Corporate Governance

CORPORATE GOVERNANCE

Introduction

Corporate governance has been defined as the system by which companies are directed and controlled. It represents the means by which direction and control is applied to stewardship organization’s assets or resources in pursuit and delivery of sustainable value creation. The concern of corporate governance arises from the fact that there is complete separation between ownership and control of corporations. The structure of corporates is such that the owners entrust the company to board of directors as agents to manage the company and deliver the owners goals. The directors as agents may fall into self-interest and fail to pursue the goals of the company and by extension those of the shareholders. The sell-interest is referred to as the agency problem

Aspects of corporate Governance

  1. Mechanisms by which corporations are directed and controlled.
  2. Mechanisms by which those who direct and control the corporations are monitored and supervised.

 

  1. Mechanisms by which corporations are directed and controlled

Companies are generally controlled by the majority shareholders who can appoint themselves or appoint others to the board. The board then appoints the executive who runs the business on a day to day basis. The director’s crafts the vision, mission, goals and objectives. To ensure that the vision and the goals are realized the directors’ needs to put in place the mechanisms such as risk management systems, controls, framework for strategic planning etc.

  1. Mechanisms by which those who direct and control the corporations are monitored and supervised.

These are the methods by which the actions of the BOD can be examined and controlled. The mechanisms include, internal auditing, Audit committees, inclusion of the non-executive directors in committees, inclusion of the non-executive directors in committees, inclusion of the shareholder’s representative in committees.

Matters of concern in corporate governance

  • In whose interests is a company governed?
  • Who has the power to make decisions for a company?
  • To what aims or purpose are those powers used?
  • Who else might influence the governance of a company?
  • Are the governors of a company held accountable for the way in which they use their powers? 4 How are risks managed?

 

Reasons why corporate governance has gained a lot of attention in the recent past

  1. Increased corporate failure.
  2. Increased frequent and corrupt behavior.
  3. Increase in high level profile corporate fraud.
  4. Notable incidences of fraud and insider trading.
  5. Powerful and dominant BOD that manipulate the shareholders and other stakeholders.
  6. Diminishing ethical behaviors.
  7. A growing demand by stakeholders for transparency and accountability ns the world embrace the larger issues of democratization and governance.
  8. Apparently excessive directions pay that is fixed by the recipient.
  9. Enlightened breed of shareholders.

 

PRINCIPLES OF GOOD CORPORATE GOVERNANCE OR LIE UNDERPINNING CONCEPTS

  1. Fairness

Values, systems and activities to take care of all the shareholders, treat all the stakeholders equally. Systems and values in the company must be balanced by considering all those who have an interest in the company.

  1. Openness and transparency

Transparency requires timely and accurate disclosure of information by a corporate company on all material facts and information regarding the corporation including its financial situation, performance and ownership. It also involves informing the financial markets immediately of price sensitive information. Transparency is a critical component of corporate governance because it ensures that all of a company’s actions can be checked at any given time by an outside observer

  1. Independence

Mechanisms to avoid or minimize potential conflict of interest that may exist. This implies that the best interest of the company prevails at all times.

  1. Honesty/probity and integrity

Honesty is about being truthful and not misleading. Probity means the quality or condition of having strong moral principles, integrity, good character, honesty and decency.

Integrity means consistency between what n director says, writes and does. It means authenticity, candor, reliability, confidentiality, solidarity, and a willingness to accept personal accountability and be bound by board decisions and a director’s own role within them. The board should lead the company to conduct its business in a fair and transparent manner that can withstand scrutiny by stakeholders. Moral and ethical issues should be considered when making decisions relevant to the organization.

  1. Responsibility and accountability

Responsibility means that those charged with governance should take responsibility of failure. They should make decisions that will create wealth for the shareholders. One of the indicators of responsibility is resignation.

Accountability is the requirement to provide an explanation for failure. Mechanisms should give investors the means to query and access the actions of the board and its committees.

  1. Reputation

This is the sum total of all the opinions of those who interact with the entity. It reflects the organizations culture. Good reputation is sustained through acting reliably, credibly, trustworthy and responsibly in the market.

  1. Judgment

Having a balanced evaluation of the information necessary to make a decision.

 

Principles of good corporate governance applied in Kenya capital market

  1. Appointment, composition, size and qualifications of Board members: The company should establish a formal and transparent procedure in the appointment of Board members and all persons offering themselves for appointment as directors should disclose any potential area of conflict that may undermine their position or service as director
  2. Board balance: The Board should comprise a balance of executive and non-executive directors, with a majority of non-executive directors. Independent non-executive directors should be at least one third of the total number of Board members.
  3. Board size: The Board should be of a sufficient size. The Board should be of such a number that enables the requirements of the company’s business to be met. The size of the Board should not be too large to undermine an interactive discussion during Board meetings or too small such that the inclusion of wider expertise and skills to improve the effectiveness of the Board and the formation of its committees is compromised.
  4. Board diversity: The Board should have a policy to ensure the achievement of diversity in its composition. The Board should consider whether its size, diversity and demographics make it effective. Diversity applies to academic qualifications, technical expertise, relevant industry knowledge, experience, nationality, age, race and gender. The appointment of Board members should be gender sensitive and shall not be perceived to represent a single or narrow constituency interest. Diverse backgrounds and experiences on corporate boards, including those of directors who represent the broad range of society, strengthen board performance and promote the creation of long-term shareholder value. Boards should develop a framework for identifying appropriately diverse candidates that allows the nominating/corporate governance committee to consider women, minorities and others with diverse backgrounds as candidates for each open board scat.
  5. Multiple directorships: There should be a limit to the number of directorships a member of the Board holds at any given time. A director of a listed company except a corporate director shall not hold such position in more than three public listed companies at any one time. This is to ensure effective participation by such directors in the Board. In a case where the corporate director has appointed an alternate director, the appointment of such alternate director shall be restricted to two public listed companies at any one time. An executive director of a listed company shall be restricted to one other directorship of another listed company. A chairperson of a public listed company shall not hold such position in more than two public listed companies at any one time, in order to allow the chairperson to devote sufficient time to
  6. Structure of the Board: The Board should be constituted to ensure effectiveness and value addition to the Company. The Board and its committees shall have the appropriate balance of skills, experience, independence and knowledge of the company and its business, to enable them discharge their respective duties and responsibilities effectively.
  7. Board committees: The Board should establish relevant committees with written terms of reference, which set out their authority and duties. The committees should include: nomination committee; risk committee, audit committee and remuneration committee.
  8. Roles of Chairperson and Chief Executive Officer (CEO): The functions of the Chairperson and the Chief Executive Officer should not be exercised by the same individual. Separation of the roles of the Chairperson and the Chief Executive Officer ensures balance of power and authority and provides for checks and balances such that no one individual has unfettered powers of decision making. The Chairperson should be a non-executive Board member
  9. Age limit for Board members: There should be an age limit for the members of the Board, The recommended age limit is seventy years. However, members, at an Annual General Meeting, may vote to retain a Board member who is over seventy years.
  10. Board tools Principle: The Board should have the necessary tools and aids in place to enable it to be effective in discharging its roles and responsibilities.
  11. A Code of Ethics and Conduct: The Board should establish formalized ethical standards through the development of a Code of Ethics and Conduct and shall ensure that it is complied with
  12. Board induction and continuous skills development Principle: All Board members should receive induction on joining the board and shall update their skills and knowledge at regular intervals. The Board shall establish a formal induction program and ensure that every incoming member is inducted.
  13. Annual evaluation of Board members, including the CEO and Company Secretary Principle: The Board should undertake an annual evaluation of its own performance, the performance of the Chairperson, that of its committees, individual members, the Chief Executive Officer and company secretary.
  14. Remuneration of Board members Principle; Companies should remunerate Board members fairly and responsibly. The Board shall establish and approve formal and transparent remuneration policies and procedures that attract and retain Board members. The remuneration policy for Board members shall clearly stipulate the elements of such remuneration including directors’ fees, attendance allowances and bonuses. The Board remuneration policies and procedures should be disclosed in the annual report
  15. Compliance with Laws, Regulations and Standards Principle: The Board should ensure the company complies with the Constitution, all applicable laws and regulations, national and international standards, as well as its internal policies
  16. Governance audit Principle: The Board should ensure that a governance audit is carried out at least annually to confirm the company is operating on sound governance practices. The Board shall subject the company to an annual governance audit by a competent and recognized professional accredited for that purpose in order to check on the level of compliance with sound governance practices. The governance audit shall among other areas cover the company’s governance practices in the following parameters: leadership and strategic management; transparency and disclosure; compliance with laws and regulations;

How sound corporate governance addresses corporate failure

  1. It addresses issues of management, management succession land agency problem and reduces the chances of the management promoting their own self-interest.
  2. A sound system of corporate governance helps to identify and manage the wide range of risks that a company can fare. Some of which can cause corporate failure.
  3. An effective code which is part of good corporate governance structure will specify a range of internal effective controls that will ensure effective use of resources minimize waste and fraud and misuse of the company’s assets.
  4. Effective codes and principles will encourage reliable and complete external reporting of financial data and other range of voluntary disclosures. By using this information investors can establish what is going on in the company and will have advanced warning of any problems. Compliance with the principles enhances the investor confidence. This confidence extends to other stake holders such as tax authorities, industry regulators etc. some of whom can cause great trouble to the company if they believe that the company is poorly managed.
  5. Sound corporate governance will encourage and attract new investments lenders likely to extend credit, investors are likely to pump in investment to the company.

 

APPROACHES TO CORPORATE GOVERNANCE

Approaches to Corporate Governance

  • Rule based Approach
  • Principle based Approach.
  • Comply or explain

 

Rule Based Approach to Corporate Governance       

 

It is based on the view that companies must be required by law to comply with established principles of good corporate governance. No exceptions are allowed and non-compliance is a criminal offence. Compliance the code is hence enforced by the law.

Advantages of the rule-based approach:

  • All companies as they do not have a choice
  • All the companies are required to meet the same minimum standards.
  • The investors’ confidence will be improved.

Disadvantages

  • Some rules may not be suitable for all companies
  • May be too rigid.
  • Regulation overload
  • Some aspects of corporate governance may not be easily negotiable

 

 

PRINCIPLES BASED APPROACH       

 

Alternative to Rules based Approach. It is based on the view that a single set of rules is inappropriate for every company. It argues that the code of good corporate governance should consist of principles and not rules. Guidelines should be provided on hov/ the principle should be applied. Companies should be allowed to ignore what is not applicable to their circumstances.

Advantages of a principles-based approach

  1. It avoids the need for inflexible legislation that companies have to comply with.
  2. It is less costly which implies It is less burdensome in terms of time1 and expenditure.
  3. A principles-based approach allows companies to develop their own approach to corporate governance that is appropriate for their circumstances within the limits laid down by stock
  4. A principles-based approach allows can allow for transitional arrangements and unusual circumstances.
  5. Enforcement on a comply or explain basis means that businesses can explain why they have departed from the specific provisions if they feel it is appropriate.
  6. A principles-based approach accompanied by disclosure requirements puts the emphasis on Investors making up their own minds about what businesses are doing (and whether they agree departures from the codes are appropriate).

 

Limitations of a principles-based approach

  1. The Principles may be too broad that they are of very little use as a guide to best corporate governance practice.
  2. Investors cannot be confident of consistency of approach. Clear rules mean that the same standards apply to all directors. A principles-based approach promotes a ‘level playing field’, preventing individual companies gaining competitive or cost advantages with lower levels of compliance.
  3. There may be confusion over what is compulsory and what isn’t. Although codes may state that they are not prescriptive, their adoption by the local stock exchange means that specific recommendations in the codes effectively become rules, which companies have to obey in order to retain their listing.
  4. Some companies may perceive a principles-based approach as non-binding and fail to comply without giving an adequate or perhaps any explanation. Not only does this demonstrate a failure to understand the purpose of principles-based codes but it also casts aspersions on the integrity of the companies’ decision-makers. A rules-based approach, particularly if backed by criminal sanctions, may give shareholders more confidence that the company and its directors are complying.
  5. A principles-based approach depends on markets understanding the seriousness of noncompliance and revaluing shares appropriately. However non-specialist shareholders may not interpret the significance of disclosures correctly.
  6. It’s been suggested that a principles-based approach requires a regime where shareholders have meaningful rights in law, such as being able to vote individual directors off the board.

 

Comply or Explain Approach

This is a hybrid of the ruled based and principle-based approach to corporate governance. In a comply or explain approach, compliance with the principles of good corporate governance is not discretionally. Companies must comply to every detail of the code, however, if a company finds that it is unable to comply with a detail of the code the company must explain the non-compliance in the annual report. If the shareholders are not satisfied with explanation for the lack of compliance, they can punish the board through for example by direct intervention, holding the board directly accountable at general meetings selling shares among other means.. Comply or explain is a bit flexible compared to the rule-based approaches it allows latitude in compliance with details of the code.

 

THEORIES OF CORPORATE GOVERNANCE

  1. Agency theory

The theory addresses the problems arising when the agent does not act in the interest of the prineipah-Ageney relationship is defined as the relationship between the principles such as the shareholders and agents as the company executives and managers. In this theory shareholders who are the owners pr (lie principal hire agents to perform work. The principals delegate running of the business to the directors or managers who are the shareholder’s agents.

The agency theory expects the agent to act and make decision in the principals’ interest. In the contrary the agent may not necessarily make decisions in the best interest of the principal. The agent may succumb to self-interest opportunistic behavior and falling short of congruence between the aspirations of the principals and the agent’s pursuit. Several conflicts arise as a result of the principal agency relationship where control and ownership is separated.

  1. Stewardship theory

Unlike the agency theory the stewardship theory stresses not on the perspective of individualism but rather on the role of the top management as stewards integrating their goals as part of the organization. Stewardship perspective suggests that stewards are satisfied and motivated when the organizational success is attained. The stewardship theory recognizes the importance of structures that empowers stewards and offers maximum autonomy built on trust. This can minimize the costs aimed at monitoring and controlling their behavior. In order to protect their own reputation as decision makers in the organization, executives and directors are inclined to operate the linn to maximum financial performance as well as shareholders profits. The stewardship theory suggests that there should be integration between the agents and the shareholder’s interests.

  1. Stakeholder’s theory

A stakeholder is any individual, group of persons or an institution that has any interest financial or otherwise in the firm, is affected by the operations of the firm and has the potential to affect the present and future wellbeing of the firm. The stakeholder’s theory suggests that the managers of a company have a network of relationships to serve: with shareholders, employees, lenders, suppliers, government among other stakeholders. The network of the relationships can affect the decision-making processes. The theory therefore focuses on managerial decision making and the interest of all the stakeholders. No set of interest is assumed to more dominate the others. Given that it is not possible for the management to meet the expectations of each stakeholder to the full the management satisfies rather than optimizes in their decision making i.e. each stakeholder gets something but not exactly what they wanted.

  1. Resource based theory

While the stakeholders’ theory focuses on relationships with many groups for individuals’ benefits. The resource-based theory concentrates on the role of B.O.D in providing access to the resources needed by the firm. The theory focuses on the role that the board plays in providing a access to essential resource to an organization through their linkages to the external environment. The resource-based theory emphasizes on appointment of representatives of independent organizations as a means of gaining access to resource critical for ‘the firm’s success. In constituting a B.O.D therefore, non-executive directors can be drawn from a law firm for a linkage to engineering resources etc. It is argued that provision of resources enhances organizations functioning, firms performing and survival. The directors should consist of insiders, business experts, support specialist’and community influence.

  1. Transaction cost theory

The theory views the firm as an organization comprising of people with different views anti objectives. The underlying assumption of the theory is that firms have become so large and in effect this has affected the allocation of resources. The theory suggests that when the principal appoints agents to act for them there are costs incurred for hiring the agent, Agents receive a reward for their activities which is a cost. Apart from this there are contractual arrangement costs and compliance costs in putting in place mechanisms to maintain the accountability of the agent, to the principal.

Directors will act rationally in the best interest of the shareholders only to a certain extent. They are bound to pursue their own interest since they too have their own aspirations and expectations from the organization. The conflict of interest needs to be maintained at a level that is tolerable and not detrimental to the interest of the organization. The theory highlights that the transaction costs are as a result of efforts to budge the information asymmetry between the directions and shareholders and alignment of interests. These are the economic costs of controlling the directors to make them more accountable.

Examples of the agency costs

  1. Monitoring costs – These includes the cost of measuring, observing and controlling the agent’s behavior. Monitoring is necessary because the agents are in possession of much more information compared to the shareholders. Therefore, the owners need to ensure that the directors are making proper use of the information for the benefit of the owners and the longterm survival of the organization. The monitoring cost may include supervision costs, cost of meetings, cost of conducting management audits and appraisals and others.
  2. Bonding costs – These are the costs incurred by the directors in setting up and adhering to . structures and systems that will enable them to act in the best interest of the shareholders, e.g. the cost of convening additional meetings, the cost of audit communities and the cost of designing and implementing Internal Control Systems.
  3. Residual loss – This is the cost that arise despite the monitoring by the shareholders and the bonding efforts by the directors, for example, the cost arising due to business decisions going wrong.

 

  1. Political theory

This theory focuses on allocation of corporate power between the shareholders the board and the executive.

Measures to improve corporate governance

  1. Having an effective board
  2. Ensuring that the role of the chairman and the CEO are clearly separated so that no one individual has unfetted powers of decision making.
  3. Establishing a remuneration committee.
  4. Through the company’s Act requirements, e.g. external auditor, AGM, maintenance of proper books of accounts etc.
  5. Inclining agency costs.
  6. Developing a code of ethics for the directors.
  7. Signing performance contracts.
  8. Threats of firing.
  9. Threats of hostile takeover.
  10. Ensuring free flow of information to the shareholders.

 

REVIEW QUESTION

MASESE MINING LIMITED (MML)

Masese Mining Limited (MML) is one of the most successful medium sized copper Mining companies in the Republic of Congo and lias its headquarters in Brazzaville, the country’s capital city. The company was established in 1928 and employs over 4,000 people. The company recognizes that to maintain the degree of success it has achieved over the years, it must adopt effective management strategies and good corporate governance practices, while at the same time create and maintain long term shareholder value.

In the late 1990s, MML suffered losses for several years that ultimately led to a high level of debt amid the global economic crisis. In the early years of 2000s, however, the world emerged into a period of greater stability. Convinced that the market pays for good corporate governance practices, MML chose to cancel its debt with the proceeds of an initial public offer (IPO) at the country’s security exchange market in 2006. This IPO permitted the company to raise approximately Sh. 11 billion. Prior to the IPO, the company took several critical steps towards improving its governance structure. These include:

  • Restructuring the Board of Directors by incorporating independent directors and establishing Board Committees.
  • Implementing a Code of Ethics and Governance Practice.
  • Formation of a Corporate Governance and Compliance Committee.

In the course of reforms, MML implemented a comprehensive set of rules, strategies and regulations to ensure good corporate governance. The reforms were inspired by reference to recommendations in major International Codes of Best Practices such as the King’s Code, the OECD Code and the Cadbury’s Report. Minority shareholders were encouraged to participate in policy and decision making, To facilitate participation in its Annual General Meeting (AGM), the company sends a notice and agenda to its shareholders 28 days in advance. Shareholders also receive proxy forms.

The top management formulates broad policies which are submitted to the Board of MML for consideration and approval. MML’s top management also oversees the business and is responsible for execution of the policy decisions of the Board of Directors. The chairman of the Board is elected by the Board members and the CEO is appointed by the Board. Other senior managers are selected by the nomination committee competitively, The Directors of the company are elected by the shareholders at the Annual General Meeting. Particulars of management remuneration are disclosed to shareholders and the public in (he annual report as well as in the company’s securities market filings. Board members receive a certain percentage of the annual net income of the company up to a maximum limit established by the AGM.

The company maintains that it is in its best interest to maintain high standards of social responsibility in order to ensure the long term success of its business. In particular, MML’s social responsibility programme expenditure totaled Sh.500 million during the 2018 financial year, This included provision for water, education, health and roads. The company also reclaims its disused mines where it plants trees and other vegetation. Most of the MML’s customers are industrial companies in the region, Asia and Europe. MML has developed a customer service charter that .supports the relationship between MML and its customers.

MML’s Board of Directors has 7 members, five of whom are independent. The company’s commitment to the highest degree of disclosure to its shareholders has led to the appointment of a nominee of the Social Security Fund to sit on MML’s Board and participate in committee activities.

There are four committees that support the Board’s work namely; Audit, Compensation, Nominations and Corporate Governance and Compliance, Each committee includes a majority, of independent directors with the audit committee composed solely of independent- Board members, MML’s Board chairman and the CEO’s roles are separate. This ensures Board impartiality in providing oversight roles. MML conducts periodic evaluation of the Board.

The Board approved a code of ethics and governance practice that is available to all stakeholders and is a required reading for company employees and Board members. The ethics and compliance officer reports to the audit committee. Both the ethics and compliance officer and the audit committee chairman can receive reports under the company’s “Whistle-Blower Programme” set to enable company stakeholders to report anonymously when they suspect or have information about possible code violations.

MML adheres to International Financial Reporting Standards and the financial reports are audited by an independent external auditor who is accountable to the MML Board. Additionally, the company discloses all business relationships and material provisions of contracts to shareholders. MML’s Chief of Internal Audit directly reports to the Board.

For MML to achieve its strategic objectives, the company adopted the European Foundation for Quality Management (EFQM) business excellence model ns a strategic monitoring and evaluation tool.

Required

  1. a) i) Explain five roles of the independent directors at MML in enhancing good corporate governance practices.                                                               (5 marks)
  2. ii) Suggest five other measures (with exception of the ones mentioned in the case study) which could be adopted by MML to improve its corporate governance.

(5 marks)

  1. b) MML has a “Whistle Blower Programme”.

Assess five quality disclosure that an employees of MML could use as a defense in case of unfair dismissal for whistle blowing.                                                  (10 marks)

  1. c) With reference to strategic monitoring and evaluation, analyze six benefits that MML could derive from adoption of European Foundation for Quality Management (EFQM) business excellence model.                                                              (6 marks)
  2. d) One of the roles of top management is to formulate broad policies which are submitted to the board for consideration and approval.

Examine six other possible roles of the top management of MML.                 (6 marks)

  1. e) Discuss four types of corporate social responsibility that MML could engage in.

(8 marks)

  1. Evaluate five shortcomings of stewardship approach to corporate governance.
  2. With reference to listed companies, analyze six roles of Capital Markets Authority in promotion of corporate governance in your country.
  3. With reference to provisions of corporate governance practice, explain the term “comply or explain”.
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