Boards: A checklist to avoid the duds
Corporate governance principles for company boards are designed to protect the interests of shareholders. But as Nathan Bell explains, the theory isnt practical enough.
In 2001 the collapse of US-listed energy giant Enron sent shockwaves around the world after it was discovered that the board and senior executives had misled shareholders about its profits. Evidently, there weren’t any. The ASX Corporate Governance Council responded with 10 principles, which fell to eight in August 2007 (see Table 1).
The principles are designed to protect stakeholders from inexperienced and greedy boards and executives. But in practice protection only comes with experience, good character and having the right incentives.
To help you uncover what really goes on in the boardroom, let’s take the Harvard Business School approach and run through some case studies.
- Corporate governance principles don’t protect shareholders
- Experience, good character and the right incentives do
- Red flags to watch out for include low share ownership, conflicts of interest and excessive remuneration
|ASX Corporate Governance Principles|
|1. Lay solid foundations for management and oversight by the Board|
|2. Structure the Board to add value|
|3. Promote ethical and responsible decision making|
|4. Safeguard integrity in financial reporting|
|5. Make timely and balanced disclosure|
|6. Respect the rights of shareholders|
|7. Recognise and manage risk|
|8. Remunerate fairly and responsibly|
Conflicts of interest
Few board members are prepared to forfeit director fees like former Rio Tinto chairman-elect Jim Leng, who reportedly quit over a disagreement with Rio’s strategy. But just because a board satisfies ASX principle two – having a majority of independent directors – doesn’t make it independent.
Take the soon-to-be listed Westfield Retail Trust, for example. Five of the trust’s eight directors are classified as ‘independent’. The remaining three are senior Westfield Group executives, including Steven Lowy, who sits on the boards of both groups.
Westfield Group also manages the trust, owns a 50% share in the trust’s underlying assets and the pair will join forces on future developments. In addition, the Lowy family – all four of which sit on Westfield Group’s board – has a large stake in both Westfield Group and the trust.
It’s an incestuous situation and it’s hard to see how Westfield Group won’t get the last word. Should that worry you? Westfield Group has a 50-year track record of adding value for securityholders. With Frank Lowy running the show regardless, why not scrap the trust’s board and save on director fees? The key lesson is that conflicts of interest can render boards and their independent directors impotent, no matter how many boxes are ticked.
More sinister is the incestuous ‘Macquarie model’ of separately listed satellite funds, which shares similarities with the Westfield situation. For example, Macquarie Group used to own a significant stake in the former Macquarie CountryWide listed property trust (now Charter Hall retail REIT). Macquarie Group also had two directors on the board and harvested a king’s ransom in fees as external manager.
The personal rewards for loading up these vehicles with debt and overpriced assets were reflected in Macquarie’s reputation as the millionaires’ factory. As we discussed in Listed property sector covers its tracks, neither the executives nor the boards were rewarded for taking a cautious stance that would have protected securityholders from the financial crisis. To paraphrase former Prime Minister Paul Keating, ‘Always back self interest because it’s the only horse who’s trying’.
Be careful who you trust
At RHG Group’s 2007 annual meeting, founder and chairman John Kinghorn said ‘the directors intend to return all net income and surplus cash to shareholders over time.’ That was the ideal result for shareholders, as cash was pouring in as the company’s mortgage book wound down.
But in light of the improved economic outlook, Kinghorn then changed his mind. He wanted the cash to seed a new venture and, given his track record, we weren’t interested in going along for the ride.
|1. Watch out for conflicts of interest|
|2. Do incentives favour the board and staff over shareholders?|
|3. Are the directors trustworthy?|
|4. Examine a director’s background; successful executives don’t necessarily make worthy directors|
|5. Relevant industry experience|
|6. Is the board hands on, or is a chief executive running wild?|
|7. How many boards are directors serving on?|
|8. Do they have any skin in the game?|
|9. Watch out for short tenures|
|10. Egregious remuneration packages|
But having failed to gain a board seat, we were trapped. Kinghorn was armed with a 24% shareholding and controlled the board; there are just four directors in total and only two are independent. Small shareholders didn’t have a say and were hostage to Kinghorn’s aspirations. Though Kinghorn has just reverted to the original plan and things have worked out relatively well, the lesson is be careful who you go to bed with. You might wake up next to someone else entirely.
A leopard doesn’t change its spots
A thorough background check is a vital part of analysing a board. In 2003 GPT Group appointed Peter Joseph as chairman. As a ‘career investment banker’, it came as no surprise when GPT announced a deal with former investment bank Babcock & Brown.
What did surprise was how easily Babcock & Brown hoodwinked Joseph and chief executive Nic Lyons, which we warned about in The General goes German. The deal almost bankrupted Australia’s oldest listed property trust.
As a director, Joseph should have protected securityholders from the wolves, not delivered them on a platter. Never assume a successful executive will make a worthy director.
Experience in short supply
Unfortunately, there aren’t enough good directors to go around, and many lack experience in the industries they serve. Richard Warburton, chairman of Westfield Retail Trust, is currently on the board of several companies, but boasts little property experience. In these situations charming chief executives armed with ambitious growth plans can destroy a company.
On the flipside, results often sour when experienced chief executives retire to the board. That’s been the experience of Infomedia, with founder and chairman Richard Graham recently rejoining the executive ranks to right the ship.
Some directors also serve too many companies and don’t have the requisite amount of time and commitment that the job requires. Nor do they have much skin in the game. Low share ownership can be a red flag as it’s a case of heads they win, tails you lose if they’re responsible for a raft of bad decisions.
Unfortunately, boards often have little to fear from apathetic investors. Few boards are given their marching orders despite gross incompetence. Short tenures are also a warning sign, as are generous executive salaries. Egregious pay packets might signal the board is beholden to a chief executive who hasn’t groomed a successor. Pokie manufacturer Aristocrat Leisure has been a serial offender in this regard.
In the final analysis, the corporate governance section of an annual report is barely worth the paper it’s printed on. What you should focus on is the board’s experience, its incentives and its genuine independence, as shown by the actions and characteristics of those who sit on it.
Without all of these elements, it’s unlikely that a wayward chief executive will be reined in. Your investment results will suffer as a consequence. Why not now analyse the boards of the companies in your portfolio using our checklist and see how they stack up?
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