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Corporate governance

Corporate governance is the system by which companies are directed and controlled (or governed). It is important that companies are governed well because companies are often directed and controlled by different people from those who have an interest (or stake) in the company. Such interested parties are known as stakeholders:

1. Shareholders – the people who invest in a company and ultimately own it

2. Directors – the people who run the company. They depend on the company for status and livelihood in terms of salaries, fees or other remuneration.

3. Employees – depend on the company for their livelihood

4. Tax authorities – rely on the company’s returns of their profitability to assess them for their tax liabilities

5. Customers and society at large – affected by the company’s product and sometimes by their processes (for example, pollution)

6. Creditors – supply the company with goods and services and depend on them to pay for those goods and services within the credit terms extended

It is important to each party that the company is well run and is not defrauded or run into unnecessary financial difficulties. The leadership of the company (the directors) are in a position by their policies to seek to prevent such problems. Bad corporate governance can open up the company to all sorts of problems.

Auditors and corporate governance

An audit is an exercise undertaken by qualified, independent professionals to ensure that the financial statements prepared by the directors for the benefit of shareholders give a true and fair view of the company’s affairs at the end of the accounting period. It consists of a number of tests and judgments, and is undertaken in accordance with national or international auditing standards.

The directors are required by law to produce financial statements for the shareholders, giving a report of how the company has performed financially (income statement) and where it stands at the end of the reporting period (statement of financial position). These have to be prepared in accordance with national or international financial reporting standards.

An audit is therefore a check on whether the directors and complying properly with this aspect of corporate governance. It is primarily for the benefit of shareholders for whom the financial statements are an indication of how their investment in the company is doing, and also what return they can expect from the company.


An executive director is a director who performs a specific role in a company under a service contract which involves a regular, possibly daily, involvement in management. A director may also be an employee (usually a member of management) of his company.

Directors who have additional management duties as employees may be distinguished by special titles such as finance director.

A non-executive director, on the other hand, acts only as a member of the board of directors. His usual involvement is to attend board meetings. He is not involved in the day to day management of the company. In a public limited company, the role of the non- executive director has become more important in recent years with the increasing emphasis on, and regulation of, good corporate governance.

The tasks of the non-executive director include the following:

1. To contribute an independent view to the board’s deliberations

2. To help the board provide the company with effective leadership

3. To ensure the continuing effectiveness of the executive directors and management

4. To ensure high standards of financial probity on the part of the company

Non-executive directors and executive directors are subject to the same statutory and fiduciary duties.

The knowledge gap

The knowledge gap is a way of describing the gap between the information about the company available to shareholders (the owners) and available to directors of the company (the managers). In some cases, the owners manage a company and shareholders are directors but this is not always the case especially with larger companies. Shareholders tend to make investments in companies that they are otherwise unconnected with and these companies are managed by others. This situation means that the owners of the company are not privy to all the day to day information available at a company and are not in a position to direct company policy.

The role of company law

Company law has been adopted to attempt to bridge this gap.

1. Financial statements – directors are required to produce financial statements on an annual basis. These financial statements have to be audited and filed on public record.

2. Annual general meeting – public companies are required to hold an annual general meeting (AGM) every year. Although management makes day to day company decisions, certain decisions such as what the memorandum and articles of association contain and who are going to be directors are reserved to shareholders in this general meeting. It is also an occasion where shareholders can put their views to directors and have dialogue with them.

3. Corporate governance codes – voluntary corporate governance codes, such as the Combined Code in the UK are becoming increasingly common for companies listed on the Stock Exchanges. These set out good practice for companies and directors.

Insider dealing

The law attempts to prevent people ‘in the know’ from making a profit or avoiding a loss

in buying or selling shares or other securities on the back of their inside knowledge and at

the expense of open dealings in the market. Significant inside knowledge, such as of a takeover, an oil strike, or a massive fall in profits, will affect the sale price when it becomes known, so it is not right that insiders should benefit from dealing in advance of the knowledge becoming generally known.

In the context of the Criminal Justice Act 1993:

1. Insider dealing is when a person deals in securities while in possession of inside information as an insider, the securities being price-affected by the information.

2. An offence is also committed if an individual in possession of information as an insider, encourages another person to deal in the price-affected securities, knowing or having reasonable cause to believe dealing would take place.

3. Finally, it is also an offence for an insider to disclose the information to another person otherwise than in the proper performance of the functions of his employment, office or profession.


Dealing means acquiring or disposing of , or agreeing to acquire or dispose of, relevant securities whether directly or through an agent or nominee or person acting according to direction.

Inside information is price-sensitive information relating to a particular issuer of securities that are price-affected and not to securities generally. If it were made public, it would have a significant effect on the security’s price. It must be specific or precise.

A person has information as an insider if it is inside information and they know it to be

inside information, and they have it and know they have it from an inside source. They will have it by virtue of being a director, employee or shareholder of the issuer of

securities, or through access because of employment, office or profession such as management consultant, auditor or accountant, or from a person who falls into one of these categories.

Defences to insider dealing

General defences:

1. The individual concerned can show that he did not expect there to be a profit or avoidance of loss.

2. He had reasonable grounds to believe that the information had been disclosed widely.

3. He would have done what he did even if he had not known the information, for example where securities are sold to pay a pressiong debt.

4. Defences to disclosure of information by an individual are that (a) he did not expect any person to deal and (b) although dealing was expected, profit or avoidance of loss was not.

Special defences:

1. Market makers and their employees in the course of business

2. Those in possession of market information, for example information provided by the Stock Exchange under its rules

3. Those engaged in price stabilisation exercise provided they act within the relevant rules.


The maximum penalties are seven years’ imprisonment and/or an unlimited fine. The person convicted may also be disqualified as a director under the Company Directors’ Disqualification Act.

Money laundering

Money laundering is the term given to attempts to make the proceeds of crime appear respectable. It covers any activity by which the apparent source and ownership of money which is the proceeds of income from criminal activities are changed so that the money appears to have been obtained legitimately.

Money laundering usually involves three phases:

1. Following illegal activity (such as selling drugs, smuggling or prostitution) the criminal receives proceeds in the form usually of cash. These proceeds are then ‘placed’ somewhere where it will not be immediately obvious where they came from. An obvious example is in a shop, where it cannot be ascertained easily how much money was handed over by customers.

2. Next comes ‘layering’ which is when money is transferred to conceal the original source. This may be from the shop to cash suppliers, or to another shop, and then to a bank.

3. Once the layering process is complete, the money is fully ‘integrated’ meaning it has the appearance of legitimate funds.

Control of money laundering

Money laundering is regulated in the UK by the Proceeds of Crime Act 2002, and also by other legislation designed to prevent and stamp out terrorism and organised crime generally. Money laundering is a criminal offence.

The Proceeds of Crime Act focuses on three categories of criminal offence:

1. The offence of laundering – the offence of laundering also covers persons assisting other persons in committing the offence of money laundering. The maximum punishment is 14 years in prison.

2. There is also the offence of failing to report knowledge or suspicion of money laundering. This is a provision which greatly affects banks and bank employees, financial advisers and accountants. Many procedures have been put in place such as the ‘know your customer’ rules to ensure that such institutions do not unwittingly commit the offence of failing to report. Any such suspicions should be notified to the Serious Organised Crime Agency (SOCA) without alerting the suspected launderer. The maximum punishment for failing to report is 5 years in prison.

3. There is also the offence of ‘tipping off’. This means disclosing information to any suspected launderer or other person if disclosure may prejudice an investigation into drug trafficking, laundering drug money, terrorist-related activities and laundering the proceeds of other criminal conduct. The maximum punishment is 5 years in prison.

The Financial Action Task Force (FATF)

FATF is an intergovernmental body made up of 29 governments and 2 international organizations (the European Union and the Gulf Cooperation Council).

FATF has two aims:

1. To develop and promote policies to combat money laundering.

2. To prevent proceeds being used in future criminal activity and interfering with legitimate economic activity.

FATF has published 40 recommendations for countries to assist their fight against money laundering. The recommendations are set out in the form of principles because situations will be different in different countries, so principles are more useful than specific rules. The FATF recommendations fall into 4 categories:

1. General framework – parties should ratify the Vienna Convention and mutual international assistance should be encouraged.

2. National legal systems – countries should take steps to criminalise money laundering and to be able to seize laundered money.

3. Financial systems – regulations should apply to all financial institutions not just banks. There should be good procedures against fraudulent financial activities such as not accepting accounts in obviously fictitious names and paying attention to unusual financial activity.

4. International cooperation – countries should be proactive in sharing information about suspicious transactions. They should also cooperate in extradition, confiscation and mutual assistance.


Despite good intentions, cooperation between different countries is not easy. The problem is compounded by the different ways money laundering can be carried out in each country and the different criminal offences relating to money laundering in each country.

The Council of Europe (CoE)

The CoE produces Conventions and Treaties for their members to adopt.

There is a Convention on money laundering produced in 1993. The provisions of the Convention are similar to the FATF recommendations. They set out recommendations for provisions at a national level and actions to take at an international level.

National level

The Convention sets out various legislative measures that should be put into place:

1. To confiscate the proceeds of money laundering

2. To trace property liable to confiscation

3. To require banks and other financial institutions to provide information

4. To provide legal remedies so as to preserve the legal rights of parties affected by the above measures

5. To establish offences under domestic law which may be committed internationally such as the illegal transfer of property or concealment of true ownership of property

International level

1. Parties shall cooperate to the widest extent in relation to investigations and proceedings

2. Parties shall assist other parties in investigations on request

3. Parties shall pass on information without prompting when it may assist in investigations

4. Parties shall carry out confiscation orders in their country on request from other parties

Fraudulent trading

Fraudulent trading means carrying on a business with the intent to defraud creditors or for any other fraudulent purpose. Carrying on a business can include a single transaction and also the mere payment of debts as distinct from making trading contracts.

Fraudulent trading may give rise to both a civil and a criminal case. This arises in civil law when the business of a company that is being liquidated is found to have been carried on with the intent to defraud creditors or for any other fraudulent purpose. The court that is involved in the liquidation may, in a civil law procedure, order that any persons who were knowingly party to fraudulent trading and who took the decision to carry on the business in this way shall be liable for the company’s debts (Insolvency Act 1986). For these purposes a business may be carried on fraudulently just by making one transaction or by paying off debts rather than making trading contracts.

Where there has been a civil order in respect of fraudulent trading the liquidator or the court will also report the facts to the Crown Prosecution Service and the Director of Public Prosecutions so that criminal proceedings can be instituted for fraudulent trading. The criminal offence may arise with or without liquidation proceedings, and can give rise to a prison term of up to 7 years and an unlimited fine. As in civil cases, in criminal cases fraudulent trading relates not only to defrauding creditors but also to carrying on a business for the purpose of any kind of fraud.