Investors look beyond top executives to guard against ‘known’ unknowns

From Enron more than a decade ago to Volkswagen this year, investors are often thrown by what some call “out of the blue” and “black swan” risks, or unexpected events that destroy shareholder value.

Some investors say these unforeseen events highlight the importance of non-executive directors in their role as risk managers in the policing of company policy and strategy.

Timothy Copnell, chairman of the Audit Committee Institute, which is sponsored by professional services company KPMG, says: “It has become harder for companies to manage risk as news moves so fast. If you make a mistake today, it is in the media very quickly and the share price can suffer.

“It puts non-executives under greater pressure to make sure they are on top of potential risks or news that can damage the company.”

John Roe, head of multi-asset funds at Legal & General Investment Management, agrees. “It can be difficult to foresee things as bad news can come out of the blue and surprise markets and investors. But a good board can make a big difference,” he says. “A strong board, which is challenging the executives and is on top of the possible risks faced by that company, will help a company produce better returns.”

A number of countries have raised the bar for risk management. In the UK, boards of listed companies must now include a “viability statement” in their reports to investors. This provides a broader assessment of long-term solvency and liquidity.

In essence, it means a company must state clearly that it is confident it will still be in business in three or five years’ time, taking into account its main risks and financial health. The board must also make clear that it understands the risks of the business.

This reporting obligation does not mean that accounting and fraud scandals such as that which engulfed Enron, the former US energy and services group founded by Kenneth Lay which crashed into bankruptcy in 2001, or the problems over carbon dioxide emissions at VW, the German car manufacturer, would have been spotted in advance. But investors say it can put extra pressure on boards to challenge executives on strategy, auditing and other contentious issues.

Mr Copnell thinks UK guidelines introduced in September will make it more important for a company to appoint the right people to their boards, and to ensure there is diversity in terms of experience, gender and background.

“Boards need greater diversity, including more women, and ever more varied experience in areas such as cyber security and emerging markets,” he says. “But even more importantly, you need a diversity of thinking. You need people who are prepared to get into the details and who know the right questions to ask.”

Roger Steare, corporate philosopher in residence at Cass Business School, who advises companies on ethics and management, says: “A board needs people with diversity of thought and an ability to adapt to their environment. This helps a company succeed.”

He adds: “It is not just about the board when it comes to risk management. A company also needs the right culture. A business where people are unafraid to speak out is more likely to manage risks more effectively.”

Clive Martin, partner at EY, a consultancy, says: “Culture, ethics, behaviour and corporate integrity go to the heart of building a good business and this is relevant on the board and every level at a company.”

Sometimes investors can decide to put pressure on companies to shake up boards that are perceived as failing to challenge the executive team over performance and risk management.

Earlier this year, New York activist hedge fund Elliott forced Alliance Trust, the Scottish investment group, to appoint new board members. Elliott, the largest single shareholder in Alliance Trust, felt performance of the Dundee-based group was poor, while costs and remuneration were too high.

It also felt the executive team, led by Katherine Garrett-Cox, was not being challenged strongly enough on strategy and policy by the board. Ms Garrett-Cox has since stepped down as group chief executive but remains at the company as chief executive of its investment arm.

James Maltin, investment director at wealth manager Rathbones, says: “Although the problems at Alliance Trust were a lot to do with performance and costs, you do need a board that challenges executives and makes sure risks are being monitored and understood.”

Mr Copnell thinks that boards and, as a result, company performances generally have improved in recent years. “Intuitively, I would say companies are better run than they were. This has been helped by the higher quality of non-executive directors on the company board,” he says. “There are always those ‘unknown’ unknowns, and managers and non-executives will still make mistakes, but there are more risk controls in place today, which should help company performance.”