Tony Featherstone explains why boards of ASX-listed companies must ensure they prepare and respond to the new Corporate Governance Principles and Recommendations.
Boards of listed companies sometimes respond to governance changes in two ways: they see new guidelines as yet another compliance burden and threat; or they underestimate the significance of change and take too long to prepare for its implementation and reporting.
That could be true of changes to the ASX Corporate Governance Council’s Corporate Governance Principles and Recommendations (the principles). The third edition, effective on 1 July 2014, means ASX-listed entities with a 30 June balance date are expected to measure and report on their governance practices against the recommendations from the 2014 – 15 financial year.
For boards, that potentially means the organisation publishes a capabilities matrix on director skills in the next annual report; outlines induction and professional development programs for directors; discloses if there is an internal audit function and how it is structured; and if there are material economic, environmental and social sustainability risks, and how they are managed.
Companies, of course, do not have to provide detail on all recommendations in the principles, thanks to the non-prescriptive “if not, why not” approach to disclosure. And companies such as BHP Billiton already provide strong disclosure around director skills.
But market pressure will build on listed companies to detail how their governance practices align with the new recommendations.
“The implications of these changes are very significant and many boards and investors have not yet come to grips with what they mean and where they will lead,” says Michael Robinson MAICD, executive director of Guerdon Associates, a leading remuneration and board consulting firm. “Proxy advisers and investors will begin by looking closely at how board skills match disclosed organisation strategy, and will exercise their voting power if there is clear misalignment.”
Governance expert Steven Cole FAICD, says: “I suspect some boards will have gone to sleep on these recommendations because they didn’t have to introduce them for 12 months. There’s a lot more in the implementation of these recommendations than meets the eye. There’s also a lot more prescription around how to disclose governance information and the general expectation is that disclosure will need to be more meaningful than it has in the past.” Cole is deputy chairman of Neometals and a non-executive director of Matrix Composites & Engineering.
As boards implement specific recommendations, the bigger question is how the changes fit together, how it affects board composition and the next steps. The format and possible publication of director skills matrices is rife with complication: what happens if a rigorous external assessment of board skills shows significant gaps and too many directors whose skills are not aligned with strategy? Will this lead to higher board turnover?
The changes should elevate the company secretary’s role within organisations. Recommendation 1.4 in the principles says the company secretary should be directly accountable to the board, through the chair, on all matters to do with the board. They will have more work, as recommendation 2.6 suggests greater focus on board induction and professional development, tasks that will surely fall on the company secretary in concert with the chair.
“It’s a very serious role that has tended to move up and down the reporting line over the years, in terms of the distance to the CEO,” says Cole. “There’s now a grand opportunity for the company secretary to really step up a few pegs, following the changes to the principles.”
Recommendation 7.3, that a listed entity should disclose it has an internal audit function, or if not, the processes used for evaluating risk and internal controls, is particularly problematic for smaller listed companies, many of which do not have specialist internal audit functions.
Recommendation 7.4, that companies disclose material sustainability risks, and how they are being managed, is another challenge. Some boards are concerned about the move to publish more non-financial information and whether quantifying these risks or providing forward-looking statements will make the organisation easier prey for activists.
Ramsay Health Care company secretary and group general counsel, John O’Grady FAICD, says there is a risk of over-regulation. “The ASX Corporate Governance Council must ensure that the principles do not divert attention of boards away from creating shareholder value and focusing on their company’s strategic goals, towards ticking more boxes for compliance.
“I feel the principles are on the brink of getting too intrusive for boards. I appreciate the ‘if not, why not’ approach provides flexibility, but there will be greater pressure on boards to ensure the organisation adheres to the new recommendations. Australia already has very high governance by global standards. I’m not convinced as to the need to impose extra governance requirements on boards in this country.”
Alan Cameron AO FAICD, chair of the ASX Corporate Governance Council, says the changes in the principles’ third edition are more about “tidying up” certain governance matters than fundamentally “raising the governance bar” or increasing the regulatory burden.
“The council is not mandating specific disclosure or seeking great detail from companies on their compliance with the recommendations, unless they choose to provide it. We do expect listed entities to show they have thought carefully about the issues in the latest edition of the principles, and if they choose not to follow them, to explain why. Allowing companies to use the websites for routine disclosures will reduce the reporting burden.”
Although it is not mandatory, Cameron expects larger ASX-listed companies to publish a board skill matrix in their annual report. “The council felt it appropriate that boards outline the skills which they collectively have or are seeking to have, and some may choose to identify any skill gaps, and the type of directors they would look to recruit to fill those gaps,” he says. “It will help directors currently not on the board, who have the required skills, to put themselves forward. And it will help investors to make up their own mind if the board’s skills are a good match with the organisation’s strategy. It’s not an onerous requirement.”
Cameron says the recommendation that boards disclose director induction and professional development programs is also manageable. “It should not substantially lift the bar on director training. What it will do is give boards reason to pause, and recognise if additional induction and development programs are needed. There is always a risk that boards neglect ongoing professional development because they assume all directors are sufficiently experienced, up to date, and knowledgeable.”
Recommendations around disclosing economic, environmental and sustainability risks, and that of the organisation’s internal audit function and risk-management processes, are an important part of the latest principles, Cameron says. It is the first full revision of the principles since the global financial crisis (GFC). The last full revision was the second edition in 2007.
“When we looked at what had happened during and after the GFC, it was clear that investors and their representatives wanted more reporting on how boards are governing organisation risk,” Cameron says. “That is entirely appropriate. Again, we don’t expect boards to outline their organisation’s risks in great detail, but to explain that there is a process to consider the main risks.”
Cameron says an elevation of the internal audit function and company secretary role in listed entities over time is a natural evolution. “In governance terms, company secretaries have a very important role. Best practice suggests they should report directly to the board on governance matters, and even if they report to the CEO on other matters, their reporting line to the board is very significant.”
Some omissions from the principles, notably around director tenure and annual elections for directors, also occupied the council’s thinking, Cameron says. “Director tenure was a big debate. When we reviewed the principles, it was clear that Australia was the only major comparable market whose basic governance guidelines made no reference to tenure.”
Recommendation 2.3 suggests disclosure of how long each director has served, but it is only in the commentary that a length of time is specified. The commentary says: “The mere fact that a director has served on a board for a substantial period does not mean that he or she has become too close to management to be considered independent. However, the board should regularly assess whether that might be the case for any director who has served in that position for more than 10 years.”
Cameron says the council deliberately put the reference to a number of years in the commentary rather than the recommendation to help boards of entities regulated by the Australian Prudential Regulation Authority (APRA). APRA tends to apply the principles on a mandatory basis to organisations it regulates. “We couldn’t leave the third edition of the principles in a way that would have made it mandatory for directors of APRA-regulated entities to retire after their third three-year term on the board.”
The third edition also includes changes that provide much greater flexibility for listed entities to make governance disclosures on their website rather than in their annual report, a noticeable improvement. With some annual reports resembling telephone books, significant streamlining of their content was long overdue.
Also, few could argue that the third edition’s increased focus on the reporting of risk oversight is inappropriate. In a press release accompanying the changes, the council said: “The recommendations on risk (recommendations 7.1 – 7.4) have been substantially enhanced to reflect the lessons of the GFC. The council would encourage all listed entities to review the enhanced risk recommendations carefully and to consider whether they need to upgrade their corporate governance practices in this area.”
Moreover, many high-performing boards, particularly those of S&P/ASX 200 companies, are well on top of the changes. The challenge, as always, is for mid-size and small companies to embrace the governance recommendations and report on their implementation, rather than take the easy approach of not complying and explaining that it is because of the organisation’s lack of resources.
Cameron is correct when he says the changes are more about governance housekeeping than a sweeping change in governance settings. But the big unknown is how institutional investors and their advisers use extra governance information to challenge boards on director skills or tenure, or how activists use information around sustainability risks to argue their case.
Never before has the alignment between board skills and organisation strategy been quantified in such a way.
Here are 13 board considerations for implementing the principles’ third edition:
1. Articulating the board skills matrix
Although it may be tempting to articulate generic skills in the matrix, such as “professionalism” and “financial expertise”, it is more useful to focus on the specific skills needed on the board that align with the organisation’s long-term strategy. BHP Billiton (in its annual report) is a good example of how skills matrices can demonstrate specific board requirements, while treating generic governance skills as threshold skill requirements.
Dr Vince Murdoch, who leads the board review practice at Egan Associates, says boards must carefully consider the capabilities represented in the skills matrix. “Some organisations will struggle with this skill matrix more than others. Too often I see elements in the capabilities matrix that are generic threshold skills that all directors should have, not specific skill requirements that provide better information for stakeholders. For example, a superannuation company might need the board to have strong skills in understanding legislative change, in mergers and acquisitions experience, or wealth management capability, yet decides to assess directors against threshold skills that are not as sensitive.”
2. A static or evolving skills matrix?
The risk is that boards, having worked with an independent adviser or developed a skills matrix internally, treat it as a static document. As organisation strategy or market circumstances change, so too should the composition of board skills.
For example, a resources company board might have decided it needed capital-raising skills to guide management as a costly new plant is financed and built. But a commodity price downturn means capital is unlikely to be raised and those board skills are less critical for the next few years. Instead, the board decides it needs more skills in asset divestments, to raise cash and help the company survive.
“Directors can lose their currency on a board, not because of their individual capability, but because circumstances change,” Murdoch says. “Keeping the skills matrix up-to-date will be a real challenge for boards as forces such as market volatility and changing customer demands require them to reassess their skill mix. The matrix is not something boards can do and leave on the shelf for five years.”
3. Hard or soft skills?
Murdoch says boards that have chosen to disclose their board skill matrices have historically been focused on hard skills, such as finance, law or strategy. They have tended to give less attention to soft skills, for example “behaviours”, required on the board.
“It’s likely to be a real challenge for boards to include required behaviours from directors in their skills matrix, even though there is much to gain from doing so,” Murdoch says. “We often think about capabilities as knowledge and technical skills, yet disclosing required behaviours at board level, and assessing directors against it, can set a strong example from the top. It sends a clear message to directors, employees, investors, customers and other stakeholders about what the organisation values.”
4. How formal is the skills assessment?
Under recommendation 2.2, disclosing a skills matrix suggests a more formal assessment of these skills is required, through independent board-effectiveness reviews.
Guerdon Associates’ Michael Robinson says board reviews need to be more systematic. “The process of the chairman reviewing individual directors, as part a board effectiveness review, is too ad hoc and informal in many companies. Some do not receive external assistance with the board effectiveness review. A more formal assessment of directors, with external assistance, will be required more often where boards are serious about sustainable high performance.”
5. Aligning the skills matrix to strategy
For some listed entities, a proper alignment of board skills with the long-term strategy could expose skill deficiencies. For example, a media company that sees its future online but has few directors with technology skills; or a service company that wants to expand into Asia in the next three years but lacks cultural diversity on the board or directors experienced in the region.
Robinson says: “Boards will have to take the strategy review a step further and ask which skills are needed around the board table to help shape and govern that strategy now and in the future, develop that into a matrix, and question whether current directors possess those skills.”
6. Managing the fall-out from skills gaps
After a formal, independent skills review, it might be obvious that the board has too many skills in one area and gaps elsewhere. A director with strong self-awareness could see that as a cue to retire from the board, knowing their skills no longer match the organisation’s needs at this point in its strategy. In other situations, the chairman might have to manage a delicate situation, to encourage directors who have surplus skills not to seek re-election to the board.
“It will take a developed level of emotional intelligence on the part of directors to recognise their skills have become redundant for that particular board,” Robinson says. “It can be hard to admit you do not have the required skills, and chairmen will have to manage that process carefully, particularly if a board has to make room for a new generation of directors. There could be a lot of difficult conversations on boards if the skills matrix is done well. But challenging conversations and good levels of emotional intelligence are a feature of high-performing boards.”
7. Competitive issues around skill disclosure
In theory, publishing a skills matrix to help investors assess the alignment between board composition and strategy makes great sense. In reality, flagging that new skills on the board are needed to oversee an evolving strategy could provide information for competitors.
For example, a telecommunications company might decide it needs more skills on the board around healthcare, as it targets the emerging e-health market. Or that it needs directors with mergers experience, because it has its eye on acquisition targets. “I expect the skills matrix will be quite generic at the start, because boards will not want to give too much information away,” Robinson says.
“Over time, the market will pressure companies for more information and boards will need to think carefully about the extent to which they disclose future required skills, and whether that disclosure could tip off the market about commercially sensitive strategy.”
8. Approaches from prospective directors
The ASX Corporate Governance Council clearly sees a published skills matrix as a way for boards to signal their needs to prospective directors. The unknown is whether that leads to more approaches from directors who would like to join the board, and higher board turnover. Egan’s Murdoch says: “It’s been commented on before in the United States, that many Fortune 500 companies have at least one director who is underperforming. A skills matrix potentially is a way for boards to identify underperforming directors, encourage them to leave or seek development, and appoint new blood on the board.
“It could also lead to boards receiving more approaches from other directors if skills gaps are disclosed. A well-considered skills matrix is a good way to help prospective directors understand if they are suited to the board.”
9. Director induction and professional development
Having a clear process for directors who join a board and ongoing development opportunities is common on boards of larger organisations. However, it might present a challenge for mid-cap and small listed companies that want to meet the new recommendation 2.6, which says a listed entity should help directors develop and maintain skills needed to perform their role.
The cost of such programs could be problematic for smaller mining companies, some of which are cutting directors’ fees to help preserve cash amid falling commodity prices. For larger companies, a skills matrix analysis could identify skills gaps that can be addressed by development opportunities and extra cost for the organisation.
10. Complications in the company secretary role
Crafting and maintaining a skills matrix, and ensuring sufficient director induction and development, probably means more work for company secretaries. The risk is that company secretaries, who have a direct reporting line to the chief executive officer or chief financial officer, find greater tension in the allocation of their time between governance and executive duties.
11. Governance information
Recommendation 6.1, that listed entities provide information about their governance on their website, sounds simple in theory. In practice, this could mean hundreds of pages of impenetrable information, at least for retail investors, on the website. Providing sufficient information that helps stakeholders understand the organisation’s governance approach, without overwhelming them, could be a bigger challenge than realised.
12. Director independence
The factors for director independence (box 2.3) have been amended to require an expansion of references to material business relationships over three years; the disclosure of any close family ties that could affect independence; and the overly long service as a director.
The material business relationships requirement could be difficult for smaller listed entities that have directors who currently, or have, served as consultants to the organisation. The family ties requirements could test directors of smaller listed entities that have a family-business background, and the tenure test, while not overly prescriptive, will put more focus on boards that have directors in their fourth term or beyond.
13. Board fees
The establishment of a new risk committee, or an expanded role for the nomination committee to focus around board skills, will add to director workloads. The response could be more requests in the annual general meeting season for a higher fee pool for directors, to compensate them for extra governance work in the third edition.
The nine new recommendations in the third edition of the ASX Corporate Governance Council’s Corporate Governance Principles and Recommendations are:
Recommendation 1.2: A listed entity should: 2 (a) undertake appropriate checks before appointing a person, or putting forward to security holders a candidate for election, as a director; and (b) provide security holders with all material information in its possession relevant to a decision on whether or not to elect or re-elect a director.
Recommendation 1.3: A listed entity should have a written agreement with each director and senior executive setting out the terms of their appointment.
Recommendation 1.4: The company secretary of a listed entity should be accountable directly to the board, through the chair, on all matters to do with the proper functioning of the board.
Recommendation 2.6: A listed entity should have a program for inducting new directors and provide appropriate professional development opportunities for directors to develop and maintain the skills and knowledge needed to perform their role as directors effectively.
Recommendation 4.3: A listed entity that has an annual general meeting (AGM) should ensure that its external auditor attends its AGM and is available to answer questions from security holders relevant to the audit.
Recommendation 6.1: A listed entity should provide information about itself and its governance to investors via its website.
Recommendation 6.4: A listed entity should give security holders the option to receive communications from, and send communications to, the entity and its security registry electronically.
Recommendation 7.3: A listed entity should disclose: (a) if it has an internal audit function, how the function is structured and what role it performs; or (b) if it does not have an internal audit function, the processes it employs for evaluating and continually improving the effectiveness of its risk management and internal control processes.
Recommendation 7.4: A listed entity should disclose whether it has any material exposure to economic, environmental and social sustainability risks and, if it does, how it manages those risks.
Of these, recommendations 1.2(b), 1.3, 1.4, 2.6, 4.3, 6.1, 6.4 and 7.3 appeared in one form or another as guidance in the commentary in the second edition and so are not completely ‘new’. They have been elevated from commentary in the second edition to recommendations in the third edition, on the basis that the Council believes that they should now be considered contemporary governance standards rather than matters of mere guidance.
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