How Is Your Board Dealing With Brexit?

Even as the votes were being counted on June 23, not many people in Britain and the whole world were expecting that the ‘Leave’ side would prevail during the recent referendum to determine whether the UK should remain in the European Union (EU) or otherwise. However, as more votes were counted later that night, the concern about something not imaginable started to become stronger. The pound started to tumble against many currencies. By the morning the day after, the ‘Leave’ campaign had won.

Brexit or Britain exiting the EU appears to be a classical black swan event, something not foreseeable to happen which eventually happened. Not only did the event split British voters into two groups, ‘Remain’ and ‘Leave’, but it also brought with it uncertainties which would persist over a long period.

The first casualty was David Cameron, the British prime minister who had to quit his job after being defeated during the referendum. His successor, Theresa May, who was from the ‘Remain’ camp, has to take over and deal with something which she herself was not convinced is good for the UK and Europe as a whole. While she had clarified that the UK would only invoke Article 50, the trigger for exit, towards the end of the year, many people are still hoping that Brexit would never materialise. Some people are even bringing this issue to court.

The Europeans would also try to make Brexit as tough as possible to deter other countries within the union to venture into the same territory. Strong remarks from Brussels and Berlin in urging for the UK to invoke Article 50 as quickly as possible could also be aimed at other member states as well in sending the message that this is not a game.

While uncertainties could be good for speculators and some could have made money in the financial markets after the Brexit decision, uncertainties would also influence sentiments and confidence of investors. There are already talks about investment moving away from the UK to other parts of the world. In the stage where the global economy is not at its optimum as what we would have liked, a black swan event like Brexit is the last thing that we need.

While many Malaysian companies may not have direct exposure to the risks arising from Brexit, this issue should not be left unattended. The risks could also be possible from secondary events such as new rules which could be applicable once the UK is no longer part of the EU. Market access to Europe, for example, could be affected if the existing entry point is only from the UK. Effects on customers or particular market segments have to be considered and even the reliability and cost effectiveness of any supply chain from the UK or Europe has to be reviewed again.

On the other hand, would there be new opportunities as well? If there are really capital flights from the UK, would there be any chance that Malaysian companies could have some share of that? What needs to be done to capture those opportunities?

It is well known that some Malaysian companies were investing heavily in the UK property sector in the past few years. For them, their exposure to the risks of Brexit is different; some of the risks could have already crystallised. If the progress of their property development projects, for example, is already half-way through, the next course of action would be vital. Do they proceed as planned, defer further investment or speed things up, pack their bags and leave the market? All these options and their consequences require deep thinking to figure out some sense of direction and logic that correspond to the realities on the ground.

While many companies are aware about what is going on around them, not many are taking those events seriously. In the absence of a systematic process where events are detected and analysed and the understanding of their impacts are discussed in C-suites and boardrooms, many clear and present dangers and opportunities would be missed. This is where board members have to be comfortable that the companies under their care regularly scan the local, regional and global landscapes to detect and analyse emerging trends and update them accordingly.

For the case in hand, it would be also good to reflect on whether the processes had detected the possibility of Brexit and whether the views formed were close to the realities that prevailed. This would be a good opportunity to assess the effectiveness of such systems and processes, and whether they were helpful in providing boards with relevant data and information in discharging their duties towards their companies and shareholders.

As the saying goes, don’t let a crisis go to waste.

This article was published in The Malaysian Reserve under the column Boardroom View http://themalaysianreserve.com/new/story/how-your-board-dealing-brexit

What Companies Can Learn From the AOB Annual Report?

The Audit Oversight Board (AOB) recently issued its sixth annual report which covered its work and observations for 2015. While the report was predominantly aimed at the auditors of public interest entities (PIEs), it also contained observations and insights relevant to companies audited by the auditors concerned.

Hence, directors who are keen to enhance the quality of governance of their companies, particularly PIEs, should pay attention to the findings of the AOB.

In the context of the AOB, audit firms are divided into two groups: major audit firms and the rest. Why? The major audit firms consist of the larger firms that have more than 10 partners and audit close to 96% of public listed companies if measured by market capitalisation.

In addition to their reputation, their size and scale enables them to take larger and complex audit engagements. This is important for companies that have a significant presence in foreign markets. The other side of the coin is the 42 medium to small firms, which have only around 4% of the market share.

The skewed distribution of audit work creates different challenges for the firms. The larger firms have more work on their plate, thus stretching their resources in meeting deadlines. The type of clients they serve also requires them to deal with more complex accounting issues and make more challenging professional judgments.

As the smaller firms have a lesser amount of work, with a majority of them dealing with only one PIE client, their exposure to the complexities of auditing PIEs may be limited. If the enforcement actions taken by AOB are taken as an indicator, it appears that some firms in this category have issues in complying with auditing standards.

One of the key observations of the AOB for the major audit firms is the increase in the percentage of engagements requiring significant improvements, from around 10% in 2012 to around 18% in 2015. This means that close to one in five audit works of the major audit firms needed significant improvements.

Among the drivers of the findings are the inability of the firms to maintain consistent quality of work across all engagements, failure to consult their relevant experts in dealing with challenging matters and the need for further improvements in their systems to monitor work quality.

For other firms, while the percentage of engagements requiring significant improvements had improved from 80% in 2012 to 45% in 2015, the percentage of work in this category remained unsatisfactory. If the findings on this category of firms are analysed further, they would have more structural challenges compared to their larger cousins.

For example, the AOB highlighted gaps in the ways their partners’ performances are assessed, where quality is not being given adequate weightage, hence not providing enough incentive for them to ensure quality work is performed.

Other gaps identified include independence and ethical issues, failures to comply with the new client acceptance process properly and inadequate training, as well as the extent of involvement of partners in audit engagements.

Like prior years, there were common deficiencies in the audit work, which were noted across all the firms. They were in the areas of revenue recognition, asset impairment, group audit, sampling and reliability of information provided by management or experts.

Notwithstanding the remediation efforts made by the firms in response to the AOB’s findings in prior years, the effectiveness of those efforts seems to be questionable.

What do these findings mean to the board of companies audited by those auditors? There are a number of issues that the company boards need to give their attention to.

First, boards need to understand the strengths and weaknesses of the firms which they engage. What are the views of the leadership of those firms with regard to audit quality and what are their efforts to ensure the assurance provided to the board every year is reliable?

Given the findings of the AOB, boards are entitled to ask whether there are adverse findings against them and what they have done to rectify those shortcomings. While audit firms may play down the findings of the AOB, that view alone is already a red flag about the attitude of the firms regarding audit quality.

The second issue is about ensuring the firms have enough experienced staff, other than the partners, to deal with specific industry issues or complexities of the companies audited. While the partners are responsible for the whole audit, most of the work would be performed by more junior staff.

Questions around the efforts of partners in supervising the audit, and the experience and expertise of senior staff assigned to the audit engagement would provide ideas about whether the firms could handle the audit risks of the engagement.

Workload and tight deadlines are the third element which could influence the quality of an audit. Boards may also want to ask about resource allocations for their audit work and whether the firms are also committed to other large clients in the same period.

The AOB annual report provides good insights about the state of affairs of the auditing industry and possible shortcomings that could pose potential risks to the level of assurance provided to boards and shareholders. Those boards which are responsive to those findings would certainly be able to have better assurance and quality of work from their auditors.

This article was published in The Malaysian Reserve under the column Boardroom View http://themalaysianreserve.com/new/story/what-audit-firms-can-learn-aob-annual-report

Reacting To Red Flags, The Enron Experience — Lessons For Boardrooms

Andrew Fastow was ashamed with what he did when he was with Enron Corp. The former CFO of this company which fell from fame spectacularly in early 2000 admitted that he was guilty and felt sorry for all those people who suffered losses.

He was in Kuala Lumpur to share some of his experiences which could be good lessons for those in boardrooms to learn from. I conducted a fishbowl session with the former Enron CFO recently.

When Enron was growing, it required a lot of financing. The shareholders preferred not to inject new capital. Fastow used structured finance to allow Enron to borrow money using special-purpose vehicles (SPVs) resulting in the liabilities not recognised on the balance sheet of Enron.

It made its financials looked sound, cost of capital reduced and the shareholders were relieved from being required to inject capital. For this he was awarded the CFO of the year by an influential financial magazine in the US. The same conducts landed him in prison!

Was the board of directors ignorant of what had happened? No, according to Fastow. The board was supplied with information that reconciled Enron’s internal credit scoring, which was assessed as closer to junk status, to the market scoring where it was rated as an investment grade.

How did the board react? Instead of being worried about the misalignment in the assessment of Enron’s risks by the banks, he was praised by one of the board members as a brilliant CFO.

Everyone’s focus at that time was whether the transactions complied with the rules. This, according to Fastow, was the main factor which provided everyone with comfort that everything was fine.

What about independent professionals such as legal counsels and auditors? When their views were sought, they were not just required to provide opinions on whether rules were complied with or not. If they felt that there were no compliances, they were expected to provide ideas and ways so that compliance was achieved.

One of the reasons why Fastow was hired by Enron was for his talent in unlocking the value of Enron’s assets. Through structured finance and fair value accounting, the future values of those assets could be booked, enhancing the value of Enron’s shares.

Fair value accounting relies on the availability of market prices. In their absence, prices of similar assets could be used. When there is no such price, complex valuation models would be used instead.

On top of the issue of market price, fair value accounting also requires future stream of cashflows generated by those assets to be estimated. They are then capitalised at certain rates which reflect the risks carried by the assets, to arrive at their fair values. The exercise relies heavily on assumptions and estimates with its results subjected to a wide range of risks.

While those rules appeared complex, Enron capitalised them to its benefits. In fact, the more complicated the rules, the more they were seen as opportunities by Enron. The complexities made the transactions and valuations more opaque. Again, the focus then was whether all those rules were complied with!

Although two senior executives of Enron were sent to prison, Enron-like cases keep on appearing including during the recent global financial crisis. The scary thing is the market appears to tolerate a certain level of envelope pushing until certain events occur when they would then cry for blood.

At this point, compliance with rules would not be adequate and people should be asking whether things are right instead.

Enron had a very prominent board. Why didn’t they react with horror when they knew what was wrong about their financial standing?

There could be a number of factors behind this. Enron was the darling of the market and it provided good financial returns, at least before it collapsed. Everyone was chasing the money and nobody was concerned as long as the rules “were followed”.

Instead of pausing and asking the question “are we doing the right thing”, the board decided to continue to dance to the music liked by the market.

The board also had the comfort of independent professionals providing opinions that every rule was complied with. While what happened to Enron was a catastrophe, how many of the present members of the board would sign off a deal based on the comfort that it is in compliance with all relevant rules?

As boards tend to achieve consensus in making decision, such culture would deter people who have opposing views from staying the course.

Fastow believes that adopting the 10th man rule is the way forward. Here, someone would play the role of a devil’s advocate and keep on opposing the views of the board until it is clear that the views are premised on sound judgment.

So, what would be your reaction in the next board meeting when, in supporting their proposals, management comfortably explains that all the rules are complied with?

This article was published in The Malaysian Reserve under the column Boardroom View http://themalaysianreserve.com/new/story/reacting-red-flags-enron-experience-—-lessons-boardrooms

Can Shareholders Pose Risks to Their Own Investments?

A CONVERSATION with a friend who used to be a senior executive for a global company based in the US triggered this question. According to him the company he was serving was doing the right thing and managed to achieve double-digit growth for many years.

Then the shareholders were exerting pressure on the board to maintain this kind of growth forever. Although the board knew that was highly improbable as that would require the company to step away from its strategy and business model, they hired a new CEO who was supposed to be great at sales, with the expectation that the new CEO could expand the business further, generate higher revenue and continue growing the company at a high pace.

Although their business model was changed, they didn’t get what they wanted. The company eventually lost its leading position in the industry it once controlled and the new CEO was asked to move on.

While boards are stewards of companies on behalf of their shareholders and are responsible for putting in place management teams that are supposed to develop and implement business strategies which would provide good returns to shareholders, the dynamics between shareholders, boards and management could influence the risk factors and sustainability of companies.

One might wonder how shareholders could pose risk to their own investments. Shareholders are not homogenous and each shareholder has their own objectives and motives for investing in a particular company. These objectives would influence their interactions with their investee companies. This is where they could influence business directions, risk appetites and the conducts of those companies.

Retail investors would come and go. While they could generate excitement in terms of volume of shares traded, especially for companies with small market capitalisation, the size of their shareholdings may not be enough to influence the direction of the company as in most cases, they are not represented on the board.

Then we have individual shareholders who, individually or through their friendly parties, have significant ownership of the company. They could be the original promoters who started the company and are generally keen to see it remaining successful. Normally their shareholdings are significant enough to enable them to have seats on the board.

Their investment objectives would be about serving their own aspirations including retaining control. If their investments are funded through borrowings, they may have an expectation on the minimum amount of dividends from their investments to service the borrowings.

Another category of shareholders are those representing collective investment schemes, pension funds and fund managers who are investing on behalf of a larger pool of investors. By their nature, they are committed to providing a certain amount of returns, and depending on their investment mandates may also be significant enough to have board representations.

Generally, only shareholders with significant presence on the board would be able to control business directions, how much risk the company is willing to take, dividend policy and the quality of corporate governance. They would pose risks if, through their representatives, they exert pressure on the board to venture into an industry in which the company has no expertise, acquire assets at inflated prices, enter into related- party transactions without proper due diligence or maintain dividend policies as such that free cashflows dry up and there is not much left for the company to invest for future business expansion or contingencies, among others.

How would such risks be mitigated? 

The first line of defence is for all the directors to remember that they are expected to act in the best interests of the company. Any decision has to be predicated on this expectation. This also applies to those representing major shareholders. The challenge for those belonging to this category is whether they can act independently and perform their legal role or succumb to the expectations of the shareholders who are represented by them.

Risks could also be mitigated if the corporate governance arrangements operate effectively. For example, in the case of acquisitions of assets, the independent directors should ensure proper due diligence is conducted and the valuation of the assets is determined, for example, by professional valuers.

Any related-party transaction has to be scrutinised in the same manner with other similar transactions. If any of these steps is committed, the independent directors should vote based on the facts and have the interests of the company as a whole in mind.

Management could also play their role in providing supporting facts in situations where the interests of shareholders would collide with the business viability of the company. In cases where unfavourable dividend policy is proposed, clear facts on how much capital is needed based on the agreed strategic plans and the consequences if the company is under capitalised must be presented before the board, so they can decide with their eyes open.

Hence, when the board considers the effectiveness of the risk management practices of the company under their care, the potential risks coming from their shareholders should not be discounted and have to be mitigated in ways similar to other risks.

This article was published in The Malaysian Reserve in the column Boardroom View http://themalaysianreserve.com/new/story/can-shareholders-pose-risks-their-own-investments

Making the Right Decisions at the Board Level

We ALL make decisions every day. Deciding what to have for lunch is a decision and sometimes we make this kind of decisions spontaneously without much reflection. 

Of course, it would be a more complicated decision if one is observing some form of diet or suffering from illnesses which require some dietary control.

Making decision is one of the key responsibilities of board members. However, given their oversight role over management in many key areas of governance, the impact of those decisions are more significant and important than deciding what to have for lunch. 

The range of the areas covered could be wide from strategy, performance and key operational issues to matters related to human potential and succession planning. Boards also set the risk appetite of the organisations which will influence the degree of risks they are willing to assume in every decision.

If the processes of appointing people into board positions are strong and only those with good track records and having the required competencies and skill sets are invited, why should board members have problems in applying judgment and making the right decisions? 

Well, there are a number of issues which may dilute the effectiveness of decision-making at this level.

The Committee of Sponsoring Organisations of the Treadway Commission (COSO) in the US had published in 2012 a discussion paper on avoiding judgement traps and biases which is worth considering here. Among the factors are rush to solve, judgment triggers, overconfidence, confirmation and availability.

Rush to solve is when boards decide on a decision without having a clear idea of what are the problems to be solved and the intended outcomes of the decisions. This could happen when they have high confidence on management who could be tabling what are seemingly workable alternatives and the decisions have to be made within a limited time.

A judgement trigger is an assumed problem which requires a decision to be made. For example, an opportunity to acquire a strategic asset appears at what management consi- ders a bargain price. The board may act to concur without even asking whether such acquisition is in line with the overall strategic objectives of the company or whether the price is really a bargain.

Overconfidence is when the decision maker overestimates their own ability to perform task or make accurate assessment of facts. Having made  similar kinds of decisions in the past may provide such overconfidence and decisions can be made using shortcuts without much consideration of the facts and circumstances of the present decision at hand.

Confirmation is when a position has been established upfront and the decision maker looks for evidences to support the position instead of looking for evidences which could disproof such position. 

The risk is of evidences to the contrary being ignored although they may surface during deliberations. This risk is also faced by auditors when considering audit evidence to support their audit opinions. 

When a decision maker limits himself or herself to the facts provided or to knowledge and information which are familiar to the person, the decision is limited to the availability of facts, knowledge and information. Further probing or obtaining views of people beyond them may provide better perspectives of an issue.

In addition to the above, decisions in boardrooms are also influenced by board dynamics. The ways the chair allows discussions before a decision is made and the culture of how the board members interact with themselves, which is built over time, could also influence decisions. 

A strong chair who takes strong views on matters to be decided upon may send signals to other members of the board on the direction of his or her thoughts. In a board where the culture to comply with the chair is strong, this could lead to arriving consensus without much deliberation. 

This factor is vital in the context of Malaysia as the power distance in our society is fairly wide and the risk of having a dominating chair is very real.

We could also have situations where the ultimate decision maker may not even be in the boardroom. Some members of the board could be representing parties which have significant stake in the organisation and could have different positions with the rest on certain matters. 

However, generally, board members have to decide based on the best interests of the organisation as a whole. How they deal with such situation would be important.

As a conclusion, being aware about what could go wrong in decision-making is very crucial for board members in performing their duties. Having clear decision-making process could be one of the ways to enhance the quality of decisions. The bottom line is, decision-making should not be taken lightly and efforts must be made to avoid missteps. 

This article was published in The Malaysia Reserve under the column Boardroom View http://themalaysianreserve.com/new/story/making-right-decisions-board-level

Where Corporate Culture Has A Role In How A Company Is Run

Those who had lived long enough would have observed crises come and go, including those in the financial markets. While some could have forgotten about the global financial crisis triggered by the sub-prime loans in 2008, the side effects from that crisis are still unfolding and some of the mysteries are still unrevealed.

Last year, the Bank of England released the Fair and Effective Market Review Report which covered the wholesale fixed income, currency and commodity markets where their value and scale affected many people globally through their influence over borrowing costs, currency exchanges and commodity prices, yet these markets remained a mystery to most people on the streets.

The report, among others, recommends that the standards, professionalism and accountability of individuals involved in those industries need to be raised. Obviously, such recommendation is aimed at ensuring their conducts and behaviours remain in check.

Last week, the Securities Commission Malaysia (SC) issued the draft Malaysian Code on Corporate Governance 2016 (MCCG 2016) for public feedback. What is interesting is that the MCCG 2016 is adopting an “apply or explain an alternative” by emphasising on the intended outcomes of the respective principles of corporate governance practices instead of just the recommended processes.

These two documents, when put together, would provide us with the idea of how regulators are focusing on conducts and behaviours of institutions under their regulations. If we extend this further, culture is now considered an important component of governance, as culture in a simple definition, is “how things are done here”. 

This does not suggest that culture was not important before. It could also been that principles and protocols established in many organisations were overridden by the “accepted day-to-day practices”. So, culture could also work in negative ways as well.

Why should the board of organisations, for profits or otherwise, be interested about the culture in the organisations which they lead? 

In the words of the South African governance icon, Mervyn King: “You all have heard of ‘the tone at the top’. I talk about ‘the tone at the top, the tune in the middle, and the beat of the feet at the bottom’. The board and top management have to make sure that the whole company has bought into the strategy and is facing in the same direction. 

“I know from my executive days that if you get your strategy right and you get buy-in, you get ordinary people to achieve the most extraordinary things! But if you don’t get it right and it doesn’t fit in with the milieu of the day, you can have the most extraordinary people, but you won’t even achieve ordinary things.”

Perhaps, we could have overlooked the fact that conducts of organisations are the results of the collective behaviours of the people who work for them, right from those in the boardrooms, the C-suites to those running the factory floors and selling things to customers. 

As most organisations are recognised as separate legal entities by law, our minds could have been deceived by the legal structures and kept on perfecting rules and regulations on the conduct and behaviour of these structures but less on the essence, the hearts and minds of the people which form the structures.

If culture is critical to ensure organisations behave in ways which benefit their stakeholders, how would the board ensures the culture in their organisations is as such? 

Before we go even further, the first question that needs to be asked is whether culture has appeared on the agenda of the board before? If not, perhaps incorporating such discussion in the next board meeting would be a great start.

While management is responsible to ensure the objectives set are met, the kind of questions asked on the ways such objectives are achieved during board meetings could also set the tone for the right culture. 

If management is challenged on the effects of their operations on environment and people living within their operational areas, such interests from the board would remind the management that the ways business are operated also matter, not just the profits which they generate. 

This strong stand from the board about getting the right results using right ways would certainly influence the “tune in the middle” which in turns would determine the “beats at the bottom”. This should also be applied in other areas such as anti- corruption and gender equality.

While rules and regulations could provide deterrence for misconducts, culture could be more effective and cost-efficient in ensuring that values are created in the most beneficiary ways for the corporations and their stakeholders. The board certainly have their hands on the levers of culture and should not abdicate this responsibility in lieu of short-term gains and immediate bottom lines results.

This article was published in The Malaysian Reserve under the column Boardroom View http://themalaysianreserve.com/new/story/where-corporate-culture-has-role-how-company-run