Organizations faced an unexpectedly tough year in 2020, with the ongoing COVID-19 pandemic, a national reckoning over racial justice, and political and economic uncertainty. As daily conversations focused on crisis management, business continuity, and organizational resilience, companies still managed to make slight improvements in governance practices, according to the 2020 American Corporate Governance Index (ACGI): Making Strides Amid Crisis, released in January.
For the second year, The IIA and the Neel Corporate Governance Center at the University of Tennessee Knoxville's Haslam College of Business collaborated to survey 131 chief audit executives (CAEs) of publicly listed U.S. companies, who anonymously responded and rated how effectively their organizations performed on eight Guiding Principles of Corporate Governance (see "Guiding Principles of Corporate Governance" below). The overall corporate governance score rose three points from 2019's index of 79 (C+ grade) to 82 (B- grade) in 2020.
Similar to last year, the majority of companies score in the B and C range overall (when all principles are considered), with less than one-fifth of companies earning a grade in the A range (see "Distribution of ACGI Scores by Letter Grade" below). Average scores across all principles improved modestly, while a few stagnant scores reveal opportunities for improvement. One mark of progress is that only 2% of companies received a failing grade in 2020, down from 10% in 2019.
Improvements in governance scores were a pleasant surprise during a year in which the quality of governance might have slid backward, given the pandemic, says Terry Neal, head of the Accounting and Information Management Department at UT Knoxville's Haslam School of Business, who conducted the study with Lauren Cunningham, director of research at the Neel Corporate Governance Center. The researchers caution that while the effects of COVID-19 on businesses and society have been pervasive, the ACGI survey was not designed to tease out exactly how the pandemic may have affected governance.
However, responses to open-ended survey questions cited the importance of existing governance practices, cooperation, and flexibility. "Our core governance and procedures remained in place, but we gave people the flexibility to get their work done," said one respondent, whose comments fairly represented the shared themes. "The company acted quickly and decisively to put flexible policies in place for each group to manage as best they could — working from home, the right IT tools, whatever equipment and personal protective equipment that was needed."
Coordination, communication, and prioritizing employee safety also came through as essential to successfully navigating the pandemic's challenges. Survey respondents gave specific examples of ways their companies increased and honed their communications: establishing an executive task force, frequent and diverse communication across all levels within the company and board, leveraging existing incident response frameworks, and setting up a COVID-19 response committee, to name a few.
Respondents who felt their companies were less effective cited management actions that were not well-coordinated and did not feature open communication and multi-stakeholder alignment. One respondent commented that internal audit helped identify some of these weaknesses and connected the people in positions to resolve the problems.
Filling the Gaps
Because publicly observable and reported measures offer a limited, inconsistent, and incomplete picture of the effectiveness of corporate governance, the ACGI was designed to fill gaps through surveying heads of internal audit who respond anonymously to offer insider perspectives. The authors of the report say the unique features of the ACGI yield a more robust overview of corporate governance effectiveness among publicly listed U.S. companies.
Surprisingly, the ACGI does not find consistent and reliable correlations among good governance and certain factors that regulators and proxy advisors accept as indicators of good governance. For example, the number of years a publicly traded company has been operating was not correlated with ACGI scores in 2020 and neither was board independence. Nor have the separation of CEO-chairman roles and frequency of board meetings proven to be reliable measures of the quality of governance, according to ACGI findings.
Cunningham and Neal are not surprised that the typically used publicly available measures do not fully and accurately capture corporate governance. “When we formed the index, working with The IIA, we purposefully did not use publicly available measures because we don’t think governance is one-size-fits-all,” Cunningham explains. “For instance, the number of board meetings doesn’t tell us anything about the quality of communication within those meetings or the follow-up after those meetings. You have to understand the quality of those relationships, communications, and accountability factors within the organization.”
Silverman says internal auditors can paint a clearer picture. “Internal auditors, specifically CAEs, have a perspective, especially when they’re able to respond anonymously, that allows them to be completely forthright. The ACGI provides the perspective of an independent and objective person who is in the boardroom and interacting at various levels throughout the organization.”
Regulation, Size, Reporting Lines Matter
In contrast to 2019 results, this year's data suggest that regulation matters, at least during a year filled with crises. Companies in regulated industries (financial services, transportation, and utilities) displayed stronger governance regardless of company size, with scores hovering in the mid-80s. Among unregulated companies, large companies (total revenues of more than $10 billion) received better governance scores than smaller ones, suggesting that size correlates positively with effective governance in the absence of regulation.
ACGI data also indicates that across all sizes of organizations, governance quality is strongest when the CAE reports administratively to the audit committee or CEO and is weakest when the CAE reports to the chief financial officer (CFO). Forty-three percent of CAEs who report administratively to the audit committee and 42% who report administratively to the CEO assigned high overall governance grades to their organizations. The percentage of high overall governance grades drops to 29% among CAEs who report administratively to the CFO.
Harold Silverman, The IIA's managing director, Professional Practices, says he has seen similar correlations in other studies, including The IIA's North American Pulse of Internal Audit. "Even if you hold constant your functional reporting, meaning that the CAE reports to the audit committee or board, who the CAE goes to on a day-to-day basis — who's leadership team they're on — also makes a difference," he says. "When a CEO has a meeting with his or her leadership team, is the CAE present?"
Room for Improvement
While modest gains in ACGI ratings are spread relatively equally across many of the guiding principles, a few areas show no or limited growth, raising questions for future research.
Notable gains occurred in many subprinciples related to Principle 3, which measures the degree to which the board balances the best interests of the company, shareholders, and other key stakeholders. Ratings improved with regard to the board's technical expertise, diversity of perspectives, push for sufficient details, time to properly execute its role, appropriate compensation, self-evaluation, and follow-through on improving weaknesses. Cunningham says these improvements may be the result of hard-won investor activism. "Shareholders have been calling for rotation of board members, for example, so you now see improvements in expertise and diverse perspectives," she says. "So I don't think that's a one-time call for 2020; even aside from COVID-19, that's been building."
However, the greatest score improvement within the index may indicate that activism slowed during the pandemic. One statement related to Principle 2 — which asked whether companies avoided shareholder proposals, proxy advisor "against" recommendations, "vote no" campaigns, proxy fights, or shareholder litigation — improved nine points from last year. This increase might be attributable to pandemic-related pullbacks in activism; however, with the index being too young to validate such a hunch, future results are needed to provide context and help identify whether the increase is an outlier.
When it comes to whether board members have the courage to offer opinions that contradict or conflict with those of the CEO, 2020 scores advanced just one point to 76. And 2019's lowest-rated principles and subprinciples continue to lag, suggesting that companies are not consciously evaluating the full system of corporate governance regularly (related to Principle 8) and board members are not effective at asking whether the information they receive is accurate and complete (related to Principle 6). The board's actions to protect proprietary information also failed to improve, stalling at 69, one of the lowest scores in the index.
CAEs Provide Key Insights
In only its second year, the ACGI is still nascent. Cunningham, Neal, and Silverman caution that it is too soon to identify trends and that explanations for the correlations are still speculative. Yet, based on the research behind ACGI and interviews with CAEs, Neal says if board members are relying on publicly available measures as check-the-box self-evaluations of governance, they are not getting the meaningful governance assessments and insights that CAEs could provide.
Cunningham says board members should be confident in CAEs' abilities to assess corporate governance. "If I were a board member reading the ACGI report today," she explains, "that would lead me to a conversation with my CAE. I would be saying, 'I want you to tell me how my organization's governance is.' Based on our interviews with CAEs, I think they are willing to evaluate governance if the board will empower them to do so."