Peter Swan

Common sense suggests company boards are best composed of directors who hold shares in the business because any poor performance is effectively ‘skin in the game’ as a cost to the director as well as to shareholders. Director’s interests align with shareholders. Directors who mismanage pay a severe price. Evidence also implies this is the case.

During the global financial crisis when the ASX200 index tumbled nearly 40%, incentivised boards suffered fewer relative stock price falls. Yet this advantage can be lost if a company’s board has too many outside directors or if the board members are too compliant to the chief executive. They fail to ask the tough questions. The size of boards is also an issue. Having executive board members who share ownership directly benefits firm performance and lowers CEO pay – but less so when ownership is combined with large boards. It seems when a firm performs poorly, too many independent directors can impede critical action – such as firing an underperforming CEO. A ‘smallish’ board of five or six highly incentivised directors, with a low proportion of outside directors who are prepared to monitor and not just advise management, is optimal, according to my research done in conjunction with Serkan Honaine.

Poor governance can squander a firm’s wealth and our study into how well the interests of independent board members and shareholders are aligned in larger Australian companies suggests large boards of eight-plus members can be very destructive for shareholder value. The average market-to-book ratio of companies with smaller boards of seven or less directors is 50% higher than those with eight or more, and nearly 40% higher when debt-financed assets are included.Our research based on an analysis 284 major Australian listed companies over the decade to 2010 shows that if businesses with large boards behaved like firms with fewer directors, they would improve their performance substantially. Reducing the size of the average large board (nine directors) of Australia’s top 200 firms in 2010, to the size of the average small board (six directors), could boost an individual company’s performance by as much as 50%.

In all likelihood, a large board indicates that management is in control with little effective supervision by shareholder representatives. Naturally, management is reluctant to give up its privileges and drastically reduce board size despite huge cost savings. Poor board monitoring and weak decision-making is collectively costing shareholders hundreds of millions of dollars. Part of the solution is to replace large boards with smaller boards that do not try to usurp the role of management by micromanaging and to focus on the important task of hiring and firing the CEO.

Risk Aversion and Big Boards

Larger boards appear to substantially drag on overall firm performance through a variety of mechanisms, such as reducing non-executive director (NED) incentive pay and raising base pay for outside directors. Such actions encourage a board, dominated by outside directors who have no incentives, to entrench poorly performing CEOs. Large boards are also more cautious because they can have more difficulty reaching a collective decision. This constrained risk-taking results in slow responses to new circumstances and slower release of new information. The resulting reduced stock price volatility appears harmful to shareholder value.

Bigger boards, dominated by outsiders unlikely to be informed of company affairs, have a tendency to keep growing. Large, externally dominated boards appoint more and more directors like themselves with little or no regard for the wishes of shareholders, who are then hit twice. Shareholders not only pay for the salaries of surplus directors but also suffer performance decline into the bargain.

Our research measured performance by comparing companies’ market values to book values. (The market-to-book ratio attempts to identify undervalued or overvalued securities by taking the market value and dividing it by book value. As a rule, the more the ratio exceeds 1, the better the performance while those below 1 are considered undervalued or poorly performing.)

We find that, based on 2010 values, property group Westfield and National Australia Bank (NAB) had below-average market-to-book ratios of 1.34 and 1.39, respectively, and 13 board members each. Publisher Fairfax Media, with 11 board members, carried a very depressed ratio of 0.58, which is well below 1 (and far lower still in 2012). National airline Qantas had 10 members on its board and its value ratio was less than 1 (at 0.83) with its ratio continuing to deteriorate.

Investment and financial services provider Macquarie Group had 10 members with a ratio of 1.03. In contrast, with only five directors on their boards, investment fund Platinum Asset Management and high technology company, Silex Systems, had ratios of 11.7 and 9, respectively.

Meanwhile travel brand group, Wotif, and electronics retailer JB Hi-Fi, each with six directors, had ratios of 13.2 and 7, respectively.

Challenging Independent Director Dominance

In theory, Australian boards appear to be wide open to influence by outside directors. Unlike the US corporate landscape, no chief executive was chairman of a big Australian publicly listed company board. As a result, non-executive directors have a greater ability to intervene in a firm’s activities.

Shareholders have greater power too. Only 40% of Australian shareholders vote at company meetings on proposals from the directors – half the rate of the US. So large shareholders of Australian companies may not need as much stock to maintain control and can make critical decisions, which puts the onus on independent directors to apply greater scrutiny.

We suggest the findings on the harmful effects of outside directors’ dominance and large boards are directly contrary to the views held by regulators, which have been shaped by big corporate collapses. Virtually every country in the world has mandated a majority of independent directors based on little more than what may be simply a coincidence: the failed US energy company, Enron, happened to have a majority of executives on their board.

We challenge the trend for corporate governance councils around the world to introduce policies for a majority of independent directors on boards. Full-time executives, especially those with shares providing skin in the game, know a great deal more about the company and where it is heading than do outside directors. Moreover, typically they stand to lose a great deal more than do part-time directors if the company fails. This may include their jobs and livelihood.

Part-time, outside directors typically have little background in the industry. If the company fails, they may lose their director’s pay that in some cases is little more than a sinecure for turning up to board meetings. If prominent in the community, they may also suffer reputational loss.

We also question the regulators’ decision – in Australia and other countries – to make share ownership a barrier to independence. The Australian Securities Exchange’s (ASX) listing rules require the majority of directors to be ‘independent’, which is defined as not being a substantial shareholder (by holding less than 5% of stock in the company) or not having worked in an executive capacity for the company or another group member for at least three years. This seems counter intuitive because large shareholders have the most to lose from bad managers. They therefore have an economic incentive to gather information and actively monitor the chief executive.

If protecting shareholder interests is the task non-executive directors are facing, then surely alignment with, and not independence from, shareholders is ideal. The New York Stock Exchange (NYSE) and NASDAQ listing rules adopt a neutral stance: stock ownership per se is not a barrier to independence, and they set the barrier at 10% of stock for directors taking on an audit committee role because of the Sarbanes Oxley Act.

It would seem that regulators, in their quest to free management of burdensome shareholder concerns, have taken Australia way out of the mainstream at a huge cost to investors and forno apparent reason other than to appease the privileged managerial class at the big end of town.

Regulators’ Response

The ASX does not see this as a burning issue. When the ASX Corporate Governance Council recently reviewed its Corporate Governance Principles, roundtable discussions were held throughout the country with representatives of directors, management, institutional and retail shareholders, proxy advisers and others with an interest in how corporate governance practices are developing, no change was recommended.

The council chair, Malcolm Starr, said the consensus view was to leave well alone because the present system was working well. He acknowledged the viewpoint that it was counter intuitive to limit non-executive directors’ shareholdings because ownership should encourage better monitoring of company management. Yet there was another opinion that complete independence (through no shareholdings in a company) was the better way to go, Starr insisted.

The Australian Institute of Company Directors agrees. “Non-executive (or independent) directors are seen as ‘custodians of the governance process. While they govern an organisation on behalf of the shareholders or members by whom they are elected, their role is to act in the long-term interests of the company, not shareholders per se, and certainly not particular shareholders,” says spokesman Steve Burrell.

We say independence is undermined by other factors – such as by the old boys’ network that traditionally has appointed directors in the first place. In theory, outside directors should confront management and champion shareholder concerns, but in practice, their motivation is suggested to be more about behaving in ways that will bring more lucrative directorships.

Non-executive directors who are often appointed through friends on the board would be more partial to showing allegiance to their friends and overlook activities by management to expropriate the wealth of shareholders. Directors who do ask questions of management are likely to be either ignored or ostracised. They face the prospect of being denied the right to stand for reelection.

Paper independence aside, high levels of fixed compensation for attending scheduled meetings, along with the barriers to equity ownership provide for little incentive for non-executive directors to exert the extra effort that would add value to the firm. Likewise, the low level of variable forms of compensation to non-executive directors provides little incentive for them to seek and endorse strategies that add value to a company, as the non-executive directors would receive little in the way of the fruits for their labour.

Yet there could still be an incentive for non-executive directors, who may be motivated to perform their role more effectively by both the lure of new directorships from other boards and the financial incentive of being a corporate insider.

Why board size counts

We show that company performance diminishes with reduced monitoring of management by directors, while future firm performance increases when executive and non-executive directors own shares in the company – but not when the board is big. Weak monitoring by large boards, in combination with a high proportion of non-executive members who do not effectively own or take responsibility for decisions – the ‘free rider’ problem – was also found, particularly when boards consisted largely of non-executive directors without shares in the company.

A standard justification for large boards may be the need for these knowledgeable or well-connected outside directors to act as advisers – particularly in big complex companies. Yet it has been long believed that companies with larger boards suffer in performance because of their difficulty reaching consensus on decisions.

Greg Medcraft, the new chairman of the Australian Securities & Investments Commission (ASIC), has warned boards they will be held to account. “For instance, in the Centro case, Mr Medcraft has said publicly that ASIC acted where it believed directors’ behaviour did not meet the expectations of the law,” emphasises an ASIC spokesman. The Federal Court recently found directors of the Centro property group breached their duties when they failed to notice multi-billion dollar errors in the property group’s accounts.

Medcraft, who was appointed in May 2011 for a five-year term, says directors play an important role and they must not uncritically adopt the work of management on major issues for which they are responsible. “The key elements of the financial position of the company are things that directors should understand,” he says.


Our findings are a challenge to the ASX and ASIC, which discourage outside directors from owning shares in companies they hold board roles on for fear it undermines their independence. Ownership can be a tool to help align shareholder and manager interests and is linked to a firm’s positive performance. It is only likely to be fully effective if the board size is restricted to no more than about five or six. If management needs advice then it should simply hire consultants, not create large unwieldy structures made up of so-called ‘advisors’ kowtowing to management.

Before accepting a board role, a prospective director needs to signal his believe in the board’s monitoring role either by substantial personal shareholdings or taking his pay in the form of escrowed shares during his tenure. He may also need to negotiate funds set aside to assist board members in their monitoring role as boards need access to resources independent of day- to-day managerial control, especially when dissatisfied with the CEO’s performance.

Professor Peter Swan AM FASSA is a Professor of Finance, Australian School of Business, The University of New South Wales. This opinion piece was previously published on the ASA Magazine.