Category Archives: Corporate Governance

What are dividends?

Twenty pound notes edited 

A simple question, I’m sure you’ll reply. Everyone knows that a dividend is money paid to shareholders by a company to reward them for owning its shares. However, a non-executive director needs to know a little more than this, as dividends can prove surprisingly complex.

 

A dividend is a form of shareholder distribution. However it is not the only form of distribution, the main alternative being a share buy-back. I’ll come back to that in a later article.

The first question that needs to be asked is whether a shareholder distribution would be legal.

Is a dividend legal?

 A company can distribute only profits to shareholders, so there must be sufficient accumulated profits in the balance sheet. This is shown by whether there are sufficient ‘distributable reserves’. If you look at the bottom of the balance sheet, you will see a number of reserve accounts listed, some of which are distributable and others not. The accounting bodies have conspired to make this highly complex, so I won’t go into the details here. However an alert non-exec will ask the CFO or Audit Partner to list out the distributable reserves to show that they exceed the shareholder distribution being proposed.

Be careful here, in that the distribution is made out of the top company accounts, not the group consolidated ones, so look at these (it may be the only time you look at the ‘company’ accounts, usually buried right at the back of an Annual Report). Also be aware that it has to be the last filed accounts that show sufficient reserves. Management accounts don’t count, nor does any profit earned after the last set of accounts filed with Companies House.

It is illegal for UK companies to pay a shareholder distribution that does not meet these conditions. If you subsequently find that an illegal distribution has been made, you will have to either claim it back from shareholders (not a great idea) or pass a retrospective EGM resolution to absolve shareholders from any claim from the company to get the money back. Best not get yourself into this position, although it does happen, especially since the law has been tightened.

Do shareholders like dividends?

There’s not much point in paying a dividend unless shareholders want one, but it’s pretty rare for them to be unpopular. Dividends do three things;

  1. Pass some of the profits onto the owners of the business (ie shareholders)
  2. Reduce cash balances or increase net debt for the company
  3. Signal confidence in the future to the market

Dividend cover: Companies normally pay out a proportion of their annual profits. This is shown by the dividend cover. A common level is a cover of 2.0 meaning that the profit after tax is twice the dividend, or to put it another way, the company is paying out half its post tax profit. As a rough rule of thumb, a non-exec should be wary if the company is paying out a lot more than this (ie cover well below 2.0). Shareholders value a stable and predictable dividend flow, so you should satisfy yourself that this level is sustainable. It is possible to have an uncovered dividend (ie the dividend is higher than the profit, a cover of less than 1.0), but it is very difficult to keep this going for long.

If the cover is 3.0 or above, shareholders may query why more isn’t paid out. There may of course be good reasons, perhaps the company is trying to reduce its borrowings or is nervous about the future.

Dividend yield: The other way to look at dividend return is expressing the annual dividend as a percentage of the share price. This is the dividend yield. It can be compared to an interest on a savings account. Shareholders might expect a yield to be higher than a savings account to take account of the risk of fluctuations in the share price. A typical dividend yield at the time of writing is 3.5%, well above most savings returns.

Shareholder might be happy with a lower dividend yield if they expect the share price to rise, perhaps as the company is investing its cash resources into expanding the business. On the other hand, a higher dividend yield may not be good news, as this may suggest that the market expects the share price to fall and indeed that the dividend may not be sustainable.

Different shareholders look for different returns. Most private (“retail”) shareholders look for income, and so favour stocks that deliver at least a market average dividend yield. This would also be true of institutional income funds. However growth funds are more focussed on the share price, and so may be relatively indifferent to the dividend.

Do dividends matter?

Theoretically dividends shouldn’t matter. It’s all shareholders money whether its distributed (dividends) or kept in the business (share price). Shareholders should worry only about total shareholder return (TSR), which is share price appreciation plus dividends paid. A higher or lower dividend should not affect TSR.

However, in practice, dividends do matter:

  1. A shareholder might have tax advantages in receiving capital gains from a rising share price, rather than income from dividends.
  2. Shareholder distribution may be part of the company moving to a different capital structure, such as increasing debt and leverage. This alters the risk profile of the company and may move the valuation of the stock.
  3. A rising dividend is sending the market a sign about management confidence and this may be reflected in a higher share price. Alternatively a cut in the dividend suggests that management is foreseeing more difficult times ahead.

Other kinds of dividend

Dividend in kind: Some companies offer investors to receive dividends in shares, either through a scrip issue of new shares or a ‘DRIP’ scheme (whereby the company purchases existing shares to give to investors). The advantages to shareholders are that, if they don’t need the cash immediately, they can reinvest the money in additional shares with no dealing costs. The advantage of a scrip issue to the company is that it preserves its cash, effectively issuing new equity. The DRIP uses cash, but slightly reduces the shares in issue, with some benefit to earnings per share. In the UK there is no tax difference in taking a cash dividend versus shares. If a new scrip or DRIP scheme is being launched, a non-exec should just ask what level of take-up is expected in order to justify the modest additional costs for the company.

Special dividend: Sometimes a company will declare a special dividend. The description ‘special’ simply implies one-off. It is typically where the company wishes to pass on the proceeds of a sale of a major asset or division, or where it wishes to increase significantly its gearing or reduce its spare cash. In other respects a special dividend is the same as an ordinary dividend.

Summary

 Dividends can be a surprisingly complex area. They need to be thought about and pitched at the right level for the cash resources, strategy and future expectations of a company.

  1. Always ask the question about distributable reserves before approving a shareholder distribution.
  2. Ask how the share register is made up, especially between income and growth investors.
  3. If the proposed dividend cover is less than 2, ask the question why such a high pay-out and is this is sustainable?
  4. If the proposed dividend cover is higher than 3, ask why the dividend is restricted to this level and could a higher payout be afforded?
  5. If the dividend yield is higher than 4, ask why. Does the market expect a dividend cut in the future?
  6. Asking the question doesn’t mean it’s wrong. It will just elicit the information a non-exec needs to understand before approving a shareholder distribution.

“Marking our homework” – Why executives resent non-execs

Management scribbles001

 

It won’t be long into your first non-executive job when you start to feel as if the executives resent you. It’s okay. You haven’t become paranoid. They really do resent you. Why?

 

 

 

Being an executive director is a tough job. You work all the hours that the Working Time directive allows, then you opt out and work some more. The market is very tough and competitive, and you end up making numerous difficult decisions. You do this for a couple of months and try to summarise what’s happened and why for the Board. Then a few part-time directors waft in and criticise the papers, ask stupid questions and lecture you about governance. What’s not to hate about that?

 

But being a non-executive director is also a tough role. You are invited to join the board of a company about which you probably know little and possibly in a sector of which you know nothing. You may get a cursory induction programme and then it’s straight into a board meeting. The performance information may be either perfunctory or so detailed that you can’t get any sort of meaningful overview. Management may be defensive, resentful and resistant to questions. You ask yourself, how can I add value to this board?

 

Executives often say they feel that non-execs come to board meetings ‘to mark their homework’. This is very difficult to avoid. Execs usually work very hard and in their heart of hearts, really want the non-execs to turn up and applaud them. There are few things more irritating than having a non-exec appear and come up with a good idea or question the execs hadn’t thought of. Even if it’s helpful, human nature means that you may resent it.

Here are some suggestions to help harmonious board discussions.

For the executive:

  1. Remind yourself that the non-exec is trying to understand your position and making sure that you have thought of all the angles.
  2. Don’t react immediately, but let the board discussion continue. The initial comment, even if naïve, may lead to a useful discussion.
  3. Remember that you are paying the non-exec to be there. Whether you like it or not, you might as well listen to something you’ve paid for!
  4. Pause a while, as what may seem initially as a strange comment from a non-exec may turn out to give a new insight or angle into a common issue. They won’t necessarily use the same jargon as you, but may still understand the problem.
  5. If the non-execs are well chosen and sensible, remember that their comments are likely to be, or at least intended to be, helpful.
  6. Avoid being defensive at all costs, and watch out for sounding defensive.

 

For the non-executive:

  1. Avoid stating the obvious or asking a question implying that executives don’t know their job.
  2. It is tempting to review paperwork and point out errors. If this is necessary, do it privately outside meetings, rather than in board discussions.
  3. I think that it is good practice to ask questions that arise from reading advance paperwork directly of executives before the day of the meeting. This can be in person, by telephone or email.
  4. Questions should generally be asked in board meetings only when they have just occurred to you or will elicit an answer that you would like everyone to hear. If the latter, you could also warn executives in advance that you intend to ask the question and give them time to prepare a good response. This will make them much less defensive as they won’t feel that you are trying to catch them out.
  5. Keep interventions and questions short. The longer you go on, the more pent up anger may build in others.
  6. Don’t confuse asking a question with making a speech. There’s a time for both, but not at the same time.
  7. Try to put important questions or points early in the discussion, rather than dropping them in like a depth charge, just as the Chairman is drawing the discussion to a close.
  8. Use cautious language, with plenty of conditional tenses and get-outs (“I was wondering if…” ,“Perhaps this might be an issue…”)
  9. Offer to meet separately (”offline”) if the discussion goes on for a long time or has generated some unwelcome heat.
  10. Remember that when you leave this meeting, you can go onto other things, but the executives are stuck dealing with the same issues full time until the next board meeting.

 

I have been in executive and non-executive roles on quite a few boards, and even temporarily moved from non-executive to executive on some boards, so I have seen these issues from both sides. I am grateful (and would like to apologise) to all my boards for allowing me to make all the mistakes listed here, and now to write from bitter experience!

 

Board meetings can very sensitive affairs. A good one informs all participants and pools their knowledge and experience to come up with good decisions. A poor meeting just stokes resentment between the various participants. Directors should remind themselves that it’s not an aural exam and board papers are intended to be the genesis for a two-way discussion. There is no marking of papers required!

 

What’s your favourite part of being a non-executive director?

Purse

Now I’m going to take a wild guess here, that the least favourite part of a typical NED role is setting executive remuneration. To the media, and now even the government, it appears that NEDs love nothing more than awarding large pay increases, bonuses and pay-offs to executives. It often seems that investors share this perception, and believe that it is only institutional shareholder intervention that can restrain the irrational generosity of the average non-exec.

Meanwhile executives are usually demanding higher remuneration and showing the Remuneration Committee comparisons that reveal how underpaid they are.

There is no right answer as to how much to pay someone. The only ‘objective’ measure is to pay what you perceive is the ‘market rate’ for the role, or some fixed relationship to it (eg upper quartile or 10% above/below). This is the first stop of the remuneration consultants, who advise NED’s. However market rate setting causes inbuilt inflation. Many companies want to pay above the average, but few want to pay below average. The rest is mathematics.

Remuneration consultants will tell you that FTSE 250 benchmark is 150% of salary in annual bonus, and it’s difficult to argue down from that. Long-term bonuses are now generally signed off any way by large shareholders from the start.

Of course not all Remuneration Committees do a good job and some make bad judgements. Personally I agree that much executive pay, like that of a few other occupations, is too high, especially long-term incentives.

The question is what to do about it. The latest proposal from a Tory MP last week, and apparently backed by leading fund manager, Neil Woodford, is that large companies should form a committee of their five largest shareholders, with a worker representative and the company chairman invited as observers. This committee would approve pay deals, recommend appointment and removal of directors and question strategy.

Most non-execs would be only too delighted to delegate remuneration to someone else. The problem is that remuneration decisions are closely linked in to the detail of a company’s operation, career development or recruitment and retention. This means that the decisions need to taken with full knowledge of a number of complex and potentially price-sensitive issues.

Many larger fund managers currently delegate governance issues to a specialist corporate governance department. However these individuals inevitably lack the knowledge of the company and sector that the fund manager has. To have any chance of this working, institutional shareholders would have to send the fund managers, not corporate governance specialists, to these committees. My suspicion is that this would not be a welcome extra task for fund managers. Mr Woodford is already a busy man.

Institutional shareholders can already nominate, vote directors in and out. Do they really want to become the Nomination Committee, even without seeing how directors perform in board meetings?

Why would it take a committee of five large shareholders to challenge company strategy? In my experience most shareholder meetings talk strategy and there is plenty of opportunity for shareholders to express their views.

There are many smaller shareholders who would be worried about how this proposal would increase the power of a few large holders. Recent rule changes have strengthened protection for smaller shareholders from single dominant shareholders. Protection of minority shareholder’s interests is a key role for directors, which could be undermined by strengthening the power of the top five over director selection.

There isn’t an easy solution to setting executive pay. Remuneration has become a leviathan, taking up absurd amounts of board time, as directors try to balance executive aspirations with many different shareholder demands and compliance requirements.

I would welcome clearer guidelines from institutions as a whole on how they would like remuneration to be set. They would of course need to agree those guidelines amongst themselves first. Fund managers could engage more with non-exec directors, both to evaluate them and to communicate their wishes, and then to vote at AGMs for non-execs they trust.

If there were clear unitary guidelines, investors could vote out directors who don’t follow these rules. Shareholders don’t need to, don’t want to, and can’t, manage companies that they invest in. They should set the rules, and then judge the directors who do manage their companies.

This would build on our existing strong corporate governance framework, rather than bowing to media and political pressure by creating new parallel structures.

 

New PM, but corporate governance is still a political punchbag

“I want to see changes in the way that big business is governed. The people who run big businesses are supposed to be accountable to outsiders, to non-executive directors who are supposed to ask the difficult questions, think about the long-term and defend the interests of shareholders.

“In practice, they are drawn from the same, narrow social and professional circles as the executive team and – as we have seen time and time again – the scrutiny they provide is just not good enough. So if I’m Prime Minister, we’re going to change that system and we’re going to have not just consumers represented on company boards, but employees as well.”

This speech was by Theresa May, not Jeremy Corbyn. It’s a topsy-turvy world. This is our new Conservative Prime Minister who is stooping to kick the corporate world – the dreaded ‘big business’ – as she strides into No10. Even madder, it was the Institute of Directors, not the Trades Union Congress, that welcomed her ideas. Let’s have a look at her charge sheet and her remedy.

“Non-executive directors… are drawn from the same, narrow social and professional circles, as the executive team”

It’s certainly true that non-executives are often serving, or more commonly former, executives. Normally that’s because running a company is a difficult, acquired skill, and so if non-executives are going to supply oversight, they too need to understand how companies are run. Pretty much all boards will have to have a chair of audit committee, who has to have a senior finance background. Similarly most will have a chair of remuneration committee who has experience of HR or corporate remuneration. Frankly, when it’s my money they are using, I want experienced non-execs looking after my interests.

“…time and time again – the scrutiny they (non-execs) provide is just not good enough.”

There are 3.5m active companies in the UK, of which 2,500 are listed on the stock exchange. How many companies have shown inadequate non-exec scrutiny? The banks perhaps in the financial crisis eight years ago? BHS? This was a private company through the recent scandal. Volkswagen in Germany perhaps?

We’ve seen many more scandals at the Home Office alone, let alone Parliament, in that time. Perhaps Mrs May could define ‘time and time again’?

“…we’re going to have not just consumers represented on company boards, but employees as well.”

When the Treasury Select Committee investigated Northern Rock’s failings, it highlighted a lack of banking qualifications on the board. It didn’t suggest that a consumer or worker on the board would have helped. Volkswagen does of course have worker representation, in line with the standard German model, of which presumably Mrs May is an admirer, although the Germans haven’t gone as far as a consumer director.

By the way, did she mean customer director, rather than consumer?

Where do we start?

Perhaps we can just ask Mrs May some simple questions;

  1. Do you believe that if I invest my money in a company, then I should decide who manages it, or do you think that Government needs to decide it for me?
  2. Do you believe that boards should be more diverse in composition than the Cabinet?
  3. How many corporate scandals have been due to poor non-exec supervision?
  4. What evidence have you got that worker and consumer directors would improve non-exec supervision?

Corporate governance is by no means perfect, and I, for one, would be delighted to hear new ideas to improve it. But this is the same old business bashing – ill thought-out and populist policy, backed by neither evidence nor analysis.

Le Roi est mort, vive la Reine.

Dodgy statistics and wild claims just patronise women

Grant Thornton has just published a Report comparing the effect on corporate return on assets (ROA) of having women on an executive board across three countries (UK, US and India). It concludes that such diverse boards cause companies to perform “Materially better”. The report quantifies the economic benefit from having more women executives on boards as “a staggering $655 billion”, boosting GDP by 3%.

Now that’s some benefit just from changing the sex of one board member per company. It sounds too good to be true, doesn’t it? Well, of course, it is. Grant Thornton seems not to have published the full workings behind this claim, but let’s examine what it has disclosed;

  1. The sample size is tiny. It is able to use just 127 of the over 1,000 companies in the top echelons of the three countries to make this dramatic conclusion. The report makes no mention of how the results could be random variation in a small sample size.
  2. It’s a static analysis that compares companies currently with a female executive board director to those without. However, this statistic does not tell you the effect of a company deciding to appoint an extra female (ie a dynamic analysis). The analysis should have tracked the change in performance of companies that did this, in order to conclude that putting more women on boards boosts performance.
  3. The analysis is not comparing all male boards with mixed ones. All but 60 of the over 1,000 boards already have female non-executive directors. There is no gradation reflecting how many females are on each board.
  4. It assumes that correlation equals causation. It may well be that higher performing companies are simply better at attracting high performing female executives. Given the pressure on boards to have more females, and the resulting increased demand for female directors, then it would be logical for women to be able to choose to work for more successful companies.
  5. The report extrapolates the average ROA from just 127 companies to over 1,000. However, if female executives are a source of competitive advantage, then this would of course be nullified if every company had such an advantage.
  6. Somehow, the extrapolated 1,000 companies gain is then turned into 3% GDP growth, worth $655bn. Even if those companies did increase their returns, the report does not explain how they have calculated such a boost to GDP. For example; higher dividends might be remitted abroad; smaller companies would be likely to suffer increased competition from the 1,000; employees might demand a greater share of the profitability; and so on.

So adding 923 female executives would create an extra $655bn in growth. That’s over $700m per female director per year! Maybe they should ask for a pay rise.

More diverse boards may well make more effective teams. We do need more talented women in senior management. But it is very patronising to women to have to argue for this using dodgy statistics and ridiculous economic claims.

Maybe Grant Thornton published this report just as a publicity gimmick. But business is crying out for regulation that is based on real evidence, not political expediency nor ridiculous statistics.

Why do we have corporate governance regulation?

Glasses & newspaperWhat drives corporate governance regulation? Is it media focus, political pressure, or a need to ’do something’?

Or is it sound analysis leading to thoughtful prescriptions? I suspect that pretty much everyone accepts that the answer is somewhere in the former list. Why does it have to be like this?

Evidence-based medicine is a well-established movement in health care. Even the UK Government published a White Paper in 1999 (“Modernising Government”), admitting that it “must produce policies that really deal with problems, that are forward-looking and shaped by evidence rather than a response to short-term pressures; that tackle causes not symptoms”. Sadly this went the way of many well-meaning political initiatives.

The UK Corporate Governance Code starts;’The purpose of corporate governance is to facilitate effective, entrepreneurial and prudent management that can deliver the long-term success of the company.’ Fine words, but how do we know that actually does this?

Corporate Governance regulators have not as yet woken up to the needs of evidence, analysis and proof. There was an outcry about executive pay. They reacted by asking the great and the good as to what should be disclosed, and then mandating it. The result is 30 pages at least in every annual report listing every last detail of directors’ remuneration. Where is the evidence that this has remedied the problem of excessive pay and payment for failure? I can see that investor interest and therefore pressure on boards has had an effect on boards, but such pressure was in fact the driver, not the result, of additional regulation.

Listed company directors now have to put themselves up for re-election every year now. This was because people thought it would be a good idea. Where is the evidence that this would help and where is the post implementation review that shows it was effective in what it set out to do?

Politicians and the media are baying for more diversity on boards. The regulators duly oblige by setting targets for more females. This time there are also claims of a statistical relationship between number of females on boards and good performance. Except that the statistics in fact are pretty dodgy, and fail to show a company performance improving over time as a result of the presence of more women (if you think about it, such a relationship would be quite extraordinary given the complexity of company profitability). Where is the post implementation analysis that shows company profitability in the UK has improved as the percentage of FTSE100 female directors has doubled? I’m not saying that there isn’t a moral or political case for female representation. If regulation is just political, then let’s not dress it up as rules for improved performance.

Would it be so hard to develop evidence-based regulation? This is what it should look like:

  • The original events that led to the ’need for regulation’ are thoroughly analysed, and their causes identified;
  • The theory is tested as to why the regulation will be effective against those causes, and what the possible impacts of the regulation might be;
  • The counterfactual is tested: what would be likely to occur if the policy were not implemented;
  • The impact of the new regulation is measured;
  • Both the direct and indirect effects of the regulation are identified;
  • The uncertainties and other influences outside of the regulation that might have an effect on the outcome are identified;
  • The analysis and tests is capable of being tested and replicated by a third party.
  • The regulation is tested to identify if it ever becomes unnecessary or develops unforeseen consequences.

This is a manifesto for good regulation. None of the current corporate governance rules would satisfy this standard. Yet, given the costs of implementing the governance rules, is it unreasonable for regulators to justify themselves with a bit of evidence?

Put simply, governance regulation should start with an analysis of what has gone wrong in companies, identify regulation to stop this recurring elsewhere, and then check that this is being successful. The analysis into what goes wrong at companies must be far-reaching and insightful, going beyond condemning individual directors and failures of risk management. It needs to look at culture and accept human fallibility.

We all need rules, but the regulators are perpetuating a lie in suggesting that rules improve performance. Football teams couldn ’t play a match without a common set of rules. But you won’t improve Manchester United’s performance by adding new rules to the game. Teams improve with better tactics, advice, and encouragement. Boards are teams too.

This would be the regulators’ toughest challenge. How can they go beyond rules and compulsion, to encouragement, best practice and helping boards? They need to accept the discipline of evidence, the limitations of rules, and open their eyes to the importance of culture and how to foster the right one. And that probably requires culture change at the Regulators themselves.