July 20, 2017

Corporate Governance . . . Innovative Thinking In South Africa’s Latest Code

Michael Judin, Leigh Roberts, Ramani Naidoo

Written on behalf of ABA Section of Business Law International Developments Committee; ABA Section of Business Law Governance and Sustainability Joint Subcommittee of the Corporate Governance and the Federal Regulation of Securities Committees.

South Africa, a country that is known around the world for the wisdom and stature of its former leader, the late Nelson Mandela, is also recognized for its contribution to ground-breaking corporate governance. With the release of the fourth King Report on Corporate Governance for South Africa (King IV), following in the wake of King III (2009) and King II (2002), South Africa has undeniably one of the best corporate governance frameworks worldwide. South Africa’s continuous leadership in corporate governance and corporate reporting have recently earned that country the rank of number one in the world—for the seventh consecutive year—in auditing and reporting standards in the World Economic Forum’s Global Competitiveness Report 2016/2017.

Corporate governance thinking is, by its nature, evolutionary; and even though individual country codes are nuanced by their respective political, economic, and cultural values, there are close parallels between the corporate governance codes of most countries with unitary board structures, where boards comprise both executive and non-executive directors, and in which share ownership forms the basis upon which shareholders exercise power over a company. South Africa, like the United States, Australia, and the United Kingdom, has a unitary board system; its latest contribution to the arena of global corporate governance—King IV—warrants a closer look by companies and policymakers around the world.

King IV (King IV Report on Corporate Governance for South Africa 2016) was released by the Institute of Directors in Southern Africa on November 1, 2016, and took effect for companies listed on the Johannesburg Stock Exchange on April 1, 2017. King IV was developed by the King Committee, led by its chairman Professor Mervyn King and written by a nine-person task team over a period which spanned more than two years. King IV supersedes earlier versions of the King Code, a code that was first inspired by the thinking of Nelson Mandela in a bid to attract foreign investment into South Africa. While King IV is a voluntary code, reflecting aspirational governance standards for all companies, as with earlier iterations of the Code, its principles will be included in the Listings Requirements of the Johannesburg Stock Exchange, making compliance with King IV mandatory for listed companies. King IV has been lauded around the world as representing “enlightened thinking” in corporate governance. Indeed, it offers a number of ideas that other corporate governance codes might consider. Some parts of King IV reflect the latest international thinking while others are truly innovative.

Immediately noticeable is its conciseness. King IV reduced the 75 principles of King III into just 16 principles that can be applied by any organization in the private or public sector to give effect to the practice of good governance. These 16 principles are designed to achieve four good governance outcomes, namely, ethical culture, good performance (performance against strategic objectives as well as achieving positive impacts on the capitals it uses and affects), effective control, and legitimacy. King IV is the first outcomes-based code in the world, meaning that implementing the principles of the Code will achieve the four desired governance outcomes.

Each principle is accompanied by recommended practices, including specific disclosures, designed to achieve its application and the related governance outcome. The recommended practices are not an obligatory checklist and King IV emphasises proportionality in line with the organization’s size, resources, extent, and complexity. Another area of corporate governance innovation in King IV is that companies “apply and explain” their adherence to each of the 16 principles as achieved by the implemented practices. This departure from the “apply or explain” approach in King III (disclosure of only the principles not applied) is designed to circumvent mindless compliance by a company, since the company must carefully consider the disclosed explanation of how it has achieved the principles, so that stakeholders can make an informed assessment of the quality of corporate governance in the company. In other words, the explanation must allow stakeholders to understand not just what corporate governance principles have been adopted by the organization, but how their application has contributed to the achievement of better corporate governance.

South African law, in general, comprises common law and statutory law, and its company law builds on foundational Roman-Dutch legal principles, as modified and interpreted by judicial precedent. Since judges of the various divisions of the High Courts of South Africa have made reference to the King Report, the King Report and Code have been made part of South Africa’s common law.

A Jump into Six Capitals

Over the years, the King Reports and Codes have increasingly acknowledged the two-way exchange between an organization’s financial capital and performance and the various other resources and relationships it relies on for its longer term success. In King IV’s foreword, Professor King states: “No governing body today can say that it is not aware of the changed world in which it is directing an organisation. Consequently, a business judgement call that does not take into account the impacts of an organisation’s business model on the triple context—the combined context of the economy, society and the environment—could lead to a decrease in the organisation’s value.”

King IV reflects the latest international thinking by referring to a company’s resources and relationships as six forms of capital, a concept set out in the International <IR> Framework released by the International Integrated Reporting Council in December 2013. The six capitals are: (1) financial capital, (2) manufactured capital, (3) intellectual capital, (4) human capital, (5) natural capital, (6) social and relationship capital. All decision making within an organization involves balancing the six capitals. For example, a decision to invest in new technology and equipment will probably decrease the organization’s financial capital (by the cost of the investment) and its human capital (as fewer employees will be needed) whilst simultaneously increasing its manufactured and natural capital (as production processes become more efficient and environmentally friendly). Fundamentally, King IV recommends that an organization’s governing body (for corporations, the board) consider all six capitals in decision making, strategy setting, evaluating and corresponding to risks and opportunities, and considering performance outcomes. Directors should also take into account the six capitals in carrying out their duty of care and in pursuing the longer term interests of an organization. The consideration of the six capitals—termed “integrated thinking”—permeates the principles of the Code, is revealed in many of its recommended practices, and is considered integral to ethical and effective leadership by the governing body.

King IV, like its predecessor codes, reflects a stakeholder-inclusive approach. Under the King Codes a corporate board considers the reasonable and legitimate needs, interests, and expectations of all material stakeholders in the best long-term interests of the organization. Effectively, the stakeholder-inclusive and integrated thinking approaches give parity to all sources of value creation (that is, the six capitals), although the Code acknowledges that giving each of the capitals equal status involves “the balancing of interests over time by way of prioritising and, in some instances, trading off interests.”

The Integrated Report

Another feature of King IV is that, like King III, it recommends the preparation of an integrated report. King IV is aligned with the terms of the International <IR> Framework, which defines an integrated report as: “A concise communication about how an organization’s strategy, governance, performance and prospects, in the context of its external environment, lead to the creation of value in the short, medium and long term.”

Companies listed on the Johannesburg Stock Exchange and many larger non-listed organizations in South Africa have been preparing annual integrated reports since 2010/2011, following the recommendation in King III. Interestingly, one of the biggest benefits cited by companies is that the practice of integrated reporting has helped them embed integrated thinking across the company, which has led to improved management and more informed decision making.

Dispute Resolution

A key feature of the most recent King Codes is their emphasis on alternative dispute resolution (ADR). The fundamental concepts section of King IV notes that as a result of the alternative dispute resolution mechanisms introduced in King III, resolving disputes has gained increased importance in South Africa, particularly where labor strikes are often protracted or hostile. Because King IV regards relationships as a form of capital on which all organizations rely, the dispute resolution process should be regarded as an opportunity not only to resolve disputes at hand, but also to maintain and enhance the social and relationship capital of the organization. Stemming from this, King IV recommends that alternative dispute resolution mechanisms and associated processes be adopted and implemented as part of the overall management of stakeholder relationships. The majority of commercial arrangements in South Africa today contain dispute resolution clauses that invariably provide for disputes to be resolved first by negotiation, if that fails by mediation, and if that fails by way of arbitration. Besides helping reduce the number of cases that are ultimately referred to litigation, the ADR process usually results in disputes being settled more quickly and cost effectively with the added benefit that parties may agree to appoint arbitrator with specific knowledge or technical expertise in the subject matter of the dispute. This is not necessarily the case with litigation.

Independence of Directors

Principle 7 of King IV states that the board should comprise the appropriate balance of knowledge, skills, experience, diversity, and independence for it to discharge its governance role and responsibilities objectively and effectively. Although board tenure (with nine years being mooted as the point beyond which directors may, although not necessarily, become non-independent) and shareholding are two factors deemed to affect independence, King IVintroduces a level of practical pragmatism into the determination of issues of independence, making it clear that there is no one-size-fits-all approach. A mix of executive and non-executive and one or more independent directors on the board mitigates the risks that emotive issues drive decision making, especially in family-owned companies, or where the authority of the founding member is entrenched. Although important, independence is but one consideration in achieving balance in the composition of the governing body.

Remuneration

In recent years, international regulators and institutional investors have started paying close attention to disclosure and voting on remuneration. King IV responds to these developments and makes some important recommendations both in regard to executive and non-executive directors. It establishes the principle that remuneration should be fair and responsible, should be disclosed, and should be sensitive to the gap between the remuneration of executives and those at the lower end of the pay scale. Although a non-binding advisory vote by shareholders on an organization’s remuneration policy has been a feature of the South African governance landscape since King III, King IV goes beyond this by requiring companies (in particular listed corporations) to engage with dissenting shareholders to ascertain their concerns and to disclose in their integrated reports the nature of shareholders’ concerns over remuneration and what steps the board has, or intends to, put in place to address these concerns.

Sector Supplements

While the principles in King IV are universally applicable to all organizations, a new feature not found in the earlier King Codes is the addition of five Sector Supplements aimed at helping organizations apply the Code in sector-specific circumstances. The five sectors covered by a Supplement are: state-owned entities, small and medium Sized Enterprises, municipalities, non-profit organizations, and retirement funds. The Sector Supplements align the broader terminology used in the Code to specific roles and functions in the sectors. For example, the role of a municipal manager is equivalent to that of the chief executive officer of a company, and that of the municipal council is largely similar to the role of the company’s board of directors.

Conclusion

The enlightened corporate governance of the King IV Code can be a role model for modern-day capitalism. All of a company’s significant resources and relationships are given respect and consideration. There is awareness that how a company treats its six capitals today influences their future cost, quality, and availability—with a direct impact on the company, its financial performance, and its longevity.

Michael Judin

Founder, Judin Combrinck Inc.

Commercial, Competition Law, Corporate, Intellectual Property, International trade laws & treaties, Internet Law / E-Commerce, Joint Ventures and Acquisitions , Labour Law, Licensing, Litigation (Commercial), Litigation (Corporate), Media , Property Law, Trade and Industry

Leigh Roberts

Founder, Leigh Roberts Consulting

I am the author, together with Mervyn King, of Integrate: Doing Business in the 21st Century (Juta), and the host of the TV series Integrated Reporting Made Simple I, II, III and the Doing Business in the 21st Century series which covers topical areas of interest to boards of directors. All of the series aired on BusinessDay TV in South Africa and are available for online viewing on the website. I am a member and co-founder of the Integrated Reporting Committee (IRC) of South Africa, the chairman of its technical Working Group, a member of the Integrated Thinking Task Force of the South African Institute of Chartered Accountants, and a Chartered Accountant (SA).

Ramani Naidoo