There was a lot of buzz around NACD’s offices earlier this month as our people learned that momentum is building to end quarterly earnings forecasts. You can’t work at NACD for very long without learning that our members champion long-term value creation and oppose short-termism, or without coming to understand how earnings guidance destroys the former and promotes the latter. (Short-Termism 101: when companies estimate the next quarter’s earnings per share, they drive a 90-day focus on meeting that projection and discourage focus on the organization’s long-term vision.)
Our communal excitement stemmed from reports of an interview on CNBC’s Squawk Box featuring Berkshire Hathaway CEO and chair Warren Buffett and JPMorgan Chase CEO and Business Roundtable member Jamie Dimon. During the June 7 interview, the two iconic businessmen agreed that companies should stop providing quarterly earnings guidance. NACD’s researchers noticed the interview and hailed it as “great news.” They praised the Business Roundtable for its “leadership” and shared links to relevant research with me, like this study asking Does the Cessation of Quarterly Earnings Guidance Reduce Investors’ Short-Termism?, and this one on Moving Beyond Quarterly Guidance: A Relic of the Past from FCLTGlobal, the think tank for focusing capital on the long term.
Later that day, NACD put out a press release noting that while NACD had called for a move away from quarterly earnings guidance in the past, the problem was still lingering in 2017. The 2017–2018 NACD Public Company Survey found that nearly three-quarters (74%) of respondents said that focus on long-term strategic goals has been compromised by pressure to deliver short-term results. Frankly, the finding was discouraging, considering how many years we have all been working to reverse short-termism.
Perhaps a flashback is in order. Dimon and Buffett were not the first to advise ridding corporate America of short-term guidance, and the Squawk Box interview wasn’t even the first time they themselves had done so.
In June 2010, exactly eight years ago this month, NACD joined the Business Roundtable as some of the first subscribers to an Aspen Institute manifesto entitled Long-Term Value Creation: Guiding Principles for Corporations and Investors. One of the principles in that document was the recommendation that companies and investors should “avoid both the provision of, and response to, estimates of quarterly earnings and other overly short-term financial targets.” I was happy to sign on. Even prior to 2010 NACD had been making recommendations against short-termism in our Blue Ribbon Commission reports, our Key Agreed Principles, and other publications, especially those addressing executive compensation.
In July 2016, both Dimon and Buffet themselves had signed onto a similar recommendation when developing Commonsense Corporate Governance Principles, which was published with backing from large institutions and companies across the investment chain. I spoke about the principles on C-Span the following month. The 2016 Principles stated that “companies should not feel obligated to provide earnings guidance—and should do so only if they believe that providing such guidance is beneficial to shareholders.” They further state that “making short-term decisions to beat guidance . . . is likely to be value destructive in the long run.”
In September 2016, I was a delegate at the General Counsel Summit on Short-Termism and Public Trust. The report from that event cited the 2016 Principles with respect to earnings guidance, as well as research from the Conference Board and others dating back more than a decade in questioning the wisdom of earnings guidance.
So looking back, the journey to end earnings guidance has been long. But that was then and this is now. Dimon today chairs the Business Roundtable (he was named chair in December 2016). And on the morning of June 7, the medium was an important part of the message: there were Dimon and Buffett, expressing their views in plain, spontaneous language, live, for all the world to see and hear in all their familiarity.
This entire history reminds me of a quote by Scottish author and government reformer Samuel Smiles, known for his treatise on self-improvement, Self-Help. He wrote: “Progress, however, of the best kind, is comparatively slow. Great results cannot be achieved at once; and we must be satisfied to advance in life as we walk, step by step.”
Thanks to many steps by many people over many years, the bell is tolling for earnings guidance at last. And that is indeed the best kind of progress.
Despite this call to action, overcoming short-termism remains a stark challenge for many companies. In fact, as the National Association of Corporate Directors’ (NACD) 2015 Blue Ribbon Commission observed, “factors encouraging a short-term focus are stronger now than ever before.” Additionally, in a 2015 report, the Conference Board contemplated whether short-term biases might jeopardize future business prosperity altogether.
Yet if short-termism is a sizable challenge, so too is the commitment to understanding why short-termism is so entrenched as a business practice and the task of mitigating its harmful effects. In July, the Anti-Fraud Collaboration, a group of organizations focused on fighting financial reporting fraud, hosted a webcast on Coming to Terms with Short-Termism. The discussion, which I was privileged to moderate, featured top experts and generated a wealth of useful takeaways for participants across the financial reporting supply chain.
Let’s look at a few key takeaways from the discussion.
1. Acknowledge and Define the Complexities of the Issue
To address the challenge of short-termism, it helps to understand the complexities of what companies are up against. For one thing, “short-termism” doesn’t equate to short-term activity, which isn’t necessarily bad. NACD Chair Karen Horn, director of Simon Property Group, observed at the outset of the webcast that the “long term is made up of many, many short-term actions.”
Another tricky step to understanding the complexities of short-termism is how to define “short-term” at your company. Is it a month? A quarter? A year? “It depends on the company,” said panelist Bill McCracken, president of Executive Consulting Group LLC. McCracken, who previously served as CEO of CA Technologies, added that even within a company the meaning of “short-term” can change according to different contexts, such as strategy or compensation.
2. Think Strategically
However complex a challenge combatting short-termism may seem, there are several simple solutions for directors to consider. One of them is this: think strategically. A strategic mindset helps short-term actions align with long-term goals. “Boards really need to be conversant with the company strategy,” said Horn. McCracken agreed, noting that board members should become “activist directors” who immerse themselves in the details of the company, its strategy, and its industry. This engaged approach, he added, can help directors be prepared to handle situations such as share buybacks or changes to dividend policy where questions of short-termism may arise.
Similarly, strategic thinking can also help directors gauge the validity of the use of non-GAAP measures. “Shouldn’t the use of non-GAAP measures also tie in to the strategy of the entity?” asked Douglas Chia, executive director of the Conference Board’s Governance Center. “Absolutely,” responded fellow panelist and KPMG Partner Jose Rodriguez.
3. Strengthen Tone at the Top…
One danger of short-termism is that it can heighten fraud risk across the enterprise. Companies need to ensure that management is setting the right tone at the top. “I can’t underemphasize tone at the top,” said Rodriquez. “How do [senior executives] talk to employees? Is everything geared around meeting that analyst’s [earnings] expectations?” From his auditor’s viewpoint, he added, “that would be concerning.
4. …But Don’t Forget the “Mood in the Middle” and “Buzz at the Bottom”
While emphasizing tone at the top, panelists also stressed that short-termism shouldn’t be a point of concern for only senior management. Many instances of fraud, noted Rodriguez, occur outside the C-suite. “It’s middle management and lower management that had to get that sales number to a certain amount of dollars,” he said, and this pressure can lead to channel stuffing or other undesirable activity. Such activity is what audit committees, auditors, and the board ought to be looking for, added Bill McCracken.
5. Dial Down the Emphasis on Quarterly Results
“Our entire [financial reporting] structure is built around quarterly reporting,” said McCracken. While eliminating this quarterly focus might not be possible—or even desirable—panelists agreed that reducing the quarter-to-quarter mindset was an important part of addressing short-termism. “Obviously you can’t get entirely away from that,” said Chia, “but there are ways you can reduce the emphasis and build on the timeline that you think is appropriate—not what you’re being told by the analyst community.”
Fostering robust communication internal and external communication is a core priority for the Anti-Fraud Collaboration, and communication at all levels was a recurring theme throughout this webcast. When discussing the use of non-GAAP measures, Horn noted that “the chairman of the compensation committee should be talking to the chairman of the audit committee as these measures work their way in to [compensation] programs.”
Likewise, communicating effectively with external investors and other stakeholder parties is critical. “Boards need to really understand investor communications,” said Horn. “The way that we can pursue long-term value creation is in partnership with our investors.”
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.