Corporate governance: a closer look

It is easy to stand with the crowd. It takes courage to stand alone.

                                              Mahatma Gandhi

 

Last week, we discussed corporate governance in the context of the Cadbury Report issued in December 1992 following a series of corporate failures. That report focused on the financial aspects of governance, mainly on the role of directors of companies, external auditing arrangements, and the work of audit committees. Some ten years later, following a series of accounting scandals in the United States, legislators found it necessary to enact the Sarbanes-Oxley (SOX) Act 2002 in a bid to restore investor confidence and to avoid any repeat of the matters that gave rise to Enron and WorldCom scandals, among others.

Accountability WatchToday, we recognize another outstanding contribution to developments in corporate governance. We refer to the work of Prof. Mervin King of South Africa whose committee produced the first volume in 1994 known as “King I”. The main outcome was a set of recommended standards of conduct for boards and directors of listed companies, banks, and certain state-owned enterprises. Following the 2002 Earth Summit in Johannesburg, King I became King II and included new sections on sustainability, the role of the corporate board and risk management.

By 2009, Prof. King recognized the mistake of having a separate chapter on sustainability which resulted in companies reporting on it in isolation of other important factors. He felt that there was a need to integrate sustainability with governance and strategy. As a consequence, King II became King III which recommends that companies produce an integrated report in place of an annual financial report and a separate sustainability report. In addition, King III advocates the integration of economic, social, and environmental reporting; and recording how the company’s business has impacted positively and negatively on the community and how it intends to enhance those positive aspects and eradicate or ameliorate the negative aspects in the year ahead.

The content of King III has also been enhanced by incorporating a number of global emerging governance trends. These include: alternative dispute resolution; risk-based internal audit; shareholder approval of non-executive directors’ remuneration; evaluation of board and directors’ performance; directors’ responsibilities as regards IT governance; and business continuity and disaster recovery planning. The code promulgated is principle-based, and encourages the practice of “apply or explain”, not “comply or else”, or “comply or explain”.

Work is progressing on King IV, due to be released later this year. Commenting on King III, Sir Adrian Cadbury asserted that “governance yesterday focused on raising standards of board effectiveness; governance today, on the role of business in society; and of course, governance of tomorrow is set by King III”.

The focus is on leadership, sustainability and good corporate citizenship. King III views effective and ethical leadership as the essence of good governance and considers that responsible leaders should direct company strategies and operations with a view to achieving sustainable economic, social, and environmental performance. In addition, it views sustainability as the primary moral and economic imperative of this century; and corporate citizenship as flowing from a company’s standing as a juristic person under the South African constitution which should operate in a sustainable manner.

 

Interview with Prof. Mervin King

In an interview to be found in IFAC website, Prof. King made the following interesting comments, among others:

  • One of the things that terrifies me about the recent financial meltdown is that governments will overregulate from a financial point of view and forget about the sustainability crisis, which will be ongoing long after the financial crisis comes to an end;
  • We have to stop destroying the quality of life on Earth, and companies are making the hugest impact on planet Earth. Therefore, corporate governance can no longer be looked at as ‘in a silo’ how companies are steered and directed by boards, how they are managed by management, or controlled by shareholders. It’s got to be integrated! Governance, strategy, and sustainability are becoming more and more inseparable because the long-term survival of organizations is no longer only affected by economic factors, but also by social and environmental ones. If you are practicing good governance in working out the long-term strategic direction of a company, you also need to assess the social and sustainability issues pertinent to the business of that company;
  • I am hoping that, one day, the whole world will be on one financial reporting standard, and I think IFRS should be the standard. However, if you just look at the financial reports of today, then you immediately understand that the average person can no longer understand them. Even some chartered accountants no longer fully do…We need to develop a simplified balance sheet, a simplified profit-and-loss statement, and simplified related notes in understandable language, so that the average person can read it and understand it;
  • Companies need to report on how the business of the company impacts, both positively and negatively, on the community in which it operates. As soon as you get all the social, environmental, and economic results of an organization in one integrated report, it starts showing the true performance of that organization;
  • Companies have to realize that their social and environmental performance is absolutely integral to their whole business and the sustainability of their company. That requires a mindset change at the top, and then the top has to make sure that the message is carried further down the organization. You all have heard of ‘the tone at the top.’ I talk about ‘the tone at the top, the tune in the middle, and the beat of the feet at the bottom’;
  • I know from my executive days that if you get your strategy right and you get buy‐in, you get ordinary people to achieve the most extraordinary things! But if you don’t get it right and it doesn’t fit in with the milieu of the day, you can have the most extraordinary people, but you won’t even achieve ordinary things;
  • I believe more in principles rather than in rules, and I don’t believe in the use of criminal sanctions to steer desired behavior. I think the ‘comply or else’ regime of, for example, the US Sarbanes-Oxley (SOX) Act does not work, because then you get mindless compliance. What people with statutory compliance do is develop manuals to tick off compliance;
  • One does not need to go into great detail, either, such as SOX did, which results in rigidity in process. We need flexibility in practice. Also, to have ‘one size fits all’ is not possible, and legislation on governance takes the focus off enterprise. This in turn impacts the ultimate social and economic responsibility of a company, which is performance, not conformance;
  • I always say that shareholders deserve the directors that they appoint, similar to the governments they vote into power. Shareholders who maintain a director who: (a) has not proven to be a good non‐executive director; (b) has not properly applied his mind and good governance principles; (c) has not asked those questions that make management really think; and (d) mindlessly agrees with a credit committee that makes a recommendation because a rating agency has approved something, should not complain because it is their fault. Certainly, if I were a shareholder I would not vote for such a person. So there it is: if shareholders have the ultimate say, they should use their powers well, and this is where the investor code becomes so important…How is it that, even after this past financial crisis, directors with a tarnished reputation can continue as directors?
  • Before the crisis, companies that were taking huge risks seemed to take in huge profits as well. Those that took a more conservative course were under severe pressure from their investors to also engage in these risky ventures. How should companies reconcile good governance with investor demand for profit? …The answer is that the ultimate duty of the director is sustainable performance. Your duty as a director is, inter alia, to balance risk and reward. Why is it that your pension fund buys equities in a company, takes positions in the money market, and has money in the bank? It invests and takes positions because it expects a better return than on money in the bank and it does not put all its eggs in one basket;
  • I always draw the analogy between a director and a curator. Imagine a young person who has been injured in a car accident and becomes incapacitated, and that you are asked to care for that person for the rest of his or her life. Medically, that person could live to 90 today. Well, as the curator, you would plan for both the short term and the long term, you would apply your mind honestly, and you would take great care to act in the best interest of that person. Those duties are exactly the same for taking care of a company in the role of a director;
  • Directors have to realize that their ultimate responsibility is social, environmental, and economic performance. It is the moral and economic imperative of the 21st century that we perform economically, but at the same time are concerned with social and environmental objectives; and
  • In my book, Transient Caretakers, I quote Catherine Sullivan, who was the first American woman to walk in space. In 1984 she was up in space and saw that beautiful blue planet below. And she thought, ‘I have to return to Earth, to this degraded Earth, and I know that every household is still contributing to the degradation of the Earth.’ That was 25 years ago. And since then, how far have we progressed? We don’t learn very quickly… If we start now, at least we have a chance of having a sustainable future. Otherwise, it will be too late for mankind on planet Earth.

 

King III list of recommendations

  1. If you are practicing good governance in working out the long‐term strategic direction of a company, you also need to integrate the sustainability issues pertinent to the business of that company.
  1. We need to develop a simplified balance sheet, a simplified profit-and-loss statement, and simplified related notes in understandable language, so that the average person can understand it.
  1. Companies need to report on how the business of the company impacts, both positively and negatively, on the community and the environment in which it operates.
  1. If you get your strategy right and you get buy‐in, you get ordinary people to achieve the most extraordinary things! But if you don’t get it right and it doesn’t fit in with the milieu of the day, you can have the most extraordinary people, but you won’t achieve even ordinary things.
  1. Develop a responsible investor code for financial institutions to actually carry out their duties, to ensure that they vote for directors with the ability and capacity to in turn carry out their duties.
  1. Directors have to realize that their ultimate responsibility is social, environmental, and economic performance.
  1. Boards should adopt a policy or a framework for the remuneration of their senior executives and put it to a non-binding vote to shareholders, so they get an indication from their shareholders as to whether they are in the right ballpark.
  1. If an executive gets an additional bonus, it must be related to something that he or she has personally contributed.
  1. An external opinion on integrated reports is essential to ensure that they are a candid, open, and transparent disclosure of what has happened in an organization.
  1. Governments need to legislate the apportionment of blame and damages for a corporate failure (to make clear that everybody has to put their shoulder to the wheel).
  1. If we start now, at least we have a chance of a sustainable future on our planet. Otherwise, it will be too late.