Tougher regulation needed for UK listed company directors

A gap has opened up in UK regulation, leaving investors exposed to Companies Act and accounting issues without a clear remedy. Despite all the focus on governance and stewardship, investors are still getting nasty surprises. Tesco and Quindell are perhaps just the highest profile of those involved in further investigations. Making the stockmarket safer should be the responsibility of boards, regulators, investors and analysts. Recent events suggest each could be doing a much better job.

Accounting and governance issues are triggering some sharp share price moves. In some cases company updates seem to question all the previous analyst forecasts and board reassurance. Others have seen share prices trashed by short selling “research”, often from online blogs. Regulation seems focused on cutting costs for investors, rather than price formation, but risks may be rising. The stockmarket does not look a safe enough place for savers and index funds that rely on share prices being right.

This year has seen many AIM stocks crash, with the light touch regulatory approach called into question. But few investors are unscathed by these overnight surprises. Some other major companies, such as Rolls Royce, have delivered continuing disappointment, with a series of profit warnings. Even where there is no suggestion of accounting fault, a share price collapse points to a failure of communication or analysis. Oil and gas explorer, Afren plc, rapidly moved into administration last month, despite previous coverage by 27 analysts and reported revenues of almost $1 billion. None seemed willing to publish a critical view when it might have helped.

The FRC Stewardship Code envisages shareholder voting and communication with the board as a key tool to resolving problems. But shareholders in Afren did tackle its chair wi. th governance concerns, only to find out the limits to stewardship. Most shareholders, with small percentage holdings, can make little impact. Selling is still the easier course.

Instead, it has been left to the much-derided short sellers and more aggressive activist investors to drive change in the worst-governed companies. But, the last 9 months have been challenging for short sellers, too, with price corrections punctuated by sharp squeezes and often misinformation. After a long rise in the market, and losses on short positions, overall short interest is now low. Yet, viewed from the perspective of less sophisticated investors and index funds, short sellers may actually make the market safer. The quicker a share price bubble is punctured, the better. There is little value for continuing investors in excessively over-valued shares or unrealistic expectations.

Unfortunately, there can be powerful incentives for troubled companies to reassure, often supported by their Nominated Adviser or broker. Primary capital raising is what drives profitability in cash equities for all but the largest companies. If business problems trigger a need to re-finance, boards and their advisers are incentivised to avoid a share price collapse. This does not support good price formation.

What is needed are strong sanctions on those offering unrealistic and superficial reassurance. The focus should be on encouraging healthy debate on share prices, not on preserving unrealistic share valuations. Regulators operate in a political world, where there are repercussions for company failure, but the regime seems too generous to boards and advisers in bad businesses. Unfortunately, the current regulatory focus is typically on those who trade around the time of sharp share falls, and not on the previous pattern of company reporting.

Technology group, Blinkx plc, has fallen almost 90% in less than 2 years, yet initially the company’s response to online criticism was largely an attack on the professionalism and motives of the blogger. It seems that some of the new analysis is actually helping the market understand prospects better, and set the right share price.

At a time of increased regulatory concern about sell-side research, and who pays for it, accounting or governance problems have often been best highlighted by independent analysts or short sellers. They are usually criticised by boards and management for inaccuracy. But for some of the problem companies the truth has been nearer the independent assessment than the board assurances trotted out to comfort shareholders. There may be a role for encouraging more independent critique. There should be more scrutiny of use of shareholder funds in litigation against analysts and critics who question a business valuation or prospects.

Belated price formation may be painful for existing shareholders, but ETFs and passive funds are often ongoing buyers of shares, whatever the rating. Investors in these funds benefit from low costs, they but in major sell-offs such as resources this year or banks in 2008, they can take on more risk than they plan.

Perhaps regulators could make it easier for bloggers to enter the mainstream, provided conflicts are disclosed. There is a case for worrying less about the price of research than its quality, and whether there is enough publicly available analysis to make markets safe.

One indication that the market has become less efficient is in the outperformance by many active managers. The Investment Association statistics on its UK All Companies sector suggests active managers are winning on average over 5 years. It seems to have become easier for them to do the job they are paid to do; finding mispriced shares. That is good news for those who can pay up for that management – provided it persists – but does suggest there are new losers from mispricing. What is healthy for the active industry may in fact be a warning signal on market quality. Buy-side analysts may not have become suddenly much better at research, but instead are benefiting from the combined effect of index fund dominance, mis-reporting and low sanctions on those involved in that.

The odds appear stacked in favour of distressed companies raising more capital at high share prices. But big share price falls point to a risky market for the average investor. The regulatory stance should be tilted back in favour of good consistent price formation.

SVM Asset Management has positions in Tesco at the time of writing.

A version of this article was published as an Op-Ed September 2015.

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. I have no business relationship with any company mentioned in this article. The information presented in this article has been obtained from sources believed to be reliable; however, I make no representation as to their accuracy or completeness and accept no liability for loss arising from the use of the material. Articles and information do not represent investment advice.

Image credit; SFO, fair use, rights reserved.

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