The changing role of the board in corporate governance

Most definitions of governance emphasize the legal aspects of what it means: rights, privileges, liabilities, and obligations. However definitions of corporate governance tend to refer to systems or processes by which companies are directed and controlled. At a nuts and bolts level, the aim of corporate governance is to address the inherent conflicts of interest between the owners/shareholders of a corporation and its managers: those who make decisions and those who execute decisions.

The main issues that are fundamental to addressing this conflict include: -

• Who speaks for the corporation?
• Who makes decisions, and for whose benefit?
• Who is accountable for these decisions and for ensuring that they are executed fairly and properly?
• Are the Board and Directors individually setting the right tone from the top?

In the debate about how to institute the best standards of corporate governance the focus has been on the role of the board in terms of what characteristics it should adopt and what considerations should inform its actions. Generally accepted objectives of a board include the following: -

• The maximisation of shareholder value
• Securing the interests of the company which should be distinguished from those of other stakeholders such as owners, employees, creditors, suppliers or clients; and
• Ensuring the company acts in a socially responsible manner to foster the sustainability of the company in its wider socio-economic environment.

Defining recommended practice of corporate governance in various frameworks has represented the interpretation and codification of what these objectives mean. In the US, the Blue Ribbon committee was convened to prepare a set of recommendations to strengthen governance practices. In the UK, a series of reports have been released in the last few years: Cadbury, Greenbury, Hampel and the Turnbull reports. The international Organization for Economic Co-operation and Development (OECD) released a set of recommendations in 1999 that builds on these national efforts.

Generally this first set of frameworks and recommended practices focused on subjects such as:

• Board composition and the role of the non executive director;
• The role of board committees in looking at complex and sensitive areas such as financial reporting;
• Whether it was best practice to have an executive chairman;
• Codes of Ethics;
• Board compensation; and
• The importance of transparency in reporting to the market.

Despite the efforts to make boards more responsive to the needs of other stakeholders and also to improve transparency the recent wave of corporate scandals – Enron, Parmalat, WorldCom and Ahold - has pushed the debate from that of recommendations of best practice to one in which the law proscribes what should be done. In the US, congress has passed the Sarbanes-Oxley Act which prescribes expected standards of board practice and related sanctions should directors fail to meet the expected standard.

Sarbanes-Oxley

The Act in simple terms attempts to improve the quality of accounting statements and internal controls over financial reporting by instituting a number of critical measures: -

The creation of a Public Company Accounting Oversight Board (PCAOB): - The purpose of this institution is to provide oversight of major accounting firms but this effectively implies that the profession itself is under scrutiny as a result of the failings of external auditors in cases such as Enron.

The second important requirement seeks to make the provision of quality accounting and operating information and related internal controls the legal responsibility of the board. The act requires each annual report of a company to contain an "internal control report", which shall:

a. state the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting; and

b. contain an assessment, as of the end of the company's fiscal year, of the effectiveness of the internal control structure and procedures of the company for financial reporting.

In addition to these stringent rules the company's auditor has to attest, and report on, the assessment made by the management of the company as well as on the effectiveness of the internal controls over financial reporting. The act clearly states that this attestation shall not be the subject of a separate engagement from the regular audit.

A separate section in the act states that the Chief Executive Officer (CEO) and Chief Financial Officer (CFO) of the company shall prepare a statement to accompany the audit report to certify the "appropriateness of the financial statements and disclosures contained in the periodic report, and that those financial statements and disclosures fairly present, in all material respects, the operations and financial condition of the issuer." A violation of this section must be knowing and intentional to give rise to liability.

Other important requirements are that the Securities and Exchange Commission (SEC) is to require each company to disclose whether it has adopted a code of ethics for its senior financial officers and to state the contents of this code. Also the SEC is to revise its regulations concerning prompt disclosure of infringements to the requirement of immediate disclosure "of any change in, or waiver of," an issuer's code of ethics.

Implications and Considerations

1. The enhanced role of the Audit Committee: - The act seeks to protect the investing public and underpin the workings of capital markets by demanding a higher standard of care from board members and company officials. In practice this has to be achieved through the role of the board and its sub committees in particular the Audit committee. Directors will ultimately be held legally accountable by other stakeholders for the adequacy of their risk management oversight.

Practical implications for the Audit Committee include the following:

a. The committee should be in charge of the relationship with the external auditor and in addition manage the financial governance system of the company;

b. It would seem that management should have at best a limited role in the relationship with the auditors. By implication the audit firms will have to rethink the scope and nature of their business relationship with their clients.

c. There must be channels for employees to communicate concerns and issues that they come across. Such channels should be structured such that employees can act without fear of reprisals. Also the committee should put in place a programme of orientation and education about this new process.

2. Though the new corporate governance laws don’t require directors to become risk management experts, they do need to know how the system works and be able to gauge and demonstrate its effectiveness. In particular CEO’s and CFO’s have to be surer of the quality of information that the company is putting out than they have been in the past. The role and expertise of internal audit departments has to be reviewed and improved to support this new regime. In particular internal audit departments have to develop Enterprise Risk Management to assist and provide assurance services to management and the board.

3. The role of independent directors is becoming even more important because their presence ensures fewer conflicts of interest. However the downside of having more independents is that they generally may not be that knowledgeable about the innate workings of the company.

4. Boards have to re-evaluate their role in terms of whether it is to monitor or to partner with top management. The act seems to insist that the board should act as a monitor. Questions that each board has to consider to resolve these issues include:

a. To what extent are we going to monitor what is going on?
b. What decisions do we really want to be engaged in?
c. And what issues do we want to offer advice on?

5. Though the act was perceived in a positive light to protect stakeholders some experts perceive it to have generated negative attention from many directors: -

a. There is speculation that attention is now more focussed on issues of form and structure rather than the substantive responsibilities of strategy, guidance and direction to top management;

b. Because of concerns about personal liability and reputation there is a fear that directors will become risk-averse which may ultimately not add to shareholder value;

c. The costs of properly instituting the act is viewed as high and may actually hinder the growth of market activity re listings, takeovers, mergers and acquisitions;

d. Issues of personal liability and also a higher level of expertise will reduce the pool of potential directors to choose from. Besides, directors may overtime become less willing to sit on more that two or three boards because of the increasing burden of responsibility.

In conclusion the role of the board is changing in response to changing codes of practice and legal requirements that are being imposed by acts such as Sarbanes-Oxley. Clearly boards have to go through a process of self-evaluation to decide on how best to respond to these new challenges. Critical amongst the issue for consideration is the balance to be struck between policing and partnering management – this will really depend on the stage of development of the company, the new structures to be put in place internally to ensure compliance and the restating of the role of the audit committee vis a vis the relationship with external auditors.