BoardAndFraud

Corporate Governance – Commonsense Principles 2.0

I was taught and still believe that corporate governance is not about power but about ensuring that decisions are made effectively and when there are mistakes, we correct them quickly and appropriately by seeking out the root cause.

After all, most performance crises are the result of errors that arise not from incompetence but from failures of judgment, or because the team of decision makers is tired.

Thus, it seems reasonable when we set out to improve corporate governance that we must rethink the role directors play.

Background

On October 18, 2018, CEOs of 20 prominent public companies, pension funds and investment firms signed and are committing to use these standards to inform the corporate governance practices within their own organizations.

These principles build on national conversation to promote Good Corporate Governance, which is critical for effective Risk Management and Compliance.

The Commonsense Principles 2.0 are an updated version of the Commonsense Corporate Governance Principles issued in July 2016.

What is Corporate Governance?

Corporate governance can be defined as a collection of systems and processes that an organization has in place to prevent or dissuade potentially self-interested persons from engaging in activities detrimental to the welfare of shareholders and stakeholders and helps to promote better overall decision making.

Practice Pointer

In my opinion, today’s governance needs to be adaptive in order to be competitive. Disruption today is faster than anytime in history!

Corporate Governance Principles 2.0

The following is a series of corporate governance principles for public companies [private and not-for-profit too where applicable], their boards of directors and their institutional shareholders (both asset managers and asset owners).

These principles are intended to provide a basic framework for sound, long-term-oriented governance. 

Given the differences among U.S. public companies – including their size, products and services, geographic footprint, history, leadership and ownership – we recognize that not every principle will be applied in the same fashion (or at all) by every company, board or shareholder. Nonetheless, we intend to use these principles to guide our thinking.

I. Board of Directors – Duties, Composition and Internal Governance a. Duties of Loyalty and Care

b. Composition

c. Elections of directors

d. Nominating directors

e. Director compensation and stock ownership

f. Board committee structure and service

g. Director tenure and retirement age

It is essential that a company attract and retain strong, experienced and knowledgeable board members.

Board refreshment should always be considered in order to ensure that the board’s skill set and perspectives remain sufficiently current and broad in dealing with fast- changing business dynamics. But the importance of fresh thinking and new perspectives should be tempered with the understanding that age and experience often bring wisdom, judgment and knowledge.

Caution: Tired Board members often make bad decisions for a variety of reasons – one is they are no longer connected to the issues of the business or the market.

h. Director effectiveness

II. Board of Directors’ Responsibilities

a. Director communication with third parties

b. Critical activities of the board; setting the agenda

The full board (including, where appropriate, through the non-executive chair or lead independent director) should have input into the setting of the board agenda.

Over the course of the year, the agenda should include and focus on the following items, among others:

a. It is important that companies engage with shareholders and receive feedback about matters relevant to long-term shareholder value.

b. Shareholder proposals. In the event that a company receives a shareholder proposal, it should consider engagement with the proposing shareholder (as well as other shareholders, to the extent appropriate) early in the process, preferably before the proposal appears in the proxy. Should the proposal receive majority shareholder support, the company should consider further engagement with shareholders and either implement the proposal (or a comparable alternative) or promptly explain why doing so would not be in the best long-term interests of the company. As a best practice, the company also should consider further engagement with shareholders to discuss shareholder proposals that receive significant but less than majority support and formulate an appropriate response. And while such response may include the adoption of the proposal (or a comparable alternative), the board should be mindful of the fact that a majority of the company’s shareholders did not support the proposal.

c. Management proposals. Similarly, in connection with a management proposal, the company should consider engagement with shareholders early in the process. Should the proposal be defeated or receive significant shareholder opposition, the company should consider further engagement with shareholders and formulate an appropriate response, again mindful of how a majority of the company’s shareholders voted.

The board (or appropriate board committee) should:

See below at VII (“Compensation of Management”).

III. Shareholder Rights

a. Public companies should allow for some form of proxy access, subject to reasonable requirements that do not make proxy access unduly burdensome for significant, long-term shareholders. Among the larger market capitalization companies that have adopted proxy access provisions, generally a shareholder (or group of up to 20 shareholders) that has continuously held a minimum of 3% of the company’s outstanding shares for three years is eligible to include on the company’s proxy statement nominees for a minimum of 20% (and, in some cases, 25%) of the company’s board seats. A higher threshold of ownership (e.g., 5%) often has been adopted for smaller market capitalization companies (e.g., less than $2 billion). In either case, as a general matter, only shares in which the shareholder has a full, unhedged economic interest should count toward satisfaction of the ownership/holding period requirements.

b. Dual class voting is not a best practice. If a company has dual class voting, which sometimes is intended to protect the company from short-term behavior, the company ordinarily should have specific sunset provisions, based upon time or a triggering event, which would eliminate dual class voting. In addition, all shareholders should be treated equally in any corporate transaction.

c. Written consent and special meeting provisions can be important mechanisms for shareholder action. Where they are adopted, there should be a reasonable minimum amount of outstanding shares required in order to prevent a small minority of shareholders from being able to abuse the rights of other shareholders or waste corporate time and resources.

d. Poison pills and other anti-takeover measures can diminish board and management accountability to shareholders. Insofar as a company adopts a poison pill or other anti- takeover measure, the board ordinarily should put the item to a vote of the shareholders and clearly explain why its adoption is in the best interests of the company’s shareholders. On a periodic basis, the board should review such measures to determine whether they remain appropriate.

IV. Public Reporting

a. Transparency around quarterly financial results is important.

b. A company should frame its required quarterly reporting in the broader context of its articulated strategy and provide an outlook, as appropriate, for trends and metrics that reflect progress (or not) on long-term goals. A company should not feel obligated to provide quarterly earnings guidance – and should determine whether providing quarterly earnings guidance for the company’s shareholders does more harm than good. If a company does provide quarterly earnings guidance, the company should be realistic and avoid inflated projections. Making short-term decisions to beat guidance (or any performance benchmark) is likely to be value destructive in the long run.

c. As appropriate, long-term goals should be disclosed and explained in a specific and measurable way.

d. A company should take a long-term strategic view, as though the company were private, and explain clearly to shareholders how material decisions and actions are consistent with that view.

e. Companies should explain when and why they are undertaking material mergers or acquisitions, major capital commitments or significant restructuring or cost-savings initiatives.

f. Companies are required to report their results in accordance with Generally Accepted Accounting Principles (“GAAP”). While it is acceptable in certain instances to use non-GAAP measures to explain and clarify results for shareholders, such measures should be sensible, and companies should provide a bridge from non-GAAP items to the most comparable GAAP items, so as not to obscure GAAP results. In this regard, it is important to note that all compensation, including equity compensation, is plainly a cost of doing business and should be reflected in any non-GAAP measurement of earnings in precisely the same manner it is reflected in GAAP earnings.

V. Board Leadership (Including the Lead Independent Director’s Role)

a. Independent leadership of the board is essential to a well-functioning board and, in particular, effective oversight of the company and its management. There are two common structures for independent board leadership in the U.S.: (1) an independent chair; or (2) a lead independent director.

b. The board’s independent directors should decide, based upon the circumstances at the time, whether it is appropriate for the company to have separate or combined chair and CEO roles. The board should periodically review its leadership structure and explain clearly (ordinarily in the company’s proxy statement) to shareholders why it has separated or combined the roles, consistent with the board’s oversight responsibilities.

c. If a board decides to combine the chair and CEO roles, it is critical that the board has in place a strong designated lead independent director and governance structure. The role of the lead independent director should be clearly defined and sufficiently robust to ensure effective and constructive leadership. The responsibilities of the lead independent director and the executive chair should be clearly delineated, agreed upon by the board, and disclosed to shareholders.

d. Depending on the circumstances, a lead independent director’s responsibilities may include:

VI. Management Succession Planning

a. Senior management bench strength can be evaluated by the board and shareholders through an assessment of key company employees; direct exposure to those employees is helpful in making that assessment.

b. Companies should inform shareholders of the process the board has for succession planning and also should have an appropriate plan if an unexpected, emergency succession is necessary.

VII. Compensation of Management

a. To be successful, companies must attract and retain the best people – and competitive compensation of management is critical in this regard. To this end, compensation plans should be appropriately tailored to the nature of the company’s business and the industry in which it competes. Varied forms of compensation may be necessary for different types of businesses and different types of employees. While a company’s compensation plans will evolve over time, they should have continuity over multiple years and ensure alignment with long-term performance.

b. Compensation should have both a current component and a long-term component.

c. Benchmarks and performance measurements (financial and otherwise) ordinarily should be disclosed to enable shareholders to evaluate the rigor of the company’s goals and the goal- setting process. That said, compensation should not be entirely formula based, and companies should retain discretion (appropriately disclosed) to consider factors that may not be easily measured, such as integrity, work ethic, effectiveness, openness, etc. Those matters are essential to a company’s long-term health and ordinarily should be part of how compensation is determined.

d. Companies should consider paying a substantial portion (e.g., for some companies, as much as 50% or more) of compensation for senior management in the form of stock, performance stock units or similar equity-like instruments. The vesting or holding period for such equity compensation should be appropriate for the business to further senior management’s economic alignment with the long-term performance of the company. With properly designed performance hurdles, stock options may be one element of effective compensation plans, particularly for the CEO. All equity grants (whether stock or options) should be made at fair market value, or higher, at the time of the grant, with particular attention given to any dilutive effect of such grants on existing shareholders.

e. Companies should clearly articulate their compensation plans to shareholders. While companies should not, in the design of their compensation plans, feel constrained by the preferences of their competitors or the models of proxy advisors, they should be prepared to articulate how their approach links compensation to performance and aligns the interests of management and shareholders over the long term. If a company has well- designed compensation plans and clearly explains its rationale for those plans, shareholders should consider giving the company latitude in connection with individual annual compensation decisions.

f. Grants to management of large special compensation awards (not normally recurring annual or biannual awards, but those considered special awards or special retention awards) should be carefully evaluated and reserved for special circumstances. The rationale for special awards to the CEO and other “Named Executive Officers” whose compensation is set forth in the company’s proxy statement should be clearly explained.

g. Companies should maintain clawback policies for both cash and equity compensation.

VIII. Investors’ Role in Corporate Governance a. Asset managers

To the extent directors are speaking directly with shareholders, the directors’ (i) knowledge of their company’s corporate governance and policies, and (ii) interest in understanding the key concerns of the company’s shareholders.

The board’s focus on a thoughtful, long-term strategic plan and on performance against that plan.

An asset manager’s ultimate decision makers on proxy issues important to long- term value creation should have access to necessary information about the company. Asset managers with significant share ownership should have access to the company’s management and, in some circumstances, the company’s board. Similarly, a company, its management and board should have access to an asset manager’s ultimate decision makers on those issues.

b. Institutional asset owners

The use of benchmarks and performance reports consistent with the asset owner’s strategy and investment time horizon

Interactions and dialogue with asset managers concerning corporate governance issues; and

The evaluation of asset managers on how they discharge their own role in corporate governance matters, as set forth above in VIII.a (“Asset managers”).

Framework

Below is a synthesized way of looking at the elements of a sound governance framework. The framework elements are all interconnected in some way and must be working harmoniously to be effective.

The principles outlined in 2.0 above, do map to the elements above.

Click here for a comparison to the July 2016 Principles.

Operating Model

A framework is great; however, an organization needs a governance operating model too. The operating model is the mechanism used by the board and management to translate the elements of the governance framework and policies into practices, procedures and job responsibilities within the corporate governance infrastructure.

A governance operating model consists of four main components:

1. Structure, which includes organization design and reporting structure, committee structures and charters, and control and support function interdependencies.

2. Oversight responsibilities, which define board oversight responsibilities, committee and management responsibilities, accountability matrices, and management hiring and firing authority.

3. Talent and culture, which enable the behaviors and activities needed for effective governance by establishing compensation policies (particularly regarding incentives), promotion policies, business and operating principles, performance measurement and management, training, and leadership and talent development programs.

4. Infrastructure, which comprises governance and risk oversight policies and procedures, reports, measures and metrics, management capabilities, and the enabling IT and communications support.

Each of the four components of an effective governance operating model contains a series of role and responsibility issues to be addressed:

Board oversight and responsibilities—The board carries out oversight responsibility across the organization in areas such as business and risk strategy, organization, financial soundness and regulatory compliance. In this regard, the governance operating model should help the board to:

Committee authorities and responsibilities—Effective board committee and management committee structures can help define the number, terms and qualifications of members, committee responsibilities, reporting and escalation mechanisms, and ways in which board and management committees will interact. For example, for a management committee, the model could:

Organizational design and reporting structure—A clear, well-thought-out organizational structure normally defines reporting lines for decision-making, risk management, financial and regulatory reporting, public disclosures and crisis preparedness and response. In an enterprise governance operating model, the organizational structure could enable executive management to:

Management accountability and authority—Well-understood authority and accountability for key responsibilities are needed at all levels and in all areas of the organization. A sound governance operating model could:

Performance management and incentives—Goals, performance measures, compensation and incentives should reflect an organization’s overall commitment to governance as well as principles of asset preservation and risk-taking for reward. In this area, the model should help the board to:

I welcome your thoughts, comments, and suggestions.

Jonathan T. Marks

Attribution:
Meyer, CCZ 2014, 113 (113); Hauschka, in: Corporate Compliance, § 1, para. 2.
Hauschka, in: Corporate Compliance, § 1, para. 4; Fuchs, in: Wertpapierhandelsgesetz, § 33, para.
Harvard Business Review
WSJ
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