Boardroom
Effectiveness - Managing the Risk Profile
Newsletter Q4 2003
Introduction
Is the goal of maximising shareholder value optimal for all
corporate stakeholders?
How can the board manage the risk profile of the business?
Corporate Governance in the UK
Recent Developments in the US
Recent Developments in Europe
Conclusion
Introduction
Building on our improving boardroom effectiveness
newsletter of Q3 2003, we will focus on developing this theme for shareholders
and other stakeholders and also review whether the corporate goal of maximising
shareholder value has been effective for all stakeholders. Moreover, we
will explore how independent non-executive directors (NEDs) can improve
a board’s effectiveness by improving the level of debate and by
signalling to the board situations which can alter the risk profile of
the business significantly.
The key recent developments in UK, Europe and US corporate governance
will be explored. These include:
• In the UK: the revised Combined Code has been approved and will
come into force on 1 November 2003. It has also been generally accepted
that the diversity of boards should increase;
• In the US: the Sarbanes-Oxley rules have been relaxed for foreign
companies and the Securities and Exchange Commission (SEC) is outlining
plans to allow shareholders to replace a certain number of directors each
year; and
• In Europe: there has been a convergence of initiatives to improve
the effectiveness of boards.
Corporate governance rules and practices are changing rapidly. Shareholders are becoming more vociferous, particularly in the UK and the US. Boardrooms will need to ensure that they are adopting best practice.
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Is the goal of maximising shareholder value optimal for all corporate
stakeholders?
Over the last two decades, the premise that the fundamental goal of a company is to increase shareholder value has been widely accepted. The main challenger to this approach is the stakeholder theory, which argues that the company should be judged not only on its long-run return to shareholders, but also by taking into account the contributions to all stakeholders, including employees, customers, suppliers of capital, the local community etc. This followed a period in the 1960’s and 1970’s where building a “stable” business and balancing of the diverse aims of stakeholder groups was paramount. This often led to the pursuit of expansion strategies and varied revenue streams, rather than to a focus on shareholder returns. At the time, external governance mechanisms, such as the threat of takeovers, were seldom used and company boards tended to be dominated by management. This resulted in weak board oversight.
One of the key drivers of the significant increase in stock market valuations during the last twenty years has been the wave of restructuring, consolidation and the focus of businesses on shareholder value.
Aligning the interest of management and shareholders through stock option plans also resulted in a significant improvement in the performance of companies. However, both in the US and in Europe, there have been well publicised instances of excess rewards for executives when the performance of the business has been poor. Therefore, longer-term incentive plans for management teams are required and are being put in place. These plans must reward sustainable performance and reduce the tendency for excessive focus on the short-term. A positive step is the recent announcement by General Electric that their CEO will be rewarded partly by performance shares. These vest over 5 years and will depend on the company achieving cash flow and shareholder return targets.
Lenders to a business are primarily concerned with its cash generating potential, the ability to service the debt levels and the level of asset security. Their interests are normally aligned with the management and the shareholders, although agreement must be reached on the risk profile of the business. The failures of Enron and WorldCom in the US; and Marconi and Vivendi in Europe are examples of the risks to lenders of a shift in the risk profile of the businesses combined with excessive rewards for short-term improvements in performance.
The focus by corporations on the creation of shareholder value has been the most effective method for meeting wider stakeholder goals in a business. However, the necessary checks and balances have to be in place to reduce the risk of failure.
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How can the board manage the risk profile of the business?
The essence of business is the taking of calculated risks.
However, the intensity of debate at board meetings must be enhanced. This
is where NED must become more prominent. They should not rely exclusively
on the information provided by the company and its advisors, but have
access to independent information in order to add positive value to the
debate. This is particularly important during a major strategic, or financing
event, or where the risk profile of the business can change markedly.
Whilst covenants in lending documentation provide lenders with a signalling
mechanism of significant changes in the performance of a business, more
effective debate of corporate and financial strategy at board level will
also have a material impact on the performance of the business for all
stakeholders.
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Corporate Governance in the UK
In mid-July 2003, a revised version of the Combined Code
on Corporate Governance was published preserving the UK’s “comply
or explain” philosophy to corporate governance. It will come into
force on 1 November 2003. This version of the Code incorporates many of
the recommendations of the Higgs Report on the role and effectiveness
of NEDs, but is less prescriptive. Therefore it provides companies with
more flexibility to explain the reasons for deviations from the provisions
of the Code. The revised Code has received broad support from the UK business
community and is viewed as a positive evolution. Most recently, shareholders
have forced changes in a number of high profile situations where companies
did not follow the principles of the Code or did not provide a satisfactory
explanation for their deviations. Examples are the succession issues at
BSkyB and the proposed appointment of an Executive Chairman and a CEO
at Carlton/Granada. The key recommendations are:
• At least half of the board should be independent.
• The CEO should not become chairman of a company unless there has
been consultation with the shareholders.
• A senior non-executive director (SID) should be appointed and should
be available to shareholders for unresolved issues. In meetings with shareholders
the SID will take a “listening role” and will not be perceived
as an alternative to the chairman.
• The board should evaluate its performance on an annual basis with
the SID and the other NEDs, meeting annually to appraise the performance
of the chairman.
• The nominations’ committee should consist of a majority of
NEDs and be chaired either by the chairman or by the SID.
• The remuneration and audit committees should consist exclusively
of NEDs.
• Under normal circumstances, non-executives should not be remunerated
with share options.
• In order to maintain their independent status, non-executives serving
for periods longer than 6 years should be the subject of a rigorous review.
It has also been widely acknowledged that the UK needs to widen the pool
of non-executives in order to enhance the diversity of skills and talents
and to improve the level of training of board members. NEDs will have
a more significant impact on corporate performance if they have access
to independent information from that provided by the executive team and
the ability to challenge management decisions more freely.
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Recent Developments in the US
Following the high-profile scandals in the US, the authorities
have taken a far more legalistic and rule-based approach to improving
corporate governance there than in Europe. This is above all the case
for the financial statements where CEOs and CFOs have to certify their
accuracy every quarter. Similarly, recent court cases have highlighted
that a failure of duty of care by independent directors can result in
legal proceedings.
However, there has been general concern that the overly prescriptive nature
of the changes to the system of US corporate governance has led to a reluctance
of businesses to take risk. Most recently, William Donaldson the head
of the Securities and Exchange Commission, urged companies not to confuse
genuine business with legal risk.
Nevertheless, there has been a relaxation of the Sarbanes–Oxley
rules for foreign companies with a US listing. Foreign companies will
be required to abide by the spirit of the Act without disrupting their
existing practices. For example the audit committee does not need to be
fully independent if that is not the practice in its home country.
Over the past few months there have also been significant positive developments
in US boardrooms. More outside directors have been elected, senior directors
have been appointed, the role of committees has been redefined and there
have been moves towards the acceptance of an independent governance budget.
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Recent Developments in Europe
Corporate governance issues have also been keenly debated
in Continental Europe, particularly following the significant reductions
in value suffered at Vivendi in France, Ahold in the Netherlands and the
furore over the approval of excessive payments to senior executives of
Mannesmann of Germany at the time of the takeover by Vodafone.
The main Western European countries are tending to follow the UK ”comply
or explain” model of corporate governance with an evolving set of
principles of best practice, rather than laying down inflexible legislation.
The Sarbanes-Oxley legislation is viewed in Europe as a hurried and overly
legalistic response to the US scandals.
The EU Commission has an action plan for corporate governance incorporating
a number of issues including:
• Increased disclosure in the annual reports on corporate governance
practice;
• Collective responsibility of all board members for financial and
non-financial statements;
• Promotion of the role of the NED;
• Move to 1 share : 1 vote; and
• Increased disclosure on executive remuneration.
France is in the process of updating its code on corporate governance with a number of proposals including an increase in NED’s to represent, as a minimum, one third of the board; the independence of the audit committee and increased evaluation of board performance.
Similarly a new Code is being prepared in Germany. This will include a limit on the number of executives on the board, enhanced levels of disclosure to shareholders and clarification on the role of the auditor.
There remain across Europe fundamental differences on board structure, particularly the widely employed two-tier structure of executive and supervisory boards and the complexity of the share capital. However, with the globalisation of shareholder bases there is increased momentum for convergence in corporate governance across Europe.
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Conclusion
The pace of change in corporate governance across Europe and the US is not relenting. Whilst a balance must be struck between the US legalistic agenda versus the UK and Continental European “soft law” approach, it is clear for all stakeholders that a board of directors which is prepared to take calculated risks following intensive discussion and debate will be more successful. With an increase in the number and diversity of non-executive directors, their effectiveness is of key importance to the functioning of the company for all stakeholders.
In summary, corporate governance rules and practices are changing rapidly. Boardrooms will need to ensure that they are up-to-date and adopt best practice into their decision making.
The views expressed in this newsletter are those of DC Dwek Corporate Finance Limited and are provided for information purposes only.
© DC DWEK Corporate Finance
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