Explain yourself

Australia is tightening up on the regulatory aspects of businesses listed there, but as Richard Lustig reports, the new regime is being shaped by those to whom it applies

On 31 March this year, the Australian Stock Exchange (ASX) Corporate Governance Council released its ‘Principles of Good Corporate Governance and Best Practice Recommendations’. Developed for ASX-listed companies, the standards outline various principles that underlie good corporate governance and provide recommendations for implementing them. The principles are among the most significant developments in the Australian corporate market in years.

In developing the standards the council undertook a best practice approach, recognising that one size does not fit all. It has adopted an ‘if not, why not?’ line, allowing listed companies to explain why they have not adopted certain standards if they consider them inappropriate in their particular circumstances.

The guidelines could not have come at a better time, with recent high-profile corporate collapses having prompted regulators and industry groups to rethink the corporate governance process and consider how they achieve genuine and effective governance as opposed to mere compliance.

Last year’s Sarbanes-Oxley Act in the US demonstrated exactly how important in a global sense the issue of corporate governance is. It significantly changed the legal and regulatory framework in which US public companies operate.

Although the ASX guidelines are not legally binding, it is expected that, if the standards are broadly adopted, they may become accepted by the courts as the benchmark for what a company should be doing to satisfy its corporate governance responsibility. This could increase the potential liability for the company and for the directors and officers who do not take steps to adopt them.

The 10 principles state that a company with good corporate governance practices should:

•lay solid foundations for management and oversight.
•structure the board to add valu.;
•promote ethical and responsible decision-making.
•safeguard integrity in financial reporting.
•make timely and balanced disclosure.
•respect the rights of shareholders.
•recognise and manage risk.
•encourage enhanced performance.
•remunerate fairly and responsibly.
•recognise the legitimate interests of stakeholders.

Generally, the standards prompt ASX-listed companies to:

•Review the extent to which their corporate governance structures, practices and documentation comply with the standards and examine what changes or improvements would be required to comply fully.
•Determine which of the standards they consider inappropriate to their circumstances and document the reasons for those conclusions.
•Take the necessary steps to change or improve their corporate governance structures, practices and procedures to comply with the standards they decide to adopt.

Within the ASX standards there are three core issues that will have the greatest impact on companies.

Board composition and independence

The most controversial standard is the imposition of a tight definition of independence, which requires a majority of the board and most of its committees to be independent, and that the chairperson be an independent director. Second, the roles of chairperson and chief executive officer (CEO) should not be exercised by the same person.

This standard also says that a board should assess the independence of a director when they are nominated for appointment and regularly thereafter. The annual report must also specify which directors are considered to be independent.

A review by Baker & McKenzie found that only 21 per cent of the top 150 ASX-listed companies applied a defined standard of independence. A significant proportion of listed companies will therefore need to adopt an appropriate independence standard, and may need to consider changing the composition of their board, or be prepared to explain their reasons for departure from this standard.

It is anticipated that companies that do decide to restructure their boards will find it challenging to find qualified independent directors.

Composition of an audit committee

The standards also require listed companies to have an audit committee comprising at least three members, consisting of only non-executive directors, a majority of independent directors and an independent chairperson who is not chairperson of the board. It should also include members who are financially literate and at least one who is a qualified accountant or other financial professional.

The committee should also have a formal charter which is disclosed along with information on procedures for the selection and appointment of the external auditor and for the rotation of external audit engagement partners. The audit committee will be central to ensuring the integrity of financial reporting for a listed entity, including overseeing both internal and external audit functions. This standard is compulsory for the top 500 ASX-listed companies effective 1 July 2005.

The Baker & McKenzie review found that most listed companies already have an audit committee. However, the standards raise the focus on having independent directors on audit committees and are likely to increase the responsibilities for members of such committees, as well as their potential liabilities.

A further recommendation is that separate nomination and remuneration committees be established for the selection and appointment of directors and to implement policies for the remuneration and assessment of the performance of directors and key executives.

The Baker & McKenzie report found that many listed companies already have nomination and remuneration committees, but smaller listed entities may decide that their functions can be fulfilled by the board rather than having further separate committees. Given the current focus on the remuneration and performance of directors and executives, it is expected that remuneration committees will play a more significant role in the future.

Sign-off of financial reporting and risk management

The standards require that listed companies have appropriate systems and policies to safeguard the integrity of their financial reporting that deal with risk oversight and management and internal control.

Notably, the CEO and chief financial officer (CFO) are required to state in writing that the financial reports present a true and fair view in all material respects of the financial condition and operational results of the company and are in accordance with relevant accounting standards.

This requirement to sign off various matters to the board does not go as far as obligations imposed under Sarbanes-Oxley, which requires similar matters to be certified in financial reports, coupled with potential significant civil and criminal penalties. However, these sign-off requirements increase the responsibilities and potential liabilities of the CEO and the CFO.

What this means is that, if a company collapses, a liquidator may seek to bring actions against those officers if the sign-offs have been done without thorough checking. In addition, auditors are likely to want to rely on these sign-offs as part of their audit process. In the US this has led to systems where sign-offs are obtained from officers of key subsidiaries or divisions prior to the CEO and CFO providing their final sign-offs, and it is likely that the adoption of similar systems will be considered in Australia.

The ASX corporate governance standards raise the bar regarding expectations of what constitutes good corporate governance for Australian-listed companies. ASX-listed companies will have to consider carefully these standards in light of their circumstances, and determine which standards they intend to comply with and what further steps they need to take to meet them.

Richard Lustig is a corporate partner at Baker & McKenzie, Melbourne