For company directors, corporate governance issues are constant. These issues are also now more public, with greater levels of disclosure required. With shareholder rights to vote on remuneration reports, director equity grants, director elections, schemes of arrangement, and other significant governance matters, judgements on director competence are also more public, with consequences for reputational risk.
Proxy advisers and activist investors constantly challenge boards. The result is much governance activity to comply with external governance guidelines without traction and real purpose.
Most public companies fall into this trap as they conform to investor and proxy adviser guidelines as they focus on maximizing investor support.
Through all this activism, boards and their investors invariably miss the real corporate governance problem. That is, they have extensive governance procedures but no governing objective.
As a result, there is no sound basis for stakeholders, including shareholders, to assess the performance of the company and its executives.
Corporate governance is a system of checks and balances that a company designs to ensure it faithfully serves its governing objective.
The governing objective is the cornerstone upon which the organisation builds its culture, communications, and choices about how it allocates capital. It is as simple as having a clear statement of what a company is fundamentally trying to achieve.
For those companies that have thought about it, there are currently two competing ‘schools of thought’ on what is a governing objective.
Let’s look at those schools of thought but, in doing so, recognize that they are not mutually exclusive. There will be a crossover of aspects of each into the other.
The first believes the company’s goal is to maximise shareholder value. Countries that operate under common law, including Australia, Canada, New Zealand, Ireland, the United States and the United Kingdom, lean in this direction, notwithstanding some recognition of other stakeholders’ interests.
The second school of thought believes the company should balance the interests of all stakeholders. Countries that operate under civil law, including France, Germany, Spain, Italy and Japan, lean to this notion.
The problem with “maximising shareholder value” is that it has been corrupted by both institutional investors and management on short-term incentives who believe, incorrectly, that the goal is to maximise short-term earnings to boost today’s share price. And woe betide any board that stands in the way of a fund manager’s short-term performance fee.
There have already been many instances of high “no” votes on remuneration reports stemming entirely from poor short-term financial results that have nothing to do with how well remuneration conforms to a properly considered governance objective.
Properly understood, maximising shareholder value means allocating resources so as to maximize long-term cumulative cash flow. Given that an organisation’s success depends on long-term relationships with each of its stakeholders, lengthening the investment time horizon will benefit customers, employees, suppliers, creditors, and communities as well as shareholders.
You can also see in this last statement that maximizing shareholder value equally has elements of balancing the interests of all stakeholders.
Alternatively, the European or Japanese approach of balancing stakeholder interests sounds like a reasonable idea. However, it cannot be a company’s governing objective because it is impossible to simultaneously satisfy the interests of all stakeholders. The heavy concentration of union representatives on a German company’s management board, or executives on a Japanese company board, did not prevent the spectacular failures of recent car company emissions and fuel economy scandals.
In the absence of a singular governing objective, executives have more influence and to balance those interests in the way they think is right. It is difficult for a board to hold them accountable for what they decide – there is no governing objective.
Company boards must take steps to establish an effective corporate governance structure based on an overall governing objective. This will ensure consistency between what they say and what they do.
We provide a checklist.
1. Corporate boards must select a clear governing objective.
2. That may mean choosing shareholder or stakeholder value, but that is not enough. Those that initially embrace maximising shareholder value as their governing objective will also need to specify the time horizons they will use in their planning and decision-making processes.
3. Companies that choose to balance the interests of stakeholders, as their governing objective must explain how they intend to manage the diverse and often conflicting interests of their stakeholders. In particular, they need to address (and potentially disclose) the acceptable limits for tradeoffs they are willing to make at the expense of their shareholders. In Australia, vertically integrated financial services businesses may need to confront this sooner rather than later.
4. Time horizon is a particularly important part of the governing objective’s definition. Some observers contend that focusing on an uncertain long term distracts the organisation from what it needs to accomplish in the short term. But the short term and the long term are not mutually exclusive concepts. The task is to focus continuously on what the organisation needs to accomplish in the short term in order to achieve its long-term goals. In one of his early books the great management thinker Peter Drucker wrote “They must, so to speak, keep their noses to the grindstone while lifting their eyes to the hills—which is quite an acrobatic feat.” (readers, and especially politicians, should see HERE)
5. Companies need to adopt a set of policies that encourage behaviours consistent with the governing objective. This includes non-financial and financial performance metrics as well as incentive plans. Boards will often reward executives when they fail to create value. As justification for proxy advisers’ clampdown on STI payments for non-financial outcomes only, there is research that shows the non-financial metrics that companies use are commonly untethered to either long-term value creation or the company’s strategic goals (see HERE).
We know it is hard to design, but incentives still remain essential for an organisation to faithfully serve its governing objective. However, they have to be the right incentive for the right outcomes. If a board prioritises an objective other than creating shareholder value (safety improvements are a good example), the board needs to disclose the acceptable limit for trade-offs it is willing to make at the expense of the shareholders.
In many ways, a governing objective can make choices on incentive design easier. If the governing objective has been framed for the long term, there is no need to agonise over whether to use a measure of underlying earnings and AASB NPAT. To the chagrin of some proxy advisers and other governance people, if the choice is between maximising NPAT or maximising the present value of future cash flows, boards would have to opt for the cash flows.
6. A board must communicate its governing objective and supporting framework with all of the stakeholders. This includes disclosure of the governing objective, the time horizon the company will use, how it will prioritise and resolve trade-offs among stakeholder interests, and the policies in place that support the governing objective. Stakeholders can then take it or leave it. Those that remain have to accept it. This alone should serve as a powerful antidote to corporate short-termism. It also provides the board with the tools to respond to criticisms of poor performance in the short term.
Given election results, perhaps a similar approach should feature as part of an annual citizenship pledge for Australians who want to retain voting rights, and their aspiring parliamentarians.
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