Financial Reform and Preempting the Rules of the NYSE: Transferring the Regulation of Independent Directors to the Commission

The concept of independent director has become the lynch pin of most corporate governance systems.  Independent directors are expected to protect the interests of shareholders (minority shareholders in most other countries) by approaching matters in a neutral manner, unaffected by managerial influence.  In fact, as we have noted often on this Blog, the definition of independence used by the exchanges does no such thing. 

Among other things, the definition does not adequately screen for personal relationships, a difficult issue that other countries address by excluding from the category directors with extensive tenure on the board.  The language on its face applies to relationships between directors and the company, not relationships between the director and executive officers.  The definition does not take into account the fees paid to directors, irrespective of the sometime extraordinary amounts.

Given these weaknesses, it is perhaps no great surprise that at least partial responsibility for the definition will be transferred to the Commission if the Senate version of the legislation passes.  Specifically, Section 952 seeks to regulate compensation committees.  If adopted, listed companies will have to have a compensation committee that resembles the audit committee, with directors having the authority to hire their own consultants and the exclusive power to hire and fire compensation consultants.

For our purposes, however, the most interesting element concerns the treatment of independent director.  The provison provides that each member of the committee must be independent.  This is no big deal since the exchanges already require this. 

As with the "super independence" requirements in SOX for the audit committee, however, the provision tightens the definition.  Rather than defining the term in the statute or leaving it to the stock exchange, the legislation essentially transfers the authority to the SEC.  The Commission will receive the authority to define the "relevant factors" that must be considered in defining independent.  These factors include "the source of compensation of a member of the board of directors of an issuer, including any consulting, advisory, or other compensatory fee paid by the issuer to such member of the board of directors" and "whether a member of the board of directors of an issuer is affiliated with the issuer, a subsidiary of the issuer, or an affiliate of a subsidiary of the issuer."

The Senate Report doesn't add much to the language of the statute.

• In determining whether a director is independent, the national securities exchanges should consider the source of compensation of a member of the board of directors of an issuer, including any consulting, advisory, or other compensatory fee paid by the issuer to such member of the board of directors; and whether a member of the board of directors of an issuer is affiliated with the issuer, a subsidiary of the issuer, or an affiliate of a subsidiary of the issuer. Any compensation counsel or adviser shall be independent.

Nonetheless, the plain language would seem to cover fees paid to directors for their service on the board.  In short, the Commission will have the authority to require the exchanges to consider the impact of directors fees. 

The short term result will be three different definitions of independent director.  There will be one for the compensation committee, one for the audit committee directors, and one used by the exchanges for all other directors.  When the SOX definition was adopted, the exchanges studiously avoided applying the definition to other independent directors.  This will need to change.  The exchanges will need to proactively adopt a common standard based upon the SEC's definition.  If they don't, the Commission may be in a position to use its new found authority to impose one.