Does holding equity in a company help to align directors with its shareholders? Or does it undermine the true value of independence? Domini Stuart reports.
Almost 4,000 years ago, King Hammurabi of Babylon ruled that if a house should collapse and kill the owner, the builder would be put to death. In a 2014 paper, authors Nassim Taleb and Constantine Sandis described this as the best risk management rule ever. “The absence of personal risk is what motivates people to appear to be doing good, rather than to actually do it,” they said.
In today’s boardroom, this can be loosely translated as having “skin in the game” – the term famously used by Warren Buffett for directors who use their own money to buy shares in the company they run.
“To boil it down to its essence, having skin in the game aligns directors more closely with the investors they represent,” says Louise Davidson, CEO at the Australian Council of Superannuation Investors (ACSI). “Each director’s holdings will differ, and that is fine, but ACSI believes that any well-governed board requires their directors to hold equity in the company.”
However, ACSI’s most recent research found that 11 per cent of ASX 200 directors own no shares in the companies they preside over. Some of these are new appointments, but many are directors who have been on the board for over 10 years. “We find this remarkable and very disappointing,” says Davidson.
It is possible that some of the more recently appointed directors are waiting for an opportunity to invest. “Directors are very sensitive to the fact that, if they choose the wrong moment, they risk being accused of insider trading,” says Martin Lawrence, a director of Ownership Matters. “Once you have joined the board it can be very, very difficult to buy your first shares or increase your stake. Like most large companies, Rio Tinto has a minimum director shareholding policy but Rod Eddington was on the board for several years before a window opened up for him to trade safely.”
One popular rule of thumb is that a director should have a year’s fees invested in stock. “I suspect that a lot of shareholders would like them to own more,” Lawrence continues. “I also think they’re more likely to notice when they own less – and that’s sure to happen at the worst possible time. As a director, you don’t want to be asking shareholders to trust you, or to back your commercial judgement, when it looks to them as though you don’t have faith in yourself.”
However, minimum shareholding requirements can have unintended consequences. “If a company makes a seat on a board conditional on investing a certain amount in shares this could preclude an entire cohort of candidates who are unable to meet that commitment,” says Daniel Smith, director of research at CGI Glass Lewis. “I don’t think it necessarily benefits shareholders to have boards consisting solely of independently wealthy directors.”
Davidson agrees that any company that does institute formal measures needs to take a flexible approach.
“Granting a director’s fees in shares is one way of ensuring that ASX 300 companies continue to promote diversity,” she says. “We don’t want to see younger directors discouraged from joining boards due to unreasonably high shareholding limits.”
Directors with a significant proportion of their wealth invested in their company could become more cautious and focused on the short term.
“I once discussed this with a senior executive of an offshore company which had an unwritten rule that board members owned shares and didn’t sell them until they stopped working there,” says Lawrence. “He [said] that, as they approached retirement and had more and more of their personal wealth tied up in the company, he could see their decision-making becoming increasingly risk averse.”
Directors with a shareholding have also been known to have a negative impact on other shareholders.
“At its worst, we have seen control of companies pass without a premium being paid to investors,” says Davidson. “These examples are hugely detrimental and will be well known in the director community. Often these situations culminate with the resignation of one or a number of independent directors from a board.”
A threat to independence?
The ASX Corporate Governance Council takes the view that a shareholding of 5 per cent or more could compromise a director’s independence.
“I think, on balance, that this is reasonable although, on its own, by no means a perfect delineation,” says Amanda Wilson GAICD, managing director of Regnan Governance Research & Engagement. “Other factors affect independence – and independence of mind is not easy to assess.”
Smith agrees that the distinction is somewhat arbitrary but, in his experience, it does indicate that a director has the potential to exert a disproportionate influence over voting decisions.
“That is not to say that directors with larger shareholdings are incapable of generating substantial value for shareholders over the long term,” he says. “The issue for us is that their interest in, for example, capital management might be a bit different from that of an ordinary portfolio shareholder.”
ACSI uses 5 per cent as a guideline when assessing company boards but discourages a “tick the box” approach.
“The critical issue is context,” says Davidson. “Each case needs to be considered on its merits because different types of shareholding give rise to different issues. For example, a director could be the nominee of a long-only investor, the company’s largest customer or even a competitor. The potential conflicts of interest, and a board’s safeguards, are very different in each instance.”
A parcel of shares in the company will also mean more to some directors than others.
“Many non-executive directors have had long careers in management and are likely to have significant wealth outside of any shareholdings in a particular company,” says Wilson. “For others, a quite modest shareholding in the company could constitute all of his or her income and assets. This would call into question this director’s ability to be completely dispassionate about events such as major transactions.”
Lawrence agrees that independence is likely to have less to do with an abstract limit on investment than a director’s personal wealth. “I’d argue that, if a director of a very large company is worth $5 million and has $2 million invested in the company’s shares, this is enough to impair his or her independence,” he says. “A former boss of mine used to say that it is easier for directors to remain truly independent when they don’t need the money.”
Wilson believes that a director’s behaviour depends entirely on the individual’s priorities and motivations.
“We have plenty of examples of founders and other directors with large shareholdings who are very focused on the long term,” she says. “Others have wanted to extract as much value as possible in as short a time as possible.”
A new definition of ‘skin’
According to some commentators, it is insulting to suggest that substantial shareholders cannot act for the benefit of the organisation as a whole.
It appears to be equally insulting to suggest that directors cannot be trusted to do the best for a company unless they have significant skin in the game.
“Surely all directors, public officers and financial advisers have a fiduciary duty to perform as if their own assets were on the line,” says Robert Gordon GAICD, CEO of Board Accord. “It’s true that research on the growth and success of private equity over the last decade has confirmed that having skin in the game brings better performance and outcomes, but this is because, for many organisations, dollar return on investment is the sole raison d’être.”
Wilson points out that the requirement for skin in the game relies on the same premise as the prevailing approach to executive pay – that a director must be financially incentivised to act in the best interests of the company.
“This may have the undesirable consequence of discouraging directors who are less materialistic and more contemplative,” she says. “Unfortunately, those who believe that skin in the game is the only strategy are often hardwired to be unable to understand the variability of intrinsic motivations.”
It could be time for a far more wide-ranging discussion about what contemporary corporate governance entails.
“Commercial return at the expense of people and planet is increasingly being challenged,” says Gordon. “The current iteration of capitalism requires the use of other metrics to ensure not only sustainable success for the organisation but the sustainability of the capitalist system itself. There are numerous examples of the need for this re-evaluation, including the recent failure of BHP and its partners in Brazil to compute the risk of a tailings dam disaster. Ironically this cost-cutting failure of judgement, risk strategy and operations will cost BHP and its partners billions of dollars.”
He advocates a more sophisticated view of skin in the game – a model which embraces all stakeholders.
“The directors and executives charged to manage the organisation in the current climate of volatility, uncertainty, complexity and ambiguity (VUCA) need to rely more on consciousness than compliance – and this is not only significant from a moral and ethical point of view,” he continues. “As BHP has discovered, it is also the best long-term commercial and sustainable framework to maximise returns for all stakeholders.”
5 per cent or more?
Having skin in the game helps to align directors with the company’s shareholders – but can you have too much skin in the game?
The case for limiting investment
- Directors with a shareholding of more than 5 per cent could have a disproportionately strong influence over voting decisions.
- The more directors have invested in their company, the more likely it is that their personal fortunes will hinge on the company’s performance. This could encourage them to focus on their own short-term interests.
The case against
- Investor independence is not necessary for independence from management.
- A significant investment in the company could motivate some directors to do a better job.
- Many shareholders are independently wealthy; a 5 per cent shareholding or less could be too small an investment to provide any genuine alignment with shareholders.
A perspective on independence
Independence is a topical issue, but research over the last 20 years has produced inconclusive results, with evidence that increasing the proportion of independent directors can have a positive, negative or indeterminate effect on firm value.
To provide a more robust framework in which to examine the value offered by independent directors, the AICD Governance Leadership Centre has commissioned research on the relationship between the proportion of independent directors on boards and organisational performance.
The research will be released in the next few months.