During the last decade, the financial services sector started to become one of the major pillars of the economy. The nature and complexity of this particular sector has needed the set up of the Financial Services Commission, as a regulator, and new enactments and amendments in laws governing financial operations.
The Collective Investment Industry has also experienced major changes. Previously, Collective Investment Schemes (CIS) were managed by Asset Managers and were fairly regulated. With the growing interest of investors in collective funds, it became necessary to regulate asset management firms as they involved large amount of funds under their management. The securities act was amended and other regulations were introduced to regulate the industry. However, though being a highly regulated industry in many countries, a series of corporate scandals and malpractices have still been witnessed in fund management.
1.2 Motivation of study
In Mauritius, evidences in many corporate governance studies and dissertations have shown that firms in various sectors as well as in the financial services sector do not maintain a robust corporate governance structure. Moreover, there has been a widely held perception that in recent years many boards have not managed the risks associated with their businesses. The Board of Directors is usually the one who is responsible for good governance practices and to implement efficient risk management procedures in an organisation. Risk mitigation and good governance practices are an important concern in CIS. However, there are little research in the field of risk management and corporate governance in the management of collective investment schemes.
The aim of this study is to examine risk management practices by CIS Managers and their compliance to the rules ascertaining good governance. Analyses are performed at board level to determine the effectiveness of board and board committees in the management of collective investment. The research also identifies the different risks and risk management techniques involved while managing the funds and how good governance practice aid in mitigating those risks.
This chapter gives an overview of the dissertation.
Chapter 2: Literature Review
It provides a study of corporate governance and good governance practices and requirements for good risk management process through board structures.
Chapter 3: Background
The purpose of this chapter is to outline the CIS industry in Mauritius and provide an overview of CIS Management companies.
Chapter 4: Research Methodology
Chapter 4 describes the means and ways adopted to carry out the research for this dissertation. A description of the types of methods used will also be given, followed by an explanation of the problems faced while collecting the data.
Chapter 5: Analysis & Findings
This part of the dissertation displays an overview and a general indication of the findings from the survey carried on corporate governance and risk management in CIS Managers.
“Reading maketh a full man; conference, a ready man; and writing, an exact man.”
~ Francis Bacon ~
2.0 Literature Review
2.1 Corporate Governance
Corporate Governance has been practised ever since the existence of corporate entities. Yet, the study of the subject is as old as about half a century only. The UK Cadbury Report in the 1990’s considerably influenced thinking about good governance practices in many countries. Soon later, many of them founded their own reports on corporate governance; for instance, the Viénot Report (1995) in France, the King Report (1995) in South Africa, the Report on corporate governance in Hong Kong (from the Hong Kong society of Accountants in 1996), the Netherlands Report (1997), amongst others. Corporate Governance is now viewed as the practise to which an organisation is run; laying emphasis on accountability, integrity and risk management.
Although being an extensively researched subject, researchers and academics have, till now, not yet arrived to a common and widely accepted definition to corporate governance. Shleifer and Vishny, (1997) put it as “dealing with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment.” Other explanations were provided by Monks and Minow (1995) essay_footnotecitation">[essay_footnotecitation_link" href="http://freedissertation.com/litreview/the-field-of-corporate-governance-in-mauritius.php#ftn1" name="bodyftn1">i] , the Cadbury report (1992) essay_footnotecitation">[essay_footnotecitation_link" href="http://freedissertation.com/litreview/the-field-of-corporate-governance-in-mauritius.php#ftn2" name="bodyftn2">ii] , the World Bank report (1999) essay_footnotecitation">[essay_footnotecitation_link" href="http://freedissertation.com/litreview/the-field-of-corporate-governance-in-mauritius.php#ftn3" name="bodyftn3">iii] , Mathiesen (2002) essay_footnotecitation">[essay_footnotecitation_link" href="http://freedissertation.com/litreview/the-field-of-corporate-governance-in-mauritius.php#ftn4" name="bodyftn4">iv] , amongst others. However, a proper and elaborated definition seems to be that of the OECD (2004), stating that: “Corporate governance involves a set of relationships between a company’s management, its board, its shareholders and other stakeholders. Corporate governance also provides the structure through which a company’s objectives are set, and the means of attaining those objectives and monitoring performance are determined. Good corporate governance should provide proper incentives for the board and management to pursue objectives that are in the interests of the company and shareholders and should facilitate effective monitoring, thereby encouraging firms to use resources more efficiently. Good corporate governance is only part of the larger economic context in which firms operate that includes, for example, macroeconomic policies and the degree of competition in product and factor markets. The corporate governance framework also depends on the legal, regulatory, and institutional environment”. The Executive summary of the King Report on Corporate Governance (2002) draws attention to the subject by listing out 7 characteristics indispensable for good corporate governance; which are: Discipline, Transparency, Independence, Fairness, Accountability, Responsibility and Social Responsibility. essay_footnotecitation">[essay_footnotecitation_link" href="http://freedissertation.com/litreview/the-field-of-corporate-governance-in-mauritius.php#ftn5" name="bodyftn5">v]
2.1.4 Organisational Structure.
In an organisation, each individual has his own duties and status within the firm. Corporate governance identifies some interest groups that have a distinct role in the governance of the company (OECD, 2004).
The principles (e.g. shareholders)
The principle is the one who has permitted or instructed another person (an agent) to act on his behalf and according to his instructions. They are the ultimate proprietors of corporate information and they have the prerogative to use them or not, so as to exert control and demand accountability.
Agents (e.g. executive managers)
The agent is someone delegated to act on behalf of the principle. They are the ones who control the information flow because all information is forwarded to them and is then disseminated to the Board of directors, and stakeholders.
Board of directors (BOD)
The Board of directors (BOD) is composed of shareholders, including executives and non-executives and is the main mechanism responsible for dealing with problems of goal incongruence between agents and principals. The company’s board has the role to set up management compensation and monitor senior management as well (Main & Johnston, 1993; Tosi et al., 1997). However, Lorsch and Maclver (1989) explain that many of the critical processes and decisions of boards of directors do not derive from the board-at-large, but rather in subcommittees such as for e.g., audit committees, compensation committees, and nominating committees (Bilimoria and Piderit, 1994; Daily, 1994, 1996). Sub committees enable directors to cope with the limited time they have available, and the complexity of the information with which they must deal (Dalton et al, 1998). Moreover, these committees are seen to specifically enhance the accountability of the board as they provide independent oversight of various board activities (Harrison, 1987).
2.1.5 Agency essay_footnotecitation">[essay_footnotecitation_link" href="http://freedissertation.com/litreview/the-field-of-corporate-governance-in-mauritius.php#ftn6" name="bodyftn6">vi] problems and Sub-Committees.
The separation of ownership and control constitutes agency problems between managers and the suppliers of capital (Berle and Means, 1932). Agency problems are multiple. Executive directors and managers have the power to control the amount and quality of the information that are transmitted to the owners and stakeholders, which can lead to a phenomenon of arrogance and power exploitation for their own interests, against the interests of the owners (Fama, 1980). It is known that managers are usually the ones who are more exposed to the necessary information and knowledge to estimate risks and opportunities rather than the board. In fact, prior to market surveys, nine-tenths of directors are not properly informed or aware about their duties and obligations as board members (Fremond and Capaul, 2002). This may result in improper monitoring of the board, as according to Jensen (1993), its role is to represent the shareholders and serve as their first line of defence against a self-serving management team. Therefore delegating authority to board committees to assist the board will help deal with complex issues which the board may not be having time to ponder on and hence provide detailed attention to specific areas of their duties.
126.96.36.199 Nomination Committee
In order to manage the company properly, a sufficient number of board members is recommended to favour appropriate supervision of the agents. However, researchers argue that that a large board size may result in less effective monitoring. Lipton and Lorsch declare that “the norms of behaviour in most boards are dysfunctional” (1992); where numbers [of Directors] increase, so do the problems associated with these norms of behaviour. Companies that have introduced a nominations committee to select and recruit directors are considered to have a more effective board control.
188.8.131.52 Remuneration Committee
Main and Johnston (1993) stated that: “There are strong theoretical reasons for expecting a Board sub-committee such as the remuneration committee to exert an influence on top executive pay. And that influence should be in the interests of the owners, i.e. the shareholders,” The importance of a remuneration committee is evident; in its absence, senior executives may desire to award themselves pay raises that are not an advantage to shareholders’ interests. In their study, Conyon and Peck, (1998) point out that the constitution of both a company’s main board and its compensation committee are essential in the closer alignment of management pay and corporate performance.
184.108.40.206 Audit Committee
Audit committees are board mechanisms that enhance accountability around the financial reporting and accounting functions. In an organisation, the audit committee guarantees the quality and reliability of financial reporting and corporate accountability (Carcello and Neal, 2000), and acts as an important governance mechanism. Krishnan (2005) presents evidence that internal control problems are less likely to occur when audit committees are well versed with financial elements. Financial expertise of audit committee members has been shown to be important for dealing with the complexities of financial reporting (Kalbers and Fogarty, 1993), detect material misstatements (Scarbrough et al., 1998; Raghunandan et al., 2001) and thus reduce the occurrence of financial restatements (Abbott et al., 2004). Therefore, the importance of an audit committee is considerable. They have the responsibility to ensure a reliable financial reporting (Blue Ribbon Committee 1999; Johnstone et al. 2001; Abbott et al. 2002). Companies without audit committees are more likely to have fraudulent financial reporting (Dechow et al. 1996) and earnings overstatements as revealed by prior period adjustments (DeFond and Jiambalvo 1991).
2.1.6 Elements of control, transparency and disclosure
Researchers, in the field of accounting (e.g. Cohen et al., 2004), suggest that it is import to align the interests of shareholders and management with mechanisms of accountability such as audit committees, internal audit and risk management to guarantee the quality in financial reporting Mechanisms of transparency, in the form of accounting, financial reporting and voluntary disclosures have also taken their place in corporate governance research. To further ensure transparency in the organisation, a system of monitoring is put in place by the principle to govern the agent. Again, traditionally, researches, from an agency theory perspective, have demonstrated that transparency, in the form of disclosures to shareholders, is an important mechanism for aligning shareholder and management interests (Healy et al., 1999; Healy and Palepu, 2001). There are various ways to disclose company information such as company reports, daily newspapers, etc. Besides, the internet has recently proven to be a highly effective information channel as well as.
2.2 Risk Management
Risk management is defined by the King report (2002) as “the identification and evaluation of actual and potential areas of risk as they pertain to a company, followed by a procedure of termination, transfer, acceptance (tolerance) or mitigation of each risk. Risk management is therefore a process that utilises internal controls as a measure to mitigate and control risk.”
In an article by Sophia Grene (Jan. 2010), it was reported that “many financial models failed in the past two years as markets demonstrated they did not behave according to conventional assumptions” and that “the main challenge for asset managers in the coming decade is understanding, managing and communicating risk.”
Risk management is often a difficult task as risks can emerge when sometimes least expected. If risks are ignored or let to get out of control, it will cause damage to the business as well as its clients, causing the survival of the business less probable in the long run.
Unlike most other institutions that need only to think about managing the risk of their own business, management companies of collective investment schemes must think about risk at two levels. On one level is the CIS manager’s fiduciary responsibility to protect the clients of the firm and on the other is the need to protect the CIS management firm itself. According to Andre Morony (1999), “There are many overlaps between these two aspects of funds management risk; for example, if a funds management firm damages client portfolios by poor investment decisions, the firm will also sooner or later damage its own business.”
2.2.2 Types of risks
Firm risk is inherent in every decision that is taken and every procedure that is executed. It also tends to be more general across industries compared to fiduciary risks. Initially, firms risk will tend to affect the clients, but it will eventually have an impact on the asset managing company itself (Morony, 1999). Hence, management of firm risk involves not just the protection of the firm’s clients but the protection of the firm itself as well.
The Ernst & Young Survey on Risk Management for Asset Management (2010), identifies 12 main risks which are faced by firms in the fund management industry; which are the:
2.2.3 Risk Management Framework
Risk management includes the examination of risks concerning the improvement of performance measures, critical success factors, and well-organized systems based on corporate strategy and corporate goals to influence decision making and managerial action plans. The Institute of Chartered Accounts in England and Wales (ICAEW) (2002) recommends a few steps, to ensure that the company has a proper continuous risk management process, which are:
identifying, classifying and sourcing the risks inherent in the company’s strategy;
selecting the correct risk management approaches and transferring or preventing those risks that the business is not competent or ready to manage;
applying control strategies to manage the remaining risks;
monitoring the efficiency of risk management methods and controls;
Learning from experience and making improvements.
The ICAEW (2002) insists that it is mandatory to follow all these steps to make sure that the process is coordinated and that management is fully informed. Making appropriate information available for internal purposes will mean that no additional systems are required to support external reporting.
2.2.4. Risk Identification techniques
To carry out the risk management process, the different risks affecting the enterprise should be identified first. Identifying an issue that is facing the organization and discussing it in advance can potentially lead to the risk being reduced. The Institute of Management Accountants (2007) proposes some techniques for identifying risks, namely:
Event inventories and loss event data
Interviews and self-assessment
Risk questionnaires and risk surveys
Other techniques (e.g. value chain analysis, Audits or physical inspection, etc)
Risks faced by the organisation can be minimised once they have been identified and located. The implementation of a risk monitoring system is then required to control the risks.
2.2.5 Risk Control
The principal goal of a control system is to maximize safeguarding of assets and capital by minimizing the exposures that can exhaust them. An effective internal control system is based upon a thorough and regular evaluation of the nature and extent of the risks faced by the enterprise. The level of risk undertaken by a company is under the responsibility of the governing body and it is the one accountable for it. The Turnbull’s report (1999) has identified 3 steps on how risk control should be established in the business processes:
The board or relevant board committee members should identify the key risks and assess how they have been evaluated and managed.
The board has to assess the efficiency of the internal control system in place, laying particular focus on the weak spots and trouble spots, identified previously.
The board must make certain that company reports cover all features of the internal control system, its procedures and its effectiveness.
Risk management activities are usually performed by a management team, external auditors, consultants, or internal auditors. The audit committee is then, the one which is at the head of the risk management process. However, the expanding roles and responsibilities of audit committees raise various criticisms and doubts as to their ability to function effectively (Alles et al., 2005; Harrison, 1987). For example, audit committees are commonly delegated with the responsibility of both financial reporting and risk management control by the board. As a result, such committees may become less effective due to the increased workload pressure. According to Alles et al. (2005, p. 22) audit committee members “however well qualified, often have full-time, high-level responsibilities elsewhere which inhibit their desire and ability to get more involved with the firm”. Moreover, managing risks generally requires a considerable understanding of evolving organisation structures and their related risks. Hence, it is evident that the setting up of a separate risk management committee is expected to be more efficient than the audit committee. In fact, risk management committees are gaining popularity as an important oversight board committee (Fields and Keys, 2003). The broad areas the risk management committee have as responsibilities commonly include:
determining the organisational risk management strategies;
evaluating the organisational risk management operations;
assessing financial reporting in the organisational; and
ensuring the organisation is in compliance with the laws and regulations (COSO, 2004; Sallivan, 2001; Soltani, 2005).
The committee members are expected to discuss with senior management the state of the organisation’s risk management, review the adequacy and management of the risk procedures, and report to the board on its findings.
2.3 Corporate Governance and Risk Management
2.3.1 Risk Management as a part of Corporate Governance.
Risk management is one of the main areas in corporate governance that has recently been much talked of; from the Cadbury Report of the early 1990s to the more recent Financial Reporting Council (FRC)’s Review of the UK’s Combined Code published in December 2009. The latter implements that there is “the need for boards to take responsibility for assessing the major risks facing the company, agreeing the company’s risk profile and tolerance of risk, and oversee the risk management systems.” Systems of risk management and internal control not only aid the prevention of governance breakdowns, but can also assist in creating an environment where innovation and continuous improvement can thrive (Australia / New Zealand Risk Management Standard, 1999). The IMA (2006) lists different reasons for which risk management is closely integrated in corporate governance; for instance, it:
Improves the flow of information between the company and the board regarding risks;
Enhances discussions of strategy and the related risks between executives and the board;
Monitors key risks by accountants and management with reports to the board;
Identifies acceptable levels of risks in the firm;
Focuses management on the risks identified;
Improves disclosures to stakeholders about risks taken and risks yet to be managed;
Reassures the board that management no longer manages risk in silos; and
Knows which of the organization’s objectives is at greatest risk. ”
2.3.2 Corporate governance and Risk Management in CIS
It is important that in the CIS industry and individual CIS ensure that robust governance structures are constructed and maintained to safeguard the interests of investors and maintain their confidence. Collective funds are used by small investors as well as sophisticated individual investors and institutional investors. However, owing to their critical role as an investment instrument for smaller savers and to their widespread applicability in providing for their future needs (e.g. retirement income), a system of good governance and risk management is important to protect the interests of the CIS investors.
The International Organization of Securities Commissions (IOSCO) (2005) describes CIS governance as “a framework for the organization and operation of CIS that seeks to ensure that CIS are organized and operated efficiently and exclusively in the interests of CIS investors (both actual and potential investors, and not in the interests of CIS insiders.” The robust CIS governance framework should:
Seek to protect the CIS assets from loss due to malfeasance or negligence on the part of those that organize or operate the CIS.
Ensure that investors are adequately informed of the risks involved in their investment and the rewards they may obtain.
Ascertain that the scheme is operated in the investors’ best interests at all times.
220.127.116.11 Internal Control
Independently of the form or model under which a CIS is organized, CIS Managers should always be subject to the fiduciary duty of acting for CIS investors in the best possible way. CIS often entail a separation of the ownership of the scheme from its management, which may incite the CIS Manager’s fiduciary duty to diverge; as stipulated by the IOSCO (2005). The IOSCO, sets forth that CIS Managers could rid themselves of unattractive securities that they own by dumping them into the collective fund. CIS Managers can also interfere in NAV calculations and overestimate the value of their assets in order to avoid showing poor performances or inadequately managed risks or to increase the size of fund by selling additional units or shares of the schemes.
Therefore, it is important to maintain appropriate controls and implement an internal structure of compliance responsible for monitoring compliance with their contractual obligations and the rules that are applicable to the CIS management activity. Many CIS Operators employ a compliance officer to help assure compliance with the rules and allow proper information to be passed to the entity responsible for enforcing fiduciary duties.
18.104.22.168 Conflict of interest and Agency abuse
The investment manger’s objective is to maximise assets under management while the investor’s objective is to maximise return in asset class. By attracting as many investors into the fund, the manager has the possibility to obtain higher fees for his service. But in so doing, the fund may become too large to be managed efficiently (OECD). In practice, potential conflicts are even greater. Collective schemes are legally a separate legal entity, such as a corporation or a trust, whereas all facilities provided to manage the fund belong to the asset management company and all managers of the fund are employed and compensated by the management company. However, most fund managers are affiliated with other financial institutions. It is feared that the fund managers use the fund to support issues of securities underwritten by the parent organisation (OECD, 2001). In extreme cases these funds can be used to purchase assets from the affiliates which could not be placed in a public offering. The fund managers could also direct securities trades to affiliated market intermediaries, rather than seeking best execution of orders. There is also the risk that the company will trade excessively in order to increase the commission income of affiliated market intermediaries. Failure to withhold information about possible trades from affiliated intermediaries can allow these intermediaries to “front run”. In all of these cases, the operator could trade at prices or commissions that are inappropriate from the point of view of investors while allowing the operator or the affiliated intermediary to earn profits from an inside relationship.
2.3.3 Corporate failures and fraudulent activities.
The focus on issues of business ethics, better corporate governance and risk management are usually directly linked to scandals and disasters. The crumbling of a large number of high-profile firms such as Enron (2001), WorldCom (2002), AIG (2004), and Satyam (2009), amongst others, in those past years have stained corporate governance reputation and questioned the effectiveness of its current structure. In their article, “Corporate Governance: A Mandate for Risk Management?” (2001), Dr Drennan and Professor Beck, report that “the current system of largely voluntary governance codes is unlikely to prevent the occurrence of future scandals, because of its inability to ‘frighten’ governance under-performers into action.” The fund industry, has also experienced such incidents such as, for instance, the world’s largest fraud ever; Bernard Madoff’s Ponzi Scheme, of at least $50 billion (Dec 2008) and other fund scandals like that of Charles Ponzi essay_footnotecitation">[essay_footnotecitation_link" href="http://freedissertation.com/litreview/the-field-of-corporate-governance-in-mauritius.php#ftn7" name="bodyftn7">1] (1920), Jerome Kerviel (2009), Ralph Cioffi and Matthew Tannin (2008), Edward Strafaci (2002), Kazutsugi Nami (2009).
Fraudulent activities occur when the company cheats on implicit or explicit contracts with creditors, employees, franchisees, or clients or when agents of the company misrepresent the company’s financial condition. It is observed that fraud is more likely to happen among companies having fewer independent members on the BOD and the audit committee (Dechow et al. 1996; Abbott et al. 2000; Beasley et al. 2000). These studies imply that when this key element of oversight is missing, there are likely to be consequences in terms of financial reporting quality.
In certain countries, legislation has been passed in order to encourage whistleblowing and protect the rights of whistleblowers in order to encourage the exposure of illegal activities and fraudulent businesses. In fact whistleblowing has been the subject of several recent ethics studies on corporate governance (e.g. Cohan, 2002; Vandekerckhove and Commers, 2004). Cohan (2002, p. 275) which call for solutions to improve whistleblower communications in corporations, such as
encouraging employees to expose wrongdoing without fear of retribution;
devising communication systems that enable important information to move upward to the proper decision-maker without distortion;
adequate training to new directors; and
expanding the number of independent directors.
“Judge a man by his questions rather than by his answers”
3.1 Background – The CIS Industry
In the capital market, various investment opportunities are available, but most individuals do not possess the necessary investment skills and can hardly afford sufficiently, diversified portfolios, or execute large trades. That is why many small investors pool their savings collectively in a large fund often called as a Collective Investment Scheme (CIS). In fact, CIS have been one of the most significant developments in financial intermediation during the past few decades. CIS are important vehicles through which investors across the world save and invest as they allow investors with relatively small savings to get better returns by pooling their money and benefit from the expertise of a professional investment manager who invest the pooled fund in a diversified portfolio of securities. In many countries Collective Investment Schemes are the main source of savings and capital for investments. A well developed Collective Investment Schemes industry helps to create jobs and mobilize savings to productive sectors.
3.2 CIS in Mauritius
In Mauritius, Collective Investment Schemes have been very popular in mopping up liquidity and for promoting savings. As at 31 December 2009, the global business sector had more than 455 CIS’s (with total assets of US$50.1 billion under administration) used by institutional and professional investors to channel their investments in different markets. essay_footnotecitation">[essay_footnotecitation_link" href="http://freedissertation.com/litreview/the-field-of-corporate-governance-in-mauritius.php#ftn8" name="bodyftn8">2]
Until 2005, the domestic Collective Investment Schemes were structured through a company (mutual funds and investment trusts) or through a trust (unit trusts) vehicle. Apart from the Unit Trusts Act 1989 and the limited provisions of Clause 35 in the Companies Act 1984 (saved under the Companies Act 2001) there existed
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