Keeping to the straight and narrow

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The Independent Online
NOW that Camelot has been chosen to run the National Lottery, one uncertainty has been settled. But in the run-up to November's launch a number of important questions remain.

Investors in the winning consortium - made up of confectionery group Cadbury Schweppes, security printer De La Rue, communications group Racal, computer maker ICL and US lottery operator G-Tech - will need to decide with some urgency what their view is of the potential cash flows and margins. And the analysis is complicated by the lack of practical experience in the UK of operating something of this type on this scale. Investors will also be mindful of the impact on many leisure stocks. The unknown factors are high, even allowing for detailed analytical observation of national lotteries in other countries.

Meanwhile, the regional electricity companies and the water companies are coming to terms with the impact of their regulators' price control regime over the medium term. With unprecedented security measures, the 'K factor' (RPI +/- %) is transmitted to those who need to know, or rather, those whom it is deemed necessary that they know.

Speculation has it that the water companies will be put under severe pressure to drive up efficiency rather than rely on 'inflation plus' pricing, though the demands for important infrastructure investment continue unabated. What will be the impact for the legion of investors?

The people who do know what the impact on share prices is likely to be, in all three scenarios I have given, are the directors of the companies involved. That is both obvious and essential. After all, they have a duty of care to their shareholders to plan for and achieve sustainable growth in stock value. They also have to align their own interests with those of their shareholders, whether individual or institutional - not necessarily the same thing.

Jon Moynihan, chief executive of PA Consulting, of which Sundridge Park is part, wrote in a recent issue of Financial Director about the difficulty of getting senior management behaviour to converge with the interests of shareholders. He explored the myths and reality of how organisations seek to align the interests of both. Among the myths is the idea that top management's incentives should cover 'a range of desired actions, not just the stock price'.

But according to Mr Moynihan, 'that is a good way to dilute beyond redemption the incentive to maximise shareholder value'. He adds: 'Unless the managers' wealth is entirely aligned to that of the shareholders, inappropriate incentives will creep in and more will quickly follow' - replacing the myth that 'if the entire market goes down, it's not my managers' fault so why should they suffer?'.

Now let's put both ingredients together. Directors and senior managers have access to commercial data that will affect the share price - whether K factor or winning the first round in the National Lottery stakes, for example. They also need to align their behaviour with the interests of their shareholders. Add the rules on insider dealing and the reputation of the City to the mix and you have a highly combustible brew. Unlike the biblical model, it is hard to see how to sort out what to render to Caesar.

At the heart of the matter is the unresolved debate on what constitutes the difference between corporate governance and management. The Cadbury Report set one viewpoint in train. The Institute of Directors is propounding another. Meanwhile, senior management share-dealing is a minefield of controls, ethics, mythology and confusion. How can the circle be squared?

Central to this is the question of the degree to which senior management share-dealing is open to interpretation by the markets. Some investors routinely follow directors' dealings. This is logical, if prone to short-sighted misinterpretation. Understandably, institutions relentlessly seek some bell-wether of fortune to protect their position. But surely this puts the wrong gloss on the link between directors' dealings and their interpretation?

John Kerrigan of Sundridge Park's financial team proposes a radical way forward, one that is intended to meet both Mr Moynihan's arguments for the alignment of senior management behaviour with the interests of their shareholders, and the proper concerns of the markets.

He says that if directors were required to give four weeks' notice of their intention to trade in their quoted company's shares, whether buying or selling, this would serve the widest interests of the markets and establish, arguably for the first time, a direct relationship between beneficial knowledge and behaviour.

The attractiveness of the concept is that transparency seems to serve the interests of all. Notably, he stresses the link between directors who commit themselves to significant holdings in their company and the ability of that company to attract quality equity funding. He adds that advance notification of directors' dealings would create a more positive climate for fund managers to invest, since risk is, to a degree, smoothed through the more certain correlation between price-significant knowledge and management behaviour.

Significance moves from the fact of the sale or purchase to the intention. Given the topical examples of the National Lottery, the K factor and innumerable other incidents of price-sensitive decisions, as well as the critical need for the City to find a better way to increase transparency, the Kerrigan proposition might well have found its time.

The author is director of marketing at Sundridge Park Management Centre

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