Friday, June 1, 2018

Brian Gaynor: Directors’ role in need of a major shake-up


Australia’s banking royal commission, officially known as “The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry”, raises serious questions about director competency.

The same questions, in this columnist’s view, can be raised on this side of the Tasman following the collapse of CBL Corporation and the poor performance of Fletcher Building, Metro Performance Glass and other companies.

The Australian business media is having a field day on the topic. The Australian Financial Review (AFR) quoted John Pollaers, the former boss of Pacific Brands and Foster’s beer business, as saying that directors are too busy building empires.

He believes these directors want to enhance their reputation, rather than protecting shareholders’ interests, and there were too many lawyers and accountants on boards with little or no direct industry experience.

This is confirmed by the latest Waterman Search Board Diversity Index, which shows that 46 per cent of ASX300 company directors have accounting, finance and/or legal backgrounds.

Diane Smith-Gander, an AGL Energy and Wesfarmers director, was quoted by the AFR as saying “we have too many part-time directors”.

Smith-Gander dislikes the term work-life balance and says anyone who thinks becoming a director will somehow deliver a better work-life balance, compared with executive roles, will be sadly mistaken.

Rag trade billionaire Solomon Lew has also had a dig at the directors of Myer, the troubled Australian department store operator.

Lew’s Premier Investments is Myer’s largest shareholder after purchasing a 10.8 per cent stake at $1.15 a share 14 months ago.

He told the AFR that the Myer board should be “ashamed” of itself and demanded that executive chairman Gary Hounsell drop his A$83,000 ($90,600) a month salary because “of this mess”.

Lew went on to say: “Premier has consistently called for the Myer board to be replaced with experienced and talented directors who have a deep knowledge of retail.”

The Australian Prudential Regulation Authority (APRA) inquiry into the Commonwealth Bank of Australia (CBA), which was released on April 30, has been another huge wake up call for corporate Australia.

APRA believes that CBA’s board audit committee had a “light hand on the tiller” which indicated a “mindset of chronic ease that had permeated CBA until recently.

The board audit committee did not send a broader signal that directors were aware, prepared and engaged on emerging non-financial risk matters, and confident to challenge management directly”.

These governance issues are reflective of a world that is changing rapidly because of increased competition, artificial intelligence, the digital revolution, a greater focus on risk management and disruption caused by dramatic innovation.

Many directors have little specific industry experience, too many directorships and a part-time attitude towards their board positions.

In this environment, governance structures need to evolve and Netflix, the US online video-on-demand giant, is a leader in this area. The Netflix solution includes a combination of more director involvement with management and fewer directorships.

Netflix was founded by Reed Hastings and Marc Randolph in California in 1997. It listed on the Nasdaq in 2002 after issuing 5.5 million shares to the public at US$15 a share.

At the US$15 a share IPO price Netflix was valued at just US$0.31 billion. The company now has a sharemarket value in excess of US$140b ($202b).

There have been several studies and articles on Netflix’s innovative governance structure with the latest by David Larcker and Brian Tayan of the Rock Centre for Corporate Governance.

This paper, which is called “Netflix Approach to Governance: Genuine Transparency with the Board”, was published on May 1.

Larcker and Tayan write: “The hallmark of good corporate governance is an independent-minded board of directors to oversee management and represent the interests of shareholders.

Its primary responsibilities are to hire and replace the CEO as needed, monitor performance, review and approve strategy, and assess financial reporting and risk management.

In a typical corporation, the vast majority of this work is carried out through board meetings and specialised board committees.

“However, it is not clear that directors receive the information they need to make fully informed decisions on all key matters. Partly, this is due to an ‘information gap’ … between management and the board: directors have a less-complete understanding of the company and the market than executives because of their limited exposure to day-to-day activities and their independence from the business.

“Directors only meet four to eight times per year in full board meetings, and two to eight times in committee meetings. The information they review generally consists of dense PowerPoint presentations with extensive tables and graphs that span, in a typical large corporation, hundreds of pages.

“Some directors find these presentations heavy on data but light on analysis and insights needed to fully understand the quality of management, decision-making and performance.

“Boardroom dynamics can further impede information flow, particularly in settings where the CEO maintains strict control over the content presented, where presentations are carefully scripted, where follow-up beyond one or two questions is discouraged due to time, and where presentations are made by only a limited number of executives — such as the CEO, CFO, general counsel, and not others.

“While fiduciary rules allow directors to rely exclusively on information provided by management, dynamics such as these reduce the quality of that information and impair their ability to make good decisions on behalf of shareholders.”

Netflix takes a radically different approach to information sharing in two specific areas.

Firstly, one board member attends the monthly meeting of the top seven executives, one to two directors attend the quarterly meeting of the top 90 executives and two to four directors attend the quarterly two-day gathering of the top 500 employees.

Directors who attend these meeting are expected to observe but not influence or participate in the discussion. Netflix directors believe that direct exposure to strategic discussions gives them substantially deeper knowledge of the company than orchestrated visits to company offices or facilities.

Larcker and Tayan note that one director contrasts Netflix with another company where interaction between the board and executives are “much more scripted, more formal … all very carefully orchestrated”.

The second Netflix innovation is that board communications are structured as 20 to 40-page online memos in narrative form that include links to supporting analysis.

Board members have open access to all data and information on the company’s internal shared systems, including the ability to ask clarifying questions of the subject authors. These board memos are also available to the top 90 executives.

Netflix’s governance approach is rooted in and reflective of the company’s culture and leadership. The Netflix culture emphasises individual initiative, the sharing of information and a focus on results rather than processes.

How many Australasian companies can make these claims? How many of our companies focus on results, rather than process?

This columnist’s impression of several troubled companies, including CBL Corporation, Fletcher Building and Metro Performance Glass, is that their CEO and senior executives were not fully transparent with their boards, directors didn’t have a deep understanding of the risks their companies were facing and some directors were in semi-retirement mode.

The clear answer to these issues is that we need younger directors with fewer board seats and more industry experience.

But companies also need to be far more transparent with their boards, including inviting directors to management meetings and giving them access to information on companies’ internal shared systems.

The Australian banking royal commission, and the disappointing performance of many of our listed companies, indicate that corporate governance must evolve to enable companies to meet the challenges of a rapidly changing world.

Brian Gaynor is an investment analyst and the Executive Director of Milford Asset Management.

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