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Corporate governance in the credit crisis: an update for in-house counsel
First published NZLawyer, 10 July 2009.
It has been eight years since Enron placed corporate governance under the spotlight for companies, investors and governments worldwide and the global financial crisis has renewed that focus.
While there have been many lessons learned and changes made since the 2001 scandal, deficiencies in corporate governance practices remain and have been highlighted by many corporate failings.
It is not surprising that corporate governance and its role in controlling and monitoring the business of companies is being scrutinised again as regulators, shareholders and others seek answers to questions such as how could it all have gone so wrong? And, more importantly, what lessons need to be learnt to avoid future crises?
The Organisation for Economic Co-operation and Development (OECD) has said that the "most obvious lesson is that corporate governance matters"1. Indeed, various reports into the crisis have revealed significant failuresin four key areas: pay and bonuses, risk management, board performance and the involvement of shareholders.
In-house counsel can expect renewed focus on governance from their boards and others and may want to consider responding proactively to latest developments. This article provides background to the issues and some suggestions for developing best practice.
Pay and bonuses
In several jurisdictions worldwide, the business, public and regulatory worlds' attention has been focussed on executive remuneration practices, which are widely thought to have encouraged excessive risk taking.
The OECD notes that "there are big problems with the 'pay for performance' system"2 which has caused a great deal of public anger in Europe, the US, Australia and elsewhere. However, according to the OECD, "pay for performance does work, but needs to be better managed and more transparent". Problems can arise, for instance, where remuneration decisions are not carried out at arm's length and it can be hard to establish the link between performance and remuneration.
Despite the OECD's view that the current system can work, reform in this area is becoming widespread. For example, in February new guidelines were introduced in the US to restrict executive pay for companies receiving government financial assistance. Reform proposals are also under consideration in Australia, aimed at curbing what the government terms "excessive golden handshakes" paid to departing company executives. Similar concerns and developments are evident in Europe and Asia.
Risk management
The global financial crisis has revealed widespread and massive failures in risk management practices. Many economists, organisations and governments have suggested a link between poor risk management and corporate failings. One interesting example was recently given by the UK's Chancellor of the Exchequer, Alistair Darling:
Last summer, just as the crisis began to bite, a senior banker told me that 'from now on we will only lend when we understand the risks involved'. I did wonder what they had been doing up until then. Months later we were the majority shareholder of that bank.3
The OECD has also recognised a connection between poor risk management and the crisis, in a report4 published in February, concluding 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".
Information and understanding the importance of risk issues
The OECD 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 about risk was used inadequately. For example, less effective boards were unaware of strategic decisions being made by management and had not implemented an effective mechanism to enable boards to oversee the banks' risk appetite. Certain boards also had 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 active risk committees was also cited with Lehman Brothers' risk committee noted as meeting only twice and Bear Stearns' committee being formed just before it collapsed.
The inferior prestige and status afforded to risk management staff was highlighted by the OECD. 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".
Best practice
The OECD acknowledged that although rating agencies, disclosure and accounting standards played a role in causing the credit crisis, the best boards used their own powers to overcome weaknesses and associated risks in these areas. Effective boards implemented systems which led to the efficient sharing of information and open dialogue across management and the board.
Mats Isaksson, the OECD's Head of Corporate Affairs, has made recommendations to ensure that risk management systems are "continuously adjusted to corporate strategy and risk appetite"5. Specifically, boards need to be more exposed to risk issues and have all the necessary information to make informed decisions. This could be achieved by appointing a "special risk officer" to report directly to the board rather than via the CEO.
Board performance
The UK Treasury published a report in May stating that "banks have failed because those leading and managing them failed"6. It 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 highlighted a failure of non-executives to effectively oversee and act as a check on executive directors, and suggested that some boards "operate as members of a 'cosy club'". The UK Treasury suggested areas for reform, including:
- limiting the number of non-executive directorships that an individual can hold;
- requiring non-executives to have a relevant professional qualification to sit on the board;
- broadening the talent pool from which the banks can draw upon in appointing non-executives; and
- examining ways to strengthen the relationship between institutional shareholders and non-executives.
Poor board performance and the failure of New Zealand finance companies
In New Zealand, the most glaring example of corporate governance failings has been among finance companies. A report from the Registrar of Companies to the Ministry of Economic Development7 highlights board composition and the competence of directors as key factors contributing to the collapse of 29 finance companies in New Zealand in the last two years.
The report says 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. The Registrar notes that several of the companies were led by a dominant chief executive and there was a pattern of several directors being previously involved in finance industry failures.
The Registrar criticised the behaviour of the boards of these companies, stating that "too often directors were not adequately informed, misled or failed to take sufficient interest in ... the company".
Shareholder passivity
Institutional shareholders have also been accused of failing in their task of scrutinising and monitoring the decisions of boards.
Ongoing developments in this area are likely, and, with the significant market falls we have seen during this crisis, institutional investors such as Legal & General Investment Management (LGIM) and others are realising that "all shareholders need to themselves take the issue of corporate governance seriously"8 and develop an active ownership approach. LGIM has suggested measures such as setting up an investment forum, where shareholders can come together, voice their opinions and unite in lobbying companies on contentious issues.
The UK Treasury has also called on the Walker Review9 on corporate governance in the banking sector to address the issue of shareholder engagement by recommending proposals to aid shareholder activism10.
While institutional shareholders, the UK Treasury and others have suggested that reform may be needed in this area, PIRC appears to consider 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"11.
Issues for New Zealand companies and in-house counsel
Where do New Zealand regulators and the government stand on the issue of reform versus better use of the current corporate governance framework? While it is difficult to say what reforms, if any, are likely to be proposed in the future, Jane Diplock, Chair of the Securities Commission, gave an interesting and perhaps telling speech in Hong Kong in May. She concluded by quoting Hector Sants, Chief Executive of the UK Financial Services Authority12:
The structure of governance in financial companies does not need radical overhaul. The attitudes and competence of the individuals who conduct that governance does. In particular we need to create governance arrangements that foster challenge without creating conflict. The effectiveness of governance is the key issue and addressing this challenge is the responsibility of all of us, not just regulators and boards.
The Securities Commission is reviewing the corporate governance disclosure practices of selected listed issuers as part of its ongoing financial reporting surveillance programme, with Jane Diplock noting that there is a need for " greater assurance that issuers have robust corporate governance arrangements in place".
Now is an opportune time for New Zealand companies to assess the effectiveness of their own corporate governance practices. In-house counsel may be able to play a key role in assessing compliance and highlighting areas for improvement, for example by prompting discussion on areas such as corporate governance and good housekeeping generally.
The starting point for any in-house corporate governance review should be based on New Zealand's own best practice guidelines, 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.
New Zealand companies and in-house counsel should also keep in mind corporate governance issues being highlighted in other jurisdictions. Here are some key corporate governance practices in-house counsel may wish to promote:
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Boards should check to 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. A "stock take" on such matters may be timely.
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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, if they have not already done so, boards should consider having separate risk and audit committees.
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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. In-house counsel may wish to review current appointment policies and guidelines and also whether ongoing information and education processes could be improved.
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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, they should be given market-specific training. In-house counsel may wish to review the relevant induction programmes.
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Companies should consider ways to encourage shareholder participation, perhaps through encouraging communication and fostering a mutual understanding between shareholders and non-executive directors. It may be timely to review policy and practice in these areas.
Although New Zealand's corporate governance framework may not be subjected to radical reform, the importance of good governance has clearly been recognised by the Securities Commission and others. It is in the best interests of all companies and organisations to assess, continually monitor and enhance corporate governance practices to improve performance, foster better relationships with shareholders and others and help avoid some of the failings that have contributed to the global financial crisis.
1 Corporate Governance and the financial crisis: questions and answers. OECD, Mats Isaksson, Head of Corporate Affairs, 17 June 2009.
2 Corporate Governance and the financial crisis: questions and answers. OECD, Mats Isaksson, Head of Corporate Affairs, 17 June 2009.
3 Speech by the Chancellor of the Exchequer, the Rt Hon Alistair Darling MP, at Mansion House, London, 17 June 2009 www.publications.parliament.uk/pa/cm/cmtreasy.htm
4 The Corporate Governance Lessons from the Financial Crisis. OECD, February 2009.
5 Corporate Governance and the financial crisis: questions and answers. OECD, Mats Isaksson, Head of Corporate Affairs, 17 June 2009.
6 Banking Crisis: reforming corporate governance and pay in the City. UK Treasury, 12 May 2009. The 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. www.publications.parliament.uk/pa/cm/cmtreasy.htm
7 2007/08 Financial Review of the Ministry of Economic Development, Report to the Commerce Committee, 19 March 2009.
8 Fundamentals: The shareholders have spoken, LGIM, 17 June 2009 (LGIM is the largest investor in the UK stock market, holding about 4.5% of shares listed on the London Stock Exchange). www.legalandgeneralmediacentre.com/Content/Detail.asp?ReleaseID=563&NewsAreaID=2
9 The Walker Review's preliminary conclusions are due in autumn and its final recommendations by the end of 2009.
10 Banking Crisis: reforming corporate governance and pay in the City. UK Treasury, 12 May 2009.
