by Cydney Posner
With a number of institutional investors and proxy advisory firms advocating that public companies adopt “board refreshment” policies, much energy has been devoted to studying the impact of director tenure in the context of corporate governance. In “Do Directors Have a Use-By Date? Examining the Impact of Board Governance on Firm Performance,” conducted by an academic from the NYU Stern School of Business along with Quantitative Management Associates, the study authors looked at the relationship between average board tenure and company value. The paper concluded there was considerable support for the concept that companies with long-serving boards tend to be rewarded with a “stability premium.” However, board effectiveness with regard to certain board functions tends to “peak” at some point, after which “long-tenured board members begin to become a drag on the company valuation.” Moreover, for high-growth companies, after the initial period of positive impact, the detrimental effect of longer board tenure on market value is even more pronounced.
Generally, the study observes, companies prefer to “retain directors for some time because their ability to monitor and advise increases, at least initially, as they acquire more knowledge about the company. Furthermore, replacing directors too frequently is costly in the time and resources a new director needs to learn about the company. Longer board tenure also signals to the markets that the company is stable and is not subject to board ‘refreshment’ efforts by activist investors.” However, some have contended that long-tenured directors may not contribute the fresh perspectives that newer directors can bring and, more significantly, that their independence from management may be compromised.
The study examined a sample of up to 3,000 firms over an 18-year period, with director tenures ranging from less than two years to more than 14 years. To frame their study, the authors posited that board members serve three main functions: “(i) monitor managers’ performance, (ii) advise managers on general business matters (for example, acquisitions, strategic directions, compensation packages or hiring decisions), and (iii) advise managers on technical aspects of the company’s business (for example, specifics of supply chain organization or a marketing campaign).” The authors expected to find that some functions would deteriorate with length of service, while others would be enhanced. More specifically, applying the “management friendliness” theory, they expected the monitoring function to deteriorate over time as directors’ independence from management was compromised over the long-term and directors became less vigilant, thus permitting management to act “opportunistically (e.g. empire building)” and reducing company value. (See this PubCo post discussing long-term directors as the ”new insiders.”) They also expected that directors’ contribution in advising management on technologies and processes would deteriorate after a certain point as board members ran out of innovative ideas about company operations or their technical expertise on technologies or processes may have become obsolete with company technology process changes, especially in fast-growing companies. However, familiarity with company operations, they posited, would probably improve with longer tenure, but then stabilize at some point, with the result that advising on general business issues would be likely to remain stable or improve over time.
To understand the impact of tenure on company value, the study examined the relationship of tenure to forward-looking measures of equity value: (i) firm market value, as measured by market-to-book value; and (ii) stock returns. With regard to an industry-adjusted market-to-book ratio, the study found that “ longer average board tenure is positively related to contemporaneous and future firm market values. However, this relationship reverses at a certain point, roughly after 8-9 years of average board tenure. Beyond this ‘benchmark’ for the average board tenure there is deterioration in valuation, and this deterioration is significantly faster for growing firms.” Likewise, with regard to stock returns, the study found that “board tenure is reflected in stock returns in a similar manner to market values and that the deteriorating effect of long board tenure is more pronounced for dynamic, growing firms.”
According to a WSJ analysis, in 2005, at 11% of large companies, a majority of directors had served on those boards for at least 10 years. Compare that to last year, where the analysis showed that board majorities at 24% of large companies had served for a decade or more. That analysis also revealed that 20% of all directors are “at least 70 years old, nearly double the rate a decade ago,” with only two boards having a median age below 50. Similarly, one-third of directors serving on S&P 500 boards in 2005 still held those seats last year, and one out of six directors had held his seat for at least 15 years. According to recruiting firm Spencer Stuart, “just 7% of board seats turn over each year at large companies.” (See this PubCo post.)
The NYU/QMA study concludes that, because company attributes, such as growth rate, affect the optimal average board tenure, a “uniform regulation limiting board tenure across companies and at all times may not be desirable.” And notably, big companies have not been moving toward adoption of mandatory director retirement policies (whether determined by age or tenure). The WSJ reports that, among the S&P 500, “only 13 had limits on director tenure last year, down from two dozen in 2010, according to Spencer Stuart—while two-thirds explicitly disavowed tenure limits. And boards with mandatory retirement ages have been nudging them higher as directors age; today a third have set them at 75 or older, compared with just 8% in 2005, Spencer Stuart found.”
However, according to the head of a corporate governance center at the Conference Board, “’[t]he tenure issue is one that is bubbling below the surface.’” The WSJ observes that BlackRock and other big money managers have begun to oppose the re-election of some long-term directors. According to the article, State Street Global Advisors has indicated that “tenure concerns” caused it to vote against 339 directors last year and 355 the prior year before. In its revised Global Governance Principles, the California Public Employees’ Retirement System indicated “that it believes ‘director independence is compromised at 12 years’ and that companies should vigorously evaluate the director and either classify them as non-independent or explain their decision otherwise.” (See this PubCo post.) Whether this NYU/QMA study will prompt more institutional investors to question whether directors may have outstayed their welcome, or to raise that issue sooner in a director’s tenure, is an open question.