An update on corporate governance in the wake of the credit crisis

A number of recent reports have identified deficiencies in the corporate governance practices of many failed companies. These findings include deficient risk management practices, weaknesses in board composition and the failure of non-executive directors and shareholders to effectively monitor decisions of the board.

Consultant Andrew Brown and solicitor Sophie Gladwell take a closer look at some of these reports and highlight some key findings for New Zealand companies' corporate governance practices.

RESEARCH HIGHLIGHTS POOR CORPORATE GOVERNANCE PRACTICES

Since the Enron scandal in 2001, there has been an increased awareness of the significance of corporate governance, and the role it plays in ensuring a company's accountability, legal compliance, stakeholder relationships and performance.

It is therefore not surprising that the current credit crisis has led to a new focus by regulators, shareholders and others on poor corporate governance practices in search of answers to the recurring question: how could it all have gone so wrong?

Attention has been particularly focused on executive remuneration practices, which are widely thought to have encouraged excessive risk taking, as one key area of corporate governance requiring reform. In February 2009, new guidelines were introduced in the United States, restricting executive pay for companies receiving government financial assistance, and a range of reform proposals are currently under consideration in Australia¹ to address executive remuneration issues. Similar concerns and developments are evident in Europe and Asia.

However, remuneration policies are not the only corporate governance issues being linked to the current economic crisis and company failures. Deficient risk management practices, weaknesses in board composition, and the failure of non-executive directors and shareholders to effectively monitor and scrutinise the decisions of boards are also being highlighted as key areas requiring reform to avoid future failures.

Risk management

The global financial crisis has been a salutary reminder of the importance of risk management at all levels of an organisation. The OECD published a report in February 2009 ("The Corporate Governance Lessons from the Financial Crisis") which concludes that the crisis can:

"to an important extent be attributed to failures and weaknesses in corporate governance arrangements which did not serve their purpose to safeguard against excessive risk taking in a number of financial service companies."

The report primarily examines the banking sector, and significant events involving banks such as UBS, Société Générale and Bear Stearns, and suggests that in some circumstances, information concerning risk was used inadequately.

The report notes that less effective boards were unaware of strategic decisions being made by management and had not implemented an effective mechanism to enable the board to oversee the bank's risk appetite. In addition, certain boards had a limited technical understanding of products (such as mortgage-backed securities) and a lack of control over balance sheet growth and liquidity needs.

The lack of an active risk committee was cited as another possible reason for ineffective risk management, as Lehman Brothers' risk committee was noted as meeting only twice (in 2006 and 2007) and Bear Stearns' committee was formed just before it collapsed.

The report also identifies the inferior prestige and status afforded to risk management staff as a possible contributing factor. For example, Société Générale informed its shareholders of an "imbalance...between the front office, focused on expanding its activities, and the control functions which were unable to develop the critical scrutiny necessary for their role". The US Securities and Exchange Commission (SEC) recognised that one feature of Bear Stearns' failure was that staff involved in risk worked in close proximity to traders, which suggested to the SEC that risk managers suffered a lack of independence.

The report also acknowledged that although rating agencies, disclosure and accounting standards played a role in causing the credit crisis, the best boards were able to use their own powers to overcome the weaknesses and associated risks in these areas. Effective boards had implemented systems that led to the efficient sharing of information, and open dialogue across management and the board.

Board composition

In New Zealand, the most glaring example of failures in corporate governance has been in the finance company sector. A recent report issued by the Registrar of Companies to the Ministry of Economic Development² highlights board composition and the competence of directors as key factors which contributed to the collapse of 29 finance companies in New Zealand over the last two years.

The report notes that the boards of these finance companies tended to lack the breadth of experience and skills required to oversee the scale, complexity and characteristics of financing operations. It also points out that several of the companies were led by a dominant chief executive who was the "principal architect of the company's modus operandi". Further, a pattern was recognised where several directors had previously been involved in finance industry failures. The new Non-Bank Deposit Taker rules should help to address this shortcoming through prescribed corporate governance standards and "fit and proper" checks for senior management.

The Registrar also criticised a raft of behaviour exercised by the boards of these companies. The report states that "too often directors were not adequately informed, misled or failed to take sufficient interest in the affairs of the company". It also identifies instances of excessive related party lending, the adoption of practices that masked the true performance of loan portfolios, and the use of funds received for investment from new investors being used to repay the maturing loans of existing investors.

Non-executive directors and shareholder passivity

The UK Treasury published a report on the banking crisis in May 2009 ("Banking Crisis: reforming corporate governance and pay in the City") which states that "banks have failed because those leading and managing them failed"³. The UK Treasury quotes PIRC, a leading UK corporate governance consultancy, which accuses boards of being primarily responsible for the failure of banks because they "approved the business strategies and products that have caused such damage".

The UK Treasury has highlighted a failure of non-executives to fulfil their role of effectively overseeing and acting as a check on executive directors, and the UK Treasury suggested that some boards "operate as members of a ‘cosy club'". In order to address the current failings of non-executives, the UK Treasury has suggested some areas for reform:

• to limit the number of non-executive directorships that an individual can hold;
• to require non-executives to have a relevant professional qualification to sit on the board;
• to broaden the talent pool from which the banks can draw upon in appointing non-executives; and
• to examine ways in which the relationship between institutional shareholders and non-executives can be strengthened.

Institutional shareholders have also been accused of failing in their task of scrutinising and monitoring the decisions of boards. While the UK Treasury suggests that further consideration should be given to reform in this area, PIRC has subsequently suggested that the problem may not be the corporate governance framework or mechanism itself, "but the failure of some shareholders to use the rights they have effectively".⁴

IMPLICATIONS FOR NEW ZEALAND

With the global spotlight on corporate governance practices and the likelihood of increased government scrutiny of corporate conduct on the horizon, it is an opportune time for New Zealand companies to assess the effectiveness of their own corporate governance practices.

The New Zealand Securities Commission has already announced that it will review the corporate governance disclosure practices of selected listed issuers as part of its ongoing financial reporting surveillance programme. In making this announcement, the commission's chair, Jane Diplock, noted that there was a need for "greater assurance that issuers have robust corporate governance arrangements in place" in the current financial climate.

The starting point for any corporate governance review will be based on New Zealand's own approach to "best practice" in corporate governance, as envisioned by company law, the NZX's Corporate Governance Best Practice Code, and the Securities Commission's set of nine principles entitled Corporate Governance in New Zealand – Principles and Guidelines . Together, these provide a comprehensive framework for companies to develop sound corporate governance practices.

However, New Zealand companies should also be mindful of the recent corporate governance issues being highlighted in other jurisdictions. Some of the key themes on corporate governance practices arising out of the reports noted above and other overseas studies include the following:

• Boards should ensure they have access to all relevant information. This includes ensuring that there are appropriate systems of control in place - in particular for risk management, financial and operational control, and compliance with the law.
• Companies should consider re-emphasising the roles of the CEO and the board in the risk management process so that they can properly oversee, monitor and have a forward looking perspective of risk issues. In addition, boards should consider having separate risk and audit committees.
• Boards should ensure that, when an independent director is selected, the focus is not only on independence and objectivity but also on capabilities. This may include acquiring appropriate skills upon appointment, and ensuring they keep up-to-date with relevant laws, regulations and changing risks through in-house and external training.
• Participation of non-executive directors should be encouraged. For example, if directors have not had sufficient experience of the specific market in which the company operates, as their experience comes from other arenas, the relevant directors should be given market specific training, enabling them to be aware of the relevant risks, and apply the corporate governance principles to their company.

For further details on New Zealand's corporate governance requirements and how to improve practice and procedure, please feel free to contact your usual Bell Gully adviser.

 

¹ Australia is proposing to introduce amendments to the Corporations Act 2001 (Cth) aimed at curbing what it terms 'excessive golden handshakes' or termination payments paid to departing company executives. It has also directed the Productivity Commission to undertake an inquiry into the current Australian regulatory framework around executive remuneration.

² 2007/08 financial review of the Ministry of Economic Development, Report to the Commerce Committee (dated 19 March 2009)

³ Banking Crisis: reforming corporate governance and pay in the City. www.publications.parliament.uk/pa/cm/cmtreasy.htm HM Treasury's report examined and made recommendations for change in areas such as corporate governance, remuneration and the roles of credit agencies, auditors, the media and accounting standards.

⁴ www.pirc.co.uk/news/story336.html

Enquiries and information

For more information on any of the cases, articles and features in Financial Services Quarterly, please email Rachel Gowing or call on 64 9 916 8825.