Rules-based corporate governance makes requirements law, as in the US (Sarbanes-Oxley). Principles-based governance sets good practice in a code that companies comply with or explain, as in the UK. Separately, insider systems have a few large owners close to management (Germany, Japan), while outsider systems have widely held shares (UK, US).
Rules-based vs principles-based
| Rules-based | Principles-based | |
|---|---|---|
| Typical country | United States | United Kingdom |
| Example | Sarbanes-Oxley Act 2002 | UK Corporate Governance Code (FRC) |
| Status | Law, enforced by regulators and courts | Code; listed companies must comply or explain |
| Focus | The letter of the law | The spirit of good governance |
| Flexibility | Low: one size fits all | High: companies can explain why they differ |
| Strength | Certainty, strong enforcement | Cheaper, adapts to each company |
| Weakness | Costly; box-ticking; loopholes | Explanations can be weak; relies on shareholders to act |
Insider vs outsider systems
| Insider system | Outsider system | |
|---|---|---|
| Ownership | Concentrated: families, banks, other companies, the state | Dispersed: many institutional and private investors |
| Where | Germany, Japan, much of Europe and Asia | UK and US |
| Main problem | Majority owners may ignore minority shareholders | Agency: managers may not act for owners |
| Strengths | Close owner-manager links, long-term view, fewer agency costs | Liquid share markets, more scrutiny, easier to raise capital |
| Weaknesses | Few independent directors, weak formal structures, hard for others to sell out | Short-termism, owners too remote to monitor |
Family-owned companies
Chapter 6 of the book treats family control as a form of insider structure.
Advantages
- Lower agency costs: owners run the business
- Family reputation encourages ethical behaviour
- Long-term decisions, aiming to pass the business on
Limitations
- Limited skills if the family lacks expertise
- Family disputes can damage the company
- Outsiders may be kept off the board
What decides a country's approach
- Ownership structure: family or bank ownership favours insider systems.
- Legal system: how enforceable and effective the law is.
- Economy: the state of the economy and economic policy.
- Culture and history: traditions shape what is accepted.
- Global and political climate: scandals often push countries towards rules, as Enron and WorldCom did in the US.
Governance approaches in ACCA SBL
This sits in governance (syllabus area B). Typical tasks: a family company preparing to list, or an overseas subsidiary in a country with a different system. Explain the governance changes needed, link the problems to agency theory, and recommend practical steps such as appointing independent NEDs.
FAQs
What is the difference between rules-based and principles-based corporate governance?
A rules-based system makes governance requirements law, so companies must comply and face penalties if they do not (the US, through the Sarbanes-Oxley Act 2002). A principles-based system sets out good practice in a code and lets companies comply or explain why they do not (the UK Corporate Governance Code).
What does comply or explain mean?
Under the UK Corporate Governance Code, listed companies must either follow each provision or explain in the annual report why they have not. Shareholders then judge whether the explanation is acceptable.
What is an insider system of corporate governance?
One where a small number of shareholders, such as families, banks or other companies, own large stakes and are closely involved with management. Common in Germany, Japan and much of continental Europe and Asia.
What is an outsider system of corporate governance?
One where shares are widely held by many investors, mainly institutions, who are separate from management. Common in the UK and US. The main problem is agency: managers may act in their own interests.
Which approach is better?
Neither is best everywhere. Principles allow flexibility and judgement but can be ignored; rules give certainty and enforcement but are costly and encourage box-ticking. The right choice depends on ownership structure, the legal system and culture.