Corporate governance, including the role of the board and the internal governance frameworks within organisations, is complex. Well-researched and written corporate governance guidance, such as the UK Corporate Governance Code, sound straight forward in principle, but there are complexities in practice related, among other things, to the execution of governance processes and the human dimension of governance. When assessing board effectiveness, it is important both to distinguish between, and understand the relationship and interdependencies between, board structure, board process and behavioural aspects of boards as well as the barriers to effective decision-making that can ensue. To be effective, a collection of individuals, led by a board chair, must leverage its collective strength, disseminate information provided by executive management, engage across a range of topics, be cognisant of a range of stakeholders, and lead a governance framework that suits its context. The provision of reporting to the board by executive management (“board information”) is a pivotal governance process to which a board’s effectiveness is highly correlated.
The Invisible Hand
In a prior article for the Institute of Directors in Ireland, I referenced ‘the invisible hand’, a concept introduced by Adam Smith as a metaphor for the way the market spontaneously regulates and transmutes voluntary conduct motivated by individual self-interest into the long term collective best interests of society. Regularly, across industries, the invisible hand is not sufficient to promote and ensure the prosperity and well-being of society, so the State intervenes through regulation. Striking the appropriate balance between the invisible hand and regulation becomes a central policy question. Many industries operate with the added dimension of regulatory overlay. Arguably, understanding the difference between regulatory compliance and governance that is overly regulatory led should be a central focus in the boardroom.
The visible hand of management and the board must be the driving force behind any sustainable business, acting as an adjunct mechanism for regulating the interaction between corporations and society. To be clear, companies must act at all times in compliance with the legal and regulatory responsibilities imposed on them. The governance framework of every organisation should support and provide assurance on compliance with that organisation’s regulatory licence to provide a service. The board and executive management should instil the importance of regulatory compliance in every facet of the business and ensure that the internal governance framework facilitates and tests this compliance. In short, the board should ensure, as with risk management and internal control, that the governance foundations are built and that the board, working in conjunction with executive management, agrees the basis of reporting on all matters of interest to the board, including regulatory compliance matters. The chair of the board, in turn, must allocate the scarce resource of time proportionately across the range of topics, key performance indicators (KPIs), key risk indicators (KRIs), and matters reserved, that require board consideration, discussion and decision. Striking the right balance between looking back at past performance and assurance versus forward at emerging risks and opportunities can be challenging for board chairs.
Directors’ Duties
There are many sources of duties and responsibilities to which companies are subject, the primary but not the exclusive source being company legislation. Companies will also have duties and responsibilities related to employment law, data protection law, health and safety law, to name just a few. As noted earlier, companies in certain sectors such as pharmaceuticals, telecommunications, financial services, and the airline industry, can only provide a product or service at the behest of a regulatory licence and must operate and be accountable within a highly regulated environment. While reiterating the point made earlier on the importance of regulatory compliance, all boards should reflect on the rhythm in the boardroom vis-à-vis ensuring the framework for compliance exists and getting assurance on its effectiveness versus allowing the regulatory agenda to consume board discussion and time. In highly regulated sectors, there is a risk that the information provided to the board and, indeed, the discussion in the boardroom is disproportionality skewed towards regulatory matters and past events, crowding out strategic, forward-looking discussions and debate. Anyone who has ever been in my corporate governance class will know that I am an advocate for regulatory compliance but not regulatory led governance. What we want is board led governance supporting a regulatory compliant culture with effective stakeholder engagement. Figure 1 below presents the characteristics that might epitomise an overly regulatory led boardroom. Poor standards in reporting to the board can encourage a regulatory led approach. A director mindset that looks only through a regulatory compliance lens can exacerbate this approach.
The Information Flow to the Board
Through my cross-sectoral discussions with board members, the managerial and detailed nature of information flowing to the board is a constant bug bear with directors, often inhibiting the ability of the board to optimise its performance. Management can often feel pressured to provide the board with a level of granular detail that they do not need, particularly where a regulator has ‘indicated’ its expectations in this regard. This approach creates risk for the board in executing its responsibilities. At a very basic level, if everything is important how does the chair prioritise discussion? If the board is ploughing through pages of managerial information, is there a danger that the critical issue will be missed? Is the benefit of both delegated authority (and the system of governance put in place to support and create accountability around it) being eroded? Are we blurring the lines between being an executive and being a non-executive director? We must not ignore our cognitive limitations either. Psychologists and behavioural economists have identified many cognitive biases that impair our ability to objectively evaluate information, form sound judgements, and make effective decisions (Beshears and Gino, 2016). It is critical to the effective operation of the board, therefore, that a proportionate, context driven basis is created for reporting to the board.
The Role of Executive Management
Executive management have an important role in contributing to the effectiveness of the board and board committees (and de facto the company) through the provision of information to the board and the standard of board papers requiring discussion, debate and decision by the board. Independent non-executive directors (INEDs) have an information asymmetry opportunity and challenge:
The Opportunity: information asymmetry supports the very objectivity and independence they bring to the boardroom.
- The Challenge: for INEDs working through board or committee papers can sometimes feel like looking for a needle in a haystack.
- In creating the basis for reporting to the board, there should be clarity on the purpose of board information. The aim is to present information in a way that supports the board chair (and board committee chairs) in setting and managing the board agenda thereby enabling the board/board committee to:
- Focus and have robust discussions on the pertinent issues.
- Get the right balance between strategic issues, emerging risks and opportunities (the future) versus assurance on matters of internal control and regulatory compliance (the past).
- Engage in effective dialogue, critical analysis, debate and collective decision-making in the company’s best interest.
- Effectively leverage the individual and collective skills on the board/board committee to support the strategic objectives of the company.
On this basis, board papers should deliver the following:
- Provide a clear picture on strategy, risk appetite and culture (including emerging threats and opportunities).
- Provide assurance to the board on adherence to policies and procedures, the systems of internal control and regulatory compliance.
- Provide assurance to the board on key group dependencies where relevant (e.g. outsourcing within group) and key third party dependencies.
- Translate technical and voluminous information into sign-posted issues and choices requiring business judgement, opinion and/or decision (on matters reserved) by the board/board committee.
- Reflect management’s opinion and recommendation, as relevant, along with key assumptions forming the basis of same.
It is so important that management work with the board (and its committees) to create the basis, format and frequency of reporting to the board (and/or its committees) across all lines of business and functions:
- Regular reporting (e.g. top ten risks at every board meeting or actual versus budget financials) and annual or semi-annual reporting (e.g. full risk register once a year).
- Exception based reporting (e.g. risks trending towards being outside of appetite);
- Assurance reporting on business delegated to management and related controls (e.g. on the results of internal and independent assessments of controls).
- Reporting requiring decisions on matters reserved for the board.
- Reporting that is for the information/knowledge of the board.
So, the questions for the board are:
- Have you established the basis for reporting to the board with executive management?
- Have you created the basis for receiving assurance as to the company’s compliance with legal and regulatory requirements and the effectiveness of the system of internal controls, in so far as is reasonably possible?
- Is the level of detail being provided in the reports crowding out the capacity of the board to execute their responsibilities?
- Are the board duplicating a management process rather than seeking assurance on it?
- Are individual directors influencing an overly regulatory led approach using up time that could be devoted to the future threats and opportunities inherent in the business?
The key question for executive management is:
- How can executive management make sure that the company meets the expectations of its board (and, as applicable, its parent) in a regulatory compliant (not regulatory led) but efficient way? Strong executive management will call out the opportunities and the challenges, supporting the evolution of the board in tandem with the evolution of the business and the industry it occupies.
References:
1. Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, 1776 and The Theory of Moral Sentiments, 1759
2. Beshears and Gino, HBR, 2016, Common Biases that Affect Decision-Making