The Uneasy Case for the Inside Director

• Author: Lisa M. Fairfax
• Position: Leroy Sorenson Research Professor of Law, George Washington University Law School
• Pages: 127-193

Lisa M. Fairfax. Leroy Sorenson Research Professor of Law, George Washington University Law School; A.B., Harvard College; J.D., Harvard Law School. Special thanks to Danielle Citron; Roger A. Fairfax, Jr.; Lawrence Mitchell; Lawrence Cunningham; and the law faculty at the George Washington University Law School for their comments on earlier versions of this draft. All errors, of course, are mine.

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I Introduction

The inside director—a director currently employed with the corporation on whose board she serves—is a dying breed.¹ Although the inside director once dominated corporate boards,² today the inside director has been painted as biased, untrustworthy, and generally antithetical to the best interests of shareholders and the corporation.³ As a result, inside directors have been banished altogether from many board committees and reduced to holding a minimal number of seats on the board as a whole.⁴

This virtual elimination of inside directors’ role on corporate boards is inextricably linked to the overwhelming consensus that boards should be dominated by “independent” directors.⁵ Such consensus stems from a belief that independent directors are better equipped to monitor the corporation, detect fraud, and protect shareholders’ interests.⁶ Pursuant to this majority view, independent directors appear to represent the perfect solution to the corporate-agency problem because they can oversee corporate affairs in a manner that prevents corporate managers from shirking their responsibilities or otherwise abusing their authority. As a result, reforms often “trumpet” the enhanced director independence as a response to corporate-governance failures, both prompting and requiring corporations to populate their boards and committees with independent directors.⁷ AndPage 131 in the current economic downturn, the pressure for increased director independence has escalated.

In addition to reducing agency costs, independent directors are thought to enable the corporation to engage in a form of self-regulation. Believing that they are better positioned to critically assess corporate conduct, regulators and courts give significant discretion to independent directors.⁸ That discretion ensures that there is rarely any substantive review of decisions made or sanctioned by independent directors. Hence, in various settings, the installation of independent directors serves as a substitute for external regulation, particularly with respect to “high risk” transactions.⁹

The assumption that independent directors represent the ideal solution to the agency problem and an appropriate substitute for external regulation has negative implications for inside directors. This is because, while there is no clear consensus with respect to the definition of an “independent director,” it is clear that an inside director is excluded from that definition.¹⁰ Legislators and governance experts presume that inside directors lack the impartiality necessary to appropriately monitor the corporation. Therefore, as corporations have embraced greater independence on their boards, the inside director has become almost obsolete.

In light of this phenomenon, this Article seeks to determine what role, if any, insiders should play on the corporate board. Focusing primarily on Delaware law,¹¹ as well as federal rules encompassed in the Sarbanes–Oxley Act of 2002 (“SOX”)¹² and corresponding federal reforms, this Article concludes that, despite the normative appeal of the independent director, insiders can and should play a pivotal role on the corporate board. In fact, this Article reveals that the independent director’s value has been vastly overstated, while the inside director has been under-appreciated and under-Page 132examined. This revelation has important implications for corporate governance and our system of external regulation.

This revelation rests on three premises. First, there exist significant limitations on independent directors’ ability to fulfill their monitoring role, and it is very difficult to overcome those limitations, especially as independent directors’ responsibilities increase. While others have recognized the defects associated with independent directors’ ability to perform their monitoring function, most nevertheless contend that those defects can be mitigated. This Article questions the legitimacy of that contention, while further amplifying the reasons why independent directors may prove ineffective.

Second, insiders can add value to the corporate board because they have the information, knowledge, and resources that not only increase corporate performance, but also may enable them to more accurately monitor and police the actions of other insiders. Importantly, this Article demonstrates that the line between insider status and independent status is significantly blurry, at least as it relates to potentially compromising ties, undermining the notion that insiders should be viewed as categorically incapable of behaving in an objective fashion.

Third, this Article highlights the flawed reliance upon independent directors as substitutes for external regulation. Particularly with respect to high-risk transactions, there is little reason to trust either inside or outside directors to make appropriate decisions, and hence our regulatory regime has inappropriately favored the independent director. In this regard, it may be that embracing insiders on the board could serve an important signaling function, decreasing courts’ willingness to defer to any director in the context of high-risk transactions. This could prompt a corresponding increase in the likelihood that corporate misconduct can be appropriately analyzed, regulated, and sanctioned. Moreover, it may increase the deterrent function of external regulation.¹³

Part II of this Article reveals the manner in which the corporate landscape has shifted to exclude inside directors from the board, and the rationale for that shift. Part III pinpoints the limits of independent directors’ ability to be truly independent and to effectively perform their monitoring role, while highlighting the difficulties associated with overcoming those limitations. This Part also examines the empirical evidence on independent directors’ impact. Part IV makes the affirmative case for the inside director and then analyzes the principal drawbacks associated with reliance on suchPage 133 directors. In particular, this Part grapples with the limits of inside directors’ role in the context of self-dealing transactions and fraud detection, while emphasizing that those limitations may not be overcome through reliance on independent directors. This Part also wrestles with the difficulties of relying on insiders who are subordinates and hence may find it difficult to objectively critique their superiors or otherwise challenge their superiors’ decisions. Part V offers some concluding thoughts.

II The Virtual Disappearance of the Inside Director

This Part demonstrates how inside directors essentially have been replaced with outside, so-called “independent,” directors. Before engaging in such demonstration, Subpart A better defines the term “inside director.” Subpart B pinpoints the manner in which independent directors have displaced inside directors, while Subparts C and D explain the rationales for such displacement.

A Defining Independence: Insiders vs. the World

Despite its prominence in corporate and securities law, the term “independent director” has no uniform definition; instead judges and legislators define the term differently.¹⁴ Moreover, the term is used differently in various contexts.¹⁵

Notwithstanding these differences, however, all definitions are uniform in their exclusion of “inside directors”—directors who are currently employed by the corporation on whose board they serve.¹⁶ At the federal level, SOX and various federal listing standards define an independent director by reference to a bright-line test that excludes inside directors. For example, under New York Stock Exchange (“NYSE”) and NASDAQ Stock Market (“NASDAQ”) rules, no director can qualify as independent if she hasPage 134 a material relationship with the company.¹⁷ The first such disqualifying material relationship is serving as an employee of the company.¹⁸ Similarly, SOX automatically excludes from...