Academic perspectives on independence – mixed views on definitions and value

There are mixed views in academia on the merits of board independence and structural definitions. Tony Featherstone explores some of the current debates.

Professor Pamela Hanrahan, a noted governance scholar, makes a telling observation when asked about the virtues of board independence. “Independent from whom and for what purpose?” she replies. “And should we define independence as a state of mind?”

These important, difficult questions go to the heart of modern governance. Under agency theory, shareholders are best protected when board and management roles are separate. Independent boards safeguard against opportunistic management behaviour and potential “agency loss”.

Stewardship theory says managers, left on their own, will act responsibly regarding assets they control. Unlike agency theory, stewardship theory assumes executives act in the best interests of the company and are better placed to make corporate and financial decisions.

The debate between agency and stewardship theory is much more than a philosophical stoush best left to academics. At its core, agency theory says boards are there to keep watch on management – an approach that has underpinned the drive towards greater independence of boards that began after a series of corporate scandals in the ‘90s and early 2000s.

Yet a growing number of institutional shareholders are questioning whether directors should have more shares in the companies they govern. They are pushing for more of a stewardship model where directors think – and act - much more like shareholders.

Hanrahan, of the University of New South Wales Business School, says the view that directors are there to monitor management is outdated and risks limiting the potential of boards to oversee their organisation’s social licence and help it deal with changing community expectations.

“Wooden definitions of director independence feel like the governance community is still fighting a war that has long been won,” says Hanrahan. “That ship has sailed. The idea that the board’s main job is to monitor management and that the more independent the board becomes, the better the job it does in that area, seems like a discussion for the previous century.

“We need a new discussion about the purpose of board independence in a world increasingly less about companies and customers, and more about companies and communities.”

Such a discussion could inform the next iteration of the ASX Corporate Governance Principles and Recommendations. The Principles include factors that can be considered in assessing whether directors are deemed to be independent. The most debated is the link to substantial shareholdings, defined in legislation as a 5 per cent shareholding. Importantly, the ASX Principles operate on an “if not, why not” model and require the board itself to engage on how the independence of directors is assessed.

Hanrahan believes the ASX definition of director independence should allow for substantial, but not controlling, shareholders. “Requiring directors to be independent of substantial shareholders is not a good idea. Do we really want to strike out people who have real skin in the game through their equity ownership as not being considered independent?”

The risk is that boards appoint directors who are technically “independent” but lack company or industry expertise or have insufficient alignment with shareholders because of a small or zero equity holding.

Or that some boards might avoid appointing non-independent directors who can add more to long-term firm performance. They might choose independent directors who may be “gifted amateurs” with limited understanding of the company and its value drivers.

As one chair said in a 2016 paper by Dr Robert Kay and Dr Chris Goldspink, of Incept Labs, for the Governance Leadership Centre: “The idea that you staff the board with a whole lot of independents, who may or may not know… about the company or its industry, is, I think, a weakness in some of the governance requirements of the day.”

Experienced director Kevin McCann AM discusses this challenge in an interview with the Governance Leadership Centre published in October 2016.

Mixed views on independence

There are divergent views on whether greater board independence enhances or diminishes long-term firm performance.

At the risk of simplification, the regulatory/supervisory communities appears to have a preference for more strictly defined board independence, while others argue for greater focus on directors who have deep industry expertise in organisations they govern and “skin in the game” through their shareholding.

Academic evidence to support these views is mixed. Studies have attempted to measure the relationship between the level of board independence and firm performance. Although the balance of academic evidence suggests board independence adds to long-term firm performance, the evidence is inconclusive.

A sweet-spot for board independence

Professor Alex Frino, Deputy Vice-Chancellor (Global Strategy) at the University of Wollongong, has found that board independence improves firm performance – to a point.

His paper, “The Relationship between Board Independence and Stock Price Performance”, was based on the largest 200 ASX companies between 2004 and 2012, and used the Securities Industry Research Centre of Asia Pacific’s (SIRCA) corporate governance database to calculate the proportion of independents on board.

The Governance Leadership Centre commissioned and funded the study, which is published this month.

Frino found that the largest 200 ASX-listed companies with balanced boards (between independent and non-independent directors) outperformed all others in terms of market-adjusted stock-price returns. Companies with boards that had 40-60 per cent independent directors performed best.

“The study reinforces the benefits of boards having a mix of independent and non-independent directors,” says Frino. “Too much independence on boards weighs on firm performance, as does too little independence. The key is getting the balance right between the two.”

Frino says 50-60 per cent of independent directors on a board is a “sweet spot” that meets the ASX Corporate Governance Principles recommendation on independence, while ensuring the company remains in the bracket of firms that outperform the market.

Frino’s paper also points to opportunities for further research, including digging deeper into the reasons why some directors are assessed as non-independent and the impact of these variables on firm performance.

Criticism of independent directors

Professor Peter Swan, AO, of the UNSW Business School, is a critic of board independence. In a 2016 paper Swan argues that market and accounting measures of firm performance decline when directors deemed to be non-independent, because of their substantial shareholding or because of a former association (for example, a retired CEO), depart the board.

“My research findings are unambiguous: every measure of firm performance worsens as the proportion of independent directors on a board increases,” says Swan. “Everybody has jumped on the bandwagon about the supposed benefits of board independence when the evidence does not support the concept,” he claims.

Swan claims it is foolhardy to believe that independent directors can govern effectively. “It’s the blind leading the blind. That’s why you end up with so many ex-lawyers on boards and professional independent directors who serve on 3-4 boards and add little value to each because they are not specialists in that particular company.” “Of course, there are some good professional directors but I am talking statistical averages.”

Swan is also a critic of promoting diversity on boards. “Consulting firms surveying boards keep trotting out research that says diverse teams make better decisions, but that does not automatically mean more diverse boards make better decisions. Both the knowledge base and incentive alignment of directors is of far more importance than ambiguous ‘diversity’.”

Swan says the argument that boards have a role beyond firm performance – for example, ensuring the organisation upholds its values – is an “excuse to socialise boards” and help them take control of companies at the expense of shareholders.

Swan favours the Nordic model of governance, where the organisation’s substantial shareholders determine who is on the board and how the organisation is governed. “The Nordic model, quite rightly, says the organisation’s largest shareholders are the main group fit to determine the directors, but typically the Nordic governance model requires a minimum number of directors, two or possibly more, independent of major shareholders.”

Professor Swan’s paper, as yet unpublished, is based on a study of 1,400 Australian companies since 2001, he says.

Balance between independence and non-independence

Professor Ian Ramsay of the Melbourne Law School believes that in some respects the move towards board independence has gone too far. “History will show there was an over-reaction in terms of the call for board independence,” says Ramsay. “The danger is that boards strive to meet independence tests in their composition and end up with too many directors who are technically independent, but lack industry expertise.”

Like Professor Hanrahan, Ramsay says there is scope to loosen the requirements for directors to be deemed independent. “I’m a strong believer in the ASX Corporate Governance Principles and Recommendations and they have become more flexible in how boards assess independence. The ultimate test of independence is whether a director can make a decision, and know that his or her judgement was not unduly influenced in some way. I doubt the current checklist of factors that determines director independence always ensures this outcome.”

Ramsay says there is merit in substantial shareholders being deemed independent directors, provided their shareholding is not too large. “It’s quite arbitrary to choose a percentage and say that a director who owns more than that percentage of shares is not independent. But there is a risk that a director with a large shareholding might make decisions in their own interests rather than the interests of all the shareholders”.

Independence is a state of mind

Hanrahan favours the approach of Sir David Walker, the former Chair of Barclays and a noted governance thinker in the United Kingdom, on board independence. The 2009 Walker Review of UK banks said: “… independence of mind (among directors) will be much more relevant than a combination of lesser experience and formal independence”. The report added: “The substance as distinct from the form of independence relates to the quality of independence of mind and spirit, of character and judgement, and a non-executive director who brings both independence of approach in this sense together with relevant industry experience is most likely to be able to bring effective and constructive challenge to the board’s decision-taking process.”

Kay and Goldspink made a similar point in their 2016 paper when they commented on director independence as a “state of mind”. The authors also argued that the “collective mindfulness” of boards needs to be considered – a thought-provoking governance insight given that independence is measured at an individual level rather than how the directors interact with each other.

Hanrahan believes viewing independence as a director mindset is more beneficial than relying on structural definitions. “What we have observed, since the recommendations that boards have a majority of independent directors came into force, is that often the same types of people who broadly have the same character and values become directors.”

She adds: “Perhaps the push towards greater independence has attracted a bunch of directors who are used to monitoring management because they came from management. Surely we need a richer discussion about how boards can attract directors who are truly independent in their thinking and can help the board set the organisation’s values and draw the line between shareholder value and long-term sustainability.

“Something is not right with the current thinking on director independence; if it was right, communities would not be losing trust in companies.”

Concluding thoughts

The problem, of course, is how boards signal whether directors think independently and how an independent mindset is measured. Checklists, for all their faults, provide a framework to assess and report on director independence. The drive towards greater board diversity is, in theory, a step towards more independent boards and some governance experts have called for the skills matrix in annual reports to include demonstrated director values and behaviours – another potential signal of a director’s capacity for independent thought.

Ultimately, the only people who know if directors have an independent mindset are their peers around the boardroom table. And a bigger, unresolved issue is governance philosophy: are boards there mostly to monitor management, or is their scope something far greater as custodians of corporate strategy, value and social licence?

Also, are regulators pushing boards towards a greater compliance/monitoring role, while financial markets want boards to focus more on firm performance?

Until these debates are resolved, the issue of director independence versus non-independence has a long way to run.