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Corporate Governance - A Guide for Investors

Updated: Feb 18

Corporate governance refers to the system of rules, practices, and processes used to direct and manage a company. As an investor, understanding corporate governance should be an important part of your research process when evaluating potential investments. Here are some key things to know.

Board of Directors

The board of directors plays a pivotal role in overseeing a company's management and strategic direction. When assessing a company's governance, look at factors like:

  • Independence - The board should have a majority of independent, non-executive directors who can provide unbiased oversight. Beware boards that are dominated by insiders or affiliates. A board comprised of mostly insiders and affiliates presents conflicts of interests and can lack accountability. An example of weak independence is Tesla's board during parts of the 2010s when several directors had close personal ties to Elon Musk despite needing more detached oversight of the visionary but erratic CEO.

  • Relevant Expertise - Board members should have skills, backgrounds, and experiences that are relevant to guiding the company and its industry. An airline company should aim for directors with transportation, logistics, customer service, or technical operation backgrounds rather than filling a board only with financiers. For example, Southwest Airlines values leaders who understand on-time operations.

  • Diversity - Diverse boards in terms of gender, ethnic, skillset and experiential diversity leads to better decision making.

  • Committee Structure - Key committees like audit, compensation, and nominating should have independent chairs and directors.

Shareholder Rights

As a part-owner of the company, shareholders have important rights including voting on major decisions and electing the board. Look for companies that avoid anti-takeover provisions that limit shareholder rights and influence. Companies may create barriers like supermajority voting provisions, classified boards, or dual-class stock that entrench leadership by limiting shareholders' power to influence the board despite owning the company. For example, Snap Inc insulated its young founders from shareholders with no-vote shares at its 2017 IPO.

Executive Compensation

Plans should provide meaningful incentives to executives for long-term, sustainable performance rather than short-term spikes. Watch for pay packages that are excessive or misaligned with company results. Compensation plans should incorporate rigorous performance benchmarks tied to metrics like return on invested capital rather than simply rewarding share price rises that may prove temporary. For example, many banks granted executives generous subprime-era bonuses before collapses and bailouts.

Financial Reporting

Ensure financial reports provide adequate transparency into company performance and any risk exposures. Beware of companies with poor accounting quality or frequent restatements. Complex off-balance sheet vehicles or lack of disclosure around tax strategies, litigation liabilities, and internal controls can obscure risks. Theranos for years used shell companies and NDAs to hide problems with its blood testing technology.

Audit Committee Oversight

The audit committee plays a crucial role in overseeing the company's financial reports, internal controls, and risk management. Look for audit committees with financially literate members, including having at least one financial expert, and whether they demonstrate diligent risk monitoring. Weak oversight can enable fraud - for example, Enron's audit committee looked the other way on dubious accounting and off-books liabilities that hid losses.

Political Spending/Lobbying Disclosure

Companies should disclose policies guiding lobbying efforts and political campaign spending to assure proper alignment with business goals and risk management. Lack of disclosure around lobbying presents reputational risks for companies if their public policy stance differs from stated values, as seen when social media platforms lobbied secretly against privacy reforms.

Environmental/Social Responsibility

Today's stakeholders expect companies to demonstrate commitment to sustainability, DEI, and other ESG priorities through transparency and accountability. Signs like lack of sustainability reporting or underrepresentation of women/minorities among executives or board director roles highlight potential governance gaps in effectively overseeing these emerging risks. For example, many investment firms now consider ESG indicators like climate policies and workforce diversity as part of their governance evaluations.

Ethical Culture

While codes of conduct set expected behavior, ethical tone starts at the top with the CEO and board promoting integrity via policies, incentives and consistent messaging. Scandals at Wells Fargo around unauthorized accounts being opened to hit sales targets exposed a win-at-all costs culture with tone deaf leadership.

The right governance foundation identifies and manages emerging risks beyond strictly financial diligence. Understanding these expanding practices provides investors fuller insight into the long-range health of a company. The examples underscore why investors should dig deeper into governance rather than taking processes for granted when researching companies. Signs of misalignment or inadequate oversight present red flags. By assessing areas like these, investors can gain assurance that critical governance foundations are in place for effective oversight and serving shareholder interests.

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