Independence and the private company board: adopting Sarbanes-like rules on director independence would impair the smooth functioning of the business.

• Author: Raymond, Doug
• Position: LEGAL BRIEF

ONE GREAT ADVANTAGE of the modern corporation is that it allows the separation of the owners, who supply needed investment capital, from the managers, who oversee the daily operations of the business. This ownership structure, which has its origins in the East India Trading Company of the 18th century, has facilitated efficient deployment of capital and the development of professional managers. This ultimately has led to the creation of highly liquid global stock markets.

While this separation has had many benefits, it has undeniably raised up a class of managers who have different interests and objectives from the owners of the businesses where they work. The development of professional managers has been crucial to the creation of the great corporations, yet it has increased the risk that the managers may sacrifice the owners' interests to line their own pockets.

Congress adopted the Sarbanes-Oxley Act partly in reaction to scandals that resulted from managers who focused more on their own self-interest than on the interests of business owners. While there are many aspects to this landmark legislation, one of its core principles is to increase directors' independence from management.

The principle is now well established that public company boards should be independent from management to ensure that the managers keep their focus on shareholder interests. Directors of public companies are to play the watch-dog, interposing themselves between the rapacious managers and the disenfranchised public owners.

The value of this principle has been repeatedly demonstrated by the failure of many public companies that did not adhere to it. But does it make sense for all corporations, or only some? Specifically, how should directors of private corporations view their relationship to management?

In many private companies, stock ownership is concentrated among relatively few people. These stockholders are not anonymous but are often deeply involved in the business and well able to look out for their own interests. Thus, in many private corporations, the public company model is inappropriate, and a different paradigm for governance is required.

Furthermore, in many private companies, the directors' core function is more collaborative than skeptical. The directors are often longtime colleagues--even relatives--of the controlling stockholder(s), and typically own significant equity in the business themselves. For these corporations, the equity owners remain...