Director Independence and the Governance Process

4 Min Read By: Bruce Dravis

This article is adapted from the Director’s Handbook: A Field Guide to 101 Situations Commonly Encountered in the Boardroom, edited by Frank Placenti, and from The Role of Independent Directors in Corporate Governance, Second Edition, by Bruce Dravis.

Even the strongest corporate governance practices cannot guarantee the quality of corporate results.

Governance is about process, not perfection. Governance is a form of corporate risk mitigation, focusing on the decision-making processes within a company to limit the likelihood boards and executives will misuse corporate assets or make ill-considered choices.

Director independence is part of that process and is not a goal in itself. Independence is an imperfect substitute for what investors and policymakers actually want: decision makers who act with integrity and who form judgments on behalf of shareholders after thoughtful and fair consideration of the salient facts, untainted by favoritism.

No rule can predict that an individual will make a virtuous choice at a critical moment. There is no objective test to ensure that a director will think and act on behalf of the best solution for the company, regardless of his or her personal stake in the outcome. Instead, the independence standards in the laws and rules for corporate governance measure potential conflicts of interest, with the assumption that independence from conflicts will produce independence in judgment.

For securities law purposes, the definition of director “independence” is derived in part from the 2002 Sarbanes Oxley Act, in part from the 2010 Dodd-Frank Act, in part from SEC regulations, and substantially from the rules of the NYSE and NASDAQ. In addition, appointment of special committees of the board, or approval of transactions between the company and insiders, can generate state law questions of independence. There are also separate IRS and SEC independence measurements connected to the approval of some executive compensation.

Accordingly, company counsel must consult multiple sources to advise the board on whether a determination of independence falls on the right side or the wrong side of a relevant definition.

Independence is typically considered in terms of a director’s independence from corporate management. Government and exchange independence rules surround corporate managers with individuals both inside and outside the corporation who are in a position to influence management’s decisions and actions, and who not only can form judgments independent of management, but also serve at times as a check on management.

In testing the independence of a director from management, the primary questions relate to whether the director has employment, family, or other significant economic or personal connections to the company, other than serving as a director. A director’s family or economic connections to the company’s outside auditor can also disqualify a director from being independent.

However, independence of directors can also be fact-specific and situational. In litigation, a director who is independent for other purposes could have a stake in the legal issues that renders him or her conflicted.

For that reason, a director who is independent for one purpose may not be independent for all purposes. The board cannot take a “set it and forget it” approach to determination of a director’s independence. If situations change, the determination of independence can change too.

Within the corporate governance process, independence is important at the board level and for committees of the board, many of which are required to be mostly or even entirely comprised of independent directors. Moreover, it is important to measure independence before electing directors or appointing them to critical committees. If a problem arises later, the company may not be able to cure the failure to meet the independence requirement.

The term “independent director” is often used interchangeably with the state corporate law term “disinterested director,” which means a director who does not have an economic or personal interest in a particular transaction or arrangement requiring board approval. The two terms overlap substantially, but they are not identical. Independent directors will be “disinterested directors,” almost as a matter of definition, but not all disinterested directors will be independent. For example, it would be possible for the CEO, as a nonindependent director, to be a “disinterested director” and to vote on a transaction in which another director had a financial or personal interest.

Management knows the day-to-day operations of a company in a way that the board cannot. The board relies on management to present complete and honest assessments of company performance in order to fulfill the board’s oversight duties. The board must ensure that it has processes to ensure that the information it receives is correct and not somehow tainted by honest error, undue optimism, or dishonest manipulation.

Directors who meet the requirements for independence can still make mistakes or misjudgments, and can still wind up being unduly influenced by management. The governance process, however, including director independence, does not promise perfection—just a process to mitigate the risks.

Director’s Handbook demonstrates that while no single legal treatise can hold the answers to all factual situations that clients encounter, one book can hold the important questions that the clients and the lawyers should be asking, offering 10 sample questions across 101 topics to get conversations going within the boardroom and between attorneys and clients. The Role of Independent Directors covers the formal and informal obligations of independent directors, derived from such varied sources as federal securities laws, state corporate and fiduciary laws, stock exchange contractual terms, and investor “best practice” considerations.

By: Bruce Dravis


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