The importance of Corporate Governance in the stock selection process

Monday, August 13 2012

Corporate governance plays an important role in how a company manages its relationships, particularly how a company’s management, its board and its shareholders deal with each other and external relationships, with an ultimate goal of reducing conflicts of interests and acting in the best interests of stakeholders.

Corporate governance practices have gained more prominence since the high-profile collapses of a number of large US corporations in early 2000 such as Enron and WorldCom, most of which involved accounting fraud and more recently the GFC which exposed lax policies. Australia has also had its share of comparable failures with Centro, HIH and One.Tel.

At Dalton Nicol Reid, we incorporate an Environment, Social and Governance (ESG) screen utilising the EIRIS Portfolio Manager ESG research software platform, supplied in Australia by CAER – Corporate Analysis. Enhanced Responsibility (CAER). Key corporate governance components we look at for in each company are:

  1. have a separate Chair and Chief Executive
  2. have more than 33% of the board as independent non-executives
  3. have an audit committee, the majority of whose members are independent non-executives
  4. disclose the remuneration of company directors

The EIRIS database reveals that 109 out of 157 (69%) Australian listed companies EIRIS analyse meet all of the four key corporate governance components. Below we have two examples of companies that have questionable corporate governance practices according to the EIRIS database.

 

Cabcharge Australia Limited (ASX:CAB)

Cabcharge contains only one of the four global governance components monitored. It has disclosed the remuneration of company directors.

Cabcharge does not:

  • have a separate chair and chief executive
  • have more than 33% of the board as independent non-executives – none of the eight directors are considered independent
  • have an audit committee, the majority of whose members are independent non-executives – none of the three audit committee members are considered independent

Further detailed analysis was carried out with respect to a succession plan on management which failed to dispel our concerns. We were concerned regarding the lack of independent directors and the risk around continuity given the CEO Reg Kermode is nearly 80.  This was further highlighted when reviewing the remuneration report in Cabcharge’s 2011 annual report, where we noticed the CEO received a salary of $1.95m compared to the average executive director of $344k and in the 2010 annual report, the CEO received a $425k cash bonus with the next largest only $15k.  The ability to attract and keep quality staff is an issue with that kind of differential.

A company where control is concentrated can lead to poor business practices as evidenced when in November 2010 Cabcharge agreed to pay the Australian Competition and Consumer Commission $15m as well as implement a compliance program after it had admitted it had breached the Trade Practices Act by refusing to allow its charge card to be processed on terminals installed by a competitor.

 

News Corporation Limited (ASX:NWS)

News Corp does not have a separate chair and chief executive, Rupert Murdoch.

There have been a number of well publicised corporate governance episodes for News Corp:

  • James Murdoch, Chairman and CEO of the Company’s Europe and Asia Pacific operations, has come under fire over claims by former newspaper executives that he misled British MPs about Britain’s phone-hacking scandal.
  • Non-family shareholders in the Company voted (EIRIS; Company proxy statement 15/10/2010) emphatically to remove James and Lachlan Murdoch from the board of directors at the Company’s AGM; however, the brothers escaped removal from the board due to the family’s ownership of 39.7% of voting stock. It is clear shareholders want a more conventional board structure with separate CEO and chair, and more independent directors.
  • A majority of the MPs on the UK’s parliamentary media committee have concluded that Rupert Murdoch, the Chairman and CEO of News Corporation, is ‘not a fit person’ to run a major international business.

 

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