The Global Governance Crisis: Boards In Denial
All board members I speak to individually are perfectly willing to admit the challenges boards face are daunting. But collectively boards pretend they are in control. They must. To admit they are not would be an admission they are not doing their job.
That boards are in denial itself a problem. As I wrote in my last article, we have a Global Governance Crisis. Large companies are facing a corporate crisis of some kind every year. And most of these crises are the result of predictable surprises. But boards are either incapable of predicting them, are incompetent when it comes to preventing them, or wilfully ignore them.
The evidence says most crises were predictable, and in most cases they were predicted. It also shows the vast majority are not caused by external factors beyond the control of leaders. They are the result of bad strategic decisions and poor management in related to internal factors within the control of boards and executive teams.
Boards must first recognise and accept the evidence in the PwC Crisis Survey 2019, and the fact the frequency of corporate crises means we are facing a Global Governance Crisis.
Next they must ask themselves why? What are the causes? And what are the solutions. Not to do so will leave boards facing growing pressures to explain why they continue failing in their primary duties to shareholders and other stakeholders.
Today’s boards face several real and daunting challenges. And the pressure on them will continue and increase. This is made clear in a paper, A Guide to the Big Ideas and Debates in Corporate Governance, by Lynn S. Paine and Suraj Srinivasan, both professors of Harvard Business School (October 14th 2019). They categorise the issues under several heading:
· The nature and purpose of the corporation
· The role of shareholders
· The composition and role of boards
· Selecting and rewarding corporate leaders
· Investing for today and tomorrow
· Defining and measuring performance
· Overseeing risk and ensuring accountability
· Defining standards for reporting and disclosure
The Nature and Purpose of the Corporation
Paine and Srinivasan note, “the nature and purpose of the corporation — and, by extension, the purpose of corporate governance — has long been a matter of debate” and “Today, the debate continues but with a new sense of urgency”.
Additionally, “with investors, regulators, and the public calling for greater clarity of corporate purpose, boards and managers will want to give this issue serious consideration and take steps to confirm that they have a shared understanding of their purpose in governing and leading”.
As with each of the topics covered, Paine and Srinivasan conclude this section with a set of questions boards should be asking themselves. Two questions stand out. The first, “Effective corporate governance starts with a shared concept of corporate purpose, but what is the purpose of a corporation?” and the other, “Do corporate directors and officers of your company have a shared understanding of the company’s purpose and their own purpose as board members and leaders?”
They stand out because, as I have reported recently, the Financial Reporting Council in the UK published The Annual Review of the UK Corporate Governance Code in January. It includes an early assessment of the adoption of the 2018 code by 82 entities and found. “Too many companies substituted what appeared to be a slogan or marketing line for their purpose or restricted it to achieving shareholder returns and profit”.
The report adds, “This approach is not acceptable for the 2018 Code. Reporting in these ways suggests that many companies have not fully considered purpose and its importance in relation to culture and strategy, nor have they sufficiently considered the views of stakeholders in their purpose statements”.
So, on this point alone we can conclude that 82 o f the largest companies in the UK are not being effectively governed. And on this basis, it can be assumed the majority of other UK businesses are not being effectively governed either.
The role of shareholders
On the role of shareholders, Paine and Srinivasan say that despite pressure from regulators and think tanks for a shift from shareholder primacy to a stakeholder model, “overall, the rise of ownership concentration, greater shareholder engagement, and hedge-fund activism point to an era of greater shareholder influence over companies”, developments that they say, “raise questions about the accountability of shareholders, particularly those who seek to influence corporate actions, and about the prevalent model of shareholder value maximization as the goal of good corporate governance”.
In particular they note, “although institutional investors style themselves both as stewards of the corporations in which they invest and as fiduciaries for their own customers and clients, some commentators question whether they can play both or, indeed either, role effectively given the inherently conflicting interests involved and the nature of the passive investors’ low-cost business model”.
They add, “the reliance of many institutional investors on proxy advisory firms to guide their voting on important corporate matters has also raised questions about their capacity to act as stewards and about the influence of proxy advisors who, themselves, have no stake in the votes they recommend”. And, “the proxy voting system and the process by which shareholders are permitted to put forth proposals for a shareholder vote have also become matters of contention”.
The authors advise that “In this context, boards and managers would be well-advised to have a thorough understanding of their companies’ shareholder base and a deliberate approach to shareholder engagement. They should be prepared to be challenged by activist investors, and their overall governance arrangements should strike an appropriate balance of power among shareholders, the board, and management”.
A quite recent high-profile case from which lessons can be learned is the hostile takeover attempt by Kraft Heinz in relation to Unilever. Whilst it ultimately failed due to the support Unilever had from large institutional investors the board of Unilever subsequently took short-term actions to fend of similar attacks which were almost certainly not in the best interests of long-term investors and other stakeholders.
The composition and role of boards
Paine and Srinivasan state, “The board’s core functions typically include selecting, monitoring, advising, and compensating the chief executive; monitoring the company’s financial structure and declaring dividends; deciding on major transactions and changes in control; monitoring the company’s financial reporting and internal controls; and overseeing the company’s strategy, performance, risk management, and compliance with relevant legal and ethical standards.”
They then observe, “Even though the functioning of boards is generally thought to have improved in recent decades, questions remain about the ability of boards, especially those of large public companies, to do the job expected of them” adding that competing interpretations of the board’s fiduciary duty only complicate the challenge.
They then ask, “As corporations have grown more complex, the demands on boards have increased accordingly, but is your company’s board up to the task expected of it today?”
Selecting and rewarding corporate leaders
On this topic they say, “In recent years, the board’s job has become more difficult in part because the CEO’s job has become more difficult. As companies have become larger and more complex, and the pace of change has accelerated, the traditional activities of corporate leadership have become more challenging”.
They go on to add, “In addition to market and competitive pressures, today’s corporate leaders face an array of adverse forces ranging from heightened investor activism and volatile capital markets, to increased social and cultural diversity, mounting social and environmental challenges, political and regulatory uncertainty, and disruptive technologies changing industries across the globe”.
They also note, “Many commentators say that traditional models are outmoded and that companies today need leaders who are equipped with a broader set of skills and capabilities and who are more diverse”.
On executive pay they observe, “Despite critiques of the “pay for performance” paradigm that underpins these programs, including studies linking aggressive targets to excessive risk-taking and destructive short-term behaviour, the paradigm continues to shape the way boards approach executive pay”.
Their question for boards is, “what kinds of leaders should boards be appointing as CEOs of today’s corporations — and how should boards evaluate and pay these leaders?”
Investing for today and tomorrow
“When corporate resource allocation is done well, companies are able to evolve and renew themselves over time, while at the same time producing a continuous flow of products and services that meet the needs of their customers and a continuous flow of profits that can be re-invested in the business or paid out to shareholders. In practice, however, resource allocation is extremely difficult” say the authors.
They then observe, “the difficulty is compounded by pressures from shareholders with differing objectives, time horizons, and tolerance for risk. As a consequence, many managers give short shrift to strategic and human complexities when making resource allocation decisions and instead rely on standard financial tools such as discounted cash flow analysis. Costs and benefits to third parties — so-called “externalities” — have not traditionally been part of this analysis”.
Pointing to potential solutions they say, “the debate about short-termism suggests that the tensions can perhaps be better managed and somewhat mitigated through better oversight over strategy, more clarity about time frames, and improved communication with investors”.
But they then add, “the debate also suggests the need for more radical innovation in how companies develop strategy and allocate resources. A first step is for boards to better understand these processes, the time frames that guide them, and the extent to which they include human, environmental, and social considerations. These matters raise questions of business judgment that boards and executives will increasingly be expected to address”.
As indicated already, boards lack clarity of purpose which is supported by the evidence in previous articles showing boards are unclear about what value the firm creates. The two are related, of course.
it is because of this lack of clarity boards are also unable to explain who they create value for, or how they create it. If boards are unable to answer these three basic strategic questions, how can boards claim the strategy of the firm is credible? And how can they possibly communicate effectively with investors, or claim to be allocating resources effectively?
In short, they are not governing strategically and effectively. And they cannot be managing resources strategically and effectively.
Defining and measuring performance
Given the last comments (above), we must also assume boards are unable to define and measure performance effectively. But as the authors points out, “as fiduciaries, boards of directors are expected to keep a close watch on corporate performance.” They also illustrate the complexity of this issue by asking, “But what is corporate performance and how should it be assessed?
They observe, “In addition to measuring financial performance, companies are also being asked to measure their social and environmental performance on various dimensions ranging from diversity and inclusion, to customer privacy and supply chain conditions, to human rights and carbon emissions”.
They then argue, “How best to define and measure corporate performance — and over what time frame — are first-order questions that should be on every board’s agenda”. Few would disagree, but how can boards be measuring performance effectively if they lack clarity about their purpose?
Overseeing risk and ensuring accountability
On the issue of risk, Paine and Srinivasan say “the board’s responsibility to oversee corporate risk is widely recognized, but interpretations of what this responsibility requires vary widely”. And they add, “boards today are expected to oversee an extensive and ever-expanding menu of risks.” Then they suggest this situation, “has created a challenge for traditional practices of internal controls and is testing the ability of boards to provide adequate oversight.”
The authors also correctly observe, “Most directors today recognize the importance of robust oversight, but it is unclear whether boards, as they are currently constituted and operate, are up to the task. The increasing size and complexity of companies, the expanding array of risk areas, and the difficulty boards have in getting the information needed to exercise effective oversight all bode poorly for a positive answer to this question.”
How boards are constituted and operate certainly matters if robust oversight is to be assured, but in my view the first consideration must be clarity of the purpose of the organisation, because any risk can only measurable in relation to its impact on the ability of the business to achieve that purpose.
Defining standards for reporting and disclosure
On the final topic covered in their article the authors say, “Boards of directors play an important role in ensuring that investors and the public receive accurate and timely information about corporate activities and performance”. It may be more correct to say that they “should”. Given all the other points raised in this article it is clear that most boards “cannot”.
This problem is made worse by outdated accounting standards, as the authors point out. Also by, “heightened demands to provide various types of non-financial information, especially about their social and environmental impacts”.
They add, “the long history of generally accepted accounting principles suggests that it is likely to be some time before sustainability or integrated reporting becomes standardized and widely accepted as a part of doing business. In the meantime, boards and companies will face difficult decisions about reporting and disclosure on both financial and non-financial matters”.
They then conclude by saying, “As demands for more extensive reporting and disclosure continue to escalate, boards and companies will be challenged to find more efficient and more meaningful ways to respond.”
The Global Governance Crisis I speak of — the inability of boards to avoid predictable and preventable crises — will not be addressed whilst only individual directors are prepared to admit the challenges are daunting and boards remain in denial.
My fear is that they will remain in denial. Their ways of thinking and the outdated methods and tools make them ill prepared to address the challenges, but are they likely to admit to their weaknesses and find new ways? If they are wise, they will. If they do not, we can expect to see many more corporate crises in the news headlines. And boards that fail to act can expect to be continuously fighting fires.
A Conference and Research-Led Inquiry
The Strategic Management Forum believes addressing the Global Governance Crisis is a top priority. We are therefore hosting a conference on March 9th in London: “UNDAUNTED: How Successful Leaders Face Up To Wicked Problems And Avoid Predictable Surprises”.
The Conference will be followed by a year-long “Inquiry Into the Nature and Causes of Predictable Surprises and How to Avoid Them”. Details: firstname.lastname@example.org