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Bonus
Feature
Investor Scrutiny Is Here to Stay Links between governance and performance are prompting more investors to get involved in corporate governance. By James C. Allen Some company executives still seem genuinely surprised—and sometimes annoyed—when investors pay close attention to their company’s governance. These presume that if there are no negative surprises, investors should not concern themselves with such issues as board independence, senior management compensation practices, and director elections. That view is no longer valid in an era of increased scrutiny by investors, who, recognizing the ties between governance and performance, are pushing for more governance reforms that will lead to future gains in profits and share values. This realization by investors is the result of both hard-earned experience and the work of researchers who have mathematically linked profitability and securities price performance to the way companies govern themselves. One 2004 study, conducted on behalf of Institutional Shareholder Services, found that companies with strong governance systems routinely reported returns on investment and equity that were 18.7 percent and 23.8 percent better, respectively, than those of poorly governed firms. This suggests that companies that treat their shareowners openly, honestly, and with respect also are likely to generate goodwill from their customers, suppliers, and employees. Numerous other studies have shown that well-governed companies have higher market multiples than companies with poorer governance standards. This relationship holds true, regardless of whether the company’s shares are listed in New York, London, Tokyo, Singapor, or South Korea. Then there are the disasters. Enron and WorldCom are just two of many examples illustrating how weak controls and feeble boards can lead to significant losses, if not bankruptcy. To help investors better understand how these links work, the CFA Centre for Financial Market Integrity recently published The Corporate Governance of Listed Companies: A Manual for Investors. Required reading for all new candidates in the Chartered Financial Analyst (CFA) program, this manual encourages investors to evaluate governance practices. It describes what governance issues to review by showing how those issues might manifest themselves. Board Independence A chief concern for investors should be the independence and competence of board members. While an independent board is certainly no guarantee for success, it is does limit conflicts between shareowners and the company’s officers and directors. Independence largely depends on the influence management has over individual board members. This influence can be direct, such as with directors who are employees or company advisers. In these cases, the chief executive has the authority to terminate employees or halt business with contractors should they fail to support management initiatives. Management also can have an indirect influence, often as a result of cross-shareholdings, common outside activities, or board memberships. In all such cases, management influence can affect the way individual directors vote. Fortunately for shareowners, positive changes are occurring. In part, this is because of listing standards mandated by the New York Stock Exchange and the NASDAQ Stock Market in 2003 requiring increased independence for the boards and audit committees of listed companies. Many companies, however, were already moving toward such a model prior to these initiatives. They had already recognized that an independent board could make well-informed decisions while also providing assurances that the board’s actions have thoroughly considered investor interests. Yet the move toward increased director independence has had the side effect of forcing companies to increase their focus on the competence of individual board members instead of their connections. Competence, in this sense, is not solely a matter of a director’s knowledge and experience but also relates to his or her ability to devote adequate time and attention to the company. Given that some strong directors have had to limit their board mandates to achieve investor expectations, it has made the process of recruiting new board candidates more difficult, yet increasingly important. Financial Experts Nowhere is the need for competent and independent directors more critical than in the audit committee. This is largely the result of changes to the listing requirements of the NYSE and NASDAQ. These rules, under which companies must have independent financial experts on their audit committees, are having tangible benefits. A recent study by Anup Agrawal and Sahiba Chadha indicates that the inclusion of such experts on audit committees reduces the likelihood of future earnings restatements. Independence of the audit committee is equally vital to ensuring that conflicts between management and the company’s external auditors are resolved in a manner that serves shareowners best. Combined, competence and independence enable committee members to provide valuable oversight of the way a company reports its financial results. Independence also is essential to the proper functioning of the nominations committee because this committee is ultimately responsible for deciding a board’s composition and competence. If its members are inclined to look to management for nominees, rather than to engage in active searches for candidates with relevant experience and expertise, then the board also is likely to comply more frequently with management’s wishes, perhaps at shareowners’ expense. Continuing Conflicts In large part, the purpose of corporate governance is to avoid or, at the very least, manage the conflicts among shareowners, management, and other parties. Yet, despite the improvements in governance mechanisms overall, conflicts of interest still create concerns among investors. A recent example of such conflicts is the pending merger between Archipelago Holdings and the New York Stock Exchange. Among the conflicts affecting this deal is the fact that the boards of both companies hired the same investment firm, Goldman, Sachs & Co., as their adviser. Additional conflicts have developed as a result of (i) the adviser’s former president acting as the NYSE’s chief executive; (ii) its role as lead underwriter for Archipelago’s 2004 initial public offering; (iii) its position as the second-largest owner of Archipelago shares; and (iv) its position as one of the NYSE’s largest and most active members. As a consequence, some, particularly at the NYSE, are questioning whether the deal is good for them. This deal is a good example of how the existence of real or perceived conflicts of interest can affect the market’s perception of a transaction, for better or worse. It also shows that boards serve their constituents best when they manage, limit, and avoid the kinds of real and perceived conflicts that can upset a deal. In this case, it is likely that a majority of shareowners of Archipelago and NYSE member firms will support the deal despite the conflicts, but the conflicts may ultimately contribute to the number of “no” votes cast on both sides. Director Elections Investors also are concerned about how companies nominate and vote for board members. If shareowners elect directors to act as their representatives on the board, then it is only reasonable that shareowners also should have some say in how those representatives are nominated. This is not the view taken by insiders, however, as evidenced by the extreme opposition company executives showed to the Securities and Exchange Commission’s proposal to permit shareowner nominees in certain, limited circumstances. While the SEC’s proposal has stalled, it does not mean that things won’t change eventually. Members of the International Corporate Governance Network and others have expressed a desire to change the director-approval process. They are pushing for a majority-vote requirement for the election of directors — a position the CFA Centre supports — which would replace the current plurality system where one vote is sufficient to win a board seat. At the ICGN’s annual meeting in London in July, only three percent of members representing some of the world’s largest investment funds voted in favor of plurality voting; 69 percent preferred a majority-vote standard. Regardless of whether majority voting becomes the standard in the near future, investors increasingly realize that corporate governance is an important element of any investment decision. Because the risks are too great to ignore any longer, many will prod companies to improve their governance in the hopes of improving their overall returns. Ultimately, it is in the best interests of shareowners — not to mention company officers and directors — for company boards to adopt sound corporate governance practices. After all, serving the best interest of shareowners is the job they were elected to do in the first place. |
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| Mr.
Allen is a senior policy analyst with the CFA Centre for Financial
Market Integrity. Copyright © 2005 Directors & Boards, P.O. Box 41966 Philadelphia, PA 19101-1966. All rights reserved. Contact the webmaster. < Privacy Notice > |
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