Friday, 11 June 2010

Obligations of independent directors - Kenmark eye opener

Friday June 11, 2010

Obligations of independent directors - Kenmark eye opener

Whose business is it anyway - by John Zinkin

IN conversations since Sime Darby Bhd and Kenmark Industrial Co (M) Bhd hit the headlines, I was struck forcefully by how often the people I met did not realise fully what the obligations or liabilities of independent directors actually are.

Perhaps it is timely to restate in simple terms what independent directors are supposed to do; and why being an independent director should not be seen as a reward for past services that does not require an active involvement in the deliberations of the board.

It is a serious duty that requires much more than just being honest and attending the required number of board meetings. As such, directors must continuously upgrade their skills and understanding of the environment in which their companies operate, investing in training to do so.

Directors must act honestly and in good faith in the best interests of the company on whose board they sit. This means that if there is conflict between the interests of the company and the people they represent as nominees, they are required by law to think of the best interests of the company and not of the people who nominated them. This is easy to say, but often difficult to do.

Ethical behaviour does not just require directors to behave ethically personally; it also requires them to see to it that the company conducts its business in accordance with the law and with a high standard of commercial morality.

This raises interesting issues about whether a company should break the law and pay the associated fine because it costs less to do so in the short term than complying with the law. Ethical behaviour would suggest not breaking the law even if it was cheaper to do so.

It is also important to remember that directors’ fiduciary duty means that they must comply with the spirit of the law and not just the letter of the law – which explains why Goldman Sachs looked so bad when they were testifying to Congress, justifying their actions on the grounds that they were legal only. As the cross-examination demonstrated, fiduciary duty of directors is not just to shareholders, but also to customers and clients as well; all the more so, if what is being offered is highly technical, complex and opaque with the potential to lose clients their money.

Directors should remember this and insist on a wider fiduciary duty if they are serious about preserving the company’s “licence to operate” in the long term.

Being diligent

This does not just mean attending the requisite number of board meetings and preparing for each board meeting by reading the board papers. Directors must devote enough time to remain familiar with the changing nature of the company’s business and environment, including mastering the impact on the business and its risk profile of the evolving political, legal, social and competitive context in which the company operates.

At a minimum this means directors must understand the make-up of the revenues and costs in the profit and loss account and be able to ask probing questions when the ratios show signs of changing as these are early warning indicators of eroding profitability.

They also must understand the asset intensity of the business and how it changes over time by being able to relate the balance sheet items to the amount of business they generate: for example, how much working capital is needed to generate a dollar of sales, how does it compare over time and with the competition?

Are there legitimate ways of reducing the asset intensity of the business and improving the return on capital employed, or are the means by which this is being done through the use of off-balance sheet items merely a form of dangerous financial engineering?

It also means that directors must personally know the first- and second-line managers of their company well enough to be able to contribute intelligently to the succession planning process for which they are responsible. They need to know this if they are to undertake that most difficult role of all – terminating the non-performing CEO without causing a major disruption to the business.

One of the most difficult roles is to ensure that minority shareholder rights are respected when there is a controlling shareholder – be it the founding family or the government. There are the obvious issues raised by differing perspectives on strategy caused by different risk appetites and time horizons of majority and minority shareholders.

There is also the issue of related party transactions which need to be vetted carefully to ensure that money invested by public shareholders is not being “upstreamed” or siphoned off to the advantage of the controlling shareholder via a related party transaction.

Directors must avoid all conflicts of interest wherever possible. Should a conflict arise, they must adhere scrupulously to the provisions laid down by the law and the constitution of the company in dealing with such conflicts. Should the conflict be continuous or material, the director involved should consider resigning after taking into account the impact of resignation on the other members of the board.

Directors cannot disclose confidential information without prior agreement from the board even if the people who nominated them require it – this is because their primary duty is to the company on whose board they sit.

It goes without saying that directors cannot abuse their access to confidential information and use such information for “insider trading”.

# The writer is CEO of Securities Industry Development Corp, the training and development arm of the Securities Commission.

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