Both the NYSE and Nasdaq require the boards of listed companies to have a majority of independent directors and audit committees that are composed solely of independent board members.
But there is an argument about what makes a board member independent. Technically, independence means that the director has no “material relationship” to the business that could present a conflict of interest in performing their duty to represent all stakeholders. Those relationships include being an employee of the company or a partner of the company (distributor, supplier, etc.).
Leo Strine, Jr., the former chief justice of the Delaware Supreme Court, says that the question of independence and the equally important question of effectiveness are deeper than often recognized, especially when independent directors have no prior connection as a stockholder to a company before they serve. Relevant issues include which other boards they serve on and where they lack relevant industry expertise.
“CEO pay was way, way lower when boards didn't have as many independent directors,” Strine says. “And the board itself is expensive for companies. The median director pay was over $200,000 the last time I looked and I'm sure is well in excess of that now.
“Given that many independent directors serve on more than one board and director pay has increased so much, the reality is that many of them do care about staying on boards and being acceptable to institutional investors and proxy advisory firms and other independent directors.”
In a 2020 letter to Berkshire Hathaway stockholders, chairman and CEO Warren Buffett said that high rates of compensation can discourage independent directors from being a challenging voice in the boardroom.
“Is it any wonder that a non-wealthy director (“NWD”) now hopes — or even yearns — to be asked to join a second board, thereby vaulting into the $500,000-600,000 class?
“To achieve this goal, the NWD will need help. The CEO of a company searching for board members will almost certainly check with the NWD's current CEO as to whether the NWD is a ‘good' director. ‘Good,' of course, is a code word. If the NWD has seriously challenged his/her present CEO's compensation or acquisition dreams, his or her candidacy will silently die.
“When seeking directors, CEOs don't look for pit bulls. It's the cocker spaniel that gets taken home.”
Similarly, Lucian Bebchuk, the James Barr Ames Professor of Law, Economics and Finance and director of the program on corporate governance at Harvard Law School, says that directors nominated by institutional investors may bow to the goals of those shareholders.
“In companies with a controlling shareholder, our corporate law system places excessive reliance on the mechanism of nominally independent directors,” Bebchuk says. “It is important to recognize that effective oversight requires alternative or supplemental mechanisms.”
In order to distance a director from relying on management or institutional investors to get or keep a seat on the boards, Bebchuk proposes “enhanced independence.”
“In our academic work, we put forward enhanced independence — making the appointment of some directors depend not solely on the controlling shareholder but also on the support of a majority of the public investors — as a mechanism that could produce directors with improved incentives for carrying out their oversight role,” Bebchuk says.
Buffett also suggests that directors should invest their own money into the company they serve — in addition to the shares that are granted as their compensation package. Having that kind of “skin in the game” would classify a director as an insider but would also create the motivation to make the company successful in the long term.
Strine says he's “dubious” that giving an independent director stock as part of their board pay “makes them think like a real long-term stockholder.” He believes a director should be a serious investor in the company personally.
Ed Garden, chief investment officer and a founding partner at Trian Fund Management, L.P., believes all directors should have an “ownership mentality.”
“If you're an owner of a company and you have a lot of skin in the game, then satisfied customers, employees, suppliers, communities are just table stakes,” Garden said at a Directors & Boards forum in 2020. “If you're truly an owner of the company, you want to be best-in-class from an environmental or diversity and inclusion standpoint because it's good for the business.”
Steve Odland, lead independent director for General Mills and president and CEO of The Conference Board, sees the logic in directors owning stock.
“If directors own shares, however attained, they begin thinking more like shareholders,” he says. “However, requiring shares to be purchased by directors may discriminate against those people not wealthy enough to afford the shares and therefore skew the type of director on a board.”
But overall, independent directors like Paul Williams, who serves on boards including Compass Minerals International, Inc. and Romeo Power, say they have faith in the system and that a majority of independent directors provides impartial governance and the checks and balances needed in corporate America.
“I look at it differently,” Williams says. “There is greater risk of short-term thinking if only insiders are laser-focused on whether or not they keep their jobs or their economic fortunes are tied inextricably to that company.”
Through independence, directors can consider all stakeholders, as is their mandate.
“I'm not saying the system can't be tweaked,” Williams says. “For instance, you need to make sure the skillsets of independent directors are aligned with where the company needs to go.
“But the advantages of an independent board ultimately outweigh any disadvantages.”