Widespread ownership of shares by non-institutional investors is changing perceptions of the governance of public companies and having a big effect on the role of boards and chief executives. By David James
There is no doubt that expectations of public companies have profoundly changed over the last decade. Ten years ago, says Gervaise Greene, public affairs spokesman for the Australian Stock Exchange, the local stockmarket was a “professional market”, dominated by institutional investors (pension funds and insurance companies).
In 2003, the situation is very different. About 37% of the adult Australian population (5.4 million people) directly invest in shares, and almost half (7 million) invest directly or indirectly (through vehicles such as unit trusts or private superannuation). Sixteen per cent of the funds invested by Australian adults go into the stockmarket.
Institutions nevertheless continue to dominate. Local institutions hold about a quarter of public equity, and foreign institutions hold one-fifth. But the expectations brought about by the broader share ownership have profoundly altered the dynamics of the market – and the perception of corporate governance.
The scale of executive greed and financial malfeasance in Australia has been far less than the abuses that occurred in the United States. Between 1995 and 1999 the proportion of equity held by senior executives in the top 500 US companies rose from 2% to 12%. Yet the public outrage has scarcely been more muted.
Because more retail investors are personally interested in what happens in the market, there is less tolerance of misbehavior, real or perceived, but there is also less familiarity with what constitutes “normal” practices in executive rewards. Whereas professional investors are likely to be unfazed by chief executives getting large payouts – it is hardly new – retail investors are more likely to see them as close to theft.
The attempt to improve corporate governance is as much a symptom of greater public interest in the stockmarket as a response to an uncovering of fundamental structural problems. The excesses of the late 1980s were far greater than anything in the late 1990s. The infamous “entrepreneurs” of that era – Christopher Skase, Alan Bond, Robert Holmes a Court, Laurie Connell – created far more economic damage than any recent corporate failures.
In the 1990s the Australian market matured, and the orientation became, if anything, too defensive (that defensive emphasis now seems quite sound in a bear market). Alan Carroll, executive chairman of the Pacific Rim Forum, says: “Dividend imputation has made Australian companies too riskaverse. There has been too much concentration on maximising dividend returns and not enough on expanding the business.”
Carroll identifies the companies with global aspirations at the beginning of the 1990s.
The relationship between corporate governance structures and company returns is hard to track, but there are differences.
Four basic corporate governance structures are available.
First the American model, in which the chairman and the chief executive are often the same person. In three out of four companies in the Standard & Poor’s 500 companies, the role of chairman and chief executive are combined. In Australia, this is comparatively rare. Phil Ruthven, chairman of IBIS World, compares the American approach with a Roman “senate” – the chief executive is the emperor and the board operates mainly in an advisory capacity. He considers this approach to be the most financially effective: most large American companies aim for a return on shareholders’ funds (ROSF) that is in excess of 20%.
A second approach, favored in Britain and Australia, is to treat the board and the executive as competing forces – a “balance of powers” that is intended to reflect shareholders’ interests. Although this should prevent the more extreme abuses, it does not necessarily assure globally competitive returns. Ruthven says only the better British companies aim for an ROSF higher than 15%.
In Australia the approach to corporate governance is similar to the British style of the balance of powers. However, it is not working. Over the past decade, the ROSF for Australia’s public companies has fallen from 12% to below 7% – which is less than the cost of equity capital (10.5%). In many of our public companies, the ROSF is getting dangerously close to the bond rate of 4.75% – the minimum requirement (because a government bond is risk free, whereas a share investment carries risk).
Attempts to make boards stronger and executives more accountable may actually exacerbate the lack of risk-taking and ultimately make large Australian companies weaker. European corporate governance tends to be more broadbased. In Germany, for example, companies are required to have two-tier boards: a management board and a supervisory board. This may be a more enhanced diffusion of power, but Europe has much smaller equity markets than the US (and, in relative terms, than Australia) and the boundary lines between banks and the stockmarket are more blurred than in English-speaking markets.
Asian corporate governance is perhaps the weakest; it is based on networks of the privileged – keiretsu in Japan and chaebol in South Korea – that confer few rights on minority shareholders. Not surprisingly, the returns on capital are exceptionally poor, especially in Japan (often less than 2%).
In Taiwan, where only retail investors are allowed, corporate governance structures are weak. But in Hong Kong (where a large provident fund is being developed), Singapore (where institutional capital has been established for some time), and Malaysia (where institutional capital formation is burgeoning), the governance structures have more of a resemblance to the British model.
None of these corporate governance structures unambiguously solve the “agency problem” at the heart of corporate governance: the difficulty of ensuring that company managers will act in the interests of the shareholder owners for whom they are, in theory, supposed to be no more than agents. Neither does the “one size fits all” approach to governance seem sufficiently flexible to deal with the different rewards and risks that face senior executives of public companies.
Michael Jensen, Jesse Isidor Strauss professor of business administration at the Harvard Business School, writes: “What we call separation of residual risk-bearing from decision management is the separation of ownership and control that has long bothered students of open corporations.”
Jensen writes that the effect of incentive systems, such as high pay for senior executives, is poorly studied in economics, including the “general reluctance of employers to fire, penalise or give poor performance evaluations to employees.” In the corporate governance context, those employers are typically the board members, which, having often chosen the chief executive, are often reluctant to recognise poor performance (most Australian chief executives of public companies are strictly employees, rather than substantial owners).
Jensen writes: “The conflict of interest between managers and shareholders is a classical agency problem, but the small observed pay-performance sensitivity seems inconsistent with the implications of formal principalagent models. Two alternative hypotheses consistent with the observed relation between pay and performance are: (1) that CEOs are not, in fact, important agents of shareholders; and (2) that CEO incentives are unimportant because their actions depend only on innate ability or competence. There has not been careful empirical documentation of the ways in which CEOs affect the performance of their firms, but there is considerable evidence that the competence and actions of a CEO are important to the productivity of the firm.” In short, it is not certain that chief executives who will perform better if they are paid more really represent shareholders, nor exactly how they affect the firm’s performance.
The most problematic distinction is the one between chief executives who are “true capitalists” and those who are employees. Frank Lowy of Westfield, Kerry Packer, Rupert Murdoch, and Peter Farrell of Resmed are in the first category: chairmen or chief executives who created the companies, and who have substantial equity holdings – they are owners as well as managers.
Telstra’s Ziggy Switkowski, the heads of the big banks, and Richard Humphrey of the Australian Stock Exchange are at the other extreme: leaders who lead enterprises that were dominant long before them, and whose job it is to maximise existing wealth as much as create it.
In between are chief executives such as Michael Chaney of Wesfarmers, Alan Moss of Macquarie Bank and Wal King of Leighton Group, who have exhibited a blend of entrepreneurialism and wealth maximisation. Ideally, the corporate governance structure should reflect these differences. Similarly, small listed companies require flexible corporate governance if they are to thrive.
No single set of corporate governance strictures is likely to suit. Yet legal strictures must be common to all. Corporate governance cannot be expected to protect investors against poor performance, or even outright incompetence. It can only offer a barrier against the worst abuses, and only a partly effective one.
The introduction of better law is unlikely to be enough to create lasting change. As financing becomes more sophisticated, accounting models – the basis of any governance – are getting weaker.
Tom Copeland, finance analyst for the US-based Monitor Group, says: “I personally believe the loss of confidence caused by the misuse of the accounting system has caused a mirage of sorts. I think that people are over-reacting.
“There are two things going on. In some cases there have been very bad business decisions that people tried to cover up through accounting means. In other cases there are very legitimate accounting issues about when to report income and how to report income, where reasonable people would disagree.
The reporting of contingent liabilities, for example, on the balance sheet – a lawsuit that is placed against the firm that has a very low probability of ever being won in the courts because it is frivolous – should that be placed on the balance sheet? The information that the public is getting is almost by necessity incomplete, because you simply can’t list all the contingent claims.
“In horse racing the highest economic gain is from the horse that exceeds expectations by most. Some of them say to me we are using EVA [economic value added] or earnings growth but what they are really doing is studying expectations targets. In a way, the more training we get that is of the wrong sort the more our behavior becomes counter-intuitive.”