Enforcement, more than regulations, laws-on-the-books or voluntary codes, is key to effective corporate governance in legal practice (Erik Berglof and Stijn Claessens ‘Corporate Governance and Enforcement’ (https://www.researchgate.net, accessed February 18, 2023)). Supervision and enforcement of corporate governance (CG) rules are the task of the sector supervisor/regulator (Klaus J Hopt ‘Comparative Corporate Governance: The State of the Art and International Regulation’ (https://papers.ssrn.com, accessed February 18, 2023)). Much depends on the competence and regulatory style of the supervisory agency, which may be more active or passive. Competence and regulatory style of improving supervision and enforcement of CG rules stiffen enforcement practices and powers of supervisory agency. Self-regulatory bodies play an important role as supplements to existing CG rules by more flexible, as well as more detailed standards improving the CG practice.
Enforcement takes place through various instruments (Eddy Wymeersch ‘Enforcement of Corporate Governance Codes’ (https://papers.ssrn.com, accessed February 18, 2023)). The code has been structured on a voluntary basis, it is not legally binding, and there are no specific enforcement techniques. In legal practice, enforcement can be by a “comply and explain” principle. Explanation should be provided with reference to practices that demonstrate the application of the principle (Institute of Directors of South Africa (IoDSA): KING IV Report on Corporate Governance (2016) p 37). The explanation should address which recommended or other practices have been implemented, and how these achieve or give effect to the principle.
Some of the voluntarily disclosed CG information could apply on a statutory basis as rules or as voluntary codes of principles and practices or as a combination of the two– e.g., annual reports. “Here there is a legal basis for the disclosure of information and any violation of a statutory disclosure duty would trigger the legal enforcement tools that are available in the applicable regulation” (Eddy Wymeersch (op cit) p 8). The regulator should have adequate enforcement instruments at its disposal, mandating the necessary disclosures by being entitled to impose administrative fines.
The Legal Practice Act 28 of 2014(LPA) contains provisions dealing with elaborate internal controls. Rule 126.96.36.199 of the Legal Practice Council (LPC) Rules made under the authority of ss 95(1), 95(3) and 109(2) of the LPA, requires the legal practitioner to implement and design internal controls to provide reasonable assurance of reliable financial reporting and to ensure that they operate effectively, and are monitored regularly throughout the reporting period. The practitioner is ultimately responsible for the integration of risk management into the daily business activities of the organisation.
Law firms may issue a separate declaration as an annexure to the annual report that is not subject to auditing requirements (Klaus J. Hopt (op cit). In legal practice, a declaration such as maintaining a compliance framework and keeping proper books of account is a practice that demonstrates ethical leadership examplified by integrity, competency, responsibility, accountability, fairness and transparency in the operations of the legal practice. The formal requirement to adhere to a CG code and to implement its provisions can be the subject of external monitoring by the LPC or auditor. CG needs the help of gatekeepers such as auditors. The most important instrument is mandatory auditing by external auditors.
The code remains a mere recommendation and its observance is voluntary. Klaus J. Hopt argues that the code is not enforced other than by peer pressure and self-interest. Self-regulation depends largely on peer pressure, and in the CG field, peer pressure is at the heart of CG codes. CG codes function within a given legal environment (Eddy Wymeersch (op cit)). Enforcement may be based on the rules of the LPC supporting the code. Enforcement techniques and efficiency will be directly dependent on the legal status of the codes.
Codes are self-regulatory instruments that can, under certain circumstances be absorbed by the general legal system through interpretation through the principles of CG being cited by the courts, and through that becoming part of legal precedent and those principles then become binding in law (The Department of Trade and Industry (SA): South African Company Law for the 21st Century Guidelines for Corporate Law Reform (May 2004) (https://static.pmg.org.za, accessed February 18, 2023)). The absorption occurs through general negligence liability and specific remedies attached to mismanagement.
The codes usually concentrate on the GB and internal CG including auditing (Klaus J. Hopt (op cit)). The “comply or explain” declaration is issued by the GB. It is the prime responsibility of the GB (management) that the code is complied with. Shareholder protection is the major concern of CG. Protection can be achieved either by imposing fiduciary duties on the controlling shareholders or minorities can also be given rights to protect themselves. Apart from financial rights and general voting rights, there are rights to disclosure. Information rights of shareholders complement various reporting and disclosure rules, in particular the annual report, and CG statements.
The system by which corporations are directed and controlled depends on the shareholder structure of an organisation. The main principal-agent relationship is between the shareholders and the GB, or between the minority (shareholders) and controlling shareholder(s). The principal-agent conflict in firms with concentrated ownership is between the minority shareholders and the controlling shareholder(s). CG deals with the rights and responsibilities of management, GB, shareholders and various stakeholders. “CG ultimately rests on the cooperation between the corporate actors, i.e., the GB, the shareholders and other stakeholders, and the GB is the most prominent actor in CG” (Klaus J. Hopt (op cit)). The presence of non-executive directors and their supervisory performance contributes the declined conflicts of interest existing between the shareholders and directors of the firm. Non-executive directors can be regarded as professional referees.
Management and control are two functions that are complementary and this separation may legally just be good practice (Klaus J. Hopt (op cit). Evaluation of the performance of the GB, including the supervisory board, has become part of good CG. The division between the tasks of the management and supervisory boards varies according to the business sector. The board structure tends to reflect the firm’s industry and the need for monitoring of activities (Philip Brown et al. ‘Corporate governance, accounting and finance: a review’ (www.academia.edu, accessed February 18, 2023)). In legal practice, where ownership environment is concentrated, the one-tier board is a feature of corporate structure; and unites the management and control functions that are separated in a two-tier system. The two-tier board has separate management and supervisory boards. The supervisory board has an advisory function.
Enforcement of corporate laws remains the underbelly of the legal and CG system (Dr Farida Virani ‘Effective Corporate Governance (CG) – Ethical Perspective’ (www.academia.edu, accessed February 18, 2023)). CG is characterized by a firm commitment and adoption of ethical practices by an organisation across its entire value chain and in all of its dealings with a wide group of stakeholders encompassing employees, consumers, regulators, and shareholders (including minority shareholders), in both good times and bad times.
The legal system plays a crucial role in creating an effective CG mechanism and protecting the rights of investors and creditors (Dr Farida Virani (op cit)). This system encompasses the protection offered in laws (de jure) and to what extent the laws are enforced in real life (de facto). Legal compliance mechanisms tend to promote a rule-based or stick approach which corresponds to the letter of the law which may not necessarily inspire excellence. Ethical compliance mechanisms promote a principled-based or the carrot approach which corresponds to the spirit of the law. Ethical behaviour requires directors to see to it that the organisation conducts its business in accordance with the law and with a high standard of commercial morality. Ethical CG mechanisms and controls are designed to monitor managers’ behaviour.
Directors’ fiduciary duty means that they must comply with the spirit of the law and not just the letter of the law. “Fiduciary duty of directors is not just to shareholders, but also to customers and clients as well, all the more so, if what is being offered is highly technical, complex and opaque with the potential to lose clients their money” (Dr Farida Virani (op cit)). Directors must be familiar with the changing nature of the organisation’s business and environment, including them mastering the impact on the business and its risk profile of evolving competitive context in which the organisation operates.
The CG requirements in legal practice may be enhanced through increasing the responsibilities of the practitioners and making them more accountable. Law firms need to be more proactive in creating ethical culture and climate than to be reactive and operate in compliance. There is a need for strong ethical corporate culture and leadership in law firms (Dr Farida Virani (op cit)). Ethics fosters the development of trust; and business ethics could be managed to gain a competitive advantage – corporate ethics. Ethics is an essential ingredient for business success, and corporate ethics has an internal emphasis.
Ethical CG is a must not only to gain credibility and trust but also as part of strategic management for survival, consolidation and growth. The spirit of CG is more important than the form. Substance is more important than style. The LPC, at best can provide certain environment, which will be favourable for such an attitude, but the primary responsibility is of the practitioners. “Successful CG underscores the importance of adopting systems that ensure adherence to ethical business practices, spotting deviations and curbing them since unethical practices reduce productivity, drain resources, and cause significant behavioural issues” (Dr Farida Virani (op cit)). Outside assessment and self-assessment need to be regular events to ensure the effectiveness of CG.
A legal practitioner faces a commitment problem of assuring investors (clients) that he will disclose relevant information and ultimately repays the investors (Erik Berglof and Stijn Claessens (op cit)). CG is about this commitment, and the mechanisms to commit may be missing or incomplete due to poor enforcement of property rights. CG is not only about mitigating the commitment problem, but about balancing the rights and interests of multiple stakeholders. CG is also structures in place that can help resolve conflicts of interest among multiple stakeholders. These forms of CG involve enforcement as well since mechanisms that can help resolve conflicts among certain stakeholders ex-post need to be enforced.
Unilateral enforcement mechanisms involve efforts of individual firms to potentially improve their commitment power (Erik Berglof and Stijn Claessens (op cit)). The most common unilateral mechanism is reputation. In the absence of a well-functioning general enforcement environment, unilateral actions can be important. Reputation and self-enforcement are important when enforcement is weak, but stronger when environment is stronger.
In legal practice, regulatory intervention in the CG area will require some backing of the court system for enforcement (Klaus J. Hopt (op cit)). The quality of general enforcement environment affects the functioning of legal mechanisms specific to investor and creditor protection. The legal and regulatory requirements that affect CG practices should be consistent with the rule of law, transparent and enforceable. (Organisation for Economic Co-operation and Development (OECD) `Supervision and Enforcement in Corporate Governance` (www.oecd.org, accessed February 18, 2023)).
The effectiveness of enforcement mechanisms in the area of CG in legal practice depends on the general institutional environment (Erik Berglof and Stijn Claessens (op cit)). Controlling owners in legal practice are a feature of a weak environment. CG in weak environments has to strike a balance between the benefits of the controlling shareholders and the protection of minority interests. A combination of poor protection of property rights and weak resolution mechanisms gives rise to CG failures and the non-observance of mandatory legal rules. Effective enforcement requires the availability of effective, proportionate and dissuasive sanctions in the event of non-compliance (OECD (op cit)).
Legal standards and enforcement are complements (Erik Berglof and Stijn Claessens (op cit)). A heightened level of enforcement can help reinforce the primary CG mechanism in legal practice (OECD (op cit)). Litigation can help develop standards against which legal practitioners know they will be judged. CG rules are only as good as their enforcement (Klaus J. Hopt (op cit)). Regulations should support effective CG, and CG actors need some form of supervision. This can be done by the legal services sector regulatory body, the LPC.