Individuals emerge as chief providers of capital
August 18, 2009

By Mervyn King

The new reality of corporate governance is that capitalisation of companies has changed. From the providers of capital being the wealthy families of the world, . the individual has become the provider of capital indirectly through pension funds.

A download of beneficial owners of dematerialised scrip indicates that on the great stock exchanges, the major shareholder is, in fact, the pension fund.

The other change in corporate governance is that corporate reporting is not what it used to be. The stakeholder is a much wider body than it was from the 18th century to the first half of the 20th century.

The individual has become not only the provider of capital, but also the customer and citizen of the country in which the company operates. If each citizen expects his or her neighbour to act as a good citizen, so today stakeholders expect firms to be, and to be seen to be, good corporate citizens.

Boards today have to take account of the legitimate expectations and interests of all the stakeholders linked to the company, which includes the shareholders. The importance of this is illustrated in the economic value of a company as opposed to its book value. The market capitalisation of a firm on a stock exchange is never equal to book value. If it is, it is purely coincidental.

The reason is that the investor makes an assessment of issues such as some calculation of future earnings, brand, goodwill, the reputation of management, the reputation of the board, the quality of governance, the sustainability of the business and to what extent the company has taken account of the non-financial aspects pertinent to its business.

Has the company been able to report how it has affected, both positively and negatively, the communities in which it operates? Has it given its stakeholders forward-looking information so that they can make a more informed assessment of the economic value of the company?

The G3 Guidelines of the Global Reporting Initiative is generally accepted as the number one setter of standards for sustainability reporting. Applying the guidelines provides the holistic information sought by stakeholders, particularly the financial institutions, which invest their beneficiaries' money.

Further, governance, strategy and sustainability have become inseparable. In debating and approving the long-term strategies of the company, the board can no longer ignore sustainability issues pertinent to the business.

For example, a board would be failing in its duty if its business was the manufacture of beverages and it ignored the risk of water, which has become the scarcest commodity on Earth.

In consequence, King 3 has recommended integrated reporting and that internal audit has to be risk-centric, rather than compliance-centric. Internal audit needs to understand the long-term strategic plan of the company and the risk factors of that plan. Only in this way can the corporate audit executive assess whether the controls of the business are adequate or not.

In recognising that some 90-odd firms listed on the JSE have executive chairmen, the King 3 code of governance principles for southern Africa has proposed that those firms have lead independent directors, so when the executive chairman is conflicted, the lead independent director can adopt the role of chairman or mediate the conflict.

The advance of information technology (IT) is evidenced by the fact that IT governance and IT security was not specifically dealt with in King 2, which was issued in 2002. Today it has become a critical factor in good governance.

IT security is important because most firms do not have chief information officers and internal programmers and consequently use outside service providers. This increases risk to the company, because confidential information is outside the portals of the company.

Another reality of corporate governance is that the judicial system has not kept up with commerce. Commerce is carried on in a flat, borderless world and capital moves 24/7 with the click of a mouse. Consequently, part of a director's duty of care today is to ensure that when a dispute arises, those disputes are resolved as efficiently and effectively as possible.

This can only be done with an adequate dispute resolution clause in major procurement contracts. This is recommended in King 3 and a precedent clause will be included in its practice notes.

With regards to share options, the US and Canada insist that directors, both executive and non-executive, receive share options, whereas the EU and the Commonwealth countries have inclined to non-executive directors not receiving share options because from the outside looking in, it appears to dilute their objectivity.

King 2 recommended share options provided they were approved by shareholders in general meetings. This recommendation has been followed in the new Companies Act, but King 3 has followed the trend of the EU and Commonwealth countries, which are our major trading partners, and recommended that share options should not be granted after March 31 next year, when King 3 becomes operative.

Because of the millions of stakeholders linked to firms that have become the medium with the greatest pool of human and monetary capital in the world, King 3 has a chapter on stakeholder relationships.

In short, the new reality of corporate governance is that boards must take account of financial capital provided by shareholders, human capital from employees, natural capital provided by land, air and water and social capital provided by the community and society in which the company operates.

· Mervyn King is the doyen of corporate governance, not only in South Africa but internationally. The views he expresses in this column provide the basis for his upcoming address at the 20th anniversary conference of the East, Central and Southern African Federation of Accountants scheduled to take place in Johannesburg from September 21 to 23.