What sanctions are necessary?

No regime of corporate governance can ever completely eradicate the possibility of governance failures and any attempt to do so is only likely to undermine capital markets and wealth creation. So, what sanctions are necessary to ensure sufficient but not excess accountability?

The Virtuous Circle of corporate governance

To be able to review our system of accountability, we need to define which ‘rules’ constitute the corporate governance landscape and what drives companies and boards to adopt appropriate governance standards. The Virtuous Circle is a rudimentary depiction of that landscape and of those drivers (see figure 8.1).

The Virtuous Circle is divided into four segments, with the overarching, high-level reasons for boards to comply with the principles of good governance described in the outer ring of each. Consequently, we believe there are four main drivers:

law and regulation

the Courts

shareholder pressure

good corporate citizenship.

Moving in from that, the next ring shows the main protagonists: those organisations and bodies which either develop the rules or guidelines and/or apply pressure on boards.

Finally, in the main section of each segment are the means through which pressure is applied.

Ultimately, pressure is applied on boards, hence their position at the centre of the Virtuous Circle and at the heart of the corporate governance regime. The objective of this pressure is good governance, which can be summarised as:

compliance with law, regulation and best practice

a balanced board making quality decisions

focus on risk management strategies

balanced, accessible and regular assessments of the company’s position and prospects

transparency of board remuneration

good corporate citizenship.

Law and regulation in the Virtuous Circle

The law is the primary source of pressure on boards. Much of this emanates from the EU, particularly in the form of the Company Law Directives2 and,

2In particular the Fourth (Directive 78/660/EEC), Seventh (83/349/EEC) and Eighth (Directive 84/253/EEC) Directives.

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more recently, the Modernisation Directive3 which contained the requirement for companies to produce a business review in annual reports. The Department for Business, Enterprise and Regulatory Reform (BERR) and the Treasury also play a major part here in promoting legislation in relation to companies and financial services respectively. In addition, the BERR investigates and enforces certain aspects of the regime and has the power to appoint investigators, whereas the Treasury has largely delegated these functions to the Financial Services Authority (FSA).

3 Directive 2003/51/EC.

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What sanctions are necessary?

The intended outcomes of the Virtuous Circle of corporate governance:

BOARDS : GOOD GOVERNANCE AND COMPLIANCE

The purpose of the Virtuous Circle :

-Compliance with law, regulation and best practice

-A balanced board making quality decisions

-Focus on risk management strategies

-Balanced, accessible and regular assessments of the company’s position and prospects

-Transparency of board remuneration

-Good corporate citizenship

KEY

ABI : Association of British Insurers

AIC : Association of Investment Companies

APB : Auditing Practices Board, an operating body of the FRC

AIDB : Accountancy Investigation and Discipline Board, an operating body of the FRC

CO SECS : Company Secretaries

FRC : Financial Reporting Council

FRRP : Financial Reporting Review Panel, an operating body of the FRC

FSA : Financial Services Authority

IMA : Investment Managers Association

LSE : London Stock Exchange (for AIM Listed companies)

NAPF : National Association of Pension Funds

POB : Public Oversight Board, an operating body of the FRC

QCA : Quoted Companies Alliance

© 2007 Addleshaw Goddard LLP. All rights reserved.

Figure 8.1 (cont.)

A small number of statutes are at the heart of the law and regulation segment in the Virtuous Circle:

the Companies Act 1985 (1985 Act) as variously amended, most pertinently by the Directors’ Remuneration Report Regulations 2002 (Remuneration Regulations) and the Companies (Audit, Investigations and Community Enterprise) Act 2004 (C(A,ICE) Act), and which is in the process of being further amended and superseded by the 2006 Act (taken together, the Companies Acts); and

the Financial Services and Markets Act 2000 (FSMA).

Companies admitted to Official Listing and to trading on regulated markets also have regulatory obligations which derive from Part VI of FSMA, and which are contained in the Listing Rules and Disclosure and Transparency Rules (together,

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Part 6 Rules). These rules are overlain by Listing Principles and enforced by the FSA. For companies listed on the Alternative Investment Market (AIM), as it is an ‘exchange regulated market’, pressure is applied through the AIM Rules for Companies (AIM Rules) enforced by the London Stock Exchange (LSE).

In terms of corporate reporting, centre stage in the Virtuous Circle are the Companies Acts requiring the production of annual accounts with prescribed contents. For companies admitted to regulated markets, these must now be produced on a consolidated basis in accordance with International Financial Reporting Standards (IFRS). Standards of corporate reporting are also upheld through the audit process and the scrutiny of independent auditors, who themselves are governed by auditing standards.

There are several other organisations surrounding boards in this segment of the Virtuous Circle compelling compliance, directly and indirectly, with the corporate reporting process. Most prominent among these are:

the Financial Reporting Review Panel (FRRP) whose powers were significantly enhanced by the C(A,ICE) Act; the FRRP seeks to ensure that the provision of financial information by public and large private companies complies with Companies Acts; it has enforcement functions in relation to narrative reporting, not least in relation to directors’ reports and, in due course, in relation to Business Reviews; it also monitors compliance with the accounting disclosure requirements of the Listing Rules;

the Auditing Practices Board (APB), which sets auditing standards and gives guidance on the performance of external audits and other activities undertaken by auditors;

the Audit Inspection Unit (AIU) of the Professional Oversight Board (POB), which was established following the Government’s post-Enron review of the UK accountancy profession; under the regulatory framework established as a result of this review, the professional Accountancy Bodies (defined below), continue to register firms to conduct audit work, with their regulatory activities being overseen by the POB; the AIU assists the POB in this role by monitoring the quality of audits of all entities with listed securities and other entities in whose financial condition there is considered to be a ‘major public interest’; AIU reports are sent to the senior management of the auditor in question as well as to the Accountancy Body with which the firm is registered, and consequently the AIU/POB acts as an indirect source of pressure on boards;

the Accountancy Investigation and Discipline Board (AIDB), which acts as an independent investigative and disciplinary body for accountants in the UK; like the AIU/POB, the focus of the AIDB is on cases of public interest – for example, those pertaining to larger companies with sizeable shareholder bases which have been referred to them by Accountancy Bodies with whom an individual accountancy firm is registered; other cases will continue to be dealt with by the Accountancy Bodies;

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