Ethical Boardroom Spring 2019 by Ethical Boardroom

Published by Ethical Board Group Limited | www.ethicalboardroom.com

Keeping it above board ● Spring 2019 Help! I settled with an activist The unsettling truth about settlement agreements Taking anti-money laundering compliance seriously How boards can prevent money laundering within European banks

Identifying and managing risk Making board and management risk committees effective Whistleblower protection in the digital age Executives who witness fraud should pay attention to governing rules

Strengthening

Boardroom Diversity Investors use their influence to put the spotlight on diversity and inclusion

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ISSN 205 8- 61 1 6

Ethical Boardroom | Contents

COMMENTARY

How activism is making boardrooms more challenging Companies need to recognise the importance of engaging with and knowing their shareholders

ESG investing: Truths, half-truths and lies What investors want and what they get from environmental, social and governance data

Focussing on corporate culture The fundamental disconnect between corporate boards and ethics and compliance

ASIA

Global News: Asia Gender diversity, shareholder revolts and money laundering

BOARD LEADERSHIP

Leading by example Diversity improvements must begin and end with the attitude of those already at the top

22 26

Strengthening board diversity A push from the SEC and Congress

Proxy season: A springboard for diversity discussion Investors push for board diversity, but power to change remains with companies

Composing the board for competitive advantage Businesses must be at the top of their game to seek out gains that will improve performance

Failure is an option Corporate failures should not trigger a change to the governance paradigm

Independent external board reviews Board evaluations build board effectiveness, but it is time to raise the level across all companies

50 10

4 Ethical Boardroom | Spring 2019

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Contents | Ethical Boardroom

LATIN AMERICA & CARIBBEAN

Global News: Latin America & Caribbean Green loans, transparency, an IPO and a corporate rebrand

CONTENTS 58

Gender diversity across Latin America Bringing women on board creates value and sustainability in an organisation

Exponential boards: Evaluation 4.0 To make better business decisions and consolidate a culture of innovation within conglomerates, board evaluations must evolve to the next level

BOARD GOVERNANCE

Applying Commonsense Principles 2.0 The continuing momentum of the governance conversation

Remuneration trends across Europe 2007 Shareholder Rights Directive amendments will affect executive compensation practices in Europe for many years

CEO pay: Shareholders care more than ever Board directors need to ask more questions

Global audit committee: Looking ahead in 2019 Insight into the key drivers and pitfalls that audit committees need to know

Identifying and managing risk Making board and management risk committees effective

NORTH AMERICA

Global News: North America Financial misconduct, boardroom shake-ups and board diversity

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Spring 2019 | Ethical Boardroom 5

ACTIVISM & ENGAGEMENT

Help! I settled with an activist! The unsettling truth about settlement agreements

Strengthening boards Board development and director succession in the age of shareholder activism, engagement and stewardship

Investors confront the tech sector The shareholder fi ght to curb ‘surveillance capitalism’ and other emerging risks

104

MIDDLE EAST

Creating an ethical work culture Why codes of ethics are an important part of good corporate governance

THE EB 2019 CORPORATE GOVERNANCE AWARDS

Introduction & Winners list We reveal our 2019 Middle East and Africa winners

Access Bank: Effective governance Practising good corporate governance for building sustainable, responsible businesses

AFRICA

Nigeria’s Code: Attaining good governance in 2019 The Nigerian Code of Corporate Governance 2018 is an important step forward

Global News: Africa Whistleblowing, governance codes and governance charters

TECHNOLOGY

Good corporate governance begins with good data Boards can ensure they stay on top by using smart solutions

6 Ethical Boardroom | Spring 2019

68 100

More than data Businesses need analytics to make faster and more confident decisions but with the human touch, too

104

Information Governance: Achieving data ethics, privacy and trust How organisations can make the most of an information governance programme

126

RISK MANAGEMENT

108

Leveraging data at the board level Improving cybersecurity outcomes by sharing information across your organisation

112

Overcoming culture clashes Promoting a collaborative approach to transitioning financial crime risk compliance during an acquisition is a key ingredient for success

116

Paradise lost or a money laundering paradise? The role of board of directors in preventing money laundering within European banks

EUROPE

122

120

Global News: Europe Digital tax, shareholder revolt, gender diversity and litigation

82 122

REGULATORY & COMPLIANCE Whistleblower protection in the digital age Executives who witness fraud should pay attention to governing rules

126

Are you as ethical as you think? Behavioural ethics can enhance compliance programme assessments

AUSTRALASIA

130

Global News: Australasia Brand reputation, corporate change and gender diversity

Spring 2019 | Ethical Boardroom 7

Ethical Boardroom | Foreword

Embracing diversity Welcome to the Spring 2019 edition of Being able to draw upon a diverse set of competencies and knowledge is essential in understanding opportunities, anticipating challenges and assessing risks. Organisations are also discovering that supporting and promoting a diverse and inclusive workplace brings many benefits. Studies suggest that increasing the diversity of leadership teams leads to more and better innovation and improved financial performance. According to PwC’s most recent Annual Corporate Directors Survey, 94 per cent of board directors surveyed indicated that a diverse board brings unique perspectives, 84 per cent responded that diversity enhances board performance and 91 per cent reported that their boards are taking steps to increase diversity.

8 Ethical Boardroom | Spring 2019

Ethical Boardroom magazine

A study from the Boston Consulting Group also found a ‘strong and statistically significant correlation’ between the diversity of management teams and overall innovation. Companies that reported above-average diversity on their management teams also reported innovation revenue that was 19 percentage points higher than that of companies with below-average leadership diversity – 45 per cent of total revenue versus 26 per cent. There has been a slew of regulatory or statutory changes and campaigns or initiatives that aim to increase board diversity. The US Securities and Exchange Commission (SEC) recently issued new ‘Compliance & Disclosure Interpretations’ encouraging public companies to provide details on how they consider diversity when making decisions regarding the makeup of their boards of directors. The Improving Corporate Governance Th rough Diversity Act of 2019 was recently introduced by Democrats to both houses of Congress and would require public companies to annually disclose the gender,

race, ethnicity, and veteran status of their board directors, nominees and senior executive officers. The Th irty Percent Coalition has launched an awareness campaign to promote women of colour on corporate boards. According to the Coalition, women of colour comprise nearly 40 per cent of the US female population and have a buying power estimated to be more than $1trillion. Yet women of colour including African American, Asian, Hispanic and Native American who represent only 3.5 per cent of S&P 1500 director positions. In the UK, Legal & General Investment Management – the country’s biggest fund management group – voted against more than 100 chairmen last year, at fi rms including Barclays, Ted Baker and Sports Direct, for failing to boost the number of women in their boardrooms (read more about this on page 120). In this issue of Ethical Boardroom, associates at Weil’s Public Company Advisory Group expand on the SEC changes and the Diversity Act, while we also hear from consultant Alejandra Mastrangelo on the drive to increase gender diversity on Latin American boards.

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Contributors List | Ethical Boardroom

OUR THANKS TO THIS ISSUE’S CONTRIBUTING WRITERS ALISSA AMICO Managing Director, GOVERN

JIM DELOACH Managing Director, Protiviti

ANIEL MAHABIER Chief Executive Officer, CGLytics

DR MATHIAS BAUER Partner, Center of Excellence for Data & Analytics, KPMG

HOWARD DICKER, ADÉ HEYLIGER & AABHA SHARMA Howard is Co-Head, Adé is a Partner and Aabha is an associate at Weil’s Public Company Advisory Group

ALEJANDRA MASTRANGELO Consultant, Corporate Identity and Governance

ANDRES BERNAL Partner, Governance Consultants SA FABIO BIANCONI Director at Morrow Sodali LISA BLAIS & ASHLEY SUMMERFIELD Lisa leads the US Board Practice and Ashley leads the Global Board Consulting Practice at Egon Zehnder KRISTIN BRESNAHAN Executive Director of the Ira M. Millstein Center for Global Markets and Corporate Ownership at Columbia Law School SONIA CHENG & STEVE McNEW Sonia is the Managing Director, Steve is Senior Managing Director, Technology, FTI Consulting MICHAEL CONNOR Executive Director, Open MIC TIMOTHY COPNELL Executive Chairman, KPMG’s UK Audit Committee Institute

SABASTIAN V. NILES Partner at Wachtell, Lipton, Rosen & Katz, New York

ANDERSON DY, PHD Vice President of Sales for Northern/Eastern Europe and Africa, Diligent Corporation

HELEN PITCHER OBE Chair at Advanced Boardroom Excellence

SUNDAY EKWOCHI Company Secretary at Access Bank

SAMANTHA SHEEN Founder and Director of Ex Ante Advisory Services Limited

DR NECHI EZEAKO Executive Director, Institute of Directors, Nigeria

EVAN SILLS & REDA BAIG Evan is a Director and Reda, Associate at Good Harbor Security Risk Management

CHRISTOPHER J. HEWITT & JAYNE E. JUVAN Chris and Jayne are partners and co-chairs of the Corporate Governance Practice Group at Tucker Ellis LLP and practice law in Cleveland, Ohio

SVEN STUMBAUER Globally recognised financial crimes expert

JEFFREY M. KAPLAN & REBECCA WALKER Jeffrey and Rebecca are partners in the law firm of Kaplan & Walker LLP. Jeffrey is a Member of the New York and New Jersey Bars, and Rebecca is a Member of the California and New York Bars

CHARLOTTE VALEUR Chair, Institute of Directors

STEPHEN M. KOHN Partner at Kohn, Kohn and Colapinto, Chairman at whistleblowers.org KAI HAAKON E. LIEKEFETT Chair of the Shareholder Activism Practice, Sidley Austin LLP

RICH THOMAS Managing Director at Lazard, Head of European Shareholder Advisory

JANE VALLS Executive Director for the GCC Board Directors Institute (GCCBDI) MICHAEL VOLKOV CEO and owner of The Volkov Law Group ROSANNA LANDIS WEAVER Programme Manager for Power of the Proxy: Executive Compensation at As You Sow

EDITOR Claire Woffenden DEPUTY EDITOR Spencer Cameron EXECUTIVE EDITOR Miles Hamilton-Scott ART DIRECTOR Chris Swales CHIEF SUB Sue Scott HEAD OF ONLINE DEVELOPMENT Solomon Vaughan ONLINE DEVELOPMENT Georgina King, Rosemary Anderson SUBSCRIPTIONS MANAGER Lucinda Green MARKETING MANAGER Vivian Sinclair CIRCULATION MANAGER Benjamin Murray HEAD OF SALES Guy Miller PRODUCTION EDITORS Dominic White VIDEO EDITOR Frederick Carver VIDEO PRODUCTION Tom Barkley BUSINESS DEVELOPMENT Michael Brown, James Walters, Henry Smart ASSOCIATE PRODUCER Lea Jakobiak HEAD OF ACCOUNTS Penelope Shaw PUBLISHER Loreto Carcamo Ethical Board Group Ltd ● Ethical Boardroom Magazine 51 Philpot Street ● London E1 2JH ● S/B: +44 (0)207 183 6735 ● ISSN 2058-6116 www.ethicalboardroom.com Ethical Boardroom twitter.com/ethicalboard Designed by Yorkshire Creative Media | www.yorkshirecreativemedia.co.uk. Printed in the UK by Cambrian Printers. Images by www.istockphoto.com All information contained in this publication has been obtained from sources the proprietors believe to be correct, however no legal liability can be accepted for any errors. No part of this publication can be reproduced without prior consent from the publisher.

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Spring 2019 | Ethical Boardroom 9

Commentary | Shareholder Activists

How activism is making boardrooms more challenging Companies need to recognise the importance of engaging with and knowing their shareholders Rich Thomas

Managing Director at Lazard, Head of European Shareholder Advisory

I was recently presenting to the board of a large European public company on the topic of activism when one of the directors asked me a question that perfectly illustrated the way activism is changing the conditions inside the boardroom. The director asked: “Do activists not understand how the fiduciary duty of boards extends beyond simply servicing their shareholders? Do they not understand the appropriate order of how strategic decisions are made by a company?” The answer is simple and embodies the confl ict facing companies when attacked by an activist. Yes, they understand but, no, that does not change how they approach their investments. Over the past three to five years, the shareholder-issuer dynamic has transformed and today shareholders are asserting views and pressuring companies to adopt more shareholder-focussed strategies and policies. The most visible form of this are the high-profi le activists that deploy the media

10 Ethical Boardroom | Spring 2019

as a tool to pressure companies and boards and are supported by a broader shareholder base that is no longer willing to be deferential to the views of a management team or decisions of a board. In today’s new paradigm for public companies, the expectations of companies and boards are much higher, and the risks associated with underperformance are much more severe. Th is is making boardrooms a more challenging place for directors and for management teams. Management teams need to deliver more value and under a shorter time horizon. Boards are under greater pressure to challenge the management on issues of strategy and performance. The qualifications and skills of individual directors are under greater scrutiny.

Creating value

But why would an activist target your company in the fi rst place? Activists are seeking the same objective as most other shareholders – value creation. The difference lies in that they want value realisation faster and are willing to compel the company to undertake a different plan that delivers. They look for companies that are undervalued, and for which they have a strategy that could create more value than the current plan. Then they seek to assert their ideas by way of escalating direct pressure, gaining the support of other shareholders and aggressive public criticism. Indeed, an activist who owns two per cent of

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Shareholder Activists | Commentary

a company and launches a campaign, public or not, is only effective if he can convince a majority of the other 98 per cent that the board or management aren’t doing everything they can and should to create value for the shareholders. If there is sufficient discontent festering in the shareholder base, then they will push forward to implement their strategy, either alongside company leadership, or over the top of management and the board, at the cost of many a CEO’s or director’s career. We also see a change in style of activist campaigns on the continent, with a shift toward more bellicose, public activism. There are many reasons for this change: first, the shareholder base of European companies is increasingly global, and those global, traditional investors are more and more inclined to listen to activist theses and vote alongside them. Second, as passive investors continue to win the battle for new investment capital ($1.5trillion has flowed out of active management and into index strategies in the past 10 years), actively managed funds have become more and more engaged with the companies they invest in and are increasingly becoming drivers of activism themselves. Activism is no longer a category of shareholders; it has become a shareholder behaviour that many traditional investors may adopt at certain times. In fact, according to Lazard’s latest annual survey of activism globally, in 2018, 25 per cent of activists were ‘first timers’ to public agitation. At its worst, an activist campaign can drive significant damage on the management and board’s reputation. At best, a public campaign causes managements to devote a significant part of their time and resources to responding to the campaign, instead of focussing on running the business, as they should. But with proper preparation, many risks can be mitigated. So, what should companies and boards do to protect themselves? Boards in Europe have a responsibility to ensure that the companies they oversee are prepared – better prepared companies get better outcomes.

Five steps to follow

professional advisors, so everyone knows what their roles would be if attacked. Companies need to be prepared to react very quickly to an activist approach (hours, not days) so they can avoid a communication vacuum and maintain control of the narrative.

director on every board will have to prove how he/she uniquely contributes to the oversight of strategy and management. Being an accomplished business leader alone is no longer a sufficient qualification to be a director.

Th is form of preparation is moving from a best practice, to an obligation of boards. In today’s environment, every board should be asking the question ‘are we prepared to receive a letter or white paper from an activist today? Would we be able to react publicly within two to three hours if needed? What should we be doing to better prepare ourselves to get the best outcome possible, if attacked?’. Failing to do so means putting the company and the Build direct and personal relationships leadership at considerable risk (operational, with your largest shareholders professional and reputational). through direct engagement Clearly, this is a trend that by CEOs, CFOs and chairman is not going away. The European Activism is or lead independents. Amid market used to be perceived no longer a an attack, relationships and as unsuitable for activism, category of trust is as important as the but this is no longer the case. relevance and strength of champions have shareholders; National rebuttal arguments. IR should been attacked. Regulated it has become sectors, such as financial be thought of as a strategic component of value creation, a shareholder institutions have been targeted. as important as capital Family-owned iconic European behaviour allocation and M&A. businesses have been attacked. It would be simplistic that many Companies should to view the rise of activism traditional update their investor as a short termist trend investors may that will. Rather one should relations plan and communicate proactively consider this is a new world adopt at around the most sensitive for shareholder relations, certain times where management and areas of vulnerability. Be transparent with board members have to shareholders about strategy and governance engage and listen much more to initiatives, but also what the Company has their shareholder comments chosen not to undertake. The day after an and concerns. activist attack cannot be the fi rst time you address sensitive subjects with shareholders.

Companies must engage in a preparation exercise in effect, being their own activist, to assess their vulnerabilities from a shareholder perspective in terms of strategy and performance – for this step, having an external advisor on board with extensive experience of activist campaigns can provide that highly valuable ‘activist lens’.

Finally, managements and boards 5 should reconsider their governance

structure and apply best-in-class global principles to the board. Increasingly, every

ARE YOU PREPARED FOR A CHALLENGE? Every board should be ready to answer an activist’s questions

It is important for companies to organise themselves internally and with

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Spring 2019 | Ethical Boardroom 11

Commentary | ESG

ESG INVESTING:

Truths, half-truths and lies Over the past decade, environmental, social and governance (ESG) investing has arguably emerged as the most fashionable concept in the world of finance, surpassing the widely popular ‘BRICS’ (Brazil, Russia, India and China) at state level and ‘FANG’ (Facebook, Amazon, Netflix, and Google) at corporate level. To be sure, as a philosophy, ESG has the fangs and the potential to embrace both government and corporate spheres. Herein lies its danger. Contrary to popular perceptions, ESG is not merely about investing in well-governed enterprises. And, contrary to common discourse, the actual impact of ESG-focussed policies on the bottom line is far from guaranteed. Indeed, a number of ESG regional and country-specific investment indices have not necessarily been correlated with positive financial performance and have generally attracted minimal investor following. Perhaps more importantly, the purported adoption of ESG policies by corporate boards has, in many instances, focussed shareholder attention on immaterial, philanthropic policies and away from critical governance questions. A myriad of corporate annual reports boast positive ESG impact without reference to any methodology, all the while skirting key governance issues, such as board independence. In the absence of a substantive, comparable methodology, the ESG movement – as it is currently defined – has the potential to seed confusion, creating a ‘corporate saint’ intended to address how companies are governed, what imprint they leave on the society and how they treat the environment. While these might indeed be mutually reinforcing, they need not be and, in many cases, they are not. One can easily imagine a corporation which, while having a board of directors dominated by insiders, deeply cares about the community it operates in. And while institutional players have wholeheartedly jumped on the bandwagon

12 Ethical Boardroom | Spring 2019

What investors want and what they get from environmental, social and governance data Alissa Amico

Managing Director, GOVERN of ESG investing, questions ought to be asked about the implications of their enthusiasm on the investing public and on the corporate world. Th is is especially critical following a significant shift of ownership in public equity markets from retail to institutional actors, today estimated to control more than 50 per cent of total investments in developed markets. It is no wonder that following the financial crisis, a soul-searching regarding institutional investor responsibilities as stewards has been underway. International governance guidelines, such as the OECD Principles of Corporate Governance, have been revised to encompass

In the absence of a substantive, comparable methodology, the ESG movement has the potential to seed confusion, creating a ‘corporate saint’ intended to address how companies are governed investor responsibilities and conflicts of interests. The UN Principles for Responsible Investment (UNPRI), arguably the most famous stewardship standard, have on several occasions been criticised for not having tangible impact on investor behaviour, creating a pop culture of enthused signatories. The same scepticism has met national stewardship codes, such as the UK code, until it grew some teeth, categorising investors according to the level of their adherence. Th is transition of stewardship responsibilities to institutional investors has

resulted in their gradual creeping and trespassing in the domain of government policy and also of corporate enforcement. As such, institutional investors have become not only the new kid, but also the new cop on the block, policing governance and ethics of the largest corporations. Th is represents an arguably dangerous shift of decision-making powers from elected governments to unelected investors, who now control the savings of entire countries. Th is shift may be acceptable in Norway where these are administered by a sovereign actor whose motivations are not purely financial. As a government investment vehicle, Norges – Norway’s central bank – has been able to make bold decisions, divesting from coal and tobacco companies at a financial loss to its portfolio. In recent months, this has generated a vigorous internal debate in Norway and within the leadership of the fund about its performance and governance. The same bold actions by private institutional asset owners, who are judged by purely financial metrics, can less conceivably be envisioned. Indeed, they would be difficult to justify, given that many institutional investors have a fiduciary duty to protect the savings entrusted to them. Nor are senior executives leading these investors incentivised to be tree hugging, child labour-protecting folk. The focus of executive remuneration schemes in the financial services sector has in past years shifted to avoiding financial short-termism, not – or, at least, not yet – to ESG metrics. Under the guise of better stewardship, the gradual devolvement of responsibility from governments to institutional investors has been in turn mirrored by a corresponding delegation of institutional investor responsibilities to corporate boards.

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ESG | Commentary

A key manifestation of this is the wave of provisions on ‘corporate purpose’ recently incorporated or being considered for laws and governance codes in France, Germany, and the UK. In essence, these provisions ask boards to define

corporate purpose in the interest of the entire stakeholder community. The direction of this new wave of corporate well-doing has quickly caught the imagination of institutional investors. The recent and widely publicised letter by Larry Fink, BlackRock CEO,

INVESTING IN THE ENVIRONMENT Questions need to be asked about what value investors really get from ESG reports

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focusses on the concept of ‘corporate purpose’, with the expectation that boards consider broader stakeholder interests. “Purpose is not a mere tagline or marketing campaign; it is a company’s fundamental reason for being – what it does every day to create value for its stakeholders,” wrote Fink in his annual letter to CEOs. This year, he is also trying to draw what he refers to as an ‘inextricable link’ between purpose and profit to make clear that institutional investors – no matter how well-intentioned – cannot trade-off profit with either E or S or G. Already last year, however, he admitted that BlackRock cannot divest from companies featured in certain indices, engagement remaining the only option. Legally speaking, it’s far from clear how corporate purpose shall be defined to encompass all stakeholder rights and how fiduciary duties of directors will be affected by this broadening of parties whose interests they are to consider and serve. Likewise, stakeholder legal redress rights vis-à-vis institutional investors and corporate boards is an unchartered territory that neither regulators nor Adolph Huxley appear to have considered in his Brave New World of ‘stakeholder capitalism’. While institutional investors and corporate boards have today become ultimately responsible for human rights, environmental policy and corporate social impact, their resources for policing the implementation of this new and vast ‘corporate purpose’ have not increased proportionately. The governance team of Norges – the largest sovereign investor globally – is less than a dozen people, barely the size of an early stage tech start-up, but it is one of the more equipped and vocal investors. The devolvement of duties from policymakers to investors to boards represents a potentially slippery slope. It is premised on a delegation of government prerogatives to actors – some of which, under the present conditions – have neither the incentives nor the resources to do so. Stewardship and governance codes, which regulators are actively promoting, are not going to suffice. Expecting investors and boards to fi ll policymakers’ shoes is at best naïve and at worst risky, especially at a time when trust in state power to protect vulnerable social groups is on the verge of being revoked worldwide.

Spring 2019 | Ethical Boardroom 13

Commentary | Compliance

Focussing on corporate culture The compliance revolution has had a dramatic impact on numerous actors in the corporate governance world, including chief compliance officers, internal auditors, human resources and finance officers. Additionally, we have seen new strategies, controls and procedures to maximise the impact of ethics and compliance programmes. Yet for all these changes, we have failed to see any significant changes where it matters most – at the corporate board level. Corporate board members devote significant time to financial oversight and strategy, while ignoring steps needed to protect and promote its most important intangible asset – its culture and reputation. Corporate board members would rather discuss strategy issues and ignore the important questions surrounding its culture. Corporate boards are due for a rude awakening – compliance expectations and competing stakeholders are demanding more effective oversight. Over the last 10 years, we have witnessed corporate scandals and misconduct that could have been prevented or, at least, mitigated by a corporate board’s proper oversight and management of a company’s culture and compliance programme. All too often, corporate boards fail to identify

EFFECTIVE SUPERVISION Every company should have a former or current compliance officer on the board 14 Ethical Boardroom | Spring 2019

The fundamental disconnect between corporate boards and ethics and compliance Michael Volkov

CEO and owner of The Volkov Law Group potential red flags of serious misconduct issues, or ignore obvious risks that result in corporate disasters, reputational harm and significant enforcement actions, coupled with collateral litigation. In this era of accountability and increasing demand by corporate stakeholders, including activist owners and shareholders, corporate boards have to step up and bring about a new and improved level of performance.

High-profile corporate board oversight failures

The corporate governance landscape is littered with failures and corporate disasters. These scandals occurred under the watch and oversight of allegedly sophisticated boards. Let’s consider three examples: ■ Wells Fargo Bank suffered serious legal and reputational harm at the hands of a multitude of scandals, which have only highlighted the board’s failure to implement appropriate risk management and ethics and compliance programme oversight. Wells Fargo has yet to emerge with a new and effective risk management system with adequate resources to support an independent and effective ethics and compliance programme ■ Theranos was a multi-billiondollar blood testing company that ultimately collapsed because it was built on CEO-directed fraud. Theranos’s allegedly highprofi le corporate board failed to detect this pervasive fraud, despite numerous warning signs

and red flags. Former CEO and COO, Elizabeth Holmes and Ramesh ‘Sunny’ Balwani await a federal criminal trial on fraud charges ■ Volkswagen and its related companies have suffered from a massive fraudulent emissions-cheating scandal that was orchestrated at the CEO and senior management level of the company. The VW board, however, was a significant contributing part of the problem. A former VW executive described the scandal as ‘all but inevitable’, due to ‘the company’s isolation, its clannish board and a deep-rooted hostility to environmental regulation among its engineers’. It is easy to imagine but hard to accept that VW would have chosen the same path had the board and its executive team been trained and understood the implications of its misguided strategy to avoid environmental regulatory requirements In picking through the rubble of a corporate scandal and disaster, it is always important to examine what the board knew or should have known and what might have occurred under proper oversight and management. The old adage – pennywise but pound foolish – applies when a company fails to invest in its board ethics and compliance programme responsibilities, especially when considering the consequences to a company that suffers from a corporate scandal like those listed above.

Bringing the board up to speed Let’s face it – corporate boards are not adept at overseeing a company’s ethics and compliance programme. Every company should have a former or existing compliance professional serving on its board. In the absence of one or more compliance professionals appointed to a corporate board, it is imperative that corporate boards devote more time and attention to learning how to monitor and effectively supervise an effective ethics and compliance programme. In the absence of a board member who has prior compliance expertise, corporate boards either ignore or struggle to fulfi l their compliance oversight responsibilities. Corporate board performance is suffering from this serious gap between compliance responsibilities and capabilities. Corporate boards are under increasing pressure to improve their performance, including in the area of compliance. There are five steps that corporate boards have to undertake:

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Compliance | Commentary

Acknowledgement a new and more holistic responsibility to oversee, monitor and manage a company’s culture and its compliance programme. Corporate culture is a valuable intangible asset that promotes productivity, improves financial performance and protects against employee misconduct. To promote and protect this asset, board members have to participate in the management and oversight of this valuable asset. No longer can corporate board members sit back and exercise board responsibilities as a passive manager, dealing directly with the CEO and senior management. Corporate boards have to embrace a new active agenda. regular training to 2 Attendance exercise additional responsibilities for

managing a company’s culture. Corporate board members have to increase training on corporate culture and compliance issues. The company’s chief ethics and/or compliance officers, respectively, have to coordinate on these efforts and raise the board’s awareness and ability to exercise meaningful oversight and management. coordination among 3 Increased and have meetings with CEO, senior

management, chief ethics or compliance officer(s), to adopt important strategies and impose robust reporting requirements to ensure that the board is fully engaged on issues relating to culture and compliance. ethics and compliance oversight 4 Annual plans developed at the board level

to ensure that the board’s information and review needs are being met. In other words, the board should develop its own requirements to ensure that there is a meeting of the minds with ethics and compliance staff as to annual expectations for ethics and compliance programmes and strategies.

Conduct an annual evaluation of the board’s own performance in overseeing and monitoring the company’s ethics and compliance programme. The board’s evaluation should be conducted by an independent third party and should be exclusively shared with the board members for development of enhancements to improve overall board functioning relating to ethics and compliance programme oversight and performance.

New board ‘training’ programme

”There is nothing training cannot do. Nothing is above its reach. It can turn bad morals to good; it can destroy bad principles and recreate good ones; it can lift men to angelship.” Mark Twain Chief compliance officers, with the backing of the CEO and senior management, www.ethicalboardroom.com

should ‘train’ the board for at least two hours each year (and preferably more). When I use the term train, I really mean ‘educate’ the board on risks, the law and the company’s ethics and compliance programme and, most importantly, how to oversee and monitor the company’s compliance programme. The CCO has to cover a number of important topics, including: ■ Board responsibility for independent review of a company’s compliance programme ■ What information should the board require and how often should such information be provided to the board ■ Elements of an effective ethics and compliance programme ■ Requirement that the company has ‘devoted adequate staffing and resources to the compliance programme’. Management, resources and operation of compliance programme ■ Company culture, assessment, trends and measurement ■ Budget, resources and planning in relation to business, growth, development and planning ■ Trending issues and priorities for addressing gaps ■ What are the company’s legal and compliance risks, who are the stakeholders and what is the process for risk evaluation and analysis (as well as continuous monitoring)? ■ Familiarity with code of conduct ■ Compliant, reporting and detection of issues ■ Internal investigation programme performance: significant investigations, trends and data

Corporate change requires leadership from the board, demanding attention to corporate culture as an important intangible asset Th is list is not exhaustive and has many subparts that can be added. But as a starting point, the board should understand each of the above-listed topics and be able to articulate the importance of each topic and how they relate to each other. Also, a board has to understand how to communicate with the CCO and develop a robust communication framework. In particular, the board has to inquire about the CCO’s position and function within the company. These issues include: ■ Is anyone or operational function preventing you/CCO from implementing any of the elements of an effective ethics and compliance programme?

■ Does the ethics and compliance function have adequate independence, authority and resources? ■ Are there any issues that have been reported to you/CCO or that you learned of that are not being addressed? ■ Are we aware of, and staying current on, trends in enforcement and effective compliance programme? If there are gaps in our programme, how are we addressing these areas? ■ What is the current assessment of our culture? What specific metrics are supporting your assessment? ■ What steps can the board and/or senior management take to support the compliance programme? ■ Do you/CCO feel that leadership and employees are comfortable reporting potential issues and are these issues being appropriately addressed? ■ Have we had any allegations of retaliation? What steps are we taking to identify subtle attempts to retaliate? ■ Are we identifying and prioritising the company’s ethics and compliance risks? Is our programme tailored properly to our current and short-term risk profi le? ■ Are we appropriately holding senior management and employees accountable for ethics and compliance responsibilities? ■ What steps and controls have we implemented to monitor and audit our programme, potential misconduct and detect wrongdoing? How is this programme working? These are just a sample of basic questions for discussion between the CCO and the board. There are many other issues that can develop, depending on the company’s circumstances.

Ethics and compliance culture

In this era of accountability and increasing demand by corporate stakeholders, including activist owners and shareholders, corporate boards have to step up and bring about a new and improved level of performance. Corporate culture is a valuable asset that must be maintained and promoted by the company’s board. The board must be accountable for managing and overseeing this asset as an important strategy to prevent possible misconduct, legal enforcement and reputational damage. Unfortunately, corporate boards are very slow to change. Historically, corporate boards resist change, despite shareholder demands and even activist investors. Th is narrow mindset has to be abandoned. Corporate change requires leadership from the board, demanding attention to corporate culture as an important intangible asset. Spring 2019 | Ethical Boardroom 15

Global News Asia Diversity progress in Malaysian boardrooms Malaysia’s Securities Commission (SC) has released its inaugural Corporate Governance Monitor, which shows progress in the area of gender diversity in boardrooms. Malaysia recorded a seven per cent increase in women participation on boards of the top 100 listed companies from 16.6 per cent in 2016 to 23.68 per cent in 2018. Women now account for 28 per cent of senior management positions for all listed companies, higher than the Asia Pacific average of 23 per cent.

Minister of Finance, YB Tuan Lim Guan Eng, commenting on the Monitor’s launch, said: “I’m encouraged by the fact that since February 2019, there are no more all-male boards for our top 100 listed companies and this indeed sets the tone for other PLCs to follow.” The CG Monitor 2019 presents observations on three thematic reviews on long-serving independent directors (policies and practices), gender diversity on boards and CEO remuneration of the top 100 listed companies.

1MDB: US to return $200million in funds The US is to hand over close to $200million to Malaysia in funds recovered from asset seizures tied to scandal-hit state fund 1MDB. 1MDB was set up by Malaysia’s former prime minister Najib Razak in 2009 to turn Kuala Lumpur into a financial hub and boost the Malaysian economy. Since 2016, the US Department of Justice has filed lawsuits to seize around $1.7billion of goods allegedly bought with funds stolen from 1MDB, including a private jet, luxury property, artwork and jewellery. US ambassador to Malaysia, Kamala Shirin Lahkdhir, told Reuters: “We are extremely pleased that this first tranche of assets from this Justice Department investigation is being transferred back to Malaysia, demonstrating the US commitment to return these assets for the benefit of the people of Malaysia.” Razak — currently on trial on charges of money laundering and corruption — denies any wrongdoing.

Scandal-hit Korean Air chairman dies

Shareholders flush out Lixil CEO Two top executives of Japanese luxury toilet maker Lixil Group — the CEO and chief operating officer — have stepped down following pressure from shareholders. The Tokyo-based company’s chairman and CEO Yoichiro Ushioda, a member of one of the group’s founding families, announced he would step down in May. President and chief operating officer Hirokazu Yamanashi also announced his resignation. The boardroom departures are the latest development in a clash between Ushioda and the previous president and CEO

16 Ethical Boardroom | Spring 2019

Kinya Seto, who was dismissed at the end of 2018 in a move questioned by shareholders, including BlackRock and Marathon Asset Management. The latest resignations followed a call by shareholders – Marathon Asset Management, Indus Capital Partners, Polar Capital Holdings Plc and Taiyo Pacific Partners LP – for an extraordinary shareholders’ meeting to vote out Ushioda and Yamanashi from the board.

Cho Yang-ho (pictured) – the chairman of South Korea’s flag carrier Korean Air – has passed away just weeks after he was voted off his own board. The chairman, whose leadership included scandals such as his daughter’s infamous incident of ‘nut rage’, died due to illness, the company said. Mr Cho, who was on trial for corruption, was ousted from the company board in March. He lost his seat after winning 64.1 per cent of shareholders’ votes, just shy of the two-thirds majority he required to retain his seat. His son Cho Won-tae, Korean Air’s president, is expected to succeed him as chairman, according to the Financial Times. Cho Yang-ho was the first founding family member of any major South Korean company to be forced off a board, according to media reports.

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Board Leadership | Diversity

Leading byexample Charlotte Valeur

Chair, Institute of Directors

Diversity improvements must begin and end with the attitude of those already at the top The story of Margaret Mackworth, later Viscountess Rhondda, bears retelling – and not just because she was the first female president of the Institute of Directors. Born in June 1883, Mackworth studied at the University of Oxford at a time when for a woman to do such a thing broke the mould, and later became an active campaigner for women’s suff rage through the Women’s Social and Political Union (better known as the suff ragettes). Growing in prominence within the suff rage movement, she was eventually imprisoned for seeking to destroy a postbox. Having been incarcerated, Mackworth went on hunger strike and was released in a matter of days. With the advent of the First World War, however, Mackworth resolved like many in the suff rage movement to put her energies into her country’s war efforts. (In later years, she would return to her campaign for equality and played a pivotal role in the commemoration of Emmeline Pankhurst with a statue, which stands just outside the House of Commons in London.) During the war, she helped supply munitions from the US to British forces alongside her father, who was so fond of his daughter’s precocity that when he received a peerage he stipulated that his seat in the House of Lords must transfer to her upon his death.

18 Ethical Boardroom | Spring 2019

At this point, Mackworth’s life took an almost novelistic turn. She was on board the Lusitania when it was sunk by a German submarine in the Atlantic, going down 11 miles off the Irish coast. She survived, though hypothermia had rendered her unconscious. Following her recovery and the end of the war, Mackworth went on to use her acumen in the business world, serving as director for 33 different companies and eventually as president of the Institute of Directors. But not all doors could be opened, even to this most trailblazing of figures. Though Mackworth inherited her father’s peerage, the House of Lords barred her entry on account of her gender. The first woman would eventually enter the upper chamber mere days after Mackworth’s passing in 1958. The final twist in Margaret Mackworth’s tale illustrates the fact that no matter how hard someone might be able to knock, it depends to a large extent on the people inside whether the door will be opened.

Where we are now

Needless to say, the conversation over diversity has changed incrementally but dramatically over recent decades, in the UK and across the world. Put in a contemporary context, Mackworth’s story would still be inspiring, though a little less anomalous. Attitudes towards under-represented groups have shifted. The upper rungs of society are less and less the sole preserve of a single type of person.

Some doors, however, remain frustratingly difficult to open. In some lights, the business world seems to be dragging its feet on this issue. A couple of years ago, Deloitte estimated that around four per cent of CEO and chair positions globally were held by women. In the UK, recent reports have pointed out that more CEOs of FTSE 100 fi rms in the UK were named ‘David’ or ‘Steve’ than were women. Gender diversity has perhaps gained the greatest attention over recent years, but if anything, the situation could be even more frustrating when it comes to other forms of diversity. The Parker Review, the UK government’s independent study into ethnic diversity on UK boards, found that UK-born people of colour make up but two per cent of the total FTSE 100 director population. And that’s before we start to consider other areas, such as neurodiversity or age diversity.

Perspectives on diversity

So, what do those at the top of the business world think? The Hampton-Alexander Review into gender diversity on UK boards and senior management hit the headlines recently when it published quotes from some FTSE executives outlining their thinking on the matter. When asked why so few women held senior positions, reported justifications included ‘I don’t think women fit comfortably into the board environment’, and ‘we have one woman already on the board, so we are done – it is someone else’s turn’. Or how

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| Board Leadership

DIFFERENT PERSPECTIVES Diverse groups make better decisions

internalised the arguments in favour of acting on this knowledge. As an issue, it still appears to be perceived as something pushed from outside, something that is extra-curricular and not fundamental to good corporate governance. This, I would argue, is the wrong way of looking at things. Furthermore, if this continues to be the mindset, then progress beyond our current situation will remain slow and uncertain.

Improving board performance

about ‘all the good women have already been snapped up’. Though this review looked specifically at gender, I’m sure we can imagine this logic being transferred to other strands of diversity, too. Reading these kinds of statements certainly jars in our day and age, but we would hope they represent a tiny minority. Data on a wider scale seems to paint a brighter picture. For instance, in 2018 PwC’s Annual Corporate Directors Survey of US executives found that 94 per felt that diversity brings Effective boards cent unique perspectives.1 Not far must aspire off that proportion – 84 per cent – also felt that diversity to ‘see with all enhances board performance. eyes’, feeding At the same time, however, the report seemed to evidence in as wide as a degree of ‘double-think’ possible a view among the directors surveyed. on the business While the vast majority felt diversity improved the landscape to the that effectiveness of boards, more decision-making than half also said that efforts process of their to improve diversity were driven by political correctness. organisation Similarly, 48 per cent felt shareholders were too preoccupied with the topic. It’s hard to know what to make of these conflicting results. On the one hand, the benefits of diversity on the board seem to be broadly recognised. On the other hand, as business leaders we seem not to have fully

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Diversity in the board and, more broadly, at a senior management level, should instead be considered a central factor in and indicator of an organisation’s overall governance. A complete lack of diversity is a risk, just as one might consider aspects of the balance sheet or the operating model as a risk. It raises a red flag and should trigger immediate questions about a firm’s practices and culture. It is always possible that these questions may be answered in a satisfactory manner. Then again, they may not be. Indeed, this has increasingly been the stance taken by influential asset managers, such as BlackRock. ‘Board diversity is important’ a 2017 report from the investing giant argued, ‘from a sustainable investment perspective, given that diverse groups have been demonstrated to make better decisions.’ Expanding on this point, BlackRock contended that organisations ‘are better able to consider, where appropriate, alternatives to current strategies – a proposition that can ultimately lead to sustained value creation’. Effective boards must aspire to ‘see with all eyes’, feeding in as wide as possible a view on the business landscape to the decision-making process of their organisation. They must leave no stone unturned as they consider possible risks, so it makes little sense to tie one hand behind their back as they do so. Limiting those in charge to one particular type of person would seem to do exactly that. Without delving too far into counterfactuals, it’s difficult not to wonder, for instance, about the case of Blockbuster. Had its board included a younger, more digitally native member, might it have acted differently?

Spring 2019 | Ethical Boardroom 19

Board Leadership | Diversity

The beneﬁt of diversity to all

Diversity shouldn’t only be seen in terms of board-level effectiveness. It is also pertinent to the individual members of the board: their own capabilities and progression. In many respects, an open and inclusive mindset should be seen as a core aptitude for any board member – just as we might see awareness of risk, or strategic thinking as abilities that every leader should seek to hone continuously throughout their career. But the link between professional development and encountering diversity is multifaceted. Diversity is not only an area in which one can improve; it is a means to improve.

groups were observed to discuss a wider range of information pertaining to the ‘crime’ in question, thus indicating the importance of diverse groups in bringing new information and ideas to the table. Perhaps more interesting, however, was the finding that white members of the juries cited more factual evidence – and were more accurate in doing so – when they were part of a mixed jury. Th is gets to the heart of an often overlooked result of diversity. Not only can it be to the benefit of those who were previously excluded, not only does it benefit the organisations that embrace it, but it also is to the good of the existing group at the top

and technical skills. The Higher Education Statistics Agency found that women, for instance, made up 17 per cent of computer science undergraduates in the UK. Elsewhere, providing women training for board-level and executive roles specifically can provide a route to the board when internal company pipelines are found wanting. Building women’s networks is also another area we can look to improve. While women have historically been shut out of ‘old boys’ clubs’, we can seek to recast business networks, opening them out to more people, and enabling a wider range representation of society to access the opportunities that a strong network can facilitate.

Providing women training for board-level and executive roles speciﬁcally can provide a route to the board when internal company pipelines are found wanting Th is is because introducing ‘outsiders’ to a boardroom doesn’t only add to the quantity of what is discussed – thus helping the organisation as a whole – it also helps the quality of discussion. By bringing a new perspective, the newcomer forces the existing group to clarify its thinking, ensuring it is not only intelligible to the ‘in group’. It is through this process that flaws in logic are mostly often lighted upon. Research by academics from Tufts University in the US illustrates this aptly. For its study, On Racial Diversity and Group Decision-making, a group of social psychologists asked different ‘juries’ of people to adjudicate in a mock trial. The juries varied in their make-up: some were all white or all black, and others comprised a mix of ethnicities. Unsurprisingly, the more heterogeneous 20 Ethical Boardroom | Spring 2019

– the very people who are sometimes said to be ‘endangered’ by diversity.

The way forward

While many of the benefits of diversity can and do accrue to the companies that embrace it, it must be recognised that this issue is not a problem for enterprise to solve alone. Inequities start more in the playground than the boardroom. To widen the pipeline at the top, you must start at the bottom. Education is, as with many issues, pivotal. We must be alive to any factors that might be holding under-represented groups back from studying in areas that often speed the climb to the C-suite. Traditionally, such subjects might have included finance or business administration but, in the present climate, the real game-changer is digital

At the end of the day, however, any efforts to improve diversity must begin and end with the attitude of those already at the top and the companies they lead. It is in their gift to be asking the difficult questions of their recruitment policies – and their recruiters, too. It might be argued that business can only move as quickly as the society it is in. How can individual fi rms change the tide, when clearly concerns around diversity do not begin and end in the world of enterprise? In my view, businesses should aspire to be ahead of the times, not behind them. Margaret Mackworth became an established figure in business even as she was barred by the political establishment. https://www.pwc.com/us/en/governance-insights-center/ annual-corporate-directors-survey/assets/pwc-annualcorporate-directors-survey-2018.pdf.

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Board Leadership | Diversity

Strengthening board diversity A push from the SEC and Congress Howard Dicker, Adé Heyliger & Aabha Sharma

Public company boards of directors and nominating and governance committees, in particular, are under mounting pressure to take a critical look at their own board compositions in an effort to improve board diversity. With the growing view that greater diversity leads to innovation and better decision-making, there has been increasing momentum from institutional investors, pension funds, proxy advisors and even certain state legislatures to enhance board diversity. Washington D.C. is also speaking up, and possibly influencing proxy statement disclosures for the upcoming proxy season, with a push for board diversity from the US Securities and Exchange Commission (SEC) and the US Congress.

SEC focusses on diversity disclosure

The Division of Corporation Finance Division of the SEC, on 6 February 2019 addressed board diversity disclosure through two identical compliance and disclosure interpretations (CDIs) under Regulation S-K – 116.111 and 133.132. The CDI addresses what type of disclosure is required in connection with Items 401 (director qualifications) and 407 (director nominee qualifications) when board members or nominees have consented to the company’s disclosure of certain ‘self-identified’ diversity characteristics, such as their race, gender, ethnicity, religion, nationality, disability, sexual orientation, or cultural background. The Division provides that to the extent the board or nominating committee, in determining the specific experience, 22 Ethical Boardroom | Spring 2019

qualifications, attributes, or skills, considered self-identified diversity characteristics, it would expect the company’s disclosure to include, but not necessarily be limited to, ‘identifying those characteristics and how they were considered’ (the ‘qualifications’ disclosure required by Item 401). Moreover, it would expect any description of diversity policies followed by the company under Item 407 to include a discussion of how the company considers self-identified diversity attributes of nominees as well as any other qualifications its diversity policy takes into account, such as diverse work experiences, military service, or socio-economic or demographic characteristics. An interesting aspect arising from the CDI is that directors and director nominees would need to both, self-identify, with certain diversity characteristics, as well as consent, to the company’s disclosure of these characteristics. Currently, it is not common practice for director questionnaires or similar forms to ask directors and nominees to identify diversity characteristics, diminishing the opportunity for self-identification. Moreover, even if a director or nominee chooses to self-identify and consents to the disclosure of this information, under the CDI, the company would only be required to disclose those diversity characteristics if the board considered such characteristics in concluding that the individual should serve as a director, or otherwise has a policy that includes the consideration of such diversity in identifying director

Illustration by Brendon Ward www.inkermancreative.com

Howard is Co-Head, Adé is a Partner and Aabha is an associate at Weil’s Public Company Advisory Group

Diversity | Board Leadership

GETTING TOUGH Shareholders will increasing focus on diversity

nominees. Even then, it appears that the company would only be required to disclose how it considered these diversity characteristics and would not necessarily be required to disclose the racial, ethnic or gender composition of the board. As proxy season is underway, we are starting to see a few prominent companies disclosing the boards’ consideration of director self-identified diversity characteristics in their proxy statements. These companies generally have robust disclosure of the board’s consideration of diversity characteristics for director candidates with accompanying graphics illustrating the company’s comprehensive nomination process.

Congressional proposals seek greater diversity through expanded disclosures

After the Democratic Party took command of the House of Representatives following the 2018 midterm elections, efforts by party members for greater board diversity disclosure began ramping up – the latest being the Improving Corporate Governance Th rough Diversity Act of 2019. 3 The bill was introduced in February by Representative Gregory W. Meeks, with a companion bill simultaneously introduced by Senator Bob Menendez in the Senate. Th is comes as no surprise, as certain Democratic members of the US Congress, through legislative proposals and letters to the SEC Chairman, have been for years pushing for greater board diversity disclosure. The bill, which garnered the support of the Council for Institutional Investors and the US Chamber of Commerce, would require public companies to disclose annually in their proxy statements data on the racial, ethnic and gender composition, as well as veteran status, of its board of directors, director nominees and executive officers, based on voluntary self-identification. Moreover, disclosure regarding the adoption of any board policy, plan or strategy to promote racial, ethnic and gender diversity would be required. In addition to these disclosure requirements, the bill directs the SEC’s Office of Minority and Women Inclusion to publish best practices for corporate reporting on diversity. Interestingly, while the spotlight on diversity has mostly focussed on the board, the bill goes a step further to cover executive officers as well. Spring 2019 | Ethical Boardroom 23

Board Leadership | Diversity

Spotlight on gender diversity shines brighter

INCREASING WOMEN IN BOARD POSITIONS Investors are using their position to influence elections

The CDI and congressional corporate Diversity Bill are the latest evidence that efforts to enhance board diversity are quickly gaining traction. Over the past two years, investors, proxy advisory firms and state governments have also continued to ratchet up the pressure on public companies to improve board gender diversity. Importantly, consequences arising from lack of gender diversity are no longer hypothetical – with many companies under fire for failing to increase the number of women on their boards. Investors take the lead With board diversity at the forefront, several significant investors are using their influence in director elections to effect change in the boardroom. From launching its Fearless Girl campaign as ‘a symbol of the power of women in leadership’ to being the first major institutional investor to adopt a formal policy voting against directors due to lack of gender diversity on boards, State Street has been a leader in driving board diversity efforts. Other recent measures by investors to increase the number of women in boardrooms include: ■ BlackRock stated it ‘would normally expect to see at least two women directors on every board’ ■ State Street will vote against the entire nominating committee of a company with no female directors that has not engaged with State Street on gender diversity for three consecutive years, beginning in 2020. During last year’s proxy season, State Street had voted against the re-election of nominating/ governance committee directors at more than 500 companies in the US, UK and Australia that ‘failed to make any significant efforts to address the issue’ ■ Vanguard joined the 30% Club, a global organisation that advocates greater representation of women in boardrooms and leadership roles ■ CalPERS withheld votes or voted against more than 271 directors at 85 companies due to board diversity concerns during last year’s proxy season ■ Shareholders fi led 29 board diversity proposals during last year’s proxy season, making it one of the top environmental, social and governance (ESG) issues for shareholder proposals In addition to institutional investors, the New York City Comptroller has also publicly advocated for greater board diversity. As part of its Boardroom Accountability Project, the Comptroller called on 151 US companies to disclose the race and gender of their 24 Ethical Boardroom | Spring 2019

directors, along with board members’ skills, in a ‘matrix’ format – and to enter into a dialogue regarding their board’s ‘refreshment’ process. As Rakhi Kumar, head of ESG Investments at State Street, boldly put it: “We want them [directors] to know that we’re watching. We know who you are. You have another year to be quiet, after which there are consequences to not engaging with us.” Directors should expect this sentiment to increasingly permeate among investors who will continue to probe deeper into issues of board diversity.

Proxy advisor voting policies prioritise board diversity With investors urging greater board diversity, it is no surprise that the largest proxy advisory fi rms, Institutional Shareholder Services (ISS) and Glass Lewis & Co. (Glass Lewis), have recently updated their voting policies regarding board diversity in a continued effort to influence www.ethicalboardroom.com

Diversity | Board Leadership governance policies and practices through the director election and annual meeting voting process. Specifically, recognising that ‘diversity benefits companies by providing a broad range of perspectives and insights’, Glass Lewis, beginning with annual meetings held on or after 1 January 2019, will generally recommend voting against the nominating committee chair at companies with no female directors. In formulating its voting recommendation, Glass Lewis will take into account the company’s disclosure of its diversity considerations, rationale for not having any female board members and disclosed plan to address the lack of diversity on the board. A similar ISS policy will apply to annual meetings held on or after February 2020. ISS will take into consideration mitigating factors that may temporarily excuse the absence of a female director, such as: ■ A fi rm commitment in the proxy statement to appoint at least one female director to the board in the near term ■ The presence of a female on the board at the preceding annual meeting ■ Other relevant factors as applicable Moreover, boards should expect the increasing focus on diversity to also include management and the broader employee base. This year, ISS added new categories to its QualityScore that evaluate the number of women on the board serving in leadership positions, such as lead director or committee chair, as well as the number of women that serve in named executive officer positions. States get tough on gender diversity In an unprecedented move, we have recently seen US state governments stepping in to drive gender diversity in public company boardrooms. Under a bill signed into law on 30 September 2018, California became the first state to require a minimum number of women on boards.4 The bill requires public companies (whether or not incorporated in California) with principal executive offices in California to have at least one woman on their boards by 31 December 2019. By the end of 2021, these companies must have at least two or three female directors, www.ethicalboardroom.com

depending on the size of their boards. Failure to comply with the law could result in steep monetary fines for the company. According to a recent ISS paper, 89 per cent of Californiabased companies will need to make changes to their board composition in the next three years to meet these new requirements. Following in California’s footsteps, New Jersey also proposed a similar bill on 26 November 2018.5 Under the bill, a public company with a principal executive office in New Jersey must have at least one female director on the board by the end of this year. Moreover, a company with more than five directors must have at least three women on the board by the end of 2021. Similar to California, failure to comply with the requirements could result in the imposition of fines. Going a step further, the Illinois House of Representatives on 29 March 2019, passed a bill requiring publicly held companies with principal executive offices in Illinois to have at least one female director and one African American director on their boards by the end of 2020.6 The California law and the other state proposals, if enacted as proposed, could be subject to legal challenge. Their constitutionality could be challenged on equal protection grounds due to the creation of an express gender classification and quota system. In addition, they could be challenged under the internal affairs doctrine, given their application to companies incorporated outside of the state. It is not clear whether any other jurisdiction, such as Delaware, would enforce them.

Concluding thoughts

We expect the push for board diversity to continue, or even accelerate, in the upcoming year. Moreover, board diversity issues will again be a significant area of focus for shareholders in 2019, including campaigns for enhanced disclosure regarding board diversity initiatives and diversity policies. Directors and senior management therefore should be prepared to respond to the many forces seeking change, including by taking a proactive approach to evaluating their Companies own board composition, as should well as considering how to best tell the “company’s view proxy story” through shareholder statements engagement efforts. Below are as a tool to recommendations for companies they try to meet investor and help bring to as regulatory expectations to improve life, among their own board diversity.

other things, company board diversity efforts

■ Assess board composition Boards and their nominating committees should take a proactive approach to board composition and succession planning by reviewing the skills,

■

diversity and tenure of board members in connection with the annual nomination process. Companies should be able to clearly articulate the reasons for any lack of board diversity, as well as plans to address the issue in the near term. ‘Paint’ a picture of diversity initiatives In connection with engagement efforts to discuss matters that shareholders consider important in formulating voting decisions, including board diversity, companies should carefully consider which communication tools will be the most effective. Companies should view proxy statements as a tool to help bring to life, among other things, company board diversity efforts. Consider whether to include disclosure addressing the SEC staff ’s ‘expectation’ that to the extent the board or nominating committee considered the self-identified diversity characteristics of directors and director nominees, the company’s disclosure identifies those characteristics and how they were considered. Strengthen stakeholder efforts Companies should recognise not only shareholder expectations regarding corporate diversity, but also other significant stakeholder expectations – including customers, employees, suppliers and the community from which the corporation draws its resources or that may otherwise be affected by its actions. Stakeholder outreach programmes should be tailored to meet diverse stakeholder priorities and expectations. Review director and nominee questionnaires In light of the SEC staff ’s recent CDI, companies with policies that actively consider and promote the disclosure of certain diversity characteristics among its board members (e.g. race, gender, ethnicity, religion, nationality, disability, sexual orientation, or cultural background), should review their questionnaires and consider adding a diversity self-identification question and option for directors and nominees to consent to the release of such information. Monitor applicable state legislation Companies with a principal executive office in California should prepare to comply with the new California law mandating a minimum number of female directors or face the consequences for any non-compliance (including adverse publicity) and follow any efforts that challenge the validity of the law. Other companies should monitor applicable state law developments in this area.

https://www.sec.gov/divisions/corpfin/guidance/regs-kinterp. htm#116-11 2https://www.sec.gov/divisions/corpfin/guidance/ regs-kinterp.htm#133-13 3https://www.congress.gov/116/ bills/hr1018/BILLS-116hr1018ih.pdf 4https://leginfo.legislature. ca.gov/faces/billTextClient.xhtml?bill_id=201720180SB826 5 https://www.njleg.state.nj.us/2018/Bills/A5000/4726_I1.HTM 6 http://www.ilga.gov/legislation/101/HB/10100HB3394lv.htm 1

Spring 2019 | Ethical Boardroom 25

Board Leadership | Investors

Proxy season:

A springboard for diversity discussion Investors are continuing their push for board diversity in the 2019 proxy season that was set into motion two years ago. Drawing on the energy from events, such as BlackRock’s letter to CEOs, demanding meaningful change in board composition, more investors are becoming vocal and more deﬁnitive about what constitutes boardroom diversity.

Th is year, the New York City Pension Fund will continue its push for disclosure via a matrix that will disclose directors’ gender, race and skills. Th is is part of its ongoing Boardroom Accountability Project 2.0 that focusses on electing more diverse directors to public company boards. While disclosure doesn’t always translate into the election of more diverse directors, it does shine a light on what qualities and skills companies are prioritising in the boardroom.

Investors push for board diversity, but power to change remains with companies Lisa Blais & Ashley Summerfield

Lisa leads the US Board Practice and Ashley leads the Global Board Consulting Practice at Egon Zehnder In addition to investors, proxy advisors are taking a stronger stance on diversity in 2019. Glass Lewis has implemented a policy where it will recommend voting against nominating committee chairs if a board lacks female directors. Institutional Shareholder Services (ISS) has plans for a similar policy that will take effect in 2020. For 2019, ISS has added a board diversity subcategory, which includes questions about women on the board and named executive officers as well. In 2020, for companies in the Russell 3000 or S&P 1500 indices, ISS will ‘vote against or withhold from the chair of the nominating committee (or other directors on a case-by-case basis) at companies when there are no women on the company’s board’, according to its 2019 policies. ISS did note that there were a few mitigating factors it would consider next

year, including a fi rm commitment in the proxy statement to appoint at least one female to the board in the near term. Eyes will also be on California companies to see if those companies lacking female directors have begun to change, given the mandate that companies headquartered in that state must have at least one female director by the end of 2019. Some boards will be required to add up to three women by the end of 2021, based on their board size. A recent article published by Bloomberg noted that the California law will open up about 692 board seats to women. If 49 other states followed suit, about 3,732 seats would open up to women. But for all the talk about board diversity, are the demands from investors and additional disclosure requests from proxy advisors actually making change in board composition?

DIVERSITY AT TOP OF MIND Investors are increasingly focussed on establishing a diverse boardroom 26 Ethical Boardroom | Spring 2019

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Investors | Board Leadership

Are investors getting results?

So far, it seems the answer is yes, though progress may not be occurring as quickly as many would like. Egon Zehnder’s 2018 Global Board Diversity Tracker, which has been tracking board diversity for 14 years across 44 countries, highlighted that while 84.9 per cent of large cap companies had at least one female director, 15 per cent of these still have no women on the boards, as was the case with large companies in 25 of the countries we studied. For comparison, in 2016, 84 per cent of large cap companies had at least one woman on their board and nearly 19 per cent of seats on the boards of the largest companies globally were held by women, up from about 14 per cent in 2012. The increased engagement from investors over the past few years has produced some tangible results. Some investors sent letters to companies informing them that they would vote against nominating committee chairs if there were no female directors or candidates. As a result, some companies added a female director to the board or noted that they would add a woman in the near future. During the 2017 proxy season, State Street sent letters to 600 companies in the US, the UK and Australia, explaining that it would vote against the chair of their nominating committees if there were no female directors or candidates. During the 2017 proxy season State Street Global Advisors voted against 512 companies for failing to take action regarding their board gender diversity. In the first half of 2018, through several country proxy voting seasons, it voted against 581 companies. But there was some progress made. As a direct result of the engagement, State Street reported that 152 companies added a female director to their board and 34 companies agreed to do so in the future. Another outcome of this push for diversity disclosure from investors and proxy advisors is transparency into the board nomination and election process. The election process is generally controlled by the existing board, so if you don’t have a diverse board to begin with, it will be more difficult for your nomination and election process to source candidates who have strong commonalities with current directors. This doesn’t make changing the system easy. While there has been some progress made, there is still work to be done to include more female voices in the boardroom. According to our study, nearly half of S&P 500 boards had at least three female directors. However, if you broaden the lens globally, the numbers aren’t as inspiring. According to the Egon Zehnder Board Diversity Tracker, only 13 of the 44 countries in our study averaged three or more women on the board and eight of those 13 countries had quotas that mandated a specific number of women. So why the slow progress? The most common answers are that companies can’t www.ethicalboardroom.com

find women who have the qualifications they are seeking or that board turnover rates are low, leaving few seats available every year. Both of these responses can easily be debunked, but one of the overlooked causes is the lack of women who hold leadership roles on the board. Only 5.6 per cent of board seats are held by women in board leadership positions, according to our Global Board Diversity Tracker. A study done by Deloitte noted that companies with a female chair had almost twice as many female directors as male-chaired companies.

How to improve your board composition

With the 2019 proxy season underway, there are several actions boards can take to ensure they are in compliance or proactively adding diverse members to the board.

During the 2017 proxy season, State Street sent letters to 600 companies in the US, the UK and Australia, explaining that it would vote against the chair of their nominating committees if there were no female directors or candidates ■■ Open the aperture when looking for new directors As boards look to diversify, they will need to expand the lens through which they assess potential new directors. There are relatively few female CEOs and CFOs (the typically desired titles in board recruits) – Egon Zehnder’s Global Board Diversity Tracker found only 3.7 per cent of CEOs and 12.2 per cent of CFOs are women. To recruit more diverse candidates, boards need to expand the types of experience and backgrounds they look for in potential directors. Think about the needs of your company today and tomorrow and look for directors who bring those skills. For example, if you are expanding into a new market, perhaps a director with experience doing business in that country would be helpful, but not necessarily a CEO or CFO. ■■ Aim for more than one diverse director While investors haven’t set a specific number of female directors they like to see on boards, many companies have pointed to three as the magic number it takes to really affect the way boards make decisions. There is still more progress to be made in getting to critical mass, as less than half of

boards globally have at least three women, according to our 2018 study. ■■ Expand your board While you don’t want to have an unwieldy number of board members, sometimes even a temporary expansion of the board can make a big difference in diversity and in board performance. For example, when ITT was conducting a board search, the company identified two women with different credentials who were both very strong candidates. Rather than select just one and lose out on the expertise of another, ITT expanded its board to accommodate adding both directors. ■■ Enhance your disclosure narrative Many companies are responding to investors this year by including enhanced disclosures about their board refreshment practices. This is an opportunity for the nominating and governance committee to explain its philosophy about board recruitment and to use tenure or age-limiting mechanisms to refresh the board. ■■ Use emerging priorities as a mechanism to find new talent As environmental, social and human capital concerns become more significant for investors and the public at large, boards need to disclose how they are considering and integrating processes that create a sustainable trajectory for the company. These issues are a major part of risk management and strategy development and directors with experience in these areas would benefit boardroom discussions. As you seek different types of expertise, you may find more gender diverse candidates organically. For Hering, a $900million market-cap retailer in Brazil, shareholders had pushed the board to recruit directors who had more retail and digital expertise. While seeking that talent, the company ultimately added two women to the board who possessed just the type of experience it needed. ■■ Implement a robust board succession planning process Succession planning is not a one-time event – it is an ongoing process that allows the board to continually take stock of the skills it currently possesses and to evaluate what skills it will need in the future. When directors view the process that way, it is more likely that candid conversations can be held if an individual director’s skills are no longer required on the board. While these actions illustrate several ways for boards to add diversity, not every suggestion is applicable to every company. At a minimum, though, every company should have ongoing discussions about the talent needed in the boardroom to truly make their companies strong, competitive, resilient and innovative. Spring 2019 | Ethical Boardroom 27

Board Leadership | Performance

Anderson Dy, PhD

Vice President of Sales for Northern/Eastern Europe and Africa, Diligent Corporation

Composing the board for competitive advantage

Businesses must be at the top of their game to seek out gains that will improve performance As organisations wrestle with the challenges of digital, business process and cultural transformation, their priorities are increasing efficiency, boosting productivity and creating a fertile environment for innovation.

While competitive advantages are sought at all levels of the organisation, businesses are increasingly starting at the top, scrutinising the performance and composition of the board of directors as a potential source of differentiation and success. They are right to do so. The boardâ&#x20AC;&#x2122;s role as guardian of stakeholder value and steward of corporate culture makes it one of the most important instruments a business possesses for enabling transformation. Thus, the board needs to be fit for purpose now and for the future, capable of adapting 28 Ethical Boardroom | Spring 2019

to the changing circumstances and challenges the company faces. Th is means addressing board composition and succession strategy in order to improve diversity and ensure the right mix of skills and perspectives are available to the organisation. Reflecting the swift pace of modern business, it also means that the board should be seen as an evolving instrument that must be regularly monitored to identify risk exposure and areas for improvement.

Diversity pays dividends

An increasing body of evidence suggests that, when it comes to business, diversity pays dividends. A study completed by global management consultancy McKinsey found companies that were in the top quartile for gender diversity were 21 per cent more likely to experience above average profitability.1 Companies with the most ethnically and culturally diverse executive teams were 33 per cent more

likely to outperform rivals on profitability. Even apart from the moral issues of equal rights and social justice, businesses can boost their competitive performance by increasing diversity. The recently revised UK Corporate Governance Code sought to enshrine a positive approach to improving diversity with the inclusion of the principle that appointments and succession plans â&#x20AC;&#x2DC;promote diversity of gender, social and ethnic backgrounds, cognitive and personal strengthsâ&#x20AC;&#x2122;.

Closing the gender gap

In 2011, the Davies review into female representation on boards set a target of seeing 25 per cent of FTSE 100 directorships held by women by 2015. By 2018, the figure had reached 27 per cent, indicating that a proactive focus on the issue bears fruit. Moving the conversation forward, the influential Hampton-Alexander review set a target of 33 per cent representation for www.ethicalboardroom.com

Performance | Board Leadership

ethnic diversity of UK boards recommended that FTSE 100 boards aim to have at least one director from an ethnic minority background by 2021 and for each FTSE 250 board to do the same by 2024, in addition to developing pipeline career mentoring programmes to support BAME (black, Asian and minority ethnic groups) executives. In the year since the report’s publication, however, the number of FTSE 100 directorships held by people from BAME backgrounds has fallen slightly, showing that the needle is moving in the wrong direction if we are to see more diverse backgrounds represented in the boardroom.

Rejuvenating the aging boardroom

women on FTSE 250 boards by 2020, and by autumn 2018, 70 companies had achieved it. In spring 2019, there are now only three boards in the FTSE 350 that have no women directors, and there is a real hope that, by the end of the year, the era of all-male boards in the FTSE 350 will be at an end. 2 Nevertheless, while the numbers appear positive, a deeper dive shows that there is still a long way to go to see women wielding a genuine balance of influence in the boardroom. A study by Cranfield University found that, while there was an increase in the number of women being appointed to non-executive directorships, the number holding top board positions and leading influential committees fell in 2018. 3 Similarly, Spencer Stuart’s annual board survey found that, while 43 per cent of new non-executive director appointments in FTSE 150 companies went to women, there was a decline in the number of women in www. ethicalboardroom.com

While experience is one of the most desirable assets in a director and understandably comes with age, UK businesses are increasingly appointing older directors. The average age of executive directors rose to 54 in 2018, compared with 50 in 2008, while the average age of non-executive directors topped 60 Big data is for the fi rst time. Th is increasingly may be indicative of a being used longer active working life, but organisations across all areas should be mindful of business to that, as millennials become the largest deliver detailed group in the insight and workforce, gaining intelligence that insight into the executive and helps organisations priorities committee roles. perspectives of this make better, To meet the 33 influential segment per cent target in is important and more informed the FTSE 350 by 2020, should be a factor in decisions, and the Hampton-Alexander succession planning. review has calculated that board succession In a recent CGLytics half of all the available appointments on US boards, planning should report must go to women. With companies the data revealed a required to address the shortfall of clear and positive be no different women in leadership roles under the correlation between terms of the new UK Corporate Governance the number of younger directors on the Code, and the competitive benefits of board and one-year company total diverse boards, it’s vital that companies shareholder return (TSR).4 The pace of technology development also enshrine a proactive approach to recruiting means that older directors may not be women to senior board roles in their as skilled in emerging areas of strategy succession planning strategies. and risk oversight that are now becoming Ethnic and cultural diversity vital elements of the boardroom skillset. There may be a definite sense of momentum Skillsets that reﬂect today’s behind recruiting women to boards, but progress in improving ethnic diversity corporate risk landscape As we navigate the fourth industrial remains slow. Just eight per cent of revolution, with its fusion of technologies directorships in the FTSE 100 are held by blurring the digital, physical and biological people from ethnic minorities and, of those, spheres, the diversification of the board’s only two per cent are held by people from skillset is essential if the business is to fully UK backgrounds, despite this group reap the rewards of, and navigate the pitfalls representing 14 per cent of the UK inherent in, a rapidly changing world. population. The 2017 Parker Review into the Spring 2019 | Ethical Boardroom 29

Board Leadership | Performance While financial and legal expertise remain important cornerstones, business dependence on technology means that cybersecurity has become an essential element of organisational risk management. The increasing compliance burden around data protection is an added factor that is elevating cyber risk management to the boardroom, meaning recruiting directors with skills in cybersecurity and business continuity is critical if businesses are to effectively understand and mitigate the associated risks. Furthermore, the advent of technologies, such as robotics, automation, AI and machine learning all have the potential to fundamentally alter the workplace and impact employee roles, creating new opportunities, but also making some functions redundant. A growing focus on organisations’ social responsibilities means that boards need to bolster skills around HR management and corporate social responsibility to navigate the workforce challenges that are likely to arise. All of these skills should be incorporated into director recruitment initiatives and succession planning so the company has the expertise it needs to draw on when necessary.

launched the GIRL fund, which favours companies that have achieved a higher level of gender diversity. Low female and ethnic representation causes practical issues, too. Engaging with the company’s workforce is one of the key responsibilities of the board, an aspect that was strengthened in the new UK Corporate Governance Code. Understanding and supporting a heterogenous workforce is far more effective if the board reflects that diversity, meaning employees can engage with directors with whom they feel a connection. Otherwise, the board risks being viewed as an ivory tower that is out of touch and missing any common ground with the workforce. There have been several recent examples where an absence of different perspectives has caused disturbing failures. Take the soap dispenser5 whose automated sensor didn’t recognise black skin, or the health app that purported to track every metric of the user’s life but didn’t include the menstrual cycle.6 These examples may be symptomatic of a wider lack of diversity in the technology sector, but improving diversity has to start at the top (i.e. in the boardroom). An organisation that is tone-deaf to the IMPROVING BOARD PERFORMANCE Diverse members will bring different ideas and perspectives

Risks for homogenous boards

The competitive benefits of improving board diversity should be enough of a carrot to encourage organisations to act, but if further stimulus were needed, the risks of director homogeneity ought to ring warning bells. The most obvious risks for homogenous boards is groupthink, an absence of challenge and a stifling of innovation when it comes to problem-solving. If all directors have a cognitively similar approach, there is less chance that discussions will produce novel, and therefore competitively valuable, strategies. Investor perception is another critical area where a lack of diversity is increasingly likely to be punished. Recently, Legal & General Asset Management stated that it would vote against chairs of FTSE 350 companies where less than a quarter of directors were female and stated its intention to penalise boards whose diversity initiatives were ‘lacklustre’. On the flip side of this, Legal & General also 30 Ethical Boardroom | Spring 2019

diverse world in which it operates risks significant reputational and commercial damage, as well as missing out on the opportunities that broader oversight and more varied perspectives can unlock. The currently low levels of diversity in boardrooms, taken alongside the proven financial advantages diversity delivers, means there’s a huge opportunity for businesses to gain an edge over their competition. By prioritising a review of board composition and recruiting directors with the backgrounds, experience and skillsets, forward-thinking organisations can deliver major benefits, compared with industry peers that fail to make this move.

Widening the net of director recruitment and turning big data to the board’s advantage

Improving board diversity requires deliberate focus on widening the net of director recruitment to counter unconscious bias.

In its Six Step Guide to Best Practice in Improving Board Diversity, the Equality and Human Rights Commission counsels against selecting candidates on the basis of intangible criteria such as ‘chemistry’ and ‘fit’, recognising that such subjective factors tend towards groups appointing people in their own image and, therefore, albeit subconsciously, stifling diversity.7 The use of external selection consultants is also recommended in preference to reliance on word-of-mouth or the personal networks of existing directors. Big data is increasingly being used across all areas of business to deliver detailed insight and intelligence that helps organisations make better, more informed decisions and board succession planning should be no different. Big data offers businesses a more objective and wide-ranging route to identifying future directors and it’s the basis of Diligent’s new Directors Network module. The module uses a rich set of independent data, provided by a leading data provider partner, giving boards access to the same data that is used for proxy filings. The data can be analysed to identify strengths and weaknesses in the composition, governance and skillset of the company’s own board, as well as offering an overview of competitive boards, so areas of comparative advantage or disadvantage can be identified and leveraged or mitigated as a result. The module also provides a searchable global database of more than 200,000 C-level executive profiles, significantly extending recruitment reach beyond the company’s immediate ecosystem and providing a far richer and more diverse pool of potential candidates from which to draw, so that the company can gain the vital perspectives and skillset it needs to build a board that can function as a competitive edge as the business moves forward.

Overcoming the ‘knowing-doing gap’

There’s undoubtedly much to be done to get the boards of businesses more representative of the society in which they operate. As Dominic Barton of McKinsey & Co comments: “Companies suffer a ‘knowing-doing gap’. Most executives know how strong the empirical evidence is that proves the link between fostering more diverse mindsets and achieving superior financial performance. But progress is still too slow.” Conscious focus on building a more diverse board, ushered in by directives such as the corporate governance code and encouraged by institutional investor expectations, will combine to create more momentum. By spreading the recruitment net wider and utilising global data sources, organisations can identify the directors who will transform their board into a source of competitive advantage that delivers added value to the business. Footnotes for the article will be published in full online.

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THE ROLE OF SUPERVISORY BOARDS TO SHAPE A HIGH PERFORMANCE CULTURE

Board Audit and Assessment Board Development Board Values and Ethical Code

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Board Customer Orientation Board Composition and Team Effectiveness

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Board Leadership | Reputation

Failure is an Option Not a year has gone by in recent memory without a major corporate scandal being prominently featured by the world’s leading media outlets. No matter the era, companies once touted as darlings reliably stumble every year, often mightily and very publicly. Most recently, organisations have been criticised for sexual harassment abuses by key executives that have gone either undetected or unpunished, false claims about the development and commercialisation of their company’s products, illegal consumer practices, and many more. In the United States, under applicable state corporate law, the board of directors is charged with managing the business and affairs of the corporation. Given this responsibility, the media often turns a spotlight on the board when something unfavourable unfolds – examining the board’s actions with exacting scrutiny and applying a standard of review that appears more rigorous than the applicable legal standard. The media and countless others undoubtedly claim that the board was at fault or that the time-tested corporate governance legal framework is failing. Instead of analysing the myriad corporations where the current framework is helping corporations create value and thrive, some commentators inevitably call for an enhanced governance paradigm and increased regulation. Whether boards, practically speaking, can actually ever fulfi l what has become the high standard of absolute accountability is ripe for review. Whether this enhanced standard is actually good for business is another question that deserves analysis. Th is article will compare the US legal standard applicable to boards of directors and contrast it with the standard that the press and others often apply to boards. The article will argue that the legal framework in the US is appropriate in providing protections to shareholders and will share lessons boards can learn from the current environment to better protect themselves from a reputational standpoint.

The US governance model strikes the right balance

Delaware law provides that the business and affairs of a corporation are to be managed 32 Ethical Boardroom | Spring 2019

Corporate failures should not trigger a change to the governance paradigm

the action taken is ‘entirely fair’ to the corporation. Should the directors fail to meet this high standard, the court could invalidate the action taken by the board or could, in theory, impose personal liability on the directors. Another protection afforded directors under Delaware is exculpation for a breach Christopher J. Hewitt of the duty of care. The corporation may & Jayne E. Juvan include a provision in its certificate of Chris and Jayne are partners incorporation that eliminates or limits the and co-chairs of the personal liability of a director for a breach of Corporate Governance the duty of care. Exculpation is not available Practice Group at Tucker Ellis LLP and practice law for a breach of the duty of loyalty. The effect in Cleveland, Ohio of this exculpation is that an aggrieved stockholder can seek to enjoin the action by and under the direction of a board of taken, but cannot seek personal liability directors.1 In discharging this responsibility, against the directors. Delaware law imposes certain fiduciary Finally, Delaware law allows the duties on directors, namely the duty of care corporation to indemnify directors in cases and the duty of loyalty. The duty of care alleging a breach of their fiduciary duties. requires the director to act in an informed At a high level, if the director is successful and thoughtful manner. The duty of loyalty on the merits, the corporation must requires the director to act in good faith and indemnify the director for any expenses in a manner that the director reasonably incurred in defending the litigation. If believes to be in the best interest of the the director is not successful, the director stockholders and the corporation. may still be indemnified for expenses and As a corollary to these fiduciary duties, damages if the director acted in good faith Delaware courts have developed the and in a manner the director believed to so-called ‘business judgement be in or not opposed to rule’ when called upon to Whether boards, the best interests of the review the actions of the corporation. The corporation practically board. Under the business may also advance the speaking, can judgement rule, courts will director’s expenses if the not enjoin board action or director undertakes to repay actually ever impose director liability such amounts if it is ultimately fulfil what has unless a complaining determined the director is not shareholder establishes that entitled to indemnification. become the the director breached either Most corporations adopt these high standard the duty of care or the duty of indemnification provisions loyalty. Courts have expressly in their governing documents of absolute indicated that they apply in indemnification accountability is and the business judgement rule agreements with directors, ripe for review and purchase D&O insurance because they are operating with the benefit of hindsight to backstop these obligations. and also do not believe that they are in the Practically speaking, the sum total of best position to make business decisions. these protections – business judgement rule, Consequently, in the normal functioning exculpation, indemnification and D&O of the board, if the directors reasonably insurance – mean that individual directors inform themselves of available information, are rarely held personally liable when an act in good faith, and are independent organisation engages in misconduct. Th is and free from self-dealing, a court will not package of protections is beneficial from a second guess the board’s decision, even if business standpoint because it encourages the course of action ultimately fails. prominent individuals with significant If a stockholder can establish a breach expertise and a proven track record of of the duty of care or loyalty by directors in success to serve as directors without fear approving corporate action, the directors that poor performance alone will result lose the protection of the business judgement in personal liability. Otherwise, these rule. In this instance, the burden would then individuals would be reluctant to hold shift to the directors to demonstrate that board positions. Nevertheless, the media www.ethicalboardroom.com

Reputation | Board Leadership and other commentators have not hesitated to second guess director decision-making from the sidelines.

The dismantling of corporate protections

Long before the current wave of shareholder activism, certain individual and institutional shareholders dismantled various board protections. Th is, in turn, created many of todayâ&#x20AC;&#x2122;s activist shareholders, who further accelerated the demise of structural protections like poison pills, staggered boards and restrictions on acting by written consent, calling special shareholder meetings and removing directors, among others. Then came calls to split the chairman and CEO roles, reduce management compensation, eliminate change in control severance agreements, and, more recently, limit the terms of directors. All of these changes were championed in the name of good corporate governance. But these changes do not indict the fundamental elements of the board paradigm under Delaware law, and the essence of the paradigm should stay intact. There is no question but that a small minority of boards were either asleep at the switch, grossly negligent, or actively engaged in fraud. Similarly, some of these changes were likely beneficial, or at least neutral, at many corporations. In our opinion, however, none of these types of provisions are either beneficial or hurtful on their face. As with many things, the crucial factor is how these provisions are used. Are they used to allow the board time to adequately consider proposals in the exercise of their fiduciary duties, or are they used to entrench underperforming directors and management or, worse, reallocate economics from the shareholders to directors and management? The issue, as we see it, is that the actions of a distinct minority have cast a long shadow on the reputations of the many. Everyone can identify the high-profi le corporate scandals â&#x20AC;&#x201C; Enron, Worldcom, and Theranos. Of course, there are others. The problem is that some people, in particular the media, corporate critics and many academics, extrapolate these isolated situations out to the entire population of corporations and their boards of directors. There are literally over six million companies in the US when privately held companies are added to the mix. The vast majority of these boards of directors function perfectly well, and yet there are calls to dismantle or revise the basic board framework because human nature caused a small minority of directors to implode their boards and companies. www.ethicalboardroom.com

HANDLING A CORPORATE CRISIS Boards can learn from mistakes and restore their credibility Spring 2019 | Ethical Boardroom 33

Board Leadership | Reputation

Failure is a part of capitalism

The best protection for investors is to conduct thorough due diligence. To the extent shareholders desire to be wellinformed about corporate strategy, they have avenues to engage with the board. Not every corporation will succeed for the long run, and the responsibility for making good capital allocation decisions lies with investors themselves. If investors believe an organisation is not living up to its potential or that the board is operating in a manner that is not conducive to corporate growth, they can act through the existing board paradigm to replace directors, or they can reallocate their capital to organisations that are meeting their standards. In our view, if some companies are not routinely failing, the economy as a whole is not progressing. The Kodaks and Blockbusters of the world need to give way to the Apples and Netfl ixes. So, in this era of strict scrutiny of boards, how can directors best protect themselves from reputational risk?

Tune out the noise from uninformed third parties

As we posited earlier, most boards of directors function properly. Most privately held companies will fly under the radar screen. Notable exceptions include Airbnb and other such high-profi le companies. Thus, it is mostly the boards of public companies that bear the brunt of corporate governance criticism. In that regard, too many directors, in our opinion, have let themselves be distracted by things like their ‘Governance QualityScores’ or similar governance measurements, and withhold votes. They end up letting irrelevant outside agents with limited, imperfect information influence the function of the board behind closed doors. If directors are confident in their deliberations and their actions, they should own their decisions and dismiss such non-specific criticism as just so much noise. Well-qualified, thoughtful judges have decided that even they should not play too much a role in corporate decision-making.

The board only meets a limited number times a year. The role of directors in the US is essentially part time, with many directors either holding multiple directorship positions or serving both as a director in one company and as a C-suite executive at another organisation. The board is fi rmly the overseer of the corporation and sets strategy, but the chief executive officer and management teams are responsible for day-to-day execution of the board’s plan. Thus, the board’s most critical task is to ensure that it selects a qualified CEO, capable of fulfi lling the board’s mission without noteworthy missteps. Investing the necessary time to develop an effective approach to CEO recruitment and oversight is critical. 34 Ethical Boardroom | Spring 2019

Ensure the board Is functioning at a high level

The board should invest the necessary time and resources to develop a framework of mutually agreed upon conduct by individual directors and the board as a whole. Directors should not only attend meetings, but they should also actively participate. Diversity of thought and perspective should be viewed as a necessary protection for the organisation, not a threat. Directors should be able to critically examine issues before them and discuss and debate topics without fear of retaliation. The chairman or lead director should also discourage directors from developing factions or cliques that interfere with the collective ‘sins’ work of the board.

SELECTING THE RIGHT LEADER Capable CEOs can ensure success via good decision-making

Take care to select the right CEO

the corporation never suffers from the same misconduct again. These excursions can be both time consuming and costly. The lengthy reports can result in a ‘check the box’ approach that gives the board a false sense of security – if it just ensures every element is met, the organisation is better protected. The problem with this approach is that organisations operate in a dynamic world, and the risks of yesterday and today bear little resemblance to the risks of tomorrow. A board that operates by spending too much time looking in the rear-view mirror fails to see the landscape through the window before it. In a worst-case scenario, this may cause the board to insufficiently prepare for other risks and threats or, importantly, opportunities that may materialise.

If they don’t have a seat at the table, why should other third parties with far less information?

The of a few Conclusion corporations The ‘sins’ of a few corporations should not should not be attributed to be attributed the many organisations that are functioning at a high level. to the many To attribute them to the many organisations exceptionally performing companies that strive day in that are day out to make decisions functioning at and in the best interests of their organisations would be a a high level

Stop fighting the last war

After encountering a troubling situation, boards often go to painstaking efforts to investigate the incident to better understand it and ensure that it doesn’t happen again. In many instances, boards will establish special committees whose sole task it is to get to the bottom of the situation. Investigations can involve many, if not all, members of the board in some capacity, lawyers, consultants, and other stakeholders. Oftentimes they can go on for months, if not years, until the board is satisfied there was no stone left unturned. The board then receives a list of recommendations to implement to ensure

mistake. Even more importantly, the time-tested governance framework does not need a major overhaul every time a new scandal emerges. Because of human nature, not all corporations will function at a high level all the time. There will be those that make good decisions and those that make poor decisions. Regardless of how much companies spend on research and development, there is no guarantee they will be the one to develop the next blockbuster innovation. Whether we like it or not, modifying the governance framework will not change these truths. In the US, Delaware law is considered by many to be the gold standard for corporations. Delaware corporate case law is well-developed, and, as a result, organisations often incorporate in this jurisdiction.

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Board Leadership | Evaluation

INDEPENDENT EXTERNAL BOARD REVIEWS Board evaluations build board effectiveness, but it is time to raise the level across all companies Helen Pitcher OBE

Chair at Advanced Boardroom Excellence

discretion and control. Best practice has been led by the FTSE 100 companies and influenced by the governance compliance indexes, which inform the investor communities of the ‘governance footprint’ of a company.

Independent external board evaluations emerged in parallel with the general development of the governance code for companies. The question now arises whether their current shape is fit for purpose in the modern corporate environment, where society/CSR and employee engagement are playing an increasing part in the context of a company’s right to operate and accumulate numerous benefits and advantages from society? As the code of governance became more formal, so the question arose of how the effectiveness of the board would be monitored. While the legal aspects of operating a company has a built-in ‘monitor’ through the courts and regulatory agencies, governance monitoring has emerged as a voluntary process, over which the company and board have significant 36 Ethical Boardroom | Spring 2019

The emerging code and evaluation

Under the FRC (Financial Reporting Council) Governance Code, the use of independent external board evaluation has staggered into existence in the form it has today. Emerging from the Higgs Report in 2003 the combined code suggested good practice to be ‘an annual evaluation of board performance’ with the suggestion that ‘use of an external third party will bring objectivity to the process’. The 2006 code retained the annual performance evaluation, but the reference to external facilitation disappeared! It wasn’t until 2010 that an externally facilitated review at least every three years became part of the code for the FTSE 350, this included a statement of the facilitator’s connection to the company. The following year the FRC produced a ‘Guidance on Board Effectiveness’, which set out a detailed approach to the ‘independent externally facilitated board evaluation’. Th is started a process of creating a board evaluation standard, but which was still voluntary under the ‘comply or explain’ doctrine. Since 2011 the ‘independent external board evaluation’ process has meandered

on, with various failed attempts at a code of practice, including our own code of Advanced Boardroom Excellence published in 2014, which sought to advance the discussion. All these endeavours called for greater formalisation of what would be covered by a board review. Consequently, the interpretation of what should be covered in an independent and externally facilitated review was, and still is, at the discretion of the board and covers a wide range of standards applied to supporting the effectiveness of the board.

The 2018 drop kick

In 2018, after an extensive period of consultation, the FRC launched a revised ‘Code and Board Effectiveness Guidance’, under the watchful eye of the Government. The revised code takes a much more strident and prescriptive view of what the structure of an externally facilitated board performance review, conducted at least every three years, should look like: no questionnaires only, observations of boards and committees, review of board papers, meeting executives, shareholders, advisors and workforce. The new guidance is also more assertive on the independence issue, stating that a board should be ‘mindful of existing commercial relationships and other confl icts of interest and select an evaluator who is able to exercise independent judgement’ but still subject to comply or explain. However, following various parliamentary inquiries and reports, the Government has clearly lost patience with and confidence in the FRC www.ethicalboardroom.com

Evaluation | Board Leadership PROGRESSING EFFECTIVENESS Independent, external evaluations can help a company’s development

as an effective regulator and is in the process of a major reform of its duties, responsibilities and accountabilities. While a further revision of the code is unlikely in the near future after such an extensive consultation process, the bite applied to the provisions is likely to become fiercer, much in the style of the Financial Service Regulator, which has limited tolerance for non-compliance with its guidance and principles. In an additional drive to rejuvenate the quality of board governance and effectiveness reviews, the Government has also invited the governance institute ICSA (Institute of Chartered Secretaries and Administrators) – to convene a group of investors and companies to develop a ‘code of practice for external board evaluations’. Th is best practice code is long overdue and is attempting to bring some semblance of standardisation and increased professionalism to the arena of board evaluation.

The current mandate for independent external board reviews

However, while the investors, companies and board evaluation practitioners consult with ICSA and await the publication of the code of practice, there is a pressing need to support boards in their performance evaluations in response to the revised Corporate Governance Code, which become active from the start of this year. The revisions to the Governance Code are significant and take many boards into territory that they will be unfamiliar with. Some of the key changes, for example, include: www.ethicalboardroom.com

■ An expanded board remit to promote ‘contributing to wider society’ ■ Workforce policies and practices, consistent with the company’s values and supportive of its long-term sustainability ■ An expanded focus on purpose, culture and values, monitoring and reporting on culture throughout the company ■ The engagement with the views of the company’s key stakeholders beyond the shareholders, with the consideration of their interests in board discussions and decision-making ■ A workforce engagement process (workforce includes beyond just those with formal employment contracts) ■ A greater focus on the issue of overboarding for board appointments ■ An intensification of effort in promoting and creating diversity and building diversity throughout the workforce and executive pipeline ■ Emphasis on the remuneration committee’s independent judgement and discretion in reviewing the executive and workforce remuneration, incentives and rewards, ensuring alignment with the culture and long-term success of the company

Board reviews have in the past placed too much emphasis on the procedural building blocks of the board and often failed to emphasise the board dynamics aspects of an effective board

■ The remuneration committee’s expanded remit to include determining senior management remuneration and pension alignment of executive directors to the wider workforce These are significant changes, which are likely to be assertively monitored and questioned by a revamped FRC, with a more active control of the standards and monitoring of board of directors. Consequently, the role of the independent external boards evaluation becomes not only to review the current performance of the board but also to provide a development roadmap and recommendations to progress the effectiveness of the board. Th is is in keeping with a developing trend for a new generation of NEDs, who perceive their personal reputations to be exposed and at risk, to see an effective independent external board evaluation as a quality benchmark.

The process of independent external board reviews

Board reviews have in the past placed too much emphasis on the procedural building blocks of the board and often failed to emphasise the board dynamics aspects of an effective board. Understanding and effectively assessing board dynamics through observations, direct discussions, procedural and written information, requires experience, professional insight and a depth of understanding of group and organisational dynamics. The benchmark of a good board is the effective contribution from the whole board and in an open manner, which accesses and leverages the knowledge, skills and experience of the entire board of non-executive directors and executive directors. Spring 2019 | Ethical Boardroom 37

Board Leadership | Evaluation As we look at a board’s landscape, the hierarchical nature of effectiveness shines through, as we gain insight and understanding of the dynamics of a well-functioning board. BOARD EFFECTIVENESS HIERARCHY BOARD DYNAMICS Challenge Tone & Participation & debate openness & teamwork SELF-ACTUALISATION OVERSIGHT & REVIEW Strategic Performance Knowing the intent monitoring unknown ANALYSIS AND INSIGHT BOARD STRUCTURE & PROCESS Governance Board Board framework information composition FOUNDATION PLATFORM @ABExcellence2019

Principles of independent external board reviews

The structure of what goes into an effective independent external board evaluation, has no common framework. The 2018 report from The All Party Parliamentary Corporate Governance Group (APPCGG 15 Years of Reviewing the Performance of Boards, Lessons from the FTSE All Share and Beyond), indicated an improving value but with a wide range of attitudes and reasons for carrying out a board review, of which the top four are: ■ ■ ■ ■

to emerge around a framework, which ensures a greater standardisation and professionalism of the process. While the flexibility should still exist for the company to shape the board review process, this should be to enhance the board review and not to minimise its scope. The key to the success of independent external board evaluation will be effective independent oversight of the code of practice – definitely a case of practicing what you preach. Th is should provide a strong impetus for an independent, objective and reflective view of the board, unhindered by perceived weakness of the current approach, which is seen as too focussed on not upsetting the client and downplaying hard news, according to the APPCGG report. One of the longer term issues will also be how the private sector is brought into the independent external board evaluation world. Under the current, recently published Private Company Governance Code (Wates Principles), there is no requirement to undertake an independent external board evaluation. It will be interesting to see where the new FRC leads on this.

unlike the audit committee guidance under the code which has an implied threat from the FRC as ‘the competent authority for audit in the UK’ and ‘regulatory authority of the accountancy and actuarial professional bodies’. This contrasts starkly with the introductory wording of the board effectiveness guidance, which seems to bend over backwards to ‘lighten’ the guidance: “The primary purpose of the guidance on board effectiveness is to stimulate boards’ thinking and the guidance is not mandatory and is not prescriptive.” The mood of Parliament, in response to public pressure and disbelief in the corporate values on display, reinforced by interest group lobbying, has swung decisively towards bringing companies into a full participant in society and to eradicate the almost daily scandals, which are currently defining the corporate sector. Resetting the guidance on board effectiveness with a presumption of excellence and compliance to the clear standards it contains, would only take a few tweaks, without the need for any wholescale

Recalibrating focus & agreeing priorities Raising issues & prompting open discussion Improving board dynamics & engagement Providing an external view & best practice

The future of independent external board evaluations will be measured by their usefulness to the board in providing a mirror to their own performance and in a manner that is honest, productive and futurefocussed. There is no doubt that the inner world of boards and the executive team is more exposed than it has ever been, unfortunately, this has, by and large, not been a confidence-boosting process. Boards will increasingly need to show their metal and steer a delicate path between greater oversight, guidance and leadership of a company’s landscape, while still facilitating the executive to fulfi l its purpose and goals. While there is no intention to usurp executive decision-making and leadership, the board NEDs are required to be familiar and cognisant with the broader society pressures, strategic landscape and future horizons of the company to fulfi l their role.

What does the future hold?

The independent external board evaluation will continue to emerge and be refined, supported by the development of a code of practice for external board evaluations. The key elements of this code of practice are likely 38 Ethical Boardroom | Spring 2019

GEARING UP FOR CHANGE New governance regulations will require companies to up their game

As Simon Osborne, Chief Executive of ICSA said in taking on the Government’s challenge to create an external independent board evaluation code of practice: “We fi rmly believe that a high-quality independent board evaluation or board effectiveness review is valuable for companies, indeed organisations, of all sizes and in all sectors.”

Conclusions

The exciting world of board evaluation is at a crossroads. History shows us that the best aspire to the best standards while the rest will seek to minimise and marginalise the board effectiveness provisions of the code and the guidance. Up to this point, there has been no real sanction for any dereliction,

revision. The new FRC governance regulator is also likely to be give an oversight on the standards and disqualification of boards directors, as part of a revised brief, bringing a consequent level of leverage that has been hitherto been missing. While some will cry over governance and cost, the reality is that these are the standards our best boards are achieving and it is time to raise the level across all companies. The voluntary nature of governance has had a good run for its money and there is a mounting pressure from government, society, employees and the massive pension investor funds, for companies to get in step with the changes in today’s society and growing expectations of the corporate sector. www.ethicalboardroom.com

This is what the world’s most valuable currency would look like.

If only it were a coin! In today’s dynamic and unpredictable business world its value is continually growing. It cannot simply be bought, it has to be found. It is not dependent on market fluctuations. It guarantees that a company will develop and grow in value. It is universally sought-after. You’ve probably already guessed what this currency is. It is comprised of the most talented, fast, agile and creative minds, who have a proven record of acting responsibly and successfully. Amrop advises the world’s most dynamic organisations on finding and positioning Leaders For What’s Next — adept at working across borders, in markets around the world. With 77 offices in 49 countries, Amrop is one of the world’s largest retained executive search partnerships. amrop.com

Global News Latin America & Caribbean Jamaica urged to enhance transparency Tackling governance issues swiftly and forcefully is necessary to enhance transparency and accountability in Jamaica, according to the International Monetary Fund (IMF). The executive board of the IMF, in its fifth review of Jamaica’s performance, concluded the country fares relatively poorly on corruption-correlated measures and public corporate governance. The IMF wants new regulations to ensure a transparent and competency-based process for

board appointments to public bodies’ boards. In May, the World Bank announced a new $140million financing package to help promote ‘growth, jobs and resilience for Jamaica’. The Bank said that for Jamaica to ‘continue to grow and prosper, it needs to develop the skills for the workforce of tomorrow, especially in the areas of technology and digitalisation’.

Neoenergia unveils IPO plan Brazilian electric utility Neoenergia has filed for an initial public offering (IPO) on the Novo Mercado — a special listing segment of the Sao Paulo’s stock exchange — after gaining both shareholder and board approval. Iberdrola, which holds a 52.45 per cent stake in Neoenergia, said the listing would take place in the first half of this year. In 2017, Neoenergia backed out of an IPO at the last moment citing market conditions as pricing fell short of the expectations of its Brazilian shareholders. According to Reuters, shareholders expect a higher valuation now, as Neoenergia’s results have improved since a merger with smaller rival Elektro in June 2017.

Banks push for green lending in LATAM Interest for green deals has started to pick up in Latin America, according to bankers and investors in the region, who warn that data and technology costs remain a barrier to understanding environmental, social and governance (ESG) investment. According to a Reuters report, banks active in Latin America have earmarked potential green loans for corporate borrowers, which seek to advance ESG criteria. Only two companies have raised green loans in Latin America so far. Spanish utility Iberdrola raised $400million for its Mexican subsidiary

and Peruvian conglomerate Ferreycorp signed a $70million loan with BBVA. Jorge González-Jacob, global head of corporate loans at BBVA, told Reuters: “Green loans are not a pure debt instrument, there is an opportunity to combine investment with advisory services. There is a value-added expertise and banks know this is something they have to do to deepen their client base.” “Sustainable revolving credit facilities are in demand throughout the syndicated lending space,” González-Jacob added. “It started with (green) bonds but through 2019 and 2020 we will see more green lending.”

Odebrecht rebrands to OEC

Brazil’s Vale in board shakeup Brazilian mining giant Vale has appointed a new chairman and a new CEO as the iron ore producer works to recover from the deadly collapse of one of its mining dams in January, which killed more than 300 people. Eduardo Bartolomeo is the company’s new chief executive. He took over as interim head of Vale in March when his predecessor Fabio Schvartsman resigned. José Maurício Pereira Coelho is Vale’s new chairman, replacing Gueitiro Matsuo Genso.

40 Ethical Boardroom | Spring 2019

Vale has also announced the creation of the ‘Special Executive Board for Recovery and Development’, which has the mission to ensure focus is on structuring actions that involve repairing the damages caused by the breach of Dam I in Brumadinho (Minas Gerais). The new executive board will be responsible for all social, humanitarian, environmental and structural recovery actions to be carried out in Brumadinho and in the 16 municipalities along Paraopeba river up to Retiro Baixo dam.

Brazilian civil engineering and construction firm Odebrecht SA is rebranding, in an effort to distance itself from a series of political corruption scandals. Odebrecht will now be known by the initials OEC, although its logo still will feature the words ‘Odebrecht Engineering & Construction’. The change reflects what the company calls its ‘Transformational Journey’, with ‘important advances in its governance, such as the implementation of a new compliance system; incorporation of independent advisors; the update and adoption of new policies and guideline; and a new succession process’. In 2016, the Brazilian-based group signed what has been described as the world’s largest leniency deal with US and Swiss authorities, in which it confessed to corruption and paid $2.6billion in fines. Odebrecht executives confessed to paying bribes in exchange for contracts not only in Brazil, but in various parts of the world. www.ethicalboardroom.com

Latin America | Female Diversity

ADVANCING WOMEN TO LEADERSHIP ROLES Introducing talented women to your board can bring fresh perspective 42 Ethical Boardroom | Spring 2019

www.ethicalboardroom.com

Female Diversity | Latin America

Gender diversity across Latin America It is clear that there’s a huge gender gap in business leadership positions, in particular on boards of directors, and that the process to create a critical mass of women in governance is very slow.

However, at this point, we need to leave the diagnostic stage and focus instead on effective tactics. And, although in many cases the results are small, they are not without value, as they offer a concrete basis to straighten out a historical problem.

Limitations for Latin American women

In Latin America, organisations exist within a social and cultural environment where gender parity is conditioned by multiple factors that directly or indirectly affect the business. These include, for example, local and transnational corruption (the Panama Papers, Lava Jato, Odebrecht), the shadow economy and paternalism. In order to achieve anything close to international standards in the medium term, we must identify the barriers that stand in the way of advancing women to decision-making positions. These must be overcome with creative and effective tools that often emerge from local entities. Only by taking into consideration the specific situation of each country and by working side by side with the local actors will it be possible to accelerate the representation of women in senior management.

Opportunities in the short and medium term

In an emerging region where many countries struggle with instability, unemployment, underemployment and poverty, opportunities for women are limited in both the public and private sectors. So, what’s the best way for women to progress to senior management positions? At a high level, there is a great opportunity in stock exchanges of individual countries to lead the charge in their listed companies. For five years, the United Nations has carried out a gender awareness initiative on International Women’s Day (8 March) called ‘Ring the Bell for Gender Equality’ where women ring the bell in the world’s stock exchanges. In 2019, more than 80 countries rang the bell but in Latin America only the stock exchanges of www.ethicalboardroom.com

Bringing women on board creates value and sustainability in an organisation Alejandra Mastrangelo

Consultant, Corporate Identity and Governance

In family businesses in Latin America, on average 69 per cent of the company’s shares are held by the controlling family. In many of these organisations there are only 10 per cent of women on their boards. Mexico has an even lower representation of just four per cent. Although nepotism sends the message to the rest of the organisation that merits and professional effort are not enough to achieve managerial positions, in this article we look at the advantages of practicing it and as a way to advance women to leadership positions.

Argentina, Brazil, Chile, Colombia, Costa Rica, Mexico, Panama and Peru took part. The advantages of nepotism Experts in business ethics consider that According to the arguments in favour of the tone at the top is the decisive factor that nepotism offered by the companies that shapes the organisational culture to prevent practice it, it offers a competitive advantage fraud and other unethical practices. Recent as the children grow up surrounded by the studies have concluded that women are more vicissitudes of the business, day by day; they risk averse to violating norms and policies. breathe in a large amount of idiosyncratic This confirms that having more women in knowledge that is not taught in universities compliance can strengthen governance. or business schools and this And, because of the type of is how they naturally become experience and training women In family potential candidates to take on acquire in compliance, this is businesses in the helm of the organisation. an excellent way to get them In addition, when faced with to the organisation’s board Latin America, a crisis, it is considered more of directors. Other spaces on average 69 likely that a family member where there are opportunities to advance women to leadership per cent of the will be willing to make the sacrifices to preserve positions are: company’s shares necessary family assets. A family member ■ International companies can also be the most appropriate are held by with presence in Latin person to understand the the controlling America offer the responsibility of maintaining family opportunity to choose the family brand and the women as CEOs of the local relationships with the different subsidiary (many use legal and stakeholders built up throughout the history commercial formats that don’t require of the company. Let’s look at how we can the creation of a board of directors) limit the negative consequences of nepotism ■ In family-controlled companies, and continue validating a meritocratic women who are part of the boards of organisational culture: directors are usually members of ■ Establish a family protocol that the controlling family. In this case, clarifies policies on hiring family nepotism, normally considered negative members and limits the entry of in other circumstances, has proven to unqualified family members by avoiding improve the statistics the promotion of inexperienced people Nepotism in family businesses to decision-making positions It is known that nepotism is practiced ■ Ensure the proper preparation of the openly in family businesses. The reason next generation that will take over the given by those who practice it is that they company through planning, education, need trustworthy and loyal people to training and experience so that the occupy key positions. Th is power, however, succession is seamless at the time the is usually exercised in favour of men and founders decide to retire or a force to the detriment of women. majeure situation arises Spring 2019 | Ethical Boardroom 43

Latin America | Female Diversity ■ Create programmes and internships so that family members can voluntarily and non-coercively learn about the business of the company from an early age ■ Require that family candidates work certain amount of time outside the organisation to obtain experience in the real world and acquire competitive skills. Th is requirement is intended for family members who plan to enter the company to demonstrate their own merits which put them on an equal footing with non-family managers ■ Incorporate non-family managers to demonstrate to the rest of the organisation that there are opportunities to move up to management positions ■ Create an equitable system of remuneration and professional development for both non-family managers and family members ■ Conduct performance evaluations of family employees in exactly the same way as you do for non-family employees, with adequate feedback according to short-, medium- and long-term performance objectives ■ Establish meetings facilitated by external professionals to create a space for objective debate around interests, personal relationships, and proper handling of family confl icts so that they don’t contaminate the organisational environment ■ Maintain a clear separation of roles and act from the appropriate one at each moment. This aims to avoid conflicts that arise when the roles of owner, father/mother, boss, etc, are mixed at the time of decision-making

How to use nepotism to increase gender diversity on a family business board

Given the worldwide trend towards a higher graduation of women than men with university degrees, it is clear that we have moved away from the time when women’s main role was to marry and have children while men were preparing to inherit the management of the family business.1 Nowadays, with the high level of competitiveness present in every market, any company that seeks to grow and succeed must consider 100 per cent of the available talent. As the vast majority of boards (both in family businesses and large corporations) are usually homogeneous, bringing women on board contributes to create value and sustainability in the organisation. They offer a different perspective and different traits: ■ They tend to have a more holistic view of the risk map by taking into account all the stakeholders ■ They have great capacity to empathise with the various stakeholders and create consensus to achieve decision-making 44 Ethical Boardroom | Spring 2019

■ They tend to have very developed listening skills and a collaborative leadership style

As board members, women could mitigate the risk inherent in high concentration of power

The concentration of ownership in Latin America allows certain majority shareholders to manage the business and make decisions that negatively affect minority shareholders. In listed companies, it is mandatory to mitigate this imbalance with the participation of independent directors. These have become a strength of corporate governance. Their mission, like any director, is to work according to the company’s objectives. However, it is more likely that by not having commitments or links with any specific power group, they will tend to act objectively when decisions involve confl icts of interest. At the same time, independent directors function as a mitigating element of the accumulation of power. In this sense, independent directors become the main supervisors of the administration of the company, being able to disagree when they deem it necessary and to initiate actions to bring transparency to any administration practices. Any company wishing to professionalise its governance system should opt for the incorporation of women as independent directors. As we saw earlier, they will provide a greater diversity of perspective since they constitute the least represented gender on current boards.

The participation of women on committees improves the work of the board

Going back to listed companies and according to different legislations, the independent directors are responsible for committees such as audit, compensation and remuneration among others. Here again we find opportunities for companies to create a pipeline of women who can access the highest decision-making positions.

In addition to the mandatory and statutory committees, a company can create specific committees to resolve certain aspects needed to carry out the strategic plan. Th is is achieved with internal and external experts. A concrete example took place with one of my clients – a family business. After the directors were evaluated, the company decided to professionalise its governance system. In order to achieve this, we had to strengthen the board of directors and reorient the work in certain weak areas. To this end, we created ad hoc committees to bring the new generations to the decision table so we could test 100 per cent of the company’s talent. We opened the doors to family and non-family women who proved to the organisation that they had the capacity and experience to contribute to the board.

Conclusion

In today’s dynamic marketplace, it is a must to form dynamic corporate governance systems made up of polymaths. That is, individuals who have competencies and knowledge in diverse fields of science, the arts, or the humanities and are able to cover the diversity of tactical and strategic challenges that businesses demand. The goal is for these people to strengthen the company’s potential, to balance risks associated with organisational complexity and make the company sustainable. If an organisation wishes to stay competitive, 100 per cent of the talent pool must be part of this equation. Including women fosters a broader and more flexible perspective to deal with the high demands of the current VUCA (volatile, uncertain, complex, and ambiguous) environment – and especially in Latin America, where women are an increasingly influential consumer 2 https://www.harvard-deusto.com/como-se-gobiernolas-mayores-empresas-de-control-familiar-de-america -latina 2http://www.sseinitiative.org/gender-equality/ 3 https://hbr.org/2014/01/what-vuca-really-means-for-you 1

BALANACED BOARDROOMS More women need access to decision-making roles in Latin America www.ethicalboardroom.com

Advertorial | Latin America

Exponential boards: Evaluation 4.0 To make better business decisions and consolidate a culture of innovation within conglomerates, board evaluations must evolve to the next level through a combination of self-evaluation, peer evaluation and feedback from management with the guidance of an external facilitator There are two main global corporate governance challenges: how to govern conglomerates and how to really improve a board’s performance.

Andres Bernal

Partner, Governance Consultants SA

of four elements: self-evaluation, peer evaluation, feedback from management, and external expert guidance. This strategy has contributed to address different challenges Although it is easy to find abundant to make the group’s boards better governing academic research and theories about these bodies. Self-evaluation facilitated internal topics, there are only a few good samples analysis and discussions on how the boards to learn from. A case that deserves to be could be more effective and better address highlighted is how Grupo Energía de Bogotá their responsibilities. Through peer evaluation, members have (GEB), a Colombian listed multinational accessed individual feedback about their group controlled by the city of Bogota, has work (in our methodology peers assessed impacted its governance model through other member’s knowledge, better board evaluations. preparation, contribution Our experience as A good board assertiveness). Feedback governance advisors of evaluation system and from the management several Latin American about the work of the board, corporations and especially creates a great contributed to identify facilitating board transformation the areas in which it needs evaluations, has shown us support, leading to enhance that a good board evaluation that is in the board focus. An external system is the origin of end transferred guidance support contributed internal conversations that to financial to preserve confidentiality, lead to boards that create maintain an objective point value. At the same time, performance of view and access best global through a conscious and practices. The main lesson in this case is that deep evaluation, boards have been able a good board evaluation system – properly to improve their effectiveness, identify executed through the right leadership and needs or knowledge and introduce support from the group’s CEO – creates a great operational adjustments (such as new transformation that is in the end transferred committees, changes to the annual board to financial performance. The experience agenda, better quality of information and of Grupo Energía de Bogotá has shown: enhanced mechanisms for following up a board’s decisions). The board of the holding company In GEB’s case, a key foundation for its has successfully set an example for transformation was the adoption of a all the companies in the group about the consistent strategy for board evaluations. This implementation of different evaluation strategy has been applied through a board systems. The board evaluation system evaluation system based on a combination

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has exponentially created cultural transformations that aligned and incentivised individuals all along the ‘chain of command’ of the holding and its subsidiaries A systematic board evaluation strategy has enabled the consolidation of governance data to have a comprehensive view on how the boards within the group are operating. The evaluations results are gathered in a business intelligence platform, which facilitates different kinds of analysis to implement improvement strategies (training, new policies and board composition, among others)

Finally, through this evaluation strategy, holding and subsidiaries can better adopt innovative initiatives to maximise business growth and development through a better decision-making process. Additionally, it has promoted and reaffirmed a culture of accountability, ethics and transparency that unfolded from the boards to management and operational teams. The logic is simple: companies are made from decisions and decisions are inspired, made and controlled by boards. If the board’s method to make decisions improves (through a good board evaluation strategy), the quality of decisions will consequently make better companies. .

Governance Consultants S.A.

Carrera 11 Nº 86-60, Oficina 302 Bogotá, Colombia +(57) 1 474 43 99 contacto@gcsa.co www.governanceconsultants.com

Spring 2019 | Ethical Boardroom 45

Board Governance | Best Practice

APPLYING COMMONSENSE PRINCIPLES 2.0 The continuing momentum of the governance conversation

For decades, the governance community has been working to build consensus around a set of best practices for US public companies and provide a framework for sound, long-term oriented governance. Now, that movement is gaining traction. As shareholders have become more engaged and the general public has become more focussed on how corporations in the US and around the world run themselves, different groups have put forward their ideas on how to best advance the interests of sound corporate governance. The result has been a robust and healthy conversation that continues to evolve the thinking on what constitutes good governance for publicly owned companies. Governance experts and the media took notice in 2016 when a group of about a dozen leading executives published the Commonsense Principles of Corporate Governance.1 Their work represented an effort to reach common ground among representatives of some of America’s largest corporations and institutional investors. With the long-term prosperity of millions of American workers, retirees and investors depending on the effective governance of American public companies, they felt it was critical to foster a dialogue about the responsibilities and need for constructive engagement among those companies, their boards and their investors. These original Commonsense Principles were not prescriptive, nor did they require a pledge to uphold a particular approach to an issue. Instead, they laid the baseline for what sound corporate governance, supported by a range of stakeholders, can look like in boardrooms of public companies. This group of leaders recognised that each stakeholder’s unique perspective may colour their thinking about a specific policy, but that it was possible and beneficial to develop a widely accepted framework to be used as a foundation for their 46 Ethical Boardroom | Spring 2019

Kristin Bresnahan

Executive Director of the Ira M. Millstein Center for Global Markets and Corporate Ownership at Columbia Law School decision-making. By putting these principles on paper, these leaders helped advance a national conversation that has only gained momentum since. Other seminal works on the subject include an investor-led effort by the Investor Stewardship Group (ISG) called the Framework for US Stewardship and Governance,2 a business-led effort by the Business Roundtable (BRT) called Principles of Corporate Governance3 and a piece by Martin Lipton, a founding partner of the law firm of Wachtell, Lipton, Rosen & Katz, for the International Business Council of the World Economic Forum, called The New Paradigm.4 Each additional work added something to the broader discussion. The Stewardship Principles brought together 25 of the largest asset managers and asked them to pledge ENGAGING WITH to use their influence with the companies STAKEHOLDERS in their investment portfolios to further Directors should have a duty of the cause of good governance. The group loyalty and care encouraged other asset managers to sign on. The Business Roundtable’s The first Commonsense Principles were Principles added important authored by executives representing perspective from the business diverse points of view, including: community at large and the Tim Armour Capital Group Business Council of the World Economic Forum added an Mary Barra General Motors Company international perspective. Warren Buffett Berkshire Hathaway Inc. The authors of the Jamie Dimon JPMorgan Chase Commonsense Principles Mary Erdoes JPMorgan Asset Management endorsed these additions to the governance conversation Larry Fink BlackRock and continued to keep up with Mark Machin Canada Pension the discourse. In 2018, they Plan Investment Board reconvened to update their principles to reflect the evolving Lowell McAdam Verizon Communications Bill McNabb Vanguard conversation and developments across the field of corporate Ronald O’Hanley State Street governance. The Commonsense Global Advisors Principles 2.0 were published Brian Rogers T. Rowe Price in October 2018 and this time Jeff Ubben ValueAct Capital the signers were asked to make www.ethicalboardroom.com

Best Practice | Board Governance a pledge to uphold the principles at their own companies. The group expanded from the original signers and is now almost double the size. At Columbia Law Schoolâ&#x20AC;&#x2122;s Ira M. Millstein Center for Global Markets and Corporate Ownership, we have partnered with the leaders of the Commonsense Principles to foster this critical dialogue and advance the ball to benefit investors, public companies and the broader American public, all of whom are impacted by the decisions made in boardrooms in the US and around the world.5 Through our engagement with business leaders on the toughest decisions they are facing in the boardroom and our academic research on these issues, we have learned how critical it is to have a baseline of core principles to guide the discussion. Identifying these best practices and bringing academic rigour to the process is core to our mission and we believe that the Commonsense Principles 2.0 make important progress to that end.

The original Commonsense Principles

When they were first issued in 2016, the Commonsense Principles of Corporate Governance contributed to the broader conversation on a number of topics.6 The authors did not seek to opine on every issue of importance in the boardroom. Instead, they aimed to understand where there was broad consensus that could set the baseline for ongoing discussions among constituencies with different points of view. By putting their ideas in one place with such broad authorship, they reframed the conversation from advancing individual perspectives to collectively advancing the interests of all Through our stakeholders over the long term. The initial principles touched engagement on topics ranging from board with business composition and independence to a boardâ&#x20AC;&#x2122;s active engagement leaders on and access to leadership and the toughest information. Going beyond the boardroom, they noted the decisions they for thoughtful practice are facing in the need around the frequency of earnings boardroom and guidance and laid out best practices for investor engagement our academic with corporate leaders, including research on both management and the board, to help inform sound these issues, decision-making. we have learned With the caveat that the recommendations were not meant how critical to be absolute, and a recognition it is to have a that the significant variation baseline of among public companies would inevitably and appropriately core principles be reflected in their approach to guide the to corporate governance, the Commonsense Principles included discussion the following key points: www.ethicalboardroom.com

Spring 2019 | Ethical Boardroom 47

Board Governance | Best Practice ■■ Truly independent corporate boards are vital to effective governance, so no board should be beholden to the CEO or management. Every board should meet regularly without the CEO present, and every board should have active and direct engagement with executives below the CEO level ■■ Diverse boards make better decisions, so every board should have members with complementary and diverse skills, backgrounds and experiences. It’s also important to balance the wisdom and judgement that accompany experience and tenure with the need for fresh thinking and perspectives of new board members ■■ Every board needs a strong leader who is independent of management. The board’s independent directors usually are in the best position to evaluate whether the roles of chairman and CEO should be separate or combined, and if the board decides on a combined role, it is essential that the board has a strong lead independent director with clearly defined authorities and responsibilities ■■ Our financial markets have become too obsessed with quarterly earnings forecasts. Companies should not feel obligated to provide earnings guidance and should do so only if they believe that providing such guidance is beneficial to shareholders ■■ A common accounting standard is critical for corporate transparency, so while companies may use non-Generally Accepted Accounting Principles (GAAP) to explain and clarify their results, they should never do so in a way that obscures GAAP-reported results. In particular, since stock- or options-based compensation is plainly a cost of doing business, equity compensation should always be reflected in non-GAAP measurements of earnings ■■ Effective governance requires constructive engagement between a company and its shareholders. The company’s institutional investors making decisions on proxy issues important to long-term value creation should have access to the company, its management and, in some circumstances, the board; similarly, a company, its management and board should have access to institutional investors’ ultimate decision-makers on those issues

What’s changed?

The Commonsense Principles 2.0 built on the strong foundation of the 2016 Principles to reflect the evolving conversation and drive forward a more developed understanding of, and agreement on, the key tenants of corporate governance that support long-term value for all shareholders.7 48 Ethical Boardroom | Spring 2019

Additional signees at that time included: Edward Breen DowDuPont Alex Gorsky Johnson & Johnson Brian Moynihan Bank of America James Quincey Coca-Cola Ginni Rometty IBM Charlie Scharf BNY Mellon Randall Stephenson AT&T David Taylor Procter & Gamble Theresa Whitmarsh Washington State Investment Board Notably, 2.0 speaks to additional areas where boards and investors can be better positioned to drive long-term value creation. These updates and enhancements include recommendations regarding board tenure, transparency around staggered boards, proxy access, engagement on important proxy proposals and consideration of anti-takeover provisions. Finally, the updated principles call for enhanced transparency on the part of both companies and asset managers to ensure greater understanding between shareholders and the companies in which they invest. Some noteworthy additions to the Commonsense Principles made in version 2.0 include: ■■ Board members should be prepared to serve for a minimum of three years ■■ If board elections are not annual, companies should explain why ■■ Companies and shareholders are encouraged to engage early on important proxy proposals ■■ Companies should allow some form of proxy access ■■ Poison pills and other anti-takeover defences should be put to a shareholder vote and re-evaluated by the board on a periodic basis ■■ Asset managers should disclose if they rely on proxy advisors to inform their decision-making ■■ Asset managers should disclose their conflict of interest policies in their proxy voting and shareholder engagement activities ■■ Portfolio managers should be compensated based on performance over an appropriate term, given the strategy and investment time horizon for the portfolio ■■ Asset owners should promote sound, long-term oriented governance in their direct interactions with both companies and asset managers ■■ Asset owners should use benchmarks and performance reports consistent with their investment time horizon to affect governance outcomes with asset managers and evaluate the asset managers’ performance on both investment returns and governance

Importantly, the developments enumerated in the Commonsense Principles 2.0 are not meant to be a final statement on these topics. Rather, they represent the growing consensus around key issues that will drive this conversation forward.

What’s next?

Like software, the Commonsense Principles will continue to be reviewed, considered and updated to best reflect the practices, policies and structures that emerge as the governance conversation progresses. While the Commonsense Principles 2.0 reflect the status quo of late 2018, we have no doubt that they will continue to serve as a touchpoint in the conversation about how to best serve the long-term interests of public companies, shareholders and other stakeholders. As one of the world’s leading bodies studying corporate governance, the Millstein Center is eager to foster a robust, ongoing dialogue about these issues. We welcome any and all stakeholders to review the Commonsense Principles 2.0 and provide feedback about what can be done to enhance corporate governance to support the health of our economy. Because of the complex global landscape of corporate governance, the Commonsense Principles 2.0 focusses on US companies. However, the spirit of the conversation and the ideas and policies it contains are applicable around the world. We look forward to broadening this conversation to understand how these principles might benefit from international learnings and how the international governance community can be supported by adopting parts – or all – of the Commonsense Principles 2.0. Whether in the boardroom or around the kitchen table, these issues will become increasingly important in the years ahead. A sound governance framework that ensures transparency, shapes best practices and upholds the values that we as a society hold dear is indispensable to any stakeholder weighing investment decisions. The outcome impacts the health of the companies who adopt these governance standards and the millions of investors around the world who have staked their future on such investments. As stewards of this important work, we will continue to welcome and consider any and all perspectives to ensure that this conversation continues to reflect the best practices of our times. 1 http://www.governanceprinciples.org/ 2https:// isgframework.org/ 3https://www.businessroundtable. org/policy-perspectives/corporate-governance/ principles-of-corporate-governance 4https://corpgov. law.harvard.edu/2017/01/11/corporate-governancethe-new-paradigm/ 5https://millstein.law.columbia. edu/ 6http://www.governanceprinciples.org/wpcontent/uploads/2018/10/2016-Open-Letter-Principles. pdf 7https://millstein.law.columbia.edu/content/ commonsense-principles-20

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Board Governance | Compensation

Remuneration trends across Europe 2007 Shareholder Rights Directive amendments will affect executive compensation practices in Europe for many years In the view of European Parliament and the Council, a company’s remuneration policy should contribute to the business strategy, long-term interests and sustainability of the company, and should not be linked entirely or mainly to short-term objectives. Under the EU’s revised Shareholder Rights Directive, which will begin to be implemented in 2019, directors’ performance should be assessed using both financial and non-financial performance criteria, including, where appropriate, environmental, social and governance factors. It will be essential to assess the remuneration and performance of directors not only annually, but also over an appropriate period of time to enable shareholders, potential investors and stakeholders to properly assess whether the remuneration rewards long-term performance and to measure the mid-to-long-term evolution of directors’ performance and remuneration, in relation to company performance. Regulatory developments will then affect many member states, strengthening shareholder power across EU markets. As of today, many countries have initiated the transposition of the directive into local law with certain flexibility. Proxy season 2020 will be the testing ground for the implementation of the directive and for the real impact on shareholders’ voting behaviour at general meetings. Compensation-related resolutions at 2018 general meetings across Europe were still in the limelight. The approval of incentive share plans remains the most contentious item, recording the highest dissent on average. The latest Morrow Sodali survey confi rmed executive pay as one of the main areas where boards and shareholders are still likely to disagree.1 Institutional investors are expected to demand enhanced disclosure of pay metrics 50 Ethical Boardroom | Spring 2019

Fabio Bianconi

Director at Morrow Sodali and seek a closer alignment between pay and performance. When evaluating incentive schemes, institutional investors are keen to understand how sustainability key performance indicators (KPIs) are utilised, particularly those linked to a company’s risk management and long-term business strategy. Investors might, for example require introducing verifiable metrics related to climate change into executive compensation plans. Investors are refining their expectations for boards while managing strategic oversight. There has been an increasing awareness on remuneration committees in promoting actions and behaviours reflecting companies’ values and culture. Remuneration committees are tasked with a pivotal role in defining incentive structures that are really tied to a sustainable long-term achievement of financial, operational and individual objectives, consistent with the company’s industrial plans. Communication between the chairman of the remuneration committee and shareholders has gained momentum over the past two years. Investors generally welcome having a line of sight into decisions taken in the boardroom about executive compensation and the willingness of directors to engage in dialogue can be perceived as a signal of board effectiveness and solid board culture.

FRANCE

All French-listed companies are required by law to submit the remuneration report and remuneration policy of their executive corporate officers to shareholders for binding approval. The level of average ‘free float dissent’ (as percentage of votes not aligned with management recommendations, excluding reference shareholders) has decreased significantly over the last few years, from 15 per cent in 2017 to 11 per cent in 2018. Executive compensation remains a high-profi le topic, concentrating about 50 per cent of company-contested situations. All ex-ante

resolutions on compensation policies were approved with an average adoption rate of approximately 88 per cent. The compensation policy for two chairmen and chief executive officers was, however, approved at a rate of less than 60 per cent. Their 2017 compensation had also been approved with a score of less than 60 per cent. 2018 was the fi rst year of implementation of ex-post, say-on-pay, as required by law. The average approval rate for these resolutions reached approximately 91 per cent. The compensation of four senior managers was approved at a rate of less than 60 per cent. Of these four senior managers, three saw an increase in their total compensation between 2016 and 2017. Two of the increases were less than 15 per cent and one was 80 per cent. Th is last increase had been pre-announced by the company in its 2016 registration document as the prior compensation was below that of comparable companies.2 Institutional investors’ main concerns relate to the level of disclosure on incentive schemes and stringency of performance conditions. According to the last AMF report on corporate governance and executive compensation in listed companies, most of the French companies did not disclose the exact performance criteria associated with variable compensation, for reasons relating to business plan confidentiality. Conversely, only some companies described the content and weighting of each performance criterion in detail in a table. Greater attention is paid to the possible offsetting mechanisms for performance criteria on short-term bonus or LTIP awards (underachievement of some criteria offset through overachievement of others). Lack of information on post-mandate vesting of awards and pro-rating for time also remain a frequent driver of negative votes. Nonetheless, discretionary decisions of the board and lack of information on the assessment of qualitative criteria are perceived as a concern. Degree of tolerance of exceptional remuneration remains low. www.ethicalboardroom.com

Compensation | Board Governance

For 2019, investors will probably place greater focus on vested LTIP awards. Compelling justifications are expected in case of change in the performance conditions initially provided under the plans.

GERMANY

Only eight companies among the DAX 30 constituencies submitted say-on-pay resolutions to shareholder approval. In Germany,

DECISION-MAKING ON DIRECTOR PAY The EU Directive is designed to assess systemic risks and promote transparency

say-on-pay is still voluntary rather than binding and typically, only occurs every five to seven years. Overall support for compensation-related resolutions, including also the provisions for non-executive directors, has dropped significantly to 86 per cent of votes cast. Remuneration concerns that have consistently been raised by shareholders point mainly to disclosure levels for both

GERMANY: DAX AND AVERAGE SUPPORT ■ 2016 ■ 2017 ■ 2018

99.1%

99.6% 99.2%

98.7%

94.5% 98.7%

77.2% 74.9% 79.0%

Equity plans www.ethicalboardroom.com

Executive remuneration

Non-executive remuneration

short- and long-term incentive plans, overall level of independence for remuneration committees, performance measures utilised and infrequent use of equity as a remuneration component. In some cases, investors have raised issue with the excessive supervisory board discretion in granting special one-off bonuses or adjusting pay-out awards (which is mostly due to a lack of disclosure, rather than arbitrary decision-making processes). Along with the upcoming implementation of the Shareholder Rights Directive, the revision of the German Corporate Governance Code foreseen for June 2019 provides prescriptive recommendations on long-term incentive plan designs. Companies are praised to disclose the target levels, weightings, and vesting schedules, at least retrospectively. Other recommendations will then affect the introduction of clawback and malus clauses, as well as ownership guidelines. Spring 2019 | Ethical Boardroom 51

Board Governance | Compensation

ITALY

In Italy, the dominant form of ownership is still de-facto control, but the number of widely held companies is increasing, especially within the banking sector. During the last years, most Italian companies introduced remarkable changes in their respective remuneration policies, improving disclosure practices.

ITALY: FTSE MIB REMUNERATION POLICY 74%

75%

76%

(% Institutional investor support) 71% 65%

this extent, many companies have improved the disclosure with respect to performance measures by detailing the weight of each performance criteria, a minimum target level and vesting thresholds. In some situations, companies have started detailing their incentive KPIs by providing narrow, absolute target levels and corresponding vesting schedules aligned with the guidance divulged in strategic business plans. Investors envisage material enhancements in disclosure practices after the transposition and implementation of the revised Shareholder Rights Directive. In fact, for the first time, shareholders will be given the right to vote on the remuneration report, assessing the real pay-for-performance alignment.

SPAIN

2014

2015

2016

2017

2018

In general, the approval level for remuneration policies in 2018 attained approximately 88 per cent of votes cast and slightly below the average registered in other European markets. A more in-depth analysis, which considers only the voting instructions submitted by institutional investors, reveals that in 2018 only 65 per cent of them backed remuneration policy reports. Despite the data showing a progressive alignment between institutional investor expectations and compensation practices of Italian-listed companies over the past five years, the last proxy season undoubtedly marked a step back. The dissent manifested by international funds in 2017 was even lower – 71 per cent of minorities supported the resolution (while in 2016, the figure reached 76 per cent). It must be noted that several companies have progressively reduced the severance agreement packages on behalf of executive directors to two years of annual compensation. Th is represents a positive improvement with respect to previous years when the remuneration policy of these companies included clauses giving access to indemnity payments over three years’ compensation. A move away from cashbased, long-term incentive plans to rolling share-based plans represents a new trend. To

In anticipation of the revised Shareholder Rights Directive, Spain has adopted a say-on-pay model, which introduced a binding vote on remuneration policies (ex-ante) at least every three years and an annual advisory vote on the ex-post report. While only in a few cases overall dissent for remuneration policies exceeded 10 per cent of votes cast, the opposition of shareholders was more pronounced on the implementation report.

SPAIN: AVERAGE SUPPORT ■ Remuneration policy ■ Remuneration report

95%

94%

92%

2017

92%

2018

Frequent misalignments between company and investor expectations are usually around excessive pay contributions to saving plans, salary and bonus opportunities increased without compelling explanations, poor disclosure levels on performance outcome in variable remuneration, performance metrics and vesting requirements. Institutional

investors have also criticised unexplained, extraordinary bonuses and excessive severance arrangements. In order to reinforce the independence of the remuneration and nomination committees, the National Securities Market Commission (CNMV) has recently released a technical guide. The aim of this document is to promote the proper functioning of these committees in Spanish-listed companies, given that the selection, appointment and system for remuneration of board members and senior managers are key aspects of good corporate governance. To this end, the technical guide encloses a series of principles, good practices, and criteria on how these committees can improve the performance of their functions.

Looking forward

Say-on-pay has proved that investors’ active stewardship, through voting and engagement, is positively related to the increased awareness over pay for performance. Political uncertainty and social instability suggest that a sustainable compensation should embed also non-financial elements and focus on external stakeholders. A new approach to thinking is needed and remuneration committees could drive this cultural change bringing ESG (environmental, social and governance) metrics into the mainstream of executive pay. The fertilisation of this new philosophy among employees is essential. Companies should have a clear motivation for socially responsible actions in executive compensation systems in order to implement the business strategy effectively. To this extent, the revised Shareholder Rights Directive is recommending companies clearly indicate the financial and non-financial performance criteria in their remuneration policies, including, where appropriate, targets related to ESG factors. Th is would motivate directors to recognise the best long-term interests of the company and its environmental and social impacts. The Morrow Sodali survey, the fourth of its kind, was conducted in December 2018. Forty-six global Institutional Investors, with $33trillion of assets under management, responded to the survey. 2 AMF 2018 Report on corporate governance and executive compensation in listed companies. 1

SAY-ON-PAY Listed companies must have a renumeration policy

52 Ethical Boardroom | Spring 2019

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Board Governance | Remuneration

CEO pay: Shareholders care more than ever Every year, As You Sow – the leading US non-profit shareholder advocate – identifies the 100 most overpaid CEOs of the S&P 500 and analyses whether or not pension funds and financial managers have held companies accountable for excessive compensation.

In February 2019, As You Sow issued its fi fth annual report, The 100 Most Overpaid CEOs: Are Money Managers Asleep at the Wheel?, created in order to bring the problem of excessive CEO pay into focus.1 Under provision 951 of the 2010 Dodd-Frank fi nancial reform act, shareholders of US companies were given the right for the fi rst time to vote on compensation as presented in the company’s annual proxy statement for the five named executive officers (NEOs). The provision grew out of decades of shareholder activism at hundreds of companies, with shareholders demanding disclosure on CEO pay. In the years leading up to the act, shareholder proposals that called for such a vote began receiving majority support. Several companies agreed to voluntarily adopt what some called a say-on-pay policy. Shareholder votes began in 2011 and the fi rst votes covered by our report were from 2013, when how funds were exercising this fiduciary duty was still unclear. The fi rst year that I authored the CEO pay report, I expected and dreaded hearing from investor relations or other executives, pushing back against the idea that a particular CEO was overpaid. That was not the case. In fact, I only heard from one senior executive, at a company I will not name. He told me, confidentially, that he believed the CEO of his company was unjustifiably overpaid and should have been on our list. I told him that we were only focussing on S&P 500 companies. I left that conversation with a realisation that even highly placed executives outside the C-suite often think CEO pay is excessive. Now that As You Sow has been releasing the report for five years, there’s a routine to the publication and I can anticipate to some extent what kind of calls and emails I will get from press and investors after the release.

54 Ethical Boardroom | Spring 2019

Board directors need to ask more questions Rosanna Landis Weaver

Programme Manager for Power of the Proxy: Executive Compensation at As You Sow There was a new request this year from a fund that voted against a higher proportion of compensation packages than many of its peers. It wondered if it could use a copy of a particular chart in its client presentations. It wanted to advertise how rigorous it was in voting against CEO pay packages. To me, this was a telling moment about where we are. The issue of overpaid CEOs, inextricably linked to larger concerns about income inequality, has risen to such a high prominence that the votes are something fund customers care about. This is reflected in my own experience. Many of the investors I speak with are continuing to lose patience with CEO compensation, seeing it as a systemic issue and going further to address that. Because we’ve been compiling this report for several years, we have seen a number of significant fi ndings. We’ve analysed how these fi rms’ stock prices performed since we originally identified their CEOs as overpaid. We then found that the 10 companies we identified as having the most overpaid CEOs, in aggregate, underperformed the S&P 500 index by an incredible 10.5 percentage points and actually destroyed shareholder value, with a negative 5.7 per cent fi nancial return. We’ve observed that several of the most overpaid companies are in some way insulated in some manner from annual shareholder votes. Companies with triennial votes appear to be awarding mega-grants on years when their shareholders don’t vote, which suggests that they may fear shareholder backlash. The trend I’m highlighting here is shareholders’ growing dissatisfaction with excessive pay. As You Sow’s research has found there are more funds that have

significantly (by more than five per cent) increased their level of opposition than followed the opposite trajectory. We found 18 funds, each with assets under management (AUM) of more than $90billion that voted against more than 40 per cent of the S&P 500 CEO pay packages. If the threshold of AUM of $1billion is used, there were 87 funds that met the same criteria. Several of these funds have more than doubled the number of CEO pay packages they vote against. The largest US pension fund, California Public Employees’ Retirement System (CalPERS, with assets of more than $350billion) has increased the number of S&P 500 CEO pay packages that it voted against by a factor of almost eight. In 2013, CalPERS opposed only 6.4 per cent of S&P 500 CEO pay packages, last year CalPERS opposed 45 per cent of them. That increasing level of opposition may come as a surprise to some directors who routinely see levels of support above 90 per

The issue of overpaid CEOs, inextricably linked to larger concerns about income inequality, has risen to such a high prominence that the votes are something fund customers care about

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Remuneration | Board Governance

cent and think that their shareholders are satisfied with their pay practices. Th is by no means suggests that shareholders are happy with the quantum and system of CEO pay, but simply that your company may not be an outlier. While in the aggregate, CEO pay packages still receive a large number of positive shareholder votes, that number is declining. In 2018, it declined to 90.4 per cent – the lowest level since 2012. Large ownership stakes by passive mutual funds that rarely vote against management often mask the true level of shareholder opposition to pay. In his paper, Asset Manager Stewardship and the Tension Between Fiduciary Duty and Social License, Patrick Jahnke notes that in the past it had been a winning strategy to remain neutral and “kept [large fund managers] out of the limelight and away from regulatory interest, while maximising the potential client base”. However, he believes it is “doubtful that the same strategy will work in the future, now that asset managers have grown to such a size that they have become household names”. As Jahnke notes, “in a democratic capitalist society, failure to maintain the ‘social license’ or perceived legitimacy may result in consumer boycotts and ultimately in calls for stricter regulation”. We agree with Jahnke and other scholars that the broader and building consensus that CEOs are overpaid may move shareholder investing decisions. Of course, most shareholders have their shares held and voted by a fi nancial intermediary (i.e. mutual funds, ETFs, pension funds, fi nancial managers or people whose full-time job is to watch the companies they invest in and monitor the performance of their boards, their CEOs and their compensation). Increasingly these investors are moving to funds they believe will vote their values.

BACKLASH OVER MONEY Shareholders are increasingly dissatisfied with excessive pay

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Spring 2019 | Ethical Boardroom 55

Board Governance | Remuneration According to the Forum for Sustainable and Responsible Investments, 26 per cent of professional managed assets – with a value of $12trillion – was invested in funds with an environmental, social and governance (ESG) component in 2018, an increase of 36 per cent in just two years. Many institutional shareholders, particularly at funds with significant Canadian or European influence, have led the way in a more broadly based opposition to the systemic issues surrounding CEO pay. Allians Global Investors, with an AUM of $598billion, voted against 75 per cent of the pay packages of S&P 500 companies. A representative told us that the company applies a global corporate governance standard: “In the US, those guidelines are hard on remuneration, because we are taking the view that what is best at incentivising a human being in Europe is probably what is best an incentivising a human being in the US or Asia as well.” The growing concerns about CEO pay are taking place amid a growing discussion of income inequality. CEO pay has grown an astounding 997 per cent over the past 36 years, greatly outpacing the S&P 500, which has grown only 504 per cent in this time period. Meanwhile, pay for the median worker for many years has remained essentially flat. In October 2018, the UN Principles for Responsible Investment (UN PRI) published a critical report, Why And How Investors Can Respond To Income Inequality.2 In the foreword, UN PRI CEO Fiona Reynolds writes: “Institutional investors have increasingly begun to realise that inequality has the potential to negatively impact institutional investors’ portfolios, increase financial and social system level instability; lower output and slow economic growth; and contribute to the rise of nationalistic populism and tendencies toward isolationism and protectionism.” Shareholders have also become discouraged about some of the false promises of pay for performance. Former CEO Steve Clifford served on a compensation committee and the questions he asked on CEO pay ultimately led him to write the book The CEO Pay Machine: How It Trashes America And How To Stop It. 3 In the book, he describes ‘the performance delusion’ that corporate boards suffer when rewarding CEOs. Here he notes: “I could observe an evening of roulette and conclude that the best gamblers were rewarded for their performance. How do I know they were the best gamblers? Easy. They won the most money.” Th is is essentially what some compensation consultants do in defending a link between pay and performance. Directors need to ask the hard questions of consultants, executives and themselves. Our discussion with investors and review 56 Ethical Boardroom | Spring 2019

of guidelines suggest these questions should include: ■ Is there an overreliance on peer groups? Peer groups, particularly when cherry-picked, are one of the most self-reinforcing aspects of executive pay moving in an upward-ratcheting direction. Do these peers make sense? Does an analysis examine pay within the company as well as outside? Is the same peer group used when determining pay at lower levels of the company? Why was a particular new peer added to the list? (Th is year, for example, oilfield service company Schlumberger added extremely high paying video streaming company Netfl ix to its peer group). ■ Are metrics and targets clearly disclosed and appropriate? Are short-term incentive programmes’ or long-term incentive programmes’ thresholds and maximums sufficiently disclosed? Is there an identifiable limit or cap for each of the different components within the policy?

The growing concerns about CEO pay are taking place amid a growing discussion of income inequality. CEO pay has grown an astounding 997 per cent over the past 36 years ■ Are metrics immune from tactical moves that may boost short-term earnings but undermine sustainable growth? Are the metrics muddled by non-GAAP (generally accepted accounting principles) figures? Recent research by MIT’s Robert Pozen, Nicholas Guest, and S.P. Kothari looked into such figures and published an article High Non-GAAP Earnings Predict Abnormally High CEO Pay.4 Pozen subsequently co-authored with SEC Commissioner Robert Jackson an opinion piece in the Wall Street Journal where they noted: “The SEC’s disclosure rules have not kept pace with changes in compensation practices, so investors cannot easily distinguish between high pay based on good performance and bloated pay justified by accounting gimmicks.”5 Does the board include accounting experts or hire external ones regarding analysis of non-GAAP figures? ■ Are there any perverse incentives being created? At Boeing, executive bonuses were awarded in part on the basis of reaching cost-cutting goals. How was that message conveyed throughout the company? Was it always appropriately coupled with an adequate level of concern about safety?

■ Are bonuses truly used to reward excellent/stretching behaviour? ■ How do threshold and targets compare to prior year’s achievements? Is there a discretionary element of payments? Many shareholders vote against discretionary awards as well as any performance requirement that allows vesting when performance is below the median of peers. ■ Many shareholders have come to view stock options – particularly in this extended bull market – as a windfall based on market movement rather than a suitable reward reflecting individual effort. Th is is of particular concern when CEO ownership is not growing proportionally as options are exercised, another factor for boards to consider. ■ The shareholder inclined to vote ■ most diligently are shareholders with long-term horizons They are particularly concerned with insufficient long-term emphasis and risk mitigation practices. Does the company have long-term incentive plans with performance cycles shorter than three years, which are truly not long-term? Are there adequate clawbacks for variable remuneration that extend beyond accounting statements? Are there sufficient holding period requirements? ■ Finally, look at pay not just in the C-suite but throughout the company. Beginning in 2018, with implementation of a much-delayed provision of the Dodd-Frank Act, companies are required to disclose the pay ratio between the CEO and median employee. While As You Sow did not include pay ratio as a criterion in identifying overpaid CEOs, we did find a predictable correlation between our list of overpaid CEOs and the pay ratio. The median pay ratio for the S&P 500 is 142:1, while the median for companies on As You Sow’s list of the 100 most overpaid CEOs is more than twice as much, namely 300:1. Looking at pay ratio and pay ratio disclosure at the company and its peers is an important new task for directors.

Conclusion

As Bloomberg columnist Nir Kaissar noted in a recent editorial: “As the grim pay disclosures pile up year after year, the backlash against the corporate elite will intensify. If corporate boards can’t find a better balance in their pay structure, outside forces will, and at a potentially far greater cost to companies and their shareholders.”6 Ultimately, the real test of say-on-pay is not in the voting, but in reform. The hope is that calling out those that violate corporate governance standards and reasonable pay norms encourages best practices. We believe the increased opposition to pay packages will grow until practices change. Footnotes for the article will be published in full online.

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Board Governance | Auditing

Global audit committee: Looking ahead in 2019 Audit committees can expect their company’s ﬁnancial reporting, compliance, risk and internal control environment to be put to the test in the year ahead.

Insight into the key drivers and pitfalls that audit committees need to know

Among the key drivers and pitfalls are investor demands for transparency, technology advances and long-term economic uncertainty (with concerns about Brexit, mounting trade tensions, resurging debt and market valuations). In this article I look at just some of the issues driving the audit committee agenda and some of the questions audit committees should be asking.

Executive Chairman, KPMG’s UK Audit Committee Institute

Investors are demanding strong and transparent oversight of the audit relationship Overseeing the auditor selection process, including any (mandatory) tender process and auditor independence, is a key part of an audit committee’s role – and one that continues to be driven hard by global regulators and the investment community. Regular audit tendering and rotation is already ‘business as usual’ for many audit committees, but new rules and expectations can introduce complexities that are difficult to navigate and, in some cases, will significantly impact the way audit committees operate in practice. To ensure the auditor’s independence from management and to obtain critical judgement

58 Ethical Boardroom | Spring 2019

Timothy Copnell

and insights that add value to the company, the audit committee’s direct oversight responsibility for the auditor must be more than just words in the audit committee’s terms of reference or items on its agenda. All parties – the audit committee, external auditor and senior management – must

acknowledge and continually reinforce this direct reporting relationship between the audit committee and the external auditor in their everyday interactions, activities, communications and expectations. Th ink about how technology innovation might drive the quality of the external audit and whether the audit fi rm is making the most of the opportunities available.

Technology is driving the transformation of ﬁnance functions

Technology is a driver, as well as being a potential bear trap, in other areas of audit committee oversight, too. Over the next two years, finance functions are likely to undergo the greatest technological transformation since the 90s and the Y2K ramp-up. Th is will

Auditing | Board Governance present important opportunities for finance to reinvent itself and add greater value to the business. As much of finance’s work involves data gathering, audit committees should be thinking about the organisation’s plans to leverage robotics and Cloud technologies to automate as many manual activities as possible, reduce costs and improve efficiencies. Also, how can finance use data and analytics and artificial intelligence to develop sharper predictive insights and better deployment of capital? The finance function is well-positioned to guide the company’s data and analytics agenda – and to consider the implications of new transaction-related technologies, from blockchain to cryptocurrencies. As historical analysis becomes fully automated, the organisation’s analytics capabilities should evolve to include predictive analytics, an important opportunity to add real value. Finally, as the finance function combines strong analytics and strategic capabilities with traditional financial reporting, accounting and auditing

skills, its talent and skill sets may need to change. Is finance attracting, developing and retaining the talent and skills necessary to deepen its bench strength and match its evolving needs? It is essential that the audit committee devotes adequate time to understand finance’s transformation strategy.

Brexit and mounting trade tensions are creating economic uncertainty

Major geopolitical risks are a board issue, but they can provide a challenge for audit committees, too. Take, for example, the risks and reporting consequences associated with Brexit. Not just an issue for UK companies – if you have any exposure to the UK, direct or otherwise, then your supply chain, your customer base, your taxes, tariffs or financing may be affected. With this in mind, audit committees need to really understand the potential impacts and ensure that any related disclosures are clear and company-specific. Whatever the driver, increased uncertainty will impact company reporting

and audit committees need to ensure that both the narrative disclosures and the numbers themselves are reflected correctly. Where there are particular threats, for example the possible effect of changes in import/export taxes or delays to their supply chain, these should be clearly identified along with any actions taken (or planned) to manage the potential impact. This may mean recognising or re-measuring certain items in the balance sheet. Audit committees need to ensure sufficient information is disclosed to help users understand the degree of sensitivity of assets and liabilities to changes in management’s assumptions. Consider the wide range of reasonably possible outcomes when performing sensitivity analysis on the cash flow projections and which should be disclosed and explained – and which, if any, have an impact on the organisation’s business model and, in extremis, the ability to continue as a going concern. Committees should also be cognisant of any changes between the balance sheet date and the date of signing the accounts, and ensure a comprehensive post balance sheet events review is factored into the year-end reporting plan in order to identify both adjusting and non-adjusting events and to make the necessary disclosures.

Newspapers and social media are highlighting lapses in corporate culture Corporate culture is front and centre for companies, shareholders, regulators, employees and customers – as it should be for every board. Headlines of sexual harassment, bullying and other wrongdoing – with corporate culture as the culprit – have put boards and audit committees squarely in the spotlight: Where were the directors? What are they doing to fix the culture?

KEEPING FOCUSSED ON EMERGING RISKS Audit committees need to set clear expectations for ensuring compliance Spring 2019 | Ethical Boardroom 59

Board Governance | Auditing Given the critical role that corporate organisation. What sources of value have not culture plays in driving a company’s been recognised in the financial statements performance and reputation – for better or, as and how are those sources of value managed, evidenced by the #MeToo movement, for worse sustained, developed and communicated. – boards are taking a more proactive approach Th inking about these things is particularly to understanding, shaping and assessing important today as major investors are corporate culture, and audit committees are increasingly voicing their expectations for playing a key role in ensuring the board has companies to focus on long-term value both appropriate assurance in place and creation and the factors driving it: strategy regulatory compliance and monitoring and risk, talent, R&D investment, culture programmes that are up-to-date and cover all and incentives, and environmental, social, vendors in the global supply chain, as well as and governance (ESG) issues – particularly clearly communicate the company’s climate change and diversity. In his seminal expectations for high ethical standards. ‘letter to CEOs’, BlackRock’s Larry Fink The audit committee should have a emphasised corporate purpose and a laser focus on the tone set by senior stakeholder-focussed model of governance: management and zero “Without a sense of tolerance for conduct The audit committee purpose, no company, that is inconsistent with either public or private, can should have a laser the company’s values achieve its full potential. and ethical standards, focus on the tone set It will ultimately lose the including any ‘code of to operate from by senior management license silence’ or omertà. Be key stakeholders. It will and zero tolerance sensitive to early warning succumb to short-term signs and verify that the pressures to distribute for conduct that is company has robust earnings, and, in the inconsistent with whistle-blower and other process, sacrifice reporting mechanisms in investments in employee the company’s place; and that employees development, innovation, are not afraid to use them. values and ethical and capital expenditures Understand the standards, including that are necessary for company’s actual culture growth.” If any ‘code of silence’ long-term (the unwritten rules there is a driver for more or omertà versus those posted on integrated corporate the breakroom wall); use reporting – where all the all the tools available – surveys, internal major sources of value generation (and audit, hotlines and social media. Also, destruction) are addressed – then this is it. walk the floors and do site visits to monitor Think about accounting the culture and see it in action. Recognise developments, but that the tone at the top is easier to gauge don’t forget the basics than the mood in the middle and the buzz Audit committees have to stay on top of at the bottom. How does the board gain the financial statements and that includes visibility into the middle and bottom levels thinking about the implementation of of the organisation? Do employees have the new accounting standards. New Revenue confidence to escalate bad behaviour and Recognition and Financial Instrument trust their concerns will be taken seriously? standards were live for 2018 calendar Investors want conﬁdence year-end companies producing financial in the non-GAAP measures statements in accordance with IFRS and the ‘true’ drivers of value or US GAAP; and looking forward, the Non-GAAP measures are still high on new leasing standard (IFRS16) is almost the agenda of global regulators and the here, so the impact on the business, investor community alike. Audit committees systems, controls, disclosures, and should be having a robust dialogue with resource requirements should be a key management about the process and controls area of audit committee focus. by which management develops and selects But, audit committees should be the alternative performance measures careful to ensure management do not it provides; also their correlation to the lose sight of the basics. In times of change actual state of the business and results, and uncertainty – whether due to new and whether the alternative performance accounting standards or broader economic measures are being used to improve and geopolitical events, management’s transparency and not distort the balance attention will rightly be focussed on of the annual report. ensuring that there is quality disclosure Audit committees should also be ensuring around the key judgements and estimates management are giving due attention to they make in determining material matters disclosing any broader value drivers that in their reports and accounts. However, contribute to the long-term success of the management also needs to have effective 60 Ethical Boardroom | Spring 2019

procedures in place to ensure compliance with the basic reporting requirements, which investors take as a given in audited reports and accounts. The audit committee is ideally placed to stand back and reflect on whether the financial statements are really ‘true and fair’ as the ‘public’ would expect.

Scanning the horizon for emerging risks

The audit committee should work with the internal audit function and/or risk managers to help identify the risks that pose the greatest threat to the company’s reputation, strategy and operations and help ensure that internal audit is focussed on those risks and related controls. As business environmental change accelerates, audit committees should be thinking specifically about the quality of management’s horizon scanning and those existential risks that seem to emerge where none appeared imminent even a year ago. Question whether the internal audit plan is risk-based and flexible enough to adjust to changing business and risk conditions? Have there been changes in the operating environment? What are the risks posed by the company’s digital transformation and by the company’s extended organisation –sourcing, outsourcing, sales and distribution channels? Is the company sensitive to early warning signs regarding safety, product quality and compliance? Is internal audit helping to assess and monitor the company’s culture? Audit committees should be setting clear expectations, but also helping to ensure that internal audit has the resources, skills and expertise to succeed and help the chief audit executive think through the impact of digital technologies on internal audit. Finally, just as technology impacts the finance function and the external audit, think about how internal audit might leverage new technology and innovation. This receives less attention than technology within the external audit but probably presents the greater opportunity to move to a continuous assurance model and enhance the quality of overall assurance.

Has it all become too much?

Finally, audit committees should take a fresh look at their agenda and workload to ensure they have the capacity and skills to oversee the ‘new’ areas finding their way to the committee’s agenda (such as cybersecurity, supply chain and other operational risks) in addition to their core oversight responsibilities (financial reporting and related internal controls, and oversight of internal and external auditors). Do some of these new areas require more attention at the full board or perhaps at a separate board committee? Is there a need for a compliance or risk committee? Keeping the audit committee’s agenda focussed and on point will require vigilance. www.ethicalboardroom.com

Board Governance | Risk Management

Jim DeLoach

Managing Director, Protiviti

Identifying and managing risk Making board and management risk committees effective Most directors and governance authorities agree that the full board should retain overall responsibility for risk oversight, mirroring its overall responsibility for strategy. In the absence of statutory requirements to the contrary, the board has the flexibility to organise itself for risk oversight as it sees fit, given its company’s size, structure, complexity and risk profi le, as well as the composition and structure of the board itself. The Dodd-Frank legislation in the US requires a separate risk committee consisting of independent directors for certain publicly traded bank holding companies. Over the years, we have seen a ‘trickle-down effect’ of this approach to other companies, particularly those with complex environments shaped by the nature of their industry, risks inherent in their strategy and business model and the sophistication of their risk management infrastructure. When the collective agendas of the full board and its standing committees are too packed to give risk oversight sufficient attention, directors may choose to form a focussed risk committee.

Making a board risk committee effective

When a separate risk committee is established, the question arises as to how to make it effective. The following are some suggestions:

Evaluate committee composition and service terms Select independent

62 Ethical Boardroom | Spring 2019

directors with the requisite qualifications to oversee the enterprise’s risks. Consider whether a ‘risk expert’ should serve on the committee – i.e. someone with a background in risk management or oversight relevant to the nature of the organisation’s operations, a role analogous to the audit committee financial expert. In defining the terms of service for members and the committee chair, note that for the sake of continuity term limits may not be desirable. The committee chair may be rotated, appointed or reappointed by the board chair, or elected by majority committee vote. Ensure risk is integrated with strategy-setting and business planning Evaluate whether appropriate risks are taken in creating value and challenge management’s assumptions underlying key strategies and decisions. Understand the company’s risk management infrastructure and capabilities and assess their alignment with management’s strategy and risk appetite, both overall and by line of business. Oversee and position the risk management organisation for success Approve company-wide policies with respect to risk assessment and risk management practices. If there is a chief risk officer (or equivalent executive), review his or her appointment and performance in consultation with the full board; ensure he or she has sufficient stature, authority and independence within the organisation; and oversee his or her activities through ongoing communications, risk reporting and periodic executive sessions. Periodically inquire as to the adequacy of resources allocated to risk management.

Oversee risk reporting and 4 monitoring Ascertain whether

management is identifying, prioritising and monitoring the appropriate types, levels and concentrations of risk, both by line of business and enterprise-wide. Ensure risk reporting is responsive to the needs of the committee and the board and is focussed on the critical enterprise risks and emerging risks, as well as the response strategies for addressing them. Advise management on critical risk matters on a timely basis Review the results of enterprise-wide risk assessments, including the identification and reporting of critical enterprise and emerging risks (the risks that matter). Engage management in an ongoing risk appetite dialogue as conditions and circumstances change and new opportunities arise. Review crisis management plans to ensure management has in place actionable response plans to address key risks, including plausible and extreme scenarios. Influence risk culture In cooperation with the compensation committee, watch for behaviour that could undermine risk management effectiveness, such as compensation incentives that may encourage inappropriate risk-taking. Oversee communications about escalating risks on a timely basis and pay attention to the warning signs of a dysfunctional

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Risk Management | Board Governance

KNOWING THE ODDS Establishing a risk committee enables the board to focus on potential critical issues

When the collective agendas of the full board and its standing committees are too packed to give risk oversight sufficient attention, directors may choose to form a focussed risk committee culture. Oversee remediation of issues to ensure they are addressed in a timely manner (e.g. limits violations, near misses, noncompliance, control deficiencies, etc). Coordinate risk oversight with other board committees As the board’s various standing committees typically address risks germane to their respective chartered responsibilities, coordinate with these committees to avoid gaps and overlaps in the board’s overall risk oversight process and identify risk interdependencies warranting consideration. For example, the audit committee may focus on compliance risk and certain technology risks; therefore, the scope of the risk committee’s oversight should consider that coverage and coordination undertaken with the audit

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committee to ensure the organisation’s internal audit plan addresses the key risks. Report to the full board at least annually Present the committee’s appraisal of the company’s risk management programme, along with any deficiencies noted and input from the other board committees. Establish criteria for risk reporting to the board and recommend for board approval. Review the charter at least annually and update it as needed to respond to changing risk profi les, oversight priorities, and regulatory or other requirements, and submit it for approval to the board. Review disclosures in public reports related to risk and board risk oversight and provide input to the board and audit committee. Consult external experts as necessary Obtain outside advice regarding risk-related matters and when conducting investigations into any matters within the committee’s scope of responsibility. Align meeting activities with chartered responsibilities Monitor the committee’s activities against the various responsibilities outlined in the charter (general counsel can help with this). It is important that the committee fulfi ls

the terms of its charter. To that end, meeting frequency should be driven by the nature and volatility of the organisation’s strategy, operations and risks. A board risk committee is not a panacea, nor is it a substitute for independent directors possessing deep knowledge and experience in dealing with critical industry issues and risks. It enables focussed attention at the board level on the company’s most critical and complex risks and risk management capabilities. It fosters an integrated, enterprise-wide approach to identifying and managing risk and provides an impetus toward improving the quality of risk reporting and monitoring, both for management and the board. Thus, it can assist the board in focussing on the big picture from a strategic perspective.

Making a management risk committee effective

When management sees fit to form a management risk committee, another question arises: what makes that committee function effectively in relation to the board’s oversight? Spring 2019 | Ethical Boardroom 63

Board Governance | Risk Management Whether organised in the form of a designated management risk committee (MRC) or a de facto risk committee,1 the use of MRCs has increased over the years.2 This increase is likely due to the growing complexity of risks inherent in the organisation’s strategy and business model and increasing sophistication of risk management infrastructure. The CEO’s executive committee agenda may be too crowded to cover certain risk matters sufficiently. Extenuating circumstances – e.g. a history of unexpected surprises, substantive improvements required in risk management capabilities, a critical risk meriting special attention and/or a need to strengthen risk culture – may also be a contributing factor. Formed by senior management, an MRC sometimes focusses on managing specific risks inherent in the enterprise’s strategy that either are not managed by the business units or are more effectively managed enterprise-wide by a central risk unit. With support-staff assistance and in cooperation with the business units, the MRC evaluates, pools, reduces, transfers and exploits the risks for which it is accountable. It may even have veto and/or escalatory authority with respect to certain business activities and may share responsibility for managing specific risks with the business units. Other MRCs may have less authority and be more focussed on the risk management process, with no day-to-day responsibility for mitigating risks. If there is a chief risk officer (or equivalent executive), he or she may support and even chair the committee. There is no standard one-size-fits-all model. MRCs are more commonly found in financial institutions, commodity-based businesses or operations with hazardous activities, where management of certain risks must be executed skilfully within the company’s risk appetite and established risk tolerances. These risks may include interest rate risk; currency risk; commodity price risk; credit risk; catastrophic risk; or health, safety and environmental risk. Functioning under the auspices of the CEO and/or executive committee, the MRC assesses and monitors the organisation’s internal and external environment and provides insights and recommendations to executive, operational and functional leaders, all in the spirit of improving the company’s risk management capabilities continuously as the business environment changes. Both the board and executive team can benefit from an effective MRC. The following are some suggestions for creating and operating this committee:

Use the MRC charter to clarify responsibilities Use the charter to articulate the committee’s mission or purpose, membership, duties and responsibilities, and authorities (if any), 64 Ethical Boardroom | Spring 2019

and, to the extent necessary, specific activities the committee is to perform. It should be approved by the executive team and reviewed with the appropriate committee of the board. Gain CEO and executive team support Don’t leave home without it. Consider the appropriate committee composition Seek a diverse range of strategic, operational and functional perspectives and experience as well as knowledge of the business. At least one senior executive should be a member (i.e. an executive sponsor). Keep it manageable Avoid too large a group, as it inhibits discussion. Manage the numbers by designating ex officio members who contribute when they have fresh insights to offer – e.g. it may make sense for the general counsel and a representative from the disclosure committee to be present from time to time.

2 3

responsible are appropriate, sufficient time should be allowed for discussion and input. Provide briefing materials in advance of each regularly scheduled meeting. Don’t let the committee get stale Consider mixing things up and refreshing the focus, depending on the organisation’s current needs. When attendance declines or senior personnel who are supposed to attend start sending delegates, it’s a clear sign something is wrong. Too broad a focus and doing the same things over time sap energy, engagement and enthusiasm. Focus dialogue on what executives and directors may not know The MRC’s value primarily comes from focussed dialogue around what’s new and what’s changing and the implications in terms of emerging opportunities and risks. Heads turn when the committee escalates insights and issues that aren’t on the radar of the organisation’s leaders. Spot the warning signs of a deteriorating risk culture The committee should watch out for signs of a dysfunctional culture and be sensitive to operating units engaging in unethical or irresponsible business behaviour or foregoing attractive market opportunities through risk-averse thinking. A pattern of limits violations, near misses, noncompliance incidents, internal control deficiencies and foot-dragging on remediation of issues is a sign of potential cultural issues that warrant escalation.

BOOST ENTHUSIASM AND ENGAGEMENT An effective management risk committee will need to be informed and motivated

Meeting frequency should match the risk profile Meet quarterly, monthly or more frequently, considering the nature and volatility of the organisation’s strategy, operations and risks as well as the responsibilities outlined in the charter. Conform the committee’s activities to specs Align meeting agendas with the requirements of the charter and suggestions from committee members and executive management. Agendas might include specific risk issues (e.g. drill-downs on specific risks or evaluation of risk appetite), as well as open discussions of emerging internal and external developments. Meetings should be inclusive Make sure everyone is engaged. While presentations by risk owners explaining how they are addressing risks for which they are

MRCs often facilitate the board’s risk oversight. The CEO and the executive committee dictate the MRC’s scope, delegating responsibilities consistent with business priorities. The board provides input into this direction and approves the MRC charter to ensure the committee’s activities are adequate to inform the board’s risk oversight.

Summary

The above points are illustrative and are intended to be neither exhaustive nor prescriptive. This article is also not intended to suggest that every board must have a risk committee and every company must have an MRC. Directors and senior management must decide how best to oversee and manage risks, and a risk committee is but one tool to consider. 1 A de facto risk committee may exist through a subcommittee of the executive committee or an equivalent group with a name other than ‘management risk committee’. 2According to The State of Risk Oversight: An Overview of Enterprise Risk Management Practices by Mark Beasley, Bruce Branson and Bonnie Hancock (March 2017), in the United States, 80 per cent of the largest organisations (greater than $1billion in revenue) and 83 per cent of public companies had a management risk committee in 2016. Usage of these committees since 2014 increased across all types of organisations and specifically for the largest organisations and public companies by 17.6 per cent and 18.6 per cent, respectively. Since 2009, usage increased dramatically (by 164 per cent) for all organisations.

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Board surveys around the world indicate growing dissatisfaction with traditional internal audit and ERM methods and tools. Find out why boards arenâ&#x20AC;&#x2122;t getting what they need and what to do about it. www.riskoversightsolutions.com

A better response to risk

Global News North America Facebook nominates Peggy Alford for board election Facebook has nominated PayPal executive Peggy Alford (right) to join its board of directors, making her the first Black woman and the second Black person to join the company’s nine-member board. Alford was appointed PayPal senior vice president in March. She previously served as CFO and head of operations for the Chan Zuckerberg Initiative, a philanthropic organisation by Facebook CEO Mark Zuckerberg and his wife Dr Priscilla Chan. Alford said: “What excites me about the opportunity to join Facebook’s board is the company’s drive and desire to face hard issues head-on while continuing to improve on the amazing connection experiences they have built over the years.” “I look forward to working with Mark and the other directors as the company builds new and inspiring ways to help people connect and build community.” Alford’s impending board arrival coincides with long-time directors Netflix CEO Reed Hastings and Erskine Bowles leaving their posts.

Uber urged to shake up boardroom An investor group called for Uber to strengthen its board of directors ahead of its initial public offering arguing that board member John Thain put shareholders at risk. CtW Investment Group, an adviser to pension funds, outlined concerns about Thain — the former Merrill Lynch chief executive — in a letter to Uber chairman Ronald Sugar. Thain chairs Uber’s audit committee, putting him in charge of oversight of the company’s financial reporting, legal compliance and corporate governance.

Dieter Waizenegger, executive director at CtW, wrote: “We strongly believe that Thain’s close relationship with Uber CFO Nelson Chai could impede Thain’s ability as audit committee chair to exercise independent judgement over the accuracy, credibility and integrity of the company’s financial statements.” “We urge the company to restructure its board to reflect directors that are independent, objective and will represent the interests of all the company’s shareholders.”

Shareholders frustrated with Boeing board Boeing CEO and chairman Dennis a has survived a shareholder motion to split his roles and has pledged to lead the company through crisis following two fatal accidents involving its 737 Max aircraft. The proposal to separate the CEO and board chairman roles did not pass at the aerospace manufacturer’s annual shareholder meeting in April. Investors controlling about a third of Boeing shares voted in favour of the proposal, which was also backed by America’s top shareholder advisory firms. The company has come under fire in recent months following two deadly crashes involving the 737 Max. In October, a Lion Air flight crashed and killed all 189 people on board and, in March, an Ethiopian Airlines flight crashed and killed all 157 people on board.

66 Ethical Boardroom | Spring 2019

Kraft Heinz to restate earnings Kraft Heinz will restate more than two years of financial results after some of its employees engaged in misconduct, the company has announced. The US food giant said it will restate its financial statements for 2016 and 2017 by $181million, after a review into its procurement and accounting procedures discovered employee misconduct. Kraft Heinz disclosed in February that the Securities and Exchange Commission was investigating its accounting and it had received a subpoena from the regulator related to its accounting policies, procedures and internal controls. Kraft Heinz’s chief executive Bernardo Hees said in April that he was leaving the company and would be replaced by Miguel Patricio, a marketing executive from the brewer AB InBev.

Shareholders get vocal at Wells Fargo

C. Allen Parker, the interim chairman of Wells Fargo, was repeatedly interrupted during the bank’s annual meeting in April by activists who called executives ‘frauds and criminals’. Shareholders at the meeting also criticised Wells Fargo over the bank’s sales practice scandals and financing oil and gas companies. However, Wells Fargo shareholders voted to elect all of the company-nominated directors during the rowdy meeting, despite a dozen attendees being kicked out for heckling executives and board members, according to Reuters. Scandals at the fourth-largest US lender — including opening millions of unauthorised accounts in customers’ names — have resulted in billions of fines and penalties and claimed two CEOs.

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September 21–24, 2019 THE MARRIOTT MARQUIS I WASHINGTON, DC

Join thousands of directors from across the globe for four days of learning, inspiration, and connection. The NACD Global Board Leaders’ Summit is where the greatest minds in governance convene to take on the most critical issues facing boardrooms and to collectively shape the future of board performance.

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Activism & Engagement | Settlements

HELP! I SETTLED WITH AN ACTIVIST! The unsettling truth about settlement agreements Kai Haakon E. Liekefett

Chair of the Shareholder Activism Practice, Sidley Austin LLP

Public companies in the US and around the world are increasingly signing settlement agreements as a means to put shareholder activist campaigns to rest. While companies are allured by the prospect of a quick end to the public side of an activist campaign, settlement agreements often invite new disruptions inside the boardroom and interrupt a board’s ability to concentrate on executing a long-term strategy. Moreover, settlement agreements are of increasingly shorter duration, meaning that the peace boards bargained for often becomes merely a fleeting respite from what is, in fact, a multi-year campaign of the activist.

The anatomy of a settlement agreement

At fi rst sight, settlement agreements with activists have much to offer. The downside for the incumbent board is nearly always that

one or more activist designees will join the board, often immediately. If the activist had leverage in the negotiations, it will have successfully pushed for ‘replacement rights’ – the right of the activist to designate a replacement for any of its designees on the board who leave for ostensibly unforeseen reasons. Replacement rights create the possibility that an activist can replace a ‘good cop’ that it fi rst designated to the board with a ‘bad cop’ who will push his or her agenda harder in the boardroom. Often, the activist designees are principals or employees of the activist fund. Regularly, settlement agreements provide that activist designees on the board will occupy seats on key committees. The upsides to a company may seem appealing, however. Most importantly, a settlement agreement buys peace for a period of time. A well-negotiated settlement agreement will commit the activist to not running further campaigns and keeping out of the public eye in respect of the company for one to two proxy seasons. A settlement agreement also allows a company to limit the number of activist designees who will join the board. The settlement agreement may also allow the company to swap one or more less desirable nominees of the activist for alternative nominees whose prospects for making positive contributions are higher.

What could possibly go wrong? A settlement agreement may save a company a few months of crisis mode operations. But, now the new member of your club has arrived for dinner. Not content to wait around in the living room, rest assured he or she will head right for the kitchen to examine how the sausage is made – and determine whether another sausage maker is willing to buy you. The seating of a new director at the table can create positive results. Occasionally, activist designees are generators of good ideas, shareholder returns, and maybe even long-term value. Sometimes, new blood in the boardroom will break old alliances that stifled progress and facilitate a new consensus that is productive. Every once in a while, directors and activists who battled for a period of time find that they get on well together in person. The question is about what happens in all those other times. Many settlement agreements place activist designees on boards whom the incumbent directors had never heard of until the campaign. In many cases, the activist

HANDLING ATTENTION Companies can underestimate the disruption new board members can bring

68 Ethical Boardroom | Spring 2019

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Settlements | Activism & Engagement

designees have little or no experience in the company’s industry. Most funds place directors on a board because they want those directors to execute on the fund’s agenda – more often than not, the agenda is to sell the company as quickly as possible. Many activist directors purposefully try to be bulls in the china shop because they want to pressure their fellow board members to cave and sell the company. All too often, companies negotiating settlement agreements underestimate the disruption that these new board members may cause. Settlement agreements generally do not constrain the ability of activist designees to push a board in directions that it would otherwise not go. Activist designees may ask for large amounts of information. In many legal regimes, a directors’ ability to refuse these requests is limited. The activist director can use this information to steer conversations in their preferred directions and ‘reopen the books’ on closed topics. Activist designees almost universally claim to be independent and may try to be involved in discussions that touch upon the interests of funds that nominated them – this can give way to internal boardroom confl icts over the creation and constitution of special committees, and the access of the excluded directors to information created by, and discussions had within, those committees. Activists also often create fi les with ‘dirt’ on their fellow directors and management team, using this as bargaining leverage to push their agenda. In several jurisdictions (including Delaware), an activist designee is permitted to share information with the shareholder who secured the designee’s position on the board – information that the director

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could not legally provide to other shareholders. Many clients are amazed to learn about the extent of Delaware’s leniency in this regard. Th is information, once passed up to the activist fund, may not be information that the fund can trade on, but it can become grist in the mill of the activist’s agenda. While your activist may have put down its slingshot for the term of the settlement agreement, its designees on the board are collecting stones. On the topic of settlement duration, the peacetime period provided by standstill provisions can also turn out to be much shorter than the company appreciated. Companies often do not get the time they

While your activist may have put down its slingshot for the term of the settlement agreement, its designees on the board are collecting stones needed to adequately address the issues that were the focal point of an activist campaign before the settlement. Many agreements provide for peace only until next year’s proxy season, which is often only six to nine months away. If a board is executing on a long-term strategy for the good of the company, the board should carefully consider how much of that strategy can be accomplished during the standstill period.

Decapitating the target companies — why CEOs are in the crosshairs

Although directors appear to be fi rst targets in the line of an activist’s fi re, the CEO is often the true primary

target. Companies facing shareholder activism typically see a departure of their CEO within 18 to 24 months after an activist designee joins the board. For example, an activist fund we recently encountered prompted the departure of a CEO in 14 of its last 17 campaigns. Notably, this fund did not always make the CEO an explicit target during its proxy campaign. When activist campaigns occur, heavy media focus is put on the negative attacks made against CEOs by activists. Suddenly, not just attentive shareholders but the public at large are treated to sensational claims of activists that are surprisingly often false, misleading or based on a selective use of facts. Th is kind of news unfortunately sells. What does not sell news as well, and thus is not given equal coverage, is news about how the CEO has patiently added value, stability and promise to the long-term strategy of the company. Shareholders wanting this information are more likely to find it tucked inside of the company’s specialised proxy soliciting materials. Against this background, activists and the business media unduly, and with surprising effectiveness, condition and inure shareholders to the continuous targeting of talented and effective CEOs. But why are activists focussed on getting CEOs fired? Because once management is decapitated, it is easier for an activist to push for its agenda – often a sale or break-up of the company. A board should consider the potential consequences for its CEO when negotiating with an activist, particularly if the board considers the CEO fundamental to the company’s current strategy. When an activist enters a boardroom, it may militate over a period of time for significant changes to management, whether or not the activist made this topic a pillar of its public campaign.

Spring 2019 | Ethical Boardroom 69

Activism & Engagement | Settlements

Fiduciary duties afford limited protection

Boards often underestimate the potential for an activist to disrupt the boardroom process because they overestimate of the legal implications of fiduciary duties. It is axiomatic in boardrooms that under the law of Delaware and other jurisdictions, directors owe fiduciary duties to the company’s shareholders and must take into account the interests of all shareholders equally. Delaware courts have consistently rejected the concept of ‘constituency directors’ or the idea that a director can serve the interests of one group of stockholders to the neglect of the others. It is too often assumed that these legal standards should give the company and its incumbent directors comfort that a designee of an activist fund, upon joining the board will cast aside his earthly ties to the fund and focus instead on creating long-term value all shareholders. In reality, fiduciary duties do not prevent activist designees from pursuing policies and taking positions in the boardroom that advance agendas of the funds that nominated them. The activist director needs to merely conclude that the interests of the fund and the interests of ‘all shareholders’ are aligned – and it is difficult to prove otherwise.

subjected to new books and records requests? Does the draft agreement adequately regulate the activist’s ability to communicate with its designees on the board? Is the board comfortable that the new director will not unduly harm productive dynamics in the board room? Is the duration of the standstill sufficient to allow the company to accomplish objectives it would

that knock is as soon as possible. If the activist fails to push its agenda inside the boardroom, another fight is likely. If the company is not prepared for this, the activist may return after the settlement agreement to take control of the narrative before the company does. Your activist will then look to take credit for your best ideas in addition to his or her own,

TAKING ON THE CHALLENGE Rushed settlements can lead to further battles with activists

No peace — ‘failed’ settlement agreements

A settlement agreement may fail to provide an enduring peace. Many activist situations that were resolved with a rushed settlement subsequently escalated into a full-blown public fight after the standstill period expired. In other words, many settlements ultimately fail to While achieve the board’s primary objective of preventing a public settlement proxy battle. agreements The fi rst important action a board can take if it is continue to considering settling with an be common, activist is to make sure it is boards still negotiating state-of-the-art terms. Settlement agreements prevail in proxy in shareholder activism are contests more trend-driven; activists are reluctant to accept terms that frequently need to accomplish to prewill make them look weaker than activists empt a repeat activist campaign than their competitors. At when the standstill period ends? the same time, with the right If the answers to any of these questions are incentives they can be encouraged to sign a less than satisfying, the board may need to settlement agreement that commits them to go back to the negotiating table if it still can. a longer and more comprehensive standstill provision than they might otherwise accept. Sometimes a proxy Before signing the settlement agreement, contest is the best option the board should make sure it has thought If your board is like many others, you may through all of the ways in which this activist be watching the clock tick on a settlement can harm the board and management during agreement and waiting for the next knock the term of the agreement. Will the CEO be at the door. The time to start planning for specifically targeted? Will the board be 70 Ethical Boardroom | Spring 2019

unless you openly lay claim to those ideas and initiatives fi rst. Therefore, boards should not give up on the idea of a proxy fight until they have made a full and informed analysis on their potential path to victory in a contested election. While settlement agreements continue to be common, boards still prevail in proxy contests more frequently than activists. If your company is one of those with a good case for itself, then your company may be better off facing the activist head-on and dispensing with its campaign sooner rather than later. www.ethicalboardroom.com

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Activism & Engagement | Board Development

STRENGTHENING

BOARDS Board development and director succession in the age of shareholder activism, engagement and stewardship Sabastian V. Niles

Partner at Wachtell, Lipton, Rosen & Katz, New York

The intensifying spotlight turned on boards of directors and management teams by investors prompts a fresh look at how public companies might approach board development, director succession planning and refreshment in advance of an activist attack, shareholder unrest or a crisis that results in heightened scrutiny. As the new paradigm of corporate governance takes hold, the major index fund asset managers, many actively managed funds and the two largest proxy advisory fi rms have each formally incorporated questions relating to board quality and practices into their direct engagements with companies, voting policies and how they evaluate a proxy contest to remove or replace existing board members and CEOs. In addition, activist hedge funds will re-frame matters of corporate strategy and performance into referendums on the board, questioning whether the board had the right skillsets and practices in place to oversee important business decisions. Examples of renewed investor and proxy advisory firm interest in such matters include: ■ BlackRock “We encourage boards to disclose their views on the mix of competencies, experience, and other qualities required to effectively oversee 72 Ethical Boardroom | Spring 2019

and guide management in light of the stated long-term strategy of the company… we may vote against… the independent chair or lead independent director, members of the nominating/ governance committee, and/or the longest tenured director(s), where we observe… a failure to promote adequate board succession planning.” ■ State Street “[A] well-constituted board of directors, with a balance of skills, expertise and independence, provides the foundations for a well-governed company. We view board quality as a measure of director independence, director succession planning, board diversity, evaluations and refreshment, and company governance practices… boards should continually self-assess the skills and experience of their board members and seek to continually enhance their capabilities by addressing any skill, experience or other gaps.”

A well-constituted board of directors, with a balance of skills, expertise and independence, provides the foundations for a well-governed company ■ Vanguard Commonly asked questions by Vanguard of company leaders and directors include: “Based on your company’s strategy, what skills and experience are most critical for board members, now and in the future? How does the board plan for evolution and future director selection (that is, for strategic board evolution)?” In analysing proxy contests and whether to vote for the company’s proposed directors or the activist dissident’s directors, a key area of focus for Vanguard includes: “The quality of the company and dissident board nominees… Are the directors proposed by the dissident (whether the full slate or a subset) well-suited to address the

company’s needs, and is this a stronger alternative to the current board?” ■ Glass Lewis “[W]e may consider recommending shareholders vote against the chair of the nominating committee where the board’s failure to ensure the board has directors with relevant experience, either through periodic director assessment or board refreshment, has contributed to a company’s poor performance.”2 ■ ISS In the context of assessing mandatory director retirement ages, “[W]e scrutinise boards where the average tenure of all directors exceeds 15 years for independence from management and for suﬃcient turnover to ensure that new perspectives are being added to the board.” Accordingly, company practices are evolving to meet the expectations of more vocal and engaged investors and ensure that the board itself continues to be a strategic asset to the company and the management team. In this new environment, companies may wish to consider some of the considerations and emerging practices outlined below when developing or updating board development and director succession plans, taking into account their own needs, circumstances and investor feedback: ■ Deciding it matters The board may explicitly acknowledge in governance guidelines, board policies and public disclosures the importance of board development and succession planning as part of the company’s

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Board Development | Activism & Engagement commitment to strong governance and aﬃ rm its belief that such planning will strengthen the board’s ability to further the best long-term interests of the company and its shareholders and other stakeholders and achieve the company’s purpose. ■ Playing offence in board development Especially if the company has been the subject of public controversies, activist attacks or heightened scrutiny, consider potentially favourable ‘signaling’ aspects of changes in board composition and ensure that actions regarding board composition align with the broader narrative and messaging that the company seeks to convey. The company should put itself in a position to present effectively the diverse skills, expertise

and attributes of the board as a whole and of individual members and to link those to company-specific needs and risks. ■ Self-assess for the future Review periodically the board’s composition to assess whether it reflects the knowledge, experience, skills and diversity that will best enable the board to fulfill its duties, taking into account the current and future needs of the company, the company’s current and future business strategies, industry and competitive landscape, the expectations placed on boards beyond legal requirementsand the potential for the company’s circumstances to change over time. Consider using a ‘skills and attribute matrix’ to support the board’s self-assessment of its composition and evaluate whether to disclose an appropriate matrix to provide shareholders with a ‘big picture’ view of how directors fit holistically together.

■ The value of a balanced board Balance board refreshment with retaining institutional knowledge. A variety of backgrounds, ages, tenure, experiences and skills is generally desirable to have in the boardroom. Such variety helps promote board quality, stability and continuity while bringing different perspectives to board discussions without the harm of excessive churn and turnover. A balanced board also preserves the heightened oversight that longer tenured directors can bring, especially in businesses with long development or product cycles and where institutional and company-specific knowledge and culture matter. ■ Board diversity Advance board diversity in the self-assessment, recruitment and nomination process, including but not limited to diversity in gender, ethnicity, race, age, experience, geographic location, skills, and perspectives. Consider increasing the size of the board to accommodate new talent in advance of an incumbent director's departure, including in the case of highly qualified diverse candidates.

DEVELOPING A ROBUST BOARD Does your board have the right skills and insights to make informed decisions? www.ethicalboardroom.com

Spring 2019 | Ethical Boardroom 73

Activism & Engagement | Board Development ■■ Plan ahead Plan for director succession in advance of retirements over an appropriate time horizon (e.g. at least a two- to five-year timeframe). In advance of retirements, develop a point of view as to what kinds of skills and experiences could be useful to have represented in the boardroom and what skills, backgrounds or networks would be lost in connection with a retiring or departing director. ■■ Build the pipeline Maintain a strong pipeline of candidates to consider for membership on the board. This facilitates the orderly identification and selection of new directors and improves the position of the board when faced by demands from activist hedge funds or other third parties for accelerated board refreshment. ■■ Expanding the pool Reflect on the company’s processes by which candidates are identified and selected, including the use of professional search firms, director or management networks, third-party databases, investor or stakeholder recommendations and other sources to find quality candidates. Consider whether to expand the pool of candidates from which board members may be chosen beyond historical criteria. ■■ Board culture matters Discuss what kind of board culture the company wishes to promote and how to foster the right board culture. A vibrant board culture of constructive support and engaged challenge is a valuable asset to management and investors, a source of competitive advantage and vital to the creation and protection of long-term value. Strong cultures will help the board and management team navigate stress, pressure, transition and crisis. Consider the positive or negative impact on board culture if a particular director candidate were to join the board, leveraging appropriate diligence, reference checks and interviews. ■■ Substantive evaluations v. hard-wired refreshment Consider whether regular, substantive self-evaluation is superior to hard-wired mechanisms to promote evolution of the board and its practices. Evaluate retirement ages, term limits, waivers or hybrid approaches combining age and tenure (or other measures) carefully. Discuss whether existing board, committee and director evaluation processes are substantive exercises that inform board roles, succession planning and refreshment objectives. Assess whether there are ways to incorporate the results of the board’s self-evaluations into director development, coaching, succession and (re)nomination decisions,

74 Ethical Boardroom | Spring 2019

including reviewing the on-going contribution of incumbent directors to the overall effectiveness of the board as a whole and identifying helpful methods for enhancing such contributions. ■■ Managing lengthy tenure Where there are many long-tenured directors, assess whether to bring the average tenure of the board as a whole in line with the policies of the company’s major shareholders over time or peer averages through a combination of adding new directors and anticipating future director retirements and decide whether to set a target date (which may or may not be externally disclosed). Discuss whether advisory directors or directors emeritus would be useful and appropriate to facilitate board succession. ■■ Better onboarding Accelerate the ability of newly added directors to get up to speed and contribute quickly from the beginning of his or her term, even while learning about the company and its business. This requires prioritising strong director orientation and ‘onboarding’ programmes, and creating early and repeated opportunities for longer tenured directors and senior management to get to know new directors. Onboarding is a process that now takes place within the larger context of the unprecedented diversification

Failing to plan ahead on matters of board practices and composition increasingly exposes public companies to opportunistic activism shareholder unrest of directors in background, expertise, and outlook, and this is an area where diversity of board tenure can facilitate mentoring, development and knowledge exchange among directors. More seasoned and experienced members of the board can offer insight and guidance to newer members and newer members can share their perspectives and experiences with longer tenured directors. ■■ Director education and expert tutorials Expand director education, tutorials and retreats involving internal and external experts to ensure that all directors stay apprised of relevant developments, changes in the business environment, competitive threats, business opportunities and the takeover, activist and governance landscape. Especially in complicated, multi-industry and new-technology companies, implement practices to ensure that the

directors have the information and expertise they need to respond to disruption, evaluate current strategy and strategise beyond the immediate horizon. ■■ Tailor governance processes and documents Tailor annual board and committee agendas and workloads, committee charters and corporate governance guidelines and other policies to reflect board priorities and processes and promote effective board and committee functioning. ■■ Consider rotation Plan for the rotation or succession of board roles over time, including that of the lead director/board chair and the chairs of various committees and consider whether to rotate committee memberships periodically. ■■ Engaging with investors Board strength, composition and practices are now routinely assessed by institutional investors and other stakeholders. When engaging with investors on these matters and considering proactive disclosures, companies should (1) explain why the company believes the right set of directors are in the boardroom, assess how best to communicate board development and succession plans and the company’s progress against them, and carefully explain procedures for increasing the diversity of the board and for ensuring that directors possess the skills required to oversee and direct the course of the company with management; (2) proactively share how their directors are integrated into strategic planning, guide and oversee strategic choices and risks, and test and challenge with management business strategies and execution; and (3) prepare for director-level interactions with major shareholders about these topics and know when and how to involve directors – proactively or upon appropriate request – without encroaching upon management effectiveness. Failing to plan ahead on matters of board practices and composition increasingly exposes public companies to opportunistic activism and creates other vulnerabilities. Effective board development and director succession planning holds the promise of facilitating the thoughtful evolution, over time, of board composition and board practices during periods of ‘peace’ rather than stress. Taking a fresh look at these matters, including associated disclosures, will also help companies strengthen their relationships with major investors and increase the likelihood that investors give the board the benefit of doubt on matters of complex business judgement or where patience is needed before business initiatives bear fruit. www.ethicalboardroom.com

2015 2016 2017 2018

And Still Trying Harder Innisfree has advised on more M&A transactions and activism situations than any of our competitors, according to league tables published by Corporate Control Alert tracking deals with a value of $100 million or more and Activism Scorecards published by Refinitiv (formerly Thomson Reuters) for each of the 2015, 2016, 2017 and 2018 calendar years.

Proxy Fights I Shareholder Meetings I Stock Surveillance I Activism Defense Executive Compensation Consulting I Corporate Governance Consulting I Tender Offers Innisfree M&A Incorporated 501 Madison Avenue, 20th Floor, New York, NY 10022 212 750 5833

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Activism & Engagement | Technology

SHAPING THE DIGITAL FUTURE Embrace technology but remain focussed on long-term value creation

Investors confront the tech sector 76 Ethical Boardroom | Spring 2019

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Technology | Activism & Engagement

It’s no secret: the technology sector is booming. Currently, half of the world’s 10 largest companies by market capitalisation are US-based tech companies: Microsoft, Apple, Amazon, Alphabet and Facebook.1 And not far behind them are hundreds more tech ﬁrms, in the US and other countries, with billions of customers and billions more in revenue and proﬁt. These companies urge consumers around the globe to embed digital technologies in almost every aspect of everyday life. They promise to honour and protect users’ privacy. And, increasingly, they promise that their artificial intelligence (AI) and machine learning technologies will lead to huge breakthroughs across fields such as business, science, medicine, transportation, housing and government. Yet today, this same tech sector is in many ways confronting an existential failure. While espousing values of innovation, ease and openness, the tech sector stands accused of facilitating social divergence and helping to dissolve social cohesion on a global scale. Regulators and legislators in multiple countries charge tech companies with privacy violations affecting hundreds of millions of people. And, as more and more companies deploy data-driven technology to target advertisements to potential buyers, recruit new employees and offer loans and mortgages, research shows these tools can bring about massive unintended harms and discriminatory outcomes. At Open MIC – the Open Media and Information Companies Initiative – we believe that tech companies must develop policies and practices that provide transparent oversight. It’s essential that they account for the impact of tech products and services on people’s lives and our social contract. Failure to do that, we believe, is bad business. Founded in 2007, Open MIC is a US-based non profit that works to foster greater corporate accountability in the media and technology sectors. Our primary tool is shareholder engagement. We work closely with investor partners – sustainable, responsible, impact (SRI) investors – who operate from the organising principle that responsible corporate behaviour is better business. We aim to deploy the collective power of investment management and advisory fi rms, mutual fund companies, foundations, pension funds and advocacy groups to help shape corporate media policies and practices. www.ethicalboardroom.com

The shareholder fight to curb ‘surveillance capitalism’ and other emerging risks

Myanmar or New Zealand or Pittsburgh. At YouTube, on multiple occasions, leading global advertisers have withdrawn advertising that appeared adjacent to online hate speech. Those risks to companies have concerned shareholders and prompted action. In 2018, Open MIC facilitated a public sign-on letter Michael Connor seeking support for shareholder proposals Executive Director, Open MIC from Facebook’s largest institutional investors, attracting signatures from Open MIC promotes values of openness, more than 80 civil and human rights equity, privacy, diversity and transparency organisations as well as investors with – values that provide long-term benefits for $62billion in assets under management. companies, the economy and the health of Following Facebook’s annual meeting, society. The goal is to foster the kind of open Open MIC’s analysis of the ‘independent’ internet and tech ecosystem that enabled shareholder vote – the investor vote the early and unprecedented success of excluding shares of CEO Mark Zuckerberg these companies in the fi rst place. and other Facebook insiders – showed Open MIC is unique in its application of that some 51 per cent of outside investors shareholder engagement to the tech sector. had supported a proposal to establish a But the broader shareholder engagement board-level risk committee and 41 per cent process is well-established in US fi nancial voted for a proposal demanding markets. SRI investors have for decades a report on how Facebook is managing provided corporate management and content governance, including on issues of boards with input on a wide range of election interference, so-called ‘fake news’, corporate governance and public policy hate speech and harassment online. matters, such as climate change, political Two weeks later, Facebook’s board spending and lobbying, of directors responded executive compensation and to pressure from shareholders Data is the governance, civil rights and and quietly adopted important lifeblood of human rights, and more. and substantial changes to Shareholder proposals the charter of one of the board’s the digital frequently highlight committees, renaming economy and key company-specific and/or the committee to include systemic issues that pose now the most the responsibility for ‘risk’ significant risks to companies, broadening its mission valuable asset and the economy and society. With to include oversight of issues for many the explosion of new digital that have placed the social technologies, Open MIC’s media platform at the centre of technology work highlights emerging global controversy, including companies risks confronting not only privacy, data use, community tech companies but business safety and cybersecurity. globally sectors of all types, globally. Th is year, alongside shareholders, such as the New York The risks of ‘social’ media State Common Retirement Fund and For several years, Open MIC has worked Arjuna Capital, Open MIC continues to with shareholders to press leading social press Facebook, Google and Twitter on media platforms – Facebook, Twitter ‘content governance’ policies. Separately, and Google – on issues that have exposed Open MIC is working with multiple the companies to significant legal, fi nancial organisations to encourage shareholders and regulatory risk. When dialogue with to withhold their vote for Mark Zuckerberg the companies has failed, Open MIC has as a member of Facebook’s board – to send organised proposals to be voted on by a strong signal of shareholder discontent shareholders at the companies’ annual to the company founder, who also controls general meetings. a majority of its shares. Data is the lifeblood of the digital Facial recognition and economy and now the most valuable asset surveillance capitalism for many technology companies globally. The phrase surveillance capitalism, But the potential value of data – including popularised by Harvard Business School’s its fi nancial value – is impacted by Shoshana Zuboff, refers to the economic consumers’ trust in companies to safely pressures that incentivise companies’ manage theirs. The social media platforms commodification of personal information have been widely criticised, for example, in the digital age – separating society for the role that online hate speech has into the ‘watchers’ and the ‘watched’. played in violence offl ine, whether in Spring 2019 | Ethical Boardroom 77

Activism & Engagement | Technology This includes the ways in which many representing more than $3billion in assets tech companies have made central to their under management this year filed a proposal business models the extraction of personal at Alphabet Inc., parent of Google, asking the information, the sale of consumer data to company to publish a human rights impact undisclosed third parties and government, assessment for a controversial censored the unregulated use of tech products and search product – Dragonfly – that Google services, including as a means to surveil and has reportedly been developing for use in track consumers throughout everyday life. China. Led by Azzad Asset Management, the We believe these practices present massive shareholders expressed concern that Google’s long-term risks to companies and society. compliance with China’s repressive laws One of the best examples of this is would facilitate and legitimise surveillance Rekognition, a facial recognition technology and censorship, posing human rights risks. which is marketed by the Amazon Web The shareholders’ call to action at Google Services (AWS) unit of Amazon. Rekognition was timely, given recent reports that the performs image and video analysis of faces, company is already censoring its search including identifying and tracking people and product in Russia, blacklisting websites their emotions. Tests of the technology have raised concerns that it is biased, inaccurate ARTIFICIAL INTELLIGENCE and dangerous. In one test, Rekognition Boards need to keep technology disproportionately misidentified an eye on potential African-American and Latino members of risks of emerging technologies the US Congress as people in criminal mug shots, incorrectly matching 28 members of Congress with people who had been arrested, amounting to a five per cent error rate among legislators – and an even higher one among members of colour. In the hands of government, Rekognition threatens civil liberties and civil rights for all members of society, and especially for people who are more likely to be surveilled, profiled and targeted, including people of colour and immigrants. We have organised two shareholder proposals that will be voted on at this year’s Amazon annual general meeting in May. One resolution asks Amazon to halt sales of Rekognition to government unless the board ‘concludes the technology Tech companies, does not pose actual or potential which have civil and human rights risk’, the benefited from other resolution requests the board commission an independent study operating in of Rekognition regarding the extent an unregulated according to government to which the technology may environment, now instructions. India’s ‘endanger, threaten, or violate’ government is privacy or civil rights. The proposals face increasing considering new rules echo concerns of more than pressure to abide that could again implicate 70 civil rights and civil liberties Google in censorship. groups, hundreds of Amazon’s own by standards In submitting the employees, and 150,000 people who resolution, shareholders are asking Google signed a petition – all seeking to end sales to demonstrate that the company’s stated of Rekognition to government agencies. ethical codes, values, and policies are truly Human rights on a global scale informing all its products in the global Global tech firms increasingly face the market. Human rights experts say that a challenge of whether and how to market their Google search product in China would serve products in countries with authoritarian as an additional surveillance tool for the governments that demand control of government to use against all residents in information. It can be a risky negotiation f that country, and that Uighurs and religious or a company, especially a company with an minorities – who already face state violence, avowed commitment to human rights. We systemic discrimination and grave human support shareholders in asking companies to rights abuses – face the greatest danger. uphold a commitment to human rights and Looking ahead free expression for all consumers, regardless of How can the tech sector do better? where they live – as these open internet values And what role should shareholders are precisely what fuel the tech sector’s success. play in the digital future? For example, a coalition of shareholders 78 Ethical Boardroom | Spring 2019

There can be dialogue between investors and corporate management that leads to the adoption of policies and practices that improve outcomes for companies and society. The shareholder proposal process often serves as an early warning signal to alert corporate managers and boards of emerging risks. Those risks are greatest in the tech sector, where calls for ‘innovation’ at all costs have increasingly trumped respect for human rights. Tech companies, which have benefited from operating in an unregulated environment, now face increasing pressure to abide by standards, such as the Guiding Principles on Business and Human Rights (the United Nations ‘Protect, Respect and Remedy’ Framework) and must comply with laws like the European Union’s General Data Protection Regulation (GDPR). When introducing new products and services, companies should carry out human rights impact assessments that are transparent, accountable, and provide an avenue for remedy for those affected by corporate actions. Tech companies are increasingly being pressed by regulators and even their own researchers to set up self-governance systems that scrutinise issues from privacy and consent to the potential for bias and discrimination built into machine-learning and AI systems. In early 2019, Google unveiled a high-profile, global, independent ethics council to guide ‘responsible development of AI’ at Google. Thousands of Google employees signed a petition calling for the removal of one of council member over her transphobic comments about trans people and her organisation’s scepticism of climate change – and a week later, Google disbanded the council, saying it ‘was going back to the drawing board.’ As artificial intelligence technologies are deployed across banking, retail, healthcare, education, travel and more, many industries will face similar challenges. Corporate boards and management need to be alert to the potential for AI to introduce into their businesses high elements of risk – risk which needs to be assessed and managed on a constant basis. Smart companies will insist on having digital and human rights expertise among board members, so they can better understand the implications of these new technologies. Shareholders will play a critical role in this emerging process; investors can be key players in encouraging companies to assess and address the potential impacts of tech products and services before they are deployed. Responsible businesses must step up to participate in policy dialogues, advocate for values-based industry practices and help set and implement technical standards that promote long-term, sustainable and equitable economic solutions. At Open MIC, we believe shareholder engagement is essential to ensure they do. www.ethicalboardroom.com

How do you sustain momentum? Startups, mid caps, and large enterprises all grow differently, face unique challenges, and move at various paces. But despite their distinctions, they share a common goal: to not only build momentum but to sustain it in the long term. Sustaining momentum means avoiding obstacles, driving growth, and delivering results. And with the right partner, now you can. For more than 70 years, D.F. King, an AST Company, has maintained leadership in strategic advisory, securityholder identification and solicitation, corporate governance, and information agent services. We leverage in-depth research and strategic analysis to help companies anticipate obstacles and better understand and communicate with their ownership. You’ve worked hard to gain momentum. We’ll make sure you keep it by preparing your team with the critical data and insights that you will need this engagement season. Download and share your 2018 Fall Engagement Guide at: www.dfking.com/2018engagementguide

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Global News Middle East

Hawkamah conference addresses sustainability Dubai-based Hawkamah Institute for Corporate Governance held its 13th annual conference in April — with global experts focussing on governance challenges for large, non-listed companies. Hosted in conjunction with ICSA: The Governance Institute, the conference highlighted good corporate governance practices that support sustainable growth in the face of rapid change and growing economic pressures. Dr Ahmad Al Shaikh, chairman of Hawkamah, said: “Governance can determine whether a company’s success and profits are sustainable or heavily dependent on external variables such as a booming economy. “Good corporate governance is essential to the region’s financial and economic development. According to the S&P/Hawkamah ESG Pan Arab Index, good governance practices are associated with better stock performance and higher returns on investment.”

Oman MSMEs urged to embrace good governance Micro, small and medium enterprises (MSMEs) in Oman can make better decisions and improve performance by adopting corporate governance practices, according to speakers at a workshop in April. The workshop, organised by the Pearl Initiative, highlighted how MSMEs in the region can benefit from adopting corporate governance practices to ensure enhanced business outcomes. A report by the Pearl Initiative found that 76 per cent of regional MSMEs are looking to grow their businesses, but face challenges related to hiring the right staff, acquiring capital and funding and adverse economic conditions. “Governance is not just for established companies – businesses of all sizes can and should use good governance practices,” said Yasmine Omari, executive director at the Pearl Initiative.

Female Middle East architects need support HR departments in the Middle East need to take action to ensure equal opportunities are being given to ‘qualified and talented’ women in architecture, according to a report. A survey of 141 female architects from 10 countries in the Middle East identified challenges facing women include less pay

80 Ethical Boardroom | Spring 2019

than male architects, discrimination in meetings and site visits and societal pressures influencing workplace culture. More than a third of respondents (35.5 per cent) said that their HR department does not have a clear policy on sexual discrimination, nor a robust process for handling complaints. Three in 10 survey participants said they did not know what their company policy was on such issues. Fifty-seven per cent of the women who completed the survey said they had experienced sexual discrimination in meetings with clients, contractors, engineers, planners and other architects.

Abraaj executives accused of fraud US federal prosecutors have brought charges of wire and securities fraud against executives of collapsed Dubai private equity firm Abraaj Capital. Arif Naqvi, the founder and chief executive of The Abraaj Group, was arrested and released on bail in London and faces extradition to the US to face fraud charges. Managing partner Mustafa Abdel-Wadood was also arrested in New York and has pleaded not guilty to the same charges which relate to defrauding investors, including the Bill & Melinda Gates Foundation. US prosecutors say that Naqvi and Abdel-Wadood lied about the performance of Abraaj funds, inflating their value by more than half a billion dollars and caused ‘at least hundreds of millions’ of investor funds to be misappropriated Both men say they are innocent and expect to be cleared of any charges.

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MIddle East | Ethics SHAPING A COMPANYâ&#x20AC;&#x2122;S CORPORATE CULTURE Clear guidance can help managers deal with potential ethical dilemmas

82 Ethical Boardroom | Spring 2019

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Ethics | MIddle East

CREATING AN ETHICAL

WORK CULTURE Ethics underpin good corporate governance and developing an ethical corporate culture is an essential role of the board. Ethical behaviour is in ever more urgent need of attention, as witnessed by just the most recent corporate scandals from Wells Fargo to Facebook’s Cambridge Analytica debacle to Dieselgate, Harvey Weinstein and Google’s sexual misconduct investigations.

But boards often either ignore this responsibility or simply don’t know how to embed corporate culture. It is hugely important, especially in today’s world of instant videos and social media where corporate reputation and brands, so carefully built, can be in shreds very quickly. And along with it, your share price. Facebook’s biggest scandal hit its share price dramatically when in March 2018 we learned that Global Science Research had been able to harvest 87 million Facebook users’ data and then sell it to Cambridge Analytica, who used it to create highly targeted ads to encourage users to vote for Trump and Brexit. Here in the Gulf, the collapse of the private equity fi rm Abraaj has focussed renewed scrutiny on corporate governance standards in the region and has highlighted the importance of a strong governance culture, so important for attracting international investors. So, it is clear that ethics will not manage themselves and directors and managers need clear guidance when dealing with ethical dilemmas. Decisions taken within an organisation may be made by

Why codes of ethics are an important part of good corporate governance Jane Valls

Executive Director for the GCC Board Directors Institute (GCCBDI) individuals or groups, but whoever makes them will be influenced by the corporate culture. The tone at the top is critical to creating the right ethical culture in the workplace. Having a code of ethics is a good start, but words on paper are not enough. I am sure Barclays had a great code of ethics at the time of the libor scandal but, as Lord Salz remarked in his 2013 Libor Inquiry Report: “Culture exists regardless. If left to its own devices, it shapes itself with the inherent risk that the behaviours will not be those desired… the board sets the tone from the top of the organisation and must carry the ultimate responsibility for its values, culture and business practices.”

The company vision

So, what can or should the board do to instil a positive ethical culture? The board needs to

focus first on corporate values: the core values support the company’s vision, they shape the culture and are the essence of the company’s identity. They should be a set of commonly held beliefs and commitments, not just a marketing gimmick. These statements become the deeply ingrained principles that guide employee behaviour and company decisions and actions – the behaviours that the company, the board, the management and the employees expect of themselves. Let’s look at Starbucks for example. Coffee is a commodity which you can get anywhere these days, so that is why the Starbucks story is so impressive. It changed our perception of coffee and became the market leader. Its core values are its success story: “With our partners, our coffee and our customers at our core, we live these values: ■ Creating a culture of warmth and belonging, where everyone is welcome ■ Acting with courage, challenging the status quo and finding new ways to grow our company and each other ■ Being present, connecting with transparency, dignity and respect ■ Delivering our very best in all we do, holding ourselves accountable for results

FACEBOOK INC. (ALL SESSIONS)

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MIddle East | Ethics “We make sure everything we do is through the lens of humanity – from our commitment to the highest quality coffee in the world, to the way we engage with our customers and communities to do business responsibly.” And, when an incident happened that did not match its values, it dealt with it quickly and responsibly, closing all its US locations – more than 8,000 stores – for an afternoon for a company-wide racial bias education day. Howard Schultz set the tone at the top and developed a culture of employee respect, based on clear and well-communicated values. A company culture is either proactively created and built from the very beginning or – sadly, more often – it simply develops in a haphazard and reactive way over time through the beliefs and experiences of whoever has the most influence, good or bad.

Embedding ethics

values. Values-based leadership connects organisational values to employee behaviour in order to fulfil the organisation’s mission and constantly communicates those values at every opportunity possible – in every internal and external communication and every time a person is publicly recognised. Business ethics goes beyond simple compliance and respecting the law; it is about written and unwritten codes of principles, values and behaviours, based on the organisation’s culture, that govern decisions and actions within an organisation. It is how you make decisions and conduct business. The tone at the top is critical to creating the ethical culture of the workplace. Corporate leadership and management therefore have an important role to play in developing corporate cultures – both the board and senior management have the responsibility for ensuring that the organisation’s values are lived and breathed throughout the organisation. A recent ACCA survey showed

So, if a board wants to develop a positive ethical work culture, it needs to work hard SETTING THE TONEIN THE at the values and develop strategies and BOARDROOM policies to embed ethical behaviour in its Directors have a organisations. It needs a proper ethics duty to promote a positive culture management system with the appropriate governance and management frameworks for its organisation. Family businesses often do this best because the patriarch has instilled the family values in the first generation, but beware as these values can get lost among future generations. We live in the Johnson & Johnson is probably information the most famous with its credo age. Today’s ‘Our Values and Caring: Our Credo challenges us to put the prospective needs of customers and patients employee first. Caring is at the heart of everything we do’. has more “Acting in the highest ethical information manner is one of the critical that 61 per cent said tone at steps in achieving our vision,” is than ever the top, ahead of incentives the message of Khalid Mohamed before, and and rules and procedures, Kanoo, chairman of YBA Kanoo businesses was what most influences Group, based in Bahrain, and corporate behaviour. Justin it emphases the importance of are more King, the former boss of an ethical culture as part of transparent Sainsbury’s in the UK, says: a good corporate governance “Nothing moves a business in framework. Established in the now than a direction as powerfully as Kingdom of Bahrain in 1890 they ever corporate culture. The challenge as a small family trading and of directors and management have been shipping business, the YBA is to ensure that it moves it in Kanoo Group has evolved into the right direction.” a diversified conglomerate that provides The board and senior leadership have a broad range of products and services, governance responsibilities in driving based on strong family values that have corporate culture through setting supported its sustainability. organisational direction, making key Once an organisation’s values are clearly internal and external decisions and setting defined, they should also be the guiding behavioural examples. Collectively, they set light for how performance is evaluated at all the overall tone of the organisation, which levels. This is about values-based leadership impacts a broad framework of policies, – motivating employees by connecting processes and procedures in the organisation. organisational goals to employees’ personal 84 Ethical Boardroom | Spring 2019

Future employees

Corporate culture is also a key ingredient if organisations want to attract and retain the best employees. We live in the information age. Today’s prospective employee has more information than ever before, and businesses are more transparent now than they ever have been. It’s also important to realise that 86 per cent of millennials, according to a Bentley University Study, consider it a main priority to work for a business that conducts itself ethically and responsibly. A company’s ethics and corporate social responsibility matter more today than they did a few decades ago. Employees place a higher emphasis on the values of their employers. Moreover a 2017 Gartner Survey shows that 29 per cent of employees witnessed at least one compliance violation in the last two years and that employees who witness misconduct and perceive that the company has not addressed the issue, are twice as likely to leave an organisation. The departure of employees can

therefore signal an underlying problem in an organisation and employee attrition can have a big impact on cost, productivity and morale. This means that it is even more important to promote a culture of integrity and ethical conduct because that’s how companies attract and retain the best employees. Ultimately, it is the directors who set the tone and have a legal duty of care to do so. It is their role to ensure the governance structures and processes are in place that will ensure the ethics of the company are addressed on a regular basis by the board and the executive management. Laws, such as the UK Bribery Act, means that companies can no longer outsource their morality and turn a blind eye to what their agents or partners or suppliers are doing. An ethical culture needs ethical leadership. Without integrity at the top, the rest can be a precarious house of cards, just waiting for the next scandal to break. www.ethicalboardroom.com

Corporate Governance Awards | Introduction

The benefits of good corporate governance Middle East & Africa Winners Directors around the world share similar concerns and challenges as they look to the future for the organisations they govern. Governance is one of the top priorities of board chairs and executive management and recognised as critical to a companyâ&#x20AC;&#x2122;s sustainability, shareholder value and investment attractiveness. Good corporate governance, whether in a family business or large listed company, is crucial to unlocking value. According to the OECD, while Middle East economies have made progress in strengthening corporate governance frameworks in recent years, the region still faces challenges in adopting and implementing measures that support the economic efficiency, sustainable growth and fi nancial stability needed to foster development. With shareholders focussing on boards and regulators raising corporate governance standards, the development of directors is critical. Since its launch in the Gulf Cooperation Council (GCC) in 2007, the GCC Board Directors Institute (GCC BDI) has helped directors and boards stay informed about their changing role in the dynamic

86 Ethical Boardroom | Spring 2019

regulatory environment. The not-for-profit organisation has recently launched a Director Certification Programme in partnership with The Financial Academy. The programme has been designed to prepare directors for their roles, boost their knowledge and confidence, and empower them to make a valuable contribution to any board. Tailored to directors in the GCC region, the modules focus on knowledge,

Good corporate governance, whether in a family business or large listed company, is crucial to unlocking value

understanding, skills, mindsets, attitudes and values. Obtaining the Certificate in Board Directorship demonstrates an internationally accepted level of understanding of corporate governance. In Africa, good governance and transparency is impacting the economic performance across the region. The recently introduced Nigerian Code of Corporate Governance was issued in 2018 by the Financial Reporting Council of Nigeria and advocates for stronger governance practices within companies and accountability to shareholders. According to KPMG, considering the developing awareness and relatively low institutionalisation of leading governance practices in Nigeria, the implementation of the Code may be challenging for those who have not previously had to comply with any corporate governance codes. The Ethical Boardroom Corporate Governance Awards recognise and reward outstanding companies who have exhibited exceptional leadership in the area of governance. The awards highlight the important role that corporate governance plays in dictating a companyâ&#x20AC;&#x2122;s success and a boardâ&#x20AC;&#x2122;s contribution to the creation of long-term value. Ethical Boardroom is proud to announce its Corporate Governance Awards Winners in the Middle East and Africa.

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The Winners | Corporate Governance Awards

AWARDS2019 Financial Services Bank Audi S.A.L Lebanon Construction Materials Dangote Cement Plc

Financial Services Access Bank Plc

Leisure & Hospitality DXB Entertainment

Food & Beverage Nigerian Breweries Plc

Transportation & Logistics DP Ports

Oil & Gas Seplat Petroleum Plc Nigeria

Utilities SOE DEWA UAE

Best CEO Conglomerate Mr. Lindsay Ralph (The Bidvest Group)

Best Company Secretary Holdings Mr. Oluseye Kosoko (FBN Holdings Plc)

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Telecoms Oman Telecommunications (Omantel) Oman Conglomerate SABIC Mining Saudi Arabian Mining Co (Maâ&#x20AC;&#x2122;aden) Saudi Arabia

INDIVIDUAL AFRICA WINNERS 2019

Best Company Secretary Financial Services Mr. Sunday Ekwochi (Access Bank Plc)

Industrial Services Aluminium Bahrain (Alba) Bahrain

Insurance Abu Dhabi National Insurance Company (ADNIC)

Holdings FBN Holdings Plc

Best Company Secretary Oil & Gas Ms Mirian Kachikwu (Seplat Petroleum Development Company Plc)

MIDDLE EAST AND AFRICA WINNERS

INDIVIDUAL MIDDLE EAST WINNERS 2019 Best CEO Industrial Services Mr. Tim Murray (Alba) Conglomerate The Bidvest Group Ltd Insurance Old Mutual Ltd Telecoms Vodacom

Best CEO Telecoms Mr. Talal Said Al Mamari (Omantel) Best Company Secretary Financial Services Mr. Farid Lahoud (Bank Audi) Best General Counsel Transportation & Logistics Mr. Arif Mahmood Mirza (UAE)

Mining Anglo American South Africa South Africa

Spring 2019 | Ethical Boardroom 87

Corporate Governance Awards | Access Bank STRATEGIC VISION Maintaining a robust corporate governance system is a crucial target for Access Bank

AWARDS WINNER AFRICA 2019 FINANCIAL SERVICES

Access Bank:

Effective governance

Most successful institutions globally depend on corporate governance – a framework that speciﬁes rules and practices through directors to ensure accountability, fairness and transparency in a company’s relationship with all stakeholders. Consequently, there is a distribution of responsibilities, rights and rewards, including procedures that would reconcile possible conflicting interests of stakeholders, especially in relation to duties, privileges, roles and information flow, to serve as a system of checks and balances. Currently, Access Bank Plc operates as a full service commercial banking group, with a network over 600 branches and service outlets located in major centres across Nigeria and subsidiaries in seven countries in sub-Saharan Africa and the UK, with representative offices in China, Lebanon, India and the UAE. Access Bank’s corporate governance is founded on key pillars of accountability, responsibility, transparency, independence, fairness and discipline. Our corporate governance framework is designed to deliver good corporate governance, aligning management’s actions with the interests of shareholders while ensuring appropriate balance with the interests of other stakeholders. 88 Ethical Boardroom | Spring 2019

Practising good corporate governance for building sustainable, responsible businesses Sunday Ekwochi

Company Secretary at Access Bank With the board recognising that effective governance is a key to superior performance and sustainable prosperity, the system ensures on-going compliance with the Bank’s governance charter and relevant codes of corporate governance, including the post listing requirements of the stock exchanges where the Bank’s securities are listed.

Our building blocks

Today’s boards are required to be actively engaged, more knowledgeable and more effective than in the past as they confront myriad risks and challenges. Even with previous challenges in Nigeria, such as prevalent corrupt practices, unregulated ownership structure, non-compliance with stipulated codes and others, the need for an acceptable and relatable public reputation has led to the emergence of codes and ethical practices that have boosted investors’ confidence.

Increasingly, stakeholders’ expectations from the board are rising and the board must set its strategic priorities across diverse business segments and monitor the group’s risk profi le. The board ensures that corporate governance is not a mere box-ticking exercise by setting the right ethical tone from the top. Th is is achieved through composition, continuous training and a rigorous evaluation process, facilitated by an external and independent consultant. In the discharge of its oversight functions, the board continuously engages management in the planning, definition and execution of the group’s strategy. The board, in line with the Access Bank’s strategic planning process, holds an annual board retreat where the strategy for the upcoming year is rigorously debated and agreed between management and the board. Management provides the board with a quarterly update on implementation of the strategy, affording the board the opportunity to critique the management’s performance and access significant risk issues as well as mitigating controls implemented. The roles of the chairman and chief executive officer are performed by different individuals to ensure the balance of power and authority and to uphold the principles of good governance. The composition of the board is sufficiently diversified to optimise its performance and deliver sustainable value to www.ethicalboardroom.com

Access Bank | Corporate Governance Awards stakeholders. The board’s composition is aligned with global best practice on the parity of non-executive directors to executive directors. In 2018, the board had more non-executive directors than executive directors with four independent non-executive directors as against the two required by the Central Bank of Nigeria Code of Corporate Governance. The board is committed to improving gender diversity in its composition, with 33 per cent female membership as at 31 December 2018, above Nigeria’s national average of 12 per cent. Each committee has a written term of reference, as specified by the board, guiding its activities and expectation. All committees render reports regularly to the board. Currently, the board has seven committees covering audit, governance and nomination, risk management, credit and finance, digital and information technology, remuneration and retail expansion. While the various committees have the authority to examine issues within their remit and report to the board, the ultimate responsibility for all matters lies with the board. Board assessments provide an opportunity to identify and remove obstacles to enhanced performance and to highlight what works well. Every year, performance evaluation is conducted to ascertain the performance of the board of directors, the various committees as well as the individual directors. The board evaluation is facilitated by an independent consultant with no ties to the bank or any of its directors to ensure that candid responses are given, with the 2018 evaluation facilitated by Ernst and Young. The report of the annual board performance evaluation is always presented to the shareholders at the annual general meeting and subsequently submitted to the Central Bank of Nigeria. Directors’ training is critical to the bank and, as such, a training budget is earmarked for the development and continuous education of board members to ensure that they are armed with the advanced skills and knowledge to carry out their oversight functions. In the course of the 2018 financial year, board members were trained in diverse areas of interest cutting across digital transformation, human resource, governance, audit, finance and compliance.

Milestones

Some of the milestones achieved by the board in the corporate governance space over the past years include: ■ Access Bank was ranked best overall bank on both corporate governance and risk management disclosure in the 2010/2011 Nigeria Banks Financial Transparency Report – a publication by Business Day Media Ltd ■ In 2014, the bank participated in the pilot programme of the Corporate Governance www.ethicalboardroom.com

Rating System (CGRS), a Siemen Integrity Initiative funded project implemented by the Nigerian Stock Exchange (NSE) in conjunction with Convention for Business Integrity. The CGRS is designed to raise corporate governance standards across Nigerian corporates by providing companies with an incentive to develop better governance practice while differentiating themselves in the market for the benefit of the investing public ■ In 2015, Access Bank won the Corporate Affairs Commission Maiden Annual Corporate Citizens Award for the More Extensive Compliance Category. The award is given to companies that promote a culture of good governance in the Nigerian environment ■ In 2018, the bank was migrated to the Premium Board of the Nigerian Stock Exchange (NSE). The Premium Board was developed by NSE to promote an elite group of issuers that are industry leaders in their respective sectors and who meet the highest standards of corporate governance, capitalisation and liquidity.

ACCESS BANK’S HEADQUARTERS The company’s head office in Nigeria

■ In 2018, Access Bank was recognised by Th ird Observers Nigeria Limited for its long outstanding history of dividend payment since it was listed on the Nigerian Stock Exchange in 1998 ■ In 2018, the board extended its going-green initiative to all the subsidiary boards by implementing a secure electronic portant digital board book Access Bank maintains a whistle-blowing policy that covers internal and external whistle-blowers and extends to the conduct of the stakeholders, including employees, vendors and customers. The bank retains KPMG Professional Services to provide consulting assistance in the implementation of the policy. The bank’s chief audit executive is responsible for monitoring and reporting

on whistle-blowing and renders quarterly reports to the audit committee. The bank implements a securities trading policy that prohibits directors, members of the audit committee, employees and all other insiders from abusing, or placing themselves under the suspicion of abusing, price-sensitive information in relation to the bank’s securities. In line with the policy, affected persons are prohibited from trading on the company’s security during a closed period announced by the company secretary.

Looking forward

The company secretary plays an important role in entrenchment of good corporate governance across the group. The company secretary is properly empowered by the board to discharge his/her duties and responsibilities and has both functional and administrative responsibilities. The functional responsibilities are discharged to the board via the chairman, while, administratively, he/she reports to the group managing director. In line with statutory requirements, the appointment and removal of the company secretary are matters reserved for the board. The central role that a robust corporate governance system plays in the bank’s attainment of its strategic vision during the 2018-2022 strategic plan period cannot be overemphasised. In this vein, the company secretary will intensify efforts to ensure: ■ Improved institutional capacity to exceed compliance requirements ■ Robust succession planning to provide continuity of the board at all times and allow for smooth transition ■ Regular training of board members to equip them for the performance of their oversight function ■ Delivery of a robust director orientation and induction programme for new board members to equip them for the effective discharge of their role ■ The effective implementation and continuous update of the board’s confl ict of interest policy to ensure the confidence of the bank’s stakeholders is sustained ■ A robust continuing professional development programme for members of company secretariat to imbue them with the right skills and attitude required to effectively support board members ■ Implementation of comprehensive stakeholder engagement for improved brand recognition and equity

Access Bank Plc

Plot 999c, Danmole Street, Victoria Island, Lagos, Nigeria +234 (01)461 9264-9, 277 3300-99 www.accessbankplc.com info@accessbankplc.com

Spring 2019 | Ethical Boardroom 89

Africa | Corporate Governance

Nigeria’s Code: Attaining good governance in 2019 On 15 January 2019, after about ﬁve years of attempting to put together a ‘uniform’ code of corporate governance, Nigeria ﬁnally unveiled its national corporate governance code.

The Nigerian Code of Corporate Governance 2018 (2018 NCCG) was issued by the Financial Reporting Council of Nigeria (FRC) by virtue of Sections 11(c) and 51(c) FRC Act 2011. A Regulation; Adoption and Compliance with the Nigerian Code of Corporate Governance 2018 issued by the Minister for Industry Trade and Investment further to powers conferred by Section 73 of the FRC Act mandated compliance with the 2018 NCCG. Th is article provides a commentary of the Nigerian Code of Corporate Governance 2018, highlighting some of the central provisions of its 28 Principles and their associated recommended practices, while also comparing the Code with some selected national codes namely; the National Code of Corporate Governance for Mauritius 2016 (Mauritius Code), the King IV Code on Corporate Governance for Southern Africa 2016, as well as the UK Code of Corporate Governance 2018 (see chart opposite). The article highlights the entrenchment by the 2018 NCCG of some international best and leading corporate governance practices, such as board evaluation, board induction, establishment/definition of independent non-executive director (INEDs) roles, company secretary’s empowerment,

The Nigerian Code of Corporate Governance 2018 is an important step forward Dr Nechi Ezeako

Executive Director, Institute of Directors, Nigeria board diversity, etc. The article notes that the 2018 Code is a reflection of the peculiarities of the Nigerian business environment and confi rmation of the corporate governance concept of ‘no one size fits all’. The 2018 NCCG is the outcome of the review of the 2016 National Code of Corporate Governance (private sector). The unveiling of the Code was done by the Vice President of the Federal Republic of Nigeria, Professor Yemi Osinbajo, GCON, with the support of the Minister in charge of the supervising Ministry for the FRC, the Ministry of Industry, Trade and Investment, Dr Okey Enelamah. The journey to a national corporate governance code in Nigeria has been a remarkable one, playing out various acts and scenes like a veritable drama, complete with artists. However, major regulators and other corporate governance stakeholders, not least the FRC, rightly heaved a sigh of relief that the Nigerian nation finally demonstrated, in

a very practical way, its readiness to welcome the global business community by stipulating clear principles, standards and practices guiding the nation’s business environment. It will be recalled that the 2016 National Code of Corporate Governance (2016 NCCG), the review of part of which (Private Sector Code) birthed the new Nigerian Code of Corporate Governance 2018 (2018 NCCG), was suspended by the Minister barely three months into its release by the FRC. The 2016 Code was first of its kind, in that not only were its far-reaching provisions mandatory, but they also went beyond the private sector to include codification of standards for public sector as well as not-for-profit entities. Given the novelty of the issues introduced, the need for extensive engagements with critical stakeholders was recognised. Although, however, some engagements were done, the FRC under its previous leadership was perceived as merely ‘checking the box’ of stakeholders’ engagements and not sincerely taking on board the outcomes of these engagements. The result was significant pushback from different stakeholder groups, including the churches/religious organisations, some of which, not being accustomed to the level of accountability prescribed by the new Code, were reluctant to accept this. Similarly, some top audit fi rms were opposed to the level of objectivity checks introduced by the 2016 code, notably:

The introduction of joint-audit for organisations in which, if one of the joint auditors is a big fi rm, the other must be a small fi rm

LOOKING AHEAD The future direction of governance within Nigeria

90 Ethical Boardroom | Spring 2019

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Corporate Governance | Africa KEY PROVISIONS

MAURITIUS CODE

SOUTH AFRICA’S KING IV CODE

UK CODE OF CG 2018

2018 NCCG

Code Philosophy

‘Apply and Explain’ approach is adopted. Explanation on how the principles were applied to be provided in the annual report and website. The responsibility for applying the code is the board’s.

‘Apply and Explain’ approach is also adopted.

‘Comply or Explain’ approach is used. This refers to the compliance with the principles and providing explanation where they are not complied with.

‘Apply and Explain’ philosophy. This is similar to the Mauritius and King IV codes. This means that principles will be applied and explanation provided as to how specific activities best demonstrate the application or implementation of the code’s principles and practices.

Board Structure & Composition

Board and board committees should contain independently minded directors with an appropriate balance of skills, experience, knowledge and diversity, including gender, to avoid group think. To be of appropriate size and include executive directors, independent directors, non-executive directors.

Similar provisions for the governing body as in the Mauritius Code.

Board appointments should be led by the board’s nominations committee and should promote diversity of gender, social and ethnic backgrounds, cognitive and personal strengths.

Similar to the three other codes. Also provides that organisations are to determine the size and composition of their boards taking into account the scale and complexity of their operations, the need for sufficient members to serve on committees, quorum and diversity.

Transition to Silent on the transition Chairmanship of CEO to the role of Chairperson.

Discourages the transition from CEO to Chairperson. Provides for cooling-off period of three complete years after end of tenure.

Discourages transition from CEO to Chairperson. Requires prior consultations with major shareholders and reasons to be provided in the company’s website.

Similar to the King IV Code, MD/CEOs or EDs require three-year cooling-off period.

Tenure

INEDs should not serve longer than nine years.

Maximum nine-year tenure for the Chairperson and NEDs.

Introduces maximum of three three-year terms for INEDs and periodic refreshing of NEDs.

Remuneration The board should be transparent, fair and consistent in determining the remuneration policy for directors and senior executives.

The Governing Body should ensure that the organisation remunerates fairly, responsibly and transparently. The governing body should approve the remuneration policy and give effect to its directions on fair, responsible and transparent remuneration.

Remuneration policies and practices should be designed to support strategy and promote long-term sustainable success. Executive remuneration should be aligned to company purpose and values, and be clearly linked to the successful delivery of the company’s long-term strategy.

The company’s remuneration policy should be disclosed in the annual reports, alongside remuneration for all directors.

Board Evaluation

Governing Body should ensure the evaluation of its performance and that of its committees, its Chairperson and individual members. Evaluation to support continued improvement in performance and effectiveness.

Same as Mauritius Code and King IV. Includes evaluator disclosure.

Same as the other three codes but includes establishing a system for formal and rigorous annual performance evaluation and excludes evaluator disclosure requirement.

No specific provision for tenure of Board members.

a) Encourage boards to undertake formal, regular and rigorous evaluation of their own, their committees’ and individual directors’ performance by independent facilitator. b) Annual development plans to be produced.

Also provides for corporate governance evaluation to be performed annually, which will assess the code implementation.

c) The external evaluator No requirement for should be identified in the disclosure of evaluator. annual report and a statement made about any other connection it has with the company or individual directors. External Auditors

Only reference to external auditors is in Principle 15.40(d) that the governing body should oversee that the combined assurance model covers independent external assurance service providers b) The board should also ensure that the audit partner is such as external auditors. rotated at least every five years. a) The external auditor should be reappointed every year at the annual meeting and the board should consider putting the external audit contract out to tender at least every seven years.

c) A review of the audit process, the effectiveness and performance of the audit team and the output, quality and cost effectiveness of the audit is a valid alternative to the tender approach. www.ethicalboardroom.com

It is no longer sufficient for companies to disclose directors’ remuneration in their annual reports, the remuneration policy should also be disclosed.

Both evaluations are to be externally facilitated by an independent consultant at least once every three years. Silent on specific requirement Similar to the Mauritius for the appointment of external Code. States that external audit firms may be retained auditors and their rotation. for no longer than 10 years The board should establish continuously and may not be formal and transparent considered for reappointment policies and procedures to until after a seven-year ensure the independence cooling-off period. and effectiveness of internal and external audit functions.

For independence, rotation of the audit engagement partner every five years.

External auditors with more than 10 years service should cease to act as auditor at the next AGM following code commencement. Spring 2019 | Ethical Boardroom 91

Africa | Corporate Governance abrogation of baton-exchange 2 Thor etag-team audit fi rm exchange.

By this, audit fi rms, especially the big four or five, were not to be allowed to exchange mandates in the exercise of their cooling-off periods. The suggestion was that the independence and objectivity of the audit process could be jeopardised if fi rms were permitted to form tag-teams that handed over their audit mandates to one another, and could therefore possibly cover up any shortcomings The length of the cooling-off period for external auditors was considered rather long

Perhaps learning from the suspension of the 2016 NCCG, the 2018 NCCG Technical Committee’s adopted approach of extensive engagements with critical stakeholders led to successful completion of the Code’s development and subsequent unveiling of the 2018 Code.

Scope and application

As already mentioned, unlike the 2016 NCCG, the 2018 NCCG, stays within the familiar terrain of private sector corporate governance and addresses neither of the volatile areas of the nation’s economy, notably, the public sector made up of the ministries and government parastatals and the not-for-profit organisations (NfPOs) made up largely of churches, mosques and other similar entities, which Nigeria has in significant numbers. It will be recalled that the attempt by the then leadership of the FRC to bring these categories of organisations under the purview of codes of corporate governance, spelling out the principles for governance and accountability, met with significant pushback from many of those affected. Consequently, the Technical Committee set up by the FRC wisely, in this writer’s view, decided to start the 2016 NCCG review with the less problematic sector, the private sector, which is more accustomed to regulation. Thus, while the 2016 Code addressed the three sectors, the 2018 NCCG is purely a private sector code. However, with the successful unveiling of the 2018 NCCG, the code development involving the reviews of 2016 NCCG (public sector) and (NfPOs) are expected to be addressed by the Technical Committee in due course. Additionally, there were some controversial provisions in the suspended code, which the 2018 NCCG nearly completely avoids. A case in point is regulation of the external audit. It has been well established that external audit is an important aspect of corporate governance. Compared to the 2016 Code, the 2018 NCCG provisions in relation to this, perhaps in response to calls 92 Ethical Boardroom | Spring 2019

by this stakeholder group, would appear to be more mellow. Th is writer was present at a stakeholder engagement event in Lagos, prior to the 2018 NCCG unveiling, where the issue was raised and FRC’s Executive Secretary, Daniel Asapokhai, explained that the FRC would be releasing extensive regulations regarding the roles of external auditors beyond the Code’s provisions. It is therefore expected that in addition to the corporate governance codes for the public sector and NfPOs, the FRC would be releasing regulations governing the conduct of external audit in Nigeria.

The 2018 NCCG philosophy

The new code adopts an ‘apply and explain’ approach to corporate governance. Th is is unlike 2016 NCCG whose approach was ‘mandatory’, a factor that played no small role in tolling the death knell for the suspended code. By adopting the apply and explain philosophy, the technical committee again demonstrated its openness to the suggestions of stakeholders who engaged with it at various sessions. Th is writer recalls making presentations to the 2018 NCCG Technical Committee on behalf of the Institute of Directors, Nigeria, (IoDN) during each of which IoDN recommended that the

As an economic entity, Nigeria competes with other countries for investment capital and investors are increasingly attracted to where codes and international standards are observed Code should “aim to exceed mere check-box completion and aspire to attain an apply and explain philosophy (similar to that adopted by the King IV), which sees corporate governance not merely as a mindless act of compliance but as a deliberate values-based corporate culture”. The subsequent adoption of the apply and explain philosophy for the 2018 NCCG was therefore most gratifying for this writer and others at IoDN, both personally and corporately. The Code’s adoption of the apply and explain philosophy is a principle-based approach, which aims to achieve flexibility for the ‘companies of varying sizes and complexities across industries’ to which the 2018 NCCG applies. Flexibility according to the Code is the ‘ability to apply the Code in a wide range of circumstances and scalability…’ and is considered critical for the Code’s implementation. Apply and explain is a non-prescriptive approach to the practice of corporate governance. According to Dr Chris Pierce,

a view with which this writer agrees, compliance in the context of apply and explain would be achieved by companies applying the principles and explaining how they have done so. Thus, compliance with the Code is quite different from compliance with the UK Code of Corporate Governance with its comply or explain philosophy. In the UK Code, compliance is achieved by implementing the provisions of the Code or explaining why they have not been implemented.

The 2018 Code principles and practices compared with selected codes

The 2018 NCCG has 28 principles, each of which has its associated recommended practices. Borrowing from the King IV, the 2018 NCCG differentiates between its principles and its recommended practices. Some of the principles relate to key corporate governance concepts, such as the board’s role, structure and composition, including executive directors and INEDs, assurance including internal audit and control, as well as risk management, shareholder relations, business conduct with ethics, sustainability and transparency. As an economic entity, Nigeria competes with other countries for investment capital and investors are increasingly attracted to where codes and international standards are observed. The chart on the previous page is a comparative analysis of some of the 2018 NCCG principles and practices benchmarked with selected codes of corporate governance; the Mauritius 2016, the King IV, 2016; and the UK 2018. All four Codes adopt principles-based approach.

Conclusion

The 2018 NCCG is, in this writer’s view, a good fi rst step towards attaining good corporate governance in Nigeria. It is particularly gratifying that the Code has adopted leading corporate governance concepts including the ‘apply and explain’ philosophy. Th is is, in my view, more ideal for entrenching the desired culture of good corporate governance in the Nigeria context than a ‘mandatory’ or even ‘comply or explain’ approach, which Nigerian businesses tend to approach from a ‘checkbox’ mindset with mindless compliance with the letter of the minimum requirements without achieving the true ‘spirit’ of corporate governance. It is noted that this Code is the fi rst of three and the national corporate governance codes for public sector and NfPOs should follow hereafter. It is expected that 2018 NCCG Technical Committee will also adopt the method of stakeholder engagements that proved successful in the current exercise and incorporate other learnings from it. www.ethicalboardroom.com

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Global News Africa

Kenya Power turns to whistleblowers

Electricity supplier Kenya Power is looking to fight corruption by using whistleblowers and will implement a service that would allow employees to communicate securely and anonymously. The move follows the suspension of Kenya Power’s CEO Ken Tarus and charges of abuse of office and conspiracy to commit an economic crime against his predecessor Ben

Chumo and 10 senior managers. According to Business Daily, Kenya Power has invited bids from professional firms to provide a service that would ‘record, report, interpret, analyse and store data on unethical practice’. Acting CEO Jared Othieno said: “To embed a strong ethical culture, Kenya Power is putting in place an online anonymous reporting mechanism.”

NCC and FRC collaborate on governance codes

IoD-Ghana pushes to establish regional charters The Institute of Directors Ghana is stepping up its bid to improve corporate governance in the country and will look to establish charters to drive investment in the country. It said the regional charters would fast-track efforts at rebranding Ghana as a nation of choice for investors. Speaking at a forum in Ho, Rockson Dogbegah - president of the Institute, said: “If we want Ghana to grow and succeed, if we want our businesses to grow and succeed, if we want to succeed as a country, then we must accept the principles of good corporate governance." The forum on good corporate governance by the Institute was the first of its planned nationwide engagements and was attended by heads of more than 100 corporate organisations, security agencies, religious and educational institutions.

94 Ethical Boardroom | Spring 2019

The Nigerian Communications Commission (NCC) and the Financial Reporting Council of Nigeria (FRC) have joined forces to bolster corporate governance in the telecoms sector. They say that by working together they can entrench the best corporate governance practices in all sectors of the Nigerian economy. Professor Umar Danbatta, executive vice chairman of the NCC, said that while both the NCC and FRC codes of practice had broadly the same aims, there would be points of divergences that would require work. He said: “It is necessary that the NCC and FRC hold discussions to harmonise positions and agree on key issues such as the seamless operation or implementation of the codes; issues of enforcement of the codes; collaborations between the NCC and the FRC on governance issues generally."

Former Eskom staff slammed as ‘delinquent’ Corruption Watch, a non-profit organisation working to fight corruption in South Africa, has called for former Eskom employees to be barred indefinitely from directorships at state-owned entities. Earlier this year, Corruption Watch launched an application in the High Court in Pretoria, to have former board members of South African electricity public utility declared delinquent. It also urged for Brian Molefe, the former Eskom CEO, and four ex-board members to be permanently banned from holding directorships at state-owned enterprises. Corruption Watch’s executive director David Lewis told Sunday Live that Molefe and the board directors had failed in their statutory, legal and moral obligations as directors and should be banned from holding such positions in future.

Boardroom shake up at MTN MTN Group has appointed former South Africa Deputy Finance Minister Mcebisi Jonas as chairman and Nigeria’s ex-central bank governor Lamido Sanusi as a non-executive director. Jonas will replace Phuthuma Nhleko, who plans to step down in December after 20 years as either chairman or CEO of Africa’s biggest wireless carrier. MTN has faced a number of disputes in its biggest market Nigeria in recent years over dividend repatriation, tax payments and unregistered SIM cards. It also faces disputes in other markets. “In recent years MTN Group has experienced challenging regulatory environments and highly competitive trading conditions. The board is of the view that MTN Group has entered a more stable and settled phase, enabling it to now affect an evolution of the board," the company stated.

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Good governance is our anchor for sustainable business growth Vodacom is honoured to be the recipient of the Best Corporate Governance Award for the Telecoms sector in Africa.

Vodacom Power to you

Technology | Advertorial

Good corporate governance begins with good data Effective corporate governance starts with having the right information. In an ever-changing corporate governance landscape of continually increasing, publicly available information, shareholder involvement, activism, ongoing media campaigns and continual changes to governance regulations, having the right information on a timely basis from the start can be the difference between success and ongoing shareholder revolt. Boardroom diversity, fair executive compensation, compliance to regulatory requirements, how companies compare against their peers and competitors and how they are perceived by investors and proxy advisors, needs to be thoroughly understood by boards of companies to stay ahead. With heightened scrutiny of governance practices in the post-financial crisis era, it is now more important than ever for companies’ boards and their executives to be fully prepared, with the same data and information as investors and proxy advisors, before beginning engagement to avoid reputational and governance risk. CGLytics, the leading provider for global corporate governance data analytics, provides real time data and a suite of powerful benchmarking tools to help companies and their boards with data- driven insights for sustainable practices and effective oversight. These tools support boards in making smarter, more timely and better-informed decisions.

The great debate of executive compensation

Investors over the past 12 months have continued to pay attention to, and even 96 Ethical Boardroom | Spring 2019

Boards can ensure they stay on top by using smart solutions Aniel Mahabier

Chief Executive Officer, CGLytics asked more questions about, the pay practices of companies and rewards offered to their CEOs and directors. Add to this the requirements set out in the revised European Shareholder Rights Directive (SRD II) to increase transparency of the company’s pay practices, including CEO to average employee pay ratios, CEO pay relative to company’s performance and extended say on pay rights of shareholders, companies should be sitting up and paying close attention. During the last proxy season, executive pay was heavily and effectively challenged. Shareholders repeatedly voted down advisory remuneration reports and questioned short-term remuneration plans, urging companies to bring pay into line with performance. Many remuneration-related resolutions were voted down on the grounds of misalignment. The UK, in particular, was at the forefront of shareholders concerns over excessive pay. To address these concerns, the Financial Reporting Council (FRC) issued a Revised Corporate Governance Code in July 2018, which encouraged directors to exercise independent judgement and discretion when authorising remuneration outcomes, by taking into account company and individual performance along with other circumstances. CGLytics carried out a proxy review with data from its extensive, global governance database of FTSE 100 companies and their pay practices. The study revealed that in 2018, 33 companies in the index sought a binding shareholder approval for their remuneration policies. Generally, investors questioned the earning potentials in short-term incentive

plans, for example Rentokil Initial plc’s decision to increase the annual bonus from 100 per cent to 150 per cent cost the board a dissent of around 25 per cent on their remuneration policy. In addition, shareholder revolts were seen regarding remuneration reports where there was not enough clarity about contractual entitlements, as seen in the case of Royal Mail’s retiring CEO Moya Greene and new CEO Rico Back. In other markets, shareholders became increasingly involved in company strategy, as seen in the Dutch AEX study carried out by CGLytics. Of the past years’ proposals to amend executive and supervisory directors’ remuneration, the majority encountered criticism and some were withdrawn prior to the AGM, or resulted in a large number of votes against. To increase transparency and truly understand how stakeholders, including proxy advisors, are viewing executive compensation and predicting how they are going to vote, companies and their boards need access to, not only information, but also data and tools that allow them to instantly compare their company to their industry peers’. CGLytics’ extensive database hosts more than 10 years of global compensation data and is driving good corporate governance practices by increasing CEO

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Advertorial | Technology

THE POWER OF EFFECTIVE DATA CGLytics provides an independent analysis of governance practices of global listed companies

pay transparency and helping companies to be more prepared than ever before. Using the same solution as leading proxy advisors and institutional investors, companies can replicate the peer groups of proxy advisors and investors with CGLytics’ customisable peer group modeler and easily perform a pay-for-performance alignment review. This empowers boards to know exactly what investors are looking at and scrutinising prior to engagement, be proactive with their reporting and make sure there are no hidden surprises come AGM time.

Diversity in the boardroom: where are all the women?

With companies, their boards, investors and governmental stakeholders all agreeing that goals that promote long-term value creation are imperative to corporate governance health, the issue of diversity comes into play. Why? Because having a diverse board is linked to long-term value creation. A diverse board of directors with different ages, genders, nationalities, cultures, skills, experiences, tenure and backgrounds certainly creates new and interesting dialogue around best practices for long-term value creation and brings fresh ideas to the table. With the speed of change happening today, driven by technology innovations, a variety of ideas, perspectives and knowledge is mandatory to keep up and www.ethicalboardroom.com

composition of S&P 500 companies, it was make the best decisions by taking into revealed that even though there is a push account worldly happenings. And from investors for more diverse boards in government and regulatory order to maximise returns, bodies are taking note. change is not happening as With heightened In particular, during the fast as desired. scrutiny of past year, the US has seen In CGLytic’s S&P 500 strict regulation changes Diversity report it shows that governance in some states to even out from 2017 to 2018 total female practices in the representation on boards the gender imbalance in corporate boardrooms. grew marginally, reaching post-financial California was the fi rst 24 per cent, up just one per crisis era, it state to legally require female cent from 2017. In response to representation on boards engagement with the investor is now more with the California Senate community, as well as the new important Bill 826 being passed. The regulatory requirements, the than ever for law requires the appointment number of women on boards of at least one female to a rose from two in 2017 to three companies’ company’s board of directors in 2018, showing only a slight boards by 2019 and between one increase in efforts being made. and three by 2021, depending However, despite the slow and their on the size of the company. growth in overall female executives A fine of $100,000 can be representation, six of the seven expected for not complying. companies that lacked at to be fully Th is was shortly followed by least one female director in prepared New Jersey , which mimicked 2017 corrected this in 2018. California’s approach of at The report also revealed least one female director by 2019. that bringing younger directors into the Earlier this year, using CGLytics’ software boardroom does not only add value in solution that provides extensive boardroom terms of unique perspectives and improved composition data and analytics, a review innovation, but also impacts company was carried out to evaluate the progress performance.1 The findings show that there is a clear and positive correlation between made in the US market and likelihood of the number of younger board members and achieving greater diversity in the coming the total shareholder return (TSR). years. By taking a deep dive into the board Spring 2019 | Ethical Boardroom 97

Technology | Advertorial

AVERAGE AGE ON S&P 500 BOARDS AGAINST TSR (2018) 500

Number of companies Average TSR

400 Total companies

As many investors continue to encourage and push for boardroom diversity for long-term value creation, it is now crucial for companies to, fi rstly, see how their boardroom composition, including skills, expertise, age and gender diversity is seen by the outside world. And, secondly, see how their company stacks up against their peers and competitors (see graph right). Companies using the CGLytics softwareas-a-service platform now have access to boardroom intelligence and can see exactly what their investors and proxy advisors see. Using this intelligence, which includes a skills and expertise matrix of more than 5,500 listed companies across the globe, boards are better preparing for AGMs, implementing effective succession plans and, at the same time, reducing their risk to reputational damage and activist investors. In addition, having access to 125,000-plus global executive biographies in the CGLytics solution, including more than 20,000 female profi les (both existing as well as upcoming directors), with detailed information of skills, experience, compensation, interlocks and connections, nomination committees can lever new ways of scanning the market for talent, understanding corporate networks and work smarter with their search and HR fi rms when it comes to succession planning and recruitment. It really is helping companies to look beyond the standard practices and information available by leveraging technology to drive and implement good corporate governance practices and sustain a competitive advantage.

300 200 100 0

30-39

40-49

50-59 Age range

The need to keep up with intel on governance risk exposure was evident during the 2018 proxy season. The season saw record levels of shareholder activism, with some high-level campaigns – notably those of Elliott Management and Icahn Partners – hitting the headlines. Changes to board composition and M&A were the primary aims of these campaigns. A recent study performed by Lazard, shows that activists won 161 board

Why data, tools and smart technology are mandatory in the challenging times ahead

As we continue to see regulatory requirements to increase transparency of governance practices, such as CEO pay (through implementation of SRD II) and improve diversity (through legislation not only in the US but worldwide), a trend is emerging of investors becoming increasingly knowledgeable and sophisticated. Not only are leading proxy advisors and institutional investors choosing to use data and analytics delivered to them from CGLytics, but some are building their own systems to stay informed and take advantage of investment opportunities. Companies need to have access to the same information as proxy advisors and investors, with the same sophisticated tools, in order to assess risks, better prepare for shareholder engagement and avoid potential activism. With knowledge being power, and transparency becoming a mandatory requirement, in the near future companies will have no choice but to use systems, such as those offered by CGLytics, to keep up with investors and improve their reporting practices. 98 Ethical Boardroom | Spring 2019

60-69

70-79

80-89

industry peers and competitors globally. To prepare effectively for shareholder engagement and anticipate response, companies and their boards must also be looking at past voting habits and patterns, and resolutions from other AGMs during the season. By looking at the trends of past shareholder voting and keeping abreast of happenings during the current proxy season, boards can spot patterns and predict the outcomes of shareholder voting resolutions. CGLytics’ platform hosts an extensive database of N-PX fi lings with voting proposals and resolutions from 2004 onwards, covering 4,000-plus investors with more than eight million data points. With this information on hand, plus the benefit of receiving up-to-date alerts of shareholder voting outcomes, boards remain on top of voting trends and can easily identify investors for a proactive engagement.

The next era in corporate governance intelligence

seats in 2018, up 56 per cent from 2017 and continue to name accomplished candidates, with 27 per cent of activist appointees having public company CEO/CFO experience. The message is clear: boards must regularly review their governance vulnerabilities to minimise their exposure to activists, and to review vulnerabilities they must have access to the analytics and tools in platforms such as CGLytics’. And themes that were established in the 2018 season are likely to continue. Shareholder activism will increase with institutional investors playing a more active role and driving change. It also seems likely that US activists will launch campaigns focussed on European companies. Forcing European companies to have access to global data for instant comparison of not just their country peers, but their

The pressure on companies and their boards to increase transparency of executive compensation and pay practices, improve age and gender diversity, and constantly assess their board quality and effectiveness will not go away. As investors and their proxy advisors gain greater insights and intelligence by use of data and smart solutions, companies will need to do the same. Boards need to ensure they are on top of their exposure to governance risks in order to avoid activism at all costs and any possibility of reputational risk – and they need to do this efficiently.

CGLytics

1 Strand Trafalgar Square WC2N 5HR, London, United Kingdom +44 (0) 20 7660 1530 getintouch@cglytics.com www.cglytics.com

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Redefining the Business of Intellectual Property® Strategy. Valuation. Risk. Aon's Intellectual Property Solutions combines data and analytics with broad Aon United geographic and industry intellectual property expertise to transform the market for intellectual property insurance solutions, including patent infringement, theft of trade secrets, and intellectual property collateral protection coverages.

Average potential loss to intangible assets is $1.08 billion compared with $795 million in property, plant and equipment (PP&E), yet the latter has much higher insurance coverage (60% versus 16%)

Increase of 33% in the insurance protection of potential loss of intangible assets versus an increase of 9% for PP&E for the same period of time between 2015 to 2019*

“The risk industry has to keep up with a constantly evolving environment in a daily battle for relevance. As an industry, we have not kept up with a world where 75 percent of market capitalization is now driven by intangible assets.”

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*2019 Ponemon Institute “Intangible Assets Financial Statement Impact Comparison Study,” sponsored by Aon http://www.aon.com/thought-leadership/ponemoninstitutereport.jsp

aon.com/intellectualproperty

Technology | Artificial Intelligence

MORETHANDATA Artiﬁcial intelligence (AI) is the key technology that will change the way we live and do business in virtually every industry. Fired by spectacular success stories, such as smart machines defeating world champions in complex board games, discussion about AI is often narrowed down to the most recent developments in machine learning (ML).

Th is leaves the impression that AI is all about data and human experts will play an ever decreasing role in the near future. Using the example of contract analytics, I will make a case for a somewhat different approach to AI that leverages available expert knowledge to guide and focus the machine’s capabilities to process data. AI is the scientific discipline that deals with the development of systems capable of dealing with tasks for which a human would have to use his/her intelligence. Nowadays, AI is often erroneously equated with ML.1 ML stands for a set of techniques with which a system can improve its performance with respect to a certain task without explicit programming efforts. To this end, the system extracts certain types of patterns from training data and represents them in the form of a model. Such a model can be a decision tree or a neural network, with all its internal weights adjusted to the data at hand. One particularly successful ML paradigm is deep learning (DL) – an approach based on a particular type of neural networks which requires huge amounts of training data. A series of spectacular success stories, ranging

WORKING TOGETHER Systems still need expert knowledge to make sense of data collections

100 Ethical Boardroom | Spring 2019

Businesses need analytics to make faster and more confident decisions but with the human touch, too Dr Mathias Bauer

Partner, Center of Excellence for Data & Analytics, KPMG from winning a game show  to defeating the human champion of Go3 (and many more useful applications in speech recognition, natural language processing, etc) fundamentally changed the way people talk about AI. According to public mainstream discussions about AI applications (triggered by clearly overselling commercials), all we need to do is gather really large data sets, feed them into a DL system and wait for the perfect solution to be generated. While this actually is a feasible way in certain types of application scenario, there often exist significantly smarter and efficient ways to generate results of at least similar quality. In the rest of this article I will make a case

for a somewhat more ‘traditional’ approach to AI that leverages human expert knowledge and brings about a number of advantages. To this end, let’s have a closer look at the training phase of a machine learning system. For sake of brevity, we will restrict our considerations to supervised learning. In this class of ML approaches, the training data to be used needs to be labelled. That is, somebody with subject matter expertise has to provide additional information on what a certain data record actually stands for. When training an image recognition system, for example, the system has to be told explicitly what is depicted on each training image. Th is label then stands for the meta-information that image #1 belongs to the class ‘cat’ – as opposed to ‘dog’ or ‘bird’ which represent the contents of other images. While

this is an easy task for a human, things become much more complex when we want to, for example, extract certain pieces of information from a contract written in English – such as a beginning and end date, the names of the parties involved, penalties for violation of certain conditions, etc. Indicating this information in thousands of sample contracts is extremely time consuming and error-prone – even if we neglect the fact that collecting such huge numbers of documents might be unfeasible in many situations.4 In such cases, it would be great if we could use additional ‘background’ information in the form of expert knowledge to facilitate the task at hand. The hope is that this knowledge www.ethicalboardroom.com

Artificial Intelligence | Technology

AI systems still need expert knowledge to make sense of data collections. Thus, combining the respective strengths of both humans and AI systems will form the basis for many successful applications that currently exceed human capabilities alone

provides additional structure and semantics to the amount of data, thus significantly reducing the number of training data required and easing the process of generating the information extraction model. The good news is that, in many cases, this can be achieved by, for example, constructing a knowledge graph (an approach pursued by Google, among others)5 or an ontology (a network or hierarchy of semantic concepts of a domain and their interrelations).6 Such processes can be supported by computer systems, but typically require a final editing step from a human. www.ethicalboardroom.com

Spring 2019 | Ethical Boardroom 101

Technology | Artificial Intelligence Another approach consists of eliciting wording. This is mainly due to the fact that the required knowledge from a human the search space only consists of the text expert. This method obviously reaches its of one clause, not a few hundred pages limits in overly complex applications where of a complex contract. And it is easy to huge amounts of rules would be required to see that identifying one particular date adequately represent the expert’s knowledge indication (e.g. the one characterising the (which turned out to be the main reason starting date of the contract) in a short for the failure of expert systems in the text is much easier than sorting out which 1980s). For moderately complex application of the dozens of dates listed in the complete scenarios, however, doing so can be text is actually the one we are looking for. extremely valuable. Let’s get back to the The useful expert example of information extraction from To summarise, expert knowledge about contracts in English language. the clause structure of contracts can be Such a contract typically has a strictly used to accurately identify the position of a defined structure. It can be decomposed into certain clause and then extract the relevant a number of clauses such as the termination information items within this clause. The clause, the indemnification clause, etc. expert knowledge helps to significantly Each clause comprises a relatively small set of information items that could be of interest for contract analytics. With this ANALYSING DATA Humans play a crucial in mind, it is relatively easy for a legal expert role in making sense of to come up with a complete list of contract large data collections clauses and enumerate the information snippets they contain. How does this help in our attempt to train an information extraction system for contracts using a non-deep learning approach? First of all, the system has to be told where to find the various clauses in a set of sample contracts. This can be easily done by marking the respective portions of text and labelling them with the clauses names they contain. On this basis we can train a classifier model that – when reading through a previously unseen contract – recognises what type of contract clause can be found in a certain text section. With a ‘conventional’ (i.e. not DL-based) algorithm, a small number of examples should be sufficient to generate an accurate classification model that is able to partition the complete contract text into the various clauses it contains. Once a clause is identified Combining the within a certain contract respective of the training data, a human can identify and label the strengths of reduce the number of training interesting information items both humans data – and thus, the human contained within. Since the and AI systems effort required to label them text portion of one single – and facilitates the actual clause is relatively small, only will form the information extraction by a few examples are required basis for many restricting the search space to come up with an extraction to the relatively short text of model for the items in one successful the current clause. particular type of clause. applications What does this tell us about Depending on the linguistic that currently the use of artificial intelligence complexity and variability of general and machine the formulations used, this exceed human in learning in particular? First model can be either generated of all, there exists no standard using ML, by writing extraction capabilities algorithm or even paradigm rules making use of keywords, alone serving all purposes equally or – in exceptionally well. In application scenarios where huge complicated situations – by applying natural amounts of data are easily available and language processing algorithms digging can be labelled without significant effort deep into the syntactic structure of each for human experts, a purely data-driven sentence. In any case, the resulting model approach might make perfect sense. can be expected to be fairly precise and Examples include image collections, such as robust to variations in the respective 102 Ethical Boardroom | Spring 2019

YFCC100M, a collection of almost 100 million images.7 The majority of these images have been labelled by their respective photographers. This means the effort of providing additional information about the training data could be distributed among a similarly huge number of human experts. In the Go example mentioned above, the system trained itself by simply playing games against itself. Labelling then could be fully automated – the system simply marked the data representing each match as won or lost. When no crowd-sourcing or automatic labelling is feasible, making use of expert knowledge as described above can be a good alternative. Doing so not only significantly reduces the amount of training data required and the effort of labelling them, it typically

also helps create much more transparent – and thus, comprehensible – models that can be easily maintained and repaired in case of insufficient performance that might be due to changes in the domain. Deep learning models, on the other hand, currently must be considered as black boxes whose internal behaviour cannot be easily explained – doing so is the goal of ongoing research. The ultimate lesson learned from these considerations is the soothing observation that humans will continue to play a crucial role for the foreseeable future. AI systems still need expert knowledge to make sense of data collections. Thus, combining the respective strengths of both humans and AI systems will form the basis for many successful applications that currently exceed human capabilities alone. Footnotes will be run when the article is published online

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Technology | Managing Data

Information Governance: Achieving data ethics, privacy and trust How organisations can make the most of an information governance programme Sonia Cheng & Steve McNew

Sonia is the Managing Director, Steve is Senior Managing Director, Technology, FTI Consulting

Life and business today are hugely reliant on the collection, processing, sharing and analysis of information. From the adverts we see, to the music we listen to and the way we do our jobs, data is a driving force in the background.

104 Ethical Boardroom | Spring 2019

A fragile new currency

Our digital economy runs on data and entire industries are built upon the sole purpose of selling, enriching and trading it. Thus, trust has become a valuable, albeit delicate, currency in the system. For years, many organisations have communicated to employees that they should have no expectation of privacy at work, or when using employer-provided devices. Th is type of policy is common, as has been similar thinking regarding consumer privacy rights. At the core of this mindset is the presumption that data is owned solely by the institution and may be managed and monetised in any way the institution chooses. However,

AYERS OF DIGITAL ID 1: 3 L What the machine ENT E R ITY U G thinks about you FI Religious/ Political views

Content consumed

Influencer/observer

What your behaviour tells them

Generation X

Ads viewed Online What SMS history poker you share App usage Email address(es) used Device patterns Credit card numbers Self-esteem locations Car owner Photos & metadata (GPS/WiFi/ Gender Search terms Bluetooth) IP Address(es) Emojis used Coffee Running software drinker Purchase history Action Keystroke dynamics movies Mortgage Automated check-ins Health owner status Luxury consumer

Ethnic affinity

Tatoo or piercing

‘3 Layers of Digital Identity’ developed by the Panoptykon Foundation, https://en.panoptykon.org

And, every day, people around the world generate and give away massive and unprecedented amounts of personal data, often without even realising it. Data protection laws have been solidified and increasingly enforced in jurisdictions around the world, introducing privacy and data security as important global legal and business issues. The emergence of this new climate has brought concepts of fairness, integrity, honesty, transparency, accountability and trust into the spotlight (see Figure 1, right). Trust and related terms are often used loosely and, as a result, public trust in governments, fi nancial services institutions, the media and technology companies has dipped to a historic low. A Pew Research study from 2017 found that only 18 per cent of Americans today say they can trust the government in Washington to do what is right ‘just about always’ (three per cent) or ‘most of the time’ (15 per cent).1 In 2018, Gallup reported that 40 per cent of

survey respondents have very little or no confidence in newspapers and only one-third have ‘a great deal’ or ‘quite a lot’ of confidence in banks. 2 These numbers are alarmingly low when compared to survey responses from the previous decade. Broadly, consumer, client and shareholder trust in business has eroded. Yet, because trust is so vital to economic stability and growth, corporations are now under pressure to restore and maintain a foundation of accountability and reliability. Doing so requires a holistic approach that imbues ethics and transparency throughout the data lifecycle from the moment it’s collected, to how it is used, shared and disposed.

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Managing Data | Technology

Fair

Transparent

Records

RCHIV E

■ Respectful: Data processing and use should always align Business with the original purpose that was communicated to the data subject. When GDPR was fi rst activated in 2018, individuals experienced a tsunami of emails and consent popups, which, ironically, resulted in many ignoring notices that HA

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Compliance obligations have also become increasingly demanding and, in addition to combatting distrust, many organisations are also battling compliance fatigue. Ethics and a company culture based on privacy can help manage unforeseen regulatory risks and support compliance needs at the VE ER same time. The principles of information CO ES R LL P governance (IG) can help to align , EC SE legal, privacy, business and user requirements, clarify stakeholder IT obligations and proactively Data Subject identify potential compliance Principles of Legal gaps (see graphic right). data ethics Tried and true IG principles Respectful and considerations that should be examined Beneficial together with data ethics Privacy principles, including: IT USE, S

Alongside the changing trust matrix, data ethics have emerged as a new branch of applied ethics that describes the judgements and approaches made when generating, analysing and disseminating information, including the application of data protection law and use of new technologies. The UK’s Department of Digital, Culture, Media & Sport has issued a framework for data ethics to guide the design of appropriate data use in government and the wider public sector. 3 It provides insight around government expectations and best practices for information management.

Information governance to enable trust

ST OR E, A

Ethics in data processing

■ Is the organisation aware of the full extent of information that has been disclosed, how it is tracked, stored and documented and communicated to data subjects? ■ Which entities control or own data that has been or is regularly shared or sold? ■ How is/was consent obtained? Was the request for consent specific, informed, unambiguous and revocable at any time? ■ Would the data subjects be surprised to learn that their data is being retained forever, or if it was collected in the fi rst place? ■ Are the uses of the data consistent with the intentions that were originally communicated to the data subject?

were intended to secure consent and/or promote transparency. Organisations must ensure that the context of the original basis for data processing (e.g. consent) is respected and have a methodology in place that makes it possible to maintain and track these activities. ■ Beneficial: A tension exists between protecting individuals whilst enabling innovation. Where data-processing activities have a potential to impact individuals, the benefits and potential risks of the data processing activity should be defined, identified and assessed. Th is may be incorporated as part of conducting a data protection impact assessment or an ethical data impact assessment. ■ Fair: Avoid actions that seem inappropriate or might be considered offensive or cause distress. The accuracy and relevancy of data should be regularly reviewed to reduce errors and uncertainty and algorithms should be evaluated for bias or discrimination. ■ Transparent: Corporations need to be accountable for the types of processing activities being done so that expectations of the individuals to whom the data relate and/or the individuals who are impacted by the data use are considered. Also, visibility into a business’s data processing activities is only valuable if the audience can understand what is being shared. Th is means that organisations have a responsibility to explain in an honest, accurate and digestible way how their AI, data algorithms or anonymisation/ pseudonymisation tools work. Decisions made about an individual and the decision-making process should be explainable and reasonable.

as data breaches have proliferated and individuals have increasingly challenged their service providers and employers to protect their data, the dynamic is shifting. There have been countless instances of businesses being publicly accused of discrepancies between their statements and claims around consumer trust and actual practices. Privacy advocates and consumer watchdogs are increasingly raising questions about various businesses and their activities and warn about the dangers of initiatives to assign and monitor consumer trust scores or social credit scores. Technology is further complicating these issues, with advanced data analytics and surveillance tools powered by artificial intelligence (AI) coming into widespread use. To this end, the EU has published an early draft of guidelines for ‘trustworthy’ AI, which is defi ned as having principles that include: do good, do no harm, preserve human agency and operate transparently.

However, because data is so diverse and its application is highly context specific, developing a universal code for data ethics is challenging. Data use in the medical field versus financial services versus criminal investigations will vary widely. Th is is why organisations must develop their own unique, internal data ethics framework, which can encompass compliance with regulatory obligations, such as the General Data Protection Regulation (GDPR), and a balance between the commercial value of their data and its ethical use. Many organisations struggle with creating such a framework and are often stuck without clarity on where to begin. Common questions and considerations that should be evaluated at the outset of this effort include:

DI SP O

MAKING BETTER USE OF CORPORATE DATA Establishing an ethics framework can help organisations stay in control

Business

COM BINE, ANALYSE

Framework developed by FTI Consulting LLP

Spring 2019 | Ethical Boardroom 105

Technology | Managing Data

Understanding the true value of data

Data as an asset is not a new concept, but recent research shows that information is more valuable than ever before and corporations are now looking at the business value of data in new ways. The European Commission has forecast that, by 2020, personalised data will be worth €1trillion, almost eight per cent of the EU’s GDP. The World Economic Forum reported that the ‘global data economy is pegged at $3trillion’.4 Other estimates have 106 Ethical Boardroom | Spring 2019

VALUE

6 Months

1 Year

2 Years

Office Docs ■ Product Research ■

COST-TOVALUE GAP

3 Years

4 Years

Sales/Customer ■ HR ■

COST

RISK-TOVALUE GAP

5 Years

7 Years

Financials ■ Messaging ■

10 Years

15 Years

Developed by CGOC, www.cgoc.com

Some groups have begun to explore valued data at anywhere between 15 and digital ledger, in which transactions are the possibility of a universal ‘Hippocratic 60 per cent of a company’s total worth. recorded chronologically and publicly. In Oath’ for data use. Bloomberg has teamed Th is begs the question, then, what are certain cases, a private blockchain provides up with BrightHive and Data for Democracy we losing by not governing our data? Poor all these benefits, but is visible only between to tackle this, launching the Community data management can undermine value in approved parties and users. It provides a way Principles of Ethical Data Sharing (CPEDS), many ways. Th is can manifest in project to account for and openly track transactions which provides a set of guidelines on delays and high storage, legal review and between approved parties and, because it responsible data sharing and a code of technology costs relating to excessive data is de-centralised and designed for versatility, ethics for data scientists. It is important volumes. Sanctions and reputational damage it is in and of itself typically secure and for businesses to stay abreast of these resulting from data breaches and privacy difficult to alter or compromise. Initially types of developments and explore how violations are additional risks that can result implemented as the technology behind involvement in or adoption of proposed from a lack of holistic IG. cryptocurrency, introduced as a disruptor to principles may work for their business. When making a business case for stronger financial markets, blockchain uses are now Before the advent of data protection laws, privacy, teams should communicate to emerging across a wide range of industries. most organisations took the approach of company leadership the ways in which better Trust, security and transparency are gathering as much data data management can add arguably the most significant benefits as possible and saving value, as well as the ways in blockchain provides. Critical to reaping Technology everything, just in case which a lack of compliance these benefits is for blockchain solutions to advancement and it was needed. Th is is no can damage the bottom be implemented through careful planning the innovative use line. Data-driven business longer acceptable. GDPR and with an organisation’s unique forces corporations to models have created up to workflows, privacy, regulatory and security of data is not the think about the purpose 35 per cent of adjusted gross needs in mind. Like the introduction of any enemy, but it is and intent of data revenue for companies that new technology or system, blockchain use collection in the fi rst place. something that execute well. Conversely, must be vetted across key stakeholders Does it really bring value, Forrester Research within the organisation, to ensure it operates must be managed or is it being collected just estimates that data under existing IG infrastructure. Th is will because it always has been? and addressed in breaches will reach a avoid compliance and privacy pitfalls and Is the organisation storing consolidated cost of help optimise the ability for blockchain order to maintain a $2.1trillion, or 2.2 per cent certain information solutions to enable and nurture trust. healthy ecosystem. of the global GDP, this year. because ‘data is the new The tide of progress will continue to swell oil’? It is important to In 2018, one technology forward, regardless of whether organisations Organisations must weigh the value of the giant lost $120billion in try to resist or ride along with it. Technology engage about how market value following data against the liability advancement and the innovative use of data associated with unlawful is not the enemy, but it is something that to use data ethically data privacy scandals. processing and the risk to Data protection authorities must be managed and addressed in order to the individual. Not all data is of equal value in Europe have begun to issue fines and maintain a healthy ecosystem. Organisations and data depreciates over time. Therefore, penalties for GDPR non-compliance and must engage in transparent, multi-faceted disposal and remediation should be viewed enforcement is expected to ramp up and open dialogue about how to use data as methods to reduce cyber risk, secure steadily in the coming months and years. ethically. Th is will help future-proof their sensitive data and improve the value of business models and ensure they are able to The business case for blockchain enable innovation and act responsibly. analytics (see Figure 2). Over the last couple of years, the viability The heart of IG is to bring together a robust 1 http://www.people-press.org/2017/12/14/public-trust-inand range of blockchain applications have framework that connects stakeholders and government-1958-2017 2https://news.gallup.com/ become clear and the technology has evolved information. The relationship between them poll/1597/confidence-institutions.aspx 3https:\ from a theory to a usable, practical solution is always evolving and, as such, should be assets.publishing.service.gov.uk\government\ uploads\system\uploads\attachment_data\file\ for many enterprise problems. Simply, periodically reviewed and benchmarked to 737137\Data_Ethics_Framework.pdf 4https://www. blockchain is a distributed peer-to-peer keep up with rapidly changing technology weforum.org/agenda/2017/09/the-value-of-data/ and processes. Governance practices need FIGURE 2: INFORMATION GOVERNANCE RISK TO VALUE, CGOC to be holistic and revisited regularly and QUANTITY should be managed by collaboration across RISK IT, legal, privacy, data teams and the C-suite, to ensure ongoing transparent practices for ethical governance.

20 Years TIME

IT Cost ■ Risk ■

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Risk Management | Cybersecurity

Leveraging data at the board level Cybersecurity professionals increasingly rely on data to make better decisions regarding prioritising risks and threats. In addition, directors have become accustomed to using metrics to evaluate business and unit performance and return on particular investments.

Despite these trends in using more data at the board level, directors could better enable their companies in deciding how to focus their cybersecurity priorities by better valuing corporate data. Th is article will review how companies fi nd value in their own data, how that understanding does not always align with the IT security staff â&#x20AC;&#x2122;s own data valuations and how a cybersecurity programme can be strengthened by better leveraging a sophisticated understanding about where business value lies within corporate data.

Valuing data

Every corporation uses data in myriad ways to enable their current business, assess how it is doing and prosper in the future. Increasingly, businesses are using data not only to improve their customersâ&#x20AC;&#x2122; experience, but also share insights of how customers engage with third parties who can glean other information from the same dataset. Managing all of this data is no longer just an information technology or business requirement but a board concern as well. There are two ways data can offer value to a business: through direct monetisation and through better insight on how the business is operating.1 With direct monetisation, companies can sell their data directly to third parties or provide third parties with insights from the data without selling it, for example, through targeted 108 Ethical Boardroom | Spring 2019

Improving cybersecurity outcomes by sharing information across your organisation Evan Sills & Reda Baig

Evan is a Director and Reda, Associate at Good Harbor Security Risk Management

advertising. Data also provides businesses with the information needed to assess their operations and to determine if the policies implemented are bringing value to the company. Assigning exact value to data is challenging. One needs to Managing all determine how much value the data will bring to the company in of this data the short-run and the long-run. is no longer Understanding the value of data within the enterprise is just an recent study conducted critical to deciding how to protect information byAthe Ponemon Institute it. However, assigning value revealed that organisations to particular types of data is a technology are struggling to assign value complex endeavour that changes or business to data and that one business rapidly and its value may depend component is not likely to on the time frame through which it requirement have a good understanding is being viewed. Data classification but a board of the value of other data is its own specialised field and data concern within the business.2 For can be classified according to how instance, IT security rated it is created, what subject matter it as well R&D documents only half as contains and when it was created. valuable as the business unit who owned the Consider these examples. Board minutes, documents. Alternatively, some businesses containing data relating to fi nancial, legal or functions may be highly sensitive to and operational matters, may be highly personally identifiable information (PII) valuable as they are being developed and being breached due to implications for before an earnings call, but the data will be compliance or reputation but may not of much lower value afterwards. Business understand the actual costs of that type of performance data may be highly valuable breach compared to, for example, the loss internally to the company but of little of intellectual property or a ransomware value to outsiders. Research and attack that shuts down operations. development (R&D) data may be of A similar challenge currently exists in relatively low value to the business in society today, as Facebookâ&#x20AC;&#x2122;s Cambridge 2019 but it could be critical in 2021. www.ethicalboardroom.com

Cybersecurity | Risk Management

FINDING VALUE IN BUSINESS DATA Understanding what data is important can guide how it is protected

Analytica relationship illuminated. Private information of citizens may be valued highly by them personally, even if they are willing to share it, but its value to a company and their ability to monetise it may be drastically different. This puts a strain on the business’s ability to adequately secure data when part of its value to the business is to share it with others who may treat the same data differently. It also throws out of balance the short-term value of collecting and monetising data as compared to maintaining the trust between a company and its customers.

The directors’ perspective

Directors play a key role in helping companies value, manage and protect the data they own. These assessments should play an active role in helping the business decide on its overall risk tolerance and business priorities. Raising cybersecurity to the board level has been a repeated mantra for several www.ethicalboardroom.com

years. While directors have gotten more involved, their specific role continues to evolve. Boards increasingly ask sophisticated questions about the organisation’s cybersecurity posture and help set risk tolerance. However, directors should play a larger role in providing a top-level view of different risks and prioritising the protection of particular types of data.

Are we prioritising protection of the right data?

Business functions tend to view the company through their own lens. The counsel’s office will tend to prioritise its own documents and is unlikely to have a strong understanding of research data and business development data but may have a more intuitive understanding of human resources data because it relates to employment law and PII. Meanwhile, the finance office may associate value with how much particular vendors or operations cost. The board can play a key role

in helping executives provide an enterprise lens through which to view all of the data in the company. Additionally, directors tend to have a more distilled view of short- and long-term goals and priorities. Executives and directors are better prepared to evaluate how the company’s cybersecurity capabilities and strengths align with the most important data. Is encryption focussed only on PII because it provides legal benefits, but critical operational data is left less protected? For global companies, cybersecurity capabilities may not be uniform around the world, and gaps may exist in locations that are strategically important to the future growth of the company. Some companies have enterprise risk management programmes that may already be working on some of these issues, but directors sit in a prime position to be assessing the calibration of data assets to security and future growth of the corporation. Spring 2019 | Ethical Boardroom 109

Risk Management | Cybersecurity Questions to ask: ■■ How do we as a company assign value to data? ■■ Do our cybersecurity priorities align with the data that is most correlated to our business priorities? ■■ How does compliance factor into our decisions regarding data protection prioritisation?

Does our cybersecurity plan align with our data value?

Directors are increasingly asked to weigh in on the information security programme within the company. Bringing information security to the boardroom was necessary to raise its profile, increase funding and obtain buy-in from the board on risk decisions being made by the company. While numerous articles have been written about why cybersecurity is important and how it should be treated like other areas of risk by directors, our focus here is on directors providing context and top-level alignment between a company’s data and its information security programme. The automotive industry provides clear examples of some of the choices directors may face. It is clear that autonomous vehicles will play a critical role in the future of the auto industry. However, current operations still require securing vehicles and corporate operations as they exist today. Directors, with their wealth of experience and view atop the company, will have a better sense than a Chief Information Security Officer of how aggressively to pursue securing autonomous vehicles, and whether that must come at the cost of cybersecurity elsewhere in the corporation. For this industry, R&D data may be particularly vital. For any business, it is important to be aware of emerging technologies, and directors can help evaluate how quickly these technologies will cross into the mainstream. Information security teams are tasked with securing current operations and ideally, are brought into future products and service offerings early in their development. However, they are ill-suited to balancing and prioritising operations, improvements, and upgrades that align with the company’s trajectory. Some of this will happen naturally, as budget requests for major improvements are more likely to be approved in areas where the business wants to grow. However, it is not always clear to business operators or Chief Financial Officers whether a new security technology is more suited to one product line versus another. One organisational solution to this challenge has been the rise of BISOs: Business Information Security Officers. These employees, due to their position inside a business unit, have greater insight into the use and value of data for that particular part of the business. However, while this role helps information security grow within the particular business unit, it still lacks 110 Ethical Boardroom | Spring 2019

the whole-of-company perspective that directors can provide. Questions to ask: ■■ How can the company leverage its cybersecurity strategy in a manner that will enable business growth in the future? ■■ What emerging technologies may fundamentally change our business in the future and how do/will they change our risk profile today and in the future? ■■ Does our cybersecurity leadership have the information it needs to understand which of our business operations are most critical and how to secure them?

Are we investing in cybersecurity technologies that align with our business data? One of the challenges of cybersecurity for directors is that it does not succeed or fail independently. It is necessarily tied to the product, network or company it is attempting to protect. This can make it particularly difficult for directors to judge which security technologies are in need of upgrade and make them reliant on the IT security staff pushing for the upgrade.

but also to understand how they may or may not complement future products and services, and the data they will generate. One high-profile area that many companies are currently reviewing is moving data and applications to the Cloud. This is an opportunity for directors to ask about how that move would affect data the company currently stores, and how that will change in the future. Additionally, how your business uses Cloud services should influence the cybersecurity plan, as varying technologies may be needed. 3 Questions to ask: ■■ Are we investing in cybersecurity technologies that we will continue to need in the future? ■■ Are there new areas of cybersecurity that we should be investing in that align with our business plan? ■■ How do geography and changing regulatory landscapes affect our investment decisions? Directors can play a critical role in helping companies understand the data they possess, how it is used, and where the business is

STAYING AHEAD OF THE GAME Directors can take a holistic view of data across the company

For this reason, it is essential that directors receive information about the information security programme, including how individual technologies align to particular risks. In particular, directors should seek information regarding how different technologies work in combination to address risks such as unauthorised access. This can take cybersecurity out of the jargon of the cybersecurity industry and force IT security executives to articulate how the technologies work in the business context. Some tools, such as firewalls, authentication and endpoint protection technologies are important for every company to possess. In addition, businesses should be looking at technologies that align with its data profile. Building familiarity with security tools and metrics is helpful not only to understand what they do and why,

headed. They also can provide a necessary outsider’s perspective on how data is being used and raise privacy and societal concerns that may not be clearly visible in the day-to-day activities of the corporation. Most importantly, the boardroom is where issues that cut across many operational and corporate functions should be raised to ensure that they are properly calibrated to the overall direction of the company. As each corner of the company is busy creating, managing and sharing its own data, it falls to directors to oversee not only the cybersecurity programme, but also how it aligns with the activities taking place within the organisation. https://sloanreview.mit.edu/article/your-data-is-worthmore-than-you-think/ 2“Understanding the Value of Information Assets”, Ponemon Institute, November 3 https://www.forbes.com/sites/julianmitchell/2018/01/31/ how-machine-learning-and-other-tech-trends-will-disruptcyber-security-in-2018/#5b1fbf5f8009 1

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Risk Management | Acquisitions PRIORITISING INTEGRATION A poor compliance culture can leave a business vulnerable to ﬁnancial crime risks

Overcoming culture clashes

Promoting a collaborative approach to transitioning financial crime risk compliance during an acquisition is a key ingredient for success Many years ago, I worked for a large law ﬁrm. One of the ﬁrm’s areas of expertise was corporate mergers and acquisitions. As a junior solicitor, I spent many hours toiling away in due diligence data rooms, reviewing documentation to identify whether a company that a client was targeting for acquisition (target company) had areas of possible regulatory risk.

The types of regulatory risk I reviewed ranged from health and safety, environment and other regulatory requirements, for which a licence or other authorisation was needed. In those days, regulations relating to financial crime were not as developed as they are today and were not seen as being as big a regulatory risk. The findings from these reviews were assessed by partners overseeing the acquisition and were then incorporated. 112 Ethical Boardroom | Spring 2019

Samantha Sheen

Founder and Director of Ex Ante Advisory Services Limited The findings were then incorporated into reports provided to the client and advice given where areas of elevated regulatory risk were identified. The types of risks included were instances where the target company was conducting unauthorised regulated commercial activity, was the subject of a regulatory investigation, or had been fined by a regulator. At that time, my knowledge about the relevance of these findings was limited to what impact they had upon the negotiated purchase price and the conditions and warranties attached to the transaction. Often, those warranties included the seller ‘promising’ that it had disclosed all actual fines and censures imposed on it by a regulator and any pending regulatory investigations that could give rise to future financial liabilities post-acquisition. Fast forward to 2019. These days, due diligence undertaken on target companies is

both more sophisticated and complicated. Regulatory obligations related to detecting and preventing financial crime are a significant consideration. The existence of an appropriate and effective compliance programme to mitigate financial crime risks – an anti-financial crime (AFC) compliance programme – is a crucial part of the due diligence process, along with whether a target company’ activities would violate any AFC regulations the acquiring company’s was required to comply with.

Regulatory compliance basics

It’s fair to say that most businesses are aware of their obligation to comply with financial crime regulations. They range from regulations on anti-money laundering, terrorist financing, bribery and corruption, tax evasion and sanctions. Responsibility for complying with regulatory requirements runs across the ‘three lines of defence’ – the front office, the compliance department and the internal/external audit function. Sitting atop the three lines is the board or an equivalent www.ethicalboardroom.com

Acquisitions | Risk Management body that is responsible for overseeing the implementation of the AFC compliance programme and reviewing material findings of non-compliance with its requirements. Now this, in theory, is relatively straightforward. In practice however, particularly for a business with a global reach, this is an ongoing challenge for which considerable resources in the form of time, people and finances are involved. This can be further complicated when a global business chooses to expand its operational reach by acquiring a business outside of its parent company’s jurisdiction. One of the areas that companies who grow in this way still struggle with is the alignment of compliance cultures between the parent company and the entities they acquire. This, as I have observed, can have a material impact on the effective integration of the parent company’s AFC compliance programme into the existing activities of a target company. More importantly, however, a misalignment of compliance cultures can expose both the parent company and the target company to even greater risks of violating AFC regulations.

Acquisitions and the importance of compliance culture

I conducted a search on the internet and discovered a veritable ocean of articles on how acquisitions should be managed. There is no shortage of advice on how to deal with the logistics, the regulatory transition of licences and authorisations and even the transitioning of staff and technology. But the one area I did not see a great deal of information or advice on was how to successfully transition compliance culture. And yet, when it comes to compliance culture, there is no shortage of cases describing how a poor compliance culture can leave a business vulnerable to financial crime risks from customers and third parties, misconduct by employees and decline in staff morale. I previously wrote an article for this periodical where I touched on this topic. To quickly reiterate, corporate culture – and, in turn, compliance culture – is important because human behaviour is always co-determined by the set of social norms that prevail in a company.1 It is in a company’s interest to shape these norms through a cooperative culture that mobilises employees’ voluntary cooperation in the pursuit of its overall goals.2 But what should be done when a target company has a VERY different culture, to achieve this sort of cooperation?

Compliance culture — trust us, we know better

In my career, I have worked with two companies who were subsequently acquired by another business, with little previous knowledge about the regulatory requirements our business had to comply www.ethicalboardroom.com

with. I also worked with a business where its growth was acquisition-based, having acquired several companies in different jurisdictions. In relation to all three of these experiences, I’ve subsequently identified a common problem that I will to refer to in this article as the ‘trust us, we know better’ or the TUWKB problem. The TUWKB problem happens like this: post-acquisition, the parent company assumes that the target company needs ‘fixing’ in order to be integrated into its group of companies. It assumes, in relation to compliance, that its own AFC compliance programme is effective and appropriate to mitigate the AFC risks of the target company. It also emphasises that its regulator expects it to impose its AFC compliance programme on the target company. The company assumes that employees of the target company will be cooperative and apply the new requirements, regardless of any additional work needed to incorporate them into the daily activities of the business. And lots of representatives from the parent company visit the target company – managers who will now oversee the business, heads of HR, finance, technology and even external consultants hired to advise on post-acquisition transition

When it comes to compliance culture, there is no shortage of cases describing how a poor compliance culture can leave a business vulnerable to financial crime risks from customers and third parties, misconduct by employees and decline in staff morale activities. All make very nice presentations on how things are going to change for the better, emphasise the company’s commitment to the continued success of the target company and undertake ‘listening’ exercises with the target company’s staff about challenges identified by them about the integration. This is then interpreted by the parent company to be a collaborative approach and it then expects the target company’s staff to be fully cooperative and participative in the process. A litany of emails, conference calls and briefing are subsequently undertaken, informing the target company of all the new policies and procedures that must be followed by the target business. This includes the parent company’s AFC compliance programme. Deadlines are imposed on the target company for their implementation and

regular reports are issued to the company’s board, advising them about the progress. The TUWKB approach leads the parent company to believe that cultural concerns have been addressed and that compliance with new requirements will be willingly adopted by the target company staff. The problem? Each time I have watched or taken part in this process, the target company’s staff view this as something happening to them. Compliance staff often complain that their warnings about conflicts with their local AFC regulations and the parent company’s AFC compliance programme are ignored. Other business lines note that products and services rated as high risk under the parent company’s AFC compliance programme are not similarly rated by the target company. Despite attempting to explain the operational impact and additional resources needed as a result of that rating change, no meaningful consideration appears to be given to this impact by the parent company. Most significantly, no consideration appears to be given to whether those changes were suitable for the target business or their potential impact upon that business. The process did little to communicate a compliance culture that would encourage target company staff to cooperate with the implementation of the parent company’s AFC compliance programme’s requirements. And ultimately, there was little buy-in by target company staff for the measures required under the parent company’s AFC compliance programme.

Recent cases and the TUWKB problem

Some recent cases illustrate how the TUWKB problem might contribute towards elevating the risk of AFC regulatory non-compliance by a target company. Earlier in 2019, the USA Office of Foreign Asset Controls (OFAC) and Kollmorgen Corporation – a company based in Radford, Virginia, agreed to pay $13,381, on behalf of its Turkish affiliate, Elsim Elektroteknic Sistemler Sanayi ve Ticaret Anonim Sirketi for apparent violations of the US Iran sanction restrictions. 3 In early 2013, Kollmorgen identified Elsim as possible acquisition target and undertook due diligence before it acquired the business. The due diligence disclosed that Elsim was making sales to, and had customers in, Iran. At that time, Elsim was not subject to the Iran OFAC restrictions and so it did not have an AFC compliance programme in place that restricted undertaking business with Iran.4 But post-acquisition, Elsim would need to introduce the controls used by Kollmorgen to mitigate the risk of violating these restrictions. This also included ceasing to do business in Iran. Kollmorgen determined the target company would also need to be educated on “the applicability of US sanctions”.5 Spring 2019 | Ethical Boardroom 113

Risk Management | Acquisitions Kollmorgen subsequently implemented a wide range of pre- and post-acquisition measures to make sure that Elsim complied with its AFC compliance programme requirements that restricted business with Iran. These measures included:

Applying controls to block Elsim’s Iran-related customers from making future orders Circulating a memo to Elsim employees, telling them not to sell products or services to Iran Conducting in-person training for Elsim’s employees about its AFC compliance programme policies, specifically including Iran Requiring Elsim’s senior management to certify, on a quarterly basis, that no Elsim products or services were being sent or provided to Iran Ordering Elsim’s senior management to immediately cease transactions with Iran Implementing an ethics hotline for reporting violations of law

2 3

4 5 6

Post-acquisition, and in spite of the measures taken by Kollmorgen, Elsim dispatched employees to Iran to fulfil service agreements and engaged in other transactions related to Iran. Elsim serviced machines containing Elsim products located in Iran and provided products, parts, or services valued at $14,867 with knowledge they were destined for Iranian end-users Elsim management threatened to fire employees if they refused to travel to Iran. Upon returning from the service trips in Iran, Elsim employees were directed by Elsim management to falsify corporate records by listing the travel as vacation rather than business related. Over the two years the transactions took place, Elsim management regularly and fraudulently certified to Kollmorgen that no Elsim products or services were being sent to Iran. It was only after an Elsim employee filed an internal complaint with Kollmorgen via the company’s ethics hotline in late October 2015 that the conduct came to light. After these events were uncovered, Kollmorgen took a series of remedial actions designed to rectify the situation, which included: the employment of Elsim 1 Terminating managers responsible for the violations new procedures to 2 Implementing educate Elsim employees on compliance

with US sanctions Requiring Elsim to seek pre-approval from an officer based outside of Turkey for all foreign after-sales service trips Requiring Elsim to inform its major Turkish customers that Elsim cannot provide goods or services to Iran6

114 Ethical Boardroom | Spring 2019

A similar set of facts was also identified in major problem was management style and the recent 2019 case of Stanley Black & Decker, practices or, to put it more broadly, clashes of Inc. (SB&D) and its Chinese subsidiary Jiangsu corporate culture.9 The two cases I have noted above illustrate Guoqiang Tools Co (GQ), for an amount of the impact that failed integration efforts roughly $1.9million for apparent violations, around compliance programmes can have again, of US sanctions against Iran.7 In 2011, SB&D planned to acquire a when undertaken with a one-sided approach. controlling interest in the shares of GQ and The TUWKB problem can create unintended undertook pre-acquisition due diligence. consequences, which can have the effect of SB&D discovered that GQ was exporting actually increasing regulatory risk, rather goods to Iran.8 SB&D took steps to stop GQ’s than mitigating it. Most articles I reviewed sales to Iran prior to the acquisition so that for this piece on acquisitions describe post-acquisition, its activities would be in measures that should be taken to the target compliance with SB&D’s AFC compliance business or imposed enhanced monitoring programme and, in particular, its prohibition on that business. Checklists and change on undertaking business with Iran. For management processes around regulatory example, GQ senior management was required compliance read as if the goal is to bend the to sign agreements stating that they would not target company to accede to the will of the engage in further transactions with Iran. acquiring business. Again, shades of the Following its acquisition of GQ, SB&D TUWKB problem. conducted sanctions and export compliance My sense in the two cases I have training with GQ. The extent of that training summarised was that the TUWKB problem included, in early August 2013, arranging for an SB&D China employee to review SB&D’s sanction compliance policies and procedures with GQ’s manager by telephone. After this one training session, the GQ manager was expected to provide the same training to her team within GQ. However, SB&D did not implement procedures to monitor or audit GQ’s operations to ensure that the sales to Iran had in fact stopped. Between June 2013 and December 2014, GQ exported or attempted to export 23 shipments of power tools and spare parts to Iran with a total value of more than $3.2million. After learning about Business growth the continuing violations, by way of SB&D conducted an internal investigation and discovered acquisition will that GQ employees had sought continue to take to hide its continuing export activity to Iran by using six place on a global trading companies (four United scale. So too will Arab Emirates companies and the AFC regulatory two Chinese companies) and arose there as well. Even fake bills of lading with incorrect landscape and the the remedial measures ports of discharge and places of undertaken and later delivery, to conceal its activities. scope of controls agreed with OFAC are In addition to the fine, SB&D and restrictions one sided, save for the and GQ agreed to implement imposed by them one measure noted in a series of compliance the SB&D case where the procedures to reduce the risk of culture was identified as a responsibility of reoccurrence of similar violations and both the parent company and GQ. promote a ‘culture of compliance’. Promoting a collaborative approach to Clash of compliance cultures identifying AFC compliance programme and the TUWKB problem challenges involved in integrating a parent According to a management survey company’s policies and procedures might go a undertaken by the British Institute of long way towards cultivating cooperation and Management, one of the most important engagement by a target company. A study by reasons for acquisition failures is ‘the behavioural economist Ernst Fehr found that underestimation of difficulties of merging the average willingness to cooperate and the two cultures’ while a study undertaken by awareness of the positive side effects of a large Coopers & Lybrand indicates that 85 per cent group-wide project can help to change the of the executives from 100 companies with culture for the better.10 Fehr also found that if the average willingness to cooperate is low failed or troubled mergers, said that the www.ethicalboardroom.com

Acquisitions | Risk Management and employees have little awareness of the gains from cooperation, a more thorough set of measures that combine communication campaigns with changes in normative prescriptions and financial incentives for cooperation was necessary to achieve the desired change.11 In this study, Fehr looked at a large organisation in Germany that had acquired a number of smaller businesses. The smaller businesses were able to pursue their own local business strategies. Fehr looked at what happened when the parent company wanted the local businesses to cooperate on a project that would increase revenues for the parent company, but drive business away from the local business in doing so. Fehr found that the acquired local businesses identified ways to formally implement the parent company’s project, and thus appear to be compliant, but did not really embrace those changes as part of their activities so as to actually be

Fehr’s observations around cooperation and the ingredients for a conducive corporate culture apply equally to compliance. In both the cases above, it was clear that while the significance of the sanctions’ restrictions were emphasised, the willingness to cooperate with the restrictions imposed was very low. When I read these cases I wondered: how were the acquired businesses expected to make up or replace the revenues they once generated from their business in Iran? How much time were they given to secure business in order to replace that revenue? What support was offered by the acquiring business to achieve this? I also wondered whether the nature of the training offered played a factor. Given the global scale of the sanctions that have been imposed on Iran, the problem was likely not the level of knowledge in both of these target companies. Both of these cases identified orchestrated efforts to circumvent sanction

compliance programme controls and to show them the mutual gains from cooperation The parent company and the target company management should work collaboratively to formulate a joint agreement where they define a new set of very specific appropriate behaviours to solve the cooperation problem, and each manager individually signs this agreement13 Include in any agreement how the managers will communicate with one another about the progress of integrating the parent company’s AFC compliance programmes, and the challenges experienced, as an ongoing process All managers agree to enforce the restrictions under the AFC compliance programmes at their respective companies i.e. ‘We will give direct feedback to those employees who do not comply’ Undertake an information campaign informing all employees of the new compliance requirements, at both the parent and target company. This should be undertaken by management at both companies and not solely the parent company Change financial incentives to ensure that all areas of the business comply with the AFC compliance programmes. Tie remuneration to the overall performance of the company group, instead of tying it to local operations, which may be significantly impeded by the new restrictions imposed by the parent company’s AFC compliance programmes Challenge confidence levels – this is my own addition. The board is key to challenging the confidence that an acquisition team has in the changes they propose to integrate an AFC compliance programme into a target company. In the cases noted above, why were the team confident to proceed with the deals knowing that the risk of violating the Iran sanctions existed? Why were the teams confident that the controls proposed (e.g. having managers sign agreements to comply with the new controls and not undertake business with Iran) would, at a practical level, work to mitigate this risk?

4 5 6

CULTIVATING COOPERATION Both parties in an acquistion should look to ensuring AFC compliance

compliant and meet the parent company’s desired objective.12 What was needed was the voluntary, proactive, cooperation of the local businesses but, instead, the way in which their cooperation was sought was only perfunctory. The need to ensure that an initiative is both clearly communicated, but also is genuinely collaborative and shared as an objective, is the key to success. The sanctions cases I mention above were used by the regulator to reinforce the importance of post-acquisition monitoring to ensure that they are applying compliance controls as required. But I think that we are missing a trick here if we fail to acknowledge that the TUWKB problem has also played a role in, at times, distracting acquiring firms from understanding the significance of compliance culture and investing the resources necessary to mitigate the potential risks post-acquisition. www.ethicalboardroom.com

restrictions and conceal those activities. What sort of training, if any, would have achieved the desired outcome in these cases – i.e. achieving buy-in that the loss of business with Iran was far outweighed by applying the acquiring business’ compliance controls prohibiting it? How seriously were target company employees going to take SB&D AML compliance training or buy-in to cooperating in observing these restrictions, when it was undertaken with one employee over the telephone? This article is intended to provide some food for thought and ask the reader to consider whether they have experienced the TUWKB problem. Fehr provides some helpful advice, which I have paraphrased here, that I think might help to solve this problem:

Make target company managers aware of the benefits to applying the AML

Conclusion

Business growth by way of acquisition will continue to take place on a global scale. So too will the AFC regulatory landscape and the scope of controls and restrictions imposed by them. The integration of an AFC compliance programme may involve many different policies and procedures, and cause pain and disruption to a target company’s operations. But unless that integration strategy starts with a campaign to ensure that the right compliance culture is introduced and avoids the TUWKB problem, real and worthwhile cooperation with and implementation of the AFC compliance programme may prove elusive and, in some cases, costly. Footnotes for the article will be published in full online.

Spring 2019 | Ethical Boardroom 115

Risk Management | Anti-Money Laundering

Paradise lost or a money laundering paradise? The role of board of directors in preventing money laundering within European banks. Sven Stumbauer

Globally recognised ﬁnancial crimes expert

The first quarter of 2019 and most of 2018 were marked by an uptick in money laundering scandals. More surprising is the fact that it has been more than three years after the Panama Papers scandal made headlines. Offshore secrecy and the use of offshore structures, which dominated the banking clientele in the Baltics (so-called non-resident clients), should have been at the forefront of all board of directors’ minds globally, but especially those with a large non-resident customer basis.

Notwithstanding the number of articles written in the press about banks being involved in these scandals, one must wonder why boards of directors have not questioned management more proactively, conducted internal investigations to determine their 116 Ethical Boardroom | Spring 2019

exposure to ongoing and anticipated scandals and developed contingency plans in case of shareholder and regulatory inquiries. It seems, however, that board members at some banks have adopted a ‘head in the sand’ approach, rather than actively managing the crisis that not only comes with reputational issues but also adversely impacts shareholders – as evident in the decline of share prices at some European financial institutions.

The irreparable cost of inaction Since the release of the Panama Papers and the broad coverage received in the media, financial institutions around the world would have been well advised to review their current client portfolios and determine their exposure not only to entities revealed through the Papers but also to their client portfolios in general.

While an offshore structure, such as a personal investment company or trust, may not itself be indicative of illicit activity, some shell companies and other complex structures cited in the Panama Papers have been accused of being used as vehicles for money laundering, payments of bribes, tax evasion and other illicit activities in the past. These structures, which tend to lack transparency in formation and operation, can provide an opportunity for entities to move money without having to disclose their true identities or the nature or purpose of the transactions. The use of offshore accounts www.ethicalboardroom.com

Anti-Money Laundering | Risk Management OFFSHORE SCHEMES These involve layers of anonymously held shell companies and unregistered trusts

highlights why financial institutions need to have adequate controls and procedures in place. It has become increasingly important that institutions review their accounts with a holistic view to quantify their exposure and risk, and determine with whom they are ultimately doing business and that the activity involving such accounts is consistent with previous due diligence. Some financial institutions considered taking prompt action and among other things: ■■ Determined whether Panamanian or other offshore structures held at the institution and, depending on the level of their respective exposure, conducted appropriate internal investigations ■■ Reviewed and, if necessary, revised customer due diligence, effectively performing a ‘true-up’ of the know-your-customer (KYC) information collected and the due diligence conducted ■■ Depending on their risk appetite, exposure determined, exited certain relationships or ‘de-risked’ their relationships with other financial institutions known to maintain relationships not consummate with their risk appetite However, as the recent money laundering scandals in the Baltics and Scandinavia point to, not all financial institutions asked themselves whether their current clients should be seen as ‘friends, foes, or enemy within’. Those financial institutions are now paying the price for past inactions, since as reporting on certain regions and banks intensifies, it is becoming harder for management and boards of directors to properly respond to media reports, regulatory www.ethicalboardroom.com

inquiries and probes, and management and boards are finding themselves in the peculiar situation of no longer being in charge of their destiny. They are now discovering that ‘a penny of prevention is worth a pound of cure’ holds true.

Missed warning signs

For the past decade, numerous headlines and enforcement actions showed increased scrutiny of regulatory bodies, particularly of US regulators, on financial institutions’ boards of directors and senior management for failing to correct alleged compliance shortcomings. As a result, the issues of individual accountability for anti-money laundering (AML) violations continued to gain traction. Board involvement plays an important role in the adoption and implementation of effective enterprise-wide AML compliance programmes. Several regulatory enforcement actions in the past decade have called for the establishment of AML compliance committees composed of outside directors and direct oversight of boards of directors in remedial efforts, as well as the hiring of so-called ‘independent compliance monitors’. Actions have also held board members personally accountable for financial institutions’ lack of compliance and, in some cases, have resulted in exposure to shareholder litigation risk, due to a decline in shareholder value.

Tone at the top

Tone at the top remains as vital as ever in preventing and detecting wrongdoing. It remains one of the main ingredients that can make or break an AML compliance programme. Ultimately, the responsibility for

establishing a financial institution’s strategic vision rests with the board of directors and senior management. As part of that vision, it is vital that financial institutions establish AML risk compliance tolerances, but also a deep understanding of risk exposure. This also includes establishing proper incentives – including compensation measures – to meet needed goals. Under current US regulations of both the Bank Secrecy Act and the USA PATRIOT Act of 2001, the board of directors of a financial institution is required to approve an enterprise-wide AML compliance programme that, at a minimum, includes the following:1 ■■ Policies, procedures and controls that mitigate the institution’s money laundering risks ■■ A designated AML-compliance officer with sufficient, board-conferred authority across the institution to implement the mitigating policies, procedures and controls ■■ Ongoing and adequate training for employees of the institution ■■ Ongoing independent testing and auditing However, in order to comply with more than just the technical regulatory requirements, a board should, on an ongoing basis, consider that it is also ultimately responsible for the financial institution’s AML compliance efforts as executed by management and should on an ongoing basis question management’s effort in this area. Similarly, the board should be responsible for establishing a culture of compliance that serves (1) to reduce the risk of potential regulatory action based on lack of board oversight and (2) to minimise shareholder litigation risk. Spring 2019 | Ethical Boardroom 117

Risk Management Perhaps it is not surprising, then, that in August 2014, the US Department of the Treasury’s Financial Crimes Enforcement Network (FinCEN) issued an advisory on this topic.2 One observation from the FinCEN advisory is that it has become particularly important that senior management and board members at financial institutions of all sizes maintain strong cultures of compliance. The FinCEN advisory pinpoints several deficiencies that were identified in recent AML-related enforcement actions that offer important insights for financial institutions and their management and boards. In particular, it reaffirms the notion that a financial institution can improve AML compliance culture by ensuring the following elements exist: ■■ Leadership is engaged ■■ Compliance is not compromised by revenue interests ■■ Information is shared throughout the organisation ■■ Leadership provides adequate human and technological resources ■■ The compliance programme is effective and has been tested by an independent and competent party ■■ Both leadership and management understand how their various AML reports are used While the FinCEN advisory sent a strong message to financial institutions – namely, that an entire organisation, from staff to board members, may be held accountable AML compliance failures – perhaps, more importantly, the advisory was intended to serve as a reminder of the importance for institutions to conduct reviews of their AML engagements of senior management and boards of directors to learn whether those engagements adhere only to the strict interpretation of the letter of the law or whether a true culture of compliance is in place. While at the time the advisory did not contain any specific new guidance that has not been promulgated previously in speeches or enforcement actions, industry practitioners considered this advisory a ‘warning shot over the bow’ to many financial institutions that senior management and boards will be held accountable to a larger degree than historically.

Tone at the top is not enough!

There is virtually no financial institution that would not claim to be compliant with AML rules and regulations in their particular jurisdiction. However, while setting the right tone at the top is important, regulatory bodies will not only consider the tone at the top, but actions taken from the top in their consideration of both whether to sanction a financial institution, or the severity of monetary and non-monetary sanctions, such 118 Ethical Boardroom | Spring 2019

TAKING MATTERS MORE SERIOUSLY Some companies are investing more in AML compliance programmes

as the appointment of an independent monitor. Boards and senior management should set the tone for their organisations by creating a culture of compliance. On the other hand, if compliance officers are bootstrapped and cannot obtain adequate support and resources, then it’s likely that the financial institution’s leadership is not seriously engaged in AML compliance and tone can become lip service. Boards of directors should keep in mind that they have a duty to ensure that their financial institutions reach not only their financial goals but also their regulatory compliance and corporate governance goals. Considering recent enforcement actions, in which certain AML compliance officers were personally sanctioned and other scandals surrounding financial institutions led to the resignation of CEOs and board members, senior management teams and boards of directors should deepen their involvement in AML efforts rather than employing a check-the-box mindset.

Lack of war games and contingency planning

While most financial institutions globally conduct some form of an AML risk assessment, focussed on customers, products and different lines of businesses, few financial institutions consider ‘regulatory or enforcement risk’ as part of their risk assessment and even fewer ‘pressure’ test their AML compliance programmes or conduct ‘war games’ for ‘what if’ scenarios. Historically, many financial institutions

believed that de-risking, or exiting certain relationships was seen as a quick fix to, hopefully, address concerns and/or historical non-compliance by simply exiting customers. De-risking over the years, however, introduced a significant level of opacity and lack of transparency into the global financial system, since the termination of relationships forced entities and individuals into less-regulated/unregulated channels or to conduct business with financial institutions whose levels of AML compliance were not top of mind of senior management, but business trumped any compliance concerns. De-risking, contrary to the term itself, for some financial institutions actually created greater challenges in adequately identifying AML risks, by adding an intermediary layer between themselves and the de-risked customer, hoping for safe harbour as business continued, albeit through one or more additional layers between themselves and the ultimate customer. Probably the most notable example can be found in the notice of proposed rulemaking (NPRM) issued by FinCEN on 13 February 2018 for ABLV Bank. 3 ABLV Bank at the time of the NPRM did not maintain direct US correspondent relationships with financial institutions, but through nested and indirect relationships, the bank was still able to execute US dollar transactions that were potentially not being recognised as being ABLV’s transactions, or were not given the required attention such transactions should have received. According to FinCEN’s NPRM: “ABLV www.ethicalboardroom.com

Anti-Money Laundering | Risk Management regulations. The bank proactively pushes money laundering and regulatory circumvention schemes to its client base and ensures that fraudulent documentation produced to support financial schemes, some of which is produced by bank employees. In 2014, ABLV was involved in the theft of over $1billion in assets from three Moldovan banks, BC Unibank S.A., Banca Sociala S.A. and Banca de Economii S.A., in which criminals took over the three Moldovan banks using a non-transparent ownership structure, partly financed by loans from offshore entities banking at ABLV. Separately, ABLV previously developed a scheme to assist customers in circumventing foreign currency controls, in which the bank disguised illegal currency trades as international trade transactions using fraudulent documentation and shell company accounts.”4 Despite complying with the proposed prohibition on covered financial institutions from opening or maintaining correspondent accounts AML compliance in the US for ABLV Bank, remains a significant financial institutions globally with prior exposure challenge for ABLV Bank, should financial institutions to have deployed their contingency plan for globally, with executives, shareholders preparedness and notable differences regulatory and employees have response, assuming such a between regions institutionalised money plan existed, which based laundering as a pillar of on press reports over the past the bank’s business practices. ABLV 12 months do not seem commonplace. 5 Most financial institutions have management orchestrates and permits the contingency plans in place for data intrusion, bank and its employees to engage in money Ponzi schemes, natural disasters, health laundering schemes. Management solicits the pandemic emergencies, branch robberies, high-risk shell company activity that enables terror threats and attacks, cyberattacks and the bank and its customers to launder funds, other risk to their continued operations. But maintains inadequate controls over high-risk very few have sensible contingency and action shell company accounts and is complicit in plans as in the place for significant regulatory the circumvention of AML/CFT controls at events, like in the case of ABLV Bank, or the bank. As a result, multiple actors have money laundering scandals, causing delayed, exploited the bank in furtherance of illicit if any, response, or premature statements financial activity, including transactions for by CEOs that no issues exist, often leading to parties connected to US and UN- designated a further escalation of the actual problems. entities, some of which are involved in North Boards and senior management should Korea’s procurement or export of ballistic consider, at a minimum, adopting robust missiles. In addition, ABLV management plans to react adequately and in an organised seeks to obstruct enforcement of Latvian way to regulatory events or events. such as AML/CFT rules. the Panama Papers or the NPRM of FinCEN “Through 2017, ABLV executives and regarding ABLV Bank. Such plans should, management have used bribery to influence at a minimum consider the following: Latvian officials when challenging enforcement actions and perceived threats ■ Qualified internal and external resources to their high-risk business. ABLV’s business are available in case of a particular practices enable the provision of financial event to conduct a very robust internal services to clients seeking to evade financial investigation to determine our exposure regulatory requirements. Bank executives ■ Risk exposures previously identified and employees are complicit in their clients’ internally and thought off as having been illicit financial activities, including money adequately covered by internal controls laundering and the use of shell companies to ■ Response to regulatory bodies conceal the true nature of illicit transactions and the production of records and the identities of those responsible. ABLV subsequently requested is considered innovative and forward leaning ■ Response to shareholders in its approaches to circumventing financial www.ethicalboardroom.com

■ Response to media inquiries and media management However, most as common with plans, most situations generally do not go according to plan and financial institutions should consider alternate measures, along with pressure testing existing plans that may be in place through the use of war games/what-if scenarios, to determine the potentially worst outcome for the financial institution and to develop potential methods by which they may mitigate any adverse impact on the financial institution.

The future

AML compliance remains a significant challenge for financial institutions globally, with notable differences between regions. As financial institutions become more complex and more interconnected across jurisdictions and as rules and regulations continue to evolve and the enforcement of those rules and regulations is being taken more seriously by various regulatory bodies, financial institutions will need to devote considerable resources to AML compliance matters, both for their ongoing operations, and for contingency planning purposes. Some boards appear to be taking AML compliance matters more seriously and are investing significant resources in the design and implementation of policies, procedures, systems, controls and training that will enable them to meet their compliance requirements more efficiently and cost-effectively. However, based on historical enforcement differences and/or the lack of comprehensive rules and regulations in parts of the world historically, we may conclude that boards at some financial institutions are not yet fully engaged and senior management is playing catch-up in some areas. The race to keep up with differing compliance standards has redrawn the competitive landscape for banks. Those that can get AML compliance right will undoubtedly emerge as winners in the increasingly global competitive landscape, while those banks that continue relying on solely strict legal interpretation of rules and regulations and/or past inaction of regulatory bodies, might find themselves in the limelight of the popular press, followed by severely intensified regulatory scrutiny, prosecution efforts and the lack of correspondent relationships in the future as their counterparties ‘de-risk’ too risky relationships. Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act 2FIN-2014-A007 - https://www.fincen. gov/resources/advisories/fincen-advisory-fin-2014-a007 3 FinCEN Names ABLV Bank of Latvia an Institution of Primary Money Laundering Concern and Proposes Section 311 Special Measure 4https://www.fincen.gov/ news/news-releases/fincen-names-ablv-bank-latviainstitution-primary-money-laundering-concern-and 5 As defined by Section 312 of the USA PATRIOT Act 1

Spring 2019 | Ethical Boardroom 119

Global News Europe Bayer investors rebuke board Shareholders have slammed Bayer chief executive Werner Baumann (right), venting their anger over the company’s stock price slump and mounting litigation risks. The German drugmaker’s $63billion takeover of US seeds and pesticides maker Monsanto has seen €30billion wiped off Bayer’s market value since August 2018. Bayer also faces 13,400 lawsuits claiming that Monsanto’s Roundup weedkiller causes cancer. Fifty-five per cent of shareholders have refused to endorse management’s actions in the past year, indicating that investors lack confidence in how the company is being run. Deutsche Bank’s asset managing arm DWS said shareholders should have been consulted before the takeover, which was agreed in 2016 and closed in June last year.

Legal & General wants more gender diversity Legal & General Investment Management (LGIM), the UK’s largest money manager, has pledged to be more active in ensuring boards are more diverse. Last year, the £1trillion fund manager voted against 100 board chairs because of a lack of women at senior level, more than double the figure for the previous year and a large jump from just 13 in 2016. Helena Morrissey, LGIM’s head of personal investing, said: “Frankly, it’s disappointing that we continue to have to make our voices heard as investors by voting against so many chairs on diversity issue, but we are not going to go away.” “LGIM will continue to be active on this issue until we see boards protecting companies from ‘groupthink’ by becoming more diverse.” LGIM also said it was prepared to use its UK pension fund investments to take action on climate change.

Boardrooms focus on digital tax Making Tax Digital (MTD) for VAT, the UK government’s initiative for digitising the tax system, has seen an increase in attention on tax compliance and planning at the board level, a survey has found. Seventy-six per cent of senior tax executives have seen an increase in attention on tax compliance and planning in boardrooms, according to the Thomson Reuters 2019 Tax Technology Survey. Steven Smith, propositions lead in Europe for Thomson Reuters, said: “Tax affairs are now being scrutinised in terms of investor relations and share price and there is evidence that forecasting on tax is increasingly becoming a forethought rather than an afterthought.” “MTD for VAT is the UK’s focus, but this is following in the wake of digital initiatives in Spain, Portugal, Poland and with more countries following, including Germany and Norway.”

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Shake-up of UK corporate register Companies House is to gain new powers to tackle criminal misuse of the corporate register and better protect the personal data of business owners. The reforms will ‘support the fight against the use of dirty money in the UK and enhance the protections for entrepreneurs and directors from criminal activity’. Under the new proposals, officials at Companies House will have more powers to verify details on directors by cross-checking with other government agencies. Limits are also set to be imposed on the number of directorships an individual can hold, while the consultation will also consider identity verification for larger shareholders.

UBS shareholders revolt against managers UBS Group shareholders have refused to endorse the performance of the Swiss bank’s leadership following a €4.5billion tax evasion fine. The bank was hit with the fine after being found guilty of money laundering and helping rich French clients avoid paying tax. UBS has strongly denied any wrongdoing and has launched an appeal. However, a vote to release directors and executives from liability failed to get the 50 per cent needed at the bank’s annual general meeting in May. The last time UBS investors refused to back executives was in 2010, after the bank ran up massive losses during the financial crisis. While the vote has no immediate consequences, experts say the move could help shareholders in any potential lawsuits against the bank.

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Regulatory & Compliance | Whistleblowing

Whistleblower protection in the digital age Executives who witness fraud should pay attention to governing rules Stephen M. Kohn

Partner at Kohn, Kohn and Colapinto, Chairman at whistleblowers.org

Whistleblower protection has radically changed in the US over the past 15 years. Top corporate officials, including all directors, officers and compliance managers, can (and have) blown the whistle directly to government regulators. They can do so confidentially or anonymously on potential violations related to corporate fraud, money laundering or violations of the Foreign Corrupt Practices Act. Nondisclosure agreements cannot prevent this whistleblowing. Even information classified as a ‘trade secret’ can be reported to law enforcement investigators. Not only are these types of disclosures protected, those who provide ‘original information’ in accordance with the rules of the Internal Revenue Service (IRS), Securities and Exchange Commission (SEC) or Department of Justice (DOJ) can qualify for multimillion-dollar rewards. Under the new whistleblower laws, compensation can be paid without any public notice and neither the public nor the whistleblower’s employers have a right to learn their identity. This is all radically different from the whistleblowing depicted in popular culture. It has nothing to do with employee grievances or the stealing of national security secrets. Done correctly, an employer never learns the identity of the whistleblowers and, thus, traditional employment retaliation cases become relics of a time when whistleblowers lacked safe, confidential and effective reporting mechanisms. These changes need to be embraced, not opposed. The issue is no longer the 122 Ethical Boardroom | Spring 2019

whistleblower, but whether a company will tolerate criminal activity in order to profit. Turning a blind eye to corruption can have disastrous consequences. Unquestionably, the new whistleblower laws have been very effective in enabling the government to detect otherwise well-hidden frauds. As employees learn of the opportunity to blow the whistle safely and effectively, the impact of these laws will expand. The effectiveness of these laws is already a matter of public record.1 As understood by the former chairman of the SEC, they are our best hope in ending widespread corporate fraud, incentivising companies to have effective and independent compliance programmes and ensuring that honest companies that do not cheat the market can compete with those who want to break the law for profit.2 Trying to silence whistleblowers is the biggest mistake any corporate executive can make. It can constitute a criminal obstruction justice.3 Retaliation will drive honest employees away from internal corporate compliance programmes and into confidential government programmes, where the whistleblowers can be effective informants to the DOJ, IRS or SEC. As an attorney who has worked on corporate fraud cases years before the enactment of the Sarbanes-Oxley Act (SOX), the progress of these whistleblower protections was logical and absolutely necessary. Here is how we got where we are. Prior to the collapse of ENRON and WorldCom, employees on Wall Street had no effective whistleblower protections. There was no federal law covering employees who reported securities frauds and the handful of cases filed under state law were forced to arbitrate their employment disputes in pro-employer forums. The fact that there were highly credible whistleblowers at both WorldCom and ENRON – two of whom were named by Time Magazine as #Persons of the Year in 2002 – triggered a change in public attitudes toward whistleblowers. Senators Patrick Leahy (D-Vermont) and Chuck Grassley (R-Iowa) obtained unanimous bi-partisan support for the first securities fraud whistleblower law, www.ethicalboardroom.com

Whistleblowing | Regulatory & Compliance

KEEPING FRAUD WITNESSES SAFE Everyone should be given protection to report corruption

approved as an amendment to SOX. Additionally, the then chair of the House Judiciary Committee, Rep. Jim Sensenbrenner (R-Wisconsin), successfully included another amendment to the law. It made economic, job-related retaliation against ‘any person’ who reported, in good faith, possible crimes to any federal law enforcement official, a felony, subjecting the retaliator to up to 10 years in prison. This also passed. Under SOX, employee whistleblowers were promised job protection. Their reports to internal compliance programmes were also fully protected. A strong message was sent, but corporate behaviour did not change. Companies were very effective in undermining these reforms. Instead of embracing the reforms mandated by Congress, in case after case corporations used every legal trick to defeat the whistleblowers. They tried to exempt subsidiaries or mutual fund companies from coverage, they successfully narrowed the scope of protected disclosures, they forced employees to arbitrate their cases in pro-employer forums and they were highly successful in defeating the vast majority of whistleblower claims. Thousands of employees who relied upon SOX lost their jobs. In regard to compliance programmes, companies also tried to work around the new procedures that protected internal whistleblowers. The most common tactic was to have compliance programmes report ultimately to the company’s General Counsel. Under Supreme Court precedent, corporations worked to ensure that whistleblower disclosures to attorneysupervised compliance programmes were covered under a corporate attorney-client privilege, giving the company an option to keep the whistleblower information secret and open confidential investigations on those who made the reports.4 All in all, the fi rst go-around with SOX was a failure. The overwhelming majority of employees who fi led claims lost. But, in hindsight, the failure of corporate executives to embrace and enhance the SOX reforms was a massive mistake.

Reform failures

Between 2002 to 2008, whatever trust may have been forged between corporate management and employee whistleblowers, as had been envisioned by Congress as part of the SOX reforms, was lost. The 2008 financial crisis laid bare these failures, both in terms of the protections afforded under law and the abysmal failure of Wall Street to change its anti-whistleblower culture. Thus, it is not surprising that when Congress again looked at Wall Street reforms in 2009 and

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2010, the failure of the whistleblower programmes was one of the major topics revisited. As part of discussions leading to the Dodd-Frank Act reforms, this author discussed the whistleblower laws with representatives from the Senate Banking Committee.5 The views of these congressional staff members were clear – if an employee is ever known to be a whistleblower, their career on Wall Street is over. The committee staff, had clearly reviewed the history behind SOX and most likely interviewed numerous employees, were emphatic as to their opinion as to how whistleblowers were treated by corporate executives. The heart of the Dodd-Frank Act’s Wall Street reforms directly confronted the reality that employees who worked in financial services faced and the failures of SOX. The reforms were numerous: ■ SOX itself was reformed. Jury trials were guaranteed, mandatory arbitration was prohibited and subsidiaries were directly covered ■ Anonymous whistleblowing was permitted under the Securities and Commodity Exchange Acts ■ Qui tam rewards were made available to whistleblowers whose information resulted in an enforcement action in which the SEC or CFTC obtained sanctions of more than $1million ■ The definition of a whistleblower was changed from an ‘employee’ to ‘any individual with original information’ After Dodd-Frank was enacted, a rulemaking battle erupted within the SEC. Corporations wanted to limit the rights of their executives or compliance officials to blow the whistle. Rules were proposed that would have blocked the ability of directors, officers, trustees, partners, audit committee members or chief compliance officers to benefit from the new reforms. Instead of embracing change, or creating a culture that would encourage whistleblowing, every major corporation and trade association that weighed in on the new Dodd-Frank rulemaking proceedings wanted to limit the scope of the law and block all executives from qualifying as whistleblowers entitled to a reward. Not surprisingly, those efforts failed. The statutory definition of a whistleblower as meaning ‘any individual’ could not be squared with the efforts to strip entire classes of ‘individuals’ from coverage. At the end of the day, under intense pressure from Wall Street, the SEC reached a compromise on executive whistleblowing. Officers, partners and directors of corporations and other employees who had a fiduciary duty to prevent fraud were given a qualified right to blow the whistle to the government and obtain a monetary reward.6 Spring 2019 | Ethical Boardroom 123

Regulatory & Compliance | Whistleblowing The rules governing executive whistleblowing are simple. If a company engaged in retaliation or if a fraud is very large, executives can immediately report those violations confidentially or anonymously to the SEC and qualify for a reward. Moreover, if a company is informed of a fraud, but fails to self-report that fraud to the SEC within 120 days, any executive and/or individual employed in a compliance capacity can report those issues to the government, anonymously and confidentially and obtain a monetary reward. Under the IRS programme, there is no waiting period whatsoever and executives can immediately report tax frauds and money laundering violations to the IRS. The ability to report violations anonymously and confidentially has made it possible for high-ranking executives to safely blow the whistle to the SEC, IRS and the Commodity Futures Trading Commission (CFTC). Moreover, although the IRS does not permit anonymous whistleblowing, its rules providing near iron-clad confidentiality protections are, in many ways, even stronger then the SEC and CFTC requirements. Executives are taking advantage of these new options. And they should. There is no reason for any employee, including an executive vice president, a CFO, a chief compliance officer, or a member of the board of directors of a publicly traded company, to ignore the new whistleblower rules. If a company is profiting from illegal activities, such as fraud, money laundering or foreign bribery, there is a realistic and effective avenue to report these crimes and qualify for monetary rewards. In FY 2018, the IRS reported that whistleblowers triggered the collection of more than $1.4billion in criminal fines, civil forfeitures and reporting violations7 and 217 whistleblowers received a total of $312,207,590 in rewards. Other programmes were similarly successful. Under the securities commodities and government fraud/qui tam reward programmes, billions upon billions of dollars in frauds were recovered and whistleblowers obtained $301,728,654 under the False Claims Act programme, $160million under the SEC programme and another $75million under the CFTC programme.8 All in all, in FY 2018 whistleblowers who reported original information that resulted in actual collection of sanctions from fraudsters obtained more than $856million in awards.

Disappointing response

In the face of this unprecedented success in whistleblowing, what was the response of major corporations and the Chamber of Commerce? As incredible as it may seem, the Chamber of Commerce, claiming to represent ‘three million companies and 124 Ethical Boardroom | Spring 2019

professional organisations’ argued before the Supreme Court that employees who reported frauds internally to their companies were not protected as whistleblowers under the Dodd-Frank Act. The Chamber pointed favourably to cases in which employees who reported to the Audit Committee, the General Counsel and the Chief Compliance Officers and were fi red.9 Th is is worth repeating. The Chamber of Commerce and its corporate allies, argued successfully to the Supreme Court that employees who wanted to be protected as whistleblowers under the Dodd-Frank Act, were required to bypass internal reporting structures and report their concerns directly to the SEC in order to be protected from retaliation under the Dodd-Frank Act.

The rules governing executive whistleblowing are simple. If a company engaged in retaliation or if a fraud is very large, executives can immediately report those violations confidentially or anonymously to the SEC and qualify for a reward These arguments should have been condemned by every responsible corporation in the United States. Corporations should have defended their internal reporting structures and compliance programmes and demanded that the Supreme Court protect employees who reported internally. But not one corporation made this argument. Although this silence was deafening, it was most revealing as to the state of corporate culture and the acceptance of whistleblowing. On 21 February 2018, the Supreme Court sided with the Chamber of Commerce and unanimously held that in order to

be a protected whistleblower under the Dodd-Frank Act, an employee was required to report their concerns directly to the SEC. The whistleblower in that case, who reported his concerns to the company’s directors, lost. The Supreme Court upheld his termination and the de facto destruction of his career and livelihood. The Supreme Court, siding with the Chamber of Commerce, held: The ‘definition’ of a whistleblower under the Dodd-Frank Act was ‘unequivocal.’ To be a whistleblower an individual must report ‘a violation of the securities laws to the Commission.’ (emphasis by the Supreme Court). Th is case, known as Digital Reality v. Somers, should be viewed as among the most important whistleblower cases ever decided by the Supreme Court. It laid bare the animus that runs deep in corporate culture against whistleblowers. It demonstrated the wisdom and practical necessity of the confidentiality requirements given to whistleblowers who expose violations under the Securities or Commodity Exchange Acts, the Foreign Corrupt Practices Act and the Internal Revenue Act. It demonstrated that the fear of retaliation was well-founded and that whistleblowers needed to listen carefully to the unanimous verdict of the Supreme Court (as fully supported by the Chamber of Commerce): ‘The ‘core objective’ of Dodd-Frank’s robust whistleblower programme is ‘to motivate people who know of securities law violations to tell the SEC.’’ Executives who witness fraud should take advantage of the governing whistleblower rules to safely report their concerns in the manner demanded by the Supreme Court in Digital. This is the outcome that the Chamber of Commerce so viciously argued for and, for better or worse, it turned out to be correct. If you want protection as a whistleblower, the best route is to anonymously and confidentially report your concerns, in the manner set forth under the controlling laws, to the appropriate government agency and work with that agency to ensure that every corporation plays by the same rules and that criminal practices, such as money laundering, bribery and securities and tax frauds, are driven from the market. Reporting crimes to the police is not radical. It is the cornerstone of good citizenship. 1 https://www.kkc.com/assets/site_18/files/sec/sec annual report 2018 .pdf 2http://thewhistleblowers blogboutique.lexblogplatformthree.com/wp-content/ uploads/sites/480/2015/04/SECWhistleblowersAdvocate.pdf 3http://thewhistleblowersblogboutique. lexblogplatformthree.com/wp-content/uploads/ sites/480/2015/04/SECWhistleblowers-Advocate.pdf 4 https://www.kkc.com/assets/site_18/files/resources/18 uscs _ 1513 (1).pdf 5https://www.kkc.com/assets/site_18/ files/dodd-frank-act-111-176.pdf 6https://www.kkc.com/ assets/site_18/files/paper-by-sm-kohn_wall-street-lawyer_ the-secs-final-whistleblower-rules-their-impact-on-internalcompliance-oct-2011.pdf 7https://www.irs.gov/compliance/ whistleblower-office-annual-reports 8https://www. kkc.com/assets/site_18/files/fca/doj fy 2018.pdf 9https:// www.supremecourt.gov/opinions/17pdf/16-1276_bond.pdf

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Regulatory & Compliance | Behaviour

Are you as

ethical as you think?

The science of behavioural ethics is drawing considerable attention these days from compliance and ethics (C&E) professionals for, among other things, its research showing that we may not be as ethical as we think we are. In light of this and other findings, behavioural ethics has the promise to substantially improve the way that C&E programmes are designed and operated. In this article we will look at the opportunities and challenges that behavioural ethics offers for C&E programmes. We do this largely through the lens of C&E programme assessments – a process that many companies have undertaken to determine to what extent their respective programmes are fit for purpose and how they can be improved. As we will discuss, such evaluations can (among other things) serve as a delivery device to bring behavioural ethics ideas and information into C&E programmes.

Behavioural ethics

Behavioural ethics is an offshoot of a well-established school of social science called behavioural economics, which teaches that we may not be as rational as we think we are. Behavioural ethics extends this approach to the ethicality – rather than rationality – of thought and deed. Among the fi ndings of behavioural ethics are that: ■ A process of ethical fading diminishes the ethical dimensions in some decision-making. For instance, framing ethically fraught choices as business decisions can largely remove them from the realm of right and wrong ■ Outcome biases allow us to ignore bad decisions if they happen to lead to desirable results – thereby encouraging future bad decision-making (including making unethical choices) 126 Ethical Boardroom | Spring 2019

Behavioural ethics can enhance compliance programme assessments Jeffrey M. Kaplan & Rebecca Walker

Jeffrey and Rebecca are partners in the law firm of Kaplan & Walker LLP. Jeffrey is a Member of the New York and New Jersey Bars, and Rebecca is a Member of the California and New York Bars ■ Under the phenomenon of victim distance, the likelihood of an unethical deed increases where we do not know who may be impacted by a contemplated act ■ Similarly, due to a strong tendency to over-discount the future, we feel more ethically comfortable engaging in harmful actions that will impact others at a later time compared to wrongdoing with a short-term impact ■ Doing something ethical can morally licence an individual to do something unethical later on ■ Contrary to the received wisdom regarding confl icts of interest, disclosure can actually increase the likelihood of confl ict-driven harm ■ Power really does corrupt, meaning that being in a position of power increases the likelihood of acting unethically ■ Due to conformity bias, individuals are more likely to act unethically when their peers do so ■ ‘Slippery slopes’ can lead to bounded ethicality. In one fascinating study, individuals who were told that they were wearing counterfeit sunglasses were more likely to cheat than those who were told that their sunglasses were authentic ■ Motivated blindness contributes to not noticing others’ wrongdoing, depending on the observer’s interests that could be impacted by the misconduct at issue ■ Pressure to produce business results can lead otherwise ethical individuals to cross legal lines1

As is perhaps clear from the above, not all behavioural ethics fi ndings are truly surprising (although most are). Some prove things that have long been known, but only anecdotally, such as that power corrupts or pressure to produce results can lead to wrongdoing. Th is type of data can be particularly helpful when dealing with decision-makers within a company who may insist on seeing ‘proof’ before accepting C&E-based limitations on how business is conducted or increasing the company’s investment in C&E.

C&E programme assessments

Numerous legal requirements and enforcement guidance set forth an expectation that companies will engage in some form of C&E programme assessment. For instance, the US Sentencing Guidelines for Organisations – which contain the most influential general standards for effective C&E programmes – provide that an organisation should periodically assess the effectiveness of its programme. Guidance regarding the UK Bribery Act also has a provision of this sort and there are many other such examples. Indeed, it would be unusual for a set of official C&E standards not to have an assessment provision.

Behavioural ethics can shape the expectations of those to whom an assessment report is addressed — particularly boards of directors and senior managers Programme assessments, which typically include the assessment of each component of a programme (e.g. C&E programme structure and oversight, policies, training and communications, auditing and monitoring, reporting, investigations, response), can help a company design and implement a programme in a way that is www.ethicalboardroom.com

Behaviour | Regulatory & Compliance

HELPING DECISION-MAKERS RECOGNISE OPPORTUNITIES Bringing in behavioural ethics ideas can help companies assess compliance progress

not only effective but also efficient. They can also help bring momentum into a programme– often an important consideration over the course of time. And they can increase the level of buy-in and engagement among employees, including, in particular, senior leaders who participate in the assessment. Finally, should a company ever face a criminal investigation, having conducted an assessment may – in some circumstances – help the company earn leniency.

Bringing behavioural ethics into the assessment

There are basically two ways in which behavioural ethics can be helpful to programme assessments. First, and on a general level, behavioural ethics can shape the expectations of those to whom the assessment report is addressed – particularly boards of directors and senior managers. These and other decision-makers might not be fully understanding of the need for strong C&E measures. To them, ethical conduct might seem like the natural state of affairs. However, appreciating that www.ethicalboardroom.com

we might not be as ethical as we think we are potentially changes this perspective. If we (and all employees) are more subject to making unethical choices than we had otherwise assumed, that raises the bar for what a C&E programme needs to have to be effective. And it highlights the importance of having a strong C&E programme. Th is perspective can help focus decision-makers on the importance of the assessment generally. Spring 2019 | Ethical Boardroom 127

Regulatory & Compliance | Behaviour Second, some of the findings of behavioural ethics can be utilised in reviewing and enhancing different programme components (referred to generally as ‘elements’). Below, we discuss how behavioural ethics can enhance several C&E programme elements.

Risk assessment

A key area for importing behavioural ethics into C&E programmes is risk assessment. A great many behavioural ethics findings can be used to understand what a company’s risks are. For instance, the above-mentioned research on victim distance suggests that companies should determine if the potential victims of wrongdoing are distant from employees, for example, where there are multiple levels of commerce between a company and the ultimate user of its product or service or where users are anonymous. If this is the case, then that can be addressed through training or other communications that help make the interests of those at risk seem less abstract. (One company with which we are familiar helps do this by having its employees make ethics pledges to customers.) Similarly, the research findings on slippery slopes discussed above should also be considered for risk assessment purposes. Among other things, one should identify areas of risk that are seemingly minor but that could serve as a gateway breach leading to more consequential acts of wrongdoing. An example would be that a lax and poorly enforced gifts and entertainment policy could lead to greater risk of bribes.

Training and communications

Behavioural ethics offers a near endless source of ideas and information for training and other communications. But above all, the focus should be on the core message: we are not as ethical as we think we are. Important in this regard are the power corrupts findings referred to earlier. A very high percentage of major corporate scandals involve senior company officials, but few companies do enough to aim mitigation efforts ‘at the top’ because such officials often feel that they individually are impervious to risk. Addressing this issue head on in training and communications can be a way of reducing a potentially significant source of risk. A different way in which behavioural ethics can enhance C&E training and communications is based on experiments that demonstrate that focussing individuals’ attention on pertinent ethical standards immediately prior to their facing a chance to engage in wrongdoing increases the salience of such standards in a way that positively impacts behaviour. Th is insight can be used to reduce various types of risk: ■ Anti-corruption Before interactions with government officials and 128 Ethical Boardroom | Spring 2019

third-party intermediaries ■ Competition law Before meetings with competitors (e.g. at trade association events) ■ Insider trading/Reg FD During key transactions, before preparing earnings reports ■ Protection of confidential information When receiving such information from third parties pursuant to an NDA ■ Accuracy of sales/marketing In connection with developing advertising, making pitches ■ Employment law While conducting performance reviews2

Investigations and discipline

From the behavioural ethics research concerning motivated blindness, we can conclude that managers should not conduct investigations and discipline into the actions of subordinates to whom – for whatever reason – they are motivated to be lenient. Research on in-group bias, which demonstrates that we tend to be less harsh in our response to the misconduct of others with whom we identify more, should also be considered when assessing investigations and response. Also relevant in this regard is the sentencing guidelines expectation that organisations

■ Ask if auditors take these requirements into account in their audits of investigative and disciplinary records

Conflicts of interest

As noted above, one of the more interesting (and counter-intuitive) findings of behavioural ethics research is that disclosure regarding conflicts can actually increase the likelihood of conflicts-related harm. Disclosure of a conflict can create a type of moral licence in the person subject to the conflict that can lead to even more biased conduct than would have occurred absent the disclosure. Disclosure of a conflict is thus not the panacea that we had previously assumed it was. It alone cannot control for conflicts issues. Organisations should thus consider implementing additional controls where feasible, such as ethics walls to create a barrier between the person subject to the conflict and the activity or decision-making at issue. The concept of bounded ethicality also mentioned above, provides additional insights into how organisations can more effectively create controls regarding conflicts of interest. Bounded ethicality suggests that we tend to view ourselves as moral and deserving, which decreases our ability to recognise that we, in fact, have a conflict

IS THERE CONFLICT OF INTEREST? Managers should explain the importance of disclosure to employees

should impose discipline on employees not only for engaging in wrongful conduct but also ‘for failing to take reasonable steps to prevent or detect’ wrongdoing by others. To meet this important expectation, companies may wish to take the following measures: ■ Build the notion of supervisory accountability into their policies (e.g. in the managers’ duties section of a code of conduct) ■ Speak forcefully to the issue in C&E training and other communications for managers ■ Train investigators on the notion of managerial accountability and address it in the forms they use so that they are prompted to consider if a manager’s inattention facilitated the violation in question ■ Publicise (in an appropriate way) that managers have in fact been disciplined for supervisory lapses

of interest and increases our perceptions of our ability to deal with conflicts of interest in an ethical way. In light of this tendency, it is helpful for organisations to define conflicts of interest clearly and with numerous relevant examples in conflicts policies and procedures, which helps employees recognise their own conflicts and understand the importance of disclosure.

Conclusion

Behavioural ethics holds enormous promise for the enhancement of C&E programmes. A number of research findings in this area can be applied to C&E programmes to make them more effective, relevant and stronger. 1 Information about the studies referenced above can be found in Bazerman and Tenbrunsel, Blind Spots: Why We Fail to Do What’s Right and What to Do About It (Princeton 2012) and on the Conflict of Interest Blog http://conflictofinterestblog. com/2019/01/behavioral-ethics-and-compliance-index-2019. html. 2Kaplan, Behavioral Ethics and Just-in-Time Compliance Communications the Conflict of Interest Blog, January. 29, 2012, http://conflictofinterestblog.com/2012/01/behavioralethics-and-just-in-time-compliance-communications.html

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Global News Australasia Superannuation investors call for corporate change The Australian Council of Superannuation Investors (ACSI) has proposed a series of changes to update Australia’s corporate governance framework. The proposals would hold companies more accountable for conduct that harms investors and the community. Key changes include the requirement for companies to submit their pay policies to a binding vote every three years and giving investors access to a simple process for submitting non-binding resolutions to a vote by the company’s shareholders. According to the ACSI, the measures would encourage boards to ensure that they are ‘adequately informed about business issues, properly equipped to oversee management and prepared to take appropriate remedial action when things go wrong’. ACSI has also developed two policy proposals designed to ensure company boards are focussed on culture and diversity. All listed entities should be required to regularly assess their culture and disclose the action taken and listed companies should be required to set a time frame within which they will achieve gender balance on their boards.

Slow progress for diverse boards

Air New Zealand tops reputation index Air New Zealand has been recognised as Australia’s most trusted company for a third year running in the 2019 Australian Corporate Reputation Index (ACRI). Reputation Institute’s ACRI ranks brands based on the opinions of Australians on a number of factors, including product, service and financial performance. Airline Air New Zealand outperformed businesses, including Australian carrier Qantas Airways, JB Hifi, Toyota and Mazda Australia. However, Air New Zealand had to settle for second in the NZ Corporate Reputation Index, which measures how New Zealanders view the nation’s top 25 companies, behind Toyota.

130 Ethical Boardroom | Spring 2019

Female directors account for 29.5 per cent of all board positions – according to the latest gender diversity statistics of Australia’s ASX 200 companies. The Australian Institute of Company Directors (AICD) statistics reveal that there are still four companies with no women on their boards and 50 companies only have one female board member. AICD managing director and CEO Angus Armour said: “At the beginning of this year we expected to achieve our 30 per cent target imminently, but unfortunately the overall percentage has fallen since the start of this year.” “I challenge all boards to look around their boardroom and ask if there is sufficient diversity of skills, experience and gender to effectively meet the demands of a challenging governance landscape.” “Diverse boards help prevent group-think, leading to better outcomes for shareholders, consumers, employees and the community. They promote greater innovation and improved bottom lines.”

NZ directors to come under spotlight Directors will face increased scrutiny from shareholders, stakeholders and regulators, according to the annual New Zealand Corporate Governance — Trends and Insights report from law firm Chapman Tripp. According to the report, based on the analysis of annual report disclosures from the top 75 listed issuers in New Zealand, the country’s shareholder primacy model may also be under threat. For many years, the NZ approach to directors’ obligations has been founded on the premise that the job of the board is to maximise the wealth of all shareholders as a class and that the ‘best interests of the company is generally whatever will create the most value for shareholders’. But according to the Chapman Tripp report, the model could be out of step with recent changes to the UK’s Companies Act, which indicates that third parties, such as employees, customers and the environment, should be given as much status as shareholders.

Shareholders give nod to MYOB takeover Shareholders of accounting software firm MYOB have approved a A$1.6billion takeover offer put forward by private equity firm KKR & Co. Seventy-three per cent of eligible shareholders voted on whether to sell their shares for $3.40 each, with 82 per cent of votes cast in favour and 17 per cent against. MYOB chairman Justin Milne says the vote confirms the strength of the deal offered by KKR and that it showed shareholders agreed with the board that the offer was in the best interests of shareholders. “MYOB is a great Australian company and the board has every confidence it will continue to thrive under the care of its new owners,” Milne said.

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