Monday, April 30, 2012

Taking Board Independence Seriously

What does an "independent" board look like? Who is an "independent" director?

Board independence is defined in such a way that boards need not be very independent at all, especially from the senior executives they supposedly supervise.

For example, under the Sarbanes-Oxley Act of 2002, every public firm must have an independent audit committee. However, independence only means that the director does not receive any compensation from the firm other than directors fees.

Similarly, the NYSE requires that all listed companies have a majority of independent directors. Independence here means that the director "has no material relationship with the listed company." The exchange rules then prohibit many specific relationships with the company, such as: the director cannot be an employee of the company (over the past three years); cannot be an immediate family member of an executive officer (over the past three years); has not received $120,000 per annum (over the past three years) from the company; cannot have an immediate family member who received $120,000 per annum from the company (over the past three years); cannot be a current partner or employee of a firm that is the listed company's internal or external auditor (nor have an immediate family member who is a current partner of such a firm), and so on. (For more details see NYSE Listing Standard 303A.02 Independence Tests).

The NASDAQ defines independence to mean: "a person other than an Executive Officer or employee of the Company or any other individual having a relationship which, in the opinion of the Company's board of directors, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director." The NASDAQ rules then list numerous relationships that are deemed not to suffice for independence.

There are also enhanced standards for the audit committee.

Very complicated, and unnecessarily so.

The penalties for non-compliance fall upon the company (if any), not the board or the senior executives.

So, for example, the following can be independent directors under all of these rules: the CEO's best friend, the CEO's college roommate or fraternity brother, the CEO's cousin or nephew, the CEO's personal attorney, the CEO's pastor or rabbi, and, of course, other CEOs from firms in the same industry. Indeed, CEOs may serve on each others' boards and still be deemed independent (unless one serves on the compensation committee).

If the law were serious about independence it would simply prohibit the board from nominating anyone with a substantial personal, financial, social or familial relationship with any senior executive officer from serving on the board. Any fees paid to a director appointed in violation of this standard would be trebled (tripled) and recoverable (along with attorney's fees and costs) in a private action jury trial against the board of directors and the senior manager jointly and severally. Violators would then be barred from serving as a director or officer of a public firm. This is similar to penalties applicable to short swing profits by insiders under section 16 of the Securities Exchange Act of 1934, albeit with more teeth.

Crony capitalism would no longer be an option and would quickly vanish. Of course, such a regime with such serious penalties would require governing elites who were serious about ending crony capitalism.

Is it really too much to ask for corporate America to ween itself off CEO cronies for the board of directors that supervises the CEO?