The Rise of the Independent Director: A Historical and Comparative Perspective

Harald Baum is Senior Research Fellow and Head of the Japanese Department at the Max Planck Institute for Comparative and International Private Law, Hamburg; Professor at the University of Hamburg; and a Research Associate at the European Corporate Governance Institute, Brussels. This post is based on a recent paper authored by Professor Baum.

My paper provides a historical analysis of the rise of the independent director and the related model of a “monitoring board of directors” in the US and the UK. These two jurisdictions are commonly credited with creating the concept of the independent director and exporting it around the world. As of 2016, most Member States of the European Union and virtually all major Asian jurisdictions have rules for appointing at least some independent directors to their companies’ boards. On the supra-national level, the OECD Principles of Corporate Governance of 2015 recommend to assign 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. This is somewhat surprising giving the fact that there is only shaky empirical support for staffing boards with independent directors.

The term “independent director” is indiscriminately used in the international discussion about corporate governance but there is no universal definition and the context in which independent directors operate in each jurisdiction is highly path-dependent. If the main task assigned to the independent directors is to monitor management as a means to solve the classic agency conflict between managers and dispersed shareholders (owners), independence from the entrenched CEO of the stereotypical US Berle-Means corporation seems to be the most important criterion. If, on the other hand, the directors’ task is defined predominantly as protecting minority shareholders against a controlling block holder in an archetypical Continental European or many Asian companies, independence from the latter will be the decisive characteristic.

In the first half of the twentieth century, a managerialist model of corporate governance dominated in the US. Inside directors, chosen and controlled by the CEO, dominated corporate boards. The concept of the independent director and the related model of the “monitoring board” only appeared in the 1970s. Two watershed events sparked this dramatic change: First, the sudden collapse of the major railway company Penn Central in 1970; and, second, Eisenberg’s influential book “The Structure of the Corporation,” published in 1976. According to Eisenberg, the board’s essential function was to monitor the company’s management by being independent from it. By the end of the 1970s, after a prolonged, intense, and sometimes vicious discussion, business circles finally accepted the inevitability of a monitoring board at least partly staffed with independent directors

Today the reliance on independent directors as a panacea for various corporate governance ills has reached its zenith in the US. In 2013, in US public companies, 85% of directors were independent and 60% of boards had so-called “super-majority boards” with only one non-independent director—the Chief Executive Officer. Over the last decades, the primary legislative and judicial response to almost every major corporate scandal in the US has been to increase reliance on independent directors.

As in the US, the typical British board of the 1950s was an advisory board dominated by insiders. Only in the 1990s, with the beginning of the British corporate governance movement after the publication of the Cadbury Report, the concept of independent directors was picked up in the UK. Different from the US, the rules on independent directors in the UK are not of statutory nature but are established on a self-regulatory basis in UK Corporate Governance Code. In the years between 2001 and 2009 the number of independent directors on the boards of companies listed in the UK oscillated around the high benchmark of 90%. In 2010 the strong emphasis on independent non-executive directors as an antidote to an individual or a small group of individuals dominating the board was changed to the recommendation that “the board and its committees should have the appropriate balance of skills, experience, independence and knowledge of the company to enable them to discharge their respective duties and responsibilities effectively.” This shift from independence to competence and expertise was a quick and pragmatic reaction to the Global Financial Crisis. It comes as no surprise that by 2011 the number of independent directors on the boards of companies listed in the UK had sunk to 61% in reaction to this change.

Though the UK was late to embrace the independent monitoring model pioneered by the US, it was able to make considerable refinements to the independent monitoring model. From there, the concept of the independent director started to conquer the European Union as a fundamental corporate governance principle. The European Model Company Act of 2015 recommends to assign important tasks to independent board members. In the early 2000s Germany added the independent director to its long history of rigid separation between executive managing and non-executive (outside) monitoring directors, which was introduced as early as 1861.

The empirical support for staffing boards with independent directors is dubious. The global financial crisis of 2008 added further doubts. The only definitive statement that can be made about the wide ranging empirical studies is that they are clearly unclear. It does seem that the empirical evidence leans towards indicating that there is no obvious benefit to including independent directors on boards. It also suggests that too much independence may be a bad thing. Future developments will probably bring a more flexible and competence oriented board composed of a mix of directors with ex post and ex ante monitoring functions.

The full version of the paper can be accessed here.

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