One of the most important aspects of investing in a company is ensuring that management is up to standard and consists of the right people to be running the business. In this article, we are going to look at what the role of the board really is and how a strong corporate governance framework should look.
The board of a company is effectively the chosen representatives of the shareholders. Like elected officials, the board is supposed to represent, as accurately as possible, the wishes of the majority of shareholders. As part of this process, they will appoint managers who will run the company well with goals of creating both a profitable and ethically sound company. When the board of a company operates in an ineffective or dishonest manner it is a near certainty that average shareholders will pay the price at some point.
Company directors are classified as either executive or non-executive. Executive board members are involved with the day to day operations of the business and make decisions regarding implementation of the overall business strategy. Non-executive directors, on the other hand, generally only make decisions on the overarching business strategy. Non-executive directors will often be independent of the management team and therefore have a much lower possibility of having any conflict of interest. Truly independent, non-executive directors are an important part of a company board and can help to keep management ‘honest’.
A company board will (should) also include separate committees for audit and remuneration. The responsibilities of the remuneration committee will include setting the remuneration packages for the board members as well as senior management. Ideally, the remuneration committee will include at least one independent board member to reduce conflicts of interest. Shareholders, unfortunately, have relatively little say in the remuneration of the board and management and this has led to some executives receiving what many might consider ‘excessive’ remuneration. Shareholders get the opportunity to vote on the proposed remuneration packages but the result of the shareholder vote is non-binding, rather it is simply advisory. The power of this vote comes through the ‘two strikes policy’ where two consecutive votes against (more than 25%) the remuneration policy triggers a board spill where all director are put up for re-election. This is a relatively new law that gives shareholders some power in controlling the level of executive remuneration. Recently, there have been several companies whose shareholders have expressed displeasure at the level of executive remuneration, such as AGL and CSL. It is yet to be seen what effect this will have on executive pay but it certainly seems like a good idea for increasing the power of shareholders in this matter.
Ideally board members will maintain an independent stance with respect to senior management. Shareholders need to know that if management are not performing up to standard, or are acting in a way contrary to the interests of shareholder or the business, that the board will have no hesitation in replacing the offending managers. When the board and management are too ‘cosy’ there may arise a situation where the board is reluctant to fire managers that they have a personal relationship with.
Strong boards are a requirement for giving shareholders confidence that the company is being run effectively and that their interests are being served. There are plenty of examples throughout history where a weak board allowed management fraud to continue for a lot longer than it should have. As a result, losses to shareholders in these cases was certainly more than it otherwise would have. On the other hand, companies with strong boards will almost certainly perform better in the long run compared to conflicted or weak boards. The average investor won’t necessarily be able to perform an in-depth evaluation of the quality of the board of any given company but ideally small investors should at least look at the composition and experience of the board to ensure there are some independent directors and no obvious conflict of interest.
