Ethical Boardroom Spring 2017 by Ethical Boardroom

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

Spring 2017

Keeping it above board

Effective risk management

Maximising value from your three lines of defence

Negotiating the NED minefield How you can help boards succeed

Keeping it in the family

Evolving governance across the Middle East

Fighting fraud

Strong collaboration is the key to success

The art of good governance Structure, strategy and dynamics make for better boards

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Why all bets are off when it comes to predicting the next money-laundering scandal

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Russian roulette

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Ethical Boardroom | Contents

COMMENTARY

ES and CG: Two sides of the same value-creation coin Develop your environmental, social and corporate governance creation story to achieve sustainability

COVER STORY: The Global Laundromat and British banks Failure to adopt an appropriate, risk-based approach to anti-money laundering could leave you exposed

ExxonMobil and the ‘Rexit’ retirement package Reconfiguring CEO Rex Tillerson’s retirement package is a positive move. But why was it worth $180million?

Investor stewardship and future priorities Dialogue between investors and the board will help promote investor stewardship and governance

When anti-corruption and CSR collide Does anti-corruption compliance always itself comply with corporate social responsibility?

EUROPE

22 24

Global News Europe Long-term incentive plans, CEO pay and gender diversity

Advancing corporate governance reform The UK is seeking to calm public concern about falling standards by revisiting corporate frameworks

Swiss stock index to reward ethical firms The first Swiss stock exchange index dedicated to corporate governance will underweight companies that fall short

Corporate ethics boost confidence in Spain Spain has seen solid advances in good corporate governance and transparency

C O V E R

S T O R Y

Cultivating trust Red Eléctrica on fostering a trust-based relationship with investors and shareholders

BOARD GOVERNANCE

Collaboration is key to fighting fraud To address accounting challenges, tap the power of policies and people

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Contents | Ethical Boardroom

Building businesses for the long term Focussing ERM and internal audit on what really matters: long-term value creation and preservation

Deregulation and the new era of self-governance Companies who establish a self-governing culture during uncertain times will inspire trust and innovation

Assessing corporate compliance programmes Assessing whether your compliance programme is ‘fit for purpose’ is a key element of oversight responsibility

Internal governance: The next frontier Boards need to consider how power is allocated and exercised at the management level

A holistic approach to executive pay policy ‘Integrated remuneration’ is the way to solve the conundrum of executive compensation

NORTH AMERICA

62 64

Global News North America Institutional investors, gender inequality and US reforms

CONTENTS

The birth of consensus How a grassroots movement is changing the way investors operate – from the inside out

BOARD LEADERSHIP

Making board evaluation more robust Demonstrating board assessments provides investors with a signal the board is actively listening to its shareholders’ governance concerns

The art of board effectiveness Structure, strategy and healthy dynamics make for better boards and better business

Negotiating the NED minefield Non-executive directors should encourage an integrated approach to governance where ERM and culture guide decision-making

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Looking at culture through governance lenses Do we agree that culture is important for ensuring effective decision-making in the boardroom? Spring 2017 | Ethical Boardroom 5

Ethical Boardroom | Contents

Boardrooms: the perpetual gender gap Are companies fully on board or has the commitment to board diversity become overstated?

Gender diversity on US boards What more can we do to ensure boards are well-equipped to serve the future marketplace?

SOUTH AMERICA

90 92

Global News South America Corruption, bribery, Colombia, Brazil and Venezuela Brazilâ&#x20AC;&#x2122;s push for corporate governance reforms A collective dissatisfaction with recent cases of massive corruption has seen best governance practices accelerate in Brazil

ACTIVISM & ENGAGEMENT

Interpreting the statistics on US proxy fights Activists targeting mid-sized companies tend to be smaller, younger and more aggressive funds

Future of shareholder activism in Europe The gloves are coming off as full-blooded, US-style activism attacks EU boardrooms. But are they prepared?

102

Shareholder activism in Canada: 2017 Trends observed over the last year and predictions of what we might expect

106

Activism in Germany Clarifying misconceptions about shareholder and hedge fund activism

MIDDLE EAST

110 112

Global News Middle East Gender diversity, sovereign wealth and international investors

126

The EB 2017 Corporate Governance Awards Introduction & Winners list We reveal our 2017 Middle East winners

114

Evolving governance for MENA family businesses Adopting both corporate and family governance structures protects legacy and ensures continuity

118

Gender diversity on MENA boards Shattering the glass ceiling is an economic imperative in the Middle East

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Contents | Ethical Boardroom

122

Improving performance within the boardroom Investing in director training is essential for ensuring continual professional development

TECHNOLOGY

126

Brexit & beyond: nationalism and corporate data Investing in e-discovery skills is the smartest route to meeting the challenges of changing regulations

REGULATORY & COMPLIANCE

130

Overseeing the board’s compliance programme How can a board fulfil its duty of oversight if it’s not trained in how to avoid disaster?

130

134

Anti-corruption trends across Latin America To do business in Latin America, companies need to understand recent anti-corruption enforcement changes

138

Complying with modern slavery legislation Is the Modern Slavery Act a groundbreaking legislation or a velvet glove in need of an iron fist?

ASIA & AUSTRALASIA

140

Global News Asia & Australasia Reputation, cybersecurity, gender diversity and sustainability

RISK MANAGEMENT

142

Effective risk management The key to a successful governance framework is using risk data within the three lines of defence model

102

146

New York’s cybersecurity game changer Elevating cybersecurity to the board; the DFS’s new regulations could reach other US states

AFRICA

150 152

Global News Africa Whistleblowing, CEO pay, gender equality and lawsuits

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Nigeria’s National Code of Corporate Governance From conception to controversy and why a more collaborative approach is needed Spring 2017 | Ethical Boardroom 7

Ethical Boardroom | Foreword

Welcome to the Spring 2017 edition of Ethical Boardroom magazine

Cracking the code of corporate change Since its creation 25 years ago, the UK Corporate Governance Code has become respected worldwide and is a key reason why global investors commit their capital to UK listed companies. Introduced following the publication of the Cadbury Report in 1992 – a response to corporate scandals at the time involving BCCI, Polly Peck and Maxwell – the Code has been instrumental in spreading best boardroom practice. However, recent major corporate governance failings at BHS and Sports Direct have prompted the government to reassess the accountability of those responsible for the performance and management of UK companies. It was in her first major speech on the economy that Prime Minister Theresa May pledged an overhaul of corporate governance. There’s since been no shortage of opinions on how to ensure that the UK’s framework of corporate governance continues to evolve. First came the Government’s Green Paper on corporate governance reforms, followed by the Financial Reporting Council’s (FRC) review of the Code. Then in April, the Business, Energy and Industrial Strategy (BEIS) Select Committee published the report of its inquiry on corporate governance. The overarching sense is that the Code is ‘not bad… but could do better’. While recognising the overall strength of the UK corporate governance system, the reports note the damage caused

8 Ethical Boardroom | Spring 2017

by high-profile failings and the rise of executive pay in recent years. The BEIS Select Committee’s inquiry has focussed on three key areas: directors’ duties, executive pay and board composition, while the government’s consultation focusses on executive pay, employee and stakeholder voice, and large privately held businesses. The FRC, the UK’s independent regulator responsible for overseeing the UK Corporate Governance Code, wants to simplify and shorten it in order to “set it on its course for the next 25 years”. It has committed to a fundamental review of the Code later this year and will “take into account work done by itself on corporate culture and succession planning, and the issues raised in the Green Paper and the BEIS inquiry”. In this issue of Ethical Boardroom, contributor Tim Copnell takes a deeper look at the three central pillars in the government’s Green Paper and questions how effective a new-look Code would be in practice (page 24). On page 44, John Palmiero shares concerns that companies have become too dependent on strict regulations and overseeing bodies to guide them towards good governance and compliance processes, and wonders if it is not those companies that establish a self-governing culture during uncertain times that will inspire trust and innovation? On page 70, Helen Pitcher discusses whether boards should be thinking about their own development and effectiveness – after all, one of the markers of great boards is a continuous questioning of how they can improve. And, Gabe Shawn Varges continues this theme, on page 52, addressing how boards are looking more critically in the mirror and identifying gaps in their own structures and way of working.

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Contributors List | Ethical Boardroom

Our thanks to this issue’s contributing writers SANAA ABOUZAID IFC Corporate Governance Lead, MENA VICTOR BANJO Corporate Governance and Board Effectiveness Coach HELOISA B. BEDICKS MD of Instituto Brasileiro de Governanca Corporativa IBGC (Brazilian Institute of Corporate Governance) STEVEN R. CHABINSKY & JUDY SELBY Steven is a Partner at White & Case LLP, Judy is National Leader of Insurance Advisory and Technology Advisory Teams at BDO USA LLP AMI DE CHAPEAUROUGE Senior Partner, de Chapeaurouge + Partners (Frankfurt, Hamburg and New York), admitted in Frankfurt and New York TIMOTHY COPNELL Chairman of KPMG’s UK Audit Committee Institute ALLAN DOHERTY Senior Director at Modern Slavery Consultants Ltd CHARLES M. ELSON Edgar S. Woolard Jr Chair in Corporate Governance and the Director of the John L. Weinberg Center for Corporate Governance at the University of Delaware CINDY FORNELLI Executive Director of the Center for Audit Quality FERNANDO FRÍAS Non-Director Vice-Secretary of the Board of Directors, Head of Compliance and Corporate Governance, Red Eléctrica Corporacion SA DR ASHRAF GAMAL EL DIN Chief Executive Officer, Hawkamah ANTHONY GOODMAN & RUSTY O’KELLEY Anthony and Rusty are leading members of Russell Reynolds Associates Board and CEO Advisory Group

HOLLY J. GREGORY & REBECCA GRAPSAS Holly is a Partner and Co-Chair of the Global Corporate Governance & Executive Compensation Practice & Rebecca is Counsel in the Corporate Governance & Executive Compensation Practice at Sidley Austin LLP DUNCAN HAMES Director of Policy at Transparency International UK DARRIN R. HARTZLER Manager of the Corporate Governance Group in the Transactional Risk Solutions Department, Environment, Social and Governance, at IFC DUNCAN HERRINGTON Managing Director and Head of the Activism Response and Contested Situations Team, Raymond James BRUCE HOROWITZ President, Center for the Study of Bribery, Extortion and Coercion Situations, and Founding Partner, Paz Horowitz DAVID HORRIGAN E-discovery Counsel and Legal Content Director, kCura JO IWASAKI Head of Corporate Governance at ACCA VINCENT KAUFMANN CEO of Ethos Foundation, Switzerland RAKHI KUMAR Managing Director and Head of ESG Investments and Asset Stewardship at State Street Global Advisor CÉDRIC LAVÉRIE Head of Corporate Governance at Amundi Asset Management TIM J. LEECH Managing Director at Risk Oversight Solutions Inc

DAN MARCEC Director of Content at Equilar ANA MARÍA MARTÍNEZ-PINA GARCÍA Vice Chairperson of the Comisión Nacional del Mercado de Valores (CNMV) JAMES G. McGOVERN & ROBERT TOLL James is a Partner and Robert an Associate at Hogan Lovells JOHN PALMIERO Vice President at MetricStream BEATRIZ PESSÔA DE ARAÚJO Partner at Baker McKenzie HELEN PITCHER OBE Chairman, Advanced Boardroom Excellence BRANDE STELLINGS, JD Vice President, Corporate Board Services at Catalyst JON SZEHOFNER & PAUL SAUNDERS Jon and Paul are both Co-founders of GD Financial Markets LLP JANE VALLS Executive Director, GCC Board Directors Institute GABE SHAWN VARGES Senior Partner at HCM International & Chairman of the GECN Group MICHAEL VOLKOV CEO and owner of The Volkov Law Group KERRIE WARING Executive Director, International Corporate Governance Network STEVE WOLOSKY, ANDREW FREEDMAN AND RON S. BERENBLAT Members of Olshan Frome Wolosky’s Activist & Equity Investment Group TREVOR ZEYL Associate, Norton Rose Fulbright Canada LLP

EDITOR Claire Woffenden DEPUTY EDITOR Spencer Cameron EXECUTIVE EDITOR Miles Hamilton-Scott ART DIRECTOR Chris Swales CHIEF SUB Sue Scott ONLINE EDITORS Allegra Cartwright, Hermione Bell PRODUCTION MANAGER Jeremy Daniels SUBSCRIPTIONS MANAGER Lucinda Green HEAD OF ONLINE DEVELOPMENT Solomon Vaughan ONLINE DEVELOPMENT Georgina King, Rosemary Anderson MARKETING MANAGER Vivian Sinclair CIRCULATION MANAGER Benjamin Murray HEAD OF SALES Guy Miller SALES EXECUTIVE Michael Brown PRODUCTION EDITORS Tobias Blake, Dominic White VIDEO EDITOR Frederick Carver VIDEO PRODUCTION Tom Barkley BUSINESS DEVELOPMENT Dammian Botello, Giles Abbott, Gerald Fox, Steven Buckley ASSOCIATE PRODUCER Suzy Taylor ADMINISTRATIVE ASSISTANT Abigail Fitzwilliam HEAD OF ACCOUNTS Penelope Shaw PUBLISHER Loreto Carcamo Ethical Board Group Ltd | Ethical Boardroom Magazine | 1st Floor, 34 South Molton Street, Mayfair | London W1K 5RG 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 Webmart Ltd. Images by www.shutterstock.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 2017 | Ethical Boardroom 9

Commentary | Sustainability

Darrin R. Hartzler

Manager of the Corporate Governance Group, ESG Sustainability Advice and Solutions, at IFC

ES and CG: Two sides of the same value-creation coin Companies need to develop their environmental, social and corporate governance value-creation story to achieve sustainability In my role as manager of IFC’s Corporate Governance Group, I spend a great deal of time talking with business leaders in emerging markets about how to make companies sustainable, including the value of good corporate governance practices for companies. There is growing global acceptance of the connection between strong corporate governance and solid business performance. But even as more companies see the value, it is becoming increasing clear that corporate governance alone – with its internal focus on the structures by which companies are directed and controlled – is not sufficient to mitigate the full breadth of risks that companies face today. Environmental practices, labour relations, land acquisition, impacts on biodiversity – such issues, if handled poorly or overlooked entirely, can pose major problems for companies. They can lead to community unrest, labour disputes, disrupted operations, negative media coverage and burdensome reactive regulation. Ultimately, this can impact company profitability, valuation, share price and cost of capital. By contrast, heightened focus on environmental and social practices and issues represents a strong business opportunity. Support for the global Sustainable Development Goals agreed by the United Nations agenda can yield significant brand enhancements, for example. Demonstrated commitment to them can translate to competitive advantage – particularly as renewed international commitments on climate change and international development have triggered trillions of dollars in public finance toward projects in emerging 10 Ethical Boardroom | Spring 2017

markets to promote development and environmental stewardship. This is of particular importance for family owned firms, which dominate the markets where IFC invests. Improving corporate governance and reducing environmental and social risks will safeguard the family’s good name as sustainable leaders in the marketplace.

Taking the longer view

Conventional business wisdom suggests that addressing environmental and social issues is a cost, pure and simple. For instance, a company that is constructing a new facility may not see the value in funding the relocation of a squatter community or preserving a culturally significant site near the property. Instead, what they see is a rising project price tag in additional transaction costs, project delays and budget overruns. In fact, the opposite is true. Companies that fail to attend to the potential environmental and social issues that could impact on

Whereas governance strengthens the internal functioning of a company, environmental and social stewardship also strengthens its outwardfacing relationships business operations could incur even greater transaction costs, longer project delays and larger budget overruns, resulting from lack of community acceptance and disapproval. Climate change falls into this category, too. Even more than political and regulatory risks, the physical risks associated with climate change pose real challenges for businesses. Issues such as water scarcity, weather volatilities, rising sea levels, powerful storm surges, all impact everything from business continuity

to supply chain disruptions, from changing consumer preferences to facilities and infrastructure damage. In 2011 alone, extreme weather events – the rising frequency of which are related to incremental changes in environmental conditions – resulted in overall losses of more than $148billion and insured losses of more than $55billion, according to a report from Ceres. A lack of focus here could cost companies well beyond what they might have spent to mitigate potential impacts upfront.

Integrated approach to complementary issues

There is real value in pushing for more integration on corporate governance and environmental and social sustainability because they are highly complementary issues. Whereas governance strengthens the internal functioning of a company, environmental and social stewardship also strengthens its outward-facing relationships. At IFC, we are a work in progress on this integration. We are updating our corporate governance methodology – used to assess companies’ internal governance practices, uncover gaps and recommend changes – to include sustainability in the governance of companies. A new section addresses stakeholder engagement. In addition to governance, our performance standards address the range of social and environmental considerations. The reason is simple: the more experience we gain in emerging markets, the more we understand that the business case for each is incomplete without the other. This holistic approach allows a more complete picture of the full slate of risks companies face – as well as the potential opportunity to create value and longer term company sustainability.

All roads lead back to the board Strong environmental and social performance requires board-level commitment. The tone for stewardship is set at the top, with a

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Sustainability | Commentary healthy, well-functioning and diverse board that will make the right decisions regarding the company’s environmental and social exposure. For family firms, it is often the second or third generation of leaders that brings this focus to the board. This leadership is particularly important in emerging markets, which may lack regulatory frameworks to require a minimum baseline of compliance. A 2016 study from Cambridge Associates quantifies this, revealing a stronger correlation between company performance and the presence of an integrated environmental, social and governance (ESG) strategy in emerging markets than in developed markets. Our own experience in Myanmar demonstrates the importance of strengthening the board in building an effective environmental and social strategy. The integrated effort helped Yoma Bank access the capital it needed to grow in a fragile market only just opening up. Our multi-pronged advisory assistance programme started with establishing a formal board and setting clear board policies and procedures, along with other governance upgrades. In parallel, we worked with this new board and bank leadership to develop environmental and social guidelines to support the bank’s lending due diligence processes. In combination with additional guidance and support, these efforts paved the way for new financing in the form of a $5million convertible IFC loan.

Investors are taking notice

As a development finance institution, IFC is inherently focussed on environmental and social stewardship. It is embedded in our mission to promote private sector growth as a means to end extreme poverty and boost shared prosperity. To access IFC financing, Yoma Bank needed to make a series of changes to meet our ESG standards. We’re not alone. A growing number of institutional investors are adopting models to analyse and price increasingly complex and acute social and environmental issues. In the United States, for instance, assets under management using ESG strategies are estimated at more than $8trillion, a 33 per cent increase since 2014. Regulators, too, are exploring the addition of environmental and social standards into their compacts, meaning that companies will be forced to address the issues.

Balancing the cost story with the value-creation story

SUSTAINABLE DEVELOPMENT Companies promoting good corporate governance will reap the rewards www.ethicalboardroom.com

Still, there is indeed a cost. To ensure the appropriate cost-benefit balance, companies will need to develop their environmental, social and governance value-creation story. Creating this value stems from three inter-related components: a sustainability strategy, a clear business case and a business model that realises the benefits – the proverbial triple bottom line of people, planet and profit. Spring 2017 | Ethical Boardroom 11

Commentary | Editorial content PLAYING RUSSIAN ROULETTE Errors and lack of oversight can lead to money laundering and reputational damage

The Global Laundromat and British banks 12 Ethical Boardroom | Spring 2017

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Money Laundering | Commentary

Illustration by Brendon Ward www.inkermancreative.com

Not since the financial crisis has Britain’s banking sector and its customers been under so much scrutiny. It’s not hard to understand why.

Earlier this year, several UK banks were exposed for handling substantial amounts of suspicious money of Russian origin between 2010 and 2014. Investigations into this are currently ongoing, but initial estimates suggest that these payments were part of a wider money laundering scheme worth up to $80billion. Two months before that, Deutsche Bank made news for all the wrong reasons after being fined more than $630million in fines for moving billions of suspect cash through highly dubious ‘mirror trades’ between its Moscow and London offices. On top of this, there are still enquiries being made into allegations that came out of the Panama Papers last year. And, all of this comes not too long after UK regulators hit Barclays with a then record fine (now superseded by Deutsche Bank’s) for failing to comply with basic anti-money laundering rules during a multi-billion-dollar deal. I could go on, but you get the picture. Money laundering is no longer just a niche issue for compliance, it’s a financial hazard and reputational risk that affects some of the world’s biggest businesses. Chief executives throughout the sector will anxiously anticipate the next, almost inevitable, leak that could paste their names all over the national press. Despite recent fines still being short of a credible deterrent, losing hundreds of millions at a stroke is not something anyone would want to be associated with. That’s just the start. Behind cash penalties is the cost of litigation. Putting a number on that is difficult, but it heightens the risk for the sector and, in some cases, banks are already putting shareholders on notice that the cost of legal action against them could hit profit margins. Then there’s the reputational damage. Over time, patterns begin to emerge, with some banks – whether fairly or not – being seen as negligent at best and complicit at worst. Ascribing a financial cost to that is even more challenging, but it should be a strategic concern. So, what has gone wrong and why? A common thread runs through these scandals: a neglect of some pretty basic customer service. Those involved failed to really get to know who they were doing business with and what that business was. Some may dismiss this as misty-eyed nostalgia – having a personal relationship with your customers is something that’s gone the way of the www.ethicalboardroom.com

Failure to adopt an appropriate, risk-based approach to anti-money laundering could leave your company exposed Duncan Hames

Director of Policy at Transparency International UK telegram and the chequebook; it’s a relic of a bygone era. However, it’s now probably more essential than ever.

Taking evasive action

Would you like to wake up to news that you’ve got a terrorist financer on your books? How trustworthy do you think you would be perceived if you’ve wilfully or unwittingly been involved in stealing an eighth of a developing country’s annual GDP? Knowing your customer is not obstructive red tape imposed by stuffy bureaucrats, it’s a business imperative. Given this is now becoming a boardroom issue, what do boards need to be ready for next? Remember the three Ls: legislation, law enforcement and leaks. In the UK and across Europe, there are moves to tighten the requirements on what banks should be doing as part of their money laundering checks. The EU’s Fourth Money Laundering Directive will have to be

Compliance should not be a tick-box exercise. If you go through the motions and do the bare minimum then you’re bound to come unstuck at some point transposed into UK law by the end of June and further amendments are expected after that. Unless, after Brexit, the UK wants to turn itself into the clearing house for the corrupt, these rules will remain a feature of the regulatory landscape. Alongside tighter rules, their law enforcer – the Financial Conduct Authority – has been issuing fines of growing magnitude for breaches. In 2016, it also introduced the Senior Managers Regime, which is aimed at increasing individual accountability within the sector. Although these changes are still to bed-in and, in some respects, are much weaker than originally drafted, they might just start resulting in individuals being held responsible for bad behaviour, not just the banks as a whole.

Media coverage

Then there’s the media. Despite some doomsayers, investigative journalism is still

alive and well, fed by material from whistle-blowers at the heart of some of the most secretive businesses in the financial sector, and crafted into hard-hitting material by experienced, knowledgeable and well-connected reporters. In recent years, we’ve had the Luxemburg Leaks, the Swiss Leaks, the Bahamas Leaks, the Panama Papers and the Global Laundromat exposé. These scandals could be just the beginning of a more concerted campaign to highlight bad practice in the banking and financial sector. We work closely with these journalists to develop policy responses to the underlying issues and make the case for them to government. With every new release those involved become more knowledgeable, more organised and more focussed on their targets. Overall, in terms of risk, these trends mean there is an increased likelihood of being caught out and a greater impact when you are. There is some cause for optimism. Much of the wrongdoing outlined above happened two to three years ago, or before. Many of those involved will have moved on and there’s an opportunity for some of the banks who’ve been implicated to redeem themselves. Here’s how: Compliance should not be a tick-box exercise. If you go through the motions and do the bare minimum then you’re bound to come unstuck at some point. You have to spend money on this function anyway, so make it an investment in your reputation rather than seeing it as a block to business or a drag on your margins. Changing culture is difficult, but essential. So often firms put short-term financial gains ahead of long-term stability. We saw this in the financial crash of 2008 and again in the environment in which Libor rigging took place, giving the sector such a bad name. One of the key drivers of bad practice is the incentives staff are given, which often put immediate returns in conflict with more strategic goals. Think about the incentives you’re currently providing staff and how they can be redesigned to help meet your business needs and embed a culture that is intolerant of corruption, not complicit in it. Lead by example, don’t wait for your hand to be forced. There are a number of ways banks can be at the forefront of the fight against illicit finance. Share information with law enforcement and peers through the UK’s Joint Money Laundering Intelligence Taskforce. Re-evaluate your strategic priorities and how they interact with emerging money laundering risks. Even engage civil society in dialogue about past failures and new approaches. At Transparency International, we find many in business, government and civil society are keen to identify common ground and find workable solutions. You can be part of the answer, too. Spring 2017 | Ethical Boardroom 13

Commentary | Corporate Social Responsibility

Charles M. Elson

Edgar S. Woolard Jr Chair in Corporate Governance and the Director of the John L. Weinberg Center for Corporate Governance at the University of Delaware

ExxonMobil and the ‘Rexit’ retirement package Reconfiguring the terms of CEO Rex Tillerson’s retirement package to allow him to take up public office sends a positive message. But why was it worth $180million? I have been a longstanding critic of oversized executive pay – particularly significant severance or retirement packages. So, when the ExxonMobil board announced that CEO Rex Tillerson was to receive a $180million stock-based retirement package upon his nomination as the US Secretary of State, many thought that I would react quite negatively.

After all, he was exiting some time before his long–anticipated retirement date and the board could have denied him the significant benefits that he would have been entitled to had he remained at the company. But they were right to essentially preserve his package the way they did, despite criticism from many. Ultimately, though, there is a much more troubling aspect to this whole controversy. The theory behind the original package that Tillerson was set to receive was decently

14 Ethical Boardroom | Spring 2017

conceived and shareholder friendly. To prevent him from ‘gaming’ his actions near retirement to artificially inflate the stock price so that he could sell his shares at a premium value, only later to see the stock fall, he and the board had agreed to a 10-year vesting schedule for his retirement shares. This was to incentivise him to continually focus on the long-term value of the company, even as he neared retirement. But when he was unexpectedly tapped to go into government service, the board, among other things, gave him a cash payment equivalent to the unvested shares’ value at the time of his early departure that would be placed in trust and allowed to be invested elsewhere. Tillerson was reportedly giving up about $7million in benefits that he would have received had he not taken the appointment. For the board, this was a completely unexpected and unpredictable event. It certainly couldn’t have ever been anticipated or even contemplated as Tillerson was approaching retirement. He had worked at the company his entire career. To completely deny him the benefits accruing from his lifetime’s

efforts unless he stayed a bit longer would have been inappropriate and sent the wrong message to the rest of the organisation. An organisation must be loyal to its employees if it is to expect loyalty from them. To have removed all benefits would only have bred contempt for the organisation in others working there. Second, Tillerson gave up something quite significant in the bargain, even though he was cashed out. Oil prices have been at a low point for quite some time now. At some point over the next decade, they certainly will regain value and Tillerson, by exiting at a low point, has given up all of the upside that retaining the shares, even unvested, would have provided. On the flip side, his fellow ExxonMobil shareholders will take a little more of the upside home, as he will no longer be invested.

Wrong signal

It is critically important at this juncture of America’s history that citizens encourage those with long-standing successful business careers to enter public service. The dearth of

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Corporate Social Responsibility | Commentary

productive government – something all of us would hope for. Finally, in this highly politically charged environment, it was almost impossible for the board to have escaped criticism from some quarters, whatever it had done. The directors were in the classic Catch 22. I, however, can find no real fault in their or Tillerson’s actions and believe that all made the best of a tough situation. The shareholders in this instance were decently represented by their board and should be comfortable with what was ultimately agreed. Had I been in the board’s shoes, I might very well have done the same thing.

Elephant in the room

No one begrudges a Bill Gates or Steve Jobs, who made large fortunes as CEOs, because they were the entrepreneurs who founded their businesses and took significant personal financial risks in the creation and operation of them those with business sense in government is highly troubling and may partially explain the significant mistrust that a large part of the citizenry has toward

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GOLDEN PARACHUTE ExxonMobil’s CEO Rex Tillerson will receive a $180million pay-off

public officials. Certainly, some new faces in public service, who are not part of the political class, are worth a try. Should the board have effectively denied Tillerson of this position by virtue of denying his retirement benefits, it would certainly have been the wrong signal to send from a large and respected company to other corporate organisations and the nation generally. We need talented, business-experienced and savvy men and women in government. A government agency is a vast and highly complex organism. Having those in charge who ran similar organisations successfully in the private sector may lead to more efficient and

So, I understand the board found itself in a quandary and I also understand the reason behind its decision. But there is a bigger issue here that so far has been unmentioned in the controversy. That is, why would Tillerson, under any scenario, receive at least $180million on his retirement? This is the proverbial elephant in the room. Too often we have seen large, entrepreneurialstyle returns paid to managers who either were terminated – the case of the $42million paid to Carly Fiorina of Hewlett-Packard comes to mind or, more recently, the $134million package presented to John Stumpf of Wells Fargo – or simply retired normally – Tillerson’s predecessor, Lee Raymond, ignited a firestorm when he was paid over $400million when he left the company. No one begrudges a Bill Gates or Steve Jobs, who made large fortunes as CEOs, because they were the entrepreneurs who founded their businesses and took significant personal financial risks in the creation and operation of them. They deserved entrepreneurial-sized returns because they took entrepreneurial-styled risks. However, Fiorina, Stumpf, Tillerson and Raymond were managers. While they took on employment risk in accepting their positions, their personal wealth was not at stake in the same way Jobs’ and Gates’ were. The odds of ExxonMobil, Wells Fargo, or Hewlett–Packard disappearing under their watch were slim. Therefore, it seems inappropriate for them to have achieved an entrepreneurial return by simply taking managerial risk. This is really what the issue created by the Tillerson package should have been about. While I have no problem with the way the board responded to Tillerson’s change in circumstance, I am troubled by the board’s creation of so large a retirement package in the first place. That should have been the lesson of this controversy.

Spring 2017 | Ethical Boardroom 15

Commentary | Stewardship

Investor stewardship and future priorities

Dialogue between investors and board members is strongly encouraged to continue the momentum of promoting investor stewardship and corporate governance around the world Last month, Thailand and the US became the latest markets to publish ‘stewardship principles’. This brings the tally to 18 known codes around the world since the publication of the International Corporate Governance Network (ICGN) Statement of Institutional Investor Responsibilities in 2003.1 Over the coming years we expect to see this number double. Codes in India and South Korea are already underway and ICGN has established an informal Network of Stewardship Code Developers to help foster effective implementation.2 As we begin to gain critical mass of national codes, it is important to take stock of progress and consider next steps to ensure that stewardship codes are embraced, not just in principle, but in practice. This was the theme of our opening plenary at the ICGN Conference in Washington DC in March when a number of useful observations were made.

Encouraging stewardship code application

Firstly, there is no ‘one size fits all’ approach to

16 Ethical Boardroom | Spring 2017

Kerrie Waring

Executive Director, International Corporate Governance Network stewardship code development or application. The extent to which code enforcement relies on a market-based approach or a rules-based approach depends largely on political priorities, economic climate and the degree to which there is a body of shareholders willing (and able) to effectively embrace stewardship responsibilities. The UK Stewardship Code3, published in 2010 by the Financial Reporting Council (FRC), was derived from an existing set of principles developed by the Institutional Shareholders Committee in 2003, which had largely been adopted by UK investors. This meant that there was broad and immediate acceptance of the FRC code when it was introduced – the difference was that it now had regulatory bite. Financial Conduct Authority rules require asset managers to disclose the ‘nature of their commitment’ to the code or alternative investment strategy under a ‘comply or explain’ mechanism. This is monitored by the UK FRC, which maintains a list of code signatories.

More recently, in November 2016, the FRC introduced a tier system that aims to strengthen the quality of signatory reporting by distinguishing between those who report well and those where improvements could be made. As such it aims to help asset owners in their deliberations when selecting and awarding investment mandates. It is early days, but the initial impact has been an improvement in the quality of stewardship disclosures. There are around 140 signatories in Tier One, 80 signatories in Tier Two and a further 30 signatories in Tier Three. This latter camp is subject to imminent de-listing if improvements are not forthcoming. The Japanese system also follows a ‘comply or explain’ mechanism under the auspices of the Financial Services Authority (FSA). At the time of writing, the Japan Stewardship Code is subject to review and we expect to see a strengthening of the role of asset owners, enhanced requirements around conflicts of interest and more granularity around vote disclosure, similar to what is prescribed in ICGN’s Global Stewardship Principles.4 The FSA is successfully positioning Japan, along with the UK, as a leading market

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Stewardship | Commentary in promoting the application of stewardship among its investment community. This is complemented by prominent championing by one of the world’s largest asset owners, the Government Pension Investment Fund and others, such as the Pension Fund Association. Most other markets rely purely on voluntary mechanisms to oversee and implement respective national codes. This is no small task and, regardless of the lack of regulatory teeth, the presence of clearly defined principles around company monitoring, voting and engagement provides a helpful roadmap for investors and companies alike. More challenging is the application of stewardship in markets that are dominated by controlled companies. For stewardship to take proper effect here minority investors must be able to influence the governance of investee companies though adequate voting rights. Engagement tactics should focus not just on dialogue with company boards but also with the controlling owner constituent in efforts to align interests. In some regions we are likely to see change towards a more mandatory approach. The passing of the European Shareholder Rights Directive in March was a watershed moment. All 27 member states (with probably the exception of the UK) will require the mandatory disclosure of stewardship policies. Asset owners will need to report publicly on how their investment strategy and stewardship approach contributes to the long-term performance of their assets and it requires asset managers to report to their clients on the same issue.

Understanding stewardship in practice

Assuming there is a sound mechanism in place to promote and encourage investor stewardship, it is incumbent on all of us to help raise awareness of what ‘stewardship’ actually means in practice. Nearly 250 years ago Adam Smith defined the problem that corporate governance seeks to address in his seminal publication The Wealth of Nations: “The directors of companies, being managers of other people’s money cannot be expected to watch over it with the same anxious vigilance with which they might watch over their own money.... negligence and profusion therefore prevails in the management of the affairs of such a company.” So, at a basic level, corporate governance is about keeping in check any ‘negligence and profusion’. It is the responsibility of shareholders, in their role as fiduciaries on behalf of the investing public to provide that ‘check’ by holding boards to account in promoting the long-term success of the companies for the benefit of its members while having regard to a wider constituency of stakeholders.

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Fast forward to 1992 when Sir Adrian Cadbury and his committee introduced the world’s first corporate governance code. What is often overlooked is the fact that this code included inaugural stewardship principles. Section B had specific recommendations for investors to enter into constructive dialogue with companies and to make considered use of their votes. Both recommendations remain core principles of modern stewardship codes. In essence, stewardship is about the proper use of entrusted power. In an investment context, this means using share-ownership rights responsibly to effectively oversee investee companies to protect and enhance value. In a company context, stewardship relates to the accountability of the board of directors to investors in ensuring good corporate governance and the long-term corporate success.

Stewardship and long-term value creation

The concept of stewardship is not just for the realm of corporate governance oversight. It has become synonymous with today’s financial market challenges in meeting the Sustainable Development Goals (SDGs) set out by the United Nations in September 2015.

Achieving successful dialogue between companies and shareholders, with a consensus to focus on long-term value creation, will yield an environment in which good corporate governance and investor stewardship can thrive The SDGs define ‘17 goals to transform our world’ and aim to ‘end poverty, protect the planet and ensure prosperity for all’. Two months later, 195 countries pledged to deal with the effects of climate change by limiting global warming to well below 2°C as part of the Paris Agreement. We are also living in a time of radical uncertainty. This is true, both economically and politically. High levels of income inequality between the top one per cent of earners and those at the bottom is a priority issue on both sides of the Atlantic. The perceived disconnect between the ‘privileged few’ and ordinary society, as characterised by the British Prime Minister Theresa May, has led to a review of the UK corporate governance system and the effectiveness of investor stewardship. One possible outcome is to further empower shareholders to have a greater

voice and influence around areas such as executive remuneration. Also under the spotlight is the degree to which stakeholders in society should play a role in governance oversight. In stewardship terms this is translated into a range of actions, which are described in Principle 6 of the ICGN Global Stewardship Principles: ■■ Firstly, we encourage asset owners to align their investment strategies with the profile and duration of their liabilities – particularly long-term liabilities. This should be incorporated into the asset manager selection process and included in contractual mandates. Crucially, this also calls for monitoring the performance of asset managers in meeting this obligation. ■■ Secondly, we advocate for awareness of environment, social and corporate governance (ESG) factors that influence risks and opportunities affecting a company’s long-term performance. Company engagement is no longer just around financial returns but also around issues such as demographics, technological change, water scarcity, climate change and so on. It is imperative that boards and investors alike understand these issues to the degree they affect the long-term success of the company. ■■ Thirdly, we support integrated reporting that puts historical performance into context and portrays the risks, opportunities and prospects for the company in the future. This helps highlight a company’s strategic objectives and its progress towards sustainable value creation. Other guidance points relate to ESG integration through the investment decision-making process as well as taking into account systemic threats that can impact overall economic development, financial market efficiency and stability. There is no silver bullet to achieving a perfect stewardship ecosystem. What is vitally important is that we continue the momentum of promoting investor stewardship and corporate governance around the world. Ultimately, achieving successful dialogue between companies and shareholders, with a consensus to focus on long-term value creation, will yield an environment in which good corporate governance and investor stewardship can thrive for the benefit of all. 1 The ICGN Statement of Institutional Investor Responsibilities: goo.gl/3hafJs 2The ICGN Global Stewardship Codes Network: https://www.icgn.org/ global-stewardship-codes-network 3UK Stewardship Code: https://www.frc.org.uk/Our-Work/Publications/CorporateGovernance/UK-Stewardship-Code-September-2012.pdf 4 Japan Stewardship Code: http://www.fsa.go.jp/en/refer/ councils/stewardship/20140407/01.pdf

Spring 2017 | Ethical Boardroom 17

Commentary | Corporate Social Responsibility

Bruce Horowitz

President, Center for the Study of Bribery, Extortion and Coercion Situations, and Founding Partner, Paz Horowitz

When anti-corruption and CSR collide We tend to assume that ethics and anti-corruption compliance are complementary ingredients in the recipe for good governance. Let us consider whether, in some situations, anti-corruption compliance might violate ethics that are ordinarily seen as virtues. Indeed, whether it might already be harming not only good governance, but also good government.

In particular, we will discuss why and how human nature should be taken into account when making and enforcing ever-more-encompassing anti-corruption compliance rules.

18 Ethical Boardroom | Spring 2017

Does anti-corruption compliance always itself comply with corporate social responsibility?

In Sweden, the National Council for Crime Prevention urges officials ‘to discourage hospitality and gratitude’, two classical virtues.1 Under Swedish law, ‘bribery’ in both the government and the private sector, includes not only ‘bribes’ but also ‘other illegitimate rewards to express gratitude for services already performed’.2 Based on this anti-corruption law, it happened in Sweden that a florist’s assistant told how one of her customers, who had been ill for a prolonged period, gave flowers to a nurse. This nurse had been very important during this person’s illness, but

the customer was unable to send the flowers to the nurse’s workplace, as the patient had wished. The nurse did not want to receive it in such an open way for fear of being accused of corruption. Instead, the customer paid in advance and the nurse came to the shop later to pick up the flowers. The florist’s assistant was sorry about the situation, partly because it was troublesome for the nurse and partly because it made everyone involved feel a bit sleazy, ‘as if committing a crime’.3 Sweden clearly surpasses many other countries in attempting to avoid acts of apparent kindness, which include ‘self-serving’ intentions, by prohibiting those actions under administrative or criminal law. Another example is Sweden’s governmental prohibition against Swedish adoption agencies providing volunteers to help orphans in foreign countries, because even such life- and health-saving volunteer work could, and does,

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Corporate Social Respnsibility | Commentary

provide incentives for the foreign orphanage to favour Swedish adoptive parents.4 To a lesser extent, many countries now prohibit forms of socialising, sharing, use of personal charm, compliments, cordiality and other acts of apparent kindness, that had not previously been legally punished or conditioned. This is not because the giving of gifts, including the gift of hospitality, was never used before in order to ‘gain an advantage’. Since antiquity, gifts have always been known throughout the world as being able to create a mixture of gratitude and trust on the one hand, but with a sense of obligation and trade opportunities (reciprocal exchange) between the giver and the receiver, on the other – as social anthropologists and psychologists have reported for the last century.5 The sense or the observable fact that many acts of sharing, kindness, charm and simply ‘paying attention to the other person’ at least partially intended to create a sense of loyalty or obligation in the person on the receiving end. This realisation has led legislatures, informed by prosecutors, to enact laws that prohibit not only direct bribery, but also these attentive acts of sharing, kindness, a charming demeanour or even simple cordiality. As noted in Sweden, it is hard to build a wall between what is ‘due’ and what is ‘undue’ and, therefore, between what is ‘corrupt’ and what is ‘innocent’.

Simians, rats and four-year-old humans to the rescue

As Frans de Waal of the Yerkes National Primate Research Center and Malini Suchak of the Psychology Department of Emory University notes: “Non-human primates are marked by well-developed prosocial and cooperative tendencies as reflected in the way they support each other in fights, hunt together, share food and console victims of aggression… Even if a behaviour is ultimately self-serving, the motivation behind it may be genuinely unselfish. A sharp distinction needs to be drawn, therefore, between (i) altruistic and cooperative behaviour with knowable benefits to the actor, which may lead actors aware of these benefits to seek them by acting cooperatively or altruistically, and (ii) altruistic behaviour that offers the actor no knowable rewards. The latter is the case if return benefits occur too unpredictably, too distantly in time or are of an indirect nature, such as increased inclusive fitness.”6 In a later study, capuchin monkeys, rats and four-year-old children were repeatedly caught in the act of benefiting others without any expectation of benefits in return, especially if they had recently received kind or

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beneficial attention from another monkey, rat or tot.7 But both the children and the monkeys also tended to pass on unkind treatment to third parties.8 One of the conclusions of the study was that neither monkeys nor humans require higher cognitive capacity to pass a kindness or a meanness on to a third party. Meanwhile, it does take at least a four-year-old human to directly reciprocate a kindness for the purpose of repeating that experience between two interested parties.

Why monkeys and toddlers are important for legislators and compliance officers

As we see from the countries with the most advanced anti-corruption laws and where compliance is most highly operationalised, a lot of the compliance requires withdrawing from normal human interactions, some of which fulfil psychological needs for self-respect and which enable us to treat others with respect and kindness. Therefore, we need to make sure that the present tendency to withhold kindnesses, or non-confidential information, or expressions of personal concern and consideration, is not simply a part of a general urban withdrawal into individual isolation in society. Art Buchwald was a well-known columnist for the New York Times and the Washington Post newspapers. Many of his columns

If compliance requires us to treat others at arm’s length, it may avoid the creation of undue loyalties and obligations, but it is also an evasion of personal and corporate social responsibilities became famous. For us, one of his stories tells us why the ‘arm’s length’ rule needs some retro-humanisation. It is called Love and the Cabbie and was recently reprinted in Chicken Soup for the Soul: 20th Anniversary Edition.9 In the story, Art Buchwald is in a New York taxi with a friend. As they are getting out of the cab, his friend says to the taxi driver: “Thank you for the ride. You did a superb job of driving.” The driver responds: “Are you a wise guy or something?” Art Buchwald asks his friend: “What was that all about?” The friend replied: “I am trying to bring love back to New York.” Art: “How can one man save New York?”

The friend: “It’s not one man. I believe that I have made that taxi driver’s day. I’m aware that the system isn’t foolproof. If out of 10 [different people] I can make three of them happy, then eventually I can indirectly influence the attitudes of 3,000 more.” “I have made a study of this. No one tells people what a good job they’re doing. They’re not doing a good job because they feel that no one cares if they do or not.” And, as the capuchin monkeys and the four-year-olds are telling us, and as we know from the daily stories of how people treat their dogs, their families, their neighbours and complete strangers. Think of a work-day that is only and always at ‘arm’s length’. Negative or cold treatment during our work day leads to our negative treatment of others at work, on the way home and at home. If compliance requires us to treat others at arm’s length, it may avoid the creation of undue loyalties and obligations, but it is also an evasion of personal and corporate social responsibilities to the community. In the end, what is more important: assuring the avoidance of all ‘undue’ loyalty, obligations and mutually advantageous reciprocity; or permitting kindly, respectful human interactions to improve the sense of self-worth of the people in the interaction? While a part of human nature is self-interest and conniving behaviour, we need to accept that when monkeys, little children and rats can be kind and thoughtful to each other, we should be allowed to be kind, share with and show a caring attitude to others who happen to be public servants or potential customers, clients or patients. It is our corporate and personal social responsibility and it seems to be lodged within some of our more ancient genes. And, yes, the dangers are clear and part of tomorrow’s risk assessment. 1 SUSPICIOUS GIFTS: Bribery, Morality and Professional Ethics. Malin Akerstrom. Transaction Publishers, New Brunswick, New Jersey, USA (2014) 2Ibid. Including footnote 4: www.cabinetoffice.gov.uk/resource-library/ ministerial:gifts-hospitality 3Ibid. , Chap.2, loc. 672 4 Ibid., Chap. 4 5For Phil. Trans. R. Soc. B (2010) 365, 2711–2722 doi:10.1098/rstb.2010.0119. http://rstb. royalsocietypublishing.org/ 6Ibid., Chap. 4, See, for instance, Mauss, Marcel. The Gift (1925). For de Waal and Suchak, “Prosocial primates: selfish and unselfish motivations” 7Give What You Get: Capuchin Monkeys (Cebus apella) and 4-Year-Old Children Pay Forward Positive and Negative Outcomes to Conspecifics. Kristin L. Leimgruber, F. Ward, Jane Widness, Michael I. Norton, Kristina R. Olson, Kurt Gray, Laurie R. Santos. Published: January 29, 2014 http://dx.doi.org/10.1371/journal. pone.0087035 8Actors’ distributions were strongly related to previously received outcomes, for both monkeys (n=4 participants, 22 trials, Fisher’s exact, p=.03) and children (n=48 children, 48 trials, Fisher’s exact, p=.009). Monkeys paid forward negative outcomes 75% of the time and positive outcomes 80% of the time; children paid forward negative outcomes 72% of the time and positive outcomes 70% of the time. 9http://www.chickensoup.com/bookstory/36172/love-and-the-cabbie

Spring 2017 | Ethical Boardroom 19

Global News Europe Klaus Kleinfeld steps down from three boards

UK crackdown on long-term incentives British businesses should tackle executive pay, including long-term incentive plans, to address a ‘worrying lack of trust of business among the public’, the Business, Energy and Industrial Strategy (BEIS) Committee has said. A report by the BEIS Committee, whose recommendations are not binding, highlighted long-term incentive plans (LTIPs) as lacking in transparency and suggested that bonus schemes based on LTIPs should be scrapped from 2018. It also recommends that pay ratios comparing the salaries of the CEO and senior directors with those of the workforce should be published. According to a separate report produced by consultancy firm PwC, executive pay levels are falling. Its analysis of 40 FTSE 100 companies’ remuneration reports indicates 42.5 per cent of executives have received no salary increase this year to date and the median total pay figure received by CEOs has fallen from £4.3m to £4.1m.

Norway wealth fund addresses CEO pay

Credit Suisse bank in shareholder revolt Credit Suisse is at loggerheads with shareholders over compensation for its top managers, despite announcing a 40 per cent bonus cut for senior executives. Members of the Swiss bank’s executive board said they would slash performance-based rewards after shareholders objected to high pay in a year of losses for the bank. Credit Suisse posted a loss of 2.35billion Swiss francs for the last three months of 2016 and unveiled plans to axe 6,500 employees by the end of the year. In an interview with the Financial Times, Credit Suisse chairman Urs Rohner said the anti-bonus reaction “was more than I expected, and particularly among UK and professional or institutional investors and proxy advisers”. 22 Ethical Boardroom | Spring 2017

Norway’s huge sovereign wealth fund has called for less excessive CEO remuneration. Norges Bank Investment Management (NBIM), which invests the proceeds of Norway’s vast offshore oil and gas production, also encourages companies to pay more tax in the jurisdictions in which they generate. In a position paper, it stated “As a global investor, our main concern is that CEO remuneration should be value-creating for the company. The board should develop pay practices that are simple and do not put undue strain on corporate governance.” NBIM said it will invite investors to “consider shared principles for effective remuneration” in due course.

German-born businessman Klaus Kleinfeld (pictured below) has stepped down as chairman and chief executive of auto parts maker Arconic and resigned from the boards of financial firm Morgan Stanley and tech giant Hewlett Packard Enterprise Co. Kleinfeld agreed to leave Arconic after the company’s board of directors discovered that he had sent a letter to activist investor Elliott Management “without consultation with, or authorisation by the board”. Elliott Management, which had called for better corporate governance and a new chief executive at Arconic, had described Kleinfeld’s letter as a “threat to intimidate or extort”. In the space of a week, Kleinfeld also left boards at Morgan Stanley and HP.

Study compares global CEOs Women continue to make up a small proportion of CEOs in the UK, France, Germany and the US, according to a demographic study of global chief executives. The Route to the Top report by search company Heidrick & Struggles found that women CEOs are significantly rare in France and Germany, with the proportion standing at just two per cent and one per cent respectively. Other findings reveal that CEOs in the United States are likely to be older than their counterparts in France, Germany and the UK, and that internal promotions remain the most common route to the top – in Germany, 68 per cent of CEOs are promoted from within. www.ethicalboardroom.com

Hosted by:

Premier Partner:

ICGN Annual Conference 2017 Kuala Lumpur, Shangri-La Hotel | 11-13 July

This event will involve a variety of breakout sessions, company meetings to facilitate dialogue with global investors, enhanced networking opportunities and social functions to engage with this international community across this three day event.

Agenda will cover:

Conﬁrmed speakers include:

• Redeﬁning capitalism for a sustainable global economy • Global round-up: Governance priorities and challenges in major markets • Regional round-up: Unique characteristics in Asian markets • Contrasting approaches to board composition: Is there an optimum model? • The dynamics of investor stewardship in the face of multiple corporate structures • Enlightened approaches to corporate reporting • Responsible Investment – incorporating ESG as the norm, not the exception

Nik Amlizan Mohamed, Chief Investment Ofﬁcer, KWAP, Malaysia Pru Bennett, Head of Investment Stewardship APAC, BlackRock, Hong Kong Mike Cho, President, Korea Corporate Governance Services, Korea Gerben Everts, Board Member, IOSCO, The Netherlands

Dana Hollinger, Board Member, CalPERS, USA Sau Kwan, President, E-Fund, China David Styles, Director of Corporate Governance, FRC, UK Yasumasa Tahara, Director, Corporate Accounting & Disclosure, FSA, Japan

To Register: For more agenda details and how to book, visit our website: www.icgn.org Special discount for Ethical Boardroom readers: select ‘Non-member’ when registering and use the discount code EBKL2017 (case sensitive) to receive a £200 fee reduction. If you have any queries during your booking process please contact: Ravina Patel, Events Administrator | By email: ravina.patel@icgn.org | By telephone: +44 (0)20 7612 7089

For sponsorship opportunities, please contact: Florence Doel, Senior Events Producer | By email: Florence.doel@icgn.org | By telephone: +44 (0)20 7612 7091

Europe | Governance Reform

Advancing corporate governance reform

The UK is seeking to calm public concern about falling standards in business life by revisiting corporate frameworks... but it’s not all about codes of practice

The UK Government’s recent Green Paper on Corporate Governance Reform seeks to find a new approach to corporate governance that gives the UK an international competitive advantage, makes the UK an attractive place in which to invest and helps ensure we have an economy that works for everyone.

It focusses on giving a greater voice to employees and consumers in the boardroom, ensuring that executive pay is properly aligned to long-term performance and raising the bar for governance standards in the largest privately held companies. These

24 Ethical Boardroom | Spring 2017

Timothy Copnell

Chairman of KPMG’s UK Audit Committee Institute are issues about fairness and addressing public disquiet about standards in business life as much as they are about competitiveness and creating the right conditions for investment. This feels right. If the events of 2016 have taught us anything it is that public concerns can no longer be ignored. However, public concerns about standards in business life involve broader issues than corporate governance. There are many high-profile examples that, while not representative of the whole, have damaged public trust in business and raise genuine questions as to why some companies have done things that are unlawful or engaged in

practices the public perceive to be ‘bad’ even though they appear to be lawful? Regarding the former, the Government needs to address the perception – real or imagined – that individuals are not being held to account for what might appear to be unlawful practices. Is law enforcement – including the Company Directors Disqualification Act – working as satisfactorily as it might do and, if not, why not? After all, this might be expected to be a natural mechanism to address public concerns relating to standards in business life. The question as to why some companies have engaged in practices the public perceive to be ‘bad’ even though they appear to be lawful goes straight to the heart of a company’s ‘licence to operate’ – the relationship between the company

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Governance Reform | Europe

and its stakeholders. It’s a relationship brought into stark focus in the social media age where society has proved to be an effective driver of cultural change in areas such as tax planning and transparency.

Reducing the pay gap requires a change of mind-set One area undermining the public’s trust in business is the thorny topic of executive pay – one of three central pillars in the Green Paper. This is a complex area and one that has vexed Government, the investment community and society at large since the early 1990s. At first sight, executive pay structures might be considered a private matter between a company and its shareholders. However, a constantly widening pay gap might be telling of a

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such as total shareholder return, that are company’s attitude towards employees strongly influenced by capital market and any impact on employee morale will conditions and other generic factors rather compromise a company’s productivity than the implementation of long-term and ability to hire and retain talent. Also, strategy. Of course, reducing a complicated at a macro level, there is a cost to society. strategy into a small number of metrics Corporate leaderships do not exist is difficult, and choosing metrics that independently of the economies in which reflect the executive’s role and contribution they operate, so public disquiet about the to that strategy and company performance remuneration of corporate leadership is, can be even more challenging. therefore, a legitimate point of view with These issues prompt the question as to which business must engage and respond. whether LTIPs are doing what they are However, there is no silver bullet and supposed to do and, in many cases, the it is unlikely that any single measure will answer is that they are not. Consequently, remedy the problem. Reducing the gap a new approach is needed where the default between high earners and everyone else – if pay structure is not the LTIP – possibly that is an ‘unspoken’ objective of the Green even an approach where variable pay is Paper – will require a radical solution only a fraction of basic pay rather than a as successive reforms focussed on multiple, as is the case transparency, remuneration for most employees, committees and shareholder One area including those considered votes have done little to curb public concerns. More radical undermining the to be in short supply. While basic pay would necessarily solutions might include a public’s trust in rise, greater transparency wage cap (an idea that is business is the around a larger proportion largely discredited and of pay would address imposed by no major economy thorny topic of the impact of complex in modern times other executive pay LTIPs, which have largely than Cuba) or at the very been the source of the least a shift in culture and – one of three aspirations. Perhaps even central pillars in widening pay gap. a change of mind-set is required, wherein business the Green Paper. Promoting the leaders revert to being viewed This is a complex stakeholder perspective through and rewarded as managers area and one transparency of businesses rather than The second pillar in the as entrepreneurs. That said, that has vexed Green Paper looks at this must be balanced with Government, how employees and the need for incentive consumers might be given arrangements in the UK not the investment a stronger voice in the hampering UK companies community boardroom. At the heart from securing the talent to of this is the question of ensure their competitiveness, and society at directors’ responsibilities given the mobility of senior large since the which, as set out in the executives in a global early 1990s Companies Act 2006, are marketplace. to act in a way most likely Executive pay structures are to promote the success of the company overly complicated and the link between for the benefit of the members. However, the pay and performance can be opaque. Not subsequent emphasis that, in so promoting only does executive pay fail to incentivise the company, the directors should have performance, the complexity of the system regard to a wide range of other matters is creating a growing reputational risk for (including the interests of employees, companies and investors alike. the impact of the company’s operations Long-term incentive plans (LTIPs) – with on the community and the environment, all the inherent difficulties in agreeing etc) gives rise to certain challenges, not appropriate performance metrics – have least the extent to which directors have been allowed to dominate executive pay such regard, which at one end of the to the exclusion of other remuneration spectrum might verge on accountability structures that may be more appropriate and at the other might merely be to be to a company’s business model or strategy. cognisant of such matters. Furthermore, we have performance metrics,

Spring 2017 | Ethical Boardroom 25

Europe | Governance Reform Directors’ responsibilities were codified as recently as 2006 so there is probably little appetite to re-open that debate by (say) calling for an extension of their accountability to parties other than the members as a whole. Therefore, the challenge is whether the requirement to ‘have regard to a wider range of factors’ needs to be enhanced with guidance or whether better and more consistent governance could be achieved by greater transparency as to how the directors have taken such factors into account. The former risks creating a ‘tick-box’ approach which would be inconsistent with the best traditions of UK corporate governance. The latter is, however, more readily achievable by creating an explicit requirement to disclose within a company’s annual report the key stakeholders identified by the board and the information necessary to enable shareholders to understand how the board has had regard to those stakeholders in acting to promote the success of the company for members. This could be supported by augmenting the Financial Reporting Council’s 2014 Guidance on the Strategic Report to provide examples of good practice.

believe it is in their best interests to do so. Of course, such individuals would be subject to the same broad responsibilities as other (non-stakeholder aligned) directors with a duty to promote the company’s interests for the benefit of the members, rather than participating as a director with the sole focus on promoting the interests of the stakeholder group they represent. And, like other unitary board members, they would serve subject to the appointment of shareholders and act to promote the interests of shareholders – albeit being well placed to understand the interests of whatever stakeholder group they have experience of.

Raising governance standards

Corporate governance codes alone are not an effective means for raising governance standards in large privately held businesses – but good governance is in the interests of owner-managers.

held to account for their behaviour. For UK companies with a premium listing on the main market this is a combination of the Listing Rule disclosure requirements and the oversight provided by institutional shareholders. It is difficult to see what equivalent mechanisms could be employed effectively in the privately-held sector. More importantly, there is a question as to whether the introduction of any code for such companies will actually address the board behaviours that have likely triggered the need for the Green Paper. It would be regrettable if the regulatory response to recent events was to encourage or even mandate practices that are out of tune with the value achievable. It is often stated that the UK has a world-leading corporate governance framework and that the UK Corporate Governance Code is admired across the world. This is certainly true. But, and this is

WORKING TOGETHER Advisory panels can ensure key stakeholders are being heard at the board level

...but be wary of undermining the unitary board

Other mechanisms to encourage a stronger voice for employees and consumers in the boardroom might include stakeholder advisory panels, assigning individual non-executive directors with the responsibility to ensure key stakeholders are being heard at the board, or appointing individual Diverse boards stakeholder representatives, such as ‘workers’ to the board. – comprising Each of these ideas has some individuals merit, but ultimately the with different wider group of stakeholders are not proxy owners perspectives (albeit any company will be – can be more cognisant of the views of the wider stakeholder community able to consider The final pillar of the Green if it is to succeed), so great issues in a Paper looks at raising the bar care must be taken to avoid for governance standards in both undermining the rounded way UK’s largest privately held unitary board concept and than boards that the companies by either extending creating a conflict with the are less diverse the application of the UK’s general duties of directors. Corporate Governance Code All directors – executive from premium listed companies and non-executive – are to encompass such businesses or through responsible for having regard to stakeholder developing a separate governance code tailored interests to promote the success of the specifically to the needs and challenges faced company for the benefit of by privately held businesses. The problem is its shareholders. that corporate governance codes are only one That said, diverse boards – comprising means of raising governance standards and individuals with different perspectives – can while it would be a fairly easy task to adapt be more able to consider issues in a rounded or craft a governance code specifically for way than boards that are less diverse. In this large privately held companies, there is a big regard, it makes sense to appoint directors question mark as to how effective such a code with an understanding of specific stakeholder would be in practice. For codes to be effective viewpoints (including ‘non-executive’ they need a mechanism whereby boards are employees) where the shareholders as a whole 26 Ethical Boardroom | Spring 2017

the crux of the matter, success breeds complacency. While codes have proved useful in improving governance structures and tightening governance processes, particularly in those companies that embrace good governance practices, they have proved less useful at exposing and addressing some of the behavioural deficiencies at the root of the most notorious cases of governance failure – in the UK or elsewhere. Indeed, when it comes to behaviours that directly disadvantage the wider group of stakeholders, such as treating employees and customers poorly or failing to be a responsible tax payer, then maybe the world has moved on and public disquiet – given a voice through social media – is now a more effective tool for bringing boards to account than the codes that have become such a common feature of business life. www.ethicalboardroom.com

Europe | Switzerland

Swiss stock index to reward ethical firms The first Swiss stock exchange index dedicated to corporate governance will underweight companies that fall short of good practice In the follow-up to its 20th anniversary, the Ethos Foundation in Switzerland has launched a new stock exchange index dedicated to corporate governance of Swiss listed companies in collaboration with the Swiss Stock Exchange (SIX Swiss Exchange).

Vincent Kaufmann

CEO of Ethos Foundation, Switzerland The launch of the ESCGI is an innovative new way to promote good corporate governance in listed companies by privileging the companies that implement best practices. The respect of best practice in corporate governance serves as a reference for the weighting attribution to the companies comprised in the classic index of the Swiss market, the Swiss Performance Index (SPI). In fact, traditional indices are constructed based on the market capitalisation of each stock adjusted to the free float of the stocks. Apart from liquidity considerations, no specific rules drive the inclusion and weighting of a stock in standard indices.

The Ethos Swiss Corporate Governance Index (ESCGI) takes into account the main corporate governance best practice criteria in order to define the weight of the different constituents. This is the first index of its type on the Swiss stock market and allows investors to reduce the weight Reduce corporate of companies that entail a The index is governance risks of corporate governance risk. passive investments The Ethos Foundation has intended as The past decade has seen a been active in the promotion an additional steady rise of passive investment of good corporate governance mechanism of by institutional investors. in Swiss listed companies investments usually since its creation in 1997. self-regulation Passive have lower management fees The integration of best in listed and allow a close replication practices in corporate of the relevant stock index’s governance has always been companies, performance. However, passive an integral part of Ethos’ incentivising investments also imply that analysis of companies in investors automatically invest relation to the construction them to in all constituents of the index of its investment funds. As a implement and become captive investors. responsible investor, Ethos best practices Investing in the entire market exercises the voting rights means that the portfolio of attached to its investments in corporate investors may include companies based on its voting guidelines governance with poor corporate governance that take into consideration practices. The so-called ‘exit strategy’ internationally recognised is no longer an option for passive investors. best practices in corporate governance. In Active ownership is the only way to influence December 2016, Ethos published the 16th companies to improve their practices. edition of its Proxy Voting Guidelines and In this context, Ethos believes that it is Corporate Governance Principles. As part of its necessary to rethink the way traditional stewardship duties, Ethos engages in dialogue stock indices are calculated by adding with listed companies with a particular focus further considerations. In particular, the on shareholder rights, board composition ESCG Index aims to: and board and executive remuneration. 28 Ethical Boardroom | Spring 2017

■■ Reduce the corporate governance risks by underweighting or excluding companies that do not apply best governance practices ■■ Reduce the carbon impact of the index by underweighting companies with significant carbon emissions ■■ Avoid overweighting companies that are under a serious controversy ■■ Avoid overweighting companies with a weight in the SPI exceeding 15 per cent ■■ Overweight companies that do not fall into one of the above categories

Focus on corporate governance risks

The criteria that are applied in order to measure the corporate governance risks are evaluated according to the Ethos Corporate Governance Principles, which are based on www.ethicalboardroom.com

Switzerland | Europe

MEASURING ETHICS A new stock market index tells investors which firms are the best long-term ethical bet

corporate governance best practices. The index focusses on a selected list of corporate governance risks as an evaluation and weighting factor. The weighting of the different stocks can decrease to zero per cent compared to the standard index, depending on the intensity of the governance risks identified. In particular, the index focusses on corporate governance risks relating to shareholder rights, board composition as well as on board and executive remuneration.

Shareholder rights

Shareholder rights are paramount to the healthy functioning of a listed company. The index privileges companies respecting the one-share, one-vote principle. In addition, the duty to make an offer in the case of a change of control of more than 33.3 per cent of the voting rights must be respected as stipulated www.ethicalboardroom.com

by the Swiss Financial Market Infrastructures legislation. In fact, the Swiss legislation allows companies to introduce in their articles of association the possibility to derogate from this obligation (so called ‘opting out’ clause). The combination of multiple classes of shares and an opting out clause entails an important risk for minority shareholders. This combination might create an opportunity for the controlling shareholder to sell his stake with an important control premium at the expense of other shareholders. The buyer can gain control of the company with a small part of the capital and without having to make an offer for the rest of the capital. In such a case, the other shareholders who often represent the majority of the capital but the minority of the votes may see a new shareholder with potentially divergent interest taking control of the company. The impact

on the valuation of the company can be substantial. The combination of multiple classes of shares and the opting out clause leads to a higher underweighting in the Ethos’ index than each measure taken separately. This scenario actually took place at the Swiss listed company Sika. The historical controlling shareholder with 17 per cent of the share capital and 53 per cent of the voting rights decided in December 2014 to sell its stake to the competitor Saint-Gobain. The articles of association of Sika included an opting out clause allowing Saint-Gobain to gain control without having to make a takeover offer. Saint-Gobain therefore offered an 80 per cent premium to the historical shareholder to acquire their stake. On the day of the announcement of the transaction, Sika’s share price fell by almost 30 per cent. Spring 2017 | Ethical Boardroom 29

Europe | Switzerland REDUCING THE RISK The Ethos index will underweight or exclude companies that do not apply best governance practice

However, the articles of association of Sika include a voting right limitation on the privileged shares, which were intended as a safeguard against a hostile shareholder taking control of the privileged shares. The historical controlling shareholder benefited from an exception to this limitation. Due to the announced change of control of the privileged shares, the majority of the board, who were not connected to the controlling shareholder, decided to remove the exception to the voting right restriction and strictly apply the articles of association. The controlling shareholder filed a lawsuit at the Zug Cantonal Court against this decision. On 28 October 2016, the court rejected the claim of the controlling shareholder. The latter has announced its intention to appeal this decision at Zug’s higher court. The case is still pending, but it demonstrates the potential risk for investors when investing in companies that include such privileges for a single shareholder.

Board composition

The board composition is a central part of the governance of a company. In terms of composition, an adequate balance between size, independence, experience, diversity and expertise has to be reached. To ensure a balanced composition of the board, the board size should be sufficient but not excessive. However, in the Swiss market, several listed companies operate with a board of three or even two members. Apart from a Swiss law, which requires a minimum board size of one director, there is no listing requirement of a minimum board size. A board size of less than four members is a major risk for investors who are automatically invested in such companies if they want to replicate the standard index. The Ethos’ index therefore underweights significantly companies with a board of less than four members. 30 Ethical Boardroom | Spring 2017

The board should also include sufficient directors who are independent from management in order to carry out its supervision duties with objectivity and in the interests of all the shareholders. To be considered sufficiently independent, the board should include a certain number of independent directors. In the case of companies with an important shareholder (or group of shareholders), the overrepresentation of important shareholders on the board is not desirable. This could lead to a major shareholder controlling not only the general meeting but also the board, which carries serious risks for minority shareholders and other stakeholders in the company. This is particularly important when the control of the company is obtained via a double class of shares. Ethos’ index underweights companies where the board lacks independence or where the controlling shareholder holds more than 50 per cent of the board seats. In addition, the Ethos index will underweight companies with a combined chairman and CEO. Chairing a board of directors and running a company are two very important but distinct tasks. The separation of the offices of chairman of the board and chief executive officer is designed to ensure a balance of power. It reinforces the board’s ability to make independent decisions and to monitor the conduct of business by executive management.

Board and executive remuneration

Particular attention has been paid to board and executive remuneration over recent years and has resulted in several new legislative measures worldwide. In particular, with the introduction of the Minder initiative, Switzerland is the country where the shareholders of listed companies have most rights with regard to voting board and executive remuneration. The shareholders now have the non-transferable right to vote on the

total amounts of remuneration to be paid not only to the board of directors, but also to the executive management. The design of the remuneration system is very important for three reasons. First, a remuneration system that yields excessive payouts is an important cost borne by the company’s shareholders. Secondly, the remuneration system can strongly influence the attitude of managers toward risk taking, thereby impacting the strategic orientation of a company. Finally, an inappropriate remuneration system raises questions of internal fairness and constitutes an important reputational risk, which can compromise investors’ trust and the motivation of employees. Ethos’ index focusses on two different practices that create a particular risk. The index underweights companies that grant stock options to their non-executive board members. This practice may significantly impair non-executive directors’ ability to exercise their judgement in an independent way, in particular when the exercise period is approaching. The index also underweights companies where executive management systematically receives very high variable remuneration as a percentage of their base salary with poor connection to the performance of the company and the long-term value creation.

Characteristics of the index

In aggregate, compared to the standard SPI, Ethos’ index overweights 76 companies, gives a neutral weight to six companies, underweights 97 companies and currently excludes 26 companies for major governance risk. Based on the backtesting made by Ethos, the index has a tracking error close to one per cent compared to the standard index and very close correlation. This index therefore offers a robust alternative for investors wishing to track the market, while reducing the corporate governance risk of their investments. The index is also intended as an additional mechanism of self-regulation in listed companies, incentivising them to implement best practices in corporate governance. www.ethicalboardroom.com

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Europe | Spain

Corporate ethics boost confidence in Spain

Spain has seen solid advances in good corporate governance and transparency Ensuring corporate transparency and the smooth running of corporate boards, as well as fostering competitiveness, has been one of Spain’s key targets during the past few years. To that effect, in-depth reforms have been implemented to strengthen the corporate governance framework of listed companies.

These changes, which have seen Spain at the forefront of such matters internationally, have had an impact both at a regulatory level and on good governance recommendations. It is obvious, and indeed has been proved by recent events in the business world, that good governance goes beyond the specific interests of a company and its investors, since it also promotes market stability and enhances third parties’ confidence. An appropriate governance framework prevents short-term management, limits taking on excessive risk and contributes to the sustainability of every company – in particular of economic growth overall. In 2014, a major reform of the Corporate Enterprises Act (Ley de Sociedades de Capital) Act 31/2014 was implemented and, in February 2015, a new Good Governance Code of Listed Companies was approved, updated and adapted to the new regulations and recommendations. Now, after years of intense legislative modifications and of good practices, we believe that companies will benefit from a period of stability, so that they may adapt their practices to the new legal framework as well as to the recommendations under the new Code. 32 Ethical Boardroom | Spring 2017

Ana María Martínez–Pina García

Vice Chairperson of the Comisión Nacional del Mercado de Valores (CNMV)

The data disclosed last year by companies in their corporate governance statements are encouraging. They revealed a high degree of compliance with the new Code, considering it was the first year of its enforcement. Indeed, listed companies fully complied with 81.8 per cent of the Code’s recommendations and, in addition, they partially complied with another 8.8 per cent. The timeliness of the changes and their favourable reception by companies are confirmed by these results.

Regulatory changes

The reform, in regard to corporate governance, has mainly focussed on achieving a greater degree of involvement in corporate management, both on the part of companies’ partners through shareholders’ general meetings and on the part of directors through administrative bodies. Shareholders’ greater involvement in corporate governance – by exercising voting rights, taking part in general meetings and maintaining an active dialogue within the company’s governance bodies – is key to improving companies’ financial and non-financial performance. Three aspects that have been subject to reform are worth highlighting. Firstly, the competencies of the annual general meetings have increased. Certain transactions, such as the acquisition or disposal of core operating assets or the transfer of core activities to subsidiaries, which were subject to board approval until 2014, must now be approved at the AGM.

It is also worth noting the reduction to three per cent of the share capital (formerly five per cent) as the threshold for the exercise of a minority right – for example, to request calling a shareholders’ general meeting or to include proposals in the agenda. Secondly, measures have been adopted in order to revive the functioning of shareholders’ meetings by opening new channels for shareholders’ active participation. Listed companies must make available on their website an electronic forum that enables shareholders to communicate ahead of general meetings. Through this forum, shareholders may post proposals, adhere to them or carry out initiatives to reach the required percentage to exercise a minority right, as well as post offers or requests for voluntary representation. Likewise, each listed company’s shareholders may create specific and voluntary associations to exercise their representation at general meetings. Finally, the reform of directors’ remuneration stands out. According to consensus, one of the catalysts for the outbreak of the financial crisis was the director remuneration system in listed companies, since, in certain cases, it encouraged excessive risk taking without effective control by shareholders. The reform of the Corporate Enterprises Act has laid down shareholders’ right to issue a binding vote on directors’ remuneration policy and has forbidden any remuneration that has not been approved at a general meeting. This policy must establish the maximum amount of the annual remuneration to be paid to the directors in aggregate and the amount of the salaries and other remuneration items for executive directors. Shareholders are also entitled to give an opinion on the directors’ remuneration report, which records how the www.ethicalboardroom.com

Spain | Europe remuneration policy has been implemented throughout the year, including a breakdown of the remuneration earned by each director.

Public information on CG

In Spain, issuers of securities admitted to trading must publish, on an annual basis, a corporate governance report (IAGC) and, in the case of issuers whose shares are listed, also a directors remuneration report (IARC). Both reports are intended to offer investors a clear and comprehensive overview of the corporate governance practices of listed companies so that they may have an informed opinion. The responsibility for drafting and publishing these reports lies with the board of directors, which, in turn, holds the non-delegable power of setting out the corporate governance policy. The Corporate Governance Report must be drafted and published following a model approved by the Comisión Nacional del Mercado de Valores, (CNMV, the Spanish Securities Market Commission) and structured as per the recommendations contained in the Corporate Governance Code. It must include, among others, the following details: ■■ The company’s shareholding structure: identification of shareholders with significant shareholdings and their representation on the board of directors, directors’ shareholdings and existence of shareholders agreements, as well as information on share capital and treasury shares (own shares) ■■ Functioning of the shareholders’ general meeting ■■ Composition, rules on the organisation and running of the company’s board of directors and its committees ■■ The company’s transactions with its shareholders, directors and officers ■■ Internal control and risk management systems in relation to financial reporting ■■ Degree of compliance with the corporate governance recommendations The CNMV is responsible for monitoring compliance with corporate governance rules and, to that effect, it may seek such information as it may require about it, as well as disclose any information it considers relevant on the effective degree of compliance. In turn, the directors’ remuneration statement must include comprehensive, clear and understandable information on directors’ remuneration policy, as well as an overall summary on the application of this policy during the financial year, together with a breakdown of the remuneration earned by each director. Based on the information gathered, the CNMV annually publishes two reports in which it provides an account of the main characteristics of corporate governance structures in Spain, as well as the details of remuneration policies and practices that listed companies have in place for their www.ethicalboardroom.com

directors. Likewise, directors’ remuneration figures are analysed.

Comply or explain

One of the areas that has been of particular concern for us in the past few months, since it is where greater margin for improvement exists both in Spain and in our neighbouring countries, is the way in which companies apply the comply or explain principle, in particular with regards to the quality of explanations when good governance code recommendations are only partly complied with. When reviewing corporate governance reports we have found that, in certain cases, the information provided by companies to explain their non-compliance of the recommendations is not sufficiently clear or specific for its appropriate assessment by the market. With a view to improve the quality of these explanations, the CNMV published, in the summer of 2016, a technical guide to provide companies with a clear guidance when the recommendations of the Code are not fully complied with. This guide also incorporates the commission recommendation of 9 April 2014 on the quality of corporate governance reporting (comply or explain). The guide aims to promote a change on how listed companies and their boards of directors address their actions in the field of corporate governance. The intention is that the explanations on compliance with the recommendations of the Code do not consist of a mere exercise that is carried out at the time of completing corporate governance reports, but that a previous and reasoned assessment is made of the reasons why a company decides to depart from one or more recommendations.

Since 2014, numerous reforms have been implemented in Spain in order to improve the corporate governance of listed companies and to enhance CSR awareness It is true that, in certain cases, total or partial non-compliance of a recommendation of the Code may allow more efficient governance. In those cases, a clear and comprehensive explanation must be provided and this is only possible following the spirit of the European Commission recommendations and providing the details recommended by our technical guide.

Corporate social responsibility

At present, there is no doubt that corporate social responsibility (CSR) is a basic tool to guarantee corporate sustainability in the long term and to evidence the commitment towards the environment in which companies operate. Along this line, one of the main novelties in the reform of the Corporate Enterprises Act was to highlight its importance when

including, within the board’s non-delegable powers, the approval of the CSR policy. Furthermore, with the next implementation in our national legal system of the 2014 non-financial reporting directive, large public-interest entities with more than 500 employees should publish information on social, labour and environmental matters. The should also publish information in respect of the protection of human rights or the fight against corruption and bribery, either as part of their management report or in a separate report that shall be incorporated to the management report by reference. In the same sense, the Code of Good Governance of Listed Companies has considered it appropriate to develop the recommended minimum contents of the CSR policy and to express the principle of transparent reporting, based on the need of informing on both financial and non-financial business aspects. To that effect, the Code includes one principle and three recommendations. Recommendation 54 advises that the CSR policy should state the principles or commitments the company will voluntarily adhere to in its dealings with stakeholder groups, specifying at least: ■■ The goals and corporate strategy in regard to sustainability, the environment and social issues ■■ The specific practices adopted ■■ The systems for monitoring results ■■ The mechanisms for supervising nonfinancial risk, ethics and business conduct ■■ The channels for stakeholder groups communication and dialogue ■■ Responsible communication practices that prevent the manipulation of information and protect honour and integrity In addition to having a CSR policy with this minimum content, the Code also considers it is important to give publicity to these issues, to which end it recommends that information on them is provided in a separate document or in the management report, using any of the internationally accepted methodologies.

Conclusions

Since 2014, numerous reforms have been implemented in Spain in order to improve the corporate governance of listed companies and to enhance CSR awareness. The effort made in our country in the past few years by regulators and supervisors, as well as by businesses, is beginning to bear fruit. We have started to analyse if the implementation of these reforms in pursuit of transparency, participation and accountability contribute to the development of a culture of professional and ethical values and to promote sustainability and investors’ confidence in our companies. The analysis carried out so far shows positive results, which can only improve by introducing points of clarification and simplification to ensure a period of regulatory stability. Spring 2017 | Ethical Boardroom 33

Europe | Red Eléctrica

Fernando Frías

Non-Director Vice-Secretary of the Board of Directors, Head of Compliance and Corporate Governance, Red Eléctrica Corporacion SA

Cultivating trust How empathetic engagement between a Spanish listed company and its shareholders evolves towards a new corporate mindset and culture When Ethical Boardroom invited me to write an article on corporate governance for the prestigious magazine, I immediately felt grateful considering the first-class professionals who usually contribute to the publication with their articles: leading experts who have a deep knowledge of the international good corporate governance scene. I accepted the invitation under the personal commitment to address the topic with honesty while sharing some of the reflections I have forged over my long experience in Red Eléctrica Corporacion (REC), a Spanish public company listed on the Ibex 35 stock market index. This article is not intended to be an inventory of the company’s corporate governance practices over its history nor a review of the policies adopted in the past year. In fact, any interested readers may find on our website both our corporate governance story in a modern, schematic and friendly format and our annual corporate governance report, as approved by the board of directors. So please continue reading, I promise to keep it interesting. I do wish to start my article however by mentioning that REC was recently awarded Best Corporate Governance in the utilities industry in Europe by Ethical Boardroom in its Winter 2017 edition. We have received this honour with great satisfaction. The main activities undertaken by Red Eléctrica Group, offered on an exclusive basis within a regulated sector, are energy transmission – which covers the construction and maintenance of the high voltage grid – and the operation of the electricity system in Spain, thus guaranteeing an uninterrupted, safe and quality power supply for all citizens. Additionally, the Group is also devoted to expand its business base through telecommunications and international activities. REC has been quoted on Spanish stock exchanges since 1999. Its current shareholder 34 Ethical Boardroom | Spring 2017

structure includes the State Industrial Holding Company (SEPI, Sociedad Estatal de Participaciones Industriales), which holds 20 per cent of the capital stock, around 70 per cent foreign institutional shareholders, mostly Anglo-Saxon, and some minority institutional and retail shareholders from Spain.

Driving good governance

Furthermore, it must be noted that about 63 per cent of the total attendance of the annual general meeting held in April 2016 was represented by foreign institutional shareholders, who are particularly active, engaged and a clear majority at the AGM; hence the power and real influence of foreign institutional shareholders and the proxy advisors on REC today. They are the main drivers of good corporate governance practices in listed companies sustained in the long run. Looking back to 1999, when the company first went public, we could say our journey has been long and complex: the board of directors, led by different chairmen and with a particular structure and make-up throughout the years, has gradually become aware of the relevance of corporate governance in the company and, little by little, has understood, incorporated and progressed towards notable good governance practices. These in turn emerged and evolved as our foreign shareholders, proxy advisors and investors expressed their interests, thanks to a genuine and reliable engagement process. Good governance certainly has evolved ever since.

The board of directors of our company is able to embrace the reasons and arguments in favour of good governance expressed by our foreign shareholders

Listening to shareholders

REC has advanced from an attitude towards our shareholders of simple or passive listening in its early years as a quoted company – when we struggled to even understand the reasons underlying each good governance recommendation – to a more proactive and participatory style, which allows for a dialogue between both www.ethicalboardroom.com

Red Eléctrica | Europe NURTURING A HEALTHY CORPORATE CULTURE Red Eléctrica is fostering a trust-based relationship with investors and shareholders

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parties. Today we could even describe our relationship as ‘empathetic or committed’, one in which each of the parties can understand the other’s concerns. Our shareholders express their recommendations to us, but they are also open to listening, understanding and adapting to the local particularities in our country, in our industry and even in our company, and suggest alternatives or allow the company to make gradual progress. Likewise, the board of directors of our company is able to embrace the reasons and arguments in favour of good governance expressed by our foreign shareholders. As a result of this ‘empathetic’ engagement process, REC took a pioneering step in Spain between 2015 and 2016: the CEO role was separated from that of non-executive chairman of the board of directors. This measure was fully supported by the board, which called an extraordinary general meeting to put it to the vote of its shareholders and made all the necessary information and documentation available. It was massively upheld and welcomed by our shareholders. We must remember that the boards often forget that the company belongs to the shareholders. Therefore, our developments in the area of good governance have meant an actual shift in the mindset and culture of our company, but also of the board of directors. We have been able to assimilate into our DNA the chromosome of genuine and credible corporate governance. In my opinion, this was our greatest accomplishment: the finish line of a journey where our foreign shareholders and the proxy advisors on the one hand, and the board of directors (led by the chairman in office at each time), on the other, have walked together, shoulder to shoulder with genuine and exhilarating as well as deliberate, proactive, constructive, transparent, anticipated and bilateral engagement. We know that incorporating engagement as an actual and sustainable part of our culture has required much effort in the past to understand and accept our shareholders’ requests and will certainly require us to go the extra mile in the future. The result of this actual and sustainable engagement can be summarized with one word: trust. In an equity market, such as the stock exchange, trust is key to the economic and social growth of a company, of a nation and, essentially, to the development and social and economic balance of our world. Before I conclude these reflections, it is only fair that I express my sincere gratitude to all the individuals and institutions in the foreign investment world who, over these years, have offered us their constant cooperation, support, patience, understanding and, ultimately, their trust. We hope to cultivate this trust with our empathetic and sustainable engagement, trying to protect and foster an asset shared by the company and its shareholders. Spring 2017 | Ethical Boardroom 35

Board Governance | Accounting

Collaboration is key to fighting fraud To address accounting challenges, tap the power of policies and people Accounting is the ‘language of business’ and that language can be challenging indeed. Grey areas, complexities, subjective elements: accounting has all these in abundance. Yet, in a sense, confronting the many challenges of accounting is fairly simple. Companies need two things, essentially: 1) sound accounting policies; and 2) the right kind of people to manage those policies. Each of these should be supported by a set of equally simple (and powerful) tenets, including clarity, communication and scepticism. The Anti-Fraud Collaboration, a coalition of top US groups representing key constituents of the financial reporting supply chain, explored these ideas in depth at a pair of 2016 workshops in New York and San Francisco. The events brought together audit committee members, financial executives, internal auditors, external auditors, as well as regulators from the US Securities and Exchange Commission and the Public Company Accounting Oversight Board. They generated a wealth of insights on leading accounting practices that can help companies enhance financial reporting, deter financial fraud and build thriving businesses.

Policies: clarity and communication are key

At both the New York and San Francisco workshops, an oft-repeated admonition was that companies must strive to adopt policies that are understandable and clear, even (perhaps especially) in areas of accounting complexity. Although policy is often written by a company’s technical accountants, it is primarily non-accountants, such as the sales force, whose actions have an impact on the accounting results. Moreover, policies must be married to process. Strong communication between the owners of accounting policies and the employees in the field is a must and

36 Ethical Boardroom | Spring 2017

Cindy Fornelli

Executive Director of the Center for Audit Quality (CAQ) accounting policies should be reviewed at regular intervals and address how to identify and monitor changes. They must specify what happens when new, unforeseen issues arise – and how to communicate them. Accounting policies and procedures are thus living documents, undergoing change through an iterative process. Policies and procedures must be tested in the field prior to implementation and then monitored post-implementation to ensure they are being applied consistently.

Revenue recognition is a complex accounting area where application guidance varies by revenue stream. Policy and training are not ‘one-size-fits-all’ in highly diverse and geographically dispersed organisations

compliance and behaviour 5 Tie to compensation 1

Policy challenges: revenue recognition

Revenue recognition figured heavily in the discussion at both workshops, in large part because of the new revenue recognition standard that will become effective in the US on 1 January 2018 for calendar year-end public companies. Yet no matter what the state of the standard, revenue recognition is an area where effective accounting policy plays a critical role. What makes revenue recognition so challenging? For one, it is closely tied to key metrics – earnings, margins and revenue itself – that are reported both externally and internally. Externally, these metrics are

The risk to the organisation from an accounting policy that is either not implemented or not implementable as written is substantial.

Recommendations for implementing accounting policies

Create policies that are in lock-step with authoritative guidance and, if possible, in plain language Develop examples to help those in the different business lines understand how to apply the guidance/policy Communicate the policies and examples developed by corporate accounting with operations and perform field tests Embed or involve accounting/finance professionals in or with operations

2 3

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Accounting | Board Governance crucial to Wall Street’s valuation of the company’s stock. Internally, they have a major impact on employees in the area of compensation and in the C-suite. Therefore, many employees in the organisation are under pressure, in one form or another, to meet expectations for these metrics. Moreover, revenue recognition is a complex accounting area where application guidance varies by revenue stream. Policy and training are not ‘one-size-fits-all’ in large, highly diverse and geographically dispersed organisations. In some companies, a large percentage of revenue comes from overseas activities, which can lead to extensive communication, training and coordination challenges. To craft effective accounting policies related to revenue recognition, workshop participants made several recommendations. First, accounting policies in this area should be granular, because even slight differences in interpretation can have a major impact on revenue recognition. Where possible, the policy should include examples that

are understandable to non-accountants to assist in implementation. This is especially important as companies implement the new revenue recognition standard. Second, an effort should be made to standardise contract terms and deviations from typical contract terms should be well documented and approved by senior management. The accounting function should be made aware of such deviations. One participant strongly recommended that an accounting expert be involved in contract negotiations. Review of final sales contracts and completion of a revenue recognition checklist are common internal controls. Third, because accounting policy is affected by the actions of the sales force and other parts of the organisation, internal audit or a business control function should test whether executed contracts have been accounted for in accordance with the accounting policy. Fourth, clear responsibility and clear lines of communication among legal,

business and finance must be created so that all key players understand sales transactions. Finally, internal controls need to be dynamic and updated as business activities evolve and requirements change under generally accepted accounting principles. This includes controls to adopt and implement the new revenue recognition standard.

People: critical thinking, communication and character are key

No matter what the issue, sound accounting policies are necessary but not sufficient. Even the best accounting policies will fall short without good people to implement them. Hence, the Anti-Fraud Collaboration’s New York and San Francisco workshops also devoted considerable time to the topic of staffing. Simply put, hiring, retaining, training and motivating staff are paramount to navigating a complex accounting environment.

TIME FOR A RETHINK Working together can improve accounting policies www.ethicalboardroom.com

Spring 2017 | Ethical Boardroom 37

Board Governance | Accounting Addressing these human resource challenges is no easy task, yet workshop participants agreed that finding the right people is much more than a hunt for technical expertise. For one, it’s about mindset. When considering potential hires, a few basic questions are in order: ■■ Do they possess sufficient critical thinking skills? ■■ How do they go about reaching a decision? ■■ How do they work with staff at different levels of the organisation to obtain information? ■■ Are they comfortable developing and expressing their own views in a team setting, or do they just follow the herd? ■■ What examples can they show to demonstrate their thinking had an impact on their organisation? ■■ Do they have natural curiosity? (One participant said: “I want my staff to be asking ‘why, why, why?”) Beyond these basics, communication skills are indispensable. Accounting staff must often deliver news that isn’t welcome, as well as information that may not be considered the highest priority, to both senior and junior members of the organisation. Can the employees communicate with staff in different functions at different levels in a way that will affect their behaviour? Character, of course, is also key and part of the hiring process should involve attempting to identify applicants who can act with integrity. However, it’s equally important to remember that screens in the hiring process are no guarantee against fraud. Under unusual pressure, even people of integrity and good background may do wrong.

People challenge: staffing for complex accounting issues

Staffing for complex accounting issues, such as derivatives, taxation and securitisation, presents a special challenge. These are areas where knowledge is highly specialised and expertise is limited. The company employee responsible for such an area may be considered an expert. But auditors must obtain sufficient evidence when testing controls for the accounting area to support their audit procedures, regardless of management’s assessment of the expertise of such in-house staff. Some participants suggested that the accounting department (or in some cases the audit committee) be given the resources to confer with an outside expert in such instances. Complex accounting issues may also create challenges around the segregation of duties. The potential for fraud is heightened by the ‘expert’ in an accounting area who – using the excuse that no one else can do the job – avoids taking mandatory vacations (control failures are often exposed during periods when a replacement takes over the 38 Ethical Boardroom | Spring 2017

responsibilities of a vacationing employee). Further, even if there are no problems with the employee’s work, the company needs to have sufficient resources and documentation should the staff member be absent for an extended period or leave the organisation. What controls can be implemented to assess significant assumptions and judgments made by such in-house experts? One solution may be for the audit committee to encourage management to engage someone from outside the company to review the in-house expert’s processes and conclusions. An outsourced or co-sourced internal audit function offers another solution, especially for smaller companies. There may be objections raised that only the in-house expert has the necessary knowledge, but in most accounting

perspective and advice: “I have seen a lot of different ways of staffing internal audit. One that I liked was rotating executives, financial and non-financial, through internal audit. It gave them the ability to learn about the business, plus the mix of expertise helped blend skills.” While perhaps not as wide in scope as internal audit, staffing considerations for external auditors are varied, in that external auditors are concerned with assessing the adequacy and competency of their clients’ financial reporting staff, as well as finding the right people for their own firms. On the former, in performing the audit, external auditors have an opportunity to assess the technical expertise and professional demeanour of the issuer’s financial reporting staff. External auditors may discuss deficiencies in these

SHARING INSIGHTS In-house experts can not be considered ‘untouchable’

areas, there are numerous qualified people who can be enlisted to independently assess an accounting estimate for reasonableness or test a related control. The important thing is that in-house experts cannot be considered ‘untouchable’. Companies need to have people who can question and challenge their findings and conclusions.

The role of auditors: staffing considerations

External and internal auditors can play that questioning role in a variety of contexts, a reality that should influence staffing decisions and practices of both groups. For internal audit, an important consideration is the remarkable breadth of issues that internal audit covers, including complex accounting areas. Hence, from a staffing perspective, internal auditors should have skill sets necessary to address this wide scope. What’s more, to be effective, internal auditors must not only have knowledge of the business – they must have the confidence of the management that is being audited. Along these lines, one workshop participant offered some

areas with senior management and, where necessary, the audit committee. In hiring for their own firms, the external auditors need to determine whether a candidate will, as an engagement team member, possess those character traits that are likely to manifest sufficient professional scepticism. External audit firms seek to hire people who won’t shrink from asking challenging questions of company staff or from having sensitive conversations with senior management.

Tapping the power of each other In our dynamic, evolving business environment, complex accounting issues will always pose a stark challenge. Companies have powerful helpers in facing these challenges, including crafting clear, effective accounting policies and hiring the right people. Equally powerful, as these workshops showcased, is the ability of participants in the financial reporting supply chain to come together to share insights for the benefit of all.

1 Anti-Fraud Collaboration, Addressing Challenges for Highly Subjective and Complex Accounting Areas, March 2017

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Board Governance |ERM UPS AND DOWNS Companies need to rethink their growth strategies

Building businesses for the long-term Investors, particularly institutional investors, representing in excess of a billion future pensioners, are flexing their muscles and calling on companies around the globe to significantly change their approach to value creation.

A letter dated 1 February 2016 from Larry Fink, CEO of BlackRock (the largest money manager in the world with more than $5.1trillion of assets under management) to thousands of CEOs of the biggest companies in the world is a good proxy for the movement. In it he said “We are asking that every CEO lay out for shareholders each year a strategic framework for long-term value creation. Additionally, because boards have a critical role to play in strategic planning, we believe CEOs should explicitly affirm that their boards have reviewed these plans. BlackRock’s corporate governance team, in their engagement with companies, will be looking for this framework and board review.”1 Fink goes on to add a stern caution and then a caveat: “Those activists who focus on long-term value creation sometimes do offer better strategies than management. In those cases, BlackRock’s corporate governance team will support activist plans. During the 2015 proxy season, in the 18 largest US proxy contests (as measured by market cap), BlackRock voted with activists 39 per cent of the time.” “We recognise that the culture of short-term results is not something that can be solved by CEOs and their boards alone. Investors, the media and public officials all have a role to play.”2 The recent launch in February 2017 40 Ethical Boardroom | Spring 2017

Focussing ERM and internal audit on what really matters: long-term value creation and preservation Tim J. Leech

Managing Director at Risk Oversight Solutions Inc of the Investors Stewardship Group (ISG), representing more than $17trillion of assets, is expected to add fuel to this movement. 3 The release of the 2016 Principles of Corporate Governance by the Business Roundtable with CEO signatories from US investment companies with more than $7trillion in annual revenues laid a solid foundation for the formation of the ISG.4 The International Corporate Governance Network (ICGN), a global not-for-profit representing companies with assets under management totalling more than $26trillion, calls on investors to start by focussing their attention on the boards of investee companies: “The risk oversight process begins with the board. The unitary or supervisory board has an overarching responsibility for deciding the company’s strategy and business model and understanding and agreeing on the level of risk that goes with it. The board has the task of overseeing management’s implementation of strategic and operational risk management.”5 On the long-term value preservation front, Institutional Shareholder Services (ISS), the leading proxy advisory firm, has laid

out its position quite clearly. It says “ ISS will recommend voting ‘against’ or ‘withhold’ in director elections, even in uncontested elections, when the company has experienced certain extraordinary circumstances, including material failures of risk oversight. In 2012, ISS clarified that such failures of risk oversight will include bribery, large or serial fines or sanctions from regulatory bodies and significant adverse legal judgments or settlements.”6 This article calls on boards and CEOs to demand something Larry Fink has not explicitly asked for to date – that senior management, internal auditors and ERM specialists radically change their risk management and internal audit methods and provide substantially more and better information to boards on the true state of retained risk, linked to top value creation and preservation objectives.

Broadly, the criticism is this:

Traditional approach to risk management – populate a risk register, update it once or twice a year and produce risk lists and heat maps for the board - is not up to the task As investors call for greater focus on long-term value creation and board oversight of that process, advocates, including Larry Fink, the Business Roundtable, ICGN and ISS, need to recognise that focussing on long-term value creation and, by extension, avoiding major erosion of entity value, requires a lot more than some changes to the annual strategic planning exercise and more rigorous board review of that plan. A large percentage of the risk assessment work done during the strategic planning process in companies around the world today has not used generally accepted risk www.ethicalboardroom.com

ERM | Board Governance assessment methods, often relying on ‘brain storming’ and intuition, or been subjected to independent review by ERM specialists or internal audit. Based on annual risk oversight surveys,7 assumptions made by the authors of the 2016 COSO Enterprise Risk Management (ERM) exposure draft and the author’s 30 years of work in the ERM space globally, the vast majority of companies have interpreted calls to enhance enterprise risk management (ERM) to mean constructing a corporate ‘risk register’, developing lists of the top 10/20/30 risks and providing boards with nice colour ‘risk heat maps’.The focus of these efforts has predominantly been on hazard avoidance, not long-term value creation objectives. Most importantly, in the majority of companies, it has not meant documenting the top value creation and value preservation objectives being considered and implemented; assigning responsibility for those objectives to specific senior managers; requiring those managers to demonstrate they have taken reasonable steps to identify and assess risks that threaten the achievement of those objectives; and providing reliable reports to the board on the true state of retained risk linked to the company’s top value creation/preservation objectives. Traditional ERM and internal audit – a bad case of paradigm paralysis and ill-equipped to support long-term value creation strategies A 2016 study produced by the AICPA and North Carolina State University 7 reported that only 30 per cent of the organisations surveyed have boards that ‘mostly’ or ‘extensively’ review the top risk exposures facing the organisation when the board discusses the organisation’s strategic plan. Investors are not only demanding more details on the organisation’s long-term value creation plans, they want more and better information on the risks that threaten the achievement of those plans and they want board review of those risks. In large organisations with revenues in excess of $1billion, 87 per cent of respondents want more information from senior executives on risks impacting core growth strategies (see Figure 1).

Demands for more information on risk

At the same time as heightened calls from investors for more and better board oversight of risks to key strategic value creation objectives, there is strong evidence that implementation of risk-centric approaches to ERM, which typically use risk registers as a foundation with annual/ semi-annual updates, are stalled globally. They have not been embraced by the C-suite or boards as a useful tool to help the organisation create long-term value – see Figure 2.

Risk-centric ERM stalled

Coincident with the surveys disclosing major problems with traditional approaches to enterprise risk management (See Figure 3), www.ethicalboardroom.com

stakeholders are signalling they want far more from internal auditors than the traditional 20-50 spot-in-time internal audits each year with internal auditor opinions on the effectiveness of ‘internal controls’ on a small fraction of the risk universe. A study done by the Institute of Internal Auditors released in 2016 is indicative of the new demands.8

Calls for change in internal audit focus

accounting controls and hazard areas, such as cybersecurity and business continuity, to one that includes providing management with assistance identifying and assessing risks to the company’s most important strategic objectives – see Figure 4.

What’s wrong with ERM/internal audit?

Unfortunately, both the ERM and internal audit communities have strong, even emotional attachment to traditional risk management and internal audit methods, methods that are increasingly demonstrating they are not equipped to help organisations with today’s rapidly changing environments and demands. One only needs to recall the demise of companies, such as Kodak, Xerox, Blackberry and others to see what happens when a paradigm shifts but companies don’t.

In that 2016 IIA report on stakeholder expectations one CEO identified what most needed to change: “We need to better define how we link internal audit objectives to the achievement of strategic objectives’”9 A majority of the senior managers and board members surveyed around the world want to see internal auditors shift from their traditional heavy focus on financial

FIGURE 1: EXTENT THAT EXTERNAL PARTIES ARE APPLYING PRESSURE ON SENIOR EXECUTIVES TO PROVIDE MORE INFORMATION ABOUT RISKS AFFECTING THE ORGANISATION Full sample 11%

Largest Organisations (Revenues >$1B) 17%

Public companies 18%

Financial services 24%

Not-for-profit organisations 5%

Mostly

26%

34%

30%

35%

22%

Somewhat

29%

36%

33%

23%

27%

Combined

66%

87%

81%

82%

54%

Extensively

FIGURE 2: COMPLETE ERM IN PLACE: FULL SAMPLE 23%

25% 25% 25%

FIGURE 4: DO YOU BELIEVE INTERNAL AUDIT SHOULD BE MORE ACTIVE WITH ASSESSING STRATEGIC RISK? No 24%

15% 9%

11%

Yes 58%

Unsure 18%

2009 2010 2011 2012 2013 2014 2015

FIGURE 3: CALLS FOR CHANGE IN INTERNAL AUDIT FOCUS Identify known and emerging risk areas

85%

Facilitate and monitor effective risk management practices by operational management

78%

Identify appropriate risk management frameworks, practices and processes

78%

Consult on business process improvements

76%

Alert operational management to emerging issues and changing regulatory and risk scenarios

74%

Assurance on compliance with legal and regulatory requirements

71%

20%

40%

60%

80%

100%

Spring 2017 | Ethical Boardroom 41

Board Governance | ERM Readers who want more details on the ‘paradigm paralysis’ afflicting ERM specialists and internal audit should refer to the Summer 2016 Ethical Boardroom article Paradigm paralysis in ERM and internal audit.

consolidated report provided to the board of directors on the state of residual risk, linked to top value creation and preservation objectives.

What are the top barriers to increasing the focus on long-term value creation and preservation?

on whether they have achieved their annual internal audit plan reporting on whether they believe internal controls are ‘effective’ or ‘ineffective’ on a small percentage of the total risk universe. But there is often little or no coverage of top strategic value creation and preservation objectives (see Figure 5 below). CROs are often hired and paid to create and maintain risk registers and provide lists of risks and risk heat maps for senior management and the board. If long-term value creation is to be the new focus, there needs to be a unified focus on developing the right long-term value creation and preservation objectives and assessing and managing the risks that threaten the achievement of those objectives. CROs should be measured on the amount of help they provide to senior managers in identifying long-term value creation and preservation objectives and assessing and managing risks to the most important of those objectives. CAEs should be measured on the quality of their reports on the process used to report to boards on top value creation and preservation objectives and the reliability of the information the board is receiving on the true state of risk linked to them.

What needs to change to increase focus on long-term value creation and preservation? The process senior management Misaligned reward systems One only needs uses to define and document the to scan the amount of work the Financial organisation’s top current and proposed value Stability Board has dedicated to reforming creation and preservation objectives should compensation practices following the 2008 be transparent and overseen financial crisis, post-mortems by the company’s board of done on major governance Investors directors. The company’s top failures, and recent examples, representing long-term value creation such as Wells Fargo, to realise and preservation objectives, misaligned reward literally trillions that should be documented in an systems represent a top risk of dollars of entity’s objectives register. to the goal of long-term value Each objective that has creation and preservation.10 pension funds been deemed important/ The reward misalignment and billions dangerous enough to warrant related to both the short-term the cost of formal risk focus objectives that were of individual assessment and board oversight being remunerated by investors and included in the objectives organisations at the core of the pensioners register should be assigned 2008 financial crisis, as well as an owner/sponsor. That how well senior management are calling for person should be responsible evaluated and reported to major change. for identifying and assessing boards on the risks to those Managers at all levels often lack the risks to those objectives and skills to identify and treat risks to top Companies and objectives. The AICPA/NCSU reporting upwards to the board 2016 annual risk oversight strategic objectives If boards are to receive their boards on the true state of residual survey provides insight reliable reports on the top value creation and risk, linked to those objectives. into current compensation preservation objectives, surveys indicate quite will have to The company’s CEO practices.11 It is important to clearly that management at all levels will need decide if they or his/her designate note that if the survey question substantially more training. This is necessary are willing should be assigned shown in Figure 5 used to if they are to evolve from informal/ad hoc responsibility for providing the poll current remuneration risk management methods to structured risk to make the board with regular reports on practices linked to risk management capable of providing reliable changes the evolution of the company’s management was revised to reports on the status of risks to top value top value-creation and ask about something more creation and preservation objectives. The 2016 necessary preservation objectives and specific than ‘risk management AICPA/NCS survey of risk oversight practices the current state of residual activities’ –such as ‘providing disclosed a very telling fact – 63 per cent have risk linked to those objectives. reliable reports on the true state of retained not provided or only minimally provided Management personnel, particularly risk linked to top strategic objectives to the training and guidance on risk management.12 Risk specialists often don’t link risk those that are owners/sponsors, need to board’ – the negative numbers you see below assessment work done by management to top be provided with sufficient training to prepare would be much higher. value creation objectives – a large percentage reliable risk assessments on the organisation’s Linkages between risk of ERM efforts today do not explicitly focus top value creation and preservation objectives. Risk specialist groups, in companies management and remuneration on assessing the risks to top value creation It is important to note that I believe a key that have them, should be assigned and preservation objectives. The majority of element of reward system evaluation has been responsibility for helping the company build ERM efforts use risk registers, not objectives missed by these post-crisis regulator postand maintain its objectives register; helping registers as the foundation for their efforts. mortems – the reward systems of Chief Audit owners/sponsors assigned to those objectives Figure 6 from the 2016 AICPA/NCSU survey of Executives (CAEs) and Chief Risk Officers complete risk assessments; and facilitating risk oversight practices provides an indication (CROs). All too often, CAEs are remunerated reporting upwards on residual/retained of the extent organisations integrate strategic risk status linked to top objectives to the board of directors. Boards should hold FIGURE 5:TO WHAT EXTENT ARE RISK MANAGEMENT ERM specialist groups responsible for ACTIVITIES AN EXPLICIT COMPONENT IN DETERMINING providing regular reports on the reliability MANAGEMENT PERFORMANCE COMPENSATION? and maturity of the process used to report to them on the true state of residual risk, Largest linked to the organisation’s top value Full organisations Public Financial Not-for-profit sample (revenues >$1B) companies services organisations creation and preservation objectives. Internal audit should be assigned formal Not at all 29% 10% 12% 19% 46% responsibility for providing independent Minimally 26% 28% 27% 21% 18% reports on the reliability of the company’s Combined 55% 38% 39% 40% 64% enterprise risk management process and the

4 5

42 Ethical Boardroom | Spring 2017

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ERM | Board Governance

FIGURE 6: EXTENT TO WHICH TOP RISK EXPOSURES ARE FORMALLY DISCUSSED BY THE BOARD OF DIRECTORS WHEN THEY DISCUSS THE ORGANISATION’S STRATEGIC PLAN

“Extensively”

Full Sample 9%

Largest Organisations (Revenues >$1B) 18%

Public Companies 18%

Financial Services 15%

Not-for-Profit Organisations 7%

“Mostly”

21%

28%

32%

31%

17%

Combined

30%

46%

50%

46%

24%

planning and work done to identify and assess the risks to the company’s strategic plan.

How many are linking risk management and the strategic plan?

The majority of internal auditors today have not received much training on formal risk assessment methods The focus of the majority of internal audit departments in the world today has been on doing spot-in-time audits of topics drawn from what is commonly called internal audit’s ‘audit universe’. They opine on the effectiveness of ‘internal controls’ on a small percentage of the total risk universe, not on whether the true state of residual risk linked to top value creation and preservation objectives is being reported upwards to the board. Few audit universes have, at least to date, included their organisation’s top value creation objectives. Most don’t include specific end result objectives at all, focussing instead on processes, business units, topics, or audit themes. The harsh truth is that the majority of internal auditors today have received very little training on how to complete formal risk assessments on value creation and preservation objectives that use the type of methods promoted by the world’s global risk management standard, ISO 31000, or even the more risk-centric risk assessment methods outlined in the 2016 COSO ERM exposure draft. A major global retraining effort will be required if internal auditors are to help their organisations reliably assess and report to boards on the retained risk status linked to top value creation and preservation objectives. Majority of boards in the world have not been demanding strategic plans be accompanied by high-quality risk assessments Last, but certainly not least, is the fundamental truth that board members around the world have received little or no training on risk oversight. This is necessary if they are to help them assess whether formal risk assessments they receive, if any, linked to the company’s strategic plans are likely reliable; and often have not demanded that management’s strategic plans be accompanied by formal structured risk assessments that clearly show the company’s residual risk status position. This isn’t particularly surprising as a large percentage of board members are, or were previously, senior www.ethicalboardroom.com

executives, executives that often used intuitive and informal risk assessment methods in running the business and they didn’t use/require formal risk assessment methods when developing their strategic plans. It is important to note that boards globally should be excused on this issue as the professional risk management and internal audit communities, including the current COSO project team to update the 2004 COSO ERM guidance scheduled for release in mid-2017 and the ISO 31000 technical committee charged with updating the 2009 global risk management standard, are in a state of confusion and division on the best way forward for ERM. Both COSO and ISO are vacillating over whether to advocate ‘objective-centric ERM’ that uses objectives registers as a foundation for all risk management efforts with a heavy focus on strategic value creation objectives, or stick with what has been largely risk-centric/risk register/hazard-focussed approaches to ERM.13

Focus on what really matters — long-term value creation and preservation

If investors demanding companies focus on long-term value creation are truly serious about putting the focus on long-term value creation and board oversight of the risks linked to those strategies, they have a tremendous opportunity to drive the changes needed. Those same investors, however, need to recognise that public companies and the boards that oversee them have been conducting business using largely the same strategic planning, internal audit and ERM assurance methods that have been used for decades. If the changes being demanded by investors are to occur on a wide scale, radical changes will have to be made to planning, risk management and assurance methods in use in millions of public companies today. Larry Fink, CEO of BlackRock in his 2016 letter to CEOs was correct when he said that the lack of focus on long-term value creation and

short-termism is a problem that will require a concerted effort from multiple parties. To quote Fink: “We recognise that the culture of short-term results is not something that can be solved by CEOs and their boards alone. Investors, the media and public officials all have a role to play.”14 ERM specialists and internal auditors need to be added to Mr Fink’s list. Investors representing literally trillions of dollars of pension funds and billions of individual investors and pensioners are calling for major change. Companies and their boards will have to decide if they are willing to make the changes necessary to truly make long-term value creation and preservation their focus and reality. Text of Larry Fink, CEO of BlackRock’s 2016 Corporate Governance Letter to CEOs, February 1, 2016, page 1 2Ibid, page 2 3https://www.isgframework.org/ 4Principles of Corporate Governance 2016, Business Roundtable 5ICGN Guidance on Corporate Risk Oversight, Third Edition, 2015 6 Martin Lipton, Risk Management and the Board of Director, Harvard Law School Forum on Governance and Financial Regulations, Feb 15, 2017. 7The State of Risk Oversight: An Overview of Enterprise Risk Management Practices 7th Edition, AICPA and NCS Poole College of Management, April 2016 8Relationships and Risks: Insights from Stakeholders in North America, IIA Research Foundation, A CBOK Stakeholder Report, 2016, page 4. 9 Ibid, p. 5. 10See http://www.fsb.org/publications/? policy_area%5B%5D=24 for details 11The State of Risk Oversight: An Overview of Enterprise Risk Management Practices 7th Edition, AICPA and NCS Poole College of Management, April 2016 12Ibid, page 3. 13For details on the polarisation of views see Risk Oversight Solutions response to the COSO June 2016 ERM exposure draft (https://goo.gl/ ro5ljS) 14Ibid, page 2 1

BUILDING A FUTURE Investors have a role to play to drive change

Spring 2017 | Ethical Boardroom 43

Board Governance | Internal Governance

Deregulation and the new era of self-governance

Companies who establish a self-governing culture during uncertain times will inspire trust and innovation Corporate governance failings can be catastrophic. Not only can they greatly impact the business, sometimes fatally, but they can also have effects on the economy surrounding them.

For instance, the 2007-2008 subprime mortgage scandal, where banks were selling mortgages to people who couldn’t afford them, led to the bankruptcy of Lehman Brothers Holdings, the bail out of the Royal Bank of Scotland and the global crash. Due to the huge impact the events had on economies across the globe, regulators introduced acts, such as Dodd-Frank and Basel III to guide financial institutions along the path of best practice and reduce the chance of a recurrence. Since then, strict regulations and overseeing 44 Ethical Boardroom | Spring 2017

John Palmiero

Vice President at MetricStream bodies, as well as the financial punishments for non-compliance, have helped to keep sectors in check. Yet, the question now is whether companies have become too dependent on these factors to guide them towards good governance and compliance processes.

Fuelling the need for self-governance

Merriam-Webster defines self-governance simply as ‘control of one’s own affairs’ – a short and sweet summary. In a business sense, this means conducting operations in a way considered ethical and socially responsible, without being forced to do so by external pressures, such as regulations. Indeed, as regulatory easing begins in post-election United

States, it will not be enough for companies to be seen just to follow regulations. They must actively move to implement their own culture of compliance, or risk irreparable reputational damage. 2016 saw both Trump’s election and the Brexit vote shake the US and the European Union, creating a new political landscape that will shape future corporate governance requirements and expectations. While nothing will happen overnight, the Trump administration is aiming to drastically scale back regulations to make things less onerous to businesses. The Doddwww.ethicalboardroom.com

Internal Governance | Board Governance AUTONOMOUS APROACH Businesses must prepare for more responsibility to be passed to themselves

Frank act has been specifically targeted, with some experts believing that removing some of the shackles will give a boost to the economy. Similarly, in voting to leave the European Union, Great Britain leaves itself vulnerable to massive regulatory change. While the Financial Conduct Authority (FCA), the Information Commissioner’s Office (ICO) and other UK regulators will have their own agenda, it’s unknown how they will operate without the involvement of Brussels and what impact this will have on laws governing organisations operating in and with the UK. In light of these progressive changes, businesses must prepare for more responsibility to be passed to themselves.

Eastern corporate governance culture Businesses operating in Asia, particularly those within the Orient, have traditionally found themselves facing the opposite challenge. Undeveloped corporate governance and a general lack of focus from governments and regulators means organisations have needed to instil their own self-governance measures. Yet, the recent unravelling of the Samsung corruption scandal, which includes the heir to the company, Lee Jae-Yeong, being charged with bribery and embezzlement, www.ethicalboardroom.com

new platforms. Hundreds of thousands, or even millions, of individuals can apply highlights that some companies aren’t and pressure onto organisations directly, have been given little reason to. The scandal regardless of whether they’ve actually ever stretches beyond Samsung and incorporates been a customer. Non-makeup wearers can President Park Geun-hye as well, meaning lobby against cosmetic organisations and the outcome of the upcoming trials will have animal testing, or vegetarians can voice their significant impacts on the company, political concerns against the meat industry. Firms are space and South Korea’s economy. now consistently in the firing line. Such examples may force more Asian Should businesses ignore appeals from governments and regulators into action, and the public and relax alongside regulatory increasingly they are becoming easing, it will be a great risk more and more influenced by to their own survival. Take the In today’s age western regulators. In order 2015 Volkswagen scandal for of transparency, example. The lack of internal to attract investment from the West, UK and US businesses corporate governance demand for are demanding proof, metrics encouraged an environment corporate and measurability of a strong of malpractice and cheating corporate compliance culture, the diesel emissions test. responsibility which helps to mitigate the risks discovery of the scandal, and governance On of investments being lost due to the company suffered an scandals or links to unethical immediate £22billion fall in isn’t coming activities. However, creating valuation. This exclusively from company and passing new regulations amount was generated through regulators, the is a long process, and ensuring the cost of reclaiming the that businesses are compliant vehicles and clean-up, however, normal person drastically increases the it is the loss of customer respect expects more timeline. Eastern companies that cost the company dearest. must, therefore, want to instil a Similarly, an example of how strong self-governed governance, risk and companies can benefit from listening to public compliance (GRC) culture, taking it upon sentiment is the American pharmacy chain themselves to respond to the requirements CVS. Once it made the high-profile decision to western firms are governed by, and stop selling tobacco products, its reputational incorporating the measures into their processes. value soared after an initial profit loss. Placing itself in a favourable position in the market Pressures from the street allowed it to recover from the short-term In today’s age of transparency, demand for profit loss with new customers who respected corporate responsibility and governance isn’t and trusted its new business programme. coming exclusively from regulators; the normal How self-governance person expects more, too. They think ‘if I pay can drive business value my taxes, I want Starbucks to pay its taxes’. Companies are starting to understand Traditionally, customers would vote with their the benefits of self-governance from both feet, boycotting companies and industries that a preservative and reputational stance, they believe are acting unethically, but social and there’s a few reasons why. media and social lobbying sites have provided Spring 2017 | Ethical Boardroom 45

Board Governance | Internal Governance Companies who have acted to establish a self-governing culture are able to streamline internal processes for maximum efficiency. Having every process – internal audit, compliance, legal and risk management – working together under the same umbrella and focussing on the same aims enables accurate and fast reporting to the board and other strategic decision-makers. Furthermore, businesses – particularly those in the finance sector where regulators are heavy on the ground – have found that if there is a measurable culture of compliance and the internal business capability for change management are all readily available, regulators tend to leave them alone to self-discipline. In this sense, companies have already seen the value of self-governance and opening themselves up to a more transparent relationship with regulators. In the eventuality of regulatory easing, it is those companies used to implementing their own culture that will find it easier to cope in the new environment.

how their role helps to achieve the business’ objectives, but their buy-in requires them to also believe that upper management is truly behind the new approach. This means management acting in ways deemed to be ethical and held accountable for the times when they don’t. Encourage employee participation Offering a recognition scheme to reward employees who spot flaws or potential improvements in the systems can help forge culture. Any self-governed GRC programme should be evaluated at regular intervals and combining a rewards scheme with process evaluation is a win-win. This will include testing to see if potential risks are being identified and mitigated, compliance standards are being met, and appropriate actions are taken when red flags arise. Centralise the compliance function Organisations must unify any siloed and disparate GRC operations across multiple geographies and business units, and align them with the overall business strategy KEEPING TRACK Monitor social media feeds and follow regulatory bodies to stay informed

Self-governing organisations also harbour a culture of trust and values throughout employee ranks. This means everyone knows how their role fits into the bigger picture and they are less likely to act in ways that are self-serving. This commitment breeds innovation, with collaboration driven by the enterprise-wide goal of constant improvement as well as higher employee and customer loyalty and retention. Companies with strong employee and customer bases are more resilient to changes in the landscape, giving them greater breathing space to react.

Instilling a self-governance culture As the likelihood of deregulation draws near, and consumers continue to lobby businesses directly, it is time that companies established an internal culture of self-governance. Corporate culture is hard to amend and implement, but there are certain actions an organisation can take in order to streamline the process. Establish a tone at the top The success of self-governance is reliant on the right tone being set and enforced from the top. Every employee should be participating and know 46 Ethical Boardroom | Spring 2017

and objectives. This will help to create an enterprise-wide and integrated view of the risks and compliance requirements across multiple regulations that are affecting the organisation. Implement holistic and integrated GRC processes Implementing a holistic and integrated GRC approach will help businesses to standardise compliance management processes, taxonomy and operations. This will reduce many of the redundancies created through multiple control tests, policies, risk assessments, audits, and reports configured for meeting different regulatory requirements. Each regulation will be mapped to the organisational objectives, business processes, risks, controls and policies, which will help identify similar patterns across multiple business units and areas of compliance. Track regulatory intelligence and consumer sentiment To stay abreast of the numerous regulatory updates and consumer feelings toward relevant topics, organisations need to refer to a variety of intelligence sources. Regulatory agencies and trade associations are useful sources of regulatory content, followed by trade industry

publications, and national and specialised media. Regarding social sentiment, businesses should monitor social media feeds, particularly ones belonging to change influencers, as well as relevant sites and media, in order to analyse whether there will be demonstrations or other actions that are likely to impact processes. Instead of having to track all these sources individually, which will be time consuming and inefficient, a single and centralised content repository can route the content to specific business units and professionals for their analysis and review based on pre-defined business rules, streamlining the whole process. Ensure consistent and efficient data flows There has been a data overload in some organisations because of the various compliance requirements that they need to cope with. Regulators are constantly demanding more information to be submitted, which is getting accumulated in data warehouses. The information created through self-governance streams will simply add to the noise, so businesses need to streamline collection and analysis to ensure actionable intelligence isn’t being ignored. In fact, according to Deloitte, data analytics and reporting are among the top three challenges. Maintaining a centralised and uniform data library, which connects to the other elements in the GRC framework, ensures that each employee is seeing the data that is relevant to them. Furthermore, it will help to keep costs under control. Standardising data across the board will also help create directly comparable metrics. Utilise technology Companies must adopt technology that allows employees to actively or passively, engage with GRC processes and, increasingly this means turning to tools that have been consumerised. Self-governance requires GRC to be imbedded into all processes, but corners are more likely to be cut if workloads are drastically added to. Technology that can enhance productivity and create new ways of working, without impacting employees’ ability to carry out their responsibilities, will drive business value. Technology plays a critical role in strengthening monitoring and management of both internal and external procedures. Integrated technology solutions offer a common platform to provide greater visibility into risks and compliance issues. They also automate processes, streamlining and reducing costs of admin and data-heavy processes as well as storing any important or relevant information in a centralised database for easy access. Ultimately, it is not enough for companies simply to follow and implement new processes based on regulations. They have to want to adopt ways of working that encourage good governance and ethical responsibility. Whether it’s in response to deregulation or social movements, self-governance can ensure consistency and resilience in any organisation, no matter what external pressures they face. www.ethicalboardroom.com

Corporate Governance Programmes

“Thanks to the International Directors Programme, I changed my behaviour. Now I spend two-thirds of my time at board meetings listening and only one-third talking – asking the right questions.”

Henri Nejade

(IDP-C)*

CEO and President of Brenntag Asia Paciﬁc *INSEAD Certiﬁed Director

__________

EXPAND YOUR HORIZON. MAKE AN IMPACT. __________

www.insead.edu/executive-education/corporate-governance

Board Governance | Oversight

Holly J. Gregory & Rebecca Grapsas

Holly is a Partner and Co-Chair of the Global Corporate Governance & Executive Compensation Practice & Rebecca is Counsel in the Corporate Governance & Executive Compensation Practice, at Sidley Austin LLP

THE CHALLENGE What’s missing in your compliance programme?

Assessing corporate compliance programmes Assessing whether your compliance programme is ‘fit for purpose’ is a key element of the board’s oversight responsibility

48 Ethical Boardroom | Spring 2017

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Oversight | Board Governance

Corporations and their shareholders are well served in the long run by a corporate culture that emphasises compliance with the laws and regulations that the company is subject to and the ethical standards expected in the industry.

The cost of a compliance failure can be significant. Costs may result directly from penalties, settlements, legal fees, increased insurance costs, and management and board distraction. They may also result from damage to corporate reputation with its potential impact on stock price, customer and employee retention, credit ratings and the cost of capital. For these reasons, oversight of the corporation’s tone at the top and the compliance programmes designed to establish and maintain that tone and detect problems is an important board responsibility. As board and committee agendas become ever more packed, boards may find it challenging to focus on this oversight responsibility, but periodic attention to compliance matters – and, in particular, periodic assessment of whether the compliance programme is well aligned with the risks and needs of the company – remains of critical importance. This article discusses key considerations for boards in their efforts to assess whether the company’s compliance programme is fit for purpose.

Compliance: more than a paper exercise?

Corporate compliance programmes are common although there is a great deal of variation in programme size, scope, structure and resources – as well as the level of commitment from the board and senior management. It is up to each company to implement the compliance programme that best suits its needs and the level of compliance risk it is willing to take. This is a business judgment for the board as it fulfils its fiduciary responsibility to provide oversight of the compliance programme. A company’s compliance programme will fall somewhere along a continuum, with a basic effective compliance programme at the centre of the continuum, a programme that exists ‘on paper’ but is not effective to the left-hand side and a more robust programme to the right-hand side (see below). When assessing the compliance programme, boards should determine where the programme currently falls on the continuum and whether adjustments Paperprogramme Basic effective More robust ‘lip service’ programme programme

THE COMPLIANCE PROGRAMME CONTINUUM www.ethicalboardroom.com

are required. In the US, boards should consider whether to undertake such an assessment now in light of new guidance from the Department of Justice (DOJ) for evaluating compliance programmes (discussed below), whether or not the company currently has any compliance issues.

The federal compliance framework in the States

As fiduciaries, directors are required to consider the legal and regulatory compliance framework that has developed and ensure that the company has appropriate compliance-related reporting and information systems and internal controls in place. Regardless of the enforcement climate, which may or may not change under the new administration in the United States, a company and its directors, officers, employees and shareholders benefit from a corporate culture that emphasises compliance. Each company should, at a minimum, have a basic effective compliance programme in place, i.e. a programme falling at least in the middle of the continuum described above. As well as making good business sense for a range of reasons, having an effective compliance programme can influence a federal prosecutor’s decision on whether to charge

It is up to each company to implement the compliance programme that best suits its needs and the level of compliance risk it is willing to take. This is a business judgment for the board as it fulfils its fiduciary responsibility to provide oversight of the compliance programme a company for the bad acts of its employees or officers and the extent to which the company may receive credit for cooperation in a settlement while helping to mitigate penalties if corporate wrongdoing is found. As recognised in the Ethics & Compliance Initiative’s (ECI) recent report, Principles & Practices of High-Quality Ethics and Compliance Program, the de facto standard for effectiveness in compliance programme design is set out in Chapter 8 of the US Federal Sentencing Guidelines, which provides that a company must: ■■ Establish standards and procedures to prevent and detect criminal conduct ■■ Ensure board oversight of the compliance programme ■■ Appoint a high-level individual (such as a chief compliance officer) who has overall responsibility for the compliance programme ■■ Exercise due diligence to exclude unethical individuals from positions of authority

■■ Communicate information about the compliance programme to employees and directors ■■ Monitor the compliance programme’s effectiveness ■■ Promote and consistently enforce the compliance programme ■■ Respond to violations and make necessary modifications to the compliance programme1 The DOJ’s Principles of Federal Prosecution of Business Organizations emphasise that critical factors in evaluating a compliance programme are ‘whether the programme is adequately designed for maximum effectiveness in preventing and detecting wrongdoing by employees and whether corporate management is enforcing the programme or is tacitly encouraging or pressuring employees to engage in misconduct to achieve business objectives’.2 In February 2017, the Fraud Section of the DOJ issued new guidance to provide more specific examples of how federal prosecutors will evaluate a company’s compliance programme under these factors in the process of investigating and resolving an enforcement matter, while emphasising that it does not use a ‘rigid formula’ to make such assessments. This is the latest communication forming part of the Fraud Section’s Compliance Initiative, which began with the Fraud Section’s hiring of Hui Chen as full-time compliance counsel commencing November 2015. The document contains probing questions regarding the following 11 topics: ■■ Analysis and remediation of underlying misconduct (including prior indications) ■■ Senior and middle management (including conduct at the top, shared commitment and oversight) ■■ Autonomy and resources (including compliance function stature, experience, qualifications and empowerment) ■■ Policies and procedures (including gatekeepers, accessibility, operational integration, controls and vendor management) ■■ Risk assessment (including information gathering and analysis, and manifested risks) ■■ Training and communications (including availability of guidance) ■■ Confidential reporting and investigation (including response to investigations) ■■ Incentives and disciplinary measures ■■ Continuous improvement, periodic testing and review ■■ Third-party management ■■ Mergers and acquisitions (including due diligence process, integration in the M&A process and process connecting due diligence to implementation) For each topic, the questions posed are designed to look behind a company’s paper programme and evaluate how the programme has been implemented, updated and enforced in practice. Spring 2017 | Ethical Boardroom 49

Board Governance | Oversight Although some of the questions focus on the effectiveness of a company’s compliance programme in the context of specific misconduct (for example, what caused the misconduct, whether there were prior indications of the misconduct and which controls failed), many of the questions focus on the compliance programme more broadly, including, for example, whether compliance personnel report directly to the board, what methodology the company uses to identify, analyse and address the risks it faces, and how the company incentivises compliance and ethical behaviour.

Compliance programme assessments

Periodic assessment of the compliance programme, in a process overseen by the board or a board committee, helps ensure that the programme continues to be fit for purpose by identifying areas for improvement, while also creating evidence of the company’s commitment to compliance for use in any future regulatory enforcement actions. Assessments should be risk-based to reflect the company’s changing risk environment and to help ensure that limited compliance resources are prioritised to focus on the most significant risks. The assessment should focus on the adequacy and effectiveness of the framework that the company has in place to fulfil the purposes of the compliance programme, which are described in the ECI Report as ‘almost universal,’ as follows (at 11-12): ■■ Ensure and sustain integrity in the company’s performance and its reputation as a responsible business ■■ Reduce the risk of wrongdoing by the company’s employees or parties aligned with the company ■■ Increase the likelihood that the company’s management will be made aware of wrongdoing when it occurs ■■ Increase the likelihood that the company will responsibly handle suspected and confirmed wrongdoing ■■ Mitigate penalties imposed by regulatory and governmental authorities for any violations that occur The assessment criteria should be based on the elements of an effective compliance programme outlined in federal guidance discussed above, including specific guidance from regulators regarding the company’s industry. The assessment criteria should also reflect trends in settlement agreements, developing notions of recommended practices (both generally and within the company’s specific industry), and the practices of peer companies, to the extent that benchmarking data is available. For example, the ECI Report discusses five core principles and supporting objectives of high-quality compliance 50 Ethical Boardroom | Spring 2017

programmes, including examples of ‘leading practices’ and common pitfalls to avoid. The focus of the board’s assessment efforts should be on the company’s policies, systems, incentives, and resources, as well as how senior management communicates internally about the importance of compliance. A specific area for board consideration is the extent to which the board is satisfied that the ethical tone in the company emphasises that compliance is central to strategy and therefore related to business success and priorities, and that everyone is responsible for compliance. The assessment typically relies on a combination of document review, controls and procedures testing, interviews and surveys. The board should evaluate the following and, in doing so, consider how it would answer the specific questions set forth in the DOJ’s new guidance:

Compliance programme assessment is a key element of the board’s oversight of compliance programmes

■■ Role of compliance in strategic and operational decisions ■■ Key compliance risks, risk assessment processes and risk mitigation ■■ Senior management conduct and commitment to compliance, and how the company monitors this ■■ Communication efforts by the board, CEO, other senior executives, and middle management regarding expectations and tone ■■ Education and training regarding compliance generally and the company’s programme, policies, and procedures at all levels ■■ Understanding of corporate commitment to compliance at all levels ■■ Awareness and use of mechanisms to seek guidance and/or to report possible compliance violations, and fear of retaliation ■■ Specific problems that have arisen, why they arose and how they were identified and resolved ■■ Investigation protocols and experiences ■■ Performance incentives, accountability, disciplinary measures and enforcement ■■ Remediation and efforts to apply lessons learned Basic compliance programmes include periodic assessments but there are questions around how often to conduct the assessment and how robust the process is. A recent PwC survey of compliance executives indicates that compliance risk assessments are typically conducted annually – 65 per cent of companies surveyed by PwC in 2016 (compared with eight per cent conducting assessments every two years).3 The board will need to determine in its business judgment how often to conduct compliance programme assessments and the process for conducting assessments.

■■ The board’s level of oversight including availability of compliance expertise, private sessions with compliance personnel and information ■■ Reporting lines and related structures ■■ Experience, qualifications and performance of the chief compliance officer and compliance function ■■ Compliance function responsibilities, budget and budget allocation (including employees, outside advisors and other resources), staff turnover rate and outsourcing ■■ Written corporate policies and procedures regarding ethics and compliance (including legal and regulatory risks), and the process for designing, reviewing and evaluating the effectiveness of policies and procedures ■■ Internal controls to reduce the likelihood of improper conduct and compliance violations ■■ Ongoing monitoring, control testing and auditing processes to assess the effectiveness of the programme and any improper conduct

Remaining fit for purpose

Compliance programme assessment is a key element of the board’s oversight of compliance programmes. Such assessments should be conducted periodically to identify areas for improvement in light of the company’s evolving risks and regulatory preferences with respect to compliance structures and practices. The DOJ’s new guidance and emerging best practice recommendations, such as those described in the ECI Report, should help boards determine the assessment process that is appropriate for the company and determine whether the company’s programme continues to be effective and fit for purpose. U.S. Sentencing Guidelines Manual §§ 8B2.1(b), 8C2.5(f).” 2DOJ, US Attorneys’ Manual § 9-28.800, comment (2015) 3PwC’s State of Compliance Study 2016 – Chart Pack (2016) at 17. This article has been prepared for informational purposes only and does not constitute legal advice. This information is not intended to create, and the receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon this without seeking advice from professional advisers. The content therein does not reflect the views of the firm. 1

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Board Governance | Internal Governance EFFECTIVE LEADERSHIP A board needs to consider how power is allocated and exercised at the management level

Internal governance: The next frontier Thinking of relaxing now that you have your board governance in order? Donâ&#x20AC;&#x2122;t. Governance below the board is just as important In the face of corporate mishaps across various industries, boards of directors in recent years have been taking heed of the call to heighten their ability to provide oversight of the company and its activities.

Boards are looking more critically in the mirror and identifying gaps in their own composition, independence, skills, structures and way of working.1 But while boards work on their own governance, how clear a line of sight do they have on the â&#x20AC;&#x2DC;governance underneathâ&#x20AC;&#x2122;? Here are five central questions that boards can ask about internal governance, the governance at the management level. Not only can this 52 Ethical Boardroom | Spring 2017

Gabe Shawn Varges

Senior Partner at HCM International & Chairman of the GECN Group allow the board to better size up the power dynamics among executives, but it can also improve the quality of information the board receives and send an important signal that the board cares about how decisions are made at all levels of the company. After all, the concept of checks and balances does not just apply between board and management, but within management itself.

Is it a real executive committee? CEOs have long known the benefit of organising the key members of the executive team in a formal body. This may go under different

names, such as executive committee (Exco), management committee, or management board. Depending on the jurisdiction and industry, this may be an optional choice or a legal or regulatory requirement.2 Either way, there is a range of ways in which executive committees and similar bodies operate. The board will want to understand if the Exco at its company is just a consultative body to the CEO or a real decision-making body. In the former case, the CEO may be using the Exco to gather input and motivate his or her team, but the committee members may lack any right to a formal vote or say. In another constellation, the Exco is set up to take decisions but its ability to do so may be constrained. One restriction can be scope. The committee may be empowered to vote on www.ethicalboardroom.com

Internal Governance | Board Governance

Internal governance

Board level governance

Internal governance

Board level governance

certain matters – for example, approving for the exercise of its oversight responsibilities.5 A DIFFERENT VIEW: TAKING the company’s financial statements before One way is for the board to probe into the MORE INTEREST IN THE they go to the board – but not on others, governance of how information gets bubbled GOVERANCE UNDERNEATH such as on new corporate strategic initiatives. up to it. Who besides the CEO, or a couple of Or restrictions can be built into the voting his or her lieutenants, is involved in ultimately structure. For example, each Exco member shaping what, how and when something is may have one vote, but the CEO may have reported to the board? What checks and veto power, a double vote, or can only lose balances are there to avoid the withholding of a decision if every other member does not information or the delivery of partial or delayed vote along with him or her. In another information? This was apparently a problem variation, the CEO has only one vote, like at Wells Fargo recently. There, the board was other Exco members, but, in the event of reportedly among the last to learn about the an impasse, can cast the tie-breaking vote. bank’s client account opening practices that Since the right Exco governance for a ultimately resulted in billions of reduced company depends on the totality of its market value, a CEO resignation, and the THE GOAL OF circumstances, it is essential for board prospect of years of regulatory investigations INTERNAL GOVERANCE members to inform themselves on how it and lawsuits.6 In working to address how information comes to it, the board’s interest currently works at their company and form thus is not just the output (the information a view if adjustments are needed. If the board received) but the very integrity is worried about an unduly of the governance process that dominant CEO, for example, it The concept may wish for the Exco to have of checks and produces such information. a formal voting process so as balances does Does the company to create transparency and have IGBs? Particularly give other members a stronger not just apply Not just to improve the quality of information since the 2008-2009 financial chance to be heard and have to the board, but to provide the board between crisis regulators have been influence. On the other hand, if (and external stakeholders) with more comfort that, even on matters not having to pushing companies to have the CEO manages by consensus board and be reported to the board or disclosed publicly, stronger so-called control and there are other checks decisions below the board are being made management, or assurance functions. and balances, such as a strong in an informed, objective way. These include the internal but within chief risk officer, then the ©2017 Gabe Shawn Varges auditor, the risk officer and Exco’s decision-making process management often cross-disciplinary teams with a targeted the compliance officer.7 may not need to be as formal. itself The emphasis on these functions mandate to review, report on, or even decide Another variation is allowing is justified since it is still an on certain matters important to the company. the CEO to have veto power but underdeveloped area at many companies. Unlike project teams or taskforces, IGBs are requiring that the board be informed each However, such focus has tended to permanent bodies and, unlike traditional time the CEO uses such power. In many overshadow another opportunity that can management committees, they have a cases, those joining a board don’t ask about also contribute to better internal governance. well-spelled out charter that defines their the governance of the Exco, assuming it is The opportunity lies in internal governance governance authority and have more than just immutable or solely for the CEO to determine. bodies or IGBs. These bodies, often called senior management members. When properly But if a board wants to provide effective committees or councils, are at the management staffed and not part of the regular hierarchy, governance leadership, it will need to concern (not board) level. They are not functions an IGB can add to the checks and balances and itself with how power is allocated and (such as accounting) or departments (such as increase the chances of a matter being handled exercised below its level, i.e. within the human resources) or traditional management objectively and with less colouring from any management ranks. committees, but instead cross-functional and power machinations in the company. Who decides what gets reported to the board? So-called ‘information IGBs AS PART OF THE CORPORATE ECOSYSTEM asymmetry’ is often cited as among the most Executive significant challenges for boards. 3 The term Office of the CEO and COO CEO committee refers to the fact that management (being Board of directors relations day-to-day involved in the operation of the Executive committee relations company) possesses far more information Chief operating External relations than the board ever could (which meets only officer Personal assistants a few times a year and for limited hours). This gives management tremendous Business division 1 Function A IGBs advantage and reduces the board’s confidence IGBs and ability to challenge management. The board, of course, can improve its hand by Business division 2 Function B asking the right questions and getting support IGBs 4 from independent external experts. But Business division 3 Function C IGBs the board can hardly hope to ever achieve information symmetry with management. IGBs However, there are ways for the board to Business increase its comfort that it is getting Function …X division…X More commercially-oriented More control-oriented information that is a) objective and balanced, b) timely, and c) on the matters most relevant ©2017 Gabe Shawn Varges

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Spring 2017 | Ethical Boardroom 53

Board Governance | Internal Governance For example, worried about the accuracy discussion that are sometimes stifled by of what they need to disclose publicly and hierarchy. Thus, who sits around the table to regulators, some companies are creating as a member of the IGB and who chairs it, a disclosure committee (i.e. an IGB) to handle are as fundamental as whether the IGB exists the financial, regulatory and other information in the first place. required or expected to be disclosed. Rather Connecting to incentives than having a single function (e.g. legal) Another IGB success factor is: are its members or a single executive (e.g. the CFO) handle properly incentivised on their work for the disclosures, the disclosure IGB brings together IGB? If serving on an IGB is perceived as a professionals from a mix of functions who voluntary or peripheral task and not part of the can help avoid inaccuracies and consider all manager’s core responsibilities, the manager angles of the disclosure challenge, including, may tend to give short shrift to his or her for example, from a reputational and work on the IGB, particularly when faced with shareholder needs perspective. As indicated deadlines from the ‘real earlier, the value is not just in the job’. One company, for information produced. Having a The value of a example, has created a well-composed and operated corporate responsibility disclosure IGB gives comfort to the well-designed IGB to address the board and the company’s external and operated increasing demands stakeholders that a disclosure went IGB lies in from investors and through a balanced review process on and no one person unduly influenced breaking down consumers environmental and social its content or the ‘spin’ given to it. silos and issues. The members Are the company’s IGBs include representatives opening lines being operated to extract communications, of cooperation, from the most value? Having IGB human resources, in and of themselves will not information strengthen internal governance if sharing and they simply duplicate or reinforce discussion that existing hierarchical relationships. Thus, a company having a are sometimes management-level risk committee stifled by may get reduced benefit if the committee’s membership simply hierarchy replicates the membership of the executive committee or another senior group body, or is made up only of risk people. Instead, more value is gained if the IGB includes members who bring additional perspectives, such as from different regions, business lines and functional areas.8 In the case of Wells Fargo, for example, it might have helped if the bank had had a well-balanced and robust sales practices IGB whose mandate included ensuring that the account growth strategy would not be pursued at the engineering, compliance and investor detriment of the bank’s long-term reputation relations. The IGB is charged with overseeing or the customer’s interests. the implementation of the company’s strategy Similar considerations are needed in in this area. Importantly, each member has selecting the chair of an IGB. For example, his or her work on the IGB as part of his some companies may think it is apt to have or her annual objectives. At the end of the the most senior member of the IGB serve year, the member is assessed on his or her as its chair. But using this approach only performance on the IGB and on the IGB’s reinforces hierarchy and may contribute to own performance. The results count in an atmosphere where less senior members determining the member’s variable pay. may be reluctant to challenge. It can be equally unhelpful having the CEO chair an IGB. Even Is the board leveraging sufficiently on when the CEO’s style is participatory, his or her internal governance? IGBs are not the presence on the IGB will likely have a chilling only manifestation of good internal governance effect on open discussion. IGB members may, but they can contribute considerably to it. if only subconsciously, act more deferentially As such, IGBs should not only be on the and be less frank in criticising approaches board’s radar but the board should find ways known to be supported by the CEO. The value to leverage more on their work. of a well-designed and operated IGB lies in At one level, this may simply involve breaking down silos and opening lines of supporting management in creating wellcooperation, information sharing and

54 Ethical Boardroom | Spring 2017

crafted IGBs and other ways to give deeper focus on priority areas, while reducing undue concentrations of power or silos that can restrict information flow. Some of the types of IGBs that companies are creating today include: new business, capital & liquidity, assets & liability management, corporate culture, remediation, regulator relations, ethics, and policy exceptions committees. In the performance and compensation areas, particular progress has been made recently with some companies creating a pay adjustments or similar IGB. Such an IGB reflects the goal of bringing more objectivity to downward adjustments made to variable pay when a manager commits a personal breach or the units for which he is responsible underperform on risk or compliance measures.9 Such an IGB typically has several functions represented, including compliance, and is empowered to review the nature of the transgression or other compliance underperformance and determine objectively what impact this should have on the manager’s pay. But at another level, the board may wish to take more steps to formally validate that the governance beneath its level is sound.

EXTRACTING VALUE An IGB will strengthen internal governance if it includes a diverse mix of members

This may involve periodically assessing the company’s internal governance in general, including IGBs. This could include mapping such IGBs to identify gaps or overlaps and doing deeper dives into specific IGBs to assess their governance health and general effectiveness. This helps not only the company in general but the board itself. For example, with the increased focus on cyber risk, the expectation is growing that the board makes this a priority topic for its oversight.10 The board thus would not only wish to assure that IT or risk are working hard in this area, but that others who can help bring fresh ideas to this complex challenge are also involved. Having a well-calibrated cyber risk IGB could be one appropriate vehicle for this purpose and one which could also help the board in fulfilling its oversight responsibilities in this critical area. Footnotes will be published in full online.

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Board Governance | Executive Pay ADDRESSING REMUNERATION Shareholders are ready to show their hands over executive pay

56 Ethical Boardroom | Spring 2017

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Executive Pay | Board Governance

A holistic approach to executive pay policy ‘Integrated remuneration’ is the way to solve the conundrum of executive compensation 2016 was labelled as a shareholder spring – with high-profile cases of shareholder revolt over executive pay in numerous countries, such as BP in the UK, Renault in France and Deutsche Bank in Germany. 2017 appears to be in the same vein – its first casualty being Imperial Brand, which had to withdraw its new remuneration policy due to shareholders’ opposition.

Our dialogues with companies to prepare for the 2017 proxy season are also very focussed on remuneration issues and you can feel some anxiety from issuers. Some of it may be due to the specific nature of 2017 with the renewal of remuneration policies in the UK or the implementation of the Sapin II law in France and its double ex-ante/ex-post binding vote. But that anxiety also comes from the multiple and, sometimes, contradictory demands that issuers can receive from shareholders. The Renault case in 2016 is especially interesting as it had to face multiple criticisms on very different aspects of its pay package. The French State was expecting a substantial decrease of remuneration (around 30%) from companies where it had a minority holding. Some shareholders were concerned by the quantum of Carlos Gohsn‘s total pay in his dual roles at both Renault and Nissan. Other shareholders were concerned at the lack of transparency of the Nissan package as Renault, despite owning more than 40 per cent of Nissan, considers it is not legally controlling it and so does not have to follow the French requirements on remuneration disclosure. Another group of shareholders, in line with Institutional Shareholder Services research, were concerned by the limited transparency of the deferred part of the bonus. And, a final group of investors were preoccupied with the challenging aspects of the criteria of the long-term plans where 80 per cent of the incentive could vest for performance below the peer group or under the budget. And probably some other investors also criticised other aspects of the remuneration, such

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Cédric Lavérie

implementation is more complicated. First, performance is plural, can be assessed on multiple approaches and is very linked to the sector and strategy of the company. as length of vesting period, weight of Unfortunately, a narrow vision of performance non-financial criteria (too much or not seems to have been often chosen by issuers enough), balance between fixed, short-term and investors with the Total Shareholder and long-term parts, etc. Return (TSR). Relative TSR has the advantage The board tried to react to that situation, of being transparent, not commercially even before the meeting where the say-on-pay sensitive, aligning remuneration with the was finally rejected. They strengthened the experience of investors and quite binary vesting scale of the long-term plan, once before when you have to build a vesting scale. Those the AGM and once after it, in order to remove advantages, combined with the P4P model payments for underperformance. They reduced of a leading proxy advisor, the Dodd-Frank the target short-term incentive (STI) from 150 approach to pay for performance and the to 120 per cent (but not the maximum of 180 temptation for both investors and issuers to per cent), removed the performance criteria opt for the easy solution has led to an excessive under the deferred part and announced that the use of TSR. Investors are realising that pitfall. CEO would donate €1million The Executive Remuneration of his variable remuneration Working Group in the UK Investors to projects financed by a recently concluded that ‘the foundation. Recently, Nissan market needs to move away have been announced that Ghosn has from a one-size-fits-all approach tasked with just stepped down as CEO to a system where companies the impossible have more flexibility to choose of Nissan, probably solving the issue of the double the remuneration structure mission of remuneration. Each board that is most appropriate for their reigning in reaction seems to try to tackle business’. The latest ISS survey the previous criticism and I revealed that 79 per cent of executive pay must admit that most of them, its clients wanted to introduce as politicians taken separately, represent other financial criteria in were not an improvement on a specific the P4P assessment beyond aspect of the remuneration. Hermes Investment willing to enter TSR. But as a whole, is that new Management in its latest that sensitive remuneration package better document on remuneration or more aligned with the principles stated that ‘executives arena long-term development of should be incentivised to deliver the company? Are scattered strategic goals (as opposed to TSR) decisions taken by different actors consistent? and be mindful of the company’s impact on key stakeholders’.

Head of Corporate Governance at Amundi Asset Management

Pay for performance

Investors have been tasked with the impossible mission of reigning in executive pay as politicians were not willing to enter that sensitive arena. Some investors are not endorsing that responsibility as often illustrated by their proxy voting records but others are taking that duty seriously. In order to assess remunerations, investors have established policies and guidelines. Pay for performance (P4P) is one of the most common. On the face of it, it appears to be a good principle but the

Sophisticated investors

Being too prescriptive can lead to unintended consequences or simplistic implementation of our recommendations. But, as the public debate on remuneration continues and as investors are becoming more and more sophisticated, deepening their analysis and trying to find solutions, several new recommendations/ideas on remunerations have been expressed by investors, but can we build the prefect remuneration with them?

Spring 2017 | Ethical Boardroom 57

Board Governance | Executive Pay Hermes suggests merging short-term and long-term incentive schemes and implementing a simpler structure by reintegrating the ‘always paid’ part of the variable remuneration into fixed but with a 50 per cent discount. The Executive Remuneration Working Group suggests a new approach by transferring performance-based long-term incentive plans (LTIPs) to restricted shares with a discount rate (Weir plc partially tried to implement that idea but got its remuneration report rejected). Some investors, such as ERAFP or Ircantec in France, have established ‘maximum socially tolerable’ ceilings for pay, either with reference to local minimal wages or to the median pay inside the issuer. Mirova is opposing resolutions on remuneration if it does not integrate environmental and social performance metrics, Fidelity is voting against companies that do not have minimum five-year retention periods on performance share awards and many others have found specific criteria to improve executive compensation. Such recommendations and guidelines are nearly always valuable to tackle specific issues of remunerations but we cannot avoid the possibility that some are not compatible, some cannot be stacked together or some cannot be adequate to every situation faced by a company. It is sometimes disconcerting to hear companies justifying changes in some part of their remuneration policy by following the practices recommended by some investors or proxy advisors without much concern about how it fits with the rest of the package and the strategy of the company. Our duty as shareholders is to monitor companies and hold boards accountable to ensure the long-term success of investee companies. As we are not part of the companies and only one stakeholder among others, we must not try to micromanage. I totally agree with the conclusions of the Executive Remuneration Working Group that the board and its remuneration committee should be fully accountable for the remuneration with the flexibility to choose the most adequate structure and the necessary discretion to adapt its outcomes. Nevertheless, while we must be confident in its ability to do it properly, we must monitor the output and vote accordingly in the numerous countries where shareholders have a say on remunerations and when we must renew the members of the remuneration committee. Prescriptive guidelines and policies and self-centered principles of ‘pay for (market) performance’ or ‘alignment with shareholders (only) interest’ seem to have failed previously, so we, the investors, must find a new, more holistic framework to assess the quality of the proposals submitted by companies and to guide our dialogues with boards on that issue.

another objective in which we are involved: integrated thinking and integrated reporting. So how would the integrated reporting framework apply to remuneration? Here are the seven guiding principles developed by the International Integrated Reporting Council (IIRC) for its international reporting (IR)framework and how it could fit our remuneration conundrum:

reports is essential. When regulations are not sufficient to ensure these objectives, guidance on reporting established with stakeholders can be useful. In that aspect, the GC100 and Investor Group guidance is a good example, whereas the application guide for the Afep-Medef code seems less effective as it was developed by issuers alone without taking into account the needs of investors.

Strategic focus and future orientation This covers the alignment of the remuneration with the company’s strategy, and even its purpose and culture, to the long-term horizon to the company. The choice of the types of performance metrics (financial, extra-financial, qualitative), balance of fixed, short-term and long-term parts and length of holding period are part of that principle.

Consistency and comparability Consistency over time in presentation should allow stakeholders to understand more easily the evolution of the remuneration policy and how it fits the dynamic of the company’s strategy implementation. Guidance on reporting established with stakeholders can also be helpful for comparability.

Connectivity of information This principle is more about the fine-tuning of remuneration to fit challenges in the implementation of the strategy. The dynamic in setting performance criteria and targets, vesting scales and the discretion of the committee are part of that principle. Stakeholder relationship The remuneration policy should take into account and respond to the interests of stakeholders. Engagement with shareholders, employee representatives in remuneration committees, stakeholder advisory panels or consultation/ communication with stakeholders on remuneration are part of that principle. Materiality The remuneration report should disclose information about all the elements that affect the remuneration output. This principle can cover the question of transparency of the targets of the performance criteria, elements of benchmarking or pay ratio reporting to understand the setting of the remuneration. Conciseness A remuneration policy should try to aim for the simplest structure necessary to reflect the first principle. Suppressing or merging incentive schemes when they are not fully relevant are part of the implementation of that principle.

My thoughts on using the integrated reporting framework for the issue of remuneration are quite recent and still superficial but I believe that this direction could create an interest from others, possibly leading to a deeper investigation of the idea. As the process is centered on companies and their boards, it would require some integrated thinking to be done to implement but for those already producing integrated reports it would only be a short step. Several of those companies, especially in South Africa, are already approaching what could be an ‘integrated remuneration’ in their integrated reports. As investors, we can push that process through our engagement with companies by questioning their remuneration policies through the scope of the three first strategic principles (the four other being more operational). This approach would be mutually beneficial as companies would get more flexibility in setting their remuneration structure and less contradictory demands from shareholders. Investors should benefit from a more comprehensive framework to understand how the remuneration fits the value creation process for the company and its stakeholders. Finally, I just hope that this idea will not be another element contributing to making the actual conundrum even more intractable.

Reliability and completeness Complete and balanced disclosure in remuneration

Guiding principles

I realised that this need for a holistic approach on strategy, value creation over time and accountability to stakeholders resonated with 58 Ethical Boardroom | Spring 2017

TIME FOR CHANGE Pressure is on organisations to reform executive remuneration www.ethicalboardroom.com

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Ethical Boardroom Keeping it Above Board

â&#x20AC;&#x153;Essential reading for boards who want to stay ahead of the governance curveâ&#x20AC;?

Global News North America

Trump targets Dodd-Frank rules President Donald Trump has signed executive orders that could roll back regulations adopted following the 2008 financial crisis — the Dodd-Frank Wall Street Reform and Consumer Protection Act. Trump has directed US Treasury Secretary Steve Mnuchin to lead a review of parts of Dodd-Frank, specifically, regulators’ authority to unwind a bank on the brink of failure and to label insurance companies, private equity firms and hedge funds as risky institutions. Mnuchin said: “Let me make it absolutely clear. President Trump is absolutely committed to make sure taxpayers are not at risk of government bailouts of entities that are too big to fail.” It has also been reported that the Trump administration is planning a dramatic reduction in the rate of corporation tax from 35 to 15 per cent.

Canadian shareholders focus on gender inequality Progress on gender diversity in boardrooms and executive suites is slow across Canada and is a concern for investors, according to the Shareholder Association for Research & Education (SHARE). Only 12 per cent of Canadian board seats are occupied by women and women hold just eight per cent of executive positions at Canada’s 100 largest companies. SHARE has unveiled efforts to tackle gender diversity and gender-related pay gaps across corporate Canada. This includes a pledge to vote against the entire nominating committee of the board of directors if a company’s board has zero women and does not disclose a clear policy aimed at increasing that number.

Investors shy away from US stocks Institutional investors are pulling cash out of America and buying European and emerging market stocks, according to the latest Bank of America (BofA) Merrill Lynch fund manager report. Fund managers’ allocation to US stocks has plunged to the lowest level since January 2008 — from a net one per cent overweight in March to a 20 per cent underweight in April. Twenty-one per cent of those surveyed for the report said a delay in US corporate tax reform was their biggest investment concern. Michael Hartnett, chief investment strategist at BofA Merrill Lynch, said: “Investors are showing love for Europe and scrambling out of US equities, as the majority find US stocks overvalued and perceive a risk of delayed US tax reform.”

62 Ethical Boardroom | Spring 2017

Men dominate life sciences boards

Women represent just 13 per cent of C-suite executives at life science public companies in the US, a new report has revealed. Almost nine out of 10 director positions are held by men at more than 400 biopharma and medical device boardrooms, according to research by consulting firm Epsen Fuller Group. “The numbers paint a harsh but clear picture of what is happening in boards and C-suites today,” said managing partner, Thomas Fuller. “What’s worse, this flies in the face of evidence that gender diversity is not a ‘nice-to-have’, it delivers better results, period.” Large cap companies (with valuations greater than $10billion) fare slightly better — on average, two out of 10 of their directors are female.

United Airlines CEO ‘won’t become chairman’

United Airlines has scrapped plans for its CEO Oscar Munoz (above) to take broader control of the company, following a high-profile incident in which a passenger was forcibly removed from an aircraft. Munoz had been expected to become chairman next year but the company has revised its compensation programme with the announcement that the “board believes that separating the roles of chief executive officer and chairman of the board is the most appropriate structure at this time”. Executive compensation will now depend on “progress in 2017 on significant improvement in the customer experience at United and aligned changes to United’s culture and processes”, according to a securities filing. www.ethicalboardroom.com

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North America | Institutional Investors

The birth of consensus

How a grassroots movement is changing the way investors operate - from the inside out The seeds of what was to become the US Investor Stewardship Group (ISG) were sowed in the fall of 2014 on the sidelines of the Council of Institutional Investors’ conference in Los Angeles.

There, a small cadre of asset owners and asset managers met against an unsettling backdrop of criticisms that, generally speaking, institutional investors didn’t operate according to a set of common beliefs, nor were they doing their own analysis and arriving at studied conclusions to vote their proxies. Blindly following the recommendations of proxy firms, critics maintained, was the order of the day. In the initial meetings, the group deliberated on how to help mitigate many of the criticisms being levelled at the investment industry, particularly at those who voted their own proxies: what were their overall governance policies and were there any commonalities in the public-facing polices of the group’s members? Over the course of the next three months, Allison Bennington of ValueAct Capital analysed public documents to isolate common principles, if any. As a next step, an online survey was fielded to test how much agreement there was among the group’s members on key issues. The survey included statements, such as ‘the majority of board members should be independent’, ‘issuers should adopt a vote share one vote standard’ and ‘boards should have a policy on periodic refreshment of directors’, among many others. Respondents were asked to rank their answers on a one to five scale, with five equalling ‘I completely agree’, one equalling I don’t agree at all’ and 3 equalling ‘this subject doesn’t matter to me’.

Building consensus

The survey was completed several weeks later and, as a member of the group, we studied the results to see if any commonalities existed among us. What we found was high agreement on 15 of the policy and rights statements, high overall agreement with some indifference to 17 of the statements and some disagreement with 13 of them. Our objective was to focus only on where there was complete agreement and, by fall of 2015, we had drafted our first set 64 Ethical Boardroom | Spring 2017

Rakhi Kumar

Managing Director and Head of ESG Investments and Asset Stewardship at State Street Global Advisor of common corporate governance principles that were based on only those principles that were supported by all members of the group. In September 2015, the group met again, this time at State Street Global Advisors’ offices during the Council of Institutional Investors’ Boston conference. We reviewed the draft principles, which were company-related only at that time, and noted the members’ feedback for later incorporation These stewardship into the second draft. principles were At that point, we took the liberty of developing a set of accompanying designed to stewardship principles that would hold institutional apply to any institutional investor who would be signing on to the investors principles. These stewardship accountable to principles were designed to hold institutional investors accountable their clients for to their clients for their stewardship their stewardship activities related to the oversight of activities related their clients’/beneficiaries’ investments in portfolio companies. to the oversight of Our rationale was that, as the their clients’/ Principles – were being initiative was primarily developed by a cadre investor-driven, we needed to hold beneficiaries’ of eminent CEOs. ourselves to a set of principles, too. investments Fortunately, after That’s how they came into being. speaking with the As for the company version, we in portfolio ‘Commonsense group’, were very happy with the second companies it turned out that draft. Reaction to the stewardship its principles were principles was also very positive complementary and primarily boardroom-led, and the group voted unanimously to which continued to make our investor-led work incorporate them as part of the framework unique. We opted to let the Commonsense we were developing. group come to market first with its manifesto, If you had to ask me to isolate one common with ours set to follow several months later. thread, one DNA strand, that unites both the At the end of the day, our principles turned stewardship and governance principles, I’d say into exactly what we’d hoped they’d be: a it was the concept of accountability. Directors historic initiative by some of the largest are accountable to shareholders and US-based institutional investors and global shareholders are accountable to beneficiaries. asset managers, along with several Common ground international counterparts, that had created As early 2016 rolled around, we were satisfied a framework for US Stewardship and that we had a good draft of both the company Governance – in other words, the basic and stewardship principles when news standards of investment stewardship and broke that another set of principles – the corporate governance for US institutional Commonsense Corporate Governance investor and boardroom conduct. www.ethicalboardroom.com

Institutional Investors | North America

INVESTORS UNITED New guiding principles on stewardship and governance come into effect next year

$17trillion and counting

With the conclusion to our work in sight, what remained was to encourage asset managers and asset owners to put their names to the principles. We were thrilled that the following prestigious brands, representing some $17trillion in assets, enthusiastically agreed to be our founding signatories and endorsers (endorser designation is for non-US investors only): BlackRock; CalSTRS; Florida State Board of Administration (SBA); GIC Private Limited (Singapore’s Sovereign Wealth Fund); Legal and General Investment Management; MFS Investment Management; MN Netherlands; PGGM; Royal Bank of Canada Global Asset Management; State Street Global Advisors; TIAA Investments; Rowe Price Associates, Inc.; ValueAct Capital; Vanguard; Washington State Investment Board; and Wellington Management. The principles of the Investor Stewardship Group – as follows – were made public on 31 January 2017 and will come into effect on 1 January 2018. www.ethicalboardroom.com

Stewardship framework for institutional investors

Principle A. Institutional investors are accountable to those whose money they invest. ■■ A.1 Asset managers are responsible to their clients, whose money they manage. Asset owners are responsible to their beneficiaries ■■ A.2 Institutional investors should ensure that they or their managers, as the case may be, oversee client and/or beneficiary assets in a responsible manner Principle B. Institutional investors should demonstrate how they evaluate corporate governance factors with respect to the companies in which they invest. ■■ B.1 Good corporate governance is essential to long-term value creation and risk mitigation by companies. Therefore, institutional investors should adopt and disclose guidelines and practices that help them oversee the corporate governance practices of their investment portfolio

companies. These should include a description of their philosophy on including corporate governance factors in the investment process, as well as their proxy voting and engagement guidelines ■■ B.2 Institutional investors should hold portfolio companies accountable to the corporate governance principles set out in this document, as well as any principles established by their own organisation. They should consider dedicating resources to help evaluate and engage portfolio companies on corporate governance and other matters consistent with the long-term interests of their clients and/or beneficiaries ■■ B.3 On a periodic basis and as appropriate, institutional investors should disclose, publicly or to clients, the proxy voting and general engagement activities undertaken to monitor corporate governance practices of their portfolio companies ■■ B.4 Asset owners who delegate their corporate governance-related tasks to their asset managers should, on a periodic basis, evaluate how their managers are executing these responsibilities and whether they are doing so in line with the owners’ investment objectives Principle C: Institutional investors should disclose, in general terms, how they manage potential conflicts of interest that may arise in their proxy voting and engagement activities. ■■ C.1 The proxy voting and engagement guidelines of investors should generally be designed to protect the interests of their clients and/or beneficiaries in accordance with their objectives ■■ C.2 Institutional investors should have clear procedures that help identify and mitigate potential conflicts of interest that could compromise their ability to put their clients’ and/or beneficiaries’ interests first ■■ C.3 Institutional investors who delegate their proxy voting responsibilities to asset managers should ensure that the asset managers have appropriate mechanisms to identify and mitigate potential conflicts of interest that may be inherent in their business Principle D. Institutional investors are responsible for proxy voting decisions and should monitor the relevant activities and policies of third parties that advise them on those decisions. ■■ D.1 Institutional investors that delegate their proxy voting responsibilities to a third party have an affirmative obligation to evaluate the third party’s processes, policies and capabilities. The evaluation should help ensure that the third party’s processes, policies and capabilities continue to protect the institutional investors’ (and their beneficiaries’ and/or clients’) long-term interests, in accordance with their objectives Spring 2017 | Ethical Boardroom 65

North America | Institutional Investors ■■ D.2 Institutional investors that rely on third-party recommendations for proxy voting decisions should ensure that the agent has processes in place to avoid/ mitigate conflicts of interest Principle E: Institutional investors should address and attempt to resolve differences with companies in a constructive and pragmatic manner. ■■ E.1 Institutional investors should disclose to companies how to contact them regarding voting and engagement ■■ E.2 Institutional investors should engage with companies in a manner that is intended to build a foundation of trust and common understanding ■■ E.3 As part of their engagement process, institutional investors should clearly communicate their views and any concerns with a company’s practices on governance-related matters. Companies and investors should identify mutually held objectives and areas of disagreement, and ensure their respective views are understood ■■ E.4 Institutional investors should disclose, in general, what further actions they may take in the event they are dissatisfied with the outcome of their engagement efforts Principle F: Institutional investors should work together, where appropriate, to encourage the adoption and implementation of the Corporate Governance and Stewardship Principles. ■■ F.1 As corporate governance norms evolve over time, institutional investors should collaborate, where appropriate, to ensure that the framework continues to represent their common views on corporate governance best practices ■■ F.2 Institutional investors should consider addressing common concerns related to corporate governance practices, public policy and/or shareholder rights by participating, for example, in discussions as members of industry organisations or associations

Corporate governance framework for US listed companies

Principle 1: Boards are accountable to shareholders. ■■ 1.1 It is a fundamental right of shareholders to elect directors whom they believe are best suited to represent their interests and the long-term interests of the company. Directors are accountable to shareholders, and their performance is evaluated through the company’s overall long-term performance, financial and otherwise ■■ 1.2 Requiring directors to stand for election annually helps increase their accountability to shareholders. Classified boards can reduce the accountability of companies and directors to their shareholders. With classified boards, a minority of directors 66 Ethical Boardroom | Spring 2017

stand for elections in a given year, thereby preventing shareholders from voting on all directors in a timely manner ■■ 1.3 Individual directors who fail to receive a majority of the votes cast in an uncontested election should tender their resignation. The board should accept the resignation or provide a timely, robust, written rationale for not accepting the resignation. In the absence of an explicit explanation by the board, a director who has failed to receive a majority of shareholder votes should not be allowed to remain on the board ■■ 1.4 As a means of enhancing board accountability, shareholders who own a meaningful stake in the company and have owned such stake for a sufficient period of time, should have, in the form of proxy access, the ability to nominate directors to appear on the management ballot at shareholder meetings ■■ 1.5 Anti-takeover measures adopted by companies can reduce board accountability and can prevent shareholders from realising maximum value for their shares. If a board adopts such measures, directors should explain to shareholders why adopting these measures are in the best long-term interest of the company ■■ 1.6 In order to enhance the board’s accountability to shareholders, directors should encourage companies to disclose sufficient information about their corporate governance and board practices Principle 2: Shareholders should be entitled to voting rights in proportion to their economic interest. ■■ 2.1 Companies should adopt a one-share, one-vote standard and avoid adopting

share structures that create unequal voting rights among their shareholders ■■ 2.2 Boards of companies that already have dual or multiple class share structures are expected to review these structures on a regular basis, or as company circumstances change, and establish mechanisms to end or phase out controlling structures at the appropriate time, while minimising costs to shareholders Principle 3: Boards should be responsive to shareholders and be proactive in order to understand their perspectives. ■■ 3.1 Boards should respond to a shareholder proposal that receives significant shareholder support by implementing the proposed change(s) or by providing an explanation to shareholders why the actions they have taken or not taken are in the best long-term interests of the company ■■ 3.2 Boards should seek to understand the reasons for and respond to significant shareholder opposition to management proposals ■■ 3.3 The appropriate independent directors should be available to engage in dialogue with shareholders on matters of significance, in order to understand shareholders’ views ■■ 3.4 Shareholders expect responsive boards to work for their benefit and in the best interest of the company. It is reasonable for shareholders to oppose the re-election of directors when they have persistently failed to respond to feedback from their shareholders Principle 4: Boards should have a strong, independent leadership structure. ■■ 4.1 Independent leadership of the board www.ethicalboardroom.com

Institutional Investors | North America GLOBAL COLLABORATION International investors representing $17trillion in assets have signed up to the framework

is essential to good governance. One of the primary functions of the board is to oversee and guide management. In turn, management is responsible for managing the business. Independent leadership of the board is necessary to oversee a company’s strategy, assess management’s performance, ensure board and board committee effectiveness and provide a voice independent from management that is accountable directly to shareholders and other stakeholders ■■ 4.2 There are two common structures for independent board leadership in the US: 1) an independent chairperson; or 2) a lead independent director. Some investor signatories believe that independent board leadership requires an independent chairperson, while others believe a credible independent lead director also achieves this objective ■■ 4.3 The role of the independent board leader should be clearly defined and sufficiently robust to ensure effective and constructive leadership. The responsibilities of the independent board leader and the executive chairperson (if present) should be agreed upon by the board, clearly established in writing and disclosed to shareholders. Further, boards should periodically review the structure and explain how, in their view, the division of responsibilities between the two roles is intended to maintain the integrity of the oversight function of the board Principle 5: Boards should adopt structures and practices that enhance their effectiveness. ■■ 5.1 Boards should be composed of www.ethicalboardroom.com

directors having a mix of direct industry expertise and experience and skills relevant to the company’s current and future strategy. In addition, a well-composed board should also embody and encourage diversity, including diversity of thought and background ■■ 5.2 A majority of directors on the board should be independent. A board with a majority of independent directors is well positioned to effectively monitor management, provide guidance and perform the oversight functions necessary to protect all shareholder interests ■■ 5.3 Boards should establish committees to which they delegate certain tasks to fulfil their oversight responsibilities. At a minimum, these committees should include fully independent audit, executive compensation, and nominating and/or governance committees ■■ 5.4 The responsibilities of a public company director are complex and demanding. Directors need to make the substantial time commitment required to fulfil their responsibilities and duties to the company and its shareholders. When considering the nomination of both new and continuing directors, the nominating committee should assess a candidate’s ability to dedicate sufficient time to the company in the context of their relevant outside commitments ■■ 5.5 Attending board and committee meetings is a prerequisite for a director to be engaged and able to represent and protect shareholder interests; attendance is integral to a director’s oversight responsibilities. Directors should aim to attend all board meetings, including the annual meeting, and poor attendance should be explained to shareholders ■■ 5.6 Boards should ensure that there is a mechanism for individual directors to

receive the information they seek regarding any aspect of the business or activities undertaken or proposed by management. Directors should seek access to information from a variety of sources relevant to their role as a director (including for example, outside auditors and mid-level management) and not rely solely on information provided to them by executive management ■■ 5.7 Boards should disclose mechanisms to ensure there is appropriate board refreshment. Such mechanisms should include a regular and robust evaluation process, as well as an evaluation of policies relating to term limits and/or retirement ages Principle 6: Boards should develop management incentive structures that are aligned with the long-term strategy of the company. ■■ 6.1 As part of their oversight responsibility, the board or its compensation committee should identify short- and long-term performance goals that underpin the company’s long-term strategy. These goals should be incorporated into the management incentive plans and serve as significant drivers of incentive awards. Boards should clearly communicate these drivers to shareholders and demonstrate how they establish a clear link to the company’s long-term strategy and sustainable economic value creation. All extraordinary pay decisions for the named executive officers should be explained to shareholders ■■ 6.2 A change in the company’s long-term strategy should necessitate a re-evaluation of management incentive structures in order to determine whether they continue to incentivise management to achieve the goals of the new strategy

In conclusion

This was and, still is, a grassroots effort. In the fall of 2014, we didn’t know what we had to work with or what we’d end up with, if anything. Thus far, reaction to the Framework has been overwhelmingly positive. Since the January launch, an additional 14 asset owners and asset managers representing assets of some $1.5trillion have signed up to the principles; others are seeking permission from their organisations to do so.1 But to shape the macro effort in line with our vision, every asset manager and asset owner who invests in the US should be encouraged to join this initiative. We have governance structures in place to facilitate the inclusion of more members. Our principles are not static. They will be refreshed over time to keep pace with changes in the US governance landscape and we need new members who can help us ensure the viability and dynamism of the Investor Stewardship Group’s Framework for stewardship and governance in the US. https://www.isgframework.org/signatories-and-endorsers/

Spring 2017 | Ethical Boardroom 67

Board Leadership | Evaluation

Making board evaluation more robust Anthony Goodman & Rusty O’Kelley

Anthony and Rusty are leading members of Russell Reynolds Associates Board and CEO Advisory Group

Demonstrating board assessments provides investors with a signal the board is actively listening to its shareholders’ governance concerns Board evaluation is a topic that yields mixed sentiments from directors, who often praise the concept but in practice do very little to drive a robust process that would result in meaningful changes.

Accordingly, board evaluations tend to produce only incremental change that fails to keep pace with their companies’ evolving strategies or with changing investor expectations. In survey after survey, directors have expressed their dissatisfaction with board evaluation. For instance, Stanford University’s Rock Center survey found that “satisfaction levels with board evaluations are modest” and PwC’s 2016 Annual Directors Survey found that only about half of directors (49 per cent) say their board actually made changes as a result of their evaluation.1 However, the pressure to adopt a more robust board assessment process is coming from institutional investors, governments and regulators globally. Take a few recent examples: ■■ In February 2017, the Council of Experts Concerning the Follow-up of Japan’s Corporate Governance Code issued guidance noting that, beginning this spring, companies will be expected to evaluate their boards with “primary importance…placed on an honest evaluation of the board by each board member”. Earlier, in January, the Securities 68 Ethical Boardroom | Spring 2017

and Exchange Board of India issued its long-awaited guidance on board evaluations, which have been mandatory for Indian companies since 2013.2 By comparison, the UK’s Corporate Governance Code has, since 2010, called for externally facilitated board evaluations every three years, while France’s AFEPMEDEF code began making similar recommendations in 2003. ■■ Also in January 2017, the Investor Stewardship Group, a coalition of more than 25 global institutional investors, launched its Framework for US Stewardship and Governance calling for boards to have a “regular and robust evaluation process”.3 That statement built on the earlier work of a group of business leaders and investors – led by Jamie Dimon and Warren Buffett and launched in July 2016 – called the Common Sense Principles for Corporate Governance. 4 The Principles recommended that “boards should have a robust process to evaluate themselves on a regular basis”. In 2015, ISS and Glass Lewis, the two-leading proxy advisory firms, had defined a ‘robust’ board evaluation process in the US as one that includes external evaluations and individual director assessments. When we speak with the large, global institutional investors who are shaping the changes to corporate governance internationally, they are very clear that there are three things a board needs to do to be effective. 5 The first is to be involved in the

development of strategy and monitor its execution, the second is to ensure an orderly CEO succession and understand bench strength outside the C-suite and the third is to ensure the board’s own composition is regularly refreshed and designed to oversee the company’s strategy over the longer term.

What does a robust board evaluation look like?

Clearly, different markets are at different stages of evolution on the subject of board evaluation. In Japan and India, the challenge may simply be conducting an assessment in the first place. In the US, it may be more a question of ratcheting up the quality of what is being done and, periodically, bringing in objective third party evaluators. In the UK and France, which have been in evaluation mode a lot longer, the challenge may simply be to keep the process fresh and meaningful. There are many ways to conduct board evaluations, such as 360-degree interviews and surveys with management and the board (and even external stakeholders). The purpose of this article is not to focus on the mechanics but on the substance of evaluations. If a board evaluation is to be a value adding experience, rather than a tick-the-box compliance activity, we believe there are certain elements that need to be present. These are:

An assessment of whether directors feel fully involved in the development of strategy and if there is genuine alignment around the strategy. www.ethicalboardroom.com

Evaluation | Board Leadership review of whether directors feel 2 Acomfortable that the board is doing

enough to ensure an effective CEO succession in both the short term (emergency succession) and longer term. Do they also have a good grasp of the bench strength beyond the C-suite? An honest appraisal of the board’s strengths and areas for development when it comes to people (board leadership, composition and culture) as well as process. Benchmarking of the board against a range of reliable outside indicators, such as peer and best-in-class companies, governance best practices and investor perspectives. Evaluation of individual director performance and contribution to the board.

4 5

Board evaluations (internal or external) sometimes fail to have the desired impact because they are not robust enough, the process doesn’t dive deep enough into the ‘issues behind the issues’ and they fail to consider emerging trends in corporate governance and changing investor expectations. The following section explores these five elements of an effective evaluation in more detail.

Strategic alignment

Having conducted dozens of board evaluations around the world, we sometimes find that board directors are not fully aligned on the company’s strategy nor adequately engaged in the strategy development process. On occasion, we find that within a board some directors may articulate alternate versions of what the strategy says – sometimes with entirely different areas of competitive differentiation. This misalignment often stems from the lack of time devoted to substantive discussion of the strategy at the board level or the board being engaged in the strategy development process at too late a stage; one annual board strategy retreat is rarely sufficient. Board leaders can use a board self-evaluation to assess director satisfaction with and understanding of the strategy. The remedy is often for management to understand that strategy is a process, not an event. Directors are more likely to understand a strategy that is regularly used to provide context for board discussions and decisions. Board leaders (the CEO, chair, lead director) need to spend time with each individual director outside the formal board meetings to ensure they are aligned with the strategy.

planning 2 Succession The second most likely area of concern

in our board evaluations is related to CEO succession planning. Again, this issue often presents itself as a complaint about the lack of time devoted to board-level discussion or the lack of interaction between the board and potential successors, particularly outside the setting of the formal board meeting. If the only www.ethicalboardroom.com

time a director sees an internal candidate is in a boardroom presentation, the range of skills that are assessed will be too narrow. CEO succession needs to start shortly after a new CEO is appointed. It should be a naturally occurring process, mandated by the board. Boards should not be afraid to undertake regular scans of the market to understand both the internal and external options. Board retreats should take place in locations where the board can meet with management outside the head office, as well as with customers and other stakeholders. Board meetings and dinners should provide a range of formal and informal settings for getting to know senior management. While the board leadership can and should assess satisfaction with the succession planning process through the board’s self-evaluation, they should consider engaging a third party to provide an objective assessment of internal talent and to explore external hiring opportunities.

and process 3 People Boards are usually good at critiquing

their processes (the quality and length of board books, how information flows, the usefulness of various committees and the appropriate balance of board discussion and presentation). Directors often serve on several boards and can share best practices they have seen. However, based on our own experience, boards are less robust when it comes to tackling issues, such as who should lead the board, how board composition should change to match an evolving strategy and what sort of behaviour is acceptable and what is not. Board leadership succession – who should chair the board and each committee – is typically not well planned far enough in advance. Many boards don’t think ahead to rotate directors through key committees before asking them to chair one. Board composition is less often planned over the long term to bring in the talent required by key committees until a specific vacancy occurs. The board’s own competency matrix is often developed with the corporate secretary and can suffer from a form of ‘grade inflation’. This is an area where a board should focus on improving its own processes. In a world of activist investors, business media and NGOs who can conduct very robust analyses of your board leadership and composition, being prepared to do the same is common sense (and good self-defence).

4 Benchmarking Even good boards often lack an

outside-in view of how the board is perceived by investors and other stakeholders. The general counsel, corporate secretary or investor relations professional should take time to educate the board about what their investors expect.6 Engaging with investors directly can provide powerful feedback. Looking at the composition and board structure of peer and best-in-class

companies can also help, and understanding the latest thinking on governance best practices is important. Gaining an external point of view on best (and poor) governance practices from someone who has engaged with many boards can be of particular value.

director assessment 5 Individual Newer corporate governance codes

in places, such as India, require individual director assessment, but it is easier to mandate than to implement. Many directors shy away from giving or receiving feedback from their peers. Some board leaders are reluctant to give feedback to directors whose behaviour (interrupting, being unprepared, talking too much or too little) is bothering a number of their colleagues. The importance of preserving a ‘collegial atmosphere’ often masks some fairly un-collegial behaviour. Beyond the behavioural issues, the contribution of each director should be assessed to understand if their skills and experience are still adding value to the board’s important discussions. Are they still current? Is the rationale for why they were brought onto the board still applicable? Many boards ask an outsider to conduct the individual director assessment of the board as it can be more objective and is usually done in a confidential and robust manner. There are many approaches for assessing directors and they are usually seen as developmental and positive. We have used the insights and findings from our Global Board Culture Survey to assess directors against the five behaviours that can move a board from good to great performance.7 Boards have many choices when it comes to both self- and external evaluation. Once you have picked the right robust evaluation approach for your board you may want to consider disclosing that you conducted such an exercise to get the credit from your investors (in certain jurisdictions disclosure is required). The more you can demonstrate the robustness of the process, the more credit you will receive from investors. Investors think that robust board evaluation will prove a better means of refreshing the board than age or tenure limits. It is increasingly important that boards show they are conducting a robust evaluation and tackle the issues their investors care about. https://www.pwc.com/us/en/corporate-governance/ annual-corporate-directors-survey/assets/pwc-2016annual-corporate--directors--survey.pdf 2http://www.sebi. gov.in/cms/sebi_data/attachdocs/1483607537807.pdf 3 https://www.isgframework.org/corporate-governanceprinciples/ 4http://www.governanceprinciples.org/ wp-content/uploads/2016/07/GovernancePrinciples_ Principles.pdf 5http://www.russellreynolds.com/en/ Insights/thought-leadership/Documents/Global%20 and%20Regional%20Trends%20in%20Corporate%20 Governance%20for%202017.pdf 6http://www. russellreynolds.com/en/Insights/thought-leadership/ Documents/The%20investor-savvy%20board.pdf 7http:// www.russellreynolds.com/en/Insights/thought-leadership/ Documents/Russell%20Reynolds%202016%20 Global%20Board%20Culture%20Survey.pdf 1

Spring 2017 | Ethical Boardroom 69

Board Leadership | Board Effectiveness

The art of board

effectiveness

Structure, strategy and healthy dynamics make for better boards and better business In the 25 years since the Cadbury Report on corporate governance, how have boards been doing? Are boards able to understand and analyse what makes them effective and successful? Can they articulate and illuminate the characteristics of an effective board?

The FRC 2011 Board Effectiveness Guidance defines the board’s role as ‘to provide entrepreneurial leadership of the company within a framework of prudent and effective controls which enables risk to be assessed and managed’. This is consistent with other regulatory authorities and makes the point that the board is there to assess and manage risk and not to stop it all together. There are many reports and column inches of advice and guidance on the characteristics of an effective board, some are consistent, some not. What emerges from research, qualitative director interviews and experience of board reviews and observations,

70 Ethical Boardroom | Spring 2017

Helen Pitcher OBE

Chairman, Advanced Boardroom Excellence

is that effective boards perform at a level of interpersonal engagement, optimised to create effective decision-making. In my own experience as a board effectiveness consultant and non-executive director (NED), we progress to this point of effectiveness through the three key lenses of: ■■ Structure: which provides a platform for an effective board ■■ Oversight engagement: determining where the board should focus e.g. strategy to operations to culture

■■ Dynamics: ensuring the board as a team is able to apply its collective expertise to the key questions facing the business and interact successfully with the executive team

The structure

The structural elements should be considered as a qualifying criteria and foundation to create the platform and conditions for board effectiveness. Governance framework Ensure the company has a governance structure that is sensible and effective for its business and its aspirations – governance is not a one size fits all. Does governance go beyond the paper policy and become an active part of the operations management? Board composition Is it fit for purpose, are the capabilities right, both now and for the future and is there active ongoing consideration of these needs? An effective board needs a range of NEDs who are independent, have experience and

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Board Effectiveness | Board Leadership knowledge of the industry, are financially literate and who can take a broad strategic perspective within and beyond the sector. Considerations should also include whether the sector is under threat, facing disruption or in a downturn, as these will shape the skills, knowledge and experience needed on an effective board. At the same time, an effective board also needs a diversity of thinking, that can build upon an ‘expert’ view to achieve a collective intelligence that minimises bias and filters to effective decision-making. Board information Given the asymmetrical knowledge between full-time executives and part-time NEDs, the ‘board information’ and ‘papers’ should be specifically designed to aid rapid assimilation, ease of engagement with the key issues and avoid dense, irrelevant detail. Timeliness, while always an issue, needs to balance the tension between historical and current information, with digital delivery tempting late entry data which is difficult to ignore, but which often debilitates effective decision- making.

Oversight

The above elements, when achieved effectively, are supportive of good decision-making. However, the time, energy and focus that boards devote to key operations, strategic challenges and sustainability are vitally important. This effective oversight engagement, is a difficult but important balance. Too much time

concentrating on the dials, without looking at achieved anything of a similar scale/ the road ahead, has caused many a corporate disruption? What is the probability that we ‘car crash’. have the resources and capability to succeed? Performance monitoring This is often the These questions were not designed to ‘kill’ a slickest part of a board’s oversight. Usually a strategic initiative, but to engage the executive board will have plenty of financial expertise in a dialogue to better support success. and a strong audit committee to delve into the Knowing the unknown Effective boards, detail, with KPIs abounding. What can be less by dint of their NED capability, have a wealth impressive, is calling out when things start to of skill, experience and knowledge to steer slide in the wrong direction. Some and support the executive team of the research data on board through unchartered territory, How a board effectiveness suggest ineffective heightening the awareness handles its boards, through lack of of what is needed to succeed. interaction, are more reluctant to strategic input Experienced NEDs will, call out weakening performance, be sensitive to the and interaction however, especially where the CEO is levels of scrutiny required for is an important different levels of risk. Ludo Van in a dominant position. Strategy interaction How a Heyden, INSEAD Professor marker for an der board handles its strategic input Corporate Governance, has effective board articulated the difficulties facing and interaction is an important marker for an effective board. boards to ‘know the unknown’. Question: is an effective board one in a However, a sensitivity to the strategic booming sector, which allows the CEO and landscape illuminates the levels of care and executive team to get on with it without too attention an effective board should be focussed much interference? The watch words for on (see chart below). strategic interaction should be sustainability Board dynamics and long-term value. Above all, the board’s Board dynamics is often talked about, role in supporting the strategic aims of the particularly the lack of it, which is blamed for company should be defined and well many corporate disasters and dysfunctional understood. The board should be using its behaviours. So, what is it and what does it look independence and expertise to support and like? Essentially, it is the final mix, which builds enhance the strategic considerations. It should upon our previous building blocks. It is the equally, clearly define the criteria for success application of interpersonal engagement, which as the company embarks into less well-known leverages a good governance model, engages territory. One veteran NED has a simple set capable and diverse directors and provides of questions he poses as the ‘PowerPoint’ oversight on the right strategic questions and glides effortlessly into unknown territory. Has challenges. Easily said, but how is it enacted? anybody ever experienced this? Have we ever

COMPANY

HEADING IN THE RIGHT DIRECTION One of the markers of great boards is their continuous questioning of themselves www.ethicalboardroom.com

MARKETS

BOARD OVERSIGHT

WELL KNOWN A recognised area of the company’s expertise and operations. House builders, for example

KNOWN Clear and well covered area of strategic and customer information readily available. Population data, customer and economic information readily available

Routine oversight and monitoring from a well-established information flow and benchmarks. Watchful eye on economic data

KNOWN An area of expertise and strength for the company e.g. Amazon logistic expertise

UNKNOWN New and fresh market to apply the areas of expertise.

More sensitive monitoring with specific review points against forecast achievements

UNKNOWN Not a current area of expertise of the company. Needs to be built to address a known market. Lots of companies building their digital capabilities are at this point

KNOWN A clear, often rapidly developing market threat, often allied to or substituting for existing markets

A careful strategy to build capability, recognition of cost escalations and benchmark achievements. Recognition of context: is this an existential risk/threat or profit opportunity. Are we betting the farm?

UNKNOWN This is ‘black swan’ territory

UNKNOWN Risk and threats

Impossible to prepare for in traditional ways. However, ensuring a company has resilience, is swift in reacting to its environment, has its head-up regarding its markets and impactive PEST conditions could put you ahead of the competition

Spring 2017 | Ethical Boardroom 71

Board Leadership | Board Effectiveness

72 Ethical Boardroom | Spring 2017

THE KEY TO BOARD SUCCESS Companies need directors that engage with each other

uncertainty of Brexit, certainly a ‘known unknown’, are you on a board gearing up your awareness and intelligence for the ride ahead? There will be great challenges, but equally many opportunities. Are the right people literally on the board for this journey? Are they challenging and supporting the CEO to create an organisation that is ‘fit for purpose’ and ‘fleet of foot’ in response to the vagaries of the unknown? While the financial crisis has served up many challenges to boards, in conversation with one UK board NED recently, he was dusting off his manufacturing credentials and organising a tour of the German Mittelstand companies to increase his strategic awareness and intelligence for the coming unknown. Great companies, large and small, deserve and create great boards. It is the applied capabilities of the NEDs and executive board directors, as they engage with each other, which creates a collective source of knowledge and inspiration to achieve goals and ambitions.

FIGURE 1: WHERE WOULD YOU POSITION YOUR BOARD? +VE

BOARD EFFECTIVENESS

Challenge and debate The environment and scant time of challenge and debate has many influences during board but there are a number which are prime meetings to look and seen in effective boardrooms. How the to board dynamics. chairman and CEO shape the environment Consequently, the is a key determinant of the confidence of other process, events and activities directors to provide constructive challenge they do undertake, together to the executive and other colleagues on the or in smaller groups, become board. The sense that decisions, initiatives important points of interaction and strategies will be improved and honed by and engagement. The formal a collective consideration, is a well-researched board dinner. which is a dimension outside the boardroom, so will tradition and cliché, takes equally apply inside the boardroom. It does, on a different dimension however, require commitment to this when it is one of the few philosophy of reason and sensitivity to others. opportunities for team and At a more prosaic level, to support board consensus building. effectiveness, the information should be ‘fit There are many other factors and for purpose’ for a board and, crucially, there characteristics that have been should be time to undertake proper debate identified as markers of effective boards. and discussion. Too many packed agendas Namely, these are size, shareholder relations, of procedural and redundant information remuneration philosophy and, more recently, are the death knell to board effectiveness. executive succession planning and culture, Tone Hard to describe but clearly identified to mention but a few. Effective boards will, when experienced, the tone consists of an however, be happy and able to enter an inclusiveness, often set by a chairman, who effective dialogue to find the optimum values input and views and provides an open balance of these many competing factors. dynamic where contribution is welcomed. Value creation Equally important is an atmosphere of Value creation is a singularly important tolerance of ideas and opinions, often set driver for boards and board effectiveness. It by the CEO, combined with a language of colours the appreciation of a successful board. constructive criticism which is professional, However, we can have great boards in failing mature and respectful. companies, as we can have dysfunctional Participation and team work Unless boards in successful companies. There is no there is an engagement and participation guarantee that an effective of the whole board, as a team, looking to make Effective boards take board will be successful. What we can strive for is more effective decisions, a self-development that within your company, the positive dynamics seen focus and make within your environment, on effective boards will be the board is seeking to stunted. This requires a this part of their be the best it can be. tolerance of the diversity of collective and Where does your contribution, an openness company sit on the graph to those contributions and individual agendas of board effectiveness and critically a congruence with the challenge of your sector? See Figure 1. sharing and building of ideas to a better Going back to the strategy question, is solution. A board can have a massively your company setting sail into an unknown competent group of individuals but if the sea, with a leaky hull, tattered sails, an individual ‘experts’ dominate there is no undermanned crew and a demented captain? enhancement and improvement of ideas. Sometimes stopping value destruction is Board development the most effective strategy for the board. So, what should boards look to when thinking Consequently, the characteristic of an about their own development and effectiveness? effective board is contextual and, while we can Effective boards take a self-development point to broad areas of good and best practice, focus and make this part of their collective and it is the sense that a board is deliberating individual agendas. They use the mandated and engaging with its own development and annual and third year external review as a effectiveness, that marks out those boards catalyst for their development and progression. which are truly effective boards, whether They will typically take a view point of ‘what their sector is in free fall or booming. What does our board need to know about the we do know, is that as a sector implodes, a business and the environment to support dysfunctional boards’ weaknesses start to good decision-making and effectiveness?’ emerge and often compound the problems. This places an importance on the induction of In summary new directors and the on-going development One of the markers of great boards is their and updating of existing board directors. continuous questioning of themselves There is very little available time for and how they can improve. As we enter the directors to team build in the formal sense

GREAT BOARD IN TOUGH ENVIRONMENT

GREAT BOARD IN POSITIVE ENVIRONMENT

WEAK BOARD IN TOUGH ENVIRONMENT

WEAK BOARD IN POSITIVE ENVIRONMENT

-VE -VE +VE CHALLENGE & BUSINESS CONTEXT www.ethicalboardroom.com

INCREASE YOUR BOARDROOM EFFECTIVENESS VALUE CREATION THROUGH EFFECTIVE BOARDS

A WAY TO LEARN A MARK TO MAKE A WORLD TO CHANGE

Barcelona, June 12-15, 2017 For more information please contact: Julie Cook at infogm@iese.edu www.iese.edu/boards IESE: BARCELONA 路 MADRID 路 MUNICH 路 NEW YORK 路 SAO PAULO

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Board Leadership | Non-Executive Directors

Negotiating the NED minefield

Non-executive directors should encourage an integrated approach to governance where ERM and culture guide decision-making Whether in a listed or unlisted company, the role of the non-executive director (NED) is always evolving. The broad scope of legal requirements imposed on directors, together with increased personal liability, make the role evermore challenging, but the most effective NEDs meet that challenge head on, armed with the most powerful weapon in the boardroom: information. Three words of advice to NEDs: ask, ask, ask. To ask the right questions, it is vital to have a clear understanding of the responsibilities of the role, as well as the actions that fall within a director’s role of oversight, and focus on long-term and sustainable value. For a NED to succeed, he or she needs to be part of an effective board. Broadly speaking, there are four areas of responsibility in ensuring board effectiveness.

74 Ethical Boardroom | Spring 2017

Beatriz Pessôa de Araújo

Partner at Baker McKenzie

Focus: to guide strategy, monitor the financials, manage people and integrate risks (as well as deal with crises when these arise). Value: to identify blind spots, to serve as a sounding board to management, to manage conflicts of interest and to ensure compliance and proper reporting. Troubleshooting: to identify key obstacles that the board must address, to bridge the information gap between the executives and the non-executives, to consider team dynamics where these might not be working well and, of course, to negotiate the time squeeze that many board members will feel between the oversight function and the strategic function. Governance: to ensure all processes and procedures set up at a governance level help the board create and protect value and, more importantly, avoid value destruction. This will include setting and monitoring corporate culture and building organisational trust and reputation, both internally and externally.

2 3

Meanwhile, board members should always be clear as to whom they owe their duties to and as to whose responsibility this is (NED or management), as well as carefully considering how they invest their time (strategy v. oversight) and ensure they have all the information necessary to perform their role. It is important to reinforce the fact that in the majority of countries, the law stipulates that directors owe their duties first and foremost to the companies they serve – not to the parent or group company, nor to the shareholders. Understanding this is critical for directors of both listed and private companies. In listed companies, this is because of the pressure investors can exert on management and boards to deliver short-term returns. In private companies, this is because the lines between the interests of the owner and those of the board can be blurred, as the owner or manager often exerts the most influence in the boardroom. There is a movement in some countries, including the UK, to enforce duties of directors and boards more effectively to ensure that they also take into account the impact of their decisions on the long-term prospects of the company as

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Non-Executive Directors | Board Leadership well as the interests of other stakeholders such as the company’s employees, its suppliers, customers and other third-party business partners, the wider community and the environment. And of course, the lens of regulators is acutely focussed on companies maintaining a reputation for high standards of business conduct.

A voice in the boardroom

Understanding the broader picture is essential in examining the topics of governance, risk and ethics. How a company approaches each of these topics will depend on how they are viewed in the boardroom and how successfully the board embeds such views in the whole organisation. The principles of good corporate governance can act as an effective integrator of all the different strands of a company’s pursuit of its strategic model. So how should a NED approach governance, risk and ethics on the boards he or she serves? In a nutshell, by using his or her voice in the boardroom to encourage an integrated approach to corporate governance where enterprise risk management and corporate culture sit at the heart of all decision-making. For a NED to assess how corporate governance is approached in a company, he or she needs to start with the question: how do things get done here? The concept of corporate governance is not new. Some 25 years ago, the Cadbury Committee Report in the UK stated: “Governance is the system of rules, procedures and processes by which a company is directed and controlled. Specifically,

it is a framework by which various stakeholder authorities, corporate compliance interests are balanced and efficiently and programmes have been designed specifically to professionally managed.” Nor is the concept help prevent corporate officers and employees limited only to other Anglo-Saxon or advanced from engaging in illegal practices while at economies. The Organisation of Economic the same time trying to address a wide array Co-operation and Development (OECD) defines of other compliance and risk management the concept as follows: “Corporate challenges. This in itself governance involves a set of presents a challenge: are risks For a NED to relationships between a company’s in companies addressed assess how management, its shareholders and holistically or piecemeal? corporate other stakeholders. Corporate Can the introduction of such governance also provides a governance is programmes end up in a ‘tick in structure through which the the box’ exercise rather than a approached in means to an end, the end being objectives of the company are set and the means of attaining a company, he a company with compliance those objectives and monitoring embedded at all levels, or she needs to culture performance are determined.” where the stated values are start with the During the past decade lived, not just written in a code or so, particularly in light conduct or on a website? question: how of Over of the aggressive pursuit by the past decade, we have do things get enforcement authorities of been advising our clients that to companies guilty of regulatory be effective at meeting the wide done here? shortfalls, antitrust breaches and variety of law enforcement corrupt practices, boards have been focussed expectations around the world, corporate on setting up credible compliance functions compliance programmes, whether global or and programmes in their companies or purely local in reach, will have the following five upgrading any they already had in place. elements: (i) tone at the top/leadership; (ii) With the proliferation of effective risk assessment; (iii) standards and regulation, punishing fines and controls; (iv) training and communication; and cross-border co-operation (v) oversight. To this we must add a decisionof enforcement making process – or corporate governance regime – that includes communications and top down oversight, from managers, who are clear as to what their responsibilities are, all the way down the organisation, as well as bottom up accountability, from the lowest ranked employee up the chain to the top. This way, when employees make choices about their behaviour, they can be relied on to do the right thing, to act ethically and to live by the values set by the board. Leadership at all levels of the organisation, assisted by clear corporate governance, engenders a positive values system that over time, becomes the desired corporate culture.

DANGEROUS WATERS Serving as a company director can be perilous; obtaining information is key to survival www.ethicalboardroom.com

Spring 2017 | Ethical Boardroom 75

Board Leadership | Non-Executive Directors

Risk management, corporate culture and governance

Similarly, risk management must be integrated within the culture of the organisation and this will include mandate, leadership and commitment from the board. Achieving a good risk aware culture is ensured by establishing an appropriate risk architecture, strategy and protocols – or risk governance. Roles and responsibilities for risk management must be clear and usually this will be set out in a risk management policy. The role of the board does not stop with identifying risk and setting the risk appetite and tolerances within the business, in the context of the strategy adopted by the board. It must also identify the information it requires from management for it to monitor risk and require any additional controls it deems appropriate. The executive will assist the board in such a monitoring role and will also be tasked with implementing the risk strategy and controls set by the board.

culture is a valuable asset, a source of competitive advantage and vital to the creation and protection of long-term value; they should not wait for a crisis before they focus on company culture. It is the board’s responsibility to choose a chief executive officer who embodies the desired culture and is incentivised to lead in a way that all employees of the company and its suppliers, know the corporate values and are in turn incentivised to exhibit behaviours that reflect such values. All of the company’s interactions with stakeholders, both internally and externally, should be transparent and there should be clear accountability for actions at all levels of the organisation. Companies should engage constructively with shareholders and wider stakeholders about culture. The voice of all stakeholders in the boardroom should be strengthened. Assuming the board is doing all of the above – setting up strong governance mechanisms throughout the company; recognising the

company, externally and internally? What is the approach for incentivising staff, from the CEO to lowest paid employee? What are typical KPIs? Risk What risk management framework is in place and how often is it reviewed? Has the board clearly articulated the risk appetite it has set for the company’s activities? How does the company assess risk and what are its risk management methodologies? Which risks have been identified as the most significant for the company? How does the risk reporting to the board take place and can management be relied upon to implement the board’s risk strategy effectively and to report back in full? Is there a clear protocol as to how the board would respond to a crisis? Ethics What are the company’s trust levels with its customers, suppliers, employees, communities and other stakeholders? How connected is the board to the business?

ASK, ASK, ASK NEDs will help the board succeed by getting answers to important questions

Clients, customers, employees and stakeholders around the world now demand greater transparency and ethical behaviour from the businesses they engage with. Growth is no longer sufficient, what is wanted is ‘good growth’ As with compliance programmes, risk management is inextricably linked with culture and ethics to the extent that behaviours play an important role in the action taken around specific risk categories. In turn, strong governance underpins a healthy culture and boards should demonstrate good practice in the boardroom and promote good governance throughout the business. The board should set the company’s values and its standards and ensure that its obligations are understood and met. Directors should recognise that a healthy corporate 76 Ethical Boardroom | Spring 2017

value of culture and demonstrating leadership, including in the choice of CEO; seeking to embed and integrate that culture across the whole company and aligning the incentives – how then, does a board know that it has succeeded? This is the real challenge for many boards and the answer lies in setting metrics against which to measure progress, while receiving information that allows for the evaluation and measure of success, or lack thereof. This becomes even more critical as the reporting requirements on companies continue to grow, for example, with regard to slavery and human trafficking, tax strategies, gender pay gap reporting, payment practices and performance and non-financial reporting more generally. And so, if a board’s role is to ‘ask, ask, ask’, here are some of the questions that a NED should be posing regarding governance, risk and ethics: Governance How are decisions made here? Are roles and responsibilities clear? What is the hierarchy of accountability and is monitoring and supervision adequate? What delegations of authority are in place? How are decisions communicated and implemented across the company? How transparent is the

What are the values of this organisation? Do they need to be defined? Does the CEO represent such values? How are these values communicated internally and externally? Does management have a set of metrics against which they regularly measure corporate culture and report back to the board? How do reward systems work and which behaviours are rewarded? How are employees informed of the tools available to help them operate in line with the company’s core values and ethical principles? Clients, customers, employees and stakeholders around the world now demand greater transparency and ethical behaviour from the businesses they engage with. Growth is no longer sufficient, what is wanted is ‘good growth’. Boards are increasingly finding that trust is on their agenda as a key business enabler – and that not only means trust in the business itself, but also in its leadership, its stakeholders and its network of suppliers. Corporate structures and processes are essential, but they must be overlaid with an ethos and values that have at their heart integrity, transparency and a respect for the rule of law. Sound corporate governance is key. www.ethicalboardroom.com

Board Leadership | Culture TONE AT THE TOP Leaders have the power to impact their organisation’s corporate culture

Looking at culture through governance lenses Do we agree that culture is important for ensuring effective decision-making in the boardroom? Culture in the professional context has become a commonplace conversation today. A report published last year by the UK’s Financial Reporting Council appears to confirm that ‘boards and executive management can steer corporate behaviour to create a culture that will deliver sustainable good performance’.1

Sharing the views of senior business leaders, the report also says that a clear purpose – why the company exists and what it is there to do – is the starting point for a successful company and is closely tied to culture. There are many who agree that culture is fundamental to a successful 78 Ethical Boardroom | Spring 2017

business from risk management to effective decision-making in the boardroom.

Exploring the link between culture and behaviour

ACCA began looking into the interaction between culture and the conduct of individuals as early as 2012. Prompted initially by the global financial crash of 2008, we wanted to explore why rules and regulations could not pre-empt the problems associated with dysfunctional behaviours at work. Already then, many commentators pointed to poor corporate culture as the root cause of many wrongdoings leading up to the crisis. Subsequently, ACCA conducted a desktop study of organisational science literature, followed by a series of roundtables in London, Brussels, New York, Dubai and Bangalore, capturing views of more than 150 senior business leaders. Finally, we

Jo Iwasaki

Head of Corporate Governance at ACCA gathered insights on corporate culture from nearly 2,000 members globally.2 The project uncovered that corporate leadership has a critical role to play in setting organisational values. Channelling functional behaviours also involves considering incentives and performance measurement systems, as well as internal communication and investment in human resources. We also received valuable insights on instances when and how participants in the research perceived the impact of corporate culture in their own context.

What have we learnt?

Projects like these can help us virtually simulate many people’s experiences and actions. I am a great fan of good practice examples: sometimes, after events and talks, I go home remembering episodes and anecdotes but not always technical www.ethicalboardroom.com

Culture | Board Leadership

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Tone, processes and procedures

Organisational Support objectives

ate ilit Fac

■■ Corporate culture is decisive in determining whether an organisation will do the right thing. It is important to recognise that an organisation – or it might be a department or office – has its own culture and way of acting. An organisation is not a random assembly of people who are acting completely independently. People gathered in a professional context will understand how they are expected to act – this is an important element of corporate culture. ■■ Culture is often driven from the top – the leadership, both the board and senior management, has the responsibility for ensuring that organisation’s values are lived and breathed throughout the organisation. But culture is not one-directional. The findings also highlighted the importance of interaction within the organisation. Everyone,

including the leadership, is bound by peer pressure, formal and informal norms and collective identity-building. We all mirror the behaviour of one another. ■■ Culture is made up of both tangible and intangible elements. The former may be appraisal, hierarchy, pay structure, access to decision-making processes, recruitment policy and training, while the latter may include peer pressure, accountability and the existence of organisational identity. Most processes and procedures are tangible but people often form ideas about what would be considered desirable and acceptable behaviour based on their experience of them; these ideas then form the intangible elements. Inconsistency between the two can create dysfunctional behaviour.

& n Devel urt op ure

explanations. We are pleased that there are many experiences and stories that we can share in relation to the culture debate that can be so vague at times. Similarly, it is also important to understand the mechanism of how culture interacts with aspects, such as organisational value and strategy or governance. Without a holistic picture it is difficult, particularly for organisation leaders, to plan and start a change regarding corporate culture, The key issues regarding corporate culture include:

Behaviour

■■ It is also fundamental to recognise that organisations can trigger a culture change. This is particularly relevant for those who are responsible for governance of the organisation. Both the roundtables and the survey pointed this out again and again. A participant at a London roundtable recounted the example of a chief executive who extensively consulted his staff for months before defining the strategic outcomes that the organisation should aim at; the CEO also asked what each department could contribute in order to enable these outcomes. By directly engaging staff in designing the strategy as well as setting operational level objectives, people felt supported and involved and the company has progressed from FTSE 500 to FTSE 100. The responses from our member survey back up this story. Sixty-one per cent of 1,800 members said tone at the top, ahead of incentives (not just financial, 20 per cent) and rules and procedures (10 per cent), was what most influences corporate behaviour. The board and senior leadership have governance responsibilities in driving corporate culture through setting organisational direction, making key internal and external decisions and set behavioural examples. Collectively, they set the overall tone of the organisation, which impacts a broad framework for the processes and procedures of the organisation. Spring 2017 | Ethical Boardroom 79

Board Leadership | Culture

Presenting the idea visually

Let’s imagine that you clicked on ‘organisational values’. It will open up two sets of processes and procedures. One of the lists is linked to both ‘organisational values’ and ‘interconnections’: ■■ Decision-making and handling of challenge/diversity ■■ Collective sense-making and identity-building ■■ Formal and informal norms/sub-cultures ■■ Alignment with individual values ■■ Peer pressure The other set is related to ‘organisational values’ and ‘risk-taking and transparency’, consisting of: ■■ Performance measurement and time frame ■■ People management and talent retention ■■ Training/recruiting/sub-contracting ■■ Rewards and remuneration ■■ Incentives and sanctions ■■ Risk appetite

OR G

This should help you start measuring the culture of your organisation by referring to PROCESS AND PR NAL O I OC AT ED S I U N Or A s g n a o i n ct va isat ne lue ion on c s al er t n I Tone at the top Performance management Communication Mission

S RE

80 Ethical Boardroom | Spring 2017

DRIVING A VISION FOR THE FUTURE Assessing culture can initiate positive change in a systematic matter

Risk -tak in tran and g spa ren cy

lity abi tain Sus

In the diagram below, we have placed corporate leadership at the core to show that it is a primary source of impact on corporate culture: to set the right tone at the top, to develop a mission that incorporates the organisational values and to set the broad framework for performance management and communication. Leadership comes from both the board and senior management, so we have decided not to differentiate the two – at least in the context of corporate culture, they need to work together. They are often equally important in corporate culture debate. Furthermore, this also enables the application of the tool to organisations that do not fit into a traditional board structure. The layer in the middle shows a set of governance ‘lenses’. These lenses can help in analysing corporate culture in a systematic order and then introducing changes. These lenses are closely aligned with well-established principles of corporate governance, apart from ‘interconnections’. People often ask what we mean by this term. So let me explain. In developing the diagram, we analysed the findings of roundtables and surveys to identify signs and triggers that indicate in our minds what culture an organisation embodies. We extracted them and realised that we could bundle them into five groups because they are similar or related and gave a name to each of them. Interestingly, for four groups we could use terms that are well established in existing corporate governance frameworks. This left, however, one that relates to how people are connected to their organisation, each other and even external stakeholders. We thought that this is important as we often hear that better integrated organisations perform better. For this the top needs to reach out to the whole of the organisation, while it requires the buy-in from the rest of the organisation, too. Admittedly, in a traditional corporate governance framework, inter-connectivity does not seem to exist. However, the diagram was developed to summarise what we learnt, thus we decided to include this. Things that fell into this category include organisational structure, employee involvement in decision-making and the diversity of the organisation. Finally, the outside layer shows organisational processes and procedures. Many of these are something that we see and experience in our everyday life, but there are many others that escape exact definition or allow manipulation, for example, norms and peer pressure. These collectively represent an organisational ‘culture’. An interactive PDF on our website allows you to click on any of the governance lenses, that will then take you to the list of relevant ‘processes and procedures’, which also includes ‘intangible’ aspects, too. 3

Accountability and trust

Governance lenses

Organisational culture

Responsibility for leadership

these processes and procedures in relation to aspects related to organisational values. Your organisations might have other processes and procedures: fine, you can add them because every organisation is different. The diagram is a starting point. In addition to reviewing processes and procedures, information available from staff survey results can help understand the ‘intangible’ side of culture. Once you have done so, check the consistency from inside to out, from the messages coming out from corporate leadership to what everyone experiences, as well as the horizontal consistency. Corporate culture is, after all, not made up of one element, but the consistent messaging that we experience professionally, day to day. Once inconsistencies are identified, you can start planning what needs to change first.

What can we do with this?

In the interactive PDF, we suggest specific examples when you might want to use the tool: ■■ When organisations are going through rapid change and need to manage culture, such as – growing fast – change to ownership structure, for example a merger – when planning succession ■■ When developing structured narratives on culture, to communicate internally or to disclose in the annual report ■■ When speaking with interested stakeholders. Some investors take an active interest in corporate culture and the tool can help you prepare While the tool is made as practical as possible, it is not a set of tick boxes. You need to allow time and resources to work out what you need to do. One might question if it is worth the effort. We can only say that it is hard to measure the benefit of culture change, but so many ideas in the area of corporate governance are like that – many of us believe in their long-term value and follow the best practice. Now, do you? Corporate culture and the role of boards, FRC, 2016 www.accaglobal.com/culture www.accaglobal.com/culturegovernance

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Board Leadership | Gender Diversity MIND THE GAP Research suggests that diverse boards lead to better performing companies

Boardrooms: the perpetual gender gap Are companies fully on board or has the commitment to board diversity become overstated? 82 Ethical Boardroom | Spring 2017

Dan Marcec

Director of Content at Equilar

www.ethicalboardroom.com

Gender Diversity | Board Leadership

In the past few years, corporate stakeholders and observers, including institutional investors, legislators and advocacy groups, have set their sights on board composition and diversity as a top governance issue. They believe that if the individuals responsible for overseeing management and the direction of the company are of the same background and mindset, the board potentially exposes itself to greater risks. There is also a growing volume of research that suggests diverse boards lead to better performing companies. Pressure from these stakeholders has led to a lot of talk about commitment to dedicated efforts to recruit diverse candidates for board positions. However, there has been very little meaningful change in board composition overall, at least as far as the data shows.

Laying the foundation

It’s worth taking a few words to recognise some elephants in the room before continuing. First, most of the statistics below reflect data on executives and board members collected from public filings with the US Securities and Exchange Commission (SEC). In other words, if this article seems US-centric, it is, but where possible it will address parallel data and information from non-US markets. In addition, because this information is pulled from public filings, the data is limited to what is actively disclosed by these companies. In the US, there are still very few – if any – quotas or requirements to disclose diversity in board composition, despite the best efforts of some legislators and influential investors (more on that later). As a related point, this article is solely focussed on gender diversity. Diversity is a fluid and wide-ranging concept and it can mean many things – race, ethnicity, gender, age, language, skill set, etc. Gender is by no means the only nor ‘most important’ definition of diversity. It is, however, the most straightforward demographic split to analyse based on data that companies disclose. Furthermore, gender parity on boards is a prominent representation of the broader diversity issue. In the US, nearly 50 per cent of the workforce is female and a majority of university and post-graduate degrees are being awarded to women.1 Yet representation of females in executive and board leadership positions is far below their overall contribution to the workplace. www.ethicalboardroom.com

The road to gender parity in the boardroom

seats were held by women.3 A November 2015 study of 4,218 companies worldwide by MSCI The Equilar Gender Diversity Index (GDI) is revealed that females accounted for 15 per cent a quarterly benchmark of US public company of board seats. One element that’s notable in boards that measures the relative level of the MSCI study is that the rate of growth was males and females in the Russell 3000, which higher for the global sample set than for the is commonly identified as a benchmark for Russell 3000, increasing from 12.4 per cent the the entire US stock market. As of the end of previous year.4 Some of the growth may be due to quotas 2016, women accounted for 15.1 per cent of enacted by several countries to add more board positions at Russell 3000 companies, women to boards, which penalise companies approximately one-third of the way toward that are out of compliance. For example, parity. During 2016, there were 398 females a July 2016 study from the Association for added to boards, representing a net gain of Psychological Science noted that countries 1.2 percentage points from 13.9 per cent the with quotas, such as Norway, previous year.2 See the GDI graphic, below. Iceland, Finland and Sweden, The gap in While there has been steady ‘nearly double the gender diversity had growth over the past several average percentage of is not limited to years, at the current rate it women on boards (about would take more than 40 years 34 per cent) than countries overall board for there to be gender parity on without those measures positions and, in had (about 18 per cent)’.5 Russell 3000 boards. Currently, the compound annual growth fact, is even more In the US, former SEC Chairman Mary Jo White had rate (CAGR) for this group of stark when it suggested and advocated for companies adding women to stricter disclosure rules the board is 3.1 per cent. For comes to around board diversity for boards to reach gender parity by leadership roles public companies. As recently the year 2040, that figure would as September 2016, White wrote have to accelerate to 5.1 per an op-ed on this topic, touting board diversity cent and increase to an 8.9 per cent CAGR as ‘the right thing to do’.6 This was just two to garner equal representation by 2030 months before White – a Democrat, the – nearly triple the current rate of growth. opposing major political party to President The gap in gender diversity is not limited Trump – resigned from her post. to overall board positions and in fact is even The focus on deregulation in the Trump more stark when it comes to leadership roles. administration may delay or deter a proposal Just 3.5 per cent of individuals serving as on board diversity disclosure from being CEO and chair of the board at Russell 3000 passed, but indications do not show any companies are female, according to Equilar sign of slowing from advocates. For example, data, compared to a similar percentage of US House of Representatives Congresswoman 3.7 per cent who served as non-executive Carolyn Maloney, from the state of New board chairs. The prevalence of women in lead York, proposed a bill in March 2017 called the director positions – an independent director Gender Diversity in Corporate Leadership Act. that often serves alongside a CEO-chair – was According to Maloney’s announcement, ‘the notably higher, with 7.6 per cent of those roles new legislation [is] modelled on policies in being occupied by women, an increase from Canada and Australia [and] would instruct 6.9 per cent the previous year. the SEC to recommend strategies for increasing Legislative (in)action women’s representation on corporate boards. The trends uncovered in the Equilar GDI are The bill also requires companies to report mirror images of several recent studies tracking their policies to encourage the nomination similar data in boardrooms globally. According of women for board seats as well as the 1 to a 2015 study of 3,000 global proportion of women on their board companies by Credit Suisse, and in senior executive 14.7 per cent of board leadership’.7

0.3 0

Corporate leadership has a gender gap. There are very few more obvious statements that could be made about the demographic make-up at the top levels of global corporations, yet the discussion around a lack of diversity in the workplace continues unabated, often seeming to cover similar ground time and again.

1 = equal representation of both males and females on Russell 3000 boards

THE EQUILAR GENDER DIVERSITY INDEX (GDI) Spring 2017 | Ethical Boardroom 83

Board Leadership | Gender Diversity

If this legislation doesn’t pass – and given the other priorities of the President and Congress, it seems unlikely – boards that ignore diversity aren’t off the hook. In fact, the expected lack of legislative action seems to be empowering investors and other stakeholders to push even harder to bring awareness to these issues. Major institutional investors, such as BlackRock, State Street and Vanguard, all have openly stated that their investment decisions are reliant on boards’ commitments to evaluation, refreshment and diversity.8, 9, 10

Admitting to board amnesia

Though quotas have become a catalyst for change in many markets, the US and others that are unlikely to enact these types of requirements any time soon, will rely on voluntary adoption of board refreshment initiatives to increase diversity. Many boards have willingly committed to these types of initiatives, but many have also pushed back. The most common objection is that even when they consider adding more diverse directors to their boards, there is a lack of qualified diverse candidates available. According to the traditional way of looking for new board members – that is, looking around the boardroom table and asking ‘who else do we know?’ – it’s understandable that there would be a limited number of candidates surfacing. However, a recent Equilar study found that the average S&P 500 director has 94 professional connections to other executives and board members. When applied to an entire board, that could represent thousands of first-degree connections and

that’s just including individuals who have investments over a five-, 10-, 20-, served in the C-suite or as sitting board 30-year period, they want to ensure members. While a board member with a that directors now are also thinking 40-year career may have worked directly about the potential implications of their with hundreds if not thousands of qualified decisions down the road. candidates, it’s reasonable to believe they The pace of change in the boardroom has simply can’t remember them accelerated in the past few off the top of their head – a years and the importance Despite some concept Equilar has termed placed on composition is of the rhetoric ‘board amnesia’. driving boards to have out there, the With the availability of systems in place to regularly data resources and social evaluate, assess and refresh numbers are networking tools that can help their board when new them tap a much broader pool slow to increase strategic imperatives arise. of candidates, boards have Ten years ago, very few because there little excuse not to access boards could have predicted these extended networks. And is not enough the imminent risks posed by of course, board amnesia only cybersecurity or shareholder commitment to applies to directors’ personal activism, for example. change at a networks – it doesn’t include Now, virtually everyone broad level, and the thousands of other on the board is expected qualified executives out there. many investors to have at least a working For example, Equilar data knowledge of or experience shows 5,500 females that have say it will take with these issues. been disclosed in SEC filings Despite some of the strong efforts to currently serving as public rhetoric out there, the prove to them company executives and numbers are slow to increase nearly 80 per cent of them because there is not enough they need fresh have never served on a board. commitment to change faces in the In other words, the good at a broad level, and many boardroom news is that board members investors say it will take have access to a pool of strong efforts to prove to them candidates that is much bigger and they need fresh faces in the boardroom. more diverse than they realise, literally According to the PwC Annual Corporate at their fingertips. Directors Survey, 35 per cent of board members polled said that at least one Investors’ growing impatience director should no longer be on the board. 11 Investors are not impressed with excuses As the statistic implies, some directors about the lack of qualified candidates. may not be carrying their weight in the As their updated voting guidelines and boardroom. And there’s not always campaigns to increase board diversity something wrong with that. It could be clearly display, this is an issue they will for a simple reason that the company focus on for years to come. And they’ve has changed direction and one director’s begun to question the overall commitment skills and experience are needed less than from their portfolio companies. in a new area with a fresh perspective. One thing boards should also understand However, it’s the role of the nominating and is that the diversity discussion does governance committee to set expectations not exist in a vacuum – it’s not on the front end that a directorship is about diversity for diversity’s sake. not a permanent retirement hobby and Shareholders are pushing this issue evaluation processes must be in place for as a by-product and continuation directors to honestly assess themselves of the larger trend to bring more in the face of change – and make those independent leadership into the changes when necessary. boardroom. As they evaluate their Footnotes will be run in full online.

BENCHMARKING BOARDROOMS Women account for 15.1 per cent of board positions at Russell 3000 companies

84 Ethical Boardroom | Spring 2017

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Board Leadership | Gender Diversity

Brande Stellings, JD

Vice President, Corporate Board Services at Catalyst

Gender diversity on US boards What more can we do to ensure boards are well-equipped to serve the future marketplace? A recent study from EY found that there are more men named John, Robert, William and James than there are women on the corporate boards of the top 1,500 companies of the S&P.1 Although we’re well in to the 21st century, with women in the United States earning the majority of advanced degrees, constituting about half of the workforce and controlling a significant portion of consumer spending, women’s representation on corporate boards is not even close to parity. Only about 20 per cent of S&P 500 board seats are held by women; in other words, almost four out of every five directors are men.

The good news is...

In what may seem surprising news to some, the representation of women on corporate boards is higher on the boards of the largest companies in the US. In the Alliance for Board Diversity’s (ABD) and Deloitte’s new census of Fortune 500 (F500) boards, the Fortune F100 (F100) company boards outperformed the F500 boards in terms of representation of women and minority directors with 35.9 per cent of women and minorities holding board seats, compared with 30.8 per cent in the rest of the Fortune 500. Currently, 65 per cent of F100 boards have greater than 30 per cent board diversity, compared to just under 50 per cent of F500 boards in the census.2 Smart companies understand that they can no longer compete effectively in a global economy without leveraging the talents of 100 per cent of their workforce. Those that have embraced inclusive workplaces recognise they need a diversity of experiences, talents and perspectives to be successful. Another bright spot among the larger companies of the US economy is that the companies with zero women board directors has been declining. 3 Just a little over 10 years ago, 11 per cent of S&P500 boards had zero women directors. In 2016, it was just about 86 Ethical Boardroom | Spring 2017

one per cent and you can count those companies on two hands. However, when one broadens the pool beyond the 500 largest companies to include the Russell 3000, for example, we see that more than 700 companies have zero women board directors.4 In other important sectors of the economy, women’s representation on boards is also dismally low. According to the Boardlist’s survey of ‘unicorn’ companies (private tech companies valued at $1billion+), women hold only about 10 per cent of the total board seats.5

What about women of colour?

Even worse, women of colour are under-represented on S&P 500 and Fortune 500 boards. The ABD/Deloitte report found that women of colour held only 3.8 per cent of F500 board seats. More specifically, in 2016, Latinas held 41 seats; Asian/Pacific Islander women held 44 seats; and black women held 122 seats. All told, about 200 board seats are held by women of colour, barely enough to fill one small movie theatre. Yet, when we look to the future, we see that ‘minority’ women will represent the majority of women in the United States in 2050. The low representation of women and women of colour in particular begs the question: are corporate boards well-equipped to serve the future marketplace of talent and customers? Catalyst and ABD/Deloitte research shows that women of colour are more likely to hold multiple board seats, meaning that the same pool of women of colour candidates is tapped for board service.6 This places women of colour candidates in a unique catch-22: in order to serve on a board, they need to already be on a board. The slow – even stagnant – progress made towards gender-balanced boards in the United States is out of step with the pace of change in other regions, particularly Western Europe. Egon Zehnder’s recently released 2016 Global Diversity Analysis underscores that while the United States has been treading water with respect to its representation of women on corporate boards, Western Europe has been pulling ahead.7

With women in the United States earning the majority of advanced degrees, constituting about half of the workforce and controlling a significant portion of consumer spending, women’s representation on corporate boards is not even close to parity www.ethicalboardroom.com

Gender Diversity | Board Leadership

CHANGING FACE OF LEADERSHIP Work is needed to increase womenâ&#x20AC;&#x2122;s board representation www.ethicalboardroom.com

Spring 2017 | Ethical Boardroom 87

Board Leadership | Gender Diversity To be sure, Western Europe has seen the board term limits were more gender-diverse introduction of quotas in several countries. than those without. Boards should consider But progress has also occurred at a rapid pace adopting term limits or a retirement age in the UK, which has taken a business-led to facilitate board renewal. approach to increasing women’s representation Sponsor women for board service on boards. In 2010, women held only Catalyst research and programmes 12.5 per cent of FTSE100 board seats; their demonstrate that sponsorship works. representation had more than doubled by 2015, Sponsorship is the active support by someone to comprise 26 per cent of FTSE100 board seats. appropriately placed in an organisation The stagnant progress in the United and who has significant influence on States remains in spite of research establishing decision-making processes and advocates for, the business case for gender diversity on protects and fights for the career advancement boards. We have more than a decade of of an individual. The Catalyst Women On research – by Catalyst and other highly Board programme demonstrates the impact regarded organisations that focus on these of sponsorship. The programme pairs a CEO issues – that shows that having women in or board chair with a leadership positions is good for senior executive woman business and good for society. It A decade of who aspires to board improves the long-term business performance and improves raising awareness, service for a two-year partnership. The mentor/ problem-solving and innovation. leadership from sponsors provide valuable And yet, despite this the advice and counsel and, numbers have not really moved. many prominent critically, introduce the This lack of progress suggests business leaders women candidates to the business case may provide and organisations their network of sitting the justification but not the directors. Since the motivation – to improve and women programme began diversity on boards. knocking on nearly 10 years ago, A decade of raising almost 60 per cent of awareness, leadership from the doors of programme alumnae many prominent business boardrooms, has have been appointed individuals and organisations to corporate boards. and women knocking on the had little impact Most recently, doors of boardrooms, has had Stephanie C. Hill, Vice little impact. Bold action is President and General Manager, MST-Ship required to accelerate progress for women on and Aviation Systems, Lockheed Martin boards. There is no ONE right way to diversify Corporation, who was paired with Douglas boards – there are many approaches. Conant, former CEO, Campbell Soup Here are a few essential ways to help move Company and current Chairman, Kellogg the needle: Executive Leadership Institute, was 7 steps to increase board diversity appointed to the board of S&P Global. Set a goal and measure your progress Alternate director appointments by Set an intention around board diversity gender Consider adopting the strategy and a time frame to achieving the goal. outlined in the Committee for Economic Businesses set goals for many business Development’s ‘Every Other One’ campaign. metrics that matter; why not set one for This campaign advocates that every other gender diversity on your board? This example board seat vacated by a retiring director is confirmed on a broader scale through should be filled by a woman. research. Catalyst’s research in conjunction with the Government of Ontario and the Insist on gender-balanced candidate Rotman School of Management found slates Require that lists of potential that, on average, companies that explicitly board candidates consist of at least 50 per considered gender when recruiting new cent women candidates with the skills and board positions had much more diverse profile sought and include women from diverse boards. In fact, in our report, companies communities. Follow through by requiring that disclosed that they had a policy of that women – including women from diverse considering gender when recruiting board communities – comprise at least 50 per cent members almost doubled the representation of the interview pool for every open board of women on their boards over five years. 8 position. Research shows that if you have only Adopt at least one means to one woman on your slate, the odds of her being facilitate board refreshment selected statistically are the same as if you Catalyst research in conjunction with the had zero women on your slate. Consider going Government of Ontario and the Rotman a step further and adopt the strategy urged by School of Management found that boards with search consultant Beth Stewart: interview the a higher rate of board renewal and those with women candidates first. Her firm, Trewstar,

88 Ethical Boardroom | Spring 2017

has successfully completed searches for many F500, mid-cap and private equity companies utilising this approach. broadly for talented directors 6 Look Deconstruct the competencies needed and

expand the search beyond the default criteria of ‘CEO’. As Tanya van Biesen, Executive Director, Catalyst Canada, commented in the Financial Post: “If you define merit as only ever having been a CEO, then that’s a problem.” It’s simply a myth that there’s not a supply of exceptional women director candidates. The better question is: are the companies really looking? Tap into networks of CEO-sponsored women candidates provided by Catalyst Women On Board, the Women’s Forum of New York and numerous other groups, including Equilar. with inclusion Diversity and 7 Lead inclusion should be a regular part

of the agenda for boards and for corporate leadership. As the president and CEO of CIBC, Victor Dodig, made clear at a recent event hosted by Catalyst and the 30% Club Canada, it is important to ‘engage your men and women leaders around the business imperative of gender diversity’.

Looking to the future

Every newly appointed director is an opportunity to change the leadership landscape. All too frequently, boards have missed this opportunity. More than two-thirds of S&P 500 new board directorships go to men, ensuring that change will continue at the current slow pace. But the increasing representation of women on the boards of the largest companies in the United States shows that with intention and effort it is possible to build leadership teams that more closely resemble the communities they serve. For those companies that have difficulty locating women candidates for their boards, the question comes to mind: what else might they be missing or overlooking? Many of today’s boardrooms reflect the workplace and marketplace of the past: are they ready for the future? Boards would do well to heed ice hockey legend Wayne Gretzky’s advice quoting his father: “I skate to where the puck is going to be, not to where it has been.” It’s well past time for boards to reflect the changing demographics of the talent pool and the marketplace. Their financial performance and global economic competitiveness depend on it. http://www.ey.com/gl/en/issues/governance-andreporting/women-on-us-boards---what-are-weseeing#gender-diversity-is-rising 2http://www.catalyst. org/knowledge/missing-pieces-report-2016-boarddiversity-census-women-and-minorities-fortune-500boards 3https://www.spencerstuart.com/research-andinsight/spencer-stuart-board-index-2016 4http://www. equilar.com/blogs/212-boards-will-reach-gender-parityin-2055.html 5https://theboardlist.com/research 6 http://www.catalyst.org/knowledge/still-too-few-womencolor-boards 7http://www.egonzehnder.com/GBDA 8 http://www.catalyst.org/knowledge/gender-diversityboards-canada-recommendations-accelerating-progress 1

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Global News Central&South America Brazilian firm Odebrecht to pay $2.6billion fine A US judge has fined Brazilian construction giant Odebrecht $2.6 billion to settle corruption charges in a plea bargain linked to a corruption case around Petrobras, the country’s largest oil company. Odebrecht pleaded guilty in December to charges brought in the US, accusing the company of paying $788million to officials in 12 countries, mainly in Latin America. The judge said Brazil will receive $2.39billion, with the rest going to authorities

in the US and Switzerland. It is the largest fine awarded against a company under the US Foreign Corrupt Practices Act. The family-owned Odebrecht group was one of 16 companies that prosecutors alleged had shared billions of dollars of bribes with leading officials of Petrobras. Odebrecht agreed to a plea bargain deal late last year in return for compliance with the investigations. Reports say Odebrecht has provided evidence of collusion between the company and Brazil’s political parties.

Colombia unveils corruption crackdown Colombia’s president Juan Manuel Santos has announced a wave of measures to combat corruption, including proposed legislation aimed at protecting whistleblowers. According to a Latin American Herald Tribune report, Santos has plans to strengthen an anti-corruption unit within the National Police’s Directorate of Criminal Investigation and Interpol. He also plans to provide more tools to entities responsible for overseeing different areas of the economy. Santos was speaking at a conference – Corruption in Colombia: the worst form of violence – alongside the president of Transparency International, Nadine Heredia.

90 Ethical Boardroom | Spring 2017

Venezuela to investigate Movistar Venezuelan President Nicolás Maduro has accused mobile operator Movistar, a subsidiary of Spain’s Telefónica, of helping to orchestrate mass protests against against his government. Maduro has ordered an investigation into Movistar for alleged ‘coup-mongering’ following the biggest anti-government demonstrations to have taken place in the country in years. Movistar has been accused of sending millions of messages, costing more than $100million, that called for anti-government demonstrators to take public action. In a separate move, Motors has halted operations in the country after it said the Venezuelan authorities seized its car making plant. The company sent a message to almost 2,700 staff, informing them that they were no longer employed by the company and had received severance pay in their bank accounts.

Shareholders go to war at Avianca Avianca, the national airline of Colombia, has seen its share price nosedive following a rift between the company’s two largest shareholders. Salvadorean businessman Roberto Kriete, who owns 22 per cent of the company, is suing Bolivian billionaire German Efromovich — Avianca’s chairman and largest shareholder with a 78 per cent ownership — accusing him of ‘plundering’ Avianca for personal gain. Avianca’s lawyers have countersued, accusing Mr Kriete of being ‘a disloyal director’ who used a ‘smear campaign… to undermine’ Avianca ‘for his own selfish purposes’. www.ethicalboardroom.com

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South America | Brazil

BRAZILIAN EVOLUTION There has been increasing internal pressure for Brazil to improve its transparency

Brazil’s push for corporate governance reforms A collective dissatisfaction with recent cases of massive corruption has seen the adoption of best governance practices accelerate in Brazil Corruption is not a new problem for Brazil as it is not (despite different levels) in other developing countries – even the most developed ones. However, the proportion and the broad impact of recent corruption scandals have given a boost to major reforms in the landscape of corporate governance. Maybe it is too early to predict any concrete results, but there are clear signs that misconduct is becoming less and less tolerated. Firstly, it is imperative to acknowledge the role played by the so-called ‘Lava-Jato’ (Car Wash) investigation. Initiated in March 2014, the Lava-Jato Operation is an investigation into the years in which a cartel of large contractors 92 Ethical Boardroom | Spring 2017

Heloisa B. Bedicks

MD of Instituto Brasileiro de Governança Corporativa IBGC (Brazilian Institute of Corporate Governance) paid bribes to executives from Petrobras, Brazil’s largest state-owned enterprise (SOE) and other public officials – including leaders of political parties – to carry out overpriced works for the oil and gas company. The fees associated with the crimes so far reported total R$6.4billion (around $2billion), according to estimates from the Federal Public Prosecution Office (MPF). The magnitude of the damage was such that it contributed strongly to the impeachment of the former President Dilma Rousseff (completed by the end of September 2016), although the technical reasons for the outcome were not the crimes investigated by Lava-Jato. Besides the fuss caused by Lava-Jato, two other wide-ranging cases have targeted VIPs

from the business world: the Zelotes and Greenfield investigations. The former erupted in 2015 and investigated the fees paid by companies to members of the Board of Tax Appeals (CARF), the body responsible for judging fines imposed by the International Revenue Service (IRS). The latter has investigated fraudulent activities that allowed pension funds sponsored by SOEs, under the influence of political parties, to invest in overvalued assets.

Improving transparency

Cases such as these illustrate major failures of corporate governance: lack of effectiveness of compliance programmes and risk management systems; lack of mechanisms for prevention and resolution of conflict of interests; and prevalence of party-political interests in the selection of managers of state-owned enterprises. The most pessimistic person could simply regret the occurrence of these problems, but the willingness to correct them today is www.ethicalboardroom.com

Brazil | South America greater due to pressure from the Brazilian society and its need to improve transparency. Whenever the intention is to improve governance, the course historically taken has been to reinforce regulation – a concept that includes both legislation and self-regulation. What this regulatory pendulum also shows is that we have got into the habit of managing serious governance challenges by coping with its form rather than with its essence. After a period of some accommodation, resulting from the economic bonanza of the second half of the last decade, we are now trying again to make progress in the formalisation of governance practices – external rules and organisations’ internal procedures. In response to corruption scandals and economic downturn, there is a new and unusual wave of regulation. We can mention various initiatives currently underway or recently completed, aimed at strengthening the governance of Brazilian companies and institutions. The Brazilian Anti-Corruption Law was finally regulated in 2015, two years after its enactment, turning compliance programmes into key tools for companies accused of acts against the public administration. In the same year, the former Controladoria Geral da União (CGU, now the Ministry of Transparency, Supervision and Control) published integrity handbooks for private and state-owned companies and São Paulo Stock Exchange launched a programme designed to improve the governance of listed SOEs.

Comply or explain

More reforms began in 2016. SOEs have gained a new law, which has an entire chapter dedicated to corporate governance, inspired by the São Paulo Stock Exchange’s programme. By the way, the São Paulo Stock Exchange is reviewing the rules of its special listing segments with differentiated governance practices. Reporting on a ‘comply or explain’ approach to the provisions of the brand new Brazilian Corporate Governance Code for listed companies is about to become mandatory. The regulatory move does not involve companies only. Institutional investors are also acting to evolve: the organisation that represents Brazilian pension funds (ABRAPP) launched a self-regulation code for its members and the Association of Investors in Capital Markets (AMEC) also created its own stewardship code. The evolution in formal aspects is clear-cut, especially if one takes into account the previous two decades, a period in which the concept of corporate governance has been strengthened and disseminated. Debate on good practices began to be shaped during the 1990s in Brazil with the opening of national markets and privatisations in an environment that still had no protection for minority shareholders and no governance rules for corporations. In 1995, a group of pioneers founded the Brazilian Institute of Corporate Directors (IBCA) with www.ethicalboardroom.com

the mission of strengthening the work of necessary to ensure that the ecosystems, boards of directors. At that time, the concept formed by internal and external factors of of ‘corporate governance’ wasn’t yet translated companies, will actually work, operate in into Portuguese. a virtuous cycle and deserve the trust of Soon, the discussions started to be agents who, in fact, expect good governance. extended to include themes such as property, A business environment with greater management, board of auditors, independent geographic integration, technological auditing and stakeholders, among other sophistication and regulatory complexities issues. They resulted in the change of names amplifies the challenges to achieve corporate from IBCA to Brazilian Institute of Corporate objectives and requires more elaborate Governance (IBGC) in 1999. In that same strategic decisions. The multiplicity of year, IBGC released the first edition of its relations that organisations establish with Code of Best Practices of Corporate a variety of audiences also increases risks. Governance, the first of its kind in Brazil. Issued on November 2015, the last edition Although its adoption was voluntary, the of IBGC’s Code of Best Practices of Corporate Governance reflects this scenario, highlighting concept of the Code was very well received. today’s most vexing issues. We highlighted The development of Novo Mercado, the principles of corporate governance, so São Paulo Stock Exchange’s special listing that the practices reflect the essence of the segment launched in 2000, reinforced the recommendations, going beyond formal principle of ‘one share, one vote’, accepting only structures and mechanisms. We also stress companies that issued common shares, and the need for migration from the exclusive granted minority shareholders tag along rights focus on shareholder – seen as a source for the on a 100 per cent basis of the price paid to the disregard of environmental aspects, social and controlling shareholder. The idea of independent governance (ESG) – for a broader view, which board members, today so widespread, includes the concerns of all stakeholders. became the rule of this segment only in According to the Code, corporate 2006, when 20 per cent of board members governance is the system by which companies would have to be professionals adhering to and other organisations are managed, minimum independence requirements. monitored and motivated, involving relations Those measures were important to among partners, board of directors, prepare markets for the coming years, when management, supervisory and controlling most initial public offerings (IPOs) would bodies and other stakeholders. Good practices choose Novo Mercado with strong support convert basic principles into from foreign investors. Such objective recommendations, ingredients helped to develop In response aligning interests with the an aura of good governance for the special listing segments, to corruption purpose of preserving and optimising the organisation’s albeit subject to criticism. From scandals and long-term economic value, June 2001 to June 2016, IGC – economic facilitating its access to the São Paulo’s Stock Exchange resources and helping to index made up of companies downturn, enhance management quality, listed on special segments (Novo there is a new its durability and benefits Mercado, Level 2 and Level 1) generated for society as a whole. – has consistently outperformed and unusual Ibovespa, the main composite wave of Ethical values index of Brazil’s stock exchange Putting into place and activity: 795 per cent versus regulation strengthening the compliance 353 per cent of nominal gains, structures are only the first few steps. respectively, in 15 years. In the The more advanced stage is the development same period, 253 companies joined some of an ethical culture, based on the belief special segment of corporate governance. that reputation has economic value and that, From a historical perspective, it is also despite all challenges, companies that practise worth mentioning the Law 11,638/2007 that ethical values inspired by their leaders are established international financial reporting more likely to stay in business longer. Hence, standards (IFRS) in Brazil, as well as the the tone set by the leadership is crucial. creation in 2009 of the reference form, a The message is an invitation to board document that substantially expanded the members and other governance agents to range of information disclosed by companies take a new approach to decision-making, regulated by the Securities and Exchange considering the impacts and expectations Commission of Brazil (CVM). of an increasingly diverse and complex Good practices set of stakeholders. Ethical principles are the When we think about the evolution of basis for these deliberations. To encourage corporate governance in Brazil, the question this to happen we made it clear that the is whether we are going beyond form and ultimate goal of good governance is not appearance. Regulation and formal adoption only good performance or longevity of the of good practices are not sufficient. It is business, but the common good. Spring 2017 | Ethical Boardroom 93

Activism & Engagement | Activism in the US

Duncan Herrington

Managing Director and Head of the Activism Response and Contested Situations Team, Raymond James

Interpreting the statistics on US proxy fights

Activists targeting mid-sized companies tend to be smaller, younger funds that can be more aggressive with their approach and demands

A BAD MOVE Conflicts can become public sooner and quickly escalate to a proxy fight

94 Ethical Boardroom | Spring 2017

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Activism in the US | Activism & Engagement

Go to the website of The Wall Street Journal or any other major financial news source, submit a search for ‘shareholder activism campaign’ and there will be no shortage of stories on recent high-profile public battles between a listed company and one or more activist shareholders. After reading a handful of these articles some consistent themes begin to emerge. The target: a very large, even mega-cap company, probably a household name, such as American Express, DuPont, eBay or Walgreens. All of them are massive companies with extensive resources at their disposal, including a multibillion dollar war chest, fully-staffed investor and public relations departments and an army of financial, legal and other advisors with which to go into battle. And on the dissident side: a well-known activist hedge fund managing tens of billions of dollars, with many years of experience and dozens of campaigns under its belt. It’s likely a name heard regularly on the financial news, such as ValueAct, Trian, Carl Icahn and JANA. But how accurate then is this narrative, often described in the media, compared to a ‘typical’ activist campaign? To find out, we looked at the numbers from last year’s proxy season and the results are strikingly different. Looking at the median data from SharkRepellent on all instances in the US where an activist submitted board nominations publicly for a shareholder vote scheduled for calendar year 2016, one can see that activist targets are normally a small fraction of the size of the mega-cap targets more commonly covered in the news. Moreover, the activists themselves are not just much smaller than the likes of Carl Icahn; they also often have little or no previous activism experience. To explain this trend, we need to look in more detail at the actual numbers and the ramifications with respect to the attributes of both the target company and the activist and what that may mean for the development and outcome of a campaign.

Profile of an activist target

The median market cap for activist target companies last year was actually about $270million, or less than one per cent of the size of the household names mentioned above. More than 80 per cent of activist targets have a market cap below $1billion. This is for good reasons, too: there are a much greater number of potential targets in this market cap range, the cost to build a significant position in the stock is much lower and the ability to employ an M&A

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strategy (the most common activist objective is to seek the breakup or sale of a company) is much easier, given the greater universe of potential buyers for a smaller sized target. What are the consequences for small-cap firms? First, an activist target of this size would have a small fraction of the resources at its disposal compared to its larger cap peers. While bigger companies may have fully staffed departments for finance, legal and investor and public relations that would be needed to fight out several months of a public activist campaign, for small cap companies those functions tend to be shared between just two or three people. As a result, the time and attention required from these staff, as well as management and the board, will be exponentially greater. Therefore, the distraction from day-to-day duties and the disruption to the business, will be much greater, too. Additionally, a small cap target would lack the financial resources a larger firm would have to hire experienced advisors who would have the tactical and analytical expertise often required to win a proxy fight. Second, an activist target of this size would usually fall below the radar of the largest investment banks and top-tier law firms, where most of the activism advisor

The typical activist target is not only small and lacks the resources to defend itself in a public battle, but also has a management team and board uninformed about shareholder activism and unprepared to respond teams reside. These teams work with a client company well in advance of an activist approach to educate the management team and board about activist tactics and how to be prepared for a possible attack. The upshot is that the typical activist target is not only small and lacks the resources to defend itself in a public battle, but also has a management team and board that may be uninformed about shareholder activism and unprepared to respond to it. They don’t know where they might be susceptible to an attack and how they might preempt it. They don’t engage with their long-term shareholders to proactively learn their perspectives and build their support. They don’t have a response team or protocol

established so they know what to do in those critical moments when an activist situation first surfaces. Finally, they are unsophisticated about activists and their tactics and agendas, or about the process of a proxy fight and the strategies to win one; moreover, their regular corporate counsel may be, as well. As a result, in 63 per cent of the cases where an activist demanded seats on a company’s board last year, the activist was successful in having some or all of its demands met. The vast majority of these via settlement, as the cost and distraction of the campaign, weighed against the uncertainty of winning a proxy contest, often causes the company to capitulate rather than to fight. In the cases that do go all the way to a shareholder vote, more than 80 per cent of the proxy fights were at companies with a market cap of around $500million or below and in these cases roughly one third of the time the activist was successful in winning the vote. In terms of top sectors targeted, last year more than half of activist targets were either technology companies (30 per cent) or financial companies (23 per cent). However, the industry breakdown can vary quite a bit year to year. Look at the 13D filings (made by investors who acquire more than five per cent of a company’s common stock) that were filed in the first two months of this year versus last year, for example. The number of financial companies targeted is about half of last year, due in part to the higher valuations many financial companies have enjoyed since the US presidential election this past November, making them less viable M&A targets, while the number of energy, retail and industrial companies targeted has increased substantially. Therefore, very few if any sectors are completely immune.

Profile of an activist

The median size of activist funds that launched proxy fights last year is also smaller than one might expect: at approximately $270million, the assets under management are much less than the many billions managed by the big names mentioned at the beginning of this article. The statistics on proxy fights that went all the way to a shareholder vote suggest that the dissident commonly has very little experience as an activist as well. Looking at the median numbers, the typical dissident in these fights has employed activism publicly as a strategy for well under two years, has only a couple previous campaigns under its belt and no previous proxy fight experience. Less than 40 per cent of proxy fights in 2016 were launched by activists that are members of the SharkWatch50, SharkRepellent’s selection of the most significant activist investors.

Spring 2017 | Ethical Boardroom 95

Activism & Engagement | Activism in the US The involvement of a small and contests), demonstrating the additional inexperienced activist can have important burden an activist faces to win the shareholder implications in terms of what tactics to expect support to take control of the board. and how a campaign might develop. Younger As mentioned above, in the majority of funds can often be much more cases, board seats were aggressive and less nuanced in won by an activist via Given how their approach and demands. If settlement rather than a unexpectedly they have recently raised funds shareholder vote. Looking to be used for activism, these just at the fights that did an approach activists will be under some go the distance, there are from an activist some important differences. pressure to achieve a public ‘win’ early on, to establish a As would be expected, can occur and track record, gain credibility campaigns that went to a how quickly with the market and prove vote tended to last longer, themselves to their investors. typically just under six a conflict can This means the activist might months. Although the escalate, the be less willing to approach median number of board most effective a target constructively and seats sought was still three, in private and try to work management was more likely practice is together with management to in a vote scenario to keep to be prepared bring about positive change the activists from winning at the company. Encounters well in advance any seats, as the median with a younger activist fund number of seats won was of a campaign thus often become public zero. However, that was not sooner and may be more likely being launched the case for board control to develop into a proxy fight. contests. In those cases the dissident was more likely than not to gain Proxy fight outcomes in 2016 board seats and in 43 per cent of the majority So how successful were activists last year in contests the activist was actually successful winning board seats? Again, looking at the in taking control of the board. In all votes median numbers, activists who ran proxy fights for board control, the target’s market cap last year typically sought three board seats was under $500million and in the majority and were successful in getting one. In only of cases the dissident had no prior known 20 per cent of proxy fights was the activist able experience with activism. to get all seats sought. The typical length of last Conclusions year’s proxy fights from public announcement The key takeaway when looking at the to outcome (whether withdrawal by the statistics from last year is that in most activist, shareholder vote, or settlement) activism campaigns both the target and was just over three and a half months. activist are actually much smaller than the Campaigns where the activists sought a examples we read about in the financial majority of the seats on board represented news and usually have little, if any, prior 35 per cent of last year’s proxy fights. As might experience with activism. A younger, less be expected, these campaigns were typically experienced activist is prone to agitate for a larger number of seats (five) and activists more aggressively and be more likely to were most often successful in getting two. escalate the matter publicly to a proxy Interestingly, in these contests for board fight, while the target is likely to be control the activist was successful in getting unsophisticated about activism all seats sought only 11 per cent of the time and unprepared to respond to it. (almost half the success rate for minority

As a result, in the majority of fights the activist will be successful in forcing change in the boardroom and in some cases even taking control of the board. More often than not, these conflicts can arise unexpectedly and bring about transformative change within a company, whether positive or negative, within just a few months. In this environment, it is critical for management teams and boards at small-cap companies, regardless of sector or performance, to think ahead of time about the possibility of an activist approach. There are a number of key elements to this strategy. First, companies should have in place an activism response plan and team, including members of both senior management and the board, as well as an external ‘go-to’ advisor team experienced in these matters. These advisors can often tell a company in advance where it might be more vulnerable to criticism by an activist and can work with the company to mitigate those vulnerabilities. Secondly, companies should regularly seek feedback from their various shareholder constituencies to be aware of their views on potential issues and how they can be resolved. Given how unexpectedly an approach from an activist can occur and how quickly a conflict can escalate, the most effective practice is to be prepared well in advance of a campaign being launched. Source: Shark Repellent

CHECK MATE Smaller companies are often less prepared for greater levels of activism than larger firms

96 Ethical Boardroom | Spring 2017

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Words and actions matter when it comes to protecting and enhancing value through times of change. Trust us to be your partner in change.

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Activism & Engagement | Europe

Steve Wolosky, Andrew Freedman and Ron S. Berenblat Members of Olshan Frome Wolosky’s Activist & Equity Investment Group

Future of shareholder activism in Europe The gloves are coming off as full-blooded, US-style activism attacks EU boardrooms. But are they prepared? Shareholder activism is no longer just a US phenomenon and continues to spread across the globe. In this article, we discuss our views on the future of shareholder activism in Europe, drawing from our experience as the leading law firm to activists in the US. According to Activist Insight , 97 European companies were publicly targeted by activists during 2016, representing a 35 per cent increase compared to 2015. Homegrown investment funds engaged in shareholder activism, such as TCI Fund Management, Crystal Amber and Cevian Capital, are leading the crusade to maximise shareholder value and protect the interests of all shareholders. Blue chip US activists have also recently been involved in European campaigns with successful outcomes, including ValueAct Capital’s US-style settlement agreement for board representation at Rolls-Royce in the UK. As more seasoned activists take the plunge into activism in Europe, we believe smaller players from both the US and other jurisdictions will follow suit. For example, Active Ownership Capital, a relatively new activist fund, based in Luxembourg, successfully replaced the chairman of the supervisory board of German pharmaceutical company STADA Arzneimittel at its 2016 annual general meeting. The noticeable uptick in shareholder activism in Europe is not only evidenced by the growing number of publicly disclosed activist situations. We see signs of a boom beyond these numbers. Advisers 98 Ethical Boardroom | Spring 2017

specialising in activism are bolstering their European presence. Media coverage of activist situations unfolding across Europe is a daily occurrence. A recent wave of corporate governance reforms and awareness in various jurisdictions in Europe could make it a natural breeding ground for activist situations. For example, Germany is in the process of amending its corporate governance code (Deutsche Corporate Governance Kodex) to require more transparency at listed companies with the goal of allowing investors to better assess and provide feedback to the supervisory board on corporate governance matters.

A recent wave of corporate governance reforms and awareness in various jurisdictions in Europe could make it a natural breeding ground for activist situations The preamble of the code is being amended to emphasise the ‘particular importance’ of institutional investors to their portfolio companies and to specifically state that ‘it is expected of them that they exercise their ownership rights actively and responsibly on the basis of transparent principles which take into consideration the concept of sustainability’. Similar policies encouraging institutional investors to serve as active stewards of shareholder interests, if adopted by other European countries, could give added staying power to European activism. Based on our experience in the US, we predict that over the next two to three

years, various trends will emerge in Europe consistent with those that we saw during the early stages of the US activism cycle in the early 2000s.

Wolves and lambs

While more confrontational campaigns are beginning to surface in Europe, they still occur less frequently than in the US. Most activist situations in Europe are relatively tame by US standards and behind-thescenes discussions have been the preferred means of engagement. We sometimes hear people say that due to cultural differences between the US and European countries, a more hostile US-style approach will generally not be successful in Europe and a more subtle, private approach is required for an activist to be effective. We believe that activism in Europe will become more confrontational as it proliferates throughout the region and activists get more comfortable navigating the regulations, voting mechanics and cultures specific to each jurisdiction. Kinder and gentler activism strategies will be replaced by somewhat more aggressive tactics, including the public issuance of fight letters and detailed white papers and slide presentations that are common in US proxy fights today. Newer and younger activists that will follow the more mature activists that are currently taking a leading role in the space could be instrumental in escalating things. We are already seeing more aggressive US-style activist situations in Europe. TCI Fund Management, one of the more prolific European activists, is publicly opposing Safran S.A.’s proposed acquisition of Zodiac Aerospace. Both Safran and Zodiac are French corporations listed on the Euronext Paris exchange. In a highly critical public www.ethicalboardroom.com

Europe | Activism & Engagement UP FOR A FIGHT Gentle activism strategies will be replaced with more aggressive tactics

intervene in the event that the tender offer is in fact initiated before the merger vote. More recently, following Zodiac’s announcement of poor financial results, TCI Fund sent a public letter to Safran’s chairman, threatening to seek his removal at the upcoming annual general meeting if he did not pull the plug on the deal. TCI Fund also sent a letter to all the Safran board members, warning them that they would be held personally responsible for the full amount of any losses suffered by Safran as a result of the transaction. Similar to US activist campaigns today, these public letters, together with a 49-page slide presentation condemning the transaction, were posted by TCI Fund to a website it created specifically for the campaign.1

Ruffled feathers

fight letter addressed to the chairman of Safran, TCI Fund argues that Safran is ‘significantly overpaying’ for Zodiac. In addition, TCI Fund argues that the deal is structured to force the hands of Safran shareholders as it claims the Safran board has intentionally decided to hold the merger vote after the consummation of Safran’s tender offer for Zodiac. Since a successful tender offer would result in Safran owning a majority of Zodiac, TCI Fund claims that even if Safran shareholders oppose the merger, they will be inclined to vote in favour of the deal to avoid a precipitous drop in Zodiac’s share price that would result if the merger is rejected. www.ethicalboardroom.com

According to TCI Fund: “The sequencing has been designed specifically to ambush the public shareholders of Safran in an unethical manner. The fact that the board has agreed to ransom the company and its shareholders in such a way is underhand, unfair, unscrupulous and unbecoming of a company with such a long and impressive history of success.” TCI Fund subsequently issued a public letter urging shareholders to demand that the merger vote take place before the tender offer, vote against the merger and transfer their shares into registered form in order to qualify for double voting. TCI Fund also sent public letters to France’s Autorité des Marchés Financiers alerting it of the situation and urging it to

As we saw in the US during the early 2000s, when activism was beginning to gain traction, we believe boards and management teams of European companies, particularly those of smaller-cap companies, will need to be prepared for this more aggressive style of activism. Feathers will be ruffled and the knee-jerk reaction of many target companies will be to put up defences designed to ward off the dissident. The types of defences that may be implemented by targets will vary, depending on the laws of the local jurisdiction. Companies may also take advantage of existing laws that could insulate them from attack. For example, in Spain, public companies (sociedades anónimas), both listed and unlisted, are permitted under the Spanish Companies Act (Ley de Sociedades de Capital) to adopt bylaws imposing a ceiling on the number of votes that may be cast by a single shareholder, group of shareholders or shareholders acting in concert (without prejudice to certain rules only applicable to listed companies in the context of a takeover bid). However, if the voting limitation is not already contained in the bylaws, shareholder approval is required to amend the bylaws in order to adopt the voting limitation. We may also see more targets commence lawsuits against activists as part of their defence strategies, similar to what we used to see being used often in the US, alleging undisclosed groups, violations of ‘early warning’ reporting obligations and other disclosure deficiencies. More aggressive activist campaigns that call into question the personal reputation and integrity of members of the board and management in public fight letters could be met with defamation proceedings against the dissident. Spring 2017 | Ethical Boardroom 99

Activism & Engagement | Europe Just as in the US, it may take a few years before these companies take things less personally and realise that they are better off engaging with activists rather than commencing legal proceedings to silence them.

Activism strategies will evolve

The evolution of the specific types of activist strategies that will be utilised in Europe during the coming years will be very interesting to watch. In the US, the predominant activist strategy has always been to obtain board representation. In the early stages of the US activism cycle, it was extremely common for activists to use a corporate governance platform to make their case for seeking such board representation. The types of activist strategies being utilised in Europe vary, but according to FTI Consulting, the strategies of choice include seeking board representation, attempting to remove the CEO or other board members and expressing opposition to proposed business combinations. Of course, the order of predominance of these and other strategies varies depending on the regulatory frameworks, economic state of affairs and other factors specific to each country. For example, in Germany, where a two-tiered board structure is mandatory, activists have been less inclined to seek board representation and, according to FTI Consulting, campaigns focussed on corporate governance concerns, such as excessive remuneration and lack of transparency, are more common. Offensives mounted by various funds against Volkswagen in reaction to these types of corporate governance concerns following its emissions scandal especially come to mind. Following the emissions scandal, Hermes Investment Management and other institutional investors demanded that Volkswagen conduct a truly transparent and independent investigation of both the management and supervisory boards’ involvement in the matter. Prior to Volkswagen’s 2016 annual general meeting, Hermes reiterated its concerns with Volkswagen’s corporate governance and the effectiveness of the supervisory board. Hermes asserted that the ‘questionable composition of the supervisory board’ and the company’s ‘continuous disregard of fundamental corporate governance principles’ may have contributed to the emissions scandal. TCI Fund has pressed Volkswagen to revamp its executive remuneration policies, which it contended are excessive, incentivise risky behaviour and also contributed to the emissions scandal. Volkswagen recently announced the restructuring of its remuneration policies, but many believe the company has not gone far enough. Over the past few years, activists in the US have lightened up on their corporate governance platforms in connection with seeking board representation and have pivoted towards platforms identifying operational changes that 100 Ethical Boardroom | Spring 2017

should be implemented to maximise value (referred to as ‘operational activism’) as well as alternatives for preserving cash or deploying excess cash in ways that are accretive to shareholders (referred to as ‘balance sheet activism’). During the next few years, we may see more activists in Europe emulate these strategies. These two strategies have already been deployed by Crown Ocean Capital in its recently concluded proxy fight against Bowleven PLC, a UK oil and gas exploration company focussed on Africa. In January 2017, Crown Ocean requisitioned a general meeting of shareholders for the purpose of removing six directors from the seven-member board and appointing two independent director candidates. Crown Ocean utilised an operational activism strategy by arguing that

Activists in the US have lightened up on corporate governance platforms and pivoted towards platforms identifying operational changes

Bowleven should focus on its highly promising Etinde asset and openly and objectively re-evaluate its Bomono project. At the same time, Crown Ocean utilised a balance sheet activism strategy by arguing that management had overseen a cash burn of more than $100million during the previous two fiscal years ‘without tangible, successful results’ and that it should preserve cash. According to Crown Ocean, cash should be distributed to shareholders in a tax-efficient manner only to the extent a ‘prudent board’ determines the cash is not required to advance the Etinde project. At the general meeting, both of Crown Ocean’s candidates were appointed to the board and five incumbent directors were removed. Notably,

Crown Ocean failed to remove William Allan, the chairman of the board. Crown Ocean then submitted a notice to Bowleven, requisitioning a second general meeting for the purpose of removing Chairman Allan, stating that ‘the incumbent Chairman is reluctant to accept the verdict of shareholders over the future strategy of Bowleven’ and appointing two additional independent directors. Shortly thereafter, Allan resigned from the board and Crown Ocean withdrew its requisition notice for a general meeting. Similarly structured platforms could be used by activists in Europe to bolster their case for effecting change on the board.

Local proxy rules will be tested

Particularly in countries where proxy fights are currently a rarity, controversies of a substantive as well as procedural nature relating to election contests will surface. For example, issues relating to voting thresholds required to elect directors when the number of candidates up for election exceeds the number of directorships to be filled at a meeting may not be clearly addressed by applicable laws.

Similarly, a company’s organisational documents and applicable law may not adequately address matters of meeting procedure when a dissident is running a competing slate of directors. Can management or the dissident validly adjourn a meeting in a contested situation if a quorum is already present? Once votes have been tallied, are there procedures for the losing party to contest the results of the meeting? As proxy contests become more commonplace, companies’ organisational documents and local regulations will evolve in order to address these uncertainties. www.aStrongerSafran.com

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A COMPUTERSHARE COMPANY

Activism & Engagement | Canada CORPORATE CANADA Boards are now more prepared for traditional activist approaches

Shareholder activism in Canada: 2017

Discussing trends observed over the last year and our predictions of what we might see going forward

102 Ethical Boardroom | Spring 2017

Trevor Zeyl

Associate, Norton Rose Fulbright Canada LLP

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Canada | Activism & Engagement

Despite its reputation for being placid and polite, Canada has become something of a global hotspot for shareholder activism in the past few years.

In 2015, Canadian capital markets saw unprecedented levels of activist activity. Last year, although not matching the levels of activist activity in 2015, was also an objectively strong year, despite the down market for resource issuers. As activist tactics shift and corporate defences evolve, several factors are facilitating a continued strong role for shareholder activism in the Canadian capital markets in 2017.

A historical perspective

Until relatively recently, institutional investors were reluctant to engage or align with activists. Passive investment management dominated. Boards were unused to noisy shareholder agitation. Yet, the past five years has seen a wave of dramatic and sometimes vitriolic proxy contests against some of corporate Canada’s household names, including TELUS, Canadian Pacific Railway and Agrium. In some cases, Canadian boards have been caught flat-footed by activists. They have been subject to unannounced public attacks that have garnered unexpected shareholder support. In other cases, Canadian companies defeated determined activists by employing novel strategies, surprising foreign observers with their pluck and willingness to fight back. Activism has now become a prominent feature of Canadian corporate life.

2016 in Canadian activism: topline trends

By most accounts, although 2015 was a record year for Canadian activism, activity settled down slightly in 2016. According to Activist Insight, 60 companies were publicly subjected to activist demands in 2015, compared to 49 in 2016.1 There are several explanations for this dip in public activism. First, much of the open warfare of past years has shifted behind the scenes. Second, while the balance of power once seemed heavily tilted in favour of activists, boards have regained some of the initiative, at least for now. This may have prompted some activists to think twice. According to data from Kingsdale Advisors, in the past 10 years, only 2007 and 2016 saw management win more proxy contests than activists. For many years, the numbers have been lopsided in favour of activists. But of the 38 proxy contests initiated in 2016, management won 20, activists won or partially won 12 and six remain to be decided.2 These figures likely reflect the fact that boards are now more prepared for traditional activist approaches. The showdowns of the past few years have made activism a top-of-mind issue in Canadian boardrooms. www.ethicalboardroom.com

Defensive measures, such as provisions for advance notice, forum selection and enhanced quorum, are now common. Canadian issuers have also paid greater attention to their governance practices. In addition, overall market conditions in 2016 were less favourable to activism in Canada than in 2015. As in other countries, political and economic uncertainty led many investors to trim their sails. In 2015, the economic difficulties faced by the resources sector and low commodity prices heightened the unique attraction of Canadian commodities issuers to activists, whereas 2016 saw some signs of economic recovery. 3

The Canadian legal regime: background

Canada is widely considered to have one of the world’s most investor-friendly legal regimes. Indeed, Canada’s strong protections for investor rights are among its greatest attractions for foreign investors. Among activist-friendly features of the legal regime are: ■■ The right for the registered holder of five per cent of a company’s shares to requisition a meeting at any time, for example, to replace any or all of a company’s directors ■■ The ability in most Canadian jurisdictions to solicit proxies without distributing a dissident circular if the solicitation is made to 15 or fewer shareholders or if the solicitation is ‘made to the public by broadcast, speech or publication’ ■■ The high disclosure threshold, requiring a shareholder or group of shareholders to disclose their stake only when they cross the 10 per cent threshold

practice tactical poison pills could be used to prolong this period. The new regime, which applies across Canada, has three main new features: ■■ Bids must now remain open for a minimum of 105 days (waivable by the target board to no less than 35 days) ■■ An irrevocable minimum tender condition of 50 per cent of the outstanding shares subject to the bid ■■ The requirement to extend the bid for a minimum of 10 days once the minimum tender has been met One expected effect of this regime, of which there is already some evidence, is the encouragement of merger activism and ‘bumpitrage’ – the scenario where an activist buys into a company’s stock after a bid is announced in order to demand a higher price. Another likely effect is the deterrence of hostile bids in the first place, given that the regime requires bidders to place a fully financed bid on the table that remains open for 105 days. In these circumstances, bidders may find it less onerous to launch a proxy contest to gain effective control of a company, instead of a traditional hostile bid exposed to interloper risk and share price fluctuations. Nonetheless, one potential upside for bidders is that, in normal circumstances, securities regulators will likely not allow tactical shareholder rights plans (or ‘poison pills’) to remain in place past the 105-day mark.

Other changes to Canadian law and regulations

In September of 2016, Canada’s federal government proposed a series of amendments Canadian regulators have Canadian to the Canada Business generally not intervened to curb Corporations Act. If adopted, activism, perhaps because they regulators have they will, among other accept that activism has an generally not things, require annual, important place in vibrant intervened to individual election of capital markets. For instance, directors. Directors will in 2014, after extensive public curb activism, also only be elected if the consultations, the Canadian perhaps because majority of votes are cast Securities Administrators ‘for’ rather than ‘withheld’ (the CSA) – the body made up they accept it majority voting). of all of Canada’s provincial has an important (so-called These proposals largely securities regulators – declined mirror changes to the to follow the US by lowering the place in vibrant Toronto Stock Exchange’s reporting threshold to five per capital markets director election rules, cent. In contrast to regulatory which were implemented in intervention in other countries, stages between 2012 and 2014. Canadian regulators have not yet intervened While these proposals may not propel to curb perceived ‘short-termism’. activism as such, they contribute to a climate of Recent changes to rising expectations for directors. They reinforce Canadian takeover bid rules a message that activists have long been Recent legislative changes have added sending: that being a director of a Canadian yet more incentives for contested activity public company is an increasingly serious and in Canada. In May of 2016, the CSA’s demanding business and that investors will long-awaited new takeover bid rules took punish boards that do not appear to treat it as effect. Previously, takeover bids were required such – often through caustic, highly personal to remain open only for 35 days, though in attacks in the public arena. Spring 2017 | Ethical Boardroom 103

Activism & Engagement | Canada

The changing face of Canadian activism

the activist sought majority representation or a change to the entire board.4 Activists In the past year activists have shown they are enjoying especially high rates of success have no fixed demands or tactics, only fixed where they do not make maximalist demands. interests. As they continue trying to narrow Another trend gaining in prominence is the gap between the market value and the the rise of short-selling activism. Perhaps (perceived) intrinsic value of stocks, activists the most high-profile case of a short-selling are showing more flexibility activist anywhere occurred in their methods. In 2016, the against a Canadian-listed The outlook classic image of shareholder issuer, Valeant Pharmaceuticals. activism, in which a hedge for shareholder In late 2015, short seller fund frontally attacks a Citron Research alleged that activism in company and seeks majority Valeant was engaged in, among board representation and Canada appears other things, accounting a comprehensive strategic While Citron did strong for 2017, manipulation. overhaul, was less and not itself seek a proxy contest, spurred by a less reflective of reality. the knock-on effects of negative Nonetheless, a few notable publicity led to upheaval at the weak Canadian trends have emerged in the company and in the share price. dollar and a past year or two. Advice for activists As noted above, much target-rich Investors should know that activist activity now occurs environment any major shareholder with a quietly, with no public solid value creation proposition, campaigning. Many activists or a well-articulated objection to poor are willing to approach companies to management, can either be or join forces with negotiate before going public with demands. a shareholder activist. Indeed, institutional In turn, many boards are willing to investors and passive managers are becoming engage constructively with activists and more vocal about governance and more even to reach quick formal settlements willing to engage. involving board representation. If activists present a strong, detailed thesis, Regardless of whether activism becomes they may be surprised by who is willing to public or not, one accelerating trend is listen. That may even include the company’s the frequency of activists making particular board. While activists may have to display demands that do not, at least at first, more flexibility and creativity to achieve their pertain to board composition. Subjects goals than in the age when they could simply of activist attention have been as diverse overawe unprepared boards, opportunities as accounting practices, executive pay, for activism remain abundant in Canada. dividends, the redemption features of a No company is too big – or small – to furnish company’s securities, or perceived public an opportunity for profitable activism. interest considerations. In 2015 and 2016, campaigns with short Advice for boards slates – that is, campaigns where an activist In his war memoirs, General de Gaulle wrote: seeks only minority representation – enjoyed “Just as a besieged fortress is near surrender increased success in Canadian proxy contests. as soon as the governor talks of one, so Kingsdale Advisors’ data shows that in 2016, France was heading for an armistice because 80 per cent of such campaigns were activist the head of her government officially wins or partial wins, against 25 per cent where 60 50 40

*Based on data from Kingsdale Advisors, current as of March 14, 2017. Activist win is defined as the activist achieving more than a majority of objectives; activist partial win is defined as the activist achieving equal to or less than the majority of objectives

■ TBD ■ Activist win or partial win ■ Management win 30

13 8 4

4 5

13 9

20 12

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

104 Ethical Boardroom | Spring 2017

contemplated one.”5 Activists will seize on any weakness they perceive, including an unfocussed communications strategy. For this reason, boards should not be afraid, if warranted, to firmly and consistently refuse activist demands, particularly where the activist appears to have a weak case and little willingness to press a serious attack – as tends to be true of many activists. Boards should be their own activists. There is no more powerful response to an activist’s business proposition than to say that the board had previously considered it, but rejected it for specific reasons. That said, if an activist has sensible demands, a board should not simply reject them because an activist proposes them. Boards should, above all, continuously engage their shareholder bases. Canadian companies should also update their defensive tactics to reflect current best practices. Our firm continues to be surprised by the number of Canadian issuers who have not yet, for example, introduced advance notice provisions.

The outlook for 2017

The outlook for shareholder activism in Canada appears strong for 2017, spurred by a weak Canadian dollar and a target-rich environment for funds from other countries looking for new investment opportunities. US activists continue to look outside of the US for targets and are focussing on smaller companies than they have in the past. We expect to see some of this outbound activist activity in Canada. Moreover, we expect the bulk of activism to focus on mid-sized and smaller Canadian companies, companies that are small by US standards and easier to accumulate a position in and exert influence over. Such companies also have fewer resources to mount a defence against activists. As mentioned, the new takeover bid rules will do their part to drive activist activity to a heightened level in 2017. Specifically, the new rules may drive prospective acquirers seeking to avoid the new and more onerous takeover bid regime to use traditional activist tactics to effect an acquisition, including running agitation campaigns, starting proxy fights, or using bully M&A tactics. Written with the assistance of Joe Bricker, Articling Student, Norton Rose Fulbright Canada LLP Activist Insight in association with Schulte Roth and Zabel, ‘The Activist Investing Review 2017,’ p. 22 2 Based on data from Kingsdale Advisors, current as of March 14, 2017. The authors are grateful to Kingsdale Advisors for sharing this information. For the most detailed study of activist activity in Canada in 2016, readers are encouraged to consult Kingsdale Advisors’ ‘2016 Proxy Season Review.’ 3‘Commodity-price shock over? Black shoots, jobs mirage and a CPI Signal: Canada economy watch,’ Financial Post (February 13, 2017) 4Based on data from Kingsdale Advisors, current as of March 14, 2017. 5 Charles de Gaulle, The Complete War Memoirs of Charles de Gaulle, trans. Jonathan Griffin and Richard Howard (New York: Carroll and Graf Publishers, Inc., 1998), p. 70. 1

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Activism & Engagement | Germany

Activism in Germany

Clarifying misconceptions about shareholder and hedge fund activism in Germany Shareholder and hedge fund activism has become an influential force in German corporate life over the past 15 years or so, both in terms of corporate governance improvements and value creation, with approximately 400 campaigns launched by 100 (predominantly foreign) activist hedge funds against 200 of the country’s 650 public corporations.

Game changer

Until recently, it was the threat of hostile takeovers that was deemed the principal corrective for poor management decisions and shareholder value destruction due to performance failures. Today, in Germany it has shifted to active monitoring by engaged or activist value minority investors – characterised by such an alignment of interests with and persuasion of fellow shareholders and institutional investors to generate support in the form of the requisite general shareholders’ meeting (AGM) majorities, if necessary. With 60 to 70 per cent (sometimes an even higher percentage) of the voting stock of leading German corporates owned by foreign institutional investors, this train of thought must be taken seriously. There are two significant factors that help contextualise activist campaigns and market acceptance of shareholder and hedge fund activism in the German corporate governance debate. 106 Ethical Boardroom | Spring 2017

Ami de Chapeaurouge

Senior Partner, de Chapeaurouge + Partners (Frankfurt, Hamburg and New York), admitted in Frankfurt and New York Firstly, 60 per cent of all 650 German publicly listed companies are controlled or dominated via share block ownership by families, founders, management teams, investors or holding companies. Thus only 250 German public companies lend themselves to the presumption that activism is dependent on a widely-held, dispersed shareholder ownership/population so that when negotiations with target management break down, the activist may resort to launching a confrontational proxy fight in order to replace some or all members of the supervisory board. They, in turn, may recall the management and replace them with new managers who agree with the activists’ strategic plan. Second, there is a certain consensus-oriented German corporate culture, etiquette and decorum that, over time, has demonstrated how publicity and accusatory campaigns against sitting management or supervisory board, proxy fights or resorting to litigation are by and large unsuccessful strategies, with only 20 per cent of all campaigns ever becoming public knowledge. There has only been one precedent (out of a total of seven attempts) where activists were capable of replacing the chairman of a supervisory board in an adversarial proxy fight - at pharmaceutical company Stada AG in August 2016. In the view of many, the separation of ownership and control (Berle-Means) and the principal-agent problem (Jensen-Meckling) has recently led to sharp market cap drops and share price value-losses at the expense of shareholders

in large DAX 30 German corporations and corporate groups, such as the utilities RWE and E.on, but also TUI, Commerzbank, Volkswagen and Deutsche Bank. It is no secret that concerned institutional investors have initiated discussions with activist hedge funds on these matters (see illustration opposite). Observers believe that leading activist hedge funds, who acquire usually a minority position in the one to 10 per cent range (seldom more than 15 per cent total, depending on target size), could exert such additional monitoring function on behalf of all shareholders without necessarily destabilising the balance of powers between the AGM (shareholders), supervisory board and management board. First, they are not imposing their views on anybody, least of all management or the supervisory board, but seek to engage and present well-thought out alternative courses of action. Second, they have to win the votes and confidence of fellow shareholders and institutional investors in the first place in order to have any strategic impact.

The informal character of German activist campaigns

So, to recap, there have been approximately 400 equity activist campaigns in the past 15 years or so in Germany, attaching to 200 public targets (out of a total of 650 listed companies), mostly hidden from the public. Further, assuming a base line of 400 campaigns, Thamm/Schiereck claim that 75 per cent of these samples have been kept under the lid and were never in the public limelight, on social media or mentioned in the press or legal/economic writings, reflecting the mainly informal approach take in these campaigns. This corresponds with our own findings. Over www.ethicalboardroom.com

Germany | Activism & Engagement the years, we have only been able to identify 70 to 80 activist attempts at value creation with public German target corporations. There is another fork in the road and bifurcation of observations. If we assume 400 activist engagements in total, 250 took place before the financial crisis, the remainder thereafter. The early ones were fairly multi-faceted attempts at value creation. The majority of the subsequent 150 activist interventions since 2009 mostly follow the script of more or less unimaginative takeover arbitrage, by (i) opposing a mergers and acquisition (M&A) transaction as value-destructive; (ii) pushing for a business combination involving the portfolio company as creating value; or else (iii) reflecting an attitude towards a public M&A transaction that could be called supportive in general, except for the consideration promised to the hold-out shareholders who are refusing to sell their stock position to the acquiring entity for the same consideration proffered to all other shareholders – activists simply extract a better price. Here, at the so-called back-end, activists attempt to negotiate or litigate for additional compensation for their hold-out stock position at odds with the interests of all other shareholders. Or else they block a M&A transaction from the very beginning and attempt to extract better terms for their preferred or convertible stock positions. They need not share this with any other shareholders who receive only minimum compensation for their shares. In the event of the acquirer concluding a domination, profit and loss sharing agreement with the target (requiring a 75 per cent majority), activists follow through with judicial action, seeking a better Parties and communication lines or actions involved in a German equity activist campaign — it is not M&A control play, but mostly influence-seeking minority investment US institutional investor such as X, Y, Z

price for their hold-out position instead. In Germany, more than 75 per cent of activist interventions following an investment take place in confidential discussions between hedge funds and management and/or supervisory board that never become public. Any communication between company and activist is subject to the mandatory equal treatment of all shareholders pursuant to the section 53a Stock Corporation Act (AktG). If other shareholders so demand during an AGM, management is compelled to disclose to all other shareholders any far-reaching information shared with activists beforehand so long as the piece of information conveyed to such activist investor was tied to their being shareholders of the company, pursuant to section 131 Abs. 4 Satz 1 AktG. From this may be inferred that informal one-on-one discussions are admissible with the result that any other shareholders have no claim to find out the contents of such meetings outside an AGM. Management and supervisory board are prohibited from sharing inside information with activists (pursuant to section 14 Abs. 1 Nr. 2 Securities Trading Act [WpHG]) unless there are overriding justifications. It is certainly permissible to explain the business model and thereby deepen an activist’s understanding of company strategy – below the threshold of giving away secrets. Passing on secret information to an activist may only be justifiable if it is in the interest of the company to create exceptions from confidentiality obligations of management and supervisory board (section 93 Abs. 1 Satz 3, 116 Satz 1 u. 2, 93 Abs. 1 Satz 3 AktG).

Annual update of DCGK

Additional information Special dividend or stock buyback Other capital allocation

Supervisory board

Sale of assets — strategy change Business model changes

Activist hedge fund A

German Public Portfolio Company (AG)

Monetise other assets Supervisory board seat Management board seat

Management board

Other changes in governance Argue for spin-off

Activist hedge fund B + C

Induce company to sell itself Frustrate or push for a M&A deal Publicity, proxy fight or litigation

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With their usual average shareholding range between five to 10 per cent, by resorting to informal tactics predicated on personal relationships with members of both boards, activists enjoy the advantage of influencing corporate decision-making directly, with a built-in timing and flexibility advantage, independent of an AGM setting, and their actual weight expressed in the percentage of their stock position in the company. There is sufficient empirical evidence that, within the already outlined restrictions imposed on company representatives, such personal interfacing is considered the most appropriate means to influence the target corporate leadership for activists and institutional investors alike. Under certain circumstances, the very fact that discussions with an activist have taken place may constitute inside information that is to be made public if such meetings could influence the target stock price appreciably (section 15 Abs. 1 Satz 1, 13 WpHG). It is usually within the frame of a personal meeting or teleconference that activist managers communicate their impressions, provide deeper analysis or air criticism as to corporate strategy and value. Public campaigns usually happen in only about 20 per cent of all cases. Proxy fights are even rarer and hardly ever successful. The 2007 AGM proxy fight by Wyser Pratte with Cewe Color proved value-destructive, eating up €2.75million of €5.9million corporate earnings after taxes. In this particular contest, because of flawed strategy, the activist neither pushed through a special dividend nor board membership for its four supervisory board nominees.

Parameters for adversarial campaigns and proxy fights

It is important to remember that the management board has the sole authority over a whole host of issues where neither the AGM nor the supervisory board may interfere or intervene. Shareholders may not instruct the management board in corporate structure matters, such as the sale of divisions or subsidiaries or carve-outs, dismissal of workers or employees or in any of the capital structure modifications they would like to see through. It is the management board that is vested with sole authority on a stock buyback programme or special dividend payout. Nor can they officially remove a management board member. If activist shareholders are dissatisfied with one or several management board member(s), they can build a case and exert pressure on the supervisory board to carry out such dismissal. The direct influence of activist minority shareholders is confined to suggesting (not nominating) members for the supervisory board, causing a special audit when there is suspicion of wrong-doing, or else push for a more aggressive disbursement of corporate earnings to the shareholders. Spring 2017 | Ethical Boardroom 107

Activism & Engagement | Germany The suggestion and nomination of new supervisory candidate members has to be agreed upon with the management board, the chairman of the supervisory board or at least an important supervisory board member beforehand behind closed doors. Should the activist elect to engage in a proxy fight, the management board is obligated to inform all shareholders at the expense of the issuer/company and must express, together with the supervisory board, its recommendation on how to vote on controversial issues. Unlike the US, activists can exploit the obligation incumbent on the issuer to inform all shareholders about the activist‘s motions and agenda items and thus make public their proposals without them incurring any financial charge. The reverse side of the coin, however, is that shareholders may never burden their proxy campaign costs on the target/issuer – think Sotheby‘s assuming Dan Loeb‘s campaign expenses of $20million – and this is an important variation. As a rule of thumb, a German management board may neither buy back shares held by activists directly in order to get rid of their inherent nuisance value, nor can they make financial concessions in order to broker a compromise or settlement. Activist minority shareholders in Germany are hampered by two further idiosyncracies in the German proxy process. For one, in the US shareholders have a right to identify the names and addresses of all other shareholders by inspecting the company register. In Germany, however, each shareholder only has the right to inform themselves about the data entered into the registry with respect to their very own stock position (section 67 Abs. 6 Satz 1 AktG). So, activists in Germany are hindered factually from exploring whom they have to reach out to in order to convince them of the superiority of their plan in contrast to the strategy of incumbent management. An activist may only demand to inspect the participants list of the last AGM pursuant to section 129 Abs. 4 Satz 2 AktG. Given the complexity of custodial chains in modern corporations, this only goes so far. The activist could get in touch with the depositary banks and ask them to pass on the activist agenda to their customers. Finally, an activist could attempt to avail themselves of the Aktionärsforum (section 127a AktG), where it could place a reference to its website (section 127a Abs. 3 AktG), but his is considered a weak tactical avenue. An activist has to be mindful of acting-inconcert charges in connection with such proxy solicitations (section 30 Abs. 1 Satz 1 Nr. 6 Alt 2 Takeover Code) so that the votes thus solicited are not counted towards their own shareholdings. It can stay clear of this campaign structuring risk if it doesn’t exert its own margin of discretion when voting on behalf of the other shareholders, but sticks strictly to their voting instructions. A second setback, next to lack of inspection 108 Ethical Boardroom | Spring 2017

in terms of being in a position to influence right of the company registry for purposes firm-specific corporate governance measures, of identifying and reaching out to the entire as well as minority shareholder protection. issuer shareholder base in Germany, is the It is very possible for a minority shareholder German proxy process itself. to gain supervisory board representation. In the Unlike in the US, where it is considered cases of KUKA, Deutsche Börse and Curanum sufficient that a proxy advisor receives proxies there were also changes on the management without the shareholder giving explicit voting board level attributable to activist interventions. instructions, pursuant to section 2.3.2 of the Although in most instances the board seats German Corporate Governance Code, the were obtained at corporations without a large management board should provide for a blockholder, the cases of Deutsche Telekom proxy representative that can cast the votes and Cewe Color Holding demonstrate that according to the instructions given to it. It is board seats can even be obtained in spite of controversial in the literature whether his the existence of a large shareholder. casting a vote depends on an explicit voting The Demag Cranes case shows that (i) instruction or whether a blank minority shareholder rights in proxy would do. For credit Germany are well-developed and institutions, a specific strong; (ii) minority voting instruction is Activists in Germany shareholders have required. A general the opportunity instruction ‘to vote are hindered factually to obtain with the management from exploring whom supervisory board board’ would do. Some argue that they have to reach out to representation; (iii) minority the requirement in order to convince them and shareholder of an explicit activism can have voting instruction of the superiority of their an impact on a can be waived plan in contrast to the firm’s corporate if the issuer strategy of incumbent governance. has designated an Interests and independent proxy management strategies of both activist representative. Should hedge funds and German they be an employee of the issuer, blockholders defy easy categorisation. this would make a specific instruction Activists aim at creating value expressed in advisable (to avoid conflict of interest). an increased share price of their portfolio The first successful proxy fight (Stada, companies. They employ intervention and August 2016) resulted in replacing the campaigns built around some of the building chairman of the supervisory board; six prior blocks that we have presented. KUKA attempts (Babcock Borsig (2002), Volkswagen demonstrates that hedge funds may align (2006), CeWe Color (2007), Ehlebracht (2010), themselves with blockholders to ride a rising Infineon (2010), Balda (2012) had failed. stock price. On the other hand, German family Evidence for improvements blockholders may use activists to attract the and value creation interest of international institutional investors The Demag Cranes case evidences support following the latter’s recommendations with for the strong shareholder rights perspective. the ultimate objective of boosting share value Cevian Capital through its shareholder and selling their position – displacement rights obtained supervisory board through defection. Some activists adapt representation by dint of negotiation and their strategies to the German context and actively participated in the firm’s corporate demonstrate commitment to their portfolio governance. The transaction created companies, while German blockholders substantial value for all investors. Assuming utilise activists to increase the value of their that the shares were purchased at €26 and holdings, thus changing their preferences sold at the increased offer consideration from commitment to liquidity. of €45.50 per share, this represents a Not unlike studies in the US, there are 75 per cent gain for the investors within one empirical findings in Germany that show year. Demag’s shares later peaked at €60 there is considerable disciplinary power and were trading above €50 for most of 2012. inhering in activist hedge funds. Virtually So it appears that in Germany, both the all listed companies in Germany (which corporate governance framework of listed have shrunk from about 1,000 to 650 in companies and minority shareholder rights recent years) have an IR department now, are strengthened in comparison to the US. monitoring closely their investor base. Cevian is currently invested in Bilfinger Many of them anticipate potential Berger and KruppThyssen, having been also investments, interventions and engagements engaged earlier with Daimler and Munich Re. by activists and, in order to thwart campaigns, Cevian seems to display confidence in the implement some of the typical activist current German corporate environment for demands, such as extra dividends, share engaged minority value shareholders, both buybacks or selling non-core divisions. www.ethicalboardroom.com

Global News Middle East

Dubai’s first woman-led hotel UAE-based hospitality brand Time Hotels has unveiled plans for a new Dubai hotel that will be managed almost entirely by women. The new four-star accommodation in the city’s Al Barsha shopping district will aim for the workforce to be 80 per cent female. “The concept will provide career opportunities for more than 100 women, contributing towards goals set out by His Highness Sheikh Mohammed bin Rashid Al Maktoum, VicePresident and Prime Minister of the UAE and Ruler of Dubai (pictured below), to increase the presence of women in the workplace,” said Time Hotels’ CEO Mohamed Awadalla. “We want them [female staff] to feel special, as part of an exciting initiative advancing the case for more women in hospitality boardrooms.”

LafargeHolcim CEO quits over Syria scandal Eric Olsen (pictured below) is stepping down as chief executive of LafargeHolcim — the world’s largest cement maker — after the company admitted it paid armed groups to keep a factory operating in Syria. LafargeHolcim confirmed it paid protection money to various local militias to guarantee safe passage for employees and to supply its Jalabiya plant in northern Syria. The factory opened in 2010, after an investment of $680million over three years, and stopped operating in September 2014.

Qatar looks beyond trophy assets Tadawul seeks out foreign investors Saudi stock exchange Tadawul has moved to a two-day settlement cycle for listed securities in an effort to attract more international investors. As well as a shift to the T+2 cycle, Tadawul has also introduced securities borrowing and lending, as well as covered short selling. “Tadawul’s shift to T+2 and introduction of securities borrowing and lending together with other recently implemented changes constitute a major delivery of far-reaching capital market reforms to enhance access, liquidity, efficiency and transparency in the Saudi market,” said Khalid Abdullah Al Hussan, chief executive officer of Tadawul. “With these changes, we are determined that Tadawul will become an important new factor in global equity markets, both as a source of capital and an investment destination.”

110 Ethical Boardroom | Spring 2017

First Abu Dhabi Bank gets shareholder nod

Shareholders of the National Bank of Abu Dhabi have approved a proposal to change its name to First Abu Dhabi Bank. The name change follows the legal completion of the merger between First Gulf Bank and National Bank of Abu Dhabi, making it UAE’s largest bank and one of the biggest in the MENA region, with total assets in excess of AED 670billion (£140million). The bank’s CEO, Abdulhamid Mohammed Saeed, said it will be “focussed on establishing itself as a financial services leader that puts its customers first, delivers top shareholder value and drives individual and institutional prosperity,” said chief executive officer Abdulhamid Saeed.

The Qatar Investment Authority (QIA), the world’s ninth-largest sovereign wealth fund, is making a shift from ‘trophy assets’ to a low-cost, passive style of investment, FT.com reports. It claims that the QIA is exploring more ‘plain vanilla’ investment and less foreign visibility in luxury businesses, as it looks to diversify its holdings in light of low oil prices. Investment by national funds in trophy assets aimed at wealthy customers, including Tiffany, Porsche and LVMH, fell from $13billion in 2009 to $1.4billion in 2015, according to analysis by Madrid-based IE Business School. www.ethicalboardroom.com

For registration and more information:

www.hawkamahconference.org www.hawkamah.org

Corporate Governance Awards | Introduction

Ethical Boardroom Middle East award winners 2017 Family owned and managed companies constitute a major part of the economies of the Middle East – figures suggest that around 80 per cent of organisations are ‘in the family’, producing more than 90 per cent of the region’s non-oil wealth.

While the region’s family businesses continue to be successful, changing political and economic environments are affecting both their current performance and growth expectations. Governing them can also be very complex. Compared to their western counterparts, many Middle East family businesses are relatively young and facing succession issues for the first time. A worrying 91 per cent of Middle Eastern family businesses have no succession plan, which is higher than the global average of 85 per cent, according to PwC’s Middle East Family Business Survey 2016. As discussed in this issue of Ethical Boardroom, effective family governance is about putting in place frameworks to allow for business continuity to the next generation while protecting the legacy of the founders. Successful family businesses will view succession as a long-term process

that is personal and addresses family issues and anxieties. High-performing boards will also ensure that individuals are developed and that effective succession plans are in place, maintaining a governance framework that adds value to the business while safeguarding and enhancing the company’s values and reputation. Having more female representation on the board and at senior management is an area where Middle East companies could also gain tremendously. While countries in the region have been making progress in recent decades to bridge the gender gap, they still lag far behind their western counterparts. According to a 2016 study of nearly 1,500 publicly-listed

companies in 13 countries across the MENA region, only 17 per cent had some female representation on their boards. Out of the 249 companies with female representation on their boards, only four per cent had female board chairs – far fewer than the ratios in most developed economies. Increased female representation in the boardroom and among the ranks of senior management is essential – not only for driving better performance but also for improving economic growth across the region. The companies that excel in the Middle East are aware of the importance of this as a key corporate governance issue and ensure such good governance spreads throughout their organisations via strong policies and procedures. 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 company’s success and a board’s contribution to the creation of long-term value. Ethical Boardroom is proud to announce its Corporate Governance Awards Winners in the Middle East.

The companies excelling in the Middle East are aware of the importance of good corporate governance and ensure this spread throughout their organisations via strong policies and procedures

112 Ethical Boardroom | Spring 2017

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AWARDS

The Winners | Corporate Governance Awards

WINNERS 2017

MIDDLE EAST

OUR WINNERS TELECOMS: ZAIN GROUP (KUWAIT) FINANCIAL SERVICES: BANK AUDI S.A.L (LEBANON) CONGLOMERATE: SAUDI BASIC INDUSTRIES CORPORATION (SABIC) MINING: SAUDI ARABIAN MINING COMPANY (MA’ADEN) FOOD & BEVERAGE: AGTHIA GROUP PJSC TRANSPORTATION & LOGISTICS: DP WORLD OIL & GAS: DANA GAS PJSC INDUSTRIAL SERVICES: ALUMINIUM BAHRAIN (ALBA)

LEBANON ■ Bank Audi S.A.L

SAUDI ARABIA ■ Saudi Arabian Mining Company (Ma’aden) ■ Saudi Basic Industries Corporation (SABIC)

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BAHRAIN ■ Aluminium Bahrain (Alba) KUWAIT ■ Zain Group

UNITED ARAB EMIRATES ■ Agthia Group PJSC ■ Dana Gas PJSC ■ DP World

Spring 2017 | Ethical Boardroom 113

MIddle East | Family Governance

Dr Ashraf Gamal El Din

Chief Executive Officer, Hawkamah

Evolving governance for MENA family businesses Corporate governance practices in the MENA region have improved significantly over the past decade. Regulators across the region have developed corporate governance codes and frameworks for listed companies and, in many cases, for banks, which have resulted in substantial improvements. State and family-owned enterprises often fall outside governance regulations, but increasingly such companies are recognising the benefits of good corporate governance in terms of better decision- making and control processes and many have taken steps to ensure that effective governance structures are in place. However, for family businesses the effectiveness of corporate governance is largely dependent on an additional element – on family governance.

Family businesses in the region Listed companies and state-owned enterprises may be the most visible 114 Ethical Boardroom | Spring 2017

Adopting both corporate and family governance structures protects the legacy and ensures continuity companies, but family businesses are the core of the Gulf economies. Figures suggest that around 80 per cent of the companies in the region, producing more than 90 per cent of its non-oil wealth, are family-owned or controlled. Most of these companies are relatively young, with many of the successful businesses having been set up in the 1970s boom years. It is also estimated that over the next decade half of these companies, controlling assets worth $1trillion dollars, will be passed on to the next generation. This is a case for concern. Family businesses are notoriously vulnerable during periods of transition. The oft-quoted statistic states that only about 30 per cent of family and businesses survive into the second generation, 12 per cent are still viable into the third generation, and only about three per cent of all family

businesses operate into the fourth generation or beyond. Or as the Chinese saying goes: ‘fu bu guo san dai’, which roughly translates as: ‘wealth does not pass three generations’. The most critical issues facing family businesses are not business-based but family-based. And the challenge facing family businesses is often understood to be a problem of succession, both management and ownership succession. Who will take over the reins at the company? How will the ownership be shared among the family members? And how will the owners be involved in the business? These are all sources of potential conflict among family members. It has been estimated that the great majority of Saudi family businesses have at least one succession related dispute in the courts.

Succession as a long-term process

Succession is often a sensitive topic to discuss. Founders often find it difficult to let go of the business they have built and from which they derive much of their identity – they see the company as an extension of themselves. The children are www.ethicalboardroom.com

Family Governance | MIddle East

LOOKING TO THE FUTURE Family governance requires a framework put in place to allow for business continuity

often uncomfortable discussing their parentâ&#x20AC;&#x2122;s mortality and do not wish to open such conversations for fear of being seen greedy. Non-family employees are often not in a position to instigate such discussions, either, and they may not be comfortable with potential changes. There is a tendency to view succession as a one-off event, for which the required responses are deemed to be rather technical in nature, best dealt with by estate lawyers, accountants, tax advisors and recruitment consultants in the case of hiring a non-family CEO. However, instead of looking at succession from the technical perspective, family businesses should view succession as a long-term process which is personal and often emotional, addressing family issues and anxieties. In fact, successful succession is typically dependent on how well the overall family governance systems have been instituted.

Family governance process

Studies show that family businesses tend to outperform their non-family counterparts and this is often because of the family element, meaning that there is a higher level of trust and commitment than usually found in non-family businesses. The family element, i.e. the emotional bond that helps the family business strive, may become the source of interference. The key is to develop a mechanism to preserve the inherent strengths of family businesses, while minimising their inherent weaknesses. The family governance process should start by articulating the vision for the business and its relationship with the family. www.ethicalboardroom.com

Studies show that family businesses tend to outperform their non-family counterparts and this is often because of the family element, meaning that there is a higher level of trust and commitment than usually found in non-family businesses The success of family businesses is dependent on their owners. During the first generation, family members, executives and employees tend to be aligned on what the business stands for and are united towards the same goals, but there is a danger of this alignment breaking down in subsequent generations. As the second generation starts to take over the business, the issues tend to become more complex and the level of complexity depends on the number of family members. Owners who are unanimous about the direction and means for developing their company, and who select the best representatives from among themselves and external professionals to manage the company, are able to run profitable and successful family business. Diverse expectations of the business among various family members will dissociate and weaken the business, family and ownership. Spring 2017 | Ethical Boardroom 115

MIddle East | Family Governance The key is to create conditions in which not only the ownership of the business is transferred to the next generation, but also the values and purpose of the business, and to build family legacy – i.e. attachment to the company that goes beyond mere financial relationship. This requires open communication within the family, between the generations, identifying the expectations, values and ultimately determining whether the governing principle should be ‘family first’ or ‘business first’. The outcome of these discussions should be formalised in a mission statement or a family constitution, which then regulates the family’s relationship with the business. The family owners should then establish policies to support this relationship. Such policies include a family employment policy that clarifies expectations to both family and non-family employees. It may contain several conditions for family members before entering the business on a full-time basis, such as required education and outside work experience. Employment policies often stipulate that family employees should not report to other members of the family, that family employees are subject to regular performance review practices and that their compensation levels are based on market value. Other key policies that family owners should formulate include dividend policy, family ownership policy and philanthropy policy, which are typically included in the family constitution.

Family communication

In order to maintain continuity across the generations, family owners should formulate mechanisms for regular communication between family members. Some family constitutions specify annual family retreats or regular family forums to ensure a good flow of information as well facilitate sharing of ideas and opinions. Such forums also help nurture the next generation of stewards of the family business. In families with a large number of members, family owners often set up a family council in which selected family members are entrusted to engage with the company, while reporting to the wider family (or family assembly). The underlying principle is that the family members should have systems in place for communicating with each other as well as a mechanism through which the family can speak to the company with one voice. One size does not fit all when it comes to family governance. Each family will have their own solutions to each step of this process, depending on their history, values, resources and circumstances. The contents of each family constitution vary greatly, but what is important is that families follow a similar

In order to maintain continuity across the generations, family owners should formulate mechanisms for regular communication between family members

process to establish the rules and values governing the relationship between the family and the business. A proper family governance framework provides a solid ground for the company’s corporate governance framework to grow. When the family speaks with one voice, the company’s board of directors will have a clear long-term vision on what is expected of them and this will result in an empowered board reporting to active, long-term owners. Without a proper family governance framework, boards and management are often subjected to operational and even contradictory interference by various family members. A strong family governance framework will limit such interference and help management focus on executing the long-term strategy for the company. Family governance is about putting in place frameworks to allow for business continuity to the next generation while protecting the legacy of the founders. Some of the most famous companies around the world, including Mars, Cargill, BMW and Walmart are family businesses and they continue to be successful across multiple generations. This is not a matter of luck. Such families put in the effort to maintain and refine their family governance frameworks on an ongoing basis. They recognise the challenge and earn their success. Instituting a family governance framework is challenging but it is essentially about fixing the roof while the sun is shining.

IT’S GOOD TO TALK Family members should have a system in place to communicate with each other

116 Ethical Boardroom | Spring 2017

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Middle East | Gender Diversity

Gender diversity on MENA boards Let’s start with a story. A leading retailer operates department stores in malls across the Middle East. The company’s customer base is overwhelmingly female – in fact, women make up more than 80 per cent of its customers. It would stand to reason, then, that the team building strategy for this company, whose fortunes are so intertwined with catering to the tastes of its female customers, would include several women. But, no. On a nine-member company board, only one director was female. This begs the question: for a company playing in a competitive industry so heavily reliant on being right about fast-moving fashion trends and consumer tastes, how could they make good decisions if they didn’t have representation from among the ranks of the very people who would – or would not – buy their products? The point here is not to single out one company. Rather, the point is that having more female representation at the board and senior management levels enables companies to make better decisions, which will drive stronger performance, increased profitability, improved valuation and greater potential for growth. Qualified women bring strong skills, fresh perspectives and a different way of handling issues than their male counterparts. Numerous studies have shown that diverse boards enable companies to operate more efficiently and perform more effectively, helping them improve profit margins, return on equity and valuation, while reducing their risk of exposure to corruption, fraud and scandal. Such evidence of outperformance is making investors sit up and take notice. Recently, US-based State Street Global Advisors, one of the world’s largest asset managers, announced that it will be issuing new gender guidance to increase female representation on the boards of companies in which it invests. It’s not merely because women comprise 50 per cent of the global workforce and it’s the right thing to do. Rather, the issue is achieving strong financial performance, determined in large part by the direction the board sets. “As the third largest asset manager in the world and a significant shareholder, we believe that board diversity enhances board quality – bringing together directors with different skills, 118 Ethical Boardroom | Spring 2017

Shattering the glass ceiling is an economic imperative in the Middle East Sanaa Abouzaid

IFC Corporate Governance Lead, MENA backgrounds and expertise,” said Jill Mavro, senior managing director at State Street.

On women in leadership positions, MENA lags behind other regions

In 2016, publicly traded companies in 16 countries worldwide averaged three or more female directors – considered the critical mass needed to optimise the positive benefits of diversity. Of these 16 nations, all but two – Canada and South Africa – were in western and northern Europe, according to research from executive search firm Egon Zehnder. Other regions, such as Latin America and Asia, aren’t doing all that well. The Middle East and North Africa region lags behind them all. Here, the lack of diversity is severe. The numbers are actually quite alarming. A 2016 study of nearly 1,500 publicly listed companies in 13 countries across the MENA region by Shareholder Rights and the EuroMena Funds found that only 17 per cent had some female representation on their boards. Out of the 249 companies that did have female representation on their boards, only four per cent had female board chairs. “Arab markets on average have female board members in one of six companies. This is much lower than the ratios in most developed economies,” the report noted. Of the industry sectors reviewed, the banking and financial services industry had the highest female representation, with 93 companies reporting that they had at least one female director. Among the worst performers were media companies, none of which had a single woman on their boards. Another study, this time by IFC, of just one country – Jordan – revealed similar findings. Of more than 1,200 Jordanian companies surveyed in this IFC study, nearly 80 per cent had no female representation on their boards. Of the companies that did have women directors, fewer than four per cent had more than one woman on the board.

The same IFC study draws a link between greater diversity and improved financial performance, as reflected by return on assets and equity: the Jordanian companies with female directors had three times the return on assets and double the return on equity compared to companies with no women on their boards. One female Jordanian executive – the founder and general manager of a confectionary company – summed up the business case for more women in the boardroom this way: “Diversity leads to excellence in business, less corruption and more proactive and productive boards.”

Why the stakes are so high for MENA countries

Simply put MENA countries really need vibrant private sectors. In a region where many countries struggle with instability, unemployment is high, opportunity is limited and the public sector is overwhelmed, growing the private sector is the path to economic progress. However, this requires attention to the factors that are getting in the way of private sector growth, including an overall gender gap in the labour pool and lack of female representation at the highest levels of business leadership. The International Monetary Fund recently quantified the value of increased women’s participation in the global workforce at all levels. Among the statistics cited in this paper, one stands out: closing the gender gap in Egypt’s labour market would raise that country’s GDP by more than 34 per cent. Imagine what that would mean in real terms: higher personal incomes, reduced poverty, more manufacturing and services output, greater private sector growth and increased tax revenue to support critical public sector projects and social welfare initiatives.

Understanding root causes of inequality is key

The reasons for MENA’s poor performance on measures of gender parity, particularly when it comes to board and senior management, are many, complex and inter-related – too lengthy to detail fully in this short article. However, it’s important to share a few of these issues, because any effort to create lasting solutions requires an understanding of these underlying causes. For instance, the region still has a long way to go in ensuring equal access to quality education. While this is not the case region-wide, female literacy remains a huge challenge in many countries. If you can’t read and write, very little will follow. www.ethicalboardroom.com

Gender Diversity | Middle East

A 2016 study of nearly 1,500 publicly listed companies in 13 countries across the MENA region found that only 17 per cent had some female representation on their boards

ROLE TO PLAY Leaders must get better at addressing diversity www.ethicalboardroom.com

Spring 2017 | Ethical Boardroom 119

Middle East | Gender Diversity

120 Ethical Boardroom | Spring 2017

their part by working hard, moving up through the ranks, being prepared and actively seeking out ways to build their skills and networks – signing up for training, joining professional organisations, networking and reaching out to others who have made it.

Focus on diversity yields results The retailer I mentioned at the start is but one of many companies in MENA that are now paying more attention to board composition as part of a broader corporate governance strategy aimed at strengthening the company. Another firm, a Jordanian microfinance institution with a 96 per cent female customer base, recently worked with IFC on an overhaul of its board of directors, in addition to other governance upgrades. The company weeded out poor performers and brought on more women and independent directors, among other actions. Today, the board is comprised of 42 per cent women, while 70 per cent of its workforce and 80 per cent of its branch managers are women. The firm’s top three executives – general manager, chief operating officer and chief financial officer – are all women. These changes have yielded significant benefits: increased access to capital, lower cost of financing, improved decision-making, expanded product portfolio and enhanced market reputation. The bottom line here is that for MENA, failure on the diversity issue truly is not an option. Increased female representation in the boardroom and among the ranks of senior management is an absolute must to boost private sector performance and improve economic growth across a region that desperately needs it.

MENA AT A GLANCE: FEMALE REPRESENTATION ON BOARDS 240 Source: Women Representation on Boards of Directors on MENA Exchanges, Shareholder Rights, October 2016, page 9

220 200 180 160 140 120 100 80 60 40

n Total number of companies

n Total number of companies with board information

Lebanon

Qatar

Bahrain

Palestine

Dubai

UAE

Morocco

Tunisia

Iraq

Oman

Saudi Arabia

Kuwait

20 Egypt

How to address such complex problems? The answer requires multipronged approaches tailored to the specific country, industry and market context. Just as there are many factors contributing to the problems, the responsibility for solving them must be shared. To begin, we need to raise awareness on the issue. It always comes as a surprise when smart, capable and effective male leaders, who are otherwise acutely tuned in to indicators, such as declining share value, revenue shortfalls, or failure to hit profitability targets, don’t realise that the lack of diversity in the boardroom could be a reason for disappointing performance. In particular, leaders of family-owned companies have an outsized role to play, given the predominance and size of such firms in the MENA region. These leaders – often the family patriarchs – are in a powerful position and can bring about significant change. By encouraging a steady career progression for their female family members, they are nurturing a growing talent pipeline, ensuring that these women develop the qualifications and experience to eventually assume senior-level responsibilities. At the company level, individual firms must get better at providing career planning,

Jordan

Progress requires solutions that address underlying problems

coaching and mentoring to keep women from dropping out of the workforce or falling behind at the mid-point in their professional lives. Meanwhile, their boards need to make room for the women who are coming up through the ranks by setting term limits, mandatory retirement ages and a mechanism to evaluate performance. If directors are not doing the job, they should be asked to step aside. Training is a critical aspect as well. Training for all board directors, particularly in emerging market countries, has proven helpful in providing grounding in board fundamentals. For women, additional modules focussed on soft skills, such as making one’s voice heard and dealing with strong personality types, will increase their effectiveness as they perform their directorial duties. Local corporate governance institutes can provide such programmes, as well as networking and knowledge-sharing opportunities. They also can serve as central clearing houses, maintaining databases of qualified female candidates so that companies in search of more diversity can easily access lists of potential directors who could meet their needs. Regulatory bodies also have a part to play in this. To be sure, quotas are a controversial topic. However, regulators can still take steps to prioritise gender diversity, even if they don’t want to go the quota route. For example, encouraging more gender diversity on the board aligns well with the growing international push for more independent directors as a way to broaden perspectives and add complementary skills. Finally, women themselves need to own the issue. Rather than sitting back and blaming others for lack of opportunity, they can do

Total number of boards of directors

In other countries, even though educational attainment is quite high and more women than men graduate from university, fewer of these women enter the workforce. In Kuwait, for example, women comprise 60 per cent of university graduates and only 22 per cent of the workforce. Several dynamics play into this disparity, including cultural barriers, family wealth that obviates the need for two incomes and struggles with work-life balance. Other factors include attrition at the mid-management levels, with women often dropping out of the workforce during their child-bearing years. The result is that the female talent pipeline, which may have been closer to equivalency at the entry level, begins to narrow mid-way through. With a smaller pool of qualified women who have come up through the ranks, more of the senior management positions go to men. A similar phenomenon seems to occur in other professions, creating a shortage of qualified women who could potentially serve as independent directors, such as bankers, accountants and consultants. Also playing into the problem is lack of training for potential directors and limited information on available female candidates. In addition, the nature of boards, with very little turnover and static composition – drawing from the same small group of male professionals – means that on the rare occasion when an opening does occur, the seat is quickly filled by someone well known to everyone else who is within the same male-dominated networks.

n Total number of companies with female directors www.ethicalboardroom.com

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Middle East | Board Evaluation EXECUTIVE COACHING Director training is essential for keeping up with the latest trends

Jane Valls

Executive Director, GCC Board Directors Institute

Improving performance within the boardroom Boards are only as good as their individual directors, so why wouldn’t you want to invest in their continual professional development? “Behavioural psychologists and organisational earning experts agree that people and organisations cannot learn without feedback. No matter how good a board is, it is bound to get better if it is reviewed intelligently.”1 So wrote Jeffrey Sonnenfeld in the Harvard Business Review. And he’s right, but while more and more attention these days is paid to the qualifications of senior management

122 Ethical Boardroom | Spring 2017

to carry out their responsibilities, there has never been any formal qualification required to run an organisation. And none to be a director. This gives rise to the importance of director training. Successful governance depends first and foremost on the skills, dedication and integrity of the company’s leaders. And the heart of sound corporate governance lies in the boardroom with directors’ responsibility and accountability. Directors and senior management therefore need to fully understand the underlying principles of good corporate governance. They need to understand best practices

and how to adapt and implement them in their organisation. Boards also need to ensure the development of a business culture that is conducive and receptive to sound business principles. A sound corporate culture is essential. The tone starts at the top and boards must be concerned with the reputation of their institution. The awareness of the importance of corporate governance must permeate all the way through the organisation and boards must ensure that good policies and procedures are in place to prevent and detect any violations of regulations.

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Board Evaluation | Middle East

And the role of the chairman of the board is crucial. Chairmen need to understand that their role is to lead the board; to facilitate board decisions and board dynamics. Their role is not to manage the company. I see many boards that could be so much more effective if they had proper corporate governance practices in place. Apart from anything else, busy directors benefit from good governance, from efficiently run board meetings, good board and committee processes and keeping up to date with the latest director trends. Commenting on the VW emissions scandal, governance advisor Seamus Gillen observed “Companies don’t fail - boards do.”2 So, if you believe that prevention is better than cure, including knowledge of the principles and the practice of corporate governance, director training is essential. The role of the director has evolved. Companies operate in more and more complex globalised business environments. So, it is only right that directorship has finally begun to be seen as a profession, or at least a discipline, requiring specific professional training and development. Director training and board induction should be mandatory.

Importance of good governance For the developing countries in the Arab region, the importance of good corporate governance is a key consideration. It is an important part of our individual national visions. And it is a sine qua non if we are to attract more foreign direct investment. The implementation and the maintenance of sound corporate governance practices and structures at every level of our societies is imperative for the continued well-being and development of our economies. A key part of our mission at GCC Board Directors Institute is to build better board director capabilities and we do that by sharing best board practices. Our two essential core director workshops are: ■■ Foundations of directorship ■■ Mastering the boardroom These workshops are based on our competency matrix of the six pillars of board effectiveness – see the graphic right. In addition to the above workshops, GCC BDI offers a range of other workshops to broaden and deepen directors’ knowledge and skills. We believe that professional director development is not just a one off, but a continuing programme of honing skills and updating knowledge mixed with practical boardroom experience and application. So, our programmes offer directors the opportunity to share knowledge, experiences, effective practices and challenges faced by their boards as well as network with like-minded individuals in an informal

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environment – either an open workshop where culture and goals of a particular board and they can also network or in the privacy and company in order to be effective. The key confidentiality of their own boardroom. to success is for the board to be actively Director coaching is also becoming popular engaged in the assessment process. It is and helps to bring out the best in individual equally important to be clear about the directors to enable the board to work better objectives in the assessment process and as a team. Executive coaching for directors what they really want to accomplish. is usually based on one-to-one coaching to There are a few different approaches, which help individual directors address specific can be mixed and matched, in undertaking professional development board evaluations, depending issues or assist them in taking For a board that upon the board’s needs, on a new role. It is particularly prior experience, chemistry is tackling an relevant for new or and appetite for the evaluation for the process. They include: prospective directors, for non-executive directors first time, it is best Survey Any survey should and as part of a board to start with some be carefully tailored and development programme. Improving the effectiveness general discussion designed for a specific company and its board and of the board is a priority at the committee be constructed by drawing for leading organisations from the corporation’s bylaws, everywhere. The heightened level and then committee charters, the level of accountability and follow this at roles and responsibilities responsibility, which requires board level of directors and corporate boards to improve their own governance guidelines. The performance, means that survey should produce reliable results and boards need to carefully review the board’s feedback is usually presented in the context of roles and responsibilities and then determine a goal-setting process with the board, intended whether it is performing adequately to protect to improve performance and educate the board. the interests of all stakeholders. So, board evaluation is a key activity for the board. Interviews Interviews of the board often The purpose of the exercise is to ensure that are used prior to a board assessment – boards are staffed and led appropriately; that particularly where boards have not previously board members are effective in fulfilling their done an evaluation – to gain an understanding obligations; that reliable processes are in place of the issues on directors’ minds. Typically, to satisfy important oversight requirements; an outside facilitator interviews directors and that key board activities are being individually, using a structured questionnaire addressed. Evaluations should take into that takes into account the company’s account context, key issues and sensitivities bylaws, charters, guidelines and codes of as well as performance. conduct and ethics. Based on the results For a board that is tackling an evaluation of the interviews, the governance committee for the first time, it is best to start with some provides anonymous feedback to the board, general discussion at the committee level often in the form of a narrative report that and then follow this at board level. Board is organised thematically, according to key evaluation is not a one-size-fits-all proposition areas for board improvement. and needs to be tailored to the 6 BOARD EVALUATION AND RENEWAL

1 Board composition and directors’ capabilities

2 Director duties and responsibilities

3 Board structure, processes and protocols

5. EFFECTIVE BOARD DYNAMICS Interactive meetings, discipline in discussions, probing & conflict management 4. DELIVERING ON THE ROLES OF THE BOARD 4a Strategy development

4b Performance management

4c Risk management

4d Capital markets

4e Senior management evaluation & development

6 PILLARS OF BOARD EFFECTIVENESS

Spring 2017 | Ethical Boardroom 123

Middle East | Board Evaluation GROUP TRAINING The primary objective of board evaluation is to improve performance

Group evaluation During a group evaluation, a trained consultant engages the board and the CEO in an interactive dialogue. Working against a backdrop of general best governance practices and the specific bylaws and guidelines for the company, the discussion focusses on how a board can improve its performance. This approach works best when directors are able to talk candidly and openly and have a limited amount of time to devote to the process. Once again, feedback is geared to setting goals for the board to improve its performance and the real value of the assessment exercise is derived through the final session when the board evaluates the findings and discusses what measures, if any, to act upon. Boards should view evaluations as a valuable opportunity to refocus on critical issues and improve performance. Of course, evaluations on their own are not enough and need to be followed up to have the maximum impact. This includes engaging directors in discussion about the results, following through with a plan of action for addressing points that arise from the discussion and assigning follow-up responsibilities to the governance committee or the board chair. In order to be truly effective, board evaluations should be done on a consistent annual basis. Board evaluations will and should change somewhat from year to year; priorities may shift, depending on the critical issues facing the board. Questions should be relevant to the board’s current tasks and should be based on the needs of the board at the particular time when the evaluation is planned. Moreover, questions should be targeted to focus on areas of board

124 Ethical Boardroom | Spring 2017

performance, not CEO and staff performance, which also are essential exercises, but discrete ones from evaluating the board. The prime objective of board evaluation is therefore to improve the performance of the board and the company. Assessment is merely the tool. A well-planned and well-executed board evaluation that focusses on the unique culture, bylaws and needs of the board can reveal issues that hinder optimal board performance. Identifying and addressing these issues and reinforcing the appropriate board roles and responsibilities, can yield significant benefits to the board, the company and all stakeholders.

The board of directors has to understand that the buck stops with them. They have to live up to their duties and responsibilities. It is this corporate leadership that will ensure full confidence in our capital markets GCC BDI’s proprietary board evaluation tool assesses the effectiveness of boards based on our six pillars of board effectiveness and combines a survey as well as one-on-one interviews – all conducted in a non-attributive and confidential manner – to produce a fact-base and a road map of improvement opportunities. “The challenge for boards is to prevent crises in the organisations they govern.

Performance evaluation is a key means by which boards can recognise and correct corporate governance problems and add real value to their organisations.”3 The following are some common characteristics of high-performing boards: ■■ Clarity regarding role and focus ■■ An effective chairperson ■■ A balanced board team ■■ A culture of trust and respect High-performing boards will focus on a common set of tasks, which include responding to executive strategy and contributing to rigorous debate, monitoring the implementation of the strategy through the operational plans, overseeing the quality of leadership and management, ensuring that individuals are developed and that effective succession plans are in place, maintaining a governance framework that adds value to the business and safeguarding and enhancing the company’s values and reputation. The board evaluation will help the directors to take a step back and appraise all these questions. The board of directors has to understand that the buck stops with them. They have to live up to their duties and responsibilities. It is this corporate leadership that will ensure full confidence in our capital markets. Why would you not want to evaluate your board and see how they can perform better? What makes great boards great, Jeffrey Sonnenfeld (September 2002); Harvard Business Review pp. 106-113 Seamus Gillen on Volkswagen emissions scandal 3 Geoffrey C Kiel and Gavin J Nicholson (2005) Evaluating Boards and Directors. Corporate Governance: An International Review 13(5):pp. 613 631. (http://eprints.qut.edu.au/4935/1/4935.pdf) 1

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Technology | E-discovery

Brexit & beyond: nationalism and corporate data Investing in e-discovery skills is the smartest route to meeting the challenges of changing regulations For decades, prevailing winds have blown towards globalisation and open borders for data and information. However, these winds seem to have run out of puff, leaving organisations around the world becalmed and in uncertain waters.

This may be the age of big data, but it’s also the era of Brexit and surging nationalism. What seemed to be a clear path towards goodwill and cooperation is now open to reevaluation. In this brave new world, it is incumbent on boards of directors serving international organisations to understand the laws of many lands, the new jurisdictional challenges, and the strategies to address them. One of the clear battlegrounds will be in data, which remains one of the most potent and profound corporate and personal assets of the day. 126 Ethical Boardroom | Spring 2017

David Horrigan

E-discovery Counsel and Legal Content Director, kCura Data affects everything, from how we eat to who we elect. Data helps hospitals refine treatments for diseases we’ve struggled to beat for years while helping corporations retain and serve customers. And data helps – and potentially hurts – litigation and compliance; growing digital data volumes have turned every case into a potential e-disclosure case. Whether it’s in the United Kingdom, the United States, Russia, or China, nationalism affects British companies and the decisions that must be made in the ethical boardroom.

Brexit and the General Data Protection Regulation

Brexit is happening. When Article 50 was triggered on 29 March 2017, the world’s furtive discussions about the ‘if’ and ‘when’

were, in all likelihood, rendered academic. Tax lawyer Jolyon Maugham and others have filed litigation in Ireland in an attempt to halt the Brexit process, but in the United Kingdom, the people voted, Downing Street is following through, and Europe is preparing for the impacts, whatever they may be. Of course, the process of leaving the European Union isn’t as capricious as it could be. With a minimum of two years of negotiations ahead, there will be a measure of time that can be used to untangle the millions of knots joining the UK and the European Union. This is all evident to anyone reading the news. However, thoughts of a two-year distant decoupling or a longshot legal challenge by Mr Maugham must not distract corporate decision-makers from the very real jurisdictional challenges that will arise in the interim. Take, for instance, the EU’s General Data Protection Regulation (GDPR), one of the www.ethicalboardroom.com

E-discovery | Technology E-DISCOVERY IN THE BREXIT ERA The time is now to think about corporate data protection and personal data privacy

strongest steps ever taken to protect individuals’ data privacy rights and increase the requirements for the protection of corporate data. The GDPR replaces Directive 95/46/ EC of the European Parliament and of the Council of 24 October 1995 on the Protection of Individuals with Regard to the Processing of Personal Data and on the Free Movement of Such Data, known commonly as the 1995 EU Data Protection Directive, although it became effective in 1998. The change from the Directive to the GDPR was, in large part, an attempt to harmonise data privacy and protection law throughout Europe – a goal that goes by the wayside with Brexit. Or does it? Although adopted in 2016, the GDPR will not go in effect until May 2018. However, that will still be before Brexit is completed. Thus, despite Brexit, the GDPR will take effect in the UK. In fact, although Prime Minister Teresa May has said famously, ‘Brexit means Brexit,’ she has acknowledged that EU laws in force before departure will become UK law. Thus, corporate boards must plan and govern themselves according to the provisions of the GDPR. Among these provisions are data breach notification requirements, data subject consent requirements and the right to erasure (right to be forgotten), substantial www.ethicalboardroom.com

administrative fines for violations by data controllers and processors, and more. Of course, complicating matters is that corporate boards must also consider the possibility that in the post-Brexit world of 2019 and beyond, these data privacy and protection provisions could change once again if the UK decides to alter things post-departure. Thus, organisations that house data in the UK may be compelled to comply with three different data privacy and protection frameworks in the course of only a few years: the status quo, the GDPR, and whatever the post-Brexit world may bring. Another concern is that organisations with distributed data might seek to find another country in which to keep it before a changeover happens. Dublin has already seen an uptick in business inquiries since the Brexit vote. In any case, these jurisdictions may shift rapidly and the unprepared organisation has the most to lose. There are other examples, but Brexit is the clarion call that the time is now to think about corporate data protection and personal data privacy. It’s not just about choosing between the UK and EU, but rather how to navigate transfers between the UK and the rest of the world. To take the coming issues seriously, it would be smart business to bring a data protection and privacy wonk into the organisation as a trusted advisor and strategic decision-maker. One of the hot jobs in this new, shifting landscape will be chief privacy officer – boards should put

their executive recruitment firms to work as a soon as possible to beat the rush.

Understanding international litigation strategy

When litigation hits the fan, the strategies used to resolve it vary from country to country. One of the brightest promises of the EU has been legal integration. The original goal of the original European Economic Community (EEC) was that countries would buy in to an international business system. Of course, as corporate boards know, business and legal systems go hand in hand, and with the Maastricht Treaty in 1992, the European Community dropped the ‘Economic,’ and became part of the European Union, signaling business, legal, and – to a certain extent – cultural integration. Noble work towards that dream continues on the Continent, but nobody can pick up a legal system from a briefing book. For the curious mind, however, litigation rules are as good a place to start as any. And some of the most knowledgeable litigators can be found working in disclosure, a discipline that requires a handle on the system from even the hint of litigation through to the very final decision. As the disclosure expert on your team can tell you, EU laws currently allow organisations to file claims and begin litigation in one of several countries, depending on where the issue at hand occurred and where the damages occurred. Spring 2017 | Ethical Boardroom 127

Technology | E-discovery That means – depending on the facts of the case – an organisation can choose to litigate in disclosure-enabled countries, such as the UK, or opt for many of the civil law nations in the EU with less of a tradition of e-disclosure or e-discovery. Of course, some corporate boards may be glad that a post-Brexit Britain may limit such legal forum shopping. On the other hand, since the formation of the EU, members have relied on these litigation options and sovereign laws. Contract composition and data norms have meshed together. Extracting a solution will be difficult if the trend away from globalising these systems continues. Of course, organisations could take a page from the US playbook and look at alternative dispute resolutions; most cases in the States are settled between counsel and clients outside of the courtroom. Of course, this is not to say, litigation costs are less in the United States. They’re often substantially higher. In any case, in the same sense that it’s time for organisations to understand their data, they must understand their litigation options. The experts at e-disclosure and other legal services firms are key resources in reaching understanding. Already prepared for cross-border legal issues, they could provide much-needed perspective during strategy shifts.

The privacy v. security debate

Governments have developed a taste for data. New demands for the opening of private data are happening all the time on domestic and international scales. And while data can provide measures of security, it is worth questioning how much we value that security against individual or corporate privacy. With that question in mind, think on another as well: who ultimately makes the rules as far as privacy and security are concerned? Government intelligence agencies could well make an overbroad bulk collection of data and claim all that data was necessary to keep the people safe. It has happened around the world. As international privacy advocates note, mass surveillance will only continue to grow, and this surveillance should be a factor in corporate data decisions. Organisations, of course, have very different concerns than do private individuals. And a core concern is – or should be – about privacy liability for where data is handled and stored.

law, the Stored Communications Act, it mattered not where the data were stored, but who controlled the data – in this case, Microsoft, a US corporation subject to US law. On the other hand, Microsoft argued the US government lacked the legal right to seize the data in Ireland. The government prevailed at the trial court, but an appellate court reversed the decision, siding with Microsoft. However, the issue may not be resolved. In a 2017 decision, In re Search Warrant No. 16-960-M-01, a federal trial court in the US state of Pennsylvania ruled for prosecutors in a similar case involving a warrant to Google. What have been battles between tech companies and prosecutors may become a battle between US courts reaching different legal conclusions.

The ethical boardroom owes a duty to its organisation to govern its data in compliance with applicable laws and regulations. Increasing global nationalism increases this challenge, but meeting these duties isn’t impossible Although these cases originated in the US legal system, the question of when governments might compel companies to provide data is very much an international one. In a more globalised world, we might work towards a unified theory of data privacy. However, we’re not heading in that direction. In fact, laws such as Russia’s 2015 data localisation law, restrict the movement of certain types of data outside the nation’s borders. In addition, China’s State Secrets Law and its upcoming Cybersecurity Law have the unfortunate combination of being very broad and very vague. In addition to court decisions and new laws, global nationalism – and legitimate

privacy concerns – threaten agreements, such as the Privacy Shield Framework. Complicating these legal issues are technical issues, namely the nature of digital data itself. You can have your data centre in one country, but data lives everywhere all at once. With distributed networks and a mobile global population, information travels. If it was difficult in a globalising economy to get government and organisations to cooperate and agree on privacy standards in the face of such movement, it may only become more so going forward.

Going forward with nationalism and corporate data As we’ve noted, Brexit is by no means the only example of nationalism affecting corporate data across the globe. Even before the nationalistic issues in last year’s US presidential election, US prosecutors believed they had the duty to fight crime by seizing data in overseas servers controlled by Americans. Whatever its motives may be, Russia feels the need to stop the flow of data from its borders, and China feels the same. The ethical boardroom owes a duty to its organisation to govern its data in compliance with applicable laws and regulations. Increasing global nationalism increases this challenge, but meeting these duties isn’t impossible. Whether it’s EU nations with data protection officers or other nations with chief privacy officers and data protection teams, internal controls will help. Of course, monitoring international laws is a given – especially when we may see rollbacks of international agreements, such as the Privacy Shield Framework It also goes without saying that outside counsel can help meet these challenges. In addition, an old maxim applies here: for every problem technology creates, more technology can solve. The combination of learned counsel and new technologies has met challenges in the past, and it will in the future – even in an era of global nationalism.

Beyond Brexit

These jurisdictional considerations and the privacy v. security debate aren’t solely issues of Brexit and the GDPR – yet they can still affect decisions in a British boardroom. One case in the United States was a flashpoint in this discussion: the 2016 case of Microsoft Corp. v. United States, known commonly as the Microsoft Dublin warrant case. In Microsoft, government prosecutors sought user data located on Microsoft servers in Dublin, arguing that – under a US 128 Ethical Boardroom | Spring 2017

GLOBAL NATIONALISM Companies have a duty to consider how they govern data www.ethicalboardroom.com

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Regulatory & Compliance | Board Compliance

Overseeing the board’s compliance programme Recent corporate scandals have revealed a weakness in many compliance programmes – board oversight. We have seen time and again the detrimental results of a board that is not trained to manage compliance issues. The VW emissions scandal and last year’s VimpelCom enforcement action are great examples of what can go wrong. When a company’s board does not fully understand its duty of oversight and is not providing effective leadership on corporate culture, it is doomed to fail in its fiduciary responsibilities to detect and prevent misconduct. The VimpelCom enforcement action from last year was a shocking example of a board that had nearly abdicated its compliance oversight responsibilities. When VimpelCom executives were seeking approval to acquire two companies, the board simply never asked a very basic question – who are the beneficial owners of the target companies to be acquired? If they had obtained the answer to this basic question, VimpelCom could have possibly avoided the FCPA disaster resulting in more than $700million in fines and penalties. So, how do you ensure that your board is fully aware of its compliance oversight responsibilities? With training.

The training deficit

Unfortunately, the numbers show that board members and senior management are chronically under-trained. Based on a recent survey by Navex Global, more than 40 per cent of organisations do not train board members and only 20 per cent train new board members. For example, only 12 per cent of companies trained board members on workplace harassment; 33 per cent trained on conflict of interest; and only 22 per cent trained on cybersecurity. With corporate boards and senior leadership ultimately responsible for a company’s ethics and compliance programme, the lack of education and training stands as a significant risk to a company’s compliance programme. It is no secret that training a board is not an easy task – experienced and busy people who believe they already have the knowledge they need are not the most attentive or committed audience. In reality, board members often do not know as much as they claim and need a 130 Ethical Boardroom | Spring 2017

Michael Volkov

CEO and owner of The Volkov Law Group

How can a board fulfil its duty of oversight if it’s not trained in how to avoid disaster? refresher to remind them of both their responsibilities of programme oversight and how to set the tone for an organisation to develop a culture of compliance. Corporate boards are increasing their focus on compliance issues. Unless a board member has prior experience in the field, the board must be trained on compliance and has to learn how to oversee and monitor compliance issues. A compliance professional adds significant value to the board by ensuring that the board exercises appropriate oversight of

It is no secret that training a board is not an easy task – experienced and busy people who believe they already have the knowledge they need are not the most attentive or committed audience the compliance functions, monitors senior management compliance activities and devotes significant time and resources to the compliance and ethics function. Training board members is not about explaining the basics – they know that already. Instead, board training should focus on the role of a board in a compliance programme and how members can contribute to building a culture of compliance. A CCO should spend at least 30 minutes each quarter with his or her reporting board or committee. The report has to include an executive session during which honest and candid questions and discussions can occur. Frankly, a CCO who reports for longer than that – up to an hour – is better practice, especially in today’s multi-risk environment.

Any board and executive training programme should include some or all of these components:

Legal responsibility for compliance oversight

Board members often are familiar with their fiduciary duties, legal obligations imposed upon board members to act in the best interests of the company. When it comes to a compliance programme, a board should be informed of the ‘duty of oversight.’ This requires the board to make sure the company acts lawfully. In the United States, the law largely draws from two Delaware Court of Chancery decisions - a 1996 decision, In re Caremark International Inc. Derivative Litigation, and a 2006 decision, Stone v. Ritter. These cases provide that a board that ‘utterly fails to implement any reporting or information system or controls’ or, having implemented controls, ‘consciously fails to monitor or oversee its operations’ may face liability for breach of its fiduciary duties. Without digging too deeply into legal nuances, suffice it to say that directors who fail to oversee

an adequate compliance programme could face personal liability for losses due to compliance programme failures. When training directors, this is a critical element to communicate. Not only does it encourage directors to pay attention to remaining training topics, it also is a fundamental part of a board’s duty overall.

Company risk sources

A board member should be able to tick off the largest risk sources facing the company, including anti-corruption risks. Often this requires an understanding of nuances of anti-corruption law, such as the risks third www.ethicalboardroom.com

Board Compliance | Regulatory & Compliance parties pose. It might be easy to tell a board that the company doesnâ&#x20AC;&#x2122;t make sales to public entities, suggesting a low risk of bribery. But what about your third parties; do they make sales to government entities? Do you use third parties to assist with export compliance? These are the type of risk nuances that a board should be familiar with and know enough to dig deeper. Make sure your board has enough awareness of risk sources to do so. A great example is the VimpelCom action described above. In that case, the board was aware it had some duty to review the proposed transaction, but did not have enough information to know to ask about beneficial ownership of the shell companies involved in the transactions. A well-trained board will have an understanding of the risk landscape, both risks the company currently faces and may in the future. A board should be aware of the largest corruption risk sources and it is the compliance programmeâ&#x20AC;&#x2122;s job to make sure they know. When training the board on this area, it is important to keep the content high-level. The importance of corporate culture: While training for managers and employees may focus on a speak-up culture, training for board members should also focus on how the board can build a strong culture of compliance from top down. Offering specific, actionable options to board members will help them to lead. For example, you might suggest that a board member provides a message of compliance to top executives via email or at an annual meeting. Or, you may invite board members to sign a statement of support for the code of conduct or anti-corruption policy.

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DUTY OF OVERSIGHT Make sure your board has enough awareness of risk sources to dig deeper

Spring 2017 | Ethical Boardroom 131

Regulatory & Compliance | Board Compliance A best-practice is to enlist the support of the board in training senior managers on the importance of the compliance programme. The message then is very powerful – the board takes compliance seriously and will actively participate by talking directly to senior management. Offering specific ideas to board members will allow them to focus on the ones that make the most sense for the company.

Internal investigation procedures and outcomes

business. In almost every significant business transaction – a bank loan, convertible debt, acquisition of equity or assets – company lawyers are demanding that each participant demonstrates and provides proof of their respective compliance programmes. My translation of this requirement is simple – compliance has become an important currency in the business transactions. This demand for ethics and compliance reaches into the global marketplace. Companies want to do business with other companies that are committed to ethics and compliance. Companies do not want to deal with shady companies that may be suffering from a range of unethical conduct or legal risks. Recognising this context, compliance officers have the opportunity to ‘sell’ the board on the value of a compliance programme, the elements of an effective compliance

Board training should provide high-level information on a company’s internal investigation programme. One effective way to inform the board about the state of company culture is to develop a robust internal reporting and investigation system that tracks outcomes in a standardised, comparable way. This will allow a company to track violation sources over time to identify trends and remediate weaknesses. By taking complex, individualised situations and standardising the tracking of them, you are creating quantitative metrics that provide immense value to a board in evaluating how the company’s culture is doing. This also allows the compliance department to inform the board about what steps have been taken to remediate areas identified as concerns. Many of my clients have anonymous hotlines in Demand for place but haven’t put in ethics and the support function to leverage the information compliance you learn from these reaches into anonymous reports. While it is commonly accepted the global that 70 per cent of hotline marketplace. reports will relate to human resource and Companies want workplace concerns, the to do business rest can provide valuable with other information about potential risks. A company companies that that encourages and are committed fosters a speak-up culture programme, documents they is building a valuable to ethics and can use to promote compliance, governance resource. A compliance and an overall message about company that retaliates, their company – the company is such as Wells Fargo, which committed to trust and integrity throughout fired numerous whistleblowers who all of its operations. attempted to raise concerns about the bank’s Turning compliance into a sales advantage sales programme, will suffer serious harm is a win-win because it provides tangible to its culture and foster an environment in and substantive advantage to the sales and which employees are more apt to engage compliance missions for both compliance in misconduct. officers and sales staff. For customers, the The ability to track those reports and company’s message is powerful: you never outcomes is invaluable, specific information have to worry about misconduct, bad that cannot be obtained elsewhere. Board headlines or publicity when conducting training should include details on the business with us. Moreover, the message of importance of tracking hotline reports trust and integrity provides an important and the trends over time. reassurance on overall business trust – a Compliance as a marketing advantage: company committed to trust and integrity is Finally, board training should emphasise less likely to engage in fraud, delay in invoice the value of an ethical culture. Compliance payments, or unscrupulous business dealings. programmes should be win-win for the 132 Ethical Boardroom | Spring 2017

In other words, the trust factor is an important competitive benefit. In a close competitive match, a government agency or a company may award significant credit to a company that has a robust and/or mature ethics and compliance programme.

The risks of not training are too great

Board training is not an easy task to tackle but is vital to the long-term success of a company’s compliance programme. The first step is to get in front of the board – put it on the board’s calendar and then make the time you have as productive as possible. Charts and graphs, along with numbers and metrics, are all important parts of the oversight and monitoring process. There are many third-party vendors who can provide assistance on this issue and have training

programmes designed specifically for senior executives and board members. If the car maker VW’s board had understood the importance of tone at the top, it may have chosen to clarify VW’s priorities and acted to obey the law rather than increase profits by violating the law. Instead, VW faced publicity, such as The New York Times 25 September 2015 article Problems at Volkswagen Start in the Boardroom. The article cites a former executive as describing 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. www.ethicalboardroom.com

Regulatory & Compliance | Latin America

CLEANING UP THEIR ACT Latin American countries have introduced a raft of anti-corruption legislation 134 Ethical Boardroom | Spring 2017

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Latin America | Regulatory & Compliance

Anti-corruption trends across Latin America To do business in Latin America, companies need to understand recent developments in anti-corruption enforcement The UK Bribery Act and the Foreign Corrupt Practices Act (FCPA) in the US started a trend that has spread across the globe, including Latin America, to crack down on corruption. Anti-bribery laws and enforcement efforts attract business from multinational companies that may be less inclined to do business in countries deemed unsafe.

Of the 42 countries that have ratified or acceded to the Organisation for Economic Cooperation and Development (OECD) Anti-Bribery Convention, five are from Latin America.1 Although OECD has no authority to enforce the Convention, signatories to it are required to implement legislation that criminalises the act of bribing foreign public officials in international business transactions.2 Thus far, countries in Latin America – both signatories and non-signatories alike – appear to be adopting and enforcing legislation to sniff out bribery and corruption. Perhaps part of the growth of local anti-corruption efforts stems from the apparent cooperation of foreign and Latin American authorities to root out corruption. Of the 53 combined United States FCPA enforcement actions in 2016, about one-third arose out of alleged misconduct in Latin America. 3 By passing and enforcing their own laws and regulations, Latin American countries are able to join in any financial recovery, while also receiving the added benefit of being on the right side of history.

Argentina

In Argentina, President Mauricio Macri has made it a priority to enhance punishment of corruption. In late 2016, his predecessor, Cristina Fernandez de Kirchner, was indicted for fraud on corruption charges related to a large public works project. President Macri has put forth a series of laws to crack down on corruption, one of which would expand liability so that prosecutors www.ethicalboardroom.com

James G. McGovern & Robert Toll James is a Partner, Robert an Associate at Hogan Lovells

could bring criminal charges against of public officials of a foreign government corporations that engage in bribery.4 or international organisation committed Currently, Argentine law only allows for within Peru, or when the payment of the the prosecution of individuals who actually bribe is intended to obtain or keep business break the law; businesses do not face any in Peru. Penalties include fines of up to six consequences. This bill, set for consideration times the benefit obtained or expected to be by Argentina’s National Congress in the obtained by the commission of the crime.8 Although they are not yet a signatory to the coming months, would encourage businesses OECD Anti-Bribery Convention, Peru has to prevent corruption by allowing participated as an observer in the OECD corporations to avoid sanctions if they can Working Group on Bribery in International show they have compliance systems in place Business Transactions. to prevent such corruption. In addition, the National Congress is also contemplating a Brazil civil forfeiture regime, which would allow Operation Lava Jato (or ‘Car Wash’ in English) the state to forfeit assets that are presumed in Brazil has changed the way the country to have an illicit origin without having to approaches investigations, plea agreements, obtain a criminal judgment.5 On the enforcement front, Argentina has cooperation and international collaboration. conducted several follow-up investigations The investigation initially looked into money after companies have been investigated by laundering, but has expanded to cover foreign entities. After both corruption allegations at Siemens and Ralph Lauren Petrobras, the state-owned Part of the settled FCPA claims oil company. Lavo Jato alone growth of local with the US Securities & has implicated more than 20 Exchange Commission construction companies and anti-corruption (SEC) and the Department more than 100 individuals in efforts stems of Justice (DoJ), Argentine alleged corruption, bribery officials investigated as well. from the apparent and antitrust violations Most recently, after the and has resulted in $1billion cooperation CEO of the airline LAN in restitution to the of foreign and reached a $22million government. The operation settlement with the SEC in has also spawned other Latin American July 2016, it was speculated including authorities to root investigations, that it would lead to local Operation Radioactivity, investigations in Argentina, out corruption involving alleged contractor too.6 Cooperation is not graft in a nuclear power limited solely to the US; Argentina has plant operated by a subsidiary of Brazil’s investigated several companies implicated state-run energy corporation.9 Brazil’s other well-known corruption probe is the in Brazil’s Operation Lava Jato (discussed Zelotes Operation, an investigation into below) for bribery of government officials.7 70 companies for more than $6billion in Peru bribes allegedly paid to members of Brazil’s Similar to Argentina’s proposed law, Peru’s tax appellate council to reduce fines or Corporate Corruption Act, passed in March dismiss claims of tax evasion. As part of 2016 and scheduled to take effect in July 2017, that operation, in May 2016, the president holds both public and private companies of Mitsubishi’s distributor in Brazil was liable for bribery, even if the individual convicted for his involvement in a bribery person responsible for the crime has not scheme and sentenced to more than four been prosecuted. The law applies to bribery years in prison.10 Spring 2017 | Ethical Boardroom 135

Regulatory & Compliance | Latin America In addition, the recent $205million settlement in the Embraer case shows the benefits of cooperation with other countries and potentially signals a more active role in corruption investigations for Brazil’s Comissão de Valores Mobiliários (CVM), much like the US’s SEC.11 Previously, organisations other than the CVM, such as the federal audit court or the attorney general’s office, had played significant roles in resolving bribery cases, but in the Embraer settlement, the CVM acted with the SEC and prosecutors in the US and Brazil to secure a $2million fine.

Chile

Chile provides yet another example of the benefits of cooperation with other countries. This past January, Chilean chemicals and mining company Sociedad Química y Minera de Chile (SQM) agreed to pay more than $30million to the DoJ and the SEC in connection with payments to politically connected individuals in Chile in violation of the FCPA.12 In addition to the DoJ and SEC, the investigation was carried out by Chilean tax authorities. Chile has been a leader in Latin America when it comes to anti-corruption legislation. The country is deemed to be one of the least corrupt countries in Transparency International’s Corruption Perception Index.13 Showing a strong desire to join the OECD Anti-Bribery Convention, Chile’s legislature passed the Corporate Criminal Liability Law in 2009, criminalising money laundering and bribery of public and foreign officials.14 The law also credits companies for having adequate corporate compliance programmes.

Colombia

In early 2016, Colombia passed its first foreign bribery law, Law 1778, known as the Transnational Corruption Act (TCA). The TCA allows for corporate liability when a director, employee, contractor, or shareholder gives, offers, or promises money or any other benefit to a foreign public official in INTERNATIONAL CRACKDOWN Foreign and Latin America regulators are working together to tackle corruption

136 Ethical Boardroom | Spring 2017

exchange for the official to perform, omit, or delay any act related to the exercise of their functions in relation to international business transactions.15 The TCA also increases potential sanctions to approximately $45million and provides for debarment of companies from contracting with the Colombian government for up to 20 years.16

Mexico

Perhaps the biggest mover and shaker in recent Latin American anti-corruption efforts is Mexico. In July 2016, President Enrique Peña Nieto announced the approval of sweeping changes to Mexico’s anti-corruption laws. The new anti-corruption measures are the culmination of a multi-year process that originated with a citizen petition and the work of civil society groups. These grassroots efforts resulted in constitutional reform in 2015 and the recently passed laws represent the statutory implementation of this reform. Among the protections in the new laws and the revisions to existing laws, are provisions to create an independent anti-corruption prosecutor, strengthened whistleblower protections for individuals and mechanisms to enhance cooperation among Mexican governmental entities at the local and national levels. One of the newly drafted laws is the General Law for Administrative Responsibility, which is meant to protect against public and administrative bodies engaging in corrupt activities, such as bribery, collusion in public bidding, influence peddling and misallocation of public resources. Public officials will also be obliged to disclose existing assets, potential conflicts of interest and their tax information to ensure that they are not taking bribes or misallocating public resources. Under current Mexican law, companies may also be sanctioned

for the actions of individuals acting on their behalf or for their benefit. Companies may be sanctioned as much as twice the amount that they benefited from the actions of the individuals, as well as being deemed ineligible to participate in procurement, leases, services or state-owned projects for up to 10 years, in addition to compensatory and/or punitive damages. Other potential sanctions against companies can include government dissolution of partnerships. Nevertheless, companies can protect themselves by putting in place compliance and anti-corruption ‘integrity policies’ that are deemed adequate by the relevant authority. The law provides that companies implementing such policies can be protected if they have adopted an organisation and procedures manual that includes the responsibilities of each company’s division, specifies the company’s chain of command, includes adequate whistleblower and reporting systems so as to report corruption to the appropriate authority and includes measures for disciplining employees. Companies may also receive a cooperation credit that reduces the percentage of their sanction if the company self-reports violations and cooperates in any government investigation. As for enforcement, Mexico’s securities regulator investigated OHL Mexico SAB after recordings were released that purportedly showed bribes made to judges and public officials. Although the investigation did not reveal evidence of fraud, the company was fined $1.4million for its accounting practices.17 In addition, four businessmen, including one Mexican national and two former Mexican government officials, recently pleaded guilty for their involvement in schemes to bribe Mexican officials in order to secure aircraft maintenance contracts with government-owned entities.18

Conclusion

The increased focus on bribery and corruption in Latin America is unlikely to slow down any time soon. Given the recent wave of legislation and enforcement actions across Latin America, companies and individuals doing business there should take steps to understand the new anti-corruption regime and the expanding web of potential liability from Latin American, US, European and other foreign authorities related to corruption and fraud. Footnotes will be run in full online.

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Regulatory & Compliance | Modern Slavery Act THROWING OFF THE SHACKLES The Modern Slavery Act was introduced in 2015 to tackle supply chain transparency

Complying with modern slavery legislation It is now two years since the UKâ&#x20AC;&#x2122;s Modern Slavery Act came into force. Let me explain how the Act could affect your business and how effective it has been to date.

I spent more than 30 years with West Yorkshire Police, investigating serious crimes, including murders, armed robberies and major drugs conspiracies. After I left the police I worked closely with the families of murder victims to provide emotional and practical support. I also managed intelligence around crime risk on behalf of the Post Office before I eventually ran the operational activity of an organisation that investigated and rescued victims of modern day slavery. During this time, my team of experienced investigators rescued more than 200 victims of slavery. We also trained more than 5,000 frontline professionals, such as the police and social services, to spot the signs of human trafficking. Many people think that slavery is something that happens in foreign places and does not affect them. Nothing could be further from the truth. In 2014 our team began to rescue a number of men in West Yorkshire and it soon became 138 Ethical Boardroom | Spring 2017

Is the Modern Slavery Act a groundbreaking legislation or a velvet glove in need of an iron fist?

Allan Doherty

Senior Director at Modern Slavery Consultants Ltd clear that they had all been trafficked by the same gang. After many months of painstaking work, we took our evidence to the police and a major investigation was launched. Over the next few months, more than 30 victims were identified and rescued by us and the police, many of the men were working in a bed factory in Dewsbury. This factory supplied beds for Next and John Lewis among others. Two traffickers were eventually arrested, and later sent to prison for their crimes. The misery inflicted upon their victims was among the worse I had ever seen throughout my career. It was clear to us that the traffickers had not been acting alone and that the management at

the factory must have had knowledge of their activities; cheap labour is cheap for a reason and turning a blind eye is not an option. A second investigation was launched, this time targeting the directors and management of the bed factory involved. This investigation resulted in the arrest and conviction of the factory owner who was sentenced (at Leeds Crown Court in February 2016) to 27 months in custody. Sadly, the factory also closed, resulting in the loss of more than 180 jobs to the local community.

Tackling supply chain transparency

So why should all this concern you? Well, in March 2015, the government introduced the Modern Slavery Act and made it a legal obligation for certain businesses to be transparent regarding the steps taken to prevent modern slavery, both in its own organisation and across its supply chains. Such transparency is aimed at allowing the public, consumers, employees and investors to know what is being done to tackle modern slavery. This will open up all organisations to greater scrutiny from the media, pressure groups and potential business partners. www.ethicalboardroom.com

Modern Slavery Act | Regulatory & Compliance Failing to comply with the legislation may result in severe pressure not to engage with an organisation who is seen to be not taking the issue of modern slavery seriously and thus there is the risk of becoming an organisational pariah. Ultimately, failure to comply may result in legal punishment and serious reputational damage, which in turn may affect profits and even the organisation’s survival in an increasingly ethical trading environment. The legislation is not simply a one-off tick box exercise. It is intended that organisations will build on the steps they are taking on a year-on-year basis, indeed the government seeks to create a ‘race to the top’ and those who do not engage may find finishing at the bottom of the table an uncomfortable place to be with many difficult questions to answer. Compliance with the legislation requires an organisation to produce and publish an annual statement. The guidance issued by the government suggests the statement may include information on the organisation’s structure, business and supply chains, its policies and due diligence processes in relation to slavery and human trafficking, an assessment of the risk of slavery and human trafficking taking place and of the effectiveness of the prevention measures employed, evaluated by appropriate performance indicators. It should also highlight the training and capacity building measures that have been provided to ensure everyone in its organisation is alive to the risks and able to effectively identify and combat modern day slavery.

Scant reporting

Many organisations have been slow to publish their slavery statements, this is due in part to confusion around the requirement and the date by which the statements must be produced and made public. In simple terms, any business with a global turnover in excess of £36million must publish a statement within six months of each financial year end from 31 March 2015 onwards. Therefore, if your business financial year ended anytime between 31/3/2016 and 30/9/2016 and you have not yet published your statement, you are already in breach of the Act. Many of the published statements we have seen so far lack meaningful quality, substance and detail, and many simply point out that the business will not tolerate modern slavery. Very few set out the real detail that might reassure investors and consumers that effective measures are in place. Many fail to meet the minimum requirements, such as sign-off from senior leadership and placement in a prominent position on the homepage of the company’s website, let alone provide any in-depth analysis of supply chain risks. The six areas, suggested by the government, that businesses should cover in their statements are nothing more than suggestions, there is no legal stipulation. www.ethicalboardroom.com

Indeed, it is quite legal for a company to simply publish a statement stating it has carried out no steps to prevent modern slavery although any such statement would be likely to attract adverse media attention and we should not rely on the media to police and enforce such a critical piece of legislation. The UK Anti-Slavery Commissioner is Kevin Hyland, a former inspector with the Metropolitan Police. The Commissioner has had a series of discussions with CEOs and directors from some of the UK’s largest companies to ensure they understand what is required and produce statements that both comply with the Act’s obligations and point to decisive action being taken. In order to promote strong reporting and anti-slavery efforts, the Commissioner has: communicated with more than 1,000 companies operating in the UK; written to them detailing his expectations of companies in relation to their reporting requirements under Section 54 of the Modern Slavery Act 2015 (Transparency in Supply Chains); met with sustainability leaders from the big five supermarkets to discuss their commitments to respond to the risks of modern slavery in supply chains; led private sector roundtables on supply chain transparency; and is working with trade bodies to tackle modern slavery in high risk sectors. At the moment, no action has been taken against any organisation that has failed to produce its statement. It’s fair to say the

Better policing

Many people believe the transparency in the supply chain section of the Act must be better policed and that some action must be taken against businesses who fail to comply. The threat of a prison sentence may seem excessive but would certainly focus the attention of a director responsible for preventing vulnerable people being placed in modern slavery at the end of a long and seemingly distant supply chain. Recently, a proposal to amend the Modern Slavery Act received a second reading in the House of Lords. Under the amendment, companies would be required to report on slavery and human trafficking in their annual reports and accounts. Currently the

requirement is limited to a statement on company websites. Those who fail to comply would be excluded from procurement practices by contracting authorities. Our own efforts in checking for compliance has revealed many examples of no statements published and a real difficulty in getting people to actually speak about the issue. Many organisations hide behind a ‘no names policy’ to obstruct any attempt to speak with the person responsible for the issue. Those people who campaign for a more stringent enforcement policy make it their business to monitor compliance and produce articles naming and shaming when possible, but as yet these have not surfaced beyond professional publications. Supply chain software provider Segura recently conducted research and found that of 34 retailers who should have produced statements on their websites by 31 January 2017, 11 had failed to do so. Segura named five of the most recognisable brands included in the 11, causing some avoidable embarrassment and dented reputations. During our conversations with the business community, we found many people were only vaguely aware of the Act, or that their company has a modern slavery policy. Most believe that any policy has not been communicated effectively and many can see no evidence of it being put into practice. Many members of staff have reported their senior team needs to do more to enforce compliance to the Modern Slavery Act. Modern slavery is a big challenge, far beyond the responsibilities of the compliance manager alone. The need to allocate more time and resources to up-skilling staff is key. Many corporate buyers, and even professional auditors, lack the specialist knowledge to understand and identify modern slavery issues and many acknowledged that current processes are ill equipped to deal with them. Critics argue it is little more than a box-ticking exercise for some businesses and that it is difficult for the government and the public to keep track of who has published a statement, who has not and – more importantly – who is up to scratch. A key issue in ensuring compliance is the introduction of a government-administered central repository that lists which companies must comply with the Act. This repository should be accessible to the public and should contain a link to the statements published. The government has estimated that more than 12,000 companies in the UK should be complying with the Modern Slavery Act, the two-year anniversary will provide an opportunity for some to expose the weakness of the current legislation and the organisations that are merely paying lip service to it. It will be interesting to see when and how the government will begin turning the screws to ensure full compliance. Spring 2017 | Ethical Boardroom 139

Global News Asia & Australasia

Hong Kong takes time to embrace gender diversity Hong Kong continues to lag behind its global counterparts for board diversity but has made some progress, according to the Women on Boards Hong Kong 2017 report. The annual study, which examines the representation of women on the boards of Hong Kong’s top 50 listed companies, reports a modest increase in the representation of women from 11.1 to 12.4 per cent, with 78 women out of 628 directorships in total. The number of boards with zero women has dropped from 16 to 11 and there has been a decline in the number of boards that have never had female directors. However, the actual number of female directors in the top 10 companies with the highest representation of women on their boards has remained stagnant at 37 since 2016. More than two thirds of companies also show no improvement in the representation of women on their boards.

New Zealand airline tops Australian poll New Zealand’s national airline Air New Zealand is considered the most reputable company in Australia by consumers, according to the Australian Corporate Reputation Index. The airline topped the index ahead of Mazda, JB Hi-Fi, Toyota and Australia’s own national airline Qantas. Research agency AMR’s managing director Oliver Freedman said it was highly unusual for a “clearly overseas” company to take a spot on a list of most reputable companies. “These are incredibly strong results for a company clearly based overseas. Australians view the company to be authentic and focussed on the community, rating highly across the individual measurements of workplace, citizenship, governance, and leadership,” said Freedman.

Fujifilm Holdings was forced to delay the release of its fourth-quarter earnings after it found accounting irregularities at its sales subsidiary in New Zealand. NZ First leader Winston Peters called for a government inquiry into Fuji Xerox NZ, following the announcement that it was being investigated by its Tokyo-based parent for accounting practices that are expected to cause losses of 22 billion yen. Fujifilm has commissioned a three-member panel of outside lawyers and an accountant to investigate “appropriateness of accounting practices”. Japan’s Toshiba also delayed filing its audited earnings for the three months through December as it probed allegations of improper accounting at its nuclear subsidiary Westinghouse Electric.

NZX joins UN sustainability finance initiative

Cyber risk concerns for uncertain ASX 100 boards Australia’s biggest listed companies have non-existent or limited understanding of the biggest IT security risks to their organisation, according to a report. The ASX 100 Cyber Health Check Report surveyed the boards of Australia’s largest publicly listed companies about their readiness for managing cyber threats. Almost two thirds of the surveyed boards said they had a non-existent or limited understanding of their biggest cyber security vulnerabilities. Only eight per cent said they had a clear understanding of their company’s key cyber resilience controls. Three quarters of companies said they have implemented ongoing staff training programme on cyber awareness, with the majority of the remainder planning to do so in the next year.

140 Ethical Boardroom | Spring 2017

Fujifilm probes NZ accounting

New Zealand’s stock exchange NZX Limited has hooked up with more than 60 other global exchanges by joining the United Nations Sustainable Stock Exchange (SSE). The SSE initiative provides a platform for exchanges to discuss environmental, social and corporate governance enhancements and stimulate discussions about sustainable investments. Mark Peterson, NZX’s new chief executive, said: “Given the role NZX plays at the centre of New Zealand’s capital markets, we have a unique opportunity to work with listed companies to encourage and enhance the quality of environmental, social and corporate governance reporting.” As part of the initiative, NZX will also join United Nations discussions on ways stock exchanges can work with regulators, policy makers, listed companies and investors to better support a transition to greener economies. www.ethicalboardroom.com

Risk Management | Three Lines of Defence

Jon Szehofner & Paul Saunders Jon and Paul are both Co-founders of GD Financial Markets LLP

Effective risk management The key to a successful governance framework is using risk data within the three lines of defence model In recent years, there have been many issues that have impacted the financial stability of global markets, resulting in a shift of the regulatory focus (from both conduct and prudential regulators) to the importance of identifying and mitigating conduct risk within financial services. In support of this objective in the UK, both the conduct (Financial Conduct Authority, or FCA) and prudential regulators (Prudential Regulation Authority, or PRA) have introduced the senior manager’s regime (SMR) that aims to improve how conduct risk is managed through increased individual accountability. The need for dynamic risk management and effective governance frameworks has become critical across the so-called ‘three lines of defence’: the first line consisting of frontline staff; the second comprising risk management and compliance; and a third line composed of internal audit.

An introduction

Since the financial crisis, headlines about Libor-fixing, PPI mis-selling, rogue trading and other technical breaches of the consumer credit act have revealed an alarming concentration of poor risk management, ineffective governance structures, bad individual conduct and misaligned incentives across the financial services industry. These failings have propelled conduct risk to the top of the agenda for both senior management and global regulators, further reinforcing the need for firms to demonstrably treat 142 Ethical Boardroom | Spring 2017

customers fairly and enforce proper The FCA’s introduction of SMR specifies standards of market conduct. One of the key that senior managers can be held personally responses to this by the regulator is the accountable for any misconduct that falls implementation of new regimes that aim to within their areas of responsibilities. The increase individual accountability within new certification regime and conduct rules the banking sector. In the UK, both the FCA also aim to hold individuals working at all and the PRA are introducing a range of levels in the firm to appropriate standards policy changes to achieve that goal: the new of conduct. Senior management is now senior management regime, the certification required to attest to the effectiveness of regime and also the conduct rules. the organisation’s control frameworks, Outside of the direct regulatory response, develop a culture of accountability at all the financial crisis has also levels in the firm, and explain reinforced the focus of financial The need for the principles of good conduct institutions to implement customers and markets dynamic risk towards robust risk management and incorporate these principles management in the business. frameworks. These frameworks have primarily presented Furthermore, increasing and effective regulatory themselves in the shape of the scrutiny, media governance three lines of defence paradigm attention and consumer and need to be leveraged to frameworks awareness is creating greater demonstrate compliance with implications for organisations. across the the new regulatory regimes. Those firms that don’t adapt Although the three lines of three lines of will continue to suffer fines, defence model can be effective, damage, litigation defence has reputational it also presents significant costs and the non-optimum become weaknesses if it is not fully allocation of resources and embedded. It needs capital. It will then not be long critical enhancements in order to before regulatory patience wears enable senior managers to demonstrably thin and consumer confidence is lost, or the assure themselves that those within their redress as a result of claims pushes a firm to business are operating within the defined the limit of its financial capacity. policies and procedures. However, and on a more positive note, In my view, the key to establishing a firms that do adapt could benefit from successful framework is the effective use of the upside of this risk and gain competitive data within the three lines of defence model. advantage, acquiring a larger share of the market as clients switch providers, Increased personal accountability become more efficient as the costs of and risk to organisations compliance and remediation decrease Senior managers can no longer assume that and, ultimately, become more profitable the three lines of defence model is effectively through building a more sustainable identifying conduct risk and assessing the business model, underpinned by trusted effectiveness of governance and controls. relationships with their clients. www.ethicalboardroom.com

Three Lines of Defence | Risk Management

RISK AVENGERS But you need to arm your three lines of defence

The three lines of defence model

Regulators are not looking for financial institutions to avoid risk completely, but it is incumbent on these organisations to better understand the risks that they are taking and ensure that risk management is central to making business decisions. To ensure the effectiveness of an organisation’s risk management framework, the board and senior management need to be able to rely on the functions within the

organisation. The three lines of defence model, an important part of the Basel Committee on Banking Supervision’s 2011 principles for the sound management of operational risk, has been successful in explaining the relationship between these functions and acts as a guide for how responsibilities should be allocated (see Figure 1, below). The model is, however, limited, as evidenced by the failings across the market. The framework, when not fully embedded,

FIGURE 1: THE THREE LINES OF DEFENCE MODEL FIRST LINE: SECOND LINE: BUSINESS RISK CONTROLS OPERATIONS & COMPLIANCE The second line The first line believes that the risks they fail to recognise will be picked up by the second or third line

l Responsibilty & accountability of risk l Manage risk (risk definition and assessment) l Reporting of riskrelated information

l Guidance & implementation facilitation (policies & procedures) l Monitoring of execution

l Independent & objective assurance

THIRD LINE: AUDIT & ASSURANCE www.ethicalboardroom.com

believes that their guidance must be working as the first line highlighted no risks or issues

The third line believes that all risks and issues would have been picked up by either the first or second line

can lead to the duplication of processes and a lack of understanding of roles and responsibilities across the breadth of organisations. It is clear that adequate quality and effective risk management cannot solely be achieved by the implementation of a theoretical model.

Challenges implementing the defence model

One challenge faced by firms is how to best organise the different lines and then make sure that they act in a way that they are supposed to do. It is obvious where a trader, an operational risk manager or an internal auditor should go, but it’s less clear how to organise functions such as cybersecurity, technology and other specialist risk managers who sit within the individual business lines. There is also the presence of conflicting incentives across the lines i.e. the first line is typically rewarded for taking risk, not managing it. The second line can also fail at staying halfway between the first and third lines without getting too close. The obvious issue is that the first line – the source of the firm’s profits – will exert its gravitational pull, causing risk managers to become ineffective. Spring 2017 | Ethical Boardroom 143

Risk Management | Three Lines of Defence The three lines of defence model also does not specifically address risk data management. The model needs to be part of a risk framework that responds quickly to risk indicators, evaluates new requirements (e.g. regulatory or market driven), and facilitates controlled change-management. In the absence of such an approach, the exercise of predicting risks that are more or less unknown at present but that could materialise in the future is not adequately performed. A rigid three lines of defence model materialises in an overreliance on backward-looking risk models, suffering from the additional weaknesses of: ■ Varying volumes and quality of information from various parts of the organisation ■ Poor timeliness of data ■ Data duplication due to the need to access data from a multitude of different sources ■ A lack of understanding as to what data is actually needed ■ Use of external data that presents emerging issues from within an organisation’s peer group Organisations also need to better understand who the people are that are making risk decisions on behalf of the firm, and how these people are recruited, trained and incentivised. In a fast-moving customer-focussed environment where clients are using different methods to engage with service providers (ranging from no personal contact to face-toface interactions), those accountable for risk are typically not the ones taking daily risk decisions; it is those employees ‘closer to the coal face’. This causes the RACI (responsible, accountable, consulted, informed) model within the three lines of defence to break as those accountable for risk are only informed, or at best consulted long after the risk has manifested as a reality.

DATA CAPTURE New technology will help reshape the risk landscape

■ Comprehensive, traceable, accurate and timely ■ Measured and reported on at an appropriate frequency To get proper engagement from the frontline, conduct risk management needs to be described as good business practice rather than just compliance with the rules. The medium-term prize for the fundamental shift is competitive differentiation. Firms can increase their revenue by demonstrating superiority in testing product suitability, offering transparency and advice in the sales process and providing robust post-sales servicing and issue resolution.

A way forward

An alternative approach: data-driven risk management

The case to upgrade the model has never been stronger. A revised model needs to focus on ensuring greater accountability of risk by the first line while building better coordination within the second line, implementing new technologies to increase effectiveness and reduce costs, and revising talent management strategies to get the right people in the right roles. All of this should be underpinned by the right data being harnessed and made available to decision-makers to enable risk management decisions to be made in good time. The key characteristics of this data are: ■ Outcomes-focussed and forwardlooking management information ■ Management information linked to risk appetite and business strategy ■ Acted upon and documented ■ Supports open communication, validation and challenge 144 Ethical Boardroom | Spring 2017

impose a definitive separation between the three lines. Finally, and perhaps most importantly, firms need to take advantage of technology to better access and manage all of the data available. The excessive amount of data, along with new methods to capture it and the declining costs of doing so, will reshape the risk and control landscape. Data-driven quantitative analysis will have a fundamental role to play, but to achieve a holistic setup it needs to be complemented by qualitative judgment – which can only come from people with extensive risk management and wider business experience. Qualitative judgement can efficiently be derived from scenario planning and stress testing of various options, or in other words; proactively looking for trouble.

Board and senior management drives

CULTURE & VALUES POLICIES ROLES & RESPONSIBILITIES First line

Second line

Third line

RISK DATA The board must also take the lead in defining values, providing oversight and embedding good conduct into the institution’s culture. They will also have to define the roles and responsibilities of different participants in the first, second and third lines of defence and

Ultimately, a cultural shift needs to occur so that everyone in the organisation understands that they have their part in owning the risk, and the consequences if they fail to comply. The organisation also needs to help its people manage the conflict of doing the right thing and acting in the interest of the client and the market versus acting in the interest of the firm. It can do this through demonstrating strong and visible risk leadership and rewarding good behaviours. By empowering the three lines of defence with the right people and providing them with the appropriate awareness, training and monitoring, successful risk governance against regulatory standards becomes more attainable. Then to achieve true risk preparedness, the organisation needs to make risk data central to its risk strategy. Implementing dynamic quantitative models and overlaying that with informed, qualitative risk judgement to their outcomes will be the key to effectively mitigate conduct risk. www.ethicalboardroom.com

WHEN CYBERSECURITY

DELVES BENEATH THE SURFACE,

APPEARANCES WON’T DECEIVE YOU.

There’s no test, software or process that can ensure absolute security. But with the right partner and an approach that fits your company, you can be confident you’ve taken all the right precautions. At Protiviti, we’ll collaborate with you to put in place technology, people and processes that protect the areas of your business that matter most.

Risk Management | Cybersecurity

New York’s cybersecurity game changer Elevating cybersecurity to the board; the DFS’s new regulations could reach other US states

Steven R. Chabinsky & Judy Selby

Steven is a Partner at White & Case LLP, Judy is National Leader of Insurance Advisory and Technology Advisory Teams at BDO USA LLP

New York State’s powerful financial regulator, the Department of Financial Services (DFS), has recently grabbed the cybersecurity spotlight by issuing a first-in-the-nation cybersecurity regulation, which went into effect on 1 March 2017.

The regulation is a game changer for directors with responsibility over any financial institutions (including banks, trusts and insurance companies, referred to here as covered entities) that are required to operate under a licence, registration, or similar authorisation under New York’s Banking Law, Insurance Law or Financial Services Law. Although the regulation does not directly apply to national banks and federal branches of foreign banks, it does apply for example to New York-licensed lenders and branches of foreign banks. Because it applies regardless of where the institution is domiciled, the regulation’s impact is being felt around the world. It is groundbreaking in several respects. First, it is a mandatory regulation, as opposed to ‘guidance’, that requires covered entities to establish a cybersecurity programme designed to protect the confidentiality, integrity and availability of the institution’s information systems and nonpublic information. Although the DFS does not spell out specific fines or penalties associated with violations, the regulation provides that it will be enforced pursuant to DFS authority ‘under any applicable laws’. Second, the regulation is comprehensive in scope, covering security risks throughout the entire information lifecycle. It mandates the implementation of a cybersecurity programme that is supported by policy and based on a risk 146 Ethical Boardroom | Spring 2017

assessment. To the extent they apply to the institution’s operations, the cybersecurity policy must address the following areas: ■■ Information security ■■ Data governance and classification ■■ Asset inventory and device management ■■ Access controls and identity management ■■ Business continuity and disaster ■■ Recovery planning and Resources ■■ Systems operations and availability concerns ■■ Systems and network security ■■ Systems and network monitoring ■■ Systems and application development and quality assurance ■■ Physical security and environmental controls ■■ Customer data privacy ■■ Vendor and third-party service provider management ■■ Risk assessment ■■ Incident response But perhaps the most extraordinary aspect of the regulation is that it places responsibility for cybersecurity squarely on the board of directors and senior management of the covered entity, effectively requiring boards to engage in active and informed oversight of the entity’s overall cybersecurity.

Board and senior officer mandates

The regulation contains a number of specific obligations, highlighted below, that may directly apply to the covered entity’s corporate directors. Those requirements mandate board oversight of cybersecurity and prescribe reporting systems from management directly to the board. ■■ Under the regulation, each covered entity must implement and maintain a comprehensive written cybersecurity

DIGITAL LEADERSHIP Boards must engage in active and informed oversight of their company’s overall cybersecurity www.ethicalboardroom.com

Cybersecurity | Risk Management policy that is ‘approved by a senior officer or the covered entity’s board of directors (or an appropriate committee thereof) or equivalent governing body’. ■■ The regulation also requires each covered entity to designate a qualified individual, such as a chief information security officer (CISO), to be responsible for overseeing and implementing the institution’s cybersecurity programme and enforcing its policy. The CISO, in turn, must provide a written report, at least annually, to the board of directors, covering the entity’s cybersecurity programme and material cybersecurity risks. ■■ The CISO’s written report to the board must be based on considerations, as applicable, of (i) the confidentiality of the institution’s sensitive information (which goes beyond personal data to include business-related information the tampering with which or unauthorised disclosure, access or use of which, would cause a material adverse impact on the institution’s business, operations, or security); (ii) the integrity and availability of systems; (iii) the entity’s policies and procedures; (iv) its material cybersecurity risks; (v) overall cybersecurity effectiveness (which is quite difficult, if not impossible, to Perhaps the most measure) and (vi) material groundbreaking cybersecurity events during part of the new the reporting period. ■ Perhaps the regulation is most groundbreaking the requirement part of the regulation is the requirement for a written for a written certification of compliance, certification of signed either by the chairperson of the board compliance, of directors or a senior signed either by officer. Whoever puts their the chairperson name on that document is expected to certify to the of the board of best of their knowledge either directors or a that the entire board of directors, or one or more senior officer specifically named senior officers ‘reviewed documents, reports, certifications and opinions of such officers, employees, representatives, outside vendors and other individuals or entities as necessary’ to comply with the regulation. ■■ The institution also must document the identification and remedial efforts planned or underway to address, any ‘areas, systems or processes that require material improvement, updating or redesign’.

Director duties to oversee cybersecurity

Corporate directors are charged with the responsibility to monitor and oversee corporate risk, to include material data privacy and cybersecurity risks. That responsibility is based on the duties of care and loyalty owed by directors to the corporation. www.ethicalboardroom.com

Spring 2017 | Ethical Boardroom 147

Risk Management | Cybersecurity With respect to care, the prevailing view is that a lack of good faith is a necessary condition to liability. Under Delaware law, ‘a director’s obligation includes a duty to attempt in good faith to assure that a corporate information and reporting system, which the board concludes is adequate, exists and that failure to do so under some circumstances may, in theory at least, render a director liable for losses caused by non-compliance with applicable legal standards’. 1 When it comes to the duty of loyalty and a director’s failure to monitor and oversee corporate risk, the threshold for liability is high and can be imputed to individual board members only where: ‘(a) the directors utterly failed to implement any reporting or information system or controls; or (b) having implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention’.2 It is hard to imagine a common situation where the first prong of this test would be met. The second prong is likely to be tested soon, however, following a cyber breach of a covered entity that has certified compliance with the regulation. To be sure, the mere fact of a breach is not sufficient to suggest, no less find, director liability. But, it is certain to lead to questions

quality of the data the institution acquires, retains and transfers, the rapidity of technology innovation and adoption, outsourcing demands and a constant barrage of existing, emerging and escalating criminal and nation-state threat actors.

The top 12 questions every board should ask about the regulation Clearly, boards will need to consider what actions are necessary to ensure that a reasonable reporting system exists when it comes to complying with New York’s no-nonsense cyber mandate. The following are some suggested areas of inquiry that directors can use to help improve their organisation’s performance while spotting and addressing red flags:

Is the institution’s general counsel informed of and involved with, compliance efforts for the regulation? Has the institution designated a qualified individual (such as a CISO) to oversee and implement the institution’s cybersecurity programme and enforce its policies? Does the institution have a roadmap for implementing each of the 17 substantive sections of the regulation and does it take into account their varying due dates, how much

2 3

NEW YORK’S CYBER RULES DFS-supervised entities must assess their cybersecurity risks

about board engagement. Shareholders and regulators are always on the hunt for ‘red flags’, those facts, for example, that might show the board was aware that internal cybersecurity controls were inadequate, that these inadequacies would result in material harm to the institution and that the board chose to do nothing about the problems it knew existed. Faced with the changing nature of cybersecurity risk, directors also might consider the views of the Committee of Sponsoring Organisations of the Treadway Commission (COSO), which recommends that a board focus, at least annually, on ‘changes in the critical assumptions and inherent risks underlying the organisation’s strategy’. For many organisations, these assumptions and risks change frequently, based on the increasing quantity and 148 Ethical Boardroom | Spring 2017

lead time is anticipated for their completion, the resources that will be required to do so and how it will measure success? Does the institution use industry-recognised guidance, frameworks, or best practices to address each of the 14 cybersecurity policy areas outlined in the regulation? Has the institution determined who will sign the annual certification of compliance and is that person qualified to do so? Is the chairperson of the board expected to sign it? How is the institution maintaining the records, schedules and data to support the annual certification which, by regulation, must be maintained for a period of five years? What does the institution view as its most significant internal and

4 5 6 7

external risks to the security or integrity of its data and systems? Is there a written risk assessment, made available to the board, assessing the adequacy of existing controls in the context of identified risks? What are the gaps? What are the institution’s requirements for either mitigating or accepting identified cybersecurity risks and are they consistent with the institution’s risk profile and regulatory requirements? (When it comes to risk acceptance, directors should be aware that NYDFS has stated ‘the risk assessment is not intended to permit a cost-benefit analysis of acceptable losses where an institution is faced with cybersecurity risks’.) How is the institution identifying and documenting (in a manner that can be made available to DFS) the remedial efforts that are planned and underway to address areas, systems or processes that require material improvement, updating, or redesign? How is the institution addressing the regulation’s requirement that it encrypt non-public information while it is in transit over external networks and while it is at rest, unless it is ‘infeasible’ to do so? To the extent encryption is not being used, how was infeasibility determined and has the CISO reviewed and approved effective, alternative compensating controls? When and how does the board get notified of cybersecurity events that are reported to DFS?

8 9

10 11

Final thoughts

The DFS regulation makes clear that cybersecurity is, without doubt, a board issue. The outlined questions are offered merely as a starting point for directors to use when considering their entity’s cybersecurity posture and its compliance with the regulation. One or more directors should have the responsibility and capability to drill down into each of these areas, ensuring that they have a full understanding of the entity’s cybersecurity risk profile and the reasons behind the steps being taken – and not taken – to protect the institution’s information systems and non-public information. Boards that cannot accomplish this, based on their existing composition, should consider retaining independent cybersecurity advisors and counsel to assist with their review and provide objective advice concerning cybersecurity compliance. Active, engaged and informed oversight by the board on a continual basis is crucial to protect an entity and its board members from cybersecurity threats and liabilities and to ensure compliance with the regulation. Caremark International Derivative Litigation, 698 A.2d 959, 970 (Del.Ch. 1996) 2 Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006) 1

This publication is provided for your convenience and does not constitute legal advice. www.ethicalboardroom.com

59% of boards say cybersecurity is the most challenging business risk.1 What do they see that the others don’t? Cyber security is a technical challenge, but the real consequences of a hack are financial. Data breaches, IT system failures, cyber extortion — these start in the server room and are felt in the boardroom. Are you confident you’ve properly valued your cyber risk and invested wisely to protect your firm? Marsh helps you reimagine cyber risk as an opportunity for performance improvement. By optimizing the efficiency of your investments in technology and insurance, we can replace worry with confidence, and help you unlock capital to power your business. So you can pursue the risks you want to take, not just the ones you are afraid of.

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Data-driven measurement of value at risk, tailored to your business.

Insure and Secure

Capitalefficient risk mitigation and award-winning risk transfer solutions.

Respond and Recover

Resilient cyber event management, from start to finish.

NACD, Public Company Governance Survey, 2016-2017

BECOME CYBER CONFIDENT To start getting ahead of cyber risk, contact Marsh’s cyber team or visit us at marsh.com/cyber. Tom Reagan +1 212 345 9452 thomas.reagan@marsh.com

Global News Africa

Zuku shareholders challenge CEO

AfDB focusses on gender equality The board of directors at the African Development Bank (AfDB) has approved the introduction of a new management framework that includes a focus on gender equality. AfDB says it will place ‘renewed emphasis’ on tracking progress in reducing the gaps between men and women. Currently, women represent one third of all AfDB’s staff, with one third in management, one third of professional experts and close to two thirds of support staff.

“At the bank, we are working hard internally to close the gender gap. Of the recent senior management appointments I have made to run the business of the bank in our five regional offices, 50 per cent are women,” said AfDB President Akinwumi Adesina. AfDB has also launched the Affirmative Finance Action for Women scheme to help leverage $3billion for women-owned businesses.

South Africa’s minister blocks Eskom payout South Africa’s public enterprises minister has blocked power utility company Eskom from giving its former chief executive a 30million rand pension payout. Lynne Brown said the proposed payout to Brian Molefe could not be justified in “light of the current financial challenges faced not only by state-owned companies, but by the country as a whole”. Molefe resigned last year from Eskom after 18 months at the company, following a report by South Africa’s public

protector into the use of state companies for personal enrichment. Molefe has denied any wrongdoing. Brown said: “I found the argument presented by the board lacking in legal rationale and it cannot be substantiated as a performance reward because Molefe has already been granted a performance bonus for his contribution to the turnaround of Eskom.”

Broadcaster at war with ex-COO Hlaudi Motsoeneng, the former chief operating officer of the South African Broadcasting Corporation (SABC), could face misconduct charges after publicly criticising the public broadcaster’s interim board. Motsoeneng was suspended from the SABC in 2016 after a parliamentary committee report found that the previous board had mismanaged the broadcaster and that Motsoeneng’s appointment as COO was invalid. In a controversial press briefing in April, Motsoeneng (pictured right) defended the policies that he implemented at SABC and accused the interim board of being “conflicted and lacking integrity”. 150 Ethical Boardroom | Spring 2017

Motsoeneng could now face charges for “violating the broadcaster’s code of conduct”. The interim board was appointed in March by President Jacob Zuma with the mandate to “bring stability to the SABC within six months and restore confidence”.

Shareholders of Zuku – the East African based internet and TV service provider – have accused the company’s chief executive Richard Bell (pictured above) of mismanagement, asset stripping and tax fraud schemes, it has been reported. According to Business Daily, shareholders Wananchi Nominees Limited claim Bell is planning an “irregular sale” of one of Zuku’s most profitable business arms Wananchi Business Services. Bell has said the planned civil and criminal proceedings are part of a scheme by a section of ‘disgruntled shareholders’ who want him to buy their shares at above market rates. He has obtained a temporary court order barring legal action against him.

Millions seized in Lagos raid Nigeria’s anti-corruption investigators have seized more than $43million in cash from a flat in the country’s major city Lagos (pictured above). Investigators also found nearly £27,800 and 23millions naira at the four-bedroom flat in the city’s affluent Ikoyi area, following a tip off. The Economic and Financial Crimes Commission (EFCC), Nigeria’s anti-graft agency, said the funds are “suspected to be proceeds of unlawful activity”, although local reports have also linked the cash to Nigeria’s National Intelligence Agency. The EFCC has made a number of cash seizures this year after Nigeria’s finance minister introduced a new whistleblowing policy in December. www.ethicalboardroom.com

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Africa | Nigeria CODE CONFUSION The Nigerian government has suspended the implementation of a governance framework

Nigeria’s National Code of Corporate Governance Following a Federal High Court ruling on 17 October 2016 that the Financial Reporting Council of Nigeria (FRC) has the powers to issue codes and, in accordance with Section 50 of the FRC Act 2011, the FRC released the National Code of Corporate Governance (2016) on the same day – almost three years later than the originally planned implementation date of January 2014. The Code, according to FRC, is aimed at enhancing management credibility, preserving long-term investments, improving access to new capital and lowering the cost of capital. The Code, says the FRC, will help to drive increased transparency and accountability in financial reporting through enhanced disclosures in financial statements, thereby supporting investment decisions and shareholders’ value. Three days after the release of the Code, the Nigerian Stock 152 Ethical Boardroom | Spring 2017

From conception to controversy and why a more collaborative approach is needed

Victor Banjo

Corporate Governance and Board Effectiveness Coach Exchange directed all listed companies to comply with it. This was a clear confidence booster for the FRC. Fast forward to Monday 9 January 2017 and the federal government suspended the implementation of the Code. The suspension, according to the Nigerian Minister of Industry, Trade and Investment – Okechukwu Enelamah – was necessary in order to carry out a detailed review of its application after extensive consultations with stakeholders. On the same day, Nigerian President Muhammadu Buhari, approved the immediate removal of the Executive Secretary of the FRC, Jim Obazee, and the reconstitution of the board of the agency. Several stakeholders, such as the

Nigeria Employers’ Consultative Association (NECA) backed the decision of the federal government to suspend the Code, saying it was a product of unilateral decision by the FRC, as the organised private sector (OPS) was never consulted or its input sought by the council. NECA, like other key stakeholders, had accused the FRC of failure to secure their buy-in on such an important guideline. So, what went wrong?

Reservations on mandatory compliance

The OPS had reservations about aspects of the Code, particularly the mandatory compliance clause affecting its members, and it vehemently protested during the public hearing organised by the FRC. The major objection that led to the suspension of the Code and removal of the executive secretary came from the not-for-profit sector. On 29 April 2015, I attended a public hearing organised by Nigeria’s FRC at a Lagos hotel. On this particular day, the leadership of the FRC was set to meet with organisations that would be affected by the draft Code for the not-for-profit sector. This included professional associations and religious bodies. Prior to the arrival of the FRC team, the tone of the conversation in the various www.ethicalboardroom.com

Nigeria | Africa

clusters in the hall gave an indication that plenty of drama was in store. I was not disappointed. The religious bodies were the most vocal at the session. Speaker after speaker voiced stern opposition at the attempt by FRC to regulate what they referred to as ‘God’s activities’. Had the FRC gone beyond its mandate? The FRC replaced the National Accounting Standards Board, set up by an Act of Parliament in 2003. When the Financial Reporting Council of Nigeria Act 2011 was enacted, the Council was charged with the responsibility for, among other things, developing and publishing accounting and financial reporting standards to be observed in the preparation of financial statements of public entities in Nigeria and for related matters. It is empowered to serve as the national coordinating body responsible for all matters pertaining to corporate governance. Section 51(c) of the Act empowers the FRC to issue the Code of Corporate Governance and guidelines, and develop a mechanism for their periodic assessment of the code and guidelines. Through its Directorate of Corporate Governance, FRC was empowered to ‘develop principles and practices of corporate governance’. At the time that the 2011 FRC Act came into force, there were no less than four sectoral codes of corporate governance operational in Nigeria. Therefore,

the FRC appeared to be right in wanting to have one harmonised code for the country.

A three-in-one code

The new Code released by the FRC is a three-in-one code: 1) National Code of Corporate Governance for the Private Sector in Nigeria 2016 (Private Sector Code); 2) Public Sector Governance Code in Nigeria 2016 (Public Sector Code); and 3) Not-For-Profit Organisations Governance Code 2016 (Not-For-Profit Code). The Code of Corporate Governance for the Private Sector harmonised the various sectoral codes previously in existence. These are the: ■■ Code of Corporate Governance for Banks in Nigeria Post-Consolidation 2006 ■■ Code of Corporate Governance for licensed Pension Operators 2008 ■■ Code of Corporate Governance for Insurance Industry in Nigeria 2009 ■■ Securities and Exchange Commission Code of Corporate Governance in Nigeria 2003, reviewed 2011 ■■ Central Bank of Nigeria Code of Corporate Governance for Banks and Discount Houses in Nigeria, 2014 The Code of Corporate Governance for the Telecommunications Industry (July 2014), issued by the National Communications

Commission, is expected to be treated as a supplementary guideline based on new FRC guidelines. The FRC Code for the private sector is mandatory (except for companies with eight or fewer employees, regardless of status of such companies). It covers all public companies (whether listed or not), all private companies that are holding companies or subsidiaries of public companies, private companies that file returns to any regulatory authority other than the Federal Inland Revenue Service and the Corporate Affairs Commission. The Code of governance for not-for-profit entities is based on a ‘comply or justify non-compliance’. Where they do not comply, they are required to give a reason. The Code for the public sector will not be applicable until an executive directive is secured from the federal government. This is because the enabling laws that set up most government establishments already carry some form of governance structures. Therefore, there may be need for umbrella legislation, which will seek to harmonise the different provisions of those laws and synchronise them with the Code. When the executive directive is secured, the Code for the public sector, will be applicable to all public sector entities (government agencies, parastatals, ministries, departments, and other state-owned entities).

At the time the 2011 FRC Act came into force, there were no less than four sectoral codes of corporate governance operational in Nigeria. Therefore, the FRC appeared to be right in wanting to have one harmonised code for the country www.ethicalboardroom.com

Spring 2017 | Ethical Boardroom 153

Africa | Nigeria

Private sector

The major elements of the new Code of Corporate Governance for the Private Sector, which supersedes any corporate governance code in existence before the date of its commencement, are: ■■ Managing director/CEO cannot become chairman except in exceptional cases where a cooling off period of seven years must be allowed, among other requirements ■■ Requires that an annual meeting of independent directors is held ■■ An annual corporate governance evaluation is made by an independent consultant, registered by the regulator for this purpose, a copy of which shall be sent to the regulator, presented at the company annual general meeting and made available on the investor relations portal of the company ■■ Outlaws clandestine dominance of board or management by a board member after retirement ■■ Stipulates a minimum of two-thirds of board members to be non-executive directors ■■ Insists on clear separation of position of chairman and CEO ■■ Stops more than two members of the same or extended family from sitting on the same board ■■ Companies are required to establish a diversity policy to include measurable objectives for achieving gender diversity ■■ Full disclosure of the remuneration of executive directors in company ■■ Annual reports ■■ Executive directors prohibited from collecting sitting allowances or directors’ fees ■■ Managing director/CEO can only serve a maximum of two terms of five years each ■■ Non-executive directors can only serve a maximum of three terms of four years each ■■ Executive directors can only serve maximum of three terms of four years each ■■ Borrowings and maturity dates now required to be included in company annual reports ■■ Sustainability issues as they relate to other stakeholders (health, environment, safety, equality and diversity in employment, anti-corruption) required to be presented for consideration ■■ In case of conflict with any sectoral guideline, the provisions of the FRC Code will override such guidelines ■■ The FRC Code allows sector-specific guidelines issued by sectoral regulators on specific matters relating to corporate governance as a supplement ■■ Independent non-executive directors are required to make an annual declaration of independent status and disclosure of same in annual reports and on the company website Notwithstanding what the new Code says, the pre-existing sectoral codes are still 154 Ethical Boardroom | Spring 2017

operational as the sectoral operators have not issued directives indicating the discontinuation of those codes. Commentators have pointed out that some of the provisions of the Code are inconsistent with substantive legislation, primarily the Companies and Allied Matters Act 1990 (CAMA), which contains the core provisions of Nigeria’s company law framework. The FRC Code says the remuneration of MD/CEO should be determined by the remuneration committee while CAMA says it is the responsibility of the board of directors. The Code says membership of the board shall not be less than eight (or five in the case of regulated private companies), while CAMA recommends a minimum of two members. With regards to the subsequent appointment of auditors, CAMA recommended that a poll is the preferred way of appointment, whereas the FRC Code only requires a show of hands in an AGM. While the FRC Code directs that boards must meet every quarter, CAMA encourages the board to determine how often it should meet. Compelling boards to meet may place a

Making the Code for the private sector mandatory, contrary to the advice and expectations of many stakeholders, is seen as a major disincentive for investors. FRC should support the government’s drive to create an enabling environment for foreign direct investment (FDI) into the country. The deployment of the Code of Corporate Governance in its current form will not encourage investors, because it conflicts with global best practice. The codes that have been implemented and embraced in many countries are voluntary and principle-driven. The new King IV code of corporate governance in South Africa, launched in December 2016, is set to came into effect in April 2017. It is instructive to note that this latest version of the King Code still maintains a voluntary, principle-based approach. A comply or explain basis for the private sector, as obtainable in the UK and South Africa, would have been well received by Nigerian private sector stakeholders. The leadership of the FRC ignored a key principle that religion does not mix well with

STALLED A comply or explain basis for the Code would have been better received

heavy burden on businesses. While CAMA stipulates that board decisions shall be based on the majority of votes, based on one vote per director, the FRC Code suggests that independent non-executive directors may have extra powers to block decisions. The proposed repeal and replacement of the Companies and Allied Matters Act 1990 by the Corporate Affairs Commission is timely. Once completed, the Act will be replaced by a new Act – the Companies and Allied Matters Act 2016 – which, hopefully, should resolve some of the areas of conflict with the national Code of Corporate Governance. This presents an opportunity for the FRC to collaborate with the Corporate Affairs Commission in ensuring that the rules and guidelines issued by both bodies complement each other, rather than confuse stakeholders – as is the case is at the moment.

secular regulation. With the benefit of hindsight, the FRC would probably have excluded religious associations from its list of governed entities if it knew that it would threaten the rollout of the codes for other sectors. When the suspension is lifted and implementation resumes, the FRC, perceived by many to be rigid, should adopt a more collaborative ethos. This would make it easier for the harmonisation to achieve the desired objectives. If not for the suspension, the codes would have ensured that shareholders, donors, investors and all other stakeholders can have a fair understanding of what to expect in Nigeria’s corporate governance administration. As it stands today, until a new council is inaugurated for the FRC, there will be no progress on a much-needed code of corporate governance in Nigeria. www.ethicalboardroom.com

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