When Directors Go Bad

Published in Investing on 14 December 2009

How can you spot the signs of excess in the boardroom?

If you own shares in a company you need to pay attention to your agents. Unfortunately these agents are nothing like James Bond, particularly when it comes to a sense of duty and honour, and sometimes they are more like the stereotypical football agent whose primary concern is maximising their own take whilst the devil takes the hindmost.

Shareholders' agents are the directors of those companies in which they have invested. The directors of a business collectively form the mind of the business and an investor's returns will to some extent depend upon their actions. Unfortunately some directors are far more interested in feathering their nests than in looking after the interests of their shareholders.

Shareholder Abuse

In a few companies the directors act first and foremost in their personal interests, treating the company as their private fief whilst ignoring the shareholders as much as possible. These directors are invariably overpaid, have a tremendous array of perks and their bonus schemes require little or nothing in the way of performance and, of course, are invariably nodded through by their cronies on the board. Sometimes in order to discourage those pesky shareholders from asking awkward questions, the company's annual general meetings are held at extremely inconvenient times and/or in remote locations (e.g. on Christmas Eve after the trains have stopped running).

In the last two years it has become apparent that many directors in the financial sector, both in Britain and America, made decisions which were primarily for their personal financial benefit. In these instances management paid themselves massive bonuses for total failure as their companies collapsed around them, only to have the gall to return to the trough for more bonuses.

In principle shareholders with large stakes in a company should be able to influence the directors but all too often this is impractical because they are unable to exercise day-to-day control over the directors (and other shareholders might not feel the same way in any event). All a dissident shareholder can do is sell up.

Corporate Piggery

One of the more outrageous examples of corporate piggery was seen in the case of Tyco International which resulted in the CEO and another director being sentenced to 25 years of jail time back in 2005. These executives defrauded over $150 million by treating Tyco as their "personal piggy bank." This included paying themselves unauthorised bonuses, charging half the cost of a $2 million dollar birthday party to the company, having Tyco pay over $14 million for their impressionist paintings and also spending $15,000 on a "dog umbrella stand" (don't ask me what that is).

Better known in Britain is the story of Conrad Black, the former owner of the Daily Telegraph and chairman of Hollinger International, who was convicted in 2007 for stealing $6.1 million from the company. Amongst the things that Black charged up to Hollinger were his wife's designer handbags and $42,870 for her birthday party (more details of the excesses can be found here). MPs seem quite well-behaved in comparison.

Spotting The Dodgy Directors

How can you spot shareholder abuse? A good example is where directors' pay is well out of line with what comparable businesses pay, or where they are getting massive pay rises, bonuses and perks which bear no relation to performance. Backdating share options awards and/or "rebasing" (cutting) their exercise price is another sign that the directors are living it up at their shareholders' expense (your share purchases won't get the same treatment). If the directors hold no shares, or just a trivial stake in the company, that's also a sign that they might be pigging out at their shareholders' expense!

Companies which operate a two-tier share structure, where one class of shares has extra votes, are another form of shareholder abuse. This is most commonly seen in formerly family-owned companies where the family wanted to sell some of their stake but still retain control of the company. So whilst the second-class shareholders own the majority of the company they only have a minority of the votes so the directors can totally ignore them.

I've found over the years that if an annual report contains lots of photographs which have nothing to do with the business, particularly of scenery, fountains, corporate jets and/or helicopters, or if the report trumpets totally irrelevant factors such as the Chairman's wife's charity work, these are strong signs that the directors don't really work for the shareholders. Going to the AGM can be useful; it can give you hints as to the directors' behaviour (how they treat others, do they appear to be particularly shifty, etc.).

How To Fix It

Whilst the vast majority of private investors do not have sufficient clout to make directors change their ways, increasingly groups of private investors who collectively own a significant stake have been able to effect changes, including removing directors who have had their noses in the trough. The internet has greatly helped in this and some regulars on The Motley Fool have in the past organised action groups which have changed directors' behaviour at smaller companies.

Unfortunately most of the time all you can do when they discover that the directors are fleecing the shareholders is to sell up and go elsewhere.

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Comments

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MrContrarian 14 Dec 2009 , 8:40am

if an annual report contains lots of photographs which have nothing to do with the business, particularly of scenery, fountains, corporate jets and/or helicopters, or if the report trumpets totally irrelevant factors such as the Chairman's wife's charity work, these are strong signs that the directors don't really work for the shareholders.
Excellent!

CGDaveS 14 Dec 2009 , 9:13am

Going to the AGM can be useful; it can give you hints as to the directors' behaviour (how they treat others, do they appear to be particularly shifty, etc.)

Do they even turn up?

rober00 14 Dec 2009 , 5:20pm

Many companies now video and/or record their AGM presentations and make them available shortly afterwards on their web sites. These often include the subsequent question and answer session which can be useful.

If they do not then one might question why!!!

henrybenson 16 Dec 2009 , 12:16pm

Nothing will change until the law requires that pension funds and institutions can only cast votes according to the wishes of their constituent shareholders and enforced blanket proxies in favour of such institutions are disallowed.

gordonbanks42 18 Dec 2009 , 3:38pm

henrybenson:

If you are saying that you advocate such a measure, then I agree. It would take a lot of sorting out logitically, but I think it's important that with so many shares being held by pension funds and collective investment vehicles of one sort or another, voting should reflect the wishes and interests of the beneficiaries (us), not the institutional investment managers.

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