Corporate Governance

DEVELOPMENT OF THE UK CODE OF

CORPORATE GOVERNANCE

Written by

Jason Cates

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© Jason Cates, 2012

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To be delivered to the University of Hertfordshire on or by

26 November 2012

Ordered by Jason Cates to be printed

21 November 2012

Printed in the United Kingdom

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‘Encouraging transparency, accountability and long-term stability will promote healthy long-

term growth and help UK industry gain public trust’

(Financial Reporting Council 2010)

Part I: Explain how the corporate collapses of the 1990s and early 2000s led to the

publication of the first Combined Code in 2003. (70%)

Part II: With reference to the above quotation evaluate whether or not the Code in its

current format is adequate for protecting the interests of stakeholders in public limited

companies (30%)

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Contents Introduction ................................................................................................................................ 4

Part I ........................................................................................................................................... 5

Case Studies ........................................................................................................................................ 5

Maxwell ........................................................................................................................................... 5

Polly Peck ........................................................................................................................................ 5

BCCI ................................................................................................................................................. 6

Barings ............................................................................................................................................ 6

WorldCom and Enron ...................................................................................................................... 7

Publishing of the UK Corporate Governance Code ............................................................................. 8

Chairman and CEO .......................................................................................................................... 8

Board of Directors ........................................................................................................................... 8

Auditing and Whistle-blowers ......................................................................................................... 9

Internal Control ............................................................................................................................. 10

Conclusion ..................................................................................................................................... 10

Part II ........................................................................................................................................ 11

Healthy Growth vs. High Growth ...................................................................................................... 11

Public Trust ....................................................................................................................................... 12

Conclusions ....................................................................................................................................... 12

Recommendations ............................................................................................................................ 13

Part III ....................................................................................................................................... 14

Signatories......................................................................................................................................... 14

References ........................................................................................................................................ 15

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Introduction This paper will analyse and evaluate the adequacy of the 2003 Combined Code to promote

“transparency, accountability and long-term stability”. This will include considering how the

Combined Code was initially developed in the context of the corporate collapses of the 1990’s and

early 2000’s, these being Polly Peck, Maxwell, Barings, BCCI, Enron and WorldCom.

In addition, this paper will evaluate the role of the combined code in the modern business

context and its role in recent failures in corporate governance. Once completed, this paper will make

appropriate recommendations in light of these failures and other relevant findings.

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Part I Case Studies

Maxwell

Robert Maxwell owned the publisher Pergamon Press and later bought the Mirror group in

1984 for £90m. This fulfilled a lifelong ambition of his of “controlling a major UK newspaper”.

Maxwell would then go on to pledge funds from his company’s pension fund to fuel this ambition

and purchase further publishing companies, both in the UK and abroad. In total, Maxwell “stole”

£400m from the pension fund of Mirror Group in order to fuel this ambition. (Wearing, R., 2005)

Maxwell was also renowned for settling disputes through the courts and suing those who

would criticize him or his business practices in public. This led to many potential whistle-blowers

being afraid to criticize him in public, thus helping him to keep his business activities under wraps.

(Wearing, R., 2005)

Polly Peck

Asil Nadir owned 24% of Polly Peck and was both Chairman and CEO. Polly Peck went into

administration in 1990 with debt levels totalling £1.3bn which was largely secured against shares in

the company. When creditors became concerned about Polly Peck’s ability to repay its debt, they

went on to sell their shares causing a significant decline in Polly Peck’s share price. Furthermore,

Nadir with the aid of the Swiss based broker Jason Davies ran a share-buying operation in order to

help bolster Polly Pecks share price. This was with the aim of increasing the company’s ability to

obtain further debt finance secured against Polly Peck’s shares. (Wearing, R., 2005)

These cases raise the issue of concentration of power and the need to separate the roles of

Chairman and CEO.

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BCCI

For BCCI, there were concerns relating to its ability to repay its debt, this led to leading

figures at BCCI falsifying its accounts in order to hide losses. In addition, false documentation was

provided to the auditors Price Waterhouse in order to further cover us these losses. Once

uncovered, Price Waterhouse raised its concerns to the Bank of England and was aided by

information provided by a whistle-blower. However, these concerns were largely brushed aside by

the Bank. In addition, Price Waterhouse also acted as a management consultant to BCCI, thus

leading to a possible conflict of interest in its role as auditor. (Wearing, R., 2005)

This case raises the issue of whistleblowing, potential conflicts of interest for auditors and

the role played by regulators such as the Bank of England.

Barings

For Barings, the derivatives trader Nick Leeson was allowed to put at risk £742m, twice the

reported capital of Barings unchecked. This led to Barings making loses of £830m in 1995 with

Leesons losses being hidden in a dormant error account. These losses weren’t picked up on due to

Leeson himself accounting for these trades in the “back office”. Simply speaking, there was a lack of

internal controls to check over Leesons work and ensure adequate accounting procedures were

enforced. This was in spite of multiple managers having concerns regarding Leesons trading

activities. Leeson then went on to fool the external auditors Coopers and Lybrand with falsified

letters from clients to further cover his tracks. (Wearing, R., 2005)

This case highlights the need for adequate internal control systems facilitating internal

accountability.

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WorldCom and Enron

At WorldCom, expenses were misrepresented as capital expenditure in the accounts. This

was aimed at improving Enron’s profit figures in addition to improving the asset figures as shown in

the company’s balance sheet. This activity was picked up on by Cynthia Cooper, an internal auditor

at WorldCom who informed WorldCom’s Audit Committee of her concerns, but was largely ignored.

This issue was again overlooked by WorldCom’s external auditors Arthur Anderson. Anderson were

later unable to explain how they missed such an overstatement in corporate cash flows totalling

$3.8bn. (Wearing, R., 2005)

For Enron, the issue was its use of Special Purpose Vehicles which were established with the

intention of hiding debt. Moreover, those involved in these SPV’s were paid significant remuneration

with the CFO Andrew Fastow making $30m for his role in establishing these partnerships. (Wearing,

R., 2005)

Furthermore, the independence of Enron’s audit committee was put into question. This

included one committee member being a paid consultant for Enron. Sherron Watkins, an accountant

at Enron, raised her concerns by sending an anonymous email to CEO Ken Lay. Her concerns were

investigated, but the independence of this investigation could also be questioned. (Wearing, R.,

2005)

These cases raise the need to appoint adequate and independent auditors, both internally

and externally. In addition, the need for an appropriate policy regarding whistleblowing has also

been raised by these two above cases.

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Publishing of the UK Corporate Governance Code

This paper will now discuss how the above cases led to the combined Code of 2003. This will

be carried out by discussing how the specific aspects of the code were developed and their role in

the wider business context.

Chairman and CEO

A recurring theme in the above cases was the concentration of power. This coupled with an

insufficient system of accountability had considerable ramifications in these cases. This issue relates

specifically to Pergamon and Polly Peck where power was concentrated around a single individual.

(Wearing, R., 2005)

This issue was raised in the Cadbury Report which stated the role of chairman should be

separate from that of CEO. (Cadbury, 1992) This allows the chairman to “stand sufficiently back from

the day-to-day running of the business”. This led the Combined Code to state “there should be a

clear division of responsibilities at the head of the company” and “no one individual should have

unfettered powers of decision”. (FRC, 2003)

This is to help ensure appropriate accountability at the highest levels of the corporate ladder

with no one individual going unquestioned or unchallenged, whatever their role may be.

Board of Directors

The issue of directors again relates specifically to the cases of Maxwell and Polly Peck and

the concentration of power. In order to counterbalance the power of the executive directors, the

combined code states that at least half the board, excluding its chairman, should be non-executives.

Thus helping to ensure the majority of the board are appropriately independent. (FRC, 2003)

A nomination committee should be established consisting mainly of non-executive directors

with the role of recommending appointments to the board of directors. This committee should

“evaluate the balance of skills, knowledge and experience on the board” and make appointments as

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appropriate. Thus, the knowledge and experience of the board should be as broad and varied as

possible ensuring the board’s long-term effectiveness. (FRC, 2003)

The board should also establish a Remuneration committee consisting of at least 3 non-

executive directors. Moreover, no executive directors are permitted to sit on this committee in line

with the Greenbury and Cadbury reports. (Greenbury, 1995) (Cadbury, 1992) The role of the

remuneration committee is to determine the “remuneration for all executive directors and the

chairman”. Furthermore, this remuneration should largely be linked to individual performance and

considered relative with other companies. (FRC, 2003)

Simply speaking, the board of directors should be appropriately independent with no single

individual having overriding control of the company. Additionally, issues such as remuneration and

appointments to the board should be largely handled by the non-executive directors. This is to

ensure remuneration is kept appropriate and nominations independent, thus preventing power

gravitation towards a single individual. (FRC, 2003)

Auditing and Whistle-blowers

In regards to the audit function, this issue specially relates to the WorldCom and Enron cases

and the need for adequate independence in relation to external auditors. In addition, the issue of

fraud and how this should be handled was a prominent feature of the BCCI and Enron cases. As such,

the Combined Code states that the audit committee should be responsible reviewing the company’s

internal control and risk management systems. Thus helping to prevent and mitigate fraud within

the organisation. Additionally, the committee is responsible for monitoring the external auditor’s

independence with a focus on the supply of non-audit services and its implications on independence.

(FRC, 2003)

The issue of whistle-blowing was a prominent issue in the BCCI, WorldCom and Enron cases.

In light of these cases, the code states that arrangements should be reviewed as to allow staff in

confidence to “raise concerns about possible improprieties” within the organisation. In addition, the

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audit committee should act upon this information with systems allowing for appropriate

investigation and follow-up action. As such, information provided in this fashion should not be

“overlooked” or ignored as was the issue in the above cases. (FRC, 2003)

Internal Control

Continuing on from this, internal controls should be established to “safeguard shareholders’

investment and the company’s assets”. This issue relates specifically to Barings where the internal

control systems failed to pick up and prevent Leesons trading activities leading to the companies

collapse. This issue was highlighted in the Turnbull report which provided guidance on managing risk

and providing adequate disclosure in the annual report. (Turnbull, 1999) These controls were

designed to help facilitate the internal auditing process and help prevent fraud and

misrepresentation of the organisations financial information. Thus, this advice can be viewed as

being a direct result of the failures of companies such as Barings. (FRC, 2003)

In addition, the combined code states that these controls should be reviewed on an annual

basis and reported to the shareholders as appropriate. This includes reviewing the organisations

compliance with the combined code and providing shareholders with appropriate explanation in

instances of non-compliance. (FRC, 2003)

Conclusion

In conclusion, specific aspects of the code appear to have been developed with the cases

discussed directly in mind. This includes being designed to help prevent or at least reduce the

chances of such failures from arising again in the future. However, the recent banking crisis brings

the suitability and vigour of the combined code into question.

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Part II Healthy Growth vs. High Growth

It can be argued that growth cannot be consistently high, yet remain healthy. This issue was

highlighted in the recent banking crises where the financial services industry experienced significant

growth, but was built on unstable foundations which later led to its collapse. (BBC, 2009)

These unstable foundations included a lack of transparency and understandability of the

activity undertaken by these financial institutions which led to significant risk-taking. In relation to

the combined code, this issue relates specifically to internal controls and how they failed to prevent

such significant risk-taking. Simply, during times of high economic growth, as business confidence

was growing, companies such as banks were more willing to take on risk. However, this confidence

was to be unfounded when debtors soon started to default on their loans. (BBC, 2009) Hence, not

only do internal controls need to be developed, but they need to be appropriately enforced in order

to be effective. This was highlighted at UBS where the trader Kweku Adoboli lost the bank £1.4bn

and in total risked loses reaching £7.5bn. In this case, it wasn’t the lack of internal controls, but the

fact that they weren’t adequateky enforced by “senior managers”. Furthermore, fraudulent

behaviour by Adoboli allowed him to further hide his loses. (BBC, 2012)

However, it can be argued that this “boom and bust” is a natural part of the economic cycle

and cannot be prevented, merely its effects mitigated. Simply, corporate collapses will continue to

occur, regardless of how effective the combined code is made. Therefore, any alterations to the

combined code should focus on mitigation rather than on prevention. This may include requiring

companies to be in a position to withstand extreme economic and financial pressures. An example

would be requiring companies to hold a greater level of capital in reserve. This will bring the

combined code in line with the policies of the European Banking Authority which now requires banks

to hold 9% of their assets in capital reserves. Although this type of policy may hinder economic

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growth in the short-to-medium term, future economic growth could be considered “healthier”, thus

creating long-term stability. (EBA, 2012)

Public Trust

In terms of public trust, this paper looks toward the Scandinavian economic model. The

Scandinavian model sees greater cooperation between organisations and stakeholders. This

facilitates greater transparency, protects stakeholders and builds public trust. This trust can become

significant in times of economic uncertainty when companies need the support of stakeholders such

as employees and investors. This is compared to the liberal model of Anglo-Saxon countries where

there is significant distrust between companies and stakeholders such as trade unions. (Euroframe,

2007)

Therefore, the combined code needs to consider and gain inspiration from such alternative

economic models in order to allow organisations to gain public trust. This may, for example, include

having representatives of major stakeholders on a company’s board of directors. This will help

encourage greater transparency and cooperation, while at the same time provide companies the

flexibility they need in times of greater uncertainty. (Euroframe, 2007)

Conclusions

To conclude, the “boom and bust” and cyclical nature of the economic cycle cannot be

prevented, only its effects mitigated. Therefore, this should be the main focus of any alterations to

the combined code. The combined code should encourage companies to be in a position to

withstand extreme economic stresses, thus reducing the risk of corporate collapse. Additionally,

internal controls should be tailored to encourage greater consistency in regards to risk-taking. This is

compared to the current system where risk-taking is strongly correlated with the economic cycle.

Furthermore, in regards to protecting stakeholders, the combined code should use the Scandinavian

model as a basis for future standards in corporate governance. This will help facilitate greater

cooperation between organisations and stakeholders and help build public trust. (BBC, 2009)

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Recommendations

In light of the recent banking crises, as well as the fraud highlighted at UBS and the findings

of this paper, we make the following recommendations to the combined code. These

recommendations are aimed at mitigating the effects of corporate governance failures and

facilitating greater engagement with major organisational stakeholders.

Auditors should ensure internal controls are adequately and consistency enforced by all

levels of senior management, thus implementation of internal controls should remain

consistent throughout the economic cycle.

Companies should hold adequate capital reserves to withstand severe failures in corporate

activity. This may include, but not exclusively, fraud, regulatory failures and/or significant

economic uncertainty.

Specific directors should be appointed to the board based on their relationship with major

stakeholders such as employees and local communities. This will facilitate greater

cooperation with major stakeholders and help build public trust.

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Part III

Signatories I commend this paper to the University of Hertfordshire to be delivered on or by 26 November 2012.

Jason Cates

___________

Mail: AdrJasonCates@GoogleMail.com

Portfolio: SlideShare.net/AdrJasonCates

LinkedIn: LinkedIn.com/in/AdrJasonCates

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References (In line with Harvard Referencing)

BBC (2009) Timeline: Credit crunch to downturn. [Online] Available at:

http://news.bbc.co.uk/1/hi/business/7521250.stm [Accessed: 21st November 2012]

BBC (2012) Kweku Adoboli jailed for fraud over £1.4bn UBS loss. [Online] Available at:

http://www.bbc.co.uk/news/uk-20338042 [Accessed: 20th November 2012]

Cadbury (1992) The Financial Aspects of Corporate Governance. [Online] Available at:

http://www.icaew.com/~/media/Files/Library/subjects/corporate%20governance/financial%20aspe

cts%20of%20corporate%20governance.pdf [Accessed: 1st November 2012]

Euroframe (2007) European Socio-Economic Models: Experiences and Reform Perspectives. [Online]

Available at:

http://www.euroframe.org/fileadmin/user_upload/euroframe/efn/autumn2007/Annex3_WIFO.pdf

[Accessed: 19th November 2012]

European Banking Authority (2012) Final report on the implementation of Capital Plans following the

EBA’s 2011 Recommendation on the creation of temporary capital buffers to restore market

confidence. [Online] Available at:

http://eba.europa.eu/capitalexercise2012/Finalreportrecapitalisationexercise.pdf [Accessed: 19th

November 2012]

Financial Reporting Council (2003) Combined Code 2003. [Online] Available at:

http://www.frc.org.uk/Our-Work/Codes-Standards/Corporate-governance/UK-Corporate-

Governance-Code.aspx [Accessed: 14th October 2012]

Greenbury (1995) Directors Remuneration. [Online] Available at:

http://www.ecgi.org/codes/documents/greenbury.pdf [Accessed: 1st November 2012]

Turnball (1995) Internal Control. [Online] Available at: http://frc.org.uk/getattachment/5e4d12e4-

a94f-4186-9d6f-19e17aeb5351/Turnbull-guidance-October-2005.aspx [Accessed: 1st November

2012]