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Twelve ways boards can avoid Sino-Forest-inspired disasters

The recent Sino-Forest debacle hits home for corporate directors how important reputation and risk management is.

(Photo: Richard Boll/Getty)

As I wrote in a related article, A Black Eye for Bay Street, the recent Sino-Forest debacle hits home for corporate directors how important reputation and risk management is.

I have been asked for advice by directors who have been approached to sit on boards of companies traded on North American stock exchanges with the majority of their activities or assets in India or China. Here is what I recommend, as a starting point for any director asked to serve on the board of such a company, all of which should be in writing or agreed to prior to the director joining the board:

1. Quality audit: The company must be audited by a licensed and properly qualified and staffed accounting firm that includes Anglo-American trained accountants who speak Mandarin (for Chinese companies). The accounting firm itself should be independently and annually assessed and have no adverse examinations. All quality assurance recommendations should be implemented by the accounting firm, including coordinated assurance cooperation by local audit stakeholders such as vendors, banks, government entities, and other creditors, suppliers and customers.

2. Effective governance assessment: The company must comply with all corporate governance standards (in spirit and form) and there must be independent (e.g., Anglo-American) assurance of this compliance.

3. CFO and finance department: The CFO and finance department of the company must be properly qualified and trained, have the necessary authority and work at the headquarters of the company. The CFO must report directly to, and be assessed by, the Audit Committee. The CEO should not be in the room when the CFO reports.

4. Internal audit: An internal audit function must exist, and this function must report directly to the audit committee at every meeting, with the CEO and CFO excused. The audit committee must approve the work-plan, qualifications, selection and compensation of the head of internal audit. The audit committee must be composed exclusively of independent directors with no ties, past or present—In any form whatsoever—to management, to the company or to the auditors.

5. Board independence and industry experience: The board of directors must have a majority of directors who are independent of management and the significant shareholder, if one exists. Half of the independent directors should have direct industry experience, narrowly defined.

6. Authority to fire the CEO: Independent directors must have the authority to replace the CEO if necessary, even if resisted by the significant shareholder, particularly if the CEO is the significant shareholder.

7. Conflicts of interest, whistle-blowing and ethics: Independent directors should have authority to approve all related-party transactions (transactions with company directors or officers). Related parties must not vote nor be in the room when the transaction is discussed. The code of conduct should be written in Mandarin and all employees and key suppliers should sign-off annually. Compliance should be independently assured (not by the company law firm) and reported directly to the audit committee. Follow up directives from the Audit Committee must be implemented. The audit committee must have access to resources and advisors to fulfill its obligations. A proper whistle-blowing procedure should also exist, with external reporting to, and clarification provided by, an independent service provider, preferably offshore.

8. D&O insurance: Director insurance and indemnification must be externally reviewed and adequate so the independent director is protected. Provisions to fund special committees and independent advisors should be provided, under the control of independent directors.

9. Risk assurance providers: Independent directors must have authority to direct their choice and funding of external independent assurance providers for any material business risk and/or internal controls, including over corruption, financial reporting and reputation risk. In Sino-Forest’s case, this would mean that the forestry consultant, Pöyry, would not qualify because Pöyry owned stock in Sino-Forest. The external assurance provider must be accountable to the independent directors and must not, as a firm (including any partners or related parties), provide any services whatsoever to management. The independent directors must have authority to hire, compensate and replace this assurance provider. Important assurance providers should meet directly with the relevant board committee, without management present.

10. Board leadership: The chair of the board must be an independent director with leadership and industry experience sitting on listed Anglo-American company boards. In Sino-Forest’s case, Allen Chan, who resides in Hong Kong, would have to have relinquished his position as chair. Lead directors are not adequate for Chinese and Indian companies. The notion of an independent director, without industry experience, sitting in board meetings being run by the CEO, who may be offshore, who controls the agenda, information, discussions and minutes (which are responsibilities of the chair), is very problematic.

11. Audit committee leadership: The chair of the audit committee must be an independent financial expert with experience sitting on listed Anglo-American company audit committees.

12. Local board meetings and exposure to operations: The board must meet at least once a year in China (or India as the case may be). Independent directors should meet separately with local management and important stakeholders without senior management present. All recommendations must be acted upon and with a progress report provided to independent directors.

So what can we glean from the Sino-Forest debacle?

Do your homework before you accept a board appointment to a China- and India-based company. The governance shortcomings of Sino-Forest were several. Sophisticated directors are well-advised—when their reputation and assets are put at risk in sitting on any board with operations in corrupt jurisdictions—to insist on proper governance safeguards like the ones mentioned above, to provide a corruption risk surcharge.

The mistake is made in not doing one’s governance due diligence at the front end of a board appointment. Once one is sitting on the board, and has accepted the status quo, it may be too late and a price may be paid.