ remuneration should be designed to promote the long-term success of the company. Performance-related elements should be transparent, stretching and rigorously applied.
- Procedure There should be a formal and transparent procedure for developing policy on executive remuneration and for fixing the remuneration packages of individual directors. No director should be involved in deciding his or her own remuneration.
e - Relations with shareholders
- Dialogue with shareholders There should be a dialogue with shareholders based on the mutual understanding of objectives. The board as a whole has responsibility for ensuring that a satisfactory dialogue with shareholders takes place.
- Constructive use of general meetings The board should use general meetings to communicate with investors and to encourage their participation.
The legal framework
The starting point for tracing governance in the UK is the system of company law. This is a statute-based law, further developed by the courts through precedent.
At its heart are the relevant provisions of the Companies Act 2006, which replaced, revised and sought to modernise previous companies legislation. The Companies Act 2006 was brought into effect over several years, the final provisions coming into force in October 2009.
The Act sets out, for the first time, the principal duties owed by directors to their companies. These duties apply to all companies, public and private, holding and subsidiary, and are a statutory benchmark of best practice for all. They are not, however, comprehensive. Other general duties are contained in the Insolvency Act 1986, as well as specific requirements and liabilities under a host of other legislation relating to health and safety, competition, tax etc. Some reference to case law precedents is also likely to be needed.
The self-regulatory framework
Much of governance goes beyond the legal framework. Company law deals at length with the individual and collective responsibilities of directors, but hardly mentions processes, quality standards or outcomes. Hence the development of the self-regulatory governance framework in the UK through various reports, which were driven and backed by those to whom the board is accountable. These reports concentrated on issues concerning the mechanics of controlling the boards of companies and their directors, preventing fraud, improving information about companies, and making boards of directors more accountable to shareholders.
Comply or explain
All the UK reports and codes, including the latest Code, have taken the ‘comply or explain’ approach. Although only quoted companies (UK and overseas) with a premium listing on the London Stock Exchange are obliged to report how they apply the Code principles and whether they comply with the Code provisions and, where they do not, explain their departures from them, the Code has had a noticeable wider impact on governance. This is true not just of non-quoted companies, but also of organisations outside the commercial corporate sector where parallel codes of governance are emerging. For a quoted company reporting on its application of the Code is one of its continuing obligations under the Listing Rules published by the UK Listing Authority (UKLA). If quoted companies ignore the Code, then there will be penalties under the Listing Rules.
The key corporate governance issues were the reasons why the reports came into being. They include:
- Board structure and membership
- Board management
- Directors’ remuneration
- Financial controls
- Accountability and audit
- Relations with shareholders
In all these issues, what has emerged is a corporate governance framework to enable companies to create prosperity within margins that are recognised and understood by their shareholders.
Companies are complex, wealth-producing machines. Shareholders own claims on the company. They have great powers – they can appoint and dismiss directors, they can wind up the company and they can change the nature of its business. All stakeholders have the potential to influence – for better or worse – the survival and prosperity of the company.
It is up to the board to manage the company’s relations with shareholders and other stakeholders, to balance stakeholder interests and the company’s interests, in the light of market forces, the law and regulation.
At the most basic level, it is about complying with the law and applying structural requirements that are underpinned by a business reason. Beyond that the policies, procedures and culture of the company inform its governance. In the end in developing the governance of the company, one has to come back to the purpose of the board: to provide the leadership to create prosperity.
© Institute of Directors. All rights reserved.