Corporate Governance Series - 1

Whenever investing in a company, one of the most overlooked parameters is Corporate Governance. Having a working knowledge of this can help steer away from bad investments. Here's my take on it.

and sorry for not posting for almost a month. I was busy with my new role, but going forward I'll ensure that that newsletter is more regular.

Corporate Governance

There is no absolute definition of what corporate governance is! We can look at it as a process that ensures the value of the amount invested by the Shareholders or Investors progressively increases. Many would argue that corporate governance also deals with ensuring that debt is being serviced, society is not adversely impacted, and regulations are followed as stated by the regulator. Ensuring that the latter 3 areas are well taken care of; increases the value for the shareholder or investor. In another way, well-governed credit management, financial regulations, and social risk management create a by-product, Shareholder Value.

There are 4 components to the environment around a company:

• Investor or Shareholder
• Debtor or Lender
• Society and Customer
• Financial Markets

The above 4 components in an ideal scenario will transact and communicate at high efficiency. How?

The investor or shareholder may keep the CXOs in tight control so that they work to the benefit of the shareholders or CXOs might have a significant stake in the shareholding of the company that it becomes natural to them to work towards increasing shareholder value.

The debtor or lenders are well secured because the company thinks keeping good faith and a relationship with them will help them raise more debt in the future. Another case might be, that banks could come up with some covenants saying that the company can’t kick us away until our money is paid back to us.

The products/services of your company have no social cost, and if any, it can be easily traced back to the company’s doorsteps

The company is communicating with the financial market in a transparent and full disclosure manner ensuring that shareholders or potential investors can effectively decide to invest in the company assuming the investors act rationally.

In reality, not even an atom is the same as you think let alone the functioning of a company.

The companies function in a very different, and sometimes illegal & unethical manner. Many cases like Enron, Madoff, Satyam and many more despite having so many checks, at least on paper. So let’s look a little deep into this.

This is important to understand because you, as an investor, are not only investing in the company but in the people as well

The shareholders of a company have 2 processes to keep a check on the CXOs so that they work in the best interest of the company, the Annual Meeting and the Board of Directors.

Annual Meetings

It’s that time of the year when shareholders gather in a large room, and give the management spiked chairs and ask them all the hard questions, and if the year went well they’ll give them a Macallan 21 years old, and flooding cash. The real problem here is that I as an investor won’t make the effort of going to the annual meeting and will rather just skip or proxy my vote, and the 1st choice of the proxy vote is the CEO. So even before the meeting started, the ball is in CEO’s court making the decision-making process slightly skewed.

In a few cases, your votes might not even matter as much. For eg., most of the tech companies’ founders ensure that there are multiple classes of shares, and the one that the founders hold has super-voting rights. What does that mean? It means 1 share that the founder holds, it will be equivalent to 10 voting shares. Look at the voting structure at Google and Facebook, and you will realise how the founders protect themselves with the voting power without having the money. This can create a conflict of interest between founders and investors.

Board of Directors

Investors appoint the Board of Directors to look after their interest in the company by regulating and monitoring the daily operations of the company. The economics, behaviour and consensus play out intensely in a board room.

Most of us think that people serving on the Board of Directors are the ones with great expertise in the business. I won’t disagree but I’ll put out some points that orient towards disagreement.

• Most of the members of BOD are present on multiple boards which supports only marginal involvement from the members. Giving a board seat doesn’t guarantee a very high compensation, and hence the board members ensure that their income comes from multiple boards. Surprisingly, the compensation ranges from INR 1L to INR 20L depending on the size of the company. Companies closer to INR 20L are RIL, TCS, Infosys and the likes, which are very few.
• Members of the Board of Directors will only work towards increasing shareholder value if they have skin in the game. To ensure that some boards like RIL attach compensation of the members of the board to stock options. But again, this is a very rare practice and most of the members are paid cash which doesn’t give them enough incentive to work towards investor welfare.
• Not all members of the Board of Directors have intense knowledge of the business operations as many of them come from different backgrounds. Take the example of HomeShopping 18, a lot of the board members of the company weren’t from the online and air shopping industry. So, in any decision making the board members would agree to a consensus with the one with the most knowledge about the daily operations, the CEO.
• Board Members should consist of outsiders and independent individuals who can provide unbiased direction, solutions, and decisions. Unfortunately, a lot of companies have insiders as their board members which raises conflict of interest if the insiders do not have a major part of their compensation attached to stocks. If the company you are investing in does not have a nominating committee, then you should take this as an orange flag if not a red one.
• Institutional investors who have a sizeable investment in the company won’t bother to go through the mess of structuring growth plans or devising acquisition strategy, in case they don’t see enough upside. They’ll “vote with their feet” i.e. sell their share and move out.?

To summarise your above reading, the company you are investing in should have clean corporate governance. If it doesn’t have one, it’s about time that the company will start seeing cracks. This was part 1 of the Corporate Governance Series. I’ll take this topic forward in part 2.

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