Investor Perspectives on independence – demand for flexibility and ‘skin in the game’

Investors want directors to hold greater equity in the companies they govern – to a point. Are more flexible ‘rules’ on director independence needed?

Institutional investors talk about the need for “competent” directors, not only independent ones, and for boards to have more “skin in the game” so that their interests are better aligned with shareholders. But these broad-based arguments often lack precision.

For example, how much equity should directors hold to ensure their interests are aligned with shareholders? At what level does equity ownership weigh on board independence and risk good governance? And should equity ownership be based on the company’s situation?

The concept of a “competent” director is equally vague. The notion of competence is as much based on how directors interact with their peers in the boardroom as it is with their demonstrated experiences and skills. How can boards signal this internal boardroom dynamic?

Skin in the game

The Australian Council of Superannuation Investors (ACSI) argues that well-structured boards require directors to hold equity in the company they govern. But nearly 11 per cent of non-executive directors in top 100 ASX-listed companies had no equity, found ACSI’s latest Board Composition and Non-Executive Director Pay in ASX 200 Companies report.

“This is a poor result and we hope the number begins to improve,” said ACSI CEO Louise Davidson. “While we don’t mandate how many shares an individual director should own, we do believe that having skin in the game aligns directors more closely with the investors they represent.”

ASX Corporate Governance Principles and Recommendations suggests that a director who has a substantial shareholding in the company they govern, or is associated with one, may not be deemed independent. Section 9 of The Corporations Act defines a substantial shareholding as 5 per cent or more of the total number of votes attached to voting shares in the company.

Ed John, Executive Manager, Governance Engagement and Policy at ACSI, says assessments of a director’s ‘skin the game’ must be situational and not based on arbitrary rules. “The key is that directors hold some shares in the company they govern, providing stronger alignment between their interests and those of shareholders. We don’t set arbitrary limits but we have regularly seen directors who have sat on a board for 10-15 years and not bought a single share in the company. It’s unacceptable for directors to have zero or a bare minimum of shares in companies which they govern.”

The 5 per cent cut-off for independence (based on substantial shareholding rules) should be flexibly applied, says John. “We look at board representation against the level of ownership and the contribution of the individual non-executive director to the board.”

John views the concept of ‘skin in the game’ and ‘director independence’ as fundamentally different issues. “ACSI views skin in the game as an issue of alignment between boards and shareholders. Board independence is about making decisions in the best interests of the company, and managing potential conflicts of interest such as related-party transactions.”

Right mix is key

Institutional investors, says John, are shifting the independence debate to a conversation around board quality, diversity and competence. “Investors want to know that the board has the right mix of directors with the right skills, and sufficient diversity to avoid the risk of groupthink. That is more important than structural definitions of director independence.”

John says the oversight of related-party transactions is a key indicator of board independence. “For example, how does a board deal with transactions involving major shareholders or the company’s founder? We have seen plenty of examples where these issues have compromised the interests of minority shareholders in ASX200 companies”.

Leading governance analyst, Pru Bennett, head of BlackRock’s Investment Stewardship team in Asia-Pacific, also believes director competence is a bigger issue in board assessments. “Independent does not always equate to competence and our focus is on competent directors.”

Beyond structural definitions

Martin Lawrence, research director at proxy adviser Ownership Matters, says the 5 per cent substantial shareholding test for director independence does not work for all companies. “A director who owns 1 per cent of a bank stock would have far more of their wealth tied up in the company compared to another who owns 5 per cent of a small-cap stock. The bank director might be overly aligned and incapable of independent governance.”

He says director independence tests should be considered “rules of thumb” and adds: “The only people who truly know if a director is independent in their thinking are the other directors who sit around the boardroom table. The board signals its independence through its actions.”

Lawrence says executive pay is still the best test of board independence. “The reason proxy advisers pay so much attention to executive pay is because it is one of few places where you see evidence of the contest between the board and management. Boards that don’t stand up the CEO on pay, and don’t make CEOs accountable for performance, clearly lack independence.”

Regular meetings with institutional investors and proxy advisers are another way boards signal their independence to the market. The ASX Corporate Governance Principles suggest that boards publish a skill matrix in their annual report, which lists director skills, and this is encouraging more debate on current and needed board competencies.

However, Lawrence says the governance community is not ready for a genuine debate on director competency and judgement. “Whenever investors question the bona fides of a director seeking re-election, they are inevitably told by the board that the director is an excellent candidate. It’s much easier for boards to have rigid rules around director independence and skills checklists than to have an open, honest conversation around director competency and performance.”

Lawrence believes directors who resign from a board should be required to sign a statement, published to the market, that there were no material disagreements between the director and board – similar to the process in the United States when the board replaces the organisation’s audit firm.

“This process would better protect directors who fundamentally disagree with the board over an issue,” Lawrence says. “They could inform the market of their concerns, and have some qualified privilege, without blowing up their governance career. That would be true independence.”