SINGAPORE (July 2): Robert Maxwell, the flamboyant British newspaper baron, who was found naked and dead at sea in November 1991, after apparently falling overboard his yacht as it sailed near the Canary Islands, left his companies in financial disarray. In particular, some £440 million in employee pension funds at his Mirror Group was found to be missing. The scandal came on the heels of an investigation into unaccountable losses and irregularities at Bank of Credit and Commerce International, and the collapse of a fast-growing London-listed company called Polly Peck. These incidents shook confidence in Britain’s corporate sector, and helped spur an inquiry into the state of corporate governance in the country.
In 1992, a committee headed by the late Adrian Cadbury published a landmark report that transformed the way public-listed companies are run. Among the key recommendations of the so-called Cadbury report were that the posts of chairman and CEO should be kept separate, and that there should be non-executive directors of sufficient calibre and number to carry significant weight in a company’s decisions.
A decade later, in 2002, the US Congress passed the Sarbanes-Oxley Act, which was designed to protect investors from fraudulent accounting practices. This too was spurred by a number of scandals, including those involving Enron Corp and WorldCom. Among other things, the new law requires both the CEO and chief financial officer of a company to certify the accuracy of financial information published by their companies. And, they could face stiff penalties if they sign off on financial reports that are misleading or fraudulent.
While the importance of corporate governance tends to become acutely evident in the aftermath of scandals, the cost of the rules to ensure that trouble is averted in the future often becomes a point of contention when things calm down. Critics of the Sarbanes-Oxley Act have argued for years that the new law burdened the US corporate sector with greater regulatory complexity and compliance costs.
In Singapore, where corporate governance is not taken lightly, a series of scandals over the last few months — from a bribery case at Keppel Corp that resulted in fines totalling US$422 million ($577 million) in three jurisdictions, to a series of unauthorised loans taken by Midas Holdings that resulted in its shares being suspended and an investigation by the Commercial Affairs Department — has led to calls for stricter regulation. The challenge is to find a path towards lifting investor confidence without making it any more difficult and costly for public-listed companies to function.
Ownership versus control
Corporate governance is primarily about overcoming the problems related to the separation of ownership and control. How do the owners of a public-listed company ensure that its managers do not expropriate or waste their money? How can the owners be sure that diversification and expansion initiatives are a good use of their capital rather than acts of empire building by their managers? And, how can they be assured that financial statements accurately reflect the true state of affairs at their company?
For the most part, shareholders rely on extensive legal protections. Notably, they elect directors who are responsible for looking after their interests. The permission of shareholders is also explicitly required for certain large corporate transactions. But there are shortcomings with all of these protections. Public shareholders may lack the expertise to properly judge the performance of the company’s directors. Meanwhile, executive directors are naturally conflicted as they are members of the management team. And, non-executive directors often have little to gain personally from improvements in the performance of their companies. Non-executive directors may also owe their positions to the top executives of those companies.
These risks could be mitigated if the company has a single dominant shareholder, as there would be less distance between ownership and control. Indeed, before investing in a stock, I always try to determine whether the company has a principal shareholder, and whether that shareholder can be trusted to act in my interests. In many cases, that principal shareholder is the key driver of the company and the main reason that many investors buy the stock in the first place. Would there be as much interest in Berkshire Hathaway without Warren Buffett? Or, Facebook without Mark Zuckerberg? Or, CK Hutchison Holdings without Li Ka-shing?
The presence of a dominant shareholder cuts both ways, though. While it may reduce the likelihood of managers expropriating or wasting money, there is a risk of the dominant shareholder not acting in the interest of all the other shareholders. For instance, profits may be diverted through transactions with companies privately held by the dominant shareholder. Minority investors may also not receive full value for their shares in the event the dominant shareholder decides to take the company private.
The problems related to the separation of ownership and control might also be mitigated through contracts with managers that align their interests with those of shareholders. A classic example of this are remuneration terms that include an element of profit-sharing or stock options. Yet, even here, there is a risk of managers acting in their own interest by, say, deliberately timing the pricing of the stock options before the release of good news or after the release of bad news. More importantly, managers may choose to take outsized risks, as they will get a share of the upside but none of the downside.
So, should the calls by investors for more accountability be met with the provision of more legal protection and the imposition of greater duties on directors? Or, is there a different way forward?
Make existing mechanisms work
In my view, regulators should focus on ensuring that mechanisms already in place to monitor and control the management of a company are working efficiently. For starters, independent news gathering and research ought to be fostered by ensuring that public-listed companies make information they possess widely available and limiting their ability to sue for defamation. Varied insight on the financial performance of a company is useful in determining if its directors and executives are living up to the spirit of their commitment to act in the interest of investors. Yet, reticence and the threat of legal action have a chilling effect on the expression of opinion — specifically, negative opinion.
It is perhaps not surprising that the most insightful negative views on locally listed companies in recent years have come from outside the mainstream analyst community. Case in point: An outfit known as Iceberg Research accused commodities trader Noble Group in early 2015 of exploiting accounting loopholes to avoid large impairments and fabricate profits. Noble dismissed the claims and attempted to sue. Three years on, Noble’s market value has shrunk by about 98%. Why did all the parties who were supposed to be looking after the interests of investors fail to see what Iceberg saw?
In a similar vein, regulators ought to examine the practical hurdles that investors face in replacing boards that fail to properly monitor and control the managers of a company. In theory, shareholders who feel that their board is not performing up to the mark can propose a new slate of directors. But does the lack of information and the risk of defamation suits prevent them from airing their grievances and canvassing support from their fellow shareholders? What can be done to ensure that legitimate requisitions for extraordinary general meetings are not stymied by resistant boards and top executives?
Academic literature also cites hostile takeovers as a potential mechanism for monitoring and controlling managers. In such corporate exercises, top executives are often replaced, and assets acquired as part of their empire building are usually sold. A company’s capital structure can also be tailored to check the power of managers. For instance, a significant debt load on a company’s balance sheet could force managers to drive improvements in efficiency. So, it seems logical to me that reducing the hurdles of hostile takeovers and introducing tax policies that promote levered capital structures would have a positive effect on corporate governance.
Lesson from the past?
Finally, the distance between ownership and control could perhaps be reduced by directly involving shareholders — especially professional money managers with particular insight into corporate governance matters — in reviews of a company’s performance. An academic paper about the Chesapeake and Ohio Canal Company (C&O), one of the earliest US corporations, provides a framework for this.
The origins of C&O date back to the late 1700s, to another corporation called The Potomac Company, which George Washington helped create. The Potomac Company improved navigation on the Potomac River by removing obstacles and building lock systems. In 1823, C&O was formed. It absorbed The Potomac Company and went on to build a canal from the Potomac to the Ohio River. C&O created a committee of shareholders every year to review the annual report of its president and directors. And, the committee left detailed records of these reviews.
According to the academic paper on C&O, the shareholder committees made numerous observations and recommendations over the years. These included how financial information should be classified and presented as well as noting shortcomings in the way the company conducted its affairs. This practice of annual audits by a shareholder committee continued until C&O ceased to exist in 1889. “Maybe we can learn from history and find additional solutions to the corporate governance problem that have been lost in time. In the US, the distance between managers and providers of capital increases the agency problem. Corporate managers have greater discretionary power over the allocation of corporate resources than might otherwise be if owners were actively involved in corporate management,” the academic paper notes.
“In the case of C&O, the stockholder review committee gave the providers of capital, the stockholders, a more active involvement in corporate management... [and] the stockholder committee utilised by C&O might very well be utilised in corporate governance today,” the paper adds. It goes on to suggest that shareholder review committees today could be formed with representatives of mutual funds and retirement funds that own a company’s shares. “A review committee composed in such a manner would not have any allegiance to corporate management and would likely monitor management more closely and with greater scrutiny than the board of directors.”
A new approach to corporate governance rather than more regulation is probably what is needed now.
This story first appeared in The Edge Singapore (Issue 837, week of July 2), which is on sale now. To subscribe, click here