The developments in corporate governance are discussed below.
3.6.1 Corporate Governance 2.0
Harvard Law School Professor Guhan Subramanian developed his corporate governance model Corporate Governance 2.0. Subramanian (2015:97) lists three principles as underpinning the model: company boards should be given the authority to manage how the business is run for the long term; company boards should have procedures in place to ensure that the best possible people are appointed in the
144
boardroom; and Boards should give shareholders an orderly voice. The aforementioned principles assume that the board is competent.
3.6.2 The case for professional boards
Harvard Business School lecturing staff, such as Robert C. Pozen, concur with Subramanian and have conceived a model of professional directorship to respond directly to the three main factors behind apparent ineffective decision-making. Pozen expresses the view that directors should have sufficient expertise in the relevant industry and that boards should have a maximum size of seven people. He suggests that management should be represented by the CEO and that the other six board members should be independent directors. He is of the view that independent directors should have extensive expertise in the line of business and should spend at least two days a month on company business beyond the regulatory board meetings. He gives the example of the American bank, Citigroup. During the 2008 financial crisis, Citigroup had 18 directors, of which 16 were independent. Only one of the independent directors had ever worked at a financial services firm (Pozen, 2010:52).
3.6.3 Four ways to fix banks
Krawcheck (2012) argues that, although the primary causes of the 2008 financial meltdown were resolved, big banks continue to suffer from governance-related problems. She posits that upgrading bank boards could be the solution to these problems and makes the following suggestions:
• Pay executives with bonds as well as stock
Krawcheck (2012) argues that management compensation is a powerful driver of corporate behaviour. She argues that since the financial crisis of 2008, regulators and boards have gravitated toward increasing the amount of stock- based compensation and lengthening the mandatory holding period to induce senior banking executives to behave properly (Krawcheck, 2012:108).
• Pay dividends as a percentage of earnings
Krawcheck (2012) posits that the traditional way of paying dividends per share should be replaced with a more risk-sensitive approach of paying dividends as a percentage of reported earnings. She also states that when earnings begin
145
to deteriorate, management teams or bank boards are usually too slow to cut dividends, which drain capital when it is most needed (Krawcheck, 2012:109).
• Don’t judge managers (just) by earnings
She argues that boards should pay close attention to indicators other than earnings. She writes that perhaps the most crucial metric is customer satisfaction. More business from happy customers represents quality earnings (Krawcheck, 2012:111).
• Give board scrutiny to booming businesses, too
Board members are assumed to be spending most of their time on governance- related issues, business updates and “problem children”. Krawcheck (2012:111) argues that they should focus instead on businesses that use capital.
3.6.4 The boardroom’s quiet revolution
Parsons and Feigen (2014:99) are of the view that forward-looking boards have been discreetly transforming themselves. Parsons is the former CEO of Time Warner and chairman of Citigroup, while Feigen is the founder of Feigen Advisors, a management adviser to Fortune 300 CEOs and boards. These authors present what they deem to be striking innovations in board practice in four main categories:
• Overseeing strategy and talent
Parsons and Feigen (2014:100) argue that the tradition of directors listening to presentations by management, what is known as “death by slide”, should be replaced by directors visiting customers. By visiting customers, the directors will know where to invest, where to divest, and where to grow.
• Getting board composition right
Many of the serving directors of the US boards have business acumen and valuable experience, argue Parsons and Feigen (2014:101), but many lack industry-specific expertise. Parsons and Feigen (2014:102) seem to support the notion of “professional directors” as advocated by the Harvard Business School Professor, Robert Pozen (see Section 3.6.2). They caution that, although Pozen’s notion is somewhat extreme, more and more boards are looking for relevant experience.
146
Parsons and Feigen (2014:102) state that, “Boards are more actively monitoring the contributions of individual members. At one Fortune 500 company each director is asked annually to nominate five other directors whom he or she would wish to keep on the board. A director who makes no one’s list is asked to leave.”
• Managing the quality of the conversation
The board needs to have quality conversation with managers. According to Parsons and Feigen (2014:102), “Good directors are also aware that when meeting with the board, even well-intentioned managers may succumb to a normal human tendency to overstate opportunity, understate risk, or sugar coat problems. Both points reflect the shortcomings of discourse in many boardrooms, and conscientious directors work hard to get below the surface to the key issues.”
• Engaging with the CEO
Parsons and Feigen (2014:103) posit that smart CEOs know the value of good communication with the board and invest a lot of time in keeping close to their board members.
3.6.5 Sustainability in the boardroom
Paine (2014) states that surveys show that not more than 10% of US public company boards have a stand-alone corporate responsibility or sustainability committee. She argues that,
In view of growing concern about business and sustainability, and given the importance of corporate responsibility for ongoing value creation, directors should be asking whether their board’s oversight in those areas is sufficient.
Recent surveys suggest that no more than 10% of U.S. public company boards have a committee dedicated solely to corporate responsibility or sustainability.
Nike’s experience indicates that such a committee could be a useful addition to many if not most boards in at least five ways: as a source of knowledge and expertise, as a sounding board and constructive critic, as a driver of accountability, as a stimulus for innovation, and as a resource for the full board.
147
A look at how Nike’s corporate responsibility committee has served each of these functions will show why. (Paine, 2014:89)
In summary, Paine identifies a primary problem as being that although more and more companies recognise the importance of corporate responsibility and sustainability for their long-term success, these issues are not dealt with sufficiently in boardrooms. In her view, the solution lies with addressing the risks and opportunities arising from problems such as climate change, water pollution, corruption, and uneven access to wealth, health and education. She commends Nike for establishing a dedicated corporate responsibility committee in 2001. Prior to this Nike was often criticised for the labour conditions in its Asian contracted manufacturing countries. Paine (2014:89) believes that companies could learn from the Nike experience by setting up such a committee.
3.6.6 Where boards fall short
Barton and Wiseman (2015:100) are of the view that boards are not carrying out their core function of providing strong oversight and strategic support for management in their attempt to create value in the long term. This is despite regulatory reforms and guidelines from institutions such as the ICGN. Additionally, Barton and Wiseman (2015:100) write that:
A mere 34% of the 772 directors surveyed by McKinsey in 2013 agreed that the boards on which they served fully comprehended their companies’ strategies.
Only 22% said their boards were completely aware of how their firms created value, and just 16% claimed that their boards had a strong understanding of the dynamics of their firms’ industries.
In line with the long-term value-creation model advocated by the IIRC and King IV™, the authors state that “the mental discipline of keeping long-term value creation foremost in the mind would help clarify choices and reform board behaviors” (Barton
& Wiseman, 2015:101). They advocate the following changes to boards:
148
• Selecting the right people
They are in favour of directors who have substantial real-life experience from having worked through difficult times. They also believe that mandatory retirement rules for directors should be applied intelligently to achieve the optimal balance between refreshing the board and retaining valuable experience (Barton & Wiseman, 2015:102).
• Spending quality time on strategy
“The first question I would ask boards is whether they are spending enough time and effort assessing the organization’s long-term strategy,” states Sir David Walker, chairman of the board at Barclays and a noted authority on corporate governance in the UK (cited in Barton & Wiseman, 2015:102). He continues: “If they are honest, the answer will almost always be no.” The suggestion for directors to spend more time understanding the company’s strategy and how the company creates wealth is in line with what authors such as Pozen and King IV™ are proposing.
• Engaging with long-term investors
Barton and Wiseman (2015:103) emphasise the importance of engaging with long-term investors by stating that, “While boards may be guilty of pushing executives to maximize short-term results, we have no doubt where that pressure really originates: the financial markets.” For this reason, they find that it is essential to persuade institutional investors to be a counterforce. Focusing capital on the long term is discussed in Section 3.6.7 below.
• Paying directors more
Barton and Wiseman (2015:104) advocate that directors are paid more for the services they render. They argue that, “Good capitalists believe in incentives.
If we are going to ask directors to engage more deeply and more publicly, to spend a lot more time exploring and communicating long-term strategy, and to take on any attendant reputational risk, then we should give them a substantial raise. There is a growing consensus that directors should sit on fewer boards and get paid more – substantially more than the current average annual compensation of $249,000. We fully agree, but the even more important issue is how that pay is structured. A number of companies have already shifted the mix toward longer-term rewards.”
149 3.6.7 Focusing capital on the long term
Barton and Wiseman (2014) are of the view that big investors have an obligation to end the plague of short-termism. This is in line with the thinking of, amongst others, King IV™ and the IIRC. Unlike in most countries, American listed companies report their results quarterly, which puts pressure on management to meet short-term financial goals. Countries such as South Africa and the UK require listed companies to report every six months.
Barton and Wiseman (2014:45) put it succinctly:
Since the 2008 financial crisis and the onset of the Great Recession, a growing chorus of voices has urged the United States and other economies to move away from their focus on “quarterly capitalism” and toward a true long-term mind-set.
This topic is routinely on the meeting agendas of the OECD, the World Economic Forum, the G30, and other international bodies. A host of solutions have been offered – from “shared value” to “sustainable capitalism” – that spell out in detail the societal benefits of such a shift in the way corporate executives lead and invest. Yet despite this proliferation of thoughtful frameworks, the shadow of short-termism has continued to advance – and the situation may actually be getting worse. As a result, companies are less able to invest and build value for the long term, undermining broad economic growth and lowering returns on investment for savers.
To encourage long-term investing, they argue, investors should clearly define what they mean by long-term investment. The definition should include a multi-year time horizon for value creation.
3.6.8 What CEOs really think of their boards
Sonnenfeld et al. (2013:98) argue that: “Over the past several years, in the wake of corporate missteps that have taken a toll on shareholders and communities alike, we've heard plenty about how boards of directors should have been more responsible stewards. Corporate watchdogs, investors and analysts, members of the media, regulators, and pundits have proposed guidelines and new practices. But one voice
150
has been notably missing from this chorus – and it belongs to the constituency that knows boards and their failings best. It's the voice of the CEO.”
After interviewing a number of veteran CEOs, Sonnenfeld et al. (2013) came up with five overarching pieces of advice for boards:
• Don't shun risk or see it in personal terms – The board should serve as a check on a recalcitrant CEO;
• Do the homework and stay consistently plugged in – No one should accept a board appointment unless he or she is willing to prepare for boardroom discussions thoroughly. Directors should make sure they understand the workings of the company and stay abreast of the industry developments;
• Bring character and credentials not celebrity to the table – CEOs interviewed did not want their sporting mates as board members. They wanted diversity in order to bring perspective and specialised knowledge to bear on discussions.
• Constructively challenge strategy – CEOs interviewed did not resent people such as shareholders and members of the public questioning their plans. They were disappointed by the absence of energetic debate in the boardroom.
• Make succession transitions less awkward not more so – CEOs interviewed were frustrated when boards fell short in this most visible and high- impact responsibility. Sonnefeld et al. (2013:98) conclude by stating that CEOs were also frustrated with boards’ tendencies to fall in love with external candidates, i.e. preferring external candidates.
3.6.9 The big lie of strategic planning Martin (2014) states that:
The plan is typically supported with detailed spreadsheets that project costs and revenue quite far into the future. By the end of the process, everyone feels a lot less scared. This is a truly terrible way to make strategy. It may be an excellent way to cope with fear of the unknown, but fear and discomfort are an essential part of strategy making. In fact, if you are entirely comfortable with your strategy, there’s a strong chance it isn’t very good…You need to be uncomfortable and
151
apprehensive: True strategy is about placing bets and making hard choices. The objective is not to eliminate risk but to increase the odds of success (Martin, 2014:80).
The problem
According to Martin (2014:81), “In an effort to get a handle on strategy, managers spend thousands of hours drawing up detailed plans that project revenue far into the future.” He adds that these plans may make managers feel good, but often matter very little to performance.
Why it happens
Martin (2014:81) is of the view that: “Strategy making is uncomfortable; it’s about taking risks and facing the unknown. Surprisingly, managers try to turn it into a comfortable set of activities. But reassurance won’t deliver performance.”
The solution
Finally, Martin (2014:81) states that managers should reconcile themselves to feeling uncomfortable and follow three rules:
• “Keep it simple. Capture your strategy in a one-pager that addresses where you will play and how you will win.
• Don’t look for perfection. Strategy isn’t about finding answers. It’s about placing bets and shortening odds.
• Make the logic explicit. Be clear about what must change for you to achieve your strategic goal.”
3.6.10 Sustainability as a social movement
Robert G. Eccles, Professor of management practice at Harvard Business School, delivered a paper at the annual New York State Society of Certified Public Accountants – Hedge Fund Roundtable Sustainability Investment Leadership Conference held on 6 May 2016. The speech focused on corporate sustainability reporting as a social movement and included the context of integrated reporting, materiality and fiduciary duty. He began his speech by acknowledging the good work done by Prof. Mervyn
152
King in South Africa with regard to integrated reporting. He stated that: “I like to think of myself as a capital market activist, and that’s where you get the title of my most recent book – The Integrated Reporting Movement. I think of this as a social movement. The only country where integrated reporting is mandated, thanks to the leadership of Mervyn King, is South Africa. What he did in South Africa is interesting, because it was reporting in a governance context. You can think about this talk as corporate reporting meets corporate governance” (Eccles, 2016:26).
Eccles (2016:30) related that he met with this Swedish company called Atlas Copco, an industry products company, about a year ago. They’ve been doing integrated reporting for a couple of years. He added that it was interesting the language that they use is that was their strategy for sustainable profitable growth. Figure 3.13 presents the materiality mapping results of Atlas Copco, the world’s leading manufacturer of mining equipment.
Figure 3. 13: Atlas Copco materiality mapping results
Source: Atlas Copco Materiality Mapping Results (Eccles, 2016:29).
153
Atlas Copco produces materiality mapping results. The company takes into consideration what other stakeholders think is important. In Figure 3.13, the X axis indicates materiality to the company. The Y axis indicates the company’s perception of importance to stakeholders (see: Eccles, 2016:30).
According to Eccles (2016:30), Atlas Copco went through a very sophisticated engagement process, which is key.
One of the major distinctions between today and the financial reporting of the
’50s and ’60s is the much higher levels of genuine engagement on the part of corporations. They’re basically saying that “business ethics, bribery, safety – they’re material to us and we recognize they’re important to society. Productivity is important to us, but society is not too worried about it. There are some things that really are not material to us as a company, given our sector, like climate change. We recognize society cares about it, and so we have an obligation to report on it. And then there are some things down here in the bottom left-hand box that aren’t material to us and we don’t think society cares all that much.” Now this is tremendously important because this is showing the ability to exercise judgment and not greenwash and say, “We care about sustainability and we’re going to create value by taking care of all of our stakeholders.” No, you’ve got limited resources. You have to choose, and so why don’t you just be transparent about that?
It is important to state that the UNPRI; the IIRC’s <IR> Framework; the King Report on Corporate Governance; Sustainable Capitalism; and other corporate governance instruments stress the importance of the materiality of ESG reporting.