Transcript The Harold Ford Memorial Lecture University of Melbourne

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 board’s 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 owner-manager 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 Chandler’s “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 corporation’s 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 nonindependent 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 decision-making; selecting and dismissing
members of the chief executive’s office and monitoring their performance
• The advice and counsel function was, in his view, not essential to the
corporation’s 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 board’s 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
board’s semi-autonomous function of monitoring the results
achieved by the chief executive’s 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 Eisenberg’s 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 Eisenberg’s 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 20th 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)
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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 Council’s 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
company’s 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 delegate’s 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 director’s 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 officer’s “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 company’s
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 board’s 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 Eisenberg’s 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 company’s 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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