Over the last several years there has been heightened federal legislation and administrative rulemaking relating to the supervision and oversight of public companies. In light of the recent financial scandals resulting, in part, from the failure of the existing oversight regime to identify and prevent abuse, investor confidence in the proper workings of the existing regulatory system has suffered and there is a widespread belief among the investment community that increased scrutiny is necessary; yet there is much disagreement as to the best mechanism to implement to achieve the desired oversight that would protect the investing public. We do not favor a complete overhaul of the existing regulatory system, nor increased government intervention. Rather, we propose an adjustment to the current director independence requirements which are already in place.
The independence of the board of directors of public companies traded on an exchange is a cornerstone of securities law. Both the Nasdaq and NYSE listing standards mandate a majority of independent directors. The Nasdaq Stock Market Corporate Governance Rule 4350(c) provides that “[a] majority of the board of directors must be comprised of independent directors.” Similarly, according to Section 303A.01 of the NYSE Listed Company Manual, “Listed companies must have a majority of independent directors.” The Commentary to this section explains: “Effective boards of directors exercise independent judgment in carrying out their responsibilities. Requiring a majority of independent directors will increase the quality of board oversight and lessen the possibility of damaging conflicts of interest.”
However, in determining whether a particular director is independent, neither receipt of director’s and committee fees nor ownership of stock in the company will, on its own, result in a finding of a lack of independence. The Commentary to Section 303A.02(a) of the NYSE Listed Company Manual explains: “As the concern is independence from management, the Exchange does not view ownership of even a significant amount of stock, by itself, as a bar to an independence finding.”
Similarly, under Delawarecorporate law, receipt of director’s fees and ownership of stock options do not, in the absence of other facts suggesting a lack of independence, demonstrate a reasonable doubt as to director’s loyalty. (See In re The Ltd., Inc. S’holders Litig., 2002 Del Ch. LEXIS 28 at 18-19, Ryan v. Lyondell Chemical Co., (Del. Ch. 2008)). The Delaware Courts have justified their rule that fees and stock options do not impair independence by asserting that to find otherwise would result in all directors being “deemed biased” (See Grobow v. Perot, 526 A.2d 914, 923 n.12 (Del Ch. 1987), aff’d 539 A.2d 180 (Del. 1988)), or would result in only wealthy individuals agreeing to sit on company boards (See In re The Walt Disney Co. Derivative Litig., 731 A.2d 342, 359 (Del. Ch. 1998), aff’d in part, rev’d in part sub nom. Brehm v. Eisner,746 A.2d 244 (Del. 2000)).
Moreover, the Delawarecourts believe that granting stock options to independent directors is beneficial since having a stake in a corporation aligns the interests of the directors with those of the other shareholders. See Orman v. Cullman, 794 A.2d 5, 27 n.56 (Del. Ch. 2002) (“A director who is also a shareholder of his corporation is more likely to have interests that are aligned with other shareholders”); In re Pennaco Energy, Inc. Sh’holders Litig.,787 A.2d 691, 709 (Del. Ch. 2001) (stating that the board’s grant of options to itself was consistent with a policy of aligning the board’s interests with those of the stockholders, which is a permissible purpose).
Nevertheless, the fact that a director receives director’s fees or stock options may very well have an impact on the director’s decision-making process. A director may be averse to criticizing his source of income. In addition, he may refrain from finding fault in management since his ability to continue to receive benefits is dependent on continuing to serve as a director. Furthermore, as long as stock options have not vested, a director may desist from actions that may jeopardize his continued service and the vesting of his options. Finally, with regard to particular transactions, the economic benefits that the director himself may realize may serve to cloud his independent judgment.
One commentator is so incensed by the courts’ failure to take into account fees paid and stock options granted to directors in determining whether director independence has been impaired, that he has categorized director independence as a charade. (See J. Robert Brown, Jr., “The Delaware Courts and the Charade of Director Independence,” www.theracetothebottom.org/indpendent-directors, August 18, 2008; see also J. Robert Brown, Jr., Disloyalty without Limits: “Independent” Directors and the Elimination of the Duty of Loyalty, 95 Kentucky Law Journal 53 (2006-2007)).
Regardless of the accepted view that director’s fees and stock options do not compromise director independence, any relationship, whether financial or social, that results in a director being beholden to the company, its executive officers, or the non-independent directors, may impair independent decision-making and serve as legitimate grounds for a finding of a lack of independence. Thus, a whole host of influences may deprive a director of his independence, including the receipt of director’s fees, the grant of stock options, and friendships with management.
Since state courts have not shown any inclination to implement more stringent independence requirements, the time is ripe for federal intervention and oversight of director independence to ensure that truly neutral decision-makers sit on the board of directors of public companies that are traded on an exchange.
While we are not interested in government involvement in the actual Board decision-making process, we do believe that there is room for greater federal oversight of director independence without comprising the Board of Directors’ traditional exercise of its business judgment. By fortifying the director independence requirements, we believe that we would be able to buttress the oversight mechanism from within, without having to impose a new supervisory regime from without.
In this light, we propose the following:
1.The federal government will establish an independent agency to be responsible for delineating qualification criteria for independent directors and ensuring that proposed independent directors actually qualify by satisfying these independence standards.
2.All persons who wish to serve as independent directors will register with this independent agency, and the independent agency will have the responsibility to place independent directors on the boards of public companies.
3.The operating costs of the independent agency will be covered by annual fees to be paid by public companies that are required to have a majority of independent directors serve on their boards of directors.
4.Independent directors will not receive any compensation, whether in the form of fees or stock options, from the public companies on which they sit.
5.Rather, independent directors will receive director’s fees from the independent agency, whose costs will be covered by the fees paid to it by public companies.
6.The number of years that any independent director may serve on any company’s board will be limited to 4 years, at which time, the company will be required to retain a different independent director (who shall be provided by the independent agency).
We believe our proposed approach will ensure greater board independence by diminishing the structural problems with maintaining independence that the current system is unable to address. Shareholder confidence and effective oversight can be maintained only if independent directors are truly free from interested influence.
By: Steve Kronengold and David C. Zuckerbrot. © January 2011. All rights reserved.
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