Governance vs Performance in SoBE’s

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By governance I mean good governance as a process as an attitude and as a mechanism to do business. Specifically, this relates to concerns raised during discussions with state owned business enterprises (SoBE) on how public institutions should conduct public affairs and manage public resources for the benefit of the country. This write up centers around the need for the government and governing bodies to improve governance aspects to meet the needs of its people as opposed to looking after the wants of a select group in society.

In Sri Lanka, public sector plays a significant role in economic growth and contributes a major portion to GDP. As a result public sector also consumes a significant portion of resources and due to bad practices, waste is also very high. Good governance in the public sector can encourage the efficient use of resources, strengthen accountability for the effective use of those resources. Transparency in managing resources will improve confidence in those organizations, lead to efficient and effective management practices and thereby contribute to improving peoples’ lives.
However, transparency, integrity and accountability are not norms in many public enterprises. Many can relate to the several negative comments heard about Boards of many government bodies, as listed below;
↗️ Political stooges with no knowledge of business are appointed to Boards as a favour.
↗️ Every time the minister changes, a new chairman is appointed to SoBE without any evaluation
↗️ Persons are appointed to positions to enable politicians to collect their harvest(?)
↗️ Management is capable of serving the public but those at the top are interested in making money for themselves.
↗️ When management follows rules and does something, those above will stop that to the detriment of the organization and the society.
↗️ When the Board does not see personal benefit, they use good governance as an excuse to delay or defer the decision.
↗️ As the Board is incapable of making decisions, performance is affected due to significant delays in decision making.
↗️ Timeliness of decisions is not considered, due to the fear of being blamed later.

Reducing such negative impressions of pubic sector boards is key to making them great. Aspects of governance in the public sector have been addressed by the Committee on Standards in Public Life (the Nolan Committee (U.K.)), the first report of which was published in May 1995. The report (the Nolan report) identified and defined seven general principles of conduct that should underpin public life, and recommended that all public sector entities should draw up codes of conduct incorporating these principles. These “principles of public life” are:
* selflessness;
* integrity;
* objectivity;
* accountability;
* openness;
* honesty; and
* leadership.
These principles along with the purpose of achieving transparency and effective use of resources for social benefit should balance governance and performance in state owned enterprises, through good structures, policies and procedures. Over a period such good governance practices will lead to better performance.

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Lessons for us from Kotak Panel (India) Report on Corporate Governance

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The Securities and Exchange Board of India (SEBI) is planning to surge ahead by proposing for greater focus on transparency and disclosures to improve corporate governance, with its latest Kotak Panel report. The recommendations cover a wide range of requirements for independent directors, composition of the board, separation of chairmanship and role of CEO, the make-up of board committees, treatment of subsidiaries, related-party transactions and auditor evaluations.

Some of the key proposals that will be of interest to the SEC in Sri Lanka and many similar developing countries are;

It is proposed for Companies to make public the relevant skills of directors necessitating the companies to develop a skills matrix to justify nominations. This will keep dud appointees away from boards. Directors are also required to attend at least half the total board meetings held over two financial years. If they fail to do so, they would require shareholders’ nod for continuing.

Another useful proposal is for the chairperson of a listed company to be a non-executive director to ensure that s/he is independent of the management. Which automatically means the role of CEO cannot be held by the Chairperson! This also makes sense in terms of having proper oversight. The same person cannot plan, execute and also chair the board to supervise.

The proposal is also to increase the minimum number of Board meetings to five a year. Whereas, companies currently have to meet quarterly to approve accounts. Therefore, now companies will have another fifth meeting will discuss, among other things, corporate strategy, succession plan, adherence to governance standards, board evaluation, etc. In addition, every board meeting would require the presence of an independent director.

It is recommended for the number of independent directors on a company board to be increased from 33% to 50%. Also, a great addition is to require detailed reasons to be furnished when an independent director resigns. This is to ensure that they remain independent of the company management. What is not spelt out is the role of the regulator once such reasons are given. Such rules without a monitoring mechanism is futile in countries in this region?

The audit committee is being proposed with the mandate to look into utilization of funds infused by a listed entity into unlisted subsidiaries, including foreign subsidiaries in cases where the total investment is at least Rs100 crore or 10% of the asset size of the subsidiary. This would hopefully minimize the occurrence of some of the famous collapses of companies in Sri Lanka.

SEBI may also get the power to grant immunity to whistle blowers to encourage such a system to work. This is the way to go if staff and auditors are required to report material non compliances outside the corporate structure.

Finally the recommendations have something for Ministers also. For government companies or SOEs as referred to in Sri Lanka, the committee has recommended that the board have the final say on appointment of independent directors and not the subject minister or his secretary!.

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Does an Audit contribute to Better Governance

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Audits are part of the governance process in companies. However, no governance system, however well designed, will fully prevent greedy, dishonest people from putting their personal interests ahead of the interests of the companies they manage. Frauds can be covered up by withholding information or fraudsters using low quality auditors to perpetrate and perpetuate fraudulent practices. Therefore, just because of mismanagement, one should not underestimate the value of audits, instead you should make it valuable to the company. Many steps can be taken to improve audit quality and corporate governance to reduce opportunities for fraud.

To meet its obligations to shareholders, the board must ensure that it receives relevant and reliable information and appoints appropriately qualified independent auditors for the job. The board can use auditors to report on the accuracy of information provided to them by auditing the R2R process. Record to Report or R2R is the management process for providing strategic, financial and operational feedback to understand how a business is performing. If this is misstated intentionally or otherwise by management the board will be misled. Many instances of misreporting of financial information that caused significant losses could have been prevented this way.

There must be open and honest dialogue between the auditors and the board. This would help the auditor to understand the board’s concerns and assist them in achieving their goal, through an effective audit process.

An effective audit committee is a vital component of an effective corporate governance system. It’s not necessary that such an audit committee should only be formed in listed companies. The Audit Committee and the auditors should maintain an ongoing dialogue independent of management and the rest of the board to address all significant matters affecting the financial statements, in the audit.

The auditing profession has an important role to play,as well. It should have a monitoring process in place to keep the auditors in check. If professional standards are not followed by audit firms the professional body should punish those who don’t meet such requirements. This will prevent low quality audits and increase market confidence in audits and auditors. Further, the auditors who are objective, independent and reporting on the factual status will not fear losing their client to a non compliant auditor.

Many such initiatives taken together will no doubt contribute to better governance.

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Convergence of Risk Management and Governance

Risk management is the identification, assessment, and prioritization of risks. Risk management in normal life means that it should be avoided but in corporate life it does not mean the same. It is defined in ISO 31000 as the effect of uncertainty on objectives (whether positive or negative) followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities.

Therefore a Company will focus on achieving growth and profitability within appropriate risk/control boundaries. The people in charge of governance must ensure that there are adequate controls in place for monitoring risks. Whereas the people in charge of the unit tasked with risk management must ensure they probe, analyse and take steps to mitigate negative impact and accept risk within the agreed appetite for risk and set boundaries.

The senior management recruited to develop plans to execute the strategy set by the board must ensure also put in place a process to manage risks arising from execution. Oversight responsibilities for the senior management activities rest with the board. To fulfill this responsibility the board should select competent board members and establish guidelines to govern the board, approve the overall risk appetite of the company and the plans prepared by senior management for which they should have recruited competent senior management. The convergence of governance with risk management activities takes place when the board performs these important tasks.
The COSO framework made up of eight components, as listed below may be followed to have an effective risk management function;
* Internal Environment – risk management philosophy and risk appetite, ethical values, etc
* Objective setting – Management must have process to set objectives and ensure it aligns with entity’s mission and are consistent with risk appetite
* Event Identification – Internal and external events affecting achievement of objectives must be identified, distilling between risk and opportunity
* Risk Assessment – Risks are identified and analyzed considering likelihood and impact, as a basis for determining how they are managed.
* Risk response – Develop set of actions in line with risk appetite – avoid, accept, reduce or share risks
* Control Activities – Policies and procedures to ensure risk response is effectively implemented
* Information and Communication – relevant information is identified and communicated in time for people to execute functions
* Monitoring – Entirety of enterprise risk management is monitored and modifications made as appropriate, regularly.

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Benefits of institutional investors entering the Sri Lankan capital market

It was reported in the news today that the Colombo stock index ended at 6,292.94 on 7 April, its highest close since 14 December 2016. The index has climbed 5.32% in the last nine sessions through Friday. The key reason being  Foreign, institutional, and high-net worth investors are buying shares. Institutional investors specially foreign funds buying at the expense of retailers has many benefits and hope these investors will drive the governance agenda in the local companies, too.

Hope our local Boards will be challenged by the impact of changing pressures and dynamics that boards in the developed world face. These Institutional investors should continue their push for more uniform standards of corporate governance in Sri Lanka.

They should hopefully keep the local listed companies in check, in relation to:

* Company plans for sustained long term value creation,
* Avoiding short-term priorities that compromise long-term interests,
* Strengthening the process for Directors and CEO remuneration, so that it may not be an irresponsible action,
* Having appropriate key performance indicators to measure board and CEO performance,
* Improving focus on board composition and diversity,
* Setting up effective sub committees of the board,
* Paying attention to significant changes being introduced by new accounting standards,
* Ensuring related party transactions are on arms length basis.

If the institutional investors get adequate representation on the boards of local listed companies, some benefits will accrue not only to the company and its shareholders but also confidence in the capital market will grow. We would like to see these institutional investors pressuring boards to demonstrate that they are actively involved in guiding a company’s strategy for long-term value creation. They should also replace non performing board members with skilled members, rather than leave the existing old boys club to continue their marriage vow of ‘until death do us part’.

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Board Diversity and Shareholder Value

One of the important governance issues facing shareholders, regulators and interest groups seems to be the gender composition of board of directors. But yet, a key driver for good corporate governance should be a positive relationship between board diversity and shareholder value creation. Should this be legislative or voluntary is another point of contention.

In India, the 2013 Companies Act introduced a mandatory minimum of at least one female director for most listed companies which has increased India’s gender diversity at the board level to one of the highest rates in Asia, with 14% of all directorships held by women. Gender diversity remains a challenge for Japanese boards, with only 3% of directorships held by women. Many countries in Europe continue to encourage gender diversity at the board level, as national laws regulating the number of female directors proliferate on the back of an EU directive. On average, 21.2 % of board members of the largest publicly listed companies in the EU were women, in 2015, and only 19.2% of corporate directors in the Fortune 500 were women.

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Board diversity took shape as the right thing to do and to create equal opportunity for women who make up half the population, at the highest level. However, there is research to indicate that diversity actually enhances shareholder value. Therefore, board diversity must be considered in the context of shareholder value as opposed to making a token appointment to look good. There is however a possibility that a portion of the women appointed may come from the controlling families of the company.

One such study which examines the relationship between board diversity and firm value for Fortune 1000 firms was published in 2003 titled- “Corporate Governance, Board Diversity, and Firm Value” by David A. Carter∗ Betty J. Simkins W. Gary Simpson, Oklahoma State University, D.A.Carter et al./The Financial Review 38 (2003) 33–53. This research was important because it presented the first empirical evidence examining whether board diversity is associated with improved financial value. After controlling for size, industry, and other corporate governance measures, they found a significant positive relationship between the fraction of women or minorities on the board and firm value.

For Sri Lanka to improve diversity ratio on boards, it’s not going to be voluntary. The only option for effecting change is to take a top-down approach that will force organizations to change from the top to create a work environment that will allow female executives to thrive and add value. The number of qualified professional women has been growing in Sri Lanka. They can add value, but corporate Sri Lanka needs a strong push, so that it can take the first steps toward a legislated change.

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“You needed me” love song for your Auditor.

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Independent auditors have been under fire from regulators and the public for over 15 years due to several global scandals and collapse of corporates. This is a very important profession to protect the interests of the shareholders and one that supports the growth of the capital markets, unhindered. So, had to find a love song for my 2017 Valentine’s Day message that could motivate auditors and reflect the way they would like to be appreciated when they try to help directors to do the right thing but don’t get appreciate for their efforts.

The song “You needed me” by Anne Murray is this year’s winner! The lyrics below would be a lovely message to hear from a member of the client board of directors who has benefited from an auditor performing his duty in compliance with the rules.

“I cried a tear, you wiped it dry ….(for some wrong doing)
I was confused, you cleared my mind….(did some wrong recording)
I sold my soul, you bought it back for me…(on fraudulent reporting)
And held me up and gave me dignity…(by rectifying the errors)
Somehow I needed you (changed from you needed me)

You gave me strength to stand alone again….(because of the audit)
To face the world out on my own again
You put me high upon a pedestal
So high that I could almost see eternity…”

If directors truthfully admit the assistance provided by auditors who ensure compliance with regulations and standards by companies, they should say that it gave them dignity and they were put on a pedestal rather than in the dog house by regulators. Though many don’t want to acknowledge this fact, when financial statements have been audited by an external auditor they are considered more reliable by investors, lenders, regulators and the public than those that have not. An audit also provides some assurance that your financial statements are free of material error and that you have not committed fraud or misreported facts while compiling the statements. With properly audited financial statements you can face the world confidently on your own, as you have nothing to hide.

When you hear Anne Murray sing this song, think of your auditor, next time!

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