Are Boards Responsible for Corporate Culture?

Introduction?

Do directors have a responsibility over corporate culture in Australia? While it’s not explicitly mandated as a legal responsibility as per the letter of the law, we can look to various legal frameworks, precedence set in case law, regulatory standards and industry practices that implicitly appoints directors as being responsible, even potentially liable for corporate culture. This article will outline the significance of this question, define key terms and key concepts such as the importance of ethical leadership and the challenges in governing corporate culture. It will also consider the findings identified in the Royal Commission into Misconduct in the Banking, Superannuation, and Financial Services Industry, commonly known as the Banking Royal Commission (BRC), as well as consider how directors may be sanctioned should the interests of a company be damaged as a result of poor culture. In addition to this, some of the subtopics covered include the risks of holding directors liable for culture, when directors may be considered responsible or even liable, benefits of ethical leadership at the board level and well as the challenges in monitoring and measuring corporate culture.?

Significance of the Question?

The BRC findings demonstrate poor corporate culture, lack of oversight from boards and poor regulatory enforcement as being some of the root causes for a failure in governance across the industry; hence the significance of this question fundamentally comes down to the desired outcome, which is preventing the damage caused by organisational misconduct, which generally stems from poor corporate culture. This begs the question, would an increased focus on governance and ethical leadership prevent similar incidents again from happening in the future???

Key Terms?

For us to understand the question, we need to define some key terms.?

Corporate Culture?

Corporate Culture has many definitions; however, it is fundamentally the shared values and norms amongst employees that becomes the identity of the organisation. It sets the rules on what behaviours are rewarded, and what behaviours are punished.??

Ethical Leadership?

Similarly to Corporate Culture, Ethical Leadership has multiple definitions, however De Hoogh & Den Hartog’s explain it best and very simply as “the process of influencing the activities of a group toward goal achievement in a socially responsible way”.

Key Concepts?

Importance of Corporate Culture and Ethical Leadership?

Why is Corporate Culture and Ethical Leadership Important? If an organisation has a poor corporate culture, examples of misconduct will be more common than those with a positive corporate culture. As such, considering it takes influence to shape culture, and considering the board of directors is one of the most influential groups in an organisation, it would make sense that shaping corporate culture is a director’s responsibility, as they are in a position to visibly demonstrate ethical leadership and implement controls to shape culture.?

Underlying Problems in Banking Royal Commission?

If we consider examples of poor corporate culture in the BRC, we can draw out several root causes for misconduct, being a lack of accountability amongst the board and senior executives, tolerance for unethical behaviour such as customer deception, lack of oversight by the board, and the pursuit of short-term profits over long term sustainable success and compliance.?

Challenges in Governing?

It is argued that directors should be accountable for corporate culture as part of their broader governance duties, particularly in light of its identification as a key cause for misconduct in the Banking Royal Commission. Some suggest that making directors liable for this would encourage director advocation for fostering positive corporate cultures, while others argue that holding directors liable would result in the resignation of many experienced and skilful directors from boards, as the personal risk would be too high, should they be held liable for the misconduct of others. There is also a significant challenge in determining how to assess and oversee corporate culture, given the absence of universally agreed-upon, objective metrics. Moreover, corporate culture is influenced by various factors, some of which may be beyond the directors' control or awareness.?

Relevant Materials??

Legislation?

Inference in Legislation?

Looking at relevant areas of the Corporations Act, there are two predominant sections that suggest implicitly that directors are liable for corporate culture, namely s180 which covers duty of care and diligence; and s181 which covers the duty to act in good faith in the best interests of the corporation. Having a positive corporate culture is usually crucial to achieving the highest levels of organisational success as indicated in a number of management studies, hence it can be argued that overseeing and fostering a positive culture is an act of care and diligence and acting in the best interests of the organisation. Because of this, although the letter of the law does not outline corporate culture directly as a director’s responsibility, these two sections are the ones that implicitly assigns this responsibility and could also mean that directors are liable.?

This highlights the need for directors to shape corporate culture in light of corporate governance failures uncovered in the BRC and the importance of considering what sanctions may be applicable to directors for not fulfilling their responsibilities. It is also important to note that the wording of s180 of the Corporations Act 2001 uses the wording “(1) if they: (a) were a director or officer of a corporation in the corporation’s circumstances”, which is fairly ambiguous in terms of the contexts in which this responsibility comes into effect and allows for “best practices” and other frameworks such as ASX CGPR to come into consideration.?

Leading by Example?

In addition to these two sections, there are three other sections relating to the subject of corporate culture, being s191 which covers the duty to avoid conflicts of interest, s182 which outlines the duty to use the position properly and s183 which is the duty not to make improper use of information. Although these sections do not implicitly suggest that directors are responsible for corporate culture, it is important to consider the context of why directors would be responsible for corporate culture. As previously mentioned, if we consider the role of a director, it is very much one of the most influential roles within the organisation, wielding with it the highest degree of authority. As such compliance with s191, s182 and s183 is a good demonstration of ethical leadership. The additional three sections of the Corporations Act mentioned, while not being specifically relating to a director’s responsibility over corporate culture, set the legal expectation that director’s conduct themselves in an ethical way. Compliance against these duties become an observable example of what it means to lead ethically, which can be used as an instrument in shaping a good culture throughout an organisation.??

Case Law?

Looking at relevant areas of general or case law there are several that are relating to director’s duties and corporate culture.??

Example of Director Being Held Liable?

If we consider ASIC v. Adler (2002) ASIC pressed charges against Rodney Adler who was a director of HIH Insurance for failing to fulfil his director duties, namely, to act with a duty of care and diligence. Adler and other directors failed to execute appropriate oversight on the financial position of the organisation, while Adler was also involved in misleading conduct and also working for his own self-interest as opposed to that of the company. While his actions were as an individual in the context of corporate culture, his actions as a director set an example to others on what the acceptable norms were in the organisation, which in this case was deception and self-interest above the company’s interest. While the Adler case did not set any new rules, it is one of the prominent cases where a director has been charged for failing to fulfil their director duties and serves as an example of how the actions of a director can taint and contribute to a poor corporate culture.?

Banking Royal Commission?

In the cases against the big banks following the BRC, various themes were identified including poor culture with tolerances for misconduct, lack of board oversight and corporate governance, the need for a regulatory body such as ASIC to hold corporations accountable, and the reputational damage faced by the institutions involved. Findings from the BRC indicate that boards are responsible for corporate culture, thus directors should be held accountable for fostering an ethical, legal and compliant culture to protect the interests of stakeholders.?

Industry Practice?

The Australian Securities Exchange (ASX) developed the Corporate Governance Principles and Recommendations (CGPRs) which interestingly under Listing Rule 4.10.3 requires listed entities to benchmark their corporate governance practices against these principles and recommendations. While it is not required for listed companies to adopt the CGPRs, they do need to provide explanations on why they have deviated from these standards if they have chosen to do so. What this means is that listed organisations do not have an obligation or mandate to comply with the CGPRs however, the benchmark has been set to encourage investor confidence and require companies to at least think about why they are or are not complying with these industry standards.??

There are a few of the eight principles that are relevant to a director’s responsibility over corporate culture which is Principle 3, 7 & 8, but most specifically Principle 3, which is to “instil a culture of acting lawfully, ethically and responsibly”. As mentioned, organisations are not legally required to adopt these principles, however the value in this principle, is that it at least provides a baseline of what a desired culture looks like from a corporate governance point of view, which is one that acts lawfully, ethically, and responsibly…??

In addition to Principle 3, Principle 7 & 8, “recognise and manage risk” and “remunerate fairly and responsibly” also suggests responsibility over culture and avenues for how the board may go about managing culture. In terms of Principle 7, the risk of misconduct, reputational damage, technology misuse and many other risks should be managed and monitored by the risk committee based on the severity of the risk and the organisations risk appetite. While this is not the silver bullet for getting boards to manage the culture of an organisation, in the event where a risk severity goes beyond the organisations risk appetite, and the decision is to mitigate or avoid the risk, then the board and risk committee are in a sense shaping culture through risk management.??

Now in relation to Principle 8, this is a compelling way for the board to manage culture, that is through remuneration. Remuneration sends a powerful message through an organisation about the values and priorities of the board. A well ran organisation will generally have goal alignment through the different levels of the organisation, that is to say in the context of remuneration, if an executive receives a bonus based on “goal A”, this executive will set goals and key performance indicators (KPIs) that are aligned with “goal A” amongst their direct reports, and their direct reports’ direct reports. What this means, is that if the board and remuneration committee prioritize ethical, long term and sustainable goals tied to executive remuneration, one can expect to see ethical, long term and sustainable behaviour. On the flip side, if an organisation remunerates solely on short term, unsustainable financial targets, then one can expect to see short term, unsustainable behaviour. Based on this, it important for a board to incorporate a range of KPIs that balance out financial targets, with long term, sustainable and ethical targets.???

Understanding the ASX principles is important when assessing accountability for corporate culture within a board, especially in light of the BRC where these three principles can be used to scrutinize the effectiveness of the involved financial institutions’ corporate governance controls.?

Problems & Issues??

What Are the Risks of Holding Directors Liable??

We need to clarify the difference between responsibility and liability, which is to say that responsibility would be where a director is answerable for their actions on a social, moral or ethical standard while liability would be where a director has legal obligations and consequences for their actions… At the moment, the common viewpoint shared by those such as corporate governance scholar Pamela Hanrahan is that directors are not liable for corporate culture, however they do hold some responsibility. There is a reluctance for holding directors liable for corporate culture, as any additions to that already outlined in the Director’s Duties of the Corporations Act, has a risk of overstepping resulting in directorship becoming undesirable causing a reduction of experienced and skilled directors available to sit on boards. The individual legal risks and consequences of being a director may cause individuals to say, “it is not worth it”.??

The ramifications for a withdrawal of skilled directors from boards due to the legal risks would likely result in a reduction in board effectiveness as board positions would either sit vacant or be filled with less skilled individuals who do not have the same ability or experience to effectively implement and maintain effect corporate governance controls. While it is reasonable to expect at a minimum that directors fulfil their Directors Duties outlined in the Corporations Act and perhaps adhere to the ASX CGPRs, going beyond this, transferring company liability to director liability, may cause more damage than that mitigated, hence any change to liability should be thoughtfully considered before implemented.?

Who Should Have Legal Obligations??

There would be catastrophic damage to the country if our banks were to fail, especially since they operate in an oligopolistic market. As such, industries such as finance need stricter governance controls and regulatory oversight to ensure the community continues to have faith in its financial institutions. Governance and regulatory compliance for large, publicly listed banks are and should be vastly different to that of, for example, a small takeaway chain. This is the reason why we have additional regulatory bodies such as Australian Prudential Regulation Authority (APRA) to monitor our financial industry. As such, the argument here, is that it is not fair for all boards to have the same responsibilities as boards of publicly listed financial institutions, as the cost of compliance would be an additional overhead for all organisations and would negatively impact productivity and innovation.??

It does make sense though, and is the case today that if a director is grossly negligent in their duties as a director, going back to s180 and s181 of the Corporations Act, that they are liable for these failings which was seen in the case of ASIC v. Adler… It is reasonable that if a director knows the culture of the corporation is one that tolerates misconduct and is unwilling to setup some method of measuring or managing culture, that this is viewed as not acting with care or in the best interests of the organisation, especially if the director is encouraging or condoning the poor corporate culture. In examples such as this where there has been a clear breach of fiduciary duty, it is reasonable that the offending director faces fines and loss of directorship as sanctions for non-compliance, seen in ASIC v. Adler.?This emphasises the need to explore the cross overs between law, governance practices and director accountability.

What are the Benefits of Ethical Leadership at the Board Level??

There is an ethical necessity to build and maintain a positive corporate culture, not to mention befits for the organisation. Considering the level of influence directors have within an organisation, one of the key reasons that can justify a director as being responsible for culture include their unique position to showcase ethical leadership. The demonstrations of ethical leadership showcase to the organisation that acting honestly and with integrity is valued within the organisation. This level of leadership fosters a good culture which in turn reduces the likelihood of misconduct, while increasing staff retention and productivity, considering that studies link high performance with positive culture and staff value alignment.?

In essence, showcasing ethical leadership at the board level is good for the people and organisation at large. It can lead to an increased in productivity and staff retention as well as prevent reputational harm and regulatory backlash such as that seen in the Banking Royal Commission. Demonstrating ethical leadership is acting with a duty of care and diligence while working in the best interests of the organization.??

What are the Challenges in Monitoring and Measuring Corporate Culture??

There are three key questions when it comes to monitoring and measuring which is what, how and why. What would be an effective metric to measure, how are we going measure this metric, and why should we measure this specific metric. It is not entirely clear on what metrics reflect a positive corporate culture, although there is some speculation on leading indicators. In terms of how we measure this, some of the indicators may be more subjective and qualitative as opposed to objective and quantitative. This also gives rise to the question of why we should be trying to monitor or measure corporate culture, as culture is developed from an array of factors, including but not limited to hiring practices, political influences, social norms, demographics, and management teams which may not be visible or manageable by the board. In addition to this, as also argued in some studies, culture is not led from the top, but from within the organisation at different levels. Many workplaces have cultural champions who are looked to as an example of what it means to be effective or successful in an organisation. The cultural champions could even have different opinions and values to those of the board and executive, subsequently driving a counterculture which works and competes against the board’s desired outcomes. Because of this, it would be prudent for directors and executives to work collaboratively with these cultural champions when developing or maintaining a desired corporate culture within the organisation.??

Irrespective of this, should an organisation wish to monitor and measure corporate culture, some of the metrics could include trending examples of misconduct in the organisation, regulatory compliance or scoring, staff retention and satisfaction as well as customer satisfaction. Whatever it is, it needs to be aligned with executive key performance indicators and subsequently executive remuneration as remuneration is a strong incentive for driving behaviour and subsequently culture. An example of this may be a shared responsibility amongst the executive team for different sets of metrics that are correlated with culture… A sales team, although primarily focussed on sales metrics, could also have other performance indicators that require sales targets to be achieved through sustainable and ethical ways… some of these “balancing” metrics could include process adoption and customer satisfaction scoring, where failure to meet these metrics could result in penalties on overall remuneration.?

Monitoring and measuring corporate culture is complex and goes beyond simply collecting data. It requires intimate knowledge of the organisational dynamics, and while metrics such as misconduct and regulatory compliance offer insights, the correlation between this and corporate culture is fairly subjective and may not capture or portray the true state of the company’s culture. Because of this, organisations seeking to monitor and manage corporate culture may need to consider qualitative indictors and the cultural influencers within the organisation to gain a more complete understanding of state of the organisation’s culture. In addition to this, by aligning performance and remuneration with organizational values, boards can contribute to developing a healthier corporate culture and mitigate the risk of governance failures.

Conclusion?

It becomes evident that directors are responsible for corporate culture. This aligns with their duty of care, diligence and to act within the best interests of the organisation as stipulated in s180 and s181 of the Corporations Act. In addition to this, the ASX advocates the nurturing of a positive culture, characterizing positive culture as one that acts lawfully, ethically, and responsibly which reinforces the argument that directors are responsible for culture. Beyond legality, there is an ethical imperative for boards to oversee and promote a culture that acts in the best interests of the company and its stakeholders. Organisations must also navigate through the complexities of monitoring and reporting on culture, as well as select appropriate metrics for reporting and align remuneration with their desired cultural outcomes. While directors are responsible for culture, liability relies on proving gross negligence under section 180 and 181 of the Corporations Act and potentially instances of criminal activity driven by self-interest.??

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