A CONVERSATION with a friend who used to be a senior executive for a global company based in the US triggered this question. According to him the company he was serving was doing the right thing and managed to achieve double-digit growth for many years.
Then the shareholders were exerting pressure on the board to maintain this kind of growth forever. Although the board knew that was highly improbable as that would require the company to step away from its strategy and business model, they hired a new CEO who was supposed to be great at sales, with the expectation that the new CEO could expand the business further, generate higher revenue and continue growing the company at a high pace.
Although their business model was changed, they didn’t get what they wanted. The company eventually lost its leading position in the industry it once controlled and the new CEO was asked to move on.
While boards are stewards of companies on behalf of their shareholders and are responsible for putting in place management teams that are supposed to develop and implement business strategies which would provide good returns to shareholders, the dynamics between shareholders, boards and management could influence the risk factors and sustainability of companies.
One might wonder how shareholders could pose risk to their own investments. Shareholders are not homogenous and each shareholder has their own objectives and motives for investing in a particular company. These objectives would influence their interactions with their investee companies. This is where they could influence business directions, risk appetites and the conducts of those companies.
Retail investors would come and go. While they could generate excitement in terms of volume of shares traded, especially for companies with small market capitalisation, the size of their shareholdings may not be enough to influence the direction of the company as in most cases, they are not represented on the board.
Then we have individual shareholders who, individually or through their friendly parties, have significant ownership of the company. They could be the original promoters who started the company and are generally keen to see it remaining successful. Normally their shareholdings are significant enough to enable them to have seats on the board.
Their investment objectives would be about serving their own aspirations including retaining control. If their investments are funded through borrowings, they may have an expectation on the minimum amount of dividends from their investments to service the borrowings.
Another category of shareholders are those representing collective investment schemes, pension funds and fund managers who are investing on behalf of a larger pool of investors. By their nature, they are committed to providing a certain amount of returns, and depending on their investment mandates may also be significant enough to have board representations.
Generally, only shareholders with significant presence on the board would be able to control business directions, how much risk the company is willing to take, dividend policy and the quality of corporate governance. They would pose risks if, through their representatives, they exert pressure on the board to venture into an industry in which the company has no expertise, acquire assets at inflated prices, enter into related- party transactions without proper due diligence or maintain dividend policies as such that free cashflows dry up and there is not much left for the company to invest for future business expansion or contingencies, among others.
How would such risks be mitigated?
The first line of defence is for all the directors to remember that they are expected to act in the best interests of the company. Any decision has to be predicated on this expectation. This also applies to those representing major shareholders. The challenge for those belonging to this category is whether they can act independently and perform their legal role or succumb to the expectations of the shareholders who are represented by them.
Risks could also be mitigated if the corporate governance arrangements operate effectively. For example, in the case of acquisitions of assets, the independent directors should ensure proper due diligence is conducted and the valuation of the assets is determined, for example, by professional valuers.
Any related-party transaction has to be scrutinised in the same manner with other similar transactions. If any of these steps is committed, the independent directors should vote based on the facts and have the interests of the company as a whole in mind.
Management could also play their role in providing supporting facts in situations where the interests of shareholders would collide with the business viability of the company. In cases where unfavourable dividend policy is proposed, clear facts on how much capital is needed based on the agreed strategic plans and the consequences if the company is under capitalised must be presented before the board, so they can decide with their eyes open.
Hence, when the board considers the effectiveness of the risk management practices of the company under their care, the potential risks coming from their shareholders should not be discounted and have to be mitigated in ways similar to other risks.
This article was published in The Malaysian Reserve in the column Boardroom View http://themalaysianreserve.com/new/story/can-shareholders-pose-risks-their-own-investments