OLD ARTICLE – Original posted on June 18, 2015
There is a lot emphasis on independence in various roles in financial markets. External auditors have to be independent, advisors hopefully too, wealth managers, some members of company Boards, and so on. All independent.
The theory goes that if a person is independent, then they will make decisions devoid of bias and, if their role is protect others’ interests, that this lack of bias will ensure fair treatment.
An independent director on a Board will look after shareholders from unscrupulous executive directors, rather than look after the Board and their own agenda. An independent wealth manager will allocate his clients funds to the best available fund(s), rather than the fund that pays him the most amount of money (called “rebates”) to allocate to it. An external auditor should be independent so as to make a fair and impartial decision on the financial records of the company, unswayed by if the financials are good or bad. And so on the list goes…
So independence is good.
Well, yes and no… There is a dark side to independence.
Independence is unbiased by virtue of its nature, but it can also be very much uninvolved and uncaring by this same virtue. There is a fine line between unbiased and uncaring.
By the simple virtue of being an independent non-executive director, the said director will know less of the internal affairs of a company than its executive directors. Thus, if the independent non-executive director is lazy, mislead or fed misinformation, then there effective is impaired and, really, let’s be honest, they add no value and do not protect shareholders from anything. And, other than picking up their directors fees, they might not even care much about all of this as they have no real downside in not caring.
Same with external auditors and wealth managers and the full list of so-called “independents” in our financial markets.
I might stand alone here, but I do not value independence very highly at all. Independent roles can be left in the wilderness of uncaring as they have no “skin in the game”.
What I find far more valuable is: incentives.
There is a whisper story I’ve heard a couple times about a CEO that was hired to turn a failing airline around. They hired him with a massive bonus pinning on his ability to make the airline generate a positive EBITDA.
Now, if you know EBITDA, it stands for “Earnings Before Interest, Tax and Depreciation”. It is a theoretical cash proxy and often used as a valuable financial measure.
But, it is also easily manipulatable (and legally too!)…
What this smart CEO did was he bought back all the leases (planes, buildings and other assets) that the airline was paying.
Well, if you are renting an asset, then its rent is going through your Operating Expense line item. If you buy the asset back, then the cost of the asset is now on your balance sheet and you begin depreciating it.
It’s old rental cost that was going through EBITDA now moves to depreciation, which is excluded from EBITDA. Hence, without doing anything real, you have boosted EBITDA.
And, low and behold, the airline turned a positive EBITDA, the CEO was paid a massive bonus per his contract and he promptly resigned. The airline, though, was still making horrific losses and ultimately was left in an even worse state because of all the assets that had been moved on-balance sheet.
Who is to blame?
I would say that the Board that hired the CEO is to blame. The CEO simply acted according to his poorly-worded incentive and he did so to the letter.
The moral of the story: people act according to their incentives.
This may not only be a good lesson for analysing companies and management teams in listed stocks, but in life in general. People act according to their incentives, so if you understand their incentives you can very well guess how they will act.
Hence, independence is overrated: it has no incentives. With no real incentives, independence often, well, does nothing.
In closing, I would take a highly incentivized, aggressively bias CEO and management team over a vague, impartial and unmotivated independent one any day of the week. Please, can I have less non-execs and more cleverly structured, well-balance incentives on my Boards?