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The Seven Bad Habits of Poorly Governed Companies

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Psychologists affirm that establishing new habits and breaking old ones involve a process of assiduous repetition for a set period of time to ensure the new habits becomes second nature. 

Corporations, as organizations and dynamic organisms, can set in place a series of good habits that can directly shape and be woven into the fabric of their governance. Incorporating these good-governance habits, which are guided by specific metrics, will allow firms to function successfully for prolonged periods as these good habits become intrinsic to their operation and strategy.

Forbes issues its list of 100 most trusted companies in America every April, as if to signal to the markets it's time for a spring cleaning of habitually bad governance practices. There is a common thread running through the practices, or habits, of trustworthy companies. 

They have successfully eliminated the bad habits that restrict their strategy and hinder their growth. The long-term effects of better governance habits are a virtuous circle: a strong reputation for reliability leads to increased revenues, thus attracting long term investment. Such investment allows for expanded strategies, setting in place a cycle of increased revenues.

A close examination of the data provided by GMI Ratings, that Forbes uses to identify the 100 most trusted companies in America, proves that successful and unsuccessful companies alike have habitual patterns that guide their behavior.

In 2009 I conducted a study (originally published at directorship.com) of over 7,000 nonfinancial companies. These companies were sorted down to only those having a market capitalization of more than $2 billion. In addition, they reflected poor financial indicators and fell in the top quintile of statistical exposure to negative events including SEC enforcement action, class action litigation, default, and precipitous drop in shareholder value. The results showed a remarkable consistency in the shared bad habits of the 200 companies identified. 

The top seven of these prominent bad habits are described below. Bankers should take these bad habits into account when assessing credit exposure in their corporate portfolio and when assessing vendor risk which can be critical to operations.

1. Chairman and CEO are the same individual. The functions of establishing strategy and executing it should be segregated. It is unfair to charge one individual, even the most talented, with the job of executing strategy and leading the board members who are charged with overseeing the quality of that execution.

2. High inventory coupled with low asset turnover. This combination exposes management to address downward pressure on earnings. It can indicate that one's valuations of products on the shelves are outdated – or, worse, distorted to begin with.

3. Low expenses compared to competitors within the same industry. Efficiency is a fine operating principle. But abnormal differences on the efficiency front when compared to competitors can indicate poor controls around capitalization and expense policies. In the worst case, it can be an attempt to avoid expenses on one’s income statement (i.e., leaving them on the balance sheet) to prop up earnings.

4. Revenue gains from M&A activity, rather than organic growth. While there are sound and valid reasons for making a strategic purchase, acquisitions can also be a sign that the organic strategy is not leading to long term revenue gains. Each acquisition is therefore presented to the markets as the foundation for future growth.

5. Intangibles and goodwill on the balance sheet higher than for competitors or peers. This situation prompts the markets to ask about the quality of capital. Intangibles are often not earning assets and are difficult to value. 

6. High leverage. Financing a business through debt can indicate the equity markets do not see value in management’s strategy or operations, impelling the entity to fund through debt.

7. Compensation policies out of balance with market expectations. There is no shortage of discussion these days about say-on-pay provisions. But GMI data reveals that the analysis of compensation is more nuanced than simply the size of executive packages. What is more important to a company's governance is the weighting of incentive compensation as compared to total compensation, the difference between members of the executive team which skews required balances within the executive suite, and incentive compensation that is overly generated by short term earnings-per-share data.

As forward-looking companies expand the use of metrics to measure their effectiveness, it is wise for them to evolve from company-specific data to larger populations of competitive market data. Such data can assist corporations in shedding bad governance habits that will not only help them to build a reputation for quality and trustworthiness, but also set them on a path of expanding strategies, accelerating revenue and attracting long term investment.  

Walter Smiechewicz is the chief risk officer of First Niagara Financial Group.

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Comments (1)
Oftentimes corporate strategies of questionable purpose and longterm adverse consquences are justified by supposedly t"tking advantage of" tax gimmicks. Split-ups of oilcos whereby the sum of the parts is greater than the whole are typical. These conceal plans for commodity traders to gain control over split-off master limited partnerships. The driver is supposedly the tax efficiency of a single-tier tax structure. However the heavoily leveraged [via partnership units] MLPS are desirable devices for offshore unregulated players to gain control over midstream assets and alter commodity prices for speculatrive purposes. The alerations can be accomplished by subtle misreporting of inventories and crude or product movements that alter the inventory picture and affect prices. Ultimately the residual companies and ther shareholders and creditors are left holding the bag while commodity traders on the inside of the MLP structures diregard normal business practices in order to maximize short term commodity speculation gains.
Posted by OLDER&WISER | Sunday, April 01 2012 at 6:31PM ET
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