Is the Independent Director Model Broken?

At common law, an interested director was barred from participating in corporate decisions in which he had an interest, and therefore “disinterested” directors became desirable. This concept of the disinterested, director developed into the model of an “independent director” and was advocated by the Securities and Exchange Commission (SEC or Commission) and court decisions as a general ideal in a variety of situations. The SEC’s view of the need for independent directors should be understood in the context of Adolph Berle’s theory of the 1930s that shareholders had abdicated control of public corporations to corporate managers, and fiduciary duties needed to be imposed upon corporate boards in order to compensate for this loss of shareholder control. Berle’s writings laid the foundation for shareholder primacy as the theory of the firm, a theory embraced by the SEC, which viewed itself as a surrogate for investors.

The SEC has generally succeeded in imposing its corporate governance views in the wake of scandals. Following the sensitive payments enforcement program of the 1970s, the SEC embarked on an activist corporate governance reform program. During the merger and acquisition frenzy of the 1980s, the SEC used the Williams Act to foster the view that the market for corporate control constrained incompetent managers. After the bursting of the technology bubble in 2000, and the financial reporting scandals that ensued, the SEC was able to incorporate its views on independent directors into the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley). Following the financial crisis of 2008, the SEC further enforced its views on the requirements for independent directors in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank).

The composition and behavior of securities markets and investors has changed drastically since the SEC was established in 1934. Yet, the SEC has persisted in its path-dependent view that independent directors, ever more stringently defined, should dominate the boards of public companies.

The independent director ideal has not been embraced all over the world. Neither has shareholder primacy. In particular, in some countries a director representing the controlling shareholder is considered to be not independent because one of the goals of corporate governance is the protection of minority shareholders. Also, where the government is a major shareholder, the independent director model is problematic. After the 2008 financial crisis, the conflicts between shareholders and creditors became more apparent. Should the independent director be independent of major shareholders as well as managers in order to preserve and increase the value of the firm?

The independent director model advocated by the SEC has been accepted in many jurisdictions, either as a mandatory requirement for public companies or a recommended structure. Yet, boards of independent directors did not prevent the scandals of Enron, WorldCom and other companies in the United States and in Europe after the bursting of the technology bubble of the 1990s. Neither did such boards prevent the financial institution meltdowns of 2008. Thus, a rethinking of this model is necessary.

Since 2008, director diligence and expertise have been areas of focus. But a board of independent directors remains dependent on a corporation’s management for information. Regulation cannot compel those personal qualities that make a director excellent: intelligence, integrity, experience, competence and a willingness to question herd decision-making. Also, a public corporation should not be some battleground where executives, directors and shareholders are adversaries. Neither should the board of directors become a super compliance committee, more concerned about government regulations than a corporation’s operations and strategy.

Public corporations should have a mix of independent and non-independent directors, with directors having a duty to the corporation as a whole. The interests of employees, customers, and creditors should be balanced against a duty to shareholders, especially when those shareholder interests are short-term. Although such complicated duties may prove more difficult to enforce than a simple duty to obtain economic gain for shareholders, shareholder primacy has brought business to a sorry pass, especially in the United States, where our industrial base had been seriously impaired and speculation in the financial markets has wreaked havoc on the real economy. Only an experienced, competent, and fully informed board can possibly help to steer a forward course for public corporations in our complex global economy. The board needs to be informed by expert and responsible insiders (including service providers to the firm such as commercial bankers, lawyers, and also retired company officers) with a stake in the future of the corporation, as well as independent outsiders who have the expertise and ability to both question, challenge, and advise management.

In the United States and elsewhere, “independence” now carries a statutory or stock exchange definition that has frequently led to the selection of former government officials, other famous personalities, educators, and CEOs from other companies, who meet the definition of independence but who are not sufficiently expert or diverse to assist in the creation of overall firm value. The qualities that make a director truly independent do not come from a statutory definition, but rather come from intelligence, experience, and a strong sense of ethical responsibility. The ability to challenge the conventional wisdom, to tell truth to power, is rare, and even rarer, is the director who can do so but not destroy the collegiality of the boardroom. Yet, seeking such individuals should be the object of director selection.

The full paper is available for download here.