A Real Look at Real World Corporate Governance by David Larcker/Brian Tayan

Preface. How do you assemble the best board of directors? How do you pick the best CEO? This books examines the factors for corporate success.

Introduction. Societal leaders should do more. Lehman Brothers went under and there was a need to shake up the industry. The Dodd-Frank Wall Street Reform and Consumer Protection Act was passed in 2010. Is this the solution to all problems? There is an issue of ‘procedure over substance’. There might be unintended consequences to improving corporate governance. High-level ideas might not be met well at the ground level. As it is empirical in nature, corporate governance can be research and studied. This is better than just theory. It is essentially the theory of separation between owners and the management. The fear is that the management protects self-interest at the expense of shareholders. This is essentially an agency problem that needs to be solved. One will want to do so in a cost effective manner. The requirements must be clear as those that are ambiguous are not effective in the long run. The issue of poor corporate governance is actually quite poor in recent times. The problems are there but finding the solutions are much harder. We need to focus on the big-picture issues.

Board of Directors. Most of the board members should be ‘independent’ of management. They are elected by shareholders. The board’s role is to advise and monitor management. They have a right to question management’s plans in order to ensure that it is adding to shareholder value. Sometimes, they can also offer strategic advice to management. They are also expected to maintain an oversight function and monitor management. What does it mean when a board is functioning well? How do you know that the board selected can perform all of the above satisfactorily?

Lehman Brothers – A Case of Form over Substance. A board also has to provide oversight so that regulatory and legal requirements are being met. Some of the ‘best practices’ in the market have not been proven before and appear vague. There are issues when choosing board members as giving them a 3 year term might seem too long. Does independence standards help to improve corporate performance? Very little. Interlocked directors might lack independence but they have the know-how of the two companies and can form synergies. How can you tell whether a board is effective? The Lehman Board had diverse directors on-board. What went wrong? Upon closer inspection, you will realize that there is no one of financial expertise on-board. In addition, there is a lack of people with current business experience. Some of them were also well into retirement and couldn’t be expected to understand complex finance. Those with non-profit backgrounds didn’t help to value-add as well. The guy appointed to chair audit committee didn’t know about finance. There were also not many finance committee meetings. Structure of the board is important. However, there is little evidence to show that it is effective.

Are CEOs the best Directors? A CEO is very important as a candidate for a director in another company. This is because he has the right experience in making decisions etc. It is not uncommon for CEOs to sit on the boards of other organizations. However, this trend is declining. This is because companies have guidelines that prohibit outside directorships for their current CEO. Now, the trend is to recruit more junior senior management or retired CEOs. Current CEOs may not be the best bet. This could be because they are too busy caring about the affairs at their current company. CEOs have the ability to deal with failure/crises. In recent studies, there is little evidence to show that hiring CEOs as directors can positively contribute to operating performance. Is there a shelf life to director experience? Earning fees elsewhere might also impair their independence.

Are the Directors of Failed Companies Tainted? After a failure or scandal, the stock price will plunge. The damage might be long-lasting as well. The company might face lawsuits as well. Lastly, there might be turnover in the company too. Non-executive directors from failed banks managed to find directorships elsewhere. The reputation of the directors might get hit. Is it the directors’ responsibility to detect any malfeasance? There is some evidence that shows that executives of failed companies are treated more strictly. The Board is assumed to have less time to detect problems and hence cannot be fully blamed for any malfeasance. This is an issue that must be discussed in greater detail.

Part II: Accounting and Controls. Hiring an external auditor has a deterrence and detection help. External auditors only check on a sampling basis. They tend to focus on revenue accounts that rely on management estimates. This leaves room for manipulation. Auditors are expected to maintain professional scepticism throughout the audit. Accounting requires discretion at times and there might not be ‘correct’ accounting. Malfeasance can still occur even in the audited accounts. Revenue recognition/expense recognition/misclassification/OCI/tax accounting are all areas that can go wrong.

What’s Wrong with GAAP? In the US, GAAP is used. Companies can still retain considerable discretion over financial reporting. Non-GAAP information might also be reported as a supplement. These often include non-cash items, amortization, restructuring etc. Non-GAAP often paint a rosier picture of the company. SOX requires a company which non-GAAP earning to reconcile them with GAAP earnings and provide both figures. Often, one-time costs are included in the GAAP earnings. It is important to try and steer clear from non-GAAP adjustments. However, non-GAAP earnings might have higher information value. Non-GAAP earnings usually do not include one-off items that are unlikely to recur. Fluctuations on mark-to-market instruments also hit GAAP earnings even though contracts specify that some options cannot be exercised until expiration. Companies have to report a gain when their credit quality deteriorates as they can repurchase their bonds in the open market at a discount.

Royal Dutch Shell: A Shell Game with Reserves. For investors, it is difficult to know the frequency to which accounting manipulation occurs. Management is often involved in accounting fraud. There often has to be multiple failures of governance issues. The organization might have poor culture. Fraud escalates over time. Shell overstated their oil reserves by over 23% in 2004. How did such an incident occur? Governance and leadership failures occurred. Royal Dutch Shell was known for their scenario planning. Decision making was institutionalized. Lower oil prices in the 1990s and 2000s put pressure on profits. Standards for rigorous training fell and managers were given less autonomy. Employees were asked to contribute ideas on operating. The culture was shifting unknowingly. Management also promised investors unrealistic results on looking for new oil reserves to replenish used ones. Oil companies are required to disclose their proven reserves as it indicates their future profitability. These do not affect the current balance sheet though. Reserve calculations are not audited. Valuers’ are supposed to select the most conservative estimate. Management did not communicate important information to the board. There was a lack of oversight by the Board. How do auditors satisfy themselves that estimates are accurate/reasonable.

Baker Hughes: De-Corrupting Foreign Practices. What can a company do to fix its problems? How did Baker Hughes respond to FCPA violations? It improved its practices. Effective governance solutions are business-like. It is common to accept bribes etc. FCPA was enacted in 1977. It was illegal for a US company to offer payments to a foreign official for the purpose of ‘obtaining or retaining business’ or ‘securing any improper advantage’. If your company has dealings overseas, it is very difficult to track. There is a fine line between facilitating payment and a bribe. The company, Baker Hughes, started strengthening their reforms. Before hiring agents, sufficient due diligence according to FCPA must be conducted. Compliance will review large value transactions etc. The company’s business operations improved thereafter. Division managers were more aware of the regulations etc. Controls should not just restrict activity, it should promote positive performance. Can company’s act and improve controls even before a crisis emerges? That is the challenge. What metrics should be measured.

Even at its best, there is a limit to how effective internal controls can be. Controls restrict activity but they cannot prevent malfeasance. At some point, an awareness of correct behaviour needs to be ingrained in the culture of the company. – David Larcker and Brian Tayan

Part III: CEO Succession Planning. The CEO is extremely important for the company. There are 4 ways to select: 1) CEO-in-waiting; 2) horse race; 3) external recruit; 4) inside-outside approach (two-prong). Board members tend not to favour external candidates. As for internal candidates, there is a risk that they may not perform as they have not assumed such a role before. Succession planning is a process that must be managed well. It is the board’s responsibility to choose well. The right structure must be set and be in place.

Sudden Death of a CEO. A well groomed company might learn to adapt to changing situations. Most boards require at least 90 days to find someone. This is a topic that not many boards spend sufficient time on. For sudden death cases, it is imperative to find someone suitable fast. Internal candidates should be constantly groomed to take up greater leadership roles and responsibilities. Poor succession planning can have an effect on future profitability of a company. Succession planning should be treated seriously. Disclosure of such plans may not be wise as well. The stock price immediately after the sudden death of the CEO reflects whether the company had good/poor governance mechanisms. The benefit of hiring internally is that it is much faster.

HP: The CEO Merry-Go-Round. The Board must plan for contingencies. The current CEO must also be open and receptive about such discussions. HP is an example where multiple breakdowns occurred. HQ acquiring Compaq was a major issue as the board didn’t agree with it. It appeared that HP was moving away from its core business model. There was a HP tried to grow through external acquisitions rather than grow organically. There were also issues with disclosure of financial information with the board and a sexual harassment scandal with the ex-CEO. There were frequent changes in CEO from 2000 to 2011. The board were not clear on their strategy of hiring a CEO. Is it right to constantly view internal candidates as bad?

Apple: Is CEO Health Public or Private? The SEC encourages companies to disclose information about whether a company will be adversely affected due to vacancy in leadership. Health information is private in nature. Should such information be disclosed? When Steve Jobs’ health failed in 2008, the Board covered it up. In Jan 2009, Apple claimed that it was a hormonal imbalance that caused him to lose weight. Warren Buffett had no qualms about disclosing his state of health to his shareholders. He felt that such information would allow shareholders to make informed decisions of the company. How extensive should the disclosure be?

Part IV: Executive Compensation. This is a controversial process indeed. Compensation must be at a level where it attracts, retains and motivates people. It should be paid in a manner that encourages unnecessary risk taking. The compensation committee should design a suitable package. It should use benchmarking and evaluation against the external labor market. The plan must be approved by the Board. Now, shareholders can give their ‘say on pay’. The Board must consider what reactions their pay package will have on significant shareholders. What is a ‘correct’ pay package?

What is a CEO Talent Worth? Some believe that CEOs are over-paid. In such cases, shareholder activism is encouraged. Is the rise in CEO compensation commensurate with the growth rates in revenue of the company? The highest paid CEOs and celebrities earn about the same amounts. There is a distinction as CEOs of large companies earn substantially more than CEOs of small companies. It is important for a certain amount of pay to be based on performance.

What does it make to make $1 million? There are various methods to calculating executive compensation. It is not so straightforward as there might be vesting periods, contingent payments and accruals. The first method is the ‘expected compensation’ for the year. The next method is ‘earned compensation’ for the year. This refers to those that an executive ‘earns the right to keep’ as cash. The last method is ‘realized compensation’, meaning how much executive can keep as cash for a given year. Which is preferred? It depends on whether you are forward or backward looking in nature.

Netflix: Equity on Demand. It is important to align compensation with corporate objectives. Netflix offers a lot of flexibility and room for empowerment in their culture. They treat employees like adults. Pay is very attractive at Netflix as they do not want employees to leave. However, they expect employees to work hard and to do the job of 2 normal workers. Only the best performers get retained. Their involuntary turnover is higher than the industry. However, those that get cut receive a severance package. Employees are definitely receiving a competitive wage. They have unlimited vacation time. They are however, expected to take as much as they deem is necessary. They also can choose how to be compensated, either via cash or stocks. Usually, one will not be able to exercise stock options immediately. If you expect the company stock price to rise, it might not wise to exercise it so soon. Many companies use BS model to estimate liability at balance sheet date for financial reporting. Stock options are good because they encourage risk taking and provide better alignment to company’s objectives. Netflix doesn’t offer cash bonuses. Employees can choose a compensation mix that is right for them.

Conclusion. The board must be qualified and engaged in their work. They have possess the requisite skills and knowledge. Case-by-case analysis must be made in order to assess board quality. Controls can only do so much to protect the organization against fraud. Succession planning is an on-going process and must be executed well. There is no ‘one-size-fit-all’ governance solutions that can be implemented. To have effective governance, one needs to learn from case studies etc.



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