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Policy Guideline:
NEW ZEALAND SHAREHOLDERS’ ASSOCIATION INC
LISTED COMPANY ANNUAL REPORTS
AND
TOPICS FOR ANNUAL GENERAL MEETINGS
Preface
Our organisation was established in May 2001 and our relative freshness on the investment scene will initially mean that there may be a number of what our members consider serious educational matters that should immediately be addressed. We make no apology for our lack of response to date; it is important that we give priority to those events that are of concern to the largest number of our members, or where the point of principle is so important we feel we must speak out.
For a long time New Zealand has been accustomed to a loose regulatory regime with our Securities Commission unable, through lack of funds, to embark on enforcement activities. We hope this position will soon change. However annual reports do not always provide the information that a shareholder wants, nor in the timeframe desirable.
We have concluded that we should as a matter of priority assist our members and the investing public into an understanding and interpretation of annual reports and several corporate governance matters. Our objective is to give members the confidence to ask questions and support fellow shareholders when they seek information.
The material that follows is our attempt to fulfil the above objective. We intend to update these pages regularly with new material and for assistance we will note the latest update at the end of the text.
Introduction
There is a perception that shareholders who ask questions at AGMs are usually those people who seek to get their name in the media and like the sound of their own voice. Possibly the criticism may have merit in certain cases but it requires a rare steely resolve for someone to stand up in front of possibly hundreds of fellow shareholders just to enjoy a moment of publicity. It is a fact that whatever lengths a company may go to in an effort to keep shareholders informed there will inevitably be the odd question. Many of these questions are not financially or market significant and may easily be dealt with by a call to the company. However there are occasions when a query at an AGM is the proper place for a shareholder concern to be dealt with. If the question is important it may be pointless, if you are earnest in your concern, asking the chairman to respond without prior advice so always put your query in writing to the company. That way you should not be disappointed by an evasive response.
You should be aware that the chairman will have been provided with a list of queries and answers by management and these will be discussed in detail before the meeting, so there are unlikely to be many subjects not already deliberated. You should also know that the minutes of previous meetings will have been considered as a reminder of what has previously been covered and the response made. Make sure your written query is mailed in time for the company to undertake research if required; the longer you give, the more detailed should be the answer.
Attendance
The fact that you are reading this paper is heartening because it is quite likely that one day soon you may consider attending and voting at an annual general meeting. It is your duty, if you own shares in a company, to make every effort to attend and vote at an AGM. It you are unable to attend then you should appoint a proxy to attend and vote for you or, at the very least, return the proxy signed with directions to the chairman as to how you wish to vote on each matter.
The Auditor
There have been proposals by various bodies recently that the audit firm charged with responsibility for reporting on the accounts of a listed company be changed at appropriate intervals - 5 to 7 years has been mentioned. We believe that it is far more important that the audit partner signing the audit report be changed rather than another audit firm to do due diligence in the knowledge that the job will change in say five years time. However, irrespective of any discussions on this topic, a change of auditor should be given the most critical scrutiny by shareholders. If the sole intimation of such change appears in the Notice of Meeting for the AGM without any reasonable explanation then we suggest that giving your proxy to the chairman of the meeting to do with as he or she thinks fit is inappropriate.
The Audit Report
This report should be one of the first pages to turn to when opening an annual report; a word of explanation.
When the 1993 Companies Act was being considered the legislators decided that qualified audit reports should receive a greater degree of attention than had previously been the custom. As a result, Section 16 of the Financial Reporting Act 1993 included a clause that all qualified audit reports should be forwarded by the Registrar of Companies to the Securities Commission and the Accounting Standards Review Board. The legislators realised in their wisdom that there may be some difference of opinion as to when an audit report is qualified and they therefore regulated that auditors should clearly state whether an audit report was qualified or not. The result of this decision has been that ever since the regulations became law the report of only one listed company has so far received a qualified opinion. Investors should therefore be aware that a realistic qualification will be found immediately above the title ‘unqualified opinion’. For example the direst qualification will be found under the description ‘Fundamental Uncertainty’.
You should therefore look immediately above the words ‘Unqualified Opinion’ for any truly important matter affecting the viability of the company that the auditor wants you to consider.
As a matter of interest an auditor is also required to refer in the audit report to any conflicts of interest and the existence of any other relationship with the reporting entity.
Please also be aware that the auditor is appointed at an AGM and the term runs to the close of the following AGM when automatic reappointment takes place unless the auditor does not seek reappointment. In practice except for resignations, retirements or other factors that lead to a casual vacancy, you will never have an opportunity to vote for or against the election of an auditor for the simple reason that the Act permits the incumbent auditor to continue in office. However if you note that there is a different auditor from the previous year (see the remarks above) this is a matter for a question to the chairman. You may also, through the chairman, wish to make an enquiry of the previous auditor if there were reasons for the firm not seeking to continue in office.
Cash Flow
Sometimes an unexpected variation in net Cash Inflow from Operating Activities compared to the disclosed results can force you to re-examine the financial statements. A good example was the 2002 annual report of Horizon Energy Distribution Limited. Here the company had been in extended litigation with Todd Energy Limited for which a provision of $2 million had been made in a prior year.
The court ruling favoured Horizon and the provision was reversed in the current year. The only indication of this matter was a brief comment in the chairman’s report and a contingent liability note to the financial statements. The future maintainable results were therefore some $2 million less than shown by the financial performance report, which amount was not indicated in that report. The unfortunate point for investors is that the newspapers have taken the disclosed profit as being the right figure with the result that the p/e is 50% lower than it should be.
The Chairman’s Report
Sometimes this may be described as ‘Letter to shareholders’ in which case it will be expressed in a less formal manner. Whatever the description the statement made by the chairman is important because this is where you will find the assessment of prospects for the future.
Chairmen seldom go out of the way to give any great expansive commentary on what is expected for the next year. These days speed of progress and outside forces usually tend to make conservatism the preferred choice. It is a pity because shareholders are entitled to be advised what management are forecasting for the year ahead. The Board after all, knows these figures and there seems no reason why, given real time disclosure, a guideline figure cannot be revealed. Comments such as ‘although the short-term prospects are difficult to forecast with precision I am sure that the group will continue to deliver consistent and increasing value to its shareholders’ and ‘Whether the same level of profit can be achieved next year depends to some extent on circumstances beyond our control’ do little to generate insight, particularly if repeated for years on end.
The Chairman’s Report should also be viewed for two other important matters for shareholders: the dividend policy statement and the level of debt to equity that the Board have fixed as the target for the company. Both these matters are considered elsewhere in this paper. If you can find no mention of these matters a question to the Chair is called for.
Debt
The definition of debt in this context is all interest bearing debt. Shareholders should be aware that every well run company may have an element of interest bearing debt as part of its financial armoury. There are a number of reasons. The first and most important is taxation - see below. The second is that a second pair of eyes will have an interest in the prosperity of the company. So long as the bank does not seek to lend too much or take too much security shareholders should be pleased that the procedures the bank puts in place will act as a barometer for the ability of companies to borrow. A third party review by professional analysts will ensure that the business is being properly run. Banks take great care over corporate lending, after all they too have a responsibility to their depositors as well as their own shareholders.
It is however important to ensure that debt is kept within strictly controlled guidelines. Look in the corporate governance statement or the chairman’s report for indications of the policy on this subject. It is possible that it may not have been disclosed in the latest annual report in which case a question as to what the Board policy is on the relationship between debt and equity is a good starting point.
Each industry and company within that industry will have its own perception as to the maximum debt levels desirable. It has not been unknown for some CEO’ to refuse to have any debt at all in their accounts because they have had an unfortunate experience with banks in the past and refuse to be in any way beholden to them in the future. This is a point of view that whilst being understandable is nevertheless unfortunate because there is a clear and undeniable benefit from using debt and that is the interest is usually tax deductible whereas dividend distributions are not.
Directors
It is obligatory for listed companies to include in their annual report particulars of directors and the other directorships that may be held. Many companies, indeed far too many, seem reluctant to expand on the limited information that the law requires. Thus at the time of the AGM it is often difficult to determine the reason for inclusion as a director.
It may seem relevant to question this and of course if you ask about the introduction of a lady director you will be provided with Standard Answer No 1 which is that the matter will be considered for next year.
A way of avoiding this step and at the same time gauging the capability of a director is to ask the chairman to let each director who is up for re-election (and all those whose appointment is being considered for the first time) to address the meeting and tell shareholders how they are able to contribute to the experience and knowledge of the Board. The question should be asked after the resolution for the election of each director is seconded.
This question rarely needs to be repeated at future meetings as those directors subjected to this query will ensure that in future annual reports will include sufficient information for shareholders to be able to assess the worth of their representative.
There is one further aspect about the appointment process that may be relevant. It is very rare for the Board to give explanations as to the process undertaken to search for new directors. The board of Tranz Rail was almost completely renewed in 2002 and yet the process by which new candidates were selected and chosen received little comment.
The appointment and reappointment of directors is the single most important matter that shareholders are called upon to consider and it is one that this Association will be concentrating on in the near future. Our colleagues across the Tasman, Australian Shareholders’ Association pinpointed the dilemma of shareholders of a listed company whose performance is mediocre. David Jones Limited, the retail store had suffered poorly performing financial statistics since 1996 and the chairman of this company had been on the Board for that period of time. The ASA advised that all undirected proxies given to their representative would be voted against the re-election of the chairman.
Dividends
The chairman’s message will give shareholders details of what has been decided in the way of dividend payments for the period under review. Due to a recent change in accounting practice it is now no longer possible to find this item in either the Statement of Financial Performance or the Statement of Movement in Equity for the simple reason that it is no longer accepted accounting practice to provide for the final dividend until it has been passed by the Board. Unless a Board declares a dividend prior to the year end it is unable, other than by way of note, to advise the rate and amount of a final dividend.
A company with good corporate governance will advise shareholders what the Board policy is regarding dividends. The days are long since gone when a chairman can stand up and say the payment of a dividend is purely a matter for the Board. Dividend policy is usually expressed as a percentage of the net profit after taxation. It will probably be hedged with cautionary words such as “the amount of dividend in any year will be dependent on the capital expenditure requirements of the group”. However given the restraints and reservations indicated in the policy statement, shareholders are entitled to know what dividend expectations are in store for the future. Any shareholder is perfectly entitled to ask about dividend policy and if not set out in the annual report then to be reminded of what is stated in the policy.
Intangible assets
This heading covers such items as Brands, Goodwill, Newspaper Mastheads, Research and Development, Patents and Copyrights.
The distinction between brands and goodwill is somewhat nebulous but where they are both included in the accounts their treatment is different. Goodwill has to be amortised over a period of not more than 20 years. On the other hand Brands do not have to be amortised at all. They may be revalued every year and any difference is taken directly to reserves. Mastheads are treated in a similar fashion to Brands.
Brands may represent a very substantial part of the assets of some companies and it is surprising how little information is disclosed in the accounts about the names of the brands involved, who undertakes the valuation, the basis for such valuation and the reasons for any appreciable change in values in the period. This item can stand some careful questioning by shareholders.
The Managing Director’s Report
You will generally find that this report will deal with the operational activities of the business and may cover market share, divisional results and the integration of new acquisitions. These days, the report may also mention environmental, health and safety matters. In fact if any of these activities are not mentioned and the company business is dependent on a good and unblemished record in any of these areas then a question on one of the topics would not go amiss.
We are sure now and again you will have seen mention of executives complaining in their annual report that the share price of their company does not reflect the true value of the business. The comment may infer that the market is being unreasonable and does not understand the operations of the company. These comments are usually made because the company has under-performed and this has come as a surprise to the market which has marked down the share price appropriately or there are other risks, maybe associated with too much debt, that company management refuse to recognise. It has been shown that nine times out of ten the market will eventually be shown to have made the correct prediction. Be very suspicious when managers blame the market!
Related party information
Details under this heading will be found in the Notes to the Financial Statements. The information will contain the conflicts of interest disclosures concerning dealings that the majority shareholder, management or directors may have when transacting business with the company. The longer this statement the more thoroughly shareholders should spend reading the transactions. It is not unknown for a Board to set up a Related Party Committee of independent directors to review and approve all related party transactions. Frequently after describing a transaction there will be a statement that ‘the transaction was in the ordinary course of business and at market rates’. The problem with this statement is that there is sometimes no means of establishing what the market rate may be at that time. This is specially true of services where there has been no competitive tender process. If you are the minority shareholder in a company controlled by one organisation you should read this section with great care. Do not be reluctant to raise any questionable matter with the Board. If the information under this heading extends to several pages you should seriously review your holding in the company.
Shareholders
It is a requirement of the New Zealand Stock Exchange that the top 20 shareholders be listed in each annual report. This rule is useful for shareholders as the people who have a major stake in the company can be seen at a glance. To benefit even more from this requirement it is suggested that you always retain the previous annual report so that you can compare lists and familiarise yourself with any strategic change in ownership. Control is always very important since the direction of the company may change following any large movement in shareholding. As a rule of thumb effective control of a large organisation may be as little as 30% depending on the size of other shareholdings. Be aware also that substantial holdings in excess of 5% are also required to be disclosed but this information may not be on the same page as the top 20 list. If you have difficulty in marrying the two lists this is because the Top 20 List represents the names of the registered holders and these may be nominees whereas the Substantial Holding Notice must disclose the beneficial owner.
There is a long and so far unsettled debate as to whether directors should have a financial stake in their company. Career directors sometimes vehemently deny the argument that a director will take greater care if he or she has a financial stake in the company. Their view is that they are appointed to do a job and, so long as they are reasonably paid, a shareholding interest will make no difference to their decisions or attitude. What is undeniable is that real time disclosure of changes in the shareholdings of directors is of particular interest and the reasons for such movement, whether it is the taking up of options or selling in order to finance other enterprises will be open to question.
The information in this paper was completed on 27 May 2003 and will be updated from time to time on the Association website www.nzshareholders.co.nz
It was first distributed at the Association Annual General Meeting held on Tuesday 24 June 2003.
AGM queries
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