Driving Governance

Monday, October 1, 2007 - 11:10

Governance has shot up the corporate agenda in recent times, but what is driving it and where is it all headed? By Ann-Maree Moodie

It's often said of corporate governance that change takes time to achieve, but once started, the pace of improvement tends to increase exponentially.

Six years ago, the key issues facing Australian boardrooms were how directors were recruited and whether the board's performance should be assessed. However, directors were keen to keep the doors of the boardroom firmly closed.

But the corporate collapses like One.Tel and HIH in Australia and Enron and WorldCom in the US received such an angry reaction from shareholders and the community at large, that the long-closed boardroom door finally cracked open.

New laws were quickly passed in the US to deal with the apparent inability of companies to properly manage the investments of shareholders; in Australia, a voluntary set of principles were introduced.

Meanwhile the UN "oil-for-food" scandal showed that the malfeasance that toppled HIH or Enron was equally apparent in the public sector.

It's almost laughable to read what directors said about corporate governance in 2001 compared with how commonplace it is today for the board to discuss its role in developing the strategy of a company, public utility or not-for-profit organisation.

At the time my book, The Twenty-First Century Board, was published, directors argued against the use of executive search firms to find candidates for board vacancies; board assessment was often "a quiet chat with the chairman". The idea of continuous professional education for directors was rejected as board members didn't want their attendance to be interpreted as them not knowing how to do their job.

"Some years ago, as I participated in a discussion about hiring a new director, I was dismayed by the lack of professionalism my fellow directors and I exhibited as we played the game of 'who do you know?'," wrote Linda Nicholls, the former chairman of Australia Post, in her foreword to the book.

"We would never have acted in this way during our executive careers - it was clear to me that we were behaving in this way, because, as a group, Australian directors believe that the boardroom operates by a different set of rules to those by which we abided when we were senior executives."

Today, even a small or medium-sized company will engage a search firm to help establish its first board; board performance assessment has become a niche industry, and public courses are so prevalent that corporate governance is taught at postgraduate level.

Nevertheless, board recruitment, performance and succession planning are simple concerns compared with the issues chairmen, directors and CEOs are now tackling. The list includes the rise of shareholder activism, the increasing influence and power of institutional investors and the inevitable formalisation of corporate social responsibility issues in law.

In the not-for-profit sector, the growth of charitable gift funds means that philanthropists have greater control of how their donations are spent. Boards and management teams of charities are now under pressure to perform more professionally.

Meanwhile, in the public arena, the conclusions of a Federal Government-commissioned review of public sector governance in 2003 by John Uhrig led to a set of reforms of governance practice in the public sector.

New standards

The most influential document on governance behaviour has been Principles of Good Corporate Governance and Best Practice Recommendations set out by the ASX Corporate Governance Council. Intended as non-mandatory guidelines for listed companies, they have become a quasi benchmark for listed and private companies of all sizes, as well as for entities in the public and not-for-profit sectors.

Currently under review, and expected to be ready to report against from early 2008 (see box on page 21), the guidelines will be compressed to eight principles, with the alterations focused on risk management.

"The other major difference will be changing the name from 'best' practice to 'good' practice because the word 'best' implies that there is only one way of doing things," Eric Mayne, the Chairman of the ASX Corporate Governance Council told a Chartered Secretaries Association seminar mid-year.

Mayne says that 90 per cent of listed companies comply with Principles; however, in a review by Grant Thornton, only 45 per cent of ASX-listed companies are fully compliant with best practice.

Nevertheless, the "if not, why not?" approach to compliance means that companies tend to self-regulate. Standards are raised due to the competition between companies about what issues are publicly disclosed.

For example, an idea that is peculiar to a major bank board, but could well be copied by other companies, is a monthly review of the previous board meeting. A board member makes a verbal presentation and provides his colleagues with a three-page report about behaviours that should be commended or improved. The task is shared between board members and the item is featured on each meeting's agenda.

Despite so many changes within a short period of time, new research from the US concludes that directors and institutional investors are dissatisfied with the pace and extent of governance reform.

"Directors and shareholders cite resistance from management and directors themselves as reasons for the slow change," a recent survey by consultants McKinsey found. "They agree that the reforms that are most needed are: splitting the roles of chairman and CEO; increasing the accountability of directors; and reducing executive compensation."

The reforms are led by institutional investors who have become the major driving force in governance. "Companies with the best governance records probably will not only earn a premium from investors but will also be in a better position to attract talented independent directors," the survey says.

According to Erik Mather, of governance research firm Regnan, the rise of institutional investors and their consequent power and influence is having a deep and lasting impact on governance reform.

Regnan was formed in 2007 to assess companies' environmental, social and governance performance. Its premise is that a company's primary role is to generate and protect long-term shareholder value by operating within a framework that is economically, ethically and socially responsible and sustainable.

"The next round of changes in governance will be driven by the institutional shareholders who are holding companies accountable directly," says Mather.

"Effective governance will be determined by the strength of the alignment between the interests of long-term investors and the directors and managers who work on behalf of the owners of the company.

"For example, corporate social responsibility (CSR) issues will be core to identifying the long-term interests of a company, and anyone who thinks the issue is going to go away will be disappointed."

At present, CSR issues are viewed dubiously and seen more as a cost than a benefit. The popular argument is that "soft" management issues can't be formally measured and costed.

"There was no consensus in the submissions received during the review of Principles about what is meant by CSR or sustainability," says Eric Mayne. "There is evidence that a number of companies are looking into the issues, but it's too early to publish recommendations on how these activities should be disclosed."

Nevertheless, a formal approach to CSR reporting is apparent, with the International Accounting Standards Board (IASB) investigating how accounting mechanisms can address emission trading schemes. These schemes are designed to reduce greenhouse gas through the use of tradeable pollution rights. Australia is a member of the IASB and would therefore be committed to altering domestic accounting standards.

Some large Australian companies are also pushing CSR as a serious business issue by creating board sub-committees to deal with sustainability. For example, the Social Responsibility Committee of the Westpac Bank Board considers issues such as OH&S, climate change and indigenous employment.

Becoming more accountable

The UN Principle of Socially Responsible Investment is another driver of governance. A company reports against this standard on issues such as the type of engagement it has on environmental, social and corporate (ESC) issues, its level of disclosure on ESC issues and how it collaborates with other investors. In Australia , three superannuation funds are already using the UN protocol.

This type of "peer pressure" is often the catalyst for change in other companies, especially when CSR initiatives by companies are recognised by the Sustainability Reporting Award through the annual Australasian Reporting Awards.

Back in 2001, I predicted in The Twenty-First Century Board the imminent emergence of the "professional director" who would be recruited using formal protocols, given a position description, be assessed for performance, and be limited to a certain number of board seats.

Today, boards of companies of all sizes aspire to be more accountable. This trend is also apparent in the government and in not-for-profit organisations.

As part of this change, directors are behaving more like overseers. Cognisant of not being the managers of the company, directors want to protect themselves by having greater control over how information is presented to the board. Anecdotal evidence also shows directors are asking more challenging questions. The CEO is now the one in the spotlight.

"Directors on the boards of public companies strongly desire greater access to financial, strategic, or operational information from the management," according to the 2007 global governance review by McKinsey. "To obtain this information, directors would like to forge deeper relationships with executives outside the C suite, and with more experts who can help them understand it."

Every year since that rash of major corporate collapses, there has been another example of corporate governance breakdown: witness the National Australia Bank's "rogue trader" scandal; Hewlett Packard's internal spy scandal in the US; the James Hardie board's provision of inadequate funds to its Medical Research and Compensation Fund for asbestos victims; questions over the competence of the Qantas board after the collapse of a $11.1 billion Qantas takeover bid by Airline Partners. So, where is governance headed?

Future key issues

The key corporate governance issues to be addressed over the next few years will be: the increasing influence of institutional investors; the independence of company directors; and the push for more diversity in the boardroom.

The concept of universal ownership, in which the pension funds own every stage of the production process, is gaining weight. Universal ownership means that institutional investors will own or have large investments in companies involved in exploration, manufacturing, production, retailing and everything in between.

Directors and executives usually deal with fund managers, but Erik Mather believes this will soon change, and companies will increasingly deal directly with pension funds. This means that the share price of a company will be deemed a "lagging indicator" while the degree to which a board is independent of management will be considered a "leading indicator". But despite its importance in governance ratings scales, independence is a concept that may yet take time to be properly determined.

At present, independence is defined in material terms, such as whether a certain period of time has elapsed between when a director was the company's chief executive or a major adviser.

Other research shows that independence also needs to be considered as a way of behaving within a group situation, such as a board that makes collective decisions.

While the way in which directors are recruited has certainly improved, search consultants and boards themselves are still, to use the jargon, "fishing in a shallow pond". The tradition of hiring "people like us" needs to be finally demolished, and instead board members must be chosen based on merit, skills and experience, and fit with the company's strategic direction.

This means that diversity must be the goal for the composition of any board, and especially of its succession planning. Demand for independent, non-executive directors will grow as a result.

Of course, diversity is often seen as analogous with gender and certainly women continue to be under represented in Australian boardrooms. The 2006 Australian Census of Women in Leadership, published by the Equal Opportunity for Women in the Workplace, shows that the ASX 200 companies have only made incremental progress increasing the numbers of female board members. The facts are that only 8.7 per cent of ASX 200 company directors are women.

It's expected that this figure will begin to rise, albeit slowly, as the incumbent generation of chairmen retire, and are replaced by former chief executives who have hired and worked with women in senior executive roles.

But diversity is not about men and women; it concerns variety of thought, experience and contribution. This means that any board must compose itself as a group with the combined skills and experience to challenge management and to provide thorough oversight.

Whether that means the board is made up of all men, all women or a combination of both sexes, the board members must be selected based on who is best to oversee the company in any particular stage of its business cycle. For example, the inventor of the technology of a biotech company may not be the right chairman when the company goes public, acquires new businesses or expands overseas.

Clearly this is the time for today's high-potential leaders and senior managers to widen their networks through membership of professional and governance associations in order to become visible to those who will be recruiting for the boardroom.

The first board position may be with a small company, a not-for-profit charity or a government board. A board portfolio can then be nurtured.

Viewing a company from the perspective of the boardroom is very different to being in management. Many chief executives have commented on the benefit of one board seat at a non-competing organisation during their term as the boss. The chief executive is in control, individualistic and possibly lonely; as a board member the manager becomes part of a group of overseers. The roles are quite different.

Ultimately, effective governance of a company is a two-way street and involves both directors and managers. The board's role is one of strategy; the executives and managers manage. This separation of roles and duties is often misunderstood and is regularly blurred in small companies, and particularly in those that are family-owned.

In the future, the board must deliver clearer communication to management about what it expects from papers and presentations; management in turn will benefit from better understanding the board's role.

In the middle is the chief executive, whose role it is to manage the relationship between two groups that traditionally rarely interact.

Effective governance also means considering a high-performing board as one that works within a framework of regulations and compliance, but also aspires to be a professional decision-making body comprising independent, competent individuals.

Creating a culture where board members feel free to challenge one another, as well as the chief executive, can only lead to more considered decision making.

Finally, effective governance is about "getting it right". As HIH Royal Commissioner Justice Neville Owen commented, "Did anyone stand back and ask themselves the simple question, 'Is this right?'." Commissioner Cole made a similar remark in his report into the inquiry for the oil for food scandal: "No-one asked, 'What is the right thing to do?'."

Effective governance is not limited to the boardroom or the senior executive ranks. In the future it will be seen as a "whole-of-business concept" where even the receptionist will know that she has a valued role in protecting corporate reputation.