There is also a greater focus on risk management.
However there is no change in the Council's fundamental approach - the Council does not make detailed prescriptions for companies on a "one size fits all" basis. The new title reflects this by removing references to "Good" or "Best" practice, because what is "best" for one company may not be ideal for another, and the term "best practice" was sometimes interpreted as elevating "recommendations" to "standards".
Council also considered whether certain Recommendations should be explicitly carved out for smaller companies but decided that the Principles and Recommendations should be the same for everyone. In this way, all listed companies follow the same framework for disclosure to help readers assess the quality of the corporate governance structures that the company has put in place. The revised Principles do acknowledge the situation of smaller listed companies by recognising that they are likely to choose to adopt different practices to the "recommendations".
Companies will be required to report against the new principles from the first financial year commencing on or after 1 January 2008. Therefore they will first be reflected in annual reports for the year ended 31 December 2008. However companies are encouraged to make an early transition and consider reporting by reference to the revised Recommendations before then.
Summary of main action items
Companies should review their governance processes at least once a year, to ensure they still serve the company. The new version of the Principles does not involve a significant change, but these are the main areas in which to consider adjustment:
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Companies who only have a statement of matters reserved for the Board or statement of matters delegated to management should consider having both.
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Board Committee Charters should deal with how non committee members are invited to meetings.
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Boards should consider how to improve their processes for selecting new directors and deciding on whether to support the re election of directors.
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Boards should look at their companies' codes of conduct, particularly how they are integrated into the day-to-day activities of their employees.
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Trading policies and rules of equity schemes should be updated to deal with hedging by employees with equity-based remuneration.
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Boards should be proactive in disclosing matters relating to directors' and senior executives' remuneration, to "avoid surprises".
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All companies should ensure their website contains a section on corporate governance.
The area for greatest attention is risk management:
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Boards and senior management should review their risk management philosophy and processes to ensure that the company understands its risk profile and has the right processes to reduce risk of adverse events and to take advantage of opportunities.
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As the Board needs to seek annual assurances from management the Board should consider how this can be done intelligently, by making the Company’s risk management and internal control processes a natural part of daily business, rather than an annual form-signing exercise
The rest of this article examines the changes in more detail, principle by principle…
Changes to Principle 1 – Lay Solid Foundations for Management and Oversight
As is the case throughout the redraft Principle 1 now refers to "senior executives" where previously it referred to "management" or "senior management". "Senior executives" are defined as the senior management team, as distinct from the Board, being those who have the opportunity to materially influence the integrity, strategy and operation of the company and its financial performance.
Recommendation 1.2 is that companies should disclose the process for evaluating the performance of senior executives and companies are asked to say whether an evaluation of senior executives has taken place, and if it has followed the disclosed process. This largely reproduces material which was previously in Principle 8.
Changes to Principle 2 – Structure the Board to Add Value
Recommendation 2.1 still provides that a majority of a board should be independent directors. However Principle 2 now gives greater prominence to the notion of "independent decision making" – all directors not just those who fit the criteria of being "independent" should bring an independent judgment to bear on board decisions. The list of relationships relevant to a consideration of independence has been changed so that it now reads "relationships affecting independent status". This recognises that those relationships may but do not automatically affect the ability of a director to exercise judgment that is independent. NOTE: There is no expectation that companies would disclose the actual results of any evaluation process.
Where a director has a "relationship affecting independent status" but the company regards the director as still being independent, the corporate governance report needs to disclose the existence of those relationships. Length of service has been removed from the list of factors which may affect independence. Council regards length of service as being more related to succession planning, which is covered in Recommendation 2.5.
Recommendation 2.2 (the chair should be an independent director) now notes that the role of chair is a demanding one and requires a significant time commitment, so that the chair's other commitments should be not so heavy that they hinder effective performance in the role of chair.
Recommendation 2.4 (nomination committees), has been revamped in line with the other recommendations on board committees. While a board nomination committee can be an effective way of examining the selection and appointment practices of the company, the board is ultimately responsible for these matters whether or not there was a separate nomination committee. The commentary also now recommends that the charter of the committee deal with the process for inviting non-committee members to attend committee meetings. This is to avoid committees becoming dominated by uninvited attendees. The guide to reporting on Principle 2 now recommends that where companies do not have a nomination committee, they describe how they carry out the functions of a nomination committee. This encourages companies to focus on the goals underlying the Principles rather than on having particular structures.
Recommendation 2.4 includes new material on the process of selecting, appointing and re-electing directors, reminding boards and nomination committees of the importance of:
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understanding the range of skills, experience and expertise presently represented on the board and what is desirable in new candidates in order to enhance board effectiveness;
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considering board renewal and the length of service of individual directors when considering succession planning;
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ensuring that the board is large enough to incorporate a variety of perspectives and skills and to represent the best interests of the company as a whole rather than of individual shareholders or interest groups but not be so large that effective decision making is hindered. In addition to the information already recommended to be provided to shareholders when a director is seeking re-election, the term of their directorship should also be disclosed.
Recommendation 2.5 (companies should disclose the process for evaluating the performance of the board, committees and individual directors) is taken from the previous Principle 8. The content is largely the same but uses new headings "Induction and Education", "Access to Information" and "The Board and the Company Secretary" to make it easier to read. There are some minor changes:
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the recommendation that board performance be regularly reviewed against measurable and qualitative indicators now refers to "appropriate measures";
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the material on induction of directors now includes that directors should not only be provided with information about their own rights, duties and responsibilities but the roles and responsibilities of senior executives;
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the company secretary's responsibilities now include the "timely" completion and despatch of board agenda and briefing material rather than simply the completion and despatch of board agendas and briefing material;
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all directors should have access to the company secretary.
The guide to reporting on Principle 2 requires that a company not only disclose whether a performance evaluation of the board and its members has taken place in the reporting period but whether it was in accordance with the process disclosed. The guide also recommends that the Company not only publish its procedure for selection and appointment of new directors but its procedure for the re-election of incumbent directors.
Streamlining of Principle 3 – Promote Ethical and Responsible Decision Making
The new version of Principle 3 recognises the confusion experienced by Companies regarding the distinction between Recommendations 3.1 and 10.1 which had each referred to Codes of Conduct. Recommendation 3.1 now combines Recommendation 3.1 (that there should be a code of conduct for directors and senior executives as to how to maintain confidence in the company's integrity and how individuals should report and investigate reports of unethical practices) with the former Recommendation 10.1 (that there should be a code of conduct to guide companies in compliance with their legal and other obligations to legitimate stakeholders).
Recommendation 3.1 recommends that a code of conduct applies to directors, senior executives and all employees but leaves it up to the company as to whether they wish to adopt specific codes of conduct for directors. The revised list of the content of the code of conduct groups related items together according to subject.
The commentary on Recommendation 3.1 emphasises:
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the Board's responsibility to set the tone and the ethical standards of the company and to oversee the adherence to those standards;
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the responsibility of senior executives to implement practices that are consistent with those standards;
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that companies should ensure that their training on the code of conduct is regularly updated, and that advisers, consultants and contractors are informed of the company's expectations as reflected in the code of conduct.
Recommendation 3.2 (companies should establish and disclose a policy concerning trading in company securities by directors, senior executives and employees), now emphasises that where designated officers must notify an appropriate senior member of the company of their intention to trade, that notification includes any proposed transaction in associated products which is intended to limit the economic risk of security holdings in the company. The commentary notes that:
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equity-based remuneration is intended to align the interests of the recipient with the interests of other shareholders, so that the recipient's remuneration is at risk and depends on achieving the performance benchmark.
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there have recently been a number of concerns about "hedging" entitlements under equity-based incentive schemes so as to limit the economic risk of the entitlement. The recommended content of a trading policy is clarified so that it should prohibit entering transactions to limit the economic risk of security holdings in the company over unvested entitlements. Council also recommends that where vested entitlements are hedged this should be disclosed to the company.
The guide to reporting on Principle 3 now allows disclosure of a summary of the code of conduct as an alternative to publishing the entire code.
Changes to Principle 4 – Safeguard Integrity and Financial Reporting
The previous Recommendation 4.1, requiring the CEO and CFO to sign off on financial statements, has been removed because this is now set out in Section 295A of the Corporations Act.
Recommendation 4.1 now refers to audit committees and emphasises that where a company does not have an audit committee, it should still have procedures in place to consider the issues which would otherwise be considered by an audit committee. Companies need to describe how their alternative approach assures the integrity of the financial statements and the external auditor's independence.
In line with the other provisions on board committees, the recommendation on audit committees notes that the ultimate responsibility for integrity of the company's financial reports rests with the full board whether or not they have a separate audit committee. The recommendation also includes a note that all board members should be "financially literate".
Recommendation 4.3 (the audit committee should have a formal charter) now recommends that the charter set out the procedures for inviting non-committee members to attend meetings. It also refers to the need to ensure that the audit committee can access internal and external auditors without management present. The recommendation as to matters on which the audit committee should report to the board has emphasised that where the external auditor provides non-audit services, the report should state whether the audit committee is satisfied that the provision of those services has not compromised the auditor's independence.
The guide to reporting on Principle 4 also makes clearer that the company should report on the attendance of committee members at committee meetings (bringing it into line with other sections on committees).
Minor Changes to Principle 5 – Make Timely and Balanced Disclosure
There have been minor changes to this principle. In particular, in an effort to increase communication, a new section in Principle 5 - "Eliminating Surprise" - notes that shareholders' concerns about executive payments are often exacerbated by a lack of information on entitlements. It suggests as an example that termination entitlements of a CEO or equivalent be disclosed to the market at the time of agreement as well as the time of actual payment.
Changes to Principle 6 – Respect the Rights of Shareholders
Recommendation 6.1 now recommends that all companies (not just substantial ones) have a website and encourages all companies to communicate electronically with shareholders. This aims to assist Companies in empowering their shareholders by giving them ready access to balanced and understandable information about the company and corporate proposals.
The previous recommendation 6.2 (that the auditor be requested to attend the AGM) has been deleted as it became mandatory for listed companies with the CLERP 9 amendments to the Corporations Act. However the principles recommend that other listed entities eg trusts and foreign companies, consider how to achieve the same ends, and comment on this matter in their annual report.
Overhaul of Principle 7 – Recognise and Manage Risk
This has been substantially overhauled because many companies had difficulties with understanding and then reporting against Principle 7. For example, there was confusion as to whether the CEO/CFO sign off as to risk management systems was only intended to cover systems to deal with financial reporting risks or to have broader coverage.
The new version of Principle 7 begins by defining risk managements as:
"the culture, processes and structures that are directed towards taking advantage of potential opportunities while managing potential adverse affects".
This reflects that "risk" can be positive as well as negative.
In line with other recommendations on committees, Principle 7 notes that it is the board's responsibility to oversee risk management, even where there may be a separate risk management committee. Therefore, Recommendation 7.1 now states that the Company as a whole should establish policies on risk oversight and management, and management of material business risks, and disclose a summary of those policies.
The new Principle 7 clarifies that "material business risks" can include:
- financial risks (risk of a material error in financial statements); and
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other risks such as operational, environmental, sustainability, compliance, strategic or external, ethical conduct, reputation or brand, technological, product or service quality and human capital;
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all of which if not properly managed can impact the company.
Council noted that they had deliberately avoided the term "non-financial risks" because they felt it was not well understood and did not have a commonly accepted definition and therefore could increase rather than decrease confusion.
The revised draft of Principle 7 includes and builds on material previously in Principle 10 concerning the link between risk and factors such as compliance with legal obligations and corporate reputation:
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the company's risk management system should consider the company's legal obligations and the expectations of its stakeholders;
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companies should consider who their stakeholders are Council noted the current Recommendation 7 was prepared at a time when the Sarbanes-Oxley legislation was still in process and the notion of CEO/CFO sign offs was very new for some companies. Council indicated that it had always intended that the Board should receive assurance as to the effectiveness of the risk management and internal control system, beyond the sign off of financial statements now mandated under Section 295A of the Corporations Act. Therefore the levels of assurance have been clarified.
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The new Recommendation 7.2 recommends that the Board:
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Require management to plan and implement the risk management and internal control system to manage material business risks, and report on whether the risks are being managed effectively; and
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Disclose that management has reported on the effectiveness of risk management.
The section on internal audit does not prescribe a reporting line for the internal audit function but notes that the internal audit function and the audit committee should have direct access to each other.
Recommendation 7.3 now recommends that the CEO/CFO provide assurance to the board that the sign off under Section 295A of the Corporations Act is based on a sound system of risk management and that in relation to "financial reporting risks" the system is "operating effectively in all material respects". The revised draft has dropped the requirement to also comment on whether the system was operating "efficiently" as this had been a source of confusion.
Changes to Principle 8 (formerly Principle 9) – Remunerate Fairly and Responsibly
Principle 8 was previously referred to as Principle 9. The introduction to Principle 8 reminds companies of the importance of linking remuneration and performance.
Recommendation 8.1 which previously listed certain disclosures to be made about remuneration policies has been removed because of the overlap with material in Accounting Standards and the CLERP 9 legislation. The revised Recommendation 8.1 now covers remuneration committees.
Recommendation 8.2 distinguishes between the structure of senior executive and executive director remuneration on the one hand and non-executive director remuneration on the other. It includes a new recommendation that equity-based remuneration schemes should prohibit entering into transactions or arrangements which limit the economic risk of participating in unvested entitlements under these schemes.
Recommendation 8.2 notes that companies are generally not required to obtain shareholder approval for equity-based incentive plans for senior executives who are not directors. However, Recommendation 8.2 provides that companies may find it useful to submit to shareholders proposed equity based incentive plans which will involve the issue of new shares to senior executives prior to implementing them in order to provide the board with a timely assurance that a plan is reasonable.
In line with other provisions on committees, Principle 8 notes that the board has the ultimate responsibility for overseeing matters relating to remuneration and that where a company does not have a remuneration committee it should explain how the functions of a remuneration committee are carried out.
Corporate Responsibility and Sustainability
In the course of reviewing the principles, the Council gave considerable thought to whether to focus more on corporate responsibility and sustainability.
The Council encourages companies to consider sustainability/CR issues relevant to their business and to report on these issues in the most appropriate way for them. This could involve comments in Principle 3 (ethical decision making) and Principle 7 (risk management) and/or in a separate part of their annual report and/or website.
However the Council has not added any detailed recommendations to the Principles.
Lis Boyce, Partner, Sydney, 61 2 82339566, mailto:|lis.boyce@dibbsbarker.com
