Australia’s activist awakening

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By Gabriel Radzyminski – Fund Manager, Sandon Capital

 

 

 

We consider 2018 to be a watershed year in Australia for what constitutes good governance and good, decent, corporate stewardship – but not as one might expect.

2018 will be remembered as the year when the great and good of corporate Australia (as well as perceptions of what constitutes good governance) were dealt a severe blow to their credibility by two events:

1. The report of the Prudential Inquiry into the Commonwealth Bank of Australia (CBA), commissioned by the Australian Prudential Regulatory Authority (APRA); and

2. The Royal Commission into Misconduct into Banking, Superannuation and Financial Services Industry (the Royal Commission)

Australia’s corporate governance practices have been shown wanting. The APRA inquiry was established after a number of very public stumbles by CBA, including a money laundering scandal. Among the many findings of the inquiry, several should act as a wake-up call to investors. The inquiry found, for example, that ‘there was not sufficient challenge from the board to group executives’[1] and that there was a general lack of accountability in the organisation.[2]

The APRA inquiry stripped away many of the long-held illusions (or perhaps delusions) of how good governance operates. Being a CBA director was one of the most prestigious directorships in the land. The inquiry has cost the CEO his job and several directors have retired. The Royal Commission then proceeded to make the CBA inquiry look like a walk in the park. So far there have been a number of recommendations of criminal prosecution of several companies, including specific executives, although no charges have yet been laid.

AMP was the first high-profile victim of the Royal Commission. Under cross examination, AMP executives admitted to charging fees to clients who had died and charging fees for no service (something other banks and financial services providers have also done). The CEO, chairman and several non-executive directors stepped down from their roles.

The insurance industry is now under scrutiny by the Royal Commission and, given the behaviour that has come to light so far, that industry is unlikely to fare much better than the banking and superannuation industries.

Failing standards

Governance, and particularly its failures, have been at the heart of many of the problems identified by each of these investigations. The APRA inquiry, by virtue of its terms of reference, provided insight into where and how problems began at board level’.

All and sundry, even government ministers, are now heaping (well-deserved) opprobrium upon those culprits who’ve been exposed. Prime Minister Scott Morrison was reported (when Treasurer) as describing the CBA board as ‘an ineffective board that lacked zeal and failed to provide oversight’.

Others, including some leading lights of corporate Australia, have sought to deflect responsibility onto shareholders, saying the mantra of shareholder returns are at fault. We do not agree. Ultimately, directors must shoulder the blame, but so too must the shareholders as they allowed the poor oversight to continue, largely unchecked.

Trust has been lost. Distrustful and dissatisfied customers eventually lead to the loss of shareholder value. Indeed, shareholders as a group may end up paying a price greater than the aggrieved customers of those miscreant companies.

Yet how can this possibly have happened? There are a number of possible explanations.

Benjamin Graham explained, when writing about a 1920s’ proxy fight, ‘the business of Wall Street was largely a gentlemen’s game, played by an elaborate set of rules. One of the basic rules was ‘no poaching on the other man’s preserves’.[3] Wall Street’s basic rule of the 1920s is well and truly alive in Australian corporate life today.

Unbalanced ecosystem

One of the challenges in Australia is that the size of the corporate gene pool is small. Most C-level executives, company directors and the investment analysts and fund managers covering those companies know each other within three, if not two, degrees of separation.

Acceding to the inner sanctum of the directors’ club, like any club, requires conformity and strict adherence to the club rules. Collegiality seems to have been misinterpreted by many to mean conformity. Those with directorial aspirations must play by the rules or they risk forfeiting those aspirations.

Changing club rules will prove difficult. Perhaps a more effective paradigm is to think of the corporate world as an ecosystem where balances change (and need to change) all the time. Perhaps the corporate ecosystem has been allowed to fall out of kilter and needs a change of balance.

“Shareholders are typically presented with a predetermined slate of directors for election, candidates not selected by shareholders, but rather by the incumbent board”

Prior to 1970, corporate boards around the world were dominated by inside directors, chosen and controlled by management. Their function was largely an advisory one, characterised by consultation activities. Following a number of corporate scandals in the US in the 1970s, the functions and structure of boards began to change. In particular, the concept of independent directors and the related model of a ‘monitoring board of directors’ was established. Marvin Eisenberg’s influential book published in 1976 The Structure of the Corporation was the first to espouse that the essential function of a board was to monitor the company’s management by being independent from it.

Australian governance standards were slow to adapt to the changes that occurred overseas. As a result of the excesses of the late 1980s, the Bosch Report recommended more independent directors on boards. In 1992, the Australian Securities Exchange (ASX) proposed the introduction of mandatory requirements for independent directors. However, the business community campaigned strongly against this. Following a number of high-profile corporate failures at the beginning of the 2000s, the ASX implemented a requirement in 2004 for listed companies to adopt a majority of independent directors.

Today, the focus of independence of directors seems to have evolved from an independence from management, to an independence from the owners of a company, the shareholders. There are numerous reasons why this independence from owners has evolved. We believe one reason lies in how directors are proposed and elected. Shareholders are typically presented with a predetermined slate of directors for election, candidates not selected by shareholders, but rather by the incumbent board. Corporate voting is more akin to a one-party state than a western liberal democracy.

We believe some shareholders have become too far removed from the companies in which they invest and this has contributed to increasing agency risks. At the same time, investment analysts and portfolio managers (and others) value close relationships with corporate management and directors.

Australian companies, especially our largest ones, have been largely immune to the attentions of activist investors. Other than BHP Limited, which was the target of a campaign by Elliott Advisors, a US activist firm, far fewer of Australia’s largest companies have found themselves in an activist’s cross hairs than the largest companies in the US.

We believe there are numerous factors that have led to this situation, but not because Australian companies are such exemplary performers. One factor that might contribute to this complacency might simply be due to the laid-back Aussie culture. Keep in mind that wonderful Australian idiom ‘she’ll be right’. This expression is often used to refer to something that will fix or correct itself in time.

Other factors that we believe may contribute to this complacency include the fact that Australian superannuation funds have been vocal (and effective) in reigning in some of the worst excesses of executive remuneration. Australian investors have a powerful tool at their disposal, referred to as the ‘two strikes’ rule. This rule, which allows shareholders to vote on a company’s remuneration report, means that any company that receives two ‘strikes’ (25 per cent or more of shares voting against the remuneration report) are obliged to call a general meeting to spill the board. Although there have been no successful spill motions at any large companies, the fear of public rebuke has led boards to engage with shareholders on remuneration matters.

A sense of ‘mission accomplished’ may have emerged among many institutional investors (particularly our pension or superannuation funds) as a result of their successes reigning in the excesses of remuneration. However, while remuneration is typically an easy topic on which to find consensus (typically, more is bad, less is good), we find that significantly more value is destroyed through errors of strategic commission and omission.

Sanction and confrontation, challenging at the best of times, become more difficult when the ties that bind risk being cut. The relatively small investment and business community means that Graham’s Basic Rule thrives and serves to protect the entrenched and the established.

“While traditional investors might be able to step up part of the way, we believe corporate Australia still needs the added scrutiny of a well-capitalised cohort of genuinely activist investors”

In all of this, shareholders should be asking serious questions of the effectiveness of the governance structures of these organisations. Although their customers have paid terribly for such transgressions, it is the shareholders who will ultimately pay the highest price. As customer trust is broken, shareholder value risks being eroded, by reduced prospects and to a lesser extent, class actions.

Part of the problem is that too much faith has been placed in the tenets of good governance. The main risk that governance seeks to mitigate is agency risk. Yet good governance alone cannot solve agency issues and the conflicts of interest these engender.

Tackling the problem

We believe the best way to mitigate agency risks is effective ownership. Frankly, this means harder and more time-consuming analysis of investment opportunities (which is increasingly difficult as pressure on fees and the move to passive management grows). A genuinely well-informed owner can test and challenge a company. This then allows for an adequate tension between owners, directors and executives.

A lack of proper and pro-active oversight of directors by shareholders is a large part of why governance may have failed. Just as a strong board overseeing management will bring out their best (and nip in the bud the worst), so too are strong forward-thinking shareholders needed to bring out the best in boards.

Directors are rarely judged by shareholders on the performance of their companies, rather they are judged by their peers in the board room. It is rare for a nominated director not to be elected. In 2017, we saw shareholders call for (and draw) blood at several companies, including two of our largest, BHP and Commonwealth Bank. For many directors, especially those at the highest echelons, this was probably an all-too-rare taste of shareholders expressing their displeasure.  Given the likely preliminary findings of the Royal Commission, there may well be more directors facing shareholder wrath.

Another way to foster some greater ‘tension’ might be to have more directors nominated by shareholders rather than simply by invitation from incumbent directors. This might serve
to create a class of director whose interests are not only aligned with, but also dependent on the satisfaction of shareholders.

We find very few people prepared to allow themselves to be nominated by us (as an activist shareholder) for fear of the consequences on their non-executive directors’ careers. They fear being perceived as not being team players and trying to circumvent the traditional path for board accession.

While traditional investors might be able to step up part of the way, we believe corporate Australia still needs the added scrutiny of a well-capitalised cohort of genuinely activist investors. Activists play a very particular role in the corporate ecosystem. They emerge as shareholders where more traditional forms of influence have not yielded change or where changes are occurring too slowly.

The activist investor will often focus on issues or fears that other investors dare not make public for fear of sanction. It is rare for an activist’s proposal to be completely unique. Instead, they are often proposals that other shareholders would like to see but are not prepared to fight for. The activist’s proposals may also be those considered by the board, but not prioritised by management (for many varied reasons).

Perhaps, when reading these words from the other side of the world, one might conclude that activism in Australia will never blossom. That would be wrong: all the factors we have cited above contribute to a very rich opportunity set for the activist investor.

Telstra Corporation, Australia’s largest telecommunications (and ninth largest) company, faced an enormous investor backlash at its recent AGM.  62% of those voting voted against its remuneration report – one of the largest such votes ever against a top company.

 

About the Author:

As the founder of Sandon Capital, Gabriel Radzyminski has been involved in the financial services sector for almost 20 years. He has significant investment experience across a range of asset classes. Prior to founding Sandon Capital, Gabriel held portfolio and overall management responsibilities for Specialised Private Capital Ltd, a boutique funds management business which at the time had $150 million of funds under management.

Gabriel began his career working for First State Fund Managers (now Colonial First State). He worked as an investment analyst for Godfrey Pembroke, was co-head of research at Berkley Group, and prior to founding Sandon Capital, was Head of Private Capital at Centric Wealth. He was a director of Centric Wealth Ltd from 2005-2007, a director of Specialised Private Capital Ltd from 2005-2008, a director of Berkley Group Holdings Ltd from 2004-2008.

Footnote:

1. Page 14, the Prudential Inquiry into the Commonwealth Bank of Australia

2. Chapter 7, the Prudential Inquiry into the Commonwealth Bank of Australia

3. J Gramm & G Radzyminski, Australian Governance Summit 2018 Reader, AICD Reader, Chapter 8 “The evolution of activism: is your board ready?  What we can learn from the rise of activism in America.”