Stock Exchanges and Director Independence

We have noted problems associated with enforcement of listing standards.  The issue comes up most clearly in the context of director independence.  The NYSE provides that directors will not be independent if they have a "material relationship with the listed company (either directly or as a partner, shareholder or officer of an organization that has a relationship with the company)."  NYSE Guide 303A.02.  According to the attached comment,

• it is best that boards making "independence" determinations broadly consider all relevant facts and circumstances. In particular, when assessing the materiality of a director's relationship with the listed company, the board should consider the issue not merely from the standpoint of the director, but also from that of persons or organizations with which the director has an affiliation. Material relationships can include commercial, industrial, banking, consulting, legal, accounting, charitable and familial relationships, among others. However, as the concern is independence from management, the Exchange does not view ownership of even a significant amount of stock, by itself, as a bar to an independence finding.

In other words, its up to the board but the board should take into account all relevant facts and circumstances.  In addition to "material relationships," the NYSE includes a number of categorical rules that result in the payment of more than $100,000 in direct compensation from the listed company.  The $100,000 is calculated without considering "director and committee fees."   As the rule notes, this test is "in addition" to the material relationship test. 

So, under the rules, the board must first screen for material relationships, taking into account all relevant facts and circumstances.  Even where the board concludes that there is no material relationship, payments in excess of $100,000 render a director not independent.  While fees are specifically excluded from the $100,000 test, they are not specifically excluded from the material relationship portion of the definition. 

Proxy statements are full of representations that they have complied with the rules and made the requisite determinations.  See International Games 2008 Proxy Statement ("Our board of directors has made an affirmative determination that the following members of the board, constituting a majority of our directors, meet the standards for “independence” set forth in our Corporate Governance Guidelines and applicable NYSE rules.").  In making that determination, however, it is quite clear that boards do not typically consider fees when determining independence, including application of the material relationship portion. 

Some even admit it.  See Merrill Lynch2007 proxy statement (noting that compensation "for service as a Director is not considered in making independence determinations.").   And, where there is any doubt, there's always a pass from the stock exchange.  See Owens Corning Oct. 2007 Proxy Statement  ("The New York Stock Exchange has confirmed to us that receipt of such fees should not be considered in evaluating Mr. McMonagle's independence as a director of the Company.").   

There is little question that fees can result in a material relationship, whether objectively or subjectively.  Not always of course.  But it seems clear that with respect to fees, the stock exchanges simply do not enforce the "material relationship" test.  The failure to consider fees makes the concept of independence a charade.  Moreover, it also makes a mockery of the requirement in the listing standards that independence is lost through the existence of a "material relationship with the listed company."

We understand the motivation by the NYSE for not giving sufficient content to the "material relationship" requirement.  It is, after all, a for profit company.  But what about the Commission?  The Agency has increasingly relied on independent directors to ensure the integrity of the financial disclosure process.  Why isn't the Commission making sure that directors calling themselves "independent" in fact have no material relationship with the company, including through the payment of fees?