Responding to public support, the Commission adopted what it calls “principles-based” approach in relation to the promotion/regulation of corporate governance. It means the principles are not enacted into legislation but are merely intended to set “guidelines for behaviour” which organisations may choose to follow and report on. The Commission suggests organisations disclose their corporate governance practices through mediums such as the annual report.
By contrast, the United States adopted “rules-based” approach by enacting the Public Company Accounting and Investor Protection Act 2002 (also called the Sarbanes-Oxley Act), which prescribes specific rules relating to financial disclosure and other corporate governance practices and includes specific sanctions if companies breach particular rules.
One of the advantages of “principles-based” approach is that management retains the discretion to decide whether it is appropriate or feasible for its organisation to comply with each or any of the principles identified, and the extent and method of compliance and disclosure. However, inherent in providing that discretion is the risk that no proactive action is taken to implement the suggestions contained in the guidelines.
What is required is an incentive to act. An increase in obligations to spend more time and effort (and consequently costs) on corporate governance issues is unlikely to provide the motivation some boards of directors need to act. Consider for moment the principle requiring board of directors to have clear policy in respect of stakeholder relationships. Designing, enforcing, reviewing and updating policy, monitoring and reporting on compliance, and dealing with non-compliance is labour and cost intensive process.
The Commission’s principle six (“Risk Management”) requires board to “regularly verify” that the company has rigorous processes to identify and manage risk. This principle addresses an important issue which is not currently legislated for in this form. Administration of risk management procedures can be onerous. Overseas banking organisations find that many man hours and considerable cost are committed to defining levels of risk, and to developing systems for reporting, monitoring and managing it.
The Commission acknowledged submitters’ concerns over the issue of risk management by suggesting in its key consultation findings that “focus on risk should not stifle business”. This is essentially reference to the importance of balancing risk management with the effort involved and the overall effectiveness of instituting policies, procedures, reviews etc.
One way of helping organisations achieve more positive balance would have been for the Commission to provide some guidance on the type and level of risk (at the most basic level, “real” commercial risk as opposed to everyday operational risk) and the manner of managing risk the Commission perceives is important in promoting corporate governance.
Perhaps this lack of detail in the guidelines is result of the Commission’s aim to develop principles and guidelines to cover wide range of companies and other entities and therefore specific details are not appropriate.
Prompted no doubt by recent world events involving rogue organisations, the Commission addresses the issues relating to the independence of auditors and the integrity of financial reports. It considers independent oversight of auditors as an important method of ensuring both audit quality and auditor independence. The Commission intends recommending the Government adopt practices similar to those of other jurisdictions including the establishment of body independent of the audit profession to oversee its work. As it currently stands, an enterprise’s obligation is limited to hiring suitably qualified auditors to perform an annual audit.
In the meantime, the Commission provides reasonable guidance on the role company may take in ensuring “the quality and independence of the external audit process”. Some of the rules set out in the Sarbanes-Oxley Act aimed at ensuring the preservation of the auditor’s independence may have been useful as guide in this context such as the list of non-audit services that an auditor should not be involved in. The guidelines provide for the rotation of lead audit partners every five years, which is in line with the new US legislation. It is arguable whether this is possible in market as small as New Zealand and populated by accounting firms that are comparatively small.
The report does, however, provide useful benchmark for entities to evaluate the extent their corporate governance practices currently meet community expectations. On the other hand, the decision to develop principles and guidelines applicable to range of organisations means that in some instances the report is insufficiently prescriptive. The flexibility available to boards may be counterproductive. Too much time and effort may be spent on determining the appropriateness of certain principles to particular organisation and the extent and method of compliance, rather than ensuring good corporate governance.
There is clearly need for an overall review of corporate governance rules, focusing on determining which approach is suitable for New Zealand purposes and developing principles and guidelines for different types of organisations. An enquiry would probably include (among other things) an analysis of the feasibility of particular approach from an economic perspective and should focus on whether the approach would unduly increase compliance costs and/or reduce management efficiency and effectiveness.
The Commerce Minister, Margaret Wilson, has released discussion document which is “the first part of two-part review of the Financial Reporting Act, and forms part of the Government’s efforts to strengthen corporate governance in New Zealand”. The discussion document includes review of any changes that need to occur to New Zealand law “to prevent the type of corporate scandals that have recently occurred in Europe, the United States and Australia”. We anticipate that with corporate governance reform being priority for Government the issues raised by the Securities Commission will soon get merited consideration.
By Kevin Jaffe and Peter Hinton, partners in Simpson Grierson’s Corporate Advisory.
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