Director Independence and Friendship: The Evidence

Corporate governance places heavy reliance on the use of "independent" directors to protect the interests of shareholders.  The stock exchanges require that listed companies have a majority of independent directors.  Delaware, in turn, provides legal benefits to boards with a majority of independent directors, either by facilitating the dismissal of derivative suits or by allowing conflict of interest transactions to be reviewed under the duty of care.  

Yet as we have noted often, neither the exchanges nor the Delaware courts adequately ensure that directors characterized as independent are in fact independent.  The definitions do not, for example, take into account the fees paid to directors, even when they exceed extraordinary amounts (say $700,000).  They also don't take into account friendship.  The exchanges ignore the issue and the Delaware courts have developed a defintion that makes it all but impossible to disqualify directors from being treated as independent because of their friendship with officers serving on the board, particularly the CEO. 

In other words, a board treated as independent can be loaded with persons having a financial incentive to act in the best interest of management or can be loaded with friends of managment who have the same incentive. The directors are called independent but in practice are not.  This is discussed in greater detail in Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty. 

This is widely understood but lacking in empirical evidence.  Evidence, however, may have surfaced.  James D. Westphal and Melissa E. Graebner have written a paper, A Matter of Appearances: How Corporate Leaders Manage the Impressions of Financial Analysts about the Conduct of Their Boards, that was recently discussed in the Economist.  The piece looked at management's efforts to fool analysts by making superficial changes in corporate governance.  They would add additional "independent" directors to the board in an effort to create the appearance of greater board oversight

• The authors found that chief executives commonly respond to negative appraisals from Wall Street by managing appearances, rather than making changes that actually improve corporate governance: boards are made more formally independent, but without actually increasing their ability to control management. This is typically done by hiring directors who, although they may have no business ties to the company, are socially close to its top brass. According to James Westphal, one of the study’s co-authors, some 45% of the members of nominating committees on the boards of large American firms have “friendship” ties to the boss—though this varies widely from company to company.

So there are the statistics.  45% of directors on nominating committees have "friendship" ties.  In other words, they meet the definition of independent but in fact have a pre-existing relationship with the CEO. The relationships in some instances, presumably, impair the ability of the directors to act in the best interests of shareholders.

One suspects that if anything the percentage is low.  Presumably there were other directors who had friendship ties that could not be objectively ascertained.  Moreover, one likewise suspects that a similar study done on the compensation committee would generate similar results.

Independent directors are not necessarily independent.  Yet shareholders and investors are led to believe that they are.  It would be better not even to use the term.  Moreover, with "friends" on the nominating committee, there is likely a bias towards nominees who favor management rather than shareholders.  The only way to gain true independence on the board is to facilitate the election of directors who are nominated by shareholders, not the board.  In short, shareholders need changes that lower the cost of nominating and electing directors.  In short, they need access and the SEC should act on the rule proposal that would grant shareholders such authority.