Gaynor: Power to the people keeps balance

By BRIAN GAYNOR

Corporate governance is a hot topic in New Zealand and throughout the world following the collapse of Enron. But it is a vast issue that is not easy to summarise, somewhat similar to the debate concerning good government.

In simple terms, corporate governance is about the relationship between shareholders, directors and a company's management. Good governance is where all shareholders have an influence over a company and poor governance is where management is in a dominant position.

The relationship between shareholders, directors and management has become more formal because of the separation of ownership and control in the modern corporation.

The interaction is governed by securities regulations (legislation and stock exchange rules), companies' constitutions and, most importantly, the voluntary behaviour of the principal participants. Directors play the pivotal role as they establish and maintain governance standards and monitor the performance of senior management on behalf of shareholders.

Although corporate governance is a reasonably complex issue, some basic assertions can be made. These are: fusqi Good corporate government gives superior returns to shareholders.

Companies should adopt several core principles.

Governance standards in New Zealand have improved substantially but further progress can still be made.

Several academic studies in the United States have demonstrated that companies with good corporate governance outperform those with lax standards.

One of these was recently published by the National Bureau of Economic Research (NBER)*.

The study identified 24 corporate governance standards and built a Governance Index based on approximately 1500 companies. It found companies with the strongest shareholder rights and the lowest management power substantially outperformed those with weak shareholder rights and the highest management power.

Some of the specific findings included: fusqi An investment of $100,000 in a portfolio of companies with strong shareholder rights increased to $707,000 in the nine years to December 1999, whereas a similar investment in companies with the highest management power grew to just $339,000 over the same period.

Companies with weak shareholder rights are less profitable and have lower sales growth than other firms in their industry.

Companies with strong management power have higher capital expenditure and make more acquisitions. This is because these strategies increase the size of the firm and, as a consequence, the power and status of management and the remuneration paid to them.

The NBER study gives a clear message that companies with good corporate governance - that is, those with strong shareholder rights - perform better than companies with weak governance and where management is in the dominant position.

The major corporate governance concerns vary from country to country. The principle of one share/one vote, which is taken for granted in the US, Britain, Australia and New Zealand, is a big issue in many European countries. The separation of the role of the chairman and chief executive, which is strongly endorsed in Britain, has only recently become an issue in the US.

The independence of non-executive directors is widely accepted but there is no agreement on the definition of independence and the percentage of directors that should be independent.

In New Zealand the Institute of Directors has published a Code of Proper Practice for Directors that contains several important provisions. These include:

fusqi In the case of Stock Exchange-listed companies there should be a majority of non-executive directors.

The role of chairman and chief executive should be kept separate.

Companies should have an effective audit committee and, in appropriate circumstances, other board committees to assist with such issues as remuneration, nomination etc.

The New Zealand code is less definitive than in other countries. For example, the Combined Code in Britain, which has been endorsed by the Financial Services Authority, specifically states that a nomination committee should formally recommend the appointment of all new directors. This is to ensure that good-quality independent directors, instead of close associates of the existing directors or management, are appointed.

In some countries, senior executives are encouraged to take one outside directorship. This has long-term benefits for the corporate sector as, over time, it increases the pool of experienced people from which non-executive directors can be drawn.

The British code also has several specific recommendations on the remuneration of senior executives and directors, including share option schemes, and the role of institutional shareholders.

Governance codes in other countries have established a mandatory retirement age for directors and moves are afoot in the United States to disqualify auditors from undertaking non-audit work for client companies. The debate over auditors reflects the fluid nature of the corporate governance debate; issues usually come to the fore after a major company collapse or some other disaster.

The main corporate governance issue in New Zealand is the shortage of strong independent directors and the dominance of management. In the 1980s many of our largest companies had few, if any, independent directors and were completely controlled by management.

Chase Corporation had no non-executive directors and Colin Reynolds was chairman and chief executive. Equiticorp had eight executive and three non-executive directors and Allan Hawkins was chairman and chief executive.

Bob Matthew was executive chairman of management-dominated Brierley Investments. Management appointed directors instead of the other way around.

Fletcher Challenge also had a number of executive directors and at one stage had five executives and a former executive on its 10-person board.

The most recent example of a poor corporate governance structure is Force Corporation. When the cinema operator entered Argentina in 1996, through a joint venture with Village Roadshow of Australia, it had five directors and Peter Francis filled the role as both chairman and chief executive. Force had three executive directors, another from Village Roadshow and the last one was a close personal friend of the chairman.

Although Force shareholders approved the transaction, the company had no truly independent directors to scrutinise the deal before it was put to a vote.

The outcome was disastrous; Force nearly went belly-up because of its ill-conceived Argentinean investment.

The poor performance of our management-dominated companies is consistent with the findings of the NBER study.

It is also questionable whether some of our non-executive directors are truly independent. Many are lawyers or stockbrokers who either act for the listed company or are touting for business, while others are close friends of senior management.

But the good news is that there has been a substantial improvement in corporate governance standards in recent years. This is partly thanks to the Institute of Directors and the leadership role of several senior directors, including Bill Falconer and David Sadler.

Few companies now have the same individual as chairman and chief executive and most boards have a majority of non-executive, independent directors. But one, Trans Tasman Properties, is a reminder of the dreadful corporate governance standards of earlier years.

Don Fletcher is both chairman and managing director of Trans Tasman and only two of the five directors are non-executives and independent of Sea Holdings, the controlling shareholder.

One independent director is a partner in a law firm that advises the group; the other is managing director of a merchant bank.

Trans Tasman's dreadful track record is entirely consistent with US studies on corporate governance and share-price performances.

* Disclosure of interests: Brian Gaynor is a Trans Tasman Properties shareholder.

* bgaynor@xtra.co.nz

* Corporate Governance and Equity Prices by Paul A. Gompers, Joy L Ishii, Andrew Maetrick (Paper available at the National Bureau of Economic Research).