Corporate governance: “trust, but check”

In contrast to the Western world, corporate governance is not taken very seriously in our developing markets. It is simply because we have only first generation of entrepreneurs, who are still be able to run their business themselves. But any owner needs sooner or later to move away from operational management and transfers the government into the other hands. This is exactly time for them to think about creating a balance of power, a system of offsets as well as a system of proper control over hired top management.

In this article I will describe the main roles and functions in this game for the management board and the supervisory board. I really hope that this information will help business owners in practice build healthy corporate governance and arrange adequate control over the hired management.

Management Board

Corporate governance is a hot topic for open joint stock companies, in which there are many owners or different sources of capital, that means there are many stakeholders. At the same time, indirect interest in the activities of such companies arises from regulatory authorities, stock exchanges, customers, suppliers and employees. A direct interest in information and control arises from investors and owners.

All the complexity comprises in the organization of effective control over the activities of the company’s management board, which usually consists of a Chief Executive Officer / CEO, Chief Commercial Officer / CCO, a Chief Risk Manager / CRM, a Chief Financial Officer / CFO, Chief Operational Officer / COO, Chief IT Officer / CIT IT, and today, Chief Data Officer / CDO.

These top managers are responsible to the supervisory board and shareholders meeting for strategic planning, achieving strategic goals and financial results. In addition, the board must provide and periodically report to the supervisory board (consisting of owners and / or their representatives) for the results of the audit, for compliance with laws and policies, for the risk management and internal control system.

The Board is obliged to submit to the Supervisory Board for approval the operational and financial goals of the company, the strategy and tactics for their achievement, as well as build key financial indicators, that are used to evaluate the strategy. The Management Board should create a risk management and internal control systems based on sound operational and financial goals of the company, as well as create monitoring and reporting systems of goals fulfillment.

In the annual report, the Board shall declare, that the internal risk management and control systems are adequate and effective, clearly substantiate this and report on risk management status within the reporting period. In addition, it is important to describe any significant changes made to these systems and show, that these changes have been discussed with the audit committee and the supervisory board. In the annual report of the board, it is important to describe the sensitivity of the company’s performance to external factors and risks.

There is an interesting nuance regarding the risk management system in the West, that is nevertheless confronted with our mentality. The work with “informants” is openly encouraged as one of the key elements of the operational risk management there. The board must ensure that employees can report potential violations of a general, production and financial processes to the chairman or to the employee appointed by him, with guaranteed confidentiality of the “informant”. In this case, a report on possible violations relating to the activities of board members should be submitted to the head of the supervisory board. The scheme of work with “informers” should be published on the company’s website.

In our mentality, such a practice is condemned and often associated with the Stalinist system of denunciations, which badly ended not only for the “culprit”, but also for the “informant”. In the West, this is a standard element of the operational risk management system.

Supervisory Board

The role of a supervisory board is to oversee the policy of a management board and general business directions of a company and its affiliates, as well as provide advice to the board.

In fulfilling this role, the supervisory board acts in the interests of the company and its affiliates, taking into account the interests of all stakeholders. The supervisory board is responsible for the quality of its activities. The distribution of duties in the supervisory board should be defined in a set of internal regulatory documents.

The Supervisory Board should provide for a regulation regarding relations with the management board, the general meeting of shareholders and, if necessary, with the labor council. Relevant regulations must be published on the company’s website.

The annual financial report of the company should also contain the report of the supervisory board, the main sections of which describe the composition, experience and profile of supervisory board members, their functions, corporate strategy, achievement of goals, risk factors, control systems, reporting system, compliance with legal norms and requirements.

One of the most important functions of the supervisory board is to identify policies and systems for risk management and internal control, policies and systems for generating financial information (accounting policies, management reporting, stress-testing simulations and forecasting systems), policies in the field of tax planning, company financing, and investments in information and communication technologies (ICT).

The supervisory board determines the activities of the internal audit and is the main point of contact for external auditors for the implementation of audit recommendations. Sometimes this function may be delegated to the audit committee. The supervisory board or audit committee determines the frequency of meetings, who and when should be presented at meetings with an external auditor. But the meeting should be held at least once a year and subject to the absence of members of management board.

The audit committee should not be headed by the chairman of the supervisory board or a former member of the management board. At least one member of the audit committee must be a qualified financial expert. The committee determines relations with the external auditor assuring audit independence, payments and provision of non-audit services.

In addition, the supervisory board is required to establish a fair level of payment to management board members, depending on the results of their work. Sometimes the supervisory board delegates this function to the remuneration committee on the basis of an approved remuneration policy, that describes the selection criteria for the composition of the management board and the supervisory board, the assessment of management board members and the supervisory board members, and the procedure for appointing senior management. The head of the remuneration committee in this case should not be the head of the supervisory board.

As a rule, a remuneration policy describes the principles of wage formation for board members such as orientation to the market level of payments, fixed and variable parts of remuneration, lack of remuneration for poor management, options, insider trading, annual salary upon dismissal (a “golden parachute”), no loans on conditions other, than for other employees, disclosure of public information about salary, gift policy, conflict of interest, terms of appointment and on-boarding, training, appointment period. According to international best practice, management board members are appointed for no more than four years and can be reappointed for the same term one more time.

The head of the supervisory board determines the agenda of meetings, conducts meetings, organizes the adequate distribution of information to supervisory board members, assuring needed time for decision making process, monitors the work of the committees, organizes the on-board program for the newly appointed members of the committees, is the main contact person for management board members, initiates an assessment of the members of the supervisory board, ensures, that the shareholders’ meetings are organized and efficient.

The corporate secretary assists the head of the supervisory board on the above functions. He or she is appointed and dismissed by the management board after agreement with the supervisory board.

A little bit philosophy

I will indulge myself to be distracted and cite a dispute that broke out in 1918 in my favorite Viennese cafe “Landman” during a meeting between the German sociologist Max Weber and Austrian economist Josef Schumpeter and the famous Viennese banker Felix Zomari, to whom we owe valuable evidence of this dispute.

They were talking about the Russian revolution of 1917. Schumpeter joyfully declared that socialism had finally gave up to be only a “paper discussion” and would be forced to prove its viability. Weber objected, that the attempt to introduce socialism in Russia, given the level of its economic development, is, in fact, a crime and will end in disaster. According to the memoirs of Zomari, Schumpeter coldly remarked, that this could very likely happen, but Russia is still a “wonderful laboratory”. Weber sharply objected: “A laboratory with a mountain of corpses”. In response, Schumpeter cynically added: “Like any anatomical theater.”

I think, that in order not to become the “anatomical theater” once again in history, it is worth to use the experience of others, critically to rethink it and to applying the best approaches for our mentality and our reality. I hope this article helps. So, bellow are the key conclusions.

The best practice

In a previous article, I already wrote that there are two fundamentally different models of corporate governance:
— a single-level or Anglo-Saxon model, typical for British and American companies;
a two-level model, typical for European companies, which is legally fixed in our countries as well.

Each of the models has pros and cons. If we make an analogy with the state system, then we are disputing between the “presidential” and “parliamentary” governance models.

To simplify, in a single-level model, a management board that consists of hired managers and a supervisory board that consists of owners or their representatives work as one Board of Directors. We can say, that Board of Directors combines both of them in one bottle.

It turned out, that among the companies with the Anglo-Saxon management model are there more market leaders, but there are also more bankruptcies. Continental European companies have more stability, but less efficiency and less profitability.

In short, the “parliamentary” model creates stability and/or stagnation, and the “presidential” leadership model increases the likelihood of either failure or success. Everything will depend on whether the company was lucky with the leader or not, the good or evil “king” is in power.

After analyzing many successful companies and the reasons for bankruptcy, experts came up to the following conclusions and recommendations on corporate governance:
Separation of the positions of the head of the management board and the head of the supervisory board, the head of the supervisory board should not be a former member of the management board;
The presence of one strong, independent non-executive director and the presence of at least three non-executive directors on the supervisory board;
Only non-executive directors should be in the remuneration committee;;
A member of the management board is appointed for no more than four years and may be re-elected one more time for the same term;
The management board submits for approval to the supervisory board the financial and operational goals of the company, the strategy and tactical plans for achieving goals, key indicators to assess the implementation of the strategy;
— The supervisory board establishes a transparent remuneration system for management board members (market-based payment, lack of rewards in case of poor management, stock options, annual salary in case of dismissal, insider trading, etc.);
— The supervisory board at least once a year should, without the participation of the board, discuss issues of its own activities, the composition, competencies and work of its individual members, as well as issues of the work of the board and its members;
— A member of the supervisory board may be dismissed in case of poor performance, structural conflict of interest, frequent absence;
— The supervisory board should at least once a year discuss the company’s strategy and business risks, any significant changes in the systems of internal control, risk management and finance;
— The head of the supervisory board determines meetings agenda, conducts meetings, organizes the adequate information to members;
— The corporate secretary helps him on all of the above issues.

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