Why limit independence to nine years?

COMPANIES are always looking for independent directors. And, there is a popular perception that independent directors who have served for many years on a company’s board are likely less effective than the board’s most recent members.

That is because the market perceives such long-serving directors as entrenched in the company, a captive of its management and so no longer keen to be objective for the company’s ultimate good. Therefore, not independent.

We have seen in many companies that even newly-appointed directors are not really independent. Some of the appointments are based on existing “consultant type” relationships or in some cases, are even existing clients.

So, why pick on the tenure of a director to determine if an individual is really “independent”?

Several countries previously endorsed this view, by introducing laws to limit the tenure of independent directors.

The United Kingdom, for one, recently legislated that independent directors can serve a maximum of nine years. If they wish to carry on in the same company after that, they have first to prove why their long tenure does not compromise their independence.

In France, any independent director who has been on a board for more than 12 years is no longer considered independent.

In Australia, however, the CG council has dropped its proposal that companies cap the tenures of independent directors at nine years, like the United Kingdom. Companies that refuse to do so will have to explain to investors.

We have reviewed some research which stated that, just “because an independent director has served for a long time, he or she should not automatically be branded as partial to a company’s management.”

The argument continues to state that limiting the tenure of an independent director “fails to acknowledge the benefits that can be derived from having directors with longer lengths of tenure” especially for organisation or sector specific knowledge. So in a simple statement, corporate memory.

There seems to be conclusive evidence that having long-tenure directors is especially important in capital-intensive industries where investments have very long lead times; such as mining, infrastructure or life insurance, but clearly less important in start-ups.

So being wary of long-serving independent directors across all sectors may not be the way to go if one really wants transparency. At their best, independent directors should speak out against such company abuses which include CEOs paying themselves excessively high salaries, managers who under-perform shamelessly or acquire poor-quality assets or make other moves that do not benefit the company’s shareholders as a whole.

More and more studies are showing that independent directors do not grow tired and complacent in their posts, just because they have been on a board for a long while.

More often than not, these long-serving independents are also likely to be a member of one of the major board monitoring committees.

And, without a doubt, these experienced directors have a deeper knowledge of a company’s operations, compared with their relatively newer members on the board.

More immediately, research is showing that long-serving independent directors seem to be able to stand up to a company’s management more firmly.

For example, studies have shown that “if a company has just one more experienced independent director on its compensation committee, the average pay of that company’s CEO decreases by about 3.2% against market rates”.

As another example, when a company has more independent directors, they make the CEO work harder, that is, whether or not he gets to keep his job depends on how the company performs.

Additionally, seasoned independent directors often have the foresight and experience to thwart the aspirations of any CEO with empire-building ambitions or “divide and conquer” mentality. Watch out for those CEOs who are constantly refreshing their board.

Apart from profit-making, there is research to show that “just having one more experienced independent director on a company’s audit committee is likely to reduce the probability of deliberate misreporting by as much as 25%, compared to firms with no such presence”.

​We have also witnessed long-serving board members who actually give a company’s management more courage to pursue strategies that could disrupt profitability in the short-term.

This is because being innovative means taking risks, and many CEOs are often slow to do so, as they may lose their jobs if the innovations fail.

But if long-term directors support the CEO’s risk-taking, that could give shareholders more confidence in the move, as they know fully well that such long-term directors are in a better position to judge the CEO’s business.

It is commonly accepted that the CEO knows much more than board members. And very often, the CEO only informs the board members on “a need to know basis”. However, if you have long-serving board members, this imbalance of information is not so lop-sided.

Optimal tenures are now being debated. We are seeing two decades as a limit. Of course, some directors may not have the energy (watch for multiple naps or multiple restroom breaks during board meetings), nor have the necessary (IT) skills to be a board member which has pushed for the reasons to refresh the board.

Those situations aside, what is being highlighted now is that, by having directors with long serving sector experience, the corporate governance levels within firms are raised.

Source: The Star paper

Columnist: Datuk Shireen Muhiudeen is MD of Corston-Smith Asset Management in Malaysia, a fund management company that makes investment decisions based on corporate governance.