The Control of the Corporate Governance Code by the Italian Board of Statutory Auditors

The Control of the Corporate Governance Codeby the Italian Board of Statutory Auditors

Fabio La Rosa*

INTRODUCTION

Ever since the early 90’s the debate on corporate governance has focused on the role of corporate gov-ernance codes (CGCs) as a means to make it more effective. Codes of good governance may be defined as a set of best practice recommendations regarding the board of directors (BoD) and other governance mechanisms, issued in addressing deficiencies and to fill in perceived gaps in a country’s governance systems (Zattoni & Cuomo, 2008).

Ahead of recent corporate failures, CGCs are considered a significant solution in restoring investors confidence (Davies & Schlitzer, 2008), as transparency is generally one of their basic purposes (Cad-bury Committee, 1992). As a consequence, scholars have started to study a variety of effects, especially in terms of disclosure, in the adoption of, and compliance with CGCs. Good corporate governance practices are supposed to be consistent with value maximization (Corporate Governance Committee, 2006; Cheung, Connelly, Limpaphayom & Zhou, 2007). In fact, firms that announce the approval of an internal code of conduct have experienced positive abnormal returns (Fernández-Rodríguez, Gómez-Ansón & Cuervo-García, 2004). This means that investors do value positively the monitoring role of recommendations set in the code of best practice. According to these studies CGCs actually contribute to changes in corporate governance practices in view of the fact that firms initiate adaptations to recom-mended standards which were not being applied in the past.

However, some empirical results showed that CGCs are not the best in any context, because they do not guarantee the good conduct of executives, and compliance does not necessarily improve the firm’s profitability (Carver, 2007; Jong, DeJong, Mertens, & Wasley, 2005). An explanation for this is that firms may tend to comply with CGCs in an opportunistic manner (Shabbir, 2008) or to state complete con-formity to the code even when this concerns only specific recommendations (Fernández-Rodríguez, Gómez-Ansón & Cuervo-García, 2004). Generally speaking, the issuance of CGCs in civil law coun-

*Kore University of Ennaty

2 Part 2: GOVERNANCE

Fabio La Rosa

tries may be prompted more by legitimation reasons than by the determination to improve governance practices (Zattoni & Cuomo, 2008). As a consequence, compliance rates based on public information may overstate actual compliance (Akkermans, Ees, Hermes, Hooghiemstra, Der Laan, Postma & Wit-teloostuijn, 2007) and they could be irrelevant (Nowak, Rott & Mahr, 2006). These contrasting results lead to the relevant topic of an apparent compliance with CGCs. In other words, although developed economies are recording a growing adherence level to CGCs, some problems still remain, such as:

• how seriously do firms implement and practice the recommendations that they disclose as adopted (Talaulicar & Werder, 2008);

• how is non-compliance monitored and excused (Macneil & Xiao, 2006).

Scholars have recognized the relevance of the problem, i.e. whilst it might be easy to comply with the form of recommendations, doing so in spirit could be more complicated (Hermes, Postma & Zivkov, 2006; Werder, Talaulicar & Kolat, 2005; Ow-Yong & Kooi Guan, 2000) and such a type of compliance would not prevent fraudulent behaviour (Jones, 2004). Even though corporate scandals are usually con-sidered causes of CGCs issued, it appears that the production of codes alone is not sufficient to avoid massive corporate failure. Some kind of enforcement mechanism based on either internal or external auditing on actual compliance with CGCs seems to be necessary. In particular, enforcement could be also achieved, rather than by BoD self-assessment, by auditing CGC real implementation, as recently occurred in Italy for the Board of Statutory Auditors (BosA).

This chapter aims to expand the CGC literature by discussing the nature and effectiveness of the Italian CGC auditing performed by the BoSA. To this aim, we examine the empirical question of the substantiality of BosA’ governance auditing by examining BoSA’ reports. In fact, although analyzing ac-tual compliance with CGCs is very difficult to achieve, as this means analyzing the firm’s actual behav-iour, some relevant information could be gained by investigating audit reports on CGCs. Thus, whilst previous research has examined mainly the disclosure of compliance-related information by manage-ment (often disclosing only formal compliance), this study examines the disclosure of compliance by an internal control board. As a second step of the analysis, we investigate the association between some characteristics of the BoSA and BoSA disclosures related to the control of the CGC. More specifically, we examine the association between the composition and the degree of activity of the BoSA, in terms of the time it spends in its institutional duties and the disclosure of a set of nine different controls on CGC included in an index of substantial governance auditing.

BACKGROUND AND RESEARCH QUESTION

This section discusses some determinants of the formal compliance with CGCs and the need to adopt enforcement mechanisms in order to prevent it. Formal compliance with CGCs, that is the tendency “to judge corporate governance by ticking off boxes rather than undertaking a deeper analysis” (Coombes & Chiu-Yin Wong, 2004, p. 53), has been outlined in several studies. For example, Carver (2007) finds that in the UsA corporate boards have not become more interested in corporate governance per se, but only

MANAGEMENT, GovErNANcE AND ENTrEPrENEUrSHIP - New Perspectives and challenges

acutely more interested in lawful compliance. Ow-Yong and Kooi Guan (2000) find that, despite KLsE listing requirements, audit committees were found to be ineffective and, in many cases, “they were set up merely to comply with the form and not the spirit of the regulation” (p. 131). Pass (2006) observes that, whilst 22 firms took action to comply or proffered “acceptable” explanations as to why not to comply, 11 firms remained in breach of the code on one or more counts, despite either taking action (but insuf-ficient) or proffering an explanation (but “unacceptable”). According to Shabbir (2008), firms tend to comply in an opportunistic manner, becoming more compliant when their prior period stock market performance declines and less so with improvements in their operating performance.

Formal adoption of CGCs may have different explanations. First of all, the issuance of codes in civil law countries can be prompted more by legitimation reasons than by the determination to improve the governance practices of national firms (Zattoni & Cuomo, 2008). Although codes and principles are usually voluntary, the fact that they are often adopted as listing requirements for associations and stock exchanges gives them a rather formal character (Dewing & Russell, 2004). Especially where the recom-mendations differ from current practices, the behaviour of firms could not change or could change only slowly (Hermes, Postma & Zivkov, 2006; Werder, Talaulicar & Kolat, 2005), and this is also because CGCs are complex instruments and often reflect only aspirations. This increases the possibilities for camouflage and formal or symbolic compliance (Akkermans, Ees, Hermes, Hooghiemstra, Der Laan, Postma & Witteloostuijn, 2007).

Moreover, CGC recommendations are rarely presented in univocal terms, which allows a compli-ance simply expressed with a “yes” or a “no”, and often are ambiguous and lenient (Zattoni & Cuomo, 2008). CGCs are also dynamic instruments, regularly reviewed and continuously evolving in their con-tent; therefore, their observance and control are not easy duties, because these codes also configure themselves as dynamic processes. For instance, the Italian CGC was first issued in October 1999, re-vised in July 2002, with a second edition issued in March 2006, and the latest version being published in December 2011.

Furthermore, CGCs are often organized as flexible frameworks, such as the Italian CGC that is based on both “principles and criteria”, by virtue of which mandatory disclosure is required, and “com-ments” that firms are simply invited to take into account.

Lastly, a CGC may be only formally adopted by firms, since its promoters (commissions set up by stock market or by managers’ associations) do not consider some specific characteristics of the country where it is implemented in terms of national regulatory environments, law systems, perceptions on the role of shareholders, agency relations and business cultures (Hermes, Postma & Zivkov, 2006).

In front of a risk of a merely formal compliance with CGCs, different enforcement mechanisms may be implemented. The enforcement of CGCs is a complex matter (Wymeersch, 2005, 2006) and it has been suggested that studies concerning this subject should be aimed at analyzing the effect of different enforcement mechanisms at a country level (Zattoni & Cuomo, 2008), in order to choose the best one to apply to stimulate good governance of firms (Hermes, Postma & Zivkov, 2006). The debate on enforcement mechanisms of CGCs is essentially focused on the dilemma of either pre-scribing compulsory regulation on the basis of the “one rule fits all” principle (regulatory approach), or

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preserving a voluntary governance system on the basis of the “comply or explain” principle (market-based approach).

Under the regulatory approach, compliance is compulsory and non-compliance is penalized and punished. The enforcement of codes by law or by the supervision of a government body could en-sure substantial changes in firm governance behaviour, even though severe reporting requirements may imply higher costs and more time consumption, as well as less flexibility. Since the choice of the code enforcement mechanism to successfully improve corporate governance should differ per country (Hermes, Postma & Zivkov, 2006), it is widely accepted that a “one size fits all” approach is unrealistic (Davies & Schlitzer, 2008). Besides, even if the code adherence is binding as a requirement, it is not binding as to substance (Wymeersch, 2006).

Within the “comply or explain” approach, which could be considered as a “corollary” of the more general “freedom with accountability” principle (Cadbury Committee, 1992), CGC enforcement is generally assigned to the responsibility of both the firms themselves, by means of the BoD who control executive managers (Shleifer & Vishny, 1997), and of external market forces. Firms can deviate from the code norms, although justifying provisions that are not agreed upon and, above all, disclosing deviations in a statement of conformity (or “governance statement”). In this sense, codes guarantee flexibility and they could be conceived as a form of soft law, since they are able to reflect sector and firm-specific re-quirements. Market forces and public pressure (i.e., the fear of reputational damage, rather than formal sanctions) from rating agencies and other actors, or pressure from peers (e.g., other boards or com-mittees within the same firm) are able to single out firms who decide not to comply with its principles (Goncharov, Werner & Zimmermann, 2006).

With the exception of the UsA – where the sOX Act works on the basis of “comply or be punished” – OECD countries adopting legal systems have all introduced CGCs that work on the “comply or ex-plain” principle. The “comply or explain” rule is judged as good, in order to enhance the rate of code compliance, “because corporate constituencies become aware of code deviations and can call for justi-fications, or even modifications, of the chosen governance arrangements” (Talaulicar & Werder, 2008, p. 255) and it seems effective at least in raising a minimum level of disclosure. It also would encourage complying in spirit rather than in letter (Cadbury Committee, 1992).

However, even under the “comply or explain principle” some enforcement difficulties can occur depending on the country law system. In fact, it has been noted that whilst the intrinsic characteristics of the common law system facilitate the enforcement of CGCs, in a civil law based country (such as Italy) the development of CGCs does not automatically provide additional mechanisms to protect investors’ rights and the effectiveness of a code of best practices is limited because of the low enforce-ability of their recommendations in comparison to Anglo-Saxon common law based countries (Cu-ervo, 2002; Zattoni & Cuomo, 2008). Thus, actual enforcement could be also achieved, in addition to self-assessment, also by checking CGCs using some form of internal control or an independent verification (Burritt, 2005).

For example, in Germany the Supervisory Board, together with the Management Board, reports each year on the firm’s Corporate Governance in the Annual Report, even though it has been found

that only 9 per cent of the German firms had a formal committee to review its corporate governance processes or written guidelines (Charkham, 2005). Thus, the effectiveness of a control on actual com-pliance with CGCs performed by an internal board should also be tested. So, we pose the following main research question:

RQ: In order to guarantee a substantial compliance with the CGC that listed firms state to adopt, is the governance auditing performed by an internal control board sufficient?

MAIN FOCUS OF THE CHAPTER

Italy has an insider corporate governance system in which, whilst agency problems between manage-ment and shareholders do not characterize it, an agency problem survives between large and powerful shareholders (blockholders) and minority shareholders. As a direct result of the low level of separation between ownership and control, the possibilities for abusing power are high (Solomon & Solomon, 2004). In fact, control over a listed firm may be exercised through a cross shareholding or pyramid structure and the controlling shareholder may engage in activities that maximize his perquisites or expropriate the rights of minority shareholders. Hence, the Italian corporate governance system could be summarized by the sentence “weak managers, strong blockholders and unprotected minority share-holders” (Melis, 2000, p. 351).

The most common corporate governance model adopted by Italian firms is a “two-tier horizontal model”, in which shareholders appoint both the BoD and the BosA. The Board of Statutory Auditors is the traditional internal control board which supervises the compliance of acts and decisions of the BoD with laws and principles and verifies the adequacy of the organization in relation to the internal control system and administrative and accounting requirements.

As a guarantee of protection for minority shareholders seems to be necessary, in 1998 Italy intro-duced the first edition of the CGC and, after the Italian “Savings Protection Law” 2005/262, a new key duty has been introduced for the BosA which we define as “governance auditing”, since this internal control board shall check “the arrangements for implementing the corporate governance rules provided for in codes of conduct drawn up by management firms of regulated markets or by trade associations that the firm, by means of public disclosures, declares it complies with” (art. 149, Legislative Decree 1998/58 or T.U.F.). BoSA is also required by law to refer to the shareholders’ meeting of controls per-formed (art. 153, TUF).

Research Hypothesis

In the Italian context, BosA is considered “a core element in building corporate credibility” and “the most reliable body of control” (CNDC, 2003), able to ensure protection, not only of ownership in-terests (both majority and minority shareholders’ interests), but also of all stakeholders of the firm (Bertini, 2004). In fact, in order to ensure that the BosA reflects the willingness of all shareholders, including minority ones, Consob, the public authority responsible for regulating and controlling the

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Italian securities markets, “establishes the rules for the election procedure by list vote of a member of the BosA by minority shareholders” (art. 148, TUF). However, there is also a questionable view about the general capability of the BoSA to guarantee the enforcement of law, its powers to manage key duties and its independence. The powers of BosA are not adequate “to avoid the executive directors’ decisions and behaviours that may pursue controlling shareholders’ interests at the expense of minority share-holders” (Melis, 2004, p. 81), and it can be inefficient because of the lack both of access to information related to shareholders activities and of independence from the controlling shareholders (as the latter could not re-appoint the former). Moreover, the BosA duties seem to be defined in very general terms (Consob, 2008). This is witnessed by the fact that the greater majority of BosA reports contains set formulae and summary attestations, and often refers to information already provided by the executive directors’ report. Reports rarely contain action taken by the BosA, “more concerned with complying with formal requirements (in order to avoid any sanction), rather than on giving substantial information to shareholders” (Melis, 2004, p. 81).

Thus, in a corporate governance system characterized by the presence of a strong blockholder, the BosA seems to provide a legitimating device, rather than a substantive monitoring mechanism and an effective role of the whistle-blower, even when the board includes a statutory auditor elected by minor-ity shareholders (Melis, 2004), although this device seems to be respected merely in a few cases (Con-sob, 2008). As a result of above considerations, the control body may not have an important role for the actual enforcement of CGCs and it could comply with formal requirements.

However, whilst the limits and deficiencies above summarized concern all Italian BoSA, the likeli-hood for each of them to perform a substantial control on actual compliance with CGC will depend on some of its intrinsic characteristics, such as its composition (in terms of presence of auditors appointed by the minority shareholders) and the time and degree of participation that their members effectively spend in their institutional duties (in terms of number of BosA meetings, degree of participation of its members to the BosA meetings, number of positions – as auditors, directors or other – assumed in other listed firms). We refer to these characteristics as “BoSA’s mixed composition and activism”. This leads to the following main hypothesis:

Hp.1: There is a positive association between BoSA’ mixed composition and activism, and the disclosure of a sub-stantial governance auditing on CGCs.

Research Method

Based on the discussions in the preceding sections, we examine the empirical question of the substan-tiality of the BoSA’ governance auditing. In order to test the above hypothesis we firstly need to define the BoSA’ control object, namely the content of its activity within this specific key duty. We assume that one way to check if the BoSA is substantially verifying the concrete implementation of the CGC is to analyse whether it is carrying out tasks required by the same CGC. This should make sure that a minimum of the CGC provisions are actually applied. To this aim, we firstly analyzed all the phrases in the Italian CGC where the BoSA was quoted and, then, we selected those in which it was expressly involved in a control activity. Moreover, we added other control items that, even though not explicitly

required by the CGC, BoSA should not ignore, since they are distinctive of any CGC around the world. After comparing and contrasting data numerous times, we classified BosA’ statements as shown in table 1, showing BosA’s controls explicitly stated by CGC (from 1 to 6), and those which we identified as other control functions (from 7 to 9).

Table 1. Dummy variables definition related to the BoSA’ governance auditing controls

Dummy Variables Each variable takes a value of 1 if the BoSA discloses:

1.IndBoD it has checked the correct application of the independence criteria adopted by the board of directors, 0 otherwise.

2.IndBoSA it has checked the compliance with the independence criteria adopted by the board of directors for the assessment of its own independence, 0 otherwise.

3. IndAudit it has checked the independence of the audit firm, including verifying the nature and extent of services other than the accounting control provided to the issuer and its subsidiaries by the same audit firm and by the entities belonging to the same network, 0 otherwise.

4.ConfInfor that documents and information concerning the issuer are kept confidential by the existence of a pro-cedure for their internal handling and disclosure to third parties, 0 otherwise.

5.InterContr it has participated in the work for the internal control, 0 otherwise.

6.InterCom either the existence and the real functioning, or the inexistence of the Internal Control Committee, 0 otherwise.

7.NominCom either the existence and the real functioning, or the inexistence of the Nomination Committee, 0 otherwise.

8.RemunCom either the existence and the real functioning, or the inexistence of the Remuneration Committee, 0 otherwise.

9.Dual either CEO is not the chairman of the board of directors or, if that is the case, whether the lead inde-pendent director has been appointed, 0 otherwise.

Data Collection, Sample and Data Analysis

Data collection for the dependent variable “governance auditing disclosure index” started from BoSA’ reports extracted from the Borsa Italiana site web (www.borsaitaliana.it), while information on inde-pendent variables related to the “composition and activism of the BoSA” was extracted from the annual report on the compliance of the corporate governance model adopted by a given firm with the Italian CGC.

We adopted a non-probability sample constructed of 191 firms (corresponding to the number of BoSA’ reports available on the Borsa Italiana web site) out of 308 firms listed on the Italian Stock Exchange in the reporting year 2007 (about 62%). We excluded firms where the BoSA did not make any reference to the adoption of the code at all (21 firms) or disclosed that the firm did not adopt the Italian CGC (4 firms). Lastly, where one or more of independent variables data were not avail-able the firm was excluded from the sample, even though the BoSA’ report was present (21 firms). Therefore, the final sample was formed from 145 firms (about 47% of all Italian listed firms for the year 2007).

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Table 2 shows the sample distribution by size and industry. The Italian Stock Exchange included four main indices: “Blue Chips”, “STAR” (High Requirements Securities Segment), “Standard”, and “Ex-pandi”. Firm size in the sample was proxied by the level of the market capitalization. Since “Blue Chips” and “STAR” are large capitalization indices, firms who belonged to both of them were considered as large, whilst firms who belonged to both “Standard” and “Expandi” were considered as small. Industry was split in order to distinguish manufacturing or service firms from entities offering financial services (banks, insurance firms, etc.).

Table 2. Distribution of the sample by size and industry

Size No. % %High/Low Cap. Industry No. % %Non Fin./Fin.

Blue Chips 47 32,4%H Cap.: 53,8%

Manufacturing 67 46,2%NF: 73,1%

STAR 31 21,4% Services 39 26,9%

Standard 52 35,9%L Cap.: 46,2%

Financial 39 26,9% F: 26,9%

Expandi 15 10,3% services

TOT 145 100% 100% TOT 145 100% 100%

Data analysis of BosA’ statements on governance auditing employed the method of content analy-sis, usually adopted for disclosure studies (Krippendorff, 1980; Neuendorf, 2002; Beattie, Mcinnes & Fearnley, 2004). In general, we applied a conservative coding approach, i.e., statements on BosA’s re-ports were rated as “control not performed” in cases of any doubt.

In order to achieve the general research objective of this study, that is verifying if the BoSA control activity may be considered as effective in order to guarantee a concrete and actual implementation of the Italian CGC, we analyzed:

1. the nature of information, i.e. which kind of controls the BoSA performs;

2. the quantity of information, i.e. how many controls the BoSA performs;

3. the locus of information, i.e. where controls the BoSA performs are disclosed within its report.

In particular, data on the quantity of information of the BoSA’s activity is employed to construct a “substantial governance disclosure index”, in order to proxy the substantial level of the control on CGC, so that higher levels of the index correspond to substantial levels of control on CGC.

Logistic Regression Model Adopted

The hypothesis above formulated about the relationship between the characteristics of the BoSA and its attitude to perform a substantial governance audit was tested using a logistic regression model. The general model was:

GovAudDisci = α + β1NumMeeti + β2AttendMeeti + β3NumPositi + β4NumMinAudi + β5Industryi + β6Sizei + εi

Where:

GovAudDisci = index of governance auditing disclosure, proxied by the number of control duties performed by the BoSA; it takes 1 whether the BoSA disclosed between 5 and 9 duties, 0 otherwise (between 0 and 4 duties);

NumMeeti = number of BoSA meetings held during the financial year;

AttendMeeti = average attendance of BoSA’ members to the BoSA meetings;

NumPositi = number of other positions charged by the BoSA’ members;

NumMinAudi = number of BoSA’ members appointed by the minority shareholders;

Industryi = it takes 1 whether the firm belongs to financial services industries, 0 otherwise.

Sizei = it takes 1 whether the firm belongs to an high capitalization market index, 0 otherwise;

This model assumes that the probability to perform a substantial governance auditing is associated to the independent variables related to the time and the degree of participation BoSA dedicates to its institutional duties. These variables were found by prior studies of the audit committee (that is the BoSA equivalent in other countries’ corporate governance model) related to financial auditing (e.g., Farber, 2005; Stewart & Munro, 2007). Size and industry were also introduced into the model as con-trol variables. In fact, firms from the financial sector appear to be more sensitive to corporate govern-ance (Krambia-Kapardis & Psaros, 2006), whilst code compliance, and consequently also the control on codes, tends to increase with the size of the firm, given that larger firms suffer lower relative compliance costs, as well as greater visibility (e.g., Talaulicar & Werder, 2008; Werder, Talaulicar & Kolat, 2005; Ded-man, 2000). Moreover, in order to test the above relationship on each of the nine audit duties, logistic regression was repeated for each of them.

Results

As a first sign of the involvement in performing governance auditing by the BoSA, we notice that while the BoSA discloses the adoption of, or the updating to, the newer edition (March 2006) of the Italian CGC in 59 firms (41% of the sample), in 81 firms (56%) it discloses only the adoption of the code, without specifying the edition. Only in 5 cases (3%) does it emphases the adoption of an older version of the code and the progressive updating to the more recent ones. This lack of information could wit-ness that internal auditors really do not know the relevance of changes introduced in each edition of the code. Since implementing new provisions of a newer edition of the code is time-consuming for a firm, the BoSA may prefer not to state which recommendations are actually adopted, even though new dis-closure is required. In fact, according to Sheridan, Jones & Marston (2006), when UK CGCs are taken as a sequence of events rather than a single event, only the first three codes had a significant effect on the number of news announcements issued by firms.

As to the governance auditing controls we identified, table 3 shows descriptive statistics of the vari-ables selected in this study.

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Table 3. Descriptive Statistics

Variables # firms % Mean 1st quartile Median 3rd

quartileStddev Min Max

1.IndBoD 78 54% 0,54 0 1 1 0,50 0 1

2.IndBoSA 50 34% 0,35 0 0 1 0,48 0 1

3.IndAudit 50 34% 0,35 0 0 1 0,48 0 1

4.ConfInfor 29 20% 0,20 0 0 0 0,40 0 1

5.InterContr 86 59% 0,59 0 1 1 0,49 0 1

6.InterCom 117 81% 0,81 1 1 1 0,40 0 1

7.NominCom 14 10% 0,10 0 0 0 0,30 0 1

8.RemunCom 70 48% 0,48 0 0 1 0,50 0 1

9.Dual 16 11% 0,11 0 0 0 0,32 0 1

GovAuditDisc 132* 91% 3,52 2 4 5 2,04 0 8

NumMeet 145* 100% 10,53 6 8 12 8,91 3 71

AttendMeet 145* 100% 95% 93% 100% 100% 7% 67% 100%

NumPosit 124* 86% 24,12 2 6 36 31,38 0 123

NumMinAud 115* 79% 0,25 0 0 0 0,55 0 2

* Number of firms where the variable has a value higher than zero.

We firstly detail data on the nature of information, that can be gained by looking at specific governance audit controls. As to the control on the independence of the BoD members, it is the BoD which in fact decides as to whether an individual is “independent”, and this may involve an element of subjectivity. Likewise, we found 78 firms (54%) for which BosA discloses to carry out this verification, with only 2 cases of deviation disclosed from the Italian CGC. Where this control is not performed, in few cases the BosA just specifies the number of non-executive and independent directors, as resulting from the governance statement of the BoD. These results confirm the Arena and Maccarone (2007) survey that finds 5 firms considering this test performed by the BosA as a formal one.

Figures about the verification of the independence on the BosA members are still lesser (34%), with 3 deviations from the code disclosed. Similarly, the control of the independence of the audit firm is disclosed only for 50 firms (34%), although the BosA very often discloses to verify also the nature and extent of services different from the financial auditing provided to the firm and its subsidiaries, by the audit firm and the entities belonging to its network. For 4 firms, the BosA states to check the independ-ence of the audit firm by examining the “attestation of independence” issued by the same audit firm, thus confirming the formal nature of this control.

Checking the existence of a procedure for the internal handling and disclosure to third parties of such documents and information is disclosed in only 29 firms (20%), participation in the work for the internal control in 86 firms (59%), and only one case where BosA recommends to improve the func-tioning of the internal control.

As to the “three-committee system”, the existence and the real functioning (by stating the num-ber of meetings) of the internal control committee is disclosed in 117 firms (81%), with 5 cases of deviation from the provisions of the code, therefore showing the highest percentage of information disclosed. This seems to confirm the relevance of the audit committees as essential committees of the board (European Commission, 1996) and shows that the audit committee concept has been accepted in Italy, as well in many European countries (Collier & Zaman, 2005). As to the remuneration commit-tee, percentages of application of, and compliance with, provisions regarding remuneration of board members are significantly lower than those pertaining to other code provisions (Werder, Talaulicar & Kolat, 2005).

In fact, the BosA discloses the existence and the real functioning of the remuneration committee only in 70 firms (48%), with 8 cases of deviation from the code, i.e. committee not instituted. Addition-ally, the BosA specifies that the remuneration committee is connected together with the nomination committee (5 cases). The existence, if any, and the functioning of the nomination committee are dis-closed in 14 firms (10%), with 11 deviations from the code which outlines the only voluntary nature of such committee. This result seems consistent with the survey of Assonime (2007) reporting that only 13% of the listed firms have set up a nomination committee.

Finally, checking the duality chairman/CEO or the existence of the lead independent director, is performed in 16 firms (11%), with one deviation marked and one case where the BosA recommends the improvement of this governance mechanism. However, it has been argued that some corporate gov-ernance rules, such as CEO duality, are not necessary in two-tier corporate governance systems (such as the Italian one), that is where there are two distinct and clearly separated organs for managing and supervising the firm (Werder, Talaulicar & Kolat, 2005).

As a further level of analysis, we determined the number of controls that the BosA performed for each firm (quantity of information). Whilst a major problem faced by transparency or disclosure research is obtaining an accurate measure of disclosure quantity and quality, we tried to shape an index of “sub-stantial governance auditing” which includes all of the nine items defined. It shows that in 132 (91%) firms the BoSA discloses to perform at least one of the nine controls, although there is no firm where all of the controls are disclosed. The mean and median number of controls is about 4. We also cat-egorize this index as a binary variable and we define “formal governance auditing” if it assumes values between 0 (lack of control) and 4, and “substantial governance auditing” if it assumes values between 5 and 9. As shown in table 4, a substantial auditing is performed only in 46 firms (31,7%), whereas com-plementary percentage refers to a formal audit performed in 99 firms (68,3%), and included an absence of control (9,0%).

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Table 4. Values of the Governance Auditing Disclosure Index

# controls performed

# firms % cumulative %Number and percentage Formal/

Substantial Audit

0 13 9,0% 9,0%

Formal:

99 (68,3%)

1 13 9,0% 18,0%

2 20 13,8% 31,8%

3 25 17,2% 49,0%

4 28 19,3% 68,3%

5 20 13,8% 82,1%

Substantial:

46 (31,7%)

6 16 11,0% 93,1%

7 6 4,1% 97,2%

8 4 2,8% 100%

9 0 0% 100%

TOT 145 100% 100%

As a possible additional sign for analyzing the substantiality of the BOsA control we analyzed the information locus, namely the position where the governance audit process is disclosed within the BosA report. While the CONSOB provides a specific exposure order for the other BosA’ controls, the gov-ernance auditing has not been regulated yet as to the location. In fact, we observed that there is not a really standard structure and content within the BoSA’ report, and auditors can choose where to docu-ment the governance auditing process. We think that a formal audit leads to locate the disclosure in a minority position in respect to other controls. Whereas, in only 8 firms (6%) the BosA discloses govern-ance auditing in a priority position, and in 19 firms (13%) the BosA tends to respect the exposure order indicated in the TUF, in 118 firms (81%) the governance audit process disclosure receives a minority position throughout the BosA report, i.e. at the end of it.

Empirical evidence seems to show a formal manner in performing governance auditing by the BoSA, hence confirming the idea proposed by scholars about low independence and limited powers of this control board.

FINDINGS FROM LOGISTIC REGRESSION MODEL

We delved more in depth into the analysis by introducing independent and control variables related to the composition and the activism of the BoSA in order to test Hp.1. While descriptive statistics of the independent variables are included in table 4, table 5 shows Pearson’s correlations amongst all variables considered.

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’s co

Fabio La Rosa

In particular, correlations can be noted between disclosures related to verifying the independence of the BoD, the BoSA and the audit firm, probably as these duties incorporate similar types of control. A significant, although moderate correlation concerns the control on the independence of the BoD and BoSA, being criteria adopted by the BoSA for the assessment of its own independence, identical to those of the BoD.

Also the “three committees system” disclosures appear moderately correlated, with information on the NominCom related to disclosure of the RemunCom (as the former is often jointed to the latter) and, in turn, disclosure on the RemunCom related to the information on InterCom. The correlation between NumMinAud and NumMeet seems to be interesting because where the BoSA is formed by one or more members representing minority shareholders, the BoSA is more frequent.

Size and Industry are both correlated to NumMeet, clearly showing that for larger firms and for those offering financial services, Internal Auditors asked for more frequent BoSA meetings during the finan-cial year in order to perform their control duties. Finally, NumMeet is differently correlated to a few of governance auditing controls, and in particular to NominCom.

The analysis of logistic regression was completed in order to test the hypothesis proposed for this study and results are revealed in table 6.

The regression carried out suggests that the model correctly classifies 62,8% of the firms surveyed. Omnibus tests the model coefficients, this is the Chi-square statistic (13,322) and its significant level. In this case, the model is statistically significant due to the fact that the p-value is 0,038. The Hosmer & Lemeshow test (not reported) also indicates the goodness-of-fit of the model, with Chi-square value of 2,531 and p-value of 0,960, and it indicates that the binary logistic model fits well for the data. Hence, the validity of the model has been tested and it adequately describes the data.

The study also suggests that AttendMeet, NumPosit and NumMinAudit have no significant correlation with governance auditing, although there is a strong and positive correlation in all of them except Num-Meet. The summary of the binary logistic regression model found that one predictor variable, which is the number of meetings, positively influenced the level of governance auditing at sig. value 0,05. There-fore, Hp1 is only partly supported. In general, this model shows that one factor of the BoSA activism is associated with governance auditing. By having a higher number of meetings, the members of the BoSA are likely to improve their awareness of CGC compliance and to document controls performed in their report.

e 6. L

Fabio La Rosa

FUTURE RESEARCH DIRECTIONS

Further research, in order to check if the governance auditing performed by the BosA is substantial or formal, could be conducted by comparing contents of the BosA’ reports and the BoD’ code compliance statements. In this case, if some information about single provisions is omitted from both reports, the BosA audit should be considered as formal, as it stems directly from statements of the board. Further-more, this study may be improved upon by including other variables that may affect governance audit-ing from a longer term perspective.

CONCLUSIONS

With the Decree Law no. 2005/262, the Italian CGC enforcement mechanism moved from not only the BoD self-assessment, but also to an internal verification of the BosA, in order to guarantee substantial CGC implementation. Yet, the aim to contrast only a formal compliance with the Italian CGC does not eliminate the risk that the BosA can perform a merely “ritual” control as well. Every country has a unique set of corporate governance procedures due to factors such as the legal and financial system, corporate ownership structure, culture, and the national economic situation (Davies & Schlitzer, 2008). Because of its own unique features, the Italian corporate governance system does not easily fit into in-ternational taxonomies (Melis, 2000). As a result, the adoption of the CGC by Italian listed firms and the control by the BosA could reveal to be only a formal type of control, if Italian firms see the Italian CGC only as a readjustment of the Cadbury Code.

Even though exploring actual compliance with CGCs by firms is very difficult (Wymeersch, 2006), as this means analyzing firm actual behaviour, this chapter tried to add new knowledge by investigating a sample of reports containing disclosure on governance auditing by an internal control board, i.e. the BoSA in Italian listed firms. Hence, the aim of the chapter was to empirically examine the effectiveness of governance auditing performed by the BoSA and to analyse whether this is related to some BoSA characteristics such as its composition and activism.

Information provided in annual reports on the control performed according to the recommenda-tions of the Italian CGC were scant, and often the BosA seem to be not aware of its governance auditing duties. Results also indicate that only the BoSA’ number of meetings appear to drive towards a substan-tial governance auditing, proxied by the number of controls performed. All the other variables were instead not found to have a significant relationship with CGC recommendations, although they have shown a correlation with certain specific controls. Therefore, this study recommends that the frequency of the BoSA meetings should be increased in order to improve access to information and make BoSA’ members aware of the actual compliance of the CGC.

A main implication stemming from this study is that, to guarantee an effective enforcement of CGCs, self-assessment and internal verification could not be sufficient. Other mechanisms, such as ap-pointing a separate corporate governance committee (as revealed by a BosA in one case of the sample) or calling on external expertise, should be considered. Thus, in the near future, it cannot be excluded

that, in face of the BosA’s limits, the governance auditing will move from the internal to an external control by auditors. In fact, from the public perspective, third party verification offers more credibility than self-reporting (Burritt, 2005).

Fabio La Rosa

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The Control of the Corporate Governance Code by the Italian Board of Statutory Auditors

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