The term “board refreshment” may elicit some giggles – no, we’re not talking about shots of The Balvenie 50-Year Old Single Malt Scotch Whisky, Speyside, Scotland – but the topic of director tenure is increasingly becoming the focus of both academics and investors. Why? Don’t long-term directors contribute deep knowledge of the company and provide experience and continuity to the board? Or, as some contend, is director independence compromised over the long term: that is, are long-term directors, especially those with C-suite backgrounds, really the “new insiders”?
As discussed in this article in the WSJ, in the last several of years, some academics and institutional investors have begun to question whether, after a long tenure on the board, an “independent” director is really still independent, especially when the director is a retired CEO or C-suite executive from another firm. Of course, they’re not talking about independence in the technical sense of the NYSE or Nasdaq definitions; rather, the concept here is more in the nature of “social independence.” One concept of “social independence” was described in the academic paper “Seven Myths of Boards of Directors,” as based on “education, experiences, and upbringing—positing that people who share social connections feel psychological affinity that might bias them to overly trust or rely on one another without sufficient objectivity.” In the paper, the authors discuss a study of directors of Fortune 100 companies between the years 1996 and 2005, which showed that the absence of “social independence” is “correlated with higher executive compensation, lower probability of CEO turnover following poor operating performance, and higher likelihood that the CEO manipulates earnings to increase his or her bonus. They conclude that social relations compromise the ability of the board to maintain an arm’s-length negotiation with management, even if they are independent by NYSE standards.” (See this PubCo post.)
Sidebar: Notably, the WSJ also suggests that this type of “longevity tends to ensconce white males, whose dominance of boards has been criticized for leading to less robust risk management, among other things.”
According to the WSJ, long board tenure, together with the rise in the appointment to boards of retired CEOs or other C-suite executives from other firms, is giving rise to a new class of director: the “new insider.” One academic cited in the article speculates that the “increasing use of board members who serve for longer periods and come with a predisposed background as corporate insiders elsewhere is not accidental, but is in fact an effort on the part of companies to import the benefits that an ‘insider’ board would have produced.” (According to the article, he ventured that this corporate reaction could be “a sign that regulation stressing the need for independent directors ‘may have gone too far,’ and could be inducing public companies to seek proxies for their ‘missing’ insiders in the board room.”)
Although in the U.K., the WSJ reports, an independence review is mandatory after nine years of service, no similar review is required in the U.S., where there are a significant number of companies with long-term directors. TheWSJ reports that, according to Legal & General Investment Management, part of a U.K.-based insurance and investment management company, “only 3% of S&P 500 companies have term limits for directors, and independent directors at more than 100 S&P 500 companies have served for more than 25 years.” The article also reports that, according to academic research, the “number of S&P 500 directors with tenure exceeding 10 years rose 35% to 2013 from 2007, and for those with tenure of over 15 years, the rise was 31% in the same period.”
The NACD has previously identified director tenure as a critical issue for board focus and encouraged boards to consider succession planning and proactive approaches to refreshment. (See this PubCo post.) Some investors have also taken up the cause, becoming more proactive in addressing board tenure. The WSJ identifies two institutions that have indicated that director tenure could shape their votes: LGIM said that, beginning in 2017, it will vote against the chair of the nominating committee if average board tenure is 15 years or higher or if there have been no new board appointments in five years. In addition, the group will vote against committee members or lead independent directors if they have been serving for more than 15 years. And last year, in its revised Global Governance Principles, CalPERS indicated “that it believes ‘director independence is compromised at 12 years’ and that companies should vigorously evaluate the director and either classify them as non-independent or explain their decision otherwise.” Although, at this point, the key proxy advisory firms typically do not support shareholder proposals for mandatory retirement age or term limits, ISS has indicated that it will “scrutinize boards where the average tenure of all directors exceeds 15 years for independence from management and for sufficient turnover to ensure that new perspectives are being added to the board.” Similarly, Glass Lewis favors “periodic board refreshment to foster the sharing of new perspectives in the boardroom and the generation of new ideas and business strategies.”
One problem raised in the article is figuring out how long is too long and “how old is too old.” But reliance on mandatory retirement age policies may sometimes be misguided and arbitrary: the head of corporate governance North America for LGIM contended that directors “‘need to be on the board because they are relevant, because they have the right skills….I think that conversation has been halted because [boards] rely on age of retirement’ to replace [their] members.” That view is echoed by Glass Lewis: “While we understand that age limits can be a way to force change where boards are unwilling to make changes on their own, the long-term impact of age limits restricts experienced and potentially valuable board members from service through an arbitrary means. Further, age limits unfairly imply that older (or, in rare cases, younger) directors cannot contribute to company oversight.” According to the executive director of the Conference Board Governance Center, “Whatever you decide on, it’s going to be arbitrary.’ Avoiding an arbitrary number seems to be a key point in the debate, but the absence of any guidelines leaves key board members at a loss on how to approach directors that need to be asked to leave.” How then to implement changes? The corporate governance expert from LGIM advises that developing “some kind of roadmap will help companies maintain a board that can adapt as the corporate challenges and strategy change over time…. ‘A more continued process, a more thoughtful process will help lead directors to have those conversations with their boards….’”
Experts cited in the article warn that, while potential loss of independence for long-term directors can be an issue, “any board reshuffle should be mindful of preserving valuable experience gained by length of service while bringing in a new perspective.” Ironically, appointing new directors is itself not without risk of compromised independence: in “Seven Myths,” the authors point to studies that found that, with respect to the concept of “social independence,” directors appointed by the current CEO are more likely to be sympathetic to the CEO’s decisions. What’s more, the larger the proportion of board members “appointed during the current CEO’s tenure, the worse the board performs its monitoring function—measured in terms of pay level, pay-for-performance sensitivity, and the sensitivity of CEO turnover to performance.”