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A Comment on Commonsense Principles of Corporate Governance

Ask 100 people to define good corporate governance and you’ll get 100 answers. It’s time that changed.

By Stephen Cutler

"Good corporate governance” is a highly elastic catchphrase. While everyone would say it’s important, ask 100 people what good corporate governance is and you’ll get 100 different answers. Indeed, the term is something of a Rorschach test. Your definition of good corporate governance may say more about you (or, perhaps, whether you approach the topic as shareholder, regulator, board director, or member of senior management) than anything else.  

So maybe it’s not all that surprising that, in the last two years alone, there have been many efforts to compile principles of good corporate governance. Among them are reports from two Blue Ribbon Commissions of The National Association of Corporate Directors, one entitled “The Board and Long-Term Value Creation” and the other entitled “Building the Strategic Asset Board”; the OECD’s “Report to the Finance Ministers and Central Bank Governors of the G-20 on Principles of Corporate Governance”; and the Business Roundtable’s “Principles of Corporate Governance.” Similarly, The Clearing House’s “Role of the Board of Directors in Promoting Effective Governance and Safety and Soundness for Large U.S. Banking Organizations” and a 2015 update to its “Guiding Principles for Enhancing U.S. Banking Organization Corporate Governance” focus on the governance of major U.S. banking organizations. What may be most significant about the recent efforts of an ad hoc group of 13 business leaders that has resulted in still another set of corporate governance principles – this one called “Commonsense Principles of Corporate Governance” – is the composition of that group: CEOs of Fortune 500 companies, heads of some of the largest institutional money managers in the world, as well as the heads of a public pension fund and well-known activist investor. In full disclosure, I work closely with one of those CEOs, and spoke with him frequently about the Commonsense Principles as they were being crafted.

Commonsense Corporate Governance Principles Signatories

 

The 13 signatories to the Commonsense Corporate Governance Principles
are a veritable who’s who of business and finance.

 

Tim Armour, Capital Group

Jeff Immelt, General Electric

Mary Barra, General Motors

Mark Machin, CPP Investment Board

Warren Buffet

Lowell McAdam, Verizon

Jamie Dimon, JPMorgan Chase

William McNabb, Vanguard

Mary Erdoes, J.P. Morgan Asset Management

Ronald O’Hanley, State Street Global Advisors

Larry Fink, BlackRock

Brian Rogers, T. Rowe Price

 

Jeff Ubben, ValueAct Capital

                
It’s noteworthy that a collection of leaders as high-powered and diverse as this one was able to come to something of an agreement at all on just what good corporate governance for U.S. public companies means. I say “something of an agreement” because the ad hoc group’s Commonsense Principles, published in July of this year, were accompanied by an open letter that included the caveat that its signatories “hold[] varied opinions on corporate governance.” And the preamble to the Principles themselves says: “[G]iven the differences among our many public companies – including their size, their products and services, their history and their leadership – not every principle (or every part of every principle) will work for every company, and not every principle will be applied in the same fashion by all companies.” The Principles, implored the ad hoc group, are meant to be the beginning of a conversation – or perhaps, the continuation of one – about corporate governance, rather than the final word.

Maybe it was inevitable, given the ad hoc group’s diversity – and its members’ desire to speak with one voice – that the Commonsense Principles largely focus on familiar tenets of corporate governance, such as board diversity and independence, the importance of aligning board and management compensation incentives with shareholder interests, and the primacy of CEO (and management) succession planning. Befitting a document that’s labeled “Commonsense” (and with apologies to Thomas Paine), there may not be a lot here that will strike the casual reader as radical or unfamiliar. Shortly after the Principles were published, proxy advisor Glass Lewis said about them, “[They] generally recommend practices either generally already in place at most (particularly large-cap) companies or required by regulations or stock exchange listing rules.” And the Principles don’t answer some of the more controversial questions currently being discussed in corporate governance circles.

Still, the Commonsense Principles take a firm stand on a wide array of important issues, and more than a few of those positions are on the leading edge of corporate governance practices (even if they might not be described as novel or groundbreaking). While I highlight some of those below, I first step back and summarize the basic tenets that would seem to underlie the ad hoc group’s effort – that is, the principles behind the Principles. 

The Corporate Governance Principles leave a number of important corporate governance questions unanswered. Among them:

  • Should public companies provide “proxy access” to their shareholders? The Commonsense Principles simply say that some public companies and asset managers have recently reviewed their approach to proxy access and others have not yet done so; that among those companies that have adopted proxy access, the larger market capitalization companies have adopted a lower threshold of ownership for including board nominees on a company’s ballot; and that only shares in which proposing shareholders have full, unhedged economic interest generally count toward satisfaction of the threshold ownership requirements.

  • Should non-executive directors communicate directly with shareholders? Again, the Commonsense Principles don’t provide an answer. Instead, they say that, while robust communication with shareholders is important, “[t]here are multiple ways of going about it.”

  • Should companies have a mandatory retirement age or impose a limit on years of service for board members? The Commonsense Principles say only that some companies have them and others don’t, and that “[w]hatever the case, companies should clearly articulate their approach,” and “should explain ... why a particular exception was warranted.”

  • How many boards are too many for an outside director? While International Shareholder Services currently will recommend against a non-executive director who serves on more than five boards, the Commonsense Principles don’t include a maximum number of boards for such outside directors, instead saying only that “the board should carefully consider a director’s service on multiple boards and other commitments” when it “assess[es] the ability of its members to maintain appropriate focus.”

  • Should there be higher ownership or other thresholds for shareholder proxy proposals? Currently, any shareholder owning $2,000 worth of stock may put a proposal on the company’s ballot, without paying a filing fee; and a proposal may be put on the ballot again unless it has been defeated within the past five years by more than 97% of the vote. The SEC has not revisited these thresholds for many years, despite calls from a number of commentators, including Delaware Chief Justice Leo Strine, to do so. The Commonsense Principles don’t address this issue at all.

  • Are poison pills, classified boards, supermajority vote requirements and other anti-takeover defenses appropriate? If so, under what circumstances? The Commonsense Principles are silent on these matters.

  • Should the way in which asset managers compensate their portfolio managers be revisited? The Commonsense Principles don’t raise this issue, but a number of commentators have argued that to the extent portfolio managers are rewarded (or not) based on short-term performance (how did the manager’s portfolio perform this year?), they may be too focused on the short-term results of the companies in their portfolio, and unwilling to support long-term oriented investments that dampen those short-term results.

 

First and foremost, the Principles are focused on “long-term oriented” governance. Consistent with recent and not-so-recent statements from, among others, lawyers Marty Lipton and Ira Millstein, Vice President Joe Biden, and prominent institutional investors – including the ad hoc group’s Larry Fink and Ronald O’Hanley – decrying public company (and shareholder) preoccupation with short-term results at the expense of long-term value creation, the authors of the Commonsense Principles note in their open letter: “Our future depends on [public] companies being managed effectively for long-term prosperity.” And the Principles themselves reference the importance of long-term thinking in a number of places. For example:  

  • The board “should seek the proper calibration of risk and reward as it focuses on the long-term interests of the company’s shareholders.”

  • “Companies should ... provide an outlook, as appropriate, for trends and metrics that reflect progress (or not) on long-term goals.”

  • “[A] company’s compensation plans ... should ... ensure alignment with long-term performance.”

  • “As appropriate, long-term goals should be disclosed and explained in a specific and measurable way.”

  • Asset managers ... should evaluate ... [t]he board’s focus on a thoughtful, long-term strategic plan and on performance against that plan.”

While the Principles’ drumbeat in support of long-termism might be viewed by some as a shot across the bow of current shareholder activists, the inclusion of an activist among the ad hoc group would suggest otherwise – that even activist shareholders can and should play a part in promoting corporate governance aimed at long-term value creation instead of short-term increases in stock price. Shortly after publication of the Principles, Nelson Peltz, the CEO of activist investor Trian Partners, said: “These principles are music to our ears. … Sound corporate governance can lead to better long-term growth and performance at public companies.”  

Second, the Commonsense Principles don’t adopt a one-size-fits-all approach. They allow for a company, as well as its board, management, and shareholders to tailor their approach in light of the company’s industry, history, personnel, and particular context and circumstance. In their open letter accompanying the Principles, the ad hoc group acknowledges “that there is significant variation among our public companies and that their approach to corporate governance will inevitably (and appropriately) reflect those differences.”

 

The Principles recognize that board refreshment is important, but they also recognize that experience brings wisdom, judgement, and knowledge.

 

Third, it’s notable (though perhaps unsurprising, given their emphasis on long-term performance and value creation) that nowhere in the Commonsense Principles is there a mention of profit maximization. The lens of the Principles would appear to be broader, for among the duties of a board highlighted in the Principles are “maintaining and strengthening of the company’s culture and values,” and “[m]aterial corporate responsibility matters.”

Fourth, the ad hoc group clearly sought to bring to its task the mindset of a private company owner. That is, throughout its work, the group seemed to have in mind the question, “What would you do if you owned 100% of a company?” Thus, the Commonsense Principles note that a board should be “encouraging the sort of long-term thinking owners of a private company might bring to their strategic discussions, including investments that may not pay off in the short run.”

Fifth, good corporate governance is not just the province of a company’s board. It’s also the responsibility of company management, as well as company shareholders. Governance, in other words, is a shared responsibility. As noted in the open letter: “Effective governance requires constructive engagement between a company and its shareholders.” And the last topic of the Commonsense Principles speaks directly to the role of asset managers in promoting good corporate governance.

So with that foundation, I turn to the Principles themselves. There are 58 of them, organized into eight different topics: 1. Board Composition and Internal Governance; 2. Board Responsibilities; 3. Shareholder Rights; 4. Public Reporting; 5. Board Leadership (Including the Lead Independent Director’s Role); 6. Management Succession Planning; 7. Compensation of Management; and 8. Asset Managers’ Role in Corporate Governance. In the balance of this article, I highlight and comment on an idiosyncratic list of notable items from each topic (rather than comment on each of the 58 principles).

The full text of the Principles and the open letter accompanying them are available at www.governanceprinciples.org.

1. Board Composition and Internal Governance
he Principles underline the importance of diversity in the boardroom, not just for the sake of diversity itself (or the importance of diversity as a social goal), but because diversity – in the backgrounds, skills, and experiences of board members – can lead to a better-functioning board. That means, among other things, embracing the possibility of board members whose professional experiences aren’t “directly relevant” to a company’s business. The Principles recognize that “some of the best ideas, insights and contributions” may originate with those directors.

The Principles also recognize “small” as a virtue (without defining what small is) when it comes to board size. The Principles say that boards should be as small as practicable, in order promote an open dialogue among board members, though large enough to achieve diversity and to accomplish all of the tasks required of the board.

As for those tasks, the ad hoc group appears to have aligned itself with those (including The Clearing House and Federal Reserve Board Governor Daniel Tarullo) concerned that the number of responsibilities being shouldered by boards is ever-growing. Whether that growth is a function of more regulation, or a reflexive desire to hold boards responsible for whatever a company does (what did the board know and when did it know it?), or something else, the Principles note that task overload can impede the recruitment and retention of strong directors. The Principles also say that a board “should minimize the amount of time it spends on frivolous or non-essential matters.”  

The Principles address two elements of director compensation worthy of mention. First, in order to align director incentives with the long-term performance of the company, the Principles say that companies should consider paying “a substantial portion” (meaning as much as 50% for some companies) of director compensation in stock or comparable equity-like instruments. Second, the Principles say that directors should be equally compensated for their service – recognizing that additional compensation may be appropriate for committee service, as well as service as a lead independent director or committee chair. That principle has important implications for any company with an activist or private equity representative on its board. For it’s not unusual for that board member to receive additional compensation from the activist investor or private equity firm – even though a director’s receipt of compensation from a single shareholder could call into question the director’s loyalty to the company as a whole.

The Principles recognize that board refreshment is important, but they also recognize that “age and experience often bring wisdom, judgment and knowledge.” Thus, as noted above, the Principles don’t take a firm position on the question whether companies should adopt a mandatory retirement age or term limits for board members. But particularly in the absence of such rules, a board “should have the fortitude to replace ineffective directors.”

2. Board Responsibilities
The Principles note that one of a board’s most important jobs is ensuring that the company has the right CEO – and say that a board should act promptly if the company doesn’t have that CEO. The Principles highlight the responsibility of a board to communicate with shareholders, but don’t take a position on whether that should be done directly or can be done through management.

The full board should have input on the setting of the board agenda, and over the course of a year, the agenda should include, among other things, the following:

  • “a robust, forward-looking discussion of the business”

  • the performance of and succession planning for the CEO and senior management

  • long-term strategy

  • significant risks

  • culture and values

  • material corporate responsibility matters

  • key shareholder concerns

  • management compensation

At each meeting, the board should convene an executive session without the CEO or other members of management present.

3. Shareholder Rights
The Principles characterize dual class voting as “not a best practice.” If a company has such voting (and the ad hoc group recognizes that sometimes that structure is intended to protect a company from short-term pressures), the company should consider a sunset provision.

The Principles also note that the threshold levels of share ownership required to call special shareholder meetings or to proceed by written shareholder consent should be high enough to prevent a small minority of shareholders from being able to trample on the rights of the majority of shareholders or waste the company’s resources.

4. Public Reporting
Among perhaps the most discussed pronouncements in the Principles is this one: “A company should not feel obligated to provide earnings guidance – and should determine whether providing earnings guidance for the company’s shareholders does more harm than good.” While the ad hoc group didn’t specify what harm could arise from earnings guidance, it’s reasonable to assume that its members were concerned that such guidance can make even more acute an unhealthy focus on short-term results.

Also worth noting is the ad hoc group’s alignment with Securities and Exchange Commission Chair Mary Jo White on the subject of non-GAAP (generally accepted accounting principles) results. Like some recent guidance from the SEC, the Principles say that non-GAAP measures shouldn’t be used to obscure GAAP results – or defy common sense. The example that the Principles cite in support of the latter proposition is one that may not meet with universal agreement in all corners of the issuer community: “Equity compensation,” say the Principles, “is plainly a cost of doing business and should be reflected in any non-GAAP measurement of earnings in precisely the same manner it is reflected in GAAP earnings.” In this regard, the Principles are in accord with recently reported concerns of banking regulators that loans for leveraged buyouts have been too liberal with adjustments to earnings – including the exclusion of equity compensation – in order to meet regulatory leverage guidelines.8

5. Board Leadership
The Principles take a firm stand on the question whether the CEO and chairman roles should be combined or separate: The board’s independent directors should decide. Thus, the ad hoc group doesn’t believe that combining or separating the roles is a matter of principle, but rather, is a function of “the circumstances at the time.” The Principles go on to say that if a board decides to combine the roles, there should be a strong lead independent director. His or her responsibilities should include, among other things, the authority to call meetings of the independent directors; ensuring that the board has appropriate input into meeting agendas; and guiding the board’s self-assessment process, CEO succession planning process, and consideration of CEO compensation.

6. Management Succession Planning
The Principles recommend that companies have both peacetime and emergency succession plans. Board should have direct exposure to the “bench” of potential CEO and senior management successors in order to aid its succession planning process. And companies should inform shareholders of the process for succession planning.

7. Compensation of Management
The Principles say that compensation should not be wholly formula based – that is, companies should “retain discretion ... to consider qualitative factors, such as integrity, work ethic, effectiveness, openness, [and other] matters ... essential to a company’s long-term health.” As with director compensation, companies should consider paying a “substantial portion” (again, meaning as much as 50% or more) of senior management compensation in stock or similar equity-like instruments in order to align incentives with the long-term performance of the company.

The Principles say that some latitude should be given to a company’s compensation plans if those plans are “well-designed ... and clearly explain[ed],” even if the plans don’t match proxy adviser models or those of competitors.

8. Asset Managers’ Role in Corporate Governance
To facilitate appropriate senior-level oversight by asset managers of proxy voting and corporate governance activities, the Principles say that asset managers should have access to the company, its management, and, in certain circumstances, its board. By the same token, a company should also be able to communicate directly with  the asset manager’s senior decision makers on these issues.

Asset managers should exercise their voting rights thoughtfully and in the long-term interests of their clients. Although asset managers may rely on various sources to inform their voting decisions, ultimately their votes should be independent and based on their own voting guidelines and policies rather than be wholly outsourced to proxy advisors. Asset managers should consider sharing their proxy voting processes and standards in order to facilitate a constructive dialogue between asset managers and the companies in which they are invested.

Conclusion
While the Commonsense Principles on Corporate Governance don’t purport to apply to every company in the same manner, may not stray far from the tried and true, and don’t seek to address every issue in the realm of corporate governance, they do contain some important recommendations. Despite the “commonsense” appellation, some of those recommendations are at the vanguard of corporate governance practices. That they were endorsed by a group of, among others, respected CEOs and leaders of the some of the largest institutional investors in the world is especially noteworthy. If blog posts, news articles, and conference agendas are any indication, the ad hoc group has succeeded in jump-starting a national dialogue about U.S. public company corporate governance. The Principles will be no doubt an important part of the corporate governance landscape in the years ahead.

About the Author: 
Stephen M. Cutler is Vice Chairman of JPMorgan Chase & Co. From 2007 through 2015, he was the company’s General Counsel. Before joining JPMC, Cutler was a partner and co-chair of the Securities Department at Wilmer Cutler Pickering Hale and Dorr LLP in Washington, D.C. From to 2001 to 2005, Cutler served as Director of the U.S. Securities and Exchange Commission’s Division of Enforcement, where he oversaw the Commission’s investigations of Enron and WorldCom, among others. Before joining the SEC, Cutler was a partner at Wilmer, Cutler & Pickering in Washington, D.C. 

He is a 1985 graduate of Yale Law School, where he served as an editor of the Yale Law Journal, and a 1982 graduate (summa cum laude) of Yale University. Following law school, he was a law clerk to Judge Dorothy Nelson of the U.S. Court of Appeals for the Ninth Circuit. Cutler is on the boards of the Legal Action Center, the National Women’s Law Center, and the Metropolitan Museum of Art.