Why Director Independence May Not Be All It’s Cracked Up To Be

The blog Conglomerate pointed us to a paper, “The Fetishization of Independence,” by one of its one-time writers, Usha Rodrigues, Assistant Professor of Law at the University of Georgia. They argue it is a “great” paper. I’m not sure I’d go that far, but is well documented and certain to cause a lot of debate. It will (hopefully) sharpen thinking about what makes for a good board, and good oversight. You can download it here (there’s a bit of fuss in registering, but no cost).

Her core argument is:

Behind all these rules lurks the belief that, by closing off all conceivable connections to management, rulemakers can create the ideal board. As discussed….this presumption has led to the modern ascendancy of the supermajority independent board, one free from ties to the corporation. I will argue that this move fetishizes independence, by viewing outsider status as a proxy for excellence as a corporate agent. I will also argue that this approach is both wrong and counterproductive.

She claims that good directors are hard to find, so the constraint of independence makes the process even harder, and that even if there were a large pool of director talent, the independence requirement is counterproductive.

I don’t buy her first argument. It is true that companies complain they find it hard to find directors, but the problem is in part, if not entirely, self-created. The involvement of search professionals has led companies to set overly exacting standards for who should be a director (and let’s face it, making the search more difficult justifies the headhunter’s fees). The same condition, of setting the bar for hiring well in excess of what is necessary for good performance, also exists with top, and increasingly routine, corporate jobs.

Companies are increasingly looking for the “out-of-central-casting” director, one with excellent management experience and a great Rolodex. It’s the people with the Rolodexes that are in short supply. Corporations would do better to move to the model of venture capital, and have an advisory board in addition to the board of directors. Members of the advisory board would have comparatively few duties, so the time requirements would be far less (and the liability would be minimal), so they could be involved with more companies. Unfortunately, that approach would represent a radical change in corporate governance, so it’s likely not to be viable except at relatively small companies.

Similarly, in support of her first argument, she claims that directors’ and officers’ insurance premiums have been rising. That is plain wrong. They have fallen, considerably, since the implementation of Sarbanes Oxley.

Nevertheless, her second argument, is more persuasive, although I found her detailed argument could lead to a different conclusion than her summary above. She cites studies that show that having independent directors hasn’t led to better outcomes. These studies are very few in number, so it is hard to have confidence in their findings.

The best part of the paper is a very lengthy discussion, from various perspectives, of the approach towards independence taken under Delaware law, which is more situational, than Sarbox, which is rule based. Sarbox famously has missed cases, like UnitedHealth, where directors had financial connections to other enterprises tied to the CEO. Similarly, board members often have ties to corporate officers through common charities, clubs, or membership on other boards.

Rodrigues argues that Delaware law is better able to deal with situations like these. It distinguishes between “interest,” when an individual has a clear financial stake in a situation, versus “independence” when he may be beholden to the company, its officers, or other key participants.

Now not being a legal expert, the big question I have is if the Delaware notion of independence is more useful and germane, why was it ineffective in preventing the accounting scandals of 2002 that led to the passage of Sarbox? The number of companies was sufficiently large (29) that a fair number of them must have been incorporated in Delaware.

Perhaps the problem isn’t what she argues, that independence (as defined by Sarbox and even under Delaware law) is overvalued, but that it can’t be achieved under current corporate practice. The slate of directors is nominated by management. Presumably, directors want to continue as directors. It’s prestigious and pretty well paid. That very fact makes them hopelessly beholden to management and therefore ineffective overseers.

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