When a non-executive director on three ASX boards heard about Tanarra Group’s idea that each board member should own shares equivalent to two years of director fees, the response was: “It should be shares worth three years of fees.”
The director said this far more aggressive target for ownership of shares would ensure that directors “shared the pain” when making strategic decisions such as takeovers and equity capital raisings.
The common policy in Australia is for non-executive directors to accumulate shares equivalent to about a year of a director’s fees over a three- to five-year period.
This is a minimal financial commitment that shows poor alignment between those in the boardroom and shareholders, according to John Wylie, Tanarra’s founder and principal, and, Vidhur Rangaswamy, portfolio manager of Tanarra’s Long Term Value Fund.
In a letter released this week, Wylie and Rangaswamy have urged companies in the S&P ASX 300 index to adopt a “2 in 2” principle, which means a non-executive director should own shares worth a minimum of two years’ fees, no less than two years after joining a board.
“Non-executive directors with little financial skin in the game can be more inclined to sign off on ‘growth for growth’s sake’ M&A, or dilutive or overly conservative equity raises,” they say.
“In the long term, this dilutes returns for all Australian investors and superannuants.
“We believe that in the long run, boards with greater shareholding interests are more inclined to make good decisions for their shareholders.”
One of the strongest arguments against directors owning shares in companies they oversee is that it erodes their independence from management teams. The shares allegedly lead to their stewardship being distorted or unduly influenced by financial interests.
Tanarra says this is appropriate and important at the small-cap and entrepreneurial end of the market, where independence in the boardroom is a particularly valuable commodity.
“For large companies, however, the need is reversed. The Australian economy needs more boards and directors with real skin in the game and the genuine mindset of a shareholder,” Wylie and Rangaswamy say.
The ASX Corporate Governance Guidelines have a wishy-washy statement saying: “It is generally acceptable for NEDs to receive securities as part of their remuneration to align their interests with the interests of other security holders.”
One critical issue that will arise for boards is when younger women and men join boards without having a lifetime of earnings in the bank.
Wylie and Rangaswamy say that shares worth two years of fees should be purchased upfront. In situations where that is not possible, the company should make an interest-free loan that is fully recourse and repayable in five years.
Research undertaken last year by governance advisers Ownership Matters found that 25 per cent of ASX 300 boards have less than one year of board fees invested in the companies they steward.
The research found that 51 of these boards had less than $1 million in aggregate at risk, and 37 per cent of directors (625 of 1683) held less equity at prevailing market prices than the median annual board fee.
Ownership Matters co-founder Dean Paatsch says Tanarra’s “2 in 2” principle is a good one that aligns the interests of directors with shareholders.
He says that if directors bought their shares over an extended period it would be possible to overcome concerns about insider trading by having an automatic share-buying program.
Philip Foo, vice-president of APAC research and engagement at CGI Glass Lewis, supports the “2 in 2” principle because it means directors would be encouraged to think like equity owners.
He says share ownership means directors have a better understanding of the consequences of the risks being taken by a company.
The non-executive director who recommended directors own shares worth the equivalent of three years of a director’s fees warned of the dangers of employing directors who needed the fees for their day-to-day income.
“I have seen the poor behaviour and conduct of people who could not afford to walk away,” the director said.
“Someone who is a director because they rely on the fees as a means of income has an inherent conflict of interest. They will find it harder to act independently.”
There is no guarantee that having greater skin in the game will result in better outcomes for shareholders. But Wylie and Rangaswamy say the success of the private equity asset class shows the strength of the “skin in the game” culture.
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