A Commonsense Corporate Governance Definition

In July 2016, a group of leading executives – including Warren Buffett (Berkshire Hathaway), Jamie Dimon (JP Morgan), Bill McNabb (Vanguard), Larry Fink (BlackRock), and Jeff Immelt (General Electric) – released an open letter titled Commonsense Principles of Corporate Governance.

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As these executives wrote in the open letter:

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Well-managed and well-governed businesses are the engine of our economy, good corporate governance must be more than just a catch phrase or fad. It’s an imperative – especially when it comes to our publicly owned companies. Though they account for only 5,000 of our country’s 28 million businesses, our public companies are responsible for one-third of all private sector employment and one-half of all business capital spending, both of which ultimately drive the productivity and health of the country. To ensure their continued strength – to maintain our global competitiveness and to provide opportunities for all Americans – we think it essential that our public companies take a long-term approach to the management and governance of their business (the sort of approach you’d take if you owned 100% of a company).

Having and implementing corporate governance best practices is extremely important; it can be the difference between a company with a bright future that generates positive returns for its shareholders, lenders, employees, and community – and an Enron.

But what is corporate governance anyways? And what is good corporate governance?

A Commonsense Corporate Governance Definition

Investopedia gives this corporate governance definition: Corporate governance is the system of rules, practices and processes by which a company is directed and controlled. A company has many different stakeholders – such as shareholders, management, customers, suppliers, financiers, government, and the community – and corporate governance helps to balance the interest of each of these stakeholders.

This is a neat and fairly lucid definition, yet there has not been a lot of agreement on how exactly a company should go about balancing its stakeholders’ interests (i.e. what is good corporate governance and how can you implement it?).

The following is a series of corporate governance principles for public companies, their board of directors, and their shareholders that the corporate executives came up with. The principles are intended to provide a basic framework for sound, long-term-oriented governance but not every principle (or every part of every principle) will work for every company, and not every principle will be applied in the same fashion by all companies (given the differences in size, products and services, history, and leadership of public companies).

Corporate Governance Principles for Public Companies

The principles are broken down into 8 parts – Board of Directors (Composition and Internal Governance); Board of Directors’ Responsibilities; Shareholder Rights; Public Reporting; Board Leadership (Including the Lead Independent Director’s Role); Management Succession Planning; Compensation of Management; Asset Managers’ Role in Corporate Governance – and include the following guidlines:

  • Truly independent corporate boards are vital to effective governance, so no board should be beholden to the CEO or management. Every board should meet regularly without the CEO present, and every board should have active and direct engagement with executives below the CEO level;
  • Diverse boards make better decisions, so every board should have members with complementary and diverse skills, backgrounds and experiences. It’s also important to balance wisdom and judgment that accompany experience and tenure with the need for fresh thinking and perspectives of new board members;
  • Every board needs a strong leader who is independent of management. The board’s independent directors usually are in the best position to evaluate whether the roles of chairman and CEO should be separate or combined; and if the board decides on a combined role, it is essential that the board have a strong lead independent director with clearly defined authorities and responsibilities;
  • Our financial markets have become too obsessed with quarterly earnings forecasts. Companies should not feel obligated to provide earnings guidance — and should do so only if they believe that providing such guidance is beneficial to shareholders;
  • A common accounting standard is critical for corporate transparency, so while companies may use non-Generally Accepted Accounting Principles (“GAAP”) to explain and clarify their results, they never should do so in such a way as to obscure GAAP-reported results; and in particular, since stock- or options-based compensation is plainly a cost of doing business, it always should be reflected in non-GAAP measurements of earnings; and
  • Effective governance requires constructive engagement between a company and its shareholders. So the company’s institutional investors making decisions on proxy issues important to long-term value creation should have access to the company, its management and, in some circumstances, the board; similarly, a company, its management and board should have access to institutional investors’ ultimate decision makers on those issues.

You can read the full Commonsense Principles of Corporate Governance here.

What Does Corporate Governance Mean for Value Investors?

Whether you run a large public company or are an investor in one, knowing good corporate governance best practices is vital for the success of the company. When you are analyzing a management team as a value investor (Warren Buffett’s third investing principle), you should also be analyzing the company’s corporate governance. Before you invest, you should ask yourself these questions:

  • Is management obsessed with hitting their quarterly earnings forecasts? Or are they more concerned with long-term profitability?
  • Is the company’s financial reporting clear and transparent? Is management forthcoming with information? Or does is seem like management is trying to obscure numbers in order to mask or hide poor performance?
  • Who is on the Board of Directors? Is the Board balanced in terms of diversity, background, and experience? Or is the Board comprised of the CEO’s golf buddies and sister-in-law?

The Principles of Corporate Governance go into much more detail and help raise many more questions that can help you think about the management of a company. The Open Letter and the Principles can be accessed here.

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