Out of Sight Out of Mind: The Case for Improving Director Independence Disclosure

Yaron Nili is Assistant Professor at University of Wisconsin Law School. This post is based on his recent article, forthcoming in the Journal of Corporation Law.

In July 2016, a coalition of 13 CEOs and heads of major investment firms—which included names like JPMorgan Chase CEO Jamie Dimon, Berkshire Hathaway CEO Warren Buffett, General Motors CEO Mary Barra and BlackRock CEO Larry Fink—released the Commonsense Principles of Corporate Governance (discussed on the Forum here). These Principles emphasize the critical role of director independence in corporate America, stating that: “[t]ruly independent corporate boards are vital to effective governance, so no board should be beholden to the CEO or management” and that “[d]irectors should be strong and steadfast, independent of mind and willing to challenge [management] constructively.” Indeed, this recent statement echoes the importance and emphasis that academics, investors, regulators and companies alike, have placed on director independence.

Two months later, on September 7, 2016 Apple and Nike announced a new collaboration with one another on the Apple Watch. In their announcement, the companies declared their new Apple Watch Nike+ to be “the latest result of a long-standing partnership” between the world-renowned brands. Significantly, the announced initiative came on the heels of Nike appointing Mr. Tim Cook, Apple’s CEO, as Nike’s lead independent director. Despite the new collaboration, the companies did not refer to any potential conflicts of interest or to Mr. Cook’s status as lead independent director in their press release. Apple itself has similarly straddled the line regarding the independence of its “independent” directors. Bob Iger, Disney’s CEO, is one of Apple’s five independent directors. The two companies have a close and frequent business collaboration with one another, but Apple does nothing more than disclose that “in the ordinary course of its business, Apple enters into commercial dealings with Disney that it considers arms-length.” In regards to Mr. Iger’s independence, Apple has stated that it “does not believe that Mr. Iger has a material direct or indirect interest in any of such commercial dealings.”

Apple’s short statement concerning Mr. Iger’s independence is indicative of a larger practice taken by public firms. Many public companies can, and do, satisfy their stock exchange’s disclosure requirements by simply declaring that “the Board of Directors has determined that all non-employee Directors who served during [the fiscal year] are ‘independent’ under the listing standards of the [NYSE/NASDAQ].” Investors receive very little value from these unsubstantiated statements.

Indeed, in the current regulatory regime, public companies’ boards self-designate their peer directors as “independent directors” and boards are only required to disclose very specific, and very limited, information regarding their designation of a director as an “independent director”—leaving shareholders with minimal knowledge regarding the true level of independence that their elected directors actually have.

In my article, Out of Sight Out of Mind: The Case for Improving Director Independence Disclosure, which is forthcoming in the Journal of Corporation Law, I address this issue of director independence disclosures, in light of the rise of the independent board. The article makes three important contributions to the current discourse regarding director independence:

First, the article exposes a fundamental concern regarding the functional independence of “independent” directors, and highlights what it terms as the “empty” nature of the current regulatory framework. As the article details in length, the current framework can be summed up as being too much, too little, too late and too soft. It provides companies with too much discretion, as boards retain too much power to assert the independence of their peer directors and they may suffer from behavioral bias in doing so. It provides investors with too little information regarding the factual context against which a director is considered to be independent. Further, even when a director’s independence designation is scrutinized through state law, it is often too late, as these assessments are done post-hoc when it is too late to address many of the issues that director independence is meant to protect against. Finally, it is too soft, as companies’ self-designations of director independence are left uncontested and without proper vetting by the stock exchanges or the SEC, as they have shown no effort to proactively enforce their own requirements.

Second, the article is the first to provide hand-collected empirical evidence corroborating the lack of proper disclosure by companies in the context of their director independence designations. To do so, using a hand collected data set, the article analyzed the disclosure statements of one hundred public companies. To account for both large, high profile, companies as well as smaller, less visible public companies, fifty of the companies make up the Fortune 50 and the remaining 50 are Fortune 2000 small-cap companies. For each company, the company’s independence disclosure in its proxy statements in the years 2000, 2004, 2008, 2012 and 2016, were analyzed and coded. Indeed, as further analyzed in greater detail in the article, the majority of companies provide very little information about their director independence designations, potentially violating the already lax rules governing independence disclosure. Furthermore, several companies have in fact regressed over time in regards to the level of transparency they are providing to investors. In essence, much of the information that boards are expected to consider when determining whether a director is independent is contained in a “black box,” to which shareholders have no access.

Finally, the article argues that at its core, the failure of current regulatory standards to ensure an effective director independence regime stems from the fact that any independence definition is destined to suffer from ambiguity and interpretive freedom. Instead, we should recognize that the true value of director independence requirements is not only in that they strive to ensure actual independence, but rather also in that they empower investors. Each investor may have a distinctive, subjective comfort level with the myriad independence questions that may arise, balanced against the benefits that the various business and personal connections of each director may provide to the company. Information about directors’ ties and dealings gives investors a means of making informed decisions, both regarding the election of a director as well as their actual level of independence on any specific issue. As a result, effective director independence standards should facilitate an environment where companies are accountable to their investors for their choice of directors.

Therefore, responding to the SEC’s call for input on possible ways to improve the discourse regime under Regulation S-K, this article calls for a re-conceptualizing of the current approach to regulating company disclosures. This new approach will shift some of the focus from the definition and designation of a director as independent to a disclosure-based regime. Alongside the current designation regime, companies would have to disclose, for each “independent” director, the entirety of the information they considered when declaring a director as independent, including some mandatory information that is currently hard or costly to independently obtain or verify. This in turn will allow investors and regulators not only to confirm the judgment of the board on each director but also to possess a more nuanced view regarding the functional independence of each director in regards to each matter at hand.

The complete article is available for download here.

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