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The Rise of Principles-Based Corporate Governance

    Client Alerts
  • August 08, 2016

In late July, executives at thirteen major companies and investor institutions published and widely advertised their “Commonsense Principles of Corporate Governance” for public companies, boards of directors and shareholders. According to its introduction, the Commonsense Principles’ intent is to “provide a basic framework for sound, long-term-oriented governance,” which is certainly a commendable undertaking. As I read through its various recommendations and guidelines, a few things came to mind.

Continuing convergence of international standards…

Principles-based corporate governance has been around for a long time outside of the U.S. For example, the U.K. Corporate Governance Code, a creation of the U.K.’s Financial Reporting Council, dates back to 1992. Applicable to companies with a Premium listing on the London Stock Exchange, it is divided into five sections (Leadership, Effectiveness, Accountability, Remuneration and Relations with Shareholders), each of which includes several related principles, and “aims to deliver high quality corporate governance with in-built flexibility for companies to adapt their practices….”

Likewise, the U.K. Stewardship Code, also a product of the FRC, has been around since 2010, though multiple predecessors date back to 2002. The Code sets forth seven basic principles of conduct to be followed by institutional investors and asset managers that are designed to “protect and enhance the value that accrues to the ultimate beneficiary.”

These new Commonsense Principles, while useful in their own right, might also be considered as another step toward the seemingly inevitable convergence of international governance standards.

The principles themselves…

As you might expect from its title, the common sense principles themselves are somewhat basic and do not break much new ground in the world of corporate governance (other than, perhaps, by invoking common sense itself). They are divided into eight categories, each with numerous subsets and bullet points, and cover nine pages. I’ve quoted a few of the more interesting, and in some cases provocative, recommendations below:

Board of Directors—Composition and Internal Governance.

  • Diversity along multiple dimensions is critical….Director candidates should be drawn from a rigorously diverse pool.
  • [C]arefully consider a director’s service on multiple boards and other commitments.
  • Directors should be elected by a majority of the votes cast….
  • Companies should consider paying a substantial portion…of director compensation in stock….Companies also should consider requiring directors to retain a significant portion of their equity compensation for the duration of their tenure….
  • [C]ompanies should clearly articulate their approach on term limits and retirement age.

Board of Directors’ Responsibilities.

  • Directors who communicate directly with shareholders ideally will be experienced in such matters.
  • Directors should speak with the media about the company only if authorized….

Shareholder Rights.

  • Dual class voting is not a best practice.

Public Reporting.

  • A company should not feel obligated to provide earnings guidance—and should determine whether [it]…does more harm than good.
  • …[A]ll compensation, including equity compensation, is plainly a cost of doing business and should be reflected in any non-GAAP measurement of earnings in precisely the same manner it is reflected in GAAP earnings.

Board Leadership.

  • If a board decides to combine the chair and CEO roles, it is critical that the board has in place a strong designated lead independent director and governance structure.

Management Succession Planning.

  • Companies should inform shareholders of the process the board has for succession planning and also should have an appropriate plan if an unexpected, emergency succession is necessary.

Compensation Management.

  • [C]ompensation should not be entirely formula based and companies should retain discretion (appropriately disclosed) to consider qualitative factors, such as integrity, work ethic, effectiveness, openness, etc.
  • Companies should consider paying a substantial portion (e.g., for some companies, as much as 50% or more) of compensation for senior management in the form of stock, performance stock units or similar equity-like instruments.
  • Companies should maintain clawback policies for both cash and equity compensation.

Asset Managers’ Role in Corporate Governance.

  • Asset managers should exercise their voting rights thoughtfully and act in what they believe to be the long-term economic interests of their clients.
  • Asset managers should actively engage, as appropriate, based on the issues, with the management and/or board….
  • Asset managers should raise critical issues to companies (and vice versa) as early as possible in a constructive and proactive way.
  • [Asset manager] votes should be based on independent application of their own voting guidelines and policies.

It will be interesting to see whether these principles, or the concept of principles-based corporate governance generally, continue to gain momentum.