The Harold Ford Memorial Lecture University of Melbourne 30 ...

The Harold Ford Memorial Lecture University of Melbourne 30 ...

The Harold Ford Memorial Lecture University of Melbourne 30 April 2013 From Managing to Monitoring: The Evolution of the Listed Company Board By RP Austin Outline of my paper 1. Introduction 2. Reflections on the history of corporate governance to the 20th century 3. The emergence of the monitoring theory, 1950-2010 4. Corporate governance and statute 5. Corporate governance and case law 6. Corporate governance: accommodating the monitoring

theory 7. Corporate governance and public perception 8. Implications of the monitoring function for future development 1. Introduction (a) My focus is on the governance of Australian listed public companies The history of corporate management (Part 2) shows that the modern corporation of the UK, the US and Australia emerged from an owner-manager model, rather than a policy-setting or monitoring model The idea that the boards role is to monitor the performance of management in the interests of shareholders was not plainly and fully articulated until the 1970s, in particular by

Myles Mace and Melvin Eisenberg (Part 3) 1. Introduction (b) Eisenberg emphasised that the monitoring role cannot succeed unless the board, or a majority of it, are truly independent As Gordon showed, there was a dramatic growth in the number of independent directors on major company boards in the 1970s and 1980s The monitoring function of UK boards, and hence the need for the independent directors, was articulated comprehensively in the Cadbury Report 1992, and those ideas were adopted in Australia about the same time 1. Introduction (c)

Consequently we have had a fully articulated monitoring theory of corporate governance in Australia for only about 20 years, and a soft requirement for a majority of independent directors for even less time The substitution of the monitoring theory for the older idea that the boards are part of operational management has some profound implications for statute law and regulation (Part 4), case law (Part 5), other corporate governance principles (Part 6), and public perception (Part 7) I will conclude my paper with some observations about the future development of the board, in light of monitoring theory (Part 8) 2. Reflections on the history of corporate governance to the 20th century (a)

The history of UK and US governance ideas shows the central importance of the owner-manager (partnership) model Medieval times: partnerships or sole traders, eventually letting in investors who received member shares as beneficiaries, within an unincorporated joint stock company structure The growth of the joint stock company was stunted by the incredible rise and fall of chartered corporations in the 17th and 18th centuries But chartered corporations became unpopular after the South Sea bubble, and because of the cost and delay of new formation With the repeal of the Bubble Act, the formation of joint stock companies surged in Britain 2. Reflections on the history of corporate governance to the 20th century (b)

1844-1856: UK joint stock companies were given a simple method of incorporation by registration, which established them as the foundation of the modern company based, note, on the ownermanager model The US economy rapidly outgrew the UK, but until the 20th century even large US enterprises used a variety of legal forms, including trust and partnership, and corporate formation tended to be reserved for public utilities In the US between the late 19th century and the 1950s, a professional manager class took control of large corporations Chandlers managerial capitalism, but the board was not conceived as a monitor of management for the benefit of shareholders 2. Reflections on the history of corporate governance to the 20th century (c) In the unincorporated joint stock company formed by deed of

settlement, directors were treated as the agents of the shareholders Consequently shareholders could give binding directions to the board But this model was eventually superseded, after joint stock companies were given corporate status, and so the board became a separate corporate organ vested with management power, to the exclusion of the shareholders: Automatic SelfCleansing Filter Syndicate v Cuninghame (1906) 3. The emergence of the monitoring theory, 1950-2010 (a) In the US the central problem of corporate governance has long been the separation of ownership and control in the large widely held corporation (the core fissure in US corporate governance) In 1932 Berle and Means argued that modern company law had

destroyed the unity of property, as shareholders were typically uninterested in day today affairs of the company, allowing managers (including directors) to manage the resources of the company to their own advantage, without effective shareholder scrutiny Important though it was, the Berle and Means thesis did not distinguish between the roles of directors and management: for them, control lay in the hands of those with actual power to select the board, which directed the activities of the corporation 3. The emergence of the monitoring theory, 1950-2010 (b) Alfred Chandler criticised historians and economists for failing to perceive the rise of the professional managerial class in the period from the late 19th century to the 1950s By the late 1950s the managerial firm had become the

standard form of modern US business enterprise, and the decision-makers were the professional managerial class For Chandler, the board was dominated by professional managers, with owner and financier representatives having only a right of veto, and there was no significant role for independent directors to act as a check on management 3. The emergence of the monitoring theory, 1950-2010 (c) Myles Mace conducted field research in the late 1960s to find out how boards actually operated (Directors: Myth and Reality, 1971) He concluded that boards did not engage in routine operational management, and their key functions were to provide advice and counsel, to serve as some sort of discipline and to act in a crisis situation Discipline arose not because directors would ask embarrassing

questions, but because the very requirement for senior management to appear before a board of respected business peers led top executives to analyse their situation and be prepared to answer all possible questions Mace did not originally address the role of, or require the appointment of independent directors, but by 1986 he accepted that directors should represent shareholders and all but a few directors should be independent of the CEO 3. The emergence of the monitoring theory, 1950-2010 (d) In a series of seminal and highly influential articles from 1969 to 1975, published in book form in 1976 (The Structure of the Corporation), Melvin Eisenberg cogently proclaimed the monitoring theory and urged the appointment of truly independent directors He said that all serious students of corporate affairs recognise that

notwithstanding statutory law, in the typical large publicly held corporation the board does not manage the corporations business and that function is vested in the executives Further, the typical board no more makes business policy than manages the business, and policy-making is an executive function Typically boards of large companies approve management proposals, rather than initiating them (relying on Mace) 3. The emergence of the monitoring theory, 1950-2010 (e) These outcomes are the product of constraints on board time, constraints on information, and constraints on board composition, selection and tenure In particular, typical board members are economically or psychologically dependent on the chief executive who (at that stage)

controlled hiring and firing, and a substantial number of board seats were held by executives themselves (a graphic description of the pre-1977 board comprising non-independent directors!) Eisenberg rejected proposals for filling board places with professional directors, largely because there were not enough of them, and he considered and rejected proposals for full-time directors and for staff support for boards 3. The emergence of the monitoring theory, 1950-2010 (f) Eisenberg identified four classes of functions for the board: providing advice and counsel to the CEO; authorising major corporate actions; providing a modality by which non-executives could be formally represented in corporate decisionmaking; selecting and dismissing members of the chief executives office and monitoring their performance The advice and counsel function was, in his view, not essential to the

corporations operation and could be replaced by advice from the executive ranks (for example, through constituting an executive committee) As to authorising major corporate actions, he said the boards role was merely to review management proposals, and was of limited importance, except as a potential check in conflict-of-interest cases The board provides a modality by which, say, major shareholders or creditors can influence corporate action, but its importance is generally confined to major shareholder representation and not representation of other groups (in contrast with Germany) 3. The emergence of the monitoring theory, 1950-2010 (g) For Eisenberg, the function of selecting and removing the chief executive is often considerably more than a formality The removal power is especially important because it subsumes

the boards semi-autonomous function of monitoring the results achieved by the chief executives office The premise of the monitoring model is that management is a function of the executives, whose ultimate responsibility is located in the office of the chief executive, and the role of the board is to hold the executives accountable for adequate results While the board must properly pay deference to the incumbent chief executive, it must be completely independent of the chief executive in order to monitor his or her performance objectively 3. The emergence of the monitoring theory, 1950-2010 (h) In 1976, while the monitoring role of the board had become crucial, most boards did not perform the function well, and would remove the chief executive for inefficiency only if the corporation had entered the crisis zone (as with Penn

Central) In Eisenbergs view, effective monitoring had been all but precluded by current corporate ideology and practice, according to which most boards were neither independent nor capable of obtaining adequate information concerning management Amongst Eisenbergs alternative recommendations for altering the existing governance model were: a wholly independent board; a board with a majority of independent directors; and a two-tier board in which managers and supervisors were members of separate corporate organs On grounds of practicality, he advocated the second alternative, a majority of independent directors, which is now in operation in Australia on a comply or explain basis 3. The emergence of the monitoring theory, 1950-2010 (i)

The monitoring theory of board governance, and the corollary that boards should comprise a majority of independent directors, became dominant in the 1980s, although in 1982 Victor Brudney doubted the efficacy of the independent director model The dominance of the monitoring theory was confirmed when the American Law Institute, led by Professor Eisenberg as principal reporter, publish the Principles of Corporate Governance: Analysis and Recommendations, 1994 Jeffrey Gordon, writing in 2007, has documented the rise of independent

directors, noting that it was only at the end of the 20 th century that standard US practice became to delegate responsibility for selecting new directors to a committee of outside directors 3. The emergence of the monitoring theory, 1950-2010 (j) In the AWA case in 1991, Justice Rogers, ahead of his time, articulated a monitoring role for directors, though without encouragement from the Tricontinental Commissioners or even the New South Wales Court of Appeal Nevertheless the monitoring and independent director approach received some support from the Bosch Committee in the early 1990s For the United Kingdom and indirectly for Australia, the monitoring theory with its corollary need for director independence were confirmed emphatically by the UK Cadbury Committee, which reported in 1992 Although modified from time to time in later reports and Codes, the essential tenets of

the Cadbury philosophy have endured for over 20 years The monitoring role of the board of a large corporation, and the requirement of majority director independence, are linchpins of the ASX Corporate Governance Councils Corporate Governance Principles and Recommendations, and the CAMAC Guide to Directors (2010) But the implications of this approach are yet to be fully addressed by statutory law, case law and corporate governance bodies 4. Corporate governance and statute (a) In this part of my paper concentrate on general statutory principles concerning the board function; I do not review the COAG principles for Director Liability and their translation into multiple legislative amendments at the Commonwealth, State and Territory levels The standard management clause in Australia, the UK and the US, vested management power exclusively (or almost exclusively) in the

board, but allowed the board to delegate In Australia s 198A , following the Delaware General Corporation Law, introduced a replaceable rule under which the business of the company was to be managed by or under the direction of the directors That wording is ambiguous, as to whether it authorises monitoring, or merely delegation 4. Corporate governance and statute (b) Corporate constitutions invariably authorise broad delegations to the chief executive or other executives Listed company boards put in place detailed delegations of authority, typically with monetary or other limits, sometimes delegating wholly through the CEO with power to sub-delegate, and sometimes by direct delegations to the CEO, other officers such as the CFO, or to the executive committee

Section 198D confers a statutory delegation power on directors unless the companys constitution provides otherwise If the directors delegate power under s 198D, the directors are responsible under s 190 for the exercise of the power by the delegate unless the directors can show belief on reasonable grounds at all times that the delegate would act in conformity with the duties of directors; and belief on reasonable grounds, in good faith and after making proper inquiry where needed, that the delegate was reliable and competent 4. Corporate governance and statute (c) Arguably if the delegation is made under constitutional power rather than under s 198D, the constitution can exclude the directors residual power and hence remove their responsibility for the delegates actions The application of the principles of liability in s 190 is difficult and

almost unmanageable in large corporations, given that the board will be aware of the detailed system of delegations of authority Further difficulty arises because the directors responsibility, for the purposes of application of their statutory duty of care and diligence, is likely to be affected by the operation of s 190 In governance terms, the delegation arrangements are inconsistent with monitoring theory and make it difficult for the board to operate in the manner advocated by modern corporate governance theory 4. Corporate governance and statute (d) The Corporations Act draws a distinction between cases where directors delegate management power to others, and cases where directors themselves make decisions in reliance on information or advice The reliance category is particularly important because boards typically operate by making decisions in reliance on reports from management, board committees

or external advisers Section 189, amended somewhat chaotically in the Senate during the passage of the 1998 Bill, provides that reliance on information or advice is taken to be reasonable if made in good faith, and after making an independent assessment of the information or advice, having regard to the directors knowledge of the corporation and the complexity of its structure and operations Section 189 is compatible with the monitoring theory but it raises the question of how, in the monitoring context, the board is required to independently assess advisory inputs 5. Corporate governance and case law (a) Two parts of general law and statutory directors duties are especially pertinent to the debate about the monitoring function: whether directors have an objective duty of skill; and what are their responsibilities for the purpose of judging their duty of care and

diligence Historically the director was required to bring to the office only such skill as he or she possessed, and there was no objective standard of skill That changed in a series of cases dealing with insolvent trading, then adapted and extended in the Centro case In those cases the courts recognised a core, irreducible requirement of skill extending to basic financial literacy and in the case of a listed public company board, a measure of understanding of financial accounting standards 5. Corporate governance and case law (b) Is there an objective standard of skill beyond financial competence? The absence of any reference to skill in s 180 is apparently not determinative, because the courts have inferred an objective standard of financial skill under that section

The question of an officers responsibilities is primarily a question of fact, and there is some authority that corporate governance writing may be admissible on that question As a matter of personal observation, I wonder if in Australia we are moving, indeed moving rapidly, to recognition of a professional director class, where directors are expected to equip themselves for office by specialist training in key skills (e.g. finance, accounting and governance), and to gain a good understanding of their companys business operations, risks and prospects promptly on appointment, if not before Will that trend ultimately be recognised by the courts? 5. Corporate governance and case law (c) As to care and diligence, now that the dust has settled the key decisions are James Hardie at first instance (plus some reliance dicta in the Court of Appeal), Centro, some fleeting dicta at first instance in

Bell Group, and Fortescue Metals in the Full Federal Court Bell Group and some passages in Centro demonstrate the persistence of the view that boards are responsible for operational management, even though they cannot carry it out (they sit at the apex of the management structure, and inscribed on the boardroom door there should be the motto the buck stops here), but on the whole the case law now more strongly supports the monitoring theory Fortescue Metals is interesting because it sets the standard of care and diligence at a high level when it comes to steering the company away from statutory contraventions 5. Corporate governance and case law (d) But undoubtedly the most important proposition, arising from James Hardie and Centro, is that there is an implied limit to the boards powers of delegation and reliance, quite apart from the

statutory requirements Broadly, boards must approach their functions with an inquiring mind, and cannot avoid liability by relying on others when their knowledge of the company and their common sense point in a different direction That outcome, which has noticeably raised the stakes for Australian directors compared with their US and UK counterparts, is consistent with the monitoring theory, because it emphasises the relatively high standard that monitoring requires 6. Corporate governance: accommodating the monitoring theory (a) The full implications of the monitoring theory for principles of corporate governance are still being developed In doing so, corporate governance bodies would be well advised to

consult Professor Eisenbergs work, which is remarkably prescient One of the key issues is whether to insist on separation of the chief executive and chairman roles: rigorous application of the monitoring theory requires separation, but for some companies (particularly in the US) that will be a process of evolution rather than implementation Another issue relates to the role of the chairman: monitoring theory seems to entail enhanced functions and consequently enhanced responsibility 6. Corporate governance: accommodating the monitoring theory (b) An importantdevelopment relates to whether, and to what extent, it is necessary to curtail the de facto or even legal powers of a majority or substantial shareholder in order to ensure director

independence and hence effective monitoring of management Research has shown that in most of the developed world (except for the US, the UK and to some extent Australia), widely dispersed shareholding is the exception and influential ownership or voting blocks are generally common, and so this governance issue is quite pressing It has come to prominence in London recently as a result of a relatively lax listing policy, and in Australia in the recent controversy about board independence in Leighton Holdings 7. Corporate governance and public perception (a) It is only necessary here to reiterate a message I conveyed in my McPherson lectures at the University of Queensland in 2010: that there is a marked dichotomy between the requirements of

modern corporate governance and public expectations fuelled by the media (which I have called an expectation gap) When corporate calamities or failures occur, inevitably some media commentary will demand accountability by or even punishment of the companys directors, typically without investigation of whether the directors are actually to blame The underlying assumption of such commentary is that the buck stops with the directors, that is, they sit at the apex of operational management and are responsible for what goes on 7. Corporate governance and public perception (b) A similar approach can be detected in some commentary and guidance by regulators, particularly APRA The proposition that directors who have taken all reasonable

steps to guide and monitor management should have no further responsibility for management failure seems unlikely to win the argument, for the time being The AICD is doing what it can to educate those who deal with boards regarding the limits of directors responsibilities, but there is much to be done 8. Implications of the monitoring function for future development (a) Analysis of these areas suggests that the lesson of history has not been fully learned, and so boards are sometimes treated as at the apex of operational management, and sometimes as having a separate governance role, as monitors of corporate management for the benefit of shareholders Inevitably statute, case law, corporate governance and even

public perception will respond to the growth of the monitoring board Equally inevitably, boardroom practice will develop to accommodate the new regulatory circumstances 8. Implications of the monitoring function for future development (b) I suggest that the limited role that boards currently have to make operational decisions that exceed the limits of management delegations is bound, over time, to shrink because of the expanding monitoring workload, and correspondingly the scope of delegated decision-making power for the CEO and executive committee will increase When that happens, operationally if not formally we will have a two-tier board system, comprising a supervisory board and a

management committee, with special Aussie characteristics The legal and regulatory implications of that further development will also be profound *******

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