Independent directors

Corporate governance codes, guidelines and rules generally assert that a significant proportion (and in some cases, all) of the directors of a company should be “independent directors”.  But what exactly does it mean to be an “independent director”?

The Institute of Directors in New Zealand provides a principles-based definition:

“Independent director means independent of management and free from any business or other relationship or circumstance that could materially interfere with the exercise of a director’s objective and independent judgement.” (The Four Pillars of Governance Best Practice, Institute of Directors in New Zealand, 2014).

And some authorities provide specific rules or examples as to what would mitigate against a person being considered to be “independent”, such as being (or recently having been, or being an associated person of) an executive, auditor, professional advisor, major stakeholder, or of long tenure as a director of that company.

However, there is no separate category of “independent director” defined in the New Zealand companies legislation:  Every director of a company is required by law to act in the company’s best interests (section 131, Companies Act 1993).  [Note: There are some technical exceptions to this, such as the provision that enables a subsidiary company director to act in the holding company’s best interests in some circumstances.]  Further, it is generally recognised that, from time to time, any director might have conflicts of interest that need to be managed.

So why the distinction?

If all directors are required to act independently of ulterior influences, this begs the question of what is the purpose of this apparently artificial distinction between “independent” and “non-independent” directors?

Here are two possible reasons:

  • To keep everyone honest:  There might be a view that “non-independent” directors are more likely to have latent conflicts of interest, and that they cannot be trusted to act entirely in the company’s best interests, either deliberately or unconsciously, and that the “independent” directors therefore are required to push back and ensure that the board as a whole meets its legal obligations.  This seems to imply that, in the absence of a rule requiring “independent directors”, boards would fail to adequately manage conflicts of interest.
  • To enhance diversity:  There might be a view that people who meet the definition of an “independent” director would be likely to bring to the board more diversity — skills, experience and ways of thinking — than “non-independent” directors, and thus improved company performance.  This seems to imply that, in the absence of a rule requiring “independent directors”, boards would fail to achieve an optimally diverse composition.

Neither of these reasons is particularly complimentary about unbridled board behaviour, but the accepted wisdom seems to be that having at least some (if not a majority, or all) demonstrably “independent” directors on the board is an incontrovertible element of good governance.

In the United Kingdom, the emphasis on “independent” directors can be traced to the 1992 Cadbury Report, and it is a central element in the Financial Reporting Council’s UK Corporate Governance Code, assigning specific roles to “independent” directors.  Similarly in the G20/OECD Principles of Corporate Governance, which summarises good corporate governance practice across jurisdictions.

Why let the evidence get in the way of a good story?

One difficulty with the rationale for “independent” directors outlined above is that the empirical evidence is ambivalent on the relation between board independence and firm performance.  For example, see Bhagat, Sanjai and Black, Bernard S., The Non-Correlation Between Board Independence and Long-Term Firm Performance (Journal of Corporation Law, Vol. 27, pp. 231-273, 2002) and Gay, Sebastien and Denning, Chris, Corporate Governance Principal-Agent Problem: The Equity Cost of Independent Directors (2014).

Recent research by Professor Alex Frino, sponsored by the Australian Institute of Company Directors (AICD), “The relationship between board independence and stock price performance” (October 2016), examines the adjusted average stock market returns on the largest 200 stocks listed on the Australian Stock Exchange (ASX) from 2004 to 2012 for portfolios formed on the proportion of independent board members.  Their results indicate a “sweet spot” in which firms with boards comprising between 30% and 60% independent directors achieved higher stock price returns than firms with either fewer, or more, directors.

frino2016

Explanations for this apparent limit on the benefits of “independent” directors could be that an over-emphasis on board independence results in:

  • an aloofness from the company’s business that compromises strategy-setting;
  • information asymmetry between board and management that compromises effective monitoring;
  • blunted incentives from a lack of rewards to “independent” directors related to firm performance; and
  • appointment of individuals who have no particular value to add, other than that they “tick the box” of being “independent”.

What are the policy implications?

The main policy implication is that a singular focus on “independent” directors in company regulation would be misguided.  Other factors are at least as relevant, including skills, experience, and knowledge of the business, along with the manageability of any potential conflicts of interest.

A more specific public policy implication arises in respect of appointments to the boards of state-owned enterprises (SOEs) and other Crown-owned companies.  These appointments would all invariably be regarded as “independent”.  Could this be a contributing factor to the patchy performance, through to abject failure, that we see in that sector?

[Updated October 2016]