Recent Research Insights (February 2017)

A snapshot of recent papers on governance studies and trends. Board size, personal morals, cyber-security and crisis management feature.

1. The case for smaller boards

What is the optimal board size? The answer varies by firm and situation, but the governance trend has been towards smaller boards this decade.

However, academic research on this topic is mixed. Some studies have found large boards are advantageous because they provide superior advice to management. Other studies contend larger boards are detrimental because they are associated with weaker firm monitoring and slower decision-making.

Also, large boards have been shown to be more “polite” and less critical of management compared to smaller boards, and tend towards conservative investments.

Australian (University of Technology Sydney) and French researchers studied the effect of board size on firm value in Australia. The authors, Pascal Nguyen, Nahid Rahman, Alex Tong and Lucy Zhao examined 1,411 unique local firms over 2001-2011, using SIRCA’s corporate governance database.

The authors found that Australian firms with a large board size are associated with lower market values. Past performance was identified with a larger board size; that is, as the firm grew it increased its board size after shareholder value was created.

“We find that investors are justified in assigning lower values to firms with large boards, the authors wrote. “The reason is that the latter are less profitable and associated with higher operating costs. Large boards also offer higher CEO compensation that is unrelated to firm performance, but rather depends on the size of the firm’s balance sheet. This type of compensation is likely to encourage the accumulation of assets at the expense of shareholder value.”

An intriguing finding was the effect of large boards by firm size. The authors found the negative influence of large boards is most profound in smaller firms. “A likely explanation is that small firms require less (board) advice and have greater difficulty attracting talented directors,” wrote the authors. “As a result, increasing board size tends to bring fewer advantages than in large firms.”

The authors concluded: “While Australian corporate boards are relatively small, with an average of 5.2 directors, increasing their size might not have the benign consequences that one would expect. In fact, adding one director is likely to cause a decrease in firm value of about 7 per cent (based on the study).”

• Nguyen, P., Rahman, N., Tong, A. et al. ‘Board size and firm value: evidence from Australia’, Journal of Management & Governance (Dec 2016), Vol 20. Issue. 4

2. The role personal morals play – study suggests greater emphasis on ethics

The link between director ethics and corporate governance practice is well established. It is accepted that boards with strong codes of ethics and directors with high personal moral values are likelier to provide enhanced corporate governance for their organisation.

But most studies on the role of director values in corporate governance take an empirical (quantitative) approach. They examine the relationship of external factors, such as board structure to firm performance, to draw links with board values.

Auckland University of Technology researchers, Patricia Grant and Peter McGhee, have published a qualitative study* based on interviews with 33 New Zealand directors to understand the “how” and “why” of their personal moral values in governing the organisation.

Their findings have implications for governance observers who believe the Board Skills Matrix published in annual reports for ASX-listed companies (that publish a skills matrix) should be expanded to include demonstrated director values and behaviours.

Three themes emerged in study’s findings. First, that personal moral values are a powerful driver of ethical decisions. The authors wrote: “Directors’ personal moral values seemed to be the determining factor for deciding how to handle the challenging situations or uncomfortable circumstances in which they found themselves.” At least six directors interviewed cited preserving moral integrity as the reason for resigning from a board.

The second theme was that personal values are more influential than codes – an important finding for regulators that consider attempting to enforce board values through enforceable ethics codes. “The findings of this current study to some extent suggest that personal morals are just as, if not more, important than codes of ethics for the attainment of ethical corporate governance,” wrote the authors.

The third finding was that personal moral values are a key part of director identity. “It was found that directors understand these values to define who they are as a person and so should motivate them always, both inside and outside of work.”

The authors said the study reveals that directors’ personal ethics are extremely influential in their ethical decision-making at board level. They argue the findings provide impetus to those calling for more attention to be given to the personal ethics of directors to achieve best-practice governance.

Ethics training programmes that target the development of character and reinforcement of moral values could be required, along with structural reforms, the authors suggest. Moreover, in director performance appraisals, added importance should be given to the demonstration of ethical competency by including it as a key performance indicator. The authors say that proven moral integrity could become a bigger point of investigation prior to a director appointment.

• * Patricia Grant, Peter McGhee , (2017), ‘Personal moral values of directors and corporate governance’, Corporate Governance: The International Journal of Business in Society, Vol. 17 Iss 1 pp. 1 - 12

3. ISS survey of institutional investors shows board ‘refreshment’ becoming an even bigger issue for global companies.

The most dangerous thing a business can do is become complacent and, realising this, many are turning their attention to board ‘refreshment’ or renewal’: the extent to which company boards turn over their directors, limit board tenures, avoid stagnation and encourage diversity.

According to the Institutional Shareholders Services’ (ISS) 2016-2017 Global Policy Survey of 120 institutional investors shareholders consider refreshment a vital issue. The survey found that directors’ tenure was the greatest cause for concern (68 per cent).

An absence of newly appointed independent directors was considered another potential problem (53 per cent). Other factors considered of concern were: directors’ ages, a high overlap between the tenure of the CEO and the tenure of the non-executive directors, and the combination of lengthy average tenure and underperformance.

Another survey, jointly conducted by ISS and the Investor Responsibility Research Center Institute (IRRC), tracked refreshment trends in the S&P 1500 over the eight year period between 2008 and 2016. It found that the typical director serving on a board at an S&P 1500 firm is 62.5 years old, the age high watermark for the study period. The average boardroom tenure rose from 8.4 years in 2008 to a peak of 9 years in 2013. Since then, it has been slowly declining.

Male directors have longer average tenures (9.2 years) than women (6.4 years). The tenure for women directors in 2016 is identical to the level recorded in 2008.

Older directors are getting more seats: the share of all S&P 1500 directorships held by 70-something board members rose from 11.7 per cent in 2008 to 18.6 per cent in 2016. The bulk of board seats, however, are held by people in their 50s and 60s, reflecting a generational shift.

The number of new directors is increasing. In 2012, new nominees represented less than 6 per cent of total directorships but by 2016 new directors accounted for 9.5 per cent. This has especially favoured women. In 2016, women claimed 24.4 per cent of the ‘new’ board positions at S&P 1500 companies, double the level in 2009.

Boards have only limited tools to drive refreshment. Two fifths of boards have mandated retirement ages, which equates with a lower average age. Tenure limits are rarely used, although they have been shown to be effective at managing tenure and encouraging turnover.

Evaluations are used by 97 per cent of boards, which makes it hard to assess the impact on refreshment. However, the companies with no board assessment process in place generally have higher average director ages.

• ‘Board Refreshment Trends at S&P1500 Firms’, Harvard Law School Forum on Corporate Governance and Financial Regulation. Feb 2017.

4. What happens when executives are overlooked for CEO role?

One of the most important task boards undertake is the selection of a new CEO. How boards choose new leaders is crucial to a company’s long-term performance.

Less considered is what happens to top internal executives who are shortlisted for the CEO role and miss out – an important issue for boards that spend years ensuring a appropriate pool of internal executive talent is developed.

A study by Stanford Graduate School of Business academics David F. Larcker and Brian Tayan, and Stephen A. Miles of the Miles Group examined all CEO succession events among the largest 100 corporations between 2005 and 2015. It included 77 companies and 121 transitions.

Unsurprisingly, it found that most potential successors who are passed over often do not stay. With companies that had more than one named potential successor, only 26 per cent of those passed over chose to remain at the company, and 74 per cent left. Of those who left, 30 per cent eventually went on to become the CEO of another company.

Succession events create instability in senior ranks: the Chief Financial Officer, Chief Operating Officer, and divisional presidents. Of these, 24 per cent eventually became the CEO of another company, 41 per cent joined another company in a position below the CEO level, and 24 per cent permanently retired.

A comparison of the stock price performance offers some limited insights. Over a three-year period, succession ‘winners’ tend to get cumulative stock price returns of 8 per cent (about the same as the S&P 500), while executives who became CEO at another company oversaw a 3-year, cumulative loss of 13 per cent.

This may be because companies that hire external CEOs are experiencing more difficulties, and thus lower firm returns. Nevertheless, the study modestly suggests that corporate boards do a reasonable job of identifying CEO talent.

• ‘Succession 'Losers': What Happens to Executives Passed Over for the CEO Job?’ David F. Larcker, Brian Tayan, and Stephen A. Miles, 2016. Rock Centre for Corporate Governance, Stanford University.

5. Governing through the ‘crisis era’ – PwC Global CEO Survey

Crisis-management becoming a key board skill in volatile markets.

The greatest fear of many CEOs is that they will faced with a business crisis. A PwC survey of 164 global CEOs found that the greatest threat was global economic uncertainty (72 per cent), increased regulation (55 per cent) exchange rate volatility (47 per cent) and speed of technological change (47 per cent).

Crises seem to be a common experience for business leaders. In the past three years, 65 per cent of CEOs said they had experienced at least one crisis; more than half had gone through two or more and 15 per cent had been hit by five or more crises.

There is little expectation that things will change for the better. Only 16 per cent of CEOs said they expected to face fewer crises in the next three years and 30 per cent said they expect to face more.

Most CEOs (80 per cent) say they have experienced a financial crisis. Just over half say they have been hit by an operational or human capital crisis.

The key vulnerabilities are: gathering the right information quickly (65 per cent), out of date business continuity plan (57 per cent), communicating adequately with external stakeholders (55 per cent), communicating adequately with internal stakeholders (51 per cent) and unclear definition of what a crisis is (47 per cent).

If dealing with crises is one of the most challenging aspects of business leadership, being able to manage them effectively can deliver significant business benefits. PwC says what is required is to have a strategy, a clear plan and an appropriate structure. In particular, it is necessary to have a core and an extended team, with each person having defined responsibilities and the CEO in an oversight and strategic role.

The crisis plan should involve assessing the level of risk; checking the leadership vision is strong; making sure lines of command are well understood; defining all roles; ensuring there is an appropriate blend of skills; making sure processes, resources and technologies are in place; and establishing appropriate drills.

• ‘Welcome to the crisis era’: Are you ready? PwC.

6. Cybersecurity top of board risk list

Many boards and CEOs are insufficiently involved in managing cyber risk according to a new Accenture report: The Cyber-committed CEO and board. This is despite cyber risk being considered by most company boards to be a high priority.

The study polled executives across 12 industries and 15 countries. It found that 70 per cent of respondents agreed that “cyber security at our organization is a board-level concern and supported by our highest-level executives”.

The level of preparedness, however, appears to be low. The study found that only 32 per cent of the companies surveyed had competent cyber-attack scenarios and only 27 per cent had prepared for risks related to high value assets and business processes. Only 32 per cent competently monitored business-relevant threats.

The level of preparedness and co-ordination is also poor. According to the Accenture study, only 34 per cent of companies have cyber incident ‘escalation paths’ (ability to involve appropriate stakeholders) and only 32 per cent have the ability to ensure stakeholder involvement.

The solution, says the report, is a high level of engagement by both the board and the CEO.

“That means not shying away from or fearing cyber risk because it is new or they do not understand security,” the report says.

“The CEO needs to understand security, and manage it like any other business risk.”

The Accenture report says a precondition of sound strategic engagement by boards and the CEO is to measure and communicate security risk in non-technical business terms. It is important to identify threats to the most important lines of business, consider the strategic options when looking to manage risks and identify what decisions or actions are required from the board.

• ‘The cyber-committed CEO and boards’, Accenture, 2017.