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Corporations depend on a variety of financial partners for their development and survival, including stockowners, bondholders, private investors, and, at financial services firms, depositors. Boards of directors, corporate managers, and those entrusted with the management of investors’ funds act as fiduciaries and agents for others. As such, they bear a particular obligation to communicate clearly and transparently with these financial partners, to manage their assets with the utmost integrity, to act in the best interests of investors, and to maintain the highest levels of ethical responsibility.
This obligation can be subsumed under the rubric of good corporate governance. However, the term corporate governance is often used narrowly, particularly in the United States, to assert an obligation on the part of boards of directors and corporate managers to maximize profits for shareholders. Properly understood, we believe that corporate governance should encompass a responsibility to the corporation as a whole and include a duty to understand and address the full range of social and environmental risks faced by the firm itself and posed by the firm for others. As such, it is of great concern to us.
Although the term corporate governance is not specifically used in the themes described here, we believe that companies that perform well in the areas outlined below must, essentially by definition, be governed well. Our positions on the more traditional measures of good governance (e.g., separation of the roles of chairman of the board and chief executive officer, staggered boards, independence of key board committees, and so on) are described in our Proxy Voting Guidelines. These structural mechanisms can help ensure that there are checks and balances in place, and create an environment where broader accountability is at least possible.
A company’s financial partners play a crucial role in maintaining the credit, stock price, liquidity, and financial viability of a firm and their good faith and trust is therefore vital to the firm. This reciprocal relationship is crucial to the long-term financial viability of the corporation, as it is to the long-term financial prospects of its various investors.
The following are the four major themes by which we assess the strength of corporations’ relationships with their financial partners:
- Accounting, Credibility, and Business Ethics
- Openness in Communications
- Commitment to Diversity of Representation
- Relationships with Controlling Owners
While other issues are also important in this regard, these four are those which we believe we can most meaningfully and consistently assess.
Markets cannot be efficient and effective unless they are honest. Financial regulators and legislators have devoted much attention to assuring the credibility of the financial accounting systems for publicly traded companies. In addition, an increasing number of companies are voluntarily implementing ethics programs to assure that employees conduct their affairs honestly. When companies such as Enron or Parmalat lie outright about their financial condition, the cost to the public can be tremendous. Similarly, bribery scandals can cause firms major political and financial difficulties. Once this trust is broken, it is difficult to restore. At the same time, we recognize that accounting is a profession involving considerable judgment, and honest differences can arise between regulators and firms. By the same token, the line between questionable payments and legitimate business practices is not always clear.
We consequently look for companies that cultivate a culture of honest accounting and business practices throughout their daily operations, with adequate systems and safeguards in place to prevent systematic abuse,and view with concern those that have a pattern of accounting fraud or business scandals.
Markets also cannot be efficient and effective unless communications are open and free with shareholders, bond owners, and others who have invested financial assets in a firm. In our opinion, these communications should cover not only traditional financial indicators, but also nontraditional financial indicators such as social and environment factors. We believe that these social and environmental factors are relevant to investors’ assessments of the competence and quality of management, and can have profound long-term (and occasionally short-term) financial implications for firms that often go unrecognized by the mainstream financial community.
We therefore look for companies that communicate openly about the challenges they face, are willing to be thorough in the data they provide, and are willing to enter into ongoing dialogue with stakeholders with legitimate concerns in these areas.We do not, however, automatically take failure to communicate as a sign that a company has no positive initiatives, nor do we automatically take willingness to communicate as a positive indicator. It is the quality of these communications and the company’s actual record that are our primary concern.
As with diversity among employees, diversity on a firm’s board of directors can bring vitality and openness to a corporation.It is surprising to us, for example, when consumer products companies that serve primarily female consumers have boards consisting of only men. Similarly, in an increasingly diverse global economy, individuals with diverse ethnic and racial backgrounds can provide valuable insights about doing business in different countries, cultures, and economic environments. Moreover, as the pace of innovation increases, a culturally diverse board is likely to understand new trends, to innovate, and to seek changes that benefit society broadly. Finally, the public is generally well served by corporations that lead by example in giving equal opportunity to all segments of society in this strategically important and high-profile public role.
Cross-ownership among companies or ownership by governments, foundations, or families can raise complicated questions for us in setting standards. If controlling interest rests with an organization other than the firm itself, we generally evaluate the company as if it were a wholly owned subsidiary of the controlling entity. When the controlling entity is a corporation, this process is fairly straightforward — a positive or negative record for the controlling company becomes the crucial factor in our decision-making, outweighing most other factors.
However, when the controlling owner is a family or individual, a foundation, or a government, the situation becomes more complicated. We evaluate these situations case-by-case, but some general principles apply.When the controlling owner is an individual or family, we generally do not factor the family’s reputation or politics into our analysis. However, if the owners have a record of public or political involvement that in our opinion threatens to cause conflicts of interest in the operation of the company or to harm the company’s reputation, we will take these factors into account. Our sensitivity to such conflicts varies from industry to industry. For example, if a media company is controlled by an individual holding high public office, we view this with great concern.
In general, we regard ownership by foundations with a public service mission favorably. If, however, the foundation is simply a vehicle for family control, the same positives do not necessarily apply. Indeed, in family-controlled companies, whether the control is direct or through a foundation, the owners may on occasion have access to financial information not available to general investors in the marketplace that introduces conflicts and inefficiencies into stock pricing and even potentially into the management of the firm.
Finally, in the case of majority ownership by national governments, we evaluate such situations carefully. Although it can be argued that the state should logically be expected to play the role of an owner who takes the public interest to heart, in fact numerous possibilities for conflicts of interest exist under state control. We look to several factors in our evaluations, including the government’s record for honesty and public service and the likelihood of the abuse of the company for purely personal or political purposes.
When third parties own 20% to 50% of a company’s stock, we look for indications of whether these parties exercise significant or effective control. If they do, then we apply the same general principles as if they held a majority ownership. If they do not, we consider them passive investors, and do not take their ownership into account. The relationship between such owners and the companies in which they hold stock is often difficult to evaluate and considerable judgment is required on our part.