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Focus: Corporate Governance – August 2007

ASX Corporate Governance Council releases revised Corporate Governance Principles and Recommendations

In brief: The revised Corporate Governance Principles and Recommendations released by the ASX Corporate Governance Council constitute a refinement rather than a rewriting of the existing Principles and Recommendations. Partner Steve Clifford (view CV) , Consultant Professor Bryan Horrigan (view CV) and Senior Associate Simon Lewis survey the key changes and highlight the impact for ASX listed entities.

How does it affect you?

  • The Revised Principles and Recommendations applies from 1 January 2008 and, in general, the amendments:
    • result in few changes being made to the existing substantive obligations of the previous Principles and Recommendations;
    • confirm the workability and flexibility of the 'if not, why not' reporting structure and hence the legitimacy of alternative approaches to implementing recommendations; and
    • confirm the application of the current Principles and Recommendations to small- and medium-sized companies, trusts and externally managed listed entities.
  • The Revised Principles and Recommendations provide guidance and elaboration on specific matters, including:
    • the assessment of, and reporting on, the independence of directors;
    • a new requirement to disclose the process of performance measurement for the board and senior executives;
    • the coverage and disclosure of corporate codes of conduct;
    • the development and disclosure of shareholder communication strategies;
    • the delineation of the respective responsibilities of boards and management in reporting on risk management and control systems;
    • a new requirement to disclose a summary of policies for managing material business risks, without any need to disclose the substance of the actual risk; and
    • incorporating financial and non-financial drivers of material business risks in overall risk management systems and policies.
  • There is no additional reporting requirement in relation to corporate responsibility and sustainability as foreshadowed.
Background

The ASX Corporate Governance Council (the Council) published its Principles of Good Corporate Governance and Best Practice Recommendations in March 2003 (the Principles and Recommendations). The document contains principles of corporate governance to which listed entities should aspire, formal recommendations from the Council as to how this can be achieved, and commentary to guide entities in compliance with the recommendations. All ASX-listed entities are obliged to disclose in their annual reports the way in which they have complied with the recommendations and specific disclosure obligations (but not the suggestions contained in the commentary), or else explain any departures under Rule 4.10.3 of the ASX Listing Rules.

As part of a broader corporate governance and regulatory reform program under way in Australia, the Council announced a review of the Principles and Recommendations in 2006, releasing a draft of changes in November 2006 for comment (the Discussion Draft). The Discussion Draft raised expectations in the community of heightened reporting obligations, particularly in relation to risk management and reporting on corporate responsibility and sustainability, and generated significant comment. In light of public and business feedback on its Discussion Draft, the Council backed away from some of the more contentious proposals in the revised version of the Principles and Recommendations released on 2 August 2007 (the Revised Principles and Recommendations).

Changes to the substance of the recommendations are comparatively few. Many of the changes to the Recommendations and Principles have been made to rationalise the organisation of the document, such as consolidating and relocating material relating to the same subject (eg risk). There is additional commentary to assist entities in complying with particular recommendations. While following this guidance is not mandatory, its promulgation can contribute to market expectations about reporting norms and, hence, is likely to inform market practice.

All ASX-listed entities will need to disclose against the recommendations and disclosure obligations contained in the Revised Principles and Recommendations in the annual report on the first financial year after 1 January 2008. For companies with a 31 December year end, this will be the report issued for the year ending 31 December 2008; for those with a 30 June year end, this will be the report for the year ending 30 June 2009.

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'If not, why not'

The Council has emphasised that the recommendations contained in the Revised Principles and Recommendations are only one way in which an entity may conform with the principles and may not be the best way for a particular entity. A proper explanation of a departure is a perfectly valid alternative.

The Council has included some guidance as to what constitutes a valid explanation for departing from a recommendation – a point of confusion in the past – noting that the disclosure should:

  • identify the recommendation that has not been followed;
  • explain why the recommendation has not been followed; and
  • explain how the practices of the entity accord with the 'spirit' of the principle to which the recommendation relates, that the entity understands the relevant issues, and has considered the impact of its alternative approach.

While it is not mandatory that entities provide this level of detail, and it is only guidance, it is likely to become market practice to do so. As such, directors will need to carefully consider whether the adoption of an alternative practice in departure from a recommendation is in keeping with the spirit of a relevant principle.

There was some debate as to whether the Principles and Recommendations should apply to small- and medium-sized entities listed on ASX. There have been various instances of smaller listed entities struggling to satisfy many of the Principles and Recommendations. The Council has confirmed that the Revised Principles and Recommendations will apply to all entities, noting that the flexibility of the 'if not, why not' structure enables these entities sufficient flexibility to comply with the spirit of the principles. There is evidence to suggest that entities are making use of 'if not, why not' disclosure, particularly in relation to the recommendations that the majority of directors be independent and that a nominations committee exists.1 

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Risk management and disclosure

Much of the excitement generated by the Discussion Draft centred on the proposed changes to Principle 7 (Recognise and Manage Risk). The changes found in the Revised Principles and Recommendations are not as extensive as those proposed in the Discussion Draft but include:

  • A change to Recommendation 7.1 to require that a summary of policies for risk oversight and management of material business risks be disclosed, rather than simply formulated.
  • Commentary accompanying Recommendation 7.1, as well as a definition in the glossary, that makes it clear that material business risks can relate to both financial and non-financial factors.
  • Commentary suggesting that, when developing a risk management policy, an entity should include material business risks relating to the reasonable expectation of stakeholders (in addition to their strict legal rights).

Importantly, the mooted introduction of a new Recommendation 7.4 requiring entities to disclose their material business risks (as opposed to the policies adopted to manage such risks) was not included.

The minimalist changes to Principle 7 reflect the significant opposition to increased mandatory reporting on the material business risks themselves, including matters of corporate social responsibility and sustainability, shown in the submissions relating to the Disclosure Draft. The changes do, however, give companies scope to report on these matters to the extent considered appropriate in considering and reporting on material business risks.

So, in line with the regulatory trend set by last year's Corporations and Markets Advisory Committee (CAMAC) and federal parliamentary reports on corporate social responsibility (see AAR Focus: Corporate Governance – December 2006 and AAR Focus: Corporate Responsibility – July 2006), for the moment corporate social responsibility (CSR) and sustainability concerns are largely framed as either voluntary aspects of corporate activity beyond compliance with the law or else matters of relevance to corporate risk and disclosure as part of an overall assessment and management of material business risks.

Pressure for increased scrutiny of corporate responsibility and sustainability is growing both nationally and internationally, especially in external corporate ratings, investment decision-making, and multi-stakeholder reporting and other standard-setting initiatives (eg Global Reporting Initiative, Global Compact, and UN Principles for Responsible Investment). In this regard, the recent declaration from the G8 Summit in June 2007 was notable:

We invite the companies listed on our Stock Markets to assess, in their annual reports, the way they comply with CSR standards and principles.

  

Accordingly, business should keep a watching brief as such wider aspects of today's business environment further evolve, especially in relation to the performance and reporting of corporate responsibility and sustainability.

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Equity-based remuneration

Confusion around whether previous recommendation 9.4 required separate shareholder approval of equity-based remuneration to executives (as opposed to directors) has been resolved with the deletion of the provision. However, the Revised Principles and Recommendations suggest that companies may nevertheless find it useful to submit such equity-based executive remuneration proposals to shareholders first. This may not always be a practical approach.

The Revised Principles and Recommendations provide for an entity to disclose a summary of its policy prohibiting hedging of unvested entitlements of equity-based remuneration schemes, which suggests that such hedging arrangements should not be utilised. As the Revised Principles and Recommendations are silent on whether vested entitlements can be hedged, it is assumed that they can be.

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Performance measurement

In changes to Recommendations 1 and 2, entities will need to disclose the process for evaluating the performance of each of the board, board committees, individual directors and senior executives, whether the evaluation has occurred during the reporting period and whether the evaluation was conducted in accordance with the policy. It is questionable whether this degree of detail will be helpful to investors.

Director independence

Entities will now be required to disclose the existence of certain relationships which may affect the independence of a director, in addition to explaining why such a director remains independent despite those relationships.

Another change of note is that longevity of service has been removed as one of the circumstances that may impair the independence of a director.

Conclusion

On balance, the Revised Principles and Recommendations are a worthwhile refinement of the existing position from the perspective of companies and the market. Although full compliance with the recommended disclosures might lead to information overload for investors, the strengthening of the 'if not, why not' approach should provide sufficient flexibility to ensure the continued workability of the existing model of corporate governance.

Footnotes
  1. Research by the Council has shown that 47 per cent of listed entities reporting against recommendation 2.1 (majority independent board) departed from the recommendation and 57 per cent departed from recommendation 2.4 (nominations committee), 2005 Analysis of Corporate Governance Practice Disclosure, ASX Corporate Governance Council; 22 May 2005, page 2.

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