APRA debate yields divergent views on governance and board roles

Calls for directors to have full-time resources, greater clarity on workloads.

APRA’s report on the Commonwealth Bank – considered an Australian governance landmark – has sent shockwaves through business. Less considered is how, or whether, the governance community will respond with changes to board structures and resourcing.

Suggestions range from companies establishing an Office of the Board that provides full-time resources for directors; to a Nordic-style points system to establish director workloads; to more appointments of industry specialists as directors; to changes to ASX Corporate Governance Council processes to quicken updates of governance principles.

But some observers argue that the governance community risks over-reacting to APRA’s findings. Regulators could damage governance by blurring the line between management and boards; the best response is measured, incremental governance change.

Either way, APRA’s report, which identified governance shortcomings at CBA and called for more rigorous board oversight, demands debate. The report suggests boards must urgently deepen their oversight of financial and non-financial risks, and organisation culture.

“APRA’s report on CBA is a game-changer for Australian governance,” says Graham Bradley, AM, FAICD, Chairman of HSBC Bank Australia, EnergyAustralia and GrainCorp. “APRA’s report is an unprecedented public analysis of a bank’s internal governance. It may well be more influential on governance than (findings) from the Financial Services Royal Commission.”

Bradley says APRA’s report will influence Australian governance for many years. “Discussion of APRA’s findings is a compulsory item on every one of my boards, including those unrelated to financial services. Directors everywhere are comparing their board’s practices to APRA’s view of better-practice governance.”

The report will also influence regulators across the world, says Bradley. “Regulators here and overseas will pore over the report because it sets a benchmark for how regulators will view the board’s role. The report essentially calls for more rigorous, fine-grained oversight of management performance by boards and sub-committees.”

APRA’s view

The Australian Prudential Regulation Authority (APRA) released its Prudential Inquiry into the Commonwealth Bank of Australia (Final Report) in May. Eight months in the making, the report responded to several incidents at CBA in recent years.

The Report found: “… at all levels, the degree of attention and priority afforded to the governance and management of non-financial risks in CBA was not to the standard it would have expected in a domestic systemically important bank. … The Board, together with its Risk, Audit and Remuneration Committees, demonstrated significant shortcomings in the governance of non-financial risks. For much of the period under review, the Board did not demonstrate rigour of oversight and challenge to CBA management. The tone at the top was unclear.”

APRA made several recommendations to strengthen accountability, governance and culture within CBA. They included:

• More rigorous board and executive committee governance of non-financial risks;
• Exacting accountability standards reinforced by remuneration practices;
• Substantial upgrading of the authority and capability of operational risk management and compliance functions;
• Injection into CBA’s DNA of the “Should We?” question in relation to all dealings;
• Cultural change that moves the dial from reactive and complacent to empowered, challenging and striving for best practice in risk identification and remediation.

“All of this suggests that boards will need to spend more time on their oversight role,” says Bradley. “Directors will have to re-examine the data they receive on the organisation’s risk culture, spend more time with executives beyond the CEO, and have greater focus on corporate culture indicators such as customer complaints in detail rather than relying on aggregate scores in surveys.”

Responding to APRA’s view

The governance community, arguably, has three possible responses to APRA’s findings.

The first is no response. Directors could contend that the governance shortcomings that APRA identified are not reflected across industry. Corporate Australia is generally well governed and good boards have spent years safeguarding against the issues APRA has raised.

Also, shortcomings in bank governance may reflect a lag in industry efforts to improve culture, accountability and oversight at management and board level. Banks have implemented many initiatives to improve culture and governance, but some results may take years to emerge.

The second response is around board time, effort and composition. APRA’s report implies that boards must be more involved in the business, meaning greater time and work for directors. Directors could respond by allocating more time to their role and holding fewer boards seats.

This trend has been in play for years and it’s questionable as to how much extra work high-performing boards can and should do, and its benefits, under existing governance models.

Proxy advisor guidelines have been designed to reduce “overboarding” – the practice of directors having too many roles and being unable to fulfil them, particularly in a crisis.

For some directors, taking on more board work would require moving to a quasi-executive role – something many in the governance community are against for it could threaten board independence.

APRA’s finding may encourage more companies to appoint industry specialists rather than governance generalists to the board. “Inevitably, boards will be looking for directors with deep experience in the company’s industry,” says Bradley. “Unless you have a strong industry background, it can take two or three years on a board to truly add value. That is increasingly unrealistic given APRA’s view that boards urgently need to dig deeper within the business.”

The third response is based on variations to existing governance structures. It recognises that boards can only do so much with their current systems and that fundamental change is needed to give boards extra resources to extend their role.

Fundamentally, the third response questions whether the current model of part-time, non-executive directors stewarding increasingly large and complex organisations is still the right one. Or if variations to the model could strengthen governance.

Suggestions for change

Leading remuneration consultant, John Egan, has floated the idea of large companies forming an Office of the Board (OTB). The OTB would consist of two or three full-time executives who report solely to the board and act as an additional research tool for directors.

“Regulators, institutional shareholders and retail shareholders (through the Australian Shareholders’ Association) have implied for some time that boards need to be more forensic and engaged in their role,” says Egan, founder of Egan Associates.

“Perhaps it’s time for boards of large organisations to have a small, independent, full-time secretariat that can undertake detailed investigation and research on the board’s behalf. The idea needs careful consideration and debate, but fundamentally it’s about giving boards more resources, so that they can better respond to regulator, investor and community expectations.”

Egan says the OTB could, in time, reduce board size. “A 10-member board, for example, might condense to seven directors, with a secretariat of two or three full-time staff added. A smaller board could streamline board focus and decision-making, and a full-time resource of a few senior staff would significantly boost the board’s resources and ability to source information.”

The Chair would form the OTB and choose its staff (who are not board members but might attend board and committee meetings). “The staff would have the Chairman’s imprimatur to access whatever information they need in the organisation, much like a Chief of Staff in a government department has the Minister’s backing to get information,” says Egan.

In addition to extra resources, an OTB could make it easier for directors to test data. Rather than go through the Chair, and rely on busy executives to provide information, directors in theory would have greater scope to source information on governance issues.

The idea has complications. Wesfarmers and AGL Energy non-executive director, Diane Smith Gander, supports the OTB concept in principle, with caveats. “I couldn’t support any proposal where management is looking at an issue and the board is looking at the same issue independently through the Office of the Board. Nor would I support any additional resource that is set up to check on management or withholds information from them.”

Smith-Gander says an OTB could work if it expanded existing governance resources. “The board must always establish, own and maintain the organisation’s governance architecture, in consultation with management. That can never be outsourced. That said, if boards can access an additional resource that fleshes out that architecture, and conduct deeper dives within the organisation, I suspect there would be support for the idea.”

Transparency on director workloads

Smith-Gander says there is merit in debating a Nordic-style points system to understand and assess director workloads. The Netherlands, for example, associates points with different directorships roles, creating greater clarity and comparability around board workloads.

Director workloads have become a bigger issue in Australia and overseas as investors pressure directors to serve on fewer boards, particularly in financial services.

Proxy-advisory guildines based on board appointments may not provide enough detail. A director who chairs a bank board’s risk committee may be busier than another who has two directorships of small ASX-listed companies and a not-for-profit. A director who has a part-time executive role, in a consultancy for example, may have a higher workload again. Smith-Gander says a points system would provide an opportunity for directors to talk to the Chair about their points profile and boards could better inform the market on director workloads. Investors, for example, could compare the points profile of one bank board to another. They could also pressure boards that have too high a combined points profile to refresh through director retirements and appointments.

“The problem with current guidelines on overboarding is that they are based on raw numbers,” says Smith-Gander. “A more nuanced points systems could account for differences in the complexity and workload of different board roles across sectors and include any executive-style work.”

The OTB also raises questions about company investment in governance. The director pool of a big-four bank could be half the CEO’s total pay and the organisation might spend a few million each year to govern a multi-billion-dollar company.

That investment does not account for internal or external auditing or other resources that contribute to governance. But few have asked: What is an appropriate amount of investment in governance relative to organisation size and complexity? And does it need to increase, through extra governance resources or higher board fees that recognise higher director workloads?

ASX Corporate Governance Council

Smith-Gander says debate is needed on how the ASX Corporate Governance Council can speed up reviews of the Corporate Governance Principles and Recommendations, which set out recommended governance practices for ASX-listed entities and are sometimes adopted by larger private-sector or not-for-profit organisations.

There have been three editions of the Principles since their introduction in 2003. A fourth edition is underway; Council released a consultation paper on them in May. Assuming the final report is released next year, it could be up to five years between reviews.

“A four or five-year cycle to update the Principles is inappropriate in the governance world we live in,” says Smith-Gander. “By the time the Fourth Edition on the Principles is released, community expectations for governance will have changed again. Meeting the Principles today is not enough because, in some respects, they are outdated and lagging market demands.”

Smith-Gander says the Council and its Principles make an important governance contribution. “It’s not about changing the system or introducing a more formal, regulated approach, but rather speeding it up. We need to find ways to update the Principle every two or three years, not every five, to better keep pace with a changing governance landscape.

An opposing view

One of Australia’s most experienced company directors, Nora Scheinkestel, FAICD, warns against kneejerk reactions from the governance community towards APRA’s report.

“If people are pushing for change, to what end?” asks Dr Scheinkestel, FAICD, chair of Atlas Arteria, and a non-executive director of Telstra Corporation, AusNet Services and OceanaGold. Scheinkestel has served on more than two dozen boards over 25 years.

She says: “People need to reflect on what the governance model is, what it can do and what it can’t do. The non-executive board was designed to be the representatives of distant and dispersed shareholders, acting in sufficient proximity to the management team to monitor and review but also to challenge, coach and bring an external and diverse perspective to important board discussions.

“Suggestions that boards should be given extra resources so that they can get more involved in management-style tasks fundamentally misses the point. That is not the board’s job. That is what management are there for and if management are not performing or not providing the board with the necessary information to do their job, the obligation is to fix it or change management but not to do the job themselves.”

Scheinkestel adds: “The current debate seems to be reinforcing the idea that senior management, let alone boards, can prevent all bad stuff happening in their companies. That is not realistic. Good systems and processes supported by the right culture should reveal much bad behaviour or mistakes early but in large organisations, almost every day, someone deep in the company will be doing the wrong thing, sometimes with good intentions, sometimes not. What seems to be fuelling much of the current debate is a misunderstanding of the role of boards – and the limitations of our model. It cannot provide an all-encompassing guarantee.”

Scheinkestel says directors should not interpret APRA’s report on CBA as suggesting the line between board and management should be moved. “That line does flex, according to the needs and situation of the company. But while the report may suggest that the bank’s board needed deeper engagement in the business, this shouldn’t be taken to mean that the board should be effectively involved in management of the business.”

Scheinkestel fears that the coverage of APRA’s report on CBA implies that the financial services sector is fundamentally broken. “Not for a minute should we downplay the terrible conduct unearthed through the banking Royal Commission or the hardship created for affected people. But in my experience, most executives and directors across many large organisations in Australia, including the banks, are diligent and hardworking and take their responsibilities seriously and have delivered for customers as well as shareholders and other stakeholders.”

The concept of an Office of the Board and other sweeping governance changes is short-sighted, says Scheinkestel. “Frankly, an Office of The Board is a terrible idea. Management should be providing whatever information boards need to discharge their obligations, supplemented, of course, by directors getting out of the board room and getting direct exposure to employees, work sites and seeking external feedback and seeking diverse ways to inform themselves. Effective boards oversee the establishment - by management - of strong systems and processes, bring a curious mind and challenge to management and board discussions. There should not be a need for extra full-time dedicated resources to do their job.”

Scheinkestel says the APRA report should cause boards to reflect on their governance system and standards. “It is a sensible report and it would be a missed opportunity if boards do not consider and discuss APRA’s views on governance. But the ideas are not new - effective boards have been talking about these issues and driving governance change long before the APRA report and addressing the very issues that APRA raises. We don’t and won’t always get it right and we can always improve.”