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October 1, 2009 10:26 pm
Opponents of post-meltdown reforms to corporate governance are trying to hold back change by focusing on Washington. The US Chamber of Commerce is spending $100m (€69m, £63m) to try to defeat any substantive reforms. They are missing the point. No matter what happens in Washington, the market is forcing through significant and pervasive reforms. The companies that first understand that will benefit from a lower cost of capital and more committed long-term investors. As we understand better the mistakes of the past and the challenges ahead, fund managers and analysts will look at “new fundamentals”, four elements that will become as important as cash flow and return on investment.
First, accounting. The pressure is increasing to harmonise global accounting standards. As markets are unshackled from the borders of geography, cross-border apples-to-apples comparisons become more significant. Even more important, however, is the pressure to rethink the value of our traditional approach to accounting. There is a reason accounting principles are called “generally accepted” rather than “generally accurate”. The accounting system is too grounded in a 19th-century notion of value based on hard assets. What useful information did we get from this about the value of subprime derivatives?
Investors will be looking for more and better information about human and intellectual capital, such as employee training, turnover and patents. They will be looking for more and better information about risk management. Accounting will evolve to put less emphasis on providing a snapshot and more on the basis for projections and on “what-if” scenarios. And investors will look for more and better information about carbon footprints and other environmental impacts. Like tobacco, climate change has moved from social policy to the risk management category. Dumb companies will ignore it. Benchmark-driven companies will have a compliance-based approach and tick the boxes. But innovative companies will recognise strategic opportunities created by this increased focus.
Second, boards of directors. In 1986, the audit committee at Infinity Broadcasting had just two members; neither had expertise in accounting or finance; and one was O.J. Simpson. I would like to think that today this would be considered a risk factor.
But in the years before its collapse, the Lehman Brothers board included a theatrical producer, an actress and a retired admiral. More importantly, as with most of the banks, Lehman’s board had almost no expertise in the kinds of financial instruments and transactions that were an essential part of its balance sheet.
Investors are paying attention. It is possible to track particular directors who are serial offenders in excessive compensation, accounting problems and other board failures. Stopping US brokers using client votes to support management and the prospect that US investors will be able to nominate competing directors will put directors and boards under more pressure. Investors will look for companies with board members who make a significant investment, do not engage in related-party transactions, ensure pay is tied to performance, refrain from empire-building acquisitions, handle chief executive succession planning effectively, and oversee prompt and meaningful financial disclosure.
Third, executive compensation. All-upside, no-downside pay packages were both a symptom and a cause of the financial meltdown. Even the tip-of-the-iceberg disclosures made it clear that trouble was ahead and bonuses based on the quantity, not quality, of transactions all but guaranteed disaster. Investors now understand that pay practices are a key indicator of risk, and one less susceptible to massage than profit figures.
Shockingly, many companies are perpetuating past abusive practices. Investors will look at executive pay as they do capital expenditure, in terms of return on investment. Companies which reduce the value of option grants by the performance of an index and have real provisions to claw back bonuses after poor performance will benefit from investor confidence.
Fourth, investors. Our data show that one of the most overlooked predictors of return is the structure of a company’s investors. If no big investor is overweight relative to the index, for example, it can be a powerful indicator of investment risk. This may be cause or effect; it could reflect a lack of confidence in management or it could be that companies with highly diversified holdings are inadequately monitored. On the other side, significant holdings by investors with a record of monitoring is a positive.
They say the definition of insanity is doing the same thing over and over and expecting a different result. Investors understand they need to examine different data, and treat traditional data differently, to make better decisions. Directors who are paying attention understand that these new fundamentals are not just the best way to attract investors; they are the best way to ensure sustainable growth.
The writer is editor and co-founder of the Corporate Library
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