The basics of Corporate Governance

Summary

This script delves into the necessity and intricacies of corporate governance, highlighting the separation of ownership and control. It underscores the importance of aligning directors' actions with shareholders' interests, ensuring long-term wealth creation over short-term profits. The discussion covers various governance structures, with a focus on the unitary board system. It contrasts regulatory approaches, favoring the principles-based method over the rules-based one. The script outlines best practices, including a majority of non-executive directors, separate roles for the chair and CEO, and key subcommittees like audit, nomination, and remuneration. It also touches on international standards, emphasizing the OECD and ICGN frameworks, and concludes with practical advice for exams, suggesting that understanding shareholder concerns is key to grasping governance codes.

Takeaways

• 📈 Corporate governance is essential due to the separation of ownership and control in businesses, ensuring directors act in shareholders' best interests.
• 👔 Directors may have different objectives from shareholders, potentially leading to actions that benefit them personally but not the long-term health of the company.
• 🏢 The structure of corporate governance includes board composition, director roles, and internal controls, which are crucial for directing and controlling organizations.
• 🌐 Board structures can vary globally, with multi-tier systems featuring a supervisory board and a management board, or a more common unitary board with a mix of executive and non-executive directors.
• 📚 Corporate governance can be enforced through a rules-based approach, like the Sarbanes-Oxley Act in the USA, or a principles-based approach, which is more flexible and adaptable.
• 🔍 A principles-based approach requires companies to comply with best practice principles and disclose any deviations, allowing investors to make informed judgments.
• 🌟 Best practice in corporate governance often includes having at least half of the board composed of non-executive directors to ensure independent oversight.
• 🛠️ Key roles of non-executive directors include strategy development, scrutiny of executives, ensuring proper risk management, and overseeing human resources within the board.
• 🔑 It's a best practice for the roles of the chairperson and CEO to be separate to prevent concentration of power and to ensure clear division of responsibilities.
• 💼 Board subcommittees such as audit, nomination, and remuneration committees play vital roles in financial oversight, director appointments, and compensation, respectively.
• 🌱 The inclusion of a risk committee is becoming more common, focusing specifically on risk management and allowing for the involvement of executive directors.

Q & A

Why is corporate governance necessary?

Corporate governance is necessary due to the separation between ownership and control. It ensures that directors act in a manner that aligns with the objectives of the shareholders, preventing potential conflicts of interest that may arise from directors' personal objectives differing from those of the shareholders.

What is the primary role of non-executive directors (NEDs) in a unitary board structure?

Non-executive directors serve to represent the interests of shareholders without having operational responsibilities within the company. They are crucial in decision-making to prevent business decisions from being dominated by those with operational interests, thus ensuring a balance of power and oversight.

What are the four key roles of non-executive directors as outlined in the script?

The four key roles of non-executive directors are: Strategy (contributing to the company's strategic direction), Scrutiny (overseeing and challenging the decisions made by executive directors), Risk (ensuring proper risk management processes are in place), and People (assisting in board composition and director appointments).

Why should the roles of the chairperson and the CEO be separate in a corporate governance structure?

Separating the roles of the chairperson and the CEO prevents the concentration of power in one individual, which can be a concern for shareholders and the business. It allows for a clear division of responsibilities, with the chairperson focusing on running the board effectively and the CEO managing the business operations.

What is the significance of having a majority of independent non-executive directors on a board?

Having a majority of independent non-executive directors ensures that decisions are not dominated by those with operational responsibilities within the company. This helps maintain objectivity and focus on the long-term interests of the shareholders, rather than short-term operational gains.

What is the purpose of the audit committee in corporate governance?

The audit committee reviews the financial statements, oversees internal and external audits, and ensures there is an effective risk management process in place. It is typically composed of non-executive directors with financial expertise to provide independent oversight of the company's financial integrity.

What does the nomination committee in a corporate governance structure focus on?

The nomination committee is responsible for the board's composition, considering the structure, size, diversity, and the appointment of directors. It makes recommendations for the board's composition to ensure it has the right mix of skills and experience.

What is the remuneration committee's role in corporate governance?

The remuneration committee determines the compensation of directors, balancing fixed salaries with performance-related pay to motivate directors without encouraging excessive risk-taking. It ensures that the compensation structure aligns with the long-term goals of the shareholders.

Why is a risk committee sometimes established as a separate board subcommittee?

A risk committee can provide specific focus on risk management, separate from the audit committee, which typically consists of non-executive directors. This allows for the inclusion of executive directors in risk oversight, ensuring that risk management is given the necessary attention and is well-integrated within the business.

How does corporate governance relate to the principles-based approach versus the rules-based approach?

Corporate governance can follow a principles-based approach, which is more flexible and allows for the application of best practice principles in various circumstances. Alternatively, a rules-based approach, such as the Sarbanes-Oxley Act in the USA, mandates specific legal requirements with enforceable consequences, providing a more rigid structure.

Outlines

00:00

🏢 Corporate Governance Overview

This paragraph introduces the concept of corporate governance, emphasizing its necessity due to the separation between ownership and control in businesses. It highlights the potential misalignment of interests between shareholders and directors, and how corporate governance aims to ensure directors act in the best interest of shareholders. The paragraph also outlines the broad aspects of corporate governance, including board structure, director roles, and internal controls. Different governance structures, such as multi-tier and unitary board systems, are discussed, along with the advantages and disadvantages of each. The importance of having a clear governance structure to establish effective internal controls is also highlighted.

05:02

📜 Regulatory Approaches and Best Practices

The second paragraph delves into the regulatory environment of corporate governance, contrasting a rules-based approach with a principles-based approach. It explains that while rules-based systems like the Sarbanes-Oxley Act in the USA provide strict legal requirements, principles-based systems offer more flexibility and rely on best practice guidelines. The paragraph also discusses the 'complier explained' basis, which is a requirement for listed companies in the UK to apply the corporate governance code and disclose any non-compliance. International codes like the OECD and ICGN are mentioned as frameworks for best practice in corporate governance, with a focus on unitary boards, the composition of non-executive directors, and the separation of the chairperson and CEO roles.

10:05

🔍 Roles and Committees in Corporate Governance

This paragraph focuses on the roles and responsibilities within a unitary board structure, particularly the importance of non-executive directors (NEDs) who are there to represent shareholder interests. It outlines the four key roles of NEDs: Strategy, Scrutiny, Risk, and People. The paragraph also discusses the separation of the chairperson and CEO roles to ensure independence and checks on power. Furthermore, it details the functions of three key board subcommittees: the audit committee, which reviews financial statements and oversees internal and external audits; the nomination committee, responsible for director appointments and board structure; and the remuneration committee, which sets director pay to align with shareholder interests. The potential addition of a risk committee is also mentioned to give risk management specific attention.

15:11

🌟 Best Practice Principles and Governance Codes

The final paragraph summarizes the key principles of best practice in corporate governance, including the establishment of effective board leadership with separate roles for the chairperson and CEO, ensuring board effectiveness through adequate time and information for directors, and clarifying accountability within the board. It also emphasizes the importance of director remuneration that aligns with shareholder interests and maintaining strong relationships with shareholders. The paragraph suggests that understanding corporate governance from a shareholder's perspective can help in grasping the underlying logic of governance codes, which is beneficial for exam preparation.

Keywords

💡Corporate Governance

Corporate governance refers to the system of rules, practices, and processes by which a company is directed and controlled. It encompasses the relationship among various stakeholders, including the board, management, shareholders, and other corporate entities. The video emphasizes the importance of corporate governance due to the separation of ownership and control, ensuring that directors act in the best interests of shareholders. It is central to the video's theme, as it discusses the structures and practices that make up good governance.

💡Ownership and Control

The separation of ownership and control is a fundamental concept in corporate governance. It refers to the situation where the owners of a company (shareholders) do not directly manage the company and instead hire managers (directors) to do so. The video explains this divorce as a reason for the necessity of corporate governance, to align the interests of directors with those of the shareholders, ensuring that the company is managed to meet long-term shareholder objectives.

💡Directors

Directors are individuals elected by the shareholders to oversee the management of the company and to act in the best interests of the shareholders. The video discusses the potential conflict of interest between directors and shareholders, where directors might have different objectives, such as maximizing short-term profits for their bonuses, which may not align with long-term shareholder wealth. Good corporate governance structures aim to mitigate such conflicts.

💡Board Structure

Board structure pertains to the composition and organization of a company's board of directors. The video mentions two types of structures: multi-tier and unitary. In a multi-tier system, there is a separation between a supervisory board of non-executive directors and a management board of executives. In contrast, a unitary board combines both executive and non-executive directors. The choice of structure can impact how the board functions and the checks and balances in place.

💡Non-Executive Directors (NEDs)

Non-executive directors are members of the board who do not have executive responsibilities within the company. They are crucial for providing independent oversight and ensuring that the company is managed in the best interests of shareholders. The video stresses that at least half of the board should be composed of NEDs to prevent decisions from being dominated by executives and to provide a check on their actions.

💡Executive Directors

Executive directors are members of the board who also hold executive positions within the company, such as the CEO or CFO. They are responsible for the day-to-day management of the company. The video discusses the importance of balancing the board with non-executive directors to prevent executive directors from dominating board decisions and to ensure a focus on long-term shareholder value.

💡Unitary Board Structure

A unitary board structure is a model where the board of directors comprises both executive and non-executive directors. The video highlights this as the more common approach in practice, as opposed to the multi-tier system. It allows for a single board to oversee all aspects of the company's operations and strategy, which can lead to more efficient decision-making.

💡Regulatory Environment

The regulatory environment in corporate governance refers to the legal and regulatory framework within which companies operate. The video discusses two approaches: rules-based, where there are specific legal requirements to follow, exemplified by the Sarbanes-Oxley Act in the USA; and principles-based, which provides more flexibility and is guided by best practice principles. The video suggests that a principles-based approach is more common and allows for better adaptation to different circumstances.

💡Comply or Explain

Comply or explain is a principle that requires companies to either comply with best practice corporate governance codes or explain why they have not done so. The video uses the UK corporate governance code as an example, where listed companies must apply the code and disclose any deviations and their reasons. This principle ensures transparency and allows investors to make informed decisions.

💡Risk Management

Risk management in the context of corporate governance involves identifying, assessing, and mitigating potential risks that could impact the company's operations and strategy. The video mentions that non-executive directors play a role in ensuring that risk management processes are in place and operating effectively. It also discusses the possibility of having a separate risk committee to focus specifically on risk management.

💡Subcommittees

Subcommittees are smaller groups within the board of directors that focus on specific areas of responsibility, such as audit, nomination, and remuneration. The video explains that these committees are essential for good governance as they provide specialized oversight in critical areas. For example, the audit committee reviews financial statements and oversees the audit process, while the remuneration committee sets executive pay to align with shareholder interests.

Highlights

Corporate governance is necessary due to the separation of ownership and control.

Shareholders' objectives may differ from those of directors.

Directors might prioritize short-term profits over long-term shareholder wealth.

Corporate governance aims to align directors' behavior with shareholders' objectives.

Governance involves the structure of the board, directors' roles, and internal controls.

Multi-tier systems separate supervisory and management boards, while unitary boards combine them.

Unitary boards are more common and consist of executive and non-executive directors.

Regulatory environments can be rules-based, with legal requirements, or principles-based, offering flexibility.

The principles-based approach outlines best practices that can be adapted to different circumstances.

Compliance with governance codes is often required for listed companies.

The OECD code and ICGN report provide international best practice guidelines for corporate governance.

At least half of a unitary board should be composed of non-executive directors.

Non-executive directors play roles in strategy, scrutiny, risk, and people management.

The chairperson and CEO should be separate roles to prevent concentration of power.

Board subcommittees typically include audit, nomination, and remuneration committees.

The audit committee is responsible for financial oversight and risk management.

The nomination committee focuses on board composition and director appointments.

The remuneration committee sets executive pay to align with shareholder interests.

A risk committee can provide specific focus on risk management within the business.

Governance codes focus on leadership, effectiveness, accountability, remuneration, and shareholder relations.

Corporate governance can be understood by considering the concerns of a shareholder.

Transcripts

Let's have a look at corporate governance.

Why we need it?

What exactly it is?

And what constitutes best practice?

Corporate governance is required because of a divorce between ownership and control.

Shareholders own a business and they have their own objectives.

What they would like the directors to do in the business is to work to ensure that their

own objectives are met, to make sure the shareholders objectives are met.

But, directors have their own objectives too.

And they may on occasion differ from what the shareholders want.

So, for example if the directors are being paid a bonus based on profits produced for

this year, it's no surprise that directors will work hard to produce profits for this

year.

That's not necessarily the same as producing long term shareholder wealth.

I could increase my profits this year by cutting back on training, by cutting back on research

and development, by cutting corners.

And I would make a profit this year and a bonus but it wouldn't necessarily be good

for the business.

So, what corporate governance does is seek to try and ensure that the directors behave

in such a way as to insure the shareholders objectives are met.

Now, corporate governance is fairly big picture, is to do with the structure of the board,

the roles of the directors on the board and the subcommittee's on that board and how the

board works basically, internal controls and trickles down from there.

So, once you've got the governance structures right in the first place, internal controls

then follows.

So, corporate governance is the method by which organizations are directed and controlled.

Is to do the board structure composition and roles.

Now, starting off with board structure, there are various alternatives around the world

for ways in which corporate governance structures are decided upon at a senior level.

At some jurisdictions have what's known as a multi tier system, where they'll have a

supervisory board?

Which is the senior board on which non-executive directors sit?

So, everyone on that board has no executive responsibilities within the business, no operational

responsibilities.

And reporting into that supervisory board, we have a management board and this is where

all the executives sit.

They are the people that have operational responsibilities in the business.

So, your head of Finance, your head of HR, your head of IT will sit on the management

board and report up to the supervisory board.

Keeping those two separate has lots of advantages.

It means that you get, the supervisory board are not in any way encumbered or threatened

potentially by the executive directors being in the same meeting.

But it does mean that you have lots of separate meetings going on and you don't have all the

brains in the room at the same time when you're making key decisions.

So, it's also a relatively expensive way to set it up because of all the meetings and

the communication that's required between the two boards.

The much more usual approach is for to have a unitary board structure, which just means

the organization has one board.

And on that board there are the executive directors and the executive directors of people

with operational responsibilities in the business and the non-executive directors, the people

are there purely to ensure the business is being run on behalf of the shareholders.

We're going to focus most of our attention on the unitary board that side of things because

it is most common in the real world.

Now, corporate governance as a regulatory sort of environment can take one of two forms.

We can either have a rules based approach and a rules based approach is where you have

typically some legislation like in the USA we have the Sarbanes-Oxley Act, sometimes

shortened to SAR box.

And that's a legal requirement for companies to follow, the rules laid down in the Sarbanes-Oxley

Act.

And if you don't comply with the requirements of that act, then there are legal consequences,

you can be taken to court, you could potentially be sent to prison.

That is relatively rare; it's a relatively sort of strict legally enforceable regime.

The usual approach is to go for a more principles based approach, which is a little bit more

flexible in its application.

One of the issues the rules-based approach is that it's very difficult to come up with

rules that suit every single set of circumstances.

So with the principles based approach, you lay out best practice principles that can

be applied flexibly in different term, in different circumstances.

So, the principles based approach is outlined best practice and we'll come on to what that

best practice generally is in a minute.

And it's normally required to be implemented on what's known as a complier explained basis.

This is slightly different from saying it's a voluntary code just because it's best practice.

So, for example, in the UK, if you're a listed business, listed company on the stock exchange

then by virtue of being listed, you agree to apply the UK code on corporate governance

on a complier explained basis.

Which means, you need to state in your financial statements whether you fully comply with that

code or if you don't, the way in which you don't and why you don't?

And provided, you've disclosed the way in which you don't comply then you're covered

as far as the listing rules are concerned.

And that means then the investors have all the information they need to then help them

decide whether or not they're happy with your lack of compliance.

And sort of in the background here is the thought that there could be a perfectly good

reason why you don't or can't comply with one elements of the corporate governance code.

And it's up to then the investors to decide whether or not they're happy with that.

One of the advantages it's often quoted for the principles based approach is that the

judgments are being made by the owners of the business here, the investors, as opposed

to a rules based approach where judgment is being made by the courts.

So, it's not voluntary.

It's best practice.

It's not voluntary, if you're a listed business.

So, you need to apply it on a complier explained basis.

Now, as far as international rules are concerned with corporate governance, generally speaking

corporate governance is a very jurisdiction or country specific thing.

But there are codes out there that are espousing general and best practice.

And probably, the best known is the OECD code, which is quite a high-level sort of code that

talks about the rights of shareholders and so on the obligations of directors and the

International Corporate Governance Network, the ICGN, took the OECD framework and made

it much more sort of applicable.

So, it's kind of guidance notes to help people understand how to apply the principles in

their own businesses.

So, the ICGN report is really the best we have for international best practice as far

as corporate governance is concerned.

That said, that its jurisdiction specific.

As you go round the different jurisdictions in principles based approaches, they are all

very similar and there's a lot of things that flow through them all and let's have a look

at what constitutes best practice now.

So, for a unitary board, first of all, we have at least half the board made up of non-executive

directors or Ned's as they're known for short.

These people have no operational responsibilities on the board.

They are typically part-timers, they're usually paid a salary, they're often very experienced

business people and they are there to represent the needs of the shareholder.

And the reason why we say we have at least 50% of the board being Ned's is that it means

it's any decisions cannot be dominated by people with operational responsibilities within

the business.

So, if you get the finance director for example, who is an executive director because he's

also head of finance, dominating decisions they might be sidetracked or compromised by

what's going on in their own department rather than thinking of the business as a whole.

And to try and stop that from happening we have a majority or said we would don't have

a majority of executive directors, we have at least half the people in the room being

non executives and maybe there'll be a majority.

So, the four roles of a non-executive director, you can learn with this list of forwards SSRP,

Strategy Scrutiny Sisk in People.

So, they are there to contribute to the strategy of the business and they are there to scrutinize

the executive directors and to make sure that the decisions the executive directors make

is in the best interests of the shareholders.

Now, they are to ensure that risk management processes are in place and operating.

And on the people side of things, that they're to make sure that the board has the right

number of people on it, the right types of people on it, they've got the right sorts

of roles and that last one, people tends to get sorted out through the various committees

that we'll talk about in a moment.

Another key principle of best practice is that the chair person, who runs the board

and the CEO, the chief executive officer, who is the manager of the executives in the

business should be separate roles, there should be two separate people.

If you have one person doing both those roles, first of all it's a lot of work for one person

to do and you'd have to question whether they can do both roles well.

Secondly, it puts an awful lot of power into one pair of hands which might be a concern

for shareholders and for the business.

And it also means that the chair and the CEO can keep their respective responsibilities

completely apart.

So the chairperson runs the board, the CEO runs the business.

And yes, the two couldn't sort of bounce ideas off each other.

And hopefully, we get better answers as a result.

But keeping the role separate ultimately should mean that the board and the executive function

in the business operates a little bit more independently and a little bit better.

And then, at various board subcommittees, the majority of best practice codes say there

should be three boards subcommittees, the audit committee, the nominating committee,

and the remuneration committee.

The audit committee reviews the financial statements.

It is the clearance point for internal and external audit.

And the reason for that is that the audit committee is made up of typically three non-executive

directors, independent non-executive directors, at least one of which needs to have relevant

and recent financial experience.

So they know what they're, where they're, what they're doing when they're reading a

set of financial statements.

And they are relatively independent which means an internal audit cleared to them, internal

auditor therefore independent and if external audit clear to them, that helps make their

all a little bit easier.

Because you don't want for example external audit to be clear into the finance director,

if the external audit team have got something to say about the way the finance department

is run.

So, they clear internal audit, external audit, review the financial statements.

And then also, if there isn't a separate risk committee, will come on to the risk committee

in a minute.

They'll also take responsibility for ensuring that there is a risk management process in

place and operating.

The nomination committee is to do with who is on the board.

So, nomination naming, so who is named as directors on the on the board and they'll

consider things like the structure of the board, how big it needs to be?

Whether we should have more internally promoted people or bring people in from the outside.

Now, consider issues like diversity and so on and make recommendations for approval.

The remuneration committee looks at how directors are paid.

So, they'll look at things like the proportion of fixed salary to a bonus or performance-related

pay.

If the performance-related pay, they'll make sure it's sufficient to motivate directors

but not so excessive that it causes them to take silly risks, and they'll make sure that

it's structured in such a way as to encourage the directors to work towards the long term

goals of the shareholders.

So they'll set the pay effectively for the executive directors in the business.

It's also becoming increasingly common these days for there to be a fourth committee, the

risk committee to take the responsibility off the audit committee and give risk management

a bit of specific focus.

Now, that's good in many ways.

Not only does it give it specific focus, it also means that we can get some executive

directors involved.

Because remember, the audit committee is made up of non-executive directors.

So, if the audit committee you're looking after risk, then there won't be any executive

directors involved directly in looking after risk.

So, the risk committee gives it a bit of separate consideration to make sure that risk management

is given the profile that it needs and the focus that it needs to operate well within

the business.

So, they're the general sort of principles of best practice that you'll see with corporate

governance.

There are various others, but that's the main ones.

Now, let's cope with governance codes, this is based only on the UK code but this would

be the same for any codes really around the world.

Right, focus on these five areas.

So, they'll look at leadership, so they'll look at the role of the chairman and the role

of the CEO and make sure those roles are separate and how they work and make sure they work

together well, and the effectiveness of the board, so making sure for example that directors

have sufficient time to do their job, they have sufficient information given to them

in sufficient time before meetings to enable them to come to well reasoned decisions and

they ensure accountability of the board and clarify accountability of the different members

of the board, they've got the different subcommittees there but also to clarify that the board of

directors are responsible for the performance and operations of the business as a whole,

to ensure that directors are remunerated in an appropriate way, to encourage them to think

like shareholders and to behave how shareholders would want them to behave.

And also, to ensure they maintain relationships with those shareholders.

So, for example not seeing the annual general meeting as purely legal administrative exercise

but using the AGM as a way to communicate with shareholders and to get shareholders

involved in making key decisions in the business.

It's also increasingly common to identify particular non-executive directors, sometimes

called a senior non-executive director, to give them as a point of contact for shareholders

to contact if they have any questions throughout the year to try and improve relations with

shareholders.

There's a general point to finish on for the exam.

Although, there is a lot of sort of ideas and concepts surrounding corporate governance,

if you imagine being a shareholder and you're employing somebody else to look after your

business for you.

If you think about the kind of things that you would worry about and how you'd make yourself

feel better about those things, those are the control mechanisms you'd put in place.

You usually find that what you're actually doing is describing the corporate governance

code.

So they have they have an underlying logic to them which helps us in exams.

Thanks for listening.