Food for thought

Non-executive directors needing to prolong top-level involvement in the commercial community, or relying on boardroom income in their retirement, may lose objectivity when decisions could result in loss of office, says Leigh Warnick.

Corporate governance is the flavour of the month. All over Australia, company directors are scanning the menu drawn up by the ASX Corporate Governance Council – and waiting to see what CLERP 9 serves up for dessert. Here are a few thought bites to whet the appetites of non-executive directors (NEDs).

Board charters should be grounded in reality

The document issued by the ASX Corporate Governance Council, with the catchy and confident title Principles of Good Corporate Governance and Best Practice Recommendations (CGC Guidelines), encourages companies to prepare and adopt a number of policy statements. These include board charters, share trading policies, codes of conduct, committee charters, continuous disclosure policies, communications strategies, risk management systems, board performance review procedures and remuneration policies.

It is intended that most or all of these policy documents should be disclosed publicly, either completely or in summary form, so that the market can form its own view about the company's commitment to good corporate governance. This is important – these statements will become representations to the market about what a company will do. Not unlike a prospectus, really...

Therein lies a danger. In writing these statements people are tempted to aim high. They articulate best practice – not necessarily what their company is actually capable of doing. This is a particular risk when smaller companies "borrow", with or without adaptation, the published policies of market leaders which are larger and better-resourced.

In case the danger of this approach is not obvious, it is illustrated by the judgment in Ali v Hartley Poynton (Justice Smith, Victorian Supreme Court, 2002). In awarding exemplary damages against broking firm Hartley Poynton, the judge referred to statements in the firm's published governance statements about its core values which included acting with integrity and complying with the spirit as well as the letter of acts, rules, regulations and policies. But on the evidence in the case, nothing effective had been done to enforce the relevant law or policies. Justice Smith said: "To promote itself publicly, in the way the defendant did, and to recognise the need for, and develop, policies which will address the rights and interests of clients but do nothing effective to enforce them, shows a contempt for the rights and interests of all clients."

So to publish aspirational policies but not comply with them in practice is to live dangerously. It is the antithesis of good corporate governance. What is more, it can create legal liability in a couple of different ways which are, or should be, worrying to directors:

• Exaggerating corporate governance practices is almost certainly misleading or deceptive conduct which may be actionable, if an investor suffers loss from relying on it.

• If the point ever comes when the liability of the company's directors is being considered by a court, directors should expect their conduct to be judged against the full rigour of the published standard.

As Justice Austin of the NSW Supreme Court made clear this year in ASIC v Rich (the preliminary stage of the civil action against One.Tel chairman John Greaves), courts will look at directors' responsibilities in terms of any special arrangements within the com-pany, "and the expectations placed by those arrangements on the shoulders of the individual director". So by publicly proclaiming their companies' high corporate governance standards but not delivering on them, directors may be raising the liability bar for themselves.

None of this is intended as an argument against high corporate governance standards. It is simply a warning that published standards of corporate governance should be set no higher than what the company is capable of delivering in the real world.

A helpful way of testing this is to verify corporate governance statements before they are published, as happens with a prospectus. Go through the statement line by line and every time a claim is made about what the company does, footnote it and list the evidence which proves that the claim corresponds with reality. This method is not foolproof but it does introduce a good discipline.

Why NEDs need to get more involved, and how

You could say that all you need to know about being a non-executive director, you can learn from one line in a Kenny Rogers song: "Know when to hold 'em, and know when to fold 'em".

To put this into practice you need judgment, integrity, courage and knowledge. There have been failures of judgment, integrity and courage, but I think the vast majority of Australian NEDs have their fair share of these attributes. If Australian NEDs fall short of the Kenny Rogers standard, it is most often because they lack detailed knowledge of their company and their industry.

There are several possible reasons for this. One is that NEDs are reluctant to drill down into the affairs of the company, for fear of upsetting management. Another is that this takes more time than many directors have to give, or are prepared to give (or are paid to give) to their role. A third, which may encompass the first two, is that the traditional view of a company director has not expected this degree of involvement in the company and the industry.

But that has changed. Consider this corporate governance model:

• Management's job is to come up with the ideas, and run the company so as to turn the ideas into money, while acting responsibly within an established risk framework.

• The board's job is to put the right people into top management, (occasionally) stimulate the production of ideas and (always) test the ideas produced, set the appetite for risk and make sure that management is making money while acting responsibly within the agreed risk framework.

A lot is expected of the board under this model. NEDs cannot meet these expectations without a very clear understanding of the company's business, the risks that affect it and the landscape in which it operates. Perhaps the most important of the board's functions is knowing what the key risks are and making sure they are managed. Without detailed knowledge this cannot be done.

The history of corporate failures in Australia, both recent and not so recent, suggests that in many cases the NEDs have not had enough knowledge to arrest the slide or even to know that it was happening. This was certainly an issue raised by Justice Owen in his report on HIH.

If the non-executive director profession in Australia wants to achieve a significant lift in performance standards, the gap it should be closing is the knowledge gap. NEDs must know enough to challenge management in a constructive but penetrating way. Extensive reliance on management, with just enough knowledge to question self-evident failings, is no longer an acceptable standard of professional performance. This is not interfering with management – it is learning enough to manage management.

No doubt some NEDs in Australia are at this standard already, but a lot of others will only get to it if they work harder and put in more time. They may also need to steel themselves for the unpopular corollary: asking for more money.

The dependent independent director

Public debate about the CGC Guidelines focused on the recommendation that board should have a majority of independent directors, and in particular on the criteria for independence. Controversy surrounded the suggestion that a director lost independence after having been on the board for a specified period of time. In the end the guidelines included this criterion but left open the period (Box 2.1 in the CGC Guidelines, item 6).

The view is open that this, and some of the other criteria in Box 2.1, are blunt instruments which are only needed because the scalpel, the board evaluation process, is not doing its job. On a strong board which evaluates itself properly, NEDs who lose objectivity will be excised.

But lest this should seem too brutal, let us turn to an observation about where directors are likely to come from in the future.

Increasingly, professional firms are reluctant to allow partners to serve as directors and corporations require their executives to keep their eyes on their own corporate ball. The result of this is likely to be that in the future, there will be fewer NEDs with day jobs.

One may speculate that the pools from which NEDs will be drawn will be retired partners of professional service firms, and retired company executives – especially chief executives. It may also be that the male candidates will predominantly be in the 55 plus bracket, although female candidates may have left the workforce earlier and be younger.

There is nothing wrong with this. In fact it is good, if it means non-executives have more time to give to the role because they are not trying to do day jobs as well. But there is a danger.

If NEDs are reliant on their directorships to supplement retirement income, or to prolong the experience of top-level involvement in the commercial community that they have enjoyed for many years, then they may lose objectivity if a situation arises where a possible consequence is loss of office.

It's really just another case of knowing when to fold 'em. It can't be covered in Box 2.1 or any other box. It's a matter for the integrity of individual directors to deal with; and if that doesn't work, it will become a test of the board's ability to evaluate and reconstruct itself – or failing that, of the market's capacity to detect, judge and punish poor governance surviving behind the facade of published corporate governance statements.

* Leigh Warnick is a partner, corporate advisory group with Blake Dawson Waldron.

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