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Code of Corporate Governance, 2012 – The SECP initiative

Over the past two decades, the need for developing good corporate governance policies and practices has increasingly being emphasized by regulatory bodies and policy makers around the globe. It has been witnessed that good corporate practices contribute a fair amount to competitiveness, facilitates corporate access to capital markets, develop financial markets and spur economic activity. Essentially, well-governed companies are better positioned to fulfill their economic, environmental, and social responsibilities, and contribute to sustainable growth.

Good corporate governance is fundamentally based on four principles which are: transparency, accountability, fairness, and responsibility. These principles are universal in their application; however, the way they are put into practice varies from jurisdiction to jurisdiction. Varied approaches have been adopted to establish effective systems and processes to ensure that a company is governed in the best interest of all stakeholders. In some countries corporate governance codes are implemented through statutory regulation with provisions mandatory to be complied with whereas in others it is through self-regulation adopting the principle of ‘comply’ or ‘explain’. The principle of ‘comply’ or ‘explain’ denotes that companies obliged to apply the Code do not always have to comply with every provision of the Code. If a particular provision is practically not suitable in a given situation, the company can choose another solution. The company must, however, clearly state and appropriately disclose in their annual reports that it has not complied with a provision, along with an explanation of the company’s preferred solution.

We know that corporate governance principles and systems are constantly evolving. Experience tells us that in some cases these corporate governance systems were not sufficient to prevent instances of major corporate misconduct like in Enron, Worldcom, Tyco, AIG financial meltdown etc. These corporate governance failures indicate that the internal checks and balances being used by these companies at the time were not sufficient. It has been viewed that companies with strong governance systems held more audit committee meetings which increased opportunities for board members to scrutinize the company’s books and hence supported fraud detection.

The history of governance reforms in the corporate sector of Pakistan is not an ancient one.  The Securities and Exchange Commission of Pakistan (SECP) in March 2002 issued the first Code of Corporate Governance for listed companies as part of the stock exchanges’ regulations. Later, in December 2004, the Pakistan Institute of Corporate Governance (PICG) was established as a not-for-profit company aimed at promoting awareness and encouraging good corporate governance practices in Pakistan. As part of its efforts to further enhance the corporate governance landscape in the country and to keep pace with globally set benchmarks, the SECP, in April 2012, issued a revised/new Code of Corporate Governance, 2012 for listed companies. The process adopted for the revision exercise was quite extensive and included various sessions of stakeholder consultation. The process also benefited greatly from the insights of members of PICG task force who were mandated with the review exercise by the SECP.

The key changes to the Code, 2012 are focused to the areas of constitution of the board of directors, separation of the office of the CEO and Chairman, board committees, removal and qualification criteria for Chief Financial Officer, Company Secretary and Head of Internal Audit, board’s evaluation and training of directors.

The board of directors in a company has the overall responsibility for management and direction of its affairs while ensuring the integrity of accounting and financial reporting systems and overseeing the process of disclosure and communications. The relatively large number of listed closely held companies in Pakistan and other emerging markets makes the transition to internationalized behavioral norms particularly important and challenging.

We have seen that with the evolution of corporate governance standards, the role of independent directors has gained more importance. An independent director is duty bound, and legally bound, to act in the interest of the company as a whole. These directors are able to exercise objective judgment on corporate affairs independently. This is especially critical in areas where the interests of management, the company and shareholders may diverge. One view suggests that the shareholders of a company expect the independent directors to be there primarily to protect the interests of the minority shareholders. And more specifically, vis-à-vis the interests of a major or controlling shareholder. This is probably so as a major or controlling shareholder has the ability to appoint its nominees to the board, and the minority shareholders often do not. Since independent directors do not have any relationship with the major shareholder, the company or its management, they would by default, be seen as the representatives of the minority shareholders.

The Code, 2012 requires the board of directors to have appropriate representation of minority interests. Contrary to the 2002 Code, the 2012 Code makes the representation of at least one independent director mandatory while preferring one third of the board to comprise of directors independent of majority shareholders. A more comprehensive criteria for assessment of independence have been prescribed by substantially expanding the requirements stipulated for the same earlier along with prescribing a formal and transparent procedure for remuneration of directors with appropriate aggregate disclosure in the annual report.

Additionally, the number of executive directors which was restricted to not more than 75% of elected directors including CEO has now been fixed at maximum of one-third of the elected directors. To ensure quality participation and commitment multiple directorships have been limited to a maximum of seven at any one time. However, this limit excludes directorship in listed subsidiaries of a listed holding company.

Under the new Code, the roles of the Chairman and CEO have been segregated which was not a mandatory provision earlier. Most commonly it is argued that the separation of the Chairman and CEO roles increases the board’s independence from management and therefore leads to better monitoring and oversight. It is also felt that since the CEO manages the company and the Chairman leads the board in overseeing the CEO on behalf of shareholders, conflict of interest arises if one person occupies both the positions.

It goes without saying that to perform their duties effectively, directors should possess a good understanding of the company’s operations as well have sufficient knowledge of areas such as finance, law, and risk management that will allow them to form a broad strategic perspective. In particular, directors must understand their legal and fiduciary responsibilities before they seek to discharge these responsibilities effectively. Directors’ training has therefore become essential. The Code 2012, compared to the 2002 Code allows more flexibility and diversity of choice with respect to attaining training from a institution local or foreign that meets a set criteria approved by the SECP. Earlier such directors’ training was mandatorily to be acquired only from the PICG which limited the choice and outreach.

Globally, effective boards have board committees on specific areas; this approach allows the boards to concentrate on broader and strategic issues and strengthens the board’s governance role. Mainly these committees include Audit Committee, Nomination Committee or Human Resources and Remuneration Committee. The Code, 2012 requires the board of directors of every listed company to establish an Audit Committee and Human Resource and Remuneration Committee. The Audit Committee shall comprise of at least three members comprising of non-executive directors with the Chairman being an independent director. The Human Resource and Remuneration Committee must comprise of 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 and also shall not participate in the proceedings on matters directly related to his performance and compensation.

Further, considering the critical role of the head of internal audit in ensuring effective internal control arrangements and promoting good corporate governance, detailed qualifications in terms of education and experience have been stipulated. Also, such criteria for the company secretary and chief financial officer have also been laid down.

In an increasingly globalised world economy where competition is intense, the adoption of good corporate governance standards can make a real difference to how Pakistani companies are viewed both domestically and within the international community. The introduction of the Code, 2012 marks an important milestone in the development of corporate governance in Pakistan. To stay abreast of constantly changing circumstances, the SECP would need to closely follow developments in the corporate governance world, identifying trends and put in place standards that conform to international acclaimed principles.

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