Directors who own shares are not independent

Share ownership or retention requirements for NXDs are almost universal in the US, but there is another way.

According to a Willis Towers Watson governance survey, non-executive director stock ownership guidelines and retention requirements are nearly universal in the S&P 500 in the US, with 95% of companies having one or both.

Such findings clearly show a ‘nearly universal’ acceptance of the theory that it is good for non-executive directors (NXDs) to own stock in the company on whose board they sit. 

But what about outside the US?

According to compensation consultants, Meridian Partners, a substantial majority of companies in Canada also have ownership requirements for NXDs. And outside the North American continent, for example, in Australia, market commentators have been encouraging NXDs to own shares in order to align their interests with those of other shareholders. The Australian corporate governance code notes it is “generally acceptable” for NEDs to be paid in shares, to “align their interests with the interests of other security holders”. According to Australian law firm Allens, most of the ASX 20 requires NXDs to own at least one year’s pay in stock.

"The cornerstone of non-executive director remuneration programmes should be alignment of interests through the attainment of significant equity holdings in the company meaningful to each individual director." ICGN

The Singapore Institute of Directors in an e-guide says yes, NXDs should own shares, but not too many, as overexposure could be as bad as underexposure.

Perhaps most recently, coming into force this year, the Belgian Code on Corporate Governance recommends that non-executive directors receive part of their remuneration in restricted shares.

And, according to a PwC report, the practice of equity remuneration, equity holding guidelines and requirements is also gaining traction for NXDs in South Africa.

The International Corporate Governance Network (ICGN) is slightly more ambivalent, though only slightly. Its Non-executive Director Remuneration Guidelines and Policies says: “The cornerstone of non-executive director remuneration programmes should be alignment of interests through the attainment of significant equity holdings in the company meaningful to each individual director.” It believes that “equity obtained with an individual’s own capital” is the best way to do this – though, like the US presidential race, this could preclude all but the richest candidates from ever being nominated. 

Nevertheless, I have a certain sympathy with this view: use your own money to buy shares rather than have them given to you free in the form of an equity retainer. 

Remember that ownership of a small number of shares can be as meaningful to someone with low income, such as an employee director, as high levels of ownership to a highly-paid NXD; if you earn little and own only a small amount, the risk is as great as if you are rich and own a lot.

The ICGN recommends: “long-term holding requirements… and ownership requirements” to achieve this alignment. But here comes the ambivalence. ICGN admits in this same passage that “views on this topic have been mixed”. Nevertheless, it restates that the “benefits of immediate alignment of interests with shareowners and the maintenance of independence and objectivity for the director are of primary importance”.

I can understand the theory behind all this. Owning shares makes you a shareholder, thus aligning your interests with other shareholders so that you can represent them – the role of an NXD after all – more effectively. And while most NXDs in the US are required to hold the stock they receive as pay only until shareholding requirements are met, some are required to hold them until they leave the board. All this seems best practice and eminently sensible.

But let’s step back a moment and think about this; just because something is becoming almost universal doesn’t mean that it is effective.

Say a board had to make a series of decisions that might badly affect the company’s stock price in the short to medium-term, but would lead to significant value in the long-term; and by long-term I don’t mean three years, I mean 10 or more. While the Conference Board’s Corporate Board Practices Report notes that average tenure in the Russell 3000 is more than 10 years, median tenure is around nine. So, even if directors were required to hold shares until they are off the board – the highest level of stock retention – they would be unlikely to reap the benefits. This does not align their interests with long-term shareholders, it skews them.

'[A]ny alternative theory "would be a very hard sell to some US institutional investors". Ken Bertsch, CII executive director

But what if they were just paid in cash, and the decision meant no financial harm to them but huge financial gains for long-term shareholders? Wouldn’t that kind of independent NXD be much more likely to make the right decision?

‘NXDs should not own shares because it compromises their independence’ was a theory that was widespread during the 1990s, when I first started writing about governance. However, at least in the US and much of the rest of the world, almost everyone seems to have forgotten the theory. I haven’t seen anyone even mention it for years and when I checked with US academia, I came up with nothing. Nevertheless, isn’t it just common sense that for NXDs who see their stock retainers and equity ownership drop in value it would be a disincentive to making such long-term decisions; unless they were altruistic enough to continue to own stock well into their retirement.

When asked about this alternative theory, CII’s executive director Ken Bertsch said: “I think that is a view of some Europeans, but I would disagree.” He noted that he disliked the use of stock options – a common form of pay in biotechnology, though less common elsewhere – but was fully supportive of pay in the form of long-vesting stock and a prohibition on selling any shares while on the board. As a second thought, he added that “many of our members would be even more supportive of paying directors in stock” and suggested that any alternative theory “would be a very hard sell to some US institutional investors”. 

Lucian Bebchuk, Harvard’s James Barr Ames Professor of Law, Economics, and Finance, reminded me that any non-independence criticism might not apply to shares that cannot be cashed for a long period. This is quite true, but, according to the Willis Towers Watson survey, most retention requirements, almost three-fifths, mandate a holding period lasting only until the stock ownership guidelines are met.

Where might such a theory – shares compromise independence – appear to have some support? 

The UK’s Corporate Governance Code is silent on the matter, forbidding stock options only. 

While the code is only ‘comply or explain’, its lack of an opinion is significant for UK practice. In the latest study from Deloitte, produced at the end of 2018, only 11% of FTSE 250 companies have formal shareholding guidelines in place for NXDs, while two-fifths of FTSE 100 companies have them. 

So, why is it acceptable in the UK for independent directors to be independent of stock ownership, but not elsewhere?