According to conventional wisdom, a supermajority independent board of directors is the ideal corporate governance structure. Debate nevertheless continues: empirical evidence suggests that independent boards do not improve firm performance. Independence proponents respond that past studies reflect a flawed definition of independence.
Remarkably, neither side in the independence debate has looked to Delaware, the preeminent state source for corporate law. Comparing Delaware's notions of independence with those of Sarbanes-Oxley and its attendant reforms reveals two fundamentally different conceptions of independence. Sarbanes-Oxley equates independence with outsider status. An independent director is one who lacks financial ties to the corporation and is not a close relative of management. Delaware's approach to independence, in contrast, is situational. As different conflicts arise in different contexts, the focus of concern--the influence from which we wish to insulate directors--varies as well.
There are at least two lessons for corporate reformers. First, the definition of independence should be refined to address the conflict at hand. For example, if the area of concern is executive compensation, the question is not merely whether the director lacks financial ties to the corporation and familial ties to corporate executives, but also whether the director lacks financial ties to the executives being compensated. Current independence rules overlook this obvious hole. Second, and more fundamentally, independent directors are useful only in situations where a conflict exists. An independent director--a part-timer whose contact with the corporation is necessarily limited--is not inherently better suited to further the interests of shareholders than an inside director. Current rules thus over-rely on independence, transforming an essentially negative quality--lack of ties to the corporation--into an end in itself, and thereby fetishizing independence.
INTRODUCTION II. THE DOMINANCE OF INDEPENDENCE A. The Conventional Definition: Independence as Status B. The State of the Independence Debate III. WHY REVISIT INDEPENDENCE? A. Lack of Candidates and Increasing Cost of Independents B. The Value of Outside Independent Directors C. Empirical Evidence That Independence Does Not Matter D. Resisting the Fetishization of Independence IV. "INDEPENDENCE" UNDER DELAWARE LAW A. Distinguishing Between Independence and Interest B. Conflicting Interest Transactions and Self-Dealing 1. Delaware's Exploration of the Nuances of "Interest" 2. Section 144: Another Example of Delaware's Flexibility 3. Interest Summarized C. Derivative Suits 1. A Brief Review of Derivative Suits' Procedural Posture: Suing to Make the Corporation Sue 2. Interest 3. Independence D. Takeovers 1. Freezeout Mergers 2. Defensive Measures Against Hostile Takeovers E. Independence Summarized V. LESSONS LEARNED A. Refining the Definition: The Executive Compensation Case Study B. The Ends of Independence and Revisiting the Fetishization of the Proxy VI. POTENTIAL OBJECTIONS TO GENERALIZING FROM DELAWARE'S INDEPENDENCE TO CORPORATE GOVERNANCE A. Apples and Oranges B. The Interest Group Objection C. Apples and Oranges Redux: The Public/Private Divide D. A False Dichotomy E. Administrability VII. CONCLUSION I. INTRODUCTION
Consider a hypothetical major U.S. corporation that presents a textbook example of good corporate governance. Two highly knowledgeable insiders (the CEO and CFO) sit on the board, as does the former CEO. Also on the board are seven independent (1) directors who have no management role, thus forming a strong supermajority bloc of wholly independent board members. (2) Further illustrating corporate governance best practices, the board's chairwoman is one of the independent directors, carefully chosen to take the helm in conjunction with the ouster of the corporation's former CEO. A sophisticated and seasoned financial executive, the chairwoman has studied books on governance, attended directors' workshops, and hired consultants to update the board's handbooks. With this independent board in place--meticulously selected to right the mistakes of the recent past--the corporation's stock has soared. But then, within the course of a month, the tapestry of success unravels. (3) One independent director, a flashy, risk-loving Silicon Valley mogul, (4) clashes repeatedly with the chairwoman. Allegations of board leaks, potential criminal behavior, and internecine conflict between board members lead to the chair's resignation and scandal for the entire corporation.
This corporation, as it turns out, is not a hypothetical firm, but in fact is Hewlett-Packard (HP), the 14th largest corporation in the United States. (5) Regardless of the blame that may ultimately be assigned to the various individuals on the board, the HP story illustrates the perils of relying on "best practices" corporate governance--such as a supermajority independent board--alone. Nevertheless, a student of corporate governance discourse over the past 40 years could easily conclude that independent boards are an essential--indeed, a natural--part of good corporate governance. (6) It is now conventional wisdom that independent boards must run companies, so obvious that it does not even warrant discussion. (7)
Even so, in some corners of academia, debate about the value of independent directors persists.8 Empirical studies have shown that a majority independent board does not improve firm performance--that is, firms with a majority of independent directors do not perform better for shareholders than those with a minority of independents. (9) In response, proponents urge ever-stricter definitions of independence. Surprisingly, however, participants in this debate have failed to examine the role of independence in Delaware, the preeminent source of corporate law in the United States. (10) This omission is particularly notable because Delaware's theory of independence differs radically from the conventional approach. Although practitioners have parsed Delaware's independence requirements in specific areas, (11) there has been no systematic examination of the role that independent directors play in Delaware, nor has anyone compared that role with the recommendations of independence-minded corporate governance activists.
This Article uses Delaware's approach to independence to question both the means and ends of director independence as currently conceived. (12) By "means," I refer to the way that independence is defined. The Sarbanes-Oxley Act of 2002 (13) (SOX) and self-regulatory organizations (SROs) such as the NASDAQ and the New York Stock Exchange (NYSE) define independence by way of status: "independence" means outsider status. The hallmark of the independent director, so conceived, is an absence of ties to those in control of the corporation. SOX and the SROs gauge this lack of ties through the use of two metrics: (1) lack of financial ties to the corporation, and (2) lack of familial ties to the managers of the corporation. For example, under the NYSE rules, directors are not independent if they have received more than $100,000 in non-director fees, or are a close relative of executive management. Delaware, by contrast, takes a more contextual approach. Under Delaware law, one cannot determine independent status ex ante, before a conflict arises. Once a conflict triggers the need for an inquiry, Delaware looks to the specifics of the situation in order to determine independence. As a result, a person not related to an executive and who has never taken compensation from the corporation nonetheless may be deemed to lack independence for reasons of past obligation, (14) or even friendship with key managerial personnel. (15)
Delaware's approach provides a lesson for the SROs and corporate reformers (16) generally: a genuine concern about board-member independence requires focus on the conflict at hand. Both SOX and the SROs' definitional approaches suffer from the same deficiency: they address financial conflicts with the corporation and familial conflicts with corporate managers, but overlook financial conflicts with managers. For example, the chairman of UnitedHealth's compensation committee was independent under NYSE rules, but nevertheless arguably conflicted due to financial ties to the CEO.
But it would be a mistake to extrapolate from Delaware's concept of independence merely that the SROs' definitions of independence must be tweaked. Delaware's model provides the basis for a more trenchant critique of a conventional conception of independent directors. The SROs prescribe an independent board as the safeguard of shareholder interest, but this emphasis misconceives the ends of independence. Corporate governance advocates implicitly expect the director who lacks ties to the management of the corporation to be a positive good to the corporation. Delaware reminds us of the "end" board independence is supposed to achieve: a mechanism for handling conflicting interest. Public corporations inevitably face conflict situations in which the interests of management do not align with those of shareholders. It makes sense, for example, to place independents on audit committees (in case management is cooking the books), compensation committees (so management does not set its own salary), and nominating committees (so management does not select the board that is tasked with overseeing it). It does not follow, however, that it makes sense to require independence from all or most board members, as the SEC has historically recommended. At the least, because empirical data has shown that majority independent boards do not improve firm performance, a close look at the value of the SEC approach is in order.
Thousands of widely dispersed shareholders cannot run a corporation themselves: the board and corporate executives manage it for them. Therefore, the goal of corporate governance...