What does good governance really mean? What does it mean to follow best practices? Are there really best practices that make sense for all companies? Do we tend to latch onto easily identified and measured structural features that may not really be effective for good governance and ignore qualities that may be more effective but are not as easily identified or measured? Do we even have a common understanding of the meaning of concepts central to governance? These are some of the questions addressed in an interesting paper, “Loosey-Goosey Governance Four Misunderstood Terms in Corporate Governance,” from the Rock Center for Corporate Governance at Stanford.
The authors contend that, years of study notwithstanding, “we still do not have a clear understanding of the factors that make a governance system effective.” The authors identify two problems: the “tendency to overgeneralize across companies—to advocate common solutions without regard to size, industry, or geography, and without understanding how situational differences influence correct choices. The second problem is the tendency to refer to central concepts or terminology without first defining them. That is, concepts are loosely referred to without a clear understanding of the premises, evidence, or implications of what is being discussed,” i.e., it’s “loosey-goosey.”
First among these misunderstood terms is the main category itself: what is “good governance”? Although it’s highly valued, it’s meaning is often misconstrued. According to the authors, good governance is “a set of processes or organizational features that, on average, improve decision making and reduce the likelihood of poor outcomes arising from strategic, operating, or financial choices, or from ethical or behavioral lapses within an organization.” But instead of this broad and encompassing definition, the authors contend, many use the term to refer to the adoption of “certain structural features that increase board independence and shareholder rights, under the assumption that these are synonymous with good governance.” But do these standards actually improve governance quality? Not so much, say the authors.
For example, according to the article, shareholder proposals to separate combined CEO/board chair positions and require an independent board chair were the most common governance-related shareholder proposal submitted in 2019. Presumably, the argument is that an independent chair without ties to management will provide more vigilant oversight, acting as an effective counterweight to management when required. Nevertheless, the authors contend, the research does not support the conclusion that independent board chairs are necessarily beneficial. Several studies showed no correlation between chair status and performance, or on attributes of governance quality such as managerial entrenchment, organizational risk taking, or executive pay practices; one study even showed that compelled separation of chair and CEO positions was detrimental to performance.
The authors make some of the same arguments in their 2015 paper, “Seven Myths of Boards of Directors,” concluding that the costs and benefits of requiring an independent chair depend on the circumstances, and quoting the former head of the FDIC, Sheila Bair: “Too much is made of separating these roles. … It’s really more about the people and whether they are competent and setting the right tone and culture.” (See this PubCo post.) But is it still the prevailing view that independent board chairs are de rigueur? Even proxy advisor ISS is proposing to codify its current, somewhat nuanced view of independent board chair proposals, generally voting in favor if certain factors are present, such as a weak or poorly defined lead independent director role, a non-independent or executive chair, or various enumerated failures of oversight. (See this PubCo post.)
Staggered boards are another frequent target of governance mavens. Because staggered boards can serve to insulate management and deter unsolicited takeovers (requiring two years to complete a proxy contest successfully), they are often viewed by governance experts to be adverse to shareholders’ interests and, as a result, both proxy advisory firms will regularly vote in favor of de-staggering boards. Although the authors acknowledge research showing that classified boards can be detrimental when they are used to entrench management and prevent deals that might be attractive to shareholders, lowering firm value, they also highlight research showing that staggered boards can be beneficial for shareholders in some circumstances, such as to “protect valuable business relations, thwart unsolicited offers, and boost firm value….A staggered-board structure itself is not indicative of governance quality. It can be a feature of good governance or a feature of bad governance, depending on the company and the people who control it.”
The authors’ 2015 paper cited a study that found that “staggered boards are more prevalent among newly public companies if the company has one or more large customers, is dependent on one or more key suppliers, or has an important strategic alliance in place. [The study also found] that long-term operating performance is positively related to the use of staggered boards among these firms. Other studies also suggest that staggered boards can benefit companies by committing management to longer investment horizons.”
And then, of course, there is the much maligned multi-class share structure, frequently vilified as a “poor governance choice” because it gives a group of shareholders voting rights that are disproportionate to their economic interest. (Of course, some might argue that there would be a much lower incidence of multi-class structures if there were more tolerance among governance experts of features such as staggered boards.) The authors acknowledge that, although much of the research on multi-class structures
“tends to be negative, it is not universally so. A dual-class share structure can provide potential benefits, such as insulating management and the board from external pressure and allowing a company to invest in the long term without the threat of an opportunistic takeover. Cremers, Lauterbach, and Pajuste (2018) find that companies with dual-class shares have similar long-term performance to companies with a single class of stock. Anderson, Ottolenghi, and Reeb (2017) find that the governance quality of dual-class share companies depends on factors other than their share structure, such as the composition of the controlling shareholder group…. That is, requiring a single class of stock might be consistent with good governance, and it might not.”
However, opposition to multi-class structures in governance circles is widespread. ISS, for example, has proposed a new policy, for newly public companies, under which ISS would generally vote against or withhold from the entire board (except new nominees, who would be considered on a case-by-case basis) if, before or as part of the IPO, the company implemented a multi-class capital structure with unequal voting rights—unless the structure is subject to a reasonable, time-based sunset provision. By definition, however, any sunset longer than seven years would not be considered “reasonable.” ISS reports that 55% of investor respondents to its 2019 Global Policy Survey agreed that a maximum seven-year sunset was appropriate. But ISS also frowns on other types of shareholder protection measures that some may view as more moderate in impact than multi-class structures. Accordingly, even if a company adopts a sunset provision on its multi-class structure, ISS may still recommend against its directors (case by case) if the company retains vestiges of its other IPO protection measures, such as a classified board or supermajority vote requirements to amend the governing documents.
And, recently, Rick Fleming, the SEC’s Investor Advocate, gave a speech entitled “Dual-Class Shares: A Recipe for Disaster.” Nuff said? He characterizes the increased use of dual-class shares as a “troubling trend” and a “festering wound,” resulting in a “wave of companies with weak corporate governance.” In addition, he indicates that a “growing body of research suggests that, over the long term, entrenchment of founders produces lower returns for investors. Specifically, companies with dual-class structures tend to underperform companies with dispersed voting power.” An even bigger danger, he predicts, is the lack of appropriate level of accountability to shareholders, potentially leading to self-dealing, insular group-think and a host of other ills. He recommends that the SEC adopt enhanced disclosure requirements and that the exchanges take stronger action to address the issue, such as by requiring sunset provisions.
Although it is widely considered to best practice for corporate governance to avoid these three board structural features, the authors argue that the research does not necessarily support that conclusion. In particular, take a look at Exhibit 4, which contains a table showing the research findings with regard to the impact on performance and monitoring of 15 board attributes and structural features commonly associated with good governance: much of the evidence is mixed and little of it demonstrates a clear impact, with the exceptions of overboarding (negative) and audit committee requirements (positive). Instead of these conventional attributes, the authors contend,
“a reliable governance system depends on organizational features that are unrelated to the structure of the board and shareholder rights and yet improve decision making and reduce the likelihood of misbehavior. Without providing an exhaustive list, these include leadership quality (the skill, knowledge, judgment, and character of both the board and management team), culture (the modes of behavior prevalent in the organization that guide individual choices), and incentives (the financial and nonfinancial rewards that reinforce behavior and shape decision making). While these are inherently more difficult to measure than structural features, research and observation suggest they are likely more significant determinants of good governance.”
The authors suggest that the “Commonsense Principles of Governance” released in 2016 (see this PubCo post) and updated in 2018 (see this PubCo post) are on the right track “by emphasizing the knowledge, judgment, and character of board leadership and management, and allowing for discretion in the choice of governance features.” Perhaps, the authors suggest, more study should be devoted to looking at common attributes of companies with poor outcomes: “do common organizational features exist among companies that exhibit FCPA violations, material restatements, litigation, etc.? Do common features exist among companies that have low levels of violations and superior financial performance over long periods of time?”
In their earlier paper, the authors question why, in light of the data, governance experts focus on structural features of the board, such as its independence and classification, instead of focusing on “the process by which the board fulfills its obligations to shareholders.” In addition, they suggest that, in light of the absence of empirical support for many of the governance practices of boards, these practices should be voluntary rather than mandated by laws and rules as is currently the case: would more flexible standards, they ask, “lead to more suitable market-based solutions, or to more failures?” Finally, they ask, how shareholders, “as outsiders, [can] more effectively evaluate the performance of the board and its members?”
What does “board oversight” really entail? A director’s job is to both “advise and monitor” the corporation and management, concepts that in some respects are inherently inconsistent—one conveying a form of collaboration and the other suggesting independence. Boards have extensive oversight responsibilities, yet companies with rigorous board oversight mechanisms can perform poorly and boards with weak oversight mechanisms can perform very well. What’s more, it is often difficult to discern how much of the company’s performance is attributable to management and how much to the board’s oversight, if any. If shareholders don’t have broad insight into what board oversight involves, how can they judge the quality of the oversight their boards provide?
Nevertheless, the authors contend, “research shows that intangible factors contribute to board quality, and on average, these contribute to performance. Among these are expertise, independence, and board culture.” Research supports the idea that boards with greater industry-related expertise or connections seem to provide better oversight. In addition, independent judgment—but not necessarily as defined in Exchange listing standards—can improve board oversight. “The research literature,” they observe, “is highly mixed on this point.” NYSE standards for independence measure primarily commercial independence, based on business- or comp-related ties, but directors can be indebted to management in other ways, through a kind of “social dependence” in terms of work experience, education and background. (Of course, the NYSE definition recognizes the limitations of its definition and advises that, in determining independence, all relevant facts and circumstances be considered.) In their earlier article, the authors posit that “people who share social connections feel psychological affinity that might bias them to overly trust or rely on one another without sufficient objectivity.” One study showed that socially independent directors provided “better oversight in terms of setting compensation and willingness to terminate underperforming CEOs.” Another study showed that companies with a high percentage of directors appointed during the current CEO’s tenure (who tend to be less independent, or “co-opted,” than those appointed previously) have “higher CEO pay levels, lower pay-for-performance, and lower sensitivity of CEO turnover to performance.” And yet another study demonstrated that powerful directors (those with large professional networks and lots of opportunities) are “associated with more valuable merger-and-acquisition decisions, stricter oversight of CEO performance, and less earnings management.”
Finally, the authors identify cultural practices that they believe “positively contribute to board oversight, including high engagement, honest and open discussion, and continuous board refreshment to ensure a proper mix of skills.” But survey data showed that almost half of directors responding did not view their boards as effective in refreshing board composition, being open to new viewpoints or tolerant of dissent, and a third lacked trust in other directors and management. According to the authors, an “objective evaluation of board quality requires understanding the composition and skills of individual directors and the board as a whole, the quality of information that a board has access to, and cultural factors that influence how boards process this information to reach decisions. These are inherently difficult for outside observers to assess.”
Pay for Performance
It’s not exactly news that most people think that CEOs are paid too much and that their pay is not really tied to performance. But the authors suggest that the concept of pay for performance is not well understood. First, as anyone who looks at proxy statements knows, despite voluminous disclosure, the size of a /ceo pay package is not very clear: the complex structure of comp plans can make them indecipherable, and the pay tables reflect a confusing combination of elements: amounts realized, contingent amounts, accounting values, forward-looking amounts and backward-looking amounts. Not to mention “individual practices—such as severance agreements, golden parachute provisions, and supplemental pensions—and it becomes more evident why outside observers express frustration over the size and structure of CEO pay.”
In addition, the authors highlight, when addressing performance, how much of the performance was actually created during the period and how much was attributable to the work of the CEO? If stock price is a measure, it can easily be influenced by outside factors. Even relative measures and KPIs compared to peers can be affected by outside factors and may not reflect real operating improvements. As a result, comp plans often include a mix of metrics, but the complexity still makes it hard to determine the level of value creation.
Finally, how do you determine the proportion of value created that is attributable to the efforts of the CEO? The authors report that “[s]urvey data shows—rightly or wrongly—that the boards of most companies do believe their CEO and senior management teams are responsible for most of the value created at their companies. A 2015 survey finds that, on average, board members of Fortune 500 companies estimate that the senior management team is directly responsible for almost three-quarters (73 percent) of the company’s overall performance, and that the CEO is directly responsible for 40 percent of performance.” Of course, those estimates are completely subjective and many critics would disagree.
Finally, the authors contend that the concept of sustainability is not well understood. A common complaint is that “companies today are too short-term oriented and are not making sufficient investment in important stakeholder groups (such as employees, customers, suppliers, or the general public) because they are overly focused on short-term profit maximization. As a result, their business models are presumed to be unsustainable,” leading to a deterioration or societal ills at some point in the future. The solution on offer is typically to make companies more sustainable and, the authors maintain, there is a cottage industry of consultants to help with that effort. But are companies really that myopic? The authors take issue with underlying criticism:
“it is not clear that companies today are unsustainable nor is it clear that senior executives are mostly short-term focused or overlook stakeholder interests as they develop their strategy and investment plans. A 2019 survey of the CEOs and CFOs of S&P 1500 companies finds that 78 percent use an investment horizon of 3 or more years to manage their business; less than 2 percent have an investment horizon of less than a year. The vast majority (89 percent) believe non-shareholder stakeholder interests are important to business planning….It is simply not the case that most U.S. companies ignore sustainability concerns. The positive assessment is not limited to CEO perception surveys. External ratings providers also rate companies—particularly large companies—extremely favorably in terms of successfully incorporating ESG criteria into their organizations.”
To support that contention, the authors point out that 68% of the Fortune 100, with a combined market value of $9.4 trillion, are recognized on at least one ESG list. Moreover, the authors, indicate, “[e]ven companies that are widely criticized by advocacy groups for their business practices are rated highly by third-party observers for ESG factors….If third-party providers are reliable, corporate America is already sustainable.”