Archive for the ‘Auditors’ Category

Divide and Conquer? Splitting the Roles of Chair and CEO

 It is widely recognised that corporate scandals and collapses often occur when there is a single powerful individual in control of a company.  This is exacerbated when there is a lack of independent non-executive directors on the board.  Therefore it seems axiomatic that powerful individuals can be constrained, and the temptations they may face conquered, by having in place a sound corporate governance structure achieved through dividing the roles of Chair and CEO.

UK Context

Back in 1992, the much lauded Report of the Committee on the Financial Aspects of Corporate  Governance, often referred to as the Cadbury Report after the Chair of the Committee, Sir Adrian Cadbury, identified the potential danger of combining the roles of Chair and CEO in one person.  The Cadbury report recommended ‘there should be a clearly accepted division of responsibilities at the head of a company, which will ensure a balance of power and authority, such that no one individual has unfettered powers of decision’.  This principle was embodied in corporate governance best practice in the UK, with the Combined Code on Corporate Governance (2008) stating ‘there should be a clear division of responsibilities at the head of the company between the running of the board and the executive responsibility for the running of the company’s business. No one individual should have unfettered powers of decision’, and furthermore the Combined Code explicitly states ‘the roles of chairman and chief executive should not be exercised by the same individual.’

Whilst combining the roles of Chair and CEO is rare in the UK’s largest companies, Marks and Spencer PLC is a notable exception.  In May 2004 Sir Stuart Rose was appointed to the position of Chief Executive and subsequently in 2008 he became both chairman and CEO until July 2011.  This combination of roles goes against the Combined Code’s recommendations of best practice.  As a result in 2008 some 22 per cent of the shareholders did not support the appointment of Sir Stuart Rose as chairman.  Nonetheless he remains in the combined role although there is still considerable shareholder unrest and 2009 has seen more dissent by shareholders on this issue.

US Context

In the US, the roles of Chair and CEO have often been combined but now more and more companies are appointing separate individuals to the two roles.  A recent example of a US company which has decided to appoint an independent chairman is Sara Lee, the famous producer of gateaux, beverages and body care products.  Sara Lee has decided to make this change as a response to investor pressure and also the growing trend in the US to split the two roles.  Kate Burgess (FT Page 27, 9th October 09) in her article ‘Sara Lee to separate executive roles’ explores this case in more detail.

Institutional Investor Pressure

In the UK there has long been pressure brought to bear by institutional investors on companies which have tried to combine these roles.  This pressure, together with the long history in UK corporate governance codes against the combination of roles, means that few large companies seek to combine the roles (although as noted above, Marks and Spencer plc is an exception).

Recently Norges Bank Investment Management (NBIM), a separate part of the Norwegian central bank (Norges Bank) and responsible for investing the international assets of the Norwegian Government Pension Fund, has started a campaign to convince US companies to split the roles of Chair and CEO and appoint independent chairmen.   Kate Burgess (FTfm Page 10, 12th October 09) in her article ‘Norwegian fund steps up campaign’ highlights how NBIM has submitted resolutions to four US companies calling on them to appoint independent chairmen.  The four companies are Harris Corporation, Parker Hannifin, Cardinal Health Inc, and Clorox.  In addition NBIM has also voted against combined Chair/CEOs at some 700 US companies.  Interestingly Sara Lee had also been the focus of action by NBIM before agreeing to appoint separate individuals to the roles in future. Also in Kate Burgess’ article, Nell Minow of The Corporate Library http://www.thecorporatelibrary.com/ states ‘NBIM can leverage a lot of shareholder frustration and a widespread sense that this is a sensible, meaningful but not disruptive initiative’.

Concluding comments

It seems to be only a matter of time before the vast majority of companies will split the roles of Chair and CEO.   Of course the individuals appointed to those roles must be both capable of fulfilling the tasks expected of them, and of ensuring that ultimately the two roles, carried out by separate individuals, unite the company under a common leadership approach.  That may prove more difficult than many imagine and so the appointments process must consider fully the many traits needed to ensure success.

 Chris Mallin 16th October 2009

Rethinking Corporate Governance

Sir David Walker’s government-commissioned review of corporate governance in UK banks and other financial entities was published on 16 July 2009, and a new acronym joins the corporate governance lexicon: BOFI boards: boards of banks and other financial institutions.

Britain has already produced more reports on corporate governance than any other country in the world. (Corporate Governance – principles, policies and practices, OUP 2009, page146). This is the tenth, if we include the UK combined code.  With 140 pages, Walker’s report is significantly longer than the first and paragon Cadbury Report in 1992 which had 90 pages. 

Walker believes that UK corporate governance should stay with the ‘comply with the Combined Code or explain why you have not’ principle.  No US corporate governance by law and Sarbanes Oxley Act for the UK.  

He concludes that the principal deficiency is the way directors behave.  They do not challenge the executives enough.  The right sequence in board discussion on major issues, says Walker, should be presentation by the executive, a disciplined process of challenge, decision on the policy or strategy to be adopted and then full empowerment of the executive to implement.  Yes.  One wonders what they did before.

A board structure needs the right mix of both financial industry capability and critical perspective from high-level experience in other major business, Walker concludes.  “Independence of mind is more relevant than formal independence.”  He also calls for a materially increased time commitment from non-executive directors. 

Leadership skills of the chairman of the board are important, too, Walker says, together with the “ability to get confidently and competently to grips with major strategic issues.”   So true.  One has only to read the Northern Rock case (Corporate Governance page 344) to see why.  The challenge to chairman is such that “the chairman’s role will involve a priority of commitment that will leave little time for other business activity.” 

The report calls for better risk management, with more attention to the monitoring of risk, with NED involvement in enterprise risk management, including risk strategies, quite separate from the work of the management risk committee.

Then Walker echoes a call heard many times before that shareholders should engage with the companies they invest in for long-term performance improvement. And the reaction is likely to be the same: some fund managers will continue their initiatives to improve governance and the rest will take the short-term view, voting with their feet when they feel like it.

Finally, Walker proposes that the “remit and responsibility of board remuneration committees be extended beyond board members to cover the remuneration framework for the whole entity.”  This is a response to the prevailing public anger at allegedly excessive executive bonuses and perceived rewards for failure. 

In other words, Walker calls for more of the same, only more so.  But as long as grandees of the City of London continue to write these reports, this is what we should expect. 

The metamorphosis of corporate governance will not happen until the 19th century concept of the limited liability company is rethought and brought in line with the reality of business in the 21st century. 

Alternatives that might be considered include:

  • public companies to have realistic constitutions, which define and limit their objectives as society’s price for allowing their incorporation of the entity with limited liability
  • a new governance structure – a governing body of independent directors appointed by the shareholders – not to run the company but to govern it
  • this governing body to question the directors in public, scrutinizing strategies, policies and outcomes (as previously mentioned on this site)
  • the external auditors to report to the regulators not the directors who appoint and pay them (as previously discussed on this site)
  • developing a taxonomy for companies that reflects the way power is actually exercised over them

Where were the auditors?

– in which Bob Tricker explains why he resigned from the Institute of Chartered Accountants in England and suggests a provocative future for auditors*

In the ongoing crisis facing financial institutions around the world, plenty of questions are being asked: why did the independent directors not act, did they even understand the risks in the business models being pursued; did the regulators fail; were the credit agencies at fault; are the risks of securitisation still properly understood; did short-term performance bonuses encourage greed and excessive risk taking?

But a crucial question remains: where were the auditors? Audit reports reassured readers about these companies’ accounts even though, as we now know, the underlying strategic model was suspect and the businesses exposed to massive risk, even the possibility of trading when insolvent.

In the original 19th century model of the joint-stock company, the state permitted incorporation of limited-liability entities provided certain safeguards were met to protect society. Auditors, appointed from amongst the investors, reported to these shareholder-owners that the directors of their company had faithfully recorded the company’s financial situation.

Then the accounting profession emerged. Small firms at first but, as companies grew in scale and complexity, they grew larger. Mergers enabled them to grow further. By the end of the twentieth century the world’s major listed companies were audited by just five vast, international accounting firms.

However, in essence the auditors’ duty has not changed since the founding years. It is still to report that the information given by the directors to the shareholders reasonably reflects the truth. But the relationship of the auditors to the companies they audit has changed. As scale and complexity increased, the role of the auditors properly became more professional. Inevitably, their relationships with the directors of their client companies grew closer. Although in many jurisdictions the shareholders still voted on a resolution to appoint the auditors, it was the board of directors who really made the decisions. And although nominally the auditors reported to the shareholders of the company, their detailed reports went to the directors.

Inevitably, a close relationship developed between the auditors and the staff of their client, particularly in the finance department. Issues that arose during the audit – questions about asset valuations, capital or revenue decisions, risk assessment or management control, for example – were resolved without the board even being aware of them. So audit committees were introduced, first in the US and then, following the Cadbury Report, in the UK. Sub-committees of the main board, these audit committees relied on independent outside directors to provide a bridge between company and auditor, avoiding too close a relationship between executive directors and audit staff, and ensuring that the directors were fully aware of audit issues.

Following the Enron debacle, the listing rules of most stock exchanges demanded audit committees composed entirely of independent directors, the rotation of audit managing partners, the prohibition of consultancy work for their audit clients, and a cooling-off period before audit staff could join the finance department of a client. The rotation of audit firms, though called for by some, was not demanded.

But I believe the issues go deeper. The real question is whether audit and accountancy is a profession or a business. Do the auditors offer a service to management or are they part of society’s regulatory function?

In the 1950s I was articled to a professional audit practice, which provided service for a fee. The number of partners was small. The phrase corporate governance had yet to be coined. In those days the accounting profession consisted mainly of relatively small firms. Of course, our partners were keen to be successful. In their community they were respected and well to do; but they were not rich. Neither would they compromise their principles. They would not sign an audit report, stating that the client’s account’s showed a true and fair view, unless the partner was personally convinced that they did. Better to lose a client than your integrity. This was a profession, after all. The audit process demanded absolute objectivity of thought and independence from the client.

How different at the beginning of the 21st century. The five major accounting firms had become vast, international and concentrated. They are major businesses, offering products and solutions, with market share and profit performance as watchwords. Partners were judged by fee generation and growth. Then in 2002 one of the five, Arthur Andersen, collapsed, brought down by the Enron catastrophe in the United States. Then there were four.

Partners’ expectations have been influenced by the remuneration levels of their ‘fat cat’ clients. But auditing is not astro-physics. True, the work demands detailed, intense and up-to-date work, but it is not actually difficult. Admittedly, too, these days the risks of litigation and forced resignation are higher. But the real challenge lies in determining standards and living up to them, as it always did.

When I began my accounting career in England, the Institute of Chartered Accountants was at the head of a self-regulating profession. Today, as the Arthur Anderson saga has shown, the market place, not the profession, regulates. Indeed, I believe that auditing has ceased to be a profession: it has become a business. So after nearly fifty years as a Chartered Accountant, including service as a member of its governing Council, I decided that the profession I had joined no longer existed and resigned my Fellowship.

Of course the business world has changed. Nostalgia has no place in strategic thinking. There is no going back to the profession of half a century ago. But I suspect that, unless auditing rediscovers what it means to be a profession and returns to its roots, state regulation of the audit process will have to be imposed to protect creditors, investors and the wider community.

Serious questions have to be asked about the auditors’ position. Who are their real clients: the directors or the shareholders? The de jure response that the client is the company and that somehow this means the body of shareholders will no longer wash. The de facto reality is that the client is the board, backed up by the board’s audit sub-committee. Is this satisfactory under current circumstances? What are the alternatives?

Consider some options:
1. Open the audit market with the second tier firms playing an increasing role in the audit of major listed companies. There has been slight movement in opening the market for audit. But financial markets like the assurance they think they get from an audit opinion signed by one of the big four firms. Predictably, the partners of the firms in this global oligopoly do not favour this solution.

2. Increase regulation introducing further rules to regulate auditors’ activities. This has been the approach adopted in many countries, with the Sarbannes Oxley Act (SOX) in the US, and tighter regulations and stock exchanges’ listing rules elsewhere. But SOX has proved far more demanding, expensive, and bureaucratic than expected; and less effective, as we see from its failure to identify the exposure underlying the financial institutions that have collapsed.

3. Face reality, require auditors to be appointed by and report to the state. It is the state that permits companies to incorporate, and the state that is responsible for protecting the interests of investors, creditors and other stakeholders. That is why we have regulators. A start could be made by introducing this requirement in those companies that have just been massively funded by the state. Surely, the auditors of companies that have been bailed out should not report solely to the directors. He who pays the piper…

The regulatory organisational structures already exist to manage such a relationship. The regulators, working with the shareholders in general meeting, would appoint, re-appoint, or if necessary replace the auditors, agree their fees and receive their reports. The company would, as now, bear the costs.

In this way cosy relationships between directors and auditors would be avoided. If they reported to the regulator rather than the directors, the auditors would have to develop a new mind set. Moreover, shareholders would now have a direct line to their auditors and the board’s audit committee.

Eventually, such an arrangement could be applied to all listed companies. Shareholders would benefit. Investors would know that their auditors worked for them, just as in the 19th century model.

Bob Tricker
* This is a personal view and the ideas are not necessarily shared by my fellow blogger Professor Chris Mallin nor the Oxford University Press.