Majority of Independent Directors

Discussion

For years institutional shareholders have promoted board independence as a hallmark of good governance. Independent outside directors can bring objectivity and a fresh perspective to the issues facing the company. They also bring new contacts and skills to their boards. Moreover, the conflict of interest problem boards face in designing executive compensation policies and responding to takeover offers is much less severe for outsiders than it is for executive officers. Perhaps the most important role of outside directors is to objectively evaluate the performance of top management. That same objectivity cannot be exercised by directors inside the company because they may be too close to the problem to see it clearly, they may be part of the problem, or they may see it but be reluctant to "blow the whistle" for fear of losing their directorship or their job.

Developments at several major companies have demonstrated that many boards owing an allegiance to the company or its CEO (who may have hand-picked many of directors) have been complacent in the face of poor performance. An independent board is one way to assure that shareholders' interests will be adequately represented by a board that is independent of management and that does not have an interest in the company different from the interests of other shareholders.

While empirical evidence has not found a direct link between board composition and financial performance or shareholder value, studies have shown that the advantages of an active, outside board are most evident in specific circumstances. For example, an outside-dominated board is more likely to replace a poorly performing CEO, make better acquisition offers, and bargain more intensively when facing takeover bids. [1]

For a more complete discussion of the importance of director independence and ISS's definition of director independence, please refer to the discussion in the section, "Voting on Director Nominees in Uncontested Elections."

New Listing Rules

Following a spate of corporate scandals in 2002, the New York Stock Exchange (NYSE) and NASDAQ amended their listing rules toughening board independence requirements as a way of improving board oversight. Both of the self-regulatory organizations (SROs) mandate that boards of most listed companies be majority independent by their 2004 annual meeting and that the three key board committees (audit, compensation, and nominating) consist solely of independent outside directors. (NASDAQ does not require separate compensation and nominating committees, but only that a majority of independent directors oversee these functions.)

For some companies, compliance with the SRO proposals will involve extensive board and committee makeovers. Many issuers, however, reconfigured their boards and committees in anticipation of the rule changes. According to 2003 ISS data, out of 5,500 companies, 77 percent had boards that were at least majority independent; at 57 percent of the companies, the independence was two-thirds or more. Of this same universe of companies, 75 percent had independent audit committees, 68 percent had independent compensation committees, and 58 percent had independent nominating committees.

In the post-Enron environment, finding qualified director candidates willing to serve on boards, and on audit committees in particular, will become harder. According to executive recruiter Christian & Timbers, there could be as much as 50-percent turnover in boardrooms of Fortune 1000 companies, especially among chief executives sitting on multiple boards. [2] Apart from the increased workload, potential board candidates are shying away from the heightened liability in light of corporate reforms.

Shareholder initiatives

Over the years, shareholders have submitted proposals requesting that the board adopt a policy or even a bylaw amendment to require a majority of independent directors on the board. While most of these proposals were filed at companies that did not have a majority of independent directors, some of these companies' boards already met the proposals' standards. In the latter instances, the proponent sought to have the company formalize this standard of independence, arguing that objective decision-making would be in the best interests of shareholders in the long term.

With the new independence requirements of the SROs, institutional investors are raising the bar on independence to higher levels. Many investors, as well as corporate groups such as the Business Roundtable, National Association of Corporate Directors, and a blue ribbon panel of the Conference Board, advocate that a substantial majority of board members be independent. By 2002, over half of the shareholder resolutions bolstered the threshold to a two-thirds independent board, one of which (Simon Property Group, Inc.) received majority support. Majority votes have also been won on independence proposals at EMC Corp.; St. Jude Medical, Inc. (adopted the proposal); and ICN Pharmaceuticals, Inc. (reconstituted the board but faced year-on-year proxy fights).

While some investors go so far as to advocate only a single insider on the board (the CEO), studies have not found that percentages of independence greater than 50 percent add incremental value. This is because most board decisions are determined by majority rule. In fact, non-independent directors can actually be beneficial to a board in certain circumstances. For example, insiders can provide a more comprehensive view of the company and managerial succession. Outside directors connected to a firm's investment or commercial bank may lend financial expertise that is not available in house. [3]

Voting on independence proposals

Even though board independence is a cornerstone of effective governance and accountability, shareholders should not automatically endorse board independence proposals. These proposals require a case-by-case determination. In particular, some proposals may advocate a different definition of independence than ISS's or one that is not easily verifiable through company disclosures. If the company already meets the independence threshold being sought (per ISS's definition), a formal policy or bylaw amendment mandating this structure may not be necessary. On the other hand, board compensation, audit, and nominating committees should be restricted to independent, outside directors. The committees exist because allowing officers to set their own pay, evaluate their own performance, and recruit the directors who are supposed to oversee them is fraught with obvious conflicts of interest.

In summary, in evaluating proposals requiring that a majority or substantial majority of the board be composed of independent directors, shareholders should closely examine the current composition of the board, the proponent's definition of independence, the board's responsiveness to shareholder concerns, and the board's oversight role regarding executive and company performance. If the board composition is poor or the board has not fulfilled its fiduciary duties, then shareholders should vote in favor of a proposal which would require a greater number of outsiders on the board. However, if the board is already sufficiently independent and is fulfilling its fiduciary duty, support of such a proposal is unnecessary.

Shareholders should support proposals that require that the board's committees responsible for reviewing executive pay, qualifications of director nominees, and the company's financial statements be restricted to independent outsiders only, unless those committees are already fully independent.