Corporate governance

Corporate governance

Executive Summary

With the advent of globalization, the relationship between corporations and their shareholders is very important. Globalization has brought about a new range of global investment options thereby requiring corporations to focus on building long term relationships with the investors. This relationship should be based on communication and trust between the parties. This will ensure that the corporation obtains the maximum benefits of listing. However, there is an “expectation gap” that affects this relationship. This “expectation gap” results from the difference in public expectation of the roles and responsibilities of directors of organization and the actual roles and responsibilities of the directors as provided in the laws of the land. This organization is alive to the fact that there exists this expectation gap. This white paper has therefore been written for the Australian public especially shareholders of this organization. At the end, it is expected that the paper will help many in developing a good understanding of the proper role of directors of companies and thereby help in bridging the “expectation gap”.

Introduction

Corporations play a very important role in the social and economic well being of the Australian society. The corporations are governed and managed by people who act as directors. The general expectation of the public is that directors of both listed and non-listed corporations should act in good faith to the best interest of the nation. It is the belief of many people that directors should be loosely involved in the affairs of the corporations so that they ensure that nothing goes wrong (Brooks & Dunn, 2009 p. 6). However, this expectation requires that all directors be full time employees of the corporation. This would undermine the independence and objectivity especially of the non-executive directors who are always brought in to provide oversight and objectivity in management of the affairs of the corporation. The “expectation gap” and the manner in which regulators, parliamentarians and other policy makers have responded to it have put a lot of pressure on corporate directors. The result of this is that much time has been spent on corporate compliance leaving less time for strategy, innovation, entrepreneurship and prudent management of the corporations to put them in the global map. This has had an adverse effect on the corporations in terms of business efficiency, financial outcomes and stability and reputation of Australian businesses. It is important that this “expectation gap” is bridged to help develop and maintain competitiveness of Australian businesses (Cole, 2012 p. 7).

Nature of expectation gap surrounding directors’ responsibilities

The directors of the corporation have different functions which include but not limited to: setting the strategic direction of the company; determination and approval of the corporate policy; appointment of the chief executive officer (CEO) of the corporation; management and monitoring of risk; overseeing the performance of the CEO and other senior managers of the corporation; and overall governance framework (Chen, Dyball & Wright, 2009 p. 208).

Unfortunately, even with the clear roles and responsibilities of the director as outlined above, there are instances when the public, the media and the parliamentarians in Australia have not clearly understood the roles and responsibilities of the directors. In understanding the expectation gap, there are pertinent questions that are considered: what are the responsibilities of a director in this corporation? How have the shareholders and the general public separated the corporation from the management? What is the public perception about the role of a director and how does this compare with the practice and the laws of the land? To the extent that there is a difference of opinion between the public perception and the reality on the ground, what is the level of this “expectation gap”? How can this gap be bridged by legislation or practical governance to ensure that the expectations are real?

Other pertinent issues include the fact that there are different types of shareholders in an organization. The institutional and individual shareholders have different expectations from the directors. Shareholders from different countries and cultural backgrounds also have different expectations on the role of directors. The other issue is the remuneration of the shareholders and whether this remuneration meets the expectations of the shareholders (Brennan, 2006 p. 607).

It is important to note that the management and the board of directors all have a common objective of maximizing shareholder value (Brennan, 2006 p. 577). The management is mainly concerned with the day to day operations of the corporation while the board of directors ensures that shareholders are represented adequately in the decisions of the corporation. However, many boards also consist of management which makes it difficult for some shareholders to separate the functions of the two. There is a distinction of roles between the board chairman and the CEO and this distinction should be well understood by the shareholders (Coombs & Holladay, 2011). The role of the chairman is to ensure that the board of directors has an efficient leader. The chairman helps in maintaining the integrity of the corporation and acts as a link between the senior management team and the shareholders. On the other hand, the CEO is in charge of the daily activities of the organization and reports directly to the board of directors (Clarke, 2007).

The board of directors has taken note of the fact that there are instances when the shareholders’ expectations have not been met with regards to the company’s growth prospects. The management may hire the skills to deliver the growth. However, the growth may not be achieved due to other business dynamics thereby creating an expectation gap (McEnroe & Martens, 2001).

As has been mentioned above, there exists an “expectation gap” that results from the difference in public expectation of the roles and responsibilities of directors of organization and the actual roles and responsibilities of the directors as provided in the laws of the land. The extent of this gap has affected the performance of the organization in some instances. It is expected that shareholders should have a better understanding of the roles of directors in listed corporations (Keay, 2007).

How the expectation gap will be resolved

It is important that directors of corporations including the non-executive directors to improve their performance and enhance their behavior in the eyes of the shareholders to help in bridging the expectation gap. The following other recommendations are proposed:

  • That directors take a more active role in their engagement with the organization. This will help in developing and improving understanding of the roles of the directors. This will also eliminate the legitimate expectations that the shareholders might have. The engagement will help in building trust and confidence between the shareholders and the directors (Hooghiemstra & van Manen, 2004).
  • It is hereby proposed that the non-executive directors engage themselves and become more visible at times when the organization is experiencing a crisis. Although the crises are always few and far between, the solidarity of approach and the support that the non-executive directors will display will help them gain support and confidence among the shareholders.
  • The shareholders are hereby advised to do extensive reading and understand the role of directors in corporations. Through this self reading, the shareholders will understand the responsibilities and limitations of the directors.
  • That shareholders approve of directors to take courses that are administered by institutions like the Australian Institute of Company Directors. These courses and programs will be for the purposes of improving the governance standards of the board members to ensure that they are more visible and meet their expectations as board directors.
  • The roles of the CEO and chairman of the board of directors should be defined clearly. This will ensure that they do not have conflicting roles that may confuse the shareholders.
  • The board of directors and management should professionally manage the expectations of the shareholders especially with regards to maximization of value for the shareholders. This is mainly on issues like growth prospects and expansion strategies (Langevoort, 2003). 

Benefits and costs of the ‘two strike’ rule

Introduction

The purpose of the ‘two-strike’ rule is to ensure that directors are accountable for the salaries and bonuses received by the executive. The implication of this is that shareholders have the power to change the entire board of directors if they do not feel convinced on the amount of salaries and bonuses that directors receive. This law came into force on July 1, 2011 after the amendment of the Corporations Act. In this rule, the first strike occurs when the remuneration report that outlines the salary and bonuses of all directors is rejected by a ‘no’ vote; this is 25% or more of the shareholders present at the annual general meeting. The second strike occurs when the subsequent remuneration report is also rejected by a ‘no’ vote of 25% or more of the shareholders present at the annual general meeting (Monem & Ng, 2013 p. 239).  When the second strike occurs, the shareholders will vote to determine whether all the directors will need to stand for re-election. If this passes with 50% of the eligible vote, then a spill meeting will have to be held within 90 days. The ‘two-strike’ rule has different benefits and costs (Bruner, 2013 p. 70).

Benefits of the ‘two-strikes’ rule

The two-strikes’ rule allows shareholders to access important information about the remuneration of directors in the company. This will help shareholders and prospective shareholders determine the company values and how the directors work towards achieving the company values. For example, companies that are concerned mainly with the retention of key executives are likely to pay bonuses to the executives without much regard to performance of the executives; companies concerned about growth may pay bonus after a takeover or acquisition even if the takeover or acquisition may later prove to be unsuccessful; companies concerned about reputation may pay bonus based on attainment of customer satisfaction targets without considering the performance levels. There are also instances when non-executive directors have been put in the same remuneration order as executives. From the above, it should be seen that there are instances when the resources of a company may be used to pay directors yet the directors may not deserve the pay (Monem & Ng, 2013 p. 240).

Apart from highlighting the important aspect of the remuneration of directors, the ‘two-strikes’ rule also helps shareholders understand other important issues like corporate governance and transparency (Clarkson, Walker & Nicholls, 2011 p. 50). This means that the ‘two-strikes’ rule has forced directors to be obliged to the shareholders of the company. This has helped in promoting transparency and accountability especially in handling issues of remuneration of directors (Vickovich, 2013).

The ‘two-strikes’ rule has given shareholders more power in handling the affairs of the company. This means that directors must prove that they have really worked for the company to justify their pay (Brown, Beekes & Verhoeven, 2011 p. 100). If this is not the case, then a ‘two-strike’ will occur. This means that directors have a responsibility of engaging with shareholders on the different issues that the shareholders have raised (Kovacevic, 2012 p. 104). For instance, after the introduction of the ‘two-strikes’ rule, shareholders have had the opportunity of engaging companies on social and environmental issues. A case in point is where shareholders have proposed for companies to engage in corporate social responsibility activities to help protect the environment and also give back to the community.

Costs of the ‘two-strikes’ rule

The ‘two-strikes’ rule has put management in a situation where they only mind about the issues raised by the shareholders. This may limit innovation in the company and may make the company not be competitive in the long run because it will not be considering other factors in the competing environment. This has created additional costs and administrative burdens which has affected the productivity and global competitiveness of Australian companies (Daveson & O’Hara, 2013).  For example, during the second strike, managers cannot vote on their remuneration due to issues of conflict of interest. However, they are allowed to vote on whether they should be back on board of directors. Most people have therefore considered the second strike as an expensive affair that does not achieve the intended objectives (Peters & Handschin, 2012).

The ‘two-strike’ regulation has created a situation where boards can be taken over through ‘coups’. This is where certain shareholders or groups of shareholders may liaise with their colleagues to kick out certain directors for the sole reason that they do not like the directors despite the performance of the directors. This can have a negative effect on productivity and performance of the company. This is based on the low threshold that is required during voting for such issues.

Due to such factors, the ‘two-strike’ rule has discouraged many people from taking roles as directors of listed companies. Some of the people shying from these roles are very innovative and could bring fresh ideas to the companies. However, due to the regulations and the fear for their reputation, they are not taking up the roles. This will have a long term effect on the international competitiveness of Australian companies (Ferrara, Abikoff & Gansler, 2013).

Recommendation for improving corporate governance practices

To avert a second-strike, it is important that there is more engagement between the company and its shareholders throughout the year. Specifically, the company should:

  • Improve disclosure on performance of different directors. If this is done, it will be clear in the minds of shareholders the performance of directors and whether they deserve the pay they receive.
  • Non-executive directors should not be given the same remuneration as executives. This is because the performance and roles of these non-executive directors are not the same as for executives.
  • Improving the balance between the interests of shareholders and interests of the management. This can be done by allocating more bonus shares to the shareholders. Through this, the shareholders will feel that the management has played a role in improving the value of their money.
  • Directors of companies should engage more with shareholders. This will help in understanding the needs, concerns and interests of shareholders.
  • The threshold for first strike should be increased to ensure that boardroom ‘coups’ do not happen in companies. Raising the threshold will make it difficult for interested groups to marshal the numbers that can instigate a boardroom ‘coup’.
  • The company should change their auditors after some period of time or if they maintain the same audit company, then the partner auditing the company should be different. This will allow for fresh ideas by new auditors and increase the independence of auditors. The result of this is that there will be reduced risk for the shareholders in the sense that the auditors will not be able to collude with the directors to alter the books of accounts especially with regards to remuneration of directors (Pacces, 2013).

 

 

References

Brennan N. (2006). Boards of Directors and Firm Performance: Is there an Expectation Gap?

Corporate Governance: An International Review, 14(6): 577-593.

Brooks L.J, Dunn P. (2009). Business & Professional Ethics for Directors, Executives & Accountants. Melbourne: Cengage Learning.

Brown, P., Beekes, W., Verhoeven, P., (2011). Corporate governance, accounting and finance: a

review. Accounting and finance 51, 96–172.

Bruner, C. M. (2013). Corporate Governance in the Common-Law World: The Political Foundations of Shareholder Power. Cambridge : Cambridge University Press.

Chen R; Dyball M.C; Wright S. (2009). The link between board composition and corporate

diversification in Australian corporations. Corporate Governance: An International Review, 17(2): 208-223.

Clarke, T. (2007). International Corporate Governance: A Comparative Approach. New York: Routledge.

Clarkson, P., Walker, J., Nicholls, S., (2011). Disclosure, shareholder oversight and the pay-performance link. Journal of Contemporary Accounting & Economics 7, 47–64.

Cole S. (2012). Mind the Expectation Gap: The Role of a Company Director. Australian Institute of Company Directors. Retrieved from: http://www.companydirectors.com.au/~/media/Resources/Director%20Resource%20Centre/Publications/Books/PDFs%20various/Mind%20the%20Expectation%20Gap%20whitepaper%20FREE%20PDF.ashx

Coombs W. T., Holladay S. J. (2011). Managing Corporate Social Responsibility: A Communication Approach. New York: John Wiley & Sons.

Daveson S; O’Hara A. (March 7 2013). Executive remuneration: Results of spill meetings put

effectiveness of two strikes in question. Corr Chambers Westgarth. Retrieved from: http://www.corrs.com.au/thinking/insights/executive-remuneration-results-of-spill-meetings-put-effectiveness-of-two-strikes-in-question/

Ferrara R.C, Abikoff K.T., Gansler L. L. (2013). Shareholder Derivative Litigation: Besieging the Board. New York: Law Journal Press.

Hooghiemstra, R.; van Manen, J. (2004). Non-executive directors in the Netherlands: another expectations gap? Accounting and Business Research, 34, 1, 25-42.

Keay, A. (2007). Company Directors’ Responsibilities to Creditors. New York: Routledge.

Kovacevic S. (2012). Executive remuneration developments in Australia: Responses and reactions. The Economic and Labour Relations Review, 23(2): 99-115.

Langevoort, D. C. (2003) Managing the expectation gap in investor protection: The SEC and post-Enron reform agenda, Villanova Law Review, 48, 1139-1165.

McEnroe, J.E.; Martens, S.C. (2001). Auditors’ and investors’ perceptions of the audit expectations gap, Accounting Horizons, 15, 4, 345-358.

Monem R; Ng C. (2013). Australia’s ‘two-strikes’ rule and the pay-performance link: Are shareholders judicious? Journal of Contemporary Accounting & Economics, 9(2): 237-254.

Pacces, A. (2013). Rethinking Corporate Governance: The Law and Economics of Control Powers. New York: Routledge.

Peters A, Handschin L. (2012). Conflict of Interest in Global, Public and Corporate Governance. Cambridge : Cambridge University Press.

Vickovich A. (January 17 2013). Two-strike rule has improved corporate governance.

InvestorDaily. Retrieved from: http://www.investordaily.com.au/21835-two-strike-rule-has-improved-corporate-governance