The board of directors can put a lot of things right

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Humpty Dumpty sat on a wall

Humpty Dumpty had a great fall

All the king’s horses and all the king’s men

Couldn’t put Humpty together again.

– Nursery rhyme

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Is the financial world Humpty Dumpty? The developed world’s economies are grappling with an unprecedented financial collapse and de-leveraging process. Analysts are drawing on the pre-World War II period for comparisons. There is one commonality running through it all that is not specific to any period, however: a failure of governance and a lack of transparency.

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Had governance structures been sturdy and management and board oversight strong and effective, the degree of risk exposure that has felled some of the titans of the American financial industry and started the domino effect into the balance sheets of the household sector would have been far less prevalent.

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The question now, of course, is whether the companies that have been knocked off Humpty’s wall by the recent storms can be put back together again. The answer centres on those individuals responsible for oversight of corporate management and strategy: the board of directors.

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Despite the financial crisis, we have continued to do our regular rounds, visiting companies and looking for attractive investment ideas. One thing we always look at, and which has recently gained importance significantly, is the board of the companies we might invest in.

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When we examine a board’s structure, a critical question is whether it has independent directors and if so, how many. These independent directors are supposed to be the custodians providing the check and balance that will ensure transparency and proper implementation of the company’s strategy.

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How independent a director is, what relevant skills and experience he can bring to bear in board debate and, last but not least, whether that independent director is willing to generate that debate and, if necessary, disagree vigorously with other board members, is vital to ensure that a board is effective.

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Unfortunately, in Asean markets just as in the developed world, the degrees of independence and expertise of listed company directors are often questionable. We were recently forced to investigate the role of independent directors in two companies, one here in Malaysia and one in India.

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Both companies made cash purchases of stakes in related party companies. We immediately asked what the rationale behind these purchases was and whether the price paid was a fair one. We were particularly concerned that the decision to do so wasn’t brought to shareholders for a vote.

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At a time like this, when demonstrations of good governance are one of the key ways of bringing trust back into the equity markets, these two companies initially completely ignored minority shareholders’ interests. In India, the company was forced to backtrack when investors’ ire at the announcement drove its ADR (American depository receipt) price down by 55%. The company subsequently aborted the deal.

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In Malaysia, however, the deal went through. Unfortunately, because the company in question has a high level of foreign ownership, many foreign investors have thrown their hands up in despair with this purchase and with Malaysian equities, frustrated with a management team that they used to think highly of.

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We have asked ourselves whether the boards of these companies properly debated the consequences of these proposals for shareholders. Was there sufficient independence of mind? Were sufficient relevant experience and skill brought to bear? Was there a proper and full debate on each board?

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We fear not.

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In Malaysia, you may well come across the following sorts of directors listed in annual reports: independent non-executive, non-independent non-executive, and non-independent executive. If the titles are confusing you, you are not alone! But nomenclature aside, the key issue is what value these sorts of directors add to a board and what risks they can pose for it. Viewed from that perspective, one of the most potentially contentious is the non-independent non-executive director, or NiNeD in short.

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During our visits, we have held many discussions with companies in Asean about their NiNeDs. Some of these raised red flags for us, such as the telecommunications company whose NiNeD was involved in deciding on procurement decisions. We had to question whether these decisions were always in the best interests of the company and whether contracts were inappropriately awarded to a related party.

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Another interesting case involved a NiNeD closely involved in product development decisions. Given that the NiNeD represented a major shareholder, we felt there was a real danger of conflict of interests. For minority shareholders, the danger that such a director will attempt to steer the company in a direction that might not be in the interests of minority shareholders is significant.

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In fact, the presence of NiNeDs can be misleading, making it look as though the board is more robust in form, though in fact it is actually less robust in substance. Going forward, we would suggest that board members should try to ensure that NiNeDs do not exceed their authority and that there are checks and balances built in through board committees with a majority of independent directors who can ensure that the board and the company’s management make decisions that are truly in the interests of all investors. Some NiNEDs can bring useful skills, but boards do not serve themselves well by institutionalising conflicts of interest.

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At a time like this, when investors are running scared and regulators and governments are scrambling to restore confidence in the world’s capital markets and in the companies that are the underpinning of our economic systems, having a robust and appropriate board structure and directors who are free of conflict and persons of integrity is something that companies have direct control over.

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They must take that control because the current crisis has evolved from a financial crisis to a worldwide confidence crisis. Poor governance and the ensuing lack of investor confidence have taken the market down.

 

Strong governance resulting from strong boards can help take the market back up.