Corporate Governance Matters but Not in the Way You Think

Corporate Governance Matters: A Closer Look at Organizational Choices and Their Consequences by David Larcker and Brian Tayan. Larcker is the James Irvin Miller Professor of Accounting, Stanford Graduate School of Business. Brian Tayan is a member of the Corporate Governance Research Program at the Stanford Graduate School of Business.

The authors make a good case that corporate governance “suffers from considerable rhetoric.” Using available empirical evidence, they spend a considerable portion of the book debunking what are currently considered “best practices.” Fortunately, it doesn’t read like a diatribe, but rather a grounded framework that should be a valuable resource to anyone interested in this important subject.

After introductory chapters placing corporate governance in context, they devote substantial attention to the board: their duties and liabilities, selection, compensation, removal, structure. They also take a good hard look at CEOs: the labor market for CEOs, succession planning, compensation, and equity ownership. Other chapters cover organizational strategy, financial reporting and audits, market for control, investors, and ratings.

In 1994 the Council of Institutional Investors (CII) released Does Ownership Add Value?: A Collection of 100 Empirical Studies on the effectiveness of ownership structures and initiatives. Studies cited in that slim volume mostly supported shareowner activism or were inconclusive, while those cited by Larcker and Tayan lean even more to the inconclusive side. Perhaps the low hanging fruit reforms have mostly been implemented and those that some of us believe hold great promise, like proxy access, remain mostly untested.

One nice feature of the CII book that I would recommend to Larcker and Tayan for future editions was an appendix with a one line summary of each study grouped by topics, including a table indicating if the researchers found support for value added, subtracted or if the findings with respect to a practice were unclear.

The Larcker/Tayan book is more of a corporate governance text than a review of research but it does contain substantially more of the later than most texts on the subject. Still, because of a paucity of research in the field, the authors are frequently left to speculate. “Anecdotal evidence” was cited several times. Additionally, how much credence should we give to a survey of board members that finds they believe they “effectively challenged management” when necessary? Much of the value of research in the field is of questionable validity.

Still, anecdotal evidence can be enlightening, especially when it reveals directors being self-critical as when fewer than half reported believing they received excellent or good information about product quality, product innovation, relationships with business partners, customer satisfaction and employee commitment.

Another eye-opener is standard practice when recruiting directors. Companies generally assemble a list of top candidates, rank them in order of preference and then approaches them one at a time.

In effect, the board (or the nominating and governance committee) decides who it wants to nominate before meeting face-to-face with the candidates… this is done because it is considered inappropriate to approach a qualified candidate (one who has been highly successful in a professional career) only to reject him or her in favor of another. Although some people might cringe at this as reminiscent of an ‘old boys’ network,” it is not clear whether a competitive process would improve board quality or whether the most qualified candidates would choose not to engage in interviews.

Yes, I’m still cringing. What are we dealing with, potential corporate directors or temperamental movie stars? There’s plenty of ammunition throughout the book for shareowner activists, CEOs and directors about how to improve their performance. Unfortunately, most of the studies on “best practices” find mixed results, so one might expect their selective use to support whatever position one wants to advocate.

They cite a Corporate Board Member magazine survey that found almost a quarter of officers have directors they felt should be replaced: 36% lack necessary skills; 31% aren’t engaged. Yet, Audit Analytics counts only 106 dismissals out of the entire population of thousands of public directors in 2009. As Dr. Richard Leblanc points out in a recent post on Governance Gateway Blog, to be a company director in Ontario, Canada, “you need to be over 18, not insane (or at least found to be insane by a judge), and not bankrupt. That’s it.” I doubt qualifications are much stricter in the States. I would note that in California you need to be licensed to cut hair and it requires a training program of 1,500 hours.

The authors are quite good about parsing studies with additional considerations. For example, most studies of the effect of stock ownership by directors do not take into account that ownership guidelines for corporations are not usually calibrated to the individual director’s wealth. That could have a big impact on the likelihood of a correlation between director stock ownership and increased operating performance or firm value.

Another example is a study they cite that parsed out the difference between conventional financial independence of directors and social independence. “They found that social dependence is correlated with higher executive compensation, lower probability of CEO turnover following poor operating performance, and higher likelihood that the CEO manipulate earnings to increase his or her bonus.”

In any volume citing so many studies readers assume all are covered but that would be unrealistic. Even so, in a discussion of the impact of employee stock ownership they cited a study that concluded such firms have slower growth, have lower labor productivity, etc. This flies in the face of my own experience in working with employee owned firms where productivity soared. Perhaps a key difference was that the companies I am am familiar with also instituted systems facilitating greater participation by employees in decision-making. For balance in this area, I would refer readers to a variety of studies cataloged at the National Center for Employee Ownership.

Another eye-opener. In 2007 the Conference Board found most companies had not integrated risk management into strategic planning and general operations. PricewaterhouseCoopers LLP found only 20 percent of CEOs understand their responsibilities to manage risk. Of course, since the financial crisis one would expect much more attention in this area… at least we can hope. Another study cited in the book grouped companies into quartiles based on operating performance over rolling five year periods and found termination rates for CEOs in the bottom quartile of 2.7% per year, versus 0.8 in highest. “For our purposes, this study suggests that labor market forces are not always effective in removing senior-level executives.”

An amazingly counterproductive practice mentioned was search consultants that negotiate the CEO-elect’s compensation and are paid based on a percentage of that pay. And also this: “according to a study by Equilar, the average CEO stands to receive $29 million in cash and accelerate equity grants following a change in control.” That’s something to think about when reviewing your next CD&A for possibly inappropriate incentives. Another study found executie turnover rates double following an acquisition and that executive turnover remains elevated for ten years. Currently the richest 1% of households earns as much as the bottom 60% and possesses as much wealth as the bottom 90% of Americans put together.  Americans are getting disgusted with such excesses. Soon, they’ll be occupying Wall Street.

When it comes to assessing the value of shareowner democracy, the authors and I certainly have differences. They point out that a problem with majority vote requirements is that

dissenting votes are often issue-driven and not personal to the director. For example, an institutional investor might withhold votes to reelect members of the compensation committee if they believe the company’s compensation practices are excessive.

True, but such votes also took place before companies adopted majority vote requirements; majority voting just gives the votes more clout. More importantly, perhaps a director who dissents on compensation or other issues should be able to speak out. Then we shareowners would have a way of differentiating directors. Research from Cassandra D. Marshall entitled Are Dissenting Directors Rewarded? shows that corporate directors who resign from their post in protest pay a penalty in the job market over the following five years. The most common reasons for directors resigning in dissent are:

agency problems or corporate wrongdoing (34% of cases); differences in opinion about corporate strategy or the future direction of the company (30% of cases); a dysfunctional or inefficient board (24% of cases); and other/miscellaneous reasons (12% of cases).

Wouldn’t it be nice to get to a point where dissenting directors are rewarded, instead of punished, when their dissent is well grounded? The authors are worried that shareowner democracy may reduce shareowner value and the supply of high-quality executives to public firms. Evidence is in the form of negative market reactions to potential say on pay regulations and proxy access, especially among companies most likely to be affected. Sure, the market reacts negatively to the possibility of proxy access and at least one possible reason was confirmed when the DC Court overturned the SEC’s Rule 14a-11, essentially finding the SEC vastly underestimated the amount of money boards would spend from corporate coffers to keep themselves entrenched. Sears spent a small fortune to keep Robert Monks from obtaining one seat on their board. Imagine how how companies will spend to avoid two potentially dissident directors.

That’s where Larcker and Tayan fall a little short… in their use of imagination. Moving away from proxy contests involving separate cards to a system where all candidates are listed on the same ballot and voters can cross “interest” lines could just be the equivalent of moving from a system of warfare to one of democracy. Democracy is generally less expensive and more creative. Another point of disagreement is their contention that empirically proving the value of reform must be “a precondition to all governance changes, both those mandated by law and those voluntarily adopted.” You cannot prove what you aren’t allowed to try. Perhaps proxy access through private ordering under the amended Rule 14a-8 will provide the equivalent of laboratory experiments.

Despite several contentious issues, I found many more points of agreement and learned of many studies I hadn’t been aware of. I certainly agree that there has been too much focus on what they call the “features” of governance, instead of the “functions.” The presence of a feature shouldn’t imply the function is performed properly as we have seen over and over again in highly rated companies that had simply checked all the right boxes but with little in the way of real content.

Yes, issues are firm specific and the typical governance review of a firm like ISS can easily fall short because they don’t have the resources to dig very far beneath the surface given the meager fees investors are willing to pay when subscribing to a service that offers opinions on every company in their portfolio.

A better model might be one proposed by Mark Latham in his Proxy Voting Brand Competition. Under that system companies would pay for much more extensive reviews than those currently performed by proxy monitors like ISS. Instead of spending an average of $2,000 gathering and analyzing data, companies would pay more on the order of $100,000 to a reviewer selected by shareowners and the reviewer would make their findings available to all shareowners, not just to subscribers.

Just as DNA sequencing has allowed us to move to personalized medicine, Latham’s proposal would allow corporate governance reforms to be specifically tailored to individual companies. Such a system would allow examination in context of what Larker and Tayan see as real issues, such as organizational design, culture, the personality of the CEO and quality of the board.

In Corporate Governance Matters, you’ll find a wealth of information regarding best and standard practices, as well as a review of a multitude of studies attempting to measure their effectiveness. Certainly, this is the kind of book we need if “good” corporate governance is to have any meaning.

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