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.
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.