Corporate Governance: Some Uncommon Red Flags – ValueWalk Premium

Corporate Governance: Some Uncommon Red Flags

Corporate Governance: Some Uncommon Red Flags

Investing is basically betting on the long term potential of the organization. This is ultimately linked to how well the organization is governed. If the shareholders get a whiff that the organization is deviating from the optimal strategic or moral path, they can take an informed decision in time.

A lot of material information about the company’s governance practices is available on its website. The board structure, the committees, code of ethics etc., are all available at the click of a button. Also, from time to time, quarterly & annual reports (10Q & 10K) are released and the proxy statements are uploaded for the shareholders to see.  However, as they say, the devil lies in the detail. Therefore, instead of taking management commentary on face value, it is usually better to delve slightly deeper and even compare it with peers. Some important aspects which merit attention are given below as examples.

Dividends – Can be bad?

While it is great to receive a good stream of dividends, it is advisable to see whether they are based on the cash generated during the current period or the surplus cash available with the organization. Some companies maintain very good payment track record despite falling revenues & net income. A good example is Baytex Energy Corp (NYSE:BTE) which is paying monthly dividends despite recent erratic & falling net income comes.

In some cases, the net income may be based on high level of debtors where allowance for bad debts is not sufficient. Shareholders should exercise caution in such a situation. It is a good idea to compare the debtor to sales ratio of the company with that of the peers. Even fictitious debtors (non-existent sales) have been known to exist!! Since the biggest beneficiaries of the dividend payouts are the insiders, dividends without fundamentals are a time tested method to siphon off money. Such practices show the governance in very poor light.

Investors keep mum because they are themselves being benefited, but such payments reduce the competitive ability of the organization. To probe this, one can look at the growth statistics, move beyond the Income statement & get to the balance sheet. The source of dividends is important.

Compensation – Look beyond the size

An obvious area to look is the Management/Director compensation and its growth. However, usually one is fixated with the amount of compensation because the huge numbers create a halo effect. Although what is also important, is to understand whether the amount is being paid out of cash generated by the company.

As in the case of hollow dividends, if the receivables are very high, the CEO will either be paid through digging into company’s reserves or even through debt! The structure of the compensation should be examined in detail. For instance, in the case of Chesapeake Energy Corporation (NYSE:CHK), shareholders noticed that the compensation structure was not linked with the company performance and the CEO, Aubrey McClendon, made hay even when the sun did not shine.

Further, it is good to calculate what percentage of the net income is being handed over to the managers. It is also important to see if the directors or the managers are getting any soft loans from the company. This is sometimes a conduit of channelizing company money to inefficient incumbents.

Directors – Capability & independence

Another important aspect is the capability of the directors which are entrusted with the oversight of the management. It is important to analyze whether the new director, or the director whose term is being extended, has the relevant experience.

For example, if the particular director is supposed to be part of the audit committee, then he should have a strong background in finance. In case of JPMorgan Chase & Co. (NYSE:JPM) in the recent Whale trade loss, it was found that the person in charge of risk management was not sufficiently qualified or experienced.

It is also good to know which other companies the director is serving (or has served) in same or any other capacity. This information helps understand any potential conflict of interest or nepotism involved in appointment. This obviously may affect the director’s ability to perform fiduciary duties. Similar principles apply to appointment of CEOs and other members of the senior management team. If the company appoints incapable CEOs/directors or is forced to continue with them, it is a definite sign of perilous unprofessionalism.

Board – Attendance & agenda

Even if good directors are appointed, what matters is the quality and quantity of work they put in. Director’s attendance details are a good way to understand whether the directors were sufficiently active. Further more, the business transacted by the directors during the board meetings, especially related to management oversight, strategic matters etc., has to be observed.

Here, Bayerische Motoren Werke AG (FRA:BMW) is a good example where such information is clearly available on the website (Report of the supervisory board). Regular evaluation of performance of the board is also as important as measuring the worth of the CEOs / management. Signs of healthy dissent should be welcomed.

Auditors – Under influence?

One way to hide poor performance or misrepresentations is to “influence” the auditors. Obviously, too much money being paid to the auditors or a tremendous rise proposed over the payment made last year should ring some bells. Here, comparison with peers can help. Similarly, if the auditors are changed, one should look for reasons behind the decision. It is possible that potential whistle blowers are shunted out for some cover-up. (Remember the Enron Disaster?)

Culture & past history

In addition to above, it is also important to keep a tab on the news flow about the organization. One should be confident that the board culture fosters innovation and openness. Closed minds or overpowering CEOs, lead to increased friction amongst board members and also between directors and the management.

The ethics of the corporation should promote transparency and voluntary disclosures. A good place to look is the footnotes of the balance sheet. Normally, they should explain accounting practices, deviation from past practices & contingent liabilities in simple terms.

Past actions against errant officials is also an indication whether the board comprises of upright & capable people. In a recent example, Chesapeake Energy Corporation (NYSE:CHK) CEO had so much influence that the board that he got away with murdering the company stock due to his reckless behavior several times. The board should be capable enough to take decisions which have long term focus and not simply measure success with the yardstick of stock price growth. Past history of good strategic decisions of the directors are usually available in the press releases by the company.

If the company scores poorly on any of these fronts, it is possible that personal interests are taking precedence over shareholder wealth maximization principles. The shareholders should always be on the lookout for these & other signs and learn the language of good & bad corporate governance.


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