by Michael W. Peregrine, McDermott Will & Emery
This is the third in a series of articles discussing the long term governance implications of the Sarbanes Oxley movement.
The value placed on the independent director is an important governance legacy of the Sarbanes-Oxley Act, which “celebrates” the tenth anniversary of its enactment this coming July. Whether by statute or “best practice,” board and key committee control in independent directors is now a boardroom staple. This is the case in both the for profit and nonprofit sectors. It is thus a worthy board education exercise to revisit both the public policy rationale for the independence emphasis, and its various practical applications.
The basic principle is that a substantial number of board seats should be filled by directors who are independent of management in both fact and appearance. Effective corporate governance is perceived as a byproduct of attentive, independent board members focused on the best interests of the organization they serve, and its underlying business mission. Active oversight and prudent judgment may suffer when large numbers of directors are beholden to, or closely associated with, executive leadership.
Of course, the independent director was not a Sarbanes-specific creation. It has long been part of the corporate governance lexicon, albeit with periodically evolving interpretations and applications. Indeed, initial independence concepts centered on related party transactions. But it was the Sarbanes law, and the corporate responsibility environment the law created, that significantly expanded its boardroom importance to a matter of “separation of powers.”
And the reasons remain important, 10 years later—especially for those who weren’t in active board service “back then.” The emphasis on independence arose from a variety of concerns central to the foundational corporate scandals: ineffective and biased board oversight of the independent audit process; excessive deference by board members to senior management, to preserve individual business relationships with the company; other financial, familial or professional relationships with the company potentially compromising director vigilance; interlocking directorships, etc. The solution was to augment the independence of non-management directors and by that to foster a boardroom culture of active oversight and constructive skepticism.
These Sarbanes-era concerns remain valid today, and have been expanded by related issues such as the need for independence from excessively powerful board chairs; preserving independent reporting relationships of key compliance and legal officers, and preserving the independence of committees with oversight of sensitive topics such as compliance, executive compensation and governance. A particular challenge is the adoption of an effective, reasonable definition of independence when the company is not legally bound to a particular standard. In this case, the definition should accurately capture the scope of the company’s business and encompass the broadest reasonable types of relationships that could compromise effective oversight. The board should also assure an effective disclosure process that incentivizes disclosure and facilitates independence determinations; incorporates an awareness of independence-related factors that may not be subject to disclosure; and promotes a boardroom appreciation of the differences between independence and conflicts of interest. The former being a matter of a director’s positional relationship to management and the company, and the latter being an episodic matter involving arrangements that appear to or actually create bias in the director’s decision making. Indeed, there is no “one size fits all” definition, and the involved board will periodically revisit the effectiveness of its own independence definition and related policies.
The tenth anniversary of the seminal Sarbanes Oxley Act provides an excellent opportunity to revisit the critical governance importance that continues to be attributed to preserving board and key committee control in a substantial majority of independent directors. There is no greater mechanism available to help preserve the necessary checks and balances between the board and executive management.
Topic tags: board of directors, corporate governance, independent director, Sarbanes-Oxley Act