P1 5 Answers

By Clifford Carter,2014-05-22 14:03
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P1 5 Answers


    Question 1

    (a) JPX’s current corporate governance arrangements

Inadequacy of JPX’s current corporate governance arrangements

    The case highlights a number of ways in which the corporate governance at JPX is inadequate. JPX’s history as a privately run family business may partly explain its apparent

    slowness to develop the corporate governance structures and systems expected in many parts of the world. There are five ways, from the case, that JPX can be said to be inadequate in its corporate governance although these are linked. There is overlap between the points made.

    In the first instance, the case mentions that there were no independent non-executive directors (NEDs) on the JPX board. It follows that JPX would be without the necessary balance and external expertise that NEDs can provide. Second, there is evidence of a corporate culture at JPX dominated by the members of the family. The case study notes that they dominate the upper tier of the board. This may have been acceptable when JPX was a family owned company, but as a public company floated on a stock exchange and hence accountable to external shareholders, a wider participation in board membership is necessary. Third, the two-tier board, whilst not necessarily being a problem in itself (two-tier boards work well in many circumstances), raises concern because the department heads, who are on the lower tier of the board, are excluded from strategic discussions at board level. It is likely that as line managers in the business, the departmental heads would have vital inputs to make into such discussions, especially on such issues as the implementation of strategies. It is also likely that their opinions on the viabilities of different strategic options would be of value. Fourth, it could be argued that JPX’s reporting is less than ideal with, for

    example, its oblique reference to a ‘negative local environmental impact. However, it might be noted that ambiguity in reporting is also evident in European and American reporting. Finally, having been subject to its own country’s less rigorous corporate governance

    requirements for all of its previous history, it is likely that adjusting to the requirements of complying with the European-centred demands of Chemco will present a challenge.

    (b) Risks of the proposed acquisition

    Risks that Chemco might incur in acquiring JPX.

    The case describes a number of risks that Chemco could become exposed to if the acquisition was successful. Explicitly, the case highlights a possible environmental risk (the ‘negative local environmental impact’) that may or may not be eventually valued as a provision (depending on whether or not it is likely to result in a liability). Other risks are likely to emerge as the proposed acquisition develops. Exchange rate risks apply to any

    business dealing with revenue or capital flows between two or more currency zones. The case explicitly describes Chemco and JPX existing in different regions of the world. Whilst exchange rate volatility can undermine confidence in cash flow projections, it should also be borne in mind that medium term increases or decreases in exchange values can materially affect the returns on an investment (in this case, Chemco’s investment in JPX). There is some market risk in Chemco’s valuation of JPX stock. This could be a substantial risk because of

    JPX’s relatively recent flotation where the market price of JPX may not have yet found its intrinsic level. In addition, it is not certain that Chemco has full knowledge of the fair price to pay for each JPX share given the issues of dealing across national borders and in valuing stock in JPX’s country. All mergers and acquisitions (‘integrations’) are exposed to synergy risks. Whilst it is expected and hoped that every merger or acquisition will result in synergies (perhaps from scale economies as the case mentions), in practice, many integrations fail to realise any. In extreme cases, the costs arising from integration can threaten the very survival of the companies involved. Finally, there are risks associated with the bringing-together of the two board structures. Specifically, structural and cultural changes will be required at JPX to bring it in line with Chemco’s. The creation of a unitary board and the increased involvement of NEDs and departmental heads may be problematic, for example, Chemco’s board is likely to insist on such changes post-acquisition.

Assessment of risk

    The assessment of the risk exposure of any organisation has five components. Firstly, the identity (nature and extent) of the risks facing the company should be identified (such as considering the risks involved in acquiring JPX ). This may involve consulting with relevant senior managers, consultants and other stakeholders. Second the company should decide on the categories of risk that are regarded as acceptable for the company to bear. Of course any decision to discontinue exposure to a given risk will have implications for the activities of the company and this cost will need to be considered against the benefit of the reduced risk. Third, the assessment of risk should quantify, as far as possible, the likelihood (probability) of the identified risks materialising. Risks with a high probability of occurring will attract higher levels of management attention than those with lower probabilities. Fourth, an assessment of risk will entail an examination of the company’s ability to reduce the impact on the business of risks that do materialise. Consultation with affected parties (e.g. departmental heads, stakeholders, etc.) is likely to be beneficial, as information on minimising negative impact may sometimes be a matter of technical detail. Fifth and finally, risk assessment involves an understanding of the costs of operating particular controls to review and manage the related risks. These costs will include information gathering costs, management overhead, external consultancy where appropriate, etc.

    (c) Unitary and two-tier board structures

    Advantages of unitary board structure in general

    There are arguments for and against unitary and two-tier boards. Both have their ‘place’

    depending on business cultures, size of business and a range of other factors. In general, however, the following arguments can be put for unitary boards.

    One of the main features of a unitary board is that all directors, including managing

    directors, departmental (or divisional) directors and NEDs all have equal legal and executive status in law. This does not mean that all are equal in terms of the organisational hierarchy, but that all are responsible and can be held accountable for board decisions. This has a number of benefits. Firstly, NEDs are empowered, being accorded equal status to executive directors. NEDs can bring not only independent scrutiny to the board, but also experience and expertise that may be of invaluable help in devising strategy and the assessment of risk. Second, board accountability is enhanced by providing a greater protection against fraud and malpractice and by holding all directors equally accountable under a ‘cabinet government’ arrangement. These first two benefits provide a major underpinning to the

    confidence that markets have in listed companies. Third, unitary board arrangements reduce the likelihood of abuse of (self-serving) power by a small number of senior directors. Small ‘exclusivist’ boards such as have been evident in some corporate ‘scandals’ are discouraged by unitary board arrangements. Fourth, the fact that the board is likely to be larger than a given tier of a two-tier board means that more viewpoints are likely to be expressed in board deliberations and discussions. In addition to enriching the intellectual strength of the board, the inclusivity of the board should mean that strategies are more robustly scrutinised before being implemented.

    Relevance to JPX in particular

    If the JPX acquisition was to proceed, there would be a unitary board at Chemco overseeing a two-tier board at JPX. The first specific argument for JPX adopting a unitary board would be to bring it into line with Chemco’s. Chemco clearly believes in unitary board arrangements and would presumably prefer to have the benefits of unitary boards in place so as to have as much confidence as possible in JPX’s governance. This may be especially important if JPX is to remain an ‘arms length’ or decentralised part of Chemco’s international

    operation. Second, there is an argument for making changes at JPX in order to signal a departure from the ‘old’ systems when JPX was independent of the ‘new’ systems under Chemco’s ownership. A strong way of helping to ‘unfreeze’ previous ways of working is to

    make important symbolic changes and a rearrangement of the board structure would be a good example of this. Third, it is clear that the family members who currently run JPX have a disproportionate influence on the company and its strategy (the ‘family business culture’).

    Widening the board would, over time, change the culture of the board and reduce that influence. Fourth, a unitary board structure would empower the departmental heads at JPX whose opinions and support are likely to be important in the transition period following the acquisition.

    (d) Non executive directors

    Four roles of non-executive directors.

    The Higgs Report (2003) in the United Kingdom helpfully described the function of non-executive directors (NEDs) in terms of four distinct roles. These were the strategy role, the scrutinising role, the risk advising role and the ‘people’ role. These roles may be

    undertaken as part of the general discussion occurring at Board meetings or more formally, through the corporate governance committee structure.

    The strategy role recognises that NEDs are full members of a unitary board and thus have the right and responsibility to contribute to the strategic success of the organisation for the benefit of shareholders. In this role they may challenge any aspect of strategy they see fit, and offer advice or input to help to develop successful strategy.

    In the scrutinising role, NEDs are required to hold executive colleagues to account for decisions taken and results obtained. In this respect they are required to represent the shareholders’ interests against the possibility that agency issues arise to reduce shareholder


    The risk role involves NEDs ensuring the company has an adequate system of internal controls and systems of risk management in place. This is often informed by prescribed codes (such as Turnbull) but some industries, such as chemicals, have other systems in place, some of which fall under International Organisation for Standardisation (ISO) standards.

    Finally, the ‘people’ role involves NEDs overseeing a range of responsibilities with regard to the management of the executive members of the board. This typically involves issues on appointments and remuneration, but might also involve contractual or disciplinary issues.

    Specific benefits for JPX of having NEDs

    The specific benefits that NEDs could bring to JPX concern the need for a balance against excessive family influence and the prior domination of the ‘family business culture’. Chemco, as JPX’s new majority shareholder, is unlikely to want to retain a cabal’ of an

    upper tier at JPX and the recruitment of a number of NEDs will clearly help in that regard. Second, NEDs will perform an important role in representing external shareholders’ interests (as well as internal shareholders). Specifically, shareholders will include Chemco. Third, Chemco’s own board discussion included Bill White’s view that the exclusion of

    departmental heads was resulting in important views not being heard when devising strategy. This is a major potential danger to JPX and NEDs could be appointed to the board in order to ensure that future board discussions include all affected parties including the previously disenfranchised department heads.

Environmental reporting.


    From: Professional Accountant

    To: Leena Sharif

    Date: DD/MM/YYYY

    Re: environmental issues at Chemco and JPX


    I have been asked to write to you on two matters of potential importance to Chemco in respect of environmental issues.

    The first of these is to consider the meaning of the term, ‘environmental footprint’ and the second is to briefly review the arguments for inviting JPX (should the acquisition proceed) to introduce environmental reporting. Environmental footprint’

    Explanation of ‘environmental footprint’ The use of the term ‘footprint’ with regard to the

    environment is intended to convey a meaning similar to its use in everyday language. In the same way that humans and animals leave physical footprints that show where they have been, so organisations such as Chemco leave evidence of their operations in the environment. They operate at a net cost to the environment. The environmental footprint is an attempt to evaluate the size of Chemco’s impact on the environment in three respects. Firstly, concerning the company’s resource consumption where resources are defined in terms of inputs such as energy, feedstock, water, land use, etc. Second, concerning any harm to the environment brought about by pollution emissions. These include emissions of carbon and other chemicals, local emissions, spillages, etc. It is likely that as a chemical manufacturer, both of these impacts will be larger for Chemco than for some other types of business.

    Thirdly, the environmental footprint includes a measurement of the resource consumption and pollution emissions in terms of harm to the environment in either qualitative, quantitative or replacement terms.

    Environmental reporting at JPX.

    Arguments for environmental reporting at JPXThere are number of arguments for environmental reporting in general and others that may be specifically relevant to JPX. In general terms and firstly, I’m sure as company secretary you will recognise the importance of observing the corporate governance and reporting principles of transparency, openness, responsibility and fairness wherever possible. We should invite JPX to adopt these values should the acquisition proceed. Any deliberate concealment would clearly be counter to these principles and so ‘more’ rather than ‘less’ reporting is always beneficial. Second, it is important to present a balanced and understandable assessment of the company’s position and prospects to external stakeholders.

    Third, it is important that JPX recognises the existence and size of its environment footprint, and reporting is a useful means if doing this. Fourth, and specifically with regard to JPX and other companies with a substantial potential environmental footprint, there is a need to explain environmental strategy to investors and other interested stakeholders (eg Chemco). Finally, there is a need to explain in more detail the ‘negative local environmental impact’ and an environmental report would be an ideal place for such an explanation.

    Question 2

    (a) Typical roles of a risk management committee

    The typical roles of a risk management committee are as follows:

    To agree and approve the risk management strategy and policies. The design of risk policy will take into account theenvironment, the strategic posture towards risk, the product type and a range of other relevant factors.

    Receiving and reviewing risk reports from affected departments. Some departments will file regular reports on key risks (such as liquidity assessments from the accounting department, legal risks from the company secretariat or product risks from thesales manager). Monitoring overall exposure and specific risks. If the risk policy places limits on the total risk exposure for a given risk then this role ensures that limits are adhered to. In the case of certain strategic risks, monitoring could occur on a very frequent basis whereas for more operational risks, monitoring will more typically occur to coincide with risk management committee meetings.

    Assessing the effectiveness of risk management systems. This involves getting feedback from departments and the internal audit function on the workings of current management and risk mitigation systems. Providing general and explicit guidance to the main board on emerging risks and to report on existing risks. This will involve preparing reports on apparent risks and assessing their probability of being realised and their potential impact if they do.

    To work with the audit committee on designing and monitoring internal controls for the management and mitigation of risks. If the risk committee is part of the executive structure, it will likely have an advisory role in respect of its input into the audit committee. If it is non-executive, its input may be more directly influential.

    (b) Risk management strategies and Chen Products

    Risk transference strategy

    This would involve the company accepting a portion of the risk and seeking to transfer a part to a third party. Although an unlikely possibility given the state of existing claims, insurance against future claims would serve to limit Chen’s potential losses and place a limit

    on its losses. Outsourcing manufacture may be a way of transferring risk if the ourtsourcee can be persuaded to accept some of the product liability.

    Risk avoidance strategy

    An avoidance strategy involves discontinuing the activity that is exposing the company to risk. In the case of Chen this would involve ceasing production of Product 2. This would be pursued if the impact (hazard) and probability of incurring an acceptable level of liability were both considered to be unacceptably high and there were no options for transference or reduction.

    Risk reduction strategy

    A risk reduction strategy involves seeking to retain a component of the risk (in order to enjoy the return assumed to be associated with that risk) but to reduce it and thereby limit

    its ability to create liability. Chen produces four products and it could reconfigure its production capacity to produce proportionately more of Products 1, 3 and 4 and proportionately less of Product 2. This would reduce Product 2 in the overall portfolio and therefore Chen’s exposure to its risks. This would need to be associated with instructions to

    other departments (e.g. sales and marketing) to similarly reconfigure activities to sell more of the other products and less of Product 2.

    Risk acceptance strategy

    A risk acceptance strategy involves taking limited or no action to reduce the exposure to risk and would be taken if the returns expected from bearing the risk were expected to be greater than the potential liabilities. The case mentions that Product 2 is highly profitable and it may be that the returns attainable by maintaining and even increasing Product 2’s

    sales are worth the liabilities incurred by compensation claims. This is a risk acceptance strategy.

    (c) Risk committee members can be either executive on non-executive.

    Risk committee members can be either executive on non-executive.

    (i) Distinguish between executive and non-executive directors

    Executive directors are full time members of staff, have management positions in the organisation, are part of the executive structure and typically have industry or activity-relevant knowledge or expertise, which is the basis of their value to the organisation.

    Non-executive directors are engaged part time by the organisation, bring relevant independent, external input and scrutiny to the board, and typically occupy positions in the committee structure.

    (ii) Advantages and disadvantages of being non-executive rather than executive

    The UK Combined Code, for example, allows for risk committees to be made up of either executive or non-executive members.

    Advantages of non-executive membership

    Separation and detachment from the content being discussed is more likely to bring independent scrutiny. Sensitive issues relating to one or more areas of executive oversight can be aired without vested interests being present. Non-executive directors often bring specific expertise that will be more relevant to a risk problem than more operationally-minded executive directors will have.

    Chen’s four members, being from different backgrounds, are likely to bring a range of perspectives and suggested strategies which may enrich the options open to the committee when considering specific risks.

    Disadvantages of non-executive membership (advantages of executive membership)

    Direct input and relevant information would be available from executives working directly with the products, systems and procedures being discussed if they were on the committee. Non-executives are less likely to have specialist knowledge of products, systems and procedures being discussed and will therefore be less likely to be able to comment intelligently during meetings.

    The membership, of four people, none of whom ‘had direct experience of Chen’s industry or products’ could produce decisions taken without relevant information that an

executive member could provide.

    Non-executive directors will need to report their findings to the executive board. This reporting stage slows down the process, thus requiring more time before actions can be implemented, and introducing the possibility of some misunderstanding.

Question 3

    (a) Rights and responsibilities

    Rights and responsibilities

    The comment by Albert Doo identifies rights and responsibilities as being two essential characteristics of citizenship, be it human or organisational in nature. In the same way that individuals have rights and responsibilities in society, so do business organisations such as Biggo. The question asks about rights and responsibilities in the context of Biggo.

    A right is an expectation of the benefits that Biggo can receive, by virtue of citizenship, from society. Biggo can expect the right to have the freedom to conduct business by engaging in resource and product markets, to enjoy the protection of the law and the goodwill of other members of society in supporting the right of the organisation to exist, to innovate and grow. Biggo had the right, for example, to expect fair treatment under law in respect of its planning application (and in fact received this permission).

    A responsibility is a duty owed, by the citizen (in this case, Biggo), back to society as a quid pro quo for the extension of rights. These are owed by virtue of the citizen’s membership of society. In most societies, responsibilities extend to compliance with all relevant laws and regulations, including the payment of taxes, and compliance with the behavioural norms of that society. Biggo, along with all other businesses, has a number of legal and ethical responsibilities but it is the extent to which the ethical responsibilities are recognised that is the subject of dispute along the Gray, Owen & Adams continuum.

Gray, Owen & Adams’s perspectives

    Gray, Owen & Adams described seven possible positions that can be adopted on a company’s relations with its stakeholders. These concern the ethical assumptions of the roles of a business in society and are as follows: the pristine capitalist, the expedient, the social contractarian, the socialist, the social ecologist, the radical feminist and the deep green. The range of views along this continuum are primarily characterised by the ways in which they interpret the rights and responsibilities of business.

    Broadly speaking, the nearer to the pristine capitalist end of the continuum, the greater the rights of shareholders and the fewer their responsibilities to a wider constituency. Conversely, the nearer the ‘deep green’ end of the continuum, the fewer the perceived rights and the greater the

    responsibilities of the company and its agents to a more widely defined group of stakeholders. At the ‘pristine capitalist’ end of the continuum, rights and responsibilities are understood

    principally in terms of economic measures. The company has the right to pursue its legal business activity and to develop that business with the support of society and the governing authorities. In return, its responsibilities are limited to the profitable production of goods and services and, accordingly, the generation of profits that are entirely attributable to shareholders. It is not the responsibility of businesses to pursue any other social, environmental or benevolent end. In this context, it is clearly not the company’s responsibility to use shareholders’ money to contribute to

    the new children’s play area.

    At the socialist-to-green end of the continuum, it is argued that businesses like Biggo have fewer (and contestable) rights and much greater responsibilities. According to positions at the deep green end, Biggo, does not, for example, have the right to consume non-sustainable resources ‘simply’ for the purposes of wealth creation. They may not have the moral right, even if they have

    a legal right, to build on the community’s play area. At the same time, Biggo has a wide responsibility to society and to the environment that might seriously constrain their behaviour and activities.

(b) The two comments

    Robert Tens is closest to the expedient position. The expedient position is one in which

    social responsibility is seen in terms of what return can be gained from social responsibility

    policies and actions. In other words, it may be expedient to adopt social responsibility

    actions but only if by doing so, it furthers its strategic interests. The expedient position does

    not recognize any implicit social responsibility as such and social policies are therefore only

    pursued if a clear strategic rationale can be identified for them.

    His comment considers the actions towards the community in terms of cultivating

    current and future employees: it is an exercise of specific stakeholder management with the

    key stakeholder being the local community. By engaging in activities that give the appearance

    of being socially responsible, i.e. making the requested donating, other economically

    advantageous ends can be achieved. He highlighted three strategic benefits that might arise:

    it might ‘cultivate the company’s reputation’ specifically in order ‘help in future recruitment’.

    Third, it might ‘help to reduce resistance to any future expansion the company might need to

    make.’ He clearly sees the donation in instrumental terms.

    Margaret Heggs’s comment is closest to the pristine capitalist position. Her comment

    suggests that she believes that the social responsibilities of Biggo do not extend beyond the

    social benefits it already provides through employment and the provision of ‘excellent

    products’. The purpose of Biggo is not to engage in costly social responsibility my asures such

    as community donations, even if they can be shown to have a positive strategic benefit. That

    is not the purpose of a business. In accepting that the company had ‘no further contractual

    or ethical duties to the local government nor to the local community’, she was demonstrating

    a pristine capitalist perspective.

(c) SR and short/long term

    Social responsibility

    This phrase refers to the belief that companies such as Biggo must act in the general

    public interest as well as in the specific interest of their shareholders. This can apply to the

    company’s strategy and the way in which the company is governed, but Mr Doo is referring

    to the specific social footprint that the company has locally. It can also apply to the

    environmental footprint that a company has, i.e. the effect of company activities on resource

    consumption or the effect that emissions from operations have. It is possible to interpret this

    phrase narrowly, as Margaret Heggs has done, or more widely, as Albert Doo has.

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