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Basel Committee Issues Corporate Governance Principles, Strong Role Seen for Internal and External Audit

By Jim Hamilton

The Basel Committee has issued corporate governance principles emphasizing transparency, aligning executive compensation with prudent risk taking, and making more and better use of internal and external auditors. A central principle envisions the board and senior management making very broad use of internal audit and effectively engaging the independent outside auditor. Independent and qualified internal and external auditors, as well as other internal control functions, are vital to the corporate governance process, said the committee.

The board and senior management can enhance the ability of the internal audit function to identify problems with the firm?s governance, risk management and internal control systems by encouraging internal auditors to adhere to national and international professional standards, requiring that audit staff have skills that are commensurate with the business activities and risks of the firm, promoting the independence of the internal auditor by ensuring that internal audit reports are provided to the board and that the internal auditor has direct access to the board or the board's audit committee. Importantly, the board should also engage the internal auditors to judge the effectiveness of the risk management and compliance functions, including the quality of risk reporting to the board and senior management.

The board and senior management can also contribute to the effectiveness of external auditors by including in engagement letters the expectation that the external auditor will be in compliance with applicable domestic and international codes and standards of professional practice. Also, non-executive board members should have the right to meet regularly, in the absence of senior management, with the external auditor and the heads of the internal audit and compliance functions. This can strengthen the ability of the board to oversee senior management?s implementation of the board?s policies and ensure that business strategies and risk exposures are consistent with risk parameters established by the board.

Another principle demands active board oversight of compensation so that it is aligned with risk management and prudent risk taking. Sound governance means that compensation is sensitive to the time horizon of risks and that the mix of cash, equity and other forms of compensation is consistent with risk alignment. Since employees can generate equivalent short-term revenues while taking on vastly different amounts of risk in the longer term, a firm should adjust variable compensation to take into account the risks an employee takes. This should consider all types of risk over a timeframe sufficient for risk outcomes to be revealed. It is appropriate to use both quantitative risk measures and human judgment in determining risk adjustments. Where firms make such adjustments, all material risks should be taken into account, including difficult-to-measure risks such as reputational risk and potentially severe risk outcomes.

In addition, compensation should be sensitive to risk outcomes over a multi-year horizon. This is typically achieved through arrangements that defer compensation until risk outcomes have been realized, and may include clawback provisions under which compensation is reduced or reversed if employees generate exposures that cause the firm to perform poorly in subsequent years or if the employee has failed to comply with internal policies or legal requirements.
The principles flatly state that golden parachute arrangements under which terminated executives receive large payouts irrespective of performance are generally not consistent with sound compensation practice.

A broad principle holds that transparency is essential for sound and effective corporate governance. It is difficult for shareholders and relevant stakeholders and market participants to effectively monitor and properly hold accountable the board and senior management when there is insufficient transparency. The objective of transparency in the area of corporate governance is therefore to provide these parties key information necessary to enable them to assess the effectiveness of the board and senior management.

As part of transparency, the company should disclose material information on its objectives, organizational and governance structures and policies, in particular the content of any corporate governance code or policy and the process by which it is implemented, major share ownership, and related parties transactions, as well as its incentive and compensation policy. The firm should also disclose key points concerning its risk tolerance appetite, along with a description of the process for defining it and information concerning the board?s involvement in such process.

Full post as published by Jim Hamilton's World of Securities Regulation on October 22, 2010 (boomark / email).