The Evolution of Director Independence
The notion of director independence has its roots in long-standing
corporate statutes and case law in the U.S., with similar concepts applying in
other jurisdictions.
The fiduciary duty of loyalty requires directors to act in
the best interests of the corporation, uncompromised by third-party interests.
It follows that in shareholder lawsuits against corporations and their
directors, courts accord greater deference to director decision-making that is
handled by individuals with no self-interest in the actions at issue.
Thus
there is an emphasis, particularly with respect to significant transactions, on
involving only those directors who do not have any business or personal
interest in the outcome of the decision.
Since the early 2000s, a number of high-profile corporate failures have led
investors and Congress to favor a broader concept of director independence for
corporations that are publicly traded on a U.S. exchange (regardless of
domicile). For example, following the Enron collapse, Congress and the SEC were
troubled by the fact that Enron’s board of directors included:
- Three individuals who were paid for consulting services in addition to
board services;
- An individual who also served on the board of an Enron supplier;
- Four individuals who had been employed by or affiliated with
organizations that had received charitable donations from the Enron
Foundation; and
- An individual who had served as an executive to a company that
purchased an Enron affiliate and engaged in financial transactions with
Enron.
The Senate report on Enron found that these relationships contributed to
the directors’ reluctance to challenge management and inhibited their exercise
of independent judgment. As a result of the findings, stock exchanges were
directed to revise their standards to require listed companies to maintain a
majority of “independent” directors, to utilize audit, compensation and
nominating committees consisting solely of independent directors, and to
observe certain other corporate governance formalities.
Defining Independence
For U.S. publicly-traded companies, the concept of independence is governed
by overlapping definitions under the Exchange Act, Internal Revenue Code, stock
exchange listing standards, investor policies and company policies. The goal of
each set of rules is the same: to ensure that the board includes persons who
are free of financial, personal or other relationships that could meaningfully
influence objectivity in the boardroom.
Relationships that would preclude independence and/or cause investors to
vote against that director’s election to the board generally include:
- Employment. Directors who are employed, or whose
immediate family members are employed as executive officers, by the listed
company;
- Compensatory Payments. Directors or
immediate family members who receive, in any 12-month period, more than
$120,000 in direct compensation from the company (other than director
fees, compensation paid to a non-executive family member, or benefits
under a tax-qualified retirement plan or non-discretionary compensation),
or who provide professional services in excess of $10,000 to the company,
an affiliate of the company, or an individual officer of the company or
one of its affiliates, whether directly or through another entity;
- Indirect Payments To or From Other
Entities. Directors who are current partners or employees of, or have immediate
family members who are controlling shareholders or executives of, other
entities that have made payments to or received payments or contributions
from the listed company in an amount that exceeds the greater of $1
million dollars or 2 percent of the receiving entity’s gross revenues (for
NYSE-listed issuers), or the greater of $200,000 or 5 percent of the recipient’s
gross revenues (for Nasdaq-listed issuers);
- Auditor Affiliations. Directors who have
certain relationships with the listed company’s auditor; and
- Compensation Committee Interlocks. Directors who are
executives at other entities where any of the listed company’s executives
serve on the compensation committee.
Hence, the term “independent” excludes not only management directors but
also any directors who are financially or personally beholden in some way to
management or have any other professional or personal relationship that could
affect their ability to exercise objective judgment. Most of the applicable
rules apply a three-year lookback period.
Enhanced Independence for Audit and Compensation
Committees
The Sarbanes-Oxley Act of 2002 further emphasized the concept of
independence by imposing enhanced independence standards on the audit
committees of NYSE and other exchange-listed companies. Generally speaking,
these rules prohibit committee members from receiving any compensation,
advisory or other compensatory fees from the listed company or engaging in any
direct or indirect transactions that would imply that they control or are under
common control with the listed company or any of its subsidiaries, such as very
significant equity ownership.
Following the 2009 financial crisis, Congress used the Dodd-Frank Wall
Street Reform and Consumer Protection Act of 2010 to address public concern
over executive pay, requiring boards of directors of listed companies to
consider enhanced independence factors when evaluating the independence of
compensation committee members. These factors mirror the enhanced independence
criteria applicable to audit committee members. It is also important for compensation
committee members to avoid consulting and other relationships with the company,
which could have the impact of imposing a six-month holding period on
committee-approved equity grants to officers and directors and could affect the
company’s ability to take a tax deduction for performance-based compensation in
excess of $1 million.
Recommended Company Policies and Procedures
Most public companies maintain policies and procedures to protect director
independence, avoid inadvertent conflicts of interest and ensure legal
compliance, including:
- Charters for the Audit, Nominating and
Compensation Committees that require the committee members to meet all applicable
independence requirements;
- Principles of Corporate Governance that require
independent directors to constitute a majority of the company’s board of
directors, require an annual independence determination for each director,
provide that directors will promptly notify the chair of the Nominating
and Corporate Governance Committee of any matters that could affect their
independence or that could constitute a related party transaction, and
address whether the chairperson of the board is required to be an
independent director;
- Codes of Conduct that require board
or committee review of any situation that involves or may reasonably be
expected to involve a director conflict of interest; and
- Related Party Transaction Policy that requires a
board committee to review and approve almost all types of transactions
involving the company or subsidiaries in which directors have a direct or
indirect interest.
Directors who have potential relationships with the company should share
all relevant facts with the applicable committee chair and recuse themselves
from discussions and approvals. Due to potential disclosure, listing and voting
implications, directors should also share relevant information with the
company’s legal department.
Key Takeaways for Director Independence
Although having a predominately independent board does not guarantee
infallible decisions, it does reduce the risk of self-interested actions and
provide comfort to the investing public and regulators that a fair and thorough
decision-making process is employed. In this regard, it cultivates favorable
investor perceptions and reduces liability risks for directors (by reducing the
likelihood of a lawsuit and increasing the likelihood of a favorable judgment
and insurance coverage).
Independence is an evolving concept that may become more stringent in the
future (for example, through restrictions on director tenure or requirements
imposed by ESG ratings agencies). It is important for boards to continue to
observe applicable standards and policies when structuring any relationships in
which directors may have an interest. This attention will help ensure that a
majority of the board remains independent, that members of key committees
satisfy all applicable enhanced independence criteria, that conflicts of
interest are avoided, and that the company maintains a positive relationship
with its investors.
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