Corporate governance links to the system in which firms and organisations are engaged and governed (ICAEW, 2016). Its existence is to facilitate efficient and judicious management that can bring the long-term success of the company to its shareholders. To do that, it requires both shareholders and board of directors to incorporate with each other effectively to set out an appropriate governance structure for the firm.
Corporate governance has been a controversial debate in the UK since a string of corporate scandals happened in the 1980s and 1990s decade. Consequently, the Cadbury Report was published to address issues such as relationship between chairman and executive directors, responsibilities of non-executive directors (NEDs), etc. (FRC, 2010). However, the collapse of many corporations in the financial crisis in 2007-2008 urged an re-consideration of this system. It was because these failures did not only abolish equity of many shareholders but also generate various systematic risks in the global economy and financial market.
This essay found out that roles of shareholders are not going well as it should be due to flaws within the comply-or-explain approach. The Stewardship Code was established to solve the problems of comply-or-explain basis as well as improve the roles of institutional shareholders. However, it was formed initially too hasty, as a result, could not target to the foreign investors.
THE ROLES OF SHAREHOLDERS IN THE UK CORPORATE GOVERNANCE
- The nature of the UK share ownership
The nature of share ownership in the UK sees the dispersed ownership where each shareholder holds only a small amount at stake rather than a few big shareholders have the majority of firm’s ownership (Charkham, 1990, Armour et al., 2003). The foreign investors’ shareholdings has increased significantly to over 50 percent due to the light of globalisation (ONS, 2012). Back in 1992, the Cadbury report realised the crucial role played by institutional shareholders, which are financial entities pooling funds from third parties for investment under its own name but on behalf of its clients (OECD, 2011), by stating that “the institutions’ influence as owners should be used to guarantee that the firms they have invested comply with the Code”. Since then, institutional investors have become the main party that have been emphasised by various Codes.
The problem between shareholders and managers is one of the oldest and commonest kind of social interaction as well as in the case of an organisation (Ross, 1973). On the other hand, (O’Dwyer, 2014) rephrases to the Dodd-Berle debate where Dodd put the community is in the heart of directors’ activities (Dodd, 1932) and Berle considered that managers should act for their shareholders’ wealth only (Berle, 1931). Unlike the debate’s result decades ago, the Companies Act (2006), s172, put clearly shareholders as the centre in that the company’s director has a duty to “promote the success of the company for the benefit of its members”. Clearly, shareholder is the most crucial party in a company, therefore a director must act on behalf of the shareholders in order to promote the success of the company as well as shareholders’ benefits.
When shareholders delegate their permission to the firm’s director as their agent to execute a project/service for them, that is the place where the corporate governance issue arises (Jensen and Meckling, 1976). Investors are not motivated to intervene in the running of the company because engagement in governance requires much time and effort to be really involved in. Consequently, the director can take advantage of this situation and perform following their own interests rather than for shareholders because he can use shareholders’ equity without any controls from uninterested institutional (Roach, 2011, O’Dwyer, 2014).
- Roles of Shareholders under the ‘Comply-or-Explain’ Approach
Since its establishment in the Cadbury report, ‘comply-or-explain’ approach has been underpinning as a proper regulatory framework that can make a good governance between shareholders and their firms without the need of regulatory intervention. Therefore, it helps the Corporate Governance Code (a consolidation of various Codes and guidelines), Stewardship Code and also the Companies Act 2006 into setting the rights of shareholders in the UK corporate governance.
Under the Companies Act 2006, shareholders can make some certain decisions such as: appointing or dismissing a firm’s director, changing the company’s name or authorising a service contract for a director. For listed companies on the London Stock Exchange, any “related party transactions” and class 1 transactions need to be approved by its shareholders (Summerfield and McKenzie, 2015). If a company is with Premium Listing, it has to deliver a ‘comply-or-explain’ statement in its annual report to enlighten how it has applied the Corporate Governance Code.
It is not simple to evaluate whether comply-or-explain approach is working effectively. Even if there is a large number of non-compliant companies, it does not mean that this approach works ineffectively because it does not include those not abiding explicate their non-compliance sufficiently. However, there are some concerns of comply-or-explain approach that make it works improperly.
Comply-or-explain approach aims to create a regular and effective dialogue between shareholders and firms (O’Dwyer, 2014). To make it commendably, shareholders must be active and work in collaboration with management to be attentive to the company’s operations (Sants, 2009). If not, they may not figure out the situation when company does not comply the Code, thus they will not look for an explanation or take any other actions. In fact, the passivity of shareholders, with side effects by time and costs, contributes to shareholders’ unwillingness to monitor their companies. Moreover, (Keay, 2014) claims that investors in listed companies are dependent on usual information route, i.e. annual report. Therefore, it seems that shareholders know about tools they can use to make their relationship with boards better but they do not utilise them. They have tendency to engage in free-riding rather than really involve in monitoring the firm (O’Dwyer, 2014). As a result, it will dampen investors who spend time and costs for their efforts and others may take advantage of this action without any contribution to the task. In other words, all institutional investors will move from investing in a long-term period to a short-term period as there is no added value in monitoring engagement with the firm.
Another problem of this approach is that there was a significant problem with the quality of explanations by companies when they explain for their non-compliance. They tend to use some ‘brief and uninformative’ and sometimes even non-existent explanations (MacNeil and Li, 2006, Keay, 2014) or give the same justifications with ‘boilerplate statements’ (Moore, 2009) from one time to another for their non-compliance with the Code. If shareholders monitor their firm effectively, they will recognise and come to the conclusion easily that the firm is non-compliant. Otherwise, shareholders cannot keep boards to account sufficiently in case of being unable to assess the explanation because they do not know whether the company’s view is right or its non-compliance is inappropriate. Also, some investors use the firm’s financial performance to decide whether it is non-compliant in place of examining the firm’s statement (Reisberg, 2011). It means that they will not supervise the firm as long as its financial performance is still in the good position. Only when the performance is not good, they tend to begin monitoring the boards.
THE STEWARDSHIP CODE
For many years, the UK share ownership has changed not to be dispersed as it was before. At this time, institutional investors hold a large proportion of shares and experts consider them as being ready to respond to companies’ activities (Goergen et al., 2008). Furthermore, there were no official conclusion involving the engagement of institutional investors even though there were some authors taking its roles critically (Keay, 2014, Reisberg, 2015). That is one certain reason why the Financial Reporting Council (hereafter FRC) presented the Stewardship Code in 2010, to inspire the institutional shareholders to replace their short-term attitudes by a more long-term engagement in monitoring the company.
- Criticisms of the Stewardship Code
In spite of FRC’s efforts to sell a ‘successful story’ (FRC, 2011) about Stewardship Code since its launch in 2010, there various critical questions about the extent to which it has participated to solve the problem of ‘comply-or-explain’ approach.
Stewardship Code was formed based on the ‘comply-or-explain’ approach like various Codes in the past. On the other hand, it was published after only a six-month consultation period without any major changes to the Institutional Shareholders’ Committee code (FRC, 2012) or any testing procedures (Myners, 2009). It means that Stewardship Code keeps the same problem of comply-or-explain approach and might not be apposite with the current governance system. In the author’s view, the FRC should have taken a step back to go deeper and propose principles and practices that could change institutional investors’ behaviours in a long-term period. Their rush action reflects on various weaknesses in the Code. One example is that Principle 4 states that investors should have clear guidelines on time and method they use for their stewardship activities (FRC, 2012). It seems to be an informal recommendation which causes deficient motivation for shareholders to follow. (Roach, 2011) shares the similar viewpoint.
Secondly, the Stewardship Code fails to target to the foreign investors. For recent decades, the foreign investors’ shareholdings has increased significantly to over 50 percent due to the light of globalisation (ONS, 2012). On one hand, this figure shows that the principle of stewardship and the UK governance model have been vibrating broadly outside the UK border (Hogg, 2010). On the other hand, it raised a concern of overseas companies enjoy the benefits of being a London listing company but operate and control outside the UK to neglect the UK shareholders (Smerdon, 2013). Moreover, the problem could be originated from the difference in the UK corporate governance and the investors’ local regulations. One additional point is that overseas investors are not compelled to follow the Code but only encouraged to do so (FRC, 2011). If so, they would definitely not comply the Stewardship Code and its impact in the UK and international market would be diminished.
Finally, diversification has a big impact on how institutional shareholders engage with their firm’s responsibilities. It is also a popular modern management technique to handle the risk caused by each investment. However, many institutional investors have exploited this method that causes excessive diversification (Kay, 2012). Each equity portfolio comprises many different shares and certainly, the higher the number of shares, the lesser attention to supervise each firm’s activities. They have limited resources (both efforts and time) to engage completely with each issue arising in each investing firm. As a result, institutional investors does not commit with the future of one particular company because each company comprises a small amount of incentive that they might concern.
For sophisticated problems of stewardship, one simple approach is definitely inadequate. The best solution to ensure that the stewardship issue is going to be better is that implementing a comprehensive method which includes roles multiple parties. However, it is fair to say that the role of the regulators, in this case, FRC is undoubtedly vital because they are the one who set the scene for any success or failure of the UK governance system.
The first solution FRC could do is that identifying and defining role of each institutional investor and their respective stewardship responsibilities. To do this, FRC must work to form transparent criteria and metrics which the engagement can be judged (FRC, 2011). These performance metrics would help all involved players, from institutional shareholders to their clients and even FRC itself, to know what Stewardship Code is achieving.
Secondly, FRC should analyse what are expected to be engaged by institutional shareholders and the level they might follow. There are various players who are driven by different incentives and they would have divergent interests to concern. For example, short-term oriented investors should be treated differently from investors who follow the long-term orientation model (Reisberg, 2015). If FRC can identify and answer this issue thoroughly, it will certainly facilitate the partnership between institutional investors themselves and also investors and FRC.
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Every year, there are a sizeable number of recognised business insolvencies which has happened without any signs. These failures has affected to all involved parties including shareholders and stakeholders, as a result, all parties have tried to force their company to oblige with a good corporate governance. There were various companies which have complied with related corporate governance regulations, for example: Companies Act 2006 and the UK Corporate Governance Code 2016. However, there are some cases that need to be evaluated in order to identify and solve governance issues arising in their day-to-day business.
Therefore, this report will critically discuss and analyse the case of Aston Sportswear plc (hereafter “the company”) to review its corporate governance structure with its board of directors in place and to make recommendations for improving the company’s governance position. The second issue is to evaluate the roles and general duties of the company’s directors to see any potential breaches of the Companies Act 2006.
FINDINGS AND RECOMMENDATIONS
- Executive Team
The executive team at the company is led by Mr. Evans who is the chief executive. However, Mr. Smith’s role at the company is on the spotlight where he is the founder, executive director and also occupies the position of Deputy Executive Chairman. Mr. Smith has involved in almost all activities at the top of the company. The United Nations (2006) states that one person should not incorporate too much power at the highest level of an organisation. In fact, Mr. Smith does not breach the separation of duties, however, the relationship between Mr. Evans and Mr. Smith is really close as he is Mr. Smith’s son-in-law.
Within the board of directors, it does not require much effort to see that Mr. Smith has also three close relationships, which are: Mr. Keys as his long-standing family friend, Mr. Isaacs as his colleague in Aston Gym plc where he is the chief executive and Mr. Blakemore who has served on the board for 11 years so far. As a result, it might harm the company as they can dominate the board of director easily due to their superior position. Such a power by a group of individuals is warned by (FRC, 2016).
On the other hand, it seems that Mr. Smith’s action has been violating the Companies Act 2006 during his tenure at the company. Firstly, Mr. Smith often chairs the board’s meeting even though Mr. Blakemore, the chairman, still be attending the meeting. It is fair to say that Mr. Smith has already violated s171(b) which states that the director only exercises powers for the purposes for which they are conferred. More seriously, during the meeting, Mr. Smith often declared that he has been on the board to serve for only his and his family’s interests and put it above all others. As a result, he could infringe s172(1) which requires a director should promote the success of the company and s175(1) in which a director must prevent the situation of his direct interest conflicting with the interests of the firm. He did also not inform the board about the fact that his wife and son held the largest amount of shares of the property development company which had the agreement of sites closure. By doing this, he violated s177(1) for not declare ‘related party transactions’ to the board of directors.
The first key recommendation needs to be implemented is that the company should reduce Mr. Smith’s influence in its structure. In the author’s viewpoint, Mr. Smith should resign his positions in the company. Based on the analysis, Mr. Smith’s standpoint has been different than the company’s interests and he did not care of other members’ benefits. Although Mr. Smith is the major shareholder, other institutional shareholders’ interests still be important and the company could not ignore them and serve for only Mr. Smith’s family.
- Board of Directors
The company employs an unitary board which comprise of three non-executive directors (NEDs). They have the duty to supervise the executive directors (OECD, 2015). There are three non-executive directors which is below the acceptable range as it should be between five and fifteen as suggested by (CII, 2015)or a public company should have more non-executive directors than executive directors (ACCA, 2014). Moreover, there is no current non-executive director who has recent and relevant financial experience.
To solve the lack of non-executive directors, the company should start recruiting more non-executive directors, especially those who have relevant experience in the financial sector. They also need more non-executive directors who know well on sportswear sector to manage all activities of the executive team. The new non-executive directors would be allocated to audit and remuneration committee which will be discussed later. Overall, the company needs to recruit at least four new non-executive directors.
The meetings are conducted on a semi-annual basis and let executive directors do their jobs, as suggested by Mr. Blakemore and Mr. Smith. With only three non-executive directors, it is hard to understand how they can deal with a huge workload of a FTSE100 company while they have only two meetings annually. One recommendation should be applied immediately is that the company must change the meeting schedule from semi-annual basis to, for example, a monthly basis which represents a common practice (Souster, 2012). When the company has more directors as well as a busier meeting schedule, they can obviously solve more issues of the company and keep the executive team under control.
Among three current non-executive directors, Mr. Keys has not attended board’s meeting for five years and left works of the company to other directors. There is no information of the reason why Mr. Keys could not attend the meeting and work for the company. However, the board of directors should dismiss his position at the company and replace him by an expert in this sector.
Mr. Isaacs currently serves on board of another public company, Aston Gym plc. FRC (2016) requests the directors to dedicate sufficient time to the company to their board responsibilities. However, as research contemplate three to four director’s roles to be still proper (Bar-Hava et al., 2013), Mr. Isaacs can still serve on two companies as normal. Despite having a concern about the negative working conditions and the use of children labour in sub-contractors’ factories, he did not raise his voice. It is fair to say that Mr. Isaacs violated s172 (1d) in which he concerns about the working conditions and s172 (1e) in which he worries about the reputation damage the company might take if the media finds out the child labour issue.
Finally, Mr. Blakemore is currently the company’s Chairman and one of these non-executive directors. It is easy to see that Mr. Blakemore’s background is engineering, therefore he has not any experience in the sportswear retailing sector which is a potential breach of s174 (2a) in which he has to deliver the general knowledge and skill might be expected of a director of the company. Also, it was his responsibility when the major institutional shareholders had several failed attempts to meet the board when the scandal blew up. Mr. Blakemore has held the chairman position for 11 years so far, which is considered as threatening independence and requires him to be re-elected annually (FRC, 2012). There is not enough information to criticise whether the board did or did not take re-election in the past, however, the role of Mr. Blakemore as a non-executive director will be criticised carefully at the next annual general meeting.
- Board Committee
- Audit Committee
The main purpose of an audit committee is to deliver supervision of the reporting process, the audit process and the compliance with laws and regulations (PwC, 2013). Looking at the audit committee’s structure, it does not meet the requirement of having at least three non-executive directors as only Mr. Isaacs is a non-executive director. Moreover, the audit committee at the company has three members and there is no member who has recent and relevant financial experience as well as the proficiency of the sportswear sector, as recommended by the (FRC, 2016). The solution has been delivered in the earlier section as the company should appoint immediately one non-executive director with relevant financial experience (i.e. being a CPA or ACCA holder is a plus) and one with the a good knowledge and understanding in the sportswear sector.
The external audit of financial statements gives shareholders with guarantee that the statements give a true and fair view of the company (ACCA, 2014). The company is known of having a close liaison with the auditors with more than 20 years of cooperation and the lead audit partner has known Mr. Smith for many years. Although a good relationship with external auditors can enhance the working performance between the two firms, it also form the threat of compromising independence and affects the quality of audit process.
In the short term, Aston Audit LLP should replace the lead audit partner by another lead partner without any relations with the company’s audit committee, but with a sufficient proficiency to support the audit team. For a longer term, the company needs to launch an auditor rotation process that will provide the highest quality, most efficient and effective audit (FRC, 2017). Although there is no dispute between Aston Audit LLP and the company, the need of auditor rotation is undeniable due to the new regulation of the European Union in which requires companies must change their external auditor at least every 20 years (Scannell, 2016). The company should start the process soon because the whole procedure might last several months to years as it could take long time for the shadow working to keep the transition going smoothly.
- Remuneration Committee
This remuneration committee decides on the executive directors’ remuneration and sometimes, other senior executives (ACCA, 2014). During the year, the committee proposes a bonus scheme for all directors with 300% of their salary based on the 12-month performance. In many cases, the bonus scheme based on short-term share performance did not normally favour the company’s longevity. Directors might focus too much on short-term goals to reach the target for bonus and forget all long-term benefits of the company.
The adjustment for the current bonus scheme should be implemented immediately because it can change all activities of the company to reach the year-end target which affects to the company’s long-term objectives. The committee should motivate directors by a competitive basic salary and fringe benefits with some rewards related to long-term targets of the company.
As same as the audit committee, the remuneration committee does not have enough non-executive directors as established by (FRC, 2016) with only Mr. Blakemore is a non-executive director. This composition also reflects another issue of the committee as it should consist completely of independent non-executive directors (ACCA, 2014) which is consistent with the principle in section D, the Code that no director should be participated in deciding his own remuneration. With the relationship between Mr. Evans and Mr. Smith, they can set a ‘special’ remuneration package for each other without violating the core principle that is against the company’s best interests.
To solve this, the company should replace all current members of remuneration committee by new non-executive directors who have a good understanding on the sportswear industry to construct a competitive remuneration package that linked with the long-term objectives of the company to prolong its success.
Looking at the company’s structure and condition at that time, it is likely to see that Mr. Smith created a one-man company which is totally formed around his and his family’s interests by involving in almost all activities of the company. While there is no information about the performance of the company, it is unsure of the impact of one-man model in the company. However, the Smith family is not the only one shareholder that the company has the responsibility to serve, therefore putting them above others is unacceptable.
To sum up, there are some key recommendations that the company needs to follow up, including appointing more non-executive directors, especially those have financial and retailing experiences and Mr. Smith has to be dismissed from his position. For the committees, the remuneration scheme must be adjusted in the next six months to be suitable for the long-term development of the company while the most important thing should be done in the audit committee is the auditor rotation procedure which requires at least a year to be completed.
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