Independent Directors and Controlling Shareholders

Lucian Bebchuk is the James Barr Ames Professor of Law, Economics, and Finance, and Director of the Program on Corporate Governance, at Harvard Law School. Assaf Hamdani is the Wachtell, Lipton, Rosen & Katz Professor of Corporate Law at Hebrew University of Jerusalem. This post is based on their Article, Independent Directors and Controlling Shareholders, forthcoming in the University of Pennsylvania Law Review. The Article is part of the research undertaken by the Controlling Shareholders Project of the Program on Corporate Governance.

Independent directors are an important feature of modern corporate law and courts and lawmakers around the world increasingly rely on these directors to protect investors from controlling shareholder opportunism. In our Article, Independent Directors and Controlling Shareholders, forthcoming in the University of Pennsylvania Law Review, we examine this reliance. We show that the existing director-election regime significantly undermines the ability of independent directors to effectively perform their oversight role.

Both the election and retention of independent directors normally depend on the controlling shareholders. As a result, these directors have incentives to go along with controllers’ wishes, or, at least, inadequate incentives to protect public investors.

To induce independent directors to perform their oversight role, we argue, some independent directors should be accountable to public investors. This can be achieved by empowering investors to determine or at least substantially influence the election or retention of these directors. These “enhanced-independence” directors should play a key role in vetting “conflicted decisions,” where the interests of the controller and public investors substantially diverge, but not have a special role with respect to other corporate issues. Enhancing the independence of some directors would substantially improve the protection of public investors without undermining the ability of the controller to set the firm’s strategy.

We explain how the Delaware courts, as well as other lawmakers in the United States and around the world, can introduce or encourage enhanced-independence arrangements. Our analysis offers a framework of director election rules that allows policymakers to produce the precise balance of power between controlling shareholders and public investors that they find appropriate. We also analyze the proper role of enhanced-independence directors as well as respond to objections to their use. Overall, we show that relying on enhanced-independence directors, rather than independent directors whose election fully depend on the controller, can provide a better foundation for investor protection in controlled companies.

We do not argue that independent directors should play a key role in protecting public investors at controlled companies. Some may believe that market forces can discourage controller opportunism. Others may find other measures—such as public enforcement or approval by minority shareholders—to be necessary or effective in enhancing investor protection. We take as a given that corporate law has long substantially relied on independent directors in controlled companies to protect public investors in cases of controller conflicts. Given this pervasive reliance on independent directors, our contribution is twofold. First, we show that, by itself, approval by independent directors who serve at the pleasure of the controller cannot serve as an effective device for vetting conflicted decisions. Second, we analyze how to turn independent directors into more effective guardians of the interests of public investors in conflicted decisions.

Below we outline in more detail the analysis of the Article:

In 2012, Google adopted a controversial recapitalization plan that allowed it to issue a new class of nonvoting stock. This plan enabled Google to continue raising capital without weakening its founders’ control over the company. To address the concern that the plan would benefit the company’s controlling shareholders at the expense of its public investors, Google formed a special committee of independent directors to negotiate and approve the terms of the recapitalization. Furthermore, in the settlement of the litigation over the recapitalization, Google’s independent directors were assigned an important ongoing role to enforce certain restrictions on the company’s founders.

If a company, like Google, has a controlling shareholder, a main concern of corporate law is to address potential conflicts of interest between the controller and public investors. Corporate law has long relied on oversight by independent directors—directors who have no ties to the controller or the company other than their service on the board—over corporate decisions where the interests of the controller substantially diverge from those of the company or its public investors [hereinafter “conflicted decisions”]. Both courts and lawmakers have sought to use independent directors to safeguard against such controller opportunism.

As we explain in this Article, the existing arrangements for electing directors undermine the effectiveness of independent director oversight. Because these arrangements provide controllers with decisive power to appoint independent directors and decide whether to retain them, independent directors have significant incentives to side with the controller and insufficient countervailing incentives to protect public investors in conflicted decisions. Thus, independent directors currently relied upon to contain controllers’ conflicts cannot be expected to be effective guardians of public investors’ interests.

We also show how the rules governing the appointment of independent directors could be refined to make their oversight more effective. To improve the effectiveness of independent directors in cases of controllers’ conflicts, some directors should be elected in ways that would make them at least somewhat accountable to public investors. These directors, which we call “enhanced-independence directors,” should play a key role in approving self-dealing transactions. We develop a framework of alternative legal rules for obtaining enhanced independence without undermining the controller’s ability to determine business strategy in non-conflicted decisions. We also explain how courts, regulators, and investors could require or encourage companies to introduce enhanced-independence directors.

Consider again the Google example. Suppose that minority shareholders had the right to elect, or at least veto the appointment of, two independent directors. Such enhanced-independence directors would have had greater incentives to resist a recapitalization plan that benefitted the controller at the expense of public investors. The approval of the plan by such independent directors would have been a more meaningful signal than approval by independent directors who serve only at the controller’s will.

The enhanced-independence approach that we put forward can address longstanding dilemmas with which the Delaware courts have been wrestling. In well-known decisions involving freezeout transactions, Delaware courts have recognized the structural problems afflicting independent directors, choosing not to defer to the approval of freezeouts by such directors and, instead, to grant judicial deference only to transactions also approved by a majority vote of minority shareholders. Outside the freezeout context, however, the Delaware courts have not always followed such an approach, and some decisions have granted significant cleansing power to independent director approval in cases of controller conflicts. For example, Delaware courts substantially rely on independent directors to make decisions regarding derivative actions against the controller. Such judicial decisions might be due to concerns about the costs of alternatives.  For courts influenced by such concerns, enhanced-independence directors can offer a workable alternative within the existing framework of corporate law doctrine.

Our analysis proceeds as follows. Part I of the Article provides background on controlled companies and independent directors. Controlled companies constitute a sizeable minority of large, publicly traded firms in the United States, including well-known companies such as Facebook, Google, News Corp, and Viacom. Controlled companies are even more prevalent outside the United States, dominating public capital markets in Europe and in most countries around the world.

In widely held firms, the chief governance concern is to prevent professional managers from behaving opportunistically at the expense of investors. In controlled companies, by contrast, controllers have both the incentives and the power to police management, but they may use their power to divert value at the expense of public investors. In these companies, therefore, a primary governance concern is to protect public investors from controller opportunism and value diversion. Corporate law commonly addresses this concern by requiring or encouraging the use of independent directors and relying on such directors to vet self-dealing transactions and other conflicted decisions.

Part II explains the fundamental shortcoming of this approach. Under existing arrangements, controlling shareholders normally play a decisive role in the appointment and retention of independent directors. Even independent directors, therefore, are inherently dependent on the controller for their election and retention as board members. This regime incentivizes independent directors to favor the controller, and it fails to provide them countervailing incentives to protect public investors.

Learning from widely held firms reinforces our critique. The CEOs of such firms once wielded substantial influence over independent directors’ appointment. Today, however, there is widespread recognition that, to enable independent directors to monitor the CEO effectively, we should both limit the CEO’s influence over their appointment and make these directors accountable to public investors. This recognition underlies the litany of reforms focused on director elections at widely held firms, including placing director selection in the hands of nominating committees composed solely of independent directors, providing for majority voting, and enabling proxy access. If CEOs’ informal influence over the selection of independent directors compromises their ability to contain CEO opportunism, controlling shareholders’ absolute control over the appointment and retention of independent directors is all the more problematic.

Part II concludes by introducing our proposed approach for making independent directors more effective guardians of the interests of public investors in controlled companies. Such companies, we argue, should have some directors who (i) lack the incentives produced by the controller’s decisive influence over the directors’ appointment and retention and (ii) have some incentives that flow from making the directors accountable to public investors. A regime of such enhanced-independence directors requires measures that will limit controllers’ power over the appointment of these directors while providing public investors with some degree of influence over this appointment. Such measures, we show, are not an ivory-tower idea without real-world precedent. The American Stock Exchange (AMEX) required them for dual-class companies that went public during a certain period, and they have been recently introduced in the United Kingdom, Italy, and Israel.

Part III develops a framework for designing enhanced-independence rules with the desired balance between enhancing independence to limit controller opportunism and controllers’ legitimate interests in making business decisions. Public investors may participate in three stages of director elections: initial appointment, reelection, and termination. For each stage, we identify different degrees of public investors’ input rights and evaluate the impact of these rights on investor protection. Public investors, we argue, should at least have veto rights over the initial appointment, reelection, and termination of enhanced-independence directors. We also explain, however, that there are good reasons to consider going beyond veto rights—for example, by empowering public investors to determine whether enhanced-independence directors are reelected and terminated.

Part IV focuses on the strategies for implementing an enhanced-independence approach. Regimes based on judge-made law, such as in Delaware, can encourage the use of enhanced-independence directors by according significant cleansing powers only to the approval of conflicted decisions by such directors. By contrast, regimes based on legislative or regulatory mandates can require the appointment of some enhanced-independence directors and the approval of certain conflicted decisions by such directors.

We also discuss the desirable number and role of enhanced-independence directors. To protect public investors, these directors should play a dominant role in—and only in—vetting self-dealing transactions and other conflicted decisions. To preserve controllers’ ability to set the company’s business strategy, however, such directors should not play a dominant role in other corporate affairs, and they should therefore not constitute a substantial fraction of the members of the board.

Part V considers potential objections to an enhanced-independence approach. We address claims that enhanced-independence directors would be harmful by interfering with the controller’s ability to run the company, undermining the board’s collegiality and cohesiveness, or facilitating abuse by some opportunistic minority shareholders. We also consider claims that such directors would not add significantly to the protection of public investors. We show that these objections do not undermine the case for enhanced-independence directors.

While we use the terms “minority shareholders” or “public investors” to refer to shareholders other than the controller, we note that these shareholders sometimes hold a majority of the equity capital. This is likely to be the case when a dual-class structure, or another aspect of the corporate structure, separates voting rights from cash flow rights and enables the controller to retain a lock on control while holding a minority, even a small minority, of the company’s equity. A substantial body of evidence suggests that the risk of value diversion increases when controllers use dual-class or other ownership structures for separating cash flow rights from votes. Thus, even those who would not support enhanced-independence directors for controlled companies in general should consider using them for dual-class companies and other structures that separate voting and cash flow rights.

Our Article is available here.

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  1. jesus alfaro
    Posted Friday, May 5, 2017 at 12:06 pm | Permalink
  2. Javier
    Posted Tuesday, October 3, 2017 at 4:10 pm | Permalink

    This is the kind of problems that we deal in Europe and our generally controlled listed companies. The trustability of independent directors as an internal control mechanism is not so deep, and the debate in Academy is how to improve his function in the context of monitoring model.