Corporate Governance: It's Your Responsibility Too – Some Inconvenient and Uncomfortable Truths

Hate to Be Contrary But You Have A Responsibility for Corporate Governance

Warning:  This post contains some inconvenient and uncomfortable “truths” about your responsibility for corporate governance.  To make corporate governance work, you actually have to do something more than whinge about the failings of others.  Or issue calls for vague enhancements to corporate governance like calling on firms, auditors, regulators, and others to “step up their games”.     

Corporate governance generally focuses on roles and responsibilities of the board of directors, external auditors, and regulators.  Shareholders’ roles and responsibilities are not sufficiently discussed.  You can see this in the “founding document” of corporate governance the Cadbury Report (1992) which was sparked by perceptions of corporate misgovernance in Robert Maxwell’s companies. 

Typically the role of shareholder is summarized in a single sentence:  

“The shareholders’ role in governance is to appoint the directors and the auditors and to satisfy themselves that an appropriate governance structure is in place.”  

This post argues that there are clear defects in that formulation and more importantly shareholders’ responsibilities exceed those outlined therein.  If corporate governance is going to be built on this slender reed alone, should we expect brilliant results?  

First to the defects. 

As a practical matter, the shareholders’ role in “appointing directors and auditors” is generally to vote on the candidates proposed by the board of directors.  Often there is a nominations committee of the board generally structured to be “independent” of executive directors (e.g., senior management) that recommends candidates to the full board (which includes executive directors).  There’s a great deal of reliance on “independence” of the nominating committee here.  

In general boards have not demonstrated a lot of “independence”, but perhaps they are when we're not looking.  Or perhaps not.  The full board then decides whether to approve the candidate.  There’s a potential conflict of interest in this arrangement. The full board includes executive directors.  Management may therefore have a significant role in hiring those who are supposed to monitor its performance.   

But there’s more.  

Generally the board only recommends a single candidate for a position.  If there are 6 director slots open, shareholders get to vote on six candidates. If it’s time to appoint auditors, one firm is proposed. Shareholders have all the choice given voters in “democratic” elections in one-party states.  On a positive note for shareholders, a “no” vote doesn’t usually lead to unhappy consequences. In either case it is “take it or leave it” which probably explains why the directors’ recommended candidates win, except in extreme cases.   

There are two reasons for this state of affairs. 

1. As a practical matter how would shareholders—usually an unwieldy large number--select potential board members or auditors?  Do they have the skills, contacts, knowledge?  How would consensus be achieved among shareholders over their competing candidates?  If consensus cannot be reached, there could be a plethora of candidates which could be as problematic as having only one candidate. 
2. While individual shareholders generally have a right to nominate directors, the directors’ candidates have a much easier road to election.   If you look at a typical US proxy, shareholder resolutions are included in a separate section with management arguments as to why these should be rejected. When a hedge fund or other professional investor wishes to get its own slate of directors elected, it typically hires third parties to draft, print, and mail its own proxy to each shareholder.  Why does it incur this not inconsiderable expense? It doesn’t believe that management will give its slate a fair shake in the management proxy.  It can’t wait until the meeting to propose directors and make its case because “management” proxies will already have been voted for directors and most shareholders skip the AGM.  They do give management representatives the right to vote their shares, but realistically are management representatives going to vote for the insurgent slate of directors?   
3. In some jurisdictions, if a shareholder owns 10% or more of the stock of a company, that shareholder can name a director and there is no requirement for other shareholders to support.  Differences in cumulative versus non-cumulative voting rights also affect the election of directors.  
4. But in general shareholders’ oversight through the election of directors is more theoretical than real. 

Given the very practical limitations on shareholder selection of directors and the numerous cases of board “failure” in corporate governance, including by ostensibly “independent” directors, shareholders need to do more to protect their interests and to foster good corporate governance.   

This is key because people are the critical variable in good corporate governance.  It wasn’t Enron’s corporate governance structure that caused problems at Enron. It was people. 

Let’s run through what the “more” shareholders must do by way of questions.  

These will allow you to check just how real your commitment to corporate governance is.  Are you Augustine of Hippo or St. Augustine of Hippo?  

Do Corporate Governance Principles  Inform Your Investment Behaviour?

Let’s assume that indeed you are firm believer in corporate governance. Or at least claim to be whenever there is corporate governance failure. 

Among the good practice principles you endorse is that the roles of chairman and chief executive officer be separated and that the chairman be an independent director, not an executive of the firm. Do you refuse to invest in corporations where the roles are combined? 

Suppose your principles also include a requirement for strong risk controls and non-manipulation of markets.  If your bank holdings include one that like Sea World has “whales”, do you refuse to invest or divest your holdings?      

How many of your firmly held corporate governance principles can a firm violate before you take concrete action?   

Remember that the road to corporate governance failure is a slippery slope.  It begins with a first bending of one rule and eventually the breaking of more.  If the firm is highly profitable, can you easily justify poor corporate governance?  Sure they lost US$ 6 billion but they still made a profit. 

In applying your corporate governance principles, do you allow yourself more slack that the CEO of a firm?  You wouldn’t tolerate his breaking even a single rule, but you can let your own principles slide a bit and perhaps even quite a bit, depending on profitability.  

Do You Perform Proper Due Diligence Before Investing?

Do you read more than the glossy pitchbook they give you?  Consider more than the cut of their suits and flash of their MontBlanc cuff links?  Read beyond the gushing appellation “Goldman Sachs of the GCC” or similar in the local press.   Or a shrieking recommendation delivered by Brother Jim on the TV?  

Does that due diligence include checking on corporate governance?  And situations that might cause corporate governance to fail, i.e., distressed financial conditions? 

Do You Know How to Perform Due Diligence Properly?  

Have you bothered to learn how to do due diligence on an investment?

Do you know the tricks used to enhance the presentation of performance in sales pitches?  When you were presented with financial performance, did you check what standards were used for reporting?  A good rule:  No GIPS no investment.  Were there model portfolios included?  Projections to the past:  “Using our strategy on a proforma basis, over the past 10 years we would have earned an IRR of 35%”.  What they don’t say is:  Of course, we didn’t, but it sure looks good.  And if we pick the right time period, we can find a sweet spot IRR.”  

If they're lying to you or stretching the truth in their pitches, what should infer about their ethics and their corporate governance?  

Do you know a bit about financial statements so you can at least spot if cashflow is not in line with reported income?  Would you have noticed that despite Dubious Gas’s reported income, the KRG and Egypt weren’t paying DG what they owed it?  

Understand that under accrual accounting, there can be different methods of recognizing the same transactions both on the balance sheet and the income statement? 

Do you know what the role of auditors, regulators, stock markets are? And what reliance you can or cannot put on them to look after your interests?  

Know what to look for in corporate governance structures, if you're looking for one that is complete and well-structured?  

Do you know the “red flags” of corporate distress?  As stated in my previous post, unless a firm is set up as a criminal enterprise, corporate misgovernance is more likely to occur when management is dealing with a serious problem than when things are going well.  

Some practical examples, before investing in one of Abraaj’s funds, did you look to see where their parent, the management company, etc were incorporated?  Did you understand that offshore companies in the Cayman Islands and other similar jurisdictions are lightly regulated (first euphemism of this post and in a long time)?  Did you ask why? A plausible answer might have been tax planning, but the flag of light regulation should have caught your eye.  

Did you ask for audited financials?  A good but not necessarily foolproof way to check if the firm is in financial distress.  The sort of “occasion of sin” that might lead to corporate misgovernance.   It's also a good way to check on the business performance.  If the funds they manage are performing well, that is, have a flow of exits and good returns, the bonanza of carried interest fees should show up here.  

But they might have told you: “No PE firm publishes financials.  We’re a partnership.  Our partners don’t want their remuneration disclosed.”  Did you know that Charterhouse Capital Partners and associated companies publish financials and that you can obtain a copy at Companies House?  You don’t get individual details but you get an aggregate number.  

Ask about performance of their funds?  If you had asked about their flagship “infrastructure” fund (IGCF) you might have noticed rather dismal performance as Arkad has pointed out. The delay in closing the “sale” of Karachi Electric might have caught your eye. You might have noticed that the GOP wasn’t paying K-El.  Or that K-El had been in Abraaj’s portfolio for some time. Might you have wondered about their wisdom in plunking down a whale-sized amount to invest in power in the subcontinent?  Or wondered what made this investment different from others in the subcontinent?  Enron Dabhol.    

If you looked at that fund’s investments, you might wonder, as Sabah Al-Binali did, why a Private Equity firm was buying listed stocks and what this meant about their stated investment mandate and adherence thereto.   Assuming it was a pure private equity fund, if they won't keep to the mandate, what other promises might they not keep?

What Post-Purchase Investment Monitoring Do You Perform? 

The Abraaj scandal came to light because a few investors saw something that raised red flags and they acted on that information.   

Do you read the company’s financials and investor presentations carefully and not just rely on company press releases or puff pieces in the press for your monitoring?   Local press analysis often being little more than a regurgitation of the press release.  

Do you look for changes in behaviour or reporting by the firm that are red flags of potential problems? 

Do You Exercise Your Corporate Governance Rights?  

Do you attend the annual shareholders’ meeting?  Ask questions you have from your post-purchase monitoring?  Listen to the questions of other shareholders and management’s responses?  React and participate? 

Where there are proxy materials, do you actually read them?  Do you vote your proxy?  Do you do more than “tick” yes on the management recommendations?    

In some jurisdictions there aren’t proxies. Some of this information is in the audited annual report.  Or in separate corporate governance reports.   

If you've got a problem with information provided have you ever complained in the AGM (with auditors, representatives from the MOIC or equivalent, and directors present) that information in financials and disclosures is insufficient.  Ever make similar complaints in writing to your stock market or local regulator about insufficient, unclear or misleading disclosures?    

CONCLUSION 

At this point I imagine that some of you are thinking.  

But this is hard work. It’s unrealistic.   We don’t have the skills or time to do all of this. The auditors, the board, the regulators should do their jobs properly and we won’t have to.  Quite!  Police and neighbors should be keeping watch to prevent burglaries.   I shouldn’t have to lock my door. 

Or wait just a minute, AA.  Are you seriously arguing that if we do this, there won’t be corporate misgovernance?  

No!  But you may make it harder.  You may create an environment that encourages other shareholders to take similar actions.  

You may deliver a very clear message to board members that you are watching.  Auditors, regulators, the MOIC may be awakened to action.

On the other hand, you can decide that this is too much and not really your responsibility. You can remain among the sheep. That entitles you to bleat on-and-on about corporate misgovernance whenever you’re sheared.