Muhammad Azeem Rafi..

1 NUML Lahore CHAPTER 1 AN OVERVIEW

What is Corporate Governance? Corporate Governance is concerned with governing the corporate entities. What is corporate entity (Company)? A company is a form of business ownership with the following characteristics: Its capital consists of several units, called shares. The shares are generally transferable. The shareholders have no liability towards the debts of company. A company is considered a legal person and has an entity of its own, quite separate from its shareholders. Perpetual existence (Infinite life). Management of company is entrusted to people called directors. Unlimited Companies. These are the companies where shareholders have an unlimited liability towards the liabilities of the company. They may or may not have share capital. They resemble partnership. Limited Companies. These are the companies where shareholders liability towards the companys sum is restricted to a limited sum. Limited Liability Company is of two types: Company limited by guarantee Company limited by shares

Types of Companies

Private Limited Companies. Its shares are generally not freely transferable. It has to be approved by the company. It can have not less than two and not more than fifty members excluding employees. Its shares are not offered for subscription to general public. The word Private forms part of the name of the company. Public Limited Companies. Its shares are freely transferable. It can have any number of shareholders in excess to seven which is the minimum requirement. The shares can be offered for public subscription. They are of two types: Listed companies Unlisted companies The hierarchy of a company comprises of the following three stages:-

Hierarchy of a Company.

First Stage: Management is appointed by, takes its directions from and reports to the Board of Directors. It runs the company on a day to day basis Second Stage: Board of directors is elected by and reports to the shareholders. It provides the overall guidance for running the company, draws up its policies and appoints the management Third Stage: Shareholders who are the owners of a company hold the ultimate power to make decisions about the affairs of the company. They elect the directors usually from among themselves, to provide the overall guidance for running the company. Shareholders who elect the board of directors. Chairman of the board may or may not be the executive of the company. Directors who may be employees (Executive) and those who only serve the board (Non-Executive). Chief executive officer who may or may not be the director of the company. Senior Managers who actually run the company on day to day basis.

Key Players in a Company

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Stakeholders in a Company. A stakeholder is a person who has an interest (or stake) in a company. Shareholders are the main group who has a stake in the well being of the company, but they are not the only ones. A number of other people are also affected by the financial position and performance of a company and therefore need to be kept happy by those who run the company. Such people include creditors, lenders, customers, suppliers, employees, general public, society at large, government, etc. Classification of Stakeholders Owners. Individuals as well as institutional investors. They have the greatest interest in the company. Lenders. They extend financial advances to the company. Employees. Executive directors, senior managers and all others who are on the payroll. Business Associates. Company suppliers and clients Society. Public at large. Government. Tax authorities

What is governance? The mechanism used to control and direct the affairs of a corporate body in order to serve and protect the individual and collective interests of all its stakeholders. Corporate governance focuses on some structures and mechanisms that would ensure the proper internal structure and rules of the board of directors, creation of independent committees, and rules for disclosure of information to shareholders and creditors, transparency of operations and impeccable process of decision making and control of management. Corporate governance is the system by which companies are directed and controlled. (Cadbury Report 1992) If management is about running businesses, governance is about seeing that it is being run properly. (Prof. Bob Ticker) Corporate governance as a set of mechanisms through which outside investors protect themselves against expropriation by the insiders. He defines insiders as both managers and controlling shareholders. (La Porta 2000) Ownership is separate from Management. Conventional focus is on shareholders wealth maximization. Many of large organizations are multinationals and global companies. Bad governance impact would be colossal. Adversely affects economic activity. Stakeholders interest is significant. Corporate need to be socially responsible as well.

Why Corporate Governance?

Corporate Sins. There are three attributes frequently found among directors and senior managers which are considered as corporate sins: Sloth. Greed. Fear. This is the unwillingness to take risks and initiatives. Is the desire of managers to get the best for themselves, even at the expense of others It is a tendency to refrain from doing anything so as not to displease a boss, or an investor.

These sins are responsible for majority of cases of poor governance.

Corporate Governance

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Approaches to Corporate Governance. There are three approaches available to the board of directors, to govern a company:

Shareholders approach to Corporate Governance. It is generally believed that the board of directors of a company should govern the company in the best interest of its shareholders, i.e., the owners of the company. Because directors are elected by and answerable to shareholders. This approach leads the board to formulate policies that aim at maximizing the shareholders value often at the expense of other stakeholders. Stakeholders approach to Corporate Governance. Under this approach, the board of directors should aim at formulating policies that provide for equal (or almost equal) care of the interests of all stakeholders (not just the shareholders). This is ideal but not a practical approach for the simple reason that directors are elected by and accountable only to shareholders. Enlightened shareholders approach. This approach offers a compromise between the two approaches. It requires the board of directors to work for the best interest of shareholders, but without damaging or misappropriating the interests of other stakeholders, i.e. having a fair balance of interests. Distinguishing the roles of Board and Management Composition of Board and related Issues Separation of role of CEO and chairperson Should the board have committees Appointment to the board and directors re-election Directors and executives remuneration Disclosure and audit Protection of shareholders rights and their expectations Dialogue with Institutional shareholders Should Investors have a say in making corporate as socially responsible corporate citizen Business is to be managed by or under the direction of board Board delegates powers to CEO CEO delegates it to management Board is the link between shareholders and management. Board selects, decides the remuneration, evaluates and change the CEO where necessary Oversee the conduct of business Review and approves financial plans, corporate plans and objectives Render advice and counsel to top management Identify and recommend candidates to shareholders for electing them to BOD Review the adequacy of system to comply with all applicable laws and regulations Right of shareholders Equitable treatment of shareholders Role of Stakeholders Disclosure and Transparency Responsibilities of Board of Directors

Issues in Corporate Governance

Distinguishing the Roles of Board & Management

Key Parameters of Corporate Governance

Corporate Governance

Muhammad Azeem Rafi.. Corporate Governance-Benefits to Society

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Transparency Minority Interest & Liquid capital markets Competition for product and capital Check on corruption Improvement in Management System Creation and enhancement of competitive advantage Prevention of frauds and malpractices Protection to shareholders interests Enhancing valuation of an enterprise Ensuring compliance of laws and regulations. CHAPTER 2 A BRIEF HISTORY OF CORPORATE GOVERNANCE

Corporate Governance-Benefits to Corporate

What is Corporate. A corporate is an association of persons recognized by law with a contribution towards common stock to undertake trade and business and to share the profits arising there from. It has following characteristics: Artificial legal persons Perpetual Existence Common Seal Extensive membership Separation of management from ownership Limited Liability Transferability of shares The process of decision-making and the process by which decisions are implemented. Governance Structure can be formal and informal. Governance could be national governance, international governance, local governance, corporate governance. Governance is as old as human civilization. Shareholders are owners They are Principals Management, selected directly & indirectly by shareholders, are agents. Agent to perform for the benefit of Principal Reduction of agency costs or loss: Fair & accurate financial disclosures Efficient & Independent Board of Directors

What is Governance

Theoretical Basis of Corporate Governance-Agency Theory

Stewardship Theory Governance approach is sociological and psychological. Managers are stewards Managers motives are aligned with Principals objectives

Corporate Governance

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Managers are trustworthy and attach significant value to their reputation Steward behavior will not depart from interest of his organization Control can be counter-productive. Time frame is long term Risk orientation is done through trust. Agency Theory Behavioral Differences Stewardship Theory

A Comparison of Agency and Stewardship Theory

Managers act as agents Governance approach is materialistic

Managers act as stewards Governance approach is sociological and psychological Behavior Patter is Individualistic, Opportunistic Behavior pattern is collectivistic, proand self-serving organizational and trustworthy Managers are motivated by their own objectives Managers are motivated by principals objectives Interest of managers and principals differ Interest of principal and agents converge Role of management is to monitor and control The role of management is to facilitate and empower Owners attitude is to avoid Owner attitude is to take risk Principal relationship is based on control Principal-agent relationship is based on trust. Situational Mechanism Management philosophy is control oriented Greater control and supervision for dealing with uncertainty and risk Time frame is short The objective is cost control Management philosophy is involvement oriented Training, empowerment, motivating and making jobs challenging is the way to deal with risk and uncertainty Time frame is long The objective is improving performance Psychological Mechanism Motivation around higher order needs Greater attachment to company Power rests with personnel.

Motivation around lower order needs Little attachment to company Power rests with institution Stakeholders Theory

Managers accomplish their tasks as efficiently as possible by building up a contract with stakeholders that is equitable for both the parties to benefit. Theory is based on ethics of care, ethics of fiduciary relationships, social contract theory etc. Theory dates back to 1930 Theory is hardly found in practice Board composition, implication for power and wealth distribution in society Bigger Challenge: Concentration of directorship in hands of privileged class Board composition, financial reporting, disclosures and auditing mechanism promote equity and fairness.

Sociological Theory

Corporate Governance

Muhammad Azeem Rafi.. Corporate Governance Models Anglo-American Model

6 NUML Lahore

All directors participate in a single board comprising both executive and non executive directors in varying proportions. Shareholding is almost equally divided between institutional and individual shareholders. Fairly clear separation of management from ownership. Institutional investors are reluctant activists. Protect small investors Disclosure norms are comprehensive. America, Britain Canada, Australia Corporate Governance is exercised through two boards, in which the upper board supervises the executive board on behalf of stakeholders. Supervisory board is equally elected by shareholders and labor unions and employees. Shareholders elect 50 per cent of members of supervisory board and the other half is appointed by labour unions. This ensures that employees and labourers also enjoy a share in the governance. The supervisory board appoints and monitors the management board. Management board independently conducts the day to day operations. Shareholders and main bank together appoint the supervisory board including president. President who consults both the supervisory board and the executive management (primarily board of directors) Banks and financial institutional have large stakes in equity. Lending banks have important role. Institutional investors consider themselves as long term investors. Shareholding is vested with directors, relatives, other corporates, Public and institutions Board composition is executive and non-executive Board independence is little Control of corporate is linked with ownership Shareholding is vested with directors, relatives, other corporates, Public and institutions Board composition is executive and non-executive Board independence is little Control of corporate is linked with ownership

German Model

The Japanese Model

Indian Model

Pakistan Model

What is Good Corporate Governance Bad governance is being recognized now as one of the root causes of corrupt practices in our societies. Institutional investors and international financial institutions provide their aid and loans on the condition that ensure good governance is put in place by the recipient nations. As with nations, corporations too are expected to provide good governance to benefit all their stakeholders. At the same time, good corporate are
Corporate Governance

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not born, but are made by the combined efforts of all stakeholders, which include shareholders, board of directors, employees, customers, dealers, government and the society at large. Law and regulation alone cannot bring about changes in corporates to behave better to benefit all concerned. Obligation to Society at large National interest Legal compliances Honest and ethical conduct Ethical behaviour Corporate social responsibility Healthy and safe working environment Trusteeship Effectiveness and efficiency Uphold fair name of the country Political non-alignment Rule of law Corporate citizenship Social concerns Environment friendliness Competition Accountability Timely responsiveness

Obligation to Investors Towards shareholders Financial reporting and records Promote transparency and informed shareholders participation Fair employment practices Encourage whistle blowing Participation Equity and inclusiveness Equal opportunities employer Human treatment Empowerment Participative and collaborative environment Products at affordable prices

Obligation to Employees

Obligation to Customers Quality of products and services Unwavering commitment to customer satisfaction Protecting companys assets Control Gifts and donations Direction and management must be separate

Managerial Obligations Behavior towards government agencies Consensus-oriented Role & responsibilities of boards and directors Devotion

CHAPTER 3 THE SHAREHOLDERS Who is a shareholder? He is a person who owns shares in a company. He is considered a member of the company and its co-owner with certain rights and obligations. Now a company may issue different types of shares, each with its own peculiar attributes. The rights, powers and obligations of the shareholder will depend on the type of shares held by him. Types of Shares Ordinary Permanency Residual claim on profits Voting rights Preferred Dividend Residual claim on assets Right to purchase new shares Features of Ordinary Shares

Corporate Governance

Muhammad Azeem Rafi.. Features of Preference shares No voting power Claim on companys assets

8 NUML Lahore

Claim on companys profits

The Real Owners of a Company. Ordinary shareholders are entitled to the residual of profits and residual of companys assets. This makes them the real risk-bearers in the company, whose rights on the companys profits and assets come after the claims of everyone else, have been satisfied in full. At the same time, they are the ones who benefit if the profits or the assets of the company increase. Classification of Equity shareholders. Equity shareholders can be classified into two broad groups:Those who invest in a company with an intention to own, control and run the company, this group of shareholders is considered as internal shareholders. Those who invest in a company with a view to earn a return on their investment but have no intention of participating in the management of the company, or putting their nominees on the board. This group of shareholders is considered as external shareholders. Types of Shareholders

Internal Shareholders

External Shareholders

Companies that own other companies

Large Private Investors

Small Private Investors

Investing Organizations

MNCs holding companies, conglomerates

Families and close friends

Individuals

Mutual funds, Pension funds, Investment & Commercial Banks

Corporate investors Internal Shareholders

Individual Investors

Institutional Investors

Controlling shareholders Majority of directors on the board In Pakistan, internal shareholders generally own more than 50% of the shares, which enables them to ensure that all or most of directors on the board are their nominees. In USA & Europe, several companies are controlled by shareholders, holding much less than half of the companys total shares. Nominees are elected with the help of external shareholders who may have trust in the management ability. No or less representation in the board Seldom able to unite and vote collectively Management scientists studying the performance of company boards believe that the prime cause of corporate governance problems is lack of unity between external shareholders

External Shareholders

Corporate Governance

Muhammad Azeem Rafi.. Capabilities of Institutional Shareholders

9 NUML Lahore

Large sums of money on behalf of their depositors Wants to earn a reasonable return to keep their clients happy Professional and competent staff Institutional investors are knowledgeable and organized investors They divide their portfolios into various categories like duration of investment or volume. In practice, institutional investors refrain from having direct representation on the board. Instead, they use their influence by having a relationship with the companys board or management. In this way, they can communicate their preferences to the company and be sure of being listened do. In Britain and USA, Institutional investors are the ones who raised voice against huge remuneration of directors. Generally institutional shareholders allocate a good percentage of its investment portfolio to long term shareholding. They are interested in the sustainable growth of share price, also dividends Due to the size of their shareholding, they can influence the policy making processes of the investee companies. Institutional investors have two main qualities i.e. Professional competence and size of investment. They are therefore in a position to influence the decision making process at the board. Three principal forms of intervention by

Institutional Shareholders Perspective

Role of Institutional Investors in Corporate Governance

Principal forms of Intervention by Institutional Investors. institutional investors are:

Having a dialogue with the board of directors of investee company, making them aware of their concerns and preferences Carrying our regular evaluation of financial and other reports issued by the company Making a judicious use of their vote. Even if they are not interested in running the affairs of the company. The shareholders, particularly the external ones,

What do shareholders expect from the company? expect the following from the company:

The board of the company should be accountable to them There should be transparency in all decision making processes in honest manner. It should be recorded in minutes. Directors should not allow self interest to prevail over the interest of the company, or other stakeholders. Directors should manage their companies effectively and efficiently, showing good profits and good growth in the market value of their shares. Executive directors should not award themselves unreasonably high remuneration at the expense of dividends to the shareholders. Larger transactions made by the company, must be disclosed to and approved by the shareholders. The defining size of such transactions may differ from company to company, but generally any transaction that is in excess of say 25% of companys equity is classified as class 1 transaction.

Tools Available to Shareholders

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All transactions made by the company with related parties must be disclosed to the shareholders. Related parties in this context include directors, major shareholders and other companies in the group, or other companies in which directors, majority shareholders or managers of the reporting company may have an interest. Law requires listed companies to issue periodic financial statements to shareholders. These statements must be audited. The appointment of auditors is approved by the shareholders and the audit report is addressed to the shareholders. Directors remuneration must be approved by the shareholders.

AGM of Shareholders. The code of corporate governance makes the following recommendations in respect of AGM: The company must encourage attendance by members at AGM. This means that meeting should be held after a suitable notice and at a convenient place and time. The company must ensure that all members get the notice of the meeting and attachments in good time to enable them participate effectively at the meeting. Members should be encouraged to ask questions. Their queries should not be suppressed, rather dealt with respect and dignity. Matters should be put to vote individually. Vote count at AGM is based on one vote per share, not one vote per shareholder. Shareholders do not have to be physically present at the meeting. They can authorize someone else to attend the meeting on their behalf.

Shareholders Activism. It is relatively new trend in the corporate world. It involves shareholders taking a stand against the recommendations made by the board of directors at the AGM. It is not necessary that such a stand would lead to withdrawal of the recommendation; but it does send signals to the board about how shareholders feel on any particular issue. If institutional shareholders support shareholders activism, then the board may find it difficult to get its recommendations, on directors remuneration or dividend declaration, approved by the members. CHAPTER 4 THE BOARD OF DIRECTORS Director. Section 2(13) defines a director as including any person occupying the position of director, by whatever name called; A director may therefore be defined as a person having control over the direction, conduct, management or superintendence of the affairs of company Further any person in accordance with whose direction or instructions, the board of directors of a company is accustomed to act is deemed to be a director of company. Agent. Directors act as agents of company and company acts as principal Trustee. Directors are trustees of assets of a company but they are not trustees of individual shareholders. Listed Public Company Unlisted Public Company Private Company Single Member Company 7 3 2 1

Minimum Number of Director

Corporate Governance

Muhammad Azeem Rafi.. Directors Appointment

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First Board of Directors is usually appointed by virtue of provisions of articles of association. In the absence thereof, the number and names of directors shall be determined in writing by the subscribers of the Memorandum of Association or by majority of them. If not, the subscribers of MOA become the directors. First directors hold their office up till the holding of first AGM and taking over by next BOD. Executive Directors Full time working director covered by a service contract. EDs are in charge of day to day conduct of the affairs of the company Together with other team members collectively known as Management. Nothing to do with day to day management of company. They may attend meetings of BOD and meetings of committees to which they are members.

Kinds of Directors

Non-Executive Directors

Nominee Directors. A nominee director is generally appointed in a company by the creditors and or by other special interest to ensure that affairs of the company are conducted in the manner dictated by law governing companies and to ensure good corporate governance. Independent Director. The board of directors of each listed company shall have at least one and preferably one third of the total members of the board as independent directors. The board shall state in the annual report the names of the non-executive, executive and independent director(s). Explanation: For the purpose of this clause, the expression "independent director" means a director who is not connected or does not have any other relationship, whether pecuniary or otherwise, with the listed company, its associated companies, subsidiaries, holding company or directors. The test of independence principally emanates from the fact whether such person can be reasonably perceived as being able to exercise independent business judgment without being subservient to any form of conflict of interest. Provided that without prejudice to the generality of this explanation no director shall be considered independent if one or more of the following circumstances exist: He/she has been an employee of the company, any of its subsidiaries or holding company within the last three years; He/she is or has been the CEO of subsidiaries, associated company, associated undertaking or holding company in the last three years; He/she has, or has had within the last three years, a material business relationship with the company either directly, or indirectly as a partner, major shareholder or director of a body that has such a relationship with the company: Explanation: The major shareholder means a person who, individually or in concert with his family or as part of a group, holds 10% or more shares having voting rights in the paid-up capital of the company; He/she has received remuneration in the three years preceding his/her appointment as a director or receives additional remuneration, excluding retirement benefits from the company apart from a directors fee or has participated in the companys share option or a performance-related pay scheme; He/she is a close relative of the companys promoters, directors or major shareholders:

Corporate Governance

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Explanation: close relative means spouse(s), lineal ascendants and descendants and siblings; He/she holds cross-directorships or has significant links with other directors through involvement in other companies or bodies; He/she has served on the board for more than three consecutive terms from the date of his first appointment provided that such person shall be deemed independent director after a lapse of one term.

Any person nominated as a director under Sections 182 and 183 of the Ordinance shall not be taken to be an "independent director" for the above-mentioned purposes. The director representing an institutional investor shall be selected by such investor through a resolution of its board of directors, either specifically or generally, and the policy with regard to selection of such person for election on the board of directors of the investee company shall be annexed to the Directors' Report of the investor company. Board of Directors If BOD is responsible and effective, the quality of its governance will be good and its stakeholders will generally be happier. The overall performance of the company will improve due to access to larger and cheaper capital, better reputation in the market, availability of better workers, etc. A board can translate the wishers of stakeholders into workable policies, communicate them to the management and ensure that these are actually followed. All the codes of corporate governance issued in various countries of the world are essentially directed at the board of a company for bringing about necessary reforms for the protection of all stakeholders interest.

Role of the Board It should be Strategic Board Small size of Board-Cohesiveness and decision making. Independence of Board lesser insider and more outsiders. Diversity of the Board experience and professional diversity plus ethnic and cultural diversity. A well informed Board Intelligent, timely and accurate information. Longer Vision and Broader responsibility.

It must arrange for resources needed to implement the strategic plans. It should review the performance of the management to ensure that boards plan is being effectively and efficiently implemented. It should set the companys values and standards; this involves companys vision and mission statement, code of conduct of managers and employees. Rubber Stamp Board or Yes Men Board. forward by the executive directors Simply approves whatever proposal or resolution is put

Types of Ineffective Boards

Good Old Boys Board or Country Club Board. Comprising of old friends of old friends of the chairman (or principal shareholder of the company) who simply meet for board meetings but actually talk only about good old days rather than companys business. Paper Board. That exists only on paper and plays no role in the company, e.g. wives and daughters of principal shareholder of the company.

Corporate Governance

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Trophy Board. Comprises of people who have a big name in the society like major sports stars, film actors, politicians, etc.) but have no interest in the conduct of the business.

Powers of Board. The board of directors of a company normally has absolute powers to conduct the affairs of the company. Whatever a company is authorized to do by its memorandum of association, the board can do it on behalf of the company. However, these are the collective powers of the board. Sources of Power The companys constitution The Law Resolutions passed by shareholders Sometimes practices prevailing in particular industry The Oversight Function Approving and monitoring strategic plans Approving annual budgets and plan Ensuring the integrity and reliability of companys annual reports Setting the vision mission statement Appointment of CEO Planning for succession of Senior Executives Appointment of committees General guidance to the management

Functions of Board

The Directional Function

The Advisory Function. Composition of the board Independence of the board Committees External Help Consultation with the govt.

Tools Available to a Board

Responsibilities of a Board. It can be discussed in two broad groups, collective responsibilities and individual responsibilities. It is important to note that a board is responsible for its acts and accountable only to the company, and not to any other party. Anyone else having a grievance must seek redress from the company, and not from its directors, except where a director acts illegally or fraudulently, he cannot be held responsible personally for steps taken on behalf of the company. The collective responsibilities: Acting in the best interest of the company Accountability to the owners Statutory duties Proper minutes of the meetings Periodic reports Stock exchange regulations Statutory duties

Fiduciary or trusteeship duties

Corporate Governance

Muhammad Azeem Rafi.. Borrowing Powers of the Board.

14 NUML Lahore

The companies Ordinance does not place any limitation on the amount of borrowings that a company can make. The prudential regulations issued by the state bank of Pakistan do place some restrictions on the amount of loan a bank or other financial institutions governed by the SBP can lend to a company. The SBP has come up with a requirement that all the directors of a company must extend a personal guarantee to the lending financial institution for any loans being given to the company.

Types of Boards

Types of Boards

Composition Unitary Boards

Types of Boards

Tenure of Members Common Tenure Boards Staggered Board

Two tiered Boards

Unitary Board. A unitary board does not have tiers or divisions. All members of the board are equal status and participate in the decisions of the board simultaneously. Two-Tier Board. A two-tier board has two distinct tiers: the upper tier is often called supervisory board and the lower tier is called management board. Common Tenure Board. All the directors in such a board have the same tenure. They are elected at the same time for the same duration of tenure and retire at the same time at the end of their tenure. Staggered Board. Under this arrangement, only a part of the board retires at the end of a stated tenure while the duration of each director remains fixed. The board enjoys a degree of stability as the entire board does not go out at any one time. This ensures that there is continuation of policies and no radical changes ensue after each election. Frequent re-elections infuse new members into the board, thereby enabling it to get new blood, fresh ideas and better exposure to the outside world.

Advantages of Staggered Board

Balance on the Board. The key to success of a board is to have a balanced board. A board is said to be balanced if it has the right blend and proportion of the different attributes needed in its members. Board of directors should be balanced in four respects: Balance of Representation. All the stakeholders should have adequate representation on the board. Balance of Talents and Abilities. Having a blend of all the necessary talents and technical expertise needed to lead the company. Balance of Power. Having an adequate number of truly independent non-executive directors on a board. Non Executive Directors (NED), Representative Non Executive Directors (RNED), Independent Non Executive Directors (INED). Balance of Attitudes. Having diversity of views at the board that ensures presence of a wide range of social, moral and managerial attitudes of directors.

Corporate Governance

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Role of Chairman of the Board. The chairman of the board is also considered the chairman of the company. His functions include: Running the board, chairing all its meetings, setting its agenda, conducting its proceeding, and leading all discussions at board and shareholders meetings. Ensuring that directors get adequate and timely information. Acting as a bridge between the board and shareholders. Evaluating the performance of the board as a whole and of each of its individual members. Act as an arbiter for any issues between different members of the board or management. Also known as CEO, Managing Director or President. Head of the management. Responsible for the management. He is answerable to the board in respect of all operational and managerial matters-every one else in the companys management is answerable to him. Most CEOs are also member of the companys board. In many companies the offices of chairman and CEO are held by the same person.

Role of the Chief Executive Officer

Duality of Office: Chairman and CEO. The company law and articles of association of most companies permit one person to hold both the offices of chairman and CEO. Advantages are: Speeds up the decision making process. Saves the cost to the company as often chairman and CEO draws salary for one office. Has greater influence on the company and is able to conduct its affairs more effectively.

Revision of Code of Corporate Governance 2012. Code has made it mandatory that these two offices should be held by different persons in listed companies. Non listed and private limited companies are so far exempt from the provision of the code. It provides an extra layer of answerability, making the CEO more careful. The chairman should be non-executive director. This adds independence. A non-executive chairman is more likely to listen attentively to the grievances of stakeholders. Appointment Terms. The appointment, remuneration and terms and conditions of employment of the CFO, the company secretary and the head of internal audit shall be determined by the CEO with the approval of the board of directors. Qualifications. CFO should be a member of recognized body of professional accountants; or he should be a recognized university graduate having five years experience in dealing corporate and financial affairs at listed company or a financial institution. The company secretary should fulfill the same condition. Requirement of Attending the Board Meetings. The CFO and Company Secretary of listed company should attend the meeting of Board of Directors. However, they will vote at the meeting only if they are elected directors. CHAPTER 5 COMMITTEES OF THE BOARD Introduction. Board of directors is a body that meets not more than four or five times a year to perform its oversight, directional and advisory functions. It is therefore necessary that the board should get some
Corporate Governance

CFO & Company Secretary

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assistance from certain quarters, other than the management. Forming committees of the board is one way to get such assistance. Some of the committees are required by law, while others may be formed purely as a convenience and a tool for better governance. Advantages of Committee Professional directors get the information from many sources other than management. The workload of directors is reduced. The detailed work is done by the committee members while the board receives a summarized report and / or recommendations. With the induction of outside consultants or specialists in such committees, the board can get more detailed and specialized information for a more dependable decision making. Committees are often accused of slowing down the process of decision making. Once a committee is formed about a particular matter, many board members stop caring or even thinking about it. If the committee is not performing its work properly, the whole board and hence the company suffers. Board committees are often used by the real management of the company to get legitimacy for their decisions without taking responsibility for them. Audit Committee Human Resource and Remuneration Committee Executive Committee Compliance Committee

Issues & Problems

Common Committees

THE AUDIT COMMITTEE. The code requires listed companies to form an audit committee comprising of three or four board members. It is charged with the responsibility to oversee certain functions on behalf of the board and to brief the board there-on. Membership of Audit Committee. Code:- The board of directors of every listed company shall establish an Audit Committee, at least of three members comprising of non-executive directors. The chairman of the committee shall be an independent director, who shall not be the chairman of the board. The board shall satisfy itself such that at least one member of the audit committee has relevant financial skills/expertise and experience. Responsibility of Audit Committee Oversight of financial reporting and accounting systems/policies Liaison with external auditors of the company Ensuring regulatory compliance in respect of disclosure and other requirements of law relating to financial statements Monitoring the internal control process of the company Oversight of the risk management processes of the company

Terms of Reference. The Audit Committee of a listed company shall meet at least once every quarter of the financial year. These meetings shall be held prior to the approval of interim results of the listed company by its Board of Directors and before and after completion of external audit. A meeting of the Audit Committee shall also be held, if requested by the external auditors or the Head of Internal Audit.

Corporate Governance

Muhammad Azeem Rafi..

17 NUML Lahore

The Board of Directors of every listed company shall determine the terms of reference of the Audit Committee. The Board shall provide adequate resources and authority to enable the Audit Committee carry out its responsibilities effectively. The Audit Committee shall, inter alia, recommend to the Board of Directors the appointment of external auditors, their removal, audit fees, the provision by the external auditors of any service to the listed company in addition to audit of its financial statements. The Board of Directors shall give due consideration to the recommendations of the Audit Committee in all these matters and where it acts otherwise; it shall record the reasons thereof. The terms of reference of the Audit Committee shall also include the following: Determination of appropriate measures to safeguard the listed companys assets; Review of quarterly, half-yearly and annual financial statements of the listed company, prior to their approval by the Board of Directors, focusing on: Major judgmental areas; Significant adjustments resulting from the audit; The going concern assumption; Any changes in accounting policies and practices; Compliance with applicable accounting standards; Compliance with listing regulations and other statutory and regulatory requirements; and Significant related party transactions.

Review of preliminary announcements of results prior to publication; Facilitating the external audit and discussion with external auditors of major observations arising from interim and final audits and any matter that the auditors may wish to highlight (in the absence of management, where necessary); Review of management letter issued by external auditors and managements response thereto; ensuring coordination between the internal and external auditors of the listed company; Review of the scope and extent of internal audit and ensuring that the internal audit function has adequate resources and is appropriately placed within the listed company; Consideration of major findings of internal investigations of activities characterized by fraud, corruption and abuse of power and management's response thereto; Ascertaining that the internal control systems including financial and operational controls, accounting systems for timely and appropriate recording of purchases and sales, receipts and payments, assets and liabilities and the reporting structure are adequate and effective; Review of the listed companys statement on internal control systems prior to endorsement by the Board of Directors and internal audit reports; Instituting special projects, value for money studies or other investigations on any matter specified by the Board of Directors, in consultation with the CEO and to consider remittance of any matter to the external auditors or to any other external body; Determination of compliance with relevant statutory requirements; Monitoring compliance with the best practices of corporate governance and identification of significant violations thereof; and Consideration of any other issue or matter as may be assigned by the Board of Directors.

Corporate Governance

Muhammad Azeem Rafi..

18 NUML Lahore

Nature of Audit Committee. Despite its apparent importance and influence on the governance of a company, it is wise to remember that an Audit Committee is not an executive body. It does not carry out any executive function at all. It does not draw up the accounting policy, neither does it approve. The management draws accounting policies and procedures while the board of directors approve them. Committee is to advise the board on the efficacy of the policy and its implementation. Audit committee does not perform internal or external audit. It does not issue any instructions to the either auditor. It simply oversees their work and reviews their reports. Audit committee reports to the board of directors and gives findings, advice and recommendations to the board. In certain situations, it lies within the prerogative of the audit committee to give a report direct to the shareholders, or to communicate with them through some other formal or informal means to convey its views. Managing its Agenda Frequency of interaction with management (with CEO, CFO, Internal Audit Manager, External auditor, tax advisor etc.) Regular Executive sessions (formal scheduled meetings b/w the audit committee and key managerial staff or external auditors) Regular evaluation (each member performance) AC should maintain constant liaison with the external auditor. AC has to check the details of the qualifications, experience, past record etc. of any firm of auditors whose name is proposed at AGM. AC should ensure the independence of the external auditor by verifying that there are no linkages b/w auditor and the management. AC should ensure rotation of external auditors after suitable periods. AC should monitor the performance of external auditors and report its finding to the board.

Best Practices. The following advice is available to audit committees for conducting its business effectively:

Audit Committee and the External Auditor

Situation of Audit Committees in Pakistan Sadly most audit committees are far from independence. Some companies nominate their executives, even the director finance, on such committee. Others assign the chairmanship of audit committee to the chairman of the company. In many companies, since most directors are family members, it is common that one brother is chairman of the company, another is the CFO while the third is chairman of the audit committee. THE HUMAN RESOURCE AND REMUNERATION COMMITTEE. There shall also be a Human Resource and Remuneration (HR&R) Committee at least of three members comprising a majority of non-executive directors, including preferably an independent director. The CEO may be included as a member of the committee but not as the chairman of committee. The CEO if member of HR&R Committee shall not participate in the proceedings of the committee on matters that directly relate to his performance and compensation. Responsibilities of Committee Formalization of the process of finding suitable directors, including both the executive and non executive directors.

Corporate Governance

Muhammad Azeem Rafi..

19 NUML Lahore

It does not appoint the directors, but makes recommendations to the board. Formulation of policy regarding remuneration of executive, non executive as well as senior managers of the company. Periodic performance evaluation of executive directors, non executive director and senior management. Succession planning of directors and senior officials including the chairman. Making recommendation on the board size and structure. Ensuring that directors are not being paid any additional fees, or given assignments or such other contracts that may undermine their independence. If the company operates any bonus scheme for directors or senior officials, the committee should be involved in devising such a scheme. Ensuring that disclosures relating to directors remuneration are correctly made in periodic financial statements.

Directors Remuneration. Over the recent past, these executive directors have been paying themselves huge salaries and bonuses, causing a lot of concern to not only the shareholders who were directly affected by these enormous payments but also other stakeholders whose interests were also adversely affected, e.g. Enron had 970 million dollar profit and 750 million dollar bonuses to executive directors. Basis of Remunerating Directors. 1. Fixed Salary 2. Performance Based Pay Fixed Salary Only Approach. If a company pays only a fixed salary to its directors, it does not motivate them to work harder for companys profitability or growth. Restricting directors remuneration to only salary also takes away the entrepreneurial instincts and initiative from their working. Performance Based Pay A performance based pay or incentive pay, promotes motivation. It gives the directors a reason for better performance as they stand to gain personally from companys profitability or growth. Cash bonus, free shares, share options Directors pay is generally divided into two segments:

Executive Committee. Since board members are busy people they cannot get together very frequently. An executive committee is formed with powers to make decisions on many of the matters (up to a specific limit) thereby eliminating the need of bringing every matter to the board. It has following advantages: It reduces work load on the board of directors. It has an opportunity to consult internal and external resources before putting up any matter to the board. Ad hoc Committees of the Board. Companies also form additional committees from time to time to attend to issues that during the course of operations of the company. They may include: Investigations Committee. To investigate any breach of companys operational code. Negotiations Committee. To negotiate with unions, government or any other external party. Projects Committee. To supervise any project or acquisition. Communications Committee. For better communications with stakeholders, investors and media.

Corporate Governance

Muhammad Azeem Rafi..

20 NUML Lahore CHAPTER 7 FINANCIAL REPORTING

Annual report. For legal and necessity reasons, Companies publish a formal report at the end of each financial year. This annual document has three broad sections: Directors Report Financial Statements Audit Report

Directors Report. Often in the form of a letter from the companys chairman to its shareholders giving three important pieces of information: 1. Comment on the financial performance of the company during the year to which the report relates. This part is often referred to as OFR, i.e., Operational and Financial Review. 2. Assessment of what lies in the immediate future 3. A statement about the companys policies, principles and strategies developed to meet the challenges of future. Financial Statements 1. 2. 3. 4. Income statement Balance sheet Cash flow statement Statement of changes in equity

Each statement is accompanied with a large number of notes providing explanation of the items contained therein. Notes to the accounts are considered to be as important as the accounts themselves. Audit Report. The third section of the annual report contains a report from the external auditors which essentially gives his opinion on the financial statements. The Need for Publishing Financial Statements The Informational Function. investors, govt. etc. Shareholders, lenders, suppliers, customers, managers, employees,

The Control Function. How much dividend to declare, what portion of profit to reinvest, comparison with similar companies, and also comparison within the deptt. The Planning Function. Plan or budget for the next few years, set targets and make attainable plans

Balance Sheet Capital Employed. = Equity + Long Term Liabilities = (Fixed Assets + Intangible Assets + Investments) + Working Capital = Noncurrent Assets + Working Capital Equity. It is shown on the liabilities side of the balance sheet. It comprises of companys paid up share capital, reserves and un appropriated profits. Long Term Liabilities. Fixed Assets. Non-Tangible Assets. patent etc. The obligations company has to pay after at least a year. These assets do not have a physical shape but are used to do business like The assets that a company uses to do the business with.

Corporate Governance

Muhammad Azeem Rafi.. Investments. etc. Working Capital.

21 NUML Lahore

These are financial assets and may be in form of shares of other companies or bonds This is the excess of current assets over current liabilities at any moment of time.

Current Assets. The assets that are reasonably expected to be sold, consumed or converted into cash during a normal operating cycle of the company. Current Liabilities. The obligations that must be discharged by the company within its operating cycle. Capital Employed. Total of each side of the balance sheet represents the capital employed. The first part is called the trading account. It shows the sales revenue earned by the company, the total direct costs incurred to earn and the resultant gross profit. The second part is the profit & loss account. All incidental incomes are added to gross profit to get gross operating profit. All expenses (overheads) are deducted to get years net profit. The third part is the profit and loss appropriation account. This shows how the profit earned is being used. After deduction of taxes profit after tax is deduced. Cash flow from operating activities Cash flow from financing activities Cash flow from investing activities Equity of a company comprises of essentially three parts.
Share Premium 80 1,000 3,050 2,500 9,500 1,080 4,240 (2,500) (1,500) 1,509 (1,500) 16,329 General Reserves 1,740 Retained Earning 2,459 Total Equity 9,779 5,000 3,050 Share Capital

Income Statement

Cash Flow Statement

Statement of Changes in Equity.

Bal as on 31 Dec 09 Shares issued in 2012 Net profit for the year Tfr from P&LC A/C Dividend final Bal as on 31 Dec 10 5,500 4,000

Notes to the Financial Statements.

Notes provide the additional information:-

An explanation of accounting methods or policies used. Greater details regarding certain figures in the financial statements. Statutory Disclosures. Changes in accounting policies, methods or nature of business during the year. Details of off-balance sheet items.

Limitation of Financial Statements. Financial Statements are very useful source of information to all those people who have an interest, or stake, in the company. Companies take great care in preparation of these statements. Law also prescribes certain disclosure requirements as well. However, financial statements suffer from some inherent defects. These are briefly discussed: Most balance sheets show values of assets, in particular the fixed assets, at cost less accumulated depreciation. These values may be vastly different from the prevailing market value of these items. Accounting policies of companies differ even within an industry. Financial statements contain absolute figures.

Corporate Governance

Muhammad Azeem Rafi..

22 NUML Lahore

Certain assets or liabilities may not be shown in the financial statements e.g., contingent liabilities, disputed receivable.

Stakeholders Interest in Financial Statements. Financial Statements are perhaps the most important communication from the board/management of the company with its stakeholders. Shareholders use them to decide how they should vote at various issues. Investors use them for making investment decisions, like to hold or sell the shares. Investment analysts use them for rating the company or its shares and bonds. Major investors use them for making acquisitions, mergers and demerger decisions. Creditors use them for accessing the credit worthiness or risk weight of the company. Management uses them to plan for the future. Employees use them to negotiate better terms of employment. Government uses them to calculate taxes. A good set of financial statements should have the following qualities:Clear and understandable Reliable Honest Compliance with applicable standards The Management. Who keeps the books, chooses the accounting policies, maintain the books of accounts, prepares the Financial Statements and facilitates the external auditor. The Board. Who oversee the preparation of accounts, ensure that all due legal disclosures are made Audit Committee. who liaises with internal and external auditors and recommends the Financial Statements to the board External Auditor. Who examines the accounting and related records as well as the Financial Statements and gives a formal opinion on them

Qualities of Financial Statements.

Responsibility for the Health of Financial Statements

(The company law says that the ultimate responsibility for the health and integrity of the companys Financial Statements lies with its board of directors.) Audit Committee Role It reviews the internal control processes of the company. It reviews the reports of the internal auditor. It plays a pivotal role in selection of external auditor. It maintains liaison with external auditor. It can directly go to chairman if feels that that executive directors are impeding work. Statements are said to be misleading if:They are not consistent with the accounting records. They are not based on correct accounting policies. They do not comply with applicable accounting standards. They do not disclose the true profit or loss. They do not value the assets and liabilities of the company correctly. They do not provide adequate information or disclosure.

Misleading Financial Statements.

Corporate Governance

Muhammad Azeem Rafi..

23 NUML Lahore

Consequences of Unreliable Financial Statements. A lot of people related with the company make number of their decisions on the basis of its financial statements. For example, investors decide about buying more shares, or selling off their present holding in light of the information contained in the financial statement. Creditors make decisions about extending more terms or calling back their existing loans on the strength of these statements. Management draws future plans and employees make their long term decisions. Why does company make unreliable Financial Statements? Over-Statement of Profits To meant the expectations of general public. To maintain share price. To meet with contractual obligations with creditors. To maintain image of rising profits. To prepare the company for higher price if merger or sale of the company is in the offing. To save corporation tax. To avoid having to pay dividends. To smoothen the earning trend. There are several reasons:-

Under-Statement of Profits

Misstatement of Financial Position Stating the assets and liabilities at incorrect value. To show a healthy position of the company. Creative Accounting. A systematic and intentional misrepresentation of the true income and financial position of an entity to achieve certain objectives. This involves using such accounting policies and techniques that assist in misstating the financial statements. For example, companies are generally free to choose the basis of valuing their stock in trade. A company could therefore deliberately select or change the basis of stock valuation with the intention of overstating its stocks at a particular time.

Role of the External Auditor. The law requires all public limited companies to get their financial statements audited by duly licensed external auditors who should be appointed by the shareholders. The reason for this requirement is quite obvious it is one the strongest tools in the hands of shareholders to ensure that what they are being told by the companys management is essentially correct. Purpose of Audit. The purpose of audit is to provide the shareholders and other stakeholders an independent opinion about the state of financial statements. Stakeholders attach a lot of importance to external auditors report because: External auditor is appointed by shareholders, not the management. He is independent, not a part of the companys management. He is competent to examine the accounts and financial statements and give an opinion thereon. Only professionally qualified persons can get a license to act as external auditors to a company. He is believed to have a high degree of integrity as he belongs to a profession that is strictly regulated by a professional body.

Audit Report. This report is given by the external auditor after they have examined the accounting records, supporting evidence and financial statements prepared on the basis of such records at the end of the year. It essentially gives the auditors opinion on the financial statements, generally covering the following areas: Steps taken by the external auditor to form his opinion on the financial statements.

Corporate Governance

Muhammad Azeem Rafi.. Auditors opinion on whether or not:

24 NUML Lahore

The books of accounts have been properly kept and are complete in all necessary aspects. The financial statements are in accordance with the accounting records. The financial statement give a true and fair view of companys profit for the year ended and its financial position at the end of the year. The financial statements provide all the disclosures required by relevant laws.

An external auditors task is only to give an opinion; not to ensure the accuracy of financial statements. He is not expected to advise management on how to get the accounts in order. His responsibility is to say in his report whatever is revealed by his examination of accounting records and financial statements. If anything is in order or not in order, he simply indicates so. He is however responsible for the correctness of his report. A lot of people depend on his report and if he gives an inaccurate report, he can in certain circumstances be held liable for damages. (e.g. Enron Scandal) Types of Audit Reports Unqualified Report Qualified Report Adverse Report Disclaimer

Independence of External Auditor. It is often said that financial statements are of little or no value if they are not accompanied by a substantially unqualified audit report. With that much importance being attached to the audit report, it is essential that the external auditor must be independent and allowed to do his work independently. The following are some of the means used to ensure the independence of external auditors: The firm performing the external audit should not be given any other professional work. If an audit firm earns a large percentage of its total revenue from a particular company through fees for audit, accounting, tax, consultancy, financial advisory services, etc. It is likely that its independence may be impaired. Auditors should be rotated frequently so that familiarity does not lead to loss of independence. There should be no relationship between the partners of an audit firm and companys directors All the external auditors are members of Institute of Chartered Accountants of Pakistan (ICAP). This body strictly regulates the conduct of its members providing them with comprehensive code of conduct and monitoring their work. In addition, SECP also monitors the conduct of audit firms in Pakistan. There are also several international professional bodies which issue standards / guidelines for accounting and auditing practices. ICAP is a member of most of these international professional bodies and makes it compulsory for its own members to follow the internationally recognized standards and guidelines. CHAPTER 7 - RISK MANAGEMENT Risk. Risk is:Uncertainty Chance of loss Variability of returns The actual result may be different from those that were expected. Inevitability Reward

Why take a risk?

Corporate Governance

Muhammad Azeem Rafi..

25 NUML Lahore

Risk Aversion. Risk aversion refers to an individual person or companys attitude towards risk. Some people are willing to take risk and others are not. Risk averse people are willing to pay to reduce their exposure to risk. Risk Exposure. The risk faced by an individual or firm, for example, if you are a temporary office worker, your exposure to the risk of a layoff is relatively high. And if you are a permanent employee, your exposure to the risk of a layoff is relatively low. Risk Faced by Firms. The financial system can be used to transfer some of the risks faced by a company to other parties. Specialized financial firms, such as insurance companies, perform the service of pooling and transferring risks. Production and operations risk Price risk of outputs or market risk Price risk of inputs Economic conditions risk Political risk Environmental risks Project risk Reputational risk The shareholders are not the only people who bear the risks of the business. The companys managers Employees Creditors Customers Tax authorities

Who Bears These Risks?

Risk Management. The process of formulating the benefit-cost trade-offs of risk reduction and deciding on the course of action to take, to reduce or eliminate risks is called risk management. Responsibility for Managing Risks. The companys board of directors is ultimately responsible for managing the risks faced by a company because of its basic duty to protect the companys assets. Hence, risk management is very much a governance issue. While the actual process of risk management will be carried out by the management, it must be overseen by the board. Risk Management Process. A systematic attempt to analyze and deal with risk. Risk Identification Risk Assessment Selection of risk-management techniques Implementation Review

Risk Identification. Before a company can make any plan or policy about how to handle the risks it faces, it must be fully aware of all the risks it is exposed to. Risk Assessment. Risk assessment will involve finding answers to the following questions:How likely is it for any of these risks to happen? What is the maximum possible financial loss that you will suffer in each of the listed situations? What would be the cost of eliminating or transferring this risk to some on else?

Corporate Governance

Muhammad Azeem Rafi..

26 NUML Lahore

Selection of Risk Management Techniques. The next step is to decide what steps to take to eliminate or reduce the impact of risk. There are four basic techniques available for reducing risk, namely: Risk Avoidance. If the risk is inevitable, we cannot avoid it. But some of the risks can be avoided. For example, a person who does not buy shares at a stock exchange eliminates the risk of loss in value of his investments. Loss Prevention and Control. This refers to actions taken to reduce the likelihood or the severity of losses. For example, you can reduce your exposure to the risk of illness by eating well, getting plenty of sleep, abstain from smoking etc. Similarly, companies can reduce the risk of fire at factories by taking necessary precautions, by having fire extinguishing equipment. Risk Retention. This refers to absorbing the risk and covering losses out of ones own resources. For example, some people do not buy comprehensive car insurance. They prefer to save insurance premium by agreeing to meet any repair costs that may ensue from an accident. Risk Transfer. One way to cover you against risks is to transfer the risk to others. For example, when you insure your car, you transfer the risk to the insurance company. Following a decision about how to handle the risks identified,

Implementation of Risk Management Plan. one must implement the technique selected. Regular review of the Risk Situation. and revised. Risk Transfer Techniques

It is a dynamic process in which the decisions are periodically reviewed

Hedging. Action taken to reduce ones exposure to a loss also causes one to give up the possibility of a gain. For example, farmers who sell their future crops before the harvest at a fixed price to eliminate the risk of a low price and also give up the possibility of profiting from high price. Options. An option gives the buyer a right to buy (or sell) an item at pre-determined price on a predetermined date. Insurance. Insurance means paying a premium to avoid losses. Diversification. Diversifying means holding many risky assets instead of concentrating all of your investment in only one. Insurance companies Stock exchanges Specialized traders in forward contracts and options Mutual funds Financial institutions offering guarantees, LCs, underwriting of shares and bond issues etc.

Institutions for Risk Management.

Disaster Recovery The role of Government in Risk Management Report by Board on Risk Management

Corporate Governance