A path through the governance minefield in 2020

Four directors explore complex issues boards need to deal with in 2020.

Will 2020 prove to be a year of change for boards – a year in which listed-company boards respond decisively to growing stakeholder pressure for organisation change?

Governance trends, of course, are usually years in the making and effective boards respond proactively to them in considered, measured tones. Suggestions that boards will make sudden or dramatic changes to their governance processes in 2020 are misguided.

But also true is that several governance debates hit new levels in the past 12 months, intensifying pressure on boards. Climate change is an example; BlackRock CEO Larry Fink this year in his annual letter said the firm will begin to exit investments that pose a high-sustainability risk. The view of BlackRock, the world’s largest asset manager, has the potential to influence climate-change conversations in boardrooms worldwide.

Related to this was unprecedented focus from institutional investors on corporate Environmental, Social and Governance (ESG) performance in the past 12 months. Expect more boards this year to lift scrutiny on their organisation’s key non-financial performance metrics – and to ensure organisation culture and purpose, people and incentives are aligned to ESG.

In Australia, the fallout from the Banking Royal Commission, which issued its final report in February 2019, continues to reverberate through boardrooms. More than ever, boards have to consider the needs of a wider group of stakeholders, in addition to shareholders, in governance decisions.

For some boards, that will mean testing their governance systems, board papers and agenda, board composition and decision-making process to ensure they are equipped to better understand and govern for employees, customers, suppliers and the community. It could also create governance tensions between the needs of shareholders and other stakeholders.

The Banking Royal Commission could also encourage other regulatory bodies to take a more aggressive enforcement approach and pursue more prosecutions. It seems inevitable that organisations – and by default, their boards – will face greater regulatory risk in 2020.

Risk will play out in other ways this year. Significant increases in Directors and Officers (D&O) Insurance premiums reinforce the market’s view that governance risks are rising. So too are financial, legal and reputation risks for directors, at a time when board fees have remained largely static for several years, and when there is pressure for directors to hold fewer roles.

There has been talk for years that listed-company directorships will become less attractive if governance risks outweigh the rewards, but there is little evidence of director shortages or a “talent drain” so far. Still, it’s a trend worth watching if fewer ex-CEOs join boards than in years past, and if high-quality current or prospective directors choose boards of private-equity-backed companies over their listed peers, because they perceive they are more attractive.

The Governance Leadership Centre asked four experienced directors for their view on key governance issues to watch in 2020. Here is an edited extract of their response:

Diane Smith-Gander, AO, FAICD

Non-executive director of Wesfarmers and AGL Energy. Chair of Safe Work Australia and Chair of the Asbestos Safety and Eradication Council.

The big challenge for listed-company boards in 2020 will relate to what I call the three ‘Ps’: Purpose, People and Performance.

The need for boards to focus more on organisation purpose was underscored in Larry Fink’s (BlackRock CEO) annual letter (published in January 2020). The media focused on Fink’s views on climate change, but his views around organisation purpose stood out to me.

More than ever, boards will need to ask: Is the organisation’s purpose being translated consistently through all of its levels? Are all the staff aware of the purpose and living up to it? Does the organisation’s culture support the purpose and how is adherence to it measured?

The banking sector is a reminder of what happens when parts of organisations become misaligned with purpose – and the need for boards to test that purpose is not an esoteric concept the organisation talks about, but something that consistently informs actions and behaviours among all employees. Directors need to know that all the staff understand and live up to the purpose; not just assume that it happens.

Breach data is one of the best proxy measures of purpose. Boards should have clear information on when the organisation’s guidelines or rules were breached; whether the response was proportional to the problem and even-handed; and how quickly it took for bad news to surface. That tells you a lot about whether organisations truly and consistently live up to their purpose.

Governance of people is closely related to purpose. Boards in 2020 will need deeper understanding of the organisation’s human-capital capabilities. Not only in the executive team, but further down the company. Directors need to know the organisation has the right people to execute the purpose, and not only rely on management’s view in this regard.

Boards will rethink aspects of remuneration design in 2020, principally around incorporating non-financial targets into incentives. For example, if organisations are serious about managing climate change, they will need to build carbon-emission targets into incentive schemes for some of their leaders. If companies want to reduce gender inequity in their organisation, they will need targets around this built into remuneration.

If financial markets increasingly assess companies on non-financial performance around ESG, the next step must be to align those expectations with remuneration design. Incorporating non-financial targets in remuneration has challenged some companies in the past, but REM committees have to step up on this issue and ensure there are clear, hard and measurable targets for non-financial outcomes. It will take time to do this because it’s hard to change remuneration plans already in place. But this change is needed – and boardrooms will require courage to make this happen.

The third issue for 2020 – performance – is related to people and purpose. Boards will need to focus more on understanding performance in non-financial areas. Boardrooms will need to be more creative and entrepreneurial about assessing whether the organisation and its people are living up to the purpose – and whether that is reflected in the organisation’s financial and non-financial performance.

Graham Bradley, AM, FAICD

Chair of HSBC Bank Australia, EnergyAustralia Holdings and GrainCorp.

Public-company directorship will be more hazardous in 2020. As a result of the Banking Royal Commission, regulators in energy, building, the environment and other areas will feel emboldened to take a tougher stance on companies. The result will be an increase in prosecutions, even for relatively minor infringements.

Previously, regulators might have issued fines or made allowances for companies that self-reported on issues. Increasingly, regulators will move to prosecute, partly as a response to growing public and government pressure on them to take stronger action.

In my experience, boards take the threat of prosecutions very seriously and regulatory action can be a significant distraction for management. Sometimes, the response by boards and management is disproportionate to the mistake made, because of overzealous regulation and the risk of prosecution.

An increase in class actions in 2020 will be a consequence of this regulatory approach. More companies being prosecuted for breaching the law inevitably means more law firms teaming up with litigation funders to organise and pursue shareholder class actions. I expect to see more class actions involving special-interest groups on alleged ESG breaches around climate change or other non-financial issues in 2020.

Operating in a low interest rate environment will be another governance challenge this year. There have been calls for companies to reduce their hurdle rate of return on new projects, to stimulate business investment. The factors that boards weigh up when setting hurdle rates are complex. Boards have to judge if a low cost of capital is sustainable and what will happen if interest rates rise or there is an unexpected change in government policy. The real problem is not hurdle rates; it is the lack of attractive projects because of the soft Australian economy and lack of policy reform.

Climate change will continue to be a key governance issue in 2020. Pressure will build on boards to increase disclosure of their organisation’s climate-change risks in the annual report. I’m concerned that, in many cases, these disclosures will be too general and of little value to stakeholders. Extensive disclosure of climate change is fraught with danger for companies because the long-term effects of global warming are hard to predict.

The combination of these trends will increase the risks of company directorship and reduce its appeal. D&O Insurance premiums have increased substantially and I have seen instances of it being 3-4 times the cost of the total board fee pool. That indicates the markets perceive there is a lot more risk in directorships than companies are compensating directors for through fees that have been flat for years.

My concern is that some companies will cut back on D&O Insurance as premiums rise, in turn adding to directorship risk and reducing its appeal. There will always be plenty of people wanting to join boards, but I suspect some high-calibre candidates, such as former CEOs, will find listed-company boards are too much work and risk, for not enough reward. They may favour governance of private-equity-backed ventures that are more hands-on and less public.

Dr Roger Sexton, AM, FAICD

Chair of emerging listed food innovator Beston Global Food Company and President of the AICD South Australia/Northern Territory division. Former Chair of IOOF Holdings.

There is greater public interest in corporate governance of listed companies after the Banking Royal Commission and how boards ensure their organisation is meeting the needs of a range of stakeholders, such as employees, customers and the community.

This debate about the purpose of the corporation – is it there to serve shareholders, or stakeholders, or both? – will continue to play out in 2020. In turn, boards will spend more time this year understanding stakeholders, considering their needs in governance decisions, and ensuring there are strong reporting systems on ESG performance.

I expect more boards in 2020 will test whether they have the right structures in place not only to govern on behalf of shareholders, but also to ensure the organisation lives up to broader societal expectations.

Global megatrends will continue to influence boards in 2020. Climate change will be an ever bigger board focus. Operating in a low-interest-rate environment, population growth, rising inequality, cybersecurity, artificial intelligence and the ongoing digitisation of business are other challenges. None of these trends are new, but their impact on industry is growing and boards will spend more time assessing how they could affect organisation risk and return.

I expect to see more shareholder activism around non-financial issues in 2020. Companies will need to be more engaged with regulators and have strategies to address instances where activists misuse regulations, such as the Two Strikes Rule, out of self-interest. Generally, there is a risk that the regulatory environment becomes too prescriptive in the next few years.

As boards face more complex governance issues, director professional development will be a bigger issue in 2020. I’m seeing more directors undertaking courses to add to their skills and there has been higher attendance at AICD events in South Australia and the Northern Territory, for example. Directors recognise they need to add new skills as governance challenges grow.

This skills focus extends to people who want directorships. Prospective directors appear to be undertaking a lot more board education before their first board role than in years past, and being more active in the board community. As more is expected of boards, first-time directors realise they need to have well-developed governance skills before they join a board, and a commitment to keep adding skills through professional-development plans and training.

Keith DeLacy, AM, FAICD

Former Queensland Treasurer, former Chair of Macarthur Coal and a former Queensland President of the Australian Institute of Company Directors. Awarded the AICD Gold Medal in 2019.

I have never seen the business sector held in such low regard. It seems to me that more than half of the Australian people now see the private sector, the business sector, as the enemy. Taking cheap shots at business is par for the course – from mainstream media, social media, politicians, the public, social activists and so the list goes on.

The question is, is that our fault or someone else’s? Of course, some of the fault lies with business itself – there are times when business performance has been less than perfect, and this has been exposed in various ways, most recently in the Banking Royal Commission. But in my view, the negative perception is greatly overstated. The vast majority of businesses in Australia, under the guidance of their boards, act ethically and competently – as well as anywhere in the world.

As we move into 2020, the old challenges are still there – technology and disruption, and what is called the Fourth Industrial Revolution, the national and global economies, and the uncertainties caused by trade wars, sovereignty issues and political rivalries.

But there are a whole range of new challenges emerging, and mostly in what I call the socio-political environment. Directors are no longer primarily being held to account for their commercial performance, but increasingly for what is referred to as Corporate Social Responsibility, or as ESG criteria.

Some say the social activists have finished their long march through the obvious institutions and are now turning their attention to the limited liability company, the fundamental driver of wealth creation and living standards in the Western world.

As directors, and I accept this, we have to deal with the world as it exists, not as we want it to be. There are so many more forces to deal with these days, many of them vague and invisible – sexual harassment, bullying, discrimination, diversity, sustainability, climate change, social and environmental activists banging on about ESG, and the list goes on – and you need to be equipped to face up to these challenges.

But the main advice, and best protection, in this confused world, is to do what’s right – Integrity with a capital I. Respect the primacy of shareholders, and stick to the director’s golden rule, the fiduciary duty – act honestly, in good faith and to the best of your ability. It’s not that hard.

My secondary advice is to be prepared to argue your case. Don’t roll over and get into virtue signalling. It aggravates me when certain corporates appropriate the status of their company to push the social-justice causes of the day, foisting them onto employees and unsuspecting customers alike.

How do those boards know they accord with the views of their shareholders? And is it consistent with their duty to act for a proper purpose, in good faith and in the best interest of the company? The money companies spend on these social frolics is not their money to play with, it is shareholder money.