Defining an effective and efficient board

By Cassandra Mascarenhas

Delving into what really makes an effective board of directors, the Sri Lanka Institute of Directors (SLID) questioned if boards were now purely ceremonial with regular meetings held for compliance or if they were performing to their maximum potential, ensuring the long-term growth and sustainability of the company.

Improving the effectiveness of boards could significantly improve the success of companies and understanding this, SLID as part of its series of seminars held this year, summed it up in a seminar which featured United Motors PLC Chairman and former SLID Chairman Ranjith Fernando as a keynote speaker, who aired his views on what really makes an effective board.

Collapse of board governance

The global meltdown in 2007/08, the after effects of which are still ongoing, and despite whatever we may agree or disagree with on the causes of the meltdown, there is one on which there is unanimity – that the collapse of board governance was one of the issues that lead to the crisis, stated Fernando in the opening lines of his presentation.

This has brought a renewed focus and a re-examination of the performance of boards trying to find out what exactly makes an effective board. The high profile failures of institutions like Lehman Brothers and the rest, which everyone is now familiar with, has brought up the question: What is it that makes a board effective?

“Is it the people, the numbers, the composition of the board, regularity of the meetings? People have been thinking aloud as to what really makes an effective board. Now, one also asks the question, when looking at these failures, the high profile boards of many of these companies, for example Enron, which has a dean from Stanford University, another high profile banker, a CEO of an insurance company on its board – were they all asleep when these trends in the risk of the particular companies took place, were they engineering the collapse for personal benefit or were they so blind as not to see the emerging clouds of the storm that was to come?” questioned the Chairman.

The remuneration packages, the creation of risk in search of more and more profits, taking risks that were not desirable from the company’s point of view and the CEO’s incentive packages resulted in the growth of the business and the increase of risk. Fernando pointed out that if there was one point of consolation, they were not the only people asleep.

Macroeconomics over the past two decades

“If you look at what has really happened over the past two decades in a macroeconomic sense, today in hindsight you will see that your risk is a chart of the current account balances of two sets of countries. On the top, the growth of the current account balances like the oil rich countries, Japan and China and below the deficit in the current account balances of countries such as the US, UK and Italy,” he emphasised.

“When you look at this, you find a shift in the economic wellbeing of certain countries at the cost of others and the people who made money in countries like Japan and China found that the savings in those countries were more than the investment needs of the country. Therefore the excess funds in those countries were taken out, not for investment in equity or property in outside countries, but in gilt-edged securities which were near-risk or risk free.”

Looking at the growth of those investments in those countries, you will find that there was a tremendous growth in bonds. The ownership of treasury bonds in the US by parties outside the US saw enormous growth of nearly 60% of bond issues which are held by foreign parties. As a result of this, the yield in those bonds fell sharply.

Fernando explained that the investing countries sought to really go behind a basis-point change in the yield. A 15% to 30% basis point change attracted them and financial innovation took place in the receiving countries, which made use of different instruments which gave them a slightly higher yield. They split most of those instruments horizontally and vertically, which packaged and constructed yields that were slightly higher than the gilt-edged yields which attracted these investors.

“So the financial sector grew in terms of tremendous growth in the assets of companies – the investment and commercial banks which really created instruments which were of diverse character with mathematical formulae being used to really look at the yield, which very few people understood, even the regulators and the capital requirements on those increased assets were done away with because most of these instruments were off the balance sheet. Therefore they got away from the minimum capital requirements that a bank should have with the growth of assets,” he stated.

Another thing that took place was debt in the economies of those countries increased because there was plentiful money in the banks and they lent liberally, the Chairman asserted. Looking at the increasing debt in the US, UK and EU countries from 1997 to 2007, there was tremendous growth in the assets of companies. The UK debt as percentage of GDP was nearly 400% of the GDP of that country. Sri Lanka was alarmed at one point when borrowings were 100% of GDP.

Similarly in the US, the debt as a percentage of GDP was nearly 300% of the GDP of that country. The massive increase of debt resulted from the oversupply of money to those countries with yields down, and innovation taking place gave them a slight edge over the yields of risk-free products.

“Now these developments over a period of time did not strike many of the economists of that period. An extract from an IMF report on the state of the global economy from April 2006 said that there was growing recognition that the dispersion of credit risk by banks to a broader and more diverse group of investors rather than warehousing such risk on their balance sheets has helped make the banking and the overall financial system more resilient,” said Fernando.

The genesis of corporate entities

Understanding the causes and why the boards missed these kinds of developments that was taking place called for an examination of a corporate entity. Looking at the genesis of corporate entities, a company is a legal personality created by the law. It has a distinct existence from the shareholders who own it and it came about with investment needs becoming larger and larger, that an individual couldn’t provide the resources nor take the risk from his personal assets from those resources; therefore a collection of individuals got recognition in the form of a corporate entity. It is the creature of a statute.

“Our own Companies Act No. 7 of 2007 deals with what this entity is. If you look at the anatomy of a corporate entity, you find that there are three parties in the company – the shareholders, the board and the executives,” he said.

“These three parties are recognised by referencing the different sections but it is strange how some of the issues we grapple with are not dealt with in the act, although for a very good reason. Structural and procedural aspects of a company are more what is dealt with in the statute than the behavioural aspects of a company and its components which you cannot legislate on, the morality and behavioural aspects of a company which really affect the effectiveness of a company cannot be largely defined in the act because they are concepts you cannot put in the law.”

Therefore, for instance, some of the issues that companies face today or faced several companies at the time of the downturn were the result of some of those behavioural aspects. He pointed out that in several cases, it was found that the executive who was running the company paid themselves very high salaries.

There were codes of conduct that were formulated by certain committees that were appointed, the Cadbury Committee for instance, dealing with excess payment to directors, of control of checks and balances which really grew, were the kind of problems that arose because the law provided for procedural and structural part of the company but not the behavioural interrelationships that are needed in a entity.

As a result, many problems arose – the need for audit committees came about because it couldn’t define what controls that needed to be there and who really had to report to whom. These problems resulted in certain checks and balances and the separation of powers of the three entities.

“Now that again if you look at the act it doesn’t recognise so; in fact the act has no definition of a board. It refers to a chairman but not to how a chairman is elected and the constitution of a board. It makes no distinction between executive and non-executive directors,” Fernando critiqued.

“In the act, the reference to the board, chairman and duties of directors are defined but the duties of the board itself are very scantily dealt with in the act. Now the duties of the board are set out in certain sections of the act; Section 134 for instance deals with the need to have an annual General Meeting. Section 150 talks of obligation to prepare financial statements – again a duty of the board.”

But most of the other provisions are the requirements of the duties of a director but in the case of the board there are very few sections that define the role of a chairman; there is no distinction between independent directors – they are not even quoted in the act or cited in any of the sections.

“You find that 152 deals with the obligation to prepare group accounts, 164 deals again with the auditors’ access to information. There are a very few sections in the legislation that refer to the duties of a board but more or less focuses on the individual director but if you take the model article of the act, it talks of a chairman who may or may not be there in a company.”

It says that if a chairman is there in the company, he shall preside at meetings. If he is not there, one of the directors could chair the meeting. The whole act is designed on the basis that it does not recognise the tripartite arrangement between the three parties that form the constitution of a company – the shareholders, the directors and the board and the management but rather a loosely a set of duties.

Sections 187, 188 and 189 are again important as they spell out the duties of a director, he added. The concept of an independent director does not emanate from the act.

Defining the behavioural aspects of a company

Therefore, with these provisions not dealing with the behavioural aspects and the problems that arise with the functioning of a company, there was a new body of guidelines, rules and regulations dealing with the behavioural aspects that came about in the development of the corporate entity.

He explained that these could be found in the articles, codes, rules, regulations and directions of regulators, which have brought about an added role of the board in terms of defining the behavioural aspects of a company so that the company functions in a proper manner.

“Seeing that the law has not provided, and for good reason as the law cannot legislate on the morality of a person, in that sense we find that the whole concept of corporate governance was built up around the statute and various other documents,” Fernando said.

“If you look at the directions given by the Central Bank, it goes into great length unlike the statute, of defining the duties of the directors and the responsibilities of the board – the board should resume overall responsibility and accountability in respect of the management of the affairs, conduct of business and maintenance of a prudent risk management, the safety and soundness of the bank.”

Governance has now been defined as the way companies are run and managed; it refers to interactions between the three parties and not really the structure or form of those parties, but rather the behavioural aspects of how they should act in terms of issues that come up.

Apart from the box-ticking kind of compliance that is really ensured in acts, there is a whole body of rules and regulations that came about into the content of a board’s work. The CIMA publication calls it enterprise governance.

“Now it is not only the compliance aspect of a company but also the performance aspect and they divide it into two components – the conformance processes and the performance processes; which is involved in enterprise governance. Accountability and audit are part of the compliance part of it but value creation and strategy is part of performance part of a company and that is part of enterprise governance which is also a responsibility of the board. These aspects which are not brought up in acts are now brought up in corporate governance and have brought about the redefinition of the role of a board,” he explained.

Main duties of a board

Looking at the main duties of the board from the point of view of compliance and performance, there are five to six areas for which the board is responsible and the main duties and responsibilities lie within these areas.

“One is the appointment of a CEO and management team. It is said that the most important decision that the board makes is the appointment of a CEO because he is the person who manages the company on a day to day basis. If you make a mistake here, the board is responsible for that and the board needs to take great care when making these selections – now this is not included in the act,” Fernando said.

“The second is obtaining a business plan and strategy from the chief executive and management with clear targets and goals. The board has to approve that corporate business plan. What is a business plan and how many of our board members appreciate what a strategic plan is to demand such a plan from the management? How many boards insist on certain specific targets and a clear vision for the company?” the Chairman asked of the audience.

The third is understanding risk control measures and the effectiveness of these measures.

“The board should know what is the risk in the business, where things can go wrong, how much of risk the company runs on growing its assets and so on. The board must be aware of the risk and the controls that have been put in to manage that risk, either to prevent the risk from happening, to transfer the risk or to mitigate it. What profile of risk the company should take is also a matter for the board and should hold the management responsible for not taking the company beyond a certain level of risk in search of profits,” he stated.

Then to set the governance framework of the company – the separation of functions and duties within the three parties, the code of conduct and values of the company and unless a company has this framework, the board is not doing its duty to set out the operations of the company in a manner that is desirable, Fernando stressed.

The board also has a responsibility to oversee the functions of the management of a company. For this there has to be a regular review of all the information that comes before the board. Compliance with all the laws and regulations that apply to that specific industry – it’s the duty of the board to ensure that the company conforms to those legal requirements in the act and regulations and have an assurance that they are being fulfilled and conformed to by the company.

Finally, the integrity of the financial information – the board has a responsibility towards the shareholders to ensure that the financial information that is provided to them is true and provides a fair view of the company, again this is the responsibility of the board and it is spelt out in the act which calls for the need for an AGM and so on.

Interactive Q&A

The seminar came to a close with a Q and A session moderated by John Keells Group Finance Director Ronnie Peiris where Fernando dealt with questions brought up by members of the audience:

Q: How can we get the independent director more involved in the implementation of strategy?

A: The role of the board is not the preparation of strategy – that’s the role of the management. It is reacting to the strategy presented to the board, looking at other options, sharpening the strategies and improving them that is the role of the board and I think that the board can play a role talking to staff, mapping the implementation process with them; that’s something that the board could and should do.

Q: What are your views on the Sri Lankan business community? Most directors are not really trained to be a director – don’t you think that within a company there should be a process to train the directors?

A: I agree with you, training is necessary and if companies can put them through a familiarisation process and the institute too is playing a role in that, but it would be a good thing if especially the bigger companies did that.

Peiris: That is what we as an institute will endeavour to do, the SEC is also thinking of introducing for any new director being appointed, that they go though some sort of training or certification as done in Malaysia.

Q: When you reflect on board performances, is there a materialism creeping in through one’s life, are a sense of values going away?

A: I certainly feel that there is some connection between the upbringings of a person and their performance on a board. The ability of say what is right and stand for what is right is something that comes from who you are and I don’t think we are doing any good making boards by appointing people who do not exude those characteristics.

Pix by Indraratne Balasuriya