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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.
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.
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