Escape from the Rock

I gave a nervous laugh. The headhunter asked me if I would like my first non-executive director role, joining the board of Northern Rock. It was October 2007, a few weeks since the first run on a UK bank for 150 years. Struck by an uncharacteristic sense of adventure, I did indeed agree to serve on the Northern Rock board for the next year, becoming Chair of the Audit Committee, through the various bids, nationalisation and the rebuilding of its business model.

Northern Rock was a highly successful and fast growing UK bank that predominantly offered domestic mortgages. It financed itself by a mix of retail deposits, wholesale borrowing, asset-backed bonds and securitisation of mortgage portfolios. In September 2007, as the credit markets tightened, it found itself unable to raise enough on the wholesale and securitisation markets to cover the mortgages that it had already issued, and so turned to the Bank of England for support. This was leaked to the BBC, who reported it in such a fashion that a run developed almost immediately. The subsequent £12bn cash outflow ensured that the bank would need long term help, becoming nationalised four months later.

Much has been written what went wrong at Northern Rock, particularly now that we are at the 10 year anniversary. Very little, perhaps understandably, has been heard from those inside the business. So with the benefit of 10 years distance, I thought I would list the lessons I learnt from the sad demise of Northern Rock.

1. Retail banks lend long and borrow short

Some say that this was Northern Rock’s problem. It relied too heavily on wholesale market funding, and not enough using retail deposits from savers. However it is not as simple as this. Half of the wholesale funding was more than 1 year maturity, whereas the bulk of the retail deposits were effectively on demand (hence the £12bn cash outflow in the run). Few banks could withstand the liquidity drain from a run, however well funded they are.

 2. Don’t rely on the Regulator

There was a lot of fuss at the time about relative blames of the Tripartite regulation of the Treasury, Bank of England and Financial Services Authority (FSA), but in practice they all missed the systemic risk incurred by the credit crunch on Northern Rock. The FSA even wrote¹ on 14 September 2007 (the day the run started);

“Northern Rock is solvent, exceeds its regulatory capital requirement and has a good quality loan book.”

The Bank of England, under the academic Mervyn King was still worrying about the ‘moral hazard’ of bailing out Northern Rock as the bank was failing. That was a bit like calling off the fire fighters because the householders shouldn’t have let their house catch fire in the first place.

In my experience on the board, after the run, the FSA was still singled-mindedly pursuing its ‘Treating Customers Fairly” campaign with the bank even as those customers were fleeing out the doors with all their savings. The FSA gave me an exit interview as I was stepping down from the board, but didn’t ask a single question about the run and its lessons.²

Regulators like to establish rules and processes and then operate within these limits. They are not generally blessed with great insight or entrepreneurial understanding, so they cannot be relied on to protect their target industries or customers. They do however have a knack of closing the door shortly after all the horses have bolted.

3. Don’t rely on the auditors

Why didn’t the auditors identify the risks in the Northern Rock business model? In practice, auditors very rarely find the ‘big holes’ in the accounts. These are usually found by management eventually, or events reveal them as here. This is true from Enron to Northern Rock to Tesco.

Auditors review the accounts. Their job is not to challenge the business model. They reviewed the Going Concern statement, but they failed to challenge the underlying assumptions in Northern Rock as, just like others, they saw an extreme credit crunch as highly unlikely. Even if they had, it’s hard to imagine that they would have qualified the accounts for what seemed such an unlikely risk. This is why auditors hardly ever get sued for their role in business collapses.

4. Sometimes the risk is hidden in plain sight

The 2006 Northern Rock Annual Report stated that, whilst it had £8bn of assets maturing in the next 3 months, it had £33bn of liabilities maturing, giving a liquidity gap to be filled of £25bn. An ING analyst report³ in 2006 noted;

“The inability to fund cheap wholesale funding given its huge reliance on the market to fund its expansion would impact our outlook negatively.”

In 2007, the Bank of England admitted⁴ that most banks’ reliance on wholesale funding had risen in recent years.

It may have taken hindsight to spot it, but Northern Rock’s liquidity risk was clearly and publically stated. I have since gone into two companies that had massive derivative black holes that were clearly laid out in their Annual Reports, but no-one noticed them.

5. Think the unthinkable

All the risk models in the world are useless if what happens was not envisaged to be possible. Nobody in Northern Rock, nor anywhere else in authority, seems to have believed that a credit crunch would lead to an implausible freeze, where even banks wouldn’t lend to each other. The repeated mantra was that a crunch would instead lead to a ‘flight to quality’, and that would be fine as Northern Rock’s paper was rated highly.

In 2006, the FSA was explicit⁵, asking that management; “takes severe but plausible scenarios into account…”.

Hector Sants, then CEO of the FSA, said¹ later;

“No reasonable professional would have anticipated the complete closure to them of all reasonable funding mechanisms…I think that the set of circumstances …were highly unusual…”

Academics call this underestimation of ‘thick tailed’ – or ‘black swan’ – events. A 1 in 100 year event has a high probability of happening once in your lifetime. There have even been two world wars in the last hundred years. It is too easy to dismiss a risk as implausible or a very rare event. Rare events do happen and usually more frequently than people expect. Every risk model should work through how the business would react and survive every highly, unusual and implausible, event.

When evaluating a company’s ‘risk appetite’, it is worth asking the question whether there is a 1 in 100 year event that could destroy the company. As an investor you would need to accumulate your share of those risks. Say you invest for a pension over 20 years in 10 companies that are willing to tolerate a 1 in 100 chance of a terminal threat. You, as an investor, would then have the likelihood of two of those companies suffering a catastrophic event in your pension pot.

Of course, hindsight gifted politicians and media with the clear knowledge that it should have been obvious to the Northern Rock Board that its model was fatally flawed. It wasn’t however obvious to the participants at the time because they, like almost everyone-else, blinded themselves to the extreme risks.

6. Risks are multiplicative not individual

People have a tendency to think about risks in isolation. However, this assumes that the risks are completely independent, whereas in practice the worst events happen when two risks crystallise at once, either randomly or because one risk tends to increase the likelihood of another.

In Northern Rock’s case the freezing of the wholesale markets caused a liquidity problem, but this could possibly have been handled by the Bank of England support facilities. However the proposed use of these led to a leak that caused a loss of confidence among savers. The former problem became multiplied by the second.

The typical business risk model has one axis for probability of a risk happening and one axis for resulting financial impact. But this static model is woefully inadequate if more than one risk can occur at a time, particularly as the result may well be multiplicative – much more dramatic even than the sum of the two independent risks.

7. The reassuring herd

Northern Rock was an outlier. It did things differently to other banks. Its retail deposits in 2006 were 27% of its total funding, against 49% at Bradford & Bingley and 43% at Alliance & Leicester. Northern Rock was taking a 25% market share in new mortgages and growing its balance sheet much faster than others.

Instead of querying how its model was so uniquely successful, Northern Rock argued that its excess reliance on such funding would only be appropriate for a growing bank and so that’s why others didn’t follow. There doesn’t seem to have been much challenge to this circular thinking.

I’m not arguing for businesses to follow the herd all the time. However, it ought to be an immediate amber light for risk when one business is doing things radically different to others, even if that appears highly successful for a long period.

8. Success is intoxicating

Northern Rock was growing rapidly and its share price reflected this. Large salaries and bonuses were being awarded to executives. Who would be a Cassandra against this success? Businesses need a certain paranoia when they are very successful to ensure that this performance doesn’t contain the seeds of its own destruction. When very successful businesses falter, it can happen very quickly, as shown by the whole banking system, Enron, Worldcom, Polly Peck and so on.

9. Group-think is a powerful drug

“The Board considers that Northern Rock is a well-controlled, risk-averse business that continues to adopt a prudent stance in the management of risk.” ⁶

Although Northern Rock did have reasonable business controls, it was in fact taking on massively more risk than it appreciated at the time. But management believed what they were saying at the time.

You can’t underestimate the tendency of people to adopt group-think, and accept conventional wisdom. This is particularly true when things are going well. There was no evidence to prove that a severe credit crunch was very unlikely. The fact that there hadn’t been such a credit crunch since the 1930’s meant that people believed it couldn’t happen (as opposed to believing that it was a 1 in 80 year event). There was no evidence that a credit crunch would lead solely to a flight to quality. It’s just that the more people said it, the more it was believed.

The Treasury Select Committee report¹ made much of the Northern Rock CEO not being a ‘qualified’ banker. This was irrelevant as the CEO understood banking very well. There is no evidence that having taken some exams twenty years previously would have made him address risk differently. The issue was that there was too much conventional wisdom being accepted as proven fact in mass group-think, and far too few people anywhere were ever sceptical or open minded enough to challenge it.

10. A very powerful Chief Executive is dangerous

This is pretty well acknowledged in corporate governance now, but it needs reiterating. It is not just that you end up with too much power in one person, but that it tends also to attract ‘yes men’ to the business, who may not be of the highest quality. If you then layer on great success and high rewards to this, group-think and lack of challenge is almost guaranteed.

11. Don’t always believe the answer, especially if you don’t ask the right question

I have lost count of the times in my life that I have received a reassuring answer to a question, only to later realise that the answer was misleading because the question wasn’t quite right or too vague. When I tried to understand the liquidity position at Northern Rock, I was told that the average mortgage lasted only three years. It seemed a little low, but I accepted that. It was only much later that I realised that this referred to the average length of a mortgage package. In reality, an average mortgage lasts something like seven years, but during this period it may be switched between deals (such as a particular rate fix), so the answer I got was very misleading even if technically accurate.

Sometimes it takes the same question asked several times in different ways to be sure that you have got the whole truth. Sometimes you are just not told the whole story. Northern Rock underreported its mortgage arrears, claiming them to be half that of the industry. In fact it was treating many arrears as being rescheduled over the remaining life of the mortgage, effectively increasing the size of the mortgage rather than being classified as being in arrears⁷.

12. Organisation matters

Internal audit and risk teams are major protections for a company in understanding their risks. However, reporting lines can frustrate this. One of the major governance improvements over the last few years has been raising the profile and importance of such teams. But they must be heard at the right level (usually the Audit Committee) and without operational management acting as a filter. At Northern Rock, the Treasury Risk team reported into the Treasury function, not Group Risk. This meant that the Group Risk team was not in a position to offer a robust challenge to Treasury.

13. Once public, stories have a life of their own

The run started after the BBC ran a high profile story about the Bank of England’s support for Northern Rock. Robert Peston, the journalist, claims that he handled it in a responsible way. This may be true, but the prominence of the story on the BBC was such that it emphasised to the public that this was a major event, much more so than anything he actually said. He got the story from a leak. It’s difficult to imagine anyone benefited from this leak. Some think that it came from the Labour government itself, anxious to show the country how it was having to bail out irresponsible bankers. If so, it back fired, because once out, the leaker couldn’t control how it would be reported, and it became almost certainly a much more dramatic event than anticipated.

14. Get it in writing

This is advice more for executives that are involved in difficult situations. When asked to do something that you are not sure is right, somehow make sure that there is a written/email reference to it, even if you do the writing. If something is not quite right, the instructions are far more likely to be given verbally than in writing. When Northern Rock had been underreporting its mortgage arrears, on investigation there was nothing in writing confirming that senior management knew about it.

My conclusion

There are many lessons from any corporate failure, but the best ones are not generally those identified by politicians and the media. Sadly, the real lessons are also rarely understood by corporate regulators either, as they tend to be most sensitive to the clarion calls for action from those politicians and commentators. Rarely do you see corporate failures analysed to provide governance insights. I have listed some cultural and practical lessons I learnt from what really happened.

Ten years on, I have kept to another, more personal, lesson. Being a non-executive director on a bank is an extremely difficult, detailed and risk-prone job. I escaped from the Rock, vowing that I wouldn’t ever serve again on the board of a bank. There are easier ways to earn a living.

___________________________________________________

¹ ‘The run on the Rock’ – Treasury Select Committee, January 2008

² The FSA did in fact hold an Internal Audit inquiry into its own conduct, which looked at its own internal processes rather than understanding why the bank failed.

³ ‘Northern Rock. The train has left the station’ – ING September 2006

⁴ Bank of England Financial Stability Report – April 2007 Issue No 21

⁵ Letter from the FSA to Northern Rock – 9 October 2006

⁶ Annual Report Northern Rock 2006

⁷ Two Northern Rock directors were subsequently fined by the FSA for this.

Image by Alex Gunningham from London, Perfidious Albion (UK plc)

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To buy or not to buy, that is the question

 

Whether ‘tis nobler to buy back

shares or pay a dividend?

 

 

Introduction

Maybe Hamlet was not so concerned with shareholder distribution, but most modern company directors certainly are. In an earlier article I reviewed why and how companies make shareholder distributions and in particular pay dividends. However there is another form of distribution, the share buy-back.

Share buy-backs

Companies can purchase their own shares, using cash that otherwise could have been used to pay a dividend. This requires shareholder permission, and it is common for an AGM resolution to be put routinely annually to give boards the power to undertake share buybacks. The company also has to comply with the same rules about having distributable reserves as when paying a dividend.

Why do a share buy-back?

If a company buys back its own shares, this will reduce the issued share capital. In the first instance this shouldn’t have any effect on the share price, as the company loses the cash, and thus value, proportionate to the reduction in the number of shares. However any further gain in the value of the company would be spread over fewer shares, boosting earnings per share (EPS) or net asset value per share growth.

The buy-back, like any distribution, also signals management confidence in the future, which may boost the company valuation and thus share price. This is particularly true if the buy back is part of an established ongoing programme of repurchases. A buy back may also be initiated as a one-off, if for example a significant part of the business has been sold off or the company gets a one-off receipt of cash. In this case the benefit is likely to be one-off as well.

Share buy-backs or dividends?

Share buy-backs fundamentally offer capital gains in place of dividend income. Some shareholders (such as growth funds) may prefer capital gains and others (such as private shareholders or income funds) may favour income. Most tax authorities levy lower rates of tax on capital gains than income, so there may be tax advantages to buy backs over dividends. Buy backs also enable shareholders to defer tax paid as it is charged only when shares are subsequently sold.

On the other hand, some shareholders may favour cash in hand, so they may prefer dividends to buy backs.

Dividends tend to be ‘sticky’. Shareholders don’t like the dividend being cut, so management is reluctant to reduce the rate of pay out unless there is a lasting downturn in profit expected. Buy backs, on the other hand, can be more flexible, as there isn’t necessarily the expectation that they will be repeated at the same level.

Share buybacks are more likely to benefit earnings per share. This is because, although the company loses interest from paying cash out in any form, the buyback offsets this by reducing the number of shares in issue. Management may be incentivised to grow EPS, and so may prefer buybacks.

Is there evidence that favours either buybacks or dividends?

Any evidence is difficult to assess as it’s a bit circular. If a company is doing well, it is more likely to pay higher distributions. Separating out the underlying cash flow performance from the impact of the subsequent distribution is difficult. However the best data comes from the US, where buy backs are fairly common.

Shareholder distributions are a large factor in total shareholder return (TSR – the sum of shareholder distributions and share price appreciation). Over the last 80 years, 44% of the TSR of Standard & Poors 500 companies came from distributions¹.

Buybacks have become a more popular form of distribution in recent years. Until the early ‘80s, less than 10% of shareholder distributions in the US were buy-backs, but nowadays they are 50-60%².

McKinsey² found that there was no significant relationship between growth in TSR and whether the company paid dividends or bought back shares. It did conclude that companies that did frequent buy backs did best. However this seems a little circular. Only very successful, cash generative companies can afford to do frequent buy backs and they are likely to be companies whose share price is likely to reflect that performance!

Some argue that companies should buy back shares when the board feels that the company is undervalued. However, this would suggest that the board must have a better understanding of market value than the market. McKinsey² concludes that they have ‘rarely seen companies with a good track record of repurchasing shares when they were undervalued; more often than not, we see companies repurchasing shares when prices are high.’

Conclusion

The theory is that, unless shareholders put a significant weight on the tax benefits of buybacks, they should be indifferent to share repurchases compared to dividends. The statistics, such as they are, back this. The form of distribution has no significant impact of shareholder returns.

The underlying financial performance plus the decision to pass some of the success on in shareholder distributions, in whatever form, are the key drivers of shareholder return. It is strong financial returns plus the determination of the board to reward shareholders that delivers total shareholder return.

Managements who don’t take account of shareholders’ interests in this way risk getting punished. Or as Hamlet put it;

And enterprises of great pith and moment

With this regard their currents turn awry

And lose the name of action.

 

 _____________________________________________________________________________________

 ¹ CFA magazine http://www.cfapubs.org/doi/pdf/10.2469/cfm.v21.n6.3

² McKinsey http://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/paying-back-your-shareholders

 

 

What are dividends?

 

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

 

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?

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.

 

Someone getting emotional?

 People are only human. Occasionally they fall in love with other people. Ideally, the ‘other person’ works elsewhere, but sometimes the two work together.

Many executives will have come across co-workers, who are in a relationship. This knowledge can vary from being a matter of mild interest to one of real discomfort. I had a boss once who was having an affair with their deputy in our small team. It was very uncomfortable most of the time, but also hilarious at others, especially when they tried comically to hide what everyone already knew. Most companies these days will have policies against relationships with subordinates, particularly as they could be construed as sexual harassment.

However, rules don’t guarantee compliance, especially in matters of the heart. So, as a non-executive, what do you do if you discover that there is a relationship at a company at board level or involving a board member?

Firstly look up the rules to establish the legal position. Is there a company rule that forbids or defines parameters for such relationships? The rules may well be different for relationships between co-workers as opposed to those between boss and subordinate.

The easiest thing for a non-exec is to ignore the situation. You may feel that you should ‘do something’ but if it doesn’t seem to be interfering with work and you don’t feel that it is exploitative, there may be plenty of other more important matters to worry about. Just keep an eye on it. If you don’t feel comfortable with this, the next step is to quietly mention it to the Chairman, and leave the ‘hot potato’ steaming nicely in their lap.

The most problematic relationship is often one a CEO and a senior executive. I have seem this a few times, and it is rarely a good thing. Inevitably other executives know about it, resent the special bond, and fear the pillow talk. This cannot, I think, be ignored. A non-exec would be wise to discuss it privately with the Chairman, and if they refuse to engage on it, raise it at a non-exec meeting. The very least you should aim for is that all non-execs are aware of the issue and can take it into account when they participate in board discussions and decisions.

If you feel that the relationship is exploitative, then you must raise it at board level. If the board declines to take any action, then you must decide whether to live with it or resign.

Beyond this, any non-exec has to apply their own discretion and judgement. How dysfunctional is the relationship to the company and its board? How concerned are the other non-execs? How much fuss do you want to make? There is no right answer here, but you should try to work out, all things considered, what is in the best long term interests of the company?

A final word on your due diligence when you join a board. When one Chairman asked me to lunch shortly after I joined the board, I assumed that he was being welcoming and that we could get to know each other a little better. In fact, he wanted to tell me that there was a relationship that I needed to know about. How kind of him to tell me a week after I had signed on. That taught me as much about the Chairman as it did about the participants.

I would recommend that in your final due diligence before being appointed as a non-exec, you ask the Chairman a direct question as to whether there is anything you should know about personal relationships in the senior management and the board. If you get an astonished denial, you can rest more easily. That’s what due diligence is for. But you might just find out something that could save you a lot of trouble later on.

Summary

1. Relationship happen at work. They are not necessarily harmful.
2. Check the company rules on relationships.
3. You can ignore it, if it does no harm. If in doubt, consult the Chairman.
4. If the Chairman doesn’t do anything, you can consult your fellow non-execs.
5. If the relationship risks being exploitative, you should take action.
6. Worth asking a question during your due diligence.

 

Notes from a non-executive director

A series of articles looking at practical issues and problems that arise on boards.

1. Becoming a non-executive director
   1. What you need to know for your first NED interview
   2. How to choose your first NED role
   3. How to assess your NED Offer Letter
2. Learning to be a non-executive director
   1. Your first 100 days as an NED
   2. “Marking our homework” – why execs resent non-execs
   3. What if you have no financial experience?
   4. What’s all the fuss about cash?
   5. What’s your favourite part of being a non-executive?
3. Things it’s worth knowing as a non-executive director
   1. What are pre-emption right and why do they matter?
   2. What are dividends?
   3. To buy or not to buy – share buybacks or dividends?
   4. Escape from the Rock. Lessons from the Northern Rock failure.
4. What to do if your company gets bid for
   1. What if you get an unsolicited approach for the company?
   2. Let battle commence. The unsolicited approach
   3. Just say ‘No’ – Assessing an offer for the company
5. Difficult issues that board sometimes face
   1. Is management telling the whole story?
   2. Is someone getting emotional?