CEO Succession planning

Australia’s governance community has persistently warned that boards will find it harder to recruit experienced directors if directorship risks keep rising. Those fears look prescient, amid warnings that former CEOs are becoming less interested in listed-company boards.

A heightened regulatory environment after the Banking Royal Commission and greater legal, financial and reputational risks for directors top the concerns. Increased governance workloads, stagnant board fees and competition from private-equity boards are other issues.

“Some retiring CEOs in that 55-plus age bracket are becoming gun-shy of listed-company directorships,” says Korn Ferry head of board services, Robert Webster. “They look at the work, risk and scrutiny involved – and what boards pay – and think it is no longer worth it.”

Webster adds: “Increasingly, retiring CEOs are finding appeal in private-equity boards that potentially offer greater rewards through equity incentives, allow directors to focus more on strategy than compliance, and don’t operate under the glare of governing a listed company.”

The veteran search-firm expert, known for advising boards of some of Australia’s largest companies, say declining CEO interest in directorship is worrisome. “Retiring CEOs are a natural source of future directors and chairpersons. But that trend is changing and it has implications for board succession planning. A large experience gap on boards could emerge.”

Australian boardrooms are among the world’s oldest by average age and a generation of leading company directors in their late 60s or early 70s are expected retire in five to 10 years.

The average age of ASX 200 directors in 2015 was almost 62, down from a peak of 62.9 in 2012, according to the Australian Council of Superannuation Investors. An increase in female directors, who on average tend to be younger than their male peers, has slightly lowered the average.

Governance expert Dr Ulysses Chioatto says: “A demographic cliff is approaching for Australian boardrooms in the next three to six years. You can’t fudge the statistics; there are a lot of directors in that 65 to 75 age bracket who will retire in that timeframe, based on board term cycles.”

“A lot of directors who have been around a long time will start to retire or cut back on board duties and there will be fewer ex-CEOs to replace them. We need more discussion about broadening the supply of future directors.”

Former CEOs who join boards do more than replace ageing directors. There have been calls from investors for boards to have a higher proportion of industry experts who live and breathe operational detail. Typically, retiring CEOs are a key source of industry expertise; for example, an ex-bank CEO joining the board of a financial services group.

Webster says the confluence of these trends will lead to a shortage of experienced company directors in the next decade. “A lot of directors who have been around a long time will start to retire or cut back on board duties and there will be fewer ex-CEOs to replace them. We need more discussion about broadening the supply of future directors.”

Age diversity debate

Debates on board succession planning are typically based on anecdotal rather than empirical evidence. There is a long list of directors wanting to serve on ASX 200 boards because of the professional challenge, prestige and higher fees. The debate about whether enough of these directors are sufficiently experienced and skilled for an ASX 200 board is subjective.

Also, gauging the views of retiring CEOs on listed-company directors is problematic. The pool of retiring CEOs is, by its nature, small. Many ex-CEOs take some personal time off before resuming their career and are unlikely to rule out a governance career in listed companies.

However, data shows higher regulation is affecting the appeal of boards. About 43 per cent of respondents to the AICD Director Sentiment Index (first-half 2019) said the impact of legislation on director liability affected their willingness to continue to serve on boards. And 52 per cent said it affected their willingness to accept a new board appointment.

Those results may not fully include the effect of new white-collar crime laws in the Treasury Laws Amendment (Strengthening Corporate and Financial Sector Penalties) Bill 2018, which Parliament passed in March 2019. The reforms enable the Australian Securities and Investments Commission (ASIC) to pursue heavier civil and criminal sanctions against banks and other companies, and executives who breach corporate and financial services laws.

Prison terms for the most serious offences in the Corporations Act increase from five to 15 years and there are sharply higher financial penalties in the reforms. The maximum financial penalty for contraventions of a relevant civil penalty provision, currently $200,000 for an individual, increases to the greater of $1.05 million or three times the benefit gained or loss avoided.

Dr Chioatto says the penalty reforms elevate directorship risks and reduce the appeal of listed-company governance for retiring CEOs. “The legal risks of serving on a board are arguably the highest they have ever been and Australia’s new civil and criminal penalty regime is among the toughest in the world. I suspect ex-CEOs will increasingly ask if the financial and career rewards of serving on a board are still worth it relative to the risk and pay.”

Stagnant growth in director fees is another consideration. As the Governance Leadership Centre reported last month, increases in listed-company board fees in the past three years have barely matched inflation, according to remuneration consultant Egan Associates.

Dr Chioatto believes static fee growth hinders listed-company boards in the recruitment of former CEOs. “The average total pay is about $6 million for an ASX 100 CEO and $2 million across the ASX 200,” he says. “A non-executive director, even if they have three or four directorships and a full-time governance portfolio, earns nothing like an executive salary. If board fee growth remains flat, directorship will have less appeal, at least in terms of financial reward, to retiring CEOs.”

Compounding the fee challenge is the push from proxy advisers to reduce “overboarding”, where directors serve on too many boards and have limited time should a company emergency arise. Simply, directors are expected to serve on fewer listed-company boards, reducing their earnings capacity and potentially making boards financially less appealing for full-time directors who rely on that income.

Low growth in board fees also affects the competitiveness of listed-company directorships with those in the private sector. “We are seeing retiring CEOs joining the boards of private-equity companies rather than listed companies,” says Dr Chioatto. “It’s not a huge trend yet, but there’s greater potential financial upside for directors on private-equity boards, less focus on compliance and more on strategy. That appeals to ex-CEOs who like building companies.”

New thinking on future supply of directors required

Dr Chioatto believes listed-company boards will need to think differently about the supply of directors. Broadening the pool to include senior consultants is the starting place. “Boards traditionally have been reluctant to appoint management consultants because they are not seen as having sufficient operational experience,” says Dr Chioatto, who is a former strategy consultant.

“But an ex-partner of a top global consulting firm can add huge value to a board in terms of cross-industry knowledge, skills in strategy development and ability to make complex decisions in fast-changing markets without all the facts.”

Korn Ferry’s Webster says boards will need to source more offshore-based directors. Australian boards mostly source Australian-based directors who they know and who are less affected by time zones and travel to board meetings. More ASX 200 companies, especially those expanding offshore, are appointing foreign directors but change is slow. The globalisation of Australian business has not spread widely to boardrooms.

The pool of offshore-based directors, including retired CEOs, is exponentially larger than that available in Australia and far more diverse. However, sourcing foreign directors can be problematic because Australian boards typically pay lower fees than US boards and expect more work from directors, making international directors a small part of the succession answer.

Recruiting younger directors is another succession strategy and increasingly favoured by boards needing skills in technology and the digital economy. Webster says it is harder to recruit younger directors than boards realise. “It sounds good on paper, but there are not a lot of young executives out there who have the general experience needed to serve on an ASX 200 board. A young director needs to be able to govern across a wide range of issues, not only technology, and have well-developed business judgement and broad experience.”

Another option is expanding the appointment of alternate directors who act for a company director for a set period, or the use of “shadow” advisory boards. In theory, this would help boards establish a pool of potential directors who could serve on the main board, and assess their performance. It would also help potential directors learn about the organisation before serving on its board and hit the ground faster in their first term on the board.

But greater use of alternate directors and shadow boards, although mooted over the years by some chairpersons, involves extra governance costs and has never taken off in Australia. Both practices might need to be revisited if director supply is constrained.

Boards could also consider ways to keep older directors serving for longer. The view that directors should serve no more than three three-year terms – lest they become “institutionalised” in their company – might need revisiting in circumstances where longstanding directors continue to add governance value.

Moreover, the perception that a director in their early 70s is due for retirement or will contribute less to the board, is as demeaning as it is short-sighted. Every director is different and it is likely that the average age of boardrooms will rise as the population ages and people work longer and are healthier.

Equally, it would be wrong to avoid board succession-planning debates for fear of “ageism”. As more is expected of directors, it is legitimate for stakeholders to ask if boards have sufficient age diversity and a considered succession plan to replace those directors who are likely to retire or cut back directorships in the next three to six years.