Corporate governance can be defined as a system of policies and procedures used by stakeholders to address the conflicts of interest that come with using the corporate form of business. Basically, corporate governance policies are supposed to minimize conflicts of interests and ensure that company assets are being used efficiently.
What's all this talk about?
Lululemon's (NASDAQ:LULU) founder and director Dennis Wilson, who controls 27% of the company, recently made the investing public very aware about his disapproval of the board of directors. Apparently the best time to voice your concern is hours before the annual shareholder meeting and board vote is set to take place. Mr. Wilson voiced his concerns that the current board is not aligned with the products and innovation that Lululemon so thrived on before it's share price tanked over 40%, a dip that cost Mr. Wilson a substantial amount of money on paper. He did, however, give his approval to the newly elected CEO, Laurent Potdevin. Despite Wilson's ownership stake of 27%, he failed, and the directors he voted against were reelected. A lot of his concerns can be related to governance issues, so lets dig more deeply and evaluate Lululemon's policies.
Board of directors
A board's purpose is to be a link between management and shareholders, provide long-term strategic goals, set executive compensation, and evaluate the CEO's performance. Lululemon's board consists of ten directors, and company policy states no director should serve on more than four public company boards. Corporate governance best practice states the board should consist of primarily independent directors. All of Lululemon's directors are independent except for two--Dennis Wilson, who is the company founder, and Laurent Potdevin, the CEO. Mr. Wilson does not sit on any of the committees, which reflects solid corporate governance. Robert Bensoussan, a newly elected director, serves on the boards of eight other companies, with five of them being public. Serving on that many boards is a negative sign because his time is not as devoted to Lululemon's business as it should be.
Note that Lululemon has separated the role of CEO and chairman of the board. By general views this is good governance practice. But one red flag is that the board is staggered, which means not all directors are up for reelection at the same time. This limits shareholder's abilities to induce change in management or board composition. Mr. Wilson would no doubt have loved to vote against the whole board at the same time, but due to it's staggered nature he could not. Other than the issues gone over above, Lululemon has solid governance policies in place relating to it's board. Do not be fooled, though--just because good policies are in place does not necessarily mean the board does it's job well.
Compensation and ownership policies
Executive compensation, as outlined in Lululemon's SEC filings, is based on both short and long-term business objectives. Long-term goals are expected to be rewarded, but short-term goals should not. Short-term goals, depending on what that means (as they do not say), can be manipulated or may not be good for the long-standing health of the company. In other words, achieving short-term goals may come at the expense of using company assets most efficiently or lead to an artificially boosted share price.
The measures used to evaluate performance over the long-term include revenue, gross margin, and operating income targets. These measures are fine since they cannot be as easily manipulated as net income or stock price increases. Lululemon pays the bulk of executive compensation in stock options and grants. The compensation committee sets the value of the stock options or grants based on an evaluation of a peer group's use of stock in their compensation plans. This keeps executive pay in-line with peers.
Lululemon has a policy in-place to make directors and executive officers aligned to the long-term performance of company goals and share in the risk with investors. The policy requires directors and executives to own a certain amount of equity in the company. Independent directors are required to own, at minimum, five times their base salary in company stock. The CEO and other executives have to own six and three times their base salary in stock, respectively. When looking to see if they abide by this rule we see seven out of ten directors well above the requirement. Three directors are either very close or under depending on what value you use for Lululemon's stock price. There are no golden parachutes, excessive compensation due to change in control, or policies for termination with or without cause.
A company's governance policies or lack thereof imply different risks. Mr. Wilson's ownership stake along with a board seat board raises some issues depending on if shareholders share in his views and dissidence. He will have a large say if there is a takeover attempt or large strategic change in the company. Mr. Wilson has significant influence over company operations and as of late has been not so friendly toward management. Some of the directors have been on the board for almost ten years. This a negative because they may become complacent with executive's decisions and not bring any new thoughts to the table. Short-term goals can incentivize management to take measures to meet certain criteria. If this is the case then the long-term health of the company can be jeopardized.
There are also a couple of on-going lawsuits against Lululemon, as outlined in this article. One lawsuit alleges Lululemon misled investors over the real reason for the see-through pants debacle. The plaintiffs allege it was to cut costs and increase profits. The other lawsuit is about the increase in executive compensation before the recall of the see-through pants was made public. For now we can give Lululemon the benefit of the doubt since the investigations are ongoing. But, if any of these allegations turn out to be true, it would show that directors did not behave ethically or serve their shareholders.
Investors should not only consider financial performance when evaluating companies. Attention should be paid to corporate governance policies. These policies speak to the character of the higher-ups and how they see a given company should be run. Governance policies can greatly influence performance over the long-term. In the case of Lululemon, there appear to be mostly solid corporate governance policies in-place with a few that could use some work. Investors should keep an eye on Lululemon to see how these issues pan out.
Zach Friesner has no position in any stocks mentioned. The Motley Fool recommends Lululemon Athletica. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.