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Full Circle on Independent Boards

Estimated Reading time: 10 minutes

The Walking Dead 

“Great things in business are never done by one person. They’re done by a team of people.” Steve Jobs

I started the most formative part of my career working with Wally Carucci at Carr Securities. “Wally World,” as his friends would call special situations nano-cap land, was filled with zombie owner-operators that would plod along without any developments for years. Watching paint dry was more interesting than following many of these stocks.

An inherent problem with many of these nano-cap owner-operators is often that the controlling position by a manager can lead to the lack of any real debate taking place in the board room. It becomes the epitome of a “rubber stamp” board. Nepotism rules the day at many of these firms, where the total annual income available from the company’s treasury overwhelms the value of the controlling manager’s stock holdings.

Status quo sets in, as the annual income removes any sense of urgency to reach for more discontinuous outcomes. Every annual shareholder meeting then reinforces the status quo by confirming the control of the manager in place, with small private shareholders having little alternatives on the company’s ballot.

The role of the independent director was born to hold these controlling managers accountable to other shareholders, who collectively often own the majority of shares. They are the “silent majority.” At their best, independent directors represent these shareholders, and challenge the managers with their career expertise, and help improve company plans with outside views, fresh perspectives and a greater sense of how peers are run.

Unfortunately, many of these nanocaps are unable to afford such highly-skilled independent directors, and so it often ends up being friends from the golf club, or candidates trying to rebuild their resumes.

Peer Review Pearls of Wisdom

“A few yes men may be born, but mostly they are made. Fear is a great breeder of them.” William Wrigley

During editor and peer review for our White Paper on owner-operators, a great suggestion was made for us to compare our analysis to prior studies on the link between ownership, governance and company performance. The syllabus is significant, so it took a few months to thoroughly review.

One topic we paid great interest to was the role of independent directors. Research by Bhagat and Black has linked a higher proportion of independent directors to less favorable company performance.

Their paper, “The non-correlation between board independence and long term firm performance“ resolves that from 1985-1995, firms with a greater composition of independent directors on the board had fairly significant negative correlations to company performance. They measured the Q Ratio (-0.44 correlation), to estimate the company’s valuation relative to replacement value. They also looked at return on assets (-0.07 correlation), as well as sales to asset ratio (-0.21 correlation) showing negative correlations across the board on nearly 1,000 US public companies.

As cited in their paper, independent directors on US boards grew from 20% of the board in 1970 to 31% in 1980, and then up to 54% by 1983. It kept gaining steam from there, with 64% of the American boardroom being comprised of independent directors in 1991.

Corporate governance expert advisors then exported this “wisdom” of independence to the rest of the world by codifying into exchange rules and providing proxy advisory firms, ISS and Glass Lewis, more ammunition to push independence. As a result, boards are even more independent today than they were when Bhagat’s and Black’s study was conducted.

On the boards where I serve, I personally find independent directors incredibly useful in providing unbiased feedback. Having highly skilled and true independent directors that can challenge the owners’ initiatives, as well as management’s plans, is extremely helpful. This is most often the case where the directors have deep prior career experience with the industry. While they must theoretically answer to shareholders as their elected representatives, that link is largely broken thanks to many onerous regulations and laws, like Reg FD, and the significant rise of the passive investor base led by ETFs. The two-way dialog between the representative and the elector is dead today.

The Silent Majority

“Nothing is given. Everything is earned.” Lebron James

At Amazon meetings, Jeff Bezos would always leave a chair at the table for someone to articulate the voice of the customer, the most important stakeholder in any business. He would ensure that this “silent” stakeholder was top of mind for managers as they’d meet to discuss plans.

The religion of independence has now gone so far that, in my experience, not only are a “majority” of independent board members now required by exchanges and proxy advisors, but the insinuation is that pretty much the entire board except the CEO should be independent. In fact, in last year’s campaign for the board of Leonardo, we learned that the nominee of a competing ballot was actually telling shareholders that I was unfit to serve because I personally owned shares of the company, and thus not independent.

After decades of an incessant drumbeat on the importance of independence, the voice of the shareholder is now largely gone in the board room — and there is no chair left to represent them. Not only does this remove accountability between company performance and director roles, but it also removes the link between representatives and companies’ owners – the shareholders. It’s not taxation without representation, but representation without accountability.

While some would counter that directors are elected by shareholders, with 74% of recent director votes being  uncontested, the silent majority of shareholders actually have little choice but the candidates the board chooses, reinforcing status quo. If they withhold their votes, most nominees pass by even collecting as little as one vote.

Again, having been born in Wally World and having seen the downsides of boards exhibiting little independent thought from the controlling manager, I greatly appreciate independent directors. So, while firm performance points towards less attractive company performance the more the board is independent, it has become clear from personal experience why an owner’s voice, or voices, matter on the board.

When Push Comes to Shove

“A ‘No’ uttered from the deepest conviction is better than a ‘Yes’ merely uttered to please, or worse, to avoid trouble.” Gandhi

The most obvious reason to have owners on the board, is that long-term owners dig their heels in when there’s an important point that’s being unappreciated by the room. Without significant skin in the game, there is zero incentive to dig in one’s heels when push comes to shove. The one caveat is that while short-term investors presumably give little thought to terminal value, long-term investors are left holding the bag at the end of the day. Terminal value is of utmost importance to us at GreenWood.

Nearly all of that terminal value will be determined by capital allocation determined over the medium-term. As Warren Buffett said in his 1987 letter to shareholders:

“The lack of skill that many CEOs have at capital allocation is no small matter: After ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.

CEOs who recognize their lack of capital-allocation skills (which not all do) will often try to compensate by turning to their staffs, management consultants, or investment bankers. Charlie and I have frequently observed the consequences of such ‘help.’ On balance, we feel it is more likely to accentuate the capital-allocation problem than to solve it.”

Most major capital allocation decisions that come from boards have ample consultant reports behind them. This is “cover your ass” insurance, with independent members being able to blame an external party in case the price paid for an acquisition ends up being a disaster.

Committed shareholders, on the other hand, aren’t looking to cover their ass, rather, they are looking to maximize their reward while minimizing the risk associated with such investments. They are covering their assets.

While not all consultants or bankers are created equally, the bulk of their incentives lies in the fees they receive over the short-term. They are not accountable to the long-term results of their advice. Neither are directors without any significant skin in the game.

We also appreciate that not all shareholders are created equally. Many are myopically focused on the headline cadence over the course of a few weeks. But the bulk of the humans involved in asset allocation carry out their time horizons to a matter of years as opposed to weeks.

Our investors are committed to medium-term and long-term outcomes. It’s for them that I have sometimes dug my heels in during capital allocation discussions. I vividly recall a board debate regarding investing in government bonds at a time when the yields were scraping into negative territory.

Few thought it was even a debate worth having, but for me, the push became a shove when I argued against investing in a capital-destructive instrument. Less than a year passed between that “push come to shove” debate and the SVB debacle which created a run on the bank due to its investments in long-duration low-yielding debt.

Debates Polish the Jewel

The gem cannot be polished without friction nor man without trials.” Confucius

Nearly no boardroom will allow “push & shove” conduct, as the settings are almost always cordial, if not formal. However, when I’ve seen governance at its best, is when all directors are free to disagree with each other.

While split votes on boards almost never happen — for everything is expected to be largely unanimous — the quality of the debate can fundamentally shape the outcome. Disagreement is not pleasant. But it doesn’t have to be destructive. In fact, it’s often more constructive than passive by-standing.

Many of the initiatives that I’ve proposed on the boards where I serve are not immediately accepted by other board members. Given our funds never have full control of an asset — indeed are far from it — I’ve found that these initiatives often are an opening to spark a necessary conversation amongst my fellow directors.

Often the first idea is not the best idea. But rather than not raise the question, I try to begin the debate and collaborate with my fellow directors to refine the concept. The burden is on me to work on the idea, persuade the other independent directors who come from a different background than investing and capital allocation, and incorporate any constructive feedback.

That is the power of a long-term owner on the board — and particularly one that cannot control the outcome, debate and usually the shareholder vote. If an idea has merit, and has the possibility to create substantial shareholder value, an owner will not abandon the idea.

This relationship is quite different from a “check-the-box” independent board member because we are committed. We are committed and accountable.

Full Circle

“Countless words count less than the silent balance between yin and yang.” Lao Tsu

What started in my career as a reticence towards heavy insider ownership of a company has turned into an attraction to having ownership present in the boardroom — when that investor’s intentions are constantly focused on long-term value creation.

However, there is no blanket panacea.

A board of only independent members will likely be beholden to the CEO for their ongoing inclusion in the group. But oddly enough, on boards where managers control over 50% of the votes, the same dynamic often applies.

No one will actually fight a point — they just reinforce the views of the owner — even if the idea is not in the best interest of the minority shareholders. Once the accountability of being plausibly removed from office is gone, the status quo rules.

Bolloré is a great example of this dynamic. While Vincent Bolloré created a significant amount of value from nothing in the first part of his career, the directors on his various holding companies have zero incentive to stand up and advocate against the status quo. However, status quo has led to the company barely keeping pace with indices over the past decade.

The one single decision that could create the most amount of value for shareholders — the merger of Bolloré and Compagnie de l’Odet — has been elusive to even the most patient believers. The consolidation of these share structures would overnight eliminate nearly three quarters of the shares outstanding. Yet, it would also eliminate the convenient roles for family members in management.

Both boards could use some independent directors.

It would seem as though I’ve come full circle back to Wally World’s precepts – that owner managers are detractors to company performance.

But isn’t that contradicting both our own recent research and Bhagat’s & Black’s?

The nuance here is that the yin and yang of accountable owners and independent experts with fresh perspectives is key for balancing the short-term with the long-term, or the status quo versus discontinuity. Entrenched and controlling managers are in no one’s best interest, including those entrenched.

So, while heavy management ownership can sometimes be a hurdle working against a sense of urgency to create value, it is also required in order to drive long-term performance.

Our suspicion is that the near 1,000 companies studied by Bhagat and Black found a negative link between board independence and company performance because of the narrative that has come to dominate corporate governance that only independent members create healthy board dynamics.

The notion that I was personally not qualified to serve on a board because I own shares is a great example of this religion being taken too far. We believe it’s time for boards to be more balanced, and bring the silent shareholder back into the debate.

Research supports it, as does common sense, and personal experience.

As long as the debates remain robust and dynamic, full of healthy disagreements and accountable participants, a world of uncertainty can be transformed into opportunistic moments to create transformational value.



This article has been distributed for informational purposes only. Neither the information nor any opinions expressed constitute a recommendation to buy or sell the securities or assets mentioned, or to invest in any investment product or strategy related to such securities or assets. It is not intended to provide personal investment advice, and it does not take into account the specific investment objectives, financial situation or particular needs of any person or entity that may receive this article. Persons reading this article should seek professional financial advice regarding the appropriateness of investing in any securities or assets discussed in this article. The author’s opinions are subject to change without notice. Forecasts, estimates, and certain information contained herein are based upon proprietary research, and the information used in such process was obtained from publicly available sources. Information contained herein has been obtained from sources believed to be reliable, but such reliability is not guaranteed. Investment accounts managed by GreenWood Investors LLC and its affiliates may have a position in the securities or assets discussed in this article. GreenWood Investors LLC may re-evaluate its holdings in such positions and sell or cover certain positions without notice. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of GreenWood Investors LLC.

Past performance is no guarantee of future results.

This Post Has One Comment

  1. I’m posting some feedback received from a close friend (who’s also an independent board member on multiple boards). Amen to this definition of independence! –SW

    Buffett defines it as having the willingness and ability as a board member to say no to a good and charismatic CEO who wants to do a value destroying deal…and to do that he has found it necessary for (i) a director to have purchased shares with their own after tax money (“skin in the game”) and not granted RSUs or options, in an amount that is material to them and (ii) not be dependent on the director’s comp in their lives or the stature as a result of being on a given board. His (and Munger’s before he passed) view was based on extensive personal experience (I think he sat on well over 22 public boards in his lifetime, not to mention private company boards, University board (Grinnell) when he was young, etc.) and and study as a control, large but minority and passive investor.

    The proxy advisors like ISS and Glass Lewis, NYSE/NASDAQ and other Exchanges, the “governance groups” at large indexers like BlackRock, Vanguard and State Street, the executive search firms, consultants and the lawyers define it very very differently. Their definition of independence relates to consanguinity and business dealings between controlled entities (so for example KO disclosed that Buffett was not “independent” when he sat on the KO Board because it had a few hundred thousand dollars of sales to Berkshire owned McClane – when BRK owned billions of KO stock!…yet it was Buffett and Herb Allen who forced the change in CEO at KO when it was stumbling, and prevented KO from overpaying on a large acquisition). In how Boards function, their definition of independence is legal…. not business reality or practice driven.

    Most of the research on “independence” fails to have a true understanding or what to consider in terms of how real owners or capitalists think about independence. Moreover, many “owner operator” studies get ownership off by including options and RSU grants that are not vested or exercised and the shares held. The problem is that getting at true independence is not a matter that is easily screened but requires extensive research on each director at each firm.

    Real owners, those with their own after tax money at risk, in my experience (and Buffett/Munger’s) always consider what other real owners think and say, but take responsibility for their decisions and the consequences ….I also find that, even when there is a disagreement in judgment, they tend to defer to the capitalist with the most capital at risk.

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