InvestmentsSep 21 2015

When you see a red flag, pay attention

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Every now and then the market sends a reminder of why corporate governance matters, and why investors need to pay attention.

Ask any governance expert, and many of them will tell you that the writing was on the wall for Afren many years ago. The Nigerian-focused oil company was listed on the London Stock Exchange, but has now gone into administration.

A glance at its board in 2011 said it all; as far as many investors were concerned, there was not a single independent director on it. One director received a monthly retainer for consulting services while serving on the audit and remuneration committees. Two directors had unexercised share options, a hangover from its days as an Aim-listed company and a governance no-no for main market companies. One previously worked at the company’s stockbroking firm, which also acted as its nominated adviser or Nomad for listing on Aim; and another director provided consulting services to Afren before he was appointed an ‘independent’ director.

Yet in true ‘comply or explain’ fashion, the company asserted that “the relationships do not interfere with the directors’ exercise of objective, unfettered or independent judgment or their ability to act in the best interests of our business”. Directors consistently received a high number of votes against their re-election, some as much as 41 per cent, but they continued to serve on the board. The company also regularly reported high non-audit fees paid to its external auditors – which in theory, can point to a problem with the independence of the auditor.

The remuneration report failed to receive majority support from shareholders in 2011 and 2013, with 40 per cent and 20 per cent support respectively. According to figures from Manifest, the proxy voting agency, Afren’s executive directors were granted £47m in options and shares from the time it was listed on Aim in 2005 until August this year when it went into administration. Many lapsed, but just under £20m was exercised. Directors received £29m in salaries, bonuses and fees in the 10 years since listing; executives made regular, unauthorised use of the company’s private jet; and Afren also notified the UK’s Serious Fraud Office over concerns relating to expenses payments earlier this year.

However, the directors were slick and well spoken. They had a good story to tell; they were a start-up oil company successfully operating in difficult countries where Shell and Chevron were struggling. Their approach was based on mutual respect and supporting local communities through resource development and corporate responsibility programmes. Investors wanted it to succeed.

But there was always something that just did not stack up. One red flag emerged in 2013 when Afren announced it had failed to disclose that the chairman, chief executive and finance director held personal shares in First Hydrocarbon Nigeria (FHN). Afren later purchased 18 million shares in FHN, providing them with a windfall paper profit of nearly $23m (£15m). It was a glaring omission but the directors shrugged it off as a case of bad advice and everyone moved on.

It was a little like a slow-motion train wreck – you can see it happening, but it seems as though no single action by investors is likely to stop the carnage. Several profit warnings, write-offs, defaults and firings later, investors have lost more than £1bn in just 12 months.

Governance is an essential but under-used risk management tool. Sadly, many more companies have displayed warning signs long before any problems materialised – Toshiba (where an accounting scandal forced chief executive Hisao Tanaka to quit), ENRC, Essar Energy, Olympus and even Tesco come to mind.

Investors need to remain diligent about monitoring these issues across FTSE 100 companies. The biggest red flags are ineffective chairmen, poor relations with shareholders, dominant chief executives, complex corporate structures with limited board oversight, use of creative accounting, and a toxic corporate culture. The symptoms are not hard to spot, but investors are sometimes hesitant to act on them.

Of course, not all companies will have gold-plated governance; there must be room for differentiation in the market. For example, governance at an entrepreneurial start-up will look very different from that at a FTSE 100 company. Investors will account for each company’s unique circumstances when they vote their proxies and engage with the directors.

But the lesson from Afren is clear: consistently poor governance and executive largesse is often the tip of the iceberg and a sign of scandal to come.

Ashley Hamilton Claxton is corporate governance manager at Royal London Asset Management