Is the Independent Director Model Broken?
| Publication year | 2013 |
I. INTRODUCTION
At common law, an interested director was barred from participating in corporate decisions in which he had an interest, and therefore "disinterested" directors became desirable. This concept of the disinterested director developed into the model of an "independent director" and was advocated by the Securities and Exchange Commission (SEC or Commission) and court decisions as a general ideal in a variety of situations. The SEC's policy preference for independent directors was embodied in the Investment Company Act of 1940(fn1) and highlighted in some early cases.(fn2) Although the term "independent director" is often used rather loosely, it should be understood to mean a director without any general conflict of interest with the corporation. An interested director, by contrast, is a director who has a conflicting interest in a particular transaction.
The SEC's view of the need for independent directors should be understood in the context of Adolph Berle's theory of the 1930s. It posits that shareholders had abdicated control of public corporations to corporate managers, and fiduciary duties needed to be imposed upon corporate boards to compensate for this loss of shareholder control.(fn3) Berle's writings laid the foundation for shareholder primacy as the theory of the firm-a theory embraced by the SEC, which viewed itself as a surrogate for investors. Pursuant to this theory, a corporation is managed for the benefit of its shareholders.
The SEC has generally succeeded in imposing its corporate governance views in the wake of scandals. Following the sensitive payments enforcement program of the 1970s, the SEC embarked on an activist corporate governance reform program. During the merger and acquisition frenzy of the 1980s, the SEC used the Williams Act(fn4) to foster the view that the market for corporate control constrained incompetent managers. After the bursting of the technology bubble in 2000 and the financial reporting scandals that ensued, the SEC was able to incorporate its views on independent directors into the Sarbanes-Oxley Act of 2002 (Sar-banes-Oxley).(fn5) Following the financial crisis of 2008, the SEC further enforced its views on independent directors in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank).(fn6)
The composition and behavior of securities markets and investors has changed drastically since the SEC was established in 1934. Yet, the SEC has persisted in its path-dependent view that independent directors, ever more stringently defined, should dominate the boards of public companies. What is the function and rationale for such directors? If it is to assure that corporations comply with laws and regulations imposed on public corporations, then they become just another (probably ineffectual) gatekeeper. If it is to weaken the power of the CEO, it should be noted that there is some doubt whether independent directors can or should do so. If it is to be responsive to the needs and views of shareholders, which shareholders of an increasingly diverse body should be served? In recent years, and particularly in the aftermath of the 2008 financial crisis, academics and others have been questioning both the shareholder primacy model of the firm and the independent director model of board governance.
The independent director ideal has not been embraced all over the world. Neither has shareholder primacy. In some countries, a director representing the controlling shareholder is considered to be not independent because one of the goals of corporate governance is the protection of minority shareholders. Also, where the government is a majorshareholder, the independent director model is problematic. After the 2008 financial crisis, the conflicts between shareholders and creditors became more apparent. Should the independent director be independent of major shareholders as well as managers in order to preserve and increase the value of the firm?
I have never been entirely comfortable with the SEC's view that the best public company boards are those composed of directors whose only compensation for sitting on a board comes from directors' fees and who have no potentially conflicting business interests (past or present) with the company. The debates about independent directors were heated while I was a commissioner of the SEC from 1977 to 1980. Afterwards I served as an independent director of a large public company for twenty years, as a public director of the New York Stock Exchange from 1983 to 1989, and on the Advisory Committee for the American Law Institute Corporate Governance Project.(fn7) Many of my views are colored by these experiences. In particular, when I was a director, I found the insights of inside directors invaluable in decision making. Since 2008, my doubts about the independent director model have increased. This Article will explore those doubts and suggest that director expertise may be more important than director independence. Further, directors should have an obligation to the long-term viability of a corporation. Such an obligation would infringe upon the shareholder primacy theory of the firm, especially to the extent that this model encapsulates running the company for short-term economic gain. Furthermore, in an institutionalized marketplace, retail shareholders may need to be protected against institutionalinvestors.(fn8)
Part II of this Article outlines the evolution of the independent director model as championed by the SEC. Part III discusses criticisms of the independent director model. Part IV discusses shareholder primacy and sets forth alternatives to the shareholder primacy theory of the firm. Part V discuses corporate governance models outside the United States. Part VI concludes.
II. TWENTIETH-CENTURY SEC VIEWS ON INDEPENDENT DIRECTORS
Over time, this limited view of the SEC's statutory authority and expertise gave way to a more activist approach to corporate governance. In its reports on the financial collapse of Penn Central, the SEC cited lapses by the railroad's board of directors: "They failed to perceive the complexities of the company's financial operations, problems, or the critical nature of the company's financial situation [and] permitted management to operate without any effective review or control" because they "were uninformed of important developments and activities."(fn13)
The SEC staffs view of the need for corporate governance reform has generally been aired in the context of corporate scandals. In the early 1970s, a number of influential voices cried out for federal corporate chartering in order to curtail the deleterious influence of giant corporations.(fn14) The SEC then embarked on an activist corporate governance reform program in the context of a general post-Watergate hysteria-an effort to blame business for a prevailing climate of corruption, a stagflation economy, and a long-bear market. The immediate spur to this program was the questionable foreign payments cases, where approximately 400 public companies consented to injunctions to cease paying commercial bribes to foreign government agents in order to obtain business.(fn15) Some of these consents included the restructuring of a company's corporate board.
In response to the sensitive payments cases, Congress passed the Foreign Corrupt Practices Act,(fn16) which criminalized the payment of bribes to foreign officials.(fn17) It also required companies registered with the SEC to maintain accurate books and records, and to develop a system of internal accounting controls.(fn18) This was the first statute in which the SEC was given direct power to regulate the internal affairs of public corporations. Ironically, the statute was passed almost simultaneously with a Supreme Court decision prohibiting the use of Section 10(b) and Rule 10b-5 under the Securities Exchange Act of 1934 (Exchange Act) from being used to regulate directorial breaches of fiduciary duty.(fn19) According to the Court, such an extension of the securities laws would overlap and interfere with state corporation law: "Absent a clear indication of congressional intent, we are reluctant to federalize the substantial portion of the law of corporations that deals with transactions in securities."(fn20) Therefore, the SEC obtained a new power to impact corporate governance with regard to internal controls at the same time the Court expressed the view that Congress did not intend to create...
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