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Performance reviews (also known as evaluations) are conducted to ensure the board/committee:

• is operating effectively
• has a strong ethical basis and active participation in decision making
• has the skills, knowledge, and experience to meet current and future organisational challenges.

Benefits of board and committee performance reviews

The key benefits derived from board/committee-level reviews include:

1. An objective assessment of common issues for boards such as leadership, relationships, size and tenure. This also provides an insight into the engagement of each director with the organisation and the dynamic environment in which it operates.
2. Helping to set the board/committee’s culture and build cohesion that flows through the organisation.
3. Keeping the board/committee in step with organisational needs through renewal and training.
4. Identifying excellence in current practices and letting directors and board/committee members provide honest feedback through an independent party.

This all leads to continuous improvement of board and committee practices and better outcomes from their interactions. A high-functioning board or management committee provides a solid grounding for effective decision-making and better manages strategic risks. It also delivers opportunities to identify improvements that will lead to enhanced organisational performance that creates greater business value.

Five steps for best practice reviews

1. Clarify the scope with the chair/CEO/head of governance

This is a critical first step because it will determine how outcomes from the performance review will drive the organisation’s governance settings for the next year.

The scope of the review should consider measurable elements such as:

• performance relative to strategy
• adherence to regulatory requirements where applicable
• board skills assessment
• benchmarking against others in the industry.

2. Design the methodology to suit the organisational structure and industry

The methodology may consist of an individual questionnaire, individual interviews, workshops, a review of documentation, policies and minutes or attendance at meetings, for example.

3. Conduct the review and analyse results

When conducting the review, it’s important to clearly communicate the scope and methodology with board and committee members to ensure they understand the type of feedback needed, how it should be submitted, and the submission deadline. This will help analyse results faster and easier.

4. Prepare draft report for discussion with chair

Ensure the draft report outlines the scope and methodology used for the performance evaluation, along with results and recommendations. Graphics are a powerful tool to highlight results and show a direct comparison with previous reporting periods, or others in the industry.

It is essential that this report is clear and easy to understand, and that the recommendations are relatively straightforward to implement.

5. Present approved report to the board/committee

Assist the chair to socialise the report to the board/committee by presenting the findings and providing copies of the report to board/committee members. A best practice presentation includes the use of graphics to show comparisons as well as board/committee strengths, weaknesses, and opportunities. Include recommendations as agreed with the chair and aim to agree on board/committee actions for improvement.

If you need assistance with achieving best practice performance evaluations for your board or management committee, contact our expert team at PFS Consulting.

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This article highlights the key issues for Boards, particularly Remuneration Committees, and provides some commentary on how these recommendations might change the executive remuneration landscape.

Design Issues

Two comments caught my eye in this section.

“…financial metrics must not determine remuneration. Risk of all kinds, including reputation risk, compliance risk and conduct risk, must be taken into account in both designing and implementing the remuneration system.” P350

“…focusing only, or largely, on a measure of total shareholder return when deciding whether long-term variable remuneration should be paid does not allow consideration of all relevant aspects of the executive’s performance. In particular, I would add, it does not allow consideration of how the executive has managed risk.” P356

Most Long-Term-Incentives (LTI) in Australia are designed to vest on the employee meeting two conditions. Firstly, a service condition – the executive must still be working for the company at the end of the performance period – and secondly a performance condition. In most cases, the performance condition is the achievement of a financial metric over the performance period. This metric is typically Total Shareholder Return (TSR) relative to a defined peer group, or an absolute hurdle. How the company achieves the financial outcome isn’t directly taken into account.

Commissioner Hayne is critical of the heavy emphasis on financial metrics as the primary measure to determine LTI bonuses. So, should companies replace the TSR metric as a vesting condition in the LTI design?

Under current accounting standards removing a market based financial metric such as TSR will have significant implications for the accounting cost of the bonus, as non-financial vesting conditions may not be taken into account in the valuation. Furthermore, as noted in the report, shareholders may resist changes to LTI design which mean incentives are not directly linked with shareholder returns.

Rather than replacing the TSR metric an alternative could be to introduce a risk management element as an additional vesting criterion. This would make payment of the LTI bonuses subject to three conditions: service, financial performance AND risk management performance.

As with most changes, there are pros and cons with each option and companies need to fully understand the practical consequences of any changes before proposing them to shareholders.

Implementation Issues

A large part of this section of the Royal Commission report is dedicated to analysing the failings of CBA’s remuneration arrangements – specifically, it’s near full payment of Short-Term Incentives in 2016 despite major breaches by its life insurance business as well as scandals relating to money laundering etc. The report highlights the importance of remuneration committees of Boards having the necessary information systems to make informed and timely decisions. Two comments are noteworthy:

“Although good design of remuneration arrangements is critical to reducing the risk of misconduct, the issues demonstrated by the evidence before the Commission were often issues of implementation rather than design.” P359

“As recently as April 2018, APRA observed in its information paper on remuneration practices at large financial institutions that its review ‘noted instances of poor quality, incomplete or inadequate documentation’ about risk management performance being provided to board committees.” P361

This section also discusses the issue of transparency and whether companies need to disclose details when bonuses are reduced (referred to as “risk related adjustments”). On this issue, the APRA representative made the point that requiring companies to make public disclosures of risk related adjustments could deter companies from reducing bonuses. This response highlights one of the key problems with using subjective non-financial hurdles; that is ultimately, these vesting decisions are made by individuals (or Boards) with personal relationships with the recipient, who are potentially conflicted.

Regulatory Compliance and Oversight

The prudential standards and regulatory oversight also came under heavy criticism from Commissioner Hayne.

“…the prudential standards should expressly require APRA regulated institutions to design their remuneration systems to encourage sound management of non-financial risks, and to reduce the risk of misconduct.” P351

“…the prudential standards should expressly require the board of a financial institution (whether through its remuneration committee or otherwise) to make regular assessments of the effectiveness of the remuneration system in encouraging sound management of nonfinancial risks and reducing the risk of misconduct.” P352

“APRA (and, where appropriate, ASIC) should do more to gather information about the way that remuneration systems are being applied in practice, and about whether those systems are actually encouraging sound management of non-financial risks and reducing the risk of misconduct.” P352

“APRA should set limits on the use of financial metrics in connection with long-term variable remuneration.” P365

It is clear from these comments and recommendations that the Commissioner believes there needs to be more restrictions around remuneration structures and greater oversight from APRA. The report also suggests that regulators need to collect more data on executive remuneration arrangements and outcomes.

Banks and other deposit taking institutions already have some constraints on remuneration design through the need to comply with BEAR. It is inevitable that these restrictions will increase (APRA is currently undertaking a review). Any changes that apply to APRA regulated entities are likely to be looked at carefully by ASIC and potentially extended to cover companies in other industries.

We will continue to monitor developments in this regard, in particular the outcomes of the APRA review later this year which will provide a good indication of changes to come.

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High lights (or Low lights)

Overall, the Commissioner laid the blame for the various acts of misconduct at the feet of the boards and senior management of the entities involved. He identified the key issues as culture, governance and remuneration practices

1) The Commissioner posed four key questions in making his recommendations:

• To what extent can the law be simplified so that its intent is met, rather than merely its terms being complied with, and how can this be done?
• Should the approach to addressing conflicts of interest change from managing conflicts to removing them, either by banning all or some forms of conflicted remuneration and sales or profit based remuneration and/or changing industry structures?
• What can be done to improve compliance with the law (and industry codes), and the effectiveness of the regulators, to deter misconduct and ensure that grave misconduct meets with proportionate consequences?
• What more can be done to achieve effective leadership, good governance and appropriate culture within financial services firms so that firms ‘obey the law, do not mislead or deceive, are fair, provide fit for purpose service with care and skill, and act in the best interests of their clients’

2) He defined acceptable norms of behaviour which should be complied with as follows:

• obey the law
• do not mislead or deceive
• act fairly
• provide services that are fit for purpose
• deliver services with reasonable care and skill, and
• when acting for another, act in the best interests of that other

3) Although these norms are reflected in existing law, the Commissioner pointed out that is piecemeal, and articulated some general rules in response to the issues that were identified during the hearings:

• the law must be applied and enforced
• industry codes should be approved under statute, and breach of key promises made to customers in the codes should be a breach of the statute
• no financial product should be ‘hawked’ to retail clients
• intermediaries should act only on behalf of, and in the interests of, the party who pays the intermediary
• exceptions to the ban on conflicted remuneration should be eliminated
• culture and governance practices (including remuneration arrangements) both in the industry generally and in individual entities, must be improved.

In addition, we welcome the Commissioner’s recommendation to establish a compensation scheme of last resort to provide redress to businesses and retail consumers where compensation awarded to them goes unpaid. We have long supported this concept, with the scheme funded by the sector of the industry giving rise to the unpaid claims.

From our perspective overwhelmingly the main findings relate to the shortcomings in the culture and governance of the organisations investigated.

We believe there needs to be enhanced attention given to culture and governance throughout the financial services sector and suggest you do not wait for these recommendations to become law and/or policy. That process will be long and politicised.

Consider the constructive steps you can take now to assess your culture and governance arrangements and how you can improve these – PFS Consulting can help.

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APRA paints a picture of an organisation that became dangerously overconfident. Buoyed by financial success, this confidence led to complacency and an overly-collaborative culture in which nothing was challenged and non-financial risk management was swept under the table.

Collaboration and teamwork are generally thought to be a hallmark of a sound culture, so why did it become so dangerous at CBA?

A victim of its own success

In short, the CBA was a victim of its own success. Because everything was going well financially there was no need to question anything. APRA referred to “a pervasive sense of chronic ease” as a clear weakness in CBA’s culture. This is in contrast to the chronic unease that drives safety cultures. In such cultures it is never assumed that everything is okay, and everything is always open to challenge. Proactive and pre-emptive risk management is the norm.

CBA’s success created complacency and reactivity, which facilitated development of a collegial and overly collaborative culture. This in turn led to pursuit of consensus, which meant insufficient challenge and constructive criticism, particularly in relation to management of non-financial risks.

What can be done about this?

The key lesson is that a desire for collaboration and teamwork must be balanced by recognition of the need for appropriate challenge and questioning. Getting this wrong can be particularly damaging in relation to governance and risk governance.

To achieve the right balance, governance arrangements need to include people with a range of diverse perspectives. People who see issues from different perspectives will offer challenge and questioning, and are less likely to fall into the trap of being “chronically at ease.”

For help achieving the right balance in your governance culture, or with your risk governance or other aspects of your risk management framework, contact PFS Consulting today.

Note that APRA acknowledges that CBA had already introduced a number of initiatives to improve the position before publication of the report, and CBA will implement all 35 recommendations of the report.

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Upgrading your organisation’s digital infrastructure was once a way to stand out from the crowd. Now, it’s a necessity in order to avoid missing out on the forecasted US $1.16 trillion increase in the Asia-Pacific region’s GDP by 2021 that widespread digital transformation will contribute (according to Microsoft & IDC Asia Pacific research).

But to begin your business’ digital transformation, you need the full involvement of your directors. Change should come from the top – and with the right skill sets, you can confidently reap the benefits of the digital economy. How can the board help with digital transformation?

What do boards need to lead digital transformation?

In order to get the journey towards total digital transformation underway, businesses need to ask these five questions:

1. What are the trends, technological or otherwise, affecting our customers and markets?
2. How can our current business model embrace disruption?
3. Similarly, how robust is our company’s infrastructure, supplier system and customer base?
4. What is our response strategy?
5. What technology and new skill sets do we need to make this response happen?

Embracing digital disruption requires major thought about your business’ structures and skills.

Once those questions have answers, your board can begin to map a digital strategy for the future.

An MIT Sloan School of Management survey found future-ready companies performed much better than their industry peers. Leading this change requires you to dissect your board members’ strengths and experiences. The ideal board of the future Australian business is comprised of members with a diverse range of skills, and has digital literacy high on the list of priorities. Your board should also have:

• Digital expertise. No matter your industry, include board members with past experience in the digital sphere.
• Diversity in age, race and gender. As well as providing different viewpoints on business strategy, a mix of opinions can also bring innovative ideas on how to use technology to digitally transform your operations and satisfy your customer’s needs.
• Access to outside information. Gathering reports and data on current digital transformation in your sector means you can keep abreast of what is working for your competitors.

Restructuring your governance arrangements

Recruiting the right board members who can take your business forward in the long term requires long and hard thought about how the board is structured and the strategies used to make decisions in all areas of your business, not just the parts affected by digital transformation. Unsurprisingly, this can be a tough area of decision making.

What changes do you need from your board to become ready for digital transformation?

To ensure your board’s organisational structure is robust enough to face the changes to come, you need the right advice. At PFS Consulting, we are focused on helping our clients build, maintain and improve their governance structures. This includes assistance with:

• Developing optimal governance frameworks.
• Improving governance documentation.
• Arranging board performance evaluations
• Setting your board up for future high performance.

Getting your board ready to embrace digital transformation requires you first to think about whether its governance strategy is set up for success.

Need advice on enhancing your governance in the digital age?

PFS Consulting offers a range of Governance consulting services to help your business reach its full potential, including advice on organisational structures, documentation, and facilitating strategic workshops. For more information on our governance services, please contact your PFS consultant.

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