Is Corporate Governance for Shareholders or Stakeholders? – A Critique of the King Report

It may be argued that the single most important task of any Board of Directors is to appoint the right person for the job of CEO. And to ensure that the company and its staff, led by the executive directors, fulfil the legal obligations of the company, while they deal sensitively and effectively with the claims of all the stakeholders in the company that will influence the long-term success of the company.

Corporate governors have to manage the separation of ownership and control of the company
It is the inevitable separation of ownership of the company by a highly diffused, ever-changing group of shareholders and the control of the decisions made by the company by professional managers, that characterises the modern public corporation. It is managing the separation of ownership and control that constitutes for me the essential challenge to the Board when governing the corporation. The owner-managed business does not suffer from possible conflicts of interest between owners and managers. It may of course have all sorts of other problems that limit its progress – not least, access to capital on favourable terms and the capabilities of the owner-managers themselves.

The interests of executive directors and shareholders will not always be aligned
The interests of the most senior managers and the shareholders represented by the Board are not perfectly aligned. Put in stark terms, senior managers would clearly prefer to receive more generous rewards that are well secured, even should the company under-perform. Shareholders would naturally prefer to pay as little as possible to hire the right CEO and CFO and secure complete freedom to appoint replacements should performance prove less than satisfactory.

Golden handshakes may prove to be particularly expensive to shareholders and highly frustrating when such contracts have to be fulfilled. Especially when the company has performed very poorly and the wider public becomes enraged when the (presumably contracted for) rewards, despite failure, are realised. But many senior managers, knowing they are highly vulnerable to dismissal, and well aware of their market value, will bargain for this kind of protection when signing up.

A further issue that may well divide the shareholders and their managers is the degree of market risk the company should assume. Well-diversified shareholders may have much greater tolerance for risk than managers when they seek higher returns from company action. The managers may have everything to lose, their careers and the shares and share options they hold in the company that form a large part of their savings, should the risk-taking of the company prove to be dangerously ambitious.

When it comes to dealing effectively with all the claims on the company that will be made by all the other competing stakeholders, for example the Receiver of Revenue, organised labour, junior managers or even organised environmentalists, the Board, the executive directors and shareholders are likely to be on the same side. That is to say if the incentive system of the company is well designed to reward managers and workers when they achieve objectives that are consistent with value added by the company for shareholders over the long run. When managers and directors are also shareholders in a meaningful way this surely helps to align their interests with shareholders.

The shareholders’ case for an independent share-owning director – not recommended by King
The King Report recommends strong representation on the Board by independent directors. The Report, however, recommends that the independent non-executive directors and the chair of the Board not be shareholders. Why the independent directors are better able to assume these tasks and responsibilities without any material interest in the company, as recommended by King, is not obvious.

The interests of shareholders would surely support the opposite conclusion. Independent directors, who own a significant stake in the companies they serve, are much more likely to act independently of management and in the interest of shareholders rather than serve the purpose of other stakeholders, including senior management. Directors with a material stake in the company are surely more likely to be more vigorous defenders of the rights of shareholders when other stakeholders dispute such rights.

King 3 however does allow non-executive independent directors to own up to 5% of the company without prejudicing their independent status. A 5% stake in a large public company would represent a very large proportion of the wealth of almost all directors and more than enough to make them very directly concerned with the share price.

The King Report exhorts SA companies to accept responsibilities and undertake actions over and above their legal duties. The King Committee, by my reading, does not provide a robust defence of the interest of shareholders in the company. Nor is this its intention I would suggest. Shareholders are but among the stakeholders the company is meant to serve in the judgment of King. King therefore presents an invitation to the other stakeholders in the company to carve out a bigger slice of the company at the expense of shareholders. This presumably is thought to be easier to achieve when other stakeholders have to deal with directors who are not significant shareholders in the company. I would therefore recommend that SA shareholders should continue to seek an alignment of their own interest in income and wealth preservation with those of share-owning managers and directors.

Companies can fail despite the best of corporate governance
The failure of any company represents the failure of the Board to have made good judgments, including especially judgments about its key appointments that, with the advantage of hindsight would have or could have secured the survival of the firm. The chosen strategy might even have been sound but its execution poor enough to lead to huge disappointment for shareholders or even to bankruptcy. Corporate governance is about process not action. Hopefully good process makes for good actions and good appointments, but process alone will not guarantee the survival of the firm – even the best-governed companies can fail.

Author: Brian Kantor is Emeritus Professor of economics at UCT and investment strategist at Investec Securities. This article may be republished without prior consent but with acknowledgement to the author. The views expressed in the article are the authors’ and are not necessarily shared by members of the Free Market Foundation.

Author’s note: It needs to be emphasised that these responses to the King Committee Report are my own only and do not represent the views of my employer, Investec Bank, or of my colleagues on the Board of JSE listed Acucap Properties Limited, (ACP) of which I am the independent non-executive chairman of its Board of Directors. Neither the Bank nor Acucap have reviewed or commented upon this essay and bear no responsibility for it.

FMF Feature Article / 21 July 2009

Help FMF promote the rule of law, personal liberty, and economic freedom become an individual member / donor HERE ... become a corporate member / donor HERE