Recent corporate failures and scandals have only served to fuel the growing wave of cynicism which now exists among investors and other stakeholders over the limitations of rule books and manuals. This is first generation governance - linear and prescriptive.
In any five year period, a business and its operating environment are prone to fundamental change. When this is coupled with shifts in strategic priorities designed to sustain competitive advantage, there is clearly a serious risk of governance drift. This can result in a company's management, structures, systems and controls being out of tune with the surrounding landscape. However, those companies who are prepared to adapt their approach to governance, are more likely to survive and prosper.
Adopting a second generation adaptive approach, my own organisation's risk advisory team has developed 'Dynamic Governance' designed to understand governance in action. Dynamic Governance is explored through four mindsets - the strategist, the tactician, the complier and the minimalist. Observing governance in action, has allowed us to identify some imperatives.
The linear approach
Hitherto, good governance has been akin to the corporate airbag: you only notice you do not have it when there is a crash. Moreover, models of governance are generally linear in format. For example, if you balance your board, split the roles of chairman and chief executive, and provide a boiler-plate Turnbull statement you will have 'good governance'. The obvious problem with all linear models is that their one-size-fits-all approach can result in it fitting no-one. Even within the UK's principle based system, with its emphasis on comply-or-explain, there remains the concept of a perfect model within a linear framework.
A fresh perspective
From our experience advising a wide variety of businesses, we know that such linear models are not always appropriate. Instead, evolution is often the key. We also know that there is more to governance than being seen to tick the right boxes. So, when we began to look at governance again, we decided to look at it rather differently.
Firstly we asked: 'what is governance there to achieve?' We knew that traditional governance has focused on preventing corporate failure. Many of the codes and models were developed in the aftermath of a high-profile failure. But ultimately the majority of corporate failures cannot be attributed simply to not having a separate chairman and chief executive. Furthermore, if companies are spending so much time and money on the 'onerous burden of regulation', would it not make sense for them also to be able to achieve an upside from all their effort? We take the view that good governance equals good management, and that by having good governance a company should enhance shareholder value.
Part of the path to growth is responding to the changing circumstances a business finds itself in. Taking this into account, together with our belief that good governance should add value, we developed the concept of Dynamic Governance.
The present linear model does not reflect the needs of businesses as they evolve and their operating environment changes. Dynamic Governance involves the consideration of an individual organisation's internal structure and its operational environment. In light of these factors, it should include the defining of risk appetite, the implementation of appropriate controls and allocation of adequate resources. We see Dynamic Governance as being in tune with enterprise risk management, - a continuous process overseen at a senior level and instituted on an organisation-wide basis.
This means that the board of the company must set the tone, define the company's risk-appetite and make sure it is aware of the changing nature of both internal and external operating environments. But it is not enough for there to be good board governance. The concepts and structures in place at the highest level must be embedded throughout the organisation.
Our approach to Dynamic Governance is focused on two axes of behaviour (figure 1).
The vertical axis may be termed the 'spirit of governance', measuring the extent to which an organisation embraces or resists the concepts. These concepts include such ideas as accountability and transparency. The horizontal axis is concerned with architecture or systems of governance, ranging from adherence to a codified governance system, such as the UK's Combined Code, to a fully bespoke approach. Therefore, the vertical axis may be termed governance with a small 'g', focusing as it does on attitude. The horizontal axis is Governance with a capital 'G', with its more traditional focus on architecture and systems.
Through this analysis we have created four governance mindsets - complier, minimalist, tactician and strategist. These mind-sets reflect both a corporate body's overall approach to governance, combined with the governance system it has in place.
A complier mindset has a tendency to follow the accepted structure or rules in a positive manner. This may result in a strong internal controls framework and propensity to focus on minimising risk.
A minimalist approach has a preference for adherence to the rules, but only to the degree that this conforms to a clear cost-benefit trade-off.
A tactician's focus lies not on compliance, but on reaction to business circumstance and increased risk appetite. Tacticians resist over-focusing on control, but concentrate instead on immediate success.
A strategist embraces the spirit of governance but does not dogmatically comply, preferring a bespoke approach. driven by the desire to maximise opportunities and performance.
Within the model (figure 2), the left half of the circle is performance focused, while the right half is more focused on conformance.
The difference in concept
This mindset approach differs from traditional concepts in two important ways. Firstly, there is no perfect model for governing an organisation; a business can operate successfully in any paradigm in given circumstances. Secondly, we consider that because a company can operate effectively with any approach, the risk of failure comes from extreme behaviour and operating in an inappropriate paradigm.
This recognition that the danger comes from extreme behaviour is reflected in the model by the change in colour from green to red. In any paradigm there is a safe area of operation - this is the target area - where a company can mitigate the risk of failure while minimising any hindrance to achieving its objectives. If, however, an organisation drifts into the red zone, it is at risk of a governance failure. For example, a company operating in the red area of tactician may be suffering from weak internal controls. Those operating in the red area of complier may be in danger of becoming too rigid in their approach to controls, and hence unable to react to change and embrace opportunities.
Dynamic Governance by its very nature recognises that organisations will move gradually into different areas, depending upon, among other things, changing circumstances and business maturity. Figure 3 provides an example of a company maturing within the Dynamic Governance framework.
As we began to develop our Dynamic Governance approach, we became aware that one of the problems with the term 'governance' relates to its ambiguity. If all the areas of corporate behaviour that 'governance' may cover were aggregated into one model the danger of a false result would occur. So, for example, there may be no direct correlation between a company's environmental risk management policy and whether it has appointed a senior independent director. Hence we have created a dashboard approach, slicing governance up into different areas. We consider that this approach enables a company to more effectively assess its situation.
Past, present and future
Finally, we also consider the Dynamic Governance tool not only useful for determining past and present performance, but for determining where a company wants to move in the future and how it can use its governance framework to achieve this.
We have also developed some governance imperatives or tips for using it effectively (see below).
Paul Forrest is national head of risk advisory services, BDO Stoy Hayward, E-mail:email@example.com
Fit for Purpose Governance systems and structures need to be both dynamic and adaptive, continuously evolving as the business and its operating environment change.
Accountability A strong culture is necessary to clearly define acceptable corporate and individual conduct and instil a sense of ownership.
Embedded For Dynamic Governance to be effective its principles must be embedded throughout the organisation, so much so that they become part of the language and instinctive behaviour of those doing business.
Risk Appetite Risk appetite must be clearly communicated, since by doing so operating parameters are set and activity is aligned with decision making.
Transparency Maximise the use of technology to disseminate real time information and communicate with interested parties.
Performance Dynamic Governance should not sit in a silo, but instead be used as a strategic tool to enhance performance and realise objectives.
Scrutiny Build in formal independent checks when making strategic and operational decisions.