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When box ticking goes too far

Date: September 11, 2009

“Computer says no!” is how I felt when told of the decision of Institutional Shareholder Services (ISS), a subsidiary of Riskmetrics, to declare that all our Non-Executive Directors (NED) were not “independent”.

Regulations are supposed to be a good thing, but of course, they can have perverse results like anything else. It is very difficult to create rules that produce sound judgements every time. People who are asked to review broken systems and propose new regulations end up compromising something in order to achieve the greater good. I would, however, hope that the application of rules and regulations could be framed within some guiding principles laid out by the authors. That way, future generations can understand the spirit of the law not just the letter. The American Constitution sets out fundamental principals that help guide all laws in USA. In the same way, the corporate governance rules that apply to UK stocks ought to set out the over-riding principals so that when there is confusion and conflict, the rules can be interpreted better.

I would say that the overall objective, of the corporate governance rules in the UK, is to protect the majority of shareholders’ interests versus the vested interests of select groups of shareholders and/or the management. The objective being that whilst there are always disagreements about strategy, there should be clear agreement that the main objective is to create value for all shareholders equally.

The biggest problem faced is an over-mighty Chief Executive who appoints yes-men to the board whom he or she easily dominates. For this reason it is considered essential that non-executive directors who are independent of the CEO are in the majority of the board so that the executive can be held in check. For an example of superb corporate governance see RBS, HBOS and Lloyds.

Greater minds have looked at this problem and tried to look for clues that might suggest that a non-executive director is not “independent”. One clue appears to be that if the non-executive was once employed by the company, he or she might be more inclined to side with or sympathise with the executive team. Personally, I doubt this. I would have thought that ex-executives are more likely to be a proverbial pain in the neck to the “junior ticks” who take over running things. But nevertheless, the impression of cosiness between old pals is deemed to outweigh the real benefit that ex-executives actually know the business very well and will know when the CEO is being completely candid or not.

Another rule of independence is whether the NED owns no more than 3% of the company’s shares. The worry here is that a scheming NED might sway the agenda of the board towards the benefit of his, or her, own interest. I believe this to be nonsensical as there is a presumption of guilt. A shareholder is a shareholder. If you have shares you will want to maximise the value of them. Of course outright fraud is possible, but to consider someone suspect because they own too many shares in the company they serve strikes me as arbitrary. I am sure that a NED with 3% of the business is going to pay a lot more attention to what the CEO proposes than a NED with a nominal holding. If a NED with 3% of Lloyds TSB had sat on the board would they have backed the purchase of HBOS? I very much doubt it. The acquisition made sense for the executives as their personal wealth and power was bound to benefit, but it was pretty clear that the acquisition would destroy value for Lloyds’ shareholders in the short, medium and probably long term, which is why the announcement of the acquisition was followed by a massive fall in the Lloyds share price.

So this brings me to the current situation for StatPro Group plc. For a start StatPro is a small cap business (circa £40 million market capitalisation at the moment) on AiM. As we are on AiM the governance rules do not apply. However, we try to abide by the rules as much as possible and in consultation with our NOMAD. Where complying would be overly burdensome and expensive or clearly irrelevant for a small business we adopt a pragmatic approach that sticks to the spirit of protecting Shareholders interests, which for me includes not wasting their money on meaningless exercises. After all rules devised for vast public companies with a market capitalisation of £10 – £100 billion are unlikely to be exactly suited to a flotilla of micro-cap < companies worth between £10 – £100 million.

There is a significant quantum difference between the smallest and largest quoted companies. For example, paying a director of a business with £10 million revenue £150K salary might seem perfectly fine, but would you pay £150 million salary for someone to run a £10 billion revenue company? Given some pay awards, it is probably best not to answer that question, but let’s just say that the scale of a big business can result in excessive rewards being handed out to an individual without obvious material loss to the shareholders. Thus it is potentially much easier for executives to line their pockets at the expense of shareholders without causing sufficient harm to ruin the business. Shareholders therefore need NEDs to be on their side in the remuneration negotiations and on major strategic forays such as vain-glorious acquisitions. In other words, with Footsie 100 companies the executives are entrusted with such vast resources it is essential to have a little policing of how they carry out their administration and that they don’t abuse the great responsibility they have been given. Not very different perhaps to MPs and their expense claims…

With a company the size of StatPro, however, there is simply not enough meat on the carcass to argue about who gets what share. There can only be one objective: make StatPro worth more and as such we need NEDs to help fulfil that objective. StatPro’s NEDs are there to give advice, provide support and guidance as well as ensure that good corporate governance is maintained. They have to be fully engaged in StatPro and end up working many more hours than they are actually paid for. It is in fact very hard to find people who are willing to devote so much time and energy to a small business for quite small financial reward and significant penalties should things go wrong. This is why the best NEDs of small companies are independently wealthy individuals with experience of running and building small companies. If these people are not interested in buying the shares of the company, then what are they doing as directors? It can’t be for the annual fee, the risk-reward ratio doesn’t add up.

Our Board consists of two executives (Andy Fabian the Finance Director and me) and three non-executives with Carl Bacon the Chairman, Charles Fairbairn and Mark Adorian. Carl is an expert in performance measurement which is our business, Charles is a financial expert and Mark is a proven entrepreneur. Thus our board has a rounded set of skills where Charles matches Andy on finance and Mark matches me on business and strategy and Carl provides insight into our clients’ needs and the market place.

When Mark joined the StatPro board in 2002 he had 50,000 shares. Since then he has bought more and more shares in the market so that now he has over 2.5 million shares. You would have thought that this proves his complete alignment with other shareholder’s interests, but no, as he has 4.2% of StatPro the rules say he is not independent and so ISS are forced to recommend to our shareholders that they don’t vote for his re-election as a director of StatPro.

Carl was briefly employed by us to work 2-3 days a week so that StatPro could benefit from his industry expertise. For this reason he was executive Chairman for a short period. When he had finished this work he reverted to non-executive Chairman. The rules say that if you have been executive, you are not independent, thus ISS feel they must recommend that Carl is not re-elected as Chairman.

Charles stepped into the breach as acting finance director in 2000 for 3 months whilst we searched for a new FD. Apparently this brief stint as executive again forces ISS to say that consequentially he is not independent.

RBS famously had wonderful corporate governance yet the board managed to let Sir Fred destroy more shareholder value in less time than almost anyone in history. It probably would have happened whatever rules were in place, because these things sometimes do happen. However, StatPro and companies like us need a different set of rules and completely different types of directors to nurture us. In other words, the NEDs of big companies are there to be policemen, but the NEDs of small companies are there to be, well, Directors: offering advice and support. I believe the code should reflect this and perhaps someone should draw up a specific code for AiM companies.

Happily, we have spoken to our major shareholders directly about the false conclusions of ISS (a service most of them subscribe to). They have all been supportive and will not follow the recommendations of ISS in this instance. ISS is only applying the rules not making them up and I am sure there are many occasions when ISS provides invaluable benefit to shareholders bombarded with proxy forms, but they would be able to do a better job if the rules were better formed in the first place.

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