Paper No 72/2013 July 2013
Independent Directors: After the Crisis
WOLF-GEORG RINGE
Independent Directors: After the Crisis
Wolf-Georg Ringe*
* Professor of International Commercial Law, Copenhagen Business School and University of Oxford. This contribution benefited from comments made by participants at the Conference of the Nordic Company Law Scholars Network, held at Aarhus University in November 2012.
Abstract
This paper re-evaluates the corporate governance concept of ‘board independence’ against the disappointing experiences during the 2007-08 financial crisis.
Independent or outside directors had long been seen as an essential tool to improve the monitoring role of the board.
Yet the crisis revealed that they did not prevent firms’ excessive risk-taking; further, these directors sometimes showed serious deficits in understanding the business they were supposed to control, and remained passive in addressing structural problems.
🡪Under the surface of seemingly unanimous consensus about board independence in Western jurisdictions, 🡪a disharmony prevails about the justification, extent and purpose of independence requirements.
Instead, this paper proposes a new, ‘functional’ concept of board independence. This would redefine independence to include those directors that are independent of the firm’s controller, but at the same time it would require them to be more accountable to (minority) shareholders.
1. Introduction
A large proportion of directors should be independent.
🡪Independent directors have in no way prevented firms’ excessive risk-taking; further, they have sometimes shown serious deficits in understanding the business they were supposed to control, and have remained very passive in addressing structural problems
🡪Western jurisdictions, a surprising disharmony prevails about the justification, extent and purpose of independence requirements.
‘Functional’ concept of board independence proposed 🡪 It would include directors that are independent of the firm’s controller, but at the same time more accountable to (minority) shareholders.
2. Independent directors and the financial crisis
The concept of board independence has originated in the United States.
US🡪independent and non-employee directors,
US🡪company boards should include a majority of independent directors
US🡪key committees be composed of independent directors.
Regulation is often scandal-driven or responds to economic crises. As a response to a number of major corporate and accounting scandals, including those affecting Enron and WorldCom, the Sarbanes-Oxley Act reformed large parts of US corporate law and capital market regulation. This included a strengthening of board independence: inter alia,
Sarbanes-Oxley Act required publicly traded companies to have wholly independent audit committees with the power and the duty to select outside auditors.
Independent directors were partly blamed for the major failures of ‘checks and balances’.
🡪boards made poor decisions with respect to compensation, operations and investment at financial institutions.
In sum, these accounts view the financial crisis and poor bank performance as a function of corporate governance failure, particularly of monitoring boards.
Directors failed, for example, at risk management because they lacked appropriate incentives, expertise or information.
Directors did not have the power, tools or advisers to properly supervise and assess risk.
The solution these accounts arrive at is to enhance the influence of independent directors and to strengthen their independence and accountability – in short, a ‘more of the same, just better’.
Legal standards need to be revised and to push independent directors to further supervise the risk management of the company and to have some level of expertise in such matters. - Legal liability standards are to be enhanced
Greater regulatory intervention to erect structures to improve observed behavioural deficits of boards and directors.
2.1 The regulatory and quasi-regulatory push
The Walker Report 🡪 focuses on structural aspects. Fundamental aspects of board composition, leadership and commitment. Also, need for increased board oversight of risk management and compensation practices as well as board engagement with long-term shareholders.
2010 Principles for Enhancing Corporate Governance, 🡪banks should have a formal written policy for dealing with conflicts of interests of board members as well as an objective compliance process for implementing this policy.
Dodd-Frank Act provides
for the creation of risk committees to ensure proper management of risk at financial and non-financial firms; these must be comprised of independent directors and include at least one expert in risk management.
It further requires compensation committee members to be fully independent.
board-centred reform enhancing the power of inside directors has become a commonly used regulatory technique in the US by lawmakers
The net result is that directors, and particularly independent directors, have emerged as a potentially more powerful and autonomous monitoring organ in post-financial crisis corporate governance.
3.1 Improving the board’s performance
director independence has been justified by the proper role of boards: to provide effective and unbiased monitoring.
conflict of interest dimension: independence is seen as a coarse pre-condition for ensuring ex ante that board decisions are not tainted by arbitrary considerations.
Our initial sense of policy is supported by a brief survey of justifications usually cited. For example, the requirements of the New York Stock Exchange state that ‘[r]equiring a majority of independent directors will increase the quality of board oversight and lessen the possibility of damaging conflicts of interest’.
Independence ultimately has the goal of furthering the interests of the shareholders, and that it is not an end in itself. From this perspective, independent directors are seen as a ‘trustee’ for shareholders, to mitigate managerial agency costs.
-Independent directors are said to prevent self-dealing by examining conflict-of-interest transactions;
they should monitor management to detect and prevent managerial fraud;
Further, independent directors are supposed to examine corporate affairs and thus to prevent managerial mismanagement.
Contra: Independent directors serve not just the interests not just of the shareholders, but those of all stakeholders, if not of society as a whole.
Thus, Gordon (2007) argues, independent directors are more valuable than insiders since they are less captured by the management.
The more developed and informed the stock market is, the easier it is for independent directors to monitor the management and, consequently, the more functional it is to have independent directors on the board, avoiding reliance on explicit expertise.
3.2 Criteria of independence
Definition of independent- ‘key characteristic of independence is the ability to exercise objective, independent judgment after fair consideration of all relevant information and views without undue influence from executives or from inappropriate external parties or interests’.
🡪German Corporate Governance Code:
“a director is not deemed independent ‘if he/she has personal or business relations with the company, its executive bodies, a controlling shareholder or an enterprise associated with the latter which may cause a substantial and not merely temporary conflict of interests.’
This appears to be a middle ground between the two extreme models described above:
The above-mentioned criteria are then only non-binding guidelines for the board, which is free to deviate under the well-known ‘comply or explain’ principle. This approach ultimately leaves the question to the market to judge. 13
In summary, it appears that a closer look at the legal systems of Western economies testifies to a large divergence in the understanding of ‘independence’ of board members. This is true for both the regulatory justification of the concept and the precise criteria that are relevant for determining independence.
4. Challenges to independence
4.1 Matching independence with industry and ownership structure
Independent directors need to be understood as one tool in the larger toolkit for dealing with shareholder conflicts; it follows that independence from the controlling shareholder is an essential criterion when determining whether a particular person is independent.
By contrast, in dispersed ownership structures, where managerial agency costs tend to be high, this criterion is largely irrelevant, if not counterproductive.
To illustrate the implications of both scenarios in practice, consider the following two examples.
German corporate structure is traditionally dominated by strong blockholders.
By contrast, the UK is famously known for its dispersed shareholder ownership structure. Its insistence that independence within the meaning of the UK Corporate Governance Code includes the absence of any links with a significant shareholder must be surprising, to say the very least.
there is no universal definition of ‘independence’. ‘’
4.2 Empirical evidence
The second challenge to independence is the mixed empirical support it has received in recent years. Essentially, scholars have tried to evaluate whether independent directors improve firm performance and have come up with overall mixed results.
Together, the empirical studies show that board independence will at least not always be helpful in improving company performance. This raises the question of why regulators (and, indeed, companies themselves) continue adding ever more independence criteria. It is conceivable that diminishing marginal returns mean that the optimal number of independent directors, at least for US companies, may already have been well exceeded.
4.3 Incentive problems
Another problem might be that independence in itself is not enough; scholars have recently been focusing increasingly on the proper incentive structure for independent directors. This intuitively makes sense, given the numerous tasks we assign to independent directors and the almost superhuman results we expect from them: we expect them to guard against self-dealing by examining conflict-of-interest transactions; we expect them to actively oversee management and to detect and prevent fraud; further, independent directors are supposed to examine corporate affairs and thus prevent managerial mismanagement.89
In short: we ask a lot of them. In particular, we expect independent directors to speak out and to take a proactive role in monitoring. What, other than possibly reputational or moral constraints, can incentivise them to take up this challenge? What, as some have described it, can encourage them to ‘fight the battle’ rather than enjoy an easy life by pursuing a laid-back approach to monitoring?
Lawmakers have suggested the obvious solutions, for example, to strengthen liability standards or to incentivise directors financially. Whatever approach, it is positive that this aspect of the debate – to consider the incentives side – has now reached the mainstream policy discussion. It has too often been neglected in the traditional debate.
4.4 Substitutes for independence
Finally, consider the situation in the UK, where independent directors should have a role in representing shareholders’ interests in general as against management, following our rationale developed above.104 Although the conflict situation resembles the starting point in the US, research shows that UK boards employ significantly fewer independent directors than their US counterparts.105 A superficial comparison, therefore, would conclude that UK boards should generally increase the proportion of independent directors. This, however, disregards the much stronger rights of shareholder to remove and appoint board members.106 In the UK, shareholders can remove directors at will with a 50% majority requirement. Arguably, this power (and already the threat of using it) makes management much more accountable to shareholders than US law. Again, we see that the mere number of independent members on the board as such is not a meaningful element of a sound legal comparison.
5. Towards a functional understanding of board independence
The insights developed above now allow us to develop a concept of ‘functional independence’ of directors. Central to this theory is the understanding that independence is not a panacea, and certainly not an end in itself. Rather, it is submitted, independence is a tool for solving a specific problem. On a very general and abstract level, it is a procedural instrument to protect weak groups within the company and to mitigate agency costs. As we have seen, it might work to the benefit of shareholders in general (dispersed shareholder environment) or minority shareholders, as opposed to controlling shareholders (concentrated shareholder environment). The important point then is to understand that independence needs to be designed in accordance with the corporate environment and the specific purpose it is designed for in a given jurisdiction.
This allows us to develop the following cornerstones for a functional understanding of director independence.
5.1 Improving independence
First, independence should be functional in respect to its purpose. Lawmakers availing themselves of the instrument of board independence should carefully consider what role the concept should play in their jurisdiction. This should include taking into account the typical or prevailing shareholder structure and industry structure in the jurisdiction. As we have emphasised, one fundamental (yet coarse) distinction is the traditional divide between concentrated and dispersed ownership, where the focus of independence should lie on strengthening minority shareholders or shareholders generally, respectively.107 This will have far-reaching implications for the respective definition of independence, in particular whom the director should be independent of (majority shareholder versus board). At the same time, as we have shown, lawmakers should respect and/or complement pre-existing equivalent substitutes. If adequate safeguards are already in place, additional independence standards will not be necessary and may even be counterproductive. It is in line with this argument to emphasise the importance of independence in particular in situations where conflicts of interests are most salient, for example, in the appointment or removal of managers, when setting executive pay, or when auditing executive performance.
It is against this background that we can make predictions of the usefulness of different independence criteria against the specific situation in any given jurisdiction. To illustrate, the recent review of the German Corporate Governance Code – to include ‘independence from a controlling shareholder’ – can be said to be a step in the right direction 22
(whereby technical details are still debated).108 By contrast, the fact that the UK Code lists as one of its independence criteria the absence of any links with a significant shareholder must be surprising, given the highly dispersed shareholder structure in this country.109
Secondly, in order for independence to be functional, it needs to address its very own weaknesses. As recent empirical research has shown, independence is often associated with ignorance.110 Lawmakers should therefore ensure that independence is accompanied and supplemented with proper expertise or appropriate ongoing training. This could, for example, be monitored by regular external control. Apart from expertise, avenues that regulators should explore could be to raise the accountability of independent directors to shareholders or minority shareholders – this argument is further developed below.111 Alternatively, monetary or non-monetary incentives could be introduced by law, for example, specific target benchmarks. These measures should address the low incentives to engage with the company that we currently see among directors.
5.2 Combining independence with dependence
Thirdly, lawmakers should think about coupling independence with dependence. What sounds like a contradiction is designed to achieve the following: independence is usually framed as a negative criterion – independence from some group or person, for example. The downside to this approach is that ‘independence’ is ambiguous as such: a passive concept, bare of any positive, proactive element. The policy discourse would benefit from more experimenting with ‘dependent’ or ‘accountable’ directors who would represent the constituency which the legal rules intend to protect. To make this more concrete: minority shareholders in a concentrated ownership system are currently very much at the mercy of low-incentivised independent directors. If, however, such independent directors were at the same time associated with a specific constituency, they would have a more meaningful, positive role. For example, a director could at the same time be independent of a controlling shareholder, but accountable to minority shareholders. This is what is intended by minority appointment rights, as exist in, for example, Italy. Italian company law mandates board representation for minority shareholders in listed companies through an elaborate system of board lists.112 Since 2007, all listed companies are required to ‘reserve’ at least one board seat for candidates drawn from slates submitted by minority shareholders; consequently, even investors holding a comparatively small block of shares can have access to the board.113 It is encouraging that the European Commission, in its latest Green Paper on Corporate Governance, mentions the Italian system as a good example of making the board more accountable to minority shareholders.114 Another example is the well-known and much-discussed German system of employee representation on the board. Similarly to how the Italian law protects minority shareholders, the German law takes care of employees. It is important to note, however, that these ‘appointed’ directors have duties and liabilities like any other director, including in particular the duty to protect the interests of the company as a whole. Nevertheless, their position as appointed representative of a certain group facilitates information flows between the company or management and the represented group (in both directions), and helps ensure that the concerns of this group are at least heard and considered at board level, thus raising awareness of their positions and encouraging discussions. All of this would be very much in line with the strand of research that has become known as the theory of the board as a ‘mediating hierarch’, in a sense that the board as an institution brokers the relationship between the various different constituencies affected by the company.
Transferring this line of reasoning to the US/UK context of corporate governance, where ownership is more dispersed, independent directors should not just be independent of management, but, to some extent, be accountable to the shareholders as well. This has been advocated already some time ago, but is not reflected in the current legislative framework.116 24
Indeed, some argue that boards should be more accountable to shareholders, relying on empirical data from the financial crisis.117
Incidentally, improving the representation of shareholders or minority groups on the board would have positive side effects. Looking at the weaknesses of the typical current independent director as discussed above,118 there is a good chance that, for example, group representatives would have better expertise – simply because the minority group would make sure they put forward a candidate who best represents their interest in a sophisticated manner. Similarly, we can expect that the incentive problem will be mitigated: directors who directly represent a specific group will have a much stronger incentive to pursue a certain agenda than the ‘empty’, disinterested standard director. It may be hoped that this will result in an open, fresh dialogue: the ultimate goal would be for representative directors to present new arguments and possible strategies to their fellow independent directors and argue for certain ways forward, informing and inspiring the entire board and ultimately benefiting the entire company.
On the other hand – μηδέν άγαν (‘nothing in excess’). It would have fatal consequences were the board only composed of representatives of certain interest groups. This could lead to overprotection and overrepresentation of (potentially different) minority groups and activists, blocking an effective organisation of and decision-making by the board. The consequence would be trench warfare and deadlock in decision-making. It is moreover beneficial to have a proportion of truly independent outsiders on the board, as they can overcome groupthink and bring in new, fresh ideas. A good balance is essential and a mixture of all of these groups is desirable. The ultimate tenet must be the one from the former Combined Code,119 which insists that an appropriate balance of directors is essential ‘… such that no individual or small group of individuals can dominate the board’s decision taking’.120 These simple words aptly describe the objective of board composition better than many lengthy articles.
In sum, this paper supports the idea to combine board independence with a certain, balanced dependence on (or accountability towards) certain constituencies and stakeholders. 25
We have seen that the following benefits are to be expected. First, having a representative on the board will be a direct tool to voice the concerns of the protected group (minority shareholders, for example) and to raise awareness for their positions. Secondly, certain weaknesses that independent directors have shown during the financial crisis may be overcome, notably expertise deficits and incentive problems. Having appointed representatives with a clear agenda on the board will ensure that these individuals are better incentivised and experienced. Thirdly, an indirect impact may be expected on the incentives of the other, non-appointed directors. Being exposed to new, clearly formulated arguments and (sometimes contrasting) positions within the board dialogue will stimulate more controversial thinking, improve the quality of the dialogue and raise the general standard of discussions. This will enhance the standard of board activity overall, to the benefit of the company as a whole. Fourthly, representative board members stand to improve information flows beyond the board – even if they cannot always force through their position, they can at least raise awareness of the views of minority groups. Conversely, they can also improve the information stream by reporting back to their principals about deliberations in the board and thus contribute to more transparency within the company.
6. Conclusion
The dismal performance of many companies during the financial crisis has reopened the debate on board corporate governance, and in particular on the long-established element of director independence. Many current initiatives and policy discussions seem to suggest that they want to strengthen independence, thus a clear ‘more of the same’. By contrast, this paper calls for a reflection on the inherent purpose of director independence and develops a ‘functional’ notion of director independence, overcoming its deficiencies.
This is against the background that ‘independence’ is often used in an undifferentiated way, lacking a clear, unambiguous definition. This complicates in particular cross-border comparisons. This paper suggests that it is necessary to perform an analysis not only of the notion of independence, but also of the concept. Thus, independent directors are understood as a means to better control the management and to mitigate agency costs by protecting minority groups. The specific role that independent directors have to play depends on the specific jurisdiction, in particular on the business environment, shareholder structure and industry characteristics. It is therefore crucial to determine whom the director should be independent of.
But, this paper argues, independence as such is not enough. The second step is that independence should be carefully balanced with a certain amount of dependence. This refers to accountability of directors to certain minority groups which they should protect. Strengthening directors’ accountability promises to overcome certain weaknesses that they have displayed over the past years, most notably expertise and incentive problems. Minority shareholder appointment rights in Italy are an example of a useful concept in a concentrated ownership environment. The corresponding tool for a more dispersed ownership scenario would be a director directly appointed by the shareholders.
Overall, the challenge is to find the right balance between independence and dependence. Independence from the ‘controller’ (management and/or majority shareholder) should be guaranteed, but a certain accountability to the underrepresented group would be an equally important component in motivating and stimulating the board to perform a meaningful role.
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