As noted earlier, a prerequisite for duty of loyalty is for directors to be independent, not influenced by either friendship with, moral obligations to, or fear of dismissal by management. Directors can be friends of management as long as both parties understand and expect that the director’s fiduciary obligation to shareholders will outweigh friendship. Independence can be compromised if directors as much as suspect that they are obligated to management for their seat on the board. Many directors need the compensation they receive. If keeping their jobs depends on keeping management happy, they will not be able to execute their fiduciary responsibilities to shareholders.
Two conditions must exist for an entire board of directors to meet the duty of loyalty standards. The first is an independent state of mind, reinforced by meaningful rules that hopefully increase the probability of independence. The second condition is that a majority of a board’s directors come from outside the company and not from the company’s executive management team. These two conditions are interrelated. With more rigorous standards of independence, a simple majority of independent directors will be more likely to assure duty of loyalty for the whole board. With lower standards, a greater majority is needed to counterbalance a director or directors who do not exhibit independence on a given issue.
Exercising duty of loyalty without at least a majority of independent directors is very difficult. In recognition of that, the New York Stock Exchange and Nasdaq guidelines recently required a majority of independent directors on the boards of listed companies, whereas Sarbanes-Oxley was silent on the matter of board makeup.
Defining Independence
The legal definition of independence, as found in the Sarbanes-Oxley Act of 2002, is perhaps the narrowest interpretation of independence that could have been written. It fails to address many, if not most, of the most critical issues that affect duty of loyalty. According to Sarbanes-Oxley, independence means “not receiving, other than for service on the board, any consulting, advisory, or other compensatory fee from the issuer, and as not being an affiliated person of the issuer, or any subsidiary thereof.” In other words, according to this act, independence means not being paid directly or specially and not being a member of management. It ignores the real-life issues that might cause directors to put management’s interests ahead of shareholder, including:
- friendships with the CEO or other senior executives
- appointment to and continued service on the board, with its prestige and compensation at the pleasure of the CEO
- being CEOs themselves and therefore having a viewpoint sympathetic to that of management
- being part of interlocking directorships
Independence according to the National Association of Corporate Directors. The Blue Ribbon Commission (BRC) on Audit Committees of the National Association of Corporate Directors articulated a more detailed and marginally better definition of independence in its 2000 report. This definition says that a director will be considered independent if he or she:
- has not been an employee of the corporation or any of its subsidiaries within the last five years
- is not a close relative of any management-level employee of the company
- provides no significant services or goods to the company
- is not employed by any firm providing major services to the company, and
- receives no significant compensation from the company, other than director’s fee
The BRC notes that its definition is modeled after one previously published in the 1994 Report of the Blue Ribbon Commission on Performance Evaluation of Chief Executive Officers, Boards, and Directors. This means that the definition of independence, similar to Sarbanes-Oxley, has, for a decade, ignored many of the same real-life factors that can affect a director’s ability to demonstrate true independence from management.
Independence according to The Business Roundtable. The membership of The Business Roundtable consists of CEOs of the 150 largest U.S. companies. Although this group has been criticized for procrastinating on governance issues in the past, they have, to their credit, developed one of the more thoughtful definitions of director independence. Certainly the CEOs of the largest companies in America should be well aware of all the factors that might make independent directors behave less independently. They should be applauded for taking a position that supports greater independence. The test will be whether or not they practice what they preach.
The Business Roundtable includes this in the discussion of independence in its white paper, “Principles of Corporate Governance,” published in May 2002: “A substantial majority of directors of the board of a publicly owned corporation should be independent of management, both in fact and appearance, as determined by the board” and that an independent director should be “free of any relationship with the corporation or its management that may impair, or appear to impair, the director’s ability to make independent judgments.”
The publication references the listing standards of the major securities markets as “useful guidance in determining whether a particular director is ‘independent.’” It also says that boards should consider whether “close personal relationships between potential board members and senior management might affect a director’s actual or perceived independence.”
For an entire board of directors to meet the duty of loyalty standards, the majority must come from outside the company and not from the company’s executive suite.
Practicing Independence
This Business Roundtable definition sounds good, but can boards live by it? Many boards declare through a vote that individual directors are independent, even if there are indications that they might not be. For example, many directors who provide services to the company and are paid directly or indirectly for those services have been declared independent. While a board may declare a director to be independent, shareholders should be able to judge for themselves if the board’s declaration is reasonable. They can’t do that if they don’t know which qualities the boards considered in making its determination. If individual directors must disclose to the board information that might call their independence into question, shouldn’t boards then disclose that information to investors? Better yet, shouldn’t boards explain to shareholders why they have deemed a director independent?
In their 1932 classic, The Modern Corporation & Private Property, Adolf Berle and Gardiner Means articulated this concept of disclosure:
The one ethical point on which everyone is agreed is that the adverse interest, if any, must be disclosed. There appears to be a general feeling that where a man represents adverse interests without letting that fact be known, he has created a situation so dangerous as not to be tolerated in the business community.
Although this basic concept seems to have fallen by the wayside, it sounds like a sensible position for the business community and for directors in particular to take today.
From Russia With Independence
Understandably, changes to governance standards in the United States, including a reasonable definition of independence, have tended to be incremental. Interestingly, the Russian government has issued the most comprehensive and specific definition of independence by basically starting from scratch. The definition was part of an effort to demonstrate good governance in Russia to enable Russian companies to be listed on the London stock exchange. According to the Investor Protection Association, the definition was developed, based “on recommendations of international financial institutions, major Russian and foreign investors and issuers.” Being the most comprehensive does not necessarily make it the ultimate definition, but at least it candidly describes the many issues that could impact independence.