Trends in corporate governance
By Louis Roberts
The American investment giant Merrill Lynch responded to criticism by banning its own equity analysts from purchasing stock in the companies they cover. The US Securities and Exchange Commission fined Arthur Anderson LLP and three partners over US 7 million concerning improper accounting practices of Waste Management Inc, a garbage-hauling company. And, most recently, Arthur Anderson is once again under intense public scrutiny for failing to warn regulators, investors and the public of massive debts held within obscure and unreported partnership arrangements at Enron. The ensuing bankruptcy has left thousands jobless and vaporised pension assets.

In Canada, tough recommendations have been made on how investment dealer research is performed and to mitigate personal conflicts of interest. The focus of these recommendations is on disclosure of, and prohibition on trading in, stock covered by any research study.

For the first time in South Korea, business executives at Samsung Electronics have been held legally responsible for mismanagement and ordered to pay back US 73.5 million to the company.

And in Sri Lanka, activist shareholders, citing instances of discrepant financials and dissatisfaction with the dividend payments record, refused to approve the statements of accounts of one of the oldest finance companies.

The winds of change are inexorably drifting through corporate boardrooms toward more effective corporate governance and accountability. An increasingly borderless financial world, the ongoing technological revolution and the growing financial muscle of institutional investors have forced a radical reappraisal of company performance and its monitoring.

Corporate governance does make individuals perform better, more effectively and more professionally as directors. It also helps boards of directors function better without losing sight of their two fundamental responsibilities: oversight of long-term company strategy and the selection, evaluation and compensation of the chief executive officer (CEO).

Corporate governance calls for a company to:
n Align its business objectives to shareholders' expectations.
n Strive to increase its soundness and operational efficiency consistent with shareholders' desires.
n Satisfy and certainly exceed the return on investment that shareholders demand.
Boards of directors have a high degree of freedom to discharge their responsibilities and drive companies forward, within a framework of effective accountability.
The objective of the board is to lead and control the business. Its effectiveness is measured by the manner in which members work as a whole together under the chairman. Its litmus test is to provide both leadership and the checks and balances that effective governance demands. To this end, the unitary board system - made up of executive directors (with intimate knowledge of the business) and a preponderance of outside (non-executive/independent) directors under a chairman - has been most successful.

The common understanding of a truly "independent" director is one who has no connection with the company other than a seat on its board. Some companies exclude its own lawyers, bankers, consultants and even anyone with connections to its suppliers, creditors and customers.
What key factors affect board performance? They are:
Composition
The ability of a board to act as a catalyst for change diminishes if the group becomes too unwieldy.
In large, unwieldy boards, responsibility is diffused and one is likely to encounter hesitant members, unwilling or unable to make their fullest contributions, thus failing the shareholders they have a fiduciary duty to represent. In many cases, boards are perceived to represent the interests of management rather than the shareholders.
On the other hand, small boards can place undue burdens on directors. This can lead to important responsibilities being overlooked or ignored.

Boards require a degree of diversity to have their greatest impact. Involving members from a variety of professions, backgrounds and even different ages is most effective. In many industrialised countries, gender is also an important consideration. However, too much diversity can be counter-productive. While greater diversity reaps novel and creative ideas, building a consensus in decision-making may be difficult.
In many companies, particularly in North America, benchmarks, procedures and job descriptions are already in place to assess, evaluate and review the performance of all board members including the CEO and the board itself. Directors are evaluated on stature, preparation, participation, knowledge of the business, attendance, time allocation and financial literacy. Evaluation results in a review of talent and energy within the board and, when necessary, the replacement of members including the CEO.

Activity
The composition of a board is irrelevant if it is not actively involved in monitoring the performance of the company and its CEO.
Clearly, time and energy must be devoted to the discipline of governing and of protecting the interests of shareholders.

Power
Boards are often perceived as mere veneers of formality with neither the power nor the desire to instigate change. This perception is validated when the CEO is both a board member and the chair. As board membership is a privilege, it is understandable why members appointed by him are most likely to 'swim with the tide'. Such passivity is often prejudicial to shareholder interests.

In this context, boards are more powerful when someone other than the CEO is responsible for board nominations. Indeed, the present trend is to appoint only independent (outside) directors to audit and to nominate compensation committees.
The presence and convergence of all three elements - composition, activity and power - constitute a high-performing and dynamic board.

Companies intent on retaining a powerful, competitive edge maintain strong, active and independent boards of directors focused on their main functions:
Strategic aims
In the past, boards of directors were content to play a nominal role in the management of companies and relinquished most responsibility to senior management. However, concern over corporate governance and intense competition in the marketplace have highlighted the imperative need to work together as partners with senior management in crafting the company's mission and vision and developing competitive strategies.

Board members must therefore have the freedom to elicit feedback from company employees, particularly senior managers. At the same time, they need to respect the fine line that divides such empowerment from interference with the day-to-day management of the company.

Supervising management
A group of directors that is diverse - in terms of industry experience, qualifications, skills and gender - can broaden, deepen and enrich the quality of advice available to senior management.

Independent directors bring new perspectives and objectivity to all issues and must be free to question and probe. The contributions of strong, able, independent directors in lively discussions of opposing views are the pulse and lifeblood of an effective board.

The board's primary responsibility is to monitor the behaviour, decisions and performance of the CEO. The CEO evaluation process is critical to the furtherance of shareholder interests.

The effectiveness of such processes and the political will to effect change is directly dependent on the quality of board leadership. This is vested in the chairman who is the key link between the directors, shareholders and management.

In many companies, the roles of the chairman and the CEO are combined with onerous responsibilities for running the company as well as the stewardship of the board. Vesting dual responsibilities in one person only results in the blurring of important differences in responsibility and accountability of the two offices.

To diffuse the concentration of power that invariably attaches to the combined chairman/CEO arrangement, corporate governance advocates are making strident demands to split the function. A board that is "elected" by a CEO/chairman severs the primary accountability link with ordinary shareholders. The result is power without accountability. A division of the roles ensures a balance of power and authority and strengthens the board's oversight capacity.

To play a valuable role in the development of corporate strategy and managing the business, directors rely on information that directly facilitates decision-making processes. The information flow and function has to be managed.

Frequently, boards encounter three hurdles. Information provided - (a) focuses on past results rather than leading indicators; (b) is management - controlled; (c) is unedited and frequently unintelligible. The resultant dangers are clear: knowing too little too late. Even when willing to act to confront a growing problem or crisis, the board is often powerless to do so.

Accurate and transparent information and disclosure can enhance investor relations. Institutional investors, particularly, dissatisfied and impatient with the quality of information and disclosure, are forcing accounting, regulatory and supervisory bodies to take a closer look at annual reporting. These efforts will result in more comprehensive, transparent, timely and fair disclosure.

Changes are also expected in non-financial data reporting, emphasising future earnings and intangible value. Markets have already rewarded many companies with stock prices many times over their published book values.

The wording in accounts is also expected to change. "The Economist" of February 9, 2002 quoted Harvey Pitt (Chairman, US Securities & Exchange Commission) as saying that financial statements should be written in plain English. As he put it - "the current system of disclosure is designed to avoid liability, not to inform anybody".

Reporting on stewardship
Shareholders elect the directors. The directors are obliged to report on their stewardship to the shareholders. Shareholders must insist on a high standard of governance and hold directors liable if they neglect their fiduciary responsibilities.
Setting standards of ethical conduct.

Despite codes of conduct and other value statements, no system of corporate governance can be totally secure against fraud, mismanagement or incompetence. Risks can be mitigated, however, by an effective system of internal controls and by making all participants accountable. This will not only deter ethical misconduct but also facilitate swift remedial action.

In summary, an effective board needs a clear, written statement encompassing:
n A corporate philosophy and mission.
n A review of corporate strategy, major plans for action, risk policy, annual budgets and business plans, setting performance objectives, monitoring implementation and corporate performance and overseeing major capital expenditures, acquisitions and divestitures.
n Guidelines for selecting, compensating and monitoring the CEO and key executives and succession planning.
n Requirements for maintaining the integrity of financial reporting systems including independent audit.
n Means to monitor and review the effectiveness of governance practices.
n Guidelines for disclosure and communications.
n Measures to assess board effectiveness, its performance, accountability and transparency.

Finally, let us examine the rationale for the growing emphasis on corporate governance and board effectiveness. Michael Porter, Harvard Business School elaborates - "To compete effectively in international markets, companies must continuously innovate and upgrade their competitive advantages. This requires sustained investment in a wide variety of forms, including not only physical assets but also intangible assets such as R&D, employee training and skills development, information systems, organisational development and close supplier relationships".
Academic Roberta Romano speaks of the primacy of shareholder interests - "we focus on enhancing shareholder value because when looking at a corporation, it is difficult to conceive who else's interests would be appropriate for determining the efficient allocation of resources in the economy".

The urgency for setting corporate governance standards is dictated by three factors:
n Problems in the corporate performance of leading companies.
n The perceived lack of board oversight that contributed to those problems.
n Pressure for change from institutional investors.
To achieve this end, there must be critical evaluation of the following aspects:
Independence
"Outsiders cannot be guaranteed to be independent, any more than insiders can be assumed to be deferent. Directors do not become independent just because they have no economic ties to the company beyond their job as a director. The key is whether a director's interests are aligned with those of the shareholders. Put simply, he must be a shareholder. No director is going to remain passive if a quarter or even a tenth of his net worth is at stake". (Monks & Minow).

Executive session meetings
"One of the key advances of the past decade has been the regular scheduling of executive session meetings of the outside directors, without any of the management team present". (Monks & Minow).

Information
The extent and power of board oversight depends entirely on the access to, and quality of, information. Most managements make impressive presentations on future plans and how those goals can be achieved. However, when such plans and goals do not materialise, they have little interest in bringing it to anyone's attention, least of all to that of the board.

Board oversight is concerned not with promise but with accomplishment. It is in this context that the board should insist on and be directly involved in determining the content, consistency and regularity of such information.

Independent audits
The institution of audit, nominating and compensation committees wholly comprised of and chaired by independent (outside) directors is a key advance. For example, Daniel Deli and Stuart Gillan in their paper "On the Demand for Independent and Active Audit Committees," make the following observation - "An independent audit committee reinforces the objectivity of the internal auditing department, by giving the internal audit dept. a conduit to the board other than through management".

The board selection process is set up, conducted and monitored by an independent nominating committee without management intervention.

In recent years, CEO and senior management compensation have spiralled even in the face of deteriorating corporate performance. The primary goal of the compensation committee is to ensure compensation is linked to performance - performance that is directly aligned to shareholder interests.

Shareholder relations
Companies are now making concerted attempts to ensure direct communications between institutional holders and top management. "A system that not only allows but actively seeks out shareholder feedback can ensure that corporations are continually apprised of the perspectives and concerns of their holder". (Skowronski, Lockheed Corporation & Pound, Harvard University).

Non-financial indicators
In knowledge-based enterprises spawned by the information age, reliance on traditional financial measurements of corporate performance is no longer sufficient or appropriate. Because accounting numbers rarely reflect economic reality, more emphasis must be given to non-financial indicators. Some key indicators are:
n Product and Service quality.
n Customer and Employee satisfaction.
n Employee Training.
n Employee Turnover.
n Total quality management.
n Resources committed to strategic repositioning.
(Stern Stewart Roundtable on Relationship Investing and Shareholder Communication, April 1993).

Most agree the ultimate goal of a corporate governance structure is continual re-evaluation, to adapt to changing times and the demands of the marketplace.
The conclusion is inescapable and irrefutable: companies big and small that ignore the setting up of effective governance standards imperil their own survival. In a broader sense, they also threaten the proper functioning and stability of the economies in which they operate.

"As regulatory barriers between national economies fall and global competition for capital increases, investment capital will follow the path to those corporations that have adopted efficient governance standards, which include acceptable accounting and disclosure standards, satisfactory investor protections and board practices designed to provide independent, accountable oversight of managers". (Extract, Millstein Report, April 1998).

(About the author: Roberts, a former Sri Lankan investment banker, is a Member of the Academy of Fellows of the Canadian Securities Institute. Before he migrated to Canada, he was Head of Customer Services/Private Banking at Deutsche Bank, Colombo, where he worked for 16 years in various departments in progressively responsible positions. His last assignment in Sri Lanka was Head of Corporate Affairs at Lanka Orix Leasing Co).

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