An Economic Entity

To take off, survive, and thrive, a company's economics must work. There must be enough demand for its products and services to generate revenue to cover costs, expenses, and other obligations. The company must operate efficiently enough to enable it to compete successfully on price, quality, and service. To attract essential capital, the company must, over time, earn a competitive return on investment.

For directors, the company as an economic entity is a cornerstone assumption in governance. There is nothing worse than directors who don't understand basic economics. They are the equivalent of drivers without drivers' training. They shouldn't be behind the wheel.

Of all the principles of economics, the most important is supply and demand. When something is in short supply and demand is high, its price and value go up. When something is abundantly supplied and demand is low, its price and value go down

My years on the board of EQR have instilled in me the importance of directors looking at business through the lens of supply and demand. Sam Zell likes to say that competition is a great thing—for the other guy! Limited supply makes things dearer and positions a company to be more profitable.

 

Supply and Demand in Action. Let me offer an example of supply and demand as it has played out at EQR, much to the advantage of our shareholders. It is the story of repositioning EQR's portfolio of apartment buildings into high barrier to entry markets across the nation.

EQR was created as a public company in 1993 to provide an infusion of growth capital into Sam Zell's privately owned apartment business along with a portfolio of properties provided by a company named Starwood and its founder, a brilliant real estate entrepreneur named Barry Sternlicht. The recession had deeply depressed demand for and, therefore, prices of apartment properties across the country. In addition, the Federal Deposit Insurance Corporation was making available for sale properties that it owned as a result of the savings and loan crisis. Capitalizing on these opportunities, EQR tapped the public debt and equity markets and went on an aggressive, multi-year buying spree, acquiring quality garden apartment properties across the nation from motivated sellers at bargain basement prices.

A decade later, EQR was humming. Demand for apartments had rebounded. Occupancy levels and rents had risen, substantially increasing the value of the properties EQR purchased in the 1990s. After careful consideration of the future of supply and demand for apartments, the board, on management's recommendation, made a strategic decision to reposition EQR's entire portfolio. We sold much of what we owned, exiting certain geographical markets where we forecast too little demand or too much new supply and bought properties in markets where we forecast high demand for apartments and little new supply. Our catch phrase for the demand side of the equation was that EQR would be "where people want to live, work, and play." The catch phrase for low supply conditions was "high barrier to entry markets." We bought and developed properties in densely populated, desirable urban areas, primarily on the east and west coasts, with low land availability and strenuous permitting conditions for building new properties. Think Boston, New York, Washington, San Francisco, and Seattle.

The repositioning strategy—which completely changed EQR's property portfolio—was entirely driven by considerations of supply and demand.

 

Financial Statement Analysis. A company's economic health is measured primarily with financial data. This brings us to the issue of financial literacy and the importance of having one or more financial experts on the board.

The terms financial literacy and financial experts are not randomly chosen. Stock exchange listing standards (the requirements companies must meet to be listed and have their shares traded on the exchange) use them to specify the level of financial knowledge directors must have to serve on the board's audit committee.

For example, the listing standards of the New York Stock Exchange state that each member of the audit committee must be financially literate, as such qualification is determined by the board in its business judgment. The standards also require that at least one member of the company must have "accounting or related financial management expertise." This requirement relates to Section 407 of the Sarbanes-Oxley Act of 2002, which requires public companies to disclose whether their audit committees include at least one member who is an "audit committee financial expert." The SEC defines a financial expert as a person with all of the following attributes:

 

• An understanding of generally accepted accounting principles and financial statements

• The ability to assess the general application of such principles in connection with the accounting for estimates, accruals, and reserves

• Experience preparing, auditing, analyzing, or evaluating financial statements or actively supervising one or more persons engaged in such activities

• An understanding of internal controls and procedures for financial reporting

• An understanding of audit committee functions

 

The audit committee financial expert must have acquired these qualifications through experience as a principal financial officer, accounting officer, public accountant, controller, or auditor; or experience actively supervising one of these; or experience overseeing or assessing the performance of companies or public accountants in the preparation, auditing, or evaluation of financial statements.

The standards for a director to qualify as a financial expert are high, and they should be. While the fundamentals of key financial statements (profit and loss, balance sheet, cash flow) are simple, in large companies these statements can be extraordinarily complex with apparently precise numbers masking myriad estimates, judgments, and other less-than-precise determinations.

Financial literacy requirements are not as stringent as those for the financial expert. They include the ability to read and analyze (in a basic way) financial statements and accompanying notes and to understand accounting policies, estimates, and judgments. Still, I believe that every director (not just those on the audit committee) should have the ability and determination to forge through many pages of financial statements, footnotes, and management discussion and analysis to exercise proper fiduciary diligence and, on behalf of shareholders, know the company's true financial condition.

It's great if a person has the requisite financial literacy or expertise to be a director. If not, it's essential to acquire it. Nothing undermines a director's credibility and gravitas in all domains like weakness with the numbers.

As a motivator for the education that may be needed, let me share a few insights from my son, Brian, who is a faculty member in accounting at the University of Texas at Austin. At my request, he made a presentation on analysis of financial statements to an undergraduate class I teach composed mainly of nonbusiness majors. He concluded with some points that rang true to me as a long-time director and on which I think any financially literate director should be able to write an informed essay:

 

• Financial statements use a standardized format and measurement to facilitate comparisons

• Accrual-based accounting can make accounting information more useful to reflect underlying economics

• Accruals require judgment and discretion—there is a tradeoff between better information and potential for abuse

• Financial statement numbers are only useful in context and with some transformation including vertical/horizontal income statements and ratio analysis.

 

If a director is not ready to write these essays, financial literacy education is in order. Consider a finance for non-financial managers executive education course or a financial statements analysis course at a local business school.