The problem with independent directors

Director independence is essential to protect boards—and shareholders—from governance failure. Yet compromised independence is rampant. Here’s what we can do about it
By Richard Leblanc

“The board chair is owned by the CEO,” the directors told me after the regulator called me in to assess their board. I wasn’t surprised. I have not assessed a board when there was not at least one director, and often several, who are viewed as non-independent by their fellow directors—even though these directors are independent by regulatory standards.

Independence can be compromised in many ways: a close social or personal relationship with another director or member of management; excessive tenure on the board; excessive director pay or expenses; an office at the company for the director; the use of secretarial staff; vacations with other directors, a significant shareholder or management. The list goes on.

But why does compromised independence so often go undetected? Blame, first, a lack of external measurement, a situation that can be readily exploited by clever, self-serving management and by directors who allow it to occur.

The second factor is the use, in Canada, of a subjective assessment standard (what directors believe), rather than an objective one (what is reasonable to believe). This means that if directors collectively believe that a director does not have a “material” relationship that can reasonably be “expected” to “interfere” with that director’s independent judgment, then that is the end of the analysis. The absence of an objective, reasonable or perceived point of view is glaring. What should matter is what is reasonable, not what a director or a board believes.

The blame here lies with regulators as much as directors. When director independence is compromised and regulatory standards fail to detect this, it means the regulators have failed.

If directors are to possess independence of mind coming onto the board and maintain it once they are on, reforms are in order. Here are some I use and recommend:

• Regulatory reform should occur so independence of directors espoused by regulators equates with actual independence inside boardrooms. An objective, reasonable person standard should be used.

• Boards should enact a robust conflict of interest policy, for directors, not drafted by management, and this policy should be disclosed to shareholders. Codes of conduct should also be drafted for boards of directors.

• Independent advisers should facilitate an annual peer review of director independence. The review process should be disclosed and acted upon.

• Boards (and if not, regulators) should impose reasonable term limits on director tenure, beyond which the director is not regarded as independent.

• Boards should require the confidential disclosure of directorial perceived conflicts (including assets and financial information relevant to the company’s business) to the audit committee, including that of family and affiliates of the director. Audit committees, in turn, should review and recommend to the board perceived conflicts, and create a special committee of independent directors, if and when required, with independent advisers.

• An anonymous procedure for reporting on directors who do not disclose potential conflicts should exist.

• The governance committee should recommend independent board and committee chairs, and the board chair should be selected by confidential ballot without CEO presence/influence.

• For significant shareholder boards, independent directors should be chosen by and from minority shareholders, so a portion of directors are independent of the significant shareholder, commensurate with the significant shareholder’s portion of common shares.

• For widely held boards, shareholders should select a portion of directors so directors are independent of each other and management.

• Boards (and if not, regulators) should diversify to ensure directors come from different pools and boards should disclose how each director came to be recommended for election.

Richard Leblanc is an associate professor, governance, law & ethics, at York University’s Faculty of Liberal Arts and Professional Studies and a member of the Ontario Bar. E-mail: rleblanc@yorku.ca.

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