Financial Times; Jun 09, 2004

By Michael Skapinker

Our series on US corporate governance, which ran on these pages last week, reported that some companies were in a sulk about having to certify to the New York Stock Exchange that the majority of their directors were independent.

Indeed, my colleagues found that many US chief executives were moaning about anything that might limit their power. They appeared particularly exercised over the increasing tendency for the owners of their companies to behave as if they owned the place.

The Business Roundtable, an association of chief executives, while happy about independent directors, is resisting the idea that shareholders should have a decent shot at electing their own candidates to the board. It outlined its objections to the Securities and Exchange Commission, which is considering improving shareholders' election rights in certain limited circumstances.

The Roundtable says these modest proposals could have alarming and improbable consequences, such as shareholders voting to appoint competitors' employees as directors. Ingersoll-Rand, the security and industrial company, indicated last week that it was not keen on requiring all directors to seek re-nomination every year, even though 80 per cent of shareholders said this is what they wanted. Gillette last month ignored a similar shareholders' resolution, approved by 68 per cent.

There has been a lively debate in recent years about whether companies should be accountable to shareholders or to a wider range of stakeholders, including employees, customers and the community. The more pressing question is whether US chief executives are accountable to anybody.

British shareholders have more power than their US counterparts, although they have only recently begun exercising it to any great extent, pushing executives to adopt one-year notice periods rather than two or three, and forcing out several chief executives, most recently Roger Holmes at Marks and Spencer.

But the UK experience carries its own warning: corporate governance reform is no guarantee against shareholder loss. Britain escaped the corporate frauds that afflicted the US this time round, but saw some notable commercial failures. Marconi, the telecommunications equipment company, had the required complement of independent directors, but lost its way anyway.

While simple justice demands that shareholders be listened to - they are, after all, the companies' owners while the chief executives are merely hired hands - there is no evidence that the presence of independent directors prevents fraud or mismanagement.

I know of no research that shows that the right sort of board structure makes much difference - except one. In 2000, Donald Hambrick and Eric Jackson published a study in the California Management Review entitled "Outside Directors with a Stake: The Linchpin in Improving Governance", which showed companies performed better when outside directors bought a substantial number of shares with their own money.

The two researchers looked at 40 companies that had done better than their peers between 1987 and 1996 and 40 that had lagged behind. They found one important difference between the two groups of companies: in 1987, the outside directors of the best-performing companies owned an average of $470,000 of the company's shares. In the trailing companies, the figure was $80,000. The decision to look at shareholdings in 1987 was significant: at that time, few companies had formal share ownership programmes for directors. The directors had paid for the shares out of their own pockets.

The finding is unsurprising. One outside director told the researchers that he had been on several boards and had always bought a small number of shares. "But now I am on a board where the CEO encouraged us to buy significant shares. I am in for about half a million dollars and I can tell you I'm a heck of a lot more attentive."

There is a company that has applied this philosophy for years: Berkshire Hathaway. Until recently, its board looked like a corporate governance travesty. The company's 2002 annual report listed seven directors, three of them with the surname Buffett: chairman Warren, his wife Susan and his son Howard. Other members of the board were Charles Munger, the vice-chairman, and Ronald Olson, Berkshire's lawyer.

Nevertheless, Berkshire's shareholders are a famously devoted crowd, largely because their holdings have appreciated handsomely but also because of Mr Buffett's constant reminders that all the board members have invested huge amounts of their own money in the company.

Required to satisfy the NYSE stipulation on having a majority of independent directors, Mr Buffett asked shareholders to nominate themselves. The would-be directors had to have integrity, business savvy and a genuine interest in the company. There was another qualification: they and their families had to have large holdings of the company's shares. There were over 20 applications, all of which the board rejected in favour of four of Mr Buffett's friends, all of them substantial shareholders.

Owning large numbers of shares does not mean directors always speak up when they see things going wrong. As Mr Buffett acknowledged in his most recent letter to shareholders, he has sat on the boards of companies in which Berkshire had huge stakes "and remained silent as questionable proposals were rubber-stamped". Perhaps he was referring to Coca-Cola, which, in spite of his presence on the board, has repeatedly made a mess of its chief executive succession.

In their book Back to the Drawing Board, Colin Carter of the Boston Consulting Group, and Jay Lorsch of Harvard Business School, asked chief executives if they thought their outside directors remembered what had happened at the previous board meeting. Only 56 per cent said they did. I bet those with a couple of hundred thousand dollars of their own money invested remembered most of all. michael.skapinker@ft.com