Academic journal article IUP Journal of Corporate Governance

The Cadbury Code Reforms and Corporate Performance

Academic journal article IUP Journal of Corporate Governance

The Cadbury Code Reforms and Corporate Performance

Article excerpt

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Introduction

The separation of ownership and control gives rise to agency problems in listed companies (Jensen and Meckling, 1976). One way of reducing agency costs is to have effective corporate governance mechanisms. In the UK, Cadbury Committee's report, Cadbury (1992), laid out a model of corporate governance that was believed to be effective in reducing information asymmetry, agency costs and hence improve performance. These concerns have also been the subject of much debate in other countries, especially in the US, where recent corporate scandals have inspired new corporate governance reforms.1

The governance model identified by Cadbury, and also in later UK reports such as Hampel (1998) and the Combined Code (1998), concentrated on board structures and functions. Cadbury's report recommended a number of board-related monitoring mechanisms that the listed firms should adopt. It is important to emphasize that the Code was a series of recommendations rather than a set of compulsory rules which firms had to follow. However, although made in the form of recommendations, pressure was placed on the firms to adopt them. One of the key recommendations that the listed firms had to include in their annual report was a corporate governance report which, detailed whether or not, the company had adopted the recommendations of the Code. This is referred to as 'comply or explain'. The purpose of the report is to provide shareholders with a clear statement of the expected effectiveness of the company's internal governance mechanisms. If shareholders concluded that the mechanisms were inconsistent with the Code, the board could be pressurized to adopt the Code's recommendations.

The main recommendations of the Cadbury Report were as follows. First, the posts of Chief Executive Officer (CEO) and Chairman of the Board should be separated, i.e., the Chairman CEO duality should be done away with. Second, boards should have a meaningful representation of independent non-executive directors. Third, the boards should establish audit and remuneration committees, with a minimum number of non-executive, or outside, directors. It was argued that these board-related mechanisms would improve monitoring and make managerial discretion more difficult, thereby reducing agency costs and improving performance.

This paper makes a number of contributions to the research debate on the relationship between corporate governance mechanisms and company performance. First, we use panel data, rather than cross section data, which enables us to take account of both time series and cross section effects. Second, the use of a panel permits us to assess the impact of the adoption of governance mechanisms on performance. Third, we provide a rationale for differentiating fixed and random effects models. Fourth, the study offers broader insights into the effects of the introduction of a system of corporate governance which firms are pressured to adopt.

The main findings are as follows: First, there is a positive association between corporate performance and the adoption of the Code of Best Practices. Second, assigning the positions of the Chairman of the Board and the CEO to two different individuals has not had any impact on corporate performance. Third, the establishment of an audit committee and/or remuneration committee is positively associated with corporate performance. Fourth, the presence of a key executive director in the audit and/or remuneration committee is negatively associated with corporate performance. Fifth, there is a negative association between corporate performance and the proportion of non-executive directors, but a positive association between corporate performance and the square of the proportion of non-executive directors. This suggests that there is a nonlinear association between these two variables. Sixth, contrary to prior evidences, there is no strong positive association between company performance and the proportion of shares owned by directors, nor is there a negative association between performance and the square of the proportion of shares owned by directors. …

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