The Paradox of Independence

‘Independence’ is a central concept in debates over corporate governance, but remains relatively unexamined. Given the potential problems of professional managers running the firm unchecked, most reports or codes of corporate governance recommend oversight by ‘independent’ board members that are capable of effective engaging with and (when needed) exercising power over managers. But if directors are accountable to independent directors, to whom are independent directors accountable?

What do we mean by independence?

1. Independence from managers. Independent directors should not be chosen by or beholden to the managers they are supposed to monitor. Independence implies that these persons are not company insiders, but have autonomy from the firm and existing managers. Their 'outsider' position does, however, raise issues about their competence in understanding the complex operations and business environment of the firm. (As their independence from managers grows, their dependence on those managers may increase for information about the firm!)

2. Independence from shareholders. Independent directors are often seen as representing the interests of shareholders. However, they are not the shareholders themselves. And most often, they are not directly chosen by the shareholders, although their appointment may be approved by shareholder vote. To the extent that directors directly represent particular shareholders, they are often seen as lacking independence and being a vehicle of special interests. Conversely, if shareholders put their people on the board, this compromises the liquidity of their ownership stakes and puts them at risk of insider trading. Put another way, the discourse of ‘independent directors’ reflects a situation of dispersed share ownership where shareholders themselves are unable or unwilling to monitor managers themselves.

A Paradox results in that independence from managers is unlikely to be achieved at the same time as independence from shareholders. If independent directors do not represent anyone outside the management and are not held accountable to them, it is very unlikely that independent directors will remain independent from managers. There is probably trade-off between these two aspects, whereby one aspects of independence increases inversely to the other.

In the UK, independence is conventionally dealt with through the Nomination Committee. Here, the independent directors are nominated by other independent directors. This structure raises a number of important questions. One issue is the first mover. Who nominates the first independent nominating committee? Usually, it is done by company insiders, chosen from friends or friends-of-friends, old boys, members of the same golf clubs and so on. These people may be full of valuable, and non-redundant advice and expertise, but they are unlikely to rock the boat, unless it means saving their own skin. Most often these persons are similarly managers of firms with independent directors, who themselves don’t wish to be confronted with tough independent scrutiny. At worse, they may share similar ‘class interests’ such as rising managerial salaries. Of course, the selection of independent directors is increasingly ‘professionalized’ by outside advisors, head hunters and consultants who legitimate these choices and ostensibly serve as a source of professional norms. But the basic question of who chooses is a fundamental one.

A second and perhaps more important issue relates to whom these independent persons are accountable. Here a common answer is to offer stock options and other performance-based pay incentives to independent directors, which are the same incentive given to the directors’ they monitor. So ‘the market’ is left to monitor both groups. This system is quite different from, say, checks and balances that operate on opposing organizing principles such as in the political system, where the legislature represents the majority of polity and judiciary represents the legal or constitutional protections against the tyranny of that very same majority.

Given these two problems, it seems doubtful whether the Nomination Committee, as a structural feature of boards, is sufficient to guard against the ‘capture’ of independent board members or to ensure vigilant processes of engagement by the board. So despite the popularity of independence and high compliance with the provisions of the Combined Code among large UK firms, the social science evidence has failed to show a clear link between independence in terms of the formal structure of boards and good performance outcomes. As Terry McNultey (University of Liverpool) and others have argued, processes within the board may be much more important. What matters is engagement, but how do we get it?

At least a partial answer must relate to the second aspect of independence from shareholdres. Can we have directors that are independent from inside managers without having more transparent representation of shareholders or even other stakeholders? Must we not have investors that behave more responsibly? This could be achieved by the following:

1. Direct representation of particular shareholders in the board, but this has associated problems noted above.

2. New forms of professionalization and associations for independent directors that institutional investors could credibly nominate to represent shareholder interests. This seems an interesting angle worth exploring. If there is a market failure, what sort of associations or public action might fill the gap.

3. Representation of other stakeholder groups like employees, who would be willing to be directly involved in the selection of directors. German codetermination model follows this model, and some evidence does suggest that employee directors make beneficial contributions to governance, given their independence and also quasi-insider knowledge about what is going on in the firm.

While the principle of independence is most often applied to the board, it is a fundamental theme that extends to a variety of other gatekeepers, such as auditing firms, accountants and so on. A further issue is how independence relates to the degree of information and competence for understanding the business. More on that later!