The global financial crisis represents the biggest and most damaging failure of corporate leadership of modern times.
In March 2009, the president of the International Federation of Accountants (IFAC), Robert Bunting, argued: “Regardless of who is to blame, the crisis was unquestionably exacerbated by corporate governance failures.” He specifically criticised the lack of proper risk management processes and governance systems, which “do not seem to provide adequately for challenging management’s risky strategies.”
Only a month earlier, the Organisation for Economic Cooperation and Development (OECD) had highlighted in its own review of the financial crisis the importance of qualified board oversight and robust risk management.
The review by Sir David Walker, who headed a government enquiry into governance in the UK banking industry, similarly emphasises the board of directors’ role in overseeing corporate strategy and risk. Published in November 2009, the Walker report concludes that, when a board discusses major strategic and risk issues, there must be a disciplined process of challenge from directors.
The review demands that “board level engagement in the high level risk process should be materially increased,” with particular focus on the organisation’s risk appetite and tolerance. It also argues for corporate stress testing, where directors should ensure that they “understand the circumstances under which the entity would fail and be satisfied with the level of risk mitigation that is built in.”
The CIMA report, Enterprise Governance: Restoring Boardroom Leadership,explores some of the corporate governance issues in an effort to help boards understand what they must do to be more effective. It considers the processes and practices that enable directors to challenge management more constructively. It goes on to examine how executives and Neds (non-executive directors) can build an effective relationship that is challenging and questioning, yet positive and productive.
The publication also stresses the importance of succession planning and long-term talent management as important aspects of the strategic role of boards – a factor that can make or break their organisations.
Underpinning CIMA’s thinking is the philosophy of enterprise governance, based on the goal of running a company so that long-term sustainable performance is paramount. The fundamental question it asks is: what practices can organisations adopt throughout the business cycle to deliver sustainable performance?
We argue that a key practice is to ensure that the board exercises its responsibilities effectively so that the right things are done – and done well.
CIMA’s report includes examples from the banking industry, especially in the UK, but its insights can be applied in other sectors worldwide. Corporate leadership failed spectacularly in some leading UK companies. It is therefore inevitable that some of the most dramatic and relevant lessons can be learnt from British experiences. By painful necessity, the UK is now among those leading the way in corporate governance reform.
It is also evident that the public sector is in no way immune – for example, governance lapses at the Mid Staffordshire NHS Foundation Trust in March revealed that systematic failures can exist even where the profit motive is absent. The non executive role is coming increasingly under pressure where budgets are being squeezed and, in the view of some, public services potentially compromised. NHS (National Health Service) trust boards are facing public pressure expressed through the media and vocal public representatives where services are said to be suffering in order to meet stringent efficiency targets.
Among the questions to ask are: what happens when a non executive board member is of the view that the plans for financial breakeven may compromise patient safety? Also, are non-executive board members getting the right level of information to give them assurance that risks are being appropriately managed?
Enterprise governance framework
In 2002, IFAC’s professional accountants in business committee explored the emerging concept of enterprise governance. The project considered why corporate governance often fails in companies and how to make it succeed.
The enterprise governance framework encompasses two main processes: the conformance process and the performance process.
Conformance encompasses board structures and roles, and executive remuneration. Codes and/or standards can generally help in this area, with compliance subject to assurance and audit.
Performance oversight, meanwhile, centres on strategy and value creation. A board needs to make strategic decisions while understanding appetite for risk and the key drivers of performance. This does not fit easily with a regime of standards and audit. It is therefore desirable to develop a range of best practice tools and techniques that can be applied intelligently in different types of organisations.
IFAC’s enterprise governance project was undertaken against the backdrop of the failures of Enron and WorldCom in the US and of Marconi in the UK. Most shareholder value in these firms was lost. The failures eroded confidence in the corporate world in the West and much effort went into understanding how such incidents could be averted in future.
Based on a series of case studies, IFAC/CIMA published the findings in 2004 in the joint report Enterprise Governance: Getting the Balance Right. Its key message was that companies must balance conformance and performance.
One worry was that the principal official response to the crisis was a tightening of corporate governance codes and legislation – particularly the US Sarbanes-Oxley Act of 2002 – and that this would prove excessive. The IFAC/CIMA report argued that, while compliance was important, companies should not overlook long-term strategic performance as a way to achieve sustainable success. In other words, good corporate governance might prevent failure, but it cannot ensure success.
The 2004 report’s case studies highlighted four crucial factors:
- Culture and tone at the top. The words and actions of senior managers can reinforce the application of appropriate behaviour or do the opposite. Enron’s board directors spoke frequently about ethics and codes of conduct, yet the employees realised that this was not reinforced. What they actually valued most was rapid growth and bottom line earnings.
- Checks and balances. Chief executives, especially those with dominant personalities, can come to exercise unfettered power, pursuing ambitious strategies with little restraint.
- Strong oversight. Directors can be weak, failing to provide sufficient oversight of the chief executive and management team.
- Robust internal controls. Internal controls need to be strong, with relevant management information fed constantly to the board.
A board must set the organisation’s direction and fully accept the role placed on its shoulders to enable the business to succeed. The following are the key factors in this endeavour:
- choice and clarity of strategy
- strategy execution
- responsiveness to abrupt changes, fast moving market conditions and information flows
- competence in mergers and acquisitions
- effective risk management
We identified two key issues for more detailed research:
- strategic oversight and board performance
- risk management
Recent events as the financial crisis unfolded have illustrated that many boards are not able to perform these tasks effectively. This underlines the need for a better understanding of the factors that contribute to effective boardroom leadership.
The Boardroom Leadership diagram below (click for a bigger view) represents two sets of priorities and responsibilities: people and behaviours, and frameworks, processes and structures.
Each segment is connected to all the others. For example, the right approach to reward or remuneration requires a high degree of risk awareness. Similarly, a culture of ‘effective challenge’ requires a shared ethical approach built on mutual respect, backed by high quality management information that provides the basis for such a challenge.
The many previous official reviews of governance have led to the codification of the roles and responsibilities of boards, and those of their risk and other sub committees. But recent events have demonstrated that structures and processes, while useful, are insufficient by themselves. Behaviour is crucial.
It is important not to make too rigid a distinction between structure and culture in shaping behaviour. Structure and culture can, and indeed should, reinforce each other. As a FTSE 350 director told a recent CIMA round table discussion: “Good structures and processes can, and often do, drive behaviour.”
Codification can set cultural change in motion. Weak processes can lead to complacency and box ticking. Consequently, processes may need to change in order to bring about a culture of effective challenge.
Self evidently, the right people should be appointed to the board. And they should work together as an effective team (it is acceptable to have a member who is time-poor but experience-rich, for example).
Nevertheless, taken as a whole, the board must be appropriate for the business. The board’s composition should also take into account the independence of non-executive directors (Neds). Many corporate governance codes have specified that a significant proportion of Neds should be independent. But recent corporate failures – particularly in financial services – suggest that more value needs to be placed on their experience and technical knowledge.
Another consideration is diversity. Attempts have been made to broaden the range of people serving on boards. In Norway, for example, the boards of all public companies are legally required to have a female membership of at least 40 per cent.
Diversity covers more than gender, of course. A board may appear homogeneous, yet it could contain a diverse range of life experiences, knowledge, attitudes and personalities. Conversely, a board that is superficially diverse may in practice comprise people with very similar backgrounds and personality types.
About the Author
Gillian Lees is an enterprise governance specialist within the knowledge unit in CIMA’s communications department. She was heavily involved in the IFAC/CIMA enterprise governance project as well as CIMA’s initiative to develop the CIMA Strategic ScorecardTM. Her particular interest is how boards can oversee strategy and risk effectively.