Monday June 25, 2012

Independent directors: Nine-year cap sensible?

Comment by John Zinkin

The term limit seems to be an arbitrary cut-off point, only justified on the grounds other jurisdictions have settled on nine years

THE Malaysian Code on Corporate Governance 2012 (MCCG 2012) published in March stipulates that directors are deemed to cease being independent once they have been on a board for nine years. This brings Malaysia in line with other jurisdictions like the United Kingdom, Singapore and Hong Kong.

Clearly this makes sense when seen through the eyes of international investors who are comparing and contrasting Malaysia as investment destination with other markets. Having the same regulations make it easier for foreign investors to decide where to put their money.

However, the question remains whether it makes the same amount of sense from a company perspective.

Case for term limits

The case for term limits is based on three powerful ideas.

First, there is a general belief that when directors are involved for more than a certain amount of time with the same company, they lose their ability to keep the emotional distance needed to provide genuinely independent advice and counsel. This is because they have become too intimately involved in the strategy they helped formulate and review in the first place.

This school of thought argues that any constructive criticism of strategic execution becomes harder with the passage of time because the directors are increasingly “implicated” in what is going on.

So the first problem is how can independent directors preserve the necessary distance from execution to be able to monitor and supervise business performance appropriately when they have been involved in coaching and advising the CEO in the development of the strategy they are supposed to oversee?

Second, when directors work together for too long, the interpersonal dynamics tend to become so clubby that it becomes more difficult to challenge constructively. People don't want to upset their friends, and this is even more of an issue in cultures where group harmony is a prized asset.

This creates the second problem the dreaded “groupthink”. Groupthink undermines independence of thought in an invisible way because the interpersonal dynamics make it harder and harder over time to challenge the collective conventional wisdom of the group.

Third, there are some directors on boards who are no longer able to keep up with the ever greater demands being placed on them by regulators and society. The bar is raised year by year by new court rulings around the world and regulatory reactions to crises like the Asian financial crisis in 1997-98 or the global financial crisis of 2007-08.

I have heard it argued that Malaysians are too forgiving of poor performance; so having a fixed, defined time limit is an effective way of getting poor performers off boards while saving face for all concerned.

Whether that is special pleading or not, it is true that having a fixed term limit does mean directors can be removed without unpleasantness or loss of face.

Case against term limits

The case against term limits is based on equally powerful ideas.

First, there is the argument that independence is the result of a director's state of mind and integrity. Directors either think independently or they don't.

Those that do will continue to do so regardless of the time they spend on a board because it is in their nature. I know many directors of listed companies who have been on their boards for more than nine years and who continue to be scrupulously independent in their thinking and in their effectiveness as constructive challengers of the CEO.

They have learnt how to reconcile the fact they are involved in the formulation of the strategy and in advising the CEO in its development with the need to keep their distance to oversee and monitor its execution.

Second, some would argue that the longer the directors have been on the board, the better they get for two related reasons:

● Independent directors are at a systemic disadvantage compared with executive directors; the former do not have access to the same amount or quality of information. So they need time to understand the drivers of the business at a detailed level, and if they only meet four times a year, it may take several years before they really are able to get under the skin of the business.

Some people say independent directors only become really useful after four or five years (it may take longer depending on the complexity of the business) and so to ask them to step down at nine years is to lose them when they are just at their peak; and

● This is perhaps even more the case when the company is closely controlled because it takes time for the independent director to learn what the controlling shareholder agenda is, and therefore how best to challenge constructively without being asked to step down in the words of Tan Sri Azman Yahya “rocking the boat without sinking it”.

Third, boards are required to report annually on the effectiveness and independence of their directors. On this basis, some people argue there is no need to have a fixed term limit.

Every year becomes the test for independence rather than waiting for nine years. After all, what is the point of keeping a compliant director on the board until nine years are up, if independence of mind is the key to adding value on a board?

Lastly, why nine years and not 12 or six? Nine years seem to be an arbitrary cut-off point, only justified on the grounds that other jurisdictions have settled on nine.

● John Zinkin is managing director, corporate governance, of The Iclif Leadership & Governance Centre.

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Monday June 25, 2012

Independent directors: Nine-year cap sensible?

Comment by John Zinkin