Independence Reconceived

Originally conceived as guardians of shareholder interests that could safeguard a corporate board’s ability to check management’s power, independent directors have become a marquee feature of modern corporate governance. But what makes a director independent? Scholars, regulators, and investors have grappled with this question for decades. Independence has traditionally been defined by reference to ties. An independent director is a director without personal, business, or financial ties to management. But does this conception of independence serve its intended purpose?

While corporate governance has historically focused on reining in managerial agency costs, identifying managers who help themselves at the expense of their companies as the problem and independent directors as the solution—some of the most scandal-ridden companies have had boards comprised mostly of independent directors with no ties to management.

In a recent article, we address this puzzling tension and argue that independence, defined as lack of personal, business, or financial ties to management, does not sufficiently get at the aims of and obstacles to board monitoring. The problems that independence would seem situated to address go well beyond managerial agency costs, and the solution of independence as a lack of ties to management, while perhaps doing a plausible job with some classic managerial agency costs, has significant shortcomings in dealing with the aggressive ways modern corporations attempt to pursue their goals. Recognizing the mismatch between classical agency concerns and the need for board monitoring for issues other than those relating to managerial agency costs, we offer a novel theoretical and practical reframing of the decades-old discourse around independent directors.

The historical focus on managerial agency costs focuses on mitigating managerial slack or value extraction while overlooking the critical role of directors in curbing overzealous managers. For instance, management might pursue profits without sufficiently considering potential risks in the short and the long term, and the downside for both shareholders and other stakeholders. Acknowledging that directors today are responsible as much or more for preventing managerial overzealousness than for preventing managerial slack has important implications. While managerial agency costs are important, the continuing emphasis on independence as the absence of ties to management unduly detracts from a broader and more holistic view that considers the value of truly independent thought and perspective in the boardroom.

Our paper divides what directors are to be monitoring for into three categories. The first is classic managerial agency costs. The officer is helping herself at the expense of the company and probably doing so consciously. The second category is ‘mixed motives.’ This is a murkier and more capacious category, involving managerial conduct that the managers believe benefits the firm. They also believe it would benefit them, since their compensation, prestige, and professional prospects would presumably reflect the success of their ideas. The third category is the inquiry ‘what might we be missing?’ For instance, GM’s ignition switch issues did not come to the attention of top management or the board in ways that indicated their importance. Why not, and how do we understand what happened? Notwithstanding a culture in which many of the right things were said, a competing culture gave profits and cost-cutting pride of place, and ‘messengers’ were, if not shot, certainly not rewarded.

In each category, why might independent directors fall short? There are several reasons. One is passivity and deference. Even independent directors might be too trusting of management, especially given management’s superior information; or they might simply be passive, not wanting to ‘rock the boat,’ or inclined to accept what they are told at face value. Or they might have a self- serving reason for their deference, hoping to serve on other boards and thinking that deference to management would be a useful reputation to have. They might be concerned that, if they stand up to management, they will lose their board seat. Or directors who are themselves managers of other corporations might value a norm of deference, in hopes that it would somehow carry through to their own board. Relatedly, independent directors might favor high compensation for a CEO to encourage high compensation for CEOs and executives generally, and most notably for themselves as CEOs or other executives at their own companies.

Our reconception starts with an analysis of what, beyond managerial agency costs, might yield managerial decisions that are not good for the company. Lacking problematic ties to management is generally a good starting point, but independent directors also need to be independent-minded, providing a needed critical perspective and check on management’s decisions. When managers are advancing a particular course of action, independent directors should not just consider how a manager might be helping herself at the expense of the company. Rather, the inquiry should be broader: How might the manager’s proposed course of action be harmful to the company? What might the managers be missing in promoting the course of action? The need for independence in  perspective is sometimes discussed in the literature, and in commentary bemoaning ‘rubber stamp’ boards, but the law has not sufficiently kept up, focusing more on expanding the types of ties that compromise independence, while not doing enough to address the perspective issue.

Most important, reconceiving director independence bears on some of the most heated debates in contemporary corporate governance. How and why should boards be diverse? How should stakeholders be accounted for in the corporation’s actions and structure? Should we encourage or limit shareholder activism? Our proposed framework provides initial answers to all these questions, but also opens the door for further exploration, research, and debate. One thing is clear: A single notion of director independence is no longer viable. Our article is an explicit invitation to engage with the vision of what it should mean.

The authors’ paper is available here.

A version of this post was first published on the Columbia Blue Sky Blog, available here.

Claire A. Hill is a Professor and the James L. Krusemark Chair in Law at the University of Minnesota Law School.

Yaron Nili is a Professor of Law and the Smith-Rowe Faculty Fellow in Business Law at the University of Wisconsin-Madison Law School.