Which are elements of corporate governance that are tied to ethics?

Throughout history, we have seen countless examples of weak governance practices leading to significant erosion in market valuation. We saw it in 2001 during the highly publicized accounting scandal that wiped out Enron. We witnessed it again in 2014 when GM’s failure to heed a whistle blower’s warnings about its faulty ignition switches resulted in over $2 billion in fines, penalties and settlements. More recently, the employees, customers, and shareholders of Wells Fargo were all affected by investigations into aggressive product cross selling tactics and misleading brokerage clients about trading high fee debt products.

So what constitutes an effective corporate governance program that will increase a company’s potential for success instead of failure? I’ve outlined six key elements below.

But before jumping in, let me offer a working definition of corporate governance to set the stage:

Corporate governance is basically a set of rules, practices, and procedures that guides company oversight and control by its Board of Director and independent committees. It involves balancing the interests of a company’s stakeholders—including management, employees, suppliers, customers, and the community—with the need to deliver value to its shareholders/owners. Having a strong, active, governance program is absolutely critical to the ongoing financial health, growth, and success of an enterprise over time.

Keeping that definition in mind, here are the essential elements for effective corporate governance:

1.  Director independence and performance

The Board of Directors plays a key role in company oversight, including:

• driving long-term strategic vision, and
• appointing and overseeing the Chief Executive Officer.

The most effective boards have a majority of independent directors who are able to supervise company management and independent committees for the benefit of shareholders. These directors should attend the meetings and be prepared to discuss key issues. They also should be evaluated based on how long they have served on a particular board. Long-tenured directors can become too entrenched in a company to be considered truly independent.

The practice of “overboarding” by board members should also be a concern. This refers to situations where directors hold too many seats on the boards of other publicly-traded companies or nonprofit organizations to be effective. As a result, these directors may be unable to attend meetings, prepare questions, discuss key issues, or adequately serve the shareholders who elected them.

Typically, the roles of the Chairperson of the Board and the CEO for a company should be filled separately. But in some cases, it may be appropriate to have the roles combined if there is an independent leadership position on the board such as a Lead Director to provide a counterbalance. Otherwise, the combined CEO/Chair may unduly influence the Board to make rules that create a conflict of interest. An example of this type of conflict would be allowing a CEO to structure a loan with inappropriate or self-serving terms. 

In reviewing board candidates, shareholders should also evaluate the performance of directors who have held seats on boards of companies that experienced significant accounting or ethical scandals. Perhaps those directors should have identified the issues more proactively and taken a different course of action?

[1] https://www.conference-board.org/blog/postdetail.cfm?post=5955
 

2.  A focus on diversity

Studies have shown that companies with more diversified boards are more risk averse, have less volatile stock returns, and are more likely to pay dividends. So, it can be argued that diversity by gender, age, and minority representation should be a key goal for the composition of every company’s board and senior management ranks.

  But, in fact, a 2016 report from the Alliance for Board Diversity and Deloitte consulting found that women and minorities held just 30.8% of Fortune 500 company board seats.  The report also found that Caucasian men were much more likely to serve as board chairs, lead directors, or chairs of key board committees.

  Many investors are now pushing for more board diversity, and companies are beginning to take heed. BlackRock recently declared diversity to be a corporate governance priority and both State Street Advisors and the State of Massachusetts Pension Fund now consider a board’s diversity when voting proxies.

3.  Regular compensation review and management

Another essential element of corporate governance is the review and management of compensation at both the board and executive management levels.

Director compensation has been increasing in recent years as the hours devoted to board positions have been growing. According to a 2016 Pay Governance review, the median compensation received by directors at S&P 500 companies was $265,487. And while the role that board members play should not be diminished, it’s also true this is a part-time position and many directors are employed full time elsewhere. In addition, when compensation is too high, there may be concerns that directors will not adequately question the actions of senior management for fear of losing their board fees.

The scope and method of management compensation should be considered as well, with proxy statements a good source of information about executive compensation plans. Institutional Shareholder Services (ISS), a proxy voting recommendation service, has established these five compensation guidelines as part of their proxy voting principles:

1. Pay should be aligned with performance, with an emphasis on the long term.
2. Avoid “paying for failure,” by avoiding guaranteed compensation and excessive severance packages.
3. Create an independent compensation committee for effective oversight.
4. Ensure transparent and comprehensive compensation disclosures.
5. Manage payments made to nonexecutive directors. Overpaid nonexecutive directors may not make independent judgments on managers’ compensation and performance.

4.  Auditor independence and transparency

A review of audit practices and company accounting can also signal problems to come. Auditors should be independent (with no financial interest in a company) with the majority of their revenues derived from audit activities, not consultation services. Accounting issues should be handled in a transparent manner, with complete, detailed information and reports always available to the board and measures put in place to prevent recurrence of any questionable findings.

5.  Shareholder rights and takeover provisions

Investors should consider shareholder rights as a key element of good governance as well.
For example:

• Do all shareholders hold equal voting rights or is one share class advantaged over the other?

Multiple shares/classes do not necessarily indicate poor governance, but they are a factor to consider. In the information technology sector, for example, it is common for company founders and insiders to hold shares that have greater voting rights than outside investors.

• Do shareholders have access to place proposals on proxy ballots or nominate directors?

A company’s record of dealing with shareholder proposals that receive a majority of votes may also be an indicator of how a company deals with its shareholders.

• What actions can a board take without shareholder approval, such as amending company bylaws?
• Are there plans in place, such as poison pills, that can make it difficult for a company to be acquired? How is management rewarded in the event of a takeover?

Takeover provisions should be reviewed and shareholders should have adequate rights to vote on these provisions.

6.  Proxy voting and shareholder influence

Increasingly, investors are using proxy voting as a means to influence a board’s corporate oversight as well as its commitment to improving its governance on issues such as climate change, income inequality, and shareholder proxy access.

  Shareholders must have the ability to use their votes to send a message to the board by withholding votes for the directors in cases where the company has delayed taking action on winning shareholder proposals, failed to deal with a director’s poor performance, or did not improve board accountability and oversight.

  Letter writing campaigns also can be successful in lobbying for change in a company’s corporate governance and, in some cases, have taken the place of putting proposals on shareholder ballots. Pension funds and asset managers, for example, may join forces to successfully use letter writing to bring about new voting measures, including majority voting, repealing classified boards, and removing supermajority voting provisions.

[1] 2016 Board Diversity Census of Women and Minorities on Fortune 500 Boards, http://www.catalyst.org/system/files/2016_board_diversity_census_deloitte_abd.pdf

[2] The Evolution and Current State of Director Compensation Plans, PayGovernance.com http://paygovernance.com/the-evolution-and-current-state-of-director-compensation-plans/

This article is for informational purposes only and should not be construed as investment or legal advice. 

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