This module focuses on how a board ensures effective governance.
Conformance and Performance Functions
In Module 1, the four main functions of the board of directors were considered for deploying good governance in the organisation. The functions are shown in the image.
We will now look at how the board interacts with the senior executives in the organisation to perform these functions.
Strategy Formulation and Policy Making are known as the Performance Functions of the board. These are two functions that establish the performance of the organisation both now and in the future. They are also regarded as “Future Focused” because the directors need to look to the future in order to put strategies and policies in place to serve the organisation. Strategy Formulation is considered to be Outward Looking as the environment in which the organisation operates needs to be considered. Policy making on the other hand is inward-looking because it sets up the process of how the organisation will act internally.
The other two areas of Accountability and Supervision of Executive Activities are regarded as conformance areas of the governance process. Both of these activities are past and present-focused. Accountability refers to compliance reporting and reporting to shareholders and other stakeholders. The supervision component is inward-looking as it focuses on the performance of executives within the organisation.
The formulation of strategy sets the strategic direction of the organisation. Part of this process is consideration of the core values of the organisation, its purpose and its level of risk tolerance. Documentation related to this process is the Vision Statement, Mission Statement, Values Statement and Purpose Statement. These are all established by the Directors and set out what the organisation is about and how they intend to achieve their goals.
Executive directors, as you would expect, have a deeper understanding and knowledge of the organisation than non-executive directors. As a result, they can contribute significantly towards the formulation of strategy. This is a two-edged sword however and the Agency Problem can come into play if executive directors use their position to benefit themselves as opposed to the shareholders. The independence of non-executive directors is therefore crucial in providing balance and good governance.
Irrespective of the process of determining strategy, the board needs to be able to demonstrate good governance processes and independence regarding the outcomes.
Strategic planning is the first step. After that, the organisation needs to put policies in place to guide the actions of management. Quality policies are essential to any organisation. They should clearly define what processes, systems and procedures should be applied in managerial circumstances. Because of their operational knowledge, senior executives would arrange for the drafting of these policies which are ultimately reviewed and approved by the board. A significant test of a policy is that it must support the strategic direction of the organisation that has been agreed upon. The purpose of board approval of policies again comes back to the Agency Problem and puts the independence of the Board into the mix.
Supervision of Executive Activities
The most widely used tool for the supervision of executive activities is accounting based. Financial reports provide information on budget to actual, collection periods for debtors, rate of inventory turnover etc. Directors need a good working knowledge of such reports and ratios in order to fulfil their duties in the supervision of executives.
In addition to accounting information, a board may also look at customer satisfaction surveys, employee turnover and even market reputation factors.
Traditionally, the view has been that boards are accountable only to the shareholders. This view is changing however as a result of triple bottom line and ESG reporting where stakeholders are also an important factor. Indeed, it could be argued that the satisfaction of stakeholders is something that shareholders would want to be informed about. Stakeholder satisfaction, as has been demonstrated in Financial Management areas, leads to greater levels of sustainability for an organisation.
In addition to shareholders and stakeholders, there are also legal requirements by which an organisation is bound. These include corporations law or similar depending on structure, securities exchange regulations, accounting standards and taxation law.
The Board, like management, needs to be divided into tiers in order to achieve the greatest level of effectiveness. One way of doing this is to create sub-committees. Certain responsibilities can be delegated to these sub-committees to save the time of the board.
As a result of the 1992 UK Cadbury Report, governance codes now suggest a system comprising an audit committee, a remuneration committee and a nomination committee. Names of these sub-committees will vary between organisations, but their function will be similar. Sub-committees also provide the opportunity to match directors with particular skill sets that suit. It is however recommended that the chair of such committees be independent non-executive directors to maintain independence and help prevent executive directors from dominating the processes when making decisions.
The function of the audit committee is critical to any organisation. According to Principle 4 from the Corporate Governance Principles and Recommendations (ASX 2019, p. 19), “a listed entity should have appropriate processes to verify the integrity of its corporate reports”. It could well be argued that this is not a tenet to be observed only by corporates but by not-for-profits and other organisations as well.
An audit committee is essential as a link between external auditors and the board. When external audits take place, they are done on the basis of exception, that is only problems are noted. These would be raised with financial staff in the audit process and may well be rectified before the audit report is written and lodged with the organisation. Consequently, board members may never become aware of areas within the organisation that are having problems that need resolving. The audit committee solves this problem by keeping the board appraised of any issues that arise.
The role of the audit committee will be established through a charter or terms of reference that will be approved by the board.
Although the audit committee has a significant number of roles and responsibilities, some are regarded as critical and include (Tricker 2019, p.408):
- advising the board of the company’s systems of internal management control
- oversight of internal audit
- liaison with the auditors and reporting to the board on the audit process and any issues
- reviewing financial information to be provided to shareholders and others
- advising the board on matters of board accountability
- oversight of enterprise risk management corporate governance compliance.
Tricker (2019) also lists many other activities of the audit committee that are too extensive to detail in these notes.
The Remuneration Committee
The remuneration committee structures the packages of the directors and senior management. The area of packages for CEOs and others is a matter of robust debate, particularly in the area of bonuses. Here it is worthwhile quoting the Australian Securities Exchange on director’s remuneration.
“A listed entity should pay director remuneration sufficient to attract and retain high quality directors and design its executive remuneration to attract, retain and motivate high quality senior executives and to align their interests with the creation of value for security holders and with the entity’s values and risk appetite”(ASX 2019, p29).
Packages need to be finely balanced to retain quality staff at market rates and motivate them to maximise the organisation’s performance, not just in terms of profit, but in terms of all stakeholders’ interests. The Agency Problem rears its head yet again.
The Nomination Committee
The second principle in the Australian Securities Exchange Corporate Governance Principles and Recommendations states that:
“to facilitate the effective functioning of the board and to promote investor confidence, there should be a formal, rigorous and transparent process for the appointment and reappointment of directors to the board”.(ASX 2019, p12)
The appointment and reappointment of directors is an important process of the board. Transparency is essential as is diversity and inclusion when it comes to stakeholders and balance on the board. It would seem that the nomination committee is one of the most favoured to serve on as it can ultimately influence control of the board. The committee has specific roles which include:
- board succession planning
- induction and continuing professional development programs for directors
- the development and implementation of a process for evaluating the performance of the board, its committees and directors
- the process for recruiting a new director, including evaluating the balance of skills, knowledge, experience, independence and diversity on the board and, according to this evaluation, preparing a description of the role and capabilities required for a particular appointment
- the appointment and re-election of directors
- ensuring that there are plans in place to manage the succession of the CEO and other senior executives.
Organisations can set up various committees that may be unique to their particular needs in their areas of operation. Financial services for example may have a risk committee to evaluate their loan portfolio, rates of delinquency etc. Others may have a committee that oversees Corporate Social Responsibility (CSR) and apparently, BHP has set up a sustainability committee, one that is possibly very important given climate change and environmental controls around the mining industry.
The functions of a board have been divided into four specific roles which clearly define activities it needs to pursue. For an organisation to be sustainable, it must be forward-looking, so an appropriate amount of time needs to be allocated to strategic planning and then monitoring performance.
We have also discussed sub-committees here and their role in specialist functions, utilisation of the skillsets from particular directors and reducing the overall work of the board itself.
Two issues that this module highlights are the need for constant awareness of the Agency Problem and the importance of independence on the board and with directors and their decisions.
Assessment 1 requires the review of a public company Board and comparing with another in the same industry. I have chosen to review Rio Tinto Ltd and compare it to Fortescue Metals Group. In particular I intend to research the actions at Juukan Gorge and the impact it had on Rio Tinto’s share price and reputation.References
- Tricker, B 2019, Corporate governance: Principles, policies and practice, 4th edn, Oxford University Press, London.
- ASX Corporate Governance Council 2019, Corporate Governance Principles and Recommendations 4th Edition, viewed 5 November 2022, <https://www.asx.com.au/documents/asx-compliance/cgc-principles-and-recommendations-fourth-edn.pdf>.