Tuesday, April 12, 2011

The Appearance of Reality: Independence

This is the third post in my effort to clarify corporate governance terms that now seem misleading to me. We all know what these words mean in a literal sense but in the context of governance, of business and of our post-crash world do they still mean the same thing?
I look forward to your comments.

Independence & Legal Independence
Effective governance of corporations requires that the board include individuals and committees independent of the management. Under the current system, in which boards of directors are essentially self perpetuating, it strains credulity that any individual board member could be considered to be “independent” of the board and the CEO. Directors chosen and endorsed by management inherently have a conflict of interest. Those entrusted with auditing and compensating management cannot be dependent on the favor of management without destroying the legitimacy of the process.

The criteria for independence is defined according to the charter of each corporation, state incorporation statutes and the various Stock Exchanges. In his recent essay on the HLS Corporate Governance Forum, Martin Lipton recently wrote: “friends can and should be independent directors. There is absolutely no basis for second-guessing a board’s reasonable determination that a friend of the CEO, or a friend of another director, is independent” (Corporate Governance Adrift).  Plainly, there is such a thing as legal independence but is it what we want or does it operate so as to legitimate a management based power structure?

Legal independence is a construction that exists outside reality. A legally independent director may or not be independent-minded. People want to be directors, it is a coveted position. If an individual is “gifted” a directorship it seems naïve to believe that he will be independent of the person who offers him the position. The only way to characterize an individual as truly independent is to have him nominated from outside the present power system – for example, as the SEC has recently proposed.

Specific criteria of independence are often painfully wrought, but does compliance with them assure quality independence – “real” independence -- essential for a system of effective governance? Can the corporate system flourish in reliance on “legally independent” compensation committees, audit committees and their creatures?

#1 – Is a system based on “legal independence” at best a charade and at worst a deception?

#2 – Can shareholders have assurance that any person selected according to the prevailing system of board self perpetuation is actually independent?

#3 – Or, is it therefore necessary that some interested parties – a percentage of long term shareholders - outside of the incumbent board and management choose those individuals whose independence is essential to the integrity of the corporate governance?

April 12, 2011 in independent directors , corporate governance , board collegiality , accountability , CEO power , Disinformation  |  7 comments  | 

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Posted by Bob Monks on Apr 14, 2011 at 10:33 PM
Alex --
I hold no brief for the superior entitlement of shareholders among the whole constellation of stakeholders in the corporate enterprise. In my efforts (not dramatically successful, I fear) to encourage corporate governance, I have encountered the problem called "collective action"
which simply contrasts the position of an individual taking all the risk, bearing all the costs, of initiative and enjoying the prospect of only a pro rata share of the returns if she succeeds. Shareholders are more fortunately placed than employees, customers, suppliers, domicile towns in that they are relatively free of reprisals. It would be most
difficult for suppliers, for example, to organize effective protest against their own customer. Not easy for employees, either. Also, shareholders can have simple minded objectives - value optimization. Thus, the shareholder is sufficiently independent to act (assuming we
get over the collective action problem) and has genuine economic motivation. It is for these reasons rather than any sense that ownership is more important than other components of the corporate calculus that I continue to work with shareholders.
Posted by Bob Monks on Apr 14, 2011 at 7:59 PM
Broc --
At some point, maybe, I will open discussion on the "tolerated confusion" over the core mission of directors. The statutes and the scholars all confer on boards a range of responsibilities that would humble the Book of Genesis. There is no prioritization and, therefore, no focus. As a result, it is extremely difficult to identify the appropriate characteristics in candidates. My experience on a dozen listed company board over fifty years is humbling and clear - my only contributions of indisputable value to the enterprise were in maintaining careful attention to the "health" - psychical and psychological - of the CEO. You don't find that one in the text books !
Posted by Broc Romanek on Apr 14, 2011 at 3:57 PM
Yes, true independence is tough. But another issue just as relevant is whether the director is truly qualified. Because in order to be asking the tough questions, you must not only be independent in mind, you need to be knowledgeable about the topic area to know whether - and what - to ask.

I believe that is one of the reasons that many directors allow excessive pay packages to continue - they don\\\'t know the area well enough to ask hard questions. However, if they want to sit on a board, they should be motivated to learn enough about the area to get it right.

Then again, I do recognize that they need to learn the industry, strategy, financials and so much more. It makes me wonder whether the current three-legged system can truly work in its current form...
Posted by Rob Berick on Apr 14, 2011 at 3:04 PM
Bob - thank you for examining this topic. In particular, I think the topic of independence becomes even more cloudy in situations of shareholder activism. My experience suggests that these "appointed" directors are anything but independent from the funds that forced them into the Board room.
Posted by Doug Chia on Apr 14, 2011 at 3:00 PM
Since you have served on public company boards, perhaps you could share your own experiences about who asked you to join those boards, what your relationship was with those people, and what type of independence you felt while serving on those boards. I have no doubt that you were truly independent on paper, in spirit, and in every other manner, but it would be interesting for us to get a perspective from inside your mind about how you viewed your role at the time and what it was that made you feel independent from those who asked you to serve (assuming they were somehow already related to the board or management). Were there questions you had to ask yourself. and be satisfied with the answers, before joining a board? Perhaps those questions could be a starting point for having prospective board members get in the right mindset to be a truly independent board member?
Posted by James McRitchie on Apr 14, 2011 at 2:08 PM
The Canadian definition Alex mentions is only a little better..."no direct or indirect material relationship with the issuer." Best friends, okay. They guy who saved your life in Iraq is fine too.

We don't need independent directors; we need directors that are dependent on long-term shareowners for the positions. The proxy access rules now in court offer at least a step in the right direction.

Great to see you asking these fundamental questions.
Posted by Alex Todd on Apr 13, 2011 at 7:38 PM
Bob, this is an interesting and timely topic, as just yesterday I commented publicly on a CCGG proposal that addresses the same topic (see http://is.gd/7jns7Q). Although those comments applied specifically to a Canadian context, I believe that, notwithstanding practical restrictions, mature boards should strive to follow some universally sound principles. Here are the ones I advocate:

1. Corporations are a public policy instrument used by capitalist jurisdictions to create economic prosperity;

2. Corporate boards owe a fiduciary duty of loyalty to the corporation, much like parents do to their children;

3. Corporate boards should fairly balance the interests of all stakeholders, including shareholders (and not give preference to shareholders or any shareholder groups) in order to ensure the firm can sustain its business value creating activities (the one exception may be shareholders who have directly contributed capital to the firm, which likely should be guided by distinct principles);

4. I like Canada's definition for an "independent director" for the purposes of serving on an audit committee (see Section 1.4 in http://is.gd/3IAVNn), namely that "the member has no direct or indirect material relationship with the issuer," and feel it should apply to all "independent directors" (which brings up the issue of appropriate director compensation and share ownership);

5. I agree that boards need to be accountable to parties outside the board and that those parties should have the ability to elect, remove, veto, and propose directors individually. However, I disagree that these outside parties ought to exclusively be shareholders. Instead, I believe that corporations and their stakeholders would be much better served in the long run if a stakeholder council and/or a supervisory board, comprised of strategic stakeholders (including shareholders in most cases), were empowered to direct the board.

Regardless of legal requirements that typically lag best practices and societal trends, progressive boards should seek innovative new ways to improve their effectiveness to affect business value creation. To that end, "independent directors" need to be independently minded.
Copyright 2022 by Robert A. G. Monks