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Correlates of Good Governance

Board Effectiveness

Concerning board effectiveness, a good example of relevant guidance is provided in Principle 2 of the ASX Code under the heading “Structure the board to add value,” where it is stated that “a board of an appropriate size, composition, skills and commitment [will be enabled] to discharge its duties effectively.”25 An effective board is one that has independent nonexecutive directors who can challenge management and hold them accountable. This can be achieved by26 (a) having a nomination committee comprising at least three independent directors, its chair to be an independent director, or if it does not have a nomination committee, the process it employs to address board succession issues should be disclosed; (b) utilizing and disclosing a skills matrix showing the mix of skills and diversity of the board; (c) disclosing the names of the independent directors and the duration of service of each director as well as the director’s interests, positions, associations, or relationships that could bear upon his or her independence; (d) having a majority of the board being independent directors; (e) having the chair of the board be an independent director and not the same person as the CEO; and (f) introducing an induction program for new directors to provide them with the appropriate professional development opportunities, skills, and knowledge required to perform their duties effectively.

Improved performance is the result of an interaction effect between structured and people elements of governance. As already mentioned, strong leadership is a must for effective governance. In their report on “Taming Narcissus: Managing Behavioural Risk in Top Business Leaders 2012,” the MWM Consulting authors drew attention to the fact that adhering to CG is not enough and this fact poses a basic challenge. The backdrop for meeting this challenge is that “over the last decade a ‘seat on the Board’ has gone from being a virtual guarantee of a painless and sustained passage into the hierarchy of the ‘Great and the Good’, to being a highly visible and pressured role, exposed to the commentary of anybody and everybody, together with the far more prevalent threat of litigation” (MWM 2012, 1). The report goes on to remind its readers that for a board to add value to a company it is not enough to have clear robust processes in place and to comply with governance principles; its members must also be courageous and possess the necessary judgment to effectively tackle real issues confronting the company when they need to do so (p. 2).

In order to find out what makes a successful board, MWM Consulting (2014) interviewed about 70 board directors, totaling approximately 1,000 years of experience as CEOs and/or as company directors, on more than

125 public companies in the United Kingdom and 75 others internationally in more than 20 countries. With a response rate of 90 percent, the study found that (a) the key to a board’s effectiveness is the chairman; (b) the CEO must engage constructively with the board; (c) it is essential to have good balance between the chairman and the CEO, the CEO, and his/her team and finally between the nonexecutive members; (d) being a successful nonexecutive director means combining both competence as well as character; (e) the chairman of the board must ensure that the board functions like a high- performing team; (f) an effective board has the benefit and safety valves in the form of the senior independent director and the board’s effectiveness is regularly reviewed, and has the support of the company secretary; and (g) when potentially destructive issues arise, the senior management quickly identifies a problem and deals with it effectively (p. 3).

A strong argument for demanding a strong governance culture in a country and a company provides stakeholders, particularly investors and creditors, a sense of assurance. As Sir Winfried Bischoff, the Chairman of the Financial Reporting Council (FRC) in the United Kingdom, stated in his introduction to the FRC’s 2015 report,27 referring to the United Kingdom, strong governance encourages companies to list on the country’s stock exchange and “provides assurance to investors that the information they receive from boards, is fair, balanced and understandable” (p. 1). Interestingly, the FRC also reported an increase in compliance with the UK CG Code, first introduced in 1993. The rates of compliance reported by Grant Thornton for 2014 by FTSE 350 companies were very high indeed: 94 percent of companies complied with all, or all except one or two, of the code’s provisions, 61 percent complied fully, an increase of 4 percent on 2013. However, 10 percent of the companies surveyed by Grant Thornton had not complied with the code provision that at least half of the board, excluding the chairman, should be independent. High code compliance rates were also reported by Manifest on the basis of a survey of a sample of 276 companies, 259 on the Small Cap Index and 17 on the Fledging Index (cited by FRC 2015, 8). Finally, regarding CG Code compliance as far as diversity is concerned, according to the FRC, there was a significant increase in the percentage of female executive directors in FTSE 100 companies in 2014—it increased to 8.4 percent from 5 to 6 percent in previous years. Gender, of course, is only one attribute included by the code under diversity that boards should consider; the others are race, experience, and approach.

Sir Bischoff reminded readers of the 2015 FRC report that the governance of a given company “depends crucially on culture... [and] boards have responsibility for shaping the culture, both within the boardroom and across the organisation as a whole and that requires constant vigilance” (p. 1).

Furthermore, according to FRC (2015), in order to facilitate the implementation of the European Commission’s April 2014 Recommendation on the quality of CG reporting (p. 4), it will re-emphasize the value of “comply or explain” in attaining good governance in 2015. It should be noted in this context that the aim of the European Commission’s (2014c) recommendation on the quality of CG reporting (the comply or explain principle) is to improve the quality of explanations provided by firms for not having followed CG Code recommendations. EU member states were required to make the Commission aware of their arrangements by mid-April 2015.

Returning to the importance of company culture, given that whatever governance framework permeates a company, there will always be a risk that the “tone from the top” will change. The UK FRC’s answer to the insoluble question of “what represents an acceptable level of corporate failure” in its 2015 report is that one should not be complacent but rather continue searching for new ways to prevent and confront bad governance practices (p. 3). In this context as far as CG is concerned, for frontier markets (i.e., what developing markets were more than 10 years ago) Crittenden and Crittenden (2014) emphasized the lead role the accounting profession has to take to create the standards needed to deal with issues unique to frontier nations and to create the transparency necessary to help stakeholders evaluate risk.28

Regarding what detracts from good governance, in the words of the Chairman of the UK’s FRC, while a high-level of compliance with the CG Code is to be welcomed, the FRC “does not wish to preside over a culture of compliance where ‘box ticking’ is preferable to thoughtful consideration of the Code’s provisions, as this detracts from good governance” (FRC 2015, 3). Do good CG practices such as those prescribed by the OECD (2004) in an emerging economy mitigate controlling shareholder expropriation (i.e., when controlling shareholders in publicly listed companies pursue their self-interest at the expense of minority shareholders and of corporate performance)? To answer this question, Chen, Li, and Shapiro (2011) examined over 1,100 Chinese listed companies during 2001—2003 inclusive and found that such CG practices cannot mitigate the adverse impact on corporate performance of controlling-shareholder expropriation in an emerging economy.

Cheung, Stouraitis, and Tan (2010) constructed an index during 2002— 2005 of CG based on the OECD 2004 CG principles from the public shareholders’ perspective in Hong Kong. Using 510 publicly listed companies, they found that bad governance was associated with family firms and concentrated ownership structures. Such firms were found to improve their CG practices slower than their peers. By contrast, good CG was found to be a good predictor of higher future company stock returns and low risk. A study of companies listed at Karachi Stock Exchange during 2001—2010 by Azeem,

Hassan, and Kouser (2013) also reported that quality CG significantly determined firm performance. Corporate board culture is of course an important aspect of CG, but research into it has only just begun (see Evans 2014).

CG is also affected by political interference. As illustrated by Arsalidou and Krambia-Kapardis (2015), when politicians interfere in the appointment of directors, they create a client-customer relationship with the members of the board and as a result pressure may be exerted for specific actions to be taken by the board members. Thus, political motives, amateurism, and conflict of interest do not allow good governance to flourish.

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