Ignore corporate governance at your own peril

The financial crisis in the USA sub-prime market that emerged in 2007 had a considerable impact on several countries worldwide. In the first semester of 2009, South Africa experienced a recession for the first time in 17 years when the gross domestic product (GDP) contracted by 6.4%. As a result, about 900 000 workers lost their jobs.

It is disconcerting that only six years later, we barely avoided a second recession. South Africa’s GDP contracted by 1.3% in the second quarter of 2015 and grew by only 0.7% in the third term. Lacklustre economic performance coupled with depressed business confidence further continues to undermine investment prospects in the country.

The current state of affairs cannot be defined as a financial crisis in the strictest sense of the word, i.e. a significant disruption to financial markets. Directors, managers and shareholders would nonetheless do well to heed some lessons from the past.

Financial crises are typically caused by monetary excesses that give rise to a prosperous period followed by an inevitable financial collapse. Research shows that weak corporate governance has not only triggered financial crises in the past, but also aggravated some crises once they gained momentum.

The word governance originates from the Greek verb kubernáo, which means “to steer”. In a business context, corporate governance thus refers to the system by which a company is steered, directed and controlled. The board of directors takes the lead in this regard. Directors are obligated to monitor the actions of managers on behalf of the shareholders who elected them.

Their monitoring role is key during periods of economic uncertainty. Unfortunately, the monitoring of risks and excessive remuneration packages were largely ignored by directors and shareholders prior to the 2008 crisis. In particular, local shareholders rarely publically challenged weak corporate governance policies and practices.

Three important developments

Three significant developments have taken place in the corporate governance arena since the late 2000s. In the first instance, directors have become more aware of the relationship between corporate governance and their companies’ financial performance. Secondly, the disclosure of corporate governance aspects in the annual integrated reports of JSE-listed companies improved. Thirdly, local shareholders have become more vocal about the need for improved transparency.

In the light of these developments, we investigated the nature of the relationship between corporate governance compliance and financial performance for a relatively large sample of JSE-listed companies. The analysis was conducted over the period 2002 to 2010. Our results showed that investors could have benefited, in risk-adjusted terms, by investing in those JSE-listed companies that exhibited superior corporate governance practices over the research period.

The surveyed companies disclosed noticeably more corporate governance-related details towards the end of the study period. Reports included more information on board diversity, remuneration packages and sustainability practices.

Companies that were at the bottom end of the compliance scale at the beginning of the research period showed substantial improvement over time, more so than those at the top end of the scale. The acceptability of the surveyed companies’ corporate governance practices (measured by considering selected King II recommendations) furthermore improved considerably between 2008 and 2010.

Shareholder activism gets a boost

Increased local shareholder activism is the third development that deserves attention. Activism in South Africa still largely takes place behind closed doors between institutional investors and investee companies. As such, the extent to which investors’ concerns about weak corporate governance is raised and addressed, remains largely unknown.

A local fund manager justified this modus operandi by stating that “disagreements are unlikely to be resolved in an amicable fashion once the dirty laundry has been aired in public”. Although his argument carries some weight, the power of public activism should not be underestimated. Advances in social media, particularly Twitter, are enabling shareholder activists to have a much bigger impact on market sentiment towards companies with poor corporate governance practices than in the previous decade. Examples in this regard include Volkswagen and the MTN Group.

What shareholders can do

Based on these three developments and the knowledge that corporate governance is intricately linked to financial performance (and ultimately the state of an economy), we offer the following suggestions. Firstly, shareholders should do more to encourage diverse boards that include individuals from different backgrounds, as they have different perspectives on business matters. Research highlights that financial performance is indeed higher in companies with diverse boards compared to their less diverse counterparts (with specific reference to gender diversity).

It is often argued that the number of suitable directors in South Africa is limited. Over-boardedness (the result of serving on too many boards simultaneously) is therefore a major problem. Over-boardedness can result in meeting schedule conflicts and inadequate preparation for board meetings. Directors may also struggle to give sufficient attention to the activities of the various companies on which boards they serve.

As a result, key issues might be overlooked or not timeously addressed. A possible solution is to appoint less experienced candidates as shadow directors. These individuals can then be mentored by more experienced directors and those planning to retire in the near future. The importance of continuous board evaluation, training and fair compensation should not be underestimated.

Communication between board members, management and shareholders should be clearer. If shareholders have sufficient information, they could make more informed voting and shareholder engagement decisions. Furthermore, by advancing electronic voting, more shareholders might cast their votes. As the owners of listed companies, they have a responsibility to voice their concerns.

The 14th century poet Geoffrey Chaucer warned that “time and tide wait for no man”. More recently, Warren Buffett was quoted as saying that it is only when the tide goes out that you discover who has been swimming naked. Shareholders, directors and managers are thus urged to pay more attention to corporate governance policies and practices before the economic tide in South Africa takes a more drastic downturn. Ignore corporate governance at your own peril.

Source: fin24

Error loading MacroEngine script (file: news-sidebar.cshtml)