RETHINKING CORPORATE GOVERNANCE

Being a director of a listed company is fast becoming more complex and less attractive… and yet the role has never been more important. Nearly 30 years after his seminal exploration of boards and governance in Strictly Boardroom, published as part of a Sydney Institute initiative, Professor Fred Hilmer AO has revisited the state of leadership in corporate Australia in a new publication What’s Wrong With Boards. Economic policy and reform strategist, Fred Hilmer AO was the chief executive officer of John Fairfax Holdings from 1998 to 2005 and vice-chancellor of the University of New South Wales from 2006 to 2015. He addressed The Sydney Institute to speak on his new book on Tuesday 16 August 2022.

RETHINKING CORPORATE GOVERNANCE

FRED HILMER

Thank you, Gerard, and welcome.

As Gerard said, it is 30 years since we did Strictly Boardroom; in 1992. However, the older you get, the more time seems to be compressed, so 30 years seems like 20 years. This book came together for a number of reasons. One was, Byron Pirola at Port Jackson Partners who was quite interested in doing something on governance. In addition, people were independently coming to me saying, “You wrote Strictly Boardroom, why don’t you bring it up to date?” As old friends, we eventually got together and tried to work out a way we might, if we were lucky, complete a book. It is a great thrill to actually see that the book now exists. It will be even better if people read it, and it would be superb if they read it and use it as an opportunity to question some of the practices that we now associate with good governance.

Now some perspective.  Governance is a hard problem. It’s not easy to be a good director; it’s certainly not easy to chair a company. And the pressures on boards are only going one way, and that’s up. In that environment, you keep thinking, “is there a better way?” not because directors are failing, but because effective governance is hard, and it’s getting harder. I’ll come back to some of those pressures that are put upon boards of directors.

A few ideas, by way of introduction. The publicly listed company – the vehicle through which the board operates – is a key institution. It’s an important source of capital; capital for big things that require scale, but also capital for little things that you hope will blossom. But, it’s an unusual source of capital, because it not only is a source of capital, it’s also a source of investment opportunities. The term I have heard used is that it “democratises investments”. To everyone who is issuing shares, there is someone buying shares. The level of share ownership in Australia is quite surprising – about 35 per cent of people own shares in listed companies, excluding what they own through their superannuation.

So, share ownership and governance isn’t just for the top half per cent or the top 10 per cent. This is a vehicle that creates investment opportunities and provides capital. In that sense, it’s an important institution.

But all is not well in public company land.

Public companies had a pretty rough time, you could say of their own making. We’ve had the Royal Commission, which was an extremely thorough piece of work; it raised quite important issues. We’ve had the prudential and the corporate regulators looking at this; and we’ve had individual companies looking at themselves. The prevailing feeling out of all of this is negative. There is very little in any of those reports that say, “People are doing a great job”. Instead it is a case of, “This is messed up”, “That’s messed up”, “You shouldn’t have done it that way”, “Why didn’t you do this?” and so on. So, we’re coming into this time where we want to rethink governance, with a very negative view of what the listed company board does.

The other thing that really makes the landscape unattractive at the moment is that there are many casualties. I still have to pinch myself when I say that all the big four have lost chairs and CEOs; Wealth management firms have also lost CEOs and chairs. We’ve never seen a turnover like that in corporate leadership positions in this country. That’s telling us something that we ignore at our peril. All is not well in public company land.

There’s another way to look at these issues. We should look at what the challenges are that the public company boards are trying to deal with. In our study, we have identified two areas of failure; failure of performance and ethical and legal performance. If you think about it, the most significant of failures of performance is the acceptance by any board of marginal results or marginal performance. That’s the “damned if you do, damned if you don’t” position. We have talked to directors who tell us their MD is adequate but not outstanding and ask what should they do. You’re damned if you do get rid of the person and the replacement is no better. If you don’t get rid of that person you continue to live with the uncomfortable feeling of “Are we really doing our job? Are we really engaging properly in terms of the performance that we expect?”

The other side of that failure of performance is what we call can kicking; in the book there are a number of examples. When life gets tough and you see a can on the side of the road, kick it down the road and, if you’re lucky, someone else will pick it up. If you’re unlucky, kick it again. That’s a metaphor for what I think is an important area of performance that gets away from the board, and then becomes too hard.

The other side of the ethical and legal failures goes beyond boards. The Royal Commission did quite an elegant job in terms of defining what that was. In simplest terms, we have to draw a distinction between what I can do and what I should do. When we mix that up, we get into trouble. Particularly when, what I can do allows me to enrich myself, and what I should do does not. Here develops the tension that characterised the Royal Commission. In public company land, as we have found, there are some tough reviews needing big changes in terms of personnel, not all of which were applauded. Changes to deal with some of the ethical challenges and performance challenges that, after all, is what the public company is there for.

So, how does the public company work? It seems to me that not much has changed since we did Strictly Boardroom in 1992, which was also the year that Sir Adrian Cadbury came out with The Cadbury Report, or the blueprint for the way in which governance is dealt with. There were four key ideas in The Cadbury Report. The first is independence of directors which is really important – if you do not have directors whose sole and obsessive interest is the welfare of the company, you are going to have trouble with the governance regime. So, independence is really important. Cadbury’s second point was the independent non-executive chair – that’s more controversial and I’ll come back to it. The third point was transparent, accurate and relevant disclosures. If you don’t know what’s going on – and I think these commissions and reviews have shown this – you can’t do anything about it. Keeping directors properly informed with the chair of the board driving full and accurate disclosure is the third Cadbury principle. The fourth was to have supportive processes; such as audit committees, risk and personnel, and to have people involved in those committees who were going to do a good job. That’s where Cadbury was, and I don’t think that much has changed.

What has changed is, firstly, that boards are being asked to take on significant new roles; ESG, employment implications, ethics, values, environment, diversity, sense of purpose. Any one of those can become a topic that requires work and debate. And, if it’s there, the ability to take advantage of an opportunity. There are new roles but, at the same time, the traditional role of providing good governance has become more difficult. One of the things we looked at was to compare some of the big corporations 20 years ago with today. It’s the same governance, but it’s not the same company.

We see complexity, not just through size, but also through the challenges that they have to field. For example, disruptors who say, “I think we’ve got a better way to do what you do” – how do you then deal with that? The other side to what has changed is that we had a very simple plan with Cadbury but it was oversimplified, and it wasn’t supported by research. When you’ve got a founder with potentially controlling shareholders, when you’ve got a founder who knows and who grows the business, who lives the business, then the idea that there’s going to be a non-executive over that person, and over that process makes no sense. There’s a nice saying, “Even at a round table, someone sits at the head”. The research tells you that having a non-executive shareholder will lead to worse results.

The other thing that has changed or has come onto the scene is this word “best practice”. You know when you sit and play around with your computer, at times you come up with gems. I put in “best practice” and I thought “What’s going to come up?” I found that Professor Cuban, who is at Stanford, in the Education School, was similarly perplexed as to what best practice really meant. He checked around the blogosphere and its origin seems to be in the business sector, with management consultants and corporate gurus. It’s become a buzzword. In becoming popular, the phrase has drifted away linguistically from its original meaning of effective practices, to mean faddish or trendy activities.

The result of a fetish with best practice is that people who believe in it believe there is only one way to run a company and that’s the best practice way. But that idea was discredited over 50 years ago. There is no one best way. The best way is contingent upon circumstances you have to deal with. Rather than best practice, we prefer “best fit”. This asks, “What does this company or board need to do in light of who it is, who its competitors are, what’s happening with regulation, what’s happening with its people and their willingness and ability to implement?”

What has changed is that there is increasing complexity facing the companies. But we have an opportunity to simplify things if we could get rid of some of the non-research supported ideas and high on the list is best practice. I take three case studies that make that point more graphically. The first one I take is the skills matrix. Who is familiar with the skills matrix? Are you embarrassed that you do one? The skills matrix has an interesting genesis. In 2003, there was no skills matrix. The additions of the ASX guidelines didn’t mention skills matrix. In 2007 came the next revision, silence, not a word about skills matrix.

Then, in 2010, the third addition saw the introduction of a skills matrix as a formal recommendation, requiring companies to have one and disclose it. It became something that companies had to do and put into their annual reports. In 2019, the Governance Institute picked up the ball up, and wrote quite a lengthy paper on the skills matrix. But it’s all assertion. Take one of the phrases – “Having a skills matrix is good governance”. Why? What company, in their right mind, is going to lay out skills in a way that is obviously transparent and shows their competitor exactly where they want to hit? The other good example is independence. While independence is an important concept, it is defined in the listing rules very mechanistically. Ask the following – “Have you had some sort of financial interest with the company that would in some way influence your ability to be objective and single minded about performance?” Going along with that is the belief that more is better. So, if you have seven non-executive directors, then you should have seven who will stay independent and none who are not independent. Again, if you look at the research in the United States, more isn’t better. You get all the benefit of independence, as long as there’s at least a simple majority.

If it is not a numbers game, having a majority is useful. But what are you actually going to expect them to do, and how are you going to assess independence? The independence that matters is not whether you were on the audit team three years ago. The independence that matters is, have you got independence of mind, and the experience and the nose to make judgements about the veracity of people, the skills that they’re bringing to bear and about their ability to function as a member of a body like a board. Independence, in practice, is nothing like independence in the listing rules. It’s not trivial, and it’s an area where quite a bit more work is needed to find better ways to gauge independence and to make that judgement.

So, what do we do? The last three chapters in the book deal with ideas for getting out of these various traps that have emerged along the way. The first is to think about how you might structure a board, how you might structure governance. We are, at the moment, still stuck with “There’s one way and it’s the ASX way”. But if you look, not too far, around Western countries in particular, but also Europe, there are at least five models of what could be a best fit approach to governance, that should be considered. The first is the ASX board, and we’re not saying it’s a hopeless model; it’s a model that works in certain circumstances. It works when business can be readily understood, it works when you’ve got a competitive market, and it works when your market is relatively stable. Under those conditions, this sort of a board works reasonably well. When times get more complex, and tougher, you need more input. In the ASX board, the premium is on independence rather than knowledge and expertise.

When you move away from an ASX board, to what we call an “industry heavy board”, the premium is on knowledge. You’re trying to recruit people to the board who have independence of mind, but also have knowledge that can contribute, and that it isn’t easily obtained and used. So, you have an executive heavy board. Executives might be the chair – that’s one version of it – it could be retiring executives who have more to contribute but can do that more effectively as a director, and it might be experts that you want to bring on the board. But all of those have ways in which you supplement independence with knowledge than.

There’s another board that exists around here and that we see increasing, and that’s the private equity board. That is a real challenge, because a private equity board is about improvement. That’s why they buy in, and they buy in to sell out, and in the process have to add value and improve. If you look at that board, which is probably not able to be constructed in accordance with ASX guidelines, it’s a board that offers something economically that other boards don’t. Then there’s two others I want to talk about briefly.

One is what’s called Governance 3.0. This has come out of the US. It’s intriguing, but probably impracticable. The idea is, you have a management team and they are 24/7 on the business, and they know their stuff. You’ve got directors, particularly independent directors, who maybe do 250 hours/year on their director activities. Some of them do less and many of them have other important roles as chairman or managing director somewhere else. Governance 3.0 says, “What about having two of your directors as full-time members, supporting the governance activities of the rest of the board?” It’s an intriguing idea but no one has implemented it yet. Again, if we’re coming to this task as something where we want to make improvements, and we want to think differently to do that, then Governance 3.0 might have something in it. Particularly when you look at some of the struggles and the failures of an audit process. Having a full-time experienced person supporting the non-executives might make a lot of sense.

Lastly, is the two-tiered board, which is very much the German/European model. You have a supervisory board, which deals with compliance. Then you have a management board, which deals with running the business. The two work hand in hand. A lot of people thought this was really good, and that it would avoid the problems that exist with a single board. Graham Bradley wrote a paper where he said, “By the way, they’ve had the same problems in Europe, and now, just in the last few weeks, we’ve seen a similar problem in Japan with Toyota”. So, first, is to look at the structures, and have an open mind about board structures that could work. The second is, how do you deal with the broadening agenda. You can’t just take more time for board meetings. Board meetings are already taking much longer than they did. When I started, it was lunch and 2:00pm meeting, or 11-1 meeting and lunch.

We need some sort of forcing device to use time better. In the next chapter of the book, we talk about focus and delegation as partners, not one or the other. If you focus without delegation, you can be overwhelmed. That’s what’s happening – conversely if you delegate without focus, you abdicate. You need to find the right balance between the complimentary ideas; focus and delegation.

The final thing I wanted to talk about is leadership, particularly the leadership of the chair of the board. We held many informal discussions with people about the issues in governance. Out of that, it was clear that the way in which the chair was selected, the leadership role that the chair undertook and the type of partnerships between the CEO and the chair were critical and areas where you could improve performance. So, our third suggestion is to pick that up.

In summary, two contrasts capture what I’ve been trying to say. The first one is, think about “best fit”, not “best practice”. Second, be evidence based not belief based. If we bring that hard thinking to what is a difficult to structure, a messy but important problem, then I’m optimistic we can start to move forward.