The mobs are baying for the blood of high-profile CEOs and their right-hand money men in the aftermath of a string of corporate collapses. Derrick Heywood FCPA, lays out a framework for avoiding the next implosion and asks why company directors have avoided much of the flak.
Criticism over the financial debacles both home and abroad in recent months has been directed at three groups of professionals, and with much justification. First, at CFOs for their failure to apply accounting standards and for contributing to overstatements of earnings and net worth by entering into schemes that border on the edge of legality if not fraud. Secondly, at external auditors for not having discovered and reported these failures and schemes.
Thirdly, at CEOs and other senior executives for having benefited personally from participation and or collusion, even where there have been failures of their companies, at the expense of creditors and other employees.
In addition to this type of criticism, there has been a high level of shareholder frustration at what are considered to be exorbitant and unjustified levels of executive compensation by way of either huge bonuses being paid when company results have been negative or significantly reduced from previous levels or in retirement allowances. This frustration springs from two aspects.
First, the lack of knowledge due to inadequate or complete absence of disclosure of the liability until payment is made. Secondly, the basis of calculation, which to many shareholders appears unreasonable or, even, completely without justification.
There is another group of individuals who are deeply involved in all of the above issues but who appear to have avoided much of the criticism, if there was any directed at them at all. This group comprises the directors. It seems surprising that they have received very little attention (for which they are probably very grateful).
There are several reasons why attention should be focused on individuals holding appointments of elected directors. In their roles as directors, they have a crucial part in the direction of their company and have substantial power in determining the strategy and other key aspects.
Directors are responsible for recruiting CEOs and CFOs, so, surely, they must be accountable for the actions or lack of actions of executives they have appointed.
They determine the terms and conditions of the service contracts of employment. In many cases, contracts appear to be worded in such a way that they readily provide for substantial compensation for loss of office during the tenure of the contract for whatever reason.
Setting of performance targets for the exercise of options and the strike prices is also a director's responsibility. In principle, share options are intended to provide incentive rewards for superior performance of senior executives by linking their remuneration to increased profits or increased market value of the company's shares.
They appoint the external auditors and ensure that both the external and internal auditors have direct and unimpeded access to the board and have freedom to report in confidence on any issues crucial to the company's ethical conduct and overall performance.
A director is also supposed to review and approve the business strategies and the future direction of their company, which should include appropriate controls to ensure compliance with predetermined objectives and comprehensive systems for reporting progress towards key objectives.
Responsibility for effective systems of internal controls also rests with the directors, as does ensuring compliance with statutory obligations for continued reporting.
In addition to the above specific powers and responsibilities, directors have an overall obligation to act in the interests of shareholders and to protect shareholders' financial investment in the company. An argument could be advanced that where a company reports substantial losses that are totally unexpected by the market, or is suddenly faced with the prospect of going into liquidation, there is a very good case that the directors may have failed to fully comply with one or more of their responsibilities. As a minimum, the directors should have a statutory requirement to report fully and objectively the causes and explanations of major losses, with appropriate identification of executive accountability.
The issue of assigning fault or responsibility for major failures can be a minefield and an area full of potential litigation, especially when it is a situation where a particular strategy of policy seemed acceptable at the time although it resulted in substantial losses. There may be a conflict as to who shoulders the responsibility; the executive who proposed it, the board who approved it, or those responsible for its execution.
The justification for focusing on this issue is that the concept of executive remuneration seems to be a one-way street. If financial results improve, executives receive additional compensation. However, if losses result, the executives involved do not seem to be penalised and in many instances still receive bonuses. A case of 'heads I win, tails you lose'.
Hopefully, many boards in Australia are in the process of examining what actions their directors could take to step up to these responsibilities. The following ideas may be of help, particularly to non-executive, independent directors who may not have extensive experience of the role of directors.
Boards need to apply more stringent tests of suitability for employment before engagement of new executives and include clear statements of expected achievements and the basis of evaluating performance. This could reduce the all too frequent occurrence of the employment of senior executives being terminated in the early stages of a five-year contract with a payout to the end of the contract.
New contracts should include two major changes to those that appear to have been standard in the past. Firstly, they should include clauses that provide for termination of employment for non- performance or dereliction of duty, without excessive compensation for loss of office. Secondly, to ensure that any performance bonuses are directly related to performance improvements that result solely from the efforts of the relevant executives. Also, that a cap applies in order to avoid excessive amounts being paid in one year regardless of the financial results of succeeding years.
A clear statement of targets should be included in contracts. One that can be measured objectively and that evaluates results and achievements progressively.
If options and bonuses are offered as part of remuneration, then the terms of such remuneration should be structured in a manner that the rewards are relevant to a profit improvement target or a quantifiable increase in shareholder wealth that is entirely due to the efforts of the executives involved and is not due to the effect of a favourable change in general economic conditions. It would probably help, in this case, if directors recognised that options do have a cost to the company, since new shares issued at below what a rights issue would yield result in a lower intake of cash as well as a dilution effect on existing shareholders. (See box for more suggestions for the board.)
The topics of options and share buy-backs are intertwined and rather complex and it may be that directors are not reviewing all implications when they approve a recommendation by the chief executive to undertake a share buy-back. The main implications may include: an outflow of cash reducing funds available for employment in the company which would reduce the level of future profits; a buy back on market supports boosting executive share options; an exercise of options adding to the capital funds in the company and coinciding with a period when there is excess capital and therefore contributing to the argument that there should be a buy back!
There is another aspect of company performance that seems to slip by with little comment. That is, the write off of millions, and frequently, billions of dollars for investments that did not succeed or assets (frequently goodwill) subsequently deemed to be substantially over-valued. These frequently receive minor comment from boards with words such as 'we need to put this behind us and move forward'.
The Group of 100 has recently issued a code of conduct for CFOs made up of 10 governing principles that require them to observe the rule and spirit of law, disclose to company boards any conflicts of interest and exercise good faith in preparing financial statements. The code says that CFOs should: 'Observe the principles of independence, accuracy and integrity in dealings with board, audit committees, board committees, external and internal auditors and other senior managers within the organisation and other relevant bodies external to the organisation.' Further, 'CFOs should be the champions of good corporate governance throughout an organisation and in the wider business community in Australia.'
The federal government appears to be considering legislation that seeks to address at least two aspects of public concerns. Firstly, to minimise the loss to shareholders by clawing back remuneration of directors and senior executives, particularly excessive bonuses, in cases of company failure.
Secondly, to require remuneration contracts to be disclosed at the time they are entered into and providing empowerment of shareholders to have a say on a board policy before any contract is signed.
There is even a proposal that termination payments should not be tax-deductible, presumably on the basis that they are of a capital nature, and, in any event should not be subsidised by the taxpayer.
It has also been reported that the Australian Stock Exchange is considering implementing additional requirements to require the full disclosure of pay and termination packages of top executives.
With all the focus on overall levels of remuneration and components of remuneration, it is surprising that there is little if any attention being given to certain aspects of directors' remuneration. While the quantum of annual fees paid to directors is subject to shareholder approval and is reported every year, the calculation and payment of retiring allowances appears to slip by without visibility and is either not approved by shareholders or is not recognised by them as inappropriate remuneration. Thus, while shareholders can keep a rein on annual fees that frequently raise their ire at AGMs, the individual shareholders appear not to learn of cases of retirement allowances that, in many situations, are a significant multiple of annual fees.
There seems to be no indication in the public arena that directors as a group are seriously reviewing whether any changes are necessary in the conduct of directors and in the training and education of directors. One further aspect that would bear analysis is a limit on the number of appointments to boards that a director can hold, and the number of offices of chairman of the board that a director can hold. Even for part-time directors, there must be a limit to the number of complex company operations that they can dedicate themselves to and do full justice.
It is reasonable to ask how and whether directors, individually or as a group, will be responding to the issues that are outlined above.
A Board should:
Have a heart-to-heart with the senior partner of the external audit firm and stress the reliance of the directors on a quality audit.
Have an independent, in-depth review conducted of the system of internal controls in order to be absolutely satisfied that they are effective.
Seek assurances that the external auditors consider that the internal controls are adequate and appropriate.
Review the way that strategies and objectives are phrased so that actual performance and achievements can be measured in such a way that changes in financial reporting, accounting standards or deviations in accounting practices would be highlighted.
Think about what the board has to do to achieve a high level of protection for the shareholders.
Act in a searching manner in reviewing presentations to the board.
Not be afraid to ask questions.
Not be intimidated by the senior executives.
Ensure that statements of policy governing the conduct of the entity's performance stress strict application of high standards of ethics and conformance with approved accounting standards in the spirit as well as in the letter of the law.
Check that directors have enough time to devote to the demanding affairs of each of the companies for which they are directors. This may mean limiting the number of companies for which they have board responsibilities.
Further reading
'Directors' duties & ASIC v Adler' by Carmel Mulhern, TEN video: level 3, July 2002
Duties and responsibilities of company directors and officers by Robert Baxt and AICD, CCH 2002, 17th edition
'Enron, board governance and moral failings' by Gerald Zandstra, Corporate governance: the international journal for effective board performance, volume 2, number 2, 2002
'The myth of governance' by Nicholas Way and James Thomson, Business Review Weekly, volume 25, number 14, April 17, 2003
This article was written by Derrick Heywood FCPA, former CFO of Westpac Banking Corporation.
