Before you buy shares in a company, do you bother to check if its board members own shares too? You don?t care? Maybe you should, especially after a recent landmark academic study which reveals for the first time that companies with non-executive directors who have significant personal shareholdings have outperformed companies with boards that don?t, and by a big margin.
This is big news, yet perversely it is bad news for shareholders.
That?s because Australian non-executive directors share ownership is low, largely because corporate governance gospel is biased against it, due to misplaced concerns that shareholdings can prejudice a director?s independence.
The study, covering the top 200 listed firms over the period 2004 to 2009, by Sekan Honeine and Professor Peter L Swan from University of NSW?s Australian School of Business, found that companies with non-executive shareholdings just one standard deviation above the mean generally performed 28.2 per cent better than the mean. And this held pretty true even during the depths of the global financial crisis.
A performance boost of that size is hardly to be sneezed at.
It is therefore unsurprising that the academics argue in their paper, Is company performance dependant on outside director ?skin in the game'?, that ?rules that attempt to mandate non-shareholder aligned boards are positively harmful in apparently destroying very substantial quantities of wealth.?
In other words, instead of being wary of non-executive directors share ownership, Australian investors should actively start to encourage it.
And they need to because, overall, Australian non-executive directors are not big shareholders in the companies whose boards they sit on. A couple of years ago, I analysed non-executive directors share ownership for the ASX100 companies, and found that 10 per cent of non-executive directors own no shares at all, and almost 40 per cent didn?t own even a single year?s worth of their fees in shares.
But before you have a big whinge about directors not being willing to put their hands in their pockets, it?s first worth exploring why this is so, and then seeing what you, as an investor, can do about it.
The first reason is the mantra of current governance practice ? that strong share ownership impairs a director?s independence. Yet the absurdity of this is apparent if you pose the question, "Sure, we want independent directors, but who do we want them to be independent of?" The answer, of course, is that we want them to be independent of management. And we want them positively aligned with the broad shareholder base, hardly independent of them. (This first complaint could be valid, however, if non-executive directors own enough stock to entrench themselves, but such situations are rare.)
The second reason for low ownership is that share-owning non-executive directors suffer high uncompensated costs that are well in excess of those experienced by ordinary investors. This is due to the liquidity risk and concentration risk that non-executive directors face ? risks that are super-imposed on those faced by other shareholders.
Long blackout periods when non-executive directors can?t trade, short windows when they can and a concern that selling may send the market inappropriate signals mean non-executive directors have little liquidity for their investment ? one of the key benefits of listed shares ? and because of signalling issues, they will be reluctant to sell even when they can do it legally. So, unlike ordinary shareholders, non-executive directors? shareholdings are highly illiquid.
Further, a shareholding that is personally significant in value ? something many shareholders want to see in their boards ? means a non-executive directors will have a high portfolio concentration risk, which financial advisors specifically warn against. So many directors simply shrug and say, ?Why bother buying shares if the personal costs and risks to me are so high??
Third, many non-executive directors simply don?t have the spare cash to lock up in sizeable chunks of shares. Personal wealth and available cash are not pre-requisites for being a good director, nor should they be.
Yet the Honeine/Swan research paper, in clearly demonstrating a positive correlation between non-executive directors share ownership and better company performance, reinforces the obvious point that strong non-executive directors share ownership encourages directors to think like shareholders and less like risk-averse trustees. Stronger board share ownership is likely to sway part-time directors into giving a board more of their attention and, for growth-oriented companies, nudge them into a more entrepreneurial mindset.
So what do we do about it? If smart shareholders want to positively encourage their directors to buy shares, they will need to challenge the old governance gospel. More than that, they will need to recognise the unusual costs and risks directors face and offer a fair adjustment for them.
Until recently, non-executive directors got a tax deferral if they sacrificed some of their annual board fees into shares. That went some of the way to help compensate them for their higher costs and risks, but regrettably that was scrapped by the federal government. It should be reinstated.
A variety of other mechanisms could also help, but nothing will happen about this unless directors and shareholders start a constructive dialogue and reach a consensus. To get broader discussion rolling, here are a few ideas.
-- Early fee conversion: Instead of drip-feeding fees into shares yearly, how about non-executive directors pre-converting up to a full term of three years? fees into shares as soon as they?re elected or re-elected, buying at the current market price? Full ownership of these shares would only vest progressively as the directors? fees are actually earned, say, a third vesting annually.
Companies promoting director/shareholder alignment more aggressively ? growth companies, for example ? could offer non-executive directors two or three terms? worth, but with the vesting also accruing progressively. Of course, some non-executive directors will need their fees to live on, and others may already own enough shares, so not all would take this up fully or at all.
-- Stock-matching: Another solution could be that companies match non-executive directors' personal on-market share purchases with one free share for every one, two or three shares they buy, up to a shareholder-set cap. The securities granted couldn?t be sold for, say, 10 years or until the non-executive directors leave the board. (There would need to be appropriate rules for when a non-executive directors resigns before term, or on liquidation or takeover.)
-- Options: Non-executive directors stock options dropped out of favour years ago but, despite their imperfections, they could be revisited as part of any genuine effort to gain more director/shareholder alignment and to help make non-executive director share ownership more appealing.
To be implemented, ideas like these should, of course, require prior shareholder approval, and also may need changes to tax law.
Smart investors will want their companies? boards to be more closely aligned to shareholder interests. I suspect even more will seek it as this academic study becomes better known.
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