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Fortune
Fortune
Nick Rockel

Why director independence matters, and how can boards ensure it

(Credit: Getty Images)

Debra McCormack regularly sits down with corporate directors to help them gauge how independent their board is.

“Boards are often bringing us in to have these facilitated discussions,” says McCormack, global board effectiveness and sustainability lead with Accenture. “It’s because they’re hard. So they say, ‘Debbie, will you come in and help us talk about, do we have the right level of independence, and are we meeting the expectations that are required of us?’”

For McCormack, director independence is critical because it allows board members to take positions that are in opposition to management.

“It’s that healthy board-management tension that needs to be out there, having the robust discussions that they have,” she says. “Independence is important from the advisory and the monitoring function so that [directors] can actually do their oversight and be objective about it. Most importantly, I think board members need to make those decisions that are in the best interests of the shareholders, so it means there’s no conflict of interest.”

Public companies must meet legal requirements for appointing directors who don’t have a material relationship with the business and stay out of its day-to-day operations. However, some experts question how useful the current definition of independence is and argue that board members can easily fall under management’s sway, leaving the organization vulnerable to activist investors.

Meanwhile, long tenures by directors who might be independent in name only are hindering efforts to boost board diversity.

“Public companies have always been well served by independent directors who bring different perspectives, experiences, different industry backgrounds,” says Tierney Remick, vice chair and co-leader of the global board and CEO succession practice at organizational consulting firm Korn Ferry. “When they’re sitting around the table, they’re bringing a perspective that’s both about the company but also what they see in other similar or aligned situations. They’re also, first and foremost, always focused on the stakeholders.”

In the U.S., the federal Sarbanes-Oxley Act of 2002 mandates that boards of public companies have only independent directors on their audit, compensation, and nominating and governance committees, McCormack says. “The exchanges also have adopted their standards for it, and they of course tie out to what the legal mandate is.” There are rules at the state level too.

The New York Stock Exchange and the NASDAQ Stock Exchange both require that the majority of board members of a listed company be independent. The two exchanges also mandate that to qualify as independent, a director of a public company can receive no more than $120,000 in compensation from it during a 12-month period.

However, there are no mandated term limits for directors, which could put their independence at risk. “Board members who may have worked with management over long periods of time can form really great friendships, and it may challenge the independence,” McCormack says. “They become friendly with management versus being truly objective.”

Many European countries have set term limits, McCormack notes. “It actually makes them require refreshment on the board to meet the requirement of having that majority of the board members be independent,” she says. “That’s one area where we see some challenge in the boardroom, because you want those board members to be asking those difficult questions.”

When it comes to director independence, boards have made progress, Remick argues: “Ten, 15 years ago, it was very much a relational connectivity that created the composition of a board,” she says. “Over the last 10 years, and especially the last five years, the highly functional boards are very strategic, very objective in how they go about bringing new board members in. The timing; how it balances with all the other skills on the board; how does it align with the strategic need. So I think there’s been a shift in terms of how boards approach this.”

Korn Ferry has noticed another shift, Remick adds. “We’re actually seeing an increased amount of private boards that don’t, frankly, have the requirement to be as independent, but they are actively seeking multiple independent directors for private boards, including private equity boards, for the same reason,” she says. “They want objective, stakeholder-managed; they can’t be bought off by management for whatever reason. They bring great experiences, great perspectives. They can challenge without being super critical if they’re well trained.”

But according to governance expert Richard Leblanc, the definition of director independence is flawed. “It doesn’t identify preexisting social, political, personal relationships that a director may have who may qualify to be independent but may not have independence of mind inside the boardroom,” says Leblanc, a professor of governance, law, and ethics at York University in Toronto. For example, a director might have attended college with the CEO.

Leblanc, who also flags the absence of mandated term limits, gives a few examples of inducements that management can offer directors. “‘Would you like to go for dinner? Would you like to come to a meeting? Would you like to go to the club? Would you like to go to the resort?’ All of these things are below the radar screen.”

It’s easy to “capture” a board of directors, Leblanc maintains. “You spend 10, 20 grand, and you now own the board,” he says. “Even if you get an independent director on the board, there’s nothing to say that you can’t use management resources to capture that person.”

Activist investors are taking advantage of this situation, Leblanc warns. “When I help activist investors,” he says, “they tell me that every single director is captured. It’s just a matter of finding out the relationship, the interlock.”

If they decide to attack a company, activists hire people to delve into each director’s background and show preexisting ties with management, Leblanc explains. “It might be scholastic, it might be work-related, it might be favors, gratuities, gifts,” he says. “The activists are really stepping into the regulatory breach.”

When McCormack talks to clients, they keep bringing up the length of time that some people serve on a board. In the 2022 U.S. Spencer Stuart Board Index published by the executive search and leadership consulting firm, the average tenure of an independent S&P 500 board member is 7.8 years, she notes.

“Some board members have been on the board for over 20, and some of them…this is their first year,” McCormack says. “But they’re all still evenly considered independent. And some of those, if you think about it, have likely been there longer than the CEO or multiple CEOs.”

That impacts board diversity, McCormack stresses. Last year, 68% of directors on S&P 500 boards were men, according to Spencer Stuart. “Is that where we want to be?”

It looks like many corporate leaders share the same concern. In the recent United Nations Global Compact–Accenture CEO Study, 31% of the roughly 2,600 chief executives surveyed said they want to increase the diversity of their boards, McCormack says. “If we’re not pushing on refreshment, then that’s not going to happen.”

Do the rules around director independence need reform? Yaron Nili, an associate professor of law at the University of Wisconsin–Madison, would like to see some changes. Today, in response to pressure from investors, the vast majority of directors at large-cap U.S. public companies are so-called independents, he relates. “But what does it mean in practice?”

Most of those organizations now also have an independent chair or a lead independent director who is meant to help the board keep management’s power in check. But after examining data from 900 companies for a recent paper, Nili found that many “board gatekeepers” don’t live up to the title. “Even though companies designate those types of roles, they often lack any material powers.”

That shortcoming exposes the trouble with relying on the abstract concept of independence, which can mean different things to different people, Nili says. For him, the answer is better disclosure: “Regulation that makes sure companies provide investors with adequate information so that they can determine for themselves that they view that person, that director, as independent or not.”

Such a move would empower directors, Nili reckons. “Once they allow investors to have more information on how companies designate a director as independent, they can push companies to provide them with more substantive tools,” he says. “With more information that they can utilize in order to provide checks and balances to management, with more powers that are granted them in the corporate documents that allow them to create a board environment that allows independence to actually manifest in practice.”

Although he doesn’t see much appetite in the U.S. for more regulatory reform, Leblanc recommends a similar change. “The definition should be tightened so that you’re actually measuring true independence,” he says.

Leblanc also thinks the Securities and Exchange Commission should compel listed companies to disclose the origination of each proposed board member. “How and why did you choose this director?” he asks. “You should also be compelled to explain your nomination procedure.”

Besides competencies, that explanation should address gender and diversity, Leblanc suggests. “There’s been some movement on diversity, but there still is a considerable latitude that directors and boards have,” he says. “It’s the old adage: It’s who you know. That doesn’t build a good board. A good board is based on what you know, not who you know. Who you know should be disqualifying.”

In the U.K., boards of public companies must undergo regular peer reviews of their independence by third parties. Along the same lines, many U.S. boards now do an evaluation every two or three years, observes Remick, who calls it a “board effectiveness health check.” This process aims to ensure that all directors are contributing as anticipated and that the boardroom culture is conducive to supporting management, she says. “The chair leads that effort, but you usually have a third party who helps activate around it.”

McCormack favors such assessments: “Our clients find that the board evaluations are critical to enhance their overall performance and effectiveness, and independence is part of that, especially when a third party would come in.”

She also recommends having an annual discussion about board members’ independence. “Is there someone who’s been providing services to the board?” McCormack asks by way of example. “Does it hit the $120,000 threshold?”

For McCormack, it comes back to board refreshment too. “Boards should look at their skills matrix each year and determine if they have the right directors to support the company’s strategy,” she says. “That is something that will help them look at their independence and help them look at knowing if they have the right skills, versus do they have to go find those skills.”

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