Governance

1. Board balance and effectiveness

Boards need to make strategic decisions about how to employ financial capital in the best interests of their shareholders, employing the company’s business model (or indeed modifying it if necessary) to build the value of all the six capitals to deliver a sustainable return on investment. The primary roles of the board include:

• Participation in formulation of strategy,
• Counselling management on the execution of strategy,
• Monitoring management performance and
• Scanning the operating environment for compliance with regulatory and legal requirements and the emergence of risks and opportunities inherent in the company’s strategy and positioning.

Aligning the interests of leadership with interests of minority investors
It is crucial that the balance of power on the board and the executive leadership is in balance in order to best take advantage of the leadership’s collective wisdom and acumen, while ensuring that power is not concentrated within one (or more) individuals, raising the risk of corruption, or actions not in the interest of the company and its shareholders (particularly minority shareholders). Companies with relatively concentrated shareholding or with multiple classes of shares which concentrate control in certain individuals or groups also present a heightened materiality.

Entrenched boards and management teams also present a form of ‘key-man risk’, especially where charismatic or long standing leadership (who often forgo the management systems and controls befitting large and complex companies) depart, leaving companies exposed to governance challenges. Thus, power on the board and the executive leadership needs to be kept in balance in order to best take advantage of the leadership’s collective wisdom and acumen, while ensuring that power is not concentrated within one (or more) individuals, raising the risk of corruption, or actions not in the interest of the company and its shareholders (particularly minority shareholders).

Exposures
Exposure relating to board balance and effectiveness

• Size, complexity
• Concentration of power, control, ownership

2. Audit independence

In order for the company’s shareholders to be assured of an unbiased opinion on the validity and reliability of the financial statements, the auditors should be of independent mind and uninfluenced by the relationship between the company and the auditing firm. The close and dependent relationship between Arthur Andersen and Enron was one of the main contributors to the downfall of Enron in 2002. South African companies have, until recently, been largely complacent on this issue, but KPMG’s alleged improper relationships with companies related to state capture have brought the issues into the limelight. Globally (and in SA, see regulation promulgated by IRBA seeking to limit audit tenure), regulation presents an emerging issue requiring a mature response.

Aspects that influence audit independence include:

• Audit committee members with pre-existing relationships with audit firms
• Complexity of financial engineering in the company’s financials
• The extent to which non-audit services, which could compromise independence, are provided by the company’s auditors
• Audit tenure
• Importance of the audit fee in the auditor’s life

The first four aspects above are given more weight in the FarSight analysis. While audit tenure is easy to monitor, we feel that the ‘interdependent’ relationship that may develop from audit tenure is likely to achieve maximum vulnerability well within the proposed 10-year term, with hardly any further increase in vulnerability for longer tenure. On the other hand, individual relationships can quickly become compromising for the independence of the audit.

3. Leadership selection and preparation

This issue considers predominantly leadership at board and executive level, though also the pipeline of leadership at higher management levels that contribute to sustainable succession of leadership for the company.

Aspects that raise exposure include:

• The age of the leadership, with leaders nearing retirement raising the materiality of the issue for the company.
• Whether the CEO is an insider or an outsider
• Key-man risk relating to a powerful and charismatic leader

A proxy indicator that can be combined with the above to derive a sense of vulnerability is the ratio of CEO pay to the pay of other top execs, such as the CFO.

4. Remuneration and incentives

There are four sub-issues relating to remuneration and incentives:

• Remuneration governance – how remuneration is governed at board level – Composition, attendance, practices (attendance), whether they vote, discretion or by formula, use of remuneration consultants and their fees (adds or detracts from robustness)
• Link between remuneration policy and company strategy (mostly around share price performance)
• Link between remuneration outcome and company performance outcome, in particular performance against sustainability issues, or identified material issues
• Fairness from an equity standpoint – this relates to the gap between executive remuneration and general worker pay

Remuneration governance speaks to the way remuneration is governed at board level. It speaks to the composition of the remuneration committee in terms of skills and independence and their attendance at meetings. It also concerns practices on the committee including whether executives attend or not and whether this is by standing invitation and also whether they vote on remuneration matters. It also concerns the extent of the discretion to alter remuneration outcomes granted to the Remco vs a formula-driven approach to remuneration outcome. It also involves consideration of the use of remuneration consultants, as well as their independence and fees. These issues give an understanding of the soundness or lack thereof in the policies and processes through which companies set their remuneration.

The link between remuneration policy and company strategy identifies the extent to which the remuneration policy defined by the company speaks cogently to the strategic imperatives which the company itself has identified. Where strategic imperatives are not quantified and incentivised, the potential is created for the interests of management and those of the company (and ultimately the shareholders) to diverge – a precursor to the destruction of shareholder value.

The link between remuneration outcome and company performance outcome speaks to the extent to which incentives truly incentivise management to perform, or whether they amount to de facto guaranteed pay because of their generosity. This factor also speaks to the type of performance which is incentivised, the balance between being short-term in nature or based on long-term performance, with long-term vesting periods and the potential for clawbacks; whether it relies on an element of financial engineering by management or is entirely organic; whether it speaks only to financial outcomes or to a broader set of measurable firm incentives.

Fairness in terms of equity – Society is increasingly becoming concerned with the growing wage gap between highest and lowest paid workers. This widening gap is regarded as one of the chief indicators of an economy headed towards an unsustainable outcome. Executive pay should relate to the economy as a whole, not only to equity within the industry, as some boards may use high average employee pay as a smokescreen to hide remuneration levels out of proportion to the economy. The global regulatory environment has put pressure on reducing the gap between top executive pay and that of the lowest paid worker (eg. In Switzerland proposals sought to limit it to 12X). South Africa is the world’s most unequal society, not only in terms of employment (millions are unemployed), but also because of the dispersion between top and bottom earners.

5. System integrity

This issue refers to the ability of the business to deal with new complexities it takes on that potentially disrupt the business’ systems or its business model. These could be a result of new risks the business takes on, such as:

• an acquisition strategy
• integrating vertically into the supply chain
• entering new geographies
• taking on significant debt
• forming significant relationships with new business partners
• adopting a new, possibly experimental, technology

Likewise, the business’ systems or business model may also be disrupted by new models introduced by competitors, such as the disintermediation of mobile banking and supermarket banking in the banking sector.

Part of the role of the board is to scan the environment for opportunities and threats, and to take on risks, or make investments to secure returns to shareholders. However, in doing so, the firm’s leadership should understand how these new complexities impact on the ability of the firm to continue to serve customers, retain employees, maintain balance sheet strength and cash flow, preserve intellectual/manufactured capital and natural resources, as well as other relational capital aspects, such as suppliers, the regulatory environment, etc.

Aspects include the core systems and models that ensure the sustainability of the business. These systems and models can range from financial models, such as management of liquidity in a bank, to IT systems required to maintain business continuity and defend against disruptive innovation from competitors. Some sub-issues:

• Systems and models to manage financial risks
• IT systems to manage business and operational risk
• Preparation for and bedding down of acquisitions

IT governance

IT systems are becoming the nerve centres of modern firms. Companies that deal with big data and with data that serve customers, are particularly vulnerable to business continuity being disrupted by failures in the reliability of IT systems. Mission-critical systems, particularly in the logistics environment, as well as where safety of stakeholders is concerned, also require careful governance

Not only does this issue have a direct impact on the competitiveness of the business, such as where new, disruptive technologies overtake traditional business models (e.g. Uber in the taxi industry), but shortcomings and failures in IT governance may result in both direct loss to the company, as well as indirectly, through loss of confidence, trust and reputation.