Watch Out For Dodgy Directors

By David McEwen

Monday 27th November 2000

New Zealand companies don't make money because they have bad managers and directors. That is an opinion commonly given by international commentators to explain why so few companies in this country consistently build wealth for their shareholders.

This view is open to debate but there is one distinction that investors should be aware of. That's the difference between the directors of a listed company who are working in the best interests of shareholders, and those who are working in the best interests of themselves. The performance of companies and their share prices under the latter tend not to do so well in the long run.

According to the newly released second edition of investment book "Making Money on the New Zealand Sharemarket" by Frank Newman and Phil Briggs, some people are drawn to the boards of companies solely by the opportunities to enrich themselves.

They achieve this through a number of "scams" such as the following:

a. Management fees
Rather than take a straight salary or directors' fee, some businesspeople organise lucrative management contracts for themselves. There is usually very little explanation of how the prices of such contracts are determined and it can be hard for investors to know whether their company is getting good value.

b. Reverse acquisitions
Businesspeople buy a controlling interest in a low-quality (and thus cheap) listed company then sell credible business assets into it in return for shares. Then they launch a public relations blitz that persuades other investors that the company has a bright future. When the price moves up, the directors sell, making huge profits virtually overnight.

c. Rights issues
A director, or a company in which they have an interest, acts as an underwriter for a heavily discounted rights issue.

The director wins two ways. Firstly they pick up an underwriting fee on an issue that is so heavily discounted that it didn't need to be underwritten, and secondly, they pick up the unsubscribed rights.

Invariably some rights are not taken up, simply because some shareholders may be away, have moved or they simply forgot.

The book warns investors to beware especially of companies making a heavily discounted cash issue with a short acceptance period that closes during the Christmas break.

d. Incentive schemes
Directors allocate themselves options or partly paid shares as an incentive to boost the share price. Options cost nothing while partly paid shares cost only a tiny fraction of their worth with the balance payable in a few years' time. The hope is that by then the share price will be much higher than the purchase price of the shares under option or that have been partly paid. This allows the shares to be sold immediately for a healthy, no-risk profit.

These "scams" that the book talks about are legitimate business tools when used properly. Their use by any company is not necessarily evidence of improper or unethical behaviour.

However, there is potential for them to be abused and there is no doubt that in the past this has occurred.

To avoid such abuses taking place, investors should look out for companies with a high percentage of independent or non-executive directors and a comprehensive corporate governance regime.

David McEwen is an investment adviser and author of weekly share market newsletter McEwen's Investment Report. He is commissioned by the New Zealand Stock Exchange to write an independent personal investment column. He can be reached by email at davidm@mcewen.co.nz.

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