Do Independent Boards Destroy Performance?

Research carried out by the University of New South Wales questions the validity of the ASX’s 2003 corporate governance recommendation that organisations implement a majority independent Board.

Do Independent Directors Destroy Value

The introduction of this non-mandatory guideline  created a quasi-natural experiment, according to Professor Peter Swan and Marc-Oliver Fischer, as some companies adopted the comply and explain recommendation while others did not.

Swan and Fischer examined the top 500 companies for the period from 2001 to 2011, involving a total sample of 969 organisations, given the constituents of the top 500 change over time.

During that period, 57% of the sample implemented the recommendation, with the bulk adopting it in 2003 and 2004. Larger companies were more likely to adopt than smaller companies.

The researchers examined the performance of those companies that had implemented the recommendation versus those which had not, calling them “treated” versus “untreated” firms.

The group found that “treatment” coincided with large and statistically significant falls in Tobin’s Q (the ratio between the market value and replacement value of the same physical asset), Market-to-Book ratio and Return on Assets. The longer an organisation had been “treated” the poorer its performance, they found. The research also revealed relatively poorly performing CEOs were less likely to be replaced and CEO pay and Director fees increased as performance deteriorates.

Swan and Fischer estimated that the introduction of the guideline had led to the destruction of $69 billion in shareholder wealth.

Swan is of the opinion that independent Directors by definition have less skin in the game and less company specific expertise. In his own words:

“Independent Directors by definition have either no prior experience with the firm, or at least no recent experience. Moreover, many are professional Directors with no specific knowledge or background in the industry and their part-time nature means that acquisition of such information is difficult and is never likely to be comparable to that of full-time executives. Quite simply, they are not as good, and shareholders suffer as a result.”

His opinions dovetail with those of the head of Queens University’s law school in Belfast, Professor Sally Wheeler. She reportedly stated at an Association of Superannuation Funds of Australia event in August that structural independence might not lead to the kind of behavioural independence its proponents are looking for.

“There’s real confusion there I think between independent ideas and thinking and independence as an identity, and what we want surely is independent ideas and thinking rather than people who have independence as some sort of identity,” she reportedly said. “You’re trying to solve a demographic deficit argument with issues about cognitive skills and behavioural attributes and that just doesn’t work.” 

Swan and Fisher themselves stated in their paper that theirs is not the first foray into the relationship between Board performance and Director independence, with prior studies split between being favourable towards independent Boards and the reverse.

It is healthy that we continue to review regulations we have created, considering them from a different point of view.

The reasoning behind the majority independence guideline was that the Board must act as a watchdog, looking for possible errors and keeping an eye management, which it cannot do effectively if it is following its own agenda, or is too closely linked to the management team.

In our opinion, the spirit of this requirement is correct, but we acknowledge it could be abused if treated purely as a box ticking exercise. There is no point in appointing a Director because they are independent if they do not add to the Board in another way.

Creating the right Board is about building a balance of industry expertise, capabilities and diversity. It is about considering each Director in terms of what they bring to the Board – we note for example that some proxy advisors make exceptions to the independence rules where founders who are essential to the business are involved.

The balance of expertise will be different for each company and will vary throughout their stages of development. This is why it is beneficial that the independence guideline is only a comply or explain requirement. Companies need flexibility to do what is right for them.

It is easiest to gain a picture of what exactly the Board requires by using a skills capability matrix within the framework of a Board review.  Egan Associates is able to assist companies with this process.

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