QUALIPORT
How To Act On Poor Corporate Governance

By Maynard Paton (TMFMayn)
August 12, 2002

The economic downturn has revealed all sorts of boardroom misdemeanours recently. As such, judging how a company meets corporate governance guidelines is an important consideration for private investors.

Combined Code

On Thursday, the provisions of the Combined Code that cover directors and the formation of company boardrooms were reviewed. Today, directors' remuneration and auditing will be considered. To see how effective the Code is, the sixteen companies that make up the Qualiport's watch list will be put to the test.

Directors' remuneration

Investigating directors' remuneration can be a minefield.

The Code states that "levels of remuneration should be sufficient to attract and retain the directors needed to run the company successfully" and also suggests "Remuneration committees... should be aware what comparable companies are paying and should take account of relative performance."

For shareholders, difficulties arise in judging what exactly are suitable levels of pay. As this article shows, investors need to consider all the different payment types (salaries, bonuses, options etc.) involved. All in all, rather than consider the Code per se, boardroom pay packets should be assessed with reference to other companies. However, there are some Code provisions that can help identify overly generous pay packages in isolation:

B.1 The Level and Make-up of Remuneration

Provision:

There is a strong case for setting notice or contract periods at, or reducing them to, one year or less.

B.2. Procedure

Provision:

To avoid potential conflicts of interest, boards of directors should set up remuneration committees of independent non-executive directors to make recommendations to the board... and to determine on their behalf specific remuneration packages for each of the executive directors.

Remuneration committees should consist exclusively of non-executive directors who are independent of management and free from any business or other relationship which could interfere with the exercise of their independent judgement.

In short, executive directors with a contract term of more than one year can receive excessive payoffs if they leave early. In addition, remuneration committees not exclusively 'independent' can be vulnerable to greedy executive influences.

Here's how the Qualiport sixteen stand up:

Company         Executive service contracts  Remuneration committee
                    1 year or less?          exclusively independent?


Allied Domecq              N                         Y
Carpetright                N                         Y
DFS Furniture              Y                         Y
Emap                       Y                         Y
Gallaher                   N                         Y
Games Workshop             Y                         Y
Imperial Tobacco           Y                         Y
Johnston Press             N                         Y
Lloyds TSB                 N                         Y
London Stock Exchange      Y                         N
Metal Bulletin             Y                         Y
PizzaExpress               Y                         N
Renishaw             No service contracts            N
SSL International          N                         Y
Ulster Television          N                         Y
Ultraframe                 Y                         Y     

Of the seven companies that have executive directors with service contracts lasting greater than one year, Gallaher (LSE: GLH), Johnston Press (LSE: JPR) and Lloyds TSB (LSE: LLOY) are due to reduce them to one-year terms in the near future. Allied Domecq (LSE: ALLD), Carpetright (LSE: CPR), SSL International (LSE: SSL) and Ulster Television (LSE: UTV) all employ executive directors that will remain on two-year contracts. Renishaw's executives have no service contracts.

London Stock Exchange (LSE: LSE) and PizzaExpress (LSE: PIZ) each have a 'not independent' non-executive sitting on their remuneration committees, although they are outnumbered by independent non-execs. However, of the three members of Renishaw's remuneration committee, two are executive directors.

Accountability and audit

"The Group has a long established Internal Audit Department which operates an extensive programme of reviews from which formal reports are prepared for managers, executive directors, external auditors and the Audit Committee. The Department provides independent and objective assurance to the Board that the system of internal control is effectively applied..."

That statement was taken from the 2001 Independent Insurance annual report. It was written four months before the fraudulent activities of the company's executive directors caused the firm to go bust.

The Combined Code states: "The Board should maintain a sound system of internal control to safeguard shareholders' investment and the company's assets". Companies have to outline their internal control systems in the annual report. However, as Independent Insurance showed, describing what seems to be a robust audit framework doesn't actually mean it's effective. That said, there are other Code points that may reveal lax auditing:

D.3 Audit Committee and Auditors

Provisions:

"The board should establish an audit committee of at least three directors, all non-executive... a majority of whom should be independent non-executive".

"The duties of the audit committee should include keeping under review the scope and results of the audit and its cost effectiveness and the independence and the objectivity of the auditors. Where the auditors also supply a substantial volume of non-audit services to the company, the committee should... seek to balance the maintenance of objectivity and value for money".

"Companies which do not have an internal audit function should from time to time review the need for one."

Here's how the Qualiport watch list stand up to those guidelines:

Company             Audit committee     Auditor's fees     Internal
                    suitably formed?   audit  non-audit   audit dept?
                                         (£k)     (£k)

Allied Domecq            Y              2,000   4,000         Y
Carpetright              Y                 58      59         Y
DFS Furniture            Y                 53      41         Y
Emap                     Y                600   1,100         Y
Gallaher                 Y                800   7,800         Y
Games Workshop           Y                134     272         Y
Imperial Tobacco         Y                800   1,400         Y
Johnston Press           Y                250     485         N
Lloyds TSB               Y             17,000   4,000         Y
London Stock Exchange    Y                100     700         Y
Metal Bulletin           Y                 45     700         Y
PizzaExpress             Y                100     100         N
Renishaw                 N                145     195         Y
SSL International        Y                600   2,200         Y
Ulster Television        Y                 50      88         Y
Ultraframe               N                101     917         N

Only Renishaw and Ultraframe did not have suitable audit committees. The majority of Renishaw's audit committee were executive directors while Ultraframe had just two non-execs on its committee.

Many Qualiport companies also engaged their auditors in expensive non-audit work. Most concerned acquisitions (e.g. Ultraframe (LSE: UTF)) or tax advice (e.g. Emap (LSE: EMA)), but there was one notable exception: Gallaher (LSE: GLH) paid £4.8m to their auditors for help with an IT implementation. Meanwhile, Allied Domecq (LSE: ALLD) failed to declare why their auditors received £4m for non-audit work.

In addition, three companies do not operate in-house internal audit functions. Johnston Press (LSE: JPR) "reviewed the need for an internal audit department and... did not believe it necessary for the Group to maintain a department."

Meanwhile, Ultraframe have "concluded that there is a need for Internal Audit... [which] has initially been outsourced to a specialist service provider". And PizzaExpress (LSE: PIZ) "does not operate an internal audit function as such, the function being carried out by two unannounced audits of each restaurant per year by an independent firm of retail audit specialists."

Does corporate governance matter?

From this two-part review, every Qualiport watch list company has at least one non-compliance with the Combined Code. Renishaw, London Stock Exchange, Carpetright and Allied Domecq are probably the worst overall offenders. But does poor corporate governance actually make shareholders worse off in reality?

Take Renishaw. Having just one non-executive director means the company flouts many corporate governance guidelines. Yet long-term, Renishaw shareholders have been rewarded by the board's industry experience and common sense management style (e.g. no acquisitions/diversification, company's large cash pile, continued large shareholding, no dilutive share option scheme etc.). The same could be said of Carpetright and DFS. It's worth noting that William Morrison (LSE: MRW) breaks many Combined Code guidelines as well (the supermarket employs no non-executives), yet has improved profits every year since 1967!

To a certain extent then, investors should take a "if it ain't broke, don't fix it" view of 'poor' corporate governance. If a boardroom has an established record of rewarding investors through straightforward management -- and importantly, provide clear-cut accounts to prove it -- then their actions should speak much louder to investors than their corporate governance words. Put another way, when a company doesn't meet corporate governance guidelines, then there has to be an obviously good reason to go ahead and invest.

However, where a company exhibits creative accounting, poor cash flow, a history of acquisitions, a liking for diversification, too much debt or regular exceptional items, a failure to meet corporate governance guidelines will just add further evidence of it being a share to avoid. Generally speaking, if there's something not quite right in the accounts, there'll also be something not quite right in the boardroom.

More: Corporate Governance: Part I

The author owns shares in Carpetright, DFS Furniture, Games Workshop, Johnston Press and PizzaExpress.