Corporate governance issues in the junior market

By Shellon Williams, GUEST COLUMNIST

THE ISSUE of good corporate governance is important in equity investing, but has received little attention locally.

As companies transition from privately held to being publicly traded, the need to establish a good corporate governance framework becomes even more relevant.

The junior market has been abuzz with activity with 11 companies being listed between 2010 and present, and there are indications that more listings are in the pipeline.

The junior market now has a total of 12 companies.

Local investors have displayed strong interest in these new listings as all have been oversubscribed.

The most recent offering was oversubscribed by more than J$575 million.

Despite strong investor interest, it is likely the case that most investors have not given much thought to the issue of corporate governance.

Investors in emerging markets tend to place greater focus on returns rather than the governance framework within which companies operate, despite the fact that the absence of a solid governance structure could adversely impact a company's long-term performance.

Studies have shown a strong link between good governance and strong profitability of publicly traded companies in both developed and emerging economies.

As such, the need for a proper corporate governance framework and adherence to good governance are not issues to be ignored by investors when they purchase equities.

Effective corporate governance underscores the importance of transparency in disclosures regarding performance, risk and the financial position of a company.

CONCENTRATED OWNERSHIP

Perhaps the most important aspect lies in the protection of shareholders rights and interests. Corporate governance can be thought of as having two levels: governance at the regulatory or legislative level entails the requirements stipulated by law and regulatory bodies, while internal governance standards adopted by individual companies are more granular and are intended to support regulatory requirements.

Locally, corporate governance standards are enacted through applicable laws, such as the Companies Act, as well as the Jamaica Stock Exchange (JSE) rules, which seek to provide guidelines for the conduct of businesses.

Junior market rules allow companies to raise between J$50 million and J$500 million in equity capital at initial public offering.

Junior market companies so far have raised an average of J$125 million on average, which results in little equity dilution and allows them to retain considerable ownership despite going public.

Currently, all junior listings are closely held considering that, in all except one company, the founders and connected parties retain at least 80 per cent of outstanding equity.

This means that the ability of minority shareholders to influence the direction of the company through active participation and the enactment of resolutions is limited, because shares are not widely held.

With lower shareholder representation in a closely held company, minority shareholders operate at the behest of majority shareholders.

The problem is compounded as statutory voting, the most common voting method where each share represents one vote, results in lower shareholder representation.

The fact that most junior market companies are closely held, does not automatically translate to weak governance. Rule 503 and 504, as well as company-level governance standards, should assist in strengthening their operating framework.

Rules 503 and 504, which speak to mentor and board-level requirements, add some element of structure to the operating framework of companies and assist in addressing possible violations that could emanate from concentrated ownership.

They require all junior market companies to have a mentor who acts as a compliance adviser to their respective boards. The duties and the responsibilities of the mentor as it relates to governance include establishing procedures and controls for the purposes of compliance with good standard of corporate governance, among them: holding regular board meetings, establishment of board committees - audit and remuneration, good fiscal discipline, and adhering to junior market rules.

Not well articulated

While the duties and responsibilities of the mentor assist in forming a good base for governance, the requirements set by the junior market are limited and are not well articulated when compared to the rules of international stock exchanges such as the New York Stock Exchange.

The Jamaican junior market rule relating to the board gives only a cursory view of recommended standards. Given the less than comprehensive nature of the regulatory standards, the strength of governance rests with the internal standards established by individual companies.

Close examination of these companies internal standards point to a less than favourable framework when benchmarked against international best practice standards.

In contravention of best-practice standards which recommends that 75 per cent of the board be independent and that the roles of CEO and chairman be separated, at least one company currently violates the latter recommendation.

All junior market companies have opted for non-executive directors as opposed to truly independent directors. Non-executive directors are not necessarily independent, as individuals in this category may be connected through family ties, which is an observable trend on the JSE.

They may also be affiliated with management or a part of a cross-directorship arrangement with another listed company.

The lack of true director independence can compromise the strength of the board and the subcommittees which are intended to further augment governance.

Subcommittees such as audit and remuneration are intended to strengthen the company's operating framework.

The independence of members is an important factor to weigh in evaluating the degree to which these committees are dedicated to achieving what is best for the company and its shareholders and to avoid improper influence by management and other insiders.

The independence of the subcommittees could potentially be compromised if there are insufficient independent directors.

This further increases the likelihood of committee members not having the requisite skill set given the small size of these boards and the pool from which members are selected, as well as conflict of interest as members may sit on multiple committees.

In fact, in at least one company, two directors sat on both the audit and compensation committees, which undoubtedly opens up the possibility of an impairment of governance.

The junior market has performed creditably considering the 66.57 per cent year-to-date return on the index. However, the importance of corporate governance cannot be discounted as the long-term performance of these companies may be adversely impacted if governance issues are not clearly addressed. The classic example of the failure of multibillion-dollar companies in the United States, such as Enron and WorldCom, provide a glaring reminder of the need for strong governance.

Although short-term returns are desirable, the absence of strong governance could have negative implications on long-term returns, considering that governance and performance are the yin and yang of successful organisations.

Shellon Williams is a research analyst at NCB Capital Markets.

business@gleanerjm.com