What's keeping directors awake at night?

Risk, relationships and remuneration are major topics of concern for ASX 200 directors, according to the doctoral research of Saranne Cooke.

ASX 200 directors are arguably under more pressure and scrutiny than ever before, so how do they govern the biggest listed companies in Australia? How do they perceive their governance responsibilities and enact them? And what keeps them awake at night?

I recently completed my doctoral thesis at University of New England, interviewing 41 ASX 200 directors, who between them held 70 ASX 200 current board roles. They were asked about governing under the ASX Corporate Governance Council’s (ASXCGC) Corporate Governance Principles and Recommendations (3rd edition). The research found that when reflecting on their practice of governance, ASX 200 directors primarily focus on three main areas: relationships, risk and the process of establishing executive remuneration.

Risk

Risk is at the forefront of ASX 200 directors’ minds, and was prominent in their reflections on governing their companies. The third edition of Principles and Recommendations enhanced the number of recommendations concerning risk. It is clear that this, combined with other external pressures and corporate collapses, has resulted in a significant increase in the focus on risk by ASX 200 directors. It is at the forefront of their thinking and invariably what keeps many directors awake at night.

Risk from internal factors

Directors interviewed focused on various risks stemming from breakdowns in internal controls when they reflected on their governance practices in relation to the Principles and Recommendations. These risks included incidences of unethical behaviour within the organisation, a failure to disclose appropriately to the market and inaccurate corporate reporting.

ASX 200 directors reported being very focused on the culture of the organisation in their efforts to eliminate unethical behaviour. They are equally aware of the potential for reputational damage from unethical practices in the company — acutely conscious that it takes a long time to build the reputation of the organisation and that reputation can be destroyed quickly if the organisation is found to be acting unethically.

Directors take maintaining the integrity of corporate reporting seriously. They are focused on having extensive and varied levels of assurance, and in their interviews they reflected on the potential for severe ramifications for the company and directors of making mistakes in reporting.

The risk surrounding disclosure is significant. Extensive judgement is required to determine whether to disclose information — and, if so, how — in order to meet disclosure requirements that are only ever tested in hindsight. Directors further have the complication of timing and often need to delegate some of their disclosure responsibilities to ensure it takes place between board meetings as required. This delegation requires substantial trust to be placed in the executives involved, for which strong, open, transparent relationships between the board and executive are a prerequisite. Some non-executive directors were of the view that the laws on disclosure should be changed because of the inherent difficulties faced in being expected to know everything that must be disclosed without being involved in the day-to-day management of the business.

Risk from external factors

Directors are also focused on various risks that stem from external factors to the operations of the company. In particular, directors are concerned about potential areas of risk they failed to identify; the “thing they don’t know” or “didn’t plan for”. Unknowns they are concerned about include their business becoming obsolete in the market or being faced with a catastrophic incident they had not adequately planned for.

Aversion to risk

ASX 200 directors with international experience and perspective shared the view that in Australia, directors “are not willing to take a lot of risk, not willing to put their reputation on the line”. They further noted the cultural differences in other jurisdictions where there is a greater degree of tolerance when something does go wrong in governing and managing companies. In these jurisdictions, companies were able to enjoy the benefits or upsides of risk-taking more frequently.

None of the directors interviewed mentioned the protection of the business judgement rule in the Corporations Act 2001 (Cth) when considering risk to themselves or the organisation, or their broader governance responsibilities. Most directors were acutely aware of the potential risks to both the company and themselves. “The downside is so great, the responsibility is enormous and you can lose your house, and you can go to jail,” summed up one director.

Relationships

The presence of strong working relationships between ASX 200 directors and key parties and stakeholders is essential in enabling ASX 200 directors to govern effectively. The board acts as a team in fulfilling their collective responsibilities, and the team’s effectiveness depends on there being strong relationships that facilitate dependency, reciprocity and trust. The research examined relationships from two perspectives — within the board; and between board and management.

Relationships within the board

While there has been much focus on the need to recruit new blood to the boardroom, the interviews revealed directors are cautious about the recruitment process for new directors, focusing on the necessity of finding candidates who are a suitable fit for the board team. The need to be able to work with the person was seen as being critical, given the negative impact conflict can have on decision-making and board effectiveness.

This concern and caution heavily influences the appointment process and how some boards search for board directors. However, there were two distinct schools of thought around director recruitment. One school was strongly of the view of selecting directors from their existing networks to reduce the aforementioned risk.

The second was focused on looking for new talent outside known networks (which some perceived to be riskier). Directors also raised the practical difficulties in removing directors who do not have the right skills and attributes, or those who cannot work as part of the team.

The role of the chair was seen by the ASX 200 directors as important in facilitating the effectiveness of the team and fostering relationships between board members. The chair requires strong interpersonal, social and leadership skills in order to facilitate discussion and be able to manage the complex nature of relationships between directors and executives.

Relationships with management

In practice, ASX 200 boards are mostly made up of non-executive directors who rely on executives for resources and information to perform their directing and governing role. Without a good relationship with senior executives, which enables trust and thus the provision of information, non-executive directors are limited in their ability to perform their governing role. Boards and executives must exhibit openness, honesty and trust — all of which are founded on respectful professional relationships — to perform their roles effectively.

The relationship between the board and company executives is complex. It must be strong and trusting, but also distant enough so as not to impact independence and the role of the non-executive director. “There is always a tension between management and conscientious directors,” said one director, although, “what is sure is that you can’t have the board managing the business”. For the relationship to work, “you need a very open and transparent environment”.

The risk associated with relationship breakdowns is significant because it can have a major impact on the effectiveness of the governance of the company. Some ASX 200 directors also reported that boards are increasingly recognising the benefits of connecting effectively and, with employees, more broadly. Some companies have used their board diversity strategy to ensure the board more closely reflects their employee base so as to better connect with that stakeholder group.

Relationships with stakeholders

Relationships that boards have with key stakeholders are critical enablers of good governance and board effectiveness. Stakeholder groups are varied, depending on the organisation and industry, but usually include shareholders, proxy advisors, consultants and regulators.

The interviewees made it clear that modern ASX 200 board governance requires chairs and CEOs to have closer proximity to certain stakeholders, including proxy advisors.

In respecting the rights of investors, boards must facilitate open and reasonable communications and also have an avenue for investors to hold the company to account. Despite this, participants made it clear the traditional AGM format is less effective as a mechanism for facilitating an appropriate avenue for this purpose, as proxy voting by major investors usually means smaller investors have little influence on the outcomes of voting matters.

Remuneration

ASX Principle 8 (to remunerate fairly and responsibly) is a contentious theme, revealing the tensions surrounding the process of setting executive remuneration. It illustrates a significant contention around current practices that has emerged following a period of scrutiny and legislative change. As one director noted: “It’s the most emotive part of any organisation… externally, it’s the thing most people are interested in.”

Since the introduction of the “two strikes” rule in the Corporations Act in 2011 (meaning an entire company board can face re-election if shareholders disagree with how much executives are being paid) and with increased external pressures, directors have experienced and are increasingly concerned about significantly altered power structures in the remuneration process in relation to obtaining stakeholder support and approval.

The role of remuneration consultants has risen dramatically in recent years, with directors and boards using them to provide external validation of their remuneration structures. This is seen as an effective mitigant to risk. Many directors have the view that boards have become beholden to the advice of remuneration consultants.

The complexity of the remuneration report was also of great concern to directors interviewed. The power of proxy advisors has risen dramatically in recent years, and a key strategy for boards in avoiding a strike has been to establish relationships with them and engage, particularly in the lead-up to the AGM, on executive remuneration. ASX 200 directors were critical of proxy advisors for forcing boards to design remuneration structures that centre to norms not necessarily suitable for their organisation, industry or individual executives. They reported that this has resulted in increased complexity and, at times, unrealistic expectations being placed on boards by stakeholders when setting appropriate remuneration structures for their executives.

Directors are concerned about the significant amount of time being devoted to remuneration when managing various stakeholders to minimise the “risk of a strike” (referring to the two strikes and re-election process in relation to the non-binding shareholder vote on the remuneration report). Having experienced various AGMs where the non-binding vote was used by investors to express their dissatisfaction with matters other than remuneration, directors felt stymied by the use of the mechanism in this way.

They also reflected on unintended consequences of the remuneration process (under the current two-strikes rule), most significantly the effect it has had on putting upward pressure on executive remuneration. ASX 200 directors were uneasy about excessive remuneration for executives and increasing disparity with the average wage in Australia.

“We definitely need to put a break on executive remuneration … The calculation of how many multiples of the average wage is the average CEO salary, and the gender inequity of CEO and executive salaries, tells me there is something really crook,” said one director.