BROOKLYN: 10 May 2013 - At common law, an interested director was barred from participating in corporate decisions in which he had an interest and therefore “disinterested” directors became desirable. This concept of the disinterested director developed into the model of an independent director and was advocated by the Securities and Exchange Commission (SEC) as a general ideal and by court decisions in a variety of situations.

The SEC has generally succeeded in imposing its corporate governance views in the wake of scandals. Following the sensitive payments enforcement program of the 1970s, the SEC embarked on an activist corporate governance reform program. During the merger and acquisition frenzy of the 1980s, the SEC used the Williams Act to foster the view that the market for corporate control constrained incompetent managers. After the bursting of the technology bubble in 2000, and the financial reporting scandals that ensued, the SEC was able to incorporate its views on independent directors into the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley). Following the financial crisis of 2008, the SEC further enforced its views on the requirements for independent directors in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank).

The composition and behavior of securities markets and investors has changed drastically since the SEC was established in 1934. Yet the SEC has persisted in its path dependent view that independent directors, ever more stringently defined, should dominate the boards of public companies. What is the function and rationale for such directors? If it is to assure that corporations comply with laws and regulations imposed on public corporations, they become just another (probably ineffectual) gatekeeper. If it is to weaken the power of the CEO, there is some doubt independent directors can or should do so.  If it is to be responsive to the needs and views of shareholders, which shareholders of an increasingly diverse body should be served? In recent years, and particularly in the aftermath of the 2008 financial crisis, academics and others have been questioning both the shareholder primacy model of the firm and the independent director model of board governance.

The independent director ideal has not been embraced all over the world.  Neither has shareholder primacy.  In particular, in some countries the controlling shareholder is considered to be not independent because one of the goals of corporate governance is the protection of minority shareholders. Also, where the government is a major shareholder, the independent director model is problematic.

This Article will outline the evolution of the independent director model as championed by the SEC, and discuss criticisms of the independent director model. The Article will also set forth alternatives to the shareholder primacy theory of the firm because shareholder primacy is related to the independent director model. Corporate governance models outside the United States will be referenced.

The independent director model has been accepted in many jurisdictions, either as a mandatory requirement for public companies or a recommended structure. Yet, boards of independent directors did not prevent the scandals of Enron, WorldCom and other companies in the United States and in Europe after the bursting of the technology bubble of the 1990s. Neither did such boards prevent the financial institution meltdowns of 2008. A rethinking of this model is therefore in order.

Although inside or executive directors may have conflicts of interest, they are more knowledgeable than outsiders and more involved in making business decisions for the corporation, both short-term and long-term. Their most serious conflict of interest decisions relate to compensation, but where directors and officers are both compensated, in whole or in part, on the basis of contingent stock awards, insiders and outsiders have similar conflicts. Further, such compensation has resulted in shareholder primacy run amuck. It also encouraged the risk taking that resulted in the 2008 financial crisis.  Accordingly, shareholder primacy also needs to be re-examined.

Since 2008, director diligence and expertise have been focused upon. But a board of independent directors remains dependent on a corporation’s management for information. Regulation cannot compel those personal qualities that make a director excellent—intelligence, integrity, experience, competence and a willingness to question herd decision-making. Further, a public corporation should not be some battle ground where executives, directors and shareholders are adversaries.

In my opinion, public corporations should have a mix of independent and non-independent directors, and directors should be held to a duty to the corporation as a whole. The interests of employees, customers and creditors should be balanced against a duty to shareholders, especially when those shareholder interests are short-term. Although such complicated duties may prove more difficult to enforce, shareholder primacy has brought business to a sorry pass, especially in the United States, where our industrial base had been seriously impaired and speculation in the financial markets has wrecked havoc on the real economy. Only a fully informed board can possibly help to steer a forward course for public corporations in our global, complex world. The board needs to be informed by experienced and responsible insiders with a stake in the future of the corporation as well as independent outsiders who have the expertise and ability to both question and advise management.