IN-DEPTH: Buffett’s declaration against independent directors
This article was first published on Activist Insight Online on March 03, 2020. For more information about the module, click here.
Warren Buffett likes bridge, ice cream and actuarial tables. But he’s less a fan of independent directors, lamenting in his latest letter to shareholders that they tend to be overpaid, uninformed and generally overrated in their ability to rein in misguided management teams. According to figures gathered by Activist Insight Online, he may be right. But current boardroom trends like the push for diversity and political insights could deepen his frustration.
Seen as an antidote to the type of insider collusion that contributed to corporate disasters like Enron and WorldCom, the Securities and Exchange Commission (SEC) and stock exchanges have for years been pushing companies to add more independents. The average director independence at companies in the S&P 500 Index is now around 86%, up from around 82% a decade ago, and 82% for the Russell 3000. Around 34% of chairmen are now independent, versus 16% in 2019. In 1950, it is estimated only 20% of directors of large public companies were independent.
But anecdotal evidence indicates board independence does not correlate with performance. Over 91% of the directors at four of the five worst-performing companies in the Dow Jones Industrial Average last year – Boeing, Pfizer, Dow and 3M – are independent. Nine of the 10 companies currently most vulnerable to shareholder activists according to Activist Insight Vulnerability have boards that are from 85% to over 90% “independent,” essentially meaning that that only one board member, usually the chief executive, actually works, or recently worked for the company, and thus has an in-depth understanding of its business operations, history and culture.
That strikes to the heart of Buffett’s complaint about independent directors – that what he terms “non-wealthy directors” are often more interested in boosting their income than doing right for shareholders. Even worse, might they “yearn” for another board seat, with a recommendation from their current CEO, “thereby vaulting into the $500,000-600,000 class?” Indeed, the average total compensation for S&P 500 non-employee directors, including independent chairs, was around $305,000 in 2019, up 43% from an average $213,000 in 2009, according to a study by Spencer Stuart. Around 57% of payment was in stock awards and 38% in cash.
But the strongest point made in his letter is that the best directors are usually seasoned business or financial executives, who know how to run a major company in the same sector as the board they sit on and read a balance sheet. Most independent directors are amateurs when it comes to the companies they oversee, or as Buffett says, they are “decent, likable and intelligent,” but are “people I would never have chosen to handle money or business matters. It simply was not their game.” Likewise, “they, in turn, would never have asked me for help in removing a tooth, decorating their home or improving their golf swing,” Buffett quips.
Investors and academics have long argued the same thing. In a 2007 paper titled The Fetishization of Independence, University of Georgia School of Law professor Usha Rodrigues argued, “An independent director – a part-timer whose contact with the corporation is necessarily limited – is not inherently better suited to further the interests of shareholders than is an inside director.”
Despite Buffett’s concerns, current boardroom trends are taking corporate America in the opposite direction.
Of the 432 new independent directors appointed by S&P 500 companies last year, 59% were women and/or minorities, according to Spencer Stuart. And only 19% of so-called “diverse directors” joining S&P 500 boards were current or former CEOs, compared to 44% percent of the “non-diverse” men. Of the incoming class of “diverse directors,” 31% were “current or former line or functional leaders” representing the lower levels of management within an organizational hierarchy, and, one might expect, likely to fall squarely into the category of “non-wealthy directors.”
Likewise, almost 7% of independent S&P 500 directors appointed in 2019 had a military, political, or government background, such as former members of congress, cabinet officials, heads of federal agencies, military chiefs and state governors, according to Activist Insight Governance.
“People whom I would never have chosen to handle money or business matters. It simply was not their game,” Buffett might say.