Corporate Governance - can it be achieved with controls alone?

Henk de Jong – Axisto

Content: • Introduction • Purpose and core values • Leadership • Goal Setting • Business Balanced Scorecard • Incentive systems • Conslusions

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Corporate Governance – can it be achieved with controls alone?

Can corporate governance work with control elders?

The value of good corporate governance cannot be underestimated today. Companies that are confident of their governance, and have found implementing relevant legislation easy, base their success on preconditions in their business. A well-managed company will have relevant behaviours aligned and manage their core values. “It’s all about values” said a large global client of Axisto, and in our experience Sarbanes Oxley is missing that point.

Following a series of accounting scandals, worldwide initiatives were undertaken to find out what changes were necessary to avoid such malpractices recurring in the future and restore confidence of investors by ‘improving the accuracy and reliability of corporate disclosures’. In the United States this led to the Sarbanes-Oxley Act, while other countries also have or are introducing similar types of acts or codes, often only different in terms of their legal ramifications.

These codes of conduct focus on the presence and proper implementation of a good internal risk management and control system. However, the presence of such systems in itself is seen as insufficient which is why they proceed to stipulate that executives must guarantee that the ‘internal control systems are adequate and effective’. In addition, the codes determine that the Supervisory Board should monitor the operation and the results of the internal risk management and control systems, while the external auditor should conduct a limited test of the Executive Board statements. These new codes on corporate governance are built on the assumption that extensive control systems will keep things in check. That is where these codes of conduct are missing the point.

It is not so much that there were major deficiencies in the internal control systems, the real problem was and is behaviour. Recent research targeted at European CFO’s showed that more than 80% of respondents do not think that rules or systems will facilitate the desired transformation, but people behaviour will. Rogues like the ones who caused the scandals at companies like Enron, Anderson, Ahold, Mitsubishi, and Parmalat have and will always be around. Just as they will always find ways to beat the system, whichever control regime is used. These people have a set of values that do not fit with the desired values of a well-managed company or even our society. A recent study1 showed that financial mismanagement was caused by egos and greed. Let’s put one issue up front. People that do not have the values that are important for your company do not belong there. However successful they might appear, remove them: They are a liability!

1  How  Greed  and  Egotism  Destroy  Companies  -­‐  Boston  Consulting  Group  March  4,  2005  1  Built  to  Last  –  JC  Collins,  JI  Porras

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Corporate Governance – can it be achieved with controls alone?

Purpose and core values

Proper Corporate Governance starts with the purpose 2 of the firm: The organisation’s reason for existence. The purpose focuses on the deeper reasons for an organisation’s existence beyond just money making. It should not be confused with specific goals or business strategies. It is a guiding star on the horizon. Some examples are:

• 3M: To solve unsolved problems innovatively

• Walt Disney: To make people happy

The purpose gives the framework for the board of a company to work from and to reference decisions against. Other elements for the Board to be explicit about for an effective contribution to corporate governance are the presumptions the Board has, their unwritten laws, and the things they believe in. Once that is clear, proper delegation of accountabilities is possible. For the sake of absolute clarity, single point accountability is by far to be preferred to a matrix. And all this needs to be underpinned by explicit core values. The core values are the guiding principles. A company has them because they define what they stand for and they would even be attained to if they became a competitive disadvantage.

Leadership

The responsibility to verify if someone does a good job lies in the line. How that is done needs to fit the specific culture and it will be different in different companies. Irrespective of which company management information systems are used in that process. High data integrity is essential, but it is less the way these information systems are designed than that it is the way they are lived that determines the quality. Leadership behaviours demonstrating the core values in the day-to-day interaction with employees are essential. Their behaviour sets the tone. Leadership having to “walk the talk” is not an empty phrase anymore….

Fortunately most employees do have the right values, but can get into situations where they don’t really want to be and might feel forced to do something they typically wouldn’t do. It is difficult to speculate about why people display undesired behaviour and tamper with the data in the systems. Nevertheless it is safe to assume that by doing it, they expect to be better off: They cover their back, are promoted, get the job they want, get better salaries, get better bonuses, etc. The incentive system typically triggers quite a few of these (personal) gains. The goal setting process generates the basis for the incentive system: what do people have to deliver as a base and what are the goals that trigger the more interesting levels of bonuses.

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Corporate Governance – can it be achieved with controls alone?

Goal setting

Studies have shown that goals can either help preventing rogue behaviour or even help generating it. A recent study showed that the growth objectives of the CEO’s involved in recent book keeping scandals were about 250 percent higher than the growth objectives of the CEO of the comparison group of companies. If goals are unrealistic and too stretched, people might switch off, leave the company or they might chose to tamper with the data.

The key in the goal setting process is a number of things. First goals need to be set based on real insight and real data. Often this is not the case and unrealistic goals are set. Secondly the individual with whom goals are agreed needs to be able to influence the process. He/she needs to feel that, together with the boss, realistic goals are set.

The giving and agreeing together on the goals can best be described as “catch ball”. One throws the ball and the receiver has to actually catch the ball or in other words accept the challenge.

Thirdly we need to realise that in modern business life we live in a world of high interdependencies. This means that the complete set of personal goals is often only partly inalienable by the individual. Partly he or she is dependent on others. In other words, the goals of other employees around (peers, bosses and subordinates) have to be linked and synchronised. If not tensions between employees and departments will arise. Fourthly, goals need to be balanced in a sense of what and how. This is where core values translated into observable behaviours come in. This means that not only symptoms like growth (in revenue and margin) need to be covered in the goals, but also the behaviours that one needs to display in achieving these symptoms. For various levels in an organisation now leadership style and behaviour and role modelling get real meaning.

Business Balanced Scorecard

A lot of companies use the Business Balanced Scorecard (BBS) as a tool for performance measurement and management. The standard BBS3 emphasises the balance between multiple dimensions of performance, ensuring that good performance in one area is not offset by poor performance elsewhere. In these companies the BBS format is cascaded down the organisation and the goals in the scorecard area also cascaded down and generating input for the goals at individual and group/team level. The BBS is a strong tool in many respects: if applied correctly it will facilitate alignment and it will help the prioritisation of activities that employees at any level in an organisation need to focus on.

3 Robert S. Kaplan and David P. Norton have developed what is considered to be the standard Business Balanced Scorecard template. 3 Axisto supports her clients in performance and change management through organisational development and by building on the principles of good corporate governance as described in this article.

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Corporate Governance – can it be achieved with controls alone?

The standard template addresses four perspectives:

• Financial: How do we look to shareholders?

• Customer: How do customers see us?

• Internal Business Process: What must we excel at?

• Innovation and Learning: Can we continue to improve our employees’

skills and create value for our clients?

The first two perspectives can be classed as symptoms whereas the other two address the systemic elements of conducting business: The elements that produce the symptoms. The big omission is behaviours, though!

Starting the individual goals setting process from the top level BBS in which goals are mentioned and actual performance is measured against, there is an almost natural tendency to forget about behaviours. This has to be corrected and in Axisto’s4 experience companies must go through a behavioural change journey to align core values with good governance. Company values (and translated into observable behaviour) is the accountability of the top leadership team. If they don’t have it on their radar screen, if they don’t live them by role modelling and being consistent then there is a major threat that there are more places where there is unwanted behaviour then you would like to see.

Incentive systems

The incentive systems give a weighing factor to each of the components of the goals. They help determining what is really important and what is less important. They help getting some focus; setting the priorities. Incentive systems have to be designed and applied with care. Again the BCG study proves how it can go horribly wrong: The value of the share options of the CEO’s involved in the book keeping scandals was in average ten times higher than the value of the comparison group.

Typically the biggest incentives are put on the symptoms like revenue and margin growth and not on the way these symptoms are achieved, i.e. the behaviours representing the core values of the company.

4 Axisto supports her clients in performance and change management through organisational development and by building on the principles of good corporate governance as described in this article.

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Corporate Governance – can it be achieved with controls alone?

Conclusions

Good corporate governance always has been important. The huge scandals of recent times have only highlighted how important it is. Unfortunately, the Sarbanes-Oxley Act only focuses on controls to restore confidence, whereas behaviours are the fundamental problem. Ridiculous incentives on similar ridiculous objectives stimulate wrong behaviours.

The context for true corporate governance is created by an explicit company purpose. System elements like management information systems, goal setting and incentives help if applied correctly. But real delivery of corporate governance is only possible if core values are truly lived through observable behaviours: If the leadership is really “walking the talk”. Contact Henk de Jong E: henk@axistoconsulting.com