The second part of the Corporate Governance series focusses on effective governance of management. There are broadly three areas: information disclosure, strategic direction and operational governance. For the board to discharge its duties in these areas it needs to take a proactive and consistent approach.
The foundation of any decision making process is information. Although it is the responsibility of management to assemble information it is imperative that the board leads the way in deciding what information is collected and how it is presented. The reasons for this are not only to avoid dishonesty but also to minimise the natural selection bias present in nearly any human endeavour. Examples of such information might include presentation of quality of revenue. Diversified, sustainable revenue generated from ordinary operations is considered high quality whereas a one time profit from the sale of a non-operating asset would be considered poor quality.
On the profit side it is now understood that free cashflow should be considered when assessing the quality of profits. There are however many other factors to consider. One such factor that was prevalent in the aftermath of the financial sector meltdown is cost cutting. There is a big difference between cutting excess capacity which generates sustainable profit increases and cutting actual capacity which generates short term profit increases that will reverse in a year and decrease the long term viability of the business. The seduction of thoughtlessly increasing profits in the near term at the expense of long term profits is particularly insidious, as there is always pressure to increase immediate profits and management will rarely be around to be held accountable for this maneuver.
The next main area that the board is responsible for in terms of overseeing management is strategic direction. The first major sign of failure is when management or the board abdicate their responsibility in this matter to external management consultants. The issue here has nothing to do with the debate of whether consultants add value and everything to do with the realities of transforming primary ideas around identified opportunities into viable businesses with sustainable profits. Many government related projects suffer this issue, correctly identifying strategic opportunities but naively assuming that a combination of technocrats and consultants can produce anything other than missed targets and cashflow black holes. What is needed is experienced private sector leaders who understand that successful strategy is driven top down by the internal team, optionally with consultants in a support role.
The second major failure in driving the strategy of a business is understanding the relationship, often adversarial, between consistent positive short term performance and long term strategic achievements. Simply put, delaying or even canceling capital investments in the near term can lead to stronger profit numbers but will lead to the inevitable and irreversible decline of the company. It takes a strong board to support its management to focus on longer term goals in a world dominated by pressure for short term results.
The final main area is operational governance. The foundation is the authorities matrix, the corporate document outlining who has the authority to make decisions and take actions. This should not be restricted to financial controls only. All facets of the business need to be covered including HR rules around recruitment and termination, handling of errors as well as rules on branding. Again, this starts from the top and any decisions taken by the CEO regarding HR matters to do with his direct reports must be approved by a committee of the board in charge of such matters. Similarly, authorities should be diffuse whenever possible so as to avoid the concentrations of power that have led to mismanagement, neglect and even fraud. The standard method for this is to create standing management committees for various facets of the business, e.g. Finance, HR, Operations, and imbue those committees with authorities instead of individual executives.
Another operational governance point is the interpretation of performance data. It is one thing to receive information along with management analysis but it is something completely different to synthesize into something meaningful. One example is the new CEO cushion: taking reserves in excess of what is necessary whilst blaming the outgoing CEO. These reserves can then be reversed the next year for an easy profit boost. This also happens when senior executives in charge of P/L leave. There is also the never appearing pipeline play: every quarter management say they have a pipeline of potential business that they are certain will generate revenue. The following quarter this pipeline has not materialised, the excuses are many and a new pipeline is presented. Unchecked this con-game can be rolled over ad nauseum.
A final note. The above is a small sampling of the responsibilities of a board and to discharge this responsibility the directors need to understand that when they agree to be appointed they are not simply signing up to four meetings a year and possibly some committee meetings. They need to spend another two weeks per annum to discharge their duty.
Part 1 of the Corporate Governance Series.
This article was originally published in The National.