This month the Institute’s eighth biennial Corporate Governance Conference (CGC) will ask whether the institution of the board of directors, inherited from the 17th century, is fit for purpose in today’s business environment. CSj looks at the evolution of the modern board of directors and gives a company secretary’s perspective on how to improve board effectiveness
f you were designing an institution to sit at the top of the corporate decisionmaking hierarchy, tasked with taking all the company’s most important decisions, setting strategic direction and keeping a watchful eye on the performance of management, how likely is it that you would come up with something akin to the board of directors that sits at the helm of most companies globally today? Well, there are a number of fairly obvious design faults with the board as it is currently constituted.
Two of the more salient faults have been recognised for some time. Firstly, one of the primary roles of the board is to monitor management, but it carries out this important task on the basis of information supplied to it by… you guessed it, management. Something not quite right there. Secondly, the other primary role of the board of directors is to direct the company. The proverbial ‘buck’ stops with the board. Directors make all the major strategic decisions that need to be taken and they take collective responsibility for those decisions. But to whom do we entrust all this power and responsibility? Part-timers. Boards typically meet around eight times per year and directors typically spend an average of 16–20 hours a month on board business (see Korn/ Ferry ’34th Annual Board of Directors Study’, 2007).
The fact is, of course, that the board of directors has not been designed but has evolved over the last few hundred years from the governing boards of trading companies in the 17th century. The sheer prevalence of the board of directors as the top institution of corporate governance around the world may give the impression that it is the institution best suited to the governance of modern companies, but is it? As Franklin A Gevurtz, Professor of Law, University of the Pacific, McGeorge School of Law, points out in his 2004 article, ‘The European origins and the spread of the corporate board of directors’, the board is not like the steam engine or the personal computer – a brilliant innovation that quickly spreads around the world because of its obvious advantages. While it certainly has spread to all parts of the world, professor Gevurtz believes that it has done so, not so much through its own merits, but because it hitch-hiked on the global spread of the joint-stock company (see ‘Highly evolved?’ opposite).
So is it time to give the board of directors a rethink? Can the problems mentioned above be overcome, or, more radically, do we need to devise a completely different governance structure to direct companies in the 21st century? A new degree of urgency has been given to these questions since the board spectacularly failed the ‘stress test’ of the global financial crisis. In 2007/ 2008, when a broad range of financial institutions were heading for catastrophic losses and bankruptcy, their boards were apparently oblivious to the risk, continuing to approve management performance and, to add insult to injury, continuing to award themselves hefty pay increases and bonuses for the hard work they were putting into watching over the demise of their companies. The crisis has led to a new willingness to consider alternatives to the institution of the board of directors. ‘The board of directors has outlived its purpose,’ writes Kelli Alces, Florida State University College of Law, in her 2011 article ‘Beyond the board of directors’ (published on SSRN at: http://papers.ssrn.com/sol3/papers. cfm?abstract_id=1893207). It has also led to a number of reports – such as those by the OECD and the Walker Review in the UK – which have tried to identify and correct existing obstacles to board effectiveness. ‘Our approach to regulation in the past was based on the assumption that financial markets could to a large extent be left to themselves, and that financial institutions and their boards were best placed to control risk and defend their firms. These assumptions took a hard hit in the crisis, causing an abrupt shift to far more intrusive regulation,’ writes Howard Davies, former Chairman of Britain’s Financial Services Authority, in a recent article – ‘Economics in denial’ published on the project syndicate website (www.project-syndicate.org).
One positive benefit of the global financial crisis has been to ask some hard questions about board effectiveness and the measures needed to address the deficiencies so graphically highlighted by the crisis. Since an effective board of directors is arguably the most critical element to good corporate governance, the importance of getting this right cannot be underestimated. For these reasons the Hong Kong Institute of Chartered Secretaries has put these issues at the centre of its latest corporate governance conference. In this special conference edition, CSj takes a look at the evolution of the modern board of directors and gives a company secretary’s perspective on improving board effectiveness.
The independence paradox
The original prototype of today’s boards – the governing boards of 17th-century trading companies – were ‘management’ boards because they were made up primarily of controlling owner/ shareholders. This, of course, is still the case with family-run companies where the board is mainly composed of the founders of the business and their closest friends and relatives.
In more widely-held companies, however, where you do not have controlling shareholders, the board’s role tends to become increasingly advisory. Modern corporate governance regulation tends to accelerate this transition from ‘management’ to ‘monitoring’ boards through requirements for a greater number of independent directors and greater reliance on those directors – they are commonly mandated for example in audit and remuneration committees.
Independence is beneficial for the effective monitoring of management and ensuring accountability (the socalled ‘conformance’ role of the board). There are also benefits to be gained in terms of providing owner/ managers with an independent perspective on the direction of the company. If independence is taken too far, however, the board may lose touch with the company and be ineffective at its ’performance’ role (setting corporate strategy and ensuring that it is properly translated into policies and plans for management action).
In interview with CSj (see our June 2010 edition), author and governance expert Bob Tricker called this the independence paradox. ‘Many independent directors fulfil the criteria for being “independent”. They have not been employees, they are not major suppliers or customers, they have no family affiliation with the company, but what you actually need is a director who understands the business, who knows the company, who is familiar with its work and can decide the risks it faces. Here lies the paradox, the more you know about the company the less independent you become, by definition. I believe you need directors who understand the business but are independently minded. They need to be tough-minded enough to take a stand against a powerful chairman, particularly where the chairman is also the chief executive.’
Both of the ‘design faults’ highlighted at the beginning of this article are related to this central dilemma the board faces – how to reconcile its conformance and performance roles. What is the ideal balance between independent and executive directors on the board? Are boards, as they are currently constituted, ‘both too independent to be good managers and not independent enough to be good monitors,’ as Kelli Alces puts it? Of course, different boards address this issue in different ways. Two-tier boards split the conformance and performance roles between two boards, supervisory and executive. Dr YRK Reddy, Founder Trustee & Head, Academy of Corporate Governance, and a speaker in session one of the conference, discusses some of the different approaches, two-tier, unitary and hybrid, in this month’s third cover story on pages 16-19.
Improving board effectiveness – a company secretarial perspective
Improving board effectiveness has become a corporate governance priority since the global financial crisis and regulators, politicians, academics and the media have weighed into this debate – but what useful contribution can company secretaries make?
As readers of this journal are well aware, the company secretary occupies a unique role with regard to the board, and regulators have increasingly been seeking to exploit the opportunities of this role to enhance board effectiveness. For example, changes have been made to Hong Kong’s Corporate Governance Code to make more explicit the role company secretaries are expected to play in ensuring boards function properly.
In particular, Hong Kong Exchanges and Clearing (HKEx) has sought to highlight in the code company secretaries’ governance advisory roles, as well as their responsibility to ensure that directors have access to independent and reliable information. This is perhaps where company secretaries can make their most significant contribution to improving board effectiveness. They are responsible for, among other things:
• advising the board on corporate governance issues
• preparing and circulating board papers before board meetings
• facilitating proper induction and ongoing training and meeting the information needs of board members, particularly non-executive directors, and
• ensuring communication flows between the board and the established committees (audit, remuneration, nomination).
Of course, company secretaries are a part of senior management so they may seem to be of little use in reducing the reliance of the board of directors on information supplied by senior management, but they are in an unusual position in contrast to other senior managers. While as officers of the company they owe loyalty to their company, they also owe loyalty to their profession. They are in-house gatekeepers, their job description and their professional integrity requires them to have the determination to stand up for ethical practice. Moreover, they are explicitly required to be independent in providing advice, and where necessary they are responsible for assisting directors to seek outside, independent, professional advice.
Both the UK and Hong Kong corporate governance codes make explicit the company secretary’s duty to ensure directors’ access to information. For example, new section F of Hong Kong’s Corporate Governance Code states that the company secretary is responsible for, among other things:
• ensuring good information flow within the board
• advising the board on governance matters, and
• facilitating induction and directors’ professional development.
Section F also states that the company secretary is responsible for ‘ensuring board policy and procedures are followed.’ This innocuous sounding item is arguably just as critical as the provision of independent advice. The company secretary’s administrative board support tasks – such as arranging meetings; ensuring board procedures are followed; ensuring that the board complies with regulatory requirements; and that directors have appropriate levels of Directors & Officers liability insurance – are vital components of a supportive decision-making environment for the board.