Domini Stuart investigates what makes a director independent and whether independence adds value for shareholders.

    The idea that the majority of directors of a listed public company should be independent is relatively new.

    “Before the 1970s, boards of directors were presumed to be management in committee, helped by people who could make a specific contribution – for example, by having useful contacts or an understanding of the industry,” says Professor Robert Austin, head of corporate HQ advisory at Minter Ellison (Twitter @minterellison).

    More recently, a series of catastrophic corporate governance failures around the world triggered widespread changes to regulation and policy, including new requirements for director independence. In Australia, the 2003 Australian Securities Exchange (ASX) Governance Council guidelines recommended that a majority of the board should be independent directors. Any company that fails to comply must disclose this fact in its annual report.

    “The requirement for director independence is solidly based on the need for fiduciaries to not be in a state of conflict between their personal interests and those who they serve, which is also known as the conflict rule,” says Dr Ulysses Chioatto MAICD, executive director and head of research Australia and New Zealand at Institutional Shareholder Services (ISS).

    According to the ASX council, independent directors are not members of management and are free of any business or other relationship that could materially interfere with – or could reasonably be perceived to interfere with – the independent exercise of their judgement. They hold less than five per cent of stock in the company and have not worked in an executive capacity for the company or an associated company for at least three years.

    “While the sentiment captured in the ASX definition of independence is fair and reasonable, shareholders – and companies – would be well advised to be pragmatic when considering the suitability of any one particular director,” says Karin Halliday GAICD, corporate governance manager at AMP Capital Investors (Twitter @AMP_AU).

    “AMP Capital will not vote against a director due solely to a lack of independence. What is important to us as shareholders is that the board as a whole is constituted in such a way that it can effectively govern the company on our behalf and can reasonably be expected to act in the interests of public shareholders. We are more interested in the sum of the parts than the independence of individual directors – the experience, diversity, skills, effectiveness and independence of the total group. However, I do admit it is often very difficult for shareholders to make that judgement from the outside.”

    No one definition of independence could be expected to apply to all companies in all situations. Investor relations experts, fund managers, investors and proxy advisers are all likely to have different views, as are directors themselves. Investors’ beliefs and time horizons will also affect their expectations.

    “We represent investors with a very long-term view,” says Amanda Wilson MAICD, managing director of Regnan (Twitter @Regnan_ESG). “Most are managing money on behalf of superannuants who may not see the results of their investment for decades. For them, it’s important that boards are not motivated to maximise short-term gain at the expense of long-term value creation.”

    She agrees it is not easy to assess directors’ independence of thought. “This is why the definition needs some tangible indicators, such as tenure limits,” she says.

    If proposed changes to the ASX corporate governance guidelines are adopted this year, directors who have served more than nine years with any one company will be no longer be considered independent.

    However, that would not necessarily exclude them from the boardroom. ISS did not consider David Crawford to be independent when he applied to extend his 10-year tenure on the board of BHP Billiton last year, but it did support his re-election.

    “We strictly apply a policy of majority independence in terms of the board and all committees,” says Chioatto. “But it is also a matter of policy that we consider the suitability of directors on a case-by-case basis.”

    Austin finds it hard to imagine how boards could do their job of monitoring and controlling management if they are not independent from them. But Dr Simon Marais, managing director of Allan Gray, makes the point that while directors may be independent of the company, they are unlikely to be independent of each other.

    “They’re often friends, they may have worked together before and they’re very often known to the CEO before they join the board,” he says. “All of this is wrong, in my opinion.”

    He also believes directors should have a real interest in the company. “I think it’s a good thing for directors to have a substantial stake in the organisation as long as they don’t do anything to promote their shareholding at the expense of others,” he continues.

    “Shareholders all have skin in the game and they’d like nothing more than for directors’ interests to be aligned with theirs.”

    A recent report by Macquarie Equities, based on data provided by ISS, showed that companies whose directors are substantial shareholders outperform the market.

    “These findings coincide with an announcement made by Suncorp that directors must own at least $200,000 of share stock,” says Chioatto. “The theory is that directors with skin in the game are more motivated to improve company performance and there is a significant body of literature supporting this theory.”

    AMP Capital encourages directors to hold ordinary shares in their companies. “These are the same as those held by shareholders,” says Halliday. “We discourage companies from issuing identical incentives to non-executive directors and senior executives because directors’ allegiance should be to shareholders, not management.”

    However, Chioatto is concerned that having skin in the game can compromise a director’s independence. “They could be conflicted,” he says. “Where employees’ or directors’ remuneration is based predominantly on ‘gaming’ their performance, there is a risk that they may resort to unethical behaviour. It could be argued that a material conflict of interest arises where an individual who holds a large package of shares is also responsible for signing off on financial statements and making strategic and transactional decisions. Having the director’s skin involved also brings into play issues of insider trading and breaches of related-party transactions by the director concerned; directors are themselves related parties when giving themselves financial benefits from the company assets.”

    There is also a danger that the significance of the investment could be disproportionate to its size.

    “Someone may not hold a substantial amount of the stock, but it could constitute all of his or her income and assets,” says Wilson. “This would call into question this person’s ability to be completely dispassionate about events such as major transactions.”

    Austin is concerned about the unresolved tension between the “five per cent” rule of independence and the law that allows a majority of shareholders to replace the whole board. “What corporate governance is saying to shareholders who have a controlling stake in the company is that, while you own enough shares to sack every director, you must allow independent directors to form the majority of your board,” he says. “There’s a conflict between corporate governance and the proprietary rights of controlling shareholders, and I don’t think we have the balance quite right yet.”

    Peter Swan AM, Professor of Finance at the University of New South Wales’ Australian School of Business (Twitter @UNSW), has described the requirement for a majority of directors to be independent as the most costly and disastrous regulatory change ever implemented in Australia by a private regulator. He argues that, by definition, independent directors are unlikely to have prior experience with the company and no recent experience. They may have no background in the industry and the part-time nature of the job makes it difficult to acquire a depth of knowledge comparable with full-time executives. Shareholders can suffer as a result.

    “This has nothing to do with the personal integrity of the directors – I believe they’re doing the very best they can for the companies on whose boards they sit,” he says. “I’m simply raising legitimate questions as to whether the governance council knows better than the shareholders themselves as to how the board should be structured.”

    Chioatto suggests that the kind of complex statistical analysis used by Swan fails to address the failures of oversight that prompted the change in regulation.

    “The mathematics of statistics is not good at identifying underlying causes. It requires some other form of judgement,” he says. “Correlation does not mean causation.”

    However, Swan counters that there is no verified link between lack of independence and the corporate collapses that prompted regulatory change.

    “It’s not clear whether there was a majority of independent directors on these boards or, if there wasn’t, whether there was a causal relationship between this and their failure,” he says.

    Others are concerned that Swan’s results could have been skewed by the success of smaller mining companies during the boom and the effects of the global financial crisis (GFC).

    “We controlled for miners and the fact that Australian banks performed relatively well during the GFC as well as every industry,” says Swan. “But, as I said last year, the study is far from perfect. That’s why I’m putting huge resources into upgrading the data and producing a new version we’re hoping to release soon.”

    His original research found that compared with other Australian listed companies, those which reshaped their boards in response to the 2003 listing rules lost almost $70 billion in value. However, before the rules came into force, few companies reported whether their directors were independent. “This makes it hard to know whether independent directors were already in the majority,” says Swan.

    “To clarify this, I’ve been assigning status to thousands of directors in the early 2000s, so the new version will be more rigorous in this respect. However, a lot of the earlier study didn’t depend on the ASX recommendations per se. It just looked at how lack of skin in the game, board independence and large boards can all conspire to reduce company performance.”

    Wilson is not surprised that companies with, for example, a particularly talented entrepreneurial majority shareholder, would sometimes outperform more independent boards.

    “But we also need to look at how the system of checks and balances, including the requirement for independence, has underpinned confidence in the market,” she says. “This is crucial for an economy such as Australia’s, with its mandatory superannuation regime. To some extent, most working Australians have been coerced into becoming shareholders. Many of them do not have the financial expertise, the understanding of the risks involved or a clear enough understanding of agency costs to make day-to-day decisions about their shareholdings. That is why we need some of these pesky rules.”

    At the same time, she concedes that a requirement for independence has the potential to inappropriately elevate it above other necessary and useful factors. “Investors certainly need to be able to be confident that a board is able to be disinterested when reviewing management proposals or performance, but the skills and abilities to do this well are distinct from ‘independence’,” she adds.

    In some Asian countries, it is very difficult to have a majority of independent directors because many listed companies are family controlled and, of course, the family wants the majority of the board to represent them.

    “In India, where 80 per cent of the companies listed on the largest stock exchange are family controlled, they have just passed legislation requiring a third of the board to be independent,” says Austin. “But even that is proving to be highly controversial.”

    Meanwhile, stock exchanges are big businesses in search of listings and this could force them to reconsider their own definitions of independence.

    “Alibaba is a Chinese company with 28 partners, founders and executive staff all insisting on their right to appoint the majority of the board,” continues Austin. “At the same time, they want the company to be listed on a stock exchange with the normal rule of majority independence.”

    When Hong Kong refused their application, they turned to New York and, in October last year, the New York Times reported that both the New York Stock Exchange and the NASDAQ stock market had confirmed they would accept a partnership governance structure where a group of its founders and top executives would nominate a majority of board members. Meanwhile, the South China Morning Post has reported that Hong Kong’s stock exchange could consider changing its listing rules to allow Alibaba and other technology companies to list on the Growth Enterprise Market. This also has special shareholder structures but, because it was established to help small companies raise funds and upgrade to the main board, it is something of a mismatch for the world’s largest e-commerce company with an anticipated value of more than $75 billion.

    “This raises the prospect that we might start to see exchanges listing companies with two alternative forms of governance,” says Austin. “Grade A would insist on a majority of truly independent directors, while Grade B would allow majority board representation of a controlling shareholder group or groups with skin in the game. If that happens, it will be fascinating to see whether the market values Grade A higher than Grade B.”

    Meanwhile, he believes the Australian system is working well for the larger ASX-listed companies.

    “I think independent directorships are an important concept for publicly owned entities and even superannuation boards, which is one of the centres of the debate now,” he adds. “But it may be necessary to modify the five per cent ownership limit to some extent and we may have to recognise that in other countries, including Asian countries, the independence requirement won’t be universally observed.”

    Twitter @DominiStuart

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