Agency risk
Companies separate ownership from management. Shareholders own the company; a separate team headed by the CEO or managing director runs it day to day and reports to a board of directors appointed by the shareholders. The separation creates agency risk: shareholders rely on management to work in the interest of the company and its owners, but management may pursue personal interests at shareholders' cost, or may simply not be capable of running the organisation well.
Evaluating the competency and integrity of management and board is therefore critical, and extremely hard. Competency is challenging to assess; integrity is almost impossible, and without reasonable evidence it is inappropriate to cast aspersions on anyone's integrity. So the analyst looks instead at the corporate governance structure and whether it has the controls to prevent inappropriate actions.
The sample question asks which aspect of management corporate governance considers: integrity, not profitability or efficiency. Governance is the set of controls that keeps managers honest when nobody can measure honesty directly.
Ten questions on competence
Top management (CEO, CFO, COO and other C-level officers) has years of experience across disciplines, and the analyst rarely has the skills to judge all of them. These questions help.
- 1Do they have the educational qualifications for their discipline? Often checked, but never definitive, since many other factors shape competence.
- 2How many years of experience? More years mean more past challenges faced, which helps with future ones.
- 3If they held senior roles for years at any company, how did those companies perform then? A critical data point, but not definitive, because performance also depends on external conditions and other managers.
- 4How long have they been with this company and how has it performed in their tenure? Success elsewhere need not repeat, but long tenure with delivered results makes continued performance more likely.
- 5Do they have a vision for long-term goals and strategic direction? Shareholder value is built over the long term. They need not disclose every strategy, since competitors are listening.
- 6Do they have experience executing the current strategy? A company betting on innovation should have someone who has successfully led research projects.
- 7Do they give guidance on near-term performance and typically achieve it? A record of meeting or beating guidance suggests control over the business.
- 8Do they ensure timely regulatory compliance? Management in control complies well within time; failure suggests they are not in control and is also a red flag on integrity.
- 9Is decision making sufficiently delegated? Broad-based delegation gives continuity through churn; concentrated decision making creates keyman risk.
- 10Is there a succession plan for top management? Its absence creates trouble if the current management has to be replaced for any reason.
The third sample question asks what a good analyst tracks periodically to judge a company: its disclosures, its commitments and its deliveries, all three. Guidance is a commitment; results are the delivery; filings and compliance are the disclosures.
Corporate governance
Corporate governance is the rules, processes and procedures followed in managing and operating a firm, meant to ensure the company is run well for all stakeholders: shareholders, lenders, employees, suppliers and customers. Regulatory standards focus on protecting investors, with extra attention to minority or non-promoter shareholders. In India, SEBI's Clause 49 of the listing agreement sets the corporate governance standards. Those are minimum standards; some companies set higher ones. Strong governance prevents agency risk, or at least detects and rectifies it in time.
Board composition: directors may be independent, non-executive (not management, but not independent either) or executive. Ideally a majority should be independent; SEBI requires independent directors to be at least 50% of the board if the chairman is an executive director, and one third in all other cases.
Separation of chairman and MD or CEO: the CEO answers to the board, so the chairman should not be the CEO or managing director. SEBI mandates this for the top 1,000 listed companies, and where it applies the CEO must also not be from the promoter group.
Nomination committee: independent directors are more independent when executives play no part in appointing them, so the committee should ideally consist exclusively of independent directors.
Auditor independence: an auditor must not depend too heavily on fees from one entity or group; check that remuneration for all services to the group or entity is less than 10% of the auditor's overall income.
Auditor rotation: once in five years, so that facts concealed by management in connivance with an auditor have a chance to surface.
Audit committee: reviews the financial statements and nominates auditors; ideally entirely independent, and SEBI requires at least two thirds of members to be independent.
Related party transactions: to stop transactions that enrich the promoter group or majority holders at minority expense, all material related party transactions should ideally be pre-approved by the audit committee. SEBI does not mandate pre-approval but requires all related party transactions to be placed before the audit committee, with justification when a transaction is not at arm's length.
Remuneration committee: decides pay of directors and senior management; ideally all independent. SEBI requires all members to be non-executive directors and the chairman to be an independent director.
Remuneration of independent directors: all income an independent director earns from the company for all assignments must be thoroughly disclosed, so shareholders can judge true independence.
SEBI's regulation has further provisions on board and committee meetings. Good practice covers all nine checks, and companies that go beyond the mandated minimum are preferable.
A company with an executive chairman and a ten-member board needs at least five independent directors; with a non-executive chairman it would need at least four. If its audit committee has six members, at least four must be independent. If the auditor earned 15% of its total income from this group, the independence test fails even though every filing is in order.
- Shareholders own the company; a management team led by the CEO or MD runs it and reports to a board the shareholders appoint. That separation creates agency risk: managers may pursue their own interests or lack the ability to run the firm.
- Competence is judged through questions on qualifications, years of experience, track record in senior roles elsewhere, tenure and performance at this company, long-term vision and strategic direction, experience relevant to the current strategy, guidance and the record of meeting it, timely regulatory compliance, delegation versus keyman risk, and succession planning. Integrity is almost impossible to assess and must not be questioned without reasonable evidence, so the analyst examines governance controls instead.
- Corporate governance is the rules, processes and procedures for running a firm for all stakeholders; regulation focuses on investors, especially minority and non-promoter shareholders, with SEBI's Clause 49 of the listing agreement setting India's standards as a minimum.
- Nine checks: board composition, separation of chairman from MD or CEO (and CEO not from the promoter group where applicable), a nomination committee of independent directors, auditor independence, auditor rotation, audit committee composition, related party transactions placed before the audit committee with justification if not at arm's length, a remuneration committee of non-executive directors chaired by an independent director, and full disclosure of independent directors' income from the company.