How to Enhance Directors' Independence at Controlled Companies.

• Author: Strampelli, Giovanni

1. Introduction II. Independent Directors at Controlled Companies A. Supervising Related-Party Transactions and Preventing Tunneling B. Why Directors' Independence at Controlled Companies Is Different C. Definition of Directors' Independence at Controlled Companies 1. Dispersed Ownership Countries 2. Concentrated Ownership Countries III. The limits to the Formal Approach to Directors' Independence A. The Basic Distinction Between Independence in Appearance and Independence in Mind B. The Need for Incentives Designed to Nudge (Truly) Independent Conduct by Directors IV. Reducing Controlling Shareholders' Influence on Independent Directors A. Making Independent Directors More Accountable to Minority Shareholders: Independent Directors' Election and Removal Regime B. Who Should Appoint Enhanced-Independence Directors? The Rise of Passive Investing and the Propulsive Role of Activist Hedge Funds 1. The Case for Promoting the Involvement of Institutional Investors in the Election of Enhanced-Independence Directors 2. The Italian Institutional Investor-Driven Model for the Election of Enhanced-Independence Directors: Curbing Investors' 'Rational Reticence' and Risks for Board Cohesiveness V. INDEPENDENT DIRECTORS AT CONTROLLED COMPANIES AND THE SOCIAL Nature of the Board: Tackling Social Ties and Inter-Group Biases A. Limiting Independent Directors' Tenure B. Promoting Directors' Independence in the Context of Transactions Influenced by Controlling Shareholders: Insights from Italian Related Party Transactions Regime. 1. Defining the Role of Independent Directors in the Context of Transactions Influenced by Controlling Shareholders 2. Granting Enhanced-Independence Directors Full Access to Relevant Information Concerning Transactions with Controlling Shareholders 3. Disclosure Duties Concerning Related Party Transactions as an Independence-Enhancing Tool. VI. Conclusion I. INTRODUCTION

   Director independence has become a common feature of issuer governance all around the world. In many legal systems, corporate governance rules and principles require a large part--often, the majority--of the board to be independent. (1) The role of independent directors was first enhanced with the rise of the monitoring board model--introduced by Eisenberg's seminal 1976 book "The Structure of the Corporation" (2)--according to which the main function of the board is to monitor the management of the company. subsequently, the role of independent directors was further expanded following the financial scandals during the early 2000s, which prompted regulatory responses on both sides of the Atlantic that were heavily reliant on the monitoring function of independent directors. In the United States, the Sarbanes-Oxley Act of 2002 (SOX) (3) provided for the establishment of an audit committee comprised entirely of independent directors. In addition, the NYSE, NASDAQ, and AMEX listing standards introduced a requirement that the boards of public companies--with the notable exception of corporations with a controlling shareholder holding a stake of 50% or higher--must have a majority of independent directors. (4)

   In Europe, building on the U.K. experience, (5) in 2005 the European Commission issued a non-binding recommendation on the role of non-executive or supervisory directors of listed companies and (supervisory) board committees, (6) prompting the presence in the board of a sufficient number of committed non-executive or supervisory directors "who play no role in the management of the company or its group and who are independent in that they are free of any material conflict of interest." (7) Subsequently, in line with the Commission's recommendation, almost all corporate governance codes adopted at EU Member State level recommend that the board include a minimum number or a ratio of independent directors. (8)

   However, in the wake of the financial crisis, the independent monitoring board model has come under attack. It has been blamed for contributing to the crisis, since the independent monitoring board model is claimed to have made it difficult for financial institutions to find independent directors with an adequate level of expertise in their industry, thereby reducing the overall competence of the board. (9) In spite of these criticisms, directors' independence is still regarded as a key element within issuer corporate governance, and is widely acknowledged by corporate governance rules and principles, which continue to place their trust in board independence as a useful tool to limit the negative consequences of agency problems affecting corporations. (10)

   Nevertheless, the inability of independent directors to play an active role in preventing a large number of financial scandals and related corporate failures has highlighted the limits of the formal approach to directors' independence "that takes into account only a corporate director's relationship with the corporation and not the tools a director needs to achieve substantive independence." (11) Those shortcomings prompted corporate governance experts to reconsider the very function and notion of directors' independence, and stimulated an intense debate about what directors' independence actually means, and how it can effectively improve issuer corporate governance. (12)

   Although the debate is still ongoing and some are still skeptical about directors' independence as a regulatory tool, (13) a key point has been already made. Some divergences persist within the global convergence on independent directors. (14) In particular, the definition of independence and the role of independent directors are not universally defined, as they largely depend on ownership patterns, industry structure and regulatory goals. (15) While the main agency problem in diffusely owned firms is opportunism on the part of the management, and independent directors are required to protect the interests of the shareholders vis-a-vis the management, in controlled firms independent directors are mainly called upon to protect minority shareholders vis-a-vis the controlling shareholders. Therefore, in a context of concentrated ownership, independent directors are mainly involved in vetting operations involving conflicts of interest and preventing tunneling by controlling shareholders. (16)

   Having been substantially ignored for a considerable period of time, (17) the distinction between controlled firms and widely owned firms is now accepted as fundamental within a large body of corporate governance scholarship. (18)

   As far as controlled firms are concerned, in a recent groundbreaking article, Professors Lucian Bebchuk and Assaf Hamdani have shed new light on the role of independent directors, providing an analytical framework aimed at making independent directors more effective in overseeing decisions involving conflicts of interest and solving the basic agency problem affecting controlled firms. (19) According to Bebchuk and Hamdani, to incentivize independent directors to perform their oversight role effectively, they should be made accountable to public investors. Therefore, in firms with controlling shareholders, the main characteristic of directors who are expected to monitor transactions influenced by controlling shareholders should be accountability to minority (or public) shareholders rather than mere independence. (20) Specifically, to turn independent directors into enhanced independence directors, (21) "public investors at controlled firms should have at least veto rights over enhanced-independence directors' initial appointment, reelection, and termination." (22) However, in line with jurisdictions that have already adopted reforms of this type, Bebchuk and Hamdani suggest that public investors should not have the "power to influence the election of all directors or even all independent directors." (23) Rather, they "believe that the election of some directors--enhanced-independence directors--should not be dictated by the controller." (24)

   Starting from these relevant conclusions, this Article will focus on directors' independence within controlled companies and will seek to extend the Bebchuk and Hamdani framework further in several directions to render it more effective and adaptable to different jurisdictions. To be sure, allowing minority shareholders to play a role in the election and retention of a minority of directors is essential to enhancing the independence of these directors and to make them more accountable to public investors. Nevertheless, it remains doubtful whether providing public investors with influence over the election and retention of some directors will be enough to promote truly independent and objective conduct by these board members.

   First, especially when minority shareholders are allowed to appoint some independent directors, potential apathy on the part of minority shareholders could lead to their failure to participate in directors' elections and consequently limit the practical relevance of enhanced-independence directors. In addition, it seems that the effectiveness of the Bebchuk and Hamdani proposal may depend also on the type of public investors supporting the election of enhanced-independence directors. In particular, since a purely activist-driven approach could present some drawbacks and can barely be adapted to jurisdictions where activist campaigns are rare, alternatives aimed at stimulating and favoring the involvement of institutional investors in the election of enhanced-independence directors should be developed.

   Second, and more generally, to induce these directors to perform their oversight function in a truly independent way, the formal approach to independence currently adopted internationally should be replaced with a more effective regulatory strategy aimed at providing directors with incentives to stimulate their independent conduct. obviously, to turn independent directors into enhanced-independence directors by reducing controlling...