The assistance of Chuanchan Ma, Law Clerk, of Addisons in the preparation of this article is noted and greatly appreciated.
In November 2010, the Institute of Directors and the European Confederation of Directors' Association jointly published a paper entitled "Corporate Governance Guidance and Principles for Unlisted Companies in the UK" (Principles). While corporate governance guidelines and regulations have traditionally focused on listed entities, the Principles represent an attempt to tailor corporate governance theory to the needs of unlisted and smaller companies.
In Australia, companies listed on the ASX are required to report on the extent to which they have followed the ASX's Corporate Governance Principles and Recommendations1 and explain their reasons for any that are not followed. Correctly (in our view) there are no similar obligations for Australian unlisted companies, but there can be real benefits to unlisted companies considering and, in some cases, adopting better approaches to corporate governance.
While the Principles were written and published in the UK context, the fourteen voluntary "best practice" Principles are equally applicable to Australian enterprises. The primary focus of these Principles is not on compliance with formal rules and regulations, but rather on establishing a framework of company processes and attitudes that add value to the business, help build its reputation, and seek to ensure its long-term continuity and success.
What is Corporate Governance?
Corporate Governance is "the framework of rules, relationships, systems and processes within and by which authority is exercised and controlled in corporations." It encompasses the mechanisms by which companies, and those in control, are held to account.2
This can be considered in terms of three key components: 3
- a set of relationships between a company's management, its board, its shareholders and other stakeholders;
- a structure through which the objectives of the company are set and the means of attaining those objectives and monitoring performance are determined; and
- proper incentives for the board and management to pursue objectives that are in the interest of the company and its shareholders.
Isn't this just more red-tape? Why is Corporate Governance important for unlisted companies?
Corporate governance can contribute to the long-term survival, success and value of an unlisted company for a number of reasons:
- Success, value and succession: A governance
framework which enhances the professionalism in the company's
decision-making processes and attitudes will lift a significant
burden from the founding entrepreneur and allow the company to
access a wider pool of expertise and know-how.
It can also facilitate succession planning or an exit strategy, allowing a company (especially an owner-managed business) to outlive the interest or working life of the founder and for the founder to maximise the value of what they have created.
For example, a company whose success is not entirely dependent on the ongoing efforts of one or two key personnel, will tend to be a more attractive investment target for a trade sale or IPO.
- Access to capital: Shares in unlisted companies are typically illiquid, which creates a significant investment risk for shareholders and financiers. An explicit and effective governance framework will assure existing and potential shareholders and financiers that their investments are well-managed and interests safeguarded, helping to secure their commitment as sources of long-term patient capital for the company.
- Building corporate reputation: In the wake of the Global Financial Crisis, businesses are under greater scrutiny generally, and transparency is highly regarded. A proper governance structure can be a key plank in gaining the respect of external stakeholders, such as actual and potential financiers, employees and customers.
Principles of Corporate Governance for unlisted companies
The fourteen Principles are structured into two phases. Phase 1 Principles represent a core governance framework and can apply to all kinds of unlisted companies, regardless of size or level of complexity. Phase 2 Principles, on the other hand, are more sophisticated governance measures that are more relevant to larger or more complex enterprises, especially those preparing for future listings.
Phase 1 Principles
Principle 1: Shareholders should establish an appropriate constitutional and governance framework for the company.
Constitutional documents, which can only be amended via a special resolution of shareholders, are a robust way of establishing a company's basic governance structures and procedures. A constitutional framework which protects the long-term interests of investors can be an important determinant in their decision to invest in the company.
Principle 2: Every company should strive to establish an effective board, which is collectively responsible for the long-term success of the company, including the definition of the corporate strategy. However, an interim step on the road to an effective (and independent) board may be the creation of an advisory board.
At an early stage of a company's development, the distinction between the members of the governance tripod (ie board, management, and shareholders) is often unclear and owner-managers may fulfil multiple roles concurrently. The introduction of an advisory board can improve the board's capabilities in terms of expertise, business control and network, while still allowing the owner-manager to maintain undiluted decision-making powers.
Principle 3: The size and composition of the board should reflect the scale and complexity of the company's activities.
As the company grows, greater focus will be placed on the board as the key decision-making body of the company. It is in the interest of the owner-manager and also external financiers to introduce onto the board experts in key strategic areas (eg members of the advisory board), people with different perspectives and ideas and, potentially, independent non-executive directors.
Principle 4: The board should meet sufficiently regularly to discharge its duties, and be supplied in a timely manner with appropriate information.
Too many board meetings can make the board too operational, while too few meetings can impede the board from fulfilling its duties. In addition to an appropriate number of board meetings, an accurate record of properly documented meetings is an important indicator of professionalism, which will also provide an important legal safeguard for directors and may assist smaller companies in obtaining external financing.
Principle 5: Levels of remuneration should be sufficient to attract, retain, and motivate executives and non-executives of the quality required to run the company successfully.
Linking executive directors' remuneration with company performance helps to align their interests with that of shareholders. In contrast, remunerating non-executive directors on a fixed fee basis ensures that they retain an objective and independent perspective on the company's activities. A remuneration policy statement, while initially difficult to adopt for some unlisted companies, is an important step towards a higher degree of professionalism and transparency.
Principle 6: The board is responsible for risk oversight and should maintain a sound system of internal control to safeguard shareholders' investment and the company's assets.
While risk issues in an owner-managed company are often addressed in a relatively informal manner, documenting the risks helps to focus decision-making and demonstrate that directors have approached risk management with the necessary care and diligence. As a company grows in size and complexity, moving towards a more professional system of internal control becomes a necessary requirement for obtaining external sources of capital.
Principle 7: There should be a dialogue between the board and the shareholders based on a mutual understanding of objectives. The board as a whole has responsibility for ensuring that a satisfactory dialogue with shareholders takes place. The board should not forget that all shareholders have to be treated equally.
In an unlisted company where shareholding is relatively illiquid, a close dialogue with the board is particularly valuable to shareholders. Ongoing engagement and communication with the board assures shareholders that the company is moving in a direction consistent with their interests.
Principle 8: All directors should receive induction on joining the board and should regularly update and refresh their skills and knowledge.
Director orientations will offer non-executive directors the informational building blocks they need to engage effectively in strategic reflection and oversight, as well as prepare executive directors who come from an operational background and have little experience with overseeing the company.
Principle 9: Family-controlled companies should establish family governance mechanism that promote coordination and mutual understanding amongst family members, as well as organise the relationship between family governance and corporate governance.
Family companies, which are typically unlisted, tend to have a short lifespan beyond the generation of the founding-entrepreneur. As the company expands, family members may develop different preferences for the business and have varying levels of access to information. Appropriate family governance structure, which involves levelling the playing field for information, establishing family institutions, promoting discipline among family members and preventing potential conflicts, will help to ensure the continuity of the business.
Phase 2 Principles
Principle 10: There should be a clear division of responsibilities at the head of the company between the running of the board and the running of the company's business. No one individual should have unfettered powers of decision.
As a company enters Phase 2, the roles of chairman and chief executive should be exercised by different individuals. As the chairman has the responsibility of ensuring that the executive team is subject to a sufficient degree of oversight, there is a danger of this role being compromised if the chief executive is also the chairman.
Principle 11: All boards should contain directors with a sufficient mix of competencies and experience. No single person (or small group of individuals) should dominate the board's decision-making.
An independent board with a large proportion of non-executive directors is pivotal to the long-term success of an unlisted company, especially as they become larger with more complex shareholding structures. Introducing independent non-executive directors onto the board will have a significant impact on boardroom behaviour and culture. It signals the company's willingness to become more open and accountable.
Principle 12: The board should establish appropriate board committees in order to allow a more effective discharge of its duties.
Specific board committees such as the nomination committee, remuneration committee and audit committee will allow key responsibilities of the board (eg proposing appointments to the board and monitoring the company's internal audit functions) to be discharged at a more in-depth and informed level by people with experience and expertise in the particular area.
Principle 13: The board should undertake a periodic appraisal of its own performance and that of each individual director.
As companies grow, the appraisal techniques adopted by their boards shall also adjust accordingly. For larger companies, board appraisals conducted by independent external facilitators are likely to be more objective in their rigour than self-evaluations.
Principle 14: The board should present a balanced and understandable assessment of the company's position and prospects for external stakeholders, and establish a suitable programme of stakeholder engagement.
A strong disclosure regime that promotes transparency will improve public understanding of the company's structure and activities, as well as its policies with respect to environmental and ethical standards and its relationship with the communities in which it operates.
The Principles represent a sound framework for consideration by Australian unlisted companies. While adopting all or even many of the Principles may not be appropriate for some companies at this point, the process itself of considering the Principles and their potential applicability to the company can be a valuable exercise in is own right.
1. ASX Corporate Governance Council, Corporate Governance Principles and Recommendations with 2010 Amendments, 2nd Edition, 2010.
3. OECD, OECD Principles of Corporate Governance, 2nd Edition, 2004, page 11.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.