Do directors need more skin in the game?

Gina Rinehart's argument that 'true believer' board members should own stock in their companies matches the advice of many fund managers. But it's not a fail-proof measurement of good management values.

Leading Company

Fairfax’s board members aren’t "true believers”, the media company’s largest shareholder suggested yesterday.

John Klepec, the chief development officer at Gina Rinehart-owned Hancock Prospecting (who in turn owns 13 per cent of Fairfax), told the Australian Financial Review earlier this week the Fairfax board’s failure to significantly invest in Fairfax was troubling.

"If the chairman and board are true believers in the strategy to assist the company, surely they would have a reasonable percentage of their net worth in Fairfax and be taking opportunities to add to this when the opportunity arises,” he said.

It’s the latest grenade thrown by Gina Rinehart at the Fairfax board, which has refused to give her a board seat (or, for that matter, the two she is now asking for). Her argument about the directors not owning stock makes sense, not least to other investors.

"She’s asking a very good question,” Adrian Ezquerro, an analyst at Clime Investment Management tells LeadingCompany. "But it’s aimed at the wrong company,” he adds. "Fairfax is a terrible investment.”

Business leaders with "skin in the game” are generally better regarded, fund managers say.

Ezquerro says it’s certainly something he looks for.

"We like to align ourselves with managers who in turn align themselves to the best interests of shareholders. A good way of judging that is by how much stock they own.”

Vas Kolesnikoff, chief executive of the Australian Shareholders Association, says it’s his preference and recommends an amount.

"We want [company directors] to own stock,” he says, adding that the association recommends half of executive bonuses should be paid in stock, although this percentage is under review.

Martin Lawrence of proxy advisory firm Ownership Managers say, "investors certainly notice [director investment] isn’t there”.

The unambiguous preference of shareholders and their representatives underlines what economists call the "agency problem”. Its pedigree is as old as economics itself, having been discussed by Adam Smith in The Wealth of Nations.

The root of the problem lies in a belief that incentives matter. Business leaders are hired to represent shareholders but, as they aren’t shareholders themselves, they may not always act in the best interests of their company owners. Investors would rather put their faith in the self-interest as well as the professionalism of their hires. Executives owning stock aligns everyone’s interests more closely. They’re all in it together.

So, could there possibly be negatives to managers owning a lot of stock?

Ian Ramsey, the director of the Centre for Corporate Law and Securities Regulation, offers a few possibilities.

"In some instances, there can be problems with executives owning substantial shares in the company, because they may be tempted to prefer their own interest rather than those of other shareholders. So for example, they might, as we’ve seen with some foreign companies, engage in misreporting if that can mean they benefit through receiving share options to increase their stake.”

Lawrence says during the global financial crisis he heard concerns that ownership interests were influencing decision-making to an unhealthy degree.

"Here’s an example,” he says. "If you as an individual own 5 per cent of a company, and have debts outside of the company that you need dividends to pay, you may boost the dividend even if the company needs to cut it.”

"The other one might be capital-raising – you may not have the money to participate, but as you don’t want to dilute your share, you might limit or not conduct capital raisings despite it being in the interests of the other shareholders and the company as a whole.”

In some jurisdictions, stock markets question whether a director on the board should own stock as it casts doubts on their ability to be independent, Ramsey says. This reflects a view that shareholdings compromise directors.

Significant shareholdings do not always ensure a well-managed company. ABC Learning founder and chief executive Eddy Groves owned 14.9 per cent of the childcare operator with his then wife. That didn’t stop the company collapsing under a heavy debt burden caused by overexpansion in 2008.

Ramsey says studies into the ideal level of managerial ownership are inconclusive.

"I think it would be very difficult, if not impossible, to come up with even a guideline on how much managers should own,” he says. "It’s for individual companies to work out.”

Some companies have done just that. Westpac directors are, under the company’s deed of settlement, required to own 4,000 shares, which at today’s price costs $82,000. However, chief executive Gail Kelly owns almost $30 million worth of Westpac shares.

Companies whose executives own the most stock tend to have company founders still at their head. For example, Rupert Murdoch owns $6.01 billion of News Corp shares, while Fortescue chairman Andrew Forrest topped the executive rich list in 2011 with $6.2 billion in shares.

Fairfax chair Roger Corbett holds 99,206 shares in the company, at today’s price worth $59,524. He received compensation last year of $412,629, none of which was in shares.

Meanwhile, Fairfax chief executive Greg Hywood added 118,343 shares last year (worth $71,006), after receiving $1.5 million in compensation, none of which was in shares.

All directors apart from Michael Anderson have some equity in the company, going by the 2011 annual report. But if we remove the three directors who have resigned since then, John and Nick Fairfax along with Brian McCarthy, the remaining directors held only 603,222 shares in 2011, worth a paltry $361,933.20 at today’s price.

The last director at Fairfax to hold a lot of shares was John Fairfax, who had a 9.7 per cent stake in the company. He retired in November 2010, and sold out his holdings a year later for $193 million.

This story first appeared on www.leadingcompany.com.au. Republished with permission.

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