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Focus: Corporate Governance – March 2003

ASX Corporate Governance Council – Best Practice Recommendations

In brief: Prescriptive laws may have been avoided but prescriptive disclosure has arrived with the release of the ASX Corporate Governance Council's Best Practice Recommendations on 31 March 2003. As John Cadell and Richard Alcock explain, listed companies should start considering these issues as soon as possible.

Changing regulatory climate

It was inevitable that corporate governance best practice in Australia would follow developments in the United States and the United Kingdom in increasing the obligations on directors to document and communicate in greater detail corporate governance practices to stakeholders. More information on the Recommendations, including the long list of policies and procedures by which ASX-listed entities will be measured on corporate governance, can be found at our website: www.aar.com.au/corpgov

Most ASX-listed companies no doubt already have policies and procedures in many of these areas but they may not be documented to the extent recommended by the ASX Corporate Governance Council (CGC) or expected by a growing number of corporate governance commentators and emerging 'ratings' organisations. In some cases, ASX-listed entities will need to make changes to their committee structures and to the individuals who sit on those committees based on a categorisation of directors as 'independent' or 'not independent'. Even if existing practices are broadly in compliance, listed entities are unlikely to have all the recommended disclosures and policies on their website as suggested in the Recommendations.

Considering these issues and adopting new policies and procedures, where appropriate, is likely to take some months and we recommend that listed companies begin the task as soon as possible.

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Timing

The Recommendations will begin to affect ASX-listed entities from the start of their next financial year. When considering the timing for implementation of the Recommendations it should be noted that the new ASX Listing Rule 4.10.3 requires that the entity's Annual Report set out both the period of compliance and any period of non-compliance.

Some listed entities may seek to comply with the new ASX Listing Rule 4.10.3 in respect of their current financial year. The guidelines to the Recommendations encourage early adoption. We suggest listed entities consider these issues well in advance of the start of their next financial year (the official commencement date). The 2003 Annual Report or the Chairman's address at the 2003 Annual General Meeting may be an opportunity to announce the changes to be made progressively over the coming financial year.

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Comply or explain regime

Listing Rule 4.10.3 was amended on 1 January 2003 to require that every listed entity discloses in its Annual Report the extent to which it complies with the Recommendations and, where it does not, to explain why.

The Recommendations relate to 10 key principles of corporate governance and include guidance on how to comply with particular principles. Guidance includes additional disclosures to be made in the Annual Report and, in certain circumstances, the publication of charters, policies and procedures on a dedicated corporate governance section of the company's website. Failure to do so must be explained in the Annual Report. While an explanation of reasons for departure from some Recommendations may be appropriate (depending on the circumstances of the listed entity), a failure to formalise and publish policies, charters and codes will be very difficult to justify.

A possible implication of Listing Rule 4.10.3 is that a listed entity will be deemed to have represented to its shareholders in its Annual Report its full compliance with the Recommendations except to the extent to which it discloses the details of its own practices where they are non-conforming. The likely focus on comprehensive disclosure of any possible non-conformance would be contrary to the stated policy that the Recommendations not result in a 'one size fits all' approach.

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Audit committees

For listed entities included in the S&P All Ordinaries Index, it is mandatory under Listing Rule 12.7 that they each have an audit committee with the composition, operation and responsibilities recommended by the Recommendations. Listed entities that are not in the S&P All Ordinaries Index at the beginning of the financial year will not be required to comply with Listing Rule 12.7, but they will be required to disclose in their Annual Report whether or not they had an audit committee and whether its composition, operation and responsibilities complied with the best practice recommendations.

Unlike other Recommendations, transitional arrangements are in place in respect of how audit committees should be composed. Until 1 July 2005, the audit committee must be comprised of a majority of non-executive directors, not necessarily 'independent' directors, although at least one director must be an independent director. The Recommendations provide that it is preferable that the chair of the committee be 'independent'.

After 1 July 2005, the audit committee must be comprised only of non-executive directors, of whom a majority must be 'independent'. The audit committee must have at least three members and the chair of the committee must also be 'independent' and not the chair of the listed entity.

Transitional provisions do not apply to the operation and responsibilities of the audit committee, and as a result it will be necessary for listed entities in the S & P All Ordinaries Index to post on their website (or at least make publicly available) a copy of their audit committee charter by the commencement of their next financial year.

It also will be necessary at that time to make information publicly available on procedures for the selection and appointment of the external auditor, and for the rotation of external audit engagement partners. This is an area that is likely to be subject to reform under the amendments to the Corporations Act known as CLERP 9. The CLERP 9 Discussion Paper has recommended that the law is changed to require compulsory rotation after five years for both the lead engagement partner and review partner but that this should be staggered, to maintain continuity between the partners. (The Government has indicated its intent to table the CLERP 9 Bill in Parliament after the HIH Royal Commission Report is handed down. Realistically, the Bill is unlikely to be tabled earlier than the second half of this year).

Finally, the types of responsibilities to be prescribed by the audit committee charter will include overseeing the independence and objectivity of the external auditor having regard to Professional Statement F1. This is likely to bring into effect another proposal from the CLERP 9 Discussion Paper that the audit committee provide a statement for inclusion in the Annual Report as to why the provision of certain non-audit services, if any, is compatible with independence. Such non-audit services include valuation services, internal audit services, legal services and corporate finance services.

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Constitution and responsibilities of the main board and committees

In line with existing best practice, there are Recommendations for the majority of the board to be 'independent' directors and for the chair to be 'independent'.

The chair of the audit committee should not be the chair of the listed entity. This division of power within the board lessens the possibility of power congregating in the hands of just the chair and chief executive officer.

In addition to the audit committee requirements, there are also Recommendations for the establishment of nomination committees and remuneration committees with a majority of 'independent' directors. Each committee should have a minimum of three members, with responsibilities to be set out in a charter to be published on the website.

The nomination committee, for instance, is to develop and publish policies for the selection and appointment of new directors and to ensure an effective board with an appropriate mix of skills. Non-executive directors should have a formal letter of appointment that sets out their the responsibilities as well as their rights. This process is likely to have wider ramifications, especially having regard to the recent interlocutory decision of the New South Wales Supreme Court in ASIC v Rich in relation to the responsibilities of chairs (see our March Focus: Corporate Governance for a discussion of the implications of this decision).

The process of focusing on the particular skills that a director brings to the board may affect the director's responsibilities and the breadth of their duty of care and diligence. We expect the existence of sound risk management policies on internal controls and delegation will also be relevant to directors' relief from breach of directors' duties.

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Remuneration

Given the recent pre-occupation of the media with executive remuneration, it is not surprising that the Recommendations encourage listed entities to agree on termination payments for Chief Executive Officers in advance, including detailed provisions in case of early termination. Where Listing Rule 3.1 on continuous disclosure would require disclosure to the ASX of price-sensitive information resulting from the entry into, or crystallisation of, an obligation under an employment agreement with a key executive, the Recommendations encourage disclosure of a summary of the main terms of the agreement, including termination entitlements. In addition, the sign-on payments received by any of the five highest paid executives must be disclosed.

Perhaps more surprising is the recognition of the need for a careful balance in the amount and type of disclosure, to avoid accelerating levels of individual remuneration packages to the detriment of shareholders.

The CGC has also recognised the need to clarify the relevant disclosure requirements of the Corporations Act and finalise the relevant accounting standards and has agreed, as a matter of priority, to examine the need for additional disclosure of remuneration perhaps applying to a range of executives wider than the five who are the highest paid in any year.

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Independence of directors

When exercising their duties, each director must act and make decisions in good faith and for a proper purpose. They must act objectively, without seeking to gain an advantage for themselves or someone else. The Recommendations take up the notion of 'independence', a concept that has developed internationally and in Australia (ie the Investment and Financial Services Associated Limited (IFSA) Blue Book) as a way of distinguishing those directors who could be perceived as having more regard to other influences (eg management, a substantial shareholder or supplier) than directors without any such influences.

Under the Recommendations, a board should regularly receive disclosure from each director of their interests and at least annually decide whether that director is to be treated as an 'independent' director for the purposes of sitting on committees and disclosure in the Annual Report. The Recommendations set out a definition (not the definition) of independence. Under the recommended test, an independent director is a non-executive director who:

  • is not, or is not associated with, a substantial shareholder;
  • has not been employed in an executive capacity by the company in the previous three years;
  • within the last three years has not been a principal, or materially engaged employee, of a professional adviser that has a material relationship with the company;
  • is not, or is not associated with, a material supplier or customer and does not have a material contractual relationship; and
  • is free from any relationship that could materially interfere with the director's ability to act in the best interests of the company.

The recommended test is very similar to that recommended by IFSA and a board is 'to state its reasons if it considers a director to be independent notwithstanding the existence of relationships' set out above. Most of the requirements are subject to 'materiality' thresholds. These materiality thresholds are to be determined by the board and included in the annual report. For example, some listed entities determine that a supplier is a material supplier if the revenue for that supplier is more than a fixed percentage (eg 5 percent) of the supplier's revenue. This will have to be considered afresh for every listed entity.

There is also an additional requirement that the director has not occupied a position on the board for a period of time that could be perceived to interfere materially with the director's independence. The Recommendations refer to the UK Higgs Report which suggests that 10 years might constitute such a period. It is not clear to us that experience should compromise independence.

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Risk management, internal controls and delegation

The Recommendations include that a company's chief executive officer and chief financial officer certify to the board that the company's reports present a true and fair view. Currently, the Corporations Act requires directors to provide this certification. Senior officers who provide information on which the directors rely are also deemed to be responsible if the information is false or misleading. In a further step, the Recommendations require that this certification is based on a system of risk management and internal compliance and control that is operating effectively. This requirement implies that the systems themselves are regularly reviewed and is similar to that required by Rule 302 of the United States' Sarbanes-Oxley Act.

For many listed entities, this function will be the responsibility of the audit committee.

The law recognises that directors delegate management of the company to the chief executive that the chief executive delegates to management and that this chain of delegation continues throughout the company and subsidiaries. The essential legal principle behind the court's recognition of responsible risk taking is that directors (in good faith, and having made an independent assessment of information or advice provided by management) are able to rely on that information or advice given or prepared by management whom the directors believe on reasonable grounds to be reliable and competent. Effective reliance requires ongoing review of competency of management and the efficacy of internal controls and systems.

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A tailored approach

The Recommendations are prefaced by an important qualification that we believe should remain a paramount consideration in a company's response to the Recommendations:

The best practice recommendations are not prescriptions. They are guidelines, designed to produce an efficiency, quality or integrity outcome. This document does not require a 'one size fits all' approach to corporate governance. Instead, it states aspirations of best practice for optimising corporate performance and accountability in the interest of shareholders and the broader economy.

The risk is that superficial analysis by an increasing number of external corporate governance commentators and ratings organisations will not give sufficient recognition to a company's own informed assessment of its circumstances.

The challenge will be the extent to which an entity's tailored (non-conforming) corporate governance practices can be communicated effectively to external stakeholders and the market as part of the 'comply or explain' regime that will apply under the ASX Listing Rules. We would encourage listed entities to accept this challenge and to determine what is best practice for them, consistent with the flexibility permitted by the Listing Rules.

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