Friday, March 9, 2007
Posted by Jeff Lipshaw
As Vic Fleischer over at Conglomerate observes, The Fetishization of Independence just posted by Usha Rodrigues (Georgia, right) is a terrific piece of work. Here is the abstract, with some comments following (in Larry Solum blue):
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 is 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.
I wholeheartedly agree with Vic: this is a tremendously thoughtful approach to an issue often overwhelmed not only by conventional wisdom (as Usha puts it), but by those (within academia and without) with a particular agenda to push. Here are some additional thoughts on the subject:
1. My intuition (primarily as an old practitioner who spent a lot of time in corporate boardrooms) is that the SOX and SRO rules for non-independence are asymmetric as to their over-inclusiveness and under-inclusiveness. That is, I would venture that many directors are independent under the rules but not really courageous, smart and/or experienced enough to be independent in the Delaware sense (think, for example, about the court's characterization of Sidney Poitier's role in the Disney case. Fine actor, upright and moral citizen, but "independent" in a good governance sense?) On the other hand, if somebody has a conflicting financial interest, you at least know that there is some agency cost basis for thinking they might not be independent, or appear to be independent. So the definition of non-independence may be under-inclusive in not picking up the the patsies, and over-inclusive in picking up fine directors who happen to have a financial tie. My intuition is there is more of the former than the latter. And from a policy standpoint, I understand the over-inclusiveness more than the under-inclusiveness, but for that you have to think about the following point.
2. As Usha points out, the more fundamental question goes to the question whether there is any relationship between independence, however determined, and "good governance," whatever that means (and I suspect my definition matches hers). I think she is onto something near the end on comparing rules and standards, and Delaware's standards based approach truly does better approximate that inquiry than the meat-ax rules approach of SOX and the NYSE.
3. Not that I am hankering for a citation (I've already sent a contribution to Usha's favorite charity), but I discussed the failure of the rules-based approach to good governance two years ago in my Wayne Law Review article on the jurisprudence of Sarbanes-Oxley. Then I picked on the general meaninglessness of the SOX requirement of an audit committee financial expert (the infamous "ACFE"), and always thought that independence was another prime target. I am delighted to see Usha take it to the next level.