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Corporate governance doesn't get much attention, until things go bad. Simon Keane explains why being one of the good guys does pay off

Corporate governance pays off in vastly improved share price performance, fact. A recent Association of British Insurers’ (ABI) study proves the point beyond doubt, its findings showing that companies with high governance standards outperform poorly-governed businesses by, on average, 18% over five years.

Yet as impressive as this statistic is, the City largely pays little more than lip service to good governance, only switching on to the issue when things go badly wrong. When times are good abuses are ignored but when the house of cards comes crashing down the recriminations start flying. Now is the time for investors, fund managers and analysts to learn from the lessons of history.

Good corporate governance has many faces, ranging from best practice in the issuance of new shares, avoiding hefty dilution to existing shareholder stakes, and the number non-executive directors on a firm’s board. In recognition of subject’s complex nature the ABI advises its pension fund clients on 14 governance areas ahead of each company’s AGM. But of all its many shades, executive remuneration and board composition, particularly the balance between executive and non-executive directors, are the two highest profile corporate governance issues.

Question time

In the middle of a ‘one-in-a-generation’ banking crisis serious questions are now being asked about the way in which we reward executives and the level of scrutiny to which their strategies have been subjected. Poorly structured and clearly excessive bonus payments (outside from the City professions where else do employees view their salary as a ‘base’ payment for merely turning up in the morning?) are being blamed for the mess our banks find themselves in. In particular some are now questioning the way in which the Royal Bank of Scotland (RBS) structures its executive share option plan.

Did the plan, structured only to reward earnings per share (EPS) growth, spur chief executive Fred Goodwin and his team to pay a top-heavy price for Dutch bank ABN Amro? Feeding into the questions around RBS others ask whether the non-executives on the bank’s board properly challenged Goodwin on the acquisition. But, having asked few questions on the way up (RBS’s executive share option scheme, which is taking plenty of criticism now, was passed at the 2007 AGM with 74% of votes cast ) it is no good suddenly coming down heavy in hindsight. A more consistent, considered approach is required. Starting from now fund managers, and analysts, should realise good corporate governance really does pay.

If there is any common theme to the disparate face of corporate governance then it is the Combined Code. The bible of City best practice, the Combined Code on Corporate Governance, lays down standards on remuneration and board compensation, the latter taking in a whole array of sub issues, the most prominent of which being stipulations about the number of independent non-executives on a board (at least half the board for FTSE 350 companies and two for anything outside that) and the separation of the role of chief executive and chairman.

If ever there was a ten commandments of the Combined Code, the separation of the chairman and chief executive would be near the top and for this reason investors should be paying close attention to Marks & Spencer right now. M&S investors should be very worried about Stuart Rose’s stated intention to become the chairman as well as chief executive.

In the firing line

The arguments over Rose have prompted a flurry of public statements from pension fund giant Legal & General (L&G) while Richard Buxton, the head of UK equities at Schroders, has used national newspapers to raise his concerns. Once all the noise has died down, the real test will be if these same institutions use their voting power (Rose is be put up for re-election at July’s AGM) to stop Rose dead in his tracks. If ever there is a time to fight the corner for corporate governance it has to be now as we pick up the pieces of a shattered banking sector.

Rose’s planned promotion to executive chairman comes as serious questions are asked about his strategy. Is it really wise to have such concentration of power in the hands of a single man, especially one with a reputation for not taking criticism terribly well?

Some say that Richard Greenbury’s all-powerful grip on M&S during his time as executive chairman in the 1990s was much to blame for the collapse in profits seen after 1998 – we may well be heading for a re-run of history.

As the institutions mull over their next move on M&S they should spend time to reflect on some of the past failures associated with poor corporate governance of which supermarkets group William Morrison is perhaps the clearest example.

History repeats

Up until its acquisition of Safeway in March 2004 Morrison had an almost unblemished record. In the 15 years to March 2004 the company’s share price increased a staggering 11-fold, from 23p to 250p, its charismatic leader, and founder, Sir Ken Morrison could not put a foot wrong and the fact he had never had any non-executive directors was neither here nor there. But the botched acquisition of Safeway resulted in a series of profit warnings accompanied by a collapse in the share price, taking another two and a half years to recover back to the levels before the ill-executed Safeway deal.

The appointment of David Jones as a non-executive in May 2004 is widely credited with helping Morrison work its way out of the Safeway problem (see ‘What went wrong at Morrison’). The problems took a while to work through and in March 2006, following yet more profit warnings, the supermarket reported its first ever loss. But by September 2006 interims were better than expected. Exponents of corporate governance argue that Ken Morrison would never have got himself into the mess he did with Safeway had the deal been subject to proper scrutiny. The doubters say Ken Morrison would have done it his way even with non-executives but that is missing the point.

It is those doubters who are now pointing to RBS, noting that, despite a full contingent of non-executive directors, no one pushed Fred Goodwin to re-negotiate the ABN Amro price. As one fund manager, who did no wish to be named, put its they just ‘stood by’. RBS declined to respond directly to this criticism.

The same fund manager goes on to describe corporate governance as ‘more of a hindrance rather than a help’. While it is true that corporate governance is not an exact science and having non-executive directors is no guarantee that mistakes won’t be made, on the balance of probabilities a board with independent voices is likely to be a better functioning one.

The proof of the pudding

The ABI has, for the first time, provided solid proof that corporate governance enhances shareholder returns. Over five years it has found that companies with good governance outperformed the ones with low standards by 18% and displayed much lower share price volatility. The ABI married up four years of information from its Institutional Voting Information Service (IVIS) with five years of share price data to discover that companies with the highest standards produced an average 20% return over five years compared to 2% from the worst.

The ABI used IVIS to rank 343 FTSE All-Share companies (all the companies that consistently remained part of the FTSE All-Share index between 2004 to 2007) into best and worst. The worst had received at least one ‘red top’ (see box on page 17) alert for every year between 2004 and 2007, the best had received no red tops during the period. The effect on share price took time to show through but for the long-time horizons of pension funds the findings are significant.

Hitting back at critics for his decision to combine the chief executive and chairman role Stuart Rose recently joked ‘It’s not as if I’m Pol Pot here, going round and chopping off heads.’ Given questions now emerging about his strategy it’s no laughing matter though, as a Rose-like iron grip on M&S appears to have the potential to do mortal damage to shareholders’ returns.

Last week saw the publication of a hard-hitting critique of Rose’s strategy by Credit Suisse analyst Tony Shiret (shares fell 3% on the day). The complaints are numerous but the nub of the criticism is that Rose has failed to extract M&S from the boom-bust cycle of a UK retailer by becoming a global player.

Forging ahead

Cash used on share buybacks should have been deployed on a UK acquisition, perhaps fashion retailer Next. The strategy of forging ahead with organic UK growth, by opening new stores, was a strategic mistake says Shiret, who longer term believes the company’s success rests on global expansion: ‘In the event they bought Next it would be obvious that with a combined 20% market share UK expansion would not be a good plan so forces them to focus on global expansion. The question is, is it going to continue to see the ups and downs of a UK stock which is becoming a medium-sized company or try to follow Tesco and become a big company.’

M&S profits this year may be back up close to their all time £1 billion highs of 1998 under Greenbury, but ‘one might conclude that getting M&S to break out of its historic UK cyclical profit pattern has again proved beyond management,’ is Shiret’s observation.

M&S is a rabbit in the headlights of the oncoming UK consumer slowdown, a situation made worse by a ‘problematic’ move from the middle to value end of the clothing market. The group’s buying ‘is not good’ necessitating a review of the supply chain, distribution systems need to be independently reviewed.

Shiret’s list of criticisms go on but what is interesting from a corporate governance perspective is that he makes a clear link between M&S’s remuneration package and strategic decision making. Shiret says that M&S’s Performance Share Plan, where top management can be awarded up to four times base salary in stock when they beat an earnings per share (EPS) hurdle rate, encouraged a focus on short-term profits. The analyst believes EPS targets drove management’s decision to embark on an aggressive UK store opening programme and buy back shares.

Mixed views

Shiret also implies a clear danger of Rose becoming the the joint chief executive and chairman: ‘I have mixed views on Stuart Rose, I’ve known him for a long time and I think he is more talented than Greenbury but there are certain areas where Stuart is weak and I think he is allowed to do things in weak areas as well as strong areas and no one is allowed to contradict him.’ M&S declined to comment.

The point Shiret makes about M&S’s remuneration package is starting to have resonance with criticisms of Royal Bank of Scotland’s decision to buy ABN Amro. RBS’s Executive Share Option Plan, which will pay out up to three times base salary, also uses EPS hurdles as the sole performance condition. Mark Westwood, a fund manager at Threadneedle Asset Management, says: ‘What worries me when you just look at EPS is it is very easy to grow earnings by just going out and buying banks which, strangely enough, is just what Sir Fred did, making a huge acquisition of ABN at the top of the cycle at highly inflated price since he got into a bid battle with Barclays. Growing earnings does not mean that created shareholder value. You have got to generate a return on the capital spent which is greater than the cost of that capital [which is where] Fred Goodwin failed.’

Mud slinging

RBS declined to comment to this criticism of its share option plan but the one problem with complaining now is it’s easy to sling the mud in hindsight (though Westwood has not invested in the RBS for ‘some considerable time’). If you look at last year’s AGM voting records for RBS the Executive Share Option Plan was voted through on a 74% of votes cast. That was despite an ‘amber top’ alert from the ABI, although the association’s complaints were not about the use of EPS as a performance criteria and instead about a lack of clarity on whether the EPS performance hurdles would be sufficiently testing.

Up until now using EPS as a performance criteria has not been an issue but institutions are suddenly paying closer attention. Schroder’s Richard Buxton has reportedly joined the growing chorus of people criticising EPS hurdles, and is said, like Westwood and Shiret, to favour total shareholder return performance hurdles. These arguments will no doubt rattle on, but the big City fund managers really have to lay their cards on the table by voting down suspect share plans when put forward at AGMs.

Corporate governance issues really do make a difference. The ABI’s study has proved this and the recent experience of Morrison and the Royal Bank of Scotland would seem to back up these empirical findings. Until the fund managers start asking difficult questions about boardroom composition and remuneration, history will no doubt repeat itself.

It is no good separating these issues since they can’t be compartmentalised (in the words of one analyst: ‘I am not paid to second-guess corporate governance, I ask is this a buy, sell or hold’). A more consistent approach to corporate governance, where issues of concern are raised in the good times as well as the bad, is required and it should start in July at Marks & Spencer’s AGM with the voting down of Stuart Rose as a director.

Colour codes - red, amber and blue tops

The ABI’s Institutional Voting Information Service (IVIS) produces two reports ahead of each company’s AGM to help its pension fund members to decide on how they should vote. These two reports are called the Proxy Report and Combined Code Report. Between them they look at 14 areas of corporate governance.

The ABI will issue red or amber top reports where it has concerns, or blue top ones with a clean bill of health. Failure to have sufficient non executives automatically qualifies for a red top while abnormal salary increases will prompt an amber top.

In the spirit of the Combined Code, the ABI operates a ‘comply-or-explain’ model in which any explanation from the company which diverges from best practice is taken into account when deciding on colour tops.

Do independent non-executive directors make a difference?

NO

Colin Morton, fund manager Rensburg Fund Management

‘Morrison was one of the best performing companies for ten to 15 years and it broke many of the rules laid down under a good corporate governance banner. It had no non-executives, Ken Morrison was in charge, everyone reported to him. Safeway was where he went wrong, his old structure for Morrison worked where there was only 120 to 130 stores. He knew every store inside out. Probably with Safeway he took on 300 stores and the systems he had in place and the management were found to be lacking. Would he have run into the problems with Safeway had there been non-executives on the board? I would like to say no but did that stop Royal Bank of Scotland buying ABN AMRO? It [all] depends on the non-executives and whether they are willing to stand up and be counted. Everyone is looking back at RBS [and asking why] it didn’t try to renegotiate the price. The problem with non-executives is in principle you’ve got them there but the issue is are they willing to stand up to the board [or does it] just become a situation where you get a cosy club. Does corporate governance work? I don’t know. Are companies making better decisions? There is not much evidence to me that they are.’

YES

Peter Montagnon, director of investment affairs, Association of British Insurers

‘If you haven’t got non-executives and a very able leader at the top of the business the chances are you’ll do very well, but the risks are higher since at some point everyone makes a mistake. Morrison had no non-executives on its board at the time the decision was made on Safeway and that decision was an unwise and poorly executed decision, the company got into deep trouble. The risks are greater, it does not mean a company is not going to succeed but usually at some point the chickens come home to roost, in the Morrison case they did [and the problems were] resolved when it recruited non-executives. Just by ticking the boxes in terms of corporate governance is no guarantee that decisions won’t go wrong. It doesn’t help if a board has not got the right measure of independence, if the board does not have the right balance the risks are much higher. I’m not going to comment on the board of Royal Bank of Scotland, I’m making a general observation that there is no fail safe.’