Board independence: Does one size fit all?
The Hayne Royal Commission brought into sharp focus the governance failures at the board level for many financial institutions. Prior to the release of the final report, the Australian Prudential Regulatory Authority had already exposed shortcomings around governance, culture and accountability at the Commonwealth Bank. It concluded that a sense of complacency and group-think among the board of directors and senior executives had contributed to poor management of non-financial risks and inadequate monitoring by the board.
These governance failures occurred despite the fact that the financial sector exhibits strong board independence. According to ESG data vendor Asset4, strictly independent directors account for around three quarters of the boards of each of Australia’s major financial institutions, well above the ASX norm of around one half. By this measure, a director is not considered independent if she has executive responsibilities with the company, has been a board member for ten years or more, is the company founder, has family ties to the company, has an ownership stake in the company of at least 5% or earns any income from the company outside of her directorship.
Since the enactment of the Sarbanes Oxley Act in the United States in the early 2000s - which mandated that listed US companies be composed of at least half independent directors - many listed stocks outside of the United States have also embraced board independence. On balance, academic research suggests that the shift towards greater board independence - controlling for other factors - has been associated with better monitoring.
Australia’s financial institutions represent an exception and their governance failures suggest that they should consider expertise and experience as well as an independence when searching for board directors, particularly given that they have complex business models and opaque operations that are difficult to monitor. The Executive Chair and founder of Technology One, Mr Adrian Di Marco, has expressed some scepticism about the one size fits all approach surrounding board independence. In particular, he is concerned at the conventional view that directors with long tenure at the same company are penalised because they are not considered to be strictly independent.
As with financial institutions, experience and expertise ought to be particularly important attributes for directors of technology companies such as Technology One because of the complexity of the business models. Indeed, research suggests that investors reward complex companies that have a larger share of insider board directors precisely because of the company specific knowledge that they bring to the table (Coles, Daniel, and Naveen, 2008, Boards: Does one size fit all? Journal of Financial Economics).
Company founders like Mr Di Marco are in a unique position to undertake a monitoring role for three reasons. First, they have valuable firm specific knowledge and intimate knowledge of senior management and board directors. Second, founders have a powerful incentive to engage in monitoring because of their financial and/or emotional stake in the company. Third, founder companies do not suffer from the classic agency conflict because there is no hard edged separation of the ownership and management of corporate assets. It is reasonable to expect therefore that board independence might not be as important for founder companies.
To test this proposition, we split the All Ords universe into founder (115) and non-founder (385) stocks. As expected, founder companies have a smaller fraction of strictly independent board directors (42%) than non-founder stocks (53%) - see chart. But the lower board independence doesn’t seem to penalise them; quite the contrary. Founder stocks trade on book multiples that are one-third higher than non-founder companies; the premium in part reflects return on capital measures that are one fifth higher - see chart. The premium might also arise due to the fact that founder companies ‘invest’ more in building organisational capital; the ratio of Selling, General & Administrative Expenses to Revenue is three quarters higher for founder companies (see Eisfeldt and Papanikolaou, 2013, Organisational capital and the cross section of stock returns, Journal of Finance).
Technology One is representative of this pattern. According to the latest estimate from Asset4, strictly independent directors account for less than 20% of the board. Yet it trades on a book multiple of 15x and achieves returns on capital of no less than 20%, well above ASX norms.
Our preliminary results suggest that the presence of a founder contributes to better operating performance, a premium rating and helps to manage agency costs effectively despite the lower fraction of strictly independent board members. Stakeholders in the industry - including analysts, investors, ESG data vendors and proxy advisers - that continue to embrace the one size fits all approach risk unduly penalising such companies for low board independence.