In his new book What’s Wrong With Boards: Rethinking corporate governance, Professor Fred Hilmer AO argues that the governance of listed companies in Australia has become overly dominated by a one-size-fits-all model, when flexibility and “best fit” are what’s needed to navigate the times. Nearly 25 years since he wrote Strictly Boardroom: Improving governance to enhance company performance, Hilmer outlines his concerns in this edited excerpt.
The public company governed by an independent board is under pressure. In our view, flawed governance is the key issue.
Almost all major decisions are and can only be made by the board.
We contend that all is not well with governance, not just in Australia, but more widely, as failures here have parallels in most economies where public companies are significant players.
Large, publicly listed companies with widely held shares are a key element of market economies. These companies bring together the capital and talent needed to operate complex, large- scale businesses, and can take risks that smaller firms cannot.
Modern, well-functioning complex economies rely on the likes of large banks and other financial institutions, retail chains, resource companies, key infrastructure providers and major technology companies. These large, publicly listed companies also provide democratised investment access to smaller shareholders, allowing them to construct portfolios that reflect their preferences for returns and risk — and the type of business that they choose to be involved with. According to an ASX study in 2020, some 6.6 million Australian adults — 35 per cent of the population — hold listed investments (excluding superannuation).
In an increasingly complex and rapidly evolving environment, these companies require strong and effective governance to serve their shareholders well. When things go awry in the large listed company world, it matters. Beyond an immediate impact on shareholder value, the consequences can damage trust in business as providers of essential services and as investors of shareholder capital.
Consequently, when things do go wrong, the immediate call is, “Who is responsible and why did they allow these undesirable outcomes to occur?”
Too often, the answer is simply and unhelpfully, poor governance.
The governance problems we now face appear to be sufficiently different to those of the past, [so] that we believe fresh thinking is required. Without this fresh thinking, we believe governance in public companies will not only not improve, but is likely to further decline.
Our overarching concern is that the expectations being created and enforced by Australia’s current approach to corporate governance are unreasonable given current governance practices — they require boards to have a command of detail, often in highly technical specialised areas, as well as a clear “big picture” perspective. As a result, the board may act in ways that may not improve outcomes, and consequently distract from more valuable activities. In other words, the current direction of governance reforms is at great risk of making leadership quality, company performance and stakeholder outcomes worse over time.
Governance crises have a common pattern. There is usually an accumulation of specific problems, including unanticipated losses, or fraudulent or unethical behaviour. Over time, a sense of an overarching brokenness appears. What follows are demands that something must be done, leading to the imposition of new rules and regulations with a declaration that this can never happen again. If only this were true.
In 1993, during one of these periods of perceived poor governance, I chaired the Sydney Institute’s review of governance. The resulting book, Strictly Boardroom, argued that: “The key role of a board should be to ensure that corporate management, properly taking account of risk, is continuously and effectively striving for above average performance. This was not to deny the board’s additional role with respect to shareholder protection.”
After analysing losses in major listed companies, the contributors concluded that poor business judgements in boom markets — paying too much or borrowing too much — rather than misconduct or inappropriate entrepreneurial behaviour, were the main causes of poor performance in the 1990s.
In the late 2010s and early 2020s, we saw a new type of governance crisis develop. This time, poor conduct is more widespread. Another difference has been the nature of the financial impacts of governance failures. Rather than causing major financial losses, in many cases the misconduct increased profit — at least in the short term — at the expense of customers and employees.
Australia is not alone in facing these issues. Australian governance problems can be seen as part of an international governance challenge.
The Bergin inquiry into Crown Casino in NSW was established in 2021 to question the fitness of Crown to hold a gaming licence. Governance issues were an important part of the inquiry’s work and a number of themes emerged. While there are obvious differences between banking, funds management and casinos, the relevant principles of good governance have much in common.
The issues this time were about ethics, compliance with the law and community expectations about standards of behaviour. This new formulation encouraged recognition and examination of conduct that was not illegal, but nevertheless unacceptable.
It recognised a newly prominent strand of thinking about the objective of governance, including how boards were being asked to balance the interests of shareholders, customers and the community at large. The report also positioned governance issues, not in a legal realm, but in the realm of ethics and of practical action. This approach suggested governance should be grounded on basic, fundamental principles and less on prescriptive rules.
As corporate Australia was coming to terms with the findings of the banking Royal Commission and reforms proposed by regulators, COVID-19 struck. No business has been exempt from its effects This is less a governance crisis and more an acute governance challenge.
For many firms, survival became the overwhelming issue. For firms with viable businesses, protecting the safety of employees and customers, as well as adapting to major changes in how people and goods could move around, was an urgent and high-stakes challenge across entire organisations.
We observed changes in governance practices in response to this challenge. It became clear that the necessities of coping with COVID-19 were revealing how large, publicly owned companies adapted governance when the pressure was on.
Boards reacted by establishing ad hoc committees, choosing how to involve directors with specialist skills in time-critical decisions, increasing the frequency — and heavily modifying the agendas — of board meetings.
While the pandemic is still playing out, some key governance issues it has triggered remain unresolved. This more innovative and substantive conversation has been slow to emerge. Instead, we have observed — and our interactions with senior directors and executives confirm — a lack of clarity about the fundamental governance problems that should be addressed. Consequently, many improvement suggestions made over recent years amount to amplifying current practices in the hope that more-of-the-same will improve governance and firm performance.
The combination of pressure to improve governance without a path to fundamental change meets a common response from directors. The tendency is to retreat into form over substance via box-ticking processes, all based on so-called best practices. Their intention is to protect themselves against accusations of failed governance when something inevitably goes wrong.
What’s missing from this conversation are ways to strengthen the board’s role, to better equip directors to meet governance challenges.
We recognise that the topic of governance generally — and specifically of large complex organisations — is not a simple matter. We found little empirical research and few systematic attempts to gather evidence about what actually works in governance. Our conclusion is that in many cases, best practice is closer to “desirable practice” or, worse, the latest fad. This makes even more surprising the tendency for these practices to be positioned not as minimum standards or broad guidance, but as compliance tasks.
In chess, there is no answer to “what is the best move?” The best move depends on the specific game and the specific opponent facing the player. Similarly, our approach to working towards improved governance has been to focus on the specific, persistent and important governance challenges that have been at the heart of company collapses, dissatisfied shareholders and stakeholders, and fraudulent and other types of illegal behaviour. We have sought to recognise that solving these problems may mean more flexibility to find and adapt “best fit” approaches.
This is a complex challenge. Australia’s default public company governance model is now competing against strong and well-established alternatives such as private equity, direct investments by large pension funds and sovereign wealth funds. If it is to survive into the next century as a vibrant part of a sophisticated and dynamic market economy, it needs to become a more efficient and effective means of marshalling financial and human capital.
The risks of continuing on the current course are that public companies become ineffective models for capital formation and wealth creation, relegating them to the graveyard of competitive corporate life. The upside is that better governance has the potential to improve performance and so strengthen the public company model. Whether and how well governance reform proposals meet the governance challenges is a useful test against which calls for changes to governance practices can then be assessed.
Equipping boards to meet the challenges
We argue that rather than focus on so-called best practice, boards should focus on “best fit”. The notion of best fit comes from contingency theory, the essence of which is captured simply by US sociologist William Scott, who specialises in institutional theory and organisation science: “The best way to organise depends on the nature of the environment to which the organisation must relate.”
We provide a framework to consider alternative governance models, and five specific governance structures are outlined and discussed. We don’t advocate a “best” model. Rather we urge boards to adopt, with shareholder consideration and approval, what best fits. This is a significant shift in mindset, and could lead to an appropriate divergence of governance models depending on a company’s situation.
Discovering and implementing best fit is only part of the story about how to improve governance. Having a board spend more time on additional prescribed issues or new areas of concern is not the answer. This has a real risk of blurring the lines between board and management — and so introducing a new governance risk.
We propose that boards should give more focus to that which only a board can decide — delegating other matters to executive leadership or board committees.
We argue for the elevation of the role of the chair in the quest for improved governance. As in most areas of economic activity, effective leadership is what distinguishes the best performers from the also-rans. Achieving best fit and appropriate focus depends critically on the leadership provided by the board chair. In our interviews it was suggested that if only one change in governance was possible, that change should be to clarify the role and improve the functioning of the chair.
The genesis of more-of-the-same
The main tenets of what is believed to be good governance for publicly listed firms are laid down in the listing rules of key stock exchanges. In Australia, these best-practice governance principles are developed by the ASX Corporate Governance Council. The principles have been updated every three or four years since their introduction in 2003. The way the principles take effect is through the ASX requirement that listed entities either comply with the principles or, if not, explain why not.
The intention of this approach was clear when established. The principles were by definition generic and therefore it was the responsibility of each listed entity to find an appropriate application of the principles to the specifics of their context. It should also be remembered that these principles are to guide a highly diverse range of companies: in size — enormous versus tiny; in maturity — early-stage versus mature; and in nature — covering every industry imaginable.
There are three important observations/trends in relation to these principles:
- They emphasise conformance rather than performance. Phrases such as “achieving excellence”, “effectively innovating” or “displaying resilience” are absent.
- With each revision, these conformance-orientated principles and their accompanying notes become increasingly detailed. The development and use of a skills matrix is a case in point.
- Most worryingly, what were initially set out to be guidelines are increasingly being treated as implicit rules — any divergence, even when explained, is unlikely to be tolerated by large shareholders and proxy advisers.
The unintended yet very real consequence of these accumulating factors is a situation where public company governance has gone long on conformance-related issues, rigidly defined. If this more-of-the-same approach coupled with increased compliance was effective, we would expect to see a reduction in governance failures. We would also expect an improvement in the performance of firms complying with the principles compared with those that did not comply. However, this does not seem to be the lived reality. The overriding impact of the more-of-the-same concept has been an emphasis on process versus outcomes across almost every area of board construction and operation. This was the most common complaint from our discussions with chairs and directors. Their experience was of an enormous tide of advice that compliance with process is, if not a sign of governance excellence, then a sign of appropriate governance practice. At times, complying with processes was also seen as delivering protection against potential legal liabilities.
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