STEP  CHANGE

Simply a matter of metrics and ethics

BY Jayashantha Jayawardhana

As Investopedia defines it, corporate governance is the system of rules, practices and processes by which an entity is directed and controlled. It encompasses practically every sphere of management, from action plans and internal controls to performance measurement and corporate disclosure.

Today, there’s hardly any serious business news that doesn’t mention corporate governance while every annual report devotes a vast space to discuss it as well. But what’s happening in the corporate landscape today begs the question whether the practice of corporate governance actually fits its definition.

Prof. Guhan Subramanian sums up this issue cleverly in his article titled Corporate Governance 2.0 in an edition of Harvard Business Review (HBR) back in March 2015.

He writes: “Achieving best practices (corporate governance) has been hindered by a patchwork system of regulation, a mix of public and private policy makers, and the lack of an accepted metric for determining what constitutes successful corporate governance.”

“The nature of the debate doesn’t help either: shrill voices, a seemingly unbridgeable divide between shareholder activists and managers, rampant conflicts of interest and previously staked out positions that crowd out thoughtful discussion. The result is a system that no one would have designed from scratch with unintended consequences that occasionally subvert both common sense and public policy,” Subramanian adds.

Two events he cites in the article are enough to throw light on such unintended consequences of current corporate governance systems that subvert both common sense and public policy.

In 2010, hedge fund titans Steve Roth and Bill Ackman acquired 27 percent of JCPenney stock before having to disclose their position. Penney’s CEO Mike Ullman discovered the raid only when Roth informed him.

And in 2012, JPMorgan Chase didn’t have directors with risk expertise on the board’s risk committee – a deficiency that was corrected only after Bruno Iksil (a.k.a. London Whale) caused US$ 6 billion in trading losses through what JPM’s CEO Jamie Dimon called a “Risk 101 mistake.”

In the same article, the writer goes on to propose three major principles that are meant to bring about a step change in the quality of corporate governance instead of an incremental meandering towards what may or may not constitute a better corporate regime.

PRINCIPLE #1 Boards should have the right to manage a company for the long run. Today’s corporate boards are obsessed with short-term performance at the expense of shareholder wealth creation in the long run. This is because the holding period of a particular stock averages less than six months these days.

But a board must be elected to manage a company for the longer term. A staggered or classified board where a third of the directors are elected each year for three year terms helps more than a unitary board where directors are appointed every year for one year terms.

PRINCIPLE #2 Boards should install mechanisms to ensure that the best possible people are in the boardroom. When a board is allowed to manage the company for the long run, it has an obligation to ensure the right mix of skills and perspectives in the boardroom.

Some companies have imposed age and term limits on their directors. These serviceable instruments are needed when directors continue, even when they contribute very little, simply because they can’t be told to step down.

On the other hand, the contribution by a competent director may have little to do with age or term. In fact, some older directors possess greater experience and seasoned corporate acumen that’s critical for efficient management.

So companies must develop an effective mechanism to court valuable candidates onto their boards and retain them – and do away with nonperforming directors with or without the aid of statutory limits. Director evaluations with an independent expert will serve this purpose to a great extent.

PRINCIPLE #3 Boards should give an orderly voice to shareholders. The new role of the board isn’t to defend the corporate bastion at any cost but serve in the best interests of shareholders. The directors must campaign hard for their point of view but leave the decision to shareholders.

If the majority of shareholders consider that a takeover offer will unlock substantial value for them – i.e. the takeover price carries a considerable premium over the current market price; or if they believe it offers better growth prospects or future earning potential – the board must carefully evaluate the offer rather than battling it at any cost.

And it must then articulate the stance taken by the majority of shareholders.