Wednesday, 01 June 2016

Professor Paul Kerin photo
Professor Paul Kerin
Head of the School of Economics, University of Adelaide

    Does the way we elect directors maximise shareholder value? The majority voting system is in shareholders’ interests, but not always for staggered boards.

    Director elections

    Does the way we elect directors maximise shareholder value? Economic research confirms that our majority voting system is in shareholders’ interests, but not always for staggered boards, writes Professor Paul Kerin.

    Director election systems used around the world differ in voting rules and frequency. In Australia, the majority-voting (MV) rule is used and almost all boards are “staggered”.

    Under MV, a candidate’s “for” votes must represent a majority of votes cast by shareholders in order to be elected/re-elected in uncontested elections; in contested elections, the candidate receiving the most “for” votes wins. On “staggered” boards, directors are elected for multi-year terms and only some face re-election at each annual general meeting.

    The alternative to MV is “plurality”. Under plurality, shareholders vote “for” or “withheld” rather than “against”; the candidate receiving the most “for” votes wins. In uncontested elections, this means that a candidate receiving only a single “for” vote is elected. The alternative to “staggered” boards is “unitary” boards, under which all directors must offer themselves for re-election annually (unless they wish to retire).

    In the US, the proportion of S&P 500 companies using MV has skyrocketed from 16 per cent in 2007 to over 90 per cent today. The proportion of S&P 500 companies with unitary boards has risen from 40 per cent in 2000 to over 90 per cent today. These shifts have enabled economists to estimate the impacts of each on shareholder value.

    Economists estimate that a company’s decision to adopt MV increases shareholder value by about 1.5 per cent on average. A decision to “de-stagger” (adopt the unitary board model) increases shareholder value by 0.4 per cent. While these percentages may sound small, they equate to billions of dollars for large companies.

    It’s nice to have confirmation that MV is in shareholders’ interests. However, most of this evidence comes from the US. As Australia’s laws are more shareholder-friendly, the value gains from de-staggering may be smaller here.

    Some argue that exposing directors to more frequent shareholder votes strengthens their motivations and incentives to act in shareholders’ interests. Evidence seems to support this. Under de-staggered boards, the links between CEO performance, compensation and retention are stronger and fewer value-destroying acquisitions are made. Even on staggered boards, the shorter the average time to election of a board’s directors, the more sensitive CEO compensation is to performance and the more likely an underperforming CEO is to be fired.

    However, others counter that staggered boards provide stability and help promote a long-term focus. Nevertheless, evidence shows that de-staggering can create value even for large, complex companies, for which one might expect stability and long-term focus to be relatively important. Five years ago, Rio Tinto became one of the few ASX-listed companies to de-stagger when it adopted the UK Corporate Governance Code’s recommendation that all FTSE 350 directors face annual elections. This hasn’t generated stability issues.

    Some argue that exposing directors to more frequent shareholder votes strengthens their motivations.

    Boards and shareholders should be able to choose the director election frequency that best suits them. In the US, newly listed and innovation-oriented companies are more likely to retain staggered boards and their stronger need for stability and long-term focus may warrant this.

    However, the overall evidence suggests that many boards may find it valuable to consider whether they should de-stagger. By voluntarily exposing themselves to annual shareholder votes, a board’s directors would send a powerful signal to shareholders that they are acting in their best interests. This can raise shareholder value.

    Much of the change in director election systems overseas has been driven by pressure from institutional shareholders and proxy advisers. The momentum for change continues. The Toronto Stock Exchange now requires listed companies to hold annual elections for all directors. It is inevitable that Australian boards will face increasing pressures to de-stagger and should prepare the case for the defence if they chose not to, as it may be needed.

    This is Professor Paul Kerin’s last column for Company Director . The July issue will feature the first in a series of regular columns from the AICD’s newly appointed chief economist, Stephen Walters.

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