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Corporate Governance

Investopedia defines "corporate governance" as "The relationship between all the stakeholders in a company." In this section, we'll discuss two important components of corporate governance -- the composition of a good board of directors and "poison pill" shareholder rights plans -- and broaden the topic a bit to discuss insider holdings and trading.

Board makeup and conflicts
Corporations are required by law to have boards of directors. While directors are not responsible for day-to-day operations, they do elect executive officers and are, in essence, supposed to be the company's watchdog by evaluating and voting on merger and acquisition opportunities, executive compensation plans, and other things.

Clearly, then, the makeup of your company's board is important -- if for no other reason that they are almost always compensated for their work. Investors should examine corporate filings to see who sits on their boards, how much they are compensated, and what their qualifications are.

It's useful to examine board members' professional backgrounds, as directors ideally have personal experience in the areas pertinent to a specific company: industry expertise, financial and venture capital experience, strategic contacts and connections, time spent working with companies of similar size or at similar stages in the growth curve, and so on.

But board members may also wave flags that go beyond the practical characteristics mentioned above. If a company's directors are primarily management -- who are generally busy with the job of running the company -- or friends and family (who may not, for obvious reasons, be as critical as they should), the board may not provide the sort of support and input that it must to create value for the company. This is especially important in the case of relatively young companies that are still run by founders or their relatives.

Also worth investigating are so-called "related party transactions." Put simply, a related party is someone who either owns some of the company, or is closely related to/affiliated with someone who does. When a company does business with such parties, details of the transaction must be reported in corporate filings.

Such dealings are common, and may include lease agreements, consulting deals, and loans. (Accounting firm Haynes, Downard & Andra's website has some useful background on this practice.) While they are by no means illegal, or even shady, investors should always check their companies' SEC filings to see whether, in their estimation, a company is compromising its stockholders -- overpaying, for example, for goods or services -- by trafficking with related parties when better deals might be found elsewhere.

Some companies take their responsibility to stockholders especially seriously. Crafts supplies retailer Michaels(Nasdaq: MIKE), for example, recently enacted several reforms: It expanded its board (adding two new independent directors), disbanding the board's executive committee -- thus turning over all key matters to the full board -- and put its entire board up for reelection at one time, rather than staggering membership.

Among the groups active in the discussion of corporate governance issues is CalPERS, short for California Public Employees' Retirement System, which owns more than 1,600 public companies and offers lots of information about its viewpoints on "strong boards" online.

"Poison pills"
Investors will regularly read press releases announcing a company's adoption of something called a shareholder rights plan. Casually called "poison pills," these plans grant stockholders special rights to purchase additional shares of their company's stock (or the acquirer's stock, if the acquirer is another public firm) should any investor acquire more than a pre-set percentage of a company's outstanding shares. (Though I say "pre-set" here, some companies will erect these defenses hastily in direct response to a specific stockholder's purchasing habits.)

The idea behind these plans is to prevent outside parties from gathering up so much stock that they could take actions that don't mesh with management's plans -- a common ploy is to collect shares in order to try for a board seat -- without approaching the company first. "Activist investors," as these folks are sometimes called, usually want management removed or restructured and the company put up for sale. With their jobs on the line and judgment called into question, executives don't always take kindly to helpful suggestions like these.

Investors should cheer "poison pill" plans if they support and trust management, since what they do is help protect the company from interlopers. Not all of them do. Mattel(NYSE: MAT) stockholders once voted in favor of removing their company's rights plan, a rare occurrence. (Mattel's board eventually voted to allow the company's rights plan to expire next early year, rather than renew it.) If that happens, it's a pretty sure sign investors don't think management has their best interests in mind -- or the ability to make them a reality.

Insider buying, selling, and ownership
As Brian Graney noted in a column for our SmallCap Foolish 8 area, it's nice to know that a company's managers "eat their own cooking" and own a measurable proportion of its stock. But how much is the right amount? There isn't a right number -- nor is it right to simply say that more is better.

But it is still a useful data point, and the Foolish 8 investing strategy screens out companies with less than 10% insider ownership. More than about ownership, however, The Motley Fool receives a pretty high volume of questions about what we think of insider trading trends -- the buying and selling of corporate stock by directors, officers, and other major stockholders, all of which must be disclosed in a timely manner in SEC filings.

Two SEC filings to track are the Form 4, in which changes to ownership are reported, and the Form 144, in which stockholders must report the intention to sell more than 500 shares -- or $10,000 worth -- of a company's stock in a three-month period. (The SEC's website has more information on investor filings and what they mean.)

Once you have that information, how should you use it? It's a difficult question: It's often said that there are a million reasons to sell, but only one reason to buy. We all buy stock when we think it's going to go up. Pretty simple, right? But when we sell it can be for any reason under the sun. As a result, we generally don't attach too much importance to this kind of news, though there are exceptions. If a number of insiders all sell or register to sell a large number of shares at one time, it may be a sign that management believes the stock is overvalued.

It may also be worthwhile to look for a history of selling (or buying) very shortly before bad (or good) news is announced. While such behavior is rare, it may constitute illegal insider trading if trades are made as a direct result of the possession of what the SEC calls "material, nonpublic information." And it goes without saying that frequent trading of a corporation's stock by key figures may signal a questionable commitment to the firm.

Next: Compensation »

Dave Marino-Nachison's (TMF Braden) stock holdings can be viewed online. The Motley Fool has a full

 disclosure policy.

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