Debate over the length of director tenure, and therefore the value of setting term limits, has emerged as a contentious topic in recent years. Early this year, The Singapore Exchange and the Corporate Governance Council launched a public consultation for amendments to the 2012 Code of Corporate Governance. One important issue lies in the review of the criteria that determines director independence.
The current Code lists six tests of director independence to determine that a director has no relationship with the firm, its related corporations, its substantial shareholders or its officers. While pecuniary relationships clearly exclude a director from being independent, a gray area is non-pecuniary relationships such as informal social ties that have developed between directors and management over time. According to the current Code, “the independence of any director who has served on the board beyond nine years from the date of his first appointment should be subject to particularly rigorous review.” This guideline was intended as a safeguard against the loss of objectivity arising from too-friendly relationships between long-serving directors and management.
The Consultation Paper by the Corporate Governance Council highlights that almost 30% of independent directors in Singapore have tenure of over nine years. This is raised as a concern, as the relatively high concentration of ownership in Singapore’s publicly listed firms accentuates the risk of expropriation against minority shareholders when long-serving independent directors become beholden to majority shareholders. Further, the lack of a strict term limit may hinder board renewal in terms of recruiting new members with relevant expertise to enhance firm value (Willie Cheng, Business Times, 10 February 2017). The issue of contention is therefore whether the nine-year rule should be revised to a mandatory limit, rather than the current “comply or explain” approach.
Indeed, governance experts have long debated the merits and perils of board tenure. On one hand, opponents of board tenure caution the risks of loss of objectivity and lack of agility. Over time, long-serving directors develop cozy relationships with management, which result in weaker monitoring and advice on strategic issues of the firm. For instance, social relationships developed between directors and CEOs have been found to result in reduction in firm value and higher executive compensation. On the other hand, proponents of board tenure espouse the benefits of deep experience and positive board dynamics. Through on-the-job experience, longer-tenured directors develop firm-specific knowledge and connections, which provide stronger monitoring and relevant counsel to management, and also ensure continuity in strategic direction.
Evidence from academic studies show mixed effects of board tenure, thereby attesting to the complex relationship between board tenure and effective corporate governance. A study of a sample of S&P 1500 firms in the US from 1998 to 2010, for instance, found an inverted U-shaped relation between board tenure and firm value. The threshold of tenure where performance starts to decline varies between seven and eleven years, depending on industry and firm characteristics that influence the firm’s monitoring and advising needs. In summary, the key takeaway to the question of how long is too long for an independent director is “it depends”.
Setting a mandatory nine-year term limit has its advantages such as reducing ambiguity over assessment of independence and retaining the director as a non-independent director if her expertise is valuable. At the same time, the board renews its capabilities by recruiting new independent directors. However, a mandatory term limit also comes with risks. First, the “optimal” length of tenure varies, such that a one-size-fits-all rule introduces strategic constraints on firms that can be detrimental. Having long-serving independent directors may not necessarily decrease firm value. To cite an anecdotal example, the Breadtalk Group, which has won multiple brand awards, has two independent directors whose tenure extends beyond nine years. Second, board renewal in terms of board membership changes may not be adaptive, but disruptive instead. For instance, our academic study of S&P 500 firms from 2003 to 2013 found that more board membership changes, brought about by incoming and outgoing director changes, led to lower firm performance, suggesting disruptive effects on board dynamics. Third, while an incoming director could be viewed as independent in terms of being newly appointed to the board, the director may already have developed friendly relations with management in other contexts (e.g., through sharing board appointments in other firms or through shared membership in social clubs).
If there is no one optimal tenure rule that fits all firms, then a mandatory nine-year limit may not be the best option. The alternative option of subjecting reappointments of long-serving independent directors to an annual vote from shareholders is preferable, especially if accompanied by disclosure of other pertinent information that would help shareholders make an informed decision. Specifically, the authorities can consider recommending firms to disclose group mean tenure and tenure diversity in boards as board characteristics can amplify either the positive or negative effects of director tenure. Both mean tenure and tenure diversity in boards are also important measures to evaluate effective corporate governance. For example, the risk of lack of objectivity of a long-tenured director may be mitigated by a board, which is diverse in length of tenure since having a balanced spread of less and more experienced directors decreases the probability of groupthink. The authorities can also enforce a stricter “comply or explain” approach by requiring more thorough disclosure of director appraisal criteria, board renewal and director succession plans, which provides stakeholders with more complete information to evaluate whether the board as a whole remains independent and relevant to the needs of the firm.
About the author
Wong Sze Sze is Associate Professor, Strategy, Management and Organisation at Nanyang Business School, NTU Singapore.
This commentary was published in The Business Times on 9 February 2018.