Too much of a good thing
The question of (fund board) independence
For this month’s pilgrimage JB gets all Taoist and bare-footed. His Diary journeys over the effects of independence on fund boards and asks: In seeking to improve culture should the Financial Conduct Authority insist on full independence?
Once more I continue my journey across non-exec land – a nomadic independent like a Kung Fu David Carradine crossing the desert asking if independent NEDs (iNEDs) should come from within the industry; should boards and committees be wholly independently constituted, composed and chaired?
Often non-executives concurrently occupy executive roles at other organisations, which is generally encouraged by the keeper of the UK corporate governance code, the Financial Reporting Council. This duality has been long fostered, going back to The Cadbury Report, published in 1992. Yet, given the genesis of independence in asset management, and reasons for it outlined in the FCA’s Asset Management Market Study (AMMS), the possibility of “a bleeding effect” between exec and non-exec looks troublesome to me.
I have seen former executives of the same fund board return (within 5 years of leaving) in a NED capacity but not as an iNED. It ensures continuity of knowledge and expertise, I can see, but their very presence potentially confuses or influences independent thinking. This could be exacerbated further if the board is chaired and composed of ex-colleagues. It then is incumbent upon the chair and iNEDs to establish clear parameters so to not confuse who is independent and who isn’t. Consider too that the ex-exec, and now NED, is subject to the primacy of sections 171–177 of the Companies Act, 2006 covering directors’ duties, whilst not within the purview of the FCA’s requirements or those of the Senior Managers & Certification Regime, which currently only applies to the fund board chair. All a bit confusing. But the FRC is clear: “The board should consider which non-executive directors are independent taking into account the circumstances set out in the Code. Non-executive directors should provide the board with sufficient information to allow them to evaluate their independence.”
That Indy Question
Almost as vociferous as the Scottish question, the idea of independent chairs and independent majority (fund) boards provokes contrasting views. The CFA Institute is supportive stating in the broader context of company boards having an independent majority. “An independent majority on the board is more likely to consider the best interests of share owners first. It also is likely to foster independent decision-making and to mitigate conflicts of interest that may arise.”. However, one of the key challenges ahead for fund boards and their committees is challenging the efficacy and resilience of long-standing models. If we link effective governance with avoidance of ‘group think’ then the reason for independence becomes to challenge, from an off-model standpoint. To that end are independents effective?
In their essay ‘Effectiveness of independent boards of UCITS funds’, Jan Jaap Hazenberg and Edwin Terink found little to support structural independence. “Using a sample of Luxembourg UCITS, we test the hypothesis that more independent boards add value for investors through lower costs and/or better investment performance, but we fail to find supporting evidence, even for funds with a higher risk of conflicts of interest.
“Oversight by independent depositaries and institutional shareholders does not seem to be effective either. It appears that board attitude and the sponsor distribution model are more important since we find evidence that boards that prioritise cost monitoring have lower costs and that independent sponsor funds have better performance. These results question the effectiveness of self-regulation or formal regulation requiring independent board members.”
Jeffrey A. Sonnenfeld in ‘What Makes Great Boards Great’ published by the Harvard Business Review is more sanguine. He notes the importance of the social dimension within Boards, as it relates to ‘group-think’. “I’m always amazed at how common group-think is in corporate boardrooms. Directors are, almost without exception, intelligent, accomplished, and comfortable with power. But if you put them into a group that discourages dissent, they nearly always start to conform. The ones that don’t, often self-select out. CEOs who don’t welcome dissent try to pack the court, and the danger of that action is particularly clear right now.”
Willis Towers’ Watson’s Thinking Ahead Institute recently published paper that suggests structure is important, but so it culture and diversity of critical thinking. The paper holds as true for fund boards, and advisory boards, just as much as for other investment committees. Indeed, in our industry these structures often overlap. The paper particularly stands out by proposing a “physically-distant but socially connected governance model”. All very new fund order.
But fully independent?
So, why not 100% independent fund boards? My nagging concern with fully independent boards is that they in essence become the incumbents, the new ‘executives’ (like with any longstanding board, independent or otherwise) rather than Sonnenfeld’s ‘dissenters’.
Group-think can apply within any group. For independence to work well you have to have constructive and continuous tension between executive and the non-executives. However, the shorter tenures in Europe may curb institutionalisation.
Nonetheless it is worth any Board considering the following:
- Remoteness versus immediacy between exec and non-exec
- Liability and accountability of the board versus the executives
- Transparency of executive decisions away from board
- The risk of board isolation and curation from the executives
- Retention of board knowledge and wisdom
- Diversity in all facets but especially knowledge expertise
- Board turnover to rejuvenate fresh thinking
It is crucial that iNEDs provide challenge within the board and use their skills, experience and knowledge to drive critical thinking and productive discussions. Independence should be evaluated throughout their tenure, to ensure they continue to demonstrate that they are holding the executives to account. Moving to independently chaired or independent majority boards should, over time, lead to better social dynamics, challenge and in turn lead to better governance. One hopes!
‘It is written in the ‘Tao Te Ching’, “Under heaven, all can see beauty as beauty only because there is ugliness. All can know good as good only because there is evil. Therefore, having and not having arise together. Difficult and easy complement each other. High and low rest upon each other. Front and back follow one another.” – Master Kan, ‘Kung Fu’, 1974, ABC network.
Financial Reporting Council
Effectiveness of independent boards of UCITS funds’, Jan Jaap Hazenberg and Edwin Terink
Jeffrey A. Sonnenfeld in ‘What Makes Great Boards Great’ published by the Harvard Business Review
Thinking Ahead Institute in the Actuarial Post
In his monthly column, Diary of an iNED, JB records his experiences on the boards of two very different organisations as he navigates the highs and lows of a plural career at a time when the fund industry is beset with challenges and opportunities in equal measure.
JB can be contacted at email@example.com.