Low Corporate Governance for Controlled Companies Part II

[vc_row][vc_column width=”2/3″][vc_column_text]Last week I demonstrated the interesting phenomenon of stock market investors who were willing to buy shares, and, in some cases, at a high price to earnings ratio, of companies that had openly stated that they were not interested in having independent directors, having a committee to nominate directors or a committee to review compensation terms for management. One more thing, these companies had little to no shareholder rights. Amongst the egregious governance dodgers are the little known Google (or rather, Alphabet, its parent), Berkshire Hathaway and Facebook.

ISS Governance, an independent corporate governance rating agency, gives NYSE and NASDAQ traded companies a quality governance score based on four pillars: audit and risk oversight, board structure, shareholder rights and Compensation. On a graduating scale of 1 to 10 with the latter being the lowest score and therefore demonstrating higher governance risk, Facebook’s governance score is a resounding 10! It gets a good score of 2 for audit but everything else slides into governance oblivion when board structure rated a 10, shareholder rights rated a 9 and compensation rated a 10.

How do these companies do this? Their capital structure typically has two classes of shares: Class A and Class B. So the owners of a private company who wish to go public to raise present or future capital, or help establish price discovery for the value of their shares, can still maintain tight control over decisions, while diluting their ownership using a dual class share structure. In a case like Facebook, Mark Zuckerberg owns only 18% of the common stock but has over of the 50% voting power, largely by structuring the class B shares that he owns to have ten times more voting power than the regular class A shares. According to a Forbes magazine May 2012 article titled “ Facebook Ownership Structure Should Scare Investors More Than Botched IPO”, these kinds of structures are fairly commonplace in Silicon Valley with the likes of Google, LinkedIn and Zynga. It is also noteworthy that other big brand names like Nike, Ralph Lauren and Estee Lauder have similar structures.
According to Investopedia, the common practice is to assign more voting rights to one class of shares than the other to give key company insiders greater control over the board and corporate actions. These super voting share structures are also good defenses against hostile takeovers where a party can purchase a significant quantity of shares on the open market as to demand a seat at the board table.

Controlled companies are able to do this because NYSE and NASDAQ rules permit these structures for as long as there is full disclosure at the Initial Public Offering stage, and further ongoing filing disclosures. These disclosures should state exactly what corporate governance standards the company is failing to comply with. Thus the American stock investor has to be savvy enough to research the share structures of the companies they wish to purchase before rocking up at the Annual General Meeting and making a fool of themselves demanding to see compensation policies for senior management and all that independent director nonsense that good corporate governance dictates.
But why should the ordinary Kenyan business owner care about all of this? Were such structures permissible on this side of the pond, then it’s fairly safe to assume that we would see more family owned businesses view the Nairobi Stock Exchange as a viable option for capital raising and price discovery without the requisite nuisance value that external shareholders are viewed to bring. A good example would be the supermarket chains such as Nakumatt, Tuskys and Naivas. Or the big local manufacturers like Bidco and Menengai Oil. The flip side of the argument is that without good corporate governance, the current cash flow issues clearly facing Nakumatt’s management would severely infect investor perceptions of other family owned businesses with opaque board structures and have a knock on effect on their market valuation. Controlled company structures require tightly run management practices that stand the test of economic vagaries. With only about 6% of American companies having these kinds of structures it demonstrates that it takes a special kind of owner to convince external shareholders to just forget about governance and put your money where our mouth is!
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Low Corporate Governance for Controlled Companies

Western Refining is an American company that operates as an independent crude oil refiner and marketer of refined products. The New York Stock Exchange (NYSE) traded company commands a price/earning ratio of 33.3, a dividend yield of 4.23% and a market capitalization of almost US$4 billion. In November last year its share price rose by 28% on the back of news that it was being acquired by another company Tesoro, its attractiveness being an efficiently run set of refining and distribution assets that were well distributed between wholesale and retail segments. But here is the interesting bit: Western Refining is a controlled company.

The NYSE defines a controlled company as a company of which more than 50% of the voting power for the election of its directors is held by a single person, entity or group and has rules for controlled companies.
So in one of their regulatory filings, this is what Western Refinery disclosed:
“Under these (NYSE) rules, a company of which more than 50% of the voting power is held by an individual, a group or another company is a “controlled company” and may elect not to comply with certain corporate governance requirements of the NYSE, including:

• the requirement that a majority of our board of directors consist of independent directors;
• the requirement that we have a nominating/corporate governance committee that is composed entirely of independent directors
• the requirement that we have a compensation committee that is composed entirely of independent directors

We presently do not have a majority of independent directors on our board and are relying on the exemptions from the NYSE corporate governance requirements set forth in the first bullet point above. Accordingly, you may not have the same protections afforded to stockholders of companies that are subject to all of the corporate governance requirements of the NYSE.

Mr. Paul Foster [and others] own approximately 55% of our common stock. As a result, Mr. Foster and the other members of this group will be able to control the election of our directors, determine our corporate and management policies and determine, without the consent of our other stockholders, the outcome of any corporate transaction or other matter submitted to our stockholders for approval, including potential mergers or acquisitions, asset sales, and other significant corporate transactions. ….The interests of Mr. Foster and the other members of this group may not coincide with the interests of other holders of our common stock.”

As of the time of writing this, Western Refining’s share was trading at $35.94 with an annual average daily volume of shares traded slightly above 1 million. The point is that there is a certain investor who cares less about how management is being compensated or monitored by an independent board and more about what their return on investment is, via capital gain on the share or dividend yields. I know you’re probably thinking who the black Jack is Western Refining anyway? It’s a random company I picked because it plays by the same rules as Warren Buffet’s Berkshire Hathaway, Facebook and Google. All these companies, and many more, are controlled companies trading on the NYSE. ISS Governance, an independent corporate governance rating agency, gives NYSE and NASDAQ traded companies a quality governance score based on four pillars: audit and risk oversight, board structure, shareholder rights and Compensation. On a graduating scale of 1 to 10 with the latter being the lowest score and evidence of higher corporate governance risk, Western Refining fares pretty well as it gets an overall score of 3, and pillar scores of 2 for audit, 7 for board structure, 2 for shareholder rights and 5 for compensation. Meanwhile, the Sage of Omaha Mr. Warren Buffet’s Berkshire Hathaway has an overall governance score of 8, with pillar scores of 1 for audit, 9 for board, 9 for shareholder rights and 4 for compensation. Alphabet, which is Google’s parent company has an overall governance score of 10, yes you read that right, 10 which is the lowest score, with pillar scores of 2 for audit, 10 for board, 10 for shareholder rights and 10 for compensation! Next week I’ll delve deeper into why this information should interest the ordinary Kenyan business.