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Monday
Dec172012

Director Independence, the Stock Exchanges, and the Role of the SEC (Part 1) 

The holy grail of corporate governance for the last several decades has been independent directors.  Improvements in the governance area have focused on the increased need for, and role of, independent directors on the board.  Under Delaware law, independent directors are not required but are encouraged.  They provide additional protections from derivative suits (in general demand is not excused if a majority of the directors are independent).  For public companies, the stock exchanges require a majority of independent directors. 

Independent directors are intended to be independent of the company and, presumably the CEO.  In theory they are in a better position to protect the interests of shareholders.  But this in turn depends upon the definition of independence.  To the extent the definition is too porous, as some have suggested, see Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty, directors will not be in a position to presumptively act in the interests of shareholders. 

Nonetheless, the definitions have been left to the Delaware courts and the stock exchanges.  Perhaps dissatisfied with these definitions, Congress has increasingly stepped into the fray.   In SOX, Congress provided that independent directors had to meet certain additional requirements in order to serve on the audit committee.  These were implemented in Rule 10A-3, 17 CFR 240.10a-3

Congress, however, went even further in Dodd Frank with respect to the concept of director independence, at least for those serving on the compensation committee.  Congress added Section 10C to the Exchange Act.  The provision requires that director independence be determined after consideration of "relevant factors."  The Section specified two of them:  the director's "source of compensation" and whether the director "is affiliated" with the company.  Congress, however, left open that there would be other factors that had to be considered and left to the SEC to resolve the matter. 

The Commission implemented these requirements in Rule 10C-1.  17 CFR 240.10C-1.  The rule commanded the exchanges to set out the "relevant factors" necessary for determining director independence.  Moreover, the adopting release more or less instructed the exchanges to include as a factor the consideration of business and personal relationships between directors and management.  As the release stated:

in response to concerns noted by some commentators that significant shareholders may have other relationships with listed companies that would result in such shareholders’ interests not being aligned with those of other shareholders, we emphasize that it is important for exchanges to consider other ties between a listed issuer and a director, in addition to share ownership, that might impair the director’s judgment as a member of the compensation committee. For example, the exchanges might conclude that personal or business relationships between members of the compensation committee and the listed issuer’s executive officers should be addressed in the definition of independence.

The exchanges dutifully proposed a new listing standard.  The NYSE proposal is here; the Nasdaq proposal is here.  We will discuss the proposals in the next post.  Some of these issues are discussed in  detail in Comment Letters: The Definition of Independent Directors Under the Listing Rules of the Stock Exchanges.

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