Letter number 37 of December 2008


News : Recent developments in corporate governance

Corporate governance is still work under progress. Developments are most obvious in the major western countries and in this article, we’ll only be looking at relationships between an individual director and:
• shareholders
• managers
•and the board of directors
1. The relationship between a director and shareholders

There is a clear trend towards strengthening the power that shareholders have over directors, which has led to a number of changes.

In the past, the board of directors submitted their nominations for new directors to shareholders for ratification at the AGM.  Increasingly, groups of shareholders are not presenting or seeking to present their own candidates during the meeting – Wendel at Saint Gobain, Havas at Aegis, the Belgian and French states at Dexia, etc. This is not necessarily unhealthy, providing that directors appointed in this way never forget that a director who sits on the board is not the spokesperson of a shareholder or a group of shareholders but a spokesperson for all of the shareholders.

The link between shareholders and directors is being strengthened by the habit adopted by large shareholders, whether institutional investors or not, to keep in regular contact with the chairman in order to obtain information on the market on which the company operates, and also, an especially common practice at Anglo-American companies, to meet up with directors on an individual basis.  They use these opportunities to make recommendations, especially when there’s a change in management.
In the UK, investment funds have adopted a best practice code that limits the size of golden parachutes and firmly disapproves of the CEO going on to become chairman of the board. Some people in this position may be tempted to interfere in the daily running of the company, making it impossible for the new CEO to operate properly (which was what happened between Serge Tchuruk and Patricia Russo at Alcatel-Lucent).

This rather dogmatic position is, in our view, regrettable, as a CEO who goes on to become the chairman, could turn into an eminence grise, able to provide invaluable advice to the new CEO, and to relieve some of the isolation that goes with the position. A pragmatic approach is probably the best way of dealing with this problem. 
In the USA, there is a clear trend towards shortening the length of the periods served by directors (two to three years at the most), and to limiting the number of boards any one director sits on to two or three, and in very exceptional cases, four.  In France, there is no limit on the number of years a director can sit on a company’s board, although any director who has held a seat on a board for more than 12 years cannot be considered to be an independent director, as defined in the Bouton report.

Subjecting the reappointment of directors to a shareholder vote on a more regular basis, enables shareholders to limit directors room for manoeuvre.  What we see happening in the USA is the development of shareholders' advisory boards.    These are new bodies made up of representatives of the main shareholders which have a consultative role.  The board of directors seeks the shareholders’ advisory board’s opinion on major investments, the strategic direction of the company, the appointment of management, M&A operations, etc.   Even though shareholders’ advisory boards have no legal status under company law and regulations and are set up by boards on a voluntary basis, they are a far cry from shareholder committees, which, in France, are groupings of minority shareholders that merely advise the company on is financial communication policy for private shareholders.

2. The relationship between a director and managers

Sight should never be lost of the fact that the main job of the board of directors is to select the company's managers, to oversee their performance, and, if necessary, to get rid of them.  There are many recent examples demonstrating that this is the case, both in theory and in practice (Citi, UBS, etc.). 

In this area, France, where for a long time power has been exercised in a rather solitary and monarchical way, is still far behind the pragmatic and complex-free approach of the USA.  At most US companies, the appointments committee of the board of directors, as part of its succession planning function, meets regularly, first to draw up and then keep updated, a list of able managers who, when the time comes, could be appointed as senior managers.  In France, except at times of crisis, it is generally the CEO who chooses his/her successor, and who then has this choice ratified by the members of the board, some of whom may have been informed of the choice in advance.

Once a manager has been selected, the board has to come up with a compensation package. There have been a lot of changes in this area and these days, most of the details of management’s compensation packages are published the company's annual report.

This doesn’t stop shareholders from wanting to have a say when management compensation packages are worked out, and increasingly, shareholders are wanting to have the last word.  In the USA, the shareholders’ advisory board,

when there is one, demands that it be consulted on this matter.  It is even possible that one day, shareholders will win the right to approve or reject management compensation packages.

The introduction of executive sessions has also resulted in closer monitoring of management's performance by the board of directors.  Executive sessions are meetings of board members from which members of management who also sit on the board are excluded.  They present an ideal opportunity to talk behind the backs of management and to discuss their compensation, their succession, and their performance, often assessed on the basis of a management appraisal grid.

Assessing risk has taken on new importance in the light of recent events.  The times are long gone when a director, even in Continental Europe, could get away with saying: "Sorry, I didn't know, nobody told me".  These days, directors have an obligation to be proactive, to ask management for information and even to adopt an almost inquisitorial approach.  Directors who fail to do so may find that they are held liable for a major incident arising as a result of decisions taken by management.

Directors can take out insurance to cover this risk, known as D&O (Director & Officer) insurance, which won’t keep them out of prison (!) but will cover their defence costs if they are held personally liable for any loss suffered.
But a director’s best protection is probably to engage in dissident action.  Directors who are against a given decision should ask that their dissent and the reasons there for be recorded in the minutes of the meeting.

3. Relationships between a director and the board of directors

Given that directors are required to work harder than in the past, that corporations are growing larger and larger and that problems companies face are becoming increasingly complex, we have seen a major development in committees such as the appointments and compensation committee, the control and risk committee, the strategy committee and the finance committee.  There’s nothing really new about committees, even though their chairs are called on to answer questions during shareholder meetings more often than in the past.  What is new though is the development in the USA of committee self-assessment. In France, committees are assessed by the board of directors, and at the moment, the board only looks at the way they operate.

The relative weakening of the role of chairman of the board is being hastened by the emergence of a system of lead independent director. Generally, the lead independent director is the oldest or the most experienced director or the chair of the compensation and appointments committee.

He/she  has a dual role and is required to replace the chairman when the latter is absent, and to steer discussions assessing the chairman's performance, providing advice on how to improve the running of the board. In the event of a crisis within the company (for example a conflict between the CEO and the chairman of the board), the lead independent director could be required to act as an arbitrator, and even to approach one of them (or both of them!) and to ask them, in the interests of the company, to step down.

The issues raised above point clearly to a trend towards directors playing a more important role and assuming greater responsibility, a trend which is unlikely to be reversed in the current climate!

Statistics : Companies with a PBR below 1

They are back! After a few year where they were nearly extinct, companies with a PBR (Price Book Ratio (1)), below 1 represent now more than a third of the market. When investors are thinking a company will not be able to earn more than its cost of equity, they value its equity with a discount to its book equity.

Now they think that more than a third of them will not be able to make it or and that their book equity should be depreciated as some assets are to be impaired.

(1) For more on PBR see chapter 19 of the Vernimmen

Research : Votes trading

Four US researchers have published an empirical study (1) which enhances our understanding of the value of voting rights attached to shares. Most of the articles on this topic have, until now, looked at capital structures with different classes of shares. 

Traditionally, the One Share - One Vote model has always been held up as the ideal (2).

The article we look at this month shows that behind the external façade of the share lending market, a lot of active trading in voting rights is going on. For companies which do not have different classes of shares, this system enables them to separate voting rights from financial exposure.

When shares are lent, revenue (in dividends and capital) on the share is paid to the original owner. Only the attached voting right is actually transferred (3). The first finding of the article is that more shares are lent when there is a vote in the company in question. Their average share in the market

capitalisation of companies appears to be low (0.25% at the time of the vote compared with 0.21% on average), but the difference is statistically significant.  This result is surprising  because it goes against the principle of One Share = One Vote, which on the contrary implies that fewer shares should be lent at the time of the vote as shareholders should be wanting to exercise their voting rights at general meetings.

Next the authors look at the price paid for these voting rights.  They show that interest paid on shares lent is the same, whether the shares have voting rights attached or not.  In other words, not only are voting rights being transferred via the lending of shares, but they are being transferred free of charge to boot! According to the authors, this could mean that the holders of these shares are prepared to hand their voting rights over to investors whom they assume are better informed than they are.  This idea, that a market for free voting rights has sprung up as a result of information asymmetry, is the central assumption of the article.

The authors use the rest of the article to test some of the predictions arising out of their main assumption.  They show that more voting rights are transferred when information asymmetry is greater (measured by the bid/ask spread), and when there is greater uncertainty about the outcome of a vote.  Additionally, it would appear that vote trading has an impact on the outcome of the vote.  An increase in vote lending increases the probability of a shareholder proposal being accepted (which only happens, across the whole of the sample, in 2% of cases) or of a management proposal being rejected (17% of cases across the sample).

The conclusions drawn by this study should, however, be viewed with some caution, as it only looks at the US market and covers a relatively short period (1998/1999). Its authors should, however, be complimented for approaching the vote trading issue from a new angle and for coming up with an assumption that is yet to be confirmed by more research. 
It also issues a timely reminder that rampant takeovers carried out through buying up voting rights, via share lending, would be a lot more difficult to implement if certain shareholders weren't quite so obliging when it comes to lending their shares.  We should all tidy up our own backyards!

(1) S.E.K. Christoffersen, C.G. Geczy, D.K. Musto and A.V. Reed (2007), Vote Trading and Information Aggregation, Journal of Finance, vol. 62, pages 2 897 to 2 929
(2) See for example S.J.Grossman and O.D.Hart (1988), One Share-One Vote and the Market for Corporate Control, Journal of Financial Economics, vol. 20, pages 175 to 202
(3) See the Vernimmen page 953 for a description of share lending

Q&A : What are the dark pools?

Dark Pools are markets on which large volumes of shares are traded with all possible measures taken to ensure a very high level of confidentiality.

Traditionally, equity markets were organised around an operator (the London Stock Exchange in the UK) that often held a monopoly over the processing of trades. 

The principle was to offer a great deal of transparency, at every stage of the trading process, over the buy and sell orders placed by traders (which made up the order book). Some exceptions were made, especially for the processing of large volumes (blocks) which if recorded on the order book would be likely to have a major impact on the share price. But it was up to the buyer (who could go through a broker) to find a counterparty and negotiate the price directly.

The implementation of the MIFID directive in Europe(1), combined with the increasing sophistication of trading algorithms, has led to the development of alternative markets to traditional stock exchanges.
The development of an internal system of confrontation of supply and demand was seen by financial institutions as a way of cashing in on the large volumes being traded by their clients and to grab the margin that until then had been monopolised by stock exchanges. These alternative trading systems attract investors from a number of different angles and convince them to trade their shares through them:
• liquidity, although it is very difficult in normal times to compete against stock exchanges that were established tens of years ago and which naturally attract very large volumes of trades,
• flexibility, many of the new players are open for business over longer hours,
• price,
• secrecy,

Platforms that guarantee confidentiality on orders are known as Dark Pools. Dark Pools may be independent (Instinet, ITG-Posit, Liquidnet, Pipeline, …) subsidiaries of banking groups (BNP Paribas, Citi - Citi Match, Credit Suisse, Fidelity Capital Markets Services, Goldman Sachs Execution and Clearing, Merrill Lynch, Morgan Stanley, UBS), or traditional stock exchanges (International Securities Exchange, NASDAQ, NYSE Euronext, BATS Trading, Direct Edge).Today, Dark Pools account for a large share of trades (15% in the USA).
There are some who criticise the (intentional) lack of transparency of Dark Pools which enables operators who have access to these markets to manipulate share prices on traditional stock exchanges. They also raise various regulatory issues. Regulators are keeping a close watch on the development of these Dark Pools and are seeking to ensure that their book-keeping complies with MIF rules on transparency. 

Dark Pools have become an established part of the share trading landscape and it is likely that the way they operate will be more tightly controlled in the future.

(1) see The Vernimmen Newsletter n°31 April 2008).