All articles in Volume 12 Issue 3

US model has pros and cons for Australian NFPs

The government may need to plug several shortfalls if it adopts a model based on Charity Navigator in the US to evaluate Australia’s charities.

At a recent Australian Institute of Company Directors lunch in Melbourne, Minister for Social Services, Kevin Andrews, said the government was considering a range of models to evaluate charities, including one based on the US-based not-for-profit (NFP) group Charity Navigator. At the same time, he confirmed plans to abolish the Australian Charities and Not-for-profits Commission (ACNC).

He said he was attracted to the Charity Navigator model, a voluntary model that is operated by the private sector and works via moral persuasion rather than government intervention.

Founded in 2001, it has become the US's largest and most-utilised evaluator of charities with its website attracting almost five million visits by donors last year.

It accepts no funding from the more than 7,000 charities it evaluates and does not charge its users either.

Aimed at helping US philanthropists to make informed giving and social investment decisions, Charity Navigator has developed a numbers-based rating system which examines two broad areas of a charity's performance: its financial health and its accountability and transparency.

Andrew Thomas, general manager of philanthropy at Perpetual, says both are good measures and should be encouraged in the sector. “The first will capture some information on the efficiency of the organisation and the second will look to the governance of the organisation.”

However, he adds: “Neither address the effectiveness of the outcomes of the organisation - which is the key issue. Who will be better off, how will they be better off and when will they be better off? How does the community really benefit?

“Now overlay a long term societal issue, such as addressing education in a disadvantaged community, or addressing homelessness, or finding a vaccine. These things don't happen in a single year and don't happen simply due to strong financial health or good governance alone.

“There may be people that think that deep rooted community issues can be solved according to a rating, but where is the rating of organisational leadership or a rating of the organisation's appetite to take risks to address these issues?

How does the organisation's approach solve the issue in a sustainable manner?

“Neither Charity Navigator nor the ACNC Annual Information Statements will necessarily provide the key information to understand how your donation will lead to long-term community outcomes. Both provide some good assistance, but let’s not simplify the challenges of the sector to such a binary level. To think that one rating scale can do so across the breadth of medical research, education, arts, environment, health, social welfare, and international development is far too simplistic.

“The relevant question might be whether the use of Charity Navigator or another ratings tool would replace the public reporting being proposed by ACNC. Ultimately both would provide a step forward, but neither is truly a full solution.

The other relevant question is: how much would each cost and is there a better use of that money?”

Anne Robinson, principal of Prolegis Lawyers, says the Charity Navigator model has several positive features, including:

  • It is independent and not funded by government.
  • It increases the information about charities that is available to the public, so that the public may make informed donor choices.
  • It provides opinion pieces (articles and two blog sites), donation tips and top-10 and bottom-10 lists that rank efficient and inefficient organisations in a number of categories.
  • The service is free and the site is navigable by charity name, location or type of activity. The site has received considerable positive feedback for its user-friendliness.

But Robinson also points out some negatives:

  • There are real questions regarding whether it is able to provide meaningful guidance to donors – see The Ratings Game: Evaluating the three groups that rate the charities, published by Stanford Social Innovation Review (2005)
  • It is a league table system, which establishes lists of charities and reports that make judgements about which charities are operated efficiently and effectively and which are not. These are made at a superficial level, do not consider the context in which charities operate and make the judgements based on its definition of what is efficient and effective.
  • The analysis is based exclusively on financial analysis derived from only one year of financial data (Form 990). One year’s data can materially change a charity’s rating. This may lead charities to try to manage reputational risk in meeting the Charity Navigator’s financial criteria, rather than focusing on their purposes.
  • There are concerns about the accuracy and reliability of Form 990 data and financial data is vulnerable to manipulation.
  • The ratings system is overly simplistic (five stars system) and does not provide any information about program effectiveness.
  • It overly focuses on “overheads” rather than effectiveness.
  • It depends on the collection of data and significant analysis of data (especially as it tries to move towards evaluating the effectiveness of charities) – it will not reduce red tape.
  • It does not evaluate all charities – for example, it does not evaluate private foundations or many religious organisations exempt under the Internal Revenue Code from filing Form 990 returns as it does not have sufficient data to evaluate their financial health.
  • Because its goal is to help individual givers, it only evaluates those charities that depend on support from individual givers. Specifically, it requires public support to be more than $500,000 and total revenue to be over $1 million in the most recent fiscal year. It excludes charities that report $0 in fundraising expenses, as it is interested only in charities that actively solicit donations from the general public. It does not review charities that receive most of their funding from government grants or from the fees they charge for their programs and services.
  • It requires seven years of Form 990 data to complete an evaluation.
  • While it uses categories of causes, difficulties remain in comparing charities and ensuring that it is comparing like with like.


A busy year ahead for nomination and remuneration committees

2014 will be another challenging year for board nomination and remuneration committees as they gear up for pay increases, heightened company takeover activity and possible initial public offerings (IPOs) and changes to government regulation.

Michael Robinson, a director at Guerdon Associates, predicts a moderate three per cent rise in median non-executive director (NED) fees this year, despite higher inflation, supply pressures to meet diversity targets and a shortage of qualified independent directors for planned IPOs. This will follow a 2.2 per cent rise in 2013.

However, he says if government proposals for more independent directors in larger super funds are implemented, the search for and placement of suitably qualified independent directors, plus additional disclosure requirements on pay imposed in 2013, will see pressure on director fees in this industry.

“Expect fee rates to increase much more than four per cent, and the rate of increase to be highly variable across funds well into 2015 and perhaps beyond,” he says.

Robinson also forecasts a rise in executive pay in 2014, particularly in the latter half as the economy picks up, with an expected median fixed pay increase of five per cent.

However, he also expects this to vary widely across industries and companies.

With a rush of IPOs expected this year, he says IPO companies need to shore up their executive remuneration practices.

“We are constantly amazed that so many prospective IPO companies miss an opportunity to provide investors with assurance that the management team is going to stay on to see through a transition to a public company and will not take the money and run as soon as their IPO stock comes out of escrow.

“If you are appointed to the board of a prospective IPO company, consider developing and disclosing in the prospectus a remuneration framework that does not leave an incentive gap between stock coming out of escrow and a performance-contingent long-term equity plan. There should be some overlap so that management retains ‘skin in the game’ at all times.

“With many IPOs likely to qualify for ASX-300 status shortly after listing, ensure an ongoing remuneration framework that does not get you into trouble with institutional investors at the first remuneration report vote. There are too many activist hedge funds seeking opportunities to short sell recent IPO stocks that may face ‘governance’ issues. Deny them an opportunity by ensuring an executive remuneration framework aligned with investor interests that extend beyond the prospectus’ forecasts.”

Robinson adds that in a year of heightened company takeover activity, it may also be circumspect for companies to review change in control provisions.

“Be particularly wary of equity that could vest on the smell of a merger or acquisition. There have been instances of this in the past whereby a merger or acquisition did not eventually take place, but equity vested to executives in full. Retain discretion to consider all factors and decide the timing and extent of any vesting in relation to changes in control.”

Robinson says nomination and remuneration committees should also be prepared for changes to government regulation.

“Already the new federal government has recognised the damage that the 2009 changes to employee share scheme taxation have done in limiting new venture start-ups. Therefore it is reasonably likely that some changes will be made. However, it is also reasonably likely that the changes will be applicable to riskier, potentially high growth companies, rather than established ASX-200 companies. Therefore, if as a director you are engaged in more entrepreneurial and speculative ventures, maintain a watch on the opportunities this may provide in pushing along your start-up plans and hiring those skilled people the business needs with stock options or similar.”

However, Robinson adds: “It is also clear that the two strikes rule has had mixed results. While, to the surprise of many, the resulting engagement between directors and investors on executive pay matters has had mutually beneficial outcomes for the ASX-300 companies with institutional investors, it has clearly been misapplied by some shareholders for matters other than executive and director pay, especially for smaller companies. So, while it needs review, there are no signs of this yet from the Abbott government.”


Start-ups welcome a review of Employee Share Schemes

The government’s review of the laws on employee share schemes (ESSs) is a welcome move which could give entrepreneurial and technology start-ups a boost in the global war for talent and investor capital.

The date for submissions to the Coalition government’s consultation paper on ESS arrangements for start-ups closed on 7 February 2014.

This review follows a similar process started by the previous Labor government back in August 2013. It was put on hold following the election in September and subsequent change of government.

Clayton Utz partners Mark Friezer notes: “Employee options arrangements are fundamental in remuneration structuring for start-ups, particularly in the technology sector. Typically, these companies do not have the cash-flow to reward employees by conventional salary or cash bonuses. The granting of an option is a cost-effective way of attracting and incentivising talent.”

Like many others, he says new employee share plan tax rules which came into play in 2009 have created significant problems, particularly for start-ups.

“Previously, the ‘discount’ on share options was only taxed when an option was exercised. The new rules accelerated the taxing time to the point at which the options vest. This means that if an employee is granted an option, that employee needs to include the market value of the option in assessable income in the year that it is granted, unless the option is subject to forfeiture. The problem with this scenario is that the tax liability accrues even though the employee hasn't realised any economic value for the option,” Friezer says.

Chris Beare, chairman and general partner of Accede Capital Venture Partners and a director of Info Technology, believes that ESSs are vital to start-ups. “ESSs promote employee ownership,” he says. “It's more than just being a part of the remuneration package. It's being part of the company. This makes a big difference to the culture of a start-up. People are prepared to work harder and take more risk when it's their company and not just a job. An ESS isn't just a means of saving cash by paying people less; it's the motivational aspect of sharing ownership in the company.”

Similarly, Darius Coveney, chief operating officer of IPscape, observes: "Having worked with a number of high growth businesses, both here and in the UK, I believe the current ESS rules here in Australia are hindering local growth. The rules add administrative overhead and cost, and leave our offshore competitors much better able to compete for global IT talent - talent that, in a lot of cases today, doesn't even need to leave home in order to change global employer. If we can stop talking about this change, and follow our global friends in simplifying the rules and the administration of ESSs, we can go a long way to helping the already growing base of Aussie companies building competitive global businesses."

In its submission in response to the government’s discussion paper, the Australian Association of Angel Investors notes that the current legislation is based on a fundamentally flawed premise that equity and cash are interchangeable in the hands of the employee.

“That can be considered true for less than two per cent of all Australian companies and not at all true for the more than 96 per cent of companies that the Australian Bureau of Statistics identifies as small businesses. For the vast majority of Australian companies, the treatment of equity awarded to an employee as taxable personal income in the year that it is awarded is a crippling inhibition.

“The purpose of an ESS is to align the interests of a company, its shareholders and its employees/directors towards the longer term success of the business. By sharing the risk in the equity all parties expect to realise substantial financial revenue in the future.”

In a submission from the Innovation Centre Sunshine Coast, CEO Mark Paddenburg, says: “The Australian taxation system has become overly complicated and the ESS legislation is another clear example of just how non-competitive our start-up ecosystem has become when you benchmark with the OECD (and in particular with the best - the US, Canada and Israel). I believe the ESS, in its current format, should be abolished… To be globally successful, secure the right team and scale quickly, most start-up founders will need to augment the reward for effort with shares or options that mean something and represent tangible value to the recipient. Currently, employees are required to pay income tax in the year the blue sky equity is acquired, rather than on disposal (or a CGT event).

“Start-ups have enormous pressure on their early stage finances. Many of our members confirm that having an effective ESS can be a very useful tool that start-ups should be utilising (as is the case in most of the markets that our start-ups compete with).

“Additionally, Australia has a limited angel/venture capital market making it challenging to fund start-ups here. Having an effective ESS (and also a pragmatic crowd funding regime) can help mitigate start-up risk and encourage jobs growth. I believe if we continue to disadvantage Australian start-ups, we will continue to drive innovation offshore.”

“One thing that everyone seems to agree on is that ESSs are broken under current legislation, but it’s now time we moved beyond the problem to helping government formulate a solution,” says Damien Tampling, technology, media and telecommunications partner at Deloitte. To assist in this process, Deloitte has launched a new website, www.retainingtalent.com.au, where it asks for further input on the issue.


What's on ASIC's radar

The enforcement efforts of Australian Securities and Investments Commission (ASIC) will soon be expanded to include loan fraud, false accounting and takeovers and shareholder disclosure, Commissioner Greg Tanzer warns.

The corporate watchdog will also continue to focus on cracking down on misleading advertising of products and services advertising, he says.

In particular, ASIC will be monitoring the comparisons of products, where differences in the products may make comparisons misleading; and in the description and labelling of structured and other complex products, especially where there are claims of capital protection.

ASIC's fifth six-monthly enforcement report reveals that ASIC achieved 340 enforcement outcomes between 1 July and 31 December 2013. This included criminal as well as civil and administrative (for example, a banning or disqualification) actions and negotiated outcomes, including enforceable undertakings (EUs).

112 outcomes were achieved in the market integrity, corporate governance and financial services areas, and 228 in the small business area.

“ASIC’s crackdown on brokers submitting fraudulent loan applications and similar behaviour has seen several individuals criminally charged or banned. We currently have more than 20 investigations underway involving falsification of loan documents and loan applications,” says Tanzer.

In addition to misleading advertising, ASIC also focused on market misconduct, including insider trading, and the responsibility of gatekeepers.

Looking ahead, ASIC plans to continue to take action to remove “bad apples” from the financial services industry. It will be placing increased attention on the conduct of Australian financial services (AFS) licensees that fail to detect, prevent or deter poor compliance practices by employees or authorised representatives, where this enables improper practices to occur.

ASIC is also focusing on breaches of takeovers laws and failure by shareholders to disclose their interests in shares.

Examples of this conduct may include an entity acquiring a controlling stake in a listed company other than in an authorised manner (such as a formal takeover bid) or a person holding a substantial interest in shares in a listed company through offshore entities and not disclosing these interests to the market.

Another area of heightened focus will be false accounting, particularly in the current economic climate. “In a market where investors are seeking high-yield investments, the temptation to exaggerate profits or disguise losses is substantial. During recent investigations, ASIC has uncovered several instances of false accounting that have resulted in the misstatement of company financials, in the process providing short term gains to company officers who have engaged in such conduct,” says ASIC in its enforcement report.

For the last six months some of ASIC's more notable outcomes included:

  • Mr Rental Port Augusta released Indigenous consumers from their rental contracts following ASIC surveillance. ASIC took action in this case to protect financially vulnerable people from exploitation.
  • The Full Court of the Federal Court of Australia upheld ASIC’s appeal against the court-approved $82.5 million settlement between former Storm Financial investors and Macquarie Bank.
  • The Federal Court found five former directors of Australian Property Custodian Holdings Ltd (APCHL) liable for breaching their duties as officers of APCHL. This was a significant outcome for investors. The conduct of the APCHL Board was unacceptable and this was reflected in the court’s judgment.
  • Clestus Weerappah, a former director of Dollarforce Financial Services Pty Ltd, was jailed for four years over his role in the collapse of the property development group. The sentence sends a clear message to corporate Australia that ASIC, the community and the courts will not tolerate criminal behaviour.

ASIC’s work will see more than $15 million refunded to consumers.

ASIC also secured EUs with a number of high profile companies including NAB, UBS, Wealthsure and Commsec.

“Negotiated outcomes, such as EUs, can offer a faster, more flexible and effective regulatory outcome than could otherwise be achieved through administrative or civil action,” says Tanzer.

“Since 1 July 2011, ASIC has entered into 63 EUs with entities and individuals. Many of these enforceable undertakings have required entities to pay compensation to consumers, improve internal compliance arrangements, appoint an independent expert to oversee elements of the entity’s business and report back to ASIC on performance.”


Working towards better implementation of strategy

In an increasingly competitive global business environment, organisations need to become more dependent not only on having good strategies, but on being able to implement them well.

Most executives recognise this. Indeed, 88 per cent of respondents to an Economist Intelligence Unit global survey conducted last year, Why good strategies fail: lessons for the C-suite, noted that executing strategic initiatives successfully would be “essential” or “very important” for their organisation’s competitiveness over the next three years.

Sadly, however, 61 per cent said their companies often struggled to bridge the gap between strategy formulation and its day-to-day implementation. Moreover, the study found that an average of just 56 per cent of strategic initiatives had been successful in the past three years.

Similarly, Dr John Kotter, Konosuke Matsushita Professor of Leadership, Emeritus, at Harvard Business School, found that around five per cent of all organisations implemented their strategies successfully, while 70 per cent of strategic initiatives failed to meet their objectives. The remaining 25 per cent had some middling success, but did not meet the full potential of the strategy devised.

So if strategy design and execution is critical, but most organisations do it badly, what is the role of the board?

Particularly, what board practices enhance the chances of organisations developing deliverable strategies that position them well, and of actually delivering those strategies?

Dr. Peter Cebon, a Senior Research Fellow at the University of Melbourne, has been studying this issue for some years, with a particular focus on risky strategies: innovation, mergers and acquisitions, organisational change and the like.

He notes that there are great differences of opinion on the board’s role.

“We have very little idea of what boards actually do - good or bad,” he says.

“At one end of the spectrum are directors who believe that the board should hire the CEO, approve the strategy and get out of the way. Underlying that belief is the recognition that management has more time, better knowledge of the industry and greater relevant skill than any director. So, what can a director add? Furthermore, those directors worry about crossing the line between governance and management.

“At the other end of the spectrum are directors who see a number of reasons why the board should get actively involved. They cite traditional governance concerns – many corporate disasters result from excessively ambitious or poorly executed strategy. They also note that internal politics, hubris and managers’ fallibilities can prevent executives taking appropriate risks and managing them prudently. Further, they point to increased attempts by stakeholders to hold directors accountable for ‘upside’ performance in addition to ‘downside’ problems. Finally, they note that shorter CEO tenures mean they need to step in as the custodians of long-term strategy.”

Indeed, Booz & Company’s latest annual Australian CEO study found that median CEO tenure continues to decline in Australia, down from 4.7 years in 2011 to 4.2 years in 2012.

Cebon’s research consists of two parts – a survey and a set of case studies of how boards and executives work together to deliver risky strategic outcomes.

His case studies have yielded really interesting findings, but Cebon says he is fascinated by how few organisations want to participate, compared to his previous research.

Generally, either the executive team or the board declines politely. “It seems that both executives and board members care about this deeply, but one party or the other is uncomfortable about having its behaviour scrutinised. Perhaps directors are not finding the current practice guidelines very helpful, and are unsure what to do.” says Cebon.

Given the lack of consensus on what boards should do around strategic risk, and lack of understanding of what they actually do, Cebon’s Ph.D. student, Conan Hom, is conducting the survey. It has two aims. The first is to get an understanding of the common practices – good and bad – by Australian boards around strategic risks. The second is to understand why.

Backed by the Australian Institute of Company Directors and the Australian Research Council, the study will examine the role of both management and the board in managing strategic risk – the risks created as a result of an organisation trying to deliver on its strategy.

“Ultimately, we will be looking to understand what is best practice, but first, we need to understand what organisations are actually doing and why, whether there are differences in what they are doing, and how these differences impact their effectiveness.

If you are a director, we invite you to participate in this anonymous survey. It should take 35 minutes to complete. Please click here to start.


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