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Home , Corporate governance

November 2020

Improving resilience through corporate

Thought Starter

Corporate governance is a key tool for ensuring value. Today, its importance has been reaffirmed as we see the extraordinary impact that COVID-19 pandemic has had and may continue to have on the global economy, as well as on the way operate every day.

The question is: Were we really prepared for this pandemic, from a corporate governance point of view?

Existing corporate governance frameworks mention the responsibility of the board regarding how companies should manage risk. For example, The /OECD Corporate Governance Principles underline that “Reviewing and guiding corporate strategy, major plans of action, risk and procedures” is one of the key functions that the board should fulfil, among other things.

While Enterprise (ERM) is one tool to realize this purpose as we try to build back better, corporate governance, and ERM will play a crucial role. It is important to note that we do not need to reinvent the wheel. We should seize this opportunity to create a more resilient and sustainable economy in the face of future disruptions by incorporating lessons learned from the COVID-19 pandemic into our corporate governance framework.

1. Broadened perspectives of Board’s responsibility and duty

Directors’ duties vary across jurisdictions, but are generally subject to an obligation to act in the best interests of the as a whole, whilst also having regard to the implications of decisions on employees, suppliers and other stakeholders. In times of financial uncertainty, it is more important than ever for directors to have clear understanding of the financial position of the company and assess whether it can pay its debts as they fall due and payable. In addition, COVID- 19 urges business to reconsider what the optimal cash position and the capital structure would be. Even though the core principle of fiduciary duty remains unchanged, the experience of COVID- 19 is a call to the board to broaden its thinking to fulfill its responsibility.

COVID-19 has made it more challenging to manage different stakeholders’ interests. As one of the more immediate concerns at the outbreak of the pandemic was employee safety, companies were intensely challenged to keep some operating in order to meet societal needs. It should be borne in mind that business sectors such as food and healthcare experienced positive economic effects during the COVID-19 outbreak at the same time. In terms of the relationship with employees, human capital management is another important topic that boards need to take into consideration. Even before COVID-19, issues such as employee well-being, diversity and inclusion had been significant concerns for businesses. With COVID-19, boards will be further

required to explore how they respond to a “new normal” by putting the right strategy and frameworks in place.

Employment can also be a key area of concern: For example, furloughs have been options for companies but this does not necessarily mean they are the best from ’ perspectives. On the one hand, these measures may also affect societal support for, or confidence in the business. On the other hand, businesses may be placed under additional pressure where they have accepted government funding in the pandemic.

In addition, the pandemic has posed a threat to the board’s responsibility on a more practical level. There have been several challenges presented by COVID-19 that could impact companies’ ability to complete the financial reporting process in a timely manner. In turn, that can lead to significant challenges for listed companies and their ability to ensure proper and timely to the . At the same time, auditors experienced certain challenges gaining access to inventory counts or even to company personnel to conduct audit procedures. In addition, liquidity and cash- flow problems, supply chain disruptions and the general collapse in demand should signal to that we may see an increase in company failures over the to medium term.

In order to respond to these challenges, it is of crucial importance for the board to have a comprehensive and inclusive view. Also, directors should consider the impact of their decisions on the company’s long-term prospects. In order for directors to respond to the ongoing challenges of balancing short-term imperatives with longer-term priorities, appropriate care of the reputational risks as well as an effective communication with company’s relevant stakeholders is essential. At a later date, the board may well have to prove due consideration of decisions made today.

Many jurisdictions already define directors’ duties to go beyond the primacy1. This approach has been further supported by best practices developed worldwide: On the one hand, corporate governance codes and principles are embracing the sustainability principles, recommending the board to promote the sustainable success of its business activity with due consideration of its stakeholders. On the other hand, business is reacting with a further development of these principles in light of the COVID-19 challenges for companies, its shareholders and its stakeholders2.

2. ERM to ensure business as a going concern – why it matters

One basic principle of business is the assumption of “going concern.” The problem with the impact of the COVID-19 outbreak on the financial statements is that it is not homogeneous - as it depends on a number of factors such as the firms’ size and sector, supply chains and the markets

1 With reference to EU jurisdictions, see Roe et alii, Response to the European Commission’s call for feedback on its Sustainable Corporate Governance Initiative, 2020, p. 9. 2 World Economic Forum, Stakeholder Principles in the Covid19 era, 2020.

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in which they operate. In this light, some negative economic effects are emerging with respect to different situations, such as the decrease of revenues due to lower or absent demand in some markets in which companies operate, downturns or interruption of business activity in companies’ supply chains, or temporary difficulty accessing bank or market financing.

Considering the timing of the COVID-19 outbreak, these issues seem not to have impacted the 2019 , as they emerged in the 2020 financial year, but they were relevant in the drafting of explanatory notes. To this end, companies have faced the challenge to provide adequate qualitative information on the possible economic effects for business activity from the spread of the outbreak, while quantitative information was very difficult to estimate due to the general unpredictability of the facts and uncertainties in the development of the pandemic3. As the sanitary crisis does not seem to recede and many economies meet a “second wave” which looks to be as severe as the first, the difficulty in foreseeing the impact of COVID-19 on companies’ business affects ongoing information, making it challenging for listed companies to ensure the proper and timely delivery of information to the market.

From a wider perspective, COVID-19 is an issue of concern to many companies’ stakeholders, in the short and long run. If companies go out of business, there can be a substantial adverse impact on its employees, capital providers, customers, and suppliers. This is especially true when faced with a global issue such as COVID-19 because business failure poses additional, often serious threats to other stakeholders, for example, supply chain disruptions. Therefore, one of the top priorities for companies in re-establishing their ERM programs is to increase resilience and ensure their own survival, bearing in mind that this protects the interest of other stakeholders and society, too.

Of course, ensuring survival is not the only objective of ERM. As the 2017 COSO-ERM framework states, ERM includes “the culture, capabilities, and practices, integrated with strategy-setting and performance, that rely on to manage risk in creating, preserving, and realizing value.”

Therefore, companies should revisit each of these aspects of risk from the pandemic now, as the board tries to look beyond the ongoing crisis. This may require wider and more frequent communication between the board and management on a range of different issues. For example, the board may wish to call on the to understand how COVID-19 has changed employees’ attitude toward teleworking. By the same token, the will need to

3 E.g. ESMA Recommendation on 11 March 2020 calling upon issuers to “issuers should provide transparency on the actual and potential impacts of COVID-19, to the extent possible based on both a qualitative and quantitative assessment on their business activities, financial situation and economic performance in their 2019 year-end financial report if these have not yet been finalized or otherwise in their interim financial reporting disclosures”.

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report to the board about a new business continuity plan that takes into account the impact of the next pandemic, ranging from employee safety to customer credit .

The COVID-19 pandemic has revealed operational risks in unanticipated ways. Even though many companies had prepared a business continuity plan, they did not always work as effectively as intended4. On the other hand, new technology such as online meeting platforms has helped companies keep their core functions alive through the lockdown periods.

Boards need to reassess both the threats and opportunities when they start discussions to update ERM. They must question their own competencies for handling new issues, and consider whether board composition structure remains fit for purpose. To deal appropriately with the urgency of COVID 19 related issues, boards should also reach out to outside expertise, particularly if their capacity is not sufficiently represented in the existing board.

3. Policy instruments to support corporate governance and sustainability The issue of corporate governance and sustainability is a major item on the agenda for a more resilient economic recovery, which will surely interest policymakers, too. We propose the following policy recommendations to support business in improving the quality of corporate governance in the post COVID-19 era, not only for the benefit of our economies but also for increased trust in business and government.

(1) Promote implementation of pandemic-resistant business continuity plans Companies need to develop business continuity plans (BCP) that respond to the unique nature of this crisis. These plans need to be inclusive and responsible: the post-pandemic BCPs need to consider the whole process of the pandemic, from the immediate response to the outbreak (or outbreaks if they become a recurrent hazard) to smooth return to work. At the same time, businesses should focus on the human element and take the safety and well-being of employees and their families into consideration. Our recommendation: The OECD should engage in research on effective business continuity plans that increase resilience to emerging risks such as pandemics. The OECD can propose measures to incentivize companies, including SMEs, to build more resilient ERM taking into account capacity constraints with regard to their size and level of organizational complexity.

(2) Assist implementation of digital tools that support corporate governance Many companies quickly innovated to respond to the crisis. For example, in many jurisdictions, companies have shifted to virtual AGMs in order to minimize the risk of infection while ensuing

4 The EY global board risk survey of 500 board directors and CEOs conducted in late 2019 revealed that only 40% said their enterprise risk management (ERM) was effective in managing atypical and emerging risks.

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shareholders’ rights to vote. Regulators’ and companies’ timely reaction to the pandemic during the 2020 AGM season has been a true bench test, which proved that adequate tools and companies’ proactive stance to face shareholders’ demands enable efficient shareholders’ attendance and participation the general meetings. In order to further develop the use of technological means in this field, rules and practices could be better developed in order to facilitate virtual meetings also after the pandemic. In this light, companies should consider the opportunities offered by technology to develop better dialogue with shareholders, paying adequate attention also to data privacy and security issues. The issue of cyber resilience is therefore an important aspect that needs to be addressed. Our recommendation: The OECD should explore what lessons can be learned from the digital shift of companies by taking stock of how companies responded and what technologies were most effective in running the meeting. What measures will last also after the COVID-19 outbreak and could serve “ordinary business” better?

(3) Allow flexibility in regulatory requirements during the pandemic response period Since the beginning of the COVID-19 pandemic, businesses have been affected by restrictions on travel and requirements to stay at home. For example, while many listed companies implemented virtual AGMs as a stop-gap measure, questions linger as to how to ensure shareholder rights and observe the existing rules on AGMs. In auditing, practical and technical challenges remain: in addition to the inability to physically access audit locations to undertake audit procedures such as inventory counts, and to obtain source documents, there are also legal restrictions in some countries, which limit the transfer of data (including audit working papers) outside the particular jurisdiction. We call on the OECD to help policymakers find solutions to these problems. Our recommendation: Take stock of the real-world examples of the COVID-19 responses and draw common approaches that can be implemented in case of the resurgence of the pandemic.

(4) Supporting companies to improve resilience and their capacity to access market financing During the first few weeks of the COVID-19 pandemic, we saw many companies struggle to secure liquidity to meet their immediate cash needs. For companies to ensure their survival when the next waves hit, it is important to foster a supportive environment for companies to establish certain degree of extra liquidity. During the first semester of 2020, many companies faced the challenge of quickly accessing capital markets. Some jurisdictions introduced temporary measures which helped alleviate some regulatory burdens, for example, the time and the competence needed for the decision to increase capital as well as limitation of pre-emption rights. Our recommendation: The OECD should call on governments to provide favorable policies such as incentives and/or temporary subsidies for companies, in particular SMEs, when they reserve funds to meet immediate cash needs in case of a pandemic or other global disruptions. As to the

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access to market financing, the OECD could assess the effectiveness of temporary measures adopted in some OECD countries and the opportunity to develop policy guidelines that can help national jurisdictions to permanently overcome regulatory burdens to access capital markets.

(5) Implement policy guidelines to facilitate smooth transformation of business As businesses face the resurgence of the virus or prepare for it, they may choose to restructure. Restructuring may involve redundancies, requirements to take holiday leave, asset sales, reductions in investment, negotiations with landlords, creditors, suppliers and other initiatives. As companies transform, they may come across new challenges. Business needs policy tools to improve their resilience without conflicting with existing . Our recommendation: The OECD can track the regulatory obstacles to improving business resilience. At the same time, the OECD can provide an overview of policies at the company level, including how boards consider broader sets of stakeholders in company decision-making, and how they operate in times of stress.

(6) Coordinate policy measures aimed at incentivizing companies’ sustainability Policy makers of many countries and regions are considering the adoption of measures in the area of corporate governance and company law to ensure a stronger consideration of sustainability issues. While those measures can play a positive role in incentivizing and supporting companies’ efforts in this direction, they must be carefully managed to avoid unintended consequences on companies’ ability to create value and on global competition. Our recommendation: The OECD, as the international standard setter in corporate governance, can develop analysis on current practices in capital markets and corporate governance that may affect the time horizon of companies’ decision-making and their attitude to duly consider stakeholders’ interests. On this basis, the OECD can provide guideline to ensure policy measures are consistent and coordinated.

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