Stock Investors
The reality of global corporate management means that boards and managers can run a business for the benefit of many constituencies, not solely shareholders. Laws permit managers to operate pretty much wherever they want along the spectrum from a shareholder orientation to a constituency orientation. One part of business analysis is evaluating the degree to which management has an owner orientation.
Sources for determining that orientation abound, probably more so in the United States but increasingly throughout the developed world. In the United States, corporations disclose volumes of information to shareholders and other interested people. Many corporations go beyond legal requirements, producing substantial information on their Web sites and Webcasting archives and you can get plenty of high-quality and reliable information from publications by reputable industry analysts such as Standard & Poor's, Dun & Bradstreet, and Robert Morris Associates as well as government agencies such as the Federal Trade Commission. Use your imagination.
Sift through these materials in looking for managers who act like stewards of shareholder capital. Use it to find the best managers, those who think like owners in making business decisions and who adopt an attitude of partnership, embracing shareholders as members of the enterprise rather than as strangers to it, those you would be happy to invite over for a Super Bowl party.
However, even owner-oriented managers sometimes have interests that conflict with those of shareholders. Work to identify and invest stock with those who make a habit of easing those conflicts and nurturing managerial stewardship of owner funds, those who exhibit Aristotelian ethical virtue.
It is not easy to detect governance indicators of an owner orientation in place at a corporation any more than it is to detect the financial or managerial performance or even value of a corporation from its financial statements. However, as with that effort, it is worth the work.
The difficulty and the possibility exist because the law requires very little of corporate governance. Yes, federal securities laws impose extensive disclosure obligations, though most of what they call for probably would be produced voluntarily by good companies participating in a vibrant market economy anyway. Yes, state laws impose duties on directors and managers, but those duties are loose and general. Some statutory rules or limits are imposed, but they are either highly formal and therefore malleable or pretty meaningless as a practical matter and can be altered in corporate by-laws or charter documents.
Corporate governance as such is not necessary. Many advocates of corporate governance argue for reforms directed toward compelling an owner orientation, usually described as aligning management and shareholder interests or enhancing board oversight of CEO performance. If a company needs these mechanisms to create an owner orientation, however, its valuation should be discounted proportionally.
Most corporate governance reforms fail to solve governance problems, and some exacerbate them. Nevertheless, institutional stock investors and other shareholder advocates have promulgated a variety of policies about corporate governance, most of which are designed to promote an owner orientation. But just as fads infect finance, they gum up governance too.
Perhaps the most popular governance idea in the past couple of decades has been the call for independent boards of directors. The National Association of Corporate Directors (NACD) and many institutional stock investors including CalPers and TIAA-CREF, urged that corporate boards be composed of at least a majority of outside directors, those without employment or other affiliation with the corporation. The idea was that this would strengthen directorial spines to keep management in check. Nearly all major companies fell into line, with 90% of Fortune 1000 companies having a majority of independent directors.
These arguments were made on the basis of intuition, however, rather than analysis. It was as if there were little or no doubt that managers needed to be kept in line and that director watchdogs could do the trick. This premise has been exploded by several studies showing that far from independent boards enhancing economic performance, there is actually a negative correlation between the degree of independence and forex financial results.
This is not to say that having some or many independent directors is never desirable (Buffett, for example, believes that most directors should be outsiders), 4 but there is no reason to give credit ipso facto to a company just because it does this. The unanswered commonsense questions are: (1) Who are these independent directors? and (2) What value do they add to the boardroom? Independent directors famous for international diplomacy or senatorial jobbery may be far worse to have at the table than a chief financial officer with extensive industry and managerial experience. A template that calls for independence is not a virtue but a mirage.
The key is to choose directors for their business savvy interest in the job, and owner orientation. To be avoided are celebrity directors and others who are chosen for nonfundamental reasons, such as adding diversity or prominence to a board.
Another popular move some companies fell for was the push to split the functions of the company's CEO from those of its board chairman. This manifested the same rationale of independence prescriptions, a need to check the boardroom power of the CEO. Only about 5% of Fortune 1000 companies succumbed to this formula, probably with good reason.
As an empirical matter, as with board independence, most evidence shows that companies that split these functions do not perform better than those which do not. 5 As an abstract matter, it is hard to justify giving a company governance credit for this separation of function, for putting a watchdog on the CEO suggests as many reasons to be suspicious of the CEO as reasons to trust him. For a company whose CEO is not to be trusted, this may be a good step, but it sounds more like probation than probity and is a strong warning signal for stock investors to run from rather than embrace the business. Only a fool, after all, thinks trust can be purchased or structured.
One aspect of this reform makes sense, however, and many companies adopted a version of it by providing for a nonexecutive board chair for critical functions such as CEO, board, and director evaluations. After all, letting the CEO grade herself and her board does pose a risk of self-delusion. An independent grader is in a better position to evaluate performance objectively, and so some governance credit is justified for a company that takes this step.
Director independence is frequently encouraged for some committees and often required for audit committees. Audit committee independence is consistent with the structure of U.S. audit practice that requires an auditing firm to be independent of the company and its management. Independence on compensation committees reflects the logic of a nonexecutive overseer for key functions such as CEO and board performance review.
However, the argument for requiring independence on other committees, such as nominating, ethics, and governance, is the same as that for independence overall. If a corporation needs those kinds of things, it has problems anyway. The mere fact that a corporation has various independent board committees does not guarantee that problems arising from collusion or delusion will be absent or disappear.
Periodic and formal evaluations of the CEO and other directors are often recommended and do seem sensible and worthy of praise. To deserve credit, however, the CEO reviews should be conducted outside the presence of the CEO, something that is not easily or commonly done. A more general way to implement this practice is to supplement such periodic reviews with regular director meetings outside the CEO's presence, a practice Buffett in particular champions. This is creditworthy not so much under the logic of suspicion of the CEO but as an independent check on the CEO's judgment.
Some gobbledygook about improved board processes is commonly bandied about. This is usually sheer nonsense or gloss. Requirements such as swift flows of quality information, statements of governance principles, and procedures for full and effective participation of all directors seem like mere bafflegab. These practices should simply be part of the normal operation of a well-governed corporation. Giving credit for the articulation of these practices is superfluous—like giving umpires extra credit for knowing the rules of baseball.
Other common and strange prescriptions take pages from the equally silly playbook of American politics. Term limits for directors? Why should a good director be forbidden from continuing in his job just because he's done it for a specified period of time? Age limits? Nearly 40% of Fortune 1000 companies adopted age limits in response to urgings from governance poobahs such as CalPers.
But a company that forbids persons older than, say, 65 or 70 is ordaining the exclusion of talent from its reach. One can applaud Jack Bogle for stepping down as Vanguard's chairman at the fund's mandated retirement age of 70, but is Vanguard really better off without Jack or any other (old!) sagacious person with integrity? And what should it matter—on its own terms—that 5 of the 18 members of Disney's board are in their seventies, if those people are savvy business leaders who seek to promote the interests of Disney's owners?
At the other end of the politically correct scale of corporate governance is the goal of trying to add diversity of gender or race to the board. Diversity itself is not a laudable business goal and is nothing for which credit should be given to the leaders of a business organization. It is just as out of place, silly, and off the mark as deliberately creating and maintaining a diversified portfolio of stocks. It may turn out to be fine and dandy, but if so, that is a consequence and not a cause of a more prudent disposition that focuses on fundamentals rather than frames. It does not matter one way or the other that GE's board has two women and one black person on it though it does matter that those people and GE's other directors are outstanding business thinkers with a strong owner orientation.
The problem with all these sorts of proposals is their universality. What is good for GM may not be good for GE, and what is good for either of them may not be good for Procter & Gamble or eBay, Wrigley or Hershey. Each corporate situation justifies and calls for its own governance structure and analysis. Broad credit can be given only for governance moves that have some inherently defensible logic, such as having the board review the CEO's performance without her being present and having independence on the audit committee.
Beyond that, these general principles are of little use. Indeed, too much emphasis on them can be affirmatively misleading. You can put all the governance bells and whistles you want on a board, but if its CEO or other strong leaders lack integrity, you can be sure they will neither ring nor blow.
