Chapter 3: Governance Structure - Overview PDF

# Chapter 3: Governance Structure - Overview ## Chapter Introduction - This chapter describes concepts in governance structure. - It includes the parties involved and their duties, the role of the audit committee, and the impact of regulation on governance. - It includes two lessons: - Lesson...

# Chapter 3: Governance Structure - Overview ## Chapter Introduction - This chapter describes concepts in governance structure. - It includes the parties involved and their duties, the role of the audit committee, and the impact of regulation on governance. - It includes two lessons: - Lesson 1: Introduction to Governance Structure - Lesson 2: Governance Structure - Overview - Summary Problem ## Governance Structure in a For-Profit Organization - **Shareholders:** Elect the board of directors - **Board of Directors:** Appoints the executive management and oversees the committees, including the audit committee - **Executive Management:** Responsible for implementation ## System of Corporate Governance - **Shareholders/Stakeholders:** Responsible for strategic direction - **Board of Directors:** Responsible for governance oversight - **Executive Management:** Responsible for implementation ## Lesson 1: Introduction to Governance Structure ### Technical Competencies - **2.1.1:** Evaluates the entity's governance structure (policies, processes, codes). - **2.1.2:** Evaluates the specific role of the audit committee in governance. - **2.1.3:** Evaluates mechanisms used for compliance purposes. ### Learning Outcomes - Describe the purpose and characteristics of an organization's governance structure. - Identify the parties involved in the governance structure of an organization. - Describe the duties of the board of directors, executive management, owners, and other stakeholders in governance. - Explain the role of self-evaluation for boards of directors. - Describe the role of the audit committee in governance. - Contrast governance in different types of organizations. - Describe the impact of regulatory bodies and regulations such as the SOX Act of 2002 on governance. - Explain the impact of corporate codes of conduct and ethics on governance. ## 3.1: Introduction to Governance Structure - Corporate governance connects an organizations' executive management, board of directors, shareholders, and stakeholders. - It provides a framework for strategic objective setting and the monitoring and measurement of those objectives. ### Purpose of Governance - Reduces ambiguity and confusion. - Enhances the effectiveness of strategy, risk management, resource allocation, monitoring, and overall organizational effectiveness. - Enhances relationships between management and principals (owners and other stakeholders). - Reduces the risk of organizational failure. ## Establishing a System of Governance - Requires a governance structure, including the development and documentation of organizational governance policies and plans, and leadership appointments. - An ongoing evaluation of the effectiveness of the system should be conducted, leading to improvement and change as the organization evolves. ### Governance Plans - Include strategic plans, risk tolerances, and resource allocations, all of which must be agreed upon by directors and executive management. - Governance policies include the organizational processes of oversight controls, measures, monitoring, audit, and disclosure practices. ## Factors Affecting Governance Practices - **Size:** number of directors and committees, size of operations - **Scope and complexity:** the nature and complexity of operations. - **Ownership structure:** whether the company is privately-held, publicly-held, or not-for-profit ## 3.1.1: Board of Directors - Most organizations have a board of directors, although the level of their activity can vary significantly. - The board of directors provides strategic direction and oversight of senior management's activities. ## A Publicly Traded Company - The members of the board are elected by the shareholders. ## A Private Corporation - The members are chosen by the shareholder(s) or appointed by the other members of the board of directors. ## A Not-for-Profit Organization - The members choose the board. ## The Board of Directors: - Works on behalf of all stakeholders to ensure that executive management works in the best interests of the long-term viability of the organization. - Holds the ultimate authority over executive management and the organization, which can present a principal-agent problem due to the presence of executive management on the board. ## The Many Responsibilities of the Board of Directors: - It is not practical for the entire board to meet on every single matter of the organization. - Various committees are created to ensure that the board performs those responsibilities in an effective and timely manner. - The board first determines the committees that are needed to best meet the governance requirements. - Matters of discussion are delegated to the committees to ensure discussion and resolution are reached. - The chair asks for a resolution appointing certain directors to serve on a committee. - Each committee elects a chair. - The committee chair reports to the chairperson or board on matters requiring board approval. - Not all board members are required to be on a committee. - An audit committee is discussed further in Section 3.1.2. ## 3.1.1.1: Board of Directors' Self-Evaluation - Like other groups, boards must strive for improvement. - Regular self-evaluations allow board members to provide input on how the entire board is performing compared to generally accepted best practices. - All directors provide a self-rating of their own performance, compared to that of the board and its committees. - Regular evaluations ensure all board members share a common understanding of expectations, both for each director and the board as a whole. - Self-evaluation allows the board to prioritize activities and focus resources where they're most needed. ### Self-Evaluation Should Be Multilevel - Each director should provide a self-assessment of their performance, based on factors such as skills, knowledge, and effort, including attendance at board and committee meetings. - Directors should perform a collective assessment of the board's performance as a whole. - Board members can also cross-evaluate each other's individual performance, but this has reporting hierarchy challenges that make it difficult to be honest. - Alternatively, a board committee can be assigned for these cross-evaluations. - Often, boards conduct the evaluation procedure for the CEO or executive director in an NPO. ### Guidelines for Self-Evaluations: - Assign responsibility for organizing and facilitating the evaluation process to a specific individual or group, such as a board committee, including agreed-upon timelines. - Approve one set of questions for individual assessment and another for the board as a whole. - Ensure questions are specific, clearly reflecting expectations and best practices. - Use Likert scales with ratings from 1 to 5. Each rating should clear defined. - Provide a "do not know" option for questions. - Include open-ended or additional comment boxes for detailed responses or explanations. - Seek comments, suggestions, and questions from individuals who frequently interact with the board, such as key shareholders, senior management, external auditors, and consultants who advise the board. - Compile and summarize results confidentially, and make them available for review and discussion. - Ensure that directors perform an honest assessment and use the results in a meaningful way. - Self-evaluation helps the board to share a common understanding of their duties and responsibilities, and the organization's goals, priorities, and expectations. - If a gap is identified in the skill sets of the current directors, the board can arrange for additional training or find additional candidates with the necessary skills. ## 3.1.2: Audit Committee - The audit committee of the board of directors oversees the quality and integrity of the organization's financial and reporting function. - All publicly traded companies in Canada are required to have this committee. ### Purpose of Audit Committees - To deal directly with both the internal and external audit functions. - To ensure that appropriate systems of internal controls are in place to prevent fraud. - To evaluate the qualifications and independence of the organization's external auditor, and monitor their performance. - To ensure the company's financial reporting process complies with legal and regulatory requirements. - To monitor new accounting standards, and review current accounting policies for their appropriateness. - To review an organization's risk assessment. ### Composition of an Audit Committee - All members must be independent of the organization. meaning they do not hold or have not held a position in the organization. - Members must be financially literate. - Every audit committee must have at least three members. ## 3.2: Governance in Different Types of Organizations - Every organization must be governed. - Basic governance functions of direction and control apply to all organizations, regardless of size or profit orientation. ### Differences in Governance: - Stem from the specific objectives and processes and the resources (time, money, skills) that are available to devote to governance. ### Governance Models - **Sole Proprietorship:** The three usual profit-oriented models of business ownership include the sole proprietorship, the partnership, and the corporation. - **Partnership:** - **Corporation:** The corporation is the most common model for businesses of any significant size. - The size, complexity, and often widely-spread ownership of most corporations presents governance challenges. - Governance of corporations is referred to as **corporate governance.** ### Corporate Governance in the Past: - Focused almost exclusively on providing value to the corporation's shareholders. - Current Canadian law requires the board of directors to consider the interests of all stakeholders. ### Board of Directors' Primary Obligation - To make decisions in the best interest of the organization rather than to promote the interests of any given stakeholder. ### Potential Conflicts of Interest in Decision Making - Board members must consider the potential impact of their decisions on all stakeholders. - They must then decide what is in the best long-term interest of the organization. - There is a trend toward broadening the range of stakeholders whose interests need to be considered. - **The board is responsible to the organization and not to any particular stakeholder.** ### The Need to Consider Non-Human Entities - Include the public interest and the natural environment. - This broader interpretation of corporate governance seeks to reduce the likelihood of ethical offenses, wrongdoing, or negative consequences that can arise from a deficiency of oversight and/or control. ### Long-Term Implications of Corporate Governance Failures - Can have serious implications for corporations. ### Directors of Not-for-Profit Boards - Have a similar legal obligation to that of their counterparts on corporate boards, to make decisions in the best interest of the organization. - Focus on ensuring appropriate strategic planning and resource allocation. ### Challenges of Governance in Not-for-Profit Organizations: - Meeting the mandate of the organization, as opposed to the profit orientation of business corporations. - Securing adequate resources. - It is more difficult to achieve good governance for NPOs, especially smaller, volunteer-run organizations. - NPOs need to appear well-governed. - Successfully meeting the challenges of funding issues, increased service demand, and heightened accountability and expectations can be challenging. ### Prioritizing Resources - Balancing and prioritizing resources is even more important for Not-for-Profit organizations because of the expanding number of stakeholders. ## 3.3: Compliance with Governance Regulations - Regulators and legislation have a pervasive effect on how corporate governance functions. - Tax policies, legislation that governs corporate activity and financial reporting. - Regulations change in response to perceived issues and shortcomings. ## Widespread Impact on Canadian Public Companies - **Canadian Securities Administrators' National Instrument 52-109 (Certification of Disclosure in Issuers' Annual and Interim Filings)** - **Sarbanes-Oxley Act of 2002 (SOX)** - Both require companies to provide information to their stakeholders, regarding the effectiveness of internal controls over financial reporting. - SOX only applies to Canadian companies listed on a U.S. stock exchange. ## Corporate Governance Requirements for Listed Companies - Examples include the **Canadian Securities Administrators (CSA)** corporate governance policy and the **Toronto Stock Exchange (National Policy 58-201, Corporate Governance Guidelines)**. - These requirements govern board composition, responsibilities, and committee structures. ## 3.4: Corporate Codes of Conduct and Ethics - Strong organizational ethics are essential for good governance. - Ethics and values cannot be assumed. - The board is ultimately responsible for ensuring that the tone from the top is appropriate, and that sufficient training and evaluation processes are in place. ### National Policy 58-201 - Requires the board to satisfy itself of the integrity of the CEO and other executive officers. - Requires the CEO and other executive officers to create a culture of integrity throughout the organization. ### Ignoring Ethics - Creates the risk of legal liability and the loss of goodwill in the community. - Senior executives who fail to develop ethical standards for their organizations face the risk of personal liability in the event of malfeasance. ### Organizational Ethics - Must reflect the values of the organization and the standards of society, not individualistic views of any one employee. - A code of conduct is adopted to standardize acceptable organizational behaviour. - It establishes standards that define acceptable and unacceptable employee conduct. - It explains the implications of any violation of the code of conduct, including suspension, penalties, and possible dismissal. ### The Greatest Tool To Minimize Unethical Behaviour - Developing and maintaining a strong ethical culture, in which all levels of the organization understand what is expected and a consistent set of principles and values applies equally to everyone. ### Developing an Ethical Culture - Develop, implement, and monitor compliance with codes of conduct for directors, officers, and all employees. - Train staff on expectations and values. - Hold staff accountable for ethical actions and decisions as part of performance evaluations. - Reward ethical behaviour. - Ensure sufficient independence of directors. - Avoid and mitigate conflicts of interest. - Determine, monitor, and communicate social responsibility. - Implement effective means to allow and encourage employees to report wrongdoing to appropriate individuals through whistleblowing systems. ## Lesson 2: Governance Structure - Overview - **Technical Competencies:** - **2.1.1:** Evaluates the entity's governance structure (policies, processes, codes). - **2.1.2:** Evaluates the specific role of the audit committee in governance. - **2.1.3:** Evaluates mechanisms used for compliance purposes. - **Learning Outcome:** Describe the governance structure in an organization. ## Summary Problem ### Required: - Describe the roles of the main parties involved in governance of a for-profit organization (shareholders, board of directors, and executive management). - Describe the role and composition of an audit committee. - Describe how an organization can demonstrate good governance through ethical actions. ### Solution 1. **The Role of Parties Involved in Governance for a For-Profit Organization** - **Shareholders**: The owners of the organization, they elect the board of directors and have a voice through votes. - **Board of Directors**: Elected by shareholders in a public corporation or appointed in a private corporation; oversee the activities of the organization, hire executive management, and have ultimate authority. - **Executive Management**: Appointed by the board of directors and hold the highest level of responsibility in managing the day-to-day operations of the organization. They carry out the directives of the board of directors, using the authority granted by the board. 2. **The Role of the Audit Committee:** - An audit committee is a committee of the board of directors that oversees the quality and integrity of the organization's financial and reporting function. - They are responsible for: - Overseeing both the internal and external audit functions. - Ensuring appropriate systems of internal controls are in place to prevent fraud. - Evaluating the qualification and independence of the organization's external auditor and monitoring their performance. - Ensuring that the financial reporting process complies with legal and regulatory requirements. - Monitoring new accounting standards and reviewing current accounting policies for their appropriateness. - Reviewing an organization's risk assessment. 3. **Demonstrating Good Governance Through Ethical Actions:** - The board of директора is responsible for ensuring that the tone at the top is appropriate. - The board must create a culture of integrity in the organization by adopting a code of conduct that describes acceptable behaviour for its management and employees. - Also, the code of conduct should describe unacceptable behaviour and the consequences, such as suspension, penalties, and possible dismissal. - Other policies that organizations can use to establish a strong ethical culture include: - Training employees on expectations and organizational values. - Ensuring that directors are independent of the organization. - Setting up a whistleblowing system in which employees are encouraged to report wrongdoing of other employees or management. - Holding staff and management accountable through a system of performance management. - Avoiding and mitigating conflicts of interest within the organization. ## END-OF-CHAPTER PRACTICE ### Practice Problems - **Practice Problem 1 (15 minutes)** - Local Biking Society was established last year with a goal of providing cyclists a voice in the community. - The board of directors has been elected for a mix of two- and three-year rolling terms. - They have heard about the importance of performing self-evaluation but are unsure what that entails. - **Required:** - Explain why performing self-evaluations is a valuable task for the board of directors. - Provide some guidelines for designing the board self-evaluation. - State a possible outcome that could result from the board performing a self-evaluation. - **Practice Problem 2 (15 minutes)** - The board of directors at Yoruba Explorations Corp. (YEC) is meeting to discuss the following issues: - An important institutional investor has requested that the company develop and implement a code of conduct. The investor raised the issue in light of a recent firing of a senior vice president, who had awarded important contracts to family members at above market prices. - The board consists of nine directors, all of whom are expected to participate in the organization's governance activities. However, only a few board members are active, with the rest claiming they lack the time or necessary skills in certain areas. - **Required:** - Explain how adopting a code of conduct can help to uphold organizational ethics. - Describe some areas that organizational policies can help when it comes to developing and maintaining a strong ethical culture. - Provide a recommendation to YEC's board to address the uneven participation in governance activities by the directors. - **Practice Problem 3 (15 minutes)** - Mark's Cattle Co. is a family operation that developed a revolutionary feed system gaining industry attention. - Limenez Farm Corp. (LFC), a public company, has offered to purchase a 40% interest in MCC and has requested that MCC establish an audit committee. - Mark is unsure about the role of an audit committee or what the composition should be. - **Required:** - Explain the purpose and function of an audit committee. - Explain whether MCC has the right board composition to establish an audit committee. ## SOLUTIONS TO PRACTICE PROBLEMS: ### Solution to Practice Problem 1: - **Competency:** 2.1.1 (Evaluates the entity's governance structure) - **Knowledge Item:** Governance Structure (Board of director self-evaluation). - **a)** Board of directors self-evaluations help to make sure the board is made up of individuals with the right skill sets, that best practices are being followed, and that the performance is appropriate at both an individual director level, and with respect to the board as a whole. - **b)** Guidelines for Board Self-Evaluation: - Responsibility for organizing and facilitating the evaluation process should be delegated to a specific individual or group, often a board committee. - The board should approve one set of questions for individual assessment and another set for evaluating the entire board. - The questions should be specific to clearly reflect expectations and best practices. - Use Likert scales (with ratings from 1 to 5), and ensure each rating is clearly defined. - Provide a "do not know" option. - Include open-ended questions or additional comment boxes for detailed responses or explanations from respondents. - Seek comments, suggestions, and questions from individuals who frequently interact with the board, including key shareholders, senior management, external auditors, and consultants who advise the board. - Compile and summarize results confidentially, and make them available for review and discussion. - Ensure that directors perform an honest assessment and use the results in a meaningful way. - **c)** Board self-evaluation helps the board to share a common understanding of their duties and responsibilities, and the organization's goals, priorities, and expectations. - If a gap is identified in the skill sets of the current directors, the board can arrange for additional training or find additional candidates with the necessary skills. ### Solution to Practice Problem 2 - **Competency:** 2.1.1 (Evaluates the entity's governance structure) - **Knowledge Item:** Governance Structure (roles and duties of various levels of the organization in the strategic management process, including the board of directors, executive management, owners, and other stakeholders; role that ethics plays in good governance). - **a)** A code of conduct is a policy document that establishes standards that define acceptable and unacceptable employee conduct, including suspension, penalties, and possible dismissal. A code of conduct is a necessary, but not sufficient means of developing and maintaining a strong ethical culture within an organization. - **b)** In addition to developing, implementing, and monitoring compliance with its code of conduct, YEC should consider developing policies that address the following areas: - Training staff on expectations and values. - Holding staff accountable for ethical actions and decisions as part of performance evaluations. - Rewarding ethical behaviour. - Ensuring sufficient independence of directors. - Avoiding and mitigating conflicts of interest. - Determining, monitoring, and communicating social responsibility. - Implementing effective means to allow and encourage employees to report wrongdoing to appropriate individuals through whistleblowing systems - **c)** During the recruiting process for board members, YEC must ensure that candidates are clear on the workload expected of the board of directors, and that, as board members, they can commit the time needed to support the governance activities . - It is often not practical for the entire board to meet on every organizational matter, nor is it likely that all directors will have the skills needed to make effective decisions in certain areas. - YEC's board should create the necessary committees to meet the governance requirements for the organization, and appoint certain directors to serve on each committee. - Various matters needing consideration should elect a committee chair, who will report back to the chairperson or the entire board on matters that require board approval. - Not all board members are required to be on a committee, and board members can serve on committees that best match their interests and skills. - Furthermore, the development of committees ensures that directors only participate in areas where they add value, which in turn, reduces the volunteer workload of the individual member. ### Solution to Practice Problem 3: - **Competency:** 2.1.2 (Evaluates the specific role of the audit committee in governance) - **Knowledge Item:** Auditor and audit committee (describe the role of the audit committee within the governance structure). - **a)** An audit committee is a board committee that oversees the quality and integrity of the organization's financial and reporting function. - It is mandatory for all publicly traded companies in Canada to have an audit committee. - In this case, the audit committee is being established at the request of a key investor. - The purpose and function of the audit committee is summarized as follows: - To deal directly with both the internal and external audit functions, and be responsible for ensuring that appropriate systems of internal controls are in place to prevent fraud. - To evaluate the qualifications and independence of the organization's external auditor and monitor their performance. - To ensure that the financial reporting process complies with legal and regulatory requirements. - To monitor new accounting standards and review current accounting policies for their appropriateness. - To review an organization's risk assessment. - **b)** Audit committees must have at least three members who are financially literate, independent of the organization, meaning that they do not hold or have not held a position in the organization, and are not closely related to management. - Unfortunately, MCC does not currently have the ideal board composition to enable setting up an audit committee. - Four of the directors are not independent and the sole independent board member is not financially literate.