Corporate governance is the set of internal controls, processes, and procedures by which firms are managed. It defines the appropriate rights, roles, and responsibilities of management, the board of directors, and shareholders within an organization. It is the firm's checks and balances. Good corporate governance practices seek to ensure that:
- The board of directors protects shareholder interests.
- The firm acts lawfully and ethically in dealings with shareholders.
- The rights of shareholders are protected and shareholders have a voice in governance.
- The board acts independently from management.
- Proper procedures and controls cover management's day-to-day operations.
- The firm's financial, operating, and governance activities are reported to shareholders in a fair, accurate, and timely manner.
To properly protect their long-term interests as shareholders, investors should consider whether:
- A majority of the board of directors is comprised of independent members (not management).
- The board meets regularly outside the presence of management.
- The chairman of the board is also the CEO or a former CEO of the firm. This may impair the ability and willingness of independent board members to express opinions contrary to those of management.
- Independent board members have a primary or leading board member in cases where the chairman is not independent.
- Board members are closely aligned with a firm supplier, customer, share-option plan or pension adviser. Can board members recuse themselves on any potential areas of conflict?
- A non-independent board is more likely to make decisions that unfairly or improperly benefit management and those who have influence over management. These also may harm shareholders' long-term interests.
There is often a need for specific, specialized, independent advice on various firm issues and risks, including compensation, mergers and acquisitions, legal, regulatory, and financial matters, and issues relating to the firm's reputation. A truly independent board will have the ability to hire external consultants without management approval. This enables the board to receive specialized advice on technical issues and provides the board with independent advice that is not influenced by management interests.
The board election should be held frequently. Anything beyond a two- or three-year limit on board member tenure limits shareowners' ability to change the board's composition if board members fail to represent shareowners' interests fairly. While reviewing firm policy regarding election of the board, investors should consider:
- Whether there are annual elections or staggered multiple-year terms (a classified board). A classified board may serve another purpose-to act as a takeover defense.
- Whether the board filled a vacant position for a remaining term without shareholder approval.
- Whether shareholders can remove a board member.
- Whether the board is the proper size for the specific facts and circumstances of the firm.
An independent board member must work to protect shareholders' long-term interests. Board members need to have not only independence, but experience and resources. The board of directors must have autonomy to operate independently from management.
If board members are not independent, they may be more likely to make decisions that benefit either management or those who have influence over management, thus harming shareholders' long-term interests.
To make sure board members act independently, the firm should have policies in place to discourage board members from receiving consulting fees for work done on the firm's behalf or receiving finders' fees for bringing mergers, acquisitions, and sales to management's attention. Further, procedures should limit board members' and associates' ability to receive compensation beyond the scope of their board responsibilities.
The firm should disclose all material related party transactions or commercial relationships it has with board members or nominees. The same goes for any property that is leased, loaned, or otherwise provided to the firm by board members or executive officers. Receiving personal benefits from the firm can create conflicts of interest.
Board members without the requisite skills and experience are more likely to defer to management when making decisions. This can be a threat to shareholder interests.
When evaluating the qualifications of board members, consider whether board members:
- Can make informed decisions about the firm's future.
- Can act with care and competence as a result of their experience with:
- Technologies, products, services which the firm offers.
- Financial operations and accounting and auditing topics.
- Legal issues.
- Strategies and planning.
- Business risks the firm faces.
- Have made any public statements indicating their ethical stances.
- Have had any legal or regulatory problems as a result of working for or serving on the firm's board or the board of another firm.
- Have other board experience.
- Regularly attend meetings.
- Are committed to shareholders. Do they have significant stock positions? Have they eliminated any conflicts of interest?
- Have necessary experience and qualifications.
- Have served on board for more than ten years. While this adds experience, these board members may be too closely allied with management.
Investors should also consider how many board and committee meetings are held, and the attendance record of the meetings; whether the board and its committees conduct self-assessments; and whether the board provides adequate training for its members.
There are more things in the corporate governance that investors should be aware of. I shall mention them in my next post.