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I Was There When It Happened - NZ Lawyer Magazine, Issue 103, 12 December 2008

Thu April 10th 2014


I Was There When It Happened

Vincent Naidu discusses how to get the corporate governance basics right

Introduction

If certain areas of administrative law had music personas, then corporate governance would probably be described as Johnny Cash – enigmatic, complicated, and often forgotten by the popular mainstream looking for fame and gain in all the wrong places. Ironically, corporate governance often seems to be most relevant in the corporate arena when troubles arise, caused largely by the failure to properly implement sound governance within the structural framework of businesses, state-owned enterprises, and not-for-profit organisations.

Topics like corporate governance rarely attract much public attention in good economic times. It seems almost exclusively reserved for scholarly discussion amongst academics and the occasional board room. A bit like Cash, it seems to have acquired a mysterious image, darkly looming in the background even when it is utterly important. But then, as in the case of some boards, acknowledging the significance of good governance in their affairs would also mean the need to address undesirable subjects like conflict of interest, misapplication of funds, ultra vires, etcetera.

For corporate governance to be effective, it must be thoughtfully directed through policy and objective, and rigorously maintained. However, for this to happen, governance must first be understood and defined within the context of the organisation in question, and then be correctly implemented and practised.

A Broad Definition

Governance is the process of resolving what an organisation will do, and doing what it takes to make it happen – planning, setting goals, and carrying out specific tasks to achieve those goals in accordance with the plans.

When we talk about corporate governance in a broad sense, we are really talking about the systems and structures a corporate entity should ordinarily have in place to watch over its affairs and operations. A more specific definition would usually be applied in context. Hence, corporate governance in the financial sector would obviously involve overseeing implementation of good audit and financial reporting systems and the capacity to identify and control business risks such as credit control, exchange rates, exposure concentration, etcetera.

Some Basic Elements

Certain elements are essential to good governance. The following summarises some fundamental requirements which any governance board must practise to be effective:

  • Have a workable (and achievable) business plan for the coming quarter/year;
  • Create a clear strategic plan for the organisation (usually for a specific period, say 24 months, being subject to review every six months);
  • Ensure that the directors have a clear understanding of the organisation's strategic plan and objectives;
  • Have the correct structures in place which will enable the implementation of the strategic plan and attainment of objectives;
  • Have the right systems in place to ensure effective execution of the board's decisions (this often involves human resources – the right people with the right skills – which are mobilised within the organisation to carry out the 'implementation');
  • Have appropriate systems in place to identify business risks and/or general risks to the organisation;
  • Ensure risks are correctly assessed and managed effectively; and
  • Have the right mechanisms to ensure the organisation's obligations are being met and correctly discharged (and by the right people), particularly when there is a requirement to fulfil statutory responsibilities and fiduciary duties.
  • There are a number of other elements which could be included in the list above, but then we would have to go beyond the introductory aspects of governance which this article intends to cover. Perhaps the most important thing to bear in mind is that effective corporate governance involves a number of different systems and structures and that its genesis lies in the culmination of the debate and discussion, vision creating, and goal setting of the board room.

    Risk

    There have been a number of recent events, both local and international, which have highlighted the significance of corporate governance in a modern economy, as well as the devastating consequences of abandoning the practice of good governance. In New Zealand, the failure to adhere to standards of good governance has led to the collapse of finance companies, law suits against directors, financial harm to shareholders and other investors, and large-scale fraud within sporting clubs and well-known charities.

    The management of risk is a cornerstone in virtually all organisations, and when there is consistent failure to adequately protect against unnecessary risk, then the consequences can be dire (or catastrophic as in the case of Arthur Anderson, Enron, and Barings Bank). Basic risk management failures, therefore, reflect a breakdown in corporate governance. They reflect poor management of conflicts of interest, inadequate understanding of key business risks, poor oversight by boards of the mechanisms for managing their businesses, and a failure to exercise diligence in ensuring that the organisation's strategic plan and objectives are properly implemented.

    Ensuring that conflicts of interest are either avoided or extremely well managed, that transparency and disclosure are promoted, and that the organisation's visions and goals are always being adhered to will create a culture where risk is not only identified expediently, but is also well quarantined. The companies that have weathered the storms of economic recession, threats of takeovers, and strife from relentless competitors have consistently demonstrated that sound corporate governance is the foundation for effective risk management.

    Good Financial Management

    For governance to be effective in the corporate environment, it is imperative that all board members have a basic understanding of financial management. The same applies to boards in the not-for-profit sector. A basic understanding of the precepts of financial systems and management is crucial for governance in both environments because board members, whether well versed in accounting and financial matters or not, have responsibility for the financial success and sustainability of their organisation. Should something go terribly wrong in the organisation due to financial mismanagement, then all members of the board have equal legal liability (which can, in certain circumstances, pierce the corporate veil).

    Therefore, board members should have some nous when it comes to financial management; a general understanding of the effect of positive cash flow (and what insolvency will mean to the organisation), and a basic ability to assess the financial health of the organisation particularly in relation to the attainment of its objectives, knowledge of the cost of borrowings to the organisation, and interpreting information about the organisation's financial performance over time. These elements are vital because the board is accountable to stakeholders, employees, and sponsors for the proper application of the organisation's finances. In addition, being able to protect the organisation's assets and capital from loss are important considerations for any board trying to meet the requirements of good financial management.

    One could be forgiven for thinking that you need an accounting qualification to practise good financial management. Thankfully, that's not quite true. A basic ability to tell the difference between a surplus and a deficit, together with some knowledge about where the organisation's funds will be best utilised, is often a good starting point. For the average non-accountant member, a key skill lies in being able to ensure the organisation has the right amount of money applied (or invested) in the right areas (at the right time) in order to meet relevant expenditure of those activities or events approved by the board, and to effectively plan ahead to meet the board's short to medium-term business goals.

    Some Key Principles

    The following are some key principles in corporate governance which all boards should promote and practise:

  • Establish a clear vision, identify opportunities for growth and development, and sett objectives.
  • Have a sound understanding of the business of the organisation, the marketplace it operates in, the other players in that marketplace (the competition); identify what is distinctive about its own business, communicate its vision clearly, and understand the nature of its risks.
  • Acknowledge that the ultimate responsibility for ensuring the organisation's risks are properly identified, monitored, and controlled lies with the board.
  • Ensure that the composition of the board reflects an ability for clear and objective thinking, reasonableness, business acumen, marketing and human resources strengths, and financial wisdom. It is important to have a good mix of non-executive and independent parties if at all possible. There must also be a clear separation in the position of Chairman and the CEO (they are not the same).
  • Acknowledge that a fundamental requirement is to be scrupulous in recognising and avoiding potential conflicts of interest. All potential conflicts must be disclosed as early as possible (collectively or individually). If they do arise, then it is best to manage conflicts in ways which do not harm the company or organisation.
  • Have rigorous internal and external audit arrangements in order to ensure transparency and independence at all times.
  • Conclusion

    In many respects, the practice of effective corporate governance is an exercise of common sense, good policy, transparency, and good financial and risk management. Corporate governance is often shrouded in mystery, and, more often than not, is neglected in many boardrooms. It is a sad fact that the importance of sound governance often only gets publicity once the significance of its absence, or the consequence of its neglect, become glaringly obvious – in the breakdown of accountability, the collapse of companies, and the fraudulent activity within organisations. However, with increasing legislative changes, and in an economy scarred by corporate collapses, the significance of good governance comes to the forefront as an integral part of any organisation – whether state owned, corporate, or not for profit.

    During an economic recession, we are reminded of the importance of sound governance. It has particular significance in the corporate arena – to ensure businesses operate well and survive – and is essential in promoting healthy organisations, ethical conduct by decision makers, honest enterprise, and financial stability.

    Vincent Naidu practises Commercial and Not-for-Profit Law in Auckland and has worked with Not-for-Profit organisations around New Zealand and internationally.