Martin Currie’s David Sheasby: The five warning signs of poor governance

We’ve seen it all before. Every year a rash of corporate failings hit the headlines as investors stand dumbfounded wondering how they could have happened. The reasons may vary, but the outcomes are always depressingly familiar. Fines are levied, executives are sacked, reputations are damaged and ultimately millions, sometimes billions, are wiped from the values of companies.

Of course, each corporate failing is different, and rarely the result of one single event. The explanations filter out over time, often through legal processes and shareholder questions, and no matter what the set of circumstances, one common theme inevitably becomes evident as part of this investment post mortem: in my experience, the issue of governance, either in its paucity, self-interest or lack of effectiveness, is always at the heart of corporate failure.

This is why an analysis of governance and engagement with companies is integrated into every part of our fundamental research, and critical to our conviction building. What we have learnt over the years, through collaboration and engagement with investee companies, is to understand the governance structures that work well; those board and corporate frameworks that ensure companies are run successfully in the interests of their shareholders. However, the opposite of these are also relevant and are areas we consider carefully in any potential investment cases:

The Fiefdom

This type of company structure has an unhelpful, and potentially, damaging concentration of power. Many companies falling into this category have overly dominant and autocratic arrangements crystallising effective power and decision making in a few or (more hazardously) in just one individual. While this kind of leadership can be effective in certain situations, in the longer term the scope for domineering personalities to exclusively determine business direction can be calamitous, think Enron for instance. Even at a less extreme level, limited outside influence in a board’s make up can lead to ‘closed thinking’ and a lack of diversified expertise.

The Conflicted

A good, old-fashioned power struggle is what’s going on here. This can come about in a number of ways, either through powerful individuals ‘locking horns’, or along more partisan lines with opposing factions massing against each other within a board. Perhaps most institutionally divisive though, and most difficult for an investor to reconcile, is when two or more equally influential governance structures exist within a company. This certainly contributed to VW’s recent debacle, where governance of the German carmaker was hamstrung by two entities of significant authority: a supervisory board and a management board, neither of which were clear where the other’s responsibilities began and ended.Irrespective of the cause of disagreements in the conflicted company, the outcome is often the same – a paralysis in decision-making.

The Behemoth

What’s the optimum number for a board of directors? The answer of course, is that there is no one-size-fits-all solution. The ideal amount will be determined by the needs of the business, its size and complexity. What is true, though, is that a board can be too big, and an excessive amount of directors can prompt us to question its effectiveness in our governance analysis. This is a concern that has recent historical precedence, as many of the financial institutions that failed in 2008 had very large boards. While larger management teams can provide more individual perspectives and manage workloads more easily, a ‘behemoth’ of a board can present some specific challenges. Logistically, there are difficulties with arranging meetings, and gaining clear representation and input from everyone involved. Decision-making is hindered and consensus building hampered. What’s more, individual accountability can often become lost in larger groups, with responsibilities more diffused in a bigger management team.

The Ill-equipped

Management teams can simply be ill-equipped to reflect the operational needs and sheer size of a business. This can result in board members carrying out multiple tasks and being unable to devote enough time to their particular roles. At worst, it can create vitals gaps in expertise. From an investment perspective (as well as a social impact), this can be devastating. Much of the criticism levelled at BP after the Deepwater Horizon explosion and oil spill in 2010 centred on the board’s failure to adequately understand the social and environmental responsibilities of its operations. For me, this underscores the importance of the governance analysis we undertake.

The Clones

Uniformity in the configuration of boards is a big warning sign in our analysis. Why? Because companies with management teams that don’t have a diversity of personalities and individual backgrounds – that in effect, resemble industry clones – are often victim to similar corporate character traits: a lack of adaptability, skills and ideas. Perhaps more concerning is the tendency in these governance structures towards ‘groupthink’, a fixed mindset potentially misaligned with the interests of the shareholders. We therefore look for boards that are not constructed passively – that is, those that are not assembled from a network of friends and peers. Diversity and independence are vital in this respect, creating the right blend of knowledge and outside experience that is necessary for an effective management team.

David Sheasby is Head of Governance and Sustainability at Martin Currie.