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Embracing Corporate Governance Principles

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By Public Institutions including The Central Bank
Business
Ruwani Dharmawardana LLB, Attorney-at-Law, MBA (UK, ACISI (UK)

The academic literature coupled with empirical evidence suggest that embracing the fundamentals of corporate governance (integrity, honesty/sincerity, transparency and responsibility) by public entities, together with clear risk management and internal control mechanisms, enable such entities achieving the efficient use of public funds, narrowing the budget deficits, operational efficiency and elimination of corruption.

The author wishes to bring about a dialogue among the professionals, to see the value addition such principles could bring to the public entities in Sri Lanka.

As per the definition of the Organization for Economic Co-Operation and Development (OECD) April 1999, “Corporate Governance” (CG) is the system by which business corporations are directed and controlled; specifies the distribution of rights and responsibilities among different participants in the corporation, such as the board, managers, shareholders and other stakeholders. CG spells out the rules and procedures for making decisions on corporate affairs and provides the structure through which the company objectives are set, and the means of attaining those objectives and monitoring performance. The McKinsey’s Global Investor Opinion Survey 2002 concluded that an overwhelming majority of investors are prepared to pay a premium for companies exhibiting high governance standards. Premium averaged 12%-14% in North America and West Europe and over 30% in Eastern Europe.

Globally, the consequences of weak corporate governance include accounting fraud. e.g. Enron, WorldCom, Tyco (USA); Lack of skill, knowledge and experience on the Board-e.g. Barings Bank (UK); Lack of Board independence–e.g. Tesla Inc. (USA); Improper risk management e.g. Lehman Brothers (USA); Unethical business practices – e.g. Volkswagen (USA); Inappropriate remuneration and rewards-e.g. Enron (USA) and Lack of consistence policies, control procedures, guidelines and mechanisms e.g. Golden Key and Pramukha Bank (SL).

Global corporate governance legislation and codes include Sarbanes-Oxley Act 2002 (USA) (Auditor independence, CEO and CFO sign off accounts for accuracy and white collar crime penalty enhancement); King Codes (South Africa) (King IV Code 2016)- “Apply and explain” approach; Cromme Code (Germany); Principles for Responsible

Institutional Investors: Japan’s Stewardship Code – Japan; UK Corporate Governance Code and NZX Code- New Zealand. Local corporate governance legislation and codes include the Companies Act, No. 07 of 2007, Colombo Stock Exchange Listing Rules (Rule 7.10–if there is a non-compliance the particular company will be transferred to the watch list and even delisting), Central Bank of Sri Lanka Directive for

corporate governance for banking and financing companies, Code of Best Practice on Corporate Governance–Institute of Chartered Accountants of Sri Lanka 2017 and Guidelines on Corporate Governance for State Owned Enterprises 2021-Ministry of Finance. All the corporate governance principles are premised on four pillars; namely, fairness, accountability, transparency and responsibility.

The principles of corporate governance are equally important for the public sector as though the corporate entities have adopted such principles, still such entities will have to operate in an economic environment where the contribution of the public sector will have a significant impact, either creating a conducive economic environment or a non-conducive economic environment. Other than the above cited corporate sector scandals, the most illustrative scandal of this kind in public sector, in the UK was the 1994 deal, “cash for questions”, when a number of members of Parliament accepted the offer from some journalist or from persons with different interests, to ask questions in Parliament, on certain themes in exchange of cash sums varying from £1000 to 2000.

In the UK, the “Nolan Principles” (1995) have articulated the following principles, as applicable to the public sector:

* a) Selflessness – Holders of public office should take decisions solely in terms of the public interest. They should not do so in order to gain financial or other material benefits for themselves, their family, or their friends.

* b) Integrity – Holders of public office should not place themselves under any financial or other obligation to outside individuals or organizations that might influence them in the performance of their official duties.

*c) Objectivity-In carrying out public business, including making public appointments, awarding contracts, or recommending individuals for rewards and benefits, holders of public office should make choices on merit.

* d) Accountability – Holders of public office are accountable for their decisions and actions to the public and must submit themselves to whatever scrutiny is appropriate to their office.

* e) Openness – Holders of public office should be as open as possible about all the decisions and actions they take. They should give reasons for their decisions and restrict information only when the wider public interest clearly demands.

* f) Honesty – Holders of public office have a duty to declare any private interests relating to their public duties and to take steps to resolve any conflicts arising in a way that protects the public interest.

* g) Leadership –Holders of public office should promote and support these principles by leadership and example.

The basic principles enunciated in governance codes, as applicable for corporate sector are as given here: separation of the roles of the Chairman and the CEO; appointment of a Senior Independent Director when the positions of the Chairman and the CEO are held by one person; the Chairman to set the Board agenda taking in to consideration matters relating to strategy, performance, resource allocation, risk management and compliance, together with the CEO and the Company Secretary; the role of the Non- Executive Directors to avoid group thinking, “fit and proper criteria” of the directors nominated to the Boards; evaluation of the Board performance by an outside specialized firm periodically; role of the Company Secretary to advise the Board but not to be a mere minute taker; establishment of Board sub-committees like Nomination Committee, Remuneration Committee, Audit Committee, Compliance Committee and Risk Management Committee etc.; Board of Directors and the management to function within the applicable legal and governance framework and to have a clearly articulated “Matters Reserved for the Board” to demarcate the operational matters and strategic matters enabling the Board to focus on strategic matters.

The view of the writer is to see how the existing governance framework of the public sector could be further improved to the next level. In this regard, as a case study, she wishes to explore the concept of the “Independence of the Central Bank”, in the light of the principles of good governance. In the academic literature, “the independence of the Central Bank” refers mainly, to what extent the Central Bank is free from direct political interferences, in terms of the monetary policy, which is mainly reflected in lower average and less variable inflation and higher average growth of real DGP, while understanding the fact that in most jurisdictions, the Central Bank by whatever named called, is not totally free from political interferences. From theoretical perspective, prudent policy making requires to focus on the medium-to-long run whereas the political business cycle focuses mainly on the short-run.

First, the writer wishes to take the readers through the history to see how this aspect has evolved over the years. After the first world war, Germany was in lot of debt and its costs were racking up as soldiers needed pension and the war widows needed compensation, in a background other countries were not willing to lend money to Germany. As a result, the Central Bank of Germany had to print more and more money and loaned the same to the Government, which resulted in hyperinflation, where the hyperinflation reached rates of more than 30,000% per month. A similar hyperinflation has been witnessed in Zimbabwe and Venezuela which had many cascading adverse, unprecedented effects on the economy. As a result, when the Bundesbank became the Germany’s Central Bank in 1957, the focus was on stable currency and managing inflation at a conducive rate. The German Bundesbank has a well-established reputation for its successful anti-inflationary policy (Alesina and Summers, 1991; Grilli et al.,1991) and the literature on the central bank independence finds the Bundesbank to be the most independent and conservative central bank in the world (Cukierman, 1992; Eijffinger and de Haan, 1996).

Similarly, the Bank of England and most of its European counterparts were still controlled by their Governments. The conventional wisdom was that the central bank could increase the money supply, inflation and people will have more jobs. In economic theory, this has reference to the “Phillips Curve”, according to which inflation and unemployment have a stable and inverse relationship. In fact, low unemployment rates help the politicians to get re-elected. However, Phillips Curve could not sustain in the long run, but resulted in “stagflation”, which is a phenomenon of persistent high inflation combined with high unemployment and stagnant demand in a country’s economy.

While the inflation rates in the U.S., U.K., Italy and Japan spiking during the great economic crisis, Germany kept the inflation at a much more modest level, so did Switzerland which had a very independent Central Bank.

Central Banks mostly have some form of oversight role, similar to a Board of Directors serving a company, being an institutional watch-dog. While the corporate Board of Directors act as the agents of the shareholder, for the best interest of the company, the Board of the Central Bank functions as an agent of the Minister of Finance (who is an agent of the general public) or the Parliament (again consisting of gents of the general public), depending on the legislative framework of the particular country, to serve the wider public interest. The functions of the Board of the Central Banks are not quite different from the functions of the Board of Directors of a company, like strategic planning, evaluating policy decisions, audit and risk. Certain legislation refers that the Central Bank shall be a body corporate with perpetual succession and a common seal and may sue or be sued in its corporate name. This is similar to the perpetual succession of a limited liability company with a separate legal personality.

In the ensuing paragraphs, the author wishes to share her views on incorporating the fundamentals of corporate governance, as applicable in other jurisdictions, for the purpose of the Central Bank, if such principles have not been embraced so far. In this aspect, the author has mostly cited the governance framework of the Reserve Bank, Australia, as an example.

* 1. Membership- The design of the board(s) and management should help depoliticize the decision making process (Romer and Romer, 1997). In terms of corporate governance, the membership will have to be vary from 7 to 12 and preferably, not below 07, as even in a limited liability company, the Board may consist of a wider representation, to have more views on Board and to make an informed decision after much deliberation independently. For example, the Reserve Bank Board, Australia comprises nine members: three ex officio members (the Governor, Deputy Governor and Secretary of the Treasury) and six non-executive members.

The Bank of Canada’s Board of Directors comprises fifteen members: the Governor, the Senior Deputy Governor, 12 independent directors and the Deputy Minister of Finance who serves as an ex officio non-voting member of the Board. The Swiss National Bank is overseen by a Bank Council, which comprises eleven members. The Bank of England is overseen by a Court of twelve individuals, comprising five officials (the Governor and four Deputy Governors) and seven non-executive directors.

* 2. Non-Executive Directors-The corporate governance codes applicable for the corporate sector requires to have more non-executive directors on Board, to bring independence view to the Board. As mentioned above, in the above cited countries, there are clearly identified Non-Executive Directors on the Boards of the Central Banks.

* 3. Fit and Proper Criteria- The corporate governance codes applicable for the corporate sector require for the directors not to fall within the disqualification criteria, which also may be extended to the Board members of the Central Bank, to ensure that the independency of the Board is not impaired and the right members are appointed to the Board. Accordingly, other than the professional qualification requirements there may be a general requirement to be fit and proper, which may be formulated as being of good moral standing (European Central Bank), have good moral character (Philippines), or unquestionable integrity (Philippines).

* 4. Remuneration- Corporate Governance Codes, as applicable for the corporate sector requires companies to establish a formal and transparent procedure for developing policy on executive remuneration and for fixing the remuneration packages of individual Directors. No Director should be involved in deciding his/her own remuneration. In Australia, one of the importance corporate governance aspect, i.e. the role of the Remuneration Committee has been captured and accordingly, the Remuneration Committee makes recommendations to the Board on the remuneration of the Governor and Deputy Governor in terms of the Reserve Bank Act and the framework and guidelines set by the Remuneration Tribunal, and is also kept informed of the general remuneration arrangements for Reserve Bank staff.

 

* 5. Code of Conduct-The principles of good governance require adopting a Code of Conduct. For example, in Australia, in recognition of their responsibility for maintaining a reputation for integrity and propriety on the part of the Board and the Reserve Bank, members have adopted a Code of Conduct.

* 6. Audit Committee and Risk Management Committee- The corporate governance principles as applicable to the corporate sector require that the Board should require the Audit Committee to ensure carrying out the reviews of the process and effectiveness of risk management and internal controls, and to document to the Board and Board takes the responsibility for the disclosures on risk management and internal controls. Extending the above to the public sector, for example, in Australia, the primary objective of the Audit Committee is to report to the Board on matters relevant to the fulfillment of the Bank’s statutory financial reporting and other obligations in terms of the Reserve Bank Act and the Public Governance, Performance and Accountability Act 2013 (PGPA Act).

If there exists only one Board entrusted primarily with policy making, it may be prudent to delegate some oversight functions, to an audit committee, chaired bya Non-Executive Board member together with external experts not being board members.

* 7. Rules and Procedures of Board of Directors’ Meetings- The corporate governance requires to have a clearly articulated manual on the same, which will ensure that a consistent approach will be adopted in conducting Board meetings, which will not vary at the discretion of the Chairman in the corporate sector and at the discretion of the Governor, when it comes to the Central Bank. This will ensure providing timely information to the Board, not necessarily, limiting only to what the Governor wants to discuss at the Board.

* 8. Avoid group thinking- In order to make an informed decision, proper deliberation of matters together with constructive exchange of diverse views across the table, is paramount. Group thinking imperils the board’s informed, unbiased decision making process. Groupthink is defined by the Merriam-Webster Dictionary as a pattern of thought characterized by self-deception, forced manufacture of consent and conformity to group values and ethics.

The term groupthink was first coined by Irving Janis as “a mode of thinking that people engage in when they are deeply involved in a cohesive in-group, when the members’ striving for unanimity override their motivation to realistically appraise alternative courses of action.” Therefore, similar to a corporate Board, avoiding group thinking is also important for its proper functioning. In other words, the Board members have to be active, but not merely passive, pertaining to the decisions taken by the Board. If they can’t agree with the majority decisions, the best option would be to step down.

The corporate governance principles could be adopted to such other public entities as well, thereby ensuring the proper management of public funds and achieving the objectives of the respective entities, for the betterment of the general public at large.

 

 

 

Thursday, June 9, 2022 – 01:00











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