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Friday December 28, 2012

Three things make role of independent directors more challenging

IN 2012, three things made the role of independent directors much more challenging. They were a blurring of boundaries between the role of boards and management; a greater need to understand the technicalities of business decisions; and a challenge to the guarantee that relying on third party expert opinion will protect directors from litigation when things go wrong.

Blurring boundaries

Although the Malaysian Code of Corporate Governance 2012 states there is a clear separation of roles between the board and management, the law is more ambivalent. In both Malaysia and Australia the Companies Acts state that boards “direct and manage”, presumably to allow boards to intervene when a company is in a state of terminal disarray or when the CEO has been terminated and there is no immediate replacement. This ambiguity is useful for politicians and the media because it permits them to shout “where was the board?” when things go wrong.

In the court of public opinion there is no such fine distinction when things go wrong. Take the case of Marcus Agius, the non-executive chairman of Barclays, when he was being cross-examined by the UK Treasury Committee regarding Barclays' Libor fixing (July 10), shown by the following exchange:

Michael Fallon:“If you were concerned that the bank's funding position should not be misinterpreted, why weren't you involved with Mr (Robert) Diamond in telling your staff to get involved with the regulatory authorities as a matter of urgency?”

Marcus Agius: “ because, for the avoidance of doubt and maybe I should have made the point earlier there is of course a distinction between what the board does and what the executive does. The executive is there to run the bank. The board does not run the bank. I stayed unusually connected with the senior management because of my concerns, but I did not make any executive decisions. That was not my job.”

Michael Fallon: “The question is: what does it say about your senior management team that in the end, an instruction to manipulate Libor was not questioned?... You have overall responsibility for the culture of the bank. That is why you have resigned.”

Directors are accountable and are expected to know how management is implementing what they have been authorised to do; they cannot hide behind the separation of roles. Understanding of technicalities

There are two more reasons why the boundaries are blurring. The first comes from the setting of CEO KPIs and remuneration. The remuneration committee and the risk committees must understand the long-term implications of the KPIs they agree with CEOs, as well as the likely impact of remuneration on how CEOs will behave. This demands an increasingly granular level of technical understanding of the strategic choices being made, their impact on the risk profile and appetite of the organisation, not just during the CEO's tenure, but long after as well. That in turn requires a very high level of technical understanding of how the business works, its drivers of value and the riskiness of the choices made both in terms of products offered, lines of business, concentration risk in customers and industries served, as well as in terms of differing time horizons.

The recent Centro decision in Australia puts the spotlight firmly on accounting standards and conventions. The Australian Securities and Investments Commission (Asic) alleged that the directors did not take reasonable steps to comply with their financial reporting obligations and had failed in their duty of care. When taken to court, the judge agreed with Asic that the financial statements failed to properly classify certain interest bearing liabilities as current, and to disclose large guarantees as a material non-adjusting subsequent event. The judge found that the directors knew or should have known of the current interest bearing liabilities and guarantees; that they should have been aware of the relevant accounting principles; and that they should have made relevant enquiries, but had failed to take these steps. The lesson of Centro is that individual directors must:

● Read, understand and consider the contents of financial statements before approving them;

● Understand the basis on which the financial statements have been prepared and to satisfy themselves in relation to the accuracy of the those financial statements; and

● Be familiar withfundamentals of the business andhaverequisite financial literacyto understand basic accounting conventions-even when recently changed.

This last point means that individual directors must understand the impact of IFRS changes on their businesses, even when they are not qualified accountants something even auditors find difficult.

Expert opinions

In the past, directors could rely on expert third party opinions to protect them from the charge of dereliction of the duty of care. Another recent Australian court decision may have changed that is the James Hardie case. In this case there were two points of contention.

The first was that despite receiving expert advice from PwC (PriceWaterhouseCoopers) and Access Economics that the funds set aside would be sufficient to meet all legitimate present and future asbestosis claims, the directors were liable when this proved not be the case and there was shortfall of over A$1bil.

The second was the directors' defence that the board could not have approved the press release stating that the liabilities were “fully funded” because it had been modified by management subsequent to the board meeting and before the release and that there were other errors in the minutes that cast doubts on the validity of the minutes. This defence was not accepted by the court. The directors were held to a higher standard of care for failing to ensure the minutes were 100% accurate, down to literally the one-word difference “fully funded” instead of “funded” in the press release that appeared months after the original minutes had been approved. The seven directors were banned from serving as directors of public-listed companies for five years and consequently fined A$30,000 each.

It is perhaps no accident that the toughest court decisions regarding directors come from Australia where the Australian Institute of Company Directors has a professional qualification for becoming and remaining a chartered director.

Canada, New Zealand, South Africa, Switzerland and the United Kingdom also have professional qualifications for directors. Perhaps, it is time to create a professional qualification for independent directors, given the higher standards they are being asked to meet.

The writer is managing director, corporate governance, of The Iclif Leadership & Governance Centre.

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