November 22, 2010

TRAINING FOR TOMORROW: Director Independence and Corporate Governance

Bruce Dravis

This article summarizes the role of independent directors in corporate governance, and describes recent material governance law changes enacted in 2010. 

Since the turn of the millennium, independent directors have become the focus of corporate governance. In this still-developing corporate governance environment, the work, time commitment, and responsibilities of independent directors have increased significantly.

This increased focus started with the massive corporate scandals and failures of the early 2000s (e.g., Enron), which propelled the passage of the Sarbanes-Oxley Act of 2002 (SOX). The financial crisis of 2007-2008 resulted in the federal government adopting the nearly $1 trillion Troubled Asset Relief Program (TARP), and in a renewed focus on the role of independent directors in evaluating corporate strategy, risk, and compensation. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) included many corporate governance provisions.

Both SOX and Dodd-Frank emphasize the importance of independent directors in the governance process.

What is Governance Good For?

The term "governance" refers to a combination of state and federal legal requirements (including statutes, regulations, and case law) and developing doctrines regarding the control of corporations.

For example, the law sets certain minimum requirements regarding how directors and officers are selected, what decision-making processes they must use, and how corporate financial reporting systems are structured and their accuracy verified. At the same time, institutional investors and their advisors are advancing an evolving set of "best practices" governance recommendations that represent standards beyond the legal minimum.

Compared to governance practices prior to 2000, there is now more active oversight of corporate management by the board and by committees of the board. On some matters, such as the authority to engage the company's auditors or advisors to the compensation committee, decisions have been taken out of management's hands entirely.

It is important to note, however, that corporate governance describes a decision making process, but does not guarantee favorable results. Moreover, directors are not guarantors of the successful outcome of their business decisions. Such a burden would prevent anyone from serving on a board. Courts recognize this and do not second-guess business decisions by boards, if those decisions have been made with due care and without a conflict of interest.

Good corporate governance practices are aimed at addressing the risk that corporate managers, who have control over the corporate resources on a day-in, day-out basis, will be tempted to use those resources for their own gratification, rather than in the best interests of the investors. As boards actively monitor executive performance, the role of independent, nonemployee directors has necessarily expanded.

Director Independence

The underlying assumption is that, in the absence of oversight, management will be tempted to use corporate resources in its own self-interest. The board acts as a check on management, and it will perform its role more effectively if its members are not part of management or financially beholden in some way to management.

The term "independent director" means a director who does not have employment, family, or other significant economic or personal connections to the corporation other than serving as a director. It is often used interchangeably with the term "disinterested director," which means a director who, for purposes of voting on a specific transaction or arrangement with the corporation, does not have an economic or personal interest in that transaction or arrangement.

The two terms overlap substantially, but they are not identical. Independent directors will be "disinterested directors," but not all disinterested directors will be independent. For example, it would be possible for the CEO, as a nonindependent director, to be a "disinterested director" and to vote on a transaction in which another director had a financial or personal interest.

The basic definition of "independence" for directors is derived from SOX, Dodd-Frank, SEC rulemaking, and the listing requirements for the New York Stock Exchange (NYSE) and NASDAQ. In some circumstances, such as participation on the audit committee or the compensation committee, or participation in a special litigation committee, independent directors have to meet additional independence requirements.

Increased Control by Federal Law

Corporations are created under state law, not federal law. State corporate law defines the specific duties of directors, but the general principle that directors have a fiduciary duty to act in the best interest of shareholders is consistent from state to state.

With SOX, and again with Dodd-Frank, Congress federalized certain elements of corporate governance for publicly traded corporations. In 2011, Dodd-Frank will require public companies to turn substantial control over the executive compensation decision to independent directors and advisors, give shareholders a non-binding vote on executive compensation ("say on pay"), and increase executive compensation disclosures. Under Dodd-Frank, the SEC will provide a process by which shareholders can use the company proxy statement for director candidates nominated by shareholders.

Dodd-Frank mandates that the compensation committee--made up solely of independent directors—shall have sole discretion over the selection of compensation consultants, legal counsel, and other advisors (each, an "outside compensation advisor") that it uses, and may only select outside compensation advisors that are independent of the company in accordance with SEC rules.

The compensation committee is responsible for the appointment, compensation, and oversight of the work performed by its outside compensation advisors. Dodd-Frank does not require a committee to obtain an outside compensation advisor, and it expressly provides that the compensation committee may make or implement decisions that are not consistent with the advice provided by the outside compensation advisor.

Subject to SEC rulemaking, Dodd-Frank will also require additional executive compensation disclosures in the proxy statement, including the ratio of CEO salary to the average pay of company employees, and a comparison of the CEO's salary to the company's performance.

Beginning in 2011, Dodd-Frank mandates that public companies must provide shareholders the opportunity to vote on whether they approve of the compensation packages provided to the corporation's executives at least once every three years. The "say on pay" votes are advisory, and not binding.

The legislation specifies that the shareholder vote on compensation shall not overrule a compensation decision by a company or its board, shall not be construed as changing or increasing the fiduciary duty of the company or its board of directors, and shall not restrict the ability of shareholders to make proposals for inclusion in proxy materials relating to executive compensation.

Nonetheless, a negative vote by shareholders against an executive compensation arrangement would be information that the board and compensation committee would want to consider as it makes compensation decisions on an ongoing basis.

Unhappy shareholders will have the opportunity to use the company proxy statement to advance the nominations of their own candidates (proxy access). Section 971 of Dodd-Frank provided the SEC with express authority to adopt rules regarding inclusion of shareholder nominees in company proxy materials.

Prior to receiving the express authority under Dodd-Frank, the SEC had proposed, but not adopted, proxy access rules. As finally adopted, the proxy access rules require that director nominations from shareholders that have certain shareholding size and longevity profiles would be required to be included in company proxy materials. In October 2010, the SEC delayed implementation of the proxy access rule in light of pending court challenges.

The practical effect of proxy access is that a shareholder that might previously have been dissuaded from incurring the expense of preparing and distributing proxy materials to offer its own nominee for director may be able to use the company's proxy materials for that candidate. The proxy access rules are not the exclusive method by which shareholders can nominate directors. Traditional proxy contests would remain available to shareholders.

Conclusion

A decade of corporate governance law changes has placed greater autonomy and responsibility in the hands of independent directors. More governance changes will be unveiled during 2011 as a result of Dodd-Frank, most of them directed at executive compensation questions. 

Bruce Dravis

Bruce Dravis is a partner at Downey Brand LLP, in Sacramento, California.