Dueling Definitions

The term “independent director” may be intended to describe hoped for independent mindedness as much as anything. In various descriptions, the term “independent in fact” seems to be growing in use, as the many definitions of independence applied can be confusing. The terms “independent,” “outside,” “non-management,” “non-executive,” and “disinterested” are often used as if they are interchangeable, but they are not. Each implies a different role for the director described and is defined by state and federal laws as well as stock exchange regulations. Not surprisingly, the result is an inconsistent set of rules across jurisdictions.

New York Stock Exchange Listing Requirements Stress Independence of Directors

In response to the requirements of SOX, corporate governance standards that require listed company boards to have a majority of independent directors were introduced in 2003. These standards further require that audit, compensation, and nomination committees must all be composed entirely of independent directors.

The NYSE Listed Company Manual requires, for example:

No director qualifies as ”independent” unless the board of directors affirmatively determines that the director has no material relationship with the listed company (either directly or as a partner, shareholder or officer of an organization that has a relationship with the company). Companies must disclose which directors are independent and disclose the basis for that determination.

Unlike SOX, the NYSE rules do not contemplate specific mandatory powers for independent directors. In addition to an audit committee, listed companies must have a nominating committee and a compensation committee, each composed solely of independent directors. Unlike the audit committee, however, these committees need not have exclusive power in their respective field and could be limited simply to making recommendations to the board as a whole. On the other hand, independent directors must constitute a majority of the board.

The NASDAQ rules give more power to independent directors. As in NYSE-listed companies, audit committees have the exclusive power to hire and fire the outside auditor. Unlike in NYSE-listed companies, however, the compensation of officers is to be decided by a majority of independent directors or by a compensation committee consisting solely of independent directors (subject to minor exceptions), and board nominations are to be decided in a similar fashion. Although both NYSE-listed and NASDAQ-listed company boards must have a majority of independent directors, the board as a whole in an NYSE-listed company could override committee recommendations in matters of compensation and nomination, but not in a NASDAQ-listed company.

We dwell on this to illustrate first that apparently small differences in definition can have a huge impact on corporate activity, and second that if the regulators and stock exchanges are neither clear nor consistent in the roles expected from independent directors, it is hardly surprising that independent directors often do not understand the expectations placed on them, and where they come from. I have spared you a recitation of the many and varied theories expressed in academic and legal precincts as to what independent directors are intended to do but suffice it to say that there are many possible useful functions and little agreement. This leaves the independent director to pick and choose, or simply to take the path of least resistance and follow the leader.

Here is an example: substantial disagreement exists regarding stock ownership by the putatively independent director. Those who see the independent director primarily as a defender of shareholder interests against management will naturally see more share ownership as better, because it will more closely align the interests of the director with the shareholders. Those who view the independent director as someone whose judgment should be untainted by any financial interest in the company are suspicious of share ownership. And adherents of each view roundly disdain the other.

The two exchanges, for their part, differ from federal law and from each other. The NYSE simply incorporates by reference the requirements of federal law as far as audit committee members are concerned. But where its own requirement for a majority of independent directors is concerned, it imposes no limits on shareholding whatsoever. In proposing its rule change, the NYSE specifically noted the views of commentators that share ownership should be viewed as desirable and stated that “as the concern is independence from management, the exchange does not view ownership of even a significant amount of stock, by itself, as a bar to an independence finding.”

NASDAQ takes a different view. It sets a limit on audit committee director shareholding of the lower of (1) whatever the SEC prescribes under the SOX, and (2) 20 percent. As we have seen, the SEC has not in fact prescribed any per se upper limit on director shareholding (although it has established a safe harbor of under 10 percent). Thus, NASDAQ may end up forbidding what the SEC, which defines affiliation via a concept of control, might allow.

There is an is important fundamental difference in approach between the SEC and both the exchanges. Both exchanges require company boards to have a majority of independent directors except when the company is a “controlled company,” i.e., when a single person, group, or company controls more than 50 percent of the voting power. In other words, they see independent directors as a protection for shareholders against management, not against other shareholders. A shareholder who controls a company does not need an external rule maker to protect him from the management team that he can appoint. Minority shareholders may need protection from controlling shareholders, but the exchanges are apparently willing to leave this task to other bodies of law, such as federal securities law requiring disclosures, and state corporate law mandating certain fiduciary duties.

The SEC’s approach, however, is different. As we have seen, an “affiliated person” cannot be “independent,” and the SEC defines affiliation, among other things, in terms of control. Under the SEC’s principle, when stock ownership is significant enough to lead to control, affiliation exists, and independence disappears. The NYSE’s approach implies that when stock ownership is enough to lead to control, the director is super-independent of management, so the need for protection by a rule disappears. Thus, the SEC’s view of the proper role of independent directors seems consistent with the view that they should have ties neither with management nor with the fortunes of the company itself.

More important than federal law for purposes of corporate governance is state law, under which corporations are organized. United States corporation law at the state level does not generally provide for the institution of independent directors as such or define them. Instead, state corporate statutes, which typically reference Delaware law as the bellwether, focus on conflict-of-interest transactions. Using this lens, certain consequences will follow depending on whether or not those with both a conflict of interest and decision-making power recuse themselves from decision-making on that matter.

For context, it is important to understand how common law would operate if state statutes did not deal with conflict-of-interest transactions. The common law rule in many states in the late 19th century was quite absolute: many conflict-of-interest transactions could be set aside at the instance of any stockholder. State statutes, then, typically operate by specifically displacing the common law rule on conflict-of-interest transactions and permitting them provided certain conditions are met. These conditions usually pertain to disclosure of the conflict of interest and approval of the transaction by disinterested decision-makers, whether directors or shareholders.

The Delaware General Corporation Law (DGCL) states in section 144 that a transaction in which a director or officer stands on both sides “shall not be voidable by reason of a conflict of interest if one of the following conditions are met: (1) the relevant facts are known to the board and a majority of disinterested directors approve; or (if, for example, the entire board has a conflict of interest) (2) the relevant facts are known to the shareholders, and the shareholders approve; or (if for any reason neither of the first two occurs) (3) the terms of the transaction are, as of the time it is authorized by the directors or the shareholders, fair to the corporation.”

In short, the Delaware concept of independence is specific to disinterestedness in a particular conflict-of-interest transaction, which is different from abstract independence. It is not assumed that such directors will always be the same person, and do not require the institution of abstractly independent directors. Instead, they take a transaction-by-transaction approach, and ask in each case whether there was approval by decision-makers who were disinterested in the transaction in question.

The Delaware judiciary has on several occasions stressed the preferability of a case-by-case analysis over the application of abstract definitions. When asked how a court would determine whether a board had acted independently, E. Norman Veasey, the former chief justice of the Delaware Supreme Court, replied,

We can’t set down rules for independence. In Delaware, we’re a judicial body, not a legislative one.... But we didn’t just fall off the turnip truck, you know. We can tell whether somebody is acting independently or not. I don’t think, for instance, that lawyers who get substantial fees from a corporation can be considered independent directors for most purposes, although they might be for some.

The Delaware approach has the advantage of dealing directly with the problem as it arises. A company’s management often does, and sometimes must (for example, in the case of compensation), engage in transactions that either are or look very much like self-dealing or in some other way create a conflict of interest. In such cases the blessing of directors, who are both disinterested in the transaction in question and independent of management, can be invaluable. As noted above, corporate statutes in the United States do not prohibit self-dealing transactions outright but instead provide a safe harbor for transactions that are approved by directors who are disinterested in the transaction in question. The good-faith use by management of such directors is recognized by courts and extremely valuable.

But the difficult problem remains: Independence is more a disposition, a state of mind, rather than a concrete fact. The relationship rules, the negative and positive incentives, the board structures, and the nomination procedures all draw on our imperfect knowledge of human nature and behavior, which itself is influenced by the shifting social and cultural environment.

Independent director requirements in other major jurisdictions have grown in importance as well but are less exacting. In the United Kingdom, for example, there is no independent director requirement at all. Instead, companies listed on the London Stock Exchange are required by its listing rules to disclose, in their annual report and accounts, a statement of how they have applied the principles in Section 1 of the Combined Code, which provide that except in smaller companies, at least half the board (excluding the chairman) should consist of non-executive directors determined by the board to be independent.

As of 2016, most Member States of the European Union (EU) and virtually all major Asian jurisdictions have rules requiring the appointment of at least some independent directors to their companies’ boards. The OECD Principles of Corporate Governance of 2015 recommend assigning important tasks to independent board members. The regulatory basis for this obligation is found either in the pertinent company laws, the listings rules and/or the corporate governance codes. Independent directors have obviously become global players.

Independent Directors Fill a Structural and Legal Need

Though there are many studies that purport to analyze the effectiveness of independent directors of public companies, to me most of them miss what seems to me to be an obvious point. If as we have seen every jurisdiction in the world requires that corporations must be supervised by a board of directors, who can perform that task?

The CEO as the top corporate officer clearly has a supervisory role, but if company employees or affiliated persons who do business with the company also serve on the board, how can these folks, who all depend in various ways on the company and the CEO, supervise the company, the CEO and even themselves? Thus, in order for the board to be able to acquit itself of its supervisory responsibilities and its fiduciary duties to the corporation, at least a majority of the directors of the corporation must be independent. This is a simple concept, based on the notion of arm’s length fair dealing. This is true regardless of whether the independent directors improve performance or not.

As an historical note, the concept of the independent director as a required party on any board was, to the best of my knowledge, introduced by the Investment Company Act of 1940, which was grappling with the tightly intertwined roles involved in the fund investment vehicle, the investment management company, and the distributor of fund shares. Funds typically have no employees, and their affairs are managed by the investment management company that organizes the fund, pursuant to a contract. Often the same people are overseeing all of the entities, which gives rise to a situation rife with conflicts of interest. What the 40 Act did was insert the concept if the independent directors as arbiters of those conflicts, with a specific mandate to watch out for the affairs of the fund vehicle. In effect, they were providing daylight, as a proxy for regulatory involvement.