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.

Conclusions

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.

Vic Edwards

China could be about to witness a sharp economic contraction. Although the World Bank has played down fears of a hard landing in China, the dynamics of Australia’s relations with China are undergoing a rapid process of change, and this will reshape international and foreign policy between our two countries.

China’s growth this year is below last year’s level as weakening external demand has hurt investment and exports. Very poor Chinese manufacturing data shows it is at a 32 month low. Alas, contagion from Europe is impacting China, and that is causing pressure on Australia.

China’s economy faces growing risks from Europe’s sovereign debt crisis and from debt held by local Chinese governments but it could engineer a soft landing by easing monetary policy, according to a report yesterday by the World Bank. It expects Chinese growth will slow to 8.4 per cent in 2012.

I feel other events will also cause problems for our relations with China. There will be some reappraisal of where China stands with Australia, following the new Trans-Pacific trade-bloc know as the Trans-Pacific Partnership that includes nine nations including Australia and the USA, but China was not given an invitation to be a member nation. We should be concerned that there is now some doubt in China as to how much Australia can be trusted and relied upon.

For some years now, China has been able to rely on Australia as being a good trading partner and friendly nation no matter whether Labor or the Coalition were in power. However in just the past week President Barack Obama’s strong admonishment of China’s currency policy, the decision by Prime Minister Julia Gillard to reverse Labor’s long standing policy of banning the sale of uranium to India, and the agreement to locate a powerful 2,500-strong American marine task force near Darwin area all reshaping international and foreign policy between Australia and China. This is particularly so because China was not consulted on several of these, and Australia has been closely associated with all events. In China’s eyes, it doesn’t look good.

The World Bank has forecast that inflation will fall further, down from the 37 month high of 6.5 per cent in July, as its economy slows.

Will China react poorly to Australia by not buying iron ore, natural gas, bauxite from us?

I think not. However, it may cause them to re-evaluate their long term trading partnerships and future investments and they will most likely diversify their sources of supply – for example more iron ore from Brazil and Mozambique and less from Australia. They may also invest in developing the plant and equipment necessary to make high grade steel in these countries. However, the measures taken in the last week have also brought Australia closer to India and this may be seen as a good longer term play as India is tipped to overtake China as a production power engine in about the year 2030.

Vic Edwards is a Visiting Fellow in Banking and Finance at the Australian School of Business

Fariborz Moshirian

Last week’s Franco-German summit provided a foundation for deeper fiscal convergence amongst the Euro zone countries in the medium term. However, it failed to satisfy the expectations of the market which wanted to see much bolder action immediately.

The QE 2 provided ample US dollars to maintain liquidity in the market and now that this source of funds has disappeared, there are signs that European banks are seeking greater access to dollar market funds and requesting that the ECB provide them with US dollars.

The request made by the New York Federal Reserve to major banks in Europe asking them to ensure that they have adequate cash to deal with their day to day obligations in the US, in the wake of further financial turmoil in Europe, has created greater sensitivity in the market. This process has made the market nervous about the health of European banks and hence the market will focus on European banks in the coming days and weeks. This may well increase the interbank lending rate and create liquidity problems in the banking system. While some may argue that the ECB will be ready, as the lender of last resort, to ensure liquidity is not frozen, there is a limit to how much intervention the ECB can make in the market.

Indeed, there is some concern about the ability of the ECB to be able to continue purchasing government bonds from Italy and Spain over time. The ECB is acting as a de-facto Government or Treasury for the Euro zone. The ECB may continue this role if all the national parliaments of the Euro zone area do not ratify the European Financial Stability Fund’s (EFSF) mission by the end of September. However this role is unsustainable in the long term.

Both Germany and France have flagged that they do not intend to increase the funding of the EFSF from its current 440 billion Euro, as they are fearful that if they increase the amount now, the market will demand more. However, the idea of turning the EFSF into a bank and use this as a way of financing the needs of the member countries may not address the current concerns of the market. Only six European countries are still triple A rated to could ensure that the EFSF will remain a triple A fund. However, further transfers of funds from countries such as France into the EFSF may lead to France losing its triple A rating. Furthermore, the market is looking for bolder action. Merely allowing small economies such as Greece or Ireland access to the EFSF or Italy and Spain to roll over their debt in the next few years are no longer the only concerns for the market.

The Euro zone has lost its steam for generating economic growth. Greece’s economy is now expected to shrink by 4.5 this year. The German economy has slowed down. As the market is now nervous about European banks, the Euro zone leaders may have to take bolder action to either save the Euro and the Euro zone or prepare for a break down of the current monetary union.

Given Germany’s commitment to the Euro, the market is keen to see the Euro zone embrace full fiscal union and in this process allow the formation of Euro zone bonds that will be supported by all member countries. The concern is that small nations will over use euro bonds without any scrutiny, in the way they used the low interest rates of the ECB associated with monetary union, to borrow too much. However, similar to the US Federal system, Euro bonds should emerge as part of a full package that includes requiring small economies to forgo their fiscal independence and be subject to scrutiny by the EC and have a clear cap as to the amount of Euro bonds that they can use. On the other hand, larger economies may see their support and guarantee of the Euro zone bonds as a more effective way to contribute to the current financial turmoil in Europe than being forced by the market to pay more to rescue their large banks which have been exposed to the sovereign debt crisis, to provide more capital for investment, as foreign capital is fleeing the Euro zone rapidly, to spend more to stimulate the Euro zone’s sluggish economy, to spend more to stimulate their export market within Europe and be prepared to pay for a rise in the cost of capital.

The emergence of Euro bonds will create a unique opportunity for Europe to directly compete with US treasury bonds and attract much needed foreign capital to its shores. Large demand for euro-bonds may well bring its yield lower than the current German bond yield and allow for stronger economies in Europe to access cheaper capital and more investment opportunities.

German demands for an increase in the competitiveness of other member countries may not mean that they all become like the German economy. However, competitiveness could increase, if foreign capital moves back to small member countries in Europe and complement the austerity measures that are now in place in more than five countries there.

One of the underlying causes of the financial turmoil is a leadership crisis in Europe. Bold leadership on the part of Germany and France would not only address the current sovereign debt and banking crises but would also ensure that both Germany and France emerge economically stronger, and that capital will flow back into smaller economies. This will result in more consumption and spending in the Euro zone which will ultimately benefit Germany’s exports and German workers’ jobs over time.

Professor Fariborz Moshirian  is a Professor of Finance and Director of the Insitute of Global Finance at UNSW.

A version of this opinion piece appeared in the Australian Financial Review on the 25 August 2011.

Jonathan Reeves

As it tries to find a way out of its debt ceiling crisis and the economic doldrums, a consequence of US policy is that inflation is being exported to the world, and that includes Australia.

Unlike the European Union, or indeed any other enterprise in the world, the US Federal Reserve has the unique ability to print more US dollars if it – and the US Treasury – deems that this is in the US economic interest.

We have had QE1, we have had QE2, and as a result of the debt ceiling compromise we may well also have QE3. The US debt deal includes major fiscal cut-backs, increasing the likelihood that the US will continue to rely on heavy monetary stimulus in its post GFC recovery phase.

It is a policy which is keeping the value of the greenback down and contributing to the record high values for the Australian dollar, a factor which is not necessarily good for our economy. Just ask the Australian education, tourism and manufacturing sectors how they are faring right now.

Inflation is a global issue and the Americans are only one, albeit large, factor in fuelling its momentum. Energy costs are rising, as is the cost of food around the world.

The reality is that US policy has intentionally devalued the $US through the mass printing of money, putting substantial pressure on the AUD$ exchange rate and the Reserve Bank’s inflation and interest rate policy.

Currently, the RBA has an inflation target of between 2 and 3 percent. Referring to this target has been a major reason why the RBA’s official cash rate have progressively risen to 4.75 percent. With a widening interest rate differential it is no surprise that the $AUD has climbed so high against the greenback, as speculators pile into a currency which – like the Brazilian real – is one of the hottest in the world right now.

All this calls into question the wisdom of the RBA’s target inflation numbers. The 2 to 3 percent per annum target is far too low in the current economic climate, and adhering to it can only exacerbate the developing exchange rate, interest rate and export issues we are currently experiencing.

Instead, the RBA should raise its inflation target to 4 percent, a move which would help us avoid some of the economic problems we have seen internationally. Raising the target would certainly take some of the pressure off the RBA to raise interest rates, and it would also take some momentum out of the $AUD’s strength.

Mining magnates may be sitting on unprecedented wealth, but a look at the rest of the economy shows that personal debt levels are at record levels – comparable to struggling economies such as Ireland. Raising rates to fight inflation would create significant financial distress and prompt sharp falls in property values, further dampening already fragile consumer and business sentiment.

Inflation at 4 percent would assist in reducing debt levels, as it did in World War II following the Great Depression.

It seems that the RBA may be mindful of this, despite maintaining its current inflation targets. Earlier this month RBA Governor Glenn Stevens said the board believed “it was prudent to maintain the current setting of monetary policy” in view of the “acute sense of uncertainty in global financial markets over recent weeks.”

The RBA has not raised rates since November 2010, and inflation has been creeping upwards and currently sits at 3.6 percent. Officially amending the inflation target would take the wind out of ongoing expectations of a rate rise and could prompt some easing in the value of the $AUD.

At 3.6 percent, Australian inflation is not high by current international comparisons and does not pose as much of a threat to our economy as record highs for the currency. Given two “evils” – inflation or an appreciating currency – it is clear that our current level of inflation is by far the lesser evil of the two.

In fact, tolerating a higher level of inflation could be the key to helping Australia navigate the turbulence of the global economy.

Dr Jonathan Reeves is a financial economist at the Australian School of Business at the University of New South Wales.

A version of this opinion piece appeared in the Australian Financial Review on the 9 August 2011.

Professor Neal Stoughton

Bad economic news over the past week has led some analysts to worry that the United States and hence the world is on the brink of a new economic downturn.

However the downgrade will have little practical impact as the US remained the world’s biggest economy and Europe provides no alternative to US bonds as a safe haven.

The downgrade of the US credit ratings on Friday by S&P is mostly cosmetic.  US bonds were already on ‘credit watch’ status, which has now actually been removed, although that has received little attention. The prospect of a real default by the US on its debt is remote.

There is still some room for manoeuvre, by engaging in yet more Quantitative Easing – or printing more money to ease an ongoing credit crunch. Unlike the European Union, or indeed any other enterprise in the world, the US Federal Reserve still has the unique ability to print more US dollars if it – and the US Treasury – deems that this is in the US economic interest.

The G7 group of major industrial powers has pledged to take whatever action is needed to stabilise the market, including a third version of Quantitative easing, or QE3.

It is far easier to simply inflate the money supply which results in a ‘soft default’ whereupon US dollars are devalued.  Given that yields on long term treasuries are still extremely low by historical standards – despite the ratings downgrade – the impact of having to borrow at slightly higher interest rates is very small.

Consider the comparison with Italy which is now having to borrow at around 6% yields which causes much more pain on its fiscal budgets. Therefore the upshot of this S&P ratings downgrade is not that significant in the scheme of things, especially when compared with the real crisis going on in Europe, which has comparatively greater issues.

Professor Neal Stoughton is the inaugural Macquarie Group Chair in Financial Services at the Australian School of Business.