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Responding positively to the nine-year rule

Perhaps the most controversial rule in the recent corporate governance changes has been the strengthening of the “nine-year rule” for independent directors.

Essentially, the revised rule, to be enshrined in the Singapore Exchange listing manual, states that companies intending to appoint independent directors beyond nine years are required to have the independence of those directors approved by a two-tier voting process of (1) all shareholders and (2) shareholders excluding the CEO, directors and their associates.

The Singapore Directorship Report 2018 by the Singapore Institute of Directors reported that the average tenure of independent directors is 7.3 years and 37 per cent of independent directors have served for more than nine years. Furthermore, 289 out of 523 SGX-listed companies which have been listed for more than nine years have at least one independent director who has served for more than nine years.

Clearly, SGX-listed companies need to prepare for the impact of the nine-year rule which comes into effect in January 2022.

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Rationale for the nine-year rule

The nine-year rule will require board nominating committees (NCs) and shareholders of SGX-listed companies to make important decisions.

NCs must decide whether to recommend the reappointments of long-tenured independent directors who have served for more than nine years. Shareholders must decide whether to approve reappointments when presented with the option.

The underlying assumption is that long-tenured independent directors may lose their independence if they stay on corporate boards for an extended period.

Research supports this principle. For instance, “It pays to have friends,” a study published in the Journal of Financial Economics, provides evidence that independent directors’ social ties with CEOs leads to poorer accountability of these CEOs.

There is also evidence that directors with longer tenure are more prone to escalate commitment to a decision. In other words, a director who has made a decision is less able to accept alternative views or oscillate to a different decision outcome, even when the situation calls for a change.

The value of experience

Nonetheless, there are benefits to longer tenure despite the potential pitfalls. Perhaps the strongest argument is that it allows directors to build up firm-specific knowledge of the company that can result in better decisions over time.

A study “On long-tenured independent directors,” by Stefano Bonini and other scholars from New York University found that “long-tenured independent directors are highly skilled individuals, and over time they accumulate information and knowledge valuable to the companies they serve in”.

In essence, there is a trade-off when an independent director serves on a corporate board for an extended period. The initial benefits of developing skills and accumulating firm-specific information to aid decision-making give way to the higher costs of poor monitoring over time and the possibility of less effective decisions due to cognitive bias.

Making the call

NCs must address two key questions when deciding whether to reappoint long-tenured independent directors.

First, are these directors willing to provide substantive oversight to reign in managerial actions detrimental to firm value? This addresses the direct concern of the nine-year rule over the continued independence of a long-tenured director.

Second, even if these long-tenured directors are substantively independent, are they able to continue adding value to the firm? This is an indirect concern that addresses the need for board renewal.

To address these questions, NCs must develop a robust performance evaluation system that captures key facets of independent and value-creating behaviours over time.

Examples include actively scrutinising management proposals, deliberating on the merits and risks of alternatives, and playing the devil’s advocate. Passive acquiescence or ingratiation are indicators of loss of independence.

Assessments should also cover whether directors exhibit cognitive bias, such as a rigid preference for status quo and aversion to change. NCs should appraise whether these directors have valuable expertise that contributes to the decision-making process.

Feedback from independent third parties who deal with these directors is useful information for shareholders.

Shareholders should welcome this additional channel of influence to increase board independence and value creation. They should reject boilerplate explanations of continued independence in favour of more substantive disclosure from boards and NCs that cover both independence and value creation of long-tenured directors.

It is also important for shareholders to assess each director within a broader context. For instance, the continued independence of a long-tenured director is more critical if the incumbent board chair lacks independence. Reappointing a long-tenured director also makes less sense if a company is facing strong headwinds with new external challenges that increase the importance of having a new director with relevant expertise and an openness to change.

Positive change

The nine-year rule institutionalises what boards and NCs should do on a regular basis, which is to assess the independence and value creation capabilities of directors. Furthermore, it provides shareholders an additional channel of influence to participate in board composition matters.

The nine-year rule is a more elegant solution than imposing mandatory term limits as it provides a way to harness the benefits of long tenure. Nine years is a reasonable timeframe for shareholders to have a say and for boards to provide a formal review of long-tenured directors.

The writer is a member of the Advocacy and Research Committee of the Singapore Institute of Directors.