Five Red Flags that may signal poor governance practices

Posted by
Aura Toader

There is no one-size-fits-all approach to good governance. Establishing an effective board requires intelligently considering best practice recommendations while applying appropriate flexibility in response to a company's unique circumstances, strategy and culture. However, here are five governance red flags that we believe could be indicators of potential negative consequences for the company’s long-term prosperity and shareholder value creation.

1. The roles of Chair and CEO are combined

Combining the roles of Chair and CEO may make the core board function of oversight of the executive function, and effectively holding management accountable, significantly more difficult. A former CEO assuming the role of Chair is also a warning sign. The new Chair would be unable to bring a fresh and independent perspective to the state of the business and key strategic decisions that were taken while they were CEO -- significantly hindering independent oversight. In addition, existing relationships with members of the management team may hamper the honesty of communication in both directions. Appointing a former CEO as Chair means that shareholders have missed out on the opportunity of bringing a fresh perspective into the boardroom.

2. Board attendance by any individual is below 75%

Though it is an arbitrary level, it is now generally accepted as a concern where any non-executive director fails to attend at least 75% of all board and committee meetings. A poor attendance rate could indicate that a director is not putting the time and effort needed to properly carry out his/her duties; certainly it is hard to be a full contributor to a board without being present regularly.  Companies should disclose the number of meetings that the board and its committees held during the financial year, the eligibility of each director to attend these meetings and their individual attendance rate. Any absences should be reported within the annual report with a brief explanation as to why this was unavoidable. If they continue for more than a year, shareholders will become particularly concerned. Particularly where more than one individual director has multiple absences, the company may begin to give the impression that it does not rate the input of the board highly, adding to concerns about the effectiveness of oversight.

3. The board is not externally evaluated at least every three years

Despite being at different stages of governance complexity, many markets recommend that the board, its committees, the Chair and individual directors be periodically evaluated. The UK Corporate Governance Code has called for board evaluations to be held annually and for the evaluation to be externally facilitated every three years. Using a third-party evaluator can meaningfully increase the objectivity of the process, reducing the influence of one or a few individuals,  and provide investors with some assurance that the board functions well. It is important that the results of the evaluation are disclosed for the various stakeholders to be able to assess whether boards identified areas for improvement and the actions taken in this respect.

4. There is no board oversight of risk culture

The importance of risk culture oversight was reinforced in the fall out of the financial crisis and is commonly labelled as "the tone at the top". This implies that the board should establish rigorous compliance mechanisms and a strong corporate culture, making clear to the whole organisation that appropriate behaviour that delivers value for clients and customers is what earns success within the business. One way to achieve this is through the board adopting greater responsibility for establishing risk appetite and risk tolerance levels.  

5. Performance metrics are not disclosed

The structure of the pay packages for members of the executive committee should be clearly disclosed, as well as the performance targets used to determine variable pay.  The performance conditions should be aligned with the company's strategy with the ultimate aim of promoting long-term prosperity and shareholder value creation while discouraging excessive risk-taking. If the company relies on adjusted measures that deviate from the company’s main KPIs, the reasons for doing so should be clearly outlined.