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Corporate Governance System’s Effectiveness in the UK

Introduction

The purpose of this paper is to critically evaluate the effectiveness of the system of corporate governance in the UK. Corporate governance is “the system by which companies are directed and controlled” (Cadbury 2002, p. 7). There have been significant developments in the UK’s corporate governance system since the publication of the Cadbury Report in 1992. The Cadbury Report required listed companies to ensure transparency in financial reporting and to establish effective internal controls. In 1995, the Greenbury Report was published to provide guidelines on determination of executive director’s remuneration. The Hampel Report introduced the Combined Code in 1998, which required auditors to report on internal control to directors. In 1999, the Turnbull Report provided guidelines to enable companies to comply with the Combined Code. The report published by Smith and Higgs in 2003 provided guidelines on the establishment of the audit committee and its role in corporate governance. It also led to the introduction of the FRC Combined Code, which provided guidelines on the roles and appointment of board members.

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Literature Review

UK’s Corporate Governance Effectiveness

The system of corporate governance in the UK has been changing from time to time. The UK Corporate Governance Code is often reviewed every two years through consultations between the Financial Reporting Council, the public, and listed companies (Tricker & Tricker 2012, p. 78). The periodic reviews have strengthened the effectiveness of corporate governance by introducing changes that address the weaknesses in the Corporate Governance Code. Thus, the corporate governance system has led to adoption of best boardroom practices in majority of listed companies (Solomon 2011, p. 71).

The corporate governance system in the UK is based “on the principle of comply or explain” (Calder 2008, p. 112). This means that listed companies are required to comply with the Corporate Governance Code. However, in the event of non-compliance listed companies are required to explain to their investors the reasons for their failure to comply. The strength of this principle is that it facilitates a self-regulation system in which shareholders use their voting rights to hold their companies to account (Gugler 2001, p. 89). However, reviewing the Corporate Governance Code often hinders compliance. The regulations are often changed before companies understand and adopt them. For instance, in 2013 only 57% of the FTSE 350 companies complied with the Corporate Governance Code since some of them were yet to understand the changes made to the code in 2012 (Mallin 2013, p. 92).

Corporate Governance Codes

Leadership Effectiveness

The UK Corporate Governance Code requires companies to have a single board that is responsible for the long-term success of the company. Moreover, the responsibilities of the board and the executives must be separated (Rani & Mishra 2009, p. 105). Effective leadership is ensured by establishing transparent procedures to appoint directors with the right skill set. Moreover, the board’s performance has to be evaluated regularly to promote effective leadership. According to the stewardship theory, directors can only provide effective leadership if they are trustworthy and able to act in good faith (Rani & Mishra 2009, p. 107). However, lack of respect and honesty often leads to poor leadership in UK companies.

Accountability

The Corporate Governance Code requires companies to establish formal and transparent systems to ensure honest reporting and risk management. This includes establishing an audit committee whose members are experienced and independent directors to ensure accountability. However, board members often find it difficult to hold executive directors to account since the later always has greater knowledge about the company than the former (Rani & Mishra 2009, p. 110).

Remuneration

According to Sirkka (2008, pp. 955-977), the remuneration committee limits the executives’ ability to overpay themselves. This perspective is based on the fact that the committee consists of non-executive directors whose decisions are not influenced by the executives. Moreover, a significant proportion of the executives’ remuneration is linked to their performance. Thus, they cannot earn more without contributing to the long-term success of the company.

Relations with Shareholders

UK’s Corporate Governance Code requires listed companies to maintain positive relationships with their shareholders through regular contacts and making resolutions for all major issues raised during general meetings (Spitzeck 2009). Shareholders are also expected to monitor the performance of their companies. However, most shareholders cannot monitor the performance of their companies due to lack of information (Crawford & Stein 2004, pp. 498-512).

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UK’s Stock Market

The companies listed at the London Stock Exchange have to comply with the provisions of the FRC Combined Code. The Code requires listed companies to have a single board that is responsible for developing their strategy. The Code allows independent chairmen of listed companies to sit in remuneration and audit committees (FRC 2005, 1-38). Furthermore, an independent non-executive director can chair more than one listed company. In order to ensure effectiveness, listed companies are required to separate the roles of the chief executive officer and the chairman. The board is required to have independent remuneration and audit committees to ensure accountability and transparency (Avison & Cowton 2012, pp. 42-53). Moreover, the performance of the board has to be evaluated annually to ensure that it acts objectively and in the interest of the shareholders.

Company Laws

The company law provides the legal enforcement mechanism for ensuring compliance with governance requirements. The UK company law requires directors to comply with their company’s by-laws and governance requirements (Lacy 2013, p. 57). This requirement is expected to motivate directors to act in the interest of the shareholders. Accordingly, non-executive directors are required to make independent judgment and to avoid conflict of interest. In addition, they must have and apply reasonable expertise when executing their duties (Usa 2009, p. 83). In this regard, the non-executive directors have two main functions. First, they evaluate the company’s strategy objectively and advise the executive. Second, they supervise the performance of the company’s executives. However, the ability of non-executive directors to perform their oversight duties is limited by their involvement in strategy development (McLaughlin 2013, p. 109). Specifically, the non-executive directors are likely to develop a sense of collective responsibility for the effectiveness of the company’s strategy, thereby undermining their ability to assess the performance of the management objectively.

Audit and Corporate Governance

Audit and Risk Management

The internal audit function plays a key role in corporate governance. It ensures that appropriate procedures are in place to identify the risks that are likely to affect the performance of the company negatively (Jones 2008, pp. 1052-1075). The audit team also discusses the risks with the management and ensures that appropriate measures are taken to minimize or eliminate their effects. For international companies, internal auditors help in assessing currency risks. This includes evaluating the impact of currency fluctuations on revenue and advising managers to mitigate the risks. Internal auditors also evaluate insurance risks that face international companies. In order to promote accountability, internal auditors assist in investigating fraud and suggesting appropriate solutions to prevent misappropriation of the company’s resources.

Relationship between External and Internal Audit

A good work relationship between the external and internal audit is central to effective corporate governance. It helps the company to cut costs by reducing audit test, eliminating duplication of audit work, and delegating part of external auditor’s work to internal auditors (Iqbal & Strong 2010, pp. 168-189). These benefits can be realized if both internal and external auditors are fully aware of the activities within the organization. The audit committee can improve the relationship between internal and external audit by acting as a mediator in the event of disagreements. The committee can also provide guidance on matters such as the accounting standards to be used and the expected level of disclosure to improve the relationship.

Discussion

The Cadbury Report recommended that the board should establish effective internal financial control systems to ensure accountability (Avison & Cowton 2012, pp. 42-53). Moreover, the board should have an audit committee to evaluate and report on the effectiveness of the company’s internal financial control systems (Ross & Crossan 2012, pp. 215-225). This requirement ignores the importance of establishing control systems to monitor the efficiency and effectiveness of non-financial business functions such as operations. As a result, the Hampel Report suggested that directors should evaluate the effectiveness of all internal controls (Davis & Aston 2011, pp. 58-81). The rationale of this recommendation is that a comprehensive evaluation of all internal controls will lead to identification of all risks that face the company (Ross & Crossan 2012, pp. 215-225).

The Greenbury Report suggested that transparency in executive compensations can be achieved if companies report the level of their directors’ remunerations to the shareholders. For instance, in 2012 Marks & Spencer’s shareholders complained about the company’s decision to pay its top executives cash incentives that were twice as much as their basic salaries in 2011 (PRIC 2012). As a result, the company’s board implemented improved remuneration policies to regulate the pay of the executives. According to the Greenbury Report, a remuneration committee should be established to ensure accountability by setting the right compensation for the directors. The effectiveness of this requirement depends on the independence of the remuneration committee and the availability of an effective compensation strategy (Florackis 2008, pp. 37-59). For instance, although Marks & Spencer had a remuneration committee that consisted of independent and qualified non-executive directors, it lacked a clear remuneration strategy. In 2009, the company’s remuneration committee awarded the executives generous compensation packages despite their underperformance (Avison & Cowton 2012, pp. 42-53). This contradicts Cadbury’s perspective that the remuneration of the executive directors should be linked to their performance.

Cadbury (2002) argued that effective leadership can be achieved if the board clearly divides the responsibilities and procedures that it uses to execute its duties (Davis & Aston 2011, pp. 58-81). He suggested that the board should have committees to undertake its duties effectively. The main problem with the committees is that they lack independence (Mertzanis 2011, pp. 222-243). For instance, the nomination committee can be influenced by powerful shareholders to recommend a particular candidate for appointment. Hampel’s report suggested that the chairman and the chief executive officer roles should be separated. Separating responsibilities improves corporate governance by preventing conflict of interest and enhancing the board’s ability to perform its oversight role (Mertzanis 2011, pp. 222-243). However, the principle of comply or explain provides a loophole for some companies to avoid complying with the separation of roles requirement. For instance, in 2008 Marks & Spencer’s chief executive officer and chairman positions were held by one person (Nash 2008). The company’s board defended itself by arguing that combining the roles would give them ample time to identify a new CEO. By providing this explanation to the shareholders, the board managed to breach the principle of separating roles without being held responsible for breaking the provisions of the Combined Code.

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The reports published by Hampel and Turnbull suggested that company’s should have an effective internal audit function to enhance corporate governance (Davis & Aston 2011, pp. 58-81). The gist of this recommendation is that internal auditors will help the board to assess the risk facing their companies by providing information on the effectiveness of internal control systems (Davies 2002, pp. 14-18). Although this strategy is likely to improve risk management, it limits the board’s ability to make independent judgment concerning the challenges facing their company (Davies 2002, pp. 14-18). This perspective is based on the fact that the decisions of the board will be based on the information provided by the internal auditors whose actions can be manipulated by the executives. Similarly, the reports provided by the auditors may not reflect the right financial position of the company if the auditors have limited or inaccurate information about the business (Avison & Cowton 2012, pp. 42-53).

According to the Higgs and Derek’s report, the effectiveness of corporate governance should be improved by evaluating the performance of the board and its committees (Davis & Aston 2011, pp. 58-81). Additionally, the board members should undergo professional development and training to improve their skills and ability to control their companies. This recommendation has helped companies to improve the performance of their board members who lack experience or skills to perform their duties effectively (Hind, Williams & Lenssen 2009, pp. 7-20). For instance, Marks & Spencer has an induction program for its non-executive directors (Marks & Spencer 2014). The induction helps new non-executive directors to get acquainted with their roles. However, evaluating the performance of board members is not often effective in improving corporate governance (Russell & Dewing 2008, pp. 978-1000). The board reports to shareholders who often lack timely and adequate information to evaluate the performance of directors (Dewing 2003, pp. 309-322). Undoubtedly, making decisions about the board’s performance during the annual general meeting is not effective. Specifically, the concerns of minority shareholders can be ignored due to their limited voting rights (Russell & Dewing 2008, pp. 978-1000).

The Flint Report suggested that the principle-based or voluntary approach is the best way to improve corporate governance in the UK. The voluntary approach encourages shareholders to ensure that board members are performing according to their expectations (Dedman & Filatotchey 2008, pp. 248-258). However, the voluntary approach lacks a legal enforcement mechanism to compel companies to operate according to the expectations of their shareholders and the regulators. The large institutional investors who are expected to hold non-executive directors to account may opt to sell their investments in the company rather than to remove the board members from office. Consequently, some companies will consistently fail to comply with the provisions of the Combined Code (Sun, Salama & Habbash 2010, pp. 679-700). This will lead to more scandals and corruption in large companies in the UK.

Conclusion

Effective corporate governance is necessary for the long-term success of companies. It facilitates effective leadership, accountability, and positive relationships between the company and its shareholders. The UK uses a principle-based approach to corporate governance where companies voluntarily comply with the provisions of the Combined Code. The main weakness of corporate governance in the UK includes the fact that the various committees that are established at the board level often lack independence. This limits the boards’ ability to make objective judgments. The principle of comply or explain has also been used by directors of some companies to avoid complying with the provisions of the Combined Code.

In light of these weaknesses, the following recommendations should be considered to improve corporate governance in the UK. First, appropriate measures should be put in place to enhance the independence of non-executive directors. This will improve the board’s ability to perform its oversight role. Second, a legal enforcement mechanism should be introduced to ensure that the principle of comply or explain is not abused by non-executive directors. Finally, the FRC should provide technical support to companies to improve compliance with the requirements of the Combined Code.

References

Avison, L & Cowton, C 2012, UK Audit Committees and the Revised Code, Corporate Governance, vol. 12 no. 1, pp. 42-53.

Cadbury, A 2002, Corporate Governance and Chairmanship: A Personal View, Macmillan, London.

Calder, A 2008, Corporate Governance, Sage, London.

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Crawford, M & Stein, W 2004, Risk Management in UK Local Authorities: The Effectiveness of Current Guidance and Practice, International Journal of Public Sector Management, vol. 17 no. 6, pp. 498-512.

Davies, H 2002, Corporate Governance and the Development of Global Capital Markets, Balance Sheet, vol. 10 no. 3, pp. 14-18.

Davies, M & Aston, J 2011, Auditing Fundamentals, Prentice Hall, New York.

Dedman, E & Filatotchey, I 2008, Corporate Governance Research: A Contingency Framework, International Journal of Managerial Finance, vol. 4 no. 4, pp. 248-258.

Dewing, I 2003, Post-Enron Developments in UK Audit and Corporate Governance Regulations, Journal of Financial Regulation and Compliance, vol. 11 no. 4, pp. 309-322.

Florackis, C 2008, Agency Costs and Corporate Governance Mechanisms: Evidence for UK Firms, International Journal of Managerial Finance, vol. 4 no. 1, pp. 37-59.

Gugler, K 2001, Corporate Governance and Economic Performance, Palgrave, London.

Hind, P, Wilson A & Lenssen, G 2009, Developing Leaders for Sustainable Business, Corporate Governance, vol. 9 no. 1, pp. 7-20.

Iqbal, A & Strong, N 2010, The Effect of Corporate Governance on Earnings Management Around UK Rights Issues, International Journal of Management Finance, vol. 6 no. 3, pp. 168-189.

Jones, M 2008, Internal Control, Accountability and Corporate Governance: Medieval and Modern Britain Compared, Accounting, Auditing and Accountability Journal, vol. 21 no. 7, pp. 1052-1075.

Lacy, J 2013, Reform of UK Company Law, Sage, London.

Mallin, C 2013, Corporate Governance, John Wiley and Sons, New York.

Marks & Spencer 2014, Corporate Governance, Web.

McLaughlin, S 2013, Unlocking Company Law, Oxford University Press, London.

Mertzanis, H 2011, The Effectiveness of Corporate Governance Policy in Greece, Journal of Financial Regulation and Compliance, vol. 19 no. 3, pp. 222-243.

Nash, T 2008, Marks & Spencer Caused an Outcry by Appointing Sir Stuart Rose as both Chairman and Chief Executive, Flying in the Face of the Combined Code, Web.

PRIC 2014, Concerns over M&S Remuneration Report, Web.

Rani, G & Mishra, R 2009, Corporate Governance, McGraw-Hill, New York.

RFC 2005, Internal Control: Revised Guidance for Directors on the Combined Code, Web.

Ross, A & Crossan, K 2012, A Review of the Influence of Corporate Governance on the Banking Crises in the United Kingdom and Germany, Corporate Governance, vol. 12 no. 2, pp. 215-225.

Russell, P & Dewing, I 2008, The Individualization of Corporate Governance: The Approved Persons’ regime for UK Financial Services Firms, Accounting, Auditing & Accountability Journal, vol. 21 no. 7, pp. 955-977.

Sirkka, P 2008, Corporate Governance: What About the Workers?, Accounting, Auditing and Accountability Journal, vol. 21 no. 7, pp. 955-977.

Spitzeck, H 2009, The Development of Governance Structures for Corporate Responsibility, Corporate Governance, vol. 9 no. 4, pp. 495-505.

Solomon, J 2011, Corporate Governance and Accountability, McGraw-Hill, New York.

Sun, N, Salama, A & Habbash, M 2010, Corporate Environmental Disclosure, Corporate Governance and Earnings Management, Managerial Auditing Journal, vol. 25 no. 7, pp. 679-700.

Tricker, B & Tricker R 2012, Corporate Governance: Principles, Politics and Practices, John Wiley and Sons, New York.

Usa, U 2009, United Kingdom Company Law, Macmillan, London.

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