Brian Gaynor: Top performers value independence

A plethora of reports on corporate governance has been released following the Enron and WorldCom collapses. These have included major studies by the New York Stock Exchange, the Higgs Report in Britain and proposed changes to New Zealand Stock Exchange listing rules.

One of the main emphases of these reports is the importance of strong, independent non-executive directors. This issue is particularly relevant to New Zealand because a large number of our poorly performing companies have an inadequate number of independent directors on their boards.

The New York Stock Exchange believes that listed companies should have a majority of independent directors. The definition of independence needs to be tightened and should not include any former employees, until five years after they have left the company, nor anyone who has had a material commercial relationship with the company (either directly or as a partner, shareholder or officer of an organisation that has a relationship with the company).

The NYSE also recommends that every board should have a remuneration and nominating committee and these must be composed entirely of independent directors. The remuneration committee determines the compensation of company executives and the nominating committee identifies and selects individuals qualified to become board members.

The Higgs report, a Review of the Role and Effectiveness of Non-executive Directors, goes further. It believes that a director is not independent if he or she represents a significant shareholder, has been an employee in the past five years, a director for more than 10 years and has had a material commercial relationship with the company in the past three years.

Higgs also believes that the role of chairman and chief executive ought to be separated and every board should have a nomination committee with a majority of independent directors, one of whom would be in the chair.

No one should be chairman of more than one top-100 company and there should be a limit on the number of directorships that any one individual holds.

The initial recommendations of the New Zealand Stock Exchange are more stringent than the NYSE's proposals. The NZSE believes that a director who is a substantial security holder or a representative of a substantial shareholder (an individual or party that holds 5 per cent or more) is not independent. It is also proposing that the minimum number of independent directors be two, or one-third of the total number of the directors.

The latest annual study by Korn/Ferry International and Egan Associates on boards of directors in Australia and New Zealand painted a favourable view of board compositions. The study of 426 companies - 27 are New Zealand listed companies - found that 72 per cent of all directors were non-executives.

But the big question is, how many of these non-executive directors are independent, and what happens when the recommendations of the NYSE, Higgs report and NZSE are applied to our biggest listed companies?

The 10 largest listed companies, by market value, have a total capitalisation of $25.1 billion, representing 60 per cent of the NZSE's total value.

They have 80 directors, of whom only 43 are independent under the strict definitions of the three reports.

Telecom does not comply with the recommendations of the Higgs report because Dr Roderick Deane, the chief executive until September 1999, is chairman. Deane went straight from chief executive to chairman, a move that is highly criticised in most corporate governance reports.

Under the Higgs recommendations, John King is also considered to be a non-independent director because he has been on the board for more than a decade.

Carter Holt's board is dominated by International Paper representatives, the company's 50.5 per cent controlling shareholder. Chairman Sir Wilson Whineray would also not be classified as an independent director under the Higgs proposals because he has been a director since 1989.

Contact Energy has three independent directors and three representing controlling shareholder Edison Mission Energy. The Higgs reports argue that there must be a majority of independent directors; an even balance is not acceptable.

An analysis of The Warehouse highlights the difficulty in defining independence. Chairman Keith Smith and director John Avery are partners in professional firms that were paid fees of $130,000 and $395,000 respectively in the latest financial year. Under the strict definition of the NYSE, Higgs and NZSE reports, Avery is probably not independent, nor is Stephen Tindall under the proposed NZSE code because he is a substantial shareholder.

This highlights the problem of black-letter rules, as most investors would have complete confidence that Avery and Tindall always put The Warehouse's interests ahead of their own.

Sky City, Air New Zealand, Auckland International Airport and Fletcher Building all have strong independent boards, although it could be argued that two of Fletcher Building's independent directors would be excluded under the Higgs report because they were appointed to the original Fletcher Challenge board more than 10 years ago.

It is probably no coincidence that the five large companies that comply with the NYSE, Higgs and NZSE recommendations have been keenly sought-after by investors.

At the other end of the scale, many of the poorly performing companies in recent years did not comply with the recommendations. For example:

* Only two of Brierley Investments' 11 directors were independent. The chairman was an executive and the remuneration committee was also chaired by an executive.

* Twelve months ago, none of Tranz Rail's directors would have been classified as independent under the Higgs and NZSE definitions.

* Air New Zealand would not have passed the Higgs or NZSE test because it had a large number of Brierley Investments and Singapore Airlines directors on its board and was chaired by a BIL representative. The company now has an independent board even though the New Zealand Government is a controlling shareholder.

* When Vertex registered its prospectus on June 7 last it had three independent directors and two non-independent directors. But independent chairman Jonathan Hartley was appointed to the board only on June 3, four days before the prospectus was registered. He would not have had the knowledge and background of the company to fully assess the prospectus forecasts. Vertex should have had a majority of independent directors when they were finalised. It should not have waited until the prospectus was being printed.

The definition of independence needs to take into account the particular circumstances of each country. But the NYSE, Higgs and NZSE proposals give some useful guidelines for New Zealand because there is strong evidence that companies with a majority of independent non-executive directors have performed much better than those that have had poor board composition.

* Email Brian Gaynor