Are Enthusiastic IPO Investors Missing an Elephant in the Room?

The past few weeks have witnessed extensive media coverage of two subjects for which investors should have taken extensive note: 1) There are an increasing number of high-profile companies whose shareholders are expressing dismay over corporate governance practices, and 2) high-profile initial public offerings (IPOs) have been drawing extraordinary interest from excited investors.

As I contemplate these two phenomena, I am struck by an interesting thought: Prospective shareholders do not scrutinize corporate governance nearly as often as shareholders who have lived with the governance of their companies over a longer period of time. I can’t help but wonder if investors who are caught up in the excitement and promise of IPOs aren’t missing an “elephant in the room”: What type of governance will the new company have once they own a piece of it?

 A recent article published by the Harvard Law School Forum on Corporate Governance and Financial Regulation examined prospectuses filed with the U.S. Securities and Exchange Commission (SEC) by the 50 largest domestic IPOs between January 2009 and August 2011. These large companies were valued at between $132 million and $18.4 billion at the time they went public. The results were fascinating:

• Only 34 percent of the IPO companies separated the role of CEO and chairman of the board (for S&P 500 companies, the number was not much better at only 38 percent).
• More than one out of five did not have fully independent audit committees.
• More than one out of four board members were not independent at the time of the IPO (with one company reporting only 29 percent were independent).
• Two of the IPO companies reported that they had no financial expert on the audit committee at the time they went public, and only 32 percent had more than one.

In fairness, many of these glaring shortcomings in corporate governance were only permitted by the listing exchanges or the SEC for a short period of time following the date of the IPO. Still, I have to wonder if potential investors paid much attention to the corporate governance models of these companies before making significant investments.

​I tend to be a bit too conservative in my personal investment philosophy to invest in IPOs. And, far be it from me to give anyone financial advice. However, if I were to make such an investment, I would want to satisfy myself about more than the business model and earnings potential of the pending IPO. I would also ask some very critical questions about its corporate governance model. (All these questions don’t have to be answered affirmatively, but a pattern of “no” answers may require further scrutiny.)

• Does the company have a strong/qualified (primarily independent) board of directors?
• Does the company separate the role of CEO from chairman of the board? If not, is there a strong “lead director” who is independent of management?
• Has the board adequately described its role in oversight of risk management? Does it play an active role with management in setting the risk appetite of the company?
• Does the board have a separate compensation committee made up entirely of independent directors, and does it clearly link performance and effective risk management to compensation of key executives?
• Does the board have a strong and effective audit committee composed entirely of independent members? Has it identified one or more financial experts?
• Does the audit committee charter clearly spell out the committee’s role in oversight of the external and internal auditors?
• Does the company have a well-resourced internal audit function with a clear reporting relationship to the audit committee and a key member of senior management (preferably the CEO)?
• Does the company have a strong corporate code of conduct with an unequivocal endorsement from the CEO and the board?

I am sure there are many other characteristics of strong corporate governance that I have overlooked. However, the point of the questions provided above is simple: You are much more likely to be satisfied with the corporate governance model of the company in which you invest if you do your “homework” before you make the investment. It beats learning the hard way that the board and management of the company in which you have already invested do not share your philosophy on strong and effective corporate governance.

I welcome your views. ​