The role of the Auditors in the UK Corporate Governance

2.2 The Boards and Functioning.

A modern British company is based on its constitution, and in particular ,its articles

of association. One of the important matters which are regulated mainly by the articles

is the division of power between the shareholders and the board of directors and the

composition, structure and operation of the board of directors. The board's task is to

approve appropriate policies and to monitor the performance of management in

implementing them. It is the board's responsibility to ensure good governance and to

account to shareholders for their record in this regard.

In Rayfield v Hands, Vaisey J. was prepared to make an order in effect for specific

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performance. Under s. 282 of CA1985, all companies must have directors. However,

the Act leaves the determination of the functions of the board very largely to the

company's constitution's affairs, so a separation will develop between those own the

133.J.Solomon and A . Solomon , ' Corporate governance and Accountability'.

134.ibid

135.[1958]All ER 194

company (shareholders) and those who manage it (directors).If we look at the Table A

we can see that it supposes that the board will be allocated a very significant role.

According to its article 70, »...the business of the company shall be managed by the

directors who may exercise all the powers of the company...»The Bullock Committee

described that `the role of a board varies from company to company and is constantly

changing with the requirements of business. It may be related to the size, complexity

and nature of the company' s operation and therefore to the organizational structure

which has been developed over many years, it may depend on the philosophy of

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management in the company or on the personality of the chief executive'.

Parkinson suggests the responsibility of the board which is for long-term strategic

planning, for example, concerning investment in new production facilities and

products, merging or making a bid for another company, closing down existing plants

137

or pulling out of unprofitable markets. Parkinson added, at least in theory, another

important function is to monitor the performance of senior executives, and also the

138

performance of the company's operating divisions and subsidiaries. The main board

will normally be made up of a chief executive, who will hold the office of managing

director, or possibly Chairman, or both, and will include a number of `heads of

139

Department', for example, the finance director, personnel director, technical director.

136. Report of the Committees of Inquiry on Industrial Democracy,1976.

137. J . E . Parkinson , ' Corporate Power and Responsibility : Issues in the Theory of

Company law'.

138. ibid

139. ibid

In general, if for some reason the board cannot or will not exercise the powers vested

in them, the general meeting may do so. In Baron v Potter, action by the general

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meeting has been held effective where there was a deadlock on the board.

In addition, although the general meeting cannot normally abort legal proceedings

141

commenced by the board in the name of the company.Normally the board of directors

142

is an important element of modern company. In practice, some of them are full-time

directors. Their function is in general to supplement the skills and experience of

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management team, often by bringing a more dispassionate; understanding to bear on

strategic and optional matters; it is also said that they are able to exercise an element

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of independent supervision over inside management. Solomon argued that for a

company to be successful it must be well governed; as well-functioning and effective

board of directors is the holy grail sought by every ambitious company; a company's

board is its heart and as a heart it needs to be healthy, fit and carefully nurtured for the

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company to run effectively.

« Good » corporate governance is viewed as essential in terms of safeguarding

company assets and maintaining investors confidence thus providing greater access to

funds and reducing the potential risks associated with fraud as there was an important

debate about corporate governance in the UK, the Financial Reporting Council and

The Stock Exchange co-sponsored a Committee chaired by Sir Adrian Cadbury. The

Committee's draft Report Financial Aspects of Corporate governance published in

1992 had as its remit: the control and reporting functions of boards, and the role of

shareholders and the role of auditors ( a strengthening of their independence).

140. [1914] 1 Ch 895.

141. J. E .Parkinson, 'Corporate governance and Responsibility'.

142. ibid

143.ibid

144. ibid

145. J. Solomon and A. Solomon ,'Corporate Governance and Accountability `.

The Cadbury Committee's definition of corporate governance as the system by which

companies are directed and controlled' (Report,para.2.5).That definition puts the

directors of a company at the centre of any discussion on corporate governance,

linked to the role of shareholders, since they appoint the directors. One of the

Cadbury Committee' s recommendations was based on the need for boards of the

Directors within listed companies to be effective. The Cadbury report reviewed the

structure of the board and the responsibilities of company directors, the report

recommended that company boards should meet frequently and should monitor

executive management .

According to J . Charkham, in 1995 ICI had sixteen directors, British Telecom

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fifteen, Grand Met. Eight, Sainsbury twenty- two, BP sixteen. The average for the

147

Top ten companies was sixteen. Smaller companies sensibly tend to have smaller

boards, for example, the Bank of England Quarterly Bulletin in May showed that

of 549 companies in The Times 1,000,39 per cent had between six and eight and

29 per cent between nine and eleven; the 3i Survey shows that 172 of the 215

companies in it had boards of six or fewer, and that this was of companies with a

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turnover of less than £ 100 million. If we look at the classical board, we can see

that it is the of number of directors who entrusted with the day-to-day

management of the company. The effect of the Cadbury Code is to make non-

executive directors mandatory in quoted companies, since they must have an audit

committee (para.4.3). In addition, the main characteristic of a non-executive director

is that he must not only be independent but be seen to be independent.

149

Sir Cadbury stating that the essential attribute of effective NED is their independence.

146.J.Charkham,'Keeping Good Company'.

147.ibid

148.ibid

149.ibid

The non- executive director (NED) should bring an independent judgement on

issues of strategy, performance, including key appointments, and standards of

conduct (para. 2.1 of Cadbury Best Practice also the Pro-NED). They should be

appointed for specific terms and re-appointment should not be automatic; NEDs

should be selected through a formal process and both this process and their

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appointment should be a matter for the board as a whole.

However, in practice there is no distinction between the roles of executive and

non- executive directors as both owe exactly the same legal duties and bear equal

responsibility for decisions taken by the board as whole. Their roles are not

formally separated as in other European systems. In the German model, for

example, there is a formal division of duties between the management and

supervisory board. Moreover, in the UK system there are some factors which

exacerbate the problem which prevent NED from being effective monitors of

management; his appointment is still largely in the hands of executives and most of

them are former executives, which mean they are more inclined to be sympathetic

rather than assertive and dynamic in their capacity as NEDs. In the USA, the

proposed new section 303 A requires that listed US companies must have a

majority of independent directors and this clearly may take time to effect.

However, the new proposed US requirement is that the majority of the board

should be `independent' not merely `NED'. Moreover, the movement towards a

greater proportion of outside directors was given a great fillip in the late 1970s as

a result of some cases of extensive misfeasance by executive directors

consequently, in 1978 the NYSE made it a listing requirement that companies

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should have audit committees of outside directors.

150. J. Charkham ,'Keeping Good Company'.

151. ibid

The outside director's remuneration is founded on an annual retainer which nearly

all companies pay, plus a `per meeting'; US companies are obliged to report

quarterly, most boards, smaller and younger and more independent than they

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were, meet about six or seven times a year. The board elects a non-executive

director as its Chairman. Contrary to the UK, the practice in the USA is to call that

person the «President»: in the UK, this title does not imply any executive

responsibilities, sometimes conferred as an honorary title. Under CA1985, article

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of Table A recognises this function. On the other hand, the collapse of Enron, the

former US energy giant focussed attention on the effectiveness of the NED

function. The scandal shook corporate America to the core, and resulted in

reforms to company law.

Enron went bankrupt in December 2001 after it emerged that the company had

Concealed millions of dollars in debts . In light of the Enron scandal, US lawmarkers

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passed the Sarbannes- Oxley Act (SOA), compelling chief executives to submit a

pledge that they fully understand and take responsibility for their firm's accounts.

Cadbury and Greenbury both recommended that the boards of listed companies

should establish a remuneration committee to develop a policy on the

remuneration of executive directors and, as appropriate, other senior executives; and

to set remuneration packages for the individuals concerned. However, S.12.43 (X)

of the Listing Rules implements most of the disclosure provisions in section B of

the Greenbury Code by requiring companies to include in their annual report:

· a report by the remuneration committee on behalf of the board, covering both

the company's remuneration policy for executive directors; and

· details of the remuneration package of each director.

152. Dorchester Finance Co .Limited v Stebbing [1989] BCLC 498

153. J . Charkham, ' Keeping Good Company ' .

154. The SOA of 2002 is a US law passed to strengthen corporate governance and restore investor

confidence ( see http://six signatutorial. Com/Sox/Sarbannes-Oxley).

In 1995, the Hampel Committee was set up. Its remit was to promote high

standards of corporate governance both to protect investors and preserve the

standing of companies listed on the Stock Exchange (para.1.7). The requirement

was to review the Cadbury Code and its implementation to ensure that the original

purpose is being achieved; to pursue any relevant matters arising from the

Greenbury Report; to look afresh at the roles of directors, shareholders and

auditors in corporate governance. The Hampel Committee produced a report in

1998. It noted that good corporate governance is not just a matter of prescribing

particular corporate structure and complying with a number of hard and fast

rules (para.1.11- 1.14). Instead there is a need for board principles which, the

Committee hoped, will command general agreement and which can be

applied flexibly and with common sense to the varying circumstances of

individual companies(para.1.11-1.20).

As Solomon argued, in some ways (such the role of institutional investors in

corporate governance) Hampel could be interpreted as being less demanding than

Cadbury; indeed, there is a widely held perception that the report represented the

interest of company directors more than those of shareholders and that much of

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the positive impact from the Cadbury Report was diluted by the Hampel Report.

Certainly, in the area of corporate social responsibility and corporate

accountability to broad range of shareholders, there was a significant change in

tack between the Cadbury Report and the Hampel Report; the latter clearly felt the

need to redress the balance between shareholders and stakeholders and made

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strong statements on these issues .

155.J.Solomon and A. Solomon , `Corporate governance and Accountability `.

156.ibid

The Hampel Committee stated that:

The importance of corporate governance lies in this contribution both to business

prosperity and to accountability. In the UK the latter has preoccupied much public

debate over the past few years .We would wish to see the balance corrected. Public

companies are now among the most accountable organisations in society...We

strongly endorse this accountability and we recognise the contribution made by the Cadbury and Greenbury Committees. But the emphasis on accountability has

tended to obscure a board's first responsibility to enhance the prosperity of the

Business over time (para.1.1).

Independent NED; while independence had been stressed in the Cadbury, many

companies have appointed NEDs who have previously held executive posts with

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the company or have been their professional advisers Committee. The Hampel

recommended that its broad principles together with the Cadbury and Greenbury

Codes of Practice should be combined in a single Code which will operate

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alongside the Listed Rules. In 2002, the UK government asked Mr Derek Higgs to

carry out a review of the role and effectiveness of NED s in comparison with its

counterpart in the USA, the Sarbannes- Oxley Act.

The consultation published a Review ( DTI January 2003). Mr Higgs noted in his

report that there was a widespread concern about the potential liability attached to

non-executive directors, he therefore considered issues relating to the liability of

NEDs in detail, and made some important recommendations as follows:

*he provided guidance, now incorporated in the Combined Code, on the position

of a NED

*he recommended that the Department of Constitutional Affairs(DCA)should

considered step to promote active case management (para.4.8-4.10).

157. Farrar's company law.

158 .ibid