The most powerful names in U.S. business have published guidance on Commonsense Principles of Corporate Governance (Commonsense Principles) to provide a framework to improve corporate governance and make it more long-term–oriented. Warren Buffett of Berkshire Hathaway, Laurence D. Fink of BlackRock, Jamie Dimon of JPMorgan Chase & Co., and others have outlined principles covering nine broad categories of governance issues that, while nonbinding, will likely spark an important dialogue in boardrooms. Eight of the categories have direct and far-reaching implications for boards, while the final group of principles relates to the role asset managers play in the governance arena. What makes this announcement unique is the unified position these leaders have taken behind one set of commonsense principles.
At the National Association of Corporate Directors (NACD), an organization that is advancing exemplary leadership among our community of 17,000 director members, our position is clear: We agree with many of the principles outlined and we can help boards implement effective governance practices. In fact, the Commonsense Principles reinforce the Key Agreed Principles to Strengthen Corporate Governance for U.S. Publicly Traded Companies that we introduced a few years ago.
While recognizing that the principles are not a one-size-fits-all solution, and that practices will likely differ based on size, industry, and specific company, we’ve included a practical list of next steps below that boards can take to implement the principles.
The Case for Improved Governance
Key drivers behind the 50+ nonbinding principles are the decline in the number of publicly traded firms, with many highly performing private companies delaying initial public offerings (IPOs), essentially reducing available investment opportunities; the current lack of trust between shareholders, boards, and management teams; concerns about the dominance of short-termism in the management of companies; and the complexity of current corporate governance rules.
The Commonsense Principles identify several areas for improvement:
Board agendas should include a focus on major strategic issues (including material mergers and acquisitions and major capital commitments) and long-term strategy, ensuring thorough consideration of operational and financial plans, quantitative and qualitative key performance indicators, and assessment of organic and inorganic growth, among other issues. A company should not feel obligated to provide earnings guidance, the business leaders suggest, and should determine whether providing earnings guidance for the company’s shareholders does more harm than good. Companies should frame their required quarterly reporting in the broader context of their articulated strategy and provide an outlook, as appropriate, for trends and metrics that reflect progress (or lack of progress) on long-term goals.
Every board needs a strong leader who is independent of management, the principles emphasize. The board’s independent directors usually are in the best position to evaluate whether the roles of chair and CEO should be separate or combined, and if the board decides on a combined role, it is essential that the board have a strong lead independent director with clearly defined authorities and responsibilities.
Diverse boards make better decisions, so every board should have members with complementary and diverse skills, backgrounds, and experiences. It’s also important to balance the wisdom and judgment that accompany experience and tenure with the need for the fresh thinking and perspectives that new board members can bring.
In financial reporting, the use of Generally Accepted Accounting Principles (GAAP) should not be obscured by the use of non-GAAP metrics.
Action Steps for Directors
You and your board/company may consider taking certain steps:
Review the principles in detail and benchmark your current governance approach against them.
Determine if identified differences are areas ripe for further discussion and possible change.
Engage your largest investors to get their take on the principles and how they plan to use them when assessing corporate governance effectiveness.
NACD Alignment With Commonsense Principles
Below I’ve highlighted just a few examples of how NACD aligns with the most significant principles. I have included links to NACD reports that can help boards make the Commonsense Principles common practice.
Focus on Long-Term Value Creation
The principles advocate for the creation of long-term shareholder value. Our guidance to members over the past several years has skewed unabashedly toward boards prioritizing long-term value creation. In fact, our 2015 Report of the NACD Blue Ribbon Commission on the Board and Long-Term Value Creation emphasizes the need for directors to align short-term goals—and executive compensation—with long-term strategy. The report provides tools and practical recommendations including, among others, the following:
Boards should consider recommending a move away from quarterly earnings guidance in favor of broader guidance parameters tied to long-term performance and strategic objectives.
The board’s CEO selection and evaluation processes should include an assessment of the extent to which he or she can be an effective advocate for the firm’s long-term strategy.
The nominating and governance committee should approach board composition and succession planning with long-term needs in mind, based on the director skills that will be most relevant to the company’s strategy in three, five, or more years.
Role of the Lead Director
The role of the lead independent director emerged as another key area where board effectiveness can improve. We at NACD believe that the lead independent director should spearhead efforts to intensify the board’s efficacy by identifying and addressing weaknesses in process and individual director performance. An effective lead independent director should be able to provide criticism that is both respectful and objective, and be able to ensure every director’s voice is heard. To put it simply, the lead independent director should bring out the very best in the board. Our NACD Blue Ribbon Commission Report on the Effective Lead Director provides practical guidance on how to do that.
Board Composition and Diversity
Public-company boards should have a diverse and complimentary mix of backgrounds, experiences, and skills, according to the Commonsense Principles. While this is an area in which we’ve not seen much movement—aside from a slight increase in gender diversity, with 79 percent of NACD survey respondents reporting they have at least one woman director on their board compared with 77 percent in 2014—our Report of the NACD Blue Ribbon Commission on the Diverse Board: Moving From Interest to Action provides very practical advice and tools, including a board-level discussion guide on diversity, that can help boards make diverse board composition a priority. Additional information can be found in NACD’s Board Diversity Resource Center.
Non-GAAP Financial Metrics
The use of non-GAAP metrics in financial reporting has been widely scrutinized by regulators. Mary Jo White, chair of the U.S. Securities and Exchange Commission, stated last December that non-GAAP metrics deserve “close attention, both to make sure that our current rules are being followed and to ask whether they are sufficiently robust in light of current market practices.” NACD’s Audit Committee Chair Advisory Council, a prestigious group of Fortune 500 committee chairs, met a few months ago to discuss the use of non-GAAP metrics. The council made an important recommendation:
From a governance perspective, audit committees should ensure that there are adequate controls in place to help mitigate the risk of management bias in measuring and reporting non-GAAP measures, and that these controls are frequently assessed.
Our resources and messaging have always been—and will continue to be—shaped by directors who actively contribute to better board-governance practice. As the largest gathering of directors in the United States, NACD’s 2016 Global Board Leaders’ Summit will convene some of the best minds in governance to continue the dialogue on how boards can adopt leading practices. We believe in and strongly support good corporate governance and will continue to provide resources to help directors effectively oversee U.S. businesses. For more information on the governance principles NACD has established, please review our Key Agreed Principles to Strengthen Corporate Governance for U.S. Publicly Traded Companies.
The sustainability information in CSR reports is not, from our perspective, “investment-grade;” that is, it is not necessarily material, not industry specific, not comparable, and not auditable.
Business news headlines on any given day highlight the importance of sustainability issues such as resource scarcity, climate change, population growth, globalization, and transformative technologies. In today’s world, management of these and other sustainability risks and opportunities influences corporate success. Thus, understandably, investors are increasingly requesting information on how companies are managing these factors.
A concept release from the Securities and Exchange Commission (SEC) on disclosure effectiveness includes a lengthy discussion of sustainability disclosure. In the release, the SEC states that it is “interested in receiving feedback on the importance of sustainability and public policy matters to informed investment and voting decisions.” We hope that the SEC’s request for input on sustainability issues signals an understanding that the information investors consider “material”—much like the world around it—is changing. As a result, corporate disclosures should also evolve to provide investors with the information they need to make informed investment and voting decisions.
Sustainability issues are increasingly important to a company’s financial condition and operating performance, and thus merit the attention of its board. At more than 55 percent of S&P 500 companies, the board oversees sustainability, according to the Investor Responsibility Research Center Institute. Such boards are to be applauded for taking a more holistic view of risk oversight, and for getting out in front of global challenges.
This shift in focus by investors and the business community is driven by a growing recognition that sustainability issues are business issues, not only born of social or political concerns. One recent study found that when companies focus their efforts on managing material sustainability factors—namely, those critically linked to their core business—they outperform their peers with significantly higher return on sales, sales growth, return on assets, and return on equity. They also show significantly improved risk-adjusted shareholder returns.
Clearly, the board plays a key role in developing a company’s capacity to create long-term value and in safeguarding its assets. In this regard, a board’s careful consideration of information on material sustainability factors would help it to fulfill its oversight responsibilities, by assisting it in understanding, prioritizing, and monitoring business-related risks and opportunities.
For example, a board should regularly consider how its company measures, manages, and reports its material sustainability risks. A pharmaceuticals company might consider how it is addressing a $431 billion counterfeit drug market, where mitigation strategies in an increasingly complex, global supply chain could stem or reverse the loss of consumer confidence and company revenues, and prevent up to 100,000 deaths each year (see Roger Bate’s 2012 book Phake: The Deadly World of Falsified and Substandard Medicines). The plunging stock price and loss of goodwill suffered by Chipotle Mexican Grill after outbreaks of E. coli and norovirus at its restaurants demonstrate the way in which a failure to manage sustainability risk factors can seriously damage a company’s reputation and shareholder value.
Moreover, sustainability issues not only raise risks, but also present opportunities that can and should be taken into account by the board as it considers development and implementation of the company’s strategic goals.
Sustainability issues may have a material impact on a company’s ability to achieve such goals. For automakers, a strategy that incorporates fuel-efficient technologies and alternative fuels can help the company capitalize on legal and consumer trends regarding fuel economy and emissions in a market where car ownership is projected to triple by 2050.
Sustainability issues directly affect a company’s financial condition and operating performance. Therefore, it is not surprising that investors are increasingly demanding more effective and useful sustainability information. Many companies have made efforts to meet this demand through disclosures in corporate social responsibility (CSR) reports, by responding to questionnaires, or otherwise engaging with investors. The sustainability information in CSR reports is not, from our perspective, “investment-grade;” that is, it is not necessarily material, not industry specific, not comparable, and not auditable. To that point, a 2015 PwC study found that 82 percent of investors said they are dissatisfied with how risks and opportunities are identified and quantified in financial terms; 74 percent of the investors polled said they are dissatisfied with the comparability of sustainability reporting between companies in the same industry.
What the markets have lacked, until now, are standards that can guide companies in disclosing material sustainability information in a format that is decision-useful. These standards must be industry specific. Sustainability issues affect financial performance differently depending on the topic and the industry. Therefore, investors need guidance on which sustainability issues are material to which industries, and they need industry-specific metrics by which to evaluate and compare the performance of reporting companies.
The Sustainability Accounting Standards Board (SASB), an independent 501(c)(3) nonprofit, was created to address this market inefficiency. The mission of SASB is to develop and disseminate industry standards for sustainability disclosure that help public corporations provide material, decision-useful information to investors via MD&A and other relevant sections of SEC filings such as the Form 10-K and 20-F. SASB’s standards are formulated with broad market participation and draw upon metrics already used by the corporate community. They will continue to evolve, as our world, and thus material sustainability issues, change.
Investors want to place their funds in entities that have good prospects for the future. To do so, they evaluate the information that is material to a company’s prospects. Not all that information rests in the financial statements that reflect a company’s current financial condition. We believe that, in today’s world, risks and opportunities not yet reflected in a company’s financial statements influence its success. And, the information that is “material” to investors—much like the world around it—has changed.
To help companies disclose material sustainability information, the capital markets need standards for disclosure of sustainability information that are created by the market, specific to industry, and compatible with U.S. securities law.
The management and disclosure of sustainability issues merits the attention of directors. The public comment period for the SEC’s disclosure effectiveness concept release runs through July 21. This is an important opportunity for publicly held companies and their directors to be heard on these critical issues, and to stress the importance of a market standard that serves investors while not overburdening issuers.
Aulana Peters was an SEC Commissioner from 1984-1988. Elisse Walter was the 30th chair of the SEC. Peters and Walter serve on the SASB board of Directors.
It has become clear that Britain’s vote to leave the European Union (EU) is a major disruption to global business plans, and its consequences clearly rise to the board level. Ongoing political chaos in the United Kingdom (UK) is having seismic economic effects and has already amplified downside political risks across Europe.
“Wait and see” is a dangerous response to a highly uncertain situation. Proactive board leaders can undertake several immediate initiatives that will minimize the damage to 2016 results in Europe and improve the resiliency of your company’s plans for 2017 and beyond.
What we know today: The UK’s economy will contract next year. Frontier Strategy Group’s (FSG) Europe, the Middle East, and Africa (EMEA) Team forecasts a sharp slowdown in UK growth in the second half of 2016, deepening into a recession of -0.5 percent in 2017. Regardless of the pace and the aim of its exit negotiations with the EU, deep splits within the UK’s major political parties and energized independence movements in Scotland and Northern Ireland guarantee governmental dysfunction and depressed sentiment among consumers and businesses.
Beyond the UK, certain economies are especially vulnerable. Ireland, Norway, and the Netherlands will be hurt quickly as UK demand shrinks. Around the world, UK and European economic woes are likely to hit Poland, South Africa, Algeria, Azerbaijan, Bangladesh, and Costa Rica especially hard in their respective regions.
What we won’t know anytime soon: As of yet, it is impossible to predict (1) whether the European Union will change fundamentally or lose additional members, (2) the political and economic effects of energized populist parties in many European countries, (3) the downside risk to the UK from regional separatism, or (4) the new destinations for foreign investment that may leave the UK. Scenarios and contingency plans are essential tools to manage risk and identify targeted opportunities in this environment.
Bolster Commercial Execution in the Second Half of 2016
Boards should expect to receive a rapid-response sales strategy review from UK executives and risk assessments for Europe overall. Is management being sufficiently proactive in managing new risks?
Prioritize risks to 2016 sales targets—In the UK, business investment is most likely to see near-term declines as companies worried about growth move to limit expenditures (hiring is sharply down in London), while consumer sentiment will be dragged down by housing-price shocks. Sterling and euro depreciation will hit specific customer segments hard. Expect management to proactively engage customers about changes to their expected spending, and redeploy sales and marketing resources to the least vulnerable territories.
Target contingency plans on talent and finance—Uncertainty about visa requirements for Europeans in the UK (and for non-UK citizens generally) is a serious engagement and retention risk. Currency effects are wiping out margins for some UK subsidiaries and should force a near-term rethink of hedging and payment terms. Expect management to document contingency plans with signposts and priority actions by function, especially for finance and human resources (HR).
Track leading indicators of changes in demand—Volatility in currency markets and commodities markets will have global ripple effects on business and consumer sentiment, and on government finances—especially in emerging markets. Ask if European management teams are adjusting their dashboards and monthly/quarterly agendas accordingly.
Stress-Test Strategic Plans for 2017 and Beyond
The next planning cycle will be more demanding than usual. Updating forecast data is a small part of the needed response. So much will remain uncertain that plans for Europe (and for markets with links to Europe) should be stress-tested for resiliency against downside scenarios. Contingency plans should be put in place for big bets.
Use scenarios to model UK and EU demand—FSG’s benchmarking found that simple scenarios are key to organizational alignment and resilience; the companies that do this best grow market share 2.1 times faster than their competition in volatile markets. My pre-Brexit vote NACD post highlights a range of risks worthy of incorporating into scenario plans.
Evaluate risk exposure in European operations and the supply chain—Profitability and pricing power for imported products will diminish if barriers to trade with the UK increase and European currencies weaken further. Scenario analysis can help evaluate potentially improved returns from localized production and supply-chain structure.
Rethink Europe/EMEA hub locations—Potential changes that affect HR, legal, regulatory, and finance teams may tip the scales in favor of revisiting the UK as a hub for EMEA, Europe, or Western Europe leadership and operations. Balance financial and political/reputational considerations along with change-management costs. Retention of European nationals currently based in the UK is becoming a factor as well.
Reassess global market-portfolio prioritization—Long-term investment plans for Europe must be rebalanced given the likelihood of a UK recession in 2017 and ripple effects varying among other European countries. Moreover, investment cases for Europe are likely to face sharply skeptical review even as EMEA leaders strive to make up the gap that UK underperformance will create. At the global level, Asia-Pacific and Latin America leaders have an opportunity to put forward more aggressive plans for 2017 and beyond. India in particular is a substantial market that remains under-penetrated by foreign companies; higher-risk big bets there may be more warmly received when Europe looks so uncertain.
When uncertainty is high, boards have a valuable role in helping management bring focus to the most important decisions rather than falling victim to firefighting and analysis paralysis. Companies that set a proactive agenda now for a mid-year course correction and forward planning will be well positioned despite market volatility in the year ahead.
Joel Whitaker is Senior Vice President of Global Research at Frontier Strategy Group (FSG), an information and advisory services firm supporting senior executives in emerging markets.
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