Governance codes: rules-based and principles-based approaches

A global pension fund can put its money in any stock market. It will choose the one where it expects fair treatment, reliable accounts and honest boards. Countries that want that money write governance codes. The question is how: do they make the rules compulsory, or do they set principles and ask companies to explain when they depart from them?

This topic covers why governance codes exist, who they apply to, the rules-based approach (with the US Sarbanes-Oxley Act 2002), the principles-based “comply or explain” approach, the history of codes in the UK and the contents of the Nigerian code, and the international statements of principle, in particular the OECD Principles and the ICGN Principles, with their limits. The previous topic covered agency theory and IT governance.

The next topics cover the board, its committees and directors’ duties. Neither the May 2014 nor the November 2014 Pathfinder sets a stand-alone question on this topic.

Key terms in plain English

Syllabus check

This topic is in syllabus area D (corporate governance, 5% of the marks). It covers:

• rules-based and principles-based approaches to governance;
• the main requirements of the Sarbanes-Oxley Act 2002;
• global developments in governance and the main OECD and ICGN principles.

CAMA 2020 and governance codes

The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria. It supplies the statutory rules, and codes add principles on top.

Why codes exist

Codes have been developed in most countries with a stock exchange. The main aim is to help and protect investors. Investors need reliable financial reporting and external audit, and information on prospects, internal control, risk management and directors’ pay. They need protection from dishonest management, such as strict laws against insider dealing. Institutions invest in many markets and can avoid those with poor governance.

Countries therefore want good codes to attract and keep investment capital. Pressure has come from two sources: the collapse of major listed companies in a major financial centre, caused largely by poor governance, and pressure from institutional investors in countries with strong codes. The ICGN, formed in 1995, says governance is one of the key factors investors consider when deciding where to invest.

Good governance is also an application of good business ethics. It is argued that it improves leadership and so long-term success, but this has not been proved either way.

Who the codes apply to

Codes and governance laws apply mainly to listed companies, because that is where investors need protection. Other companies may choose their own systems, and may adopt a code because it is right or because it may improve performance. In the UK, companies on the junior market (AIM) are not bound by the UK Code, but an unofficial code is encouraged.

A family-owned company might appoint a non-executive director to represent small or outside shareholders. That director would not be independent, but would help ensure the company is run in the interests of all shareholders.

The rules-based approach

A rules-based approach says companies must be required by law or compulsory regulation to follow established principles of good governance, with few if any exceptions.

Advantages: companies cannot ignore the rules; all meet the same minimum standard; and investor confidence may rise.

Disadvantages: the same rules may not suit every company, so the system is rigid; and some things cannot be regulated easily, such as negotiating directors’ pay, choosing the range of skills for the board and assessing the board’s performance. A country’s system is therefore a mix of rules and principles.

Every country with a stock market has some rules. Even the UK, which is associated with principles, has statutory rules:

• companies submit a directors’ report and financial statements each year
• the statements are audited
• quoted companies prepare a directors’ remuneration report
• the Companies Act 2006 sets directors’ duties

The difference between countries is one of emphasis. The country most associated with a rules-based approach is the USA.

The Sarbanes-Oxley Act 2002

In the US, governance was not seen as important until the collapse of Enron, WorldCom and others in 2001 and 2002, which damaged investor confidence. In several cases a dominant chief executive and a few executives ran the company in their own interests, financial reporting was misleading and financial controls were weak. Politicians responded with the Sarbanes-Oxley Act (named after its sponsors). Key points:

• The Public Company Accounting Oversight Board (PCAOB) oversees audits of public companies. It can inspect and discipline and sets auditing, quality control, independence and ethics standards for registered audit firms.
• Certification (section 302): all companies with a US listing, US or foreign, must include in annual and quarterly accounts a certificate to the SEC signed by the chief executive and chief financial officer that confirms the accuracy of the statements. They take direct personal responsibility.
• Internal control assessment (section 404): the annual report must include an internal control report that states management’s responsibility for adequate internal control over financial reporting and assesses its effectiveness against a suitable, recognised framework. Companies keep documentary evidence. Any material weakness must be disclosed, and a company with more than one cannot conclude that its controls are adequate. Critics say section 404 requires a great deal of work.

The principles-based approach

A principles-based approach says one set of rules cannot suit every company, or the same company over time. A code should apply to all major companies, but as principles, with provisions or guidelines that show how to apply them. Companies are expected to follow the provisions. They may depart where it suits their circumstances, but must report it to shareholders and explain why. This is comply or explain.

In the UK, listed companies must state in an annual corporate governance statement that they apply the principles of the UK Corporate Governance Code and either that they have complied with all provisions or which they have not and why. The Listing Rules and the Disclosure Guidance and Transparency Rules, enforced by the Financial Conduct Authority, require this.

Which is better?

The advantages and disadvantages of one are the reverse of the other, and there is no conclusive evidence for either. Some argue that the burden of section 404 made the US less attractive to foreign companies, which chose to list in London. That is not the only test. Which approach works better may only be seen when future scandals occur.

A short history of codes

• Cadbury Report (1992): after corporate collapses, recommended that listed companies have an audit committee and a minimum number of non-executive directors.
• Greenbury Report (1995): on excessive pay for directors.
• Hampel Report (1998): raised board responsibility for risk management and control.
• The three were combined in the first UK Combined Code (1998), a principles-based code with comply or explain.
• Sarbanes-Oxley (2002): a rules-based response in the US.

Codes have since been issued in many countries. ICAN refers to the 2018 Nigerian Code of Corporate Governance, covering the role of the board; its structure and composition; meetings and committees (nomination and governance, remuneration, audit and risk management); board evaluation; remuneration; risk management, internal audit, whistleblowing and the external auditors; relations with shareholders and shareholder rights; business conduct and ethics; sustainability; and transparency.

International codes and principles

International statements give minimum standards for countries without codes: the OECD Principles, the ICGN Statement on Global Corporate Governance Principles and the Commonwealth principles. Their main aim is to raise standards in the weakest countries to those of the best. Better governance should attract global investment, give companies more finance and strengthen economies.

The OECD Principles (2015)

The OECD aims to help governments improve the legal, regulatory and institutional framework and to guide exchanges, investors and companies. It links governance to growth: an effective system gives confidence, lowers the cost of capital and encourages efficient use of resources. The OECD has 38 member countries. Six principles:

1. Basis for an effective framework: a sound legal, regulatory and institutional framework that market participants can rely on, complemented by comply-or-explain codes for flexibility.
2. Rights and equitable treatment of shareholders: protect and help the use of shareholder rights, including for minority and foreign shareholders, with redress for violations. Rights include transfer of shares, regular information, voting at meetings, a share of profit, the right to remove directors and a say on executive pay. A rule that bars proxy voting could in effect remove foreign investors’ vote.
3. Institutional investors, stock markets and intermediaries: sound incentives through the investment chain, and responsibility for good governance in themselves and in the companies they hold.
4. The role of stakeholders: recognise rights set by law or agreement (for example employment rights) and encourage co-operation that creates wealth.
5. Disclosure and transparency: timely and accurate disclosure on all material matters: financial situation, performance, ownership and governance.
6. Responsibilities of the board: strategic guidance, effective monitoring of management and accountability to the company and shareholders. Directors act on a fully informed basis, in good faith, with due care, in the best interests of the company and shareholders, with high ethical standards and regard to stakeholders.

The ICGN Principles

The ICGN is a voluntary association of major institutional investors, companies, financial intermediaries and others. Its principles are consistent with the OECD’s but more specific about what investors look at, and stress investors’ right to take an active part.

Examples: the company’s objective is to optimise returns to shareholders over time through a long-term strategy; protect all shareholders, including minorities and foreign holders, and explain any departure from one share one vote; allow electronic voting; directors act in the best interests of the company and are accountable to shareholders as a whole, with a strong presence of independent non-executives; and support corporate citizenship and ethical conduct, with the board responsible for a culture of integrity.

Limitations of international principles

• They must be general, so they are not specific and may have limited practical value.
• They aim to raise the lowest standards and matter less where standards are already high.
• There is no regulator to enforce them, so they lack force.

The rules in more depth

Why comply or explain depends on investors

It works only if shareholders read the explanations and act on poor ones. Without that pressure it becomes a formality.

Why rules produce box-ticking

A company can meet every rule and still be badly run, as the Walker Report noted, if the chairman is weak or the board lacks balance.

Why certification matters

Personal signature turns “the company” into named people. It is hard to blame a system when your name is on the certificate.

Why foreign investors care about proxy voting

If they cannot vote without travelling, their ownership has little value, so they avoid the market.

Effect on analysis

Match the approach to the facts. For a market with weak enforcement, rules may help. For diverse companies, principles may fit better.

Worked examples

1. It must say in its governance statement that it has not complied with that provision.
2. It must explain why, for example a short transition after the founder’s retirement, and say how it manages the risk, such as a senior independent director.
3. Shareholders decide whether the explanation is acceptable.

1. The certificate confirmed that the statements were accurate, so they carry personal responsibility.
2. The company must disclose any material weakness in its controls over reporting.
3. The case shows why section 302 targets the individuals, not only the company.

1. Saving = 0.5% × 10,000m = ₦50m a year.
2. Net benefit.
   50 − 30 = ₦20m a year.
3. This is the OECD argument in numbers: good governance lowers the cost of capital, but compliance has a cost.

1. The fund cannot attend every meeting, so its votes are lost.
2. This breaches the OECD principle on shareholders’ rights and discourages foreign investment.
3. The fix is to allow proxy voting and, as the ICGN encourages, electronic voting.

How to score full marks

• Define both approaches and compare them in a table or in parallel.
• Give a country example for each.
• Use the facts to say which suits the company or market.
• State key provisions of Sarbanes-Oxley accurately: PCAOB, sections 302 and 404.
• Name the six OECD principles and give a point under each.
• Note the limit of international codes.

Common mistakes in the exam

• Saying principles-based codes are voluntary in every sense: listed companies must still explain.
• Saying the UK has no rules.
• Mixing up sections 302 and 404.
• Listing OECD principles without content.
• Ignoring the cost of rules.
• Presenting one approach as proven better.

Quick revision

• Codes protect investors and attract capital.
• Rules-based: compulsory, rigid (USA). Principles-based: comply or explain, flexible (UK).
• Sarbanes-Oxley: PCAOB, section 302 certification, section 404 internal control.
• UK history: Cadbury, Greenbury, Hampel, Combined Code.
• OECD: six principles. ICGN: investor-focused. International codes lack enforcement.
• CAMA 2020: ss. 305, 308, 377(1), 378, 385, 404(7).

Practice questions

These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer. Full model answers follow the written questions.

Recall check: multiple choice

The real ICAN paper has no multiple-choice section. These questions are for quick recall. The written questions that follow are closer to the exam.

Written questions

Model answers

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