WHY CORPORATE GOVERNANCE MATTERS? Anam Rehman (ACCA) Research Officer - PICG “The views expressed in this article are those of the author and do not necessarily represent the views of, and should not be attributed to, the Institute.” Corporate Governance is generally defined as a “system by which companies are directed and controlled”1. Simple enough, but the definition entails essentially the two most significant aspects for an organization. Direction and control not only runs throughout the organizational life cycle but actually manages how the organization shifts from one stage of cycle to another. The question arises as to what extent does direction and control matter? To rationalize the discussion, it is important to understand the relationship between direction and control. While the former is primarily the role of the board at strategic level and drills down the hierarchy through senior management to operational stage, the latter runs parallel to direction. The two concepts need further individual elaborations. In the light of agency theory, board members of companies act as the agents of the shareowners (principals). Their roles and responsibilities, in effect, are aimed to fulfill the objective of principals’ investments, without being influenced by conflict of interest between agent and principal. Board members’ duties further ensure that decisions by directors are deemed to be within the ambit of ‘Professional Behavior’, maintaining a level of ‘Professional Competence and Due Care’2, and are in the interest of both the organization and its shareowners. This is where the complexity arises in the roles of directors, the interlinking of professionalism of directors while carrying out their duties, performing actions in the best interest of the organization, while keeping in mind the objectives of shareowners. Enron, one the most discussed fraud cases, depicts that how management was involved in the manipulation of balance sheet in order to increase the share price of the company. Management’s actions were backed and pressed by the senior executives including their president and chief financial officer. While Enron scandal of 2001 is a typical example where shareowners’ well-being was not taken care of and though the share prices were reaching higher and higher peaks, neither the intentions behind these prices were clean nor the workings; the collapse of Lehman Brothers in 2008, inter-alia, could partly be due to its unique board composition. Among its board members, too few had the required professional experience (experience in financial sector). Though majority of directors were independent, they lacked professional competence, leave alone the fact that majority of board members were over 60 years of age. 1 Definition of Corporate Governance according to Cadbury Committee - 1992 The principles of ‘Professional Behavior’ and ‘Professional Competence and Due Care’ form part of the five Fundamental Principles of ACCA, as set out in ACCA’s Code of Ethics and Conduct 2 Who elected the board members, (shareowners have the right and duty to elect their stewards) is also a valid question in this case. Arguably, when Deutsche Telekom’s executives spied on their members of supervisory board, in 2005 / 2006, though their actions could be improper, they spied when they were losing their business to the competitors and headlines in papers were harsh in company’s disfavor. Maybe the executives were concerned for their investors’ wealth and did not want to bring it to harm because of leakage of some sensitive internal information; maybe their intentions were right; maybe they did not want to anticipate the fall of a leading telecommunication company. It is the four pillars of corporate governance that encircle the board of directors and directors are bound to work within the circumference of these pillars. With the trust which shareowners place on directors, directors are assigned the responsibility of safeguarding the interest of the shareowners, with fairness, their actions and decisions should be transparent and for which they are also held accountable. Hence, undoubtedly, Board’s role is fundamental as it carries out the objectives of shareowners and drives the organization in line with these objectives. The board is both a junction between owners and organizational resources and the steering wheel driving the organization. The onus of proper direction is therefore on the board and proper direction matters for a number of reasons. From balance sheet to the employee turnover ratio and from EPS3 to the culture that runs throughout the organization, its strategies and its market reach, each of these factors is affected by the tone at the top. Not only within the organization, but as the organization progresses, its impacts on the wider communities and corporate markets start appearing strongly and the stakeholders also look forward to the performance of the company (that in principle is the performance of the board). Strategies and market reach are really the matters reserved for the board and so are the budgeted targets and balance sheet / profit loss figures. When boards take decisions on these major issues, it is their intentions behind these prerogative decisions which are of comparatively higher importance. All boards want success and their company’s success is actually their own, yet how much of a company’s success is compromised by their personal attainments is really what differentiates a success story from a scandal. Likewise, executive directors compensated with stock options are inevitably under the dilemma of trying to work harder towards achieving a better price at options. How much of their efforts are sustainable in the long term, bona fide the organization is what makes the difference. So a ‘True and Fair’4 direction is reflected in the timeline of the company’s performance, irrespective of periods of losses faced by the company or the fluctuating profitability in years. It is the tone set at the board level that prevails in the organization. Although, there is no one fit culture or attitude for all organizations and the market forces continuously play their part, yet a culture of quality consciousness, dedication and effectiveness ensures that management and employees are committed and their goals are aligned with the ultimate objectives behind shareowners investments. This is when board is living up to the trust placed upon them by shareowners. An article by Steve Kaplan, Morten Sorensen & Mark Klebanov, “Aggressive CEOs trump softer peers”5 discusses a research, the findings of which revealed that CEOs with hard and aggressive skills are more successful that those with softer ones. However, it cannot be proven that typical CEO’s skills or board’s qualities will always be successful, as different organizations have different kinds of people, resources, products and it is very 3 EPS is an acronym for Earnings per Share and is calculated as [Net Income divided by Average Number of Shares] The term, True and Fair applied in this article intends to reflect the same meaning as under auditing concept, that is, representation with no material misstatements and depicting an unbiased view in spirit 5 http://economictimes.indiatimes.com/aggressive-ceos-trump-softer-peers/slideshow/2649904.cms 4 difficult to find two identical organization for the purpose of like to like comparison, but what can be suggestive is that boards which are enlightened, knowledgeable, with balanced skill set and of required professionals and who are well equipped with corporate governance will lead the organization towards prosperity and success. So, while other qualities are generally found among the directors, and their vast experience, knowledge and business sense are well suited for their companies, the knowledge of corporate governance makes the directors aware of their roles and responsibilities as directors, the ethical behavior expected from them and provides them the sense that voluntary measures beyond legal requirements and the belief in the spirit of the letter is also highly significant. In return, stakeholders value corporate governance compliant organizations, the access to finance gets easier, attracts more investment and board members are least likely to fall as victims of media trails and regulatory penalties. While it is essential that organizations have a robust system in place for controls oversight and to look after the implementation of policies, the acceptance of internal control environment in the hearts of employees is equally significant. The setting up of the internal control department and conducting the internal audit ticks the box but the spirit of these needs to be adhered to. Again, it is the emphasis from board which makes the internal control environment effective; a stronger emphasis creates the healthy control culture; otherwise, the internal audit departments are even at times face attitudes of discomfort and uneasiness by others. An ‘emphasis’, therefore, encompasses understanding the need for an internal control / internal audit function, proper reporting line of the function and regular review and appropriate actions on the reports and recommendations of the function. Consequently, proper supervision of these three areas by the board would indicate commitment from board members in safeguarding and effective utilization of resources employed as well as that organization’s health and growth is given its due significance. Principal C.3.6. of UK Corporate Governance Code – September 2012, establishes that effectiveness of internal audit activities should be monitored and reviewed by the audit committee of the board6. Code of Corporate Governance, 2012 of Pakistan also states that functional reporting line of the internal audit should directly be to the audit committee7. While these principals ensure that independence of internal audit function is maintained, it also enables that weaknesses and red flags are identified in time and save the organization from severe losses and instances of fraud. Control environment is not only a concern within the company; its ambit includes external authorities (such as auditors) and regulators as well. A question has risen in the past, who audits the auditors? The collapse of Enron which took with itself one of the then big five accounting firms Arthur Andersen LLP. raised concerns over the credibility of the external audit functions and their independence. Since then, while efforts have been made to restore confidence on the role of external auditors through quality reviews on auditors’ working papers by external authorities, the clarifications upon their scope of work and inherent limitations have given the profession prestige and respect. Likewise, revision in Pakistan’s Code of Corporate Governance in 2012 and the introduction of Public Sector Companies (Corporate Governance) Rules, 2013 indicate the eagerness of Securities and Exchange Commission of Pakistan in promoting good corporate governance practices across the various corporate sectors of the country. 6 “C.3.6. The audit committee should monitor and review the effectiveness of the internal audit activities.” - UK Corporate Governance Code – September 2012 7 “There shall be an internal audit function in every listed company. The Head of internal Audit shall functionally report to the Audit Committee and administratively to the CEO.” Section xxxi –Internal Audit, Code of Corporate Governance - 2012 So while external regulations are stepping forward towards good corporate governance measures, perhaps it is still the organization within and the board within which actually can make a difference. This is why corporate governance matters as it guarantees that the drive of the company is on the right path, duly monitored and supervised and faults rectified in time. Corporate governance matters as it is the comfort zone for the shareowners that their interest is secured and investment is safeguarded and their trust is well taken care of. What actually happens, however, needs serious attention. It is observed that as board of directors operates the business, shareowners (especially, the public in case of listed companies) gradually distant themselves from their business. A minority shareholder, for instance, may be looking forward to the announcements of dividends or company’s fluctuating share price, whereas, some other investors may only be appearing in the general meetings of the company. International Corporate Governance Network – ICGN stresses upon effective dialogue between company and its shareholders and believes it to be necessary for the prosperous growth of the organization. Under ICGN Global Corporate Governance Principles: Revised (2009), principal 9.1 delegates shareholders the duty to “act in a responsible way”8, their responsibility is, in fact, in exercising their rights, making well-informed decisions and making the best use of their votes. Corporate governance is not a law or standards; it is the mechanism which concerns internal as well as external stakeholders of the organization. State Bank of Pakistan, in its Handbook of Corporate Governance defines corporate governance and includes within the definition that corporate governance “provides structure for setting corporate objectives and mustering resources to attain those goals without compromising fairness, ethics, transparency and accountability.”9 ***** For comments on this article, follow the link http://picgblog.wordpress.com/2013/12/09/why-corporate-governancematters/ 8 “Shareholders should act in a responsible way aligned with the company’s objective of long-term value creation.” Principal 9.1 - ICGN Global Corporate Governance Principles: Revised (2009) 9 Handbook of Corporate Governance - State Bank of Pakistan (http://www.sbp.org.pk/about/corp_gov/Chapter%201%20-%20Introduction.pdf)